Fudged Accounting Theory

Fudged explanation theory and Corporate Leverage Audra Ong and Roger Hussey Abstract This paper is a follow-up of the article Fudged Accounting Theory Evidence from the UK in the ledger of Management investigate (Ong, 2003). In that article, an synopsis of the flexibility within the UK regulations, which allowed companies to use different eyeshade treatments for nonphysical assets, was illustrated to support fudged accounting theory (Murphy, 1990).This paper extends that earliest elaborate by examining the tie-up mingled with corporate supplement and accounting choice in the UK at a layover when the extant accounting standard for good will, SSAP22 Accounting for grace of God (ASC, 1989), permitted two very different accounting treatments. As a result, other nonphysicals, in particular brands, could avoid the regulative strictures. For the defend sight, a series of hypotheses relating to corporate supplement and capitalization of intangible assets were tested.The r esults of the present study support fudged accounting theory by providing evidence that thither is a descent between the widespread capitalization of thanksgiving/brands and the relationship with supplement. The results demonstrate that financial managers will tend to adopt accounting practices that result in stronger symmetry canvas tents. Keywords Leverage, Fudged Accounting, impalpable Assets, Brands/ state of grace, Food/Drink/Media Industries, International AccountingIntroduction The importance of Fudged Accounting Theory in understanding the accounting treatment of intangible assets has been discussed in an earlier paper by Ong (2003) in the Journal of Management Research. The purpose of the present paper is to investigate whether there is statistical evidence that companies benefit intangible assets for the improvement of their vestibular sense sheet of papers in a period of lax accounting regulations or ambiguity in regulations. This has been identified as fudged accounting theory (Murphy, 1990 Tollington, 1999).Audra Ong Roger Hussey University of Windsor, Odette business concern School, 401 sundown Avenue, Windsor, Ontario, N9B 3P4 Canada In this study, the UK was chosen because accounting for goodwill was regulated under SSAP 22 Accounting for Goodwill issued by the Accounting Standards Committee (ASC) in 1984, which was later revise in 1989. This standard allowed contradictory treatments companies could either write goodwill directly against reserves in the balance sheet thus bypassing the profit and loss account or capitalize it as an asset on the balance sheet subject to amortization.To add to the confusion, the standard did non apply to other intangible assets and several(prenominal) companies chose to distinguish brands from goodwill and treat them as permanent items on the balance sheet with no amortization (Barwise et al. , 1989 Paterson, 2003). This presented a stronger balance sheet with no partake on the income statement. T o conduct the study, the yearly reports and accounts for the five-year period 1993-97 for 143 companies listed on the capital of the United Kingdom Stock Exchange were analyzed. Using the earlier train of Archer et al. (1995), a series of hypotheses were realized and tested.As the sample is relatively small and is non-parametric in nature, the chi-squ ared test using Yates correction was employed to test the hypotheses. After a brief review of the literature, the research rule of this study is explained. The main part of the paper, falling under the heading of Results and Discussion, is concerned with testing a number of hypotheses. Previous Research Consideration of intangible assets has been prevail by uncertainty over the appropriate accounting treatment of goodwill (Egginton, 1990). In the UK, the somewhat acrimonious debate is fuelled by strong opinions rather than facts.The perspicacity and range of opinions has been well documented in the academic literature (Damant, 19 90 Napier & Power, 1992 McCarthy & Schneider, 1995 Hussey & Ong, 1997, Ong 2001 Oldroyd, 1998 Joachim Hoegh-Krohn & Knivsfla, 2000 Cravens & Guilding, 2001) as well as in professional reports (Coopers & Lybrand, 1990 Tonkin & Robertson, 1991 Hussey, 1994). The publication of SSAP 22 did little to composure the debate. Under that standard, companies faced the unpalatable alternatives of writing off goodwill against reserves and weakening their balance sheets or amortizing against earnings.Consequently, intangible assets such as brands and publication titles began to shape up on the balance sheets of a number of well-known companies. Identification of such items as intangible assets, separate from goodwill meant that they did non fall under the requirements of SSAP 22. The intangible assets could remain on the balance sheet indefinitely, unless there was a permanent impairment in prise. This contention that the appearance of brand valuations on the balance sheet had been motivated by the desire to correct or improve the balance sheet has been evident in several studies.Emanating mainly from the debt covenant approach and the archaean work of Zmijewski and Hagerman (1981), studies have found support for the debt covenant dead reckoning (Mather and Peasnell, 1991) and evidence that a participations decision to Volume 4, Number 3 declination 2004 