Current Cost t MMethodethod
The current cost
The current cost22 method ignores general inmethod ignores general inflflation in favor of the speciation in favor of the specifific price and costc price and cost
changes faced by the individual
changes faced by the individual fifirm. It starts with the idea that income, when properly mea-rm. It starts with the idea that income, when properly mea- sured, must include a provision for the replacement of capacity used during the
sured, must include a provision for the replacement of capacity used during the period.period.33Oth-Oth- erwise, income is overstated as it
erwise, income is overstated as it includes the consumption of capacity.includes the consumption of capacity.44 2003 Income ($1/1/01) 2003 Income ($1/1/01)$681$681$774$774$(93)$(93) 2002 Income ($1/1/01) 2002 Income ($1/1/01)$774$774$880$880$(106)$(106) 2002 Sales ($1/1/01) 2002 Sales ($1/1/01)$1,210$1,210 1.5625 1.5625$774$774 COGSCOGS $1,100 $1,100 1.25 1.25 $880$880 2
2Current cost is the term Current cost is the term used in SFAS 33 and other FASB standards. Previous accounting literature used in SFAS 33 and other FASB standards. Previous accounting literature used such termsused such terms
as replacement cost, current value, and fair value. The distinction among these terms is often more theoretic than as replacement cost, current value, and fair value. The distinction among these terms is often more theoretic than real and varies with the user. For simplicity, we ignore these distinctions throughout the appendix.
real and varies with the user. For simplicity, we ignore these distinctions throughout the appendix.
3
3J. R. Hicks,J. R. Hicks, Value and CapitalValue and Capital, 2nd ed. (Oxford: Chaundon Press, 1946), p. 176., 2nd ed. (Oxford: Chaundon Press, 1946), p. 176. 4
It follows
It follows that the that the provision for provision for the cost the cost of replacing of replacing capacity must capacity must be made be made at current at current prices.
prices.Although application of this principle is dif Although application of this principle is dif fificult in practice, it is essential in theory.cult in practice, it is essential in theory. If
If aa fifirm has used up a machine and must replace it to remain in business, it is the cost of rm has used up a machine and must replace it to remain in business, it is the cost of buying the new machine that is relevant, not the original cost of the worn-out one.
buying the new machine that is relevant, not the original cost of the worn-out one. The current cost method, therefore, measures income by
The current cost method, therefore, measures income by matching revenues with operat-matching revenues with operat- ing costs, including the cost of replacing inventory sold and
ing costs, including the cost of replacing inventory sold and fifixed assets used up during thexed assets used up during the period.
period.
Exhibit 8A-1 applies this principle to our model company. At the end of 2001, the Exhibit 8A-1 applies this principle to our model company. At the end of 2001, the fifirmrm has $1,100 as proceeds of sales. To remain in business, the
has $1,100 as proceeds of sales. To remain in business, the fifirm must purchase new inven-rm must purchase new inven- tory on January 1, 2002. The cost of that new inventory will be 1,100 (10 @ $110 per unit), tory on January 1, 2002. The cost of that new inventory will be 1,100 (10 @ $110 per unit), as prices have risen by 10%
as prices have risen by 10% since January 1, 2001. Under since January 1, 2001. Under the current cost method, therefore,the current cost method, therefore, there was no income earned in 2001:
there was no income earned in 2001:
The
The fifirm can purchase 10 units of inventory, the same as itsrm can purchase 10 units of inventory, the same as its ““capacitycapacity”” one year earlier.one year earlier. The
The fifirm has neither a prorm has neither a profifit nor a loss for 2001 but has simply maintained itst nor a loss for 2001 but has simply maintained its physical capi- physical capi- tal
tal (capacity to do business). This contrasts with the constant dollar method, which is con-(capacity to do business). This contrasts with the constant dollar method, which is con- cerned with maintaining
cerned with maintaining financial capital financial capital..
2002 and 2003 results are the same. There is no
2002 and 2003 results are the same. There is no income in current cost terms because theincome in current cost terms because the fi
firm has simply maintained its physical capital.rm has simply maintained its physical capital. Disadvantages of Current Cost
Disadvantages of Current Cost
As compared with the constant dollar method, the current cost method is more complex: the As compared with the constant dollar method, the current cost method is more complex: the fi
firm must estimate the cost to replace each type of inventory and each category of rm must estimate the cost to replace each type of inventory and each category of fifixed as-xed as- sets. We discuss the dif
sets. We discuss the dif fificulty of estimating current costs shortly. These estimates requireculty of estimating current costs shortly. These estimates require judgements about how the
judgements about how the fifirm will replace used up capacity, adding subjectivity and a lack rm will replace used up capacity, adding subjectivity and a lack of reliability to the results. Because of these factors, current cost data are more expensive and of reliability to the results. Because of these factors, current cost data are more expensive and time-consuming to prepare and audit than constant dollar data. For all these reasons,
time-consuming to prepare and audit than constant dollar data. For all these reasons, fifinan-nan- cial statement preparers and auditors have mostly opposed the presentation of current cost cial statement preparers and auditors have mostly opposed the presentation of current cost data in
data in fifinancial statements. In some cases, however, corporations have stated that theynancial statements. In some cases, however, corporations have stated that they fifindnd such data useful when managing their business.
