Accounting and financial reporting standards

The pollution produced by companies which operate in less developed countries in ways they could never do at home, in those countries in which they raise their capital: We note that often the businesses that operate this way are multinationals. They do here what they would never do in developed countries or the so-called first world.  Pope Francis

Yesterday marked the fifth anniversary of the “Accountability Watch” column. The first article, entitled “Understanding Corruption”, was carried on 4 June 2012. To date, a total of 257 articles on various topics relating to governance, transparency and accountability have been published, of which 181 were reproduced in book form in two volumes: “Accountability at the Crossroads: The Guyana Experience” and “Governance, Transparency and Accountability”.

I had the good fortune recently of watching on YouTube a presentation by former U.S. Vice-President Al Gore entitled “An Inconvenient Sequel: Truth to Power” based on a soon to-be-released film.  Some eleven years ago, Al Gore had won the Nobel Peace Prize for his earlier film “An Inconvenient Truth” in which he highlighted the stark reality of the catastrophic consequences of climate change due to global warming, including extreme droughts, record-breaking downpours and melting Arctic ice. In this presentation, the former Vice-President was somewhat more optimistic when he stated that “The exciting new reality depicted in this film is that in a growing number of areas around the world, it is now cheaper to get electricity from the sun and the wind… than it is to continue using the dirty, polluting fuels of the past…We have the solutions now, and the remaining task is to summon the political will to implement these solutions quickly enough.”

That optimism may have been tempered by the disappointing news that the United States would withdraw from the Paris Agreement entered into in 2016 by 195 countries to limit the use of planet-warming fossil fuel. Parties to the Agreement are to take appropriate measures to keep global temperature rise this century to well below 2 degrees Celsius (3.6 degrees Fahrenheit) above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. According to the United Nations Framework Convention on Combatting Climate Change (UNFCCC), the Agreement aims to strengthen the ability of countries to deal with the impact of climate change by putting in place appropriate financial flows, a new technology framework and an enhanced capacity building framework, thus supporting action by developing countries and the most vulnerable countries, in line with their own national objectives. It also provides for enhanced transparency of action and support through a more robust transparency framework. The announcement by the United States is therefore a significant setback for the achievement of the objectives of the Agreement, considering that the United States is the second largest emitter of greenhouse gases.

The year 2016 was the warmest year on record with a 1.1 degrees Celsius above pre-industrial levels; carbon levels in the atmosphere breaking new records; and sea-ice coverage reaching new lows and sea levels new highs. According to researchers, based on current trends, some of the world’s cities may be as much as eight degrees Celsius (14.4 degrees Fahrenheit) warmer by 2100. Such a temperature spike can have dire consequences for the health of city-dwellers, robbing companies and industries of able workers, and putting pressure on already strained natural resources such as water. Nearly five degrees Celsius would be attributed to global warming while the rest would be due to heat-conducting concrete and asphalt replacing cooling parks, dams and lakes. According to Pope Francis, “We were not meant to be inundated with cement, asphalt, glass and metal, and deprived of physical contact with nature”.

Today’s column is devoted to a discussion of accounting and financial reporting standards.

Accounting and financial reporting standards in perspective

Accounting standards are fundamental principles that an organization follows in recognizing, measuring and recording financial transactions as well as in periodically presenting and disclosing them in a set of financial statements comprising income, expenditure, assets and liabilities. They are in effect codes of practice developed by professional accounting bodies to facilitate uniformity of practice and consistency in the accounting treatment of transactions, and in presenting the results of operations and financial position of the organisation. They also aid comparability among organisations of a similar nature as well as across a wide variety of organisations.

An organisation can become bankrupt in the belief that it is making profits and distributing them to the owners whereas in fact it has been making losses when applying accounting standards. One recalls the Enron and WorldCom scandals where profits were inflated through the accounting chicanery of deliberately shifting operating expenditure to capital expenditure. The reverse is also true in that profits could be reduced (or losses increased) by deliberately charging transactions that are clearly of a capital expenditure to operating expenditure, especially in relation to intangible assets such as costs relating to exploration, research and development that are normally capitalized and amortised over the expected lives of the assets.

