Framework of Accounting - Essay Example

Framework of Accounting - Introduction Present world is dynamic and changing constantly in its thirst to achieve the best possible alternatives of economic excellence. Many transactions take place on a daily basis, monetary benefit realization being the sole big driver for their evolution. In this run, it becomes highly important that the results of such transactions are recorded regularly so as to provide an account of such happenings, the result thereof and also predict the future visibility. Accounting is one such function which provides the guidelines for reporting for all types of entities – corporate, partnership, sole-trader etc. While accounting for sole trader and partnership are taken up only for the purposes of tax reporting, corporate accounting is widely shared across the world so that the information can be accessed by the various users who may be affected by such information. Naturally, with a wide user base, if the reporting is not done on certain specific guidelines, interpretations may widely differ thereby destroying the very purpose of reporting. To avoid such discrepancies, a framework of concepts have been developed which bind the information into understandable statements with the underlying obligation of “relevance, objectivity and feasibility” (Anthony & Reece, 1994). These concepts combined with the three golden rules of accounting viz. Personal, Real and Nominal form the language which conveys the same meaning to all the people (Shukla, Grewal and Gupta, 2008). A small description of these concepts would give a bird’s eye view on the basics of accounting language: Money Measurement Concept: Transactions of the entity have to be measured in monetary terms. Business Entity Concept: The business is an individual in the eyes of law and the people who run the business are different from the business itself. Going Concern Concept: From the date of inception, any entity is assumed to be immortal and it has no death. The people who run the business may change but the business is perpetual. Cost Concept: Goods and services acquired are to be recorded at cost. Dual Aspect Concept: Any income is an outcome of some benefit foregone called the expense. As such, any asset is the result of liability undertaken to acquire that asset. The equation is Asset = Liabilities +Owners’ equity. Accounting Period Concept: Financial reporting has to be done for a particular period of time, usually for a year. All transactions which take place in that year have to be recorded in the books of that period. Conservatism Concept: Anticipated losses have to be recorded but gains have to be recorded only if they are materially recognized or confirmed as realizable in the near future. Realization Concept: Gains/income has to be reported when realized. Matching Concept: As far as possible, expenses of one period have to be matched to the incomes which arise due to those expenses. Consistency Concept: Accounting practices have to be standardized every year; statements are to be reported in conformity to those standards so that they are consistently understandable. Materiality Concept: Reported facts should have value of significance. Non-significant matters need not be reported to decrease the burden of over reporting to the user of accounts. The above mentioned concepts, (Anthony & Reece, 1994), give a picture of a silver line within which the financial statements are placed conveniently. However, due to the increasing diversity of the nature of transactions, it becomes imperative that a periodical review of the set standards is taken up so that the book-keepers do not face any confusion while recording such transactions. For this sake, International Accounting Standards Committee (IASC) and such account standards periodically to guide the users towards a standardized version of financial statements. After 2004, it was decided that issue of new standards are to be done only in compliance to the International Financial Reporting Standards (IFRS) to avoid future confusion in data reporting (Investopedia, 2008). An internal review of the standards issued by the IFRS and the underlying concepts guiding them along with some live examples would help us understand the practices which the accountants are supposed to follow today: Accounting Framework: IFRS suggests that general costs are to be recorded in the historical cost concept except for certain items like Property Plant and Equipment, derivatives, investments, biological assets and others which are volatile in nature have to be recorded according to their fair value which is in sharp contrast to the Historical Cost Concept. This argument is further strengthened with the second point wherein over ride of standards are granted in certain cases to ensure true and fair view of financial statements. This stance is popularly adopted in the case of depreciation wherein assets are valued to the market value. However, if we take for instance, insurance sector, wherein valuations have fallen drastically, recently, the industry men are trying to report their earnings in the form of embedded value (EV) which may be dubious as the investors may not understand as to when and how much the value would fall before it rises up. Hence care needs to be taken while audit of such entities. Further extension to this framework is inscribed in the point that effective from the date of reporting, entities should embark on full retrospective application of all IFRSs with some optional exemptions and limited mandatory exceptions. Accordingly, conceptual dilemmas are to be examined for the following primary statements: Balance Sheet: It has