Advanced Accounting Principles and Practice - Literature review Example

Topic: Advanced Accounting Principles and Practice Name: Professor: Institution: Course: Date of Submission: Introduction The practicing of accounting as a discipline is quite challenging because there are many situations that call upon one to make a judgmental decision which will have a widespread impact on the company (Jacquet & Miller, 2002). This puts managers in a very tricky situation as they must select the accounting criterion that provides information that is most all stakeholders of the company. In the process of making these reports, managers sometimes face the dilemma as they have choose whether to give true and fair reports or alter them so as to report larger gains; the latter being a better option given that their jobs would be at stake if they report the company’s poor performance as would be the case. Efficiency accounting is where managers select accounting policies that accurately provide accounting information on the firm’s performance. Opportunistic accounting on the other hand occurs when managers choose accounting procedures that mislead the public about the firm’s performance with an aim of making personal gains at the expense of shareholders and other stakeholders. In this paper, we will review three articles that concern accounting practice and managerial policy selection criteria. This paper documents the various accounting theories in light of these two accounting perspective (Curtis & Averis, 2010). This paper will also examine the measurement and reporting of intangible assets and financial instruments and the impact of the above two accounting perspectives on this practice. Accounting for intangible assets and financial in instruments presents a situation where the manager has to make a choice between two competing accounting policies. This person may either make a choice based on the existing accounting standards or may choose an accounting policy that suits his or her circumstances. In this paper we seek to unearth the reasons behind the accountant’s choice of one accounting policy over the other. Review of Literature The Role of Accounting in the Knowledge Economy This section specifically emphasizes the importance of intangible assets and intellectual capital in today’s economy. It also clearly outlines the limitations of traditional accounting practice in measuring and reporting on these assets; methods of accounting for these assets, limitations of these methods and the role of accounting in the knowledge economy. Some companies have introduced an intellectual property repot as supplementary to the annual financial reports. This measure enhances the ability of investors to better understand the value and the potential of the hidden intangible resources of an enterprise in order to make better informed judgment about its capabilities to perform in the future (Neish, 2009). The expanding impact of intellectual capital and intangible assets requires expanding potential value domains to include: business relationships; human competence; internal structures; social citizenship; environmental health and corporate identity. According to this article, intangible assets can account to as much as 85% of the company’s perceived value which is something companies have to start managing like physical and financial assets. It is therefore imperative that companies in this new age and error incorporate the measurement and reporting of intangibles as strictly as possible. It is suggested that accounting standards should be developed to measure and report not only on externally generated intangible assets but also for the internally generated ones. Intangible assets in this case include patents, mastheads, brand names, copyrights, research and development, and trademarks (Barth, Landsman & Lang, 2008). Failure to accurately account for these assets would lead to problems like higher capital cost, misallocation of capital and decreased incentives for entrepreneurs and knowledge workers. It for this and other reasons that the author insists on the need for accounting boards to come up with accounting standards both for externally generated intangible assets and the internally generated ones. It is very difficult to value and measure the actual value of intangibles through the use of traditional accounting model. There are various reasons for this. One reason is the fact that the accounting, controlling and management instruments or tools have not kept pace with the economic realities of the last few decades making it possible to measure and only report on physical assets and not intangibles (Schroeder, Clark Cathey, 2010). Another reason is the nature of the intangible asset which makes it difficult to be measured because there is no direct relationship between an intangible asset and a financial outcome. Intangible assets can be measured in three ways: using the balanced score card; the Intangible Assets Monitor and the Skandia Navigator. The balances score card is a method which combines financial with non-financial measures, such as internal business processes, learning and growth and various customer-related measures in order to give a comprehensive view of the organization’s performance. The Intangible Assets Monitor is a method with a presentation format, which displays a number of relevant indicators for measuring intangible assets in such a way that all stakeholders in the organization will be able to understand the valuation of these assets (Barth, Landsman, Lang & Williams, 2007). The Skandia Navigator focuses on five key areas for the future success of the company: financial, human, customer, process, renewal