Accounting for Business Students

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Copyright © 2017. P.Ed Australia. All rights reserved. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:28.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

AT R I L L’ S

ACCOUNTING FOR BUSINESS STUDENTS

Copyright © 2017. P.Ed Australia. All rights reserved.

ATRILL • McLANEY • HARVEY

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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A TTRR II LLLL’ S’ S A

ACCOUNTING ACCOUNTING FORBUSINESS BUSINESS FOR STUDENTS STUDENTS ATRILL • McLANEY • HARVEY

Copyright © 2017. P.Ed Australia. All rights reserved.

ATRILL • McLANEY • HARVEY

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 Pearson Australia 707 Collins Street Melbourne VIC 3008 www.pearson.com.au Authorised adaptation from the original UK editions, entitled Accounting and Finance for Non-Specialists 10/e (ISBN: 9781292135601) by Peter Atrill & Eddie McLaney © 2017 and Accounting and Finance: An Introduction 8/e (ISBN: 9781292088297) by Peter Atrill & Eddie McLaney © 2016, both published by Pearson Education Limited. Licensed for sale in Australia and New Zealand only. First adaptation edition published by Pearson Australia Group Pty Ltd, Copyright © 2018 by arrangement with Pearson Education Ltd, United Kingdom. The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact: Copyright Agency Limited, telephone: (02) 9394 7600, email: [email protected] All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Senior Portfolio Manager: Joanne Hobson Development Editor: Anna Carter Project Manager: Anubhuti Harsh Production Manager: Abhishek Agarwal, iEnergizer Aptara®, Ltd Product Manager: Sachin Dua Content Developer: Victoria Kerr Rights and Permissions Editor: Kim Morgan Copy Editor: Kathryn Lamberton Lead Editor: Dina Cloete Proofreader: iEnergizer Aptara®, Ltd Indexer: iEnergizer Aptara®, Ltd Cover and internal design by Squirt Creative Cover illustrations: coffee cup: © goner13/Envato Market; coffee beans: © Vasya Kobelev/Shutterstock.com; wave pattern: © Markovka/Shutterstock.com Typeset by iEnergizer Aptara®, Ltd Printed in Malaysia 1 2 3 4 5 22 21 20 19 18

Copyright © 2017. P.Ed Australia. All rights reserved.

National Library of Australia Cataloguing-in-Publication Data Creator: Title: ISBN: ISBN: Notes: Subjects:

Other Creators/ Contributors:

Atrill, Peter, author. Accounting for business students / Peter Atrill; Eddie McLaney; David Harvey. 9781488616570 (paperback) 9781488616594 (eBook) Includes index. Accounting--Textbooks. Financial statements. Accounting--Problems, exercises, etc. McLaney, E. J., author. Harvey, David

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them. Pearson Australia Group Pty Ltd ABN 40 004 245 943

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

BRIEF CONTENTS About the Australian author Preface

xiii

About the contributor

xvii

Acknowledgements

Copyright © 2017. P.Ed Australia. All rights reserved.

xii

xviii

For students: How do I use this book?

xx

Resources for students and educators

xxii

1

Introduction to accounting

2

Measuring and reporting financial position

46

3

Measuring and reporting financial performance

92

4

Recording transactions—the journal and ledger accounts

162

5

Accounting systems and internal control

227

6

Introduction to limited companies

280

7

Regulatory framework for companies

326

8

Measuring and reporting cash flows

376

9

Corporate social responsibility and sustainability accounting

430

10

Analysis and interpretation of financial statements

472

11

Cost–volume–profit analysis and relevant costing

534

12

Full costing

582

13

Planning and budgeting

634

14

Capital investment decisions

705

1

Glossary

759

Index

767

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

CONTENTS About the Australian author Preface About the contributor Acknowledgements For students: How do I use this book? Resources for students and educators

xii xiii xvii xviii xx xxii

Copyright © 2017. P.Ed Australia. All rights reserved.

CHAPTER 1 Introduction to accounting

1

Nature and role of accounting Accounting as a service function Costs and benefits of accounting information Accounting as an information system Users of accounting information Financial and management accounting What is the financial objective of a business? Stakeholder theory Balancing risk and return The main financial reports—an overview Financial accounting Management accounting Business and accounting What kinds of business ownership exist? How are businesses managed? Not-for-profit organisations The changing face of business and accounting Ethics and ethical behaviour in business How useful is accounting information? Why do I need to know anything about accounting and finance? The ALTC’s Academic Standards for Accounting Characteristics of successful business people

3 4 5 6 8

Summary Reference Discussion questions Case study Solutions to activities vi

9 11 13 14 15 15 18 20 20 25 26 28 30 33 34 35 37 38 39 39 41 42

CHAPTER 2 Measuring and reporting financial position Nature and purpose of the statement of financial position Assets Claims against the assets The accounting equation The effect of trading operations on the statement of financial position The classification of assets and claims The classification of assets The classification of liabilities The classification of owners’ equity Formats for statements of financial position Financial position at a point in time Factors influencing the form and content of the financial reports Conventional accounting practice Valuing assets Usefulness of the statement of financial position Statement of financial position deficiencies Summary Discussion questions Application exercises Case study Solutions to activities

46 47 47 48 50 52 55 55 56 57 58 61 62 63 67 72 74 77 78 79 87 88

CHAPTER 3 Measuring and reporting financial performance

92

The statement of financial performance— its nature and purpose, and its relationship with the statement of financial position The stock approach to calculating profit The format of the income statement Key terms Classifying expenses The reporting period

93 95 97 97 99 101

ACCOUNTING FOR BUSINESS STUDENTS

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

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Profit measurement and the recognition of revenues and expenses Recognition of revenues Recognition of expenses Profit, cash and accruals accounting—a review Profit measurement and the calculation of depreciation Calculating depreciation Selecting a depreciation method Impairment and depreciation Depreciation and the replacement of fixed assets Depreciation and judgement Profit measurement and the valuation of inventory What is inventory? What is the cost of inventory? What is the basis for transferring the inventory cost to cost of sales? The net realisable value of inventory Profit measurement and the problem of bad and doubtful debts The traditional approach The impairment of assets approach A first-principles approach Uses and usefulness of the income statement Summary Discussion questions Application exercises Case study Solutions to activities

102 102 106 110 111 112 118 119 119 119 120 120 120 121 125 127 127 129 131 137 143 144 145 156 157

CHAPTER 4 Recording transactions— the journal and ledger accounts The recording process—an overview Double-entry bookkeeping Ledger—detailed method of recording The trial balance Closing off the accounts Period-end adjustments

162 163 167 168 177 179 183

Prepayments and accruals Revenues due and prepaid Depreciation Bad and doubtful debts Inventory Manufacturing and trading accounts Adjusted trial balance and worksheet The chart of accounts

183 184 185 187 189 191 195 199

Summary Discussion questions Application exercises Case study Solutions to activities

204 204 205 214 215

CHAPTER 5 Accounting systems and internal control

227

What is internal control? Internal control in practice Internal control and e-commerce Why doesn’t internal control always work? Illustration of a functional area of a business and its internal control The ledger and subsidiary records Divisions of the ledger Subsidiary records—a traditional manual system The sales and purchases journals The cash book and cash journals The journal Control accounts and reconciliations Control accounts Reconciliation statements Computerised accounting systems Cloud computing

228 230 232 233

Summary Discussion questions Application exercises Case study Solutions to activities

265 265 266 275 275 CONTENTS

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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234 238 239 239 240 243 247 249 249 250 255 256

vii

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CHAPTER 6 Introduction to limited companies

280

The main features of companies Legal nature Unlimited (perpetual) life Limited liability Legal safeguards Public and proprietary (private) companies Transferring share ownership—the role of the stock exchange Separation of ownership and management Extensive regulation Advantages and disadvantages of the company entity structure Equity and borrowings in a company context Equity/capital (owners’ claim) of limited companies Reserves Bonus shares Raising share capital Borrowings Restrictions on the rights of shareholders to make drawings or reductions of capital The main financial statements The income statement The statement of financial position Dividends Accounting for groups of companies

281 281 281 282 282 283

Summary Discussion questions Application exercises Case study Solutions to activities

312 312 313 321 323

284 284 285 288 289 289 292 293 294 298 299 303 304 305 305 307

CHAPTER 7 Regulatory framework for companies The directors’ duty to account—the role of company law (Corporations Act) Auditors viii

326 327 328

The need for accounting rules The role of accounting standards in company accounting International accounting standards The conceptual framework The role of the Australian Securities Exchange (ASX) in company accounting Corporate governance Presentation of published financial statements Statement of financial position Statement of comprehensive income Statement of changes in equity Statement of cash flows Notes General points Segmental financial reports Segmental reporting rules Segmental disclosure Segmental reporting problems Creative accounting Creative accounting methods Checking for creative accounting Creative accounting and economic growth

331

Summary Discussion questions Application exercises Case study Solutions to activities

363 363 365 370 372

331 332 334 337 338 344 344 345 350 352 352 352 353 354 354 356 358 358 361 361

CHAPTER 8 Measuring and reporting cash flows

376

The importance of cash and cash flow Differences between the four external financial reports The statement of cash flows Preparation of the statement of cash flows—a simple example Deducing cash flows from operating activities Deducing cash flows from investing activities Deducing cash flows from financing activities

ACCOUNTING FOR BUSINESS STUDENTS

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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378 381 382 386 388 390 391

Reconciling profit for the year with cash from operating activities Some complexities in statement preparation The investing section The financing section What does the statement of cash flows tell us?

396 400 401 402 404

Summary Discussion questions Application exercises Case study Solutions to activities

408 408 409 424 425

CHAPTER 9

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Corporate social responsibility and sustainability accounting

430

Social issues in accounting General background Stakeholder concept What is social responsibility? Corporate social responsibility (CSR)— what does it mean? Accounting for corporate social responsibilities Triple bottom line reporting The Global Reporting Initiative (GRI) General background Background and development of the GRI Guidelines Current position—the GRI Standards Integrated reporting The balanced scorecard approach The financial perspective The business process perspective The customer perspective The learning and growth perspective Overall conclusion

431 431 431 433

Summary References Discussion questions Application exercises Case study Solutions to activities

462 462 463 464 467 470

436 440 442 444 444 444 446 455 457 457 458 458 458 461

CHAPTER 10 Analysis and interpretation of financial statements Financial ratios Financial ratio classification The need for comparison The key steps in financial ratio analysis The ratios calculated A brief overview Profitability ratios Return on ordinary shareholders’ funds (ROSF) (also known as return on equity (ROE)) Return on capital employed (ROCE) Operating profit margin Gross profit margin Efficiency ratios Average inventories turnover period Average settlement period for accounts receivable (debtors) Average settlement period for accounts payable (creditors) Sales revenue to capital employed Sales revenue per employee Alternative formats The relationship between profitability and efficiency Liquidity Current ratio Acid test ratio Cash flows from operations ratio Financial gearing (leverage) ratios Gearing ratio Interest cover ratio (times interest earned) An aside on personal debt Investment ratios Dividends per share ratio Dividend payout ratio Dividend yield ratio Earnings per share ratio Operating cash flow per share Price/earnings ratio CONTENTS

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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472 473 473 474 475 475 478 479 479 480 481 481 483 483 484 485 486 486 486 487 489 489 490 490 491 494 494 496 497 497 498 498 499 500 500 ix

Issues relating to financial analysis Financial ratios and the problem of overtrading Trend analysis Index or percentage analysis Ratios and prediction models Limitations of ratio analysis

502 502 503 506 507 511

Summary References Discussion questions Application exercises Case study Solutions to activities

516 517 517 518 529 529

CHAPTER 11

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Cost–volume–profit analysis and relevant costing

534

The behaviour of costs Fixed costs Variable costs Semi-fixed (semi-variable) costs Break-even analysis Contribution Profit–volume charts Margin of safety and operating gearing Weaknesses of break-even analysis Use of spreadsheets Expected costs rather than historic costs More complex cost and revenue behaviour patterns Relevant cost, outlay cost and opportunity cost Marginal analysis/relevant costing Accepting/rejecting special contracts The most efficient use of scarce resources Make or buy decisions Closing or continuing a section or department

535 535 536 537 540 543 545 546 548 551 554 555

Summary Discussion questions Application exercises Case study Solutions to activities

567 567 569 576 577

x

556 559 560 560 561 562

CHAPTER 12 Full costing

582

The nature of full costing Deriving full costs in a single or multi-product or service operation Single-product businesses Multi-product operations Segmenting the overheads Dealing with overheads on a departmental (cost centre) basis Batch costing The forward-looking nature of full costing Activity-based costing (ABC) Costing and pricing: the traditional way Costing and pricing: the new environment An alternative approach to full costing ABC contrasted with the traditional approach Attributing overheads Benefits of ABC Criticisms of ABC Uses of full (absorption) cost information Full cost (cost-plus) pricing Criticisms of full costing

583

Summary References Discussion questions Application exercises Case study Solutions to activities

618 619 619 620 628 629

584 584 585 594 594 601 602 603 603 603 604 605 606 607 610 611 612 613

CHAPTER 13 Planning and budgeting

634

Planning and control Corporate objectives, long-term plans and budgets—their relationship Exercising control The role of projected financial statements Likely information needed for forecast statements

ACCOUNTING FOR BUSINESS STUDENTS

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635 635 636 637 638

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Projected financial statements Alternative form of statement of cash flows for forecasting Evaluation of projected statements Sensitivity analysis Projections using spreadsheets Importance of forecasting Budgets and forecasts Time horizons of plans and budgets Limiting factors The interrelationship of various budgets The budget-setting process Incremental and zero-based budgeting The uses of budgets Non-financial measures in budgeting The extent to which budgets are prepared Preparing the cash budget Preparing other budgets Using budgets for control Comparing the actual performance with the budget Flexing the budget Variance analysis—more detail Standard quantities and costs Reasons for adverse variances Investigating variances Necessary conditions for effective budgetary control Limitations of the traditional approach to control General limitations concerning budgeting systems Behavioural aspects of budgetary control Beyond Budgeting Overall review Summary References Discussion questions Application exercises Case study Solutions to activities

640 642 643 645 645 646 649 649 650 650 651 652 653 655 655 656 659 662 662 663 665 668 668 669 671 672 672 672 674 677 678 679 679 681 694 695

CHAPTER 14 Capital investment decisions

705

Features of investment decisions and associated appraisal methods The nature of investment decisions Methods of investment appraisal Accounting rate of return (ARR) ARR and ROCE Problems with ARR Payback period (PP) Problems with PP Net present value (NPV) Interest lost Inflation Risk Actions of a logical investor Using discount (present value) tables The discount rate and the cost of capital Why NPV is superior to ARR and PP Discounted payback Internal rate of return (IRR) Problems with IRR—a comparison between NPV and IRR Some practical points The basis of the cash flow calculations More practical points Investment appraisal in practice Methods used Investment appraisal and planning systems Risk and uncertainty

706 706 707 709 709 710 712 713 714 715 715 715 716 718 719 720 720 721 725 728 728 732 734 734 735 738

Summary References Discussion questions Application exercises Case study Solutions to activities Appendix 14.1 Glossary Index

739 740 741 742 751 753 757 759 767

CONTENTS Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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ABOUT THE AUSTRALIAN AUTHOR Emeritus Professor David Harvey

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After qualifying as an accountant in the United Kingdom, David began lecturing in 1971 at Portsmouth Polytechnic (now Portsmouth University) with a subsequent move to Plymouth Polytechnic (now the University of Plymouth) in 1977. During his time in the United Kingdom he developed a keen interest in curriculum development and teaching methods and was involved with the writing of several books with an open learning style, many of these in collaboration with Peter Atrill and Eddie McLaney. During this time he also completed a Masters degree in Managerial Financial Controls and a PhD in the areas of investment and financing decisions. This research work covered both traditional investment appraisal and corporate strategy. In 1991 he moved to Australia to take up the position of Professor of Accounting and Head of the Centre for Accounting and Finance at the University of New England (Northern Rivers), which subsequently became Southern Cross University. In 1992 he became the Dean of the Faculty of Business and Computing, a position he held until 1996, before reverting to his Professorship. In 2000 he took up the position of the Dean of the Faculty of Commerce at the University of Southern Queensland. In 2001 the Faculty of Commerce was merged with the Faculty of Business and David became Dean of the enlarged Faculty of Business. David has had extensive experience in developing and teaching programs internationally. His most recent position was as Pro Vice-Chancellor (International Quality), a position he held from 2004 until his retirement in 2005.

xii

ACCOUNTING FOR BUSINESS STUDENTS

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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PREFACE This new textbook is primarily targeted at undergraduate and postgraduate students of business-oriented programs who want a fairly comprehensive introduction to accounting. The book aims to provide engaging and relevant content, something which we regard as critical to success for today’s learners. This first-edition textbook is the result of considerable review activity with user groups. The end product is a book which was designed for courses that require learners to be both preparers and users of financial statements. Courses of this nature require a balanced approach that is relevant to both students majoring in accounting and students of business generally. This book therefore aims to provide a comprehensive first course in accounting which will support students who wish to go on to an accounting major, and also those who plan to do other majors, or are studying general business. A critical part of this is use of a first-principles approach to accounting, from which we can then move on to the actual recording process. This avoids creating the misconception that accounting is a mechanical process; rather it enables us to focus more on the importance of critical thinking and decision making. The inclusion of two chapters on what is essentially record keeping aims to provide students with a deeper understanding of how financial information is collected and communicated, while also identifying its limitations. The emphasis of the book is clearly decision making. It uses a problem-solving approach and focuses on realworld business situations. A key objective throughout is to assist in the development of generic skills, including communication, teamwork, critical thinking, problembased learning, ethics, self-management, planning and organisation. The book provides a range of activities which should help in the development of these generic qualities.

Background This book has its origins in Accounting: An Introduction, which has been through six editions, and which has been regularly reviewed and improved. This book will in future be published as Accounting for Non-Specialists. However, after considerable market research, it was agreed that the sixth edition, while more clearly targeting the non-specialist

market, was not satisfying all market needs. As a result, Accounting for Business was developed. This book builds on the eighth edition of a second British book by Peter Atrill and Eddie McLaney, namely, Accounting and Finance: An Introduction, and uses a considerable part of it. Quite a lot of the coverage of Accounting for Business is common with the non-specialist book. However, it expands the content of most chapters, in order to provide a more comprehensive underpinning for all business students, and specifically for those who want to go on to an accounting major. Also, there has been a significant demand for content relating to the recording system, so two chapters have been added, covering journals and ledger accounts, and internal control and accounting systems in practice. In order to make room for the additional material, two chapters on finance, which are in the non-specialist book, have been omitted from the new textbook. The style of both books is very similar. It is worth noting that the two British books which underpin this book, namely Accounting and Finance for NonSpecialists and Accounting and Finance: An Introduction, are in their tenth and eighth editions respectively. These books reflect many years of development in the UK, and share content where appropriate. In Accounting for Business, we have tried to ensure that the content reflects Australian needs and conditions, while also adding some new features. We have been working together on our Australian nonspecialist book for many years and this is now in its seventh edition. Collaboration of this type has helped with the development of an international perspective on a range of issues which should provide benefit to students.

Features ▶ Interspersed throughout each chapter are numerous activities, with at least one for every learning objective. These are relatively short ‘quick-fire’ questions of a type a lecturer might pose to students during a lecture or tutorial, and are intended to serve two purposes: to give readers the opportunity to check that they have understood the preceding section, and to encourage them to think beyond the immediate topic and make linkages to topics either previously covered or covered in the next section. An answer to each activity is PREFACE

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provided at the end of the chapter, to which readers should refer only after they have attempted the activity. ▶ At the end of each section, which covers a specific learning objective, there are several concept check questions. These are short multiple-choice questions which aim to provide you with a quick check of your understanding of the learning objective/section. The answers are at the end of the chapter. ▶ Towards the end of each chapter, but also at an appropriate point in some chapters, there is a selfassessment question or questions. These are much more demanding and comprehensive than the activities, in terms of both the breadth and the depth of the material they cover. As with the activities, it is important to make a thorough attempt at each question before referring to the solution. Solutions to these questions are available online.

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▶ Discussion questions occur at the end of each chapter. These are relatively short, typically require a descriptive or analytical answer, and are intended to enable readers to assess their recollection and critical evaluation of the main principles in each chapter. They might be used as the basis for tutorial discussion. ▶ Application exercises are also positioned at the end of most chapters and these have been categorised as easy, intermediate or challenging. These are usually of a numerical type, and are designed to enable readers to further apply and consolidate their understanding of topics. A single case study can also be found at the end of each chapter. Some of these are simply more complicated problems, but in the main they are questions based on current issues. Their aim is to get students to think in a broader manner than usual, and to develop a wider approach to dealing with issues that are real and current. ▶ This new book continues to include what we have called ‘Real World’ examples (typically three or four per chapter), which aim to provide a link between theory and current practice. Following each Real World example is a set of classroom discussion xiv

points, which should facilitate discussion on issues that have occurred in business relatively recently. ▶ Each chapter has an ‘Accounting and You’ section, which aims to relate the content of the chapter to the individual student reader. All too often students feel that the content is big-business oriented and has nothing really to do with them. This section illustrates that what they are learning has real relevance to their everyday lives. Each of these also has a series of classroom discussion points for the class to ponder.

Coverage and structure Although the topics included are, to some extent, relatively conventional, the coverage and treatment of material is designed to meet the needs of business students. While the emphasis is primarily on underlying concepts, and the application and interpretation of information for decision making, this book also includes sections on data collection and recording, as well as the preparation of statements and reports. One major difference between this book and many others relates to its early structure. As business and accounting become more complicated it becomes more difficult to cover these issues in a reasonably straightforward way. So, in this book we introduce (in Chapters 2 and 3) two of the major accounting statements in the context of relatively simple business organisations, mainly sole proprietorships and partnerships or very simple companies. We use the balance-sheet approach to enable us to build up a balance sheet from a set of basic transactions, and then extend this approach by explaining the income statement as part of the equity section of the balance sheet. This is all done using a first-principles approach. The approach used in Chapters 2 and 3 enables us to cover the basic accounting statements without adding the complications of a complex corporate regulatory framework. Once the underlying principles and nature of the statement of financial position (the balance sheet) and the statement of financial performance (the income statement) have been understood, we can then complicate it by adding (Chapters 6 and 7) companies and their regulatory framework.

ACCOUNTING FOR BUSINESS STUDENTS

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In Chapters 4 and 5, we show how the two main statements are built up in practice, using a system of ledger accounts and books of original entry (or, as is more likely, by a computerised accounting system using the same basic principles). We have ordered the chapters and their component topics to reflect what we consider to be a logical sequence. For this reason, we advise readers to work through the text in the order presented, particularly since we have been careful to ensure that earlier chapters do not refer to concepts or terms that are not covered until a later chapter. Chapters 1–10 can be said to be broadly financialaccounting oriented, while Chapters 11–14 focus on what are clearly management accounting areas. Having said this, much of the financial accounting material effectively underpins the later chapters and students should not get too hung up on which area is which. For example, the financial accounting framework links very closely with the planning section in Chapter 13. Chapter 1 provides a general introduction to the scope, purpose and interrelationships of the text’s core coverage—financial accounting and management accounting—together with a brief overview of the main financial statements. It also examines user groups and their needs; introduces the main types of business organisation, together with the way in which a business is typically organised and managed and identifies ways in which business and accounting have been changing over time. This chapter includes more on stakeholder theory, ethics and ethical behaviour in business, and the Academic Standards Statement for Accounting, than does the non-specialist book. Chapter 2 explains the nature and purpose of the statement of financial position. This is done in the context of relatively simple organisations, so as to not unnecessarily complicate things. The method in which the statement is built up and its typical format are both covered, followed by the main factors that influence the content and values in the statement. Finally, the main uses and limitations of the statement are examined. Chapter 3 explains the nature and purpose of a statement of financial performance, usually referred to as an income statement. The way in which the statement is built up and the way in which it is typically presented

are covered comprehensively, for relatively simple organisations. Extra material, compared with the nonspecialist book, includes the unit-of-production method of depreciation and more on the perpetual inventory system. Chapter 4 provides the student with an introduction to double-entry book keeping, including the link with the first-principles approach, ledger accounts, use of trial balance, the closing-down process and a series of periodend adjustments. It also introduces the adjusted trial balance and worksheet, before concluding with a section on the nature and importance of the chart of accounts. Chapter 5 discusses internal control and the various ways in which accounting transactions are recorded in books of original entry, and then outlines the major elements of computerised accounting systems. Students should have a thorough grounding in the basic recording process as a result. Real-world examples in this chapter aim to prepare the student for a variety of ways in which the basic principles are applied in practice. Chapters 6 and 7 concentrate on limited companies. Chapter 6 focuses on the main features associated with limited companies. Many users will have dealings with groups of companies so the requirements of group accounts are outlined. Chapter 7 explains the importance of company law, accounting standards, the stock exchange and the importance of good corporate governance. Corporate governance remains an ongoing issue for many businesses. The chapter then identifies the main requirements relating to the published annual report. It contains far more information on accounting standards than does the non-specialist book. It also introduces sections on segment reporting and creative accounting. Chapter 8 focuses on the statement of cash flows and the importance of cash to any business. The chapter also completes the coverage of the main external reports prepared. Chapter 9 introduces the areas of corporate social responsibility together with social and environmental accounting and also explains the current state of development of sustainability reporting and integrated reporting. Further work on these areas is likely to be needed over the foreseeable future as the world faces

PREFACE Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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Chapter 13 includes a section on planning and forecasting using the basic financial statements. This includes use of spreadsheets and sensitivity analysis. This is seen as an additional feature of planning and budgeting over and above that used in the non-specialist book. The remainder of the chapter focuses on short-term planning and control and deals with various aspects of budgeting. The chapter includes a section on Beyond Budgeting. Chapter 14 deals with capital budgeting, the decision to invest in medium- and long-term assets, and considers how businesses appraise such projects. There is material on mutually exclusive projects and capital rationing, and more on practical aspects of identifying and dealing with cash flows, and the link with strategic planning. Peter Atrill Eddie McLaney David Harvey

Copyright © 2017. P.Ed Australia. All rights reserved.

continued issues including climate change, a range of other environmental issues, peak oil, world poverty, child-labour abuse, and human rights and responsibilities generally. Chapter 10 deals with the analysis and interpretation of the main financial statements. There is also more detail on ratios and prediction models than is included in the non-specialist book. Our formal coverage of management accounting begins in Chapter 11 with a discussion of the interrelationships between costs, volume and profit in decision making. Extra material, compared with the non-specialist book, includes more on semi-variable costs, and the use of spreadsheets to develop profit profiles and associated charts. Chapter 12 covers full costing and activity-based costing. Extra material, over and above that found in the non-specialist book, includes more on the apportionment process for overheads and cost-plus pricing.

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ACCOUNTING FOR BUSINESS STUDENTS

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ABOUT THE CONTRIBUTOR Maria Tyler: Chapter 5 contributor

Copyright © 2017. P.Ed Australia. All rights reserved.

Dr Maria Tyler is a certified practising accountant (CPA)  and an accounting and finance lecturer (currently with CQUniversity’s School of Business & Law). She has more than 13 years’ tertiary teaching experience at undergraduate and postgraduate levels, and is experienced in curriculum design, development and implementation. Dr Tyler gained her PhD in Accounting from CQUniversity in Mackay, Queensland, and also holds a Bachelor of Business/Bachelor of Information Systems, Bachelor of Business with First Class Honours, MBA, Graduate Certificate in Management, Graduate Diploma in Management, and a Diploma in Financial Services (Conveyancing).

ABOUT THE CONTRIBUTOR Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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ACKNOWLEDGEMENTS We are indebted to the accounting education community for the time and expertise invested as proposal reviewers, digital reviewers, manuscript reviewers and focus-group participants. Their invaluable insights have greatly improved the clarity, consistency and focus of this textbook. Dr Paul J. Blayney, University of Sydney Dr Peta Stevenson-Clarke, RMIT Dr Angela Tan-Kantor, Swinburne University of Technology Ms Dianne English, Griffith University Maria Tyler, CQ-University Mr Chris Williams, RMIT Amitav Saha, University of Notre Dame Australia Dr Terri Trireksani, Murdoch University Wes Hamilton-Jessop, University of Sydney Abdul Razeed, University of Sydney Olga Gouveros, University of Sydney Matt Dyki, University of Melbourne Nicholas McGuigan, Monash University Jodie Nelson, Griffith University Warwick Baines, Charles Stuart University Mark Vallely, University of Southern Queensland David Xiang, Edith Cowan University Youngdeok Lim, University of New South Wales Stephanie Perkiss, University of Wollongong Marcus Rodrigs, Newcastle University Julie Walker, University of Queensland Samantha Sin, Macquarie University Maurice Sheridan, RMIT

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Special thanks from the authors and publisher to Angela Tan-Kantor for carrying out the technical editing for this edition.

COPYRIGHT ASX material reproduced in this book is © ASX Corporate Governance Council Association of Superannuation Funds of Australia Ltd, ACN 002 786 290, Australian Council of Superannuation Investors, Australian Financial Markets Association Limited ACN 119 827 904, Australian Institute of Company Directors ACN 008 484 197, Australian Institute of Superannuation Trustees ACN 123 284 275, Australasian Investor Relations Association Limited ACN 095 554 153, Australian Shareholders’ Association Limited ACN 000 625 669, ASX Limited ABN 98 008 624 691 trading as Australian Securities Exchange, Business Council of Australia ACN 008 483 216, Chartered Accountants Australia and New Zealand, CPA Australia Ltd ACN 008 392 452, Financial Services Institute of Australasia ACN 066 027 389, Group of 100 Inc,

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The Institute of Actuaries of Australia ACN 000 423 656, ABN 50 084 642 571, The Institute of Internal Auditors – Australia ACN 001 797 557, Financial Services Council ACN 080 744 163, Governance Institute of Australia Ltd ACN 008 615 950, Law Council of Australia Limited ACN 005 260 622, National Institute of Accountants ACN 004 130 643, Property Council of Australia Limited ACN 008 474 422, Stockbrokers Association of Australia ACN 089 767 706. All rights reserved 2017.

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AASB material © Commonwealth of Australia (2017). All legislation herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing from the Commonwealth available from the Australian Accounting Standards Board. Requests in the first instance should be addressed to the National Director, Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.

ACKNOWLEDGEMENTS Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:48:54.

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FOR STUDENTS: HOW DO I USE THIS BOOK? 47

CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

◀ Learning objectives

CHAPTER 1

INTRODUCTION TO ACCOUNTING

These are listed at the beginning of each chapter and explain the key concepts that you should understand after studying the chapter. They are restated in the chapter, so you know where these objectives are covered. End-of-chapter questions are also keyed to the objectives.

LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain the nature and role of accounting LO2 List the main groups that use the accounting reports of a business entity, and summarise the different uses that can be made of accounting information LO3 Compare and contrast financial and management accounting LO4 Identify the main purpose of a business (while recognising a range of other influences), and explain the traditional risk–return relationship LO5 Provide an overview of the main financial reports prepared by a business LO6 Outline the main types of business ownership, describe the way in which a business is typically organised and managed, and explain the importance of accounting in a business context LO7 Identify ways in which business and accounting have been changing, together with some current issues confronting businesses and their associated reporting, including current thinking on ethics in business LO8 Explain why accounting information is generally considered to be useful, and why you need to know the basics of accounting

Key term definitions ▶ To help you understand key accounting terminology and concepts, definitions are presented in the margin. All these terms are also in the glossary at the end of the book for easy reference.

People need economic information to help them make decisions and judgements about businesses. Whether we are talking about a business manager making decisions about the most appropriate level of production, a bank manager responding to a request from the business for a bank loan or trade unionists deciding how much pay increase to seek for their members, accounting information should help them with their decision. In this opening chapter, we begin by considering the roles of accounting. As we shall see, accounting can be a valuable tool in the decision-making, planning and control process. We shall identify those people who are the main users of accounting and financial information, and discuss the ways in which this information can improve the quality of decisions that they make. In subsequent chapters, we develop this decision-making theme by considering in some detail the kinds of financial reports and methods used to aid decision-making.

435

terms, to its shareholders the choice of a more expensive production process that will yield lower pollution levels but also lower profits? If a competitor goes down the lower-cost, higher-pollution route, it will probably be able to sell at a lower price and threaten that competitor’s position. There are clearly some inherent conflicts in this area.

• Make shirking of responsibilities more costly, by regulation and law and public awareness. • Market the good citizen concept (e.g. the growth of ‘green’ consumerism), where consumers’ • •

• A probable future economic benefit. This simply means that the item is expected to have

•

•

some future monetary value, which can arise through its use in the business or through its hire or sale. Thus, an obsolete piece of equipment that can be sold for scrap would still be considered an asset, whereas an obsolete piece of equipment that could not be sold for scrap would not be regarded as an asset. The business has an exclusive right to control the benefit. Unless the business has exclusive rights over the resource, it cannot be regarded as an asset of the business. Thus, for a business offering holidays on barges or houseboats, a canal and river system is a very valuable resource. However, as the business cannot control others’ access to the system, it cannot be regarded as an asset of the business (but its barges and houseboats would count as assets). The benefit must arise from some past transaction or event. This means the transaction (or other event) giving rise to the business’s right to the benefit must have already occurred and will not arise at some future date. Thus, if a business agrees to purchase a piece of machinery at some future date, this does not make the item one of its assets at this point in time. The asset must be capable of reliable measurement in monetary terms. Unless the item can be measured in monetary terms with a reasonable degree of reliability, the item will not be included as an asset on the statement of financial position. For example, customer loyalty may be valuable to the business but impossible to quantify. Similarly, the title of a magazine (e.g. New Idea or Wheels) that was created by its publisher may be extremely valuable to that publishing business, but this value is usually difficult to quantify. It will not therefore be treated as an asset.

Note that all four of these conditions must apply. If one of them is missing, the item will not be treated as an asset for accounting purposes, and will not, therefore, appear on the statement of financial position. Figure 2.1 summarises the above discussion in the form of a decision chart. We can see that these conditions will strictly limit the kind of items that may be referred to as ‘assets’ in the statement of financial position. Certainly not all resources exploited by a business will be assets of the business for accounting purposes. Some, like the canal system or the magazine title Wheels, may well be assets in a broader sense, but not for accounting purposes. Once an asset has been acquired by a business, it will continue to be considered an asset until the benefits are exhausted or the business disposes of it in some way. Examples of items that often appear as assets in a business statement of financial position include: freehold premises; machinery and equipment; fixtures and fittings; patents and trademarks; accounts receivable; investments; cash; and inventories. Note that an asset does not have to be a physical item—it may also be a non-physical right to certain benefits. Assets that have a real physical substance are referred to as tangible assets (e.g. inventory, plant and equipment). Assets that have no physical substance but still represent potential benefits are referred to as intangible assets (e.g. copyright, trademark, patent, franchise, goodwill).

76

decisions are strongly influenced by the nature of the business, product or production method. Combine businesses into groups to develop ways of dealing with aspects of their business in a socially responsible way. Promote government action, which might include legislation, penalties for non-compliance or subsidies.

C D E

Business today cannot solely focus on wealth maximisation. Social and environmental issues should be given serious consideration by today’s businesses. Today’s business managers must consider a much broader range of issues than in the past. Businesses today unanimously accept sustainability as their primary goal. All of the above are true.

Accounting and You boxes ▶

Concept check 2 A B C D E

Some stakeholders have legitimate interests in all parts of a business. Some stakeholders have legitimate interests in only a certain part of a business. Environmentalists are seen as a relatively new stakeholder in business. Potential customers should be considered as stakeholders. All of the above.

Concept check 3 The stakeholder concept recognises a number of parties with a legitimate interest or stake in business. These stakeholder groups include: A B C D E

CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

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2 Can you think of ways in which this knowledge might be useful to you, assuming that you are operating as a manager in a business, not as an accountant? 3 If you were to develop your own business, you would be likely to do so partly for financial reasons, but also for reasons to do with factors such as flexibility, job satisfaction, etc. What kind of factors might you include in your own personal list of assets, or benefits, associated with running your own business, which would not normally be included in the business balance sheet, and how important are these likely to be to you? Would this list reduce the importance of the balance sheet?

Owners/shareholders and managers Employees and customers Government, lenders and suppliers Investment analysts All of the above.

As we have seen in earlier chapters, organisations that are more complicated than simple clubs have to produce statements that reflect movements in wealth and the net increase (profit) or decrease (loss) for the period concerned. The statement of cash flows is a fairly late addition to the annual published financial statements. At one time, companies were only required to publish an income statement and a statement of financial position. It seems the prevailing view was that all the financial information needed by users would be contained within these two statements. This view may have been based partly on the assumption that, if a business were profitable, it would also have plenty of cash. While in the long run this is likely to be true, it is not necessarily true in the short to medium term. In practice, unless a business’s cash flows are monitored in the short to medium term, there may not be a long term for that business. We saw in Chapter 3 that the income statement sets out the revenue and expenses for the period, rather than the cash inflows and outflows. This means that the profit (or loss), which represents the difference between the revenue and expenses for the period, may have little or no relation to the cash generated for the period. To illustrate this point, let us take the example of a business making a sale (generating revenue). This may well lead to an increase in wealth that will be reflected in the income statement. However, if the sale is made on credit, no cash changes hands—at least, not at the time of the sale. Instead, the increase in wealth is reflected in another asset: an increase in trade receivables. Furthermore, if an item of inventory is the subject of the sale, wealth is lost to the business through the reduction in inventories. This means that an expense is incurred in making the sale, which will also be shown in the income statement. Once again, however, no cash changes hands at the time of sale. For such reasons, the profit and the cash generated during a period rarely go hand in hand. Activity 8.1 helps to underline how particular transactions and events can affect profit and cash for a period differently.

ACTIVITY 8.1 The following is a list of business/accounting events. In each case, state the effect (i.e. increase, decrease or no effect) on both cash and profit. Event Repayment of a loan Making a sale on credit Buying a non-current asset for cash Depreciating a non-current asset Receiving cash from accounts receivable Buying some inventory for cash Making a share issue for cash

Effect On profit On cash .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... ..........

From what we have seen so far, it is clear that the income statement is not the place to look if we are to gain insights about cash movements over time. We need a separate financial statement. In 1991, a new accounting standard required entities to produce and publish, as well as the income statement and the balance sheet, a cash flow statement reflecting movements in cash. The reason for this was the growing belief that, despite their usefulness, the income statement and the balance sheet did not concentrate sufficiently on liquidity. It was believed that the ‘accrual-based’ nature of the income statement tended to obscure the question of how and where a company was generating the cash it needed to continue its operations. The standard has been updated several times and the title of the statement has subsequently been changed to ‘statement of cash flows’. Why is cash so important to businesses pursuing profit/wealth? The solution to Activity 8.1 illustrates the fact that cash and profit do not go hand in hand, so why the current preoccupation

xx

Class discussion points 1 Do you consider that knowledge as to how the accounting systems work is necessary for managers?

This feature appears in each chapter to help you see the relevance of accounting concepts to your everyday life. Following each of these are a series of class discussion points.

Which of the following statements is true?

intangible assets Assets which, while providing expected future benefits, have no physical substance (e.g. copyrights, patents).

ACCOUNTING AND YOU

Which of the following statements is false?

B

tangible assets Those assets that have a physical substance (e.g. plant and machinery, motor vehicles).

It is frequently useful for individuals to assess just what they have achieved and what they are ‘worth’. If you need to do this for purposes of obtaining a car loan, or a mortgage, you will probably find that your bank will only include assets and liabilities using the kind of approach adopted in this chapter. Yet you will probably be able to think of a number of things that you value (and others value) which your banker says are nice, but not relevant. What they mean is that they are not relevant to them. But they may well be extremely valuable to you. Your (or your parents’) investment in your education has undoubted value to you, and to prospective employers, but would not satisfy the accounting definition of an asset. Your superannuation balance is certainly of worth, but may well be so far ahead in terms of your ability to access it, that it is of no consequence in terms of current decision-making. Your collection of old model trains also has considerable worth, but obtaining a figure which can be accepted by everyone may well be difficult, if not impossible. You need to understand that the statement of financial position aims to provide a list of assets and liabilities which has a high degree of objectivity, such that almost anyone looking at a particular business or individual would come to the same conclusion, because all would be following the same rules. Our discussion about the value of brands, of soccer players and other ‘human’ assets was not intended to imply that these have no value, but that it is difficult to obtain agreement about their value. When making decisions about value, all users of accounting information have to make assumptions or judgements about the value of the assets controlled by a business. In your own life, you will need to make the same kind of judgements about worth. When looking at figures in a statement of financial position, you should be trying to ascertain the underlying values, in terms of individual assets and composite groups of assets or businesses. You also need to do this with your life. Accounting figures can be helpful, but they simply cannot make individual judgements in the way that you can and need to do.

Concept check 1 A

asset A resource held by a business which has certain characteristics.

ACCOUNTING FOR BUSINESS STUDENTS

Short multiple-choice questions which aim to provide you with a quick check of your understanding of the learning objective.

So how might business as a whole be encouraged to engage in more socially responsible behaviour? There are several possibilities:

Explain the nature and purpose of the statement of financial position (balance sheet) and its component parts

Assets An asset, for accounting purposes, is essentially a business resource that has certain characteristics. The main characteristics of an asset are:

◀ Concept check questions

ACTIVITY 9.4 Can you think of reasons why a business might still pursue activities that are less profitable but socially beneficial?

LO1

The purpose of the statement of financial position is to set out the financial position of a business at a particular point in time. It is also referred to as a ‘balance sheet’. Both terms have been used in recent years. The current recommendation is that the term ‘statement of financial position’ is to be used. This statement represents a summary of information provided in the accounts, and is effectively a listing of the balances in all of the detailed accounts—this is where the term ‘balance sheet’ comes from. The statement of financial position sets out the assets of the business on the one hand, and the claims against it on the other. Before looking at the statement in more detail, we need to be clear what these terms mean.

•

LO9 Identify the learning outcomes associated with the Australian Learning and Teaching Council’s Academic Standards Statement for Accounting: namely judgement; knowledge; application skills; communication and teamwork; and self-management; and examine how these compare with characteristics of successful business people.

CHAPTER 9 CORPORATE SOCIAL RESPONSIBILITY AND SUSTAINABILITY ACCOUNTING

NATURE AND PURPOSE OF THE STATEMENT OF FINANCIAL POSITION

379

◀ In-chapter activities These are designed to test your comprehension of the material you have just read, as well as to make links to topics already covered or still to be covered. Answers to the activities are provided at the end of each chapter.

Real World examples ▶ Integrated throughout the text, these illustrative examples highlight the practical application of accounting concepts and techniques by real businesses, including extracts from published financial reports, articles from the media, survey data and other interesting insights from business. These examples are followed by a series of class discussion points. Students may need to go back to the original examples and beyond, but the points are intended to provoke some critical thinking by the students.

CHAPTER 13 PLANNING AND BUDGETING

639

For appropriations, the implications of tax planning need to be recognised. Preference dividends should be easy. Ordinary dividends seldom reduce in practice, so any assumptions or estimates about these are likely to be seriously constrained. Real World 13.1 indicates just how BHP described the approximate impact of the principal factors that affected earnings before interest and tax (EBIT) over a period: this is not based on forecasts but on actual performance. The analysis used, however, is quite similar to the kind used to date in forecasting the income statement.

REAL WORLD 13.1 Analysis of principal factors impacting EBIT In its 2016 Annual Report BHP provided a table describing the impact of the principal factors that affected underlying EBITDA for 2016 (see page 73 of the report). What is interesting in the context of this chapter are the items included in the table, particularly the following, as they relate to the ideas discussed in the chapter to date: Changes in sales prices Price-linked costs Giving Net price impact Productivity volumes Growth volumes Giving Changes in volumes Operating cash costs Exploration and business development Giving Changes in controllable cash costs Exchange rates Inflation on costs Fuel and energy Non-cash

One-off items Giving Changes in other costs. Source: BHP Billiton Annual Report 2016, p 73. BHP Billiton.

Classroom discussion points 1 Access page 73 of the 2016 Annual Report: (a) Identify the most significant factors affecting underlying EBITDA for the financial year ending 30 June 2016. (b) Which are the more significant—changes in sales price or changes in price-linked costs? (c) Comment on the changes in volume. (d) Comment on the changes in controllable cash costs. (e) Discuss the changes in other costs. 2 How useful do you think an analysis of this type is? 3 What does an analysis of this type by a huge organisation teach you about the use of the financial accounting framework in assisting planning?

For the statement of financial position, assumptions and estimates include the following:

• Non-current assets—future acquisition and disposal of assets (including proceeds of disposal) and depreciation policies.

• Working capital—what kind of period of credit will be allowed to (and taken by) customers (accounts receivable), how quickly suppliers (accounts payable) will be paid, what levels of inventory will be targeted. The potential impact on profits and cash flow made by poor working capital management is considerable.

• Loans, raised or repaid. • Capital—new capital raised (infrequently) and the amount or proportion of profits that is retained.

Most of the assumptions and estimates identified to date relate to the statement of cash flows and include the following:

• profit • depreciation adjustments/asset disposals • acquisitions of non-current assets • levels of working capital

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550

◀ In-chapter self-assessment questions

ACCOUNTING FOR BUSINESS STUDENTS

Which of the following statements about profit–volume charts are true? A B

C

D

Profit–volume charts provide more information than break-even charts. The slope of the profit line is the same as the slope of the revenue line on the break-even chart. The slope of the profit line is the same as the slope of the total cost line on the break-even chart. None are true. All are false.

ACTIVITY 11.6 A company has existing monthly sales of $350,000 and a contribution margin of 0.15 (15%). A new product is introduced at a discounted price in an endeavour to boost custom. The new product is expected to generate sales of $18,000 per month at a negative contribution of $3,000, increase fixed costs by $7,000 per month, but boost sales of existing products by 12%. Compute the overall change (profit/loss) for the subsequent month.

SELF-ASSESSMENT QUESTION

CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

More demanding and comprehensive than the activities, these challenge you to put into practice your understanding of key concepts. The self-assessment question solutions are available online at www.pearson.com. au/9781488616570.

Concept check 9

CC1 CC2 CC3 CC4

1 launch an advertising campaign costing $50,000 2 reduce selling price to $19 3 reduce variable costs by $1.50 per unit by installing more efficient equipment, which will increase fixed costs by $40,000.

CC6 CC7 CC8 CC9 CC10

A You might have been tempted with B, but accounting reserves are never in cash

D C D E C

CC11 D CC12 E

SOLUTIONS TO ACTIVITIES

• the legal requirement for companies to prepare financial reports in conformity with statutory accounting standards • suppliers may require payment to be made in advance • creditors may require personal guarantees by the owners or management • lenders may take out a specific claim against tangible assets of the company (mortgage, bill of sale) • lending agreements may restrict the financial practices: —maximum level of debt to assets —minimum required return on assets —limitations on profit distributions —restrictions on asset sales —specification of accounting methods that can be used • the creditors rank before the shareholders in the distribution of assets in the event of a liquidation of the company.

ACTIVITY 6.2 Two ways are commonly used in practice:

These allow you to check your answers to the in-chapter activities.

The managers of the business are now considering what to do about this loss. They hope to make a profit of $30,000 in the next three months, and the following proposals have been made:

CC5

Business is a risky venture—in some cases very risky. People will usually be happier to invest money when they know the limit of their liability. If investors are given limited liability, new businesses are more likely to be formed and existing ones are likely to find it easier to raise more finance. This is good for the private-sector economy and may ultimately lead to the generation of greater wealth for society as a whole. Obviously not all suppliers of goods and services are protected, as we read regularly that they lose all or part of what is owed to them when companies are liquidated (e.g. Harris Scarfe, Ansett, HIH). However, certain factors, requirements or actions are in place to provide protection, including:

Solutions to activities and concept checks ▶

$ 300,000 180,000 120,000 150,000 30,000

Sales 15,000 units @ $20 Variable costs 15,000 units @ $12 Contribution Fixed costs Loss

E A C D

ACTIVITY 6.1

11.1

The following information concerns a business for the past three months:

323

Concept check answers

• The shareholders may insist on monitoring closely the actions of the directors and the way in which they use the resources of the company. • The shareholders may introduce incentive plans for directors that link their pay to the share performance of the company. In this way, the interests of the directors and shareholders will become more closely aligned.

ACTIVITY 6.3 The answers are as follows: Net assets Cash Shareholders’ equity Share capital (100,000 ordinary shares issued at $2—called to $1)

You have been asked to advise on: (a) the level of sales needed to make a profit of $30,000 assuming that none of the three proposals is adopted (b) the break-even point under this assumption (c) the level of sales needed, for each of these proposals, to generate the required profit (d) the impact each proposal will have on the break-even point.

Net assets Cash Shareholders’ equity Share capital (100,000 ordinary shares issued at $2—called to $1.50)

$100,000 $100,000

$150,000 $150,000

Assume that revenues and costs will remain the same in the next three months, other than those for the three proposals. M06_ATRI6570_01_SE_C06.indd 323

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

◀ Summary

77

SUMMARY OBJECTIVE

METHOD ACHIEVED

LO1: Explain the nature and purpose of the statement of financial position and its component parts

• Identified the purpose as being to set out the financial position of a business at a particular point of time • Explained that the statement included assets and claims, which consisted of external liabilities and owners’ equity • Identified and analysed the nature of assets • Identified and analysed the nature of liabilities • Identified and analysed the nature of owners’ equity • Used the accounting equation to illustrate the build-up of a statement of financial position, covering a range of transactions including trading transactions

LO2: Explain the accounting equation, and use it to build up a statement of financial position at the end of a period

• Explained the accounting equation • Illustrated by use of a practical example • Worked through an additional activity to enable us to prepare a statement of financial position after a series of transactions

LO3: Classify assets and claims

• Identified the most common classification of assets being based on the timing of receipts of benefits of ownership (e.g. current, noncurrent) • Identified the current/non-current classification as being appropriate for liabilities • Explained the difference between the various components of equity

LO4: Apply the different possible formats for the statement of financial position

• Differentiated between the entity approach and the proprietary approach • Identified the basic equation as: • proprietary: OE 5 A – L • entity: A 5 L 1 OE

LO6: Identify the main ways in which the statement of financial position can be useful for users of accounting information

Identified and analysed the following factors: • conventional accounting practice • business entity • historic cost • prudence • going concern • dual aspect • money measurement, including consideration of goodwill and brands and human resources • stable monetary unit • valuation of assets Identified the ways in which the statement of financial position can provide useful insights into: • how the business is financed and how funds are deployed • the liquidity (ability to meet short-term obligations) of the business • the value of the business • the relationship between assets and claims • the asset mix (productive or unproductive) of the business • business performance

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ACCOUNTING FOR BUSINESS STUDENTS

CHAPTER 8 CASE STUDY The management of Enviro Ltd is planning a fairly significant expansion policy for the forthcoming year (2018). You have been asked to look at the financial implications of its plans. You have asked for a clear identification of the underlying assumptions and estimates, and these are given below.

The total estimated market for 2017 is $600 million. Sales during 2017 are expected to be around $30 million. However, the business is looking to achieve an improved market share (currently 5%) in 2018 due to more aggressive marketing. A 25% increase in sales volume is expected. Given product price elasticity, prices will need to be maintained at the 2017 levels in order to achieve the planned volumes.

Economic environment The current rate of inflation is 4% and this rate is likely to continue through 2018. The business thinks that this reflects a reasonably close estimate of its specific cost inflation and is happy to proceed on this assumption. Tax is expected to be charged at 30%.

Dividend policy The dividends to be recommended for 2017 total $1 million. The business would like to increase this to $1.25 million to cover inflation and to share in the hoped for increase in profitability.

Financial structure of the company Share capital amounts to $10 million at the end of 2017, with reserves amounting to $2.5 million.

These help reinforce your understanding of chapter content. All questions are keyed to their corresponding learning objectives so you can pick and choose the areas you want to work on. The questions are divided into level of difficulty— easy, intermediate and challenging. They include: • discussion questions to help you assess your recall of the main principles covered in each chapter • application exercises to help you apply and consolidate your understanding of accounting in practice.

Care has been taken with regard to working capital management, and the business plans to maintain its working capital in the following proportions through both 2017 and 2018: Inventory Accounts receivable

Market position Cash Accounts payable

The company currently has non-current assets which had cost $12 million, with an associated aggregate depreciation which is expected to amount to $4 million at the end of 2017. Depreciation is 10% straight line. In order to support the expansion, new equipment will need to be purchased at a cost of $4 million. This is planned to occur at the start of 2018. Depreciation on this will also be at 10% straight line. Some existing assets will be sold for $60,000. These had originally cost $400,000 and had been depreciated to date by $300,000.

3

Comment on the feasibility of the plans, and suggest any courses of action that management might take.

4

Evaluate the use of the projected financial statements in terms of efficiency of planning and decisionmaking in the context of this particular business.

5

State what advantages there might be in using spreadsheets to prepare statements of this type.

6

Sensitivity analysis is an analysis in which variables in a decision are changed one at a time, with the view to identifying which variables are most important to the success of the decision, plan or project. In what ways might an analysis of this type improve your decision-making ability? What kind of variables might you examine critically?

M08_ATRI6570_01_SE_C08.indd 424

Trotman, K.T. 1979, ‘Social responsibility disclosures by Australian companies’, The Chartered Accountant in Australia, March, pp. 24–28. Trotman, K.T. & Bradley, G.W. 1981, ‘Associations between social responsibility disclosures and characteristics of companies’, Accounting, Organisations and Society, pp. 355–62.

DISCUSSION QUESTIONS EASY 9.1

LO1

Corporate social responsibility (CSR) reporting extends the traditional financial reporting into new areas. Describe three of these new areas.

9.2

LO2

What is meant by ‘corporate social responsibility’?

9.3

LO1–3

At a personal level, articulate your views on ethical governance. In the course of this, examine your views on the extent to which the search for wealth should be limited by moral values or social conscience.

9.4

LO3

Describe in detail the Australian Accounting Standards for corporate social responsibility (CSR) accounting.

9.5

LO4

List the three components of triple bottom line reporting. Which component is currently accommodated by financial accounting reporting standards? With what measure?

9.6

LO5

What does ‘GRI’ stand for? What’s one word to describe what it’s all about? Who is it meant to benefit?

9.7

LO6

List the four perspectives used with the balanced scorecard approach.

INTERMEDIATE 9.8

LO1/2

Can you think of any current issues relating to businesses or industries in your area where business interests, social needs and environmental consequences are in conflict? How might you attempt to balance these conflicts in both the short term and the long term?

9.9

LO2

Why might we expect a voluntary CSR policy to work?

9.10 LO2

Just how much responsibility should an organisation take for social and environmental issues?

9.11 LO1–3

Assume that you are the CEO of a company that is the major employer in a small town in rural New South Wales. What responsibility would you have for your employees? Would your company size affect your decision?

9.12 LO1–3

Is there any evidence that companies that are socially responsible, in terms of pollution and waste avoidance, benefit in terms of profits?

9.13 LO1–3

To what extent are social and environmental concerns consistent with a shareholder wealth maximisation objective?

9.14 LO1–3

How well equipped is the typical business person to understand the full range of issues covered by a full-scale sustainability report?

9.15 LO1

Why CSR? Don’t accountants have enough to do with their preparation of the traditional financial statements?

9.16 LO2

Discuss the potential for practical application of the Ceres Principles. Describe potential roadblocks to the use of these principles as a practical guide.

9.17 LO6

How is the balanced scorecard approach similar to the GRI?

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absorption costing A method of costing in which a ‘fair share’ of manufacturing/service provision overhead is included when calculating the cost of a particular product or service. accelerated depreciation An approach to the calculation of depreciation expense which results in depreciation expenses being higher in the early years of an asset’s life than in later years. accelerated rights issues Rights issues of this type are structured in two phases, with an initial (accelerated) issue to institutional investors (who will pay quickly), followed by a (non-accelerated) issue to the retail (non-institutional) component of the shareholders. accounting The process of identifying, measuring and communicating information to permit informed judgements and decisions by users of the information. accounting rate of return (ARR) The average accounting profit from an investment, expressed as a percentage of the average investment made. accounting standards Rules established by the professional or statutory accounting bodies, which should be followed by preparers of the annual accounts of companies. accruals accounting The system of accounting that adheres to the accruals convention. This system is followed in preparing the statement of financial position and the income statement. accruals convention A convention which asserts that profit is the excess of revenue over expenses for a period, not the excess of cash received over cash paid.

QUESTIONS Make the necessary computations to reflect the plans outlined above, clearly stating any assumptions.

KPMG Global Sustainability Services 2002, KPMG International Corporate Sustainability Reporting, KPMG, Amsterdam.

ABC system of inventories control A method of applying different levels of inventories control, based on the value of each category of inventories.

These give you real-world examples of accounting in practice and encourage you to think critically about accounting issues and controversies.

Capital expenditure/non-current assets

Explain why preparation of a set of projected financial statements might be useful.

International Integrated Reporting Council 2013, The International Framework, December.

A

◀ Case studies

Other current liabilities at the end of 2017 are estimated to be dividends and tax of $900,000. Variable costs in 2017 are expected to be 60% of sales. Fixed costs for 2017 are expected to be $9 million, including $1 million for depreciation. An extra amount of approximately $1 million will be spent on advertising in 2018 in order to capture the increased market share.

2

Holme, R. & Watts, P. 2000, Corporate Social Responsibility: Making Good Business Sense, World Business Council for Sustainable Development, UK, January.

GLOSSARY

10% of sales for the year One-sixth of sales for the year (i.e. a two-month credit period) 3% of sales for the year One-twel!h of sales for the year (i.e. a one-month credit period)d)

1

463

Guthrie, J. & Parker, L.D. 1990, ‘Corporate social disclosure practice: a comparative international analysis’, Advances in Public Interest Accounting, vol. 3, pp. 159–76.

End-of-chapter questions and problems ▶

• Illustrated the main format of the statement of financial position • Examined the following formats: • horizontal (T account) • vertical (narrative)

LO5: Identify the main factors that influence the content and values in a statement of financial position

CHAPTER 9 CORPORATE SOCIAL RESPONSIBILITY AND SUSTAINABILITY ACCOUNTING

Gray, R., Owen, D. & Adams, C. 1996, Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, Prentice Hall, London.

At the end of every chapter, the summary correlates learning objectives with the method used to achieve them. Use this as a great revision tool.

In this chapter we have achieved the following objectives in the way shown.

424

31/08/17 5:24 PM

accrued expenses Expenses which are outstanding at the end of the accounting period. acid test ratio A liquidity ratio that relates the liquid assets (usually defined as current assets less inventories and prepayments) to the current liabilities.

Glossary ▶ 31/08/17 5:57 PM

This quick reference guide at the end of the book helps jog your memory for all those important accounting terms and concepts.

activity-based costing (ABC) A technique for more accurately relating overheads to specific production or provision of a service. It is based on acceptance of the fact that overheads do not just occur: they are caused by activities, such as holding products in stores, which ‘drive’ the costs. adverse variance A difference between planned and actual performance, where the difference will cause the actual profit to be lower than the budgeted one. ageing schedule of accounts receivable A report dividing accounts receivable into categories, depending on the length of time outstanding. amortisation The writing-down of an asset—usually an intangible asset—as its benefit is used up; the equivalent of depreciation for a non-current asset. asset A resource held by a business which has certain characteristics. associate company A company which is partly owned by another company, such that the ownership does not give the

investor company control, but does give it the opportunity to exert considerable influence. Typically, the ownership is between 20% and 50%. audit A process in which a range of activities are checked to ensure that the activities have been completed in accordance with a set of rules or guidelines. audit trail A step-by-step record by which accounting data can be traced back to their source. auditors Professionals whose main duty is to make a report as to whether, in their opinion, the accounting statements of a company do what they are supposed to do; namely, to show a true and fair view, and comply with statutory and accounting standard requirements. Australian Accounting Standards Board (AASB) Australian body responsible for developing accounting standards for application to Australian entities. Australian Securities and Investments Commission (ASIC) The government body responsible for regulating companies, company borrowings, and investment advisers and dealers. average inventories turnover period ratio An efficiency ratio that measures the average period for which inventories are held by a business. average settlement period for accounts payable ratio An efficiency ratio that measures the average time taken for a business to pay its trade payables. average settlement period for accounts receivable ratio An efficiency ratio that measures the average time taken for trade receivables to pay the amounts owing.

B bad debts Amounts owed to the business that are considered to be irrecoverable. balance sheet A statement that shows the assets of a business and the claims on the business. Assets must always equal claims. Claims will relate to external liabilities and owner’s claims (known as equity). balanced scorecard Both a management system and a system for measuring and reporting performance, which includes information relating to financial aspects of the business, business processes, customers, and learning and growth, thus giving a more comprehensive (and strategic) view of the business. bank overdraft A flexible form of borrowing that allows an individual or business to have a negative current account balance. batch costing A technique for identifying full cost, where the production of many types of goods and services, particularly goods, involves producing a batch of identical or nearly identical units of output, but where each batch is distinctly different from other batches. board of directors The team of people chosen by the shareholders to manage a company on their behalf. bonds See loan stock/notes.

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RESOURCES FOR STUDENTS AND EDUCATORS Students Solutions to the self-assessment questions are available at www.pearson.com.au/ 9781488616570.

Educators A suite of resources is provided to assist with delivery of the content, as well as to support teaching and learning.

Solutions Manual The Solutions Manual provides educators with detailed, accuracy-verified solutions to in-chapter and end-of-chapter problems in the book.

Test Bank The Test Bank provides a wealth of accuracy-verified testing material. Updated for the new edition, each chapter offers a wide variety of question types, arranged by learning objective and tagged by AACSB standards. Questions can be integrated into Blackboard or Moodle Learning Management Systems.

Lecture Slides A comprehensive set of PowerPoint slides can be used by educators for class presentations or by students for lecture preview or review. They include key figures and tables, as well as a summary of key concepts and examples from the course content.

Digital Image PowerPoint Slides

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All the diagrams and tables from the course content are available for lecturer use.

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ACCOUNTING FOR BUSINESS STUDENTS

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CHAPTER 1

INTRODUCTION TO ACCOUNTING LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain the nature and role of accounting LO2 List the main groups that use the accounting reports of a business entity, and summarise the different uses that can be made of accounting information

LO3 Compare and contrast financial and management accounting LO4 Identify the main purpose of a business (while recognising a range of other influences), and explain the traditional risk–return relationship

LO5 Provide an overview of the main financial reports prepared by a business LO6 Outline the main types of business ownership, describe the way in which a business is typically organised and managed, and explain the importance of accounting in a business context

LO7 Identify ways in which business and accounting have been changing, together with some current issues confronting businesses and their associated reporting, including current thinking on ethics in business

LO8 Explain why accounting information is generally considered to be useful, and why you need to know the basics of accounting

LO9 Identify the learning outcomes associated with the Australian Learning and

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Teaching Council’s Academic Standards Statement for Accounting: namely judgement; knowledge; application skills; communication and teamwork; and self-management; and examine how these compare with characteristics of successful business people.

People need economic information to help them make decisions and judgements about businesses. Whether we are talking about a business manager making decisions about the most appropriate level of production, a bank manager responding to a request from the business for a bank loan or trade unionists deciding how much pay increase to seek for their members, accounting information should help them with their decision. In this opening chapter, we begin by considering the roles of accounting. As we shall see, accounting can be a valuable tool in the decision-making, planning and control process. We shall identify those people who are the main users of accounting and financial information, and discuss the ways in which this information can improve the quality of decisions that they make. In subsequent chapters, we develop this decision-making theme by considering in some detail the kinds of financial reports and methods used to aid decision-making.

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ACCOUNTING FOR BUSINESS STUDENTS

Since this book is mainly concerned with accounting and financial decision-making for private-sector businesses, we shall devote some time to examining the business environment. We shall, therefore, consider the key financial purpose of a private-sector business, the main forms of business enterprise and the ways in which a business may be structured, organised and managed. These are all important as they help to shape the kind of accounting and financial information that is produced. Finally, we shall consider how business is changing and identify key issues regarding stakeholder interests, ethics and sustainability. These issues have considerable implications for the public perception of business, for businesses themselves, and for accountants and their measurement and reporting systems. Some of these issues are difficult and not easily resolved, but they are issues that you need to be aware of.

ACCOUNTING AND YOU MAKING DECISIONS So how do you make decisions?

• • • •

What kind of decisions do you need to make? How important is economic information in your decision-making? How do you deal with numbers and quantitative information? Are you comfortable with these areas, or are there areas with which you are uncomfortable?

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Let us consider the kind of decisions that are commonly made at some stage of our lives.

• •

Keeping expenditure in line with income—something just about every student will wrestle with.

• •

Starting a new business venture, either on your own or in collaboration with others.

Buying new things—these might include buying simple things like a new mobile phone, or a new vehicle, whether an old banger or a new BMW, or a really major decision, such as buying a home. Investing for the future in shares or government bonds.

All of these decisions will require you to collect information, much of which can be classified as economic. Economic information is largely quantitative. The typical economic decision involves choosing the best outcome for you, given that your resources are scarce. None of what has been said to date should imply that decisions are made solely on economic lines. Many decisions are based on things such as personal preference, family considerations, a sense of duty or aesthetics, with a few people even using the stars to assist! However, many decisions have a clear economic orientation, and accounting can help with these decisions. So what information do you need to keep your expenditure in line with income? You will probably need a clear understanding of your income, its amount and nature. You will also need to have a clear understanding of your spending patterns, and you will almost certainly need to differentiate between ongoing regular expenditure and one-off expenditure. Decisions to buy new things may be relatively easy, such as buying a new phone, which may well be bought out of normal spending. Decisions about major assets, such as the purchase of a home, will require much more careful information gathering and analysis. This analysis will probably include ideas around how the asset will be funded. Decisions regarding potential business ventures also require substantial data collection and analysis. Your future lifestyle is likely to be substantially influenced by the success or failure of a venture of this type. The analysis will need to contain information about markets and competition, as well as specifics regarding the particular business.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

Decisions regarding the possible purchase of new shares or bonds will require the collection of relevant data. In the case of shares, this will probably mean detailed information about the past performance of the company and estimates of its future prospects. Clearly, any decision that has an economic element will require substantial economic information. Basically, the role of the accounting system is to provide much of that information. The system cannot and does not attempt to cover all economic input, but essentially focuses on the collection, recording and reporting of key economic data as they relate to a particular individual or entity. Just what information is covered is the subject of this book. You may not be comfortable with numbers and quantified information. However, it is difficult for an entity to be successful without having someone who does understand and can communicate such information. So good luck with your studies.

Class discussion points 1 If you were to consider starting a business, what information would you be seeking before commencing? 2 Who might you want to work with and in what capacity? 3 How important is teamwork and good communication in decision-making? Do you see any particular issues that might arise with the people identified above? 4 How comfortable are you likely to be in a team where expertise in a particular area is held by only one team member?

NATURE AND ROLE OF ACCOUNTING

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Accounting is concerned with the collection, analysis and communication of economic information. Such information can be used as a tool of decision-making, planning and control. This is to say that accounting information is useful to those who need to make decisions and plans about businesses, and for those who need to control those businesses. Examples of the kind of decisions for which the managers of businesses may need accounting information include the following:

• • • • •

decisions to develop or terminate new products or services decisions to change the price or quantity of existing products decisions to borrow money to help finance the business decisions relating to the scale of the business, and decisions to change the methods of purchasing, production or distribution.

You might spend a few moments reflecting on the implications of some of these. Some decisions have far-reaching consequences; for example, moves to take activities offshore have the potential to impact substantially on the business, its workforce, and the local and regional communities. Although managers working in a particular business are likely to be significant users of accounting information, they are by no means the only people who are likely to use accounting information about that particular business. People outside the business (whom we shall identify later) may need information to help make decisions such as whether to invest in the business—as owner or lender, whether to grant credit for goods provided or whether to enter into a major contract with the particular business. It is generally recognised that accounting fulfils two distinct roles: a ‘stewardship’ role and a ‘decision-usefulness’ role. Traditionally, accounting focused more on providing a stewardship, or accountability, report on the status of transactions for the period; that is, what was the position at the beginning of the period, what happened during the period and what the position was at the end of the period. More recently, accounting has been seen as a way of assisting a wide range of users to make informed choices about the allocation of scarce resources. Sometimes, the impression

LO1 Explain the nature and role of accounting

accounting The process of identifying, measuring and communicating information to permit informed judgements and decisions by users of the information.

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ACCOUNTING FOR BUSINESS STUDENTS

is given that the purpose of accounting is simply to prepare financial reports on a regular basis. While it is true that accountants do this kind of work, it does not represent an end in itself. The ultimate purpose of accountants’ work is to discharge the accountability function of management and to influence the decisions of those who use the information produced. This decision-making perspective of accounting is central to the theme of this book and shapes the way we deal with each chapter.

Accounting as a service function

fundamental qualities These are the two most important qualities which underline the preparation of accounting reports namely relevance and faithful representation.

Accounting can be seen as a form of service. Accountants provide financial information to their ‘clients’. These clients are the various users identified in the next main section of the chapter. The quality of the service provided will be determined by the extent to which it meets the information needs of the various user groups. To be useful to users, the information must possess certain qualities. In particular, it must be relevant and it must faithfully represent what it is supposed to represent. These two qualities, which are regarded as fundamental qualities, are covered in more detail below.

•

Relevance. Accounting information must be able to influence decisions—otherwise, there

•

Faithful representation. Accounting information should represent what it is supposed to

relevance A quality that states that, in order to be relevant, accounting information must be able to influence decisions. materiality The quality of information which has the potential to alter the decisions that users make.

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faithful representation A quality that says that accounting information should represent what it is supposed to represent—it should be complete, neutral and free from error.

really is no point in producing it. To do this, it must be relevant to the prediction of future events (such as estimating next year’s profit) or to the confirmation of past events (such as establishing last year’s profit), or to both. By confirming past events, users can check on the accuracy of their earlier predictions. This can, in turn, help them to improve the ways in which they make predictions in the future. To be relevant, accounting information must cross a threshold of materiality. A key question to be asked is whether its omission or misrepresentation would alter the decisions that users make. If the answer is no, the information is not material. This means that it should not be separately included within accounting reports, as it will merely clutter them up and, perhaps, interfere with the users’ ability to interpret them. All figures need to be included in the accounts: the question is whether a particular figure needs to be separately identified or whether it can be included elsewhere, under a more general heading. The threshold of materiality will vary from one business to the next. To identify the threshold, the nature of the information and the amounts involved must be considered within the context of the accounting reports of the particular business. represent. This means that it should be complete, by providing all of the information needed to understand what is being portrayed. It should also be neutral, which means that it should be presented and selected without bias. Finally, it should be free from error. This is not the same as saying that it must always be perfectly accurate; this is not really possible. Estimates may have to be made which eventually turn out to be inaccurate. It does mean, however, that there should be no errors in the way in which these estimates have been prepared and described. In practice, a piece of information may not perfectly represent these three aspects of faithful representation. It should try to do so, however, insofar as possible.

Note that accounting information must satisfy both fundamental qualities of relevance and reliability if it is to be useful. There is little point in producing information that is relevant, but which lacks faithful representation, or producing information that is irrelevant, but which is faithfully represented.

Further qualities Where accounting information is both relevant and faithfully represented, there are other qualities that, if present, can enhance its usefulness. These are comparability, verifiability, timeliness and understandability. Each of these qualities is now considered. comparability A quality which helps users identify similarities and differences between items of information.

•

Comparability. This quality helps users to identify similarities and differences between items of information. It may help them, for example, to identify changes in the business over time (such as the trend in sales revenue over the past five years). It may also help them to evaluate the performance of the business in relation to similar businesses. Comparability is enhanced

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

•

• •

by treating items that are basically the same in the same manner for accounting purposes. It is also enhanced by making clear the policies that have been adopted in measuring and presenting the information. Verifiability. This quality provides assurance to users that the accounting information provided faithfully represents what it is supposed to represent. Accounting information is verifiable where different, independent experts would be able to reach a consensus that it provides a faithful portrayal. Verifiable information tends to be supported by evidence. Timeliness. Accounting information should be produced in time for users to make their decisions. A lack of timeliness will undermine the usefulness of the information. Normally, the later accounting information is produced, the less useful it becomes. Understandability. Accounting information should be set out as clearly and concisely as possible. It should also be able to be understood by those at whom the information is aimed.

verifiability Something that can be checked and verified. timeliness Being available early enough to be of use to users. understandability Clearly set out to facilitate understanding.

ACTIVITY 1.1 Do you think that accounting reports should be understandable by those who have not studied accounting?

Despite the answer to Activity 1.1, the onus is clearly on accountants to provide information in a way that makes it as understandable as possible for non-accountants. It is worth emphasising that the four further qualities just discussed cannot make accounting information useful. They can only enhance the usefulness of information that is already relevant and faithfully represented. It is also worth noting that the qualitative characteristics may conflict.

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Costs and benefits of accounting information In addition to the characteristics described above, there is also a seventh key characteristic which is at least as important as any of these six. In theory, a particular piece of accounting information should be produced only if the cost of providing it is less than the benefits, or value, to be derived from its use. This cost–benefit issue will limit the amount of accounting information provided. In practice, however, these costs and benefits are difficult to assess. To illustrate the practical problems of establishing the value of information, let us assume that someone has collided with our car in a carpark, dented one of the doors and scraped the paintwork. We want to have the dent taken out and the door resprayed at a local service station. We know that the nearest service station would charge $700, but we believe that other local service stations may offer to do the job for a lower price. The only way of finding out the prices at other service stations is to visit them, so that they can see the extent of the damage. Visiting the service stations will involve using some fuel and will take up some of our time. Is it worth the cost of finding out the price for the job at the various local service stations? The answer, as we have seen, is that, if the cost of discovering the price is less than the potential benefit, it is worth having that information. To identify the various prices for the job, there are several points to be considered, including:

• • • •

5

How many service stations shall we visit? What is the cost of fuel to visit each service station? How long will it take to make all the visits? At what price do we value our time?

The economic benefit of having the information on the price of the job is probably even harder to assess. The following points need to be considered:

• What is the cheapest price that we might be quoted for the job? • How likely is it that we shall be quoted a price cheaper than $700? As we can imagine, the answers to these questions may be far from clear—remember that we have only contacted the local service station so far. When assessing the value of accounting information we are confronted with similar problems.

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Producing accounting information can be very costly. The costs, however, are often difficult to quantify. Direct out-of-pocket costs, such as salaries of accounting staff, are not usually a problem, but these are only part of the total costs involved. There are other costs, such as the cost of user’s time spent on analysing and interpreting the information provided. There are no easy answers to the problem of weighing costs and benefits. Although it is possible to apply some ‘science’ to the problem, a lot of subjective judgement is normally involved. The qualities, or characteristics, influencing the usefulness of accounting information, which have been discussed above, are summarised in Figure 1.1.

COST CONSTRAINT

Qualities

Fundamental

Enhancing

Faithful representation

Relevance

Predictive value

Confirmatory value

Completeness

Neutrality

Freedom from error

Materiality threshold Comparability

Timeliness

Verifiability

Understandability

FIGURE 1.1 The characteristics that influence the usefulness of accounting information

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Two fundamental qualities determine the usefulness of accounting information. In addition, four qualities enhance the usefulness of accounting information. The benefits of providing the information, however, should outweigh the costs.

Accounting as an information system Accounting can be seen as an important part of the total information system for a business. Users, both inside and outside the business, have to decide how to allocate scarce economic resources. To try to ensure that these allocation decisions are efficient and effective, users require economic and other information. It is the role of the accounting system to provide much of that information. Thus, we can view accounting as an information-gathering, processing and communication system. The accounting system will involve the following four stages shown in Figure 1.2: 1 identifying and capturing relevant economic information 2 recording the information collected in a systematic manner 3 analysing and interpreting the information collected 4 reporting the information in a manner that suits the needs of users.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

Information identification

Information recording

Information analysis

Information reporting

FIGURE 1.2 The accounting information system The figure shows the four sequential stages of an accounting information system. The first two stages are concerned with preparation, and the last two stages are concerned with using the information collected.

Given the decision-making emphasis of this text, we shall primarily concentrate on the final two elements of the process—the analysis and reporting of financial information. We are concerned with how information is used by, and is useful to, decision-makers rather than with how it is collected and recorded. However, in Chapters 4 and 5 we will provide a brief overview of data collection and recording for those who are interested or need a foundation for more detailed work on these two aspects of accounting.

Concept check 1 The purpose of accounting is to: A B C D E

Provide information to assist users’ decision-making Report on the status of transactions for the period Prepare financial reports on a regular basis Provide financial information to clients None of the above are true.

Concept check 2 The two most important qualities for accounting information are:

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A B C D E

Relevance and materiality Relevance and accuracy Faithful representation and relevance Completeness and relevance Freedom from error and relevance.

Concept check 3 The usefulness of accounting information is increased by: A B C D E

Not being overly complex Being provided on schedule (e.g. not late) Being supported by reasonable evidence All of the above None of the above.

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ACCOUNTING FOR BUSINESS STUDENTS

USERS OF ACCOUNTING INFORMATION LO2 List the main groups that use the accounting reports of a business entity, and summarise the different uses that can be made of accounting information

Accounting seeks to satisfy the needs of a wide range of users. In a particular business, there may be various groups who are likely to have an interest in its financial health. (Although the points made in this chapter and throughout this book may apply to a variety of organisations—such as public-sector business enterprises, local authorities and charities—we concentrate on private-sector businesses.) The major user groups for a business organisation are shown in Figure 1.3.

Owners

Customers

Competitors

Employees and their representatives

Managers

Business organisation Lenders

Suppliers

Government

Investment analysts

Community representatives

FIGURE 1.3 Main users of financial information relating to a business organisation The figure shows that several user groups have an interest in the financial information relating to a business organisation. Most of them are outside the business but, nevertheless, have a stake in it. This is not meant to be an exhaustive list of potential users, but the user groups identified here are normally the most important.

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ACTIVITY 1.2 Ptarmigon Insurance Ltd (PI) is a large motor insurance business. Taking the user groups identified in Figure 1.3, suggest, for each group, the sorts of decisions likely to be made about PI and the factors to be taken into account when making these decisions.

stakeholder theory A theory which argues that organisations have a variety of interested parties and that these interests need to be considered and incorporated in a harmonised manner, in order to achieve the best overall outcomes.

Activity 1.2 illustrates that each user group looks at the business from a different perspective and has its own particular interest. Inevitably there will be occasions when these perspectives and interests may clash. One of the more likely causes relates to the way in which the wealth of the business is generated and distributed. Recent years have seen considerable debate as to the salary level of management teams, especially that of the chief executive officer (CEO). High bonus payments in a year in which performance has not been judged to be good do not sit well with investors. Another area of potential conflict is likely to be between investors and lenders, with lenders wishing to be sure that the money lent has been invested appropriately and with due regard to their interests, while borrowers are likely to want to be able to have maximum flexibility. Stakeholder theory uses a similar approach to that set out above, but additionally provides some useful insights into just what makes a successful business, and illustrates how the various

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

user groups can interact. User groups can clearly be thought of as stakeholders in a business. Stakeholder theory was effectively introduced by R. Edward Freeman in 1984 in his book, Strategic Management: A Stakeholder Approach. Freeman’s main point was that, at that time, business pretty much saw managerial self-interest and shareholder profit as the driving force of business. Freeman argued that this wasn’t the view of the people who actually did business. They had other motivations and responded to other people—employees, customers, suppliers, regulators, industry bodies, trade unions, community groups—which Freeman called stakeholders. We shall come back to stakeholder theory later in the chapter.

Concept check 4 Accounting seeks to satisfy the needs of which of the following users? A B C D E

Shareholders Prospective shareholders Government (e.g. ATO) Stakeholders Creditors.

Concept check 5 Stakeholder theory: A B C D E

Recognises that organisations have a variety of interested users Attempts to meet the needs of the primary users Was introduced by R.E. Freeman in 1986 All of the above None of the above.

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FINANCIAL AND MANAGEMENT ACCOUNTING In providing information for the various user groups identified, accounting has divided into two main areas: management accounting and financial accounting. Management accounting, as the name suggests, is concerned with providing managers with the information they require for the day-to-day running of the organisation. Financial accounting is concerned with providing the other users with useful information. The main differences between the two types of accounting reflect the range of recipients, as follows:

• Nature of the reports produced. Financial accounting tends to produce general-purpose

•

•

financial reports; that is, they contain financial information that will be useful for a broad range of users and decisions. Management accounting reports, on the other hand, are often specific-purpose reports, designed with a particular decision or manager in mind. Level of detail. Financial accounting reports provide users with a broad overview of the position, performance and cash flows of the business for a period. As a result, information is aggregated and detail is often lost. Management accounting reports, however, often provide managers with considerable detail to help them with a particular decision. Restrictions. Financial reporting for many businesses is subject to legal and accounting regulations that seek to ensure that specified content is presented in a fairly standard form.

LO3 Compare and contrast financial and management accounting

management accounting An approach which aims to provide managers with the information they require to run the organisation. financial accounting Financial accounting provides general-purpose financial information for a variety of users, with the information being of a general-purpose nature.

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•

•

•

Because management accounting reports are for internal use only, there are no restrictions on the form and content of the reports. Reporting interval. For most businesses, financial accounting reports are produced on an annual basis. However, large companies may produce half-yearly reports and a few produce quarterly reports. Management accounting reports may be produced as frequently as required by managers. In many businesses, managers are provided with certain weekly or monthly reports to allow them to check progress on a regular basis. In addition, special-purpose reports will be prepared when required (e.g. to evaluate a proposal for a piece of equipment). Time horizon. Financial accounting reports reflect the performance and position of the business to date. In essence, they are backward-looking. Management accounting reports, on the other hand, often provide information on expected future performances as well as past performance. It is an oversimplification, however, to suggest that financial accounting reports never incorporate expectations concerning the future. Occasionally, businesses will release forecast information to other users in order to raise capital or to fight off unwanted takeover bids. Even preparation of the routine financial reports typically requires making some judgements about the future, as we shall see in Chapter 3. Range of information. Financial accounting reports concentrate on information that can be quantified in monetary terms. Management accounting produces such reports, too, but is also more likely to produce additional reports on non-financial matters, such as measures of physical quantities of inventory (stocks) and output. Financial accounting places greater emphasis on objective, verifiable evidence when preparing reports. Management accounting reports intended for managers may use information that is less objective and verifiable, but which nevertheless provides managers with the information they need. So the basic accounting statements will be used historically by the financial accountant, where the emphasis is on information which is as reliable and as objective as possible, whereas the management accountant may well use the same format to assist in some decisions, but will inevitably also use estimates which are clearly less reliable. This does not detract from the usefulness of the forecasts.

We can see from the above list that management accounting is less constrained than financial accounting. It may draw from a variety of sources and use information that has varying degrees of reliability. The only real test of the value of the information produced for managers is whether or not it improves the quality of decisions made.

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Can you think of any areas of overlap between the information needs of managers and those of other users? (Think about the time orientation and the level of detail of accounting information.)

The distinction between the two areas reflects, to some extent, the differences in access to financial information. Managers have much more control over the form and content of the information they receive. Other users have to rely on what managers are prepared to provide or what the financial reporting regulations state must be provided. Although the scope of financial accounting reports has increased over time, fears over loss of competitive advantage and fears of user ignorance about the reliability of forecast data have led businesses to resist making information available to users other than managers. There is little doubt that in the past financial accounting has been the dominant partner, and many of the ground rules reflect this. However, modern accounting systems typically are developed in a manner that enables both the specific external reporting requirements to be fulfilled and relevant management accounting reports to be prepared. Financial accounting and management accounting should not be seen as two different topics, but rather different perspectives reflecting the justifiable needs of users.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

Concept check 6 Which of the following is true? A B C

D E

Financial accounting provides greater detail than management accounting. Management accounting is subject to the same standards as financial accounting. The financial accountant can plan their annual two-week vacation more reliably than the management accountant. Financial accounting is forward-looking. None of the above.

Concept check 7 Which of the following is false? A B C

D E

Management accounting provides more scope for creativity than financial accounting. There are more rules to follow in financial accounting than in management accounting. Management accounting reports tend to provide a wider range of information than that provided by financial accounting. All of the above are false. None of the above are false.

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WHAT IS THE FINANCIAL OBJECTIVE OF A BUSINESS? A business is normally created to enhance the wealth of its owners. Throughout this book we shall assume that this is its main objective. This may come as a surprise, as there are other objectives that a business may pursue that are related to the needs of others associated with the business. For example, a business may seek to provide good working conditions for its employees, or it may seek to conserve the environment for the local community. While a business may pursue these objectives, it is normally set up with a view to increasing the wealth of its owners. In practice, the behaviour of businesses over time appears to be consistent with this objective. Within a market economy there are strong competitive forces at work that ensure that failure to enhance owners’ wealth will not be tolerated for long. Competition for the funds provided by the owners and competition for managers’ jobs will normally mean that the owners’ interests will prevail. If the managers do not provide the expected increase in ownership wealth, the owners have the power to replace the existing management team with a new team that is more responsive to owners’ needs. Does this mean that the needs of other groups associated with the business (employees, customers, suppliers, the community and so on) are not really important? The answer to this question is certainly no, if the business wishes to survive and prosper over the longer term. Satisfying the needs of other groups is usually consistent with increasing the wealth of the owners over the longer term. A business with disaffected customers, for example, may find that they turn to another supplier, resulting in a loss of shareholder wealth. A dissatisfied workforce may result in low productivity, strikes and so forth, which will in turn have an adverse effect on owners’ wealth. Similarly, a business that upsets the local community by unacceptable behaviour, such as polluting the environment or ignoring human rights issues, may attract bad publicity, resulting in a loss of customers and heavy fines. While the idea of an objective of wealth enhancement is still reasonable, there is now considerably more awareness of the damage that can be done to individuals, to the environment and to society at large, by unconstrained wealth maximisation. Real World 1.1, written when the global financial crisis was in the forefront of most people’s minds, provides clear recognition of the potential problems that can arise.

LO4 Identify the main purpose of a business (while recognising a range of other influences), and explain the traditional risk– return relationship

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We should be clear that generating wealth for the owners is not the same as seeking to maximise the current year’s profit. Wealth creation is concerned with the longer term. It relates not only to this year’s profit but to that of future years as well. In the short term, corners can be cut and risks taken that improve current profit at the expense of future profit.

REAL WORLD 1.1

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Short-term gains, long-term problems For many years, under the guise of defending capitalism, we have been allowing ourselves to degrade it. We have been poisoning the well from which we have drawn wealth. We have misunderstood the importance of values to capitalism. We have surrendered to the idea that success is pursued by making as much money as the law allowed without regard to how it was made. Thirty years ago, retailers would be quite content to source the shoes they wanted to sell as cheaply as possible. The working conditions of those who produced them was not their concern. Then headlines and protests developed. Society started to hold them responsible for previously invisible working conditions. Companies like Nike went through a transformation. They realised they were polluting their brand. Global sourcing became visible. It was no longer viable to define success simply in terms of buying at the lowest price and selling at the highest. Financial services and investment are today where footwear was thirty years ago. Public anger at the crisis will make visible what was previously hidden. Take the building up of huge portfolios of loans to poor people on US trailer parks. These loans were authorised without proper scrutiny of the circumstances of the borrowers. Somebody else then deemed them fit to be securitised and so on through credit default swaps and the rest without anyone seeing the transaction in terms of its ultimate human origin. Each of the decision makers thought it okay to act like the thoughtless footwear buyer of the 1970s. The price was attractive. There was money to make on the deal. Was it responsible? Irrelevant. It was legal, and others were making money that way. And the consequences for the banking system if everybody did it? Not our problem. The consumer has had a profound shock. Surely we could have expected the clever and wise people who invested our money to be better at risk management than they have shown themselves to be in the present crisis? How could they have been so gullible in not challenging the bankers whose lending proved so flaky? How could they have believed that the levels of bonuses that were, at least in part, coming out of their savings could have been justified in ‘incentivising’ a better performance? How could they have believed that a ‘better’ performance would be one that is achieved for one bank without regard to its effect on the whole banking

system? Where was the stewardship from those exercising investment on their behalf? The answer has been that very few of them do exercise that stewardship. Most have stood back and said it doesn’t really pay them to do so. The failure of stewardship comes from the same mindset that created the irresponsible lending in the first place. We are back to the mindset that has allowed us to poison the well: never mind the health of the system as a whole, I’m making money out of it at the moment. Responsibility means awareness for the system consequences of our actions. It is not a luxury. It is the cornerstone of prudence. Source: Extract from M. Goyder, ‘How we’ve poisoned the well of wealth’, Financial Times, 15 February 2009. © The Financial Times Limited 2009. All Rights Reserved. FT and ‘Financial Times’ are trademarks of the Financial Times.

Class discussion points 1 Try to explain the thinking behind the type of decision made by footwear companies 30 years ago, in terms of sourcing shoes from poorer countries. 2 Why do you think that Nike found it necessary to transform its business model? 3 Explain the reference to US trailer camps and the idea of the sub-prime crisis. 4 How do you feel about the idea—’it was legal and others were making money this way’? 5 How might we best move away from this attitude—and what should our approach be? 6 Estimating profit as it relates to a particular business is manageable. But measurement of social and environmental issues is more difficult. How might you approach this issue? 7 What do you understand by stewardship? Does the traditional approach to stewardship accounting accord with your view? Identify reasons why the main financial reports prepared for external use are still largely financially oriented? 8 Assume that you are a member of a superannuation fund. Which investment choices did you/will you make? Did you consider anything green, or ethically based, or did you simply go for growth? Why did you make the choice that you did?

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

13

Stakeholder theory Stakeholder theory was introduced in the section on users of accounting information, but the theory now goes way beyond what users might need from accounting. Freeman has been developing his theory for the last 30 years. A sense of his current thinking is summarised in Real World 1.2.

REAL WORLD 1.2 Stakeholder theory—current thinking

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As we saw earlier, Freeman argued strongly that managerial self-interest and shareholder profits, which he described as ‘the old story’, were not the driving force of business. He felt that people were interested in, and motivated by, far more than profit, and that all of their interests needed to be given appropriate recognition. Of course, profits were part of the story, but profits were seen as the outcome rather than the aim. So, what makes a successful business? Obvious elements include good products or services, a good and committed workforce, reliable suppliers who provide goods and services at the right quality, and a good relationship with the community at large. Freeman now talks about working to ‘harmonise’ the various stakeholders’ interests. There will of course be some conflict between some stakeholders, but such conflict should be seen as an opportunity to value-create. Value is perceived by Freeman as much broader than simply financial value. He believes ‘we create value when we do things that people find valuable’. The traditional approach is reasonably easily associated with measurement. Most businesses know how to measure customer satisfaction and whether they are creating value for their customers. Other areas, such as value for employees and the community, are less commonly addressed—and these need to be worked on.

Class discussion points 1 What value do you think a company creates for its employees? 2 What might be the components of value for employees in general? And at an individual level? 3 How might they be measured? 4 How might the social or environmental impact be identified and measured? 5 What kind of information might you collect if you thought that you needed to figure out how to create value, not just for investors, but for customers, suppliers, employees and communities? 6 Do you think, from your own experience, that the ideas of stakeholder theory, as compared with the traditional search for profit, are gaining ground, and if so in which areas and ways? 7 In recent years the banks have been the subject of much criticism. How might a bank balance the conflicting needs of shareholders, customers (both borrowers and depositors) and government?

Source: Eva Tsahuridu & David Walker, ‘R. Edward Freeman— The Stakeholder Revolutionary’, InTheBlack, 1 April 2015. It is recommended that you read the entire article.

Clearly stakeholder theory has had considerable influence over time, but whether accounting is doing enough in this area remains debatable. What is not in doubt is that social and environmental accounting has become much more important in assessing performance. Freeman believes that the way in which these have been ‘bolted on’ to the old business model of financial accounting suggests that there is a long way to go. We shall see in Chapter 9 just how many improvements have been made in reporting on social and environmental aspects and impacts, now more commonly called sustainability reporting or integrated reporting. There also remains scope for considerably more work to be carried out to deal with some of the issues implicit in Freeman’s theory. Just how easy it will be to find appropriate ways of dealing with the issues he raises remains to be seen.

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ACCOUNTING FOR BUSINESS STUDENTS

return The gain that results from a particular event or occurrence. risk The likelihood that what is projected to occur will not actually occur.

Balancing risk and return In considering wealth enhancement as our primary goal, we also need to recognise the need to balance the required return with the risk level associated with the business. All decision-making involves the future. Business decision-making is no exception. The only thing certain about the future, however, is that we cannot be sure what will happen. Things may not turn out as planned, and this risk should be carefully considered when making financial decisions. As in other aspects of life, risk and return tend to be related. Evidence shows that returns relate to risk in something like the way shown in Figure 1.4.

FIGURE 1.4

Return

Relationship between risk and return Even at zero risk, a certain level of return will be required. This will increase as the level of risk increases.

0

Risk

ACTIVITY 1.4 Look at Figure 1.4 and state, in broad terms, where an investment in: (a) (b)

a government savings account, and a lottery ticket

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should be placed on the risk–return line.

This relationship between risk and return has important implications for setting financial objectives for a business. The owners will require a minimum return to induce them to invest at all, but will require an additional return to compensate for taking risks; the higher the risk, the higher the required return. Managers must be aware of this and must strike the appropriate balance between risk and return when setting objectives and pursuing particular courses of action. The turmoil in the banking sector as a result of the global financial crisis has shown that the right balance is not always struck. Some banks took excessive risks in pursuit of higher returns and, as a consequence, incurred massive losses. There is little doubt that the risk appetite of the banks has changed dramatically over the past few years, and with good reason. Whether this change in appetite is permanent remains to be seen.

Concept check 8 A corporate mission statement would usually include an objective relating to: A B C D E

Provision of good working conditions for employees Conservation of the environment Earning of profits in the short term Enhancement of the wealth of its owners The need to be an industry leader.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

Concept check 9 Which of the following statements is false? A B C D E

The expected level of return increases as the level of risk increases. The GFC is a good example of the consequences of appropriate risk behaviour. Life without risk is death. Managers and organisations must strike a balance between risk and return. None of the above. All are true.

THE MAIN FINANCIAL REPORTS—AN OVERVIEW

Financial accounting Financial accounting grew from the old idea of stewardship accounting where stewards (managers/ representatives) gave an accounting of how they had fulfilled their responsibilities. When you remember that this was happening throughout the Industrial Revolution, you should realise that these statements were all about wealth. There was little concern about staff (workers), social issues or the environment. Human rights was not a term even thought about, other than as it related to the bosses! Times have changed, as we shall see as we progress through the book. However, the need for basic financial statements remains. A very simple illustration is given next. You will find that the rules and regulations surrounding these statements have become more rigorous as time has passed and business has become more complicated. The main financial statements are designed to provide a picture of the overall financial position and performance of the business. To do this, the accounting system normally produces three main financial reports on a recurring basis. These financial statements are concerned with answering the following questions: • What cash movements (i.e. cash in and cash out) took place over a particular period? • How much did wealth increase over a particular period as a result of operating and other activities? In other words, how much profit did the business generate from its overall activities? • What is the financial position of the business at the end of a particular period? These questions are all addressed by the three main financial reports listed below: 1 the statement of cash flows for the period

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2 the statement of financial performance for the period, commonly known as the income statement. It is often also referred to as the profit and loss statement, especially when used

internally in a business. For limited companies, the annual published statement is now called a statement of comprehensive income, and formats and requirements will be dealt with in Chapters 3 and 7. 3 the statement of financial position as at the end of the period, commonly known as the balance sheet. In due course we will also introduce a fourth statement, the statement of changes in equity, but this statement is really only important for limited companies and we will leave discussion until the appropriate later chapter. Basically, equity is the term used to indicate the share of the business which represents the owners’ interests. Taken together, the three main statements provide an overall picture of the financial health of the business. Perhaps the best way to introduce the financial reports is to look at an example of a very simple business. From this we shall be able to see what sort of useful information each of the statements can provide. We can see from the financial reports in Example 1.1 that each provides part of the picture of the financial performance and position of the business. We begin by showing the cash movements.

LO5 Provide an overview of the main financial reports prepared by a business

statement of cash flows The statement that shows the sources and uses of cash for a period. statement of financial performance/income statement/profit and loss statement The statement which measures and reports how much wealth (profit) has been generated in a period. statement of comprehensive income A statement that presents all items of income and expense recognised in a period, either in a single statement of comprehensive income or in two statements, the first being a statement displaying components of profit and loss (normal income statement), and a second which begins with profit or loss and displays components of other comprehensive income. From January 2018 the two-statement approach will need to be modified to a two-section approach, with the income statement preceding the other comprehensive income section. statement of financial position A statement that shows the assets of a business and the claim on those assets at a point in time. balance sheet A statement that shows the assets of a business and the claims on the business. Assets must always equal claims. Claims will relate to external liabilities and owner’s claims (known as equity). statement of changes in equity The statement that shows all changes in the owners’ interest in the net assets of the business as a result of transactions and events during a period. This includes total comprehensive income for the period, including profit or loss, and transactions with owners in their capacity as owners, showing contributions by and distributions to owners.

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equity The share of the business which represents the owners’ interests.

1.1

Cash is vital for any business to function effectively: to meet obligations, to acquire other resources (such as stock/inventory), to satisfy operating expenses and to meet ownership distributions. Cash has been described as the ‘life blood’ of a business, and movements in cash are usually given close scrutiny by users of financial statements.

Paul was unemployed and unable to find a job. He decided to embark on a business venture to meet his living expenses. Christmas was approaching, so he decided to buy gift-wrapping from a local supplier and sell it on the corner of his local main street. He felt that the price of wrapping paper in the shops was excessive and that this would give him a useful business opportunity. He began the venture with $600 in cash. On the first day of trading he purchased wrapping paper for $600. This is called stock (of goods) or inventory. Later in the day he sold three-quarters of his inventory for $660 cash. What cash movements took place in the first day of trading? On the first day of trading a statement of cash flows, showing the cash movements for the day, can be prepared as follows: $ Statement of cash flows for day 1 Opening balance (cash introduced) Sale of wrapping paper Purchase of wrapping paper Closing balance

600 660 1260 (600) 660

How much did wealth increase as a result of operations in the first day of trading? In other words, how much profit was generated by the business? A statement of financial performance (income statement) can be prepared to show the increase in wealth (profit) generated on the first day. The wealth generated will represent the difference between the sales made and the cost of the goods (i.e. wrapping paper) sold. $ Statement of financial performance (income statement) for day 1 Sales Cost of goods sold (¾ of $600) Profit

660 (450) 210

Note that only the cost of the wrapping paper sold is matched against the sales to find the profit, not the whole cost of wrapping paper acquired. Any unsold wrapping paper (known as inventory or stock) will be charged against future sales. Copyright © 2017. P.Ed Australia. All rights reserved.

What is the financial position at the end of the first day? To establish this we can draw up a statement of financial position listing the resources held at the end of the day. $ Statement of financial position (balance sheet) at the end of day 1 Cash (closing balance) Inventory (stock of goods for resale: ¼ of $600) Total assets held 5 Paul’s wealth in the business (equity)

660 150 810 810

Note that the profit has led to an increase in wealth ($210). In this particular business, all of the business wealth is the entitlement of Paul, so Paul’s equity can be seen to be $810. As we shall see in the next chapter, the situation in which there are no other claims on the business wealth is unusual. The situation in practice is rather more involved than that found in this simple example.

It is clear that reporting cash movements alone would not be enough to portray the financial health of the business. The changes in cash over time do not fully reveal the profit generated. The Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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statement of financial performance provides an insight into this aspect of performance. For day 1, for example, we saw that the cash balance increased by $60 but the profit generated, as shown in the statement of financial performance, was $210. The increase in wealth ($210) was represented by $60 cash and $150 in the form of stock (inventory). To determine the total wealth of the business, a statement of financial position is drawn up at the end of the day. Cash is only one form in which wealth can be held. In the case of this business, wealth is also held in the form of inventory (stock of goods for resale). Drawing up the statement of financial position involves listing both forms of wealth held. In the case of a large business, there may be many other forms of holding wealth, such as land and buildings, equipment and motor vehicles. Let us now continue with our example.

On the second day of trading, Paul purchased more wrapping paper for $300 cash. He managed to sell all the new wrapping paper and half of the earlier stock for a total of $540. The statement of cash flows on day 2 is as follows: $ Statement of cash flows for day 2 Opening balance (i.e. closing balance from day 1) Sale of wrapping paper Purchase of wrapping paper Closing balance

660 540 1200 (300) 900

1.1 continued

The statement of financial performance for day 2 is: $ Statement of financial performance for day 2 Sales Cost of goods sold ($300 1 ½ of $150) Profit

540 (375) 165

The statement of financial position (balance sheet) at the end of day 2 is: $

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Statement of financial position (balance sheet) at the end of day 2 Cash Inventory (stock of goods for resale: ½ of $150) Total assets 5 Paul’s wealth in the business (equity)

900 75 975 975

We can see that the total business wealth increased to $975 by the end of day 2. This represents an increase of $165 (i.e. $975 – $810) over the previous day. Note that this is the amount of profit made during day 2 as shown on the statement of financial performance.