its base on the Dual Aspect Concept which stresses that Assets = Liabilities +Owner’s Equity. No particular format prescribed. Consolidated statements for two years are to be presented for effective comparison. Voluntarily, companies can also present single-entity and parent company financial statements in addition to the consolidated statements. Order of liquidity is to be followed instead of current/non-current statements. This goes along with the concept of Realization which means that assets should reflect values which are certain to be realized. In very rare cases, standalone presentations are allowed. This provides a strong base for consistency concept which requires the financial statements to be comparable and prepared within regular intervals. Also, as these statements are prepared for a set period of time regularly, the Accounting Period Concept is also adhered to. Previously, consolidated statements for three consecutive years were reported to adhere to the Securities Exchange Commission (SEC) regulations. The present IFRS regulations indirectly grant relief to the private companies that they can reduce the pain to harmonize only a set of two year statements instead of three years. Care should be taken while examining these statements particularly in a depressive year like the one we are facing, in which faltering companies come out with certain fallouts in reporting which can be easily continued in the coming futures as there is no record of the third previous year thus misleading the public. Income Statement: Expenses and income are presented according to their function or nature. If a parent company holds less than 100% in its subsidiary, it is called minority interest which is to be reflected on the face of the income statement. It should contain information about: Revenue and Finance costs Share of after tax results of associates and joint ventures accounted for using equity method. Expenditure on taxation Gain or loss post tax and discontinued operation if any, are to be accounted. The net profit or loss after accounting for all the above items is to be reported. In addition, exceptional items if necessary to bestow clarity are to be disclosed in accordance to the materiality concept. This statement strongly follows the money measurement concept wherein transactions of the business are measured in monetary terms. However, if we blindly go by this statement, the information may not be comprehensive as this should be read in combination to the notes to the financial statements which presents facts not based on money measurement techniques. The recent Lehman Brothers case is a classic example for interpreting the discrepancies which can be caused by going through the income statement alone. In this case, the company posted its first ever loss this quarter from the date of its inception. Readers may take it lightly that such ups and downs are common in periods of such depression. However, notes to the financial statements reported that it has demoted its president and Chief Financial Officer citing reasons of unimpressive performance. This has deteriorated the company’s rating by the accredited rating agency – the Moody’s. If we blindly go by the money measurement concept, this information is not material in nature which is still very crucial for investment decisions into the company and adheres to the Materiality Concept. Statement of Recognized Income and Expense (SORIE): The net income which results from deducting the expenditure from the income is directly reflected in equity through: 1. Fair value gains, tangible and intangible assets, investments and other financial instruments. 2. Foreign transaction differences 3. Accounting Policy changes and its cumulative effect 4. Actuarial gains and losses. If this statement is presented, there is no need to present statement of changes in share holder’s equity and vice versa in compliance to materiality concept which states that two similar statements need not be reported as the second statement may become insignificant. This statement is a slight deviation to the Conservatism concept which stresses that Revenue recognition has to be better evidenced than recognition of loss. According to this statement, both losses and gains are recognized on equal bases which may not be accepted by the users who have undergone the stress of the issue of Enron. The case details are that the company stated unusual profits to increase its Earnings per Share by recognizing gains which were unwarranted for and finally, when there were cross checks, it lost all its credibility and was completely washed off. Cash Flow Statement: Either of direct or indirect method can be followed. Short term, highly-liquid investments excluding the short term borrowings are recorded including the bank overdrafts. Separate classification of operating, financing and investment activities are to be reported. The Cash Flow statement is backed by the Realization concept which stresses on the amount which is certain to be realized. It over rides the concepts of matching and accounting period in the sense that it never cares to match the costs and revenues nor does it stress on the particulars to which period the cash was to be accrued. In addition to the above primary statements, clarifications are given by the IFRS regarding other topics which are important for clear presentation of the financial statements, namely: Definition of a Subsidiary: It is based on controllable capacity on voting control or governing power. Majority stake holders usually exercise these controls which stress on the concept of Business Entity stating that the parent company is a single individual and the