Current Issues in Financial Reporting - Literature review Example

Current Issues in Financial Reporting Words (1512) Accounting principles and regulations legitimately allow accountants to report assets and liabilities as off balance sheet items, leading to their failure to faithfully and adequately represent economic substances of their companies. Off-balance sheet assets and liabilities are those that are not included in a company’s balance sheet (Hillier, 2010). For example, assets managed or brokered by financial institution as part of asset management and brokerage for clients. The assets belong to the clients but managed by the company. Therefore, the company does not record the assets in its balance sheet although it provides management and depository services for them. The disclosure of structured investment vehicles (SIVs) has also become a major focus. In this case, sponsoring banks may provide liquidity support to SIVs that were not capable of sustaining their financing in the short-term financial markets. Such banks consolidate the SIVs in order to add the assets and liabilities to their balance sheets. Under the US GAAP and the IFRS, operating leases are also considered as off-balance sheet financing (Little, 2002). Banks also categorize securitized loans as off-balance sheet items because they result from the sale of loans to a third party (Little, 2002). Such securitized assets are only disclosed as notes in the financial statements of the company. According to Elliot and Elliot (2011), the primary impact of off balance sheet finance is that it leads companies to understate their resources (assets) and liabilities hence going against the true and fair view. When assets or liabilities are not presented on the balance sheet, financial analysts and other users of financial reports of companies will not be able to determine the amount of capital employed or the real gearing ratio of the company in order to correctly assess the risk of the company. In this case, the financial statements do not reflect a true and fair view of the financial position and the economic substance of the company. Lack of faithful representation of the economic substance of a company due to off-balance finance may be as a result of innocent side effect of book-keeping system in the company (Miller & Bahnson, 2002). For example, a company hiring an equipment for long-term use and paying annual rentals can be able to present the rentals in the income statement but the equipment will not appear anywhere in the balance sheet because it is an off-balance sheet item not owned by the hirer. Deliberate design may also be used to provide unfaithful representation of economic substance of a company by camouflaging the substance of transactions through legal distinction. For example, loan capital arrangements may be concealed from shareholders and other creditors in order to create a wrongfully good image of the company. Off-balance sheet financial reporting can be used by companies to acquire assets through credit while at the same time maintaining the required debt ratios (Miller & Bahnson, 2002). In this case, off-balance sheet financing is used by companies to acquire assets without recording the transaction in their balance sheet. As a result, the company misrepresents its financial position and fails to faithfully represent its economic substances. Understanding the effect of off-balance sheet items on the economic substance of a company can be illustrated more clearly using an example. Assuming that company A has a line of credit worth $3 million with XYZ Bank, and the financial covenant is that the company should maintain a debt ratio of less than 0.4 at all times; if the company wants to buy a new machine it may be forced to use off-balance sheet strategy to purchase the equipment instead of using debt. This will enable the company to comply with the debt ratio requirement. For example, Company A may create a different entity that will purchase the machine and lease it to Company A through an operating lease. In this case, Company A will have full control and responsibility of the machine. It will record all the lease expense on the income statement but it will not record additional debt on its balance sheet, and it will not record an increase of assets because it does not legally own the machine. This legitimate off-balance sheet financing therefore leads company A to fail to represent its economic substance faithfully for the benefit of Bank XYZ which is one of the users of the company’s financial statements. From the example above, it is clear that companies use off-balance sheet financing to comply with financial covenants, maintain borrowing capacity, lower borrowing rates, and manage risk. However, these strategies may have a bad reputation in the company because they may fail to represent their economic substance faithfully, leading to considerable consequences. A good example of a company that failed considerably due to the use of off-balance sheet financing is Enron. The company fell into bankruptcy in 2001 after concealing its off-balance sheet debts and overstated its profits by over $500 million. Accountants often develop general misconception that as long as the figures are provided in line with current accounting legislations, then the accounts are true and fair (Elliot and Elliot, 2011). However, in reality what is reported often has little impact on the true financial health of the company. IAS 