ACTIVITY 1.5 On the third day of his business venture, Paul purchased more stock for $600 cash. However, it was raining hard for much of the day and sales were slow. A"er Paul had sold half of his total stock for $390, he decided to stop trading until the following day. Have a go at drawing up the three financial reports for day 3 of Paul’s business venture.

The solution to Activity 1.5 shows that the total business wealth increased by $52.50 (i.e. the amount of the day’s profit) even though the cash balance declined. This is due to the fact that the business is holding more of its wealth in the form of inventory rather than cash, compared with at the end of day 2. Note that the statement of financial performance and the statement of cash flows are both concerned with measuring flows (of wealth and cash, respectively) over time. The period of time

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may be one day, one month, one year, etc. The statement of financial position (balance sheet), however, is concerned with the financial position (or wealth) at a particular moment in time (the end of one day, one week, etc). Figure 1.5 illustrates this point. The statement of financial performance, statement of cash flows and statement of financial position, when taken together, are often referred to as the ‘final accounts’ of the business.

Statement of financial position at the beginning of Period 1

Statement of financial position at end of Period 1

Statement of financial position at end of Period 2

Statement of financial performance

Statement of financial performance

Statement of cash flows

Statement of cash flows

Period 1

Period 2

Time

FIGURE 1.5 The relationship between the statement of financial position, the statement of financial performance and the statement of cash flows

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The figure shows how the statement of financial performance and statement of cash flows are concerned with measuring flows of wealth over time. The statement of financial position, however, is concerned with measuring the stock of wealth at a particular moment in time.

For external users of the accounts, these reports are normally backward-looking and are based on records of past events and transactions. This can be useful as feedback on past performance and for identifying trends and clues to future performance. However, the reports can also be prepared using projected data in order to help assess likely future profits, cash flows, etc. The financial reports are normally prepared on a projected basis for internal decision-making purposes only. Managers are usually reluctant to publish these projected figures for external users. Nevertheless, as external users have to make decisions about the future, projected financial reports prepared by managers are likely to be useful for this purpose. Managers are, after all, in a good position to assess future performance, and so their assessments are likely to provide valuable information. In certain circumstances, such as raising fresh capital or resisting a hostile takeover bid, managers are prepared to depart from normal practice and issue projected figures to external users. Where publication does occur, some independent verification of the assumptions underlying the forecasts is often provided by a firm of accountants to lend credibility to the figures produced.

Management accounting By now it should be clear that management accounting uses financial information (and increasingly non-financial information) in a variety of different ways, with the general aim of achieving good decisions. The main areas of use include: prediction of future financial performance as part of long-term planning; budgeting as a means of both planning and control; cost control and savings; pricing; and project appraisal.

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Concept check 10 The statement of financial performance is also known as: A B C D E

Statement of financial position The income statement The profit and loss statement The balance sheet Statement of comprehensive income.

Concept check 11 Which statement shows all changes in the owners’ interest in the business? A B C D E

The statement of changes in equity The balance sheet The statement of financial performance The statement of comprehensive income The statement of cash flows.

Concept check 12 Which financial statements are videos rather than snapshots? A B C D

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E

Income statement and balance sheet Statement of cash flows and statement of financial position Balance sheet and statement of cash flows Statement of financial performance and statement of cash flows None of the above.

SELF-ASSESSMENT QUESTION 1.1 While on holiday on the Gold Coast, Helen had her credit cards and purse stolen from a beach where she was swimming. She was left with only $120, which she had left in her hotel room. There were three days of her holiday remaining. She was determined to continue her holiday and so decided to make some money in order to be able to complete her holiday. She decided to sell orange juice to holiday-makers on the local beach. On day 1 she purchased 80 cartons of orange juice at $1.50 each for cash, and sold 70 of these for $2.40 each. On the following day she purchased 60 cartons for cash and sold 65 at $2.40 each. On the third and final day she purchased another 60 cartons for cash. However, it rained and, as a result, business was poor. She managed to sell 20 at $2.40 each, but was forced to sell the rest of her stock at $1.20 each. Prepare a statement of financial performance (income statement) and a statement of cash flows for each day’s trading, and a statement of financial position at the end of each day’s trading.

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BUSINESS AND ACCOUNTING LO6 Outline the main types of business ownership, describe the way in which a business is typically organised and managed, and explain the importance of accounting in a business context

So far in this chapter we have talked in general terms about the kind of accounting information that might be used by various user groups. In practice, however, the forms of business ownership and the differing types of business activities engaged in will influence these needs. In the next section we will consider some of these factors.

What kinds of business ownership exist? The particular form of business ownership has important implications for accounting purposes, and so it is useful to be clear about the main forms of ownership that can arise. There are basically three arrangements:

• sole proprietorship (also known as sole trader) • partnership, and • limited company. We shall now consider the first two in reasonable detail, and limited companies in outline. Chapters 6 and 7 will provide more detail for limited companies.

Sole proprietorship

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sole proprietorship An individual in business on his or her own account.

Sole proprietorship (also known as sole trader), as the name suggests, is where an individual is

the sole owner (known as the proprietor) of a business. This type of business is often quite small in terms of total income or profits, or number of employees. However, the number of businesses that operate as sole proprietors is very large, far greater than the number of businesses that operate as companies. Examples of sole proprietor businesses can be found in most sectors, but the service sector predominates. Hence, services such as electrical repairs, plumbing, picture framing, photography, driving instruction, retail shops and hotels have a large proportion of sole proprietor businesses. A sole proprietor business is easy to set up, with no formal procedures being required. Operations can generally commence immediately (unless special permission is required because of the nature of the trade or service, such as running licensed premises). The owner has considerable discretion as to how the business is to be conducted, and is able to restructure or dissolve the business whenever it suits. A sole proprietorship has no separate legal identity. From a legal perspective there is no distinction between the owner (Bill Bloggs) and the business (Bill’s Diner). However, from an accounting perspective we distinguish clearly between the owner (Bill Bloggs) and the business (Bill’s Diner). The accounting entity (Bill’s Diner) will recognise transactions between the owner (Bill Bloggs) and the business. These transactions concern capital (funds) contributed to the business by the owner, profit earned by the business and not distributed to the owner, and distributions to the owner. Distributions to the owner, which are often labelled ‘drawings’, may be any of the following:

• cash taken out of the business on a regular (weekly) or irregular basis • other assets taken out of the business for personal consumption or use (e.g. merchandise or • •

equipment) personal accounts paid by the business (e.g. insurance, rent, electricity) personal benefits derived from business assets (e.g. accommodation, use of motor vehicle).

Another consequence of the fact that the law does not recognise the sole proprietor business as being separate from the owner is that the business will cease on the death of the owner. A sole proprietor has unlimited liability, and no distinction is made between the proprietor’s personal wealth and that of the business if there are business debts to be paid. The important characteristics of the sole proprietorship entity structure from the perspective of both the owner and other people or other entities dealing with this business are summarised in Table 1.1.

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TABLE 1.1 CHARACTERISTICS OF A SOLE PROPRIETORSHIP No separate legal entity. While the business is a separate accounting (recording/reporting) entity, it is not a separate legal entity. It cannot enter into contractual arrangements (borrow, lend, purchase, sell, sue or be sued) in its own right; rather, the legal owner must negotiate such contracts. Limited life. The sole proprietorship structure has a limited life. The life of the business is restricted to the period in which the owner continues in that position. This does not mean that the activity of the business necessarily stops when the owner dies, retires or leaves the business, but that sole proprietorship business ceases and possibly another commences (e.g. new owner, new name). Unlimited liability. The owner of a sole proprietorship has unlimited liability with respect to the activities of the business. That is, he or she is fully responsible for the obligations and debts of the business. Minimum reporting regulations. Regulations for financial recording and reporting are minimal compared with those for other entity structures. However, the introduction of the Goods and Services Tax (GST) has increased the requirement for regular detailed reports. Limited access to funds. Access to funds is potentially limited. With a sole proprietorship, the ownership funding is restricted to the personal resources of a single owner. Additionally, certain forms of borrowing are not available to sole proprietors that may be available to companies, and lenders may be more reluctant to provide credit or funds to sole proprietorships. The costs to establish a sole proprietorship structure are normally much lower than for other entity structures. By costs we are referring to those involved in setting up the business entity, not the costs to make the business operational (e.g. the necessary resources, property, plant, equipment, inventories, staff and other expenditure).

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A sole proprietor will usually need some indication of the financial performance and position of the business, and certainly will need to provide the taxation authorities with accounting information sufficient to satisfy their needs. However, there is no legal requirement to produce accounting information relating to the business for other user groups, though some may have the power (e.g. a lending bank) to demand accounting information about the business. All of this means that the range and quality of the accounting information required by a sole proprietor is likely to vary quite a bit. It is reasonable to assume that a report explaining the calculation of income for use by the Australian Taxation Office would be a minimum. Of course, many sole proprietors will require much more than this minimum and will look for as much accounting information as is considered useful. Having highlighted some key features of the sole proprietorship entity structure, we can determine its advantages and disadvantages. The advantages include:

• • • • •

they are simple and inexpensive to establish and operate there is minimal financial reporting regulation ownership and management are normally combined the financial rewards flow directly to the owner timely decision-making is possible.

Potential disadvantages of the sole proprietorship structure when compared to other structures include:

• the liability of the owner is unlimited, and personal assets may have to be used to satisfy business debts

• access to ownership funds is restricted to the personal resources of the proprietor • experience and knowledge is limited to the extent that the sole owner is frequently the sole •

manager access to non-ownership funding (suppliers of goods and services on credit, external loans) is often limited.

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Partnership partnership The relationship that exists between two or more persons carrying on a business with a view to profit.

The partnership structure represents the relationship that two or more individuals share with the aim of generating a financial profit. Partnerships are usually quite small in size (although some, such as partnerships of accountants and solicitors, can be large). Partnerships are also easy to set up. They may be established by a formal partnership agreement or an informal arrangement between the parties, or agreement may be simply inferred by the actions of two or more individuals. The partners can agree whatever arrangements suit them concerning the financial and management aspects of the business. Similarly, the partnership can be restructured or dissolved by agreement between the partners. The partnership represents a separate accounting entity distinct from the owners (partners). However, as with the sole proprietorship, there is no separate legal entity. From the viewpoint of the law there are just the individual owners. Contracts with third parties must be entered into in the name of individual partners. The partners of a business usually have unlimited liability. The main characteristics of a partnership are shown in Table 1.2.

TABLE 1.2 CHARACTERISTICS OF A PARTNERSHIP No separate legal entity. While the partnership is a separate accounting entity, there is no legal distinction between the business and the partners. As with a sole proprietorship, it is the partners, not the partnership, who enter into all contractual arrangements (e.g. borrow, lend, buy, sell, employ, dismiss, sue, be sued). Limited life. The partnership has a limited life, as each time there is a change in ownership (partners leave, new partners are introduced), the current partnership concludes and a new partnership commences. Unlimited liability. The liability of partners jointly and separately is unlimited with respect to the debts of the business. This means that each partner’s personal assets can be called upon to satisfy the claims of business creditors, well beyond the amount of the individual partner’s share of the business. Mutual agency. Each partner is responsible for the business actions of all other partners as if they had taken the action themselves. Co-ownership of assets. The partnership assets are owned by the partners in aggregate rather than individually. Co-ownership of profits. The partnership profits belong to the partners equally or in otherwise agreed proportions.

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Limited membership. There are certain restrictions on how many partners can belong to a partnership entity structure. While this is normally limited to 20, there are some exceptions in certain professions (e.g. accounting practices). Given the expanded number of owners, the access to ownership funds is normally much greater than for a sole proprietorship. Increased regulation. Most states have Partnership Acts which provide direction for the activities of partnerships and the rights and responsibilities of partners.

It is worth noting that, because of the fact that a partnership is not a separate legal entity, the partnership will pay no tax. The partnership profit or loss will be distributed to each partner, who will then include it in his or her tax return (just like a sole trader). The potential advantages of partnerships might include the following:

• there would normally be greater access to capital since there are two or more owners • the partners normally bring different skills to the partnership (professional, administrative, • •

technical) greater management flexibility is gained by having more than one owner taxation advantages often arise when the partnership income can be spread among the partners; this applies particularly to ‘husband and wife’ activities.

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When considering the potential disadvantages of partnerships, it is important to identify the entity structure with which the partnership is being compared. In comparison with a sole proprietorship, the disadvantages could include:

• • • • •

a higher level of regulation giving up profit share to other owners (co-ownership) giving up individual asset ownership (co-ownership) reduced decision-making authority (shared management) mutual agency imposes extra responsibility for the business actions of other partners. In comparing a partnership with a limited company, the disadvantages could include:

• • • • •

a limited life may affect long-term planning unlimited liability creates greater risk for ownership investment absence of a specialist management team mutual agency imposes extra responsibility for the business actions of the partners access to both ownership funds and debt funds is limited.

While not legally necessary, it is sensible for partners to have a formal and detailed partnership agreement in order to avoid the problems that invariably arise over the operation of the partnership and the relations between partners. When problems between partners cannot be resolved without recourse to the law, the requirements of the relevant Partnership Act will apply. On the distribution of partnership profit, most Partnership Acts indicate the following:

• partners are not entitled to a ‘salary or wage equivalent’ related to their input (physical or • •

mental) into the business operations partners are not entitled to an ‘interest equivalent’ on the capital contributions they make to the business the profit or loss is to be divided equally among the partners.

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However, these rules apply only in the absence of an agreement. Partners can (and should) agree to share profits in any way they choose, including payment of interest on capital and the equivalent of a wage to partners. With regard to the accounting requirements of a partnership, the only major difference between this and a sole proprietorship is that there is more than one owner. This means that the income figure will need to be divided between the partners, as will the calculation of owners’ wealth (equity). Typically, the partnership maintains individual records of each partner’s transactions with the partnership, as follows:

• resource contributions (capital) • resource withdrawals (drawings) • share of undistributed profits (either current or retained earnings—earnings made in earlier periods but not withdrawn by the owners).

Limited company Limited companies are businesses which are owned by multiple investors, each of which owns a

share of the company. Hence the owners of a limited company are often known as ‘shareholders’. Limited companies can range in size from quite small to very large. The number of individuals who invest in the company and become part-owners (known as ‘subscribing capital’) may be unlimited, which provides the opportunity to create a very large-scale business, although many are quite small. The liability of owners, however, is limited (hence ‘limited’ company), which means that those individuals subscribing capital to the company are liable only for debts incurred by the company up to the amount that they have agreed to invest. This cap on the liability of the owners is designed to limit risk and to produce greater confidence to invest. Without such limits on owner liability, it is difficult to see how a modern capitalist economy could operate. In many cases, the owners of a limited company are not involved in the day-to-day running of the business and will, therefore, invest in a business only if there is a clear limit set on the level of investment risk.

limited company An artificial legal entity which has an identity separate from that of those who own and manage it.

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limited liability The situation in which an investor in a business (a limited company) has his or her liability limited to a maximum specified amount; namely the maximum that he or she has agreed to subscribe to the business. Australian Securities and Investments Commission (ASIC) The government body responsible for regulating companies, company borrowings, and investment advisers and dealers.

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audit A process in which a range of activities are checked to ensure that the activities have been completed in accordance with a set of rules or guidelines.

board of directors The team of people chosen by the shareholders to manage a company on their behalf.

The benefit of limited liability, however, imposes certain obligations on such companies. To start up a limited company an application must be made to the Australian Securities and Investments Commission (ASIC) for registration of the company, and every person who agrees to be a shareholder, director or company secretary must register. The company will be allocated an Australian Company Number, which acts as an identifier. The company must also register for an ABN, a number which assists in transactions relating to various aspects of taxation. The Corporations Act, which covers most companies, provides a framework for company procedures and the way in which companies conduct their affairs, including the accounting and reporting requirements. Part of this regulatory framework requires annual financial reports to be made available to owners and lenders, and usually an annual general meeting of the owners has to be held to approve the reports. In addition, a copy of the annual financial reports must be lodged with the ASIC for public inspection. In this way, the financial affairs of a limited company enter the public domain. With the exception of small proprietary companies, there is also a requirement for the annual financial reports to be subject to an audit. This involves an independent firm of accountants examining the annual reports and underlying records to see whether the reports provide a true and fair view of the financial health of the company, and whether they comply with the relevant accounting rules established by law and by accounting rule-makers. Limited companies are considered in more detail in Chapters 6 and 7. All of the large household-name Australian businesses (BHP Billiton, Woolworths, Telstra, IAG and so on) are limited companies. This book concentrates on the accounting aspects of limited liability companies, because this type of business is by far the most important in economic terms. However, there are a number of complications associated with limited companies that do not exist with sole proprietorships or partnerships. Some of these relate to the structure of limited companies, and some relate to the increased regulation associated with companies. The next two chapters will introduce you to the basic accounting concepts and financial statements with reference to sole proprietorships and partnerships, together with some very simple company structures. Once we have dealt with the basic accounting principles, which are the same for all three types of business, we can then go on in later chapters to see how they are applied in more detail to limited companies. It must be emphasised that there are no differences in principle in the way these three forms of business keep their day-to-day accounting records. However, in preparing their periodic financial statements, there are certain differences that need to be considered. These differences are not ones of principle, however, but of detail. Nearly all businesses that involve more than a few owners and/or employees are set up as limited companies. Finance will come from the owners (shareholders) in the form of a cash investment in the company or by leaving in the business profits to which they are entitled. Finance can also come from lenders who earn interest on the amount lent to the business, or from suppliers who provide goods on credit. Credit means that goods and services are provided with a payment date agreed for some time in the future (typically one to three months). In larger limited companies, the owners (shareholders) tend not to be involved in the daily running of the business. They appoint a board of directors to manage the business on their behalf. The board is charged with three major tasks: 1 setting the overall direction and strategy for the business 2 monitoring and controlling the activities of the business, and 3 communicating with shareholders and others connected with the business.

Each board has a chairman, elected by the directors, who is responsible for running the board in an efficient manner. In addition, each board has a chief executive officer (CEO) (sometimes referred to as the ‘managing director’) who is responsible for running the business on a day-to-day basis. Occasionally, the roles of chairman and CEO are combined, although it is usually considered to be a good idea to separate them in order to prevent a single individual having excessive power. The board of directors represents the most senior level of management. Below this level, managers are employed, with each manager typically being given responsibility for a particular part of the business’s operations. Just how a particular business organises its operations is up to the board. Possibilities include:

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• the splitting up into separate departments, often on functional lines (e.g. production, finishing, • •

distribution, marketing, personnel and finance) running the business on geographical lines, or any number of combinations of these and others.

The implications of complicated organisations of this type are considerable for both the user and the accountant. There is a need to consider just how best to provide relevant information to help in the management process, and management accounting reports need to be appropriately detailed. In the area of financial accounting we need to consider how to best provide general-purpose accounting information that is relevant to assessing the performance of the business.

How are businesses managed? Strategic management is essentially a process of identifying, choosing and implementing

activities that will enhance the long-term performance of an organisation. It aims to provide an organisation with a clear sense of purpose and direction. It should link the internal resources of the business to the external environment of competitors, suppliers, customers and so on. This will usually involve capitalising on existing strengths and limiting exposure to weaknesses. It will also typically involve careful examination of the opportunities available to the business and any threats to the business. It is vitally important that businesses plan their future. Whatever a business is trying to achieve, it is unlikely to be successful unless its managers are clear what the plans are. Planning is vital for businesses of all sizes, but where a business involves more than one manager it is vital also that all their actions coordinate. For example, it is crucial to a manufacturing business that production levels and sales levels are related to one another. It is not feasible for sales and production to go their own separate ways. There must be plans to ensure that production and sales levels match each other. This is not to say that plans, once made, cannot be revised. Unexpected changes in the market or unforeseen production problems may well demand revision of all plans likely to be affected by these new circumstances. Closely linked to planning is decision-making. Planning involves making decisions about the best course of action.

strategic management An approach which seeks to provide a business with a clear sense of purpose and to ensure that appropriate action occurs to achieve that purpose.

Steps in the planning process Planning is usually broken down into three stages:

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1 Setting the objectives or mission of the business. This is what the particular business

is basically trying to achieve. The objectives are likely to reflect the attitudes of owners (shareholders) and managers. They tend to be framed in broad, generalised non-numerical terms. Once the objectives have been established, they are likely to remain in force for the long term—for example, 10 years. For most private-sector organisations, wealth generation is likely to be the main financial/economic objective. However, businesses typically have objectives other than the financial ones—for example, being environmentally friendly or providing employment for the family. In practice, therefore, any decision is likely to be the result of a compromise between more than one objective. 2 Setting long-term plans. These are plans setting out how the business will aim to achieve its objectives over a period of, say, five years. They are likely to deal with such matters as:

• • • • •

type of products or services to be offered by the business amounts and sources of finance required by the business capital investments (e.g. in new plant and machinery) required sources of raw materials labour requirements.

In the case of each of these, the pursuit of the established objectives of the business over the planning horizon (perhaps five years) will lay the foundation for the plans. Long-term plans tend to be stated in financial terms. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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budget A financial plan for the short term, typically one year.

3 Setting detailed short-term plans or budgets. Budgets are financial plans for the short term,

typically one year. Their role is to convert the long-term plans into actionable blueprints for the immediate future. Budgets usually define precise targets in areas such as: • cash receipts and payments • sales, broken down into amounts and prices for each of the products or services provided by the business • detailed inventory (i.e. stock of goods held for sale) requirements • detailed labour requirements • specific production requirements. It must be emphasised that planning (and decision-making) is not the role of accountants; it is the role of managers. However, much of the planning will be expressed in financial terms, and most of the data for decision-making are of an accounting nature. Therefore, accountants, because of their background knowledge, expertise and skills, together with their understanding of the accounting system, are very well placed to give technical advice and assistance to managers in this context. It is the managers of the various departments of the business who must actually do the planning, however. Only in respect of the accounting department, of which the most senior accountant will be the manager, should an accountant be taking decisions and making plans.

ACTIVITY 1.6 The approach described above suggests that decision-makers will examine all of the various courses of action available and then systematically rank them in order of preference. Do you think this is what decision-makers really do? Is this how you approach decisions—for example, choosing a career?

Control

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control To compel events to conform to the plan.

However well planned the activities of the business may be, they will come to nothing unless steps are taken to try to put them into practice. The process of making planned events actually occur is known as control. Control can be defined as compelling events to conform to the plan. This definition of control is valid in any context. For example, when we talk about controlling a car, we mean making the car do what we intend it to do. Our plan may be made only split seconds before we act on it, but, if the car is under control, it is doing what the driver intended. In a business context, accounting is very useful in the control process. This is because it is possible to state both plans and actual outcomes in the same accounting terms, thus making comparison between actual and planned outcomes relatively easy. Where actual outcomes are at variance with detailed plans (which are called ‘budgets’), this should be highlighted in the accounting information. Managers can then take steps to get the business back on track towards the achievement of the plans (budgets). Figure 1.6 shows the decision-making, planning and control process in diagrammatic form. The accountant must be aware of the fact that people can process only so much information. Too much information can be as bad as too little information, as it can overload and confuse people. This, in turn, can lead to poor evaluations and poor decisions. The information provided to managers must be restricted to what is relevant to the particular decision and to what can be absorbed. In practice, this may mean that information is produced in summarised form and that only a restricted range of options will be considered.

Not-for-profit organisations not-for-profit organisation An organisation whose main aim is not to make a profit, but to achieve some other clear goal, usually of a social nature.

Although the focus of this book is accounting as it relates to private-sector businesses, there are many not-for-profit organisations that do not exist mainly for the pursuit of profit. Examples include:

• charities • clubs and associations • universities

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Step 1

Identify business objectives

FIGURE 1.6 The planning and control process

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• • • •

Step 2

Consider options

Step 3

Evaluate options and make a selection

Step 4

Prepare a long-term plan based on the most appropriate option(s)

Step 5

Prepare short-term plans (budgets)

Step 6

Perform and collect information on actual performance

Step 7

Respond to divergences between plans and actuals, and exercise control

Step 8

Revise plans (and budgets) if necessary

The figure shows the key steps in the planning and control process as described in this chapter.

local government authorities national government departments and associated agencies churches, and trade unions.

Such organisations also need to produce accounting information for decision-making purposes. Various user groups need accounting information about these types of organisations to help them to make decisions. These groups are often the same as, or similar to, those identified for privatesector businesses. They may have a stake in the future viability of the organisation, and may use accounting information to check that the wealth of the organisation is being properly controlled and used in a way that is consistent with its objectives.

Concept check 13 You’ve decided to follow Bill Gates and dump university to go into business. You will probably set up your business initially as a: A B C D E

Limited company Partnership Non-profit organisation (NPO) Sole trader Any of the above.

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Concept check 14 Advantages of a sole proprietorship include: A B C D E

Separate legal entity Minimum reporting requirements Unlimited liability Limited life Limited access to funds.

Concept check 15 Disadvantages of a partnership include: A B C D E

Not a separate legal entity Increased regulation (Partnership Acts) Unlimited liability Have to share profits with partners All of the above.

THE CHANGING FACE OF BUSINESS AND ACCOUNTING

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LO7 Identify ways in which business and accounting have been changing, together with some current issues confronting businesses and their associated reporting, including current thinking on ethics in business

Over the past 40 years, the environment within which businesses operate has become increasingly turbulent and competitive. Various reasons have been identified to explain these changes, including:

• • • • • • •

increasingly sophisticated and demanding customers the development of a global economy where national frontiers are less important rapid changes in technology the deregulation of domestic markets (e.g. electricity, water and gas) increasing pressure from owners (shareholders) for competitive economic returns the increasing volatility of financial markets, and substantially increased awareness of the need to recognise the implications of the actions of business on the environment and society at large.

This new, more complex environment has brought new challenges for managers and other users of accounting information. Their needs have changed, and both financial accounting and management accounting have had to respond. To meet the changing needs of users there has been a radical review of the kind of information to be reported. The internationalisation of businesses has created a need for accounting rules to have an international reach. It can no longer be assumed that users of accounting information relating to a particular business are based in the country in which the business has its base, or are familiar with the accounting rules of that country. Thus, there has been increasing harmonisation of accounting rules across national frontiers. A more detailed review of these developments is included in Chapter 7. The changing business environment has also given added impetus to the search for a clear framework and principles upon which to base financial accounting reports. Various attempts have been made to clarify their purpose and to provide a more solid foundation for the development of accounting rules. The frameworks and principles that have been developed try to address fundamental questions such as:

• Who are the users of financial accounting information? • What kind of financial accounting reports should be prepared and what should they contain? Atrill, Peter, et al. Accounting for Business Students P.Edshould Australia, 2017. ProQuest Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. How items suchEbook as profit be presented and assets valued? • eBook, Created from usyd on 2018-03-05 16:43:06. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018 — 9781488616570 — Atrill/Accounting for Business Students 1e

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As a result of criticisms that the financial reports of some businesses are not clear enough to users, accounting rule-makers have tried to improve reporting rules to ensure that the accounting policies of businesses are more comparable and more transparent, and that they portray economic reality more faithfully. The importance of this work has been reinforced by a number of scandals over the past couple of decades, typically relating to the financial reports prepared for general-purpose external users. These scandals have become front-page news in Australia, and a major talking point among those connected with the world of business. Unfortunately, all this attention has been for all the wrong reasons. We have seen that investors rely on financial reports to help keep an eye on their investments and on the managers. However, these scandals clearly indicate that cases have arisen where managers have been providing misleading information to their investors. Two of the most notorious cases have been those of Enron, a Texas-based energy-trading business accused of making complicated financial arrangements to obscure losses and to inflate profits, and HIH Insurance Group, where mismanagement and an inadequate response to emerging pressures in international insurance markets led to Australia’s greatest corporate collapse, with losses of up to $5.3 billion. In the wake of these scandals, there was much closer scrutiny of businesses’ financial reports by investment analysts and investors. This has led to further businesses, in Australia and worldwide, being accused of using dubious accounting practices to bolster profits. Various reasons have been put forward to explain this spate of scandals. Some may have been caused by the pressures on managers to meet investors’ unrealistic expectations of continually rising profits; others by the greed of unscrupulous executives whose pay is linked to financial performance. However, they may all reflect a particular economic environment. The Australian legal system has made it plain that it deplores the actions of unscrupulous executives. In 2005, Ray Williams and Rodney Adler, former chiefs of HIH, were sentenced to four and a half years in prison for their part in the fraud.

ACTIVITY 1.7 Can you identify a significant Australian corporate crash in the past decade that has also brought into question accounting, financial reporting and auditing practices?

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Whatever the causes, the result of these accounting scandals has been to undermine the credibility of financial statements and to introduce much stricter regulations concerning the quality of financial information. More recently, the global financial crisis has further highlighted, among many other things, inadequacies and inconsistencies in financial reporting regulations and reporting practices. Real World 1.3 reinforces the need for the application of consistent, high-quality international financial reporting standards.

REAL WORLD 1.3 Crisis a wake-up call for change The global financial crisis was a ‘wakeup call’ for the need to have a common global standard, chairman and chief executive of the Australian Accounting Standards Board says. Kevin Stevenson said the GFC allowed standard setting to come to life. Global standards were initially issued in the 70s, beginning with the Board of the International Accounting Standards Committee, which paved the way to the current International Accounting Standards Board. That led to the International Financial Reporting Standards, which Australia moved to adopt in 2005. Head of reporting for the Institute of Chartered Accountants, Kerry Hicks, said Australian standards

have been applied to both listed and unlisted companies – any which claim they produce general purpose financial reports. Source: Tim Mendham, ‘Crisis a wake-up call for change’, Australian Financial Review, 21 April 2010.

Class discussion points 1 Did the GFC actually wake people up or have we forgotten the lessons? 2 To what extent do you think global accounting standards help when something like the GFC occurs?

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Parallel to this work are major efforts to improve corporate governance. Increasingly, concern with the environment—particularly via climate change—has led to considerably more focus being directed to environmental and social factors, typically wrapped up together under a generic heading of ‘sustainability reporting’. Many companies, especially the larger ones, now use sustainability as a core part of their business’s approach and associated planning. More recently, the idea of integrated accounting, which is all about value creation, has been developed. These topics will be considered in more detail in Chapter 9. Management accounting has also changed by becoming more outward-looking and more customer-focused. In the past, information provided to managers was largely restricted to that collected within the business. However, the attitude and behaviour of customers and rival businesses have now become the object of much information gathering. Increasingly, successful businesses are those that are able to secure and maintain competitive advantage over their rivals. In addition, information about the costs and profits of rival businesses, which can be used as ‘benchmarks’ by which to gauge competitiveness, is gathered and reported. To compete successfully, businesses must also find ways of managing costs. The cost base of modern businesses is under continual review, and this in turn has led to the development of more sophisticated methods of measuring and controlling costs.

Ethics and ethical behaviour in business

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ethics A code of behaviour considered correct, especially that of a particular group, organisation or individual.

business ethics The study of proper business policies and practices regarding potentially controversial issues, such as corporate governance, insider trading, bribery, discrimination, corporate social responsibility and fiduciary responsibilities. Business ethics are often guided by law, while other times provide a basic framework that businesses may choose to follow in order to gain public acceptance.

It is now clearly recognised that in free societies businesses need to be good corporate citizens. Also, the idea discussed in an earlier section, that businesses need to harmonise stakeholders’ interests, implies that there is a need for ethics and ethical behaviour. As we have already seen, the last couple of decades have witnessed a number of scandals in which behaviour has been identified as both illegal and unethical. The regulatory framework has been tightened as a result, as have the codes of ethics of various professional organisations. By way of illustration, the International Federation of Accountants (IFAC), an independent worldwide organisation with a stated purpose ‘to develop and enhance a coordinated worldwide accountancy profession with harmonised standards’, has developed a code of ethics for accountants in each country to use as the basis for founding their own codes of ethics. The major Australian accounting bodies have developed a ‘Code of Ethics for Professional Accountants’ based on the IFAC code. Members are expected to comply with both the words and spirit of the code. There is an overarching responsibility to act in the public interest—satisfying the needs of a particular client is not enough. A number of fundamental principles guide the code; these cover integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. Through these principles, the code emphasises professional judgement and awareness of potential threats to compliance. (For more detail on the code, see CPA Australia, ‘An overview of APES 110—Code of Ethics for Professional Accountants’.) A considerable amount of work on ethics has been done over the years. For example, the Institute for Global Ethics (www.globalethics.org), a non-profit organisation, uses the same kind of values-driven ethos implicit in Freeman’s work on stakeholder theory. Rewards identified include: increased shareholder confidence; enhanced productivity; attraction and retention of a quality workforce; protection of customer trust; improved efficiency; and expansion of compliance efforts (i.e. ensuring rules and regulations are followed). Guiding principles include: honesty and truthfulness in all dealings; responsibility and accountability in every transaction; fairness and equity in each relationship; respect and mindfulness of the dignity of every individual; and compassion and caring in each situation. The Institute’s research suggests that these principles transcend national and cultural borders, economic stratification, language, gender and religion. These principles are also important in developing a set of corporate ethical values, or ideology (the way in which a corporation actually does business). This set of values is not necessarily the same as business ethics. Business ethics has been defined as ‘The study of proper business policies and practices regarding potentially controversial issues, such as corporate governance, insider trading, bribery, discrimination, corporate social responsibility and fiduciary responsibilities. Business ethics are often guided by law, while other times provide a basic framework that businesses may choose to follow in order to gain public acceptance’ (www.investopedia.com/terms/b/business-ethics.asp).

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Conversion of this definition to what actually happens on the ground can still vary tremendously. There is undoubtedly a real concern about behaviour being ethically sound, and the general public is increasingly critical of failures in this arena. Examples of clear failures can be seen in Real World 1.4.

REAL WORLD 1.4 Ethical failures Volkswagen’s emission-cheating scandal beggars belief. Volkswagen admitted to cheating on emissions tests for nearly half a million diesel-powered cars sold since 2008. Volkswagen says that as many as 11 million vehicles worldwide use what authorities call defeat devices, or so"ware that can make cars appear cleaner than they are during regulatory tests and disable emissions controls during normal driving. Volkswagen apologised and asked for patience, while setting aside US$7.3 billion to cover fallout from the scandal. Since that time the US Justice Department has sued Volkswagen in an action that could cost Volkswagen US$18 billion. The final direct cost in the US was around $15 billion, plus a further US$4.7 billion. VW subsequently made clear that it had no intention of offering equal compensation to Europeans who had bought tainted diesel vehicles. This claim was based on differing emissions standards. VW reported a 20% slump in pre-tax profits in the first three months of 2016.

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Sources: Mike Spector, ‘Volkswagen facing barrage of litigation’, The Australian, 30 September 2015. Arona Viswanatha & Mike Spector, ‘VW faces $25bn payout in US emissions lawsuit’, The Australian, 6 January 2016. William Boston, ‘VW rejects cash offer for owners in Europe’, The Australian, 5 July 2016. Kate Palmer, ‘VW profit sharply lower as effects of emissions-rigging scandal continues’, The Daily Telegraph (UK), 1 June 2016.

Several Ponzi schemes have been identified recently. In India, Pearls Agrotech Corporation was found to have raised money from investors who thought they were buying valuable plots of land, which the company promised to develop and sell on, ostensibly generating lucrative returns. Investors were o"en assigned vaguely defined plots in regions far from where they lived, leaving them unable to check out realities on the ground. Sources: Amy Kazmin, ‘Indian real estate group fined $1.1bn for preying on investors’, Financial Times, 23 September 2013. Madhura Karnik & Manu Balachandran, ‘Yet another massive Ponzi scheme goes pop in India’, Quartz India, 12 January 2016.

In China, authorities accused an online financing platform of deceiving mostly small investors out of more than 50 billion yuan. Ezubo and its parent, Yucheng International Holdings Group, were charged with illegally soliciting funds from the public, and fraud. The companies had allegedly lured investors with promises of high-interest payouts from leasing projects. It was also alleged that 95% of the projects were false.

Source: Chuin-Wei Yap, ‘Ezubo a $10bn “Ponzi scheme”, says Bejing’, The Australian, 3 February 2016.

In 2015 ‘a joint investigation by Four Corners and Fairfax found systematic underpayment of wages and the doctoring of payroll records’ in 7-Eleven, Australia’s biggest convenience store chain (Ferguson & Danckert). Workers, many of whom were international students on particular visas with restrictions, were found to be intimidated and exploited. International students are only allowed to work 20 hours a week. ‘Many workers told the ABC that they were forced to work 40 hours a week while being paid for only 20 hours … Many others did not receive penalty rates and were threatened with losing their visas if they complained (Branley) While blame was laid at the door of individual franchisees, there remained considerable criticism of the head office, including claims of payroll non-compliance. Issues were seen as systemic, i.e. company-wide. A subsequent Senate committee heard that franchisees were ‘still taking 7-Eleven workers to ATMs to withdraw and pay back wages, and some have resorted to violence and intimidation to deter underpayment claims … On average workers were underpaid $23,000 each’ (Karp). Sources: Adele Ferguson & Sarah Danckert, ‘How 7-Eleven is ripping off its workers’, Sydney Morning Herald, www.smh.com.au/ interactiv/2015/7-eleven-revealed/-Revealed. Alison Branley, ‘7-Eleven staff work twice as long at half pay rate, investigation reveals’, ABC News, 29 August 2015, www.abc.net.au/ news/2015-08-29/7-eleven-half-pay-scam-exposed/6734174. Paul Karp, ‘7-Eleven workers beaten and forced to pay back wages, Senate enquiry told’, The Guardian, 5 February 2016, www. theguardian.com/australia-news.2016/feb/05/7-eleven-workersbeaten-and-forced-to-pay-back-wages-senate-inquiry-hears.

Class discussion points 1 In the light of the examples included in Real World 1.4, do you believe that ethics in today’s business world are improving? 2 The guiding principles of the Institute of Global Ethics, namely honesty, responsibility, fairness, respect and compassion, are laudable. How easy do you think it will be to operationalise them? 3 Summarise your views on either the Volkswagen or 7-Eleven failings identified in Real World 1.4. 4 A whistle-blower raised questions in relation to the 7-Eleven saga as to whether the practice identified above

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was a fundamental part of the way in which the business was run, and whether the business could succeed without doing things this way. What do you think? 5 Do you purchase any goods that might be categorised as Fairtrade? Why/why not? To what extent might your decision be influenced by your own particular circumstances. 6 What do you consider are ethical considerations that might occur with data mining and privacy? 7 ‘When we talk about an ethical culture, we are discussing a set of basic assumptions that is being lived out. We can

talk all we want about those values we want to embody, but without examining the basic assumptions beneath them, we won’t understand how radical a shi# we are proposing in the world we inhabit’ (Institute for Global Ethics, ‘The foundation of an ethical culture’, p. 1). Comment on this statement. Is this shi# feasible, or do we need to rely on regulation? 8 Identify and discuss any recent cases where you think behaviour has been unethical.

Real World 1.4 provides some extreme illustrations, but there are many other examples of breakdowns or failures that range from minor moral misjudgements through sloppiness in the way business is transacted and general sharp practice, to plain fraud. Also, thinking back to the section on stakeholder theory, Freeman’s ‘new story’ clearly has not reached parts of the business community (and possibly the entire community). Do we accept that this is reality, or try to do something more positive? In fact, the impact of ethical considerations is now well recognised. There have been substantial improvements in corporate governance—the system by which corporations are directed and controlled— and compliance and other regulatory requirements are more rigorous. Many superannuation funds now have investment categories with names such as ‘ethically based investments’, which enable investors to choose investments with a sound ethical (or green) underpinning. Consumers seem to be increasingly turning to businesses or industries which engage in ethical trading, such as Fairtrade coffee. In the course of this text we shall see that accountants play a very important role in compliance and certain ethical issues. Increasingly, as community expectations change, so will compliance needs. The increased emphasis in recent years on sustainability has led to substantially expanded reports, which are discussed in Chapter 9. The ideas of Freeman regarding stakeholder theory’s ‘new story’ are likely to lead to a range of new measurement systems over the next few decades. Eva Tsahuridu, in a regular piece on ethics in InTheBlack (‘How do you stop bad apples?’, May 2015) asked how we might move from a compliance-based approach to one which focuses on shared values and benefit creation. The article suggests that we need to develop a positive ethical organisation, in which doing the right thing is the normal thing to do. Such an organisation will require attention to:

• leadership that is visibly ethical, with explicit commitment to ethics • culture and informal systems that include values, role models, language, norms, symbols and heroes • formal systems that include codes of conduct, policies and rules, structure, performance Copyright © 2017. P.Ed Australia. All rights reserved.

management and reward systems, and decision-making processes.

There is considerable overlap between the ideas covered in the section on stakeholder theory and this one on ethics. The use of the term ‘values driven’ is increasingly common. Accounting has led the field in terms of measurement, and remains the principal discipline for measurement. However, many of the ideas raised in this chapter are difficult to measure, so considerable work still needs to be done.

Concept check 16 Which of the following factors have contributed to the changing business and reporting environment we live in? A B C D E

Advances in technology Deregulation of utility providers (e.g. electricity, water) Breakdown of political barriers None of the above The first three.

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Concept check 17 Which of the following is NOT a response of the accounting profession to the changing environment being faced by today’s businesses? A B C D E

Accounting standards that meet the unique needs of a particular country Increased clarity of financial reports Harmonisation of accounting rules across countries and continents Greater transparency in financial reporting Greater comparability in financial reporting.

HOW USEFUL IS ACCOUNTING INFORMATION? No-one would seriously claim that accounting information fully meets all of the needs of each of the various user groups. Accounting is still a developing subject, and we still have much to learn about user needs and the ways in which these needs should be met. Nevertheless, the information contained in accounting reports should help users make decisions relating to the business. The information should reduce uncertainty about the financial position and performance of the business. It should help to answer questions concerning the availability of funds to pay owners a return, to repay loans, to reward employees and so on. While we cannot be sure just how useful accounting information actually is to users, there is little doubt that accounting is perceived as being useful. Several studies have attempted to rank the importance of accounting information in relation to other sources of information. Generally, these studies have found that accounting information is ranked more highly than other sources of information. The impact on share prices of accounting information is one area where some clear evidence can be seen to support these views. Real World 1.5 provides examples of the impact on share prices of announcements regarding current or anticipated profits.

LO8 Explain why accounting information is generally considered to be useful, and why you need to know the basics of accounting

REAL WORLD 1.5

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Impact of financial results on share price CBA reported a better than expected profit amounting to $4.8 billion. It held the dividend steady. At this time the investor market was best described as ‘rattled’. The overall stock market was close to being in ‘bear’ territory, having lost around 20% over the last six months. Shares rose by 1.8%, a remarkably good performance under the circumstances. Source: Michael Bennet, ‘CBA posts $5bn profit but dividend frozen’, The Australian, 11 February 2016.

The Reject Shop smashed profit forecasts by reporting halfyearly profit of $18.3 million on a 5.6% li" in sales to $424.7 million. This represented a 43% increase in profit. Its share price increased by 26%. Source: Eli Greenblat,’Super profit for Reject Shop’, The Australian, 18 February 2016.

BlueScope issued an upgrade of its December half-year profit guidance, from $180 million to $230 million, for underlying earnings before interest and tax. Substantial cost savings were the main cause. The share price went up by 14%. Source: Barry FitzGerald, ‘BlueScope on a roll with shock profit upgrade’, The Weekend Australian, 13–14 February 2016.

AGL flagged a fall in profits of $100 million a"er being caught short of lower priced gas. AGL share price went lower by 6%, but recovered to only 2% lower a"er it became clear that it still expected to deliver higher earnings for 2017. Source: Barry Fitzgerald, ‘AGL flags $100m fall in gas profit’, The Australian, 8 July 2016.

Class discussion points 1 What do you understand by ‘bear’ territory? While accounting information is clearly important in determining share value, what do you think might be its relative importance compared with the level of investor confidence at a more national or global level? 2 How might The Reject Shop have achieved a 43% increase in profit with a 5.6% li# in sales? 3 Discuss how shares might be valued and which accounting information might be included in the valuation process. In discussing this, you might like to factor in to your thinking the BlueScope and AGL examples in Real World 1.5.

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Typically, there is no close substitute for the information provided by the financial statements. Thus, if users cannot glean the required information from the financial statements, it is often unavailable to them. Other sources of information concerning the financial health of a business are normally much less useful.

ACTIVITY 1.8 What other sources of information might, say, an investment analyst use in an attempt to gain an impression of the financial position and performance of a business? What kind of information might be gleaned from these sources?

Why do I need to know anything about accounting and finance? At some stage of your study you have probably asked yourself: ‘Why do I need to study accounting? I am not even sure that I want to become an accountant!’ Well, from the explanation of what accounting is about, which has broadly been the subject of this chapter, it should be clear that the accounting function within a business is a central part of its management information system. On the basis of information provided by the system, managers make decisions concerning the allocation of resources. As we have seen, these decisions may concern whether to:

• continue with or expand certain business operations • invest in particular projects, or • sell particular products. Such decisions can have a profound effect on all of those connected with the business. It is important, therefore, that all of those who intend to work in a business should have a fairly clear idea of certain important aspects of accounting and finance. These aspects include:

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• • • •

how financial reports should be read and interpreted how financial plans are made how investment decisions are made, and how businesses are financed.

Many, perhaps most, students have a career goal of being a manager within a business—perhaps a personnel manager, a production manager, a marketing manager or an IT manager. If you are one of these students, an understanding of accounting and finance is very important. When you become a manager, even a junior one, it is almost certain that you will have to use financial reports to help you to carry out your role. It is equally certain that it is largely on the basis of financial information and reports that your performance as a manager will be judged. As part of your management role, it is likely that you will be expected to help in forward planning for the business. This will often involve the preparation of projected financial statements and the setting of financial targets. If you do not understand what the financial statements really mean and the extent to which the financial information is reliable, you will find yourself at a distinct disadvantage to others who know their way around the system. Along with other managers, you will also be expected to help decide how the limited resources available to the business should be allocated between competing options. This will require an ability to evaluate the costs and benefits of the different options available. Once again, an understanding of accounting and finance is important to carrying out this management task. This is not to say that you cannot be an effective and successful personnel, production, marketing or IT manager unless you are also a qualified accountant. It does mean, however, that you need to become a bit ‘streetwise’ in accounting and finance if you are to succeed. This book should give you that street wisdom. If you intend to become an accountant, the question is not as relevant. However, it is worth noting that many accountants eventually move out of accounting per se and into general management, so for those who finish up on this track, the same arguments as above are relevant. For those who intend having a career in accounting, this book should provide you with a sound foundation for your future role and in business generally.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

Concept check 18 Which of the following statements is true? A

B C

D E

Well-prepared financial statements will meet all of the needs of most but not all user groups. Accounting information is useful only to those trained in accounting. The ability to understand financial statements is important and even critical for many non-accounting managers in business. All of the above. None of the above.

Concept check 19 Financial statements and accounting information can provide information to aid which of the following decisions? A B C D E

Whether or not to buy shares in a company Whether or not to provide credit to a business Whether to invest in a particular project Whether to buy products or services from a company All of the above.

THE ALTC’S ACADEMIC STANDARDS FOR ACCOUNTING The Australian Learning and Teaching Council (ALTC) developed a Learning and Teaching Academic Standards Statement for Accounting in 2010. This statement relates to accounting at a program level, rather than at an individual course (subject) level. The main standards statement includes the following points:

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• Accounting is concerned with the provision, analysis and communication of information to • • • •

•

a broad range of internal and external stakeholders for a variety of resource allocation and compliance purposes. Accounting can be applied at different levels, including individuals, private, public and notfor-profit organisations, markets, society and the environment. Accounting is not conducted in isolation, but is informed by various perspectives, including social, ethical, economic, regulatory and global. The body of accounting knowledge is informed by relevant research, scholarship and professional practice, and application. Topics included in the body of accounting knowledge include financial accounting, management accounting, and a selection of auditing and assurance, finance, economics, quantitative methods, information systems, commercial law, corporation law and taxation law. Many accounting degree programs prepare accounting graduates to work effectively as accounting professionals. This includes being able to manage and interact with various accounting and business contexts, think reflectively and conceptually about financial and other information, work collaboratively with accountants and other users to make informed judgements, and justify such advice to others.

LO9 Identify the learning outcomes associated with the Australian Learning and Teaching Council’s Academic Standards Statement for Accounting: namely judgement; knowledge; application skills; communication and teamwork; and selfmanagement; and examine how these compare with characteristics of successful business people

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

The statement includes a range of threshold learning outcomes that are expected of new graduates embarking on a career in accounting. These are:

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Judgement—reflecting an ability to solve accounting problems in relatively straightforward contexts, using social, ethical, regulatory and global perspectives Knowledge—an ability to integrate theoretical and technical accounting knowledge Application skills—critically apply theoretical and technical accounting knowledge and skills to solve accounting problems Communication and teamwork—justify and communicate accounting advice and ideas in a straightforward collaborative context involving both accountants and non-accountants Self-management—reflect on performance feedback to identify and action learning opportunities and self-improvement. The standards can be seen in operation at various levels in this book. The threshold learning objectives, or rather the ideas that underpin them, namely knowledge, application skills, judgement, communication and teamwork, and self-management, provide a framework for thinking about how programs and, to a lesser extent, courses need to be developed and taught. At an introductory level, much of what is included in this book is knowledge-based. We have tried to ensure that all the knowledge that might reasonably be required by a first level course has been included. Hence, it includes sections on financial accounting (both reports used and analysis), management accounting and aspects of finance, together with an introduction to governance, sustainability reporting (and its various components) and strategic management. Knowledge requires appropriate application if maximum benefit is to be obtained. Throughout the book knowledge is applied through examples, activities, and further exercises and cases. The applications are usually problem-based. Given the introductory nature of the book, the emphasis is inevitably on the first two elements, knowledge and application. However, as the book develops, there are examples and cases which build on the analysis and foster sound judgement. The inclusion of current Real World examples should enable students to reflect on how what is actually happening coincides (or not) with what is being taught. The Accounting and You features should also reinforce the ability of the student to apply knowledge and to reflect on its use. The areas of teamwork and communication are dealt with through the Class Discussion Points following the Accounting and You sections and the Real World examples, and the end-of-chapter discussion questions, application exercises and case studies. However, it must be recognised that a subject like accounting requires development of good individual skills, which of necessity means that specific time for development of teamwork is restricted, other than in the areas mentioned above. With regard to communication, students have to be able to consider how best to communicate accounting information and analyses to users of the information. The approach to this book, which is based on an open learning approach, should facilitate self-management. This approach uses a series of in-chapter activities, self-assessment questions, discussion questions, application exercises and case studies. Answers are provided to the activities and self-assessment questions. MyAccountingLab, which is designed as a virtual tutor, enables you to test your knowledge with sample tests, facilitates the development of an individually tailored study plan and enables you to target those areas where you need to develop further understanding. The standards are written from the perspective of the accounting profession. They apply to the entire field. However, many accounting issues and problems also apply to users of accounting, as the main problems are fairly generic. Ultimately, users of accounting information need to have a reasonably thorough understanding of accounting. The threshold learning objectives for the subject of Accounting will probably eventually have a great deal in common with those devised for Business students.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

37

Characteristics of successful business people It would not be appropriate in a book of this type to spend a lot of time discussing characteristics of successful business people, but it is interesting to consider how the learning outcomes described above might relate to these characteristics. Are these characteristics consistent with the learning outcomes? A supplement entitled ‘Psychology of success’, sponsored by NAB, appeared in The Australian on 9 October 2015. This supplement included a range of articles relating to a number of very successful, quite young entrepreneurs. The content of these is broadly summarised in Table 1.3.

TABLE 1.3 CHARACTERISTICS OF SUCCESSFUL BUSINESS PEOPLE • • • • • • • • • • • • • • • •

Being able to break down challenges into bite-sized chunks, and resisting looking too far into the future Being able to keep one’s nerve and avoid a crisis of confidence Having self-belief and being able to spot it in others Being able to crash through your comfort zones Avoiding the temptation to believe that the problem is external. What sets apart those who are able to conquer challenges to selfbelief is a willingness to face up to fear and the possibility of failure Being comfortable with feeling uncomfortable, and understanding that emotional fortitude is something that develops Recognising that the early days of any business are going to be something of a roller-coaster ride Not comparing yourself with others Recognising that persistence, determination and a never-say-die attitude are vital, but not the only ingredients for business success Having a need for self-awareness and balance Avoiding the pitfall that people with a lot of drive and determination can get caught up in the business and become obsessive Recognising, though, that obsession creates a source of energy, and when focused and aligned with persistence, can be a mechanism for success Never taking rejection or negative feedback personally, but deal with the rejections Recognising that a defensive reaction to criticism and negative feedback can be disastrous. There is a need to view negative feedback as a gift Recognising your own strengths and weaknesses. It is rare that one person is great at running every part of a business. Recognise your own unique talents and find people who excel where you don’t Recognising the need for sheer determination, hard work and a burning desire to succeed

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Source: Based on ‘Psychology of success’, The Australian, 9 October 2015.

What can we learn from this? Probably the most important thing is that these ideas relate to the personality of the entrepreneur. But how do they relate to the study of accounting?

ACTIVITY 1.9 You are required to: (a) (b)

discuss the kind of skill set required for a successful career in business in the future identify just how accounting can link with these characteristics.

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ACCOUNTING FOR BUSINESS STUDENTS

SUMMARY In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Explain the nature and role of accounting

• Distinguished two distinct roles—a stewardship role and a decision-usefulness role • Identified the role as the provision of economic information to assist in decision-making • Explained accounting as a service function with particular emphasis on quantitative characteristics • Explained accounting as an information system concerned with the collection, analysis and communication of economic information

LO2: List the main groups that use the accounting reports of a business entity, and summarise the different uses that can be made of accounting information

• Identified the following groups: • • • • • • • • • •

owners managers lenders suppliers investment analysts customers competitors employees and their representatives government community representatives

• Discussed uses made of accounting through an activity • Introduced stakeholder theory LO3: Compare and contrast financial and management accounting

Identified differences as follows:

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Report nature Level of detail Restrictions Reporting interval Time horizon Range of information

Financial accounting • General purpose • Aggregated • Standardised or regulated • Less frequently • Backward-looking • Primarily monetary and objective

Management accounting • Special purpose • Dissected • Minimum restrictions • More frequently • Forward-looking • Often non-monetary with less objective constraints

LO4: Identify the main purpose of a business, and explain the traditional risk–return relationship

• Identified wealth enhancement as the main objective of a business • Discussed a range of other secondary objectives that may influence the way in which a business is run • Explained the need to retain a balance between risk and return

LO5: Provide an overview of the main financial reports prepared by a business

• Illustrated the need for and development of the statement of cash flows, the statement of financial position and the statement of financial performance (profit and loss account) • Identified the typical management accounting reports prepared

LO6: Outline the main types of business ownership, describe the way in which a business is typically organised and managed, and explain the importance of accounting in a business context

• Identified and outlined the main kinds of business ownership

LO7: Identify ways in which business and accounting have been changing, together with some current issues confronting businesses and their associated reporting, including current thinking on ethics in business

• Identified the ways in which business has become increasingly complex and turbulent • Explained how internationalisation of business has led to harmonisation of accounting rules • Identified areas of concern and current activity in accounting, as a result of the greater complexity • Outlined the importance of ethics in business

• sole proprietorship • partnership • limited company • Outlined the ways in which a business is typically managed • Identified ways in which accounting is likely to be used • Identified a range of not-for-profit organisations, and explained that their information needs are similar to those of for-profit organisations

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

LO8: Explain why accounting information is generally considered to be useful, and why you need to know the basics of accounting

• Explained that accounting is central to all businesses, and that a basic knowledge is essential if you are to fulfil a managerial role in a business

LO9: Identify the learning outcomes associated with the Australian Learning and Teaching Council’s Academic Standards Statement for Accounting: namely judgement; knowledge; application skills; communication and teamwork; and self-management; and examine how these compare with characteristics of successful business people

• Identified and discussed the ALTC Academic Standards and threshold learning outcomes for Accounting • Introduced some perceived characteristics of successful business people • Discussed through an activity whether these are consistent with each other

REFERENCE CPA Australia, ‘An overview of APES 110: Code of Ethics for Professional Accountants’, April 2014, www.cpaaustralia.com.au/professional-resources/ethics/apes/overview.

DISCUSSION QUESTIONS

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EASY 1.1

LO1

What is the purpose of producing accounting information?

1.2

LO6

Why is it important to have a partnership agreement specifying the arrangement for allocating (dividing) profits between the partners?

1.3

LO3

What type of accounting information is produced more frequently? Why?

1.4

LO4

List three reasons for starting a business. Explain which reason is most important and why.

1.5

LO5

Identify the similarities and differences between the three major external financial reports (statement of financial position, statement of financial performance, statement of cash flows).

1.6

LO6

Distinguish between ‘accounting entities’ and ‘legal entities’ as business structures.

1.7

LO7

As business changes, accounting must change. Do you agree?

1.8

LO8

‘Understandability’ is identified in the text as a key characteristic of accounting information. By whom should the financial reports be readily understood?

1.9

LO3/4/6

Distinguish between ‘planning’ and ‘control’.

1.10 LO3/4/6

Within a business, how can accounting facilitate control?

1.11 LO3/4/6

How are annual budgets linked to the long-term plans of an organisation?

INTERMEDIATE 1.12 LO1

‘Relevance’ and ‘reliability’ represent two key qualitative characteristics of accounting information. What do these two terms mean in an accounting context? Are they in conflict?

1.13 LO2

As an owner of a small business, what are three key financial attributes of the business you would wish to assess when you review financial reports?

1.14 LO3

Reconcile financial accounting with management accounting. Your textbook clearly distinguishes between them. What are the similarities?

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ACCOUNTING FOR BUSINESS STUDENTS

1.15 LO4

What is meant by the ‘risk–return’ relationship? Provide a non-accounting example of the trade-off between risk and return.

1.16 LO6

Describe two advantages for each type of business organisation.

1.17 LO7

In relation to recent corporate crashes, what have been the main lessons in relation to the accounting process (recording and reporting procedures)?

1.18 LO8

Which economic principle should determine which accounting information should be produced? Should economics be the only issue here? (Consider who the users of accounting information are.)

1.19 LO5/6

Accounting is said to perform a ‘decision-usefulness role’ as well as an ‘accountability (stewardship) role’. Distinguish between these two roles and provide an example of each.

1.20 LO6

Control in accounting is linked to timely comparison between actual and budget figures. What are the implications of this relationship for: (a) the budgeting process, and (b) the financial reporting process?

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CHALLENGING 1.21 LO1

Financial accounting statements tend to reflect past events. In view of this, how can they help a user make a decision when decisions, by their very nature, can only be made about future actions?

1.22 LO2/6

However a business is organised, it must meet the needs or demands of various stakeholders. •

What are the different types of business structure?

•

What is meant by the term ‘stakeholder’?

•

Who are the stakeholders for each type of business?

•

What are their needs or demands, and why should they be met?

•

Will stakeholder demands affect the choice of business structure?

1.23 LO3

You have just graduated from university with an accounting degree and are about to start jobhunting. You want to have a job that will allow you to use your creative streak. Discuss how creativity will enhance or inhibit your performance as a financial accountant, and as a management accountant.

1.24 LO4

The global financial crisis showed us that risk is bad. Do you agree?

1.25 LO5

‘The statement of financial performance reflects the financial performance for the period and explains the changes in the statement of financial position.’ Do you agree or disagree with this statement? Why?

1.26 LO7

It has been suggested that the global financial crisis might have been avoided if we had used cashbased accounting. Discuss.

1.27 LO8

Which financial information would be useful if you were running the sales department of a large business? Can you think of any non-financial information that you might want to have?

1.28 LO7

Access the overview of APES 110 on the internet. How important, in your opinion, is acceptance of the overarching responsibility by professional accountants to act in the public interest? Discuss the fundamental principles of the code. Discuss what you think would be an appropriate course of action if you felt that compliance with the fundamental principles was threatened?

1.29 LO1–8

Accounting is normally defined in terms of ‘recording, classifying, summarising and communicating economic information about a reporting entity’. Explain and provide an example of the following key terms used in this definition: •

classifying

•

summarising

•

communicating

•

economic information.

1.30 LO9

How important do you think communication and teamwork is in business?

1.31 LO9

Self-management is one of the key threshold learning outcomes expected of new graduates embarking on a career in accounting. This is almost certainly expected of any business graduate as well. What do you understand by this term and how might you ensure that you achieve this outcome.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

CHAPTER 1 CASE STUDY Below is an article which illustrates the importance of collecting and using good financial numbers. Read the article and answer the questions that follow.

If you have the numbers, use them

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A reluctance to do the necessary financial analysis leaves many businesses flying blind. There is a great challenge facing business owners today—whatever they’re selling can usually be found cheaper online. That’s the rule for the internet age. And while you offer something of value, your prospective customers may be willing to pay shipping and handling if they can shave 20–30% off the asking price. Just ask Harvey Norman, Dick Smith or Borders. Business models are hard to change—and the tendency is to cut prices and costs to cope with this new rule. And that raises another challenge. How do you take such action and avoid going under? This is a real problem when many business owners don’t truly know how their operation is travelling day-today. US author Michael Gerber, of The E-Myth fame, talks about ‘entrepreneurial seizure’, in which a business owner falls victim to the ‘most disastrous assumption anyone can make’ about going into business, an assumption made by all people who have some skills and who go into business for themselves. That ‘fatal assumption’ (Gerber’s words) is that ‘if you understand the technical work of a business, you understand a business that does that technical work. And the reason it’s fatal is that it just isn’t true.’ In fact, it’s the root of most small business failures. Most people aren’t highly literate in financial management. Do you know the difference between cash and profit? Or direct and fixed costs? Or how to manage your accountant? Surprisingly, many business owners say no to these questions. But without financial management, they’re driving without a dashboard. Wayne Burgan, founder and chief executive of Cashflow-manager.com.au believes that in today’s competitive climate many small and mediumsized businesses fail to scrutinise their financial statements and reports. ‘They get the statements from their accountant and focus only on what they need to pay the tax office,’ he says. ‘Few do any financial analysis. Most don’t particularly like or understand financial management. They leave it to others.’ Burgan, a Certified Practising Accountant and a 20-year veteran of helping business owners become better financial managers, says that getting SMBs to do any real financial analysis, such as

a debtor analysis, cashflow forecast or accounts receivable, is crucial. Setting prices in a competitive framework requires analysis. Matching competitors’ prices may be necessary, but discounting can be dangerous to an SMB’s financial health. ‘Some business owners discount without fully appreciating the effect on profits,’ Burgan says. ‘For the average business a 10 per cent discount would need something like a 30 per cent increase in volume to maintain profit levels.’ Pricing is very much a strategic financial issue. Exactly how much profit you want to make, and by when, should show up in your overall strategic objectives. The message is to start looking at the numbers. If you have a system that can produce timely and accurate financial statements, use them. The key reports are the balance sheet, which delivers a picture of how well your investment in the business is performing; income statements, which tell you the cost of doing business; gross margin and profits; and cashflow statements, which forecast cash-crunch times. Financial management is about looking at the history of actual sales, so you can accurately estimate output and assess the differing sales of products and services. It’s about determining how much profit you’ll make by selling X product at Y dollars. Discounting may be one way to meet the competition, but if you can’t increase volumes, you might consider trimming some fat, either in fixed costs, inventory or less profitable lines. ‘With financial analysis you may find that some products or services are costing more to provide than you can ever recoup,’ Burgan says. Business owners will want to run different scenarios to determine the outcome of various price points for a product or service. Not everyone will opt for a discounting solution. When a customer feels that the value they’re receiving is worth more than the money they are exchanging for it, there’s no real competition. ‘You should be able to find a price that will work for both you and your customers. You need timely information and a system to produce reports. Today, business needs to invoice quickly and have an efficient collection method. You need to follow up.’

Source: Morris Kaplan, The Deal—The Australian Business Magazine, vol. 5, no. 1, February 2012, p. 32. News Corp.

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ACCOUNTING FOR BUSINESS STUDENTS

QUESTIONS 1

What is the main issue in running a business in the internet age?

2

What is likely to be the impact on profits of a business cutting prices to meet the competition?

3

Explain what is meant by ‘the most disastrous assumption anyone can make’.

4

Casual observation suggests that the life span of many cafes or similar businesses is very short. Yet many are run by very good cooks and make good coffee. Suggest why this phenomenon might occur.

5

Do you know the difference between profit and cash? Explain.

6

Why might you choose to use an accountant to maintain a sound system of financial reporting if you were to run a small business?

7

What kind of financial information might be useful to you in running a small business?

8

Explain what you understand by a debtors or accounts receivable analysis.

9

What kind of information would you need before you set a price for a product that you wish to sell?

10

Why does the article suggest that discounting can be dangerous to an SMB’s health?

11

Assume that you plan to sell a product for $10 that costs you $6. At that price you expect to be able to sell 1,000 units. You are being pressured to discount the price by 10%. How many units will you need to be able to sell to obtain the same amount of profit (ignoring other costs)?

12

What is the main message of the article?

13

Which ways were identified for ‘trimming the fat’?

14

What do you think might be meant by the term ‘scenario analysis’?

Concept check answers CC1 CC2 CC3 CC4 CC5

A C D D A

CC6

CC7 CC8 CC9

Possibly C though more likely to be E E D B

CC10 B but also C and E CC11 A CC12 D CC13 D CC14 B

CC15 CC16 CC17 CC18 CC19

E E A C E

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SOLUTIONS TO ACTIVITIES ACTIVITY 1.1 It would be very useful if accounting reports could be understood by everyone. This, however, is unrealistic, as complex financial events and transactions cannot normally be expressed in simple terms. It is probably best that we regard accounting reports in the same way that we regard a report written in a foreign language. To understand either of these, we need to have had some preparation. When producing accounting reports, it is normally assumed that the user not only has a reasonable knowledge of business and accounting, but is also prepared to invest some time in studying the reports.

ACTIVITY 1.2 Your answer may be along the following lines: User group

Decision

Customers

Whether to take further motor policies with PI. This might involve an assessment of PI’s ability to continue in business and to meet their needs, particularly in respect of any insurance claims made.

Competitors

How best to compete against PI or, perhaps, whether to leave the market on the grounds that it is not possible to compete profitably with PI. This might involve competitors using PI’s performance in

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

various aspects as a ‘benchmark’ when evaluating their own performance. They might also try to assess PI’s financial strength and identify significant changes that may signal PI’s future actions (e.g. raising funds as a prelude to market expansion). Employees

Whether to continue working for PI and, if so, whether to demand higher rewards for doing so. The future plans, profits and financial strength of the business are likely to be of particular interest when making these decisions.

Government

Whether PI should pay tax and, if so, how much, whether it complies with agreed pricing policies, whether financial support is needed and so on. In making these decisions, an assessment of PI’s profits, sales revenues and financial strength would be made.

Community

Whether to allow PI to expand its premises and/or whether to provide economic support for the business. PI’s ability to continue to provide employment for the community, the extent to which it is likely to use community resources, and its likely willingness to help fund environmental improvements are likely to be considered when arriving at such decisions.

Investment analysts

Whether to advise clients to invest in PI. This would involve an assessment of the likely risks and future returns associated with PI.

Suppliers

Whether to continue to supply PI and, if so, whether to supply on credit. This would involve an assessment of PI’s ability to pay for any goods and services supplied.

Lenders

Whether to lend money to PI and/or whether to require repayment of any existing loans. PI’s ability to pay the interest and to repay the principal sum would be important factors in such decisions.

Managers

Whether the performance of the business needs to be improved. Performance to date would be compared with earlier plans or some other ‘benchmark’ to decide whether action needs to be taken. Managers may also wish to decide whether there should be a change in PI’s future direction. This would involve looking at PI’s ability to perform and at the opportunities available to it.

Owners

Whether to invest more in PI or to sell all, or part, of the investment currently held. This would involve an assessment of the likely risks and returns associated with PI. Owners may also be involved with decisions on rewarding senior managers. The financial performance of the business would normally be considered when making such a decision.

Although this answer covers many of the key points, you may have identified other decisions and/or other factors to be taken into account by each group.

ACTIVITY 1.3 We thought of two points: • Managers will, at times, be interested in receiving an historical overview of business operations of the sort provided to other users. • Other users would be interested in receiving information relating to the future, such as the planned level of profits, and non-financial information, such as the state of the sales order book and the extent of product innovations.

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ACTIVITY 1.4 A government savings account is normally a very safe investment. Even if a government is in financial difficulties, it can always print more money to repay investors. Returns from this form of investment, however, are normally very low. Investing in a lottery ticket runs a very high risk of losing the whole amount invested. This is because the probability of winning is normally very low. However, a winning ticket can produce enormous returns. Thus, the government savings account should be placed towards the far left of the risk–return line and the lottery ticket towards the far right.

ACTIVITY 1.5 Statement of cash flows for day 3

$

Opening balance (from day 2)

900

Sale of wrapping paper

390 1290

Purchase of wrapping paper

600

Closing balance

690

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ACCOUNTING FOR BUSINESS STUDENTS

Statement of financial performance for day 3

$

Sales

390.00

Cost of goods sold (½ of $(600 1 75))

337.50

Profit

52.50

Statement of financial position at the end of day 3

$

Cash

690.00

Inventory (½ of $(600 1 75))

337.50

Total assets

1027.50

5 Paul’s wealth in the business—equity

1027.50

ACTIVITY 1.6 In practice, decision-makers may not be as rational and capable as implied in the planning process. Individuals may find it difficult to handle large amounts of information about a wide range of options. As a result, they may restrict their range of options or discard some information to avoid becoming overloaded. They may also adopt rather simple approaches to evaluating such a mass of information. For example, they might ignore any information that does not fit well with the decision-makers’ desired outcome.

ACTIVITY 1.7 There have been a number of corporate crashes, by far the most significant being HIH Insurance. Others that have had wide press coverage include OneTel, ABC Learning Centres, Allco, Timbercorp and Great Southern Plantations. Recently we have had Dick Smith.

ACTIVITY 1.8 Other sources of information available include: • • • • • • • •

meetings with managers of the business public announcements made by the business newspaper and magazine articles websites, including the website of the business radio and TV reports information-gathering agencies (e.g. agencies that assess businesses’ creditworthiness or credit ratings) industry reports, and economy-wide reports.

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These sources can provide information on various aspects of the business, such as new products or services being offered, management changes, new contracts offered or awarded, the competitive environment within which the business operates, the impact of new technology, changes in legislation, changes in interest rates and future levels of inflation. However, the various sources of information identified are not really substitutes for accounting reports. Rather, they are best used in conjunction with the reports in order to obtain a clearer picture of the financial health of a business.

ACTIVITY 1.9 (a) The characteristics appear to include: • • • • • • • • • • • •

ability to be analytical confidence self-belief determination emotional fortitude hard work taking responsibility/avoiding blaming others independence balanced/not obsessive self-awareness ability to take criticism ability to be a member of a team.

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(b) • Judgement implies self-awareness, balance and an ability to analyse. • Communication and teamwork implies an ability to take responsibility and not blame others, to be able to take criticism and to be an effective member of a team. • Self-management implies self-awareness, independence, self-belief and confidence. • Application skills imply hard work and determination.

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There appears to be a high degree of consistency between the characteristics and the outcomes. The characteristics identified, however, don’t all necessarily work together. A passion for hard work can sometimes result in obsession, or a feeling that others are not pulling their weight. Teamwork, to be effective, requires everyone to be working together. This can be very difficult to achieve. Dealing with criticism can be difficult, even if well intentioned. Emotional fortitude can usually last for only so long. Overall, both the characteristics and the learning outcomes have a high degree of consistency, but vigilance and care is always necessary.

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C H A P T E R X2

MEASURING AND REPORTING CHAPTER NAME FINANCIAL POSITION LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain the nature and purpose of the statement of financial position (balance sheet) and its component parts

LO2 Explain the accounting equation, and use it to build up a statement of financial position at the end of a period

LO3 Classify assets and claims LO4 Apply the different possible formats for the statement of financial position LO5 Identify the main factors that influence the content and values in a statement of financial position

LO6 Explain the main ways in which the statement of financial position can be useful for users of accounting information

LO7 Identify the main deficiencies or limitations in the statement of financial position.

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The next seven chapters essentially deal with the area known as financial accounting. In this chapter, we examine the first of the major financial reports—this report is concerned with establishing financial position. The statement of financial position, traditionally labelled the ‘balance sheet’, represents the assets of an entity and the claims against those assets, at a given point in time. The interests in, or claims against, the assets are divided into external (liability) and internal (owners’) interests. We will see how the statement is made up and how the report is prepared. We will also consider the basis on which accounts are included, measured and reported. Finally, its usefulness in decision-making will be considered and possible deficiencies highlighted. In order to enable us to focus primarily on the nature of the accounting process in this chapter and Chapter 3, we will concentrate on relatively simple business structures, mainly sole proprietorships and partnerships, although the same principles apply to limited companies. However, given the size, complexity and range of regulatory issues that confront larger companies, we have deliberately left detailed company accounting to Chapters 6 and 7.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

NATURE AND PURPOSE OF THE STATEMENT OF FINANCIAL POSITION The purpose of the statement of financial position is to set out the financial position of a business at a particular point in time. It is also referred to as a ‘balance sheet’. Both terms have been used in recent years. The current recommendation is that the term ‘statement of financial position’ is to be used. This statement represents a summary of information provided in the accounts, and is effectively a listing of the balances in all of the detailed accounts—this is where the term ‘balance sheet’ comes from. The statement of financial position sets out the assets of the business on the one hand, and the claims against it on the other. Before looking at the statement in more detail, we need to be clear what these terms mean.

LO1 Explain the nature and purpose of the statement of financial position (balance sheet) and its component parts

Assets An asset, for accounting purposes, is essentially a business resource that has certain characteristics. The main characteristics of an asset are:

• A probable future economic benefit. This simply means that the item is expected to have

•

•

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•

some future monetary value, which can arise through its use in the business or through its hire or sale. Thus, an obsolete piece of equipment that can be sold for scrap would still be considered an asset, whereas an obsolete piece of equipment that could not be sold for scrap would not be regarded as an asset. The business has an exclusive right to control the benefit. Unless the business has exclusive rights over the resource, it cannot be regarded as an asset of the business. Thus, for a business offering holidays on barges or houseboats, a canal and river system is a very valuable resource. However, as the business cannot control others’ access to the system, it cannot be regarded as an asset of the business (but its barges and houseboats would count as assets). The benefit must arise from some past transaction or event. This means the transaction (or other event) giving rise to the business’s right to the benefit must have already occurred and will not arise at some future date. Thus, if a business agrees to purchase a piece of machinery at some future date, this does not make the item one of its assets at this point in time. The asset must be capable of reliable measurement in monetary terms. Unless the item can be measured in monetary terms with a reasonable degree of reliability, the item will not be included as an asset on the statement of financial position. For example, customer loyalty may be valuable to the business but impossible to quantify. Similarly, the title of a magazine (e.g. New Idea or Wheels) that was created by its publisher may be extremely valuable to that publishing business, but this value is usually difficult to quantify. It will not therefore be treated as an asset.

Note that all four of these conditions must apply. If one of them is missing, the item will not be treated as an asset for accounting purposes, and will not, therefore, appear on the statement of financial position. Figure 2.1 summarises the above discussion in the form of a decision chart. We can see that these conditions will strictly limit the kind of items that may be referred to as ‘assets’ in the statement of financial position. Certainly not all resources exploited by a business will be assets of the business for accounting purposes. Some, like the canal system or the magazine title Wheels, may well be assets in a broader sense, but not for accounting purposes. Once an asset has been acquired by a business, it will continue to be considered an asset until the benefits are exhausted or the business disposes of it in some way. Examples of items that often appear as assets in a business statement of financial position include: freehold premises; machinery and equipment; fixtures and fittings; patents and trademarks; accounts receivable; investments; cash; and inventories. Note that an asset does not have to be a physical item—it may also be a non-physical right to certain benefits. Assets that have a real physical substance are referred to as tangible assets (e.g. inventory, plant and equipment). Assets that have no physical substance but still represent potential benefits are referred to as intangible assets (e.g. copyright, trademark, patent, franchise, goodwill).

asset A resource held by a business which has certain characteristics.

tangible assets Those assets that have a physical substance (e.g. plant and machinery, motor vehicles). intangible assets Assets which, while providing expected future benefits, have no physical substance (e.g. copyrights, patents).

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FIGURE 2.1 Decision chart for identifying an accounting asset

Is there a probable future economic benefit?

An item must possess each of the four characteristics identified to be regarded as an asset.

No

Yes

Does the benefit arise from a past transaction or event?

No

Yes

Is there a right to control the resource?

No

Yes

Can the resource be reliably measured in financial terms

No

Yes

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Accounting asset

claim An obligation on the part of the business to provide cash or some other benefit to an outside party. liabilities Claims of individuals and organisations, apart from the owner(s), that have arisen from past transactions or events, such as supplying goods or lending money to the business.

Not an accounting asset

Claims against the assets The other side of the statement of financial position includes claims against the assets of an entity, or simply the different interests in those assets. There are essentially two types of claims: external claims, known as liabilities; and internal, or ownership, claims, labelled equity, owners’ equity or capital.

Liabilities

Liabilities represent the claims of individuals and organisations, apart from those of the owner(s), which have arisen from past transactions or events, such as supplying goods and services or lending money to the business. Examples include accounts payable (creditors), bank overdrafts, personal loans, mortgages and provisions (estimates) for warranty, long-service leave, holiday pay and owners’ equity taxation. In order to be recognised as a liability, the same kinds of recognition criteria that apply to The claim of the owner(s) on assets also apply, which means the probability of occurrence and reliability of measurement need the assets of the business. to be considered. capital Most liabilities represent legal claims by external parties against the entity for satisfaction The share of the business in cash (e.g. bills or accounts payable) or for the provision of goods and services (e.g. which represents the owners’ interests. subscriptions received in advance). Another type of liability is generally classified as provisions. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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Provisions are estimated liabilities, for which there is rather less certainty regarding the

amount or timing. Provisions typically include income tax, long-service leave, warranties, etc. In certain instances, the situation arises in which a potential liability exists that might arise on the occurrence of a particular event. This is known as a contingent liability. It will become a liability contingent on that event happening. This situation does not satisfy the definition of a liability, so will not be included in the statement of financial position. For limited companies, such contingent liabilities will normally be included in the annual report as a note.

ACTIVITY 2.1 Indicate which of the following items could appear as an asset or a liability on the statement of financial position of business A. Explain your reasoning in each case. (a) $1,000 owing to business A by a customer who will never be able to pay. (b) The purchase of a licence from business B giving business A the right to produce a product designed by business B. Production of this new product is expected to increase profits over the period in which business A holds the licence. (c) The hiring by business A of a new marketing director who is confidently expected to increase profits by at least 30% over the next three years. (d) The purchase by business A of a machine that will save $10,000 per annum. It is currently being used by business A, but it has been acquired on credit and is not yet paid for. (e) $2,000 owing to business B for the satisfactory supply of goods during the past month. (f) Magazine subscriptions worth $27,400 have been received in advance by business A. (g) Business A has guaranteed a manager’s personal loan of $100,000. The manager has maintained the account in good order and $79,000 is currently owing. (h) There is a legal claim against business A for negligence over faulty workmanship. It is likely that they will settle out of court for $50,000.

provisions An estimated liability for which there is greater uncertainty regarding the amount or timing of the amount than for a normal liability. contingent liability A potential liability that might arise in the event of a particular event occurring. It will become a liability contingent on that event happening.

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Owners’ equity (OE, or simply ‘equity’) This represents the claim of the owner(s) against the business, and is sometimes referred to as the ‘owners’ capital’. Equity can be defined as the ‘residual interest in the assets of the entity after deducting all of its liabilities’. Some find it hard to understand how the owner can make a claim against the business, particularly when we consider a sole proprietor-type business like Paul’s from Chapter 1, where the owner is, in effect, the business. However, for accounting purposes, a clear distinction is made between the business (whatever its size) and the owner(s). The business is viewed as being quite separate from the owner, irrespective of whether the business has a separate legal identity or not. This means that when financial reports are prepared, they are prepared for the business rather than the owner(s). From this perspective, therefore, any funds the owner contributes to help finance the business are regarded as a claim against the business in its statement of financial position. The equity section of the statement of financial position is broadly the same irrespective of the type of business concerned. We shall see in Chapter 6 that, with limited companies, the total equity figure must be analysed according to how each part of it first arose. For example, companies must make a distinction between the part of it that arose from retained earnings (or profits) and the part that arose from the owners putting in cash to start up the business, usually by buying shares in the company. Once a claim from the owners or outsiders has been incurred by a business, it will remain as an obligation until it is settled.

Concept check 1 The statement of financial position: A B C D E

49

Is prepared at a particular point in time Is also referred to as a balanced sheet Consists of assets, reliabilities and equity All of the above are true None of the above are true.

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Concept check 2 Which of the following is a main characteristic of an asset? A B C D E

Possible future economic benefit. Exists from a future transaction or event. The business has an exclusive right to control the benefit. Cannot be reliably measured in monetary terms. All of the above are key asset characteristics.

Concept check 3 A potential liability exists that might arise on the occurrence of a particular event is known as: A B C D

LO2 Explain the accounting equation, and use it to build up a statement of financial position at the end of a period

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2.1

E

A provision A creditor A contingent liability A debt All of the above.

THE ACCOUNTING EQUATION Now that the meanings of the terms ‘assets’, ‘liabilities’ and ‘owners’ equity’ have been established, we can go on to discuss the relationship between them. It is quite simple and straightforward: if a business wishes to acquire assets it will have to raise the necessary funds from somewhere. It may raise the funds from the owner(s) or from other outside parties, or from both. The relationship is demonstrated by the new business outlined in Example 2.1.

Jerry and Co. deposits $20,000 in a bank account on 1 March to commence business. Let us assume that the cash is supplied by the owner ($6,000) and an outside party ($14,000). Raising the funds this way will give rise to a claim on the business by both the owner (capital) and the outside party (liability). If a statement of financial position of Jerry and Co. is prepared following the above transactions, the assets and claims of the business will appear as follows: Jerry and Co. Statement of financial position as at 1 March Assets Cash at bank

$ 20,000

Total assets

20,000

Claims Owners’ equity Liability—loan Total liabilities and owners’ equity

$ 6,000 14,000 20,000

We have chosen a two-sided, traditional-style statement for our example. This is primarily because this links easily with the formal recording process, which will be covered in Chapter 4. At a later stage, we will discuss other formats that are in more common use for published reports. We can see from the statement that has been prepared that the total claims are the same as the total assets. Thus: Assets 5 Owners’ equity 1 Liabilities The equation shown above—often referred to as the ‘accounting equation’—will always hold true. Whatever changes may occur to the business’s assets or the claims against it, compensating changes

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51

elsewhere will ensure that the statement of financial position always ‘balances’ (i.e. both sides agree). For example, consider some further possible transactions for Jerry and Co. Assume that, after the $20,000 had been deposited in the bank, the following transactions took place: March 2 March 3 March 4 March 6

Purchased a motor vehicle for $5,000 paying by cheque. Purchased inventory (stock-in-trade, goods to be sold) on one month’s credit for $3,000. (This means that the inventories were bought on 3 March, but payment will not be made until 3 April.) Repaid $2,000 of the loan from the outside party. Owner introduced another $4,000 into the business bank account.

2.1 continued

A statement of financial position may be drawn up after each day in which transactions have taken place. In this way, the effect of each transaction on the assets and the claims against them can be seen. The statement of financial position as at 2 March will be as follows: Jerry and Co. Statement of financial position as at 2 March Assets Cash at bank Motor vehicle Total assets

$ 15,000 5,000 20,000

Claims Owners’ equity Liabilities—loan Total liabilities and owners’ equity

$ 6,000 14,000 20,000

As you can see, the effect of purchasing a motor vehicle is to decrease the balance at the bank by $5,000 and to introduce a new asset—a motor vehicle—onto the statement. The total assets remain unchanged; only the ‘mix’ of assets has changed. The claims against the business remain the same, as there has been no change in the funding arrangements for the business. The statement of financial position as at 3 March, following the purchase of inventory, will be as follows: Jerry and Co. Statement of financial position as at 3 March Assets Cash at bank Motor vehicle Inventory Total assets

$ 15,000 5,000 3,000 23,000

Claims Owners’ equity Liabilities—loan Liabilities—accounts payable Total liabilities and owners’ equity

$ 6,000 14,000 3,000 23,000

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The effect of purchasing inventory has been to introduce another new asset (inventory) to the statement of financial position. In addition, the fact that the goods have not yet been paid for means that the claims against the business have been increased by the $3,000 owed to the supplier, who is referred to as ‘accounts payable’ on the statement of financial position. Accounts payable is also known as ‘payables’ or ‘creditors’.

ACTIVITY 2.2 Try drawing up a statement of financial position for Jerry and Co. as at 4 March and as at 6 March.

Example 2.1 illustrates the point made earlier that the accounting equation (owners’ equity 1 liabilities 5 assets) will always hold true because the equation is based on the fact that, if a business wishes to acquire assets, it must raise funds equal to the cost of those assets. These funds must be provided by the owners (owners’ equity) or other outside parties (liabilities), or both. Hence, the total cost of assets acquired should always equal the total owners’ equity (capital) plus liabilities. It is worth pointing out that a business would not draw up a statement of financial position after each day of transactions, as shown in Example 2.1. Such an approach is likely to be impractical given even a relatively small number of transactions each day. A statement of financial position for a business is usually prepared at the end of a defined reporting period. Determining the length of the reporting period involves weighing up the costs of producing the information against its perceived benefits for decision-making purposes. In practice, the reporting period varies between businesses,

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and could be monthly, quarterly, half-yearly or annually. For external reporting purposes, an annual reporting cycle is the norm (although certain large companies report more frequently than this). However, for internal reporting purposes, many businesses produce monthly financial reports.

The effect of trading operations on the statement of financial position In Example 2.1, we dealt with the effect on the statement of financial position of a number of different types of transactions that a business might undertake. These transactions covered the purchase of assets for cash and on credit, the repayment of a loan and the injection of owners’ equity. However, one form of transaction—namely, trading (an asset is sold for a price that is different from the cost to acquire or manufacture that asset)—has not yet been considered. To deal with the effect of trading transactions on the statement of financial position, let us return to Example 2.1.

We will use the statement of financial position drawn up for Jerry and Co. as at 6 March in the solution to Activity 2.2 (page 88). The statement of financial position was as follows:

2.1 continued

Jerry and Co. Statement of financial position as at 6 March Assets Cash at bank Motor vehicle Inventory Total assets

$ 17,000 5,000 3,000 25,000

Claims Owners’ equity Liabilities—loan Liabilities—accounts payable Total liabilities and owners’ equity

$ 10,000 12,000 3,000 25,000

Let us assume that, on 7 March, the business managed to sell all of its inventory for $5,000 and received a cheque immediately from the customer for this amount. The statement of financial position on 7 March, after this transaction has taken place, will be as follows: Jerry and Co.

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Statement of financial position as at 7 March Assets Cash at bank (17,000 1 5,000) Motor vehicles Inventory (3,000 2 3,000)

$ 22,000 5,000 —

Total assets

27,000

Claims Owners’ equity [10,000 1 (5,000 2 3,000)] Liabilities—loan Liabilities—accounts payable Total liabilities and owners’ equity

$ 12,000 12,000 3,000 27,000

We can see that the inventory ($3,000) has now disappeared from the statement of financial position, but the cash at bank has increased by the selling price of the inventory ($5,000). The net effect has, therefore, been to increase assets by $2,000 (i.e. $5,000 2 $3,000). This increase represents the net increase in wealth (profit) which has arisen from trading. Also note that the owners’ equity in the business has increased by $2,000 in line with the increase in assets. This increase in owners’ equity reflects the fact that increases in wealth as a result of trading or other operations will be to the benefit of the owner and will increase his or her stake in the business.

It is appropriate to consider just what the effect would have been on the statement of financial position if the inventory had been sold on 7 March for $1,000 rather than $5,000. The statement of financial position on 7 March would be as follows: JERRY AND CO. Statement of financial position as at 7 March Assets Cash at bank Motor vehicle

$ 18,000 5,000

Total assets

23,000

Claims Owners’ equity [10,000 1 (1,000 2 3,000)] Liabilities—loan Liabilities—accounts payable Total liabilities and owners’ equity

$ 8,000 12,000 3,000 23,000

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As we can see, the inventory ($3,000) will disappear from the statement of financial position, but the cash at bank will rise by only $1,000. This will mean a net reduction in assets of $2,000. This reduction will be reflected in a reduction in the equity of the owner(s). We can see that any decrease in wealth (loss) arising from trading or other transactions will lead to a reduction in the owners’ stake in the business. If the business wished to maintain the level of assets as at 6 March, it would have to obtain further funds from the owner(s) or outside parties, or both. What we have just seen means that—assuming that the owner(s) makes no injections or withdrawals of equity during the period—the accounting equation can be extended as follows: Assets at the end of the period 5 Owners’ equity at the beginning 1 Profit (or 2 Loss) 1 Liabilities at the end of the period

Any funds introduced by the owner(s), or withdrawn by the owner(s) for living expenses or other reasons, will further extend the accounting equation as follows: Assets at the end of the period 5 Owners’ equity at the beginning 1 Profit (or 2 Loss) 6 Other owners’ equity changes 1 Liabilities at the end of the period

These additions and withdrawals are typically shown separately on the statement of financial position, as is the profit figure for the period. Thus, if we assume that the above business sold the inventory for $5,000, as in the earlier example, and further assume that the owner withdrew $1,500 of the profit, the owners’ equity would appear as follows on the statement of financial position: Owners’ equity Opening balance Add profit

$ 10,000 2,000 12,000 1,500 10,500

Less drawings Closing balance

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If the drawings were in cash, then the balance of cash would decrease by $1,500 in the statement of financial position. It is highly unlikely that a statement of financial position will be required on a daily basis, but rather at the end of a specified period, typically at the end of a month or year. The same approach could theoretically be used to build up a statement of financial position at the end of a period. Self-assessment question 2.1 requires you to try to do this.

SELF-ASSESSMENT QUESTION

2.1

The statement of financial position of a business at the start of a week is as follows: Statement of financial position as at 7 February 2018 Assets Accounts receivable Inventory Furniture and fittings Freehold premises

$ 33,000 28,000 63,000 145,000 269,000

Claims Accounts payable Bank overdraft Capital (Equity)

$ 23,000 43,000 203,000 269,000

During the next week the following transactions took place: 1 Sold inventory for $11,000 cash. This inventory had cost $8,000. 2 Sold inventory for $23,000 on credit. This inventory had cost $17,000.

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3 Received cash from accounts receivable totalling $18,000. 4 The owners of the business contributed $100,000 of their own money, which was placed in a business bank account. 5 The owners contributed a second-hand motor vehicle at the start of the business, valued at $10,000 to be used in the business. No cash is involved in this transaction. 6 Bought inventory on credit for $14,000. 7 Paid accounts payable of $13,000. 8 Paid wages of $2,000. Show the statement of financial position after all these transactions have been reflected.

An alternative to the system of pluses and minuses is a worksheet approach. Table 2.1 provides an illustration of how a worksheet can achieve the same result. It uses the content of Example 2.1.

TABLE 2.1 ACCOUNTING EQUATION AND EFFECTS OF TRANSACTIONS USING A WORKSHEET Assets Cash March 1

20,000

March 2

–5,000

March 3

Inventory

5 Motor vehicle

–2,000

March 6

14,000

March 7

15,000

Accounts payable

Loan 14,000

1

Owners’ equity Owners’ contribution

Retained profit

Drawings

6,000

15,000 13,000

March 4

Liabilities

13,000 –2,000 14,000

–3,000

–1,500

12,000 _

20,500

–

5,000

11,500 3,000

12,000

10,000*

2,000*

1,500*

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*Single account $10,500 (i.e. 10,000 1 2,000 2 1,500).

It should be noted that the drawings figure is effectively a negative figure in the owners’ equity section of the statement of financial position.

Concept check 4 Which of the following correctly shows the effect on the balance sheet of a transaction in which inventory which cost $5,000 is sold on credit for $9,000. A B C D

Inventory increases by $5,000, payables increase by $9,000, capital goes up by $4,000. Inventory decreases by $5,000, receivables increase by $9,000, capital goes up by $4,000. Inventory decreases by $5,000, cash increases by $9,000, capital goes down by $4,000. Inventory increases by $5,000, receivables decrease by $9,000, capital goes down by $4,000.

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Concept check 5 Which of the following is NOT a possible representation of the accounting equation? A B C D E

Owners’ equity 1 Liabilities 5 Assets Assets 5 Liabilities 1 Owners’ equity Assets – Liabilities 5 Owners’ equity Assets – Owners’ equity 5 Liabilities All of the above are valid representations of the accounting equation.

THE CLASSIFICATION OF ASSETS AND CLAIMS LO3

The classification of assets To help users of financial information easily locate items of interest on the statement of financial position, it is customary to group assets, liabilities and equities into categories. This is designed to help users, as a haphazard listing of those items could be confusing. Assets are normally categorised as either current or non-current. The distinction between current and non-current assets is as follows. Current assets are basically assets that are held for the short term. They include cash and other assets that are expected to be consumed or converted to cash, usually within the next 12 months or within the operating cycle. To be more precise, current assets are assets that meet any of the following conditions:

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• • • •

they are held for sale or consumption during the business’s normal operating cycle they are expected to be sold within the next year they are held principally for trading, and/or they are cash, or near-cash (such as easily marketable short-term investments).

The operating cycle normally represents the time between the acquisition of the assets (e.g. raw materials or finished goods) and their ultimate realisation in cash or cash equivalents. Current assets are normally held as part of the day-to-day trading activities of the business. The most common current assets are inventory (stock), accounts receivable (trade debtors), prepayments and cash itself: these are all interrelated and circulate in a business, as shown in Figure 2.2. It is worth making the point here that most sales made by most businesses are made on credit. This is to say that the goods pass, or the service is rendered, to the customer at one point but the customer pays later. Retail sales are the only significant exception to this general practice. We can see that cash can be used to purchase inventory, which is then sold on credit. When the customers pay, the business receives an injection of cash. For purely service businesses, the situation is similar, except that inventories are not involved.

Classify assets and claims

current assets Assets that are not held on a continuing basis. They include cash and other assets which are expected to be consumed or converted to cash, usually within the next 12 months or within the operating cycle. operating cycle Normally represents the time between the acquisition of the assets and their ultimate realisation in cash or cash equivalents.

FIGURE 2.2

Inventory

The circulating nature of current assets Inventories may be sold on credit to customers. When the customers pay, the accounts receivable will be converted into cash, which can then be used to purchase more inventories, and so the cycle begins again. Cash

Accounts receivable

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non-current assets Assets held with the intention of being used to generate wealth rather than being held for resale. They can be seen as the tools of the business, and are normally held by the business on a continuing basis.

Non-current assets are simply assets which do not meet the definition of current assets. They tend to be held for long-term operations, so they are typically held for generating wealth rather than resale (although they may be sold when the business has no further use for them). They can be seen as the tools of the business. Non-current assets may be either tangible or intangible. Tangible non-current assets are normally categorised under a heading of ‘property, plant and equipment’. This is a rather broad term, which includes items such as land and buildings, motor vehicles, and fixtures and fittings. This distinction between assets that are continuously circulating within the business (current) and assets used for long-term operations (non-current) may be helpful when trying to assess the appropriateness of the mix of assets held. Most businesses will need a certain amount of both types of asset to operate effectively. It is important to appreciate that the classification of an asset may vary (i.e. between current and noncurrent) according to the nature of the business being carried out. This is because the purpose for which a particular type of business holds a certain asset may vary. For example, a motor vehicle manufacturer normally holds its motor vehicles for resale and would, therefore, classify them as inventory. On the other hand, a business that uses motor vehicles for transport would classify them as non-current assets. Assets should be classified as non-current when they do not satisfy any of the criteria for being classified as current. The accounting standard relating to presentation of financial statements also permits assets to be classified using the order of liquidity (i.e. the ability to turn the asset into cash), where appropriate. The vast majority of businesses use the current/non-current basis.

ACTIVITY 2.3 (a)

(b)

The assets of Kunalun and Co., a large metalworking business, are shown below: cash at bank fixtures and fittings office equipment motor vehicles freehold factory premises plant and machinery computer equipment stock of work-in-progress (i.e. partly completed goods) short-term investments Which of the above should be defined as current assets, and which should be defined as non-current assets? Can you identify which sort of businesses may prefer to use the liquidity basis rather than the current/non-current basis for classifying assets?

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The classification of liabilities current liabilities Amounts due for repayment to outside parties within 12 months of the statement of financial position date, or within the operating cycle.

Current liabilities are basically amounts due for settlement in the short term. To be more precise, they are liabilities that meet any of the following conditions:

• they are expected to be settled within the business’s normal operating cycle • they are held principally for trading purposes • they are due to be settled within a year after the date of the relevant statement of financial •

non-current liabilities Those amounts due to other parties which are not liable for repayment within the next 12 months after the statement of financial position date.

position, and/or there is no right to defer settlement beyond a year after the date of the relevant statement of financial position.

Non-current liabilities represent amounts due that do not meet the definition of current liabilities and so represent longer-term liabilities. Examples of current and non-current liabilities include: Current

Non-current

Accounts payable Mortgage loan Bank overdraft Long-term loans Bank loan (repayable within 12 months) Revenue received in advance (e.g. subscriptions)

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57

Unlike the case for assets, the purpose for which the liabilities are held is not an issue—only the period for which the liability is outstanding is important. Thus, a long-term liability will turn into a current liability when the settlement date comes within 12 months or one operating cycle of the statement of financial position date. For example, borrowings to be repaid 18 months after the date of a particular statement of financial position will appear as a non-current liability, but will appear as a current liability in the statement of financial position in the following year. This classification of liabilities between current and non-current helps to highlight those financial obligations that must shortly be met. Users can compare the amount of current liabilities with the amount of current assets (i.e. the assets that are either cash or will turn into cash within the normal operating cycle). This comparison should indicate whether a business can cover its maturing obligations. The classification of liabilities between current and non-current should also help to indicate how long-term finance is raised. If a business relies on long-term borrowings to finance the business, the financial risks associated with the business will increase. This is because these borrowings will bring a commitment to make periodic interest payments and capital repayments. The business may be forced to stop trading if this commitment is not fulfilled. Thus, when raising long-term finance, a business must try to strike the right balance between non-current liabilities and owners’ equity.

The classification of owners’ equity Owners’ equity is typically represented in a single account in sole proprietorships (owners’ capital). Typically, the end-of-period balance sheet of a sole proprietorship will simply show the opening capital plus profit less any drawings, giving the end of year capital. However, for most businesses it is useful, or required (as in the case of companies), to provide three separate categories: 1 Owners’ equity contributed—initial funds contributed plus any specific increases. 2 Retained profit (retained earnings)—profits made less any amounts drawn out by the owners. In

the case of partnerships, the profits and drawings are typically collected and shown in a separate current account for each partner. In the case of companies, withdrawals take the form of dividends. Retained earnings shown reflect the cumulative figure after including earnings and dividends. 3 Other reserves—profits that result from other events; for example, if an asset is revalued to a higher value, there will be a corresponding increase in the equity, and this increase is usually put in a revaluation reserve. This area will be dealt with a little later in the chapter, and further expanded in Chapters 6 and 7. It is now common for categories 2 and 3 to be combined: 1 owners’ equity 2 reserves:

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(a) retained profits (b) other reserves.

Table 2.2 shows how equity typically appears for the three types of business structure.

TABLE 2.2 PRESENTATIONS OF EQUITY IN BALANCE SHEETS, BY TYPE OF ENTERPRISE Sole proprietorship

Partnership

Company

Contributed capital

Opening capital plus

Capital accounts Partner A Partner B (etc.)

Capital contributed Share capital

Retained earnings

Profit less drawings 5 closing capital

Current accounts Partner A Partner B (etc.)

Retained earnings

Other reserves

Seldom found other than revaluation reserve

A number are possible, with revaluation being probably the most common

A variety, to be discussed in detail in later chapters

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Concept check 6 Which of the following is NOT a current asset? A B C D E

Cash Equipment Inventory Accounts receivable Debtors.

Concept check 7 Which of the following statements is true? A B C D E

Non-current assets must be tangible. Non-current assets are generally held for sale to customers. Current liabilities are amounts due for settlement within a year or two. Revenue received in advance can be either a current or a non-current liability. Accounts payable are generally classified as a non-current liability.

Concept check 8 Which of the following is NOT a component of owners’ equity? A B C D E

Share capital Retained earnings Contributed capital Revaluation reserve None of the above. All are components of owners’ equity.

