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CONCEPTS AND RULES TO REPORT EXCHANGES AND DETERMINE THE IMAGE OF FINANCIAL STATEMENTS
As already discussed, accounting ledgers (books) and the resulting financial statements are to record any and all transactions that occurred between one enterprise and another, a person acting as a corporate proprietor or an individual (“household” is the standard administrative wording). Governments and non-profit organizations are also subject to the duty to keep books and records and only persons acting privately are exempt.
The maintenance of accounting books and records is a legal obligation for any commercial person in any country in the world. As noted in French legal statutes: “any person or corporation having the qualification of a commercial person has to post any transaction influencing their enterprise's belongings. These transactions have to be chronologically posted in the books. They have to take an inventory at least once every 12 months, including the existence and the value of the enterprise's belongings, and provisions for setting up financial statements at the end of the business year” (French law article L123-12 of the commercial code).
Of key importance is the consequence resulting from posting any transaction – namely, the appearance of exchanges showing on both the debit and credit sides of the P&L (profit and loss account) will be compulsory, and the resultant recording of all sales and purchases involving counterparties will generate a debt or receivable entry in the balance sheet, along with entries reflected in updating the balance. In the same manner, any type of expense or sale of services will show on the P&L, until cleared by a corresponding payment on the balance sheet. Speed of money flows will impact the balances of each of the accounts with a third party.
If the rate at which balance sheet postings are generated exceeds the speed of the clearing process, then artificial changes in the acceleration of transactional exchange rates may indicate expansion in global transactional volume – a pattern that does not necessarily correlate with underlying economic growth. In other words, if representations of the money lent across the economy and shown on the books are driven purely by acceleration in monetary rotation (and merely reflect artificial growth in transactional volume), then such trends are largely irrelevant from an economic perspective – unless underlying transactions are coupled with tangible physical exchanges for products and/or services. Any decline in the speed of the payment process – either due to the psychological attitude of entrepreneurs or because of liquidity shortages – will further inflate figures showing transactional volume. Moreover, any additional issuance of debt (including monetary issues or buyouts of monetary instruments by central financial institutions) will also generate further balance sheet expansion, including for central financial institutions.
It should also be noted that P&L ledgers represent an annual statement reporting on transactions that occurred during a preceding period of time, usually one calendar year. This is not the case for balance sheets that track and reflect ownership of assets and debt commitments at the closing date. Even when usually closed on a yearly basis if not more frequently, these records reflect the status of ownership (which constitutes an everlasting right), until legal modifications are transacted and cleared via a sale or on the basis of “commitment satisfaction” (usually based on amounts accumulated). Not surprisingly in this setting, any analysis that seeks to explain the underlying causes for expansion or contraction of balance values can be approached only by linking transactional exchanges reported on P&Ls with balance sheets themselves.
To effectively accomplish the ever-extending purposes of financial statements – to record ownership, be evidence of ownership, inform the entrepreneur of their achievements, fight against fraud for all participants in the economy, and make financials comparable for investors or managers to appraise the enterprise's performance – many extra principles have had to be added.
General mandatory principles
■ The “financial year ” principle. So as to accurately measure and reflect financial performance, all financial statements should correspond to a clearly defined time period, usually designated as the financial or fiscal year.
■ Parallel accounting of revenues and expenses. The accounting record should reflect clear parallelism between revenues and expenses in the P&L account reported for all years, that is corresponding to any revenue reported and generated, and respective correlating accruals and expenses should be recorded and tracked in parallel. Also, parallelism of expenses or accruals is required to validate and finalize revenues. This correlation between revenues and expenses is to determine the margin and net profits of the operations.
■ Principle of “independence between financial years”. The above-noted principle of parallelism raises difficulties when a contract recorded on the ledger lacks a linear implementation period, and when it straddles a closing date for books (in constructive operational accounting reality, this will frequently be the case). This paradox is referred to as the “principle of independence between financial years”.
■ Reference currency. Books should be kept in a currency set by law. In the USA, the dollar and in the EU, the euro (for the 18 out of 28 EU countries that comprise the Eurozone).
In summary, accounting report periods should be annualized and issued independently from each other, with strict yearly cut-offs. The accounting process is intended to produce financial statements that, at a minimum, include: a balance sheet and a P&L accounting statement issued at a pre-set or compulsory frequency, with 12 months being standard. Transactions should be posted in the year to which they relate, and their influence on the previous and subsequent years' profit and loss should be reflected in corresponding accounting reports.
