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Accounting theory by Mind Map: Accounting theory
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Accounting theory

System approach to accounting


Measured elements of transactions

Throughput (method process)

Operations: the program classifying, selecting, matching


Financial statements (disclosures)

Financial statements (disclosures)

Capital Maintenance

Amount of dollars that can be distributed as income without impairing capital

Determines total income

2 major issues

1. Preserve capital

2. Distribute income


Financial Capital, Can distribute BUSINESS INCOME (COP+RHG+UHG) and still maintain capital

Physical Maintenance, Can only distribute TRADING GAINS (COP)

Net Asset = C + RE

Impact on changing prices

General Price Index (Inflation), Constant Dollar, Approach, 1. Differentiate Monetary & Non-monetary items on B/S NMA changes Changes during the yr NMA at yr end restated at yr end fig, Determine PP gains/losses, Monetary items: fixed change value, thus not affected by GPL changes -> contracted at face value, Non monetary items: variable exchange values, 2. Restate I/S to include PP gains/losses, 3. Restate B/S, No adjustments for Monetary items, Adjust all other items, R/E = adjusted income, CC is adjusted directly, Evaluaton, Structural attributes (Same as HC), Realization & cost incurrence, Revenue recognition, Matching principle, Timing errors ( same as HC), Measurement errors ( eliminated), Criticism, No index can capture all price changes & does not include quality improvements, Structure inconsistency, Monetary items and non mentally items are arbitrary, Monetary items restated twice in PP changes and to nominal values on BS, Interpretation problematic, Restatement is not current value of assets or liabilities, SPL should be used?, Creates issues, Reduction in cost of assets part of operating Y?, PP g/l on LT debts part of capital adj?, Relevant for decision making?, Worse capital maintained, Stockholders or firm?, Eg CPI, frequency and timeliness

Specific Price Index, Buying market, Input prices, Replacement Cost, Selling market, Historical entry price, Trading gain Realized cost change/ HG Unrealized cost change, Realized exit price, Measure in terms of operating capacity, Physical capital maintenance, Concept of productive capacity, Physical assets, Volume of output, Value of output, Objective to capture technology improvements & corresponding increase/decrease in the value of specific assets

What does CM Rule do?

1. Determines lifetime income

2. Defines measure of capital & measure of income

3. Determines composition of OE Section of BS, Restates beg & earned capital balances into end of period units, Excess ending capital above the restated original capital is an increment income to earned capital

4. Allocates increment btwn, Adjustment of opening capital, Income for the period

5. Differentiates return on capital from return of capital


Timing problems, Entry Price (RC)


Nominal Dollars

Constant Dollars

Accounting models


Exchanges, Reciprocal flows of services

Dr = Cr

Yesterday, Verifiable, objective evidence

Fundamentals, 3 elements mandatory, Date set, Attribute + entity, Measure, Concept of entity, Systems approach, Services (flow concept), Inputs, Costs (inflows) Revenues (outflows), Matters of observation, Concepts, Realization, Costs incurrence, Throughput: method process, Trial balance, Data sets, Financial, Money & credit, Economic, Production of goods + services, Matters of policy, Concepts, Recognition, Independent variable, Matching, Dependent variable, Output, Financial statements, I/S, Represents expired flows, duration of time, Certainty, For the year ended, Net income always a DEBIT, Dr. Income summary Cr. RE, B/S, Represents unexpired flows, Residual, point in time, spatial, Non existence, As at year end, Accounting for dead firms, Only I/S and no B/S


Elements of wealth, Sum of PnQn


Entry Value, Replacement Cost, Based on hypothetical transaction

Exit Value, Net Realizable Value, FV accounting

Fundementals, Systems approach, Scare resources (stock concept)


Expected CF, NPV


Fundementals, Systems approach, Expected cash flows (stock concept)

Summary of CM & NAV

CM determines the adj factor for items which differ in timing

CM necessary & sufficient for calculating lifetime income

But CM not sufficient for calculating periodic income

Valuation of paid-in capital depends on CM rule

NAV rule determines amt and timing of HG/L

Explicitly governs A&L effects in IS

CM Concept determines extent to which these HG & HL avail for distribution

RE affected by both CM and NAV rules

Together determines periodic Y

GDP Topics

Accounting theories

Agency theory


Economic Consequences

Net Asset Valuation


Straight line method

Economic income, Certainty, Capital is a prerequisite to determining income, Definition of income, The amt that a man can consume during a period and still be as well off at the end of the period as he was at the beginning, Lifetime income, Economic income = HC, Uncertainty

What does NAV Rule do?

