Fundamental Problem with Financial Statements Based on Historic Cost Measurement Principle

This article discusses the fundamental problem with financial statements based on the historic cost measurement principle used under US GAAP. It explores the limitations of financial statements in predicting the future value of a business and highlights the potential for fraud. The article also emphasizes the importance of critical analysis when using financial statements.

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Accounting Theory
By (Name)
Course
Instructor’s Name
Institutional Affiliation
The City and State
The Date

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Question one
What you think is the fundamental problem with financial statements based upon
the historic cost measurement principle used under US GAAP?
Financial statements refer to written records or documents of the financial situation in a
business. The financial statements are in the form of standard reports such as loss statements,
cash flow, balance sheet and profit or income statements. These are considered as the major
elements of a business's financial information about external parties. More technically, financial
statements sum up all the financial positions of different entities at differentiated period of time.
Basing on the historic cost measurement principle used under the United States Generally
accepted accounting principles (GAAP), I think financial statements are associated with a
fundamental problem of failing to have a predictive value or determining the future value of the
business(Barth, & Landsman 2010). In this case, data provided in financial statements illustrate
information concerning the business's financial status or historical results of a given date.
The financial statement cannot be in the position to provide the business predictive value
of what may take place after some time. For example the financial statement could report the
business's good performance in the current month and experiences less sales in other months as a
result of termination of the contract (Fitzgerald, et al 2016). As a result of viewing the financial
information of the past perspective, the entrepreneurs may not be able to generally understand
the current information of the enterprise hence presenting the business liabilities or assets at
"historic cost" which may result into a fundamental issue. Also, financial statements are
subjected to the problem of fraud. This happens in case the business's management team
deliberately skews the information presented in the document. The problem could come up as a
result of increased pressure to present excellent results to the company. Therefore, financial

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statementsare usually important documents to the business but it require the business owners to
make a critical analysis of the issues that are associated with their usage (Mayorga, & Sidhu
2012).
Question two
What do you think of the principle’ … accounts must reflect economic reality’ as a
core principle of measurement in accounting?
Business accounts are always presented with an enterprise's conceptual framework in
order to ensure reliability of the information to stakeholders. In this case, economic reliability
refers to information of values and figures that the enterprise presents where different financial
statements of the business are prepared. For all enterprises, principle' accounts is very important
in presenting the enterprise's financial information more effective and reliable way so as to help
users make use of the business's financial statement. Therefore, this is a major accounts principle
adopted in measuring the business financial data or information. By displaying the business's
"financial statement" in a more reliable way does not only assist the clients but also different
stakeholders, investors, government and creditors to make judgments about the business's
financial position (Bell, & Griffin 2012).
Question three
How would you measure economic reality?
Economic reality is the real situation taking place in the economy or market instead of
showing rigid principles or picture of the economy which may at times depict an organization’s
economic position that is not in line with the economic reality. For example, as a result of some
accounting principles and estimates, an enterprise may be prompted to create excess expense

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which may not be in the position to reflect the reality of the economy. In this case, I would
measure the enterprise’s economic reality by taking into consideration the knowledge
surrounding the principle of reality which indicates that "purchasing power and income is what
really matters to people, rather than face value of money and goods which is correlated to the
real versus the nominal value of something"(Barth,&Landsman2010).This implies that in the
prevailing month balance sheet it indicates profits but entrepreneurs get to understand that debtor
or buyers became bankrupt and cannot be in the position to pay back leading to losses in the
business. This implies that economic reality of a given year may be different from what is
illustrated to the business stakeholders who use financial statement. Also, I would measure the
economic reality by using the cure=rent interest rate that is in the market or economy (Boritz et
al 2016).
Question four
What is reliability in accounting?
In this case, accounting is known as the process of recording business transactions and
financial data in a chronological and systematic way. This forms the major process for preparing
an enterprise's financial statement. Therefore, this is helpful in ensuring that the prepared
business accounts are more reliable. Reliability in accounting is the trust built by an enterprise
management and different users of financial datathat originates from the business's accounting
system (Cannon 2016). Accounting reality could be formed by suing accurate and latest
accounting systems in an enterprise. Also, financials could be audited from an organization’s
accounting system and control managements done by the user of the system. In simple terms,
reliability in accounting can be referred to as "an assurance that happens on the accounting