FORMATS FOR STATEMENTS OF FINANCIAL POSITION

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LO4 Apply the different possible formats for the statement of financial position

Now that the classification of assets, liabilities and owners’ equity has been completed, it is time to consider the format of the statement of financial position. Although there is an almost infinite number of ways of presenting the same information, there are, in practice, two basic choices. You can either use the horizontal format (across the page) or the narrative format (vertical). If using the latter, you can either use the entity approach (from the viewpoint of the entity) (A 5 L 1 OE) or the proprietary approach (from the viewpoint of the owner) (OE 5 A – L or A – L 5 OE). Figures 2.3 and 2.4 provide an overview of these two perspectives.

FIGURE 2.3 The horizontal layout and entity approach The equation for the horizontal form of statement of financial position layout

Current assets

Non-current assets

Current liabilities

Non-current liabilities

Owners’ equity

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Current assets

Non-current assets

Non-current liabilities

Current liabilities

59

FIGURE 2.4 Capital

The vertical layout and proprietary approach The equation for the vertical form of the statement of financial position layout.

The style we adopted with Jerry and Co. in Example 2.1 represents a horizontal format using the entity equation. A more comprehensive example of this style is shown in Example 2.2.

Illustration of horizontal statement of financial position Brie Manufacturing Statement of financial position as at 31 December 2017 $ Current assets Cash at bank Accounts receivable Inventory

$

48,000 72,000 92,000 212,000

Non-current assets Motor vehicles Plant and machinery Property

76,000 120,000 180,000 376,000

Total assets

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$ Current liabilities Accounts payable

588,000

Non-current liabilities Loan Total liabilities Owners’ equity Opening balance Add profit

$

148,000

2.2

200,000 348,000 200,000 56,000 256,000 (16,000)

Less drawings Ending balance Total liabilities and owners’ equity

240,000 588,000

Note that within each category of asset (current and non-current), the items are listed with the most liquid (starting with cash) first, going down to the least liquid. This is standard practice, followed irrespective of the format used. Liquidity generally relates to cash or closeness to cash. Note also that this approach is not used in all countries. For example, in the United Kingdom the order is typically reversed: the list goes from the least liquid to the most liquid. Overall content is basically the same; only the order changes. In recent years, a more common form of layout for the statement of financial position is the ‘narrative’ or ‘vertical’ form of layout, which is really based on a rearrangement of the accounting equation. With the horizontal format above, the accounting equation is set out as: Current assets (CA) 1 Non-current assets (NCA)

5

Current liabilities (CL) 1 Non-current liabilities (NCL) 1 Owners’ equity (OE)

The vertical format merely rearranges this to: Entity approach CA 1 NCA 5 CL 1 NCL 1 OE

Proprietary approach CA 1 NCA – CL – NCL 5 OE

We can, therefore, rearrange the layout of Brie Manufacturing as shown in Example 2.3 and 2.4. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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Vertical statement of financial position using entity approach Brie Manufacturing

2.3

Statement of financial position as at 31 December 2017 $ Current assets Cash at bank Accounts receivable Inventory

$

48,000 72,000 92,000 212,000

Non-current assets Motor vehicles Plant and machinery Freehold premises

76,000 120,000 180,000 376,000 588,000

Total assets Current liabilities Accounts payable Non-current liabilities Loan Total liabilities Owners’ equity Opening balance Add profit

148,000 200,000 348,000

Less drawings Ending balance Total liabilities and equity

200,000 56,000 256,000 16,000 240,000 588,000

Vertical statement of financial position using proprietary approach Brie Manufacturing

2.4

Statement of financial position as at 31 December 2017 $ Current assets Cash at bank Accounts receivable Inventory

$

48,000 72,000 92,000

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212,000 Non-current assets Motor vehicles Plant and machinery Freehold premises Total assets Less liabilities Current liabilities Accounts payable Non-current liabilities Loan Total liabilities Net assets Owners’ equity Opening balance Add profit

76,000 120,000 180,000 376,000 588,000

148,000 200,000

Less drawings Total equity

348,000 240,000 200,000 56,000 256,000 16,000 240,000

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We can see that when using the proprietary approach the total liabilities are deducted from the total assets. This derives a figure for net assets—which is equal to equity. Using this format, the basic accounting equation is rearranged so that: Assets 2 Liabilities 5 Equity

This rearranged equation highlights the fact that equity represents the residual interest of the owner(s) after deducting all liabilities of the business. In terms of published statements of financial position in Australia, the most commonly presented is the vertical format based on the entity equation. Irrespective of the format, or the equation, all the statements of financial position contain the same information.

ACTIVITY 2.4 The following information relates to the Simonson Engineering Company as at 30 September 2017: Plant and machinery Accounts payable Bank overdra" Inventory Freehold premises Long-term loans Accounts receivable Capital at 1 October 2016 Cash in hand Motor vehicles Fixtures and fittings Profit for the year to 30 September 2017 Drawings for the year to 30 September 2017

$ 100,000 72,000 104,000 180,000 288,000 204,000 192,000 470,000 6,000 60,000 36,000 72,000 60,000

Prepare a statement of financial position in the vertical form.

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Financial position at a point in time As we have already seen, the statement of financial position is a statement of the financial position of the business at a specified point in time. The statement of financial position has been compared to a snapshot, ‘freezing’ a particular situation in a single moment. Events may be quite different immediately before or immediately after the photo was taken. When examining a statement of financial position, therefore, it is important to establish the date when it was drawn up and to prominently display this in the heading, as shown in the examples for Brie Manufacturing earlier. The more current the date, the better, when you are trying to assess current financial position. A business normally prepares a statement of financial position as at the close of business on the last day of its accounting year. In Australia and New Zealand, businesses are free to choose their accounting year, but most businesses select an accounting year ending 30 June to coincide with the taxation year. When making a decision on which year-end date to choose, commercial convenience is often a deciding factor. Thus, a business operating in the retail trade may choose to have a year-end date early in the calendar year (e.g. 31 January) because trade tends to be slack during that period and more staff time is available to help with the tasks of preparing the annual accounting statements (e.g. checking inventory). Since trade is slack, it is also a time when the amount of inventory held by the business is likely to be lower than it is at other times of the year. Thus, the statement of financial position, though showing a fair view of what it purports to show, may not show the more typical position of the business over the year.

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Concept check 9 Which of the following is NOT a valid format for the statement of financial position? A B C D E

Horizontal Vertical—entity approach Narrative Parallel—proprietary approach All of the above are valid formats.

Concept check 10 Which layout of the statement of financial position focuses on the owners? A B C D E

Horizontal Vertical—entity approach Narrative Vertical—proprietary approach All of the above.

Concept check 11 Which of the following statements is false? A B C D

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E

LO5 Identify the main factors that influence the content and values in a statement of financial position

reporting entity An entity with users who rely on general-purpose financial statements for their information relating to that entity.

The statement of financial position is prepared for a specified period in time. A company could choose 14 February as its year-end for accounting purposes. Many companies in Australia choose 30 June as their accounting year-end. Commercial convenience should be a factor in choosing a year-end. A balance sheet can be likened to a snapshot or financial position ‘selfie’.

FACTORS INFLUENCING THE FORM AND CONTENT OF THE FINANCIAL REPORTS There are three significant influences on the accounts included in the statement of financial position and the financial measures assigned to those accounts. These influences are: 1 traditional accounting conventions and doctrines that have underpinned accounting practice

for decades 2 more recent theoretical developments in conceptual framework projects 3 continuing development of professional and statutory accounting standards.

In Chapters 2 and 3 we focus on the first of these, but will deal with the second and third in more detail in the later chapters on limited companies. Our aim in Chapters 2 and 3 is to provide a broadly based understanding of the statement of financial position and income statement without the additional complications involved in larger-scale businesses, which are subject to much more rigorous regulation and control in terms of their financial reporting. The notion of a reporting entity is relevant here, and provides a rationale for our approach. Essentially a reporting entity is one which has a range of external users who use the financial statements to make decisions. Just which decisions users wish to make, and exactly what information

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63

they think they need, is not known precisely by the reporting entity. Consequently, the aim is to provide general-purpose information that will be of use to a variety of users. These general-purpose reports are subject to increasing amounts of regulation through accounting standards, legislation, stock exchange requirements and a variety of other bodies. In Chapters 2 and 3 we focus on the basic accounting principles which apply to all organisations. In Chapters 6 and 7 we will deal with the major area of reporting entities, namely companies, at which stage we shall consider the work on the conceptual framework together with development of accounting standards and their application.

Conventional accounting practice Accounting is based on a number of conventions or doctrines that have evolved over time. By conventions or doctrines we mean the principles, assumptions or accepted ideas on which accounting rules, records and reports were or are based. These are known as GAAP (generally accepted accounting principles). They have evolved to deal with practical problems experienced by preparers and users, rather than to reflect some theoretical ideal. In preparing the statement of financial position earlier, we adhered to various conventions, although they have not been explicitly mentioned. Below, we identify and discuss the main conventions (principles or assumptions or doctrines) that have been employed.

conventions Rules that have been devised over time in order to deal with practical problems experienced by preparers and users of financial reports.

Business entity convention For accounting purposes, the business and its owner(s) are treated as quite separate and distinct. This is why owners are treated as claimants against their own business in respect of their investment in the business. The business entity convention must be distinguished from the legal position that may exist between businesses and their owners. As we have seen, for sole proprietorships and partnerships the law does not make any distinction between the business and its owner(s). For limited companies, on the other hand, there is a clear legal distinction between the business and its owners. For accounting purposes, these legal distinctions are irrelevant, and the business entity convention applies to all forms of business entity.

business entity convention The convention which holds that, for accounting purposes, the business and its owner(s) are treated as quite separate and distinct.

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Historic cost convention Under the historic cost convention, assets are generally shown on the statement of financial position at a value that is based on their historic (acquisition) cost or its equivalent. Accountants have preferred this method of measuring asset value to methods based on some form of current value. Few commentators favour this particular convention, as outdated historical costs are unlikely to help in the assessment of current financial position. It is often argued that recording assets at their current value would provide a more realistic view of financial position and would be more relevant for a wide range of decisions. However, a system of measurement based on current values can present problems, not least because current values can be defined in a number of ways and are often difficult to establish with any real degree of objectivity. Activity 2.5 illustrates the practical problems associated with current value accounting.

historic cost convention The accounting convention which holds that assets should be recorded at their historic (acquisition) cost.

ACTIVITY 2.5 Can you think of two ways in which current values might be defined? Using your two definitions, consider the following. Plumber and Co. has some motor vans that are used by staff when visiting customers’ premises to carry out work. It is now the last day of the business’s reporting period. If it were decided to show the vans on the statement of financial position at a current value (rather than a figure based on their historic cost), how might the business arrive at a suitable value, and how reliable would this figure be?

The figures produced under a system of current value accounting may be heavily dependent on the opinion of managers. Unless these figures are capable of some form of independent verification, there is a danger that the financial statements will lose their credibility among users. The motor Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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vans discussed in Activity 2.5 are less of a problem than many types of asset. There is a ready market for motor vans, which means that a value can be obtained by contacting a dealer. For a custom-built piece of equipment, however, identifying a replacement cost, or worse still a selling price, could be very difficult. It is argued that more reliable information is produced by reporting assets at their historic cost. Reporting in this way reduces the need for subjective opinion, as the amount paid for a particular asset is usually a matter of demonstrable fact. However, information based on past costs may not always be relevant to users’ needs in terms of decisions about the allocation of scarce resources. Later in the chapter we will consider in more detail the valuation of assets in the statement of financial position. We will see that the historic cost convention is not always rigidly adhered to, and that departures from this convention are becoming more frequent.

Prudence convention prudence convention The convention which holds that financial reports should err on the side of caution, effectively anticipating losses and only recognising profits when they are realised.

The prudence convention holds that caution should be exercised when making accounting judgements. The application of this convention normally involves recording all losses at once and in full; this refers to both actual losses and expected losses. Profits, on the other hand, are recognised only when they actually arise. Greater emphasis is, therefore, placed on expected losses than on expected profits. To illustrate the application of this convention, let us assume that certain inventories held by a business prove unpopular with customers and so a decision is made to sell them below their original cost. The prudence convention requires that the expected loss from future sales be recognised immediately rather than when the goods are eventually sold. If, however, these inventories could have been sold above their original cost, profit would be recognised only at the time of sale. The prudence convention evolved to counteract the excessive optimism of some managers, and is designed to prevent an overstatement of financial position and performance. Applying this convention, however, requires judgement. This means that the way in which it is applied by preparers of financial statements may differ over time and between businesses. Where excessive prudence is applied, it will lead to an understatement of profits and financial position. This will mean a consistent bias in the reporting of both financial performance and position. In recent years, the prudence convention has weakened its grip on accounting and has become a less dominant force. Nevertheless, it remains an important convention.

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Going concern (or continuity) convention going concern (or continuity) convention The accounting convention which holds that the business will continue operations for the foreseeable future. In other words, there is no intention or need to liquidate the business.

dual aspect convention The accounting convention which holds that each financial transaction has two aspects and that each aspect must be recorded in the financial statements.

The going concern convention holds that the financial statements should be prepared on the assumption that a business will continue operations for the foreseeable future, unless there is evidence to the contrary. In other words, it is assumed that there is no intention, or need, to sell off the non-current assets of the business. Where a business is in financial difficulties, however, non-current assets may have to be sold in order to repay those who have enforceable claims against the business. This convention is important, because the value of non-current assets on a liquidation basis (which is the alternative to the going concern basis) is often low in relation to the recorded values, and an expectation of winding up would mean that anticipated losses on sale should be fully recorded. However, where there is no expectation of liquidation, the value of non-current assets can continue to be shown at their recorded values (i.e. based on historic cost). This convention, therefore, supports the historic cost convention under normal circumstances.

Dual aspect convention The dual aspect convention states that each transaction has two aspects, both of which will affect the statement of financial position. Thus, the purchase of a car for cash results in an increase in one asset (car) and a decrease in another (cash). The repayment of a loan results in the decrease in a liability (loan) and the decrease in an asset (cash/bank).

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As we saw in Example 2.1 (page 52), recording the dual aspect of each transaction ensures that the statement of financial position will continue to balance. The ‘dual aspect’ is reflected in the system of double-entry book-keeping/accounting, which underpins the recording of information in the actual accounting records. This is covered in Chapter 4.

Money measurement convention Accounting normally deals with only those items that can be expressed in monetary terms with a reasonable degree of reliability, hence the convention of money measurement. Money has the advantage of being a useful common denominator for expressing the wide variety of business resources. However, not all resources held by a business can be measured in monetary terms, so some may be excluded from the statement of financial position. As a result, the scope of the statement of financial position is limited. Examples of assets which cannot be reliably measured in money terms include the quality of the workforce, the reputation of the business’s products, the location of the business, the relationship with customers and the quality of management. Accounting is a developing subject, and the boundaries of financial measurement can change. In recent years, attempts have been made to measure particular resources of a business previously excluded from the statement of financial position. For example, we have seen ideas of valuing goodwill and brands, and also the development of human resource accounting that attempts to measure the ‘human assets’ of the business. We will briefly consider goodwill and brands, and human resources below.

double-entry bookkeeping/accounting The formal system of recording using ledger accounts which reflect the dual aspect of financial transactions. money measurement The accounting convention which holds that accounting should only deal with those items which are capable of being expressed in monetary terms.

Goodwill and brands

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65

Some intangible non-current assets are similar to tangible non-current assets: they have a clear and separate identity, and the cost of acquiring the asset can be reliably measured. Examples normally include patents, trademarks, copyrights and licences. Other intangible non-current assets, however, are quite different. They lack a clear and separate identity and reflect a hotchpotch of attributes, which are part of the essence of the business. Goodwill and product brands are often examples of assets that lack a clear and separate identity. The term ‘goodwill’ is often used to cover various attributes, such as the quality of the products, the skill of employees and the relationship with customers. The term ‘product brands’ is also used to cover various attributes, such as the brand image, the quality of the product, the trademark and so on. Where goodwill and product brands have been generated internally by the business, it is often difficult to determine their cost or to measure their current market value, or even to be clear that they really exist. They are, therefore, excluded from the statement of financial position. When they are acquired through an ‘arm’s length transaction’, however, the problems of uncertainty about their existence and measurement are resolved. (An arm’s length transaction is one that is undertaken between two unconnected parties.) If goodwill is acquired when taking over another business, or if a business acquires a particular product brand from another business, these items will be separately identified and a price agreed for them. Under these circumstances, they can be regarded as assets (for accounting purposes) by the business that acquired them, and included on the statement of financial position. To agree on a price for acquiring goodwill or product brands means that some form of valuation must take place, and this raises the question as to how it is done. Usually, the valuation will be based on estimates of future earnings from holding the asset—a process that is fraught with difficulties. Nevertheless, a number of specialist businesses now exist that are prepared to take on this challenge. Real World 2.1 shows how one specialist business ranked and valued the top 10 brands in the world for 2016.

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REAL WORLD 2.1 Brand leaders Marketing Services Group Millward Brown Optimor, part of WPP plc, produces an annual report that ranks and values the top world brands. For 2016, the top 10 brands were as follows. Ranking Brand Industry Value ($m) 1 Google Technology 229,198 2 Apple Technology 228,460 3 Microso" Technology 121,824 4 AT&T Telecom provider 107,387 5 Facebook Technology 102,551 6 Visa Payments 100,800 7 Amazon Retail 98,988 8 Verizon Telecom provider 93,220 9 McDonald’s Fast food 88,684 10 IBM Technology 86,206 We can see that the valuations placed on the brands owned are quite staggering. We can also see how technology businesses dominate the rankings. It is interesting to compare results year-on-year. Over the last year, McDonald’s remained steady, while Facebook

rose seven places to number 5. The report also lists the brand contribution, a measure of the influence of brand alone on financial value, on a scale of 1 to 5, with 5 being the highest. Source: Millward Brown Optimor, ‘2016 BrandZ™ Top 100 Most Valuable Global Brands’, http://www.millwardbrown.com/brandz/top-globalbrands/2016.

Class discussion points 1 How do you think the figures included in the ranking are derived? 2 The figures are interesting. What reliance would you place on them? Would you make any decisions based on them? 3 How easy might it be to do similar calculations for most corporations in the world? 4 Can you think of reasons that might explain Facebook’s rise in ranking? How might these reasons be quantified? 5 While undoubtedly of interest, just how useful is information of this type?

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Human resources Attempts have also been made to place a monetary measurement on the human resources of a business, but without any real success. There are, however, certain limited circumstances in which human resources are measured and reported in the statement of financial position. These circumstances normally arise with professional sports clubs. While sports clubs cannot own players, they can own the rights to the players’ services. Where these rights are acquired by compensating other clubs for releasing the players from their contracts, an arm’s length transaction arises and the amounts paid provide a reliable basis for measurement. This means that the rights to services can be regarded as an asset of the club for accounting purposes (assuming, of course, the player will also bring benefits to the club). Real World 2.2 describes how one leading soccer club reports its investment in players on the statement of financial position.

REAL WORLD 2.2 Spurs players appear on the pitch and on the statement of financial position Tottenham Hotspur Football Club (Spurs) has acquired several key players as a result of paying transfer fees to other clubs. In common with most UK football clubs, Spurs reports the cost of acquiring the rights to the players’ services on its statement of financial position. The club’s statement as at

30 June 2015 shows the total cost of registering its squad of players at about £208 million. The club treats a proportion of each player’s transfer fee as an expense each year. The exact proportion depends on the length of the particular player’s contract.

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The £208 million does not include ‘home-grown’ players, because Spurs did not pay a transfer fee for them and so no clear-cut value can be placed on their services. During the year to 30 June 2015, the club spent around £37 million on acquiring new players. Some players also le" the club during the year, and, coincidentally, £37 million was deducted from the cost of registrations. (Most years there is likely to be quite a difference between these figures.) The item of players’ registrations is shown as an intangible asset in the statement of financial position, as it is the rights to services, not the players, which are the assets. It is shown net of depreciation (or amortisation, as it is usually termed for non-current intangible assets). The carrying amount at 30 June 2015 was just over £99 million and represented 25% of Spurs assets, as shown in the statement of financial position. Source: Based on Tottenham Hotspur Ltd, Annual Report 2015.

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Class discussion points 1 Do the figures shown tell us anything about the value of the players? 2 It is interesting to note that the cost of registering its squad of players would not have included anything for ‘home-grown’ players. In earlier years, the figures would have included the cost of Gareth Bale, who was purchased by Spurs quite a few years ago. Gareth was sold to Real Madrid for £148 million in September 2013, a price well in excess of the figure included under the net intangible asset. Comment on the relevance of the asset shown. 3 How might the value of a player be determined? Should a current figure based on a (possibly) speculative value be included? How might such a figure be included?

Stable monetary unit convention When using money as the unit of measurement, we generally use the stable monetary unit convention, which means that the fact that money will change in value over time is not well recognised. Throughout much of the world, however, inflation has been a persistent problem. This has meant that the value of money has declined in relation to other assets. In past years, high rates of inflation have resulted in statements of financial position that were prepared on an historic cost basis, reflecting figures for assets that were much lower than if current values were employed. Rates of inflation have been relatively low in recent years, and so the disparity between historic cost values and current values has been less pronounced. Nevertheless, it can still be significant, and has added fuel to the debate concerning how to measure asset values on the statement of financial position. It is to this issue that we now turn.

stable monetary unit convention The accounting convention which holds that money, which is the unit of measurement in accounting, will not change in value over time.

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Valuing assets We saw earlier that, when preparing the statement of financial position, the historic cost convention is normally applied for the reporting of assets. This point requires further explanation as, in practice, things are a little more complex than this. Large businesses throughout much of the world adhere to asset valuation rules set out in International Financial Reporting Standards. (These reporting standards will be discussed in more detail in Chapter 7.) The key valuation rules are considered below.

Non-current assets Non-current assets have lives that are either finite or indefinite. Those with a finite life provide benefits to a business for a limited period of time, whereas those with an indefinite life provide benefits without a foreseeable time limit. The distinction between the two types of non-current assets applies to both tangible assets and intangible assets. Initially, non-current assets are recorded at their historic cost, which will include any amounts spent on getting them ready for use.

Non-current assets with finite lives Benefits from assets with finite lives will be used up over time as a result of market changes, wear and tear, and so on. Plant, equipment, motor vehicles and computers are examples of tangible assets that are normally considered to have a finite life. A patent, which gives the owner exclusive rights to use an invention, is an example of an intangible asset that has a finite life. (Many patents are granted for a period of 20 years.)

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The amount used up, which is referred to as depreciation (or amortisation, in the case of intangible non-current assets), must be measured for each reporting period for which the assets are held. Although we shall leave a detailed examination of depreciation until Chapter 3, we need to know that when an asset has been depreciated this must be reflected in the statement of financial position. The total depreciation that has accumulated over the period since the asset was acquired must be deducted from its cost. This net figure (i.e. the cost of the asset less the total depreciation to date) is referred to as the carrying amount. It is sometimes also known as net book value or written-down value. The procedure just described is not really a contravention of the historic cost convention. It is simply recognition of the fact that a proportion of the historic cost of the non-current asset has been allocated in the process of generating benefits for the business.

Non-current assets with indefinite lives Benefits from assets with indefinite lives may, or may not, be used up over time. Land is an example of a tangible non-current asset with an indefinite life. Purchased goodwill could be an example of an intangible one, although this is not always the case. These assets are not subject to routine annual depreciation over time.

Fair values

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fair value Exchange values in an arm’s length transaction.

Although initially historic cost is the standard or ‘benchmark’ treatment for recording non-current assets of all types (tangible and intangible, finite or indefinite lives), an alternative is allowed. Noncurrent assets may be recorded using fair values, provided that these values can be measured reliably. The fair values, in this case, are the current market values (i.e. the exchange values in an arm’s length transaction). The use of fair values, rather than cost figures, whether depreciated or not, can provide users with more up-to-date information, which may well be more relevant to their needs. It may also place the business in a better light, as assets such as property may have increased significantly in value over time. Of course, increasing the statement of financial position value of an asset does not make that asset more valuable. Perceptions of the business, however, may be altered by such a move. One consequence of upwardly revaluing non-current assets with finite lives is that the depreciation charge will be increased. This is because depreciation is based on the new (increased) value of the asset. Refer back to Example 2.2 on page 59. What would be the effect of revaluing the property to a figure of $440,000 on the statement of financial position? The effect on the statement of financial position would be to increase the property to $440,000, and the gain on revaluation (i.e. $440,000 – $180,000 5 $260,000) would be added to equity, as it is the owner(s) who will benefit from the gain. Typically, the revaluation ‘gain’ would be shown in a revaluation reserve. Once assets are revalued, the frequency of revaluation then becomes an important issue, as assets recorded at out-of-date revaluations can mislead users. Using such figures on the statement of financial position is the worst of both worlds. It lacks the objectivity and verifiability of historic cost; it also lacks the realism of current values. Where fair values are used, revaluations should therefore be frequent enough to ensure that the carrying amount of the revalued asset does not differ materially from its true fair value at the statement of financial position date. When an item of property, plant or equipment (a tangible asset) is revalued on the basis of fair values, all assets within that particular group must be revalued. Thus, it is not acceptable to revalue some items of property but not others. Although this provides some degree of consistency within a particular group of assets, it does not prevent the statement of financial position from containing a mixture of valuations. Intangible assets are not often revalued to fair values. This is because revaluations can be used only where there is an active market, thereby permitting fair values to be properly determined. Such markets, however, rarely exist for intangible assets.

The impairment of assets All types of non-current assets are at risk of suffering a significant fall in value. This may be caused by changes in market conditions, technological obsolescence and so on. In some cases, this fall Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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in value may lead to the carrying amount of the asset being higher than the amount that could be recovered from the asset through its continued use or through its sale. When this occurs, the asset value is said to be impaired, and the general rule is to reduce the value on the statement of financial position to the recoverable amount. Unless this is done, the asset value will be overstated. (This type of impairment in value should not be confused with routine depreciation of assets with finite lives.) We should bear in mind that impairment reviews involve making judgements about the appropriate value to place on assets. Employing independent valuers to make these judgements will normally give users greater confidence in the information reported. There is always a risk that managers will manipulate impairment values to portray a picture that they would like users to see. Real World 2.3 provides illustrations of a range of impairments.

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impairment The amount of loss that must be written-off for an asset in the situation where the carrying amount of the asset exceeds its recoverable amount.

REAL WORLD 2.3 Examples of recent impairments ‘Sliding oil prices forced Santos to write down $3.9bn, leading to a record $2.7bn full-year loss and the complete write-off of the Gunnedah coal-seam gas project.’ Source: Matt Chambers, ‘Oil hit forces Santos to $4bn in write-downs’, The Australian, 20–21 February 2016.

Santos ‘will write down the value of its Gladstone LNG project by another $US1.5 billion, blaming low prices and lower than expected coal seam gas production, bringing total writedowns in the past three years to more than $8bn’. Source: Matt Chambers, ‘Santos clears the deck with $2bn write-off’, The Australian, 16 August 2016, http://www.theaustralian.com.au/ business/mining-energy/santos-writes-down-gladstone-lng-by-2bn/ news-story/e15d36c6615f21ecead45146551b4727.

‘The Directors of Origin Energy carefully reviewed the carrying value of all assets, resulting in a non-cash impairment charge of $705 million. The impairment charge primarily related to Contact Energy and the Company’s upstream assets.’ Source: ‘Origin reports Statutory Loss of $658 million and Underlying Profit of $682 million; Australia Pacific LNG nearing completion’, ASX Media Release, 20 August 2015.

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Impairments included in the 2016 Origin Energy annual results showed $624 million in 2015 and $691 million for 2016. Source: Origin Energy Limited and Controlled Entities, ‘Appendix E: Results for announcement to the market’, 30 June 2016.

Woodside Petroleum announced in its 2015 Annual Report the following impairments.

•

The decline in forecast oil prices and oil field decline for the Balnaves oil asset in the Australian Oil segment resulted in an impairment loss of US$10 million for the oil and gas properties.

•

The decline in forecast oil and gas prices resulted in an impairment loss of US$1,168 million for the oil and gas properties in the Australian Oil, North West Shelf and Wheatstone operating segments.

Source: Woodside Petroleum Annual Report 2015, p. 88.

The law firm Slater & Gordon included an impairment of goodwill amounting to $876.4 million, largely relating to its British operations, in the six months to December 2015. Source: Kylar Looussikian, ‘Time is short for Slater to seal loan deal’, The Australian, 1 March 2016.

Woolworths in its 2016 Annual Report included an impairment relating to its Home Improvement market (Masters) totalling $1,431.8 million. Wesfarmers, in the same year, reported in its Annual Report a profit a"er tax of $407 million, a"er including non-cash impairments of Target and Curragh totalling $2,116 million before tax, as well as $145 million (pre-tax) of restructuring costs and provisions to reset Target.

Class discussion points 1 Several of the examples given in Real World 2.3 relate to the energy industry. Substantial reductions in oil and gas prices worldwide necessitated these impairments. Why do you think that the original valuations were made? Should they have been made more conservatively? 2 How might a soccer club such as Tottenham Hotspur deal with impairment of its playing staff due to, say, a career-ending injury or a falling out of a player with the club?

It is not only non-current assets that run the risk of a significant fall in value. The inventories of a business could also suffer this fate as a result of changes in market taste, obsolescence, deterioration, damage and so on. Where a fall in value means that the amount likely to be recovered from the sale of the inventories will be lower than their cost, this loss must be reflected in the statement of financial position. Thus, if the net realisable value (i.e. selling price less any selling costs) falls

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below the historic cost of inventories held, the former should be used as the basis of valuation. Similarly, if the book value of receivables is seen as being unlikely to be received, some write-down or impairment is needed. This will be reviewed in Chapter 3. Both of these reflect, once again, the influence of the prudence convention on the statement of financial position. The published financial statements of large businesses will normally show the basis on which inventories are valued. Real World 2.4 provides examples of how non-current assets are valued by two major retailers.

REAL WORLD 2.4 Myer: Non-current assets—valuation ‘Property, plant and equipment is stated at cost less depreciation. Cost includes expenditure that is directly attributable to the acquisition of the items’ (p. 75). ‘Goodwill and intangibles that have an indefinite life are tested annually for impairment, or more frequently if events or changes in circumstances indicate that they may be impaired … An impairment loss is recognised for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value to sell and value in use. ‘The useful life of brands are assessed on acquisition. The brands which are not considered to have foreseeable brand maturity dates have been assessed as having indefinite useful lives as there is a view that there is no foreseeable limit to the period over which key brands are expected to generate net cash inflows for the entity. These brands are therefore not amortised. Instead, these brand names are tested for impairment annually, or more frequently if events or changes in circumstances indicate that they might be impaired, and are carried at cost less accumulated impairment losses’ (p. 78).

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Source: Myer Annual Report 2016, pp. 75 and 78. © Myer Pty Ltd.

Harvey Norman Holdings Limited ‘Plant and equipment assets are stated at historical cost less accumulated depreciation and any accumulated impairment losses. Land and buildings are measured at fair value less accumulated depreciation on buildings and leasehold land and any impairment losses recognised at the date of the revaluation. Valuations are performed with sufficient frequency to ensure that the carrying amount of a revalued asset does not differ materially from its fair value’ (p. 69). (For revaluations of owner-occupied properties) ‘Fair value is determined by reference to market-based evidence, which is the amount for which the assets could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arm’s length transaction as at the valuation date’ (p. 69).

(For investment properties) ‘The fair value in respect of each investment property has been calculated using the income capitalisation valuation method, against current market rental value, and having regard to, in respect of each property … A discounted cash flow valuation or a direct sale comparison valuation is undertaken in respect of all properties as a secondary check method of the capitalisation approach, excluding property for development’ (pp. 70–71). (For available-for-sale financial assets) ‘The fair values of investments that are actively traded in organised financial markets are determined by reference to quoted market bid prices at the close of business at balance date. For investments with no active market, fair values are determined using valuation techniques’ (p. 72). Source: Harvey Norman Holdings Limited Annual Report 2016, pp. 69–72. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Class discussion points 1 How would you assess the fair value of a property that you owned? How accurate could you be? How could you convince anyone else that your estimate was reasonable? 2 Suppose that you inherited from a rich relative an allowance of $50,000 a year, starting tomorrow, when your age is 60 (there are fewer years to use in the calculation than if we assumed that you were 20). Could this (or similar cash-flow patterns) be seen as an asset? What is the allowance worth today as a lump sum? Bear in mind that there is a huge market where retirees trade a lump sum for an annuity (a regular amount received over a future period). What other factors need to be considered? 3 In a 2015 article the idea that ‘fair value’ could be problematical was raised. Once upon a time, values were based on cost, unless assets were no longer worth their cost, in which case they had to be written down. A bird in the hand was worth more than

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any number in the bush: only when the bird emerged from the bush were you permitted to count it at all. Like finance, however, accounting became cleverer, and worse. By the 1980s accounting had become the principal means by which UK graduates prepared for business. Many of these trainees found jobs in the finance sector; others took jobs in non-financial business — and, since they were smart, many rose to senior positions. Young accountants were smarter, greedier, less schooled in prudence and better schooled in economics. “Fair value” increasingly replaced conservatism as a guiding principle.

But this route to the “true and fair view” — the traditional holy grail of the accountant — o#en led to an outcome that was just the opposite of fair. Source: Extract from Kay, J., 2015, ‘Playing dice with your money’, 4 September, Ft.com. © The Financial Times Limited 2015. All Rights Reserved. FT and 'Financial Times’ are trademarks of The Financial Times Ltd.

Comment on this view. How can we ensure that values shown do lead to truth and fairness? 4 How objective is accounting? How many instances where judgement is a key element can you identify?

Concept check 12 Which of the following is NOT an official source of regulation for general-purpose financial statements? A B C D E

Accounting standards Stock exchange requirements Federal legislation Public sentiment None of the above. All are official sources of regulation.

Concept check 13 Which of the following statements is true? A

B

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D E

GAAP, or generally accepted accounting principles, are accounting rules developed by the AASB (Australian Accounting Standards Board). The entity or business entity convention provides for a clear alliance of the business and its owners. The historic cost convention values assets at their cost on the date of acquisition. Current values provide more reliable amounts for asset valuation. The prudence convention is rarely applied in actual practice.

Concept check 14 The money measurement convention: A

B C D E

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Requires expression in monetary terms with reasonable reliability for all balance sheet resources Precludes a proprietor from recording the goodwill that he has with regular customers Will result in the balance sheet understating the value of the business None of the above All of the above.

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USEFULNESS OF THE STATEMENT OF FINANCIAL POSITION LO6 Explain the main ways in which the statement of financial position can be useful for users of accounting information

The statement of financial position is the oldest of the three main financial statements, and many businesses prepare one on a regular basis, even though they may not be subject to regulations requiring it to be produced. This suggests that it is regarded as providing useful information. There are various ways in which the statement of financial position may help users, including the following:

• It provides insights about how the business is financed and how its funds are deployed.

The statement of financial position shows how much finance is contributed by the owners and how much is contributed by outside lenders. It also shows the different kinds of assets acquired and how much is invested in each kind. The relative proportion of total finance contributed by the owners and outsiders can be calculated to see whether the business depends heavily on outside financing. Heavy borrowing can incur a commitment to large interest payments and large capital repayments at regular intervals. Such legally enforceable obligations can be a real burden as they have to be paid irrespective of the financial position of the business. Funds raised from the owners of the business, on the other hand, do not impose such obligations on it.

• It provides insights into the liquidity of the business. This is the ability of the business to

meet its short-term obligations (current liabilities) from its liquid (cash and near-cash) assets. Liquidity is particularly important because business failures occur when the business cannot meet its maturing obligations, for whatever reason.

• It can provide a basis for assessing the value of the business. Since the statement of financial

position lists, and places a value on, the various assets and claims, it can provide a starting point for assessing the value of the business. It is, however, severely limited in the extent to which it can do this. We have seen earlier that accounting rules may result in assets being shown at their historic cost and that the restrictive definition of assets may exclude certain business resources from the statement of financial position. Ultimately, the value of a business will be based on its ability to generate wealth in the future. Because of this, assets need to be valued on the basis of their wealth-generating potential. Also, other business resources that do not meet the restrictive definition of assets, such as brand values, need to be similarly valued and included.

• It provides a means of assessing relationships between assets and claims. It can be useful to

look at relationships between various statement of financial position items, for example the relationship between how much wealth is tied up in current assets and how much is owed in the short term (current liabilities). From this relationship, we can see whether the business has sufficient short-term assets to cover its maturing obligations.

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• It provides insights into the ‘mix’ of assets held by the business. The relationship between

current assets and non-current assets is important. Businesses with too much of their funds tied up in non-current assets could be vulnerable to financial failure, because non-current assets are seldom easy to turn into cash to meet short-term obligations. Converting many non-current assets into cash may well lead to substantial losses for the business, because such assets are not always worth on the open market what the business paid to acquire them or what they are worth to the business. For example, a specialised piece of equipment may have great value to one business, yet little to another.

• It can help users in assessing performance. The effectiveness of a business in generating

wealth can usefully be assessed against the amount of investment that was involved. Thus, the relationship between profit earned during a period and the value of the net assets invested can be helpful to many users, particularly owners and managers.

The interpretation of the statement of financial position will be considered in more detail in Chapter 10.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

ACTIVITY 2.6 Consider the following statement of financial position of a manufacturing business: Russell Manufacturing Co. Statement of financial position as at 30 April 2017 $ Current assets Cash at bank Accounts receivable Inventory

$

48,000 176,000 192,000 416,000

Non-current assets Fixtures and fittings Motor vehicles Plant and machinery Freehold premises Total assets Current liabilities Accounts payable Bank overdra"

56,000 52,000 184,000 352,000 644,000 1,060,000 96,000 72,000 168,000

Non-current liabilities Loan Total liabilities Owners’ equity Opening balance Add profit Less drawings

640,000 808,000 168,000 128,000 296,000 44,000

Total liabilities and owners’ equity

252,000 1,060,000

What does this statement tell you about the financial position of the business?

Concept check 15 The statement of financial position helps users by: A

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B C D E

Providing insights about how the business is financed and how its funds are deployed Informing as to the liquidity of the business Providing a basis for valuation of the business Providing insights into the ‘mix’ of assets held by the business All of the above.

Concept check 16 For which of the following will the balance sheet be LEAST useful? A B C D E

Providing insights on how the business is financed and how its funds are deployed Informing as to the liquidity of the business Providing a basis for valuation of the business Providing insights into the ‘mix’ of assets held by the business None of the above. Very useful for all.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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SELF-ASSESSMENT QUESTION

2.2

Provide a report based on your evaluation of the following three statements of financial position in terms of: (a) liquidity (b) solvency (c) asset mix. A $’000 500 500 1,000 300 200 500 400 100 500

Current assets Non-current assets Total assets Current liabilities Non-current liabilities Total liabilities Owners’ contributions Reserves Total owners’ equity

B $’000 300 700 1,000 100 200 300 100 600 700

C $’000 700 300 1,000 100 600 700 200 100 300

STATEMENT OF FINANCIAL POSITION DEFICIENCIES LO7 ACTIVITY 2.7 Identify the main deficiencies or limitations in the statement of financial position

The statement of financial position has been likened to a financial photograph or snapshot of a business at a point in time. If you think about the problems you have had with particular photos you have taken, these will provide some useful insights into potential deficiencies in statements of financial position. For example, when looking at a group photograph you have taken, you may have noted that: ● ● ● ● ● ●

someone has been le" out another person is obscured by an intervening object there is a person in the photo who was not part of your group another person moved and their image is blurred the picture is skewed to one side, or there is a problem with some of the group being in the light and others in the shade.

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How can these problems with taking a group photograph relate to the possible deficiencies of a statement of financial position in presenting the financial position at a point in time?

Thinking along these lines enables us to identify some of the deficiencies or limitations that a statement of financial position has in presenting the financial position of an entity at a point in time. The statement of financial position represents the end product of the interpretation and application, by management, accountants and auditors, of the statutory and professional rules and principles of accounting and financial reporting. In interpreting and applying this body of knowledge, at least two situations may cause deficiencies in individual statements of the financial position of a given entity at a point in time. First, within this body of knowledge itself there are potential conflicts that may lead to such deficiencies. While this introductory text on accounting does not set out to review accounting theory in detail, a few examples may illustrate the possible conflicts. We stated earlier that an underlying assumption was a ‘stable monetary unit’: the economic reality is that since money is a good in its own right, subject to supply and demand fluctuations, it cannot be used accurately as a measuring unit for comparisons over time. Therefore, when accountants add building costs in 2000 to alteration costs in 2017, the aggregate makes no more sense than adding together Australian and US dollars without making some translation adjustment. That is, Australian dollars in 2000

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

do not have the same purchasing power significance as Australian dollars in 2017, so they cannot be added meaningfully. We also noted in Chapter 1 that financial information presented in the reports should be both relevant and reliable, yet these two qualities are often in conflict. Relevant information (useful in decision-making) is not always entirely reliable (faithfully representative), and if you wait for reliable information, it may not always be particularly relevant. What you paid for some equipment in 2005 can be reliably measured (external invoice and receipt), but this may not be relevant in 2017 when you have to decide whether to retain or dispose of the equipment. In 2017 you may want to know the value of that asset in use (present value of future cash flows attributable to that asset) or its value in exchange (estimated selling price less costs to sell). While these two current values are useful for decision-making, as measures they may not be reliable as they are subject to estimation error or personal bias. Second, the accounting principles and rules of the accounting body of knowledge allow management individuals considerable discretion when it comes to deciding how to record transactions. Many of these choices will be specifically discussed in Chapter 3 on the statement of financial performance, so you may find it useful to review this section after having read Chapter 3. These choices include:

• Whether expenditure is to be recognised as giving rise to an immediate asset (statement

•

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•

of financial position) or expense (statement of financial performance). There are endless examples of this choice, but a few common examples are expenditure related to advertising, research, exploration and plant repairs. Of course, the treatment selected will immediately affect the statement of financial position for assets. The requirement to make estimates or guesses about future events. Accountants are forever required to anticipate what will happen in the future. There are many examples of the estimation process. With inventory, estimates are made about their realisable value and possible losses from obsolescence, deterioration or theft. With accounts receivable, estimates are made about sales returns, discounts to be taken, the timing of the receipts and how much will not be collected. With plant and equipment, estimates are made about useful lives, residual values, the pattern of using up the economic benefits, and their individual recoverable amount. Obviously, the results of all these estimates and guesses are reflected in the final numbers in the statement of financial position The accountant nevertheless has a wide range of accounting methods or techniques for recording transactions in many areas related to the statement of financial position. In accounting for accounts receivable and bad debts, bad debts can be recognised when realised, or anticipated using a percentage of credit sales or based on the age of the debt. With inventory, the inventory on hand at the end of the period can be measured by different methods (first in, first out; last in, first out; weighted average; standard cost). With plant and equipment, various depreciation methods are acceptable (straight line; units of production; reducing balance; sum of the years’ digits). These few examples again highlight implications for the account balances in the statement of financial position.

There is still choice in some areas in terms of whether the transaction is recorded directly in the statement of financial position (recognised) or disclosed only in the notes or other parts of the report. Examples may include certain executory contracts (e.g. leases) and the market values of certain assets.

Concept check 17 The usefulness of the statement of financial position will be limited by: A B C D E

Inflation Naive users Poor estimations by the accountant Poor choice of accounting policy All of the above.

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ACCOUNTING AND YOU It is frequently useful for individuals to assess just what they have achieved and what they are ‘worth’. If you need to do this for purposes of obtaining a car loan, or a mortgage, you will probably find that your bank will only include assets and liabilities using the kind of approach adopted in this chapter. Yet you will probably be able to think of a number of things that you value (and others value) which your banker says are nice, but not relevant. What they mean is that they are not relevant to them. But they may well be extremely valuable to you. Your (or your parents’) investment in your education has undoubted value to you, and to prospective employers, but would not satisfy the accounting definition of an asset. Your superannuation balance is certainly of worth, but may well be so far ahead in terms of your ability to access it, that it is of no consequence in terms of current decision-making. Your collection of old model trains also has considerable worth, but obtaining a figure which can be accepted by everyone may well be difficult, if not impossible. You need to understand that the statement of financial position aims to provide a list of assets and liabilities which has a high degree of objectivity, such that almost anyone looking at a particular business or individual would come to the same conclusion, because all would be following the same rules. Our discussion about the value of brands, of soccer players and other ‘human’ assets was not intended to imply that these have no value, but that it is difficult to obtain agreement about their value. When making decisions about value, all users of accounting information have to make assumptions or judgements about the value of the assets controlled by a business. In your own life, you will need to make the same kind of judgements about worth. When looking at figures in a statement of financial position, you should be trying to ascertain the underlying values, in terms of individual assets and composite groups of assets or businesses. You also need to do this with your life. Accounting figures can be helpful, but they simply cannot make individual judgements in the way that you can and need to do.

Class discussion points 1 Do you consider that knowledge as to how the accounting systems work is necessary for managers? 2 Can you think of ways in which this knowledge might be useful to you, assuming that you are operating as a manager in a business, not as an accountant?

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3 If you were to develop your own business, you would be likely to do so partly for financial reasons, but also for reasons to do with factors such as flexibility, job satisfaction, etc. What kind of factors might you include in your own personal list of assets, or benefits, associated with running your own business, which would not normally be included in the business balance sheet, and how important are these likely to be to you? Would this list reduce the importance of the balance sheet?

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

SUMMARY In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Explain the nature and purpose of the statement of financial position and its component parts

• Identified the purpose as being to set out the financial position of a business at a particular point of time • Explained that the statement included assets and claims, which consisted of external liabilities and owners’ equity • Identified and analysed the nature of assets • Identified and analysed the nature of liabilities • Identified and analysed the nature of owners’ equity • Used the accounting equation to illustrate the build-up of a statement of financial position, covering a range of transactions including trading transactions

LO2: Explain the accounting equation, and use it to build up a statement of financial position at the end of a period

• Explained the accounting equation • Illustrated by use of a practical example • Worked through an additional activity to enable us to prepare a statement of financial position after a series of transactions

LO3: Classify assets and claims

• Identified the most common classification of assets being based on the timing of receipts of benefits of ownership (e.g. current, noncurrent) • Identified the current/non-current classification as being appropriate for liabilities • Explained the difference between the various components of equity

LO4: Apply the different possible formats for the statement of financial position

• Illustrated the main format of the statement of financial position • Examined the following formats: • horizontal (T account) • vertical (narrative) • Differentiated between the entity approach and the proprietary approach • Identified the basic equation as: • proprietary:

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OE 5 A – L • entity: A 5 L 1 OE LO5: Identify the main factors that influence the content and values in a statement of financial position

Identified and analysed the following factors: • conventional accounting practice • business entity • historic cost • prudence • going concern • dual aspect • money measurement, including consideration of goodwill and brands and human resources • stable monetary unit • valuation of assets

LO6: Identify the main ways in which the statement of financial position can be useful for users of accounting information

Identified the ways in which the statement of financial position can provide useful insights into: • how the business is financed and how funds are deployed • the liquidity (ability to meet short-term obligations) of the business • the value of the business • the relationship between assets and claims • the asset mix (productive or unproductive) of the business • business performance

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ACCOUNTING FOR BUSINESS STUDENTS

LO7: Identify the main deficiencies or limitations in the statement of financial position

Explained that the deficiencies of the statement of financial position in portraying financial position largely relate to: • instability of the monetary unit • conflicts between relevance and reliability • limitations related to transaction recognition • the range of alternative asset and liability financial measures

DISCUSSION QUESTIONS GENERAL EASY 2.1

LO1

What are the main characteristics of assets and liabilities from an accounting perspective? Is this consistent with a non-accounting definition?

2.2

LO5

What is the primary measure used for asset valuation on the statement of financial position? What is the source of this measure and justification for its use?

2.3

LO3

What sort of account is ‘retained earnings’?

2.4

LO3

What sort of account would be included in the intangible asset category?

INTERMEDIATE 2.5

LO1/5/7

Provide examples of valuable resources of a business that will not be included as assets on the statement of financial position. Why does this occur?

2.6

LO2

Why is the accounting equation always in balance?

2.7

LO3

Describe the basis used to determine whether an asset is classified as current or non-current. Is the same basis used for the classification of liabilities?

2.8

LO2

Why is the statement of financial position also called a ‘balance sheet’?

2.9

LO5

The prudence convention has significantly influenced financial transactions recording and reporting. (a) What is the prudence convention?

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(b) Provide examples of how it has influenced transaction recording and reporting. 2.10 LO3

What other financial measures besides historical cost might be used for asset valuation?

2.11 LO2/5

What is an accounting convention?

2.12 LO2/3

It has been said that all costs (expenditure) become expenses. (a) Do you agree with this statement? (b) Provide examples to support your position.

2.13 LO2

Distinguish between a ‘legal entity’ and an ‘accounting entity’ in relation to different business types.

CHALLENGING 2.14 LO1/5

‘Human capital’ and ‘intellectual property’ are of significant value in many organisations. Provide arguments for and against their inclusion on the statement of financial position.

2.15 LO1/2/5

Does the use of some sort of ‘current cost’ for statement of financial position valuation increase the usefulness of the statement? Does it cause problems?

2.16 LO1/2/5

An accountant prepared a statement of financial position for a business using the horizontal layout. In this statement, the capital of the owner was shown next to the liabilities. This confused the owner, who argued: ‘My capital is my major asset and so should be shown as an asset on the statement of financial position.’ How would you explain this misunderstanding to the owner?

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

2.17 LO5–7

‘The statement of financial position shows how much a business is worth.’ Do you agree with this statement? Discuss.

2.18 LO6

The statement of financial position can be used to assess the following aspects of the reporting entity:



• • •



liquidity asset mix financial structure (solvency).

(a) What do these terms mean? (b) How could they be assessed from the statement of financial position figures? (c) Which external stakeholders would have a particular interest in each aspect?

APPLICATION EXERCISES EASY 2.1a LO2

Would the following accounts be classified as assets? If not, how would they be classified? Account

Yes

No—reason

1 Accounts receivable 2 Accumulated depreciation 3 Investments purchased 4 Advance to employees 5 Prepaid insurance 6 Supplies used 7 Unearned service fees 2.1b LO3

Would the following accounts be classified as liabilities? If not, how would they be classified? Account

Yes

No—reason

1 Accounts payable 2 Loan taken out 3 Loan guarantee 4 Unused bank overdraft 5 Provision for major maintenance Copyright © 2017. P.Ed Australia. All rights reserved.

6 Provision for warranty 2.2

LO1–4

(a) Martin Russell opened his consulting business as a proprietary company on 1 November. An aggressive marketing campaign and an expansive network of friends from university resulted in Martin being ‘run off his feet’ with clients almost as soon as his office doors opened. However, in his haste and enthusiasm to begin plying his trade, Martin neglected to develop a proper accounting system. On 14 November Martin provided you with the following information for his first two weeks of operations. He’d heard it was possible to create a balance sheet at any time and he’s curious as to the financial position of his new business. Date

Transaction description

Amount $20,000

Nov 1

Opened business bank account with transfer of personal funds

Nov 10

Invoiced client (Mr T) for services provided

$5,000

Nov 13

Paid wages to associates for work performed

$3,500

Satisfy Martin’s curiosity by preparing a vertical format balance sheet as at 15 November. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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(b) Martin loved your 15 November balance sheet. It’s now 21 November and Martin has received $3,000 from Mr T in partial payment for the work done for him. All of Martin’s transactions are listed below. And can you believe it! He wants another balance sheet—this time using horizontal format. Prepare a balance sheet in horizontal format for Martin as at 21 November. (c) It’s now 30 November and guess what? You got it! Martin wants another balance sheet. This time he wants you to prepare it using the narrative format. And he’s got some more transactions (22 and 25 November) that need to be accounted for. See below. Date

Transaction description

Nov 22

Purchased office supplies on credit (to be paid next month)

Nov 25

Borrowed $20,000 from the bank to be repaid in 3 years. Interest to be charged at 6% per year. First interest payment on 30 June.

Amount $4,000 $20,000

Prepare a narrative format balance sheet for Martin Russell as at 30 November. (d) It’s now the end of January. Following is a summary of Martin’s transactions to date. Martin wants a balance sheet using narrative format. Date

Transaction description

Nov 1

Opened business bank account with transfer of personal funds

Amount $20,000

Nov to Jan

Invoiced clients for services

Nov to Jan

Paid wages to associates for November, December and January

$105,000 $10,500

Nov to Jan

Received $80,000 of payments from clients

$80,000

Nov to Jan

Purchased office supplies on credit

$14,000

Nov to Jan

Paid $9,500 of office supplies debt

$9,500

Nov 25

Borrowed $20,000 from the bank to be repaid in 3 years

$20,000

Dec 21

Paid $12,000 for office space for next year

$12,000

Dec 31

Purchased car. Cash paid $10,000 with balance payable to car dealership in two years’ time

$40,000

Jan 15

Payment received of $15,000 for services to be provided to client to cover from 1 March to 31 December

$15,000

Prepare a narrative format balance sheet for Martin Russell as at 31 January. (e) Same data as application exercise (d). This time prepare a horizontal format balance sheet for Martin Russell as at 31 January and recognise Martin’s stock count of office supplies, revealing only $5,000 still on hand.

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2.3

LO2

Business transactions have a dual, or double, effect. (They affect two or more accounts but leave the accounting equation in balance.) Identify a transaction for each of the following accounting equation changes: Accounting equation: Assets (A) = Liabilities (L) + Owners’ equity (OE) Equation’s effect

Examples

(a) A↑ 5 L↑ (b) A↑ 5 OE↑ (c) A↑ 5 A↓ (d) A↓ 5 L↓ (e) A↓ 5 OE↓ (f) L↑ 5 OE↓ (g) L↓ 5 OE↑

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

2.4

LO2

For each of the following transactions identify the effect on the balance sheet equation? Transaction 1

The owner ‘Bill’ contributes cash to the business, Bills Electrical Services

2

The business purchases supplies on credit

3

The business purchases equipment with a bank loan

4

Services provided on credit to a client

5

Cash payment for rent of storage shed for the next 6 months

6

Cash payment at the end of the month for electricity used during the month

7

Paid for supplies purchased on credit during the month

8

Used up supplies during the month

9

Interest owing on bank loan at the end of the month

10 2.5

LO2

A

Complete the table by inserting the missing figures.

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2.7

LO2/4

(b)

(c)

(d)

Current assets

13,900

18,300

13,200

?

Non-current assets

51,600

71,600

110,700

69,600

Current liabilities

14,200

11,900

9,600

17,500

Non-current liabilities

17,900

?

41,500

51,200

Opening capital

20,700

29,200

?

26,700

Profit or loss

19,600

17,900

37,400

(9,500)

?

8,700

11,700

7,200

Drawings LO5

0E

Customer pays for services provided on credit earlier in the month

(a)

2.6

L

Recognition and measurement of assets are influenced by a number of accounting principles, conventions and assumptions. For each of the following such items, provide an example of how it influences the asset specified. Principle, convention or assumption

Asset

A

Historical cost

Land

B

Prudence

Inventory

C

Matching

Accounts receivable

D

Going concern

Equipment

E

Period

Prepaid insurance

F

Materiality

Loose tools

Influence

The following is a list of assets and claims of a manufacturing business at a particular point in time: $ Bank overdraft Freehold land and buildings Inventory of raw materials Accounts payable

22,000 245,000 18,000 23,000

Plant and machinery

127,000

Loan from National Australia Bank

100,000

Inventory of finished goods

28,000

Delivery vehicles

54,000

Accounts receivable

34,000

Prepare a statement of financial position in the standard vertical format incorporating these figures. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Hint: There is a missing figure which needs to be deduced and inserted. Created from usyd on 2018-03-05 16:43:06.

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2.8

LO2/4

The following is a list of assets and claims against the assets of a manufacturing business at a particular point in time. Account Cash at bank

Amount $ 2,000

Bank loan—mortgage

25,000

Initial capital

89,000

Freehold land and buildings

80,000

Owner’s drawings

15,000

Accounts receivable

11,000

Plant and equipment

27,000

Prepayments

1,000

Accrued expenses

3,000

Profit for the period

27,000

Bank overdraft

15,000

Finished goods inventory

23,000

Use the above information to prepare a statement of financial position in vertical format. 2.9

LO2

Dominic commenced business on 1 January 2017 with equity of $200,000. During the year ending on 31 December 2017 he paid $100,000 to purchase goods for sale (all of which were sold) and $50,000 for various expenses. He sold the goods for $250,000 cash. Dominic has drawn $25,000 in cash and introduced a motor car valued at $20,000 to the business. What is Dominic’s equity at 31 December 2017?

2.10 LO2

Cohen has the following assets and liabilities at year-end: $ Property Fixtures and fittings Motor vehicles Equipment Trade payables Cash at bank

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Loan

150,000 26,000 36,000 126,000 32,000 16,000 100,000

Inventory

80,000

Trade receivables

42,000

During the year, the business made a profit of $110,000 and the owner injected $50,000 into the business. The owner’s equity at the beginning of the year was $240,000. How much did the owner withdraw during the year? 2.11 LO2/4

The following is a list of the assets and claims of Crafty Engineering Ltd as at 30 June 2017: $ Accounts payable Motor vehicles

86,000 38,000

Loan from St George Bank

260,000

Machinery and tools

207,000

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

Bank overdraft

116,000

Inventory

153,000

Freehold premises

320,000

Accounts receivable

185,000

(a) Using the vertical format, prepare the statement of financial position of the business as at 30 June 2017 from the above information. (b) Discuss the significant features revealed by this financial report.

INTERMEDIATE 2.12 LO6

The following represents a statement of financial position extract of Hi Rise Ltd over a three-year period: Account type

Account

Assets

Current

Liabilities Equity

Year 1 $

Year 2 $

Year 3 $

50,000

55,000

60,000

Non-current

100,000

145,000

240,000

Total

150,000

200,000

300,000

Current

20,000

60,000

100,000

Non-current

30,000

30,000

80,000

Contributed

100,000

100,000

100,000

Reserves Total liabilities and equities

Nil

10,000

20,000

150,000

200,000

300,000

Based on the changes over the three-year period, comment on (a) the solvency, or financial stability, of the business (b) the liquidity, or ability to meet short-term obligations. 2.13 LO2/3

Complete the table of assets below by classifying each account in terms of being: •

current

•

non-current: investments

•

non-current: property, plant and equipment

•

non-current: intangibles.

Account

Classification

Cash at bank Copyright © 2017. P.Ed Australia. All rights reserved.

Patent Equipment Prepayment Land Goodwill Accounts receivable Shares in Telstra Accumulated depreciation—equipment Inventories Leasehold improvements Interest prepaid Government bonds

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2.14 LO2

You are provided with the following statement of financial position at the start of the week and the seven transactions for the week. Complete the table to show how each transaction affected the accounts together with the balances at the end of the period. Beginning Assets

$

Cash

3,000

Accounts receivable

5,000

Inventory

7,000

Freehold premises

60,000

Furniture and fittings

18,000

Transactions 1

2

3

4

5

Ending 6

7

93,000 Liabilities Trade creditors Bank loan

3,000 30,000 33,000 60,000

Capital

93,000 Transactions for the week: 1. Purchased inventory on credit for $5,000 2. Collected $4,000 from customers 3. Sales: Cash $2,000 Credit $6,000

(Cost $1,500) (Cost $4,500)

4. Paid creditors $7,000 5. Owner’s additional cash contribution $10,000 6. Purchased furniture for cash $6,000 7. Loan repayment of $2,000.

2.15 LO2/4

On 1 March 2017 Joe Conday started a new business. During March he carried out the following transactions:

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March 1 Deposited $20,000 in a bank account. 2 Purchased fixtures and fittings for $6,000 cash, and inventory valued at $8,000 on credit. 3 Borrowed $5,000 from a relative and deposited it in the bank. 4 Purchased a car for $7,000 cash and withdrew $200 for own use. 5 Purchased another car costing $9,000. The car purchased on 4 March was given in part exchange at a value of $6,500. The balance of the purchase price for the new car was paid in cash. 6 Conday won $2,000 in a lottery and paid the amount into the business bank account. He also repaid $1,000 of the loan. (a) Prepare a statement of financial position for the business at the end of each day using the horizontal format. (b) Show how the statement of financial position you have prepared as at 6 March 2017 would be presented in the vertical format.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

CHALLENGING 2.16 LO1–3

For each of the following transactions determine: (a) Should an asset be recognised? (b) If yes, what would it be called? (c) If no, why is no asset recognised? Transaction

Yes—asset name No—reason

1 Signed a contract for a $300,000 building 2 Undertook basic research of $40,000 on a new product 3 Delivered goods to a customer related to credit sales contract 4 Special staff training program related to new regulations— cost $10,000 5 Cash purchase of a new computer for $23,000 6 Paid initial payment of $5,000 related to the financial lease of a bus 2.17 LO2

Identify the errors and prepare a classified statement of financial position to reveal account balance errors. Assets

$

Current assets Cash at bank Accounts receivable Land Supplies used Administrative expenses Total current assets

Accounts payable

37,800

16,700

Inventory

45,300

123,900 5,400

Total current liabilities

16,900

Non-current liabilities

180,500

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176,700

2,100

Prepaid insurance

85,200

Retained earnings

53,700

Long-term debentures

40,000

Short-term note payable

15,000

Equipment

53,800

Accumulated depreciation—buildings

29,400

Intangible assets

45,000

Accumulated depreciation—equipment

23,700

Unearned income

6,400

Total non-current liabilities

161,800 247,000

Total non-current assets

181,900

Total liabilities

Total assets

462,400

Shareholders’ equity Share capital

200,000 15,400

Reserves Total liabilities and shareholders’ equity 2.18 LO2/4

$

17,600

Non-current assets Buildings

Liabilities and shareholders’ equity Current liabilities

462,400

You are presented with the following statement of financial position which is an incorrect draft. Assuming the accounts and amounts are correct, prepare the statement of financial position again, making the necessary corrections. $

$

Current assets Cash at bank

9,000

Accounts payable

11,000

Plant and machinery

26,000

46,000

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ACCOUNTING FOR BUSINESS STUDENTS

Non-current assets Inventory

15,000

Asset revaluation increment

20,000

Motor vehicles

18,000

53,000 99,000

Total assets Current liabilities Accounts receivable

6,000

Prepayments

1,000

7,000

Non-current liabilities Bank overdraft

14,000

Land and buildings

50,000

Loan

10,000

74,000

Owner’s equity Opening balance

40,000

Minus profit

32,000

Add drawings

10,000

18,000 99,000

Total liabilities and owner’s equity 2.19 LO6

Provide a report based on your evaluation of the following three statements of financial position in terms of: (a) liquidity (b) solvency (c) asset mix.

A $’000

Current assets

500

Non-current assets

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C $’000

300

700

500

700

300

1,000

1,000

1,000

Current liabilities

300

100

100

Non-current liabilities

200

200

600

Total liabilities

500

300

700

Owners’ contributions

400

100

200

Reserves

100

600

100

Total owners’ equity

500

700

300

Total assets

2.20 LO2/5

B $’000

The asset accounts of Out and Down Ltd have been evaluated and the following values determined: Asset

Initial cost

Residual Replacement cost price

Net realisable value

Present value expected future cash flows

Inventory

27,000

N/A

Accounts receivable

13,500

11,200

45,000

56,000

53,400

N/A

10,800

10,100

Prepayment

1,400

800

1,000

300

N/A

Equipment

60,000

48,000

Investments

20,000

N/A

72,000

39,000

85,000

32,000

32,000

32,000

Patent

25,000

15,000

36,000

42,000

47,000

Note: Residual cost equals cost less accumulated depreciation. Net realisable value equals selling price less costs to sell. For each of the listed accounts, which figures would be permitted to be disclosed in the asset section Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. of the statement of financial position? Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

CHAPTER 2 CASE STUDY Usefulness of the statement of financial position If you were to do an internet search on ‘balance sheet uses’, you would get a series of hits ranging from Wikipedia through a number of commercial and academic sites. Undertake a search of this type and summarise your findings. Your summary should include, but not necessarily be confined to, the following: 1

The balance sheet/statement of financial position provides a summary of the assets and liabilities controlled by the business. It provides a snapshot of the assets and liabilities at a particular moment in time.

2

3 4 5 6 7 8 9

These assets and liabilities are broken down under appropriate categories. It shows how the business is funded. The amount of the owners’ equity can be clearly seen. Equity can be broken down into contributed capital and other retentions. The level of debt, and the type of debt, can be clearly seen. Liquidity can be ascertained. The balance sheet follows a fairly standard form.

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QUESTIONS 1

Do you agree that the statement of financial position provides a summary of the assets and liabilities of the business? What kind of omissions can you think of? What limitations does the statement have?

2

How useful is this summary in terms of making economic decisions?

3

The snapshot analogy is a good one, but what are the limitations of an approach of this type?

4

How does the statement of financial position help in assessing the financial health of a business?

5

Can you think of any reasons why the figure shown under equity in a statement of financial position could be misleading?

6

What do you think about the use of debt in a business? Why and when might the use of debt be appropriate?

7

Why might the absence of debt in a business be seen as displaying a sound financial approach?

8

What do you think were the main issues arising from the global financial crisis and how have they impacted on the levels of debt deemed to be acceptable or appropriate?

9

How important might financial flexibility be to a business?

10

Explain the terms ‘current’ and ‘non-current’. Why do you think current and non-current items are separately classified? How might this distinction help you in assessing the appropriateness of funding the assets?

11

What can you learn from the statement of financial position about liquidity within the business? How might you decide what level of liquidity is appropriate?

12

How does the statement of financial position help in assessing the risk inherent in the business?

Concept check answers CC1 CC2 CC3 CC4 CC5

A C C B E

CC6 CC7 CC8 CC9 CC10

B D E D D

CC11 CC12 CC13 CC14 CC15

A D C E E

CC16 C CC17 E

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ACCOUNTING FOR BUSINESS STUDENTS

SOLUTIONS TO ACTIVITIES ACTIVITY 2.1 Your answer should be along the following lines: (a) Under normal circumstances, a business would expect a customer to pay the amount owed. Such an amount is, therefore, typically shown as an asset under the heading ‘debtors’, also referred to as ‘accounts receivable’ or simply ‘receivables’. However, in this particular case the customer is unable to pay. Hence, the item cannot provide future benefits and the $1,000 owing would not be regarded as an asset. Debts that are not paid are referred to as ‘bad debts’. (b) The purchase of the licence would meet all of the conditions set out in the chapter, and would, therefore, be regarded as an asset. (c) The hiring of a new marketing director would not be considered as the acquisition of an asset. One argument against its classification as an asset is that the organisation does not have exclusive rights of control over the director. Nevertheless, it may have an exclusive right to the services that the director provides. Perhaps a stronger argument is that the value of the director cannot be measured in monetary terms with any degree of reliability. (d) The machine would be considered an asset even though it is not yet paid for. Once the organisation has agreed to purchase it and has accepted it, the machine is legally owned by the organisation even though payment is still outstanding. (The amount outstanding would be shown as a claim.) (e) This would appear as a liability known as ‘accounts payable’. Goods have been received but not paid for, so the amount as yet unpaid will appear as a liability. (f) The advance payments relating to subscriptions will be shown as a liability until such time as the magazines have been delivered and the contract completed. (g) A guarantee does not constitute a liability. It will only become a liability should the manager default. (h) This is more problematic, but it would probably be included as a liability if the business recognised that there was a high probability that the legal action would succeed and that the estimated figure was seen as a reasonable estimate.

ACTIVITY 2.2 The statement of financial position as at 4 March, following the repayment of part of the loan, will be as follows: JERRY AND CO. Statement of financial position as at 4 March Assets

Claims

$

Cash at bank

13,000

Owners’ equity

6,000

Motor vehicle

5,000

Liabilities—loan

12,000

Inventory

3,000

Liabilities—accounts payable

Total assets Copyright © 2017. P.Ed Australia. All rights reserved.

$

21,000

Total liabilities and owners’ equity

3,000 21,000

The repayment of $2,000 of the loan will result in a decrease in the balance at the bank of $2,000 and a decrease in the loan claim against the business by the same amount. The statement of financial position as at 6 March will be as follows: JERRY AND CO. Statement of financial position as at 6 March Assets

$

Claims

$

Cash at bank

17,000

Owners’ equity

10,000

Motor vehicle

5,000

Liabilities—loan

12,000

Inventory

3,000

Liabilities—accounts payable

Total assets

25,000

Total liabilities and owners’ equity

3,000 25,000

The introduction of more funds by the owner will result in an increase in the capital of $4,000 and an increase in the cash at bank by the same amount. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

ACTIVITY 2.3 (a) Your answer should be as follows: Non-current assets

Current assets

Fixtures and fittings

Cash at bank

Office equipment

Stock of work-in-progress

Motor vehicles

Short-term investments

Freehold factory premises Plant and machinery Computer equipment (b) Financial institutions such as banks and insurance companies frequently select the liquidity approach to classifying assets to provide more relevant and reliable information to the report users. The nature of their business is largely linked to matching available funds with external claims over time, and classifying both assets and liabilities on a liquidity basis provides valuable insights into the entity’s ability to service such claims.

ACTIVITY 2.4 The statement of financial position you prepare should be set out as follows: SIMONSON ENGINEERING COMPANY Statement of financial position as at 30 September 2017 $

$

Current assets Cash in hand

6,000

Accounts receivable

192,000

Inventory

180,000 378,000

Non-current assets Fixtures and fittings Motor vehicles

36,000 60,000

Plant and machinery

100,000

Freehold premises

288,000 484,000 862,000

Total assets

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Current liabilities Bank overdraft Accounts payable

104,000 72,000 176,000

Non-current liabilities Loan

204,000

Total liabilities

380,000

Capital Opening balance Add profit

470,000 72,000 542,000

Less drawings

60,000 482,000

Total liabilities and owner’s equity

862,000

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 2.5 The term ‘current value’ can be defined in various ways. For example, it can be defined broadly as either the current replacement cost or the current realisable value (selling price) of an item. These two types of valuation may produce quite different figures for the current value of an item. (Think, for example, of second-hand car values: there is often quite a difference between buying and selling prices.) In addition, the broad terms ‘replacement cost’ and ‘realisable value’ can be defined in different ways. We must, therefore, be clear about what kind of current value accounting we wish to use. There are also practical problems with implementing any system of current value accounting. For example, current values, however defined, are often difficult to establish with any real degree of objectivity. This may mean that the figures produced depend heavily on a manager’s opinion. Unless the current value figures can be independently verified in some way, the financial reports risk losing their credibility with users. Two ways of deriving a current value are to find out: • how much would have to be paid to buy vans of a similar type and condition (current replacement cost) • how much a motor van dealer would pay for the vans, were the business to sell them (current realisable value). Both options will normally rely on opinion, and so a range of possible values could be produced for each. For example, both the cost to replace the vans and the proceeds of selling them are likely to vary from one dealer to another. Moreover, the range of values for each option could be significantly different from one option to the other. (The selling prices of the vans are likely to be lower than the amount required to replace them.) Thus, any value finally decided upon could arouse some debate.

ACTIVITY 2.6 The statement of financial position provides an insight into the ‘mix’ of assets held. Thus, it can be seen that, in percentage terms, approximately 60% of assets held are in the form of non-current assets and that freehold premises comprise more than half of the non-current assets held. Current assets held are largely in the form of inventory (approximately 46% of current assets) and accounts receivable (approximately 42% of current assets). The statement of financial position also provides an insight into the liquidity of the business. The current assets are $416,000 and can be viewed as representing cash or near-cash assets held, compared to $168,000 in current liabilities. In this case, it appears that the business could be overly liquid, as the current assets exceed the current liabilities by a large amount. Liquidity is very important in order to maintain the capacity of the business to pay debts. The statement of financial position gives an indication of the financial structure of the business. In the statement provided, it can be seen that the owner is providing $252,000 and long-term lenders are providing $640,000. This means that outsiders contribute, in percentage terms, more than 71% of the total long-term finance required, and the business is, therefore, heavily reliant on outside sources of finance. The business is under pressure to make profits which are at least sufficient to pay interest and make capital repayments when they fall due.

ACTIVITY 2.7

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In a very real sense, some of the simple issues observed here with taking a group photograph are similar to the problems accountants have in taking a financial photograph of the business resources and claims against those resources. For example: • While the statement of financial position is a measure of the resources and claims against the resources at a point in time, some valuable resources, or claims against those resources, may have been left out. For resources to be included as assets, they must satisfy the asset definition and recognition tests. Valuable business resources, such as employees, will not pass such tests and, therefore, will not appear on the statement of financial position. Similarly, legally enforceable claims may not appear on the statement of financial position where contracts are deemed to be of an executory nature (unperformed on either side), such as construction contracts. • There may be incomplete transactions where the outcome is unknown at balance date and so the statement of financial position measure does not accurately reflect the ultimate situation. Will research expenditure lead to valuable future resources? Or what about the extent of future warranty or legal claims against the products or services provided by the entity? • There may be assets in the statement of financial position that ultimately will not lead to future economic benefits, such as the uncollectable accounts receivable balance or spare parts for equipment that will never be used, or liabilities that will not have to be satisfied, such as excessive provisions for future possible claims. • The actual measures used for assets and liabilities are varied and can distort the picture. For assets, we can readily observe the use of initial purchase price; replacement price; selling price; and the net present value of future cash flows expected to be generated by the asset. The aggregation of such varied measures has the potential to yield meaningless totals.

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

• The statement of financial position is largely prepared for a single set of viewers: the equity investors or owners. The content of the statement of financial position is, therefore, potentially biased in favour of a select interest group, rather than a more diversified group who may be interested in more than the economic nuts and bolts. They may also be concerned with social and environmental performance, for example. • Being a static report at a point in time, the statement of financial position cannot cope with any complex interaction of transactions and events involving the entity and its social, economic, legal and political environments. Several important potential limitations of the statement of financial position have already been identified in the analogy with a snapshot (photograph). However, the following are also often cited as deficiencies of the statement of financial position at a point in time:

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• As a result of professional and regulatory requirements or judgements, valuable resources may be excluded (e.g. human resources; research costs; internally developed intangibles). • As a result of professional and regulatory requirements or judgements, legal claims may be excluded (e.g. executory contracts related to employment contracts and purchase or sales agreements). • As a result of professional and regulatory requirements or judgements, some assets included in the statement of financial position may not translate to future economic benefits (e.g. spare parts that may never be used; obsolete inventories; delinquent accounts receivable). • As a result of professional and regulatory requirements or judgements, some liabilities included in the statement of financial position will never translate into future sacrifices (e.g. overstated provisions; convertible notes). • The aggregation of asset balances may not lead to meaningful totals where assets are valued or measured using different attributes (e.g. historic cost; replacement price; selling price; recoverable amount; net present value). • The aggregation of liability balances may not lead to meaningful totals where liabilities are valued or measured using different attributes (e.g. contracted amount; amount to settle now). • The account magnitudes result from applying accounting practices and rules that permit considerable management discretion or choice (e.g. depreciation methods; inventory methods; bad debt methods). • The account magnitudes result from applying methods that require numerous subjective management estimations (e.g. the percentage of credit sales that will not be collected; the percentage of products that will be returned; the average cost of repair for returned items; the estimated life of a depreciable asset; the estimated residual value of a depreciable asset; the estimated realisable value of inventory; the estimated future long-service leave claims). • Account classification problems. A recent problem area concerns certain types of long-term funding that may be either debt or equity depending on future events (e.g. preference shares and convertible notes).

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C H A P T E R X3

MEASURING AND REPORTING CHAPTER NAME FINANCIAL PERFORMANCE LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain the nature and purpose of a statement of financial performance, usually referred to as an income statement, and its relationship with the statement of financial position

LO2 Understand the layout of a typical statement of financial performance, and describe its component parts

LO3 Demonstrate an understanding of income and expenses in relation to definition, recognition, classification and measurement

LO4 Explain the concept of depreciation and its impact on the financial statements LO5 Identify the main issues relating to inventory in the context of the income statement and the statement of financial position

LO6 Identify the main issues regarding receivables in terms of revenue and expense

recognition, and explain their impact on the income statement and the statement of financial position

LO7 Use a first-principles approach to build up a simple set of final accounts, i.e. statement of financial position and income statement

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LO8 Review and interpret the income statement.

In this chapter we will examine the statement of financial performance. This statement has traditionally been called the income statement or the profit and loss statement, and these terminologies may continue in many areas, other than for published accounts of companies. The term ‘income statement’ is probably the most common, and we will use this name in this chapter. The term ‘profit and loss account’ is likely to continue to be used by accountants, as there will always be a need for such an account in the detailed accounting records. In the past, the published income statement was a summary of the content of the detailed account called ‘profit and loss’. However, you need to recognise that the statement of financial performance can be presented under different titles for different purposes (e.g. for internal management purposes, or externally as a general-purpose financial report) and in a range of formats, but all follow the same basic principles. Of particular note, more recently the traditional income statement for entities reporting under the Corporations Act 2001 has been expanded to include a range of gains and losses previously not included. The new statement is known as the statement of comprehensive income. It will be discussed in Chapter 7.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

THE STATEMENT OF FINANCIAL PERFORMANCE—ITS NATURE AND PURPOSE, AND ITS RELATIONSHIP WITH THE STATEMENT OF FINANCIAL POSITION In Chapter 2 we examined the nature and purpose of the statement of financial position. We saw that this statement was concerned with setting out the financial position of a business at a particular moment in time. However, most users need more than just the information on the amount of wealth held by a business at one moment in time. Businesses exist for the primary purpose of generating wealth, or profit, and the profit generated during a specific period is the primary concern of many users of financial reports. Although the amount of profit generated is of particular interest to the owners of a business, other stakeholder groups, such as managers, employees and suppliers, will also have an interest in the profit-making ability of the business. The purpose of the income statement is to measure and report how much profit (financial progress or wealth) the business has generated over a period. It also helps users to gain some impression of how that profit was made. As with the statement of financial position, the principles are the same irrespective of whether the income statement is for a sole proprietorship business, a partnership or a limited company. Profit (or loss) is the difference between the increases in owners’ equity (capital), known as income, and the decreases in owners’ equity, known as expenses. You should note that changes in equity due to additional contributions from the owner(s), or withdrawals in the form of drawings or distributions, will not form part of the profit calculation. The measurement of profit (or loss) for the period requires the calculation of the total income of the business generated during a particular period less the expenses incurred for that period. Income is defined as the increases in economic benefits through the inflow of assets (e.g. cash or amounts owed to a business by accounts receivable) or the reduction in liabilities, which will increase equity (other than those relating to owners’ equity contributions) for the particular reporting period. Income is comprised of both operating ‘revenues’ and ‘other gains/losses’. Revenues represent the gross inflows of future economic benefits gained from the different categories of operating activities (e.g. cash from sales). Other gains represent the net inflows from the non-operating activities, for example the gain on sale of investments, or the gain on foreign currency transactions. Different forms of business enterprise will generate different forms of revenue. Some examples of the different forms that revenue can take are as follows:

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• • • •

sales of goods (e.g. of a manufacturer) fees for services (e.g. of a solicitor) subscriptions (e.g. of a club) interest received (e.g. of an investment fund).

It is quite possible for a business to have more than one source of income.

LO1 Explain the nature and purpose of a statement of financial performance, usually referred to as an income statement, and its relationship with the statement of financial position

income Increases in economic benefits for the accounting period in the form of inflows of assets or decreases in liabilities that result in increases in equity, other than those relating to ownership contributions. revenues Increases in the owners’ claim as a result of operations. other gains Gains from non-operating activities.

ACTIVITY 3.1 The following represent different forms of business enterprise: 1 2 3 4 5 6 7 8 9

accountancy practice squash club bus company newspaper finance company songwriter retailer magazine publisher a large football club, e.g. Arsenal or Manchester United.

Can you identify the main source(s) of revenue for each type of business enterprise? Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

expense A measure of the outflow of assets (or increase in liabilities) incurred as a result of generating revenues.

The total expenses relating to each period must also be identified. Expense is really the opposite of revenue. An expense represents the outflow of assets (or increase in liabilities) incurred in the process of carrying on a business and generating income. The nature of the business will again determine the type of expenses incurred. Examples of some of the more common types of expense are:

• the cost of buying goods which are subsequently sold—known as ‘cost of sales’ or ‘cost of • • • • • • •

goods sold’ salaries and wages rent and rates motor vehicle running expenses insurances printing and stationery heat and light, and telephone and postage.

The income statement for a period simply shows the total income generated during a particular period (revenues and other gains), from which is deducted the total of the expenses incurred in generating that income. The difference between the total income and the total expenses will represent either profit (if income exceeds expenses) or loss (if expenses exceed income). Thus, we have: Profit (loss) for the period 5 Total income (I) 2 Total expenses (E) incurred in generating the income

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reporting period The particular period for which the accounting information is prepared.

The period over which profit or loss is normally measured is usually known as the reporting period, but it is sometimes called the ‘accounting period’ or ‘financial period’. The two major statements—statement of financial position and income statement—should not be viewed as substitutes for each other, but rather as performing different functions. The statement of financial position of a business is a report at a single point in time and is effectively a ‘snapshot’ of the stock of wealth held by the business. The income statement, on the other hand, is concerned with the generation of wealth over a period of time. The two statements are closely related. The income statement can be viewed as linking the statement of financial position at the beginning of the period with that at the end of the period. At the start of a new reporting period, the statement of financial position shows the opening wealth position of the business. After an appropriate period, an income statement is prepared to show the wealth generated over that period. A statement of financial position is then also prepared to reveal the new wealth position at the end of the period. This statement will reflect the changes in wealth that have occurred since the previous statement of financial position was drawn up. Thus, at the commencement of the business, a financial position statement will be produced to reveal the opening financial position: Abeg 5 OEbeg 1 Lbeg

where Abeg 5 assets at the beginning of the period OEbeg 5 owners’ equity (capital) at the beginning of the period, and Lbeg 5 liabilities at the beginning of the period At the end of an appropriate period, an income statement will be prepared to show the wealth generated over the period: Profit (loss) 5 Iperiod – Eperiod

where Iperiod 5 the income for the period, and Eperiod 5 the expenses for the period At the end of the period, a revised statement of financial position will be prepared to incorporate the changes in wealth that have occurred since the beginning financial position statement was

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95

drawn up. This will include adjustments to capital, reflecting the amount of profit for the period and any other owners’ changes disclosed. This means that the accounting equation can be extended as follows: Assetsend 5 OEbeg 1 Profit (or – Loss) 6 Other OEadj 1 Liabilitiesend

where Assetsend 5 the assets at the end of the period Other OEadj 5 other adjustments to equity (i.e. injections and drawings or distributions) Liabilitiesend 5 liabilities at the end of the period This equation can be further extended to: Assetsend 5 OEbeg 1 (Income – Expenses) 6 Other OEadj 1 Liabilitiesend

In theory, it would be possible to calculate profit and loss for the period by making all adjustments for income and expenses through the equity section of the statement of financial position (the capital account), as was done in the solution to Self-assessment Question 2.1. However, this would be rather cumbersome with even a small business. A better solution is to have an ‘appendix’ to the owners’ equity (capital) account in the form of an income statement. By deducting expenses from the income for the period, the profit (loss) can be derived for adjustment to the capital account. This figure represents the net effect of operating and other activities for the period. Providing this ‘appendix’ means that a detailed and more informative view of financial performance is presented to users.

The stock approach to calculating profit It is worth noting that, as a result of the relationship between the income statement and two consecutive statements of financial position, it is possible to compute the total profit or loss for a period based on what is known as the stock approach. Total equity must equal assets less external liabilities (net assets). Therefore, the difference between the opening figure and closing figure for net assets must equal the changes in equity that have occurred over the accounting period. If we know the opening equity figure, any other injections of additional capital, and any drawings by, or distributions to, owners, it should be relatively easy to calculate the profit for the year. This can be done as follows: Opening equity Plus new capital injected Less any drawings or distributions Plus profit Equals the closing equity

known known known or estimated calculate known

net assets The difference between assets and external liabilities.

Example 3.1 illustrates the stock approach. Copyright © 2017. P.Ed Australia. All rights reserved.

stock approach A calculation of profit for a period based on a comparison of net assets over the period adjusted for any known injections or withdrawals of equity, with the resulting difference providing an estimate of profit or loss for the period.

The following summary balance sheets relate to a business.

Non-current assets Current assets Total assets Current liabilities Equity Total equity and liabilities

1 January 2017 $ 600,000 300,000 900,000 150,000 750,000 900,000

31 December 2017 $ 650,000 350,000 1,000,000 175,000 825,000 1,000,000

3.1

During the year, the owners injected a further $50,000 into the business and withdrew regular drawings estimated to be of the order of $10,000 per month. How much profit do you think was made in the course of the year? Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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If we complete the summary table set out earlier, we should be able to estimate the profit figure as follows.

3.1 continued

Opening equity Plus new capital injected Less any drawing or distributions Plus profit Equals the closing equity

750,000 50,000 (120,000) x 825,000

The profit must therefore have been in the order of $145,000.

This approach to working out profit is particularly useful: • where the accounting records are incomplete • where regulatory bodies (e.g. taxation office) need to determine profit or loss when records are unavailable • for insurance assessors or other parties to determine profit or loss where records have been destroyed.

Concept check 1 The statement of financial performance: A B C D E

Is prepared at a particular point in time Is more important than the balance sheet Consists of revenues and expenses All of the above are true None of the above are true.

Concept check 2 Which of the following would not normally be an expense? A

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B C D E

Cost of goods sold Interest received Salaries and wages Utilities Rates.

Concept check 3 Which of the following is true? A B C D E

Drawings are a typical deduction in the determination of profit. The profit equation could be restated as Expenses equal Revenues minus Profit. Income is earned with increases in economic benefits through the outflow of assets. All of the above are true. None of the first three are true.

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THE FORMAT OF THE INCOME STATEMENT The format of the income statement will vary according to both the entity structure (e.g. non-profit entity, sole proprietorship, partnership, company) and the nature of its operations (e.g. manufacturing, retail, service). To illustrate an income statement, let us consider the case of a retail business (i.e. a business that buys goods in their completed state and resells them). Example 3.2 sets out a typical layout for the income statement of a retail business. Retail businesses buy goods from suppliers and resell them to customers (also commonly referred to as consumers).

LO2 Understand the layout of a typical statement of financial performance, and describe its component parts

BETTER-PRICE STORES Income statement for the year ended 31 October 2017

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Sales revenue Cost of sales Gross profit Salaries and wages Rent and rates Heat and light Telephone and postage Insurance Repairs and maintenance Motor vehicle running expenses Depreciation—fixtures and fittings Depreciation—motor vehicles Operating profit Interest on loan Interest received from investments Rent received from property Profit for the year

$ 432,000 (254,000) 178,000 (41,000) (20,000) (10,000) (2,000) (1,000) (5,000) (7,000) (2,000) (4,000) 86,000 (1,000) 2,000 6,000 93,000

3.2

Note that parentheses are used to denote when an item is to be deducted. This convention is used by accountants in preference to 1 or – signs, and this method will normally be used throughout the text. A clear understanding of the key terms used in this statement is important. These are explained below.

Key terms Gross profit The first part of the income statement is concerned with calculating the gross profit for the period. We can see that revenue, which arises from selling the goods, is the first item to appear. Deducted from this item is the cost of sales (also called ‘cost of goods sold’) during the period. This gives the gross profit, which represents the profit from buying and selling goods, without taking into account any other revenues or expenses associated with the business.

gross profit The difference between the revenues from sales and the cost of those sales.

Operating profit From the gross profit, operating expenses (overheads) that have been incurred in operating the business (salaries and wages, rent and rates, and so on) are deducted. The resulting figure is known as the Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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operating profit The increase in wealth for a period that is generated from normal operations.

operating profit for the reporting period. This represents the wealth generated during the period

from the normal activities of the business. It does not take account of any income that the business may have from activities that are not included in its normal operations. Better-Price Stores in Example 3.2 is a retailer, so the interest on some spare cash that the business has invested is not part of its operating profit. Costs of financing the business are also ignored in the calculation of the operating profit.

Profit for the period profit for the period The profit for the year after a reasonable estimate of tax likely for the year.

Having established the operating profit, we add any non-operating income (such as interest receivable) and deduct any non-operating expenses (in this example, interest payable on borrowings made by the business) to arrive at the profit for the period. This is the income that is attributable to the owner(s) of the business, and will be added to the equity figure in the statement of financial position. As can be seen, profit for the period is a residual that is, the amount remaining after deducting all expenses incurred in generating the sales revenue for the period and taking account of non-operating income.

Cost of sales

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cost of sales The cost attributable to the sales revenues.

3.3

The cost of sales (or ‘cost of goods sold’) figure for a period can be identified in different ways. In some businesses, the cost of sales amount for each individual sale is identified at the time of the transaction. Each item of sales revenue is closely matched with the relevant cost of that sale, and so identifying the cost of sales figure for inclusion in the income statement is not a problem. Many large retailers (e.g. supermarkets) have point-of-sale (checkout) devices that not only record each sale but also simultaneously pick up the cost of the goods that are the subject of the particular sale. Other businesses that sell a relatively small number of high-value items (e.g. an engineering business that produces custom-made equipment) also tend to match sales revenue with the cost of the goods sold, at the time of the sale. However, some businesses (e.g. small retailers) do not usually find it practical to match each sale to a particular cost of sales figure as the reporting period progresses. Instead, therefore, they identify the cost of sales figure at the end of the reporting period. To understand how this is done, we need to remember that the cost of sales figure represents the cost of goods that were sold by the business during the period rather than the cost of goods that were bought by that business during the period. Part of the goods bought during a particular period may remain in the business, as inventories, at the reporting period end. These will normally be sold in the next period. To derive the cost of sales for a period, we need to know the amount of opening and closing inventories for the period and the cost of goods bought during the period. Example 3.3 illustrates how the cost of sales is derived.

Better-Price Stores, which we considered in Example 3.2 began the reporting period with unsold inventories of $40,000 and during that year bought inventories at a cost of $289,000. At the end of the year, unsold inventories of $75,000 were still held by the business. The opening inventories at the beginning of the year plus the goods bought during the year will represent the total goods available for resale. Thus: Opening inventories Purchases (goods bought) Goods available for resale

$ 40,000 289,000 329,000

The closing inventories will represent that portion of the total goods available for resale that remains unsold at the end of the period. Thus, the cost of goods actually sold during the period must be the total goods available for resale less the inventories remaining at the end of the period. That is: Goods available for resale Closing inventories Cost of sales (or cost of goods sold)

$ 329,000 (75,000) 254,000

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These calculations are sometimes shown on the face of the income statement as in Example 3.4.

Sales revenue Cost of sales: Opening inventories Purchases (goods bought) Closing inventories Gross profit

$ 432,000 40,000 289,000 (75,000) (254,000) 178,000

3.4

This is just an expanded version of the first section of the income statement for Better-Price Stores, as set out in Example 3.2. We have simply included the additional information concerning inventories balances and purchases for the year in Example 3.3.

Classifying expenses The classifications for the revenue and expense items—as with the classifications of various assets and claims in the statement of financial position—are often a matter of judgement by those who design the accounting system. Thus, the income statement set out in Example 3.2 (page 97) could have included the insurance expense with the telephone and postage expense under a single heading—say, ‘general expenses’. Such decisions are normally based on how useful a particular classification will be to users. This will usually mean that expense items of material size will be shown separately. For businesses that trade as limited companies, however, there are rules that dictate the classification of various items appearing in the financial statements for external reporting purposes. In this case, and in general, expenses are normally classified under four headings: 1 cost of sales 2 selling and distribution 3 administration and general, and

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4 financial.

You should note that this classification applies only to external reporting. More detail would be required by managers in their day-to-day operations, and managerial reports would provide as much detail as was needed. Differences would occur in internal reports for retailers, service providers and manufacturers. Service providers, which might cover businesses such as law, accountancy, consultancy, health, communication, tourism, etc. are unlikely to need a calculation of the cost of sales in quite the same way as a retailer, since service providers do not buy goods for resale. Their income statement would usually include service revenues and a list of expenses to deduce a profit figure. You should note that the figures would almost certainly need to be broken down for management accounting and decision-making purposes by type of service, or by project, or however is deemed most useful by the business. Manufacturers are likely to need more detailed reporting on the manufacturing process and subsequent sale of finished goods. It is also highly likely that inventory will include work-inprogress as well as raw materials and finished goods. There is no standard format for internal reporting for a manufacturing business, but the early part of the income statement needs to identify the main elements that make up the cost of goods produced. This is effectively a manufacturing account. Example 3.5 sets out the main items likely to be found in such an account.

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Manufacturing section of the income statement for a manufacturing business

Raw materials

3.5

Opening balance Plus Purchases and carriage Less Closing balance 5 Cost of raw materials used Plus Direct labour (i.e. labour worked directly on production) Royalties

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Gives a figure known as Prime cost Add Factory overheads Rent and rates Indirect labour (ancillary labour costs related to production) Indirect materials (typically small items that cannot be related to individual jobs) Power Heat and light Depreciation of plant and equipment Plus Opening balance of work-in-progress Less Closing balance of work-in-progress 5 Cost of goods produced

This figure is then transferred into the next section of the income statement, effectively as the equivalent of purchases. The manufacturing section includes only those expenses that relate to manufacturing/production. It is important to note that the income statements prepared so far are based on typical sets of transactions, although very limited in number. The principles used are entirely consistent with those for much larger sets of transactions, but in practice preparation of an income statement for a reasonably large business is likely to be much more complicated. Most businesses have a range of goods and services in their portfolios. Most will want to know something about profitability of the various parts of their business, some of which may be quite different, with different issues at any one time. The reality is that a statement will be prepared for each part of the business, so as to enable its efficiency to be assessed, and these will be combined into a business-wide income statement. By way of example, consider Wesfarmers. Wesfarmers has a number of retail businesses, namely Coles, Bunnings, Target, Kmart and Officeworks, and also a number of industrial arms covering chemical, energy and fertilisers, industrial and safety, and resources. These areas will all require reporting and analysing. The resultant reports will then be totalled and summarised to form the report for the entire business. Large limited companies are required to prepare what are known as segment reports. These will be dealt with in Chapter 7.

ACTIVITY 3.2 The following information relates to the activities of H & S Retailers for the year ended 30 April 2018: $ Motor vehicle running expenses 4,800 Closing inventory 12,000 Rent and rates 20,000 Rent received from sub-letting 8,000 Motor vans 25,200 Annual depreciation—motor vans 6,000 Heat and light 3,600 Telephone and postage 1,800 Sales 389,600

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Goods purchased Insurance Loan interest payable Balance at bank Salaries and wages Opening inventory

273,400 3,000 2,480 19,120 41,600 16,000

Prepare an income statement for the year ended 30 April 2018. (Hint: Not all items listed should appear on this statement.)

The reporting period We have seen already that for reporting to those outside the business, a financial reporting cycle of one year is the norm, although some large businesses produce a half-yearly, or interim, financial statement to provide more frequent feedback on progress. For those who manage a business, however, it is mostly essential to have much more frequent feedback on performance. Thus it is quite common for income statements to be prepared on a quarterly, monthly, weekly or even daily basis in order to show how things are progressing.

Concept check 4 Which of the following is NOT a cause for variation in the basic format of the income statement? A B C D E

Entity structure (e.g. proprietorship) Nature of operations (e.g. retail) Entity structure (e.g. partnership) Nature of operations (e.g. manufacturing) All of the above.

Concept check 5 Which firm would typically show gross profit on their income statement? A B Copyright © 2017. P.Ed Australia. All rights reserved.

C D E

An accountancy practice A legal practice A motor vehicle repairer All of the above None of the above.

Concept check 6 It is common for an income statement to be prepared: A B C D E

Annually Quarterly Monthly All of the above None of the above.

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LO3 Demonstrate an understanding of income and expenses in relation to definition, recognition, classification and measurement

PROFIT MEASUREMENT AND THE RECOGNITION OF REVENUES AND EXPENSES

Recognition of revenues A key issue in the measurement of profit concerns the point at which income (revenue) is recognised. It is possible to recognise income at different points in the production/selling cycle, and the particular point chosen could have a significant effect on the total income reported for the period. Many business failures and corporate crashes happen when profit has been inflated by recognising income before it was realised, and in most of these cases it was never realised. Some points in the production/selling cycle of a manufacturer are identified in Figure 3.1.

Decision to make a product 1 End of the warranty/return period

Collection of the cash

2

10

Product design

3

9

4 Commencement of production

Delivery of the product 8

Receipt of order

Acquisition of raw materials

7

5 Production in process 6 Completion of production

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FIGURE 3.1 Alternative revenue recognition points within the manufacturing cycle

By way of illustration of the problem, let us consider the situation where a motor car dealer receives an order for a new car from one of its customers. The associated revenue could be recognised by the dealer:

• at the time that the order is placed by the customer • at the time that the car is collected by the customer, or • at the time that the customer pays the dealer. These three points could well be quite far apart, particularly where the order relates to a specialist car that is sold to the customer on credit.

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The point chosen is not simply a matter of academic interest: it can have a profound impact on the total revenues reported for a particular reporting period. This, in turn, could have a profound effect on profit. If the sales transaction straddled the end of a reporting period, the choice made between the three possible times for recognising the revenue could determine whether it is included as revenue of an earlier reporting period or a later one. Irrespective of whether we are dealing with the sale of goods or the provision of services, the main criteria for recognising revenue are that:

• the amount of revenue can be measured reliably, and • it is probable that the economic benefits will be received. An additional criterion, however, must be applied where the revenue comes from the sale of goods, which is that:

• ownership and control of the items should pass to the buyer. Implicit in these criteria is that the activities necessary to generate the revenue (e.g. delivery of goods, carrying out repairs) are substantially complete, and that any other related outstanding items (e.g. returns, warranty) can be determined with reasonable certainty. Referring back to the sale of a car by a motor dealer, all of the three criteria mentioned above will usually be fulfilled at the point when the goods are passed to, and accepted by, the customer. This is because:

• the selling price and the settlement terms will have been agreed and therefore the amount of • •

revenue can be reliably measured delivery and acceptance of the goods leads to ownership and control passing to the buyer, and transferring ownership gives the seller legally enforceable rights that make it probable that the buyer will pay.

We can see that the effect of applying these criteria is that a sale on credit is usually recognised before the cash is received. This means that the total sales revenue figure shown in the income statement may include sales transactions for which the cash has yet to be received. The total sales revenue figure in the income statement for a period will often, therefore, be different from the total cash received from sales during that period. For cash sales (i.e. sales where cash is paid at the same time as the goods are transferred), there will be no difference in timing between reporting sales revenue and cash received. Particular issues arise in the context of long-term contracts and services. These are dealt with in more detail below.

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Long-term contracts Some contracts, both for goods and for services, can last for more than one reporting period. If the business providing the goods or service were to wait until the contract was completely fulfilled before recognising revenue, the income statement could give a misleading impression of the wealth generated in the various reporting periods covered by the contract. This is a particular problem for businesses that undertake major long-term contracts, where a single contract could represent a large proportion of their total activities. Construction contracts often extend over a long period of time. Suppose that a customer enters into a contract with a builder to have a new factory built that will take three years to complete. In such a situation, it is possible to recognise revenue before the factory is completed, provided that the building work can be broken down into a number of stages and each stage can be measured reliably. Let us assume that building the factory could be broken down into the following stages:

• • • •

Stage 1: clearing and levelling the land and putting in the foundations Stage 2: building the walls Stage 3: putting on the roof Stage 4: putting in the windows and completing all of the interior work.

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Each stage can be awarded a separate ‘staging’ price, with the total for all the stages being equal to the total contract price for the factory. This means that, as each stage is completed, the builder can recognise the price for that stage as revenue and bill the customer accordingly. This is provided that the outcome of the contract as a whole can be estimated reliably. If the builder were to wait until the factory was completed before recognising revenue, the income statement covering the final year of the contract would recognise all of the revenue on the contract, and the income statements for each preceding year would recognise no revenue. This would give a misleading impression, as it would not reflect the work done during each period.

Services There are certain kinds of services that may take years to complete. One example is where a consultancy business installs a new computer system for the government. Under these circumstances, if the contract can be broken down into stages, and each stage can be reliably measured, a similar approach to that used for long-term construction contracts can be adopted. This will allow revenue to be recognised at each stage of completion. In some cases, a continuous service may be provided to a customer. For example, a telecommunications business may provide open access to the internet for subscribers. Here, the benefits from providing the service are usually assumed to arise evenly over time and so revenue is recognised evenly over the subscription period. Where it is not possible to break down a service into particular stages of completion, or to assume that benefits from providing the service accrue evenly over time, revenue will not usually be recognised until the service is fully completed. The work done by a solicitor on a house purchase for a client would normally be one such example. When a service is provided, there will usually be a timing difference between the recognition of revenue and the receipt of cash. Revenue for providing services is often recognised before the cash is received, as with the sale of goods on credit. However, there are occasions when it is the other way around, usually because the business demands payment before providing the service. Examples include: rent received from letting premises; telephone line rental charges; vehicle licences or TV subscription fees; and subscriptions received for the membership of clubs. Real World 3.1 provides an illustration of the difficulties and importance of determining exactly when a sale should be recognised for income purposes.

