Q1. Accounting standards play a significant role in the financial statements preparation process. The main international standard-setting organization is the International Accounting Standards Board (IASB) headquartered in London. It issues International Financial Reporting Standards (IFRS) which are used in more than 115 countries and is gaining acceptance in other states as well. These standards are also used on most foreign exchanges. Moreover, the IASB also issues framework for financial reporting and international financial reporting interpretations. Besides, the International Organization of Securities Commissions (IOSCO) also plays a significant role in the international standard-setting process. It doesn’t develop accounting standards, but it supports the use of IFRS in international offerings and listings (Warfield, Weygandt and Kieso, 2014).
The International Accounting Standards Board is composed of four organizations which are the IFRS Foundation, the IFRS Advisory Council, the IFRS Interpretation Committee, and the IASB itself (Warfield, Weygandt and Kieso, 2014). The IASB is responsible for issuing IFRS. The IFRS Foundation oversees the activities of the IASB and has the function of fund raising. The IFRS Interpretation Committee works out interpretations of IFRS which have to be approved by the IASB, and the IFRS Advisory Council provides a forum for the IASB to consult the interested parties affected by its work (Deloitte, 2016).
The IASB has elaborated a thorough and transparent due process for establishing IFRS. This process is composed of the following elements: (1) an independent standard-setting board overseen by a body of trustees; “(2) a thorough and systematic process for developing standards; (3) engagement with investors, regulators, business leaders, and the global accountancy profession at every stage of the process; and (4) collaborative efforts with the worldwide standard-setting community” (Warfield, Weygandt and Kieso, 2014).
The IASB due process starts with the identification of the topics and their placement on the agenda. Then the Board conducts research and analysis and issues preliminary views of advantages and drawbacks. The next step is organizing a public hearing on the proposed standard. Based on the research results and public response it issues exposure draft. Finally, the IASB evaluates responses, makes necessary changes to the exposure draft and issues the final standard (Warfield, Weygandt and Kieso, 2014).
As regards the USA, there are four main organizations that are involved in the standard-setting process. They include Securities and Exchange Commission (SEC), American Institute of Certified Public Accountants (AICPA), Financial Accounting Standards Board (FASB), and Government Accounting Standards Board (GASB) (Warfield, Weygandt and Kieso, 2007).
The SEC is an agency established by the federal government which monitors the activities of publicly traded companies. It requires such entities to file annual audited financial statements prepared in accordance with GAAP or IFRS. The Securities and Exchange Commission is legally responsible for setting accounting standards. However, it encouraged the development of accounting standards by private sector and delegated it to the FASB, which is a non-governmental body. Besides, the SEC is responsible for establishing accounting principles (Warfield, Weygandt and Kieso, 2007).
The AICPA is a national professional organization which has greatly contributed to the development of GAAP in the USA. Throughout its existence, it established different accounting bodies involved in the standard-setting process: Committee on accounting Principles (1939 – 1959) and Accounting Principles Board (1959 – 1973), which was replaced by Financial Standards Accounting Board (FASB) in 1973 (Warfield, Weygandt and Kieso, 2007).
The mission of the FASB is to establish and improve standards of financial accounting and reporting that serve as guidance for issuers of financial statements, auditors, and users of financial information. The FASB is responsible for issuing Statements of Financial Accounting Standards and Interpretations, Statements of Financial Accounting Concepts, Technical Bulletins, and Emerging Issues Task Force Statements (Warfield, Weygandt and Kieso, 2007).
The GASB was created in 1984 to deal with state and local governmental reporting issues (Warfield, Weygandt and Kieso, 2007). Its structure is similar to that of the FASB. Both FASB and GASB are financed by an independent private organization Financial Accounting Foundation (FAF), which is also responsible for their oversight and administration (FASB).
Besides, there are several other bodies which influence the standard-setting process. They include the American Accounting Association (AAA), the Institute of Management Accountants (IMA), the Financial Executives Institute (FEI), and the Internal Revenue Service (IRS) (Warfield, Weygandt and Kieso, 2007).
