1. What new accounting concepts evolved in the nineteenth and early twentieth centuries? Select one of these accounting concepts and describe the circumstances that motivated the development of the concept.

Solution:

Though accounting emerged maybe thousands years ago and has a very long history, the forms, the theories and the concepts of modern accounting were mainly developed in recent 200 years, especially in recent 100 years. Since the emergence of the joint stock company in England in the early eighteenth century, accounting began a long transition from a system to enable merchants to manage their own business to a system to inform investors the relevant information to make investment decision better. During the period, many accounting concepts and disciplines were developed and became the basis for the further development, like business entity concept, money measurement concept, accounting period concept, accounting equation and so on. In the latter part of twentieth century, accounting got its vigorous development in theories and concepts like accruals concept, consistency concept, decision-usefulness concept, prudence concept, cost basis, lower of cost or market value, matching, and realization, all of these helped to generate a relative completed framework for today’s accounting (Kieso etc., 2009).

Among all these concepts, a very import one is decision-usefulness concept because it led a direction for accounting theory. Before 1929, accounting was relatively unregulated with financial reporting and auditing usually voluntary, and this kind of voluntary disclosure was mainly motivated by big business to avoid regulation and to disguise their high profitability. Unfortunately, voluntary disclosure, which mainly depended on moral disciplines, was not so effective that numerous manipulations and abuses were widespread in financial reporting, which was widely believed to be major factors to the Great Depression and the 1929 Crash. Then 1934 securities legislation was created as a way to control manipulative financial reporting and to provide better-quality information to business participants. Up to the late 1960s, the accounting theory and research were mainly to argue which accounting practices and principles were “best” and no generally accepted conclusion was made. In 1963, The Possibility Theorem of Arrow led to the realization that perfect accounting standards or true net income may be not exist. At the same time, some major developments in other disciplines were taking place, such as the theory of rational decision-making under uncertainty and the theory of efficient securities market in economics and finance. In the latter half of the 1960s, all these theories begun to be reflected in accounting theory and generated the decision-usefulness concept, which then became the basis of the Conceptual Framework of the Financial Accounting Standards Board (Scott, 1997).

  1. Compare and contrast a rules-based accounting standard setting process with a principles-based accounting standard setting process. Provide examples where necessary to augment your answer.

Solution:

Rules-based standards attempt to lay down detailed rules for how to account for particular business transactions, but with the difficulties to lay down detailed rules to deal with all possible situations. While principles-based standards only attempt to lay down general principles to guide accounting practices, but with the risk to rely on professional judgments to ensure the application of the standards is not misunderstanding or misleading (Scott, 1997).

For example, with dealing with the recognition and measurement of financial instruments, the FASB 115 of Accounting for Certain Investments in Debt and Equity Securities is preferential to principles-based standards. In FASB 115, financial instruments are classified into Held-to-Maturity Securities, Trading Securities and Available-for-Sale Securities, and each classification is defined with their specific characteristics respectively. For example, Held-to-Maturity Securities is specified to such securities that only if the reporting entity has the positive intent and ability to hold them till to maturity, and Trading Securities are such securities that are bought and held principally for selling purpose in the near future. The recognition and measurement of the financial instruments are also defined based on principles-based standards, like Held-to-Maturity Securities is recognized and measured based on the Amortized Cost Method, and the recognition and measurement of Trading Securities and Available-for-Sale Securities are based on the fair value method (FASB 115, 2010). These recognitions and measurements are all provided with conceptual foundation which can be applicable to various circumstances but without detailed implementation and interpretation guidance.

Though rules-based standards and principles-based standards are different with each other, they often appear in a set of standards together and make each other more completed. Like in a set of standards, the principles-based standards often provide the conceptual framework, and the rules-based standards implement the conceptual framework into accounting practices with more details and interpretations (IASC, 1989).

  1. What are the conceptual motivations for NZIAS 38 ‘Intangible Assets’? Briefly describe what has been achieved in financial reporting with the introduction of this standard. Provide examples where appropriate.

Solution:

The conceptual motivation for NZIAS 38 ‘Intangible Assets’ is to ensure the recognition and measurement of Intangible Asset is satisfied with the criteria of the recognition and measurement of assets and to get investors protected by avoiding to overstate assets value. With the introduction of this standard, on one hand, the abuses of capitalization for internal research and development get controlled and the quality of financial information can be improved so as to get investors protected better. Intangible assets are primary from internal development and external purchase, but account for accounting for external purchase does not hinter the investors to access the value of the enterprise so much as that of internal development and these misleading accounting practices usually happen in small high technology companies. That is because small companies neither have enough money to purchase an intangible asset nor have capacity of undertake the risk and cost of internal research and development. In order to raise more money for companies’ development, these small firms usually have the motivations to overstate assets value by capitalizing internal premature research and development to impress investors, but also to leave investors exposing to more risks. For example, in 1990s, many small hi-tech firms emerged and raised much money in market by impressing investors through capitalizing premature research and development. Then with the collapse of such hi-tech firms, the confidence of market was also negatively affected. With the emergence of this standard, the capitalization of research and development was uniquely regulated and comparability between similar enterprises in the same field got improved which could provide more relevant information to investors to enable them make investment decision better. On the other hand, some research and development with potential to become a real intangible asset would be dismissed because of failing to capitalize the expenditure of research in balance sheet to attract investors, which is with great potential to be an intangible asset and to realize a new and stable economic growth. That would be the cost of this standard (Stice etc., 2008).

