Critical Accounting Essay

Cheap Custom Writing Service

This Critical Accounting Essay example is published for educational and informational purposes only. If you need a custom essay or research paper on this topic, please use our writing services. EssayEmpire.com offers reliable custom essay writing services that can help you to receive high grades and impress your professors with the quality of each essay or research paper you hand in.

Critical accounting involves the application of financial analysis in contexts that are especially vulnerable  to the selective reporting of favorable information. To use critical accounting, an organization  must   have   a   critical   accounting policy (CAP), which dictates how subjective information will be interpreted. The goal is for the CAP  to  define  a  method   that   is  consistent,   is accurate,  and  gives the most  useful “big  picture” view  of  the  place  in  the  market   the  business occupies, rather  than present information in a way that  pleases  the  intended  audience  but  that  may not give them a realistic idea of the organization’s future  prospects.

Pitfalls

Critical  accounting has  the  goal  of  avoiding  the dangers that accompany what is variously referred to  as  smoothing or  slush  fund  accounting.  Both terms  refer  to  a  practice   that   some  companies employ to deal with variations in financial performance from  year to year. There  is a widely held perception that a stable, well-managed company   will  show   consistent   and   predictable growth   in  its  earnings  over  time,  increasing  its profits  each year. This kind  of performance tends to  attract investors  because  it seems to  suggest a secure investment  and, more important, one that is relatively predictable compared with more volatile financial  instruments.

The problem  is that  this type of performance is not   typical   or   even  possible   for   all  types   of businesses,  yet  all  types  of  businesses   want   to appear  to be stable and well managed. To accomplish  this, many businesses seek to set aside assets earned in years that are unusually  profitable and then use these assets to supplement the bottom line in the years when the company  does not  perform  as  well  as  expected.  Some  refer  to  this  as “cookie  jar”  accounting because  it is similar  to a family saving extra money informally by keeping it in a cookie jar until it is needed for an emergency.

Cookie jar accounting may make investors happy in the short  term, but  it tends  to cause major  concerns further  down  the line. This is because it misrepresents  the  financial  position  of  the  company, meaning that any decisions made based on the company’s financial statements are suspect. For example, if a company  made $100 in profits during the first year of its operations, but set aside $50 in its cookie jar, then that  year’s profits  would  appear to be $50.  If the company  earned  only $40  in the second year, but wished to appear continuously profitable, it  could  take  $15  from  the  cookie  jar (leaving $35  in the jar) and  add  this to its bottom line,  so  that   the   second   year’s  earnings   would appear  to be $55—a  10-percent  increase  over the previous year’s profits. This would attract new investors  and  encourage  existing  investors  to keep their money with the company, even though the company’s performance during the second year was poorer  than  in the  previous  year.  For  a time, this trend could continue,  so that  in the third year, even if the  company’s  profits  were  only  $30,  it  could draw from the cookie jar yet again, adding an extra $30 (leaving only $5 in the jar) to the annual  profits, so that  they would  appear  to be $60—another substantial increase  over  the  previous  year’s  $55 profit.  Accountants’ concern  with  this  slush  fund strategy is clear—it misleads the public about  a company’s performance, with potentially  disastrous results.

Critical Accounting  Policies

Critical accounting is frequently  implemented through the  establishment of a  CAP. A CAP has been defined as having two distinct  characteristics. First, it concerns  accounting estimates  that  had  a significant  degree  of uncertainty at  the  time  they were made. This uncertainty may have been due to rapid   changes  occurring   in  the  segments  of  the market  in which the company  is active, difficulties internal  to the company (e.g., the departure of individuals with a large amount of institutional knowledge or the arrival of new staff with their own agendas), or noneconomic factors like political transitions, natural disasters, and so forth. Whatever the source of the uncertainty, the important point is that  it had  the potential to affect the accuracy  of the financial estimates that were made and that the parties making the estimates were aware of the potential effects of the uncertainty.

