& The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting

Theory (07 !7"#

Current Cost Accounting Introduction

In a previous lecture the CPPA system was introduced as a method of accounting for the effects of changing prices on accounting data. The system found practical expression in a provisional SSAP 7 Accounting for Changes in the Purchasing Power of Money and used the PI! a general retail price index! to ad"ust #CA figures to

inflation ad"usted num$ers. The CPPA system also too% a proprietary view of capital maintenance! i.e. the capital to $e maintained was the wealth of the shareholders defined in terms of their purchasing power. According to the provisional SSAP! CPPA financial statements were to $e supplementary to the main #CA financial statements.

#owever! in March &'() the provisional SSAP was replaced $y SSAP&* Current Cost Accounting which applied to annual financial statements relating to accounting periods starting on or after & +anuary &'(). The standard too% a very different line from its predecessor. SSAP &* re,uired specific assets to $e valued at deprival value -which the standard named .value to the $usiness/0! capital to $e maintained in terms of operating capa$ility -an entity rather than a proprietary approach0! and that the current cost accounts were the main as opposed to the supplementary accounts -i.e. the standard a$andoned the historical cost accounting system in favour of a system of current values0. SSAP &* was withdrawn in April &'(( as inflation levels fell to more

7 normal levels and firms $egan not to comply with the standard -despite the audit report ,ualifications that this attracted from their statutory auditors0. The CCA system! however! is not .theoretical/ $ut has $een tried and tested in actual accounting practice and for a time in the early &'()s CCA accounts were the only general purpose financial reports $eing produced $y large listed companies in the 12. The history of SSAP &* is the history of the only attempt in the 12 to supplant the #CA system with one $ased on current values.

Current cost operating ad"ustments

The preparation of a full set of CCA financial statements is a lengthy and involved process and the examples used here to illustrate the main ideas will $e $ased upon simplified data and price indices. The preparation of a set of CCA financial statements $egins with the profit and loss account and the calculation of current cost operating profit defined as -SSAP &*3 4)03

Current cost operating profit is the surplus arising from the ordinary activities of the $usiness in the period after allowing for the impact of price changes on the funds needed to continue the existing $usiness and maintain its operating capa$ility! whether financed $y share capital or $orrowing. It is calculated $efore interest on net $orrowing and taxation. 5ne of the important phrases in the a$ove definition is that of .operating capa$ility/ which implies an entity view of capital maintenance. The capital to $e maintained is the physical capital of the entity -SSAP &*3 6'03

The operating capa$ility of the $usiness is the amount of goods and services which the $usiness is a$le to supply with

6 its existing resources in the relevant period. These resources are represented in accounting terms $y the net operating assets at current cost. The a$ove definition necessitates another definition in order to ma%e the concept clearer -SSAP &*3 6(03

8et operating assets comprise the fixed assets -including trade investments0! stoc% and monetary wor%ing capital dealt with in an historical cost $alance sheet. Current cost operating profit is the surplus for the period after allowing for the impact of price changes on the firm/s fixed assets! stoc% and monetary wor%ing capital. The monetary wor%ing capital of a company may $e simply defined as the aggregate of de$tors! cash and creditors in an historical cost $alance sheet. The impact of these price changes on these three categories of assets is calculated $y preparing three current cost operating ad"ustments.

The first is the depreciation ad"ustment -SSAP &*3 '03

The depreciation ad"ustment allows for the impact of price changes when determining the charge against revenue for the part of fixed assets consumed in the period. It is the difference $etween the value to the $usiness of the part of fixed assets consumed during the accounting period and the amount of depreciation charged on an historical cost $asis. Although the terminology may $e different! the ad"ustment descri$ed a$ove is actually more familiar as the realised holding gain on fixed assets as calculated under the replacement cost accounting - CA0 system except that the $asis of current value measurement is deprival value rather than replacement cost.

The second ad"ustment to $e calculated is the cost of sales ad"ustment -SSAP &*3 &)03

The cost of sales ad"ustment -C5SA0 allows for the impact of price changes when determining the charge against revenue for stoc% consumed in the period. It is the difference $etween the value to the $usiness of stoc% consumed and the cost of stoc% charged on an historical cost $asis. Again! the principle should $e familiar from the CA system 9 the C5SA is the

realised holding gain on stoc% $ut in the CCA system it is calculated $ased on deprival value as opposed to replacement cost -although in practice the difference $etween the two systems is negligi$le0.

