New Century was an aggressive subprime lender catering to customers who could not qualify for conventional mortgage loans. New Century would then pool these loans and sell them in the mortgage secondary market at a profit. These loan sales came with warranties and representations which if breached could require New Century to repurchase the loans at a substantial loss. These repurchases began increasing in 2004 and were soon taking a toll on the company’s liquidity. Still, as late as the latter part of 2006, the company was able to raise $142.5 million from a new stock issue.
It all came tumbling down February 7th, 2007 when New Century admitted it was restating the company’s financial results for the first three quarters of 2006. The market reaction was a drop of 40% in the stock price from $30.16 to $19.24 according to court documents. By March 13th the stock price had declined all the way down to $.84 after a March 1st announcement informing the public that it’s 2006 10-K filing would be late along with a March 12th announcement disclosing a discontinuance of financing by some lenders. This crippled the company’s ability to honor loan repurchase demands. New Century Financial filed for bankruptcy protection on April 2nd 2007.
KPMG LLP and KPMG International KPMG LLP was New Century’s independent auditor from 1995 thru 2006. KPMG is “a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity with over 137,000 employees operating in 144 countries” according to their website.
New Century Financial – What Fraud Happened? The executives at New Century Financial violated many accounting rules and U.S. laws. The three perpetrators in this case are the former CEO Brad Morrice, former CFO Patti Dodge, and former Controller David N. Kenneally. The offenses are related to New Century’s disclosure fraud, violations of the Sarbanes- Oxley Act, violations of generally accepted accounting principles, and violations of the Securities Act.
DISCLOSURE FRAUD New Century Financial failed to make adequate disclosures regarding its loan production (the nature and risk of its products), its loan repurchase obligations, and its backlog of repurchase requests. In the 2006 Forms 10-Q, both Morrice and Dodge, failed to disclose that a substantial portion of it new loans were derived from what are termed 80/20 loans, where New Century would underwrite 80% of the first loan on the property, and underwrite a second loan for the additional 20%, actually creating a 100% loan to value ratio. These loans were risky, because the buyer of the property was able to make the purchase without risking any money of their own. In 2006 33.47% of New Century Financial’s loans were of this type, up from 23% in 2004 and 9% in 2003.
Additionally, New Century disclosed materially misleading loan to value (LTV) information on its loans. To the public, “New Century disclosed a ‘weighted average’ LTV, which in 2006, was between 80.9% and 81.4%,” of total loans made, but in company internal reports the actual numbers were between 86.6% and 87.6%. Also in the 2006 Forms 10-Q, “New Century made disclosures that downplayed the risks of its interest only and stated income loans, (loans in which one’s income is not verified).” New Century failed to disclose that through the second quarter of 2006 that it was actually experiencing greater defaults on its 80/20, stated income and layered risk loans.
Regarding New Century’s loan repurchase obligations, adequate disclosure was not given to investors. Under the contract for the loans, “New Century could be required to repurchase loans sold pursuant to repurchase agreements in two situations: (1) the representations and warranties about the loan were untrue; or (2) the borrower defaulted on the loan by failing to make the first payment due after the loan was sold.” These loan repurchase obligations would have negatively affected investor and lender expectations of New Century’s earnings potential had they been disclosed. In 2006 New Century experienced an increasing rate of Early Payment Defaults and First Payment Defaults, which could trigger the loan repurchase obligation. In 2006 New Century had to repurchase $784.3 million dollars on loans, and was left with loans with a value of 80% of the repurchase price.
In addition to its actual repurchases, New Century had a backlog of repurchase requests that it did not disclose in 2006. From 2005 to 2006 the backlog grew from $143 million to $400 million. Failure to disclose these significant facts greatly altered the information available to investors regarding the Company and would have had an unfavorable impact on net revenues and income from continuing operations.
SARBANES-OXLEY VIOLATIONS In violation of the Sarbanes-Oxley Act, the CEO, CFO, and company Controller personally signed New Century’s disclosures, first and third quarter 10-Q forms, and the Sarbanes-Oxley certifications associated with those filings knowing that the financial statements were materially misstated. Furthermore, each of the company officers benefited from the financial misstatements in terms of pay, and bonuses, none of which was returned to shareholders. During the year 2006 the CEO and CFO made misleading statements in press releases and earnings calls regarding the financial position of the company.
