Improving the conceptual framework – the unsteady state of current cost accounting

As we discussed here, the IASB has published for public consultation proposals to improve the Conceptual Framework for Financial Reporting, with comments to be received by October 26, 2015.

Here are some extracts from the proposals:

  • “The concepts of capital (proposed in the document) give rise to the following concepts of capital maintenance:
  • (a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, holders of equity claims during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.
  • (b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from holders of equity claims during the period.
  • The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
  • At the present time, it is not the intention of the IASB to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.”

This will likely be the least-perused section of the proposals – the rest of the document suggests little time was spent on it (“The existing discussion of capital maintenance is included in this Exposure Draft substantially unchanged from the existing Conceptual Framework. The IASB would consider revising the Conceptual Framework discussion of capital maintenance if it were to carry out future work on accounting for high inflation. No such work is currently planned”). Younger readers (like anyone under the age of around 50) may be surprised to learn that such concepts had a more active life in the past though. This is taken from the 2001 second edition of Accounting Standards in Evolution, by Ross Skinner and Alex Milburn:

  • “…high inflation during the 1970s led to widespread criticism of historical cost-matching accounting, and…there was a feeling that historical cost-based financial statements should be replaced, or at least supplemented, by current value information. Unfortunately, there was little agreement on which among many possible income models should be selected…
  • The CICA offered, in CICA Handbook Section 4510, a smorgasbord of supplementary current cost and general price level disclosures that could be combined in various ways to construct different concepts of current cost-operating capacity, and current cost-general-price-level-adjusted, income. In this it followed the lead of the FSAB (in SFAS 33), although the items of disclosure (differed in some respects)…
  • Most preparers did not well understand the current cost disclosures, did not find them useful, and generally did not believe that analysts and investors used the information. Accordingly, since the disclosures were voluntary, it is not surprising that few companies provided them – only about 20% of companies to whom the recommendations applied made the disclosures in 1983, and this dropped off to less than 5% in 1986.
  • Most analysts found the information of limited usefulness, in part because the low company participation rate severely limited intercompany comparisons.
  • …Section 4510 was withdrawn from the CICA Handbook in 1992. This followed abandonment of SFAS 33 in the US as a required standard in 1986, and suspension of the current cost standard in the UK in 1985.”

Fourteen years after that was written, inflation remains low (some may think deflation is actually a greater risk), and the likelihood of any revival of interest in this area seems low. But maybe there’s some small significance then in the fact that the IASB at least retained the existing material rather than trashing it. The efforts described above didn’t accomplish much, but then they seem to have been rather haphazard, falling far short of yielding relevant, reliable, comparable information from one entity to the next: any future initiatives would presumably be more rigorous. It’s not hard to intuitively grasp how profit or loss computed under current rules might become meaningless for some entities in a higher-inflation environment, where pricing determinations, replacement costs and the like are on a perpetual wild ride. Of course, if that happens, we’ll probably have much bigger problems than financial reporting ones, so let’s hope the low prominence of this area remains justified…

The opinions expressed are solely those of the author

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