Accounting Theory & Methodology - Essay Example

Accounting Theory & Methodology - A study of relevance and necessity of such methodology and theory This essay establishes the relevance and requirement of constant Accounting Theory and Methodology in modern day accounting and negates the contention that ‘Accounting theory and methodology are a waste of time’. Financial reports are the only reliable and easily available source of information about the financial health of a company and all categories of stakeholders rely on information provided in those reports. However, these figures depend entirely on the accounting policies, theories and methodologies adopted by the organization and in many instances lead to completely misleading and sometimes even erroneous information (Mueller, Gernon and Meek 1994 32). The branch of accounting that involves systematic statement of principles and methodology, as distinct from practice is known as accounting theory (Porwal, 2001 7). The purpose of this is to provide a set of principles and relationships which explain practices that are observed in the real world and predict practices that are unobserved (Schroeder et al., 2010 1). If one wishes to experience firsthand the level of confusion it can create, they should observe how Chinese companies issue three different categories of shares – ‘A’, ‘B’ and ‘H’ which are traded in three different markets by three distinct categories of shareholders. Category ‘A’ type shares are meant only for domestic investors and are transacted Shanghai and Shenzhen stock markets. Category ‘B’ shares are traded in the same stock exchange but only by foreign investors and category ‘H’ shares are traded in Hong Kong stock exchange. So, while issuing ‘A’ category shares a Chinese company has to adhere to Chinese Accounting Standard (CAS), and while issuing ‘B’ category shares it has to follow International Accounting Standard (IAS) and while issuing ‘H’ category shares it has to format its accounts as required by Hong Kong Accounting Standard (HKAS). So, a multiplicity of accounting standards, quite obviously, generates financial information of disparate levels of transparency and detailing. Hence it is becoming increasingly difficult for stakeholders to unquestioningly rely on information provided in the financial statements (Chen and Wei 2008 1). Such a lack of convergence among various accounting standards surely lead up to an extremely confusing scenario especially in an era of globalization when capital is freely flowing across continents and frontiers. Though one cannot disregard the local expediencies there must still be sufficient disclosures so that the stakeholders are able to glean the information that is necessary for them to take decisions (Meek and Saudagaran 1990 146). Moreover, the methodology should be consistent so as to minimize confusion. The areas that are most susceptible to different accounting policies are methods of depreciation and amortization, valuation of inventories, valuation of investments, valuation of fixed assets, treatment of Goodwill and treatment of contingent liabilities. Accounting theory of balancing every debit with a corresponding credit as such is never violated in any of the methodologies but the confusion arises over the treatment of certain expenditures. The Institute of Chartered Accountants of India in Accounting Standard (AS- 1) has clearly stated while choosing an accounting policy there should be certain considerations. The first such consideration should be prudence. Since future is uncertain, earnings that are realized and not merely anticipated should be taken into account while provision should be made for all liabilities even when the exact quantum of such liabilities might not be known at the time of drawing up the accounts. This is as much a matter of accounting policy as it is of accounting theory. More emphasis should be given to substance rather than blindly adhering to form as relevant information is what is important irrespective of whether it is presented strictly in accordance with a predetermined format. Materiality of information that is disclosed is also of vital importance. Any information that is considered to be vital in properly evaluating the financial status of the organization must be voluntary disclosed in an annexure to the main financial statements. If there has been a change in accounting policy during the current year, it must be disclosed along with the impact in financial terms such a change might have had on the figures presented in the financial statements that have been prepared for the current year (Institute of Chartered Accountants of India 2005 21). There are vast differences in accounting principles and methodologies in different countries and this makes it almost impossible to directly compare international financial reports and the depreciation is possibly the most inconsistently applied accounting standard in the entire world (Abdel Khalik ed. 1999 190). Moreover, the valuation bases of fixed assets also vary from country to country. Some countries like the USA and Japan values their assets on the basis of historical cost while with scope of downward valuation in cases of perceptible decline in the productive value of the asset, some other countries like UK, Netherlands and Australia also permit upward revisions in value if such a revision truly reflects the current market conditions. Though such diversities can be intelligently used by financial mangers to provide an additional gloss to financial statements, one must admit that these differences have arisen over time and is oftentimes reflective of the uniqueness of the economic structure and societal forces at work in different societies. Regulators in global securities markets therefore remain ever alert to ensure that unsuspecting small investors are not duped by large corporate houses and thus are very stringent regarding the financial information that is dished out to the prospective investors within their jurisdiction. To ensure consistency within their jurisdiction, every regulator sets a standard and this has resulted in proliferation of numerous standards and it has become almost impossible for a company that operates across frontiers to publish any unique set of financial figures for an accounting period. Let us consider a practical example. GAAP stipulates all expenses on research and development should have to be debited to Profit and Loss Account in the year they have been incurred. However, IAS 38 makes a distinction between research and development and categorizes research costs as revenue type while development costs are considered as having capital nature provided some conditions are fulfilled. Therefore, in a year when there is substantial development cost, a firm following GAPP will report lesser profit than a firm adhering to IAS (Deegan and Unerman 2006 ). There are other differences also. A company following GAPP will consider cash flows in connection with development activities under operating cash flow but a company drawing up its accounts according to IAS will consider this same cash flow under investing activities. It will not be possible for