Accounting Theory and Practice
Accounting Theory and Practice
Accounting Theory and Practice
individual
business
enterprises
keep
their
accounting
records
understood
by
commonly
accepted
definition
of
accounting
So, these two subjects are interrelated. In this perspective bringing about a
synthesis between the concept of economics and accounting, the concept of
social sciences is being applied. .
Accounting and Mathematics
Accounting and Mathematics are closely related. Accounting is the language
of business. On the other hand Mathematics is the language of Accounting.
At different stages of accounting addition, subtraction, multiplication and
division of arithmetic are applied.
Accounting expresses all its transactions and events of financial changes in
the language of mathematics. At all stages of accounting i.e. in preparing
journal, ledger, trial balance and financial statements mathematical
principles are applied.
For this reason the processes of keeping accounts become easy and short.
So, Mathematics is an indispensable part of Accounting.
Accounting and Computer Science
There is a close and effective relationship between Accounting and
Computer Science. The word computer has been derived from the word
compute. The word compute means counting and the meaning of computer
is counter.
It is possible to solve mathematical problems involving millions or even
billions of figures within a few seconds by computer and these can be
preserved in it as well.
In Accounting accounts of various transactions are to be recorded and the
results are to be determined.
It takes huge time and labor and even then the accuracy of Accounting
cannot be hundred percent ensured. Computer has eliminated all these
obstacles.
Because using all kinds of information and data relating transactions as per
definite table and program in computer, preparation of accurate accounting
is possible within very short time.
It saves time and labor. Besides, with the help of computer, preparation of
various accounts as per need, preservation and verification of validity of
ratio are possible very quickly.
In the developed countries of the modem world the application of computer
is growing fast in solving accounting problems.
In our country also the application of computer is increasing in the field of
accounting problems. Therefore, the relation between Accounting and
Computer is very close.
Accounting and Statistics
Accounting and Statistics are deeply related. The main object of these two
sciences is to make arithmetical figures understandable and logical and to
present these in the form of statements making them usable to owner,
directors or all others concerned. It makes the act of planning and decisionmaking easier.
The main function of statistics is to collect classify, analyses the
quantitative data of various events and to present them to the individuals or
organizations concerned.
For this reason a statistician presents the data in quite a short form of
reports to the individuals or organization concerned so that they can take
decision depending on this information.
On the other hand, in Accounting after completion of some accounting
processes of transactions, final accounts and financial statements are
prepared and on the basis of various information of such financial
statements; the owners and the directors of the organization concerned can
take decisions.
Accounting and Law
The prevailing laws of a land control trade and commerce mostly, So,
Accounting and Law are closely related.
The accountant and accounts officer must have clear knowledge of
partnership law, company law, tax law, industrial law, cooperative law and
other relevant laws. Because accounts of an organization are kept following
accepted principles and in accordance with relevant laws.
For example, accounts of every company are kept properly and accurately in
the light of company law. In partnership business accounts are maintained
in the light of partnership act or agreement as the case may be.
Keeping accounts, auditing of accounts of a company are mandatory as per
specific provision of the companies act. Similarly, accounts of other
organizations are to be kept in accordance with the provisions of the
relevant law.
In this context lawyers are to know the provision of laws relating to methods
of accounting, direction and controlling.
Otherwise, it is impossible on their part to extend their help in settling
conflicts and cases properly. Therefore, both Accounting and Law are closely
related subjects.
Accounting and Political Science
The main object of Political Science is to ensure law and order for
establishing rule of law in the society. Political science gives directives in
achieving welfare for the people of the society as a whole.
For this reason issues like national income and expenditure; national
development expenditure and probable income from national prospects etc.
arise from political science.
Keeping proper accounts of this national income, expenditure and providing
information in this regard are the tasks of Accounting. Besides maintaining
accounts and auditing of accounts of government tax administration,
expenditure of various projects, income tax, etc. are performed by
accounting.