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processes of an organization that is to say; proper credit and debit recording under proper head of
capital or revenue nature"(Bratten et al 2013).
Question five
How will the use of fair values affect the role of auditors and the audit function?
According to FASB, fair value is known as "the price in an orderly transaction between
market participants to sell the asset or transfer the liability in the market in which the reporting
entity would transact for the asset or liability, that is, the principal or most advantageous market
for the asset or liability"(Barth,&Landsman2010). Also, fair value can be defined as "the amount
for which an asset could be exchanged, or a liability settled, between knowledgeable willing
parties in an arm‘s length transaction"(Christensen et al,2012). The introduction of (IAS)has
created more emphasis on the use of fair value. For example, businesses are reporting more
assets at "fair values" which are also incorporated in the process of determining profits. Studies
indicate that the use of fair values in accounting has resulted into increased relevancy in
accounting value (Christensen, et al 2012). The use of fair values in the accounting sector has
created more changes in auditing. The implementation of the fair values in accounting was
intended at making values on the business's balance sheet to be more detailed hence avoiding
problems with time. As a result of various problems that were created while adapting historical
cost measurements during the loan and Savings crisis, led to the introduction of the new fair
values. In this case, large firms were not able to show their real financial status. By using fair
values in an enterprise such problems have been eliminated (Christensen, et al 2014). Fair values
have also been considered as the major contributors towards the determination of business risks.
The use of fair values is required to be used in some options or situations for valuing some
liabilities and assets. In this case, fair value should be used in allocating the transaction cost and

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in the initial measurement of the business transaction. However, the use of fair values is
considered to affect the role of auditors and audit function in different ways such as;
First, reduced need for auditors, while using fair value, different managements opt to use
valuation specialists with specialized skills in measurement fair value. The businesses prefer
employing outside specialists who can be able to conduct high-quality measurements of share
values in order to effective perform information statement. By employing fair value specialist,
the role of auditors in the company is reduced because the specialists are more skilled and
experienced in fair value concepts used for preparing financial statements (Cohen, et al 2011).
Lastly, the use of fair value will base on the assumptions of determining a business's
future event, transaction and condition. Because the assumptions of auditors are based on
available information during the auditing time, they will not be in the position to perform their
activities effectively as compared to use of fair value. As a result of such condition, auditors are
considered to have a limited role towards the financial reporting of the business (Ettredge et al
2014).
Do you think it will affect the training of accounting students? How so?
I don’t think that the use of fair value will affect the need for training accounting students
because the specialists in fair value are also required to have skills in valuation of financial
information. Most companies require employing fair vale specialists with expertise in financial
assumption and measurements. Also, the need for auditors will continuously increase auditors
help in determining the effectiveness of the fair value. Also, auditors help in making
assessments of the risks that may result because of the inaccurate fair value assumptions.
Auditors do this by considering the subjective, significance and number of predictions made

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perform estimates in financial reporting. Considering the role played by auditors, there will still
be a need for training accounting students (Financial Accounting Standards Board 2010).

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References
Barth, M., and W. R. Landsman. 2010. How did financial reporting contribute to the financial
crisis? European. Accounting Review 19 (3): 399–423. doi:10.1080/09638180.2010.498619
Bell, T. B., and J. B. Griffin. 2012. Commentary on auditing high-uncertainty fair value
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Boritz, J. E., L. A. Robinson, C. Wong, and N. Kochetova-Kozloski. 2016. Use of Specialists
During an Audit. Working paper, University of Waterloo and Saint Mary’s University.
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