Beruflich Dokumente
Kultur Dokumente
BBAT4103
Accounting Theory
Summary 30
Key Terms 31
Self-test 1 31
Self-test 2 32
Answers 239
References 268
Self-test 1 238
Self-test 2 238
INTRODUCTION
BBAT4103 Accounting Theory is one of the courses offered by the OUM Business
School at Open University Malaysia (OUM). This course is worth 3 credit hours
and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is a core course for all learners undertaking the Bachelor of Accounting
programme.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
COURSE OUTCOMES
By the end of this course, you should be able to:
10. Explain various current issues in financial reporting such as social and
environmental reporting;
COURSE SYNOPSIS
This course is divided into 13 topics. The synopsis for each topic can be listed as
follows:
Topic 1 explores the accounting theory and accounting practices. The topic also
discusses the developments in accounting theory and the role of accounting.
Topic 6 deals with recognition of issues associated with assets and liability. The
topic examines the impact of the recognition criteria on assets and liabilities and
the value in the measurement of assets and liabilities.
Topic 7 looks at the recognition of issues associated with profit, revenue and
expense. The topic also discusses the impact of uncertainty on profit
determination.
Topic 8 deals with reliability and relevance issues in accounting. It provides the
definition of relevance and reliability. The justification for the trade-off between
reliability and relevance is also discussed. Finally, the challenges posed to
qualities of accounting information are reviewed.
Learning Outcomes: This section refers to what you should achieve after you had
completely covered a topic. As you go through each topic, you should frequently
refer to these learning outcomes. By doing this, you can continuously gauge your
understanding of the topic.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details from the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
PRIOR KNOWLEDGE
Learners of this course are required to pass the BBFA1103 Introductory
Accounting course.
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Larson, K. D., Wild, J. J., & Chiappetta, B. (Omar, R., Hassan, H., Sulaiman, A.J.,
and Mohamad, L.) (2005). Accounting Principles. Malaysia: McGraw-Hill.
Lerner, J. L. & Cashin, J. M. (1998). Schaums outline of theory and problems of
principles of accounting 1 (5th ed.). Black Lick, OH: McGraw-Hill.
Loh, B. F. & Ng, K. H. Principles of accounts. Singapore: Longman/Pearson
Education Asia.
Lazar, L., Arshad, R., & Choo. (2006). Financial reporting an introduction.
Malaysia: McGraw-Hill.
Ng, E. (2009). A practical guide to financial reporting standards, Malaysia.
Singapore: CCH.
Stice, E. K., Stice, J. D., and Skousen, K. F. (2004). Intermediate Accounting (15th
ed.). Mason, OH: Thompson South-Western.
Tan, L. (2000). Financial accounting & reporting in Malaysia, Volume 1 (2nd ed.).
Malaysia: PAAC.
Tan, L. (2000). Financial accounting & reporting in Malaysia, Volume 2 (2nd ed.).
Malaysia: PAAC.
Thomson, A. (2006). Introduction to Financial Accounting. (5th ed.). Singapore:
McGraw Hill Education Asia.
Wood, F., & Sangster, A. (2002). Business accounting 1 (9th ed.). Great Britain:
Financial Times/Pearson Education.
Raymond A. Serway & John W. Jewett Jr, (2002). Principles of Physics: A
calculus-based text, Singapore: Thomson Learning.
Welcome To ICAEW.Com (2015). Retrieved from http://www.icaew.com
INTRODUCTION
„Accounting has frequently been described as a body of practices which
have been developed in response to practical needs rather than by
deliberate and systematic thinking.‰
Chambers (1963)
In order to answer the above questions, we would probably refer to the theory of
gravity (as shown in Figure 1.1), the Keynesian theory of money and accounting
theory respectively.
So, why do we have such high regard towards these theories for their powers of
explanation and prediction? In fact, what is a theory? Why is accounting theory
important to accounting?
Accounting standard setters have been, for a long time, trying to develop a
theoretical framework that would provide a more consistent treatment of like
items. However, instead of resolving the inconsistencies in practice, the
frameworks have often been used to justify or support such inconsistencies. In
addition, such frameworks are universal guidances, and thus are often too general
to provide a clear set of decision rules for the preparation of financial statements.
In this topic, we will look at the definition of accounting theory. Then, we will
examine the formulation of accounting theories and their significance. Lastly, we
will discuss the developments in accounting theories.
In this subtopic, you will learn about the accounting theory and the purposes of
these accounting theories.
Commonly, theories exist only until they are replaced by a better theory.
ACTIVITY 1.1
Example:
Example:
Deduction
Proposition 1: All companies should prepare financial reports to satisfy the
information requirements of all users of the reports.
Proposition 2: All users of financial reports are concerned about the solvency of
reporting companies.
----------------------------------------------------------------------------------------------
Conclusion and
Proposition 3: All companies should prepare financial reports to report the
solvency of the companies.
Proposition 4: The solvency of all companies is indicated by the net realisable
value of their assets.
-----------------------------------------------------------------------------------------------
Conclusion: All companies should measure assets at net realisable value in
their financial reports.
Induction
Proposition 1: Companies A and B will measure assets at net realisable value in
their financial reports.
Source: Adopted from Godfrey, J., Hodgson, A., & Holmes, S. (2003)
It is important to note that the assessments of the limitations and constraints will
restart the cycle if a research problem is identified.
ACTIVITY 1.2
For example, managers will support standards that lower taxes, reduce
political and bookkeeping costs and increase management compensation.
SELF-CHECK 1.1
For many years, accounting standard-setters have been trying to resolve the
inconsistent problems by developing a conceptual (theoretical) framework that
provides more consistent treatment of like items. However, rather than resolve
the inconsistencies in practice, the frameworks are used to justify or support such
inconsistencies. Beside, these universal guidances are too general to be able to
provide any clear set of decision rules.
7. What is the main problem with the accounting theories developed during
the „positive era‰?
5. What factors do you think might have contributed to the emergence of such
a diverse range of ideas in the golden age of accounting theory during the
1960s?
7. Using a deductive theory, develop a syllogism that moves from the premise
that (a) All firms that are unable to pay a certain rate of dividends to their
shareholders should cut back on their unprofitable operations, to the
conclusion (b) ABC company should retrench 1,000 workers from its Kuala
Selangor-based assembly plant.
INTRODUCTION
How do we study accounting theories? How do we know whether a particular
accounting theory is useful to us?
One way of doing it is to classify the theories according to the assumptions they
rely on, how they are formulated and their approaches to explaining and
predicting actual events.
The purpose of this topic is to explain how these classifications influence the
development of the accounting theories. The weaknesses and criticisms of these
various theories will also be discussed.
However, this approach has been criticised for not providing a logical assessment
of the accountantsÊ actions, that is, it does not analyse whether the accountants
are reporting in the manner that they should be reporting. Also, this approach
does not allow for changes in the accounting techniques. For example, we teach
students the accounting techniques through our observation of the practices of
accountants, and those students will one day become practising accountants,
whom we will observe to learn what to teach.
Sterling (1970) criticised the pragmatic approach for focusing too much on the
behaviour of accountants instead of measuring the attributes of the firm, such as
assets, liability and profit.
Sterling comments:
However, according to Godfrey et al. (2006), the weaknesses of this approach are
that some users may react in an illogical manner, some may already have a
preconceived opinion and others may not react when they should.
ACTIVITY 2.1
Can you think of examples of the types of issue that might cause users
to react in an illogical manner?
Even if the prediction can be verified, it verifies the prediction model of the user,
not the accounting system. Other variables such as inflation, interest rates and
consumer confidence might also affect a prediction.
ACTIVITY 2.2
conditions. Observations that conflict with the universal law of the theory will
not be accepted.
These theories can co-exist, and can complement each other. For example,
positive accounting theory can help provide understanding of the role of
accounting, which, in turn, can form a basis for developing normative theories to
improve the practice of accounting.
ACTIVITY 2.3
The HJT research describes the way in which people use and process pieces of
accounting information in a particular decision-making context.
For example: A bank officer (the decision maker) will look at the financial
ratios and other financial information (look through the lens of cues which
The strength of the Brunswik Lens model is that it is a statistical model, and
thus the random error in human judgement owing to factors such as
tiredness, illness or lack of concentration is removed.
However, the limitation of the Brunswik Lens model is that it does not
explain how a decision is made. It assumes that the decision maker is able
to process simultaneously all the information; in reality, the majority of
decision makers analyse problems in a step-by-step process, assessing one
piece of information first, then moving on to the next piece and so on until a
decision is reached.
In order to overcome the limitations of both the Brunswik Lens model and
the process tracing methods, some researchers combined the predictive and
descriptive powers of the two approaches, and produced a statistical
technique known as „Classification and Regression Trees‰ (CART).
However, it was found that under CART, the more data is available for
analysis, the more complex the resulting decision tree.
However, evidence from studies (Birnberg and Shields, 1989; Libby, 1981)
suggests that human decision makers that include accountants and auditors
are generally not good intuitive statisticians. Instead, the accountants and
auditors use the „rules of thumb‰ or biases, because of the complexity of
the types of judgements they need to make. In fact, these „rules of thumb‰
may represent an efficient and effective method of dealing with complexity
and the limitation of human cognitive processes.
... First, studies on the same topic have produced conflicting results, preventing
conclusive guidance for policy decisions. In addition, the experimental subjects
and settings used in these studies often differ from those found in real judgement
settings. Finally, accounting researchers have questioned whether policy should
be influenced by research on individual decision makers.
ACTIVITY 2.4
Accounting is a function of human behaviour and activity. As such, is
not all accounting research behavioural? Justify your answer.
Behavioural research has relied heavily on the Brunswik Lens model and the
probabilistic judgement model.
2. Can positive theories assist normative theories, or vice versa? If yes, give an
example. If no, why not?
INTRODUCTION
Nowadays, there is a debate over using and usefulness of paradigms in
accounting literature. This topic aims to discuss the meaning and implications of
different paradigms in accounting research topics. The paradigms discussed are
Mainstream (Functionalism), Interpretive, and the Critical schools of thought.
Each of these paradigms investigates one aspect of research which is also true for
accounting. But using solely one paradigm is not enough to offer a
comprehensive view of the research issue. That is why researchers are strongly
advised to analyse their research topics by the use of different paradigms.
Gross and Levitt (1994) wrote a book entitled Higher Superstition: The academic
left and its quarrels with science. Another case for this point is the paper written
by Alain Sokalwho, who later admitted that this paper was full of nonsense. The
reason that Alain published it was to show the extent that it is not at all a big deal
to have nonsense published to the public. However, these cases are not intended
to confirm that paradigms are useless. No one can deny the fact that paradigms
are not free from mistakes, but if researchers are performing the research with
appropriate approaches and also with enough precision, the resultant theories
will definitely be useful, practical and valuable.
The meaning of paradigm was first defined by Thomas Kuhn in 1962 as „The
Structure of Scientific Revolutions‰. According to this definition, researchers and
academicians conduct their research within the borders of a set of rules for a
period of time. But paradigms may not be fixed forever because they are subject
to changes, obsolescent or diminishment. This can happen as a result of new
emerging approaches which may confirm, reject, or question the previous
paradigms. Figure 3.1 presents the idea of the structure of scientific revolutions.
These two groups did not have the same idea on the objectivity of science. While
postmodernists kept criticising the existence of objectivity of methods used in
science and technology, the realists group pinpointed that the methods used in
science are pursuing a specific and clearly defined objective. Realists claimed that
postmodernists did not address the objectivity of paradigms precisely, because
postmodernists combined paradigmsÊ objectivity and political issues.
ACTIVITY 3.1
1. What are the benefits of using paradigms?
2. What type of paradigms have you ever used in accounting?
However, after paradigms reach their saturation stage, the rate of return derived
from them will decline. In addition, paradigms narrow down the scope of
consideration to the framework defined by them. Then, it is possible one day to
find out that the whole picture illustrated by the paradigm had been wrong from
the beginning. Moreover, creativity and thinking out of the box is restricted by
paradigms. That is why the problems which cannot be dealt by paradigms
continue to exist. But, the paradigms of other researchers can assist to solve these
challenges. Therefore, the co-operations of paradigms foster creativity and make
up the puzzle.
Research in accounting can be done by the use of three paradigms, including the
functionalism, interpretive and critical approaches.
Based on the functionalism approach, also called the mainstream method, people
and organisations behave externally, and they live in the surrounding
environment around them. Consequently, functionalism utilises the quantitative
methods in science. Although powers may be distributed unequally among
individuals, this method adopts this phenomenon so as to keep moving towards
a targeted purpose and avoid chaos in the society.
ACTIVITY 3.2
The other paradigm is critical school of thought which focuses on the disparities
existing in the society. According to the critical method, people must be liberated
from the constraints imposed on them in the societal context.
ACTIVITY 3.3
On the other hand, marginal return of the knowledge creation has significantly
diminished, due to the increasing number of studies on a specific topic which has
reached its saturation stage. Moreover, sticking to a unique paradigm imprisons
creativity and innovation. That is why heterogeneity is encouraged in accounting
research, since more fresh ideas and research prepositions have the chance to be
surveyed by the use of other research methods, facilitating variety in the literature.
But low efficiency within the frames of a topic is a risk of heterogeneity, which can
imprison knowledge contribution, particularly for newcomers.
instance, if two companies have the same financial statements, but different
levels of employeesÊ experience and management competency, they are not
worth the same.
ACTIVITY 3.4
ACTIVITY 3.5
What are the economic theories which can be used to facilitate the
accounting paradigms inter-communication?
Investigating the social science topics with the use of different research
tools assists the researcher to figure out the origins of occurring contradictions
or parities. The sources include methodology, assumptions, backgrounds,
affiliations and so on. Creating ontological and epistemological assumptions
and surveying the practical feasibility of these assumptions play a key role
in commencing a mixed method approach in accounting issues. Meanwhile,
scholars in each paradigm are required to check the empirical evidences of using
functionalist, critical and imperative schools of thoughts.
ACTIVITY 3.6
Find some recent accounting research papers which have used different
paradigms. Explain the way different methods are related by the
author.
Are using paradigms always beneficial for researchers? Why or why not?
INTRODUCTION
Luca Pacioli, a Franciscan monk (refer to Figure 4.1), introduced the double-entry
bookkeeping system in 1494. This system was designed to meet the needs of
small business operations such as sole proprietorships, partnerships and joint
ventures in the social and legal environment at that time.
Well, the accounting profession will probably continue to survive even without a
general theory of accounting. However, many problems have arisen due to the
lack of it. For example, allowing firms to select their own accounting methods
(refer to Figure 4.3) within the boundaries of generally accepted accounting
principles have caused confusion and debate as to what is the single most
appropriate practice for a specific circumstance.
It is a normative theory (do refer to Topic 2 if you have forgotten what this means)
and applies to general purpose financial reports only.
