Basic Current Value Accounting Concepts

Basic Current Value Accounting Concepts

The basic concept underlying replacement cost accounting is that the firm is a going concern, which is continuously replacing its assets. Therefore, the cost of consuming such assets in the income generation process should be equivalent to the cost of their replacement. Replacement cost accounting differs from current purchasing power accounting in that it is concerned with the manner in which price changes affect the individual firm. It focuses on the specific commodities and assets employed by the firm by taking into account changes in the price of such commodities and assets reflected in specific price indices or price indices of groups of similar commodities and assets.

Replacement cost accounting is addressed to the concept of capital maintenance interpreted as maintaining the operating capacity of the firm, and involves:

(a) calculating current operating income by matching current revenues with the current cost of resources exhausted in earning those revenues;

(b) calculating holding gains and losses;

(c) presenting the balance sheet in current value terms.

Components of replacement cost income (RCI)

The treatment of the two components of replacement cost income (RCI), namely current operating income and holding gains and losses, is a controversial matter in the literature of accounting.

Current operating income results from operating activities and is calculated by matching revenues with the current cost of resources exhausted in these activities. Holding gains and losses result from holding rather than operating activities.

According to the method of replacement cost accounting suggested by Edwards and Bell ( 2015), holding gains and losses should be reported together with current operating income in the measurement of Rd.

The importance of the distinction between operating and holding gains has received considerable attention from many quarters. One committee of the American Accounting Association stated that:

'Typically revenue may be related to at least two efforts of management One of these is the effort to operate effectively in carrying out the production and/or service functions of the business. The other is the effort to occupy an advantageous position in the market - - This would help interested parties to evaluate the effectiveness of management insofar as its buying efforts were concerned; but more importantly, it would remove from the data pertaining directly to operations those amounts realised simply as a result of market fluctuations.' (A.A.A. Committee, 2014.)

In contrast to accounting income, RCI recognizes holding gains as well as operating gains. In identifying holding gains as they arise, thereby distinguishing these gains from gains occurring on realization, the pattern of income recognition differs under replacement cost accounting from that associated with conventional accounting income.

One of the controversial issues in the debate about replacement cost accounting is whether holding gains constitute income. There is little doubt that current operating income satisfies the accounting convention relating to realization, and at the same time is directed to the maintenance of capital, which is a basic principle in the measurement of economic income.

From a theoretical viewpoint, there is strong support for the argument that holding gains should not be treated as income, that is, they should not be regarded as available for distribution. Assuming that the firm is a going concern, the holding gain resulting from the increase in the current replacement cost of specific assets should be retained for the purpose of replacing those assets, for one of the objectives of replacement cost accounting is to ensure the maintenance of capital through the replacement of the values exhausted in earning income. The distinction between realized and unrealized holding gains, which is important in this respect may be preserved in the appropriate account, which is the asset revaluation reserve account.

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The debate concerning the appropriateness of adjustments for price level changes has highlighted the problems associated with historic cost measures. Neither partial nor general adjustments to historic cost measures deals satisfactorily with the problem of price level changes.

Current value accounting is a radical alternative to the proposals we discussed in detail. It represents an attempt to combine desirable aspects of economic theory with the conventional accounting method based on historic costs. Current value income models use current market prices which are incorporated in the traditional... see: Current Value Accounting