Divergent Aspects That Contribute to the Problematic Construction of Economic Reality - Coursework Example

IMPLICATION FOR FINANCIAL REPORTING Student’s name Code & Course Professor’s name University City Date Contents 1.0 Introduction 3 2.0 Brief information about Economic Reality 3 3.0 Issues in financial reporting 5 3.1 Regulating Financial Reporting 5 3.2 Measurements and recognition 6 3.2.2 Different Methods of Measurement 6 3.3 Accounting for Fixed Assets 8 3.4 Measuring Performance in Corporate Reports 9 4.0 Conclusion 11 Reference List 12 1.0 Introduction The very essential premise of financial reporting is to offer an unbiased, complete and informative view of a business’ financial performance; with respect to a well-defined set of standard consistently used across various companies. Reports no longer offer an accurate depiction of the reality of the business, with important messages lost in the clutter of regulatory jargon and lengthy disclosures. Theoretically, researchers conceptualized accounting measures as a subsequent measure of the long-term or future financial performance. There are a renewed interest in the credit risk assessment of, propelled by the requirement of the explosive growth credit derivatives and Basle II market. Additionally, the concern regarding the lack of theoretical backing if the traditional accounting-ratio-based models, has resulted to the change of the valuation methodology. This paper seeks to present divergent aspects that contribute to the problematic construction of economic reality. The paper draws its analysis through the understanding of different accounting issues that pertains to accounting. This will systematically cover a number of issues that link to the problematic construct of economic reality. 2.0 Brief information about Economic Reality Economic reality is essential in determining various accounting factors in the economic platform. Nevertheless, the problematic construct of accounting reality implicates the very basis of accounting; provisioning of accurate data essential in dispensing economic functions. Various approach to economic reality as subject to inaccurate data and inefficient methodologies in determining various accounting principles. Given that accounting offers a communication between the managers and shareholders, the normative viewpoint assumes a stewardship position. Pepermans (2006) articulates that the shareholder delegate the company’s operation decision to the management, hence developingan agency relationship between the management, as agents and shareholder, as principles. The first aspect of the stewardship theory embodies the relationship where the agent’s goal conflicts to that if the principal. Simply put, the agency values the effects of the decision on the principal’s utility and follows the intended objectives in generating higher cost (Pepermans, 2006). Positive viewpoint assumes an agency relationship. Simply put, agency theory suggests that in the case of imperfect capital and labour markets, managers sought to maximize their functions at the corporate shareholders’ expense (Kothari, 2010).Nevertheless, agents have the propensity tofunction in their interest as opposed to the firm’s interest due to asymmetric information (Kothari, 2010). Financial, operating and investment decisions have divergent international implications. These implications are based on accounting information that is subject to quality from divergent point of views. King (1993) advocates that the significance of accounting consolidates in its universal value as functionality at all development stages of human society. Both normative and positive approach define financial reporting as a means of representing economic reality (Watts, 2003). They are however limited to the overreliance on efficient market hypothesis, and it assumes that the market is a representation of reality. Although accounting based approach is widely considered as an essential measure of a firm’s performance, it significantly hampers the usability of the approach. This approach necessitates the organisation if the knowledge that handles order, relationships, methods and objectives pertaining accounting practice (Johnson, 1979). While accounting developed in the practical arts, it was subject to evolving theoretical premise (Johnson, 1979). Under the practical approach, however, the accounting has relied in the trial and errors as an approach aimed at improving accounting practise in divergent aspects (Johnson, 1979). Consequently, theoretical approach has created meaningful patterns that have enhanced the general principles and procedures essential in the business transactions and events. 