Financial reporting

"The strength of the UK approach to financial reporting has been that it provides accounting policy choices to those who prepare financial statements, while specifying a minimum level of disclosure."

Abstract: The main objective in this essay is to define financial reporting and illustrate the impact of accounting policy choices (APCs) in the United Kingdom (UK). Further on, we will see its impact on the profit and loss account and the balance sheet statements by manipulating it through depreciation and stock valuation and decide whether or not these policy choices are a benefit or a drawback to the firm from a manager's point of view and the U.K. as a whole.

Introduction:

Financial reporting is defined as to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions (Weetman 2006, pp. 75). The government and a good number of boards and councils closely monitor financial reporting in the UK. In the UK The Companies Act 1985 sets many rules for investing in and operating companies. It prescribes formats and valuations in the profit and loss account and the balance sheet. The UK legislation places strong emphasis on the requirement to present a true and fair view in financial statements (pp. 85). The Financial Reporting Council's (FRC) aim is to promote confidence in corporate and governance through objectives such as high quality auditing and the integrity, competence and transparency of the accountancy profession (pp. 86) just to list a few (pp. 86). The UK Accounting Standards Board (ASB) and the Auditing Practices Board (APB) are examples of several other boards set up to regulate financial reporting in the UK.

Accounting Policy Choice in the UK:

The IASB Framework sets out qualitative characteristics that make the information provided in financial statements useful to users. The four principle qualitative characteristics are: understandability, relevance, reliability and comparability (pp. 75). In the UK companies have to comply within this framework in order to record their financial transactions. The UK is a more principle-oriented country when it comes to financial recording and thus have the choice of which accounting policies to exercise. The overall objective is to provide stakeholders with high quality information and principles are therefore set for the purpose that the spirit of standards is always followed.

Principles Vs. Rules:

Financial reporting in the UK is more principle-based with the flexibility of APCs compared to countries such as the U.S. where it's more rule-based and thus has no flexibility. The Statement of Financial Accounting Standard (SFAS) requires a corporation to report expenses in the year incurred, even if the transaction has not yet been completed and is otherwise unknown to the public. This requirement may influence when to incur an expense so as to avoid prematurely alerting the public of a potential deal (Ruffner et al, 2009). This is one of the rules set by the SFAS and although it may sound strict it keeps all companies to have consistent financial information available to the users.

Advantages:

Accounting policy choices gives users using information provided in financial statements to be readily understandable (pp. 75). This means that users can easily understand the information provided in financial accounts as all the complex information is not included. Relevance is another advantage as it represents the true economic reality of the company. It influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations (pp. 76). Reliability adds the benefit that the information is error free and biased and doesn't mislead users. Comparability gives users the benefit to be able to compare the financial statements of an enterprise over time to identify trends in its financial position and performance (pp. 77).

Disadvantages:

However, the disadvantages of these choices are that it hinders comparability in company performance if the company decides to change its choices of accounting policy and also when it comes to making comparisons company to company. Also, There is a trade-off between relevance and reliability when it comes to ensuring that information is delivered in a timely manner so that it is still relevant, and when it comes to deciding whether the costs of producing further information exceeds the benefits. Weetman also articulates that the benefits derived from information should be greater than the costs of providing it. The analysis is complicated because the benefits fall mainly on users, while the costs fall mainly on the provider (pp. 79)

Impact of APCs on Profit & Loss Account and Balance Sheet:

Companies have the option of choosing different depreciation methods to manipulate their revaluation of fixed assets, a good example being houses or property in general. Companies have to revalue their fixed assets and therefore there is knock-on effect as depreciation charges increases, therefore it reduces the profitability of the company.

Example 1: Depreciation using the reducing balance & straight-line method

A company purchases a PC costing 1000 on a reducing balance basis, using a rate of 40%.

End of Year 1: depreciation charge = 400

Value of the asset (the reduce balance) = 600

Calculations: 40/100 = 0.4

0.4 * 1000 = 400

1000 - 400 = 600 is the value of the asset.

End of Year 2: depreciation charge = 240

Value of the asset = 360

Calculations: 40/100 = 0.4

0.4 * 600 = 240

100 - (400=240) = 360 is the value of the asset.

