Financial Accounting For Business Organizations: Shortfalls And Overstatement Of Profit

Discussing about the shortfall of the current definition for liabilities

Discuss about the Financial Accounting for Business Organizations.

This study is based on the subject of financial accounting. During this study, the focus is made on the current approach that the business organizations follow to accounting for the liabilities. In the beginning, the study discusses and analyzes the shortfalls in the current definition of the liabilities in the modern business context. At the same time, the discussion focuses on the influence of current accounting approach to the liabilities on the profit overstatement. After that, the study analyses whether the definition or the current accounting approach for the liabilities needs to be changed or not. Proper justifications are provided for each argument in the study.

As per the current approach for liabilities accounting, liability refers to the economic benefits in terms of future sacrifice that an organization is liable to pay to other party or other organizations against the past transactions (Scott 2016). The resultant liability transactions or events should be settled between the parties that involves transfer of assets, use of assets, provision of business services or transfer of funds. Liability is considered as an obligation that is legally binding that incorporates accounts payable, interest payable, accrued liabilities and other payables (Rosen 2016). Besides, accounting of liabilities requires a company to recognize the amount of liability as a credit balance in the account of liability. However, accounting of liability requires to classify the liabilities as per the nature and type of obligation that is classification as per short- term and long- term and contingent liability (Arnold, Harris and Liu 2016). In several cases, liability also includes environmental liability, which refers to an obligation resulting in future payments because of the past transactions or if the liability resulted from the harm caused by environmental damage. Liabilities also include contractual obligations, deferred revenues, deposits for customers and other outstanding payments.

It can be said that the accounting of liabilities should be done appropriately by considering the relevant definition stated in the principles and standards of accounting. Many organizations fail to recognize the liabilities appropriately due to several shortfalls in the liabilities definition when it is applicable to the potentially negative environmental situation (Penner, Kreuze and Langsam 2016). Current definition of liability states that liabilities occur as present obligation due to past events, which does not provide clear understanding to many organizational management and therefore fails to recognize as and when it occurs. For instance, liability occurred with respect to interest payable against the amount of term loans borrowed from bank is required to be recognized as liability since the end of the first year. However, due to lack of clear understanding of definition of liability, organizations fail to recognize the liability on interest payable in the first year (Kumar and Misra 2016).

Another shortfall in the current definition of liability consists of clear understanding on classification of liabilities as per the nature and terms of occurrence. Accounting of liabilities depends on the nature of liabilities that involves short- term, long- term and contingent liability. There are certain liabilities arise as contingent liabilities that are disclosed under notes to the accounts in the financial report and not in the income statement or balance sheet (Song 2016). Considering the current definition, many organizations fail to classify liabilities appropriately that results in incorrect recognition in the financial statements. Shortfall in the current definition of liability involves lack of providing importance and impact on the cash flow of the organization results in inappropriate accounting in the financial statements (Irwin 2016). Such shortfall in the definition of liability provides impact on the organizational financial statements when the same is applicable to the environmental situations that are potentially negative.

Overstatement of profit due to shortfall in definition of liabilities

Liabilities are considered to be one of the essential components of financial information which represents the financial position of the organization in terms of amount of obligation that company owes to other parties (Parmar 2016). Accordingly, it is important for the organizations to recognize and represent the transactions of liabilities to provide true and fair financial position during the financial year. Inappropriate of accounting for liabilities result in misstatements in financial statements that represents incorrect profitability and incorrect financial position of the business organization (Jörgensen 2016).

In case the transaction of liability is not recognized by the organization for the accounting year in which the liability actually occurred, then the financial statements would not reflect the correct financial information (Mudel 2016). For example, if the amount of liability occurred during the current financial year, it is required to be recognized in the current year’s financial statements as per the requirement of liability’s definition. However, if the organization fails to record the amount of liability as and when it occurs i.e. in the current year, the financial statement would be reflecting inappropriate result while the profits would reflect overstated balance (Ratnatunga 2016). Further, inappropriate recognition of liability that may occur due to probable mistakes in identifying the transactions as liability would result in overstatement of profits. Provisions on assets or bad debts include liability that should be recognized as current liability in the statement of financial position. Therefore, if the organization commits mistake in measuring correct amount of provision, then the operating activities would be recognized at higher cost resulting in overstated profits during the financial year.

Other liabilities involve identification of contingent liability inappropriate accounting of which results in overstatement in organizational profitability. As per the definition of liability, contingent liability refers to the potential obligation that occurs due to tentative future event, amount of which is estimated on reasonable basis and disclosed in the financial statements under the notes to the accounts (Weidner 2016). Accordingly, if the organization fails to recognize the contingent liability correctly as well as fails to determine correct amount, then the cost of respective event would reflect lower balance and therefore, amount of profit might reflect overstated balance (Bhasin 2016). In addition, there are certain transactions occur in the business activities that represent both the feature of cost and liabilities.

