APC311 INTERNATIONAL FINANCIAL REPORTING ASSIGNMENT
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The growth of international activities has been rapid over time. These activities include areas of international trade, international investment, international bond and equity offerings, capital movements between countries and the number of multinational firms. Countries, entities and bodies who carry out these activities continuously seek to achieve growth and higher returns at lower cost of financing. This implies that there is often the need to consider international rather than national or internal alternatives of raising finance. The differences in accounting systems and principles that exist in different countries are a barrier to towards the comparability of financial information that is published by companies using different sets of accounting standards (Alexander, 2007).
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This led to ‘the pressure for international harmonization to regulate, prepare and use financial statements which are reliable, comparable and transparent (Nobes and Parker, 2000). This can only be achieved if countries employ the same accounting standards through the harmonization of accounting principles. International harmonization may be defined as a political process aimed at reducing the differences in accounting practices across the world in order to achieve comparability and compatibility (Hoarau, 1996). To achieve this feat, accounting regulators such as the IASB have attempted to advance harmonization projects in an attempt to minimize differences between different national accounting standards (O’Regan, 2006).
As argued by Choi et al (2002), harmonization will make it more likely for users of financial statements to interpret the information correctly and make better decisions based on that information. It will also reduce drastically the information asymmetry between stakeholders and companies and hence save manpower, money and resources.
The International Accounting Standards Board (IASB), issuers of International Accounting Standards (IASs) was established in 2001 and is the independent standard-setting body of the International Financial Reporting Standards (IFRSs) Foundation, an independent, private sector whose principal objectives are to develop in the public interest, a set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs) based on clearly articulated accounting principles. IFRSs are a set of high quality, understandable, enforceable and globally accepted Standards based on clearly articulated accounting principles.
The need for International Accounting Standards
The international investor
The information age and the advent of high-tech computers makes possible the availability of massive amounts of international financial information. Institutional and individuals who are interested in making international investments can therefore benefit from the global harmonization of accounting standards.
- International Accounting firms
The role of international accounting firms include providing auditing and consulting services in many countries. The absence of international accounting principles implies that they have to gain expertise in areas of domestic financial accounting principles and related laws. Gaining this expertise can substantially increase their operational costs.
- International intergovernmental organisations
International intergovernmental organizations including the United Nation (UN), the European Union (EU) and the Organization for Economic Cooperation and Development (OECD) extend credits for projects to other countries. They are therefore interested in obtaining comparable financial information in order to evaluate the projects they carry out in the various countries.as the organization. This can be achieved only if there is harmonization of international accounting principles.
- Developing countries
Developing countries often seek international financing sources for their development. It is important for their governments and accounting regulating bodies to adopt international accounting standards in order to make it easier for them to access international financing sources.
- Stock exchanges
The use of international accounting principles can enable the internationalization of Stock exchanges which can in turn increase international financing activity.
This essay will make particular reference to the UK equivalent of accounting standards i.e., the Financial Reporting Standards (FRSs) to examine the different accounting treatments in the individual accounting standards of interest in this assignment.
IAS 38 – Accounting for intangible assets
Definition: An intangible asset is an identifiable monetary asset without physical substance. An asset is a resource that that is controlled by the enterprise as a result of past events and from which future economic benefits are expected [IAS 38.8].
The objective of IAS 38 is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another IAS. The standard deals with:
- the criteria to be met before an enterprise can recognise an intangible asset;
- how to measure the carrying amount of intangible assets and the disclosures that needs to be made.
Examples of assets that may qualify as intangible assets under IAS 38 are:
computer software, copyrights, customer and supplier relationships, franchises, licenses, rights patents.
The three critical attributes of intangible assets are:
- Identifiability: In order for an intangible asset to be identifiable, it must be separable and it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. (IAS 38.12)
- Control (power to obtain benefits from the asset)
An intangible asset must be under the control of the enterprise in order for it to have the power to obtain future economic benefits from the asset. Control will usually but not necessarily emanate from legally enforceable rights, in the absence of which it is more difficult to prove the existence of an asset. For example, control over technical know-how is deemed to exist only if it is protected by legal right such as a copyright or patent.
- Recognition and measurement: IAS 38 stipulates that an intangible asset should be recognised only if both of the following occur:
- It is possible that the future economic benefits that are attributable to the asset will flow to the entity, and
- The cost can be reliably measured.
The cost of an asset must be reliably measured if the asset is acquired in a normal transaction. Also, the fact that a price has been paid for the asset, is a reflection of the expectation that future economic benefits will flow to the entity.
