Choice Between Liberal And Conservative Accounting Methods: A Case Study On Alumina Limited Essay.

Background of Alumina Limited

Discuss about the Choice of Accounting Methods for Alumina Limited.

Based on the accounting decisions made by businesses, they have to choose between liberal and conservative accounting methods. Accounting is not all about reading and interpreting facts; it also entails the financial outcome of such facts. Therefore, different companies choose accounting methods that would give them a desired outcome. An effective application of accounting principles require accountants to choose between different accounting methods.

The two main accounting methods used by accountants are conservative accounting methods and liberal accounting methods. On one hand, conservative accounting methods accelerate the recording of expenses while delay the recording of revenues to slow the process of reporting profits. On the other hand, liberal accounting methods quickens the recording to revenue while delaying the recording of expenses to declare the profit quickly. A choice of accounting method also have an impact on a company’s asset, liability, and capital

This report examines different is concerned with choice between alternative accounting recognition, measurement, and disclosure policies. In particular, the report focuses on scrutinizing the accounting method chosen by the Alumina Limited Company and how the choices help the company help the company to fulfil its desired financial outcome. Some of the accounting creative ways used by accountants to achieve desired outcome are Accounting Policy Choice, Biased Estimates or Predictions, Disclosure for Influencing Interpretation and Timing of Transactions.

Alumina Limited was established in 1970 before becoming part of the WMC Group in 1979. Prior to the demerger in 2002, the company was known as WMC Limited. The WMC Limited previously focused on nickel, fertilizer and copper business. However, Alumina Holding Company wanted to focus its business on Alumina business hence the court demerger. Alumina became an ASX listed company in 2011 and the following year the company had accumulated assets valued at $3.4 billion. Its profit at the end of December 2011 was $126.6 million which was a significant increase compared to the $34.6 million in 2010 (Alumina Limited, 2011).

Alumina is the leading resource company in Australia with its core activity in the Alumina business. The company also owns approximately 40% of the world’s alumina business. The remaining 60% of business is owned by Alumina’s partner Alcoa Limited. According to ASX listing, Alumina is among the best-performing companies in Australia based on its ongoing growth, consistent performance and strong return. Besides financial performance, Alumina has also employed at least 5000 skilled people in its mines and refinery sites. With skilled personnel, Alumina has managed to expand its market dominance globally through quality aluminum products. Production efficiency have ensured that Alumina maintains a low production cost which directly translate into low-cost products. In wealth maximization, the company has developed a sustainable expansion plan which will ensure its continued entrant into new markets as well as maintain its current position in the global alumina market (Alumina Limited, 2011).

Creative Accounting

According to the International Accounting Standards (IAS), Creative accounting is defined as;

“The process of transforming financial accounting numbers to the figures desired by the preparers from what they actually represent by taking advantage of the existing rules, while ignoring other accounting rules” (Kitson & Robert , 2009).

Creative accounting allows the preparers of books of accounts to manipulative the figure in their favour or in expense of other stakeholders of the company. Although creative accounting is not considered as an illegal practice, it is morally wrong. Although the accounting practice was brought to the limelight only two decades ago, it has been identified as one of the reasons for the financial crisis and collapse of multinational companies like Enron Corporation, Adelphia, and WorldCom among others (Kammerer, 2009). The main reasons why preparers of accounting books get engaged in creative accounting include evading taxes, attracting investors and to avoid paying maximum and appropriate dividends to the investors. Creative accounting leads to falsely presentation of an entity’s financial position (Leo, Hoggett, & Sweeting, 2012).

There are four main ways in which accountants become ‘creative’ when preparing and presenting financial statements. Preparers may; a) choose an accounting policy or change accounting policies to achieve a desired outcome; b) make estimates or predictions of future events in a way biased towards achieving a desired outcome; c) disclose transactions or events in a way that influences the interpretation of the financial statements; and d) time transactions (Woodhouse, 2012).

This section reviews the application of creative accounting by the Alumina Limited in its 2011 annual report based on the four ways of executing creative accounting.

