Corporate Tax Avoidance Project

According to Christensen et al. (2015), corporate tax avoidance means using the legal strategies to adjust the financial circumstances of an individual to lower the amount of tax the said individual is owing to the state. Corporate tax is achieved through claiming permissible credits and deductions. Most often, corporate tax avoidance is usually confused with tax evasion. Although the two phrases could sound similar, however, Armstrong et al. (2015) believe that tax evasion applies illegal techniques like under reporting the income of an individual to make him or her avoid paying the taxes. According to Sikka (2010) tax avoidance strategy of a given corporation is an ‘organized hypocrisy.’

Avoidance Strategy as an Organized Hypocrisy

I agree with Sikka’s Term that tax avoidance is an organized hypocrisy. Just to mention, companies tend to excel at speaking on social responsibilities when at the same time they devising structures to enable them evade paying taxes. The tenacity of corporate tax avoidance as well as the evasion lures a devotion to organized hypocrisy which can be properly comprehended as the gaps that exist between the decision, the action and the corporate talk, (Brunsson, 1989, 2003). Corporate tax avoidance is indeed an organized hypocrisy. In particular, a case of WorldCom, which is a US telecommunications organization, collapsed amid of allegations of fraud in the year 2002. Consequently, the second reason why I agree with Sikka’s claim that corporate tax avoidance is an organized hypocrisy is the case of KPMG that was borrowed in 1997 considering the initial fee of three million dollars. Later, KPMG recouped a half a million dollars fee which meant to carter for the feasibility study. Notably, the organization proceeded to earn the bonuses of performance totaling to extra two million dollars.

Main Costs of Tax Avoidance

According to Koester, Shevlin, and Wangerin, tax avoidance will keep on inflicting and results to costly consequences to millions of individuals as long as the leaders of low-income countries are excluded from the tax avoidance solution (2016). Notably, in July 2014 at Los Angeles College, President Obama proclaimed loudly that those who employed creative measures to ensure their taxes were reduced were merely corporate deserters renouncing their citizenship to shield profits. Gaertner (2014) reveals that such strategies by individuals to avoid corporate tax have severe costs. There are five main cost types which are generated by companies and individuals vigorously avoid tax.

First, the authorities handling tax collection attempt to counter ingenious tax avoidance practice and institute new opinions and regulations which in turn become supplementary to the tax code. Although the purpose of this measure is to increase certainty, however, the end results is a convoluted tax which leads to the second cost of tax avoidance which is corporate compliance cost.

The third cost of corporate tax avoidance is increasing the cost of administration. Forth, tax avoidance encourages the formation of lobbyists and tax specialist industries which are created to exploit the system. The last main cost of tax avoidance is the loss of the government revenue. According to Hanlon (1994) and Sikka (2003), the federal government of the United States losses fifty to one hundred and seventy billion dollars annually due to tax avoidance.

Key Issue Surrounding Tax Avoidance

According to the Guardian on 30th March 2009, developing countries often receives approximately one hundred and twenty billion dollars from G20 countries in the foreign aid in which the said developing countries are losing an approximate amount of between eight billion and one trillion dollars from the unlawful financial outflow every year to the countries of the west (Kar & Cartwright-Smith, 2008). As Baker (2005) and Cobham (2005), about five hundred billion dollars is lost over a variety of corporate tax avoidance structures in which a substantial amount is attributed to price practices which shifts profits from the developing countries to already developed countries.

Tax is a major cost to many companies and they formulate strategies which ensure that such costs are minimized thus causing tax avoidance. According to Finch (2004), although rules still remain to be rules, nevertheless, they are prone to be broken and thus no matter which legislations are in place, the lawyers and the accountants will always find a way around the game of tax avoidance. Multinational is the leading case studies of tax avoidance since they have multiple locations which allow them to organize profits in those countries which are favorable tax regimes (Bowler, 2009).

Moral and Economic Implications of Corporate Tax Avoidance

In my own thoughts, corporate tax avoidance has negative moral and economic implications. The company which avoids tax uses the definition of CSR and also relies on a set of moral principles to assess their taxpaying behaviors using the lens of morality and ethics. However, moral reasoning is more complex than one can imagine. Following the thoughts of KMPG (2006), tax payment forms a key responsibility in the contemporary corporation. Some people usually consider paying corporate tax as a moral problem although others find it as being moral while a good portion will find the payment of corporate tax as an immorality. On the other hand, economic implication of corporate tax is that it makes accounting companies be capitalist and thus cannot buck the system pressure to raise their own profits thus creating new tax avoidance schemes and reducing the contribution to the government (Sikka, 2005). When the tax is not collected fully, the accumulated tax compels the government to stop spending in critical areas like welfare and schools which leads to underdevelopment.

Ways in Which Corporate Tax Avoidance can be Restricted

I think that there are ways that can be used to restrict corporate tax avoidance. First is through legislation. Legislation can be achieved through standardizing corporate reporting systems to make the government process information and also compare taxes across firms to see who is avoiding the corporate tax. The legislation should aid in the detection of fraud and strictly monitor a company’s insiders on the matters of tax.

Corporate Tax Avoidance Project
Corporate Tax Avoidance Project

The legislation on the tax avoidance can be enforced through well-functioning courts through playing the central importance of law enforcement of the contracting parties. The other way in which tax avoidance can be restricted is through ensuring proper accounting standards. Leuz et al report that proper accounting standards bring about a global reporting coverage than often thought (2003). Single sets of accounting cannot sufficiently compare reporting and disclose any malpractice.

Harmonization of Accounting Standards- Implementation and Challenges

It is argued that there should be standardization of the accounting policy among nations to fully realize the global economy. Harmonization of accounting standards facilitates international transactions as well as minimizing the costs of exchange through the provision of standardized information to the world’s economy. The harmonization is done by the International Accounting Standards Committee (IASC), the International Accounting Standards Board (IASB) and the International Financial Reporting Standards (IFRS). The said bodies are mandated to implement the accounting standards across the world. However, there are challenges faced during the implementation. First is the challenge of comparability. Comparability can be achieved through like things looking alike as well as unlike things looking unlike (Trueblood, 1966). According to Truebold, “things” in the accounting include the regulatory culture, the culture of auditing, the culture of account as well as the financial and business culture. The other challenge is associated with the problem of interpretation in which language is a problem when translating IFRS from English or to English.

