10. Financial Accounting Issues (subjectivity) Flashcards
Who is responsible for financial statements?
The company’s board of directors
What is meant by ‘neutral’ financial statements?
Financial statements that give a true and fair view.
True:
- Prepared in accordance with the applicable financial standards.
- Do not contain material errors or omissions.
Fair:
- Prepared without bias and portray economic reality.
What are some limitations of financial accounting?
- Financial accounting is inherently BACKWARD LOOKING - investors are concerned with future earnings and cash flows.
- Financial statements may be published some months AFTER the end of the financial period.
- Not all items of value are included as assets (e.g. human resources and intangible assets developed internally). So the value of the assets for firms with these types of assets is understated.
- Values of assets are inherently SUBJECTIVE and this means reported value for equity and profit is also subjective. Accurately comparing the performance of two firms can be difficult due to the significant variation in reporting resulting from its subjective nature.
- Reporting is prone to MANIPULATION by management because of self-interest bias and they have an incentive to make the firm’s position and performance appear better than it really is due to greed (bonuses and stock ownership) and fear of job loss.
- Investors are also at RISK from FRAUD and they may not be able to tell from the reported financial statements whether it is taking place.
- Audit quality is generally low and auditors are reluctant to challenge management on the going concern assumption or to exercise sufficient professional scepticism to detect material fraud.
What is meant by objective and subjective values in accounting? Give an example of an objective value.
Objective values: one value only regardless of who is doing the counting or how it is worked out (e.g., amount of cash in hand, number of units in inventory).
Subjective values: where the value may be determined in a number of ways depending on choices and estimates.
Give examples of assets reported in the Statement of Financial Position whose values are subjective in nature explaining why the value is subjective
- Choice of accounting method is subjective: Some assets are reported at historic cost and some at market or fair value.
- Net trade receivables reflect impairment allowance (bad debt/amount of unrecoverable debt) which is a management estimate.
- Indistinguishable inventory valuation is dependent on the choice of accounting method (FIFO, LIFO or AVCO).
- Impaired inventory is written down to net realisable value (NRV) which is a management estimate.
- Gross value of PP&E depends on acquisition method. Subsequent value of PP&E depends on choice of depreciation method and management’s accounting estimates (useful economic life and residual value).
- Goodwill is determined by an estimate of how much the acquired firm is worth and the appraised value of its assets (which is also subjective).
- Net pension assets reflect actuarial assumptions (e.g., life expectancy) in defined benefit obligation.
Why is reported profit and value of equity subjective?
Management judge when performance obligations have been discharged in transactions (when revenue can be recognised).
Expenses such as depreciation and impairments are driven by asset costs which are subjective.
Method used to allocate manufacturing overheads into product costs is decided by the management.
Equity = Assets - Liabilities
Assets and liabilities are subjective. Value for equity is precise - it represents the residual interests of owners, but its value has no real meaning.
Why is it unlikely that it will ever be possible to produce “neutral” financial statements that give a “true and fair view”.
Accounting is subjective. It is a social science and not an ‘exact’ science. Accounting standards are regularly revised and changes are often driven by pressure from changing societial or political preferences or perspectives rather than objectivity. Financial statements have many user groups with different views, and attempt to satisfy everyone to a reasonable extent. The importance of each stakeholder group’s satisfaction is subjective.
The total value reported for assets is inherently subjective because it does not include everything of value that the firm possesses and what it does include is determined in a subjective way. (THEN GIVE EXAMPLES).
Equity = Assets - Liabilities, therefore reported value of equity is also subjective and so is profit (defined as increase in equity).
How are intangible assets that have been developed in-house accounted for and what does this imply for the value of reported assets at firms such as Google and Apple?
Development costs of intangible assets such as software for the company’s own use must be expensed rather than capitalised. This means the values for assets at firms such as Google and Apple are massively understated.
What is a consequence of the failure to recognise internally generated intangible assets?
Decreasing correlation between financial statement information and stock prices partly due to failure to recognise intangible assets. The GVA of intangible assets is significantly greater than that of tangible assets in the USA.
