Accounting Theory: Fair Value Accounting, US GAAP, and Audit Impact

This essay delves into the complexities of fair value accounting and its implications under US GAAP, addressing the fundamental problems associated with historical cost measurement. It emphasizes the irrelevance of historical cost in reflecting the current economic reality of companies, where market values often significantly exceed asset values. The essay further discusses the importance of accounts reflecting economic reality, the challenges in achieving this, and methods for measuring economic reality in financial data. It also examines the concept of reliability in accounting, focusing on verifiability, representation faithfulness, and neutrality. Finally, the essay analyzes the impact of fair value accounting on the roles of auditors and the audit function, highlighting the need for enhanced training for accounting students to adapt to the evolving landscape of financial reporting. Desklib provides a platform to access this assignment and many other solved papers for students.

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ACCOUNTING THEORY
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Accounting Theory
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Accounting Theory
The Fundamental Problem with Financial Statements Based Upon the Historic Cost
Measurement Principle Used Under US GAAP.
It is vital to anticipate the application of the historical cost accounting method for a
proper understanding of the correlated fundamental problem. According to the generally
accepted accounting principle (GAAP) in the US, the accounting books of the company are
documented as per the purchasing price of the assets. In other words, the assets on the balance
sheet of the firm are recorded following their purchasing expenditures. The historical cost
accounting technique is therefore conservative and based on the ancient transactions of the
company. Even though the historical cost accounting method has been said to be easy to
calculate and reliable, its fundamental problem circumnavigates its irrelevance at a later point in
time.
According to the case study, the market value of most companies is five times their asset
value. With this statement, it is clear that the asset value of the company is irrelevant today. The
historical cost of firm resources is irrelevant at a future point in time. For instance, a building
which is procured by a company some decades ago is likely to have a higher market value today
compared to the asset value recorded within the balance sheet of the company. A typical example
to illustrate this concept is the cost of multiple properties in New York one hundred years ago
($50,000) (Nicholas, 2019). Currently, the market value of the properties is $50 million
(Nicholas, 2019). However, when accountants prepare financial statements using the historical
cost accounting technique, the value of the asset ($50,000) is displayed on the balance sheet of
the firm. This aspect provided a misleading outlook of the actual financial level of the business.

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The enormous dissimilarity between the firm’s market value and the asset value may mislead
decision making in the company.
Personalities Regarding the Principle of Measurement in Accounting (Accounts
Must Reflect Economic Reality)
In order to promote investors’ satisfaction in the economist, it is fundamental to initiate a
principle-based program that promotes faithful representation of the effects of the transactions,
the economic faithfulness of the balances intended to be displayed and the finances of the entire
enterprise. Therefore, the phrase “accounts must reflect economic reality” encompasses four
significant components which are assumed to have a common meaning. These components
include, faithful representation, reflection of the economic substance, provision of fair and true
representation and present fairly.
However, arriving at accounts that represent economic reality is one of the most
challenging aspects. Several people argue that the economics of transactions are always in the
eyes of the beholder (Schneider, 2015). Nevertheless, this ideology should not oblige as an
justification against the efforts in preparing reports that provide a reasonable representation of
economic reality.
Accounts which reflect economic reality are likely to bring about volatility in earnings
(van, et, al., 2016). However, the fact remains that economic volatility represents of real market.
Therefore, accounts should aim at ensuring investors are better served by accessing data about
real volatility rather than using arcane rules that obscure this volatility. The volatility that will
appear in the financial documents of the companies will have a worrying consequence on the
market. Handling such a crisis will require investors to be taught about this volatility. On the