and development focus, and how they reflect the organization’s performance. These affirmations posit that we are yet to have adequate accounting and reporting standards for intangibles and that for quality decision making, standards should be established and upheld not only for externally generated intangible assets but also for the internally generated ones. Value Relevance of Financial Assets’ Fair Values: Case of China A report on the research conducted to investigate any change in value relevance of financial instruments following the implementation of the fair-value accounting standards in China is presented in this case. The financial instruments in question were those held for trading and the financial assets available for sale (Chen, Tang, Jiang & Lin, 2010). The traditional accounting practice was based on historical costing while the International Financial Reporting Standard had a basis on fair-value reporting. Fair value method provides more relevant information to investors while historical cost provides more relevant information. Financial instruments held for trading are also known as financial assets or financial liabilities at fair value through profit and loss. They were initially being valued using the historical cost method. Whereas this information was reliable, it is relevant to decision makers such as managers and more so investors made it questionable. It was quite difficult for investor to know the true value of their investments and also the amount of dividends they are entitled because the historical cost method was inadequate in reporting these matters. It became very important that the accounting regulatory body in this country (Curtis & Averis, 2010). Held to maturity financial instruments are non-derivative financial assets with fixed or determinable payments and a fixed maturity date that management intends to and is able to hold to their maturity. Their accurate measurement is very vital to the investors, managers and other stakeholders as it informs their decisions on various aspects of the entity. For investors, they will be able decide whether to invest in these securities or not based on the performance of the previous ones. According to International Financial Reporting Standards, these securities are initially recorded at their fair value and subsequently recognized at amortized cost using the effective interest method. This gives a true value of these financial instruments. The fact that many organization in various countries were reluctant to apply fair value costing and other International Financial Reporting procedure they believed their countries were unique with a completely different economic environment demanding for distinct accounting practices. However, it became evident that the accounting procedures being observed by these countries were giving relevant information for decision makers and it is only the observance of international accounting and reporting guidelines that would yield relevant information. The application International Financial Reporting Standards gives more valuable information than the traditional reporting standards that were based only on historical costing. Various studies have been conducted on the relationship between emotions and the accounting method. This was aimed at improving the explanatory power of the positive accounting theory. The studies seek to establish the reasons behind decisions made by managers in regard to the accounting methods used. The goal of the study was to show the role of manager’s cognitive biases on the choice of the asset revaluation method (Curtis & Averis, 2010). One hundred and twenty Tunisian managers were assed to establish what influences their choice of an asset revaluation method, whether it is the commitment to adhere to established standards or their desire to increase their personal wealth and promote other individual interests. Any leader threatened by the loss of social status seeks to enhance it at the head of his company through accounting choices such as assets revaluation. It may not be good for the company nor the leader to see the company consistently reporting declining asset value. This may have devastating effects on the company’s contracts with creditors and even investors may shy away from investing in it (Jacquet & Miller, 2002). When this happens, the management will put to task to explain why the trend is as such and if they fail to provide a clear way out of this situation, they will risk losing their jobs. As a result of this the management may keep reporting positive financial performance and position of the company even when the company is evidently performing poorly. The positive accounting theory can be used to explain the management choice of various accounting policies, asset revaluation method being one of them. For instance, the firm would change their accounting methods to recognize their assets from historical cost to fair value in order to minimize their contracting costs. The asset revaluation can be used as a tool to lower the debt/equity ratio in order to avoid default costs. Upward revaluations help avoid violations of debt covenants and improve the firm’s borrowing capacity by reporting a lower leverage ratio. They can also be used as signals of a growth opportunity as well as liquidity problem. To avoid past losses, CEOs are encouraged to use assets revaluation to create a special reserve revaluation to improve equity. This is a choice of an accounting procedure most suitable for the financial condition the company is in. This clearly indicates that managers are free to choose the accounting procedure to use based on the financial circumstances