Answer

Executive Summary

Many corporate organizations globally have implemented International Financial Reporting Standards to provide the basis on which investors can make accurate comparisons between corporations in the global capital markets. However, the standards have not lived to the expectations, but are instead responsible for significant financial problems. Some of these problems were highlighted in the article ‘Unwieldy rules useless for investors.’ International accounting standards directs companies to perform periodic asset impairment testing. During the 2017 financial year, Westpac Banking Corporation, one of the major participants in the Australian Financial sector, used specific assumptions and estimates to conduct these tests. With 2018 coming to an end, organizations are getting ready for the implementation of the new accounting standards for leasing and replacing the existing ones which the chairperson of the IASB, Hans Hoogervorst, referred to as being economically unrealistic. This report outlines the accounting theory used by Westpac Banking Corporation as well as current issues in the corporate environment regarding financial reporting, Corporate Responsibility and accounting practices. 

Contents

Executive Summary. 1

Introduction. 5

Part A: Qualitative Characteristics of Financial Reporting. 6

Relevance. 6

Faithful Representation. 6

Understandability. 7

Part B: Regulation Theories. 8

Public Interest Theory. 8

Capture Theory. 9

Economic Interest Group Theory of Regulation. 9

Part C: The Cost Model as Measuring Fixed Assets. 10

What Motivates Directors not to Revalue Fixed Assets. 10

Understatement or Overstatement of Assets. 10

The Cost Associated with Revaluation. 11

Accounting Laws and Regulations. 11

Inconsistencies in Fixed Asset Revaluation. 11

Non Revaluation Effect on the Firm’s Financial Statement 11

How the Decision not to Revalue Fixed Assets Affect Shareholders. 12

Part D: Asset Impairment Testing by Westpac Banking Corporation. 12

Assets Tested for Impairment 12

Loans. 13

Goodwill 13

Conduction of the Impairment Testing. 13

Impairment Expenditures. 14

Key Assumptions and Estimates for Loan Impairment Testing. 14

Individual Component Estimates. 14

Collective Component Estimates. 14

Key Assumptions and Estimates for Goodwill Impairment Testing. 15

Fair Value Measurement 15

Part E: International Accounting Standards Board. 15

Conclusion. 17

References. 18

Accounting Theory and Current Issues

Introduction

            This report discusses the accounting theory used by Westpac Banking Corporation as well as current issues in the corporate environment regarding financial reporting, corporate responsibility and accounting practices.  As depicted in the article ‘Unwieldy rules useless for investors’ by King, Drummond, & Rose (2012), business organizations have spent millions of dollars in implementing International Financial Reporting Standards (IFRS) to provide the basis on which investors can make accurate comparisons between corporations in the global capital markets. However, the standards have not lived to the expectations as reiterated by financial experts (King, Drummond, & Rose, 2012). Instead, they have unfortunately created major financial problems.

            Asset impairment testing is one of the accounting practices carried out periodically by different companies. As earlier stated, this report also discusses assets tested for impairment by the Westpac Banking Corporation, how impairment testing was conducted, how the organization recorded the impairment expenditure during the 2017 financial period and the assumptions made during the impairment.

            Westpac Banking Corporation is an Australian financial institution with its headquarters in Sydney. The institution offers wide-ranging financial and banking services such as accepting savings, advice on portfolio investment, insurance services, loans and other money market products. It serves, businesses, individuals and other corporations in multiple countries. According to Faff and Howard (2014), Westpac is not only the most extensive branch network in the country, but also one of the largest banks by assets.

Part A: Qualitative Characteristics of Financial Reporting

            According to the opinions of the individuals echoed in the article, the fundamental qualitative characteristics of financial reporting, as per the conceptual framework, which does not appear to be satisfied by the present reporting practices in accordance to the IFRS include:

Relevance

            The relevance characteristic of the financial information or reporting refers to the ability of the report to make a difference in the decisions made by the users of such statements who are also the providers of capital. A relevant report must always have a confirmatory value, predictive value or both. The predictive value expresses the company’s ability to generate future cash flows and is mostly considered the most crucial element in influencing investment decision making. The confirmatory value, on the other hand, confirms the present and past expectations based on prior assessments.  When financial reporting provides feedback to the users about the past events or transactions that the company participated in, it enables the users of such reports to confirm or change their expectations. The current reporting practices under IFRS does not seem to satisfy this feature. For instance, companies implement IFRS to provide the basis on which investors can make accurate investment decisions (King et al., 2012). However, investors still depend on reports by the organization and investor briefings to understand the companies’ figures as highlighted by former AXA head of finance Geoff Roberts. This implies that annual statements under IFRS lack the relevance since the investors cannot easily understand them.  

