Author: Group work Saadry Dunkel
Date: 06.11.2012
Title: Analysis of Burberry

Harvard Referencing Source System:

Saadry DUNKEL. 2012. Analysis of Burberry. [ONLINE] Available at: http://www.saadry-dunkel.com/publications/corporate-finance. [Accessed 07 April 15].

Analysis of Burberry

Index

1. Introduction
2. Company Overview
3. Corporate Governance Analysis
4. Macro Analysis of your company’s market
5. Analysis of Company Beta
6. Estimated Company Betas per business lines
7. Estimated Company Cost of Debt
8. Estimated Company Cost of Capital
9. Burberry’s Debt
10. Burberry’s Optimal Capital Structure
11. Looking at the History of Performance, Cash Flow, and Balance Sheet Realities, Decide Whether Changes are Necessary to Firm’s Capital Structure?
12. Are Change in Leverage Required?
13. What is Your Recommended Pathway of Altering Burberry’s Capital Structure?
14. Review the Business/Typical Investment Projects of Burberry’s and List the Features You’d Expect in their Financing instruments.
15. Compare the FCFE that Burberry’s Generates to The Cash Payouts it Makes (Dividends and Share Buybacks)
16. Perform a DCF Valuation of Burberry
17. Bibliography

Appendix I : Balance Sheets
Appendix II: Cash Flows
Appendix III: Income Statement

1. Introduction

The project assigned is an approach of some corporate finance aspects that we have been learning during this module. The company chosen for this assignment is Burberry that has a reasonable size to analyse. The analysis goes through the risk profile of the company, analyse the company’s capital structure, company dividend policy, and the value of the company in terms of market capitalisation.

Therefore, to get more reliable and accurate information, the analysis is based on Bloomberg, Burberry’s latest annual reports, some articles from Financial Times, and the lectures.

2. Company Overview

Burberry is a global luxury brand established in 1856. Is a British holding company that operates in the luxury goods manufacture, retailer and wholesales. The company operates in Europe, Asia Pacific, Americas and the Rest of the World. The company provides non-apparel accessories and clothing for men, women and children.

Is ranked in the FTSE100 in the Consumer Durables & Apparel Sector. The analysis compares Burberry and the other 8 securities, Hermes, LVMH, CIE, TOD’S, Christian Dior, Ralph Lauren, Coach and Hugo Boss, that belong to the same sector.

3. Corporate Governance Analysis

Corporate Governance concerns the relationship between management of a company, its shareholders, its board and other stakeholders. The corporate governance ensures an alignment between the management of an organization and the decisions taken by its members.

The Board is responsible for the success of the company. The Business strategy, trading performance, risk management and all major decisions are settled by the board of Burberry. This is composed of 8 members: Chairman, John Peace, CEO, Angela Andrehns Executive President, Stacey Cartwright, CFO, Andy Janowshki, and five non-executive directors. To assure a well-structured board is realized six scheduled meetings so that every member could be engaged and all “matters” should be solved. Also, the Chairman is responsible of leading the Board and arranges commitments with the other non-executive directors.

As referred in the annual report, the non-executive directors are independent of management and free from any business. However, they have shown an effective contribution to the company. The independence is seemed like a constructive challenge and also a responsibility to the Board’s decision-making process.

The importance of maintaining a good relationship between the shareholders is very important. Burberry communicates with is institutional investors frequently. Between the institutional shareholders are the top holders that represent almost 45% of the total shares of the company. Appendix 1.

4. Macro analysis of your company’s market

Macro-analysis of the Burberry Group can be best illustrated by considering their strengths, weaknesses, opportunities, and threats.

Strength:

First of all Burberry benefits from the company’s wide geographical presence. Currently Burberry operates in four regions as of 2011/2012. America represented 25% of retail/wholesale revenue, Europe counts for 32%, the rest of the world is 6% and the Asia Pacific counts as 37%.

Moreover, Burberry has a diversified network. The company distributes its products through retail, wholesale, e-commerce, and licensing.

Revenue increased 23% underlying to £1,857m. A 14% comparable-store sales gain combined with 11% space expansion and a 6% contribution from the China acquisition to produce 31% underlying retail revenue growth to £1,270m. Wholesale revenue increased 8% underlying (14% excluding the China transition) to £478m. Licensing revenue increased 5% underlying driven by strong performances in fragrance, timepieces and eyewear. The business achieved double-digit gains across all product divisions and regions with help of diversified distribution channels.

Furthermore, Burberry has positioned itself as a very strong brand. Company’s worldwide recognition and its record sales is further testament to its strong branding.

Weaknesses:

Burberry is experiencing weak efficiency as company’s turnover ratio is much lower than the industry average. And for the fashion brand, it is very important to have high turnover in order to be able to turn over fashion styles in order to meet constantly changing trends. Moreover, low turnover causes low efficiency.

Another weakness can be seen in low resonance in certain countries like Spain.

In 2012, the company had to discontinue its presence and operation in Spain causing the £2.5m operating profit loss. Total restructuring cash spend was £8.6m.

Opportunities:

First of all, Burberry can be benefiting from growth in emerging markets.

Also, rise in the popularity of e-retailing is growing. Rising internet penetration and increasing familiarity with online shopping is the trend of this current age. Burberry, having very strong brand equity established a strong presence in online retail already and can take further advantage and benefits.

Threats:

The main threat would be a global economic slowdown, which might cause consumers to save more, rather than spend.

Another threat can be illustrated in changing consumer preferences. The fashion industry is very competitive and trends are constantly changing. Consumers have no switching costs and can easily choose another new entering brand or even counterfeit.

According to Bloomberg, the “10-Year UK Government Bond is estimated to be around 1.53% for a coupon bond of 4.00 and a maturity date to 3rd of July 2022” (Bloomberg, s.d.). We will use this value as our risk-free rate that would be assumed for the macro analysis of the Burberry luxury goods market.

