The best of 10 Accounting conventions

The best of 10 Accounting conventions – In order to enable a very diverse population of users of financial statement a basis set of accounting conventions have to be more or less defined.

The word convention is used in a Wikipedia definition way – a set of agreed, stipulated, or generally accepted standards, norms, social norms, or criteria, often taking the form of a custom.

Let us do the same for the word accounting, the Wikipedia definition way of accounting is – the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations.

Here is a listing of conventions at the base of financial reporting. Not for the reporting itself but to ensure businesses survive, providing not only owners and employees a satisfactory return but also the world at large. The best of 10 Accounting conventions

Capital maintenance

Most entities adopt a financial concept of capital maintenance. Capital maintenance is central to the measurement of total accounting profit (see below). It concentrates on maintaining the financial capital that an entity’s owners have invested. The selection of the appropriate concept of capital maintenance depends on the needs of users. The Board does not prescribe a particular model, except where there are unusual circumstances such as hyper-inflation.

Accounting conventions

All accounting systems depend on the capital maintenance concept adopted, the basis used to value assets and the unit of measurement used. The different options available for each of these components are considered in this section. The best of 10 Accounting conventions

Capital maintenance concepts

Capital maintenance is central to the measurement of total accounting profit. Disregarding additions to capital or repayments of capital and distributions, accounting profit is the difference between a company’s capital at the start of the period and at the end of the period. The best of 10 Accounting conventions

An entity can only be considered to have made a profit if it has increased its net assets, which are represented by its capital, above what is necessary to maintain its opening capital. Total accounting profit can, therefore, only be measured once a definition has been established as to what capital is to be maintained. [Framework 8].

There are two different concepts of capital maintenance: operating capital maintenance and financial capital maintenance. Operating capital maintenance, although it can be measured in a variety of different ways, generally seeks to ensure that the business’ physical operating capacity is preserved. Financial capital maintenance attempts to conserve the value of the funds that shareholders have invested in the business.

Financial capital maintained can either be the monetary value of capital attributable to shareholders or a value adjusted by a general purchasing power index to maintain capital as a fund of real purchasing power.

Example — Two concepts of capital maintenance

A sole trader starts a business buying and selling second-hand cars. In his first year of trading, he buys one car for C1,000 and sells it for C2,000. At the time he sells the car, the cost of buying an equivalent car is C1,200; general inflation between the dates of buying and selling is 10%. Under financial capital maintenance (in monetary terms and in real terms) and operating capital maintenance, the trader’s income statement would be as follows: The best of 10 Accounting conventions

Capital maintenance concepts Amounts in C (currency) Financial capital maintenance Operating capital maintenance Monetary capital General purchasing power Sales 2,000 2,000 2,000 Cost of sales -1,000 -1,000 -1,200 Operating profit 1,000 1,000 800 Inflation adjustment to opening capital – -100 – Total gains 1,000 900 800

Monetary financial capital maintenance, which is the most commonly used basis, takes no account of the effects of inflation. The profit of C1,000 is the amount in excess of the business’s original capital. In column two, the inflation adjustment shows the effect of the general increase in prices on the opening financial capital of C1,000 and seeks to ensure that profit is measured only after preserving the opening capital in the business in terms of its general purchasing power. The profit of C900 leaves capital of C 1,100 in the business to maintain its purchasing power.

Operating capital maintenance is concerned with preserving the productive capacity of the business. In this example, this is the trader’s ability to replace the item of stock sold. Under operating capital maintenance, the trader has a profit of C800 and capital in the business of C1,200, which is sufficient to purchase a car to begin the next period’s trade.

Valuation bases

The measurement of profit is also affected by the valuation basis chosen. There are a variety of valuation bases, including historical cost, current cost and market value or fair value. [Framework 6 Measurement].

Units of measurement

The unit of measurement affects how profit is determined. Reporting can be in nominal currency or in units of constant purchasing power. Financial statements for two different years may be denominated in nominal currency, but because of inflation, the purchasing power of this nominal currency is not the same.

The use of a unit of constant purchasing power eliminates these difficulties in comparability. One method is the unit of current purchasing power. All non-monetary assets and liabilities relating to dates prior to the reporting date are restated by reference to movements in a general price index, such as the retail price index, into the value of the currency at the reporting date.

