Issues Surrounding the Recognition and Measurement of Accounts from British Airways - Assignment Example

RUNNING HEAD: Recognition and measurement issues Issues surrounding the recognition and measurement of certain accounts from British Airways plc of Student Name of Subject Name of Professor Date 1. Introduction British Airways plc (or BA) needs to grow in its financial performance just like any other companies, to convince its shareholders that the latter have made their correct decisions and that investors may continue to support the company should it seek expansion as the economy would allow the same. There is need to convince the decision makers on their need for financial reporting, which is governed by international accounting standards (IAs) as issued by the International Accounting Standards Board (IASB). This paper seeks to explore the issues surrounding the recognition and measurement of Intangibles in the financial statements of British Airways plc (2011) as governed by IAS 38. This paper will look into how IAS was possibly obeyed or violated by the company in relation to what in general a company should behave in the preparation of financial statements for users. 2. Analysis and Discussion 2.1 What are the issues surrounding recognition and measurement of elements in the financial statements? The issues surrounding the recognition and measurement of elements in the financial statements would normally pertain to those that would not comply with the requirements of international accounting standards on recognition and measurement of accounting elements. Before the accounting elements become part of the financial statements required from companies particularly the publicly listed ones, a transaction or event should comply first with the standards’ requirement on measurement. \ The accounting elements are referring to the assets, liabilities, equity, revenue and expenses (Englard, 1995). 2.2 The accounting theory on recognition of accounting elements and IASB’s framework on recognition and measurement. The accounting theory on recognition of accounting elements requires that before assets, liabilities, revenues and expenses should be recognized in the financial statements, certain requirements must be met. Recognition means the reporting of an asset, liability, income or expenses on the face of financial statements (Kieso, et al, 2007). Four main recognition principles for each accounting element are to be followed in the preparation and presentation of financial statements. These recognition principles are consistent with the IASB’s framework on recognition and measurement. The IASB framework on IASB elements allows variety of measurement bases under different combinations in the financial statements including historical cost, current cost, net realizable value and present value or discounted value. Among these four measurement bases, historical cost is most commonly used, but combined usually with other bases. The choice of particular measurement basis is governed by the specific standard on the accounting element (Delloitte Touché Tohmatsu, 2011a). The asset recognition principle will allow the reporting of an asset when it is probable that future economic benefits will flow to the entity and the assets have a cost or value that can be measured reliably. The term "probable" implies that the more than likely than not future economic benefits to arise (Englard, 1995). The future economic benefit embodied in an asset is favourable event for the entity. Thus it encompasses the likelihood to contribute directly or indirectly to the flow of cash and cash equivalents to the reporting organization. The potential includes being productive in terms of operating activities of the entity. Convertibility into cash or cash equivalents may constitute as form of it. It can also represent capability to reduce cash outflows. Lowering the cost of production can be given as an example of the latter (Englard, 1995). The liability recognition principle, on the other hand, will allow a liability to be recognized or reported if the amount of which can be measured reliability and the outflow of resources embodying economic benefits must probable (Englard, 1995). To measure liability, the essential characteristic must be understood to refer to the entity’s present obligation, which may be either be legal or constructive. Obligations may become legally compellable as a consequence of a binding contract. The same may also come in the need to comply with the legally binding laws as what happened with amounts payable for goods and services received. Income should be recognized when earned not when collected (Englard, 1995). This is the income recognition principle. It is has its connection also with conceptual framework providing that income is recognized when it is probable that an increase in future economic benefits related to an increase or a decrease is a liability has arisen; and, that the increase is economic benefits can be measured reliably (Kieso, et al). When the two conditions are present recognition of the income should follow. The probable future economic benefits will flow to the entity if there is an increase in an asset or a decrease in a liability and that the same benefits can be measured reliably. Said conditions are present at the point of sale which should be the point of income recognition. The point of sale means having mean having entity to have transferred to the buyer the significant risks and rewards of ownership of the goods (Kieso, et al, 2007). In measuring revenue from rendering