Discuss the relationship between accounting choices made by management and the values reported in financial statements and the possible reasons why those choices are made.

University Degree Business and Administrative studies

Introduction

The Age (17 May, 1988) reported that the true picture of Wormald's financial state was revealed by the accountants, Arthur Young. After a request by the National Companies and Securities Commission (NCSC) Arthur Young prepared a revised report, increasing the original loss of $54.8 million to a loss of $255.9 million. This, of course, raises the question of why there was a difference between the reports prepared by the Wormald management and those prepared by the accountants. Section 269(9) states that `the accounts are made out in accordance with applicable approved accounting standards and that, by so doing ensures the accounts give a true and fair view.' (Australian National Companies and Securities Legislation with State variations). It would appear that what constitutes a true and fair view in relation to prepared accounting reports, differs somewhat between what management and the accountants perceive it to be.

Accounting Choices

For many transactions, management is able to choose from a selection of equally acceptable accounting methods, each of which can often give very different results. Hence, differences in reported results often stem from the different accounting procedures used, rather than differences in performance. It could be suggested that Wormald, because of the availability of different accounting methods, was able to produce what it saw as a desirable result. In other words, the profits may have been manipulated by the choice of suitable accounting methods and amounts disclosed. `Choosing accounting procedures to satisfy management's objectives is sometimes referred to as creative accounting; unfortunately, this often leads to a lack of comparability in accounting reports' (Poole, 1987, pp. 42-48).

Such an example of this can be seen in Wormald's treatment of the abnormal items, doubtful debts and write-downs; inclusion would only have increased the liabilities of the firm, which in turn would have produced an even higher loss.

One reason behind the accounting choices made by management and the values reported in the financial statements of Wormald may be due to the separation of ownership from control. Management is in a more favorable position to know the likely and present performance of the company than would the shareholders (Whittred and Zimmer, 1988, p. 26).

Typically, the majority of the shareholders of a firm hold a diversified portfolio of investments and do not normally involve themselves in the management of the firm. Management is employed to perform the decision-making role of the firm. Hence, management acts as agent for the owners (shareholders). However, the objective of management may differ from those of the firms' shareholders. Shareholders could possibly assure themselves that management will make optimal decisions, but only if appropriate incentives are given and only if the management is monitored (referred to as agency costs) (Whittred and Zimmer, 1988, p. 26). This may provide an answer to the accounting choices made that gave rise to the initial total group loss of $54.8 million.

Management's wealth may have been tied to the well-being of the external shareholders. For example, if the incentives offered were 'bonus schemes and performance plans, in which management's wealth was directly linked to performance, measured in accounting terms, rather than indirectly linked as in the case of shares and share options', (Whittred and Zimmer, 1988, p. 30). Management may have been prompted to select methods which reduced the trading loss (for example by not reporting abnormal items and reporting an extraordinary item that did not recognize losses from the acquisition of Sunshine Australia Ltd).

Taxes, political costs (government intervention) and ...

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Taxes, political costs (government intervention) and regulations imposed by state or commonwealth authorities further contribute to the accounting choices made. In an attempt to avoid paying high taxes, or in anticipation of receiving or not losing available government incentives, management would tend to favour accounting techniques that would for example reduce profits (Whittred and Zimmer, 1988, pp. 34-38).

Professional and Statutory Accounting Standards

Professional and statutory bodies do recognize the availability of accounting choices. They have put in place requirements that increase disclosure of accounting methods used (through notes to the accounts) and reduce the choices of accounting methods.

Further to this 'self-regulatory' measure, Schedule 7 paragraphs 8(1)(b)(vii) and (d) requires the accounts to include notes detailing components of the abnormal items and extraordinary items. Section 269(7) requires directors to ensure that reasonable steps have been taken in writing off bad debts and making adequate provisions for doubtful debts. There are no requirements that such write-offs and provisions are to be made.

