Procedural Conventions - the Cost Convention

Procedural conventions - The cost convention

By convention, however, accountants determine the value of an asset by reference to the cost of its acquisition, and not by reference to value of the returns which are expected to be realized. Hence, the 'value in use' of assets which the going-concern convention maintains is the cost of acquisition. To the accountant, the difference between the value in use and the cost of acquisition of an asset is income:

Value in use - Cost of acquisition = Income Example

W. E. Audent & Son is a professional firm of chartered accountants with a large auditing practice. Its major asset is the staff of audit clerks. The value in use of the staff may be calculated by reference to the hourly rate at which their services may be charged out to clients; the cost of securing their services to the firm is represented by their salaries; and the annual profit of the firm is in substance the difference less, of course, the administrative expenses of running the firm.

In accounting, cost is used as a measure of the financial 'effort' exerted in gaining access to the resources which will be deployed in earning revenues. Since these resources are secured through financial transactions, the financial effort is measured at the time of acquisition, which coincides, of course, with the legal obligation to pay for those resources in money; The cost convention raises the following problems:

(a) The historic cost of acquisition of assets is not a dependable guide to their current value because it fails to reflect:

(i) changes in the general purchasing power of money;

(ii) changes in the specific value of individual assets in relation to money.

(b) The historic cost of acquisition of assets used up in the activity of earning income does not form a dependable basis for calculating income.

Example

John Smith is a dealer in hides. He obtains his yearly supplies from Canada in the autumn, and sells them in the United Kingdom during the ensuing 12 months. In October 19X0 he bought 20,000 hides at an average cost of £20 Canadian, equivalent to, let us say £10, and by September 19X1 had sold them all at an average price of £20, making an overall profit of £20,000. Meanwhile, the posted price of Canadian hides has increased by 50 per cent so that to replace inventory which he has sold during the year he will now have to pay an average of £15 a hide. Hence, the income of £20,000 is overstated by £10,000 because the hides sold have been valued at £10 instead of £15 each-which is their current value in Canada.

(c) The accounting practice of writing off the cost of certain assets as depreciation against income means that it is possible to remove the cost of these assets from the accounts altogether. For a long-time, for example, it was the practice of banks to reduce the value of land and buildings to £1 and so create secret reserves.

(d) Since incurring a cost depends upon a financial transaction, there are assets which create income for the firm which can never appear as such in the accounts. Often the major asset of a highly successful firm is the knowledge and the skill created as a result of teamwork and good organization. This asset will not appear in the accounts, since the firm has paid nothing for it, except in terms of salaries which have been written off against yearly profits. Allied to this problem is the failure in making any mention in the balance sheet of the value of the human assets of the firm. Long ago, the economist Alfred Marshall stated that 'the most valuable of all capital is that invested in human beings' (Marshall, 2004, 8th edition), and it is universally recognized that the firm's human assets are its chief source of wealth. Yet, it is only recently that accountants have begun to recognize this fact, and efforts are now being made to find ways in which information on the value of human assets may be most appropriately presented. Other important assets of which no mention is made in financial accounting statements are, for example, the value to the firm of its hold on the market, which may be a very valuable asset if the firm enjoys a monopoly position, and the value of the firm's own information system, which will affect the quality of its decisions.

Many of the most controversial issues in financial accounting theory and practice revolve around the cost convention. External users of financial statements basically wish to have information of the current worth of the firm on the basis of which they may make investment decisions. Accountants argue that there must be an objective basis to the information which they provide, and to them 'objectivity' means being able to verify information from the results of transactions which create legal rights and obligations. The need to report the legal rights and obligations existing in money terms at law, and the desire to express the value of the assets and liabilities in real terms under changing money values has been at the heart of the debate about inflation accounting.


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Read on: Procedural Conventions - the Going-concern Convention

Procedural conventions - The going-concern convention

The valuation of assets used in a business is based on the assumption that the business is a continuing business and not one on the verge of cessation. This convention is important: many assets derive their value from their employment in the firm, and should the firm cease to operate the value which could be obtained for these assets on a closing-down sale would be much less probably than their book value.

The mineshaft was sunk originally with the money raised by the issue of shares, and the other assets were financed out of loans... see: Procedural Conventions - the Going-concern Convention