week 3 current entry, exit and mixed value accounting

36
n e n a o n a F n a n c a R e p o n g a n d A n a Current entry , exit and mixed value accounting

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Financial Reporting Analysis

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Page 1: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current entry , exit and mixed value accounting

Page 2: Week 3 Current Entry, Exit and Mixed Value Accounting

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Contents

• Capital maintenance

• Replacement cost accounting and depreciation

• Current entry values: preliminary appraisal

Page 3: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance

Profit is defined as the amount generated by the business over and above that necessary to replace the assets

Capital maintenance is defined as the maintenance of the capacity to replace the resources of the business

HC profit split into: Operating profit (revenue – current replacement cost)

Holding gain (current replacement – original purchase cost)

Page 4: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

•Example: • Purchase cost: € 10

• Replacement cost: € 12

• Selling price: € 15

HC profit: 5

•Operating profit: 3

•Holding gain: 2

Both elements are realized

Page 5: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

Normally, both realized and unrealized gains will be involved

Example:

1 October 20X1 Buy 2 at €30

1 November 20X1 Sell 1 at €50, when RC is €35

31 December 20X1 RC is €38

31 January 20X2 Sell 1 at €60, when RC is €40

HC profits are:

Year 1 50 - 30 = €20

Year 2 60 - 30 = €30

Page 6: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

• A fuller analysis:

• Year 1: • Operating profit €15

• Realized holding gain €5

• Unrealized holding gain €8 (38-30)

• Year 2: • Operating profit €20

• Realized holding gain €10

• Unrealized holding gain €0

Page 7: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

•HC profit consists of two of the three elements:

HC profit = Operating profit + Realized holding gains

Year 1: € 20 = 15 + 5

Year 2: € 30 = 20 + 10

Page 8: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

Edwards and Bell (1961):

Business income =

Operating profit

+ realized holding gains recognized in the period

+ unrealized holding gains recognized in the period

Business income Year 1 = 15 + 5 + 8 = 28

Business income Year 2 = 20 + 2 + 0 = 22

Page 9: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

Accounting income includes:

realized holding gains of the period recognized in the period (1)

plus realized holding gains of the period recognized in previous periods (2)

Business income includes:

realized holding gains of the period recognized in the period (3)

plus unrealized holding gains recognized in the period (4)

Accounting income = business income – 4 + 2

Year 1: €20 = 28 - 8 + 0

Year 2: €30 = 22 - 0 + 8

Page 10: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

Edwards and Bell’s current entry approach includes all the holding gains recognized in the period as being included in income

Criticisms:

No unrealized gains included

All the holding gains, whether realized or unrealized, need to be retained in the business in order to enable it to replace resources as they are used

Page 11: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital maintenance (cont’d)

Operating profit is the gain after having retained sufficient resources to enable us to do those things that we originally had the capacity to do

Operating profit should be regarded and reported as income. Holding gains, whether realized or not, should be excluded

The central profit figure under a current entry value system should consist of the operating profit alone

Page 12: Week 3 Current Entry, Exit and Mixed Value Accounting

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Replacement cost accounting and depreciation

•Example:

• Fixed asset costs = €100

• Useful life of 4 years

• Zero scrap value

• RC of new asset rises by €20 each year

•Balance sheet position year 1:

Cost (RC) €120

Depreciation (25%) €30

Balance sheet €90

Page 13: Week 3 Current Entry, Exit and Mixed Value Accounting

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Replacement cost accounting and depreciation (cont’d)

Balance sheet position year 2: From P&L account view

RC €140

Depreciation (25%) €35

Accumulated depreciation €65

Balance sheet figure €75

Balance sheet view RC €140

Accumulated depreciation €70 (50%)

Balance sheet figure €70

In P&L €35 charge and €40 charge a in balance sheet

Page 14: Week 3 Current Entry, Exit and Mixed Value Accounting

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Replacement cost accounting and depreciation (cont’d) Problem solved: backlog depreciation Year 2 balance sheet deduction: The proper annual charge (€35) The extra figure necessary to bring the accumulated

depreciation at the beginning of year 2 up to what it would have been if the current (end of year 2) RC had been prevailing earlier (€5)