Hence, the organization is required to classify correctly the cost and liability component because recognition of cost affects the income statement while liability component affects the statement of financial position. Accordingly, if the cost component is included in the liability component of the transaction, the same would be recognized in the balance sheet instead of income statement and consequently, the same would reflect overstated profits. Moreover, overstatement of profitability in the financial statement of the organization results due to lack of creating correct provisions on debtors i.e. provision for bad and doubtful debtors (Moehrle et al. 2016). Considering the sales transaction of the organization, it includes credit sales for which provision for doubtful payments and bad debts is required to be estimated and recognized as liability. If the organization fails to estimate such provision, amount of sales would be recognized at higher value reflecting overstated profit.   

Importance in accounting if it fails to capture the information

Identification of liability is important for appropriate accounting, information of which reflects true and fair view of the company’s financial performance as well as financial performance. As the amount of liability represents the company’s total obligation to be paid in future due to past events, it is recorded in the statement of financial position based on the reasonable estimates and historical judgments (Mudel 2016). Correct identification and accounting of liabilities in the business organization is particularly relevant during the potential impact of the environment on production and disposal of materials in the manufacturing process. It is essential to recognize the correct value of costs and liabilities even in the operating activities for the purpose of determining correct financial information of the company (Song 2016).

In case, the accounting of the company fails to capture the relevant information on appropriate understanding of liabilities it matters because incorrect understanding would result in wrong estimation of liabilities that would affect the true result of financial performance. If the organizational accounting fails to capture the information on appropriate recognition criteria of liabilities in the current financial year, it will disclose incorrect accounting balance in the financial statements i.e. income statement as well as balance sheet (Moehrle et al. 2016). As per the principles and standards on accounting, it is essential to recognize the transactions and financial information at fair value and as per the best estimates so that the true and fair result can be obtained (Ratnatunga 2016). Further, in case the liabilities with respect to provisions on doubtful debts or long- term liabilities is classified and recorded incorrectly, the same would result in overstated profit and false information to the present and potential investors. Accordingly, organizational accounting is required to understand the concept of definition of liabilities to recognize it in correctly so that the transparent financial information can be determined.

However, failure to capture the appropriate information on accounting of liabilities may occur especially during the negative environmental situation that results in presenting correct business information in terms of social and environmental impact. Such misrepresentation affect the sustainability of the organization as it is disclosed in the sustainability report for the current financial year. Misrepresentation of liabilities in the statement of financial position of the company reflects incorrect financial result as well as incorrect amount of obligations that the company owes to other parties. Such misappropriation represents incorrect information on current ratio; cost of capital that involves long- term debt along with the weighted average cost of capital. Further, in case the amount of short- term liability or long- term liability is classified as contingent liability, then the same would be eliminated from the accounting of financial statements and disclosed in the notes to the accounts. Such error in considering and classification of liability would overstate the profit and reflect inappropriate financial information to the investors and other stakeholders.

As per the current definition liability stated by International Financial Reporting Standards, a liability is the present obligation of the business organizations, which is resulting from the past events and which is expected to cause the outflow of the firm’s resources in order to gain some economic benefits (Demerjian, Donovan and Larson 2016). However, as identified in the above discussion that there are some shortfalls in the current definition of liability that the business organizations follow. In the discussion, it has been identified the current definition of liability does not provide any clear classification regarding the short-term liabilities, long term liabilities and contingent liabilities (Metzger 2016). Due to this, sometimes the actual financial position of the company is not reflected by its financial statements or report. This indicates that the definition of liability must provide the clear guidance that how the business organizations or accountants should classify the liabilities in to short term, long term and contingent liabilities (Oulasvirta 2016). This will make the accounting tasks easier and at the same time, this will also help the business organizations disclosing their actual financial position clearly (Myers 2016). At the same time, the reliability of the financial statements of the company will increase more (Couch and Wu 2016).

The above discussion has also mentioned that in the current definition of liability, nothing has been mentioned about the time duration within which the business organizations must account for their liabilities. If the current definition of the liability is analyzed critically, then it can be identified that in that definition, it has been mentioned that the liability is the present obligation of the business organization, which is resulted from the past activities (Kahiya and Kahiya 2017). This may confuse the accountant or the business organizations regarding the timing within which they must account for the liabilities. Therefore, it is very important to specify the timing to account for the liability in the definition of liability.

