A Study of Accountants' Judgments With Respect to the Provision of Consolidated Financial Statements

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The release of the Australian Accounting Standards Board AASB 1024. Consolidated Accounts. in September 1991 represents a fundamental shift in concept, criteria and approach. The Standard is based on the entity concept and adopts ‘capacity to
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  ABACUS Vol. 32 No. I 996 RON DAY AND JIM PSAROS of Accountants’ Judgments With to the Provision of Consolidated Financial Statements A Study Respect The release of the Australian Accounting Standards Board AASB 1024. Consolidated Accounts. in September 1991 represents a fundamental shift in concept, criteria and approach. The Standard is based on the entity concept and adopts ‘capacity to control’ as the sole criterion for identifying related entities for the purpose of preparing consolidated financial statements. A conceptual (substance-over-form) approach is used to implement the control criterion. In essence, this approach requires accountants to make professional judgments about the existence of control based on the substance of group structures and arrangements rather than their legal form. Concerns about the subjectivity and possible variability of accountants’ judgments cast some doubt on the operational effectiveness of the conceptual approach. In response to these concerns, this paper reports the results of an experiment that examines the consolidation judgments accountants make in response to a number of hypothetical scenarios. The purpose of this paper, therefore, is to provide some insights into the likely quality and reliability of consolidation judgments under the conceptual approach adopted by AASB 1024. The results indicate that accountants can be expected to exhibit broad consensus in their consolidation judgments. In addition, an analysis of the variables suggests that the degree of share ownership is the most significant factor in making such judgments. Nevertheless, other factors including the composition of the board of directors, the existence of a special arrangement, and interactions with the other variables also proved to be significant. Overall, the study provides tentative support for the conceptual approach adopted in AASB 1024. Key words: Consolidated financial statements; Judgments. A common feature observed in recent revisions to consolidation requirements in Australia, New Zealand, and the U.K. is an increased emphasis on notions of control as a major, or even sole, consolidation criterion.’ This emphasis is most pronounced in RON DAY s a Lecturer and JIM PSAROS s a Senior Lecturer in the Department of Commerce. the University of Newcastle. I In Australia, AASB 1 24 was issued in September 1991 and adopted control as its sole criterion. In New Zealand, SSAP No 8 was revised in October 1990 and adopted majority ownership or control. In the U.K., the Companies ct (1989) adopted new definitions of parent and subsidiary undertakings that widened the consolidation criteria to also include contractual control and either dominant influence or management on a unified basis. 62  JUDGMENTS IN CONSOLIDATED STATEMENTS Australian Accounting Standards Board AASB 1024, Consolidated Accounts (AASB, 1991), which adopts control as its sole criterion and provides a conceptual approach for its implementation. In essence, AASB 1024 requires account preparers to make judgments about the existence of control based on the substance of group structures and arrangements rather than their legal form. A number of criticisms of this approach concern the choice of subjective rather than objective criteria and the potential difficulties that may arise from its application (Godfrey, 1990: Reilly, 1990; Walker, 1991a, 1991b, 1992). An important research question to emerge from these concerns is whether the subjective notion of control is operationally effective in terms of the quality and reliability of judgments that are made. BACKGROUND Alternative Consolidation Criteria and Approaches In respect of the provision of consolidated accounts, there are a number of criteria that could be used to identify the existence of a group and determine the focus of group accounts. Possible criteria include ownership per se ownership giving significant influence, ownership giving control, economic control. and responsibility for inter-entity guaranteed debt: but Leo (1987, p. 12) identifies participation and control as the two main competing criteria. Participation derives from beneficial ownership interests and relates to the potential of an entity to participate in an asset distribution from another entity. Control relates to the ability of one entity to dominate decision-making in relation to the operating and financial policies of another entity, but it is not necessarily derived from ownership interests. Leo concludes (p. 18) that it is not possible to generalize that one set of criteria is 'the best' because each is based on assumptions as to the users and uses of the consolidated accounts. Irrespective of the preferred criteria, a further choice must be made regarding how they are to be operationalized. There are two main approaches. A regulatory approach sets a level of ownership or prescribes the form of