Financial Accounting Advanced - Essay Example

1) Trace the development of financial reporting approaches to valuation / measurement from the debate over the shortcomings of historic cost (in the context of attempts to deal with inflation accounting in the 1970s) to present. In the 19th and early 20th century, valuation methods were primarily based in fair value, which is also known as replacement cost or current cost accounting. However, when the Great Depression hit the world in the 1930s, values which had been overstated during the 1920s were reversed, and hence begun the popularity of historical cost. Principles governing historical cost accounting were elaborated following the Wall Street Crash of 1929.1 Under this method property, plant and equipment and most inventories are reported at their historical cost: the amount of cash, or its equivalent, paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations. Liabilities that involve obligations to provide goods or services to customers are generally reported at historical proceeds: the amount of cash, or its equivalent, received when the obligation was incurred and may be adjusted for amortization and other allocations.2 However, this method had a number of flaws. According to the International Accounting Standards Committee, “In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued."3 Since the early 1900s, accountants in the U.K and the U.S. have contemplated about the impact inflation has on financial statements as they discussed financial reporting effects of purchasing power and the index number theory. In 1911, Irving Fisher published his book called 'The Purchasing Power of Money', which in 1936 was used by Henry W. Sweeney as he discussed constant purchasing power accounting in his book, 'Stabilized Accounting'. Sweeney's model was then employed by The American Institute of Certified Public Accountants when they conducted research and developed their study 'Reporting the Financial Effects of Price-Level Changes' and in later years by the Accounting Principles Board (USA), the Financial Standards Board (USA) and the Accounting Standards Steering Committee (UK). Sweeney proposed that a price index should be used which should encompass everything in the gross national product. Subsequently, in March of 1979, the Financial Accounting Standards Board wrote Constant Dollar Accounting, in which the Board encouraged the use of the Consumer Price Index for All Urban Consumers to adjust accounts.4 All this research and discussion took place because one can not ignore the impact of inflation on financial reporting, and specially when the historical cost system is being used. In such a scenario, two problems can occur. For one, the numbers which appear on the balance sheet and other financial statements lose their relevance with time because prices change from the time these were first incurred. And second, the numbers on financial statements do not have additive value because they represent dollars which were spent in different time periods, and hence, represent different amounts of purchasing power.5 £20,000 Cash held on December 31, 2000, if added to the historical cost of a building acquired for £20,000 in 1955, will result in a theoretically inapplicable sum because the two numbers vary to a significant extent in terms of the purchasing power they embody. This is in fact, similar to adding £20,000 to $20,000 and arriving at a total of $40,000, which is a misleading sum. In the same way, when currency amounts which represent different amount of purchasing power are subtracted, they may deceptively lead to a capital gain which might actually be a capital loss. For example, land is purchased in 1975 for £30,000 and sold in 2007 for £250,000. The apparent gain of £220,000 is misleading if the replacement cost of this land is, say, £300,000. The financial implications of such problems are many. For one, the asset values reported of inventory, equipment and plant will not represent their true economic worth to the business. Second, it is troublesome to forecast and project future earnings from historical earnings. Third, it can not be clearly ascertained how price changes affect the company's monetary assets and liabilities. Additionally, the company might be reporting profits which are higher than earnings that can be distributed to shareholders without harming the company's operations. All of these and other factors combine to distort the true economic performance of companies and businesses, which lead to social and political effects, which harm businesses in a multitude of ways.6 The above were factors which accountants had long realized and since the 1970's were a period of high inflation, there was an added emphasis on supplementing cost-based financial statements with price-level adjusted statements. At this time, the FASB was reviewing a preliminary proposal for such statements when the Securities and Exchange Commission issued the ASR190. According to this, a thousand of the largest American corporations were required to provide additional information based on replacement cost, as a consequence of which, the FSAB withdrew the proposal.7 In later years, attempts were made to solve the problem of inflationary impact on financial reporting, but in the UK, all such efforts have been exercises in futility.8 In December 