Financial Reporting and Analysis

Discuss about the Financial Reporting and Analysis.

Usefulness of alternative measurement systems to historical cost

The Historical Cost Accounting model assumes that the assets and liabilities are to be measured at the amounts paid to acquire them and this figure is taken as the base value for all the years until the existence of the asset or liability. Thus historical cost method considers only the original cost and assumes that there are no changes in the same over the years which are seen as an inaccurate assumption. For this reason, it would be pertinent to analyze the alternatives of the historical cost concept and discuss the utility of the same.

Owing to these limitations, attempts have been made to find a suitable and reliable alternative to the historical cost method.

Current Purchasing Power Method

This theory recommends that the financial statements prepared as per the historical cost are restated using an approved price index. According to Guerard (2013) the main advantage of this method is that it better represents the economic reality of the business that is considered to be more relevant and practical for decision making purposes in comparison to historical cost. The aim of this method is removing the distortions in the various figures on the financial statements as a result of the changes in general price levels in the economy.

For instance, an asset was purchased for $2000 in the year 2010. For finding the value of asset as on the balance sheet date, the general price index is compared with the price index of the year of purchase of the asset. The general price index was 200 in the year 2010 and 300 for the year 2016. So in this case, the value of the asset is worked out as: (2000 * (300/200)) which is $3,000. This implies that $2000 spent in 2010 is equivalent to $3000 paid in 2016.

Thus this method uses the general price index to arrive at the current value of the assets. But it would be pertinent to note that over time, while one asset becomes costlier, a few other assets might become cheaper whereas the general price index is common for all assets. These index numbers are also statistical figures which are not easily obtained and might make it difficult for individual firms to apply. Selection and application of a suitable price index is also a challenge.

As this method considers only the general price index and not the movement in individual firms for individual assets, this is not a very dependable method accepted by the Government and revenue authorities.

Current Cost Accounting Method

As economic conditions are pretty volatile and so the general price level tends to increase or decrease which is commonly known as inflation. This can be better explained by the fact that if 10 cookies can be purchased for $50 today, then there is a possibility that the same $50 might be able to fetch only 8 cookies at the end of the year.

The same is the case with financial statements. The figures stated against assets and liabilities do not take into consideration the inflation adjustments. To overcome this, Inflation Accounting was introduced which has an in-built mechanism of taking into consideration all these factors and restate the figures in terms of inflation adjusted costs and remove the distortions caused in the financial statements due to changes in the value of money (Landsman et. al, 2014).

The most popular methods under inflation accounting are Current Purchasing Power Method, Current Cost Accounting Method and Hybrid method with the set of calculations and workings for each.

Owing to the limitations of the current purchasing power method, the current cost method was introduced. This method uses money as a unit of measurement and the items on the financial statements are restated on the current value terms and the profits are computed based on the current value figures of assets and liabilities. Thus the general purchasing power of money is the focus point in this method.

This method requires the workings of Revaluation adjustment, Depreciation adjustment, Cost of sales adjustment and monetary working capital adjustment.

An asset is purchased on 01-01-2015 for $50,000 and on 31st December, 2015 it costs $80,000 to acquire the asset. So the unexpired service potential of the asset as on 31st December is $80,000 which is the Net replacement cost. If this machine has eight years of useful life with no scrap value then the current price of the asset at the end of first year would be $80,000 Less Depreciation for 1 year of $10,000 which yields a result of $70,000.

The deficiencies of this method are that the Net Replacement Cost is not easily available. Charging of backlog deprecation against capital reserves is not appropriate as a proper method is considered to be charging it against revenue reserves to make the future funds availability for the management for the replacement of assets. The materiality aspect is ignored in this method as the valuation has to be done for all assets and these adjustments cannot be ignored. The valuation process is also subject to the personal judgment of the managers and hence the valuations might not be real and adequate.

For all these reasons, this method is considered to be inefficient in comparison to historical cost method.

Continuous Contemporary Accounting Method

This is the accounting method that measures the assets and liabilities at their current cash price and the profit or loss is thus measured in terms of changes in values of the same. The Net Realizable values of the assets and liabilities are considered to be the current cost. As businesses evolve, their accounting practices should also evolve. As technology advances, the older assets have to be disposed off and newer assets have to be purchased. So the idea behind this method is to provide cash for this replacement. Presenting financial statements at current cost helps in making economic decisions and the current predictive prices of assets help in the calculation of the profits based on the changes in firm’s adaptive capital during the period. The financial statements can be continuously used in advising about buy and sell and thereby greater chances of survival in the competitive markets.