ACTIVITY 4.1
According to Devi, Hooper and Davey (2004), the first working group that was
formed upon the establishment of MASB is Working Group 1: Conceptual
Framework.
which do not satisfy sound conceptual values and self-interest. The accounting
principles. profession is perceived as seeking to maintain
its positions in social acceptance and
economic power.
Professional Benefit Risk of Mechanical Decision
The Framework provides a claim of a Accounting is a social science that does not
body of knowledge to ensure that the exist separately from the accountants. The
professional status of accountants is accountants play an important role in the
maintained. creation of measuring and communicating
reality. In fact, accounting may be dominated
by particular methods or assumptions, which
leads to generalisation of empirical research.
The practicing accountants at the micro level,
who need to resolve problems in specific
situations will be ignored.
Let us now look at the different needs of these users as shown in Table 4.2.
Table 4.2: Different Needs of Users
(a) Relevance
Figure 4.9 shows the four aspects of relevance.
The IASB Framework views information as relevant if it can help the users
in the following manner:
(i) Assist the users to form predictions on the outcome of past, present or
future events (Predictive Value); and/or
(ii) Help the users to confirm or correct their past evaluations (Feedback
Value).
By doing so, the users will be able to assess the rendering of accountability
by the preparers.
ACTIVITY 4.2
(b) Understandability
Understandability is defined as that quality of financial information that
exists when users of that information are able to comprehend its meaning.
In other words, information that is not understood is not useful as it
conveys no message.
(c) Reliability
The concept of reliability refers to the quality of financial information that
exists, which can be relied upon to represent faithfully and without bias or
undue error, the transaction or event.
Key Characteristics of
Explanations
Reliability
Faithful Representation Financial statements must report the actual transactions
and events that affect the firm. There are two other
concepts that help to achieve faithful representation:
• Substance over form – Transactions or events
should not be recorded merely in their legal form.
They must have substance and must reflect
economic reality.
• Prudence – This means that under the condition of
uncertainty, accountants must take caution in the
exercise of judgements when making estimations.
Verifiability Verifiable data is said to exist, when knowledgeable
and independent individuals develop essentially
similar measures or conclusions from examining the
same evidence, data or records. In other words,
verifiability focuses on whether a particular
measurement basis is correctly applied, rather than on
whether it is appropriate.
Completeness Financial information must be presented in
completeness within the boundaries of materiality and
cost. Reliability of the information is affected by
incomplete information, because an omission can cause
information to be false or misleading.
Neutrality Financial statements must be neutral. In other words,
financial information must not be presented in such a
manner as to influence the usersÊ judgement and
decision-making process.
(d) Comparability
Comparability is a concept whereby the users of the financial statements
are able to identify real similarities and differences in economic phenomena
of a firm at one time and over time, or between firms at one time and over
time. Thus, it is important that information be measured and presented in
the same manner for the firms to achieve comparability. In other words,
comparability can only be achieved when there is consistency in
measurement and display of information by the firm, from period to period
and by different firms.
ACTIVITY 4.3
Does „consistency‰ mean that a firm cannot change from one method of
accounting to another? Justify your answer.
Under the IASB Framework, the explanations for the three key assumptions
underlying the preparation of financial statements are:
(c) Periodicity
The periodicity assumption implies that the economic activities of a firm
can be divided into artificial time periods. Commonly, these periods are on
monthly, quarterly and yearly bases. Accountants need to determine the
relevant transactions to be reported for the specific accounting period.
Copyright © Open University Malaysia (OUM)
TOPIC 4 CONCEPTUAL FRAMEWORK AND STANDARD SETTING PROCESS 61
4.4.4 Constraints
Although the financial information may be relevant, reliable and material,
sometimes due to certain constraints, the information may not be selected for
inclusion in the financial statements.
(a) Timeliness
There are two aspects to this constraint:
Elements Definition
Assets are probable future economic benefits obtained or controlled by a
Assets
particular entity as a result of past transactions or events.
Liabilities are probable future sacrifices of economic benefits, arising from
present obligations of a particular entity to transfer assets, or provide
Liabilities
services to other entities in the future as a result of past transactions or
events.
Equity or net asset is the residual interest in the assets of an entity that
Equity remains after deducting its liabilities. In a business enterprise, the equity
is also called the ownership interest.
Inflows or other enhancements of assets of an entity or settlements of its
liabilities (or a combination of both) from delivering or producing goods,
Revenues
rendering services, or other activities that constitute the entityÊs ongoing
major or central operations.
Expenses are outflows or other using-up of assets or incurrence of
liabilities (or combination of both) from delivering or producing goods,
Expenses
rendering services or carrying out other activities that constitute the
entityÊs ongoing major or central operations.
Thus, a transaction or event has to satisfy both the definition and recognition
criteria for it to be an element of the financial statements. This is summarised in
the Figure 4.13.
The operating procedure is governed by the set of rules called „The Rules of
Procedures‰.
(f) Rules governing public announcements and the kinds of information made
broadly available to the public.
Although the nature of research activities depends on the project, the following
are common steps in the standard-setting process:
(a) The Board identifies financial reporting issues based on requests or
recommendations from stakeholders or through other means;
(b) The FASB decides whether to add a project to the technical agenda based
on a staff-prepared analysis of the issues;
(c) The Board deliberates at one or more public meetings the various reporting
issues identified and analysed by the staff;
(d) The Board issues an Exposure Draft to solicit broad stakeholder input (in
some projects, the Board may issue a Discussion Paper to obtain input in
the early stages of a project);
(e) The Board holds a public roundtable meeting on the Exposure Draft, if
necessary;
(f) The staff analyses comment letters, public roundtable discussions and all
other information obtained through due process activities. The Board
redeliberates the proposed provisions, carefully considering the
stakeholder input received, at one or more public meetings; and
(g) The Board issues an Accounting Standards Update describing amendments
to the Accounting Standards Codification.
The five stages are followed for Due Process of standard-setting in Malaysia:
In IASBÊs draft Discussion Paper, Exposure Draft and Request for Views, MASB
invites local constituents to comment on its website. The invited parties are the
relevant authorities, professional bodies, accounting firms, industry-related
associations and public listed companies.
The deadline of commenting is one month before IASBÊs comment deadline. The
reason is so that MASB has enough time to analyse the comments before
forwarding them to IASB.
The draft pronouncements of the IASB Board are prepared through a Working
Group (WG) meeting. The public comments are referred to in the meeting as well
(see Stage 3).
WG's comments and recommendations are summarised then and sent to the
Board for deliberation and consideration. After the Board reviews all comments
received, a comment letter to the IASB will be prepared and submitted to IASB
accordingly.
MASB Board performs the due deliberation which leads to MFRS preparation. A
copy of that will be sent to FRF before issuing the standards as a Malaysian
approved accounting standard
For FRF, a total of 19 members were appointed by the Ministry of Finance (MOF)
and their aim is to monitor the MASBÊs performance, financial and funding
arrangements. FRF also functions as an initial source of opinions for the MASB
on proposed standards and pronouncements. It must be noted that FRF is not
directly responsible for setting the accounting standard.
In terms of MASB, it makes sure that the Malaysian accounting standards are
derived from the International Accounting Standards (IAS). To date, a total of 24
accounting standards of IASs were adopted and approved.
The harmonisation of IFRS began many years ago, within 2004 to 2005. The
MASB discussed the implications and effects of IFRS adoption. Prior to this
period, MASB instructed all Malaysian listed companies to adopt 21 Financial
Reporting Standards (FRS). It was decided that January 1, 2006 was the effective
date for the harmonisation of Malaysian financial reporting with the globally
approved accounting standards. By January 1, 2012 both FRF and MASB agreed
to fully adopt all IFRS. The MASB corresponded with the IFRS numbering,
however, adding a prefix of 1 which denotes an Islamic financial reporting
standard. The following section will focus on the challenges experienced by
Malaysia in the adoption process of IFRS
Lack of enough expertise and a forced timeline for the convergence toward IFRS
in 2012 was the most common challenge. Another issue was fair value
accounting. It is still not clear how to implement fair value of financial
instruments, IFRS 9 in particular. Moreover, the earnings will not be stable by fair
value accounting implementation. As a result, it is necessary for the financial
reporters to inform the stakeholders about the impact of using IFRS on profit.
• The IASB framework has been used as a basis for the MASBÊs proposed
conceptual framework.
• There is a distinction between the definition and recognition criteria for the
elements. A transaction that meets the definition of an element, but fails in
the recognition criteria will not be included in the financial statements.
Comparability Prudence
Completeness Relevance
Conceptual framework Reliability
Consistency Representational faithfulness
Feedback value Substance over form
Materiality Timeliness
Neutrality Understandability
Predictive value Verifiability
I Lenders
II Managers
III Government
IV Public
I Relevance
II Reliability
III Understandability
IV Comparability
(a) IASB.
(b) MIA.
(c) FASB.
(d) MASB.
„Even if a liability meets the IASB framework definition, it still should not
be recognised if the firm cannot measure reliably the future sacrifice to be
made.‰
(c) Assumptions.
(d) Constraints.
INTRODUCTION
This chapter discusses earning management and its implications and
consequences. Earning management is concerned with the managersÊ intention to
manipulate the financial information of the company to make the companyÊs
overview seem favourable. As a result, the financial information of the company
lacks necessary qualitative factors. Some of the techniques to conduct the earning
management are discussed. This chapter ends with some cases regarding earning
management. Through the cases, the empirical situations in which the earning
has been manipulated in order to mislead the financial information users are
referred to as well. Next, the chapter provides some examples of local and
foreign cases that relate to creative accounting. In creative accounting,
Earning management has become so widespread on the grounds that it has a lot
of personal benefits for managers to alter not only the organisationÊs profitability
but also their own performance. Although earning management rate is on the
rise, individual investors are not able to discover it due to the current
complicated accounting rules.
There are many other techniques for earning management, even though as stated
above, it is difficult for individual investors to figure them out.
to increase income when income is below the bogey or above the cap, because
there is no potential to gain a higher bonus.
As the empirical research revealed, the average accrual of firms with the net
income between bogey and cap had been increased for 94 companies within a
period of 50 years. Consequently, the net profit had been increased which led to
higher managersÊ bonuses. On the contrary, firms with the net income either
below the bogey or above the cap had negative average accruals due to lack of
bonus opportunity for managers.
SELF-CHECK 5.1
Briefly outline the four motivation of earning menagement.
According to Amat, Blake and Dowd, 1999, creative accounting is defined as:
Creative accounting has been attracting a lot of attention in recent times due to
the many corporate scandals. For example, EnronÊs management hid debts and
inflated profits using off-balance sheet techniques; HIH employed creative
accounting techniques and obtained unqualified audit reports to hide its
insolvent position; WorldCom was under investigation for its US$7 billion
accounting misrepresentations.
There are two main reasons why a firm uses creative accounting. They are:
(a) To prevent shareholders from withdrawing capital; and
(b) To show good stewardship and performance.
The following demonstrates some local and foreign cases of creative accounting.
ACTIVITY 5.1
Creative accounting should be controlled by a stringent audit process.
Local Case:
Consequently, the shares declined from RM14 to RM8 due to the public
announcement of the scandal in May 2007. The market capitalisation
substantially suffered from this price off.
Figure 5.2 shows the Transmile Group Berhad stock price within the first 10 days
of May 2007.
Megan Media was a company dealing with optical media storage. In April 2007,
two main subsidiaries failed to provide trade facilities. The creditor bank
initiated investigation on the wholly-owned subsidiary called Memory Tech
Sdn Bhd.
The first report showed notable irregularities in the Memory TechÊs financial
statements, fictitious trade creditors and debtors, undisclosed related party
transactions and a bogus deposit payment of RM211 million for production lines.
The Security Commission commenced the scrutiny on the whole group. As was
expected, the investigations on Megan Media uncovered losses which were
shown as profit instead. Since the company defaulted in submitting its
regularisation plan to the authorities according to the PN17 timeframe, it was
delisted in April 2008.
The reason for this was announce as misappropriation of funds. The earning
was manipulated and RM1.7 million was paid to a supplier who never made
any delivery.
The total financial effect was RM5.86 million which would be adjusted in the
previous year accounts.
SCAN also reported to police about its CEOÊs intention to mislead the board of
directors by manipulating RM6.8 million of its revenue in 2005 and 2007.
Although the CEO was the major shareholder, the board removed him in an
extraordinary general meeting in March 2009.
The significance of this fraud became apparent when it was considered that the
total sales to Starlight in 2008 and 2009 were about RM131 million, but RM82
million of that had not been paid yet.
The company faced major challenges in its operations due to its suppliersÊ
disapproval to credit sell, lowered confidence in its products, failure to pay EPF
contribution and income tax and the banksÊ withdrawal of its credit facilities.
Closing remark:
All the cases reported above demonstrate creative accounting incidents. Based
on agency theory and positive accounting theory, creative accounting exists in
relation to both managers and shareholders and from the „loose‰ accounting
standards that allow managers and accountants to practice their discretionary
judgement. In conclusion, creative accounting offers a formidable challenge to
the accounting profession.
Discuss what actions can companies take in order to prevent the above
mentioned financial failures.
INTRODUCTION
What is an asset? What is a liability? The Oxford dictionary defines „asset‰ as „a
thing, especially property owned by a person, company, etc. that has value and
can be used or sold to pay debts.‰ „Liability‰ is defined as „a debt; a financial
obligation.‰
So, can we say that a firmÊs building is an asset? Most of us would say that it is an
asset.
Let us ponder on Figure 6.1. Now, assume that the building was infested with
rats and was in such a bad condition that rendered it to be unusable for a long
period of time. Would you still hold the view that the building is an asset?
What if the workers who worked near the building suffered from health
problems due to the unhygienic environment and were suing the firm? Does the
firm have a liability, even though the case has not been decided?
DonÊt worry. There is an easier of way of understanding what an asset really is.
6.1.2 Definition
Based on the Malaysian Accounting Standard BoardÊs (MASBÊs) Framework for
the Preparation and Presentation of Financial Statement, an asset is defined in
paragraph 49(a) as:
The future economic benefits may flow to the firm in the following ways:
(i) an asset may be used solely or in combination with other assets in the
production of goods and services to be sold by the firm; and
For non-profit organisations, the assets are used to provide services to the
beneficiaries. As generation of net cash inflows is not always the objective
of these organisations, these assets can benefit the organisations by enabling
them to meet their objectives of providing needed services to the
beneficiaries.
In summary, an asset is something that exists now and has the capability of
rendering service or benefit currently or in the future.
Copyright © Open University Malaysia (OUM)
TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY 91
Example:
A transport company purchases a lorry for RM200,000. It pays RM50,000
now and agrees to pay the balance in instalment over the next two years. Is
the lorry an asset of the company?
In the above example, the transport company does not have the legal ownership
for the lorry until it has fully settled the payment. However, it owns the legal
rights to use the lorry. In other words, it has the right to obtain the service of the
lorry and it has control over the lorry. Thus, the lorry can be considered as an
asset of the company in the accounting sense.
