Issues in Financial Reporting

Izza Urooj
Sap id 6884
Sir Amanullah

Time 3 Hours Total Marks 100 Weightage 20%

 All questions are compulsory and carry equal marks.
Q 1 Following is an extract from the annual report of a sugar mill. You are a financial consultant
and one of your clients, who is a shareholder of the mill, approaches you to understand these
paragraphs. He is confused as to why management uses estimates instead of facts. He is also
confused about the underlined terminologies. You are required to explain and make him
understand. Remember he is not finance educated.
SIGNIFICANT ACCOUNTING JUDGMENTS AND ESTIMATES The preparation of financial
statements in conformity with approved accounting standards requires the use of certain critical
accounting estimates. It also requires management to exercise its judgment in the process of
applying the Company's accounting policies. Estimates and judgments are continually evaluated
and are based on historic experience and other factors, including expectations of future events
that are believed to be reasonable under the circumstances. Revisions of accounting estimates are
recognized in the period in which the estimate is revised and in any future periods as appropriate.
In the process of applying the accounting policies, management has made the following
estimates and judgments which are significant to the financial statements:
i. Property, plant and equipment. The Company reviews appropriateness of the rate of
depreciation, useful life and residual value used in the calculation of depreciation.
Further, where applicable, an estimate of the recoverable amount of asset is made to
determine possible. impairment on an annual basis. In making these estimates, the
Company uses technical resources available with the Company. Any change in the
estimates in the future might affect the carrying amount of respective item of property,
plant and equipment, with a corresponding effect on the depreciation and impairment.
ii. Impairment of Assets. The Company reviews carrying amount of assets annually to
determine whether there is any indication of impairment. If any such indication exists, the
assets recoverable amount is estimated and impairment losses are recognized in the profit
and loss account.