services, the can be recognized after complying with the reliably measured amount of revenue, probable future economic benefits associated with the transaction that will flow to the entity. This is in addition to the reliable measurement of the stage of probable economic benefits of the transaction at the end of reporting period, reliably measured amount costs incurred or to be incurred in respect of the transaction (Kieso, et al, 2007). The expense recognition principle requires that expense be recognized in different ways depending on the nature of the cost. The most ideal approach is matching expense directly in relation to revenues. Thus if this is done there is attainment of matching principle and accounting which is logical (Porter and Norton, 2010). Since a business is mean to generate profits which can be measured by deducting expenses from revenues, it only logical to match the recognition of the first to the second. Thus to recognize sales revenues from sale of good must be accompanies by cost of sales. This connects also with asset recognition principle which was applied earlier when there was inventory purchase. The same is also connected with income recognition principle when there was point of sale. Sometimes indirect rather than direct matching expenses with revenues is more applicable. This latter approach happens when benefits associated with certain types costs are in use as in case of long-term assets as building, equipment and intangibles. Since these costs benefit not just the current but also the many period of the future, they will be matched with expected life of these assets as corresponding to future benefits. Thus matching will result to production of depreciation or amortization. The first would apply to buildings and equipment while the second would apply to intangibles (Porter and Norton, 2010). 2.3.1 Importance of recognition and measurement in accounting and the issue of earnings management Recognition and measurement of an accounting element strikes the very basis of accounting information as what should be and what should be part. Failure to follow therefore the requirements of standards may be deemed to be closer to practicing creative accounting or earnings management (Lee, 2007). The practice of earnings management and the methods or techniques used to do the same are realities that must be guarded by IAS 38. What could be the motives behind earnings management? Earnings management can be defined as any attempt by management to manipulate reported earnings. Thus, managers may opt to use specific accounting method over another as one method may allow management defer or accelerate expense or revenue transactions or they recognize one-time non-recurring items, or they or employ other methods (Pagach, et al, 2006). It can be deciphered from the definition that the purpose of the same is to influence short-term earning which is to send a message to the decision makers principally the investors that the company profits are meant to be kept unbroken more or less for the near future. In this way, investors or buyers of a company’s stock could be moved to purchase or invest. There is greater chance that decision makers are less informed of what is fair in the absence of rules or accounting standards to guide or restrict companies’ management in the preparation financial statements. Managers are stimulated to do earnings management due to perceived advantages for their interests. Managers want to bring their wealth maximization objective to reality (Brigham and Houston, 2002). There are different pressures both external and internal environment that could be placed on their shoulders. Having stable earnings in the short-term, stock prices of concerned companies could be expected to go up (Brigham and Houston, 2002). Occasionally if not most of the times, stock prices are forecasted by analyst with the linkage to management who may not want to lose face if profits will eventually get down. With the implied expectation to grow and be profitable, they must have to adjust their profitability, liquidity and solvency profile that could be extracted only from financial reports. This would therefore mean possibly making the financial reports to look pleasing to investors and to the public. The behaviour of the analysts could in effect induce the company’s to manage their earnings, which happens in reality (Brown, 1999.) Analyst can unethically earn in return for the validation of their forecasts. This may be a dishonest behaviour among analyst of companies but the actualities must be met since people in the business entities tend to move for their own interest. 2.3.1 The issue on intangible assets under IAS 38 and BA’s practice and compliance An intangible is an asset of value that cannot be physically touched but subject to amortization. Its becoming an asset for recognition is determined by the suitable international accounting standard. Non-compliance of the standard would have significance on decision makers. IAS 38 from the International accounting standards board (IASB) regulates the measure, recognition and disclosure requirement of intangibles. Other rules may exist under the different standards on intangibles issued from the IASB but precisely IAS 38 aims to prescribe the accounting treatment for intangibles assets that are not dealt specifically in other IAS. IAS 38 sets the criteria when to recognize intangible asset in the books and how to comply with the disclosure requirements in matters of preparing the financial statements of a company. To be considered as intangible