UNIT 5: MODELS OF ACCOUNTING

Contents
5.0 Introduction
5.1 Objectives
5.2 Historical Cost Accounting
5.3 Exit Price Accounting
5.4 Summary
5.5 Answers to Learning Activity
5.6 Answers to Check Your Progress Questions

5.0 INTRODUCTION

In the previous unit, you have learnt about the different theories of accounting which address
the perspectives from which accounting concepts, procedures, and rules are developed. This
unit is concerned with the alternative models of accounting, such as historical cost accounting,
current cost accounting, and exist price accounting. While historical cost accounting, and exist
price accounting are discussed in this unit, current cost accounting will be explained in unit 7.

5.1 OBJECTIVES

After completing this unit, you will be able to:

- understand the basic concepts of historical cost accounting model, its advantages and
limitations,
- understand the basic concepts of exit price accounting model, its advantages and
criticism.

5.2 HISTORICAL COST ACCOUNTING

5.2.0 Overview
The rationale for financial accounting, with its use of historical cost for valuation of non-
monetary assets, has come from several sources. This section focuses on the theory of
historical cost as it relates to the conventions and practices that have been adopted by

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accountants over several years. Recently, the attempts to codify and improve practice by
providing a conceptual framework have created the potential to affect the application of
historical cost practices.

5.2.1 Objectives
After completing this section, you should be able to:
- understand the basic concepts of historical cost accounting
- describe arguments in favor of historical cost accounting
- understand the limitations or criticisms of historical cost accounting

5.2.2 Basic Concepts

5.2.2.1 Objective of Accounting
Accounting information is the major source of information about the firm. In corporate form
of organizations, the ownership and control are separated. Absentee owners do not have first
hand knowledge about the operations and conditions of the firm. Therefore, they must depend
on accounting reports for information. Owners and creditors are considered external to the
organization. Both groups do not have access to the records, and accounts of the entity.
Managers have stewardship function in the organization. The accountability is critical in
historical cost accounting.

Owners and creditors are primarily concerned about what management has done with the
funds entrusted to them. The objective of accounting under historical cost accounting is
stewardship for owners and creditors. This objective emphasizes the ‘contractual’ relationship
between a firm and those who provide to it.

According to historical cost accounting model, net worth is not a relevant measure. Thus, the
determination of income is the most important function for the accountant.

5.2.2.2 Income
According to historical cost accounting, accounting exists as a means of computing income.
Revenues, expenses, and income are viewed as a measure of behavioral attributes. Revenues
indicate the accomplishments of the firm for a given period of time. Expenses represent the
efforts expended. Income, which is the difference between revenues and expenses, correlates

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with the effectiveness of the firm as an operating unit. Of course, the firm cannot act of its
own accord, rather it is really the management that makes the decisions for the entity.
Therefore, income is a measure of the performance of the managers in handling the resources
entrusted to their care and use.

Under historical cost accounting, the most important financial report is the income statement
because it shows the results of the operations of the enterprise. The balance sheet is not as
important as income statement. It serves merely as a “connecting link joining successive
income statements into a composite picture of the income stream.” This income stream
reflects the earning power of the firm. The earning power is the basis of value for the
enterprise.

5.2.2.3 Costs attach theory

The ways in which costs are measured are different in accounting and economics. Traditional
accountants believe that it is justifiable to use historical cost even if the replacement costs
have risen. On the other hand, economists argue that the replacement costs should be
considered.

The ‘costs attach’ theory is formulated to encounter the argument of the economists and to
rationalize what is done in accounting. According this theory, there are two types of cost;
namely, displacement cost and embodied cost.

Displacement cost represents what has been given up or scarified. It is synonymous with
opportunity cost.

Embodied cost, also called absorption cost, relates to the factors of production. It is related to
what has been spent on inputs rather than what has been forgone.

To illustrate, assume that a company manufactures product X. Each unit of product X takes 2
units of raw material A for which the company paid Br. 5.00 per unit. The Br. 5 attaches to
that unit of A. As A is used in production of X, the Br. 5 now attaches to X. In order to
determine the cost of product X, you simply add up all the attached costs to X, such as raw
material, labor and overhead.

