Critical Evaluation Of The Standard Accounting Essay

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Future contracts are categorized as hedging instruments. As per IAS 39, Hedging instrument is defined as an instrument whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. (International Accounting Standard 39, 2012, Paragraph 2)

A fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability which can affect profit or loss, thus future contracts can be categorized as fair value hedge instruments. (International Accounting Standard 39, 2012, Paragraph 89)

To qualify for hedge accounting at the inception of a hedge changes in the fair value or cash flows of the hedged item attributable to the hedged risk must be expected to be highly effective in offsetting the changes in the fair value or cash flows of the hedging instrument. Hedge is considered highly effective if the offsetting change is within a range of 80% to 125% of actual results. (International Accounting Standard 39, 2012, Paragraph 73)

Initial & Subsequent Measurement:

Future contracts are initially measured at fair value and any subsequent changes in the fair value are charged to the P&L account. At de-recognition any differences in the fair value of the instrument at the date of de-recognition are charged to the P&L account.


Main disclosures related to the future contracts are description of the contract, the risk it is hedging and fair value of the contract, information about the fair value changes of the hedging instrument also needs to be disclosed.


Nature of the Instrument:

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Thus the government bonds classify as the investments held to maturity. (International Accounting Standard 39, 2012, Paragraph 46)

Initial & Subsequent Measurement:

The government bond will be measured at amortized cost using the effective interest method. The principal amount would be discounted during initial recognition and periodic unwinding of interest will be charged to the P/L account as income and the unwound interest would be added to the discounted principal amount as a restated value of the bond subsequently.


The main disclosure related to the government bond relates to showing the total interest income for the period in the notes to accounts.


Nature of the Instrument:

Mandatory convertible notes would be recognized as investments held to maturity according to the criteria mentioned above in II.

Initial & Subsequent Measurement:

Although they are classified as compound financial instruments however their treatment in the financial statements with the perspective of the issue would be the same as for normal financial instruments classified in this category. (International Accounting Standard 39, 2012, Paragraph 29-30) Any converted equity would be appropriately accounted for in the financial statements.


The main disclosure related to these instruments relates to showing the total interest income for the period in the notes to accounts.


Nature of the Instrument:

As per IAS 39 financial assets that do not fall into any of the other categories or those assets that the entity has elected to classify into this category are categorizes as available-for-sale financial assets. Financial assets that are held for trading, including derivatives, cannot be classified as available-for-sale financial assets. Thus available for sale is a residual category. In light of the mentioned guidance of the standard this instrument can be classified as an available for sale financial asset. (International Accounting Standard 39, 2012, Paragraph 55)

Initial Recognition & Measurement:

The instrument would be booked and later carried at fair value. There is a presumption that fair value can be readily determined for the financial assets either by reference to an active market or by a reasonable estimation process. Any unrealized holding gains and losses would be deferred in reserves until they are realized or impairment occurs.


Main disclosures related to the available for sale financial assets relates to the items of income, expense, gains, and losses during the period and the nature of the instrument held.


Nature of the Instrument:

Investments that are held for short term gains through trading are categorized as financial assets at fair value through profit and loss. (International Accounting Standard 39, 2012, Paragraph 47)

Initial & Subsequent Measurement:

The short term investment would be measured at fair value in the balance sheet. Fair value changes on the assets would be recognized directly in the P&L account as opposed to assets held for sales. At de-recognition the resulting gain or loss would also be charged to the P&L account.


The main disclosures relates to the items of income, expense, gains, and losses during the period.


Compound financial instruments have both a liability and an equity component from the issuer's perspective. In that case, IAS 32 requires that the component parts be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or other event that changes the likelihood that the conversion option will be exercised. [IAS 32.29-30] therefore the instrument would be booked in the books of the Pretoria Ltd as follows:

The principal amount would be used to compute the interest rates expected to be received over life of the instrument. The principal amount and interest rate would then be discounted at the market interest rate to remove the effect of lower actual interest rates due to the option of converting the instrument into equity at the maturity date. A calculation of the treatment of the instrument is shown in the table below:


Principal Amount

Interest Rate


Market Interest

Net Amount





















Total value




The initial recognition would be as follows:

Dr. Cash/Bank 2,000,000

Cr. Liability 1,801,052

Cr. Equity 198,948

Subsequently the interest would be kept unwinding and charged to the P&L as income on the amount of financial liability at the rate of 10%.