As one may be aware 1.53% is a very good risk-free rate for a 10-year Governmental Bond and this is due to the fact that UK country riskiness is ranked triple-A. This means that UK is classified as a safe country to invest in compare to other countries.

UK is classified as a riskiness country, ranked as triple-A country, and its low risk-free rate is the result of the country’s rating and therefore, a much likely attractive to the investors comparing to the other countries in the analysis. For instance, the Italian brand, Todd’s, operates in a A3 country, according to Moody’s latest ranking, and its risk-free rate is about 4.95%, which is relatively high. Also, the French brand such as Hermes, LVMH and Christian Dior have a risk-free rate of 2,3%, which is not so good as UK but not so bad as Italy.

The equity risk premium is the average additional return required by an investor as compensation for investing in equities rather than a risk-free interest. Normally, the countries that have a risk-free rate high have an equity risk premium low.

The equity risk premium would be 13.956% (Bloomberg Terminal seen 03.06.2012). This is quite a big percentage of “excess return that [Burberry] provides over a risk-free rate.” (Investopedia, s.d.).

If the stocks are correctly priced in the aggregate and we can estimate the expected cash flows from buying stock, it is possible to get the expected rate of return through the IRR. Subtracting out the Risk-free rate should yield an implied equity risk premium. This implied equity premium is a forward-looking number.

5. Analysis of Company Beta

Table created from the Bloomberg Terminal 12 month period

Burberry plc. R Squared = 0.69

R Squared values range from 0 – 100. The higher the figure the stronger the relationship is between the firm and the index. A low figure suggests that there is no significant or meaningful relationship between the firm and the index. A high R squared is usually in between 75-100 and a low R squared would be in between 70 and less.

From our explanation, we can see that Burberry plc and some of the other comparable companies in this industry have a low R squared and therefore they are not significantly related to the movements in each of their individual indexes.

We can from the information we have evaluate Jensen’s alpha. It is “a risk-adjusted performance measure that represents the average return on a portfolio [compared with the] predicted capital asset pricing model (CAPM).” (Investopedia, s.d.)

As we know that

We should calculate the CAPM to understand better our Jensen’s measure.

We can see that the returns of Burberry are on the average way lower (around 75%) than the expected return of CAPM prediction.

On the Bloomberg Terminal, we have encountered two types of Beta, the raw Beta, and the adjusted Beta. The raw beta is the leveraged beta and the adjusted beta is a predicted future beta that tends to get closer to 1 (the return of the market).

For a company that has many lines of business or which operates in various products like Samsung which produce phones, tv but also fridges; it is not uncommon to encounter various betas for each product line or sector line. However, Burberry has a unique line of products so there will be no need to evaluate an average beta for each sector of production.

Besides Burberry operates in 3 different channels: retail, licensing and, Burberry is classified in only one sector, consumer durables & apparel. Therefore, there is only one beta to calculate as Burberry has a unique line of products.

6. Estimated Company’s Betas per Business Line

7. Estimated company cost of debt

Burberry plc. Is a publicly traded company in the personal goods sector of the LSE trading on the following indices, FTSE 100, FTSE 350, and FTSE All-Shares. For our analysis, we have decided to compare Burberry to FTSE100 with an expected market return of 12.30%. The cost of debt can be calculated below:
the formula for security i:

The corporation does not have traded bonds and therefore we will have to use other means of evaluation for this company-estimated cost of debt. If it had traded bonds the yield to maturity on those bonds would have been the market-required rate on the firm’s debt.

Regularly large corporations have a credit rate just like countries do from Moody’s or other rating agencies. Burberry even though it is a well-known firm and is present worldwide it is not rated by an external agency. If the firm would have been rated we could have estimated the cost of debt by adding the typical default spread on bonds with Burberry’s rating to the risk-free rate.

In their annual report, it is stated that the group has no significant volumes of credit risk. The group goes through a strict procedure to assure that wholesale sales will be made only to clients who have an acceptable and suitable credit history. Burberry states that a risk arising from other financial assets the company is holding such as cash, short-term deposits, and some derivative instruments comes from the default of the counterparty. Furthermore, the group has another policy that restricts the volume of credit exposure to financial service institutions and says that the company only deposits funds with independently rated financial institutions with a minimum rating of ‘A’.

Since we cannot use both examples mentioned above for the estimated cost of debt we will have to use a method that is used for non-rated firms. There are two ways of doing this.

1. Cost of recent long term bank borrowing
2. Estimated company rating and following the route of rated firms In our report, we will be using method number 2.

United Kingdom

The UK is a triple A-rated country and therefore the yield on the 10 year UK government bond is the risk-free rate for Burberry plc which is 1.43%. The corresponding default spread for AAA companies from January 2012 is 0.65%. Assuming on the information that we have and the ratios that we have calculated Burberry plc should be rated AAA Company.

To find out the companies cost of debt if it were to borrow money we need to add the risk-free rate of the country to the corresponding default spread.

Marginal Tax Rate

The corporate tax rate for corporations in the UK was at a rate of 26% for the year 2011. For the year 2012, the corporate tax rate has changed and has decreased to 24%.

8. Estimated Company Cost of Capital

9. Burberry’s debt:

Companies always have to decide whether to use debt or equity to finance projects within the firm such as expansion or an acquisition.
This is an important decision because whether Burberry decides to use debt or equity there will be different advantages of disadvantages. There are two main advantages of using debt for Burberry and those are tax advantages and “managerial discipline”.

The advantage that comes from using debt payments instead of equity payments is that debt payments are tax-deductible since they are “interest payments”.

Some corporations might benefit from tax benefits from government subsidies but this is not the case of Burberry plc. Companies that qualify for these sorts of subsidies are generally start-up businesses or businesses that operate in important industries that need assistance by governments due to “market failure” or declining industry. The other advantage that comes from using debt payments is management discipline. Managers are well aware of the consequences of using debt since debt is a contractual obligation and the firm will have to have a minimal amount of returns in order to pay the interest to its creditors.

