Financial Accounting Theory

Topics: Balance sheet, Asset, Generally Accepted Accounting Principles Pages: 6 (1713 words) Published: August 8, 2015
a. Outline the objective and the principles of a theory that prescribes fair value accounting.

Fair value accounting is to measure selected assets at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The objective of fair value accounting is linked with the objective of ‘decision usefulness’ of general purpose financial reporting. That is, to provide relevant information that is representationally faithful for users. IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Fair value accounting emphases assets and liabilities and includes change in asset values in revenue. The primary statement is balance sheet.

b. Outline the objective and principles of a theory that prescribes historical cost accounting.

Under historical cost accounting, assets are recorded at the amount of cash or as equivalents paid, or the fair value of the consideration given, to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances, at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. The objective of historical cost accounting is stewardship and accountability. Stewardship refers to the process wherein a manager demonstrates how he or she has used the resources that have been entrusted to them by others who generally are not directly involved in the management of the entity. Historical cost accounting maintains nominal financial capital and focus on income statements, recognizes revenue on transaction-based.

c. Evaluate the argument that a mixed or piecemeal approach to standard setting is required in order to better measure profit and financial position.

A mixed measurement model of accounting refers to an approach to accounting wherein a variety of measurement approaches are used to measure assets and liabilities. No one basis of measurement is prescribed for all classed of assets and liabilities. Using a mixed measurement model provides flexibility for preparers of financial reports. For example, when measuring there is an active market for an asset, preparer can choose fair value to record the asset, conversely, historical cost can be used when no active market existed for the asset. Furthermore, when markets become unstable such as the time of financial crisis, it might appear inappropriate to base the measurement of an asset on fair value because prices are volatile. However, there are also downsides of allowing a mixed measurement approach. First, it potentially undermines the comparability of financial reports prepared by organisations that use different measurement bases. Second, it leads to what is known as an ‘additivity problem’, wherein the sum of total assets will represent the summation of assets and liabilities measured on different bases. Lastly, where choice is available, it allows for the possibility that managers will opportunistically select the measurement basis that best suits them (that is, the method which provides a preferred result).

a. Explain the nature of the debt covenant. Explain how the gearing and...
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