The Importance Of Normative Theory And Alternatives To Historical Cost Accounting

Normative Theory for Measuring Income

Discuss about the Current Developments in Accounting Thought for Normative Theory.

In order to gauge income, the importance of normative theory is immense in the current era. The reason lies behind the use of a formula in order to ascertain income based on value, while cost is not taken into consideration. Hence, observation is not the sole factor for normative theory; however, the reliance is on the accounting process to be formulated (Barth, 2015).

Historical cost accounting (HCA) is a part of the normative accounting theory, which gauges the value in which the asset price on the statement of financial position relies on nominal cost when it is acquired. The main benefit of this measure could be observed in terms of unbiased estimation and independent verification. Due to this, the investors and other users are provided with reliable information about the financial information of the organisations (Deegan, 2014). However, its benefit is minimised during recessionary period and as a result, there is decline in the asset price.

The alternatives to HCA are numerous, three of which along with their assumptions are enumerated as follows:

Depending on everyday consumer index, this method denotes updating and recording the accounting-related items. During recession, there would be rise in price and thus, up-to-date maintenance of accounts is needed in order to adjust monetary items. The assumptions stated in going concern as well as accrual basis concepts are used in this theory (Ellul et al., 2015). Due to the supplementary preparation of CPPA statements, there is effective maintenance of the historical accounts. However, only the differences in general purchasing power are considered in this method and no attention is paid on the differences in the values of individual items.

For example, XYZ Limited bought machinery on 1^st January 2016 at an amount of $148,000. The economic life of the asset is four years and it follows the straight-line depreciation method having no residual amount. The general price level indices have been 140 on 1^st January 2016 and 150 on 1^st January 2017. Thus, the depreciation to be charged would be $37,000 ($148,000/4). However, the amount that would be reported in the income statement of the organisation on 1^st January 2017 would be $39,643 ($37,000 x 150/140).

In this method, the change in individual item price is realised because of the change in the general level of price. This method considers the method of preparing and evaluating financial statements in a way that the relevant price change is considered adequately (Henderson et al., 2015). It is assumed that the replacement cost is used to record fixed assets, while inventories are shown at market values. The primary benefit of this system is the computation of profit, as there is no change in historical profit. On the other hand, this method lacks to supply information that is needed for the investors.

Historical Cost Accounting and its Drawbacks

For instance, a ten-year life machinery could be bought for $80,000. It is assumed that the machinery could be used for additional five years having no residual amount. Due to this, the replacement cost of the machine would stand at $40,000 ($80,000 minus five-year depreciation amount).

This method provides rational and balanced estimation of the potential market asset, service or product price. In addition, it takes into account the objective factors such as demand and supply, production, acquisition, cost of distribution, replacement and subjective factors like cost, capital return, risk characteristics and individually perceived utility. However, there would be minimisation in the assets’ book values.

The above analysis clearly makes it evident that despite the availability of several alternatives to HCA, none of the methods are free from errors that could be used for measuring business performance. For CPPA, the variations are observed in general price level and adequate stress is not given to the specific price level. Due to this, the financial statements do not depict the present values related to the organisational resources (Huber, 2017).  In case of CCA, it becomes possible to ascertain tax liabilities and hence, it could not provide detailed evaluation of the true business costs. On the other hand, the investors often could not identify the use of FVA from the financial statements of the organisations. Due to this, the satisfaction level of the investors tends to decline, as the loss of value in net income could lead to loss for the investors. Therefore, none of the three alternatives are feasible in eliminating the drawbacks inherent in HCA.

The primary purpose of the IASB conceptual framework is to formulate the standards of accounting in order to assure consistency between them, while improving the credibility related to accounting information. The objective of this framework is to supply beneficial financial information to the potential and current lenders, investors and other users so that resource decisions could be undertaken (Li, 2015).  

The primary users of the general purpose financial reporting constitute of the following:

The creditors and suppliers would like to seek information that would allow them to determine that the amounts paid to them are made timely.

The lenders of a business entity might want to accumulate information regarding the loan payment schedules as they are due. With the help of such information, they could arrive at a decision whether to provide further loans to the organisation in future (Laux, 2016).

Alternative Accounting Methods

With the help of investors, a firm could risk capital in the form of funds. Moreover, these users are concerned about the inherent risk and return to be expected from the investments made.