Most accounting standards are limited in bringing convergence. It should be noted that adopting a single set of accounting cannot be sufficient to allow comparability as well as disclose relevant practice even if the said principles are compulsory to all the countries. However, the idea of adopting common sets of accounting standards cause more comparable reporting techniques as well as high-quality accounting standards like the IFRS (Leuz et al. 2003). Adopting IFRS requires that the party countries must have the asset pricing market which provides accounting values.

High accounting standards cause high quality and transparent reporting to most companies. In addition, IFRS causes economic benefits as well as cost saving. When harmonizing the accounting standards, there is a challenge of public versus private owned enterprises which includes the related party transactions. Following the observation above, the issue of comparability in accounting becomes a problem because tricky auditing problems arises (Leuz et al. 2003).

The harmonization of accounting standards requires the implementation guidance. According to Baker (2005), the IFRS have the implementation guidance to the accounting standards either through the non-authoritative guides or being standard themselves. For instance, IFRS issued the share-based guidance which is made up of forty four paragraphs relating to the application guidance. Similarly, the body issued non-authoritative guidance which guides the implementation of IFRS to guide the harmonization of the accounting standards. The IASB body on the other hand created the international financial reporting interpretation committee which oversees the share-based payment guidance. However, Trueblood (1966) believes that the countries and enterprises which apply the IFRS in their accounting standards will become more heterogonous in terms of the size, the jurisdiction, the ownership structure as well as the structure of the capital and there will be an increase the degree of accounting sophistications.

According to Brunsson (1989), the international convergence on the harmonization of standards demands that the implementation of IFRS policies and guidance must be increased in order to achieve the intended accounting standards. The scholar adds that if the IASB committee fails to respond to the demands concerning the detailed implementation guide of the accounting standards, then the preparers of the harmonized standards must look for the implementation guidance from elsewhere. The preparers can turn to EITF consensus to obtain answers to the questions concerning the application of IFRS. On the contrary, the form of convergence generated above is not as a result of cooperative behavior or the joint decision but as a result of auditors and preparers who seek guidance from a non-IASB credible source.

The implementation of the harmonization of the accounting standards exhibits a challenge in which the individual party countries’ financial reporting outcomes which are partly determined by the requirements of the accounting standards and partly by the incentives. The premise of the financial reporting outcome is that the accounting standards requires sufficient judgment by the preparers and auditors so that the figures reported are materially affected by the incentives of the financial reporting outcomes and the requirements of the accounting standards. Nevertheless, the typical relationship between the accounting standards and the incentives of the financial reporting outcomes is not well understood which forms part of the challenges in the implementation of accounting standards.

Leuz et al. (2003) institute that allowing the adoption of the IFRS will allow for the test of incentives that interacts with two or more standard regimes within the accounting standards. Warfield et al (1995) reveals that the financial reporting outcome is majorly affected by the ownership structure of the international accounting structure. The evidence which is available on the above claim reveals the marked specific jurisdiction differences in the ownership structure that affects the harmonization of the accounting standards.

La Porta et al. (1999) have analyzed the ultimate ownerships of the mid and large size firms in the twenty seven wealthy countries and identified four types of ultimate owners who play a key role in the accounting standards. The types include the public held non-financial institutions, the public owned financial institutions, the families and individuals as well as the state. The ownership structure of an enterprise needs to be considered before making implementations on the harmonization of the accounting standards.

Harmonization of the accounting standards requires the globalization of the trends involving the technology as well as globalization of finance. In the United States comparability of the financial data is one of the major driving forces behind the accounting standards. The comparability has been within the companies of the United States until 1980s where they began focusing on the capital markets. Some countries prefer comparability while others do not (Leuz et al. 2003). In 1991 the FASB board was challenged to become more actively involved in globalizing trends and the internationalization of the accounting standards. The plan published by FASB instituted the objectives for achieving comparability between the accounting standards of the United States and the major national standards-setting bodies.

References

Armstrong, Christopher S., Jennifer L. Blouin, Alan D. Jagolinzer, and David F. Larcker. “Corporate governance, incentives, and tax avoidance.” Journal of Accounting and Economics 60, no. 1 (2015): 1-17.

Avoidance: Some Evidence and Issues. Accounting Forum, Vol. 29(3), 325-343.

Baker, R.W. (2005), Capitalism‘s Achilles Heel, New Jersey: John Wiley.

Beresford, D.R., Katzenbach, N. and Rogers Jr., C.B. (2003). Report Of Investigation by The Special Investigative Committee of the Board Of Directors Of WorldCom, Inc. Washington DC.

Bowler, T. (2009, February). Countering tax avoidance in the UK: Which way forward? Institute for Fiscal Studies. Discussion Paper No. 7.

Brunsson. N. (1989), ―The Organization of Hypocrisy: Talk, Decisions and Actions in Organizations‖, John Wiley, Chichester.

Christensen, D. M., Dhaliwal, D. S., Boivie, S., & Graffin, S. D. (2015). Top management conservatism and corporate risk strategies: Evidence from managers’ personal political orientation and corporate tax avoidance. Strategic Management Journal36(12), 1918-1938.

Christensen, J. and Murphy, R. (2004), ―The Social Responsibility of Corporate Tax Avoidance: Taking CSR to the Bottom Line‖, Development, Vol. 47 No. 3, pp. 37-44.

Cobham, A. (2005). ―Working Paper 129: Tax Evasion, Tax Avoidance, and Development Finance‖. The University of Oxford Finance and Trade Policy Research Centre.

Gaertner, F. B. (2014). CEO After‐Tax compensation incentives and corporate tax avoidance. Contemporary Accounting Research31(4), 1077-1102.

Hanlon, G., (1994). The Commercialisation of Accountancy: Flexible Accumulation and the Transformation of the Service Class, London: Macmillan.

Kar, D. and Cartwright-Smith, D. (2008). Illicit Financial Flows from Developing Countries: 2002—2006. Washington DC: Global Financial Integrity.

