ACC518 Current Developments In Accounting Thought Essay.

The conceptual framework tends to spell out the various attributes that the financial statements need to achieve in order to ensure relevance for the intended users. As the key objective of the financial reporting process is to enable the underlined users to make prudent decisions, therefore the information represented in these statements must fulfill two qualitative characteristics. One of these characteristics is timeliness and the other one is faithful representation. Within the ambit of faithful representation, there are essentially three key elements namely completeness, error free and neutrality (Deegan, 2011). Neutrality implies that the information cannot be selectively chosen in order to serve vested interests of a particular sector of stakeholders. The reporting entities are expected to report the accurate information without any bias and influence of the resulting consequences. Thus, unbiased disclosures need to be made irrespective of whether the highlighted information projects the business in good light or not as the underlying emphasis is on accurate reporting so that correct information is made available to the stakeholders for facilitating correct decision making with regards to the future relations that they intend to keep with the entity (AASB, 2008).

A bigger concern is whether neutrality is feasible under current times. In this context, it is pivotal to note there is considerable uncertainty in the business environment in which the management on regular basis needs to deploy their prudent judgements while reporting the financial statements and the estimated future implications of the current activities (Deegan, 2011). This is expected to increase in the future as is apparent from the introduction of AASB 15 which deals with revenue arising from contracts and tends to provide a high deal of flexibility and scope for management judgement while application. Wherever the management is expected to make judgement, a principle assumes information that has been highlight in both IASB and FASB framework i.e. prudence. There is inherent conflict between neutrality and prudence as prudence requires a deal of conservatism in the estimates unlike neutrality which advises for realistic estimates and not to exhibit unnecessary caution (AASB, 2008). Further, while exhibiting the judgement with regards to various aspects, it would be naïve to assume that management biases do not creep in.  Considering the role of management judgement in the representation of information captured in the financial statements, it would be fair to conclude that information represented cannot be ever neutral and completely representative (Davies & Crawford, 2012).

Also, the empirical basis for the extent of accuracy that would be classified as faithful representation is lacking which necessitates the need for inclusion of faithful representation in conceptual framework.  While perfect information free from any error and bias may remain elusive but at the same time it is essential that management must make necessary efforts in order to insure that the goals of neutrality and fair representation should be met to the extent possible (Deegan, 2011). Further, in case of any intentional breach of neutrality or faithful representation, punitive measures may be deployed so as to fix accountability. This ensures that to the extent possible, neutrality and fair representation in ensured (Davies & Crawford, 2012).

The various issues with the usage of historical cost for accounting measurement are highlighted below (PwC, 2008).

(1) The value of the various assets such as land and other intangible assets is recorded at their cost price. However, the price of these assets tends to be highly volatile and thereby the current fair value of the asset might be significantly different from the reported values. As a result, utility for decision making is limited.

(2) This method does not take into effect the impact of inflation. Further, it also tends to ignore the impact of changes in currency rates which tend to reflect upon the prices particularly when the assets may not be limited to the home country only.

(3) The reporting of intangible assets is particularly misleading as there could be potentially wild swings in the value off the same depending upon a host of factors. Further, the direction and extent of price movement of intangibles also provides key information about the future prospects of the company to the investors.

Despite the weakness highlighted above, the historical cost method is extensively used for measurements due to underlying merits. One of these is that computation of depreciation & amortization on assets (both tangible and intangible) becomes easier and predictable. Also, it provides limited opportunity for the management to report inflated values of assets thus allowing for potential abuse to serve ulterior motives. It ensures representation of the cost at which asset acquisition took place and is exceptionally simple and reliable to use (Wharton, 2001).

An alternative to the above method is the fair method approach which has been endorsed by the IFRS also especially considering the volatility of asset prices in the modern business environment. The various merits of fair value approach to accounting measurements are highlighted below (Ramanna, 2013).

• Correct valuation of the organizational assets is represented in the financial assets which enable them to maintain their relevance and utility to decision making by the users.
  
  
• The fair value of the intangible asset is represented on a periodic basis which provides the investors with key insight on the future business prospects which further assists decision making.
  
  
• Also, in acquisition analysis the goodwill accounting could improve as the business assets could be valued fairly and the incremental amount paid could be attributed to the underlying goodwill.