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long term, markets are likely to adopt new well-explained volatility, which actually exists unlike
the artificial accounting volatility, which fails to report economic reality. As investors
acknowledge volatility as natural, a shift will be realized in companies to concentrate on the
fundamentals of the business rather than focusing on short-term earning measures. Therefore,
accounts which represent economic reality aim at eliminating the artificial sense of the true
picture of the monetary level of a company.
Measurement of Economic Reality
Since economic reality is a representation of the accuracy in the recording of financial
data at the time of operations, then the measure of economic reality is equivalent to the measure
of the accuracy in the recording of such financial data. Therefore, the approach used in
measuring accuracy can be utilized measuring the degree of economic reality in accounting. In
measuring economic reality, it is fundamental to research the actual values and the documented
values as per the books of account of the firm. After having the documented values in the
financial statements and the actual values, the difference is calculated by subtracting the
documented values from the actual value. In order to get the percentage error in the
representation of the data, the difference is divided by the actual value and multiplied by a
hundred. For instance, suppose a business bought a sum of goods for $50,000 and instead
recorded $45,000 as the buying price. Economic reality will be measured by calculating the
percentage error in representation as followed
Percentage error
Difference in representation = Actual value – Documented value
= $50,000-45,000

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= $5,000
% error shall be given by:
The difference in representation divided by Actual value and multiplied by 100%
=
Retrieved from: (Blackwell, Honaker, and King, 2017)
= (5000/50000) *100%
% error =10%
However, the percentage error does not represent the actual degree of economic reality.
Instead, the percentage is inversely proportional to economic reality. In other words, the larger
the percentage error, the smaller the representation of economic reality within the financial
information. On the other hand, the smaller the percentage error, the higher the representation of
economic reality in the financial data presented.
Following the fact that financial data is presented using different sets of data, economic
reality can also be measured by combining such data and calculating the level of precision of the
data. The precision of a group of dimensions can be obtained by calculating the standard
deviation of such a group of measurements where n-1 is the degree of freedom.
Retrieved from: (Jurado, Ludvigson, and Ng, 2015)

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However, the standard deviation obtained in this case is usually an absolute uncertainty.
Therefore, a relative uncertainty standard deviation can be obtained by dividing the standard
deviation by the average of the data collected and multiplying with 100% to obtain the
percentage relative standard deviation.
Retrieved from: (IAHC, 2018)
Similarly, the standard deviation measures the degree at which the experimental value
differed with the actual value. Therefore, the percentage relative standard deviation is inversely
proportional to the representation of economic reality. In other words, the larger the percentage
relative standard deviation, the lower the representation of economic reality with respect to the
financial data provided.
Reliability in Accounting
Reliability in accounting refers to the degree at which data can be proved and utilized
dependably by creditors and investors while retaining similar results. In other words, reliability
reflects the trustworthiness of financial statements (Carrington and Eklöv, 2017). Financial
statements are said to be unreliable and useless if the consumers and decision makers fail to
belief the content enshrined in them (Bauer, O'Brien, and Saeed, 2014). The notion of reliability,
in accordance with the FASB, encompasses three significant aspects. Firstly, verifiability is a
fundamental aspect. Financial data is verifiable if different independent measures have been used
to arrive at similar results. In other words, the auditors and external stakeholders of the firm can

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quantify and evaluate the financial statements of the company and present similar outcomes.
Auditors cannot offer an unqualified opinion if they can’t verify the financial data.
Secondly, representation faithfulness is essential (Kythreotis, 2014). Representation
faithfulness simply refers to the aspect whereby the financial statements represent the reality of
all transactions that occurred during the year. For instance, a company that reflects "$100,000" as
the cost of goods when the real cost was $159,000 does not reflect the reality. Therefore, such
financial information is said to be unreliable.
Finally, neutrality serves a significant role while anticipating the aspect of reliability.
Most financial statements of the company are usually biased as the managers strive to see the
company improving. Therefore, most of the companies tend to record increased performance
while neglecting unfavourable events. The aspect of neutrality requires the accountants and
financial managers to prepare financial statements that are completely unbiased. For example, a
firm with data regarding a probable lawsuit should report such information under the notes of the
financial statement. Withholding such data renders the financial statements unreliable to external
creditors and investors.
Impact of Using Fair Values on the Roles of Auditors and the Audit Function
The current focus on execution of fair value accounting will enormous complications
among the auditors. Firstly, if the fair value accounting is elected and/or the fair value
framework disseminated by the FASB is not appropriately interpreted, there will be an
impairment on the internal and external auditors’ ability to evaluate the cogency of the
management’s proclaimed estimations thus raising the audit risk (Glover, Taylor and Wu, 2016).
Additionally, the current fair value accounting will create complexities for the auditors with