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REAL WORLD 3.1 The Hewlett-Packard/Autonomy takeover Hewlett-Packard (HP) bought British so"ware company Autonomy for US$11 billion in 2011. HP subsequently argued that Autonomy included too much revenue upfront in deals selling both so"ware and continuing services to clients, and sued Autonomy. The issue surrounds the question as to when is a sale a sale? The problems identified earlier in this section on revenue recognition can be seen to be real issues in mainstream corporations. The issue seems to be based on just how the rules relating to revenue recognition are applied. Standard practice in this particular industry seems to be that a proportion is recognised upfront, with the balance being spread over the life of the service contract. Each company can determine the appropriate split for them, which then needs to be applied

consistently over time. Obviously HP was unhappy with the split determined by Autonomy. HP wrote down the value of the Autonomy deal by US$8.8 billion in 2012, blaming US$5.5 million on ‘accounting improprieties’. It referred the case to the US Securities and Exchange Commission and the British Serious Fraud Squad. In 2015 Hewlett-Packard unveiled the details of its fraud case against Mike Leach, the founder of Autonomy. Essentially it boils down to the claim that Autonomy fraudulently inflated the revenues. ‘Its purpose was to ensure that the Autonomy group’s financial performance … appeared to be that of a rapidly growing pure so"ware company.’ HP’s allegations are based on Autonomy practices such as recognising sales to resellers rather than to the ultimate

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customer, and allegations of disclosure failures relating to sales of low-margin (even loss-making) computer hardware to support its more lucrative so"ware business. In October 2015, Mike Lynch counter-claimed against Hewlett-Packard for more than US$160 million, for trashing his reputation and hampering his venture capital fundraising efforts. The UK Serious Fraud Squad closed its criminal investigation in January 2015 without bringing charges. Probes by the US Securities and Exchange Commission and the FBI appear to be continuing. Questions have been raised as to why, if there was jiggerypokery at Autonomy, it went unnoticed for so long by so many. The legal arguments continue and are not expected to be finalised until 2018. In September 2016, The Guardian reported that British firm Micro Focus will take on the remaining so"ware assets from HP’s 2011 acquisition. Sources: Andrew Peaple, ‘Accounting for Autonomy’, The Australian, 23 November 2012. ‘Fallen idols’, The Economist, 24 November 2012, www.economist.com/ news/business/21567080-we-were-duped-overpaying-british-so#warecompany-says-hp-fallen-idols. Arik Hesseldahl, ‘HP sues former Autonomy execs, seeking $5 billion in damages’, Recode, 31 March 2015,http://recode.net/2015/03/31/hpsues-former-autonomy-execs-seeking-5-billion-in-damages/. Arik Hesseldahl, ‘HP’s $5.5 billion fraud lawsuit against former Autonomy executive is now public’, Recode, 5 May 2015,http://recode/ net/2015/05/05/hps-5-billion-fraud-lawsuit-against-former-autonomyexecutives-is-now-public/.

Christopher Williams, ‘Autonomy Founder Mike Lynch sues HP for $160m over fraud claims’, The Telegraph, 1 October 2015,www. telegraph.co/uk/finance/news/bysector/mediatechnologyandtelecoms/ electronics/11905834/Autonomy-founder-Mike-Lynch-sues-HP-for160m-over-fraud-claims. Angela Monaghan, Hewlett-Packard offloads last Autonomy assets in so#ware deal, The Guardian, 9 September 2016.

Class discussion points 1 How might the issue regarding the principles of revenue recognition in this case have been addressed and possibly avoided? 2 Is this a case of buyer beware? 3 What are your thoughts on the question raised above— ’why, if there was jiggery-pokery at autonomy, it went unnoticed for so long by so many’? Should this have been at least commented on by the auditors? 4 From a variety of web sources, obtain an understanding of the ways in which the accounting practices might have been deemed fraudulent by HP. What are your opinions on the various practices you have found. Two useful starting points are: Juliette Garside, ‘Hewlett-Packard unveils details of 5bn Autonomy fraud case’, The Guardian, 6 May 2015, http://theguardian.com/ business/2015/may/05/Hewlett-pakard-unveils-details-of-5bnautonomy-case. Richard Waters, ‘Autonomy beset by revenues allegation’, #.com, 5 January 2014, www.#/com/intl/cms/s/0/574ae2ae-7635-11e3-8c8d00144fcabdc0.html.

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Cash versus accrual revenue recognition The application of these recognition criteria in accounting means that a sale on credit is usually recognised before the cash is ultimately received. The total sales figure in the income statement will, therefore, differ from the total cash received from sales. Alternatively, situations may also arise where an entity has received benefits (normally cash) in advance—that is, before providing all of the related goods and services. For example, customers often pay a deposit in advance, or pay for goods or services for a specified future time period (e.g. subscriptions, insurance premiums and service fees are regularly paid in advance). For such transactions the income recognition criteria are not fully satisfied, and the reporting entity receiving such advances should classify the advance receipts as a liability (known as ‘deferred revenue’) in the statement of financial position. They represent an obligation to provide the customer, member or client, goods or services (or a refund where goods or services are not provided) at some time in the future. At this point it is interesting to consider whether there are any other activities, apart from long-term construction contracts, where it may be appropriate to recognise income earlier in the production/selling cycle—that is, to recognise the income before the goods or services are completed or before there is a firm sales contract in place. There are a couple of possibilities:

• where there is a ready market at a given price for all production, e.g. precious minerals, oil, •

105

grain wool where there is an extended period related to the growth, maturity or extraction of the produce, e.g. timber, maturity of wine, discovery of a major oilfield.

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In this section we have distinguished cash and accrual-based accounting: cash accounting recognises income when cash is received; accruals accounting recognises income on the basis that it has been earned irrespective of whether the cash receipt is in arrears or advance. For accounting purposes, we have deemed that income is earned when it is realised, realisation being closely linked to probability of occurrence and reliability of measurement. Cash accounting systems are generally confined to some government agencies and small clubs and societies. Accruals accounting is the norm for business accounting and increasingly for government bodies. Real World 3.2 provides some examples of the way in which revenue is recognised in practice.

REAL WORLD 3.2 Revenue recognition Harvey Norman Holdings Limited Sale of goods ‘Revenue is recognised when the significant risks and rewards of ownership of the goods have passed to the buyer and the costs incurred, or to be incurred, in respect of the transaction can be measured reliably. Risks and rewards are considered passed to the buyer at the time of delivery of the goods to the customer. Lay-by sales are recognised a"er the final payment is received from the customer’ (p. 75).

Dividends ‘Revenue is recognised when the shareholders’ right to receive the payment is established’ (p. 75).

Rental income ‘Rental income arising on investment properties is accounted for on a straight-line basis over the lease terms and is included in revenue due to its operating nature’ (p. 76). Source: Harvey Norman Holdings Limited Annual Report 2016, pp. 75 and 76. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Boral

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Sales revenue is revenue earned from the provision of products or services, net of returns, discounts and allowances.

probable, the associated costs and possible return of the goods can be estimated reliably, there is no continuing management involvement with the goods and the amount of the revenue can be measured reliably.’ ‘Revenue from contracting businesses is included in sale of goods and is recognised in proportion to the stage of completion of the contract. An expected loss is recognised immediately as an expense.’ ‘Revenue from the sale of services is recognised when the service has been provided to the customer and where there are no continuing unfulfilled service obligations.’ ‘Revenue from the sale of land development projects is recognised when all of the following conditions have been met: contracts are exchanged; an appropriate non-refundable deposit is received; and material conditions contained within the contract are met.’ Source: Boral Limited Annual Report 2016, p. 85.

Class discussion points 1 Explain why you think Harvey Norman’s lay-by policy is what it is.

Significant accounting judgements, estimates and assumptions

2 Discuss Boral’s recognition criteria for land development projects, specifically whether you think that recognition should occur on a contract exchange.

‘Revenue from the sale of goods is recognised when the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is

3 What kind of measurement difficulties do you think Boral might have in terms of its recognition criteria relating to long-term contracts?

matching convention The accounting convention which holds that, in measuring income, expenses should be matched to the revenues they helped generate in the same accounting period as those revenues were realised.

Recognition of expenses Having considered the recognition of revenue, let us now turn to the recognition of expenses. The matching convention provides guidance on this. This convention states that expenses should be matched to the revenue that they helped generate. In other words, the expenses associated with a particular item of revenue must be taken into account in the same reporting period as that in which the item of revenue is included. Applying this convention often

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means that an expense reported in the income statement for a period may not be the same as the cash paid for that item during the period. Accruals accounting clearly also applies to recognition of expenses. Also, as with revenues, for an item to be treated as an expense its occurrence must be probable (more likely than less likely) and it must be capable of being reliably measured. In recognising expenses in a specific period, three possibilities arise: 1 the cash payments are the same as the expenses incurred (benefits used up or consumed) 2 the cash payments are less than the expenses incurred, or 3 the cash payments exceed the expenses incurred.

The first possibility poses no problems, as the expense that is recognised on an accrual basis is the same as the cash paid. However, with the other possibilities, the expense recognised on an accrual basis is not the same as the cash paid. We will review these two in more detail. Remember that for the accrual method of recognising expenses, the expense is recognised when it is incurred (i.e. the economic benefits are used up).

Recognising expenses where the expense for the period is more than the cash paid during the period Consider Example 3.6.

Retailer Domestic Ltd sells household electrical appliances. It pays its sales staff a commission of 2% of sales revenue generated. Total sales revenue for last year amounted to $300,000. This will mean that the commission to be paid in respect of the sales for the year will be $6,000. However, by the end of the year, the amount of sales commission that had actually been paid to staff was only $5,000. If the business reported just the amount paid, it would mean that the income statement would not reflect the full expense for the year. This would contravene the matching convention, because not all of the expenses associated with the revenue of the year would have been matched in the income statement. Also, the justification for the commission is clear (better than probable), and it is measurable with accuracy. So the adjustment needed is as follows:

3.6

• Sales commission expense in the income statement will include the amount paid plus the amount outstanding (i.e. $6,000 5 $5,000 1 $1,000).

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• The amount outstanding ($1,000) represents an outstanding liability at the end of the year and will be included under the heading accrued expenses, or ‘accruals’, in the statement of financial position. As this item will have to be paid within 12 months of the year-end, it will be treated as a current liability. • The cash will already have been reduced to reflect the commission paid ($5,000) during the period.

accrued expenses Expenses which are outstanding at the end of the accounting period.

These points are illustrated in Figure 3.2. When the outstanding sales commission is paid (probably in the next quarter): • cash will be reduced, and • the amount of the accrued expense will be reduced/eliminated.

Ideally, all expenses should be matched to the income (e.g. sales) to which they relate, in the period in which they are reported. However, it is often difficult to match certain expenses closely to income in the same way that we have matched sales commission to sales. It is unlikely, for example, that electricity charges incurred can be linked directly to particular sales in this way. As a result, the electricity charges incurred will normally be recognised in (assigned or allocated to) the period to which they relate. Example 3.7 illustrates this.

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Income statement

Statement of cash flows

Sales commission expense $6,000

Statement of financial position at year’s end

Cash $5,000

Accrual $1,000

FIGURE 3.2 Accounting for sales commission This illustrates the main points of Example 3.6. We can see that the sales commission expense of $6,000 (which appears in the income statement) is made up of a cash element of $5,000 and an accrued element of $1,000. The cash element appears in the statement of cash flows, and the accrued element will appear as a year-end liability in the statement of financial position.

3.7

Domestic Ltd has reached the end of its reporting period and has paid for electricity for only the first three quarters of the year (amounting to $1,900). This is simply because the electricity company has only just sent out bills for the quarter that ends on the same date as Domestic Ltd’s year-end. The amount of Domestic Ltd’s bill for this last quarter is $500. In this situation, the amount of the electricity expense outstanding is dealt with as follows: • Electricity expense in the income statement will include the amount paid, plus the amount of the bill for the last quarter (i.e. $1,900 1 $500 5 $2,400) in order to cover the whole year.

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• The amount of the outstanding bill ($500) represents a liability at the end of the year, and will be included under the heading ‘accruals’ or ‘accrued expenses’ in the statement of financial position. This item would normally have to be paid within 12 months of the year-end, and will, therefore, be treated as a current liability. • The cash will already have been reduced to reflect the amount ($1,900) paid for electricity during the period. This treatment will mean that the correct figure for the electricity expense for the year will be included in the income statement. It will also have the effect of showing that, at the end of the reporting period, Domestic Ltd owed the amount of the last quarter’s electricity bill. Dealing with the outstanding amount in this way reflects the dual aspect of the item and will ensure that the accounting equation is maintained.

Domestic Ltd may wish to draw up its income statement before it is able to discover how much it owes for the last quarter’s electricity. In this case it is quite normal to make a reasonable estimate of the amount of the bill, and to use this estimated amount as described above. Examples of other expenses for a retailer that cannot be linked directly to sales revenue, and for which matching will therefore be done on a time basis, include rent and rates, insurance, interest payments and licence fees.

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Recognising expenses where the amount paid during the year is more than the full expense for the period Consider Example 3.8. Domestic Ltd pays rent for its premises quarterly in advance (on 1 January, 1 April, 1 July and 1 October). On the last day of the accounting year (31 December), it pays the next quarter’s rent to the following 31 March ($3,000), which is a day earlier than required. This means that a total of five quarters’ rent has been paid during the year. If the business reported the cash paid in the income statement, this would be more than the full expense for the year. This treatment would also contravene the matching convention and the transaction recognition criterion, because a higher figure than the expenses associated with the income of the year would appear in the income statement.

3.8

This problem is overcome by dealing with the rental payment as follows: • Reduce cash to reflect the full amount of the rent paid during the year (i.e. 5 3 $3,000 5 $15,000). • Show the rent for four quarters as the appropriate expense in the income statement (i.e. 4 3 $3,000 5 $12,000). • Show the quarter’s rent paid in advance ($3,000) as a prepaid expense under assets in the statement of financial position. It is an asset because it represents future economic benefits in terms of the right to use the rented premises for the first three months of the next year. Please note that this example ignores GST, which would apply to commercial rentals. The prepaid expense will appear as a current asset in the statement of financial position, under the heading ‘prepaid expenses’ or ‘prepayments’.

prepaid expenses Expenses that have been paid in advance at the end of the reporting period.

In the next period, this prepayment will cease to be an asset and become an expense in the income statement of that period when the three months’ usage expires. This is because the rent prepaid relates to that period, and will be ‘used up’ during it. These points are illustrated in Figure 3.3.

Income statement

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Statement of cash flows

Rent payable expense $12,000

Statement of financial position at year’s end

Cash $15,000

Prepaid expense $3,000

FIGURE 3.3 Accounting for rent payable This illustrates the main points of Example 3.8. We can see that the rent expense of $12,000 (which appears in the income statement) is made up of four quarters of rent at $3,000 a quarter. This is the amount that relates to the period and is ‘used up’ in the period. The cash paid of $15,000 (which appears in the statement of cash flows) is made up of the five payments of $3,000 per quarter. Finally, the prepayment of $3,000 (which appears in the statement of financial position) represents the payment made on 31 December and relates to the next reporting period.

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materiality convention The convention which says that items need to be separately disclosed if they will be seen as important (material) by users. Items not deemed to be important enough to justify separate disclosure can be grouped together.

In practice, the treatment of accruals and prepayments will be subject to the materiality convention in accounting. This convention states that, where the amounts involved are immaterial (insignificant), we should consider only what is expedient. This may mean that an item will be treated as an expense in the period in which it is paid, rather than being strictly matched to the income to which it relates. For example, a business may find that, at the end of an accounting period, there is a bill of $5 owing for stationery used during the year. The time and effort involved in recording this as an accrual would have little effect on the measurement of profit or financial position for a business of any size, and so it would be ignored when preparing the income statement for the period. Presumably the bill would be paid in the following period and therefore it would be treated as an expense of that period.

ACTIVITY 3.3 A business commences on 1 January. During the course of the first six months the following transactions occurred. 1 2 3 4 5 6

Sales of $200,000 were made, of which 80% were paid in cash by the end of the period. Rent of $21,000 was paid, covering the period to the end of July. Insurance, amounting to $2,000, was paid for the year. Loan interest of $5,000 was paid, covering the first five months of the year. Electricity bills, amounting to $800, were received and paid for during the period ending on 30 April. No other bills were received by the end of the six months. A number of subscriptions covering the entire year were received, amounting to $2,000.

Show how these transactions will appear in the income statement for the first six months of business, and on the statement of financial position as at 30 June.

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Profit, cash and accruals accounting—a review

accruals convention A convention which asserts that profit is the excess of revenue over expenses for a period, not the excess of cash received over cash paid. accruals accounting The system of accounting that adheres to the accruals convention. This system is followed in preparing the statement of financial position and the income statement.

The previous sections on revenues and expenses show that, for a particular reporting period, total revenue does not usually represent cash received, and total expenses are not the same as cash paid. As a result, the profit figure (i.e. total revenue minus total expenses) does not normally represent the net cash generated from operations during a period, so it is important to distinguish between profitability and liquidity. Profit is a measure of achievement, or productive effort, rather than a measure of cash generated. Although making a profit will increase wealth, we have already seen in the previous chapter that cash is only one form in which that wealth may be held. These points are reflected in the accruals convention of accounting, which asserts that profit is the excess of revenue over expenses for a period, not the excess of cash receipts over cash payments. Leading on from this, the approach to accounting that is based on the accruals convention is frequently referred to as accruals accounting. The statement of financial position and the income statement are both prepared on the basis of accruals accounting. The statement of cash flows, on the other hand, is not, as it simply deals with cash receipts and payments. Until now we have been looking at simple differences between income and expense recognition under cash and accrual-based accounting systems. We label these differences ‘deferrals’ and ‘accruals’. Deferred revenue relates to the situation where the cash has been received in advance of it being earned (e.g. subscriptions). Deferred expense relates to the situation where the expense has been paid in advance of being incurred (e.g. rental). Accrued revenue relates to the situation where the revenue has been earned but not received (e.g. credit sales, interest on investments). Accrued expense relates to the situation where the expense has been incurred (economic benefits have been used up) but the payment has not been paid (e.g. wages owing at year-end). We now need to consider several more complex examples of significant deferral and accrual transactions where the cash outlay (cash-based recognition) will not be an appropriate measure of the expense (accrual-based recognition).

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Concept check 7 Revenue is generally recognised when: A B C D E

An order is placed by a customer (e.g. book your flight to Hong Kong) Payment is made The good is delivered or service provided (e.g. on the day of your flight) Any of the above At the date when the income statement is prepared.

Concept check 8 Criteria considered when recognising revenue include: A B C D E

That it is likely the business will be paid That the amount of revenue can be determined That ownership and control pass to the buyer All of the above Some but not all of the above.

Concept check 9 Which of the following businesses will have the least problems with revenue recognition? A B C D

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E

A fast food restaurant An airline An accountant A winery A toothpaste manufacturer.

PROFIT MEASUREMENT AND THE CALCULATION OF DEPRECIATION The expense of depreciation, which appeared in the income statement for Better-Price Stores, is an example of a deferred expense, where the cash is paid in advance of the expense being recognised. Non-current assets (normally with the exception of freehold land) do not have a perpetual existence. They are eventually used up in the process of generating income for the business. This ‘using up’ may relate to physical deterioration (as with a motor vehicle). It may, however, be linked to obsolescence (as with some IT software that is no longer useful) or the mere passage of time (as with a purchased patent, which has a limited period of validity). In essence, depreciation is an attempt to measure that portion of the cost (or fair value) of a non-current asset that has been depleted in generating the revenue recognised during a particular period. Depreciation tends to be relevant both to tangible non-current assets (property, plant and equipment) and to intangible non-current assets (e.g. a licence to operate a mobile phone business). We should be clear that the principle is the same for both of these types of non-current asset. Some non-current assets could have perpetual useful lives. These might include land and acquired goodwill. These assets are typically not depreciated.

LO4 Explain the concept of depreciation and its impact on the financial statements

depreciation A measure of that portion of the cost (less residual value) of a fixed asset which has been expensed during an accounting period.

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amortisation The writing down of an asset—usually an intangible asset—as its benefit is used up; the equivalent of depreciation for a noncurrent asset.

In the case of intangibles, we usually refer to the expense as amortisation, rather than ‘depreciation’. In the interests of brevity, however, we shall use the word ‘depreciation’ for both tangibles and intangibles. In effect, depreciation is a cost allocation process, as the appropriate portion of cost that has been used up can only be an estimate. Management estimates how much of the economic benefits of the related asset have been used up during the period. The depreciation charge (the measure of the economic benefits used up) is considered to be an expense of the period to which it relates.

Calculating depreciation To calculate a depreciation expense for a period, four factors have to be considered: 1 the cost (or fair value) of the asset 2 the useful life of the asset 3 the estimated residual value of the asset to the entity at the end of the useful life of the asset, and 4 the depreciation method used.

The cost (or fair value) of the asset This includes all costs incurred by the business to bring the asset to its required location and to make it ready for use. Thus, in addition to the costs of acquiring the asset, any delivery costs, installation costs (e.g. setting up a new machine) and legal costs incurred in the transfer of legal title (e.g. freehold property) are included as part of the total cost of the asset. Similarly, any costs incurred in improving or altering an asset to make it suitable for its intended use in the business are also included as part of the total cost. Example 3.9 provides an illustration.

Dalton Engineering Ltd purchased a new car for its marketing director. The invoice received from the car supplier revealed the following:

3.9

$ New Holden Cruze Delivery charge Alloy wheels Sun roof Petrol Registration Plates

$ 24,000

500 660 200 30 500 200 2,090 26,090 14,000 12,090

Trade-in: Commodore Amount outstanding

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The cost of the new car will be as follows: $ New Holden Cruze Delivery charge Alloy wheels Sun roof Plates

$ 24,000

500 660 200 200 1,560 25,560

These costs include the delivery costs and plates as they are an integral part of the asset. Improvements (alloy wheels and sunroof) are also regarded as part of the total cost of the car. The petrol costs and registration, however, represent a cost of operating the asset rather than a part of the total cost of acquiring the asset and making it ready for use, so these amounts will be charged as an expense in the period incurred (although part of the cost of the registration may be regarded as a prepaid expense if the period of the registration goes beyond the end of the current financial year). The trade-in figure shown is part-payment of the total amount outstanding, and is not relevant to a consideration of the total cost.

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The fair value of an asset was defined in Chapter 2 as the exchange value that could be obtained in an arm’s length transaction. Revaluations upwards from cost only occur if the fair value can be measured reliably. They are quite common with regard to certain types of assets (e.g. buildings), but are rare with regard to intangible non-current assets. Where fair values have been used, the depreciation expense should be based on those fair values, rather than on the historic costs.

The useful life of the asset A non-current asset has a physical life, an economic life and a useful life to the entity. The physical life of an asset becomes exhausted by wear and tear and the passage of time, although careful maintenance and improvements can extend this. The economic life of an asset is determined by the effects of technological progress and commercial realities (e.g. changes in demand). The benefits provided by the asset are eventually outweighed by the costs as it becomes unable to compete with newer assets, or becomes irrelevant to the needs of the business. The economic life of a business asset may be much shorter than its physical life. For example, a computer may have a physical life of eight years and an economic life of three years. It is the economic life of an asset that will determine its expected useful life for the purpose of calculating depreciation. Forecasting this, however, may be extremely difficult in practice, as technological progress and shifts in consumer tastes can be swift and unpredictable.

Estimated residual value (disposal value) When a business disposes of a non-current asset it may still be of value to others, and some payment may be received. This payment will represent the asset’s residual value or ‘disposal value’. To calculate the total amount to be depreciated, the estimated residual value of the asset must be deducted from its cost. The likely amount to be received on disposal is, once again, often difficult to predict. The best guide is often past experience of similar assets sold.

residual value The expected value at the end of the useful life of a non-current asset.

Depreciation methods Once the amount to be depreciated (i.e. the cost or fair value of the asset less any residual value) has been estimated, the business must select a method of allocating this depreciable amount between the reporting periods covering the asset’s useful life. There are various ways in which this can be done. These methods are normally of three types:

• straight-line depreciation—with equal depreciation expense in each period • accelerated depreciation—with systematically higher depreciation expense in the earlier

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•

periods of the asset’s useful life, and systematically smaller depreciation expense in the later periods of its useful life units of production-based depreciation—the depreciation expense allocated to each period reflects an objective measure of the asset’s life (e.g. kilometres travelled, units produced hours of operation).

Straight-line depreciation simply allocates the amount to be depreciated evenly over the useful

life of the asset. In other words, there is an equal depreciation expense for each year that the asset is held. Example 3.10 illustrates how this works.

straight-line depreciation A method of accounting for depreciation which allocates the amount to be depreciated evenly over the useful life of the asset.

Consider the following information: Cost of machine Estimated residual value at the end of its useful life Estimated useful life

$40,000 $1,024 4 years

To calculate the depreciation expense for each year, the total amount to be depreciated must be calculated. This will be the total cost less the estimated residual value: $40,000 – $1,024 5 $38,976. Having done this, the annual depreciation charge can be derived by dividing the amount to be depreciated by the estimated useful life of the asset of four years. The calculation is, therefore:

3.10

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Thus, the annual depreciation expense which appears in the income statement in relation to this asset will be $9,744 for each of the four years of the asset’s life.

3.10 continued

The amount of depreciation relating to the asset will be accumulated for as long as the asset continues to be owned by the business or until the accumulated depreciation amounts to the cost (or fair value) less the residual value. This accumulated depreciation figure will increase each year as a result of the annual depreciation expense in the income statement. This accumulated amount will be deducted from the cost (or fair value) of the asset on the statement of financial position. Thus, for example, at the end of the second year the accumulated depreciation will be $9,744 3 2 5 $19,488 and the asset details will appear on the statement of financial position as follows: $ 40,000 19,488

Machine at cost Less accumulated depreciation

$

20,512

written-down value The cost or fair value of an asset less the accumulated amount written off as depreciation to date. net book value Another term for writtendown value. carrying amount The net book value shown in the statement of financial position at a point of time.

The balance of $20,512 shown in Example 3.10 is referred to as the written-down value or net book value or carrying amount of the asset. It represents that portion of the cost (or fair value) of the asset which has still to be written off (or allocated against future income generated from using the asset). This figure does not represent the current market value, which may be quite different. The only point at which the carrying amount is intended to equal the market value of the asset is immediately before it is to be disposed of. Thus, in Example 3.10, at the end of the four-year life of the machine, the carrying amount would be $1,024—its estimated disposal value. Disclosure of the two components parts of the written-down value is generally considered to provide useful information as compared with disclosure of just a single figure. The straight-line method derives its name from the fact that the written-down value of the asset at the end of each year, when graphed against time, will result in a straight line, as shown in Figure 3.4.

Written-down 40 value ($000)

30

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20

10

0

1

2

3

4

Asset life (years)

FIGURE 3.4 Graph of written-down value against time using the straight-line depreciation method The figure shows that the written-down value of the asset declines by a constant amount each year. This is because the straight-line depreciation method provides a constant depreciation charge each year. The result, when plotted on a graph, is a straight line.

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The second approach to calculating depreciation for a period is referred to as accelerated depreciation. The most common accelerated depreciation method is known as the reducingbalance method (or declining-balance method), which applies a fixed percentage rate of depreciation to the written-down value of an asset each year. The effect of this will be higher annual depreciation charges in the early years and lower charges in the later years. Deriving the fixed percentage to be applied requires the use of the following formula: P = a1 –

Î

n

R b 3 100% C

where: P 5 the depreciation percentage n 5 the useful life of the assets (in years) R 5 the residual value of the asset C 5 the cost of the asset. In practice an estimated approximate rate is often used. The fixed percentage rate will be given in all examples used in this text. To illustrate this method, let us take the same information used in Example 3.10, but this time use a fixed percentage (60%) of the written-down value to determine the annual depreciation charge. The calculations are shown in Example 3.11.

$ 40,000 24,000 16,000 9,600 6,400 3,840 2,560 1,536 1,024

Cost of machine Year 1 depreciation charge (60% of cost) Written-down value (WDV) Year 2 depreciation charge (60% WDV) Written-down value Year 3 depreciation charge (60% WDV) Written-down value Year 4 depreciation charge (60% WDV) Residual value

accelerated depreciation An approach to the calculation of depreciation expense which results in depreciation expenses being higher in the early years of an asset’s life than in later years. reducing-balance method A method of depreciation in which a fixed percentage is applied to the written-down value of the asset.

3.11

We can see that the pattern of depreciation is quite different between the first two methods. If we plot the written-down value of the asset derived by using the reducing-balance method against time, the result will be as shown in Figure 3.5.

FIGURE 3.5

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Written-down 40 value ($000)

Graph of written-down value against time using the reducingbalance depreciation method

30

The figure shows that, under the reducing-balance depreciation method, the written-down value of an asset falls by a larger amount in the earlier years than in the later years. This is because the depreciation charge is based on a fixed-rate percentage of the written-down value.

20

10

0

1

2

3

115

4

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The third approach to calculating depreciation is based on the units of production. Under this method, the useful life of the asset changes from ‘time’ to ‘output’. This method multiplies the depreciable amount by the relative output for each period. Referring to Example 3.10, we now need to know the expected total production, and the production for each year, as shown in Example 3.12.

Year 1 2 3 4

3.12

Units of production 1,000 4,000 3,000 2,000

The formula is: Cost – Residual value Total estimated units

3 Production units in the period

($40,000 2 $1,024) 3 10,000 units 5 $3.8976 per unit Applying this method gives us the following schedule of depreciation over the four years. Cost of machine Year 1 depreciation charge (1,000 3 $3.8976) Written-down value (WDV) Year 2 depreciation charge (4,000 3 $3.8976) Written-down value Year 3 depreciation charge (3,000 3 $3.8976) Written-down value Year 4 depreciation charge (2,000 3 $3.8976) Residual value

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units of production method of depreciation A method of depreciation based on the relationship between the production achieved in a particular period and the total production expected to be achieved in the lifetime of the particular asset.

40,000 3,898 36,102 15,590 20,512 11,693 8,819 7,795 1,024

If we plot the written-down value of the asset derived by using the units of production method, the result is shown in Figure 3.6.

Written-down 40 value ($000)

36,102

30

20,512

20

10

8,819 1,024 0

1

2

3

4

Asset life (years)

FIGURE 3.6 Graph of written-down value against time using the units of production method

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At this point it is probably useful to consider the impact that use of the different depreciation methods has on profit. Let us assume that the machine used in the last three examples was owned by a business that made a profit before depreciation of $20,000 for each of the four years in which the asset was held. The impact on profit is shown below.

STRAIGHT-LINE METHOD Profit before depreciation $

Depreciation $

Profit $

Year 1

20,000

9,744

10,256

Year 2

20,000

9,744

10,256

Year 3

20,000

9,744

10,256

Year 4

20,000

9,744

10,256

38,976

41,024

Profit before depreciation $

Depreciation $

Profit/(Loss) $

Year 1

20,000

24,000

(4,000)

Year 2

20,000

9,600

10,400

Year 3

20,000

3,840

16,160

Year 4

20,000

1,536

18,464

38,976

41,024

Profit before depreciation $

Depreciation $

Profit/(Loss) $

Year 1

20,000

3,898

16,102

Year 2

20,000

15,590

4,410

Year 3

20,000

11,693

8,307

Year 4

20,000

7,795

12,205

38,976

41,024

REDUCING-BALANCE METHOD

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UNITS OF PRODUCTION METHOD

The above calculations reveal that the straight-line method of depreciation results in a constant profit figure over the four-year period. This is because both the profit before depreciation and the depreciation charge are constant over the period. The reducing-balance method, however, results in a changing profit figure over time. In the first year a loss is reported and thereafter a rising profit is reported. The unit of production method reflects variability in the use of the machine and resulting profit as the production is quite variable. Although the pattern of profit over the period will be quite different depending on the depreciation method used, the total profit for the period will remain the same. This is because the three methods of depreciating will allocate the same amount of total depreciation over the four-year period. It is only the amount allocated between years that will differ. In practice, the use of different depreciation methods may not have such a dramatic effect on profits as suggested above. This is because businesses typically have more than one depreciating noncurrent asset. Where a business replaces some of its assets each year, the total depreciation charge calculated under the reducing-balance method (or the units of production approach) will reflect a

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range of charges (from high through to low), as assets will be at different points in the replacement cycle. This could mean that the total depreciation charge under these methods may not significantly differ from the total depreciation charge that would be derived under the straight-line method.

Selecting a depreciation method How does a business choose which depreciation method to use for a particular asset? The most appropriate method is the one that best matches the depreciation expense to the income it helped generate. The business may, therefore, decide to examine the pattern of benefits flowing from the asset. Where the benefits are likely to remain fairly constant over time (e.g. buildings), the straight-line method may be most appropriate. Where assets lose their efficiency over time and the benefits decline as a result (e.g. certain types of machinery), the reducing-balance method may be more appropriate. The units of production method mentioned above is particularly relevant where depreciation relates more to use than to time, or to technological or commercial factors. Where the pattern of economic benefits provided by the asset is uncertain, the straight-line method is normally chosen. There is an accounting standard to deal with the depreciation of property, plant and equipment. As we shall see in Chapter 7, the purpose of accounting standards is to narrow areas of accounting difference and to try to ensure that information provided to users is transparent and comparable. The relevant standard endorses the view that the depreciation method chosen should reflect the pattern of economic benefits provided, but does not specify particular methods to be used. It states that the useful life, depreciation method and residual values of non-current assets should be reviewed at least annually and adjustments made where appropriate. Figure 3.7 provides an overview of the depreciation process related to non-current assets.

Cost (or fair value) less Residual value equals

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Depreciable amount

Year 1

Year 2

Year 3

Year 4

Depreciation

Depreciation

Depreciation

Depreciation

Asset life (number of years)

FIGURE 3.7 Calculating the annual depreciation charge The cost (or fair value) of an asset less the residual value represents the amount to be depreciated. This amount is depreciated over the useful life (four years in this particular case) of the asset using an appropriate depreciation method.

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Impairment and depreciation We saw in Chapter 2 that all non-current assets could be subjected to an impairment test. Where a non-current asset with a finite life has its carrying amount reduced as a result of an impairment test, depreciation expenses for future reporting periods should be based on the impaired value of that asset.

Depreciation and the replacement of fixed assets Some people appear to believe that the purpose of depreciation is to provide the funds for the replacement of a non-current asset when it reaches the end of its useful life. However, this is not the case. It was mentioned earlier that depreciation represents an attempt to allocate the cost or fair value (less any residual value) of a non-current asset over its expected useful life. The depreciation expense for a particular reporting period is used in calculating profit for that period. If a depreciation charge is excluded from the income statement, we will not have a fair measure of financial performance. Whether or not the business intends to replace the asset in the future is irrelevant. Where an asset is to be replaced, the depreciation expense in the income statement will not ensure that liquid funds are set aside specifically for this purpose. Although the depreciation expense will reduce profit, and therefore reduce the amount that the owners may decide to withdraw, the amounts retained within the business as a result may be invested in ways that are unrelated to the replacement of the asset.

Depreciation and judgement When reading the above sections on depreciation it may have struck you that accounting is not as precise and objective as is sometimes suggested. There are areas where judgement is required, and depreciation provides a good illustration of this. Examples include: the expected residual or disposal value of the asset; the expected useful life of the asset; and the choice of depreciation method. Making different judgements on these matters will produce a different pattern of depreciation expense over the life of the asset and, therefore, a different pattern of reported profits. However, any under- or over-estimations made in this context will be adjusted for in the final year of an asset’s life (as a gain or loss on disposal), so the total depreciation charge (and total profit) over the asset’s life will not be affected by estimation errors.

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ACTIVITY 3.4 Sally Dalton (Packaging) Ltd bought a machine for $40,000. At the end of its useful life of four years, the amount received on sale was $4,000. When the asset was bought, the business received two estimates of the likely residual value of the asset, which were: (a) $8,000 and (b) zero. Show the pattern of annual depreciation expenses over the four years and the total depreciation expenses for the asset under each of the two estimates. The straight-line method should be used to calculate the annual depreciation expenses.

The final adjustment for under-depreciation of an asset is often referred to as ‘loss (or deficit) on sale of non-current asset’, as the amount actually received is less than the residual value. Similarly, the adjustment for over-depreciation is often referred to as ‘profit (or surplus) on sale of non-current asset’. These final adjustments are normally made as an addition to the expense (or a reduction in the expense) for depreciation in the reporting period of disposal of the asset.

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Concept check 10 Depreciation can be caused by which of the following? A B C D E

The passage of time The physical deterioration of an asset Obsolescence A decision by management to replace an asset All of the above.

Concept check 11 The calculation of depreciation expense requires knowledge of: A B C D E

The current fair value of the asset The useful life of the asset and its residual value at the end of its useful life The depreciation method to be used All of the above Some of the above.

PROFIT MEASUREMENT AND THE VALUATION OF INVENTORY LO5

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Identify the main issues relating to inventory in the context of the income statement and the statement of financial position

As with non-current assets, inventory represents another example of a deferred expense, where the payment for the inventory precedes the recognition of the expense. The valuation of inventory and its impact on profit measurement raises the following issues: • What is inventory? • What is the cost of inventory? • What is the basis for transferring the inventory cost to cost of sales? • What is the net realisable value of inventory?

What is inventory? Inventory for accounting purposes consists of finished goods (e.g. merchandise for a retailer), raw materials (e.g. inputs to the manufacturing process—metal, paint, timber), stores or supplies (e.g. consumables—paper, cleaning liquid), and work-in-progress (e.g. partly finished goods of a manufacturer).

What is the cost of inventory? All costs directly related to bringing the inventory into a saleable state (ready to sell) should be included as part of the cost of inventory. These include: • cost of purchase—which would include the purchase price, government taxes and duties, and freight-inwards costs • costs of conversion—which would largely concern goods being manufactured, including both costs that can be readily or physically traced to the product and others that cannot be obviously traced to the product (these latter costs are referred to as ‘indirect costs’ or ‘overheads’), and • other costs incurred to bring the inventories to their present location and condition—which could include things such as storage, security and display. The ‘cost of inventory’ for profit measurement implies that any costs included in inventory will be deferred as an asset (inventory), and not recognised as an expense until the inventory is sold (cost

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121

of goods sold) or written down (inventory write-down). Costs that are not included in inventory will be recognised immediately as expenses.

What is the basis for transferring the inventory cost to cost of sales? The cost of inventories is important in determining financial performance and position. The cost of inventories sold during a reporting period will affect the calculation of profit, and the cost of inventories held at the end of the reporting period will affect the portrayal of assets held. To calculate the cost of inventories, an assumption must be made about the physical flow of inventories through the business. This assumption need not have anything to do with how inventories actually flow through the business; it is concerned only with providing useful measures of performance and position. Three common assumptions used are: 1 first in, first out (FIFO)—the earliest inventories held are the first to be used 2 last in, first out (LIFO)—the latest inventories held are the first to be used 3 weighted average cost (AVCO)—inventories entering the business lose their separate identity and go into a ‘pool’; any issues with inventories then reflect the average cost of the inventories that are held. During a period of changing prices, the choice of assumption used in costing inventories can be important. Example 3.13 provides a simple illustration of how each assumption is applied and the effect of each on financial performance and position.

first in, first out (FIFO) A method of inventory valuation based on the assumption that the first inventory received is the first to be used. last in, first out (LIFO) A method of inventory valuation based on the assumption that the last inventory received is the first to be used. weighted average cost (AVCO) A method of inventory valuation which makes the assumption that the valuation attached to cost of sales is based on an average cost of inventory.

A business supplies coal to factories and has the following transactions during a period. May

1 2 3

Opening stock/inventory Purchased Purchased

6 Sold Closing stock/inventory

Tonnes 1,000 5,000 8,000 14,000 9,000 5,000

Cost per tonne $10 $11 $12

3.13

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Let us now use this information to calculate the cost of goods sold and closing inventory figures for the business. The example shows that purchases of 14,000 tonnes were made, that 9,000 tonnes were used up and sold, and 5,000 tonnes remained as closing inventory. The question is, what value do we put on the 9,000 tonnes which were sold, and what value on the closing inventory?

First in, first out Using FIFO, the first 9,000 tonnes of the purchases are assumed to be those that were sold and the remainder to comprise the closing inventory. Thus we have:

COST OF SALES NO. OF TONNES

COST PER TONNE $

CLOSING INVENTORY TOTAL $

May 1

1,000

10

10,000

2

5,000

11

55,000

3

3,000

12

36,000

Cost of sales

101,000

NO. OF TONNES

COST PER TONNE $

TOTAL $

5,000

12

60,000

Closing inventory

60,000

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Last in, first out Using this approach, the later purchases are assumed to be the first to be sold and the earlier purchases to comprise the closing inventory. Thus we have:

CLOSING INVENTORY

COST OF SALES NO. OF TONNES

COST PER TONNE $

TOTAL $

May 3

8,000

12

96,000

2

1,000

11

11,000

1

–

NO. OF TONNES

COST PER TONNES $

TOTAL $

4,000

11

44,000

1,000

10

10,000

–

Cost of sales

107,000

Closing inventory

54,000

Weighted average cost Using this approach, a weighted average cost will be determined, to derive both the cost of sales and the cost of the remaining inventory held. Thus we have:

PURCHASES

May 1

1,000

COST PER TONNE $ 10

2

5,000

11

55,000

3

8,000 14,000

12

96,000 161,000

NO. OF TONNES

TOTAL $ 10,000

Average cost = $161,000/14,000 = $11.50 per tonne COST OF SALES

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NO. OF TONNES 9,000

COST PER TONNE $ 11.50

CLOSING INVENTORY TOTAL $ 103,500

NO. OF TONNES 5,000

COST PER TONNE $ 11.5

TOTAL $ 57,500

ACTIVITY 3.5 Suppose that the 9,000 tonnes of inventory (coal) were sold for $15 per tonne. (a) (b) (c)

Calculate the gross profit for the period under each of the three methods. How is the financial position affected by each method when prices are rising? Assume that prices are falling rather than rising. How would the financial performance and position differ under the various inventory valuation methods?

It is important to recognise that the different inventory cost allocation methods will affect only the reported profit between years. The figure derived for closing inventory will be carried forward and matched with sales in a later period. Thus, if the cheaper purchases of inventory are matched to sales in the current period, it will mean that the dearer purchases will be matched to sales in a Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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123

later period. Over the life of the business, therefore, the total profit will be the same whichever cost allocation method has been used. In reviewing the different cost allocation methods, we have used a very simple method under which all inventory purchases occur before any sales arise. In reality, the sales and purchases will be interspersed over the period. This leads us to consider briefly the two main inventory recording systems: 1 the perpetual inventory system, and 2 the physical or periodic inventory system.

Perpetual inventory system The perpetual inventory system maintains continuous records of all inventory movements at both cost and selling price. The following summarises these records of inventory and cost of sales. Transaction Purchase Purchase returns Sales (at cost price) Sales returns (at cost price) Owners’ drawings of inventory Stock count losses

Inventory Increase (1) Decrease (2) Decrease (2) Increase (1) Decrease (2) Decrease (2)

Accounts

Cost of sales Increase (1) Decrease (2)

perpetual inventory system A system of recording inventory in detail so as to always be aware of the current level and value of inventory, and which also enables immediate calculation of the transfer to cost of sales.

The advantage of the perpetual system is that at any point in time the business knows what inventory should be on hand and what the cost of sales for the period to date has been. Physical inventory counts are still undertaken to confirm the inventory balances and to assess inventory losses. The implication of the perpetual inventory system for cost allocation is that for the LIFO and average approaches the appropriate costing is determined progressively over time and not at the end of the period. Example 3.14 provides an illustration of this.

Modifying our earlier example as follows, let us recalculate the inventory and cost of sales figures: May 1 2 3 4 6

Opening stock/inventory Purchased Sold Purchased Sold Closing stock/inventory

Tonnes 1,000 5,000 4,000 8,000 5,000 5,000

Cost per tonne $10 $11 $12

3.14

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First in, first out This will be the same irrespective of when the sales are made, as shown below. Detailed records can be kept as described here. The opening balance provides a starting point. To this can be added any new purchases of stock: 1 May Opening balance 1,000 tonnes at $10 5 $10,000 2 May Purchased 5,000 tonnes at $11 5 $55,000 So total inventory at this stage equals: 1,000 tonnes at $10 5 $10,000 plus 5,000 tonnes at $11 5 $55,000 3 May Sold 4,000 tonnes

A reduction would be made reflecting the cost of sales (using FIFO) on this date: 1,000 tonnes at $10 5 $10,000 plus 3,000 tonnes at $11 5 $33,000

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The cost of this particular set of sales would be $43,000, while the remaining inventory on this date would be:

3.14

2,000 tonnes at $11 5 $22,000 4 May Purchased 8,000 tonnes at $12 5 $96,000.

So total inventory on this date equals: 2,000 tonnes at $11 5 $22,000 plus~norn~

continued

8,000 tonnes at $12 5 $96,000 6 May Sold 5,000 tonnes

A reduction would be made reflecting the cost of sales (using FIFO) on this date: 2,000 tonnes at $11 5 $22,000 plus 3,000 tonnes at $12 5 $36,000 The cost of this particular set of sales would be $58,000, while the remaining inventory on this date would be: 5,000 tonnes at $12 5 $60,000 The perpetual inventory method would give us a total cost of sales figure of $43,000 1 $58,000 5 $101,000, which is the same as using the FIFO method (see page 121). The closing inventory is $60,000. Last in, first out Use of the perpetual inventory method and LIFO will often produce figures that differ from those calculated under the earlier system. Using the same example, we find the following 1 May Opening balance 1,000 tonnes at $10 5 $10,000%} 2 May Purchased 5,000 tonnes at $11 5 $55,000%} So total inventory at this stage equals: 1,000 tonnes at $10 5 $10,000 plus 5,000 tonnes at $11 5 $65,000 3 May Sold 4,000 tonnes

A reduction would be made reflecting the cost of sales (using LIFO) on this date: 4,000 tonnes at $11 5 $44,000

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The cost of this particular set of sales would be $44,000, while the remaining inventory on this date would be: 1,000 tonnes at $10 5 $10,000 plus 1,000 tonnes at $11 5 $11,000 4 May Purchased 8,000 tonnes at $12 5 $96,000.

So total inventory on this date equals: 1,000 tonnes at $10 5 $10,000 plus 1,000 tonnes at $11 5 $11,000 plus 8,000 tonnes at $12 5 $96,000 6 May Sold 5,000 tonnes

A reduction would be made reflecting the cost of sales (using LIFO ) on this date: 5,000 tonnes at $12 5 $60,000

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125

The cost of this particular set of sales would be $60,000, while the remaining inventory on this date would be: 1,000 tonnes at $10 5 $10,000 plus

3.14

1,000 tonnes at $11 5 $11,000 plus 3,000 tonnes at $12 5 $36,000 The net effect of this method is to show cost of sales as $44,000 1 $60,000 5 $104,000, and closing stock as $57,000.

continued

Average cost When using this approach, you will adjust the average price each time there is a purchase. In the same example we find the following: May 1 May 2 May 3 May 4 May 6

Opening balance Purchased Balance equals Cost of sales Inventory balance Purchased Inventory balance Cost of sales Inventory balance

1,000 tonnes at $10 5,000 tonnes at $11 6,000 tonnes at $10.8333 4,000 tonnes at $10.8333 2,000 tonnes at $10.8333 8,000 tonnes at $12 10,000 tonnes at $11.7667 5,000 tonnes at $11.7667 5,000 tonnes at $11.7667

5 $10,000 5 $55,000 5 $65,000 5 $43,333 5 $21,667 5 $96,000 5 $117,667 5 $58,833 5 $58,833

The net effect of this method is to show cost of sales as $43,333 1 $58,833 5 $102,166, and closing stock as $58,833.

Physical or periodic inventory system

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The physical or periodic inventory system is much simpler and does not require detailed records of the cost of inventory sold to be maintained. Below is the approach used: • The inventory (asset) account remains unchanged during the year and is updated at the end of the period following the stock count. • Net purchases are recorded in the purchases account, which is an expense account. It is assumed that what is purchased will be sold during the period. • At year-end a stock count is undertaken to update the inventory balance and calculate the cost of sales. • Under this system it is not possible to determine stock losses directly as the assumption is that stock not on hand must have been sold (i.e. is in cost of sales).

periodic inventory system A system of inventory recording which is much simpler than the perpetual method, where it is necessary to count the stock at the end of the period in order to calculate cost of sales for the period.

Essentially the cost of sales is determined using a summary report as follows: Inventory at the beginning x (1) Purchases x (1) Freight inward x (–) Purchase returns (x) (5) Inventory available x (–) Inventory at the end (x) 5 Cost of sales x

The net realisable value of inventory We saw in Chapter 2 that the convention of prudence requires that inventories be valued at the lower of cost and net realisable value. In theory, this means that the valuation method applied to inventories could switch each year, depending on which of cost and net realisable value is the lower. In practice, however, the cost of the inventories held is usually below the current net realisable value—particularly during a period of rising prices. It is, therefore, the cost figure that will normally

net realisable value (NRV) The estimated selling price less any further costs that may be necessary to complete the goods and any costs involved in selling and distributing those goods.

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appear in the statement of financial position. Examples of circumstances where the net realisable value will be lower than the cost of inventories held include: where goods have deteriorated or become obsolete; where there has been a fall in the market price of the goods; where the goods are being used as a ‘loss leader’; or where bad buying decisions have been made. There is an Accounting Standard that deals with inventories. It states that, when preparing financial statements for external reporting, the cost of inventories should normally be determined using either FIFO or AVCO. The standard also requires the ‘lower of cost and net realisable value’ rule to be used, and so endorses the application of the prudence convention. The LIFO assumption is not acceptable for external reporting. There are at least three reasons why the accounting profession has consistently excluded LIFO as an approved inventory cost allocation method: 1 It is contrary to the actual physical flow of inventory where the earliest inventory purchased will normally be sold first. 2 When inventory levels increase over time, the inventory on hand valuation can become very much out of date. 3 The use of LIFO can lead to management’s manipulation of the financial position and financial performance. A large purchase of inventory at the end of the period at a high price will reduce profits (higher cost of sales); at a low price it will inflate profits (lower cost of sales).

consistency convention The accounting convention which holds that when a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time.

Inventory valuation provides a further example of the judgement required to derive the figures for inclusion in the financial statements. The main areas are: the choice of cost method (FIFO, LIFO, AVCO); deciding which items should be included in the cost of inventory (particularly for work-inprogress and the finished goods of a manufacturing business); and deriving the net realisable value figures for inventory held. Inventory valuation and depreciation provide two examples of where the consistency convention should be applied. This convention holds that when a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time. Thus, it would not be usual to switch from, say, FIFO to AVCO between periods. The purpose of this convention is to try to ensure that users can make valid comparisons between periods. Where changes of this type do occur, appropriate disclosures regarding reasons and effects are required.

Concept check 12 Which of the following would NOT be included as a cost of inventory? A B

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C D E

Delivery cost (e.g. freight outward) Purchase cost Import taxes Shipping costs (e.g. freight inward) None of the above. All are costs of inventory.

Concept check 13 Which of the following statements is NOT an inventory flow assumption? A B C D E

FIDO LIFO Weighted average cost All of the above None of the above.

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Concept check 14 Fickle Company wishes to change their inventory flow assumption. Which accounting convention or principle limits their ability to do so? A B C D E

Historical cost Matching Prudence Consistency Conservatism.

PROFIT MEASUREMENT AND THE PROBLEM OF BAD AND DOUBTFUL DEBTS

The traditional approach The recognition of bad and doubtful debts is associated with accruals accounting in general and specifically the matching principle. Most businesses sell goods on credit. When credit sales are made, the revenue is usually recognised as soon as the goods are passed to, and accepted by, the customer. Recording the dual aspect of a credit sale will involve: • increasing the sales, and • increasing accounts receivable by the amount of the credit sale.

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However, with this type of sale there is always the risk that the customer will not pay the amount due. When it is reasonably certain that the customer will not pay, the debt is considered to be ‘bad’, and this must be taken into account when preparing the financial statements. If the bad debt were not taken into account, the effect would be to overstate the assets (receivables) on the statement of financial position and the profit in the income statement, as the sale (which has been recognised) will not result in any future benefits arising. To provide a more realistic picture of financial performance and financial position, any bad debts must be ‘written off’. This will involve: • reducing accounts receivable (debtors), and • increasing expenses (by creating an expense known as ‘bad debts written off’) by the amount of the bad debt.

LO6 Identify the main issues regarding receivables in terms of revenue and expense recognition, and explain their impact on the income statement and the statement of financial position

bad debts Amounts owed to a business that are considered to be irrecoverable.

The matching convention requires that, where possible, the bad debt be written off in the same period as that of the sale that gave rise to the debt. Note that when a debt is bad, the accounting response is not simply to cancel the original sale. If we did this, the income statement would not be so informative. Reporting the bad debts as an expense can be extremely useful in evaluating management performance, particularly credit-granting policies. At the end of the accounting period it may not be possible to identify, with reasonable certainty, all the bad debts that have been incurred during the period. It may be that some debts are unlikely to be collected, but only at some later point in time will the true position become clear. Such uncertainty does not mean that, when preparing the financial reports, we should ignore the possibility that some of the accounts receivable outstanding will eventually prove to be bad. It would not be prudent to do so, nor would it comply with the need to match expenses to the period in which the associated sale is recognised. As a result, the business will normally try to identify all those debts that, at the end of the period, can be classified as ‘doubtful’ (i.e. they may eventually prove to be bad). The determination of doubtful debts is normally achieved either on the basis of the credit sales or by analysing the balances outstanding from accounts receivable.

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With a credit sales approach, a given percentage based on past experience and current expectations is often applied to the credit sales figure to determine the doubtful debts expense. Analysis of the balances outstanding in accounts receivable may involve making an account-by-account analysis of individual accounts receivable, or categorising the total ‘accounts receivable outstanding’ balance in terms of how long the amounts have been outstanding. Analysis using either the percentage of credit sales or the aged listing of accounts receivable will determine the amount of the accounts receivable balance that is not expected to be received. This will be recorded as: • an expense labelled ‘doubtful debts expense’ to be included in the income statement, and • a deduction from the accounts receivable account labelled ‘allowance for doubtful debts’ to be included in the statement of financial position. By recognising doubtful debts we take full account, in the appropriate accounting period, of those accounts receivable for which there is a risk of non-payment. This accounting treatment of doubtful debts will occur in addition to the treatment of bad debts described earlier. Example 3.15 illustrates the reporting of bad and doubtful debts.

Boston Enterprises has accounts receivable of $350,000 at the end of the accounting year to 30 June 2017. Investigation of these accounts receivable reveals that $10,000 is likely to prove irrecoverable, and that recovery of a further $30,000 is doubtful.

3.15

Extracts from the financial statements would be as shown below. Income statement (extracts) for the year ended 30 June 2017 Bad debts written off Doubtful debts expense

$ 10,000 30,000

Statement of financial position (extracts) as at 30 June 2017 Accounts receivable Less allowance for doubtful debts

$ 340,000* 30,000 310,000

*(i.e. $350,000 – $10,000) The allowance for doubtful debts is, of course, an estimate and it is quite likely that the actual amount of debts that ultimately prove to be bad will be different from the estimate.

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Let us say that during the next accounting period it was discovered that $26,000 of the debts considered doubtful proved to be irrecoverable. These debts must now be written off as follows: • reduce accounts receivable by $26,000 • reduce allowance for doubtful debts by $26,000. However, an allowance for doubtful debts of $4,000 will still remain. This amount represents an overestimate made when creating the allowance for the year to 30 June 2017. As the allowance is no longer needed, it should be eliminated. Remember that the allowance was created by raising an expense in the income statement for the year to 30 June 2017. As the expense was too high, the amount of the overestimate should be ‘written back’ in the next accounting period. In other words, it will be treated as income for the year to 30 June 2018. This will mean: • reducing the allowance for doubtful debts by $4,000 • increasing income by $4,000. Ideally, of course, the amount should be written back to the 2017 income statement; however, it is too late to do this. At the end of the year to 30 June 2018, not only will 2017’s overestimate be written back, but a new allowance should be created to take account of the trade receivables arising from 2018’s credit sales that are considered doubtful.

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In practice, you will observe at least three alternative approaches to recording bad and doubtful debts: 1 Firms that recognise ‘bad debts expense’ only on the basis of a realised uncollectable amount

(e.g. customer is bankrupt, customer is deceased, customer cannot be located). 2 Firms that recognise ‘bad debts expense’ and ‘doubtful debts expense’ separately.

The ‘bad debts expense’ is always written off directly against the accounts receivable (debtors) account, as for the conditions discussed above. The ‘doubtful debts expense/ income’ represents the adjustment required each year to the ‘allowance for doubtful debts’ account on the basis of the aged listing analysis, or a percentage of credit sales.

ACTIVITY 3.6 Clayton Conglomerates had debts outstanding at the end of the accounting year to 30 June 2017 of $870,000. The chief accountant believed that $40,000 of those debts were irrecoverable, and that a further $60,000 were doubtful. In the subsequent period, it was found that an over-estimate had been made and that only a further $45,000 of debts actually proved to be bad. Show the relevant extracts in the income statement for both 2017 and 2018 to report the bad debts written off and the allowance for doubtful debts. Also show the relevant statement of financial position extract as at 30 June 2017.

3 Firms that recognise a single ‘bad and doubtful debts expense’. The expense figure is based on

either the percentage of credit sales or the aged listing approach. When bad debts are realised, the amount is deducted from both accounts receivable and the allowance for doubtful debts account. Bad and doubtful debts represent a further area where judgement is required for deriving expenses figures for a particular period. Judgement is often required to derive a figure for bad debts incurred during a period. Views may differ over whether or not a debt is irrecoverable. The decision whether or not to write off a bad debt will affect the expenses for the period and, hence, the reported profit.

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The impairment of assets approach Since the harmonisation of Australian Accounting Standards with International Accounting Standards, an overall impairment test has been applied to many of the assets held by business entities. The standard relating to ‘impairment of assets’ stipulates that assets should not be carried at amounts exceeding the future cash flow expected to be recovered from the use and/or disposal of the particular asset. Where the recoverable amount is less than the carrying amount, the assets are to be written down to the recoverable amount, and the write-down will be labelled ‘impairment loss’. The implications of this for accounting for bad and doubtful debts are: • in calculating the bad and doubtful debts expense, consideration will be given to the amount expected to be recovered—this is essentially the same as what has already been discussed under the traditional approach • the name of the bad and doubtful debts expense may be changed to ‘impairment loss’ on accounts receivable • the reduction in receivables, typically called ‘allowance for doubtful debts’, may be changed to ‘allowance for impairment loss’, and • the asset (accounts receivable) will be said to be recorded on the basis of unimpaired cost; that is, it will be recorded on the basis of cost that has not been written down for impairment.

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Real World 3.3 provides some examples of accounting policies that relate to depreciation, inventory, and bad and doubtful debts.

REAL WORLD 3.3 Accounting policies relating to this chapter Boral Depreciation ‘Depreciation is calculated to expense the cost of items of property, plant and equipment (excluding freehold land) less their estimated residual values on a straight-line basis over their estimated useful lives’ (p. 94). ‘Estimation of useful lives has been based on historical experience. In addition, the condition of the assets is assessed at least annually and considered against the remaining useful life. Adjustments to useful lives are made when considered necessary’ (p. 94). Depreciation and amortisation rates used are: buildings 1–10%; mineral reserves and licences 1–5%; plant and equipment 5–33.3%.

Receivables ‘Trade and other receivables are initially recognised at the value of the invoice issued to the customer and subsequently at the amount considered recoverable from the customer (amortised cost using the effective interest rate method)’ (p. 93). ‘The group has considered the collectability and recoverability of trade receivables. An allowance for doubtful debts has been made for the estimated irrecoverable trade receivable amounts arising from past rendering of services, determined by reference to past default experience’ (p. 93).

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Inventories ‘Inventories are valued at the lower of cost and net realisable value. Net realisable value represents the estimated selling price less all estimated costs of completion and costs incurred in marketing, selling and distribution’ (p. 94). Land development projects are stated at the lower of cost and net realisable value. ‘Cost includes the cost of acquisition, development and holding costs during development. Costs incurred a"er completion of development are expensed as incurred’ (p. 94). Source: Boral Annual Report 2016, Boral Limited, pp. 93–94.

Harvey Norman Holdings Limited Depreciation ‘Depreciation is calculated on a straight-line basis over the estimated useful life of the asset as follows:

• •

Land—not depreciated Leasehold land—lease term

• • • •

Buildings under construction—not depreciated Buildings—20 to 40 years Owned plant and equipment—3 to 20 years Plant and equipment under finance lease—1 to 10 years.

The assets’ residual values, useful lives and amortisation methods are reviewed, and adjusted if appropriate, at each financial year end’ (p. 69).

Allowance for impairment loss on trade receivables ‘Where receivables are outstanding beyond the normal trading terms or beyond the terms specified in the loan agreement, the likelihood of the recovery of these receivables is assessed by management. ‘Due to the large number of debtors, trade receivables are assessed based on supportable past collection history and historical bad debt write-offs. Non-trade debts receivable are assessed on an individual basis if impairment indicators are present’ (p. 68).

Inventories ‘Inventories are valued at the lower of cost and net realisable value and are recorded net of all volume rebates, marketing and business development contributions and settlement discounts. Costs are on a weighted average basis and include the acquisition cost, freight, duty and other inward charges. Net realisable value is the estimated selling price in the ordinary course of business, less estimated costs necessary to make the sale’ (p. 73). Source: Harvey Norman Holdings Limited 2016 Annual Report, pp. 68, 69 and 73. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Class discussion points 1 Discuss Boral’s indicators of receivable impairment. Can you think of any other indicators. 2 Boral includes inventories and work-in-progress at the lower of cost (including materials, labour and appropriate overheads) and net realisable value. What overheads might be appropriate? 3 Comment on the various policies set out in Real World 3.3.

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Concept check 15 The primary issue with accounting for uncollectable credit sales is: A B C D E

How much expense to recognise Determining why the sale was made Determining when to recognise the bad debt expense Determining which accounts are ‘bad’ All of the above.

Concept check 16 The ‘Allowance for doubtful debts’ account is what kind of account? A B C D E

Expense Asset (i.e. contra-asset) Liability Revenue Liability (i.e. contra-liability)

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A FIRST-PRINCIPLES APPROACH You may find it useful to see how a statement of financial position and an income statement can be drawn up from first principles, using the system of pluses and minuses used in Chapter 2 and implicit in Chapter 3 to date. The aim of this section is to ensure that you can take a relatively straightforward set of transactions and build these up into the two fundamental financial statements. Working through these transactions should provide you with a better understanding of the end product, as well as the nature of business transactions. We have seen that transactions involve a dual aspect. We have also developed the following relationship for the balance sheet: Assets 5 Claims

LO7 Use a first-principles approach to build up a simple set of final accounts, i.e. statement of financial position and income statement

which can be expanded to: Assets 5 Capital (equity) 1 External liabilities

After a period of trading this can be further expanded to: Assets at the period end 5 Capital at the start of the period 1 Injections of new capital 2 Drawings 1 Profit (2loss ) 1 External liabilities at the period end

The profit or loss is the sum of revenues less expenses. The income statement is effectively an appendix to the statement of financial position and is a summary of those transactions that affect capital as a result of operations. Let us use Example 3.16 to illustrate this.

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The following is the balance sheet of Jonathan & Co., a retailer, as at 1 January 2016. Jonathan & Co. Balance sheet as at 1 January 2016

3.16

$ Current assets Cash Receivables (debtors) Inventory

$

15,000 20,000 25,000 60,000

Non-current assets Fixtures Premises

10,000 50,000 60,000 120,000

Current liabilities Payables (creditors) Non-current liabilities Loan Capital

25,000 40,000 55,000 120,000

The following is the summary of the transactions for 2016. 1 2 3 4 5 6 7 8 9 10

Purchases of inventory on credit amounted to $200,000, half being for cash and half on credit. Payments to creditors amounted to $105,000. Sales amounted to $330,000, with credit sales being $120,000 and the remainder being for cash. Receipts from debtors were $110,000. Bad debts of $5,000 were written off. Cost of sales amounted to $200,000. Interest on the loan at 7% was paid. Wages amounting to $40,000 were paid. Other expenses amounting to $15,000 were paid. Depreciation is charged as follows:

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Fixtures Premises

$2,000 $5,000

11 At the end of the year it was found that $1,000 of wages was unpaid, insurance of $100 was prepaid, and rates of $900 were outstanding. Insurance and rates are included in other expenses. 12 During the year the owner withdrew cash drawings totalling $45,000. 13 At the end of the year the owner transferred his private vehicle to the business. Its value was estimated at $14,000. The dual effect of these transactions is set out next. 1 Increase in inventory of $100,000 matched by a decrease in cash Increase of inventory of $100,000 matched by an increase in creditors 2 Reduce cash, reduce creditors—$105,000 3 Plus sales revenue (i.e. capital), plus debtors—$120,000 Plus sales revenue, plus cash—$210,000 4 Plus cash, reduce debtors—$110,000 5 Reduce capital (an expense), reduce debtors—$5,000 6 Reduce inventory, reduce capital (an expense)—$200,000 7 Reduce cash, reduce capital (an expense)—$2,800 8 Reduce cash, reduce capital (an expense)—$40,000 9 Reduce cash, reduce capital (an expense)—$15,000

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10 Reduce fixtures, reduce capital (an expense)—$2,000 Reduce premises, reduce capital (an expense)—$5,000 11 Increase a current liability (accrued wages), reduce capital (an expense)—$1,000 Increase assets (insurance prepaid), increase capital (a reduction in an expense)—$100 Increase a current liability (accrued rates), reduce capital (an expense)—$1,000 12 Cash reduced by $45,000 (capital), a drawing reduced by $45,000 13 Vehicle increased by $14,000 capital, (an injection) increased by $14,000

3.16

The transactions all reflect the dual effect. This can be reflected by including them on the balance sheet as a series of pluses or minuses, as shown in the balance sheet below. A two-sided format is used because of the duality link and the link with ledger accounts and double entry book-keeping, which will be introduced in the next chapter. The opening balances are shown in the plus column.

continued

Jonathan & Co. Statement of financial position as at 31 December 2016

Current assets Cash

Debtors/ Receivables Prepaid expenses Inventory

$ 1

$ 2

$ Net

$ 1

$ 2

$ Net

15,000 210,000 110,000

100,000 105,000 2,800 40,000

27,200

Current liabilities Creditors/ 25,000 Payables 100,000

105,000

20,000

20,000 120,000 100

25,000 100,000 100,000 Non-current assets Fixtures 10,000 Premises 50,000 Vehicle 14,000

15,000 45,000 110,000 5,000

Accrued expenses

1,000

25,000 100 25,000

2,000 5,000

8,000 45,000 14,000

Non-current liabilities Loan 40,000 Capital/equity Revenues

55,000 14,000 120,000 210,000

Expenses

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1,900

900

200,000

100

144,300

133

40,000 82,400 45,000

200,000 5,000 2,800 40,000 15,000 2,000 5,000 1,000 900 144,300

So far we have followed the approach used in Chapter 2. All the revenues and expenses are recorded directly onto the statement of financial position. We explained earlier in this chapter that the income statement is effectively an appendix to the statement of financial position. In effect, all the items shown in the statement of financial position above, under the heading revenues and expenses, could be summarised elsewhere and the net figure included in the statement of financial position.

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This would give us:

3.16 continued

Jonathan & Co. Statement of financial position as at 31 December 2016

Current assets Cash Receivables (Debtors) Prepaid expenses Inventory Non-current assets Vehicle Fixtures Premises

$ 27,200 25,000 100 25,000 14,000 8,000 45,000

$

Current liabilities Payables (Creditors) Accrued expenses

$ 20,000 1,900

Non-current liabilities Loan Equity Capital Injections Profit for the year

40,000 55,000 14,000 58,400 127,400 45,000

Less drawings

82,400 144,300

144,300 Jonathan & Co. Income statement for the year ending 31 December 2016 Expenses Cost of sales

$ 200,000

Bad debts Loan interest Wages (40,000 1 1,000) Other expenses (15,000 1 900 – 100) Depreciation Fixtures Premises

Revenues Sales—cash Sales—credit

$ 210,000 120,000

5,000 2,800 41,000 15,800 2,000 5,000 271,600 58,400 330,000

Profit

330,000

The equity section of the balance sheet will simply consist of the opening balance, plus any new injections, plus the final figure of profit (or minus any loss), less any drawings over the period. More formally, the above model can be developed as shown below. Copyright © 2017. P.Ed Australia. All rights reserved.

Assets 5 capital 1 revenues 2 expenses 1 liabilities This can be rearranged to: Assets 1 expenses 5 capital 1 liabilities 1 revenues This equation provides a base for the preparation of the income statement and the statement of financial position, so a list set out as follows must balance. Assets 1

5

Liabilities 1 Equity 1

Expenses

Revenues

The section above the dotted line represents the statement of financial position. The section below the dotted line represents the income statement. In order to separate the two sections, all that needs to be done is to calculate the profit or loss (revenues less expenses) and insert it in the capital/equity section of the statement of financial position. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

ACTIVITY 3.7 This activity builds on the previous example, so you should start with the balance sheet as at 31 December 2016. The summary transactions of Jonathan & Co. for 2017 are shown below: 1

Purchases of inventory on credit amounted to $240,000, half being for cash and half on credit.

2

Payments to creditors amounted to $125,000.

3

Sales amounted to $370,000, with credit sales being $120,000 and the remainder being for cash.

4

Receipts from debtors were $110,000.

5

Bad debts of $3,000 were written off.

6

Cost of sales amounted to $240,000.

7

Interest on the loan at 7% was paid.

8

Wages amounting to $48,000 were paid.

9

Other expenses amounting to $16,000 were paid.

10

Depreciation is charged as follows: Fixtures Premises Vehicle

11

12 13

$2,000 $5,000 $3,000

At the end of the year it was found that $2,000 of wages was unpaid, insurance of $300 was prepaid, and rates of $1,000 were outstanding. Insurance and rates are included in other expenses. During the year the owner withdrew cash drawings totalling $18,000. During the year the business paid for air-conditioning to be installed, at a cost of $10,000, in the owner’s home.

Complete the statement of financial position as at 31 December 2017 and the income statement for 2017 from the information provided earlier in the balance sheet as at 31 December 2016 and the above transactions. You should use the method illustrated above.

The above approach follows a logical, consistent, straightforward approach to recording transactions. The main area of difficulty relates to period-end adjustments. The amount included as an expense for a particular period generally includes the following:

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• any amounts that were paid in earlier periods, but which related to the period in question • that part of the amount paid in the period that related to the period, plus • any amounts due for the period that are unpaid. This means that any amounts paid in the period, but which relate to either the previous period or the following period, need to be deducted in calculating the expense for the year. Any amounts due in earlier periods should be reflected in an opening accrual, which will be paid off. Any amounts paid for a future period need to be reflected in a prepayment in the current statement of financial position. In the above activity, adjustments are needed for wages and other expenses. The cash paid in 2017 for wages was $48,000, but the expense included in the income statement should be $49,000, made up as follows:

• that part of the amount paid in the year that related to the year—$48,000—less $1,000, •

which cleared a 2017 accrual plus any amounts due for the year that are unpaid—$2,000 outstanding at the end of the year.

The ‘other expenses’ figure you should have included in the income statement ($15,900) was arrived at as follows:

• any amounts that were paid in earlier periods, but which relate to the year in question—namely the $100 prepayment

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ACCOUNTING FOR BUSINESS STUDENTS

• that part of the amount paid in the year that related to the year—$16,000 paid, less the $300 •

prepayment relating to the next year, less the $900 relating to 2017, plus any amounts due for the year which are unpaid—$1,000.

Similar adjustments may be needed to convert cash inflows into revenue flows. Sometimes we do not know the cost of sales figure. If this is the case, it is necessary to calculate it by solving the following equation: Opening inventory 1 purchases 2 closing inventory 5 cost of sales.

In exercises and questions you will either be told what the cost of sales figure is, and be left to derive the closing inventory, or you will be told the amount of the closing inventory (usually as the result of a physical count) and be left to calculate the cost of sales.

Concept check 17 Which of the following statements are not true? A B C D

E

All transactions have a dual aspect. Revenues and expenses ultimately result in a reduction in capital. Revenues and expenses can be recorded in what is effectively an appendix to capital. It is possible to keep track of what is happening using a series of first-principles pluses and minuses to record transactions. This first-principles approach can easily provide information for large and complex organisations.

Concept check 18 The owners’ contribution of capital to open the business bank account will result in which of the following: A B C

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D E

An increase in both revenue and equity An increase in revenue and a decrease in equity An increase in cash and a decrease in equity An increase in cash and an increase in equity An increase in both cash and revenue.

Concept check 19 Inventory purchased on credit: A B C D E

Increases the amount of assets Increases the amount of liabilities Increases the amount of equity Some of the above None of the above.

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SELF-ASSESSMENT QUESTION

3.1

TT Motors is a new business which started trading on 1 January 2016. The following is a summary of transactions that occurred during the first year of trading: 1 The owners introduced $70,000 of capital, which was paid into a bank account opened in the name of the business. 2 Premises were rented from 1 January 2016 at an annual rental of $20,000. During the year, rent of $25,000 was paid to the owner of the premises. 3 Rates on the premises were paid during the year as follows: For the period 1 January 2016 to 31 March 2016, $500. For the period 1 April 2016 to 31 March 2017, $1,200. 4 A delivery vehicle, bought on 1 January for $32,000, is expected to be used in the business for four years and then sold for $16,000. 5 Wages totalling $33,500 were paid during the year. At the end of the year, the business owed $630 of wages for the last week of the year. 6 Electricity bills for the first three quarters of the year were paid, totalling $1,650. After 31 December 2016, but before the accounts had been finalised for the year, the bill for the last quarter arrived showing a charge of $620. 7 Inventory totalling $143,000 was bought on credit. 8 Inventory totalling $12,000 was bought for cash. 9 Sales on credit totalled $152,000 (cost $74,000). 10 Cash sales totalled $35,000 (cost $16,000). 11 Receipts from accounts receivable totalled $132,000. 12 Payments of accounts payable totalled $121,000. 13 Vehicle running expenses paid totalled $9,400. At the end of the year it was clear that an accounts receivable of $400 would not be paid. Prepare a statement of financial position as at 31 December 2016 and an income statement for the year to that date.

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USES AND USEFULNESS OF THE INCOME STATEMENT The income statement, like the statement of financial position, has been around for a long time, and most major businesses seem to prepare an income statement on a frequent basis (monthly or even more frequently). This clearly suggests that the income statement is regarded as providing useful information. In particular, this statement should help in providing information on how effective the business has been in generating wealth and how the profit was derived. Since wealth generation is the primary reason for most businesses to exist, assessing how much wealth has been created is an important issue. The income statement reveals the profit for the period, or the ‘bottom line’, as it is sometimes called. This provides a measure of the wealth created for the owners. Gross profit and operating profit are also useful measures of wealth creation. In addition to providing various measures of profit, the income statement provides other information needed for a proper understanding of business performance. It reveals the level of

LO8 Review and interpret the income statement

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sales revenue, and the nature and amount of expenses incurred, which can help in understanding how profit was derived. Example 3.17 provides an illustration of the above points.

Consider the income statement set out below:

3.17

PATEL WHOLESALERS Income statement for the year ended 31 March 2018 Sales Less cost of sales Gross profit Less Salaries and wages Rent and rates Telephone and postage Motor vehicle expenses Depreciation—motor vehicle Depreciation—fixtures and fittings Operating profit Loan interest Profit for the year

$ 460,500 (345,800) 114,700 (45,900) (15,300) (1,400) (3,900) (2,300) (2,200) 43,700 (4,800) 38,900

To evaluate financial performance, the following points might be considered: • The sales figure represents an important measure of production, and can be compared with sales figures of earlier periods and the planned sales figure for the current period to assess the achievement of the business.

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• The gross profit figure can be related to the sales figure to find out the profitability of the goods sold. The statement above shows that the gross profit is about 25% of the sales figure or, to put it another way, for every $1 of sales generated, the gross profit is 25¢. This level of profitability may be compared with past periods, with planned levels of profitability or with comparable figures of similar businesses. • The expenses of the business may be examined and compared with past periods to evaluate operating efficiency. Individual expenses can be related to sales to assess whether the level of expenses is appropriate. Thus, for example, in the above statement, the salaries and wages represent almost 10% of sales, or for every $1 of sales generated, 10¢ is absorbed by employee costs. • Profit can also be related to sales. In the statement shown above, profit is about 8% of sales. Thus, for every $1 of sales, the owners of the business benefit by 8¢. Whether or not this is acceptable will again depend on making the kind of comparisons referred to earlier. Profit as a percentage of sales can vary substantially between different types of businesses. Usually a tradeoff can be made between profitability and sales volume. Some businesses are prepared to accept a low profit percentage in return for generating a high volume of sales. At the other extreme, some businesses may prefer to have a high profit percentage but accept a relatively low volume of sales. For example, a supermarket may fall into the former category while a trader in luxury cars may fall into the latter category.

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Concept check 20 Analysis of the income statement will NOT provide: A B C D E

Useful information An indication of how profit was derived An indication of the company’s financial position Information about sources of revenue Information about types of expenses.

Concept check 21 The ‘bottom line’ refers to: A B C D E

Gross profit Operating profit Gross margin Profit for the year All of the above.

ACTIVITY 3.8 Chan Exporters provides the following income statement:

CHAN EXPORTERS Income statement for the year ending 31 May 2017 $

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Sales Less cost of sales Gross profit Less Salaries and wages Selling and distribution expenses Rent and rates Bad debts written off Telephone and postage Insurance Motor vehicle expenses Loan interest Depreciation—motor vehicle Depreciation—fixtures and fittings Loss for the year

840,000 (620,000) 220,000 (92,000) (44,000) (30,000) (86,000) (4,000) (2,000) (8,000) (5,000) (3,000) (4,000) (58,000)

In the previous year, sales were $640,000. The gross profit was $200,000 and the net profit for the year was $37,000. Analyse the performance of the business for the year to 31 May 2017 as far as the information allows.

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ACCOUNTING FOR BUSINESS STUDENTS

SELF-ASSESSMENT QUESTION

3.2

The following is a draft set of simplified accounts for Pear Ltd for the year ended 30 September 2017. PEAR LTD Income statement for the year ended 30 September 2017 $’000 1,456 (768) 688

Sales Cost of sales Gross profit Less expenses Salaries Depreciation Other operating expenses Operating profit Interest expense Profit before taxation Taxation—30% Profit after taxation

(220) (249) (131) 88 (15) 73 (22) 51

PEAR LTD Statement of financial position as at 30 September 2017 $’000 Current assets Cash at bank Accounts receivable Inventory

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Non-current assets Cost Accumulated depreciation Total assets Current liabilities Bank overdraft Tax payable Accounts payable Other accounts payable Non-current liabilities 10% loan—repayable 2020 Total liabilities Shareholders’ equity Share capital Retained profit Total liabilities and shareholders’ equity

21 182 207 410 1,570 (690) 880 1,290 105 22 88 20 235 300 535 600 155 755 1,290

The following additional information is available: 1 Depreciation has not yet been charged on office equipment with a written-down value of $100,000. This class of asset is depreciated at 12% per annum using the reducing-balance method.

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141

2 A new machine was purchased on credit for $30,000 and delivered on 29 September, but has not been included in the financial statements. 3 A sales invoice to the value of $18,000 for September has been omitted from the accounts. (The cost of sales is stated correctly.) 4 A dividend has been proposed of $25,000. 5 The interest expense on the loan for the second half of the year has not been included in the accounts. 6 A general allowance for doubtful debts is to be made at the rate of 2% of accounts receivable. 7 An invoice for electricity to the value of $2,000 for the quarter ended 30 September 2017 arrived on 4 October and has not been included in the accounts. 8 The charge for taxation will have to be amended to take into account the above information. Prepare a revised set of financial statements for the year ended 30 September 2017, incorporating the additional information in points 1–8 above.

ACCOUNTING AND YOU INCOME TAX In this chapter we have been concerned with the measurement and reporting of income. One important aspect from a personal perspective is income tax. Given below is a summary of the main factors affecting the amount of tax you pay as an individual.

Income tax assessment

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If you’ve been living in Australia and earning money, you will most likely have paid tax to the Australian government. A#er lodging your yearly tax return, you would have received a tax assessment from the Australian Taxation Office (ATO). But have you ever wondered what all those items on your tax assessment actually refer to? Given below is a brief summary of each item at the time of writing. You should check the website of the Australian Taxation Office to ensure that you are working with current information. Taxable income

Represents the net of assessable income and allowable deductions.

Assessable income*

Represents the ordinary and statutory income items that are classified as income within the Income Tax Assessment Act 1997. This would include such things as salary and wages, share of partnership profits, interest, grossed-up dividends, rent, fees for services, taxable capital gains, etc.

Allowable deductions*

Generally you can claim for expenses that you incur in earning your assessable (taxable) income, but not private, domestic or capital expenses. Deductions might include: certain vehicle and travel expenses; gi#s and donations; home office expenses; self-education expenses; tools, equipment and other assets; and expenses incurred in earning investment income. You should note that these will depend on your particular circumstances and the conditions under which payment for these items was made. Basically, a deduction is an amount that can be taken off your assessable income, thus reducing your tax liability.

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ACCOUNTING FOR BUSINESS STUDENTS

Tax payable

This is determined by applying the applicable tax scales to the taxable income. For residents, the tax scales for the year ended 2017 were: $0–$18,200

nil

$18,201–$37,000

19%

$37,001–$87,000

32.5%

$87,001–$180,000

37%

$180,0001

45%

Levies

These represent additional amounts to be paid related to specific benefits received by the taxpayer—the main one being ‘Medicare’, which is based on 2% of the taxable income, although some reductions are available in certain cases. There is also a Temporary Budget Repair Levy, payable at a rate of 2% for taxable incomes over $180,000. Another levy is the HELP or HECS repayment levy based on the level of the debt and the income earned.

Tax offsets (also known as ‘rebates’)

Tax offsets provide a direct reduction of the tax payable. A whole range of offsets are available, but some of the more common ones relate to: spouse or dependent relatives; health insurance; medical expenses; seniors and pensioners; superannuation; and low-income earners.

Adjusted tax payable

The initial tax payable plus levies minus offsets.

Pay as you go (PAYG) withholding tax

The tax paid on the employee’s behalf by the employer during the year. The difference between the adjusted tax payable and the total paid under PAYG will give the net tax payable (or the refund due).

Franking credits

When companies pay dividends out of taxed profits, the tax credit is passed on to the shareholder receiving the dividend. Normally, tax has been paid on all of the profit out of which the dividend is paid. This is called ‘fully franked’. Thus (assuming an income tax rate for companies of 30%), a fully franked dividend of $2,800 needs to be recorded by the taxpayer as: Assessable income: Dividends $4,000 ($2,800 3 100/70) (i.e. the dividend received is net of tax, so the gross dividend is scaled up by 100/70, 30%, being the expected income tax rate for companies). Tax credit: $1,200 ($4,000 3 30%)

Net tax payable

The amount still owing by the taxpayer.

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*These items make up the taxable income but are not actually shown on the assessment. In arriving at the profit for the year for a business, most normal expenses would be treated as deductions, although in some cases the ATO applies its own rules; for example, it uses its own figures for calculating depreciation for tax purposes. Any profits made by individuals through a sole proprietorship or a partnership will be dealt with as part of the individual tax assessment of the owner. Profits made by a corporation will be taxed at a rate applying to companies. At the time of writing this was 30%.

Class discussion points 1 What do you understand by negative gearing? 2 What are the current rules regarding superannuation contributions and benefits? 3 Can you identify reasons why you might feel the need to engage in tax planning? 4 If you were considering setting up a business, which taxation factors might influence your decision to use either a sole partnership or a company?

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

SUMMARY

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In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Explain the nature and purpose of the statement of financial performance, usually referred to as an income statement, and its relationship with the statement of financial position

• Identified the purpose as being the measurement of the increment in wealth during the period • Explained the nature of the income statement • Explained the profit and loss equation • Illustrated use of the stock approach to calculate profit • Illustrated the link between the income statement and the statement of financial position

LO2: Understand the layout of a typical statement of financial performance, and describe its component parts

• Illustrated the typical format for an income statement • Explained the main components of the typical income statement • Illustrated that the income statement is for a specified period

LO3: Demonstrate an understanding of income and expenses in relation to definition, recognition, classification and measurement

Defined and explained ‘income’: • inflows of future economic benefits in the form of asset increases, or liability reductions that result in an increase in owners’ equity of a non-contribution nature • recognition: • probable that the inflow has occurred • the inflow can be reliably measured Defined and explained ‘expenses’: • outflows of future economic benefits in the form of decreases in assets or increases in liabilities that result in a decrease in owners’ equity of a non-distribution nature • recognition: • probable that the outflow has occurred • the outflow can be reliably measured Distinguished between cash and accrual-based accounting

LO4: Explain the concept of depreciation and its impact on the financial statements

Explained depreciation as the allocation of the cost or fair value of a tangible asset to reflect the consumption of that asset’s economic benefits during the period (physical deterioration, technical obsolescence, commercial obsolescence) • The most common allocation methods were identified as: • straight-line • reducing-balance (accelerated) • units of production method

LO5: Identify the main issues relating to inventory in the context of the income statement and the statement of financial position

• • • •

Identified the key issues relating to inventory Defined ‘inventory’ Illustrated what is covered in cost of inventory Illustrated how to arrive at cost of sales • first in, first out • last in, first out • weighted average cost • Illustrated how, in order to conform with the matching and prudence assumptions, inventory is valued on the basis of the lower of cost and net realisable value • Explained inventory recording methods: • perpetual (continuous) • periodic (physical stock count)

• Explained the problems associated with accounts receivable and bad debts, and examined alternative recognition methods: • bad debts are realised in the sense that both the accounts receivable and the amount can be established • doubtful debts relate to amounts that are not expected to be collected in accounts receivable but are not currently uncollectable • Illustrated alternative doubtful debt calculation methods: • applying a given percentage to sales • analysing the balances in accounts receivable Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. LO6: Identify the main issues regarding receivables in terms of revenue and expense recognition, and explain their impact on the income statement and the statement of financial position

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LO7: Use a first-principles approach to build up a simple set of final accounts, i.e. statement of financial position and income statement

Illustrated building up of financial statements from a list of transactions using a system of pluses and minuses

LO8: Review and interpret the income statement

Explained and analysed such statements by comparison with: • past performance • expectations or budget • other firms in the same industry

DISCUSSION QUESTIONS EASY 3.1

LO1/2

What is the major connection between the statements of financial position and performance?

3.2

LO4

Discuss depreciation in the context of the various accounting concepts.

3.3

LO5

Discuss the write-down of inventory to the lower of cost and net realisable value in the context of the various accounting concepts.

3.4

LO3

For accounting and financial reporting, what does it mean to say that an item of income or expense is ‘material’?

3.5

LO2/3

Provide three examples each of (a) non-operating income and (b) operating revenues. Exact classification will depend on the individual business and the nature of its operations.

INTERMEDIATE 3.6

LO1

Company Xcel Ltd announces an increase of 10% in net profit for the year to $1,700,000. As a potential investor in the company: (a) What does this announcement tell you?

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(b) What other information do you require for deciding whether or not to invest in the company? 3.7

LO6

Discuss the provision for doubtful debts in the context of the various accounting concepts.

3.8

LO8

What evidence would suggest that income statement review and analysis is considered a useful exercise? To what end are such reviews conducted?

3.9

LO3

When should income be recognised in the following situations: (a) a long-term construction project? (b) investment in a new-growth forest? (c) wine held in storage for selective ageing? (d) mining exploration?

3.10 LO3/4

It has been said that ‘all costs become expenses’. (a) Distinguish between ‘costs’ and ‘expenses’. (b) Do you agree with this statement? Why/why not?

3.11 LO2/3

‘Although the statement of financial performance is a record of past achievement, the calculations required for certain expenses involve estimates of the future.’ What is meant by this statement? Can you think of examples where estimates of the future are used?

3.12 LO5

You have read that FIFO is the preferred method of inventory valuation because the cost flows match the physical flows of goods, and inventories are recorded at current costs. (a) Do you agree with this assessment? (b) Provide a case to support the use of LIFO.

3.13 LO3

A retailer will normally calculate ‘gross profit’. (a) What is gross profit? (b) How is it related to ‘mark-up’? (c) Why is it such an important measure?

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3.14 LO6

Accounting transactions can be recognised on a ‘cash’ or an ‘accrual’ basis. (a) Explain these two terms. (b) Why have government bodies and councils moved in recent years from a ‘cash basis’ to an ‘accrual basis’ of transaction recognition?

3.15 LO 1–6

In terms of expenses, in this chapter you have specifically reviewed: (a) depreciation of property, plant and equipment (b) cost of goods sold and inventory valuation (c) bad and doubtful debts and accounts receivable. For each of these expenses discuss the significance or influence of the accounting conventions.

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CHALLENGING 3.16 LO3

When should income or revenue be recognised as being earned and recorded in the accounts? Discuss and provide examples of different types of income and revenue where the recognition date is not as clear-cut as it would be for a cash sale with immediate delivery.

3.17 LO4

Critically examine the following statements about depreciation: (a) Depreciation is a valuation adjustment. (b) Depreciation equals physical wear and tear. (c) Depreciation provides funds for replacement. (d) There is no point in depreciating buildings because their value is increasing.

3.18 LO3

Profit after tax for the period was $70,000, but the net assets increased by $180,000. What might explain the discrepancy between the two figures?

3.19 LO3/4

For ‘property, plant and equipment’, the following expenses can be observed in the income statement or attached notes: • depreciation of equipment • write-down of equipment to fair value • write-down of equipment to recoverable amount (impairment) • carrying amount of equipment sold • immediate expensing of equipment purchased. (a) Explain the difference between these ‘expenses’. (b) Identify an accounting principle that is closely linked with each of these expenses.

3.20 LO3

Revenue can be recognised at different points in the discovery/extraction/production/sales cycle. (a) How does the decision on which point is selected affect performance? (b) How does the ‘realisation convention’ of accounting assist in the decision process? (c) Identify situations where income could be recognised earlier in the cycle and also where it should not be recognised until later in the cycle.

APPLICATION EXERCISES EASY 3.1

LO2

For a restaurant, provide examples of expenses that relate to the following functions. Cost of sales

3.2

Selling and distribution

Administration and general

Financial

LO3/5

(a) Bert & Ernie Company begin the year with inventory of $5,000. During the year they purchase goods for $80,000 and have sales totalling $120,000. The business makes a uniform gross profit of 30% on sales. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. closing ProQuest Ebook Central,value http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. What is their inventory for the year? Created from usyd on 2018-03-05 16:43:06.

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(b) Mulder & Scully Company begin the year with inventory of $25,000. During the year they achieve sales totalling $120,000, earning profit at a uniform gross profit rate of 30% on sales. Inventory at the end of the year amounted to $8,000.What were Mulder & Scully’s purchases for the year? 3.3

LO3

(a) Provide answers in the shaded cells below. Jan

Feb

Rent expense

$100

Prepaid rent—start of month

$300

$200

Prepaid rent—end of month

$200

$100

Rent paid

Mar

Apr

$100

$150

$100 $750

$0

$0

$900

(b) Provide answers in the shaded cells below. Jan

Feb

Wage expense

$100

Wages payable—start of month

$300

$200

Wages payable—end of month

$200

$100

Wages paid 3.4

LO4

Mar

Apr

$100

$150

$100 $350

$250

$0

$0

(a) It’s three months before the end of the financial year and Leo Murphy, owner and operator of Murph’s Trucking, has just purchased a new truck for his cattle and hay hauling business. Costs incurred are as indicated below: Dealer charge

$240,000

Installation of GPS, safety devices, etc

$3,360

Delivery charges

$2,400

Import taxes

$4,800

Fuel cost (first fill-up)

$500

Murph estimates a useful life for the truck of 10 years, at which time it could be sold for $20,000 he reckons. Murph’s plan, however, is to upgrade to a new model in two years. He estimates resale value in two years to be $100,000. Calculate Murph’s straight-line depreciation expense for the current year. (b) It’s now the end of the next financial year after purchase of the new truck. That is, Murph’s been using his new truck for 15 months. Nothing’s changed, but now Leo wants to see how his truck will be shown on his balance sheet.

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Show how Murph’s truck will appear on the balance sheet after 15 months’ use. Remember that he’s using straight-line depreciation. 3.5

LO3

The following income statement information relates to a trading enterprise and covers four independent situations. Calculate the missing figures.

Net sales Opening inventory

(a)

(b)

(c)

(d)

$

$

$

$

200,000

600,000

800,000

?

54,000

120,000

?

230,000

Net purchases

130,000

?

500,000

?

Available inventory

184,000

?

?

?

44,000

85,000

150,000

255,000

Closing inventory

?

390,000

?

660,000

Gross profit

Cost of sales

60,000

210,000

260,000

240,000

Operating expenses

70,000

165,000

205,000

?

?

?

?

(25,000)

Profit/(Loss)

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

3.6

LO3

Fill in the values (a) to (f) in the following table on the assumption that there were no opening balances involved. Relating to period

At end of period

Expense/Revenue for period $

Prepaid $

10,000

(a)

1,000

5,000

(b)

(c)

6,000

1,000

3,000

2,500

(d)

Salaries

(e)

9,000

3,000

Rent receivable

(f)

1,500

1,500

Paid/Received $ Rent payable Rates and insurance General expenses Interest payable on borrowings

Accruals/Deferred revenues $ 1,000

INTERMEDIATE 3.7

LO4

Following on from Exercise 3.4, Murph’s expanding his business and has just bought another truck. Details of the purchase are: Dealer charge

$290,000

Installation of GPS, safety devices, etc

$4,060

Delivery charges

$2,900

Import taxes

$5,800

Murph’s been talking to some of his trucking buddies and has been advised that he should be using ‘kilometres driven’ as the basis for determining his depreciation expense. Murph estimates that he’ll get 500,000 km from the truck, at which time he’ll be able to sell it for $10,000. (a) Calculate the depreciation charge for 80,000 km of use in year 1. (b) Calculate the depreciation charge for 100,000 km of use in year 2. (c) Show how Murph’s truck will appear on the balance sheet at the end of year 2. 3.8

LO5

The Triad Trading Co recently prepared draft financial statements for the most recent year. A profit for the year of ec125,000 was reported. Subsequent investigation found that one item of inventories MNS 10Y) had been valued using the AVCO basis, whereas the policy of the business is to use the FIFO basis for all inventories. The business had the following transactions during the year for this item:

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MNS 10Y Jan 1 Jun 5 Nov 15

Opening inventories Bought Bought

Units 1,200 1,800 1,000

Dec 11

Sold

4,000 3,200

Cost/unit $20 $25 $31

It was also discovered, after the draft financial statements were prepared that the net realisable value of inventories of item MNS 10Y was $24,000. Calculate the revised profit for the year after the inventories for item MNS 10Y have been appropriately valued.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

3.9

LO2/3/5

The following information was prepared by a trainee accountant for Bise Co for Year 9. $ Sales revenue

855,000

Interest receivable

37,000

Salaries and wages

75,000

Heat and light

37,000

Telephone and postage

25,000

Insurance

12,000

Motor running expenses

67,000

Cost of sales

128,000

Examination of the underlying records revealed the following errors. 1 A prepayment for telephone and postage of $6,000 had not been taken into account. 2 Motor running expenses included interest charges incurred of $9,000 on purchase of a delivery van. 3 Closing inventories had been overstated by $19,000. Required: What is the operating profit for the year? 3.10 LO1/3

Clean and Maintain Ltd is a supplier of building maintenance services. It signed a contract with a major university on 1 August 2014, under which it will provide services for five years and receive $1 million per year. Clean and Maintain Ltd has recognised the entire $5 million ($1 million per year for five years) as revenue. What errors does this create in Clean and Maintain Ltd’s financial statements?

3.11 LO1/3

Joe’s profit and loss records for the year ended 30 June 2017 have been lost. However, you are able to extract the following statement of financial position information, together with the owner’s contributions and drawings, for the year. Beginning

End

Cash

5,300

3,700

Accounts receivable

7,900

8,700

Inventory

6,400

7,500

800

600

Land

20,000

20,000

Building

60,000

68,000

Plant and equipment

18,000

16,500

Motor vehicles

23,000

31,000

9,000

6,900

Nil

7,400

1,300

1,500

40,000

36,000

Current assets

Prepayments

Copyright © 2017. P.Ed Australia. All rights reserved.

Non-current assets

Current liabilities Accounts payable Bank overdraft Accruals Non-current liabilities Bank loan

Additional information: The owner did not make any further contributions during the year, but did withdraw cash of $12,000. Calculate the profit made by Joe’s sole proprietorship during the year ended 30 June 2017.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

3.12 LO7/8

(a) Prepare an income statement for Mostyn Company for the year ended 30 June 2017, given the following account balances. (Note: Some accounts may not be relevant.) $ Accounting and audit

4,420

Accounts payable

11,830

Accounts receivable

19,500

Accumulated depreciation—equipment

124,800

Accumulated depreciation—motor vehicles

83,200

Allowance for doubtful debts

9,500

Bad and doubtful debts

10,400

Cash

3,900

Cost of sales

208,000

Depreciation—equipment

44,160

Depreciation—motor vehicles

55,850

Equipment repairs

2,080

Heat and light

4,810

Insurance

2,600

Inventory

14,300

Loan

52,000

Loan interest

5,200

Motor vehicle running costs

2,210

Motor vehicles

41,600

Phone and internet

1,950

Rent and rates

16,120

Royalties received

2,210

Salary and wages

48,100

Sales

464,000

(b) Consider the resulting statement of financial performance. Provide a review and interpretation of this statement, giving indications of what further information is required to conduct a proper review. (c) What questions might be raised regarding the accounting treatment chosen for (a) insurance and (b) equipment repairs?

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3.13 LO5

Spratley Ltd is a builders’ merchant. On 1 September the business had 20 tonnes of sand in stock at a cost of $18 per tonne, a total cost of $360. During the first week in September the business purchased the following amounts of sand: September

Tonnes

Cost per tonne

2

48

$20

4

15

$24

6

10

$25

On 7 September the business sold 60 tonnes of sand to a local builder. Calculate: (a) The cost of goods sold based on perpetual inventory and FIFO cost allocation. (b) The closing inventory based on periodic inventory and weighted average cost allocation.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

3.14. LO5

Glen River Ltd is a supplier of trusses to the construction industry. On 1 January, the company’s inventory of pre-made roof trusses consisted of 50 trusses in stock at a cost of $25 per truss. January’s production is shown below. Week

Number of trusses produced

Cost per truss

1

300

$22

2

330

$24

3

350

$25

4

325

$26

At the end of week 3, Glen River made a credit sale for 450 trusses at $30 per truss. Assume this was the sole sales transaction during the month. (a) Calculate the cost of goods sold and the end-of-January closing inventory cost using a perpetual inventory system with FIFO cost allocation. (b) Prepare a partial income statement showing the gross profit earned by Glen River on the January sale when the FIFO method is used. (c) Would the January gross profit be more or less if Glen River used a periodic inventory with a weighted average cost inventory system? Why? 3.15 LO7

Prepare an income statement for the year ended 30 June 2017 given the following account balances. (Note: Some accounts may not be relevant.) Cash

3,000

Sales

280,000

Salary and wages

37,000

Accounts receivable

15,000

Loan interest

4,000

Insurance Loan

2,000 40,000

Telephone and postage Rent and rates Cost of sales

Copyright © 2017. P.Ed Australia. All rights reserved.

Inventory

1,500 12,400 160,000 11,000

Accounts payable

9,100

Heat and light

3,700

Motor vehicles

32,000

Equipment repairs

1,600

Depreciation—motor vehicles

4,500

Motor vehicle running costs

1,700

Depreciation—equipment

3,200

Royalties received

1,700

Accounting and audit

3,400

Bad and doubtful debts

800

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

3.16 LO3–6

On what basis would the following expenses be measured or calculated (i.e. what does the amount for each represent)? Expense account

Amount $

A Insurance

2,400

B Depreciation—buildings

5,700

C Cost of goods sold

3.17 LO7

Basis of measurement

89,500

D Bad and doubtful debts

4,700

E

Long-service leave

5,800

F

Warranty

6,300

G Write-down of land

15,000

H Impairment of goodwill

23,000

Calculate depreciation expense for each asset group for the year ended 30 June 2017. Asset

Delivery trucks

Office equipment

Computers

Acquisition cost

$250,000

$16,000

$14,200

Useful life/units (kilometres for trucks, years for rest)

200,000

10

3

30

Estimated residual value

$45,000

$3,000

$2,000

$45,000

Units of production

Straight-line

Reducingbalance*

Straight-line

$??,???