ACTIVITY 6.1
Give another two examples of assets whereby the user has control but no
legal right over the assets.
Example:
ABC Company acquired a printing machine early this year. Therefore, the
machine is an asset. ABC is budgeted to purchase a second printing
machine later this month. In this case, the second machine is not an asset as
the transaction has not yet taken place.
Well, employees certainly provide future economic benefits to the company, the
company pays their wages therefore has control over them and they are the
result of a past event (the recruitment of the employees).
(a) It is probable that the future economic benefits will flow to the entity; and
(b) The asset has a cost or value that can be measured reliably.
„Probable‰ means that it is more likely rather than less likely that future benefits
will arise.
„Measured reliably‰ means the asset must be capable of being measured reliably
before it can be recognised. If the assetÊs value cannot be determined without
being arbitrary or subjective, then the asset is not recorded.
Going back to the earlier example on human resource, it is obvious that the
employeesÊ contribution to the company cannot be measured reliably, as the
employees may fall sick, go on emergency leave, be affected by personal
problems, suffer from depression and other factors, which are very much beyond
the control of the company.
IMPORTANT!
In summary, even though the probability of realising the future economic
benefits is not important to defining an asset under MASB framework, it is
critical in deciding whether to record an asset.
SELF-CHECK 6.1
1. What are the types of assets?
2. Explain the key words that make up the definition of „asset.‰
Now that we know what assets are and when to record them, let us look at
another important element in the balance sheet – liability.
6.2.2 Definition
Based on the MASBÊs Framework for the Preparation and Presentation of
Financial Statement, a liability is defined in paragraph 49(b) as:
Again, just like the definition for assets, do pay close attention to the key words
in bold.
Do you know the parties who may have claims on the company? They are
the creditors and the owners of the company. Do bear in mind that between
the claim from creditor and claim from owner, only the claim from creditor is
a liability, because the creditor has prior claim on an asset in case of
liquidation. Also, the creditorÊs claim is almost more specific in terms of the
amount and the timing of the payment, as compared to the ownerÊs claim.
In addition, the creditorÊs claim is an obligation of the company. The
ownerÊs equity claim is basically a residual interest or claim, and not an
obligation of the company to transfer assets.
So far, we have discussed the various ways in which a company can settle
its present obligations, and the fact that only claim from creditors are
liabilities. Let us now examine the different kinds of obligations that a
company may have.
ABC Company borrows RM100,000 from XYZ Bank and promises to repay
the loan by giving 10,000 of its own ordinary shares. Is it a liability?
The answer is NO. This is because ABC is not making a transfer or sacrifice
of asset. Shares in the company are not shares of the company. In reality,
this is unlikely to happen because no bank will be willing to assume this
kind of equity risk.
Examples:
• Accounts payable arises from the purchase of goods and the usage of
services;
• An obligation to repay the bank for the receipt of bank loans; and
• Future rebates based on annual purchases by customers.
SELF-CHECK 6.2
1. What are the types of liability?
2. Explain briefly the two key words that make up the definition
of liability.
ACTIVITY 6.2
Similar to the criteria for assets, a liability is recognised in the balance sheet
when, and only when:
Most liabilities are determined on the basis of legal claims against the company
that it is obliged to meet.
6.3 MEASUREMENT
The definition of accounting measurement is the calculation of economic or
financial activities in terms of money, hours or other units. The measurement is
use to compare and evaluate accounting data.
For example, measurements can affect investment and lending decisions. Most
lending contracts contain debt covenants that specify the maximum level of
leverage that a firm can have.
What do you think will happen if the liabilities are grossly understated and
assets are grossly overstated? As individuals like investors and lenders rely on
the reported measurements when making decisions, obviously they will suffer
losses especially if the company fails or is less economically profitable than
expected. Investors may even take legal action against the company on the basis
of such losses.
ACTIVITY 6.3
There are several monetary values that can be used to value the characteristics of
assets and liabilities, such as historical cost, current cost and exit price level. We
will discuss these measurement bases in Topic 8 of this module.
Question:
Which measurement base, in terms of measuring the value of assets and
liabilities, would provide the most relevant and reliable accounting information
to managers, investors and creditors?
Basically, the firmÊs choice of measurement base will depend on whether the
measurement is in terms of:
(a) Cost; or
(b) Value.
(a) Cost
The cost of acquisition of an asset is the fair value of whatever is given in
exchange for the asset plus any cost incidental to the acquisition.
Thus, if the firm thinks that „cost‰ should provide the most reliable and
relevant accounting information to the users, then the measurement bases
to use would be historical cost and current cost accounting.
Historical cost refers to the cost at the time the asset is incurred. However, it
is rarely a truly objective measurement since it can be measured according
to a variety of assumptions.
Current cost refers to the amount that would be paid now to acquire the
best asset available to undertake the function of the asset owned. In other
words, it focuses on the cost of a currently available asset that is expected to
replace the existing asset, adjusted for the value of any operating
advantages or disadvantages of the assets owned.
(b) Value
Value refers to the preference that people have for some items over others
because of the perceived benefits to themselves. In other words, value is not
intrinsic to the specific asset or liability, but relates to the consumerÊs
willingness to give up something to obtain it.
„True economic value‰ is the most useful value to the users of financial
statements. However, it is a subjective concept as it relates to the preference
or desirability people have for one item as opposed to others.
Exit price refers to the amount received from selling an asset either to a
market for new commodity or to a second-hand market.
Net realisable value is defined as the expected selling price less expected
costs of disposition.
But,
From the objective point of view, the incurrence of cost does not necessarily
create future value that will equal to cost. This is because „cost‰ is an indicative
value at the time of exchange. Over a period of time, if there is evidence that the
value is less than cost, or greater than cost, an adjustment should be made in the
accounts to reflect the „value.‰
SELF-CHECK 6.3
1. Can you recall the importance of measurement in assets and
liabilities?
2. The measurement base of a firm depends on cost and value.
Explain briefly the two terms.
• The cost of acquiring an asset is the fair value of whatever that is given in
exchange for the asset plus any costs incidental to the acquisition.
Measurement bases to be used are historical cost and current cost.
• Value refers to preference people have for some items over others because of
perceived benefits to themselves. It relates to the consumerÊs willingness to
give up something to obtain it. Measurement bases to be used are exit price
and net realisable value.
4. Requiring the same recognition criteria of „probable‰ for all the elements of
financial statements, the MASB framework aims to make redundant which
of the following?
1. Toy World operates a chain of toy shops. The business has been operating
for five years. The chief accountant has come to you for advice about two
financial reporting issues raised at a meeting of the board of directors. For
each issue, write a brief response to the chief accountantÊs proposal. Your
advice should include reference to the definition of the elements of financial
statements in the MASB framework.
(a) The company has placed an order with a toy manufacturer in China
to build a specialised piece of equipment at a cost of RM800,000. The
company has paid a deposit of 10 per cent which will be forfeited in
the event of cancellation. The board of directors say there is no
intention of cancelling the contract. The chief accountant is proposing
to recognise the full amount as an asset on payment of the deposit.
(b) In the five years that Toy World Berhad has been operating, they have
only had to pay one claim to a customer who was injured as a result
of slipping and falling on a wet floor. The claim was settled by Toy
World for RM50,000. On the basis of that experience, the chief
accountant has proposed charging RM10,000 each year as a provision
that would grow to cover any future claims that may arise.
Copyright © Open University Malaysia (OUM)
104 TOPIC 6 RECOGNITION OF ISSUES ASSOCIATED WITH ASSET AND LIABILITY
3. What is the concept underpinning fair value? Why does a simple concept
become difficult?
4. Mesra Berhad is attempting to bring its account in line with the Malaysian
accounting standards. Advice the accountant of Mesra Berhad whether a
liability exists in each of the following cases and, if so, what the liability is:
(a) An order for raw materials has been placed with the firmÊs regular
supplier.
(b) There is a signed contract for the construction by Bina Berhad of a
major item of plant for Mesra Berhad.
(c) The firm has unsecured notes of RM1,000,000 outstanding. Interest is
payable every six months in June and December. It is now August.
Recognition
7 of Issues
Associated
with Profit,
Revenue
and Expense
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define profit, revenue and expense;
2. Identify the recognition criteria for profit, revenue and expense; and
INTRODUCTION
We have examined definitions and the recognition criteria of assets and liabilities
in Topic 6. Let us now discuss three other key elements in financial statements in
this topic – profit, revenue and expense.
Profit, generally means how much richer a person or entity has become in a given
period. Reported revenue shows the firmÊs past operation and is used to predict
future performance. Reported expense shows the firmÊs financial position and
performance in its engagement of a range of revenue-generating activities.
However, for decades, economists and accountants have been debating on the
appropriate basis for profit measurement (refer to Figure 7.1).
Figure 7.1: Debates on appropriate basis for profit measurement have been ongoing
Source: http://www.nydailynews.com
This topic will examine some of these issues in relation to profit, revenue and
expense.
„The residual amount that remains after expenses (including capital maintenance
adjustments, where appropriate) have been deducted from income⁄‰
You will notice that the term „income‰ is used in the definition instead of
„revenue‰. This is because „income‰ encompasses both „revenues‰ and „gains‰
(refer to Figure 7.2).
Gains are increases in net assets from „peripheral or incidental transaction‰ and
from other events that may be beyond the control of the firm. Examples, disposal
of non-current assets and unrealised gains on holding assets.
„⁄Any amount over and above that required to maintain the capital at the
beginning of the period is profit.‰
ABC Company invested RM10,000 cash to start a business. In the beginning of Year 1,
ABC purchased stock for RM5000. Later that year, the stock was sold for RM8000. The
owner of ABC did not take any dividend during that year.
RM10,000 RM10,000
RM13,000 RM13,000
Let us see what are the views of „profit‰ between accountants and economists in
Table 7.1.
Table 7.1: Differing Views of „Profit‰
SELF-CHECK 7.1
ACTIVITY 7.1
A transaction that is revenue in nature deals with short term items such as
income and expenses. Now, let us see in detail the definition of revenue.
In other words, the definition states that revenues are increases in the total
value of assets (or a decrease in the value of liabilities) and capital other than
Copyright © Open University Malaysia (OUM)
TOPIC 7 RECOGNITION OF ISSUES ASSOCIATED WITH PROFIT, 111
REVENUE AND EXPENSE
ACTIVITY 7.2
At what point during the earning process, with sufficient evidence, can
revenue be recorded as earned?
Similarly, the recognition criteria for revenue are based on the desire for both
relevant and reliable accounting information. Specifically, the three criteria are
shown in Figure 7.3.
ACTIVITY 7.3
Must the asset received be liquid (such as cash and receivables) before
revenue can be recognised? How about a firm that sells its product in
exchange for a non-current asset (such as plant and equipment)? Can
the revenue earned be recorded?
Questions Answers
Must a firm be a participant in the The firm does not need to be a party to the
transaction before revenue can be transaction for revenue to be recognised.
recognised? Generally, a market transaction is
sufficient.
Why is a firm allowed to recognise the The accounting profession believes that
revenue even though there is no objective evidence is the main criteria for
transaction in which the firm is involved? recognition, not the transaction itself. Thus,
as long as sufficient objective evidence
exists before the moment of sale, the sale of
the output is guaranteed. Example,
inventories such as rice, wheat and barley
can be valued at current market price.
Is market value sufficient in terms of The market value is sufficient objective
objective evidence? evidence provided that:
• the asset can be readily converted to
market value at any time; and
• it is a guaranteed sale.
Now, looking at the operating cycle, let us try to answer this simple question:
Coombes and Martin (1982) say that revenue is recognised at several points in
the earning cycle, for example:
• Point 5 (Progressively throughout production) has been the point of earned
revenue recognition in the building industry for long-term construction
contracts;
• Point 6 (Completion of production) has been the point of earned revenue
recognition for gold-mining companies and also wheat farmers. This is only
applicable when production is the critical event and the subsequent sale is
merely a routine transaction. In other words, the demand for the output must
be assured;
• Point 7 has been applied where it is the responsibility of the purchasers to
collect the goods;
For most cases, Point 8 (delivery of goods to customers) has been the point
whereby the revenue is recognised as earned. This has been applicable to, for
example, soft drinks manufacturers, furniture manufacturers etc; and
Point 9 (Receipt of cash) has been the earned revenue point for professional
practices and for instalment credit sales.
IMPORTANT NOTE!
In the process of deciding whether the revenue should be recorded as earned, your
primary consideration should be the economic substance of the transaction or event,
and not its legal form. In other words, for the revenue to be recognised as earned by the
vendor, the vendor must pass over his or her control over the future economic benefits of
the goods to the buyer.
SELF-CHECK 7.2
1. What is „revenue?‰
2. How is revenue recognised? Explain briefly.
ACTIVITY 7.4
Do you agree that revenue should be recognised in the period in
which service is rendered? Justify your answer.
Expenses are costs arising in the course of the ordinary activities, for example,
cost of sales, wages and depreciation. Normally, they are either outflows or
depletion of assets such as cash and cash equivalent, inventory, stocks, property,
plant and equipment.
In fact, for many accountants, relating expenses to revenues for a given period is
their main responsibility. However, proper matching of expenses to revenue is a
difficult task in practice because it needs a great deal of judgment from the
accountants.
For example, the recognition of certain expenses and revenues might have to be
done on a discretionary basis, some „expenses‰ might be off-balance sheet, and
sometimes less objective evidence might be required for recognition of expense.
ACTIVITY 7.5
It is important to note that the first method (cause and effect) is the ideal
method to be used. The second and third methods (systematic and rational
allocation of cost and immediate recognition) are alternatives when the first
method does not apply.
This method is based on the „cost attach concept‰, that states that goods
and services that are used up (in other words, expenses incurred) have
helped in the creation of revenue for that period.
In other words,
For example:
(i) The efforts of the sales executives in helping the firm to generate sales
revenue for the current period is represented by the commission paid
or payable to them;
(ii) Revenue from the sales of products by the firm is usually related to
the cost of the products sold; and
(iii) Employees are usually assumed to help to create the current revenue
through the services they rendered.
ACTIVITY 7.6
Can you give another example that uses the cause and effect method
of expense recognition?
Figure 7.5: Accountants match costs to the intervals of time (as a cause and effect method)
Here is an example on why the rule of cause and effect can be difficult to
prove.
So, if the cause and effect method is applied, then we are assuming that the
services rendered by the employees and workers of ABC Company
generated one-quarter of the total revenues, or RM50,000. Can this be
objectively proven to be true? Certainly not!
Figure 7.6: Matching process begins by relating expenses to segments of time and to
correlate with the revenue for that period
As you are aware, there are several different procedures for depreciation,
namely the straight-line, units-of-production, sum-of-the-years-digits and
diminishing-balance. Ideally, accountants would select a procedure that
more or less coincides with the pattern of benefits provided by the assets to
future periods of time.
