The Significance of Accounting Standards
Accounting data is the set of valuable information that reflects an image of the company. In order to understand the nature of the company, one has to refer the accounting information. Accounting data is required by both the external and internal sources of the company so as to analyze the performance as well as financial position of it. Therefore, it is important to represent such data in the best possible way so as to be able to have the qualitative characteristics, that is, Comparability, Relevance, Understandability and Reliability. Thus, here comes into picture the definition of Accounting Standards. (Antle, Garstka and Sevigny, n.d.)
Accounting Standards are the various rules and norms that guide the treatment of various topics of accountancy (Bebbington, Gray and Laughlin, 2011). It makes the accounting data presentable in the most standardized manner so as to present a true and fair image of the company. Basically, accounting standards are the norm adopted all over the world and is widely followed in every level of business world. It consists of the following three aspects:
- Recognition – this involve the question ‘How to record?’ It means how a particular item is supposed to be recorded.
- Measurement – this involves the question ‘How much to record?’ It involves determining the amount at which it is to be recorded in the books.
- Presentation – this involves the question ‘How to present it?’ It means giving the details of the items that has been recorded so that the users can understand its implications.
The past records show that due to the absence of standard accounting norms, many organizations have tried to deceive their users by manipulation of accounting information. Therefore, every business firm has to abide by all the rules set by these accounting standards. (Berry, n.d.)
In order to understand our case, we are first required to understand the accounting policies, accounting estimates and a change in accounting policy/estimate.
Accounting policies are the various principles and methods adopted by the enterprises so as to prepare the financial statements (CAANZ. and Kemp, 2017). Two different enterprises can have two different sets of accounting policies. Basically, preparation and presentation of the financial data is the management’s responsibility. So, the responsibility of selection of accounting policy, which would be the most appropriate one for that entity, lies with the management. The management is supposed to consider the following factors at the time of selection of accounting policies:
- True and Fair view: The financial statements prepared on the basis of such policies should give a true and fair view of the entity. (Chaudhry, n.d.)
- Prudence: Usually, profits are recognized only when they are actually realized (not necessarily in cash) but are not anticipated. However, a provision is made in advance for all the known liabilities and losses even though the amount cannot be determined with much certainty. This concept is also called conservatism. (Greuning, Scott and Terblanche, 2011)
- Substance over Form: The transactions to be recorded should be based entirely on their substance and not on their legal form.
- Materiality: The accounting information should disclose all the material items. An item is considered to be material if such decision can influence the decisions of the users of those financial statements.
All the accounting policies adopted by the management for the presentation and preparation of the financial statements are to be disclosed along with the financial statements under the head ‘Notes to Accounts’. Accounting policies are to be disclosed at one place (Houghton and Campbell, 2005). Disclosure of such accounting policies will provide a better understanding to the users of such data. Also, if there is a change in the accounting policy, such fact along with its effect is to be disclosed in the Notes to Accounts. An accounting policy can be changed only if such change is required:
- By an Accounting Standard,
- By a Statute, and
- For Better presentation of financial statements.
Accounting Policies and Estimates
If a change is made in the accounting policies which has no impact on the financial statements in the current period but is expected to have a material affect in the future, such disclosure is mandatorily required in the period during which such change had been adopted. Also, disclosure of accounting policies cannot correct the wrong treatment of any item in the books. Therefore, enterprises cannot take the advantage of such norms so as to correct their mistakes made in their books of accounts.
The policies adopted should provide consistency to the user so that they can compare the cash flows, profits and financial position & Performance of the entity from time to time. Therefore, it is important for an entity to apply the same accounting policies every financial year unless such change is required by the above mentioned factors (Hussey, 2011).
A change in accounting estimate is required when there are changes in the circumstances on which such estimate was based or due to flow of new information, more experience and subsequent development.
Such change involves an adjustment in the value of the assets and liabilities. The nature and amount of the change in the accounting estimate which has a material impact in the current period or may have material effect in the subsequent periods, such fact is to be disclosed. However, if in case it is impracticable to quantify such effect, such fact is to be disclosed (Hussey and Ong, n.d.).
A change in accounting estimate is accounted for the subsequent periods while a change in the accounting policy involves the retrospective effect from retrospective periods. Thus, this is how the change in accounting policy is different from the change in accounting estimate.
Considering our present case, the change in the method of depreciation reflects a change in the accounting estimate and therefore, the impact of such change is to be disclosed in the financial statements. (Klein, 2016)
Depreciation is defined as the reduction in the value of a depreciable asset that arises due to use, obsolescence or efflux of time. Depreciable assets are the assets that have an expected limited useful life and are expected to be used for more than one financial year. Also, they are held by the firm for self use or for rental purposes but not for the sale in the ordinary course of business. Depreciation is shown as a deduction from the carrying value of the asset to represent it at the correct value. Many organizations use this concept to manipulate their profits and so to commit fraud. That is why; accounting standards have been laid down to avoid such fraudulent practices and brings reliability in the accounting information. There are several methods of charging depreciation and the method of depreciation once adopted should be applied consistently from period to period. (Loftus, 2013)
Change in Accounting Policy and Change in Accounting Estimate
However, the depreciation rate should be checked on a periodical basis and if required should be changed considering several factors such as change in the useful life of the asset, or the benefits derived from it or due to change in the circumstances during which such rate of depreciation was adopted.
