Executive Summary
This paper focuses on how the banking industry is impacted by different accounting information and design by individual companies. As the industry is a key in developing and stabilizing the economy and society, it is timely to assess the effectiveness of accounting information strategy being used by banks. It is concluded that public companies particularly banks listed in the Hong Kong Stock Exchange have a profit-based decisions on how they will present accounting information. Thus, there is a call for regulation to evaluate the industry’s accounting practice to avoid future mishaps and protect users.
Introduction
Creative accounting is an earnings management that results to data manipulation and departure from the standard accounting practices (Healy & Wahlen 1999 pp. 365-383). It is also cited as the cause of recent business scandals of Enron and Worldcom. Usually it is attained by lengthening the life of an asset to reduce depreciation costs and designing accrual accounts to the benefit of an organization (Answers.com). As being creative, accountants entail to bypass rules and some ethics to achieve organizational or self-vested interests and goals. Their skills is dependent on the benefits of creative accounting which can result to attract new investors, receive debt, cut on taxes, defer on employee benefits and mitigating the effects of litigation. The more creative they are the more benefits that can be realized.
This phenomenon leads to the inception of this paper. It intends to evaluate the level of creative accounting being applied to Hong Kong’s largest banks. As these banks are public companies, the presentation of financial statement is the key to rational and productive allocation of resources within the economy. The public at large is also central in this study because they are the one that will be affected by the circumstances of these banks. Whenever an underlying creative accounting is prevalent, the speculation of dishonesty and collusion is probable. Their effect, in their very nature, is destructive to the economy and also the banking industry’s reputation. As such, early study to aid measurement on the level of accounting information’s proximity to creative accounting is deemed fruitful.
Theoretical Aspects and Challenges to Accounting Standards
HSBC
The method of valuation of investment properties is disclosed which justifies the increase of their net book value and crediting to income statement. However, there is no explicit terminology (e.g. sum-of-years, double-declining balance) to described the depreciation method being applied as well the asset’s useful lives and depreciation rates. Computations on carrying amount and accumulated depreciation are shown with current and previous year comparisons. Carrying amounts at the beginning through the end of the period are adjusted by considering additions, disposals, and exchange differences among others.
Bearing in mind that PPE of HSBC are land and buildings, other disclosure involves their nature as finance lease contracts, expenditure and commitments but there are no third party compensation clause. In the revaluation of its investment properties, HSBC disclosed the effective date of revaluation (e.g. every 31 December), involvement of independent professional valuers (e.g. DTZ Debenham Ltd), use of open market basis and recognition of contractual obligations on investment properties. However, there is no presentation on alternative cost model. There are no disposed non-current assets that HSBC has executed. As there is no specific depreciation method used, it is undeterminable to comment about its semblance with pattern of asset’s economic benefits and consumption.
In valuing intangible assets, HSBC seemingly is not within the scope of IAS 38 because it included goodwill arising from issuance contracts which is beyond the scope of the standard. However, the analysis will be focused on certain contents which coincide with the provisions of IAS 38. For example, HSBC created a classification of intangible assets under “other” account which make it impossible to assess its ground for recognition. There are also figures concerning present value of in-force long-term insurance benefits. Further, adjustments for PPE and intangible assets have the same accounts (e.g. additions, exchange differences, etc.). However, the lack of text explanations for the notes to goodwill and intangible asset presentations inflicted the validity of internally-generated software which accounts for the biggest intangible property.
The strength of HSBC especially pertaining to current assets is that it revalues its non-assets regularly to avoid huge discrepancy of the previous period to the succeeding ones. This is aided by presenting comparative revaluation results year-on-year. As investment properties are only the ones that are revalued, HSBC also rescinded in revaluing non-current assets under finance lease contracts (FLCs). This move is according to IAS guide on revaluation model. In addition, investment properties are also imputed with the same adjustments and comparative presentations like non-current assets under FLCs. As both accounting year 2006 and 2005 have revaluation surplus, it should be recorded in equity but HSBC opted to reflect it on notes under “non cash items included in profit and tax” and ultimately in income statement (IS).
One advantage of HSBC’s approach to non-current assets is that it applies a comprehensive valuation of PPEs even though the company does not gain most of its income from non-current assets such land and building. This reflects managerial evaluation due to inability of available depreciation methods to suffice representation needs. However, this strategy can also minimize the “true and fair” impression on its BS because of excessive non-objective application of valuation techniques. In contrast, HSBC is able to redeem some spots of unbiased stance by regularly evaluating its techniques, inclusion of outside valuer and stating non-current asset restrictions. However, the inability to reflect the revaluation surplus in equity account rather on IS makes the increase less useful to shareholders.