Q2. Financial reporting and accounting standards-setting processes are affected by a great number of user groups and thereby face several challenges. Thus, business entities, accounting firms, government, financial community, academicians, investing public, industry associations, and preparers (CEOs, CFOs) have an influence on the IASB and the FASB as regards to the developing of IFRS and GAAP (Warfield, Weygandt and Kieso, 2014).
The government may significantly affect the standard-setting process. Thus, although accounting standards are generally prepared in accordance with logic and empirical findings, there is still some influence and pressure from the politics and other interested groups (Warfield, Weygandt and Kieso, 2007). A good example of political influence on the standard-setting process is the dilemma about the use of fair-value accounting for financial assets during the crisis. According to IFRS, fair value should be used in financial statements as it provides most relevant and reliable information to its users. However, during the credit crisis of 2008, some countries were against the usage of fair value being afraid that the figures reported according to this principle would scare investors and depositors. Nicolas Sarkozy, who was the French president at that time, was especially concerned about this issue (Warfield, Weygandt and Kieso, 2014).
Another financial reporting challenge is the so-called “expectations gap”. This means the difference between what the public think accountants should do versus what accountants themselves think they can do (Warfield, Weygandt and Kieso, 2014). The society is concerned about fraudulent reporting cases. To decrease their number, the public companies in the USA now have to report on the effectiveness of their internal controls system (Warfield, Weygandt and Kieso, 2014). Other measures to overcome the “expectations gap” include the adoption of the Sarbanes-Oxley Act and the creation of the Public Company Accounting Oversight Board (PCAOB) (Warfield, Weygandt and Kieso, 2007).
Moreover, accountants should keep track of changing financial reporting standards. It is a rather costly process for the companies and requires hiring personnel with special skills.
Besides, financial statements do not disclose all the data that its users are eager to know. For example, there is little information about non-financial measurements and soft (intangible) assets. Moreover, the companies report their financial statements only on a quarterly basis, while investors may be willing to get real-time information (e.g. fair values of the assets). Besides, little forward-looking data is provided in the financial statements (Warfield, Weygandt and Kieso, 2014).
Moreover, there may be some confusion when different accounting standards are used. Thus, IFRS and GAAP practice different accounting approaches as they were developed for different users’ needs. The main difference between these two standards is that IFRS is considered to be simpler and more flexible in its requirements, while U.S. GAAP is more detailed. In other words, IFRS is “principles-based”, while U.S. GAAP is “rules-based”. At the moment both IASB and FASB agree that there is an increasing need for developing a single set of accounting standards to facilitate comparability of financial statements. Generally, IFRS is believed to have a better potential than U.S. GAAP. Nowadays, the SEC doesn’t require foreign companies that trade their shares in the USA to transform their financial statements according to GAAP (IFRS is also accepted) (Warfield, Weygandt and Kieso, 2014).
Finally, financial reporting faces ethical issues. Thus, some companies may place pressure on its accountants regarding financial statements preparation. For example, managers may ask the accountants to alter or omit some financial figures to strengthen the company’s financial position in the statements. Besides, an accountant led by his or her desire for a better living has a chance to misappropriate some of the company’s assets (Lister). The accountants should remain impartial and follow the ethical principles when performing their duties.
Q3. There are four main accounting assumptions which serve as the basis of financial statement preparation. They include the entity assumption, the continuity (going concern) assumption, the stable monetary unit assumption, and the time period assumption.
The entity assumption states that any organization stands apart as a separate economic unit (Harrison, Horngren and Thomas, 2013, 8). This means that the financial statements include only the information related to the business and don’t present assets or liabilities of its owners (Kaplan Publishing UK, 2012).
According to the going concern assumption, the entity will stay in business and use its existing assets for the foreseeable future. This means that “it has neither the need nor the intention to liquidate or significantly curtail its operations” (Kaplan Publishing UK, 2012). This assumption states that an entity should operate long enough to recover the cost of its assets by allocating it to business operations through the depreciation process (Harrison, Horngren and Thomas, 2013, 8).
