Accounting Principles and Practices

Accounting Principles and Practices

Accounting standards are rules and regulations followed when preparing financial reports. Accounting practices in different countries usually deviate from the requirements of the accounting standards. The deviation may be a result of ineffective penalties for noncompliance with the official accounting standards, the need to report more information than required by the standards, and the need to better present the companies’ operational results and the statement of financial position. This essay describes the accounting framework used in the following five members of the European Union:  France, Germany, the Czech Republic, the Netherlands, and the UK.

France Accounting framework

It is a must for French companies to report balance sheets, income statements, notes to the financial statements, and directors’ reports. The financial statements of larger companies must be audited, and the companies must prepare a report relating to the business bankruptcies prevention and social report. Listed companies are required to prepare half-yearly interim reports and their environmental activities results. The accounting practices discussed below are selected because they affect companies’ profits as well as the book value.

Listed companies in France comply with the IFRS when preparing the consolidated financial statements, non-listed companies also have the option of using the framework. The financial statements must be prepared under the legislation and in good faith to provide a true and fair view. French companies value their tangled assets at the historical cost. Revaluation is hardly found in practice, as much as they are allowed, because they are subjected to tax. Depreciation of fixed assets usually is on a straight-line or declining balance basis. Inventory is valued at the lower of cost or net realizable value using the FIFO or weighted average, method.

Research and development costs are treated as expenses and charged to the income statement, however, they can be capitalized in restricted conditions of which they will be amortized over a period equal to or less than five years. Leased assets are not capitalized and the rent paid is charged to the income statement. Pension and other retirement benefits are expensed when paid, and any provisions made are hardly recognized as a liability. Provisions on risks and uncertainties relating to restructurings, self-insurance, and litigation are made to allow opportunities for income smoothing.

FIFO and weighted average methods affect the value of inventory and net profit. Use of the FIFO method when the prices are increasing results in lower cost of goods sold and higher net income compared to the weighted average. Therefore, companies using the FIFO method in valuing their inventory are more likely to record high net income and higher value of inventory than companies using the weighted average method. Expensing research and development costs results in a reduction of net income while capitalizing the costs can either increase the value of the company or not affect it. Generally, French companies mostly use the cash accounting method to recognize their revenue and expenses.

Germany Accounting framework

Different requirements of accounting, auditing, and financial reporting as specified by German law depend on the size of the companies rather than the business form. The sizes are defined in terms of balance sheet totals, annual sales totals, and the total number of employees. German companies are required to report balance sheets, income statements, notes, management reports, and auditor’s reports. German law exempts small companies from auditing requirements, and they can prepare abbreviated balance sheets.  All companies, including the non-listed ones, comply with the IFRS when preparing the consolidated financial statements (Dieter, 1995). However, the financial statements of individual companies must adhere to the HGB requirements.

The revaluation method is used to value the acquired company’s assets and liabilities where the assets and liabilities are brought up to the current value, any extra amount is recognized as goodwill which must be amortized over its useful life, that is, five years or less.  The equity method should only be used in the consolidated financial statements for associates that are 20% and above owned. Foreign currency translation is done using the modified closing rate method. Fixed assets are valued at the historical costs and are depreciated using the tax depreciation rates. Inventory is valued at the lower cost or market value using the FIFO, LIFO, and weighted average methods.

German companies expense research and development costs when incurred. Finance leases are not capitalized, and pension obligations are recognized in the balance sheet as a current liability. Deferred taxes are not recognized in the individual company statements as consistent with the tax laws. In case the deferred tax appears in the consolidated statements by using different accounting methods for consolidations, a liability method must be used to set up the deferred tax liability. Provisions are used heavily to estimate future expenses or losses; this is because most expenses booked legally affect income determination directly, and they provide an opportunity for German companies to manage their income. A portion of the retained earnings is usually allocated to specific reserves, which include provisions and legal services.

The use of the revaluation method to carry forward the value of assets and liabilities of the acquired enterprises depicts the true value of the enterprises as well as the value of the Group. Taxation of the revaluation gain reduces a Group’s comprehensive income. The value of ending inventory recognized in the balance sheet, and the cost of sales charged to the balance sheet varies depending on the method of inventory valuation used. Normally prices of inventory tend to increase with time, due to this factor, companies using the FIFO method will record the lowest costs of sales and the highest value of ending inventory than companies using LIFO or weighted average. Moreover, those companies will record higher gross profit than companies using LIFO or the weighted average method. Germany adopts the accrual accounting method to recognize expenses and revenues.

Czech Republic accounting framework

Companies must prepare comparative financial statements consisting of the balance sheet, profit and loss account, and notes. The EU directives require that the notes clearly describe the accounting policies and information used in assessing the financial statements as well as including the cash flow statements. Listed companies in the Czech Republic must use IFRS for both the consolidated and the individual company’s financial statements. However, non-listed companies may choose to use the IFRS or Czech accounting standards when preparing the consolidated financial statements but must use.

Czech companies use the purchase method to account for business combinations and goodwill resulting from the acquisition is written in the first year of consolidation or capitalized and amortized over a maximum period of 20 years. The equity method is applied for the associated companies, and the joint ventures, and proportional consolidation is used. The income statement and balance sheet of foreign subsidiaries are translated using the closing exchange rate. Noncurrent assets are valued at costs and are depreciated over their economic lives. Inventory is measured at the lower of cost or net realizable value, with only FIFO and weighted average methods allowed. Research and development costs are charged to the income statement; otherwise, they are capitalized when relating to successful projects that are capable of generating future profits. Leased assets are not capitalized, and the provision for deferred income taxes is fully made for all the temporary differences.

