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The objective of this essay is to examine the issues in relation to recognition of elements in the financial statements in the context of regulation within the financial statements. Using accounting theories I shall be analysing the standards and rules in relation to recognition, to determine the approaches and practices for specific areas of recognition and any possible changes to improve the clarity of the standards that are already in place. Within the essay I will be defining recognition and providing real-life examples of working practice from multi-national corporations (MNC) and looking at four specific areas of the International Accounting Standards (IAS), as set out by the International Accounting Standards Board (IASB). I shall be critically analysing four IAS's in detail and providing personal recommendations on possible improvements in these standards; IAS 2 Inventories, IAS 18 Revenue, IAS 23 Borrowing Costs and IAS 39 Financial Instruments: Recognition and Measurement.
Ref The work of Colin Deegan states Hendriksen (1970, p.1) defines a theory as 'a coherent set of hypothetical, conceptual and pragmatic principles forming a framework of reference' for a certain area of inquiry, in this case accounting. The purpose of a theory is to; prescribe certain treatments for elements in the financial statements and what information should be provided, predict the motivation to choose certain methods, explain the impact of socio-cultural environment on information supplied and predict the relative power within an organisation. There are several different approaches to accounting; inductive/descriptive, prescriptive/normative, and positive theories.
The inductive accounting theory distilled rules from what is observed and what is already done in practice, in essence summarising good practice in accountancy at the time. An advantage of this is that a good working method can be adopted over time if it is seen to be effective, however just because it is the method mostly employed it doesn't mean it is the best and most effective method. In addition if a new issue not seen before emerges there are no useful theories to draw upon as it has never been experienced before and just keeps the equilibrium, this method does not encourage the development of new predictive ideas as there is no working example to draw from.
The normative theory takes a more prescriptive approach to accounting methods, providing rules which should be adhered to, these rules have been hypothesised and are not proven by real life examples. It provides less freedom for interpretation of the accounting methods, and this can be problematic as theories are only proven or disproven with a real life situation as it is not based on empirical research. As with the inductive theory there are practical issues as it will not necessarily reflect the best assumptions and may not reflect current policies.
Finally the positive theory takes a combined approach, in the sense that it both explains and predicts methods and approaches, using observation and empirical research. In essence this theory explains why accounting is the way it is, why accountants take the actions they do and the effect these have on people and resources. Watts and Zimmerman (1986, p. 7) define the positive theory as 'concerned with explaining accounting practice. Ref http://www.download-it.org/free_files/Pages%20from%20Chapter%207%20Positive%20Accounting%20Theory-d0385ad3b7925717c0b72a06b16de4f4.pdf Designed to explain and predict which firm will use and which firms will not use a particular method' however this theory does not say which method the firm should use. One major issue with this theory is that is based on the concept of a rational ideal of a person where the main focus is on the maximisation of wealth for personal interest and gain, it also assumes that self interest and wealth maximisation for the company have a symbiotic relationship, this may not always be the case, in addition the concept is subject and thus therefore open to interpretation. Also as it is not prescriptive it can be seen as reactionary rather than proactive with standards, they can take longer to develop than prescriptive issues as there is not hypothesis only analysis of the situation and the reactions and behaviour of firms.
The eclectic theory of accounting suggests that rather than on accounting theory being fully corrects aspects of the theories can apply to certain situations and maybe on method is more suitable for those specific conditions. This is the main approach take by most accountants, this combination, as it is the most applicable in all situations and the most adaptive to changes in the environment as it takes influences from all the approaches of a counting.
Methods of regulation:
There are many methods of regulation for financial statements; legislation of the country, regulations for participation within organisations and accounting standards and generally accepted accounting practice (GAAP). The legislation that needs to be adhered to consist of legal requirements that will vary from country to country, in the UK a good example is the UK Companies Act 2006 or Corporation Tax Act 2009; however these are slow to implement and only provide a loose base of rules, supported by case law. Also if companies want to participate in certain markets or organisations they may be required by that organisation to provide certain financial information that may not otherwise be require to be disclosed, for example the London Stock Exchange requires companies in the exchange to publish quarterly figure not required by legislation or UK GAAP or IAS.
