Conventional Accounting Does Not Provide Accurate Information Accounting Essay

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Introduction

The objective of this report is to show that the conventional accounting does not provide accurate information according to by G. Bennett Stewart III, Stern Stewart & Co. My central points will look into the agreement for and against the arguments brought forward by Stern Stewart. My areas of emphasis will look at equity capital, economic profit, economic value added, pension accounting, debt versus equity, innovation accounting and intangibles, full cost accounting and depreciation. As I feel these are the areas where convention accounting has affected the accuracy of information the most.

Equity Capital

The cost of equity is an opportunity cost but is often ignored when calculating profit. The basic principle of managing shareholder value is that the cost of equity capital must be taken into account when computing value. That is, a company only makes a real or economic profit after it has repaid the cost of capital that was used to generate it.

I think the cost of equity relies on the riskiness of projects being evaluated. This may be complex as there isn't one way of determine the level of risk of a project, which would bring us to the weighted average of the cots method by [1] Davies et all (1999). This method however might not correctly reflect the cost of equity, as measuring the cost of capital relates to returns on new investments rather that what happened in the past. Because of this, no exact way of calculating it, especially for an organisation as a whole. They will have to consider closely on the precise number for the cost of capital and use an approximate figure to apply consistently rather than assuming shareholder capital has no cost at all.

Economic profit is a more accurate method of determining shareholder value. In the same way as refined by Stern Stewart whose emphasis describes economic profit as the surplus earned by a business in a period after the deduction of all expenses, including the cost of using investor's capital in the business.

Economic Profit

Economic profit represents the amount of capital invested in a business multiplied by the performance spread, which represents the difference between the return achieved on the invested capital and the weighted average cost of capital.

The other approach deducts a capital charge (calculated as invested capital times WACC), from operating profits refer to the profits of a business before deducting non operating items, such as interest receivable, investment income ad interest payable.

It is often enticing to anticipate that operating profits after tax are basically profits after tax, before interred, less the taxation charge. This of course ignores the effect of the above non operating items on the tax charge for the organisation.

In the United Kingdom, under the taxation system, interest payable is a tax deductable expense, whereas as a general rule, interest receivable expense, and investment income. This basically means that, a company with a net interest expense, the tax charge in the profit and loss account has been reduced by the tax shield effect of interest.

To arrive at the true after tax profits from operations, the tax charge must be adjusted to reverse the effect by using at estimation by multiplying the net interest payable figure in the profit and loss account by the marginal rate of corporation tax. If this adjustment is not made, the way in which a company has been financed will distort the calculated value.

Economic profit may be a short term and single period measure; I strongly agree it is an important feature as it can be used as the basis for corporate or business unit valuations that was also recognised by [2] O'Hanlon and Peasell (1996).

Economic Value Added.

As explained by Stewart, it is effectively a refined version of the basic Economic Profit approach. From the arguments brought forward by Stewart, the EP calculation is distorted by the determinants which are as a result of the following:

Non cash, accruals based book keeping entries, which tend to obscure the true cash profitability of a business.

The fundamental accounting concept of prudence, which shows an inclination towards a systematic conservative bias which then affects the relevance of reported accounting numbers.

The write off of costs associated with investments that have failed to have a return, this thereby understates the true cost of capital of a business and also subjects the profit and loss account to one off, non-recurring gains or losses.

Stewart advocates adjustments to be made to the measure of operating profits and capital, on which EVA is based, which provides and makes sure that there is consistency in the calculation of EVA.

I agree with the measure of EVA as it has all the benefits of the basic EP, and also seems to address some of the accounting related weaknesses with the basic approach.

Pension Accounting

Concerns about whether the accounting rules used to asses pension liabilities are adequate have been raised more recently due to most economies battling rising deficits in the retirement plans they run for their employees, despite there being strong returns for investment funds in the previous years. While falling corporate bonds yields in 2009 played a role in rising deficits, low inflation has been crucial in keeping pension liabilities high.

Under the UKAS Accounting standard FRS17 that was implemented in 2001, companies had to apply fair value in accounting for their pensions in a much more rigorous framework than the previous standard.

Under FRS17, the discount rate to be used is the yield on a high quality AA rated bond. The standard also focuses on valuation assumptions; assets return assumptions, pension costs and recognition.

The original international accounting standard on pensions, IAS 19 Accounting for retirement benefits in the financial statements of enterprise was oriented towards measuring costs for the income statement, and was flexible enough to , permit companies the choice of whether or not to use salary projections in measuring the regular pension expense.

But IAS provides some alternative accounting treatments for actuarial gains and losses, and a few companies have taken advantage of these options. However, since the development of the framework, the IASC and IASB, alongside other standard setter and academics, have been giving careful thought to the conceptualisation of liabilities. Particular mention may be made by the study for the ASB by [3] Lennard 2002; the report for the Association of Chartered Certified Accountants ACCA by [4] Nobes 2003; and the review by [5] Botosan et al. 2005. A common feature is that accounting liabilities are present obligations - an obligation being defined by the framework; as a duty or responsibility to act or perform in a certain way.

