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Accounting Reality (Fair Value Accounting) Notes

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Pip Reeve ACCOUNTING HT11W2T1 In Financial Accounting, it is generally considered that accounting should reflect corporate and economic realities as they are. In what ways does accounting present corporate and economic reality? It is often claimed, however, that accounting cannot adequately reflect reality. Explain why accounting may not adequately reflect reality, particularly in relation to the technical limitation of double-entry bookkeeping and Fair Value accounting. It has been suggested that accountants, rather than simply trying to show reality, in fact construct reality. Dichev states that 'firm performance and firm valuation become an empty and self-fulfilling tautology.' 1 This may well be the case as markets go up because firms have positive earnings, which they have because markets are going up and hence their assets are re-valued up. In order to think about the concept of reality, Hines suggests that when we recognise the reality of something we 'call it the point of realisation since that is the point at which things become real.' 2 It is perhaps the case that when it comes to accounting 'there is no such thing as truth, but there is such a thing as stretching the truth too far' 3So, it is practically impossible and not necessarily beneficial to completely reflect reality in a completely neutral way, however, if accountants attempt to stretch the truth too far the likelihood of accounting scandals will increase. When discussing reality as the full picture, Hines remarks, 'but what is 'the full picture'? There is no full picture. We make the picture. This is what gives us our power: people think and act on the basis of that picture.' 4 This is true to an extent, however, there must be an element of reality in the constructed picture, 'when people have a preconceived notion of what reality is, well, we can't afford to go against it.'5 So, although in accounting reality can be constructed to an extent, it is not as simple as, 'if men define things as real, they are real in their consequences.' 6 Indeed, 'when people respond to that picture, and the consequences occur, they see it as proof of our having correctly conveyed reality.'7 This means that faith in the accounts and the people who produce them will increase. While, 'people only think of you as communicating reality, but in communicating reality, you construct reality.'8So, it seems unlikely that accountants can completely construct reality, otherwise there would be a very large number of businesses which are making no money and are shown to be making a lot of money. In order to be 'realistic' it seems likely that at some point in time the business which is being shown to be very successful in the accounts was actually successful. It is clear that accounting, rather than simply painting a picture of reality, can have very real effects on the economy. Real economic consequences arise when readers of financial statements alter their opinions or actions because of a change in accounting standards or the method of accounting used. It will very often be the case that 'nothing 'real' had actually changed because of the standard.' 9 Simply, the appearance of the firm's performance will be changed in some way which will lead to real effects. For example, Hines suggests that, as a result of changes in accounting, the following situations could occur; 'people buying less of this, more of that; investing less in this, more in that. Nothing would be the same; some people would be better off, some worse off; we would have less of some goods, more of

1 'On the balance sheet-based model of financial reporting' Dichev 2007 2'Financial accounting: in communicating reality, we construct reality' Hines 1988 3 'Financial accounting: in communicating reality, we construct reality' Hines 1988 4 'Financial accounting: in communicating reality, we construct reality' Hines 1988 5 'Financial accounting: in communicating reality, we construct reality' Hines 1988 6 'Financial accounting: in communicating reality, we construct reality' Hines 1988 7 'Financial accounting: in communicating reality, we construct reality' Hines 1988 8 'Financial accounting: in communicating reality, we construct reality' Hines 1988 9 'Financial Reporting and Analysis' Dunn 2010

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