Bookkeeping: Credit of €40 to depreciation provision Debit of €35 to P&L account Debit of €5 to holding gain account

Page 15: Week 3 Current Entry, Exit and Mixed Value Accounting

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Replacement cost accounting and depreciation (cont’d)

•Balance sheet position year 2:

• Fixed assets

RC 140

Depreciation 70

Net book value 70

• Holding gain reserve

b/f 20

add 20

less 5 35

Page 16: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current entry values: preliminary appraisal

Advantages: More useful data for decision-making purposes Proper maintenance of operating capacity – the

“business substance” A balance sheet based on current value Consistent with accounting concepts Holding gains are recognized and reported when they

occur Comparisons over time and performance analysis are

more valid and meaningful Feasible in practical application

Page 17: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current entry values: preliminary appraisal (cont’d)

•Disadvantages

• More subjectivity

• Use of replacement cost figures for assets that the firm does not intend to replace

• It fails to give an indication either of the current market value of most assets in their present state or of the business as a whole

• It fails to take account of general inflation, of changes in the purchasing power of money

Page 18: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit value accounting

•Edwards and Bells (1961) suggested two current exit value concepts: • Current values defined as values actually realized during the

current period for goods or services sold

• Opportunity costs defined as values that could currently be realized if assets were sold (without further processing) outside the firm at the best prices immediately obtainable

Page 19: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit value accounting (cont’d)

•Net realizable value (NRV): the proceeds after deducting these additional unavoidable expenses or disposal, defined as:

Yr = D + (Re – Rs)

Yr = exit value income

D = distributions (less new capital inputs)

Re = NRV of the assets at the end of the period

Rs = NRV of the assets at the start of the period

Page 20: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit value accounting (cont’d)

Example: NRV (work in progress, today): €10

NRV (finished product, today): €20

NRV (finished product, when finished): €22

Forced sale (current existing state): €6

Generally, exit values refer to assets in their existing state sold in the normal course of business, so the exit value for the work in progress would be €10

Page 21: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit value accounting (cont’d)

•Exit value capital: the amount of money that the business could obtain from its assets on a particular date

•Exit value is seen as opportunity cost concept, i.e. the amount of cash that the business could obtain if it did not keep the asset

•Exit value accounting does not conform to the going concern convention

Page 22: Week 3 Current Entry, Exit and Mixed Value Accounting

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•Exit value income (Yr) =

Realized operating gains

+ unrealized operating gains

+ realized non-operating gains

+ unrealized non-operating gains

•P&L account also value based and not cost based

• e.g. Depreciation = loss in value of the asset

Current exit value accounting (cont’d)

Page 23: Week 3 Current Entry, Exit and Mixed Value Accounting

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Capital in cash = €15.000 Fixed assets = €10.000

Year 1 (€) Year 2 (€)

NRV fixed assets 6.000 4.000

Sales 20.000 25.000

Cost of sales 11.000 12.000

Closing inventory: cost 2.000 3.000

NRV 2.500 3.800

Current exit value accounting (cont’d)

Page 24: Week 3 Current Entry, Exit and Mixed Value Accounting

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Year 1 (€) Year 2 (€)

Exit value revenue statements

Sales 20.000 25.000

Cost of sales 11.000 12.000

9.000 13.000

Depreciation 4.000 2.000

5.000 11.000

Less operating gain included in previous year - 500

5.000 10.500

Add unrealized operating gain 500 800

Realizable income 5.500 11.300

Exit value balance sheets

Fixed assets 6.000 4.000

Inventory 2.500 3.800

Cash 12.000 24.000

20.500 31.800

Capital 15.000 15.000

Realizable income 5.500 16.800

20.500 31.800

Page 25: Week 3 Current Entry, Exit and Mixed Value Accounting

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1 January year 7

Introduced capital of €25.000 and purchased a machine for €9.000

Purchased 500 items of inventory for €15 each

31 December year 7

Sold 300 items of inventory for €30 each

Paid rent for the year of €1.000

Paid other expenses for the year of €1.000

1 January year 8

Purchased 400 items of inventory for €17 each

31 December year 8

Sold 500 items of inventory for €33 each

Paid rent for the year of €1.100

Paid expenses for the year of €1.200

Current exit value accounting (cont’d)