However, this is not the case in practice, due to the inherent difficulties in
applying the cost allocation method. In fact, in the course of preparing the
financial statements, many accountants may ignore matching all together
when it suits them.
Generally the effect of advertising has long-lasting benefits, but they are
often difficult to determine. For instance, a soon-to-be mother may
purchase a certain brand of baby diapers because she has been influenced
by an advertisement she saw two years ago. Therefore, the cost of
advertising is recognised immediately as an expense as the benefits cannot
be determined in a credible manner.
SELF-CHECK 7.3
1. What is „expense?‰
2. How do we recognise „expense?‰ Describe at least two
methods of matching.
ACTIVITY 7.7
What do you think would be the best solution to resolve the ambiguity
of the matching procedure in the preparation of financial statements?
How about an allocation-free financial statement using the current exit
price? Do you think such a practice would be acceptable in the
financial community?
• Profit determination and asset/liability valuation are two sides of the same
coin.
This formula clearly reflects the economistÊs view of profit, which is the
change in wealth.
• Revenues give rise to increases in net assets and have stringent recognition
criteria.
• Expenses are monetary events which relate to a decrease in net assets of the
firm but are often recognised by convention rather than application of
principles.
1. What is the definition and concepts of profit that have been adopted and
proposed?
4. What is revenue?
6. What is expense?
7. What are the recognition criteria and the matching concept as they are
applied to expenses in the accrual accounting system?
1. Revenue was recognised when the events below occurred (accrual system).
State whether it was proper or improper according to accepted recognition
principles.
(a) An order is received from the customer for 200 boxes of chocolates. It
is approved by the credit department.
(b) A roof repairer did some work a year ago, but waited until now to
record the revenue because it took that long to collect the bill.
(c) A contract is signed by a customer who agrees to have the firm build
a house for him according to his specifications. It is estimated that
construction will take eight months. The customer will pay in full
when the house is completed.
(d) A lorry is delivered to a customer and a conditional sale contract is
signed by the customer. Title is to remain with the seller until the
customer makes full payment in six months.
(e) A vacuum cleaner is delivered to a customer. The customer made a
down payment and is expected to make monthly payments for the
next 24 months. The credit rating of the customer is good. The full
sales value was recorded as revenue.
2. Name the three basic methods of matching. Give an example of each. How
do they align with the expense recognition criteria?
INTRODUCTION
Accounting information should be provided in a way that assures users of the
qualitative characteristics to support decision making. The Financial Accounting
Standard Board (FASB) aims to provide high quality information which benefits
users such as creditors and investors. Relevance and reliability are two kinds of
financial accounting information with qualitative characteristics. This topic
discusses how these concepts are defined and include their challenges and
cautious considerations.
„Although there seems to be considerable support for the view that reliability
should be the dominant quality in the information conveyed in financial
statements, even at the expense of relevance, while the opposite is true of
information conveyed outside the financial statements, that view has in it the
seeds of danger. Like most potentially harmful generalisations, it does contain a
germ of truth: almost everyone agrees that the criteria for formally recognising
elements in financial statements call for a minimum level or threshold of
reliability of measurement, that should be higher than is usually considered
necessary for disclosing information outside financial statements. But the
remainder of the proposition does not follow. If it were carried to its logical
conclusion ... the end would be that most really useful information provided by
financial reporting would be conveyed outside the financial statements, while
the audited financial statements would increasingly convey highly reliable but
largely irrelevant, and thus useless, information. [paragraph 44]‰
Understandability means that users must understand the information within the
context of the decision being made. It is a user-specific quality, because they are
different in their capabilities to comprehend different information. The primary
financial reporting objective here is to provide comprehensible information to the
Copyright © Open University Malaysia (OUM)
TOPIC 8 REALIBILITY AND RELEVANCE ISSUES 127
Next, the two primary qualities, namely, reliability and relevance required for
financial information are explained.
ACTIVITY 8.1
8.3.1 Relevance
To make different decisions, information must have predictive and/or feedback
values. In general, useful information has both of those qualities. For instance,
when net income and the relevant components provide investor expectations on
its future cash-generating ability, then net income has feedback value. This
confirmation can also be useful in predicting future cash-generating ability in
revising the expectations.
This predictive ability is the main concept in earnings quality. It indicates the
ability of earnings to predict a companyÊs future income. This is a concept to
explore the impact on earnings quality matters. In separating a companyÊs
transitory earnings from its permanent earnings, a meaningful prediction of
future earnings could be obtained.
8.3.2 Reliability
Reliability indicates verifiable, faithful and neutral information. Verifiability
indicates satisfaction among different measurers. For example, the historical cost
of a piece of land in a transaction or purchasing the land is verifiable, though the
market value of the land is much more difficult to verify. The historical cost of
the land is objective but the landÊs market value is subjective, being influenced by
the measurerÊs past experience and prejudices. A measurement that is subjective
is difficult to verify, so it makes it more difficult for users to rely on.
For many people, the term reserve that was used for double accounts indicates a
sum of money that is set aside for future bad debts. This term did not show
representational faithfulness. The description „reserve‰ now has been changed to
„allowance for uncollectible accounts‰ or „allowance for doubtful accounts‰.
ACTIVITY 8.2
Discuss in class how reliable accounting information affects suppliersÊ
decision-making process.
Relevance and reliability have clashing qualities. For instance, provided forecast
of net income by the management of a company could have a high degree of
relevance to investors trying to predict future cash flows.
For example, when fair values of assets are stated in financial reporting and
assets valuation, although these figures are more relevant, it cannot be inferred
that the information is without reliability. Assets such as shares have continuous
updated values upon demand, whereas land and machineries market prices must
be derived from surveys by the professional practitioners. Therefore, for some
assets with subjective market prices, the recorded values are relevant, because of
fresh evaluations, and reliable, because of verifiability.
ACTIVITY 8.3
Discuss the relevance and reliability of the balance sheet figures of
a sample firm with your peers. Are assets priced according to their
current market prices?
The other challenge in observing reliability and relevance for accountants is the
use of accrual methods. Although these methods are mathematically-based, they
do not necessarily illustrate the real picture. That is why the potential of wrong
presentation of assets in financial statements rises. To clarify, let us have a look
on how Robert R. Sterling stated this fact:
ACTIVITY 8.4
Which qualitative characteristic should be paramount for auditors?
Why? Discuss.
To facilitate comparison of assets values in the US, companies are required to state
the hierarchical fair value level of all financial instruments reported in financial
statements. This classification is defined in „U.S. GAAP Codification Topic 820,
Fair Value Measurements and Disclosures (ASC 820)‰ (refer to Figure 8.2).
For the assets in Level 1, quoted prices are available in the market. Examples are
exchange traded investments, futures and actively traded debts.
Net book values of the assets in Level 2 are different from their current prices:
however, this difference is observable when measurement is made. A typical
example of this type of assets is credit swaps.
Assets that have almost no observable prices at the time of measurement are
classified in Level 3. These assets can be in the form of derivatives, auction rate
municipal securities, asset backed securities, mortgage-backed securities and
direct investments (refer to Figure 8.3).
ACTIVITY 8.5
Classify the assets recorded in the balance sheet of a company and
classify each asset level based on the ASC 820.
The accountants must decide which costs have expired and therefore are to
be matched against revenues in the profit and loss statement, and which
costs remain „unexpired‰ and are to be placed on the balance sheet
statement as assets.
(b) Stewardship
The stewardship objective of historical cost accounting emphasises the
„contractual relationship‰ between a firm and those who provide resources
to it (separation of ownership and control).
The stewardship function requires that those entrusted with the firmÊs
assets and operating activities, normally management, are accountable for
the application of assets to operations and the subsequent impact on the net
value of assets from these operations.
Table 8.1: The Reasons for the Dominance of Historical Cost Accounting
Reasons Explanations
Useful Historical cost data are based on many years of trials and
errors spent to develop those data useful for modern
industrial and managerial accounting practices.
There is insufficient Most research studies indicate that current cost data does
evidence to justify not provide any more information than historical cost
rejection of historical data.
cost accounting
However, critics say that it is the use of the non-current assets, not their
possible sale or purchase, that is relevant.
(d) Matching
No established concept exists to ascertain proper matching.
Matching is essentially a process calling for random decisions to be made,
rather than consistent analysis. There is no way to select one method over
another except arbitrarily.
Shanahan (1992) argues that balance sheets contain outdated cost prices or
valuations that does not represent current market value and, thus, can hardly be
said to be true and fair. An asset cost several years ago does not help investors
assess whether a company is a worthwhile investment.
Some experts argue that measuring assets at their net market value and
measuring liabilities at their present value provides more relevant information to
users about the firmÊs resources than does the historical cost basis of
measurement.
ACTIVITY 8.6
Do you think the complexity of alternative measurement to historical
cost approach has become an excuse for keeping the historical cost
system? Explain your answer.
However, market values are often unavailable for unique fixed assets such as
land, building and heavy equipment specially designed for a particular firm, and
also for used fixed assets that are not unique (even though second-hand market
may exist for these assets).
Items Explanations
Non-monetary items The current cost values are based with reference to:
• The current buying prices;
• Specific indices where market prices are unavailable; or
• The service potential of an identical or like item for
superseded or specialised assets.
Monetary items and loan • Monetary items are claims to a fixed number of dollars.
capital • In nominal terms, they do not change during price
inflation. Examples are trade creditors and trade debtors,
cash, prepayments as well as short-term bank overdrafts.
• Monetary assets are shown at amount they were
originally brought to account.
• Monetary liabilities are value of amount expected to be
paid.
Non-monetary assets Examples are shares and commodities such as gold and
bought and sold on the silver.
same market These assets are bought and sold in the same markets and
do not directly add to the operating capability of the
entity.
These assets are held for income-generating purposes or
for resale at a capital gain. Their ability remains
unchanged in a period of general inflation.
ACTIVITY 8.7
In contrast to Current Cost Accounting, assets are valued at the current
market selling prices for exit price accounting. Do you think these two
systems are complementary or a substitute for each other?
Under EPA, assets are valued at the net realisable amounts that the firm would
expect to obtain for them if they are disposed of in the normal course of
operations. Liabilities would be similarly valued at the amounts it would take to
pay them off as of the statement date.
The income statement for the period would be equal to the change in the net
realisable value of the firmÊs net assets occurring during the period, excluding
the effect of capital transactions.
In other words, the adaptive behaviour sees the firm as always being ready
to dispose off the asset if this action is in its best interest. The firm will keep
a fixed asset only if the present value (PV) of the future net cash flow from
the use of the asset is greater than the PV of the expected net cash from an
alternative investment.
(g) Objectivity
EPA is more objective and comparable than historical cost accounting
because exit values revealed less dispersion (in terms of accounting
estimates in useful life and residual value) than book values.
Godfrey et al. (2006) cited that when an asset is held rather than sold out, it
must be with the reason that it is worth more to its owner than its exit price,
otherwise it would be sold. In other words, the assets are purchased for the
purpose of producing goods for revenue, rather than for selling assets.
Thus, the use of exit price leads to an „absurdity and a flagrant failure to
measure up to the criterion of correspondence with the economic events
which are being recorded‰.
(c) Additivity
It is difficult to evaluate a firmÊs operating efficiency using the Exit Price
Accounting model. Anticipatory calculations cannot be added together
with current figures.
In addition, the cash equivalent of individual assets sold separately and the
same assets sold as a package may be quite different. Exit Price Accounting
does not recognise the possibility of selling assets as one package.
Edward and Bell also argue that some assets that are custom designed for a
company have value in use but little value in exchange. Thus, the management
would believe that their value in use is greater than their exit value.
ACTIVITY 8.8
What is holding gains or loss? What are the benefits of separating out the
holding gains (or loss) in profit determination? What are some of the
shortcomings of this separation?
• Reliability and relevance (validity) of financial information are the two main
important qualities.
• Relevance and reliability are not absolute in nature. But these notions are
more relatively highlighted, and they are achieved based on comparisons due
to the challenges and caveats in the course of their usage.
• One should consider cautiously the evaluation and record the fair value of
assets, relevance and reliability issues in accounting.
• Exit price financial statements are allocation free and relate better to the real
world.
• Exit price is criticised for not measuring events that actually happened;
instead it simply measures events that might happen.
1. Assume you support exit price accounting. Give at least three reasons for
your support.
2. How will the use of current cost accounting help investors make decisions
about whether to buy or sell shares in a particular company?
INTRODUCTION
This topic discusses accounting standards, especially the International Financial
Reporting Standards (IFRS). In the following subtopics, development, benefits
and costs as well as economic consequences of accounting standards adoption
are explained. For clarification, the related economic consequences as well as
sample research cases are provided. Although IFRS is defined in the US, it is
adopted in Malaysia as well. In order to illustrate the importance of financial
standards, the news on the convergence of IFRS with Malaysian Financial
Reporting Standards (MFRS) in 2012 is presented here.
„It is imperative that companies applying MFRS should put in place the
process and the resources to make the necessary assessment of the effects
on their financial statements with the various options that are made
available to them in 2012,‰ said Oong.
Financial reporting requires the costs for preparations and benefits justify these
costs. The FASB tries to improve financial reporting in the most cost-effective
manner.
ACTIVITY 9.1
According to the news stated in the introduction, discuss whether
financial performances of two of the most prominent companies in
Malaysia, namely PETRONAS and Shell Malaysia, have really
improved or not.
The FASBÊs procedures, called „due process,‰ are specifically designed in the
stages of a project, to generate feedback on costs and benefits of a proposed new
standard. The best ways for transactions and the most cost-effective ways to
implement any change are asked from the stakeholders. Technical decisions by
the Board are made in public meetings after careful consideration of the inputs.
Figure 9.1 illustrates the many elements in the BoardÊs decision-making process.
A case in point is the continual struggle between investors and companies. While
the former always pinpoint the importance of having more precise information
on the business processes, the latter try to massage the numbers to present a
favourable picture of whatever goes on in the corporation.
ACTIVITY 9.2
What are the effects on the performance of not-for-profit organisations
by adopting Accounting Standards? Discuss.
It is a fact that all paradigms are considered acceptable because each of them see
the picture from its own perspective. Therefore, there is no absolute right or
wrong opinion. This is relatively true for economic consequences of financial
accounting standards. As the standards are adopted with differing
considerations, they all have their own economic impacts in the business entities.
ACTIVITY 9.3
Discuss the economic consequences of financial reporting standards in
Malaysia.
9.4.1 Advantages
Financial accounting standards facilitate corporate governance practices and
create more efficient capital markets. Informed decision making based on proper
aspects of judgment is also affected by credible financial information. In other
words, presentation of relevant and reliable financial reports enhances its
influence on decisions, whilst it makes the reporting more applicable and
practical to direct the userÊs mind. To boost the reliability and credibility of
9.4.2 Disadvantages
Financial accounting standards implementation leads to expenses for parties
involved. These costs can be viewed at first step by noting who prepares financial
statements. Costs incurred by training, changing the accounting system processes
and revising contracts impose hindrances on standards adoption. New standards
require continuous monitoring and supervision which adds on to the initial costs.