ACCOUNTING FRAUD In line with generally accepted accounting principles, New Century Financial was required to estimate the fair value of its repurchase obligation and to reduce the gain it reported on the sale of that amount. In deriving an estimate of this obligation New Century was required to estimate, “(1) the amount of loans that it would have to repurchase, i.e., the repurchase rate: and (2) the costs that it would incur in repurchasing loans. When New Century repurchased a loan it was recorded at the loan’s unpaid balance and not at the fair value as required under SFAS 140. However, prior to the second quarter of 2006, the repurchase reserves recorded by New Century Financial were sufficient to state the net value of the assets in amounts materially in compliance with SFAS 140. In the second quarter of 2006, however, the reserve calculation methodology was changed resulting in much lower reserves. As a result of these changes, the net assets were no longer stated at fair value, a violation of SFAS 140. This reduced its repurchase expense and overstated revenues.
Also under GAAP, New Century was required to estimate contingent liabilities, in line with SFAS 5. SFAS 5 requires accrual of loss contingency if information indicates that it is probable that the liability has been incurred and the amount can be reasonably estimated. The liability related to the substantial backlog of unprocessed repurchase claims was not properly accrued, a violation of SFAS 5. This allowed New Century to overstate its financial performance.
New Century also failed to implement internal controls over financial reporting to appropriately track repurchase requests from investors to buy back their loans, further reducing the firm’s loss contingency.
As a result of improperly accounting for loan repurchase obligations, which reduced the reserve expense needed to repurchase those loans; New Century overstated its financial results, with reported pre-tax earnings 165% higher than the corrected amount (a total overstatement of approximately $84 million). In the third quarter of 2006, earnings were overstated approximately $108 million.
VIOLATIONS OF THE SECURITY ACT In connection with the November 16, 2006 securities offering both Morrice and Dodge filed with the Securities and Exchange Commission, they reported that New Century’s financial statements presented fairly in all material respects the financial condition of the company. Furthermore, it was stated that New Century Financial had no undisclosed material liabilities, and that the financial statements complied with the requirements of the Exchange Act. The reality was that, “New Century had a substantial backlog of pending repurchase claims, which were not reflected as liabilities in New Century’s financial statements.”
With all of these defalcations combined the executives at New Century Financial violated the following laws:
Fraud in the Offer or Sale of Securities, Section 17(a) of the Securities Act
Fraud in Connections with the Purchase or Sale of Securities, Section 10(b) of the Exchange Act and Rule 10b-5
Violations of Commission Periodic Reporting Requirements, Aiding and Abetting Section 13(a) of the Exchange Act and Rules 12b-20, 13a-11, and 13a-13
Circumvention of Internal Controls, Section 13(b)(5) of the Exchange Act
False Statement to Accountants, Rule 13b2-2
Certification Violations, Rule 13a-17 of the Exchange Act
Failure to Reimburse, Section 304 of the Sarbanes-Oxley Act
KPMG’s Role in the Fraud KPMG LLP (“KPMG”) was the external auditor for New Century Financial from inception (1995) to 2006. They resigned in April 2007, a few months after New Century filed for bankruptcy. Although they had completed a significant portion of the field work for the 2006 audit prior to their resignation, they did not issue an opinion on the 2006 financial statements. They issued unqualified opinions in all prior years audited by them. They also performed reviews of the quarterly financial statements through 2006 and performed audits of the effectiveness of internal controls at New Century (SOX 404 audits) for 2004 and 2005. The SOX 404 audit for 2006 was substantially completed but the opinion was not issued as of KPMG’s resignation.
Although financial statements are the responsibility of management, an independent auditor’s opinion that the statements “present fairly, in all material respects, the financial condition of the Company” “in accordance with generally accepted accounting principles” does provide investors and creditors a certain level of assurance that management’s statements are reliable. The opinion is not a “guarantee” of the accuracy of the financials but the public should be able to trust that, at a minimum, the auditor followed professional standards in the audit process. An auditor’s role in the issuance of fraudulent financial statements, then, could come from either a) their failure to exercise due care in the audit process which resulted in their failure to discover and communicate material misstatements or b) their complicity in the fraudulent misstatements.