UK GAAP consists of a collaboration of financial and accounting regulations from several sources and other accounting conventions within the UK, IAS are included in UK GAAP but they may vary slightly from company to company as the application method is open to interpretation in places. IAS's are used to provide more specific methods of treating elements in the financial statements, I will be focussing on this aspect of regulation within my essay as the accounting standards are the most specific in the treatment of elements in the financial statements. The provision of this regulation serve to provide the variety users of financial statements with a true, fair and reliable representation of the financial position of the company with which to make informed decisions in relation to that company.
The IASB is an independent standard-setting body of the International Financial Reporting Standards (IFRS) Foundation, using transparent and public methods to implement improvements or updates for IAS. The ultimate purpose of the IASB is to harmonise regulations and standards to increase accountability and comparability between companies. The IASB has compiled a conceptual framework of standards to adhere to when preparing and presenting financial statements, these are to be used as a base line for rules in conjunction with other legal requirements for financial statements such as a country's legislation and to participate within certain organisations like the stock exchanges. There are IAS's set out for specific areas of financial statements, the framework adopts a variety of accounting theories and approaches.
The importance of recognition in financial statements:
In accounting the concept of recognition is vital when considering financial statements; a clear and uniform definition of recognition can have a huge effect on the perceived performance of a firm. Within business, investors usually use publically available information on a company to make investment decisions; this means that ultimately how a company approaches recognition can have significant implications on investment opportunities. Most people using financial statements commonly use only partial sections to make decisions rather than the whole report, as they are usually looking for a snapshot of the business.
How a company recognises elements in the financial statements can alter the investors and potential investor's perspective of the progress and success within the company. Most look at the bottom line in financial statements, for example to asses the financial position of a company the balance sheet are examined for the value of assets and liabilities, the approach that the company takes to recognising the monetary values of these is integral to whether this company is perceived as a good investment opportunity.
In addition to investors' perceptions there are also the markets perceptions to consider, for example if a company was not recognising revenue using the same method as its competitors in the market it could be seen to be less successful when it may in fact be on a par with its competitors. By having a set of baseline principles such as IAS some level of comparability within the market, without a guideline companies would use a variety of methods and approaches to recognise elements in the financial statements, making comparisons between companies harder and less a significant as the disparity could be too much.
Definition of recognition and measurement IAS.
Before recognition of an element can be assessed the item needs to meet the definition of an element in financial statements, which is either; an asset, a liability, equity, income or expenses. The IAS framework defines an asset as 'a resource controlled by the enterprise as a result of past event of which they receive the future economic benefits'. (IAS framework) The framework defines a liability as 'a present obligation of the enterprise arsing fro past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits'. (IAS framework) Also defining equity as 'the residual interest in the assets of the enterprise after deducting all its liabilities' (IAS framework) and income as 'increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants' (IAS framework). Finally expenses are defined as 'decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence's of liabilities that result in decreases in equity, other than those relating to distributions to equity participants'. (IAS framework) http://www.iasplus.com/standard/framewk.htm
In addition the concepts and methods of measurement in financial statement needs to be examined, if a company cannot reasonably/reliably estimate the value or cost of an item it cannot be recognise in the financial statements such as the balance sheet or income statement. The IAS framework defines measurement a 'process of determining monetary amounts at which the element of the financial statements are to be recognised and carried in the balance sheet and income statement'. To achieve a choice of which basis of measurement to use is required either; historical cost accounting (HCA), current cost accounting (CCA), realisable value and present value.