Faithful Representation

            Faithful representation is another fundamental qualitative characteristic elaborated in the conceptual framework. For financial information to be considered faithfully presented, the data must be neutral, complete, verifiability and free from errors. This feature emphasizes the items in the financial report that must be available for it to be considered faithfully represented. Most economic phenomenon presented in the financial statements are always determined based on uncertainty conditions making it difficult to eradicate bias completely. Nonetheless, comprehensive arguments must be presented for the assumptions and estimates made to reduce bias and enhance the accuracy of the information. Based on the opinions in the article, this characteristic seems unsatisfied under the current practices. The Commonwealth Bank chief financial officer, David Craig, says that investors ignore IFRS numbers because they can easily obscure a company’s actual position (King et al. 2012). This means that the numbers are not free from bias thus cannot be depended on in making investment decisions.

Understandability

            This is an enhancing qualitative characteristic that entails clear and concise presentation and classification of financial information. The feature enables the financial report users such as investors and creditors to comprehend the meaning of the information presented in the documents. It emphasizes the clearness and transparency of the data. The current financial reporting practices provide information that is not easily understood by the users.  According to Wesfarmers finance director, Terry Bowen, understanding the notes to the IFRS accounts requires technical training to avoid misinterpretation and even analysts that examine IFRS accounts are probably misinterpreting the information under the current standards (King et al., 2012). These sentiments indicate that everyone cannot understand the information reported under the IFRS.

            The opinions in the case study are not consistent with the view that corporate financial reports satisfy the central objective of financial reporting. Unlike those presented by the conceptual framework, the opinions in the text indicate that the corporate financial reporting require technical training and may not reflect the exact position of the company (King et al., 2012). As a result, investors depend on reports by the organization and investor briefings to understand the companies’ figures. Furthermore, there is a possibility that analyst examining IFRS accounts are probably misinterpreting the information under the current standards making it impossible for the reports to serve the central purpose of financial reporting.

Part B: Regulation Theories

            After the review of the Corporations Act in 2006, the Australian government decided not to add particular social and environmental responsibilities within the Act to encourage corporate organizations to act in an eco-friendly manner and protect the environment. However, corporate social responsibility (CSR) was left for the market forces to regulate. This decision was made based on the fact that no investor, employee or consumer would like to interact with enterprises that are not embracing eco-friendly practices in their operations. The decision of the government not to amend the Act can be explained using the following concepts:

Public Interest Theory

            The public interest theory states that the economic market is very delicate and usually operates inefficiently in favor of individuals participating in it while ignoring the bigger societal goal (Hantke-Domas, 2013). Thus, to monitor and direct economic markets to work in the public interest, intervention by the government is needed. The government can intervene by introducing specific guidelines or using other available avenues. In the case of Australia, the government intervened by leaving the regulative power to the market forces. For the economic market to act in the interest of the public, the legislation must not serve the society rather than the regulators (Hantke-Domas, 2013). Therefore, society is better placed to regulate the market since it is responsible for the market forces of demand and supply. Besides, industry always seeks for market advantages for their members, meaning they will formulate social responsibility rules that grant their members market advantage. Consumers, on the other hand, are responsible for the demand of corporate offerings and if they demand disclosure of the impact of corporate actions on the environment as well as the corporate initiative to improve the adverse effect of their operations on the environment and society, the public interest would be served.

Capture Theory

            The capture theory has a minimal difference from the public interest theory. This theory states that since government agencies established to regulate the economic market in the best interest of the public it is made up of future and former industry employees. In many circumstances, they tend work in the benefit of the market participants and industry in which they regulate (Etzioni, 2014). The capture concept identifies the close relationship between government agencies and corporate organizations. The government creates regulative agencies to protect the public interest. However, when the members of these agencies are either future or former employees of the industries they are supposed to protect the public interest from, they are likely to act in favor of the corporate organizations. Therefore, the Australian government decided to leave the regulatory function for the market forces to eliminate the conflict of interest in the government agencies which are prone to company manipulations. 