1984, the FASB pronounced the SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" which identified four different measurement attributes, aside from historical cost. One was when inventories are reported at their current (replacement) cost, i.e. the amount of cash, or its equivalent, that would have to be paid if the same, or an equivalent asset, were acquired currently. Another was when investments in marketable securities are reported at their current market value: the amount of cash, or its equivalent, that could be obtained by selling an asset in an orderly liquidation. This is generally used for assets expected to be sold at prices lower than previous carrying amounts. Net realizable (settlement) value was identified to be used for some short-term receivables and inventories. This is the non-discounted amount of cash, or its equivalent, into which an asset is expected to be converted in due course of business, less direct costs, if any, necessary to make that conversion. Long-term receivables were reported at their present value (discounted at the implicit or historical rate): the present or discounted value of future cash flows into which an asset is expected to be converted in due course of business less present values of cash outflows necessary to obtain those inflows.9 Presently, the FASB is transitioning to the concept of fair value, which it defines as the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties. The term ‘‘fair value’’ has been used in the United States for many years, long before it first appeared in UK and IASC standards. However, the International Accounting Standards Board issued the IAS32 which establishes rules for determining fair value. There are certain assumptions which are incorporated in the fair market value standard. For example, it assumes that the hypothetical purchaser is reasonably prudent and rational but is not motivated by any synergistic or strategic influences. It also assumes that the business will continue as a going concern and not be liquidated, that the hypothetical transaction will be conducted in cash or equivalents; and that the parties are willing and able to consummate the transaction. There is a lot of scope for error and inaccuracy here as these assumptions might not, and usually do not, reflect the true conditions of the market in which this business might be sold. But it is necessary to make these assumptions because they result in a uniform standard of value, after applying generally-accepted valuation techniques, which consequently makes possible a meaningful comparison between businesses which are similarly situated.10 2) Discuss and critically evaluate the comparative advantages and disadvantages of the deprival value system of current value ( as adopted by the ASB in the Statement of Principles) and the exit value definition of fair value proposed by the IASB ( discussion paper Fair Value Measurements). The ASB Statement of Principles defines the deprival value method of calculating current value as that which "reflects the loss the entity would suffer if it was deprived of the asset involved". It is also known as the 'value to the business' and depends on the circumstances of the particular situation. Three situations are described. One is the most frequently experiences scenario, when the value of the asset's recoverable amount is more than its replacement cost. In such a situation, if the entity is deprived of this asset, it will replace it and the current value will simply be its current replacement cost. However, if the cost to replace it is higher than its recoverable amount, then it will not be replaced and its current value will be that recoverable amount. It also elaborates that when the most profitable use of the asset is derived from selling it, its recoverable amount will be its net realizable value; while when the most profitable use of the asset is to consume it, its recoverable amount will be its value in use.11 The exit price definition of fair value is that it is 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. This definition was given in the SFAS157 and the FASB found this to be a suitable objective because it represented "current expectations about the future inflows associated with the asset and the future outflows associated with the liability from the perspective of market participants."12 Deprival value and fair value are often perceived as "competing alternatives" and recently, fair value has replaced deprival value as the preferred measure of current value in accounting standards. The above source describes fair value as a selling price (exit value) rather than a buying price (entry value). Since deprival value can also be defined as a modified replacement cost, this interpretation of fair value as the exit price leads to an even greater potential gap between these two concepts. The objective of deprival value is to assess the value added to a business as a result of owning the asset. However, in order to apply this as a valuation base, a number of assumptions need to be made. Since the valuation is being conducted in accordance with the entity who owns the asset currently, deprival value can only be calculated if the entity is access a particular market or use the asset in a particular way. Hence, to calculate deprival value within the opportunities that are presently available to