Historical cost accounting records assets values at the amount paid for the item, and liability values are records at the cost of the item expected to be paid for the item. This method is both reliable and simple as it focuses on the actual transactions and values making booking keeping simple, whilst record a fair value at the time of purchasing. However this method can be too simplest as it does not take present values of items or costs in relation to inflation, limiting the accuracy of the data and thus financial statements as prices fluctuate and can be perceive as retrospective in it approach, without consideration for future changes in the business environment that may affect the costs and values of items making them out of date.
Current costs accounting takes current purchasing power into consideration taking a less backwards looking view of measurement, in this method inflation is taken into account, the historical cost of an item is then converted into the current value in the market at present. This can result in possible holding gains where the value of the item has increased whilst the business has owned it and operating gains where the gain can be realised or unrealised. When the replacement cost has increased, the value of the item has increased, if the value remains the same or increases there is unrealised operating gains as the value has increased, when the item is then disposed of or used within the company that value is realised in operating gains. This has an advantage over HCA as the current value of an item or cost can be more accurately estimated, making the financial statements more reliable, in addition it recognises possible gains from retaining an item if it's current value increases in the market. That does make the this method more complex and this more time consuming to apply but reduces the rise of under or over statement in the financial statements.
The realisable value method of measurement goes a little further than the current cost accounting, in the sense that it is the value of an item in the present market taking in all costs incurred if selling the item and whether this is more desirable an option than the value of the item in use within the company and it turn whether it is more economical to replace the item or continue using it. This method is more complex over both HCA and CCA as the method considers all possible costs that could arise from either the replacement costs or the costs to sell or dispose of the item. However this leads to a more accurate calculations of the true value of the item in the current market, making this method more reliable, but if this was done for every item it would be extremely time consuming, a company may adopt this method for selected items rather than for every item within the company to ensure accuracy on larger items of assets or liabilities rather than on all items.
Present value considers the future amount of value generated by the item discounted to the present value using the cost of capital rate. This method does not just examine the historical and present value but also all possible benefits from the item in the future; the discounted value provides an accurate estimate of the value of that amount at the present value. This method is the most complex but does provide the most accurate values for an item; this is because more variables are taken into consideration when making the calculation increasing accuracy, it does not take synergy of the company into account if each item is treated separately. Due to the complexity of the method the calculations it could not reasonably be applied to every item within a business, as it would be far too time consuming as well as administration difficulties and an overload of information to be calculated.
Moreover the concept of capital maintenance and thus how profit is determined also has to be considered, as the method chose will influence the value/amount of profit that will be recognised in financial statements, there are two aspects to capital maintenance; financial and physical. Financial capital maintenance is concerned with the amount/value of assets at the beginning and the end of an accounting period, if there is an increase in the value then a financial profit has been made. Whereas the physical capital maintenance is concerned with the operating capacity or physical productivity of the company at the begging and end of an accounting period if this value is higher than at the beginning of the period then profit has been made.
Without effective and common methods to measure the value or cost of an item effectively a company loses comparability in the market and can lose potential investors through over or understated assets and liabilities in the financial statements.
The IAS framework states that, if an item fulfils the criteria for the definition of an element in financial statements, should be recognised only if: 'it is probable that any future economic benefit associated with the item will flow to or from the entity and the item has a cost or value can be measured with reliability.' However this the vague baseline for what to recognise in the financial statements, the IAS framework has specific standards to deal with certain areas of the financial elements. I shall be examining three/four of the standard in detail examining the approach the framework takes to certain items and whether this approach varies from on standard to another; IAS 2, IAS 18, IAS 23 and IAS 39.
IAS 2 Inventories:
The IAS framework defines inventory as assets that are; held for sale, in the process of being produce to sell or the materials that the product is produced with and items held for reselling. The framework states the objective is to be a prescriptive role for the treatment of inventories, with exclusions; 'work in progress arising under construction contracts, financial instruments, and biological assets related to agricultural activity and agricultural produce at the point of harvest' going into specific instances where deemed necessary. http://www.iasplus.com/standard/ias02.htm
IAS 2 requires inventory to be stated 'at the lower cost and net realisable value (NRV)' where NRV is the selling price of the product less the costs of production and costs of sales for the product. In order to achieve this the cost of inventories needs to be considered, the framework sates that costs should include; purchasing costs, conversion/production costs and other related costs in acquiring the inventory. Whilst excluding certain costs that are both associated with and unassociated with costs such as:
Administrative overheads not relating to the product,
Losses due to exchange rates and interest costs incurred on the inventory'.