For instance an asset purchased for $60,000 has a net replacement value of $90,000 on the balance sheet date, then $90,000 is the current value based on which financial statements are prepared.

The weakness of this system is that it requires a shift in the accounting system due to which there is reluctance to shift from the current systems. In certain cases, the asset might have a high value within the firm but a low selling price in the external market. In this case, the exit value is taken for CoCoA method of valuation which is not completely accurate. For all these reasons, this has not become a widely accepted method.

Each of the methods has its own advantages and disadvantages. Hence none of the methods have stood the test of time and proved to be so reliable like the Historical Cost method. For this reason, IASB has also approved the Historical Cost Method to be the most superior among all other methods.

Conceptual Framework

Conceptual Framework can be defined as the group of ideals and objectives that lead to the establishment of a rules and standards with reference to the accounting nature, functions, presentation and disclosure of the financial statements. The objective of the conceptual framework is that it serves as a basis for resolving disputes related to accounting, the fundamental principles and rationale behind the accounting standards is made clear and understandable and there is no repetition in the accounting standards (Graham & Smart, 2012). The qualitative characteristics discussed and stressed upon render fair reporting in the form of financial statements.

The need for this establishment of a neural set of conceptual framework arose from a few facts like the fire fighting approach by a few bodies in response to a corporate scandal or the biased nature of the standard setting bodies that were influenced by a few factors and successive standards for the same theoretical issues like for instance, does research and development cost give rise to an asset or liability, so on and so forth. 

The FASB has with the help of conceptual framework issued consistent and useful standards with the required amendments to incorporate the changing scenarios and the new emerging problems. 

Professionals like Chartered Accountants gain expertise over this knowledge of conceptual framework which helps them legitimize their professional powers and gain autonomy and control over their works. Preparation of the Financial Statements in strict adherence to the conceptual framework is the duty of those responsible for preparation and presentation of the financial statements (Gordon et. al, 2012).

The development of the accounting and auditing profession is centered on qualities like honesty, integrity, confidentiality, independence and such other personal qualities and this gains immense respect for the professionals. The usefulness of the conceptual framework is only when the rich knowledge acquired by the professionals is put to proper application (Needles & powers, 2013). 

Due to the evolvement of the subject over various times and the many interpretations of the standards and laws, accounting profession’s legitimacy is endangered. Hence members are suggested to counteract these threats by the repeated and consistent study of the conceptual framework which is even referred to by the state and political resources in struggling times.  

The recognition of the measurement concepts is laid upon a few assumptions, principles and constraints. The analysis on the qualitative characteristics of accounting information helps in the management in making finer decisions as to which among the very many alternative treatment options will be the most beneficial to the users of the financial statements (William, 2010). The decision makers analyze on the basis of cost versus benefit and materiality.

The beneficiaries of adherence to the conceptual framework can thus be listed below:

  • The Financial Statements will be both reliable and relevant for the users. It will help in better understanding and will create enormous advantage for the end users. Reliability comes from the representation of faithfulness, verifiability, neutrality and independence (William, 2012).
  • Relevance comes due to the timeliness of the issue of financial statements to adding a predictive value and feedback value. Apart from this, financial statements lend consistency and comparability. If any comparison needs to be made then it is possible by comparing the annual reports (Brealey et. al, 2014). Further ratios can be computed and forecasting can be done through it.
  • Various statutory and revenue authorities also consider the financial statements for analysis, reference and investment purposes. The development of conceptual framework also improves the confidence level of financial reporting and makes it public. It lays a strong standard and hence benefits the entire users. Moreover, it creates a strong level of trust (Brealey et. al, 2014).
  • The conceptual framework also paves the way for the smooth transition to IFRS. In short, it can be said that conceptual framework is a backup and helps in leading to better (Daske et. al, 2008). There is more harmonization while the preparation of financial statements as the number of permitted alternatives has been narrowed down. It also assists the preparers is such issues for which there is no official standard available.

Thus to enable companies to provide high quality and transparent global reporting, conceptual framework comes as a boon. So the corporate world and professionals have highly benefitted by the development of the conceptual framework.

Financial statements are a link by which the management communicates with the shareholders. It should be provided in such a way that the agency relationship should work out on a long term basis. Accounting information should satisfy decision making and stewardship functions. The objective of the financial statements is to render decision making ability for the users of the financial statements. But there is no model or tool o measure the decision usefulness of the financial statements (Melville, 2013).

Decision making is associated with the efficient allocation of the resources in the economy; whereas stewardship aims at improving the efficiency of the contractual agreements. There are cases when there could be a potential conflict between these two functions.

