Measurement and Recognition of Issues Related to Financial Accounting - Essay Example

Measurement and recognition of issues related to financial accounting Name University Course Date Measurement and recognition of issues related to financial accounting Part 1 – historical cost accounting Abstract In the undertaking of financial accounting undertakings, the measurement and recognition of the events and activities that have taken place is a very important and crucial undertaking. This is due to the various forms with which they influence the industrial and performance of any given organization. The carrying out of the measurement of the financial transactions, there are four main methods that are used. There are however four major methods that are used and that are commonly known as principles of accounting. They are historical cost, full disclosure, revenue recognition and matching concept. Each of them has a certain role that it plays in the reporting and the disclosure of the financial statements of a given entity or firm. It is with the above policies and principles that the measurement of the values and the recognition of the assets are made possible. As pointed out the benefits of this are that they aid in the presentation of the financial statements because they all help in the determination of the actual worth. This value is later used in the valuation which is the basis that is used by the investors of any given entity in the coming up with the actual worth of a business. Historical cost accounting Historical cost accounting is the valuation of an asset based on the initial value or cost of purchase. This is by through the ignorance and assumption of the other actors in the life of an asset such as increase in the value of the asset over the period. The historical cost accounting does not put into account any unrealised holding gains that accrue from a given asset that may arise from the increase in the monetary value of the asset. This is mostly so during the periods of inflation in a given economy. In the historical cost accounting method, the inventories and stocks that are acquired at old prices are matched against all the revenues that accrue from them. They ate then expressed at the current prices. This has the effect of resulting to overstated profits especially so during the times of inflation in a given economy (Australian Accounting Standards Board, 2011). In its part, the historical cost accounting method ignores all the effects of inflation on a given asset. With this, any increase or decrease in the value of the asset because of the effects of inflation in a given economy are not considered or factored in. Historical cost accounting is characterised by the use of previous value and figures to express the value of a given business. It is as such an expression of the past performance of the business and rather not the status of the business. It is n respect to this that the historical cost accounting method is not a reliable method top analyse the financial statements or the performance of a given business. This is mostly so because it increases the value of the assets which depreciate in value such as the machinery and plants. It also has the effect of undervaluing the assets that appreciate in value such as land this is because in all the cases the prices that are stated and recorded are the prices at the beginning of the undertaking of business or the purchase prices of the said assets (Australian Accounting Research Foundation, & Australian Accounting Standards Board, 1993). Through historical cost accounting, a business is therefore described based on the value of the assets at their acquisition. The ignorance of the important aspects such as the depreciation and appreciation makes it an unreliable form of valuation of the assets. Limitations of historical cost accounting As stated, historical cost accounting has several limitations that hinder and affect its effectiveness and use in the operations of a given company. Some of the limitations as pointed out therefore are as follows; a. Overstatement of the profits – the historical cost accounting overstates the profits that are made by a given company or business. This is mostly so through the undercharging that is carried out on the assets and the depreciation charges. This is because the amount that is used for the depreciation is used on an estimated useful life of an asset over its period and use. This is also through the charging of the amounts of the costs of goods sold at the historical costs of the inventories b. Difficulty in assessing actual performance - the historical cost accounting method has the effect that it results to the use of the values of assets at the historical amounts and values. Through this, it makes it difficult for the shareholders of a given entity to determine how the actual and the current operations of the company operate. This is with past values. Through this therefore, it is difficult for them to assess the performance of the management. c. Assumption of changes in the current market conditions – historical cost accounting has the limitation that it ignores that changes that take place in the current market conditions. For example, an increase in the value of land in a certain area or locality to the invention or discovery of minerals is not accounted for (Australian Accounting Standards Board, 2000). Through this, it misleads the investors and the observers and users of the financial statements through the ignorance of this. d. Depreciation effect – the depreciation that is normally charged on the assets is based on the historically valued assets and values. With this therefore, there is the use of arbitrary figures and values that are misleading to the users of the financial statements. This is eventfully misleading, as an asset cannot constantly hold its useful life over a long period while it is in use. e. Valuation of entities – with historical cost accounting techniques, it becomes difficult and in some cases impossible to determine the actual and true value of a given business. This is also because of the misleading figures that are used in the asset description. f. Use of ratios – the use of ratios to determine the performance of a given business becomes completely unreliable and inaccurate. This is because of the overstatement of the profits that are made by the businesses. With this therefore, the ratios that are used such as the asset turnover ratio and the return on total assets are inflated. This is a misleading