The third current cost operating ad"ustment to $e calculated is also familiar despite $eing couched in rather o$scure definitional terms -SSAP &*3 &&03

Most $usinesses have other wor%ing capital $esides stoc% involved in their day:to:day operating activities. ;or example! when sales are made on credit the $usiness has funds ties up in de$tors. Conversely! if the suppliers of goods and services allow a period of credit! the amount of funds needed to support wor%ing capital is reduced. This monetary wor%ing capital is an integral part of the net operating assets of the $usiness. This <monetary wor%ing capital= ad"ustment should represent the amount of additional -or reduced0 finance needed for monetary wor%ing capital as a result of changes in the input prices of goods and services used and financed $y the $usiness. The concept $ehind the ad"ustment may $e $est understood through the consideration of a simple example in which monetary wor%ing capital consists solely of de$tors and creditors. Assume a firm which sells on the $asis that de$tors are given two months to pay $ut that creditors demand payment within one month. Assume sales of &)) units

? per month which cost >7) each sold at a mar% up of ?) per cent. Ignoring all other transactions the firm/s investment in monetary wor%ing capital is as follows3 > Trade de$tors Trade creditors Monetary wor%ing capital 7 months x &)) units x >6) & month x &)) units x >7) *!))) 7!))) 4!)))

The point that the standard is ma%ing is that the figure of >4!))) has the ,ualities of a fixed asset or permanent stoc% holding and that its value to the $usiness may increase or decrease as prices change. To illustrate this! assume that the cost of goods rises $y 7) per cent and that the mar% up of ?) per cent is maintained3 > Trade de$tors Trade creditors Monetary wor%ing capital 7 months x &)) units x >6* & month x &)) units x >74 7!7)) 7!4)) 4!())

The amount of monetary wor%ing capital needed to maintain trading at current volumes and under the same credit terms -which the company may not have the mar%et power to change0 has increased $y >()) 9 the monetary wor%ing capital ad"ustment. Although presented in a slightly different way and using different terminology this ad"ustment is not dissimilar in principle to calculating the monetary gain or loss under the CPPA system of accounting.

#ence current cost operating profit under the CCA system is found $y deducting these three current cost operating ad"ustments 9 the depreciation ad"ustment! the cost of sales ad"ustment and the monetary wor%ing capital ad"ustment 9 from historical cost operating profit -calculated in the normal way on an historical cost $asis0. This is the first step in the preparation of a set of CCA financial statements.

The gearing ad"ustment

The second stage involves the calculation of the current cost operating profit attri$uta$le to shareholders -SSAP &*3 4&03

Current cost profit attri$uta$le to shareholders is the surplus for the period after allowing for the impact of price changes on the funds needed to maintain their proportion of the operating capa$ility. It is calculated after interest! taxation and extraordinary items. The %ey to understanding this definition of current cost profit lies in understanding the ways in which firms are a$le to raise long:term finance. 5ne way for a firm to raise finance is to as% shareholders to contri$ute $y way of a share issue. Another way to raise finance! often preferred $ecause of its tax:deducti$ility! is for the firm to issue de$entures or loan stoc%. The long:term finance of a firm may $e raised from two sources 9 de$t or e,uity 9 and the relationship $etween the two is referred to as the company/s gearing. The standard ta%es the view that the additional investment re,uired to cope with the impact of rising prices on the firm/s operating capa$ility may $e partially funded $y de$t! as it has $een in the past. The gearing ad"ustment! the fourth and final ad"ustment re,uired to produce a set of CCA financial statements! represents that proportion of the current cost operating ad"ustments that will $e funded $y raising de$t instead of e,uity -SSAP &*3 &(03

The gearing ad"ustment! su$"ect to interest on $orrowing! indicates the $enefit or cost to shareholders which is realised in the period! measured $y the extent to which a proportion of the net operating assets are financed $y $orrowing.

7 The calculation of the gearing ad"ustment is $ased upon the average gearing level for the accounting period as measured in current cost -as opposed to historical cost0 terms. It is that proportion of the current cost operating ad"ustments that will $e funded -it is rather heroically assumed0 $y providers of de$t rather than e,uity capital.