Koester, A., Shevlin, T., & Wangerin, D. (2016). The role of managerial ability in corporate tax avoidance. Management Science63(10), 3285-3310.

KPMG, (2005). ―KPMG International Annual Review 2005, KPMG.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1998) Law and finance, Journal of Political Economy, 106, pp. 1113–1155.

 La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (1999) Corporate ownership around the world, Journal of Finance, 54, pp. 471–517.

Leuz, C., Nanda, D. and Wysocki, P. (2003). ‘Earnings management and investor protection: an international comparison’. Journal of Financial Economics, 69: 505– 527.

Sikka, P. and Hampton, M.P. (2005). The Role of Accountancy Firms in Tax.

Trueblood, R.M., 1966. Accounting principles: the board and its problems, in Empirical Research in Accounting: Selected Studies 1966, The Institute of Professional Accounting, Graduate School of Business, The University of Chicago, Chicago, pp. 183–191.

US Bankruptcy Court Southern District of New York, (2004). Third and Final Report of the Insolvency Examiner: In re WORLDCOM, INC., et al, Chapter 11, Case No. 02-13533 (AJG), Kirkpatrick & Lockhart LLP, Washington DC.

Werther Jr., W.B., and Chandler, D., (2005). Strategic Corporate Social Responsibility: Stakeholders in a Global Environment. London: Sage.

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Tax Fairness and Tax Efficiency

Corporate Accounting Dissertations

Corporate Accounting – Significance, Application and Standards

Corporate Accounting is one of the major parts in financial management procedures of an organization. Accounting practices are necessary for a company in order to show how an organization has been successfully operating over the course of the year and making future plans for budgets and expenditures (Das, 2011). However, it is studied that accounting is a broadest term which have several branches and areas for different business and for different purposes. In which some of them are financial accounting, cost accounting and corporate accounting (Malwitz, 2008). However, this paper is merely focusing on defining the corporate accounting by incorporating corporate accounting theories, significance, concepts, legislation, applications and standards.

Corporate accounting is a special branch of accounting which can be defined as the quantity, recording and interpretation of financial information and data of a limited company which can be either a public limited company or a joint stock company (Fyler, 2013; Ijiri, 1980). Moreover, it is found that corporate accounting is an accounting which is particularly for larger companies since smaller-scale companies, sole traders or partnerships business cannot implement corporate accounting to maintain their financial record or information.

It is because smaller-scale companies, sole traders or partnerships businesses have not much requirements and demands in order to fulfil the accounting standards and to meet with accounting principles (Ijiri, 1980). On the other hand, large scale organizations or limited companies have sufficient financial information and data that they have to show to the general public and regulatory bodies therefore they have to maintain proper financial records with the help of corporate accounting (Fyler, 2013; Ijiri, 1980; Das, 2011).

Furthermore, it is studied that corporate accounting also deals helps the limited companies or large scale organizations in term of preparing final accounts, maintaining cash flow statements, analysing and interpreting financial results of the respective company particular for any specific events such as amalgamation, absorption, and helps company in preparation of consolidated balance sheets (Paton & Littleton, 1986).

By reviewing several studies, it is identified that the corporate accounting has some basic principles and foundations on which the overall accounting practices are based. The key foundations of corporate accounting include Accounting Cycle, Double Entry Accounting, and financial statements (Bennett, 2013). In which Accounting Cycle involves the regular recording and reporting of financial data or information. The accounting cycle completed within a specific period of time as per the policies of companies. Usually, it completed in a month or year.

Corporate Accounting Cycle

The accounting cycle begins by recording all financial transactions such as cash exchanges or debits and credits by using a general ledger approach. General Ledger is a precise and clear summary of all accounts including payable and receivable (Bennett, 2013; Ijiri, 1980). The next stage of accounting cycle is the adjustment of general ledger which can be done by taking items or entries which are not the direct transactions, such as bad debt, taxes and accrued interest. Thus, it is a key area therefore accountants must ensure that revenues and expenditures are match up as per each accounting period. In case, of accountant failed to do this properly, it can lead to confusion over financial irregularities and at the end of the period it can create confusion in overall revenue and total profit for the period (Bennett, 2013; Ijiri, 1980).

The second key element of the corporate accounting is double entry accounting, which can be defined as the standard accounting concept used by limited companies or large scale organizations. The basic of double entry accounting is based on the notion that for all actions there is an equal and opposite reaction (Bennett, 2013; Ijiri, 1980). It means that when a financial gain takes place in any part of financial statement, it should be escorted by a loss somewhere else on the balance sheet.

Corporate Accounting Dissertations
Corporate Accounting Dissertations

Suppose that of if a limited purchases a product to sell, so it will show the decrease in cash in financial statement and in the same way it will show the increase in inventory of certain organization (Bennett, 2013; Ijiri, 1980). Finally, the financial statement is another key aspect of corporate accounting, which is refers to the financial reports prepared at the end of the company’s financial year.

This financial report basically includes the cash flow statements, balance sheets and income statements for the previous 12 months. The financial reports of an organization show the summary and of all financial activity including overall profits or losses incurred by respective company (Bennett, 2013; Ijiri, 1980). Furthermore, it has been examined that the financial report helps accountant of a limited company in terms of preparing tax returns, while stockbrokers and investors use the same financial reports for the comparison between respective company and international business performance.

In addition to this, it is found that the financial reports also help the managers of certain company in terms of a assessing the performance of the company as well as in making proper plan and budget for company to successfully execute its operation in upcoming year. Following is the table that represents the different accounting terms used in UK and USA (Joos & Lang, 1994):

Table 1 – Accounting Terms as Per UK and USA Standards

United States of America United Kingdom
Balance sheet/Statement of financial position Balance sheet
Inventory Stock
Treasury Stock Own Shares
Receivables Debtor
Payables Creditors
Provisions Accounting for loss contingencies
Stocks Shares
Retained Earnings Profit and loss Reserves
Paid in surplus Shares premium account
Management’s premium of operations Operating review
Management’s discussion of financial resources and liquidity Financial Review
Fiscal year Financial year
Income statement/Statement of earning Profit and loss account
Revenue/sales Turnover
Affiliated company Associated company
Earnings per share Net income per share
Scrip dividend Stock dividend
Balance sheet Balance sheet/Statement of financial position
Tangible fixed assets Property, plant and equipments

In addition to the above, it is identified that in most of the limited companies particularly in UK (United Kingdom) and USA (United States of America), for the preparation of financial reports or execute corporate accounting practices specific accounting standards are used which are only set in common law (Joos & Lang, 1994). However, in different countries, it has been studied that the corporate accounting are different from each other therefore different countries uses different accounting regulations in order to maintain financial records and for the preparation of yearly financial reports.