aspect of the business in its operations. g. Inflation aspect – the historical cost accounting method has the trait of ignoring the aspect of inflation in the valuation of the assets of the entity. With this therefore, it becomes difficult to determine the capital base of the company. With this therefore, the company undertakes to put into use items and values that are ignorant of the effects of inflation. This makes them inaccurate and unreliable in their use. (AASB, 2011) Conclusion In conclusion, the use of historical cost accounting is misleading to the affairs and the management of a given entity. This is mostly so because of the limitations of the principle. As pointed out, some of the limitations of the principle include that it ignores the accounting and the aspects of inflation in a given business. In this therefore, it is misleading to the entity and its usability is hindered. Another limitation also pointed out is that this method values the assets at the purchase or original costs. With this therefore, it is difficult to determine the exact value of the asset now. This is because the value that is also used on the depreciation is arrived at through the estimation of the probable useful life of a given asset. This is also a misleading case and factor. The use of the historical cost accounting principle ignores the changes that may occur to the asset in its useful life. Through this, there is an overstatement of the amounts that are given of the profits of the company. It is through this aspect that a business is considered to be performing in a manner that is difficult to determine for the company. The shareholders are therefore unable to ascertain the actual value and performance of the business and its management. Its exact and actual value is also an aspect that is difficult to determine. The method should therefore not be encouraged for use to due to the many limitations that are associated with it. This will be for the better of not only the shareholders but also the management of the company and the actual and potential investors. It is through this that the method is considered as being ineffective in its use. There are other methods that have been developed to alleviate the problems and the limitations that are associated with this method. They come to the benefit of the companies that seek to put them into full use. (AASB, 2005) References Australian Accounting Standards Board, 2011, consolidated financial statements, Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2011, Australian additional disclosures, Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2005, Proposed amendments to AASB 3 business combinations, Melbourne, Vic, The Board. Australian Accounting Standards Board, 2000, AASB subscription service. Caulfield, Vic, Australian Accounting Standards Board. Australian Accounting Research Foundation, & Australian Accounting Standards Board, 1993, AARF & AASB report, Caulfield, Vic, Australian Accounting Research Foundation. Part 2 - Fair value analysis Abstract In this part, there is an analysis of the concepts of fair value in the accounting field. With this therefore, a definition is given as to the components of fair value and how it is used in the general accounting practice. With this therefore, the components of fair value are pointed out. A comparison is also given as to the similarities and differences between the fair value of a given asset and the historical cost. Further on, the benefits of fair value analysis on the assets or items of a business is also given. It is though this that an in depth understanding of the concept has been arrived at. Fair value Fair value can be defined as the value for which an asset sells in a given market. The market price cannot be determined or reached with the value. As such, there is the determination of a value that will be favourable to use in the determining the value of the assets or the liabilities of a given entity. The use of the fair value analysis has become popular in the market because some items have difficulties involved in their pricing and valuation. This has come to alleviate all those difficulties. As defined by FAS 157, fair value can be defined as the price that would be received to sell a given asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (Australian Accounting Standards Board, 2011). Therefore, the price is arrived at in the determination and in the allocation of the value of a certain item between the people who are undertaking the transactions. Therefore, the value is acceptable to both parties in a given transaction. In other words, the fair value of a given asset can be defined as the relationship that exists between a market indexes or price and the actual price of a given item as agreed upon by the parties in a given transaction. With the fair value concept, many benefits have accrued to businesses. They are as pointed out below; a. Profitability – fair value aids in the creation of an agreement between parties i a given transaction. This fair value is therefore a price that is usually higher than the market value in most cases. As such, the business benefits from the valuation of their assets at their fair value. They are able therefore to derive the benefits if such things as value increments and inflation that would have previously been ignored by the historical cost accounting method. b. Favourable to the buyer – the fair value, as the name suggests, is a value that is agreed upon by the parties in a given contract or transaction. With this therefore, it is normally slightly lower than the market value. With this, the buyer gains the benefits of reduced costs buy the business with which they are trading (Australian Accounting Standards Board, 2011). This is because there is the concept of bargaining in the transaction. This is therefore also to the better of the firms that operate in the market. The buyer therefore, benefits from the discount factors that come with the use of the fair value valuation of the assets of the company and the liabilities. Through this, the misgivings that would have occurred due to the engaging with the operations with the other businesses, which use methods such as historical costs, are all eliminated. This therefore strengthens the bonds and relationships between the business and the customers. c. Factors in depreciation – the fair value component valuation on a given item factors in depreciation that may occur to a given asset. With this therefore, the business does not make losses