For instance, whether decision making or stewardship should be given priority is a subjective matter. While reporting for a privately held entity, the decision making factor might not be really important, but while reporting for a publicly held company, decision making is important. Also stewardship is significant in a privately held entity to determine the potential liabilities not only for owners but also for the lenders (Horngren, 2013).

In a publicly held company, the information given to the lenders need not be the same as the information for equity holders. Also the equity holders would be interested in knowing the efforts taken by the management which gets covered in stewardship (Horngren, 2013). On the other hand, in a private entity, the owners and management are closely aligned so there might be lack of interest in knowing the efforts of the management.

The objective of decision making is to indicate when to buy, sell or hold securities and to account for timing and uncertainty of cash flows. By stewardship, users can assess and control the management and provide a platform for dialogue (Deegan, 2011). Financial accountability is not just limited to reporting figures on the balance sheet, but also reporting on the success of the various business structures and models, reporting of significant transactions and events. It is seen that while small investors view stewardship as being a governance feature, large investors consider this to involve assessment of the management including a review of related party transactions and such areas.

The analytical literature on these two functions demonstrates the asymmetry between the two. Irrespective of this, both decision making and stewardship functions are important. It would not be wrong to say that stewardship focuses on long term considerations, completeness, transparency and reliability.  The relationship between decision making and stewardship can be explained below:

Conclusion

The information used for both these functions is the same. If different information is used for different objectives, then it becomes incompatible.  For instance, when to comes to asset valuation, stewardship function requires that the current value of the asset is provided which will help in ascertaining the productivity of the machine and factors like value in use and current replacement cost (Libby et. al, 2011). On the other hand, decision making objective would recommend the historical cost concept to be followed for asset valuations. Another example can be of acquisition costs . The stewardship approach holds the management wholly responsible for any acquisition and would expect future benefits from the same. It also requires that any impairment in the management’s decisions are also accounted for and disclosed to the share holders (Albrecht et. al, 2011). But the decision making approach does not call for any such impairments of acquisition costs.

The existing framework contained under IFRS states that accountability is the primary objective along with decision making.

There are many investors who still identify stewardship function to be synonymous with accountability. Hence to conclude it would be pertinent to state that here is a broad consensus between IASB and FASB that stewardship should be retained as a separate objective of the financial statements. It is broader than the resource allocation and it concerned about the past performance and also about the future (IASB, 2010). For this reason, it should be retained as a significant reporting feature to lay emphasis on the overall company performance and not just cash flows.  Omitting the stewardship could lead to the omission of major portions of performance reporting.

References

Albrecht, W., Stice, E. and Stice, J. (2011).  Financial accounting. Mason, OH: Thomson/South-Western.

Brealey, R, Myers, S. & Allen, F. (2014). Principles of corporate finance. New York: McGraw-Hill/Irwin.

Brigs, A.  (2013). Financial reporting & analysis. Mason, Ohio: South-Western.

Deegan, C. M., (2011).  In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill

Graham, J. and Smart, S. (2012).  Introduction to corporate finance. Australia: South-Western Cengage Learning.

Guerard, J. (2013). Introduction to financial forecasting in investment analysis. New York, NY: Springer.

Horngren, C. (2013). Financial accounting. Frenchs Forest, N.S.W: Pearson Australia Group.

IASB (2010). The Conceptual Framework for Financial Reporting, Retrieved August 21, 2016, from http://eifrs.ifrs.org

Landsman, W. R., Maydew, E. L., & Thornock, J. R. (2014). The information content of annual earnings announcements and mandatory adoption of IFRS. Journal of Accounting and Economics, 53, 34-54.

Leo, K J. (2011). Company Accounting, Boston: McGraw Hill

Libby, R., Libby, P. and Short, D. (2011).  Financial accounting. New York: McGraw-Hill/Irwin.

Melville, A (2013).  International Financial Reporting – A Practical Guide. Pearson, Education Limited, UK

Needles, B. E & Powers, M. (2013). Principles of Financial Accounting. Financial Accounting Series, Cengage Learning.

Daske, H., Hail, L., Leuz, C., & Verdi, R. S. (2008). Mandatory IFRS reporting around the world: Early evidence on the economic consequences. Journal of Accounting Research, Vol. 46, no. 5, pp. 1085-1142, 2008.

Gordon, L. A., Loeb, M. P., & Zhu, W. (2012). The impact of IFRS adoption on foreign direct investment. Journal of Accounting and Public Policy, 31(4), 374-398.

William, L. (2010). Practical Financial Management. South-Western College.

Williams, J. (2012). Financial accounting. New York: McGraw-Hill/Irwin.

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