FA Session 5

Copyright © Amity University1

PAN African eNetwork Project

Course Name-MFC

Subject Name- Financial Accounting

Semester - I

Faculty Name-Dr. Anubha Srivastava

Copyright © Amity University

• Points to discuss –

• Inflation accounting

• HRA

• Environmental accounting

• Social cost benefit analysis


Inflation accounting


Inflation: DefinitionsInflation: Definitions• Decrease in purchasing power of money due to an

increase in the general price level• “A process of steadily rising prices resulting in

diminishing purchasing power of a given nominal sum of money”

The Penguin Dictionary of Economics• “Rise in prices brought about by the expansion of

the supply of bank money, credit, etc.”

Oxford Advanced Learner’s Dictionary of Current English


Inflation

• Monetary inflation occurs when the money supply of a country is increased over and above the demand and need for currency (“too much money chasing too few goods”). This results in depreciation in the value of currency.

• The impact of monetary inflation on prices is usually not evenly distributed across all goods and services within an economy.


Inflation

• Inflation distorts, or eradicates, the meaning of financial statement numbers.

• As such, when inflation is a substantial problem, its effects need to be removed/adjusted so that financial reports remain useful.


Some Aspects on Inflation Accounting Problems:

• Subjectivity

• Often complicated calculations Benefits:

• maintaining production capacity

• shows the internal logic of accounting


Inflation Accounting – Conceptual Issues

Impact of inflation on financial statements• Understated asset values.• Overstated income • Differing impacts across companies resulting in lack of

comparability.

Learning Objective 1


Inflation Accounting

• Inflation creates two basic reporting “mistakes” when traditional accounting methods are alone employed:– Purchasing power gains/losses are not

detected and reported.– Historical cost numbers lose their relevance.


Inflation Accounting – Conceptual Issues

Net Income and Capital Maintenance• Historical cost, general purchasing power and current

cost accounting all flow from different concepts of capital maintenance.

• Net income represents the amount of dividends that can be paid out while still maintaining the company’s capital balance.



Inflation Accounting -- Methods

General Purchasing Power (GPP) Accounting• Updates historical cost accounting for changes in the

general purchasing power of the monetary unit.• Also referred to as General Price-Level-Adjusted

Historical Cost Accounting (GPLAHC).• Nonmonetary assets and liabilities, stockholders’ equity

and income statement items are restated using the General Price Index (GPI).

• Requires purchasing power gains and losses to be included in net income.



Current Purchasing Power (CPP)

Current Purchasing Power (CPP)

• Retains historic cost accounting conventions• In U.S. General Purchasing Power (GPP)


Inflation Accounting -- Methods

Current Cost (CC) Accounting• Updates historical cost of assets to the current cost to

replace those assets.• Also referred to as Current Replacement Cost

Accounting.• Nonmonetary assets are restated to current replacement

costs and expense items are based on these restated costs.

• Holding gains and losses included in equity.



Inflation Accounting Internationally

International Financial Reporting Standards• IAS 15, Information Reflecting the Effects of Changing

Prices was issued in 1981.• This standard has been withdrawn due to lack of

support.• The relevant standard now is IAS 29, Financial Reporting

in Hyperinflationary Economies.• IAS 29 is required for some companies located in

environments experiencing very high levels of inflation.



Inflation Accounting Internationally

International Financial Reporting Standards• IAS 29 includes guidelines for determining the

environments where it must be used.• Nonmonetary assets and liabilities and stockholders’

equity are restated using a general price index.• Income statement items are restated using a general

price index from the time of the transaction.• Purchasing power gains and losses are included in net

income.



HRA

The Costs and Benefits of Human Resources


Human Resource Management Activities

• Human Resource Management Activities:– Attraction– Selection – Retention – Development– Utilization

• In the past, these activities were evaluated in behavioral and statistical terms.


Behavioral Measures

• Measures of the reactions of various groups of what individuals have learned or of how their behaviors have changed on the job.

• These groups include:– Top Management– HR Specialists– Applicants– Trainees


Statistical Measures

• Statistical Measures Include:– Ratios– Percentages– Measures of Variability


Measuring Activities

• Today, because of rising costs, there is a need to evaluate HR management activities in economic terms.

