Introduction
Overview
Auditing of an organization’s performance through the assessment of the financial statements of the concerned organization is an important element as far as investors’ decisions are concerned. Agbejule and Huusko pointed out that investors rely on financial information about a given company before making any form of decision whether or not to invest in a given company (354). However, while financial reporting is very important in the assessment of the growth and potential of companies, many investors suffer from wrong reporting of the financial status of organizations, especially where organizations’ managers conspire with auditors fraudulently to alter the real financial information of the concerned company. Resultantly, investors make the right decisions based on incorrect information that might have adverse effects in the long run and lead to possible losses. According to Angelakis, Theriou, and Floropoulos, there is a need for measures that govern the process of reporting financial information for the purpose of ensuring that only the right information is provided to the investors as well as the public (88).
However, a review of the process of presenting income statements, which is the major assessment factor or organizational progress, shows that different approaches are used depending on the method used as well as the purpose of the financial statement. Based on this perspective, Marshall, McManus, and Viele asserted that various principles are used in the organization of income statements (102). The specific principles used to organize income statements include the variable costing as well as the absorption costing principle (Black and Gray 134). In addition, it is possible for accounting statements to be presented in the form of regular or annual reports. In the case of regular reports, Marshall, McManus, and Viele observed that the focus of the presentation is on the organization’s internal use while the annual reports are meant for external use (23). Weygandt, Kimmel, and Kieso pointed out that managers make use of the presented income statement in assessing the performance of their company over a given period, under specific conditions as well as with reference to changes stipulated in the reports (23).
These two principles structure their reports differently. A study carried out by Noreen, Brewer, and Garrison showed that the use of the principles of variable costing and absorption costing differ in terms of the nature of materials and costs that are taken into account in the completion of any given report and analysis (123). For this reason, a possibility exists that necessitates the availability of well-structured reports and income statement that show a clear picture of any given company’s financial position. In spite of this, it is important to note that the use of absorption costing and variable costing approaches do not guarantee efficiency for all situations and contexts (Agbejule and Huusko 354). The implication of this is that there is need for more improvement to ensure accurate presentation of income statements and financial reports. In support of this, Weygandt, Kimmel, and Kieso pointed out that at times absorption costing and variable costing can lead to wrong reflection of a company’s financial performance (25).
Angelakis, Theriou, and Floropoulos noted that there is a need for effective measures and factors that upon inclusion in the income statements of organizations can lead to improvement in the process of assessing the financial position as well as performance of organizations (87-96). Evidently, the possibility of including such factors in organizations’ income statement is a subject worth further investigation. Therefore, this study focuses on financial indicators in income statements and the possibility of including other elements in the statements for a chance to improve the efficiency of income statements prepared to reflect the performance of organizations.
Problem Statement
As pointed out earlier, financial information and effective reporting of organizations’ accounting information is important for investment decisions. As such, Black and Gray asserted that lack of efficiency in the methods of preparing income statements as well as in the general process of assessing the performance of organizations can be detrimental as far as investment decisions and the future of any investment project is concerned (142). This study is motivated by the need to come up with factors as well as any possible indicators of performance of organization in income statements as a means of boosting the efficiency of an organization’s performance assessment process. Various accounting scandals have been witnessed globally as a result of failure in the auditing process and the manipulation of accounting figures due to self-interests of organizations’ owners as well as managers, as in the case of the Enron conspiracy. The problem is in the fact that the standards regarding the presentation of income statements differ, and this aspect is directly related to disparities in the presentation of statements based on variable costing and absorption costing methods.
A study carried out by Haskin indicated that most auditing procedures that are applied to the analysis of companies’ financial statements are focused on establishing the possibility of any fraud and errors (91). In support of this assertion, Tsamenyi, Sahadev, and Qiao found that the auditing procedures employed do not explain the profitability or even the performance of any company under assessment (193). For this reason, the situation creates additional challenges for completing auditing procedures and providing any form of assessment to shareholders. Currently, shareholders face numerous problems as far as the evaluation of the performance of organizations with reference to the provided statements is concerned. Such a scenario is brought about by the fact that various approaches can be used in order to administer the report. Garrison et al. noted that it is important to note that auditors can issue unqualified reports and that the shareholders can have wrong assumptions regarding the company’s performance (792). In support of this assertion, Yalcin pointed out that these inaccuracies can lead to wrong interpretations and the use of ineffective measures in order to overcome problems related to the company’s performance (95).