$??,???

$??,???

$??,???

Depreciation method Depreciation expense

Building

Note: The trucks were driven 24,500 kilometres during the year. * The company uses an approximated reducing-balance rate of 60%. One year of depreciation has been recorded prior to the current year.

CHALLENGING 3.18 LO3/4

After the accountant of Samaras Co. had prepared the financial statements for the year ended 31 January 2017, the following errors came to light: 1 A motor van purchased at a cost of $12,000, and with accumulated depreciation at the beginning of the year of $4,000, had been depreciated at 20% using the reducing-balance method rather than the straight-line method of depreciation.

Copyright © 2017. P.Ed Australia. All rights reserved.

2 The payment of $1,500 for a trade payable had been treated as a cash purchase. 3 Withdrawals by the owner of $3,000 during the year had been treated as part of the salaries and wages expense. 4 Bank charges of $400 during the year had been treated as interest charges. The profit for the year before these errors were discovered was $42,000. What is the profit for the year after adjusting for these errors? 3.19 LO6

Dixon Supplies Co. has recently prepared draft financial statements for the most recent year. A profit for the year of $290,000 was reported. Subsequent investigation found that one item of inventories (IXL 205) had been valued using the LIFO basis, whereas the policy of the business is to use the FIFO basis for all inventories. The business had the following transactions for this item during the year. IXL 205 1 Jan 5 May 21 Sept

Opening inventories Bought Bought

Units 1,500 2,800 1,100

11 Nov

Sold

5,400 3,700

Cost/unit $20 $25 $31

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

It was also discovered, after the draft financial statements were prepared, that the net realisable value of inventories of item IXL 205 was $27,500. Calculate the revised profit for the year after the inventories for item MNS 10Y have been appropriately valued. 3.20 LO7/8

The following is the statement of financial position of WW Associates as at 31 December 2016.

WW ASSOCIATES Statement of financial position as at 31 December 2016 $ ASSETS Current assets Cash Prepaid expenses (rates) Trade receivables Inventories Non-current assets Machinery Total assets EQUITY AND LIABILITIES Current liabilities Accounts payable Accrued expenses (wages) Equity Share capital Retained earnings Total equity and liabilities

16,600 800 42,600 24,400 84,400 50,600 135,000 33,800 3,400 37,200 50,000 47,800 97,800 135,000

During 2017, the following transactions took place: 1 The owners withdrew equity in the form of cash of $46,000. 2 Premises were rented at an annual rental of $40,000. During the year, rent of $50,000 was paid to the owner of the premises.

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3 Rates on the premises were paid during the year for the period 1 April 2017 to 31 March 2018, and amounted to $4,000. 4 Some machinery (a non-current asset), which was bought on 1 January 2016 for $26,000, has proved to be unsatisfactory. It was part-exchanged for some new machinery on 1 January 2017, and WW Associates paid a cash amount of $12,000. The new machinery would have cost $30,000 had the business bought it without the trade-in. 5 Wages totalling $47,600 were paid during the year. At the end of the year, the business owed $1,720 of wages. 6 Electricity bills totalling $5,400 for the four quarters of the year were paid. 7 Inventories totalling $286,000 were bought on credit. 8 Inventories totalling $24,000 were bought for cash. 9 Sales revenue on credit totalled $422,000 (cost $254,000). 10 Cash sales revenue totalled $84,000 (cost $50,000). 11 Receipts from trade receivables totalled $396,000. 12 Payments to trade payables totalled $312,000. 13 Van running expenses paid totalled $35,000. The business uses the reducing-balance method of depreciation for non-current assets at the rate of 30% each year. Prepare an income statement for the year ended 31 December 2017 and a statement of financial position as at that date. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

3.21 LO3–7

Ambrose prepares his income statement on a cash basis. Sales Less inventory purchases Equals gross profit Less expenses Salary and wages Rent Insurance Advertising Other Equals net profit

100,000 30,000 70,000 20,000 15,000 2,000 3,000 4,000

44,000 26,000

On further investigation you find the following accrual balances: Accounts receivable Accounts payable (for inventory) Inventory Prepaid rent Prepaid insurance Accrued advertising

Beginning 6,000 700 8,400 3,000 800 Nil

Ending 1,500 4,100 6,500 1,200 1,000 600

Also, there should be depreciation of plant and equipment of $2,400, and bad and doubtful debts of $300. Prepare an accrual-based income statement. 3.22 LO4

Equipment was acquired on 1 July 2012 for $50,000 by HiLite Ltd. Its life was determined as being: •

useful—5 years

•

economic—8 years

•

physical—10 years.

The estimated residual values at the end of these respective periods are: •

after 5 years, $20,000

•

after 8 years, $4,000

•

after 10 years, nil.

(a) Over what period should HiLite depreciate the equipment? (b) What would be the difference in the depreciation expense for the year ending 30 June 2014 based on using either the straight-line method or the reducing-balance method? (c) On what basis should management select from these two methods to depreciate the equipment?

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3.23 LO4

You review the notes to the property, plant and equipment account and observe the items listed in the reconciliation between the opening and closing balance of various property, plant and equipment accounts (listed below). Description

Add or subtract

Explanation

Initial revaluation (upwards) Depreciation Acquisition Impairment loss Reversal of a write-down to fair value Partial reversal of a previous upward revaluation Disposal Impairment loss reversal For each item listed: (a) Determine whether it would have been added or subtracted from the opening balance. (b) Explain the nature of the adjustment.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

3.24 LO5

The following schedule represents the inventory movements for product ‘xtra’ for the year. Inventory is assumed to be purchased on the first day of each quarter before any sales for that quarter. You are required to compute the cost of goods sold for the year and the closing inventory at the end of the year: (a) using the perpetual inventory system (b) using the periodic system. For each inventory method make the calculation using: (i) FIFO (ii) LIFO (iii) Average. Inventory details are provided below. Quarter Opening balance

2nd

3rd

4th

Nil

30 units

100 units

110 units

Purchases

100 units

400 units

300 units

200 units

Unit cost

$11

$10.50

$10.20

$9.70

70 units

330 units

290 units

180 units

Sales 3.25 LO6

1st

The following table summarises the inventory movements of a particular product for the year under the perpetual inventory recording system. Opening balance

100 @ $1 1st quarter

2nd quarter

3rd quarter

4th quarter

Purchases

60 @ 1.10

40 @ 1.20

80 @ 1.40

100 @ 1.70

Sales

80 @ 2.10

70 @ 2.20

60 @ 2.30

120 @ 2.40

Closing stock count

47 units

(a) Calculate inventory shortage. (b) Determine cost of goods sold using FIFO cost allocation. (c) Determine the value of closing inventory using LIFO cost allocation. (d) Determine the value of inventory loss (shortage) using average-cost allocation. 3.26 LO6

The following information directly relates to sales and is obtained from the records of the first year of operation of JustCo Ltd. Account

Amount $

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For the year balances Net sales—cash

120,000

Net sales—credit

780,000

Early settlement discounts Bad debts written off Cash received from accounts receivable

9,000 21,000 547,000

Year-end balances Allowance for doubtful debts

23,000

Additional information: 1 The business writes off bad debts as they arise, but at the end of the first year an aged listing of accounts receivable is taken to determine the extent of accounts receivable balances that are doubtful (unlikely to be collected). 2 Early settlement discounts are recognised only when they are taken. (a) Determine the balance in accounts receivable at the end of the period. (b) What would be the difference for the period in recognising uncollectable accounts receivable amounts on the basis of ‘bad debts realised expense’ compared with recognising both ‘bad and doubtful debts expense’?

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

(c) For the next year, management decides to recognise ‘bad and doubtful debts expense’ on the basis of net credit sales. Provide the appropriate rate for this calculation, basing it on the first year’s experience. (d) What are the relative merits of the aged listing approach and the percentage of credit sales approach to determining the ‘bad and doubtful debts expense’ for the year? (e) The firm seemed inconsistent in its treatment of ‘bad and doubtful debts’ and ‘discounts given’. (i) What is the inconsistency? (ii) On what grounds might the firm support this practice? (iii) How could they change their accounting method to eliminate the inconsistency? 3.27 LO7

The following is the statement of financial position of TT Motors at the end of its first year of trading (from Self-assessment Question 3.1):

TT MOTORS Statement of financial position as at 31 December 2016 $ Current assets Cash at bank Accounts receivable Prepaid expenses Inventory

$

750 19,600 5,300 65,000 90,650

Non-current assets Motor vehicles—cost Accumulated depreciation

32,000 (4,000) 28,000 118,650

Total assets Current liabilities Accrued expenses Accounts payable

1,250 22,000 23,250

Owners’ equity Original Retained profit

70,000 25,400

Total equity and liabilities

95,400 118,650

Prepaid expenses included $5,000 for rent and $300 for rates.

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Accrued expenses included wages of $630 and electricity of $620. During 2017, the following transactions took place: 1 The owners withdrew capital in the form of cash of $20,000. 2 Premises continued to be rented at an annual rental of $20,000. During the year, rent of $15,000 was paid to the owner of the premises. 3 Rates on the premises were paid during the year for the period 1 April 2017 to 31 March 2018, amounting to $1,300. 4 A second delivery vehicle was bought on 1 January for $26,000. This is expected to be used in the business for four years and then to be sold for $16,000. 5 Wages totalling $36,700 were paid during the year. At the end of the year, the business owed $860 of wages for the last week of the year. 6 Electricity bills totalling $1,820 for the first three quarters of the year were paid. After 31 December 2017, but before the accounts had been finalised for the year, the bill for the last quarter arrived showing a charge of $690. 7 Inventory totalling $67,000 was bought on credit. 8 Inventory totalling $8,000 was bought for cash. 9 Sales on credit totalled $179,000 (cost $89,000). Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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10 Cash sales totalled $54,000 (cost $25,000). 11 Receipts from accounts receivable totalled $178,000. 12 Payments to accounts payable totalled $71,000. 13 Vehicle running expenses paid totalled $16,200. Prepare a statement of financial position as at 31 December 2017 and an income statement for the year to that date.

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CHAPTER 3 CASE STUDY Paul is a fine arts graduate, who has several years’ experience working on games graphics. Recently he has been made redundant, mainly due to the strength of the Australian dollar. He has now turned back to his main love, which is painting and printing, but is finding freelance work financially unproductive at the moment. While Paul is not someone who needs a huge amount of money to be content, he has realised that he needs a certain amount of regular income to enable him to survive, and also to be able to purchase materials needed for his preferred activities. Recently an opportunity has arisen which looks as though it might enable him to achieve what he wants, which is essentially a base level of income, but with enough time to devote to his main interest. There is a small motel available for sale in a small country town, which has a reputation for being something of an ‘arty’ town. There is already an art gallery there, together with a choir and a hall which is used for visiting performers. The location is close to a very popular national park, with a good prospect of high occupancy rates. As against this, occupation rates are likely to be low in the nonschool holiday times. The motel is offered as a ‘walk in, walk out’ (WIWO) facility, and is fully equipped. The purchase price for the business is $50,000. However, the buildings are not owned, but leased. The current lease expires in three years, but there are options for at least two further five-year terms in place. The current lease costs $40,000 per annum in rent. The motel has 15 rooms, 10 of which are double or twin rooms. There are a further three rooms with a third single bed, and the remaining two rooms are family rooms that will take four to five people. The motel is graded as a three-star facility, with tariffs for a double room being around $90 per night. There is a two-bedded residence for the manager as well. A full breakfast menu is provided at a charge as part of the motel service. The statement that is provided by the real estate agent includes the following information:

1 The business has been in operation for 10 years. 2 Total gross income recorded for the last year is $150,000. 3 Gross profit for the year is $125,000. 4 Total operating expenses for the year are $100,000. 5 Interest and financing costs were $2,000. 6 Depreciation was $5,000. 7 Net profit was $18,000. On investigation you are given more detail relating to the operating expenses for the last year, as follows: Bank charges

1,600

Newsagents

1,500

Telephone

2,000

Carpet cleaning

800

Accountancy fee

1,500

Car expenses

3,000

Council registration fees

900

Electricity

12,000

Rent

40,000

New towels and curtains

1,500

Water

1,000

Rates

4,000

Interest

700

Donations

1,200

Insurance

4,000

Miscellaneous expenses

7,000

Repairs and maintenance

5,000

So"ware, internet and computers

3,500

Pool chemicals and cleaning Advertising and memberships

800 8,000

Following detailed discussions with the vendor, you discover that: • No attempt has been made to segregate personal and business expenses.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

• Food is purchased from cash receipts. • The vendor estimates that he takes out about $300 every week from the cash takings.

• The car expenses are paid by the business.

QUESTIONS 1

Advise Paul on whether or not he should proceed with the purchase.

2

Advise Paul as to whether the price is appropriate.

3

Explain why not separating the figures into those relating to personal or business aspects may cause problems for decision-making.

4

Attempt to summarise the above information in such a way as to calculate a profit figure for the business.

5

Summarise the aspects of the decision that relate to Paul’s artistic leanings.

6

What other factors might be worth considering by Paul in reaching a final decision?

Concept check answers CC1 CC2 CC3 CC4 CC5 CC6

C B B E E D

CC7 CC8 CC9 CC10 CC11 CC12

C D A E E A

CC13 CC14 CC15 CC16 CC17 CC18

A D C B B&E D

CC19 D CC20 C CC21 D

SOLUTIONS TO ACTIVITIES Copyright © 2017. P.Ed Australia. All rights reserved.

ACTIVITY 3.1 Your answer should be along the following lines: 1 accountancy practice—fees for services 2 squash club—subscriptions, court fees 3 bus company—ticket sales, advertising 4 newspaper—newspaper sales, advertising 5 finance company—interest received on loans 6 songwriter—royalties, commission fees 7 retailer—sale of goods 8 magazine publisher—magazine subscriptions, sales and advertising 9 a large football club—gate takings (relatively minor), transfers of players, sponsorship, sales of merchandise, TV rights, etc.

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 3.2 Your answer should be as follows:

H & S RETAILERS Income statement for the year ended 30 April 2018 $

Sales Less cost of sales Opening inventory Purchases Closing inventory Gross profit Less Salaries and wages Rent and rates Heat and light Telephone and postage Insurance Motor vehicle running expenses Depreciation—motor vans Operating profit Rent received Loan interest Profit for the year

389,600 16,000 273,400 289,400 (12,000) (277,400) 112,200 (41,600) (20,000) (3,600) (1,800) (3,000) (4,800) (6,000) 31,400 8,000 (2,480) 36,920

The two items not included in the income statement are in fact assets (motor vans and cash) and would appear in the statement of financial position.

ACTIVITY 3.3 1 Sales will appear in the income statement as $200,000. Cash will increase in the statement of financial position by $160,000, with $40,000 being added to receivables. You should note that there will be an expense to reflect the cost of sales as well. 2 The rent paid covered seven months, so the expense in the income statement for the six months ending 30 June will be confined to $18,000, with the $3,000 extra paid being shown as a prepayment.

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3 Insurance covers the entire year. The income statement covers only the first six months, so the expense will be half of $2,000 ($1,000), with the remaining $1,000 appearing in the balance sheet as at 30 June as a prepayment. 4 The $5,000 loan interest paid all relates to the accounting period covering the first six months, so all will be included in the income statement. However, the amount of interest for June is not yet paid, so this will need to be added to the expense in the income statement (making the loan interest for the six-month period $6,000) and to a liability in the balance sheet, accrued loan interest ($1,000). 5 The $800 electricity bill all relates to the six-monthly accounting period, so will form part of the electricity expense in the income statement for the period. However, May and June remain unpaid. It will be necessary to estimate the likely expense for these two months, and add the estimated amount to the expense in the income statement and to a liability (accrued electricity) in the statement of financial position. Given that the expense for the first four months was $800, an estimate of around $200 per month seems reasonable. So the expense for the period will be $1,200 while there will also be an accrual of $400. 6 The subscriptions received cover the entire year. So not all of the amount received should appear as revenue in the income statement. Only half should be recorded as revenue, with the other half being shown as a liability (deferred revenue) in the statement of financial position. The deferred revenue is a payment in advance—to the business—and this remains a liability until the subscription is used up.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

ACTIVITY 3.4 The depreciation expense, assuming estimate (a), will be $8,000 a year (i.e. ($40,000 – $8,000)/4). The depreciation expense, assuming estimate (b), will be $10,000 a year (i.e. $40,000/4). As the actual residual value is $4,000, estimate (a) will lead to under-depreciation of $4,000 (i.e. $8,000 – $4,000) over the life of the asset, and estimate (b) will lead to over-depreciation of $4,000 (i.e. $0 – $4,000). These under- and over-estimations will be dealt with in year four. The pattern of depreciation and total depreciation expenses will therefore be: Estimate Year

(a) $

(b) $

1

Annual depreciation

8,000

10,000

2

Annual depreciation

8,000

10,000

3

Annual depreciation

8,000

10,000

4

Annual depreciation

8,000

10,000

32,000

40,000

4

Under/(over)-depreciation

4,000

(4,000)

36,000

36,000

Total depreciation

ACTIVITY 3.5 Your answer should be along the following lines:

Gross profit calculation

FIFO $’000

LIFO $’000

AVCO $’000

Sales (9,000 @ $15)

135.0

135.0

135.0

Cost of sales

101.0

107.0

103.5

Gross profit

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Closing inventory figure

34.0

28.0

31.5

$60.0

$54.0

$57.5

The above figures reveal that FIFO will give the highest gross profit during a period of rising prices. This is because sales are matched with the earlier (and cheaper) purchases. LIFO will give the lowest gross profit, as sales are matched against the more recent (and dearer) purchases. The AVCO method will normally give a figure that is between these two extremes. The closing inventory figure in the statement of financial position will be highest with the FIFO method. This is because the cost of goods still held will be based on the more recent (and dearer) purchases. LIFO will give the lowest closing inventory figure, as the goods held in stock will be based on the earlier (and cheaper) inventory purchased. Once again, the AVCO method will normally give a figure that is between these two extremes. When prices are falling, the position of FIFO and LIFO is reversed. FIFO will give the lowest gross profit, as sales are matched against the earlier (and dearer) goods purchased. LIFO will give the highest gross profit, as sales are matched against the more recent (and cheaper) goods purchased. AVCO will give a cost of sales figure between these two extremes. The closing inventory figure in the statement of financial position will be lowest under FIFO, as the cost of inventory will be based on the more recent (and cheaper) stocks purchased. LIFO will provide the highest closing inventory figure, and AVCO will provide a figure between the two extremes.

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ACTIVITY 3.6 Your answer should be as follows:

CLAYTON CONGLOMERATES Income statement (extracts) for the year ended 30 June 2017 $ 40,000 60,000

Bad debts written off Doubtful debts expense

CLAYTON CONGLOMERATES Income statement (extracts) for the year ended 30 June 2018 $ 15,000*

Doubtful debts expense written-back (a revenue or a reduction in the expense)

CLAYTON CONGLOMERATES Statement of financial position (extract) as at 30 June 2017 $ 830,000** 60,000 770,000

Accounts receivable Less allowance for doubtful debts

*This figure will usually be netted off against any allowance created for doubtful debts in respect of 2018. **$870,000 – $40,000

ACTIVITY 3.7 Balance sheet as at 31 December 2017

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Cash

Receivables Prepaid expenses Inventory

+ 27,200 250,000 110,000

– 120,000 125,000 2,800 48,000 16,000 18,000 10,000 110,000 3,000

Net 47,400

100 300

300

25,000 240,000

240,000

25,000

14,000 8,000 45,000

3,000 2,000 5,000

25,000 120,000 100

Payables Accrued expenses

32,000

+ 20,000 120,000 1,900 1,000 2,000

Loan

40,000

Capital Opening balance Profit Drawings

82,400 49,300

– 125,000

Net 15,000

1,900

3,000

40,000

18,000 10,000 103,700

Vehicles Fixtures Premises

11,000 6,000 40,000 161,700

161,700

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

Income statement for the year ended 31 December 2017

Cost of sales Wages Bad debts Interest Other expenses Depreciation Fixtures Premises Vehicles Profit

+ 240,000 48,000 2,000 3,000 2,800 16,000 100 1000 2,000 5,000 3,000

– 1,900

Net 240,000 48,100

300

3,000 2,800 16,800

Sales

+ 370,000

– 370,000

2,000 5,000 3,000 320,700 49,300 370,000

Net 187,000

370,000

The above provides the detailed workings. These workings need to be tidied up for presentation purposes.

ACTIVITY 3.8

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Sales increased by more than 30% over the previous year, but the ‘bottom line’ fell from a profit for the year of $37,000 to a loss of $58,000. The rapid expansion of the business has clearly brought problems in its wake. In the previous period, the business was making a gross profit of more than 31¢ for every $1 of sales made. This reduced in the year ending 31 May 2017 to around 26¢ for every $1 of sales made. This seems to suggest that the rapid expansion was fuelled by a reduction in prices. The gross profit increased in absolute terms by $20,000; however, there was a drastic decline in net profits during the period. In the previous period, the business was making a net profit of nearly 6¢ for every $1 of sales, whereas for the year ending 31 May 2017 this reduced to a loss of nearly 7¢ for every $1 of sales made. This means that overhead expenses have increased considerably. Some increase in overhead expenses may be expected in order to service the increased level of activity. However, the increase appears to be exceptional. If we look at the list of overhead expenses, we can see that the figure for bad debts written off seems very high (more than 10% of total sales). This may be a further effect of the rapid expansion that has taken place. In order to generate sales, insufficient regard may have been paid to the creditworthiness of customers. A comparison of overhead expenses with those of the previous period would be useful.

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C H A P T E R X4

RECORDING TRANSACTIONS— CHAPTER NAME THE JOURNAL AND LEDGER ACCOUNTS LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Provide an overview of the recording process, including the nature of business

transactions, steps in the recording process, the role of the general journal and ledger accounts, through to the final accounts

LO2 Explain how the use of double-entry bookkeeping mirrors the first-principles

approach, and use the general journal and ledger accounts to record a set of basic business transactions

LO3 Explain the importance of a trial balance and use one as part of the accounting process

LO4 Close off a simple set of accounts using the profit and loss account and complete a balance sheet from the ledger accounts

LO5 Record a series of period-end adjustments in the accounts, relating to prepayments and accruals, deferred revenues and revenues outstanding, depreciation, bad and doubtful debts, and transactions relating to inventory

LO6 Use a manufacturing account and a trading account where appropriate LO7 Use an adjusted trial balance and a worksheet to complete a set of final accounts LO8 Describe a chart of accounts and explain its importance.

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We have seen that any business must engage in a number of transactions, typically a large number of transactions. We have also seen that there is a need to record all of these transactions and then summarise them into meaningful and useful financial reports. The main reports are the income statement and the statement of financial position. In Chapters 2 and 3 we used a first-principles approach to build up the statement of financial position and the income statement, using a system of plus and minuses or a worksheet approach. This was possible because we were dealing with small numbers of transactions. The reality is different. We saw how the financial transactions of a business may be recorded by making a series of entries on the statement of financial position and/or the income statement. Each of these entries had its corresponding ‘double’, meaning that both sides of the transaction were recorded. However, adjusting the financial statements for each transaction, by hand, can be very messy and confusing. Where there a large number of transactions it is pretty certain to result in mistakes. An alternative way of dealing with this therefore needs to be used.

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For businesses whose accounting systems are on a computer, this problem is overcome as the software can deal with a series of ‘plus’ and ‘minus’ entries very reliably. Where the accounting system is not computerised, however, it is helpful to have a more practical way of keeping accounting records. Such a system not only exists, but before the advent of the computer it was the routine way of keeping accounting records. In fact, the system had been in constant use for recording business transactions since mediaeval times. It is this system that is explained in this chapter. We should be clear that this system follows exactly the same principles as those that we have met in earlier chapters. Its distinguishing feature is that it provides those keeping accounting records, by hand, with a methodical approach that allows each transaction to be clearly identified and errors minimised. For hundreds of years the basic system used has been ledger accounting, which uses a system of double entry, hence the common name of double-entry bookkeeping. This has been supplemented by a system of what are known as subsidiary records, which is a way of ensuring that every transaction is identified and noted so as to make sure that the correct entries are made in the accounts. There are also very good reasons relating to internal control and efficiency for the use of subsidiary records. Subsidiary records are also known as books of original entry. From the early 1960s the emphasis has changed almost continually to the use of computer systems. Over the years these have become more sophisticated, with far greater integration of systems and provision of almost all documentation needed. While this is not always obvious, underlying all of these systems are the principles of double-entry bookkeeping, or ledger accounting. This chapter deals with a simple subsidiary record (the general journal) and the ledger accounting system in some detail. The next chapter then deals with principles of internal control and explains the principles underlying subsidiary records before finishing with a brief review of computerised systems and accounting information systems.

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THE RECORDING PROCESS—AN OVERVIEW In Chapters 2 and 3 we recorded a range of typical transactions onto a statement of financial position (balance sheet) and statement of financial performance (income statement), using a series of pluses and minuses. We were able to use this first-principles approach to produce a statement of financial position and a statement of financial performance for the particular business organisation. We briefly indicated how a basic worksheet approach could lead to the same result. In neither case, however, would the approach handle large volumes of data. So, the first-principles approach needs to be modified to be able to handle these large volumes. Mentioned above, the system of double-entry bookkeeping, which was developed many hundreds of years ago, provides us with a starting point. This is the primary focus of the rest of this chapter. The system of ledger accounts uses what amounts to a system of pluses and minuses to record transactions. Essentially, every type of asset, liability, equity, revenue or expense that is needed in the financial statements has an individual account, in which everything that affects it is recorded. Each account has two sides, a debit side and a credit side. A debit entry is effectively a plus to an asset or expense account and a minus to an equity, liability or revenue account. A credit entry is the opposite. These will be dealt with in detail in the next section. Of course, identifying just what needs to go into a set of accounts raises other questions. In practice, a preliminary record is kept. This is known as a subsidiary record, or book of original entry. In this record, all the relevant details that are needed to record the transaction in the ledger accounts must be entered. A variety of ways of doing this are available, but at this stage we will limit ourselves to using a simple general journal. Example 4.1 shows the way in which the journal works.

LO1 Provide an overview of the recording process, including the nature of business transactions, steps in the recording process, the role of the general journal and ledger accounts, through to the final accounts

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Assume that we have two transactions: 1. Borrowed $5,000 from the NAB

4.1

2. Purchased a new Subaru for $30,000. These transactions have a twofold effect, as follows: 1. Increases cash and increases a liability to NAB 2. Increases an asset, a vehicle, and reduces cash. The journal is used to describe the transaction and to turn it into an accounting entry, i.e. it identifies the accounts to be debited and credited. The general form of the journal appears as follows, using the above transactions for illustration purposes. General Journal Date January 1

January 1

Account name and narrative reference Cash Loan Borrowed money from National Australia Bank—

Posting 1161 1250

loan agreement 222333444 Vehicle Cash Purchased vehicle Subaru Outback, reg. 1FY2H8,

1125 1161

Debit 5,000

Credit 5,000

30,000 30,000

from Gilgrave Subaru

The recording in the journal should be comprehensive, giving sufficient detail to provide both an audit trail and assurance that the subsequent entry to the ledger account is correct. The transfer to the appropriate account is known as ‘posting’ to the account. All transactions should then be incorporated in the set of ledger accounts. From these, the final accounts, i.e. the income statement and the balance sheet, can be produced, after incorporating the kind of adjustments introduced in Chapter 3.

The basic steps in the recording process can be summarised as: 1 Identify the effect of a business transaction on the accounts. 2 Record it in the journal. 3 Transfer the journal entry to the appropriate account in the ledger.

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Try with Activity 4.1 to identify the effect of a set of transactions and the entries needed in the ledger accounts.

ACTIVITY 4.1 Complete the table for the following transactions: (a)

Purchased goods on credit $10,000 (example)

(b) (c) (d) (e) (f) (g)

Sold goods on credit $5,000 Paid wages in cash $2,500 Repaid loan $5,000 Purchased vehicle for cash $30,000 Wrote off a bad debt $550 Provided depreciation on vehicles $4,000

Plus/Minus

Debit/Credit

Plus inventory Plus creditors/ payables

Debit inventory Credit creditors/ payables

The next step is to make a record of each transaction. This is done in the general journal. Try Activity 4.2.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

165

ACTIVITY 4.2 Enter the transactions in Activity 4.1 in the general journal.

Figure 4.1 summarises the links between the various parts of the recording process.

Financial statements Statement of financial position—Balance sheet Statement of financial performance—Income statement

Required by all businesses

Ledger accounts Individual accounts covering Assets Liabilities Equity Revenues Expenses

Subsidiary records

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General journal

Transactions All types of transactions

Used by all businesses though may be computerised

Subsidiary records used by all businesses, but most use a variety of such records, not restricted to general journal. the purposes of this chapter we will restrict ourselves to the general journal

All transactions to be recorded

FIGURE 4.1 The recording process summarised We can see from this figure that the financial statements represent the apex of this process. They are the principal reason for recording transactions. They are required by all businesses. The ledger accounts are an essential part of the recording process. All businesses use ledger accounts. All also use some form of subsidiary record/s, or book/s of original entry, but in reality very few use just the general journal. Clearly, all businesses need to record all transactions, but these might be recorded in a variety of ways.

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While the ledger accounting system remains at the core of the recording system, a range of other factors has meant that the recording process has become more complex, with the result that the systems supporting the double-entry system have become rather more varied. These other factors include the following:

• Greater volumes and complexity of transactions. • The importance of internal control to the recording system has always been recognised, but

•

•

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• •

additional volume and complexity has added another dimension to this area. Also, different ways of cheating the system are regularly discovered, so there is a need to constantly keep systems under review. In developing systems, attention must be given to safety, security and efficiency. With the advances in computer technology, integrated systems were developed, incorporating a range of business processes as well as supporting the recording and accounting process. These processes include much of the documentation needed to run a business, and also a range of other reports to assist in decision-making. Documents include items such as invoices and statements, credit notes, wage slips, orders, inventory records, etc. Integrated systems also enable areas such as inventory control and sales analyses (e.g. by use of barcodes) to be provided in considerable detail. Over time, linkage between the systems and appropriate supporting documentation became much more the norm. The result is that many systems now do not look much like the systems taught in the classroom. You should note that, in practice, transactions almost inevitably fall into certain types, e.g. sales, purchases, payments, receipts, wages, expenses non-current assets, which helps in overall system development. In most textbooks, the journal used is described as the general journal, and includes every entry. In practice, a host of different books of original entry can be used, in a range of different formats, and some of these will be described in Chapter 5. Typically, when discussing ledger accounts, a similar presumption is made, that all accounts are kept in a general ledger. In Chapter 5 we will see that this is not the case, and that in some cases no hard-copy ledgers are kept, rather the records are computerised. There is still a need for a well-documented audit trail. The growth of digital technology and ecommerce and developments in banking have had an impact on the systems needed. As new types of business develop, the likelihood is that new problems and opportunities will arise.

The principal aim of Chapters 4 and 5 is to provide you with a broad understanding of the underlying principles of the recording process in general, and the ledger accounting process in particular. Chapter 4 will cover the general journal and ledger accounts. Ultimately, the ledger accounting process will underpin the recording of transactions and the preparation of final accounts. Chapter 5 will address internal control generally, and then go on to discuss some of the complications identified in this section. The focus throughout is on general principles of transaction analysis and recording. By the end of Chapter 5 you should have a reasonable understanding of the underlying principles, and an insight into how these principles can be applied. It is impossible to include in this book the multitude of alternative approaches used in practice.

Concept check 1 Which of the following statements relating to Chapters 2 and 3 are not true? A B C D

E

All transactions have a dual aspect. Revenues and expenses ultimately result in a reduction in capital. Revenues and expenses can be recorded in what is effectively an appendix to capital. It is possible to keep track of what is happening using a series of first-principles pluses and minuses to record transactions. This first-principles approach can easily provide information for large and complex organisations.

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Concept check 2 Which of the following statements is false? A B C D

E

The system of ledger accounts uses what is, in effect, a system of pluses and minuses. Each account in the ledger is able to record both aspects of each single transaction. Each account has two sides, a debit side and a credit side. A debit entry in an asset or expense account will effectively increase the figure in the account. A debit entry in a liability or revenue account will effectively reduce the figure in the account.

Concept check 3 Which of the following statements is most likely to be false? A B

C D

E

All transactions need to be recorded in some kind of subsidiary record. The general journal acts like a well-kept diary, recording transactions and providing a narrative that aids understanding of what has happened. Subsidiary records are an essential part of the audit trail and internal control. Advances in computer technology mean that the principles underlying the journal are no longer valid. Competition between the accounting software packaging businesses means that packages will always tend to have some different features.

DOUBLE-ENTRY BOOKKEEPING The principal aim of the earlier chapters was to provide a broad understanding of the basic principles of accounting, particularly the statement of financial position and income statement. In doing this, we have shown how a set of final accounts can be derived from a set of transactions. While the system used in the previous chapter is relatively simple and straightforward, we have so far only been dealing with small volumes of transactions. This system of pluses and minuses will not cope with high volumes of transactions. In practice, businesses usually record their transactions in one, or a combination, of the following ways: Copyright © 2017. P.Ed Australia. All rights reserved.

• a manual system of ledger accounts—using a system based on double-entry bookkeeping,

supplemented by a range of subsidiary records to make record-keeping more manageable;

• a computerised system. Students who are going on to major in accounting need to understand these. Others may find the remainder of this chapter and Chapter 5, which together provide an overview of both approaches, useful in gaining a better understanding of just how the figures that they will use are actually prepared. Chapter 5 will discuss a range of topics, which should be of interest and use to both accounting majors and non-majors, including internal control and development of integrated systems, as well as provide some real world examples of how various types and sizes of businesses manage the recording process. In Chapter 3 we set out the following equation: Assets 1 Expenses

5

LO2 Explain how the use of double-entry bookkeeping mirrors the first-principles approach, and use the general journal and ledger accounts to record a set of basic business transactions

Liabilities 1 Equity 1 Revenues

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In fact, the equity could include drawings and injections, so a more complete equation would be:

Assets 1 Expenses

5

Liabilities 1 Equity at the start of the period 1 Injections 2 Drawings 1 Revenues

5

Liabilities 1 Equity at the start of the period 1 Injections 1 Revenues

Rearranging this gives: Assets 1 Drawings 1 Expenses

This equation must balance, assuming no mistakes are made. If we could keep track of a list along these lines, it would be straightforward to convert it to a set of final accounts, using the same kind of approach as was used in Chapter 3.

Ledger—detailed method of recording ledger The book which contains the detailed accounts for an organisation.

The book that is used to record transactions using the system of double-entry bookkeeping is known as the ledger. The ledger is broken down under a number of headings or sections, each of which is known as an account (hence the term ledger accounts). An account represents the basic record. An account is a record of one or more items, relating to a person or thing, kept under an appropriate heading. The number of accounts will be dependent on their usefulness. For example, a variety of small items of expenditure might be collected in an account called ‘miscellaneous expenses’, simply because no really useful purpose is served by breaking the account down further. Not surprisingly, the decision comes back to a cost–benefit analysis. The more detailed the accounts, the more information is available. But keeping more accounts generally costs more. The form of an account is as follows: Debit side

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Date

Account title Detail

Folio

Amount

Date

Credit side Detail

Folio

Amount

Each transaction is recorded in the relevant accounts. Transactions are entered in date order. Each account therefore provides a history— necessary for the income statement. It is also able to provide a current picture—necessary for the statement of financial position. At this stage it may be useful to refer to the statement of financial position as the balance sheet, and the income statement as the profit and loss account. You will see in due course that the profit and loss account is actually an account in which revenues and expenses are summarised, and that the statement of financial position is a summary of year-end balances on accounts held. The actual statements of financial position and the income statement can be seen to be clearly derived from the ledger accounts. Each account has two sides, a debit side and a credit side. In the equation shown above, the lefthand of the list is generally recorded on the debit side, while the right-hand side is generally recorded on the credit side. Hence, accounts for assets, drawings and expenses are generally recorded on the debit side, while capital, liabilities and revenues are generally recorded on the credit side. The debit side simply means the left-hand side and the credit side means the right-hand side. To debit an account means to enter it on the left-hand (debit) side. To credit an account means to enter it on the right-hand (credit) side. Let us now work through Example 4.2 using the general journal and double-entry bookkeeping.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

The following transactions occurred in the first week of trading of Paul & Co. January 1 January 2 January 2 January 3 January 4 January 5 January 6 January 7 January 7

Paul starts a business with $30,000, which he deposits in a bank. Purchases a vehicle for $10,000 cash. Buys inventory from J. Spratt for $8,000 on credit. Purchases petrol for $50 cash. Cash sales amount to $1,200. The cost of these sales is $700. Cash sales of $800, cost of sales $560. Pays $5,000 to J. Spratt. Pays sundry expenses in cash amounting to $500. Cash sales of $800 and credit sales of $200 are made to A. Driver. The cost of sales is

January 7

$700. Paul takes out $400 cash for his personal use.

4.2

These transactions will be journalised and posted as shown below. 1 January: The effect of this transaction is to increase cash and increase capital/equity. This will be achieved by a debit to the cash account and a credit to the capital/equity account. The entry in the general journal will be: Date Jan 1

Account name and narrative Cash Equity Being a contribution of cash as part of equity

Folio

Debit side 30,000

Credit side 30,000

This entry will be posted to the accounts as shown below: Debit side Date Jan 1

Cash Detail Capital

Folio

Amount 30,000

Debit side

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Date

Credit side Date

Detail

Folio

Capital Detail

Folio

Amount

Date Jan 1

Amount

Credit side Detail Cash

Folio

Amount 30,000

Using ledger accounts you can see that the date is recorded, providing a history; a cross-reference is used, namely the title of the other account; and the amount is recorded. The folio column provides a numerical cross-reference. While important in practice, it is unimportant for our purposes and will not be used in the remainder of the text. This column is sometimes headed journal or posting reference. Typically, the folio will be a reference back to the journal page. You should note that, in using ledger accounts, the dual effect of a single transaction is achieved by entering in two accounts, hence the name ‘double-entry bookkeeping’. 2 January: The effect of the first transaction for 2 January is to increase an asset, vehicle, and reduce cash. As you might expect from what has been said before, the vehicle account needs to be opened and debited with $10,000 and the cash account will be credited. The journal entry will appear as shown below: Date Jan 2

Account name and narrative Vehicle Cash Purchase of vehicle (reg. no. AC123) from Jill’s Autos

Folio

Debit side 10,000

Credit side 10000

This will be posted to the accounts as shown: Vehicle Jan 2

Cash

10,000

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ACCOUNTING FOR BUSINESS STUDENTS

Next we turn to the reduction in cash. This can be achieved by crediting the cash account as below: Cash Jan 1

Capital

30,000

Jan 2

Vehicle

10,000

Using a system of double-entry bookkeeping we can say:

• If we wish to increase an asset account, drawings, or an expense, we debit the account. • If we wish to reduce any one of these accounts, we credit it. • If we wish to increase a liability account, capital/equity (injections) or revenues, we credit the account.

• If we wish to decrease a liability account, equity or revenues, we debit the account. Suppose now we wished to know how much cash was recorded in the accounts. Clearly the answer is $30,000 less $10,000. As entries grow, the answer may not be as obvious. The answer is to ‘balance off’ the account. The two sides are totalled. The difference is put on the smaller side, so that the two sides balance. To preserve double entry the balance is then carried down on the larger side, as shown below. Cash Jan 1

Capital

30,000

Jan 2

Balance b/d

30,000 20,000

Jan 2 Jan 2

Vehicle Balance c/d

10,000 20,000 30,000

The letters c/d mean ‘carried down’ to the next section. The letters b/d mean ‘brought down’ from the last section. In passing, it is worth noting that some people prefer a modified form of account which keeps a running balance, as shown below: Cash Balance Date Jan 1 Jan 2

Detail Capital Vehicle

Debit 30,000

Credit

Debit 30,000 20,000

10,000

Credit

2 January: The second transaction on 2 January results in an increase in inventory and an increase in creditors. The journal entry would appear as shown below:

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Date Jan 2

Account name and narrative Inventory Creditors/payables Purchase of inventory from J. Spratt on credit

Folio

Debit side 8,000

Credit side 8,000

The ledger accounts after posting are shown below: Inventory Jan 2

Creditors

8,000 Creditors—J Spratt Jan 2

Inventory

8,000

3 January: The effect of this transaction is to reduce cash and increase an expense. The journal should look like this: Date Jan 3

Account name and narrative Vehicle expenses Cash Purchase of petrol from Caltex Wagga for cash

Folio

Debit side 50

Credit side 50

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

The accounts are as shown below: Cash Jan 1

Capital

30,000

Jan 2

Balance b/d

30,000 20,000

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3

Vehicle expenses

10,000 20,000 30,000 50

Vehicle expenses Jan 3

Cash

50

4 January: This transaction really two transactions. The first is the sale, which results in an increase in a revenue account, sales, and an increase in cash, both of $1,200. The second is the use of inventory, which leads to a reduction (a credit) in inventory and an increase in an expense (a debit), cost of sales, both of $700. The journal entry is as follows: Date Jan 4

Account name and narrative Cash Sales Cost of sales Inventory Sale for cash of inventory, which had cost $700, for $1,200

Folio Debit side Credit side 1,200 1,200 700 700

The accounts are shown below: Cash Jan 1

Capital

30,000

Jan 2 Jan 4

Balance b/d Sales

30,000 20,000 1,200

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3

Vehicle expense

10,000 20,000 30,000 50

Sales Jan 4

Cash

1,200

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Jan 2

Creditors

8,000

Jan 4

Cost of sales

700

Cost of sales Jan 4

Inventory

700

5 January: The transactions are similar to those of 4 January. The journal entry is shown below: Date Jan 5

Account name and narrative Cash Sales Cost of sales Inventory Sale for cash of $800 of goods which had cost $560

Folio

Debit side 800

Credit side 800

560 560

The accounts, after posting, would appear as follows. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

Cash Jan 1

Capital

30,000

Jan 2 Jan 4 Jan 5

Balance b/d Sales Sales

30,000 20,000 1,200 800

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3

Vehicle expenses

Jan 4 Jan 5

Cash Cash

10,000 20,000 30,000 50

Sales 1,200 800

Inventory Jan 2

Creditors

8,000

Jan 4 Jan 5

Inventory Inventory

700 560

Jan 4 Jan 5

Cost of sales Cost of sales

700 560

Cost of sales

6 January: This transaction results in a decrease in cash (a credit to cash) and a decrease in creditors (J. Spratt) (a debit). The journal would appear as follows: Date Jan 6

Account name and narrative J. Spratt Cash Being partial payment to J. Spratt, a trade creditor

Folio

Debit side 5,000

Credit side 5,000

The accounts after posting would be:

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Cash Jan 1

Capital

30,000

Jan 2 Jan 4 Jan 5

Balance b/d Sales Sales

30,000 20,000 1,200 800

Jan 6

Cash

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3 Jan 6

Vehicle expenses Creditors

10,000 20,000 30,000 50 5,000

Creditors—J. Spratt 5,000

Jan 2

Inventory

8,000

7 January: The payment of sundry expenses by cash will result in a decrease in cash (a credit) and an increase in an expense (a debit). The cash sales follow the same pattern as earlier. The credit sales result in an increase (a debit) to debtors rather than cash. The drawing leads to a reduction in capital and a reduction in cash. Typically, the reduction in capital is recorded initially in a drawings account and transferred to the capital account at the year-end. The journal entry would appear as follows: Date Jan 7

Account name and narrative Sundry expenses Cash Being payment in cash for sundry expenses to Discount Traders

Folio

Debit side 500

Credit side 500

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Jan 7

Jan 7

Jan 7

Jan 7

Cash Sales Cash sales for $800 Debtor—A. Driver Sales Being sales to A. Driver on credit for $200 Cost of sales Inventory Cost of goods sold for $1,000 on 7 January Drawings Cash Cash withdrawn by owner for personal use

800 800 200 200 700 700 400 400

The accounts after posting are shown below: Cash Jan 1

Capital

30,000

Jan 2 Jan 4 Jan 5 Jan 7

Balance b/d Sales Sales Sales

30,000 20,000 1,200 800 800

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3 Jan 6 Jan 7 Jan 7

Vehicle expenses Creditors Sundry expenses Drawings

Jan 4 Jan 5 Jan 7 Jan 7

Cash Cash Cash Debtors

10,000 20,000 30,000 50 5,000 500 400

Sales 1,200 800 800 200

Inventory Jan 2

Creditors

8,000

Jan 4 Jan 5 Jan 7

Cost of sales Cost of sales Cost of sales

700 560 700

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Cost of sales Jan 4 Jan 5 Jan 7

Inventory Inventory Inventory

700 560 700

Jan 7

Sales

200

Jan 7

Cash

400

Jan 7

Cash

500

Debtors—A. Driver

Drawings

Sundry expenses

We have recorded the transactions in the journal, which should mean that we have captured all of the transactions in one subsidiary book. We have then posted the journal to the accounts. This gives us a logical way of providing a comprehensive record of transactions that can then be used to

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ACCOUNTING FOR BUSINESS STUDENTS

build a set of final accounts. In passing, it is worth noting that duality, as applied in double-entry bookkeeping, has led to every transaction needing two entries, one a debit, one a credit. The complete set of accounts, balanced off where necessary, is set out below.

Asset accounts Vehicle Jan 2

Cash

10,000

Jan 2

Creditors

8,000

Jan 7

Balance b/d

8,000 6,040

Jan 7

Sales

Jan 1

Capital

30,000

Jan 2 Jan 4 Jan 5 Jan 7

Balance b/d Sales Sales Sales

30,000 20,000 1,200 800 800

Jan 7

Balance b/d

22,800 16,850

Inventory Jan 4 Jan 5 Jan 7 Jan 7

Cost of sales Cost of sales Cost of sales Balance c/d

700 560 700 6,040 8,000

Debtors—A. Driver 200

Cash Jan 2 Jan 2

Vehicle Balance c/d

Jan 3 Jan 6 Jan 7 Jan 7 Jan 7

Vehicle expenses Creditors Sundry expenses Drawings Balance c/d

10,000 20,000 30,000 50 5,000 500 400 16,850 22,800

Liability accounts Creditors—J. Spratt

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Jan 6 Jan 7

Cash Balance c/d

5,000 3,000 8,000

Jan 2

Inventory

8,000

Jan 7

Balance b/d

8,000 3,000

Cash

30,000

Equity accounts Capital/equity Jan 1

Drawings Jan 7

Cash

400

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Expense accounts Cost of sales Jan 4 Jan 5 Jan 7

Inventory Inventory Inventory

700 560 700 1,960

Vehicle expenses Jan 3

Cash

Jan 7

Cash

50

Sundry expenses 500

Revenue accounts Sales Jan 4 Jan 5 Jan 7 Jan 7

Cash Cash Cash Debtors

1,200 800 800 200 3,000

At this stage, you will probably have noticed that where an account has only entries on one side it has not been balanced, but simply totalled. If we were to summarise the balances using the format discussed earlier, reproduced below, we would have the basis of a set of final accounts. Liabilities 1 Equity at the start of the period Assets 1

1 5

Expenses

Injections 2 Drawings 1

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Revenues Assets Vehicles Inventory Debtors Cash Expenses Cost of sales Vehicle expenses Sundry expenses

10,000 6,040 200 16,850 1,960 50 500 35,600

Liabilities Creditors Equity Capital Less Drawings Revenues Sales

3,000 30,000 (400) 3,000

35,600

In passing, note that at this point you should be able to calculate the net profit of $490 ($3,000 – (1,960 1 50 1 500)) for the week, and simply insert this figure into the balance sheet to complete the balancing process.

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ACCOUNTING FOR BUSINESS STUDENTS

Concept check 4 Which of the following is false? A B C D E

Debits and credits are the accountant’s method of pluses and minuses. A debit to an asset account is an increase to the account. A credit to a liability account will increase the account balance. A debit to an equity account will increase the account balance. None of the above. All are true

Concept check 5 A business makes a sale on credit. Which is the correct double entry? A B C D

Debit sales, credit receivables Debit cash, credit sales Debit receivables, credit cash Debit receivables, credit sales.

Concept check 6 Which of the following could not have a credit balance unless there had been an error? A B C D

Sales Interest Cash Vehicles.

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ACTIVITY 4.3 Journalise the following transactions: (a) Inventory is purchased from G. Patel on credit for $5,000. (b) Rent of $2,000 is paid. (c) Received $2,000 from A. McMurtry, a debtor. (d) Purchased a vehicle for $20,000, funded by a loan from K Car Company. (e) The owner withdrew $1,000. (f) The owner paid for a holiday costing $4,000 from the business bank account. (g) Inventory which cost $1,000 is sold for $1,500. (h) Paid G. Patel, a creditor, $500.

ACTIVITY 4.4 Show the ledger entries for the following transactions: (a) F. Lintstone invests $150,000 in a business known as Dino’s Den. (b) The business borrows a further $50,000 from the bank.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

(c) (d) (e) (f) (g) (h) (i)

The business purchases plant and equipment for $30,000, and a vehicle for $20,000. It purchases inventory for $50,000 on credit. It pays rent of $3,000. It sells inventory that had cost $10,000 for $16,000 cash. It pays creditors $20,000. It pays wages of $1,200. F. Lintstone takes out $2,000 for his own use.

ACCOUNTING AND YOU WHY IT IS USEFUL TO KNOW THE BASICS OF THE RECORDING PROCESS You may have already decided that you do not want to become an accountant, so knowledge of doubleentry bookkeeping is unnecessary or irrelevant to you. So why might it be useful for you to know the basics? Several reasons spring to mind.

• •

Many experienced business people still use (or refer to) the traditional terminology.

•

In practice, of course, manual ledger systems are rare, with most businesses using computerised systems such as MYOB. Many of these systems still use traditional terminology, so a broad understanding of them might be useful. For example, many computer systems still refer to the ‘sales ledger’ or ‘debtors ledger’, which is simply the place where detailed individual records relating to customers are kept.

There are examples of documents where figures are represented using debits and credits (e.g. bank statements). Do you find it confusing that, if your bank statement shows a credit balance on your account, it means that you have money in your account. How can that be, given what was said earlier? The answer is straightforward. The bank statement sent to you is prepared from the bank’s viewpoint. If you have cash in the bank, the bank would show this as a liability (credit) in its accounts. In your own ledger accounts, cash in hand would be shown as a debit.

Class discussion point

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1 Discuss whether you think knowledge of the double-entry system remains useful even if you do not want to become an accountant.

LO3 THE TRIAL BALANCE The next stage of the double-entry bookkeeping process (before calculating profit) is a checking stage. With high volumes of transactions, the chance of errors increases. This involves completion of a trial balance, which is simply a listing of account balances. The form of the trial balance is given in Example 4.3 (page 178), with the figures prepared to date included.

Explain the importance of a trial balance and use one as part of the accounting process

Trial balance A listing of all accounts in a ledger as a check to see whether they balance.

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ACCOUNTING FOR BUSINESS STUDENTS

Trial balance as at 7 January Debit $

4.3

Assets Vehicles Inventory Debtors Cash Liabilities Creditors Equity Capital Drawings Expenses Cost of sales Vehicle expenses Sundry expenses Revenues Sales

Credit $

10,000 6,040 200 16,850 3,000 30,000 400 1,960 50 500

36,000

3,000 36,000

The fact that the totals for each column agree provides some indication that we have not made bookkeeping errors. We cannot, however, have total confidence that there are no errors simply because the totals of a trial balance agree. Suppose, for example, that we paid rent for the month of $900. In each of the following cases, all of which are an incorrect treatment of the transaction, the trial balance would still have agreed:

• The transaction was completely omitted from the accounts, that is, no entries were made at all. • The amount was misread as $9,000, but then (correctly) debited to the rent account and •

credited to cash. The correct amount of $900 was (incorrectly) debited to cash and credited to rent.

Nevertheless, a trial balance, where the totals agree, provides some assurance that the accounts have been correctly recorded. While the fact that a trial balance balances does not mean that there are no mistakes, a trial balance that does not balance does indicate that mistakes have been made. Preparation of a trial balance is therefore usually an important stage in the internal control process.

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Concept check 7 At the end of a period a trial balance is drawn up and the totals agree. Does this imply: A B C D

That the business has made a profit for the year? That the accounting entries have all been correctly made? That there has been a debit entry for every credit entry? That a set of final accounts should now be produced for the period?

Concept check 8 A balance of $580 has been put on the wrong side of the trial balance. Assuming everything else is correct, what would be the difference in the two totals in the trial balance?

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

A B C D

$580 $1,160 $280 $850

ACTIVITY 4.5 (a) (b)

What kind of errors can be made that do not prevent the trial balance agreeing? Which of the following errors would prevent the trial balance agreeing? i. ii. iii. iv. v. vi.

A payment for heat and light that was incorrectly debited to insurance A payment for improvements in a building that was debited to repairs and maintenance A sale that was debited to sales and debited to receivables A payment for wages that was debited as $9,900 and credited to cash as $990 A bad debt written off as a debit to the bad debts account and debited to receivables Two mistakes were made: a. A receipt from a customer of $1,000, which was in satisfaction of a debt of $1,040, the difference being discount allowed, was debited to cash $1,000, and to discount allowed $20, and credited to payables $1,040. b. A payment of rent amounting to $2,200, which was debited to rent as $2,220 and credited to cash as $2,200.

CLOSING OFF THE ACCOUNTS

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The next stage is to ‘close off’ the accounts. Basically, this involves transferring the revenues and expenses to a profit and loss account, and then transferring the balance of the profit and loss account, and the drawings account, to the capital account. The purpose of the detailed revenue and expense accounts is to provide a detailed ‘story’, but that story needs to be summarised into a profit and loss account for the period. Essentially, the next step is to transfer the revenues and expenses to the profit and loss account, as shown below. The process is completed by transferring the balance of the profit and loss account (as either a profit or loss for the year) to the capital (equity) account, and also transferring the drawings account balance to the capital account. You should note that we have not included any period-end adjustments at this stage. This will follow in the next section. The journal entries relating to closing off will appear as follows: Date January 7

January 7

January 7

January 7

January 7

January 7

Account name and narrative Profit and loss—cost of sales Cost of sales Being closure of cost of sales to profit and loss Sales Profit and loss—sales Being closure of sales to profit and loss Profit and loss—vehicle expenses Vehicle expenses Being closure of vehicle expenses to profit and loss Profit and loss—sundry expenses Sundry expenses Being closure of sundry expenses to profit and loss Profit and loss—profit Capital (profit) Being transfer of profit to capital Capital Drawings Being transfer of drawings to capital

Folio

Debit

Credit

side 1,960

side

LO4 Close off a simple set of accounts using the profit and loss account and complete a balance sheet from the ledger accounts

1,960 3,000 3,000 50 50 500 500 490 490 400 400

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The ledger accounts will appear as follows: Cost of sales Jan 4 Jan 5 Jan 7

Inventory Inventory Inventory

700 560 700 1,960

Jan 7

Profit and loss

1,960

1,960

Vehicle expenses Jan 3

Cash

Jan 7

Profit and loss

50

Jan 7

Profit and loss

50

Sales 3,000

Jan 4 Jan 5 Jan 7 Jan 7

Cash Cash Cash Debtors

3,000

1,200 800 800 200 3,000

Sundry expenses Jan 7

Cash

500

Jan 7

Profit and loss

500

Profit and loss Jan 7 Jan 7 Jan 7 Jan 7

Cost of sales Vehicle expenses Sundry expenses Capital—profit

1,960 50 500 490 3,000

Jan 7

Sales

3,000

3,000

At this stage, only the accounts that represent assets, liabilities or equity remain. These form the basis of the balance sheet. The balance sheet, technically, is a listing of those accounts that have a balance on them at the balance sheet date. The accounts that remain are listed below.

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Asset accounts Vehicle Jan 2

Cash

10,000

Jan 2

Creditors

8,000

Jan 7

Balance b/d

8,000 6,040

Jan 7

Sales

Inventory Jan 4 Jan 5 Jan 7 Jan 7

Cost of sales Cost of sales Cost of sales Balance c/d

700 560 700 6,040 8,000

Debtors—A. Driver 200

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Cash Jan 1

Capital

30,000

Jan 2 Jan 4 Jan 5 Jan 7

Balance b/d Sales Sales Sales

30,000 20,000 1,200 800 800

Jan 7

Balance b/d

22,800 16,850

Jan 2 Jan 2

Vehicle Balance c/d

Jan 3 Jan 6 Jan 7 Jan 7 Jan 7

Vehicle expenses Creditors Sundry expenses Drawings Balance c/d

10,000 20,000 30,000 50 5,000 500 400 16,850 22,800

Liability accounts Creditors—J. Spratt Jan 6 Jan 7

Cash Balance c/d

5,000 3,000 8,000

Jan 2

Inventory

8,000

Jan 7

Balance b/d

8,000 3,000

Equity accounts Capital/equity Jan 7 Jan 7

Drawings Balance c/d

400 30,090 30,490

Jan 1 Jan 7

Cash Profit and loss

Jan 7

Balance b/d

30,000 490 30,490 30,090

Drawings Jan 7

Cash

400

Jan 7

Capital

400

Balance sheet

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The balance sheet can now be drawn up in two-sided format as shown below: Current assets Cash Debtors Inventory Non-current assets Vehicle

16,850 200 6,040

Current liabilities Creditors Capital

10,000 33,090

3,000 30,090

33,090

More conventionally, the narrative format is used for presentation purposes. Normally the capital/ equity is broken down as shown below: Balance sheet as at 7 January Current assets Cash Receivables/debtors Inventory Non-current assets Vehicle Current liabilities Payables/creditors

16,850 200 6,040 10,000 33,090 3,000

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182

ACCOUNTING FOR BUSINESS STUDENTS

Capital/equity Opening balance Profit

30,000 490 30,490 400 30,090 33,090

Less Drawings

The profit and loss account will also typically be presented as an income statement in the narrative style described in Chapter 3.

Concept check 9 Which of the following will be closed off by transferring the amount due for the year to the profit and loss account as an expense? A B C D E

Accumulated depreciation Sales Drawings Doubtful debts provision Wages.

Concept check 10 Which of the following will remain on the accounts and be shown on the balance sheet? A B C D E

Equipment Equipment—depreciation Payables Receivables Equity.

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ACTIVITY 4.6 The following is the trial balance of a sole trader as at 30 June 2017. Close the accounts to include a profit and loss account and extract a balance sheet from the accounts. Trial balance as at 30 June 2017 Inventory 1 July 2016 Capital Purchases Sales Rent, rates and insurance Office expenses Heat and light General expenses Premises Cash Wages

Debit 55,000

Credit 160,000

205,000 387,100 12,000 7,500 5,000 5,600 90,000 7,000 52,000

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Equipment Receivables Payables Bad debts Drawings

50,000 56,000 27,000 4,000 25,000 574,100

574,100

Closing inventory is valued at $50,000.

PERIOD-END ADJUSTMENTS The example so far has not included any period-end adjustments for prepayments, accruals, bad debts and depreciation. The entries in the journal, and the postings to the ledger accounts, to deal with these and related adjustments are detailed next.

Prepayments and accruals

LO5 Record a series of period-end adjustments in the accounts, relating to prepayments and accruals, deferred revenues and revenues outstanding, depreciation, bad and doubtful debts, and transactions relating to inventory

If some of the amount debited to an expense account actually relates to the following period—in other words has been prepaid—the expense account needs to be reduced (credited) and an asset account (prepaid expenses) needs to be set up (debited). We will show how this is done in Example 4.4.

Suppose, in Example 4.3, that sundry expenses included a payment of $200 which related to a later period. The sundry expenses figure would need to be reduced and an asset account set up. The expense would then be transferred to the profit and loss account. The journal will appear as follows: Date January 7

January 7

Account name and narrative Prepaid expenses Sundry expenses Being reduction of expense for the period and setting up a prepayment Profit and loss—sundry expenses Sundry expenses Being closing off of the sundry expenses account to the profit and loss account

Folio

Debit side 200

Credit side

4.4

200 300 300

The accounts after posting will appear as follows:

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Sundry expenses Jan 7

Cash

500

Jan 7

500

Prepaid expenses Profit and loss

200 300 500

Prepaid expenses Jan 7

Sundry expenses

200 Profit and loss

Jan 7

Sundry expenses

300

It is possible to simply carry forward a debit balance on the sundry expenses account, rather than open a separate prepayment account. However, the opening of a separate prepayment account is entirely appropriate if a new set of ledgers is to be opened at the start of a new accounting period. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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4.5

Suppose that the vehicle expenses included in the account shown in Example 4.3 had not included the cost of servicing, which was completed, but not billed, on 6 January. The cost was $250. This needs to be included as an expense, but also shown as a liability—accrued vehicle expenses—in the balance sheet. This would be journalised as follows: Date January 7

January 7

Account name and narrative Vehicle expenses Accrued vehicle expenses (Townsend Servicing) Increasing vehicle expense by the amount unpaid. Setting up an accrual for the amount due to Townsend Servicing Profit and loss—vehicle expenses Vehicle expenses Being the closing off of the vehicles expense account to the profit and loss account

Folio

Debit side 250

Credit side 250

300 300

This will be reflected in the following accounts after posting. Vehicle expenses Jan 3 Jan 7

Cash Accrued vehicle expenses

50 250 300

Jan 7

Profit and loss

300 300

Accrued vehicle expenses Jan 7

Vehicle expenses

250

Profit and loss Jan 7

Vehicle expenses

300

Similar adjustments are necessary if there are accruals, though obviously the balance will be on the other side (see Example 4.5). If some of the expense due remains unpaid at the end of the period, the expense needs to be increased (debited) and a liability account (accrued expenses) set up and credited. The expense account is then transferred to the profit and loss account.

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In Chapter 3 we noted that cash and expenses do not always (or even usually) run in tandem. The same is true of cash and revenues, as we shall see in Example 4.6.

4.6

A publishing business sells magazines on subscription. It has a financial year that ends on 30 June. Over the course of the last year it has received subscriptions totalling $500,000. Most annual subscriptions cover the calendar year. On 30 June it estimates that it has received subscriptions, totalling $200,000, which cover the period starting on 1 July. The necessary adjustment will be journalised as follows: Date June 30

June 30

Account name and narrative Revenue from magazine subscriptions Deferred revenue subscriptions Year-end adjustment to reflect subscription received in advance Revenue from magazine subscriptions Profit and loss Being transfer of revenue from magazine subscriptions to the profit and loss account

Folio

Debit side 200,000

Credit side 200,000

300,000 300,000

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

185

After posting, the relevant account would appear as follows: Revenue from magazine subscriptions June 30

Deferred revenue— subscriptions Profit and loss

June 30

200,000

June 30

Cash over the year

300,000 500,000

500,000 500,000

Deferred revenue—subscriptions June 30

Revenue—subscriptions

200,000

Subscription revenue

300,000

4.6 continued

Profit and loss June 30

Revenues in arrears will be added to the appropriate revenue account and debited to an asset account called something like ‘Revenue in arrears’.

ACTIVITY 4.7 Journalise the year-end adjustments relating to the following transactions and then post them to the ledger accounts (incorporating any balances from the year). Show clearly any transfers to the profit and loss account. You should assume that the financial year of the business is 1 January to 31 December. (a)

(b) (c)

Electricity bills, totalling $3,000, were paid during the year ending 31 December 2017. All these bills related to 2017. One bill, amounting to $600, remains unpaid, covering the period 1 November 2017 to 31 January 2018. Stock of writing materials and stationery costing $5,000 was purchased during the year. On 31 December 2017, $500 worth remained in hand. Rates amounting to $5,800 were paid on 30 September, covering the period 1 July 2017 to 30 June 2018.

Depreciation

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Another adjustment that is needed is for depreciation (see Example 4.7). Depreciation is an expense. Accumulated depreciation (or depreciation provision) is what is known as a contra account, one which is useful to identify separately, but which offsets another account, in this case a non-current asset.

Suppose that at the end of an accounting period the cost of non-current assets totals $100,000 and that a judgement has been made (based on ideas covered in Chapter 3) that depreciation should be calculated based on 10% per annum straight line, resulting in an annual expense totalling $10,000. This would typically be journalised as shown below: Date December 31

December 31

Account name and narrative Depreciation expense Accumulated depreciation Being depreciation of non-current assets at 10% straight line Profit and loss Depreciation expense Closing off of the depreciation expense account to the profit and loss account

Folio

Debit side 10,000

Credit side

4.7

10,000 10,000 10,000

After posting, the relevant accounts would appear as shown below: Non-current assets Jan 1

Balance b/d

100,000

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Depreciation (expense) Dec 31

Non-current

10,000

Dec 31

Profit and loss

10,000

assets—Acc dep

4.7

Non-current assets—Accumulated depreciation Dec 31

continued

Non-current assets— Depreciation

10,000

Profit and loss Dec 31

Depreciation expense

10,000

We can see that the profit and loss account will include the depreciation figure and the balance sheet will include the non-current assets at cost, less the associated accumulated depreciation. In later years the depreciation provision figure will accumulate, up to the point at which the written value is the residual value. So, for the next year the accounts would appear as follows: Depreciation (expense) Dec 31

Year 2 Non-current assets— Accumulated depreciation

10,000

Dec 31

Profit and loss

10,000

Non-current assets—Accumulated depreciation Dec 31 Dec 31

Year 2 Balance c/d

20,000 20,000

Dec 31 Dec 31

Year 1 Non-current assets— Depreciation Year 2 Non-current assets— Depreciation Balance b/d

10,000 10,000 20,000 20,000

Profit and loss Dec 31

Depreciation expense

10,000

The asset will be shown in the statement of financial position under the heading of non-current assets:

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Non-current assets at cost— Accumulated depreciation

100,000 (20,000) 80,000

Frequently non-current assets are sold. They are seldom sold at book value, so an adjustment to reflect this needs to be made.

4.8

A vehicle was purchased for $30,000 three years ago. It has been depreciated at 20% per annum straight line, resulting in a net book value of $12,000. It was sold for $14,000. Using a first-principles approach, we can see that the depreciation has been overcharged by $2,000. The estimated depreciation over the three years was 60% of cost—$18,000—while the actual depreciation is $16,000. So, when the vehicle is disposed of, it will result in a reduction in the expense, which effectively increases the profit figure. It is common when disposing of non-current assets to use a disposal account. The two amounts relating to the particular asset being sold, namely cost and accumulated depreciation, are transferred to the disposal account. The entries in the journal and ledger accounts are therefore: Debit disposal account, credit vehicle account—with the cost of the vehicle being disposed of, $30,000. Debit accumulated depreciation account, credit disposal account—with the accumulated depreciation for the vehicle, $18,000.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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187

The sale will lead to some proceeds, either in the form of cash or in some kind of trade-in allowance. This will result in the following entries in the accounts for a cash sale: Debit cash, credit disposal account—with the amount of the proceeds, $14,000 Or, for a sale using a trade-in, the entries will be as follows: Debit an asset account (whatever you are trading in for) with the agreed value, credit disposal account, $14,000.

4.8

The balance on the disposal account will then be transferred to the profit and loss account, as shown below: Disposal account Dec 31

Vehicles—cost

30,000

Profit and loss account

2,000 32,000

Dec 31

continued Accumulated depreciation—vehicles Cash

18,000 14,000 32,000

In this case the double entry would be a credit to the profit and loss account, representing a surplus on disposal: Profit and loss Dec 31

Disposal

2,000

It would be quite common for ‘profits’ or ‘losses’ on disposal to be netted off to the depreciation expense account, rather than written directly to the profit and loss account, as they should be seen as final adjustments to the depreciation figure, rather than as profits or losses.

Bad and doubtful debts Bad debts represent an expense which needs to be written off.

Let us assume that a business has, at its year-end (31 December), receivables totalling $1,028,000. After careful consideration, it comes to the conclusion that debts totalling $28,000 will not be recovered and need to be written off. The journal entry would be: Date Dec 31

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Dec 31

Account name and narrative Bad debts Receivables Writing off bad debts to a bad debts expense account Profit and loss—bad debts Bad debts Writing of the bad debts expense for the year

Folio

Debit side 28,000

Credit side 28,000

4.9

28,000 28,000

The relevant ledger accounts are as shown below: Receivables Dec 31

Balance b/f

1,028,000

Dec 31

Balance b/f

1,028,000 1,000,000

Dec 31 Dec 31

Bad debts Balance c/f

28,000 1,000,000 1,028,000

Bad debts Dec 31

Receivables

28,000

Dec 31

Profit and loss

28,000

The double entry to the bad debts account is to the profit and loss account: Profit and loss Dec 31

Bad debts

28,000

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4.9 continued

These entries mean that the balance on the receivables account is $1,000,000. Remember that this balance reflects the amount left after specific decisions (i.e. write-offs) have been made about specified debtors. But, as we saw in Chapter 3, it is probably unrealistic to expect all of the debtors included in this total to pay. We can be fairly certain that some won’t pay, but we don’t know which ones, so we cannot credit the debtors account (which will be the sum of a host of individual debtor accounts). Instead, we can set up another contra account, ‘provision for doubtful debts’. Suppose that, on the basis of past experience, we decide that approximately 2.5% of the debtors will not pay. This gives us an estimate of $25,000, which is journalised as follows: Date Dec 31

December 31

Account name and narrative Increase in doubtful debts provision Doubtful debts provision The increase in the size of the doubtful debt provision for the year Profit and loss—increase in DDP Increase in doubtful debts provision Writing off to profit and loss the increase in doubtful debts provision that arose in the year

Folio

Debit side 25,000

25,000

Credit side 25,000

25,000

After posting, the accounts would be: Doubtful debts provision Dec 31

Increase in DDP

25,000

Profit and loss

25,000

Increase in doubtful debts provision Dec 31

Doubtful debts provision

25,000

Dec 31

Note that this is an expense account, which will be charged to the profit and loss account. The profit and loss account will then reflect both expenses relating to bad and doubtful debts, as shown: Profit and loss account Dec 31 Dec 31

Bad debts Increase in bad debts

28,000 25,000

As we have seen in earlier chapters, these two amounts may appear in the income statement separately, or as a single figure for bad and doubtful debts, $53,000. The figures in the balance sheet will be:

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Receivables Less Doubtful debts provision

1,000,000 25,000 975,000

In future years it is only the actual bad debts plus the amount of change in the required doubtful debts provision that needs to be transferred to the profit and loss. For example, if receivables/ debtors at the end of the next financial year had reduced to $800,000, the doubtful debts provision needed would reduce to $20,000. So, for this second year there would be the actual bad debts and a revenue—’reduction in doubtful debts’—provision that would appear in the profit and loss account.

ACTIVITY 4.8 Journalise the following adjustments and record them (and any opening balances) in ledger accounts. Show clearly any transfers to the profit and loss account. You should assume that the financial year of the business is 1 January to 31 December. (a) (b)

A vehicle shown in the books at cost of $40,000, less accumulated depreciation of $20,000, was sold for $18,000. At the end of the financial year the receivables balances totalled $154,000. Bad debts amounting to $4,000 were written off. The accounts show an opening doubtful debts provision amounting to $3,500, based on an estimate of 2.5% of receivables. This percentage is to be retained for the current year.

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189

Inventory The perpetual inventory approach is relatively easily handled using ledger accounts, though some modification to the format helps.

Suppose that a particular line of inventory had the following transactions for a period. Purchased 60 tonnes @ $20 per tonne Sold 30 tonnes

4.10

Purchased another 30 tonnes at $22 per tonne Sold 50 tonnes The business uses FIFO as its way of dealing with inventory flow assumptions. This can be recorded in a modified stock account as shown below.

Date

Debit—goods received Quantity Cost/unit Total cost 60 20 1,200

30

22

Inventory Credit—goods issued Quantity Cost/unit Total cost 30

20

600

30 20

20 22

600 440

660

Balance Quantity Cost/unit Total cost 60 20 1,200 30 20 600 30 20 600 30 22 660 10

22

220

The double entry to the debit side would be a credit to cash or (more likely) to creditors/payables. The double entry to the credit side would be a debit to the cost of sales account. All of these transactions would be journalised prior to posting in the accounts.

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We saw in Chapter 3 that, if using the periodic method of recording inventory, a physical stock count and valuation was required. This was then used to calculate the cost of sales. This approach is relatively straightforward using journal and ledger accounts.

Let us assume that we have a system of ledger accounts which on June 30, the year end, includes opening stock ($150,000) and purchases ($900,000). The value of closing stock has been determined as $200,000, but this has not yet been recorded. We need to transfer the two current balances to a cost of sales (CoS) account, then incorporate the closing stock adjustment, and then transfer the cost of sales to the profit and loss account. Journal entries needed to reflect this are as follows: Date June 30

June 30

June 30

June 30

Account name and narrative Cost of sales Opening stock Transfer of opening stock to Cost of sales Cost of sales Purchases Transfer of purchases to Cost of sales Inventory (closing) Cost of sales Adjustment of closing stock through Cost of sales Profit and loss—Cost of sales Cost of sales Transfer of Cost of sales to Profit and loss account

Folio

Debit side 150,000

4.11

Credit side 150,000

900,000 900,000 200,000 200,000 850,000 850,000

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The ledger accounts would appear as follows: Inventory (opening)

4.11

July 1

Balance b/f

150,000

June 30

Balance b/f

900,000

June 30

Cost of sales

150,000

Purchases June 30

Cost of sales

900,000

continued Inventory (closing) June 30

Cost of sales

200,000 Cost of sales

June 30 June 30

Opening inventory Purchases

June 30

Cost of sales

150,000 900,000 1,050,000

June 30 June 30

Closing inventory Profit and loss (CoS)

200,000 850,000 1,050,000

Profit and loss 850,000

An alternative to the above treatment is to bypass the cost of sales account and transfer the opening stock, purchases and closing stocks straight to the profit and loss account. Of course, the cost of sales account can become more complicated with the addition of extra costs including such things as carriage in, and by purchases returns.

ACTIVITY 4.9 A business has the following balances relating to inventory at its year-end: Opening inventory $50,000 Purchases Purchases returns Sales Sales returns

$450,000 $5,000 $900,000 $15,000

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Close off these accounts to the profit and loss account. The closing stock has been counted and valued at $52,000.

Concept check 11 Which of these statements is true? A

B C D

E

Accrued expenses result in a debit to the profit and loss account and a credit to an accrual account. Bad debts are set off against receivables in the balance sheet. Expense accounts are debited to drawings. When a non-current asset is sold at a price which is greater than its book value, the result is a debit to the profit and loss account. A business collects subscriptions in advance. These prepayments are shown as a current asset.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Concept check 12 At the end of a financial period the provision for doubtful debts account is: A B C D

Closed by transfer to the profit and loss account Carried forward and shown under current liabilities Closed by transfer to the balance sheet Carried forward and shown as a deduction from receivables.

LO6

MANUFACTURING AND TRADING ACCOUNTS Many trading businesses use a separate trading account, prior to the profit and loss account, in which they calculate gross profit on trading (see Example 4.12).

Use a manufacturing account and a trading account where appropriate

Trading account Opening inventory Purchases Carriage in Gross profit to profit and loss account

x x x x x

Purchases returns Sales Closing inventory

x x x x

4.12

Similarly, a manufacturing business will record costs of production in a manufacturing account prior to the trading account. A typical manufacturing account will include the kind of entries shown in Example 4.13.

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Manufacturing account Opening balance of raw materials b/d Purchases of raw materials Carriage in Direct labour* Royalties Direct expenses Production overheads Indirect labour** Indirect expenses*** Rent and rates Power Heat and light Depreciation Opening balance of work-in-progress

x x x x x x

Closing balance of raw materials c/d Closing balance of work-in-progress

x x

Cost of production to trading account

x

x x x x x x x x

4.13

x

*Direct labour covers the costs of labour worked directly on production. **Indirect labour covers ancillary labour costs related to production. ***Indirect expenses are typically small items that cannot be related to individual jobs.

The cost of production is then transferred to the trading account as follows: Trading Opening inventory—finished goods Cost of production Gross profit c/d

x x x x

Sales Closing inventory—finished goods

x x x

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The information contained in the manufacturing, trading and profit and loss accounts is typically presented in a more useful way. An example of how a manufacturing, trading and profit and loss suite of accounts can be presented internally is given in Example 4.14

Manufacturing, trading and profit and loss accounts for the year ending …

4.14

Sales Less sales returns Less cost of production Raw materials Opening balance Plus purchases and carriage in Less closing balance Cost of raw materials used Plus direct labour Royalties Gives a figure known as prime cost Add factory overheads Rent and rates* Indirect labour Indirect materials Power Heat and light* Depreciation of plant and equipment

x (x) x x x x (x) x x x x x x x x x x x x (x) x x (x)

Plus opening balance of work-in-progress Less closing balance of work-in-progress Cost of goods produced Plus opening balance of finished goods Less closing balance of finished goods Cost of sales Gross profit Plus Other revenues Discount received Rent Interest

x x x x x

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x Less other expenses Administration Wages/salaries* Stationery Heat and light* Rent and rates etc.* Depreciation of fixtures*

x x x x x x x

Finance Interest Bad debts

x x x

Selling/distribution Sales salaries Packaging distribution Advertising

x x x x

Profit for the period

x x

*Note that these items need to be allocated to the appropriate section. Expenses relating to production should appear in the manufacturing section, while expenses relating to administration should appear in the profit and loss section. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Concept check 13 Which of the following combinations of expenses might you expect to find in a manufacturing account? A B C D E

Carriage in, direct labour, administration Factory overheads, discount received, distribution Depreciation of plant and equipment, indirect production labour, power Factory rent and rates, depreciation of plant and equipment, depreciation of fixtures Raw materials, packaging and distribution, factory power.

ACTIVITY 4.10 The following information was provided from the accounts of a manufacturer on 30 June.

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Raw materials purchased Factory expenses Stock 1 July Finished goods Raw materials Stock 30 June Finished goods Raw materials Receivables Payables Sales Drawings Cash Factory wages General and administration expenses Capital 1 July Furniture and fittings Plant and machinery Selling expenses

$ 240,000 600,000 160,000 40,000 140,000 20,000 120,000 40,000 1,500,000 50,000 125,500 290,000 90,000 775,500 50,000 400,000 150,000

The following adjustments are to be brought into account: (a)

Amounts outstanding at 30 June Factory wages $5,000 Advertising $3,000

(b)

Amounts prepaid General expenses

(c) (d)

$22,000

$5,000 of the receivables are considered bad, while a general provision for doubtful debts is to be set up—2% of receivables. Depreciation is to be charged on plant and machinery and furniture and fittings at 10% of cost—straight line.

Prepare a manufacturing, trading and profit and loss statement for the year ending 30 June, and a balance sheet as at that date. Use a vertical form of presentation.

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SELF-ASSESSMENT QUESTION

4.1

The following is the balance sheet of Jonathan & Co., a retailer, as at 1 January 2017. Jonathan & Co. Balance sheet as at 1 January 2017 $ Current assets Cash Debtors/receivables Inventory

$

15,000 20,000 25,000 60,000

Non-current assets Fixtures Premises

10,000 50,000 60,000 120,000

Current liabilities Payables/creditors Non-current liabilities Loan Capital/equity

25,000 40,000 55,000 120,000

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Following is a summary of the transactions for 2017: 1 Purchases of inventory on credit amounted to $200,000, half being for cash and half on credit. 2 Payments to creditors amounted to $105,000. 3 Sales amounted to $330,000, with credit sales being $120,000 and the remainder being for cash. 4 Receipts from debtors were $110,000. 5 Bad debts of $5,000 were written off. 6 Cost of sales amounted to $200,000. 7 Interest on the loan at 7% was paid. 8 Wages amounting to $40,000 were paid. 9 Other expenses amounting to $15,000 were paid. 10 During the year the owner withdrew cash drawings totalling $15,000. 11 At the end of the year the owner transferred his private vehicle to the business. Its value was estimated at $14,000. At the end of the year the following information is provided to enable a range of year-end adjustments to be made: 1 Depreciation is charged as follows: Fixtures $2,000 Premises $5,000 2 $1,000 of wages was unpaid, insurance of $100 was prepaid, and rates of $900 were outstanding. Insurance and rates are included in other expenses. Record this example in the ledger accounts, prepare a trial balance, close off the accounts for the year, and prepare a profit and loss account and balance sheet.

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Several things are worth noting at this stage:

• The profit and loss account (with manufacturing and trading sections where appropriate) is part of the ledger accounting system and all revenues and expenses are channelled through this account.

• The balance sheet is effectively nothing more than a list of balances at a particular point in •

• •

time. These balances must represent assets or claims at that time. Accounts can be asset, expense, liability or revenue depending on circumstances. For example, in the answer to Self-assessment Question 4.1 (available online), the ‘other expenses’ account has cash payments that are expenses, cash payments that are prepayments (assets), and expenses that are unpaid and therefore remain as liabilities. In the answer to Self-assessment Question 4.1 the trial balance was drawn up before the year-end adjustments took place. It is quite possible (indeed desirable) for a further trial balance to be drawn up after the adjustments. Many examiners use the trial balance as a starting point for final account questions.

ADJUSTED TRIAL BALANCE AND WORKSHEET Let us use Self-assessment Question 4.1 to work through the idea of a second trial balance after the adjustments have been completed. We can see from the solution (available online) that the trial balance before any adjustments are made will be as follows: Trial balance as at 31 December 2017 Debit 57,200 25,000 25,000 10,000 14,000 50,000

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Cash Receivables Inventory Fixtures Vehicle Premises Payables Loan Equity Sales Bad debts Cost of sales Interest Other expenses Wages Drawings

Credit

LO7 Use an adjusted trial balance and a worksheet to complete a set of final accounts

20,000 40,000 69,000 330,000 5,000 200,000 2,800 15,000 40,000 15,000 459,000

459,000

We can now deal with the year-end adjustments, as shown below. Depreciation will be recorded in expense accounts and accumulated depreciation accounts as follows: Depreciation—fixtures (expense) Dec 31

Fixtures—Accumulated depreciation

2,000

Accumulated depreciation—fixtures Dec 31

Depreciation—fixtures

2,000

Depreciation expense—premises Dec 31

Premises—Accumulated depreciation

5,000

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Accumulated depreciation—premises Dec 31

Depreciation—premises

5,000

The prepayments and accruals will be dealt with as follows: Wages Dec 31

Cash Accrued wages

40,000 1,000 41,000 Accrued wages Dec 31

Wages

1,000

Other expenses Dec 31

Cash Accrued rates Balance b/d

15,000 900 15,900 15,800

Dec 31 Dec 31

Prepaid insurance Balance c/d

100 15,800 15,900

At this point, rather than closing off the revenue and expense accounts to the profit and loss account, we draw up an adjusted (final) trial balance, as a check on the correctness of the adjustments, before moving to the closing-down stage. The adjusted trial balance would appear as shown below:

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Adjusted trial balance as at 31 December 2017 Cash Receivables Prepaid insurance Inventory Fixtures Accumulated depreciation—fixtures Vehicle Premises Accumulated depreciation—premises Payables Accrued wages Accrued rates Loan Equity Sales Bad debts Cost of sales Interest Other expenses Wages Depreciation expense—fixtures Depreciation expense—premises Drawings

Debit 57.200 25,000 100 25,000 10,000

Credit

2,000 14,000 50,000 5,000 20,000 1,000 900 40,000 69,000 330,000 5,000 200,000 2,800 15,800 41,000 2,000 5,000 15,000 467,900

467,900

This approach can easily be incorporated into a spreadsheet or worksheet as shown in Table 4.1.

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TABLE 4.1 EXAMPLE OF THE WORKSHEET APPROACH Trial balance Debit

Credit

Adjustments Debit

Credit

Adjusted trial balance Debit

Credit

Profit and loss Debit

Balance sheet

Credit

Debit

Credit

Assets Current assets Cash

57,200

57,200

57,200

Receivables

25,000

25,000

25,000

Inventory

25,000

25,000

25,000

100

100

Prepayments

100

Non-current assets Vehicle

14,000

14,000

14,000

Fixtures

10,000

10,000

10,000

Accumulated depreciation

2,000

Premises

50,000

2,000

2,000

50,000

Accumulated depreciation

5,000

50,000 5,000

5,000

20,000

20,000

1,900

1,900

Current liabilities Payables

20,000

Accruals

1,000 900

Non-current liabilities Loan

40,000

40,000

40,000

Equity

69,000

69,000

69,000

Profit Drawings

58,400 15,000

15,000

15,000

Income statement Sales

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Bad debts Cost of sales

330,000

330,000

5,000

5,000

5,000

200,000

200,000

200,000

41,000

41,000

2,800

2,800

15,800

15,800

Wages

40,000

Interest

2,800

Other expenses

330,000

15,000

1,000 900

100

Depreciation— fixtures

2,000

2,000

2,000

Depreciation— premises

5,000

5,000

5,000

Profit

58,400 459,000

459,000 9,000

9,000

467,900

467,900

330,000

330,000

196,300

196,300

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This is a neat and efficient way of dealing with the preparation and checking of final accounts. We can see clearly how we can move from a trial balance through the adjustments to an adjusted trial balance, thus facilitating a further check on the accounts. From the adjusted trial balance we can then determine whether the accounts are accounts which will be closed to the profit and loss account or whether they are accounts which will be shown in the balance sheet. The final accounts are contained in the last two main column headings (i.e. profit and loss and balance sheet). All that is needed is some tidying up for presentation purposes. You should note that in this example the figure for cost of sales is shown, which presupposes that a perpetual system of inventory control has been used. Where the periodic method is used, we would expect to find the opening balance of inventory in the trial balance, together with purchases, and the closing inventory adjustment would be made in the adjustments column. In Activity 4.11 you will need to do the adjustment for inventory.

Concept check 14 Which of the following is the least likely to be found in the adjustment column of a worksheet? A B C D E

Drawings Accruals Disposals of a non-current asset Depreciation Doubtful debts provision.

ACTIVITY 4.11 The following is the trial balance of a sole trading business at the end of its financial year. Trial balance as at 30 June 2017

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Debit Inventory as at 1 July 2016 Capital Purchases Sales Rent and rates Insurance Motor expenses Office expenses Heat and light General expenses Freehold premises Cash Salaries and wages Motor vehicles—cost Motor vehicles accumulated depreciation Furniture and fittings—cost Furniture and fittings accumulated depreciation Receivables Payables Doubtful debts provision Drawings

$ 275,000 1,037,000 27,600 7,000 57,800 25,400 18,200 28,400 450,000 32,000 246,000 175,000 128,000 284,000 52,000 2,843,400

Credit $ 803,800 1,798,000

53,000 23,600 131,000 34,000 2,843,400

The following information is available at the end of the financial year: 1 2

Inventory at 30 June 2017 was physically counted and was valued at $263,000. Rates of $5,700 were owing as at 30 June 2017.

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3 4 5

A motor vehicle repair carried out on 1 June 2017, costing $2,200, was still unpaid at year-end. The doubtful debts provision is to be adjusted to 5% of receivables at 30 June 2017. Depreciation is to be provided at the rate of 25% per annum on cost for vehicles and 15% per annum on cost for fixtures and fittings.

Prepare a profit and loss account for the year ended 30 June 2017 and a balance sheet as at 30 June 2017 for the business, using a worksheet.

LO8 THE CHART OF ACCOUNTS The ledger accounting system is relatively straightforward in principle. In practice, it remains straightforward for small businesses (and other small organisations). However, as the volume of transactions and the complexity of the activities increase, there is a need to produce a greater range of information, covering a variety of different parts of the organisation. The ledger accounting system covered in this chapter is unlikely to be able to cope without some modification. Chapter 5 covers some of these modifications. However, before starting down this path, it is useful to consider the role and importance of the chart of accounts. The chart of accounts is a list of all of the accounts kept by the organisation, grouped in ways which link to the balance sheet and income statement. With manual systems, detailed folio references are used. With computerised systems, detailed systems of coding are typically found. For a small business the chart of accounts is likely to look something like Table 4.2.

Describe a chart of accounts and explain its importance

chart of accounts A listing of all of the accounts contained in the ledger accounts, usually with a system of coding, which links with the balance sheet and income statement.

TABLE 4.2 CHART OF ACCOUNTS FOR A SMALL BUSINESS Assets Cash

Share capital

Receivables

Retained earnings

Doubtful debts provision (contra account) Prepaid expenses

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Equity

Profit and loss Revenues

Inventory

Cost of sales

Non-current assets (by type)

Advertising

Accumulated depreciation (contra account/s)

Bank fees

Other assets

Interest

Liabilities

Depreciation expense

Payables

Rent and rates expense

Accrued liabilities

Utilities expense

Loans

Wages expense Other expenses

The chart of accounts must include all of the accounts that are necessary to complete the final accounts. The list above covers most of the items found in the accounts used in this chapter. Clearly, a list of this small size could only be applicable to a small organisation. Great care is needed to identify all of the items that might be needed in order to produce the necessary final accounts, but also to provide all of the historical accounting needed for management accounting purposes. The above list will not suffice for a multi-sector organisation, where detailed reports

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will be needed in order to measure performance of sections of the organisation. We saw earlier that Wesfarmers includes a range of activities, all of which need reporting on to shareholders and managers. The chart of accounts would need to be substantially expanded to deal with a business of this complexity. Even a small company will very soon need dozens of accounts in its chart of accounts. With larger organisations, the chart of accounts becomes effectively a coding system, which enables all of the relevant information to be collected and reported on. There are no hard and fast rules as to how a coding system is developed; this will be dependent on the size and nature of the organisation. However, the following are useful factors to bear in mind in designing a chart:

• Reporting requirements may well affect how a company structures its chart of accounts. • It is important to create a chart of accounts that is unlikely to change for several years.

•

Consistency is important if comparisons are to be useful. Having said this, circumstances do change, and when devising a coding system, you should always make sure that there is room for more codes, as activities change or develop. It is useful to periodically review the account list to see whether any of the accounts are redundant, in the sense that they are not producing information which is material, and, if so, move them into a larger, more general account.

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An interesting perspective on the chart of accounts is provided on the Investopedia website. The chart of accounts is compared with the list of balances you find when you log into your bank accounts online. The summary shows the balance on each account, which enables you to get the big picture as to what is happening with the management of your accounts. In the same way, the chart of accounts aims to separate assets, liabilities, equity, revenues and expenses so that users can quickly get a sense of the financial health of the organisation. The coding system can take a variety of forms, mostly numeric, sometimes alpha-numeric. The aim is to be able to break down activity into sub-parts or sections in sufficient detail to be able to produce meaningful reports on as many sections of the business as is deemed necessary and appropriate. Example 4.15 aims to provide some guidance as to how this might occur.

4.15

Assume that you currently run a restaurant in a coastal town in Victoria. This has been quite successful and you wish to expand into the next town, about 30 kilometres away. This town is inland and is heavily dependent on the dairy industry. The clientele and circumstances associated with the two restaurants are quite different. It would seem sensible to keep separate records for each of them. This could easily be done by simply setting up a second set of ledger accounts relating to the second restaurant, with an income statement for each and the profits or losses from each being then transferred to equity. However, it is likely that, as you expand, you will consider using an accounting package. The more complicated your business becomes, the more important the chart of accounts becomes. After several years of running the two restaurants, you are looking at further expansion. You have decided that expansion into the holiday rental business might provide a better link with the restaurants than opening more restaurants further away. It could also link with provision of food for conferences and related activities. This would necessitate some different types of accounts and separate reporting, all of which could be done manually, but probably would be better done using an accounting package. A possible chart of accounts for the business is shown in Table 4.3. The first column includes a reasonable chart of accounts for the single restaurant business. The second column sets out a 4-digit code which could work for this single business. The third column revises the coding system to facilitate separate record-keeping for the second business. The fourth column does the same for the third area of business and also adds some new accounts.

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TABLE 4.3 CHART OF ACCOUNTS AND ASSOCIATED CODING Assets Non-current assets Premises (if owned) Holiday accommodation Holiday accommodation—Accumulated depreciation Equipment Equipment—Accumulated depreciation Furniture and fittings Furniture and fittings—Accumulated depreciation Current assets Inventory Receivables Cash in hand Cash at bank Liabilities Equity Contributed Retained profit Profit and loss Drawings Long-term liabilities Loans Mortgage Current liabilities Payables Deposits Expenses Purchases of food Discounts allowed Wages Rent and rates Insurance Gas and electricity Interest Depreciation—equipment Depreciation—furniture and fittings Bad debts Cleaning Revenues Takings Interest receivable

1100–1199 1100–1150 1101

2100–2199 2100–2150 2101

1111 1121 1131 1141 1151–1199 1151 1161 1171 1181 1200–1270 1200–1249 1201 1211 1221 1231 1250–1270 1251

2111 2121 2131 2141 2151–2199 2151 2161 2171 2181 2200–2270 2200–2249 2201 2211 2221 2231 2250–2270 2251

1271–1300 1271

2271–2300 2271

1300–1599 1301 1321 1341 1361 1381 1401 1421 1441 1461 1481

2300–2599 2301 2321 2341 2361 2381 2401 2421 2441 2461 2481

1600–1799 1601 1651

2600–2799 2601 2651

There is no reason to suppose that the type of accounts needed to include the second restaurant would need to change. However, in order to keep track of the second restaurant separately, some means of identification would be needed. This could simply be done by changing a single digit of the code, as shown in the third column of the chart. When we come to the third area of the business, we need to add some more accounts so as to ensure that we are able to record the information necessary to enable us to see clearly how this section of the business has performed, to provide information which can be used to assess its success, and to identify ways in which improvements can be made. So, the first column includes any extra accounts needed, which are shown in italic, while the fourth column includes new codes for these new accounts and a

3100–3199 3100–3150 3101 3106 3107 3111 3121 3131 3141 3151–3199 3151 3161 3171 3181 3200–3270 3200–3249 3201 3211 3221 3231 3250–3270 3251 3261 3271–3300 3271 3281 3300–3599 3301 3321 3341 3361 3381 3401 3421 3441 3461 3481 3500 3600–3799 3601 3651

4.15 continued

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4.15 continued

change in the initial digit of the code to identify the third area of the business. The last three numbers of the code will identify a particular type of account, while the first number will identify which of the three sections of the business a particular transaction relates to. You should note that the preceding example uses a 4-digit code. This was a quite arbitrary choice. The coding system can take many different forms, but the general approach is very similar, no matter what codes are actually used. What is important is that considerable thought goes into the original chart, so that little needs to be added or changed in the short-term. A complete change in an area of the business, such as in the third area in the example, may well lead to some new accounts and associated codes being required, but if a chart is imaginatively thought through from the outset, and developed alongside a strategic plan, changes should be relatively small. Even the adding of a welldeveloped subsidiary company, as the result of a takeover or acquisition, should be capable of being quickly absorbed within a well-designed chart of accounts. It would be easy to see the chart of accounts as financial accounting oriented, but this would be a mistake. We shall see in Chapter 7 that the regulations regarding limited companies are considerable, especially regarding the financial accounts. But much of the information required is corporate-level, big-picture information. Some of it relates to segments, but very little of it comes near the detail that we would expect a management accountant (and his or her associated managers) to require in order to assess performance and develop improvement and growth strategies. The development of an appropriate chart of accounts goes to the heart of managing a business. It requires a clear strategic perspective, a detailed understanding of planning and control, and an ability to develop a sound information system.

ACTIVITY 4.12 (a) (b) (c) (d)

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(e)

From Table 4.3, what codes would give you a total figure for the three sections of the business for receivables and wages? How easy would it be to prepare a profit and loss account for the entire business in Table 4.3? Why do you think that it is important that the chart of accounts facilitates reporting of the separate sections of the business? Can you think of any areas of the restaurant business that might need more detailed reporting? Identify the accounts and suggest a code or codes for these in line with those in Table 4.3 For a retailer with a huge range of inventories, such as a supermarket, how might the chart of accounts reflect the need for a detailed system of coding for sales and cost of sales?

REAL WORLD 4.1 Charts of accounts An example chart of accounts for a very small business can be found by a web search under:

Source: National Standard Chart of Accounts, www.acnc.gov.au/ ACNC/Manage/Reporting/NSCOA/ACNC/Report/ChartofAccounts2. aspx?nole#51&hkey5179cdfe1-4e9e-412a-96c3-e0db53e0acfe.

Example chart of accounts—Business Victoria QUT, through the Australian Centre for Philanthropy and Nonprofit Studies, developed a Standard Chart of Accounts to assist non-profit organisations and funders, including government departments and agencies. The document is comprehensive and includes references to the Accounting Standards. It also uses MYOB account numbers. It was handed over to the Australian Charities and Not-for-profits Commission (ACNC) in 2013.

Class discussion points 1 If possible, obtain a variety of charts of accounts and compare them. What similarities do they have? 2 What differences do they have? Can you suggest reasons for these differences?

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It may appear that the computerised systems now so commonly found have moved away from double entry. This is not correct. The underlying principles of ledger accounts underpin computerised accounting systems. However, ledger accounting was developed at a time when businesses were smaller and easier to keep track of. Large, complex businesses require more involved record-keeping approaches. Inevitably, they will use a system which effectively uses a system of pluses and minuses or debits and credits, and which produces the same kind of final accounts as a traditional ledger system. The main advantage of the newer systems is the ease and speed with which they can produce a large amount of additional information. Also, as we shall see in the next chapter, the document flows associated with business transactions can be fully integrated into these systems.

Concept check 15 Which of the following statements is false? A

B C

D

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E

As the volume of transactions and the complexity of a business increases, the ledger accounting system, as described in this chapter, is unlikely to be able to cope without further modification. The chart of accounts is effectively a detailed system of coding for accounts. The chart of accounts should be sufficiently detailed to enable meaningful reports on as many sections of the business as is deemed necessary. The chart of accounts should facilitate obtaining a ‘big picture’ as to what is going on. The chart of accounts will need to change on a regular basis as the business changes.

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SUMMARY

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In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Provide an overview of the recording process, including the nature of business transactions, steps in the recording process, the role of the general journal and ledger accounts, through to the final accounts

• Identified the basic steps in the recording process as identification of the effect of each business transaction, recording it in a journal, and posting it to the ledger • Identified a range of complications which lead to variations in the way accounting systems operate in practice

LO2: Explain how the use of double-entry bookkeeping mirrors the first-principles approach, and use the general journal and ledger accounts to record a set of basic business transactions

• Illustrated how the double-entry system can be linked with a first-principles approach • Explained the form and purpose of the general journal, and used it to record a range of transactions • Detailed the method of ledger accounting • Used the double-entry system to record a selection of transactions • Balanced off a set of accounts

LO3: Explain the importance of a trial balance and use one as part of the accounting process

• Explained the role of the trial balance • Identified its limitations

LO4: Close off a simple set of accounts using the profit and loss account and complete a balance sheet from the ledger accounts

• Closed off the revenue and expense accounts to the profit and loss account • Saw that the balance sheet was a summary of the account balances as shown in the ledger accounts • Illustrated a series of period-end adjustments including:

LO5: Record a series of period-end adjustments in the accounts, relating to prepayments and accruals, deferred revenues and revenues outstanding, depreciation, bad and doubtful debts, and transactions relating to inventory.

• • • • •

LO6: Use a manufacturing account and a trading account where appropriate

• Prepared a set of final accounts for a trading business and a manufacturing business

LO7: Use an adjusted trial balance and a worksheet to complete a set of final accounts

• Explained and used an adjusted trial balance to assist in developing a set of final accounts

LO8: Describe a chart of accounts and explain its importance.

• Described the purpose and importance of a chart of accounts • Illustrated the development of a chart of accounts • Explained how important clear definition of a chart of accounts is, so as to be able to obtain as much information as is needed to assess performance of all parts of a business

Prepayments and accruals Revenues due and prepaid Depreciation and asset disposals Bad and doubtful debts Inventory

DISCUSSION QUESTIONS EASY 4.1

LO1

Outline the purpose of the general journal. How likely is it that it will be used for all transactions? Is it a necessary part of the recording process?

4.2

LO1

Discuss the importance of the narrative and folio sections of the journal.

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4.3

LO2–5

What are the main advantages of the double-entry system?

4.4

LO2–5

What are the main disadvantages of the double-entry system?

4.5

LO1/2

What is the typical range of accounts kept in a ledger accounting system?

4.6

LO1/2

What is the difference between journalising a transaction and posting it?

INTERMEDIATE 4.7

LO3/7

Explain the role of a trial balance.

4.8

LO3

List the kind of errors in record-keeping that might prevent a trial balance from agreeing.

4.9

LO7

Discuss the reasons for use of an adjusted trial balance.

CHALLENGING 4.10 LO7

How useful is the worksheet approach?

4.11 LO8

Discuss the importance of the chart of accounts.

4.12 LO8

How might you design a chart of accounts for the exciting business ventures that you plan? How might you deal with uncertainty regarding future directions?

4.13 LO6

Identify and explain the way in which the expenses of a manufacturing business will be split into the manufacturing, trading and profit and loss accounts in deriving profit.