• This requires gathering information from:– Accounting– Finance– Economics– Behavioral Science


Relevancy of Economic Measurements

These economic measurements are relevant to HR programs because:– They can help senior executives assess the

extent to which HR programs are consistent with and contribute to the strategic direction of an organization.

– They give visibility to the HR department.


Human Resource Accounting

• No generally accepted accounting procedures for employee valuation.

• The 1st major attempt at employee valuation was made by R.G. Barry Corporation of Columbus, OH in their 1967 annual report.

• This attempt has been described as a 1st step in developing sophisticated measurement and accounting procedures to enable the company to report accurate estimates of the worth of the organization’s human assets.


Historical Cost Approach to Employee Valuation

• Asset model of accounting– Measures the organizations investment in

employees.

• Viewed most appropriate when used for external reporting.

• Objective


Disadvantages of Historical Cost Approach

• This approach is based on the false assumption that the dollar is stable..

• Because the assets valued are not salable there is no independent check of valuation.

• This approach measures only costs to the organization. It ignores any measure of the value of the employee to the organization.


Alternatives to the Historical Cost Approach

• Replacement Cost

• Present Value of Future Earnings

• Present Value to the Organization


Replacement Costs

• Measures only the cost of replacing the employee.

• Replacement Costs Include– Recruitment– Selection – Compensation– Training cost (income forgone during the training

period)

• Biased estimates-an inefficient firm may incur greater cost.


Present Value of Future Earnings

• The organization establishes what an employee’s future contribution is worth to it today.

• The contribution can be measured by its cost or by the wages the organization will pay the employee.

– This measure is limited because it assigns a value to the average rather than any specific group or individual.


Value to the Organization

• Hekimian & Jones proposed that where an organization had several divisions seeking the same employee, the employee should be allocated to the highest bidder.

• This approach has merit, but the opportunities to use it are rare.


Limitations

• These approaches to HRA reflect only inputs and not effectiveness.

• These approaches are human asset accounting models that focus exclusively on investments in people ignoring the output those resources produce.


Extension of HRA

• Pyle suggested that HRA be extended to compute returns on assets and returns on investments.

• This approach properly compares input and output measures but still fails to distinguish between individual and group effects that produce variability in output.

• The Search Continues


Costing Employee Behaviors

• The general idea of costing human resources is not new.

• Standard cost accounting procedures are applied to employee behavior

• To accomplish this, cost elements associated with each behavior must be identified and their separate & independent dollar values computed.


2 Ways to Conceptualize Cost

• Outlay Costs vs Time Costs– Outlay – materials used in training new employees– Time – Supervisors’ time spent orienting new employees

• Distinguishes among fixed, variable, and opportunity costs.– Variable Cost- sales commission– Fixed Cost- Salaries– Opportunity Cost- reflects what the organization might have

earned had it put the resources in question to another use.


Believe It or Not

All aspects of HRM can be measured and quantified in the same manner as any operational function.


Intellectual Capital

What is it?– Knowledge– Information– Intellectual Property– Experience


Microsoft

• Total Market Value– $412 Billion

• Total Value of all Physical Assets (buildings, equipment, and furniture)– $24 Billion

• Where is the extra $388 Billion coming from?


Soft Assets

• Intangible Assets– Brand Names– Intellectual Capital– Patents– Copyrights– Expenditures for R&D

• The shift to a knowledge based economy has created a whole new category of assets which are not recognized in financial statements.

• Information is the essence of these soft assets.


The Information Revolution

• Knowledge has become the fundamental ingredient of what we make, do, buy, and sell.

• Managing Knowledge– Finding & Growing Intellectual Capital– Storing It– Selling It– Sharing It

• This new trend suggests a new way of strategic thinking, rather than a technical approach about “how to put people on the balance sheet.”


Valuing Intellectual Capital

• The first firm to attempt to account for its IC was Skandia AFS in a supplement to its 1994 annual report.


The Navigator

• Intellectual capital in a company can be found in one or more of three places:– Its people– Its structures– Its customers

• Intellectual capital comprises:– Human capital– Structural capital– Customer capital


Human Capital

The knowledge, skill, and capability of individual employees to provide solutions to problems that customers think are important.


Structural Capital

Consists of everything that remains when the employees go home, including databases, customer files, software manuals, trademarks, and organizational structures.


