Accounting Issues - Assignment Example

Case Study – Letter from Prison: External Reporting Issues Insert Date Case Study – Letter from Prison: External Reporting Issues Introduction This paper answers six questions from the case study, a letter from Prison by Soltes. In this case study three component issues which are; ethical, accounting and research, have been singled out. Stephen Richards; who wrote the letter to Eugene Soltes, is the ex- head of sales at Computer Associates International. He is now serving a seven-year prison term for financial fraud. In this case study, Richards gives answers to a number of questions raised by Soltes concerning managerial responsibility and how financial performance was manipulated. Ethical Issues 1. Critical evaluation of the ethical position adopted by Richards in justifying his actions Richards explains that Computer Associates (CA) was very aggressive in the pursuit of its goals. In a number of instances, he and the CEO would exert significant pressure on their teams to meet the goals they had set. This was probably because performance was measured by internal goals at the executive level; where targets were primarily driven by the expectations that the outsiders and analyst community had on CA. Additionally, the ability to demonstrate both improved competitive and financial performance was viewed as critical to success. Richards argues that his behaviour which included tactical execution was the result of these pressures and expectations. Non-performance was not acceptable at CA and the demonstration of improved financial and competitive performance was critical to success. The pressure to perform led to the acceptance of behaviours which blurred the lines between legal and illegal, as it relate to the practices to achieve the decisions made. These behaviours left the organization vulnerable to a wide variety of unethical and illegal practices commonly practiced by the large technology companies. These practices though legally accepted, clouded the ability to get the true picture of the organization’s health through its financial statements. From an ethical point of view, accounting ethics provides the guidelines and moral values that professionals need to follow while they are carrying out the accounting practice (Bolt-Lee & Moody, 2010). Users of financial information like shareholders and potential shareholders rely so much on the annual financial statements of a company to make informed decisions on whether to invest in the company or not. According to Brooks and Dunn (2010), these shareholders rely on the judgment of the accountants who prepared the financial statements as well as of the auditors who verified them to give them a reasonable and accurate picture of the firm. The Generally Accepted Accounting Principles (GAAP) requires that aspects of; relevance, comparability, reliability, consistency, revenue recognition, matching principle, and materiality among others should be reflected in the presentation of accounting information (Epstein, Nach & Bragg, 2009). The other aspects that should be considered are the materiality, conservatisms and industry practices principles. Materiality according to Epstein et al. (2009) allows the accounting professionals to consider certain amounts less important depending on their size in comparison with the expenses and revenues, assets and liabilities or the net income. Industry practices principles allow the fair presentation of the results of operation and financial position of particular industries to deviate from the traditional accounting theory. This could be because of the peculiar nature of events or practices that are common only to the specified industry; in the case of Richards’s scenario, it is the software industry. Conservatism allows accountants to choose solutions that are least likely to overstate incomes and assets. These three principles gave room for the practices Richards embraced; which from an analytical point of view, amount to creative accounting. Usurelu, Marin, Danaila and Loghin (2010) define creative accounting as the utilisation of accounting practices that are in line with the rules of GAAP but deviate from its spirit. Despite the fact that Richard argues that the pressure to perform and expectations of the analyst and investors made him apply aggressive accounting practices, his behaviour was unethical and illegal as it amounted to misleading stakeholders and defrauding of the company. 2. Critical evaluation of who was responsible for the content of the final reports In Richards’s opinion, operating in the gray areas of accounting is a difficult task that required more guidance from the senior management. The senior management wanted an improved financial and competitive performance since performance was critical to the success of the company. Consequently, pressure was placed upon the management of which Richards was a member, since they were responsible for financial reporting. The management thus opted for accounting flexibility options to meet this pressure and expectations. Accounting flexibility according to Wang and D’Souza (2006) comes into perspective when the game of financial numbers is played and reporting flexibility is not used for fair representation. Instead, the financial numbers are used with specific accounting principles through aggressive application. In this manner, the flexibility of the GAAP is stretched beyond its intended limits with a main purpose of altering financial results and financial positions. This is done in order to create potentially misleading impression concerning the company’s business performance. Instead of succumbing to management pressure, Richards could have opted for other accounting methods to summarize and report outcome of his sales transactions. These methods include; the cash basis, the accrual basis and inventory valuation techniques among others among others. The preferable method that Richards could have adopted is the cash accounting method where revenue is recorded when cash is received from the customer