Accounting for Defined-Benefit Schemes under IAS 19, Segmental Reporting - Research Paper Example

ADVANCED FINANCIAL ACCOUNTING Table of Contents Table of Contents 1 1.Accounting for Defined-Benefit Schemes under IAS 19 2 2.Revision of Accounting Treatment of Goodwill and Intangible Assets 3 3.Disclosure Issues Related to Segmental Reporting 5 4.Global Accounting Standard Harmonisation 7 5.Segmental Reporting Information – Costs and Benefits 9 6.‘User Needs’ Approach to Financial Reporting 10 7.Outline the reasons why management may seek to keep items 'off the balance sheet’? 12 8.What is meant by the principle that 'economic substance' should take precedence over 'legal form'? 12 1. Accounting for Defined-Benefit Schemes under IAS 19 IAS 19 sets out standards related to employee benefits offered by business entities. Its main objective is to prescribe the disclosure requirements and accounting procedures to be followed regarding employee benefits. Employee benefits actually include every type of consideration received by the business entities in lieu of the services rendered by its employees. The basic underlying principle of IAS 19 is that the recognition of costs incurred because of providing benefits to the employees by business entities should be done in the earning period of such benefits, rather that when it is paid to the employees. There were some recent changes made in IAS 19 during June 2011 by the IASB and it has a significant impact on the accounting procedures to be followed by the entities regarding defined benefit schemes in the form of pension funds. The time was just right for these changes to take place because it was long awaited by people for IASB to make such changes. One of such change in the accounting of defined benefit plans is the recognition of changes in pension related liabilities or assets to the immediate effect. Only Other Comprehensive Income (OCI) will include the actuarial profit or loss of an entity now. Previously there was other option of including such profit or loss in the income statement or making use of corridor approach by allowing deferred recognition of such profits and losses. This change can have a significant effect on the entities using the corridor approach by increasing the volatility in its balance sheets. Recent revision of IAS 19 reduces the complexity regarding the requirement of different accounting treatments to be followed in case of amendments in plan or its curtailment. The accounting treatment of service costs in past whether it is vested or unvested is now aligned together. Costs related to defined benefit schemes are now required to be segregated into three different components, namely, service costs which should be presented in profit and loss statement, finance cost which includes the net interest of liability of defined benefit schemes and re-measurements that are to be included in OCI. Revised IAS 19 also requires improved disclosure requirements like, a) the characteristics and features of the defined benefit schemes of the entities, b) recognised amounts in the financial reports of the companies, c) the details of risks associated with defined benefit schemes of the companies, d) details about the participation of company’s multi-employer schemes. Accounting treatment of termination benefits has also been modified. Business entities are now required to differentiate between the benefits offered in lieu of service and because of employee termination. Revised IAS 19 also requires clarification by business entities regarding actuarial assumptions made in certain specific items like, administration costs, payments made in lump sum, taxes, the mortality rates employed, risk sharing features, etc. Hence, it can be concluded that IASB has made significant improvements in the required standards of defined benefit schemes under IAS 19 (Deloitte, 2012a). 2. Revision of Accounting Treatment of Goodwill and Intangible Assets Accounting treatment in case of intangible assets and goodwill is quite confusing in nature and business entities face lot of difficulties on account of that. The main reason behind such confusion is the failure to find a clear distinction between intangible assets and goodwill. However, recent amendments made by IASB have made it lot easier to remove such confusions. Still a lot has to be done with regards to the treatment of goodwill in future because of the consideration of accepting the utilisation of fair values of assets. IFRS 3 deals with goodwill separately from other intangible assets and defines it as the economic benefits derived from assets in future which can neither be recognised nor identified individually. Goodwill is an inherent part of any business but it is very difficult to assess its value because of its constantly changing nature. It can even have negative values. Other form of goodwill is termed as purchased goodwill. According to IFRS 3, accounting treatment in case of purchased goodwill is considered to be related to the aspect of accounting treatment of business combination. IAS 38 deals with the accounting treatment of intangible assets other than goodwill. Goodwill cannot be identified, hence it cannot be considered as intangible assets under the purview of IAS 38. All assets which do not have a physical substance but are identifiable are regarded as intangible assets. IAS 38 has been developed by IASB only recently. Earlier R&D costs were included separately in IAS 9. Later with the development of IAS 38 it was included in it because of the intangible nature of R&D costs. However R&D costs and its accounting treatment procedures