EXIT PRICE ACCOUNTING

1. EXIT PRICE ACCOUNTING Prepared by: Ms. NARIMAH HASHIM Jabatan Perakaunan & Kewangan, FEP Universiti Putra Malaysia. NHashim....UPM....6.3.2007

2. EXIT PRICE ACCOUNTING • Most influential names associated with exit price accounting (EPA) are Raymond Chambers (1966) & Robert Sterling (1970) • An earlier advocate for EPA but not taken seriously was Kenneth MacNeal (1939) • MACNEAL’S ARGUMENT: • The accounting that exists today is the result of primitive conditions that no longer can be found in present times NHashim....UPM....6.3.2007

3. PHASES IN ACCOUNTING HISTORY MacNeal divided into 3 phases: • First era = 12th century to 17th century • Second era = 16th and 19th centuries • Third era = 20th and 21st centuries PERIOD DURING THE FIRST ERA: • Focus of accounting on the needs of the sole proprietor or owner-managed business • Especially in the Middle Ages, a business is likely to be a specific venture or a particular project • Project /venture are generally risky NHashim....UPM....6.3.2007

4. ACCOUNTANT’S TASK IN Ist. ERA • An accountant’s main task was to keep track of the total cost to date, so that the profit or loss can be ascertained at the end of the venture • Accounting provide information for the owner-manager whose primary interest is in cost determination • Cost is original or historical NHashim....UPM....6.3.2007

5. PERIOD DURING THE 2ND ERA: • Business firms were more established and less risky • Greater demand and supply of credit for business • Conditions for loans: • Creditors generally require a statement of net worth & earnings • Prepared by an independent accountant • Giving rise to ‘public accounting’ as a profession NHashim....UPM....6.3.2007

6. USERS OF FINANCIAL STATEMENTS • Accountants prepared financial statements mainly for 2 interested users: • The owners of the business – who runs the business and knows all of its details • The creditors - interested in the ability of the owner to pay back the loan when due - concerned with the ‘overstatement’ of financial reports NHashim....UPM....6.3.2007

7. PERIOD IN 2ND. ERA • Accountants tasks: To prepare conservative financial reports that can satisfy both parties • Creditors were comfortable if business owners understate their net worth & earnings • Towards the end of this period – a new form of doing business was ushered in i.e. companies, having shareholders as owners and a separate team hired for managing the business operations NHashim....UPM....6.3.2007

8. PERIOD DURING 3RD. ERA • Firms grew larger and larger • Mortgages were split into smaller segments and sold as debentures to ordinary investors • Shareholders have no knowledge of the business except what is reported in the financial statements or through the media • Accountants, main task: Stewardship & accountability NHashim....UPM....6.3.2007

9. MacNeal’s observations in 1939: • Conventional accounting do not serve the decision oriented investors well • Contains misleading & sometimes false information • Shareholders do not know the current values of the companies assets and were taken advantage of those with inside information • Accountants follow principles that were based on historical cost NHashim....UPM....6.3.2007

10. MacNeal’s conclusion: • Accountants should report all profits, losses & values as determined in competitive markets • Marketable assets should be valued at market price (exit price) • Non-marketable but reproducible assets should be valued at replacement cost • Non-marketable & non-reproducible assets should be valued at original cost • Income should include all profits and losses, whether realized or not NHashim....UPM....6.3.2007

11. CHAMBER’S COMPREHENSIVE PROPOSAL • He calls it “Continuously contemporary accounting” or CoCoA • He regards the business firm as an ADAPTIVE ENTITY engaged in buying and selling goods & services • Adaptive behavior implies the firm’s continual attempt to adjust to the competitive environment for the purpose of survival as well as to reach a certain level of satisfaction NHashim....UPM....6.3.2007

12. CoCoA • Managers make decisions for the business with the owners’ interests in mind • Owners regard the business as an instrument to increase their wealth measured in terms of their purchasing power i.e. their command over goods and services NHashim....UPM....6.3.2007

13. CoCoA • The condition for the firm’s existence is its ability to satisfy the expectations of all interested parties i.e. the owners, customers, creditors & employees • They are all interested in cash receipts for themselves from their associations with the business • To continue in business, firms must engaged in transactions and this is revealed by their financial positions NHashim....UPM....6.3.2007

14. What is Financial Position? • Financial position = relationship between the monetary value of the firm’s assets & its liabilities and owners’ equity at a given point in time • Time = present which means only current money amounts have the immediate bearing on the capability of the firm to operate its activities • The monetary value of assets & liabilities = market prices because it can be objectively determined NHashim....UPM....6.3.2007

15. Market price versus Selling Price • Market price = purchase price & selling price • However, purchase price (or current cost) does not reveal the firm’s capability to go into the market with cash to carry out its activities of selling & buying but selling price does • Selling price = realizable price of an asset on the basis of an orderly liquidation = current cash equivalents NHashim....UPM....6.3.2007

