StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

The Accounting Policy - Essay Example

Cite this document
Summary
This essay "The Accounting Policy" discusses the opportunistic choice of accounting policy in contracts, managerial remuneration contracts, debt contracts, bank loan agreements, political costs, profit smoothing and big bath accounting strategy. 
 
 …
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER93.2% of users find it useful
The Accounting Policy
Read Text Preview

Extract of sample "The Accounting Policy"

The Accounting Policy Choice Literature Introduction Accounts are the only source of statistical data related to performance of an enterprise during an accounting period. So there has always been a lot of emphasis on proper choice of accounting policies, since an alteration of accounting policies can have drastic impact on the Balance Sheet of an enterprise. Balance Sheet happens to be the only document available with external stakeholders of an enterprise, thus any shift in accounting policies which may radically alter the face of the Balance Sheet have always been under the scanner of experts in financial field. Over the years, experts have observed how opportunistic alteration of accounting policies have been done in areas of contract and political costs and how these opportunistic policy changes have been effected to favor either the management or the organization as a whole. Opportunistic Choice of Accounting Policy in Contracts Watts and Zimmerman (Watts, R. and J. Zimmerman, 1986) did semantic studies in opportunistic choice of accounting policies adopted by management to alter Balance Sheet figures to suit specific objectives and it must be mentioned not all of which are always geared towards maximizing shareholder wealth. The most glaring example of such opportunistic choice of accounting policy is found in the zone of contracts. A contract is made between an agent and a principal and if the outcome of financial results has a direct bearing on the income of an agent, there is every possibility that the agent might try to modify the financial result in such a way that increases the agent’s income. Two forms of contracts that depend entirely on financial information are management remuneration contract and those entered into with banks and other financial institutions while signing a loan agreement. One must appreciate that it is impossible to foresee all possibilities and build in preconditions which will effectively preclude any opportunistic choice of accounting policies in future to provide undue advantage to any of the contracting parties. Managerial Remuneration Contracts Holthausen and Leftwich had done extensive empirical studies (Holthausen, R.W., & Leftwich, R.W., 1983) to draw a conclusion that more often than not mangers are more prone to make an opportunistic choice of accounting policies or show creativity in accounting, as Kamal Naser preferred to describe it, if such creativity increased their personal wealth in place of the shareholders’. If management remuneration includes a clause of profit sharing, then, other things remaining constant, managers are more likely to include future earnings in current year’s income. Also the timing of declaration of financial results has a big role to play in determining management bonuses. A glaring example of such “creativity” was on display in January 1991 when Westinghouse announced massive unaudited earnings of $1 billion for the year and top management helped themselves to huge bonuses. Then, right in the next month, the company announced an equally huge write-off of $975 million of bad debts thus reducing audited profits substantially. There was nothing illegal in it, but top management furthered its own interest at the cost of shareholder wealth and is till date one of the classic examples how opportunistic top management might be. (Schroeder, M. and Spiro, L.N., 1992) While on the issue of contracts, another example may be cited to further highlight how creative accounting policies are adopted to deny rightful share of stakeholders in organizational profit. Several film companies in USA have gained infamy for excessively increasing expenditure related to a film if it becomes successful in box office. Such a hike obviously decreases accounting profit and thus all the other stakeholders of the film as the actors, scriptwriters, lyricists whose contact include a share of profit end up with hardly anything. The accountants of those film companies are known to charge excessively high depreciation rates, drastically reduce the value of closing inventory and even include contingent liabilities while calculating expenditure. (Grover, 1991) Debt Contracts (Bank Loan Agreements and Debenture Trust Deeds) Debenture Trust Deeds Let us first discuss how choice of opportunistic accounting policies can affect Debenture Trust Deeds. Here the debenture holders assume the position of principal while shareholders, rather managers working on behalf of shareholders, assume the role of agents. The total value of a firm is dependent on the sum of debt and equity and by ‘trading on equity’ a manager can legally increase the earnings per share. Trading on equity is not that complicated a procedure. A manager increases the quantum of debt in the capital structure of firm and as interest on debentures is a taxable expenditure, records a low profit. But the number of equity shareholders is also low. So, even if the numerator becomes less, the denominator also remains less and the earning per share, calculated by dividing the residual profit with number of equity shares, returns a higher figure. But such an increase of debt gives rise to another problem which is discussed in Bank Loan