Moreover, managers believe that financial accounting standards changes cost of
capital and the attractiveness of company to third parties, while they are
concerned about compliance challenges. Managers highlight these standards as
costs to organisations, because they are taken, on their behalf, to paths which
may not be required.
Auditors are the next party who must pay the price for new standards adoption.
In addition to the initial costs of adoption as well as the continuous costs of
human resources for extra work imposed by standards, the general terms stated
in standards are regarded as serious challenges to auditing. One of these is the
problem of differing interpretations on the clientsÊ sides. Each customer tries to
consider his understanding from standards, and asserts possible practical actions,
whereas the proper intent of standards is neglected by them. Another
consequence of generalisation in standards is the consequence of the customerÊs
challenge. The amount of lawsuits against auditors seriously endangers the audit
firmsÊ litigation. That is why auditors keep confirming the necessity of detailed
information within financial accounting and reporting standards.
Financial statement users are the largest group who are affected by costs due to
standards. The costs of training and monitoring of standards are common in the
other groups. But, financial statement users may pay the indirect cost of
standards. Specifically, when standards are not able to provide credibility and
consistency in information, financial statement users have to invest in re-creation
and revision of information, so that they can reach their goals and purposes.
SELF-CHECK 9.1
Some studies render it unnecessary for capital market or market participants (for
example, institutional investors) from voluntary IFRS adoption. An example is
the empirical researches on German firms, which revealed that IFRS or US GAAP
(Generally Accepted Accounting Principles) adoption caused lower bid-ask
spread, less turnover and more cost of capital in comparison to the firms without
accounting standards adoption in Germany in the years 2000 and 2006.
Another example is the Cuijpers and Buijink study, which did not create any
support for the betterment in cost of capital forecasting among European
corporations, either with or without IFRS accreditation in 2005; whereas two
years later even higher cost of capital was proved to be imbursed empirically by
the IFRS-adopted firms.
The project was in response to feedback from investors and other users of
financial statements, on the lack of transparency relating to material lease
obligations not included on the balance sheet. Although some industries indicate
that increased transparency on lease obligations would provide less favourable
economic pictures of specific companies, the objective of the standard is to
provide a fair representation of the rights of a company. The purpose is to find
the proper representation of the economic phenomena. Investors consider new
information to be favourable or unfavourable. The Board will carefully consider
the feedback received on the proposed changes to lease accounting before a final
standard is issued.
ACTIVITY 9.4
What incentives do you think increases the adoption rate of accounting
standards? How can governments motivate IFRS adoptions?
For example, researchers may search for empirical evidence about the attributes
of firms that continue to use the same accounting practices from year to year and
compare them with the attributes of firms that continually change accounting
techniques.
ACTIVITY 9.5
It is important to bear in mind that there are certain assumptions about the
behaviour of individuals that one needs to make in carrying out the positive
theory research (refer to Figure 9.5).
Important Note:
Efficient capital market in the context of Efficient Market Hypothesis does
not mean that the financial information presented by a firm is „correct‰ or
„properly‰ interpreted by the decision makers. It also does not imply that
managers make the best decisions or that investorsÊ prediction of future
prices are the most accurate. Market efficiency in Efficient Market
Hypothesis simply means that share prices reflect an aggregate impact of
all relevant information in an unbiased and rapid manner.
Let us now examine the study by Ball and Brown (1968) pertaining to the impact
of accounting profits announcements on share prices.
Ball and Brown tested the usefulness of the historical cost profit figures to
investment decisions. Using the theory in Efficient Market Hypothesis, they
argued that if the information is useful in making investment decisions, share
prices would adjust to reflect that information.
In the study, Ball and Brown used data for 261 firms between the period of 1946
to 1966. They focused on the price impact of unexpected profit announcements.
They found that 85 per cent to 90 per cent of the information contained in the
earning announcements was anticipated by the investors.
Let us now look at two other capital market research studies by Leftwich (1970)
and Kaplan and Roll (1972) on mechanistic or behavioural effect of accounting
information.
The result of Kaplan and RollÊs study indicated that firms showed negative
abnormal returns at announcement date when their investment tax credit
were changed to immediate recognition, then rising to a peak about nine
weeks after announcement before reverting to around zero.
Kaplan and RollÊs result clearly showed that the market was „fooled‰ for
some time.
You have two options on how you can get the ice-cream cake:
Option (i)
You can buy milk, cream and butter from dairy farmers, then separately contract
with a cane-grower for sugar cane, a refiner to produce the sugar, a poultry
farmer for eggs, a flour miller for self-raising flour, an electrical appliance
company to create a refrigerator to set the ice cream, an oven to bake the cake, an
electrician to wire the refrigerator and oven and so on; or
Option (ii)
You can simply purchase the ice-cream cake from a bakery or supermarket. The
bakery or supermarket would already have direct or indirect contract with all
those providers of resources used to produce the ice-cream cake.
Clearly, Option (i) is costly, impractical and time consuming, and you probably
will not get the ice-cream cake ready by Sunday. Option (ii), on the other hand, is
less costly, convenient and obviously more practical than Option (i).
Instead of an ice-cream cake, you plan to purchase a plasma television for your
father so that he can watch his favourite sports programme with comfort.
Option A
You can go to the individual electrical shops in the Klang Valley and negotiate
with the retailers; or
Option B
You can go to an electrical outlet such as Best Denki and Harvey Norman where
more choices are available and cost less. This is because these electrical outlets
have already established contracts directly or indirectly with the various
suppliers of plasma televisions.
Once again, Option A is costly, time consuming and exhausting, and you may
not be able to get the present ready for your father by this Sunday. Option B
appears to be more practical and easy, as you will have wider selection of brands
and will also save you the hassle of bargaining for prices.
The two examples described above show that a firm (the bakery or supermarket
in the first example, and the electrical outlet in the second example) represent a
legal nexus (or connection) of contractual relationships, that centralise and link
the contracts between you as a consumer and the various suppliers.
SELF-CHECK 9.2
ACTIVITY 9.6
Coase (1937) articulated the rationale of the firm (refer to Figure 9.6). He explains
that using the free market to purchase inputs is costly as it involves transaction
costs such as the cost to locate, identify, bargain for inputs and negotiate as well
as conclude contracts.
In addition, other costs have to be taken into consideration such as the cost of
internal ownership, the cost of training, monitoring and policing. Thus, in order
to save cost and to have an efficient means of organising economic activity, firms
are formed.
Although many contractual relationships exist within a firm, there are two types
of contracts that the positive accounting theory focuses on, mainly because of
their nature which often gives rise to conflict of interest between the contracting
parties. These two contracts are management contracts and debt contracts (refer
to Figure 9.7). Both of these contracts are agency contracts.
However, the agency problem arises when the agent does not act in the best
interest of the principal. This is because the agent has the authority to make
decisions, and he or she can transfer wealth from the principal to the agent
provided the principal does not intervene.
For example, in an situation whereby the agent is the manager, he or she may use
the company car during office hours to settle personal matters, or increase the
size of his or her office at the expense of the principal (the shareholders in this
case), or boost reported profits when his or her own reward is tied to results.
In other words, the core belief of the agency theory is that all contracting parties
are constantly seeking to maximise their own benefits, and this creates the
agency problem, which in turn, gives rise to agency costs.
Examples The time and effort spent in voluntary interim financial reporting, the
revenues forgone by being prohibited from selling firm secrets to a
competitor, voluntarily appoint independent directors and audit
committee.
Agency Cost Residual Loss
Definition The loss associated with not being able to fully align the interests of
the principal with the agent. In other words, it is a loss whereby the
agentÊs interest is not the same as the principalÊs interest, even though
monitoring costs and bonding costs have been incurred.
Characteristics • A deadweight loss. It is either too trivial or too costly to monitor.
• This loss occurs when the net value of the agentÊs output (or
performance) is less than if the agentÊs interests are completely
aligned to the principalÊs.
Examples Manager (agent) takes home office stationary, uses the office fax
machine for personal matters, putting in less working hours than
shareholders (principal) would prefer.
SELF-CHECK 9.3
ACTIVITY 9.7
How can the managerÊs (agent) accounting decision transfer wealth from
shareholders and lenders (principal)? Also, how can the shareholders
and lenders constrain the opportunistic reporting by the manager?
However, the separation of ownership and control means that managers, as the
agents of the shareholders, can act in their own interest. Often, the managerÊs
interest may be very different from the interest of the shareholders.
Conclusion:
Managers rationally prefer to minimise their own risk rather than maximise
the value of the firm.
Example:
The management of an established property development company has the
opportunity to invest in and operate a highly speculative housing
development project. If the project turns out to be a success, the return to
the shareholders could be more than 100 per cent in the foreseeable future.
However, if the project fails, the company will suffer great losses and the
shareholders funds might even be negative.
On the other hand, the managers would be averse to the investment in the
project because if it fails, they may lose their job.
Conclusion:
Managers may limit the firmÊs best investment opportunity.
Example:
The firmÊs investment earns a 5 per cent rate of return for the shareholders.
However, the shareholders can invest personally to earn returns of 30 per
cent. Naturally, shareholders want to be paid dividends so that they can
invest in higher earning investment, rather than to leave the money in the
firm to be invested at a lower return. However, the managers may want to
retain the funds to increase their „empire.‰ Thus, the shareholders may lose
25 per cent because of the dividend retention problem.
Example:
Managers tend to present short-term profitability through reduction of
expenses such as repairs and maintenance, training and development of
workers as well as research and development of new products. These short-
term gains will eventually be overwritten by the longer term costs such as
the cost of obsolete or damaged equipment, inefficient and low-morale
workers as well as outdated products.
Now that we know the reasons for difference in incentives of the shareholders
managers in terms of the company policies, do you think there are ways to
overcome these differences, and thus reduce the agency cost of equity?
Yes, of course there are ways that the shareholders can resolve these disparities.
In fact, the most effective and important mechanism for the shareholders to
control the managersÊ behaviour is the management compensation schemes that
link to accounting performance measures. They will provide incentives to
managers to maximise the value of the firm.
For example:
(i) To minimise the risk aversion problem, managers can be motivated to act in
the shareholdersÊ interest by paying them bonuses at a progressive rate as
reported earnings increase;
(ii) To reduce dividend retention problem, shareholders can approve a bonus
plan whereby the upper limit of the bonus is partially dependent on the
firmÊs dividend payout ratio; and
(iii) To reduce horizon problems, the managersÊ remuneration can be tied to the
share price movement.
SELF-CHECK 9.4
Why do the shareholdersÊ and managersÊ incentives regarding the
firmÊs policies differ?
ACTIVITY 9.8
Bonuses can be tied to accounting numbers such as net income, sales and return
on assets and can also be based on market based performance measure such as
share price.
9.12 SHAREHOLDERS/MANAGERS –
DEBT-HOLDERS AGENCY RELATIONSHIP
Specifically, the agency costs of debt arise due to these four main methods of
transferring wealth from debt-holders to shareholders. They are:
(a) Excessive dividend payments;
(b) Asset substitution;
(c) Underinvestment; and
(d) Claim dilution.
(c) Underinvestment
This arises when the shareholders/managers do not undertake positive net
present value projects because to do so would increase the funds available
for the firm to repay the debt-holders first, but not to the shareholders.
For example, ABC Company has a negative shareholdersÊ funds of
RM200,000 and is facing bankruptcy. It has the option of investing in a
project that would give a positive net-present-value of RM100,000.
However, the shareholders would not get any return from this project, as
the entire RM100,000 would be used to pay off the debts of the company, so
that the net debt would be reduced to RM100,000.
In practice, most likely the shareholders/managers would have incentives
to only invest in projects that earns a positive net present value in excess of
RM200,000.
In short, the shareholders/managers have no incentive to invest in positive
net present value projects, whereas the debt-holders prefer the firm to
invest in all positive net present value projects as it would increase the
funds available to repay the debts.
Breach of a debt covenant will constitute technical default on the debt contract.
This will provide the debt-holders with rights to institute actions that have been
agreed upon such as seizure of collateral.
SELF-CHECK 9.5
The agency costs of debt arise due to four main methods of
transferring wealth from debt-holders to shareholders. What are the
methods?
ACTIVITY 9.9
Give examples of debt covenants that are written into a typical debt
contract.
• Since accounting standards are adopted voluntarily, the benefits and costs of
standards adoption should be evaluated by firms.
What is the reason that financial standards adoption creates mixing economic
results in practice?
INTRODUCTION
Economic development in the Asian region has been most rapid and dynamic for
the past decade. However, do you know that the cost of such achievement has
been very high?
Evidence shows that past growth has generated high levels of pollution, resource
degradation and poverty. Thus, building a social agenda that embraces the
vulnerable group of society and to prevent further environmental decline are
important challenges for economies in this region.
Let us start with traditional financial reporting and alternative view reporting.
However, FriedmanÊs view has been under fierce attack from various
stakeholders in recent times. Stakeholders have been increasingly
demanding information not only on financial performance, but also on
social and environmental performance.
ACTIVITY 10.1
Social and environmental accounting and reporting comprises actions that have
an impact on the:
(a) Employees;
(b) Occupational health and safety of the workers;
(c) Minority and equity issues;
Copyright © Open University Malaysia (OUM)
182 TOPIC 10 SOCIAL AND ENVIRONMENTAL REPORTING
(d) Community;
(e) Indigenous people;
(f) Environment;
(g) Energy use;
(h) Products;
(i) Charitable donations;
(j) Political donations; and
(k) Support sponsorships; etc.
In other words, CSR refers to a set of policies and strategies that is said to occur
when companies voluntarily integrate social and environmental concerns in their
business operations and in their interaction with stakeholders. You can also view
CSR as making economic returns without jeopardising the environmental
stability and social development.
SELF-CHECK 10.1
1. What is „social and environmental reporting?‰
2. Elaborate on what „corporate social responsibility‰ is.
ACTIVITY 10.2
Can you think of three examples of CSR initiatives by Malaysian
companies? Discuss in class how these CSR initiatives impact the
companies.
Now that you know what CSR is, let us analyse this area further by examining a
few theoretical models.
Figure 10.2 shows the various stakeholders that might be affected by the
companyÊs decisions:
Figure 10.2: Various stakeholders that might be affected by the companyÊs decisions
Source: Adapted from Weiss, J. W. (2006)
Freeman further explains that the stakeholders can be classified into primary and
secondary groups. Primary stakeholders (for example, shareholders and
creditors) include those groups with direct and well-established legal claims on
organisational resources. Secondary stakeholders (for example, employees and
the natural environment) refer to those parties whose claims on organisational
resources are less well established in law and/or are based on non-binding
criteria such as community loyalty and ethical obligation.