The  second  component of  a  CAP  is that  the estimates   that   the   accountants  had   to   choose between  because of the uncertainty are important enough so that depending on which estimates were used,  there  could  be  a  major   difference  in  the picture  of the organization’s finances that  emerges from the accounting reports. In other words, CAPs are  not  concerned  with  trivial  uncertainties that could   only   have   minor   effects  on   the   overall financial analysis. For example, an international shipping  company  with a fleet of delivery vehicles naturally will have some uncertainty about  its performance because on any given day some of its vehicles  will  undoubtedly experience  mechanical problems.  However,  the  likely impact  on  a large company  of a handful  of delivery  vehicles being delayed for a day or even 2 days would  be minute and  would   not  change  the  company’s   financial outlook in a way that  would  be perceptible  on a macrolevel. On the other hand, if the shipping company   was  preparing its  financial  statements during  a period  when  it was  also  negotiating its way through a contentious labor  dispute  with the union   representing   its  delivery  drivers,  the  case would  be different;  if the dispute  were to drag on, it could have a major effect on the company’s profitability. Conversely, if the dispute were settled quickly  on  terms  favorable   to  the  drivers,  this would  mean greater  expense for the company  and changes to its financial  status.

Reporting  Requirements

Because critical accounting estimates can have such a large impact on how investors evaluate the financial  health  of  a  company,  there  is a  danger  that companies may choose the estimates (and their underlying assumptions) that are most favorable  to themselves,  to encourage  investors  to maintain or increase their commitment to the firm. To counteract such incentives, the Securities and Exchange Commission, the federal agency tasked  with regulating   the  stock   market,  requires   companies   to disclose their CAPs in the “management discussion and analysis” section of the company’s financial statement. The goal of this rule is to give the public access to a clear description of how  the company approached the areas of uncertainty that had to be addressed   during  the  completion of  its  financial reports, so that  if the public image of the company seems overly optimistic,  investors  can check to see whether  the corporate expectations are realistic or unduly  speculative.

Common  Issues

The need for CAPs tends to arise for many different companies   around  the   same   small   number   of issues. The  most  common  issue requiring  a CAP tends to be income tax. This is because a company’s tax  burden  depends  on  many  different  factors— sales, expenses, benefit payouts—and when making predictions  about   the  future,   the  more   factors subject to change, the greater  is the uncertainty of the  overall  prediction. Pensions  in  particular are difficult  to  predict  and  often  require  their  own CAPs.

Another  frequent  requirement for  CAPs arises because of impairments. Impairments are long-term assets  that   are  tied  to  markets   that   experience sharp   declines.  An  example   of  an  impairment would  be a company  that  spends  several  million dollars expanding its asbestos insulation plant, just 6 months before the discovery of asbestos’s carcinogenic  properties.

Some industries have CAP issues that are particular to their market  segments. The insurance industry  is one of these, as many  of the CAPs for insurance  companies  pertain  to  the  number  and size of claims liabilities. While companies  keep statistics  about  the frequency  of different  types of claims, and these are helpful in producing estimates for the future, some types of insurance are occasionally  triggered  by large-scale  disasters  that are less predictable. An example of this occurred  in 2005   when  Hurricane  Katrina   struck   the  Gulf Coast  of the  United  States,  killing  hundreds and causing nearly $150 billion in damage. Because the insurance   companies   holding   the   policies   that covered the affected properties could not have predicted  Katrina,  a “400-year storm” with a 0.25 chance   of  occurring   during   any  1-year   period, when such a storm struck, it had a huge impact on the insurance  companies’ balance  sheets.

Social  Justice

There is a difference of opinion  about  the effectiveness and appropriateness of critical accounting, both  within  the  financial  sector  and across  society. Some business  leaders  view it, and particularly its disclosure  requirements, as an unnecessary infringement on their rights to conduct business  as  they  see  fit,  and  to  pay  the  market consequences  in the  event  that  they  miscalculate. Others  in the business world  (usually those on the investment  side  of  the  equation) support critical accounting and rely on its requirements as part  of their overall investment and risk management strategy.

Looking across society, recent years have seen a rise in favorable  perceptions of the goals of critical accounting. In the wake of the 2008 market  disturbance  and  the  subsequent slow  recovery,  groups such  as  the  Occupy  Wall  Street  movement  have begun to make quite vocal demands for greater transparency in  regulation of  the  finance  sector and more objective and accessible reporting of financial  transactions and methods  of calculation. There  have  been  numerous reports  in the  media about the “shrinking middle class,” and one implication  of  such  stories   is  that   wealth   and power are being concentrated among a smaller and smaller group of elites, who maintain their positions through, among  other strategies, questionable accounting practices. Critical accounting, inasmuch as  it  advocates   an  open  sharing   of  accounting methods and assumptions, addresses these concerns and thus is frequently  advocated by proponents of financial  regulation and reform.