All though there are some advantages from using debt instead of equity there are disadvantages when using debt as well.

One of the biggest disadvantages of using debt, and this goes for all types of companies including Burberry, is the probability or possibility of going bankrupt due to the use of debt, the risk of projects not turning out as expected, and the risk of defaulting on debt.

Bankruptcy might be appealing to some people since it is seen as an easy way out of contractual obligations. But there are negative sides to going bankrupt. When firms declare themselves bankrupts the costs associated with this are generally high and leave the shareholders of the business vulnerable. The costs associated with bankruptcy, in general, are corporate lawyer fees and court fees. Another big disadvantage concerning bankruptcy is the access to funds once you have gone bankrupt. Logically once the company has been lent money and has defaulted it might be harder for the firm borrows money in the near future.
Bankruptcy should be Burberry plc’s last resort and not an easy way out of debt.

We also mentioned how debt enhanced managerial discipline, this is somewhat contradictory because once a manager is in possession of debt (borrowed funds), his goal is to maximize share value and therefore the debt would feed his risk appetite as he would want to perform well in order to receive compensation for his performance. On the other hand, if he performs badly he/she does not have any contractual obligations to the debt, the shareholders do.

One final disadvantage from using debt to finance projects is that if Burberry defaults on some of its debt obligations then this will reduce the financial flexibility of the firm, as it will be harder for Burberry to seek debt financing.

The estimated debt ratio should be:

We do believe that this ratio being relatively low is to the advantage of Burberry, as it shows no possible growth it could be explained by their strategy. We believe that they have a lower ratio because of the way they manage their product distribution line. It might also be because of the way they manage their business whereas most of the supply chain reduces rental cost by exploiting wholesales and licensing. It might also reduce the possibility of bankruptcy risk.

10. Burberry’s optimal capital structure:

From our analysis to reduce the cost of capital or the weighted average cost of capital (WACC), one could increase the use of debt financing. As we can see from our table below as the debt used to increase the WACC has a tendency to decrease:

11. Looking at the history of performance, cash flow and balance sheet realities, decide whether changes are necessary to a firm’s capital structure?

Looking at the Cash flow statement, the Income Statement, and the balance sheet, for the last 5 years (appendix), we can see that the company has managed to grow despite the difficulties they have encountered in their investment in Spain in 2009. However, they would definitively need to decrease their WACC to fit in with their competitors, rendering them slightly more competitive.

12. Are change in leverage required:

A slight change in leverage would be necessary and would eventually surface with the change in the capital structure. The change is quite consequent and might scare off the investors or current shareholders thus, a gradual transition might be more attractive and should lower the risk of failing this needed transition.

13. What is your recommended pathway for altering Burberry’s capital structure?

Burberry does not have to worry too much about its debt position, for the moment. They should however increase their usage of debt by issuing debt to finance future projects.

Their position in equity is very important and they should strongly think of buying back stock using the money collected from issuing debt to stabilize their position and their capital structure. The current situation is to our understanding to risky and relies too much on equity which exposes the company to a large variety of risks regarding the market situation.

Finally, it is more than clear to use that Burberry must withdraw its position in equity and invest in any future project using debt.

14. Review the business/ typical investment projects of Burberry and list the features you’d expect in their financing instruments:

Burberry is mainly positioned in pounds, they do operate around the world, however, and they always convert all expenditure in pounds. Their main financial operations are towards issuing and paying shares and dividends.

We have found in Burberry’s Annual Report of 2011 that they were exposed to floating interest rates and they decided to change to a fixed interest rate.

15. Compare the FCFE that Burberry generates to the cash payouts it makes (dividends and share buybacks.)

We can see that the numbers are better in 2010 than in 2011 this might be due to the fact that we have not taken into account the impact of the failed penetration of Burberry’s in Spain.

We believe that Burberry is trying to compensate for their losses in Spain and that in the long-term they are going to increase their repurchases of shares pattern.

Their returns are slightly higher than the cost of capital which is reassuring. If the company was only managing their returns lower than the cost of capital then we should be a concerned for the well-being of the company, or it would show that Burberry is a new company; which in our case is really not the position of Burberry. Burberry is now a mature mid-size company.

16. Perform a DCF valuation of Burberry

Bibliography

Bloomberg, n.d. U.K. Government Bonds. [Online] Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/uk/ [Accessed 3 June 2012].

Burberry, 2011. Annual Report, s.l.: s.n.

Investopedia, n.d. Definition of ‘Jensen’s Measure’. [Online] Available at: http://www.investopedia.com/terms/j/jensensmeasure.asp [Accessed 6 6 2012].

Investopedia, n.d. Equity Risk Premium. [Online] Available at: http://www.investopedia.com/terms/e/equityriskpremium.asp#axzz1wxz0JTe3 [Accessed 06 06 2012].

Appendix I: Balance Sheets

Appendix II: Cash Flows

2010 re-presented to exclude discontinued Spanish operations

Appendix III: Income Statement

Author: Saadry Dunkel

Date: 27.02.2011

Title: In company reporting, the measurement of the amount of impairment of many types of assets is so subjective as to be meaningless

Harvard Referencing Source System:

Saadry DUNKEL. 2011.In company reporting, the measurement of the amount of impairment of many types of assets is so subjective as to be meaningless. [ONLINE] Available at: http://www.saadry-dunkel.com/publications/company-financial-statement-2. [Accessed 07 April 15].