the entity, it is assumed that the asset is employed in the way that maximizes its value. Economic rationality is assumed when selecting the economic opportunities upon which the measurement is based, but entity-specific constraints determine the set of opportunities from which the selection is made.13 In practice, this translates into a difficult method to implement, which is why the Current Cost Accounting Standard introduced in the U.K. in 1980, which incorporated deprival value as its valuation base, lost support and was later withdrawn. It was found to be difficult to apply in practice and difficult to understand.14 "The ultimate goal of the fair-value project is to improve comparability, consistency, and reliability of fair-value measurements by creating a model that can be broadly applied to financial and non-financial assets and liabilities" (Shortridge, 2006). There is some disagreement on the definition of fair value as an exit price as it is said that an entry price also represents market-based expectations of flows of economic benefit into or out of the entity. And while these would be the same in the same market, they would differ if an asset is bought in one market and sold in another. This leads to some confusion and one of the disadvantages of such a definition is that it is not as descriptive of the measurement attribute as it should be to ensure more clarity. To prevent the confusing possibility that this definition would lead to some being forced to show losses when acquiring assets for use that could be sold only for less than the purchase price, the FASB specified that owners had to value their assets under the belief that they would sell them to a buyer who would apply them to the "highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date".15 This is one the similarities between Deprival Value and the exit price (fair value) as both strive for current valuations and they are both based on the assumption of economic rationality: DV through the idea of profit-maximization and FV through the concept of 'highest and best use'.16 Exit value definition of fair value proposed by the IASB A Discussion paper on Fair Value Measurements was published by the International Accounting Standards Board (IASB) on 30 November 2006 for public comment, which sets preliminary views of IASB pertaining to measurement of fair values, which and even though were already prescribed under existing IFRSs. The discussion paper did not propose any extensions pertaining to the use of fair values. It is noteworthy that the DP is created around SFAS 157 Fair Value Measurements issued by FASB. What is mentionable is that a single definition of fair value along in combination with a framework for measuring fair value for financial reports according to US GAAP. With the introduction of IASB’s Discussion Paper, certain key differences have arisen between the definition of fair value according current IASB position definition and SFAS 157, which are as follows: • SFAS 157 definition is explicitly an exit (selling) price. IFRS definition is neither explicitly an entry (buying) price nor an exit price. Minimal variations in different IFRS standards do exist. • SFAS 157 definition is explicitly related to market participants IFRS definition refers to say, willing parties in an arm’s length transaction and means knowledgeable. • With regard to liabilities SFAS 157 definition conveys the concept that the liability is not settled but continues to the counterparty. IFRS definition takes into account the amount at which a liability could be settled between willing parties in an arm’s length transaction and knowledgeable. As on date many analysts opine that IASB Discussion Paper is fraught with a drift towards an acceptance of the SFAS 157 position which, in turn, would mean that some of the key principles underlying many IFRS standards would significantly change. References Discussion Paper- Fair Value Measurements 2006, International Accounting Standards Board. Epstein, B. & Jermakowicz, E. (2007). Interpretation and Application of International Financial Reporting Standards. John Wiley & Sons. Fair Value 2007, Wikipedia, the free encyclopedia [Internet], Available from http://en.wikipedia.org/wiki/Fair_market_value [Accessed 6 January 2007]. Gibson, C. (2002). Financial statement Analysis: Using Financial Accounting Information. Cincinnati: South-Western Publishing. International Accounting Standards Committee. (1995). International Accounting Standard 1995. London, International Accounting Standards Committee. Statement of Principles for Financial Reporting 1999, Accounting Standards Board. van Zijl, T. & Whittington, G. (2006). Deprival value and fair value: a reinterpretation and a reconciliation. Accounting and Business Research. 36(2):121-130. Whittington, G. (1983). Inflation accounting: an introduction to the debate. Cambridge, UK: Cambridge University Press. Whittington, G. (1998). Deprival Value and Price Change Accounting in the U.K. Abacus, 34(1):28-30. Williamson, D. (2002). Accounting Concepts and Conventions, Accounting Web [Internet], Available from http://www.accountingweb.co.uk/cgi-bin/item.cgi?id=69109 [Accessed 6 January 2007]. Wolk, H., James L. D & Tearney, M. G. (2004). Accounting Theory: Conceptual Issues in a Political and Economic Environment, 6th ed. South-Western. Read More