Recent studies have found out that the continuous lack of factors or even any other indicators in financial statements that can help in accurate reflection of organizational performance is instrumental in heightening the problem of ineffective auditing and analysis of differences in income statements based on variable or absorption costing. As such, Gupta, Pevzner, and Seethamraju found that it is possible for shareholders to be misled as well as be misinformed with respect to the real situation in any given company (900). In this context, the provision of new factors or indicators may add to the financial statements, and it will be possible to improve the auditing procedure without affecting changes in the accounting standards. The improvements in the income statements that are proposed in a form of adding specific financial factors or indicators can become an appropriate response to the problem of ineffective assessments of the financial performance of organizations and any other associated problem, including making incorrect conclusions regarding investments in any given organization whose financial information might be manipulated.
Aim of study
This study primarily aims to investigate the possibility of including other factors or indicators of financial performance in income statements for the purpose of ensuring efficiency of the assessment of the financial performance of organizations. Basically, the study focuses on identifying several elements that can be added to organizations’ income statement such that the process of auditing can be effective. However, it is expected that the inclusion of such factors will not have negative impact on auditing standards, according to which variable and absorption income statements are organized. In addition, the study aims at determining indicators that can be useful in overcoming the existing gap in the auditors’ approach to analyzing two types of statements as well as in the shareholders’ understanding of the company’s performance. Such an analysis will provide solution to the problem of ineffective financial reporting and hence, reduce cases of accounting fraud.
Research questions
Research questions are used in any study to offer guidance to the researcher for the purpose of ensuring that all the necessary areas of any given study are covered in their entirety. As such, research questions were used in this study to help in investigating the possibility of improving assessment of organizational performance through the inclusion of performance indicator in an organization’s income statement. Therefore, the study had the following research questions:
- Is there a significant gap between absorption and variable methods of organizing income statements?
- Who can exploit this gap, and how is it possible in relation to completing auditing procedures and analyzing any company’s performance?
- Is there a possibility that the gap can be deepened and what conditions are associated with deepening the gap? What can be done in order to eliminate the gap?
- What are the benefits of eliminating the determined gap? Who will gain from these benefits?
- What indicators can be added to income statements and auditing reports in order to address the gap? How can these indicators influence the auditing procedures and the shareholders’ understanding of the company’s performance?
The research questions highlighted above are closely related to the aim of the study and, thus, they are intended to be used as a guide throughout the research to ensure that all important aspects of the study phenomenon are discussed comprehensively.
Significance of the study
The study on the factors and elements that can be included in income statements is important not only for academic purposes, but also as an addition to the existing literature on the role of income statements and effective financial reporting in the process of making robust decisions regarding any investment. The study will achieve this through an investigation of the possibility of including other factors or indicators of financial performance in income statements for the purpose of ensuring efficiency of the assessment of the financial performance of organizations. In general, the study will provide insights on how the efficiency of assessing the performance of organizations can be improved by factoring in additional aspects in income statements. As such, the study is quite significant to the auditing profession because it will shed light on how to overcome the existing gap in the auditors’ approach to analyzing two types of statements as well as in the shareholders’ understanding of any company’s performance. In the end, it will be possible for organizations to report accurate financial information, thereby helping in the reduction of financial frauds and manipulation of accounting information for self-interests.
Dissertation outline
This dissertation is structured in the form of six chapters. Chapter one, as evident above, covers the background information about the study phenomenon, the aims and objectives of the study, the research questions, as well as a review of the significance of carrying out this study. The next section is the review of relevant literature. This part of the dissertation provides an in-depth analysis of past studies that have been carried out covering the aspect of financial indicators in income statements and the absorption and variable costing methods. As such, the review of relevant literature serves to offer some level of significance to the entire study by analyzing past studies’ findings and their significance to the current study.