brought about much controversy regarding the recognition of research as intangible assets. IAS 38 was revised by IASB and has set out certain stringent criteria for asset recognition that are to be satisfied for R&D costs to be regarded as assets. Subsequently it can be capitalised. If the criteria of recognition of asset are not satisfied then the related expenses on R&D can be recognised only when its occurrence takes place. Accounting treatment of brands also brought about many controversies among business entities. The problem was regarding the treatment of brands as assets. IAS 38 was successful in dealing the situation by making the development that the brands which are internally generated by business entities cannot be considered as assets in any condition whatsoever. Business combination leading to the acquisition of brands is considered to be as goodwill and not intangible assets. Intangible assets are considered to be either having a finite or indefinite life based on its future useful life. IAS 38 requires intangible assets having indefinite life to be reviewed periodically and cannot be depreciated as long as it has an indefinite life (Alexander, Britton & Jorissen, 2007, p.287-290). Hence, it can be concluded that IASB has made significant developments to remove confusions and difficulties in the treatment on intangible assets and goodwill. 3. Disclosure Issues Related to Segmental Reporting IFRS 8 which is related to accounting treatment procedures and disclosure requirements regarding operating segments supersedes IAS 14 of segmental reporting for business entities. There have been several issues regarding voluntary and mandatory disclosure requirements related to segment reporting of business entities. One such issue is the disclosure of risks related to products manufactured by a company. Information disclosure regarding risks associated with the products can help its consumers to know how to utilise them after deciding to buy them. However, firms may feel reluctant to disclose the unfavourable information regarding its products which might adversely affect its prices or demand. Voluntary disclosure requirements result in avoiding bad information about its product risks being disclosed by the firms. It might have an adverse effect in a way that demand for its product might decrease because of negative inference about it by the consumers. However this negative impact would not be significant because consumers might perceive it as firms not being able to collect such information. Hence firms get an incentive for keeping silence after obtaining all such relevant information. In case of mandatory disclosure, firms will be encouraged not to obtain such unfavourable information. Hence, voluntary disclosure is favourable for firms (Polinsky & Shavell, 2006, p.2-4). A disclosure requirement regarding corporate governance practices followed by business firms is also an important issue. It is argued that an optimal framework for regulatory requirements would include a partial mandatory disclosure requirement that will minimise the associated costs but will have an incentive for firm regarding compliance. Voluntary disclosure by firms has its own advantages. Liquidity of the stock is enhanced due to increased voluntary disclosures. Moreover cost of capital is reduced with enhanced information disclosures by firms. IASB have made considerable efforts to combat the issues related to segmental reporting by the firms. IAS 14 dealing with segmental reporting standards has been revised to IFRS 8. According to IFRS 8, every business organisation is required to disclose information regarding the identification of its operating segments including products or services that generate revenues for the business concern. Information regarding profit or loss incurred by each of the operating segments is also required to be disclosed. Information disclosure is needed for the reconciliations related to revenues or profit and loss generated by the segments. All these disclosure requirements set by IFRS 8 will assist the users of the financial reports of business entities to have a clear idea about the business activities followed by the companies and also about the economic environment in which it is operating its business (Deloitte, 2006, p.2-3). 4. Global Accounting Standard Harmonisation Harmonisation can be explained as the process of enhancing the comparability of financial reports furnished by business entities by setting up limits as to how much it can differ. Globalisation has affected the business entities all around the world. A company might be operating in different parts of the world. This has led to the interdependence of different economies in the world. Hence it is very much essential for the business entities to represent their financial information in a way so that it can be easily compared by any of its stakeholders throughout the world. Recent development of IASB regarding harmonisation of accounting standards took place when the convergence agreement was signed between IASB and FASB in the year 2002. This is a critical step followed by FASB in moving towards an approach which is more of a principle based than rules based. Harmonisation efforts made by IASB are commendable and are associated with many advantages associated with the process. Harmonisation of accounting standards help to ensure that the financial reports prepared by the business entities along with the disclosure requirements are of high quality and very much reliable in nature. It can play a critical role in the economic as well as financial development of a