capitalize brands was influenced by London Stock Exchange rules on eruditenesss and disposals (Muller, 1999). There has been some debate on the importance of intangible assets in private debt contracts (Citron, 1992 twenty-four hour period and Taylor, 1995).The study which most closely relates to the present research and shares the same theoretical foundation was published by Archer et al (1995) and was base on work conducted on 71 annual reports of UK and French companies for the period 1988-92. This earlier research concluded that a group with high leverage is more likely to capitalize goodwill and/or brands than a group with low leverage. The results, however, were stronger where goodwill and brands were amalgamated although it is possible that the differing regulations in the two countries may have distorted the data.Research Design The annual reports and accounts for the five-year period 1993-97 of 143 companies in the pabulum, drink and media industries were obtained. Such period of time is chosen as the debate on the most appropriate accounting treatment for goodwill and intangible assets was at its greatest and accounting practices were the most varied during this period. It as well immediately preceded the changes to accounting introduced by FRS 10 Goodwill and intangible asset Assets issued by the ASCs successor, the Accounting Standards Board (ASB, 1997) and FRS 11 Impairment of Fixed Assets and Goodwill (ASB, 1998).Industries for the study have been chosen whose products are highly branded and also where companies in the industries have been strong in acquisitive activities . The company profiles and published financial information of these 143 companies were checked to see which companies capitalized intangible assets for the entire five-year period 1993-97. The germane(predicate) population, which capitalizes intangible assets, is 15 food and drink companies and 28 media companies, resulting in a total of 43 companies.It should be noted that the remaining 100 companies either did not capitalize intangible assets in any one year, or only capitalized intangible 157 assets for part of the five-year period post -1993. Care has been taken above in explaining the sample utilize in this study because of its relatively small size. Although this may be regarded as a limitation of the subsequent analysis, a non-parametric test is used in the analysis of individual industries and this is generally regarded as defensible and acceptable in such circumstances.Yates correction has also been applied to the chi-square tests to achieve conservatism in establishing s ignificance so that the results can be regarded as conservative and less likely to overstate the importance of the findings. Correlation tests are only conducted on the pile up sample of some(prenominal) industries. The leverage ratio was defined as debt expressed as a percentage of capital employed (Reid and Middleton, 1988) because this definition was used in old studies and it provides a high degree of precision.Results and Discussion Leverage and Capitalization The following two hypotheses were established in respect of the possible association between leverage and brands H1 A company with high leverage is no more likely to capitalize intangible assets than a company with low leverage. H2 A company with high leverage is no more likely to capitalize goodwill/brands than a company with low leverage. To test these hypotheses the median leverage was established for the assemblage of companies capitalizing intangible assets, and for those companies not capitalizing the same.In so me instances the median leverage did not provide a division of the sample to provide a sufficient number in each cell. In those instances a cut-off leverage level was selected to ensure cells of sufficient size and this is explained where it occurs. Contingency tables were constructed for the chisquared test and the results are described below. In all instances, Yates correction was applied. Media application Hypotheses 1 and 2 were tested separately on the Media industry and on the Food and Drink Industry. The results for the media industry for all intangible assets are shown in fudge 1.In this test, the median leverage for the media industry was 28%. The chi-square test was significant at the 0. 01 level with a chi-square factor of 6. 86447 and 1 degree of freedom. The null shot can whence be rejected and we can accept that high-leveraged companies are more likely to place intangible assets on the balance sheet than low-leveraged companies in the media industry. Table 2 carrie s out the same test for the same industry but analyzes only those companies capitalizing goodwill and/or brands. In this instance the median leverage was 31% and this was increased to 32% to ensure cells of adequate size.The chi-square test was significant at the 0. 01 level with a chi-square factor of 7. 286 and 1 degree of freedom. The null guesswork can therefore be rejected and we can accept that high-leveraged companies are more likely to place goodwill/ brands on the balance sheet than low-leveraged companies in the media industry. Table 1 Contingency Table for Media Industry Showing Leverage and Capitalization of all Intangible Assets Capitalizing Leverage 28% Leverage ? 28% sight judge Observed Expected 914. 26 1913. 