According to Alumina’s 2011 annual report, the company chose straight-line basis for asset depreciation. Besides the investment properties and land, all the remaining assets are written off at straight-line basis. The company chose this depreciation method instead of reducing balance depreciation techniques because it favoured its accounting and financial decisions (Baker, 2005).

The choice of straight line depreciation method over the reducing balance method is based on the factor that it is easier to apply the former in calculating the depreciating amount on a given asset. Likewise, the straight line method is highly recommended where a company lack a well-defined method of using its assets for production just as in the case of Alumina Limited. The straight-line depreciation method applies an even expenses over the life of an asset. For instance, the office furniture at Alumina Limited have a life of eight years while computers and office equipment have a life of four years. It should be known that the impact of the two depreciation methods influence the financial statement of a company in the short- term (Wolk, 2009).

Application of Creative Accounting by Alumina Limited

The Company also chose the FIFO method for inventory valuation. Interestingly, AWAC is using the LIFO method for inventory valuation. Each method has its own advantages and disadvantages. FIFO also known as the First In, First Out inventory valuation technique allows the sales of inventories that were first bought by a company. On the other hand, LIFO also known as Last In, First Out inventory valuation technique support the first sales of the latest stock to be bought a company (Wilson, 2014).

Alumina Company amortized its written off development expenditure in Brazil and USA over a period of 15 years with a amortised value of $ 1 million per annum to produce the desired results. The life of the development assets were determined by the management and they are at liberty transfer/ spread the cost of development asset over several years.

1. Provide the main reason (i.e., ‘motivation’) for accounting creativity at Alumina Limited
2. Straight-line basis for asset depreciation

The accountant at Alumina Limited chose straight-line method of depreciation because it would lead to higher income/ revenue in the earlier years. Depreciation is an expense that should be deducted from a company’s income to get the gross profit. Compared to reducing balance method, the depreciation value obtained under straight-line method is lower hence a higher income. Higher income attract more investors to the company besides presenting it a key player in the industry (Wolk, Dodd, & Rozycki, 2017).

There are several reasons that can be used to explain why companies, just like Alumina Limited, prefer to use FIFO technique over LIFO technique. First, FIFO allows a quick inventory turnover. Alumina Limited enjoys the ability to quickly turn its inventory into cash and hence an effective liquidity level. Second, Preparing the financial reports based on the FIFO technique enhance the reliability of such reports because most recent purchase prices are used; a true reflection of the market price. Third, FIFO is pivotal in obtaining the true value of the closing inventory leading to reliable financial reports and analysis (Duska, Duska, & Ragatz, 2011).

Fourth, in the case of inflation, both the costs of operating expenses and closing inventory increases. An increase in the value of the closing inventory translates into increased gross profit. In other words, FIFO stock valuation method helps in increased profitability in case of an inflation. Lastly, in its 2011 annual report, Alumina used the FIFO method because it is widely accepted by the accounting standards and regulatory bodies like GAAP and IFRS (Jones, 2011).

Opportunistic Behavior in Accounting

Through amortisation, the depreciation cost is treated as an expense over the entire period. Increased depreciation expenses leads to reduced taxable income hence increased income is registered. Just like any other company, Alumina seek to register increased profitability level per annum leading to attracting more investors (Lystra, 2017).

Both the efficiency and opportunism behaviours are mutually exclusive accounting choices used by accountants. This section examines the application of opportunistic accounting choices by accountants at the Alumina Limited to advance their wellbeing at the expense of other stakeholders (Pijper, 2016). Opportunistic behaviour in accounting is described as a choice by managers to apply accounting methods that enhance their welfare while ignoring the well-being of other stakeholders such as shareholders, suppliers, creditors, and the government among others. According to opportunism, managers are likely to apply accounting procedures that increase their income (Schroeder, 2010).

There are two methods that opportunistic managers can apply opportunistic behaviour. First, using both formal and informal compensation techniques. And second, making it hard for the shareholders to forcibly remove the CEOs after poor performances by a company arising from bad decisions.