Customer Capital

The value of an organization’s relationships with the people with whom it does business, including suppliers.


Two Principles for Measuring Intellectual Capital

1. Keep it simple.

2. Measure what is strategically important.


Environmental Accounting


Discussion

• Environmental Accounting Overview– What is environmental accounting

– Why do environmental accounting

– What is an environmental cost

• System Strategies– Reactive, Proactive, Leadership

• Business Purpose and Application– Example - Cost Allocation

• Methodologies


Environmental Accounting Overview

What is environmental accounting?

– A flexible tool to provide information not

necessarily provided in traditional managerial

systems.


Goal

• Goal of environmental accounting is to increase the amount of relevant data for those who need or can use it.

• “Relevant data ” depends on the scale and scope of coverage


Scale and Scope

• Applicable at different scales of use and scopes (types) of coverage.– Application at an individual process level

(production line), a system, a product, a facility, or an entire company level.

– Coverage (focus) may include specific costs, avoidable costs, future costs and/or social external costs


Scale and Scope

• Decisions on scale and scope of application significantly impact ability to assess and measure environmental costs– Process vs Facility– Discreet costs vs Hidden vs Contingent vs

Image Costs


Why do Environmental Accounting ?

• Environmental cost can be significantly reduced or eliminated as a result of business decisions.

• Environmental costs may provide no added value to a process, system or product (i.e. waste raw material )

• Environmental costs may be obscured in general overhead accounts and overlooked during the decision making process.


Why do Environmental Accounting ?

• Understanding environmental costs can lead to more accurate costing and pricing of products.

• Competitive advantage with customers is possible where processes and products can be shown as environmentally preferable.


Environmental Costs

• Major challenge in application of environmental accounting as a management tool is identifying relevant costs.

• Cost definition determined by intended use of data (i.e. cost allocation, budgeting, product/process design or other management decision support).


Environmental Costs

• Types of Environmental Costs– Conventional: material, supplies, structure and capital

costs need to be examined for environmental impact on decisions.

– Potentially Hidden: • Regulatory (fees, licenses, reporting, training, remediation)

• Upfront and back end (site prep, engineering, installation, closure and disposal)

• Voluntary (training, audits, monitoring and reporting)

– Contingent: penalties/fines, property liability, legal)

– Image: Relationship with employees, customers, suppliers, regulators and shareholders


Overview Summary

• Flexible tool to provide relevant data not ordinarily captured in traditional systems.

• Successful application requires up-front understanding of scale and scope of application.

• Once identified, information needs to be communicated/distributed to decision makers and considered as a component of management’s decision making criteria


System Strategies

• Environmental Accounting systems typically fall into one of three categories:– Reactive– Proactive– Leadership


Reactive Systems

• Typically spread costs (capital and expense) across various overhead categories.

• Environmental costs typically not assigned to specific line/process or activity.

• Reactive system fails to provide indication or quantification of environmental costs.

• As a result it fails to identify cost drivers and minimizes opportunity to develop tactics to reduce these costs.


Proactive systems

• Costs are categorized and assigned to specific process and activities.

• Costs incurred can be identified, classified and quantified but are limited to discreet costs.

• Decisions typically focus on incremental activities ( i.e. minimize waste, etc.).


Leadership Systems

• Includes both financial and non-financial issues in the relevant data used in the business decision process.

• Systems are designed to include value chain perspectives.

• Both the process as well as the product are evaluated for relationship between inputs and overall value provided to minimize “total costs”.


Application

• Utilization of data generated from application of environmental accounting tool can be used for a variety of decision classes including:– Cost allocation– Capital budgeting– Product design


Cost Allocationan example

• Goal - Bring environmental costs to attention of corporate stakeholders.

• Four steps in environmental cost allocation:– Determine scale and scope of the application– Identify environmental costs– Quantify those costs– Allocate those costs to responsible product,

process or system

Traditional Cost System

OtherOverhead

Toxic WasteProduct B

Product A

Allocated Overhead

Product B

Modified Allocation System

OtherOverhead

Toxic WasteProduct B

Product A

Allocated Overhead

Product B


MethodologiesRelated Accounting Topics

• Application of Environmental Accounting typically used in conjunction with:– Activity Based Costing (ABC)– Total Quality Management (TQM)– Business Process Re-engineering – Balanced Score Card


Cost-Benefit Analysis (CBA)


What is a Benefit and a Cost?