Furthermore, it has been examined that throughout the world there are two types of accounting standards are used which includes the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) (Young & Wiley, 2011; Everingham, et al., 2007).In which International Financial Reporting Standards (IFRS) provides rules for business affairs from the global perspective in which the accounts and financials of a company can be understood and compared across international boundaries (Young & Wiley, 2011; Everingham, et al., 2007). On the other hand, General Accepted Accounting Principles (GAAP) provides rules to collect and interpret financial data for multinational competitors with the help of financial statement (Young & Wiley, 2011; Everingham, et al., 2007).

International Financial Reporting Standards

It is further examined that the International Financial Reporting Standards (IFRS) are mostly adopted by the companies operating throughout the European Union. Beside it, the organization in several countries like Australia, South Africa and Russia are also now widely followed IFRS accounting standards for the recording of financial information and analysing and interpreting financial data. In contrast, specifically in the United States limited companies are bound to utilize the GAAP accounting standards for all kinds of accounting practices (Young & Wiley, 2011; Everingham, et al., 2007).

Thus, it has been concluded that, the corporate accounting system allow companies to successfully maintain financial data as per their company policies, regulated accounting standards and accounting principles or laws determined by common law.

References

Bennett, R. (2013) Corporate Accounting Basics. Free Press.

Das, B. (2011) Is Corporate Accounting a science or an art? Accounting, pp. 1-1.

Everingham, G. K., Everingham, G., Kleynhans, K., Posthumus, L., Kleynhans, J. E., & Posthumus, L. C. (2007) Principles of Generally Accepted Accounting Practice. Juta and Company Ltd.

Fyler, T. (2013) What Is A Definition Of Corporate Accounting

Ijiri, Y. (1980) An Introduction to Corporate Accounting Standards: A Review. The Accounting Review, 620-628.

Joos, P., & Lang, M. (1994) The Effects of Accounting Diversity: Evidence from the European Union. Journal of Accounting Research, 32, 141-168.

Malwitz, M. (2008) Financial Consolidation and Reporting Solutions: Adding Value to Enterprise Resource Planning Systems. Oracle Paper, pp. 1-21.

Paton, W. A., & Littleton, A. C. (1986) An Introduction to Corporate Accounting Standards. Amer Accounting Assn.

Young, E. &., & Wiley, J. (2011) International GAAP 2012 – Generally Accepted Accounting Practice Under International Financial Reporting Standards. John Wiley & Sons.

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Introduction Accounting

Introduction to branches of Accounting

Accounting is an important concept that its history can be traced back centuries ago. Many businesses, based on numerous transactions made in a day requires accountability and proper records keeping for such in information in order to enhance other activities within a business enterprise such as communication. With the absence of accounting for businesses, this would act as a stabling block for the attainment of organizational objectives such as profit maximization as management of resources requires proper innovative structures for accountability.

According to Dyson (2004) the accounting branches can be segregated into three key areas; financial, cost, tax and managerial accounting (Dyson, 2004, p.12). Accounting plays a significant role in different business enterprises especially on key areas such decision-making, giving information, protection of business from various transactions involved with other business environments and explaining the business position. Financial Accounting is the art of managing business financial recording that stipulates the business position and it progress in growth through the analysis of profits and losses. According to Babarinde (2003) financial accounting is a system that deals with explaining the situation and the state of affairs for businesses through preparation of financial statements such as the balance sheet and trade and profit loss account (Babarinde, 2003 p. 313). Financial accounting also plays a significant role in running a business enterprise as the system give the estimates of costs on products, functions, activities and the firm progress. Through financial management in a business entity can get quality information to plan through budgeting that gives estimates on expected expenditures.

Cost accounting is the system used in controlling activities of production that would regulate expenditures for the business in order to enhance profit maximization. According to Abeygunasekera and Fonseka (2013) every business has its control system that helps in cutting cost either through the production processes such as manufacturing, recruitment, training and development and delivery of services. Through such processes, cost accounting acts a system for the management to control such expenditures incurred through transactions with different business environments as well as in the processes of availing goods and services to consumers (Abeygunasekera and Fonseka, 2013).

Managerial accounting is the process that facilitates the management with information concerning the company’s progress that enhances the management in carrying out their day to day functions. The management in every business ought to have the facts in decision-making, planning, and in the development of policies and through managerial accounting such is facilitated. According to Mbroh (2013) he argued that in managerial accounting, frequent information is made obtainable to the management such as information on funds, profit and cost that gives a bulge of the business advancement and must be factual in support of truth and fairness (Mbroh, 2013).

Recommended accounting methodology for companies

It is necessary for the management of any business to how commitment in recording business transactions as this information can be retrieved for further use when such information is required. There are for instance methods of accounting that are commonly used across bossiness in the world of today. This includes the single entry and doubles entry methods that are used interchangeably in businesses. Use of double entry techniques has proved to have various advantages for many that use it. In the double entry, two columns are created for transaction entries in both what the company receives and also spends while running the business.

By following the right procedures in preparation of journals, trial balance, and final account, the use of the double entry techniques businesses benefits in different ways that is recommendable. Through such a system, the management is also to create the accounting book through a device known as the trial balance that give more accurate inform about the business transaction.

Introduction To Accounting
Introduction To Accounting

It is also easier to ascertain on the profits and losses incurred by a business if the transaction entries are properly entered in the trial balance device. According to Mbroh (2013) he also argued that a financial statement such as the balance sheet, the system gives accurate information concerning the position of the business enterprise (Mbroh, 2013). The management is also able to know if the firm has made any development such as profit maximization and growth. This as well regulates spaces for errors as the transaction entries in both the debit and the credit side should balance in the system. Through the double entry system, the management is also able to carry out a comparison study during a specific period such as between two consecutive years. It also becomes easier in making decisions for the business as the business position is made clear for instance in the trade and profit loss accounts.