In company reporting, the measurement of the amount of impairment of many types of assets is so subjective as to be meaningless

The International Accounting Standard Board (IASB) and the Federal Accounting Standard Board (FASB) are working together in order to create an international set of accounting standards. The aim is to prevent frauds, to regularize more the accountancy profession and to make it easier for users to compare different companies from their annual reports. While in process of creating the perfect sets of accounting standards the boards are in perpetual reform of their accounting standards. One of the recent discussions was talking about “the measurement of the amount of impairment of many types of assets” and the problems arising due to the subjectivity of managers’ accountants. This essay will first, define an asset and the accounting standard IAS 36. Then the discussion will explain why companies need to impair assets and how to calculate the recoverable amount. Finally, this composition will give examples to support its argumentation and define some residual problems arising with the valuation of assets.

According to the International Accounting Standard Board (IASB), “an asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise” (IASB cited in Raccountant, 2008). These items can be used to produce goods or be sold in exchange for cash. Some assets are tangible (land, buildings, machinery, etc…) others are intangible (goodwill, investments, etc…). Most assets have a limited life and need to be depreciated and amortised such that they can be replace later.

There exist factors that can affect the value of an asset. The variation of the asset can be related to fluctuation of the economic market or due to obsolescence of the asset. The value of an asset is therefore directly linked to the market; in other words, what the demand is willing to pay for the item. The Entrepreneur explains that “rapid changes in market demand can create obsolescence of plant, machines and patents and can cause assets to lose some or all of their capacity to recover their costs” (Entrepreneur, 2000).

According to IAS 36, “an asset is impaired when its carrying amount exceeds its recoverable amount” (Deloitte, 2010). The latter explains that, on the balance sheet, an asset can be over-evaluated. The recoverable amount is the “higher of an asset’s fair value less costs to sell […] and its value in use” (Deloitte, 2010; 36.6). In order to, adjust the value of this asset; the accountant must conduct an impairment test. However, once a tangible asset has been impaired it does not need to be impaired again the next year. The following table (table 1) is a summary of Richard research describing the impairment by sectors and the impairment losses by sectors. The results from the table 1 demonstrate a strong need for impairment in the sector of media, support services, transport and construction. This could be because these sectors could be using more intangible assets and goodwill than others.

Table 1: Impairment activity by sector

Table from the Richard research page 26 and 30

The standard states that an annual impairment should be exercised on goodwill, on any intangible asset which life expectancy is undefined or on an intangible asset that is not yet usable. Assuming that an asset’s “fair value less costs to sell cannot be determined, then recoverable amount is the value in use” (Deloitte, 2010: IAS 36.20). In the situation where the asset is going to be disposed of then the “recoverable amount is fair value less costs to sell” (Deloitte, 2010: IAS 36.21). An asset does not need any impairment if “fair value less costs to sell or value in use is more than carrying amount” (Deloitte, 2010: IAS 36.19).

In order to impair an asset the accountant needs to know the carrying amount of that asset. The carrying amount is the value of the asset found in the balance sheet which can vary from one accounting year to another. The amount of this asset has been reported after “deducting accumulated depreciation and accumulated impairment losses” (Deloitte, 2010: IAS 36.6).

The recoverable amount is then recorded as a loss or profit in the financial statement, the income statement and the profit and loss account.

However, Richard explains that the estimation of the “recoverable amount of the asset are open to subjectivity in their calculations the value-in-use method particularly so, as this method has a wider potential for errors” (Richard, 2006: 19). The latter argument describe that the calculation of the revaluation of the asset is not really easy and is entirely up to the accountant. The evaluation of the price the demand is willing to pay for the items is very variable and not constant, and mainly depends on the economic situation of the market at the time of the evaluation.

The impairment of assets is an important tool that can help to revaluate the risk of future investment. The impairment of asset should help describing the value of the asset with the given economic situation. In other words, accountant must calculate the recoverable amount taking in account the uncertainty and the risk of the value in use describe by the market. Indeed, “to reduce the uncertainty [and] avoid potential disclosure responsibility and risk, […] accounting personnel should test and confirm the asset impairment, and provide more reliable asset value information report to the users of information” (Sun & Xu, 2010: 199). A survey has reported that over 170 “users of financial statements” (Ernest & Young, 2009: 2), 66% are finding the impairment value in the financial statements useful for their investment decision-making process.

Therefore, the impairment is essential for shareholders and potential investors because it gives them information regarding the value of the company. The impairment made by a company can help users to evaluate if the company is well managed and have an incentive of how it responds to risk. Also, it can help shareholders understand the amount of dividend they are expected to receive.

Indeed, assuming that the accountant did not properly impair the asset of a company, the company’s entire value can be under-estimated or over-estimated. This could affect the decision-making of the investors. A good example of bad managerial accountant impairment is the case of HBOS in 2008, when Lloyds TSB wanted to buy HBOS. HBOS has “admitted […] that it had taken a surprise £3.3 billion in impairment charges against its corporate lending activities over the 11 months to the end of November” (Miles Costello and Helen Power, 2008). HBOS has had to carry heavy impairment charges which could have been avoided. The company should have perceived the abnormal economic activity and should have created a provision to cover its corporate lending activities. The company’s “impairment charges rose by £1.6 billion in just two months, October and November” (Miles Costello and Helen Power, 2008). Instead of recognizing a managerial mistake, HBOS “blamed this on sliding investment markets and the worsening economic conditions, [Furthermore] analysts were stunned by the size of the charges, which sent HBOs shares tumbling more than 18 per cent down” (Miles Costello and Helen Power, 2008).

However, a company could use the impairment tool to benefit from it by revaluating an increase in the value of assets. According to the Entrepreneur, “management uses the accounting rules and manipulates earnings either by not recognizing impairment when it has occurred or by recognizing it only when it is advantageous to do so” (Entrepreneur, 2000). Theoretically a company could manipulate impairment such that it could increase their turnover or their earning per share. Moreover, Lhaopadchan argues that “the recognition of acquired goodwill […] have resulted in providing self-interested managers with greater opportunities to engage in earnings and balance sheet manipulations that are of doubtful value to users” (S. Lhaopadchan, 2010: 1-2). Therefore, it is essential for an entity to remain ethical and to properly and objectively calculate the impairment of assets.

