Accounting Theories and Standards - Assignment Example

Accounting Theories and Standards Introduction Accounting department keeps track of all the revenues and expenditures of the firm at all times. Therefore, accountants must use generally acceptable accounting standards and principles. This enables the financial activities to be reported in a consistent and accurate manner. The firms should look for improved ways in order to be more efficient and effective in their core activities. Accounting theories has been formulated to guide the accountants and firm managers to record, prepare and disclose items in their financial statements accurately and completely. The items include employee compensation, cost of production, asset and liabilities, depreciation. It also states and explains how the items in the financial statements should be valued. This enables the financial statement reflect the true and fair value of all the activities that the firm engages in. The most utilized theories are the Positive Accounting Theory (PAT) and Normative Accounting Theory. Contrast the role of Positive Accounting Theory (PAT) and Normative Accounting Theory Positive accounting theory is an accounting based theory that seeks to state, explain and predict accounting methods, which entities are likely to use or not use in their accounting activities. The theory was developed using the concepts generated by the urgency and transactional cost theorists1. The theory focuses on the relationship between various stakeholders in the company. This includes the relationship between the shareholders (investors) and the agents that are involved in day-to-day running of the business entity. According to the theory, accounting is important in ensuring that the various stakeholders function harmoniously to promote effective and efficient processes in the firm. The main function of the theory is to predict how firms are going to react to the proposed or newly introduced accounting standards and principles. To predict the reactions, accountants need to conduct research. Therefore, they need to develop a research accounting problem, objectives and hypothesis. The accounting based hypothesis would be tested by observing the environment and collecting appropriate data that would be analyzed. The data may include various types of costs, revenues and relevant accounting ratios. Positive accounting theory can thus be tested and refuted because facts are collected and availed for analysis. The theory may predict that if the financial statements will be audited or closely monitored, the agents will not assume self-interest and profits will not be overstated. The theory also predicts that firms put in place better systems and mechanisms that align interest of managers of a given firm to those of the shareholders. The theory suggests that managers should be flexible to adapt to the changing accounting policies. Positive accounting theory does not suggest an accounting method that a firm should use but rather predicts it. The second theory is the Normative accounting theory. This is an accounting based theory arrived at because of applying some norms, standards or objectives that the entity aims to achieve2. the theory is based on prescriptions. Therefore, it cannot be ascertained or refuted because it uses deductive reasoning rather than empirical or evidence analysis. Normative accounting theory seeks to prescribe accounting methods that companies should use and standards that must be maintained at all times in their accounting activities. For example, it suggests expenses, revenues, assets and liabilities that can be reported at a particular case. According to normative accounting theory, institutions should set goals and define appropriate roles for all the stakeholders in the entity. It recommends accounting methods and systems that should be utilized in a given firm to improve the effectiveness and efficiency in firms. The accounting-based bonus schemes Accounting -based bonus scheme is a compensation that a manager or an employee receives because he or she has performed well in the organization. It is additional compensation to the traditional salaries3. The bonus scheme ties employees and managers to an accounting measure that indicate change in the performance and value of the company. Employees and their managers are given incentives to improve the performance of the company because their improved performance increases their bonuses. Consequently, firm agents will increase their concentration on firm’s activities and prevent them from shirking. It also curtails their opportunistic tendencies because they will be focused because they will be rewarded for their hard work. Most bonus schemes depend on the overall performance of the company. The bonus scheme helps the company to align the interest of both the owners and the employees of the firm to the entity’s core business. The accounting based bonus scheme is designed and implemented by the remuneration committees or supervisory board and may have conflicting interest with the shareholders who wish to maximize the profits. In addition, the accounting based bonuses schemes may encouraged the accountants and the directors of the company to manipulate accounting figures to earn maximum amount of bonuses. If the company is performing poor, the accounting figures may be manipulated upwards to enable the directors and other eligible agents to earn