However, one of the major issues with fair value approach is the difficulty in determining the fair value of asset when the active market for that market does not exist. This is particularly the case for the intangible assets which form a significant component of the total assets for a host of companies. Any overestimation of these amounts could potentially result in significant loss to stakeholders such as lenders and creditors.  Further, considering the management discretion available in the process, there are realistic chances of potential abuse which could be disastrous. Thus, in the absence of reliable valuation estimates, the historical cost measurement may prove to be a better choice (Costa & Guzzo, n.d.).

The key role of financial reporting is to enable the relevant users to improve decision making. As a result, it is pivotal that the measurement basis that is deployed should reflect the priorities of the various stakeholders particularly the investors, creditors and lenders as these three stand to lose in a major way if the company eventually goes into liquidation. The implications of measurement basis decision is closely linked to the needs of the various highlighted above (Deegan, 2011). This relationship for the various users is outlined below.

• Potential Investors – One of the key parameter influencing the investment decisions to be made by potential investors is the underlying price of the company’s stock. The pricing of the stock is closely linked to the earning per share or EPS generated. The EPS further is dependent on the net income reported in the income statement. In the computation of income, any impairment losses on the intangible assets need to be accounted for which would tend to lower the income (Davies & Crawford, 2012). Further, since the intangible assets tend to result in future cashflows, thus a reduction in their value is indicative of their lower cash flow generation which typically should lead to revision to lower stock price. As a result, historical cost based measurement could prove disastrous for the investor as it continues reporting based on historical costs which might have little relevance in the present (Costa & Guzzo, n.d.). Hence, fair value based measurement system would be more preferable.

• Creditors - For the creditors, the short term liquidity of the company along with the financial strength of the balance sheet are key aspects which need to be taken into consideration. Besides, the underlying strength of the business model along with the capacity to generate profits is also essential. As a result, it makes sense to deploy fair value based measurement of various key items in the balance sheet so as to provide an accurate analysis of the underlying balance sheet strength (Deegan, 2011). Besides, due to linkage between the income generated and the cash flow, both are pivotal information sources which tend to indicate the operational cash flows and short term liquidity based on which creditor would make decision about extending credit and the underlying terms (PwC, 2008).

• Lenders – For the lenders, more than the short term, the long term liquidity is critical. In this regard, the fair value of assets is imperative as these might be attached to the loan facilities that may be assumed. Also, a fair assessment of the asset value on a periodic basis tends to have an impact on the debt equity ratio as the changes in asset value are captured in asset revaluation which forms a part of equity. Further, the lenders also may take pledge of shares in order to provide cover on the loan facility extended (Ramanna, 2013).

It is apparent from the above that the decision by the IASB to endorse fair value based measurement as against historical cost basis is drive by the needs of the various relevant users as has been highlighted above.

AASB (2008), An improved Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-useful Financial Reporting Information, Australian Accounting Standards Board, Retrieved April 5, 2017 from http://www.aasb.gov.au/admin/file/content105/c9/ACCED164_06-08.pdf 

Costa, M. & Guzzo, G. (n.d.), Fair Value Accounting versus Historical Cost Accounting: a theoretical framework for judgment in financial crisis, Virtue Inter Press, Retrieved April 5, 2017 from http://www.virtusinterpress.org/IMG/pdf/Massimo_Costa_Giusy_Guzzo_paper.pdf 

Davies, T. & Crawford, I. (2012), Financial accounting (2^nd ed.), Harlow, England: Pearson.

Deegan, C. M. (2011), In Financial accounting theory (3^rd ed.), North Ryde, N.S.W: McGraw-Hill.

PwC (2008), Fair value accounting: Is it an appropriate measure of value for today’s financial instruments?, PwC Website, Retrieved April 5, 2017 from https://www.pwc.com/us/en/point-of-view/assets/pwc_pointofview_fairvalue.pdf 

Ramanna, K. (2013), Why “Fair Value” Is the Rule, Harvard Business Review, Retrieved April 5, 2017 from https://hbr.org/2013/03/why-fair-value-is-the-rule 

Wharton (2001), Historical Cost Vs. Current Cost: Accountants Wrestle with Reporting Question, Wharton Website, Retrieved April 5, 2017 from  http://knowledge.wharton.upenn.edu/article/historical-cost-vs-current-cost-accountants-wrestle-with-reporting-question/