Choice of accounting policies

Introduction

Australia follows the principle-based accounting standards which gives the preparers the options to choose among the accounting policies and highlight the reporting under substance over form (Psaros, 2007). Unlike the rule-based accounting, under principle based accounting method there is a high chance of exercising the creative accounting. “Studies have shown that accounting choices are influenced by a range of contracting, financing and operational factors (Shah, 1998, p. 83)”. In this backdrop the purpose of the report is to analyse the choice of accounting methods of a selected company in Australia.

Overview of the selected company

South32 Limited (hereinafter referred to as South32) is a group of companies which were part of BHP Billiton Limited (BHP) prior to its demerger in May 2015. Since then South 32 is formally demerged and standing alone as a separate entity listed in the Australian Stock Exchange (ASX) and London Stock Exchange (South32, 2015; BHP, 2015). At present the company is among the top 20 ASX companies and has a weight of 2.06 (compared to 10.67 for BHP) in the total capitalization in ASX 20 List as of 1 May 2018  (ASX 20 List, 2018).

South32 is a diversified company engaged in mining and metal with its presence in South America and South Africa and having its corporate office and operations in Australia. It has an employee base over 14,000 in 7 locations across the globe. The gross revenue of the group is mainly generated through the group production and third party production where the net margins from those are significantly differ. As such, Financial Statements (FS) report the net profit or loss from these two main sources separately. The company have expected a deterioration of commodity prices in the global market and this has in part contributed to the loss reported in 2015 and 2016. Since their demerger from BHP in 2015, this might have created a pressure to the management of group. 2017 is the first year the company made a positive net income after the demerger.

Part A; Accounting Policy Choice and Creative Accounting

Creative Accounting Example No.1: Accounting Policy Choice

Identification

AASB 116 on PPE has given the option to choose cost or revaluation. South32 used the cost model in the measurement after recognition of PPE. Proponents of fair value model advocates that far value model can yield more relevant information to the users of the FS (Mandilas, Kourtidis, & Demitriades, 2013; Palea, 2014) and increase the transparency (Palea, 2014). Further revaluation of PPE could resolve the issues caused through information asymmetry (Brown, Izan, & Loh, 1992; Mandilas, Kourtidis, & Demitriades, 2013) and studies have shown that this method could thus enhance the wealth of the shareholders (Aboody, Barth, & Kasznik, 1999).

On the other hand opponents highlighted that fair value model will compromise the reliability quality of accounting information (Cotter & Zimmer, 1995). The prior literature suggests that the firms who has higher gearing or seeking debt financing opt to report PPE under fair value method to enhance the perceived borrowing capacity (Barlev, Fried, Haddad, & Livnat, 2007; Cotter & Zimmer, 1995; Barać & Šodan, 2011; Brown, Izan, & Loh, 1992; Iatridis & Kilirgiotis, 2011).

It was noted that South32 has 31% gearing ratio and not shown any obvious signs of leverage issues. Further it was observed that PPE account for 80% of the total non-current assets. Given the negative net profit reported for the past years South32 has a perceived pressure to reduce the expenses. In this light if the company were to follow the fair value method and cost to be significantly different to the fair value, the company will have negative effects on the reported income.

For instance, if the PPE to be revalued upwards the increase in the PPE will cause higher depreciation and will further deteriorate the profits. If the PPE were to have a downward revaluation there will be recognized in the profit and loss unless “the decrease shall be recognised in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset” (AASB 116, 2015, p. 22). Thus, fair value method can result in weakening the financial performance though it could lead to strengthen the financial position if the assets are to be revalued upwards.

It was further noted that South32 has followed the straight line method to depreciate the plant and equipment. Even though plan and equipment do not generate the same level of income over the 30 years it intends to use straight line method rather than more realistic reducing balance method. Since the demerger in 2015 the firm has followed the straight line method. If the reducing balance were to be followed the financial performance of South32 could be much worse than it had reported in the early years. This too cast a doubt as to the selection of the accounting policies to portray a picture that management purport to depict.

Reasons

As Gordon (1964) suggests management put their interest before owners and select accounting policies that could maximise their own benefit. As per his income-smoothing hypothesis, “a management should within the limits of its power, i.e., the latitude allowed by accounting rule, (1) smooth reported income, and (2) smooth the rate of growth in income” (Gordon, 1964, p. 259). South32 FS has reported a profit and paid dividend for the first time in 2017 since the demerger from BHP. This suggests that management has the perceived pressure to report the profits in order to smooth the profits.