For the low-educated type of people, the BS of the company will be appreciated because it maximized managerial evaluation in determining the “true and fair” value of non-current assets for the purpose of information. However, on the part of credit rating agencies (e.g. Standard & Poor), the opposite impression will result. The same adjustment elements for non-current assets that are evaluated are also helpful in establishing ease of analysis from low-educated people. In the contrary, agencies would prefer more complex numerical data to suffice the claim like the movement in PVIF shown in adjusting the values of intangible assets. For both users, HSBC could infuse more textual explanations to the arrived figures especially in valuating goodwill and intangible assets because fewer details would mean confusion and speculations.
Hang Seng Bank
Same as HSBC, Hang Seng uses open market value, independent professional valuer and annual assessment method for its investment properties. However, unlike HSBC, Hang Seng explicitly classifies their investment properties as operating leases. The requirement disclosure of IAS 16 is not accounted as Hang Seng does not present a detailed surplus revaluation rather the note that supposedly explains the carrying amount and adjustments is inexistent. Although the basis for valuing PPE is stated, the depreciation method used or the same problem on HSBC is not explicitly disclosed. Useful lives of the PPEs are also not reflected. On the other hand, reconciliation of investment properties and PPEs are included while the restrictions on assets are stated when presenting investment properties.
Alternative presentation for the cost model is excluded like the HSBC and also changes in economic benefits and consumption pattern of PPEs and investment properties are not discussed. Possibly, this is the result when external valuers have found no significant valuation change for Hang Seng which is the present case. Provisions on disposals are eminent in both PPEs and investment properties which requires the abolition of such assets in the BS. In addition, a situation that Hang Seng would defer payment of certain properties to apply market interest is not determinable because there is no disclosure about purchase or lease transactions. But Hang Seng included direct operating expenses as expenditures for investment properties which contribute to the increase of revaluation of investment properties. In contrast, it is observable that no impairment looses that are recognized. Also, there are no recorded amortizations that concretized the fact that the Hang Seng fully-paid such assets.
When it comes in intangible asset, Hang Seng method of valuation purely shows computations without textual explanation to justify the provisions of IAS 38. Another, like HSBC, Hang Seng also included long-term insurance as intangible assets which are beyond the scope of the standard. Disclosures are also lacking and this is aggravated by the lack of textual explanations and explanatory notes. There are no indications of the useful life of the intangible assets, amortization method used and impairment looses. The focus of the presentation is to show the developments Hang Seng initiated to improve intangible assets but not the impairment looses due to the use of the asset.
Further, intangible assets that Hang Seng presented are unable to justify themselves as under this class since there is no elaboration on who controls the asset and future economic benefits of the asset (e.g. internally developed software). If any, acquired software should the one that has relatively highest merit of being in the intangible group due to the assumption of IAS 38 for business combinations. However, it is necessary to reflect the details of the acquisition in order to assess the value of the acquired intangible asset. It is also observable that Hang Seng amortized its internally generated software but the method used is not indicated.
The “true and fair” valuation of the BS of Hang Seng based on its method is not eminent because the users of such information are left in the middle of nowhere. The presentations are merely numerical in nature and there is no chance of knowing their validity according to IAS 16 and IAS 38. The lack of textual explanations which is earlier pointed as weakness of HSBC is also the undermining factor in the BS of Hang Seng. In the contrary, Hang Seng admonition that it considers its investment assets as operating leases makes the analysis from external users easy unlike HSBC approach of consolidating lands and buildings related cash flows. One core disadvantage is the inability of Hang Seng to fully discuss the characteristics of the intangible asset to clearly show its compliance to the recognition provisions of IAS 38.
For the low-educated people, the non-current assets of Hang Seng will impede understanding of the true nature of its value because of they are purely quantitative. Although this presentation would be agreeable to experts, laymen would want a more detailed valuation to use IAS guidelines in determining on what extent does the company is being true and fair. Computations can be analyzed by experts with their profound experience in financial statements but low-educated people may view them as unrealistic given that explanations of their existence and positions are unknown. On the other hand, low-educated people can appreciate the external auditors that are involved in revaluating investment assets. On the part of experts, this cannot be easily accepted as collusion between the client and service provider is probable.
