Limitations of traditional accounting

Dr. Aneirin Sion Owen

4th February 2020.
Limitations of traditional accounting.
• Here are some points raised against traditional accounting ideas, like
“prudence”, historical cost, accruals.
• This is the other side of the argument, the weaknesses of traditional
accounting.
• Many of these criticisms can be refuted, see later slides.
• These are suggested limitations, I’m not saying they are real, but….
• Economists have argued that theses limitations exist.
• Some of them are correct, but not all.
Limitations continued
• Traditional accounting “is not a theory, it is just accounting concepts”,
e.g., prudence, matching, going concern.
• “It is purely based on practice, lacking logical foundations”.
• It is backward looking, not forward.
• “Depreciation does not make sense” (to economists) it shift attention
away from cash flow.
• The accounting concepts are contradictory, e.g., matching & prudence
conflict with each other.
• “Historical cost does not make sense” (to economists), assets need to
be revalued.
Continued weaknesses
• The balance sheet does not give the value of the business, which is
one of the main roles performed by the stock market.
• Financial markets are efficient and traditional accounting ignores the
information content in share prices.
Answers to these limitations
• Information needs of investors can be used to develop a traditional theory of
accounting, see my ppt on this.
• Depreciation does make sense, as it matches costs with revenues.
• It is “cash flow” that lacks information content, it is too volatile.
• Historical cost does make sense, if you want to reduce market instability, or
increase transparency and “accountability”.
• Prudence also makes sense for the same reason.
• Future cash flow tends to be subjective, being based on estimates, while
traditional accounting is more objective and stable.
• Consistency can be achieved within traditional accounting.
Answers to these limitations
• Generally managers work on behalf of investors, and are subject to targets set by
investors.
• Managers have greater freedom if they achieve targets, e.g., EPS, dividends etc
• When targets are not met, the power of investors becomes more apparent.
• Investors can get rid of managers, but managers cannot get rid of investors,
because they own the business
• There are many economists that have argued financial markets are not efficient
e.g. Joe Stiglitz, Steve Keen.
• Share prices are volatile, so there may be little to learn from them.
I do admit
• Yes, traditional accounting is backward looking, and this is a
limitation, but not fatal.
• Yes, inflation can make historical costs outdated, but adjustments can
be made, e.g., inflation reserves.
My view
• Yes, SSAP 2 in the 1970s was not a full theory or framework, but
• “Investors” can be used to state the theory behind traditional
accounting.
• Modern accounting theory is weak in many respects, see later for the
full details.
• You do not have to agree with my view, but make sure you can see
both the strengths and the weaknesses of traditional accounting
ideas.