ACCA (2002) reported that CER in Malaysia is still in its infancy. It surveyed all
the companies listed on the Bursa MalaysiaÊs main board, and found that
between 1999 and 2001, the number of companies engaging in CER increased
from 5.3 per cent to only 7.7 per cent. All those reporting companies used their
annual report for communicating environmental information to their
stakeholders. About 95 per cent devoted less than a page to CER in their annual
reports.
There are a number of reasons as to why CER is in its infancy in Malaysia (refer
to Figure 10.4).
Johnson (2003) says the lack of pressure from other stakeholders such as the non-
government organisations and pressure groups may explain why few companies
take CER seriously. He further elaborates that CER requires the companies to be
transparent and open, characteristics that are not prevalent in Southeast Asian
cultures.
There are some difficulties in valuing social and environmental assets, especially
in those cases where there is no active market, hence no future economic benefits.
SELF-CHECK 10.2
ACTIVITY 10.3
Do you think attaching values to social and environmental assets are
difficult? Can you think of three problems in carrying out such
valuation?
In fact, this is exactly the problem with linking social and environmental impact
that has economic consequences to the entity.
Now, let us look at the arguments for and against valuation of social and
environmental issues.
SELF-CHECK 10.3
Briefly describe the issues in measurement use for social and
environmental disclosure.
ACTIVITY 10.4
Can you think of other ways of measuring social and environmental
issues?
1. Why does the traditional financial reporting differ from the alternative
views of reporting?
2. What does Friedman (1970) mean when he said „The business of business is
business?‰
7. What are the arguments for and against valuation of social and
environment issues?
1. What are the issues that constrain the development of reporting regulations
for social and environmental issues?
6. What do you think are the contributing factors for increased accountability
for social and environmental performance?
INTRODUCTION
In this topic, we will discuss the current facilitation of online financial reporting.
XBRL (eXtensible Business Reporting Language) is the programing language for
this purpose. Using XBRL has offered a number of advantages such as extracting
data and information efficiently as well as assisting financial statements analyses.
Performance measurement has also attracted a great deal of attention nowadays
because managers are paid according to their performance. Therefore, knowing
the sequences of preparation and usage of these reports are substantially
necessary.
commentary. This report comes in handy for financial information users such as
investors, when they are eager to have more comprehensive perspectives of
companies, and also when they intend to make important decisions accordingly.
Finally in this topic, we will have a look at the intellectual capital within
organisations. This kind of capital states that human resources are precious
sources of benefits for companies, and they must be highly valued as they are the
main source of creativity and innovation.
The major shortcoming of using financial statements was their text format.
Consequently, extracting the data and transferring them to the spreadsheet
format was a challenge, until XBRL (eXtensible Business Reporting Language)
was first released in 2005 in the US.
XBRL usage is adopted by different countries starting with the US, Australia,
Germany, Korea, London, New Zealand, Tokyo and many more. In addition to
the mandated financial reporting in the form of XBRL in China since 2005, the big
four accounting firms are the advocates of this language as well.
The popularity of XBRL format for online reporting is because of its benefits,
some of which are mentioned here:
(a) XBRL is online and it is related to business processes. Besides, it is
universally approved;
(b) Automation is increased by XBRL;
(c) Accuracy and reliability of financial statements information is provided;
(d) Decision qualities are elevated;
(e) The speed of analysis is improved;
(f) Cost of analysis is reduced because of automation and less manual work
required;
(g) IFRS harmonisation is assisted due to XBRL; and
(h) Information delivery and sharing financial reporting measures is assisted.
Figure 11.1: Organisation chart for Aloha Hotels and Resorts Incorporation
The Aloha Hotels and Resort performance report for February (refer to Figure
11.2) is presented as follows. The figures shown in parenthesis are related to cost
centres such as Grounds and Maintenance Department, and the Housekeeping
whereas profit and investment centres measures are shown with positive
numbers. Each department is a sample of a profit centre, but major divisions like
Maui Division, and the Oahu Division are considered as investment divisions.
It is apparent from these figures that a performance report is established from the
lowest level in an organisational chart and then forwarded to the higher level. To
show this relationship, the arrows provide the direction of combining reports
together. For example, total expenses of Kitchen department moves to Food
and Beverages department and, in turn, total profits of Food and Beverages
department makes a line in its higher department profit, Waikiki Sands Hotel.
Interestingly, total expenses shown by the above spreadsheet is quoted in the last
line of the total performance report.
Overall, performance reports are useful tools for general managers and CEOs to
assess not only their subordinatesÊ performance, but also their own performance.
Consequently, managers can make better decisions accordingly to develop
forthcoming programmes and plans, whilst upgrading the total performance of
the organisation as a whole.
ACTIVITY 11.1
ACTIVITY 11.2
Provide a management commentary report and discuss its elements
in class.
The course of accounting which deals with human capital measurement is called
Human Resource Accounting (HRA). HRA categorises the costs related to
human resources as assets in the balance sheet instead of expenditures in the
profit and lost statement. This is done because employees are assets which
benefit the company.
Adoption of HRA practices is not far away from global acceptance due to the
recent advancements in financial reporting guidelines offered by IFRS. The more
accountants are required to comply with increasing formidable rules posed by
IFRS, the more the incidents of integrating new measurements will be, including
human resource evaluations in financial statements.
ACTIVITY 11.3
Discuss in groups whether human resource accounting training in
organisations leads to higher employee retention or not? If yes, how?
CSR guidelines adoption provides firms with benefits in many aspects, such
as, risk management and brand recognition.
Financial statement users can enjoy having more useful information included
in the management commentary.
What factors have made online reporting with XBRL increasingly favourable?
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define the meaning of Islamic accounting;
2. State the objectives of Islamic accounting;
3. Explain the principles of Islamic accounting;
4. Classify Islamic accounting; and
5. Discuss the role of Accounting and Auditing Organisation for
Islamic Financial Institutions (AAOIFI)
INTRODUCTION
This topic offers an overview of the accounting practices in Islam and defines the
meaning of Islamic accounting. Since Malaysia is an Islamic country,
familiarisation with Islamic accounting practice is crucially important for learners.
The reason is that there are some differences in Islamic accounting rules and
regulations from those of current accounting practice. Therefore, those who intend
to deal with Muslims are required to be aware of the differences and similarities
between these two accounting methods. Financial institutions also have to follow
Islamic principles in their profession. Even Bank Negara Malaysia (Central Bank of
Malaysia) has included Islamic finance clarifications on its website:
This topic discusses the objectives and principles of Islamic accounting as well as
Islamic accounting core concepts.
Hence, Islamic banks, financial institutions and their applications for serving
the community have been made to look for the most appropriate ways to give
the most proper information to users of financial statements of those
institutions. Conceptual frameworks for accounting have been attempted to be
established, but they seem to be very slow, and the conceptual framework of
Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) has the same problems.
A conceptual framework is the basis and other notions derive from that; it is seen
to be required in establishing reporting standards in accounting. A conceptual
framework is used for settling and resolving accounting disputes that have arisen
during the standard-setting process on the conformity of specific standards to the
conceptual framework.
According to Karim (1990), Islamic banks have taken the initiative to self-regulate
their financial reporting. However, a uniform conceptual framework may be
difficult to achieve, since communities have different views.
ACTIVITY 12.1
Shahul (2000) states that Islamic financial institutions should provide some
information needed by the Islamic society. Khan (1994) argues that the
information requirements of an Islamic society are different from those of a
capitalist society.
It is stated in Islam, that the focus is on God and the community demands a
social accountability perspective, and not the personal accountability as in the
West. Adnan & Gaffikin (1997) indicate paying zakat should be the basic
objective of accounting information for Islamic institutions.
The aim of accounting information is clear in Islam (seeking AllahÊs pleasure and
not materialism). Anyhow, maximisation of profit (or wealth) is not the only aim
of living. Hence, the objective of decision usefulness focusing on shareholders
and creditors is not permissible in Islam. Since the centre of focus is on decision
usefulness for primary users of shareholders and investors, it results in the
objectives of AAOIFI being not in line with Islamic principles. The goals in
establishing Islamic banks are how to achieve success in the world (Karim, 1995).
ACTIVITY 12.2
(e) Islamic accounting aims to provide strong motivations and incentives for
followers to observe mankind and behavioural principles in their conducts;
and
(f) Islamic accounting has eyes not only on terrestrial matters, but also on
sacred and metaphysical aspects.
ACTIVITY 12.3
These classifications are not interchangeable because each classification has its
fixed position. However, the problem is inconsistencies are shown with some
existing standards.
(a) Accountability
This concept discusses the fact that every individual must be accountable
towards himself and other society members. Moreover, accounting for this
world as well as the next world after resurrection, is compulsory in Islamic
accounting practice.
SELF-CHECK 12.1
What are the two main notions for classification of Islamic accounting?
As Khan (1994) states, the entity concept suffers from some incongruities. This
concept is closer to the Islamic framework since the business owner is not known.
Accordingly, the proprietary concept is close to the Islamic framework since
zakat has to be calculated on the property of individuals. It is sufficiently
convincing that this concept is acceptable from an Islamic point of view.
However, we support the views by Khan (1994) that the proprietary theory is
more Islamic as compared to entity theory.
In our opinion, the going concern concept does not violate Islamic principles.
However, the conservatism concept is closely linked to other concepts, and
objectivity matching as well as realisation has resulted in many arguments.
While some suggest the use of replacement or present value-to-value assets, there
are many suggestions given to solve this problem. However, this is not easy.
Ahmed (1994) states that if all these suggestions were to be implemented, it only
serves as a temporary solution and not a permanent solution to accounting
problems in inflationary or deflationary environments. It is argued that the
application of gold or silver used in the age of the Prophet Muhammad (pbuh), is
perhaps relatively resistant to inflationary effects.
Copyright © Open University Malaysia (OUM)
TOPIC 12 ISLAMIC ACCOUNTING 213
We agree that money backed by gold price is more stable. Gold-based currency
can be applied, since it is less volatile. The differences in the gold price should be
charged to the reserve account. We do not agree that the concept of unit
measurement is Islamic. Nevertheless, continuous research must be conducted to
find better alternatives which fit more accurately to the Islamic perspectives.
Principles which govern Islamic accounting have some similarities with the
current accounting practice. The lists of these principles are:
(a) Distinguish entities between the owners of business and the business itself;
(b) Going concern for the enterprise;
(c) Periodic nature of accounting reports;
(d) Recording transactions instantly;
(e) Objectivity;
(f) Considering monetary values for transactions and records;
(g) Relevancy of assets values in terms of their current market prices;
(h) Matching revenues and expenses of each period of fiscal year;
(i) Differentiate various kinds of profits according to their sources of origin,
such as, capital profit and subsidiariesÊ profits; and
(j) Mandating disclosure of financial information for the users.
ACTIVITY 12.4
ACTIVITY 12.5
Objectives of Islamic accounting are stated in Syariah and the main sources
for these objectives are the Quran and Sunnah.
Define the major objectives of Accounting and Auditing Organisation for Islamic
Financial Institutions (AAOIFI)?
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Discuss the ethics which may be threatened in some job offers;
2. Discuss the earning management that big companies may commit;
and
3. Discuss the key function of internal auditors in fraud prevention
and detection.
INTRODUCTION
In this topic, the practical issues which may arise in companies are explained. After
reading this topic and going through the comprehensive cases, it will become
obvious how even the big firms may become bankrupt due to lack of proper
accounting practice or ethics.
The bank supports continues if the performance figures are attractive. You have
been promised a large bonus and 1 per cent share option if you massage the
figures. If you fail to do so, no bonus and share option will be given to you.
Objectivity - How can you avoid your financial interest influencing your
professional judgement?
Professional behaviour - How will you manage relationships with the affected
parties?
On May 21, Glynn Smith of the internal audit team, received an e-mail·from a
manager in Texas·that attached an article about a WorldCom employee in
Texas being fired for questioning WorldComÊs accounting for property plant and
equipment (PPE). The internal audit team was already suspicious about
approximately $2 billion of PPE expenditure that had never been authorised.
The e-mail galvanised the attention of the investigators. Ultimately, the
investigation revealed the misuse of excess reserves and the misallocation of $3.8
billion of line costs to PPE. WorldComÊs internal auditing team was untiring in
its quest to uncover the fraud.
ÂÂThere were two ways to do it: one was to change the refractive index of
the product and two, to do what we call the spacing of the product.ÊÊ
The company chose the latter one because it was easier to do and it used a
technology that the company could implement with a short period.
According to Adolph,
Titanium dioxide on its own gives a high level of whiteness and opacity,
but with Whitegold, it improves its own performance. So, together with
titanium dioxide, Whitegold performs in an unbeatable manner.
(h) Conclusion
Adolph Dias was an innovator and entrepreneur (refer to Figure 13.2) who
used his resources and competencies to develop new or improved good to
respond to the needs of customers. Innovations can result in spectacular
success for an organisation. Words of wisdom (WOW) from one of
AdolphÊs books: ÂÂSuccessful people are not a mystery; they just use the
right chemistry.ÊÊ
In the late 1990s, there began a separation of financial accounting from tax
accounting and to adopt accrual accounting for financial accounting. Thus,
companies were required to estimate the allowance for bad debt for its accounts
receivable. Although some SOEs were transformed into listed companies, their
governance remained basically unchanged because the government kept a lion
share of stocks and, thus, continued its control on corporate decisions. Unlike
that in the developed world, ChinaÊs corporate governance institutions are weak
by any measure, and yet it has managed to achieve quite spectacular levels of
growth over the last quarter of a century (Mueller, 2006). China had introduced
changes, in a pragmatic way, to its governance institutions and accounting
practices. The situation could be demonstrated by the following case.
The colour TV industry in China had more than 130 manufacturers in the
beginning of 1996. Among all, very few of them had notable sales. Even foreign
brands were suffering in the Chinese TV market at that time. The prices were
lowered in the suburbs due to smuggling. To make matters worse for local
manufacturers, import tariffs were lowered for small-screen colour TVs from 60
to 50 per cent and from 65 to 50 per cent for large-screen colour TVs. Foreign
direct investment in China was daily increasing as a result of the attractive
market size. TV productions by all of the largest TV manufacturers were
launched in China.
Company CÊs capacity was double than the second competitor for colour TV
production at that time. The company enjoyed effective relationships with key
component suppliers as it was the biggest manufacturer of many major TV
components, such as plastic injections parts, electronic components and remote
controls. As a highly vertically integrated company located in the Western
hinterland, the company enjoyed a cost advantage and earned the highest profit
margin among all domestic colour TV manufacturers. Its net profit margin was
around 20 per cent, far ahead of most of its domestic rivals. It enjoyed a high
level of brand awareness and a high quality image among domestic brands.