These two scandals have caused the United States to tighten its legislation, especially with the passing of the Sarbanes-Oxley (SOX) Act of 2002.  SOX provides for the establishment of a Public Company Accounting Oversight Board as well as enhanced standards for auditors’ independence, especially as regards conflicts of interest. In addition, the Act creates a firewall between the external audit function and other non-audit services traditionally provided by the same auditors, such as bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial services, and internal audits. It also strengthens the role of audit committees mainly in terms of reporting relationship of auditors; provides for the rotation of audit partners every five years; offers protection to whistleblowers; and makes it mandatory for audit workpapers to be maintained for at least five years.

Types of accounting standards

There are three main types of accounting standards that are recognized internationally:

  1. International Financial Reporting Standards (IFRSs) that are applicable mainly to private sector organizations. IFRSs are the successor to the International Accounting Standards developed during the period 1973-2001;
  2. International Public Sector Accounting Standards (IPSASs) that are used by governments, intergovernmental organizations, and international organizations. Developed since 1997, they are essentially IFRS-based, adjusted as appropriate to meet the specific requirements of government; and
  3. National standards that are promulgated either by the recognised professional accounting bodies in the country or by legislation. The United States, India, South Africa and several other countries have developed their own standards.

Cash basis of accounting versus accrual basis

Traditionally, countries have used the cash basis of accounting for recording and reporting financial transactions of government. Transactions are recognised as expenditure only when payments are made for the supply of goods and services, and for works undertaken, irrespective of when value is received. Similarly, revenue is recognized and recorded only when cash is received and not when the amounts are due to be collected on the presentation of invoices.

The cash basis of accounting is simple to operate and is relatively inexpensive. It also helps legislators in monitoring and controlling expenditure. However, it suffers from several shortcomings. With the emphasis on cash, proper accountability for other assets, particularly fixed assets and inventories, is largely ignored. There is also a tendency of understating liabilities, especially those relating to pensions. In addition, there is often the practice of accelerating expenditure in the closing months of the year to utilize budgetary allocations, or to postpone expenditure to avoid allocations being overrun, thereby facilitating a significant degree of manipulation of the accounts. Further, comparative analysis from one year to the next is difficult, and information about cost is restricted to a mere comparison of expenditure with budgetary allocations.

The other form of accounting is the accrual basis of accounting. This requires transactions to be recorded as expenditure when value is received as opposed to when payment is made. Similarly, recording of revenue is made when goods and services are supplied to customers, as opposed to when payments are received. Detailed accounting rules must be followed, and all income and expenditure as well as assets and liabilities are fully accounted for. Indeed, many of the shortcomings of the traditional cash-based accounting system are obviated using this framework of accounting.

The accrual basis of accounting is superior to cash basis of accounting since it gives a complete picture and provides a fairer presentation of the financial statements in terms of results of operation and financial position. It also facilitates greater transparency and enhanced accountability. Both IFRSs and IPSASs are accrual-based standards.

Status of adoption of IPSAS

Many governments, inter-governmental bodies and international organisations have recognized the limitations of the cash basis of accounting and are in the process of gravitating, or have already gravitated towards accrual accounting consistent with international accounting standards. For example, New Zealand, Australia, USA, UK, Canada, Colombia and France as well as several intergovernmental organizations, including the Commonwealth Secretariat, the European Communities, INTERPOL, NATO and most of the OECD countries, have all adopted full accrual accounting. In addition, all 24 entities that make up the United Nations system-wide operations have fully implemented IPSAS.

According to a recent survey, 75% of OECD countries have adopted full accrual accounting while 25% prepare their budgets on an accrual basis. Similarly, nearly 60% of Caribbean countries have already adopted IPSAS or national accounting standards based on IPSAS. The other 40% are at various stages of the implementation process. Most of these countries are also reforming and modernizing their financial reporting, budgeting, and auditing practices. The study highlighted that while the direct adoption of international accounting standards by national governments remains very low, many standard setters use IPSAS or IFRS as primary or explicit references for developing their national standards.

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