How to Fix Financial Reporting by David Bogoslaw - Article Example

Issues in Financial Reporting Table of Contents Table of Contents 1 Stage 1 2 Summary of the Article 2 Stage 2: Substantive Issues 3 Credit Crisis 3 Off-Balance-Sheet Financing (OBF) 6 Enron Corp. Issue 6 Pension Fund Accounting 9 Pension Fund Issues 10 The Impact of Information Technology on Corporate Financial Reporting 13 XBRL (eXtensible Business Reporting Language) Issue 14 Stage 3 16 Personal View Regarding Validity of the Implied Criticisms 16 References 17 Stage 1 Summary of the Article The article “How to Fix Financial Reporting” by David Bogoslaw, describes different issues that are related to financial reporting. The first issue was the credit crisis which had spread from US banks to Korea and Russia. The core of the problem is that many companies have failed to provide fair and accurate description of financial standing. Besides credit crisis other issues which are included in this article is off-balance-sheet financing and pension fund accounting. According to the article, the off–balance sheet financing and pension fund accounting disclose only net liability and asset which lean to misrepresent the balance sheet and create confusion for the investor. Finally there is an issue of electronic accounting. The article states that traditional financial reporting system must move to electronic database format for making analysis easy and correct. Stage 2: Substantive Issues Credit Crisis In the year 2008, the International Accounting Standards Board (IASB) took a series of steps towards resolving the problem of credit crisis. IASB has identified the need to concentrate on new market development to simplify the International Financial Reporting Standards (IFRS). IASB mainly targeted the proposal of Financial Stability Forum (FSF). IASB directly observed the development of US accounting standards to avoid pointless contradiction in accounting in IFRS and GAAP (IASB, 2008). IASB has assigned the following steps: 1. Fair Value Measurement: IASB has drafted guidelines on fair value measurement of financial instrument in market that are not active anymore. In the process of fair cost measurement IASB has formed a panel which includes expert advisors who will examine the fair cost measurement application. The expert advisors are selected according to practical experience of current market environment. The panel formed by IASB helps to review the valuation process. IASB requested the panel to judge the probable development to the regulation on ‘valuation and disclosure of financial instruments’ but in the mean time not to disclose the aptness of fair value as an approach to evaluate a particular type of financial instruments (IFRS Foundation, 2008). 2. Disclosure of Financial Instrument: IASB worked directly with FASB (Financial Accounting Standards Board) to formulate a common approach which was related to the issue of valuation of financial asset and liability. IAS 32 provides guidelines of the disclosure about financial instrument, including information of fair cost are shown below: I. The financial asset should be disclosed at fair cost through profit or loss and must be shown separately (Ellis, 2007). II. The financial liability should be considered at amortized cost. In case of loan, the liability must disclose the maximum exposure to credit risk of any loan taken, or similar exposure to credit risk. Liability should disclose the amount of change in fair value of any associated credit or related instrument that has happened during the period when the loan was designated (Ellis, 2007). III. Financial instrument also disclose held–to–maturity investments, available– for – sale financial assets and receivables (Ellis, 2007). 3. Reclassify Financial Instrument: IASB has identified the need to scrutinise the accounting principles of IFRS for financial instruments. IASB has published a report which reflects on the possible alteration of IAS 39 standards (IASB, 2008). In the year 2008, IASB published a discussion paper which reflexes public statements about reducing complexity in financial instrument reporting. IAS 39 is considered as difficult and complicated to understand. IAS 39 includes number of alternative ways to evaluate financial instrument and the discussion paper reduces the many alternative ways of evaluating the financial instruments which in turn reduces the complexity and improves comparability (IFRS Foundation, 2008). Off-Balance-Sheet Financing (OBF) Off-balance-sheet is a concept of accountancy. Prior to the release of accounting standards, the tax benefits were frequently influenced to keep asset and the related debts off the balance sheet in order to claim tax relief. Off-balance-sheet financing is either not visible or partially visible in financial reporting. It has attracted controversy in major corporate scandals. Financial instrument that can be treated away from the balance sheet are captured in its classification (Yeoh, 2007). Enron Corp. Issue In Enron Corp. the company used a strategy to avoid the debt and accordingly manage its own balance sheet. The company trained their employees to use composite financial instruments for wooing more customers. It tried to manage the earnings through keeping the debt off from the balance sheet. These deals provided tax and other benefits to customers who outsourced their energy management from Enron Corp (Bloomberg L.P., 2002). When Enron Corp. collapsed, its bankruptcy showed a debt of 13.1 billion USD for patent company and 18.1 billion USD for affiliates. Enron Corp. had salvaged the largest bankruptcy case (Bloomberg L.P., 2001). IASB took many measures for OBF exposure. In the year 2008, IASB issued proposals to strengthen and improve the requirements