Determines total amt of OE section, Measure assets and liabilities at a specific point in time, Determines timing of income recognition, Allocates lifetime income to accounting periods

Current Entry Values

Edwards & Bell Model

Focus is to evaluate past decisions of managers and efficiency of firm, Operational decisions (pt of recognition), Holding decisions & pre-recognition of values changes over time (b4 pt of recognition), Eg, COP, PCM, measure of managers &not firm, unrealized income out of carol of managers Business income, measure of firm specific price changes

Entry value income, Reflect value added to resources, Reflect an adjustment to capital for CM

3 types of holding gains based on types of resources, 1. Inventory HG, RHG, UHG in replacement cost of RM, WIP, FG, 2. Fixed Assets cost savings, RHG & UHG in RC of DEPRECIATED FA, 3. capital gains, RHG & UHG in RC of UNDEPRECIATED FA

Concept of Business Income, Accounting income HC (NI), Ya = COP + RHG' + RHG, COP = Rev - current RC, However, COP is measured in terms of PCM, The COP-HG dichotomy, Purpose, Evaluate gain from manager's operating decisions, COP is tot to b a predictor of future income, Allows assessment of PCM, COP provides for inter-period & inter-firm comparisons, The case against dichotomy, Operating & holding decisions are not mutually exclusive, Risks not separable, Fallacy of timeless production, Fallacy of decomposed attributes, COP not useful for biz decisions, Not a reliable dictator of LR profitability, No empirical evidence to support that its superior to other measures of income, The case against PCM, Current values (entry prices) are v subjective, UHG violates the recognition criterion, No capital adj for change in GPL, Robert Sterling (classic wheat example) argues, Firms must replace identical units, Firm must face continuously increasing costs, Firms must buy & sell in different markets, Firms must be fully invested in physical units, For PCM TO WORK, he's in favor of Exit Value accounting, Business income, Yb = COP + RHG + UHG, Business income is measured in terms of FCM, COP + REALIZABLE HG, What is realizable income?, Number is ex ante, doesn't reflect transactions that have taken place, Reflects COST SAVINGS to firm, Reflects an increase in NA value, Enhances ones ability to predict expected FCFs, Once all gains are realized, Ya = Yb, Ya = Yb, Ya = Yb - UHG + RHG', BI model requires a HC system, FCM vs PCM, Concerns how much can be distributable income, Firms & SHs concerns who is going to set or decide which rule to be used for accounting income, I.e., who's the regulator to put in GAAP?, Real business profit, Scale : CD, CM concept: current entry value in terms of PP, Example, RHG - fictional component = RRHG, UHG - fictional component = RUHG, Real BP = COP + RRHG + RUHG, RC model, Advantages of RC, Concentrates on maintenance of physical rather than monetary resources via COP, Aids decision maker in terms of dividend policies, By separating operational gains from HG, distinguishes gains that are and are not controllable by mgmt, Admission of current values abandons, Realization principle in HC ACCTG, Conservatism in HC ACCTG, Becoz RC data is hypothetical in terms of actual exchange, RC is feasible in terms of time & cost, Disadvantages of RC, Given HC systems, ignores intangibles, Serious prob of determining RC for identical resources becoz of, Productivity gains, Technological improvements, RC doesn't have universal application, E&B argue that realized & unrealized gains are income, Money (financial) approach to CM, SAME AS WINDFALL GAINS IN ECONOMIC MODEL, If capital is tot of in terms of physical resources, UHG may not represent a change in resources if e replacement of resources from realized cash is at a cost dff from e original costs, Are HG income?, Current value increases, there's no increase in physical resources, Therefore, UHG must b capital adj (not income), If gains not reinvested, then this implies a CM adj, COPis the only element of BP(Yb) which adds to physical resources and firm's operating capacity, Summary, If PCM, HGs not income, If FCM, HGs are income, Implications for, Standards setting, Regulation setting, International harmonization (convergence) of accounting practices & disclosures

Current Exit Values & Realizable Income

Exit value income

Yr = D + (Rn - [Rn-1]), Yr: realizable income D: periodic distribution of Y Rn: closing capital on exit price basis

Critical issues, What selling price should b used?, Assumed liquidation of whole entity, Assumption of orderly liquidation (general view), What state shud realizable values focus on?, Existing state, Finished state adjusted for future costs

Based on economic concept f opportunity cost, What it could acquire with cash IF it would have realized its existing resources

Arguments in support of Exit Value, Realizable values are measures of current sacrifices & alternatives choices, Emphasizes a vital economic decision, opportunity costs, Comparable data is required, Entry value reflects "value to owner" only, Hence, diff entity diff, but cash/CCE is command over all assets, Entry values claimed to be invalid, Don't reflect info on alternative choices, RC reflects a static or holding positions, Sterling argues that entry value model is based on the invalid & unnecessary assumption of "going concern", Exit values rely on the assumption of a definite life, Exit values are understandable, Commonly interpreted as market values, Therefore, easier to explain than RC, Evidence of use of realizable values in practice, Chambers argues that we already use exit values in many current situations, Valuation of net MA, LCNRV, UK legal disclosures for MV of lands, bldgs and invest, Occasional revaluations of certain FA, M&A and the thorny prob of goodwill, Issue of stock options (and derivatives in general)