To conclude, the measurement of the amount of impairment of many types of assets is very important because it allows users to evaluate properly the value of the company. The public demands more transparency regarding the activity of companies. This is a legitimate request, especially if it regards shareholders who have already invested their money in the company. Impairment is essential to the well-being of a company and its calculation must be dealt with professionalism and integrity. The managerial accountant must be objective when choosing which assets is to impair but at the end the importance is not which assets is impaired but more how to present it.

Bibliography:

Books:

Andrews, Richard (2006). Impairment of assets: measurement without disclosure? London: Association of Chartered Certified Accountants.

Journals:

Shipan Sun and Xia Xu. (2010). Study on the Asset Impairment Accounting. International Journal of Business and Management. 5 (6)

Suntharee Lhaopadchan . (2010). Fair value accounting and intangible assets: goodwill impairment and managerial choice . Journal of Financial Regulation and Compliance . 13 (2), 25/02/2011.

Websites:

Entrepreneur. (2000). Impairment Write-Offs: Truth or Manipulation?(corporate assets)(Statistical Data Included). Available: http://www.entrepreneur.com/tradejournals/article/64781966.html. Last accessed 25/02/2011.

Ernest & Young. (2010). Meeting today’s financial challenges – Impairment reporting: improving stakeholder confidence. Available: http://www.ey.com/Publication/vwLUAssets/Meeting_todays_financial_challenges_- _Impairment_reporting_- _Improving_stakeholder_confidence/$FILE/EY_Meeting_todays_financial_challenges_- _Impairment_reporti. . Last accessed 25/02/2011.

Miles Costello and Helen Power. (2008). Lloyds team starts work as HBOS investors vote ‘yes’. Available: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article53 33683.ece. Last accessed 25/02/2011.

Author: Saadry Dunkel
Date: 23.11.2010
Title: Accounting is essentially highly subjective. Contemporary debates in the field of accounting revolve around the advocacy of competing images and the way accounting is implicated in the construction of social reality

Harvard Referencing Source System:

Saadry DUNKEL. 2010. Accounting is essentially highly subjective. Contemporary debates in the field of accounting revolve around the advocacy of competing images and the way accounting is implicated in the construction of social reality. [ONLINE] Available at: http://www.saadry-dunkel.com/publications/company-financial-statement-1. [Accessed 07 April 15].

Accounting is essentially highly subjective. Contemporary debates in the field of accounting revolve around the advocacy of competing images and the way accounting is implicated in the construction of social reality.

Elliott and Elliott define accounting as “the art of communicating financial information about a business entity to users [.] The art lies in selecting the information that is relevant to the user and is reliable.” (Elliott&Elliott 2009) Accounting is a social science that is “attempting to survive in a changing environment” (Davis, Menon and Morgan. (1982)). It’s been a long time since governments and public companies have understood that accounting needs to become more objective [1]. Despite many attempts to make accounting an objective science, it remains “highly subjective. Contemporary debates in the field of accounting revolve around the advocacy of competing images and the way accounting is implicated in the construction of social reality.” (Davis, Menon and Morgan. (1982)) Accountants have understood that “recognizing how images and assumptions shape the understanding of context” (Davis, Menon and Morgan. (1982)) can help them to “develop [ ] new ways of approaching” (Davis, Menon and Morgan. (1982)) their profession. This essay will attempt to describe these images and their influences on accounting standards, as well as many issues which arise from these debates; finally it will present the implication in constructing a social reality throughout examples of the accounting standards.

Accounting has been shaped by four images: “a historical record, a descriptor of current economic reality, an information system, and as a commodity.” (Davis, Menon and Morgan. (1982)) The historical record incorporates the idea of objectivity by representing financial information in a “faithful record of the actual exchange events of an entity, with an emphasis on information that is reliable, verifiable and quantifiable.” (Davis, Menon and Morgan. (1982)) In other words, the accountant has to evaluate which information is reliable and relevant, then he must summarize it, and finally present it in the financial report provided that this information is verifiable and quantifiable. Because the accountant has to make this choice he is not objective anymore. Morgan argues that such a system prevents proper views of reality “presenting […] the situation in limited and one-sided ways” (Davis, Menon and Morgan. (1982))preventing to take in account certain aspect of “the transaction such as opportunity cost, replacement cost, etc.” (Davis, Menon and Morgan. (1982)) Thus, “the only event to be recorded is, while objective, also exclusive”. (Davis, Menon and Morgan. (1982)) Also, the reality of accounting has changed over the years; first, it was seen as “attempts […] to make sense of practice in terms of universal principles […] such as objectivity, consistency, conservatism, and verifiability” (Davis, Menon and Morgan. (1982)) Now Davis emphasis that the new concern is to maximize resources, increase wealth and ultimately take into account the social cost and benefits among other things.

Moreover, objectivity has to be neutral for it to be trusted. Accountants have the responsibility and control of almost all of the world’s transactions. Thus, one must understand the ethical responsibility which lies on the accountants. One should know that recent research claims that “money laundering [is] estimated to be anywhere between US$ 750 billion and a trillion dollars” (Mitchell, Sikka and Willmott. (1998)) and suggests that “such a large amounts cannot easily be laundered without the […] involvement of accountants.” (Mitchell, Sikka and Willmott. (1998))

This leads to the second image, which sees “accounting as a current economic reality”. (Davis, Menon and Morgan. (1982)) With the scandal of Enron, the downfall of Lehman brothers, and recent financial crisis, one has to realize that accounting has a very important impact on the economic markets. Zeff talks about “economic consequences […] of accounting reports on the decision making behaviour of business, government, […] investors and creditors.” (Zeff 1978) The accountant has a choice to reflect either the economical reality or the historical price in the construction and presentation of the balance sheet and the income statement. However, in order to be more accurate the current and future prices should be taken into account for they represent more accurately the value of the assets. Davis explains that “current and future prices affect enterprise behavior, and advocate the development of accounting statements […] which reflect these prices rather than the historical prices” (Davis, Menon and Morgan. (1982)) he defends that one of the major problems resides in the income and the method of valuation of price.

