Accounting and financial reporting are key obligations for businesses that need to be performed according to International Financial Reporting Standard (IFRS) and country accounting regulations for the preparation of financial statements. There are various accounting concepts and regulations in UK financial reporting, IFRS and Companies Act that set the standards for companies to produce financial statements in proper format and without misleading and false information (Stolowy and Din, 2003). This paper discusses basic accounting concepts and regulations related to UK financial reporting along with specific assumptions and flexibilities for businesses. The assumptions of financial regulatory frameworks that are underlying the preparation of financial statements are also discussed in this paper. In last, this paper also discusses about the loopholes in financial regulation or regulatory framework along with examples of companies in which they take advantage of these loopholes to gain additional benefits as well as present financial figures in a misleadingly favorable light.
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Basic Accounting Concepts and Regulations
In UK financial reporting, accounting standards are defined as legislation as well as the behavior outlined for professional bodies. There are various accounting concepts and regulations that are implemented by the Financial Reporting Council (FRC) for improving corporate reporting and governance (Stice, Skousen and Stice, 2009). Under the supervision of FRC, Accounting Standards Board (ASB) and Auditing Practices Board (APB) develop the accounting principles and issues accounting standards in order to provide a regulatory framework through which, businesses resolve their financial accounting issues and prepare financial statements (FRC, 2014). Some of the specific accounting concepts and regulations are discussed below along with permitted flexibilities for the businesses:
This is issued by ASB to provide guidance and standards for basic preparation of financial statements by entities in accurate way. Under this regulatory framework, several accounting standards are set by ASB related to preparation of cash flow statements, accounting for subsidiary undertakings, reporting financial performance, capital instruments, acquisition and mergers, reporting the substance of transactions, and fair value in acquisition accounting. All these accounting standards are useful for UK companies when producing financial statements because of the flexibility in the current version of IAS 7 and FRS 1 (Epstein and Jermakowicz, 2010). Under FRSs, some flexibility is still permitted for businesses in terms of early application for accounting periods, no requirement to offset assets and liabilities and issue of financial instruments without too many formalities (Chil, Das and Pramanik, 2009).
These flexibilities or choices are permitted regarding accounting treatment of investment in subsidiary and issue of new shares or bonds in cash flow statements by making changes in the current version of FRS 1. The main reason behind the flexibility permitted in terms of how FRSs applied is to give some space to companies, so they can improve their financial reporting by developing true and fair financial statement (Zeff, 2007). For example, Tesco used choices regarding the inclusion of items in cash flow statements by reporting two operating cash flow numbers, and including financial information of international operations and service businesses. In this example, judgments are made on the basis of provisions of FRS 1 and its relevant criteria for exemption of cash flow statements (Stice, Skousen and Stice, 2009).
In UK, the Companies Act 1996 is an Act of the Parliament that is the primary source of company law. Under this act, statutory formats of financial statements for different types of business are described in order to differentiate them on the basis of financial reporting and accounting (Mahoney, 2004). According to this act, the presentation aspects of FRS 25 and FRS 26 must be applied by all companies especially listed companies without subsidiaries when producing their financial statements for the purpose of tax legislation. Along with this, companies also need to apply generally accepted accounting practices (GAAP) in preparing the income statement, balance sheet and cash flow statements (ICAEW, 2014). At the same time, some flexibility is permitted under the Companies Act 1996 in terms of how cash flow statement exemption, consolidation exclusions, and measurement and disclosure of financial instruments are applied with statutory format (Elliott and Elliott, 2011).
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In this concern, flexibility in financial reporting is provided to those companies that are limited by shares and by guarantee under this act. The main reason behind the arising of this type of flexibility in accounting is the discretionary trust and proprietary purpose of business owner (Holt and Eccles, 2002). Apart from this, the extraordinary flexibility in relation to ownership and capital that limited companies provide can arise, if the company limited by guarantee having ordinary shares and used for private family foundations (Vitali, 2006). For example, choices are permitted in case of share repurchase, insurance against such liabilities and disclosure requirements of financial instruments under the Companies Act. These choices have greater implications for both public and private limited companies in terms of inclusion of cash equivalents, tax planning and breach of duty or trust (ICAEW, 2014).