Wing Lung Bank
The accumulated depreciation for the investment properties of Wing Lung is zero which can mean that improvements of such asset can impede the decline in the loss of its value due to usage. The non-compliance issue is eminent especially when it is known that Wing Lung had revalued its investment properties and ultimately gains surplus revaluation but depreciation is not applied. According to IAS 16, the cost model on depreciation applies on revalued assets. In addition, the surplus revaluation reflected under fixed assets has no notes that can indicate that the surplus is included in the equity section of the BS. It is also observed that all the non-current assets of Wing Lung had increased in value since 2004 from premises, investment properties and furniture/ equipments.
Additions, disposals, reclassifications and other adjusting elements for revaluation are limited to numbers which make it hard to determine their compliance with the respective provisions. This can lead to ambiguity which can undermine the “true and fair” valuation of its non-current assets. For example, there are additions in every non-current account where only amounts are indicated. Therefore, initial measurement provided by IAS 16 cannot be enforced like the recording of “other cost necessary to bring an asset to working condition” because the features and improvements of certain assets are not disclosed. In this foregoing, deferred payment applied to acquire these assets are also hindered in the eyes of the users.
The valuation of investment properties is also not done in regular manner. In fact, the 2005 revaluation is done by Wing Lung for the first time although the valuers are independent and open market value basis is applied. Most of the investment properties in 2004 are reclassified as premises but such action is not covered in IAS 16, therefore, this is no basis to analyze this strategy. However, it is noteworthy to mention that since 1995 through 2005, investment properties are increasing in value although in decreasing rate. There are also no disclosure on restrictions in title, expenditures, commitments and compensation to third parties which means that the assets of Wing Lung really owned and benefited by them. However, the same situation can lead to speculation that Wing Lung has erred in valuing its non-current assets.
The advantage of the valuation method of Wing Lung is that there are no provisions for intangible assets. Therefore, users of BS can only consider the real non-current assets of the company with less regard to the complicated nature of intangible assets when it comes in evaluation. It can be said that it is advantages for laymen to view the true and fair valuation of corporate assets because of its simplicity and absence of technicalities (e.g. PVIF). The disadvantage is on the undermining of the intangible assets of Wing Lung that unlike HSBC and Hang Seng maximized. Therefore, the company can be undervalued but this undervaluation can be redeemed when users of BS can attribute truth and fairness in the presentation. However, the absence of in-depth presentation remains the weakness of all three banks.
Reasoned Solutions and Limitations
Every capital asset (an asset whose useful life is at least one year) is used to generate revenues either direct or indirect manner. In effect, it is justified that wear-and-tear/ income generating capability of the asset would have implications in valuating its current value. However, at times when such assets are not often used or simply the firm cannot maximize its potential, is it also justifiable/ rational to valuate its current value despite of lesser usage/ inefficiency? This question can be answered by depreciation concept in accounting. Accumulated depreciation represents the money value of a capital asset charged against its historical cost to reflect the current value of such assets. The resulting amount would show the adjusted money value of the assets since the provision of depreciation in the asset becomes a contra-account to the former.
As the computed depreciation for a certain asset has its tax implications for the firm (where it can strategically defer tax payments for short-term capital), picking-up the appropriate method of depreciation computation is crucial. It can be approached by either using the useful life of the capital asset or acceleration. The former is mostly prepared for investor reference (as to view the yearly depreciation amount of the asset) while the latter for tax documents (as to take advantage of deferred tax payments). Straight line depreciation falls under useful life orientation and is considered the easiest method. Such method merely requires the firm to know the useful life of an asset, original price and salvage value to be able to determine annual depreciation. In this case, the resulting amount for following years would be similar all throughout.
Amortization catalyzes like depreciation though it reflects the value of a fixed asset by reducing its original value by the amount deemed wasted due to transactions or events specifically in leasing. The concept validates the original value of the asset against the bid of lessee which is commonly below the asset’s cost. What amortization does is to charge the annual costs of a certain lease agreement against annual profit of the firm. It is just like depreciation such that it is treated as an expense for the lessee although with a direct deduction to profit unlike depreciation which is a contra account in the balance sheet. It is written in the lessee’s balance sheet as “capital-lease asset’ and with counter-liability account “obligation under capital lease”.
They also differ because amortization refers to intangible assets such as goodwill, patents and trademarks while depreciation is on tangible ones. Further, the former periodic written-offs to earnings for a period over 40 years is considered by firms “unnecessary”. Amortization is important to avoid reliability of financial statements particularly balance sheet in which most firms place a value of their brands without amortizing them. By doing this, stock price relevant to publicly traded corporation could benefit the value-added contributions of the intangible assets of the firm.
