6. LIMITATIONS OF PUBLISHED ACCOUNTS

While the principal concern of bankers is whether customers can meet the obligations created by their financial relationships with the bank, they must be aware of the fact that they do suffer important limitations. Many of the balances reported in the accounts involve a large measure of estimation and subjective judgement, e.g. depreciation. There are areas of great uncertainty and different figures for reported profit. Users must therefore be aware of the fact that the figures contained in the accounts are the result of decisions made and opinions held by the people responsible for making the calculation, and the different individuals, all acting with the best of intentions, would be unlikely to produce the same results.

The following further major criticisms of published accounts are considered below:

1. They are backward looking rather than forward looking
2. They contain information which is usually based on 'out of date' historical costs rather than current values
3. They report some but by no means all of a company's assets and liabilities

1. They are backward looking rather than forward looking

Demands for the publication of cash forecasts and profit forecasts have been resisted by management and accountants for a number of reasons which include the problem of accurately forecasting future results and the

difficulties which would arise for the auditor if required to report on the reliability of such data.

2. Historical costs rather than current values

1. The impact of inflation - Accounts prepared for both internal and external uses have been based, traditionally, on the historical cost concept. That is, assets are normally reported at acquisition cost less, in the case of fixed assets, an appropriate charge for depreciation; while liabilities are reported at face value. In recent years, however, the following question has been asked: 'Is historical cost the correct basis or are current values more relevant?'

Current values are more relevant in the following cases

1. For use as security in a loan
2. For disposal/selling purposes
3. For performance evaluation purposes

In light of this the question which still remains is 'Why has Historical Cost Accounting (HCA) survived despite its failure to report assets at what they are worth when prices have risen?

Some of the reasons include:

• HCA data is readily available
• HCA data is broadly factual, hence more easily verifiable
• HCA procedures are well understood

2. Revaluation of fixed assets - The ownership of a fixed assets therefore gives rise to the following three major accounting problems:

1. Whether to retain the asset in the books at historical costs throughout its useful life or whether periodically to restate the fixed asset at current value
2. Whether to depreciate the fixed asset
3. How to account for any profit arising on disposal

1. Whether to retain the asset in the books at historical costs throughout its useful life or whether periodically to restate the fixed asset at current value

- The companies act permits companies to show fixed assets at either historical cost or at current valuation. Where the latter option is adopted the surplus arising must be transferred to a revaluation reserve. It is therefore perfectly permissible ( and common practice) for companies to retain a fixed assets at its historical cost, despite the fact that historical cost may bear no relationship whatsoever to the asset's current worth.

 

2. Whether to depreciate the fixed asset

- The depreciation charge is to be based on the 'carrying value' of the fixed assets, whether historical cost or revalued amount. In practice though, company directors are keen to revalue fixed assets upwards in order to display a stronger balance sheet, they are less keen to base their depreciation charge on the higher carrying value as this will result in a lower reported profit. This may seem to contradict previous knowledge.

However, a press release accompanying the issue of SSAP 12 did recognize the possible existence of circumstances in which it might not be appropriate to charge depreciation. Namely, where:

• The estimated residual value is equal to or greater than its net book value
• The estimated useful economic life is either infinite or such that any depreciation charge would be insignificant

Some companies have used this as the excuse not to depreciate some assets even after revaluing it upwards.

 

- Where a company has previously revalued its fixed assets, an important question is how any profit (or loss) on ultimate disposal should be reported in the accounts. For example, assume a company purchases a fixed assets for $1000 in year 1, revalues the asset to $1360 in year 2 (with the surplus of $360 credited to revaluation reserve), and sells the asset for $1500 in year 3. Ignoring depreciation, the following are possible calculations of the profit arising on disposal:

1. Profit $140 (i.e. 1500-1360)
2. Profit $500 (i.e. 1500-1000)

FRS3 makes it clear that the calculation should be based on the difference between sales proceeds and carrying value. (i.e. calculation1 )

 

3. They report some but by no means all of a company's assets and liabilities

1. Undisclosed Assets - SSAP13 requires R&D expenditure to be written off as soon as it is incurred with the single exception that a proportion of development expenditure may be carried forward provided certain stringent conditions are met. The result is that R&D expenditure is often excluded from the balance sheet despite the fact that a valuable asset may have been created which will help the company to earn revenues for many years to come.

The balance sheet is also deficient in that it omits other intangible assets, such as goodwill built up over a period of years. The possession of goodwill means that the company is able to earn profit in excess of that expected from its tangible assets alone.

The omission of intangibles reduces the usefulness of accounting statements, and external users need to be aware of the possible existence of undisclosed assets of this sort. On the other hand, their routine valuation and inclusion in accounting reports is rarely feasible because of the element of subjective judgement involved in assigning values to them.

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