Economic Interest Group Theory of Regulation

            This theory highlights that corporate organizations from industry groups to serve their economic interest. The groups are distinct from each other, and they have conflicting interests. As a result, they lobby the government through representatives to pass legislation that favors their economic interest (Dunford, 2010). These groups of industry players usually fail to recognize public interest in their plans. Similarly, members of the regulatory agencies are driven by self-interest as opposed to societal well-being. They plan to maintain their current social and political position through re-election. Thus, they have to grant special favors to corporate establishments since they influence the economy. In the industrial power struggle, those groups with strong powers manage to lobby the government to act on their favor. Economic interest group theory of regulation states that many potential regulations by the government may not encourage corporate accountability regarding environmental and social performance because the legislation will be established in the interest of economic groups’ interest.  These political and economic factors led the government to leave the regulatory function for the market forces to encourage corporate social responsibility among the organizations operating in the country.   

Part C: The Cost Model as Measuring Fixed Assets

            Many companies choose not to measure their fixed assets at fair value but instead apply the cost model of valuation. Using this model, the assessment of property, plant, and equipment involve deduction of depreciation and accumulated impairment loss to present the asset cost (Lin & Peasnell, 2014). This model also lowers the total assets value. Sometimes management may not be motivated to revalue their fixed assets in an agreement with the Australian Accounting Standards Board (AASB).

What Motivates Directors not to Revalue Fixed Assets

Understatement or Overstatement of Assets

            Company directors are motivated not to revalue the property, plant, and equipment because they know that revaluation of assets is likely to result in either overstatement of understatement of assets. When the assets are undervalued, the loss must be debited on profit and loss account. Meaning, it will be charged to the wealth of the company shareholders. Fixed asset overstatement, on the other hand, enhances the company’s statement of financial position by positively impacting important ratios involving fixed assets which may be fraudulent.

The Cost Associated with Revaluation

            Asset revaluation attracts additional costs to the company such as the payments to valuation officers, auditors as well as time taken to review the records and figures (Lin & Peasnell, 2014). These costs increase the company’s operating expense which eventually leads to reduced cash flow and a decline in profits.

Accounting Laws and Regulations

            Accounting laws and regulations in some countries prohibit fixed asset revaluation and financial statements prepared under the accounting principles must have substantial authoritative support. Such rules do not allow company directors to revalue their property, plant, and equipment.

Inconsistencies in Fixed Asset Revaluation

            Some company directors consider fixed asset revaluation to be inconsistent since it interrupts the traditional cost accounting principle. For instance, periodic asset revaluation is deemed to be inferior to the traditional cost accounting principle from an income perspective in faithfully presenting property, plant, and equipment (Herrmann, Saudagaran & Thomas, 2006). The conventional cost earning is considered superior because it is more objective and cannot be easily manipulated.

Non Revaluation Effect on the Firm’s Financial Statement

The decision not to revalue non-current assets have some effects on the company’s financial statements as discussed below:

            Firstly, the decision not to revalue property, plant, and equipment reduced their value in the company’s statement of financial position (Brown, Izan, & Loh, 2012). The value of fixed assets presented in the balance sheet will be fair values thus will be lower thus reducing the company’s ability to attract investment.

            The decision not to revalue the fixed assets also affect the income statement by reducing the value of depreciation charges. Failure to revalue reduces expenses such as depreciation expense which in turn presents the company’s profitability to be higher.

How the Decision not to Revalue Fixed Assets Affect Shareholders

            The decision not to revalue the company’s non-current assets affects the shareholders’ wealth. It lowers the value of fixed assets and leverage in the organization (Aboody, Barth, & Kasznik, 2013). The weak balance sheet subjects the shareholders’ wealth to business risks since it discourages additional investment.

Part D: Asset Impairment Testing by Westpac Banking Corporation

            As earlier mentioned, Westpac Banking Corporation is one of the major participants in the Australian Financial sector. The following discussion outlines the accounting theory used by the company to test its asset for impairment, and the information is retrieved from the 2017 annual report.

Assets Tested for Impairment

The assets that Westpac Banking Corporation tested for impairment in the financial period 2017 include;

Loans

            These are the amounts of capital or finances that the financial institution offers to businesses and individuals at a given interest rate for a specified period. On every balance sheet date, the Westpac Group assesses any objective impairment on any of its loan portfolios. The organization recognizes an impairment charge if there is evidence that the principal amount or interest may not be recovered and the financial impact of the unrecoverable principal or loan can be reliably determined.

Goodwill

            This is an intangible asset that arises from a business combination or when an organization acquires another existing business. Goodwill is usually recognized when the purchase price is higher than the value of both the tangible and intangible assets as well as liabilities assumed in the combination process and is measured at cost. During the 2017 financial year, the goodwill that Westpac Banking Corporation tested for impairment was brand names acquired. The brand names included RAMS, BankSA, BT, and St. George.