Answer:
My client don’t know about financial language so I’ll talk in a layman language so my client
would understand what I want to say. The first thing my client is not understanding is critical
accounting estimates.
The financial statements is based on quantitative (numerical) data and very less focus is on
qualitative data. So it is just showing us the condition of the firm in numbers. For finance it is
hard to account for each and everything in financial report. There are standard setting bodies
which are making accounting standards and companies are implementing it. that body give us a
standard no 8 which tell accountants to use estimates. For decision usefulness it is not necessary
for companies to be mathematically exact. Because for taking decision of investment, investors
need a rough image of the company’s performance on the behalf of which he can take decision.
Standards are contributing in transparency and international comparability. Companies use
expected value for planning. On the basis of which company plan its labor, expense, production
and inventory etc. because it is almost near to actual value. The error term could be decreased as
much as possible through it. And the expected results are more neared to the actual results.
Recoverable amount of asset is made to determine possible: Areas which need judgment are
accounted as accounting estimates like in case of non current assets the life of asset is an
estimate which means life of an asset is just an estimate which can be changed later and if that
change prospective effect will be made to financial statements. Prospective effect means that the
effect of change in life of asset will be reflected after the year in which change is made rather
than retrospective effect ( change made assuming it was made right form start )
The third thing my client is not clear about are Impairment of Assets. An asset become
impaired when that asset can’t be use anymore for example if a company was using a machine
for producing its products but soon a new machine came in market which more effective then the
previous one, include more advantages and benefits it will reduce the market price of that
machine as a result company will declare it as impaired asset. An asset can also be impaired if
demand of customer changes (customer no longer need that product), or damage to its physical
condition.
 Q.2 Discuss the phenomenon of income smoothing.
For a financial report the amount of income plays a very significant role because on the basis of
this value the company, shareholders, investors and other users can make knowledgeable,
economic decision. Even the quality of financial report is based on how much predictive it is.
The more the predictivety the better will be the quality. It shows the performance of the
company. Where the company stands in the market.
Income smoothing:
Income smoothing is a process of moving revenues from one accounting period to another. In
other words it is the way to level out fluctuations in the net income among different reporting
periods by using the accounting policies.
It is not illegal if the process of income smoothing follows GAAP or IFAS. Managers do it as per
the betterment of the company using estimates of accounting.
Why do company do income smoothing?
Usually there are two extremes risky nature of investors, risk seeker, and risk aversive. Risk
seeker are the investors who preferred to invest in riskier security to get higher return. The more
the value of security fluctuate the higher the risk would be associated with it. With higher risk
investor also demands for higher return and expect company to perform better and meet their
expectations in return if company is unable to fulfill their expectations they will start selling their
stocks and investing in other. Eventually demand of the share decreases which leads to decrease
in the value of the company and trust of shareholders on it.
In other words, If companies profit or loss highly vary, then investors will demand more
premium, cost of equity increases, weighted average increases, eventually EPS decreases.
On the other hand the people with the nature of risk averseness, prefer to invest in such stocks or
securities or assets which at least give them back there actual invested amount but it doesn’t
mean that they don’t want any return based on their investment they do want but there
expectations are not as high as the expectations of risk seekers. Because as they now the risk is
less they also know that comparatively return would also be less. If company builds trust in eyes
of their investors it will increase the demand of shares of the company in the market and the
value of company also increases.
Thus, the managers rationally want to do income smoothing (fluctuation of revenues and
expenses among different financial reporting) to retain more investors, to increase the demand of
their shares and the value of the company and trust in eye of the investors (through changing
assumptions like accounting policies) In this way it affects the stock prices of the company.
Management manipulate net profit and make it sure that fluctuation won’t exceed.
Advantages of using income smoothing:
 It reduces the tax (as income decreases the tax on it will also decreas)
 It attract investors (by showing stability in earnings)
  Business Strategy (a company can use when they have high profits is to increase
expenses. In this case, it might increase bonuses paid out to employees or hire more
workers to increase the cost of payroll. If income was expected to be lower for the year,
they could employ the strategy in reverse; laying off workers or reducing bonuses to
reduce expenses. These moves not only smooth out income but allow a company to
operate more efficiently depending on the circumstances.)
Frauds could take place:
Many frauds also occur because of wrong use of income smoothing. For example the case of
ENRON. They manipulate the values in a way that the value of their company increases which
attracts lots of investors and eventually it got bankrupt because the numbers it was showing were
fake. To reduce these frauds there are standards now to follow. The bodies should keep a check
and balance among companies.
 Q.3 Discuss the evolution from basic cash accounting to modern financial reporting and
how can it be termed as “A Social construct”.
History:
There is a long history behind accounting due to which today we are eable to use many
accounting policies and using accounting as an important part of a financial report and to handle
the finances of the company. In early ages when there was no concept of money, people use
barter system (they sell one thing on the hand of other by equaling the weights of the things e.g
1 kilo wheat in return of one kilo cotton.) then come Arabic numerals, people start using clay
ball and tokens, these numerals are expressed in numbers which are more accurate.
Then comes the era of Italian renaissance, in this era need for proper record occur, from this era
actual accounting starts, modern accounting has its origin in it. A system was developed named
as Italian method, today which is known as double entry book keeping. Terms like debit and
credit, asset and liability etc were introduced in this era. From 1586 to 1696 was the period of
enlargement of double entry literature (preparation of financial statements). Major contribution
of this era was the evolution of double entry book keeping which is still in use.
Then comes the era of industrial revolution, before this the business was like do a project and
after completion of the projects the accounts are completed but in this era the nature of business
changes it turns into going concern due to which a need of experienced management and large
activities arises it also give rise to management activitites. Because in this period large scale
production take place. Due to which financial challenges also arises which evolve appropriate
costing techniques. Fixed asset of many businesses start increasing due to which depreciation
accounting becomes necessary.
After stock market crash of 1929, the accounting policies were in doubt, companies lost their
trust in eye of investors, people were afraid of investing. Accounting policies were suspicious
because on the basis of these policies financial statemetns are prepared. As a result different
standard bodies came into being to keep check and balance on the financial health of the
company and to satisfy the interest of the investors. Then with in different periods of time needs
and demands of environment changes which eventually increase or decrease the policies of
accounting (e.g inflation, during the time of inflation historical cost accounting become obsolete
because it doesn’t give the true and fair value.
From the history what I conclude is change is constant, with more time there will be more
change in environment which will leads to changes in accounting policies. The quality of
accounting depends on how much it align with the environment the culture of that region.
For example: in a case study of Tokyo Disney land I learn that, the way of measuring capital
budget from Net Present Value (NPV) is not suitable in Tokyo but highly preferable in US.
Because of the diferret culture the preference of accounting policy also vary.
Accounting is social construct, as I said above accounting policies varies with change in
environment which is constant. Which means accounting policies will keep on changing. In
other words, Accounting does not rest on universal truth, but is rooted in societal value system
which they operate and socially determined. Hence it is a product of environment. Therefore, as
the socio economic environment has changed, so has the accounting standards.
Accounting is not based on absolute reality. social construct can be changes but absolute reality
can’t. For example there was a company, it set its financial statement as per American standard
and shows a profit in millions but when the same company set the financial statement as per
German standards of same fiscal year starts showing the loss in billions. This example shows
that with change in policy results changes. Which is a proof that it is social construct because if
the accounting is based on obsolete reality then whatever the assumptions would be it shows the
same results (results would be same in any case). Which is opposite in case of accounting so, we
can say that accounting is a social construct.
 Q.4 Comment on the following statement. Use examples from Financial Reporting to
illustrate your viewpoint.