• The benefits of a change are those goods or services that result from the change for which someone would be willing to make sacrifices to obtain

• We measure benefits in terms of Willingness to Pay (WTP)

• Cost is the value of opportunities forgone! (it could be a Euro value, but could include much more e.g. the value of your time).

• Opportunity Cost: An activity's opportunitycost is equal to the most net benefits thatyou could have obtained from doing something else.


1) Benefit - marginal benefit - total benefit

2) Cost - marginal cost - total cost

3) Net benefits - marginal net benefit

- total net benefit

An efficient allocation maximizes Total Net Benefit

minus

=

!!! !!!

Important Concepts


Recent Developments

Total economic value = Use value + Intrinsic valueUse value = Actual use value + Option value + Quasi-

option valueOption value = Value in potential use by self + Value in

potential use by others + Value in potential use by future individuals

Quasi-option value = Value of avoiding irreversibilities in the light of expected future knowledge

Intrinsic value = Existence value


Existence Value

Existence value is unrelated to any actual or potential use

Existence value may be related to sympathy, or stewardship; as such, existence values do not fit into neo-classical economics

Existence value may also be related to "spiritual consumption", and then it does fit

Existence value is not right-based, as rights are absolute, and values relative



by 'Cost-Benefit Analysis' we mean the social appraisal of investment projects (to appraise investments that correct for market failure).

CBA and Environment:

1) benefits in the form of the provision of goods and services that have environmental impacts (e.g., damming a river in a wilderness area; i.e. negative environmental effects)

2) projects with beneficial environmental impacts (sewage treatment plant; i.e. positive environmental effects)


CBA

CBA should be used for policies and projects, which unfold over time and be assessed by calculating a Net Present Value (NPV), or a Benefit-Cost Ratio (BCR).

4 informational inputs:

1. time horizon

2. benefit schedule

3. cost schedule

4. discount rate


Present Value ConceptTime Value of Money Concept: = a Euro today is worth more

than a Euro tomorrowwhy:

* uncertainty: the future is unknown, will you be around to spend the dollar.

* inflation: erodes the buying power of a Euro* utility gain from consumption today versus future consumption,* investment opportunities: invest today, earn interest, and have more than a Euro to spend in the future.

Basic idea is to get the present value of some future payment to be received at time t.


Present Value Concept

Discounting: = process to obtain the present value of future Euro amounts:

PV = present value, FV = future value, r = discount rate, and t is the number of periods into the future.

1

*1

tPV FV wherer

0 ttime

present value

future value

idea of discounting

Euro


Present Value Concept

Nominal versus Real: = nominal refers to the Euro value in current terms (not discounted), whereas real refers to the dollar value discounted to some base Euro value (discounted values).

Discount Rate: indicates how you value present consumption (utility) versus future consumption (utility)

- the higher the discount rate the more you value present consumption relative to future consumption

- the lower the discount rate the more you value future consumption relative to present consumption.



In any CBA, several stages must be conducted (Hanley and Spash, 1993):

1) Definition of the Project2) Identification of the Project Impacts3) Which Impacts are Economically Relevant?4) Physical Quantification of Relevant Impacts5) Monetary Valuation of Relevant Effects6) Discounting of Cost and Benefit Flows7) Applying the Net Present Value Test8) Sensitivity Analysis



Private appraisal1) The net present value test

2) The internal rate of return test

Social appraisal1) Utility based appraisal

Problems: - no general agreed social welfare function - interpersonal utility comparison are admissible - utilities are not observable

2) Consumption based appraisal

0 1

Ttt

NRNPV

r

0

01

Ttt

NR

x

NPV>0

IRR=0

0 1

Ttt

NBNPV

r



• NPV test is a potential compensation test => is concerned with allocative efficiency (select projects that move the economy toward an efficient allocation of its resources).

• The proper time horizon for the appraisal of a project is the date at which its impacts cease, not the date at which it ceases to serve the purpose for which it was intended.e.g., for a nuclear fission plant the time horizon is not the 40 years to the time when it ceases to generate electricity but the time over which it is necessary to devote resources to storing the plant's waste products - 100s of years.


