Financial Accounting Theory - Essay Example

RUNNING HEAD: Financial Accounting Theory Financial Accounting Theory of Introduction “Subjectivity lies in at the heart of all accounting.” This paper seeks to critically evaluate this statement and provide example to illustrate the same. 2. Analysis and Discussion 2.1 What subjectivity lying in the heart of all accounting means? To argue that subjectivity lies in at the heart of accounting is to argue that creativity or the power to present information according to desire of the prepare will always be the nature of accounting. Subjectivity can that creativity in accounting practice appears to be unavoidable which connotes that the accounting information can be presented in a manner that would serve the interest of the company preparing the same. Extending the implication to mean no room for accounting standards (Kieso, et al, 2007) would leave difficulty to completely agree with the proposition. The statement may be given a confirmation if the statement would mean that a reality that exists in the mind of the preparer to be in fact inherently subjective. In fact there is an old definition of accounting which considers the term as the “art of recording, classifying and summarizing transactions and events” (Rajasekaran, 2011) with subsequent interpretation of their results. This was the old one and definition has evolved to its present claim that its purpose was to present and information for decision making. In one compares the financial information provided by an accountant from news information provided by a journalist, one can note significant similarities. One would agree that both types of information would be used by person for decision making and the person providing the same information is in fact making an assertion about the information. In the nature of things, the person making the statement would utmost be making a claim that would more easily to be self-serving (Smith, 2008). In other words, seldom would want to tell something against his or her own interest unless the same is true . Thus, there is basis to accede to the truthfulness of the statement that subjectivity is the desire of many accountants because it is but natural to have that tendency to make positive assertion about oneself. Even by going to an experiential or psychological level would confirm the normal nature of things. A financial statement consisting of the income statement, balance sheet and cash flow statements (Kieso, et al, 2007) is supposed to be prepared by the management of a company, which may be represented by the owner. In case of corporations, the owner is the shareholders but the latter would have to elect or put into office directors who will constitute the board as a collegial body to make decisions for the corporation. Thus the board of directors including the chief executive officer (COE) and chief finance officer (CFO) and other officers who will be appointed by the board will constitute the top management (Financial Reporting Council, 2010). The CEO and CFO are basically the top two executive officers in the top management who will have a responsibility in the preparation of the financial statements. It may be interesting to know their attitude in the preparation of the financial statements. Their attitude will have something with the purpose of making and presenting the same financial statements. In case of a publicly listed corporation, the financial statements would be made part of the annual report (Brigham and Houston, 2022) which is required to be made available to the stockholders and to the investing public. This would therefore mean the financial statements which are the end-products of accounting would be used by decision maker on whether they would invest with the company or whether they could extend credit to the company. The first group of users would be called investors while the second of users would be called creditors. Would not management have the tendency to present accounting information with a positive note, in order to attract? It should be easy to understand that the investors or creditors would like to see the profitability, liquidity and solvency of the corporation of which one is planning to invest. Each investor wants to have his or wealth maximized (Mishkin, 2007) and this accounting information should help. The question that would be asked is whether the preparers have been influenced by their desire to make the financial statements. The answer to the question is of course a big yes. Normally the preparers would like to say that the corporation which should attract investment from the public is among others deserving of some profitability, liquidity and solvency (Needles, et al, 2007). However, the follow-up question is: “Can the preparers just do the same without some restriction or standard to follow to ensure the accuracy and reliability of the information? “ The answer to the question is a big no because there are in fact standards that must be allowed to attain the qualitative characteristics of information for the different kinds of user who will make use of the information. 2.1 Generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) guide and bind the companies’ management in the preparing the financial statements. GAAP would come from the US Financial Accounting Standards Board (FASB) and IFRS would come from International Accounting Standards Board (IASB) (Kieso, et al, 2007). These accounting standard are made for the purpose for the purpose of guiding companies in the preparation of financial statements. The standard-setting bodies may be private institutions but the standards would have the force of laws and regulation as the regulating agencies would adopt them for regulation for the purposes. This can be seen in the case of US SEC from those passed by the FASB and EU in issuing directive requiring the use of IFRS to EU companies (Mackenzie, et al, 2011). 