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Unformatted text preview: Chapter 02 - Financial Reporting and Analysis George Ramsey 2-11 Under the historical cost model, asset and liability values are determined on the basis of prices obtained from actual transactions that have occurred in the past. Under the fair value accounting model, asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements). Under historical cost method, when asset (or liability) values subsequently change, continuing to record value at the historical costi.e., at the value at which the asset was originally purchasedimpairs the usefulness of the financial statements, in particular the balance sheet. Because of this the historical cost model has come under a lot of criticism for various quarters, resulting in the move toward fair value accounting. 2-15 Financial statement information has several limitations. First, financial statements are released well after the end of the quarter and/or fiscal year. Thus, they are not entirely timely. Second, they are only released on a quarterly basis. Investors often have a need for information more often than just on a quarterly basis. Thus, financial statements are limited by the relative infrequency of their release. Third, financial statements have little forward-looking information. Investors must use the largely backward looking financial statements to generate their own beliefs about the future. Fourth, financial statements are prepared using rules that are promulgated with a relevance and reliability trade-off. The need for reliability causes the relevance of the information to be, in certain instances, compromised. Fifth, the usefulness of financial statement information may also be limited by the bias of the managers that prepare the statements. For example, managers in certain instances may have incentives to overstate or understate earnings, assets, liabilities, and/or equity. Samantha Akers 2-20 Cash flow measures of performance almost always suffer from the timing and matching problems that accrual accounting was developed to mitigate. For example, cash often is not received in the accounting period when it is earned. Further, expenses are often not paid in the period that the cash of the sale that the expense helped to generate was received. As a result, cash flow measures of performance can be very misleading. Consider for example, a company that increases inventory levels substantially in the fourth quarter of the current year. that increases inventory levels substantially in the fourth quarter of the current year....
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- Fall '11