Financial Accounting ACT 552
Financial reporting is a crucial part of any business success since stakeholders need to read through financial reports and evaluate business profitability. Even though different methods of financial accounting exist, the application of a particular financial accounting method depends on the organizational culture, ethics and values. Each firm targets the use of a method that would be easy for its stakeholders to read and understand. For any method of financial accounting used, the key objective in the organization is to maintain accountability and transparency in financial matters. Two key methods exist for financial accounting.
The first is the historical financial accounting method which involves the consideration of assets and liabilities of an organization based on historical data. A second method is the Fair Value financial accounting method which relates to the consideration of the present value of assets and the cost of liabilities i.e. what would be gained if assets were to be sold versus what would be incurred to manage liabilities (Zack, 2009). There has been a rise in the use of the Fair Value system of accounting at the expense of the Historical accounting method which is considered an old strategy.
While the proponents of the historical accounting system argue that the method is conservative and predictable (Rich, 2010) and the fair value system has the potential of resulting in the collapse of entire systems through dubious practices by some financial reporters, the fair value system is lauded for its effectiveness in the representation of market conditions in present times. A key concern in the use of either financial accounting method is in the link between capital markets and book value of equity.
Although the historical concept is considered to cause continuity in business through an understanding of past and present information, the fair value system proponents argue that it gives reliable information on present market conditions and also gives a strong basis for the formulation of hypothesis on production capabilities. One of the concerns of historical system proponents is that in a market that is not liquid, managers are likely to make up fair value financial reports for their own benefits. The historical system is said to be based on amortization and depreciation, aspects which are artificial and of limited application respectively.
The comparison of the Historical approach to financial accounting with the Fair Value system of financial accounting clearly brings out the essence of complementation in financial accounting. Each of these procedures has its own set of weaknesses and strengths, which makes it essential to combine both in financial accounting to bring out the best outcomes in terms of financial information (Weil et al., 2014). Although the historical financial accounting procedure relates to many aspects of business transaction, it does not present the market conditions as they are. However, the procedure and the reports based on it are easier to understand in comparison with the fair value financial accounting system. Also, the fair value system is regarded to be based on approximations whose accuracy depends on the ability of the reporter to predict market conditions with accuracy.
Despite the debates raised by the use of Fair value systems in financial accounting, this principle is recommended by both GAAP and IFRS based on the argument that although it is impossible to predict market conditions with utmost accuracy, the dependence on historical systems could be misleading to investors and other stakeholders since historical information is not as dynamic as the current day information. As such, historical information provided through the historical accounting method has limited application in the present day business. The most favorable method for business accounting is thus the fair value system, which is increasingly being used by companies in the contemporary times.
Rich, J. S. (2010). Cornerstones of financial & managerial accounting: Current trends update. Mason, OH: South-Western/Cengage Learning.
Weil, R. L., Schipper, K., & Francis, J. (2014). Financial accounting: An introduction to concepts, methods, and uses. Mason, OH: South-Western, Cengage Learning.
Zack, G. M. (2009). Fair value accounting fraud: New global risks and detection techniques. Hoboken, NJ: John Wiley & Sons.
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