Agreements section below. Bank Loan Agreements Almost all bank loan agreements lay down a limit to the quantum of debt present in the capital structure of a firm. Managers, in an effort to trade on equity and increase earnings per share, often hover around the danger mark. In such situations, mangers tend to choose accounting policies which attempt to include estimated future income stream in current year’s earning. Or, in extreme cases, even arrange for finance which will not appear as liability in the Balance Sheet. While on this topic, it would be worthwhile to recall an incident where change in accounting policies caused several firms to face immense problems with loan agreements. When FASB in USA decreed income from extended warranties should be spread over the duration of warranty period instead of considering it at the time of sale, consumer electronics retailers who had built up huge stocks through bank loans just did not know how to conform to the financial ratio requirements stipulated by bank loan agreements. Political Costs Too high a profit obviously attracts government and regulatory attention and almost always results in higher taxes or levies. In USA, pharmaceutical companies have been closely scrutinized right since 1992 Presidential campaign as healthcare became an ever important agenda for candidates from both Republican and Democratic camps. High profits of pharmaceutical companies have become a hot topic of discussion since then. These companies have felt the heat of high political costs and have resorted to abundant creativity in trying to reduce profits. Pharmaceutical companies have tried out various inventory valuation methods in their efforts to reduce the value of closing stocks. The most common weapon used by them was the variance between LIFO and FIFO method of valuation, choosing the one which suited them most at that particular juncture. They also altered their accounting policy of recognizing a debt as bad and increased the volume of bad debt expenses in Profit and Loss Account. The other policy change was the method by which depreciation was calculated. By shifting from written-down-value method to the straight line option the quantum of depreciation was increased and that was not the end. The assets were revalued upwards and their useful life was reduced, thus ensuring a sizeable lowering of profits. It might be mentioned it is not only the pharmaceutical companies but also the oil giants and even cable TV companies have felt political heat in recent times. Profit Smoothing Profit smoothing has been resorted to by almost all corporate houses at some point of time or the other. It is a general tendency of companies to report a smooth increase in profits year after year rather than showing high profits in good years and not so good results during rough periods. This also helps shareholders as share prices tend to be high for those companies who report steady profits year after year – investors as a clan are averse to volatility. This is achieved by creating large provisions for liabilities and also asset values during good years and reducing those provisions in years where the going is not so good. Microsoft also resorts to profit smoothing just to ensure profits forecast by the management at the beginning of the accounting period tally with actual profits. This not only creates an aura of invincibility around the organization but also helps it in predicting future profits with a high degree of accuracy. What the company does is to create large provisions for possible upgrades and customer service costs that might occur in future. This is a perfectly legal accounting policy and in keeping with the time honored tradition of accounting conservatism. (Fox, 1997, July) Big Bath accounting strategy This is a strategy adopted by some corporate houses when the going is particularly rough. If the financial results are not good in a particular year, and managers whose incomes are related to profits realize no amount of creativity can improve the situation, they do something which is exactly the opposite. Instead of trying to shore up the profits, they reduce it even further (it really does not matter by how far the target has been missed while bonuses are calculated) and make the picture look worse than it actually is. The idea behind such an action is to make even modest future profits look much better than they actually are. References Fox, J. (1997, July). Learn to play the Earnings Game. Fortune , 31. Grover, R. (1991). Curtains for tinsel town accounting? Business Week, 3 June , 138. Holthausen, R.W., & Leftwich, R.W. (1983). The Economic consequences of accounting choice: Implications of costly contracting and monitoring. Journal of Accounting and Economics, 5 , 77-117. Schroeder, M. and Spiro, L.N. (1992). Does everything add up at Westinghouse Credit? Business Week, 11 May , 80-83. Watts, R. and J. Zimmerman. (1986). Positive Accounting Theory. New Jersey: Prentice-Hall. Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(The Accounting Policy Essay Example | Topics and Well Written Essays - 1500 words, n.d.)
The Accounting Policy Essay Example | Topics and Well Written Essays - 1500 words. https://studentshare.org/finance-accounting/1716018-the-accounting-policy-choice-literature
(The Accounting Policy Essay Example | Topics and Well Written Essays - 1500 Words)
The Accounting Policy Essay Example | Topics and Well Written Essays - 1500 Words. https://studentshare.org/finance-accounting/1716018-the-accounting-policy-choice-literature.
“The Accounting Policy Essay Example | Topics and Well Written Essays - 1500 Words”. https://studentshare.org/finance-accounting/1716018-the-accounting-policy-choice-literature.
  • Cited: 0 times