Therefore there exists a close relationship between Accounting and Political
Science.
Accounting and Engineering
Among the important branches of modem social sciences accounting and
Engineering axe prominent.
These two subjects jointly work in the process of production and building.
Special type of plant and machineries are needed in factories. These plants
and machines are made by the engineers engaged in engineering work.
The estimation regarding types of goods and quantity of goods to be
produced and amount of expenditure to be involved in machineries etc. of a
concern is to be accounted for.
For this reason the entrepreneurs, directors, managers of a production
oriented business concern should have the knowledge of engineering.
Function of accountant is to find out the ratio between money invested in
plant and machineries and results arising out of it and present the same to
the managers in the form of statements.
Without the knowledge of engineering an accountant cannot provide
accurate information regarding plant and machineries.
So, in the modem age of complex and large scale production the knowledge
of accounting as well as engineering is essential for achieving target by
running a business successfully.
HISTORY OF ACCOUNTING
Accounting is as old as money itself. However, the act of accounting was not
as developed as it is today because in the early stages of civilisation, the
number
businessman was able to record and check for himself all his transactions.
Accounting was practised in India twenty three centuries ago as is clear
from
the
book
named
"Arthashastra"
written
by
Kautilya,
King
such
as relevance, reliability
comparability
and
4th level- the display mechanisms that accounting uses to convey info
include reported earnings,reporting funds flow and liquidity and reporting
financial position.
Why CF is needed?
Lack of a general theory
Permissiveness
of
accounting
practice-
accounting
standards
allows
against
political
interference-
accounting
policies
can
be
decisions
about
the
allocation
of
scarce
resources.IASB
challenge and does not allow for change. Focus in accountants behaviour
not on measuring the attributes of the firm.
Psychological
pragmatic
approach
Observe
users
response
to
theories
(prescriptive)
Concerned
with
policy
recommendations & with what should be done and how accounting should
be practiced. Based on subjective opinion of what accounts should be report
and the best way to do that.
Focus: Deriving true income in accounting period where concentrate on
deriving a single measure for assets and a unique profit figure. Discussing
type of accounting info useful in making decision (decision usefulness)
Assumptions are rarely subject to any empirical testing
Theory: Based on analytic / syntactic, and Empirical propositions
Make assumptions about the nature of a firms operations based on their
observations.
4.Positive theories (descriptive) Referred as positive methodology (testing
theories to real world). Focus on empirically (experimental) testing some of
the assumptions made by normative accounting theorists.
Survey opinions.
Test importance of accounting outputs in marketplace.
Explain on what and how and predict accounting practice.
Enable regulators to assess the economic consequences of the various
accounting practices they consider.
4.Deductive approach
5.Inductive approach
6.Ethical approach
Consist
of
the
concept
of
fairness
(fair,
unbiased
and
impartial
and
truth
(true
and
accurateaccounting
statements
without
misrepresentation).
7.Sociological approach
Formalization of an accounting theory emphasizes the social effects of
accountingtechniques.
A given accounting principles is evaluated for acceptance.
Accounting data will be useful in making social welfare judgements.
Assumes the existence of established social values that may be used as
criteria.
Concepts of internalizing social costs & social benefits of the business;
accountingshould serve public interests.
Has contributed to the evolution of new accounting subdiscipline known
associoeconomic accounting to encourage business entities to account for
the impact of their private production activities on the social environment
through measurement anddisclosure in financial statements.
8.Economic approach
Emphasizes the controlling behaviour of macroeconomic indicators that
result from the adoption of various accounting techniques.
Focus on general economic welfare.
The choice of different accounting techniques depends on their impact on
the nationaleconomic good.
Accounting policies and techniques should reflect economic reality and
depend on economic consequences.
9. Electic approach
Combination of approaches in developing accounting theory.