for identifying the entries that a company can control in balance sheet. The proposals form a part of IASB’s inclusive review of off–balance–sheet activities. The proposal focuses on tightening the requirement for consolidation to represent an overall view of organization’s involvement with off–balance-sheet entities. Consolidated financial report enables investor to identify all of the asset, liability, revenue, expenditure and cash flow which is controlled by the company. The consolidation project focuses on re-examining and clarifies the criteria for all entity (IASB, 2008). In the year 2010, IASB decided to enhance disclosure obligation for transactions involving transfers of financial assets (IASB/IFRS Foundation, 2011). The amendments need to disclose off-balance-sheet measures, present or upcoming effect of company’s financial condition, alteration in financial condition, income or expenses, outcome of operations, liquidity, capital expenses or capital resources which are significant for investors. The management of a company has to recognise and critically examine the registrant’s off-balance sheet measures, guarantee agreements, retained or conditional interest and variable interest. The company also need to identify the probability of any known development, demand, obligation, or uncertainty that might affect the off-balance sheet measures. These disclosure requirements helped investors to understand the risk of off-balance sheet. If there is no development of uncertain event then no disclosure is necessary. The registrant must reveal the material facts as well as circumstances, which can provide clear information of the balance sheet arrangement and its impact. Company must reveal the type of business and purpose of business of the off-balance sheet. The disclosure must provide the information for investor to comprehend the business activities through off-balance sheet. The disclosure should present investors imminent information about general magnitude of off–balance–sheet activities. From disclosure of off–balance–sheet an investor can understand about: The revenue, expenditure, and cash flow of the company The total amount of security issued, retained interest and other indebtedness incurred by the company The nature and amount of any liability of the company which had already cropped up or likely to arise from any event The termination or material reduction of an off–balance sheet The credit rating of any company (Securities and Exchange Commission, 2003) Pension Fund Accounting A pension is simply a form of remuneration provided to an employee in exchange of the past service. Pension accounting is an important component of clear understanding of health of company or firm and the economy. Pension fund accounting is the computation and understanding of corporate earnings. Earlier company used Defined-Benefit (DB) pension plan for paying pension benefits to employees. Disclosure needs were not present which made analysis of pension accounting very difficult. The income tax allowed organisations to deduct contribution from pension plans. Many company followed no standard for funding benefit and planning to pay employees for future earnings. Companies adopted preventive vesting requirements which provided benefits only for elder employees and ignored the younger employees, thus made them unprotected. In past when companies faced difficulties in providing pension commitment, it often terminated the underfunded plans at will and passed the insufficient pension fund to retired employees (Fortune, 2005). The DB pension plan was criticised over certain vital issues. It was said that pension accounting was distorting the financial statement. In the year 2005 SEC issued a report on off–balance sheet which recommends that: Pension plan assets and liabilities should be consolidated in the financial statement because pension plan bears the risks as well as rewards connected with the assets and debts The accounting for DB pension plan is not reliable with the accounting for further assets and liabilities The balance sheet should be transparent to display true funded status of pension plan and its benefits and debts (FASB, 2005) Pension Fund Issues Measurement Issues The employer’s contribution would be increased or decreased by the performance of plan asset. A few people believe that pension accounting should shift closer to the substantive plan model, and other believe that measurement of pension benefit should move in the opposite direction i.e. only to the legal promises. There are two benefit obligations which are Accumulated Benefit Obligation (ABO) and Projected Benefit Obligation (PBO). The ABO defines the benefit in terms of pay while PBO includes the effect of estimated increase in compensation in future. A few believe that the future compensation must not be estimated in pension plan because the plan sponsor can freeze or stop a pension plan. Others consider that future compensation is consistent with going concern concept and obligation should depend on anticipation (FASB, 2005). Expected cash outflow must be discounted to obtain the present value of measurement date. The discount rate reflects the rate of the annuity prices or fixed income investment. A few do not consider that ‘discounting at the high-quality fixed income rate yields’ a faithful measure in relation to the benefit obligation (FASB, 2005). The lump sum settlement plan defines the pension benefit in term of cash balance. Such kind of pension plan increases the annual balance with employer contribution and interest based on variable or fixed interest rates. A few believe that lump–sum settlement plan should not be based on discounted cash outflow; rather the amount should be based on the measurement date. The