control deemed to give one entity legal control over another. Alternatively, a conceptual approach requires an assessment of the substance of effective control in parent-subsidiary relationships, rather than by identifying any prescribed legal form. Neither approach has unequivocal support in the literature. A regulatory approach is objective and verifiable, but it can also be inflexible and avoidable (Shaw, 1976; Neuhausen, 1982; Walker, 1991a). Conversely, a conceptual approach offers more flexibility, but it invokes subjectivity (Godfrey, 1984: Walker, 1991a, 1991b, 1992) and is inherently difficult to operationalize (Ma, et al. 1991). Criteria and Approach Adopted in AASB 1024 The release of AASB 1024, Consolidated Accounts in September 1991 introduced a number of reforms that changed the focus and broadened the applicability of consolidation requirements in Australia. Previous requirements prescribed criteria 63  ABACUS in the Corporatiom Law that defined the existence of a holding-subsidiary relationship for the purpose of preparing a set of group accounts.? Although these requirements included dual criteria of ownership and control, the emphasis was on a holding company’s direct (and indirect) majority ownership interest in the issued participating shares of a subsidiary. AASB 1024 represents a fundamental shift in concept criteria and approach. It is based on the entity concept, which views the group as a separate economic entity comprising the parent company and any other entities it can control. Consequently, control is adopted as the sole criterion for identifying related entities for consolidated financial statements. Control is defined in AASB 1024, para 9, as: ‘the capacity of an entity to dominate decision-making, directly or indirectly, in relation to the financial and operating policies of another entity so as to enable that other entity to operate with it in pursuing the objectives of the controlling entity’. A conceptual approach is adopted to apply the definition on the basis of substance over form. As a result, account preparers and auditors must make judgments about the existence of control, based on all relevant available information. To provide some guidance, AASB 1024 lists a number of factors that normally indicate the existence of control.’ Although these factbrs may be useful in making a consolidation judgment, they are intended only to be indicative and not determinants of control. Consistent with the conceptual approach in AASB 1024, para. (xv) of the commentary to the Standard notes: ‘Whether an entity has control of another entity will always be a question to be decided in the light of the prevailing circumstances ... [and] will involve the preparer of the financial reports in exercising professional skill and judgment’. Section 46 of the Corporations Law 1990) defines a body corporate a subsidiary (in this section called the ‘first body‘) of another body corporate if. and only if (a) that other body: (i) controls the composition of the first body’s board: (ii) is in a position to cast or control the casting of more than one-half of the maximum number of votes that might be cast at a general meeting of the first body: or (iii) holds more than one-half of the issued share capital of the first-body (excluding any part of that issued capital that carries no right to participate beyond a specified amount in a distribution of either profits or capital): or (b) the first body is a subsidiary of a subsidiary of the other body. ’ AASB 1024 para (xvi) states: Any of the following factors would normally indicate the existence of control by one entity of another entity: (a) the capacity to dominate the composition of the board of directors ... (b) the capacity to appoint or remove all or a majority of directors ... ; (c) the capacity to control the casting of a majority of the votes cast at a meeting of the board of directors ... (d) the capacity to cast. or regulate the casting. of a majority of the votes that are likely to be cast at a general meeting of another entity .. and (e) the existence of a statute. agreement. or trust deed. or any other scheme, arrangement or device. which in substance. gives the entity the capacity to enjoy a majority of the benefits and to be exposed to the majority of the risks of that entity. notwithstanding that control may appear to be vested in another party. 64  JUDGMENTS IN CONSOLIDATED STATEMENTS Operational Effectiveness of SB I024 A potential criticism of AASB 1024 is the subjectivity of the substance over form approach it adopts. This approach evokes contestability, for it means there is no unique, objective criterion specified to determine whether an entity is a subsidiary and, therefore, whether accounts should be consolidated (Godfrey, 1984, p. 580). It is claimed there are some situations where determining the substance of control could be difficult and the outcome of such judgments debatable. For example, Reilly (1990, p. 46) suggests it may be difficult where control is passive, and Godfrey (1990, p. 13) contends it may be debatable where there is scope to argue that the degree of influence is significant rather than controlling. Therefore, there are two potential concerns with the conceptual approach. First, given identical circumstances, accountants may make different consolidation