According to Gorden, management assumes that their welfare will be increased at a greater rate when the owners have a greater satisfaction. He further stated that when owners are dissatisfied with management performance, the increase in the owners’ satisfaction will increase the management welfare at a greater rate than it had when the owners were already satisfied with the performance. On this grounds it could be argued that management had a pressure to report a profit in the 2017 due to the loss reported in the previous 2 years. Thus, the management used the cost model in the measurement after recognition of PPE, which will reduce the risk of having a negative impact on the income statement and greatly assist in income smoothing. Similarly, the straight line depreciation method also reduce the fluctuations in profits from one year to the other in a great deal.

Creative Accounting Example No.1: Disclosure for Influencing Interpretation

Identification

As part of IASB project to enhance the financial reporting, AASB 2015-2 Amendments to Australian Accounting Standards disclosure initiative was introduced. Among the amendments was the Amendments to AASB 101 in 2015 January. Though the standard will come into effect after 1^st January 2016, entities are permitted for an early application. This amendment has removed certain mandatory disclosures and emphasised only on material disclosures. Further it went on to supersede the mandatory minimal requirements in a standard and highlighted that an entity is not mandated to report on the prescribed disclosure if it is not material. This amendment has further broaden range of choices and has given much latitude to the preparers in the choice of disclosure and reporting of FS.

It was noted by perusing the annual report (2015), South32 has early adopted (AASB 101, 2015-2) for the financial year 2014-15 when it fact the standard will be in effect in 2016. Unsurprisingly amendment to that AASB 101 has provided more opportunities for South32 to restrain from disclosing certain information to the public on the grounds that it is not material as per application of new amendment to AASB 101. This clearly shows the opportunistic behaviour of the management by early adaptation of such amendments to their advantage.

It was further noted that in the same year the company has not opted to early adoration of other standards and interpretations such as AABD 9, AASB 15 which have profound effect on the reporting given the nature of the business. Similarly, in 2017, management has decided not to early adopt the accounting standard amendments such as AASB 107 AASB 9, AASB 16, inter alia.  This behaviour of portrays that when there is an option of the timing of the adoption of an accounting policy the management will early adopt the ones that is advantageous to them and differ the adoption of other pronouncement until it is effective date.

Reasons

Managers are more likely to early adopt a mandatory standard if it can be used to their advantage (Sweeney, 1994; Affes & Callimaci, 2007). Reducing the disclosures in FS increases the information asymmetry between management and external owners. Information asymmetry could assist managers pursuing their self-interest, as explained in the neoclassical theory, at the expense of owners. Information asymmetry and self-interest will in turn increase the opportunistic behaviour of management and increase the agency problem.

Materiality can be used as a ploy to conceal information which could otherwise draw the attention of readers (Henderson, et al., 2014). Thus, by early application of a standard to reduce the disclosure is motivated by the need to conceal the information. The opportunistic behaviour of the management is “expected to decrease in investor protection because strong protection limits insiders’ ability to acquire private control benefits, which reduces their incentives to mask firm performance” (Leuz, Nanda, & Wysocki, 2003).

Creative Accounting Example No.2: Disclosure for Influencing Interpretation

Operating cash flow (CF) can be reported either under direct method, where it requires cash payment and receipts to be reported under major classes; or indirect method, where profit(loss) is adjusted for non-cash items, accrual accounting treatments, and non-operating income and expenses. This has given an option for entities to choose among direct and indirect method. However, AASB 107 (2015) emphasises the importance of direct method and it “provides information which may be useful in estimating future CFs and which is not available under the indirect method (AASB 107, 2015, p. 8)”. Despite AASB promoting the direct method, which enhances the reporting quality (Hassan & Christopher, 2007; Bond, Bugeja, & Czernkowski, 2012; Monsen, 2001; Hughes, Hoy, & Andrew, 2010), South32 followed the indirect method of as it could reduce the disclosure of the information.