The customers would like to know about the continuation of the business operations, especially, if they depend greatly on the goods and services of the organisation.

The employees would want to know about the level of profit and the stability of the organisation, in which they work (Luke, 2016). If the position is strong, it would ensure their job security and thus, such information could be used for making salary hikes and conditions of employment.

The government and the agencies associated with it want to gain an insight regarding the allocation of resources along with the business operations of the corporate firms.

A corporate entity could directly influence these users in various ways, especially the method that helps in benefitting the overall community.

Direct implications are inherent related to the identification of the particular users on the creation of future standards of accounting and review of the existing accounting standards for presenting the financial statements effectively. Fair value as well as historical cost is taken into account in fair value accounting, since fair value depicts the actual asset values enhancing the transparency of the financial system (Magnan, Menini & Parbonetti, 2015). Five bases of measurement are inherent and there are variations in needs of the users, which are elucidated as follows:

The value could be gauged with the help of historical cost, in which the asset price on the statement of financial position relies on nominal cost at the time it is acquired. This measure is useful, since it does not encourage biasness and it could be verified independently. Thus, the overall reliability of the investors and the other users could be ensured as well. However, trust issue still lies among the users due to the fact that this method does not consider the impact of recession on the asset, which might reduce its overall value.

FVA provides balanced and unbiased estimation of the market price related to product, asset or service. It takes into account the objective factors such as demand and supply, production, acquisition, cost of distribution, replacement and subjective factors like cost, capital return, risk characteristics and individually perceived utility. However, there would be minimisation in the assets’ book values.

With the help of this method, the variation in individual item price could be recognised because of the general price level variation (Newberry, 2015). In addition, it prepares and assesses the financial statements in a way that the relevant price change is considered adequately.

Implication of IASB Framework for Financial Reporting

This is the value of the asset that could be realised when the asset is sold less acceptable estimation of eventual selling cost or disposal of asset (Penman, 2016). In case of realisable value, it becomes necessary to post the transactions fetching lower profits while minimising the chance of profit overstatement. This might restrict the investors to find an actual insight of the financial condition of the business entities.

The net worth could be termed as the value-in-use related to an asset that is calculated by projecting the future value pertaining to the disposable amount; in case, there is impairment of assets. The objective is that assets should not be evaluated at beyond their recoverable values (Ryan et al., 2014). Hence, this value fails to take into account the price at which the asset is acquired and thus, it depends on the existing market value. As a result, the investors could undertake significant decisions.

The conceptual framework for financial reporting helps in dealing with the financial reporting concerns like the objectives and uses of the financial statements along with the benefits of accounting information to the users. Moreover, it allows identifying the various elements of the financial reports, methods of measurement and recognition of these elements in preparing financial statements (Schaltegger & Zvezdov, 2015). There are various benefits that the conceptual framework provides to the users, which are enumerated as follows:

• The conceptual framework states that the standard-setters could develop a particular framework in order to prepare financial statements in such a way that the accounting practices and guidelines depend on common ideology.
• With the help of the conceptual framework, the users and developers of the financial reports could be guided about the unusual transactions (Smith & Smith, 2014).
• It ensures that random and haphazard decisions are not taken in order to sort out the accounting issues. Due to this, there is restriction on the users for utilising the inconsistent accounting approach in similar instances.
• If there is no conceptual framework, the firms might be engaged in creative representation of the financial reports, which might not disclose the true and fair view of the state of the business affairs.

According to Hines, the conceptual framework is formed for providing information to the accounting profession and the accountants are able to achieve adequate level of success in their profession. The validation of this statement could be made that the conceptual framework has enabled the accounting professionals in having a body of knowledge about accounting (Hines, 1989). Along with this, it could be observed that the framework enables in providing flexibility to the preparers and users of accounting information.

Despite these advantages, various disadvantages are present in the conceptual framework pertaining to financial reporting. The fundamental weakness of this specific framework is the difficulty in the set-up process. Moreover, plenty of time is needed for the set-up process, while it is costly as well. As a result, it would not be possible for the developing countries to formulate the conceptual framework (Taplin, Yuan & Brown, 2014). Moreover, rigidity is observed to be inherent in this particular reporting framework. Furthermore, some features are present in the conceptual framework that does not provide considerable accounting guidance. Despite the fact that this framework is encouraging, it is inflexible too and thus, new ideas could not be incorporated. Another disadvantage is the conflict between the previous standards and the conceptual framework. The past standards have very common features with those of the conceptual framework (Watts & Zuo, 2016). Thus, it provides benefits to few users; however, all the parties are not benefitted from the same.

