Theory and Current Issues in Accounting

THEORY AND CURRENT ISSUES IN ACCOUNTING 10

Theoryand Current Issues in Accounting

AccountingTheories and Analysis

Abstract

Financialaccounting theories have important application in accountingstandards. Conceptual framework is essential in addressing thepractical problems that is associated with determining financialperformance and position of an organization. Based on thisperspective the measurement and recognition of liabilities throughIFRS is inadequately theorized. There is no coherent and consistentapplicable practical theory that is well established in literature.Available conceptual frameworks are few and largely disconnected intheoretical basis on application of effective accounting standards.The use and need of effective measurement theory for liabilities hasgained impetus in the IFRS. The analysis in this paper is that thereis need for new and revised IFRS that enlists an effectivemeasurement theory for liabilities.

Keywords:Recognition, Liabilities, Measurement, Conceptual Framework, IASB,IFRS

Financialmeasurements of financial position and performance affect everybodyin organizations in one way or the other. In part, financialstatement reports helps in determining the allocation of capitalacross economic sectors, countries, companies and within an entity.Additionally, financial measurement reports determines if thebusiness is succeeding, failing, if investors will earn divided,bonus for employees and how much tax the business will pay to thegovernment (FASB, 2000). However, there is a growing controversy that the available measurement used in financial reportinghave moved from the traditional measurement based on costs to a new basisthat is of fair value. The prevailing financial measurementframeworks are complex, diverse and apparently inconsistent. There isneed for single and reviewed accounting standards. The challengebrought about by competing bases of measuring financial statements isdifficult than understanding how the frameworks works. Nonetheless,despite various measurement controversies, historical costs remainthe predominant measurement tool followed by fair value measurementapproach. IFRS is an international accounting standard that regulatesall financial measurement reports for private and public firms.However, IFRS is in the process of evolution and thus impracticalwhen measuring financial aspects like liabilities based on futureestimation this is where the use of fair value becomes handy (IASB.2010).

Liabilities(Definition)

Ideally,a liability refers to an obligation in amounts owed to suppliers andlenders. In lay man language, liabilities are sacrifices that a givenentity is presently obliged to make to other firms as a result ofcurrent, future and past transactions the settlement of theseobligations include the use of assets or provision of services(FASB, 2000). Liabilities are reported in company’s financialstatements (balance sheet) under the title ‘payables.’Liabilities include all amounts received in advance such as loans,mortgages, deferred revenues and any accrued expenses. In summary, aliability is a duty or responsibility towards obligating to terms andconditions of transactions made with other entities (IASB. 2010).

Brieflysummarize the various ways they are and can be measured by entities.

Liabilitiesare categorized in two broad groups in the balance sheet. Theseinvolves current liabilities and long-term liabilities. Currentliabilities are those liabilities expected to be liquidated within ayear and usually include payables such as accounts, taxes, wages andother accounts payables. Long-term liabilities are those liabilitiesthat are liquidated over long-period of time and this includes bonds,long-term leases, pension obligations and loans among others. Somefirms measure liabilities as amortized costs and deposit account-fairvalue (IASB. 2010). Amortized costs are expenses accrued in form ofdepreciation on the costs of assets. However, the greatest measure ofliabilities used is based on current liabilities and long-termliabilities.

Whatyou think is meant by the AARF statement

AARFis an Australian government agency that maintains and developsfinancial reporting standards for all entities in public and privatesector for the wellbeing of the Australian Economy.AustralianAccounting Research Foundation(AARF)supports the Australian government Agency and its statement is&quotConformity with Auditing Standards&quot which means enhancingethical, accountable and non-bias accounting standards (Ray,2001).In general AARF means conducting accounting processes throughprocedures and principles that are acceptable in accordance toAustralian Standards of Financial Reporting.

Discussliabilities and the problems of their measurement in the context ofthe conceptual framework.&nbsp

Theapplication of financial accounting theory is found in accountingstandards and the clarity of the conceptual for is essential inaddressing the complexities of assessing financial position andfinancial performance (IASB. 2010). Viewed from this angle, theknowledge and measurement of liabilities in IFSR has for long beeninadequately theories. In part, there is absence of consistent andcoherent applied theory in accounting standards and in the conceptualframework. However, this deficiency does not arise from the failureof applying theories found in literature rather it arises fromlimited contributions from literature and the available accountingtheories are disconnected from one another (Barth, 2006).

