Accounting Regulation - Literature review Example

ACCOUNTING REGULATION Name Course Tutor Institution Date Accounting Regulation Accounting regulations provide guidelines for firms to report their economic transactions and events (AASB 2004, p. 2). Accountants have to follow the requirements of the relevant accounting standards, when they are preparing their firms’ financial reports. The introduction of Australian Accounting Standards Board (AASB) has brought major changes on how entities should account for, and report payments that are related to share values, for example, share based payment option (AASB 2004, p.2). The use of share based payment has been in use since 1970’s (Bloomberg 2006, p. 55). A share based payment is a transaction whereby an entity offers its equity instruments after receiving goods or services (Bloomberg 2006, p. 55). An entity can choose to incur liabilities for amounts that are relative to the entity’s equity instruments or shares (Bloomberg 2006, p. 55). Many companies in Australia use equity based pay to link the interests of the executives to the interests of the owners. The executive prospers when the shareholders prosper, which is the idea of capitalism, which according to Buffini (2006, p. 8), is the best engine for prosperity. Accounting regulation has led to new accounting standards that have led to the need to change financial statements in share based payment options (Buffini 2006, p. 8). There are, however, cases of diversity in the application of accounting standards, when managing and reporting share based payment methodologies in Australian firms. I, therefore, agree with the statement by Hines (1988, p. 253) that there is nothing like the truth, but the fact that the truth can be stretched too far, exists. Hines (1988, p. 253), in his studies argued that in financial accounting, reality is only constructed when it is communicated. In addition, Hines (1988, p. 254) claims that people create their full picture by communicating what they believe in. The first objective of this essay is to explain why companies choose to use share based payments to their executives and argue that firms do not have an empirically based understanding of how to manage share based payment methods, due to regulated accounting standards. In this essay, I will use the example of issues in share based payment methods to prove that there is either little or no truth in the ways accounting regulations are used to manage, or report share based management methods. According to Emanuel (2005, p. 49), there has been a gradual rise in the use of share based payment component in various firms in Australia. Emanuel (2005, p. 49) states that stock options align the interests of the executives to those of the shareholders. Emanuel (2005, p. 49) adds that options are only valuable if the price of the stock remains above the strike price of the option. In addition, they are counted as the expense of the corporate (non-cash) which influences the income statement of the firm and enhances transparency of distribution of options to shareholders. The nature of the capitalist economy states that having serving stakeholders is important in increasing corporate value. The executives are inspired by the share based payment option because, when the shareholders or owners of the firms prosper, they also prosper (Chalmers & Godfrey 2005, p. 170). The value put on the stock or the shares in any company are important factors in determining the profit. Wrong interpretations of accounting standards can lead to errors, either over statement or understatement in stock, which has a direct impact on the profitability of a firm (Carroll 2006, p. 1). Kitney and Buffini (2006, p. 22) states that IAS 2 acts as an example of creativity in accounting because it serves the role of reducing choices of valuation methods, and making sure there is efficient disclosure. According to Buffini (2006, p. 8), creative accounting is a communicating technique whose purpose is improving the nature of information that is offered to investors. The use of different choices of valuation methods makes it hard for accounting to reflect the truth as stated by (Hines 1988, p. 254). The failure of Enron serves as a good example of overstatement and understatement of profits due to the use of inappropriate valuation methods with the purpose of reporting favourable financial performance. I agree with Hines (1988, p. 254) that there is little truth in the application of accounting standards because in some cases, corporate governance of share based payment is not forceful enough, raising issues. Lack of robust corporate governance can be evidenced in the case of Enron’s failure in December 2001. Enron serves as a good example of failures in the adoption of fair value measurements (Kitney & Buffini 2006, p. 22). According to Leiden (2006, p. 25), the AASB exposure draft, Fair-value measurements requires companies to determine fair values in reference to the market prices of the same assets being level one, similar assets being level two and internally generated estimated values and present value in the cases where prices are not appropriate, being level three. In the case of Enron, there was extensive use of level three, and in some cases level two was used to make estimates during Enron’s internal and external financial reporting (Kitney & Buffini 2006, p. 22). There was, therefore, a misuse of fair value accounting