Choice of discount rate

time horizon in years

discount rate 25 50 100 200

2 60.95 37.15 13.80 1.91

4 37.51 14.07 1.98 0.04

6 23.30 5.43 0.29 0.0009

8 14.60 2.13 0.05 0.00002

The Present Values of 100 Euros arising from 25 to 200 years ahead at discount rates from 2 -8 %

=> need for judgements

however, there is universal agreement among economists such that the real rates should be taken not nominal rates in CBA.


Environmental Cost-Benefit Analysis

0 1

Ttt

NBNPV

r

0 0 01 1 1

T T Tt t t t

t t t

B C B CNPV

r r r

d dB C

where Bd/Cd is the discounted of benefit/cost stream over the project lifetime. NPV ignores environmental impacts => NPV'.

'd dNPV B C EC NPV EC

' d dNPV B C EC

EC = environmental cost

ECBA decision rule!!!


Environmental Cost-Benefit AnalysisEC = UV + EV + OV +QOV

UV = Use Value and arises from the actual and/or planned use of the service by an individual, for recreation for example;

EV = Existence Value and arises from knowledge that the service exists and will continue to exist, independently of any actual or prospective use by the individual;

OV = Option Value and relates to willingness to pay to guarantee the availability of the service for future use by the individual;

QOV = Quasi-Option Value and relates to willingness to pay to avoid an irreversible commitment to development now, given the expectation of future growth in knowledge relevant to the implications of development.


Direct Benefit EstimationIn private CBA it it usually relatively easy to perform because

prices are readily observed.Often this is not the case (no price exist) or prices are socially

biased due to externality, public good, or market power considerations.

This problem is particularly apparent for non-use values which tend to be more intangible.

intangible = cannot be valuedif intangibles remain in our analysis, then NPV and BCR are

incomplete.So, what can we do when prices and demand information is

absent or is clearly biased?


Alternative Approaches

1. Contingent Valuation- use surveys that ask- widely applicable

2. Travel-Cost Method- obtain a demand curve by examining how participation varies with the cost of getting there.- primarily useful for recreation benefits.

3. Property value and Wage differentials (hedonic prices)- statistically investigate how these prices vary with property of job conditions- more limited application possibilities than for CV.


Indirect (Secondary) Benefits

= Ripple effects due to economic linkages

We have all heard public projects and policies being touted for their employment and income generating effects.

In a full employment economy, however, these inputs were necessarily reallocated away from other productive uses.

!! Do not count secondary effects in a full employment economy!!

also no transfer payments should be included, e.g, unemployment payments


Overall Appraisal of CBA

Cons:- intangibles- BC analysts and information sources are often biased- distributional Issues occasionally objectionable

* weighs same period impacts equally* weighs future impacts less

Pros:- help prevent bad decisions which would otherwise be undiscovered- counters rent-seeking (which might normally be successful in the political process).


Analytical Styles other than CBA

Cost Effectiveness Analysis- = try to achieve a non-economic target at least cost- often practical when there is an intangible physical quantity in need of enhancement; if it was tangible, we could just use CBA.

Impact Analysis- usually employed in lieu of or as a complement to CBA because either

* there are many intangible impacts of the policy/project and they need to be described, or

* the impacts are tangible but not allowed into CBA (such as secondary economic impacts)

Multi Criteria Analysis


CBA Example

Someone has proposed a 4-period pollution control project that will cost EUR 100.000 to construct in the initial period. After that, the project will cost EUR 10.000 to operate in each following period. After the construction is completed, the benefits of this project will be EUR 40.000 in the first period, EUR 45.000 in the second, and EUR 50.000 in the last period. The facility is expected to be non-functional for any future periods. There are no intangibles to be considered for this project.

Calculate Net Present Value (NPV), and Benefit-Cost Ration (BCR) using a discount rate of 5%.


CBA- Example

t Bt Ct NBt

0 0 100 -100

1 40 10 30

2 45 10 35

3 50 10 40

totals

1t

t

B

r 1t

t

C

r 1tt

NB

r

r = 5%

NPV = ???

BCR = ???

Thank You

Copyright@ Amity University

Please forward your query To: [email protected]: [email protected]

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FA Session 5