Measurementtheory has gained increased impetus as a role of IFRS, butimpractical when applied. IFRS is theoretically inadequate, IFRSstandards have differing proposals of recognizing and measuringliabilities and in most cases, and inconsistencies in methods arerife. The question therefore, is whether IASB is an establishedtheory or inadequately developed theory (Barth, 2006). Thesequestions are unavailable from literature and those available showinconsistencies and only indirectly focused on one challenge (IASB.2010). The process of measuring liabilities demands that theexistence of observable aspects and if the future cannot be observeddirectly, then it is hard to measure future attributes of liabilities(FASB, 2000). In part, one cannot adequately measure future cashflows and what can be measured are just expectations of future cashflow based on market trends. To this end, it is thus questionable ifbasing balance sheets on expectations is valid (Botosan, Koonce,Ryan, Stone and Wahlen, 2005).

Althoughthere are vast literature relating measurements of assets, onlylittle information exists on measuring liabilities (Barth, 2006).However, theoretical consistency is still relevant despite literaturelimitation. For instance, in practice cost transfer may not exist inmany liabilities and this case takes place when inflows occur asadvance of performance performance obligations occurring fromrevenue contracts with clients. In this case, when an inflow occurs,for instance in the case of commercial loan, liability occurs as aperformance obligation (expected outflow) (IASB. 2010).

Additionally,in practice, assets and liabilities are based on entry value of theobservable. The unknown value of an entry is set as a known value onthe other side of entry. In simpler terms, assets are valued to thecorresponding resources used, while liabilities are measuredalongside resources received. In this case, a known and observablevalue is measured against unknown or unobservable value (Ray, 2001).To this end, the assumption is that the value of assets orliabilities must be estimated. The costs of performance cannot inessence measure the future does not exist in current status and thusfuture cash flows are immeasurable (IASB. 2010). The expectedforecasts values are not measurements of wealth unless when one isreferring to wealth in state of mind’ and this brings the questionon whether it is appropriate to base balance sheet valuations onestimated liabilities. The resultant effects are that the marketmechanism comes as a measurement instrument since market prices arebased on verifiable and observable evidence. The argument on theprinciple of measurement used is based on informational andconceptual perspective. The universality of measurement is notpresumed, liabilities and assets may be deemed to exist based oninformation held about them even if it is inevitably subjective(Botosan, Koonce, Ryan, Stone and Wahlen, 2005).

Accordingto the IASB framework, a liability is recognized as a probableoutflow from the balance sheet and that the settlement of thisliability is based on current reliable amount. To this end, theIASB’s framework lacks explicit definition of a reliablemeasurement of cash flows. In this case, if the liability is measuredaccording to current observable market price, the reliability isprobable and not guaranteed in terms of stability (IASB. 2010).Contingent liabilities do not have recognized probable outflow andthus cannot be recognized and thus immeasurable. Therefore, the IASBframework is problematic and leads to unreliability of financialaccounting (IASB. 2010). Similarly, IFRS requires that items berecognized even when no exact measurement can be made. To this endtherefore, the criteria for recognizing liabilities would be moreconceptually coherent if the recognition was based on outflow ofresources.

Thecategorization and treatment of liabilities in the annual report

Categorizationof liabilities

Costmethod

Underthe cost method of liability measurement, items are valued based ontheir estimated worth. In this case, liabilities maybe measured basedin their present value. Under the cost method, liabilities aremeasured according to the prevailing market price. In some cases,liabilities are measured based on the expected future cash flows asdiscounted on present value.

Contractmethod of categorizing liabilities

Underthe contract method, liabilities are shown as excesses of billingsover costs (progress billings). Progress billings are uncompletedcontracts in excess of costs.Liabilitiesin this case become the cumulative amount billed to client since theinception of a given project.

Fairvalue

Underthe fair value, a liability is estimated as per its market price.Fair value method is used when the market price of a liability cannotbe established. Fair value is the estimated price which could be paidfor a liability. Ideally, fair value is based on historical costs andthis may lead to problems such as undervaluing of the liabilities.

Relevanceunderstandability timeliness comparability

ComparingWesfarmers through Henderson et al.2013.

