Management Accounting - Essay Example

 Management Accounting- THE NEED FOR CHANGE Accounting – A Critical Evaluation 1. Introduction Accounting has been considered as a neutral, factual and neutral representation of social reality and has been considered as helpful in assisting human beings in making decisions (Gaffikin, 2006).This image of accounting has been propagated for a long time by the account setting bodies and institutions. According to Wyatt (2002, p3) accounting is defined as “discipline that seeks to provide information about a business entity”. The two major subfields of accounting are management accounting and financial accounting. While management accounting gives information to those inside an entity like management or managers, financial accounting gives information to those outside an organization like investors, shareholders, government etc. Many individual country studies have been done on the national management accounting practices all over the world (Broomwitch and Wang, 1991; Amat etal, 1994 etc). However, the investor confidence has been deteriorating internationally in the accounting process because of the widespread occurrences of creative accounting and scandal. These two common events have created serious concerns among the investors globally. This has changed the image of management accounting as an objective discipline and showed the political nature of accounting. Many individual country case studies have been done to evaluate the existing management accounting practices globally (Broomwitch and Wang, 1991; Amat et al, 1994; Adlegan, 2000). Given this background, this essay critically evaluates the subjectivity of management accounting and the various images and practice that have shaped the subjectivity debate. The organization of the essay is given below. Section 2 discusses the debate regarding convergence to IFRS and true and fair value concept. Section 3 discusses the creative accounting in detail. Section 4 concludes the essay. 2. Convergence to IFRS and true and fair value concept The two widely used and accepted sets of accounting standards are, the US GAAP and the International Financial Reporting Standards (IFRS) The two account setting bodies behind these are Financial Accounting Standards Board (FASB) and the London based International Accounting Standards Board (IASB)(Warren,2005). It is argued that the convergence of national accounting standards and IFRS has advantages like internationally comparable financial information with high quality. Moreover, it is supposed to obtain other benefits of globalization (Purvis et al, 1991). At the same time this has created serious concerns in many nations also in spite of the above mentioned benefits of financial reporting under IFRS. The main reason for this concern is that though it has many advantages, it may sometimes avoid country specific interests (Barton, 1999). The internationalization can lead to the emergence of many account setting bodies which can have their own specific interests that can be in conflict with the interests of a particular nation. These groups can have the dominating power in such cases and the specific interests of a nation can be ignored. This has been a debatable issue in the recent years. IFRS has many major requirements, among which the main is the need for fair value reporting of their financial matters by the public companies in their financial statements. Based on this approach, the exchange price estimates need to be the basis for the asset and liability measurement in some cases. These prices need to be in a transaction at present and between parties who are not associated with each other and are known (Landsman, 2006; Ryan, 2008). However, this approach has raised many questions among the different scholars later. There have been many concerns regarding the fair value approach. In case of illiquid markets, the fair values can be obtained only by adjusting for illiquidity. Here, the market to market values or market to model values will be the adjustment done for estimation of fair values (Landsman, 2006). The reliability of fair values in such cases is questioned. In the case of non active market financial instruments, like privately placed loans, this is very much true (Landsman, 2006). On the other hand, this argument is rejected by others since it is necessary for the managers to show all information regarding fair value estimation reliability to FASB (2008). The error probability is reduced by the estimation of fair value estimates again and again each quarter. For non active market financial instruments, the figures can be manipulated or misinterpreted by managers according to their own self interests.Hence the reliability of such estimates are questionable. The two alternatives for this are Amortized Cost Accounting (AMA)1 and mixed attribute accounting2 .When the fair value accounting is compared with these two ,many have obtained the fair value as accurate and good(Ryan, 2008). In case of skewed distribution for the future cash flows, there can be wide difference between cash flows which are expected and cash flows that are most likely to occur. In this case, there is a tendency for fair values to be more close to most likely future cash flows. In this case, reliability of fair value estimates is questionable (Landsman, 2006). This case is also justified by Ryan (2008). The justification is based on the possibility of cancellation of the fair value estimation revision in the direction of most likely future cash flows and expected cash flows .On an average, thus the fair value estimate change that are not expected will have a value zero. The above two criticisms have not been accepted by the GAAP and the IFRS regarding the true and fair value reporting. This is still needed by them. The reason is that no other reliable alternative has been widely accepted