The Optimization Method of Financial Statements Based on Accounting Management Theory

Hua Zhou
School of Business Renmin University of China Beijing, China zhouhua@ruc.edu.cn

Weida Kuang
School of Business Renmin University of China Beijing, China weidakuang@hotmail.com

Yan Zhang
School of Economics and Management North China Electric Power University (NCEPU) Beijing, China E-mail:zhangyan8698@163.com

AbstractThis paper develops an approach to enhance the reliability and usefulness of financial statements. International Financial Reporting Standards (IFRS) was fundamentally flawed by fair value accounting and asset-impairment accounting. According to legal theory and accounting theory, accounting data must have legal evidence as its source document. The conventional mixed attribute accounting system should be replaced by a segregated system with historical cost and fair value being kept strictly apart in financial statements. The proposed optimizing method will significantly enhance the reliability and usefulness of financial statements. Index Termsfinancial statements, historical cost, fair value, legal evidence, financial analysis

Optimization of financial statements system should try to take all aspects of the demands of the financial statements in both macro and micro level into account. Why do companies need to prepare financial statements? Whose demands should be considered while preparing financial statements? Those questions are basic issues we should consider on the optimization of financial statements. From the perspective of "public interests", reliability and legal evidence are required as qualitative characters, which is the origin of the traditional "historical cost accounting". From the perspective of "private interest", security investors and financial regulatory authorities hope that financial statements reflect changes of market prices timely recording "objective" market conditions. This is the origin of "fair value accounting". Whether one set of financial statements can be compatible with these two different views and balance the public interest and private interest? To solve this problem, we design a new balance sheet (see Table 1) and an income statement (see Table 2). A. Optimization of the Balance Sheet First of all, we divide the balance sheet into two parts, "solid line table" and "dotted line table". The data in the solid line table is called "accounting data", which adopts historical cost accounting and possesses legal credibility. Dotted line table presents "financial analysis data", that is, market value. Secondly, we distinguish the speculative equity investments with long-term equity investments. Major improvements and the reasons are described below. The figures in solid line table are the results from pure historical cost accounting, without impairment accounting and fair value accounting. Accounting records should be supported by legal facts rather than merely by economic facts. The legal fact is the objective phenomenon that gives rise to the accounting entitys legal relation[1]. Legal facts can be proved by legal evidences, and thus possess legal significance. Accounting should be based on legal facts in order to obtain legal evidences[2]. Thus, accounting is traditionally based on historical cost. People can not deny the
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I.

INTRODUCTION

Based on international-accounting-convergence approach, the Ministry of Finance issued the Enterprise Accounting Standards in 2006 taking the International Financial Reporting Standards (hereinafter referred to as the International Standards) for reference. The Enterprise Accounting Standards carries out fair value accounting successfully, and spreads the sense that accounting should reflect market value objectively. The objective of accounting reformation following-up is to establish the accounting theory and methodology which not only use international advanced theory for reference, but also accord with the needs of China's socialist market economy construction. On the basis of a thorough evaluation of the achievements and limitations of International Standards, this paper puts forward a stand that to deepen accounting reformation and enhance the stability of accounting regulations. II. OPTIMIZATION OF FINANCIAL STATEMENTS SYSTEM: PARALLELING LISTING OF LEGAL FACTS AND FINANCIAL EXPECTATION As an important management activity, accounting should make use of information systems based on classified statistics, and serve for both micro-economic management and macro-economic regulation at the same time.

978-1-4244-8385-3/11/$26.00 2011 IEEE

MSIE 2011

existence of legal facts. The International Standards impose fair value on accounting with the result that the credibility of financial statements has been significantly weakened[3]. Recording appreciation and impairment of assets is not appropriate accounting practices for its lack of legal evidence. To some degree, fair value concept is rational, for it helps people to focus on assets fluctuation trends and concern about the potential risk. However, such information is merely indicative of risk, so its positive significance should not be exaggerated. Therefore, we recommend that such information be shown separately in dotted line table. So the net market value and total market value of assets and liabilities can be calculated[4]. These figures are all shown in the dotted line table, which do not have the legal credibility, therefore, enterprises may entrust appraisers or auditors to prepare these figures in accordance with market value only
TABLE I. Assets Current assets: Cash Inventory Short-term credit Non-current assets: Fixed assets Security investment Intangible assets Long-term credit Long-term equity investment Total of substantial assets Financial stock investment Total of assets Amount Market value Changes % % %

on the balance sheet day. So daily accounting practice does not need fair value accounting rules and impairment accounting rules and so on[4]. The non-listed companies even do not need to present the market value, because the users of market value information are mainly stock investors. B. Optimization of the Iincome Statement The income Statement is the most valuable statement for accountants, because tax declaration, profit distribution, and performance evaluation are all based on the income statement. In order to make sure that adequate attention is paid to the income statement, we also divide the income statements into two parts: the solid line table and the dotted line table (see Table 2). Major improvements and the reasons are described below.
BALANCE SHEET Debts and stock equities Amount Market value Changes % % %

% % % % % % %

Current debts: Short-term debts Non-current debts: Long-term debts Total of debts Stockholders equity: Paid in capital Additional paid in capital Surplus reserve Undistributed profit Total of substantial net assets Sum of debts and substantial net assets Undistributed profit(risk provisions) Sum of debts and net assets

% %

Note: The numbers in the dotted line table are estimated numbers, not supported by legal evidence.

