Key areas of Accounting Judgement Assessment 1 Financial Analysis (Part 1)

Accounting for Managers

Executive Summary
The financial statements are used for providing information on the financial position of a company to various stakeholders, who are associated to the company directly or indirectly. These statements help them to make decisions about their future association with the company. This makes it necessary for the financial statements to be accurate and verifiable and the essay discourses some judgement is required to be applied. key areas in financial accounting where

The financial statements of an enterprise comprises of primarily the balance sheet that summarises the assets, liabilities and shareholders equity at the end of a year or a specified period (quarter / half year etc.), the income statement also known as the profit and loss statement summarises the revenues and expenditures incurred during a specified period (year / half year / quarter) and statement of cash flows. There are various stakeholders who are interested in the financial statements. Stakeholders can be shareholders, trade creditors who have supplied material to the organisation, banks & financial institutions who have lent money, government and statutory authorities for taxes and other compliance of various provisions of law. Therefore, the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise to enable stakeholders in taking decisions or forming opinion keeping in view the kind of relationship they have with the enterprise. It is generally acknowledged that most of the users are nonaccountants and therefore necessary for the information to be understandable, relevant, reliable and comparable. Most importantly, the information provided should be unbiased. This means that the information should not be provided in a way to influence the decision or judgement to receive a favourable outcome (Abraham et al. 2008, p.11). However, these financial statements sometimes do not represent true or complete picture. Certain judgements and assessments need to be applied by the management of the enterprise while preparing the financial statements. Some of the areas that require such considerations are discussed below. Fixed assets and charging of depreciation Most assets depreciate on usage and have to be replaced at the end of its useful life. Therefore depreciation is charged as a non-cash expense. If these assets are used to generate economic benefits during a given financial year, then cost of their use must also be reported (Abraham et al. 2008, pp.342-343). While calculating the depreciation charge, three factors go into consideration, the cost of the asset, its estimated useful life and residual value realisable at the end of life period. A shorter expected life would increase depreciation charge and consequently lower the profit and vice versa. Therefore, one of the areas the managements estimation and judgement is applied is the useful life and the residual value of various assets used in the operation of the company. Understanding of 3

the classes of assets and rationality of the applied depreciation is necessary to understand the reliability of the reported profit or loss figures. According to the matching principle in accounting, the revenues of a particular period should be matched with the corresponding expenses. In order to determine the expenses for a given period, it is therefore important to include an amount representing the depreciation of the fixed assets during that period. However, companies use different methods for computing depreciation and each method results in a different value of depreciation and consequently a different amount of profit or loss. One of the methods to calculate depreciation is the Straight-line method. It calculates depreciation based on the estimated useful life of the asset and not on its usage. This method is most commonly used, due to its simplicity. Another method, the Reducing balance method uses a depreciation rate that is applied to the book value at the start of each period. Depreciation can also be calculated using the Usage based method where depreciation is charged each year based on the usage of the asset (Abraham et al. 2008, p.69). The management can choose any of these methods to calculate the depreciation on their assets. This brings us to another area of judgement that has impact on the financial statements. Abraham, Glynn, Murphy & Wilkinson (2008) stated that, a company using the Usage based depreciation method will show profits in its initial years (p.69). Definitely the method selected has a considerable impact on financial figures. This impacts the readers' understanding of the financial statements, who will not be able to judge on what basis the depreciation has be calculated (Abraham et al. 2008, p.70). Valuation of assets Though an annual depreciation is charged on the fixed assets, except land, the cost of assets shown in the books may not represent the realistic or realisable value. Therefore in order to have a realistic value, a company might undertake revaluation of assets. If the value of assets, as per assessment, has depreciated more, the company will have to provide more depreciation or write off, which will reduce the profits. On the other hand, if the valuation has increased, for instance, particularly in the case of land, there will be creation of revaluation reserve showing better financials. In case the management chooses not to revalue the assets, it could result in acquisitions. The revaluations of assets being reflected in the balance sheet obviously causes a degree of subjectivity (Abraham et al. 2008, p.344). Unless the asset is sold its true value cannot be estimated. In case of 4