References

Abeygunasekera, A.W.J.C and Fonseka, A. T (2013) Non-Compliance with Standard Practices by Small and Medium Scale Enterprises in Sri Lanka.

Babarinde A. (2003) Financial Accounting, Volume 1, Lagos: JBA Associates Ltd.

Dyson J. R (2004) Accounting For Non-Accounting Students, 6th Ed. Financial Times/ Pitman Publishing Imprint, England.

Mbroh, (2013) Control Systems Practiced By Small and Micro Enterprise Owners within the Cape Coast Metropolitan Area of Ghana in Asian Journal of Business and Management Sciences Vol. 1 No. 9 [28-47]

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IFRS IASB Frameworks

Finance Assignment – Various normative theories, measurement issues under IFRS and Conceptual framework

This report basically provides an analysis of different financial accounting measurement techniques, their advantages and disadvantages and practical implications. Accounting measurement has become a controversial issue due to its assorted nature in financial reporting system. The conceptual framework developed by both systems is unable to provide accurate cost of assets and liabilities at the end of financial year. There is a misunderstanding behind the rationale that whether measurement is a set of calculation or numbers but it provides no as such vivid explanations and is totally cognitive based. A lot of research work and publications have been made about this topic but the matter is still under consideration. Financial reporting measurement is a debatable issue and still under consideration. Most of the literature has been published on the issue of historical cost and value accounting. It shows that it is never ending issue. Historical cost measurements narrates that total assets and total liabilities should be recorded and reported at the procured price while current cost accounting states that assets and liabilities should be recorded and reported at existing market value.

Role of IASB & FASB frameworks

International Accounting Standard Board Framework

International Financial Reporting Standards (IFRS) are based on the IASB framework developed for the sake of preparation and presentation of financial statement.

Financial Accounting Standard Board Framework

FASB is U.S primary body for the development of accounting standards. It issues new rules so called Statement of Financial Accounting Standards (SFAS) based upon FASB which are basically derived from Generally Accepted Accounting Principles (GAAP).

IASB and FASB frameworks present a facility of persistent and logical formulation of IFRSs and SFAS respectively. Both of these also aim to provide its users with a platform to resolve various complex accounting issues. Hence, framework has the benefit being the status of conceptual base for development of IFRSs.

The IASB issues IFRS to more than hundred countries which also include European Union but it excludes United States. There is a strong co-relation among both IASB and FASB standards. It is probable that U.S will also move to IFRS in 2016. Despite of all this, both IASB and FASB sat together to reach at a final conclusion about this matter but still there is a room for improvement. Mary E. Barth has concluded that Fair value measurement provides somewhat precise and specific value of both assets and liabilities. The core objective of this report is to determine why other frameworks lack behind. (Mary E. Barth, 2013, pp 2-3)

Comparison of various cost approaches

There are many cost measurement techniques which are used to record assets and liabilities in financial statements; some of these are as follows:

Unmodified historical cost

This type of cost includes those amounts which were paid at the time of procurement of assets no matter whatsoever the life of asset is. It is totally inadequate way of recording measurement.

Modified historical cost

This cost is modified due to various factors like impairments, amortization due to depreciation or appreciation of asset with the passage of time. It seems to be relatively more valid type of measurements.

Fair value measurement

It is a net price which can be received while selling an asset or paying any liability in a logical transaction among market participants at the measurement time frame.

These are frequently used in financial reporting and possess different characteristics. Only one of these techniques is used to record assets and liabilities in common practice so as to draw conclusion based upon performance. Financial statements are comprised of total assets (both current and fixed), total liabilities (both current and long term) and owner’s equity. The framework indicates that equity is the difference between the assets and liabilities after proper measurements. (Mary E. Barth, 2013)

Critical Analysis

The aggregation is a qualitative attribute which slightly affects the quantity. Hence, a minor change in assets and liabilities generally affects net income and expense. However, the Framework does not elucidate the factors behind balancing effects on Statement of Financial Position (SOFP) and Comprehensive Income.

Fair value provide more effective results as compared to un modified and modified costs in case of single assets and liabilities as it contains both qualitative and take into account assets and liabilities. Whereas unmodified cost is totally irrelevant and invalid. Modified cost if not supported with accounting standards cannot be explained in a scenario. Fair value determination is only more reliable and accurate if it is acquired faithfully with an ethical mentality. Still there is an ambiguity whether modified historical cost is more appropriate than fair value determination. Hence we may conclude that fair value and unmodified costs are set according to a specific economic objective while modified is an accounting calculative work.

Despite of all these measurement techniques, only one selected technique should be used for estimation so as to achieve significant accounting results. Anyhow, other technique can be used where direct measurement is impossible for estimation. This approach will be helpful to maintain consistency, comparability and significant aggregation of accounting data. . (Mary E. Barth, 2013, pp 19-20)

IASB recommended approach

IASB also endeavours to find a single measurement technique in its own projects. IASB also favours fair value measurement that it provides more effective results, though it sometimes fails to assess the cost of any asset. Practically, all the framework of accounting regulations except IFRS is not using single approach of measurement. For instance, measurement of cost to predict operating cash flows will provide major share of turnover in going concern business approach, while fair value would be more appropriate, relevant and reliable for the valuation of marketable securities and investments. However if you use different approaches in each financial year, the descriptive authority of such aggregation would be more poor and risky.

Preliminary and Subsequent measurements

However, measurement approaches can be distinguished according to preliminary and subsequently with respect to nature of the measurement subject matter. For example, in case of going concern business, long term assets meets the pre-requisites while current liquid assets (inventories) and marketable securities are measured differently. However, it all depends upon standard setters that which measurement technique should be selected.

All the regulations of Accounting including IASB, FASB, UK Accounting Standards Board and Australian Standard Boards possess a common thing that financial statements are primarily developed to help its stake holders (external and internal users) so that they may analyze the organization. Investors can depict growth rate, market value and share value (Jiri Strouhal, 2014).

