Question

to critically analyze some of the problems associated with basing depreciation expenses on cost model and detrimental impact of fair value based revaluation model.

Answer 1

The basic purpose of financial reporting is to provide information of an economic entity to the user about method of reporting used to present a true and fair view of the state of affairs of the business.

The historical cost principle, which is the traditional reporting method, does not include price changes i.e. revaluation. Selling price is stated at current price while the cost of assets used in generating the sales are stated at historical cost “acquisition cost”. This results in overstated profit leading to overpayment of tax and dividend.

Depreciation is charged based on the acquisition cost of the assets irrespective of the current replacement cost of such assets. The effect of this is overstated profit and understated value of assets which will make replacement difficult.

The usefulness of accounting information about an enterprise increases greatly if it can be compared with similar information about other enterprises and with similar information about the same enterprise for some period or some other point in time (FASB, 1980). Comparability addresses comparing information among different entities while consistency addresses comparing information over time for the same entity. Different firms may use different accounting principles making comparison among firms, even within the industry, difficult at best.

Fair Value Accounting (FVA) does not ease the comparability problem and likely exacerbates it. Fair Value Accounting (FVA) also has a significant impact upon consistency. When the market financial assets decline precipitously and the valuation inputs change over night, it is impossible for the information to be consistent. Fair Value Accounting (FVA) seems to result in a situation where comparability and consistency are more compromised than in the traditional accounting model.

However, since the major objective of any business organization is to make profit and continue in business, what they face in the course of doing their business and the method of accounting they use in reporting their profit may make this noble objective to be unrealistic particularly during inflationary period.

Depreciatin theory according to Teemu (1991) states that depreciation should be based upon the historical cost of an asset except that where an asset has been revalued, subsequent depreciation should be based on the revalued amount.

Consistency theory according to Igben (2004) states that, when a company selects a method it should continue (unless conditions warrant a change) to use that method in subsequent periods so that a comparison of accounting figures over time is meaningful. The theory ensures that the accounting treatment of like items is consistent taking one accounting period with another.

According to Williams (1977), financial reporting is the means of conveying to management and interested outsiders, a concise picture of the profitability and financial position of the business. He concluded that, it is made up of two statements, balance sheet and income statement. Pandy (1988), on the other hand states that financial report is synonymous with financial statement and is a statement which summarizes the information of the firms, financial situation to owners, creditors and the general public. Statement of Accounting Standard (SAS) 2 recorded that, financial statements consist of the balance sheet, profit and loss account or income statement, statement of source and application of funds, value added statement note to the account and five years historical financial summary.

Objectives of Financial Statement According to the Trueblood report (1973) (in Glautier & Underdown, 1986) the objectives of financial reporting by business enterprises are as follows;

1. To provide information useful for making economic decision

2. To serve primarily those users who have limited authority, ability or resources to obtain information and who rely on financial statement as either principal source of information about an enterprise economic activity.

3. To provide information useful to investors and creditors for predicting, comparing and evaluating potential cash flow to them in terms of amount, timing and related uncertainty.

4. To provide users with information for predicting comparing and evaluating enterprise earning power.

5. To supply information useful in judging management’s ability to utilize enterprise resources effectively in achieving the primary enterprise goal.

6. To provide factual and interpretive information about transactions and other events which is useful for predicting comparing and evaluating enterprise earning power.

7. To provide information useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of user’s predictions.

Since inflation has made historical cost method of accounting to be inadequate, transactions and accounts should be made inflation compliant to ensure that profits reported from such transactions are not misleading. The historical financial statements should be published together with current cost financial statements to lay bare before the investors and shareholders.

The differences in profits measured on historical and those measured on current cost methods impact the going concern of the firm differently. The historical cost method overstates the reported profit of the firm, it is hereby recommended that during the period of changing prices, the assets of the firms should be revalued to reflect the price level changes before depreciation is calculated and charged to the accounts. This will give a high depreciation charge and high depreciation charge means low profit and vice versa.

Companies should prepare their financial report using both historical cost and fair value (current cost) methods simultaneously. This will allow the companies to know the true financial position of their companies before declaring dividend and other benefits.