Provision Accounting and International Accounting Standards - Essay Example

Provision Accounting and International Accounting Standards - IAS 37 The conventional accounting practices with respect to the treatment of the company's liabilities and creation of provisions have had abounding contribution to the manipulation of financial information. This activity on the part of the company and its management disregarded the elements of maximum disclosure and fair representation of the company's financial position and performance as contrary to the International Accounting Standards (this has not been taken from any textbook, neither previously nor now, however I've split the sentence). IASB 2003a (37-11) describes provision as a kind of liability or accrual that cannot be predicted in terms of timing or amount. Whereas, Stickney and Weil (1997, p517) describes the liability under conventional accounting practices as comprising of the three salient features i.e., the debt needs to be paid back in the future with any of the firm's resources and the amount of debt could be converted in cash value, the organization is not or negligibly willing to evade the transfer of resources, the particular transaction out of which the debt is arising has already taken place (it is not a direct quote, rather author's ideas have been re-phrased, if you want to remove the page number, you can. It was for your convenience to figure out the definition) The Popularity of Provision Accounting The trend of creating provisions under the conventional accounting practices was widely prevalent due to the fact that it allowed the companies to manipulate their earnings leading to misrepresentation of facts in the financial statements. This may relate to the "big bath" theory of accounting as defined by Healey (1985) as a method pervasively used by the companies in order to show more write offs of assets and also to project more accruals or provisions reflecting a reduction in earnings to the income statement, thus leading to the misrepresentation of the company's actual earnings. There may be several reasons behind the interest of management in the misleading reporting of the company's actual gains or losses. According to Kirschenheiter and Melumad (2002), the company's management may conceal the current years' profit or report less than actual gains with a view to report great hike in the company's profit in the future years. Abarbanell and Lehavy (2003) also confirm the same view regarding the management's discretion to conceal the company's profits. Another factor as discussed by Sikora (1999) in the case of mergers and acquisition, when new directors are appointed in the company and the management reports loss to project better management by the newly appointed directors in the future years. Healey (1985) also points out another cause for management to report less-than-actual earnings as being the expectation of change in bonus to the company's management. In this case, the company reports less than the actual increase in profit for the current year so as to show a hike in profit the next year to earn better bonus for the management. Moore (1973) further relates the concept of "big bath" theory of accounting to the change in management factor. Beneish (2001) concludes that the chief objectives of management in managing the profit may be to create a balance and stability in the company's trend of earning profit or the company may manipulate its earnings at the time when its inflating its shares for the first time in the market in order to induce the shareholder by projecting a stabilised earnings record. All of the above-stated theories Healey (1985), Kirschenheiter and Melumad (2002), Sikora (1999), Moore (1973) and Beneish (2001) relate the use of provision accounting by the companies and their management to the theory of big bath accounting. Companies used it to affect the calculation as well as presentation and communication of the company's profits to its shareholder, investors, governmental authorities and other users of financial statements. Thus, they exploited the loopholes found in provision accounting to either evade taxes or misinform the company's existing and potential shareholders and investors regarding the true financial position and performance of the company. Hence, the popularity of provision accounting was embedded in the opportunity for the management to manipulate the company's profits. Sikora (1999, 8-9) even puts forth real life case that took place in the corporate world in the early 1990s when Medtronic Inc. acquired the Sofamor Danek Group Inc. and Arterial Vascular Engineering Inc. in the same year. After the acquisition activity, the company announced the shutting down of five plants, job reduction of workers and creation of abundant reserves in the name of acquisition, and thus the company finally came up with a net loss of $35.1 million owing to the acquisition. Sikora (1999) presents the merger between Pennzoil Co. and Quaker State Corp. resulting into Pennzoil-Quaker State Co as another real-life example. The merger took place in 1998 and the company attributed abounding expenses and accruals to the acquisition including the merger costs, write offs, and cessation of one or more plants and product line. Accordingly, the company managed to report a net loss of $7.4 million at the end of the year. Both the above examples from the real corporate world indicate that the Merger and Acquisition activities most particularly allow the companies to make up significant accruals and charge more expenses in the form of acquisition costs, suspension of plants and product lines, establishment of reserves and particularly provisions. This method enables the companies to conceal the actual profits by charging and associating more-than-actual expenses in merger and acquisition activity than necessary. This was the same point as raised by Ian Griffith (1995) that the companies undertaking acquisition activity attribute abounding accruals and provisions in their balance sheet to acquisition. This point is true, as have been discussed above; there happen to be many ways by which a company can manage to manipulate its profits. The Introduction of IAS-37 and Regulation of Provision Accounting The introduction of IAS 37 has proved to be directly hitting the management's ability to conceal the company's profits and misrepresent the company's actual financial position. It provides complete specifications regarding the use of provision and liabilities by the companies. The standard requires the companies to mention all the contingent liabilities at the end of the financial year (i.e., the balance sheet date) and also show the impact of the contingent liability on the financial aspects of the company. It also requires illuminating any unpredictability in relation to the amount and timing of the transfer of resources against the liability, and the probability of any reimbursement, which provides relevant information to the investors regarding any future projection of earnings. The companies that need to follow International Accounting Standards for the purpose of financial reporting can no longer exploit any economic condition or any acquisition activity to construct unnecessary provision in order to manage their earnings. The provisions are required to be original and actual and therefore, the companies are now bound to report any liabilities with relevant information. The IAS 37 is likely to force more variability into the company's earnings, as the companies are not able to smooth their earnings as they previously did because of the loopholes found in the traditional accounting. Therefore, IAS 37 has the capability to regulate a company's present and future earnings by means of imposing restrictions on the use of provisions and accruals. Personal Opinion on the IAS-37 Approach The pitfalls of provision accounting practices in the past were pervasive and prevalent due to the loopholes found in the traditional accounting systems with respect to imposing direct restrictions regarding the extent of using provisions and liabilities. This failure gave rise to the big bath accounting and affected investors' trust in financial reporting. However, the IAS 37 approach of regulating the extent of raising provisions does not only put a ban to illegitimate management exploitation but also protects the interest of investors by the way of true and fair disclosure. Reference List Abarbanell, Jeffery and Reuven Lehavy (2003), "Can Stock recommendations Predict Earnings Management and Analysts' Earnings Forecast Errors" Journal of Accounting Research Beneish, Messod D. (2001), "Earnings Management: A Perspective", Working Paper Healey, Paul (1985), "The Effect of Bonus Schemes on Accounting Choices", Journal of Accounting & Economics Ian Griffith (1995), "New Creative Accounting", Macmillan: London Kirschenheiter, Michael and Nahum Melumad (2002), "Can "Big Bath" and Earnings Smoothing Co-exist as Equilibrium Financial Reporting Strategies" Journal of Accounting research Moore, M., 1973, Management Changes and Discretionary Accounting Decisions, Journal of Accounting Research Sikora, Martin, 1999, Timing a "Bog Bath" to an Acquisition, Mergers & Acquisition: The Dealmaker's Journal Read More