LO 3 – Current Cost Accounting
Objective of current cost accounting
Current cost accounting (CCA) is an accounting system in which assets are valued at current market buying prices and profit is determined by allocation based on current costs. What is the objective of current cost accounting? Edwards and Bell express this fundamental problem in terms of three questions: * What amount of assets should be held at any particular time? This is the expansion problem. * What should be the form of these assets? This is the composition problem. * How should the assets be financed? This is the financing problem. To formulate relatively accurate expectations, managers need to evaluate past activities and decisions. A useful tool in this evaluation is a comparison of accounting data for a given period with expectations originally specified for that period. If this comparison reveals that expectations were inaccurate, current events or expectations should be altered. Although Edwards and Bell emphasize the information needs of management, they argue that much of the data are also relevant to outsiders, such as shareholders and creditors. Under this theory, accounting information therefore serves two purposes: * Evaluation by managers of their past decisions in order to make the best possible decisions for the future * Evaluation of managers by shareholders, creditors and others Concept of business profit and financial capital
With regard to profit, management often faces two decisions: * Holding decisions about whether to ‘hold’ assets and liabilities or to dispose of them * Operating decisions about how to use and finance the entity’s operations I order to evaluate both the holding and operating decisions of managers, Edwards and Bell offer a profit concept that they call ‘business profit’ comprising (1) current operating profit and (2) realizable cost savings. Current operating profit is the excess of the current value of the output sold over the current cost of the related inputs. Realizable cost savings are the increase in the current cost of the assets held by the firm in the current period. The business profit is therefore calculated on a real basis. The term we use for realizable cost savings is ‘holding gains/losses’, which can be realized or unrealized. Capital is a real financial proprietorship concept which means that profit is determined after restating opening buying values at the general price level. Holding gains and losses
An assumption underlying business profit is that mixing holding gains/losses and operating gains/losses confuses the evaluation of management decisions and hinders the allocation of resources in the economy. Holding a certain composition of assets and liabilities is one way management tries to enhance the firm’s market position. Under historical cost accounting, gains are recorded only when the assets are disposed of. Therefore, determining whether management’s holding activities are successful or not is virtually impossible unless assets are bought and sold in the same period. Also, under historical cost accounting, when comparing firms we may be misled as to which firm is more efficient. Why holding gains are a component of profit
Revsine suggests that the inclusion of holding gains as profit may also be justified on the ground that changes in the current cost of the given assets reflect changes in the future cash flows expected to be generated from the use of the asset. Holding gains qualify as profit because the price increases on which they are based are a reflection of greater future earning power. If this assertion is true, then a profit figure that includes holding gains is highly relevant to users who are trying to predict the future cash flows of a company. Revsine’s argument implies that current cost profit id a lead indicator of future cash flows. The theoretical justification of this relationship is the connection between current cost profit and economic...
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