APPLICATION EXERCISES EASY

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4.1

4.2

LO2

LO2

Show how the following would be recorded in the general journal. January 1

A. Dele invests $100,000 in a business.

January 2

The business buys stock/inventory for $40,000 cash.

January 3

It buys further inventory on credit for $20,000.

January 4

It buys a machine for cash for $10,000.

January 5

It pays rent of $5,000.

January 6

It sells inventory, which had cost $4,000, for $7,000 on credit.

January 7

It pays wages of $1,000.

January 8

It pays some of its suppliers $5,000.

January 9

A. Dele withdraws cash of $2,000.

The opening balance on the receivables account of a business was $40,000. The following transactions occur, all of which relate to receivables: (a) Sales on credit amounted to $25,000. (b) Cash received from debtors amounted to $45,000, which was in satisfaction of debts of $45,900. (c) Bad debts of $1,200 were written off. Journalise these transactions, post the appropriate amounts in the receivables account, and balance off the account.

4.3

LO2

D. Harvey started business on 1 April with $150,000. He also borrowed $50,000 from A. Veck on a long-term loan. Both amounts were paid into a business bank account. During the next three months, the following business was transacted: (a) Rented buildings for $24,000 per annum, and paid four months rent on 1 April. (b) Purchased by cash furniture and equipment for $100,000 and a motor vehicle for $8,000. (c) Purchased inventory amounting to $80,000 on credit. (d) Sales for cash amounted to $50,000. The cost of these goods was $30,000.

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ACCOUNTING FOR BUSINESS STUDENTS

(e) Credit sales amounted to $40,000. The cost of these goods was $25,000. (f) Paid the creditors (payables) $60,000. (g) Received cash from debtors (receivables) of $30,000. (h) Business expenses paid, excluding rent, amounted to $5,000. (i) On 30 June expenses outstanding amounted to $500. You are required to: (i) calculate, using ledger accounts, the value of inventory at cost, receivables, and payables as at 30 June (ii) prepare accounts to show the balance in the bank, the gross profit, and the profit for the period (iii) prepare a balance sheet as at 30 June to show the total of fixed assets, current assets, and current liabilities. 4.4

LO2–5

On 30 November Martin Webb extracted the following trial balance from his ledger. Debit Capital Drawings

20,000

Receivables

16,000

Payables Inventory (1 January) Business expenses Rent, rates and insurance

Credit 23,000

14,000 12,000 7,500 15,000

Sales

250,000

Purchases

180,00

Cash

26,500

Fixtures

10,000 287,000

287,000

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Open accounts for each of the above items and insert the balance as at 30 November. During December, the following business was transacted: Sold goods on credit

20,000

Purchased goods on credit

20,000

Receipts from debtors (receivables)

15,000

Payments to creditors (payables)

12,000

Business expenses paid

1,000

Insurance paid

1,500

Drawings

2,000

Journalise the December transactions and post them to the above accounts. All receipts are paid into the bank and all payments are made by cheque. Martin Webb balances his accounts on 31 December each year. Balance the accounts, taking into account the adjustments given below, and prepare trading and profit and loss accounts and a balance sheet. Adjustments Business expenses of $500 were outstanding. Insurance of $500 was prepaid. Fixtures are to be depreciated by $1,000. Closing inventory is valued at $10,000.

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

4.5

LO2/5

The balance sheet of a company contained the following: 2016 (end)

2017 (end)

Plant at cost

$870,000

$920,000

Less Accumulated depreciation

$210,000

$250,000

$660,000

$670,000

During 2017 plant costing $90,000 (accumulated depreciation $60,000) was sold for $10,000. Write up the appropriate accounts. 4.6

LO2/5

Tiger Trucks purchases a truck on 1 July 2015 for $90,000. The business decides that the truck ought to last for 5 years, after which it is likely to be sold for 10,000. Tiger Trucks’ accounting year is from January to December. (a) Assuming straight-line depreciation, show the entries in the ledger accounts relating to the truck and depreciation for 2015 and 2016, clearly identifying the expense for each year, and the entries relating to vehicles that would provide the basis for the figures in the balance sheet for vehicles. Assets are to be shown at cost with associated accumulated depreciation. (b) On 31 December 2017, the truck is sold for $40,000. Show the 2017 account entries.

4.7

LO2/5

The following items appear in the balance sheet of a business as at 31 December 2016: Current assets Prepaid insurance

$3,000

Prepaid heating

$1,500

Current liabilities Accrued wages

$8,000

Deferred revenue

$1,800

During the year to 31 December 2017, the following cash receipts and payments occurred: Cash receipts Rent relating to the period 1 April to 30 September

$3,600

Cash payments Wages

$250,000

Insurance

$12,000

Heating

$10,000

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At 31 December 2017 there are $5,000 of wages and $2,000 of heating bills that remain outstanding. Of the insurance paid, $3,000 relates to 2018. Prepare ledger accounts that show the entries for rent receivable, insurance, heating, and wages, showing clearly the transfer that would be made to the profit and loss account. Also, indicate what figures relating to these accounts would be included in the balance sheet of the business as at 31 December 2017. 4.8

LO2/5

From the information given below, you are required to show the ‘Rent and insurance’ account for the business for the year ended 30 June 2017, indicating clearly the prepayments and accruals at that date and the transfer to the profit and loss account for the year. The balance on the account at 1 July 2016 showed: Rent accrued

$2,000

Insurance prepaid

$2,000

Payments made during the year to 30 June 2017 were as follows: 10 August 2016

Three months’ rent to 31 July

$3,000

15 October 2016

One year’s insurance to 31 October 2017

$6,000

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ACCOUNTING FOR BUSINESS STUDENTS

4.9

LO2/3/5

1 December 2016

Three months’ rent to 31 October 2016

$3,000

15 January 2017

Four months’ rent to 28 February 2017

$4,400

28 February 2017

Six months’ rent to 31 August 2017

$6,600

From the following information, show the ledger accounts for receivables, bad debts, provision for doubtful debts, and relevant sections of the profit and loss for 2016 and 2017. 1 January 2016

Receivables

$400,000

Provision for doubtful debts 2016

2017

$8,000

Sales

$2,210,000

Cash received

$1,900,000

Sales returns

$50,000

Bad debts

$10,000

Sales

$2,515,000

Cash received

$2,600,000

(including a bad debt recovered of $2,000) Sales returns

$40,000

Bad debts

$9,000

The provision for doubtful debts is to be maintained at 2% of debtors/receivables.

INTERMEDIATE 4.10 LO2/4/5

On 31 March 2016 the balance brought forward in the books of a business included the following: Debit Equipment at cost

Credit

50,000

Accumulated depreciation as at 31 March 2016

10,000

Rent received—prepaid to the business Rates prepaid Receivables Provision for doubtful debts

2,000 600 50,000 2,500

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You are given the following information in respect of the year to 31 March 2017. (a) The top floor office has been let since 1 January at a rental of $12,000 per annum, and the tenant should pay in advance in two instalments on 1 January and 1 July in each year. Payment for the first four months of 2016 was made on 1 January. A further $4,000 was paid on 1 October and a further $4,000 was paid on 1 March 2017. The tenant was in occupation for the entire year. (b) On 1 January 2017 a new piece of equipment was purchased at a cost of $8,000—$4,000 was paid in cash and the rest was satisfied by part exchange of a piece of equipment which had cost $5,000 and which had been depreciated by $2,500 by 31 March 2016. Depreciation on equipment is provided at 10% per annum straight line. (c) On 1 December 2016 rates were paid for the year ending 30 June 2017, amounting to $2,500. (d) The total of receivables as at 30 March 2017 amounted to $55,000. It was decided that one debt of $1,000 was irrecoverable, and that the provision for doubtful debts should remain at 5% of outstanding debtors. Show the following ledger accounts for the year to 31 March 2017: (i) Rent receivable (ii) Rates Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

(iii) Equipment (iv) Accumulated depreciation—equipment (v) Provision for doubtful debts (vi) Disposal account. No other accounts are required, but all entries in the above accounts should be cross-referenced to the other accounts affected. 4.11 LO2/4/5

A firm makes up its accounts each year to 31 December, and the following transactions took place in respect of motor vehicles: 2015

1 January

Truck 1 purchased for cash

$40,000

30 July

Truck 2 purchased

$48,000

$24,000 deposit in cash Balance being spread over 12 monthly instalments of $2,000 2016

1 March

Truck 3 purchased

$48,000

$24,000 deposit in cash Balance as for Truck 2 30 July

Truck 4 purchased

$60,000

Truck 1 part-exchanged as deposit of $32,000 Cash

$4,000

Balance as for Truck 2 2017

30 April

Truck 5 purchased

$60,000

Truck 2 part-exchanged as deposit of $36,000 Balance paid in cash Show the relevant extracts from the profit and loss accounts and balance sheets for 2015, 2016 and 2017. Depreciation is to be based on 20% per annum reducing balance. 4.12 LO2/5

On 1 January loose tools to the value of $4,000 were held by a business. During the year wages of $200,000 were paid, of which $2,000 related to work on loose tools for the business’s own use. Raw material costing $3,000 was used in this process. At the year-end the value placed on the stock of tools was $3,200. Complete the loose tools account and the depreciation account for the year.

4.13 LO2–5

The following items appear in the balance sheet of a business as at 31 December 2017: $ Current assets Prepaid insurance

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Prepaid administration

500 1,000

Current liabilities Accrued wages

3,000

During the year to 31 December 2018 the following cash payments were recorded: Cash payments Wages Insurance Administration

$ 50,000 1,200 10,000

At the year-end (31 December 2018) you ascertain that $1,000 of wages and $1,200 of administration bills remain outstanding, and that $400 of insurance has been prepaid. Prepare ledger accounts showing the entries for insurance, administration and wages, clearly showing the transfer that would be made to the profit and loss account. What figures, if any, relating to these transactions, would be included in the balance sheet as at 31 December 2018, and under what heading would they appear?

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ACCOUNTING FOR BUSINESS STUDENTS

4.14 LO3–5

The following trial balance was extracted from the accounts of Wiggs Ltd as at 31 December 2017. Wiggs Ltd Trial balance as at 31 December 2017 $

$

Sales

800,000

Purchases

500,000

Wages and salaries

100,000

Transport expenses

30,000

Bad debts

5,000

Administration expenses

40,000

Advertising

20,000

Stock/inventory at 1 January

120,000

Capital

640,000

Properties at cost

400,000

Motor vehicles—cost

80,000

Motor vehicles—depreciation provision

20,000

Unquoted investments—cost

50,000

Investment income

5,000

Debtors

145,000

Creditors

120,000

Drawings

50,000 45,000

Cash

1,585,000

1,585,000

Use a worksheet to prepare trading and profit and loss accounts for the year ending 31 December 2017 and a balance sheet as at that date, incorporating the following adjustments: (a) Closing inventory is valued at $150,000. (b) Depreciation is to be charged on vehicles at the rate of 25% on cost. (c) $2,000 of the administration expenses have been prepaid at year-end. (d) Wages of $3,000 are owing at year-end. 4.15 LO3–5

The following trial balance was prepared from the accounts of a business as at 30 June 2017.

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Trial balance as at 30 June 2017 $ Sales Purchases

$ 270,000

140,000

Inventory 1 July 2016

20,000

Wages

40,000

Administration expenses

40,000

Selling expenses

20,000

Drawings

20,000

Capital

100,000

Premises

50,000

Equipment—cost

10,000

Equipment—aggregate depreciation

4,000

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Debtors

30,000

Creditors

20,000 24,000

Cash

394,000

394,000

At year-end the following information is available: 1

$2,000 of the wages relate to the next year.

2

$500 is owed for administration expenses.

3

Bad debts are to be written off amounting to $3,000.

4

Depreciation at the rate of 20% of the cost is to be charged on equipment.

5

Closing inventory is valued at $22,000.

Prepare the final accounts for the year. 4.16 LO3–5

The following is the trial balance of a sole trading business at the end of its financial year. Trial balance as at 30 June 2017 Debit

Credit $

Motor vehicles (cost)

17,500

Motor vehicles (depreciation provision) Furniture and fittings (cost)

5,300 12,800

Furniture and fittings (depreciation provision) Debtors

2,360 25,000

Creditors Stock/inventory at 1 July 2016

14,780 29,500

Capital Purchases

120,000 105,000

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Sales

181,800

Rent, rates and insurance

5,460

Motor vehicle expenses

3,780

Office expenses

2,540

Heat and light

1,840

General expenses

2,820

Freehold premises

65,000

Cash

23,200

Salaries and wages

24,600

Drawings

$

5,200 $320,940

$320,940

The following information is also available: 1

Stock/inventory at 30 June 2017 was physically counted and was valued at $26,300.

2

Rates of $1,500 were owing at 30 June 2017.

3

Insurance of $200 was prepaid at 30 June 2017.

4

A motor vehicle repair carried out in June 2017 costing $500 was still unpaid at the end of the year.

5

Bad debts of $2,000 are to be written off.

6

Depreciation is to be provided at the rate of 25% per annum on cost for vehicles and 15% per annum on cost for furniture and fittings.

Prepare a profit and loss account for the year ended 30 June 2017 and a balance sheet as at that date for the business. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

CHALLENGING 4.17 LO3–5

The balance sheet as at 1 January 2017 of Xena and Hercules (Wargames) was as follows: Xena and Hercules (Wargames) Balance sheet as at 1 January 2017 $

$

Current assets

$

Cash

17,700

Creditors

Debtors

30,000

Accrued wages

Prepaid insurance Inventory

$

Current liabilities 24,000 3,000

300

27,000

21,000 69,000

Non-current assets

Non-current liabilities

Equipment Cost Dep provision Premises

Loan (10% interest) 81,000

Capital

30,000 162,000

(21,000) 90,000 150,000 219,000

219,000

Notes The prepaid insurance relates to a premium which covered the three months to 31 March 2017. The accrued wages relate to overtime worked in December 2016. The following represents a summary of the transactions which took place during 2017. 1 Inventory was purchased on credit for $210,000. 2 Inventory was purchased for cash for $45,000. 3 Credit sales amounted to $300,000. 4 Cash sales amounted to $120,000. 5 Wages of $75,000 were paid. 6 Rent of $3,750 was paid. This covered the 15 months to 31 March 2018. 7 General expenses of $15,000 were paid. 8 Rates and insurance of $3,000 were paid. This included a $1,000 insurance premium covering the period 1 April 2017 to 31 March 2018.

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9 Additional equipment was purchased on 1 January, for $10,000. This was financed from a loan for the full amount, with interest payable at 12% per annum. 10 Cash received from debtors amounted to $270,000, which was in satisfaction of debts of $275,000, the remainder being discount. 11 Cash paid to creditors amounted to $213,000, which was in satisfaction of debts of $215,000, the remainder being discount. 12 The owner withdrew $2,000 in inventory and $20,000 in cash. 13 The owner won $5,000 in the lottery. This was paid into the business. 14 A bill for holidays for the owner—total $1,500—was paid from the business bank account. At the end of the year the following items of additional information were obtained: 1 Bad debts amounting to $1,500 are to be written off. 2 Depreciation is to be provided for as follows: Premises—none Equipment—20% on cost. 3 The loan interest remains unpaid. 4 Wages of $2,500 have not yet been paid. 5 Closing inventory is valued at $30,000. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Record the above in a set of ledger accounts, prepare a trial balance, close off the accounts incorporating the adjustments and prepare a set of final accounts 4.18 LO3/4/5/7 The following balances appeared in the records of James Golding’s furniture business at 31 May 2017: $ Delivery truck 1

25,000

Delivery truck 2

15,000

Capital

300,000

Creditors

54,000

Premises

150,000

Loan from Mrs Golding (10%)

40,000

Inventory

90,000

Debtors

40,000

Rent receivable

2,000

Accrued administration expenses

1,400

Prepaid rates

2,000

Cash

71,400

Part of the premises are let to a firm of accountants at an annual rental of $24,000. You are given the following data concerning the year to 31 May 2018: 1 Credit sales were $300,000. 2 $360,000 was paid to suppliers for goods purchased on credit. 3 Cash sales were $200,000. 4 Rent of $30,000 was received during the year. 5 On 30 November a new truck was purchased for $48,000; truck 2 was taken in part exchange at $12,000 and it was agreed that the balance should be paid off at $1,000 per month starting 1 January. All payments were made on the due dates. 6 James Golding took inventory for his private use, goods which had cost $5,000, without paying for them. 7 The following payments were also made in the year: (a) Delivery van expenses $10,000 (b) Administration expenses $15,000 (c) Wages $70,000 (including $3,000 a month for James Golding) (d) Loan interest paid $2,000 Copyright © 2017. P.Ed Australia. All rights reserved.

(e) Rates—$3,000 paid on 1 October and $3,600 on 1 April, six months in advance in both cases. 8 Cash received from debtors amounted to $290,000. 9 Creditors for goods supplied (at 31 May 2018) amounted to $110,000. 10 Inventory on hand at 31 May 2018 amounted to $100,000. 11 An electricity bill of $3,000—covering the three months to 30 April—was unpaid; electricity is included as part of administration. 12 Depreciation is to be taken at 20% on the written-down value of vehicles held at the end of the financial year. Prepare a profit and loss account for the year and a balance sheet at the year-end. You might like to modify the worksheet approach used in Learning Objective 7 to do this.

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CHAPTER 4 CASE STUDY How good are you at keeping records? Are they sufficient to deal with your tax assessment? If you are acting as a business, this can be quite important. Many business people are not very good at doing this and stories abound of accountants being confronted with a shoebox full of bits of paper, from which they are expected to produce a set of final accounts. Under these circumstances the stock approach to calculating capital or profit dealt with in Chapter 3 is useful, but so is use of double-entry bookkeeping (at least in part) to try to work out what has happened. Invariably there are some records, bank statements, credit or debit card summaries, details of assets, etc. These provide a starting point. The normal process to prepare an estimate of how you are travelling is along the following lines: 1 Try to make as accurate an estimate of your position at the start of the year as you can. 2 Do the same for the end of the year. 3 Try to estimate the level of drawings for the year, and any capital injections. 4 This should enable you to calculate the profit for the year in total. 5 Then turn to bank and cash transactions (and credit card slips/summaries, etc.). Analyse them to separate any personal transactions from business transactions (or vice versa), and fill in as much detail as possible. Typically, it is useful to prepare cash and bank accounts and a credit card account, built up from the analysis. 6 Use both receivables and payables accounts to try to work through to sales and purchases figures. 7 Put it all together into a profit and loss and balance sheet as far as is possible.

The above situation is usually referred to as incomplete records, and the process suggested above can be used to fill in as much information as possible. This same approach can also be used when records are lost, or inventory and non-current assets are destroyed by fire or are stolen. From the information below, provided by a business, try to produce a statement of claim for the insurance company, together with a profit and loss statement for the nine-week period to 2 June and a balance sheet as at 2 June. Alan Jameson is a sole trader who undertakes sales on both a cash basis (including cards) and a credit basis. A"er the close of business on 2 June 2017 a fire occurred in the rented premises, which resulted in the complete loss of the furniture and fittings, which were owned by the business, and its stock. All detailed records were lost, although Alan had taken home the cash box, which contained a float of $2,000, and the invoices for bills outstanding. These totalled $20,000, $18,000 of which related to creditors for purchases, with $2,000 being due for electricity. Over the next few days Alan proceeded to collect as much information as he could, to help in assessing the extent of his loss. This is summarised below: (a) A"er many telephone calls, Alan estimates that the receivables outstanding on 2 June totalled $50,000. (b) All takings were banked intact (directly for cash, indirectly for card sales), except for weekly wages paid to staff, totalling $1,500 per week, and weekly drawings of $1,000, both of which are taken from the till. (c) The business balance sheet as at 31 March 2017 was as follows:

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Current assets Cash

2,000

Bank

20,000

Receivables

60,000

Prepaid rates Inventory

5,000 100,000 187,000

Non-current assets 50,000

Furniture and fittings

237,000 Current liabilities Payables Accrued electricity

25,000 1,500 26,500

Capital

210,500 237,000

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

(d) An analysis of the bank and credit card statements for the nine weeks to 2 June is summarised below: Balance 31 March

20,000

Receipts 150,000

Amounts received

170,000 Payments Expenses

20,000

Creditors

104,500 124,500 45,500

Balance 2 June (e) Payments to creditors are made net of discount of 5%. (f) The gross profit margin is 30% of selling price.

(g) Alan has an insurance policy, which provides full cover for the cost of assets lost by fire.

Concept check answers CC1 CC2 CC3 CC4

B and E B D D

CC5 CC6 CC7 CC8

D D C B

CC9 CC10 CC11 CC12

E B A D

CC13 C CC14 A CC15 E

SOLUTIONS TO ACTIVITIES ACTIVITY 4.1 (a) Plus inventory

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Plus creditors/payables (b) Plus debtors/receivables Plus sales (c) Plus wages

Debit inventory/purchases Credit payables Debit debtors/receivables Credit sales Debit wages

Less cash

Credit cash

(d) Reduce loan

Debit loan

Less cash

Credit cash

(e) Plus vehicle Less cash (f) Plus an expense—bad debt Less debtors/receivables (g) Plus depreciation expense Less vehicle

Debit vehicle Credit cash Debit bad debts Credit debtors/receivables Debit depreciation expense Credit vehicle

Or more likely: Plus accumulated depreciation

Credit accumulated depreciation

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 4.2 General Journal Date

Account name and narrative

Folio

Inventory

Debit side

Credit side

10,000

Creditors/payables

10,000

Purchase of inventory on credit Debtors/receivables

5,000

Sales

5,000

Sales on credit Wages

2,500

Cash

2,500

Payment of wages in cash Loan

5,000

Cash

5,000

Repayment of loan Vehicle

30,000

Cash

30,000

Purchase of vehicle from xxx Bad debts

550

Debtors/receivables

550

Bad debts written off Depreciation expense

4,000

Accumulated depreciation

4,000

Depreciation for period on vehicles

ACTIVITY 4.3 General Journal Date

Account name and narrative (a) Inventory

Folio

Debit side

Credit side

5,000

G. Patel—creditor

5,000

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Purchases of inventory from G. Patel (b) Rent expense

2,000

Cash

2,000

Payment of rent by cash (c) Cash

2,000

I. McMurtry—a debtor

2,000

Cash received from I. McMurtry relating to sales (d) Vehicle

20,000

Loan

20,000

Purchase of a vehicle funded by loan from K Car Company (e) Drawings

1,000

Cash

1,000

Cash withdrawn by owner

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

(f) Drawings

4,000

Cash

4,000

Payment for personal holiday for owner (g) Cash

1,500

Sales

1,500

Sales of goods for cash Cost of sales

1,000

Inventory

1,000

Cost of goods sold G. Patel—a creditor—paid relating to inventory purchases

500

Cash

500

Payment of G. Patel—a creditor—relating to purchases of inventory

ACTIVITY 4.4 Cash Plant and equipment

30,000

Loan

Capital

150,000 50,000

Vehicles

20,000

Sales

16,000

Rent Payables (creditors)

20,000

Wages

1,200

Drawings

2,000

Balance c/d 216,000 Balance b/d

3,000

139,200 216,000

139,200 Capital Cash

150,000

Loan Cash

50,000

Plant and equipment Cash

30,000

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Vehicles Cash

20,000 Inventory

Payables

50,000

Cost of sales

10,000

Balance c/d

40,000

50,000 Balance b/d

50,000

40,000 Payables

Cash

20,000

Balance c/d

30,000

Inventory

50,000

50,000 50,000

Balance b/d

30,000

Rent Cash

3,000

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ACCOUNTING FOR BUSINESS STUDENTS

Cost of sales Inventory

10,000 Sales Cash

16,000

Wages Cash

1,200 Drawings

Cash

2,000

ACTIVITY 4.5 (a) The following errors would not prevent the trial balance agreeing: • where both entries are on the wrong (i.e. opposite) side

• where incorrect figures are used in both entries • where a wrong class of account has been correctly entered, e.g. a motor vehicle has been debited to motor vehicle expenses

• compensating errors, where an error in one area is compensated by another error in the opposite direction. (b) iii, iv, v

ACTIVITY 4.6 Inventory June 30 Balance b/d

55,000

June 30 Profit and loss

50,000

June 30 Drawings

25,000

June 30 Profit and loss

55,000

Capital June 30 Balance c/d

226,000

June 30 Balance b/d June 30 Profit and loss

251,000

160,000 91,000 251,000

June 30 Balance b/d

226,000

Purchases June 30 Balance b/d

205,000

June 30 Profit and loss

387,100

June 30 Profit and loss

205,000

Sales June 30 Balance b/d

387,100

Copyright © 2017. P.Ed Australia. All rights reserved.

Rent, rates and insurance June 30 Balance b/d

12,000

June 30 Profit and loss

12,000

Office expenses June 30 Balance b/d

7,500

June 30 Balance b/d

5,000

June 30 Profit and loss

7,500

Heat and light June 30 Profit and loss

5,000

General expenses June 30 Balance b/d

5,600

June 30 Profit and loss

5,600

Premises June 30 Balance b/d

90,000 Cash

June 30 Balance b/d

7,000 Wages

June 30 Balance b/d

52,000

June 30 Profit and loss

52,000

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Equipment June 30 Balance b/d

50,000

June 30 Balance b/d

56,000

Receivables Payables June 30 Balance b/d

27,000

Bad debts June 30 Balance b/d

4,000

June 30 Balance b/d

25,000

June 30 Profit and loss

4,000

Drawings June 30 Capital

25,000

Profit and loss June 30 Inventory Purchases

55,000

June 30 Sales

205,000

Rent, rates and insurance

50,000

12,000

Office expenses

7,500

Heat and light

5,000

General expenses

5,600

Wages

387,100

Inventory

52,000 4,000

Bad debts

346,100 Capital (profit)

91,000 437,100

437,100

The balance sheet consists of a listing of the accounts which remain open at the year-end. Cash Receivables Inventory Premises Equipment

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Payables Capital

7,000 56,000 50,000 90,000 50,000 253,000 27,000 226,000 253,000

ACTIVITY 4.7 Journal Date

Account name and narrative

Dec 31

Electricity expense

Folio

Debit side

Credit side

300

Accrued electricity expense

300

Being an addition to the electricity expense to cover the amount due in the current year but unpaid Dec 31

Stock of office materials (Office expenses 2018)

500

Office expenses

500

Being adjustment to cover stock of office materials still in use at year-end Dec 31

Prepaid rates (Rates 2018)

2,900

Rates

2,900

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219

220

ACCOUNTING FOR BUSINESS STUDENTS

The accounts would appear as follows: Electricity Cash

3,000

Dec 31 Accrued electricity

Dec 31 Profit and loss

3,300

300 3,300

3,300

Accrued electricity Dec 31 Electricity

300

Stationery Cash

5,000

Dec 31 Stock-in-hand at year end

500

Dec 31 Profit and loss

4,500

5,000

5,000

Stock of office materials Dec 31 Stationery

500 Rates

Cash

5,800

Dec 31 Profit and loss

2,900

Dec 31 Prepaid rates

2,900

5,800

5,800 Prepaid rates

Dec 31 Rates

2,900

Profit and loss entries for the year are: Profit and loss Dec 31 Electricity

3,300

Dec 31 Stationery

4,500

Dec 31 Rates

2,900

ACTIVITY 4.8 (a) Journal Date

Account name and narrative

Folio

Disposal

Debit side

Credit side

40,000

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Vehicle at cost Accumulated depreciation

40,000 20,000

Disposal

20,000

Being transfer of an asset (cost and accumulated depreciation) to disposal account Cash

18,000

Disposal Profit and loss—loss on disposal

18,000 2,000

Disposal

2,000

Being sale of vehicle for $18,000 and write-off of loss on disposal

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

The entries in the accounts are as follows: Vehicle cost 40,000 Dec 31

Balance b/d

Disposal

40,000

Vehicle—accumulated depreciation 20,000

Dec 31 Disposal

Balance b/d

20,000

Cash

18,000

Dec 31

Vehicle acc depcn

20,000

Dec 31

Profit and loss

Disposal Dec 31 Vehicle cost

40,000

2,000

40,000

40,000

(b) Journal Date

Account name and narrative

Dec 31

Bad debts

Folio

Debit side

Credit side

4,000

Debtors/receivables

4,000

Being write-off of bad debts Dec 31

Increase in doubtful debts provision

250

Doubtful debt provision

250

Being adjustment for doubtful debts provision based on 2.5% of balance The entries in the accounts are as follows: Receivables Dec 31 Balance b/d

154,000 Dec 31 Dec 31

Bad debts Balance c/d

154,000 Dec 31 Balance b/d

4,000 150,000 154,000

150,000 Bad debts

Dec 31 Receivables

4,000 Dec 31

Profit and loss

4,000

Increase in doubtful debts provision Dec 31 Doubtful debts provision

250 Dec 31

Profit and loss

250

Doubtful debts provision

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Dec 31 Balance c/d (new provision)

3,750 Dec 31 Dec 31

Balance b/d Increase in DDP

3,750

3,500 250 3,750

Dec 31

Balance b/d

3,750

Profit and loss extracts for (a) and (b) Profit and loss Dec 31 Disposal (loss)

2,000

Bad debts

4,000

Increase in doubtful debts provision

250

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 4.9 Inventory Balance b/d (opening)

50,000

Balance b/d (closing)

52,000

Profit and loss

50,000

Profit and loss

450,000

Purchases Balance b/d

450,000 Purchases returns

Profit and loss

5,000

Profit and loss

900,000

Balance b/d

5,000

Balance b/d

900,000

Sales Sales returns Balance b/d

15,000

Profit and loss

15,000

Profit and loss Opening inventory Purchases Sales returns

50,000

Sales

900,000

450,000

Purchases returns

5,000

15,000

Closing inventory

52,000

ACTIVITY 4.10 Manufacturing, trading and profit and loss statement for the year ended 30 June Opening stock of raw materials

Raw materials purchased

40,000

Cost of production transferred to trading account

1,195,000

240,000 280,000

Less closing stock of raw materials Cost of materials used Depreciation—plant and machinery

20,000 260,000 40,000

Factory wages

295,000

Factory expenses

600,000 1,195,000

Opening stock of finished goods Cost of production

160,000

1,195,000 Sales

1,195,000

1,500,000

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1,355,000 Less closing stock of finished goods Cost of sales Gross profit

140,000 1,215,000 285,000 1,500,000

General and administration expenses Selling expenses

68,000

Gross profit

285,000

153,000

Bad debts

5,000

Doubful debts

2,300

Depreciation—fittings

1,500,000

5,000 233,300

Profit for year

51,700 285,000

285,000

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CHAPTER 4 RECORDING TRANSACTIONS—THE JOURNAL AND LEDGER ACCOUNTS

Balance sheet as at 30 June Current assets Cash

125,500

Receivables

115,000 2,300

Less Doubtful debts provision

112,700 Prepayments

22,000

Inventory Finished goods

140,000

Raw materials

20,000 420,200

Non-current assets Furniture and fittings

50,000 5,000

Less Accumulated depreciation

45,000 Plant and machinery Less Accumulated depreciation

400,000 40,000 360,000 405,000 825,200

Current liabilities Payables

40,000

Accruals

8,000 48,000

Capital Opening balance Profit

775,500 51,700 827,200

Less Drawings Closing balance

50,000 777,200

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825,200

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Debit

18,200

28,400

450,000

Heat and light

General expenses

Freehold premises

Purchases

Opening inventory

Cost of sales

Drawings

Doubtful debts provision

Payables

Receivables

F&F acc depcn

Furniture and fittings cost

52,000

284,000

128,000

175,000

Motor vehicles cost

MV accumulated depcn

246,000

Salaries and wages

32,000

25,400

Office expenses

Cash

57,800

7,000

27,600

1,037,000

275,000

14,000

151,000

23,600

53,000

1,798,000

803,800

Credit

Trial balance

Motor expenses

Insurance

Rent and rates

Sales

Purchases

Capital

Inventory 1 July

ACTIVITY 4.11

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1,037,000

275,000

2,200

5,700

Debit

200

19,200

35,000

1,037,000

275,000

Credit

Adjustments

1,049,000

52,000

284,000

128,000

175,000

246,000

32,000

450,000

28,400

18,200

25,400

60,000

7,000

33,300

Debit

14,200

151,000

42,800

88,000

1,798,000

803,800

Credit

Adjusted TB

1,049,000

246,000

28,400

18,200

25,400

60,000

7,000

33,300

Debit

1,798,000

Credit

Profit and loss

52,000

284,000

128,000

175,000

32,000

450,000

Debit

14,200

151,000

42,800

88,000

803,800

Credit

Balance sheet

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2,843,400

2,843,400

1,637,300

2,905,700

19,200

35,000

200

263,000

An alternative approach to dealing with inventory and cost of sales is to simply include opening inventory and purchases in the profit and loss column and then make a final adjustment between the profit and loss and balance sheet columns for the closing inventory—a credit in the profit and loss, and a debit in the balance sheet column.

1,637,300

19,200

Depreciation F&F

Profit or loss

35,000

Depreciation— vehicles

200

2,200

Accrued motor expenses

Increase in doubtful debts provision

5,700

263,000

263,000

Accrued rates

Inventory 30 June

Less closing stock

Copyright © 2017. P.Ed Australia. All rights reserved.

2,905,700

2,200

5,700

1,798,000

276,300

1,521,700

19,200

35,000

200

1,798,000

1,384,000

263,000

1,384,000

276,300

2,200

5,700

226

ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 4.12 (a) 115–199, 2151–99, 3151–99, and 1301, 2301 and 3301. (b) The figures for the entire business can be summarised by adding all the codes which end between 301 and 651. (c) Care needs to be taken to ensure that it is clear just what information is needed, and how it is to be presented. The chart of accounts is an integral part of this process. (d) Separate reporting of the costs of special events might be needed or useful. The revenue could be identified with a range of codes in the 1600–1799 category. All the associated expenses could be coded by modifying the codes from say 2300 to 2400, etc.

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(e) Most supermarkets use barcodes to keep track of sales, inventory and inventory levels. The question as to how detailed this needs to be is one which needs to be addressed. While the detail is needed for management control purposes, and for micro-managing at the product level, it will probably not be necessary to record all of the detail in the accounts. So there is a reasonably high probability that the chart of accounts will be more selective.

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CHAPTER 5

ACCOUNTING SYSTEMS AND INTERNAL CONTROL LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Identify the main elements of internal control and explain the need for sound internal control in accounting systems

LO2 Explain why in a typical manual system the ledger needs to be split up, identify

common ways of doing this, and outline the purpose and structure of a traditional manual system of subsidiary records

LO3 Explain the nature and role of sales and purchases journals and show how they are used in posting figures to the accounts in a traditional manual system

LO4 Explain the nature and role of the cash book and cash journals and show how they are used in posting figures to the accounts in a traditional manual system

LO5 Explain the nature and role of the journal and show how they are used in posting figures to the accounts

LO6 Explain the importance of control accounts and reconciliations, and prepare control accounts for debtors and creditors and a bank reconciliation

LO7 Explain the major elements of computerised accounting systems and explain how

Copyright © 2017. P.Ed Australia. All rights reserved.

these systems still use the same basic principles of accounting and internal control used by a manual system, but that they deal with large volumes of transactions more effectively, and can be linked with appropriate documentation or file production and maintenance.

In the previous chapter, you learnt about the double-entry recording process from transaction entry through to producing basic financial statements. This process can be thought of as the fundamental accounting system, with some internal control present at points such as the trial balance checking stages. The Chapter 4 recording process can be summarised using a train analogy: each stage in the process is a carriage on the train, and you progress to the next carriage only by moving through the preceding carriage. The carriages move forward, beginning with journal transactions (general and special journals), which will be dealt with in this chapter, and once completed can be posted to the general ledger. Once posted to the general ledger, an unadjusted trial balance can be prepared as one form of internal control over the accuracy of the recording process. Adjusting entries can then be prepared and recorded in the general journal, and then posted to the general ledger. Once posted, an adjusted trial balance can be prepared to once again provide a check point. From this adjusted trial balance, the Profit and Loss Statement and the Statement of Changes in Equity can be prepared. Closing entries can then be prepared and recorded in the general journal, and then posted to the general ledger. Finally, a postclosing trial balance can be prepared and, if satisfactory, the Balance Sheet can be completed, providing a set of Financial Statements for use by stakeholders. All accounting systems, manual and computerised, undergo this fundamental recording process.

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ACCOUNTING FOR BUSINESS STUDENTS

This chapter aims to provide a broad understanding of the nature of accounting systems, both manual and computerised. As we saw in Chapter 4, in practice even the system of double-entry bookkeeping becomes unwieldy as the volume of transactions increases. Ways need to be found of dealing with the scale issue. In general, the answer is to be found in subdividing the work, so as to provide manageable parts for which individuals can be given responsibility. For example, in practice, many large businesses have separate individuals (or departments in very large organisations) who are responsible for accounts receivable (debtors), accounts payable (creditors), sales, purchasing and inventory control, and reporting. Another very important feature of good accounting systems is that they provide an effective means of internal control. Accounting is at the heart of business, and inevitably this means that its systems must generate the documents that are an essential part of business and commerce. Documents include: invoices, statements, credit notes, receipts, wages slips and PAYG Payment Summaries (previously widely known as ‘Group Certificates’). The systems devised must ensure that these kinds of documents flow quite naturally from the accounting process. This chapter starts with a discussion of internal control and includes a number of practical ways in which internal control can be facilitated. Learning Objectives 2 to 6 deal with the basic principles of a fully manual accounting system. You may feel that the system described does not reflect what is currently happening in practice, and in some ways you would be correct. There are many examples where computerised systems appear to have moved a long way from the manual system, but in practice most use principles which are very similar to those of a manual system. It would also be incorrect to assume that everyone uses computerised accounting systems, or that they are inherently different from manual systems. The final section identifies the main elements of a computerised system. It is not the aim of this book to go into this area in detail, but rather to give you a flavour of the process and to identify the main principles used. In practice, you will find many variants of the systems described in this chapter, from purely manual systems to computerised systems run for large corporations. In fact, as we discussed in Chapter 4, computerised accounting systems still use the same basic principles (and often the same language), but generally facilitate more detail in record-keeping, which in turn opens up greater opportunities for detailed analysis.

WHAT IS INTERNAL CONTROL?

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LO1 Identify the main elements of internal control and explain the need for sound internal control in accounting systems

Internal control has been defined as follows: Internal control is a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance. Committee of Sponsoring Organizations of the Treadway Commission (COSO), Internal Control—Integrated Framework, May 2013, p. 3. A somewhat narrower definition of internal control is: Systematic measures (such as reviews, checks and balances, methods and procedures) instituted by an organisation to (1) conduct its business in an orderly and efficient manner, (2) safeguard its assets and resources, (3) deter and detect errors, fraud, and theft, (4) ensure accuracy and completeness of its accounting data, (5) produce reliable and timely financial and management information, and (6) ensure adherence to its policies and plans. Business Directory, www.businessdictionary.com/definition/internal-control.html. Internal controls have been defined from a similar perspective:

audit trail A step-by-step record by which accounting data can be traced back to their source.

Internal controls are methods put in place … to ensure the integrity of financial and accounting information, meet operating and profitability targets, and transmit management policies throughout the organisation. … Internal controls should be documented to create an audit trail. Investopedia, www.investopedia.com/terms/i/internalcontrols.asp.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

The main difference between the first definition and the other two is that the first one is a broad definition, which encompasses the entire organisation from top to bottom. The Integrated Framework approaches internal control from a broad perspective, and is written from an organisational perspective—with an implicit emphasis on large corporations. However, many organisations are either non-business organisations or small organisations, yet internal control remains very important to them. The approach of these smaller non-corporates is generally more clearly focused on financial aspects of internal control. There is clearly some overlap between them, but also a marked difference in emphasis. The section in Chapter 1 on how business is changing goes some way to explaining the different perspectives. COSO sees internal control as having five integrated components, relating to the following:

• Control environment. The set of standards, processes, and structures that provide the basis

•

•

•

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•

for carrying out internal control across the organisation … This comprises the integrity and ethical values of the organisation; the parameters enabling the board of directors to carry out its governance oversight responsibilities; the organizational structure and assignment of authority and responsibility; the process for attracting, developing, and retaining competent individuals; and the rigor around performance measures, incentives, and rewards to drive accountability for performance. Risk assessment. A precondition of risk assessment is the establishment of objectives, linked at different levels of the entity. Management specifies objectives within categories relating to operations, reporting, and compliance … to be able to identify and analyze risk to these objectives… Risk assessment also requires management to consider the impact of possible changes in the external environment and within its own business model that may render internal control ineffective. Control activities. The actions established through policies and procedures that help ensure that management’s directives to mitigate risks … are carried out. Control activities are performed at all levels of the entity, at various stages within business processes, and over the technology environment. They may be preventive or detective in nature and may encompass a range of manual and automated activities such as authorizations and approvals, verifications, reconciliations, and business performance reviews. Segregation of duties is typically built into the selection and development of control activities. Information and communication. Information is necessary for the entity to carry out internal control … Internal communication is the means by which information is disseminated through the organisation … It enables personnel to receive a clear message from senior management that control responsibilities must be taken seriously. External communication is twofold: it enables inbound communication of relevant external information, and it provides information to external parties in response to requirements and expectations. Monitoring activities. Ongoing evaluations, separate evaluations, or some combination of the two are used to ascertain whether each of the five components of internal control … is present and functioning. COSO, Internal control – Integrated Framework: Executive Summary, May 2013, pp. 4 and 5.

The framework then goes on to set out 17 components and principles and the requirements for an effective system of internal control. It emphasises that judgement is a key component. It also makes clear that internal control cannot prevent bad judgement or decisions, or prevent external events from causing a failure to achieve objectives. Internal control gives reasonable, but not absolute, assurance. The second definition, while dealing with the same issues of principle, approaches internal control from a narrower perspective. It possibly reflects more of an emphasis on policies and procedures, particularly financial policies and procedures. While the financial control issues are important, they reflect only one part of internal control. Key elements implicit in the integrated approach of COSO are management integrity, good communication and competent personnel, which should apply to all areas of the organisation, not just the financial.

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Internal control in practice Areas which are recognised as relevant to all, but are particularly important in the financial areas, include the following:

• Segregation of duties. This reduces the risk of mistakes, by making responsibility and

•

• •

specialism clearer. It also makes fraud and embezzlement, and a range of other inappropriate activities, more difficult. No individual should be able to initiate a transaction, then approve it, record it and control the proceeds that result. Payroll preparation, distribution and cheque writing should not be done by the same person. Good records maintenance. This ensures that proper documentation exists that can back up transactions. This requires storing and safeguarding paper or electronic records, and eventually ensuring that they are destroyed. Good records maintenance requires appropriate backup, with paper copies or, more commonly, backup computer files. Safeguards. These prevent loss of valuable business assets. Safeguards can be physical items such as security locks or safes, closed circuit cameras and restricted staff areas, or other things such as computer passwords and access controls. Approval authority. This is related to safeguards and requires specific managers to authorise certain types (or sizes) of transactions before they can go ahead.

Within the accounting system there are a number of things which are typically the focus of attention. These include the following:

• Physical audits. These audits, for example counting cash or checking that asset balances

•

•

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•

shown in the accounts actually exist in physical form, can reveal discrepancies in the system. A physical stocktake is an important part of the checking process. Records of what is owned, known as asset registers, are a necessary prerequisite of some of these checks. Standardised documents. The range of documents needed, for example invoices, material requisitions and inventory receipts, require careful linkage and standard approaches. Standardisation of document forms and types can make it easier to check forms for consistency, and pre-numbered documents enable better control to be achieved. Trial balances. The use of double-entry systems and drawing up of a trial balance, as we saw in Chapter 4, while not guaranteeing that no errors have been made, does permit some added reliability to the figures. Drawing up a trial balance on a regular basis, say weekly, would identify some discrepancies and enable them to be investigated quickly. Reconciliations. These are necessary when comparing figures from the accounts with figures for the same category, but drawn up by someone other than the accountant. Probably the most common is the bank reconciliation statement. How often, when you get your bank statement, do you wonder why the figure shown in your bank account is different from what you thought it should be? You should then reconcile the two sets of figures—your expectations with the figures shown in the bank account. This requires identification of differences such as cheques not presented, forgotten (by you) standing orders or direct debits, or payments recorded by you as having been paid into your bank account but have not materialised—yet! Such reconciliations are (or should be) a regular feature of an organisation’s (and your) internal control system. Another important area where control is needed relates to the need to keep track of individual accounts for areas such as debtors, creditors and payroll systems, yet we also want to keep a big-picture perspective on these areas. As we shall see later, control accounts, which are effectively total accounts, are regularly prepared for debtors and creditors, and often for wages. The main aim is to ensure that the balance on the control account agrees, or reconciles with, the sum of all of the individual accounts.

Internal controls can be grouped as preventive or detective. Preventive controls are policies and procedures that are designed to prevent errors, inaccuracy or fraud before it occurs. Detective internal controls are designed to identify problems that already exist. They require examination of information and include things such as the use of performance reviews, including comparisons of Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

actual figures with budgets, forecasts and benchmarks; reconciliations and subsequent analysis of discrepancies; and internal or external audits. Accounting systems are clearly an important part of the internal control system. They should aim to deliver accurate records, free from errors and the effects of fraud. This requires appropriate processes to be set up, which have a good chance of identifying and ideally preventing errors, as well as identifying where things have gone wrong. Such systems will include procedures and techniques that help to prevent errors. Summarising the discussion so far, we can say that key elements of internal control include the following:

• • • • • • •

a good staff profile with an emphasis on honesty and capability existence of a clear system of responsibility, authority, delegation and separation of duties proper procedures for ensuring transactions are properly processed production of suitable documents and accounting records so as to leave an audit trail appropriate control over assets independent verification of performance processes for checking the IT systems, to ensure that disaster recovery is possible, security is sound, and that laws are not breached (e.g. those that relate to privacy).

Detailed ways of implementing these ideas include the following:

• Develop an organisation chart and clear job descriptions such that responsibility is clear for

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• • • • • • • • • • • • • • • • • • • • • • • • • •

all functions and supervisory relationships. Make sure that a procedures manual (or similar) is prepared. Ensure that an appropriate authorisation process exists and actually occurs. Prepare a budget of expected results. Develop comparative financial statements. Complete regular reconciliations in relevant areas. Number documents where appropriate. Hire good people with good references. Ensure staff are appropriately trained. Ensure that a staff feedback process is in place. Assign responsibility for compliance where appropriate (e.g. safety officer, fire wardens). Separate record-keeping from custodianship of assets (i.e. don’t give the cashier access to records). Separate authorisation of expenditure from record-keeping. Have a policy that all payments above a specified amount need two signatures. Separate purchasing from receiving. Rotate key jobs. Run spot checks. Process customer complaints. Make sure that detailed records of assets (an asset register) are kept and limit access to those records. Ensure that all assets and liabilities actually exist. Have clear guidelines on personal use of assets. Regularly check that your records of assets reflect the assets in your possession. Have sound safeguards to protect documents and computer files, with appropriate backup and test programs. Change passwords regularly. Have firewalls and protective devices on computer systems. Conduct an annual audit and/or have regular inspections by internal audit. Deposit receipts intact so as to ensure a clear audit trail.

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• Reconcile bank statements independently. • Require annual vacations to be taken. • Ensure there is a conflict of interests policy. This should not be seen as an exhaustive list.

ACTIVITY 5.1 From an internal control perspective: (a) (b) (c) (d) (e) (f) (g) (h) (i)

Why is it important to develop a clear job specification and ensure that there is a clear separation of duties? Why is it important that authorisation of expenditure is closely controlled? Why should a cashier not have access to the accounts? Why is it important that staff are required to take their annual leave? What problems can arise regarding conflict of interests? Why is an inventory of assets owned an important part of the system of internal control? Why is it important that staff are well trained? Why is an audit important? What safeguards regarding documents and computer files might be appropriate?

Internal control and e-commerce Issues with e-commerce E-commerce has substantially changed many market models. Examples include online shopping, real estate, recorded music, news media and travel, and there are many more. The world has changed. The basic principles of internal control remain the same, but a range of new challenges has arisen in applying these principles. The main challenges are as follows: 1 Commercial transactions are made electronically in an environment which does not have the

traditional paper trail. 2 There is a need to expand an internal control system, which has traditionally been seen as 3 4

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5

6

intra-organisational, to one which can be seen as inter-organisational. Use of the internet introduces new elements of risk. These include loss of transaction integrity, pervasive security risks and the possibility of improper accounting policies. The internet is a public network, in contrast to a private network that only allows access to authorised persons or entities. Many businesses do not have the technical expertise to be able to establish and operate in-house systems that are needed to undertake e-commerce. These businesses then have to use various service agencies. This has potentially serious implications for the success of the business, and for the auditor. There are many legal and regulatory issues that arise, including different legal frameworks in various jurisdictions around the world regarding the recognition of e-commerce, differing privacy rules, the enforceability of contracts and the legality of particular activities (e.g. internet gambling), which thrives in some countries and is illegal in others.

For a more comprehensive coverage of these ideas you might read the International Auditing Practice Statement 1013, Electronic Commerce—Effect on the Audit of Financial Statements. Internal control should be seen as generic. However, applying the principle of internal control to e-commerce requires some modification to the traditional approach. Some tentative suggestions of areas that need consideration are given next. 1 Ensure that staff have the appropriate knowledge and skills to understand the effect of e-commerce. 2 Use an expert to test controls of the system by trying to break through the security system.

The use of specialist fraud prevention tools should assist in reducing risk. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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3 Ensure compliance with the Payment Card Industry (PCI) Data Security Standards, which

4 5 6 7

8 9 10

provides merchants with standards, procedures and tools for protecting sensitive account information. Ensure access to adequate records for audit purposes. These may be different from those used for a traditional business. At a high level (governance level), align e-commerce activities, including any new activity, with the overall strategy. Be aware of the implications of outsourcing activities. For example, identify the risks associated with any particular provider of services to the business or its customers. Extend and expand existing policies to cover e-commerce, or develop new policies where appropriate. Particular emphasis needs to be given to security infrastructure and related controls, particularly in the areas of identity verification, ensuring the integrity of transactions, and policies relating to privacy and information protection, payment, shipping, and returns and refunds. The terms of trade must be agreed before an order is processed, including delivery and credit terms, which usually will require payment before accepting the order. Ensure legal and regulatory issues are understood. Ensure effective use of firewalls and virus protection. Use encryption to protect messages.

Finally, any internal control system must attempt to deal with cybersecurity. This is particularly difficult for a variety of reasons. These include the fact that the issues raised are international, requiring global solutions. Diverse laws, regulations and standards relating to financial technology, data protection and cybersecurity make international consensus difficult. Threats, risks and technology move faster than the regulations and standards. Current threats include independent criminals, nation-states or terrorist groups, hacktivists (who work for political gain) and insiders (who typically abuse access by harvesting customer information). These threats lead to an almost inevitable reactive response from regulators. This will almost certainly mean that individual organisations will be exposed to significant threats in this area, so constant vigilance is necessary. (Source: European Banking Federation, Global Financial Markets Association, International Swaps and Derivatives Association, ‘International Cybersecurity, Data and Technology Principles’, Washington, May 2016.)

encryption The coding of a message to make it unintelligible to any user not authorised to read the message.

Why doesn’t internal control always work?

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Internal control can break down in certain circumstances. Typically, this occurs through the following:

• Dishonesty and judgement errors • Unexpected transactions—transactions not covered by the procedure manual may cause • • •

problems Collusion—where two or more people come together to undermine the system and commit a fraud Management override—where management and staff can see the systems getting in the way, or simply as inefficient (often associated with attempts to defraud) Weak internal controls.

The results of poor internal control include the following:

• • • • • •

Incorrect information can lead to incorrect decisions. If staff are ill-equipped to deal with a situation, the results are unlikely to be productive. Fraud may occur. Bad decisions are likely to be made. Corrective action will not occur or will not be timely. Resources will be poorly allocated.

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ACCOUNTING AND YOU PROTECTION AGAINST FINANCIAL FRAUD A national campaign led by Financial Fraud Action UK Ltd has been introduced in the UK. This campaign aims to help everyone protect themselves from preventable fraud. There are lessons for us all from this campaign. The main points of the campaign are summarised below: 1 Many victims have felt rushed, hurried and pushed into making a quick decision, so slow down and take time to reflect on what you are being told. Financial fraud isn’t confined to the home. 2 There is a range of scams out there. Criminal activity is common and generally quite easy to perpetrate. Care needs to be taken in a number of ways: (a)

Scrutinise requests for bank details and check with your own databases and other sources.

(b)

Make sure everyone in the organisation is made aware of issues generally and in relation to specific known scams.

(c)

Be conscious of scams such as invoice fraud; CEO spoofing (i.e. where emails come from people pretending to be the CEO); phone calls, texts or unsolicited emails from someone claiming to be from your bank, a trusted organisation or computer business; and online fraud.

3 Never disclose security details, particularly PINs and passwords. 4 Take a questioning approach to all emails, texts and phone calls. 5 If something doesn’t feel right it probably isn’t. For further information on this initiative go to: www.takefive-stopfraud.org.uk.

Class discussion points 1 How might you check if you felt that you might be subject to CEO spoofing? 2 Discuss the experiences the class has had with regard to phishing. 3 If you were unsure about the legitimacy of a phone call, how would you deal with it?

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4 Share your experiences of the kind of behaviour outlined in Accounting and You. How easy is it to recognise and deal with attempts of this type to defraud?

Illustration of a functional area of a business and its internal control Much of the material covered in this chapter can be said to be general and difficult to set in context. Given this criticism, we have outlined below a functional area of a fictitious organisation and have considered the likely steps needed to ensure that the process will occur efficiently and effectively. We have chosen the purchasing function for this exercise. We have made some assumptions about this particular business and the way it runs its purchasing function. We have assumed that it is large enough to have its own separate stores, that there is a separate purchasing department, or a group of staff responsible for dealing with purchases, and a separate area that deals with payments and accounting. This implies an organisation of a reasonable size. We have set out some fairly basic steps that take the process from running a separate stores department, through an assumed purchasing process when more goods are needed, and through payment and recording of all transactions. We

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have not tried to make this a sophisticated exercise, rather the aim is to get you thinking about how one relatively small part of an organisation needs to function, just what kind of documents might be needed, and what internal controls would be appropriate. Let us be quite clear about one thing. Even if you have absolutely no intention of ever becoming an accountant, you will still need to be fully aware of internal control and its manifestations in terms of policies and processes. Table 5.1 provides an overview of this simple hypothetical purchasing function which spans three areas: the stores, the purchasing department and the accounting function. The middle column identifies possible activities carried out by the three departments, while the last one identifies areas where internal control is likely to be found.

TABLE 5.1 ILLUSTRATIVE SIMPLIFIED PROCEDURE FOR A PURCHASE ROUTINE Part of organisation

Process carried out

Policies and procedures that involve internal control

Stores/warehouse

Responsibility for stock availability and control

Detailed records of stock availability and use Appropriate record-keeping Detailed ordering policies Policies regarding optimal stock levels and economic order quantities

Security

Ensure security of stock Ensure conditions do not result in waste or spoilage Carry out spot checks to ensure that records and actual stock are the same

Purchases via purchase requisition sent to purchases department

Clear policy about how purchase requisitions are to be controlled Clear responsibility for authorising requisitions

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Clear document trail Write-offs of obsolete or spoiled stock

Policy regarding how write-offs can happen and who can sign them off

Receive new stock

Policy about checking receipts and signing for them

Check delivery note and sign that goods were received

Ensure that staff signing as having received goods are not part of the purchasing routine Policy as to how delivery notes are maintained or tracked through the system

Identify any shortfalls on the order

Notify purchasing department of shortfalls or damage

Update stock records Purchasing

Receive purchase requisition

Check approver authorised Check requisition is within the spending limit Probably set up a list of approved suppliers—check requisition in line with this list Check generally the reasonableness of the requisition

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Prepare and send order

Order must be signed by an authorised individual and be within the limits of the particular delegation

Receive invoice

Check goods received Check pricing in line with expectations Seek credit notes if necessary Invoices could act as a subsidiary record—a purchases journal

Receive credit note

Credit notes could act as a subsidiary record—a purchases returns journal

Send copies of order, delivery note (or goods received note), invoice and any credit notes to the accounting section Accounting

Receive order, invoices, etc. Check code or creditor number to ensure correct creditor identified

Have a file of approved or expected suppliers with appropriate code number, identified bank account numbers and a range of other details Check creditor number correct

Update accounting records:

Use a purchases ledger control account (see later in this chapter)

• Debit stock records in as much detail as

Ensure this control account is completed by someone other than the person completing the individual accounts

• Credit individual creditor (supplier) accounts

Have stock records prepared by the accounting department to enable comparison with the records kept by stores

Check invoice not paid previously

Must be signed for by person checking

Make payment to supplier

Policy of not paying on statements, only on invoices

Probably as part of a regular payments routine

Make sure that payments above a certain amount require a second signature

required

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Preferably use direct credit transfer This payments record could be used as a subsidiary record—a cash payments journal If necessary, use an urgent payment routine— for suppliers who cannot wait until the next payment run

Set of rules developed for such payments

Update accounting records: • Debit individual creditor (supplier) account in detail • Credit a single amount to cash

Use purchases ledger control account

Receive notification of write-offs

Need entry in journal and appropriate authorisation

Record in accounts and update records

Spot checks by internal audit

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In addition to the specific internal control policies and processes referred to above, there are some general organisation-wide factors to think about, which include:

• ensuring staff are appropriately qualified and trained in their specialist areas • ensuring there is a clear system of responsibility, authority, delegation of duties and separation • • •

of duties maintaining procedures manuals ensuring there is a budget which is well understood and committed to being aware that all are subject to internal and external audit.

Table 5.1 should give you some ideas as to document flows in a function such as purchasing. Clearly, this table reflects the assumptions made. Each business has its own model, and hence its own best way of doing things. Table 5.1 is based on a reasonable sized company. A smaller business would not be able to do things in the same way as the organisation assumed in the table. It would almost certainly have to compress the range of activities across a smaller number of staff, with consequent implications for the systems that are to be used, if internal control is to be maintained. It is important that you recognise that the accounting part of the system will reflect the needs of each particular business, so documentation and ways of recording are likely to differ from one business to another. The use of ledger accounts is pretty much universal, though in many businesses the accounts are largely completed on the computer, rather than by hand. Hence, a full understanding of ledger accounts is essential if you wish to go on to a career in accounting, and will be useful if you wish to make your career in business. When it comes to the journal, or a more complete system of subsidiary records, you must anticipate many different approaches, though they are generally based on the same principles as the manual system. For this reason, the next five sections are based on a traditional manual system. When working through these sections, you should focus on the principles that underlay these systems as, almost inevitably, the systems you use when you are at work will have some practical differences.

Concept check 1 Which of the following statements is false? A B C

D

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E

Segregation of duties is an important part of internal control. Standardised unnumbered documents enable better control to be achieved. Physical audits can reveal discrepancies between what is shown in the records and what is actually there. Trial balances, while not guaranteeing that there are no errors in the accounts, do provide some added reliability. Reconciliations and control accounts enable sections of the accounts to be verified.

Concept check 2 Which of the following statements is true in the context of internal control? A

B

C

D E

It is sound business practice to develop people’s skills by keeping them on the same job for a long time. Organisations should all keep track of their assets by ensuring that everyone enters details of assets owned and disposed of in an assets register. It is good practice to make notes of passwords used and put them in your office drawer for safe-keeping. It is important that authorisation of expenditure is closely controlled. It is sensible for the person making an order to be able to follow it through to final payment.

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THE LEDGER AND SUBSIDIARY RECORDS LO2 Explain why in a typical manual system the ledger needs to be split up, identify common ways of doing this, and outline the purpose and structure of a traditional manual system of subsidiary records

We have already seen that the system of ledger accounts described in Chapter 4 is not the complete picture. Points to consider in devising an accounting system include the following:

• The high volume of transactions involved in certain accounts (e.g. cash, sales, wages, etc.)

• • •

•

means that ledger accounts will be quite clumsy. Methods of substituting totals rather than lots of individual figures are necessary if the accounting process is to be handled relatively easily. The system clearly needs to be able to cope with large amounts of data. A clear ‘audit trail’ needs to be maintained—it should be possible to track back through a transaction from its inception to its place in the final accounts. A sound system of internal check and internal control is needed, such that the action of one person acts as a check on another, and the system is designed so that responsibilities are clear and separated. For example, only a poor system would give one person responsibility for recording debtors, bad debts and cash. The splitting of responsibilities is an important part of fraud prevention. The system should be sufficiently flexible to be able to produce useful reports in the detail needed by managers.

There was an implication in Chapter 4 that all the accounts are kept in a single book, known as the ledger. In practice, this is unrealistic for the following reasons:

• The volume of transactions undertaken by many, if not most, businesses would make this • • •

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•

extremely difficult, if not impossible. As the volume of transactions grows, more staff would be needed to record them, so more than one person would need to use the ledger at the same time. Some staff will specialise in, or be responsible for, particular areas of work (e.g. keeping control of the individual accounts relating to receivables), so there are inherent difficulties in sharing access to a single ledger. Information from the ledger or the supporting source documents may need to be accessed quickly. Balancing off the ledger accounts would become a lengthy process, prone to error, if every transaction were recorded in detail.

Clearly, a single ledger is unlikely to be sufficient (or practical) for all but the smallest of businesses, so there is a need to break down the ledger into sub-ledgers. In Chapter 4 we used the general journal as a single book of original entry (also known as a subsidiary record) as a means of ensuring that every transaction was recorded. In fact, there is a host of different ways in which this information can be collected. Remember that such books provide the information to be recorded in the ledger accounts. However, this information can be entered in detail, or as a total, thus reducing the amount of detail needed in the ledger accounts. Also, it should be noted that the two entries do not have to be recorded at the same time, or by the same person. Already you should be able to see ways in which the ideas about internal control, covered in the last section, can be applied. In practice, a variety of subsidiary records are kept, either in a completely manual system or a computerised system. Many small businesses use accounting packages, which often use the same terms for the various files as those found in a manual system. A good recording system will have:

• A well-developed system of ledger accounts based on a well thought through chart of •

accounts. A number of subsidiary records to hold the day-to-day transactions until they can be recorded in the accounts. For a business of any size, the records are unlikely to be recorded manually, rather they are likely to be captured electronically. For example, the use of barcodes in a retailing business enables the point of data capture to be when the item is scanned at the point of sale.

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• A method of cross-referencing or tracing information through the system from the subsidiary books (or original point of capture) to the ledger.

Subsidiary records are not part of the double-entry system. They are essentially books of original entry—the primary source of detailed information about the transactions of the business. They are a device for ensuring that all of the transactions are recorded prior to entry into the accounts. It is important that all this information is collected. What is not important is just when (within reason) it is recorded in the accounts.

Divisions of the ledger In practice, accounts are not recorded in a single ledger. Each ledger contains certain types of accounts. Just how the accounts are split up depends on the nature, size and organisation of the accounting system of the business. A typical division is:

• Sales ledger (also known as the debtors ledger)—which contains the detailed accounts • • • •

relating to individual customers (debtors). These are effectively personal customer accounts. Purchases ledger (also known as the creditors ledger)—which contains the detailed accounts of suppliers (creditors). These are effectively personal supplier accounts. Cash book/ledger—which contains the accounts relating to cash and bank. Nominal ledger—which contains revenue and expense accounts from which the trading and profit and loss account can be prepared. General ledger—which contains the remaining accounts.

The general and nominal ledgers are often combined for convenience. The first two ledgers are typically referred to as subsidiary ledgers. These subsidiary ledgers are where the detailed accounts of individual debtors and creditors are kept. Typically, sets of total or control accounts are kept in the general ledger. These will be discussed in more detail later in the chapter. You should note that in many computerised systems there will be no actual ledger or hard copy. In these circumstances, most ‘debtors ledgers’ are kept in computer files, as are ‘creditors ledgers’ and ‘cash books’. It is quite possible that there will be few, even no, hard-copy ledgers anywhere. It is not uncommon for the hard-copy ledger to be confined to the closing down process each year. It is, however, important to note that the general principles of a manual system still apply to a computerised system.

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In traditional (non-computerised) systems the subsidiary books kept include:

• sales and sales returns journals (books), in which the credit sales and returns are recorded in • • •

detail purchases and purchase returns journals (books), in which the credit purchases and returns are recorded in detail cash receipts and payments journals, in which detailed receipts and payments are recorded a general journal, in which anything not recorded initially in the earlier books is recorded.

Clear responsibilities will be allocated for these journals, bearing in mind the basic principles of internal control. The journals will be subsequently posted to the ledgers. The advantage of a system of subsidiary records is that the postings can be carried out by different people at different times. Also, totals can be posted as appropriate. For example, a sales journal will include a list of sales and debtors. The individual debtor accounts will need to be debited, but only one total posting is needed for the credit to sales. A final advantage is that the subsidiary records should provide a record of every transaction prior to entry in the ledger. We shall examine each of these subsidiary records in more detail in the next few sections.

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Concept check 3 Which of the following statements is not true? A B C D

E

The sales ledger contains the sales accounts. The purchases ledger contains the detailed accounts of individual suppliers. The cash book contains the accounts relating to cash and bank. The nominal ledger contains the accounts which are closed off to the profit and loss account. The general ledger contains the accounts likely to appear in the balance sheet.

Concept check 4 Using the breakdown of the ledger suggested in the chapter, which of the following is not a general ledger account? A B C D E

Discount received Plant and machinery Capital Loan Drawings.

ACTIVITY 5.2 (a)

(b)

Consider the accounts of your local supermarket. What are the limitations of reliance on a simple double-entry system to record the transactions of the business? Identify ways of dealing with a business of this sort. Assuming that a business maintains the subdivision of the ledgers identified above, identify in which ledgers the following accounts would be found:

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i. ii. iii. iv. v. (c) (d) (e)

an account for David Anth, a customer administration expenses interest received premises an account for B. Fennell, a supplier.

Explain how a computerised accounting system might use computer files as part of a subsidiary record system and ledger system. How important are barcodes in data capture? Identify ways in which the use of subsidiary records can help internal control.

LO3 Explain the nature and role of sales and purchases journals and show how they are used in posting figures to the accounts in a traditional manual system

THE SALES AND PURCHASES JOURNALS Credit transactions are typically first recorded in a subsidiary record, known as a day book, book of original (or prime) entry, or journal. The usual books are:

• • • •

sales book, which records all sales on credit purchases book, which records all credit purchases sales returns book purchases returns book.

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The basic idea is very simple. When a sale is made on credit, the detail is entered in the sales book, which is simply a list of sales on credit, showing date, customer, invoice number and amount. This ensures that a record exists of the transaction, from which appropriate entries can be made in the ledger accounts, and also provides a reference to supporting documents detailing the transaction. The actual entering into the relevant accounts (which, as we saw in Chapter 4, is known as posting) can occur at a convenient time, and using totals if appropriate. The two aspects of the posting process do not have to happen at the same time, nor do they have to be done by the same person. They must be posted before the account can be balanced off, but there is a reasonable degree of flexibility. Separation of these two roles has advantages in terms of internal control. Use of a system of this sort can make it easier to give one person the overall responsibility for managing the individual debtors accounts. Example 5.1 shows a typical simple sales book.

Sales book Date 2017 July 1 July 1 July 1 July 1 July 1

Detail

Invoice number

Folio/account number

Amount $

E. Dower D. Driver B. Fry R. Young J. McCool

J1001 J1002 J1003 J1004 J1005

S200 S210 S300 S950 S500 Total to sales account

150.00 567.98 132.02 400.00 750.00 2,000.00

5.1

The basic system is: • The seller sends the invoice to the customer, while retaining a copy. • The document (copy invoice) acts as the prime (also known as source) document or voucher, which acts as the documentary evidence that a transaction has occurred. • The document initiates the recording of the transaction. • The information on the document is entered into the sales book. • At the end of each day (week or appropriate period) the total of the sales book is posted to the sales account in the nominal or general ledger. • Individual debits are made to the individual accounts in the sales ledger.

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There are no time savings in postings to the individual accounts, but these can be made at a convenient time. There are considerable savings of posting time by making the total posting to sales.

The format and procedure for the other books is very similar. The postings of the sales returns book are: a single debit entry of the total to the sales returns account, and a series of individual credit entries to the individual debtor accounts in the sales ledger. The prime document is typically the credit note that is issued. The postings of the purchases book will be a single debit to the purchases account for the total of the purchases book, while a series of individual credit entries will be made in the creditor accounts in the purchases (creditors) ledger. The prime document will be each invoice received. The postings of the purchases returns book will be a single credit to the purchases returns account, and a series of individual debits to the purchases (creditors) ledger. The prime document is typically the credit note given by the supplier. Subsidiary books can be prepared using analysis columns. Suppose sales are of different products, or covering stores in different geographical locations. The sales book can be modified to

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ACCOUNTING FOR BUSINESS STUDENTS

facilitate a breakdown of the sales along the following lines, where columns headed 1–4 reflect the breakdown that is most useful to the business. Date

Detail

Invoice

Folio

Total

1

2

3

4

Transactions will be entered into both the total column and the appropriate analysis column, permitting a breakdown of the type of sales, or sales relating to the range of stores within the business. It may be convenient to modify the form of the purchases book to include all inward invoices. All that is needed to do this is to adapt the analysis columns accordingly, along the lines shown below. Date

Detail

Invoice

Folio

Total

Purchases

Rates and

General

insurance

expenses

Fuel

Ledger

The ledger column is for items which do not fit under any of the main headings used, and will require detailed posting, whereas the totals can be used to post the other columns. It is important to note that we are concerned in this chapter with the principles of data capture and recording. We may well find that no formal book is kept, but that invoices are filed (or even just thrown) in a box, and are then posted, say, weekly or monthly. Detailed postings to creditors can be made from each invoice, and the total from a checklist can be debited to the purchases account. Many manual systems (and probably most personal systems of accounting) may well have elements that operate this way. For many computerised systems, invoices are bundled up and processed in batches. Sales and purchases books imply a trading business. Many small businesses that use manual systems are service providers, for example plumbers, electricians real estate agents. Essentially, the aim of the sales and purchases books is to provide a record, prior to entering in the accounts, of transactions that relate to revenue and expenses. This is as necessary for service and manufacturing businesses as for trading businesses. The principles of the day book remain valid; the title needs changing. It is important to note that the use of analysis columns and computer coding systems is based on the chart of accounts. The move from a simple day book, to one which uses a set of analysis columns, to a computerised system which uses a coding system derived from the chart of accounts should be seen as a logical extension of the same principle.

Concept check 5 Which of the following statements is false? A B C D

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E

The sales and sales returns journals record credit sales and customers in detail. Purchases and purchases returns journals record credit purchases and returns in detail. The general journal records anything not recorded in the other subsidiary records. The advantage of journals is that postings can be made by different people at different times. In a system of subsidiary records there is no time saving in terms of the number of entries to be posted.

Concept check 6 Which of the following postings is correct? A

B

C

D

The sales book is posted as a debit to sales in total, and a series of detailed credits to the individual creditor accounts. The purchases book is posted as a debit to purchases or inventory in total, and as a series of detailed credits to individual supplier accounts. When an analysis purchases book is used, the totals of the analysis columns are debited to purchases or inventory and credited to the accounts which reflect the title of each analysis column. The sales returns book is posted in total to the sales account and credited to the detailed customer accounts.

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ACTIVITY 5.3 (a) (b)

What kind of day book might an audiologist or a real estate agent keep? You are required to complete a purchases book and a purchases returns book from the following details, and then post the contents to the appropriate accounts in the appropriate ledger. i. ii. iii. iv. v. vi. vii.

(c)

January 1 January 1 January 2 January 2 January 3 January 3 January 3

Credit purchases from L. Howard Credit purchases from R. Sage Credit purchases from C. Johnson Credit purchases from M. Dewar Goods returned to C. Johnson Credit purchases from R. Sage Goods returned to R. Sage

$500 $350 $750 $600 $200 $400 $100

Suppose that you misread the figure from the 1 January purchases from R. Sage as $530, and also made the same mistake when totalling the purchases book. Would these errors have shown up when the trial balance was drawn up?

THE CASH BOOK AND CASH JOURNALS There are a number of ways of dealing with cash transactions. At the simplest level, maintaining a single cash account in a separate ledger is possible but highly unlikely. Other options include: • a two-column (cash and bank) cash book • a three-column cash book • cash journals.

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The two-column cash book is simply a ledger account which contains both cash columns and bank columns. The cash book doubles both as ledger accounts, namely a cash account and a bank account, and as a day or subsidiary book. Postings to complete the double entry from cash to the other side of the transaction need to be made from the cash book. There are no particular time savings that can be achieved by use of this book. The three-column cash book includes a third column, a discount column, as illustrated in Example 5.2.

Date May 1 May 2 May 3 May 2

Detail Discount Balance b/d G. Knott 4 M. Fitzwalter 8 12 Balance b/d

Cash 500 196 696 696

Cash book Bank Date 5,276 May 2 May 2 392 May 2 5,668 5,088

Detail G. Teough J. Flanagan Balance c/d

Discount 5 10 15

Cash

696 696

Bank 190 390 5,088 5,668

LO4 Explain the nature and role of the cash book and cash journals and show how they are used in posting figures to the accounts in a traditional manual system

5.2

The main advantages of this approach are:

• It facilitates the posting together of both the cash and discount figures to the individual debtor •

or creditor accounts. It enables the posting of totals to the discount allowed and discount received accounts.

Neither of the cash books referred to have the advantages that cash journals have, especially when used with analysis columns. Cash journals are subsidiary records, so they bring with them the advantage of avoiding some detailed postings. An example of the typical headings used in a simple cash receipts journal is given Atrill, Peter, et al. below. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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Cash receipts journal Date

Detail

Receipt number

Folio

Discount

Cash

Bank

The totals of the cash and bank columns can be debited to the cash and bank accounts, and the total of the discount column can be posted to the discount allowed account. A similar approach could be used for a separate cash payments journal. However, the reality is that most payments will be made by cheque, direct credit transfer or by use of internet banking, so a cash column is unlikely to be used. Using actual cash to pay for things is normally kept to an absolute minimum, and this is normally handled by a Petty Cash account which is dealt with later. Use of analysis cash journals provides a further means of reducing the detailed postings needed into the accounts. Possible headings for the two journals are given below. Cash receipts journal Date

Detail

Receipt

Total

number

Sales

Sales

region 1

region 2

Interest

Sales

Discount

Folio

Discount

Folio

ledger

Cash payments journal Date

Detail

Cheque number

Total

Purchases

Wages

Rent and

Purchases

rates

ledger

Clearly these are illustrative. In reality, many more columns will be needed to analyse the necessary detail. Prime documents for the cash receipts journal or the cash books typically include receipts issued, credit card receipt summaries and bank statements. Prime documents for the cash payments journal include invoices, receipts given to the organisation, credit card statements, and bank statements or records from online banking. Posting of the cash receipts journal would be as follows: 1 The total of the total column would be debited to the cash account. 2 The totals of the analysis columns—other than the sales ledger column—would be credited to

the appropriate account, namely sales of region 1, sales of region 2, and interest. 3 The sales ledger column contains receipts from debtors, which, together with individual

amounts of discount, need to be credited to each of these individual accounts.

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4 The total of the discount column would be debited to the discount allowed account.

imprest system A system (usually associated with petty cash) in which an allowance is given for a period, from which expenditure, of an approved nature, can be made.

The folio column enables cross-referencing to the individual debtor accounts. Similar sorts of postings apply to the cash payments journal. As already pointed out, very few payments occur in cash (as distinct from cheque or credit transfer) for reasons relating to internal control. Physical cash is very easy to lose, for one reason or another. Typically, most organisations have clear and restrictive rules on the use of cash. It is very difficult to prevent all cash expenditure, but generally cash expenditure is controlled by a small number of petty cash holders and there are strict rules about just what the cash can be spent on. Generally, petty cash systems operate on what is known as an imprest system. Typically, the petty cash system operates along the following lines. 1 There is usually a maximum amount that can be held, known as an imprest or float. 2 A detailed record, known as a petty cash book, is maintained. 3 When set up, a cheque is drawn on the main bank account for the amount of the imprest,

which is entered on the receipts side of the petty cash book. The cheque is cashed and the cash is held in a safe place. 4 Expenditure, which must be in line with the agreed policy on what can be spent in this way, is made, and the person spending the money completes a voucher, which sets out details of what the money was spent on, and attaches a receipt. These details are then recorded on the payments side of the petty cash book, and cash spent is refunded to the person who has spent the money.

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5 At the end of an appropriate period (often a month), the total amount spent (as shown in the

petty cash book) is reclaimed and a cheque is drawn and cashed, at which point the float is back to the maximum allowed, so the process can start again. 6 Postings can be made of the totals if an analysis petty cash book is used (which it usually is). This completes the double entry, matching the cheque drawn. At any point, the sum of the cash held plus the total of the vouchers held should equal the maximum balance allowed. Regular checks on this should be carried out by senior staff or audit staff as unauthorised ‘borrowings’ can be a feature of systems of this sort. Large organisations may have a significant number of petty cash accounts going at any one time. Example 5.3 provides an illustration of a (deliberately shortened) petty cash book.

Petty cash book Voucher Receipts 125.00 375.00

Folio

Date July 1 1 1 2 2 2 4 4 4 5 5 6 6 7 8

Detail Balance b/d Cash Stationery Stamps Bus fares Files Railway fares Paper clips Biro pens Sticky tape Newspaper Copier repair Magazine Copy paper Balance c/d

number

1 2 3 4 5 6 8 9 10 11 12 13

Office Total

40.00 32.30 22.00 40.00 15.00 10.50 25.00 10.80 2.70 150.00 12.00 25.00 385.30 114.70

Travel

Stationery

Postage

sundries

5.3

40.00 32.30 22.00 40.00 15.00 10.50 25.00 10.80 2.70 150.00 12.00 37.00 Total to

25.00 65.00 Total to

32.30 Total to

251.00 Total to

Travel

Stationery

Postage

Office

account

account

account

sundries account

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500.00 114.70 385.30 500.00

500.00 8

Balance b/d

The detailed postings (i.e. the total figures in the last four columns) are debit entries. The corresponding credit is $385.30 to cash. You should remember that the essence of journals is to ensure that all transactions are remembered and recorded. Another key related element is the setting up of an audit trail, which should enable the transaction to be followed up from initial transaction to final recording through a ‘document’ trail. Increasingly, with today’s modern technology, documents are not part of the normal process, but equivalent trails will be present. For example, many business executives now have credit cards from their business and have authority to use them in an approved manner. The monthly statements could be used as a kind of journal, but these statements indicate what has been spent and who has been paid, but seldom provide any detail as to what the expenditure actually covered. In general, it would be a reasonable expectation that receipts and credit card slips could be provided on request, though many people do not even take, or keep, their slips. This expectation could well be waived when a credit card is to be used only for a specific purpose (e.g. fuel) where actual expenditure could be assessed on the mileage driven.

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Concept check 7 Which of the following subsidiary records would be seen as part of the ledger accounting system? A B C D

Journal Sales returns book Cash book Purchases book.

Concept check 8 How should the total of the discount column in a cash receipts journal be posted? A B C D

Credit discount allowed Credit discount received Debit discount allowed Debit discount received.

Concept check 9 Which of the following is not an advantage of an analysis cash payments journal? A B C

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D

It reduces the detailed postings needed in the accounts. It enables purchases to be easily analysed under appropriate headings. As long as a discount column is used, it can facilitate posting to creditors for both cash and discount at the same time. The purchases ledger column means that the double entry can be limited to a single debit to purchases.

ACTIVITY 5.4 (a) (b) (c)

(d)

Explain how use of analysis columns in cash journals can save posting time. Identify any key points relating to internal control that you have noted in relation to cash journals. If you were put in charge of petty cash for a company, and were shown the petty cash book provided earlier in this section as an example, would you feel it necessary to discuss any particular expenditure included in that petty cash book? Which of the following statements relating to petty cash is true? i. The imprest is the amount of cash le" at the end of the period. ii. The imprest is the sum of the balance plus the sum of the vouchers issued for the period to date. iii. The imprest is the total payments for the month. iv. The imprest system provides an audit trail.

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THE JOURNAL While the subsidiary records dealt with to date cover the high-volume transactions, there remains a number of other transactions not covered. In order to ensure that every transaction goes through a subsidiary record, these ‘other transactions’ are recorded in what is known generically as ‘the journal’. Given that the term ‘journal’ has been used as part of the titles of other subsidiary records, it is common to refer to this journal as the ‘general journal’. You need to understand that in Chapter 4 we assumed that only the general journal would be used, and that every transaction would go through this journal and would subsequently be posted in detail. However, we have seen in the current chapter that there are ways of grouping transactions by type, which is more efficient than simply using the general journal. This means that the journal, in practice, has a more limited role than was implied in Chapter 4, but the items that are recorded in the journal are usually very important. As we saw in Chapter 4, the form of the general journal is as follows: Date

Detail Name of account to be debited Name of account to be credited Narrative description of the transaction

Folio

Debit (Dr)

LO5 Explain the nature and role of the journal and show how they are used in posting figures to the accounts

Credit (Cr)

The transactions entered in this journal require posting in detail. There are no time savings through the use of the journal. Its main advantage is that it completes the system of original entry. Other advantages are: 1 The narrative section means that a considerable amount of information can be included

explaining the transaction. 2 The risk of omission of entries is reduced. 3 Because more information can be provided, more complicated entries can be more easily understood. 4 Fraud, irregularities and errors are easier to find because full reasons are given for each

particular transaction. 5 Because the journal provides an explanation of the more recent transactions, it ensures better continuity if there are staff changes. In fact, many accountants use journal papers, rather than a formal journal, which are then filed in order. These journal papers can include a tremendous amount of detail and workings when explaining complex transactions. Example 5.4 illustrates a complex journal entry to open a set of books.

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An individual has been running a business for some time without a formal system of record-keeping. He has now decided to use a proper accounting system. The journal entry to initiate this might look something like this. Date

Detail Premises—cost Fixtures and fittings—cost Fixtures and fittings—accumulated depreciation Vehicles—cost Vehicles—accumulated depreciation Inventory Receivables A. Smith B. Gover Payables A. Rene G. Hastings Cash Capital

Folio GL1 GL2 GL3 GL4 GL5 NL1 SL300 SL200 PL200 PL100 GL20 GL99

Debit 300,000 60,000

Credit

5.4

20,000

70,000 55,000

20,000

1,000 1,500

12,500 500,000

5,000 7,000 448,000 500,000

Being the opening balances on commencement of business

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Other typical entries are:

• • • •

purchase and sale of fixed assets on credit correction of errors closing off the accounts on a monthly or annual basis other transfers.

Errors can be of two types:

• errors which do not affect the agreement of the trial balance • errors which do affect the agreement of the trial balance. The types of errors which do not affect the agreement of the trial balance include:

• • • • • •

errors of omission—where the entries have been completely omitted from the books errors of commission—where the wrong account has been debited or credited errors of principle—where an account of completely the wrong type has been debited or credited compensating errors—where an error on one side of the accounts is matched by an error equal in size on the opposite side complete reversal of entries—where the debit side entry has been made on the credit side and vice versa an error in the subsidiary record which has been posted to both sides of the accounts for an incorrect amount.

The situation where the trial balance does not agree requires a different approach, typically will require the opening of a suspense account to make the trial balance agree. Once the errors are found, the correction needs to be made with a double entry to the suspense account. Typically, certain errors in the subsidiary records, for example an incorrect totalling, or an error in the detailed debtor posting from a sales book, will result in the trial balance not agreeing. Of the other entries in the journal, probably the most important relate to the period-end adjustments. As we saw in Chapter 4, there is a range of adjustments for things such as prepayments and accruals, bad and doubtful debts, and depreciation. Many of these adjustments (e.g. depreciation) are the result of accounting standards, accounting policies and/or judgements made by management. The journal (or a set of journal papers) provides a clear indication as to the basis of the adjustments and a clear audit trail. The entries transferring the revenues and expenses to the profit and loss account are also normally journalised.

Concept check 10

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For the system of subsidiary records used in this chapter, which of the following is not true? A B C D E

Credit purchases are entered in a purchases book. Cash transactions are entered in the cash journals. Credit sales are recorded in the sales book. If an analysis purchase book is used, all other expenses will be entered in this book. The journal has a far more restricted role than was implied in Chapter 4..

Concept check 11 Which of the following statements is incorrect as far as the journal is concerned? A B C D

Only transactions not recorded elsewhere in the subsidiary records are entered in the journal. The journal is substantially used for end-of-accounting-period adjustments. The journal is not used for closing off the accounts. The journal is used to enter corrections of errors.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

Concept check 12 Which of the following statements is not true? A

B

C D E

An error of omission (where the entries have been completely omitted) will not prevent the trial balance agreeing. An error in a subsidiary book, which has been posted to both sides of the accounts, will stop the trial balance agreeing. A complete reversal of entries will not stop the trial balance agreeing. An error of principle will not prevent the trial balance agreeing. An error of commission will not prevent the trial balance agreeing.

ACTIVITY 5.5 (a) (b)

(c)

(d)

Journalise this transaction: the purchase on credit on 19 October of a new BMW for $70,000. Which of the two errors below is an error of commission and which is an error of principle? i. Sales of $350 to J. Harvey were debited to J. Hardy. ii. Wages of $2,000 relating to improvements was debited to wages. Identify the nature of the following errors and journalise the necessary corrections: i. The purchases book was incorrectly totalled, being too high by $1,000. Discount received amounting to $5,900 was incorrectly posted as $6,900. ii. Sales to F. Woody amounting to $555 were recorded in the sales book as $585. iii. A payment of $450 to K. Waterhouse was entered as a debit to the cash account and a credit to his account. How likely are the kind of errors discussed in this section to be found in a manual system? In which areas do you think that the use of computer-based systems reduces the likelihood of errors?

CONTROL ACCOUNTS AND RECONCILIATIONS There are a number of ways in which checks and balances can be introduced. This section covers two such ways, control accounts and reconciliation statements.

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Control accounts We talked earlier about the subdivision of the ledger. Unless we can find some way of isolating errors to a particular division of the ledger, all ledgers will need to be checked in order to find the errors. Control accounts provide such a way. They can be used as part of the double-entry system and appear in both the appropriate subsidiary ledger and the general ledger—effectively meaning that the subsidiary ledger should ‘self-balance’. Or the main ledger account becomes the total account in the general ledger and the detailed entries in the subsidiary ledger form a third memorandum set of entries. Basically, a control account summarises all of the transactions that have been recorded in a particular ledger. If the balance on the control account for a particular ledger agrees with the sum of the individual balances of the individual accounts in the ledger, there may be an implication that the accounts are correct. We have already seen that this is not necessarily the case. However, control accounts do provide another check on the accounts. Control accounts, being essentially summaries of the transactions of a ledger, are sometimes known as total accounts. Probably the most important of the control accounts are those relating to the sales ledger (debtors) and purchases ledger (creditors). These two ledgers are possibly going to be the biggest in terms of number of accounts, so the possibility of errors may be greater. A wages control account would also be common for other than small businesses. A typical format for a sales ledger (debtors) control account is shown in Example 5.5.

LO6 Explain the importance of control accounts and reconciliations, and prepare control accounts for debtors and creditors and a bank reconciliation

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Sales ledger control account

5.5

July 1 July 31

Balance b/d Sales

100,000 1,250,000

July 31

Balance b/d

1,350,000 124,000

July 31 July 31 July 31 July 31 July 31 July 31

Sales returns Discount allowed Cash Bad debts Purchases ledger control Balance c/d

50,000 25,000 1,100,000 49,000 2,000 124,000 1,350,000

Most of these entries are self-explanatory as they mirror the transactions in the individual debtor accounts. The only one that is new is the purchases ledger control. This transaction is likely to be a contra to an account in the sales ledger, where one person is both a debtor and a creditor and wishes to offset one account against the other. A similar process is followed for a purchases ledger (creditors) control account. Typically, the control accounts are maintained in the general ledger and are used for trial balance purposes, with the accounts in the sales and purchases ledgers being seen as a secondary detailed record. When entering amounts in a control account, it is usual to use totals wherever possible. The following advantages result: 1 The control account provides an effective check on the accuracy of the postings from the

subsidiary records and on the addition of those records. 2 Because the control account has a limited number of postings, it is possible to extract balances

extremely quickly. 3 The control account can be easily and quickly kept by someone other than the person making the detailed posting, a factor which improves internal control and makes fraud more difficult, since collusion would be necessary for fraud to be successful. Control accounts can also be used to self-balance the various ledgers. For example, a sales ledger control account can be kept and used in the sales ledger, and at the same time kept in the general ledger by a different person. This approach has the advantage of providing an opportunity for the sales ledger administrator to self-check, while at the same time a separate check can be provided by the general ledger administrator. Any differences will probably be found more easily and reconciled than if only one such account is kept.

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Reconciliation statements Historically, a bank reconciliation statement has been an important and necessary document for almost all organisations. It is usual to check the balance in the cash account in the books with the figure shown on each bank statement when it arrives. (Of course, if internet banking is used, it is easy to choose a particular date for reconciliation that suits the particular organisation.) It is unusual for these two figures to be the same, though in principle we would expect them to be. Clearly it is necessary to identify and explain any differences and make any corrections required. You should note that the aim of the reconciliation statement is confirmation of the actual cash balance at a particular date. The main reasons why the figure in the cash account in the ledger may be different from the balance shown on the bank statement are as follows: 1 Some amounts received and recorded in the accounts may not have been paid in, or they may

have been paid into a different bank and not yet been credited to the customer’s branch or bank account. 2 Money banked on the day of the issue of the bank statement may not appear on the statement.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

3 Cheques paid out by the business, which have been recorded in the cash account of the

business, may not have been paid in by the recipient or cleared by the bank. These appear on the bank reconciliation statement as unpresented cheques. 4 Some payments shown on the bank statement will not have been recorded in the accounts. Bank charges and interest are the most likely. Amounts paid relating to standing orders and direct debits are also sometimes omitted from the accounts. 5 Certain receipts on the bank statements using direct debit or credit transfer may also be omitted from the accounts. 6 Returned or dishonoured cheques will be reflected on the bank statement but not in the accounts. The best approach to preparing a bank reconciliation statement is as follows: 1 Start with the bank statement and identify any items that are not in the accounts. 2 These items can then be recorded in the accounts and a revised cash account balance (in the

ledger) calculated. 3 Add unpresented cheques paid. 4 Subtract payments made into the bank but not shown on the bank statement. 5 The result should match the balance on the bank statement.

It seems likely that preparation of a bank reconciliation statement, which is not hard, has become even easier in recent years with the decline in use of cheques and a corresponding increase in use of direct credit transfer and EFTPOS. The probable demise of cheques in the next few years will contribute further to this, but it is unlikely that we shall see the demise of bank reconciliation statements any time soon. Checking of credit and debit card statements is effectively another type of process akin to a reconciliation.

Concept check 13 In explaining the difference between the balance on the cash account in the ledger and the bank statement balance, which of the following is a genuine reconciliation statement item, as distinct from an item which requires an entry in the cash account? A B C

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D E

An unpresented cheque Bank charges A standing order A credit transfer A direct debit.

Concept check 14 Which of the following transactions relating to the debtors ledger control account is incorrect? A B C

D

E

The total of the sales book is debited to the control account. The total of the sales returns book is credited to the control account. The total of the sales ledger column in the cash receipts journal is credited to the control account. The total of the discount column in the cash receipts journal is debited to the control account. A journal entry is posted crediting an amount for bad debts to the control account.

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Concept check 15 It is important to understand how various items appear on a bank statement. Which of the following is incorrect? A B C D E

A standing order for a monthly bill would appear as a debit. Payment of your monthly salary would be a credit. Dividends paid to you via direct bank credit would be a debit. Bank charges would appear as a debit. A cheque paid in and shown as a credit, which was subsequently dishonoured, would then appear as a debit.

ACTIVITY 5.6 (a)

The following information relates to sales and purchases for a business. Balances as at 1 June 2017 Sales ledger

525,000 debit 2,000 credit 252,000 credit 1,200 debit

Purchases ledger Transactions in June 2017 Purchases on credit Allowances and rebates from suppliers Receipts from customers Allowances to customers Customers’ cheques dishonoured Discounts allowed Refunds to customers Sales on credit Discount received Payment to creditors Contra settlements Balances as at 30 June 2017 Sales ledger Purchases ledger

2,300,000 150,000 4,000,000 80,000 2,000 90,000 10,000 3,950,000 50,000 2,150,000 2,500 1,800 credit 2,500 debit

Prepare the two control accounts and derive the balances as at 30 June.

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(b)

The accounts of a business include a cash account with a balance of $35,000 as at 30 June. The bank statement has a closing balance of $35,356. A"er comparing the entries in the cash account with the bank statement, you find that: i. Cheques received amounting to $1,500 have not yet been presented for payment to the bank. ii. An amount received of $180 has been incorrectly credited to the cash account. iii. A cheque from a customer for $551 has been recorded in the cash account as $515. iv. Bank charges shown on the bank statement of $100 have not been included in the cash account. v. Interest on the bank statement of $10 has not been credited to the cash account. vi. An amount of $250 received has been entered into the cash account but has not been banked. vii. Several cheques paid out remain unpresented. These total $1,800.

Show the additional entries that need to be made to the cash account and bring down the corrected balance. Then prepare a statement reconciling the cash account with the bank statement balance.

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SELF-ASSESSMENT QUESTION

253

5.1

Assume that you are working in an organisation that keeps a system of subsidiary records which includes the following: • • • • • • •

Sales book Sales returns book Purchases book Purchases returns book Cash receipts journal Cash payments journal Journal.

The two cash journals use analysis columns as follows: • The cash receipts journal has columns for the overall total, cash sales, other revenue, cash from debtors and discount allowed. • The cash payments journal has columns for the overall total, cash purchases, administration, rent and rates, marketing, cash paid to creditors and discount received. The subsidiary records are posted every week. The organisation also maintains a sales (debtors) ledger control account and a purchases (creditors) ledger control account. The detailed personal accounts relating to debtors and creditors are kept in two subsidiary ledgers, and the two control accounts are kept in the general ledger. 1 2 3 4 5 6 7 8

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9 10

11

What postings would be made from the sales book? What postings would be made from the sales returns book? What postings would be made from the purchases book? What postings would be made from the purchases returns book? What postings would be made from the cash receipts journal? What postings would be made from the cash payments journal? Can you think of any other transactions relating to debtors and creditors that might arise? How would these be dealt with in the subsidiary records? Summarise the likely content of a sales (debtors) ledger control account and a purchases (creditors) ledger control account for this organisation. What are the advantages, in this case, of the use of analysis columns in the cash journals? From an internal control perspective, how much of the recording (both in the subsidiary records and the ledgers) could or should be carried out by one person? How do you think the various functions might best be allocated so as to ensure that the principles of internal control are applied? What are the risks should your recommendations in question 10 above not be possible?

You need to identify the basic principles of the manual system and then apply these. Many businesses do this via computerised accounting packages, but many simply adapt the manual system to suit their particular business model and their particular areas of expertise. Real World 5.1 provides an example. This business is run by a well-organised couple with considerable business acumen and flair, and a father-in-law with an accounting background (the ‘bookkeeper’) who keeps the books. The system described satisfies the needs of the business and its owners, is easy to maintain, is well controlled, and is effective.

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REAL WORLD 5.1

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An example of a modified manual system in operation This business, owned by a couple, operates in a small country town and has an annual turnover of around $1 million. It has two arms to the business, homewares and an upmarket cafe. It employs six to eight staff. These two arms of the business are run and recorded separately. While the business is seen as a single business, with synergies between the two arms, the owners want to be able to keep track of each part of the business. The nature of a business is important in devising systems. Interestingly, the homewares part of this business is seen by the owners as part of the fashion industry rather than one that supplies the same kind of inventory on a regular basis. This means that the type of inventory is continually changing, though, obviously, there will be a part of the carrying stock which will be held and replaced continuously. The end result is that there is no set pattern either for ordering inventory or for a particular type and level of stock. Orders can occur based on specific customer needs, gaps on the shelves, visits and recommendations by suppliers’ reps, and ‘gut feel’ as to what might go well. There appears to be a general feeling among customers that this ‘gut feel’ works very well. All products are barcoded, which means that inventory and sales can be analysed in detail. This enables product profitability to be identified by product lines, which also enables purchasing decisions to reflect past sales. Sales are for cash or card. Occasionally, there are orders from local public bodies, such as the local TAFE, which are via an official order with subsequent payment by credit transfer. These, including the issuing of receipts, are dealt with by the owners, and details are then passed to the person who keeps the books, typically in batches every couple of weeks. For the homewares section the barcodes enable detailed analysis to be made of the sales by product. For the cafe, the till enables sales to be categorised under four headings. Details of receipts are passed to the bookkeeper. Cash from card receipts is usually transferred into the business bank account by the end of the day. The bookkeeper regularly reconciles the credit card listings with the cash received from the credit card company. Some goods are sold on lay-by. Detailed records of these are maintained. Regarding cash receipts, cash from each arm of the business is separately banked intact (i.e. without any deductions being taken out) a"er reconciling with the till. Occasionally, the two do not reconcile, though this usually relates to the cafe takings, where errors or wrong key strokes are more likely.

Suppliers’ invoices and any other bills are paid by the owner from the business bank account, using internet banking. Copies of the invoices are sent to the bookkeeper, again typically in batches, every couple of weeks. Wages are contracted out. Time sheets are maintained and sent to the agent fortnightly. The pay calculation is externally processed and pay slips are emailed to the employee. Superannuation is arranged through a single fund, and this fund liaises with the individual employees as appropriate. Fortnightly payments are made to employees by the owner using internet banking through the business bank account. Payments are also made by the owner into the super fund once a quarter, and to the ATO once a month, again using internet banking through the business bank account. GST is based on revenue (1/11) less GST inputs, which are derived from the invoices paid, the calculation being made by the bookkeeper. Payment is made by the owner from the business bank account, again using internet banking. The annual reports are compiled by the bookkeeper from the information collected and recorded, most of which is journalised and put into a spreadsheet. The spreadsheet is prepared in such a way as to provide a detailed split between the two arms of the business, as well as facilitating detailed analysis of the profitability. The details of the income for the year are then sent to the tax agent used by the owners.

Classroom discussion points 1 In this business, transactions are largely cash based. Which areas of recording are simplified as a result? 2 What difference do you think extensive use of internet banking of the type used would make to a bank reconciliation? 3 What is the equivalent of the sales book for this business? 4 Explain how the cash receipts and payments system used by this business is consistent with a system of cash journals. 5 Explain how the use of barcodes can act as the equivalent of analysis columns. 6 How do you think a spreadsheet (or set of linked spreadsheets) could be used to produce a set of final accounts that could be analysed to produce performance reports for subdivisions of a business?

