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Accounting theory Essay

The Published Annual Financial Statements of a company is the financial report for a given period, distributed by a company to its shareholders and which may be available to other stakeholders. Financial statements, should accordingly timeously communicate information that is relevant, useful, adequate and comprehensive, facilitating informed economic decision-making for users.

In this regard it is important to note that financial statements are not prepared for the benefit of management and/or the company, but rather to ensure the transparent communication by management to shareholders and other financial statement users regarding the activities and transactions of the corporation. In this way, management discharges their stewardship and reporting responsibilities. In this context, it is important that all financial statements speak the “same language” in order to compare the financial statements of one company to that of another. This is the role of Accounting standards.

It can be argued that from a corporate governance perspective, flexibility and options in accounting standards should be limited so that stakeholders know what they get and what can expect from the financial statements. Horton and Macve2 have a contrasting view, maintaining the dilemma of ambiguity can be resolved by providing management with wide discretion to reflect the circumstance of

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their own companies. There has recently been a tendency for organisations to use “mixed measurement” accounting systems, incorporating components of the various valuation bases referred to above.

Mixed measurement system requires organisations to match the measurement basis to the particular category of assets of liabilities, within a particular situation. Mixed measurement systems are flexible utilising either the historical cost or current value dependent on the prevailing organisational circumstances and the maturity of the accounting regime. Problems with mixture measurement systems Where assets have independent cash flows, the organisation’s assessment of the present value can be used to value the cash flows.

Where the assets do not generate independent cash flows, the market’s assessment of the present value will be applied to measure the cash flows5. However, it is seldom possible to determine the net cash flows generated from individual assets. The stability of replacement cost is undermined during periods of rapid changes in markets and technology. Accordingly, inadequate adjustments for technological change and associated productivity gains are measurement errors, which could overvalue the deprecation cost and the replacement value.

Fair value information is the most important component of measurement. Fair value require several assumptions with minor changes potentially having a huge affect on the results6, providing managers with more chances to manipulate the profit. Moreover, since the assumptions are subjective it is difficult for auditors to verify. The many methods of determining fair value it make it difficult to judge management performance and to predict future performance. 8. FAIR (MARKET) VALUE In the past, the convention was to use historical cost to value assets like land and financial instruments.

For example, where a company purchased an equity investment at $5per share, the investment would have been recognised and disclosed at $5 per share. However, when the share price has dropped and those shares are only trading at only $2 per share, it is necessary that the investment value should be adjusted accordingly. This information should be disclosed to shareholders, being useful for economic decision-making. Fair value is accordingly a reality that cannot merely be ignored. 9. IMPACT OF CHANGING PRICES There are two issues related to changes in prices.

The first is the decline in the purchasing price of money. The second is the increase in prices and accordingly value of particular assets. Additionally, given the depreciating value of money, long term liabilities are likely to be overstated, since the payment, when made, will be worth less. Given that the convention has been for historical cost, the world’s major accounting bodies and industry associations are recommending (or prescribing for large company’s) the inclusion of a supplemental statement taking cognisance of inflationary pressures and specific price changes.

When an asset was purchased for a particular amount, the transaction provides an objective measure of the asset’s value. However, it may have been purchased some time ago, and may have little relevance today. Moreover, the traditional convention is to account for the gradual deterioration of the asset over its useful life, by deducting depreciation from the asset value. Whereas in some instances an asset purchased several years ago may be technologically obsolete and virtually worthless, in other instances it may be worth several times its original cost.

This is especially true in respect of land and shares and the impact of inflation. A problem exists in that it is often not feasible to objectively determine the current values of many assets. To an extent it is the desire to “be precisely wrong, rather than vaguely right”. In the USA the Securities and Exchange Commission and the Financial Accounting Standards Board are prescribing that certain assets and liabilities appear on financial statements at market vales instead of historical cost.

The affected assets and liabilities are those that trade actively in markets, including common stocks and bonds. Bankers were particularly vociferous since they were concerned about the potential volatility and the fact that some corporations were worth less than historical cost financial statements indicated. Moreover, equity investors acquire shares for future income flows, not for the value of the assets. The assets have no intrinsic value and their sole purpose is to generate future income.

However, adjusting the income statement for the effects of inflation is not enough to reflect the impact of changing price levels. Certain categories of fixed assets, particularly land and buildings should be revalued to reflect a more reasonable value on the balance sheet. TELSTRA In July 2003, the Australian Competition & Consumer Commission published a paper8 to ensure that Telstra will prepare and provide current cost accounts (CCA), as well as their existing historical cost accounts.

It is envisaged that this will allow the Commission to better understand the costs that Telstra faces as an ongoing sustainable business. The purpose is to ensure that Telstra’s CCA reporting regime adequately fulfils both the Government’s and the Commission’s policy objectives, including providing the Commission, access seekers and the public with greater transparency about Telstra’s ongoing and sustainable wholesale and retail costs.

The current cost statements for the businesses and activities were prepared under the financial capital maintenance convention in accordance with the principles set out in the handbook “Accounting for the effects of changing prices”, that was published in 1986 by the (UK) Accounting Standards Committee. The existence of this “old” guideline provides further evidence that options other than historical cost have already been considered for some time.

Under this convention, current cost profit is normally determined by adjusting historical cost profits taking account of changes in asset values and of the erosion in the purchasing power of shareholders’ equity during the year, due to general inflation. Asset values are adjusted to their value to the business, usually equivalent to their net current replacement cost. Changes in asset values are referred to as unrealized holding gains or losses. These include other movements, which are taken directly to reserves in historic cost accounting.

The effect of the revaluation of assets on the profit and loss account was to increase the historical cost profit through any unrealized holding gains (UHG) arising in the year and decreasing it by unrealized losses. In the Financial Statements, UHG’s for the various categories of fixed asset are treated in the same way as depreciation, so that losses increase costs and gains reduce them. CCA adjustments to the Profit & Loss and balance sheet values are allocated to Businesses using the same principles and processes as the historical cost values for the assets to which they relate.

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