the bonuses. If the company performs extremely well, the accounting figures are manipulated downwards to the point where the agents earn the maximum bonuses and additional profits are saved for use during the periods when company’s profit decline. The consequences of unfair manipulation can be far reaching and may cause the company to go bankrupt. However, if the accounting based bonus schemes are appropriately applied, the company’s performances automatically improves because the agents’ interest are aligned with core practices of the company. Explain the reasons why and how the accounting-based bonus schemes will motivate the managers to manipulate the accounting numbers There are many reasons why the accounting based bonuses will motivate the managers to manipulate the accounting numbers. First, bonuses increase compensation that the managers receive for rendering their services to the company. Therefore, they will always alter the accounting figures in line with their interests. Secondly, managers want to be perceived as earning much more than their peers. Therefore, they will always manipulate accounting numbers to receive the compensation that makes them richer as compared to their counterparts in other organizations. Thirdly, the managers may want to maintain the level of their bonuses at a given range4. Fourthly, the company may wish to understate the profits to reduce the amount of tax it pays to the authorities and save the rest for the next accounting period when performance is expected to be below par. Therefore, incase of companies exceptional performances, they will understate their profits to preserve the other profits for periods of bad performances. The accounting based bonus schemes are manipulated in two key ways. First, the company’s managers understate the profits of the company. This is possible when the company performed very well and a lot of profit has been made. The managers will manipulate the accounting figures down wards to the point where they earn the maximum bonuses. The extra profit beyond their maximum bonuses is saved to be recognized in future time when the business will not be performing well as expected. Secondly, the managers manipulate the accounting figures upwards when the company is performing poorly. At that point, in time, they may top up the deficit with the profits that have been saved during the exceptional periods. However, if the profits are not enough or not available, they still alter the numbers upwards to the point where they earn their maximum bonuses. Most company’s that manipulates their values upwards may eventually be bankrupt and directors questioned for their scandalous conduct. They may be prosecuted and charged in court of law for their fraudulent conducts. The results of the manipulation Accounting manipulation arise when management use their discretion to make accounting decisions on transactions to affect wealth transfer between the company and the agents, society and shareholders. Accounting based bonus plans may be manipulated by the management who seek to maximize the possibility of achieving bonus5. The managers of the company may be motivated to doctor accounting figures upwards or downwards depending on the direction of performance. If the company performed, lower than expected, the managers alter accounting figures upwards and if it performed beyond expectations, the accounting figures are altered down wards. Manipulation may be allowed by law to certain extend but it should not be used to cover up poor performances because it results to fraud. The directors and managers should avoid manipulating the accounting figures because it endangers the business entity. Excess manipulation is not desirable either upwards or downwards because it significantly distort the value of the firm. A company that is in a continuous decline should not get desperate and be tempted to manipulate profits each year. This will result in undesirable results that will be negatively felt by various actors in the economy. Firstly, the managers who manipulate profits will lose their jobs and reputation. This happens when accounting manipulation make firms bankrupt. In addition, the managers will be further investigated and if found guilty of fraud may be heavily fined or imprisoned. Managers with such an experience risk losing the importance in the corporate world and no other company will be willing to employ them. Secondly, excessive accounting manipulation makes the shareholders lose because the market will not have the confidence in the company affected. Company stakeholders such as the customers and suppliers may lose confidence in the firm. The customers shift to other suppliers and suppliers shift to other buyers. Thirdly, potential shareholders will lose if they purchase the shares of the company whose profits have been excessively manipulated. This is because they will not be able to earn the returns shown in the financial statement because the company will not be able to operate at that level. Fourthly, the existing shareholders will lose because wealth will be transferred to shareholders at their expense. Fifth, employees will lose their jobs if the company becomes bankrupt. This is because the company will cease operations. Sixth, suppliers will lose their money. If there are any outstanding monies that should be paid to them and the company goes bankrupt, they may not be in a position to get it