Essays on Financial Accounting Advanced Essay

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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.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. 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. "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. 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. £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.

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