If Converted:

In case the option is exercised then any amount that is above the booked equity would be taken to the share premium, this would depend on the number of shares that are converted and meanwhile the financial liability would be reversed.

If not Converted:

In case the option is not exercised than conversion to the equity would be reversed and taken to retained earnings. The financial liability would be reversed on receipt of consideration against the bonds.


The disclosures would include the description of the nature of the financial instruments, the market interest rates used.

Section B



The Board of Directors

Arrowbell Co


This report has been drafted as per request of the president to present the board a bird eye view of the performance of our company over the last three years period from 2009 to 2011. The following report analyses the performance of our company in terms of profitability, liquidity, gearing and investment related measures.



Profitability ratios are defined as those financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. Often this is the measure the management is most concerned about. Typical profitability measures include ROCE, gross profit and net profit margin.


The performance of the company has improved in terms of ROCE which increased from 8.5% to 8.7%. Looking in more detail at the composition of ROCE, the greater efficiency in using Fixed Assets to generate sales explains the increased ROCE. However, this improvement has been offset to a greater extent by the lower profit margins both at gross and net profit level. The potential cause appears to be the decrease in selling price of the products as a strategy to attract more customers, and the associated increased administrative and other costs due to greater volume of activity.



Liquidity ratios are defined as those financial metrics that are used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety the company possesses to cover short-term debts. Commons measures of liquidity ratios include Current ratio, Quick ratio, Inventory turnover, Receivable days and Payable days.


The liquidity of the company has deteriorated over the period. The current asset ratio has fallen from 2 in 2009 to 1.5 in 2011. The same goes for acid-test ratio which fell from 1 to 0.8. A consideration of the component elements of the current ratio suggests that the decrease in the ratio has been caused by the increased payable days and decreased inventory turnover. The increase in payable days could potentially be due to deliberate delay in paying suppliers to compensate the delay in cash that is received from the receivables. The decreased inventory turnover appears to be caused by holding greater inventories given the fact the cost of sales increased. However, the surge in accounts receivable days masked the adverse ratio to some extent. The reason for the increase in accounts receivable appears to be lose credit follow-up to encourage sales.



Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds. Investors and financial institutions frequently use this ratio to assess the level of risk associated with the entity.


The gearing of the company increased from 40% to 48%, although it helped to increase the ROCE to some extent but on the other hand the fall in interest cover from 12 to 7 suggests that the increased gearing can prove to be quite risky in case of further downfall in the profitability over the period.

Investment Ratios:


Investment ratios tend to find the relationship between the amount of money invested and the profit made from it. Investment ratios are of particular interest of investors to assess how promising the investment seems to be. The most widely used measures of investment ratios include Earnings per share (EPS) and Return on capital employed (ROE).


The ROE of the company declined over the period from 15% to 12%, this is mainly due to reduced profitability, partly explained by increased cost of sales and finance costs.

On the other hand EPS improved from being 0.55 in 2009 to 1.20 in 2011. The improved performance in terms of EPS can be explained as a result of increased net profit in absolute terms. The improved operating cash flow per share is also encouraging as it would contribute to improved profitability in the coming years.


Overall the performance of our company declined in terms of profitability and liquidity. The increased gearing also meant assuming greater risk of lower proportionate returns to the investors in case of further downfall in profitability. On the other hand improved EPS and operating cash flow per share were encouraging and indicative of better future profitability. However it is highly recommended that a comparison should also be made with the industry /competitor ratios in order to get a better picture of the performance of the entity in context of the business environment it operates.

Section C:



In recent years the recognition and measurement of intangible assets has been one of the

most controversial areas of financial reporting. Many businesses now operate and compete

with significant intangible assets such as brands, knowledge capital and people. However, there has been criticism that accounting practice in this area is out of date, unhelpful to users and in need of reform. It would appear that with regard to intangibles reliability has gained more importance than relevance.

The Standard:

Intangible assets are identifiable non-monetary assets without a physical presence. IAS 38 lays down the following criteria for recognition of an intangible asset:

The asset must be identifiable

The control of the asset must lie with the entity

It is probable that the future economic benefits will flow to the entity

The cost of the asset can be measured reliably.