Concept of Realizable income, Yr = RG + UG, Comprised 2 components in terms of exit values, Diff btwn Ya and Yr is one of realization, Yr recognizes unrealized value changes in the period they arise, Thus doesn't include realized gains of previous period, Ya = Yr - UG + RG', Ya= RG + RG', Holding gains as realizable income, Capital in exit value model is an expression of the entity's overall command over gds & svcs, Therefore, an increase in capital could properly be declared as income, No intention to maintain PC, Capital change is consumed as a dividend, then capital in terms of the command over gds + svcs is still maintained, Case against Realizable Income, Does not pay attention to operational effectiveness of entity, Arthur L. Thomas claimed that its total abandon,Eng of income measurement, Doesn't differentiate btwn those gains which are within control of mgmt, Hence, business income is better for predicting future income for DM becoz it separates operating from holding gains, Apparent assumption of liquidation of entity's resources, Difficulty of obtaining values for resources that have no market value

CoCoA model (Chambers)

Scale: CD & ND

CM: FC in terms of PP

Attribute: qty of A & L in terms of selling price or NRV, Current Cash Equivalent (CCE) or command over cash

Objective: provide firm with adaptive capacity in a world of competing alternatives

I/S format Sales Less: CoGS GP Inventory price change Adjusted GP Adjustments: Change in NRV of assets Less operating expenses CM adjustment Profit, B/S features, CCE is a calculated for A&L, Assets must be separable (otherwise zero value), Ct1 reflects a GPL adjustment, Note that if assets do not have a readily available market price, they are assumed to have a ZERO VALUE even though the asset may still be in use or be usable (VIU concept)

Contribution of model, Shows liquid position of firms in terms of a basket of cash, Gives relevant infor for, Making future decisions, Assessing present position of the firm, Evaluating firms past position, Model is allocation free, No additivity prob, Eliminates timing problem & measurement error, Basis for contemporary "mark-to-market" rule, Emphasizes a BS in terms of adaptive capital which means NRV, If environment changes, then firm must liquidate and replace with new assets to survive, No distinction made btwn operating and holding activities, No distinction btwn realized and unrealized profits, Periodic profits shud include net effect of GPL changes

Limitations, Based on a liquidation concept, Absence of markets vs assets in use, Aggregation problem (BS), Problems interpreting BS, NRV don't predict future earnings

Criticisms, A new and too radical system, Subjectivity is hnacceptable, Value and use are completely ignored meaning FA can exist with zero value, E&B rejected NRV becoz it abandons going concern assumption, Sterling rejected Business income becoz it didn't reflect sacrifices ( opportunity cost)

Current Cost Accounting

Additional concepts used in CCA model

Uses mixed values, Value to the business, Deprivation value (RC) accounting

Major premises underlying: assets held for use or for resales

Multiple values approach, Each decision requires diff valuation, Upper limit to an asset's value is RC(deprival value), This is a foundation of value to the business concept, Possible 3 valuation bases, RC, PV, NRV, Thus, 6 combinations are feasible, Use case, PV > RC > NRV (RC wins) PV > NRV > RC (RC wins) RC > PV > NRV (PV wins) NRV irrelevant, max RC, Resale case, NRV > PV > RC (RC wins) NRV > RC > PV (RC wins) RC > NRV > PV (NRV wins) PV irrelevant, max RC

General requirements of CCA

Limited to very large firms classified by, Inventories and FA, Total assets after depreciation

Considered supplementary and not subject to audit

5 key features, 1. Disclosure focused on GPP & CC data, CD info, Income from continuing operations (incl adj CoGS, dep but excl PP g/l, PP g/l on NMA, NA at YE, HC CD amts for inventory and pipe, Current cost info, Income from continuing operations (COP), NA at YE (mixtures of values), CC amts for inventory and PPE, Total cost changes for inv & PPE net of inflation ( specific price changes, RHG, UHG, RRHG, RUHG), 2. Value to biz, 3. Adj made to obtain income from continuing operations on a current cost basis, COGS adj, Dep adj, No monetary WC adj, No gearing adj, 4. No BS was required, 5. Dual concept of CM (FC & PC)


Ambiguous valuation rule which is contradictory, Concerned with use of value data for decisions abt buying, selling, and holding yet model measures past results

Deprival value is hypothetical, Entity assumed to be deprived of assets, but what abt people who want info from an on-going entity

Mixture of asset values and the additivity prob in computing CV income

Do firms adapt instantaneously to MP?

Individual purposes seem to be satisfied but what about overall utility?, No segregation of operating profits from HG, Does contribute to CV BS, Can be implemented to multiuser groups in practice

Dismissal of CCA

INFO useless, HC adequate

Info useful, but users inadequate

Info useful, but measurements inadequate

Info wld b useful, but wrong info disclosed

Info is useful, but empirical models are inadequate