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5.2.2.4 Flow of costs
The accountant must keep track of the flow of costs. i.e. they must keep account of the
operations of the business. As the firm purchases goods and services, the task of the
accountant is to trace the movement of costs as they flow through the business. In order to
calculate profit, the proper amount of costs must be determined. In other words, the
accountant must determine which expired costs are to be matched against revenues in the
income statement. Similarly, the accountant must decide which costs are Unexpired and are to
be placed on the balance sheet as assets.

Matching principle is of critical importance in historical cost accounting which guides the
accountant in deciding which costs are to be considered expenses. Cost allocation is at the
heart of historical cost (conventional) accounting.

5.2.3 Defense of historical cost

Many have attached the use of historical cost in historical cost accounting. Others, however,
strongly support historical cots. The arguments of those who support historical cost are
described below.
1. Historical cost is relevant in making economic decisions
Data on past transactions help managers in making decisions concerning future commitments.
Since managers must review their past efforts, historical cost serve managers as a measure of
there efforts. Historical cost is directly related to past decisions. Historical cost affects the
evaluation and selection of decision rules. It provides input to the ‘satisfactory’ notion.
Historical cost is used by managers because it is imposed on the decision maker by the
environment.

2. Historical cost is based on actual transaction

Historical cost is not merely possible transactions. Under historical cost accounting, a record
of the actual transactions is made and hence provides a supporting record of the figures on the
financial statements. Historical cost provides the evidence for determining how effectively
management has met its responsibilities. Records of past transactions are necessary for
accountability. As long as accountability is important and historical cost must be utilized.

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 3. Financial statements based on historical cost have been found to be useful
throughout history
If those who make management and investment decisions had not found financial reports
based on historical cost useful over the years, changes in accounting would long since have
been made.

4. The best understood concept of profit is the excess of selling price over historical
cost.
The notion of profit is accepted as a measure of successful performance. The pursuit of profit
requires that sufficient utility of time, place, and form be added to the materials,
products/services purchased so that they can be sold above cost. Decisions on whether to
continue a product line or division or plant depend on whether there is a favorable speed
between revenue and cost. People understand this basic notion of business success.

5. Accountants must guard the integrity of their data against internal modifications.
Most argue that historical cost is less subject to manipulation than current cost or selling
price. Current prices are wholly outside of the prior decisions and the recorded experience of
the enterprise. The determination of the fair presentation is possible only with historical cost.

6. The usefulness of income information based on current cost or exit price is

questionable.
Current costs may be greater than historical cost. Such variations in market prices is difficult
to measure as income especially when the asset is not intended to be sold.

7. Changes in market prices can be disclosed and supplementary data

Supporters of historical cost argue that historical cost does not differ martially from current
cost. Supplementary data on current prices are a practical and sufficient way of dealing with
such information without having to shift from historical cost to a current cost basis.

8. There is insufficient evidence to justify rejection of historical cost accounting

According to traditional accountants, there is no persuasive empirical evidence that indicates
that current cost or exit price accounting information is more useful than historical cost
information.

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5.2.4 Criticism of historical cost accounting
Although it is important in many respects, historical cost accounting is not without limitation.
Some of them are described below:
1. The objective of accounting is relatively narrow
The objective of accounting under historical cost accounting is to provide useful information
for economic decision-making. The history of accounting shows that the primary role of
accounting is to meet the decision- making needs of users. This objective is construed mean
furnishing information on the stewardship function of management. A decision-usefulness
approach calls for a ‘forward-looking position rather than a preoccupation with the past.
Besides, information on the stewardship function does not necessarily restrict accountability
to the original amount invested directly or indirectly by equity holders.

2. Historical cost is insufficient for the evaluation of business decisions

According to the proponents of historical cost accounting, management needs historical cost
data in order to evaluate their past decisions. However, whether a past decision was right or
wrong must ultimately be ascertained by what happens in the market place. A proper
evaluation of past decisions must entail a division of the total profit in a given period between
profit from operating activities and gains (or losses) due to holding assets or liabilities.
Furthermore, the operating profit and holding gains must be separated into the element of that
was expected and the element that was surprise.

3. Historical cost overstates income in time of rising prices.

During inflation (rising prices), income is overstated because it offsets historical costs against
current (inflated) revenues. The income figure under historical cost may deceive management
to the extent that dividends paid could exceed annual ‘real’ income and erode the capital.