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COMPUTERISED ACCOUNTING SYSTEMS Many businesses use computerised accounting systems for part or all of their accounting. Computerised accounting systems can range from straightforward off-the-shelf accounting packages to part of large-scale management information systems. Large organisations usually have dedicated accounting systems, and these are likely to be part of a sophisticated management information system. A typical small to medium-sized business is more likely to use a smaller computerised accounting system, but many still use manual systems in part. Some businesses start with an off-the-shelf package, which is then developed or customised in-house. It is important that when information technology is used it is used appropriately and value adds. The records kept, and the output produced, must be meaningful. In general, computerised accounting systems follow the same principles as manual systems. In fact, many accounting packages use a modular system, which mirrors much of the manual system. For example, at the time of writing, MYOB Essentials includes banking transactions and reconciliation, sales, expense, contacts, payroll and reports. MYOB has arguably been the leader in small business accounting software for the last 20 years. Also, the internal control principles introduced at the beginning of the chapter apply as much to computerised systems as to manual systems, but there are some different and difficult issues associated with the former The main elements of a computerised accounting system are set out below:

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• The computerised interface is comprised of a number of sub-systems (termed ‘modules’),

•

for example debtors, creditors, payroll, banking, inventory, etc. A business may not use all sub-systems (e.g. service businesses will not generally use the inventory module). Each sub-system is further divided so as to provide a set of individual records as required. This is generally known as a database, and is created automatically by the accounting system once the user enters information. Information is usually required to be set up in this database, before transactions can be entered, through ‘records’. Each record entered is usually termed a ‘card file’. Card files can be created for employees, suppliers, customers, etc. These card files are then used as part of transaction recording and greatly simplify the recording process. For example, consider the payroll needs of a reasonable sized business employing 100 staff doing a range of jobs under different employment conditions, and possibly using different superannuation funds. Such detailed records would be kept in each electronic card file for each employee, and then distributed by the system automatically when the regular payroll is processed. Details such as pay rate, superannuation fund and leave entitlements are all automatically pulled from the individual card files and then automatically posted back to each card file after payroll is ‘recorded’. This means that the card files are constantly being updated, so at any time current information can be obtained for any individual employee by simply opening that employee’s card file. The advantages of computerising this area is obvious. Further, the monthly wages and PAYG can be automatically completed and reported to the ATO through the online BAS lodgement linkage with the ATO system. The annual payroll PAYG Payment Summary reporting can also be automatically exported to the ATO, thus providing considerable efficiencies. A sound system of coding is required, and the system must be devised in such a way as to be able to provide information at a variety of levels, including a detailed level. The codes used will be linked to the chart of accounts, which, you will recall from Chapter 4, requires careful planning and consideration of information needs relating to the entire business (and possibly future areas of the business). The coding system is, in effect, an extension of the idea of analysis books. Rather than be limited by the size of the page, detailed coding systems can be used to replace and extend the analysis columns to as many headings as are needed. The results will be either printed out or accessible online, or, most likely, a mixture of the two. In most computerised accounting systems, the coding system has already been created for the user, so that the user can simply use it as is, or tailor it to better suit their business. Usually, there will be multiple coding systems as part of one accounting system, and each sub-system will have its own unique coding system. For example, MYOB provides separate coding

LO7 Explain the major elements of computerised accounting systems and explain how these systems still use the same basic principles of accounting and internal control used by a manual system, but that they deal with large volumes of transactions more effectively, and can be linked with appropriate documentation or file production and maintenance

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• •

•

systems for the general ledger, inventory items and jobs. One transaction, using the relevant card file, can be coded to the general ledger, the relevant job and the relevant inventory item—automatically updating each sub-system as soon as the user ‘records’ that single transaction. Properly coded information can be input into the system using a variety of ways (e.g. barcodes, keyboard, mark sensing, scanning, etc.). The accounting system records are automatically updated. Reports can be generated for aspects of each sub-system (e.g. sales, purchases, inventory, payroll, banking) or for the accounts in general (such as general ledger, financial statements). Such reports can be analysed, exported to systems such as Excel or PDF and printed out where required, with information being targeted to a specific user. Typical output includes the standard accounting reports, with as much supporting detail as is needed, whatever documents are needed to carry on the business of the organisation (e.g. invoices, credit notes, pay slips, cheques, end-of-year tax documents etc.) and other reports generated for specific purposes (e.g. inventory reports, age profile of debts, etc.). The files/databases collected provide the business with a carefully designed information set, which enables production of a range of reports, including costing and management accounting reports and historic and forecast analyses, which could not be done easily or quickly using a manual system. A rigorous system of historical recording provides a sound underpinning for forecasting. This can be done manually, but sensitivity analysis done manually can be quite tortuous, whereas when computerised a wide range of sensitivities and scenario analyses can be produced quickly.

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A typical accounting package uses a menu-driven screen. This gives the user a choice of a range of accounting tasks (modules) that can be worked on (e.g. raising invoices, processing sales orders, inventory control, payroll, paying creditors, purchases order processing and job costing). The routines usually lead the user through the transactions. These routines generally relate to one particular part of the data collection and recording process, and often cover similar areas to those covered in a manual system. In a well-designed and integrated package, however, the information will be entered only once and automatically drawn on as appropriate. The double entry, posting and updating therefore takes place automatically, thus saving time and avoiding duplication. Control accounts for debtors, creditors and wages are common, and form part of the formal ledger accounts. In general, computerised systems can be expected to eliminate some errors relating to manual data entry. They are also associated with greater speed and ease of analysis than manual systems. Certain additional security and internal control procedures may need to be added or modified. In general, computerised accounting systems follow the same broad principles as the manual system. They are likely to be used where:

• • • •

high volumes of transactions exist supporting documentation (e.g. invoices, cheques, etc.) or detailed analyses are needed savings can be achieved through automatic postings there is scope for using the data provided for a range of other useful purposes, for example analysis or planning.

Cloud computing Cloud computing has been around for several years now. Essentially, it is the ability to use and store a data file on an online server instead of a physical computer. Users purchase only the accounting system or modules that they require, which are operated ‘in the cloud’. This means that internet access is required and all software and files remain online. So as long as the internet is operating efficiently, the accounting system remains reliable and current. Furthermore, by accessing and paying for use of the services provided, there are no version updating costs since updates are performed by the service provider—a significant advantage if you have ever been on the treadmill of constant version updates!

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The cloud also offers a number of advantages for accounting systems, predominantly by minimising the redundant bookkeeping work of most businesses. Cloud accounting systems provide real-time data, which means that any authorised user can access the same up-to-date file, at any time, using any device with an internet connection. Such mobility provides real-time accounting: a sales invoice can be entered at the airport; reports can be accessed whilst overseas. This also means that multiple versions of data files are eliminated, and that a backup is automatic—a significant advantage for data security which those who have been involved in frequent data backup and storage will appreciate! Similarly to offline computer accounting system users, cloud users can be designated particular access for data security (e.g. all users excepting the payroll administrator can be denied access to payroll records). One of the main advantages of cloud accounting systems is that a business can link its accounting system to external parties, such as banks, to eliminate much of their mundane data entry. For example, users can download real-time data from their bank accounts, termed ‘live feeds’, which automatically enter bank account and credit card transaction data into the business accounting system. Further, most cloud accounting systems offer the option of automated bank reconciliations, with smart features like autocoding of repetitive transactions into the general ledger (see Real World 5.3). Automatic linking with other organisations, such as the ATO, suppliers and customers, is also increasingly commonplace. This often eliminates further data entry! Many small business owners are now sending invoices via their mobile devices (once created and emailed, the invoices are automatically entered into their accounting system); being paid by direct credit transfer (which is automatically entered into their accounting system upon linking with the bank system); and getting reconciliations completed automatically (through the same bank system linkage). This means that the traditional paper trail of documents is being replaced by an electronic audit trail of transactions, which most cloud computing packages offer as a security function in their system settings. Of course, there are a number of issues relating to the cloud, generally pertaining to data security. Such issues include:

• concerns about internet reliability, both in terms of access and unauthorised user access (e.g. •

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•

hacking) concerns relating to the reliability of the cloud accounting system provider (e.g. temporary system outages, company reputability and longevity) concerns regarding privacy and legal issues (there are regulations that some types of information should not leave the country of origin, for example certain medical data is prohibited from leaving Australia).

The cloud accounting system providers are well aware of the security concerns and processes such as encryption and tokenisation provide protection against, for example unauthorised access, but some risk does remain. Any business considering using a cloud accounting system provider should carry out due diligence regarding their financial position and the location and capacity of their data centres. The question as to what happens if the provider fails should also be considered, but for many small businesses it probably won’t be. Overall, cloud accounting programs are having a considerable impact on the way businesses, including small businesses, are keeping track of data and how they are using it. While in some ways business activity continues along the same track (a plumber or electrician is still doing the same job), the process of dealing with things such as ordering, invoicing, payroll, payment of bills and banking has changed. The end result is a system which looks quite different from the manual system described earlier. However, the basic ingredients of the mix remain the same, but the newer systems are far more streamlined and integrated and eliminate virtually all chances of arithmetical error. Effectively, what is happening is that, with computerised systems, we can safely presume that the postings that follow from the point of original entry will be accurately followed through. The systems also provide scope for greater awareness of the key elements of a business because there is less emphasis on data collection and more on how the business is travelling. Once data collection becomes easier, it is to be hoped (and expected) that the resulting information can and will be used more efficiently and effectively.

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Concept check 16 Which of the following do you see as being incorrect regarding potential advantages of computerised accounting systems? A B C D

E

Ability to deal with large volumes of transactions Greater accuracy through automatic postings Elimination of certain types of errors Ability to extend the range of reports, including more detailed management accounting reports Reduced security risks.

Concept check 17 Which of the following do you think is incorrect? A

B

C

D

E

Many computerised systems facilitate the desirable end result of minimising actual cash transactions. With a fully computerised accounting system, the importance of the chart of accounts and the system of coding is reduced. Many accounting packages use a modular system, which is based on similar principles to those of a manual system. It is common for small businesses to use a mix of parts of the manual system with modules from an accounting package. Batching of invoices in a computerised system is similar to a purchases book.

ACTIVITY 5.7 (a) (b)

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(c) (d) (e)

What kind of information needs to be part of a computerised wages record or database for each individual staff member? Assume that a company has a sound historical accounting system and wishes to use this as a base for planning over the next five years. For what areas do you think sensitivity analysis would be appropriate in determining the future financial performance of the business? Do you consider information overload an outcome of using computerised accounting systems. Does the use of a computerised accounting system reduce the required accounting knowledge of its users? Explain the importance of the chart of accounts and the coding system in a computerised accounting system.

ACTIVITY 5.8 Did you know that you can try before you buy? Most computerised accounting systems provide the option to trial a version of their so"ware or cloud for free (usually for a period up to 30 days). For this activity you will trial MYOB so"ware, since it is the leader in small business so"ware in Australia. Go to the MYOB website (https://www.myob.com/au/accounting-so"ware/compare#compare-products) and choose the version you would be most interested in using (for your business or for your personal records). Click on the ‘Try now’ or ‘Try for free’ links to learn how to use this so"ware for free! MYOB offers tutorials for operating all of their products at http://help.myob.com/teachme/. Simply choose which product you have downloaded for the trial version, click on the ‘Start learning’ button and simply follow through the prompts. Allow about 1.5 hours for the initial training on setup and a further 3 hours for learning how to use the so"ware.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

ACTIVITY 5.9 This activity aims to consolidate your understanding of all concepts in Chapters 4 and 5 by considering your own personal finances. If you have understood the recording process, then you will be able to produce a basic set of financial statements for yourself by simply using your bank/loan account and credit/debit card account transactions. First, obtain the bank statements for all of your personal accounts (savings, cheque, loan, credit and debit cards) for the same period (choose a reasonable period (e.g. one month) so that the volume of transactions will not overwhelm you.

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Decide on which chart of accounts you wish to use. This is a very important step, as you know from completing Chapter 4. You might like to begin by going through each of your statements, line by line, and ‘classifying’ each transaction—in this way creating your own chart of accounts. Assume this was your bank statement for the month of January 2017 (first three columns). You might go through and classify each transaction as follows (last column): Date 1/01/2017

Amount $197.29

3/01/2017

–$120.10

3/01/2017

Transaction details INTEREST

Category in my chart of accounts 1-1 Interest Income

PAYMENT TO GMHBA LTD

2-1 Private Health Insurance Expense

–$17.73

PAYMENT TO INSURANCE LINE

2-2 Income Protection Insurance Expense

3/01/2017

–$32.00

DIRECT DEBIT—DEBIT TO VIRGIN MOBILE

2-3 Telephone Expense (mobile)

4/01/2017

$981.50

DEPOSIT FROM XYZ—PAY FOR 4/01/2017

1-2 Income—Salary and Wages

5/01/2017

–$695.35

INTERNET BANKING BILLPAY—TMR REG RENEW

2-4 Vehicle Expense (registration)

11/01/2017

$981.50

DEPOSIT FROM XYZ—PAY FOR 11/01/2017

1-2 Income—Salary and Wages

16/01/2017

–$100.00

FUNDS TRANSFER—CHINESE ORPHANS ASSCN

2-5 Expense (donations/gi#s)

16/01/2017

–$100.00

FUNDS TRANSFER—CHINESE ORPHANS ASSCN

2-5 Expense (donations/gi#s)

17/01/2017

$692.75

DEPOSIT FROM ABC—PAY FORTNIGHT 17/01/2017

1-2 Income—Salary and Wages

18/01/2017

$981.50

DEPOSIT FROM XYZ—PAY FOR 18/01/2017

1-2 Income—Salary and Wages

18/01/2017

–$500.00

INTERNET BANKING BILLPAY VISA CARD

2-6 General Living Expenses (food, fuel)

23/01/2017

–$35.00

DIRECT DEBIT—DEBIT TO VIRGIN MOBILE

2-3 Telephone Expense (mobile)

25/01/2017

$981.50

DEPOSIT FROM XYZ—PAY FOR 25/01/2017

1-2 Income—Salary and Wages

27/01/2017

–$363.48

PAYMENT TO COLES MASTERCARD

2-6 General Living Expenses (food, fuel)

27/01/2017

–$197.19

PAYMENT TO 28 DEGREES CREDIT CARD

2-6 General Living Expenses (food, fuel)

If you have online banking, you can do the above very simply by choosing a date range and simply exporting this to a CSV file, which can be opened in Microso" Excel. You can then simply classify your chart of accounts in the next column. The benefits of using Excel will flow through to the next step, where you can use linking and simple formulae.

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Now you have enough information to prepare a simple profit and loss statement, as follows: Your Name Profit and Loss Statement for January 2017 $ INCOME Income—interest Income—salary and wages TOTAL INCOME EXPENSES Private health insurance expense Income protection insurance expense Telephone expense (mobile) Vehicle expense (registration) Expense (donations/gi"s) General living expenses (food, fuel) TOTAL EXPENSES Profit/(Loss) for the period

$ 197.29 $ 4,618.75 $ 4,816.04 –$ 120.10 –$ 17.73 –$ 67.00 –$ 695.35 –$ 200.00 –$ 1,060.67 –$ 2,160.85 $ 2,655.19

Note that the items listed as income and expenses are directly from your chart of accounts. You are simply grouping each transaction by your classification! To use Excel’s linking features, simply type ‘5’ to start a formula in the cell that you wish (for example, you can link the interest figure of $197.29 directly to the bank statement figure for this interest). This makes more sense when grouping more than one figure, for example grouping the figures for Income—Salary and Wages. You would begin with ‘5’ and then click on each bank statement figure for the pays, pressing ‘1’ in between each, and hitting ‘Enter’ to complete the linking. Excel then automatically sums all of these pays as $4,618.75. You can also enter formulae for the Profit/Loss—simply type ‘5’, then click on the TOTAL INCOME figure, and ‘1’ the TOTAL EXPENSES figure. (a)

(b)

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(c)

What is the chart of accounts so far, as illustrated in the above example? What is your own chart of accounts? Is it similar to the one shown here? Remember, you can add to your chart of accounts as you classify more of your own transactions. What level of detail could you change in the chart of accounts shown in this activity? Why might you want to do this? How might you analyse the profit and loss statement shown in this activity? Has this recording process (transaction through to financial statement) exercise been useful for you?

We have seen how a system of subsidiary records provides a kind of ‘first response’, which tries to ensure that all data is collected and can then be incorporated into the accounts. We have described a very basic set of subsidiary records which can be completed manually. The various ways in which the manual approach can be computerised were then explored. It should be clear that there is no one system that fits all. Accounting systems range from simple manual systems to fully computerised systems, and the most common among small-to-medium organisations are probably hybrid systems that use a mix of the two. It is easy for those who are used to large corporate systems to think that no-one actually still uses a manual system. Anyone who believes this need only look in their local stationery store to realise that books for entering transaction data by hand are still best-sellers. Particular favourites seem to be receipt books, which act as a subsidiary record, cash books, journals and analysis books. Most businesses that use these kinds of subsidiary records have built in some aspects of internal control. While for many businesses these may fall a long way short of the kind of ideas set out in the COSO document discussed at the beginning of the chapter, they are important and probably appropriate for small-to-medium businesses. Below are three Real World examples which illustrate just how the general principles can be applied. Real World 5.2 summarises the accounting system used by a very successful independent real estate agent. This illustrates how some modules of a computerised accounting package can be used alongside what is basically a manual system. Real World 5.3 provides an illustration of cloud accounting, while Real World 5.4 illustrates how a fully computerised system operates. Both of the last two examples illustrate the advantages of computerisation for the businesses discussed.

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261

REAL WORLD 5.2 An accounting system for a real estate agent

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The real estate agent concerned is a highly experienced real estate agent who has worked in real estate groups/franchises in the past, but who is now independent. He has one fellow agent and two staff, primarily engaged in administration. Annual commissions are well in excess of half a million dollars. Given the nature of the business, the record-keeping is divided into a separate set of trust accounts and a set of accounts for the business. All transactions relating to sales and rentals are recorded in the trust accounts. The trust accounts are done completely manually. A sale note is drawn up for every transaction. This note covers both sale transactions and rental transactions. It provides details of the purchaser or tenant, the vendor or landlord, details of the property and, if rented, the amount of the bond and rental. Details of any amounts received or spent are recorded on the sale note in the form of a journal entry. The sale note is started on signing of the contract. Until the contract is completed, this sale note is ‘alive’. Once any sale contract is complete, the amount of commission is calculated, together with any fees or expenses, and the net revenue is transferred to the business account. The sale note then becomes ‘dead’. Revenue from rentals are transferred to the business accounts on a regular basis, a"er the event. A detailed receipt book is kept for the trust accounts. These are classified as income relating to deposits, rental, bonds or advertising. All transactions relating to the trust accounts are kept completely separate from the other business accounts. In a sense, the sale note can be seen as a personal account relating to a particular customer, so it has similar characteristics to a sales book and personal debtor account all in one. The business accounts are kept completely separate to the trust accounts. Incoming invoices are held and filed, effectively acting as the source document and day book.

These are paid weekly. They are entered into a cash payments journal. A cash receipts journal is also maintained. Transactions are analysed under a number of headings. Postings are made to a double-entry accounting system on a monthly basis. MYOB is used to deal with tax and GST. It can be used to prepare financial statements and further analyses, but these are not seen as being particularly important. This is simply because the owner of the business is completely on top of the business at all times. Both sets of books are audited annually. Audits are quickly and efficiently completed. The records are generally kept by one staff member, but are reviewed by two others, with the principal taking an oversight role. The view taken by the principal is that the system works well, is clear, easy to track, keeps track of all individual contracts, and has a clear document and audit trail.

Class discussion points 1 In large organisations bills are o#en batched up and processed, using batch totals as a kind of control. Is this any different from keeping invoices together for a week and then processing them? 2 A real estate business will not have a huge number of transactions. Can you identify other businesses, for which the number of transactions are of a similar magnitude, that may find a system similar to that described in Real World 5.2 more than adequate for their purposes? 3 Even though this business is small, there are checks and balances built in. Identify them.

REAL WORLD 5.3 A small organisation using a cloud accounting system A small community health organisation in Central Queensland provides quality primary healthcare services to the local community. Patient numbers fluctuate around 3,000 annually, serviced by a staff of around 60, including both full-time and part-time. Their annual operating budget is in excess of $5 million. As the organisation is partly government-funded, it is subjected to an annual external financial statement audit covering all of its operations.

The accounting system is fully computerised using MYOB AccountRight in the cloud. The system uses a number of modules including Accounts, Banking, Sales, Purchases and Payroll, which follow most of the basic principles identified in this chapter. The chart of accounts is based on the MYOB generic coding, which has been tailored to better suit the organisation’s activities. The general ledger is coded using the MYOB numbering system: 1-XXXX numbers for assets,

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2-XXXX numbers for liabilities, 3-XXXX numbers for equity, 4-XXXX for income and 6-XXX for expenses. It does not use the 5-XXXX numbers for cost of sales, as it is predominantly a service entity. The organisation operates a number of programs under the primary health banner, including a quit-smoking program, dental unit, a maternal unit, a playgroup unit and a chronic disease team, in addition to the general clinic. Each of these programs is a separate cost centre. They are coded in the MYOB system as ‘jobs’ using numerical four-digit coding. Currently there are around 10 identified ‘jobs’. It is easy to add new codes as appropriate or required. Every transaction entered into the MYOB cloud system requires both a general ledger code and a job code. The system will not allow a user to save a transaction otherwise. The payments module uses a system that is built on a purchase order. Almost everything paid needs to start with an order, with ordering capability being restricted to a small number of staff who have financial delegation approved by the Board of Directors. This is followed by receipt of an invoice, at which stage a process of authorisation and sign-off takes place by the Finance Manager and the Executive Manager. Anything that is not supported by an official order needs to be signed off by the Finance Manager and Executive Manager. Invoices are batched up and processed every two days. Payment of bills is normally by electronic credit transfer or BPAY (90%). Occasionally cheques will be drawn, but these are kept to a minimum. Income comes from a variety of sources, but mostly from government grants and self-generated Medicare billings. A dedicated Medicare Officer enters all doctor and dental billings from the medical information systems (Medical Director, PracSo" and Exact) and bills Medicare daily. Medicare pays these invoices by directly crediting one of the organisation’s bank accounts. Payroll is performed weekly and employees must use the electronic time clock to prove their working hours. The payroll administrator collects each employee’s time card once it has been signed off by the supervisors and approved by the Executive Manager. In the MYOB payroll module, detailed records are kept of the permanent information relating to every staff member in each employee’s card file. Staff are able to engage in salary sacrifice due to the organisation being a Public Benevolent Institution, which means it can access certain Fringe Benefits Tax concessions, which assists it in attracting quality employees. Payroll is processed in MYOB and automatically exported to the organisation’s bank account, which automatically distributes it by direct credit transfer to each employee’s nominated bank account (set up in their individual card file). Pay slips are sent by email directly from the MYOB linking to the Microso" Outlook

email program. The organisation pays PAYGW tax monthly through its IAS/BAS, which is lodged through the ATO online portal, and the employees’ annual PAYG Payment Summaries are also lodged electronically through this portal. Both IAS/ BAS and PAYG Payment Summaries are prepared directly from and within MYOB. This organisation has minimised the amount of actual cash flowing through the system. Cash outgoings are confined to three cash floats (clinic reception, dental and petty cash) totalling less than $500, using the petty cash imprest system outlined in this chapter. Cash receipts are backed up by the issue of official receipts, copies of which are kept as a source document and audited by the external auditors annually. Cash receipts are typically summarised and banked daily, with details going to the finance department. The journal is also used, as full accrual accounting statements are prepared every month. Adjusting entries include those for prepaid insurance (asset) and government grants received in advance (liability). Yearend audit journal entries are also used, being only input by the external auditors as required. The system will not permit a journal entry where the debits do not equal the credits. This does not completely eliminate the possibility of errors, but does prevent a number of common types of error. Bank reconciliations are performed weekly, using the live bank feed from the cloud and automated entries from the organisation’s multiple bank accounts. Bank accounts are kept for each separate source of income. Reports are prepared for the Finance Manager monthly in regard to Medicare commissions, banking and purchases. The Finance Manager reports to the Board of Directors monthly on the financial statements directly exported from MYOB, as well as program profits and losses, using the ‘Job Profit and Loss Statement’ in MYOB. The number of users of the MYOB cloud system is limited to six. However, each authorised user can access the file at any time, anywhere—at the time of writing, one finance staff member was based in Western Australia and another was working from home. Backups can be made manually and stored; however, the system remains in the cloud. The external auditors also have access to the MYOB file at any time, providing a third-party check. This organisation uses separation of duties as a large part of its internal control. It has a stringent payment authorisation system as per the Financial Delegations Instrument decided by the Board of Directors. This, in addition to the external audit, provide further controls over transactions. It has also largely eliminated cash transactions, reducing the potential for cash fraud.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

Class discussion points

263

1 Why do you think this small organisation has chosen to operate in the cloud?

3 Discuss any ssues the organisation may have had when first deciding to move its accounting system to the cloud (hint: it is a medical organisation).

2 Discuss the use of job numbers and why it is necessary to have a job number on every transaction entered (hint: think about the flow through to the Finance Manager’s report using the Job Profit and Loss Statement).

5 Discuss the processing of payroll in relation to the principles of a manual system.

4 In relation to internal control, what is the significance of having an external audit performed?

REAL WORLD 5.4

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An organisation using a fully computerised system This is a middle-range organisation involved in health, with a staff of around 450, both full-time and part-time, and an annual operating budget in excess of $30 million. It uses a chart of accounts, which acts as a means of effectively coding figures in as much detail as needed. In terms of cost-centre allocations, the code is alpha-numeric, consisting of one alpha character and four numbers. This enables a large number of cost centres to be identified and grouped as needed and useful. Currently there are around 100 identified cost centres. It is easy to add new codes as appropriate or required. On top of this, there are code numbers allocated by income and expenditure types. This enables figures to be analysed in many different ways, either on a regular basis or on an as-needs basis. The accounting system is fully computerised. The system uses a number of modules, which follow most of the basic principles identified in the chapter. The payments module uses a system that is built on an ordering routine. Almost everything paid needs to start with an order, with ordering capability being restricted to a relatively small number of senior people. This is followed by receipt of an invoice, at which stage a process of authorisation and sign-off takes place. Anything that is not supported by an official order needs to be signed off by the cost-centre head. Invoices are batched up and processed twice a month. Payment of bills is normally by credit transfer (90%). There is a facility for urgent payments, which can be made separately, and occasionally cheques can be drawn, but these are kept to a minimum. Income comes from a variety of sources, but mostly from government agencies. Other income (fees and charges) is built up from detailed records, which enable monthly bills to be prepared and issued. In many cases (e.g. residential aged care) income is collected via direct bank credit, rather than direct debit, as bills are fairly standard. In other cases,

notification of detailed time spent and work done is collected by the staff doing the work and then details are sent to the finance section. Wages can be quite complex in reality, although quickly glossed over in texts. In this organisation, there is a variety of modules which integrate to cover what is generally known as payroll. In the basic module, detailed records are kept of the permanent information relating to every staff member. On top of this there is a variety of detailed linking modules that cover things such as leave and pay history, allowances, long-service leave, award conditions, etc. Staff are required to check in and out every shi". A range of managers are assigned responsibility for specified staff and have to sign off on the figures that result. A pay run occurs every fortnight. Pay is by direct credit transfer. Pay slips are sent by email. This organisation has minimised the amount of actual cash flowing through the system. Cash outgoings are confined to several petty cash floats, totalling less than $1,000, using the kind of approach outlined in this chapter. Cash receipts are backed up by the issue of official receipts, copies of which are kept as source documents. Cash receipts are typically summarised and banked daily, with details going to the finance department. The journal is used regularly as full accrual accounting statements are prepared every month. This requires all closing adjustments (e.g. prepayments and accruals) to be journalised. Some journal entries can be very long and complex. In inputting a journal entry, the system will not permit an entry where the debits do not equal the credits. This does not completely eliminate the possibility of errors, but does prevent a number of common types of error. The organisation uses the control account and reconciliation concepts, although in a slightly different way from that discussed in this chapter. Because the system is computerised, it is easy to produce a range of reports (o"en

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Class discussion points 1 Does the number of cost centres surprise you? 2 Discuss the batching of invoices and compare this with a traditional purchases journal. 3 Discuss the way in which actual cash is handled in this organisation. 4 Compare the systems outlined above with the traditional manual system. What are the main advantages of a computerised system of this type? 5 Discuss the extent to which the system described is grounded in the same principles as those of a manual system.

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spreadsheets), which act effectively as control accounts or reconciliations. An example is the ‘Salary and Wages Clearing Account’, which acts as a wages control account in the form of a trial balance. Other reports include a debtors’ trial balance, creditors’ trial balance and a cash at bank reconciliation. Overall, this organisation displays good internal control in a variety of ways. It has largely eliminated cash transactions, thus reducing the potential for cash fraud. It has developed systems which enable a variety of reports to be produced on either a regular basis or an as-needed basis. The system facilitates reconciliation of every item in the balance sheet. The possibility of arithmetic errors is just about zero.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

SUMMARY

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In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Identify the main elements of internal control and explain the need for sound internal control in accounting systems

• • • • • •

LO2: Explain why in a typical manual system the ledger needs to be split up, identify common ways of doing this, and outline the purpose and structure of a traditional manual system of subsidiary records

• Identified practical problems with ledger accounts • Identified possible ways of subdividing the ledger • Outlined a typical manual system of subsidiary records

LO3: Explain the nature and role of sales and purchases journals and show how they are used in posting figures to the accounts in a traditional manual system

• • • •

Outlined the principles behind sales and purchases journals Illustrated how simple sales and purchases books work Explained the advantages of use of analysis columns Showed how information is posted to the accounts

LO4: Explain the nature and role of the cash book and cash journals and show how they are used in posting figures to the accounts in a traditional manual system

• • • •

Described the cash book, including two- and three-column formats Explained the role of cash journals, including analysis journals Explained and illustrated the use of the imprest system for petty cash Showed how information is posted to the accounts

LO5: Explain the nature and role of the journal and show how they are used in posting figures to the accounts

• Explained and illustrated the use and form of the journal • Showed how postings are made to the accounts • Identified typical errors and ways of correcting them

LO6: Explain the importance of control accounts and reconciliations, and prepare control accounts for debtors and creditors and a bank reconciliation

• Explained and illustrated the role of control accounts • Explained the need to reconcile various figures in the business • Explained and illustrated the preparation of a bank reconciliation statement

LO7: Explain the major elements of computerised accounting systems and explain how these systems still use the same basic principles of accounting and internal control used by a manual system, but that they deal with large volumes of transactions more effectively, and can be linked with appropriate documentation or file production and maintenance

• Outlined the main elements of a computerised accounting system • Discussed the implications of cloud computing on accounting • Illustrated by way of Real World examples how accounting systems in practice can vary from basic manual systems through to sophisticated computer systems which facilitate detailed reporting and analysis • Reinforced throughout that the underlying basic principles are the same for manual and computerised systems, though computerised systems are better able to deal with higher volumes, provide better documentation, and are flexible enough to do much more than the basic manual system

Defined internal control Identified the main features of internal control in practice Identified issues with internal control and e-commerce Explained why internal control sometimes doesn’t work Used an Accounting and You to identify ways of avoiding being defrauded Illustrated how internal control might operate in a functional area of business (i.e. purchasing)

DISCUSSION QUESTIONS EASY 5.1

LO1

Identify the components of internal control, as defined by the Treadway Commission. Compare these components with the definition of internal control given in businessdictionary.com.

5.2

LO1

Discuss the role of the trial balance in internal control.

5.3

LO1

List as many approaches as you can that contribute to internal control.

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5.4

LO2

Why does the ledger need to be split up, and what are the main ways of doing this?

5.5

LO3

Explain the basic idea behind a purchases book or journal.

INTERMEDIATE 5.6

LO1

Discuss segregation of duties as an internal control device.

5.7

LO1

What do you think are the critical elements of good records maintenance?

5.8

LO1

Identify some physical safeguards commonly found in internal control systems.

5.9

LO1

How might the use of standardised documents help internal control?

5.10 LO1

Discuss the importance of a good staff profile to internal control.

5.11 LO1

Identify and discuss the main internal control issues that arise with e-commerce.

5.12 LO1

Why do internal control systems break down?

5.13 LO4

What are the main reasons for the development of analysis books?

5.14 LO4

Explain the reasons for use of an imprest system of petty cash.

5.15 LO5

Provide examples of transactions that might appear in a general journal.

5.16 LO6

Explain the rationale for control accounts.

5.17 LO1

Why is pre-numbering of receipts an important part of internal control relating to cash receipts?

5.18 LO1

What do you understand by the term ‘asset register’? What is its purpose? How often might it be checked?

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CHALLENGING 5.19 LO6

Discuss the notion that, as more and more transactions are carried out by direct bank transfer, the bank reconciliation is dead.

5.20 LO1/6

Are you one of the many people who never require a receipt in relation to purchases using a credit card? If so, how are you able to keep track of your financial positon?

5.21 LO7

Discuss what might be the critical components in broad terms of a system for purchasing goods, and then paying creditors, using a computerised accounting system.

5.22 LO7

Discuss the link between the recording process and the production of documents used in the business process when using a computerised accounting system.

5.23 LO1/3

Why is it important that the responsibility for ordering goods is held by someone other than the person who is responsible for paying bills?

5.24 LO1/3

Why is it important that those people making the sale are not also responsible for despatch of the goods sold and receipt of cash?

5.25 LO1/3

In devising a purchasing system, how might you prevent payment of fictitious invoices?

5.26 LO7

What do you understand by cloud accounting? What are the implications for accounting systems?

5.27 LO1/7

What kind of physical, mechanical or electronic controls have you experienced in dealing with businesses to date?

APPLICATION EXERCISES EASY 5.1

LO2

Using the ledger division suggested in the chapter, identify the ledger in which each of the following accounts would be kept.

(a) Premises (b) Accumulated depreciation—vehicles (c) Sales Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

(d) Purchases (e) Bad debts (f) Doubtful debts provision (g) Wages (h) G. Austin (a creditor) (i) M. Holmes (a debtor) (j) Drawings (k) Capital (l) Loans (m) Discount received 5.2

LO3

Draw up a sales book and a sales returns book for the following transactions, and show where the figures contained therein would be posted. (a) (b) (c) (d) (e) (f) (g) (h) (i)

5.3

LO4

January 1 January 1 January 2 January 2 January 3 January 3 January 4 January 5 January 6

LO4

$500 $1,000 $400 $100 $750 $450 $150 $900 $750

Record the following transactions in a three-column cash book. February 1 February 2 February 3 February 4 February 5

5.4

Credit sales to D. Duck Credit sales to M. Mouse Credit sales to P. Luto Credit note issued to D. Duck Credit sales to W. Disney Credit sales to W. Coyote Credit note issued to W. Disney Credit sales to R. Runner Credit sales to W. Disney

Cash in hand $500, cash at bank $25,000 Receives cash of $50 from G. Knott in settlement of a debt of $55 Receives a cheque for $350 from A. Veck in settlement of a debt of $365 Pays a cheque of $380 to S. Bastion in satisfaction of a debt of $400 Pays cash of $25 for stamps

Write up a cash payments journal and indicate the postings you would make to the ledger accounts, for the following transactions. March 1

Payments to creditors—A. Knott $190 in satisfaction of a debt of $200 —B. Stone $550 in satisfaction of a debt of $575

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—C. Bird $245 in satisfaction of a debt of $255 March 3

Paid rent of $900

March 4

Paid wages of $1,250

March 5

Paid miscellaneous expenses $400

March 8

Paid electricity $500

March 11

Paid wages $1,250

March 13

Paid fuel $150

March 15

Payments to creditors—D. Liver $175 in satisfaction of a debt of $185

March 18

Paid wages $1,350

March 25

Paid wages $1,300

March 27

Paid fuel $200

—B. Stone $500 in satisfaction of a debt of $525

5.5

LO5

B. Quick opens his business with the following assets and liabilities: Premises $500,000; Equipment $150,000; Fixtures $50,000; Inventory $100,000; Cash $45,000; Receivables—J. McCool $10,000, P. Gover $8,000; Payables—A. Hardy $20,000. Journalise the opening entry.

INTERMEDIATE 5.6

LO4

A business operates a petty cash system using the imprest system with an allocation of $1,000. The opening balance is $1,000. During October the following transactions were completed through the petty cash account.

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ACCOUNTING FOR BUSINESS STUDENTS

October 1

Bus fares claimed

$25

October 3

Stationery

$50

October 5

Stamps

$50

October 6

Office supplies

$85

October 7

Trade magazine

$15

October 9

Registered post

$12

October 11

Newspapers

October 13

Copy paper and print cartridges

October 15

Parcel postage

$30

October 16

Stationery

$50

October 18

Stamps

$50

October 20

Bus fares claimed

$25

October 22

Magazines

$35

October 23

Office supplies

October 25

Repair of office equipment

October 28

Postage

$60

October 30

Stamps

$40

$7 $120

$95 $150

Complete the petty cash book from these transactions. Are there payments made that ought not to have occurred in normal circumstances? 5.7

LO3/4

David is responsible for entries in the nominal ledger of a business. Jonathan is responsible for the sales (debtors) ledger.

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A sales book is kept in which the total for each sales invoice is recorded, along with the name of the customer. Jonathan and David complete their records on Monday and Tuesday respectively, on which days they have access to the sales book of the previous week. James is the cashier of the business. He receives cash and cheques, and records these in the cash receipts journal. (a) What recordings will David make in his ledger? (b) If the sales book were incorrectly totalled, and overstated by $1,000, what would be the impact of this error when a trial balance was drawn up? (c) If James collected cash from a customer and put it in his pocket without recording it in the cash book, what is Jonathan likely to do as a result? (d) If you were in charge of the business, would you give James authority to write off bad debts? Why/why not? (e) Assume that Jonathan was given authority to write off bad debts, how could he contrive to embezzle funds from the business? (f) Would you give Jonathan and James authority to write off bad debts given their current responsibilities? Why/why not? 5.8

LO1

Identify ways in which the recording process can use principles of internal control, relating to: (a) (b) (c) (d)

5.9

LO3–5

recording of transactions separation of roles and responsibilities within the accounting function separation of custody of assets and accounting for assets authorisation of transactions.

Assume that a business uses the subsidiary records described in this chapter. It also keeps a sales (debtors) ledger control account. At the start of a period it has a debit balance on this account of $250,000. During the next month, the totals on the various subsidiary records are as shown below: Sales book

$350,000

Cash receipts journal—sales ledger column

$325,000

Cash receipts journal—discount allowed column

$15,000

Sales returns book

$20,000

Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

Also, a journal entry writing off bad debts for the month was made, totalling $8,000. (a) Record these transactions in the control account. (b) Explain the purpose of a control account of this type, and also how the process of reconciliation with the individual debtor records will be carried out. 5.10 LO6

The bookkeeper responsible for maintaining the individual records of creditors relating to purchases prepared a schedule of the balances of individual supplier’s accounts at the end of April. This was drawn up from information in the creditors ledger. The balance was $883,660. He then passed this over to the accountant who was responsible for keeping the creditors ledger control account, for checking and reconciliation. The creditors control account was as shown below: Creditors control account April 30

$5,100

April 1

30

Cash

Purchases returns

900,000

30

Purchases

Balance b/d

30

Balance c/d

884,900

30

Discount received

30

Debtors ledger control contra

1,790,000 April 30

Balance b/d

$825,000 925,000 35,000 5,000 1,790,000

884,900

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In examining the discrepancy, a number of errors were found in both the control account and the individual accounts. You may assume that the totals posted to the control account are correct, other than when listed below: 1

One supplier had been paid $30 from Petty Cash. This had been correctly posted to his personal account, but had been left out of the control account.

2

Goods which had cost $400 had been returned, but this transaction had been omitted from the purchases returns book.

3

Discounts received amounting to $50 and $30 had been posted to the wrong side of the individual creditor accounts.

4

One balance, amounting to $1,000, had been completely omitted from the schedule.

5

A credit balance on one account amounting to $969 had been transposed in the schedule to $699.

6

The credit side of one account had been under calculated by $100. (a) Prepare a statement starting with the original closing balance on the control account, identifying and correcting the errors in the account, and concluding with an amended closing balance. (b) Prepare a statement starting with the original total of the schedule of individual creditors, then identify and correct errors in the schedule, concluding with an amended total.

5.11 LO6

You are a fairly careful person who likes to keep tabs on the balance in your bank account. You try to keep a diary, which acts as your equivalent of a ledger account. This shows the following for the month of August: Balance at the start of the month Plus wages paid in

5,000 6,000 11,000

Less Withdrawals via ATM

(1,000)

Payment of last month’s credit card

(2,400)

Direct debits World vision sponsorship

(96)

Health insurance

(400)

House insurance

(200)

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ACCOUNTING FOR BUSINESS STUDENTS

Mortgage

(1,000)

Cheques Rates—cheque number 1001

(150)

Electricity 1002

(200)

Repairs 1003

(100)

New equipment 1004

(450) 5,996 5,004

Balance at end of month Your bank statement showed the following Date

Particulars

August 1

Brought forward

August 6

Withdrawal

Debit

Credit

Balance 5,000 Cr

500

4,500 Cr

August 8

A 56667889 World Vision

August 8

Proceeds of overseas inward transfer

96

4,404 Cr

August 9

Internet transfer July card

August 12

1867888 Pay from xxx

August 13

006754321 Medibank Private

420

5,484 Cr

August 14

0158576 Allianz

200

5,284 Cr

1,000 2,500

5,404 Cr 2,904 Cr

3,000

5,904 Cr

August 20

Withdrawal

500

4,784 Cr

August 21

1001

150

4,634 Cr

August 22

1002

200

4,434 Cr

August 26

1867888 Pay from xxx

August 28

444567 Mortgage payment

August 29

P886543 Pearson Aust

August 31

1345678 McAre Benefits

August 31

002299690n5 TKLS Itm Div

3,400 990

7,834 Cr 6,844 Cr

2,500

9,344 Cr

35

9,379 Cr

500

9,879 Cr

You are pleasantly surprised by the size of the balance at the bank. Identify all of the differences between your diary record and the bank statement.

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5.12 LO4

Your business gives senior staff credit cards for use on specified purposes. Expenditure can be made on the card for fuel, accommodation, meals and entertaining up to a limit of $500 on any one transaction. You are expected to provide credit card slips and/or receipts where necessary and appropriate. Your credit card statement for February shows the following detail: Date processed

Date of transaction

Details

Amount

3/02/18

01/02/18

Narrandera Gas

$60.42

3/02/18

01/02/18

Jeans Motel Narrabri

110.00

4/02/18

01/02/18

Tenterfield Roadhouse

40.00

4/02/18

02/02/18

Beach Cafe Gold Coast

250.00

6/02/18

02/02/18

Golden View Motel Tweed Heads

120.00

8/02/18

03/02/18

Coffs Harbour Roadhouse

55.00

10/02/18

07/02/18

Lane Cove fuel

13/02/18

10/02/18

Rosie’s Restaurant Lane Cove

65.00

15/02/18

13/02/18

Gosford fuel

65.00

16/02/18

13/02/18

Roadhouse Raymond Terrace

40.00

300.00

15/02/18 Rosie’s Restaurant Lane Cove 350.00 Atrill, Peter, et al. Accounting for Business Students eBook,18/02/18 P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

20/02/18

18/02/18

Hornsby fuel

55.00

25/02/18

20/02/18

Newcastle fuel

40.00

27/02/18

23/02/18

Hornsby fuel

55.00

28/02/18

27/02/18

Newcastle eatery

45.00

(a) Identify the advantages of using credit cards for purchases of this type, with particular emphasis on internal control aspects. (b) Identify the disadvantages and dangers of their use. (c) Use the information from the statement to prepare a four-column analysis for the month that could be used for posting to the accounts. (This could be perceived as being an analysis cash payments journal of a particular type.) (d) How important is it that credit card slips and associated receipts are kept?

CHALLENGING 5.13 LO6

The trial balance of Gippsland Trading Co. includes the following items: Sales (debtors) ledger control account

$1,050,548

Purchases (creditors) ledger control account

$762,500

Suspense account (debit balance)

$39,100

You have been given the following information: 1 The sales (debtors) ledger account debit balances total $1,055,350, and the credit balances total $6,200. 2 The purchases ledger credit balances total $765,000, and the debit balances total $14,500. 3 The sales ledger includes a debit balance of $6,500 for Sale scenes, and the purchases ledger includes a credit balance of $8,000 relating to the same business. Only the net amount will eventually be paid. 4 An invoice of $3,400 has been entered in the purchases book as $4,300. 5 A cash receipt from a credit customer for $575 has been entered in the cash journal as $557. 6 The bank balance of $20,000 has been entered in the trial balance, in error, as an overdraft. 7 Included in the credit balance of the sales ledger is a balance of $6,000 in the name of R. Sage. This arose because a sales invoice for $6,000 had earlier been posted in error from the sales book to the debit of the account of R. Gaze in the purchases ledger. 8 An allowance of $5,000 against some goods damaged in transit had been omitted from the appropriate account in the sales ledger. This allowance had been included in the control account. 9 The purchases book had been overcast by $10,000.

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10 The bookkeeper had been instructed to write off $5,000 from customer George Teague’s account as a bad debt, and to reduce the provision for doubtful debts by $6,500. By mistake he had written off $6,500 from Teague’s account, and increased the provision for doubtful debts by $5,000. 11 The debit balance on the rent and rates account in the nominal ledger of $8,978 had been included in the trial balance as $9,878. Record corrections in the suspense account and control accounts. Try to reconcile the sales ledger control account with the sales ledger balances, and the purchases ledger control account with the purchases ledger balances. What further action do you recommend? N.B. Assume that the control accounts are part of the double entry and that the individual personal accounts of debtors and creditors are memorandum in nature. 5.14 LO6

The bank account for November of Mahendra Ltd, prepared by the bookkeeper, was as shown below: Bank account November

November

1

Balance b/d

5,440

2

Petty cash—cheque number 1005

400

3

MacLaney and Co

250

3

Pete’s supplies 1006

200

3

Nettleton & Co

100

6

Burford and Co 1007

50

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ACCOUNTING FOR BUSINESS STUDENTS

3

Cash sales

4,000

8

Wiggs and Cater 1008

400

Messengers storage 1009

100

10

Mahlers mysteries

700

9

14

Wagners storm

600

11

Oscars 1010

20

Gas rebate (direct credit transfer)

200

12

Office agencies 1011

280

23

Jeffs Garage

900

14

Vehicle repairs 1012

50

29

Cash sales

4,500

14

Alltoffs Hotel 1013

140

30

Balance c/d

14

Wages cash 1014

2,000

18

Shire council rates (standing order)

1,500

19

Electricity company (direct debit)

400

20

Gas agency (direct debit)

450

28

Petty cash 1015

450

28

Wages cash 1016

2,000

30

Balance c/d

8,180

______

90

16,690 Dec 1

Balance b/d

16,690

8,180

In early December the bank sent a statement covering November, which is set out below: Date

Particulars

Debit

Credit

Balance

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November 1

Balance b/d

2

Cheque 1002

500

1,890 Cr

2,390 Cr

Cheque 1003

90

1,800 Cr

Cheque 1004

150

1,650 Cr

3

Credits

7

Cheque 1005

400

4,350

5,600 Cr

6,000 Cr

14

Cheque 1014

2,000

3,600 Cr

15

Cheque 1007

50

3,550 Cr

16

Cheque 1006

200

3,350 Cr

16

Credit transfer

17

Credits

17

Cheque 1007

20

Standing order

200 1,200

3,550 Cr 4,750 Cr

50

4,700 Cr

1,500

3,200 Cr

20

Direct debit

450

2,750 Cr

21

Cheque 1009

100

2,650 Cr

22

134567

1,200

1,450 Cr

22

Cheque 1011

280

1,170 Cr

22

Cheque 1010

90

1,080 Cr

22

Credits

23

134567

900

1,980 Cr

1,200

3,180 Cr

20

3,200 Cr

28

Interest

28

Cheque 1016

2,000

5,200 Cr

28

Cheque 1013

140

5,060 Cr

28

Direct debit

450

29

Credits

4,610 Cr 4,500

9,110 Cr

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

30

Charges

100

30

Adjustment cheque 1007

30

Cheque 1015

30

Internet transfer credit card

9,010 Cr 50

9,060 Cr

450

8,610 Cr

1,000

7,610 Cr

(a) Explain the items in the bank statement. (b) Reconcile the bank account balances in the ledgers with the balance according to the bank statement. You will need to cross-check the entries carefully in order to reconcile the bank account. 5.15 LO6

The subsidiary records of your business consist of the following: Sales book Sales returns book Purchases book Purchases returns book Cash receipts journal Cash payments journal Journal. Postings are made monthly, using totals wherever possible. Control accounts are kept for the sales ledger and the purchases ledger. At the end of each month the balances on the individual debtor and creditor accounts are add listed and compared with the relevant control account balance. The lists below show the balance on the control account and the total of the add list. They do not agree. Subsequent investigation reveals the following:

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(a) A purchase of goods from J. Smith amounting to $450 had been correctly recorded in the purchases book, but had been debited to his account. (b) A payment to P. Brown of $500 had been debited to P. Bron. (c) In entering the sales book, a credit note for $150 had been included (as an invoice) with a batch of invoices. It related to goods returned by D. Lowe. The credit note will be processed in the next month. (d) $400 paid to B. Giddings for purchases had been debited to his account. (e) The purchases book had been overcast by $1,000. (f) The sale of goods to G. Templeton had been correctly recorded in the sales book at $750, but had been debited to his account as $570. (g) Discount allowed of $50 to G. Dean had been debited to his account. (h) The add list for debtors was found to be $900 short. (i) Sales of $950 to T. Dance had been correctly recorded in the sales book, but posted as $590 to his account. (j) The total of the purchases returns book ($1,500) had been debited to the sales returns account, and credited to the debtors control account. The detailed postings to the creditors accounts had been made correctly. Complete the statements below, where appropriate, showing the appropriate adjustments to the control accounts or the add lists of personal accounts to ensure that agreement is reached. Debtors Control account Balance

Add list of personal accounts

$

$

73,650

73,810

a) b) Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING FOR BUSINESS STUDENTS

c) d) e) f) g) h) i) j)

_________

_________

_________

_________

Adjusted balance Creditors Control account Balance

Add list of personal accounts

$

$

47,500

43,300

_________

_________

_________

_________

a) b) c) d) e) f) g) h) i)

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j)

Adjusted balance 5.16 LO1

Identify ways in which physical controls can be used to ensure security and safety of staff and assets.

5.17 LO1

List any potential security issues that you can see with e-commerce and identify possible ways of dealing with them.

5.18 LO1/3/4

How might you devise a sales system and related cash receipts so as to minimise scope for abuse? Using Table 5.1 as a guide, indicate what kind of documents might be needed and identify as many internal control features as you can.

5.19 LO1/4/5

Using Table 5.1 as a guide, identify the main features of a payroll system and the kind of internal controls you think would be useful.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

CHAPTER 5 CASE STUDY Find a friend or relative (or the relative of a friend) who is involved in a managerial or ownership role in a business. Try to ascertain the following relating to the business: 1 What is the size and nature of the business? 2 How are the transactions dealt with in terms of subsidiary records? 3 How does the information collected get posted to the ledger? 4 What parts of the accounting process use computerised systems? 5 What is the nature of the computerisation (i.e. spreadsheets, accounting package, dedicated system)?

6 What terms are used for the various parts of the process? Do these mirror the terms used in a manual system? 7 What part of the process is manual? 8 What reports are provided? 9 What documents are provided as part of the accounting system? 10 What kind of databases (detailed files) are kept, and how are they used? Specifically, what detail is kept relating to such things as inventory, wages, debtors and creditors? 11 Are there many special reports prepared (e.g. to assist in planning)? 12 How useful does management find the reports produced?

Concept check answers CC1 CC2 CC3 CC4 CC5

B D A A E

CC6 CC7 CC8 CC9 CC10

B C C D D

Remember expenses such as depreciation and bad debts CC11 C CC12 B

CC13 CC14 CC15 CC16 CC17

A D C E B

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SOLUTIONS TO ACTIVITIES ACTIVITY 5.1 (a) To ensure clarity regarding who does what. Separation of duties is likely to mean that collusion would be necessary to commit fraud. (b) Uncontrolled authorisation of expenditure is likely to facilitate waste, extravagance and cheating. (c) A cashier with access to both cash and the records would mean that cheating and fraud would be easy. (d) If staff are involved in anything wrong, this is likely to be identified when they are on leave. The requirement that staff take leave should be applied across the organisation. (e) Staff may have interests in both the organisation in which they work, and in outside organisations (e.g. suppliers). Sometimes these conflict, and clear policies regarding conflict of interest are needed to deal with this. (f) An inventory of assets owned is effectively a listing of these assets. Such an inventory is needed to ensure that the organisation knows what it owns and whether the assets are still held. It is quite common for assets of a certain type to ‘disappear’, and it is important that there is both a record of ownership and some means of identification when an investigation occurs. (g) Without good staff training, the probability of error and staff disengagement is high. (h) An audit is a check on a system, with an aim of checking that the system works and, if failures are found, identifying the errors occurring and possible ways of improving the system. (i) Backup copies, physical security, limited access.

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 5.2 (a) The sheer volume of transactions will mean that a simple double-entry system will not be able to cope, so ways of dealing with large volumes of transactions need to be found. The main way in which this is done is by use of barcodes, which are put on everything in the supermarket, including the things that are not prepacked, such as purchases from the deli. At the checkout the barcodes are scanned. The codes typically enable detailed records to be kept. The checkout process usually takes a relatively short time. Problems usually occur when the barcode is not clear or has been lost. The barcodes enable detailed inventory/stock records to be maintained, together with production of sales and profit reports. (b) i. Sales (debtors) ledger ii. Nominal ledger iii. Nominal ledger iv. General ledger v. Purchases (creditors) ledger (c) Individual debtor or creditor accounts are typically kept in a computer file. The cash book is often computerised, with very few transactions occurring in actual cash. (d) Barcodes are very important, as indicated above in section (a). Most retail businesses use barcodes extensively. (e) By separating roles, by summarising and using totals as doublechecks, by formalising the system of original entry so that the systems are clear and easy to follow, and by dealing (by use of the journal) with complex adjustments.

ACTIVITY 5.3 (a) To record the ‘sales’ (i.e. patients seen by an audiologist) clients relating to sales or letting for a real estate agent. For an audiologist, this might be in the form of a day book, but with considerable supporting detail, enabling invoices to be prepared based on the detail contained in this preliminary record. For a real estate agent, it is more likely that the day book would have a particular form, reflecting the ongoing needs related to a contract for sale. Different records would probably be developed to deal with contracts relating to lettings. (b)

Purchases book (1) January 1

L. Howard

PL30

500

January 1

R. Sage

PL50

350

January 2

C. Johnson

PL40

750

January 2

M. Dewar

PL20

600

January 3

R. Sage

PL50

400 2,600

NL5

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Purchases returns book (1) January 3

C. Johnson

PL40

200

January 3

R. Sage

PL50

100

NL6

300

Purchases ledger (Creditors/payables) M. Dewar January 2 Purchases

PB1

600

January 1 Purchases

PB1

500

January 2 Purchases

PB1

750

L. Howard C. Johnson January 3

Purchases returns

January 3

Balance c/d

PBR1

200 550 750

750 January 3 Balance

b/d

550

R. Sage January 3

Purchases returns

PBR1

100

January 1 Purchases

PB1

350

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January 3

Balance c/d

250

____

350

350 January 3 Balance

b/d

250

Nominal ledger Purchases January 3

Creditors/payables

PB1

2,600 Purchases returns January 3 Creditors/ payables

(c)

PRB 1

300

No.

ACTIVITY 5.4 (a) All we need to do is post the totals of any analysis columns, rather than all of the items in each column. (b) The use of cash journals enables us to post totals rather than individual figures, which acts as a check on the individual amounts. Cash books and cash journals would be prepared by someone who is responsible for the cash receipting and recording. The cashier would not have any responsibility for authorising any expenditure. (c) It would be unusual for a large amount ($150 for copy repair) to be paid for out of petty cash. This would normally be paid as part of a normal creditors payments run. (d) ii

ACTIVITY 5.5 (a) October 19 Vehicles Creditors—BMW Beauties

GL 45

70,000

GL 55

70,000

Being the purchase from BMW Beauties of BMW 5 series, registration number 1BM 3W Note that the creditor is not a trade creditor so would typically be dealt with through the journal, rather than through the purchases book. (b) (i) is an error of commission and (ii) is an error of principle (c) (i) is a compensating error (ii) is an error in the subsidiary book (iii) is a reversal of entries Date

Detail Discount received

Folio

Debit (Dr)

Credit (Cr)

1,000

Purchases

1,000

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Being correction of misposting Overcasting of purchases book by $1,000 Misposting of discount received from cash journal Sales

30

F. Woody

30

Being correction of total of sales book by $30 (see sales book 31/3) K. Waterhouse

900

Cash

900

Being correction of posting—complete reversal of entries (d) All of these kinds of errors are possible in a manual system, though probably errors of commission, errors of principle and errors in the subsidiary record are more likely than the others. In all of these types of error the likelihood of occurrence is much lower (and sometimes impossible) with a computerised system.

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 5.6 (a)

Sales ledger control account June 1

Balance b/d

525,000

June 1

Balance b/d

2,000

Customers’ cheques dishonoured

2,000

Refunds to customers

10,000

Receipts from customers

4,000,000

3,950,000

Allowances to customers

80,000

Sales on credit

Contra settlements June 30

Balance c/d

June 30

Balance b/d

1,800

June 30

Balance c/d

June 30

Balance b/d

4,488,800 404,300

2,500 404,300 4,488,800 1,800

Purchases ledger control account June 1

Balance b/d Allowances and rebates Discount received Payment to creditors Contra settlements

June 30

Balance c/d

1,200

June 1

Balance b/d

June 30

Balance c/d

150,000 50,000

Purchases on credit

(b)

Balance b/d

2,300,000 2,500

2,150,000 2,500 200,800 2,554,500

June 30

252,000

2,500

2,554,500 June 30

Balance b/d

200,800

Bank reconciliation statement Balance according to the cash account

35,000

Adjust for items in bank statement not shown in the accounts Bank charges Interest

(100) 10

Adjust for mispostings Correction of misposting b. Correction of misposting c. Adjusted cash balance in the accounts Less unpresented cheques received

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Less cash not yet banked

360 36 35,306 (1,500) (250) 33,556

Plus cheques paid but not yet presented

1,800

Bank balance as per the bank statement

35,356

ACTIVITY 5.7 (a) Information will need to be of two main types—permanent (relatively) and temporary. Permanent information will relate to personal information such as name, address, grade, whether full-time or casual, tax code, rates of pay, award conditions, holidays entitled to, cumulative pay to date, superannuation and such like. The temporary information is likely to relate to hours worked, special conditions, one-off payments, leave taken, etc. The temporary information, when linked with the permanent information, should enable the regular pay to be made and also ensure that this is added to the permanent information. (b) Sales and sales growth, costs and cost growth, profitability trends, wages and wages growth, energy costs, expense trends, non-current asset needs and growth, inventory costs and trends and such like. (c) A well-developed computerised system should facilitate an array of reports, as evidenced in Real World 5.4.

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CHAPTER 5 ACCOUNTING SYSTEMS AND INTERNAL CONTROL

However, just because something can be produced does not mean that it is sensible to produce it. Information overload is a well-acknowledged potential problem. The key is to know your business well enough to be able to establish just what information is of most use to you, and produce this information. Needs may change, but if you are on top of your business you will probably be able to identify gaps and fill them. (d) This is an interesting point. It may reduce the need to be on top of the technical recording side of the business, but other than that there is no reason to suppose that it reduces the required accounting knowledge of users. (e) The chart of accounts should be prepared in a way that facilitates production of information and reports in ways that have been identified by the user. The chart of accounts and the coding system in a computerised accounting system are two sides of the same coin and are fully integrated.

ACTIVITY 5.8 No solution is necessary for this activity as it involves trialling a real-life MYOB product. All relevant training is provided free by MYOB.

ACTIVITY 5.9 (a) The chart of accounts so far, as illustrated in this example, is as follows: INCOME 1-1 Interest income 1-2 Income—salary and wages EXPENSES 2-1 Private health insurance expense 2-2 Income protection insurance expense 2-3 Telephone expense (mobile) 2-4 Vehicle expense (registration) 2-5 Expense (donations/gifts) 2-6 General living expenses (food, fuel)

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(b) You could change the level of detail for 1-2 Income—salary and wages by having two sub-accounts, one for the pays from ABC and the other for the pays from XYZ. You would do this so that you could see how much you earn from each employer. You could also change the level of detail for 2-1 Private health insurance expense and 2-2 Income protection insurance expense, by consolidating both into one account called 2-1 Insurance expenses. You might do this so that you can see the overall amount spent on insurances in general. You could also change the level of detail for 2-6 General living expenses by splitting each category (e.g. food, fuel, etc.). You might want to do this so that you can see exactly how much you are spending on each item. (c) The profit and loss statement shows that you should have savings for the month of January! The ‘profit’ amount should be showing as a cash saving in your bank account at the end of the month of January. You could use this amount towards asset purchases, or simply save your cash in the bank.

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C H A P T E R X6

INTRODUCTION CHAPTER TO LIMITED NAME COMPANIES LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Identify and discuss the main features of companies LO2 Explain equity and borrowings in a company context LO3 Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

LO4 Explain and discuss the main financial statements prepared by a limited company LO5 Explain the concept of group or consolidated accounts.

Most businesses in Australia and New Zealand, including some of the very smallest, operate in the form of limited companies, and they account for the majority of business activity and employment. The economic significance of this type of business is not confined to Australasia; it can be seen in most of the world’s developed countries and in many developing countries. In this chapter we consider the nature of limited companies and how they differ from sole proprietorship businesses and partnerships. This expands the brief discussion of various business forms in Chapter 1. We examine the ways in which the owners provide finance, and outline the type of borrowings that companies can engage in, and then explain the constraints imposed on limited companies regarding distributions and reductions in capital.

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We shall also see how the basic financial statements are prepared for this type of business. The particular formats required by the regulators will be dealt with in Chapter 7. Finally, we provide an outline of the reasons why, and the way in which, a group of companies needs to prepare a set of consolidated accounts.

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

THE MAIN FEATURES OF COMPANIES There is a wide range of company types, but the most common in Australia is the company limited by share capital. In this book we will largely restrict our focus to this entity structure. A limited company may be owned by just one person, but most have more than one owner and some have many owners. The owners are usually known as members or shareholders. The ownership of a company is normally divided into a number, frequently a large number, of shares, each of equal size. Each owner, or shareholder, owns one or more shares in the company. Limited companies have a number of distinguishing features, which are dealt with below.

LO1 Identify and discuss the main features of companies

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Legal nature A limited company has the legal capacity of a person and has a separate legal status from those who own the entity (the shareholders). Thus, a company is able to enter into contracts with external parties (buy, sell, borrow, lend, employ, sue, be sued) in its own right. This means that the company assets are owned by the company in its own right as a legal person. This contrasts sharply with other types of businesses, such as sole proprietorships and partnerships (i.e. unincorporated businesses), where it is the owner(s) rather than the business who must sue, enter into contracts and so on, because the business has no separate legal identity. An Australian company comes into existence as a ‘body corporate’ when it is registered under the Corporations Act 2001 and is issued a certificate of registration. Since a limited company has its own legal identity, it is regarded as being quite separate from those who own and manage it. It is worth emphasising that this legal separateness of owners and the company has absolutely no connection with the business entity convention of accounting, which we discussed in Chapter 2. This accounting convention applies equally well to all business types, including sole proprietorships and partnerships where there is certainly no legal distinction between the owner(s) and the business. Another consequence of the legal separation of the limited company from its owners is that companies must be accountable to the tax authorities for tax on their profits and gains. This leads to the reporting of tax in the financial statements of limited companies. The charge for tax is shown in the income statement (the profit and loss account). The tax charge for a particular year is based on that year’s profit. Any tax due but unpaid will also appear in the end-of-year statement of financial position (the balance sheet) as a current liability. The tax position of companies contrasts with that of sole proprietorships and partnerships, where tax is levied not on the business but on the owner(s). Thus tax does not impact on the financial statements of unincorporated businesses, but is an individual matter between the owner(s) and the tax authorities. Companies are charged income tax on their profits and gains. The rate of tax is levied on the company’s taxable profit, which is not necessarily the same as the profit shown on the income statement. This is because tax law does not, in every respect, follow the normal accounting rules. Generally, however, the taxable profit and the company’s accounting profit are usually pretty close to one another. There can be tax advantages to trading as a limited company rather than as a sole proprietor or a partner. This may partly explain the rise in popularity of private limited companies over recent years.

income tax An amount levied on income, which is payable to the government.

Unlimited (perpetual) life A company is normally granted a perpetual existence, which means it will continue even where an owner of some, or even all, of the shares in the company dies. The shares of the deceased person will simply pass to the beneficiary of his or her estate. The granting of perpetual existence means that the life of a company is quite separate from the lives of those individuals who own or manage it. It is not, therefore, affected by changes in ownership that arise when individuals buy and sell shares in the company. Although a company may be granted a perpetual existence when it is first formed, it is possible for either the shareholders or the courts to bring this existence to an end. When this is done, the assets of the company are usually sold to generate cash to meet the outstanding liabilities. Any surplus arising after all liabilities have been met will then be used to pay the shareholders. Shareholders may agree to end the life of a company where it has achieved the purpose for which

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voluntary liquidation A situation in which a business is closed on a voluntary basis.

it was formed or where they feel that the company has no real future. The courts may bring the life of a company to an end where creditors have applied to the courts for this to be done because they have not been paid amounts owing. Where shareholders agree to end the life of a company, it is referred to as a voluntary liquidation.

Limited liability Since the company is a legal person in its own right, it must take responsibility for its own debts and losses. This means that once the shareholders have paid what they have agreed to pay for the shares, their obligation to the company, and to the company’s creditors, is satisfied. Thus shareholders can limit their losses to the amount that they have paid, or agreed to pay, for their shares. This is of great practical importance to potential shareholders, since they know that what they can lose, as part-owners of the business, is limited. Contrast this with the position of sole proprietors or partners. They cannot ‘ring-fence’ assets that they do not want to put into the business. If a sole proprietorship or a partnership business finds itself in a position where liabilities exceed the business assets, the law gives unsatisfied creditors the right to demand payment out of what the sole proprietor or partner may have regarded as ‘nonbusiness’ assets. Thus the sole proprietor or partner could lose everything—house, car, the lot. This is because the law sees Jill, the sole proprietor, as being the same as Jill, the private individual. The shareholder, by contrast, can lose only the amount committed to that company. Legally, the business operating as a limited company, in which Jack owns shares, is not the same as Jack himself. This is true even if Jack were to own all of the shares in the company. Although limited liability has this advantage to the providers of equity finance (the shareholders), it is not necessarily to the advantage of all of the others who have a stake in the business. Limited liability is attractive to shareholders because they can, in effect, walk away from the unpaid debts of the company if their contribution has not been sufficient to meet those debts. This is likely to make any individual, or another business, wary of entering into a contract with a limited company. This can be a real problem for smaller, less established companies. Suppliers may insist on cash payment before delivery of goods or the rendering of a service. Alternatively, they may require a personal guarantee from a major shareholder that the debt will be paid before allowing trade credit. In the latter case, the supplier circumvents the company’s limited liability status by demanding the personal liability of an individual. Larger, more established companies, on the other hand, tend to have built up the confidence of suppliers.

ACTIVITY 6.1 The fact that shareholders can limit their losses to that which they have paid, or have agreed to pay, for their shares, is of great practical importance to potential shareholders.

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Can you think of any practical benefit to a private-sector economy, in general, of this ability of shareholders to limit losses? Consider how suppliers of goods and services might be protected, given that the liability of company owners is limited to their agreed contributions.

Legal safeguards Various safeguards exist to protect individuals and businesses contemplating dealing with a limited company. These include the requirement to indicate limited liability status in the name of the company. By doing this, a warning is issued to prospective suppliers and lenders. A further safeguard is the restriction placed on the ability of shareholders to withdraw their equity from the company. These restrictions are designed to prevent shareholders from protecting their own investment and, as a result, leaving lenders and suppliers in an exposed position. We shall consider this point in more detail later in the chapter. Finally, public and large limited companies are required to produce annual financial statements (income statements, statements of financial position and statements of cash flows) and make these publicly available. This means that anyone interested can gain an impression of the financial performance

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283

and position of the company. The form and content of the first two of these statements are considered in some detail later in this chapter and in Chapter 7. Chapter 8 is devoted to the statement of cash flows. Clearly, while limited liability is an advantage to the owners, it can pose a problem to the external parties providing goods and services to the company.

Public and proprietary (private) companies Several different types of companies operate under the Corporations Act. A limited company uses the word ‘Limited’ (‘Ltd’) in its name. The two main categories are public companies and proprietary (private) companies. Public companies can offer their shares for sale to the general public; proprietary companies cannot. There is no maximum number of shareholders required for public companies, so ownership can be very widely spread. Many public companies, provided that they meet the requirements of the Australian Securities Exchange (ASX), have their shares listed on the exchange. This means that they can be freely traded, and that shareholders can sell their shares at the going market price, or existing shares can be purchased. Public companies are more rigorously regulated than proprietary companies. Proprietary companies tend to be smaller businesses where the ownership is divided between relatively few shareholders who are usually fairly close to one another (e.g. a family company). Numerically, there are more private limited companies in Australia and New Zealand than there are public ones. However, since the public ones tend to be individually larger, they represent a much more important group economically. Many proprietary companies are no more than a vehicle for operating businesses that are effectively little more than sole proprietorships or small partnerships. Proprietary companies have the words ‘Proprietary Limited’ (‘Pty Ltd’) in their name. They are restricted to no more than 50 (non-employee) shareholders, and have restricted ability to raise money from the public. Proprietary companies generally are less regulated than public companies. Small proprietary companies are relieved of many of the reporting requirements of large proprietary companies or public companies. A company is deemed to be small if it satisfies at least two of the following three requirements:

public company A company that can offer shares to the general public. Shares can be traded on a public stock exchange. proprietary (private) company A limited company for which the directors can restrict the ownership of its shares. Shares cannot be traded on a public stock exchange.

1 It has consolidated gross operating revenue of less than $25 million. 2 Its consolidated gross assets at the end of the financial year are less than $12.5 million. 3 It employs fewer than 50 employees at the end of the financial year.

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While for some forms of companies the membership may be restricted, for public companies the number of shareholders can be very large. In several significant cases in which government-owned businesses became companies (e.g. Commonwealth Bank, Telstra), the initial number of owners exceeded 250,000. With such a large number of owners, corporate entity structures can raise significant amounts of ownership funds. Also, public companies have access to certain types of debt funding that are not available to other entity structures. Large companies typically have a very large number of shareholders. Real World 6.1 illustrates the scale and range of shareholdings for two companies.

REAL WORLD 6.1 Distribution of listed shares in Telstra as disclosed in the 2016 annual report Size of holding 1–1,000 1,001– 5,000 5,001–10,000 10,001–100,000 100,001 and over Total

Number of shareholders 644,700 513,876 126,240 105,610 3,718 1,394,146

% 46.24 36.86 9.06 7.58 0.27 100.00

Number of shares 356,247,077 1,234,223,169 901,087,894 2,508,160,462 7,225,937,234 12,225,655,836

% 2.91 10.10 7.37 20.52 59.10 100.00

Source: Telstra Annual Report 2016, p. 159. Reproduced by permission of Telstra. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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Distribution of listed shares in New Zealand Oil & Gas Limited as disclosed in the 2016 annual report As at 24 August 2016 New Zealand Oil & Gas Limited had 12,157 listed ordinary shareholders owning 336 million shares. Almost 50% of these were held by only 20 shareholders. JP Morgan Chase Bank held the largest holding at just over 16%. Source: New Zealand Oil & Gas Limited Annual Report 2016, p. 50.

Class discussion points

2 Why do you think that the majority of Telstra shareholders fit into the first two categories? 3 It is not unusual for the daily number of Telstra shares traded to be in the hundreds of thousands. Which type of investors do you see being involved in buying and selling on the stock market on a regular basis? 4 Why do you think JP Morgan Chase holds so many New Zealand Oil & Gas shares?

1 Does this distribution of Telstra shares surprise you? Why/why not?

Transferring share ownership—the role of the stock exchange

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stock exchange A market where ‘secondhand’ shares may be bought and sold and new capital raised.

We have made the point that shares in companies may be transferred from one owner to another without this change of share ownership having any direct impact on the company’s business, or on the shareholders not involved with the particular transfer. With major companies, the desire of some shareholders to sell their shares, and the desire of others to buy those shares, has given rise to a formal market, or stock exchange, in which the shares can be bought and sold. The ASX, and similar organisations around the world, are marketplaces where shares in major companies are bought and sold. Prices are determined by the law of supply and demand. Supply and demand are themselves determined by investors’ perceptions of the future economic prospects of the companies concerned. This of course raises the question: if the change in ownership of a company’s shares does not directly affect that company, why would it welcome the fact that the shares are traded in a recognised market? The main reason is that investors are generally very reluctant to pledge their money unless they can see some way to turn their investment back into cash. In theory, the shares of a particular company may be very valuable if the company has a very bright economic future, but, unless this value can be realised in cash, the benefit to the shareholders is dubious. After all, you cannot spend shares; you generally need cash. This means that potential shareholders are much more likely to be prepared to buy new shares from the company (thus providing the company with new finance) where they can see a way of liquidating their investment (turning it into cash). The stock exchanges provide the means of liquidation. Although the buying and selling of ‘second-hand’ shares does not provide the company with cash, the fact that the buying and selling facility exists will make it easier for the company to raise new share capital as and when it wishes to do so.

Separation of ownership and management directors Individuals who are elected to act as the most senior level of management of a company.

A limited company may have legal personality, but it is not a human being capable of making business decisions and plans and exercising control over it. People must take on these management tasks. The most senior level of management of a company is the board of directors. The shareholders elect directors (by law there must be at least one director) to manage the company on a day-to-day basis on their behalf. In a small company, the board may be the only level of management and consist of all of the shareholders. In larger companies, the board may consist of 10 or so directors out of many thousands of shareholders. Indeed, directors are not even

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required to be shareholders. Below the board of directors of the typical large company could be several layers of management. With sole proprietorships and partnerships, the owner(s) and manager(s) are, by and large, the same people. However, companies (other than quite small ones) will generally have a separate specialist management team outside the ownership interest. There is a growing trend for key personnel in a management team to be allocated shares (ownership interests) on the basis of the company’s performance, so they may become managers and owners at the same time.

Extensive regulation The corporate entity will be subject to much stricter regulation than the partnership and sole proprietorship entity structure, due to the ‘limited liability’ benefit granted to owners (shareholders) and the fact that most shareholders are widely removed from the day-to-day activities of the business and its management. The additional regulations that apply to the limited liability company depend on the classification of that company. However, these regulations may relate to:

• company registration requirements before a company is granted a certificate of incorporation • the requirement to submit annual accounts to the Australian Securities and Investments • •

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•

Commission (ASIC) the requirement to have accounts audited by registered auditors the requirement to prepare reports in conformity with statutory Australian Accounting Standards, and reporting and other obligations imposed on the company management (directors).

These will be discussed in more detail in Chapter 7. In recent years, the issue of corporate governance has generated much debate. The term is used to describe the ways in which companies are directed and controlled. The issue of corporate governance is important because, in companies of any size, those who own the company (the shareholders) are usually divorced from the day-to-day control of the business. Since the shareholders employ the directors to manage the company for them, it seems reasonable to assume that the best interests of shareholders will guide the directors’ decisions. However, in practice this does not always occur. The directors may be more concerned with pursuing their own interests, such as increasing their pay and ‘perks’ (expensive motor cars, overseas visits and so on) and improving their job security and status. As a result, the interests of shareholders and the interests of directors may conflict. Directors who pursue their own interests at the expense of the shareholders pose a problem for the shareholders. However, they may also cause a problem to society as a whole. If shareholders feel their funds are likely to be mismanaged, they will be reluctant to invest. A shortage of funds will restrict investment choices, and the costs of funds will increase as businesses compete for available funds. Thus, a lack of concern for shareholders can profoundly affect the performance of the economy. To avoid these problems, most competitive market economies have a framework of rules to help monitor and control the behaviour of directors. These rules are usually based on three guiding principles:

corporate governance The system by which corporations are directed and controlled.

• Disclosure. This lies at the heart of good corporate governance. Adequate and timely

•

disclosure can help shareholders judge the performance of the directors. Where performance is considered unsatisfactory, this will be reflected in the price of shares. Changes should then be made to ensure the directors regain the confidence of shareholders. Accountability. This involves defining the roles and duties of the directors and establishing an adequate monitoring process. In Australia, company law requires the directors of a business to act in the best interests of the shareholders. This means, among other things, that they must not try to use their position and knowledge to make gains at the expense of the shareholders. The law also requires larger companies to have their annual financial statements independently audited. An independent audit lends credibility

audit A process in which a range of activities are checked to ensure that the activities have been completed in accordance with a set of rules or guidelines.

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•

to the financial statements prepared by the directors. An audit is effectively a checking of the financial reports so that the auditors can make a judgement as to whether the accounts show a true and fair view of the financial performance and position of the organisation. Fairness. Directors should not be able to benefit from ‘inside’ information that is not available to shareholders. As a result, both the law and the Australian Securities Exchange (ASX) place restrictions on the ability of directors to buy and sell the shares of the business. For example, the directors cannot buy or sell shares immediately before the announcement of the annual trading results of the business, or before the announcement of a significant event, such as a planned merger or the loss of the chief executive.

The number of rules designed to safeguard shareholders has increased considerably over the years. This has been in response to weaknesses in corporate governance procedures, which have been exposed through well-publicised business failures and frauds, excessive pay increases to directors, and evidence that some financial reports were being ‘massaged’ so as to mislead shareholders. Real World 6.2 provides an example of how one subsidiary tried to hide sliding profitability.

REAL WORLD 6.2

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Target inflates profit ‘Wesfarmers boss Richard Goyder has recognised that the conglomerate has taken a knock to its most prized possession, its reputation, a"er what he called a “mind blowingly stupid” decision by a clique of Target (owned by Wesfarmers) executives to hide sliding profitability, using $21 million in improper payments from suppliers’ (Durie). ‘The rebate was paid with the promise that second-half price rises would offset the payment, which was treated in the accounts as profit, contrary to Wesfarmers stated policy’ (Greenblat). Target reported increased earnings before interest and tax of $74 million, a rise of 5.6% from $70 million. Without the adjustment they would have fallen to about $60 million. Target’s boss resigned. Wesfarmers went into damage control, assuring investors that the accounting regularities were

confined to Target. The impact on the Wesfarmers overall results was relatively insignificant. Sources: John Durie, ‘Governance off target’, The Australian, 5 April, 2016. Eli Greenblat, ‘Wesfarmers takes hit from “stupid” Target’, The Australian, 12 April 2016.

Class discussion points 1 How important do you think reputation is to a business such as Wesfarmers? 2 What perceived pressures might there have been within Target that could have led to the action described? 3 What does this imply about the importance of accounting rules and attitudes to compliance?

Chapter 7 deals with corporate governance in more detail.

ACTIVITY 6.2 Can you think of ways in which the shareholders themselves may try to ensure that the directors always act in the shareholders’ best interests?

The ways in which unscrupulous directors can manipulate the financial statements are many and varied. Before leaving this section, however, it is worthwhile reminding ourselves of the importance of sound internal control, which was discussed in Chapter 5. The Accounting and You section that follows raises issues of fraud and embezzlement. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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ACCOUNTING AND YOU FRAUD AND EMBEZZLEMENT The two most typical methods used are management fraud and employee embezzlement. Management fraud o#en aims to increase share price by overstating revenues or understating expenses. This is o#en associated with increases in staff bonuses. In the extreme, we can find examples of fraud on a vast scale, such as Bernard Madoff’s infamous ponzi scheme. As we saw in Chapter 1, a ponzi scheme is a fraudulent investment scheme that pays returns to investors from their own money, or money paid by subsequent investors, rather than from any actual profit earned. In the case of Madoff’s business, the amount missing from client accounts, including fabricated gains, ran into billions of dollars. Note also Real World 1.3 for more recent examples. Employee embezzlement typically involves the misappropriation of business assets. Ways in which this can occur include:

• •

direct stealing of cash, inventory or other assets

• • •

fraud associated with cash registers

cheque tampering, or manipulating the system so that cheques are sent to the employee inappropriately travel and other expense rorts, and the taking of bribes and kickbacks.

Clearly, good systems of internal control, of the type outlined in Chapter 5, are necessary. It is important to note that, in many cases, it is perceived pressure that creates the environment in which fraud and embezzlement are likely to happen. If pressure is coupled with a perceived opportunity, the likelihood increases. Interestingly, people who commit these offences o#en have a rationalisation process, which they use as a justification.

Class discussion points 1 From your own experience, which of the ways of committing fraud have you found to be most common? If you have no such experience, which of the ways do you think is most likely? Why do you think this? How might this be prevented? 2 What do you consider are the key elements of internal control?

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3 What kind of pressures might lead to someone engaging in fraud?

The kind of events identified in Accounting and You mean that some degree of external regulation can be justified. The next chapter covers the more important aspects. Corporate governance will be picked up again in Chapter 7, as will methods of creative accounting. You need to understand, though, that even close regulation is not guaranteed to find all these crimes, and certainly not quickly. It is worth noting that the US Securities and Exchange Commission had conducted investigations into Madoff’s business practices over several years but did not uncover the fraud. The message is clear. Some regulation is appropriate, but you should not rely on this to deal with all possible events. You must have sound systems of internal control. You always need to be observant and questioning. If good internal control systems are absent, the chances of you experiencing fraud or embezzlement in your workplace increase substantially. It would be a useful exercise for you to try to identify possible gaps in internal control in your workplace just to see whether the system is as sound as possible.

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Advantages and disadvantages of the company entity structure Having highlighted some key features of the company entity structure, we can compare its potential advantages and disadvantages with those of the other common entity structures. The advantages normally include:

• • • • • • • •

the separation of ownership and management, and the existence of a specialist management team the perpetual existence of the entity, ensuring the stability of operations and long-term planning the existence of a separate legal entity, which gives the entity operational and financial freedom the limited liability for the owners (shareholders), which removes significant barriers to investment greater access to ownership funding, enhancing the business’s ability to operate and expand potentially greater access to debt funding potential taxation advantages, given that the company tax rate is less than the maximum personal taxation rate (at the time of writing the company tax rate was at 30% compared with a maximum personal tax rate of 45%), and potential increases in share values where shares are listed on the stock exchange.

Potential disadvantages include:

• • • • • • •

more expensive to establish more extensive regulatory requirements less management flexibility potential loss of control by the original owners greater scrutiny by analysts and other special interest groups greater pressure to perform over the short term by external (non-management) investors, and potential taxation disadvantages as tax is paid at 30% on all profit (from the first $1).

Note that you should check the latest figures. The above rates are correct at the time of writing.

Concept check 1 Which of the following is false? A B C

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D

E

Public companies are more rigorously regulated than proprietary companies. The two main categories are public companies and proprietary (private) companies. Many proprietary companies are no more than a vehicle for operating businesses that are effectively little more than sole proprietorships or small partnerships. Small proprietary companies are relieved of many of the reporting requirements of large proprietary companies or public companies. A proprietary company’s shares can be traded on a public stock exchange.

Concept check 2 Which of the following is NOT one of the two requirements that proprietary companies must satisfy to be deemed to be small? A B C D E

Consolidated net assets at the end of the financial year are less than $12.5 million. Consolidated gross operating revenue must be less than $25 million. The company employs fewer than 50 employees at the end of the financial year. Consolidated gross assets at the end of the financial year are less than $12.5 million. None of the above.

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Concept check 3 Advantages of the company entity structure do NOT include: A B C D E

Permanent existence Limited liability of shareholders More extensive regulatory requirements Potential tax advantages None of the above. All are advantageous.

EQUITY AND BORROWINGS IN A COMPANY CONTEXT LO2

Equity/capital (owners’ claim) of limited companies

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Our simple statement of financial position (balance sheet) in Chapter 1, which was covered in more detail in Chapter 2, was effectively a statement of wealth. In practice, this statement sets out the things that are owned, and deducts from this figure the amounts owed to outsiders. The difference represents the wealth of the business. Since the business is run for the owners’ benefit, this wealth can be seen as a measure of the owners’ claim. As a business makes more profit and increases its wealth, so the owners’ claim increases. If the business pays out some of its profits, the wealth will decrease, as will the owners’ claim. As we have seen, the owners’ claim of a sole proprietorship is normally encompassed in one figure relating to equity on the statement of financial position, usually labelled capital. This figure can be increased by further injections of funds or by making profits, or reduced by incurring losses or by drawings made by the owners. With companies, this is usually a little more complicated, although in essence the same broad principles apply. With a company, the owners’ claim is divided between shares (i.e. the original investment) on the one hand, and reserves (i.e. profits and gains subsequently made) on the other. Capital and reserves are generally referred to as ‘shareholders’ equity’. There may also be shares of more than one type and reserves of more than one type, so within the basic divisions of share capital and reserves there may well be further subdivisions. This probably seems quite complicated. Shortly we shall consider the reasons for these subdivisions and all should become clearer. When a company is first formed, those who take steps to form it (usually known as its ‘promoters’) decide how much has to be raised by the potential shareholders to set up the company with the necessary assets to operate. Example 6.1 illustrates such a case and how this is reflected in a statement of financial position.

Explain equity and borrowings in a company context

capital Another name for owners’ equity, often associated with sole proprietorships or partnerships. The owner’s claim on the assets of the business.

Let us imagine that several friends decide to form a company to operate a particular business. They estimate that the company will need $50,000 to obtain the necessary assets to operate the business. Between them they raise the cash to buy shares in the company, which issues 50,000 shares at $1 each.

6.1

At this point the statement of financial position (balance sheet) of the company would be: Statement of financial position as at 31 March 2017 Net assets (all in cash) Shareholders’ equity Share capital (50,000 shares)

50,000 50,000

For simplicity, in this and succeeding statements of financial position presented to illustrate points about shareholders’ equity, we have simply added together current and non-current assets and deducted external liabilities, giving net assets. This figure must equal shareholders’ equity. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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6.1

The company now buys the necessary non-current assets and inventory and starts to trade. During the first year it makes a profit of $10,000. This, by definition, means that both the net assets and the owners’ claim expand by $10,000. (Remember that company profits belong to the shareholders.) During the year, the shareholders (owners) make no drawings of their capital (such drawings are known as ‘dividends’ when applied to companies), so at the end of the year the summarised statement of financial position looks like this: Statement of financial position as at 31 March 2018

continued Net assets (various assets less liabilities) Shareholders’ equity Share capital (50,000 shares) Reserves (retained profits)

$ 60,000 50,000 10,000 60,000

The profit is shown in a ‘reserve’, known as ‘retained profits’ (or ‘retained earnings’). Note that we do not simply add the profit to the share capital. We must keep the two amounts separate (to satisfy the Corporations Act), because there is a legal restriction on the maximum drawings of capital (or ‘dividends’) that the owners can make. This is defined by the amount of distributable reserves, so it is helpful to show these separately. We shall look at why there is this restriction, and how it works, later in the chapter.

ordinary shares Shares of a company owned by those who are due the benefits of the company’s activities after all other stakeholders have been satisfied. dividends Transfers of assets (usually cash) made by a company to its shareholders.

Shares represent the basic units of ownership of the business. All companies issue ordinary shares, the main risk-bearing shares issued by companies (see Example 6.1). These are often referred to as ‘equities’. All other claims on the business have a higher priority in terms of repayment. Ordinary shareholders’ returns will come from distributions of profit (known as dividends) or from increases in the value of the shares. Under normal circumstances, retaining profits is likely to produce such increases. Until recently, each share had a value, known as ‘par value’, attached to it. The Company Law Review Act 1998 eliminated this, and shares are now deemed to have no par value. Shares can be issued fully or partly paid, as illustrated in Example 6.2.

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Suppose a company wishes to raise $250,000 in cash and issues 250,000 ordinary shares at a price of $1 a share.

6.2 partly paid shares Shares on which the full issue price of the share has not been paid as at reporting date. This would normally relate to shares that are to be paid in instalments or a series of calls, and not all of the total share issue price is required to be paid (or has been called up) as at the reporting date.

The resulting statement of financial position will be: Net assets Cash Shareholders’ equity Paid-up share capital (250,000 ordinary shares issued at $1)

$250,000 $250,000

These shares are fully paid as there is no further payment required of the shareholders. A company can issue partly paid shares. Suppose that instead of issuing 250,000 shares at $1, the company decides to raise the $250,000 it needs by issuing 500,000 partly paid shares, but asks for (calls) only 50¢ per share now, with the remaining 50¢ per share to be called and collected at some future date. The result will be: Net assets Cash Shareholders’ equity Share capital (500,000 ordinary shares issued at $1—called to 50¢)

$250,000 $250,000

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The shareholders, in agreeing to buy shares issued at $1, have agreed to commit $1 when required. At this stage the company has only asked for half of this, so the further liability of the shareholders is restricted to 50¢ per share. Once this has been paid, the shares become fully paid shares and the shareholders have no further liability to the company. Where calls are unpaid, this will be reflected on the balance sheet. If, for example, the call was unpaid on 5,000 shares, the statement of financial position would appear as follows: Net assets Cash Shareholders’ equity Share capital (500,000 ordinary shares issued at $1—called to 50¢) Less calls in arrears (5,000 shares at 50¢)

$247,500 250,000 (2,500) $247,500

291

6.2 continued continued fully paid shares Shares on which the shareholders have paid the full issue price.

ACTIVITY 6.3 Show the statement of financial position of a company a"er each of the following transactions:

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• •

The issue of 100,000 shares at an issue price of $2, of which $1 is payable immediately. A"er a further call of 50¢ per share.

Some companies also issue other classes of shares, preference shares being the most common. These usually guarantee that if a dividend is paid, the preference shareholders will be entitled to the first part of it up to a maximum value. This maximum is normally defined as a fixed percentage of the preference shares. If, for example, a company issues 100,000 preference shares at $1 each with a dividend rate of 6%, this means that the preference shareholders are entitled to receive the first $6,000 of any dividend paid by the company for a year. The profit in excess of the preference dividend is the entitlement of the ordinary shareholders, although this amount is not necessarily (or even normally) paid out as a cash dividend. Normally, any undistributed profits and gains accrue to the ordinary shareholders. Thus, the ordinary shareholders are the primary risk-takers. Their potential rewards reflect this risk. Power normally resides in the hands of the ordinary shareholders. Generally, only the ordinary shareholders are able to vote on issues that affect the company, such as who the directors should be. One ordinary share usually carries with it one vote. It is open to the company to issue shares of various classes, perhaps with some having unusual conditions, but it is rare to find other than straightforward ordinary and preference shares. Although a company may have different classes of shares whose holders have different rights, within each class all shares must be treated equally. The rights of the various classes of shareholders, as well as other matters relating to a particular company, are contained in that company’s constitution, or in the special resolution approving the issue. Example 6.3 illustrates the importance of ensuring that new shares are issued at an appropriate price so as to preserve the rights of existing shareholders.

preference shares Shares which have a fixed rate of dividend that must be paid before any ordinary dividend can be paid. Often preference shares have higher priority than ordinary shares in the event of the company going into liquidation.

The statement of financial position of a company is as follows: Net assets Shareholders’ equity Capital (1 million shares) Retained profits

$1,500,000 1,000,000 500,000 $1,500,000

6.3

Assuming that the market value of the shares is the same as the book value, the share price would be $1.50. The company has decided to raise an extra $600,000 cash for expansion by issuing new shares. If the shares are issued for $1.50 each, 400,000 shares must be issued, producing the following statement of financial position:

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6.3

Net assets Shareholders’ equity Capital (1.4 million shares) Retained profits

$2,100,000 1,600,000 500,000 $2,100,000

This should maintain the share price at $1.50.

continued

If the new issue of 400,000 shares was at a price less than $1.50, say $1, the end result would be as follows: Net assets Shareholders’ equity Capital (1.4 million shares) Retained profits

$1,900,000 1,400,000 500,000 $1,900,000

If we continue our assumption that book value and market value are the same, the market value per share will change to $1.9 million/1.4 million shares 5 $1.36 per share. The old shareholders are disadvantaged, whereas the new ones are better off. In practice, the situation is more complicated than this, with book value and market value almost never being the same, but the principles remain the same.

A company can issue more share capital at a later date. Given that the value of the company (and therefore of the shares) is likely to increase over time as profits are retained, the asking price for the new shares is likely to be higher than the original asking price. Generally we would expect new shareholders to buy new shares at a price very close to the current market value of the shares. The proceeds will be added to cash and capital.

ACTIVITY 6.4 A company issues 100,000 shares on formation at $1 per share. Five years later its statement of financial position is as shown below:

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Net assets Shareholders’ equity Capital Retained profits

$170,000 100,000 70,000 $170,000

The current market price of the shares is $2. A further 100,000 shares are issued at market price. Show the statement of financial position, assuming that the issue is successful.

You need to understand why it is important that any new issues are at a price close to market price. Since the new shareholders have the same rights as the old, the new shareholders must ‘buy in’ their share of any increases in value since the initial share purchase. If this does not occur, then new shareholders will benefit at the expense of the old shareholders.

Reserves reserves Amounts reflecting increases in owners’ claims.

Reserves are profits and gains that have been made by the company and that still form part of

the shareholders’ (owners’) claim. Profits and gains tend to lead to cash flowing into the company. Note that retained profits represent the largest source of new finance for Australian companies, more than share issues and borrowings combined for most companies. These ploughed-back profits create most of the typical company’s reserves. Retained profits can be held in an account with the same name, ‘retained profits’, or in an account labelled ‘general reserve’. Reserves will be reduced by distributions (typically dividends) or by any losses incurred.

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293

You should note that reserves are not cash. Reserves represent a claim by the owners on the business. In everyday usage, we tend to talk about reserves being things held as a backup, and these tend to relate to assets (e.g. cash, minerals). You must recognise that an accounting reserve represents something other than this—it is a claim. Not all reserves result from profits earned and, therefore, some reserves may not be distributable as a cash dividend. For example, a company might revalue (upwards) non-current assets, such as property bought several years ago for $250,000, now revalued to reflect its current value of, say, $400,000. The property value would be increased by $150,000 and a revaluation reserve would be increased by the same amount. Note that such capital gains can be distributed if they result from a bona fide revaluation of all assets, but such distributions are relatively rare.

Bonus shares It is always open to the company to take reserves of any kind and turn them into share capital. The new shares are known as bonus shares as they involve no cost to the shareholders. They are also known as a share dividend. Issues of bonus shares occur quite frequently. Example 6.4 illustrates how bonus shares work.

bonus shares Reserves which are converted into shares and given ‘free’ to shareholders.

The summary statement of financial position of a company is as follows: Statement of financial position as at 31 March 2018 Net assets (various assets less liabilities) Shareholders’ equity Share capital (50,000 shares issued at $1 each) Reserves

$ 128,000

6.4

50,000 78,000 128,000

The company decides that it will issue, to existing shareholders, one new $1 share for every share owned by each shareholder. The statement of financial position immediately following this will appear as follows: Statement of financial position as at 31 March 2018

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Net assets (various assets less liabilities) Shareholders’ equity Share capital (100,000 shares issued at $1 each) Reserves (78,000 – 50,000)

$ 128,000 100,000 28,000 128,000

We can see that the reserves have decreased by $50,000 and share capital has increased by the same amount. Share certificates for the 50,000 ordinary shares of $1 each, which have been created from reserves, will be issued to the existing shareholders to complete the transaction.

Assume now that a shareholder of the company in Example 6.4 owned 100 shares in the company before the bonus issue. How will things change for this shareholder, as a result of the bonus issue, with regard to the number of shares owned and to the value of the shareholding? The answer should be that the number of shares will double from 100 to 200. Now the shareholder owns one five-hundredth of the company (200/100,000). Before the bonus issue the shareholder also owned one five-hundredth of the company (100/50,000). The company’s assets and liabilities have not changed one bit as a result of the bonus issue, so, logically, one five-hundredth of the value of the company should be identical to what it was before. Thus, each share is worth half as much, but the shareholder now owns twice as many shares.

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In practice, events are not likely to take place with quite the precision implied above. One of the arguments used to support a bonus issue is that a reduction in share price might lead to higher levels of activity in the market for shares, with the result that the price might not fall as much as logic would expect, with the end result being an increase in the market value of the company. Referring to Example 6.4, such a result might leave the shares trading at a value slightly higher than 50% of the pre-bonus share price. Such a reaction may be short term if the fundamental value of the business, based on future earnings, has not changed. However, the fact that a firm undertakes a bonus issue may indicate that management has reason to believe that future earnings will improve, and if the market supports this position, then the bonus issue may be associated with increased overall share value. However, if the share value increases overall after the bonus issue, it is not possible to determine whether the share value may have increased anyhow, had the bonus not taken place. A bonus issue simply takes one part of the owners’ claim (part of a reserve) and puts it into another part of the owners’ claim (share capital). This inevitably raises the question: why bother? Three possible reasons are:

• Share price—to lower the value of each share, without reducing the shareholders’ collective or individual wealth.

• Shareholder confidence—to provide the shareholders with a ‘feel good factor’. Apparently •

shareholders like bonus issues, because it seems to make them better off, although in practice it should not affect their wealth. Lender confidence—where reserves arising from operating profits and/or realised gains on the sale of non-current assets are used to make the bonus issue, it has the effect of taking part of that portion of the owners’ claim which could be drawn by the shareholders as drawings (or dividends), and locking it up. There are severe restrictions on the extent to which shareholders may make drawings from their capital. An individual or organisation contemplating lending money to the company may insist that the dividend payment possibilities are restricted as a condition of making the loan.

Raising share capital

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A company may decide to raise additional funds by making further issues of new shares. These may be by any of the following methods, detailed below:

• • • • • •

rights issues dividend reinvestment plans offer for sale public issue private placing private equity.

Rights issues

rights issue An issue of shares for cash to existing shareholders on the basis of the number of shares already held, at a price that is usually lower than the current market price.

The company may offer existing shareholders the right to acquire new shares in the company in exchange for cash. The new shares will be allocated to shareholders in proportion to their current shareholdings. To make the issue attractive to shareholders, the new shares are usually offered at a price significantly below their current market value. Rights issues are a common form of share issue. For companies, it is a relatively cheap and straightforward way of issuing shares. Issue expenses are quite low and issue procedures are simpler than those of other forms of share issue. The fact that those who are offered new shares already have an investment in the company that presumably suits their risk–return requirements is likely to increase the chances of a successful issue. Control of the company by existing shareholders will not be diluted, providing they take up the rights offer. A rights offer allows them to acquire shares in the company at a price below the current market price. This means that entitlement to participate in a rights offer is a source of

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

value to existing shareholders. Those who do not wish to take up the rights offer can sell their rights to other investors, so long as the offer is made on a renounceable basis (the right to receive shares can be sold in the market). In contrast, non-renounceable offers must either be taken up or allowed to lapse. The traditional approach to rights issues has been adapted in recent years by the introduction of accelerated rights issues. Rights issues of this type are structured in two phases, with an initial (accelerated) issue to institutional investors (who will pay quickly) followed by a (non-accelerated) issue to the retail (non-institutional) component of the shareholders. Calculating the value of the rights offer received by shareholders is quite straightforward. Example 6.5 shows how this is done.

Shaw Holdings Ltd has 20 million ordinary shares which were issued at 50¢ each and are currently valued on the ASX at $1.60 per share. The directors of Shaw Holdings believe that the company requires additional long-term capital and have decided to make a one-for-four issue (i.e. one new share for every four shares held) at $1.30 per share. The first step in the valuation process is to calculate the price of a share following the rights issue. This is known as the ex-rights price and is simply a weighted average of the price of shares before the issue of rights and the price of the rights shares. In the Shaw example we have a one-for-four rights issue. The theoretical ex-rights price is, therefore, calculated as follows: Price of four shares before the rights issue (4 3 $1.60) Price of taking up one rights share Theoretical ex-rights price

295

accelerated rights issues Rights issues of this type are structured in two phases, with an initial (accelerated) issue to institutional investors (who will pay quickly) followed by a (non-accelerated) issue to the retail (noninstitutional) component of the shareholders.

6.5

$ 6.40 1.30 7.70 7.70/5 5 $1.54

As the price of each share, in theory, should be $1.54 following the rights issue, and the price of a rights share is $1.30, the value of the rights offer will be the difference between the two: $1.54 – $1.30 5 $0.24 per share Market forces will usually ensure that the actual price of rights and their theoretical price will be fairly close.

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ACTIVITY 6.5 Suppose that an investor with 2,000 shares in Shaw Holdings Ltd has contacted you for investment advice. She is undecided whether to take up the rights issue, sell the rights or allow the rights offer to lapse. Advise her.

When considering a rights issue, the directors of a company must first consider the amount of funds it needs to raise. This will depend on the company’s future plans and commitments. The directors must then decide on the issue price of the rights shares. Generally speaking, this decision is not crucial. In Example 6.5, the company made a one-for-four issue, with the price of the rights shares set at $1.30. However, it could have raised the same amount by making a one-for-two issue and setting the rights price at $0.65, or a one-for-one issue and setting the price at $0.325, etc. The issue price that is finally decided upon will not affect the value of the company’s underlying assets or the proportion of its underlying assets and earnings to which the shareholder is entitled. The Shaw directors must, however, ensure that the issue price is not above the current market price of the shares if the issue is to be successful. A variation on a rights issue is what is known as an entitlement offer. An entitlement offer is an offer made to a specific investor to enable the purchase of a security or other asset: that offer

entitlement offer An offer made to a specific investor to enable the purchase of a security or other asset. The offer cannot be transferred to another party. An entitlement offer is offered at a specific price and must be used during a set time frame.

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cannot be transferred to another party. An entitlement offer is offered at a specific price and must be used during a set time frame. Failure to use the offer will lead to it being withdrawn. Entitlement offers are most often used to issue new shares in the company, and are often very similar to a rights issue. The essential difference is that the existing shareholder cannot transfer the entitlement offer to anyone else. The time frame is usually one that gives existing shareholders time to consider whether they wish to take it up.

Dividend reinvestment plans dividend reinvestment plan A plan in which shareholders are permitted to reinvest all or part of their dividend payments in new shares.

issuing house A financial institution which specialises in the issuing of new securities. offer for sale An issue of shares that involves a public limited company (or its shareholders) selling the shares to a financial institution that will, in turn, sell the shares to the public.

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public issue An issue of shares that involves a public limited company making a direct invitation to the public to buy shares in the company.

tender issue Shares for sale to investors for which the investors must state the amount they are prepared to pay for the shares. private placing An issue of shares that involves a limited company arranging for the shares to be sold to the clients of particular issuing houses or stockbrokers, rather than to the general investing public.