 Language affects what people see, how they see it, and the social categories and
descriptors they use to interpret their reality. It shapes what people notice and ignore and
what they believe is and is not important (e.g., Pondy, 1978; Weick, 1979).

Language is not only a mean of communication but it develops perceptions and minds of
peoples. The way people say or show affects the behavior of others. Language make us
observable and sometimes make us to ignore something. It makes our believes which eventually
predicts attitudes and behavior.

For example Notes: in notes of financial report 1st two lines are showing the performance of
auditors in which auditor says that “it shows the true and fair value of the company” now
while reading it different people think it, see it and evaluate it in different way for a normal
people this statement means that the mathematical values shown by the company in financial
report are true company is actually earning that much return or facing that much loss and paying
that much debt or expenses. But when that statement is read by a financial student or a person
from finance field will understand that this statement doesn’t mean that company is exactly
earning that much but it means that all the accounting assumptions used by the company are used
in a right way. So this person will take decision or react accordingly. And the other person who
is not understanding the real meaning of the statement will react accordingly just based on the
values.
For example; earning; it have different definitions the way environment changes from working
on projects now there are companies with going concern. With the change in environment the
way people see and categories earning is changed. In history the simple definition of revenue
was the amount people earn by selling number of products minus the cost they spend on it. But
now as the businesses grew up, many of the businesses of a company are executing not only in a
city or country but the whole world. So the definition of earning is changed. It is different
according to different boards why its different because of the different way of thinking and
looking at things under different circumstances.

 Language plays a dominant role in the creation of meaning and the construction of
knowledge. Words can and do take on different meanings in the context of different
language games. Think of the word ‘‘love.’’ It signifies differently in a marriage
ceremony, a game of tennis, and in accepting an invitation to dinner. ‘‘Love’’ shifts its
meaning depending on the rules of the language game in which it is put into play. The
scientific method and economic theory are simply language games that get elevated to a
 ‘‘game-of games’’ status by those academics who currently seem to rule over the
accounting and finance academies. (Wittgenstein)

Language is a very important mean to communicate, to lead, to manipulate and a lot more.
Different subjects in studies have different language. For example; there are different language
of biology, physics, English, accounting etc. it creates different meanings in different context.
With the language we can lead people in wrong direction or towards right path. With language
we can manipulate people’s mind.
For example; Reserves: in English language, it means the amount we keep in our saves that we
can use later when we need. But in the language of accounting reserves mean the amount of
money company earn on its own from that money some is distributed in the shape of dividends
and the remaining is labeled as reserves in balance sheet in the side of equity. This amount is
reinvested in the company.
Asset = liabilities + Owner’s Equity
LTA + CA = (LTL+ CL) + (contributed capital + Reserves)
The money that is shown in reserves is not placed in safe but it is utilized in company, it could be
cash and bank balance, marketable securities or in long term assets.
In other words we can say that,
Reserves - Cash & bank balance – Marketable Securities = longterm asset (the remaining amount
is invested in long term assets for long term investment)
For a person who is unaware of financial language will think reserve as an amount safed
somewhere, which the company will use in its hard time. Depending on this many investors
invest because they think company have enough money to use in its hard time so their
investment won’t fail.
Capital: it is another example in term of financial reporting. In English language, capital means
something big but in accounting capital of a business is the money it has available to pay for its
day-to-day operations and to fund its future growth. In other words it mean what a company have
which includes assets and cash in a business. Capital may either be cash, machinery, receivable
accounts, property, or houses. Capital may also reflect the capital gained in a business or the
assets of the owner in a company.
 Q.5 Following is an abstract from “Professionalism and Accounting Rules”, a book by
Brian P West. Express your viewpoint with convincing arguments, both in case of
agreement or disagreement with the author.
 The recent history of accounting has been marked by the rapid escalation of a vast array
of accounting standards and other technical rules. In spite of this enormous regulatory
activity, sudden corporate collapses and other associated financial reporting failures
persist. In such a climate, audited financial reports are among the most highly regulated
yet also the least reliable of commodities. This book investigates this issue from the
perspective of accounting as a professional occupation. The author argues that the
accounting profession is beset by an inferior and incomplete notion of quality in its work,
emphasizing only compliance with processing rules rather than the correspondence with
commercial phenomena necessary to make accounting information a reliable guide for
financial decision making. It is revealed that the discourse of accounting researchers is
largely unconcerned with improving the technical quality of financial statements and that
the emphasis in accounting education is on simply the mastery of a rule-book.
Accounting practice itself has degenerated into a ritual of rule-compliance. Building from
a consideration of the function of accounting, the nature, roles and responsibilities of
professions, and the features and effects of accounting rules, it is concluded that the
professional warrant of the accounting occupation remains to be validated by the
cognitive authority expected of a professional occupation.