The second other section is on methodology and data collection. It provides a discussion on the methods of collecting and analyzing data that were used in the study. In addition, the methodology section provides justification for the use of various data collection and analysis techniques. The third section covers the results of the study. Here, the section covers a comprehensive analysis of the collected data in an attempt to provide answers to the research questions outlined above as well as achieve the research aims and objectives. The other section covers the discussion, conclusion, and recommendations based on the study results and findings.
Related literature
Overview
Transparency in the process of reporting financial information is a very important aspect as far as the assessment of the financial position and performance of organizations is concerned. In spite of this, Laux noted many organizations have failed and others caught up in accounting scandals due to lack of transparency and openness in the reporting of accounting information (239). Such a scenario can be attributed to the fact that auditors’ independence becomes compromised most of the times such that they cannot work intelligently and with integrity. While there is need for more strict laws and regulations that govern the operations of editors based on the auditing code of conduct, Yalcin asserted that there is equal need to review the elements of income statements for a chance to examine the possibility of adding various elements that can guarantee accountability and accurate reporting of companies’ financial information (95). Therefore, this section provides an in-depth review of studies carried out in the past that are closely related to the aspect of indicators of financial performance of organizations in income statements.
Corporate financial reporting
The regulation of the process of corporate reporting is instrumental in ensuring that the reports provided by companies about their performance and financial position are transparent and that they reflect the true performance of organizations. Nevertheless, Fisher and Krumwiede noted that there have been a lot of debates with respect to the efficacy of such regulations (21). This has been instigated by the numerous accounting scandals that have been reported in various parts of the world in the past. For example, Laux pointed out that the uncovering of the Enron conspiracy and the failure of the U.S.’s WorldCom has raised concerns over the need for effective corporate reporting measures (240). As such, there is a need for improvement in the reporting of financial information of companies in order to reduce cases of future accounting scandals. However, numerous scholars and researchers have expressed divergent opinions with respect to the process of assessing the financial position and performance of companies. This is attributable to the fact that various methods of assessing financial performance of companies are used. In addition, auditors and managers have been faulted for manipulation of organizations’ financial information for their benefits.
Based on the above assertion, it is evident that there is lack of trust in the current system of corporate reporting regulations. Gamble and Simms noted there are arguments that strict regulations have been put in place to control financial reporting of organizations (24). In spite of this, a lot of skepticism exists as far as the credibility of the current system of revaluation and the methods used in assessing the financial performance and position of organizations are concerned. According to Laux, the occurrence of accounting-related fraud and financial crises is attributed to interventions on financial regulations (241). For instance, in the United Kingdom, the regulations on financial reporting were not consolidated until several accounting scandals emerged in the nineties. On the other hand, the U.S. government introduced the Sarbanes Oxley Act of 2002 following the Enron scandal.
In addition, Laux asserted that a lot of pressure is currently put on financial regulations’ standards (246). In this view, standardizing the financial regulation is important in that it helps to spread expert knowledge while at the same time maintaining the consistency of financial reporting in an organization (Singleton-Green 17). This gives the auditors a background to justify their decisions. For this reason, it can be argued that the availability of strict financial regulations is very significant in the reduction of any form of risks that can accompany any given financial claim as the auditors can base their justification on the set standards. In addition, Laux argued that having robust financial regulation is important because it provides an avenue for organizations to save on some costs (256). This assertion is grounded in the fact that corporate financial regulations offer the basis for organizations to make comparison whenever preparing any financial reports.
According to Ruiz‐de‐Arbulo‐Lopez, Fortuny‐Santos, and Cuatrecasas‐Arbós, the failure of organizations to report their financial information accurately has a detrimental effect on the decisions of investors (650). However, having measures to compel organizations correctly to report their financial information can go a long way toward the reduction of financial crisis and accounting scandals. Additionally, such measures can greatly save the future of organizations because with the right financial information, investors will evaluate the viability of their investment as well as the rate of return of such investment based on the right accounting information of the concerned organization.