3.0 Issues in financial reporting 3.1 Regulating Financial Reporting Although the regulation imposes a certain degree of equality within a specific class of users, a significant scope for preparers in distinguishing different users exists. Regulators of this manner have incentives of certain forms of behaviours; i. The regulators demonstrate their effectiveness in enforcing regulatory standards in the international or regional markets ii. It is highly likely that the objectives of fair pricing can be achieved (Bushman and Landsman, 2010). iii. If the importance of financial regulators is to oversee fairness between the participants of capital, markets, it may imply that the users have equal access to the financial reporting (Watts, 1977).As such, fairness and regulatory standards is importance in ensuring accurate financial reports are presented; hence present economic reality in economic construct. The normative justification is that integration of international policies will improve consistent decision making through conforming to specific regulations and avoid cognitive mistakes. Tentatively, if the regulations are aimed at improving the maximum benefits are routinely chosen. Then affected parties will be better off in the long run. If international regulations are perceived as a positive exercise, its significance on some policies is uncertain. Whereas affected nations are consolidating international standards, there is no guarantee that all subjects will benefit from consolidating international policies. 3.2 Measurements and recognition 3.2.1 Different Measures for Similar Things Money has a time value; hence a dollar today will be more than a dollar in the future for the simple fact that an invested dollar today can yield more in the future. An imperative rule in finance is that the sum cash flows from a different point of time should never be measured before adjusting time value for money. Failure to make adjustments is likened to adding apples to oranges. Pure historic accounting posits that profits of a specific period represent the difference between fair share of historic cost and revenue recognised (Hult, 2008). Since market values are essential decision-useful information, fair values in reporting are an imperative aspect than information in the income statement. The former, therefore, assumes the primary financial statement whereas income statement offers a difference in net assets (Chambers, 1993). 3.2.2 Different Methods of Measurement Evidently, as witnessed below different calculation offers different result that may inadequately depict economic reality.Asset inclusion is imperative since it offers extensive analysis on the products depreciation.Depreciation may have different values, given the method used; economic reality with respect to depreciation is thus not clearly articulated (Allena, 2008); i. The straight-line method results in a stable and uniform revenue reduction in an asset’s values in all the accounting periods of the asset’s life. ii. With respect to the unit produced in a particular period, the depreciation expense in units-of-production will be higher or lower and may have an increased or reduced effect on assets and revenues. iii. Sum-of-the years digits results in an increased accelerated write-off of the asset as opposed to the straight line approach. iv. The assets and revenues, in the double-declining balance method, are considerably reduced in the asset’s life, as a result of increased depreciation expense, and less in the subsequent years. Inventory The chosen inventory method affects the amount of gross profit income and current asset, specifically in changing prices. The choice of inventory approach reflects on the firm’s economic circumstance, in creating accurate financial statement. As such, in times of falling prices, FIFO results to a lower gross profit, ending inventory, higher cost of goods and assets. Contrastingly, LIFO’s outcomes are typified by higher gross profits, ending inventory lower cost of goods and current assets, and the reverse applies for rising prices(Cotter, 2003). The normative view suggests that even though there is an agreement in the assumption from the results, they ultimately result to different measurements and recognition proposals in presenting economic reality. The rationale provided in support is in the case when the reporting is involved in the accounting, and all other transactions are showcased as irrelevant in the accounting purpose. On the other hand, positive view suggests that managers should obtain high selling prices for the capital assets used, regardless of the company’s depreciation strategy. 3.3 Accounting for Fixed Assets Impairment; if the value reduction is permanent, it result to the adjustment of the depreciation plan commencing from the subsequent accounting period. Pursuant to the IFRS/IAS, the devaluation is subject to be registered analogously (New York Times, 2012). Evidently, the IAS 16 indicates that potential cases when the value reduction can be accounted (New York Times, 2012). Depreciation; The indicators of devaluation takes into account the normal wear and tear. However, there is no standard rule that describes what a reasonable wear and tear is. Nonetheless, fixed assets are subject to the wear and tear. Thus, the value of the asset decreases every year((Allena, 2008). Over time, valuing such assets was challenging, resulting to unattainable valuations. This presented a cycle of write-downs as firms found it the impossible to rationalising valuations. Contrariwise, an increase in the asset’s value is never reported on the income statement. Thus, it is credited on an equity account known as “Revaluation Surplus” (Brown, 1992). About the positive viewpoint, therefore, the effects of the revaluation surplus leave out information that would otherwise assist in the true depiction of valuing assets. Since its reporting is not made on the financial income statement, economic reality is not accurately depicted. The question on these items is that the exclusion of these assets owned by the firms are not included in the balance sheets. In the positive view, on the other hand, the wear and tear attributes significantly contribute to the dispensation of incomplete information that would otherwise impact the results of the financial statements. This aspect can be proved through valuing the depreciated levels of the assets. 