an ordinary investor not professionally trained in accounts to properly navigate through so much confusion and if any direct comparison of figures drawn up under different standards is done, it would only add to further chaos (Pownall and Schipper September 1999 260). It might seem at first glance to be a product of fertile imagination, but the fact is the accounting policies of a country and the nature of accounting disclosures that are necessary according to that policy are often shaped by the economic and legal systems of that country. As for example, historically Japanese and German companies did not have to attach as many disclosures as US and UK companies had to. This has happened since these companies mostly borrowed from private banks and a few other trusted and dependable sources where mutual faith was more significant than anything else (Collins 1989 83). This divergence in Accounting Standards also forces non-US companies to undertake major recasting of their accounts to conform to GAPP if they wish to garner capital from US markets. Also, stock market regulators in US have made it compulsory for all non-US companies to confirm to several rather strict filing requirements under SEC. Though these requirements are more concerned with legal details rather than financial or accounting details, conforming to such requirements are quite costly. These restrictions have reduced the competitive edge of US capital markets and with interest rates leveling out across economies, a company might opt for stock markets in London or Amsterdam or Zurich where they can get capital at same rate (Fleming 1991 101). In most countries the financial accounting system, accounting policies, accounting methodologies and taxation rules are structurally linked to each other so that a company pays tax on the net profit as reported in its financial statements. This is most evident in European and Scandinavian countries where managers hesitate to employ income increasing accounting policies as they increase the tax burden too. However in the USA, taxes and financial reporting are interlinked only for the purpose of inventory costing and this probably explains the surfeit of accounting standards in that country to prevent managers from overstating the actual income. As an example, one may state that in the USA, expenses incurred in Research and Development must be charged to revenue expense. But this is never a compulsion anywhere in Europe, possibly because no manager in Europe would ever capitalize this expense as it would unnecessarily increase the tax burden (Gray 1988 9). The alignment of financial reports and taxation in European and Scandinavian countries has in all probabilities led to ubiquity of reserves that dominate the owners’ equity section of balance sheets of companies from that region. Reserves are an accountant’s tool to apportion profit into predetermined slots to avoid taxation on the entire quantum of profit for a particular accounting period. Though some apportionments are done from profits of US companies, the presence of reserves in Balance Sheets is nowhere near that found in European companies. Intercompany transfer pricing is also sometimes influenced by tax as companies try to distribute their total profit among several countries in such a manner that their global tax burden is reduced. The favorite tool for such a manipulation of profit is intercompany transfer pricing which is deliberately kept high for countries with a steep tax rate to ensure there is not much profit in operations within those countries (Wallace and Gernon 1991 221). Thus it can be stated that there is a genuine and urgent need for consistency in accounting standards, methodologies and theories across the globe and several developed countries are aware of the urgency and necessity of it and have started zeroing on a constant format. The Financial Reporting Standards Board (FRSB) and Accounting Standards Review Board (ASRB) have almost completed the process of setting up a fresh set of accounting principles and methodologies that would enable Balance Sheets to conform to a large extent to International Financial Reporting Standards (IFRS). The first nation in the world that crossed over to International Accounting Standards was New Zealand where all accounting reports must be drafted according to this standard since December 2004. Australia has also made it mandatory from July 2005. While introducing these new guidelines, regulators in both these countries did some modifications to suit tenets of corporate governance in their countries while sticking to the basic requirements of accounting theory. To maintain transparency in corporate governance, regulators in New Zealand insist that certain disclosures like audit fees paid, comparative prospective information and, personal details of those engaged in evaluation must accompany the annual accounts. However, these details are not necessary under IAS but New Zealand has retained these disclosures. Similarly, regulators in New Zealand discarded the notion of presenting an indirect cash flow statement and retained the earlier requirement of direct cash flow statement. Thus, while adhering to all the major requirements of IAS, New Zealand has done slight modifications to suit its own specific requirements. Australia has also modified IAS in certain areas to suit its requirements but ensured that the essential features and, more importantly, the spirit of IAS are not compromised. In conclusion it can be said shareholders and other external stakeholders in a joint stock company have Balance Sheet as the only document to assess financial health of a company and expect figures shown in it provide a true and fair picture of the financial status and be comparable across different countries and markets. Thus, there must be some consistency in accounting theory and methodology across nations and the contention that ‘Accounting theory and methodology are a waste of time’ is surely not tenable. This has assumed greater importance as capital flows freely across frontiers due to globalization. But, a complicity of accounting standards applicable in different countries have complicated the accounting scenario where a person not initiated in the intricacies of the subject would hardly be able to decipher the details and arrive at a correct judgment. Since some expenses are not constantly considered as being revenue in nature across accounting standards, final profit figures vary from one standard to another. As, reserves and intercompany pricing requirements are also not consistent across standards, multinational companies pick and choose those options that would help them in reducing the tax burden by suitably modifying profits. None of this is illegal, however, but the hapless investors are often unable to take an informed decision. Australia and New Zealand have already switched over to IAS with minor modifications to suit special requirements of their economies and it is hoped other countries would soon follow suit References Abdel Khalik ed., A. Rashad. 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Chartered Accountants Journal, July 2005: 18-21. Read More