Besides the general principles that we have quickly reviewed, and that are deemed to be included in the general framework, standards setters elaborate on the prevailing rules that accountants commit to apply – such as, for the USA, in concert with adoption of their professional statute by CPAs (mandate). In addition to other authoritative regulatory bodies (such as the SEC or its worldwide equivalents), the accounting standard setters' organizations drive the existing regulatory set-up. In Europe, after being proposed by standard setters, standards are set by regulation. Businesses are to use the standards and accountants to verify their appropriate implementation. To fill the gap left by regulation, only interpretations, opinions and determination of applicability can be decided by other authoritative bodies. They are, for instance, National Securities and Exchange Commissions, accounting profession, or advisory committees to the European Commission. As we will see further on in Chapter 7 (Figures 7.3 and 7.5) about regulation, US SEC role in standard setting is with the European banking union taken over by ESMA a coordinating surveillance agency for financial markets. As Member States of the Union have kept their own SEC equivalent National Agencies a coordination was in need and taken over by ESMA. Because SEC only regulates what is public the space left by regulation to professional organizations as the AICPA (American Institute of CPAs) is wider than it is in Europe where accounting standards when adopted are applicable to any existing enterprise. This is often called “soft regulation”. On both sides of the Atlantic, independent auditors may use their professional judgment to implement regulation and interpretations complement them in order that financial statements give a fair view of the financial situation and financial performance of the relevant business.
Accounting standards may allow some options; some compulsory standards are disputed and are discussed inside the arenas where the standards are elaborated, and some are rejected. We note that accounting standard setters have decided to work together to achieve standard convergence, but as is now the case with many topics, the trend stopped at the end of 2012 – the US SEC has issued a release stating that it is not appropriate for it to adopt IAS standards (those of the EU and other countries) and that it will stay with US FAS standards.
With the need to analyse what happened with the 2007 financial crisis, all regulators and political leaders are calling for a single set of financial reporting standards and comparability of financial standards across the world, with IFRS standards being referential. However, the limit to this convergence is the sovereignty of each monetary zone and the risk surveillance duty of national authorities. The EU opted for IFRS, but as for the IFRS to be used for public listings in the USA, the same questions arise. In November 2013 a report was issued by the Special Counsellor to the Internal Market Commissioner, entitled “Should IFRS Standards be more European?” This report raises the real issue of the legitimacy of the so-called independent bodies such as EFRAG (European Financial Reporting Advisory Group) to comment on IFRS proposals and reinforce the European Commission role at the early stages of preparation of standards, either by restructuring EFRAG, transferring its advising duties to one of the European surveillance authorities or even creating a specialized new agency within the European system. In our opinion, the issue which has so far been avoided is to have major countries decide about governance criteria at international level. Should the decision process be the European system of one member state having one vote, or should it be based on the importance of the financial world in each country? The outcome would be totally different. The topic is similar for each international monetary body, and is the financial world easy to valuate? Is the size of the economy perhaps a better criterion? How should adjustments be made for size differences? What is ultimately at stake is the supervision of the financial system which cannot wait and, practically, can ultimately only go to the existing authorities with a bilateral coordination.
The 2007 crisis, where the IASB was not able to suspend IFRS 39 (when financial instruments in portfolios could no longer be valuated) as the FASB did in due time, was a warning and justifies the new report on IFRS, questioning its governance. The sharing of sovereignty and the urgent request for clarification about this matter is at stake. Specific standards – those we will briefly describe – created by human beings, are not the laws of physics and are able to adapt to social realities where lobbyist pressures and dogmas can be destructive. The disputes between the USA and the EU on accounting topics should not be overstated. They relate to sovereignty, which is hard or impossible to remove constitutionally, and also to the interests of different sectors because of different set-ups in the financial industries and diverging priorities. For instance, putting aside the difficulties about fair market value that are necessarily dependent on the set-up of financial industries, financial markets, governmental debts and retirement benefits system realities are essentially the same. On November 6,2013 the FASB voted to move forward with preparing a final standard on revenue recognition. It is based on a substantial approach, for instance for a complex transaction with a client linking several contractual performance obligations together such as the immediate delivering of a telephone set with the carrying of telecommunication over time. In such cases, the revenue recognition, the first and usually the most important line of a P & F will apprehend over time as one the various contracts and allocate its obligations to perform after being priced economically parallel to the costs. The remaining issue of this convergence and unification of methodology is the larger leeway left to professionals for interpretation. It was adopted jointly by FASB (as Accounting Standard Update 'ASU' no. 2014-9 topic 609) and IASB (IFRS no. 15) on May 28, 2014. It will take effect in 2017 for public companies and in 2018 for private ones. As joint project between FASB and the IASB showing that convergence is possible and a joint transition resource group for revenue recognition was decided on June 3, 2014. Revenue recognition is a major item for the issuance of financial instruments and the collection of substantiated data. We will see this further at several stages of our analysis.