Numerous
attempts
by
individuals
&
professional
&
governmental
ACCOUNTING ASSUMPTIONS
(a) Business Entity Concept
As per this concept, the business is treated as distinct and separate from
the individuals who own or manage it. When recording business
transactions, the important question is how will it affect the business
entity? How they affect the persons who own it or run it or otherwise
associated with it is irrelevant.
Application of this concept enables recording of transactions of the business
entity with its owners or managers or other stakeholders. For example, if
the owner pays his personal expenses from business cash, this transaction
can be recorded in the books of business entity. This transaction will take
the cash out of business and also reduce the obligation of the business
towards the owner.
At times it is difficult to separate owners from the business. Consider an
individual, who runs a small retail outlet. In the eyes of law, there is no
distinction made between financial affairs of the outlet with that of the
individual. The creditors of the retail outlet can sue the individual and
collect his claim from personal resources of the individual. However, in
accounting, the records are kept as distinct for the retail outlet and the
individual respectively. For certain forms of business entities, such as
limited companies this distinction is easier. The limited companies are
separate legal persons in the eyes of law as well.
The entity concept requires that all the transactions are to be viewed,
interpreted and recorded from business entity point of view. An accountant
steps into the shoes of the business entity and decides to account for the
transactions. The owners capital is the obligation of business and it has to
be paid back to the owner in the event of business closure. Also, the profit
earned by the business will belong to the owner and hence is treated as
owners equity.
(b) Going Concern Concept
The basic principles of this concept is that business is assumed to exist for
an indefinite period and is not established with the objective of closing it
to the accounting information? Would it mean that the business will not pay
income tax as no income will be computed?
(e) The Accrual Concept
The accrual concept is based on recognition of both cash and credit
transactions. In case of a cash transaction, owners equity is instantly
affected as cash either is received or paid. In a credit transaction, however,
a mere obligation towards or by the business is created. When credit
transactions exist (which is generally the case), revenues are not the same
as cash receipts and expenses are not same as cash paid during the period.
When goods are sold on credit as per normally accepted trade practices, the
business gets the legal right to claim the money from the customer.
Acquiring such right to claim the consideration for sale of goods or services
is called accrual of revenue. The actual collection of money from customer
could be at a later date.
Similarly, when the business procures goods or services with the agreement
that the payment will be made at a future date, it does not mean that the
expense effect should not be recognized. Because an obligation to pay for
goods or services is created upon the procurement thereof, the expense
effect also must be recognized.
Todays accounting systems based on accrual concept are called as Accrual
System or Mercantile System of Accounting.
BASIC PRINCIPLES/ CONCEPTS
(a) The Revenue Realisation Concept
While the conservatism concept states whether or not revenue should be
recognized, the concept of realisation talks about what revenue should be
recognized. It says amount should be recognized only to the tune of which it
is certainly realizable. Thus, mere getting an order from the customer wont
make it eligible to recognize as revenue. The reasonable certainty of
realizing the money will come only when the goods ordered are actually
supplied to the customer and he is billed. This concept ensures that income
unearned or unrealized will not be considered as revenue and the firms will
not inflate profits.
Consider that a store sales goods for ` 25 lacs during a month on credit. The
experience and past data shows that generally 2% of the amount is not
realized. The revenue to be recognized will be ` 24.50 lacs.
Although conceptually the revenue to be recognized at this value, in
practice the doubtful amount of ` 50 thousand (2% of ` 25 lacs) is often
considered as expense.
(b) The Matching Concept
As we have seen the sale of goods has two effects: (i) a revenue effect, which
results in increase in owners equity by the sales value of the transaction
and (ii) an expense effect, which reduces owners equity by the cost of goods
sold, as the goods go out of the business. The net effect of these two effects
will reflect either profit or loss. In order to correctly arrive at the net result,
both these aspects must be recognized during the same accounting period.
One cannot recognize only the revenue effect thereby inflating the profit or
only the expense effect which will deflate the profit. Both the effects must
be recognized in the same accounting period. This is the principle of
matching concept.