reason is that discounted cash outflow assumes a separation of employment in the future. The measurement date is the date of financial statement (FASB, 2005). Recognition Issue The liability earned by employee must be recognised in the service period when accounting the pension. Unlike other benefits employees typically earn pension benefit until they retire. In certain condition full eligibility is included to the pension arrangement. For measuring the yearly pension rate, the return on investment on asset must be determined. The investment return is based on estimated ‘long term rate of return’ and market related value of plan asset. Some critics estimated that ‘long term rates of return’ can result in incorrect and misleading information about pension cost. The delayed recognition can include investment earning in net pension cost while the company is incurring investment losses. The pension cost also can mislead by showing increase in return year over year which is actually not increasing. Expected annual return is determined using fair market value or calculated value. Some argued that calculated value creates extra distortion between recognised ‘return on asset’ and actual ‘return on asset’. Expected returns at times are unable to signify original economic growth or losses for any period. As a consequence, the reported results do not reveal economic reality and thus investment decisions are not reflected in the financial statement on a timely basis. A number of people criticized the pension accounting because actuarial profit and losses were different than estimated return. These factors are not recognised when economic incident and transaction take place. The pension obligation must be stated without recognition delay (FASB, 2005). Amendment to a pension plan may provide further benefits to employees for past service. Those amendments are made keeping in mind that employers will comprehend economic benefits in upcoming periods. The expenditure of those extra benefits must be amortised over the upcoming service period of employees. Presentation and Display Issues Net pension cost include service cost, interest cost, the anticipated return on the asset, any income or loss from changes in estimation, amortisation of unrecognised net asset. Some argue that the net pension cost distorts operating income by adding financing and investment profits and losses in cost of sales and general or managerial expenses. Some argued that interest and return on investment should be displayed as financing income and losses because it is non–operating in nature. Other argued that net pension cost is required and the information is needed to assess operating income (FASB, 2005). The IASB had issued a draft in the year 2010 for pension accounting. The focus of the draft was on measurement and recognition of changes. According the draft the pension cost classified as operating expenses. The operating costs consist of service cost, interest cost, anticipated ‘return on plan assets’ and ‘amortisation of unrecognised’ previous year profit or losses. The affect of expenditure of interest would be limited to only net income. The expected return should be calculated with the same discount as in the interest cost and market price of plan asset. The amortisation of losses and profit must be deducted. Any change in consisting profit or loss outside service and interest cost, would be recognised as other comprehensive revenue. Such gain or losses would never be included as a component of pension cost (Senoski, 2010). The Impact of Information Technology on Corporate Financial Reporting Modern computing and multimedia technology allows many financial documents to be digitised. The digital document bears less cost for effective storage and access. At present the amount of accounting and financial documents is growing quickly. For this reason, there is a need for digital accounting for future accounting information system, because IT mechanism can manage document much effectively. In general, accounting document includes bills, purchase order, charts, tables, graphs and others. Accounting Information System (AIS) can automatically classify digital accounting document into different category in an effective manner. AIS and advanced computer system can construct images by data digitisation and provide large repository for image storage with low cost. In AIS, there are many kinds of transaction documents and graphics which are digitally archived as gray–scale accounting or image accounting. AIS automatically manage the digital financial documents for efficient storage and recovery through image database management (Tsai, 2007). XBRL (eXtensible Business Reporting Language) Issue XBRL is one of the ‘cutting edge technologies’ which has great impact on commerce and corporate financial performance. According to Financial Executives Institute (FEI) and American Institute of Certified Public Accountants (AICPA), XBRL is an essential program determining the future of the financial reporting. The use of universal business reporting language of XBRL has attracted many organisations and individuals because they want more flexibility and ease of use and low time in developing financial reporting. XBRL can remove the repetitiveness of data in accounting process. XBRL enabled software provides desired information and thus helps decision maker in making decision more efficiently and flexibly. Besides making decision making process easier, XBRL also provides benefit through regulatory compliance. The benefits of XBRL are realised in the procedure of financial reporting. XBRL can tag every piece of information which is extremely significant to financial reporting. This helps to make collection of data for the preparation of financial report