  1. Describe how recognition and measurement criteria have been applied in the accounting treatment of research and development expenditure in NZIAS 38 ‘Intangible Assets’ to take account of this special class of assets. Provide examples where appropriate.

Solution:

Suppose there is a research and development activity happening in an enterprise, here is try to explain the accounting treatment of research and development expenditure in NZIAS 38 ‘Intangible Assets’ by practicing the accounting for the research and development activity. Before accounting for the research and development activity, it should be determined that which phrase the activity is in. If the activity is in the research phrase, the expenditure should be expensed for it has not met the definition of intangible assets that the future economic benefits from it would not be brought into the enterprise probably. If the activity is in the develop phrase, two more steps would be examined. Step 1: the assets which would emerge from the development activity have met the definition of intangible assets, which is characterized with identifiability, control and future economic benefits. Step 2: the two recognition criteria have been both satisfied which includes the expected future economic benefits attributable to the assets will flow into the enterprise with great possibility and the cost of the assets can be measured reliably. If either of the two requirements was not satisfied, the expenditure of research and development will have to be expensed. If the two steps are both met, the last requirement would show up and be considered that the intangible assets should be measured initially at cost, which means the costs directly related to the intangible assets should be classified from the total costs happened in the development activities and should be accumulated as the initial cost of the intangible assets (NZIAS 38).

From the progress described above, it can be seen that the recognition and measurement criteria provides a logic clue for the accounting treatment of research and development expenditure, and this clue makes all the definitions and practices involved connect and interact with each other like a net.

  1. In the presence of serious creative accounting worldwide, discuss whether accounting standard setters should continue to grant discretion and flexibility to companies in making accounting choices. Your answer should indicate how opportunities for creative accounting arise.

Solution:

Modern joint-stock enterprises are a union of contracts and each business participant would try to protect and maximize their interests under their contractual agreements. Many contractual agreements are established based on financial information and the information in financial reporting probably determines whether the contract is successfully implemented or is unfortunately violated. However, given the same business activity, different accounting policies require different accounting treatments, which would then produce different accounting information results. So the accounting policy has a tremendous effect on the information of financial reporting, and has enormous influences on outcome of contract implementation (Scott, 1997).

A contract is imcompleted for it can’t contain all the possible conditions, and a contract is also rigid for it can’t be revised timely and effectively according to new conditions. Because of the imcompleteness and rigidity of contract, the enterprise, as a contract participant, often exposes itself to more risks by participating into contracts based on reported accounting information in complex and unpredictable business environments (Scott, 1997).

When the enterprise is about to violate a contract mainly because of unfavorable operation environments, it is neither fair nor practicable for the enterprise to undertake all the unfavorable results as agreed in a contract. However, the other contract participant is probably not willing to renegotiate with the enterprise the contract content, for the results of the contract is to his/her advantage, especially when the outcome is believed to be from his/her own management or operation. On the other hand, the progress of renegotiation is very costly and time-consuming. So the renegotiation of contracts is not available for most cases. It becomes a dilemma for accounting how to tradeoff the costs of an enterprise and the profits of the other contract participants.

Then it turned to accounting policy to seek the balance, and accounting policy did not fail the expectation. By granting an enterprise discretion and flexibility in making accounting choice, it not only permits the enterprise to enhance the capability to control the risks of violating contract, but also gets the interests of other business participants reasonably protected by limited accounting choices and limited extent the amount could be change.

References:

Scott, William R. (1997). Financial Accounting Theory. (4th edition). Toronto: Prentice Hall

 

Statement of Financial Accounting Standards. (2010). Accounting for Certain Investments in Debt and Equity Securities. (NO. 115).

 

Gornik-Tomaszewski, S. & Millan, M. A. (2005). Accounting for research and development costs. Review of Business, 26, 2 , 42-47

 

New Zealand Equivalent to International Accounting. (2004). Intangible Assets. (NZIAS 38).

 

Kieso, Donald E., Weygandt, Jerry J. & Warfield, Terry D. (2009). Intermediate Accounting. (14th edition). USA: John Wiley & Sons.

 

International Accounting Standards Committee. (1989). Frame for Preparation and Presentation of Financial Statements.

 

Stice, Earl K., Stice, James D. & Skousen, K. Fred (2008). Intermediate Accounting. (17th edition). USA: South – Western Cengage Learning.

 

Hooper, K., Davey, H., Liyanarachchi, G. & Prescott, S. (2008). Conceptual Issues in Accounting: A New Zealand Perspective. Melbourne: Cengage Learning.

Deegan, C. & Samkin, G. (2011). New Zealand Financial Accounting. (5th edition). Auckland: McGraw-Hill.