Some principles may, in limited scope, be optional if they don't contradict the fair image when required.
■ Cash versus accrual accounting. One can opt for either a “cash accounting” or an “accrual accounting”-based reporting system. In the case of cash accounting, transactions are posted only when a cash collection, bank collection or disbursement occurs. This method is only applicable to independent professions and small enterprises (within certain limits). The cash accounting option is not considered for major enterprises, as books should fairly represent the situation and therefore include all “certain commitments” (purchases to be delivered or already delivered but not paid, or expenses to be paid following use or consumption, etc.). In the case of accrual accounting, transactions are posted as soon as a contractual commitment exists or is verified. A sale is posted as it occurs – meaning the point at which parties to a transaction agree on what property is transferred, and for what price – rather than contingent on payment having been made. Neither of the two major recognized accounting standards systems recognize cash accounting for use by corporations.
■ We notice that the two methodologies differ in terms of the timing difference between the occurrence of key elements of a transaction, but not by substance. Books are said to be kept on an accrual basis or so-called “commitment accounting” (as opposed to cash accounting) in settings where transactions are posted before the resulting cash disbursement or collection from a transaction occurs. The resulting spread in the accounting process reflects the gap in the books between the time of posting the transfer of property (as a confirmation of the transactional agreement) and the subsequent receipt by the seller of the receivable due and the actual corresponding incursion of equivalent debt by the buyer.
■ Contractual or substantive approach to postings. There is a disputed bidirectional issue equally representing the triumph of form over substance and at times the reverse. A “contractual approach to postings” involves the posting of transactions, as they are legally defined, on a contract. The obvious drawback of this approach is that taxation, legal and regulatory considerations may lead to the adoption of contractual language that appears to diverge from the intended financial reality of the contractually driven transaction itself. The most common examples are commercial financing and leasing contracts. Long the oligopolistic purview of banks, classic lending activity is subject to a bank's internal limitations on volume, rates and guarantees. However, such limits do not always apply to contracts involving commercial financing or leases. In the essence of lending practice, there is little practical difference between lending and leasing. A company in need of capital equipment may purchase the latter with lending-generated money or rent it (being committed to pay a rent over a similar period of time as the loan would have been reimbursed).
The process of adhering to the letter of “contractual language” while posting a transaction can give rise to divergent posting regimens that correspond to different types of contracts. In cases involving equipment-based assets and loans made as debts with interest on those assets, these may be posted as a P&L expense entry. In other cases, a property lien will remain under ownership of a leasing institution (without entry of a classic debt), but a lease's commitment to the lessor will be confirmed in the form of notes attached to the financials. As such, a rental obligation will appear in the P&L and not as accrued interest on behalf of the landlord, etc.
Despite the existence of a range of different contracts governing an inherently similar body of substance, it has long been recognized that the mechanics of a financing arrangement will determine the movement of funds and the impact of that process. Naturally, financing agreements are subject to tax effects that are primarily attributable to depreciation rules. For instance, at the lessor's side of the transaction pipeline, this impacts the general accounting policies and tax rules that govern the financial institution. Conversely, at the user's side of the pipeline, the impact will be on user-specific accounting practice and a different set of tax rules.
In the interests of transparency, the objective of choice would point towards favouring a substance-driven rather than a contractual-centred approach, but this stratagem will encounter two categories of challenge:
■ The first challenge confronts accounting teams that represent many small and mediumsized companies. A substantive approach would disregard contractual consideration in favour of actuarial calculations coupled to a monetary “cost-of-financing” approach. The latter would also need to take into account the resulting tax differentials, compared with merely following the course of contractual execution and receipt of stipulated payments as these are processed. This is a more complicated approach for small and medium-sized companies to handle bookkeeping-wise than just posting in the books the collections and payments.