Czech companies may record high gross profit margins due to the lower cost of capital resulting from the use of FIFO or weighted average methods. Recording noncurrent assets at costs may result in a high book value for the companies operating in the country.

Accounting framework of the Netherlands

The statutory financial statements are usually filed in Dutch, but English, French, and German are also accepted. Financial statements that must be included in the report are the balance sheet, income statement, notes, directors’ report, and other prescribed information. Notes must include a description of the accounting principle used in the valuation and estimation of results. Listed Dutch companies must prepare the consolidated financial statements in compliance with the IFRS while the financial statements of the parent companies can be prepared using the IFRS, accounting guidelines of the Dutch, or a combination of the two.

The purchase method is the common method used for a business combination in the Netherlands. Goodwill is calculated as the difference between the acquisition cost and the fair value of the assets and liabilities acquired and capitalized and amortized over a maximum period of 20 years. There is also an option of charging goodwill immediately to shareholders’ equity or income. The equity method is used in the case of the associates, and joint ventures can be accounted for by applying either equity method or proportional consolidation. Companies follow the IFRS guidelines for foreign currency translation; the foreign subsidiary’s balance sheet is translated using the closing rate while the income statement is translated using the average rate. Adjustments arising from the translation are charged to the shareholders’ equity.

The Dutch accounting measurement allows companies to record tangible assets at their current values (replacement value, recoverable amount, or net realizable value) as well as the expenses associated with the assets. For instance, the cost of sales and depreciation expense must be recorded at their current value when inventory and depreciable assets are recorded at their current values. When historical cost is used, inventory is valued at the lower cost or realizable value using FIFO, LIFO, or average methods. All intangible assets are assumed to have a finite life and are amortized over a maximum period of 20 years which is their economic life while intangible assets with longer than 20 years must be tested for impairment annually. Even though current value accounting is allowed by Dutch accounting, it is not accepted for tax purposes, and in case the method is used in financial reporting, a temporary or permanent difference might be noticed.

Accounting framework of the United Kingdom

The accountancy profession was first developed in the UK. Listed companies must provide a half-year interim report and must also report basic and diluted earnings per share (www.frc.org.uk/frrp). The financial statements reported by companies included directors’ reports, profit and loss account and balance sheet statements, cash flow statements, statements of total recognized gains and losses, statements of accounting policies, notes to the financial statements, and auditor’s reports. The UK financial reporting exempts small and medium-sized companies from many financial reporting obligations (Choi & Meek, 2014).

The U.K. allows only the acquisition method for business combinations of which goodwill is determined as the difference between the cost of acquisition and the fair value of the net assets acquired. Goodwill is capitalized and amortized over a maximum period of 20 years, in case the period is definite, goodwill will be tested for impairment each year.  Assets are valued at cost, current cost, or a combination of the two, and depreciation and amortization are measured based on the valuation measurement used on respective assets. Research costs are written off in the year incurred and paid while development costs may be deferred based on the surrounding circumstances. The translation of foreign currency is made in compliance with the IFRS. Inventory is valued at the lower of cost or net realizable value using FIFO or average methods.

 Summary

Inventory valuation methods are used to influence the profitability outcome of companies in each country. The methods also influence companies’ financial ratios, for instance, the debt ratio is influenced by the inventory valuation method because of the effects of the value of ending inventory which is treated as a current asset. The FIFO method assumes that the oldest inventory are the ones that are usually sold and since prices do increase with time, the oldest units are generally the cheapest. Therefore, selling the cheapest units results in lower cost of sales and high net income. Gross profit margin and net profit margin are usually higher for companies using the FIFO method than companies using LIFO or weighted average; This also means that earnings per share of such companies are usually higher than the companies using LIFO or average methods. Debt ratio is a balance sheet ratio determined by comparing total liabilities to total assets; the higher the value of total assets the lower the ratio. Just like the profitability ratios, the inventory valuation system also affects the balance sheet. Companies using the FIFO method report a higher inventory under the current assets than the companies using the LIFO or average methods. Therefore, the use of the FIFO method results in a lower debt ratio because total assets in the balance sheet will be higher due to higher inventory value than in the case of LIFO or weighted average.

References

Financial Reporting Council: www.frc.org.uk; Accounting Standards Board and Urgent Issues Task Force: www.frc.org.uk/asb/; Financial Reporting Review Panel: www.frc.org.uk/frrp.

See Gilad Livne and Maureen McNichols, (January/March 2009) “An Empirical Investigation of the True and Fair Override in the United Kingdom,” Journal of Business Finance and Accounting: 1–30.

Dieter Ordelheide, (London: Macmillan Press, 1995) “Germany: Group Accounts,” in Transnational Accounting, 1599–1602.

Choi, F. D., & Meek, G. K. (2014). International accounting(7th ed.). Harlow, Essex: Pearson.

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Accounting Principles and Practices

Under the Required section of the exercise, you are to select an accounting principle or practice for each of the countries – France, Germany, Czech Republic, Netherlands, and the U.K.- that does not align with international norms. Organize your analysis to list the country in the header, then address points b, c, and d in the form of an essay underneath the country. A cover page, table of contents, essay, and references page should be included in your submission.

Note that the assignment is NOT to compare each country’s principle to IFRS. Utilize the textbook sections titled Accounting Measurements to assist with determining areas where countries differ in accounting principles.