Methods of organizing income statements
Accountants and auditors are inclined to use both absorption and variable methods of organizing income statements in their work. Angelakis, Theriou, and Floropoulos support the focus on using both traditional and recent approaches to documenting firms’ income (89). This approach creates the additional challenges for analyzing the factors that can influence the changes in the company’s performance because of differences in the treatment of fixed overhead costs. According to Tsamenyi, Sahadev, and Qiao, companies can use both types of statements during different stages of their development, and the choice depends on the benefits of any of the approaches (193-203). The possibility of using both approaches creates the additional barrier not only for auditors, who are focused on identifying fraud, but also for shareholders, who need to receive the most credible information regarding the company’s performance and profitability. According to Ruiz-de-Arbulo-Lopez, Fortuny-Santos, and Cuatrecasas-Arbos, manufacturers often need additional information in order to support their conclusions regarding the business’s performance (647). The disparities in statements that are organized according to two different methods can affect the overall quality of the performance evaluation.
However, researchers also agree that different accounting and cost systems have various advantages and disadvantages that should be taken into account while referring to the correctness or suitability of the proposed income statements. Fisher and Krumwiede pointed out that the management and accountants decide what accounting practices to use for the purpose of reflecting and measuring the company’s performance, and there is no single opinion regarding the benefits of this or that practice (21). According to Agbejule and Huusko, the variety of approaches to conducting the overhead analysis makes shareholders, accountants, and auditors think about the additional ways of improving the procedures (354). In their work, Zimmerman and Yahya-Zadeh discuss the use of accounting and its principles for making business decisions. In this context, the analysis of approaches to improving the income statements is regarded as a necessary option (258). In his turn, Weiss concentrates on the impact of statements’ structure on the auditing procedures and further forecasting for the company (1441). The data on costs and materials that are reflected in income statements can be supported with other information. This idea is presented in the works several researchers, such as Angelakis, Theriou, and Floropoulos (87-96) and Gupta, Pevzner, and Seethamraju (889) in the form of notes on the quality and adaptation of the absorption and variable costing methods. Still, researchers do not concentrate on this problem, and they do not discuss the possible variants to overcome the difficulties in using these statements and reports.
The analysis of the literature demonstrates that income statements based on the absorption and variable costing methods can be used by managers, accountants, auditors, and shareholders for different purposes. However, Yalcin noted that the current versions of these statements can be improved in order to provide users with an opportunity to receive the accurate interpretation of the data (95). Furthermore, it is important to pay attention to the fact that the existing literature does not provide a discussion of the changes that can be used in practice in order to contribute to the auditing procedures and shareholders’ analysis without influencing the auditing standards (Hasan 34). In spite of the fact that the use of absorption and variable methods for organizing the financial statements in order to measure the company’s performance is discussed in the literature in detail, Ruiz-de-Arbulo-Lopez, Fortuny-Santos ,and Cuatrecasas-Arbos observed that there are still gaps in determining what factors can improve the use of these methods for accounting and auditing (650). Therefore, additional research is required in this field.
Advantages and disadvantages of absorption and variable costing methods
The absorption costing method is defined as a system of costing in the preparation of income statements of firms that takes into consideration all production costs while assessing the product costs irrespective of whether or not such costs are fixed or variable (Agbejule and Huusko 354; Fisher and Krumwiede 21). Any fixed and variable overheads, as well as direct labor and materials, are factored in the unit cost of any given product. The variable costing method, on the other hand, factors in the variation of production costs and output. As such, this approach ignores the contribution of fixed manufacturing cost to the product costs and, instead, considers any fixed manufacturing costs as period cost.
According to Agbejule and Huusko, the variable approach of income statement preparation offers a clearer picture of any company financial performance due to the fact that it takes into consideration any associated incremental costs (354). As such, this approach provides information on the actual cost of production. Proponents of this method argue that any organization incurs manufacturing overhead costs irrespective of the level of production and, thus, such costs should not influence product-related decisions. Nevertheless, the exemption of fixed manufacturing costs leads to an understatement of the overall cost of a given product due to associated residual effect that has potential of driving up the production cost.