Page 26: Week 3 Current Entry, Exit and Mixed Value Accounting

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• Information about machine: 31.12.7 31.12.8

Replacement cost 10.000 12.000

Realizable value 8.000 6.000

Cost of realization 1.000 1.000

Current exit value accounting (cont’d)

Page 27: Week 3 Current Entry, Exit and Mixed Value Accounting

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P&L account

31.12.7 31.12.8

Sales 9.000 16.500

Cost of sales (4.500) (8.100)

Gross profit 4.500 8.400

Rent 1.000 1.100

Expenses 1.000 1.200

Depreciation 2.000 2.000

(4.000) (4.300)

Gross profit 500 4.100

Holding gain 3.000 (1.400)

3.500 2.700

Current exit value accounting (cont’d)

Page 28: Week 3 Current Entry, Exit and Mixed Value Accounting

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Balance sheet

31.12.7 31.12.8

Fixed assets

Machine at NRV 7.000 5.000

Current assets

Inventory at NRV 6.000 3.300

Bank 15.500 22.900

21.500 26.200

28.500 31.200

Share capital 25.000 25.000

Profit 3.500 6.200

28.500 31.200

Current exit value accounting (cont’d)

Page 29: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit values: preliminary appraisal

•Advantages:

• It follows the economic “opportunity cost” principle

• Exit values facilitate comparisons

• The concept of realizable value is easy for the non-accountant to understand

• Useful information about assets is provided to outsiders

• It is already widely used, e.g. debtors, inventory at lower of historical cost (HC) and NRV, revaluation of land and buildings

Page 30: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit values: preliminary appraisal (cont’d)

•Disadvantages:

• It is highly subjective, more so than the replacement cost accounting

• It fails to follow the going concern assumption, fails to recognize that firms do not usually sell all their assets

• It fails to concentrate attention on long-run operational effectiveness

• It fails to give realistic information about the internal usefulness of assets

Page 31: Week 3 Current Entry, Exit and Mixed Value Accounting

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Current exit values: preliminary appraisal (cont’d)

•Expected values: “values expected to be received in the future for output sold according to the firm’s planned course of action” (Edwards and Bell, 1961)

•Expected values give useful information, but are more subjective, less consistent in evaluation and fail to reflect the current reality

•Current exit values are a more useful concept to prepare statements of the current position

Page 32: Week 3 Current Entry, Exit and Mixed Value Accounting

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Exit value NRV accounting focuses more on the balance sheet than current entry value RC accounting

Profit or gain are more determined by a consideration of changes in output values of resources

Current exit value is a short run concept

Current exit values: preliminary appraisal (cont’d)

Page 33: Week 3 Current Entry, Exit and Mixed Value Accounting

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Mixed values – ad hoc methods

•Some accounting systems are flexible as regards the valuation policy companies wish to adopt

•No requirement for any consistency of approach as between one asset and another

Page 34: Week 3 Current Entry, Exit and Mixed Value Accounting

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Mixed value – Deprival value

•Deprival value (DV) is a more theoretically defensible approach for using different valuation bases for assets in different circumstances

•DV of an asset is the loss that the rational businessman or businesswoman would suffer if he or she were deprived of the asset

Page 35: Week 3 Current Entry, Exit and Mixed Value Accounting

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Deprival value (DV): appraisal

•Advantages: • All the advantages of RC accounting can be claimed here also

• As a “mixed value” system it is more realistic and relevant than either RC or NRV. It values resources at RC if it is profitable to replace them and at the expected proceeds if they would not be replaced

Page 36: Week 3 Current Entry, Exit and Mixed Value Accounting

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Deprival value (DV): appraisal (cont’d)

•Disadvantages: • Disadvantages 1, 3 and 4 of RC accounting can be claimed here too

• It is more subjective than RC

• If the balance sheet is expressed in “mixed values”, what do the asset and capital employed totals mean? Can mixed values be validly added at all?

• Firms are not in practice being continually deprived of their assets