(International Accounting Standard 38, 2012, Paragraph 08 & 21)

Further the standard requires that any cost associated with the research is to be expensed out and lays rigorous criteria for booking of development expense as an intangible asset. (International Accounting Standard 38, 2012, Paragraph 54)

Critical Evaluation of the standard:

Although IAS 38 has improved the accounting for intangible assets to a great extent but still there are issues that needs to be addressed.

IAS 38 requires that an intangible asset only be recognized as an asset if future economic benefits are expected to flow to the entity. In case of intangible assets this gets somewhat difficult e.g. consider estimating the probable economic benefits from customer lists as compared to any tangible asset. This criteria thus may prohibit a significant of expenditure not being recognized as an asset that would result in future economic benefits to the entity, thus it can be argued that the financial statements would not be presenting a true and fair value of the financial position of the entity.

As per the requirement of the standard any internally generated intangible asset cannot be recognized as an asset, except for development related expenditures (International Accounting Standard 38, 2012, Paragraph 63). For an entity with major expenses related to generating brands, mastheads etc may not be able to capitalize such expenditures despite they will result in future economic benefits and thus affecting the picture presented by the financial statements regarding the performance and position of the entity.

Not capitalizing intellectual capital management poses the same issues as mentioned above.



Creative accounting, also called cooking the books, refers to accounting practices that may follow the letter of rules of the standard accounting practices, but deviate from the spirit of those rules. They are characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations desired by the authors. Creative accounting has been in the limelight for a number of years and has been amongst the major concerns of the accounting regulatory authorities, especially after the incidents of Worldcom and Enron which once shook the confidence of the investors immensely.

Motives of Creative Accounting:

One of the most common motives of creative accounting is getting personal incentives or greed. The personal incentives/ greed could be in the form of benefits gained by claiming fictitious expenses that have actually not been incurred by the employee, or a fraud that is committed concealed by cleverly crafted creative accounting.

Saving of Tax

Saving tax is another major incentive for creative accounting. Help is taken from creative accounting to over/understate the expenses/income that would be taxable, avoiding tax.

Increases in the Price of Shares 

Creative accounting can also be used as a tool to increase the share prices of the entity. Usually false assets are shown for increasing the net worth and ROI as a move to make investment more lucrative to the investors; share prices are increased when there occurs a surge in demand of the entity's shares. This price increase ultimately may benefit insider dealing or affect positively the bonuses or other share price linked financial incentives of the managers.

Securing Loans/Debts:

Financial constraints are another important factor that can derive the management to cook the books in order to secure more loans from the financial institutions.

Ways of Creative accounting:

Creative accounting can be practiced by deliberately manipulating the revenues, profits and cost of sales in the income statement. Revenues are often overstated by not applying proper cut-offs at the period end or by not using the appropriate methods to recognize revenue as per guidance of IAS 18. Income statement related items are usually overstated to strengthen the profitability of the entity with which might management's bonuses may be attached or to improve EPS being making the investment more lucrative to potential investors. Creative accounting may also involve understating the expenses/costs in the financial statements e.g. by overstating the closing inventory to improve the gross profit margin.

Overvaluation of the fixed assets may be done in order to secure the loans and improve the position of entity in the eye of financial institutions. Methods of overvaluation would include cherry picking assets that need revaluation, etc. Another way could be to take advantage of the choice of recognizing the subsidiaries and joint ventures in the financial statements by choosing the method that shows the most favorable view rather than true and fair view.

Creative accounting can also involve under valuing the liabilities, this could include not correctly recognizing the contingent liabilities, or by not following the principle of substance over form e.g. sale and lease back may booked as sale of the asset and the net gain be shown as a profit in the income statement thus overstating the income statement and understating the liability portion of the statement of financial position.

Using inappropriate estimates and judgments in the financial statements could be another method e.g. not estimating the useful lives of the assets to understate the depreciation expense or deliberately over/understating the probable future cash flows to be received from an asset when considering impairment.

Responses of Legislators:

Responses of the legislators in the US and UK both have curbed the unfair practice of creative accounting to a greater extent. The requirements of the SOX and the codes of corporate governance on the objectivity of the auditors, composition of the audit committees, focus on the internal controls (including those relating to governance and financial reporting) have squeezed the grey area to great extent. However still many loopholes exit in the current accounting practices which are expected to be removed by time and experience.