such data useful when managing their business. For
For fifinancial analysis, however, current cost data nancial analysis, however, current cost data are greatly preferred to constant dollarare greatly preferred to constant dollar data. The main reason is the relevance of such data to the operations of speci
data. The main reason is the relevance of such data to the operations of speci fificc fifirms.rms. Accounting Series Release 190
Accounting Series Release 190 The high rate of in
The high rate of inflflation in the 1970s and large speciation in the 1970s and large specifific price changes in some industries ledc price changes in some industries led the Securities and Exchange Commission to issue Accounting Series Release (ASR) 190 the Securities and Exchange Commission to issue Accounting Series Release (ASR) 190 (1976) requiring large
(1976) requiring large fifirms to disclose the replacement cost of inventory andrms to disclose the replacement cost of inventory and fifixed assets asxed assets as well as cost of goods sold and depreciation expense computed on a replacement cost basis. well as cost of goods sold and depreciation expense computed on a replacement cost basis. Disclosures were
Disclosures were fifirst required in 1976.rst required in 1976.
At about the same time, the FASB placed in
At about the same time, the FASB placed inflflation accounting on its agenda and issuedation accounting on its agenda and issued SFAS 33 in 1979, at which time the SEC
SFAS 33 in 1979, at which time the SEC withdrew ASR 190.withdrew ASR 190. SFAS 33 Requirements
SFAS 33 Requirements
SFAS 33, Financial Reporting and Changing Prices, the
SFAS 33, Financial Reporting and Changing Prices, the fifirst U.S. accounting standard to re-rst U.S. accounting standard to re- quire disclosure of the impact of changing prices, was a hybrid; it attempted to combine both quire disclosure of the impact of changing prices, was a hybrid; it attempted to combine both the current cost and constant dollar methods into one standard. In theory, the two approaches the current cost and constant dollar methods into one standard. In theory, the two approaches can be combined. Data adjusted for speci
can be combined. Data adjusted for specifific price changes can then be further adjusted forc price changes can then be further adjusted for changes in purchasing power. The resulting complexity, however, made use of this data dif changes in purchasing power. The resulting complexity, however, made use of this data dif fifi-- cult for
cult for fifinancial analysts.nancial analysts.
SFAS 33 provided for review after
SFAS 33 provided for review after fifive years. SFAS 89 (1989) made the SFAS 33 dis-ve years. SFAS 89 (1989) made the SFAS 33 dis- closure requirements voluntary. This action resulted from three factors. First, the rate of in- closure requirements voluntary. This action resulted from three factors. First, the rate of in- fl
flation subsided greatly in the 1980s, making the issue of general ination subsided greatly in the 1980s, making the issue of general in flflation effects lessation effects less important. Second, preparers and auditors complained that the costs of compliance with important. Second, preparers and auditors complained that the costs of compliance with
2001 Income
2001 Income$1,100$1,100$1,100$1,10000
AN
SFAS 33 were too high. Finally, little or no bene
SFAS 33 were too high. Finally, little or no bene fifit could be traced to the disclosures. Be-t could be traced to the disclosures. Be- cause of the voluntary nature of
cause of the voluntary nature of SFAS 89, the SFAS 89, the disclosures are rarely provided.disclosures are rarely provided. Problems with SFAS 33 Disclosures
Problems with SFAS 33 Disclosures
The data disclosed under the provisions of SFAS 33 received little use, we believe, for the The data disclosed under the provisions of SFAS 33 received little use, we believe, for the following reasons:
following reasons: 1.
1. It was unclear whether companies should attempt to measure the market value, theIt was unclear whether companies should attempt to measure the market value, the reproduction cost, or the replacement cost of existing capacity. Each of these
reproduction cost, or the replacement cost of existing capacity. Each of these choiceschoices results in a different measure of cost and
results in a different measure of cost and a different set of problems.a different set of problems. 2.
2. Market value is often dif Market value is often dif fificult to estimate because many productive assets are cus-cult to estimate because many productive assets are cus- tomized or unique. Although market values can be estimated for of
tomized or unique. Although market values can be estimated for of fifice buildings, force buildings, for example, there is no active market for steel mills. Curiously, the FASB did not per- example, there is no active market for steel mills. Curiously, the FASB did not per- mit the disclosure of market values in lieu of current cost for such assets as oil and mit the disclosure of market values in lieu of current cost for such assets as oil and gas properties, timberland, and real estate, for which
gas properties, timberland, and real estate, for which active markets do exist.active markets do exist.55
3.
