Technical analysis

Transaction alternative 1(the original way)

The transaction will have the effect of increasing the balance in the accrued wages account while at the same time increasing wages expense for the year in the event that this approach is taken. The necessary entries would be as below:

On recognition of the amount:

DR: Wages Expense A/C (Wages expense increase)

CR: Accrued Wages A/C (Accrued wages liability increase)

At the time of preparation of end of year financial statements, the balance in the Accrued Wages A/C is taken to the balance sheet as a short-term liability. The accrued figure would already have the effect of reducing the Net Income in the income statement due to the fact that wages expense would be higher than if it were not included.

Income Statement (Extract)

Balance Sheet (Extract)

With respect to the overall accounting equation, this approach to the transaction will have no effect on the asset side of the equation. There will be an effect both on liabilities and owners’ equity.

The creation of Accrued Wages Liability increases the ‘L’ component of the Equation. On the other hand, the increased amount of wages expense has the corresponding effect of indirectly reducing the ‘OE’ component of the Equation. The indirect reduction of ‘OE’ comes via an increased wages expense for the year.

Transaction alternative 2(as proposed by Tom)

This alternative will have the effect of understating wages expense given that the corresponding revenue will already have been earned by the company. In addition, it will also understate a short-term liability in the balance sheet. By postponing the recognition of this component of wages expense, there will also be a failure to recognise the liability given that these last wages were not paid for in cash. It is a requirement of the matching concept that revenues must be matched by the resources that were consumed in generating them.

The effect of understating wages means that the Net Income in the income statement will be overstated just as the short-term liability of accrued wages will also have been understated.

The overall effect on the Accounting Equation will also mirror the above mentioned effects. For instance, there will be an understatement of the Liabilities component of the Equation while the Owners Equity component will be overstated.

Perception of users of accounting statement

Using either of the above alternative accounting approaches to the transaction would elicit varying perceptions from the many users of financial statements.

Managers

Mangers rely on financial information mainly for decision making purposes. A treatment of the transaction as originally intended would make them work hard as the company would be reporting a lower profit figure. On the other hand, the second alternative may lull the management by making them believe that the company is doing well.

Shareholders

Through the financial statements, shareholders are able to assess the performance of the management who act as their agents. The original approach to the transaction may make them feel that the management is not doing enough as profits would be low. With overstated profits in the second alternative, they may have the opposite perception of their management.

Government (tax authorities)

With the original treatment, tax authorities are likely to assess less tax on the business with the alternative approach attracting a higher assessment of tax.

Ethical analysis

Existence of a dilemma

A dilemma is, by definition, a situation where one has to make a choice between two competing alternatives and it is not easy to settle on any particular alternative. This definition perfectly fits the situation in the present case. In the first place is the alternative of going with the original plan to recognise accrued revenues. On the other hand is to follow through with Tom’s request of waiting until the following year to recognise these additional wages as expense. Given that the company has always followed the first alternative may make the situation look easy. This is, however, not the situation as the request from Tom places an enormous pressure on the ability to make either of the two choices.

Potential parties that may be affected

Whatever decision I make in this situation has the potential of affecting a number of people. Tom and I are, however, the first people to be affected by the decision. For Tom, this decision may determine whether he gets or not.  Above the small issue of getting a bonus is the wider reputational concerns that may affect both Tom and I. All other users of the financial statements are also likely to be affected by the decision. In the case of the management of the company, the decision is likely to accurately represent or misrepresent the performance of the division depending on whether the original or second alternative is taken. The tax authorities are also likely to be impacted by the level of tax they can assess on the profits of the company.

Recommendation

I would recommend proceeding to record the transaction as originally intended. From a technical perspective, adopting this option conforms to the matching principle under U.S Generally Accepted Accounting Principles (GAAP). A key feature of the matching principle is that revenues should be simultaneously recognised at the same time with the costs used in generating them. On the ethical front, independence and integrity runs through the American Institute of Certified Public Accountants’ (AICPA) Code of Professional Conduct and Bylaws. Agreeing to Tom’s request will be a direct violation of these key values.

Reference

American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct and      Bylaws 2013.

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