due to lack of understanding when to use level two and level three fair valuations (Kitney & Buffini 2006, p. 22). Enron’s financial statements were complex, and this was very confusing to analysts and shareholders. According to Leiden (2006, p. 25), Enron used unethical practices and a complex business model with the purpose of misrepresenting earnings and modifying their balance sheet to report favourable performance. The case of Enron signifies that little or no truth exists in accounting standards. The argument by Hines (1988, p. 254) that there is no truth or the truth can be stretched too far, can be witnessed in the ways AASB has been very slow in developing effective standards for new types of financial conditions and standards shares based payment transactions. This has resulted in accounting standards being vulnerable to subjective interpretation and unnecessary complexity (Buffini 2006, p. 8). A share based payment option has been exposed to several controversial accounting practices. Various errors occur from inappropriate accounting and failure to identify different types of share based payments. One of the examples of the common errors of failing to identify share based payments is limited alternative loans, known as limited recourse loans that directors are given, to allow them make shares subscriptions (Buffini 2006, p.8). According to Carroll (2006, p. 1), at the beginning of the arrangement, there is no exchange or movement of funds, and while the shares are offered to the directors, they are kept in trust until the loan, which is equivalent to the receivable price of the shares has been fully paid. Carroll (2006, p. 1) explains limited recourse loans as the loans that are secured against the shares given to the director. The effect of this kind of loan is that, if the value of the shares fall, the company takes ownership of the shares and sells them to settle the debt. According to Chalmers and Godfrey (2005, p. 158), this kind of arrangement is an example of share based payment options, but many firms fail to recognize it as one. BusinessWeekOnline (2006, p. 1) explains that in such a case, a director has two options; when the share price falls, the director fails to pay the loan and the arrangement ends or when the share prices increases, the director may choose to pay the loan and benefit from the gains from the shares Carroll (2006, p. 1). Consequently, whatever the choice the director makes, the arrangements can be equated to having been given a share option that is priced at a similar amount of the limited recourse loan. Many firms may fail to recognize such an arrangement as a share based payment option leading to incorrect entries in the financial statements (Chalmers & Godfrey 2005, p. 160). While the fair value of the option need to be determined, some firms may fail to use an option pricing model to account the amount as a share based payment, because the accounting standards do not provide for such an arrangement, leading to falsity in the reported financial statements. I agree with Chalmers and Godfrey (2005, p. 170) that when a company and its directors or management personnel enter an arrangement, where share based payments are embedded in convertible notes; there is little truth in the way accounting standards are applied. Chalmers and Godfrey (2005, p. 170) arguments are in line with the quote by Hines (1988, p. 254). According to Chalmers and Godfrey (2005, p. 170), arrangements where share based payments are embedded in convertible notes, are arrangements structured in such a way that accounting standards cannot be clearly interpreted to show that two instruments, share based payment and a loan are being issued, and not one of the above. They are also structured in such as way that it is not apparent that the fair value of the instrument is greater than the proceeds received (Emanuel 2005, p. 40). When such is the case, the option of embedded equity includes the embedded share based payment (Emanuel 2005, p. 40). The entity, which is the company benefits from the services of the directors or managers, while they are being paid through issuance of loans and a share option offered at discounts from the combined fair value (Fisher & Wise 2006, p. 35). (IASB 2004, p. 34) states that IAS 39 Financial Instruments: Recognition and Measurement requires that the transaction price should be determined from the fair value of the financial instrument as one. Consequently, the financial instrument will seem like it does not have an equity component, although it has a conversion feature, due to the fair value of the transaction price being the same as the liability component (IASB 2004, p. 34). Regulation of accounting standards fails to give the actual truth when such is the case because the arrangement has two contracts, share based payment and a loan. The above analysis based on IAS 39 Financial Instruments: Recognition and Measurement requirement, only gives consideration to the loan component, but fails to consider the share based payment option (IASB 2004, p. 34). Accounting regulation, therefore, fails to give the complete truth when accountants are reporting financial statements that have arrangements consisting of two contracts, a loan and a share based payment Accounting regulations do not have efficient requirements because when shares are given to executives by their owners, the complete truth in reporting of financial statements is