To generalize, when a given event has two effects one on revenue and the
other on expense, both must be recognized in the same accounting period.
(c) Full Disclosure Concept
As per this concept, all significant information must be disclosed.
Accounting data should properly be clarified, summarized, aggregated and
explained for the purpose of presenting the financial statements which are
useful for the users of accounting information. Practically, this principle
emphasizes on the materiality, objectivity and consistency of accounting
data which should disclose the true and fair view of the state of affairs of a
firm. This principle is going to be popular day by day as per Companies
Act, 1956 major provisions for disclosure of essential information about
accounting data and as such, concealment of material information, at
present, is not very easy. Thus, full disclosure must be made for
such material information which are useful to the users of accounting
information.
The limitation of this concept is that the Balance Sheet does not show the
market value of the assets owned by the business and accordingly the
owners equity will not reflect the real value. However, on an ongoing basis,
the assets are shown at their historical costs as reduced by depreciation.
(g) Balance Sheet Equation Concept
Under this principle, all which has been received by us must be equal to
that has been given by us and needless to say that receipts are clarified as
debits and giving is clarified as credits. The basic equation, appears as :Debit = Credit
Naturally every debit must have a corresponding credit and vice-e-versa. So,
we can write the above in the following form
Expenses + Losses + Assets = Revenues + Gains + Liabilities
And if expenses and losses, and incomes and gains are set off, the equation
takes the following form
Asset = Liabilities
or, Asset = Equity + External Liabilities
i.e., the Accounting Equation.
CONVENTIONS/ MODIFYING PRINCIPLES
(a) The Concept of Materiality
This is more of a convention than a concept. It proposes that while
accounting for various transactions, only those which may have material
effect on profitability or financial status of the business should have special
consideration for reporting. This does not mean that the accountant should
exclude some transactions from recording. e.g. even ` 20 worth conveyance
paid must be recorded as expense.
What this convention claims is to attach importance to material details and
insignificant details should be ignored while deciding certain accounting
treatment. The concept of materiality is subjective and an accountant will
have to decide on merit of each case. Generally, the effect is said to be
accepted
ways
of
recording
and
reporting
accounting
information.
GAAP is to be followed by companies so that investors have a optimum level
of consistency in the financial statements they use when analyzing
companies for investment purposes. GAAP cover such aspects like revenue
recognition, balance sheet item classification and outstanding share
measurements.
Accounting Standards
To promote world-wide uniformity in published accounts, the International
Accounting Standards Committee (IASC) has been set up in June 1973 with
nine nations as founder members. The purpose of this committee is to
formulate and publish in public interest, standards to be observed in the
presentation of audited financial statements and to promote their worldwide acceptance and observance. IASC exist to reduce the differences
between
different
countries
accounting
practices.
This
process
of
harmonisation will make it easier for the users and preparers of financial
statement to operate across international boundaries. In our country, the
Institute of Chartered Accountants of India has constituted Accounting
Standard Board (ASB) in 1977. The ASB has been empowered to formulate
and issue accounting standards, that should be followed by all business
concerns in India.
AS 2 Valuation of Inventories
AS 5 Net Profit or Loss for the period,Prior Period Items and Changes
in Accounting Policies
AS 6 Depreciation Accounting
AS 9 Revenue Recognition
2003),
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 19 Leases
Financial Statements
AS 24 Discontinuing Operations
AS 26 Intangible Assets
AS 28 Impairment of Assets
4. If the value of human resources is not duly reported in profit and loss
account and balance sheet, the important act of management on human
assets cannot be perceived.
5. Expenses on recruitment, training, etc. are treated as expenses and
written off against revenue under conventional accounting. All expenses on
human resources are to be treated as investments, since the benefits are
accrued over a period of time.
Objectives of HRA:
Rensis Likert described the following objectives of HRA:
1. Providing cost value information about acquiring, developing, allocating
and maintaining human resources.