In terms of recognition the IAS 2 focuses on what inventory to recognise, the framework refers to IAS 18 Revenue for specifics on how to treat the revenue and cost of sales of the goods sold.
The framework gives a range of methods to use when calculating the measurement of costs for inventory; standard cost method, the retail method, the weighted average, the first-in first-out (FIFO) and the last-in first-out (LIFO). The standard cost method uses normal levels within the market to calculate standard cost, this has to be updated regularly as the value changes with the market and environment around it, this method is simple and easy to use. The retail method determines the costs by looking at the sales value in relation to the gross profit margin; this is a more complex method but give a more accurate picture of the costs actually incurred. The company uses a cost formula to calculate the cost of inventories and the IAS framework give guidance as to what formula to choose in certain circumstances. Weighted average costs refer to the average cost of the item weighted to calculate the true cost. FIFO assumes that the units of invertors moving out of the business are the ones that have been in the business the longest, and the left over inventory is the latest items purchase, and the LIFO assumes the opposite, that the last items to come into the inventory will be the first to be sold, leaving the older items in the inventory.
IAS requires certain disclosures within the financial statements, this is so that anyone using the financial statements can see which method was used and that the statements are as transparent as possible to the company's business position. These disclosures include:
'The accounting policies for inventories including formulas and methods used.
The amount of inventories.... and finished goods. Classification is dependent on what is appropriate for the entity.
The amount of inventory carried at fair value less costs to sell.
The amount of any write-down of inventories recognised as an expense in the period.
The amount of inventories put as security for liabilities, costs of operating the business and cost of sales'.
The major recognition issues for IAS 2 is what to recognise as inventory and the method to calculate its cost, the framework gives basic qualifications for what is included in inventory with more detailed instructions for the treatment of specific aspects of inventory. But the biggest issues the method of costing used when calculating the cost of the inventory, as with accounting theories there are several methods for this calculation, with no specific reference as to which is preferred by the IASB.
Company's can use the IAS as a guideline for how to treat inventory, for example the notes in the financial statements of Rio Tinto state that cost formula used is the weighted average cost to get the NPV of the inventories, specifying the method of calculating the average cost, in this case by 'reference to the costs levels experienced in the current month together with those in the opening inventory' also disclosing what the cost of production includes. In addition the notes on the inventories can elaborate on specific issues that may only relate to that specific business, for examples Rio Tinto explains the true meaning of the stockpiles of ore, disclosing the methods it will be treated with depending on its value or usage. Whereas BP uses a different cost method to calculate the cost of inventories, the FIFO method, which shows inventory as a more relevant cost than using the LIFO method. The framework sates the objective of being prescriptive in the treatment of inventories however I feel that the framework is quite vague and descriptive, it suggests several methods to calculate the costs of inventory, without giving any suggestion as to which is preferred by the IASB. IAS 2 is prescriptive in the information required to be provided in the financial statements, whilst leaving the methods used subjective to the preference of the business group, by ensuring that companies detail which method is used it can eliminate some of the issues such as comparability as it can be seen which method is used in the notes. http://www.riotinto.com/annualreport2009/pdf/rio_tinto_full_annualreport2009.pdf http://www.bp.com/assets/bp_internet/globalbp/globalbp_uk_english/set_branch/STAGING/common_assets/downloads/pdf/BP_Annual_Report_and_Accounts_2009.pdf
IAS 18 Revenue:
The IAS framework defines revenue as 'the gross flow of economic benefits...arising from the ordinary operating activities of an entity...' the framework has made several assumptions here; that revenue is the gross flow rather than the revenue with consideration to any expenses incurred, it only considerers revenue from ordinary activities rather than from other revenue like unrealised holding gains from equipment and the assumption that a rise in revenue will lead to a rise in equity, this is not necessarily the case. The framework firstly addresses the measurement of revenue for IAS, stating the revenue should be measure in a fair way detailing what constitutes the generation of revenue within the exchange of goods, for example the exchange of similar goods of a similar value would not be consider to have generated revenue by the transaction. Also considering deferred inflows of cash due to certain conditions, such as interest free credit on an product if purchased, the potential future cash flows are discounted for a fair value. The framework states that if the definition of revenue is fulfilled, it will be recognised if it is 'probable that any future economic benefits associated with the item of revenue will flow to the entity and that the amount of revenue can be measured reliability', furthermore recognition of revenue is broken down into three categories for specific guidance; sales of goods, rendering of services and interest, royalties and dividends. http://www.iasplus.com/standard/ias18.htm
The framework provides a list of criteria that need to be fulfilled to be recognised as revenue for the sale of goods:
'The seller has transferred to the buyer the significant risks and rewards of ownership.
The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold.
The amount of revenue can be measured reliably.
It is probable that the economic benefit associated with the transaction will flow to the seller.
The costs incurred or to be incurred in respect to the transaction can be measured reliably.'
One issue of revenue recognition that affects the sales of goods is when to recognise revenue when a product has been purchased but will be paid for at a later date, and whether to recognise all of it at once or to recognise it in stages. The time line has to be taken into consideration, recognition may not be an issue if the purchaser is given thirty days to pay as it would still be recognised within a financial period, whereas if the purchaser is given a deal where the time period to pay is over years, for example buying a sofa and not having to pay anything for two years, in these situations not recognising the revenue until it is paid for may result the appearance of a decrease in revenue even with an increase in sales. Give examples from companies!
Moreover the company has to recognise the probability that some of the purchasers may not pay, if so does the company can either wait until full payment for recognition of the revenue in the financial statements or can allow for a certain amount of bad debt. This may only be a fraction of the actual revenue of goods sold as only a minority of purchasers will not pay for the item, the company has to decide the probability of bad debt and provide for the possibility before recognising the revenue from sales of goods. For a company to wait until it has received full payment to recognise revenue in a long term situation, over more than one accounting period can cause issues for the company, as it would cause significant fluctuations in the company's perceived performance. Due to sales being groups and recognised long term making the revenue appear sporadic and thus the company to be perceived a possibly riskier to invest in. This makes the method subjective as managers can decide on the probability of bad debt and the amount for the provision of bad debt. Give examples from companies!
Similarly the framework provides criteria for the recognition of revenue for the rendering of services with reference to the stage of completion of the transaction on the balance sheet date:
'The amount of revenue can be measured reliably.
It is probable that the economic benefits will to the seller.
The stage of completion at the balance sheet date can be reliably measured.
The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.'
The IAS framework states the percentage-of-completion method to recognise revenue for rendering of services, stating the cost recovery method to recognise revenue where it cannot be reliably measured. Britton et al. give a range of methods to estimate this percentage; 'surveys of work performed, services performed to date as a percentage of total services to be performed and the proportion of costs incurred to date bear to the estimated total costs of the transaction.' One issue is that the framework is not detailed enough on which method to take for estimating the percentage of completion for the service, by not specifying which method are perceived by IASB as the better method it can cause disparity in true values, reducing the comparability. Give examples from companies!
Finally the criteria for the recognition of interest, royalties and dividend revenue, on the provision that 'probable economic benefits will flow to the enterprise and the amount of revenue can be measured reliably, are:
For interest - using the effective interest method as set out in IAS 39.
For royalties - on an accruals basis in accordance with the substance of the relative agreement.
For dividends - when the shareholder's right to receive has been established.'