Wesfarmerscategorizes liabilities based on fair value as learned inHendersonet al. (2013) issuesof accounting. Wesfarmers categorizes liabilities asbased on fair value of current liabilities. Henderson et al. (2013)advocates for contract method of categorizing liabilities which isbased on accumulating all liabilities within a given period of aproject. Wesfarmers on the other hand, categories liabilities basedon fair value of each liability transaction incurred. However,according to Henderson et al. (2013) categorizes liabilities issimilar to the one used by Wesfarmers liabilities are considered asloss on the balance sheet and are measured on current market value.In the same way, Wesfarmers subtract liabilities from the assetsliabilities should be subtracted from assists in order to calculateowners net worth or equity.

Inboth Wesfarmers and Henderson et al. (2013) fundamentals ofaccounting, liabilities are obligations which must be met by partingwith certain amount of money over given period. These liabilities aresum of all money owed to others by business. Wesfarmers adopts theHenderson et al. (2013) accounting principles by categorizingliabilities as current and long-term liabilities. Long-termliabilities include trade and other valuables, interests-bearingloans and borrowings, income tax payables, provisions, insuranceliabilities and derivatives (Ray,2001).Non-current liabilities are interest-bearing loans and borrowings,provisions, insurance liabilities and derivatives. Wesfarmers uses anumber of approaches to manage various risks due to trading exposurebut are not used for trading speculation. Derivatives used byWesfarmers are hedgeaccounting (cash flow and fair value hedge). Wesfarmers manages itsbalance sheet in order to have satisfactory returns for shareholderswhile ensuring that credit metrics are maintained (IASB. 2010).

Wesfarmerscurrent liabilities include trade and other payables these refer toall amount billed to Wesfarmers by its suppliers for services andgoods consumed by the firm during the financial year 2014 and thusare cash out flow. Current interest bearing-loans are short-termliabilities that Wesfarmers is required to pay and this becomes itsshort-term liability (Botosan, Koonce, Ryan, Stone and Wahlen, 2005).Income tax payables are liabilities that are paid to government astaxes or royalties and this becomes a short-term financial obligationof Wesfarmers. Insurance liabilities are financed risk protection onbusiness and this becomes a liability to a firm. Money is paid toinsure business assets against risks. Wesfarmers also categorizesborrowings as liabilities and are paid either as short-term orlong-term (IASB.2010).

Howthe liabilities are in terms or understandability relevancecomparability timeliness

Theprocess of measuring liabilities demands that the existence ofobservable aspects and if the future cannot be observed directly,then it is hard to measure future attributes of liabilities (FASB,2000). In part, one cannot adequately measure future cash flows andwhat can be measured are just expectations of future cash flow basedon market trends. A liability is recognized as a probable outflowfrom the balance sheet and that the settlement of this liability isbased on current reliable amount. In this case, if the liability ismeasured according to current observable market price, thereliability is probable and not guaranteed in terms of stability(IASB. 2010). Contingent liabilities do not have recognized probableoutflow and thus cannot be recognized and thus immeasurable.

Linksbetween the measurement of liabilities in your selected annual reportand decision useful information

Financialstatements satisfy the needs of various users of financialinformation. Information contained in the measurement of liabilitiesis useful in decision making by investors. Investors will assess theliability standing of organization in order to make judgments on thelevel of risks and returns in future. Investors use measures ofliabilities to assess the firm’s ability to pay them dividends aswell as potential investors. Employees and other groups also rely onfinancial information in order to assess the stability andprofitability of their employers (IASB. 2010).

Lendersdepend on financial information concerning a given entity in order toassess its credit worthiness and ability to meet future obligationstied to amount borrowed. Creditors’ uses financial informationfrom a firm to assess its ability to meet short-term and long-termdues for goods or services rendered. Customers make transactiondecisions of a given firm based on its financial statement especiallyon the ability of a given firm business continuity. The governmentand other agencies rely on firm’s financial statements in order toregulate entities activities and assess how much tax the firm shouldremit to the government. Other users of financial statement reportsinvolve the general public, investment analysts, competitors andmanagers (Ray, 2001).

