There are certain rules and regulations that has been set up so that the companies can prepare the financial statement having a true and fair view. These rules have been set up by different authorities all over the world in order to maintain consistency and certainty. Apart from the general rules and regulation there are various accounting standards that have to be complied with. It was observed in the past years that many entities tried to manipulate with the financial information that misled the users of the financial statements. In order to solve this problem, accounting standards were set up. Therefore, it has been now made compulsory to follow all the accounting standards properly and reflect a fair picture of the financial statements. (Antle, Garstka and Sevigny, n.d.)
A proper financial statement is considered to be the one in which all the material facts has been disclosed in compliance with the accounting standards and also there should not be any kind of concealment of facts which is regarded as an unethical activity on the part of the management and may affect the goodwill of the company adversely.
The entities first should have knowledge about accounting policies and the situation in which there is a change in accounting policy and how it should be disclosed in the financial statements. We can understand the case better when we have prior knowledge about all these. Accounting standards 108 and 116- Accounting policies, Changes in the accounting Estimates and Errors has been laid down by the Australian Accounting Standard Board. This standard helps to provide guidance in the application of the accounting policies. A company must not make any changes in the accounting policies without referring to the accounting standards. (Bebbington, Gray and Laughlin, 2011)
An entity must maintain consistency in maintaining these accounting policies that has been laid down by the accounting standards. It can change the accounting policy if any other accounting standard demands it. (Berry, n.d.)
An accounting policy can be changed in the following circumstances:
The accounting policy that should be adopted depends on the nature of the transaction and such accounting policy should be selected based on the relevant accounting standards. However, the consistency must be maintained (CAANZ. and Kemp, 2017). It is important to maintain consistency as it helps the user of such financial statement in comparing the performance and financial positions of the company with the past trends, in reflecting the profitability and net cash generated from time to time. Therefore, the company must not make any changes in the accounting policy until there is any one reason that has been mentioned above.
There may arise many situations when even if there is a change in process or method it will not be considered to be change in the accounting policies (Chaudhry, n.d.). Like, if there is a transaction that was recorded in the past would have a different accounting policy for the similar transaction if the substance of the transaction is different. There may be some transactions that were not recorded earlier as they did not have any materiality but subsequently these transactions became material and adoption of accounting policy became necessary. Such adoption in the subsequent period is not considered as change in the accounting policy.
The adjustments that are made in the valuation of various assets and liabilities is known as change in the accounting estimate. This adjustment is made when new information has been received and therefore, this change cannot be regarded as correction of errors. There can be change made in the accounting estimate when the situations in which the estimates were made has changed.
The entity making any kind of changes in the accounting estimate must disclose such changes in its financial statements in the same year in which the change has been made. The entity should also disclose the effects that it may have in the future periods. In case, it I impracticable to disclose such change then the company must state such facts in the reports of the company. The change in accounting period should be accounted for in retrospective period whereas any change in the accounting estimate shall be accounted for prospective period (Spiceland, Thomas and Herrmann, n.d.).
Now, from the above information we have clearly understood how the accounting policy and accounting estimate differ from each other. The situation that has been provided to us shows that the entity has made a change in the depreciation method. Hence, it is regarded as the change in the accounting estimate and not a change in the accounting policy. The disclosure of such changes should be made by the entity.
The charge created on the various long term tangible asset of the company is known as depreciation. The assets are depreciated because of continuous usage, technological advancements or due the efflux of time. The assets should be valued at fair price in the financial statement so that the users of the financial statements know about the stability of the company. The fair value is computed by deducting depreciation from the carrying amount of the asset. This depreciation is charged on the debit side of the profit and loss account. A special accounting standard has been laid so that no companies can manipulate with the profits and take wrong advantages of it. The entity must maintain consistency with the method of depreciation.
Depreciation can be charged using different methods but the company should adopt the method which is most appropriate. A company must adopt the method which will reduce the fraudulent activities and give true picture of the entity’s financial position.
The rate of depreciation should be based on the latest information that are available and it can be reviewed every year. The factors that may affect the rate of depreciation is the change in useful life of the asset or if the asset has shown changes in the derivation of economic benefits to the business.