The current cost accounting $alance sheet

So far! little has $een said a$out the $alance sheet under the CCA system. The $alance sheet changes radically in that non:monetary assets are shown in a CCA $alance sheet at their value to the $usiness -SSAP &*3 4703

@alue to the $usiness is3 -a0 net current replacement costA or! if a permanent diminution to $elow net current replacement cost has $een recognised! -$0 recovera$le amount! which is the greater of the net realisa$le value of an asset and! where applica$le! the amount recovera$le from its further use. The definition a$ove is the same as that for deprival value! which in most cases defaults to replacement cost as the valuation $asis. Because prices generally tend to rise rather than fall the assets in a current cost $alance sheet will $e shown at values in excess of those in an historical cost $alance sheet. The valuation differences are shown in the current cost $alance sheet separately in what is %nown as the current cost reserve -SSAP &*3 7403

The current cost $alance sheet includes a reserve in addition to those included in the historical cost accounts. The additional reserve may $e referred to as the current cost reserve. The total reserves will include! where appropriate3 -a0 unrealised valuation surpluses on fixed assets! stoc% and investmentsA and

( -$0 realised amounts e,ual to the cumulative net total of the current cost ad"ustments! that is3 -i0 the depreciation ad"ustment -and any ad"ustments on the disposal of fixed assets0A -ii0 the two wor%ing capital ad"ustmentsA and -iii0 the gearing ad"ustment. The preparation of a full set of current cost accounting financial statements is a time: consuming $usiness and the main facets of the system will $e illustrated using simplified data -the @illeparisis example attached0 and using a method that simplifies the very many difficult assumptions and "udgements that need to $e made when applying the CCA system to a real set of financial statements -e.g. to what extent is cash part of wor%ing capital or is it surplus to re,uirements and $eing held for investment purposesC0. #owever! the complex calculations re,uired may $e made easier to understand $y remem$ering that essentially the CCA system is nothing new $ut merely an amalgam -more of less consistent0 of techni,ues that have $een seen $efore! especially in relation to the current cost operating ad"ustments. The gearing ad"ustment is new! $ut is also -argua$ly0 not really part of a coherent current value accounting system.

' The University of Birmingham College of Social Sciences The Birmingham Business School Department of Accounting and Finance Accounting Theory (07 !7"# Current Cost Accounting $%ample &illeparisis plc Since @illeparisis plc! a manufacturing company! started trading all prices have remained relatively constant and the $alance sheet $elow prepared as at & +anuary 7)D4 satisfies $oth the historical cost and current cost accounting conventions. Balance sheet as at ' (anuary 0)* >)))s ;ixed assets -purchased 6& Eecem$er 7)D60 Current assets Stoc% Ee$tors Cash Creditors due within one year 8et current assets Total assets less current lia$ilities Creditors due after one year 9 &) F loan stoc% 7)D' Capital and reserves 5rdinary share capital Profit and loss account >)))s 6!*)) 7!))) 7!4)) &!))) ?!4)) &!7)) 4!7)) 7!()) &!))) *!()) *!))) ()) *!())

The company/s fixed assets have a useful life of three years and are depreciated on a straight line $asis assuming no residual value. The interest on the loan stoc% is paya$le on the last day of the financial year. Purchases of stoc% and other expenses incurred were spread evenly throughout the financial year. Closing stoc% represents three months purchases. The company/s income statement for the financial year ended 6& Eecem$er 7)D4 was as detailed $elow.

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+ncome statement for the year ended ,' Decem-er 0)* >)))s Turnover Cost of sales 5pening stoc% Purchases Closing stoc% Gross profit Eepreciation 5ther expenses paid Interest paid Profit $efore tax Taxation paid Profit after tax Eividend paid etained profit for the financial year >)))s 74!))) 7!))) 77!))) 74!))) 7!4)) &!7)) *)) &))

7&!*)) 7!4)) &!')) ?)) 7)) 6)) 7)) &))

At the end of the financial year trade de$tors amounted to >7!*))!))) and creditors due within one year were >&!4))!))). The financial year to 6& Eecem$er 7)D4 was characterised $y a surge in inflation and the following price indices are relevant3 & +anuary 7)D4 ;ixed assets Stoc% Monetary capital .e/uired0 Prepare the $alance sheet of @illeparisis plc as at 6& Eecem$er 7)D4 using the historical cost accounting convention. Prepare for @illeparisis plc current cost accounts for the year ended 6& Eecem$er 7)D4 as far as the given information allows. &)) &)) &)) 6) +une 7)D4 &)? &&7 &)* 6& Eecem$er 7)D4 &&) &74 &&7