2.2 Corporate governance would restrain subjectivity by management and through the audit Corporate governance as practiced by companies at present is an evidence to require responsibility in the financial reporting if companies (Financial Reporting Council, 2010). By making management responsible for financial reports, subjectivity in accounting has to be restricted, regulated if not controlled. First the management as the preparer of a company’s financial statement has responsibility for financial statements as agent for the stockholders (Shim & Siegel 008). Management’s responsibility in measuring the value of its stewardship function through the financial statements extends to information disclosed encompassing all estimates and assumptions used in producing final numbers. Management can do this through accounting policies, which would then guide company accountants in preparing the financial statements. Management responsibility stays because the financial statements would still be signed normally the CEO and CFO (Brigham & Ehrhardt, 2010). Management responsibility encompasses the reporting process include as well as the company’s internal control to protect and safeguard the resources of the business while helping ensure that plans will materialize as formulated. 2.1.2. The Audit Committee and External and Internal auditors Audit committee is actually an extension of the management, which functions independently. It is a sub-committee of the Board of Directors, the main designed to oversee the company’s financial reporting process and the related internal control structure of the company. Audit committee responsibility extends to the appointment, compensation and oversight of the external and internal auditors of the company (Financial Reporting Council, 2010). The internal auditors are employees of the company but are not under the control of the President or CEO, while the external auditor are professionals and their function is to express and opinion as the fairness of the financial statements in accordance with generally accepted accounting standards. External auditors can use the power of their opinions to help in corporate governance. In the course of time, management responsibility has become more relevant in being in charge on the consequences of its reporting practice. The financial scandals of the past are not detachable from the change in how management should behave towards accomplishing its purpose. Management cannot argue that after it has prepared the financial statements, its work is done. Using a lens to examine management responsibilities under Sarbanes-Oxley Act of 2002 (SOX) in the aftermath of the investigation and prosecution of Enron and WorldCom fiasco, this responsibility is made clearer. The SOX now obliges CEO and CFOs of US public companies to attest to three assurances (Fernando, 2010). First they should personally certify the accuracy of quarter and annual filings of their company. Second, they need to certify the presence effective disclosure controls and procedures in their company’s policies. Third, they should periodically assess the company’s internal control as used for financial reporting of their company (Fernando, 2010). In addition to legal requirements, companies should have their ethics that would strengthen corporate governance (Crawford & Loyd, 2008). 3. Conclusion The idea of subjectivity as the inherent desire in accounting implies not necessarily holding the decision maker at the mercy of those preparing the financial statements because of the presence of accounting standards. While there is basis to the claim that subjectivity lies in the heart of all accounting or that the making the financial statements as desired by preparers is inherently true, the evolution of accounting has provided mechanism to control or to minimize the negative results of the subjectivity of the accounting information. Controlling the negative effects are the reasons for the existence of accounting reporting standards like those made by FASB and IASB which are now trying to harmonize their output due to difference in some aspect. Governments of countries would include in their regulation of the companies the need to comply corporate governance requirements along with the standards in the preparation of financial statement that would be used by decision-makers. References: Brigham & Ehrhardt (2010). Financial Management Theory and Practice. Cengage Learning Brigham, E. and Houston (2002) J. Fundamentals of Financial Management, London: Thomson South-Western Crawford, M. & Loyd (2008) D. CPAs Multistate Guide to Ethics and Professional Conduct. CCH. Fernando A.C. (2010). Business Ethics and Corporate Governance. Pearson Education India Financial Reporting Council. (2010). UK Corporate Governance Code. Retrieved 12 November 2011 from Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Mackenzie, et al (2011). Wiley Interpretation and Application of International Financial Reporting Standards 2011. John Wiley and Sons Mishkin, F. (2007). The economics of money, banking, and financial markets: The Addison-Wesley series in economics. Pearson/Addison Wesley Needles, B. et al.(2007). Principles of Accounting. Connecticut: Cengage Learning Rajasekaran (2011). Financial Accounting. Pearson Education India Shim, J. &J. Siegel (2008) Financial Management. Barrons Educational Series Smith (2008). Naked America. Michael Smith Read More