Accounting Principles and Applications - Example

Insert your name) (Insert your number) (Insert name of the professor) (Corporate Accounting) Part A Introduction Valuation is the process through which business assets and entities are measured in monetary terms. (Ball, 2006) .The international accounting standards board is faced with many challenges in formulating the necessary financial reporting standards for business entities including the valuation methods. This is because of the many aspects in business that must be considered in making the necessary regulations. It is necessary that the formulated standards help enhance to reflect a true and fair view of the business affairs. (FASB, 1999). On the same note, the board have to consider the merits for preparing financial statements which includes the following; Determining profit and loss for the business. Determination of various obligations to third parties for example taxation. Financial statements help in obtaining credit facilities from suppliers. For purposes of auditing To achieve the above purposes there are several concepts and principles used in financial reporting. Some of the principles considered in determining the valuation method to be applied are; The matching principle which requires that the expenses incurred in production of revenue should be deducted from revenues generated during that period. Revenue recognition method which states that revenues should be recognised when sales are made without considering when cash is received. Going concern principle which assumes business certainty and continuity into the future. Objectivity principle which requires accounting information to be supported with evidence but not by opinions and imaginations. A stable dollar principle which requires an assumption of inflationary trends in business. These concepts and principles need to be observed in choosing the method to use in business valuation. In historical cost method, business resources are recorded initially at their cost. In this method, exchange price determines the cost. This is the most commonly used method of valuation by adopters of international financial reporting standards. (CFA, 2005). The second method is the fair value method. This method is not commonly used by business entities for valuation. This paper seeks to compare and contrast different methods of business valuations giving emphases on their criticisms in the various steps of the accounting cycle based on cons and pron of each. The valuation methods include; Written Down Replacement Cost (WDRC), The Equivalent Present Worth In place (EPWP), Fair value valuation. Net realizable value or exit value Historical cost valuation etc Written Down Replacement Cost (WDRC) In this case, the current value is normally based on replacement cost of asset depreciation to the current condition of the asset. (Chambers, 2004). This method is very common in management accounting and use by management. It also uses current market values and prices in replacement, the current asset condition is used in determining the written down value of the asset. (Chambers, 2004). Some of the advantages of this method include; the reflection of the current prices and technology used in accounting for the assets. Secondly it is easy and simple to understand. Thirdly it is so crucial and basic in budgeting. The disadvantages includes firstly, the conjectural on the replacement cost normally depends on the market forces which are external factors and cannot be controlled within the firm. Secondly is not easy to handle and record the replacement value. (Brock, and Horace, 1991). This challenges poise allot of difficulties in valuation of assets and liabilities hence not common among many companies. The Equivalent Present worth in place (EPWP) Here is just but historical cost valuation but inflation, tear and wear cost are adjusted to it. (FASB, 1999). There is also accounting for changes in prices and the usage, this valuation method is very important in comparing the investment rates across different investments in the market. Another advantage of this valuation method is that, it uses readily available data hence quick and accurate. The short comings of these methods include its neglects to major changes in technology and other standards in the services hence making it unpopular among many people. (Chambers, 2004). Fair value valuation Fair value accounting valuation has the following advantages to the users; firstly it is usually timely, accurate and easily comparable across different companies compared to historical or other methods of valuation. Fair value also reflect current information on the future cash flow of investments compared to historical cost concept and this makes it more competitive advantage over other valuation method. (FASB, 1999). Fair value also has several limitations including not allowing most of the companies to manage their normal income and loses through trading in gains, this is because profits and losses are usually recognized when they occurred or realized. (Chambers, 2004). Net realizable value or exit value Professor Solomon, 1999 hold that, the actual value which the asset can bring into the market is the only sure way to be used as a basis of evaluating the assets and this is what should be used by accountant. Professor Solomon went further to classify these markets into two. The first market is where