The provided essay describes about the conceptual framework on quality of accounting records such as financial statements. According to Australian accounting standard board it has emphasized the relevance of faithful representation and neutrality in financial statements. After this, the essay provides a brief on historical cost accounting. It is basically recording of assets and liabilities at their purchase cost, which means the change in market value of assets and liabilities are ignored. Furthermore, the essay describes about the impact of potential users on the measurement basis of the company as chosen by international accounting standard board (Ernst and young, 2010).
The financial statement of the company must possess qualities like: relevance, reliability. Here relevance of financial statement can be ensured by considering predictive value, feedback value and timeliness. While in case of reliability the financial statement must be verifiable, neutrality and representational faithfulness. Relevance and reliability are considered as primary qualities of the financial statements. However the secondary qualities of financial statements are comparability and consistency (IFRS, 2009).
Relevance and faithful representation are considered as fundamental qualities for the financial statements. These elements are required for effective decision making in the organization. Here faithful representations are necessary in financial information so as to make the data presentable to the real world. It is necessary for the users as they don’t have time to search out the factual figures for the information provided. It also can be understood as to make a match between numbers and descriptions with actual facts and figures. For making the financial statements faithful, the quoted information must be neutral, complete and free of materialistic error. Here neutrality means the company should select information unbiased. As to benefit one group of user, over the burden on another group of user would affect the neutrality aspect of the financial statements. Hence to ensure neutrality financial reports of the company must be credible and unbiased (Baskerville, 2015).
Representation on qualititative criteria as faithful representations and neutrality
The information mentioned in the financial statements can be considered as reliable only if it is neutral. Neutrality means unbiased with the users who are potentially affected by the financial statements. According to Australian accounting standard board it is not easy for the companies to ensure neutrality in their financial statements. Besides this, it might possible that the standards issued by the Australian accounting standard board, favors one group of companies on the burden of other companies.
Critical evaluation of financial information being neutral or faithful representational
Faithful representation can only be ensured if the information in the financial statements is verifiable and neutral. For ensuring faithful representation, management has to ensure some factors indicating completeness, less error prone and neutrality. The second indicator of faithful representation is effective internal control system mechanism. The internal control system increases the confidence of public in financial statements. Besides this the opinion of auditor also plays a considerable role in ensuring the faithful representation of financial statements.
Reference to representational faithfulness within conceptual frameworks
Both international accounting standard board and financial accounting standard board has worked together to develop a statement of framework, which is called as conceptual framework. The conceptual framework develops a foundation for setting the future of accounting standard. It fulfills the goals of board that all the principles and policies are consistently followed. Faithful representations are required to fulfill the requirement of timeliness and understandability (Epstein, & Jermakowicz, 2010). According to the Australian accounting standard board, faithful representation in financial reporting is required so to ensure the completeness, neutrality and free from error (Rich, Jones, Mowen, & Hansen, 2012). Here completeness means that all the stated information is complete in all manners. There is no relevant information which is missed. Neutrality according to Australian accounting standard board means that all the information must be free from biasness to make the financial statement credible. It is required by the standard setters to make the public or general investors sure that all the mentioned information is credible and unbiased (Deloitte, 2013).
Historical cost accounting
Historical cost accounting is a measure to measure the assets and liabilities value. It is the method which helps the management in valuing the amount at which all the assets and liabilities are required to be quoted in the financial statements. Historical costs are known as original cost or nominal cost, this is the cost at which the asset or liability has been acquired by the company. This costing method was developed by GAAP (Generally Accepted Accounting Principle). According to this method, all the assets and liability has to be recorded at the amount on which the company has acquired them, which means that any changes in their respective market value would be ignored (Bakar and Said, 2007).
Weakness of historical cost accounting
Financial statements which are prepared on historical cost accounting method, has certain limitations which are as follows:
- Changes in the price level of the financial transactions would not be considered in the financial statements. Hence by not showing the changes in the value of financial assets and liabilities would lead to affect the true and fair image of financial statements (Needles, & Powers, 2010).
- In this method, fixed assets are valued at historical cost that is the price at which they were acquired by the company. Here changes in the market value of fixed assets are ignored, which will affect the realistic aspect of the company’s financial statements (Hare, 2016).
- Historical cost method also ignores provision concept. For example in case of provision for depreciation, it is charged on the historical value that is the price at which they were acquired. Hence by charging depreciation on the historical value do not gave a comparable analysis with replacement values (Kieso, Weygandt, & Warfield, 2010).
- By quoting the financial assets on historical cost the financial statements would reveal unrealistic profit. Besides this in historical accounting method, all the revenues are recorded at current value while the expenses are recorded at historical cost, hence by this the profits shown by the financial statements do not show true picture, hence the performance of the company also got affected (Henderson, Peirson, Herbohn, & Howieson, 2015).