CHECK THESE SAMPLES OF The Accounting Policy

Effects of Accounting Policy on Market Share Price

Effects of accounting policy Instructor Effects of accounting policy on market share price Introduction There have been concerns that changes in accounting policies and methods proposed by accounting regulatory bodies has had effects on the financial statements of companies and consequently affected the market value of the companies' share price.... p485-503 which is a study of the oil and gas industry's reaction to change in accounting policy....
6 Pages (1500 words) Essay

Acquisition of a Company

To summarize complex accounting information into relatively small no.... The report “Acquisition of a Company” discusses the various Valuation methods available for the managers for financial appraisal, their merits, and demerits.... It critically evaluates each valuation methods and makes a recommendation on the acquisition choice....
9 Pages (2250 words) Assignment

Accounting Treatment for Pension Plans: IAS 19

4] the accounting treatment of defined contribution plan poses no problem as the employer/employee contributions to the fund have to be written off immediately to the income statement, as there is no further obligation for the employer to contribute to the fund in case there is any shortfall in the employer's provision.... The author examines IAS 19, the objective of which is to establish accounting standards for the treatment of employee benefits....
4 Pages (1000 words) Term Paper

Accounting Recognition of Sales Revenue

the accounting treatments have been considered both from the point of view of US GAAP and IFRS (International Financial Reporting Standards) also known as IAS; and at every stage of the accounting recognition of such sales, the issues have also been considered from the practical approach adopted by a certain corporation.... In the paper “accounting Recognition of Sales Revenue” the author analyzes cash sales and sale on credit basis....
5 Pages (1250 words) Research Proposal

Analyzing the International Accounting Standard No.2 (IAS2) Inventory

This essay aims at analyzing the International accounting standard No.... hellip; IAS 2 has the objective of prescribing how inventories should be treated in accounting.... in that case, different methods may be used where inventory items were different from other groups (International accounting Standards Board, 2008, p....
6 Pages (1500 words) Essay

Financial Statement Analysis Nike Inc and Adidas Group

Lastly, the statement of retained earnings is a snapshot of the changes that have taken place in the earnings of the entity over the reporting period that is in place as part of The Accounting Policy.... Financial statements are tools that are used… to collate information regarding these transactions in a manner that allows for investors and other stakeholders to understand the true business dynamics of the entity, and their positioning in the market in terms of various metrics utilised by accountants and analysts as The generic accounting principles include four types of financial statements: balance sheet, income statement, cash flow statement and retained earnings statement (Nikolai et al, 2009)....
9 Pages (2250 words) Essay

Consistency of Accounting Standards

The author in this article discusses the importance of the consistency of the accounting standards as the need of the hour because of the fact that the reliance placed on the principles has been, thus far, unable to ensure its application consistently and the management tends to… Today, after the world gained globalization, this issue has been eradicated and guidance materials such as the International Financial Reporting Standards and the Generally Accepted Accounting Principles Consistency can only be maintained in the companies throughout, if the accounting standards are itself consistent....
4 Pages (1000 words) Essay

Financial Statements in Arsenal Plc

This work called "Financial Statements in Arsenal Plc" describes The Accounting Policy of Arsenal holding from a particular angle that relates to the capitalization of the cost of players which are amortized but do not include the current value of the market players.... Before making an analysis, we will have a historical review of how these accounting policies have emerged over a period of time.... While on the other hand, accounting of professional sports clubs has been a very complex topic and especially in the area of human resource accounting due to the striking differences between professional sportspeople and other employees....
6 Pages (1500 words) Case Study
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us