Financial Accounting-the Historical Cost Approach


Insofar as business firms are concerned, a distinction is normally made between financial accounting, which is the activity of recording and analysing the financial results of transactions as a means of arriving at a measure of the firm's success and financial soundness, and management accounting, which is the activity of providing information to enable management to make efficient decisions as regards the use and allocation of the firm's resources. In this part, the traditional practices of financial accounting based on historical cost valuations are examined. The approach used is based on a descriptive analysis of the practices of accountants, and leads to a descriptive theory of financial accounting. Therefore, we shall be concerned with what accountants do and the conventions and standards by which their activities are regulated.

The financial reports produced on the basis of financial records kept may be analysed also in terms of the relevance of the information provided to users for the purposes of decision making. We suggested that such an analysis should be conducted in terms of a normative theory. In this part, we shall restrict ourselves to the discussion of descriptive theories of financial accounting which focuses on accounting practices only, and we shall address the problem of users' needs in Part 4, using normative theories for that purpose.

The purpose of this part is to examine the nature and the practices of financial accounting which is concerned with the following activities:

(a) recording financial transactions;

(b) summarizing and presenting financial information in reports.

Financial accounting information is used by a variety of interested parties. Managers require financial information so as to evaluate the financial results of past decisions, for the evaluation of past performance is an important part of management decision making. Shareholders and investors need financial information which will enable them to predict both their income from the firm and the value of their investment, and to judge the risks attached thereto. Hence, shareholders and investors require financial accounting information for the purpose of making decisions about their investment in the firm. Besides shareholders and investors, there are other external users of financial information, notably the Inland Revenue, which requires a firm to submit financial accounts for the purpose of assessing its tax liability, and trade unions and employees who have a vested interest in the financial performance of the company.

The nature and methods of financial accounting are determined to a considerable extent by the conventions which exist among accountants for identifying, evaluating and communicating financial information. This is particularly true of the information which is provided for external users such as shareholders and Investors. It is evident that unless accountants obey the same rules as regards selecting, measuring and communicating information to external users, the latter will be placed at a great disadvantage in respect of the reliance which may be attached to the information they receive. The usefulness of accounting conventions lies in the uniformity and comparability of information which is made possible thereby. Accounting conventions do secure for external users a much greater degree of comparability in the information emanating from the same firm over a period of years. Accountants do not attempt, however, to meet the specific information needs of external users, and the information which they do provide is dictated by the conventions which they have followed for a very long time, rather than the information needs of external users.

The users of external reports have no control, therefore, over their content. We may contrast the boundaries of the financial accounting system for external users, against the user-oriented model. In this case, there is no control by the user over the final output. Hence, it may be suggested the information system for external decision makers is not user oriented. The output, and therefore also the input into this system is determined by conventions which are embodied in accounting tradition and in law. External users are provided with reports on a take-it-or-leave-it basis, although more useful information could be provided for them without imposing additional costs on the firm. However, in view of the broad objectives and definition of accounting as an information system, which we adopted in Part 1, we would expect to find inherent limitations in current external reporting practices. We shall discuss these limitations elsewhere.

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We have been concerned with an examination of the role of accounting theory in developing knowledge through the construction of theories. The importance of such theory construction for the improvement of accounting practice has also been discussed. The nature of theory was examined in detail in order to establish precisely the significance of theory to knowledge in general, and to accounting in particular. The several approaches to the development of accounting theory were reviewed. Attention was drawn to the successive stages beginning with descriptive theories, and proceeding to normative and to... see: Accounting Theory Summary