Most of what we know about KPMG’s relationship with New Century and their work as New Century’s auditors comes from a report by Michael Missal, the bankruptcy examiner in the New Century case, to the United States Bankruptcy Court. Mr. Missal was charged with identifying any potential causes of action that might arise from the New Century bankruptcy. He reviewed KPMG’s audit workpapers and New Century’s accounting records and interviewed KPMG and New Century employees as part of his research.
Missal’s report focuses primarily on KPMG’s work during 2005 and 2006. He suggests that, during those years, KPMG failed to follow professional audit standards and that certain members of the audit team were complicit in the fraud by giving advice to New Century, which was followed by them, that was inconsistent with generally accepted accounting principles and that resulted in material misstatements.
The evidence presented to support the contention that KPMG failed to act in accordance with accepted auditing standards (GAAS)) was substantial. The three general auditing standards require that 1) the auditor must be technically competent, 2) the auditor must be independent and 3) the auditor must exercise due professional care. Mr.. Missal provided evidence that KPMG failed to meet any of those standards.
Mr. Missal reviewed the New Century engagement staffing during 2005 and 2006. During the first quarter review in 2005, the entire audit team was new to the engagement (other than two junior auditors). The engagement partner was new to KPMG and had very limited experience in the mortgage banking industry. The senior manager was a recent rehire of KPMG and his only industry experience was a three year stint as an assistant controller at a small mortgage lending company. The senior manager on the 2005 SOX 404 audit had no prior SOX 404 audit experience. The concurring partner had worked primarily with financial institutions and leasing companies. Field work on two of the most sensitive areas (testing of the repurchase reserve and residual interest valuation) was done by first year auditors. Given the complexity of the mortgage banking industry, Mr. Missal argued that the team did not have the technical skill required to audit New Century.
Mr. Missal reviewed internal communications between KPMG staff and external communications between KPMG and New Century management and board members. The senior members of the audit team ignored or dismissed concerns raised by KPMG specialists about the appropriateness of certain accounting methods used by New Century. They also dismissed concerns raised by junior auditors and by members of New Century’s Audit Committee as unfounded. Mr. Missal concludes that the senior audit members were more concerned about retaining the client than they were about the quality of the audit work and therefore lacked independence.
There were numerous examples given by Mr. Missal to demonstrate KPMG’s lack of “due professional care” including their failure to follow the second and third field work standards (the auditor must design tests to adequately respond to their understanding of the entity’s internal controls (or the lack of internal controls) and is required to obtain sufficient evidential matter to support their opinion). The examples given included KPMG’s failure to expand testing based on deficiencies noted in their review of New Century’s controls as part of the audit planning process, failure to properly test the repurchase log, failure to properly test the models developed by New Century accounting personnel to determine the reserve requirements, failure to expand testing given significant changes noted in the number of loans repurchased and failure to expand planned testing when the risk assessment related to residual interests was changed to high (as part of the SOX 404 audit work in 2006). Mr. Missal also noted that certain significant control deficiencies noted as part of the 2004 SOX 404 audit were not communicated, as required, to the Board of Directors and that the 2005 SOX 404 audit did not consider, as required, the failure of New Century to resolve control deficiencies noted as part of the prior year SOX 404 audit.
Mr. Missal also provided evidence KPMG was complicit in the fraud. According to interviews of KPMG and New Century staff, the Senior Audit Manager on the engagement team suggested two changes to the calculation of the repurchase reserve which were adopted by New Century during 2006. Both changes resulted in significant reductions of the amount of the reserve recorded in the financials and both changes were contrary to GAAP. Mr. Missal does not suggest that the actions were criminal. The inference is more that the suggestions were made based on a lack of understanding of the applicable GAAP as it applied to the mortgage industry.