asset, the same must be controlled by the business organization as a result of past events which could either be by purchase or self-creation. It is also required that future economic benefits must be expected by the enterprise. Said economic benefits may take the form of cash inflows or other assets that will expand the wealth of the enterprise. Some of kinds of intangible assets are not governed by the rules under IAS 38. These would include (1) financial assets; (2) intangible assets arising from insurance contracts issued by insurance companies; (3) mineral rights and exploration and development cost incurred by mining and oil and gas companies and (4) intangibles covered by the another IAS or IFRS such as intangibles held for sale, deferred tax assets, lease assets, assets arising from employee benefits, and goodwill (Hussey & Ong, 2005). Intangibles to be classified as such should exhibit the certain attributes. The latter pertain to identifiability, control and future economic benefits, which could take the form of revenues or reduced future costs. An asset is identifiable when the assets is allowed to separated and sold, transferred, licensed, rented, or exchanged, either individually or part of the package and that the same asset arises from contractual or other legal rights. Control is present as an attribute when the company has the power of deriving benefits from the asset (Olsen and Halliwell, 2007). An intangible could only be recognized as asset whether the asset is self-created or purchase, under IAS 38, if the following are requirements are complied with: (1) it is probable that future economic benefits that are attributable to the asset will flow to the enterprise and (2) the cost of the asset can be measured reliably. If the asset is generated internally there is additional requirement. The probability of future economic benefits needs to be based on reasonable and supportable assumptions and conditions that will exist over the life of the (Delloitte Touché Tohmatsu, 2011). Under the definition given, the following could be considered examples of intangibles: copy rights, mortgage servicing rights, license, computer software, patents, import quotas, franchises, motion and picture films, customer lists and marketing rights (Delloitte Touché Tohmatsu, 2011). Note these assets are expected to produce future economic benefits, and their costs are measured reliably. What happens then if the criteria are not met? The answer would be to have the amount spent recognized as expense for the period. What then are the differences in the effects on the financial statements? To recognize it as asset, if proper under the criteria set, would in effect defer the recognition of expenses in subsequent period because of amortization and hence reported income for the current year would be higher. However when charged to expenses because of not compliance with the criteria, the expense would be higher for the current period hence net income would be lower than in the first. How would intangible be acquired? One company can buy the copyright or patent of certain from form another person whether natural or juridical. The most unique way of acquiring intangible however is in the case of business combination where there is a rebuttable presumption that the fair value (and therefore the cost) of an intangible acquired in a business combination can be measured reliably. Normally goodwill is associated with the purchase because of easier compliance with measurability and that the only instance perhaps where it would not be possible to measure reliably the fair value of an intangible asset acquired under a business combination is in case the intangible assets arise from legal or other contractual rights and it is not separable or separable. It could be separable, but one cannot present history or evidence of exchange transactions for the same or similar assets, and to estimate fair values would be to depend on incalculable variables (Delloitte Touché Tohmatsu, 2011). It can be deduced in the case of BA, that its intangible asset does not become one my mere choice of management without any basis to classify as such to influence decision makers. The company holds its intangible at cost and amortize the same on straight line basis over the economic life of these assets (British Airways, 2011). It has three types of intangible assets. One is goodwill which BA recognizes when the cost of business combination exceeds the fair value attributable to the net assets acquired. Since the same is capitalized, impairment could be recognized annually. Another intangible is the Landing rights acquired from other airlines, after deducting impairment losses. There could instances where economic life has to be revised which could affect the amortization charge (British Airways, 2011). Since intangible behaves like a property plant and equipment subject to depreciation, the related amortization of intangible gets influenced by changes in life. Another intangible of the company is software. The company separates the cost of the purchase or development of computer software from the item of related hardware. It also amortized the same over a period not exceeding four years (British Airways, 2011). 