In 1994, Company C did an IPO on the Shanghai Stock Exchange. But, after the
IPO, the company remained a SOE in the sense that the government continued to
hold 53 per cent of its shares. In 1998, it contributed about 15 per cent of its
provincial GDP and about half of the gross industrial output of the city where it
was located. Across China the company employed more than 30,000 people. To
monitor the performance of SOEs, the government established some criteria
including the increase of assets and enhance of profitability. Although the criteria
were established, the practice of executive appointment had been largely at
administrative discretion, with decisions made behind closed doors: The
emergence of the notion of „governance‰ in China was accompanied by a
critique of the system of socialist planning and associated forms of government.
One of the hallmarks of socialist planning, and the system of government in
China in general, was the combination of rewards and punishments, quotas and
reliance on administrative commands. Commencing in the 1980s, critics of the
system argued that administrative intervention was overly heavy-handed
(Sigley, 2006).
On March 26, 1996 Company C took action and fired the first shot in a price war,
announcing price reductions for all its 1700-2900 colour TVs ranging from
Rmb100 to Rmb850. Some domestic rivals followed Company CÊs suit while
others did not. As a result, the former group gained and the latter group lost
market share. Within several months after price war, Company CÊs overall
market share had increased from 16.68 to 31.64 per cent, rising to 35 per cent in
1997. As expected, foreign brands stayed away from price war. Sony and
Panasonic, for example, both decided to take the high road, focusing on quality
and functionality.
Before the price war, imported and joint venture products accounted for 64 per
cent of the market and local manufacturers for only 36 per cent. After that, the
market share of domestic products significantly increased, accounting for a total
of around 60 per cent by the end of 1996. In 1997. eight out of the top ten best
selling brands in China were Chinese. Company C had become one of the best
selling colour TV brand companies in China, with market shares at 35 per cent.
Only two foreign brands, Panasonic and Philips, muscled into the top ten, each
with about five per cent of the market share. On May 21, 1997 the companyÊs
share price reached Rmb66 per share.
The first ever large-scale price war drastically changed the landscape in the
industry in favour of Chinese companies. However, the industry as a whole
continued to be dogged by the excessive capacity. According to industry reports,
Company CÊs inventory of colour TVs had risen to five million units in 1998
when it launched another major price war, cutting prices by another 10 per cent.
But this time the price cuts did little to increase its market share and instead
squeezed its profit margin considerably.
In order to improve the situation, the government made the decision to change
the CEO. On May 15, 2000 Mr Chen was asked to retire from his CEO position
and became chairman of the board. At the time Company CÊs share price
dropped to Rmb12.5 per share. But it should be noted that in China the share
price might not be used as a reliable performance measure. Over the period from
2000 to 2005, China recorded a high-economic growth, but the Shanghai Stock
Exchange Index, the main stock market index in the country, declined from about
1,400 points at the beginning of 2000 to around 1,000 points in June 2005. It
reached its period peak in June 2001 at about 2,250 points. It has been noted that:
It was very unfortunate that the new CEO stayed in office for only about eight
months because he failed to meet the governmentÊs expectation either. As a
consequence, Mr Chen was called back to take the rein of company on February
10, 2001.
Soon after resuming the role as CEO, Mr Chen took a bold move by selling hard
in overseas markets. In November 2001, he signed a contract with Company X as
the sales agent in the US market. Initially, Company X was a small firm run by a
local Chinese. By making the best use of Company CÊs low price of TV sets,
Company X later emerged as the fifth largest colour TV supplier in the US.
Although the sales of Company C for the years 2002 and 2003 was Rmb780m and
Rmb5.04b, respectively, the financial statements illustrated that increased sales
was accompanied by a high figures in accounts receivable and an increasing
inventory. At the end of May 2004, the companyÊs share price dropped further to
Rmb7.06. After the exclusion of accounts receivable and inventories, Company C
reported a loss of Rmb3.7 bn for 2004. The share price closed at Rmb3.54 on
December 31, 2004.
Company CÊs financial statements from 2001 to 2005 are provided in Table 13.1,
together with the footnotes on accounts receivable for 2002-2004.
Table 13.1: Company C Income Statement (Rmb Million) from 2001 to 2005
2004 Footnotes
At the end of 2004, the total A/R owed by Company X was Rmb3,839m, among
which Rmb295m were within one year; Rmb3,513m one to two years; and Rmb31m
two to three years. Company X was experiencing financial difficulties and was
having trouble.
In servicing its debt, considering the situation, Company C had filed a lawsuit to
a Los Angeles court and the case was under court investigation. Given that the
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TOPIC 13 COMPREHENSIVE CASES 227
normal way for Company CÊs A/R could not truly reflect the situation, the Board
decided to set aside Rmb2,597m as a bad debt allowance for Company X.
Without such a charge, the total allowance for bad debt would have been
Rmb360 m. Thus, the net impact on net income was Rmb2,237m (Table 13.2).
Table 13.2: 2004 Year-end A/R and Allowance for Bad Debt (Rmb Million)
The financial statements received clear audit reports throughout five years
(Tables 13.3 and 13.4).
Table 13.3: Balance Sheet (Rmb Million)
2003 footnote
A/R increased considerably over 2003 with the biggest increase related to
company X, whose A/R was Rmb4,447m, among which Rmb3,512m were within
one year and Rmb934m between one and two years. On December 31, 2003 the
company C had inventory of more than Rmb7bn after writing down
approximately Rmb300m (refer to Table 13.5).
Table 13.5: 2003 Year-end A/R and Allowance for Bad Debt (Rmb Million)
2002 Footnotes
In 2002 company CÊs A/R stood at Rmb4.22b, with that owed by Company X
accounting for Rmb3.83b. The company reported a 27 per cent decrease of A/R
relative to that in 1999 (refer to Table 13.6).
Table 13.6: 2002 Year-end A/R and Allowance for Bad Debt (Rmb Million)
Discussion Questions
(a) Discuss Company CÊs performance from 2002 to 2004 based on its financial
statements. Elaborate your answer to the quality of reported earnings.
(b) Since a majority of companies were controlled by the government in terms
of their shares and top decisions, what were the agency problems between
the principal (the government) and the agent (the CEO)?
(c) The Company C abused the big bath strategy for its sales and revenue
manipulation. Discuss the accounting policy change in terms of ChinaÊs
business environment in general and Company CÊs circumstance in
particular?
However, in the years 2008 to 2009, the impact of the implementation of the
recommendations of the 6th Central Pay Commission started to become apparent
on IR finances. During the years 2008-2009, IR carried 833.39 million tonnes of
goods traffic and 7.05 billion passengers reflecting an annual growth of five per
cent and 7.81 per cent, respectively, over the previous year. The traffic receipts
during the year also grew to INR 798.37 billion showing annual growth of 11.4
per cent. However, the operating expenses increased to INR 543.49 billion.
Further, provision of INR 70 billion for depreciation and INR 104.9 billion was
provided for pension expenditure. The total working expenses increased to INR
718.39 billion by 31.9 per cent over the previous year. As a result, the surplus was
reduced to INR 91.75 billion before dividend and to INR 44.57 billion after the
dividend payment of INR 47.17 billion (refer to Table 13.7, Table 13.8 and Figure
13.3). The operating ratio deteriorated to 90.46 per cent during 2008-2009 from its
second best of 75.9 per cent in the preceding year (the best ever operating ratio of
IR was 74.7 per cent in the years 1963-1964).
The years 2009–2010 were also equally challenging for the railways. Although IR
carried 887.79 million tonnes of goods and 7.38 billion passengers with annual
growth of 6.5 and 4.8 per cent, respectively, and earned traffic receipts of INR
871.04 billion showing annual growth of 9.1 percent, implementation of the 6th
Pay CommissionÊs recommendations substantially increased operating
expenditure to INR 658.1 after provision for depreciation to INR 21.9 billion and
pension to INR 149.2 billion annual growth. The total working expenses
increased to INR 829.15 billion with 15.42 per cent growth over the previous year.
This heavily impacted the internal generation for plan investment which came
down to INR 55.44 billion before dividend and merely INR 7.5 million after
dividend payment. The operating ratio deteriorated to 95.3 per cent during 2009
to 2010 (refer to Table 13.7, Table 13.8 and Figure 13.3).
The testing times for the railways continued in 2010 to 2011 as well, due to the
impact of allowances and several post-budgetary factors. On the earnings side,
disruption of train movements due to public agitation resulted in a loss of about
INR 15 billion and another INR 20 billion due to the ban on the export of iron
imposed in certain states of the country. As a result, the loading was reduced to
924 million tonnes from a budgeted target of 944 million tonnes and actual
loading was still lower at 922 million tonnes. However, by prudent financial
management, the railways absorbed the brunt of increased staff costs, also the
operational shortfall, with a minor increase in freight rates leaving fare charges
untouched for the eight consecutive year and attained annual growth of 8.5 per
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232 TOPIC 13 COMPREHENSIVE CASES
cent in earnings which rose to INR 945 billion (refer to Table 13.7, Table 13.8 and
Figure 13.3).
On the expenditure side, two hikes in the rates of HSD oil and increased
electricity tariff in some states, higher DA rates and excise duty rates as well as
the impact of unanticipated higher salary and allowances resulted in the
ordinary working expenditure of INR 681.39 billion. After providing INR 55.15
billion towards depreciation and INR 158.20 billion for pensions, respectively, the
total working expenses increased to INR 894.74 billion by 7.91 per cent over the
previous year. Accounting for full dividend liability of INR 49.41 billion, it
attained surplus of INR 14.05 billion. However, these resources fell short of the
planned requirement of capital expenditure for which IR had to seek a bridging
loan of INR 30 billion from general revenues in 2011 to 2012 which will be
liquidated in 2012 to 2013.
As could be seen, IR has not only overcome the challenge of global slowdown
but also the increased costs without resorting to fare increases in the larger
interest of the economy. It continued to grow despite, during the above period
both in quantum and monetary terms, being well above the average gross
domestic product growth of the economy. The position was aptly explained by
the then Union Rail Minister in the Budget Speech for 2010 to 2011:
Madam Speaker, I have no hesitation in informing this August House that Indian
Railways is passing through a very difficult phase. The year 2009 10 was challenging
for the railways. Implementation of the 6th Pay CommissionÊs recommendations
increased the expenditure on staff and pension by an unprecedented 97 per cent. The
latest assessment of Pay CommissionÊs impact reveals an additional expenditure of
Rs.73,000 crore (INR 730 billion) during the XI Plan period.
This has heavily impacted our internal generation for plan investment. However, by
prudent financial management, we have not only paid the full dividend for 2009 10,
but also achieved an operating ratio of 95.3 per cent. In fact, if we do not take pay
commission arrears into consideration, which rightfully are liabilities of previous
financial years, the operating ratio would have been 84 per cent even with payment
of higher salaries and pension. If the salaries and pension are also kept at the earlier
levels, the operating ratio comes down even further to 74.1 per cent.
The budget projections for 2011-2012 envisaged annual growth of 7.7 per cent
in freight loading to 993 million tonnes and a growth of 5.9 per cent in
passenger traffic to 8.27 billion passengers. The Gross Traffic Receipts were
estimated at INR 1,062.39 billion with annual growth of 12.2 per cent. Ordinary
working expenses (OWE) were assessed at INR 736.5 billion to cater for annual
increments in salaries, allowances, higher requirement for fuel and materials
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TOPIC 13 COMPREHENSIVE CASES 233
for increased level of activity as well as lease payments after allocating INR 158
billion for pensions and INR 70 billion for depreciation. Thus, the total working
expenses were projected to INR 964.5 billion. The expected operating ratio was
91.1 per cent.
However, due to post budgetary factors, the revised projections for the year
reported in the budget projection for 2012 to 2013 indicates reduction of freight
loading to 970 million tonnes and passenger traffic to INR 8.3 billion.
Accordingly as per the revised estimates, IR is expected to earn INR 1,039 billion
and incur operating expenses of INR 986.1 billion inclusive of pensions INR 168
billion and depreciation INR 61.6 billion. The surplus before dividend is
estimated at INR 71.4 billion and that after dividend liability, of INR 56.52 billion,
at INR 14.9 billion and the operating ratio is expected to deteriorate to 95 per cent
(refer to Table 13.9).
Table 13.9: IR Budget Projection
In the interim, two expert committees were set up, namely, the High Level
Railway Safety Committee headed by Dr Anil Kakodkar and the Expert Group
on modernisation and resource mobilisation headed by Mr Sam Pitroda. Both
committees submitted their reports in February 2012 and provided a blueprint
for safety and modernisation of IR. The plan in brief had the following
recommendations:
(a) Modernise the key revenue generating assets such as track and bridges,
signalling, rolling stock and stations as well as terminals;
(b) Look for opportunities related to public private partnerships, land and
airspace, dedicated freight corridors and high speed trains to meet with
funding requirements;
(c) Review and assess capital projects sanctioned and work-in-progress,
prioritise works to ensure financial viability, social benefits and timely
completions;
(d) Focus on key enablers like information and communication technology,
indigenous development and safety;
(e) Strengthening of human resources;
(f) Disinvestment in railway public sector undertakings;
(g) Re-densification or commercialisation of surplus land in existing railway
colonies in different locations. A few pilot projects could be immediately
explored;
(h) Commercial exploitation of railway schools and hospitals, without
displacing any of the priorities from the point of view of IR employees.
Management contracts (on the basis of revenue sharing) could be tried for
some of the larger hospitals or schools with a view to achieve significant up
gradation of standards; and
(i) Levy modernisation surcharge from passengers or freight business on a per
PKM/NTKM basis and create a dedicated Reserve Fund to fund these
initiatives in a sustainable manner.
Madam, I intend to align Indian RailwaysÊ investment in the 12th Plan period
keeping in mind the recommendations of the two committees that I have set up. I
am happy to inform the Honourable Members that the 12th Plan investment
proposed by Railways at 7.35 lakh crore represents a quantum jump over the
investment during XI Plan of 1.92 lakh crore. The required resources for the plan
are proposed to be met by:
(i) Gross Budgetary Support of Rs.2.5 lakh crore (INR 2500 billion);
(ii) Government support for national projects of Rs.30,000 crore (INR 300
billion);
Thus, the railways will soon emerge stronger, leaving behind the impact of the
Pay Commission and engage fully in the revival of its financial health. To achieve
this, IR has further sharpened its economy drive to cut down costs to extant
feasible and tap all avenues for generation and revenue from both traditional and
non-traditional sources. The steps taken by the railways to increase the revenues
are optimisation of operational efficiency and earnings through progressive
increases in axle loads as well as the carrying capacity of freight cars. In addition,
the railways have also taken a number of steps to attract additional traffic, which
inter-alia include implementation of a differential tariff regime for specifically
addressing situations arising out of skewed demand during different periods of
the year as well as across different regions of the country.
A slew of freight incentives schemes are also in place for attracting traffic,
particularly in the traditional empty flow direction and during the lean season.