4. The relevance of historical cost for decision making is questionable

Cost is not a fundamental tent of accounting. There are exceptions to costs such as the lower
of cost or market (LCM) and net reliable value for inventories. Due to this, the rationale of
historical cost is flawed.

5. The basis of historical cost is realistic

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The utilization of historical cost is justified on the ground of ‘going concern’ assumption. The
supposition is that the life of the firm is indefinite so that normal expectations concerning the
non-monetary items will be fulfilled. Fixed assets are assumed to be employed in the business
fully.

However, no business has ever continued ‘indefinitely’ into the future. It would seem more
reasonable to assume cessation instead of continuity.

Learning activity 5 – 1

1. What is the objective of accounting under historical cost accounting?

2. Under historical cost accounting, revenues, expenses, and income are viewed as
______________
3. Under historical cost accounting, the accomplishment of the firm is indicated by
________________
4. Under historical cost accounting, efforts expended in the firm are indicated by
___________________
5. The effectiveness of the firm in historical cost accounting is indicated by
___________________
6. What is the most important financial report under historical cost accounting?
7. ___________ Costs are related to the factors of production.
8. Mention some of the advantages of historical cost accounting.

5.3 EXIT PRICE ACCOUNTING

5.3.0 Overview
In the previous section, you have learnt about historical cost accounting, and the arguments in
favor and against historical cost accounting. This section is concerned with exit price
accounting which is the second model of accounting. Specifically, you will learn about exit
price accounting in terms of the support for and against it.

5.3.1 Objectives

After completing this section, you should be able to:

- describe the arguments in favor of exit price accounting

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 - understand the criticism against exit price accounting.

5.3.2 Arguments in support of exit price accounting

An early advocate of exit price accounting was Kenneth MacNeal. He contended that
conventional accounting principles do not serve the decision – oriented investor well. They
provide financial statements that may be misleading or false. Many investors are unable to
learn the current values of the assets of the companies they have invested in. MacNeal
suggested that marketable assets should be valued at market price (exit price), non marketable
reproducible assets are valued at replacement cost, and occasional non-marketable no
reproducible assets are valued at original cost. According to him, income should include all
profits and losses whether realized or not.

Raymond chambers was another scholar who supported exit price accounting. He presented a
comprehensive proposal for exit price accounting, which he calls “continuously”
contemporary accounting (COCOA). According to him, the business firm is an adaptive entity
engaged in buying and selling goods and services. It is governed by the decisions of its
managers who are cognizant of the objectives of the owners. Owners consider the firm to be
an instrument by which they hope to increase their wealth. The notion of adaptive behavior
implies a continual attempt to adjust to the competitive business environments for the sake of
survival. It also implies a continual effort to reach a given level of satisfaction.

The firm cannot satisfy itself, according to chambers but through its managers it becomes
aware of the expectations of the interested parties associated with it, such as owners,
customers, employees, and creditors. A condition of a firm’s existence is that the expectations
of all interested in cash receipts to themselves from their association with the firm.

Chambers argue that a firm must have the capability to engage in transactions to continue in
business. This capability is revealed by its financial position. Financial position refers to the
relationship between the monetary value of the firm’s assets and its liabilities and owners
equity at a given point in time. That time must be present because only current money
amounts have a bearing on the immediate capability of a firm to operate its business.

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Chambers stated that the monetary values of assets and liabilities can be determined
objectively by reference to market prices (i.e. the purchase price and selling price). The
purchase price or current cost does not reveal the firm’s capability to go into market with cash
for the purpose of adopting itself to present condition, but the selling price does. The selling
price of non-monetary assets is the asset’s realizable price on the basis of an orderly
liquidation. According to chambers, market selling prices of non monetary assets are used not
because we expect a company to sell any of its assets, but because that is the only way to find
the cash equivalents of assets. In the final analysis, the survival of the firm depends on the
amount of cash it can command. Therefore, Raymond chambers is in favor of the exit price or
the selling price.

Another influential scholar who is in the favor of exit price accounting is Robert Sterling. He
believes that there is one method to determine income that is superior to all others. According
to him, income is the difference between capital at two points in time exclusive of additional
investments by and distributions to owners. He pinpointed that the problem of income
measurement is valuation.