To date, KPMG has not responded to specific issues raised in Mr. Missal’s report. They have, however, issued a general statement that they believe the firm complied with all professional standards. It should also be noted that the SEC, in their action against New Century, included a claim that New Century had lied to their auditors.
Mr. Missal does conclude that although he believes that the trustees for New Century could have a reasonable basis for suing KPMG for professional negligence, he also cites a number of possible defenses that could be raised by KPMG. All of the defenses speak directly, or indirectly, to New Century’s contributory negligence.
The Affect of the Fraud on KPMG No charges have been brought against KPMG by the SEC. However, both KPMG and their parent firm, KPMG International (KPMGI) were sued in April of 2009 by The New Century Liquidating Trust and Reorganized New Century Warehouse Corporation (the trustee overseeing the bankruptcy).
The suit against KPMGI has two causes of action. The first cause of action states that KPMG is an agent of KPMGI and therefore KPMGI is liable for the actions of KPMG (“vicarious liability”). The second cause of action claims “deceptive and unfair business practices” by KPMGI. KPMGI advertised that its member firms performed quality work but did not properly oversee or control that quality. The suit seeks, in part, actual compensatory and consequential damages and punitive damages plus costs.
The suit against KPMG has three causes of action. In the first cause, the plaintiff requests that the agreement signed by KPMG and New Century prohibiting New Century from seeking punitive damages be set aside as illegal under California law. In the second cause of action, the suit claims that KPMG was negligent in their performance as New Century’s auditors. The lawsuit includes the claims reported in Mr. Missal’s report as described in the section “KPMG’s Role in the Fraud” above. In the third cause of action, the suit claims that KPMG aided and abetted the breach of fiduciary duties by New Century’s directors and officers. The suit claims that KPMG was aware of the breaches of duty and that the engagement team provided “assistance and encouragement” in those breaches. The suit seeks, in part, actual compensatory and consequential damages (in an amount not less than $1 billion) and punitive damages plus costs. Since the suits have not been settled, there is no way to know or estimate the financial impact on KPMG.
KPMG has undoubtedly been affected in unpublicized ways. Mr. Missal notes several of the engagement team members left KPMG or were transferred out of the local office during 2007. There have probably been changes in internal processes related to engagement management and technical review. It is possible KPMG has lost clients as a result of the publicity surrounding the case.
Since the final outcome of these cases is still unknown, it’s impossible to evaluate the complete effect upon KPMG LP and KPMGI.
KPMG’s Violations of Legal and Ethical Standards New Century’s auditor, KPMG LLP (and its parent company KPMGI) is a large multinational auditor which employees over 135,000 people in over 140 countries. The breadth of accounting law and ethical standards it may be bound to is diverse and multilayered, including regional, state, national, and international provisions. To illustrate this fact both New Century and the US arm of KPMG were incorporated in Delaware, while headquartered in Irvine, California and New York City respectively, and may be subject to legal precedent in potentially any state in which material business is conducted.
United States accounting standards (GAAP) are primarily set by the Financial Accounting Standards Board. Compliance with GAAP is often required by regulatory agencies such as the SEC and by statutory law both at the state and federal level. Additionally there are an extensive number of statutory requirements which bind both public auditors like KPMG and publically traded entities like New Century on a federal level including SEC provisions and rulings of the Public Company Accounting Oversight Board (PCAOB).
Some examples of potentially breached laws and ethical standards include Article 9, Section 58 of the California Board of Accountancy Regulations which requires CPAs to comply with GAAP and GAAS (Generally Accepted Auditing Standards) since KPMG’s treatment of the reserve requirement was inconsistent under FAS 140 and FAS 5. It is also possible that Section 65 was breached since there were allegations that KPMG sought to maintain New Century as a profitable client over accurate financial reporting thus compromising independence.
At the national level, several AICPA principles and rules may have been compromised. Principles allegedly breached include the principle of objectivity and independence based on the aforementioned profitability rationale, and the principle of due care based on the inconsistent application of GAAP (and alleged technical/professional insufficiency of the audit team). Since the AICPA rules are a codification of the principles, several rules by nature would have been violated including the following, rules 101, and 102, plus rules 201 through 203.