the company can buy the asset they need at a specific time and specific form. The second market is that which the company can sell the asset at specific time and form. The price which is charged at the first market is called entry price because it is the price at which you first used to acquire the asset while the price at the second market is called the exit price since it is the price at which the company will use to dispose the asset. The argument of this method is that always accountant don’t normally appraise fixed asset but depreciate them so that they can get the value after use, but thus method should focus on the actual price one will get in the market when the asset is sold. The short coming of this method of valuation is that, it is not realistic that an asset will retain the same value after use as when it is still new, in case the asset is sold at a higher price more than the expected exist price, the excess should be recorded as a profit on disposal something which is majorly recognised by historical concept. The method further proposed that some fixed revaluation rate should be used in revaluating the entire asset and any loss realized written off accordingly, this is something which is majorly recognised by historical cost concept but not any other valuation method. (Ball, 2006) Historical cost valuation method This method is also known as exit price or conventional method. As discussed it uses the exchange price to determine cost. This is the method applied by many business entities in presenting financial information. This method has been commonly used in valuation of non-current assets such as buildings, equipment and motor vehicles. (CFA, 2005). To start with, historical cost method is very simple and accurate. This is because there is a monetary value already assigned to the asset under valuation. It is also easier to support the purchase price with the necessary documentations such as receipts hence achieving objectivity in reporting. (CFA, 2005). Historical cost is also important in achieving conservatism and prudence in valuation. This helps in showing values which are not overstated or understated since there is a cost base to relate to. This technique of valuation is also important in estimating values for depreciating an entity’s assets. Since it is a proactive approach of valuation, a business is able to estimate the value for depreciation depending on the method used. When using the straight line method, estimation is easy as the rate used can be distributed along the useful life of the asset. Historical cost therefore becomes useful in projecting costs related to running an asset. In preparing accounting information, accountants have always been adamant in recording accounting information to reflect the current market prices. This has given historical cost an upper hand in usage to become the most preferred method of recording accounting information. In this way, historical cost recording does not affect the prices of shares directly. Historical cost recording also eliminates arbitrariness in presenting accounting information. Other methods available for valuation are dependent on the person recording, or the management policy. In this way historical cost can help mitigate conflict between management and the shareholders in a corporate business. (Ball, 2006) Nevertheless historical cost valuation has some few limitations. The most known limitation as acknowledged by Ball, 2006 is that it cannot be used to reflect the current market prices. This makes it hard to use statements prepared in this method to make economic decisions. The other limitation is that historical cost focuses more on cost rather than considering even other aspects of an asset which may be important e.g. value. Among all the valuation methods, historical cost method is still common among many financial valuators due to its simplicity and flexibility. Part B. Ogre Ltd Consolidated income statement For the Year ended 30th June 2012 ($000) Sales revenue 2610 Cost of goods sold (1040) Gross profit 1570 Other expenses (370) Net profit before tax 1200 Tax at 30% (360) Net profit after tax 840 Goodwill impairment (20) Retained earnings for the year 820 Add retained earnings brought forward 1100 Add share of retained earnings in Elf Ltd 500 Retained earnings carried forward 2420 Ogre Ltd Statement of financial position For the Year ended 30th June 2012 ($000) Shareholders’ equity Retained earnings 2420 Share capital 1100 Current liabilities Accounts payable 900 Tax payable 360 Non-current liabilities Loan 1800 6580 Current assets Cash 350 Accounts receivable 700 Non-current assets Land 2000 Plant 3500 Acc depreciation (690) 2810 Goodwill 80 Investment in Elf Ltd 1100 7040 ($000) ($000) Cost of control 1100 Less Fair value of assets 2050 Liabilities (1050) (1000) Goodwill 100 Impairment (20) Goodwill carried forward 80 Reference Ball. R. 2006 international financial reporting standards IFRS research on pros and cons for Investors Brock, Horace R: 1991, Accounting Principles and Applications. Gregg Division Chambers, R.J. (2004), “Measurement and Objectivity in Accounting” CFA Institute. 2005. A Comprehensive Business Reporting Model: Financial Reporting for Investors. Financial Accounting Standards Board (FASB). 1999. Accounting for Contingencies. Solomon, D. (1999), “Economic and Accounting Concepts of Income”, the Accounting Review. Read More