■ The second challenge takes into account the potential of evolving difficulties in the relationship between two parties to a contract. One example would involve a tenantleasing issue, where posting of transactional events at the corporate tenant level would have no value in the eyes of the leasing institution (whose representatives view only the terms of the contract as being enforceable). If the substantive approach were to have been adopted in this setting, then the entire balance sheet of a tenant company encountering financial distress (alongside the potential risk of disruption in operations) would need to be reconsidered.
Ultimately, these differences primarily reflect time synchronization issues, actuarial factors and distortion effects – the latter attributable to various systems of taxation. Regardless, the choice of specific accounting options selected may lead to significant impact on the appearance of selected financial reports generated on behalf of capital- intensive industries.
Adopted principles and rules subject to implementation challenges or rejection
■ Prudence principle. This approach considers the comprehensive risk of loss-associated factors that can be attached to a transaction or an intangible asset, specifically after the transactional event occurs or is shown on the books. Examples include, among many others, social commitments that an employer has reached with staff. Statistics show that some employees in this setting would inevitably ask for indemnification and predictably litigate when quitting a company, depending on the prevailing conditions at the time of severance. As the risk of this type of occurrence is indeterminate, it is not to be posted. As a consequence of challenging the prudence principle, or setting a precise definition of what prudence is, two matters raise disputes about the timing to post reserves for depreciation. Firstly, when they have to be considered. Also, regarding the change of value of fixed assets if they have to be considered, and when they should be posted depending on whether a sale is considered and whether the asset is exploited or not.
■ Reserves mitigating against hypothetically expected loss. In comparison, a matter more closely financial in nature relates to the maintenance of reserves for the purpose of potentially mitigating against future losses in the portfolios of receivables. For instance, even if payments by a series of debtors are current when averaged over time, some of them will be in default at any one moment. This is a statistical factor that will vary over time, among other factors depending on the general economic situation. Ongoing discussions continue among standard setters as to when and how the risk of such transient defaults (defined only as a certain risk but not as an occurrence) should be posted, and in what amounts.
■ Capital gains or losses. Another example of a controversial rule involves accounting procedures designed to address potential capital gains or losses on an asset. Assets in general are submitted to an impairment valuation test at closing. If the value is under the historical posted value, a reserve may be accrued if the loss is durable, but when the asset is being used there is controversy. In cases of possible gain, due to the fact that an asset's potential sale value exceeds that of the posted value, and when the asset is being operated, such circumstances will be disregarded and no posting of profit will be made prior to its realization. If it even corresponds to a fixed asset available for sale, the posting of the potential capital gain before realization is controversial and suggests a degree of certainty that the sale will happen soon after closing. When considering only negative factors, current accounting referees reject this principle if it does not relate to an asset available for sale, and when it corresponds to a fixed asset being operated.
■ Historical value. This principle involves posting balance sheet elements at their real cost (termed “cost accounting”). The opposing accounting principles are “inflation accounting” and “fair value” (before called “fair Market value”), the latter applicable only to some liquid types of balance sheet elements such as financial portfolios. In an inflationary monetary context, determining the rise in prices for fixed assets, or for any reason such as interest rate decline, the “historical value” doctrine is also not coherent with the previously noted rejection of the “prudence principle”. In other words, prevailing practice insists that either all potential profits and losses are taken into account, or none at all if they do not correspond to liquidities.
As may be seen from the foregoing discussion, the functional scope and impact of today's money is closely linked to accounting practices presently operant on a global scale. The general interest and public domain expectations of performance criteria applicable to the accounting profession should be as homogenous as practical, so as to allow for: (1) performance assessments over time and (2) comparison with alternative operational service-sector investments, including their reliability and transparency. The public will also expect independent guarantees that their constituency expectations are met (opinions provided by independent auditors evaluating other auditors) and that sanctions are available if needed – and capable of being implemented by specialized authoritative bodies such as the SEC or the judiciary.
In short, books and records are not intended only for the entrepreneur. Rather, today's books are largely in the public domain, given that they express the functional activity of today's currency base and the results of how money in all its forms operates and modulates transactional exchanges that impact contemporary society. Accordingly, the durability of accounting standards is also an essential prerequisite that supports the need for comparison of accounting standards and their effectiveness over time – particularly given the fact that repetitive changes in accounting concepts may result from either financial innovation or excessive creativity of standard setters engaged in self-justification. Such serial changes may render some evolving accounting regimes as ineffective guarantors of future world monetary stability. Arguing against that premise, however, is the historical survival of accounting principles that, by today's standards, are ancient and have stood the test of time, in terms of both reliability and effectiveness.
Category: Financial statements