BUSF_A01.qxd

Problems with using accounting information

will be capable of being used by the business for the whole of its useful life, rather than

it being assumed that the business will be forced to dispose of the asset as a result

of the business suffering financial collapse. Thus a business can base its depreciation

policy on the cost, expected life and disposal proceeds of the particular asset, rather

than on the current value of the asset at intermediate points of its life. As a result, the

fact that many non-current assets have a current market value below their balance

sheet value does not cause the prudence convention to be invoked.

3.4 Problems with using accounting information for

decision making

There are significant problems with using accounting information to help to make

decisions. In this section we shall be considering financial statements drawn up in

good faith, that is with the preparers of the statements not seeking to mislead users.

The problems here fall under two headings: income measurement and balance sheet

values.

Income measurement

A major problem here is concerned with the costs that are matched against revenues.

The costs are normally not expressed in the same terms as the revenues where there

are changing prices (historic cost and stable monetary unit conventions). Since the

costs tend to be incurred before the revenues are recognised, there is a tendency, dur-

ing a period of price inflation, for costs to be understated, causing profit to be over-

stated. Depreciation is often a particular problem here. Depreciation expenses are

based on costs that may have been incurred many years earlier; also, depreciation is

often a significant expense. The fact that historic costs rather than opportunity costs

are used means that only a partial impression of the effect of a particular transaction

on wealth is given. Again the distortion is consistently likely to overstate profit, that

is, to imply that more wealth has been created than is justified by the facts.

Balance sheet values

Adherence to the historic cost, prudence, going concern and stable monetary unit con-

ventions, coupled with the use of a fairly restricted accounting definition of an asset,

tends to cause financial statements to understate the amount of wealth that is invested

in the business.

Many assets have a greater value than is represented by the balance sheet. Some

things that are of economic value to the business may not even be included in the bal-

ance sheet at all. Many businesses have valuable brands, that is products that have a

high level of regard in the public mind. This means that a particular business may

have an ability to earn abnormally high profits due to the existence of its brands.

Brands are rarely included in the balance sheet since their inclusion would contravene

one or other of the accounting conventions. Yet a distorted impression of the wealth

committed to the business is given if most assets are either understated or excluded.

It is perhaps worth noting that accounting’s deficiencies for decision-making pur-

poses tend to stem from the fact that financial accounting did not evolve to meet the