for the true and fair value reporting. There are separate ways of reporting the arrangements for rent, lease and hire under the existing country specific GAAP. On the other hand, a uniform method of reporting of all these is demanded by IFRS. The need for prohibiting the interest methods of depreciation and amortization by IFRS is also questionable(ASB, 2001). This has created serious doubts among the investors globally. The reason is that single accounting method considers separate treatment of some short-term arrangements. They have many advantages and at the same time many costs. In most cases, the advantages will be more than costs .So the exclusions in this regard will be high (EFRAG, 2009). This has been refuted by EFRAG (2009). They made it clear that the single accounting method will be treated uniformly and no exclusion case will be permitted. The viewpoint of lessee is considered throughout under IFRS. However, the view point of lesser is considered to be more appropriate by EFRAG (2009) for taking important decisions and rules. Another point is to examine the differences between control and ownership of an entity. This is needed for the implementation of IFRS since an entity needs to be classified in a particular group. The power for direction of an entity is meant by its control. On the other hand, voting rights based on rules and other advantages etc are included in ownership. However, there is no clear distinction between them. This is because when an authority can control an entity, they will automatically get some rights also based on law and vice versa also. .Due to this, it becomes very difficult to differentiate between control and ownership at the time of financial reports preparation under IFRS. Furthermore, the level of financial development is a main determinant of the ownership concentration in different countries which can vary widely (Ding et al, 2007). Hence, under IFRS, producing consolidated financial statements for different nations will be rally difficult. Due to the differences in the de recognition approach to financial instruments, IFRS can be problematic. It can differ based on country specific formalities .Hence, an international consensus is better in this regard .(ASB, 2001). There has been no clear dealing for the revenue component in many countries by any accounting standard. Due to this, different industries and businesses have shown the reporting of their revenues in an inconsistent manner. Since different sectors and businesses have separate ways and rules for revenue reporting, it will be really problematic while adopting uniform methods of reporting under IFRS. In this case also, an international consensus is suggested to be more practical (ASB, 2001). One major issue of concern under the implementation of IFRS is the classification of financial instruments. The distinction between debt and equity is ambiguous in many countries. The existing GAAP rules do not clearly differentiates these two. Another problem is the stringent definition for equity under IFRS. In addition to these, the definition of equity under IFRS is little bit stringent. Due to this, the equity and debt classification in many countries can overlap and can create lot of problems. This can have adverse effects on many financial instruments and the quality of information in financial statements while IFRS is implemented. There is an option for deviating from the standard GAAP rules in some special cases based on the fair value estimation. This is highly controversial option. In the case of inability to produce quality financial reports based on existing rules, it is very helpful to use the above provision. There are problems with the comparability of financial reports in different nations due to this flexibility option. There is also possibility for the managers to get more discretionary power under this provision, which can become problematic based on the method of usage of this power by the managers. This very much debatable.(Livne and McNichols, 2009). In some cases, this can lead to the figure manipulation or misinterpretation called c creative accounting. All companies are demanded to have uniformity in their rules regarding financial statement preparation and accounting treatment based on GAAP (Warren, 2005). In case of misinterpretation of the financial statements by the firm managers for their own vested interests, it will lead to creative accounting in most cases. Amat et al(2000) has pointed out the different factors that have explained the variations in national management accounting practices in different countries as government, taxation, price controls, the protection and competition, the profession of management accounting existing in a country, academics ,ownership of the firm, bonus schemes , inflation, other country influences, objectives and propensity to manipulation. In China, it has been pointed out that since 1980, the accountant profession did not have a high regard .This has resulted in an adverse effect on the development of accounting profession in China. In UK on the other hand, there has been a strong and well-supported domestic accounting system traditionally. The accounting profession grew as a independent discipline here for sting the business needs. It has been pointed out that the management accounting system in some nations like China has been under the influence of foreign country cultures and is reported as almost consistent with these country practices (Solas and Ayhan, 2008). At the same time Amat et al (2000) has shown that UK has been one among the two countries where no foreign influence is found on the accounting principles .This clearly points out the strong domestic accounting system existing in the country. Studies like Bhiman, (1996); Lizcano(1996), Amat et al(2000) etc have pointed out that only in UK has a professional body specifically