However, in this context, Wu et al. (2017) mentioned that when the companies are accounting for the transactions for a particular financial year, it is obvious that they must account for their liabilities in the same year in which the liabilities have generated. From this point of view, it cannot be said that there is any mistake in the current definition of the liability for which the definition needs to be changed. On the contrary, Cade, Ikuta and Koonce (2016) stated that the understanding of each person can differ. Hence, if the definition is not clear then the accounting techniques, which are based on the human understandings, may also differ. Apart from these, the above discussion has also stated that the current definition of liability does not provide any clue regarding the impact of liability on the cash inflows of the organization. The companies sometimes do not account for the liability fully in the year, in which the liability has been generated (Swieringa 2016). The companies do this in order to overstate their profits. It does not increase the cash inflows of the organization (Bolla, Wittig and Kohler 2016). However, if the definition itself indicates the impact of liability on the cash flow of the organization, then it may stop this kind of activity.

Therefore, from this discussion, it can be said that current definition of liability must be changed and the new definition must consider the factors like, classification of liabilities, impact of liability on the cash flow and the time span within which the company must accounting for the liabilities.

In the above discussions, it has been identified that current definition of liability does not provide complete guideline to the accounting for liabilities. The discussions have also indicated the definition of the liability must be changed so that the accounting for the liabilities can be done more accurately. However, if the liabilities are accounted or captured accurately, then some complexities may take place for the accounting and businesses. One of the broader ramifications that may take place for the accounting and businesses is – the business organizations cannot hide any situation in which the business organization earns less profit (Grahn and Bigus 2016).

Sometimes, it happens that in a particular financial year the performance of the company is down and the liabilities of the company is high. Due to this, many shareholders and investors of the company stop to invest more funds in that business (Mokhtar, Jusoh and Zulkifli 2016). Due to this, the financial health of the company becomes weaker. In order to avoid this kind of situations, the business organizations overstate the profits by showing less liability. However, if the liabilities are accurately captured, then the companies cannot overstate the profits by lowering down the liabilities (Fornaro, Lange and Lucido 2016). Hence, the actual situation will be in front of the stakeholders and that may affect the financial health of the organization negatively.

The proper accounting for the liabilities of the organizations may also de-motivate the new investors or stakeholders (Alrazi and Husin 2016). If the accountants in the business organizations account accurately for the liabilities, then the actual obligations of the business will be clear to the new investors or potential investors. If the liabilities of the company are high, then the potential investors may feel that their investment will not be safe in that company (Bolla, Wittig and Kohler 2016). On the other side, the existing shareholders and investors may feel that their current investment is not secure and due to this, they may back out from the further investment.

The accurate capture of the liabilities can also make the accounting for liabilities more critical. If the accountants of the companies account for the liabilities accurately, then they will require more knowledge regarding accounting techniques, classifications of liabilities and their impacts on the financial position of the company. At the same time, the accountant will also require detailed analysis of each liability, which will be more time consuming as well as costly (Grahn and Bigus 2016).

Moreover, the proper accounting for the liabilities will make the accounting more complex to understand. The stakeholders especially the shareholders of the companies, who are not accounting experts, will not be able to clearly understand the accounting for the liabilities (Kahiya and Kahiya 2017). If the shareholders cannot understand the financial reports due to the accounting complexities, then the companies will not be able to convince them for investing their money in the business. This will be huge loss to the company, which will affect not only the current financial position, but also the future financial position of the company.

Therefore, from the above discussion, it is clear that if the liabilities of the companies are captured accurately, then several problems or ramifications may take place. Due to the ramifications the financial position of the company may decline, which will not be acceptable to any business organization.

Conclusion

In this study, it has been identified that the current definition of liabilities has some shortfalls due to which many problems take place within the business organizations. The major shortfalls that the study has identified in the current definition of liability are – the current definition does not provide any classification of liability, though actually there are three different types of liabilities – short term liabilities, long term liabilities and contingent liability. Another shortfall is not proper time span is mentioned within which the liabilities in the business organizations must be accounted. The study has shown that this shortfall sometimes confuses the accountants regarding the time within which the accounting for the liabilities must be done. Due to these different problems or shortfalls, the study has suggested that the current definition of liability must be changed and some modifications must be made in the areas where the current definition has loopholes.

The study has also identified that if the liabilities of the companies are accounted properly, then also some problems or ramifications may take place. The major complexity that may take place is regarding the financial position of the companies. The study has stated that if the liabilities are accounted accurately, then the actual financial position of the company will be clear to every shareholder or investor and if the liability of the company is high, then the shareholders may not be agreed to invest their money in the company. At the same time, the accurate accounting for liability may increase the complexity of accounting.

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