Goodwill and brand image
In order for goodwill and brand image to be classified as intangible assets and included as assets of the enterprise, they need to be identified separately. If goodwill and brands have been acquired externally, then their cost and existence can be identified and capitalised. As regards internally generated goodwill, it cannot be recognised as an asset because:
- it is not separable from the business
- it has not arisen form contractual or other legal rights, and
- its cost cannot be reliably measured (IAS 38).
- A reconciliation of the carrying amount at the beginning and the end of the period.
FRS10, accounting for goodwill and intangible assets is the equivalent UK Financial Accounting standard to the IAS 38.
The standard views goodwill arising on acquisition as not constituting an asset or an immediate loss in value. But it relates to the cost of an investment in the financial statements of the acquirer, hence the values are attributed to the acquired asset and liabilities in the consolidated financial statements. The standard is of the view that even though purchased goodwill is not in itself an asset, including it in the assets of the reporting entity rather than deducting it from shareholder’s equity recognises that goodwill is part of a larger asset whose investment the entity’s management remains accountable. Thus, the objective of the FRS10 is that it ensures that purchased goodwill and intangible assets are charged to the income statement in the periods they are depleted.
A comparison of the different accounting treatment of intangible assets by the IFRS and UK GAAP can be seen in Appendix 1.
The IAS definition for intangible assets has its limitations as many intangibles such as patents and related drawings do have a physical substance (Tiffin, 2005 p.67). However the real issue with intangible assets is that intangibles are difficult to value and as such, attempting to measure their impairment is plagued with problems Godfrey & Koh, 2001). The uncertainty about asset values and their impairment renders them susceptible to creative accounting.
Intangible assets can be generated internally by firms. But it is difficult to accurately identify and cost such assets. IAS38 states that ‘internally generated goodwill shall not be recognised as an asset’. Research and development are therefore considered to be different parts of creating an internally generated intangible asset. The research phase is defined by IAS 38 as ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’. This implies that research costs incurred are expensed when they occur. There is consistency in classifying what constitutes an intangible asset by the standard. Of course, this treatment of research is appealing as there is a probability that an initial research may not actually lead to any economic benefit.
Accounting for leases (IAS 17)
Definition: A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
A lease falls under two main categories; a finance lease and an operating lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease. [IAS 17.
Thus, in order to accurately classify the type of lease, it is important to determine whether the risks and rewards associated with owing the asset are with the lessee or the lessor. An asset will be classified as a as a finance lease if the if the risks and rewards lie with the lessee. However, it will be classified as an operating lease if the risk and rewards lie with the lessor.
As regards a finance lease, the concept of substance over form is applied. The substance is that even though the legal owner of the asset is not the lessee, the commercial reality is that the lessee has acquired an asset by obtaining finance from the lessor, this implies the recognition of an asset and liability.
Other distinguishing factors of a finance lease include:
- The present value (PV) of the minimum lease payments at the beginning of the lease amounts to substantially all of the fair value of the asset.
- By the end of the lease, the lease agreement transfers ownership of the asset to the lessee.
- The option rests with the lessee to purchase the asset at a price expected to be substantially lower than the fair value when the option becomes exercisable.
- The leases asset must be of a specialised nature.
A comparison of the different accounting treatment of intangible assets by the IFRS and UK GAAP can be seen in Appendix 2.
Operating leases appear to be more popular as both the leased asset and liabilities can be effectively kept off the balance sheet with future lease obligations disclosed as footnotes. However, a finance lease, often treated as an ‘in substance’ purchase by the lessee and a sale by the lessor, is less popular as it requires both leased assets and liabilities to be recognized on the balance sheet. But the finance lease does produce a tax benefit because of a larger expense, interest plus depreciation, compared to an operating lease which only reports the lease payments as an expense. IAS 17 (IASB, 2008) allows managers to structure a lease in such a way as to avoid the reporting of lease assets and liabilities.
In order to ensure a complete and transparent recognition of assets and liabilities arising from lease contracts on financial statements, the IASB decided to make no distinction between finance leases and operating leases and employ the ‘right-to-use assets’ and its lease obligations that is based on the present values of future lease payments using the incremental borrowing rate of the lessee at the inception of a lease.
Capitalization of lease can impact negatively on earnings because of the increased cost due to the depreciation of the asset and interest expense. This will in turn affect expected profit margin, return on earnings (ROE) and return on assets (ROA) (Bradbury, 2003).
IAS 37 – Accounting for provisions, contingent liabilities, and contingent assets
Definition – A provision is a liability of uncertain timing or amount.
