The Role of Ethics and Judgment in the Production of Financial Reporting - Term Paper Example

The Role of Ethics and Judgment in the Production of financial reporting Name: Lecturer: Course: Date: Table of Contents Table of Contents 2 Introduction 3 The role of ethics in financial reporting 3 Key areas of judgment in financial reporting 5 Potential impact of the use of judgment 6 Illustration: Case study 10 Bibliography 11 Introduction This paper focuses on financial reporting discussions. It illustrates the ethics involved in financial reporting and their role, key areas of judgment in financial reporting and potential impact of the use of judgment. The paper also provides an illustration through case studies of the general aspects in the discussions. Ethics in financial reporting is concerned with best practices in regards to preparation, analyzing, presentation and reporting of financial information. Financial misstatement is avoided in financial ethics. Judgment in financial reporting dictates the status of a given firm, its financial position and financial performance. The role of ethics in financial reporting Ethics in financial reporting ensures efficiency in execution of roles, especially, on the part of key players in this area, such as auditors. Since auditors are charged with the role of protecting shareholder interests and interests of the public, ethics in financial reporting ensures that this role is carried out effectively and independent of management influences. Auditors are able to assure shareholders and interested public of credibility of information in financial statements disclosed by companies. Similarly, ethics in financial reporting ensures effective allocation of resources, which should be in line with the interest of the organization. Resource allocation is one of the main decisions that managers must make to ensure efficiency and continuity of the business. This decision requires that updated information on resource availability such as financial, capital and human resources are provided. International Organization for Standardization (ISO) 9001 section 5 provides the requirements that top management in an organization should adhere to, for a successful management. An indication of commitment provided by ISO 9001, in section 6, requires that the management ensures availability of resources in the organization. Management accounting is based on a conceptual framework, which is geared towards providing necessary information that must support decision making, instead of basing on cases. Management information systems are used to prepare accounts, under management accounting, so as to meet the needs of managers (Kwon and Yin 2006). Main focus of ethics in Accounting is on individuals and their relationships in provision of organizational resources, also known as an agency relationship. According to Humayun (2008), ethics and theories in accounting are based on the economic principles that describe relationships between agents, such as organization managers and debtors or owners and their managers. Ethics therefore does not seek to recommend specific actions in the accounting practice, however, decisions based on ethics affects stakeholders and other interested parties. Ethics in financial reporting is an assurance of reliability on financial information. Financial reports can be prepared for both external and internal use. These accounts are used by stakeholders, such as employees, stockholders, banks, the government and decision makers. The continuity principle provided by the generally accepted accounting principles (GAAP) requires that financial accounting is conducted by companies to ensure that a company’s operations last. Ethics ensures openness and honesty in financial reporting. This is a key tool for organization continuity. Ethics in financial reporting technically involves adherence and implementation of standards provided by the International Accounting Standards Board or Financial Accounting Standards Board in preparing financial statements. Consistency is one of the advantages of using a single set of accounting standards globally. Common standards for reporting financial information ensures that control and safeguard is instituted. The main reason for establishing international accounting standards is to ensure consistency and professionalism in carrying out accounting transactions and recording. In order to compare financial accounts of different periods and between companies, consistency in reporting of the information is vital. This is more important to the company because as an organization, it is easier to track performance and detect areas of weaknesses so as to institute change and analyze the impact of any changes made. Practicing ethics in financial reporting enhances shareholders’ trust towards the company. Information provided in financial accounting is majorly for external use. For investors to invest in a company, they need to be convinced and be sure of the investment to the company. Instilling trust to stakeholders give them an assurance that there is no accounts manipulation. Company accounts can be manipulated in such a way that presentation procedures are altered, therefore, changing the whole company’s financial information. According to Alexander et al (2008), internationally applied principles make it easier for stakeholders to interpret financial statements in the right way and judge the company position. Any changes made on methods of reporting will affect the nature of financial statement. Solution to developing trust on financial reporting is to comply with the internationally accepted guidelines for financial reporting. Key areas of judgment in financial reporting Financial ratio is a key area of judgment in financial reporting. According to McCarthy et al (2012), financial ratio analysis aids in instilling confidence among managers while managing the business resources. Given the financial reports and statements, related contents of the statement can be evaluated to identify business’ performance. Financial accounting involves historical data that reflects performance of the company, since all the information is needed by the users of the accounts. Through this, managers can gauge the market performance, liquidity, efficiency, gearing and profitability of the company. Therefore, financial accounting is not only useful to managers but also a provision of the accounting standards and legislation. At the end of every financial year or mid-year, companies are expected to prepare financial accounts reflecting current positions and performance of the company. Times interest covered = Operating profit (Before interest and tax) Pg 