back. Seventh, the clients will lose because their services will be interrupted and warranties as well as guarantees would not be honored. Eighth, the state will lose taxes that could have been paid from the profit of the company. In addition, jobs will be lost. Ninth, society will lose because the jobs will be lost and the resource will be wasted when the company goes bankrupt. The debt-to-asset ratio Debt to asset ratio is a financial ratio that measures the proportion of assets that have been financed through debt. It is computed by taking the total liabilities of the company and dividing it by the total assets. Both the assets and liabilities are found in the balance sheet. The higher the debt to asset ratio, the greater the risk associated with firm operations. High debt to asset ratio indicates that the firm has lower borrowing capacity6. Therefore, the financial flexibility of the firm is lowered significantly. On the other hand, low debt to asset ratio indicates that the firm has lower risk associated with its operations and has higher borrowing capacity. The economic consequences of asset revaluation when the entities have debt-to-asset constraints by providing related accounting figures. Many consequences are associated with the asset revaluation when entities have debt to asset constraints. Higher debt to asset ratio indicates that the company assets are largely financed by debt. Therefore, most profits that the company will generate is spent as an expense to pay fro the cost of debt. The earning per share will significantly be reduced because profits are directly affected by high debt to asset ratio. The economic consequences of leases when they are treated as finance leases and operating leases for the entities that have debt-to-asset constraints (providing related accounting figures) A finance lease is recognized as an asset, which is fully depreciated in the balance sheet. The lessee assumes the risks of ownership and enjoys some benefits. However, the lessee is responsible for maintaining and insuring the asset. Financial leases are recorded in the balance sheet as a liability or an asset. The firm claims depreciation on the on the asset annually and lease payment is deducted as an expense each year. The present value of the lease is treated as a debt and interested is computed on the fair value of the lease. Interest charged on a lease is recognized in the income statement. The lessee can sell finance lease to the third party after the lease period elapse. Capital leases increase the debts shown in the balance sheet substantially. Operating leases are recognized as long-term rental expenses. The lessor only transfers the right to use to the lessee and is appropriate when the asset is need for a shorter period. The lessee pay for the time the asset has been used and after the lease period, the asst is returned to the owner. Operating leases does not affect the balance sheet; however, the lease expense is recorded as an expense in the income statement. Conclusions Positive Accounting Theory is descriptive in nature and tries to develop relationships between accounting transactions and firms agents. The theory requires accountants and managers to be flexible to adapt changing accounting standards. Normative Accounting theory is prescriptive in nature. It suggests that firms should develop goals and strategies. Furthermore, it recommends accounting methods that firms should use to record financial transactions. Accounting based bonus schemes are becoming widely used. This is because it helps to align the interest of shareholders to those of the agents. If used appropriately, it can lead to improved performance in firms. However, accounting based bonus schemes may make the managers manipulate accounting figures to suit their interest. The managers and directors should ensure that manipulations are not exaggerated because it has adverse effect to the firm and other stakeholders. Debt asset ratios are financial ratios that show firms’ capability to borrow finance to run its operations. Higher debt asset ratio indicates that the firm has lower chances of borrowing money to run its operations. Leases are divided into capital leases and operating leases. Capital leases are recognized as assets while operating leases are recognized as expenses. The firm is affected differently according to how it treats its leases. Part 2 Air New Zealand Air New Zealand was established in April 1940 as Tasman Empire Airways Limited (TEAL). In 1953, New Zealand and Government of Australia co-owned the company. However, in April 1965, the New Zealand Government took over Tasman Empire Airways Limited and renamed it Air New Zealand. Its core business is to transport passengers and cargo within and outside Australia. It operates flights from cities in Australia to Taipei, Nagoya, Osaka and Fukuoka cities in Asia. Furthermore, the airline offers direct services flights between San Francisco and Auckland, Wellington to Fiji and Christchurch to Cook Islands, Auckland to Niue and Auckland to Adelaide. The airline also offers planned direct flights from Auckland to Shanghai. The company is planning to expand to other markets in the world especially the growing potential in Beijing, China. The premium class passengers enjoy lie flats seats with direct aisle access, video and movies in every seat. Economy offers additional legroom and increased seat recline7. Financial profile Financial indicators 2008 2008 2007 2006 2005 2004 Profit Before Taxation 304 269 106 232 240 Net Profit Attributable to Shareholders 184 (53) 96 180 166 Total Assets 5,023 4,666 4,785 4,092 3,818 Net debt 1,167 1,269 1,113 809 885 Total cash held 1,289 1,057 1,150 1,070 1,020 Return on Total Gross Assets 28.6 29.7 16. 