Sterling argues that a valuation method that yields more information is superior to others that
yield less information. This is the best criterion to decide the valuation method that is the best
for the determination of income. The primary consideration is the information content of each
valuation method. Information content pertains to the relevance and reliability (verifiability)
of information.

According to Sterling, to be relevant, information must be useful in the decision models of

accounting report users. The decision models, in turn, enable users to decide which course of
action to take from several alternatives. In communicating information, it must be recognized
that different users may be faced with different decisions and may employ different decision
models. If there were no constraints, information could be gathered that was relevant to each
urge for their given problem and decision model. But constraints do exist because information
production resources are scarce and costly. Given the constraints, the decision must be made
as to what information to report to users. It is the decision model that reveals what
information is relevant. Therefore, the problem is to select the appropriate decision model.

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Sterling concluded that the present price of item is one item of information relevant to all the
decisions. The others are relevant to all the decisions. The others are relevant to one or more,
but not all, decisions. Even when the assumption of perfect competition and stable prices is
relaxed, the present market (exit) price is found to be superior. He stated that the present
market price method of valuation is:
- relevant to all users
- reliable
- empirically meaningful
- additive (the sum of the parts is equal to the independent measurement of the whole)
- temporarily consistent (All measurement is at a single point in time)
- a valuation
- more informative

5.3.3 Other advantages of exit price accounting

Besides, the arguments made in favor of exit price accounting earning, the following points
worth mentioning:

1. Additivity
The question of additiivty is the key factor in support of exit price accounting. The primary
products of an accounting systems are financial statements (i.e. income statement and balance
sheet). Assets are acquired at different times. Liabilities are incurred at different times. No
practical or commercial meaning can be generated by adding together different amounts. It is
difficult to obtain meaningful balance sheet. If exit prices (current market prices) are used, it
is like figures that are added and resulting financial reports are meaningful.

2. Allocation
Under historical cost accounting, the cost accounting systems rely heavily upon cost
allocation for asset valuation and income determination. The positive feature of exit price
accounting is that the financial statements are allocation free. The income statement is not a
report of changes in allocated amounts, but of net inflows and changes in the exit value of a
firm’s assets and liabilities in a given period. Net income shows the amount of change in

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purchasing power of the net assets, excluding additional investments by and distributions to
owners.

3. Reality
Exit price accounting involves real-world referents because every figure refers to a present,
actual market price. The two major constraints in exit price accounting for valuation are
exchangeability and existence of a selling price with these two constraints, all items on the
financial statements can be corroborated by real world evidence.

4. Objectivity
Objectivity was defined, by James Parker, a consensus among values and comparability as a
consensus in measurements. For measures of objectivity and comparability, exit values are
found to be more objective than historical (book) values i.e show greater objectivity, and
comparability. The presence of variation in accounting estimates (such as useful life and
salvage value) are mentioned as causes for the lack of objectivity of book values.

5.3.4 Criticism of exit price accounting

Although there are strong arguments in favor of exit price accounting, this model is not
without criticism. Some of the criticisms are described below:

1. Profit concept
A meaningful function of accounting is to measure the profitability of the firm in a given
period. This is understood to mean the effectiveness of the actual performance of the company
in utilizing the resources entrusted to it. The task of accountant is not only measure profit, but
to provide data for the evaluation of plan course of action.

Using exit price does not provide the relevant data to match against revenues ot measure the
relative success or failure i.e. the performance of the firm. Accounting must measure past
events. Rather than those that might happen if the firm does something other than what was
planned. Exit price accounting does not supply useful profit information. Exit price
accounting provides relevant information only if the company plans to liquidate its assets. If
the company plans to continue in business, then the information is not relevant. Exit price
does not help at all because inventories overstated at exit price. There is not meaningful gross
profit. Instead the emphasis is on changes in prices. Exit price does not provide enough

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information to the reader to know how the company moved from its status at the beginning to
its status at the end of the year.

2. The concept of value in use versus value in exchange

Exit price ignores the concept of value in use. According to historical cost accounting, value
in use is represented by acquisition.