AAS1 and Schedule 7 only require separate identification of abnormal and extraordinary items, if they occur. In some instances management is in a position to choose if items become abnormal or extraordinary and to what extent. Management obviously was reluctant to recognize any abnormal provision for doubtful debts (a commonly contentious matter between management and auditors) because this would only increase the reported loss. Similarly, a write-off of goodwill on the takeover of Sunshine Australia was not included for the same reasons.

AAS5 and AAS6 (and ASRB1001) provide management with overriding accounting concepts. (AASA Associate Program, 1987, pp. T5.7, and T5.19). Whilst materiality is the accounting concept which governs selection of information to be separately disclosed, relevance, consistency and prudence also aid in determining the application and disclosure of accounting choices. AAS6 and AAS5 provide assistance, not advice, as to the accounting policies that ought to be adopted, (AASA Associate Program, 1987, p. T5.19) once again leaving accounting choices up to the discretion of management.

It is generally understood that non-current assets initially are recorded at historical cost. However, revaluing non-current assets is usual and can have a significant impact on financial statements (AASA Associate Program, 1987, p. I6.40). AAS10 (and ASRB1010), while not advocating revaluation of assets, do recognise that non-current assets are revalued. Hence, AAS10 requires that where a non-current asset is revalued, the entire class of assets to which that asset belongs should normally be revalued (para 21). Wormald's management by this accounting choice was able to conveniently revalue the group's Australian security service infrastructure which increased shareholder's funds and cushioned the extraordinary loss.

AAS18 (ASRB1013) describes goodwill as a future benefit from unidentifiable assets which cannot be recorded individually in the accounts (para 4); and should be amortized by systematic charges over the period ... benefits are expected ... not exceeding 20 years (para 40). Paragraph 40 of AAS18 says the unamortized balance of goodwill should be reviewed at each balance date and written down to the extent that it is not longer supported by probable future benefits. Any loss should be recognized in the profit and loss account immediately.

Wormald's policy was to amortize goodwill according to AAS18 para 40 (Pro-forma Financial Statements, 1987, p. 4). Management chose to maintain this policy and not write- off goodwill on the acquisition of Sunshine Australia. This assumedly was a decision to recognize future benefits in the acquired goodwill. The revised report reported extraordinary losses of $206.7 million which included a write-off of the purchased goodwill and write-downs in assets. So in accordance with para 41, goodwill purchased on acquiring Sunshine Australia Ltd could no longer support probable future benefits. This comparison clearly shows different accounting choices can affect the bottom line in financial statements.

Generally, Schedule 7 of the Company Code 1981 only sets out disclosure requirements by identifying matters which are to be reported separately in the financial statements. Schedule 7 does not restrict management in the accounting choices that can be made (Whittred and Zimmer, 1988, p. 90).

The AASE (Australian Associated Stock Exchange) imposes requirements on all listed companies. Again these requirements appear to relate to disclosure (and not accounting methods) that should or can be used (Whittred and Zimmer 1988, p.91).

Market Values in Valuing the 23% Investment

The main argument for the use of market values in valuing the investment of 23% is based on the concept of the efficient market. `The efficient market is seen as fully reflecting all available information in the share prices, as well as reacting to new information in an instantaneous and unbiased way' (Peirson et al., 1985, p. 443). This indicates that if the share market is efficient, the current share price should be the best available estimate of the company's true value (Peirson et al., 1985, p. 464).

From the studies reported in Whittred and Zimmer (1988, p. 81), firms that had reported lower than expected earnings in a period found that the share prices of the firms performed abnormally badly. This type of reaction from the market would prompt any management to ensure maximum gains or minimum losses in an attempt to encourage or avoid such a reaction. Nevertheless, studies of the market have shown that if it is efficient, it will not be misled by the accounting choices made to disguise the true bottom figure (Peirson et al., 1985, p. 464). In valuing the 23% investment at $1.80, the market has probably reacted to what it considered to be:

(a) a company ailing since the last financial report,

(b) a lack of accurate information about the present position of the company (due to several reports that differed significantly) and

`A company's share prices can however be affected by market wide factors, over which management has no control' (Peirson et al., 1985, p. 464). For example, the federal budget, employment trends, inflation, the daily movements of the all ordinaries index and its components, the current market both in Australia and overseas, the strength of the Australian dollar, interest rate trends and international stock movements are all factors which are generally beyond the control of management.