Rules 101 and 102 which govern independence and integrity/objectivity respectively were potentially breached by the conflict of interest associated with retaining profitability clients which would have affected both independence and objectivity. Rule 201, the General Standards is broken down into 4 parts each of which may have been broken during the anomalous treatment of the reserve requirement among other accounting guidance provided by KPMG. Rule 201 A which dictates professional competence and rule 201 C which dictates appropriate levels of planning and supervision may have been violated if the audit team was insufficient in technical skill and frequently unsupervised as alleged. Rule 201 B which prescribes due care again may have been breached by inconsistency in the application of GAAP.
Lastly there is evidence that the last and final provision of rule 201 was breached, section D discusses the acquisition of sufficient supportive evidence of audit opinions and there is evidence that the audit team may have cut the engagement short on account of time and profitability pressures.
What could have been done to prevent the fraud? Severing the financial incentive between client and auditor by mandating that auditing fees be paid via a trustee or other third party irrespective of audit findings could significantly reduce the pressure to deviate from GAAP and decrease conflicts of interest. Perhaps a pooled system like insurance could be created where publicly traded firms, those regulated by the SEC and the PCAOB, would pay into a pool of funds from which fair compensation can be disbursed, reducing profit based incentives from altering the quality of audit findings. Rotating audit firms by lottery or by imposing some form of “term limits” may prevent the collusion often formed by longstanding relationships.
The creation of an anonymous complaint system by regulatory authorities could provide an outlet for junior members in auditing firms to report major violations of standards by higher levels of management in both the company being audited and the accounting firm itself. Additional individual penalties for failure to exercise due care, especially for senior members, may insure work is not rushed or delegated improperly while preserving the limited amount of competition remaining in the public auditing industry.
But at the end of the day it is always about the basics. A framework is in place to prevent financial fraud by companies. The framework is:
Generally Accepted Accounting Principles Generally Accepted Auditing Standards Corporate governance exercised by the Board of Directors The failure of New Century Financial was not so much a regulation failure but a human failure. But this is why we have regulations-to reduce the temptations of humans. Strict adherence by KPMG to the generally accepted auditing standards would not have prevented the failure of New Century, it probably would have speeded-up its demise. But it would have given New Century’s investors, creditors, and board the critical information needed to make sound decisions.
The potential for human failure in both New Century and KPMG could have been reduced by what is now termed “the tone at the top”. New Century’s board, especially the audit committee and the upper management of KPMG did not provide the environment for the violations to come to their attention. KPMG’s ignoring of the warnings of junior staff and specialists of problems is inexcusable.
How did the New Century failure affect our group’s views and opinions? A former auditor in our group “understood the tension between the auditor’s duty to follow professional standards and their desire to retain clients. Comparable tensions exist for accountants in private industry. I also know that hindsight is 20/20 and without hearing the defendants’ side of the story, it’s difficult to fairly evaluate their work or their ethics. It’s difficult to read about the economic and personal impact that these large corporate failures have on the various stakeholders – the employees, the investors, the creditors, and the public – without wanting to see changes that will at least reduce the risks we all face. Maybe it’s time to make the auditors more independent – which might mean that auditors should be paid by someone other than the audit client and that audit firms serving public companies need to be rotated on a regular basis.”
A CPA candidate in our group felt “reminded of the constant conflict between quality and quantity; profitability and sustainability. The pressures placed on auditing firms by virtue of the free market often creates particularly troublesome adverse incentives which I may be subject to one day, this is unfortunate. These same pressures are the reasons why public accounting is needed in the first place, typified by New Century’s unsustainable financial position over time, and reminded me of just how important it is to maintain trust and faith in the public accounting industry.”
Another CPA candidate felt “disillusioned of the culture of the ‘Big Four’ accounting firms.” Noting the firms are quick to lecture others about “tone at the top” but are they looking at the “tone at the top” in their own organizations? He added “do I want to work at a place where the input of juniors is routinely dismissed? Where was the quality control mechanism at KPMG?”
Finally, one of us believed “this case only confirmed my views about the people involved in the Real Estate/Mortgage market, most of them were in the market to make a quick buck, 99% of the people in this industry had no understanding of the real estate market or did not care, and the market was doomed to collapse due to weak lending practices.”