for management accounting called Chartered Institute of Management Accountants (CIMA) . This has been acting as a support mechanism for the management accounting system there. On the other hand, in China, there has been a lack of this type of support mechanism for management accounting profession (Liao and Bisman, 2008). It has been identified that the taxation system has a major impact on management accosting practices in a country (Amat etal, 2000). In some nations like China, comprehensive tax reforms especially income tax reforms including uniformity and standardization of taxes have been implemented since 1994 aimed at moving towards a market-oriented economy with efficient macroeconomic control. However, studies show that in spite of these reforms, the Chinese tax system has been quite unstable, many problems are still left unattended and severe constraints still exist in the income tax system (Tsang and Yukshing, 1994; Flader Jr, 2009).In UK on the other hand, tax system has been robust and relatively developed as shown by studies(Highfield, 2007). The tax rates are extremely high in both China and UK. In UK, however there are lot of personal allowance and other schemes to reduce tax burden while in China there are no such provisions existing. Hence, tax burden is very high in China. Bhimani (1996) has shown that many small firms in different countries, in their attempt to avoid the tax burden prefer to under represent income through book keeping adjustment .As a result, it becomes impossible to record the actual financial flows by the management accounting system. Thus, the high tax burden can have adverse impacts on the management accounting system in China unlike UK. 3. Creative Accounting As mentioned above, one main reason for creative accounting is the possibility to deviate form the standard rules in special cases by the managers and using these for their own specific interests. Based on this approach, the exchange price estimates need to be the basis for the asset and liability measurement in some cases. These prices need to be in a transaction at present and between parties who are not associated with each other and are known (Landsman, 2006; Ryan, 2008). There is an option for deviating from the standard GAAP rules in some special cases based on the fair value estimation. This is highly controversial option. In the case of inability to produce quality financial reports based on existing rules, it is very helpful to use the above provision. There are problems with the comparability of financial reports in different nations due to this flexibility option. There is also possibility for the managers to get more discretionary power under this provision, which can become problematic based on the method of usage of this power by the managers. This can be the main reason for creative accounting. It is argued however that this option cannot be leading to creative accounting always since there can be costs also in case of misuse. In some cases, this can be very high and hence managers may be discouraged to figure manipulation. Even these costs may not discourage the managers in this regard, for the firms where the management itself enforces a self-serving contract. This again will result in creative accounting. There can be many motivating factors for creative accounting called share price effects, borrowing cost effects, bonus plan effects and political cost effects (Mulford ,2002). In the first case, the share prices figures reported will be very much different from the actual ones due to the manipulation by the managers. This is to make the investors believe in the high earning power of firms or to make the government believe about their low profits. This can have consequences on the costs for corporate borrowing. Another main reason for figure manipulation is the desire for bonus maximization by the employees. In the last case, companies want to reduce the taxes they pay and hence will believe others that they have only very low earnings. In any case, the issue of creating accounting has adverse effects for many including investors, accounting and business community, government and for a whole nation. The issue has to be seriously dealt by thoroughly analyzing the root causes and motivations behind it. There have been differing views about the different methods of creative accounting. The solution and cause of the problem can be true and fair view as shown by the discussion here. 4. Conclusion In this essay, the image of management accounting as a factual, neutral and realistic representation of society has been critically evaluated in detail. The essay shows this image set up by the accounting institutions is highly questionable, given the widespread financial frauds occurring all over the world due to manipulation of financial statements by the reports. Moreover, there were many consequences for the financial reporting based on IFRS as shown in the discussion. According to the critics, the most important problem is the ignorance of country specific cultural differences under IFRS. On the other hand, the account setting bodies who set up IFRS are supposed to have many specific interests which can be in conflict with the specific interests of nation. Hence, their vested interests will be more reflected in the financial reporting under IFRS which can contradict with the common man’s preferences in a country. References Adelegan, O.J (2000): “An Empirical Analysis of the relationship between Cashflow and Dividend Changes in Nigeria”, a paper presented at the 23rd Annual Conference of the European accounting Association, in Munich, Germany, March 29-31, 2000 Amat, J., Carmona, S. and Roberts, H. (1994) “Context and change in management accounting systems: a Spanish case study” Management Accounting Research 5 pp. 107- 122. 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