Summary and Conclusion
Banks can be considered as one of the industry that most likely consistent to IAS guidelines as they are monitored by government authorities as well as private associations. They also partake in financial statement analysis from corporations which makes its safe preparation and appearance. However, our analysis of the well-known and biggest banks listed in Hong Kong Stock Exchange proved that they are also private entities with profit-orientation. Due to this, notes to their respective BS are limited to numerical presentations without reference to the provisions of IAS 16 and 38 for the sake of readership on both expert and layman levels. In this manner, only experts can extract the needed information from these BS.
Shown in table 1 are the different valuation methods that one of the banks used in assessing the value of its non-current assets. As there are several methods that can be used or even combination of these, it is vital for these banks to ensure that they can state the valuation method being applied by their independent valuers in order for users to have an easy grasp on the framework being applied. When users would know the specific valuation method, they can be aware of its strengths and limitations and can initially have a birds-eye-view on what to expect on the BS and succeeding notes. However, even banks have their way to minimize the error that can arise once the framework used is limited in their own ways. Therefore, flexible valuation method is vital infused with managerial judgment in estimation for optimal non-current asset values.
Applied in the end of an audit, analytical auditing procedures serve as tools for the auditor to understand the entity and implications of external environment for the purpose of promoting risk assurance systems. Common risks are substantial deviation of entity forecasts and irrelevant relationship between financial and non-financial information and also components of financial information (e.g. pattern of gross margin). Depending on the situation, analytical procedures can compose a substantive allocation from the auditor’s work. An example is the comparative assessment of the entity’s financial statements with previous information, internally-accomplished future performance of the entity, anticipated results made by auditor and industry-wide data.
In execution of analytical procedures, auditors are given due independence to choose appropriate methods, frameworks and extent of evaluation. Two common selections are cyclical testing method and annual certification approach. These procedures, due to the personal judgment, may or may not deliver the purposes intended to achieve by analytical procedures; namely, understanding the entity and its environment, mitigating substantial misinterpretation to low levels and overall evaluation of financial statements applied in concluding part of auditing process. Thus, to be successful in evaluating the effectiveness of how a company in valuing its assets, it is important to apply post completion audit on the part of the reporting firm. This will not only make the financial statements more authoritative but also increase its ability to present data in unbiased manner.
Table 1: Comparison of Valuation Methods
Method
Primary Activities
Unique Feature
Practical Use
Direct Comparison
- comparison of the property with similar transactions
- can be straight or analytical comparison
- most frequent used method especially in residential property and vacant land
Summation
- comparison of vacant and developed sites
- the added value of improvements is added to the result of the primary activity
- helpful in rating and taxation valuation
Capitalization
- net passing rental is capitalized or multiplied in perpetuity
- uses a certain percentage called yield that has a formula of net rent/ sale price
- used in commercial, investment and hospitality premises whose operations are on a going concern
Hypothetical Development
- pre-supposes a development proposal on a certain property
- scenario planning for future property improvements
- applied in assessing the feasibility of a project, development option and value of the proposed development
Depreciated Replacement Cost
- methodology of summation with regards to depreciated replacement cost
- uses cost estimates and allowances for depreciation to account for property and improvement obsolesce
- evaluation of specialized assets for financial reporting purposes
Discounted Cash Flow Analysis
- use the stream of future cash flows of the property
- necessitate computation of net present value (NPV)
- use to value substantial commercial premises subject to long-term lease agreements, and also, valuing subdivisions
Appendices
1. Balance Sheet of HSBC
http://main.ednews.hk/listedco/listconews/sehk/20070306/5_158824/EWF101-3.pdf
2. Balance Sheet of Hang Seng Bank
http://main.ednews.hk/listedco/listconews/sehk/20070306/0011/F123_e.pdf
http://main.ednews.hk/listedco/listconews/sehk/20070306/LTN20070306111.htm
3. Balance Sheet of Wing Lung Bank
http://main.ednews.hk/listedco/listconews/sehk/20060327/0096/EWF122.pdf
http://main.ednews.hk/listedco/listconews/sehk/20060327/0096/EWF113.pdf
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Jacobs, F & Maiga, A 2003, “Balanced Scorecard, Activity-Based Costing and Company Performance: An Empirical Analysis”, Journal of Managerial Issues. Volume: 15. Issue: 3. Page Number: 283+.
Lindahl, F 1997, “Activity-Based Costing Implementation and Adaptation”, Human Resource Planning. Volume: 20. Issue: 2. Page Number: 62+.
Penman, S 2003, “The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble”, Accounting Horizons, vol. 17, pp. 77+.
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