As with regards to control over expenditure, there is constant endeavour on the
part of IR to avoid wasteful expenditure and control the growth of non-plan
expenditure. The steps taken include prioritisation of expenditure on works for
better use of available resources, improvement in inventory management,
optimising the fuel consumption, tight control over expenditure in areas such
as contractual payment, overtime allowance, purchase of material, etc.,
austerity and economy measures in areas such as hospitality, publicity,
advertisements, inaugural ceremonies, seminars and workshops as well as
contingent office expenses.
Budget estimates for 2012 to 2013 as presented in the Rail Budget by the Union
Rail Minister contemplates IR to carry 1,025 million tonnes of revenue earning
originating traffic, which is 55 million tonnes more than the revised estimate
target of 970 million tonnes during 2011 to 2012. The freight earnings target has
been kept at INR 893 billion, indicating a growth of 30.2 per cent over a revised
estimate of 2011 to 2012. The number of passengers is expected to increase by 5.4
per cent in the year with an increase in the number of trains and higher
occupancy. The passenger earnings have been kept at INR 361 billion, an increase
of INR 73 billion over the revised estimates of 2011 to 2012 by a minor increase in
passenger fares after a gap of nine years.
Gross traffic receipts are expected to rise to INR 1,326 billion, that is, an increase
of INR 286 billion over the revised estimates of 2011 2012. OWE are estimated at
INR 844, that is, 11.6 per cent higher than the current year to meet additional
liabilities along with provision of INR 185 billion to the pension fund and INR 95
billion for the depreciation reserve fund. The railways have budgeted to
discharge full dividend liability of INR 66.76 billion to the general exchequer for
the years 2012 to 2013, calculated on the basis of applicable rate for the current
year besides loan of INR 30 billion and still earn a surplus of INR 155.57 billion.
Although IR has rolled back the increase in passenger fares in certain classes,
which would impinge the projected passenger earnings to some extent, yet the
constant annual growth in traffic and earnings vouches for its financial strength
(refer to Table 13.10).
Table 13.10: Source Wise Plan Outlay (INR Billion)
The best ever Operating Ratio of Indian Railways was 74.7 per cent in the year
1963-1964. In consultation with the Railway Board, I am targeting to improve the
Operating Ratio from 95 per cent to less than 80 per cent by the end of 12th Plan.
This landmark improvement in railway finances would enable building up of a
strong base to meet the challenges ahead and bring back the confidence of people
in Railways, thereby dispelling all apprehensions that Indian Railways is going
downhill. I expect to achieve an Operating Ratio of 84.9 per cent in 2012 to 2013
as compared to 95 per cent in the current year. If this trend continues, I have no
doubt that my Operating Ratio will improve upon even the best ever of 74.7 per
cent within the 12th Plan.
Notes
(a) The 6th Central Pay Commission was set up by Union Cabinet of India on 5
October 2006 for revising the salaries of central governmentÊs employees;
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TOPIC 13 COMPREHENSIVE CASES 237
(b) Operating ratio is the money spent to earn INR 100 and is calculated by
dividing total revenue by total expenses;
(c) Railway Budget speech 2011 to 2012; and
(d) Budget Speech 2011 to 2012.
Refer to Table 13.11 and Figure 13.4 to see the data indicating the railway fund
balance and fluctuation or movement of total funds from 2004 until 2013.
Table 13.11: Railway Fun Balances (INR billion)
What are the key responsibilities of the internal auditor in fraud prevention?
How can firms evaluate their real performance based on their financial reports?
5. (b)
7. The main problem with these theories is that, for positive theorists, wealth
maximisation becomes the answer to every question – whatever the
observed practice, it could be construed as a means of maximising wealth.
This has attracted criticisms regarding the biased fashion in which the
positive theorists dismiss alternative viewpoints.
Self-Test 2
1. There are alternative interpretations in accounting theory. An overall
theory of accounting can be an instrument for recognising and measuring
income and capital. Essentially, it is a set of rules a blueprint for
constructing specific accounting systems for the recognition and
measurement of the income and capital of the particular entity. The results
of a specific accounting system of a particular firm provide an explanation
of what happened to the firm or serve as a basis for prediction of what may
happen, but the overall theory itself provides no explanation or prediction
of the economic events of any particular individual firm. This is in contrast
to a theory in the sciences where theory provides an explanation of a given
phenomenon and/or serves as a basis for prediction of what will occur in
every single instance.
An alternative interpretation given under positive theories of accounting is
that the place of „explanation‰ is to provide logical answers to the reasons
why accountants adopt certain accounting procedures. For example,
„explanation‰ offers reasons as to why accountants use an apparently
outdated historical cost system to measure assets and liabilities and
provides reasons for the political reactions of accountants to alternate
inflation accounting systems. „Prediction‰ provides an ex ante estimate of
the behaviour or reaction of accountants to the imposition of certain
accounting standards. In an ex post sense, „prediction‰ provides a
prediction of the unobserved behaviour of accountants · that is, how
many accountants use LIFO versus FIFO; how many accountants use
conservative procedures, etc.
7. You may come up with a range of syllogisms for discussion. Your answers
should be discussed in terms of their validity.
An example of one syllogism for a deductive theory:
Premise 1: All firms that are unable to pay a certain rate of dividends to
their shareholders should cut back on their unprofitable operations.
Premise 2: To cut back on their unprofitable operations, firms should
retrench the number of workers whose retrenchment will return the firm to
profit-making status.
Premise 3: ABC Co. is unable to pay a certain rate of dividends to its
shareholders.
Premise 4: ABCÊs operations in Kuala Selangor are unprofitable.
Conclusion: ABC should retrench 1000 workers from its Kuala Selangor-based
assembly plant.
1. (b)
2. (c)
3. (c)
4. (b)
Self-Test 2
Critical and interpretive paradigms view the research from different angles.
While the critical school of thought pays attention to the differences in societal
science research and tries to combat with them, interpretive research
methodology pinpoints the goal achievement whilst accepting the disparities.
But when mixed method is used in accounting research and paradigms are
investigated simultaneously, the common grounds would emerge in surveying
the research topic and this serves as a keystone to create homogeneity and
establish bridges between paradigms. For example, once critical paradigm
focuses on the discriminations in research, the roots of these phenomenon will be
extracted. These aspects definitely assist interpretive paradigm to effectively deal
with dissimilarities in society when targeting the desired goal, making purposes
come true more practically. Hence, co-existence of paradigms are motivated
which, in turn, leads to homogenous accounting research while having the
advantage of comprehensiveness.
Self-Test 2
Paradigms usage is not always helpful. The first reason is the fact that the return
rate of using an individual paradigm tends to decrease after some time. Then,
paradigm users are restricted to the scopes which are only covered by
paradigms. Consequently, creativity in terms of the research topics without a
related paradigm is imprisoned. Finally, these restrictions cause the previous
problems to remain unsettled. This leads to lack of courage among researchers to
address the issue, resulting in uncovered topics remaining unsolved.
1. (c)
2. (d)
3. (b)
4. (c)
5. (d)
6. (d)
Self-Test 2
3. True. IASB framework specifies definition and recognition criteria for the
elements of financial statements. Even if an element satisfies the definition
criteria it should not be recognised in the financial statements, unless it
satisfies the recognition criteria of probable occurrence and reliable
measurement.
The first thing to know in order to prevent a financial scandal from occuring is
knowing the facts that how these monetary disasters occur. The scandals are not
always commited by the defrauding managers or employees. One usual occasion
leading to this phenomenon is when a previously ethical employee makes a few
bad decisions. As this person intends to cover the track of his mistakes, the
misconduct becomes bigger and bigger. Therefore, the following approaches may
be implemented by companies to avoid financial frauds:
within any organisation, the honest and ethical employees will reveal a
number of practices which may be the fraud and/or error indications.
Self-Test 2
Based on the accounting principles, they are not obliged to disclose the profit
earned from their investment in their net profit for the year. Instead, the
following classifications are available:
1. Trading Securities: Any capital gains or dividend earnings are declared in
the operating income.
2. Available for Sale Securities: When these securities are acquired, they are
reported in „other comprehensive income‰ at the bottom of the income
statement. However, the profit or loss made from the sale of this
securities are reported in the operating income.
Because of the offering of the above mentioned options, some of the earning
management opportunities are open to abuse in companies:
1. Timing sales of securities which gained value: For companies that need
extra gains, the portfolios with added value are sold and reported in
operating profit.
2. Timing sales of securities which lost value: In the occasions where
companies aim to reduce the operating profit of the year, they sell the
sequrities which have unrealised loss.
3. Chaning of Holding Intent: Since the two classifications mentioned
have different accounting treatment in terms of one having unrealised
gain/loss, managers may classify trading securities to available-for-sale
or vice versa.
Let us take an example. When this yearÊs earning is RM500,000, and the
companies outstanding share is 100,000, the earning per share (EPS) is 5
(500,000/100,000).
If we consider the next year profit remains the same as the last year (RM
500,000), but the 10,000 of the outstanding shares are bought back, EPS will
be 5.56 {500,000/(100,000 – 10,000)}.
Although the net profit of the company had no growth the year after, the EPS
was improved.
1. The three attributes that an item must have in order for it to be defined as
an asset are:
• future economic benefits;
• controlled by reporting entity – does not rely on legal enforceability;
and
• past transactions or events – planned or budgeted transactions are
excluded.
(a) Future Economic Benefits
The future economic benefits in an asset refer to the assetÊs potential
to contribute, directly or indirectly, to the flow of cash and cash
equivalent to the firm.
(b) Control by the Entity
To be qualified as an asset, the economic benefit must be controlled by
the entity. The capacity of an entity to control benefits is usually the
results of legal rights. However, having legal rights is not the most
2. We should record an asset in the balance sheet when it meet the recognition
criteria.
An asset is recognised when:
(a) It is probable that the future economic benefits will flow to the entity;
and
(b) the asset has a cost or value that can be measured reliably.
„Probable‰ means that it is more likely rather than less likely the future
benefits will arise.
4. (d)
5. True. MASB framework specifies definition and recognition criteria for the
elements of financial statements. Even if an element satisfies the definition
criteria it should not be recognised in the financial statements unless it
satisfies the recognition criteria of probable occurrence and reliable
measurement.
Self-Test 2
1 (a) The definition for assets according to the MASB framework is:
• Future economic benefits;
• Control; and
• Past transaction.
In this case, future economic benefits would be expected to flow to Toy
World for the equipment being built. Payment of 10 per cent deposit would
not constitute control. Control of the asset would not exist until it was
delivered to Toy World. Entering into the contract and paying the deposit
would constitute a past event.
The fact that this transaction does not satisfy all the definitions necessary
for an asset to exist because there is no control at this stage would mean
that the full amount of the equipment would not be recognised. The deposit
would be recognised as a current asset and the remainder of the asset
would not.
2. The three essential features of an asset are: (i) probable future economic
benefits, (ii) control by the entity, and (iii) origin due to a past transaction or
event. Let us discuss each in reverse order.
• Firstly, the advertising is definitely due to past event or transaction.
Manis Manis Berhad has already spent money for advertising.
• Secondly, the firm has control over the content of the commercials and
obtains the benefits of the commercials.
• Thirdly, in terms of whether advertising constitutes „probable future
economic benefit‰, we need to determine whether the advertising has
future economic benefits beyond the current year. Since the product is
new, the product has become familiar to consumers through the
advertising campaign; therefore, do appear to have future benefits. The
3. Assets and liabilities should be carried in the balance sheet at fair value to
provide relevant information for decision making. Fair value can be
determined in exchange or by referring to the existing value of a
comparable item in the market place. Fair value becomes difficult when
there is no obvious market to value the item. In the case of financial
instruments, standards-setters require the use of mathematical models to
calculate the hypothetical market price.
4. (a) No liability. The pertinent event is not placing an order but receiving
title to the goods. When title passes, then a purchase has been made,
and account payable is recorded.
(b) No liability. The contract is wholly executory. Until there is
performance, there is nothing to record.
(c) Yes. Interest payable for two months. Accrued interest is to be
recorded. The event is the passing of time. The company is using the
money that was borrowed each day.
1. Profit is the increase in the value of the capital of the firm between two
points in time, excluding investments and withdrawals by owners. Profit is
the return on capital, not a return of capital. In deriving profit, the
accounting procedure involves the spreading of the flows of receipts and
payments over a period of time in a certain way. In practice the profit
concept involves numerous decisions and judgements.
3. (b)
6. Expenses are a monetary event which relates to a decrease in the net assets
of the firm. This decrease in value will eventually give rise to an outflow of
cash. Expense must be associated with a physical activity of the firm, that is,
something that the firm does. In other words, in the earning process,
production and sales generate revenue and the usage of goods and services
in support of those functions causes expenses to occur. As guidance,
standard-setters have defined expenses in terms of decreases in economic
benefits arising from the outflow or depletion of assets or the incurrence of
liability.
Self-Test 2
3. The adoption of a system that breaks the life of a firm into defined
accounting periods, which normally bears no relationship to the life of
assets employed to operate a business, requires assumptions about the
benefits derived from such assets in any one accounting period. Often it is
difficult to estimate the contribution made by assets to revenues recognised
in any one accounting period. In order to calculate profits, assumptions
often need to be made about:
• Whether revenue has been achieved because of activity within a
particular period;
• The likelihood of future realisation of the revenues;
• The allocation of expenses that extend beyond one accounting period,
or were incurred in developing assets to generate future revenues.
1. Managers are in charge of fair, unbiased and updated information. They are
the entities that decide what information should be referred to in financial
statements of the business. Consequently, managers provide financial
statements whilst they give importance to interests of different parties and
stakeholders in their consideration. Here, the possibility of occurrence of
challenges arise. Trying to fulfil the expectations of different stakeholders
may lead to conflict of interests among them. That is the reason managers
ought to give preference to a few of stakeholders like investors in terms of
their benefits and interests. Therefore, the relevance and reliability of
financial statements are in favour of the targeted groups. In addition, as
agency theory states that managers may tailor financial reporting in a way
which benefits their bonus and remuneration rather than the whole
business entity and its stakeholders. This behaviour is not ethical while
reliability and relevance of data are endangered.
Self-Test 2
Self-Test 2
There are factors which challenge the similarity of empirical studies. These
factors include:
(a) Voluntarily nature of standards adoption;
(b) Differing characteristics of firms in various industries;
(c) National law differences among different nations; and
(d) Dissimilarity of market conditions and investors overview of standards
adoption.
4. CSR refers to a set of policies and strategies that is said to occur when
companies voluntarily integrate social and environmental concerns in their
business operations and in their interaction with stakeholders.
Alternatively, CSR can be viewed as making economic returns without
jeopardising the environmental stability and social development.
Self-Test 2
Self-Test 2
2. Financial Accounting
This notion deals with accounting issues such as profit, cost, revenue and so
forth. Examples of Islamic financial accounting systems are zakat
accounting, governmental accounting and corporations accounting.
Self-Test 2
Self-Test 2
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OR
Thank you.