The stable monetary unit assumption means that the business has to report all the financial information using the same monetary unit (U.S. dollar in the USA, euro in the EU). Financial reporting has some limitations, and only measurable, quantifiable information may be provided in the financial statements.
According to the time period assumption, the entity prepares its financial statements for established periods of time (quarterly and annual financial reports in the USA) (Accounting Financial & Tax, 2009). Thus, it is not enough to state just the specific date that corresponds to the indicated values in the financial statements, the companies should also indicate the related period.
Q4. A. The Grand’s financial ratios for 2015 and 2014 are presented in table 1.
a. The gross profit percentage, or gross margin, is a profitability ratio which is computed as gross profit divided by sales (Higgins, 2012, 42). Thus, the gross margin for Grand for 2015 equals to $32,400 / $108,000 * 100% = 30%, the same ratio for 2014 is $24,000 / $64,000 * 100% = 37.5%.
Grand’s accounting ratios
b. The current ratio is a liquidity ratio which is computed as current assets divided by current liabilities (Higgins, 2012, 52). Grand’s current ratios for 2015 and 2014 are $31,000 / $20,400 = 1.52 and $23,900 / $14,200 = 1.68 respectively.
The quick ratio, or acid test ratio, is also a liquidity ratio calculated as (current assets – inventory) / current liabilities (Higgins, 2012, 52). Grand’s quick ratios for 2015 and 2014 are ($31,000 – $15,000) / $20,400 = 0.78 and ($23,900 - $12,000) / $14,200 = 0.84 respectively.
c. Accounts receivable collection period in days is determined as accounts receivable divided by credit sales per day (Higgins, 2012, 45). This ratio for Grand for 2015 and 2014 is calculated as follows: $14,000 * 365 / $108,000 = 47 (days) and $10,500 * 365 / $64,000 = 60 (days).
d. The trade accounts payable payment in days equals to accounts payable divided by credit purchases per day (Higgins, 2012, 45). The credit purchases can be found as ending inventory – beginning inventory + cost of goods sold (Kaplan Publishing UK, 2012). The Grand’s purchases for 2015 and 2014 are $15,000 - $12,000 + $75,600 = $78,600 and $12,000 - $10,000 + $40,000 = $42,000 respectively. Then, the Grand’s payables period for 2015 and 2014 is $9,400 * 365 / $78,600 = 44 (days) and $6,800 * 365 / $42,000 = 59 (days) respectively.
e. The gearing ratio, or debt-to-equity ratio, is computed as total liabilities divided by shareholders’ equity (Higgins, 2012, 48). The Grand’s gearing ratios for 2015 and 2014 are ($60,000 + $20,400) / $49,000 * 100% = 164% and ($60,000 + $14,200) / $26,000 = 285% respectively.
B. As can be seen from table 1, the Grand’s gross profit margin has fallen by (37.5% - 30%) / 30% = 20%. However, both 30% and 37.5% are rather high profit margin values compared to the wholesale industry average of 11.44% and 12.64% for 2015 and 2014 respectively (CSIMarket, Wholesale Industry. Profitability Information & Trends, 2016).
The company’s liquidity ratios have also worsened a bit in 2015 compared to 2014. Thus, the current ratio decreased from 1.68 to 1.54 and the quick ratio fell from 0.84 to 0.78. However, as the current ratio is greater than 1.00, Grand has enough current assets to cover its current liabilities, so it is within the norms. The Grand’s quick ratio is much higher than the industry average of 0.18 and 0.49 as of the end of 2015 and 2014 respectively, so the company has a better liquidity position than the majority of its competitors (CSIMarket, Wholesale Industry. Financial Strength Information & Trends, 2016).
Accounts receivable collection period has shortened by 13 days which is a good news. This means that the company collects its receivables more quickly than in the previous year.
Trade accounts payable payment period also decreased by 15 days, and the company’s suppliers should be pleased by this fact.