50,61/Interest charges (Note 5Pg 55,72) 2009 Times interest covered = 671/44 = 15.25 2010 Times interest covered = 907/45 = 20.16 2011 Times interest covered = 904/35 = 25.83 2012 Times interest covered = 973/39 = 24.95 With the times interest covered of 15.25 in 2009, 25.83 in 2011 and 25.95 in 2012, this indicates that, the numbers that Morrisons Company can cover its interest obligations without defaulting is increasing over period of three years but reduces in the fourth year; 2012. This indicates initial stability, and in 2012, indicates an increase in the debt burden for the company. Financial accounts prepared include statements of financial position and performance, company’s ratios, cash flow statements and others. According to World Bank and IMF (2005), financial ratio analysis of the company must be provided as part of the financial reports and statement, so as to state the business performance. Investors are also in a better position to make investment decisions regarding firms to invest in, from the knowledge gained from the analysis. They will know what to consider in determining profitability of a firm and predict its expected performance. All companies must be audited for accountability purposes. According to McCarthy et al (2005), financial accounting must be done to produce financial statements, which are assessed by auditors. Accounting standards require that auditors approve the accounts if they reflect a true financial position or performance of the company. The generally accepted accounting principles (GAAP) provide guidelines for financial accounting as standard model, applicable in all sorts of authority. Financial accounting is governed by rules, conventions and standards of accountancy in preparing statements of accounts. When preparing financial accounts, historical costs of previous years and revenues earned in the past are incorporated to determine the current status of the company (World Bank and IMF, 2005). Potential impact of the use of judgment The use of judgment reveals business operations and will detect any signs of bankruptcy in good time. The use of judgment is also important in resolving an issue of bankruptcy, either by dissolution or reviving the company. In case of bankruptcy, the accounting standards require that a company prepares statement of affairs and submit it to the official receiver to reflect assets available and credits accrued to the bankrupt. Approval of financial statements is done by a competent court, which also has the mandate to discharge a bankrupt after debts are paid. Items of reorganization for financing activities and investing activities are accounted for separately. Judgment in financial reporting is technically standard setting in financial reporting of organizations’ accounts and is meant to ensure that quality and transparency are observed. According to Papadopoulos (2011), reliability and relevance are issues that raise concerns in financial reporting among expertise that are involved in implementing accounting standards. Accounting standards involve the set rules and procedures adopted by firms or companies in financial data reporting. These standards majorly apply to financial accounting, which is a requirement for each company or business organization by the law. Financial accounting involves provision of financial statements for both external and internal use, as required by law. Accounting standards prevent fraud and bias in financial reporting. Different approaches to financial reporting are adopted in setting such standards. Principle-based approach, concept-based approach and rule-based approach are applicable in this case. This paper provides a critical examination and discussion of these approaches used in setting accounting standards using appropriate applications and examples. The FASB committee of American Accounting Association notes that rule-based approach only helps companies to work towards configuring their business and accounting activities to suit specific accounting treatments. This is done irrespective of consistency with the true economic status of the transaction. However, the approach provides adequate guidance needed by the companies. Illustration: Annual depreciation of fixed assets is to be provided at 5% on cost throughout the assets economic life. This rule-based standard is fixed and definite, not allowing any negotiations and disparity on amounts to be depreciated annually. Since economic backgrounds of transactions differ across firms through time, this standard becomes irrelevant since it does not display a picture of economic elements for the reported entity. However, it is easy to compare reports on expenses across the industry, when such rule that will be applicable to all firms is provided (Maines et al. 2003, p. 74). Principle-based approach adopts elements of conceptual framework to develop accounting standards but add to this a similar broader perspective, thus creating exceptions for the principles. Since principle-based approach is more of conceptual framework, illustrations of the standards are more alike (Benston et al 2006, p. 168). Illustration: Depreciation is to be done on all company fixed assets, preferably annually, using a consistent depreciation method to allow comparability. Firms are also expected to disclose all useful accounting information that will be of interest to users and not hide any of the information. With this kind of approach, standards start by stating a given goal or objective of adequate reporting in the respective area that afterwards provides an explanation to illustrate the objective at times of using examples. This allows participants to practice judgment that is guided by professional standards (Maynard 2013). For example one of the key characteristics of concept based standards is description of a given transaction that is related to the given standard. This description involves economics detail of the item. Equipment $400000 (at Cost) Description: The equipment was acquired one year ago and has an economic value of 10years depreciating at 5% on straight-line basis. The scope of concept-based standards is characterized by its double-sided nature. Therefore, heads of finance or accounts have the privilege of selecting suitable accounting treatments, which are in line with their understanding of economic background surrounding such transactions. According to Norton, Diamond and Pagach (2006), conceptual standards require a focused, intelligent and professionally guided team of financial heads, auditor and committee members of audit team to provide consistent and fair financial reports. These qualities involve professional judgment skills and willingness