Therefore by my understanding pension liability and agreeing with Stewart; this has to be recognised in the employer's financial statements at a particular point and must be based on the duty or responsibility that the employer bears at that point in time in respect of the pension arrangements between the employer and both current and past employees. As acted out in FRS17, begins by assuming that the assets and liabilities of a pension plan are essentially assets and liabilities of the sponsoring employer, and as such should be recognised at fair value on the company balance sheet. Operating costs of providing benefits are recognised in the period in which they are earned by employees and finance costs and other changes in the values of assets and liabilities are recognised in the period in which they arise. This approach is consistent with current trends in the UK accounting in the other areas.

I believe the FRS17 is more airtight as compared to what most companies had adopted to IAS 19 that provides some alternative accounting treatments for actuarial gains and losses.

Debt versus Equity

Management normally aims for the lowest feasible cost of equity for the lowest feasible cost of capital; whereas an investor seeks the greatest possible return. These goals will usually conflict, but may not necessarily be incompatible, especially with equity investors. The cost of capital can be kept low and the opportunity for return on common stockholders equity can be enhanced through leverage- a high percentage of debt relative to common equity. But increased leverage carries with it increased risk. The leverage provided by debt financing is further enhanced because the interest that corporations pay is tax deductible expense, whereas dividends to both preferred and common stockholders must be paid with after-tax money. Thus, it is argued, the lower net costs of bond interest help accrue more value for the common.

Keeping in mind, increased debt brings with it higher fixed costs that must be paid in good times and bad, and can severely limit a company's flexibility. Despite this, because of its tax advantages and stability relative to equity capital, and over time, companies use debt to buy back common shares, a practice that can improve stock performance.

Innovation Accounting and Intangibles

Accounting guidelines traditionally have treated funds spent on intangible assets as expenses, not as investments that are expected to yield future returns, as a result are not capitalised on the balance sheet. The theory of economic growth postulates that innovation is a primary source of a company's long run productivity growth.

Whether driven by innovation or competition, the impact of change on firms operations and economic conditions is not adequately reflected by the current reporting system. Although the IASB has established several guidelines pertaining to the identification, recognition, and valuation of intangible assets, the IASB has not resolved many of the conceptual issues involved in measuring them. As a result, guidelines on the recognition and reporting of intangibles assets are conceptually inconsistent. This lack of guidance hinders consistent data collection.

Per say, inputs are considered assets if they engender future benefits [6] (Lev 2001), therefore innovation activities either as physical embodiment or as knowledge/intellectual assets, should be capitalised. One may argue that knowledge is no guarantee of success, a company may invest heavily in research and not develop a single practical or profitable innovation, never the less, those innovation activities should be capitalised, just an machinery would , whether productive or not.

Full Cost Accounting

The full cost accounting method allows all operating expenses relating to locating new oil and natural gas reserves - regardless of the outcome to be capitalised. These are recorded on the balance sheet as part of long term assets. This is because like the lathes, presses and other machinery used by a manufacturing company, oil and natural gas reserves are considered productive assets for an oil and gas company. Generally Accepted Accounting Principles (GAAP) require that the costs to acquire those assets be charged against revenues are used.

I think the full cost accounting method best achieves transparency relative to an oil and gas company's accounting of its earnings and cash flow, as these represent the dominant activities of an oil and gas company, this being simply the exploration and development of oil and gas reserves. Therefore, all cost incurred in pursuit of that activity should first be capitalised and then written off over the course of a full operating cycle.

They include the depreciation of certain long lived operating equipment, the depletion of costs relating to the acquisition of property mineral rights, and the amortisation of tangible non drilling costs incurred with developing the reserves.

Depreciation.

 I think the question should be whether depreciation should be accelerated or not. The income tax law permits business' fixed assets to be depreciated over a shorter number of years than the actual useful lives of the assets. This is the deliberate economic policy of any government to encourage capital investment in newer, technologically superior resources to help improve the productivity of American business.

Accelerated depreciation deductions are higher and tax payments are lower in the early years of using fixed assets. Thus, the business has more cash flow available to reinvest in new fixed assets-both to expand capacity and to improve productivity. The income tax law regarding depreciation of fixed assets has effectively discouraged any realistic attempt at estimating the useful lives of a company's long-lived operating resources

In summary, a business has two basic alternatives regarding how to record depreciation expense on its fixed assets:

Adopt the accelerated income tax approach-use the shortest useful lives and the front-end loaded depreciation allocation allowed by the tax code.

Adopt more realistic (longer) useful life estimates for fixed assets and allocate the cost in equal amounts to each year-straight-line depreciation. 

Although accelerated depreciation has obvious income tax advantages, there are certain disadvantages. For one thing, the book (reported) values of a company's long-term operating assets are lower. The lower book values of fixed assets caused by using accelerated depreciation may, in effect, lower the debt capacity of a business (the maximum amount it could borrow).

Conclusion

Accounting rules are always in flux. Keeping in mind the limitations of financial statements: they are backward-looking by definition, and you almost never want to dwell on a single statistic or metric. At any given time, the Financial Accounting Standards Board (FASB) is working on several accounting projects. But even as accounting rules change and tighten in their application, companies will continue to have plenty of choices in their accounting. It is best not to accept a single number, such as basic or diluted earnings per share (EPS), without looking at its constituent elements.

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