There are many methods through which depreciation can be calculated:
In order to determine depreciation through straight line method, we need to deduct the salvage value from the carrying amount and the resulting figure obtained should be divided by the remaining useful life of the asset. The amount obtained is divided in the assets. To understand the concept of straight line depreciation, let us take an example. Suppose, there is an asset whose value is $200000 and the salvage value is $10000. The useful life of the asset is estimated to be 10 years. The depreciation in this case shall be $(200000-10000)/ 10 = $19000 per year. The amount of depreciation remains constant over the years.
In order to understand the concept of this method clearly we need to follow an example. Suppose there is a machinery in a factory which cost $32000, salvage value of this machinery is determined to be $2000 whereas the life of machine is 5 years only. Now, we need to sum p the number of years i.e. (1+2+3+4+5) = 15. In the first year the depreciation that should be charged is 5/15*30000= $10000. In the next year, the depreciation that should be charged is 4/15*30000= $8000. Therefore, we can conclude that the depreciation charged in the first year is the highest and it goes on decreasing over the years.
The given case clearly shows that Sunshine co. used to follow straight line method of depreciation. It is expected by the management of the company that the company will be able to acquire huge profits in the coming two years but after that two years the economic condition of the company will not remain as good as it was. It is desired by the management to have consistent profits over all the four years. They went to Maria, the accountant of the company to provide them with some idea. Maria is a little scared of losing the contract with the company and so she thinks that the only way is to change the depreciation method. He decided that he would discontinue applying straight line depreciation and would now charge depreciation according to the sum of year’s digit method. She did not make any disclosure in relation to such change as she is of the view that such change will in no way affect the shareholders of the company.
It has been clearly stated in the accounting standards that the change in the method will also be considered as a change in the accounting estimate (Harrison, Horngren and Thomas, n.d.). As we can see, that there is no change in the circumstances still the method of depreciation has been altered in order to manipulate profits. Maria’s decision to change the method is totally unjustifiable. The fact and the effect of such change should be clearly mentioned in the financial statements of the company. Since, Maria has failed to do so it is assumed that material facts have been hidden from the shareholders in order to misguide them. The monetary effect shall also be distinctly stated in the reports. However, there may arise a situation when the effect of such change is unascertainable. Then in such a case the fact should be clearly stated in the statement.
It is totally a wrong decision to change the depreciation method in order to manipulate with the profits. The company should never adopt such unethical practices as it will lose the confidence of the shareholders and there will also be a loss of reputation which could severely affect the company’s performance (Greuning, Scott and Terblanche, 2011). The company must prepare its financial statement in such a way that all the material information can be obtained from it. However, in the same situation if there was no wrong intention the company was allowed to change the depreciation method. But even then correct and appropriate disclosures were required to be made. Providing correct information to the shareholders is considered very important as they hold a interest in the company by investing their money in it. It is very difficult for the company to survive in the market if it misleads its shareholders by providing them with wrong information.
Conclusion
In the given case study, the management wants Maria to reflect consistent profits in the financial statements although the real fact is something different. Maria needs to take some unethical steps in order to keep the contract ongoing which is completely wrong. There should not be any manipulation in relation to the profits because such information are considered very important for the shareholders in order to take decisions.
Even if it was that Maria did not know about their intention she should have informed them about the various evil practices. Maria is a professional accountant and she should be well informed of complying with the accounting standard and its consequences. As the accounting standard says that all the information should be correctly stated in the financial statement in order to give a true and fair picture of the financial position. However, the company must not coceal any facts that are mandatory to be disclosed. Both the cause and the effect should be clearly stated in the reports.
References
Antle, R., Garstka, S. and Sevigny, K. (n.d.). Questions, exercises, problems, and cases to accompany financial accounting. 1st ed. Mason, Ohio: South-Western.
Bebbington, J., Gray, R. and Laughlin, R. (2011). Financial accounting. 1st ed. Australia: Cengage Learning EMEA.
Berry, A. (n.d.). Financial accounting. 1st ed. London: International Thomson Business.
CAANZ. and Kemp, S. (2017). Auditing, assurance and ethics handbook 2017 Australia. 1st ed. Milton, Qld: Wiley.
Chaudhry, A. (n.d.). Wiley 2016 interpretation and application of International Financial Reporting Standards. 1st ed.
Greuning, H., Scott, D. and Terblanche, S. (2011). International financial reporting standards. 1st ed. Washington, D.C.: World Bank.
Harrison, W., Horngren, C. and Thomas, C. (n.d.). Financial accounting. 1st ed.
Spiceland, J., Thomas, W. and Herrmann, D. (n.d.). Financial accounting. 1st ed.
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