Cash flow accounting, accrual accounting, which ones better
It is argued occasionally, cash flow accounting or accrual accounting which one that can be provided better information for users. Leading to the primary basis on which the financial results of companies are reported.
Firstly, the report would talk about review of the extant literatures between cash flow and accrual accounting’s role and intention of corporate reports. Secondly, evaluating which accounting basis satisfies the informational needs of users and implications of adoption for preparers. Finally, the report would also make some recommendations for a future improved disclosure rule.
Methods of accounting in financial statement
First of all, what is the primary objective of financial statement? ‘Financial statement is to provide information about financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.’*1 That is stated by International Accounting Standards Board (IASB). For providing information of financial statement, there are two accounting methods for companies to report their financial statement. Cash accounting and accrual accounting both are the main method to prepare the financial statement.
Cash basis accounting is a very basic form of accounting. ‘Revenue is recorded only when the cash is received, and an expense is recorded only when cash is paid. Preparing an income statement under the cash basis of accounting is prohibited under generally accepted accounting principles.’*2 For example, when a payment is received for the sales of product or services and the revenue is also recorded the date of receipt. On the contrary, when a cash or check is paid for some invoices and the expenses are also recorded the date of paid. That is the cash accounting entries in the financial statement because the main focus point of cash basis is cash. So any transactions are related to cash on that day, cash accounting is also recorded as expenses or revenue on that day.
Accrual basis accounting is combined together with the revenue recognition principle and the matching principle as a combined application. ‘For example, using the accrual basis to determine net income means recognizing revenues when earned (the revenue recognition principle) rather than when the cash is received. Likewise, under the accrual basis, expenses are recognized when incurred (the matching principle) rather than when paid.’*3 Accrual accounting compares to cash basis accounting to be more complex because it includes account receivables (amounts receive from debtors on credit sales) and account payables (amounts pay to customers on credit purchases) that can be matched the revenues are earned and the expenses are incurred to the time period. ‘The effects of transactions and other events are recognized when they occur, rather than when cash or its equivalent is received or paid, and they are reported in the financial statements of the periods to which they relate.’*4 For example, when selling a new computer in March, but the customer does not pay the bill on time until two months later. The company would record the income on credit in March in their accounting books under accrual method that is different from cash accounting.
According to upper side, cash basis and accrual basis are totally different accounting methods for providing information to prepare financial statement. In revenue and expenses, cash and accrual method are recorded when they are received and paid or they are earned and incurred respectively. Cash method reflects revenue and expenses based on cash were received or paid on that day. But accrual method is matched revenue and expenses when they are incurred in time period. At last, cash accounting is no receivables and payables that is also no available method for tracking the recognition of transactions. That means accrual basis giving more meaningful and useful corporate reports.
Advantages of accrual accounting and cash accounting
In accrual accounting, it have a concept when measuring same activities, it provides more steady financial performance and more accurate for prediction because of consistence of performance. And using historical data for preparing financial statement, it can be more reasonable truth and predictability that it is relatively objective. This means that the figures produced in financial statements are objective and not manipulated by a person that can be controlled the company. So that, providing information by accrual basis makes it easier to predict future earnings and financial position.
In cash accounting, the data are also objective and no judgment can be make as each value or amount are recorded by cash transaction with a third party. It can observe easily a company for survival in the short term, but in order to survival in the long term that the business must be make profit. Then, there is no requirement or compliance for accounting standards or disclosure of any accounting policies so that it is more easily to prepare. A more accurate picture of the amount of actual cash is provided by cash method in company’s business. The preparing time and cost can be reduced if comparing to accrual accounting. Due to cash basis is no non-cash accounts hence it does not provide a complete financial operation of the company. Information under this method may not achieve the qualitative features of relevant and reliable.
User’s need analysis
Satisfaction of user’s need is really important because financial statement is used to provide useful information for users to predict or make their own decision. Most of people have an interest to know that the activities of the business. These people are the users of accounting information. Which one would provide better information and satisfy the user’s need? The users also divide by internal and external users. The report will show seven different positions including, employees and management as an internal users and investors, customers, creditors, government and shareholders as an external users to analyze the two accounting methods.