Reasons

This decision could be seen as an opportunistic behaviour to use the choice of accounting standards to gain the benefits. Hassan & Christopher (2007) found that if a firm follows the direct method the firm value could be maximised through acting as a quality signalling. They further stated that this decision is influenced by managerial efficiency of the firm and financial risk, inter alia. Thus, in this grounds it could be argued that in order to reduce the disclosure of the management inefficiency and financial riskiness South32 has followed indirect method to report CFs from operating activities.

On the other hand another reason for adopting such an option could be to conceal information which could otherwise be revealed. Although owners the debt providers wish to gain more information, management could gain the advantage of information asymmetry. As noted in the previous section the key management also owns shares of South32 by way of share ownership schemes. “Insiders, such as controlling owners or managers, can use their control over the firm to benefit themselves at the expense of other stakeholders” (Leuz, Nanda, & Wysocki, 2003). When sensitive information is not released to market management can engaged in insider trading activities.

Part B; Accounting Policy Choice and Opportunistic Behaviour

Opportunistic behaviour

The most incriminatory evidence for the opportunistic behaviour of managers selecting accounting policies to enhance their own benefits by compromising the others is the use of policies relating to PPE. South32 management has used cost model in the measurement after recognition and the straight line method of depreciation of PPE though it does not reflect the “pattern in which the asset’s future economic benefits are expected to be consumed by the entity” (AASB 116, 2015, p. 26).

This opportunistic behaviour is prompted as the preparers of FS are influenced to portray a picture that matches the results expected by the outsiders.  In this backdrop the role of financial acumen has been discussed by (Gordon, 1964). The “management of a corporation should seek to maximize its wealth, the accountant should not be subordinated to this objective. He should simply report what has happened but that is the nub of the problem” (Gordon, 1964, p. 259).

In review annual report of South32 it was noted that key management personnel receive around 50% of their total compensation through share based payments and only 29% of the executive remuneration is fixed and the balance is tied to several performance related compensations. Thus, there is an incentive for the management to report profits and enhance the share price. The management pressure has further increased due to the losses reported immediately after the 2 years following the demerger from BHP.

 

Process of contracting

According to positive accounting theory earnings related contract can have an effect on accounting policy choice of the management (Shah, 1998). Cornett, Marcus, & Tehranian (2008) stated that earning management through the use of discretionary accruals could be reduced by governance structure and compensation tied to performance. With reference to governance structure it was argued that institutional share ownership and representation of institutional shareholders in the board can greatly reduce the opportunistic behaviour of the management as a whole. According to them, options compensations encourage the management to engage in earnings management.

In this grounds it could be argued that process contracting could align the interests of the managements with that of the owners and achieving the business activities will then achieve both owners and management objectives. The simplest method to align the interest on the management with that of the owners is to have a management compensation scheme with fixed salary and a bonus tied up to the profits. However, as discuss before this invariably promotes the earning management and opportunistic behaviour.

Having bonding and monitoring arrangements can reduce the opportunistic behaviour (Henderson, Peirson, Herbohn, Artiach, & Howieson, 2014). Under bonding strategy agreements can be entered into specifying the costs that can be incurred by management. Further, this could specify the choice of accounting policies and the use of assumptions in computing relevant accounting estimates. With regard to the monitoring, such as internal auditing, external auditing and periodic reporting could be introduced. Though these could eliminate opportunistic behaviour, it will entail agency cost.

Conclusion

The purpose of this report is to study the choice of accounting methods of a selected company in Australia, where the principle-based accounting is practiced. In the review of the FS of South32 revealed that there the management has used the choice of accounting policies for creative accounting. Firstly, it was noted that PPE has been measured after recognition under cost method where as fair value method could yield more realistic picture of the valuation of the assets. Further, the straight-line method has been used though it failed to depict the manner in which its future economic benefits are expected to be utilised. The reason behind this could be the management pressure to report positive net profits and to engage in income smoothing behaviour for their own advantage.

Secondly, the entity has early adopted the standards that reduce the disclosure requirements and deferred the adoption of the other standards till the effective date. Finally, when referring to the reporting of cash flows it was observed that even though the accounting standard encourages entities to use direct method of reporting operating CFs South32 used indirect method. Reasons for these two behaviours could be to create information asymmetry and gain benefits. Finally, the opportunistic behaviour of the management has been identified and different bonding and monitoring methods have been proposed to address this issue.

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