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respect to ascertaining that the proclaimed prices reflect economic reality, especially for financial
liabilities and assets that lack an active market.
Fair value accounting strategy will affect the training of accounting students (Brusca,
Caperchione, Cohen and Rossi, 2015). It is fundamental to realize the difference between the
historical cost accounting and the current fair value accounting in order to realize the changes
imposed on the education program. Unlike in the ancient program where assets were recorded at
their purchase price, the current strategy promotes recording assets at their market value and
taking note of the differences in the financial statements ones the recording has been made
(Chea, 2011). It is therefore to vital to train the students to be conversant with the market trends
of each and every item in the company. The students have to be empowered on research
strategies that will enable them to be updated with the market value of the company assets.
Additionally, the normal structure of the balance sheet and income statement has to change in
order to provide more columns for documenting the value changes over a given period.
Therefore, it is clear that fair value accounting shall have a significant impact on the training of
accounting students.

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References
Bauer, A.M., O'Brien, P.C. and Saeed, U., 2014. Reliability makes accounting relevant: a
comment on the IASB Conceptual Framework project. Accounting in Europe, 11(2), pp.211-217.
Blackwell, M., Honaker, J. and King, G., 2017. A unified approach to measurement error and
missing data: overview and applications. Sociological Methods & Research, 46(3), pp.303-341.
Brusca, I., Caperchione, E., Cohen, S. and Rossi, F.M., 2015. Comparing accounting systems in
Europe. In Public Sector Accounting and Auditing in Europe (pp. 235-251). Palgrave Macmillan,
London.
Carrington, T. and Eklöv Alander, G., 2017. Justifications of accounting reliability. In European
Accounting Association Congress, Valencia, Spain, 10-12 May 2017.
Chea, A.C., 2011. Fair value accounting: Its impacts on financial reporting and how it can be
enhanced to provide more clarity and reliability of information for users of financial
statements. International journal of business and social science, 2(20).

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Glover, S.M., Taylor, M.H. and Wu, Y.J., 2016. Current practices and challenges in auditing fair
value measurements and complex estimates: Implications for auditing standards and the
academy. Auditing: A Journal of Practice & Theory, 36(1), pp.63-84.
IAHC (2018). Accuracy and Precision [online]. Retrieved from:
https://www.lahc.edu/classes/chemistry/arias/Exp%201%20-%20AccPreF11.pdf (Accessed on
19th May 2019).
Jurado, K., Ludvigson, S.C. and Ng, S., 2015. Measuring uncertainty. American Economic
Review, 105(3), pp.1177-1216.
Kythreotis, A., 2014. Measurement of financial reporting quality based on IFRS conceptual
framework’s fundamental qualitative characteristics. European Journal of Accounting, Finance
& Business, 2(3), pp.4-29.
Nicholas, S., (2019). How the market-to-market accounting and historical cost accounting differ
[online]. Retrieved from: https://www.investopedia.com/ask/answers/042315/how-market-
market-accounting-different-historical-cost-accounting.asp (Accessed on 19th May 2019).
Schneider, A., 2015. Reflexivity in sustainability accounting and management: Transcending the
economic focus of corporate sustainability. Journal of Business Ethics, 127(3), pp.525-536.

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Van Mosseveld, C., Hernández-Peña, P., Arán, D., Cherilova, V. and Mataria, A., 2016. How to
ensure the quality of health accounts. Health Policy, 120(5), pp.544-551.