IFRS IASB Frameworks
IFRS IASB Frameworks

Effects of choosing wrong measurement approach

Determining right choice of measurement is very important for organizations. There are five different approaches like as fair value treatment of costs, historical cost accounting, modified historical cost accounting, current purchasing power accounting, current cost accounting and continuously contemporary accounting. All these techniques have various pros and cons. But fair value treatment of costs is mostly used and reliable approach to recognize costs. Accountant should be prudent while choosing cost approach.

Wrong choice of cost approach may adversely affects the financial statements, shareholders image towards firm’s assets and liabilities. Historical cost accounting deals with recording assets on purchased price which is wrong measurement. If any asset is to be sold, then we need to consider again choose either fair value approach or modified historical cost accounting as a measurement rather than historical cost accounting value. This type of costing is only helpful for long term basis if re-procurement of machine or asset is to be needed.

Current purchasing power accounting measurement shows the impact of inflation on the net value of money. To achieve CPP, firstly historical costs are changed into current prices with the help of consumer price index (CPI). But Price indexes quality includes simply averages and perhaps not matches with expenses incurred by even a single shareholder. It sometimes becomes ridiculous that if re-stated asset values considered everything while the changed amount is neither paid nor is asset value increased. Current cost accounting despite of its importance is not reliable for long term basis. Then we move to historical cost accounting for decision making.

International Accounting Standards

Some of the most important International Accounting Standards have been explained below to elucidate the effect of measurement and reporting accounting on current assets and liabilities.

Fair value measurement (IFRS-13)

Fair value measurements are mostly used and reporting standard. IASB, FASB, AASB lays stress to use this standard but each one provide their own standard guidelines for the determination of fair value. IFRS-13 also tells how preliminary fair value is to be measured and how successive fair value is found.

Fair value: It is an amount which can be gained when an asset is sold or a liability is transferred among market participants in normal transactions at measurement date. Market participant are usually those buyers which have economic and ethical rationale.

Fair values should be gained from principal market as it is pure competitive market and possess large volume of desired nature. If it is unavailable, then accountant should concern from advantageous market. Final fair value must contain location of asset and its condition

Assumptions

  • Transaction cost should be ignored
  • Transportation cost should be incorporated
  • In case of most advantageous market, both transaction and transportation costs should be incorporated

Inventories (IAS-2)

This standard has been developed to assist and provide a valuable accounting treatment for physical inventory which is a current asset. This treats cost of the inventory like an asset which can be easily carry forward unless it is sold. The standard also aimed to provide assistance to recognize and determine the costs along with net realizable value.

Scope

This standard is valid for all inventories excluding:

  1. It is not valid for construction contracts specially treatment of work in progress
  2. Financial instruments including marketable securities
  3. Natural assets or biological assets

Measurement of inventories

Inventories must be recorded at the lesser cost and net realizable value (NRV).

Cost of Inventory

Inventory cost includes cost of purchase, conversion cost (Labour and Production overhead) and the cost freight charges incurred to bring an asset from vendor place to factory.

Cost of purchase

This cost is comprised of purchase price, transportation charges, import duties, taxation other costs incurred to attain asset and trade discount and other discounts are deducted from original cost of purchase.

Cost formulas

Inventory once purchased can be calculated by using first in first method (FIFO) and weighted average cost method while last in first out (LIFO) is not allowed.

Cost of the inventory can be calculated through FIFO and Weighted Average Cost Method. However, LIFO method is not permitted.

Record of reversing (Expense)

Reversal of note down of equivalent inventory might be prepared up to the cost.

Events after reporting period (IAS-10)

IAS-10 tells the treatment for those events which occurs after the financial period. So, adjustments are to be made in financial statements. Management will provide final approval of accounts on 31st Mar, 2014 while final accounts will be forwarded to annual general meeting (AGM) to get approval for shareholders on 30th Apr, 2014. After this, reports will be authorized for issuance.

IAS-10 is appropriate for those events which are took place after the balance sheet date but to the date of authorization by the management i.e. 31st Dec, 2012 to 31st Mar, 2013. Event can be adjusting or non-adjusting.

Adjusting Events

Those events which present supplementary proof of their existence at the financial statement i.e. balance sheet are called adjusting events. Adjusting events are needed to be documented in the financial statements.

Example:

  • Errors and inaccuracies in financial statements if discovered after reporting period, their adjustments will be covered in adjusting events.
  • If a court case was settled validating the compulsions at the end of financial period.
  • If an asset was purchased earlier but cost of purchase confirmed after reporting period. 

Non Adjusting Events

Those events which doesn’t support supplementary proof of their existence at the financial statement i.e. balance sheet are called non-adjusting events. Non adjusting events are needed to be disclosed in the notes of financial statements.

Example:

  • Declaration of dividends is a non-adjusting event as these are recorded once these are proposed after reporting date.
  • Anomalous loss, natural disasters, amalgamation, renovation and acquisitions do not provide supplementary events so these are adjusting events.

Historical Cost Accounting

Historical cost is a sum of price which is paid by firm to acquire an asset for use. It includes all costs incurred to bring the asset for smooth operation. It is an ancient accounting standard which was developed with a rationale that prices are smooth and normal changes occur with a passage of time. Such conservative style of accounting doesn’t make and stipulation for change in purchasing power. There is less manipulation of mangers as it is only recorded at acquisition price every year. Accountants have to meet the expected return of its shareholders and investor despite of the net wealth of the firm. This shows that primarily focus is upon income statement which will be a vivid glance whether firm is working efficiently or not. (Jiri Strouhal, 2014).

Advantages

  • Historical cost has a substantive effect on appraisal evaluation and assortment of decision rules.
  • If management has to determine which decision would be more useful, it may get help from past performance.
  • Historical cost is directly associated with past decision. Past data is helpful to forecast for better decision making. There prime object is to determine what profit did they earn in past not what they can increase.

Disadvantages

Historical cost is inappropriate for decision making as it doesn’t follow stewardship function. Investors have more concern with up and down in their investments return rather stable return.

Modified historical cost

This historical cost is modified by inculcating various factors like impairments, amortization due to depreciation or appreciation of asset with the passage of time. It seems to be relatively more valid type of measurement. Modified cost basically provide better picture of firms assets and liabilities. In Australia, modified historical cost system is used instead of historical cost accounting. It states that assets should be recorded in balance sheet after fair value determination.