In the case of absorption costing, fixed manufacturing costs are included in the total cost of production and, hence, the approach gives a clearer picture of the cost of production in any given firm. This method is much preferred by investors because it takes care of all possible costs. With respect to economic standpoint, the absorption costing method gives organization an accurate representation of the importance of any given product.
For external use, it is advisable to use the absorption costing method as opposed to the variable costing approach. There are a number of reasons why the variable costing should not be used for external reporting. Laux observed that the external financial reporting standards requires the inclusion of all inventory costs and other related costs, which takes into consideration proportionate percentage of overhead in relation to manufacturing the inventory (241). However, the variable costing method ignores manufacturing overhead costs and, hence, does not meet the accounting requirements for external financial reporting.
In spite of the differences in the structure of income statement preparation, Agbejule and Huusko noted that both the absorption and variable costing methods can be used to manipulate the accounting information of any organization and subsequently its performance (354). Therefore, it is important to note of factors that can be included in the preparation of income statements, such that this challenge is eliminated. For example, adoption of a Just in Time (JIT) inventory system ensures the elimination of all inventory costs. However, there are other factors that affect the performance of any company that are often omitted in the preparation of income statement. Such factors include competitors’ actions, subsidies, government regulation, tariffs, human capital, price of raw materials, union activity, technological development, and inventory and other market demand factors.
Methodology and data collection
Overview
Denzin and Yvonna defined study design as the process of highlighting actions applicable in the process of collecting as well as well as analyzing the collected data for the purpose of achieving highlighted objectives in a study (29). Various researchers can use different study designs, such as the descriptive type of design, explorative research design, experimental, as well as the cross-sectional study design. On the other hand, Dixon noted that research methodology comprises various processes and principles, which together enhance the collection of required data in any study (45). This section of the dissertation covers the research designs, the population targeted by the study, the methods used in collecting and analyzing data, as well as the sample frame.
Study Design
This study lays much emphasis on the current state of affairs as far as the assessment of the performance of organizations is concerned. As such, the study will seek to provide a solution to the problem of incorrect presentation of accounting information based on what has been achieved so far and the need in the sector. To achieve such objectives, the study focuses on using quantitative data in relation to the performance of organizations and the representation of accounting information. Such an approach will be complemented by the use of interviews that will target managers and auditors in a bid to find out what indicators need to be added to income statements for the purpose of improving the efficiency of both financial reporting and assessment of organizations’ performance. In addition, the interviews will seek to provide insights to the various approaches of representing income statements, such as the absorption and variable costing. Generally, to achieve the objectives of the study, the research ought to be comprehensive and, hence, two research designs–case study and descriptive–will be used.
Rationale for the use of descriptive design
The achievement of the research objectives is based on the availability of answers to the research questions highlighted in chapter one. Silverman pointed out that the use of descriptive research design in any study ensures that comprehensive answers are provided on any research questions adopted with respect to any given problem under investigation (13). As such, in the case of the current study, the descriptive research design will assist in providing answers in relation to how the problem of ineffective presentation on accounting information has affected the success of investments as well as provide insights on what needs to be done with respect to the gap in absorption and variable income statements. Denzin and Yvonna pointed out the descriptive research design is used in conjunction with quantitative study and is suitable in the provision of indexes to any variables used in a study (25).
Rationale for the use of case-study design
The case-study design is used in this study as a complement to the descriptive research design. While the descriptive research design is very effective in the collection of reliable data and the provision of background for answers to research questions, the method depends largely on observation and instrumentation of measurements. For this reason, the design will complement the descriptive study for the purpose of ensuring that reliable data is collected. In addition, a case study is needed in this study intended to examine how companies from different industries can address the problem of the gap in absorption and variable income statements. Therefore, the case-study approach will allow the collection of corporate data that is appropriate for the study, with the focus on the use of absorption and variable income statements and the associated auditing procedures. Moreover, the use of the case-study approach in this study enables the collection of data on the history of any identified frauds in companies for the purpose of supporting the conclusions regarding the effectiveness of the methods used. On the other hand, there is a need for a conclusion with respect to the indicators that can be added to the income statements, which can done effectively by assessing the specific company’s performance, possible drawbacks in reporting, and problems in applying absorption and variable income statements.