The Grand’s gearing ratio decreased in 2015 compared to 2014. This means that the debt share in financing the company decreased compared to the equity share. The reason for this is that the shareholders’ equity almost doubled mostly due to the increase in retained earnings and revaluation surplus. However, as both ratios are greater than 100%, the company is still mainly financed through debt. This leads to additional risk, but the shareholders tend to benefit from a higher gearing ratio.
C. The gross profit percentage is computed as gross profit divided by sales revenue, thereby, the movement in the gross margins may be caused either by a change in gross profit or by a change in sales revenue. Grand’s gross profit percentage decreased from 37.5% to 30% in 2015. This is mainly due to a faster increase in sales revenue (by ($108,000 - $64,000) / $64,000 = 69%) than an increase in gross profit (by ($32,400 - $24,000) / $24,000 = 35%).
D. i. I agree that current ratio and quick ratio assess whether a company is able to meet its short-term debts as they fall due. However, high liquidity ratios are not always good for the company. As a rule, high current or quick ratio values are preferred as this means that a company has enough liquid assets to cover its current liabilities. However, too high current or quick ratio may mean that the company doesn’t use its assets effectively and keeps too much unnecessary liquid assets which it could invest in some profitable projects. Too high current ratio may be also a bad sign in case of a high share of accounts receivable or inventory in the total current assets of the company. In this case, the company may have problems with collecting its receivables or have much obsolete or slow-moving inventory on its balance.
ii. I partially agree with this statement. Indeed, a high financial leverage may bring additional income to the shareholders as the company gets additional resources that it can invest in profitable projects. However, the higher the gearing ratio is, the higher the risk for the company as the chances that it won’t be able to pay off its debts increase. Thus, investors and creditors would rather prefer a lower gearing ratio while shareholders usually benefit from a higher gearing ratio. Thereby, a company should find a golden mean in the proportion of its debt and equity.
References
Accounting Financial & Tax, (2009). Basic accounting: assumptions, principles, constraints. [Online] Available at: <http://accounting-financial-tax.com/2009/08/basic-accounting-assumptions-principles-constraints/> [Accessed 8 Apr. 2016].
CSIMarket, (2016). Wholesale Industry. Financial Strength Information & Trends. [Online] Available at: <http://csimarket.com/Industry/industry_Financial_Strength_Ratios.php?ind=1310> [Accessed 9 Apr. 2016].
CSIMarket, (2016). Wholesale Industry. Profitability Information & Trends. [Online] Available at: <http://csimarket.com/Industry/industry_Profitability_Ratios.php?ind=1310> [Accessed 9 Apr. 2016].
Deloitte, (2016). Role of the IFRS Advisory Council. [Online] Available at: <http://www.iasplus.com/en/resources/ifrsf/advisory/ifrs-advisory-council> [Accessed 10 Apr. 2016].
FASB. Financial Accounting Foundation. [Online] Available at: <http://www.fasb.org/jsp/FASB/Page/SectionPage%26cid=1176154526571> [Accessed 7 Apr. 2016].
Harrison, W., Horngren, C. and Thomas C. (2013). Financial Accounting. 9th ed. New Jersey: Pearson Education, Inc.
Higgins, R. (2012). Analysis for Financial Management. 10th ed. NY: McGrow-Hill Companies, Inc.
Kaplan Publishing UK (2012). ACCA Paper F3 (INT/UK) and FIA Diploma in Accounting and Business. Financial Accounting (FA/FFA). Complete Text. Berkshire: Kaplan Publishing UK.
Lister, J. Ethical Issues Facing the Accounting Profession. [Online] Hearst Newspapers, LLC. Available at: <http://smallbusiness.chron.com/ethical-issues-facing-accounting-profession-18307.html> [Accessed 8 Apr. 2016].
Warfield, T., Weygandt, J. and Kieso, D. (2014). Intermediate Accounting: IFRS edition. 2nd ed. John Wiley & Sons.
Warfield, T., Weygandt, J. and Kieso, D. (2007). Intermediate Accounting: Principles and Analysis. 2nd ed. Wiley Global Education.