effective as well as efficient. The tagging and automation of report generation in XBRL prevent the misleading of financial system through improving the transparency. Through XBRL organisation can easily access the necessary data to accumulate report under different set of standards. Through the introduction of XBRL, the audit process has shifted from manual audit to computer based audit. Computer based audit gained more efficiency in the audit process compared to manual audit. Collecting information and converting it into meaningful data format is an especially costly process. Traditionally, people spent much time in collecting data through traditional financial report and once data is collected the user manually keyed the data into various accounting software. XBRL allows acquiring the desired information directly into the analytic software which can decrease cost and improve the accuracy of data collection and conversion. Through developing the efficiency of complete financial reporting procedure, it helps to decrease audit cost and make efficient distribution of financial reports. Presently more than 500 organisations, firms and various regulatory agencies are concerned with the improvement of XBRL technology. Approximately 24 countries including India, Japan, China, Ireland, and South Africa are also adopting or in process of adopting XBRL system for electronic database filling. According to Securities & Exchange Commission (SEC) of US, XBRL tagging is mandatory for SEC filing, i.e. stock exchanges of US must file XBRL tagged in financial reporting and publish those reports on their corporate websites. Besides SEC, many regulatory agencies such as Australian Prudential Regulation Authority and Federal Deposit Insurance Corporation (FDIC) of US are engaged to use XBRL for regulatory and financial reporting (Baldwin & Trinkle, 2011). Worldwide companies spent considerable amount of time, money as well as other resources to convert to IFRS and the conversion cost is basically related to IT. The effect of IFRS conversion on IT structure created the requirement for new information, changed computation and changes in financial reporting procedure. To facilitate these changes information system must be implemented, customized and reconfigured. IFRS is driven by accounting but it will drive major changes to IT system as well as business financial reporting process (KPMG LLP, 2008). Stage 3 Personal View Regarding Validity of the Implied Criticisms Accounting is an important issue in every organisation. It helps to reveal the financial condition of any organisation and helps an investor to understand about a company. There are various issues regarding financial accounting such as balance sheet issue, credit crisis issue and pension fund issue. There are various measures in handling those issues. The credit crisis can be hedged through proper disclosure of financial instrument and fair value measurement of assets and liabilities. In case of balance sheet, it should be simple and must disclose financial condition, alteration in financial condition, all incomes and expenses, outcome of operations, liquidity, capital expenses or capital resources, development, demand, obligation, and uncertainty that might affect the financial condition of any company. An organisation must implement cutting edge technology for effective financial reporting and spent less amount of time and money for accounting. References Bloomberg L.P., 2002. The Perfect Sales Pitch: No Debt, No Worries. Special Report -- The Enron Scandal. [Online] Available at: http://www.businessweek.com/magazine/content/02_04/b3767703.htm [Accessed April 1, 2011]. Bloomberg L.P., 2001. The Fall of Enron. Cover Story. [Online] Available at: http://www.businessweek.com/magazine/content/01_51/b3762001.htm [Accessed April 1, 2011]. Baldwin, A. A. & Trinkle, B. S., 2011. The Impact of XBRL: A Delphi Investigation. 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[Online] Available at: http://www.iasb.org/NR/rdonlyres/C852569A-8BA6-4636-8C0D-DB7EEB088A26/0/IASBannouncesnextstepsinresponsetothecreditcrisis.pdf [Accessed April 1, 2011]. IFRS Foundation, 2008. IASB Provides Update On Response To The Credit Crisis, Issues Draft Report From Expert Advisory Panel. Press Releases. [Online] Available at: http://www.ifrs.org/News/Press+Releases/IASB+provides+update+on+response+to+credit+crisis.htm [Accessed April 1, 2011]. IASB/IFRS Foundation, 2011. Response to G 20 Conclusion. IFRS. [Online] Available at: http://www.ifrs.org/NR/rdonlyres/FAFA7E92-E34B-481E-AF3B-AD576380E371/0/G20response.pdf [Accessed April 1, 2011]. KPMG LLP, 2008. The Effects of IFRS on Information Systems. Information Technology Advisory Services. [Online] Available at: https://www.in.kpmg.com/securedata/ifrs_Institute/Files/Effects_of_IFRS_on_IS.pdf [Accessed April 1, 2011]. Securities and Exchange Commission, 2003. Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations. Final Rule. [Online] Available at: http://www.sec.gov/rules/final/33-8182.htm#IIIC [Accessed April 1, 2011]. Senoski, M. J., 2010. Pension Fund Accounting and the Bottom Line. Pyramis Global Advisors. [Online] Available at: http://www.pyramis.com/fileadmin/templates/pyramis_public/downloads/us/pension_fund_acct_bot_line.pdf [Accessed April 1, 2011]. Tsai, C. F., 2007. On Classifying Digital Accounting Documents. The International Journal of Digital Accounting Research. [Online] Available at: http://www.uhu.es/ijdar/10.4192/1577-8517-v7_3.pdf [Accessed April 1, 2011]. Yeoh, P. S., 2007. The Legal Implications Of Off Balance Sheet Financing. University of Wolverhampton. [Online] Available at: http://wlv.openrepository.com/wlv/bitstream/2436/17614/1/Yeoh%20PhD%20thesis.pdf [Accessed April 1, 2011]. Read More