3. Reproduction cost is an estimate of the cost to build existing facilities at currentReproduction cost is an estimate of the cost to build existing facilities at current prices. However, it is hard to price machines that are no longer being manufactured prices. However, it is hard to price machines that are no longer being manufactured (having been replaced by newer models or machines using different production (having been replaced by newer models or machines using different production processes). Use of reproduction cost also assumes that the
processes). Use of reproduction cost also assumes that the fifirm would replace its ex-rm would replace its ex- isting capacity with exactly the same mix of
isting capacity with exactly the same mix of factory sizes and locations.factory sizes and locations.
Replacement cost is, in theory, the cost of replacing existing productive capacity. Such Replacement cost is, in theory, the cost of replacing existing productive capacity. Such an estimate must,
an estimate must, fifirst, derst, defifine whether capacity should be measured in physical units (tons of ne whether capacity should be measured in physical units (tons of steel or pairs of shoes) or
steel or pairs of shoes) or fifinancial units (dollars of revenue). Second, thenancial units (dollars of revenue). Second, the fifirm must deciderm must decide what mix of geographic locations and plant
what mix of geographic locations and plant capacities it would construct if it were to capacities it would construct if it were to replacereplace its facilities today. Finally, the
its facilities today. Finally, the fifirm must estimate what production processes, raw and inter-rm must estimate what production processes, raw and inter- mediate materials, and markets it would pursue if
mediate materials, and markets it would pursue if it couldit could ““start from scratch.start from scratch.”” The computations become increasingly speculative as one moves
The computations become increasingly speculative as one moves from the market valuefrom the market value of assets to reproduction cost to replacement cost. In many cases, companies complied with of assets to reproduction cost to replacement cost. In many cases, companies complied with SFAS 33 by simply applying construction and machinery cost indices to the historical cost of SFAS 33 by simply applying construction and machinery cost indices to the historical cost of fi
fixed assets.xed assets.
Problems with Current Cost Depreciation Problems with Current Cost Depreciation
SFAS 33 also required that companies providing current cost data disclose depreciation ex- SFAS 33 also required that companies providing current cost data disclose depreciation ex- pense on a current cost basis. At
pense on a current cost basis. At fifirst glance, this is a simple exercise; companies simplyrst glance, this is a simple exercise; companies simply apply their existing depreciation methods and lives to their estimated current cost of apply their existing depreciation methods and lives to their estimated current cost of fifixedxed assets.
assets. The dif
The dif fificulties in deculties in defifining current cost carry over to the dening current cost carry over to the defifinition of current cost depre-nition of current cost depre- ciation expense. In addition, the interpretation of current cost depreciation expense is subject ciation expense. In addition, the interpretation of current cost depreciation expense is subject to another problem. Replacement of historical cost depreciation with current cost deprecia- to another problem. Replacement of historical cost depreciation with current cost deprecia- tion assumes that the operating costs of the
tion assumes that the operating costs of the fifirm are unaffected by therm are unaffected by the ““replacementreplacement”” process.process. It assumes that more expensive new machines and processes are no more cost ef
It assumes that more expensive new machines and processes are no more cost ef fificient thancient than the original machines and processes.
the original machines and processes.
That assumption is, of course, absurd in most cases. In theory, therefore, the operating That assumption is, of course, absurd in most cases. In theory, therefore, the operating costs of the
costs of the fifirm should be adjusted to rerm should be adjusted to reflflect the greater ef ect the greater ef fificiency of the new equipment.ciency of the new equipment. Such adjustments are subjective when made by the
Such adjustments are subjective when made by the fifirm; arm; a fifinancial analyst outside thenancial analyst outside the fifirmrm cannot begin to make them.
cannot begin to make them.
Because of the subjectivity of the data, lack of comparability of disclosures by compet- Because of the subjectivity of the data, lack of comparability of disclosures by compet- ing
ing fifirms, dif rms, dif fificulty of interpreting the data, and lack of a well-deculty of interpreting the data, and lack of a well-de fifined way of incorporatingned way of incorporating the data into investment decision models, use of the current cost data provided by SFAS 33 the data into investment decision models, use of the current cost data provided by SFAS 33 was limited. Perhaps for that reason there is
was limited. Perhaps for that reason there is little evidence that current cost data impactedlittle evidence that current cost data impacted fifi-- nancial markets.
nancial markets.
5
5SFAS 39, Mining and Oil and Gas, SFAS 40, Timberlands, and SFAS 41, Income Producing Real Estate, were allSFAS 39, Mining and Oil and Gas, SFAS 40, Timberlands, and SFAS 41, Income Producing Real Estate, were all
issued in 1980 as supplements to