company which it holds is an asset of the entity. As stated earlier, consolidated statements are to be presented as the shareholders of the parent company are the owners of the subsidiary also and they need to have fair information of the company’s dealings. If the subsidiary is put on sale, standalone reporting is allowed as the shareholders can understand the fair value of the asset under sale. A Business Associate company wherein the parent holds 20% or more interest, post tax results are shown in the parent company’s financial statements at cost or at fair value as discussed earlier in the accounting framework. Similar is the case with joint ventures and employee stock trusts. Business Combinations: All types are called as acquisitions. In this case, tangible/intangible assets like goodwill, liabilities/contingent liabilities are all recorded at fair value in compliance to the Realization concept and not according to historical cost concept so that the users of financial statements are assured of transparency. Accordingly in line to the realization concept future expected losses or liabilities as a result of such business combinations cannot be recorded. These items are re-assessed regularly at Cash Generating Unit level and any excess realized there of is recorded as income immediately in lines with the above mentioned concept. Disclosure of Purchase methods imply reporting of description and names of entities to be combined, acquisition date, fair values and the impact of such combinations on the financial position of the entity in that quarter to comply with the concept of materiality to disclose all important material facts. However, for combinations of entities under common control, such disclosures are not required as material differences are not violated in this case. Revenue recognition can be done when there is a transfer of risk and reward for which there is a reliable scope of revenue generation in lines with Realization concept. In cases of construction contracts, percentage of completion method is used to adhere to the matching concept wherein percentage of expenses incurred is allocated to the percentage of revenue realizable. Expense recognition has various heads under it. Depreciation: Contrasting the historical cost concept, this expense is deducted to reflect the fair value of assets in line with realization concept. Interest Expense: In line with accounting period concept, it is recognized on an accrual basis and non-cash financial charges are amortized to record the effective yield in line with the money measurement concept. Employee benefits: The embedded concept is that of matching wherein the services rendered by the employee are matched to the liability which the employer owes to him within a certain accounting period. These services are measured in terms of money or stock thereby complying to the money measurement concept. The dual aspect is also triggered when consideration is paid in monetary terms, employer’s liability increases, if paid in stock terms, equity increases and the counter effect is to be felt in the increased asset values. Contingent liabilities which occur after the balance sheet if materially sizeable may dent the belief of going concern concept. However materiality concept states that unless the loss is materially measurable that it impacts the future earnings of the entity, it need not be recorded. Disclosure to that extent has to be made in the next earnings statements. Recognition of provisions for restructuring is based on the concept of conservatism wherein anticipated losses due to such an exercise in the near future are to be accounted for so that the users get the clarity that the company was not involved in any unhealthy practices. Deferred income taxes are fully accountable in line with the conservatism concept, unless there is a probability of recovery, wherein, deferred tax assets are recognized only if it is more likely than not. Fringe benefits tax follows the matching concept that it follows the benefits which were instrumental in incurring such tax expense. Government grants are recognized as deferred income for amortization. Capital grants which represent a liability may be offset against the respective asset values following the Dual aspect concept and the Matching concept. Buy back of shares by the company for any reason, are shown as a deduction in the shareholders equity at cost following the historical cost concept. Profit or loss arising of subsequent sale of shares is shown as change in equity. Dividends are deducted from the shareholders’ equity in the statement of shareholders equity for the same accounting period in which they have been paid following the Accounting Period concept. Reporting of derivatives and hedging activities have to be recorded at fair value except the cash flow hedges which are directly recorded in the share holders equity until the basis underlying transaction is recognized in the income statement. Effective portion is recorded in the equity and the ineffective portion is recorded in the income statement. Similar treatment has to be taken up for losses due to these activities also. This is in line with the realization concept and materiality concept. A classic example for hedging losses is the subprime losses which many financial institutions had to report in this quarter. The worst hit being the ICICI bank which even induced its customers into fancy hedging instruments and the customers had later on pulled it to court to make good their losses. Currency definition follows the money measurement concept according to which the financial statements are presented in the currency in vogue in the country