and expenses are recorded when cash is paid out. According to Wang and D’Souza (2006), this approach provides minimal opportunities for manipulation, deceit and misrepresentation of financial data. Brandt, Biesebroeck and Zhang (2012) argue that this approach will force the company to concentrate on one accounting rule and policy that is ethically accepted even if it does not provide them with their preferred image. Furthermore, this approach will minimize chances of unavoidable estimations, predictions and judgements that characterize flexible accounting (Bohren, Haug & Michalsen, 2004). Evans and Sridhar (2006) argue that this approach will reduce chances of entering artificial transactions to manipulate balance sheet figures and upscale profits between the accounting periods. In relation to how Richards dealt with the situation, it appeared he was forced by the management and the existing circumstances to utilize earnings management in order to relay an impression that the company was performing. According to Klapper and Love (2004), corporate governance sets the pace and determines the organizational operational culture. Practices that the management allows will definitely be practiced by the juniors as a way of conforming to the organizational system requirements. Additionally, the management has the overall responsibility of the accounting reports since the GAAP allows them to use the reporting style that best reflects their image (Brandt et al., 2012). Accounting Issues 3. Computer Associate’s motivations to manage earnings and the financial ratios as represented in the accounting statements From Richards’s answers it is evident that both external and internal pressure motivated the management of earnings; a practice in which the management uses judgement in its financial reporting to alter financial reports (Brooks & Dunn, 2010). Richards confessed that he and the CEO exerted pressure on their teams to achieve the goals they had set for themselves. Additionally, expectations set by outside parties, specifically the industry savvy analyst community and the institutional investors influenced the utilization of earnings management. Demonstration of improved competitive and financial performance was critical to business success as they determined the buy-sell-hold decision of institutional investors which was made based on the analyst information. The analyst opinion was never influenced by strategy but by execution. The execution efforts motivated and drove Richards’s focus in the business. According to Kasznik and Lev (2005), the management can wish to display a certain level of earning or follow a certain pattern in financial reporting through aggressive accounting in order to woe these analysts and investors. This is carried out through searching for loopholes in financial reporting guidelines and allowing the adjustment of numbers as much as is practicable to realize the desired goal or satisfy the projections set by the financial analysts (Kasznik & Lev, 2005). Additionally management of financial performance had become a widely practiced science in the technology industry as seen in practices like reserve manipulation, product release lattés, and sales incentives among others. These practices are legal despite the fact that they cloud the ability of getting a true picture of the organization’s health through the financial statements. Managerial flexibility blurred the distinguishing lines between legal and illegal as it made these practices subject to individual interpretation. The main goal of these behaviours was to meet expectations of the organization and achieve performance. In essence, this led to inability of the framework in place to classify behaviours as legal or illegal since only inconsistent rules for the organization to operate on were left. 4. Critical review of different international accounting standards that allow software firms to recognize value of licensing contract as revenue The GAAP requires that revenues from software licensing be recognized once the contract is signed, the software delivered, and payment reasonably assured (ASSB, 2008). Once these three conditions have been met, the software firm could go ahead and recognize the entire value of the licensing fee as an income or revenue. CA had recorded the entire present value of the licensing contract in the specific quarter when these three revenue criteria were met as required by GAAP. GAAP additionally requires that all the revenues are recorded when they are realized or realizable or when they are earned and not necessarily when the cash is received (Epstein et al., 2009). The International Financial Reporting Standards (IFRS) requires that revenue be recognised when monetary amounts is received. In this respect, the value of the licensing contract will be recognized as revenue when their monetary value has been received (Epstein et al., 2009). This standpoint affirms that the booking of revenue at the end of the quarter when the monetary value has been received is in line with the IFRS requirement. The revenue recognition additionally stipulates that revenue can be recognized under four types of transactions in licensing contracts. First of all, they can be recognized at the date of sale or date of delivery, when service has been completed and billed, when the assets or software have been used or at the point of sale. In all these scenarios, it is a requirement that the values of licensing contracts should be recorded in the first quarter as revenues. According to the Australian accounting standards; commonly referred to as the A-IFRS issued by the Australian Accounting Standards Board (AASB), revenue should be recognised from contracts under five steps. These steps are; Identifying the contract with the customer, Recognizing the separate performance obligations specified in the contract, Determining the price used in transaction, Allocating this transaction price to the different performance obligations as stipulated in the contract, and Recognizing the revenue when or immediately