Purpose of the employees finds a job that is mainly to maintain the stable live. So, they highly concern the stability of the job and ability of the company to pay their salaries, remuneration and bonus on times. Their point of view in cash uniquely focuses on it. If the financial statement is used cash accounting method that can indicate the amount of cash in hand easily so the employees can assess the company’s ability to pay their salaries. Moreover, cash accounting for employees is clearly to understand the trend of cash flow than the complexity of accrual accounting.
Management uses the past information in financial statement to emphasis on making future prediction or use in planning in their business. They need to determine the overall review on the trading business what decision should be made or not. The planning directly affects the operating of company in the future so management would review the financial statement as a reference to investigate the future trend or predict the future profit or loss. And management would be set the policy for the company in financial or operating dimensions. Such as credit period for customers that how long of time period should pay the bills, ninety days or hundred days or so on. All of them are depended on the debtors of financial statement so accrual basis or cash basis accounting are needed to provide in that information.
Investors are one of the main users of the financial statement. They need to decide whether the value of company invests or not as they want to assess the company’s profitability and the future performance. Every investor only focuses on higher rate of return in lower risk condition. So, they will assess the financial statement of the company to reduce the higher risk opportunity. Based on previously presentation, accrual accounting is to provide steady net profit pattern that also represent the company having steady operating performance. It can help the investors to make the prediction more accurate.
Although the performance of company is also very important, focus point of the customers is about going concern of the company. They want to know the ability of company to act as a long term partner for trading. So, they would like to see the sufficient inventory level to delivery on times. This can be more easily to control the stock level of their shop or industry to reduce the holding cost. Accrual accounting gives a more accurate picture of profit and loss and the overall financial performance. It should assist the customers to determine the delivery and holding cost for trading business.
Trading business between company and creditors is based on a partnership. Creditors review the liquidity and the ability of company to pay the debt. Cash method can show the cash balance straightly but it does not show the account payable balance on the statement. Because cash method is no account payable or account receivable, it just only demonstrates cash transactions. That means it may not provide complete and sufficient financial information to creditors. For instance, company has an available bank balance about two million. This means that the company has ability to pay the debt. However, the company has an account payables balance over ten million. Consequently, it does not effort the debt to pay. Creditors should focus on overall financial performance that why accrual accounting is much better to present the information.
Regarding to completeness of the corporate report, accuracy and the compliance with accounting standard, government is mainly concerned them. Cash accounting does not have any disclosure requirement and more complex reporting but accrual accounting is commonly used in every company (listed or non-listed) in the world compliance with International Accounting Standards (IAS). Therefore, accrual accounting would be more suitable for government that is persuasiveness because of followed by IAS.
Shareholders are the owners of the company. They just know the profit of company and dividends at each period to pay. Because they have the ownership of company, they also consider the going concern problems. Review the overall performance of the company that is the purpose to reach the primary objective of making profit. The dividend payout is depended on the amount of net profit that the company earned in the year. If the current year is no net profit made, the company may not payout any dividend in that year. That moment, the shareholders are disappointed that may lead them to divest the company. In accrual accounting provides more steady net profit pattern and more accurate picture of organization the finances. Inversely, cash accounting is directly affected by cash so that it is more fluctuated. In this situation, accrual accounting can predict the net profit and dividends according to historical information.
The comparison of the above, investors, customers, creditors, government and shareholders are supported accrual accounting. All of them are external users thus all of financial statement reports to external users under accrual accounting. This shows its information can provide better information of users.
Implications of adoption for preparers
What are the factors that influence preparers to adopt an accounting method? ‘The following were the results of the survey on factors that influence the company to adopt a particular accounting method. Normally, five main factors are influence the preparers. It is included sizes of company, nature of business, complexity, cost and taxation.’*5
Nature of business
Nature of business in the companies may affect to choose which accounting method to prepare the financial statement. Pawnshops and restaurants should apply the cash method because it is easy to determine the revenue amount at that time of the sale. On the other hand, manufacturing, trading and transportation services should use the accrual method because it is difficult to receive the whole of the amount immediately. Some customers would be like to prepay the bill first for trading business. That can be easy to match the revenue and expenses in this transaction under accrual basis. Also, it helps to plan the operating cycle especially in the management of inflow and outflow of cash. So, different nature of business may apply different accounting method.
