On 1 April 2019, Bahtiar acquired 80% of the equity interests of Masla, a privately owned entity, for a consideration of RM 57 million. The consideration comprised cash of RM 52 million and the transfer of non-depreciable land with a fair value of RM 5 million.

(a)  When Bahtiar acquired the majority shareholding in Masla, there was an option on the remaining non-controlling interest (NCI), which could be exercised at any time up to 31 December 2020. On 30 April 2020, Bahtiar acquired the remaining NCI which related to the purchase of Masla. The payment for the NCI was structured so that it contained a fixed initial payment and a series of contingent amounts payable over the following two years. The contingent payments were to be based on the future profits of Masla up to a maximum amount. Bahtiar felt that the fixed initial payment was an equity transaction. Additionally, Bahtiar was unsure as to whether the contingent payments were equity, financial liabilities or contingent liabilities. After a board discussion which contained disagreement as to the accounting treatment, Bahtiar is preparing to disclose the contingent payments in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The disclosure will include the estimated timing of the payments and the directors' estimate of the amounts to be settled.

Required:

Advise Bahtiar on the difference between equity and liabilities and on the proposed accounting treatment of the contingent payments on acquisition of the NCI of Masla

(b)  The directors of Bahtiar are considering the purchase of a company in the USA. They have heard that the accounting standards in the USA are 'rules based' and that there are significant differences of opinion as to whether 'rules based' standards are superior to 'principles based' standards. It is said that this is due to established national approaches and contrasting regulatory philosophies. The directors feel that 'principles based' standards are a greater ethical challenge to an accountant than 'rules based' standards.

Required:

Discuss the philosophy behind 'rules based' and 'principles based' accounting standards, setting out the ethical challenges which may be faced by accountants if there were a switch in a jurisdiction from 'rules based' to 'principles based' accounting standards.

 

Answer:

The Framework defines a liability as a present obligation, arising from past events and there is an expected outflow of economic benefits. IAS 32 Financial Instruments: Presentation establishes principles for presenting financial instruments as liabilities or equity.

IAS 32 does not classify a financial instrument as equity or financial liability on the basis of its legal form but on the substance of the transaction. The key feature of a financial liability is that the issuer is obliged to deliver either cash or another financial asset to the holder. An obligation may arise from a requirement to repay principal or interest or dividends. In contrast, equity has a residual interest in the entity's assets after deducting all of its liabilities. An equity instrument includes no obligation to deliver cash or another financial asset to another entity. A contract which will be settled by the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. However, if there is any variability in the amount of cash or own equity instruments which will be delivered or received, then such a contract is a financial asset or liability as applicable. The contingent payments should not be treated as contingent liabilities but they should be recognised as financial liabilities and measured at fair value at initial recognition. IAS 37 Provisions, Contingent Liabilities and Contingent Assets excludes from its scope contracts which are executory in nature, and therefore prevents the recognition of a liability. Additionally, there is no onerous contract in this scenario. Contingent consideration for a business must be recognised at the time of acquisition, in accordance with IFRS 3 Business Combinations. However, IFRS do not contain any guidance when accounting for contingent consideration for the acquisition of a NCI in a subsidiary. The contract for contingent payments does meet the definition of a financial liability under IAS 32.

Bahtiar has an obligation to pay cash to the vendor of the NCI under the terms of a contract. It is not within Bahtiar's control to be able to avoid that obligation. The amount of the contingent payments depends on the profitability of Mach, which itself depends on a number of factors which are uncontrollable. IAS 32 states that a contingent obligation to pay cash which is outside the control of both parties to a contract meets the definition of a financial liability which shall be initially measured at fair value. Since the contingent payments relate to the acquisition of the NCI, the offsetting entry would be recognised directly in equity.