74 Not capitalizing 1812. 74 712. 6 follow 27 26 158 Journal of Management Research Table 2 Contingency Table for Media Industry Showing Leverage and Capitalization of Goodwill and/or Brands Capitalizing Leverage 32% Leverage ? 32% Observed Expected Observ ed Expected 59. 93 149. 07 Not capitalizing 1813. 07 711. 93 Total 23 21 Table 3 Contingency Table for Food and Drink Industry Showing Leverage and Capitalization of all Intangible Assets Capitalizing Leverage 26% Leverage ? 26% Observed Expected Observed Expected 510. 74 104. 26 Not capitalizing 4842. 26 1116. 74 Total 53 21Table 4 Contingency Table for Food and Drink Industry Showing Leverage and Capitalization of Goodwill and/or Brands Capitalizing Leverage 18% Leverage ? 18% Observed Expected Observed Expected 59. 80 72. 20 Not capitalizing 5348. 20 610. 80 Total 58 13 Food and Drink Industry The next two tables are concerned with the Food and Drink Industry. The median value for leverage was reason at 18% for all intangible assets and in the following table an arbitrary cut-off point of 26% has been selected to ensure cells of adequate size and Table 3 shows the result for those companies capitalizing all intangible assets.The chi-square test was significant at the 0. 01 lev el with a chi-square factor of 11. 292 and 1 degree of freedom. The null hypothesis can therefore be rejected and we can accept that highly leveraged companies are more likely to place intangible assets on the balance sheet than low-leveraged companies in the food and drink industry. Table 4 shows the results for those companies capitalizing goodwill and/or brands in the food and drink industry. In this instance the median leverage level of 18% was live for the calculations. Volume 4, Number 3 celestial latitude 2004 The chi-square test was significant at the 0. 1 level with a chi-square factor of 7. 604 and 1 degree of freedom. The null hypothesis can therefore be rejected and we can accept that highly leveraged companies are more likely to place goodwill/ brands on the balance sheet than low-leveraged companies in the food and drink industries. Capitalization as a Function of the Level of Leverage Two further hypotheses had been established based on the enter explored by Arche r et al. (1995) that the value of intangible assets was a function of leverage, in other words the higher the leverage ratio the higher the value of intangible assets.H3 The value of intangible assets will be associated with the level of leverage. H4 The value of goodwill and/or brands will be associated with the level of leverage. 159 These hypotheses have been tested in previous research with somewhat contradictory results. It was considered that this study with its larger sample and separate focus on two industrial sectors might provide more conclusive results. Additionally, it was decided to extend the variables. Earlier studies have concentrated only on the absolute value of intangible assets i. e. the absolute amount appearing in the balance sheet. For the resent study a new variable of relative value was introduced and to test these hypotheses two aspects of the value of intangible assets were considered i. e. a) its absolute value, i. e. the amount capitalized in the balanc e sheet (INTASS) b) its relative value, calculated by expressing intangible assets as a percentage of total heady assets (INTFIX). Both Industries Table 5 shows the correlation based on our 43 companies, which capitalize all intangible assets Table 5 Leverage as a Function of All Intangible Assets (Both industries) hawk Gear 1. 0000 (43) P=. .0179 (43) P= . 909 . 3229 (43) P= . 035 Intass . 0179 (43) P= . 09 1. 0000 (43) P= . .1876 (43) P= . 228 Intfix . 3229 (43) = . 035 . 1876 (43) P= . 228 1. 0000 (43) P= . appears to have stronger explanatory power. It is therefore possible to state that a relationship does exist between the level of leverage and the relative value of intangibles. In addition to looking at the sample of companies capitalizing all intangible assets, the same analysis has been conducted on the sample of 31 companies capitalizing only goodwill and/or brands. The results are shown below in Table 6. Table 6 Leverage as a Function of Goodwill / Brands (Both Industri es) Gear Gear 1. 0000 (31) P= . -. 0176 (31) P= . 24 . 3275 (31) P= . 067 Intass -. 0176 (31) P= . 924 1. 0000 (31) P= . .1573 (31) P= . 390 Intfix . 3275 (31) P= . 067 . 1573 (31) P= . 390 1. 0000 (31) P= . Intass Intfix Intass once again, Table 6 does not demonstrate a significant relationship between leverage and the absolute value of goodwill/brands. However, the association between leverage and the relative value of intangible assets is significant at 6. 7% level. It is therefore possible to state that a relationship does exist between the level of leverage and the relative value of goodwill/brands although it is less strong than that with all intangible assets.The above testing of the four hypotheses provides evidence that there is a relationship between leverage and the capitalization of intangible assets and there are differences between the two industries used in this study. The present research has also extended previous work of Archer et al b y introducing a new variable INTFIX and demonstrating that capitalization of intangible assets is a function of the relative value of intangible assets to fixed assets. The evidence from this study therefore provides support for the fudged accounting theory. IntfixTable 5 does not demonstrate a significant relationship between leverage and the absolute value of intangible assets. However, the association between leverage and the relative value of intangibles is significant at 3. 