2. Enabling management to monitor the use of human resources.
3. Finding depreciation or appreciation among human resources.
4. Assisting in developing effective management practices.
5. Increasing managerial awareness of the value of human resources.
6. For better human resource planning.
7. For better decisions about people, based on improved information system.
8. Assisting in effective utilization of manpower.
Methods of Valuation of Human Resources:
There are certain methods advocated for valuation of human resources.
These methods include historical method, replacement cost method, present
value method, opportunity cost method and standard cost method. All
methods have certain benefits as well as limitations.
Benefits of HRA:
There are certain benefits for accounting of human resources, which are
explained as follows:
1. The system of HRA discloses the value of human resources, which helps
in proper interpretation of return on capital employed.
Under
conventional
accounting,
certain
standards
are
accepted
the first attempts to estimate the money value of human beings was made
around 1691 by Sir William Petty [10]. Petty considered labor the father of
wealth and thus felt that labor must be included in any estimate of
national wealth. Accordingly, this first attempt at human asset valuation
estimated the value of the stock of human capital by capitalizing the wage
bill in perpetuity at the market interest rate; the wage bill being determined
by deducting property income from national income.
The first truly scientific procedure for finding the money value of human
beings was devised in 1853 by Farr [4]. He advocated the substitution of a
property tax for the existing English income tax system. The former would
include property consisting of the capi-talized value of earning capacity. His
procedure for estimating capitalized earning capacity was to calculate the
present value of an individuals net future earnings.
Ernst Engels writings around 1883 recommended a cost-of-pro-duction
procedure for estimating the monetary value of human beings [3]. He
reasoned that expenditures for rearing children were costs to their parents
and that this cost might be estimated and taken as a measure of their
monetary value.1
In 1867, a composite version reflecting Farrs capitalized earn-ings and
anticipating Engels cost-of-production approach surfaced when Wittstein
argued that an individuals lifetime earnings are equal to his lifetime
maintenance cost plus education [19].
Alfred Marshall was perhaps the most forceful proponent of the concept of
human assets [14]. His theoretical approach took on a capitalized-netearnings flavor. However, departing from his con-ceptual arguments,
Marshall held that it would be out of touch with the marketplace to treat
humans as capital in practical analysis,
Human Resources As Consumption Expenditures
Marshalls view of human capital as being unrealistic was per-haps a
major contribution to the virtual exclusion of the concept of human
resources from the main stream of economic thought from the beginning of
the twentieth century to the recent renewal of interest. Marshalls view, if
not a causal factor, is certainly descriptive of the general view that it was
neither appropriate nor practical to apply the concept of capital to human
beings.
The contribution of labor toward the growth rate of real national income is
increasing as a percentage while the percentage contrib-uted by physical
capital is decreasing. Labors increasing marginal product can be attributed
in part to expenditures for training. Re-search by Thurow directed attention
toward the existence of human capital resulting from investments in
training programs [18].
The Beginning of Human Resource Accounting
The revival of interest by economists in the topic of human capital was
accompanied by, or perhaps caused, an examination of the concept of
human resource accounting by accounting theorists. Until then,
accountants had considered the problem of valuing human resources to be
part of the larger problem of valuing goodwill.
The recent research in this area attempts to distinguish economic values
attributable to the human resources of a firm from the values attributable
to other components of goodwill. These projects and limited implementation
of research results is subsumed under the title of human resource
accounting.
Research in human resource accounting reflects the two routes evidenced in
contemporary accounting theory. One segment of the research is directed
toward the investigation of concepts for the measurement of human
resource costs: original cost, replacement cost, and opportunity cost.
Another segment investigates the determinants of the value of human
resources of employees as a group or of individual employees. This
branching of current research in human resource accounting closely
parallels the cost-of-produc-tion and capitalized earnings measurement
approaches taken by early economists many decades ago.