16. CASH POSITION • For survival purposes, the firm depends on the amount of cash at its command • When a firm purchases assets, it cash balance is reduced as well as its capability for adaptation • When it purchases assets on credit, it reduces the firm’s ability to obtain further credit NHashim....UPM....6.3.2007

17. CONCEPT OF ADAPTIVE BEHAVIOR • Concept of adaptive behavior sees the firm as always being ready to dispose of its assets if this action is in the best interest of the firm • The firm will keep its assets only if the present value (discounted) of the future net cash flow from the use of the assets is greater than the present value of the expected net cash flow from an alternative investment of the exit value of the asset • Its an opportunity cost concept which is the selling price not the replacement price of the assets NHashim....UPM....6.3.2007

18. Chamber’s conclusion: • Adaptive behavior requires the knowledge of the cash and current cash equivalents of the firm’s net assets • In principle, every asset has 2 types of value: value in exchange (market value) & value in use NHashim....UPM....6.3.2007

19. MARKET VALUE • Represents the firm’s capability to buy things and pay debts at a given date • It is relevant to all courses of action • It is determined by the market not the owner • It is therefore objective & understandable to every one NHashim....UPM....6.3.2007

20. VALUE IN USE • Represents beliefs about the future, not facts of the present • It is personal to the owner & the firm • It is subjective, not interpretable & understandable to others without full explanation of the expectation NHashim....UPM....6.3.2007

21. STERLING’S EXIT PRICE ACCOUNTING • There is one superior method to determine income • That is the difference between capital at 2 points in time excluding additional investments by and distributions to owners • The problem with income measurement is valuation • He uses the decision making model of a wheat trader NHashim....UPM....6.3.2007

22. 3 DECISION PROBLEM • A wheat trader faces 3 decision problems: • The continuing decision to enter and stay in the market • The continuing decision to hold cash or wheat • The evaluation of past decisions NHashim....UPM....6.3.2007

23. Relevan informatIon for decision-making • The relevant information required to make the decision: • The expected future price of wheat • The expected future price of other alternatives • The present price of wheat • The present price of other alternatives NHashim....UPM....6.3.2007

24. Relevan information for Decision making • The price at the last evaluation • The quantity of wheat & money at the last evaluation • The present quantities STERLING’s conclusion: The present price of wheat is the one item of information relevant to all decisions NHashim....UPM....6.3.2007

25. Advantages of Market Price • The present market price is superior to all other methods of valuation because: • Relevant to all users • Reliable • Empirical meaningful • Additive = that the sum of parts is equal to the independent measurement of the whole NHashim....UPM....6.3.2007

26. Advantages of Market Price • Temporarily consistent, all measurement is at a single point in time • A valuation, in that the trader desires their selected position more than the others • More informative, because it indicates the direction of the trader’s expectation NHashim....UPM....6.3.2007

27. ADVANTAGES OF EXIT PRICE • ADDITIVITY • Chamber:The key factor to support CoCoA • An appropriate unit of measurement for financial reporting purposes = add, subtract & divisible • The valuation of all elements in the financial statements is at their money equivalents (exit values) • It is self consistent NHashim....UPM....6.3.2007

28. 2. ALLOCATION • Positive feature according to Thomas: all financial statements are allocation free • The P&L account is a report of asset inflows and changes in exit values of a firm’s assets & liabilities in a given period • Net income is the amount of change in purchasing power NHashim....UPM....6.3.2007

29. Advantages of exit price • REALITY • Exit price accounting have references to the real-world examples • Every figure have a present , actual market price • Depreciation is defined in the economic sense not the accounting sense NHashim....UPM....6.3.2007

30. Advantages of Exit Price • If no realizable value can be attributed to an item , then it will have zero balance e.g.WIP. Its cost can be written off • Exchangeability and severability are the 2 constraints for the definition of assets 4. OBJECTIVITY • Research studies indicate that market prices are more objective than what most people believe NHashim....UPM....6.3.2007

31. CRITICISMS OF EPA • PROFIT CONCEPT • To measure profitability in a given period means the effectiveness of actual performance of the company’s utilizing the resources entrusted to them • Bell’s (a CCA advocate): Requires an evaluation of expected plans against actual outcome NHashim....UPM....6.3.2007

32. Profit Concept • If exit price is used, the plan will always be short term maximizations of cash equivalents of net assets on the balance sheet against current revenues • This is possible in the simple model of the wheat trader • To determine the relative success or failure of the firm - must compare with past performances NHashim....UPM....6.3.2007

33. RELATIVE SUCCESS • Accounting measures past events thus provide the information of what actually happened but using exit price does not provide the relevant information to match against revenues • According to Weston (a supporter of HCA): For a typical manufacturing or service company, investors & management requires answers to the following questions: NHashim....UPM....6.3.2007