TABLE II. Item 1Revenue Minus: Operating taxes Cost of sales Cost of wages Selling expense General and administrative expense Financial expense 2Operating profit Add: Gains Minus: Losses 3Profit-before-tax Minus: Income tax 4Profit-after-tax Add: Expected gains (Gains of fair value changes) Minus: Expected loss (Losses of assets impairment) Minus: Expected income tax 5Comrehensive income Basic earnings per share (Basic EPS) Diluted earnings per share (Diluted EPS)

INCOME STATEMENT Amount

Note: The numbers in the dotted line table are estimated numbers, not supported by legal evidence.

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The presentation of figures in solid line table follows historical cost accounting concepts and implements realization principles. The profit before tax in solid line table is basically equivalent to the amount of taxable income that is recognized by Enterprise Income Tax Law, which makes paying taxes much easier. The "income tax" in the solid line table is the income tax that the enterprise actually pays. The profit-after-tax is the net profit available for distribution, which is in consistent with the Company Law [5]. Income from changes in fair value is essentially one kind of expected income, and the impairment loss is essentially expected loss, they are not realized incomes and losses. So such information lacks legal evidences. Therefore, when calculating profits, we should not take those expected financial factors into consideration[6]. We recommend that all financial expectations be presented in the dotted line table, and be marked with shadow to avoid mixed presentation of expected profit and real profit, which often mislead the readers of financial statements. From 1992 to 2006, a lot of new ideas and new perspectives are introduced into China's accounting practices from international accounting standards in a gradual manner during the accounting reform in China. These ideas and perspectives enriched the understanding of the financial statements in China. These achievements deserve our full assessment and should be fully affirmed. However, academia and standard-setters are also aware that International Standards are still in the process of developing [7] . The purpose of proposing new formats of financial statements in this paper is to push forward the accounting reform into a deeper level on the basis of international convergence. III. THE PRACTICABILITY OF IMPROVING THE FINANCIAL STATEMENTS SYSTEM

information will be recorded in accordance with assessment only at the balance sheet date and only in the annual financial statements. Historical cost accounting is more likely to be recognized by the tax authorities, which saves heavy workload of the tax adjustment. Accountants will not need to calculate the deferred income tax expense any longer, and the profit-after-tax in the solid line table is acknowledged by the Company Law, which solves the problem of determining the profit available for distribution. Accountants do not need to record the fair value information needed by security investors in the accounting books; instead, they only need to list the fair value information at the balance sheet date. In addition, because the data in the solid line table has legal credibility, so the legal risks of accountants can be well controlled [8]. Secondly, the arbitrariness of the accounting process will be reduced, and the auditors review process will be greatly simplified. The independent auditors will not have to bear the considerable legal risk for the dotted-line table they audit, because the risk of fair value information has been prompted as "not supported by legal evidences". Accountants and auditors can quickly adapt to this financial statements system, without the need of training. In this way, they can save a lot of time to help companies to improve management efficiency. Surveys show that the above design of financial statements is popular with accountants and auditors. Since the workloads of accounting and auditing have been substantially reduced, therefore, the total expenses for auditing and evaluation will not exceed current level as well. B. Views from the Perspective of Demand-side The new financial statements will significantly reduce the information asymmetry between the supply-side and demand-side. As the historical cost data based on legal evidence and the fair value data based on the financial expectation are separately listed, the usefulness of financial statements would be enhanced. Tax authorities can directly use the data in the solid line table of the income statement to collect income tax only with minor adjustments, so the workload of tax audit can also be greatly reduced. Commercial banks can use historical cost accounting information and fair value information as references for credits decision. Financial regulatory agencies have a choice to use the data in the financial statements to implement capital adequacy regulation, solvency regulation and risk control. For investors, they can contrast the historical cost information with the fair value information to adjust their expectations[10]. In short, from the perspectives of both supply-side and demand-side, the improved financial statements are expected to enhance the usefulness of financial statements, without increase the burden of the supply-side. IV. CONCLUSIONS AND POLICY RECOMMENDATIONS

Whether the financial statements are able to maintain their stability? It is necessary to mobilize the initiatives of both supply-side and demand-side at the same time. We should consider whether financial statements could meet the demands of the macro-economic regulation and business administration, and whether they are popular with millions of accountants. A. Views from the Perspective of the Supply-side Accountants are responsible for preparing financial statements and auditors are responsible for auditing. They will benefit from the implementation of the new financial statements. Firstly, for the accountants, under the isolated design of historical cost accounting and fair value accounting, their daily accounting practice is greatly simplified. Accounting process will not need assets impairment and fair value any longer. Accounting books will not record impairment and appreciation of assets any longer, for the historical cost accounting is comprehensively implemented. Fair value

The current rule of mixed presentation of fair value data and historical cost data could be improved. The core concept of fair value is to make financial statements reflect the fair

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value of assets and liabilities, so that we can subtract the fair value of liabilities from assets to obtain the net fair value[11]. However, the current International Standards do not implement this concept, but try to partly transform the historical cost accounting, which leads to mixed using of impairment accounting and fair value accounting. China's accounting academic research has followed up step by step since 1980s, and now has already introduced a mixedattributes model into corporate financial statements. By distinguishing legal facts from financial expectations, we can balance public interests and private interests and can redesign the financial statements system with enhancing management efficiency and implementing higher-level laws as main objective. By presenting fair value and historical cost in one set of financial statements at the same time, the statements will not only meet the needs of keeping books according to domestic laws, but also meet the demand from financial regulatory authorities and security investors[12] [13]. We hope that practitioners and theorists offer advices and suggestions on the problem of improving the financial statements to build a financial statements system which not only meets the domestic needs, but also converges with the International Standards. REFERENCES
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