- The financial statements of the company comprises of monetary as well as non monetary items. In case of historical accounting method, the monetary items such as debtors, cash, creditors, loan etc, are shown at their current value, while in case of non monetary items they are shown at historical values. Hence by this, during the inflation time, all the non monetary items show understated values. This affects the true and fair view concept of financial statements (Brown).
Importance of historical cost accounting in financial statements
In financial statements historical cost is preferred because accounting is done by keeping past events. Hence to bring consistency and comparability the accounting transactions are recorded in historical costs. Following are the key points which show the relevance of historical cost method in financial statements:
- Simplicity: historical cost method is mostly preferred in the organization for valuing the assets and liabilities. The reason behind this is management does not require conducting research and valuations to measure the market values of its assets and liabilities. Hence by quoting the assets and liabilities at a single cost makes provision easier for the management as well as user. The reasons behind this, the change in values are not considered in the company’s financial statements. The following are key points which are show the relevance of historical cost accounting in financial statements:
- Objectivity: the motive of the management is to make the financial statements objectives and comparable. This is the reason which gave importance to present document evidence such as: invoice, cheque, statements, voucher or receipt.
- Consistency: historical cost accounting is preferred in the organization due to the reason of providing consistency with the purpose of providing consistency in the organization and recording the values accurately (Whittington, 2012).
- Conservative: the motive of historical cost accounting is not to distort the value of financial statements. By following conservative approach, it is meant that the appreciations in the value of assets are not considered until and unless it is secured by current sale in the market. While if fair value accounting would be considered it would open the opportunities for the management for accounting creatively, and would also affect the true and fair view of financial statements by making changes in the accounting values management can earn personal gain. Hence to avoid such situation in a company, historical costing method is preferred (Bernstein).
Alternatives of historical cost accounting
The alternatives of historical cost accounting are as: current cost, realizable value, present value, accrual basis, cash basis.
- Current cost basis: in this method, assets and liabilities are recorded at their total cost. It means that the expenses, commissions are also included in the cost of asset and liabilities.
- Realizable basis: in this method assets and liabilities are recorded at an amount of their selling price less selling cost such as its completion or disposable cost.
- Present value basis: this method is preferable so to reflect the time value of money in assets and liabilities.
- Accrual basis: in this method, transactions are recorded as and when they occur, this means that whether the money from that transaction has been realized or not, it will not affect the recording of transactions (Weil, Schipper, & Francis, 2013).
- Cash basis: in this method, the income and expenses are recorded on the basis of their receivables and disbursements respectively. This method is usually preferable in those organizations which are small in size and net worth (Bernstein).
Measurement basis suggested by IASB and their impact on potential users
The measurement bases as referred by international accounting standard board are historical cost, fair value, and realizable value. Here potential users are existing and potential investors, lenders and other creditors for making decisions. There are different types of users of the financial statements. Every potential user has a different perspective regarding the valuation of assets and liabilities. For example potential investor would like to value the financial statements at their present value. While in case of lenders and creditors, they want to value the financial statements at realizable value. Hence it is said that every user has a different perspective regarding financial statements hence, financial statements cannot be made by following one accounting method as suggested by International accounting standard board (IFRS, 2012).
Importance of fair value accounting or historical cost for users
Fair value accounting and historical cost accounting are two methods that need to be adopted by the company, for valuing the assets and liabilities of the company. In fair value accounting the assets and liabilities are valued at their current price. While in historical cost method, the valuation is done on the basis of past prices. There is no method which can be said as more preferable to user. The reason behind this is, both the method provides some useful information in different contexts (Alexander, Britton, & Jorrison, 2007). If the management would be considering only one accounting method, it might be possible that financial statements start giving misleading results. Both fair value accounting method and historical costing method levies some risk. Besides this, different users have different perspective regarding the valuation methods adopted. Like in case of risky company it is preferable by the user to follow fair value accounting method in the company financial statements. While in case of stabilized company which has stable earning, the user has preferred historical cost method to be followed in the financial statements (ICAEW, 2011).
By analyzing the essay over accounting cost theories it is said that, choosing one accounting method is very complicated task for the management. The reason behind this is, each and every method of valuation of assets and liabilities in the financial statements has its advantages as well as disadvantages. If the organisation opts for historical cost method due to its simplicity, fair value method considers this as obsolete method. According to international accounting standard board, that accounting method should be adopted by the organization which provides best quality of its financial statements in terms of liquidity. In case of financial statements showing true and accurate picture, international accounting standard board has recommended for the use of fair value accounting method. Even if the organization has adopted for historical cost accounting, the company must use fair value accounting in showing some of the transaction in its disclosures. This is required to show the exact picture of the company in market for example in calculating ratios like market price per share, price earnings ratio etc. hence it is concluded that there is no specific method that can be referred to be followed by the company, while it is suggested that method should be opted depending upon the risk factors of the company and its potential users.
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