6 20.3 22.3 Return on Assets 7.1 6.2 3.1 5.2 6.1 Return on Equity 13.8 15.9 6.0 11.7 13.7 Basic Earnings Per Ordinary Share 20.7 21.6 9.6 21.4 24.4 Source: Air New Zealand Company 2008 annual report The above table shows the financial indicators of the company. The indicators have been positive within the 2004 and 2008. For example, the net profit before taxation falls between A $106 million and A $304 million between 2008 and 2004 and return on equity is between 6.0 and 15.98. This shows that the company has been making profits. Air New Zealand shares (‘A’ shares) were listed on the New Zealand Stock Exchange in October 1989 and “B” shares in December 1991. Air New Zealand purchased 50% of Ansett Holdings at a cost of A $475 million in October 1996 and purchased the remaining 50% of A$580m of Ansett Holdings Limited from News Corporation Limited in 2000. Accounting standards required by the AASB 116 (Property, plant and equipment) and 138 (intangible assets) and other relevant accounting standards. An asset is considered an item of property, equipment and plant, if future economic benefits associated with the asset will flow to the entity and the cost of the asset can be accurately measure. The asset that qualify for recognition should be measured at the purchase price and shall consist of purchase price, taxes, duties, transportation cost, professional fees, testing, cost of site preparation, delivery and handling cost, installation and assembly. The cost of the asset is the cash equivalent at the day that it was recognised and shall be measured using the fair value. A significant asset shall be depreciated separately and the depreciation charge is recognized in the profit and loss account. Depreciation is recognized on a systematic basis over its useful life and the depreciation method must reflect the pattern in which the asset is used in the organization. Depreciation methods that can be used include the straight-line method, diminishing balance method, and units of production method. Assets are derecognized on disposal or when there are no future economic benefits that can be achieved. Gain or losses arising asset de-recognition is recognized in the profit and loss account9. Accounting standards 138 on intangible assets requires that the cost of intangible assets that have been acquired separately should be recognized at its purchase price. The cost price shall include all expenses incurred. The expenses are the trade discounts, rebates, non-refundable taxes and import duties. Furthermore, it considers all the cost that are directly associated with the asset preparation. The costs are professional fees, asset testing fee as well as transportation costs. The intangible assets with well-defined useful life must be amortized over its useful life since the time it become operation or functional. An intangible asset should be easily identifiable, possess future economic benefits and the entity should be able to control it. The benefit must flow into the entity and its cost must be accurately measured. AASB 138 does not recognized internally generated internal assets such as brands, publishing titles, master heads, customer list and internal research project. Internal generated goodwill is not recognized as an intangible asset. The residual value of intangible asset is considered zero unless a third party has committed to purchase the asset at the end of its useful life or the market of the residual asset can easily be determined and available10. The intangible assets that do not have defined useful life must not be amortized. It should be tested for impairment annually. The intangible asset is derecognized on disposal or when it fail to have future benefits. The gain or losses from disposal of the intangible asset are recognized in the profit and loss account. How the selected items are disclosed in terms of accounting methods, disclosure in note to financial statement Intangible assets are disclosed as follows. The usefulness life of an intangible asset should be stated as to either finite or indefinite. If the usefulness of the intangible asset can be ascertained, then amortization rate and method should be clearly stated. Total accumulated amortization should be shown at the beginning and the end of the accounting period. Amortization must be reflected in the income statement and a detailed reconciliation of the carrying amount at the beginning and in the end of the accounting period. Carrying amount of indefinite useful life of intangible asset should stated and accompanied by reasons supporting assessment of the indefinite useful life. Other disclosures include carrying amounts of intangible assets whose title is restricted and the contractual commitments of for intangible assets acquisition. Finally, there should be a total expenditure amount of research and development incurred during the period. Tangible assets are disclosed as follows. The basis of determining the carrying amount of the asset, the depreciation method used and the useful lives or depreciation rate used. The gross carrying amount and the accumulated depreciation should