3.4 Measuring Performance in Corporate Reports The accounting numbers approach specifically used under the accounting ratio based models, are modelled through a large number of accounting ratio of underperforming and successful firms (Keats and Hitt, 1988). Tentatively, the very nature of the statements derived from these models cast a doubt of the validity or economic reality. These include; i. The accounting numbers are subject to manipulation by the affected management. Evidently, it is realized that the background earnings management is limited to the manipulation of the accounting figures, as opposed to profit manipulation involving real business situation. Falsification, on the other hand, involves the dispensation of wrongful data. ii. Hillegeist (2004) suggest that since accounting statements are prepared through a going-concern basis, they are inherently limited instrument in focusing the bankruptcy. Positive view argues that the fair value is a limited measure and managers can easily manipulate information(Chambers, 1993). Evidently, managers reported earnings for the purpose it serves. As such, it offers variations in wage growth, the discount rate, equity return spreadand discount rate spread rate. The normative view, on the other hand, advocate that the accounting numbers are insignificant since they are computed through multiple variations base(Watts, 2003). Smoothing The term income smoothing is linked with creative accounting, manipulation of earnings and aggressive interpretation of acceptable accounting principles(Hillegeist, 2004).Perhaps the firms might increase its allowance of the doubtful accounts with huge charges to bad debts expense in the years (Hillegeist, 2004). Normatively, on average and over a considerable length of time, a firm’s instability has limited or no effect on the budget balance. Hence, trade openness has limited effects on budget balance through its effect on instability of the firm’s revenue. Contrariwise, positive viewpoints cannot explain the trade openness on budget balance through the firm’s instability(Watts, 2003). Moreover, it cannot explain the high budget deficit experienced at firm level. Earnings Management The problem is that managers use the judgment to create opportunities for earnings management, where the managers choose a reporting method and estimates that inaccurately depicts economic reality (Healy and Wahlen, 1999). Accelerating expense strategies also known as “big bath”, involves sacrificing current earnings to improve future earnings. For instance, a firm may front load expenses in its current period with an aim of reducing expenses in the latter period. However, challenges to earnings management are confronted by a number of issues, including, but not limited to a proffered method of accounting and a set of records and books(Healy, 1999). Positive view argues that the rewards of reduced volatility results to reduced cost of capital (Chambers, 1993). The reduction can propel the reduction of the risk premium. Applying a long term management, nevertheless, has a positive effect on the company’s credit rating. A normative approach argues that earnings management has a negative consequence resulting to financial disasters(Watts, 2003). 4.0 Conclusion Presumably, the lack of efficient and dependable disclosure carries the inherent defects in presenting economic reality. The modern economic regulation, however, seems to focus largely on understanding the defects of the regulatory solutions. Manipulation of accounting number questions the very ethics of accounting information in provisioning accounting reality. Despite the usefulness of earnings management, most managers are seen to manipulate information to improve predictability hence reduce the perceived economic reality. Fair value, on the other hand, offer limited information hence is insignificant in offering measures. Evidently, smoothing is increases with outside shareholder’s ownership stake since it increases the insider’s incentives in managing outside anticipations. However, manipulation of accounting numbers has a profound effect on economic reality across divergent aspects. Moreover, the use of divergent measuring approach ultimately result to different measurement and recognition proposals that may be insignificant in depicting proffered economic reality. The lack of international policy regulations adversely affects the accounting principles in that different regions have a different approach to measures in accounting. Reference List Allena, F. & Carletti, E., 2008. Mark-to-market accounting and liquidity pricing. p.358 Brown, P., Izan, H. Y., & Loh, A. L. 1992. Fixed asset revaluations and managerial incentives. Abacus, 28 (1), 36–57. Barney, J., 2002. Gaining and sustaining competitive Advantage. 2nd Ed. Upper Saddle River, NJ: Prentice hall. Bushman, R., and Landsman, W., 2010.The pros and cons of regulating corporate reporting: a Critical review of the arguments. Available at . Chambers, R. J., 1993. 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