judgments. Second, the conceptual approach may provide scope for accountants to make opportunistic consolidation decisions using their freedom of judgment as justification. Despite these concerns, it may be claimed that judgments, which require the application of accumulated knowledge, experience and skill lie at the heart of the professional activity accountants claim to be undertaking. Therefore, the fact that consolidation judgments are by their nature subjective is not undesirable per se provided the outcomes of such judgments are quality decisions. As it is impossible to evaluate the quality of substance over form judgments against an objective criterion, this study relies on the prior work of Libby and Lewis (1982) and Ashton (1985) in using consensus as a surrogate for quality and accuracy of judgments in general and for the operational effectiveness of AASB 1024 in particular. SB 1024 and the Importance of Employment Sector AASB 1024 impacts potentially on accountants and managers from various sectors of the business community (e.g., public sector, private sector, professional practice, and academidresearch). Accountants or managers from any one of the sectors can reasonably claim to have a legitimate ‘stake’ in the content of accounting standards. Even public sector accountants may be affected directly by AASB 1024, as the Standard applies to all parent reporting entities (public and private). Therefore, to judge the effectiveness (‘success’) of AASB 1024, it is important to obtain evidence from each of the constituent groups. From the organizational theory literature, Pfeffer and Salancik (1978, p. 2) warn: ‘organizations survive to the extent that they are effective. Their effectiveness derives from the management of demands, particularly the demands of interest groups upon which the organizations depend for resources and support.’ While Pfeffer and Salancik’s message was intended for organizations, it seems no less appropriate for professional and government bodies. To fail to consider the views of important constituent groups is to risk losing support for accounting standards in general and AASB 1024 in particular. Thus, the success of AASB 1024 is more likely if it is interpreted similarly by accountants from different employment sectors. Interestingly, previous accounting studies investigated whether an individual’s employment sector may explain, in part, his or her perceptions and preferences in respect of accounting issues. For example, Patel (1990), Karlinsky et al. (1987), Teoh 65  ABACUS and Brooks (1987), and McComb (1979) provide evidence of different preferences and perceptions of accountants that seem to link to their employment sector. Each study suggests the findings may be associated with different economic concerns and perceptual fields of the participants that are partly attributable to their particular sectors of employment. It therefore seems important to determine whether the findings also hold for consolidated financial reporting. Accordingly, some of the analysis that follows in this paper is based on the employment sector of the participants. RESEARCH METHOD It would have been ideal to examine the operational effectiveness of AASB 1024 using real-world referents. Unfortunately, information on the consensus of consolidation judgments and on the factors used in forming such judgments is unattainable from real-world events because the circumstances of each judgment are unique. As a result, an experiment was designed to enable consolidation judgments to be examined using a number of hypothetical cases. These cases were formed from all unicpe combinations of selected cues operating at two discrete levek4 Research Design The experiment used a within-subjects repeated measures design, thus exposing each participant to more than one level of the experimental study.5 This type of design has been used successfully in an accounting choice context by Pany and Reckers (1984), Knapp (1985), and Pasewark and Strawser (1992). The design is useful in that it facilitates the evaluation of the degree of consensus and also enables a large number of factors to be considered from a relatively small number of respondents. Participants The research instrument was distributed to delegates at accounting seminars organized by the Australian Accounting Research Foundation (AARF) in Melbourne, Sydney and Brisbane. The focus of the seminars was to discuss conceptual framework developments in Australian accounting. As such, it seems reasonable to presume the vast majority of the delegates had an understanding of, or at least interest in, advanced accounting issues. While participants did not have an opportunity to complete the research instrument at the seminars, they were encouraged by the seminar organizer (AARF) to complete it at a later time. Participants were thus given a package that contained a research instrument and a reply-paid envelope for its return. This method was developed by Hoffman et al. (1968) to examine cue usage. consensus and consistency. It has since been extensively used in policy-capturing research in the auditing literature (Brownell and Trotman. 1988, p. 341). For a detailed and mathematical discussion of a within-subject design . see Kirk (1982). Ch. 6. 66
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