One can understand that because companies are profit-seeking organizations, they will try to reassure their shareholders, as much as possible, in order to make more profit. The idea is to emphasize the positive part and to hide, shadow or sometimes not reveal the bad figures or information. In contrast to the historical view, which records the actual price, the economic reality offers a variety of valuation methods, which depend on the point of view of the accountant. These could be “replacement costs” or “net realizable values”, as suggested by (Davis, Menon and Morgan. (1982)). Economic reality gives an opportunity to chose from a range of different valuation methods, therefore it allows to “play” with numbers, so that for example the manager by choosing the method that makes the profits look bigger, shows the shareholders a better view of the company then there would be if he had used another valuation approach, thus justifying his bigger bonus payment.

Thus, those methods of valuation play a key role when dealing with the presentation of the figures in the financial statements. Furthermore, Zeff explains that the presentation of those financial statements is also important because it affects the users. For example, the “foreign exchange currency translation and the accounting for unsuccessful exploration activity in the petroleum industry have relied heavily on economic consequences” (Davis, Menon and Morgan. (1982)) Thus, choosing what to account for and what to disclaim can have an important impact on the economy.

Then, the third image describing accounting as an information system is best presented by the diagram of Sterling.

Diagram taken from the article (Davis, Menon and Morgan. (1982))

It explains how the accountant selects information that is quantifiable and useful to be redistributed to the users. Previously, the “AICPA [2] described accounting as: the art of recording, classifying, and summarizing in a significant manner […] transactions and events […] and interpreting the results thereof.” (Davis, Menon and Morgan. (1982)) This interpretation allowed accountants to be more flexible in their presentation and interpretation of the information used for decision-making. Now the Financial Accounting Standards Board has defined that accountants should “provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions”. (Davis, Menon and Morgan. (1982)) The information needed to be based on a more or less objective interpretation of every transaction; now the information is selected based on its utility or level of usefulness. This introduces another problem – how does one decide what is useful? – accounting is becoming less and less objective and is falling into the interpretation of the accountant. Following this logic, the users might have a better insight of what is useful for them than the accountant. Because of this, accountancy is described as being highly subjective.

Because there exists a demand and a supply for financial information, “accounting information is seen as an economic commodity” (Davis, Menon and Morgan. (1982)) and such a commodity must be regulated “in order to obtain a better allocation of resources in the economy” by “standard settings” (Davis, Menon and Morgan. (1982)). In other words, the fourth image explains the origin of the International Accounting Standards Board and the Financial Accounting Standards Board in the US. Their aim is to provide a proper conceptual framework and eventually to promote it internationally. Thus, the government is indirectly forcing companies to follow those regulations dictated by the IASB or FASB, by making each company represented in the market to publish annual reports. Those annual reports have an impact on the company, the employees and on the current and future investors. Depending on the situation of the company, the annual report can reassure the investors or make them worry about the situation (well-being) of the company; and this will have an impact on the market. For example, if the company announces a good turnover the investors could be motivated to buy more shares from the company. On the over hand, if the company announces that it has decreased the price of earnings per share, the investors might decide to sell their shares. These financial decisions will have a repercussion on the value of the company in the market.

Finally, the social impact of these images can be seen not only from the outside environment of the company but also from the inside. Indeed, accountants tend to forget the importance of the labour forces and see them as just a cost to be paid (the salaries of employees). While gathering information for financial decision-making, the accountant ignores all information concerning the employees. Looking at the Annual report of GSK [3], one can see that there is no information regarding the labor forces. This is a real problem because they are the ones suffering from any decision that the director or the board takes. On their hand, they carry all the obligations and risks without any compensation, retribution or security. Thus, those images have also an important social impact on the company. For example, in those past years, many companies have decided to close down their factories in France because it was too costly; this has had a dramatic effect on the labor forces. Those decisions have left hundreds of workers in the streets. Those workers have no diplomas and they cannot do anything else than what they have been doing because they do not know anything else.

Moreover, the creation of new accounting standards will have an impact on social reality [4]. In other words, social reality can be explained by the indirect agreement of a concept by a group or a community, such that it becomes a shared reality or a reality taken for granted. In fact, accounting is often implicated in the construction of social reality every time a new accounting standard is published. When the IASB and FASB are publishing a new accounting standard the accounting community will have to take it for granted and will have to use it according to those principles. An example to illustrate that is the IAS 36 (Impairment of Assets) the objective of which is “to ensure that assets are carried at no more than their recoverable amount and to define how recoverable amount is determined.” (Deloitte 2010) All assets can be impaired except for inventories, deferred tax assets, financial assets, etc… Accounting standards are guidelines to help accountants make decisions. However, those standards are often imposed and not submitted to the vote of the general population.

To conclude, accounting is evolving, it is moving towards the creation of a global conceptual framework. However, the profession should understand the importance it has on the social reality and help the system to become more ethical, reliable, and most of all objective. Images such as the historical record (cost), current economic reality, information system, and commodity; have provided accountants with a better understanding of their profession but more images will eventually appear; more financial difficulties. The idea is that accountancy must learn from their past mistakes and makes itself in the future; moreover, it should evaluate its situation periodically to understand where it is going. Indeed, just like a marketing or financial decision accounting profession should plan, implement, control, and evaluate its reforms.