land, the value can be estimated by the professionals. But there are certain assets that cannot be evaluated easily, and management takes a call on the value to be associated with the asset. Thus, management can take this as an advantage to show profitability. Recoverability of receivables The current assets of the company are the assets that will get converted to cash normally within 12 months of the balance sheet date. Businesses can operate on cash basis or credit basis. Credit transactions create accounts receivables or sundry debtors. Over a period, these sundry debtors accumulate due to disputes, discrepancies or inability to pay. The company therefore has to make allowances for doubtful debts based on an assessment of recoverability. This, if the company is not sincere and does not make adequate provision could result in overstating the profit. Therefore, it is critical to know the recoverability of sundry debtors and the companys policy on making adequate provisions. This calls for a judgement on the financial position based on additional information. Accounting of intangibles The expenditure of a company on Research and Development, patents and copyrights, licensing contracts and goodwill etc., which add value to the business is accounted under intangible assets. Wyatt and Abernethy (2008) state that, any kind of investment involves expenditure and that stands true for intangible assets as well, therefore they should be accounted for in the financial statements. It is suggested that, an intangible asset can be capitalised or charged to the profit and loss account as an expense. Intangibles with a fixed life (such as contracts) can be liquidated against income over the lifetime of the asset, a portion of the original cost to be expensed every year. Intangibles with an indefinite life (such as goodwill) cannot be liquidated, but can be accounted by estimating their residual value (pp. 95-107). Hence, ...the recognition and measurement of intangible assets must be evaluated on a case by case basis (Quilligan 2008, pp. 10-12). Even though there are methods to value intangible assets, these methods still involve considerable amount of estimates. Recognition of revenues in construction contracts The revenues from a construction contract may be realised as per agreed payment terms, which may or may not correspond to the stage of completion. The stage of 5

completion method is used to represent the contract revenue and expenses in the profit and loss statement. The stage of completion is determined by the proportion of contract costs incurred for the work performed to date, to the estimated total contract costs. Significant estimation is required in determining the stage of completion, the contract costs and expenses. These estimations are based on past experiences and evaluation by the experts. This judgement has impact on the stated profit or loss of the company. Policy on capitalisation of assets The company has to make judgements on the capitalisation policy of its expenditure as assets. It simply means that the company delays the recognition of expenses by recording the expense as long-term assets. This method helps them to spread the cost over specific period of time. The decision lies with the company as to what level they want to make an expense an asset. Valuation of inventory Goods sold or used during an accounting period may not exactly correspond to the goods bought or produced, resulting in closing stocks and requirement of valuation thereof. There are three methods of inventory valuation. First-in-first-out (FIFO), wherein the company assumes the oldest stocks are used first. Therefore, in calculating the cost of goods sold, the cost is taken in the order from the oldest. In Last-in-first-out (LIFO) method, the assumption is that in the sale or manufacture, the latest stocks are used first and go backward. Accordingly, in calculation of cost, the cost from last and backwards is taken. The third method is an averaging method, here the average cost of the total stock is recalculated each time a new stock arrives. If FIFO method is used, there is a likelihood of overstating the profit as against current sales revenues; cost of oldest material is taken. This is reverse in LIFO. The third method is an average of the two. Therefore, the analyser of financial statements has to look into the methodology of valuation of inventory to have a fairer understanding of the true nature of reported profit or loss. Contingent liabilities Contingent liabilities are those liabilities, incurring of which is dependent on happening or 6

not happening of an event or a set of events, for instance lawsuits. Liquidated damages for not meeting agreed performance parameters of machinery supplied will becomes payable only if the machinery supplied does not meet the parameters, i.e. the liability is contingent on happening if that situation arises. A guarantee given by the company to any other person or entity is also a contingent liability. The guarantee enforcement will depend on happening of certain events. These liabilities needed to be recognised in the company's balance sheet. A footnote generally provides their details. Probable, reasonably possible, or remote are used to describe the likelihood of loss. The ability to estimate the happening of the event(s) is important to assess the likelihood of incurring the liability. Management attempts to use these areas of judgement to their favour, to reflect a better position in the financial statements. Making adjustments in the depreciable life of an asset to reduce profits, under-accruing expenses, under assessment of contingent liabilities, inconsistent inventory valuation methods etc., are some of the ways the management attempts to mislead stakeholders with its accounting, in order to overstate or understate the net income. However, there are situations where the company has to make estimations in accounting in order to avoid acquisitions, like in the case of understating their fixed assets. This leaves us to understand that a company's financial statements are prepared with not just fact and figures that are verifiability, but also figures that are based on estimation and judgement.

Reference list
Abraham, A, Glynn, J, Murphy, M & Wilkinson, B 2008, Accounting For Managers, 4th edn,Cengage Learning EMEA, London. Quilligan, L 2008, 'Intangible Assets identification and valuation under IFRS 3', Accountancy Ireland, vol. 38,no. 3,pp. 10-12. Wyatt, A & Abernethy,M 2008, 'Accounting for Intangible investments', Australian Accounting Review, vol. 18,no. 2,pp. 95-107.