Managers use formal accounting plans that have formed to create incentives and compensations to them as a way of applying accounting methods that increase their earning. Likewise, managers can easily inflate pre-managed earnings to inflate their income. With companies that lack formal incentive plans but CEO’s earnings is calculated using accounting earnings, managers tend to choose accounting methods that increase company earnings (Opperman, 2009). Their motive is to increase their compensation benefits and not to present the company’s strong profitability level in the market. Likewise, directors might also encourage the use of income increasing accounting methods with an aim of lowering their legal liability to the company in case of a lawsuit by shareholders (Everingham, Kleynhans, & Posthumus, 2007).

There are two methods of replacing CEOs of a company. A CEO can either be fired by the board or replaced in case of a takeover. Studies have shown that boards rely on accounting earnings when deciding the future of a CEO. Studies have shown higher chances of a CEO being fired when accounting earnings is lower compared to that of the previous year. Therefore, managers are more likely to use earning increasing accounting methods to protect the CEO from being fired because of a company’s poor performance (Schmitt, 2013).

According to opportunistic behaviour, accounting choice such as compensation and CEO termination is used by the managers to advance their objectives in the expenses of the shareholders. A critical review of Alumina Limited’s 2011 annual report shows no evidence of transactions or events that were used by the managers to advance their interests. Therefore, the analysis has been based on two policies in the annual report i.e. the compensation policy and the review of the CEO’s performance (Sherry, 2009).

Alumina Limited has enacted a compensation committee to review the remuneration process and structure from time to time. The review shows a correlations between individual and company performance and remuneration. In other words, the higher the performance of the company, the higher the remuneration awarded to the CEO and executive members. The compensation committee has a responsibility of aligning the remuneration of the executive board and shareholders’ interests and recognising and rewarding the performance of senior executive members.

Both the CEO, professional employees and senior executives have the same remuneration structure. The remuneration structure is comprises of long-term and short-term incentives. Short-term incentives is based on specific, and measurable targets and objectives for individual employees and the executive. Short-term incentives is purely performance based.

The performance of each senior employee is reviewed semi-annually and annually. Awarding of short-term remuneration is based on individual performance, achievement of company objectives, return on capital targets and the company’s earnings per share. On the other hand, the long-term incentives is awarded based on the company’s total shareholder return. However, long-term incentives are compared with that of peer companies in the industry to maintain consistency (Nikolai, Bazley, & Jones, 2009).

For the year ended December 31, 2011, Alumina Limited paid $ 5,848,080 as a compensation to its Executive and directors. The figure presented a significant increase compared to $ 4,146,585 in 2010 and $ 3,184,848 in 2009. The compensation packages increased with an average of 12% subject to company and individual performance.

Besides, safeguarding company’s interest, the executive also have their personal interests and objectives to meet. No individual is ready lose his/ her job as a result to poor performance. Therefore, the managers and other executive members are more likely to use opportunistic accounting choices to ensure their jobs are protected. Application of Opportunistic accounting choices is not illegal but are considered immoral. The executive is at liberty to apply them to advance their interests (Di Pietra, McLeay, & Ronen, 2014).

John Bevan, the current Chief Executive Officer of Alumina Limited is not employed under fixed terms. His employment is purely based on individual and company performance. Bevan's performance is subject to review semi-annually and annually by outside directors who have the power to terminate his employment based on poor performance.

As established earlier, CEOs are likely to lose their jobs when a company’s performance (accounting earnings) is low. With the firing of the CEO, executives are more likely to lose trust from the shareholder’s too. Therefore, managers are more likely to use earning increasing accounting methods to protect the CEO from being fired because of a company’s poor performance (Kitson & Robert , 2009).

Conclusion

Annual reports released on annually basis are supposed to reflect the true and fair value of a company. Such reports are relied upon by different stakeholders to make their decisions. However, accounting preparers and managers tend to manipulate accounting information to achieve desired outcome. Creative accounting and opportunistic behaviours are some of accounting practices used by accountants and managers to achieve desired accounting outcome. Creative accounting refer to using existing accounting regulations to manipulate accounting figures. On the other hand, opportunistic behaviours refers to managers using accounting policies to advance their interest at expense of shareholders. The study have established the existence of creative accounting and opportunistic behaviours in the 2011 Alumina Limited annual report.

References

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