Bibliography:

Book

Barry Elliott and Jamie Elliott (2009). Financial Accounting and Reporting. 13th ed. England: Pearson Education Limited

Encyclopaedia

Microsoft ® Encarta ® 2009. © 1993-2008 Microsoft Corporation. Objectivity. Last accessed 23 November 2010

Journals:

Edward Stamp. (1981). Why can accounting not become a science like physics?. Abacus. 17 (n°1), p13-27.

Gareth Morgan. (1988). Accounting as reality construction: Towards a new epistemology for accounting practice. Accounting, Organizations and Society. n°5 (88), p477-485.

Stanley W. Davis, Krishnagopal Menon and Gareth Morgan. (1982). The images that have shaped accounting theory. Accounting, Organizations and Society. 7 (n°4), p307-318.

Stephen A. Zeff. (1978). The rise of economic consequences. Journal of Accountancy. December (78), p56-63.

Web-pages:

• Austin Mitchell, Prem Sikka and Hugh Willmott. (1998). The accountant’s laundromat. Available: http://www.sec.gov/rules/proposed/s71300/sikka1c.htm#summary. Last accessed 23 November 2010.
• Deloitte. (2010). IAS 36 IMPAIRMENT OF ASSETS. Available: http://www.iasplus.com/standard/ias36.htm. Last accessed 23 November 2010.
• Webster’s Online Dictionary. (2010). Extended Definition: Social reality. Available: http://www.websters-online-dictionary.org/definitions/social+reality?cx=partner-pub-0939450753529744%3Av0qd01-tdlq&cof=FORID%3A9&ie=UTF-8&q=social+reality&sa=Search#938. Last accessed 23 November 2010.

Online Annual Reports [PDF]

GlaxoSmithKline Plc, Annual Report 2007 [online] Available at: http://www.gsk.com/investors/reps07/annual-report-2007.pdf [Accessed 23 November 2010]

[1] See Britannica Dictionary 2009: Objective represent the reality: relating to, or being an object, phenomenon, or condition in the realm of sensible experience independent of individual thought and perceptible by all observers: having reality independent of the mind.

[2] The American Institute of Certified Public Accountants

[3] GlaxoSmithKline Plc

[4] Definition found on www.websters-online-dictionary.org: is distinct from biological reality or individual cognitive reality, and consists of the accepted social tenets of a community.

Author: Saadry Dunkel
Date: 18.02.2011
Title: Accountancy is a profession

Harvard Referencing Source System:

Saadry DUNKEL. 2011. Accountancy is a profession. [ONLINE] Available at: http://www.saadry-dunkel.com/publications/accountancy-is-a-profession. [Accessed 07 April 15].

Accountancy is a Profession

The current global financial crisis has had an unprecedented effect on the greater part of international markets. Too risky investments of some companies, among other reasons, have caused an unprecedented recession, which is now affecting the public interests, with a very significant increase in unemployment. Many ask for reassurance and therefore turn to the accountancy profession. More than ever, people need to know if “accountancy is a profession”. To justify this claim, this essay will analyze several theories of social professionalism; namely the Weberian and Marxian perspectives. The Weberian theory regards capitalism as a positive asset motivating the labour force. On the other hand, Marxians promote socialism and emphasis on the need to regularize production. The discussion will include the role of professions and their interaction with both the government and the community and discuss whether accountancy can be defines as a profession.

Primarily, one must understand the definition of profession and the role it plays in the society. The aim of a profession is to serve the community by producing goods or services for individuals or groups. The professionalism can be defined as “the skill, competence, or character expected of a member of a highly trained profession” (Encarta 2009). Quite often professions have a code of ethics, Higgins and Olson suggest that “a code of ethics […] is vital to the process of professional self-discipline” (1972: 33). For example, in medicine, students have to swear to respect the Oath of Hippocrates before they can become doctors.

As expert in their field, professions must ensure that they can be trusted by the community. “People turn to professionals not only for service but for advice” (Higgins & Olson, 1972:39), they have an important responsibility and they should influence people in a professional manner. This is why a “code of ethics bears not only internally on a profession’s own affairs but externally on its position in society” (Higgins & Olson, 1972: 39). Carr-Saunders and Wilson presented in Mitchell et al., explain that “members of a professions are altruistic, unselfishly promote the public interest and adhere to a professional code of conduct” (Carr- Saunders and Wilson, 1933 cited by A. Mitchell, T. Puxty, P. Sikka and H. Willmott, 1994: 40).

Macdonald explains that “the professional project […] needs to strive both economically and socially. […] The service that professionals provide are […] intangible and the purchaser has to take them on trust” (1995: 32). Indeed, vocations need to satisfy the interest of the community and their own economic interests to survive in this capitalistic world. The latter argument describes a conflict of interests because professions are profit seekers. Weberians, cited by Macdonald, recognize that “professions are interested groups [engage] in competition with each other”. (1995: 32) Therefore, they cannot really be objective or protect fully the “public‟s interests”. Baker argues that the public interest is often defined by “a particular social class or group, and not necessarily those of a ruling or dominant class” (2005: 692). The latter argument emphasises the need to dissociate the interests of several social classes, and not to take in account only the dominating one. Social interests or public interests also include the interest of the labour forces, the pensioners or the unemployed class.

Caramanis points out that professional “major objective is the achievement of (preferential) access to the market for their expertise and the advancement of the interests of their (most influential) members” (Caramanis, 2005: 196). The expansion of professions was predictable but they need proper governance. Marxian defines, cited by Macdonald, capitalistic market as “an inherent tendency to monopoly, which enables the owners of the means of production to dominate all markets and therefore society” (1999: 36). Profession cannot pretend to be ethical when their only concern is the satisfaction of one group of individuals. Monopolies are interesting for profit-seeking organisations but they are not beneficial to institutions. Accounting profession dominate markets and seeks expansion to other countries and other markets. Sikka explains that, “government departments have been colonised by accountants and accounting technologies with little evidence of any improvement in government accountability or performance” (Sikka, 2009). Logically, the public was expecting that with the increase of accounting professionals; there would be an improvement in the governance of the profession. However, the expansion is such that almost every transaction needs an accountant. Despite governments attempts to regulate the accountancy profession they have “failed to deliver the promised advances in business transparency, accountability and good governance” (Sikka, 2009).