that may arise due to the lack of acknowledgement and recognition of the depreciation of its assets over their useful life. Through the factoring in of depreciation, a business is able to determine the net book value that is exact of the assets and liabilities that it has. Through this, the determination of the values that can be derived from them will be accurate and therefore, beneficial to the company. This mostly performs to the better of the company, as it is able to undertake its transactions with adequate knowledge of how it is placed in the market and how much its assets are worth in the market. d. Accurate valuation of a business- the use of the fair value accounting method of valuation of a given firm aids in the determination of the actual value of the business or the entity. This is because it takes into account all the market factors that affect the operations of a given asset or item. With this therefore, a business can be determined in an easy and a more accurate manner as compared to the use of the historical cost accounting method. This is also to the better of the performance of the company. e. Performance measurement – fair value valuation of a given business aids in the assessing of the actual performance of the management or the policies that are put in place on a given business. This is through the consideration of the actual valuation of a business and all the market forces being factored in. Through the enabling of actual performance measurement, a business can be able to know which policies are fruitful and which ones are not in the business undertaking of its tasks. This is usually to the better of the company. Through this also, the shareholders can know whether the management is aiding in the goal attainment process f the company or not. f. Use of ratios – historical cost accounting method of valuation had one demerit of overstating the profits that are made by a given company. With this therefore, the ratios that are arrived at in the business operations are inaccurate and unreliable. However, on the case of the fair value valuation, there is the use of the actual business performance and the determination of the true business value. With this, it is easy for the business to carry out ratio analysis on its items both profitability and liquidity ratios. The outcomes of the ratio analysis is also accurate and can be relied upon by the users of the financial statements of a given business or entity. This is therefore to the better of the company. As pointed out above, many benefits accrue to the businesses that put into full use the aspects of fair value accounting. This is because it becomes easy for them to gain advantage over those that use the historical cost accounting techniques. As pointed out above, some of the advantages that accrue from the use of the fair value analysis method include the ability for the firm to use and put in place ratio analysis techniques. Ratio analysis helps in the determination of the profitability and the aspects of the business that are beneficial to them. It is though this that the performance of the various departments in a given business is analysed. With the fair value method of asset valuation, the business can also be able to ascertain its actual value and impact to the market and the industry. Though this, the shareholders will be able of the policies that have been put in place and the strategies that have been implemented by the management and the effectiveness of each one of them. This is also to the benefit of the company (Australian Accounting Standards Board, 2005). As pointed out also, it will result to the determination of the actual levels of profitability. This is because it factors in all the market conditions and environment. These are such things as depreciation, appreciation and the inflation that may all affect the assets. These are all aspects that had been skipped and ignored by the historical cost accounting method. This is also to the better of the company that uses the method. The determination of the actual values of depreciation aids also in the determining of the actual worth of the assets and the liabilities of the company. References Australian Accounting Standards Board, 2011, Consolidated financial statements, Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2011, Australian additional disclosures. Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2005, Proposed amendments to AASB 3 business combinations. Melbourne, Vic, The Board. PART 3 – ISSUES WITH THE MEASUREMENT AND RECOGNITION OF ASSETS AND ITEMS Abstract In this part, there is the analysis of the issues as pertains to the measurement and the recognition of the instruments in the financial statements. The policies that have been set aside by the AASB have also been pointed out and their impact on the functionality of Woolworths. In this, the policies, rules and guidelines that have been developed as to control this have also been pointed out. Some of the assumptions as to the measurement of the items have also been pointed out. This is in order to aid in the creation of understanding of the factors to do with the financial instruments and their recognition and use by businesses and firms (Australian Accounting Standards Board, 2011). The concept that is used is the Australian case. The benefits of the analysis of this are it will create a basis of understanding on the various principles that have been formed and developed for the better of the firms and their operations. Recognition of an instrument can be defined as the value that the items should be given to an item so that it can be noted and included in the financial statements of a given company or entity. There are guidelines that govern the measurement and the recognition of an item in the books of accounts of a given entity. There are guidelines as to the materiality of a given item so that it can be recorded in the financial statements. There are therefore four key guidelines as to the threshold that the items must fulfil in order to be recognised in the financial statements. They are as indicated below; 1. Measurability – for an item to be recognised in the financial statements, it should have the ability to be measured in monetary terms (Australian Accounting Standards Board, 2005). The measurement of the items should also be accurate and should give the true value of the item. 2. Reliability – the information that seeks to be used is truthful in its representation and can be relied upon by the users of the financial statements. 