Attempts to measure human resource cost have resulted in the development
of three different concepts and measurement models. The first of these
measurement concepts, original cost, is illustrated in the works of
Brummet, Flamholtz, and Pyle who individually and collectively have
developed concepts, models, and techniques for measuring the historical
cost of human resources [1]. Concern has been expressed over the historical
cost conceptnamely, that the real economic value of the investment may
be significantly different than its cost [15].
The model of Brummet, et. al. is a generalized model which can be extended
to incorporate replacement costs. Other researchers have developed models
for the measurement of human resource replacement cost [6]. The end
result of the operation of such models is a measure o f the cost to replace
individuals occupying organizational position.
Perceived deficiencies in the replacement cost approach to measurements
led others to develop the concept of opportunity cost to value human
resources. Hekimian and Jones, for example, have suggested a system of
competitive bidding to obtain managerial assessments of opportunity cost of
human assets. Like the other measurement concepts, opportunity cost
measurement has its critics as well [8].
Essentially, the suggestions to value human assets at historical or original
cost are accounting adaptations of the cost of produc-tion techniques
developed by Engels in 1883 and suggested by Shultz in 1960. Proposals to
obtain replacement or opportunity cost measures parallel the current
conceptual debate in accounting theory to fi nd an acceptable alternate to
historical cost.
While one segment of accounting research in human resource accounting
has been directed toward measurement concepts, an-other is directed
toward the investigation of the determinants of the value of human assets.
The development of this theory is proceeding from two different approaches.
Growing out of the studies on organization and leadership at the University
of Michigans Institute for Social Research, Likert [13] and others have
attempted to develop a model of determinants of a groups value to an
organization. Hermanson proposed two possible techniques for the
monetary valuation of the total human assets of a firm [7]. Additionally,
Brummet, Flamholtz, and Pyle [1] as well as Lev and Schwartz [12] have
suggested methods to arrive at the value of employees as a group. In a
different approach, Flamholtz has attempted to develop a model of the
determinants of an individuals value to a firm [5].
With the exception of Likerts model, the methods proposed for determining
the value of employees or groups of employees to an organization are similar
in principle to the proposal of the econo-mist William Farr. At the core of
the proposals is the realization that the value of people to an organization is
the present worth of the future services they are expected to renderthe
capitalized earnings approach.
Likerts model per se is not intended to measure the value of human
resources, but the efficiency of various types of management systems.
retirement. out of these a few employee may leave the organization before
attaining the superannuation. This is similar to physical asset e.g:- If
company spends one lakh on an employee recruited at 25years he lives the
organization at the age 50. he serves the company for 25 years but actually
his retirement age was 55years. the company has recovered rupees
83333.33 so the unamortized amount of rupees 16666.66 should be
charged to p&l account i.e.
100000\30=3333.33
3333.33*25=83333.33
100000-83333.33=16666.67
This method is the only method of human resource accounting which is
based on sound accounting principals and policies.
Limitations:
This method measures only the costs to the organization but ignores
completely any measure of the value of the employee to the organization
(Cascio 3).
Replacement Cost approach
This approach measures the cost of replacing an employee. According to
Likert
(1985)
replacement
cost
include
recruitment,
selection,
compensation, and training cost (including the income foregone during the
training period). The data derived from this method could be useful in
deciding whether to dismiss or replace the staff.
Limitations:
T=Y
Y
where E (Vy) = expected value of a y year old persons human capital T =
the persons retirement age Py (t) = probability of the person leaving the
organisation I(t) = expected earnings of the person in period I r = discount
rate
Limitations:
The measure assigns more weight to averages than to the value of any
specific group or individual (Cascio 4-5).
Value to the organization:
Hekimian and Jones (1967) proposed that where an organization had
several divisions seeking the same employee, the employee should be
allocated to the highest bidder and the bid price incorporated into that
divisions investment base. For example a value of a professional athletes
service is often determined by how much money a particular team, acting in
an open competitive market is willing to pay him or her.
Limitations:
impact of inflation in everyday life. Neither can we wish away inflation nor
can we remain insensitive spectators.