Conventions

Capital maintenance concepts, asset valuation bases and the units of measurement used can be combined in different ways to create different accounting conventions. The options outlined above would result in many different accounting conventions, but not all the combinations are sensible. The more common conventions are summarised below.

Historical cost convention

The historical cost convention values assets at their historical cost, uses financial capital maintenance and uses the nominal currency as its unit of measurement. However, when prices are rising, historical cost accounting may distort reported profits and balance sheet values. The best of 10 Accounting conventions

It is, therefore, less useful for making investment decisions or decisions about amounts to distribute. In the example presented above, if the trader had taken the profit of C1,000 for his own use, there would not be sufficient funds in the business for it to continue to trade at the same level. The best of 10 Accounting conventions

Modified historical cost convention

Sometimes the historical cost convention is modified by the revaluation of certain non-current assets. Modified historical cost accounting uses financial capital maintenance and uses the nominal currency as its unit of measurement. But certain non-current assets, usually land and buildings, are included at a valuation above historical cost. The best of 10 Accounting conventions

This gives some indication of the value to the business of some of the assets employed. The unrealised gains as a result of revaluing assets are generally not recognised in the income statement. This suggests that the gain is an element of the capital of the business that must be retained in order to maintain the business’ operating capacity, although no attempt is made to employ operating capital maintenance.

In addition, not all companies revalue their assets and, in the past, not all companies that revalued their assets did so on a regular basis. Therefore, comparability between different companies is reduced. If valuations are allowed to become out of date, their usefulness as an indication of the value of the assets to the business diminishes. The best of 10 Accounting conventions

IAS 16, therefore, requires that where an entity adopts a policy of revaluation, these should be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

Modified historical cost/fair value convention

Recent years have seen the development of a system of accounting based on historical cost but an increasing number of assets (and a few liabilities) reported at fair value. Fair value is defined in IFRS 13 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. [IFRS 13 9].

Standards that incorporate the use of fair values include IAS 19, IAS 39, IAS 40, IAS 41, and IFRS 2. However, many assets such a property, plant and equipment, intangibles and inventories are generally recorded at historical cost, as are most liabilities. The system is, therefore, sometimes described as a ‘mixed measurement model’. The best of 10 Accounting conventions

The IASB has pioneered the use of fair value, as it argues that it gives more relevant information to users of accounts. There are major questions, however, as to how much further fair value can be used. A current discussion is whether it should be applied to all financial instruments; most commentators believe this would be a step too far.

Current purchasing power

The current purchasing power (CPP) convention also values assets at their historical cost and uses financial capital maintenance. CPP uses a unit of constant purchasing power rather than the nominal currency for measurement. All non-monetary items in the financial statements, including capital, are restated by reference to a general price index. The best of 10 Accounting conventions

This maintains capital in terms of what shareholders can do with their funds in the economy as a whole, but the general price index used may not move the same way as the input prices specific to the company. Therefore, the resulting asset values may bear no relationship to their current value to the business. In addition, the capital maintained may be either too much or too little to maintain the business’s operating capacity.

In the example presented above, the increase in the general price index was less than the increase specific to second-hand cars. If the trader had taken all the CPP profit out of the business, he would not have had sufficient capital to replace his stock.

An example of the use of CPP accounting is in hyperinflationary economies. IAS 29 gives guidance in this area.

Current cost accounting

Current cost accounting conventions value assets at their current value to the business. Although this is often combined with operating capital maintenance and measurement in nominal currency, it can also be combined with financial capital maintenance and units of constant purchasing power. As combining current costs with nominal currency usually results in useful information, the additional complexity introduced by using units of constant purchasing power is often not warranted except in trend information. The best of 10 Accounting conventions

Current cost operating profit shows the current trading margin achieved by the business, as it charges the costs incurred at the prices applying when the sales were made. In other words, it takes inflationary ‘holding gains’ out of the measurement of income. It gives an indication of the entity’s ability to generate profits from its current operations and also maintains its current operating capacity. In the operating capital maintenance example above, the operating profit is lower than under financial capital maintenance. This allows sufficient capital to be retained to replace stock and continue trading and may also give a more forward-looking perspective on future profits.

The best of 10 Accounting conventions