As per my understanding and learnings, accounting is not build on absolute reality but on social
construct which shows that it will keep on changing with the change in environment. As
environment changes needs and demands are changing so the accounting policies. Some
accounting policies become obsolete with the change in environment for example; historical cost
valuation become obsolete in inflation. But some stays for example; double entry book keeping.
As we see it is a social construct there could be more place of improvement. Manics argue that
accounting does not work in isolation, its existence depends on rules and standards of
accounting, made and refined by humans. So they could be wrong, could be with problems, and
are also able to solve some problems.
Most of accounting users are not clear about the basics of fundamental concepts of accounting,
we can’t understand something deeply until we are not clear about the basic fundamental
concepts of any particular field. Most of the accounting researches are based on quantitative data
not on qualitative due to which it is unable to give the actual value or showing the true position
of the company in the market. Dr. hayek recommend in his speech that there is a need of
qualitative research in accounting.
Accounting is very controversial and it is hard to understand it, and to solve it complexities.
There are uncertainties in the balance for example asset, there are multiple ways to record it.
either from LIFO or FIFO etc. as accounting is based on quantitative factors, for example
intangible asset, it is the excess of the purchase price paid for an acquired firm, over the fair
value of its separately identifiable net assets. Q; the difference between purchase price and net
assets is good will but that difference is not only because of good will there could be other
factors involved. The imprecision is not only in balance sheet but also in income statement e.g,
what is income how to measure it. Although there are some uncertainties in financial statement.
But for taking a decision regarding investment, it gives a rough view of company’s performance
which is enough. Financial standards are made by human beings, due to which there will always
be a room for more improvement. And standards setters will keep working on improvement.
Because economy is so complex and unpredictable that it is hard for the companies to identify
which factors will help out in decision usefulness and which won’t. Because of this reason many
famous companies revise their financial statement which also affects them. There are so many
doubts with the role of accounting and with the way it can be effective.
According to the findings of Megnan and markarian, there are some loopholes in structural
foundation of accounting, Financial Statements are potentially weak in expressing economic
performance. Even after so many standards of financial statements still scandals are taking place.
Why is that so because even though the accounting standards are there, standard setting bodies
are there, but there are still scandals. That is because of so many loop holes in accounting. People
find ways to do frauds. According to Dr. Hayek with these three principles principles,
pragmatism, persistence IASB can move towards improvement.
And unfortunately sometimes the responsible bodies are unable to catch them on time and as a
result scandal take place.
Comparatively, McKernan (2007), based on anti-representationlist philosophy approach of
Davidson. Defends objectivity and argue. So up to his argument there is true and fair accounting
system which can be attained in a relative way but not absolute. Because of some concepts in
economics. Accounting data represents economic resources and obligations which is effected by
economic events.
Financial statements are giving us estimated values based on which we can take decisions. Many
investors are investing based on the financial statements and are getting return on their
investment. For example Warren Buffe, he invests a lot in stock market and earn a lot according
to his learning you should clearly see and analyze the financial report and some other factors
which shows that financial statement can act as decision usefulness.

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