Research Strategy
Research can either be quantitative or qualitative. However, there are cases when both research approaches are used. Often, the mixed methods approach is more advantageous because problems encountered in one approach can be overcome through the significance of the other approach (Silverman 11). For this study, the mixed-methods approach will be used. The choice of the mixed-methods approach was informed by the fact that there is a need to carry out thorough analysis of any available data and information that can be used to ensure efficiency in the assessment of organizations’ performance and the presentation of income statements. As such, both qualitative and quantitative data should be collected for further analysis in order to study the problem, address the research aim, and provide specific and detailed answers to the research questions.
The qualitative methodology is used in order to examine how companies from different industries can address the problem of the gap in absorption and variable income statements. In order to collect the corporate data that are appropriate for the study, it is relevant to use the case study as the qualitative method. The focus was on the collection of corporate data that is related to the use of absorption and variable income statements and the associated auditing procedures. The data on the history of identified frauds in companies was also gathered during the data collection process for the purpose of supporting the conclusions regarding the effectiveness of the used methods. In order to come to a conclusion about the indicators that can be added to the income statements, it was also necessary to collect numerical data regarding the company’s performance, possible drawbacks in reporting, and problems in applying absorption and variable income statements. These specific data also included the expectations regarding the use of additional indicators that can be collected with the help of the questionnaire based on the Likert scale in order to determine what gaps and challenges should be addressed and what factors are preferred. The use of the Likert scale is appropriate for studies when it is necessary to transform the information that is qualitative in its nature into numerical data.
While using this quantitative methodology, the focus was on the analysis of the gap in approaches and possible indicators with reference to the numerical representations (scores) of these aspects’ effects on the shareholders’ understanding of the problem. Much attention was paid to the data analysis with the focus on the frequency distribution. It is important to note that the frequency distribution was helpful in the determination of indicators that are preferable from the managers and accountants’ viewpoints. The use of these methods provided an opportunity to determine the tendencies of using statements based on absorption and variable costing methods in companies and to identify the factors that are distinguished by accountants and auditors as relevant to be added to statements.
Target Population
Dixon defined target populations in a study as any units or people from which data is to be collected about a given research phenomenon (46). In the case of the current study, the focus is on the methods of income statement presentation and the performance of organizations. As such, the study targeted managers, auditors, and other individuals in the corporate world. The research targets both the private and public organizations for the purpose of collecting the necessary data to provide answers to the highlighted research questions. In addition, the study will carry out interviews on any stakeholders in the selected sample frame, which include investors, auditors, and organizations’ managers.
Sampling frame and technique
The sample frame adopted for this study was the public and private organizations in the USA. Such organizations make use of accounting information more often. As such, the public and private organizations are beneficiaries of accounting information and the use of income statements, especially when investors show any interests in making investment with them.
Given that there are so many public and private organizations, auditors, managers, and investors in the USA, the study adopted the simple random sampling technique to select the sample size for the study. Such a method was chosen due to eth fact that there was a need to give each study unit a chance to be factored in the sample. In addition, Dixon pointed out that researchers gain a lot of benefits from the use of the simple random sampling procedure in that it does not take into consideration the classification of errors and the technique bias free (46).
As such, the use of simple random sampling technique allowed the study to use 100 respondents comprising of managers, auditors, and investors. The choice of such a sample size was informed by the required data, as well as on the number of replication applicable to draw meaningful inferences.
Methods of data collection
Primarily, the study sought to establish the possibility of improving the assessment of organizational performance through the inclusion of financial indicators in income statements. Therefore, to establish the challenges that organizations, auditors, managers, and investors face in the process of assessing the performance of organizations, the study adopted research questions that were used as a guide to ensure that all necessary aspects of the study phenomenon were covered. Therefore, the study used both primary and secondary sources of data. Questionnaires were used to collect the primary data, while secondary data was obtained from websites, books, and journals. The collected data was recorded and synthesized for a chance to provide the necessary insights on the subject under study as well as provide answers to the research questions.