Criticism

Critical  accounting is not  an  approach that  has been  embraced  by  all. In addition to  those  who resist  it because  of the  personal  inconvenience  it causes  them,  there  are  some  who  oppose  it  on more   philosophical  grounds.   One   such   group objects  to  the  political  agenda  they  attribute to critical  accounting. They  view critical  accounting not as a valid and objective method  of accounting but  as a social and  political  movement  seeking to redistribute wealth  by imposing  reporting requirements  that  interfere  with  businesses’  attempts to operate   in  their  investors’  best  interests.   Those who hold such views argue that critical accounting is unnecessary  because  the  issues that  it seeks to shed light on would  eventually be corrected  by the natural  operation of  the  market—unsustainable businesses would close or be acquired by other entities.  This  view  generally  does  not  take  into account  the  negative  consequences  that  investors in such a business  would  experience,  loss of their investment  being  first  and  foremost, because  the information that  would  have  helped  them  avoid such a disaster  was not available  to them.

Another  criticism of critical accounting is based on the perceived connection between critical accounting and postmodernism. Postmodernism is a  philosophical perspective  that  rejects  the  idea that the world contains objective truths that are discoverable  and comprehensible; instead, postmodernism suggests that  the world  we know  is a social construct built up out of our individual  and shared  perceptions of reality.  Many  people  reject this  view  of  the  world  because  it  provides  very little  in the  way  of security  or  stability:  Nothing can be depended  on; nothing  can be trusted;  all is merely subjective perception and appearance. This is sometimes called relativism, since truths  are believed  to  only  exist  relative   to  the  observer rather   than  objectively:  An  apple  is red  because that is how we perceive it, not because its essential nature   includes   an   abstract  trait   of  “redness.” Many  object to relativism  because they feel that  it permits  people  to do anything  they want;  if there are  no  rules,  then  the  only  limitation is on  what one can get away with under the circumstances. In the context  of accounting, this type of objection  to a critical  accounting approach generally takes  the form   of  opposition  to   the   proposition  that   a business entity is not either a good investment  or a bad  investment  but  that  its value depends  on the observer and the value judgments  she or he makes about   the  accounting methods   being  used.  This view  of  the  world  has  too  much  ambiguity  for those who would  prefer to have clear-cut  answers about   whether   or  not  an  investment   strategy  is sound.

Bibliography:

  1. Arthur, Alexander  Critical Accounting Theory  and Practical Philosophy:  Applying the Tools. Aberdeen, Scotland:  University of Aberdeen,  Departments of Accountancy and of Economics, 1991.
  2. Broadbent, Jane and Richard   Accounting Control  and Controlling Accounting: Interdisciplinary and Critical Perspectives. Bingley, UK: Emerald,  2013.
  3. Friedlan, Financial Accounting:  A Critical Approach. Whitby, Ontario, Canada: McGraw-Hill Ryerson, 2013.
  4. Harms, David B. and Edward  Rosen. The Impact  of Enron: Regulatory, Ethical, and Practice Issues for Counsel to Issuers, Underwriters, and Financial Intermediaries. New York: Practising Law Institute, 2002.
  5. Lawrence, Janice E. and Martha L. Loudder.  Financial Accounting:  Critical Thinking Activities.  Houston, TX: Dame Publications, 1998.
  6. Riahi-Belkaoui, Ahmed. Critical Financial Accounting Problems: Issues and Solutions. Westport, CT: Quorum Books, 1998.
  7. Van, Riper R. Setting Standards for Financial Reporting: FASB and the Struggle for Control  of a Critical Process. Westport, CT: Quorum Books, 1994.

See also:

ORDER HIGH QUALITY CUSTOM PAPER


Always on-time

Plagiarism-Free

100% Confidentiality
Special offer! Get discount 10% for the first order. Promo code: cd1a428655