The framework also specifies for each what time period for it to be recognised in the financial statements. Give examples from companies!
The IAS framework required disclosure for this IAS are:
'The accounting policy use for recognising revenue.
Amounts for each of the following types of revenue:
~ Sales of goods
~ Rendering of services
~ Within each of the categories, the amount of revenue from exchanges of goods and services.'
Again the IAS framework is quite vague and descriptive in nature about which method may be preferred by the IASB only giving options of methods rather than advice over which is more effective, efficient and accurate. This lack of a prescriptive method can lead to misinterpretations or confusion over the varying methods.
IAS 23 Borrowing Costs: Britton et al. page 196
Britton et al. define borrowing costs as 'interest and other costs incurred by an enterprise in connection with the borrowing of funds'. The original IAS framework stated borrowing costs include:
'Interest on bank overdrafts and borrowings
Amortisation of discounts and premiums on borrowings
Interest expense calculated by the effective interest method under IAS 39.
Finance charges in respect of financial leases recognised in accordance with IAS 17 Leases.
Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.' http://www.iasplus.com/standard/ias23.htm
This standard does not include 'imputed or actual cost of equity', which is dealt with separately. The issue that arises with borrowing costs is what to recognise and when to recognise the amount, and whether the whole or staged partial amounts should be recognised and in what time frame. The framework's benchmark method for treatment is to recognise all borrowing costs as an expense in the period incurred in. Give examples from companies!
The framework defines a qualifying asset as an asset that takes significant time to be prepared for its intended use or for sale such as in the development period of an intangible asset with the exclusion of 'qualifying assets measured at fair value....and inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis and that take a substantial period to get ready for use of sale.'
The IASB amended the framework for IAS 23 in March 2007, 'prohibiting' the use of the recognition in the time period incurred method advising the capitalisation of cost directly credited to acquisition of the qualifying asset and all other borrowing costs to be recognised as an expense. The framework states where funds were borrowed specifically for the acquisition of the asset the 'costs that are eligible for capitalisation are the actual costs incurred less any income earning on investment on the borrowings in that period', however for more general terms the 'eligible amount is determined by applying a weighted average of borrowing costs to the expenditure on that asset'. This may require the determination of an amount for borrowing costs to be subjectively calculated, this can raise issues of human error and miscalculation, where an over or under estimation of a value that could possible affect the financial statements. The IAS advise starting the capitalisation when expenditures and borrowing costs are being incurred in addition to when activities to ready the product for use or sale are underway, temporarily halting capitalisation when the periods of active development are interrupted and ceased altogether when all activates to prepare the asset for sale or use have been completed. This amendment by the IASB is overtly prescriptive in its nature, not just advising but 'prohibiting' the use of the method; this has been the only IAS that I have examined that has had a definite and clear instruction for the treatment of a borrowing costs in the financial statements. Give examples from companies!
The framework requires the disclosure of:
'The accounting policy adopted which is only required if the previously prohibited model was used.
The amount of borrowing costs capitalised during the period.
Capitalisation rate used.'
Unlike the other IAS I have examined in this essay IAS 23 is the most overly prescriptive in its nature, providing clear and concise advice about the treatment of borrowing costs, even banning the use of an historical method, this leave little room for interpretation or alternative methods, this increases the comparability and accuracy of the values in the financial statements.
The IAS framework seems to take more of an eclectic approach rather than prescriptive or descriptive, this vagueness and ambiguity does open the IAS framework to disparity between the companies increasing the difficulty of comparability between companies in the market. The 2007 amendment of IAS 23 would have taken a long time to culminate before being agreed upon by the IASB, taking years to be fully implements in the conceptual framework. This is one major hindrance with the IAS, the change or even amend a standard requires countless meetings and discussing to even get to a draft level, so even if the IASB reacted immediately to an issue that has arise in the preparation and presentation of financial statements the reaction would not be in effect for at least a year possibly longer.