2.3.2 Further Compliance with Amendments to IAS 38 The international accounting standards issued by the IAS are not meant to be fixed and insensitive to the changes in the economic and political environments with which companies from different industries operate. From time to time amendments are made to reflect the need to address changes. IAS 38 was therefore amended to require expenditure on advertising and promotional activities to be recognized as an expense as soon as the entity has the “right to access” the goods or has received the services (British Airways, 2011). BP however determined that amendments do not have a material impact on company’s financial statements and which the company did its disclosures. The company has no evidence to have violated this requirement based on its 2010 annual report (Delloitte Touché Tohmatsu, 2011). Another amendment to IAS 38 on Intangible assets is on provision of additional guidance on the valuation techniques to be used in measurement of fair value of intangible assets acquired as a result of business combinations that are traded in active markets. The amendment was made effective 1 January 2010 and after (Delloitte Touché Tohmatsu, 2011). BP complied with the above amendments in its 2009 financial statements under its network airline operations and OpenSkies. Under first its Network airline operations, an impairment of intangible assets was found not to be recognized since the recoverable amount of the assets under this type operations was found to have exceeding the carrying value by about £1.4 billion in 2010 and £400 million in 2009. BP determines that recoverable amount is determined by changes in discount rates and forecast for operating margin. By assuming that the discount rate would increase by more than 300 points in 2010 and less than a hundred in 2009 or that the operating margin was to decline by 25% in 2010 and 2% in 2009, the clearance would amount to zero in British pounds (British Airways, 2011). On the other hand, BP recoverable amount for its assets with the OpenSkies also exceeded the carrying value by £200 in 2010 and by zero in 2009. The computation of the recoverable amount was similarly determined by changes in discount rates and forecast for operating margin. The management of BP there is reason to assume no change in the carrying value of the assets under any reasonable change in the discount rate and the forecast operating margin (British Airways, 2011.) From its 2010 and 2009 financial statements, it could be noted that BP’s intangible assets were basically found to have higher recoverable value than book value and hence not recognizing impairment loss on intangibles for 2009 and 2010 can be justified under IAS requirements. It only recognized amortization of intangible assets which means that life of its previous intangibles did not change (British Airways, 2011). 3. Conclusion This paper has discussed and explored the issues surrounding issues on measurement and recognition of elements in the financial statements, in the context of accounting theory and its relevance to practices in financial reporting. By using the cases of British Airways this paper investigated the application of possible issues on recognition under IAS 38 on Intangibles. BA’s compliance with IAS 38 in effect resulted to compliance with asset recognition principle and liability recognition principle when the Intangible assets were recognized. It also implied complied with expense recognition principle by recognizing periodic amortization of intangible. Said practices also indirectly complies with matching principles as expense recognition must be flow with income recognition principle which is deemed to have complied as well in its revenues reported under its income statement for the period analyzed. As determined, the issues on measurement and recognition most probably arise because of the tendency of management to do something they believe would be good for the company but would not be good for other stakeholders. Such practice of earning management or creative accounting is precisely a recurring and continuously evolving problem which the accounting standards try to address. Standards by themselves cannot accomplish their purpose without the help of auditors to prevent the more dangerous part in the practice of earnings management. External auditors thus need to have integrity and independence in attitude as they attest to the compliance of companies to accounting standards in the preparation of the financial statements. References: Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, London: Thomson South-Western British Airways (2011). Annual Report for 2009/2010. Retrieved 1 December 2011 from < http://www.britishairways.com/cms/global/microsites/ba_reports0910/pdfs/BA_AR_2010.pdf> Brown (1999). The regulation of corporate disclosure Front Cover. Aspen Publishers Online Delloitte Touché Tohmatsu (2011) IASB Agenda Project – on IAS 38. Retrieved 1 December 2011 from http://www.iasplus.com/standard/ias38.htm Delloitte Touché Tohmatsu (2011a). Conceptual Framework For Financial Reporting 2010. Retrieved 5 December 2011 from < http://www.iasplus.com/standard/framewk.htm> Englard (1995). Schaums outline of theory and problems of intermediate accounting I. McGraw-Hill Professional Hussey & Ong (2005). International Financial Reporting Standards Desk Reference: Overview, Guide, and Dictionary. John Wiley and Sons. Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Lee (2007). Financial Reporting and Corporate Governance. John Wiley and Sons Olsen and Halliwell (2007). Intangible Value: Delineating between Shades of Gray: How Do You Quantify Things You Cant Feel, See or Weigh?; Journal of Accountancy, Vol. 203. Pagach, et al (2006). Intermediate accounting: financial reporting and analysis. Cengage Learning Porter and Norton (2010). 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