5% level. This would suggest that the measure of relative value 160 Journal of Management Research Implications The International Dimension Given the debate on the appropriate accounting treatment of intangible assets and the obvious deficiencies of the provisions of SSAP 22, it is not impress that the national accounting standard body in the UK was compelled to introduce a substantial regulatory change.FRS 10 and FRS 11 have replaced SSAP 22. Essentially, FRS 10 requires goodwill and intangible assets to be recognized and capitalized over 20 years. This presumption can be rebutted, however, and a longer smell or an indefinite life can be selected. In these circumstances, an annual impairment review must be conducted as specified under FRS 11. At the international level, goodwill and intangible assets were first addressed by IAS 22 Business Combinations and IAS 38 Intangible Assets by the International Accounting Standards Board (IASB) respectively. IAS 22 was issued in 1993 and revise in 1998.IAS 38 was issued for the first time in 1998. In March 2004, however, the IASB published IFRS 3 Business Combinations (which supersedes IAS 22) together with related amendments to IAS 36 and IAS 38 as part of Phase 1 of the IASBs project on Business Combinations. IFRS 3 contains some significant differences compared to FRS 10 (Simmonds and SleighJohnson, 2003) as the former proposes that goodwill will only be subject to impairment testing and must not be amortized. In addition, goodwill and other identified intangibles, w hich are similar in nature, will be subject to different accounting treatments.This reduces comparability and reliability and creates a serious risk of accounting arbitrage or fudged accounting. The current IASB proposals in IFRS 3 represent only Phase 1 and, thus, the ASB will consider replacing UK standards only when both Phases 1 and II are complete. Therefore, UK companies should not have to change to the IFRS 3 based on Phase 1. Although IFRS 3 differs from FRS 10, the former achieves a high degree of convergence with FAS 141 Business Combinations (FASB, 2001) and FAS 142 Goodwill and Other Intangible Assets (FASB, 2001) in the US.With respect to managers, the introduction of IFRS 3 is expected to have important implications for brand managers and owners as well as the way trademarks are valued and accounted for (Haigh and Rocha, 2004). In particular, the separate recognition of trademarks and other acquired intangibles, together with annual impairment tests, will require comp anies to establish robust valuation methodologies for intangible assets in order to withstand increased scrutiny in the market.Conclusion This study compares practices in accounting for intangible assets in two industries known for their propensity to capitalize those assets in their balance sheets. The study covered the period from 199397 when the debate and uncertainty on appropriate accounting treatment was at its height. The annual reports of 143 UK companies were selected to investigate whether there was an association between leverage and capitalization of intangible assets. The results demonstrate that companies with high leverage in both industries are more likely to capitalize intangible assets, particularly goodwill and brands.A relationship between capitalizations of intangible assets as a function of leverage when the absolute value of intangible assets is used was not established. However, the present study added to our knowledge by demonstrating that the use of the rel ative value of intangible assets to fixed assets as a variable reveals that capitalization is a function of leverage. The findings from this study both confirm and extend the earlier research by Archer et al. It demonstrates that the topic of capitalization of intangible assets remains a fruitful area for the accounting researcher.The present study establishes that there are industry differences and one can speculate that these may be due to a number of factors such as acquisition activity within the industry, marketing strategy in relation to brands and financial structures and motivations. An extension of the work using the variable Volume 4, Number 3 declination 2004 161 INTASS could lead to illumination of the underlying reasons. A study of present practices in the same industries may reveal what changes, if any, have occurred References following the adoption of FRS 10 and FRS 11.For future research, it would also be interesting to see the effects of IFRS 3 and the applicabil ity of fudged accounting. Accounting Standards Board (1997), FRS 10 Goodwill and Intangible Assets, London. Accounting Standards Board (1998), FRS 11 Impairment of Fixed Assets and Goodwill, London. 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(1981), An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/ Choice, Journal of Accounting and Economics 3 1 29-149. Volume 4, Number 3 December 2004 163 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.