Analysis of results
Introduction
Primarily, this study examined the possibility of a significant gap between absorption and variable methods of organizing income statements, sought to establish what indicators can be added to income statements and auditing reports in order to address the gap, as well as how these indicators influence the auditing procedures and the shareholders’ understanding of the company’s performance. To achieve the objectives of the research, this study used the questionnaire method to collect primary data from 100 study participants who were randomly selected. The questionnaires were distributed and collected for analysis of the feedback. This section of the dissertation provides an analysis of the results from the study.
Description of sample
The study used a sample of 100 individuals who were randomly selected. However, the inclusion criteria required that the study participants should be managers, auditors, or investors.
Ages of respondents
Majority of the study participants were above 30 years and these accounted for 30% of the total number of study participants. The respondents who were aged between 41 and 50 years were 28 while those aged between 31 and 40 years were 26 and the remainder (16%) were aged between 18 and 30 years.
Profession of respondents
The study sample has 100 study participants; 25% of the total study participants were auditors, 40% managers, and the remainder (35%) were investors.
Results
The study examined the two methods of organizing income, absorption, and variable approaches in order to establish whether there is any significant gap between these two methods. The review of related literature showed that there is a lot of support from researchers and scholars on the use of both traditional and recent approaches to documenting firms’ income. In spite of the support, there are concerns that the use of these two approaches of presenting the income statement of firms can be challenging as far as analyzing the factors that can influence the changes in the company’s performance is concerned. Majority of the auditors surveyed (80%) reported that in most of cases, they used both approaches to assess the performance of any firm.
In addition, the study found out that the two methods have varied differences is the approaches they use to organize income statements. Most of the investors (90%) pointed out that the combination of both strategies gives them a clear picture of the total costs of production for easy assessment of the potential of a given product and, subsequently, the organization. However, in terms of preference, the majority of the study participants (95%) prefer the absorption income organization approach.
Based on a scale of 1 to 5, where 1 represented total agreement and 5 complete disagreement, most of the study participants (97%) believed that there exists a gap between absorption and variable methods of organizing income statements for any organization. All the study participants reported that the difference between these two methods of income representation is brought about by the difference in costs factored in the preparation of the income statements.
The study found out the difference in absorption and variable costing approaches can be solved by auditors in the course of assessing the performance of any given company over a particular trading period. In addition, the study found out that such difference can be eliminated through elimination of all types of inventory in relation to completing auditing procedures and analyzing any company’s performance.
Evidently, elimination of the differences in the two costing methods ensures accurate reflection of the profitability of a company. Therefore, investors and organization’s managers are more likely to benefit from such information as it helps them in decision making.
Based on the analysis of the difference in variable and absorption approaches, all the study participants pointed out that there was a need for additional financial factors to income statements and auditing reports in order to provide a clear picture of a company’s financial performance. The study found out that there are factors that are not represented in income statements that might have enormous effect in the past, current, and present performance of an organization. Some of the factors identified include effect of competitors’ actions, subsidies, government regulations, tariffs, human capital, price of raw materials, union activity, technological development, and inventory, as well as other market demand factors. Ensuring that these indicators are factored in the preparation of income statements could influence the auditing procedures and the shareholders’ understanding of the company’s performance as they form have a lot of effect on the financial position and prospects of any organization.
Discussion
Different organizations use different approaches to income statement preparation based on the intended use of the statement. Agbejule and Huusko noted that in most cases, variable costing approach is commonly used for internal reporting (354). However, accounting standards of financial reporting requires the use of the absorption costing method for external reports on the financial position and performance of any company. Such preference is attributed to the fact that the absorption costing method factors in manufacturing overhead costs in the calculation of the total product’s cost.