IFRS is a set of accounting standards for financial reporting that is developed by the International Accounting Standards Board (IASB) to provide global regulatory framework and general guidance to public companies for the preparation and disclosing of their financial statements. Most of jurisdictions worldwide along with European Union (EU) adopted IFRS as an international standard in order to improve accounting and financial reporting of companies in their respective region (IFRS, 2014). The regulatory framework of IFRS is significant for companies and especially for large multinational companies that have subsidiaries in different countries due to presence of a single set of world-wide standards for accounting procedure. Under this regulatory framework, some flexibility permitted in the areas of financial reporting, whereby more than one accounting treatment is allowed by the standards to enterprises (Needles and Powers, 2012).
For example, IFRS allows disclosure of operating activities and inclusion of additional subtotals to companies in case of preparing single financial statements by including all operating items of subsidiaries (IFRS, 2014). Along with this, an entity has choice to present the analysis of expenses either by nature of expenses or their function within the organization when making judgments regarding the accounting treatments of business expenses in financial reports (Paul and Burks, 2013). Additionally, choices in case of measurement approach at each reporting stage and implementation of changes in financial reporting on a retrospective or prospective basis are also given. Both these choices are important for companies to improve their accounting procedures as well as take advantage in case of liabilities and expenses (Pacter, 2014). For example, most of the UK companies are utilizing the permitted flexibilities of accounting standards to reduce their liabilities and deficit in case of pension scheme (Smith, 2012).
Along with company law and accounting standards, a set of Stock Exchange rules is also an important source of accounting regulations for limited companies in UK. It is because Stock Exchange rules are equally important to provide guidance to listed companies in order to ensure that they comply fully with UK GAAP and FRSs. In addition, it also requires that listed companies must disclose the extent of compliance with corporate governance and reasons for non-compliance in their accounting and financial reporting according to Stock Exchange rules (Nielsson, 2009). Apart from this, the Stock Exchange regulations also require that all listed companies must publish a statement of whether it has applied the principles of Code or not in their annual reports (Sealy and Worthington, 2013). There are some flexible regulatory requirements that provide various choices to listed companies in case of disclosure of debt securities, investment instruments and corporate governance expenses in their financial statements (Piotroski, 2013).
For instance, the Stock Exchange rules allow Islamic companies to issue debt securities without the requirements for a full prospectus of issue. In this way, the disclosure requirements of debt securities leave a significant choice in the accounting treatments of these transitions either the regulatory framework of GAAP or IFRS (London Stock Exchange, 2014). Along with this, capital rising for merger and acquisitions, admission process of new shares, Exchange Traded Funds (ETFs) and issuance of “Sukuk” are also some areas in concern of Stock Exchange rules that still leave choices in accounting treatments (Sealy and Worthington, 2013). These choices have greater significance for UK companies in terms of listing and issuance costs, avoiding regulatory problems, develop cost effective investment tool and enhances visibility among international investors (Miihkinen, 2012).
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It is identified from the above discussion that many areas in concern of the Companies Act, UK FRSs, IFRSs and Stock Exchange rules leave significant choices for companies in case of accounting treatments. From such choices, various implications are arising that can be significant for UK companies to reduce their costs, cut deficit, facilitate efficient tax planning, and enhance financial reporting of financial instruments, cash flow statement and consolidated accounts (Nielsson, 2009). It is because flexibility in accounting regulations in regard to choices for accounting reporting of different financial transactions provides an advantage to UK companies through which they can reduce their expenses and present financial figures according to their suitability (Lewis and Buzdrev, 2012). Along with this, following implications are also arising from such choices that are permitted in accounting regulations of UK:
- Enable the companies to show the true balance of business profits and gain in the income tax acts in their financial statements (Pacter, 2014).
- Provide more suitable measure to match long-term profile of pension payments with company’s expenses (Smith, 2012).
- The inclusion of cash equivalents is available in IFRS cash flow statements under FRS 102 (Holt and Eccles, 2002).
- The measurement of financial instruments may be broadly equivalent to current practices in case of authorized funds (Miihkinen, 2012).
- The inherent flexibility in accounting regulation and financial reporting standards can act as more effective fraud deterrent (Lewis and Buzdrev, 2012).
- The reduction in owner’s liabilities can also arise from the choices in case of accounting treatment of debt securities, financial instruments and bond issue with personal interest (Piotroski, 2013).
