Current Cost Accounting
Current cost accounting is an accounting standards method that values assets, liabilities, and equity at their current replacement cost rather than their original purchase price. This approach aims to provide a more accurate representation of a company's financial position and performance, particularly during periods of significant inflation. By adjusting the value of non-monetary assets to reflect their present-day cost, current cost accounting seeks to measure true economic income and facilitate better decision-making for management and investors.
History and Origin
The concept of accounting for changing prices gained prominence during periods of high inflation in the 1970s, as traditional historical cost accounting failed to reflect the real economic position of companies. In the United States, this led to the Financial Accounting Standards Board (FASB) issuing Statement No. 33, "Financial Reporting and Changing Prices," in September 1979. FAS 33 required large public enterprises to disclose supplementary information on the effects of changing prices, including both general inflation (constant purchasing power) and current cost data, without altering their primary financial statements7, 8.
The purpose was to provide users of financial reports with a clearer picture of financial performance under inflationary conditions. The Securities and Exchange Commission (SEC) also supported this initiative, emphasizing the importance of such information for resource allocation and investor understanding6. However, the mandate for current cost accounting was eventually rescinded due to complexity, high implementation costs, and a subsequent decline in inflation rates. Despite its limited mandatory application, the underlying principles continue to be relevant in discussions about the impact of price changes on financial reporting.
Key Takeaways
- Current cost accounting revalues assets and liabilities at their present replacement cost, offering a more contemporary view than historical cost.
- It aims to mitigate the distorting effects of inflation on financial reporting, particularly concerning non-monetary assets like property, plant, and equipment.
- This method can provide a more realistic measure of a company's maintainable operating profit and loss and its true economic capital maintenance.
- While not widely mandated today, its principles remain relevant for internal management decisions and in certain specialized industries or high-inflation economies.
Formula and Calculation
Current cost accounting involves adjusting the book values of certain assets and expenses to their current replacement costs. The core idea is to measure the resources consumed at their current value rather than their historical cost.
For example, to calculate current cost depreciation, the formula would be:
Similarly, for the cost of goods sold, the adjustment would reflect the cost to replace the inventory at the time of sale:
When preparing a current cost balance sheet, non-monetary assets are revalued. The revaluation surplus (or deficit) is recognized directly in equity, reflecting the change in the economic value of the assets.
Interpreting the Current Cost Accounting
Interpreting financial statements prepared using current cost accounting requires focusing on the economic reality they aim to convey. Unlike historical cost, which reflects past transactions, current cost accounting provides a measure of what it would cost to replace the productive capacity of the entity today.
For example, a company's income statement prepared under current cost accounting would show a "current cost operating profit" that is derived after deducting the current cost of resources consumed, such as cost of goods sold and depreciation. This profit figure is often lower than historical cost profit during inflationary periods, as it reflects the higher cost of replacing used assets and inventory. This lower profit can be a more realistic indicator of how much a company can distribute as dividends while still maintaining its operating capacity. Furthermore, a current cost balance sheet reveals the up-to-date value of a company’s physical assets, providing a more relevant picture for evaluating its net worth and future investment needs.
Hypothetical Example
Consider a small manufacturing company, "Widgets Inc.," that purchased a machine five years ago for $100,000. Under historical cost accounting, its annual depreciation (assuming a 10-year useful life) would be $10,000. Now, imagine that due to inflation and technological advancements, the current cost to replace that exact machine (or its equivalent productive capacity) is $150,000.
Under current cost accounting, Widgets Inc. would adjust the machine's value on its balance sheet to $150,000. The accumulated depreciation would also be adjusted based on this new current cost. If five years have passed, half of its useful life, the accumulated depreciation would be 50% of $150,000, or $75,000. Therefore, the net book value of the machine would be $75,000 ($150,000 current cost minus $75,000 accumulated current cost depreciation).
For the current year's depreciation expense, instead of recording $10,000 (historical cost / 10 years), Widgets Inc. would record $15,000 ($150,000 current cost / 10 years). This higher expense would result in a lower reported profit, which more accurately reflects the real cost of maintaining the company's productive capacity in an inflationary environment.