Problems associated with inflation must be brought in to sharp focus to
understand their magnitude.
Money is the medium of expression of values in modern life. Effects of
various economic activities are measured and expressed in terms of money.
For measuring anything, it is mandatory that the measure itself is constant.
Money as a medium of expression of value and measure of economic activity
is expected to have a constant value. But this expectation has been
Sanjeev Pandit, Inflation Accounting. Meenakshi Prakashan, Meerut 1989
India, P.i. belied. "Constant value of money"'has remained a very unrealistic
assumption. Changing value of' money has resulted in a chaos and
distortion while reporting results of economic activities of business
enterprises.
According to the American Institute of certified Public Accountants
(AICPA), "Inflation Accounting is a system for accounting which purports to
record as a built in mechanism all economic events in terms of current
cost".
Inflation and its Impact on Financial Statements :
The monetary postulate underlying historical cost accounting does not
holdgood during the period of changing prices. Consequently, a host of
problems began to creep in to the accounts with the movement - upwards or
downwards - in prices. Such problems have the effect of distorting the
accounting results in various ways. These distortions are manifested in the
form, among others, of an overstatement of profits and an understatement
of assets during inflation conversely there is an understatement of profits
and an overstatement of assets when there is deflation. Mainly two types of
assets are included in the Balance Sheet. One is current assets and the
other is fixed assets.
Fixed assets are the main victims of inflation or in other sense the effect of
inflation is more pronounced in the case of these types of assets: The
depreciation is calculated on the historical cost basis which is usually lower
than that of those calculated at replacement value.
Second the operating expenses and incomes are taken at current prices,
stock shows at cost or market price whichever is lower. Purchasing power
gains,losses occurs simply because the firm is holding some monetary
liabilities and assets which gain or lose purchasing power during inflation.
Since nominal values of assets, profits and other items from corporate
accounts form the basis of many other decisions having important effects,
like calculation of tax liability, action under MRTP Act, actions regarding
The second major aspect of price change is the specific price changes in
asset values. The historical cost approach, which recognises revenues only
when they are realised, will produce periodic profits which represent both
the results of the current years operations and gains made in previous
periods which are only realised in the current period (although gains which
are unrealised in the current period are excluded).
One response to this problem is to recognise unrealised gains in the period
to which they relate but to treat these not as part of operating profit.
Instead, they can be regarded as holding gains, i.e. gains from continuing to
own assets during price rises. Measuring profit in relation to opening and
closing capital restated to include holding gains of the period produces a
concept of physical/operating capital maintenance, i.e. identifying the gains
that can be withdrawn while permitting a business to own the same
physical assets. Profit would be restated by eliminating holding gains. This
is aptly described as operating profit, showing the ability of a business to
produce revenues over and above the current cost of producing them
through operating activities. Any adjustments necessary to eliminate
holding gains from profit would be those necessary to restate historical
costs, included in the comprehensive income statement, to current costs.
A version of this approach known as current cost accounting (CCA) includes
such adjustments in three components. These are a depreciation
adjustment, modifying depreciation to one based on the current cost of
assets rather than the historical cost; a cost of sales adjustment, adjusting
inventory values and purchases to current costs; and a monetary working
capital adjustment, adjusting for the price change of purchases during the
creditor period and sales during the debt collection period. There has been
much debate about whether there should also be a fourth adjustment,
known as a gearing adjustment. This is intended to reflect the benefits of
having debt capital during periods of increasing prices. The last two
adjustments are relatively complicated, and generally regarded as beyond
the introductory level.
Considerable subjectivity is involved in identifying suitable specific price
level indices for each of the possible specific price changes. The resulting
reduction in reliability together with the costs of implementing the approach
with all its complexities are considered to outweigh the advantages,
particularly where the period of holding assets is relatively short and hence
the impact of the adjustments is small. Current cost accounting has been
widely abandoned as a result.