Current purchasing power accounting

It is an accounting measurement which shows the impact of inflation on the net vale of money. To achieve CPP, firstly historical costs are changed into current prices with the help of consumer price index (CPI).

This theory is basically derived from macroeconomic “inflation” perspective that persistent rise in general price level of commodities also called inflation adversely affects currency value. If pound value is decreased then it becomes difficult to compare financial statements by using this approach.

Strengths

  • CPP recognized the worth of money which should be generated and maintained in business to sustain overall shareholder’s purchasing power.
  • It is comparatively easy, cheaper and improves overall shareholders worth by eliminating inflationary elements which arise from change in currency from monetary profit.

Weaknesses

  • Price indexes quality includes simply averages and perhaps not matches with expenses incurred by even a single shareholder.
  • It sometimes becomes ridiculous that if re-stated asset values considered everything while the changed amount is never paid nor is asset value increased.

Current Cost Accounting

Assets are usually values at specific amount of cash or its equivalents if same asset is to be acquired for use in firm. Similarly, liabilities are also settled with the discounted amount of cash or its equivalents needed to reconcile the obligation presently.

Advantages

Current cost accounting use present clearer picture of an asset as compared with historical cost accounting which is helpful for decision making. Due to high degree of precariousness in business environment, financial statements should also demonstrate reality instead of past transactions. A study on New Zeland company directors by Duncan & Moorers (1988) signified that current cost accounting presents more valid and reliable information than historical cost accounting.

Disadvantages

Peasnell et. al. (1987) stated that cost accounting information is used by investors in short term assortment decision making. It also doesn’t work as a driving force for long term returns. Shareholders are more concerned with historical cost accounting to get information about investment returns.

Continuously contemporary accounting

This famous accounting theory commonly known as CocoA was given by an Australian Raymond Chambers. The purchasing primacy of money is highly volatile or current and is subject to change with the passage of time. This model basically tells that the current worth of the business is equal to the total cash equivalents of its assets. It just like current cost accounting system measure both assets and liabilities at the existing cash price.

Strengths

The model is designed in this way that accountants can easily deploy it in developing balance sheets and financial statements. The true picture of assets and liabilities in cash price provide an assistance to firm in rapidly changing environment. CoCoA balance sheets only estimates what will be received if its assets are sold to meet short term liquidity challenge.

Weaknesses

CoCoA system requires from the management to shift from cost based system to way out price which is highly opposed by top management in many firms. The CoCoA balance sheets are mostly failing in calculating internal worth of the assets as they only focus on market prices.

Finance Accounting Dissertation Topics
Finance Accounting Dissertation Topics

Case Study (valuation of roads and highways)

Renewal accounting method basically determines the impairment of highway infrastructure and roads. Highway infrastructure is considered a single asset and many performance indicators are applied to evaluate impairment on asset. Asset valuation involves measures to calculate firm’s assets and their current value in monetary terms. Current monetary value is also evaluated by depreciated replacement cost method for highway infrastructure assets specially.

DRC = Gross Replacement Cost – Accumulated Consumption

Impairment should be calculated by a consistent approach. Once an approach is set, valuation should be prescribed. Finite life assets and components by using conventional method is valid valuation impairment approach for highway infrastructure and roads.

All the assets and components can be categorized into two types:

  • Conditions based maintenance

This identifies physical condition and performance data is also used for estimation of consumption of the asset whereas maintenance cost is also paid to make it look new.

  • Time based maintenance

This approach identifies the asset consumption by its age and condition

Modified historical cost would be more applicable for smooth reporting and recording of costs in this case. As roads and highways are long term projects and their value also changes with the passage of time.

References

  1. Mary E. Barth (2013). Measurement in Financial Reporting: The Need for Concepts. Forthcoming, Accounting Horizons 2014, 40(1) 2-20
  2. Jiri Strouhal (2014) Historical Costs or Fair Value in Accounting: Impact on Selected Financial Ratios, Journal of Economics, Business and Management 2015, 3(5)1-5
  3. IASCF Staff (2005). Measurement Bases for Financial Accounting-Measurement on Initial Recognition 70(1) 101-180
  4. International Accounting Standards Board, 2011, International Financial Reporting Standard 2 IASB, London.
  5. International Accounting Standards Board, 2011, International Financial Reporting Standard 13 Fair value measurement. IASB, London.
  6. International Accounting Standards Board, 2011, International Financial Reporting Standard 10 Events after reporting period. IASB, London.
  7. Current-purchasing-power (CPP)
  8. Continuously contemporary accounting (CCA), retrieved Dec, 2014
  9. Guidance Document for Highway Infrastructure Asset Valuation taken

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International Accounting Standard 2

International Accounting Standard 2

The criteria to record and recognize the inventory is also explained as instructed under International Accounting Standard 2. Inventory is separated from the Non-Current Assets like plant and equipment which are held for sale at maturity and a further categorization of inventory is given in two forms like By-Products and Main products. The item which is normally sold out by the companies through ordinary course of its activities are termed as Inventory. Generally three forms of inventory are founded in any manufacturing companies which are Finished Products, Raw Material and Work-In-Process. All three inventories have different cost classifications and nature and should be measure on separate basis. There are four cost formulas to measure the inventory and are generally practiced in the US. Four formulas are LIFO, FIFO, Weighted Average Method and Specific Identification. This also explains the concept at which the reporting cost of the inventory is provided and Inventory should be reported at lower of Cost or Net Realizable Value (NRV). Cost is the value at which the inventory is purchased including purchase cost, carriage inwards and other taxes paid on the purchase whereas the Net Realizable Value id the amount at which the inventory can be sold out in the market less any expected expenses to complete the sale process.