Conduction of the Impairment Testing

            For goodwill, impairment is tested annually or when there is a sign of impairment. An impairment charge on goodwill is recorded whenever the carrying value of cash generating Units surpasses their recoverable amounts. Whereby, the recoverable amount is the higher of the cost generating units’ fair value less their value-in-use and the cost to sell them.

            For loans, the group tests for impairment when there is objective evidence of impairment which could include default on principal or interest payments, financial difficulties by a borrower or economic conditions that makes loan payments difficult. The impairment charge on loans is presented as the difference between the present values of the loan’s projected future cash flows and its current carrying amount (Westpac Banking Corporation, 2017).  The expected future cash flows exclude any potential future credit losses that are yet to occur. The original loan’s effective interest rate is used to discount the future cash flows to their present value. The current effective interest rate is used to measure impairment if the loan has a flexible interest rate.

Impairment Expenditures

            Westpac Banking Corporation recorded impairment expenditure on loan portfolio during the 2017 financial year. For instance, the group presented an impairment adjustment of $7000, 000 on the individually assessed loans as indicated in note 14. Again, the company recognizes a goodwill adjustment of $18,000,000 during the same period as shown in footnote 26 of the annual report.

Key Assumptions and Estimates for Loan Impairment Testing

            Westpac Banking Corporation regularly reviews the assumptions and methodology used to estimate future cash flows with the aim of reducing the difference between actual losses and impairment provisions. Some of the estimates used for the period include:

Individual Component Estimates

            These include the realizable value of the security, the customers’ business prospects, the borrowing cost, loan duration and the reliability of the information given by the customer.

Collective Component Estimates

            These entail prevailing economic conditions in the market, levels of arrears, portfolio trends and past losses experienced by the company.      

Key Assumptions and Estimates for Goodwill Impairment Testing

            The group uses assumptions to determine the cost generating units’ recoverable amount for goodwill based on value-in-use calculations. The assumptions include:

1. The group assumes that the cash flows will experience zero growth rate beyond the forecasting period of two years.
2. The company also assumed that the current market expectation of the future and historical information could be used to determine business performance.

• Current market expectations determine the economic market conditions.

            After going through the impairment testing, I did not find any subjectivity involved in the process that can affect the outcome. What I found interesting in the impairment testing is that the company only tested for impairment annually or when there is objective evidence of impairment. Moreover, the new insight I have gained on how companies conduct impairment testing is that certain assumptions and estimates are used to determine the value of cash flows and intangible assets.

Fair Value Measurement

            Based on the assignment, my comment is that fair value measurement is necessary because it provides accurate values of liability and assets to the users of financial reports. It also enables the company to reflect the reduction in market asset prices in the amounts included in the financial statements.       

Part E: International Accounting Standards Board

3. The former accounting standard for leases did not require companies to include operating leases in their balance sheets, and as a result, many liabilities and assets were not represented in the financial statements. According to the International Accounting Standards Board (IASB), approximately 85% of the $3.3 trillion worth of lease commitments were not reflected in the balance sheet. Therefore, the information obtained from the balance sheet by investors was inaccurate as it understated the companies’ liabilities and thousands of assets under operating lease commitments did not appear in the statements. Thus, to the chairperson of the IASB, this did not reflect economic reality.
4. Under the former accounting standard, reporting companies’ off-balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet because many entities had serious off-balance sheet debt agreement which were not being reflected in their balance sheets. The firms also had assets under operating leases that generated real liabilities unrecognized in the books.

• There was no level playing field’ between some airline companies under the former accounting standard for leases because some airline companies leased most of their aircraft while others bought the air crafts. Even though the financial obligation of the two groups of companies may be similar, the leasing companies can access the assets they need which less impact on their cash flows and capital expenditure. Again the leasing companies avoid ownership responsibilities and expenses while still enjoy the full benefits of the assets.

16. I think the Chairperson said that the new accounting standard for leases would not be popular with everyone because not everyone will appreciate the new changes. I believe the unpopularity will arise as a result of costs associated with the implementation of the new regulations. For instance, companies will have to update their systems to implement IFRS 16.
17. The new standards for leases will improve the investment decisions made by investors because all the lease agreements will be reflected in the balance sheet and investor will now be able to assess the company’s financial positions easily. Again, unlike under the former standards, management will have to consider both buying and leasing options during asset acquisition comprehensively

Conclusion

            In summary, new changes to the IFRS are being initiated despite the varied views on their effectiveness in influencing decision making. One of such changes in the soon to be implemented IFRS 16. Like other companies, Westpac Banking Corporation bases its impairment testing in various assumptions and estimates to make the process more reliable.