not given (Fisher & Wise 2006, p. 35). In some cases, an entity may choose to issue shares and instead of issuing new shares that would categorically fall into share based payment arrangement; some of the existing shareholders may instead choose to transfer part of their shares (Fisher & Wise 2006, p. 35). Sometimes, an entity may have restrictions on the issuance of new shares. The existing shareholders may, on behalf of the entity, give their own shares according to the proportion of their shareholdings (Gray 2006, p. 54). In other cases, it is more tax effective for an investor who owns one hundred percent of an entity that is starting up, to transfer some of his existing shares on behalf of the entity, rather than the entity giving new shares (Gray 2006, p. 54). According to IASC Foundation (2005, p. 12), some firms misinterpret the requirements of IAS 2 on the grounds that because there is no issuance of new shares, the arrangement of transferring ownership of shares from existing owners does not exist in the scope of IAS 2. IASC Foundation (2005, p. 12) gives a clear highlight of the requirement of IAS 2.3A, which states that a shareholder or another group can settle a share based payment in place of the recipient of the goods or services. While some firms may not have the clear interpretation of the requirement of the standard, IAS 2 is clear that any transfers made by a shareholder, in addition to shares that an entity is issuing on itself can lead to share based payment (IASC Foundation 2005, p. 12). IAS 2 however, does not account for transactions made between an employee and an entity within the capacity of the employee as a holder of equity shares being share based payment transactions. According to Kaplan and Ruland (1991, p. 370), such arrangements may come up within family owned businesses, whereby family members transfer ownership of shares to change ownership from one generation to another. Accounting regulations, therefore, have not given provisions for when such transactions within family members are viewed as compensation for services (Kaplan & Ruland 1991, p. 367). An example is when a family member who is receiving large transfers of shares and is the only family member who has been working in the related business for a period to the point when the business is announced in the public market. Such a transaction should be viewed as share based payment for the services of the family member. Many firms will not report the transaction as a share based payment because it was among family members, and this financial statement reporting lacks truth because there was payment of services offered to the entity. In conclusion, I agree with the quote by Hines (1988, p. 253) that there is a lack of truth in accounting regulations and at times, the truth is stretched too far. The role of accounting regulation is to set standards that provide guidelines for financial reporting. There is evidence of diversities in the interpretation and application of any accounting standards in share based payment methods, which lead to errors in financial reporting. Errors in reporting of stock option grants in Enron and its manipulation of fair value trading, serves as a good examples of the fact that sometimes the truth is stretched too far in accounting, as a result of wrong interpretations of accounting standards. Reference List Australian Government – Australian Accounting Standards Board, 2004, ‘AASB 2 Share-based Payment’, Australia. Bloomberg (anon), 2006, ‘McAfee hit by stock-option virus’, in The Australian Financial Review, 31 July, pp. 55. Buffini, F R, 2006, ‘Executive incentives fail the test’, The Australian Financial Review, 14 August, pp. 8. BusinessWeekOnline, 2006, http://www.businessweek.com/investor/content/jun2006/pi20060602_552084.htm Carroll, P, 2006, ‘The private management of public regulation: The need for research’, Occasional paper presented to the School of Accounting and Corporate Governance, University of Tasmania, August. Chalmers, K, & Godfrey, J, 2005, ‘Expensing stock-based payments: A material concern?’, Journal of International Accounting, Auditing and Taxation, Vol 14, pp. 157-173. Emanuel, D, 2005, ‘Accounting for share-based payments under NZIFRS-2’, University of Auckland Business Review, spring, pp. 39-44. IASB - International Accounting Standards Board, 2004, ‘IASB issues final statement on accounting for share-based payment’, news release 12/16/2004, International Accounting Standards Board, www.fasb.org/news/nr121604_ebc.shtml Fisher, C, & Wise, V, 2006, ‘An exploration of the earnings impact of share-based payments’, Third International Conference on Contemporary Business – Conference Proceedings, Sydney, September. Gray, P, 2006, ‘Share-based payments: A serious issue’, Intheblack, October pp. 54-56. Hines, RD 1988, ‘Financial accounting: in communicating reality, we construct reality,’ Accounting, Organizations and Society, 13(3), pp. 251-261. IASC Foundation, 2005, ‘International Financial Reporting Standard 2 Share-based Payment, John Wiley and Sons Australia Ltd’ Kaplan, SE & Ruland, RG, 1991, ‘Positive theory, rationality and accounting regulation,’ Critical Perspectives on Accounting, 2(4), pp. 361-374. Kitney D & Buffini, F, 2006, ‘ASIC offers reprieve on tough reporting rules’, The Australian Financial Review,7 August, pp.1, 11. Ledden, M, 2006, ‘Ready to meet the challenge’, National Accountant, April/May, pp.22-26. Read More