According to Laux, there is a common practice among organizations to use both methods to compare their performance at different stages of their development (239). In spite of this, Marshall, McManus, and Viele noted the use of both approaches creates the additional barrier not only for auditors, who are focused on identifying frauds, but also for shareholders, who need to receive the most credible information regarding the company’s performance and profitability (24). For example, variable costing does not show the residual effect on the overall cost of product associated with manufacturing overhead costs and, thus, investment decisions are based on the provided costs alone. According to Yalcin, such an approach can have a negative effect on the performance of any investment that does not factor in the effect of manufacturing overhead costs on any given product’s rate of turnover (96).
On the other hand, Angelakis, Theriou, and Floropoulos noted that while the absorption costing is preferred in the presentation of external financial reports for any organization, it has a number of disadvantages (87). The most common challenge in the use of the absorption costing method is that it can be used in accounting tricks for the purpose of increasing the net income through a move of the manufacturing overhead costs to the balance sheet. Such a move increases the volume of production disproportionately with respect to the volume of sales.
Manufacturers often need additional information in order to support their conclusions regarding the business’s performance. Black and Gray asserted that the disparities in statements that are organized according to two different methods can affect the overall quality of the performance evaluation (142). However, Fisher, and Krumwiede also agree that different accounting and cost systems have various advantages and disadvantages that should be taken into account while referring to the correctness or suitability of the proposed income statements (14). In most cases, organizations’ management and accountants decide what accounting practices to use for the purpose of reflecting and measuring the company’s performance. The variety of approaches to conducting the overhead analysis makes shareholders, accountants, and auditors think about the additional ways of improving the procedures. For example, there is a need to use accounting and its principles for making business decisions; and, in this context, the analysis of approaches to improving the income statements is regarded as a necessary option.
With regard to the results of the study, making investment decisions depends on any available financial information and reports of organizations’ accounting information. Therefore, in a case where the methods used in the preparation of such statements are not effective, the implication is that investment decisions could be founded on incorrect information, thereby affecting the sustainability of any investment based on such decisions (Black and Gray 133; Yalcin 95). The study found out there are increased cases of fraudulent manipulation of accounting information by managers and owners of organizations for self-interests. Such findings align with situations in some of the major accounting scandals ever witnessed so far, such as the U.S.’s WorldCom and Enron. For this reason, more indicator factors are required in income statements for effective presentation of any company’s financial potential.
Conclusion and recommendations
The study found out that one of the problems of effective assessment of financial performance of companies is associated with the fact that the standards regarding the presentation of income statements differ, and this aspect is directly related to disparities in the presentation of statements based on variable costing and absorption costing methods. In addition, a lot of emphasis during auditing procedures is on the establishment of the possibility of any fraud and errors as opposed to explaining the profitability or even the performance of any company under assessment.
Therefore, this study recommends review of auditing procedures to take note of the performance and profitability of organization by reviewing success factors. Such an approach would solve the challenges for completing auditing procedures and providing any form of assessment to shareholders. This is based on the fact that shareholders face numerous problems as far as the evaluation of the performance of organizations with reference to the provided statements is concerned.
Secondly, measures should be put in place to curb the practices of auditors of issuing unqualified reports. Such scenarios are dangerous to the lifespan of any investment because they influence wrongful interpretations and the use of ineffective measures in order to overcome problems related to the company’s performance. In addition, such a scenario can be eliminated; the continuous inclusion of factors or even any other indicators in financial statements for the purpose of accurately reflecting organizational performance. Therefore, the study recommends the inclusion of operating/non-operating presentation in income statements because this covers aspects such as non-recurring items, capital campaign activities, bequests, endowments, and other related aspects that might have residual impact on the performance of any given company.
In addition, there is a need to consider the input of other factors such as demand market factors, influence of government’s regulation and subsidies, union activity, advancement in technology, human capital, actions of competitors, as well as acts of nature. These factors are important in that they add a lot of weight to the accounting information that is commonly presented. For example, increase in tariffs might have increased cost of production for a given company during a certain trading period and, hence, reduced its operating income significantly. However, such a case is not likely to occur all the time. The implication is that most auditing procedures omit important information that can influence the performance of an organization in the future.
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Appendices
Table 1: Age of respondents.