country in some cases. A multinational company which has its subsidiaries spread over different parts of the world can be benefited from this harmonisation process by enabling them to provide the facility of performance evaluation in a systematic manner. The comparability of the performance of a company with the other competitors of the company can also be enhanced because of comparable accounting standards followed by them. The international credibility of the organisation also gets increased. Harmonisation process can prove to be the pathway for having an access to the capital markets in other economies of the world. This would result in the reduction of capital cost for the company and thereby increasing its performance efficiency. All the countries come to the same playing level because of this harmonisation process and avoid any merits or demerits for a country due to different accounting practices followed by them. With respect to the users of the financial reports of the companies like the investors and stakeholders, it can prove to be very much advantageous to them. It can assist them in the decision making process of making investments in the companies through comparable financial information across companies and countries. Harmonisation of accounting standards is associated with some of its demerits as well. Some criticise the fact of introducing international standard being a simple solution for a very complex problem. They fear that International Accounting Standards may not be acceptable by all the nations in the world having different economic scenario and other differences between different countries. Some feel that it is a tactical move by some of the giant international accounting firms in order to expand their market. Some fear that it may lead to overload of standards for the companies which they are compelled to comply with (Choi & Meek, 2007, p.295-297). However, it can be concluded that harmonisation of accounting standards is a critical step towards the benefit of the business entities as well as its stakeholders as a whole. 5. Segmental Reporting Information – Costs and Benefits IFRS 8 which deals with the accounting standards of operating segments supersedes IAS 14 which dealt with segment reporting. The main principle behind IFRS 8 is that information should be disclosed by the business organisations so that the person who uses its various financial reporting statements is able to evaluate the financial effects or consequences of the operating business activities followed by the company and the operating economic environment of the organisation. Any disclosure of information might result in the benefit of some entity and difficulty for some other entity. Business entities may be affected by both costs as well as benefits. The benefits and costs associated with the disclosure of information by any business entity is driven by the interests of the owners and stakeholders of the company, the non-owners of the company or may be because of some national interest. The owners of the company always strive for the maximisation of wealth of the stakeholders of the company. Any business entity derives benefits from disclosure if it leads to the reduction of the cost of capital of the company. Higher disclosure of information by business entities are associated with lower risk premium related to information and thereby lower cost of capital for the company. The cost of capital is the required rate of return for a company as perceived by its investors. With more information available to the investors about the economic risk associated with the business concern it leads to significant reduction in the required rate of return for the company. However the development and presentation of disclosure is associated with a cost that is solely borne by the owners of the company. Insufficient or inadequate disclosure by business concerns may lead to litigation as well. Hence litigation costs can be avoided through proper adequate disclosures of information by the companies. However, higher information disclosure can give rise to litigation too because of disclosed information which is misleading to others. Disclosure may lead to competitive disadvantage for companies as well. Information regarding the technological innovations of a company or information related to the operational strategies followed by a company may lead to a disadvantageous position for the company because competitor might take advantage of such information. Timing of disclosure of such information is the key towards company being able to prevent such competitive disadvantage in the market. Information disclosure is associated with benefits in the form of public relations with the investment community. The investors who are not the owners of the company get benefited from information disclosure through reduced risk of making an error while allocating their investments. Effective capital allocation because of increase in information disclosure is in accordance with the national interest of any nation in the world (Elliott & Jacobson, 1994, p. 80-90). Hence, disclosure requirements serve for the purpose of interest of different nations in the world as well. 6. ‘User Needs’ Approach to Financial Reporting The International Accounting Standards Board (IASB) Framework, also known as Conceptual Framework provides information and guidelines that are to be maintained while preparing and presenting financial reports by business entities. The standards that are set out contains information regarding concepts about objectives of financial statements, the underlying assumptions