surrounding the firm (Christie & Zimmerman, 1994). Given this possibility, managers can at some point choose to apply accounting procedures that will give misleading information for personal gains. This is known as opportunistic accounting as it is aimed at promoting the managers’ selfish interests and no necessarily the interest of the company as a whole. This research established that emotions play a significant role in the choice of an accounting procedure by managers. Indeed, we cannot underestimate the impact of these cognitive bias frames on the quality, reliability and relevance of accounting information disclosed. Given the effects and benefits of the personal, social and professional biases, the cognitive defects imply that it is important to control them. Analysis A theory is a coherent group of propositions or principles forming a general and explanatory framework. There are so many accounting theories which can be classified either as positive or as normative theories. Positive theories explain and predict accounting practice while normative theories prescribe what a particular accounting practice should be. According to (Richard et al, 2010), positive accounting theories describe what is without indicating hoe things should be. Normative theories on the other hand are based on a set of goals that prescribe the way things should be. The positive accounting theory focuses on relationships or contracts between principles and agents, what is known as the agency relationship. Examples of such relationships are the shareholder/manager where the shareholder is the principle while the manager is the agent. We also have the shareholder/creditor relationship in which case the creditor is the principle while the shareholder is the agent (Ciftci, 2010). This theory focuses on informational asymmetries and how various stakeholders in a company exploit them. Information asymmetry is a state in which one party in company has access to more information about the firm than the other, a situation which gives the former an opportunity to exploit the later. The theory assumes that both the principal and the agent are economically rational, motivated solely by self-interest and self-wealth maximisation and act opportunistically. This simply means that all individuals in an organization are motivated by their self interest to maximise their wealth. Loyalty and morality have no place in the organization according to this theory and that the organization is a collection of self-interested individuals who agree to cooperate only to the extent it is in their interest to do so. This means that, given an opportunity, one party in an organization will easily exploit for self gain. Managers are in charge of the running of the company which is owned by shareholders. They manage all aspects of the company and at the end of the financial period, they report on the performance of the organization and financial position of the entity. Sometimes, there rewards and remunerations are dependent on the performance of this company (Schroeder, Clark Cathey, 2010). This tempts them to report positive performance even when the company is not performing well. This may also happen when these managers fear losing their jobs as a result of continued poor performance of the company. To protect their jobs and increase their remunerations, these managers give false reports concerning the performance of the company. This is referred to as creative accounting. According to the AASB Conceptual framework, unrecognized externally acquired identifiable intangible resources are expensed and may not be later written back as an asset. They must stay written off since they are not assets but were written off as expenses (Sangiuolo & Seidman, 2009). However, a manager in company whose value of assets is declining may in an attempt to win back investors’ confidence choose to write back such an asset. This will increase the asset value of the company in the eyes of investors and the general public when in real sense the company is running out of assets. Such a practice by managers will be an opportunistic and selfish move to select accounting methods that do not add value to the organization. After the initial recognition of an externally acquired intangible asset at cost, an entity must choose whether to measure the assets using the cost model or the revaluation model. Under the cost model, the asset is recorded at its initial cost and is then subject to periodic amortization and impairment testing (Neish, 2009). Amortization is not required if useful life is indefinite. Under the revaluation model, the asset is first revalued upwards or downwards to its fair value, and is then subject to amortization of this value over the remaining useful life and impairment testing. Amortization not required if useful life is indefinite. The revaluation model is only used if there is an active market. An unethical and dishonest manager may choose to revalue the asset even when there is no active market A financial instrument is cash, an ownership interest in another firm or a contract that conveys an obligation and a corresponding right to require delivery exchange of a financial instrument. The right may be contingent such as an option or unconditional such as a loan. A financial instrument is ultimately convertible into cash and does not involve delivery of goods or services. Examples of financial instruments include financial assets, financial liabilities, derivative instruments, equity instruments and pervasive issues like offsetting and fair value measures. All these financial instruments have unique measuring reporting requirements, (Rosemarie Sangiuolo, Leslie