For example, consider the effects of the share-market crash in late 1987 on industry. After the crash investors would be pessimistic about the future performance of the market, reducing activity on the share-market and competition for stocks. The crash may possibly have contributed to the market share price of $1.80. To obtain an accurate idea of how the market value of $1.80 reflects Wormald's value, a comparison with other share market values in similar industries to Wormald would need to be made. This would be to see if all values were down, or whether Wormald's value stood alone. The question remains as to why a firm is valued at a premium of $3.75, when the market valued is only $1.80. The market crash may have played a significant part in the write down of the Sunshine group asset which was found to be worth far less than the acquired price.

Negative Pledge Loans

Wormald reported that the company was in breach of one covenant of its negative pledge agreement, which Wormald had attempted to remedy by a revaluation of non-current asset.

A negative pledge is where the `borrowing company promises the retailer that it will not grant security interests in favour of other lenders without the prior written consent of the lender' (Ford, 1986, p. 264). A negative pledge is a contractual promise rather than a security, although a breach of a negative pledge depends on the terms and conditions of the negative pledge loan agreement. For example, such a breach may accelerate the date for repayment of the principal and put into place procedures to enforce repayment (Ford, 1986, p. 264). In the event of a temporary breach, the terms and conditions of the contract would need to be relied on. As implied by the word temporary, the breach may be remedied (Wormald's breach would be remedied by the sale of the shares it held in itself) and the pledge restored. There may be no need for the creditor to accelerate the date for repayment, but, as mentioned, the terms and conditions and the creditors legal rights would determine this.

Whether Further Regulations are Warranted

When deciding whether the Wormald experience should or should not be grounds for accounting regulators to require half-yearly financial results to be audited, several issues need to be considered:

Availability of resources; the impact of additional regulations of the business community as a whole; timing issues; the benefits that will be derived from additional requirements; the additional costs in implementing such requirements.

Whilst on the face of it, it is easy to agree that another Wormald situation should not be allowed to happen, one also needs to remind oneself that if the situation is irregular, surely there are enough regulations already in place to deal with such situations. In fact, the Wormald example illustrates that there are sufficient regulations in place. For on becoming concerned with the financial information that Wormald was publishing, the NCSC was in a position of authority to request that a company's interim reports be audited.

So whilst agreeing that audited interim reports would provide more accurate reporting of the financial position of a company, it possibly cannot be justified on an economic and financial basis.

Conclusion

The relationship between accounting choices made by management and the values reported in financial statements appear to be affected by: the financial contracts made between principal and agent; regulations imposed by professional, statutory and political bodies and the maintenance of a reputation both in the debt and stock markets. Bearing this in mind, management will continue to use its discretion in the selection of appropriate accounting techniques when preparing financial reports.

Reference List

The Age (1988), 17 May, Melbourne.

AASA Associate Programme (1987), Melbourne.

Australian National Companies and Securities Legislation with State Variations (1989), Students Abridged Edition, Canberra.

Peirson, G., Bird, R. and Brown, R. (1985), Business Finance, (4th edn), McGraw Hill, Melbourne.

Phillips, G.R.E. and Hunt, L.J. (1985), Writing Essays and Dissertations - A Guide to the Preparation of Written Assignments in Colleges and Universities, University of West Australia Press, Perth.

Poole, L. (1987), "Creative Accounting - A Race for the Bottom?", The Chartered Accountant in Australia, Melbourne.

Wormald International Limited (1987), Pro-forma Financial Statements as at December 31, 1987, Melbourne.