Financial statements are useless because they are incomplete; not all assets or liabilities are included
Financial statements show the financial position of a company. Determination of the financial position helps the management in strategic planning. In addition, financial statements are the most important documents that help investors in making investment decisions. However, the reporting formula of the financial statements of most companies is gradually making the investors lack interest in the financial statements (Francis & Schipper, 1999). It is critical for an organization to include all assets and liabilities in the financial statements. Failure to have the accurate value of these entries may make an organization unable to determine its exact financial position.
It is a fact that financial statements disclose abundant financial information. The amount of disclosure in financial statements has increased dramatically with time. However, there is no comprehensive accounting theory that ensures that there is mandatory disclosure of certain financial information (Schipper, 2007). Therefore, in most instances, organizations fail to disclose certain assets or liabilities in their financial information. This renders financial statements useless in determining the exact financial position of the organization.
Intangible assets pose a great accounting problem. This is because it is difficult to determine the monetary value of certain intangible assets. Intangible assets are the main factors that determine the competitiveness of an organization (Uzma, 2011). In the US, the Financial Accounting Standards Board (FASB) does not require company to provide non-financial information in their financial statements (Barth & Clinch, 1998). Therefore, an organization may fail to report various intangible assets or contingent liabilities. These two entries may have a significant effect on the financial position of the company. Failure to provide full disclosure of intangible assets and contingent liabilities may reduce the relevance of financial statements in determining the financial position of the company (Sharma, 2012).
However, organizations strive to include all assets and liabilities in their financial statements. Despite the fact that the financial statements may not portray the exact financial position of the company, they provide the best approximation of the financial position of the company. The financial statement of organizations that do not have complex operations may provide the most accurate financial position of the company (Francis & Schipper, 1999).
In addition, it is extremely difficult to report certain information in the financial statements. One of the entries that pose significant accounting problems is intangible assets. Valuation of intangible assets may be contrary to the statement guidelines that companies use in valuing other accounting entries. Fair value is the most economically correct valuation method. However, fair value is not efficient in valuing intangible assets. Therefore, using fair value may reduce the reliability of the financial reports (Uzma, 2011).
Financial statements are useless because they present assets at their historical costs rather than their fair market values
It is vital for any organization to know the real value of various assets. This would help in determining the financial position of the company. However, it is extremely difficult to determine the exact value of various assets. Companies simply make an approximation of assets. In most instances, companies use the cost of production of the assets and the price of the asset during acquisition to determine the value of the asset. There is no precise method of valuing assets. The methods vary from country to country (Sharpe, 1991).
In determining the fair value of assets, the main issue is not on ‘how’ but ‘when’ companies should value assets. Companies may value their assets while taking into consideration the value of asset during acquisition. This is historical valuation. The major demerit of historical valuation is the fact the book value in the financial statements is not the real value of the asset. Passage of time makes the historical value of assets become irrelevant (Penman, 2007). In the US it is wrong for companies to value assets in financial statements at a price that is higher that the historical value.
It is critical for organizations to use fair value in determining the value of assets. Fair value is the most efficient method of reporting change in wealth. Fair value adopts the Hicksian definition of income as a change in wealth. It is a fact that “change in fair value of net assets on the balance sheet yields income” (Penman, 2007, p. 33). Use of fair value enables the organization to have up-to-date financial information. In addition, fair value is largely unaffected by various factors that are specific to various entries in the financial statement. This enables fair value to provide unbiased financial information across various entries of the financial statement. This makes fair value provide the most accurate financial information. Therefore, it is critical for companies to use fair value in valuation of its assets.
However, exclusive use of fair value in financial statements would not portray the real financial position of the company. Organizations should use historical cost and fair value interchangeably for the same asset or liability. However, organizations should use the two valuation methods to determine the value of the asset or liability at different times. This is because accounting is mainly historical. Therefore, fair value is only applicable under certain circumstances. An organization may use fair value in fresh-start accounting. However, subsequent accounting will follow historical cost accounting (Penman, 2007).
Barth, M.E. & Clinch, G. (1998). Revalued financial, tangible, and intangible assets: Associations with share prices and non-market-based value estimates. Journal of Accounting Research. Vol. 36. Pp. 199-233.
Francis, J. & Schipper, K. (1999). Have financial statements lost their relevance. Journal of Accounting Research. Vol. 37, no. 2. 319-352.
Penman, S.H. (2007). Financial reporting quality: is fair value a plus or a minus. Accounting & Business Research. Vol. 37, no. 1. Pp. 33-44.
Schipper, K. (2007). Required disclosures in financial reports. The Accounting Review. Vol. 82, no. 2. Pp. 301-326.
Sharma, N. (2012). Intangible assets: A study of valuation methods. BVIMR Management Edge. Vol. 5, no. 1. Pp. 61-69.
Sharpe, W.F. (1991). The arithmetic of active management. Financial Analysts Journal. Vol. 47, no. 1. Pp. 7-9.
Uzma, S.H. (2011). Challenges of reporting intangible assets in financial statements. The IUP Journal of Accounting Research & Audit Practices. Vol. X, no. 4. Pp. 28-38.