the entity fulfils each performance obligation (AASB, 2008). Additionally, AASB requires that revenue be recognized when it is feasible that future economic benefits which can be measured reliably, will flow (Bolt-Lee & Moody, 2010). The culture at CA which allowed accounting flexibility and management of earnings could not enable the satisfaction of these requirements. Management had found it difficult to forecast earnings and revenues for each quarter and in addition; failed to warn the analyst of unexpected shortfalls. In this respect, adoption of creative accounting strategies was seen as the only alternative, which in turn created a unique culture at CA. Research Component 5. Concept of income proposed in this project in reference to the IASB The Comprehensive Income Project (CIP) implemented by the IASB has a main objective of providing guidance on how comprehensive incomes of all entities can be reported (Cauwenberge & Beelde, 2007). This project involves amending IAS 1(presentation of financial statements) to a system of reporting that requires a single and continuous statement which captures other comprehensive incomes (OCI). According to Cauwenberge and Beelde (2007), the comprehensive income project eliminates the presentation of separate statements for profits or losses and other comprehensive incomes. These entities will all be presented in a single continuous statement that covers both the profit and loss statement and other comprehensive incomes for the specified period. According to Cauwenberge and Beelde (2007), the present IASB accounting model utilises a mix of two income determination systems; fair value accounting and historical cost accounting. Historical cost accounting makes use of asset values that are based on the actual money amounts paid for assets. No adjustment for inflation is made in this respect and hence only realized income is utilised. Current accounting standards make use of historical accounting apart from the few exceptions which include net realisable value and fair value and other revaluations. Fair value accounting utilises the fair value of assets or the amount at which they could be bought or sold in a present-day transaction between willing parties. This method of accounting provides more transparency compared to historical cost accounting as indicated in IFRS 13 (Cauwenberge & Beelde, 2007). The payment of executive bonuses will not be affected by the CIP since they form part of expenses. 6. Critical review of two academic research papers that differently asses the value and information relevance of comprehensive income Comprehensive income has been defined by Dana (2009) as all changes in stockholders equity during a specified period. These changes are non-inclusive of those that result from stockholders’ investment and dividend. Comprehensive income is obtained by adding or subtracting other comprehensive income (OCI) from net incomes. This author claims that most companies report comprehensive income in their financial statements in three ways; on the annual income statement, in a different statement of comprehensive income, or alternatively, in the stakeholders’ equity statement. This author further argues that comprehensive income consists of four items of a company which are; Any unrealized gains or loss in the reasonable value of investments Specific pensions plan gains, losses and any prior service cost adjustments, Specific gains and losses on derived financial tools and Any translation alterations from changing the annual financial statements of foreign operations into local currency. Whittington (2008) argues that the comprehensive income is simply an attempt to measure the total of financial and operating events that have worked to change the value of the interest the owner had in a business. In this author’s perspective, comprehensive income is calculated on a per-share criterion so that the effects of options and dilutions are captured. IASB recommends that earnings per share should be calculated for profits or loss attributable to the ordinary equity holders of parent entity (Epstein et al., 2009). Earnings per share have to be presented as both basis and as diluted earnings per share amounts. Instead of relying on the weighted average number of shares to measure the earnings per share the IASB can utilize an average number of shares since they give the actual figure of the existing shares. Conclusion In conclusion, the behaviour by Richardson though legally acceptable was unethical as it involved use of aggressive accounting strategies to portray a picture of improved performance. This behaviour was carried out n order to woe investors and to make more sales. Bibliography AASB (Australian Accounting Standards Board). 2008. Amendments to Australian accounting standards to facilitate GAAP/GFS harmonisation. http://www.worldgaapinfo.com/australia.php. Viewed April 5, 2012. Bolt-Lee, C. E., & Moody, J. 2010. Highlights of finance accounting ethics research. The Journal of Accountancy, 27: 85-94. Bohren, O., Haugh, J., Michalsen, D. 2004. Compliance with flexible accounting standards. International Journal of Accounting, 39: 1-19. Brandt, L., Biesebroeck, J. V., & Zhang, Y. 2012. Creative accounting-creative destruction? The Journal of Development Economics, 47: 339-351. Brooks, L. J., & Dunn, P. 2010. The business and professional ethics for executives, directors and accountants. Mason, OH: South-Western Cengage. Cauwenberge, V. P., & Beelde, D. I. 2007. IASB comprehensive income project: Analysis of the dual income display case. A Journal of Accounting, Finance and Business Studies, 43: 1-26. Dana, D. 2009. New comprehensive income. Journal of Competitiveness, 3: 21-32. Epstein, B. J., Nach, S., & Bragg, R. 2009. The Wiley GAAP 2010: Interpretation and application. Hoboken, NJ: John Wiley & Sons. Evans, J. H., & Sridhar, S. S. 2006. Multiple control systems, accrual accounting, and earnings management. Journal of Accounting Research, 34: 45-65. Whittington, G. R. 2008. 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