IAS 37 ensures that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events.
- Definition: A contingent liability is: a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence of events not wholly within the control of the entity; or
- A present obligation that arises from past events but is not recognised because it is not probable that an outflow of economic benefits will be required to settle the obligation; or
- A present obligation that arises from past events but is not recognised because the amount of the obligation cannot be measured with sufficient reliability.
An entity should disclose a contingent liability in a note, unless the possibility of an outflow of economic benefits is remote.
A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
An entity shall not recognise a contingent asset. When the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition as revenue is appropriate.
A comparison of the different accounting treatment of intangible assets by the IFRS and UK GAAP can be seen in Appendix 3.
IAS 137 aims at ensuring that only genuine obligations are dealt with in the financial statements i.e. planned future expenditure even when authorised by the board of directors or equivalent governing body, is excluded from recognition. Appropriate recognition criteria and
measurement bases are applied to provision, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount.
The standard seeks to ensure that for example assets are not overvalued. Accounts receivables may be overvalued if reasonable provision for bad debts is not made. This has the tendency to inflate earnings and in such instances the provision for bad debts will prove to be inadequate in future, whilst in the short term account receivables and earnings receive a temporary boost.
Also, contingent liabilities which are obligations that are dependent on future events for the confirmation of the existence of an obligation. If companies fail to record a contingent liability that is likely to be incurred and subjected to reasonable estimation, it has the effect of understating their liabilities and overstating their net income or shareholders equity.
The above examples are indications of how companies use creative accounting to manipulate their financial statements especially their balance sheets.
Accounting for intangible assets, accounting for leases and accounting for provisions, contingent liabilities, and contingent assets are all complex areas which are prone to manipulation in the form of creative accounting which is defined as
“ the transformation of financial accounting figures from what they actually are to what preparer desires by taking advantage of the existing rules and/or ignoring some or all of them” (Kamal Naser, 1992).
Creative accounting in whatever form it takes is usually meant to overstate assets or understate liabilities.
The collapse of a number of corporate giants such as Enron Corporation, Tyco International, World Com, Global Crossing, Arthur Anderson, Parlmalat etc. have not only destroyed investor confidence and shareholder values but it has also damaged the accounting profession. The situation is even made worse when there are different accounting standards that are used in preparing financial statements.
This is made even worse when there are different accounting standards used in preparing financial statements.
The adoption of one set of global financial reporting standard such as the international financial reporting standard (IFRS) that confers with investors, stock markets, accounting professionals and accounting standards setters will go a long way to reduce the practice.
Arguably, accounting standards whether in the US, UK, Australia or the IAS will not have all the answers to accounting and financial reporting problems but it is hoped that it will largely reduce its occurrence.
APPENDIX 1 – Comparison of IFRSs with UK GAAP treatment of intangible assets
IAS 38 recognises a wider range of intangible assets than the FRS 10. For example, software license is treated as an intangible asset whereas it is regarded as a tangible fixed asset under FRS 10 (UK standards)
Under FRS 10, identifiability of an asset depends on its capability of being sold separately from the entity. Whilst IAS 38 includes this definition, it also identifies intangible assets arising from contractual or other legal rights.
Under FRS 10, there is a presumption that the useful economic life of an intangible asset is 20 years or less. IAS 38 allows an intangible asset to have indefinite life, in which case there is no need for amortisation.
FRS 10 requires the useful economic life of intangible assets should be reviewed at the end of the 20-year useful life period. IAS 38 requires impairment review only if there is an indication of impairment.
Research costs must be written off as incurred, whereas development costs should be capitalised under IAS 38 just as FRS 10.
Appendix 2: Comparison of IFRSs with UK GAAP treatment of Lease
Accounting for leases and hire purchase contracts
Reporting the substance of transactions
For the classification of land and buildings, IAS 17 requires the separation of the land and building elements. Lease of land is usually considered to be an operating lease.
IAS 17 requires more extensive disclosures than SSAP 21. Whilst IAS 17 requires lessees to disclose the total of future minimum lease payments, SSAP 21 requires disclosure only of details of the payments that the lessee is committed to make in the next year.
APPENDIX 3 – Comparison of IFRSs with UK GAAP treatment of provisions, contingent liabilities, and contingent assets
Relevant UK Standard
Provisions, contingent liabilities and contingent assets
Provisions, contingent liabilities and contingent assets
No significant differences. FRS 12 contains more guidance than IAS 37 on the discount rate to be used in determining the present value of a provision.
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