You have recently been appointed as a graduate accountant for a publicly listed firm. The firm is facing some temporary financial difficulties and your manager has asked you to investigate and prepare a discussion paper on what earnings management techniques the firm could carry out that would be less likely to be scrutinised by auditors, but would assist the firm meeting its earnings targets.
Discuss the earnings management techniques that you believe would meet your manager’s requirements. Include three examples to support your advice.
The management of companies generally involves into earning management activities either to mislead the stakeholders or to achieve certain outcomes that are dependent upon the financial performance of the company. In this case of audit of a public listed company, the audit manager is interested in knowing about those earnings management techniques which would have been used by the firm’s management for achieving their earnings targets, however, are of such form that these techniques have a lesser chance of being detected by the auditors. The most common earnings management technique that is used by management to manage the earnings so as to reflect better earnings performance is the selection of accounting policies. A firm may choose that accounting policy from the available choice, which enables it to fulfil its objective of earnings management. For example- A firm may choose to select the straight-line method of depreciation instead of written down value method (even if WDV is more suitable) as the former would record a steady depreciation charge and profits would be more consistent.
Another important earnings management technique used by management to achieve their earnings targets is the use of accrual accounting. The firms use this technique to deliberately delay or accelerate the recording of income and expenses. For example- a service-based firm may record an amount as revenue in its books of accounts even though the criteria of revenue recognition as per the accounting standard may not have been met.
The firms also involve another type of earnings management activity which is known as income smoothing. In this technique, the firm's try to shift income to more successful years to less successful years. For example- an entity may intentionally make a delay in recognizing sales revenue so as to shift it to later years which is expected to have lower sales.
“Because exploration and mining activities are inherently risky and uncertain, all exploration and evaluation expenditures should be expensed as incurred.”
Evaluate this statement in the context of why the expenditure would be undertaken, in the context of financial reporting and the context of the purpose of financial reporting.
The expenditure incurred by an entity on exploration and evaluation of mineral resources should be expensed if the technical and commercial feasibility of extracting a mineral resource could not be established. However, if the entity is able to collect strong evidence of technical and commercial feasibility of extraction of a mineral resource, then its meets the criteria for recognition as a property plant or equipment as provide by AASB 116 Property, Plant and Equipment or the criteria for recognition as an intangible asset a provided AASB 138 Intangible Assets. The objective of financial reporting is that true and correct picture about the financial position and financial performance of the entity must be reflected in its financial statements. In view of this, it would be against the objective of financial reporting to record al the expenditure on exploration and evaluation as an expense in the profit or loss statement, if the said expenditure qualifies for recognition as a Property, plant and equipment or as an Intangible Asset as it would lead to an intentional understatement of profits.
AASB 121 mandates the immediate recognition method where exchange differences on monetary items are recognised in the profit or loss in the period of exchange rate movement. Other methods, such as the ‘defer and amortise’, or ‘recognition on realisation’ are not permitted.
Do you agree that the correct decision been made from the point of view of the conceptual framework? Defend your view with a comprehension argument in the context of AASB 121 and its predecessor AASB 20. Are there other reasons to prefer the immediate recognition method? Consider the alternatives in your discussion.
The AASB 121 which applies to accounting periods beginning on or after 01.01.2020 provides that exchange differences that take place upon the settlement of monetary items or on the translation of certain monetary items due to the settlement or translation were made at an exchange rate that was different from the exchange rate that was used at the time of initial recognition, should be recorded as an income or expense in the profit or loss statement of the period in which those exchange differences arose. According to this accounting treatment of immediate recognition of exchange difference on the profit or loss of the period leads to recognition of those items as incomes and expenses in the income statements which have not yet been realized by the entity. The conceptual framework of accounting provides that an item should be recognized as an income when an increase in future economic benefits either by way of increase in the value of an asset or reduction in the value of a liability is possible to be measured reliably (Finance Train, n.d.).
This means that an item must actually provide some economic benefit that can be realized whether by reduction of the amount of liability or increase of the value of the asset. However, the accounting treatment provided by AASB 121 is against the conceptual framework because it would lead to recognition of those items as incomes which are not actually realizable. Similarly, the conceptual framework provides that expenses should be recognized only when there is an actual decrease in economic benefits which are possible to measured reliably and lead to a decrease in the value of asset or liability (Finance Train, n.d.). The accounting treatment prescribed by AASB 121 is not in accordance with the conceptual framework as the said treatment leads to recognition of even those exchange differences as expenses which are not actually realized or borne by the entity.
It must be noted that this accounting treatment of immediate recognition of exchange differences ie.e exchange gains and losses is criticized particularly because it leads to recognition of both gains and losses from the translation on those monetary transactions that have not yet been settled. Even though certain researchers have argued that this approach leads to systematical treatment of profits and leads to a fair measurement of performance of the entity, this approach is very much against the concept of prudence which prohibits recognition of those profits that have not yet been realized (Shodhganga, n.d.). The two alternative methods, recognition on realization and defer and amortize methods are far better than the approach of immediate recognition as under both these methods, gains cannot be recognized until they are recognized. Under recognition on realization method, while losses are recognized and included in profit or loss statement, the recognition of gains is deferred until the settlement date. Further, the defer and amortize method defers the recognition of gains and losses on exchange and require them to be presented as assets and liabilities in the balance sheet (Shodhganga, n.d.). The treatment prescribed by both these alternative methods leads to a much better and correct presentation and fair representation of the economic performance of the company as compared to the other two methods.
Finance Train. (n.d.). Conceptual Framework – Recognition of Elements of Financial Statements. Retrieved from https://financetrain.com/conceptual-framework-recognition-of-elements-of-financial-statements/#:~:text=Income%3A%20Income%20is%20recognized%20in,that%20can%20be%20measured%20reliably.
Shodhganga. (n.d.). Translation of Foreign Currency Transactions: Measurement & Disclosure. Retrieved from https://shodhganga.inflibnet.ac.in/bitstream/10603/162244/14/11_chapter%204.pdf
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