F. Seidman 2008) Financial instruments held to maturity are initially recorded at the fair value with subsequent adjustments being made to fair value. Changes in the carrying amount are then recorded in the profit or loss account for that period. The revaluation process must be accurate enough as to reflect the market share of the asset and not more or less the value. Based on the positive accounting theory, managers may choose to use the effective accounting policy selection the opportunistic accounting selection policy. With the effective policy, they will choose the revaluation method that is in line with the set accounting standards. However, if they choose any other method apart from the accepted standards, then this will be opportunistic accounting which should be discouraged. Normative theories seek to provide guidance in selecting accounting procedures that are most appropriate. They prescribe what should be done to ensure that financial reports being made are true reflections of the financial performance and financial position of the firm in question (Ciftci, 2010). The conceptual framework is considered a normative theory. It seeks to identify the objective of General-Purpose Financial Reporting. This theory seeks to provide recognition and measurement rules within a ‘coherent’ and ‘consistent’ framework besides identifying the qualitative characteristics financial information should possess. It also makes recommendations that depart from current practice but which are aimed at improving the accounting and reporting standards. Other normative theories include the stakeholder theory, the legitimacy theory and the institutional theory. These theories are based on the assumption that the entity is influenced by the society in which it operates, and in turn it has an influence on that society (Elbannan, 2011). The stakeholder theory states that managers should manage the entity for the benefit of all stakeholders. It has two branches: the ethical branch which prescribes how stakeholders should be treated and the managerial branch which seeks to explain and predict how an organization will react to the demands of its various stakeholders. The legitimacy theory posits organizations continually seek to ensure that they operate within the bounds, rules and norms of the specific society in which they operate while according to the institutional theory explains why organizations within particular ‘fields’ tend to take on similar characteristics and form. Conclusion In conclusion, the management base on both the efficiency and opportunistic criteria in selecting financial accounting policies. However, the extent to which these arguments form the basis for accounting policy selection varies from one firm to another. A larger number of managers base on the efficiency approach as it is the acceptable accounting procedure which creates investor confidence in the firm and guarantees the firm’s future success. These are managers who endeavour run the affairs of the company for the benefit of shareholders and the public at large. They subordinate their interest to the interest of the firm as a whole. The ex ante or “efficiency” argument holds in this case. While this is the case for a number of companies, there are also other companies whose managers do not have any interest in the company’s welfare. Their commitment to integrity and other ethical concerns is questionable. They are managers who will use creative accounting at the slightest opportunity in order to promote their interests and this is done at the expense of the company’s economic welfare (Neish, 2009). Their selection of accounting policies will be mostly informed by their opportunistic tendencies and therefore. In their measurement and reporting on intangible assets and financial instruments, one would find many inconsistencies in the application of accounting policies. The ex post or “opportunistic” argument will hold in this case. References Jacquet, J & Miller, W. (2002). The accounting cycle: a primer for nonfinancial managers Fifty-Minute series. Edition2, revised, Crisp Publications. Curtis, V & Averis, L. (2010). Bookkeeping For Dummies. John Wiley and Sons. Neish, B. (2009). Computer accounting using MYOB business software. Edition12.McGraw- Hill. Schroeder, R, Clark, M & Cathey, J, 2010, Financial Accounting Theory and Analysis: Text and Cases. Edition10, John Wiley and Sons. Sangiuolo, R & Seidman, L, 2009, Financial Instruments: A Comprehensive Guide to Accounting and Reporting. CCH. Christie, A & Zimmerman, J, 1994, Efficient and Opportunistic Choices of Accounting Procedures: Corporate Control Contests. Accounting Review; Oct., 1994, Vol. 69 Issue 4, p539-566. Elbannan, M, 2011, Accounting and Stock Market Effects of International Accounting Standards Adoption in an Emerging Economy. Review of Quantitative Finance and Accounting, February 2011, v. 36, iss. 2, pp. 207-45 Chen, H, Tang, Q, Jiang, Y & Lin, Z, 2010, The Role of International Financial Reporting Standards in Accounting Quality: Evidence from the European Union. Journal of International Financial Management & Accounting, Autumn2010, Vol. 21 Issue 3, p220- 278 Barth, M., Landsman and M. Lang, 2008, ‘‘International Accounting Standards and Accounting Quality,’’ Journal of Accounting Research 46(3) (2008), pp. 467–498. Barth, M., Landsman, M. Lang and C. Williams, 2007, ‘‘Accounting Quality: International Accounting Standards and US GAAP,’’ Working Paper, Stanford University and University of North Carolina. Ciftci, M, 2010, Accounting Choice and Earnings Quality: The Case of Software Development. European Accounting Review, 2010, Vol. 19 Issue 3, p429-459 Read More