Step-by-step explanation

Nearly all companies are required to prepare their financial statements as set out by the Financial Accounting Standards Board (FASB), whose standards are generally principles-based. FASB uses these principles in establishing its accounting practices and methods.1 Law requires U.S. companies to adhere to accounting standards when reporting their financial statements, but the specifics can vary depending on where a company is headquartered.

KEY TAKEAWAYS

• Nearly all companies are required to prepare their financial statements as set out by FASB, whose standards are generally principles-based.
• The rules-based Generally Accepted Accounting Principles (GAAP) system is the accounting method used in the United States.
• Critics of principles-based accounting systems say they give companies too much freedom in reporting.
• On the other hand, critics of rules-based methods like GAAP cite that the system can often be too complex.

Understanding Principles-Based Accounting

Principles-based accounting seems to be the most popular accounting method around the globe. Most countries opt for a principles-based system, as it is often better to adjust accounting principles to a company's transactions rather than adjusting a company's operations to accounting rules.

The international financial reporting standards (IFRS) system—the most common international accounting standard—is not a rules-based system. The IFRS states that a company's financial statements must be understandable, readable, comparable, and relevant to current financial transactions.2

Rules-Based Accounting

Rules-based accounting is a standardized process of reporting financial statements. The Generally Accepted Accounting Principles (GAAP) system is the rules-based accounting method used in the United States. Companies and their accountants must adhere to the rules when they compile their financial statements. These allow investors an easy way to compare the financial information of different companies.

There are 10 principles of the rules-based GAAP accounting system:

1. Regularity
2. Consistency
3. Sincerity with an accurate representation of the company's financial situation
4. Permanence of methods
5. No expectation of compensation
6. Prudence with no semblance of speculation
7. Continuity
8. Dividing entries across appropriate periods of time
9. Full disclosure in all financial reporting
10. Good faith and honesty in all transactions3

The GAAP method is used when a company releases its financial statements to the public. It covers a number of things such as revenue recognition, balance sheet classification, and how outstanding shares are measured.4

Companies and accountants that do not follow GAAP standards could be brought to court if their judgments and reporting of the financial statements were incorrect.

Principles-Based vs. Rules-Based Accounting

The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes compel managers to manipulate the statements to fit what is compulsory.

On the other hand, when there are strict rules that need to be followed, like those in the U.S. GAAP system, the possibility of lawsuits is diminished. Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management.

Compliance to GAAP helps to ensure transparency in the financial reporting process by standardizing the various methods, terminology, definitions, and financial ratios. For example, GAAP allows investors to compare the financial statements of two companies by having standardized reporting methods. Companies must formulate their balance sheet, income statement, and cash flow statement in the same manner, so that they can be more easily evaluated.

If companies were able to report their financial numbers in any manner they chose, investors would be open to risk. Without a rules-based accounting system, companies could report only the numbers that made them appear financially successful while avoiding reporting any negative news or losses.

Problems With Both Systems

The main problem overall is that there is no one set accounting method that has been universally adopted. There are currently more than 144 jurisdictions that use IFRS as their accounting standards, while the U.S. uses the rules-based GAAP method.5 As a result, investments, acquisitions, and mergers may require a different lens when comparing international competitors such as Exxon and BP, which use different accounting methods.

Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency. They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of its financial health.

In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. And having strict rules means that accountants may try to make their companies more profitable than they actually are because of the responsibility to their shareholders.

Example of Accounting Manipulation

Enron was a major energy company in the 1990s. In 2001, Enron shareholders lost almost $75 billion in value after the company's executives used fraudulent accounting practices to overstate revenue while hiding debt in its subsidiaries.6

Enron declared bankruptcy-and with $63 billion in assets-was the largest U.S. bankruptcy at that time.7 The company's collapse sent shockwaves throughout the financial markets leading to a wave of additional regulations.

When contemplating which accounting method is best, make certain that the information provided in the financial statements is relevant, reliable, and comparable across reporting periods and entities. Although there are benefits to principle-based accounting, it is recognized that the method may need to be modified to make it more effective and efficient.