- At the same time, implications for cross-border business activities and their accounting in financial statements are also arising from the flexibility permitted in accounting regulations (Carmona and Trombetta, 2008).
In concern of the UK financial reporting, there are some loopholes associated with current accounting or financial regulations of regulators. In last one decade, there are lots of examples of UK companies in which they gain advantage of loopholes in regulatory framework when producing their financial statements (Holt and Eccles, 2002). Loopholes represent the weak points of the financial regulations that enable the companies, and their directors and accounting managers to present financial figures in a misleadingly favorable light to gain personal benefits without violating the rules (Holt and Eccles, 2002). Financial loopholes in the regulatory framework contributed to develop an extremely complex and opaque financial system in UK. It is because loopholes in accounting regulations increase possibility of happening financial scandals (Michie, 2014). Some of the major loopholes in regard to accounting regulations and standards are discussed below-
Loopholes of Accounting Profession: The loophole of accounting profession is a significant factor that contributes to create weaknesses in the regulatory framework by providing ways to take unethical benefits. The loopholes of accounting profession are arising from their strong attachment with accounting regulations and reporting standards, if they fail to allocate capital efficiently and restore financial stability (Smith, 2012). There are many examples in which companies have exploited the weaknesses of accounting professionals through money in order to prepare financial statements according to their suitability for personal gains. For instance, some of the companies have exploited this loophole with the help of charted accountants (CAs) by producing financial statements with misleading information or figures (Sealy and Worthington, 2013).
Tax Loopholes: There are also some instances in which companies have exploited the tax loopholes of specific accounting regulations and standards. In most of the cases, companies have achieved accounting scandals or misleading financial information by giving wrong information about their revenue and expenses in financial statements for tax avoidance. In this way, large companies have exploited the loopholes of IFRSs and FRSs in order to protect them from high amount of taxes (Holt and Eccles, 2002). In last one decade, many cases related to tax evasion and frauds are reported in the UK in which firms took advantage of tax loopholes by misleading the auditors and regulator through wrong figures. For example, large accountancy firms, KPMG, Deloitte and Ernst & Young are some companies that have exploited the tax loopholes of financial regulations in order to minimize the tax liability for their clients by showing wrong figures of revenue in their income statement (Sikka, 2013).
Accounting Loopholes: In the current regulatory framework, some of the UK companies have also exploited the accounting loopholes by using the flexibility permitted in the accounting regulation of IFRS and FRS. For example, banks utilize accounting loopholes to inflate their profits and bolster bonuses of their staff members. Generally, accounting loopholes provide an advantage to banks through which they easily use complex financial products or instruments in order to make risky investment to show themselves more profitable than actually they are (Treasor, 2011). In this type of case, most of the banks exploited the accounting loopholes of IFRS to gain unauthorized gain or profits from the investments. Banks have achieved inflate profits and high gain from accounting loopholes of financial regulations by producing income statements and balance sheet with misleading financial information about the investment in risky assets and their respective profits (Paul and Burks, 2013). HSBC is a good example of a UK bank that has exploited the accounting loopholes of FRSs by presetting false information about investment in its cash flow statement (Holt and Eccles, 2002).
On the basis of the above discussion, it can be concluded that accounting is an important area of business activity, which needs effective regulatory standards and regulations in order to ensure proper accounting and financial reporting by the companies. From the above discussion, it is summarized that FRSs. IFRSs, Companies Act 1996 and Stock Exchanges rules are some of the important financial regulations that provide regulatory framework to companies for accounting and financial reporting of their business transactions. It is also summarized that there are various flexibility permitted in the accounting regulations in each of these accounting standards, which provide choices to companies in the financial regulations to manage the measurements and preparations of the accounts according to their suitability and personal gain. From the above discussion, it can be also concluded that there are some loopholes in the UK regulatory framework in terms of accounting loopholes, tax loopholes and accounting profession loopholes, which played a major role in creating accounting scandals and frauds by the companies. Large accounting firms, banks, retail firms and real estate organizations are some of examples in which they achieved the presentation of misleading financial information related to taxes, debt securities, profits of subsidiaries and bonuses in their financial statement by taking advantage of loopholes and flexibility permitted in financial regulations.