Straight-line:

Fixed asset at cost: 1000

Estimated life = 2 years

Estimated residual value = 50

Depreciation charge =

Original cost of the asset - estimated residual value/Estimated life of the asset (years)

(1000 - 50) / 2 years = 475 p.a.

Value of assets:

End of 1st year: 1000 - 475 = 525

End of 2nd year: 525 - 475 = 50

The difference is certainly clear between using the two choices of depreciation. According to the examples given the value of assets decreases quicker using the straight-line method in comparison to the reducing balance. The Net Book Value of the PC at the end of 2 years is 360 using the reducing balance method and 50 using the straight-line method. Ironically enough the straight-line method is the one commonly used. The results might be different if we used this method to revalue assets that cost higher and have a longer life. Managers have the choice between choosing from the two methods available. Although both methods have the effect of reducing profit every year and reduce the value of the asset, managers would choose to apply a method that shows higher profits whilst also showing a healthy value of assets. The reducing balance method is also used especially when companies such as banks want to show a high asset base.

Stock valuation is another accounting policy choice where the manager of a company could choose to apply the First In First Out (FIFO), Last In First Out (LIFO) or Weighted Average Cost (AVCO).

Example 2: Stock valuation using FIFO, LIFO & AVCO

Grindels Limited is a manufacturing company. It buys stocks of component X, which it uses in production.

Stocks of component X at 1st March were 55 units at 3 each.

The following movement of stock took place in March:

From the example given above FIFO would be the most obvious choice given the fact that the total cost of materials transferred to production in that month is 325.00 which is lower than applying either LIFO or FIFO. The same can be said for value of closing stock, which is 352 and is higher than the other two methods. The IASB standard IAS 2 prohibits the use of LIFO. In the UK tax authorities will not accept LIFO valuation. In the USA the LIFO method of valuation is permitted (pp. 249). This is abit contradictory to the principle vs. rules oriented way of presenting financial information. The U.S. being more rule-based allows for flexibility with this method while the UK doesn't. Stock valuation options have a provision of bad-debt meaning that not all debtors or customers will pay back. Therefore a high provision of bad debt decreases profits of a company.

Manager's Perspective:

Although the role of the manager's has been briefly discussed in regard to depreciation method and stock valuation there are other factors that influence the manager's decision on the choices available. By following the rules managers have to make sure that the financial accounts truly reflect the economic reality of a company. These choices also allow managers to manipulate profits and decrease them in order to pay lower taxes.

On the other side they can show profits as being higher by using the reducing balance method. This is done to show the shareholders of the company that the company is performing well and increase the manager's chances of getting bonuses and performance appraisals. Since in most large companies there is a separation of ownership and control, managers and shareholders are involved in the principle-agent dilemma. It comes with the choice of stock valuation as an example whereby if there were no regulations, companies that wished to show high profits might prefer FIFO. Companies that wished to show lower profits might prefer FIFO to reduce tax bills (pp. 248). Thus, LIFO is not allowed in order for companies to show a 'true and fair view' of the company's financial information.

Conclusion:

Although APCs gives freedom to managers and companies overall as to how to record their accounting transactions it still doesn't put all the companies on the same page in order to show how they perform. Some companies might choose to record transactions that show they are performing well. However, in these times where the U.K. has recently entered an economic recession, if all companies had to follow rules the U.K. economy would have better prepared themselves for this current economic recession.

References:

  • Weetman, P. (2006). 'Ensuring the quality of financial statements', in: Financial and Management Accounting An Introduction. 4th edition. Essex: Pearson Education Limited. Pp. 75-93.
  • Weetman, P. (2006). 'Current Assets', in: Financial and Management Accounting An Introduction. 4th edition. Essex: Pearson Education Limited. Pp. 247-249.
  • Ruffner, W. G., Klausman, D. L., Wilkes, K. (2009). The Impact of Financial Accounting and Tax Rules on M&A.
  • MG1052 Introduction to Accounting. Lecture 10, Adjustments. Brunel University. 2008.
  • MG1052 Introduction To Accounting. Workshop 7. Brunel University. 2008

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