Practical Applications
While not universally mandated for primary financial reporting today, the principles of current cost accounting find practical applications in various areas. Businesses often use current cost information internally for strategic planning, pricing decisions, and performance evaluation, especially in industries with significant physical assets or volatile input costs. Understanding the current replacement cost of productive assets helps management determine appropriate reinvestment levels and assess the true profitability of operations.
Moreover, economic analysis often considers current cost principles. For instance, the Federal Reserve Bank of San Francisco has discussed how inflation impacts corporate profits, highlighting the distinction between nominal and real earnings—a distinction that current cost accounting aims to address. In5ternational bodies like the International Monetary Fund (IMF) have also analyzed the broader implications of inflation for financial reporting, underscoring the importance of understanding the real value of monetary assets and non-monetary items. Th4is perspective helps policymakers and economists gauge the true health of industries and economies, particularly when price levels are changing.
Limitations and Criticisms
Despite its theoretical advantages in reflecting economic reality, current cost accounting faces several significant limitations and criticisms. A primary challenge is the subjectivity and difficulty in accurately determining the current replacement cost of every asset and liability. Market prices for identical assets may not always be readily available, especially for specialized equipment, land, or unique inventory items, requiring estimations that can introduce bias and reduce verifiability. This complexity can lead to higher preparation costs and potential inconsistencies across companies.
Furthermore, the adoption of current cost accounting has historically been resisted due to its perceived departure from the principle of verifiability inherent in historical cost. During the periods of high inflation in the 1970s, many companies found the requirements of FASB Statement No. 33 burdensome to implement, which contributed to its eventual suspension. Cr2, 3itics also argue that while it accounts for price changes in specific assets, it does not fully address the impact of general purchasing power changes on all monetary items, which some believe is equally, if not more, important for a complete picture of inflation's effects. The challenge of integrating current cost data with financial analysis and reporting also remains a practical hurdle. Financial market participants, including investors, sometimes struggle to fully integrate the adjusted figures into their decision-making processes, preferring the simpler, more objective historical cost basis, even if less economically accurate.
#1# Current Cost Accounting vs. Historical Cost Accounting
The fundamental difference between current cost accounting and historical cost accounting lies in their valuation basis. Historical cost accounting, the most common method, records assets and liabilities at their original purchase price. This method is praised for its objectivity and verifiability, as the cost is based on actual transaction data. However, during periods of significant inflation, historical cost can lead to an overstatement of profits (due to lower depreciation and cost of goods sold) and an understatement of asset values on the balance sheet, misrepresenting a company's true financial health and ability to replace its assets.
Current cost accounting, in contrast, attempts to mitigate these distortions by revaluing assets and expenses based on their current replacement cost or fair value at the reporting date. This provides a more economically relevant picture of a company's performance and position, reflecting the real resources required for its operations. While current cost offers greater relevance, it sacrifices a degree of objectivity due to the subjective nature of determining current replacement values. The choice between these methods often boils down to a trade-off between relevance and reliability in financial reporting.
FAQs
Why is current cost accounting not widely used today?
Current cost accounting is not widely used for primary financial statements because of its complexity and the subjective nature of determining current replacement costs, which can reduce the comparability and verifiability of financial reports. Additionally, the periods of high inflation that prompted its consideration have generally subsided in major economies, lessening the immediate perceived need for such a comprehensive system.
How does current cost accounting affect a company's reported profits?
During inflationary periods, current cost accounting generally results in lower reported profits compared to historical cost accounting. This is because the cost of goods sold and depreciation expenses are calculated based on higher current replacement costs, rather than lower historical costs, leading to a more realistic measure of distributable income and sustainable profit and loss.
What types of assets are most impacted by current cost accounting?
Non-monetary assets are most impacted by current cost accounting. These typically include fixed assets like property, plant, and equipment, as well as inventory. Monetary assets (like cash or receivables) are not typically revalued under current cost accounting, as their value is already expressed in current monetary units.