37 is provided to ensure that the balance sheet of a company the true position of the company in terms of assets and liabilities (Sec Advisory Committee on Improvements of Financial Reporting, 2008). Furthermore, the conceptual framework regulates that companies should reflect the substance of their transactions when providing their financial statements. The framework for the preparation and presentation of financial statements has three key characteristics that affect the off-balance sheet finance: reliability, faithful representation and substance over form. Reliability is enhanced when the information is free from bias and material error and users of financial information can use it for faithful representation of what the company represents (Sec Advisory Committee on Improvements of Financial Reporting, 2008). In terms of faithful representation, companies are required to represent faithfully all transactions and events that it purports to represent. For example, transactions that result in assets and liabilities of the entity should be faithfully represented at the reporting date. In order to achieve faithful representation, the items need to be represented according to the substance and economic reality rather than their legal form. A good example of a situation in which a company failed to represent its economic substance faithfully in the balance is that of Enron mentioned above. In order to apply the three characteristics of the framework for the preparation and presentation of financial statements in real life example, it is important to explain the Enron problem in depth. The company used the limitation of accounting principles on off-balance sheet financing to misrepresent their earnings and modify their statement of financial position to show a favorable performance of $500 million profit, few debts and a large amount of assets (Fox, 2003). The company’s knowledgeable executives created off-balance sheet vehicles, deals and financial structures that enabled them to hide the company’s debts (Salter, 2008). These issues finally led to the bankruptcy of the company. The accounting limitation that allows many assets and liabilities to be reported as off balance sheet items led the executives of Enron to hide its debts and create off balance sheet vehicles in order to reflect a positive image of the company about its performance. The actions of these executives did not reflect the principles of reliability, faithful representations and substance over form. The information was not reliable because it had material errors and bias in terms of the amount of debts and profits. These errors were hidden by the fact that some assets and liabilities are legitimately allowed to be reported as off balance sheet items (Ronen et al, 1990). The executives also used the accounting limitation as a means of failure to provide faithful representation of financial information in their financial statements as required by the conceptual framework of presentation and preparation of financial statements (De, 1985). The IASB provides a conceptual framework which allows companies to disclose their off-balance sheet items in the notes section of their financial statements (Anderson, 2013). Enron failed to disclose such information, overstating its economic substance by over $500 million in profit. Therefore, the reliance of accounting legislations for true and fair representation of a company’s financial statements may lead accountants to represent their economic substance unfaithfully. This may finally lead to financial problems such as bankruptcies. This discussion indicates that the legitimate off-balance sheet financing leads companies to fail to provide faithful representation of their economic substance. There are some classes of assets and liabilities that can be reported off balance sheet including operating leases, structured investment vehicles and securitized assets. Companies may exclude such assets and liabilities from their balance sheet in order to comply with the covenants they enter with creditors or lenders. The legitimate off balance sheet financing also allows managers to hide material errors and bias, and manipulate figures in order to overstate their financial performance. It leads to the failure of companies to represent their financial positions in a true and fair manner. References list Anderson, T.J. (2013). The value of debt: How to manage both sides of a balance sheet to maximize wealth. Hoboken, New Jersey: Wiley. De, M.R. (1985). Off balance sheet finance. London: Graham & Trotman. Elliot, B. and Elliot, J. (2011). Financial Accounting and Reporting. Harlow: Pearson. Fox, L. (2003). Enron: The Rise and Fall. Hoboken: John Wiley & Sons Hillier, D. (2010). Corporate finance. London: McGraw-Hill Higher Education. Little, N.R. (2002). Synthetic lease financing: Keeping debt off the balance sheet. Chicago, Ill: Section of Real Property, Probate, and Trust Law, American Bar Association. Miller, P.B.W., & Bahnson, P.R. (2002). Quality financial reporting. New York: McGraw-Hill. Ronen, J., Saunders, A., Sondhi, A.C., Vincent C. (1990). Off-balance sheet activities. New York: Quorum Books. Salter, M.S. (2008). Innovation Corrupted: The Origins and Legacy of Enrons Collapse. Harvard: Harvard University Press. Sec Advisory Committee on Improvements of Financial Reporting (2008). Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission. Washington, DC: Securities and Exchange Commission. Read More