Size of business
The size of business also affects the adoption of accounting method. For instance, a small size of company will trend to apply the cash accounting because the amount of trading cash flow is not large and the whole company only is a few transactions. So a company uses an accrual basis, they need to train the staffs and establish accrual accounting system for the company. Small company is no enough the staffs and budget to apply accrual basis because they may not have ability to cover the cost of the system. The key point is that they no need to spend lots of money only for a few transactions. It may lead to decrease the efficiency and effectiveness of company than using cash basis.
Accrual accounting requires more complex reporting and disclosure requirements than cash accounting. There is much depreciation accounting method to calculate the fixed asset or current asset in a company. If the company selects a wrong depreciation method, it may lead to the financial statement having a loss in the year from the gain in original. Disclosure requirements in accrual basis are followed by IAS that may be many attachments to compliance. All the accountants in the world must follow because of providing better information to users. So that, companies may concern their employees who have or have not such specified skills to achieve the accounting standards.
Accrual accounting is more expensive than cash accounting. As accrual basis is more complex, all the accountants need to have enough training for preparing more accuracy financial statement to provide better information for users. Training for accountants to achieve the international accounting standards that are higher cost, they need specified and professional skills to complete it and also need regular to update their knowledge and skills. The next point is that company would be established up an accounting system for accrual basis method so that company has ability to effort the budget cost.
The company should balance the cost and benefit to choose the two accounting method which will not adopt accrual basis accounting.
Under accrual method, accrued expenses can partly allowable to deduct in that financial year even if the expenses is not paid yet but the creditors need to reserve the taxes on expenses in accounting books. This obtains a lot of benefits and advantages though tax payable. In cash method, expenses and income are recorded when it is received or paid so it can deduct depending on the customers to pay cash or check on the received time. There is no prediction for the future year of financial position and performance.
Recommendations for future disclosure
‘According to IAS 1, it requires that an entity shall prepare its financial statement, except cash flow information, using the accrual basis of accounting. When the accrual basis of accounting is used, items are recognized as assets, liabilities, equity, income and expenses when they satisfy the definitions and recognition criteria for those elements in this framework.’*6 So, the future financial statement must include cash flow statement. It can show cash flow balance and detail in the year to provide useful information for confirming decisions such as operating cash flows before working capital changes, cash generated from operations after working capital changes and cash flows from investing activities and financial activities that is largely free from allocation and valuation events. This information can assess and review previous assessment of cash flow. ‘Cash flow accounting appears to satisfy the need to supply owners and others with stewardship orientated information as well as with decision orientated information.’*7 It gives users more information about solvency and liquidity of companies and enables them to compare the other similar firms. When using accrual basis method is difficult to make the assumption. If the users just concern the cash balance in financial statement only, this may be easily occur misunderstanding to influence the future economic decision of the users. So cash flow statement must be included in financial statement for a future as a supporting document between the statement of financial position and the statement of comprehensive income.
Between cash and accrual basis method, accrual method is more applicable to company providing better information for the users. It reflects better the true of financial situation of the company and providing a real picture of the business as a reference for users to make decisions. It also matches the right expenses and revenue when they are earned or incurred at the period under matching principle and revenue recognition principle. That’s mean for tracing each transaction or keeping records which may be more convenience for company. Hence, accrual accounting is matched the primary objective of financial statement that is reliable, understandable, relevant and comparable. ‘In professional accounting practice requires reports to external users to be on an accrual accounting basis. This is because the accrual accounting profit figure is a better predictor for investors of the future cash flows likely to arise from the dividends paid to them by the business.’*8 Therefore, accrual accounting finds more advantages to use rather than cash accounting. As a result, the majority of the world of company’s financial statement uses the accrual accounting basis as well.