involved, the fundamental qualitative characteristics that shows how the information are useful in financial statements, the definitions of sources of financial information obtained and the criteria of reporting the financial information. This framework actually helps or guides IASB while setting up new standards. Relevance, Comparability and Reliability are some of the fundamental characteristics that are laid by the Conceptual Framework. Conceptual Framework have utilised ‘user needs’ as an approach towards setting up standards for financial reporting by business concerns. The financial statements prepared by organisations are mostly represented by companies in order to assist its users like the investors or stakeholders of the company to help them in their decision making process. Hence IASB framework strives for representation of financial information by business entities in a way that it could be easily understood by its users so that they can easily take decisions based on it. In order to facilitate proper and accurate decisions taken by the users, the information provided in the financial statements of the companies must be reliable and relevant too. Moreover faithful representation of the financial information of business entities is the key towards helping users to take correct investments decisions. Hence it can be concluded that the ‘user needs’ approach towards financial reporting by companies have led the IASB framework towards considering faithful representation of financial statements and relevant financial information being the two most important and basic qualitative characteristics of any type of financial information furnished by the business entities. The financial information of an organisation can result in different decisions being taken by the users only when it has predictive and confirmatory value both. Financial information provided by the company should have a key characteristic of presenting a true and fair view about the company. In order to ensure this fact, the information must be represented in a faithful manner. This fundamental characteristic helps in making the financial information full proof and error free for the users. Usefulness of financial information which is relevant to the users is enhanced through certain inherent characteristics like understand ability, verifiability, comparability, etc. The financial information of a business entity can prove to be more useful for its users if it is comparable with other business concerns. Verifiability of presented financial data helps to ensure the users that it represents the economic activities of the companies correctly. Clear and concise financial data can help the users to understand it easily to facilitate their decision making process. Timeliness of the financial information being represented by companies is also a key factor in a sense that the information will be available to the users in the right time to be able to influence the decisions taken by them (Deloitte, 2012b). Hence ‘user needs’ approach towards reporting financial information is a key element to be followed by all the business entities. 7. Outline the reasons why management may seek to keep items 'off the balance sheet’? The disclosure requirements of off balance sheet items or activities are included in IFRS 10, 11 and 12. Management incentive in keeping the off balance sheet items is that it helps the management to take advantage of opportunities in business which would not be available if those items are not mentioned. Also it can result in reduction in debt and liabilities of a firm creating an opportunity for the firm to represent a more profitable picture in its financial statements. 8. What is meant by the principle that 'economic substance' should take precedence over 'legal form'? Faithful Representation being one of the qualitative characteristics of information that are to be represented in the financial statements is based on this principle of “Substance over Form”. It implies that the transactions or events that are needed to be mentioned in the financial statements must be accounted in a way that it represents the economic substance and not merely the legal form. Hence if the legal form of a transaction is different its substance then such transaction must be taken into account in relation to its economic reality. This would prevent the distortion of economic reality. References Alexander, D., Britton, A. & Jorissen, A. (2007). International Financial Reporting and Analysis. (Ed.3). USA: Cengage Learning. Choi, F. D. S. & Meek, G. K. (2007). International Accounting. (Ed.5). India: Pearson Education India. Deloitte. (2006). IFRS 8 Operating Segments. IASPlus. {Online]. Available at: http://www.iasplus.com/en/binary/iasplus/0612ifrs8.pdf. [Accessed on April 21, 2012]. Deloitte. (2012a). IAS 19 – Employee Benefits (1998). IASPlus. [Online]. Available at: http://www.iasplus.com/en/standards/standard17. [Accessed on April 21, 2012]. Deloitte. (2012b) Conceptual Framework for Financial reporting 2010. IASPlus. [Online]. Available at: http://www.iasplus.com/en/standards/standard4. [Accessed on April 21, 2012]. Elliott, R. K. & Jacobson, P.D. (1994). Costs and Benefits of Business Information Disclosure. Accounting Horizons. 8(4). [Pdf]. Available at: http://raw.rutgers.edu/docs/Elliott/15Cost%20and%20benefits%20of%20Business%20Information%20disclosure.pdf. [Accessed on April 20, 2012]. Polinsky, A. M. & Shavell, S. (2006). Mandatory versus Voluntary Disclosure of Product Risks. [Pdf]. Available at: http://www.nber.org/papers/w12776.pdf. [Accessed on April 21, 2012]. Read More