Measurementof liabilities at Wesfarmers

Measurementof liabilities at Wesfarmers is based on fairvalue approachin which all liabilities are recorded amounts of proceeds received inexchange of an obligation or the amount of cash equivalent that isexpected to be paid in the normal course of business. Wesfarmersuses a fair value accounting approach when measuring the liabilities(Botosan, Koonce, Ryan, Stone and Wahlen, 2005).The fair value incorporates market information in financialstatements and this helps in meeting the conceptual frameworkcriteria based on qualitative aspects of accounting information(FASB, 2000).It is argued that fair value results in faithful representation ofliabilities that are neutral, comparable and timely. However, thefair value approach used by Wesfarmershas many potentiallimitations that involve market illiquidity during credit crunch(IASB.2010).Other concerns are problems in ability to determine fair valueestimates and fair value in estimates.

Wesfarmersmeasurement of liabilities and decision useful information

Currentliabilities include trade and other valuables are measured accordingto the faire value and this has the implication on decision making bysuppliers. Suppliers assess the trade payable liabilities in order toassess the ability of an entity meeting its current and non-currentliabilities (Ray,2001).Since the trade payables are measured at fair value which is based oncurrent market prices, the reliability of the trade payables is higheven if based on estimates.

Interests-bearingloans are also measured on fair value approach amount of interestsaccrued on loans are important measures when making decisions aboutthe credit worthiness and the ability of business to service itsloans in future(FASB, 2000). In this case, Wesfarmers uses a fair value approach to measure loansand borrowings owed to lenders based on current market prices (IASB.2010).

Wesfarmersmeasures its Insurance liabilities based on prevailing market priceand this helps lenders and investors use measurements of insuranceliabilities to make decisions about the profitability and stabilityof Wesfarmers. Since most of the insurance liabilities are measuredfair values, this measurement may not give investors and lendersclearer decision about the future stability of Wesfarmers. However,insurance liabilities are quoted at fair values and this has lessimpact on investors’ decisions about investing at Wesfarmers.

Similarly,Wesfarmers borrowed loan is also measured on fair value investorsand lenders also use financial information on an entity’s creditstatus to make decisions about the ability of the firm to service itslong-term credit obligations (Ray,2001).In this case, since all long-term loans and borrowings are measuredat fair values, this has the potential of influencing lenders to makepositive decision on credit competitiveness of Wesfarmers. Incomepayables refer to income taxes paid to government by business(FASB, 2000).Wesfarmers income tax is measured at prevailing market price and thisshows that it is not subject to significant change in value overtime. Income tax information is useful when making decisions byGovernments and investors since it indicates the capacity of businessto meet its legal obligations (IASB.2010).

Derivativesare used to manage various risks in business and this information isuseful to lenders, investors and clients. Measures of derivativesthat are based on current market value are important in indicatingthe capacity of business to manage unforeseeable risks (Barth,2006).As such, derivatives information that is based on fair value has apotential of attracting lenders, clients and investors towards thebusiness since they are assured that the firm is well prepared forunseen risks(Ray, 2001).Provisions are extra costs incurred in the maintenance of machines,premises or land. In this case, all provisions at Wesfarmers weremade at fair value and this helps in providing positive estimates ofexpenses incurred on plants, land and premises(FASB, 2000).Provision information is useful indecision making for investors whomight be worried about change of provision liabilities since thisliability consumes organizations profits (IASB.2010).

Conclusion

Conceptualframeworks plays an integral role in evaluation financial statementsand decision making by various entities linked to a given firm.Various users such as creditors, lenders, customers, employees andinvestors, rely on financial information derived from organization’sbalance sheet in order to make conclusive decisions about thebusiness. However, although there are various conceptual frameworksdeveloped for ensuring good accounting standards, the availableconceptual frameworks based on IASB and IAFRs do not providecomprehensive basis for measuring liabilities. There is need forreview of the IFRS measurement and recognition in order to make itconsistent with measurement theory,

References

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Barth,Mary E. (2006). ‘Including estimates of the future in today’sfinancial statements’, AccountingHorizons,vol. 20, no. 3, pp 271-85.

FASB,(2000). Statement of Financial Accounting Concepts No 7, UsingCash Flow Information and Present Value in Accounting Measurements,Norwalk: FASB.

HendersonScott, Peirson Graham, Herbohn Kathy, Artiach Tracy and HowiesonBryan. (2013). Issuesin Financial Accounting.Pearson Higher Education AU.

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