wherein the entity carries on its operations. If different currency is opted for, assets and liabilities are translated at the exchange rate on the balance sheet date. Average exchange rates are taken up to record the items in the income statement. The technology giants like Infosys and Wipro which have their presence all over the world take up this exchange rate exercise during their financial reporting. On acquisition of a foreign entity, goodwill is recorded at the closing rate following the realization concept. The closing rate is determined as the net of the payments made and the benefits received as such due to those payments. There can be instances of negative goodwill also. Earnings per share (EPS) disclosed by entities whose shares are publicly traded are the basis of the share price in the capital markets. It is calculated as profit available to shareholders divided by the average number of shares outstanding during the period. For the sake of comparison, EPS is adjusted for bonus issue and rights issue to follow the concept of consistency in reporting the true and fair EPS value to the shareholders. Disclosure of related party transactions like the total weight age of a particular creditor/debtor which implies that the business is partly dependent on that third party is of material importance and as such has to be made in the notes to the financial statements. The relationship of the related party, its name, terms and nature of outstanding balances, doubtful balances from that party if any to the company has to be sufficiently disclosed. Specific requirements are laid out for segment reporting, namely: scope, identification, measurement and disclosure. Scope: Listed and unlisted entities in the process of listing have to adhere to the guidelines. Further, all banks and Financial Institutions which have turnover of 500 million or above or whose credit disbursements exceed 100 million also have to adhere to segment reporting guidelines. Identification: Based on profile of risks and returns, similar products and services are grouped on basic six factors namely: focus on economic and political conditions, special risks, exchange control regulations and risks of currency. Threshold of segments: Segments of assets more than 10% of all segments subject to a condition that 75% threshold of segments are to be reported. Smaller segments are not reported as they are considered in pursuance to the Materiality concept. Accounting policies for segment reporting have to be in tandem to those adopted for consolidated financial statements to adhere to the concept of Consistency. Disclosure of discontinued operations have to be made at carrying value or fair value less costs whichever is lower following the conservatism concept and the money measurement concept. It has to be usually completed within a single Accounting period and separate classification on the balance sheet for the current period only has to be made with a special mention in the notes for both current and prior periods. This will ensure concepts of consistency of disclosure. The above mentioned treatments hold good even for post balance sheet events like unforeseen contingencies, non adjusting events, interim financial reporting etc. to make sure that the financial statements are in conformity to the concept of Consistency. Conclusion It has been observed that financial reporting which is currently done according to the guidelines of the IFRS follows to a great extent the underlying age old accounting concepts and over ride of such concepts is granted only if such need arises for fair and true presentation of all material facts to its users. One more interesting point to be noted here is that, confirming to one concept may result to overriding of another concept in which case, the concept which results in the ultimate transparency is preferred. Such a stance is taken up to ensure that entities do not involve themselves into dubious reporting. However, there are cases wherein tampering has been done which is against the IFRS, GAAP and the SEC guidelines and detection of such frauds may result in serious allegations like the one suffered by Enron recently. Book References: Anthony N. & Reece S., 1994, Accounting Principles, New Delhi, AITBS Publishers and Distributors. Reddy. D, 2004, Advanced Managerial Accounting, Hyderabad,Osmania University. Shukla. M.C., Grewal. T.S. Gupta. S.C., 2008, Advanced Accounts, Volume 1, New Delhi, S. Chand & Company Ltd. Internet References: Anonymous, Writer in Investopedia, 2008, International Financial Reporting Standards – IFRS, Investopedia.com, 30th July, 2008, http://www.investopedia.com/terms/i/ifrs.asp Anonymous, Writer in CFO.com, 29th July, 2008, Black Box Blues, CFO.Com, 30th July, 2008, http://www.cfo.com/article.cfm/11826286/2/c_11830278?f=home_todayinfinance Anonymous, Writer in Conde Nast Portfolio.com, 18th July, 2008, Moody’s cut long term rating of Lehman Brothers, 30th July, 2008, http://www.portfolio.com/news-markets/national-news/ap/2008/07/18/moodys-cuts-long-term-rating-of-lehman-brothers Daniel Fisher, Writer in Forbes.com, 2nd March, 2003, Enron’s questionable deals, Forbes.com, 30th July, 2008http://www.forbes.com/business/2003/02/03/cz_df_0203enron_3.html Press release of ICICI on prdomain.com, 4th March, 2008, Minister’s statement on ICICI Bank’s 264 million subprime loss sends markets into jitters, 30th July, 2008, http://www.domain-b.com/finance/banks/ICICI_Bank/20080304_loss_sends.html Bibliography: Mohapatra. A.K., 2007, International Accounting, New Delhi, Prentice Hall of India Pvt. Ltd. Vijay Kumar M.P., 2008, Accounting Standards, New Delhi, Sara Graphics. Read More