3. Relevance – the item or instrument in question should have the ability to influence the decision making process in the given entity with its inclusion or omission. 4. Definition – the item in question should meet the definition that has been set for an item to appear in the financial statement so as given firm. It is through this that it becomes easy and possible to identify the items that should be recorded and those that should not be recognised in the financial statements. The policies to do with the recognition and the recording of financial instruments in Australia are governed by the Australian Accounting Standards Board (AASB). This is concerned with the determination of the rightful policies to govern the adherence to the recognition and the measurement of the instruments in the financial statement. Recent years have seen changes and advancements in the guidelines as to the recognition and the reporting of the instruments (Australian Accounting Standards Board and Perkins, 1996). Some of the guidelines that have been developed and that are adhered to by all Australian firms including Woolworths Limited include; a. All the investments of the company excluding the investments that are accounted for using the equity method of accounting or those, which will result to the consolidation of the investee, should be measured at their fair value and the changes that accrue from them recognised in the net income of the business. This has come to eliminate or reduce the use of the historical cost accounting in the valuation of the investments. This has been to the better of the Woolworths shareholders as they are able to know the values of the investments that the company has made. b. All the public business entities should put into full use the exit price notion in the measurement of the fair value of the financial instruments for disclosure purposes. With this, the prices and the published statements that are released to the public by the company have all item and asset prices and the fair value price valuation. This aids in the decision making process of the people. This is for the better of the operations of the company. This is because all the users of the financial statements will have a clear picture as to the performance of Woolworths. (AASB, 1993) c. There should be a separate presentation of the financial assets and the financial liabilities of a given entity. This is by their measurement category. This has been through the association with the form of the asset. This has aided in the creation of a proper distinction as to the items such as loans, securities and receivables in the books. In the case of Woolworths, this has aided the users of the financial statements to be aware of the accurate value of each of the items as is recorded in the books. This is for the better of the operations of the company as it has in respect to these attracted investments into its operations. Through the accurate reporting also, the businesses have been able to undertake its operations in a manner as to be able to know the value of each of its items. d. Another guideline that has been put in place is that there is the elimination of the requirement to disclose the fair value financial instruments measured at amortized costs for the organizations that are not public business entities. This on the part of Woolworths has not been of much significance as it only applies to non public companies whereas Woolworths is a publicly traded company. (AASB 2011) e. Elimination of the requirement for the businesses that are operating publicly to disclose the methods and the assumptions that have been used when arriving at the values of the fair values of the financial instruments to be disclosed for the amortization purposes. Woolworths has over the past, sold some of its assets and by being concerned with the retail business, it is involved with major valuation requirements of the items such as the inventories and the other assets. Based on this, the company is not required to make it public how the values that are used and the assumptions that are applied in the arriving at the fair values have originated. Though this, the company has had the freedom to use whichever method or assumption they deem to be fit for the application if the values of the assets. f. The final regulation has been on the requirement that a reporting organization should present separately in the comprehensive income the portion of the total deviation and variation in the fair value of a liability that has accrued following a change in the instrument-specific credit risk. Woolworths based on this regulation is not required to report to any one the amounts or values of the liabilities that have arisen because of the changes in the fair value valuations (Australian Accounting Standards Board, 2000). The liabilities therefore only have to be stated at their fair value amounts and no more information should be given as to their origin or occurrence. With this therefore, there is the freedom of the company to adjust the fair values at their own will. As pointed out above, there are principles and regulations that have been set by the governing body as to the use and the control of the values of the items in the financial statements of the companies. This has impacted to a great proportion the reporting that is done by the company in terms of the instruments on the fair values. The items that have been mostly affected include the assets, liabilities and the investments. The Australian Accounting Standard Board has played a key role in the regulation of the measures that are put in place by the companies to control the recognition and recording of instruments in the financial statements. References Australian Accounting Standards Board, 2011, Consolidated financial statements, Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2011, Australian additional disclosures. Melbourne, Australian Accounting Standards Board. Australian Accounting Standards Board, 2005, Proposed amendments to AASB 3 business combinations. Melbourne, Vic, The Board. Australian Accounting Standards Board, & Perkins, S, 1996, AASB accounting standards handbook, North Ryde, N.S.W., CCH Australia. Australian Accounting Standards Board, 2000, AASB subscription service, Caulfield, Vic, Australian Accounting Standards Board. Australian Accounting Research Foundation, & Australian Accounting Standards Board, 1993, Aarf & Aasb Report. Caulfield, Vic, Australian Accounting Research Foundation. Read More