to impede bias in financial reporting. This approach might give room for manipulation of financial reports if the team is focused on self-interests, since it supports accounting treatments that fail to reflect true and fair economic status of accounting elements (Maines et al. 2003, p. 76). According to IFAC (2005), conceptual framework equips accounting and finance staff with adequate knowledge on financial information for decision making, based on accounting reports. One of the objectives of FASB is to provide equal grounds for understanding the purpose and nature of data provided by a company’s financial reports. Concept-based standards, therefore, meet this objective to the latter. The investing section of cash flow statement indicates cash flows of assets sold that are usually unnecessary for the company being reorganized. Judgment plays a bigger role in ensuring transparency and continuity of the company. Bragg (2011) notes that, companies need to evaluate their financial health and stability of their operations. Other than the top management level, financial calculation and evaluation are important for the overall company and its continuity. Managers need information from the finance unit in the resource allocation process and in facilitating the routine operations of the company. Judgment in financial reporting in government organizations is important for the government to take cause of action. Bajkowski (1999) states that regulators are able to use knowledge provided by financial reports to determine performance and make decision on whether to issue orders for closure or support. Since corporations are public entities, the government regulators will know when the government is needed to intervene. Current ratios, profitability ratios, liquidity and ratios are ratios that organizations are expected to apply regulations provided by international accounting standards. They also provide knowledge on ratio analysis, which organizations will require in decision making. This knowledge is also used by investors, managers and regulators. Through professional financial judgment, managers can gauge the market performance, liquidity, efficiency, gearing and profitability of the company. Stakeholders can review the performance through ratios expressed in percentage, fractions or statements, rather than lengthy financial statements. The usefulness of ratio analysis is attained by comparing Company ratios over different financial periods or against same ratios of other Companies in the industry. Judgment in financial reporting such as ratio analysis also has its own limitations. Financial judgment can discourage effort of employees and might also be abused by top managers and demean other workers in the company. Due to firms operating in different environments, market structures and industries, comparison of companies’ performances might be faulty. This can be solved by only comparing firms operating in similar industries, using similar ratio categories and rationalizing the rates to consider business environments. Since ratios utilize accounting information, the analysis might be less useful. This is because some accounting policies limit comparison through estimates and assumptions. It also utilizes historical information, which might not be needed by users. This is solved by implementing certain intervals for calculation of the ratios and updated calculation to the recent period. Illustration: Case study Enron Founded in 1985, the American based Company, Enron indicated spectacular growth. The company got into records among top performing and most admired companies in the United States. The company was formed as a result of amalgamation However, in the year 2001, after a disclosure of major financial tax returns and information pertaining to the returns, following investigations, the company was declared bankrupt and later reorganized. This was after the resignation of its president, Jeffrey Skilling. Misappropriation of financial statements was the main cause of Enron’s downfall. Judgment was vital in establishing that the company was using, special purpose entities, offshore entities and tax shelter arrangements. Use of the key judgments like employee compensation arrangements at Enron, including tax-qualified retirement plans, nonqualified deferred compensation arrangements, and other arrangements, in order to analyze the factors that may have contributed to the loss of benefits and the extent to which losses were experienced by different groups of employees. Bibliography Humayun M. Kabir 2008, Positive Accounting Theory and Science.Journal of Centrum Cathedra. Sun S. K. & Qin J. Y 2006, Executive compensation, investment opportunities and earnings management. Journal of accounting, Auditing and finance. Vol. 21 No.2 New York Bragg, S. M 2011, Wiley GAAP 2012: Interpretation and application of generally accepted accounting principles. Hoboken, NJ: John Wiley & Sons. McCarthy, J. H., Shelmon, N. E., & Mattie, J. A 2012,  Financial and Accounting Guide for Not-for-Profit Organizations. Hoboken: John Wiley & Sons. Balakrishnan, R., Sivaramakrishnan, K., & Sprinkle, G 2008, Managerial accounting: Models for decision-making. Hoboken, N.J: Wiley. Bajkowski, J 1999, Financial ratio analysis: Putting the numbers to work. AAII Journal. World Bank., & International Monetary Fund. (2005). Financial Sector Assessment: An Handbook. Washington, D.C: World Bank and International Monetary Fun Print. Alexander, D, & Archer, S 2008, International Accounting/Financial Reporting Standards Guide 2009. Chicago: CCH. Wm Morrison Supermarket 2012, Annual report and Financial statements 2011/2012. Wm Morrison Supermarkets PLC < www.morrisons.co.uk/corporate/investor- centre/Financial-reports/> Benston, GJ, Bromwich, M & Wagenhofer, A 2006, ‘Principles verses rules based accounting standards: The FASB’s standard setting strategy’, Abacus, vol. 42, no. 2, pp. 165-188, viewed 31 March 2014, Maynard, J 2013, Financial accounting, reporting, and analysis, Oxford University Press, Oxford. Norton, CL, Diamond, MA & Pagach, DP 2006, Intermediate accounting: Financial reporting and analysis, Houghton Mifflin Co., Boston. IFAC 2005, International Public Sector Accounting Standards (IPSASs) and statistical bases of financial reporting: an analysis of differences and recommendations for convergence, International Federation of Accountants, New York. Maines, et al 2003, ‘Evaluating concepts based vs. rules based approaches to standard setting’, Accounting Horizons, vol. 17, no. 1, pp. 73-89, viewed 31 March 2014, Papadopoulos, P 2011, Approaches and theories to standard setting in accounting, GRIN Verlag GmbH, München. Read More