be stated at the beginning and at the end of the accounting period. There must be a reconciliation of the carrying amount at the beginning or at the end of accounting period should be shown. In addition, reconciliation should include additions, assets held for sale, increases or decreases from revaluations, impairment losses must be recognised in the profit and loss, depreciation and net exchange differences. Restrictions on title and assets should be disclosed, amount of expenditures recognized in the carrying amount of the an asset, amount of contractual commitment for acquisitions of assets. Evaluating whether the accounting method or disclosure is consistent with the requirements of the AASB 116 and 138 Air New Zealand has disclosed its intangibles inline with the requirements of AASB 138. the company did not disclosed internally generated goodwill. It has also disclosed its computer software and licenses. Intangible assets of Air New Zealand 2008 2007 Internally developed software 20 21 externally purchase soft ware 15 21 Goodwill 0 0 Source: Air New Zealand It also disclosed its intangibles inline with the requirements of AASB 116. This is because the company has shown accumulated depreciation, depreciation rates for each class of assets and leaseholds. For example, aircraft fleet is calculated in a straight-line basis to an estimated residual value over their economic useful life. Aircrafts Airframe is between 10-22 years and engines are between 5-22 years. For non-aircraft assets, buildings are estimated between 50-100 years, aircraft specific plant and equipment is estimated between 10-20 years. Plant, equipment, furniture and vehicles are estimated to have a useful life of between 3 - 10 years. Finally, gains and losses on disposals are recognised in the profit and loss account. 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Air New Zealand Balance sheet As at as at 30 JUNE 2008 Current Assets 2008 2007 $M $M Bank and short term deposits 1,279 1,051 Trade and other receivables 418 408 Inventories 109 106 Derivative financial assets 208 35 Income taxation 33 113 Other assets 246 224 Total Current Assets 2,293 1,937 Non-Current Assets Trade and other receivables - 1 Property, plant and equipment 1,088 1,178 Intangible assets 35 42 Investments 284 190 Derivative financial assets 6 1 Other assets 236 173 Total Non-Current Assets 1,649 1,585 Total Assets 3,942 3,522 Current Liabilities Bank overdraft and short term borrowings 1 1 Trade and other payables 419 328 Revenue in advance 815 721 Interest-bearing liabilities 21 20 Derivative financial liabilities 84 139 Provisions 27 55 Other liabilities 1,159 1,106 Total Current Liabilities 2,526 2,370 Non-Current Liabilities Revenue in advance 109 102 Interest-bearing liabilities 253 274 Derivative financial liabilities 3 6 Provisions 115 91 Other liabilities 128 133 Deferred taxation 136 24 Total Non-Current Liabilities 744 630 Total Liabilities 3,270 3,000 Net Assets 672 522 equity Issued capital 2,235 2,223 Reserves (1,563) (1,701) Total Equity 672 522 Source: Air New Zealand Annual Plan 2008 Air New Zealand Cash flow statement As at as at 30 JUNE 2008 2008 2007 $M $M Operating Revenue Passenger revenue 3,205 2,867 Cargo 412 392 Contract services 237 227 Other revenue 368 218 4,222 3,704 Operating Expenditure Labour (831) (756) Fuel (1,024) (1,006) Maintenance (210) (178) Aircraft operations (320) (301) Passenger services (243) (210) Sales and marketing (309) (270) Other expenses (452) (491) (3,389) (3,212) Earnings Before Finance Costs, Depreciation, Amortisation, Rental Expenses and Taxation 833 492 Depreciation and amortisation (194) (192) Rental and lease expenses (426) (458) Earnings Before Finance Costs and Taxation 213 (158) Finance income 143 114 Finance costs (140) (73) Earnings Before Unusual Items and Taxation 216 (117) Unusual items* - 4 Profit Before Taxation 216 (113) Taxation (expense)/credit (32) 60 Net Profit Attributable to Shareholders of Parent Company 184 (53) Source: Air New Zealand Annual Plan 2008 Air New Zealand Cash flow statement As at as at 30 JUNE 2008 2008 2009 $M $M Cash Flows from Operating Activities Receipts from customers 4,314 3,795 Payments to suppliers and employees (3,845) (3,573) Income tax refund/(paid) 32 (19) Interest paid (71) (61) Interest received 111 107 541 249 Rollover of foreign exchange contracts* 81 (171) Net Cash Flow from Operating Activities 622 78 Cash Flows from Investing Activities Disposal of property, plant and equipment and intangibles 2 10 Acquisition of property, plant and equipment and intangibles (156) (98) Rollover of foreign exchange contracts* (17) (20) Secured deposi (10) (15) Acquisition of investments (425) (10) Net Cash Flow from Investing Activities (606) (133) Cash Flows from Financing Activities Shares issued 1 - Interest-bearing liabilities drawdowns - - Net increase in related party funding 378 111 Interest-bearing liabilities payments (19) (17) Rollover of foreign exchange contracts* (48) 27 Dividend on Ordinary Shares (100) (160) Net Cash Flow from Financing Activities 212 (39) Increase/(Decrease) in Cash and Cash Equivalents 228 (94) Cash and cash equivalents at beginning of the year 1,050 1,144 Cash and Cash Equivalents at End of the Year 1,278 1,050 * Relates to gains/losses on rollover of foreign exchange contracts that hedge exposures in other financial periods Source: Air New Zealand Annual Plan 2008 Read More