There are certain points of differences between the opinion of Hines and the benefits provided on the part of the conceptual framework, which are elucidated as follows:

Points of differences	Opinion of Hines	Arguments in favour of the conceptual framework
Concept	According to Hines, the conceptual framework is formed for providing information to the accounting profession and the accountants are able to achieve adequate level of success in their profession. The validation of this statement could be made that the conceptual framework has enabled the accounting professionals in having a body of knowledge about accounting (Yong, Lim & Tan, 2016).	The primary purpose of the conceptual framework of IASB is to formulate the standards of accounting in order to assure consistency between them, while improving the credibility related to accounting information. The objective of this framework is to supply beneficial financial information to the potential and current lenders, investors and other users so that resource decisions could be undertaken.
Common ideology and decision-making	Despite the fact that this framework is encouraging, it is inflexible too and thus, new ideas could not be incorporated. Moreover, plenty of time is needed for the set-up process, while it is costly as well.	The conceptual framework states that the standard-setters could develop a particular framework in order to prepare financial statements in such a way that the accounting practices and guidelines depend on common ideology. It ensures that random and haphazard decisions are not taken in order to sort out the accounting issues.

References:

Barth, M. E. (2015). Financial accounting research, practice, and financial accountability. Abacus, 51(4), 499-510.

Deegan, C. (2014). Financial Accounting Theory (4th ed.). McGraw-Hill: Sydney. 

Ellul, A., Jotikasthira, C., Lundblad, C. T., & Wang, Y. (2015). Is historical cost accounting a panacea? Market stress, incentive distortions, and gains trading. The Journal of Finance, 70(6), 2489-2538.

Henderson, S., Peirson, G., Herbohn, K., & Howieson, B. (2015). Issues in financial accounting. Pearson Higher Education AU.

Hines, R.D. (1989). Financial accounting knowledge, conceptual framework projects and the social construction of the accounting profession. Accounting, Auditing & Accountability Journal, 2(2).

Huber, W. D. (2017). Irreconcilable differences? The FASB’s conceptual framework and the public interest. International Journal of Critical Accounting, 9(5-6), 514-523.

Laux, C. (2016). The economic consequences of extending the use of fair value accounting in regulatory capital calculations: A discussion. Journal of Accounting and Economics, 62(2-3), 204-208.

Li, X. (2015). Accounting conservatism and the cost of capital: An international analysis. Journal of Business Finance & Accounting, 42(5-6), 555-582.

Luke, B. (2016). Measuring and reporting on social performance: from numbers and narratives to a useful reporting framework for social enterprises. Social and Environmental Accountability Journal, 36(2), 103-123.

Magnan, M., Menini, A., & Parbonetti, A. (2015). Fair value accounting: information or confusion for financial markets?. Review of Accounting Studies, 20(1), 559-591.

Newberry, S. (2015). Public sector accounting: shifting concepts of accountability. Public Money & Management, 35(5), 371-376.

Penman, S. (2016). Valuation: accounting for risk and the expected return. Abacus, 52(1), 106-130.

Ryan, C., Mack, J., Tooley, S., & Irvine, H. (2014). Do Not?For?Profits Need Their Own Conceptual Framework?. Financial Accountability & Management, 30(4), 383-402.

Schaltegger, S., & Zvezdov, D. (2015). Expanding material flow cost accounting. Framework, review and potentials. Journal of Cleaner Production, 108, 1333-1341.

Smith, S. R., & Smith, K. R. (2014). The journey from historical cost accounting to fair value accounting: The case of acquisition costs. Journal of Business and Accounting, 7(1), 3.

Taplin, R., Yuan, W., & Brown, A. (2014). The use of fair value and historical cost accounting for investment properties in China. Australasian Accounting Business & Finance Journal, 8(1), 101.

Watts, R. L., & Zuo, L. (2016). Understanding practice and institutions: A historical perspective. Accounting Horizons, 30(3), 409-423.

Yong, K. O., Lim, C. Y., & Tan, P. (2016). Theory and practice of the proposed conceptual framework: Evidence from the field. Advances in Accounting, 35, 62-74.