International Accounting Standard 2 is one of the Accounting Standards issued by the Accounting Standard Committee to record and measure the financial items pertaining financial features. International Accounting Standard 2 encompasses the recording and measurement of Inventory. Inventory is defined in the International Accounting Standard 2 as “Assets which are held for sale in the ordinary course of activity by the company and it comprises Finished Products, Raw Materials and Work-in-Process. Inventories are the goods manufactured by the company in order to obtain the economic benefits from the sale to the customers. The main objective of the issuance of this standard is to separate the Non-Current Assets of the company from the inventory which is a Current Asset. Prior to the interpretation of International Accounting Standard 2, most of the companies have faced problems in the identification and recognition of the inventory and commonly the estimation and recording of the cost of inventory was a key concern for them. International Accounting Standard 2 has led the management to maintain and report the inventory at the reasonable and appropriate value. International Accounting Standard 2 defines the items of Inventory along with the methods to record the inventory. The methods which are being interpreted under International Accounting Standard 2 are FIFO, AVCO and LIFO. First in First Out (FIFO) is the method which explains that the oldest inventory should be sold out first and then the next one whereas the Weighted Average Cost Method (AVCO) means the inventory should be recorded by calculating the average cost of available inventory and then multiply this with the number of units in stock. Last in First Out (LIFO) is a method which is not being used currently because of some drawbacks attached to it as it promotes the system to sale the most recent purchases to be sold out prior to sale the old inventory. This Standard provides detail of each and every feature associated to the inventory and how to deal with that.

Methodology

Due to the misappropriation of inventory there was a need to guide the companies as to record the inventories properly. This is why the International Accounting Standard 2 was issued and interpreted in a detailed way. If the company is involved in the sale and purchase of something then it is likely to hold inventory which can be in the form of Raw Materials, Finished goods and Work-in-process. Theoretically everything which is held for sale is termed as inventory but the question rises that either the plant and machinery held for sale are also termed as inventory then the answer would be ‘No’. Everything which is sold out through ordinary course of business is termed as sales and purchases eventually known as inventory. So the Non-Current Assets are not classified as Inventory under IAS 2. There are further 3 techniques are issued under this standard to record the inventory and inventory handling. First in First out (FIFO) is a method which tends to sale the oldest unit of inventory first and it makes sense as it would reduce the threat of inventory obsolescence. Weighted Average Cost Method (AVCO) is method which uses an average cost for all the units of inventory and records the inventory on this basis so there is no separation of recent and old purchases. Last in First out (LIFO) method promotes the sale of most recent purchases and there are more chances of obsolescence of inventory. Apart from these techniques the cost recognition criteria is also listed in this standard. As per International Accounting Standard 2, inventory should be recognized at lower of Cost or Net Realizable Value (NRV). Net Realizable Value is the value at which the inventory can be sold in the market or simple the market value. Theoretically this is the fair value concept and more appropriate to record the assets as it would lead to a fair appropriation of the assets of the company and no chance of being misled.

Literature Review

International Accounting Standard 2 defines the criteria to record inventory “Inventory should be recorded at lower of Cost or Net Realizable value (NRV). Cost is the amount at which the Inventory is being purchased initially and whereas the NRV is the amount at which inventory can be sold out. Net Realizable Value is the amount of cost less any expenses required to make inventory into a saleable state. Though there are some problems in the recognition of inventory because there are three types of inventories in a company which are subject to value at the most appropriate amount before recognition. Finished goods are required to be valued so that it can be recorded at lower of NRV or Cost as they do not require any further assessment criteria but Work-in-Process requires some extra work to make an appropriate valuation of inventory. There is a need to consider that how much material has been incurred to the product till that date and how many labor hours has been spent on the product. There is also a further calculation of overheads cost as to how much overheads should be allocated to the Work-in-process units as they are not yet completed so there is a need to calculate the amount of overheads. Generally the overheads are absorbed by the companies by using labor hours but mostly companies also use the machine hours as the absorption base. So this can ease the calculation of overheads allocation just simply cost of labor per hour multiply by the number of labor hours or machine hours incurred to the product. Generally the wastage costs, idle labor hours, storage costs and other costs like these are also included in the product cost. In most of the production processed two type of products are produced in a single process and are named as Main product and By-Product. By-products are the products which are produced unintentionally as these are not the ordinary items of the company for sale purposes but these should also be recorded as inventory because the economic benefits are expected to flow to entity from the sale of these products and the cost of such products can be measured at the joint process phase of production.

International Accounting Standard 2
International Accounting Standard 2

After the recognition of per unit cost, there are some formulas for the inventory valuation generally practiced in the US. LIFO, FIFO, Weighted Average Method and Specific Identification. Under IFRS and US GAAP all these formulas are same but the practice of some formulas are limited across the world due to the drawbacks attached to them and these methods are LIFO and Specific Identification. Main drawbacks to LIFO are much more in general as it promotes the threat of Inventory obsolescence and more risk in the incorrect valuation of the inventory. Due to this reason LIFO is discouraged across the world and now Weighted Average Method and FIFO are used extensively. In the past most of companies used the LIFO as their tax shields to reduce the profits and other manipulations but after the consideration of such issues the application of LIFO is now restricted and now limited to some states only.

There are some costs which cannot be the part of inventory in any case and they should be reported as an expense to the income statement. Most common examples of these costs are:

  • Abnormal Wastage of material
  • Abnormal Idle hours of Labor
  • Abnormal overheads due to the Abnormal Idle Hours
  • Reduction in the Net Realizable value of the inventory
  • There are some handling costs which are not important for the product but incurred and these should not be measured in the inventory cost as well
  • Admin expenses and other costs associated to admin department

Conclusion

This research provided a complete detail of the International Accounting Standard 2. The complete criteria and detail of the inventory recognition and measurement criteria is explained in this assignment. The measurement of the inventory is based on the management’s perception but with the introduction of this standard, all the criteria and relevant aspects have cleared. Management is guided thoroughly on the measurement of inventory and the recognition of the inventory instruments as to remove the ambiguity between the inventory and other assets of the company. Management has four different formulas to record the cost of the inventory and the most practical and generally accepted formulas are the FIFO and weighted average method. Management should use the cost formula among both of these as these are the recommended and practically accepted under IFRS and US GAAP. There would not be any problem in the inventory measurement if these rules are followed. Management is required to differentiate the By-products and Main products as both of these have different characteristics and benefits and need to be separately identified. The relevant cost should be ascertained to the inventory whilst the other should be charged to the expenses like abnormal wastage and labor cost etc.

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