34. Questions? • How much better off is the company at the end of the year compared with the beginning of the year? • Exit price accounting provides relevant information only if the company plans to liquidate its assets • If the company plans to continue in business, the information is not relevant • So preparing financial statements using exit price basis as primary published data is unnecessary for its an unrealistic decision in the real world NHashim....UPM....6.3.2007

35. Questions? • How did the company achieve this? With respect to what and how that form the significant aspects of management performance • Using exit price is no help at all. Because inventories are restated at exit price, no meaningful gross profit figure can be obtained NHashim....UPM....6.3.2007

36. Insufficient Information • Instead emphasis is now on the changes in prices • Not enough information to show how the company moved from one status at the beginning to the status at the end of the period NHashim....UPM....6.3.2007

37. Questions? • How does the performance of the company compare with that of other companies? • This question is important to investors • All accounting systems failed in this aspect • Exit price too - for the important comparative data like purchases, production and sales are buried in the price changes section NHashim....UPM....6.3.2007

38. Comparability • Exit price supporters believe that it provides comparable accounting reports because: (a) Comparing the balance sheets of different companies will determine which company has the greatest adaptability to changing market conditions by virtue of having the highest cash equivalents NHashim....UPM....6.3.2007

39. Comparability (b) P&L accounts can be compared to show which company increased the purchasing power of their net assets more or less than others • Exit price advocates argue that conventional accounting does not facilitate comparability because it does not incorporate the effect of changing prices on the firm NHashim....UPM....6.3.2007

40. Questions? • How will the company perform in the future? • How will all this affect the yield of the investors? • All accounting systems are deficient in this aspect, they are backward looking and not future oriented NHashim....UPM....6.3.2007

41. For Exit Price • But exit price reports the purchasing power of the firm’s net assets so their supporters argue that their system provide information that can help assess the firm’s ability to survive and adapt to changing economic environment • Critics argue that it does not report how well the firm will perform under any set of circumstances since this is dependent upon management decisions not just adaptive capacity NHashim....UPM....6.3.2007

42. VALUE IN USE VERSUS VALUE IN EXCHANGE • Both supporters of HCA (measured by acquisition cost) & CCA (measured by current cost) accuse EPA of ignoring the concept of value in use • Solomon’s belief that if the asset is not for sale does not directly cause its owner to suffer if the exit price drop unless the drop in price is related to expectation NHashim....UPM....6.3.2007

43. VALUE? • Value is related to expectation, & there is no expectation to sell for what is more relevant here is ‘value to the owner or the firm’ • Solomon argues that for non-marketable fixed assets which are highly specific to a particular firm and represent an excellent investment to the business, & have no alternative use outside the business, exit price suggests that the firm record a loss because of no resale value, is absurd NHashim....UPM....6.3.2007

44. NO RESALE VALUE? • How can a sound investment be recorded as a loss? • Solomon argues that if there is no value than Exit Price fails to record an economic event • On the other hand, if Exit Price represent an opportunity cost, it is also unjustified • The opportunity cost of using an asset is obtained from the value forgone of the next best alternative, which is not necessarily to sell it NHashim....UPM....6.3.2007

45. CURRENT USE VERSUS FUTURE USE • Often, the next best alternative is current use versus future use • Solomon argues that the opportunity cost of using an asset now should be determined by the loss of future cash flows resulting from present use rather than future use NHashim....UPM....6.3.2007

46. SEVERABILITY • A precondition to exit price accounting is that assets be severable (can be sold separately) • If otherwise, it does not help the firm to adapt to changing environment • Critics conclude: that EPA consider exchangeability as the only way to determine value • An assets according to the critics have value in use to the business rather than value in a sale NHashim....UPM....6.3.2007

47. ADDITIVITY • According to EPA, for a measurement to be objective it must be based on past & present events • Thus Chamber’s current cash equivalents of assets is determined by a gradual and orderly liquidation NHashim....UPM....6.3.2007

48. Force Liquidation • According to them anticipatory calculations cannot be added together with current figures • Critics argued that assets sold immediately in a forced liquidation has value different from the value from a gradual & orderly liquidation • Thus exit price model violates the principle of exclusion of anticipatory calculations in determining the current cash equivalents of assets NHashim....UPM....6.3.2007

49. Varying Values? • Other critics, Larson & Schattke (1966): assets sold separately or as a package will have different values or using different procedures for selling them • Selling assets as a package or in a gradual & systematic procedure, may fetched a higher price, but exit price ignores this possibility • Thus they conclude that current cash equivalents are not additive & do not give consideration to intangible factors NHashim....UPM....6.3.2007

50. CRITICISMS • Another critic, Staubus argues that different measurement methods applied to an asset are surrogates of its present value • Although imperfect, does not mean they are useless • Even realizable value is not useful information unless it can be relied on as a representative of what can or will happen NHashim....UPM....6.3.2007