When there is a change in the rate or method of depreciation, such change is accounted as a change in accounting estimate (Needles and Powers, 2010). The entity should justify such change in the notes and should display all the material facts in the disclosure part along with the effect of it on the profits of the company. Now let us discuss the two methods of depreciation that are stated in our case:
- Single Line Method: This is the most commonly used depreciation method that requires the entities to depreciate their fixed assets with a uniform amount over the useful life of such asset. Since a uniform amount of depreciation expense is charged to the income statement every year, the carrying value of the asset gets reduced in a uniform straight line manner. However, such method is not appropriate in many situations as the fixed assets get reduced with more amounts in its initial years. Here, there is a salvage value which is reduced from the actual cost of the asset and divided by the useful life of the asset. Such an amount is called the depreciation amount which is deducted every year from the carrying value of the asset. For example, the cost of the asset is Rs. 200,000 and its salvage value is Rs. 10,000 and the useful life of the asset is 10 years. Therefore, the Depreciation = (200000-10000)/10= Rs. 19,000.
- Sum Of Years Digits Method: It is one of the accelerated methods of depreciation that is based on the fact that the fixed assets are more productive during its initial years and its productivity decreases with time. The depreciation is calculated by multiplying the depreciable base with the remaining useful life of the asset and divided by the sum of digits of the years the asset is useful. Here, the depreciable base refers to the difference in amount between the actual cost and its scrap value. This can be better understood with the following illustration. Let the cost of the asset be Rs. 65000 and its scrap value is Rs. 5000. The useful life of the asset is 5 years and the asset is depreciating on a yearly basis. Therefore, under this method, the sum of useful years of the asset = 15 (5+4+3+2+1) and the depreciable base is Rs.60, 000 (Rs. 65,000-Rs.5000). Thus, in the first year, the depreciation is Rs.60, 000*5/15 = Rs. 20,000 while in the second year is Rs. 60,000*4/15=Rs.16, 000. This illustration shows that depreciation charged in the initial years is more as the production level is high during the beginning year of the asset. (Needles and Powers, 2011)
In the current situation, we see that there is a company called Sunshine Ltd. That follows the straight line method of depreciation. Management made a record profit and predicted that the profits in the coming up 2 years will be high but it will face a downfall in the further 2 years due to economic slowdown. Thus, the management approached their accountant Maria to find a solution as they wanted to have a uniform profit in all the four years. Maria, being afraid that her contract with the company may get terminated in the next term for not providing an appropriate solution, decided to change the method of depreciation from straight line to sum of years digit method. Also, she decided to not disclose such fact in the financial statements as such change won’t be justified in the view of shareholders. (Picker, 2010)
The accounting standard clearly states that a change in the depreciation method is considered as a change in the accounting estimate provided the circumstances under which it was formulated have also changed. However, in the given situation, there was no change in the circumstances still Maria changed the depreciation method so as to manipulate the profits of the company. Though in the view of the general manager, Kam, such a change is to have consistent profits in the next four years that will ultimately keep the shareholders happy yet Maria is not satisfied with Kam’s understanding of the situation. The standard clearly lays down the norms that any change in the accounting policies or estimate is to be disclosed in the financial statements along with its monetary effect. In case, the amount is not ascertainable, such fact should be disclosed in the form of a note.
Thus, Maria’s step of not disclosing the facts is ethically wrong and is no less than deceiving the shareholders. Also, the intention of doing so is just to even the profits in the four years is not justified with proper reasons. So, making decisions on the basis of mere intentions goes against the responsibilities of an accountant. (Warren, Reeve and Duchac, 2007)
Conclusion
Thus, we see that the whole scenario of the management wanting even profits and Maria taking unethical steps is not correct. Maria should have discussed the matter with the general manager, Kam, considering the ethical limitations as well as the effect of such changes (Larson and Miller, n.d.). Also such unethical solution could later on drive the company into legal litigations. Therefore, Maria should make ethical changes and should discuss about the consequences with the manager so as to avoid any future disputes.
References
Antle, R., Garstka, S. and Sevigny, K. (n.d.). Questions, exercises, problems, and cases to accompany financial accounting. 1st ed. Mason, Ohio: South-Western.
Bebbington, J., Gray, R. and Laughlin, R. (2011). Financial accounting. 1st ed. Australia: Cengage Learning EMEA.
Berry, A. (n.d.). Financial accounting. 1st ed. London: International Thomson Business.
CAANZ. and Kemp, S. (2017). Auditing, assurance and ethics handbook 2017 Australia. 1st ed. Milton, Qld: Wiley.
Chaudhry, A. (n.d.). Wiley 2016 interpretation and application of International Financial Reporting Standards. 1st ed.
Greuning, H., Scott, D. and Terblanche, S. (2011). International financial reporting standards. 1st ed. Washington, D.C.: World Bank.
Houghton, K. and Campbell, T. (2005). Ethics and Auditing. 1st ed. Canberra: ANU Press.
Hussey, R. (2011). Fundamentals of international financial accounting and reporting. 1st ed. New Jersey [u.a.]: World Scientific.
Hussey, R. and Ong, A. (n.d.). International financial reporting standards desk reference. 1st ed. Hoboken, N.J.: Wiley.
Klein, G. (2016). Ethics in accounting. 1st ed. Hoboken, NJ: Wiley.
Larson, K. and Miller, P. (n.d.). Financial accounting. 1st ed. Chicago, Ill: Irwin.
Loftus, J. (2013). Understanding Australian accounting standards. 1st ed. Milton, Qld.: John Wiley and Sons.
Needles, B. and Powers, M. (2010). Financial accounting. 1st ed. Mason, OH: South-Western Cengage Learning.
Needles, B. and Powers, M. (2011). International financial reporting standards. 1st ed. Mason, Ohio: South Western Cengage Learning.
Picker, R. (2010). Australian accounting standards. 1st ed. Milton, Qld.: John Wiley & Sons Australia, Ltd.
Warren, C., Reeve, J. and Duchac, J. (2007). Financial accounting. 1st ed. Mason, OH: Thomson/South-Western.
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