The distinction between value in use and value in exchange. According to the advocates of
historical cost, the purpose of the statements is the expression of the utilization of the
economic resources of the enterprise in financial terms and the resultant changes in and
position of the interests of the creditors and investors. Thus, accounting is not essentially a
process of valuation, but the allocation of historical costs.

The value to the firm/owner is the relevant perspective. An assets that is held rather than sold
out must be worth more to its owner than its exit price. A firm can consider an asset to have
value because of its use in the business rather than its sale.

3. Additively
The supporters of exit price argue that accounting measurements must only be bared on past
and present events if there are to be objective. Anticipatory figures cannot be added together
with current figures. According to exit price accounting, current cash equivalent of assets is to
be determined on the assumption of a gradual and orderly liquidation. If that is the cash, then
something about the future is assumed when the current cash equivalent is recorded on the
balance sheet date. If anticipations cannot be avoided in ascertaining current cash equivalent,
then the exit price accounting model itself violates the principle of exclusion of anticipatory
calculations.

Learning activity 5 – 2
1. Who is the early advocate of exit price accounting?
2. According to MacNeal, what type of assets are valued at exit price?
3. Who has presented a comprehensive proposal on exit price accounting called
“continuously contemporary accounting”
4. What does the notion of adaptive behavior of Raymond Chambers imply?

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 5. What basis historical cost or exit price is suggested by exit pricing accounting in
preparing financial statements?
6. According to Robert Sterling, the main problem of income measurement is
__________

5.4 SUMMARY

This unit is concerned with the different models of accounting which address the perspective
from accounting concepts, procedures are rules are developed. Generally, there are three
major models of accounting; namely, historical sot accounting, exit price accounting, and
current cost accounting.

Under historical cost accounting, the objective of accounting is mainly the stewardship
function of management. The four main concepts in conventional historical cost accounting
are accountability of entity to equity holders, emphasis on income (point of sale revenue
recognition and matching principle), historical cost valuation, and flow of cost (cost allocation
and cost attach).

Under exit price accounting, the current exit prices are suggested to be used because historical
cost accounting fails to provide the kind of information users need. According to exit price
accounting, exit prices are adaptive because they pertain to the same property for assets and
liabilities which is cash and current cash equivalents. Exit price financial statements are also
allocation free, and have real-world referents.

5.5 ANSWERS TO LEARNING ACTIVITY

Learning activity 5 – 1
1. Accountability or stewardship for owners and creditors.
2. A measure of behavioral attributes
3. Revenues
4. Expenses
5. Income
6. Income statement

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 7. Embodied/ absorption
8. - Relevant in making economic decisions
- Based on actual transactions
- Found to be useful in the history
- Enables to determine the best understood concept of profit
- Guard against the integrity of data against internal modifications.

Learning activity 5 – 2
1. Kenneth McaNeal
2. Marketable assets
3. Raymond Chambers
4. It implies two things
a) A continual attempt to adjust to the competitive business environment for the
sake of survival
b) A continual effort to reach a given level of satisfaction
5. Exit price
6. Valuation

Check your progress question 5 – 1

1. Under historical cost accounting, which financial statement serves as a connecting link
joining successive income statements into a composite picture of the income stream?
2. What are the two types of costs according to cost attach theory?
3. Displacement cost is synonymous with ____________
4. __________ costs are related to what has been spent on inputs rather than what has
been forgone.
5. ___________ costs represent what have been given up or scarified.
6. __________ is at the heart of historical cost accounting.
7. What are some of the limitations of historical cost accounting?
8. According to Kenneth MacNeal, what type assets are valued at replacement costs?
9. Mention some of the advantages of exit price accounting.

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5.6 ANSWER TO CHECK YOUR PROGRESS QUESTIONS 5 – 1

1. Balance sheet
2. Displacement costs and embodied costs
3. Opportunity cost
4. Embodied/Absorption
5. Displacement
6. Cost allocation
7. - The objective of accounting is relatively narrow
- Insufficient for the evaluation of business decisions
- Overstates income during inflation
- Its relevance is questionable for decision-making
- The basis of historical cost is unrealistic
8. Nonmarkatable reproducible assets
9. - Minimizes additivity problem
- The financial statements are allocation free
- Involves real world referents
- Exit values are more objective

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