The accountancy vocation has failed to satisfy the public expectation and they are losing their credibility. Johnson remains us that, “a profession is not, then, an occupation, but a means of controlling an occupation” (1972: 45). Governments need to regulate the economy and are relying on accountants to avoid fraud and unethical behaviour. The AICPA1 defines that “a distinguishing mark of a profession is acceptance of its responsibility to the public […] interest [which] is defined as the […] well-being of the community”. Despite the latter argument, accounting profession uses “their expertise to excel at money laundering, bribery, corruption and other antisocial practices” (Sikka, 2009). Rules are necessary but apparently not efficient; Sikka explains that despite the effort of the “elected governments […] to develop tax laws, […] accountancy firms can undermine them within hours [in pursuit of private profits.]” (Sikka, 2005).

The profession of accountancy has become an industrial process which has downgraded the quality of their product. The accounting products are now commercialized and advertise to attract new „clients‟. An article mentiones that “an accountancy firm partner was bold enough to state recently [that] „No matter what legislation is in place, the accountants and lawyers will find a way around it. Rules are rules, but rules are meant to be broken.‟” (Sikka 2005) This statement proves that the ethics of the accounting profession cannot be trusted. KPMG has stated in their annual report that their clients “look to us to design tailor-made tax strategies allowing them to be both compliant and tax efficient” and that “the Tax practices in our Swiss, UK and German firms are particularly active in supporting family offices, a growing source of global investment capital.” (KPMG, 2010) Such a claim can be problematic for the credibility of the firm when Teather reveals that “KPMG […] agreed to pay $456m (£255m) to settle allegations that it promoted illegal tax shelters, avoiding a potentially devastating criminal prosecution” (2005).

To conclude, accounting is a profession and as such faces challenges. Accountancy profession needs a proper code of ethics and more rigid governance by the government. The profession of accountancy should serve the public interest. Communities are revolted by the actions of accountants, and they demand retribution. The collapse of Enron and Lehman Brothers has left employees without jobs. The profession needs to be more transparent in their actions in order for them to regain the public trust. Many scholars are claiming that the behavior of accountancy profession is not representing a proper profession. The profession of accountancy is not interested in the general opinion, only that of shareholders which they should satisfy. Therefore, in order to regain their title of professional, accountants should help government reduce unethical behavior. A solution could be to nationalize the accountancy profession or big accounting firms. For example, in the profession of medicine, hospitals are owned by the government. In Canada, doctors are remunerated directly from the community and no individual has to pay extra for a prestation. This could help governments to have a direct impact on accountant‟s actions. However, this would mean the end of big bonuses of accountants.

Bibliography:

Annual Report:

KPMG , Annual Report 2010 [online] Available at: http://annualreport.kpmg.eu/documents/financials/ellp_ara_2010_final_combined_lr.p df, Accessed 18/02/2011

Articles:

Alistair Preston, David J. Cooper, D. Paul Scarbrough and Robert C. Chilton. (1995). Changes In The Code Of Ethics Of The U.S. Accounting Profession, 1917 And 1988: The Continual Quest For Legitimation. Accounting, Organization.s and Society. 20 (6), 507-546.

Baker, C.R. (2005). What is the meaning of “the public interest”? Examining the ideology of the American public accounting profession, Accounting, Auditing and Accountability Journal, 18(5) 690-703

Higgins, G. & Olson, W. E., Restating the Ethics Code: A Decision for the Times, Journal of Accountancy (March 1972) 34-39

Austin Mitchell, Tony Puxty, Prem Sikka and Hugh (1994). Ethical Statements as Smokescreens for Sectional Interests: The Case of the UK Accountancy Profession. Journal of Business Ethics. 13 (1), 39-51.

Richard Baker. (2005). What is the meaning of “the public interest”? : Examining the ideology of the American public accounting profession. Accounting, Auditing & Accountability Journal. 18 (5), 609-703.

Constantinos Caramanis. (2005). Rationalisation, charisma and accounting professionalisation: perspectives on the intra-professional conflict in Greece, 1993– 2001. Accounting, Organizations and Society. 30 (2), 195-221.

Books:

Carr-Saunders (1964). „The Professions‟. 2nd London, Frank Cass & Co Ltd. p 208-220.

Keith Macdonald (1999). „The Sociology of the Professions‟, 2nd ed. London, Sage. 36.

Stanley Charles Abraham (1978). „The Public Accounting Profession‟, in Toronto, Lexington

Terence Johnson (1972). „Professions and Power‟, 6th ed. London, Macmillan Education Ltd. 21-51.

Encyclopedia:

Microsoft Encarta © 2009

Websites:

(2006). ET Section 53 – Article II The Public Interest . Available: http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/et_section_53 artic le_ii_the_public_interest.aspx. Last accessed 18/02/2011.

David (2005). KPMG escapes prosecution but fined $456m for tax shelters . Available: http://www.guardian.co.uk/business/2005/aug/30/5/print. Last accessed 18/02/2011.

Prem (2005). Accountants: a threat to democracy . Available: http://www.guardian.co.uk/politics/2005/sep/05/publicservices.economy/print. Last accessed 18/02/2011.

Prem (2009). A Nation of Accountants. Available: http://www.guardian.co.uk/commentisfree/2009/jun/13/accountants-audit-corruption- fraud/print. Last accessed 18/02/2011.

Douglas (2001). Profession. Available: http://www.etymonline.com/index.php?term=profession. Last accessed 18/02/2011.

1 The American Institute of Certified Public Accountants.