With a dividend reinvestment plan, shareholders are permitted to reinvest all or part of their dividend payments in new shares. Such a plan can be a very efficient source of funds for a company that pays dividends. Surprisingly large sums are raised. Many companies listed on the ASX have plans of this sort.

Offer for sale This type of issue can involve a public limited company selling a new issue of shares to a financial institution known as an issuing house. However, shares that are already in issue may also be sold to an issuing house. In this case, existing shareholders agree to sell their shares to the issuing house. The issuing house, in turn, sells the shares purchased from either the company or its shareholders to the public. The issuing house publishes a prospectus that sets out details of the company and the type of shares to be sold, and investors are invited to apply for shares. The advantage of an offer for sale from the company’s viewpoint is that the sale proceeds of the shares are certain. The issuing house takes on the risk of selling the shares to investors. This type of issue is often used when a company is seeking a listing on the ASX and wishes to raise a large amount of funds.

Public issue A public issue involves a company making a direct invitation to the public to purchase shares in it, usually in a newspaper advertisement. The shares may once again be a new issue or shares already in issue. An issuing house may be asked by the company to help administer the issue of the shares to the public and to advise on an appropriate selling price. However, the company, rather than the issuing house, will take on the risk of selling the shares. An offer for sale and a public issue both extend share ownership in the company. When making an issue of shares, the company or the issuing house usually sets a price for the shares. However, establishing a share price may not be easy, particularly if the market is volatile or if the company has unique characteristics. If the share price is set too high, the issue will be undersubscribed and the company (or issuing house) will not receive the amount expected. If the share price is set too low, the issue will be oversubscribed and the company (or issuing house) will receive less than it might have. One way of dealing with the problem is to make a tender issue of shares. This involves the investors determining the price at which the shares will be issued. Although the company (or issuing house) may publish a reserve price to help guide investors, it will be up to the individual investor to determine the number of shares to be purchased and the price the investor wishes to pay. Once the offers from investors have been received, a price at which all the shares can be sold will be established (known as the strike price). Investors who have made offers at, or above, the strike price will be issued shares at the strike price, and offers received below this price will be rejected. Although this form of issue is adopted occasionally, it is not popular with investors and is, therefore, not in widespread use.

Private placing This method does not involve inviting the public to subscribe to shares. Instead, with private placing, the shares are ‘placed’ with selected investors, such as large financial institutions. This can be a quick and relatively cheap way to raise funds as it saves some advertising and legal costs. However, the ownership of the company can end up being concentrated in a few hands. Usually, unlisted companies seeking relatively small amounts of cash employ this form of issue. Moreover, both listed and unlisted firms often follow a private placement with a rights issue to their shareholders to give them the opportunity to increase their holdings on favourable terms.

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The ASX imposes limitations on how much companies can raise by way of a non-pro-rata equity issue. It allows them to issue up to 15% of their capital by non-pro-rata raisings in each 12-month period, without securing shareholder approval. Beyond this amount, shareholder approval is needed. However, the ASX has relaxed the rule so that more than 15% of the capital can be issued, provided it is accompanied by a share purchase plan (SPP). Clearly, the most equitable form of capital raising is by way of a renounceable rights issue, as there is no dilution of the shareholders’ proportion of equity. Share purchase plans aim to try to balance shareholders’ rights with the need to be able to raise funds quickly and efficiently. Essentially, share purchase plans are a means of issuing small amounts of shares to existing shareholders without the need for a prospectus. The shares offered must be non-renounceable and offered at a discount, and fall within the limits mentioned above. The risks of inequitable treatment are seen as being small, while the reduction in costs, together with a discounted price, are seen as providing an advantage to retail investors. For companies that are not included in the S&P/ASX300 index, and have a market capitalisation equal to or less than $300 million, a further 10% of their issued capital (over and above the 15% referred to above) can be issued within the next 12 months, as long as this is approved at the Annual General Meeting and passed by a 75% majority.

297

share purchase plan (SPP) A plan that aims to balance shareholders’ rights with the need to be able to raise funds quickly and cheaply.

Private equity Although the ASX provides an important source of long-term finance for large businesses, it is not really suitable for small businesses, as the minimum value of shares for a listing is of the order of $1 million. The more important sources of finance available to small businesses are private equity, in the form of venture capital, and business angels (see below). Venture capital is long-term capital provided by certain institutions to help businesses exploit profitable opportunities. The businesses most likely to interest the venture capitalist will have higher levels of risk (and hence higher potential earnings) than would normally be acceptable to traditional providers of finance, such as the major clearing banks. Venture capital providers may be interested in a variety of businesses for various purposes and reasons, including the following:

• Business start-ups. Venture capital is available to businesses that are not fully developed

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• • •

and may need finance to help refine their business concept or for product development or marketing. Early-stage capital. This is available for businesses ready to commence trading. Expansion capital. This is additional funding provided to young, existing or expanding businesses. Buy-out or buy-in capital. This is used to fund the acquisition of a business by the existing management team (buy-out) or by a new management team (buy-in). Management buyouts (MBOs) and management buy-ins (MBIs) often occur when a large business wishes to divest itself of one of its operating units, or where a family business wishes to sell because of succession problems. Sometimes one of the owners of an existing business is bought out.

private equity Equity finance, primarily for small or medium-sized businesses, provided by venture capitalists, such as large financial institutions. venture capital Long-term finance provided by certain institutions to small and medium-sized businesses in order to exploit relatively high-risk opportunities.

The risks such businesses carry can vary, in practice, but are often due to the nature of their products or to the fact that they are new businesses that either lack a trading record or have new management. Although the risks are higher, these businesses also have potentially higher levels of return—hence their attraction to the venture capitalist. The venture capitalist often makes a substantial investment in the business, and this normally takes the form of ordinary shares. To keep an eye on the sum invested, the venture capitalist usually requires a representative on the board of directors as a condition of the investment. The venture capitalist may not be looking for a quick return and may well be prepared to invest in a business for five years or more. The return may take the form of a capital gain on the realisation of the investment. Although venture capital is extremely important for some businesses, the vast majority of small businesses obtain their finance from other sources. Private equity is capital invested in a private company, which is not, therefore, listed on the ASX (or any other stock exchange), in return for a stake in the company. While it can be venture capital, the more common form in recent years has been a leveraged buy-out. Typically, the business being invested in is then delisted and restructured, with the aim of improving management and cutting costs. Some time down the track, it is listed again and sold off at a substantial profit.

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business angel An individual who supplies finance (usually equity finance) to a start-up business or a small business wishing to expand. Often business angels take a close interest in the running of the businesses in which they invest.

Business angels are often wealthy individuals who have been successful in business. They are usually willing to invest, through a shareholding in a start-up or developing business. They will often invest for a period of between three and five years, and sometimes longer. They normally have a minority stake in the business and do not become involved in its day-to-day management. Business angels fill an important gap in the market, as the size and nature of the investment that they find appealing does not appeal to venture capitalists. Business angels may be attractive to small businesses for a number of reasons, including:

• They may be able to make investment decisions quickly, particularly if they are familiar with the industry in which the business operates.

• They may also be able to offer a wealth of business experience to budding tycoons. • Some may be prepared to accept lower returns than those required by venture capitalists in exchange for the opportunity to become involved in a new and interesting project.

Business angels offer an informal source of share finance, and so it is not always easy to identify a suitable angel. However, numerous business angel networks have now developed to help owners of small businesses find their ‘perfect partner’. During its lifetime, a company may use any or all of these approaches to raising funds through issuing new shares.

Borrowings

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loan notes Long-term borrowings usually made by limited companies.

Most companies borrow to supplement the funds raised from share issues and retained profits. In the statement of financial position, long-term loans will be categorised as non-current liabilities, while short-term loans will be categorised as current liabilities. Usually, long-term loans are secured on assets of the company. This would give the lender the right to seize the assets concerned, sell them and satisfy the repayment obligation, should the company default on either its interest payments or the repayment of the loan. A common form of borrowing is through the issue of loan notes. Where a large issue of loan notes is made, it can sometimes be taken up in small slices, by private investors, or in large slices, by investing institutions such as pension funds and insurance companies. These slices of loans can also, at times, be bought and sold through the stock exchange. This means that investors need not wait the full term of the loan to obtain repayment, but can sell their slice of it to another investor at any point. Loan notes are often known as ‘loan stock’, ‘debentures’ or ‘corporate bonds’. The fact that loan notes may be traded on the stock exchange can lead to confusing loan notes with shares. They are, however, quite different. Holders of shares own the company, and share in its losses and profits. Holders of loan notes simply lend money to the company under a legally binding contract. It is important to the prosperity and stability of a company that it strikes a suitable balance between finance provided by the shareholders (equity) and finance from borrowing. This topic will be explored in Chapter 10.

Concept check 4 Which of the following statements is false? A B C

D

E

Capital is the term used for owners’ equity in proprietorships and partnerships. Shares represent the basic units of ownership of a company. Partly paid shares are shares on which the full issue price of the share has not been paid as at reporting date. Preference shares generally have lower priority than ordinary shares in the event of the company going into liquidation. A company may have different classes of shares with different rights.

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Concept check 5 Which of the following statements is true? A

B C

D E

Reserves are profits and gains that have been made by the company and that still form part of the shareholders’ (owners’) claim. Reserves are usually in the form of cash. Retained profits (retained earnings) is a reserve of profits that has been paid out to shareholders. Reserves represent a claim by the lenders to the business. None of the above.

Concept check 6 Which of the following is NOT a characteristic of bonus share issues? A B C D E

They convert a reserve into share capital. They are also known as share dividends. They lower the value of an individual share. They lower overall shareholder wealth. They provide shareholders with a ‘feel good factor’.

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RESTRICTIONS ON THE RIGHTS OF SHAREHOLDERS TO MAKE DRAWINGS OR REDUCTIONS OF CAPITAL Limited companies are required by law to distinguish between that part of their capital (shareholders’ claim) which may be withdrawn by the shareholders and that part which may not be. The distributable (withdrawable) part, which has arisen from operating profits and from realised profits on the disposal of fixed assets (both on an after-tax basis), is called retained profit. As mentioned earlier, unrealised capital profits obtained by a bona fide revaluation of all assets are also distributable. The non-distributable part (which cannot be withdrawn) normally consists of what arose from funds injected by shareholders buying shares in the company. In fact, many companies treat unrealised capital gains obtained by a revaluation as, effectively, a nondistributable revaluation reserve. The reason why limited companies are required to distinguish different parts of their equity relates to limited liability, which company shareholders enjoy, but which owners of unincorporated businesses do not. If a sole trader withdraws all of the owner’s claim, or even more than this, the position of the business’s creditors is not weakened since they can legally enforce their claims against the sole trader as an individual. With a limited company, in which the business and the owners are legally separated, such legal right does not exist. However, to protect the company’s creditors the law insists that a specific part of the capital of a company cannot legally be withdrawn by the shareholders. The law does not specify how large the non-distributable part of a particular company’s capital should be. It simply requires that anyone dealing with the company must be able to tell how large it is by looking at the company’s statement of financial position. In the light of this, a particular prospective lender, or supplier of goods or services on credit, can make a commercial judgement as to whether or not to deal with the company. Example 6.6 illustrates both the extent to which external claims can be protected, and also the limits.

LO3 Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

retained profit The amount of profit made over the life of a business which has not been taken out by owners in the form of drawings or dividends.

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The summary statement of financial position of a company is as follows: Statement of financial position as at 30 June 2017

6.6

$ Net assets Current and non-current assets less short-term liabilities Shareholders’ equity Share capital (20,000 shares issued at $1 each) Retained profits

43,000 20,000 23,000 43,000

The company has asked a bank to make it a $25,000 long-term loan. If the bank agrees, straightaway the statement of financial position will appear as follows: Statement of financial position as at 30 June 2017 $ Net assets Current and non-current assets less short-term liabilities (43,000 1 25,000) Less non-current (long-term) liabilities Shareholders’ equity Share capital (20,000 shares issued at $1 each) Retained profits

68,000 25,000 43,000 20,000 23,000 43,000

As things stand, there are assets of $68,000 to meet the bank’s claim of $25,000. However, the company could pay a dividend of $23,000, perfectly legally. If it did, the statement of financial position would appear as follows: Net assets Current and non-current assets less short-term liabilities (68,000 – 23,000) Less non-current liabilities Shareholders’ equity Share capital (20,000 shares issued at $1 each) Retained profits (23,000 – 23,000)

45,000 25,000 $20,000 20,000 – $20,000

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This leaves the bank in a much weaker position, because net assets are now shown as having a value of $45,000 to meet a claim of $25,000. Note that the difference between the amount of the bank loan and the other net assets always equals the capital and reserves total. The capital represents a ‘margin of safety’ for creditors. The larger the amount of the owners’ claim that is withdrawable by the shareholders, the smaller the potential margin of safety for creditors.

The law is quite specific that it is illegal, under normal circumstances, for shareholders to withdraw that part of their claim which is represented by capital. This means that potential creditors of the company know the maximum amount of the shareholders’ claim that can be drawn or withdrawn by the shareholders. It is important to remember that company law says nothing about how large this margin of safety must be. What is desirable is left as a matter of commercial judgement by the company concerned. The larger it is, the easier the company will find it to persuade potential lenders to lend and suppliers to supply goods and services on credit. Sometimes, a potential creditor may insist that some of the retained profits are converted to bonus shares (or ‘capitalised’) to increase the margin of safety, as a condition of granting the loan. Also, most potential long-term lenders try to secure their loan against one of the company’s assets, such as freehold property. This gives them the right to seize the specific asset concerned, sell it and

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301

satisfy their claim should the company default. Lenders often place restrictions or covenants on the borrowing company’s freedom of action as a condition of granting the loan. These covenants typically restrict the level of risk to which the company, and thus the lender’s asset, is exposed. Also, it would be quite rare for a company to pay out all of its revenue reserves as a dividend: a legal right to do so does not necessarily make it a good idea. Most companies see ploughedback profits as a major—usually the major—source of new finance. The factors that influence the dividend decision are likely to include:

• the availability of cash to pay a dividend—it would not be illegal to borrow to pay a dividend, but it would be unusual and, possibly, imprudent

• the needs of the business for finance for investment • possibly a need for the directors to create good relations with investors, who may regard a dividend as a positive feature.

Large companies tend to have a clear and consistent policy towards the payment of dividends, and any change in the policy provokes considerable interest. It is usually interpreted by shareholders as a signal of the directors’ views concerning the future. For example, an increase in dividends may be taken as a signal from the directors that future prospects are bright: a higher dividend is seen as tangible evidence of their confidence. Real World 6.3 provides an example of how commercial realities led to a change in the level of dividends paid by two very large companies, as well as providing a rare example of non-compliance regarding distributions.

REAL WORLD 6.3 Dividend policy and distributions

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(a) Dividend policy Rio Tinto and BHP Billiton, probably the two biggest resources companies in the world, have both changed their dividend policies as a result of the crash in commodity prices and the associated impact on their results and future prospects. Each has had a progressive policy (i.e. always increasing). For 2015 Rio maintained its final dividend, but foreshadowed a potential near halving of dividends for 2016, with a payout ratio of between 40% and 60% a"erwards. BHP also slashed its interim dividend (from US62¢ per share to US16¢), the first time the dividend had been cut since the very early days of the company. It flagged that, in the future, the dividend would be a minimum of 50% of underlying profit for the period. Both companies recognised that they were in danger. Concerns were generally about the levels of costs, capital expenditure, debt and productivity, alongside dramatic reductions in selling prices. Rio’s full year underlying profit fell 51%, in spite of a reduction in its global wages bill of $US1.2 billion. A"er impairments, the full year loss was US$866 million. Source: Stephen Bartholomeusz, ‘Rio Tinto snookers BHP by dumping progressive dividend policy’, The Weekend Australian, 13–14 February 2016. Robert Gottliebsen, ‘BHP’s management lesson for all Australian companies’, The Australian, 24 February 2016. Matt Chambers, ‘Rio Tinto shrinks its wages bill by $US1.2bn’, The Australian, 4 March 2016.

The final result for BHP Billiton for 2016 was a loss from operations of $US6.235 billion, but an underlying figure of earnings before interest and tax, depreciation and amortisation (EBITDA) of US$12.3 billion. A final dividend of 14 cents per share was agreed, making the total for the year US30¢. In accordance with the Group dividend policy, this comprises the minimum payout of US8¢ per share and an additional US6¢ per share, reflecting continued balance sheet strength and strong, free cash flow during the period. In the first half of 2016 Rio paid a dividend per share of US45¢ per share compared with US107.5¢ for the equivalent period of 2015. Sources: Rio Tinto, ‘Half year results 2016’. BHP Billiton, ‘Reports and presentations’, 2016.

(b) Distributability of dividends In the United Kingdom, Betfair returned £80 million to investors in violation of accounting rules, the gambling company admitted. The embarrassing breach—which occurred in 2011, 2012 and 2013 before being noticed— involved Betfair paying out more in dividends and share buybacks than it was legally permitted to. Betfair announced its first dividend as a public company in June 2011, partly to reassure investors who had seen the company’s shares halve since its flotation six months earlier. It paid out £30 million in relation to the 2011, 2012 and 2013

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financial years, and also bought back £50 million in shares. However, the payments did not comply with a rule change on how a company’s realised profits and distributable reserves are defined. Betfair said in its latest annual report that, ‘as a result of certain changes to the technical guidance issued by the Institute of Chartered Accountants in England and Wales (the “ICAEW”) in October 2010, the Company did not have sufficient distributable reserves to make those distributions and so they should not have been paid by the Company to its shareholders’. Deed polls have now been used to ensure that investors do not have to repay the dividends, and the company’s annual general meeting in September will be asked to approve the cancellation of ordinary shares affected by the buyback.

Source: Extract from Mance, H. (2014) ‘Betfair admits to £80m payouts mistake’, #.com, 3 August. © The Financial Times Limited 2014. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

Class discussion points 1 Summarise the rules relating to payment of dividends. Do these rules adequately protect creditors and lenders? 2 Is a progressive dividend policy realistic? 3 Do you think that either BHP or Rio had any real choice other than a reduction in dividends? 4 What broad principles might guide a company’s dividend policy?

It is possible for certain preference shares (called ‘redeemable preference shares’) to be redeemed (repurchased by the company). Where any such preference shares redeemed are replaced by new shares there is no real problem, as the creditor’s position relative to shareholders is unchanged. However, where preference shares are redeemed without any new capital issue, there seems to be a direct contradiction of what has been said so far in this section, as the shareholders’ equity would be reduced. It is, therefore, necessary for an amount equivalent to the amount of preference capital redeemed to be transferred from retained profits directly to capital, thus maintaining the total capital of the business. Without this proviso, unscrupulous directors could redeem capital and pay out retained profits, disadvantaging creditors and lenders. A company is not allowed to acquire and hold its own shares, but it can buy them back and cancel them, so long as the buyback does not materially prejudice the creditors.

ACTIVITY 6.6 Why might a company wish to buy back its shares?

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What advantages might result for shareholders?

SELF-ASSESSMENT QUESTION 6.1 The summarised statement of financial position of Bonanza Ltd is as follows: BONANZA LTD Statement of financial position as at 31 December 2017 Net assets (various assets less liabilities) Shareholders’ equity Share capital (100,000 shares issued at $1.30 each) Revaluation reserve Retained profits

$ 235,000 130,000 37,000 68,000 235,000

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1 Without any other transactions occurring at the same time, the company made a one-for-five rights share issue at $2 per share payable in cash (all shareholders took up their rights) and, immediately after, made a one-for-four bonus issue, at an issue price of $2. Show the statement of financial position immediately following the bonus issue, assuming that the directors want to retain the maximum dividend payment potential for the future. 2 Explain what external influence might cause the directors to choose not to retain the maximum dividend payment possibilities. 3 Show the statement of financial position immediately following the bonus issue, assuming that the directors want to retain the minimum dividend payment potential for the future. (For the purposes of questions 3 and 4, assume that the company does not consider the revaluation reserve to be distributable as a cash dividend.) 4 What maximum dividend could be paid before and after the events described in question 1 if the minimum dividend payment potential is achieved? 5 Lee owned 100 shares in Bonanza Ltd before the events described in question 1. Assuming that the company’s net assets have a value equal to that shown in the accounts, show how these events will affect Lee’s wealth.

Concept check 7 Which statement is false? A

B

C

D E

Retained profits are profits made over the life of a business which have not been taken out by owners in the form of drawings or dividends. It is law that a specific part of the capital of a company cannot legally be withdrawn by the shareholders. Large companies tend to have an opaque and changing policy towards the payment of dividends. The availability of cash is quite possibly a factor in a dividend payment decision. None of the above.

Concept check 8 Which of the following is false? Copyright © 2017. P.Ed Australia. All rights reserved.

A

B

C D E

Many companies treat unrealised capital gains obtained by a revaluation as a non-distributable revaluation reserve. To protect the company’s creditors, the law insists that a specific part of the capital of a company cannot legally be withdrawn by the shareholders. Many companies treat retained profits as a source of finance. It is illegal for a company to borrow money to pay a dividend. None of the above are false.

LO4 THE MAIN FINANCIAL STATEMENTS The financial statements of a limited company are, in principle, the same as those of a sole proprietorship or a partnership. There are, however, differences in detail, which we shall now consider. Example 6.7 sets out the income statement and statement of financial position of a limited company.

Explain and discuss the main financial statements prepared by a limited company

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DA SILVA LTD Income statement for the year ending 31 December 2017

6.7

$m 840 (520) 320 (98) (18) (24) (20) (4) (12) (45) (4) 95 (10) 85 (24) 61

Revenue Cost of sales Gross profit Wages and salaries Heat and light Rent and rates Motor vehicle expenses Insurance Printing and stationery Depreciation Audit fee Operating profit Interest expense Profit before taxation Taxation Profit for the year

DA SILVA LTD Statement of financial position as at 31 December 2017 $m Current assets Cash Accounts receivable Inventories Non-current assets Property, plant and equipment Intangible assets

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Total assets Current liabilities Accounts payable Taxation Non-current liabilities Borrowings Equity Ordinary shares issued at $0.50 each Other reserves Retained earnings Total equity and liabilities

36 112 65 213 203 100 303 516 99 12 111 100 200 80 25 305 516

Let us now go through these statements and pick up those aspects that are unique to limited companies.

The income statement The main points for consideration in the income statement are as follows.

Profit Following the calculation of operating profit, two further measures of profit are shown.

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The first of these is the profit before taxation. Interest charges are deducted from the operating profit to derive this figure. In the case of a sole proprietor or a partnership business, the income statement would end here. The second measure of profit is the profit for the period (usually a year). As the company is a separate legal entity, it is liable to pay tax on the profits generated. (This contrasts with the sole proprietor business where it is the owner rather than the business who is liable for the tax on profits, as we saw earlier in the chapter.) This measure of profit after tax represents the amount that is available for the shareholders.

profit before taxation The result when all of the appropriately matched expenses of running a business have been deducted from the revenue for the year, but before the taxation charge has been deducted.

Audit fee

profit for the period The profit for the year after a reasonable estimate of tax likely for the year.

Companies beyond a certain size are required to have their financial statements audited by an independent firm of accountants, for which a fee is charged. As we shall see in Chapter 7, the purpose of the audit is to lend credibility to the financial statements. Although it is also open to sole proprietorships and partnerships to have their financial statements audited, relatively few do, so this is an expense that is most often seen in the income statement of a company.

The statement of financial position The main points for consideration in the statement of financial position are as follows.

Taxation The amount that appears as part of the current liabilities represents any income tax due in the next 12 months.

Other reserves This will include any reserves that are not separately identified on the face of the statement of financial position. It may include a general reserve, which normally consists of trading profits that have been transferred to this separate reserve for reinvestment (‘ploughing back’) into the operations of the company. It is not at all necessary to set up a separate reserve for this purpose. The trading profits could remain unallocated and still swell the retained earnings of the company. It is not entirely clear why directors decide to make transfers to general reserves, since the profits concerned remain part of the revenue reserves, and as such they still remain available for dividend. The most plausible explanation seems to be that directors feel that placing profits in a separate reserve indicates an intention to invest the funds, represented by the reserve, permanently in the company and, therefore, not to use them to pay a dividend or to fund a share repurchase. Of course, the retained earnings appearing on the statement of financial position are also a reserve, but that fact is not indicated in its title. Real World 6.4 provides an illustration of the range of reserves found in practice. Many large companies use similar approaches, as revaluations, foreign currency translations and cash flow hedges are reasonably common. Copyright © 2017. P.Ed Australia. All rights reserved.

305

Dividends Dividends represent drawings by the shareholders of the company. They are paid out of the revenue reserves and should be deducted from these reserves (usually retained earnings) when preparing the statement of financial position. Shareholders are often paid an annual dividend, perhaps in two parts. An ‘interim’ dividend may be paid part-way through the year, and a ‘final’ dividend shortly after the year-end. Those dividends declared by the directors during the year but still unpaid at the year-end may appear as a liability in the statement of financial position. To be recognised as a liability, however, they must be properly authorised before the year-end date. This normally means that the shareholders must approve the dividend.

ACTIVITY 6.7 Assume that a company has a profit before taxation of $10 million and expects to pay income tax at the rate of 30%. It has paid an interim dividend of 10¢ per share and expects to pay a final dividend of 10¢ per There are 20 million shares issued at ProQuest a priceEbook of $1.50 each. Opening retained profits were $15 million. Atrill, Peter, et al. share. Accounting for Business Students eBook, P.Ed Australia, 2017. Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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Show your calculation of the retained profits at the end of the year, the equity section of the statement of financial position at the end of the year, and any other current liabilities that will be shown in the closing statement of financial position.

REAL WORLD 6.4 Reserves and retained profits Harvey Norman Holdings Limited, in its annual report for 2016, included the following reserves, as well as retained profits. a) Asset revaluation reserve This reserve is used to record increases in the fair value of ‘owner occupied’ land and buildings and decreases to the extent that such decreases relate to an increase on the same asset previously recognised in equity. b) Foreign currency translation reserve This reserve is used to record exchange differences arising from the translation of the financial statements of foreign subsidiaries. c) Available for sale reserve This reserve is used to record fair value changes on available-for-sale investments. d) Cash flow hedge reserve This reserve is used to record the portion of the gain or loss on a hedging instrument in a cash flow hedge that is determined to be an effective hedge.

e) Employee equity benefit reserve This reserve is used to record the value of equity benefits provided to executive directors as part of their remuneration. f) Acquisition reserve This reserve is used to record the consideration paid in excess of carrying value of non-controlling interests’ (p. 109). Some of these reserves will actually be negative and clearly will reduce total equity. Source: Harvey Norman Holdings Limited Annual Report 2016, p. 109. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Class discussion points 1 What do you think is meant by an ‘effective hedge’? 2 Which of the listed reserves would you expect to have the most movement in any one year?

Concept check 9 Which of the following is false? A

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B

C D E

The financial statements of a limited company are fundamentally the same as those of a sole proprietorship. The financial statements of a limited company are fundamentally the same as those of a partnership. Tax expense is recognised by a company when profits are earned. Unpaid taxes will be part of a company’s current liabilities. None of the above. All are true.

Concept check 10 Which of the following statements is false? A

B C D E

The asset revaluation reserve account is used to record increases in the fair value of ‘owner occupied’ land and buildings. Dividends are the corporate version of drawings. The creation of a general reserve is a sensible business decision in many contexts. The creation of a general reserve does not affect the ability of the company to pay dividends. None of the above. All are true.

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

ACCOUNTING FOR GROUPS OF COMPANIES The treatment of companies so far has dealt with single companies. In fact, many companies acquire shares in other companies to obtain a controlling interest in these companies. There are a number of reasons for this, including:

• • • •

elimination of, or at least reduction in, competition safeguarding of sources of supply or sales outlets risk reduction through diversification access to economies of scale.

Control can normally be achieved by ownership of at least 50% of the ordinary share capital. The controlling company is known as the parent company (or holding company), and the (partly) owned company is known as a subsidiary company. Many large companies control multiple subsidiaries. Just how these operate together varies tremendously, but they are nevertheless seen to operate as a group, and this has certain consequences.

ACTIVITY 6.8

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It is important to note that, even in the case where a subsidiary is 100% owned, there may be good reasons to retain a separate identity. Identify these reasons.

In most cases each individual company is still required to prepare its own accounts, but the parent company is also required to prepare a set of group or consolidated accounts. These group accounts amalgamate the financial statements of all the group members. Thus the group accounts will include all of the revenues and expenses incurred by the individual members of the group, and all of the assets and liabilities of the members of the group, subject to some adjustments dealt with below. The overall aim of a set of group or consolidated accounts is to show the accounts as if the parent owns and operates all of the assets of the business directly, rather than via a set of subsidiaries. In principle, the process of consolidation is relatively straightforward. In essence, all that is needed is to add up the various revenues and expenses that appear in the individual company income statements to obtain the group income statement, and all of the assets and claims in the various statements of financial position to obtain the group statement of financial position. However, while this is the case in principle, a number of complications usually occur, the most important of which are dealt with below:

• Goodwill arising on consolidation. When the amount paid by the parent is more

•

than the book value associated with a subsidiary, the extra amount paid will need to appear on the group statement of financial position as an asset, called goodwill on consolidation . Non-controlling interests (also known as minority interests). As stated above, all revenue, expenses, assets and liabilities must be reflected to their full extent in the group financial statements. This must be the case whether the parent owns 100% of the subsidiary company’s shares or less. The critical question relates to control. Where the ownership is less than 100%, then part of any net income and net assets must be attributable to interests other than that of the parent, namely non-controlling interests. Outside shareholders have financed part of the group’s activities and are entitled to part of any group income.

Example 6.8 shows how the statement of financial position for the group owned by Parent Ltd, a company which controls a subsidiary, Sub Ltd, is built up.

LO5 Explain the concept of group or consolidated accounts

parent/holding company A company which invests in another company by purchasing sufficient shares to obtain a controlling interest. subsidiary company A company which is controlled by another, by the fact that this other company owns a controlling interest in the company concerned.

group or consolidated accounts An amalgamation of sets of accounts for a group of companies such that the group accounts appear as if the entire group is one entity.

goodwill on consolidation The amount paid by an investing company for purchase of sufficient shares to acquire a controlling interest in another company, less the value of the equity or net assets, usually calculated on a fair value basis. non-controlling interests/minority interests The proportion of a subsidiary company that is owned by other than the parent company.

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Parent Ltd owns 80% of the ordinary share capital of Sub Ltd. Parent Ltd paid $32 million for the controlling interest.

6.8

The statements of financial position of the two companies immediately after the takeover of control of Sub Ltd by Parent Ltd are as follows: Statements of financial position as at 31 December 2017 Parent Ltd $m

takeover Where one company buys enough shares in another to obtain a controlling interest.

Current assets Cash Accounts receivable Inventories Non-current assets Property, plant and equipment Investment in Sub Ltd—20 million shares Total assets Current liabilities Accounts payable Non-current liabilities Debentures Equity Ordinary shares issued at $1 each Reserves Total equity and liabilities

Sub Ltd $m

8 12 19 39

5 7 8 20

38 32 70 109

30

10

5

24

10

50 25 75 109

25 10 35 50

50

Under circumstances such as a takeover, we would reasonably expect the figures to be based on current fair value. The goodwill on consolidation would be calculated as follows. The investment in shares gives Parent Ltd an 80% holding, which is clearly a controlling interest, so group accounts are required. The cost of this holding is $32 million. The net assets acquired amount to 80% of the equity at the time of purchase, which is $35 million 3 80% 5 $28 million. This means that the amount paid exceeds the fair value of the net assets by $4 million and this must appear in the group statement of financial position. The non-controlling interests amount to 20% of the equity of Sub Ltd, which amounts to $35 million 3 20% 5 $7 million. The group statement of financial position can then be constructed as follows:

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Consolidated statement of financial position as at 31 December 2017 $m Current assets Cash Accounts receivable Inventories Non-current assets Property, plant and equipment Goodwill on consolidation Total assets Current liabilities Accounts payable Non-current liabilities Debentures

(8 1 5) (12 1 7) (19 1 8)

13 19 27 59

(38 1 30)

68 4 72 131

(10 1 5)

15

(24 1 10)

34

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

Equity Ordinary shares issued at $1 each Reserves Equity attributable to the parent Non-controlling interests

50 25 75 7 82 131

Total equity and liabilities

309

6.8 continued

You should note that all of the figures but two—the goodwill on consolidation and the non-controlling interest—are simply the sum of the various parts relating to the parent and subsidiary. Goodwill on consolidation is usually shown under intangible assets in the statement of financial position. In the year that follows the takeover, the summarised income statements of Parent Ltd and Sub Ltd are as shown in Example 6.9 together with a consolidated income statement and workings.

Income statements for the year ending 31 December 2018 Revenue Cost of sales Gross profit Administration expenses Distribution expenses Profit before tax Taxation Profit for the year

Parent Ltd $m 40 (20) 20 (8) (2) 10 (3) 7

Sub Ltd $m 20 (8) 12 (4) (2) 6 (1.8) 4.2

6.9

The consolidated income statement is as follows:

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Consolidated income statement for the year ending 31 December 2018 Revenue Cost of sales Gross profit Administration expenses Distribution expenses Profit before tax Taxation Profit for the year Attributable to Equity holders of the parent Non-controlling interests

(40 1 20) (20 1 8) (8 1 4) (2 1 2) (10 1 6) (3 1 1.8) (7 1 (80% 3 4.2)) (20% 3 4.2)

$m 60 (28) 32 (12) (4) 16 (4.8) 11.2 10.36 0.84 11.2

The non-controlling interest’s share of profits is 20% of the profit of Sub Ltd, with the remainder being all the entitlement of Parent Ltd.

A further complication, beyond the scope of this book, relates to intra-group transactions; that is, transactions that take place between the companies within the group. This might include loans from one member of the group to another. Such transactions need to be eliminated from the group accounts, as do any profits recognised by one company within the group that are not Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 16:43:06.

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realised by ongoing sale outside of the group. For example, if a subsidiary company sells goods to a parent at a price which yields a profit of, say, $100,000, and these goods are not sold on beyond the group, we have a profit that is realised by the subsidiary, but which has not been realised by the group.

ACTIVITY 6.9 The following summary statements of financial position relate to H Ltd and S Ltd as at 31 December 2017, immediately a"er H Ltd acquired 60% of the share capital of S Ltd for $4 million. Statement of financial position as at 31 December 2017 Current assets Non-current assets Investment in S Ltd Total assets Liabilities Equity Ordinary shares ($1 fully paid) Reserves Total equity Total equity plus liabilities

H Ltd $m 4 6 4 14 3 6 5 11 14

S Ltd $m 2 4 6 1 3 2 5 6

In the course of the next year, H Ltd made profits a"er tax of $3 million and S Ltd made $1.5 million.

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Prepare a consolidated statement of financial position as at 31 December 2017, and show how the profit a"er tax for 2018 would be allocated to H Ltd and to the non-controlling interest in the group income statement for 2018.

associate company A company which is partly owned by another company, such that the ownership does not give the investor company control, but does give it the opportunity to exert considerable influence. Typically, the ownership is between 20% and 50%.

This brief overview of group accounts is intended to help you understand the final accounts of groups of companies. Group structures and accounts can be very complicated. It is worth noting that investment in shares of another company does not always involve acquisition of a controlling interest. Frequently, a smaller amount of ownership will still enable the investing company to be able to exert an influence on the company whose shares are owned. Typically, companies that are between 20% and 50% owned by an investor company are known as associate companies of the investor company. In cases like this, the consolidated accounts also need to show:

• the share of profits or losses of the associate company • the share of tax attributable to the associate company • the share of retained profit in the associate company.

Concept check 11 Which of the following is false? A

B C

D E

A company that acquires a controlling interest of shares in another company is known as the parent or holding company. The owned (or partly owned) company is known as the subsidiary. Goodwill arising on consolidation occurs when the amount paid by the parent is more than the book value associated with the subsidiary. It is generally inappropriate to recognise goodwill except in special circumstances. None of the above. All are true.

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

Concept check 12 Which of the following statements is false? A

B C

D

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E

The minority interest is the proportion of a subsidiary company that is owned by other than the parent company. There is no minority interest if the subsidiary is 100% owned by the parent. A further complication with consolidated accounts relates to transactions that take place between the companies within the group. The overall aim of a set of consolidated accounts is to show the accounts as if the parent owned and operated all of the assets of the business directly. None of the above. All are true.

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SUMMARY In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Identify and discuss the main features of companies

• • • • • •

LO2: Explain equity and borrowings in a company context

• • • • •

LO3: Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

• Identified the legal position regarding shareholders’ ability to make drawings or reductions in capital • Illustrated the basic reason for the restrictions

LO4: Explain and discuss the main financial statements prepared by a limited company

• Identified the major differences between the final accounts of a limited company as distinct from a sole proprietorship or a partnership

LO5: Explain the concept of group or consolidated accounts

• Outlined the main issues relating to a parent–subsidiary relationship and its implications for a set of group accounts

Explained the importance and implications of corporate separate legal entity Explained the significance of perpetual life for a company Explained limited liability and its consequences Distinguished between private companies and public companies Explained the role of the stock exchange in transferring share ownership Explained the separation of ownership and management that is implicit in companies • Identified reasons for greater regulation associated with companies • Outlined the concept of corporate governance • Listed and explained the advantages and disadvantages of limited companies Identified and explained the basic ‘classification’ of equity for a limited company Explained the nature of reserves Explained and illustrated bonus shares Identified the main ways in which capital can be raised Identified the types of borrowing possible for corporate entities and their importance

DISCUSSION QUESTIONS Copyright © 2017. P.Ed Australia. All rights reserved.

EASY 6.1

LO1

What is meant by a company having ‘perpetual life’? Is this ‘life’ different for a limited company as compared to a proprietary company?

6.2

LO1/2/3

In what sense do preference shares have an ‘advantage’ or ‘priority’ over ordinary shares?

6.3

LO2

Six friends decide to form a company to start a business. They agree to supply $10,000 each to provide the initial capital. They are thinking of having a share capital of six shares each issued at a price of $10,000. Their accountant has advised them to have 60,000 shares at an issue price of $1 per share. Can you think why the accountant gave them this advice?

6.4

LO5

When are group or consolidated accounts required, and what is the purpose for their preparation?

INTERMEDIATE 6.5

LO1

How do you determine whether a company can be classified as ‘small’ under the Australian Corporations Act?

6.6

LO1

What are the main areas that directors need to disclose in their report?

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

6.7

LO1/2

Why would a business choose to make the following entity structure changes? (a) From a sole proprietorship or partnership to a private company (b) From a public company to a private company.

6.8

LO1

Is ‘limited liability’ a good thing? Explain.

6.9

LO2

What is the difference between a share issued as a ‘bonus share’ and a ‘rights share’ from the perspective of the: (a) shareholder? (b) company issuing the shares? (c) unsecured creditor?

6.10 LO3

Why is the Corporations Act particularly interested in distinguishing between ‘a return on capital’ and ‘a return of capital’?

6.11 LO1/2

Can reserve accounts have a negative balance? If yes, provide an example.

6.12 LO4

Discuss the three guiding principles relating to monitoring and control of the behaviour of directors; namely disclosure, accountability and fairness.

6.13 LO1/2

Can you think of any reason why the price at which shares are transferred from one person to another may be different from the amount originally invested in the company?

6.14 LO3

How can a company’s supplier minimise the risk carried by the limited liability of shareholders?

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CHALLENGING 6.15 LO2/3

Your non-accountant friend has asked you to explain what is represented by the ‘Reserve for Future Research & Development’ account on PHB Ltd’s balance sheet. Explain what this account represents and why it might have been created.

6.16 LO4

Describe the similarities and differences between the main financial statements prepared for a limited company and those for a sole proprietorship or partnership.

6.17 LO3

What is a chief means by which the Corporations Act protects the interests of creditors and other external lenders?

6.18 LO4

In light of the various corporate collapses and scandals in recent years (e.g. HIH Insurance), you’re concerned about the accuracy of corporate financial statements. What is your chief assurance that the financials are ‘accurate’?

6.19 LO1/2

Summarise the rules relating to payment of dividends. Do these rules adequately protect creditors and lenders?

6.20 LO5

What two corporate structure features must exist if a company is showing a ‘minority interest’ account on its balance sheet?

APPLICATION EXERCISES EASY 6.1

LO1

Test your knowledge of various aspects of limited liability companies. Match the terms in 1–10 in the first list with the corresponding definitions A–J in the second list. 1 Share 2 Ltd 3 Pty Ltd 4 Equity 5 Dividend 6 Reserves 7 Preference shares 8 Rights issue 9 Bonus issue 10 Audit

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A Shares distributed by the company to shareholders ‘for free’ B

Independent examination of a company’s finances

C Signifies a public limited company D Shares given preference when dividends are distributed E

Includes profits built up over time within the company

F

Signifies a private limited company

G Opportunity for shareholders to buy more shares H The sum of all the reserves and ordinary share capital

6.2

LO2

I

Part of reserves distributed to shareholders

J

One unit of a company’s ownership

Pillar Limited issued 10,000 ordinary shares at $5 and made a call at $3. Calls are in arrears at balance day for 500 shares. Calculate Pillar Limited’s share capital balance.

6.3

LO2

(a) Show the effect on the statement of financial position of the following transactions: (i) 100,000 shares issued at a price of $1 per share, but only 50¢ per share is called (ii) after the remaining 50¢ is called. (b) The summarised statement of financial position of a company is as follows:

Net assets Equity

5,000,000

Ordinary share capital issued at $1 per share Retained profits

3,000,000 2,000,000 5,000,000

The company is planning to raise a further $2 million via a new issue of shares. Advise the company as to the price at which the shares should be issued. 6.4

LO2

A company has the statement of financial position given below.

Net assets Ordinary share capital issued at $1 per share

200,000 100,000

Retained profits

100,000 200,000

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The market value per share is $2.50. (a) What is the book value per share? (b) The company intends to issue 100,000 more shares at the market price. Show the statement of financial position after this issue. (c) What is the book value per share after the new issue? (d) What reasons may exist for the book value per share to differ from the market price per share? 6.5

LO1/2

(a) Frothy Ltd started trading in 2016 and it made a loss for the year of $100,000. In 2017, it made a profit of $50,000. What is the maximum dividend that it could pay at the end of 2017? (b) Bubbly Ltd started trading in 2016 and made a profit for the year of $100,000. In 2017, it made a loss of $60,000. What is the maximum dividend the company could pay at the end of 2017, assuming that no dividends were paid in 2016? (c) As well as the results given in (b) above, you find that Bubbly Ltd sold a plot of land, which had cost $100,000, for $150,000, and had revalued another similar plot, which had cost $100,000, to $150,000. What is the maximum dividend that the company could pay at the end of 2017?

6.6

LO4

CBD Ltd recently paid $4,000,000 for 60% of LKJ Ltd’s equity. LKJ Ltd had total assets of $6,500,000 and liabilities of $1,300,000. What amount of goodwill on consolidation will CBD Ltd record? A $100,000 B

$2,700,000

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

C $880,000 D $1,200,000 E 6.7

LO4

None of the above

Gibbons Ltd purchased 100% of the shares of one of their competitors (PJB Ltd) at a total cost of $2,500,000. At the purchase date Gibbons Ltd had total assets of $14,000,000 and liabilities of $11,000,000, while PJB Ltd had assets of $5,000,000 and liabilities of $2,000,000. (a) What amount of goodwill on consolidation (if any) will Gibbons record? (b) What is the amount of minority interest (if any) that Gibbons will record?

6.8

LO5

The following statements of financial position relate to H Ltd and S Ltd as at 31 December 2017. H Ltd $’000

S Ltd $’000

10,200

9,000

Net assets Investments in S Ltd

6,800 17,000

9,000

12,000

6,000

5,000

3,000

17,000

9,000

Ordinary share capital Shares issued at $1 fully paid Reserves

H Ltd acquired all of S Ltd’s capital on 1 January 2016 for $6.8 million when reserves of S Ltd were $700,000. Prepare a group (consolidated) statement of financial position as at 31 December 2017. How would this statement change if the reserves of S Ltd at the time of purchase had been $1 million?

INTERMEDIATE 6.9

LO1/3

Your partner has just given you your 21st birthday present: 2,100 ‘non-redeemable, participating, cumulative, non-voting 10% preference shares’. Complete the table below, explaining the meaning of each of the descriptive terms (top row of table), and indicate whether that feature of the share is (a) ‘really good’, (b) ‘good’, (c) ‘not so good’ or (d) ‘doesn’t really matter’ for each of the share features (bottom row of table). Non-redeemable

Participating

Cumulative

Non-voting

10% Preference shares

Explanation of feature Evaluation

Copyright © 2017. P.Ed Australia. All rights reserved.

6.10 LO1/2

Comment on the following quote: Limited companies can set a limit on the amount of debts that they will meet. They tend to have reserves of cash, as well as share capital, and they can use these reserves to pay dividends to the shareholders. Many companies have preference as well as ordinary shares. The preference shares give a guaranteed dividend. The shares of many companies can be bought and sold on the stock exchange. Shareholders selling their shares can represent a useful source of new finance to the company.

6.11 LO2

A company had the following events during its most recent financial year: 1 A non-current asset was sold for a profit of $20,000. 2 A profit of $45,000 was made on trading operations. 3 An issue of 10,000 $1 ordinary shares raised $30,000. 4 Property was revalued at $10,000 above its current recorded value. Which of the above will lead to the creation of a capital reserve?

6.12 LO2

Cheshire Ltd has a general reserve of $200,000 and a bank overdraft of $300,000. The chief executive would like to distribute all of the general reserves in the form of a dividend. He therefore

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proposes to increase the overdraft to pay for the dividend distribution. However, the operations director has argued that this cannot be done for two reasons, which are: 1 The general reserve is regarded in law as a non-distributable reserve. 2 The law states that dividends cannot be paid by using borrowed funds. Which of the above statements is correct (true/false)? Explain. 6.13 LO3

Consider the following statements. A limited company cannot pay dividends to ordinary shareholders where: 1 An operating loss is made in the period to which the proposed dividends relate. 2 A decision has been made not to pay a dividend to preference shareholders. Are the above statements true or false? Explain.

6.14 LO4

Yankees Limited earned a profit before taxation of $500 million and expects to pay income tax at the rate of 30%. The company paid an interim dividend of $2 per share and expects to pay a final dividend of $3 per share. There are 50 million shares issued at a price of $12 each. Opening retained earnings were $15 million. Show your calculation of year-end retained earnings.

6.15 LO2

(a) The summarised statement of financial position of Leon Ltd is shown below: Net assets Ordinary share capital issued at $1 Preference share capital issued at $1 Retained profits

2,000,000 1,200,000 300,000 500,000 2,000,000

The directors decide to redeem the preference share capital. This is to be replaced by a further issue of 200,000 ordinary shares at $1.60 per share. Show the revised statement of financial position after this has occurred. (b) What would you have needed to do if the replacement issue had not taken place? (c) Explain the rationale for your answer to (b). 6.16 LO2

The summarised statement of financial position of CF Ltd is as follows: Net assets Ordinary share capital issued at $1 Revaluation reserve Retained profits

1,600,000 800,000 400,000 400,000 1,600,000

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CF Ltd decides to make a bonus issue on a one-for-four basis, followed by a rights issue on a one-forfive basis at a price of $2 per share. (a) Show the statement of financial position after these issues. (b) Explain the movements in reserves. 6.17 LO5

Big Box Ltd recently paid $4,000,000 for 90% of Subsid Ltd’s equity. Subsid Ltd had total assets of $4,500,000 and liabilities of $1,500,000. (a) What amount of goodwill on consolidation (if any) will Big Box record? (b) What is the amount of minority interest (if any) that Big Box will record?

6.18 LO5

The following statements of financial position relate to H Ltd and S Ltd as at 31 December 2017.

Net assets Investments in S Ltd Ordinary share capital Shares issued at $1 fully paid Reserves

H Ltd $’000 10,200 5,000 15,200

S Ltd $’000 7,500

10,000 5,200 15,200

5,000 2,500 7,500

7,500

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

The investments in S Ltd had cost $5 million, for 4 million shares, at a time when S Ltd’s reserves stood at $1 million. Prepare a group (consolidated) statement of financial position as at 31 December 2017.

CHALLENGING 6.19 LO3

Woolwell Ltd has the following equity capital at year-end: Ordinary shares of $0.25 each Revaluation reserve General reserve Retained profits

$400,000 160,000 40,000 50,000 $650,000

In addition, the company has 200,000 $1 5% preference shares in issue. The board of directors wishes to eliminate the company’s reserves. It has decided to make an immediate one-for-four bonus issue of ordinary shares. Following the issue, an annual dividend will be paid to shareholders. The board would like the amount paid to ordinary shareholders to be the maximum possible. What will be the: 1 total reserves of the company following the above transaction? 2 dividend per share to ordinary shareholders? 6.20 LO3

Efford Ltd has the following equity capital at year-end. Ordinary shares of $0.50 each Revaluation reserve General reserve Retained profits

$200,000 50,000 80,000 62,000 $392,000

In addition, the company has 400,000 $1 8% preference shares in issue. The board of directors wishes to eliminate the company’s reserves. It has decided to make an immediate one-for-two bonus issue of ordinary shares. Following the issue, an annual dividend will be paid to shareholders. What will be the required: 1 transfer from revenue reserves to effect the bonus issue? 2 dividend per ordinary share?

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6.21 LO4

Presented below is a draft set of financial statements for Chips Ltd.

CHIPS LTD Income statement for the year ended 30 June 2017 Revenue Cost of sales Gross profit Depreciation Other operating costs Operating profit Interest payable Profit before taxation Taxation Profit for the year

$’000 1,850 (1,040) 810 (220) (375) 215 (35) 180 (60) 120

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ACCOUNTING FOR BUSINESS STUDENTS

CHIPS LTD Statement of financial position as at 30 June 2017 Cost $’000

Depreciation $’000

ASSETS Current assets Cash at bank Accounts receivable Inventories Non-current assets Motor vehicles Plant and equipment Buildings

$’000 16 420 950 1,386

102 650 800 1,552

(53) (367) (112) (532)

Total assets LIABILITIES AND EQUITY Current liabilities Accounts payable Other payables Tax Non-current liabilities Borrowings (secured 10% notes) Equity Ordinary shares issued at $1, fully paid Reserves at beginning of the year Profit for the year Total liabilities and equity

49 283 688 1,020 2,406

361 117 60 538 700 800 248 120 1,168 2,406

The following additional information is available: 1 Purchase invoices for goods received on 29 June 2017 amounting to $23,000 have not been included. This means that the cost of sales figure in the income statement has been understated. 2 A motor vehicle costing $8,000, with depreciation amounting to $5,000, was sold on 30 June 2017 for $2,000, paid by cheque. This transaction has not been included in the company’s records. 3 No depreciation on motor vehicles has been charged. The annual rate is 20% of cost at year-end. 4 A sale on credit for $16,000, made on 1 July 2017, has been included in the financial statements in error. The cost of sales figure is correct in respect of this item. Copyright © 2017. P.Ed Australia. All rights reserved.

5 A half-yearly payment of interest on the secured loan, due on 30 June 2017, has not been paid. 6 The tax charge should be 30% of the reported profit before taxation. Assume that it is payable, in full, shortly after year-end. Prepare a revised set of financial statements incorporating the additional information in 1–6 above. (Work to the nearest $1,000.) 6.22 LO4

Rose Ltd operates a small chain of retail shops which sell high-quality teas and coffees. Approximately half of the sales are on credit. Abbreviated and unaudited accounts are given below.

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

ROSE LTD Income statement for the year ended 31 March 2017 $’000 Sales Cost of sales Gross profit Labour costs Depreciation Other operating costs

$’000 12,080 (6,282) 5,798

(2,658) (625) (1,003) (4,286) 1,512 (66) 1,446 (434) 1012 (300) 712 756 1,468

Operating profit Interest expense Profit before tax Tax expense Profit after tax Dividend declared Retained profit for the year Retained profit brought forward Retained profit carried forward

ROSE LTD Statement of financial position as at 31 March 2017 $’000 Current assets Cash at bank Accounts receivable Inventory Non-current assets Total assets Current liabilities Bank overdraft Tax payable Dividend payable Accounts payable Other payables

$’000

26 996 1,583 2,605 2,728 5,333 296 434 300 1,118 417

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2,565 Non-current liabilities Debenture—repayable 2020 Total liabilities Shareholders’ equity Ordinary share capital Retained profits

300 2,865 1,000 1,468

Total liabilities and shareholders’ equity

2,468 5,333

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Since the unaudited accounts for Rose Ltd were prepared, the following information has become available: 2 Invoices for credit sales on 31 March 2017 amounting to $34,000 have not yet been included; cost of sales is not affected. 3 Bad debts should be provided at a level of 2% of debtors at year-end. 4 Inventory purchased for $2,000 was damaged and is now unsaleable. assets were not included in the accounts and the purchase invoice has not been processed. the year. 7 The audit fee of $45,000 is due.

6.23 LO5

are as follows: Current assets Non-current assets Current liabilities

800 1,600 58,000 60,400 400

4,000 48,000 52,000 2,000

40,000 20,000 60,400

20,000 52,000

The following information is also available: 1 Matt Ltd acquired the shares in James Ltd on 31 December 2016 when the reserves of James Ltd were $10 million. 2 During 2017, Matt Ltd sold goods that had cost $300,000 to produce to James Ltd for $400,000. At 31 December 2017, James Ltd still had half of these goods in stock, valued at cost to James Ltd, and included in current assets. 3 At 31 December 2017, James Ltd owed Matt Ltd $200,000. This amount had been included in the current assets and current liabilities of Matt Ltd and James Ltd respectively. No dividends were paid by either company in 2016 or 2017, and none is proposed. Prepare a consolidated balance sheet as at 31 December 2017.

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6.24 LO5

The following income statements relate to H Ltd and S Ltd for the year ended 31 December 2017. Sales Cost of sales Administration Distribution Dividends receivable

20,000

10,000

10,000

5,000

400 6,400

Income tax 4,400

2,000

2,400

700

Dividends Preference Added to reserves H Ltd owns 80% of the ordinary share capital of S Ltd. Prepare a consolidated income statement for the year ended 31 December 2017.

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

CHAPTER 6 CASE STUDY The statement of financial position and the income statement for the large department store chain Myer are shown below.

As at 30 July 2016

ASSETS Cash and cash equivalents Trade and other receivables and prepayments Inventories

D1 B1 B2

Total current assets Property, plant and equipment Intangible assets Deferred tax assets Investment in associate Other non-current assets Total non-current assets Total assets

C1 C2 A4 G4

45,207 37,883 396,297

53,323 30,363 381,907

479,738

480,804

445,379 904,171 27,056

469,006 916,108 18,016

9,203 2,271 1,388,160 1,867,898

2,614 1,405,744 1,886,548

400,590 94,228 10,812 7,033

387,182 85,728 6,997 512

795 520,585

871 481,389

147,273 19,754 69,702

441,179 21,198 75,112

239,548 760,133 1,107,765

542,143 1,023,532 863,016

739,338 379,483 (11,056) 1,107,765

524,755 335,366 2,895 863,016

LIABILITIES Trade and other payables Provisions Deferred income Current tax liabilities

B3 C3 C4

Other liabilities Total current liabilities

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Borrowings Provisions Deferred income

D3 C3 C4

Total non-current liabilities Total liabilities Net assets EQUITY Contributed equity Retained earnings Reserves

F1 F2 F2

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ACCOUNTING FOR BUSINESS STUDENTS

For the period ended 30 July 2016

Total sales value Concession sales

A2 A2

Sales revenue deferred under customer loyalty program Other operating revenue Cost of goods sold

A2 A2

Other income Selling expenses Administration expenses

3,289,568 (610,553) 2,679,015 (38,861) 2,640,154 161,689 (1,527,552) 1,274,291 71 (842,217) (318,039)

3,195,626 (501,153) 2,694,473 (40,122) 2,654,351 131,423 (1,495,382) 1,290,392 108 (828,906) (328,138) (61,687) 71,769 753 (23,488)

Strategic review, restructuring, store and brand exit costs and impairment of assets

A3

Finance revenue Finance costs

A2 A3

(18,250) 95,236 906 (15,447)

Income tax expense

A4

(20,152)

(19,208)

Basic earnings per share Diluted earnings per share

A5 A5

Cents 7.7 7.7

Cents 5.1 5.1

Source: Myer Holdings Limited, Myer Annual Report 2016, pp. 60 and 62. © Myer Pty Ltd.

Use the information provided above, together with a review of the notes to the accounts found on the web, to answer the following questions.

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QUESTIONS 1

What do you understand by the term ‘cash and cash equivalents’ in the consolidated balance sheet (statement of financial position)?

2

What is the basis of valuation of trade and other receivables and inventories for 2016?

3

What do you think are likely to be the main components in the figure for ‘property, plant and equipment’ in the balance sheet (statement of financial position)?

4

What do you understand by ‘fair value’?

5

What items do you think might be covered under the heading ‘intangible assets’ in the balance sheet (statement of financial position)? How do you think the various items might be valued and subsequently amortised?

6

What items are likely to be covered under the heading ‘borrowings’? How might these borrowings be secured?

7

The ‘provisions’ in the current liabilities are mainly made up of employee benefits, leased premises and restructuring. Those in the non-current liabilities include employee benefits and leased premises. Can you suggest what these might relate to?

8

‘Reserves’ in the balance sheet (statement of financial position) are negative. What does this mean?

9

What are the main reasons for the differing performances regarding normal profit in the two years covered by the income statement?

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

Concept check answers CC3 CC4

E A C D

CC5 have been tempted with B, but accounting reserves are never in cash

CC6 CC7 CC8 CC9

D C D E C

D E

SOLUTIONS TO ACTIVITIES ACTIVITY 6.1 Business is a risky venture—in some cases very risky. People will usually be happier to invest money when they know the limit of their liability. If investors are given limited liability, new businesses are more likely to be formed and existing ones generation of greater wealth for society as a whole. Obviously not all suppliers of goods and services are protected, as we read regularly that they lose all or part of what is owed to them when companies are liquidated (e.g. Harris Scarfe, Ansett, HIH). However, certain factors, requirements or actions are in place to provide protection, including: suppliers may require payment to be made in advance creditors may require personal guarantees by the owners or management

—maximum level of debt to assets —minimum required return on assets —restrictions on asset sales the creditors rank before the shareholders in the distribution of assets in the event of a liquidation of the company.

ACTIVITY 6.2

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Two ways are commonly used in practice: The shareholders may insist on monitoring closely the actions of the directors and the way in which they use the resources of the company. The shareholders may introduce incentive plans for directors that link their pay to the share performance of the company. In this way, the interests of the directors and shareholders will become more closely aligned.

ACTIVITY 6.3 The answers are as follows: Net assets Cash Shareholders’ equity

Net assets Cash Shareholders’ equity

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 6.4 Net assets 70,000

ACTIVITY 6.5 If the investor takes up the rights issue, she will be in the following position: $

1 3

3 650

If the investor sells the rights, she will be in the following position: 3 3

120

If the investor lets the rights offer lapse, she will be in the following position: 3

allows the rights offer to lapse. In practice, however, the company may sell the rights offer on behalf of the investor and pass on the proceeds to ensure that the issue has not made her worse off.

ACTIVITY 6.6 Reasons might include the following: Where surplus funds cannot be invested to yield returns in excess of the return being paid to shareholders, it makes economic sense to buy back shares rather than to invest surplus funds. level of permanent funds is excessive, it makes sense to reduce that funding and replace it with short-term funds as required (debt). The repurchase of shares may lower the average cost of funds to the company (cost of capital), and this will mean that more potential projects will be deemed acceptable. The company’s activity in the market will increase demand for shares and potentially increase or sustain the share price, which will normally be an advantage to the company. When the share price falls, it is a good time for the company to repurchase shares.

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From the viewpoint of the shareholder, possible advantages include: The activity of the company in buying its own shares will create additional demand, and this will have a positive impact on the share price. The repurchase of shares reduces the number of shares available for trading, and this also will have a positive impact on the share price. shares. The earnings and dividends per share should increase given there are now fewer shares.

ACTIVITY 6.7

Income taxation (30%)

3

Less dividends

4

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CHAPTER 6 INTRODUCTION TO LIMITED COMPANIES

Added to reserves

3 15 18

Share capital (20 million shares issued at $1.50)

30 18

Total equity

48

Income tax

3

Final dividends due

2 5

ACTIVITY 6.8 Reasons might include: The subsidiary might have a market identity, which is important to maintain, and this can best be achieved through retention of its current corporate status. The staff of the subsidiary might feel that they have greater autonomy and independence if it retains its separate identity, or The directors of the parent might prefer to retain the limited liability status of each company individually.

ACTIVITY 6.9 $m

6 10 1 17 4

1 1 Goodwill on consolidation 1 Equity

6 5 2

Attributable to non-controlling interests

17

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The goodwill on consolidation is calculated as follows: Buys 60% of net assets ($5 million)

$3 million

Goodwill

$1 million

Non-controlling interest is 40% of net assets 5 40% 3 $5 million 5 $2 million. 1 $0.9 million goes to H Ltd, and 40% of $1.5 million is allocated to the non-controlling interest.

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C H A P T E R X7

REGULATORY FRAMEWORK CHAPTER NAME FOR COMPANIES LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain the importance of company law in relation to the directors’ duty to account, and discuss the role of the auditor in this process

LO2 Explain why there is a need for accounting rules, explain the importance of

accounting standards and map the development of accounting standards through to the development of international standards

LO3 Outline the role of the Australian Securities Exchange with regard to company

reporting and management, with particular reference to corporate governance

LO4 Identify the main requirements relating to the published annual report, including all of the financial and ancillary statements

LO5 Explain the rationale for preparing segment reports and describe the reporting requirements

LO6 Define the term creative accounting, describe the kind of methods used and identify steps that might be used to prevent it occurring.

aspects of company accounting. We begin by identifying the legal responsibilities of directors. We then go detailed consideration of these accounting rules is beyond the scope of this book, the key rules that shape

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the efforts made to ensure that these rules are underpinned by a coherent framework of principles. This is followed by an examination of the role of the Australian Securities Exchange in company accounting, with a review of some well-publicised accounting scandals, and considerable discussion on the role and importance of corporate governance. annual reports of companies, including the statement of comprehensive income and the statement of changes in equity. This extends into the next section on segment reporting as many large businesses are on these segments of the business is essential if a reasonable degree of analysis is to be possible.

This chapter therefore concludes with an outline of the problem of creative accounting and its dangers.

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

In many ways, this chapter may be seen to have less of a decision-making orientation than others. However, it is clearly important that decision-makers are able to ‘read’ (and understand) a set of accounts as published in a company annual report, as this provides probably the most comprehensive information about companies in which they have an interest, or indeed one with which they compete, A further element relating to information is compliance, which effectively is assurance that legal and other regulatory requirements have been met (complied with). Decision-makers need to understand the role of the regulatory framework (and live within it) and also the impact of that framework for their particular business. An understanding of the role of accounting standards is essential, as is a

with a particular business. Finally, an awareness of creative accounting and its implications is useful to anyone looking at a set of company accounts.

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THE DIRECTORS’ DUTY TO ACCOUNT—THE ROLE OF COMPANY LAW (CORPORATIONS ACT) As we have already seen, it is not usually possible for all of the shareholders to be involved in the general management of the company, nor do most of them wish to be involved, so they elect directors to act on their behalf. It is both logical and required by company law that directors are accountable for their actions as stewards of the company’s assets. The directors must therefore prepare (or have prepared on their behalf) financial statements that provide a fair representation of the financial position and performance of the business. This requires that they select appropriate accounting policies, make reasonable accounting estimates and adhere to all relevant accounting rules when preparing the statements. The directors are also expected to maintain appropriate internal control systems. In this context, directors of all reporting entities and disclosing entities, all public companies and all large proprietary companies, are required to prepare true and fair financial statements. (Disclosing entities include companies listed on the stock exchange and companies raising funds through a prospectus—i.e. public issue.) Small proprietary companies are not required to prepare formal financial statements or to have them audited, unless directed to by at least 5% of their shareholders or by the Australian Securities and Investments Commission (ASIC). They must, however, maintain sufficient accounting records to allow annual accounts to be prepared and audited. The financial statements are to include the statement of financial position, the statement of financial performance (in the case of companies, this is a statement of comprehensive income), the statement of changes in equity, the statement of cash flows and related notes. ‘True and fair’ has not been specifically defined, nor tested in court. However, it is normally interpreted as requiring the provision of all necessary financial information of a material nature related to both the directors’ stewardship role and financial information (decision-making) role. Information is material if its omission, misstatement or non-disclosure has the potential, individually or collectively, to:

LO1 Explain the importance of company law in relation to the directors' duty to account, and discuss the role of the auditor in this process

reporting entity

disclosing entity

available to the public via a

• influence the economic decisions of the users taken on the basis of the financial report, or • affect the discharge of accountability by the management or governing body of the entity. The Corporations Act also requires directors of disclosing entities to accompany the financial statements with a ‘directors’ declaration’ and a ‘directors’ report’. In the directors’ declaration, the directors must state whether, in their opinion, the financial statements comply with the applicable accounting standards and represent a ‘true and fair’ view of both the financial performance and the financial position of the company. They must also state whether, in their opinion, at the date of the declaration, there are reasonable grounds to believe that the company can meet its debts as and when they fall due.

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ACCOUNTING FOR BUSINESS STUDENTS

The directors’ report is generally much longer, and contains certain required information together with an increasing level of voluntary disclosures. Such disclosures include the names of directors, the emoluments of directors, the principal activities of the company, a review of the operations for the year, details of significant changes in the state of affairs of the company, the financial significance of probable future events, details of significant events that have occurred after the balance date that may affect the company and details of compliance with environmental regulations. Obviously, the voluntary disclosures extend beyond the required disclosures, and may include financial forecasts, details of human resource management strategies, significant contributions to community life and additional environmental initiatives. When one company owns a controlling interest in another, so that management of the controlled company is effectively carried out by the controlling company, ‘consolidated accounts’ (‘group accounts’) must be prepared in addition to the individual company accounts.

ACTIVITY 7.1 (a) (b)

accounting standards

preparers of the annual auditors

and accounting standard

What are the possible consequences of failing to make financial statements available to shareholders, lenders and suppliers on the ability of the business to operate? How important is the publication of well-regulated annual reports to the efficiency of the private sector?

The financial reports must comply with accounting standards. Companies’ financial reports should be checked by an auditor and reported on (unless the company is a small proprietary company—and even then, shareholders or ASIC may require an audit).

Auditors Shareholders are required to appoint a qualified and independent person or, more usually, a firm to act as auditor. The main duty of auditors is to make a report declaring whether or not the statements do what they are supposed to do: that is, whether they fairly reflect the entity’s financial performance, financial position and liquidity, and whether they comply with statutory requirements and accounting standards. This requires the auditors to critically examine the annual accounting statements prepared by the directors, and the evidence on which they are based. The auditors’ opinion must be included with the accounting statements that are sent to the shareholders and to the ASIC. The auditor’s report provides a check on the credibility and reliability of the financial reports and indicates whether or not the report complies with the Corporations Act. The auditor’s report tends to be fairly short and normally includes:

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• the identification of the financial reports covered by the audit report, together with • • •

responsibilities a statement that the audit (the check) was carried out in accordance with Australian Auditing Standards a statement that the financial statements comply with Australian Accounting Standards an opinion section, in which the auditor concludes whether or not the financial reports fairly represent the company’s financial performance, financial position and cash flows—if the auditor does not think that this is the case, the report will be ‘qualified’ with a section explaining why, and the extent to which, the statements do not comply with the statements and tests reviewed above.

Note that an audit report gives an opinion but no guarantees. In general, however, given the number of legal cases made against auditors, it is true to say that with all the care and attention to detail involved in audit work, an unqualified audit report should reassure the investing public. Even qualified reports rarely pose problems when the rationale for the qualification is understood. Overall, the onus on the directors of limited companies to report on the activities is extensive. Originally, the prime motivation was a ‘stewardship’ report, in which the directors reported to the shareholders on their stewardship of the resources entrusted to them. Over the past 30 years the

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

329

FIGURE 7.1 Directors

account elect

review report

Shareholders

elect

Auditors

stewardship report has developed into a general-purpose report of use to a variety of users and potential users, such as shareholders, potential shareholders, lenders, creditors, employees, social activists and environmentalists. The relationship between the shareholders, the directors and the auditors is illustrated in Figure 7.1, which shows that the shareholders appoint the directors to act on their behalf in the day-to-day running of the company. The directors are required to ‘account’ to the shareholders on the performance, position and cash flows of the company on an annual basis (and on a half-yearly basis for disclosing entities). The shareholders also appoint auditors, whose role is to give them an impression of the reliability of the accounting statements prepared by the directors. In spite of all of these rules, there is evidence of some dissatisfaction, as can be seen from Real World 7.1.

REAL WORLD 7.1

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ASIC comments on recent audits In December 2015 ASIC released a regular audit inspection report, which included the following:

6

1

7

2 3

4

5

In 19% of audit areas auditors did not obtain reasonable assurance that the financial report as a whole was free of material misstatement. The findings are similar to those of audit oversight regulators in other countries. There is a continued need for audit firms to improve audit quality and the consistency of audit execution. While firms continue to make good efforts to improve audit quality, these are yet to be reflected in the riskbased inspection findings. ASIC’s findings do not necessarily mean that audited financial statements were materially misstated, rather that the auditor did not have a sufficient basis to support their opinion on the financial report. Audit inspections suggest improvements are needed in: • the sufficiency and appropriateness of audit evidence obtained by the auditor • the level of auditors’ professional scepticism, and • appropriate use of the work of experts and other auditors.

8

Many of the findings related to accounting estimates (including impairment) and accounting policy choices. The report outlines areas auditors should continue to focus on to improve audit quality and consistency of audit execution. The report encourages firms to consider reviewing staffing to ensure sufficient and appropriate experience and expertise is available for auditing increasingly complex entities and audits that require significant judgement.

Source: 15-385MR ASIC audit inspection findings for 2014–15, 15 December 2015, ASIC. © Australian Securities & Investments Commission. Reproduced with permission.

Class discussion points 1 How important are auditors in assuring that investors are dealing with a confident and informed market? 2 What is the relationship between the directors and the auditors? 3 What do you think is understood by the term ‘professional scepticism’? Can you think of examples of ways in which

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a lack of professional scepticism might cause problems? You might like to think about fair value measurement and impairment issues. 4 Many of the findings related to accounting estimates (including impairment) and accounting policy choices. One area of business that the report focused on was extractive industries. What kind of areas in these industries might have been of concern to ASIC?

5 Adele Ferguson, in an article entitled ‘Conflict of interest at the heart of audit disasters’ (The Age, 5 December 2012), relating to an earlier ASIC audit report argued that there is a real or perceived conflict of interest because auditors get paid by the company they have been hired to independently audit. She argued that another option might be for the regulator to appoint an auditor, rather than leave it to the company. Do you think that she is correct?

ACTIVITY 7.2 How important is the role of the auditor in financial reporting?

Concept check 1 Which of the following is NOT true? A

B

C D E

It is not usually possible for all of a company’s shareholders to be involved in the general management of the company in which they own shares. Most shareholders do not wish to be involved in the general management of the company in which they own shares. The shareholders are expected to maintain appropriate internal control systems. Directors are accountable for the actions of the company. Directors act as stewards of the company’s assets.

Concept check 2 Which of the following is NOT true? A B C

The auditor’s report provides a detailed account of the audit procedures performed. The auditor’s report includes a statement that the audit has been conducted in accordance with Australian Auditing Standards.

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D

E

statements fairly represent the company. All of the above.

Concept check 3 Public companies and all large proprietary companies are required A B

Income statement Balance sheet

C D E

A and B A, B and C.

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THE NEED FOR ACCOUNTING RULES If we accept the need for directors to prepare and publish financial statements, we should also accept the need for rules about how they are prepared and presented. Without rules, there is a much greater risk that unscrupulous directors will adopt accounting policies and practices that portray an unrealistic view of financial health. There is also a much greater risk that the financial statements will not be comparable over time or with those of other businesses. Accounting rules can narrow areas of differences and reduce the variety of accounting methods. This can help ensure that similar transactions are treated in a similar way. Although accounting rules should help to provide confidence in the integrity of financial statements, users must be realistic about what can be achieved. Problems of manipulation and of concealment can still occur even within a highly regulated environment. The scale of these problems, however, should be reduced where there is a practical set of rules. Problems of comparability can also still occur, as judgements and estimates must be made when preparing financial statements. There is the added problem that no two companies are identical, and so accounting policies may vary between companies for entirely valid reasons.

LO2 Explain why there is a need for accounting rules, explain the importance of accounting standards and map the development of accounting standards through to the development of international standards

The role of accounting standards in company accounting Accounting standards (rules) have been developed over time. Over the years we have moved from Generally Accepted Accounting Principles (GAAP), through attempts to develop a conceptual framework (a theoretical underpinning), through to the harmonisation and subsequent internationalisation of rules. This process is briefly outlined below. For much of the 20th century, accounting practice and financial reporting in Australia was guided by a body of loosely connected ideas labelled ‘generally accepted accounting principles’. Some of these ideas (variously labelled as principles, doctrines or conventions) were discussed in some detail in Chapter 2. They include the principles included in Table 7.1.

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TABLE 7.1 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Entity

The reporting entity (e.g. company) is separate from the owners.

Monetary basis

The common denominator for recording transactions and events is money.

Historical cost

Transactions are to be initially recorded on the basis of an external transaction price or its equivalent.

Stable monetary unit

The assumption that the value of the monetary measuring unit does not change over time.

Accounting period

The life of the business is divided up into unique periods of time (usually one year) for reporting purposes.

Objectivity Prudence (conservatism) and asset amounts and higher liabilities amounts. Going concern (continuity)

The assumption that a business will continue to operate in the future as it has in the past.

Consistency

Applying comparable methods from one period to the next.

Realisation

That stringent conditions should be met before revenue can be recognised. The entity must have completed its contractual commitments and must have an unavoidable claim against the customer.

Matching

That expenses should be aligned with the revenue to which they relate, and occur in the same period in which the revenue is recognised.

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Australian Accounting Standards Board (AASB) for developing accounting standards for application to

Up until the 1970s a limited number of specific and formal accounting directives on external financial reporting were imposed on management by the accounting profession and corporate regulators. However, at this time there were significant numbers of corporate crashes, and the accuracy and reliability of accounting reports came under question. How was it that seemingly profitable organisations with substantial assets on their statement of financial position had apparently become worthless overnight? Clearly there must have been some issues with GAAP that were unresolved or in conflict with each other and with economic reality. Many of these have already been identified in earlier chapters. As a result, pressure was placed on the accounting profession in Australia to codify accounting rules and restrict the variety of unacceptable accounting practices. So, from the 1970s through to the early 1980s, the two major Australian accounting bodies (the Institute of Chartered Accountants and the Australian Society of Accountants [now CPA Australia]), through their joint research body (the Australian Accounting Research Foundation [AARF]), produced a significant number of accounting standards. In the mid-1980s, a statutory body was set up to issue accounting standards that would be mandatory for all companies and certain other disclosing entities. This body was initially known as the ‘Accounting Standards Review Board’ but later its name was changed to the ‘Australian Accounting Standards Board’ (AASB). This Board is responsible for the setting of accounting standards in Australia. Accounting standards narrow management’s range of methods for recording and reporting transactions, which means there is greater consistency and comparability in application and assessment. Companies are required by law to comply with the accounting standards. If management considers that complying with a particular accounting standard will prevent a true and fair view of the financial position or performance, they still must adhere to the standard. They can then, if they choose, provide additional information in the notes about their concerns in relation to applying that standard.

International accounting standards Over the last 30 years there has been an increasing trend towards the internationalisation of business and the integration of financial markets. These trends have helped to strengthen the case for:

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• initially, the international harmonisation of accounting rules, and • subsequently, a move to adoption of common standards.

International Financial Reporting Standards Transnational accounting rules that have been Standards Board which should be followed in preparing the published

International Accounting Standards See

By adopting a common set of rules, users of financial statements should be better placed to compare the financial health of companies based in different countries. It should also relieve international companies of some of the burden of preparing multiple financial statements, as different financial statements would no longer be required to comply with the rules of the different countries in which a particular company operates. The International Accounting Standards Board (IASB) is an independent body that is dedicated to developing a single set of high-quality global accounting rules. These rules are known as International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS) and deal with key issues such as:

• • • •

what information should be disclosed how information should be presented how assets should be valued how profit should be measured.

ACTIVITY 7.3 We have already come across some IAS and IFRS in earlier chapters. Try to recall at least two topics where financial reporting standards were mentioned.

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

333

Several important developments have greatly increased the authority of the IASB in recent years, including the following:

• In 2002 the Financial Reporting Council (FRC), which is the supervisory body that oversees the • • • • •

AASB, announced that by 2005 Australia would ‘adopt’ the International Accounting Standards. The European Commission required nearly all companies listed on the stock exchanges of European Union member states to adopt IFRSs for reporting periods commencing on or after 1 January 2005. In 2006 the IASB and the US Financial Accounting Standards Board agreed a roadmap for convergence between IFRSs and US accounting rules. Also in 2006 China closely aligned its financial reporting standards with IFRSs. In 2007 Brazil, Canada, Chile, India, Japan and Korea all announced their intention to adopt, or converge with, IFRSs. By 2010 all major economies had either adopted IFRSs or had set timelines to adopt, or converge with, IFRSs. The move towards international convergence is supported by the group of 20 major economies (G20).

Australia and the International Accounting Standards Australia decided to adopt the international standards in 2005. The process of adoption recognised the importance of ensuring that the Australian standards included the same requirements as IFRSs in respect of for-profit organisations. However, there were to be some minor differences in the wording. The Australian standards still have their own numbers, but these are matched to the numbers of the International Accounting Standards. Real World 7.2 provides a list of IASB/AASB standards that were in force as at 1 November 2016. It clearly shows the matching and gives some idea of the range of topics that are covered.

REAL WORLD 7.2

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International standards The following is a list of the International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) in issue as at 1 November 2016 (the latter term is used for standards issued from 2003 onwards) together with their equivalent Australian Accounting Standard. Several standards have been issued and subsequently withdrawn, which explains the gaps in the numerical sequence. In addition, several have been revised and reissued. IAS 1 IAS 2 IAS 7 IAS 8

AASB101 AASB102 AASB107 AASB108

IAS 10 IAS 12 IAS 16 IAS 19 IAS 20

AASB110 AASB112 AASB116 AASB119 AASB120

IAS 21

AASB121

IAS 23 IAS 24 IAS 27

AASB123 AASB124 AASB127

Presentation of Financial Statements Inventories Statement of Cash Flows Accounting Policies, Changes in Accounting Estimates and Errors Events a!er the Reporting Period Income Taxes Property, Plant and Equipment Employee Benefits Accounting for Government Grants and Disclosure of Government Assistance The Effects of Changes in Foreign Exchange Rates Borrowing Costs Related Party Disclosures Consolidated and Separate Financial

IAS 28 IAS 29 IAS 32 IAS 33 IAS 34 IAS 36 IAS 37 IAS 38 IAS39 IAS 40 IAS 41 IFRS 1 IFRS 2 IFRS 3 IFRS 4 IFRS 5 IFRS 6 IFRS 7

Statements AASB128 Investments in Associates AASB129 Financial Reporting in Hyperinflationary Economies AASB132 Financial Instruments: Presentation AASB133 Earnings per Share AASB134 Interim Financial Reporting AASB136 Impairment of Assets AASB137 Provisions, Contingent Liabilities and Contingent Assets AASB138 Intangible Assets AASB139 Financial Instruments, Recognition and Measurement AASB140 Investment Property AASB141 Agriculture AASB1 First-time Adoption of International Financial Reporting Standards AASB2 Share-based Payment AASB3 Business Combinations AASB4 Insurance Contracts AASB5 Non-current Assets Held for Sale and Discontinued Operations AASB6 Exploration for and Evaluation of Mineral Resources AASB7 Financial Instruments: Disclosures

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IFRS 8 IFRS 9 IFRS 10 IFRS 11 IFRS 12 IFRS 13 IFRS 14 IFRS 15 IIFRS 16

AASB8 AASB9 AASB 10 AASB 11 AASB 12 AASB 13 AASB 14 AASB 15 AASB 16

Operating Segments Financial Instruments Consolidated Financial Statements Joint Arrangements Disclosure of Interests in Other Entities Fair Value Measurement Regulatory Deferral Accounts Revenue from Contracts with Customers Leases

Class discussion points 1 Check the AASB website (www.aasb.gov.au) to identify updates. 2 Under the section ‘About the AASB’ click on ‘The standardsetting process’. Then discuss the process outlined.

Source: International Accounting Standards Board, IFRS as issued at 1 November 2016, www.iasb.org.uk; Australian Accounting Standards Board, www.aasb.gov.au/Pronouncements/Current-standards.aspx.

ACTIVITY 7.4 (a) (b) (c)

What have been the main reasons for pressure towards international harmonisation of accounting practices and adoption of common standards? What benefits could be gained from the Australian Accounting Standards Board adopting the International Accounting Standards? Can you think of any disadvantages for Australia in adopting the International Accounting Standards?

There are likely to be further changes in accounting standards over coming years as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in the United States work together to reduce differences between the accounting standards of these two major bodies. As the older IAS standards are revised, they typically drop off the IAS list and become IFRS standards.

The conceptual framework

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conceptual framework

In Chapters 2 and 3 we came across various accounting conventions such as the prudence, historic cost and going concern conventions. These were developed as a practical response to particular problems that were confronted when preparing financial statements. They have stood the test of time and are still of value to preparers today. However, they do not provide, and were never designed to provide, a conceptual framework, or framework of principles, to guide the development of financial statements. Such a framework should provide clear answers to such fundamental questions as:

• • • • •

Who are the main users of financial statements? What is the purpose of financial statements? What qualities should financial information possess? What are the main elements of financial statements? How should these elements be defined, recognised and measured?

If these questions can be answered, accounting rule-makers, such as the AASB and IASB, will be in a stronger position to identify best practice and to develop more coherent rules. This should, in turn, increase the credibility of financial reports in the eyes of users. As we grapple with increasingly complex financial reporting problems, the need to have a sound understanding of why we account for things in a particular way has become more pressing. Knowing why we account, rather than simply how we account, is vital if we are to improve the quality of financial statements.

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The quest for a conceptual framework began in earnest in the 1970s when the Financial Accounting Standards Board (FASB) in the US devoted a large amount of time and resources to this task. It resulted in a broad framework, which other rule-making bodies, including the IASB, then drew upon to develop their own frameworks. The IASB Framework for the Preparation and Presentation of Financial Statements was produced in 1989 and has since provided guidance for the development of the International Financial Reporting Standards. Many of the standards that predated the framework have now been replaced or revised. However, the IASB Framework is itself currently being revised, as we shall see later. In Australia during the late 1980s and 1990s a considerable amount of work was carried out on the development of a conceptual framework for accounting. Up until 2004, four statements of accounting concepts (SACs) had been issued under the Australian Conceptual Framework project:

• • • •

SAC 1 ‘Definition of the Reporting Entity’ SAC 2 ‘Objective of General Purpose Financial Reporting’ SAC 3 ‘Qualitative Characteristics of Financial Information’ SAC 4 ‘Definition and Recognition of the Elements of Financial Statements’.

During 2004 the Australian Accounting Standards Board, in moving to adopt the International Accounting Standards, replaced the Australian Conceptual Framework with the International Framework, which is now called the AASB Framework (in Australia—it is still called the IASB Framework elsewhere). Subsequent revisions of the framework mean that SACs 2, 3 and 4 have now been replaced by the IASB version. SAC 1 remains as there is no comparable international statement on this topic at the moment. The rationale for preparing a conceptual framework included the following ideas:

• Accounting standards developed from such a framework would be more consistent and logical.

• The accounting standards developed would be more comparable with those in other countries • • •

using similar frameworks. The accounting standard-setting body would be more accountable for its decisions as these would be based on a specific set of ideas. Accountants would be better able to communicate the basis of the reported figures, and the framework would support their position in the event of conflict. The framework should reduce the number of standards and allow a more efficient standardsetting process.

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ACTIVITY 7.5 How do you think the development of a conceptual framework would help reduce the number of rules required?

The IASB and FASB have embarked on a joint project to produce a common conceptual framework that will underpin the financial reporting standards of both bodies. This project, which is ongoing, represents a major step towards convergence that will eventually led to the replacement of the existing IASB framework. In 2010, the IASB and FASB announced completion of the first phase of the project, which deals with the objective and qualitative characteristics of financial reporting. Following this announcement, the IASB issued a document, Conceptual Framework for Financial Reporting 2010, followed in 2011 by its counterpart, which incorporate these revisions into its existing framework. The revised IASB Framework asserts that the objective of general-purpose financial reporting is ‘to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’

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(p. 9). Note that it is the providers of finance that are seen as the primary users of general-purpose financial reports. This is because investors, lenders and other creditors largely rely on these reports to make their investment decisions. Although other users may find general-purpose financial reports useful, the reports are not aimed at them. The IASB Framework also sets out the qualitative characteristics that make financial statements useful. These are the same as those we considered in Chapter 1.

ACTIVITY 7.6

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Can you recall what the qualitative characteristics are?

The framework acknowledges that producing financial information incurs costs, which must be justified by the benefits provided. The IASB Framework identifies two important accounting conventions: going concern and accruals. It states that financial statements should normally be prepared on the assumption that a business is a going concern. If this assumption cannot be applied, a different basis of reporting will be required. This will affect the valuation of assets held. The framework supports the accruals convention, which is seen as a better means of assessing past and future performance than reliance on cash receipts and payments. Nevertheless, information on cash flows is also considered useful for assessing financing and investing activities, liquidity and solvency. The IASB Framework goes on to identify the main elements of financial statements. Those relating to the measurement of financial position are assets, liabilities and equity. Those relating to the measurement of performance are income and expense. Each of these elements is defined and the definitions provided are similar to those discussed in Chapters 2 and 3. The IASB Framework identifies different measurement bases, such as historic cost, current cost and realisable value. There is no attempt, however, to support a particular measurement basis. The framework simply notes that historic cost is the most widely used basis but it is often used in conjunction with other measurement bases. To determine which measurement bases should be used for a particular situation, relevant financial reporting standards must be consulted. The IASB Framework does not have the same legal status as the IASB standards. Nevertheless, it offers guidance for dealing with accounting issues, particularly where no relevant financial reporting standard exists. Managers are required to consider the framework when dealing with issues that fall outside the scope of existing standards. Overall, the IASB Framework has provoked little controversy and the principles that it contains appear to enjoy widespread acceptance. There has been some criticism, mainly from academics, that the framework is really a descriptive document and does not provide theoretical underpinning to the financial statements. It has also been suggested that the framework is too broad in nature to provide useful guidance for developing financial reporting standards or to deal with emerging accounting issues. These criticisms have not, however, sparked any major debates. You will recall that all of these points have been covered (albeit less formally) in the earlier chapters of this text. In May 2015, the IASB issued an Exposure Draft (a draft put out for comment) on the ‘Conceptual Framework for Financial Reporting’. The closing date for submissions was October 2015. The main reasons for revisiting the conceptual framework are:

• Some important areas are not covered in the existing framework. • The guidance in some areas is unclear. • Some aspects are out of date. The Conceptual Framework project aims to improve financial reporting by providing a more complete, clear and updated set of concepts. The Exposure Draft identifies a range of areas that

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

are not currently covered, or are not covered in enough detail, lists areas that require greater clarification, and updates parts that are out of date. The aim is to make significant improvements to the Conceptual Framework which should improve standard setting.

Concept check 4 A

Prevent unscrupulous directors from adopting accounting policies and practices

B

Allow comparison between companies

C D E

All of the above Some of the above.

Concept check 5 A

B

C D E

Are transnational accounting rules adopted (or developed) by the International Accounting Standards Board (IASB) Are transnational accounting rules that should be followed in preparing the published Are now adopted or will be adopted by all major economies Have minor wording differences to Australian Accounting Standards All of the above.

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ACTIVITY 7.7 AASB 101 says that the financial statements are required to show a ‘fair representation’ of financial health. It does not say that the statements should show a ‘correct’ or an ‘accurate’ representation of financial health. Why, in your opinion, does it not use those words? (Hint: Think of depreciation of non-current assets.)

LO3 THE ROLE OF THE AUSTRALIAN SECURITIES EXCHANGE (ASX) IN COMPANY ACCOUNTING The Australian Securities Exchange (ASX) extends the accounting rules for those companies listed as eligible to have their shares traded on the exchange. These extensions include summarised interim (half-year) accounts in addition to the statutorily required annual accounts, along with several specific requirements for matters such as takeovers, capital, options and sundry administrative concerns. Figure 7.2 illustrates the sources of accounting rules with which listed Australian companies must comply.

Outline the role of the Australian Securities Exchange with regard to company reporting and management, with particular reference to corporate governance

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FIGURE 7.2 External accounting rules

Company law

International accounting standards

Stock exchange rules imposed by ASX

ACTIVITY 7.8 (a) (b)

Can you think of a reason why directors pursuing their own interests may be a problem for society as a whole? Why do you think Stock Exchange listed companies are required to disclose more information about their business than other companies?

Corporate governance Chapter 1 introduced the role of accounting information and identified the main user groups. Chapters 2 and 3 introduced sole proprietorships and partnerships, and Chapter 6 discussed companies extensively. The size and nature of companies requires rather more complex rules of governance than do sole proprietorships or partnerships. For this reason Chapter 6 dealt with issues such as:

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• • • • • •

types of companies roles and responsibilities of directors different types of shares and the rights associated with them recognition of the importance and need for greater regulation regarding company operations and financial reporting the role of the stock exchange in transferring ownership rights of shareholders to withdraw capital.

Chapter 6 also examined the directors’ duty to account:

• in company law, including preparation of financial statements, provision of a directors’ report and a directors’ statement

• by complying with accounting standards • by providing an audit report. Generally, all the issues covered until now relate to the idea of developing sound systems of corporate governance corporations are directed

corporate governance, the system by which corporations are directed and controlled. As such,

it typically details the rights and responsibilities of the corporation’s different participants. This explains the prevailing emphasis on such things as rules for directors, matters relating to the board as a whole, different types of shareholders and other stakeholders. Governance also typically requires some detailed rules and procedures for decision-making, including objective-setting and performance evaluation.

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In spite of this, corporate governance remains an ongoing issue. It became a serious concern in the late 1980s, when the global share market collapsed. Certain high-profile corporate failures, such as Bond Corporation and Quintex Corporation (Christopher Skase), added fuel to the debate and led to some changes. More recently, in the early years of this century, the collapse of Enron, Ansett, One.Tel and HIH led to something of a crisis of confidence. The collapse of Arthur Andersen, a major auditor with a worldwide reputation, added fuel to the fire. The reactions in different parts of the world were not the same. In the United States, the resulting legislation (the Sarbanes-Oxley Act of 2002) aimed to curtail the misbehaviour and excesses of senior managers and to ensure the correctness of the financial statements. In Australia, the following occurred:

• A Royal Commission was held over the HIH collapse. • The ASX set up a council on corporate governance. • The Corporate Law Economic Reform Program (CLERP) gave the Australian Securities and

Investments Commission (ASIC) power to fine companies for breaches of the disclosure rules.

The HIH Royal Commission basically found that HIH was mismanaged, that decisions were ill-conceived and that the management culture was unsound.

ACTIVITY 7.9 Do you think that mismanagement can be avoided by imposing highly prescriptive governance systems and structures? Why/why not?

In general, the Royal Commission’s report found that imposing highly prescriptive governance systems and structures would be fraught with danger. A ‘one size fits all’ approach would not work. The report focused more on the role of boards and directors, and the associated cultures. The culture of HIH and its board was considered to have major shortcomings—but there were no significant recommendations for change.

ACTIVITY 7.10

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What does this imply about the difficulties in ensuring that reports are sound, in terms of setting in place detailed rules of corporate governance?

The ASX set up the Corporate Governance Council in 2002 and Principles of Good Corporate Governance and Best Practice Recommendations was published in 2003 (© 2016 ASX Corporate Governance Council). The main mission identified in the 2003 publication was ‘to develop and deliver an industry-wide, supportable and supported framework for corporate governance which could provide a practical guide for listed companies, their investors, the wider market and the Australian community’ (‘Foreword’). The Council required that the guidelines be applied, arguing that ‘maintaining an informed and efficient market and preserving investor confidence remain the constant imperatives’ (‘Foreword’, Principles of Good Corporate Governance and Best Practice Recommendations, 2003 © Copyright 2017 ASX Corporate Governance Council Association of Superannuation Funds of Australia Ltd. All rights reserved 2017.) The 2003 document identified the essential corporate governance principles. Ten such principles were identified. In August 2007 the principles and recommendations were reviewed and revised into eight principles. A minor revision was made in 2010. Following a comprehensive review in 2012–13, the third edition of the Principles and Recommendations was approved. Changes reflect global developments in corporate governance and enhanced risk recommendations. The structure has also been simplified and greater flexibility provided in terms of where governance disclosures are made. The revised principles identified by the ASX Corporate Governance Council are set out in Table 7.2.

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TABLE 7.2 THE ASX CORPORATE GOVERNANCE PRINCIPLES A listed entity should establish and disclose the respective roles and responsibilities of its board and management and how their performance is monitored and evaluated. A listed entity should have a board of an appropriate size, composition, skills and commitment to discharge its duties effectively. A listed entity should act ethically and responsibly. A listed entity should have formal and rigorous processes that independently verify and safeguard the integrity of its corporate reporting. A listed entity should make timely and balanced disclosure of all matters concerning it that a reasonable person would expect to have a material effect on the price or value of its securities. A listed entity should respect the rights of its security holders by providing them with appropriate information and facilities to allow them to exercise those rights effectively. A listed company should establish a sound risk management framework and periodically review the effectiveness of this framework.

to attract, retain and motivate high-quality senior executives and to align their interests with the creation of value for security holders. Source: ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 3rd Edition, 2014, pp. 21 and 22. © 2017 ASX Corporate Governance Council.

Each principle is supported by several recommendations. For example, Principle 4, ‘Safeguard integrity in financial reporting’, is supported as follows:

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Recommendation 4.1 The board of a listed entity should: (a) have an audit committee which: 1) has at least three members, all of whom are non-executive directors and a majority of whom are independent directors; and 2) is chaired by an independent director, who is not the chair of the board; and disclose 3) the charter of the committee; 4) the relevant qualifications and experience of the members of the committee; and 5) in relation to each reporting period, the number of times the committee met throughout the period and the individual attendances of the members at those meetings. (b) If it does not have an audit committee, disclose that fact and the processes it employs that independently verify and safeguard the integrity of its corporate reporting, including the processes for the appointment and removal of the external auditor and the rotation of the audit engagement partner. Recommendation 4.2 The board of a listed entity should, before it approves the entity’s financial statements for a financial period, receive from its CEO and CFO a declaration that, in their opinion, the financial Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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341

records of the entity have been properly maintained and that the financial statements comply with the appropriate accounting standards, and give a true and fair view of the financial position and performance of the entity and that the opinion has been formed on the basis of a sound system of risk management and internal control which is operating effectively. Recommendation 4.3 A listed entity that has an AGM should ensure that its external auditor attends its AGM and is available to answer questions from security holders relevant to the audit. Source: ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 3rd Edition, 2014, pp. 21 and 22. © 2017 ASX Corporate Governance Council. We recommend that you read the third edition of Corporate Governance Principles and Recommendations, which can be found at http://www.asx.com.au/documents/asx-compliance/cgcprinciples-and-recommendations-3rd-edn.pdf The board of a listed company can decide that a recommendation is not appropriate for them. If it decides that this is so, then it must explain why it has not adopted the recommendation. The principles adopt an ‘if not, why not’ approach. Failure to do one or other of these can lead to the company’s shares being suspended from listing. This is an important sanction against noncompliant directors. A major advantage of a stock exchange listing is that it enables investors to sell their shares whenever they wish. A company that is suspended from listing would find it hard—and, therefore, expensive—to raise funds from investors, because there would be no ready market for the shares. A corporate governance statement is now part of the annual report of listed companies. Real World 7.3 provides a summary of such a statement from the 2016 Annual Report for New Zealand Oil & Gas Limited, a company which is quoted on the New Zealand Stock Exchange.

REAL WORLD 7.3 Corporate Governance Statement of New Zealand Oil & Gas Limited—a summary performance of the Board, committees of the Board, and individual directors; reviewing systems of risk management, internal compliance and control, codes of conduct, and legal compliance; approving and monitoring the progress of any major capital expenditure, capital management, and acquisitions and divestures; reviewing and ratifying HSSE Sustainability and Operational Risk policies and the HSSE Sustainability and Operational Risk Management System, and monitoring its implementation and performance; approving and monitoring financial and other reporting; ensuring that the Company provides continuous disclosure of information such that shareholders and the investment community have available all information to enable them to make informed assessments of the Company’s prospects; ensuring overall corporate governance of the consolidated entity; determining the key messages that the Company wishes to convey to the market from time to time; and monitoring information commitments and continuous disclosure obligations.

New Zealand Oil & Gas Limited has a nine-page section on corporate governance in its 2016 annual report, which covers:

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• •

•

Board of Directors: responsibilities, constitution, details of Board members, when appointed, qualifications, independent directors and Board proceedings. Board Committees: Audit Committee, Nomination and Remuneration Committee, and HSSE (health, safety, security and environment), Sustainability and Operational Risk Committee. Responsibilities of the Board: approval of corporate strategy and performance objectives; establishing policies appropriate for the Company; oversight of the Company, including its control and accountability systems; approving major investments and monitoring their return on investment; overall risk management and control framework; appointing, removing and evaluating the performance of the CEO; reviewing performance of senior management; appointing and removing the Company secretary; setting broad remuneration policy; nominating and appointing new directors to the Board; evaluating the

•

Delegation to management: a range of policies relating to Health and Safety; Environment; Code of Conduct

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and Ethics; Communications, Market and Social Media Disclosure; Securities Trading; Directors’ Interests; Whistleblowers; Diversity; Delegated Authorities Manual; Remuneration and Performance Appraisal; Treasury; ETS Obligations and Carbon Liability; Email and Internet Use; Anti-Harassment; and Drugs and Alcohol. Corporate Governance Best Practice Code. This is effectively a comparison of Company practice with that implicit in the NZX code of practice. This section therefore identifies those areas where Company practice differs from that found in the NZX code of practice.

Class discussion points 1 Page 45 of the New Zealand Oil & Gas Limited Annual Report 2016 sets out in more detail the company’s Code of Business Conduct and Ethics. Discuss this code and compare it with the ideas raised in Chapter 1. 2 Evaluate this statement in terms of the ASX Corporate Governance Principles? 3 Do you feel that the environmental and social sustainability issues are addressed sufficiently in the report?

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Source: New Zealand Oil & Gas Limited Annual Report 2016, pp. 41–49.

The existence of the ASX Corporate Governance Principles has generally been agreed to have improved the quality of information available to shareholders, resulted in better checks on the powers of directors and provided greater transparency in corporate affairs. However, rules can only be a partial answer. A balance must be struck between the need to protect shareholders and the need to encourage the entrepreneurial spirit of directors, which could be stifled under a welter of rules. This implies that rules should not be too tight, but tight enough to limit unscrupulous directors’ attempts to find ways around them. It is interesting to note that the revised (2010) version of the principles did not change any of the basic principles. Yet the world had been through the global financial crisis, which surely must rank as a failure of leadership. The third edition has taken on board a number of issues raised by the global financial crisis, notably in the area of risk management, but it still seems reasonable to ask the question: are the basic principles sufficient? The International Federation of Accountants (IFAC) prepared a study on enterprise governance (CIMA & IFAC, 2004). Enterprise governance was defined as ‘the set of responsibilities and practices exercised by the board and executive management with the goal of providing strategic direction, ensuring that objectives are achieved, ascertaining that risks are managed appropriately and verifying that the organisation’s resources are used responsibly’. What was particularly interesting about this study was that it identified two aspects of enterprise governance— conformance and performance—and argued that these two need to be in balance. Basically, corporate governance was identified with conformance (namely accountability and assurance), while business governance was associated with performance (namely value creation and resource utilisation). Central to the argument was the idea that good corporate governance on its own cannot make a company successful. Good corporate governance needs to be linked strategically with good performance management systems that focus on the key drivers of business success. The Chapter 7 Case Study (page 370) provides a summary of an interesting discussion paper with some observations that have been made on corporate governance recently. We recommend you read the whole paper. It includes a number of examples of behaviour and attitudes that relate to the global financial crisis that are very revealing. Good governance is clearly important, but care is necessary to ensure that the process doesn’t become more important than the substance.

ACTIVITY 7.11 What do you see as the likely future of corporate governance? What about ongoing issues? Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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ACCOUNTING AND YOU You may not aspire to become a board member of a corporation. However, you are quite likely to become a member of a club, such as a sports club, and may well become a key member of the organising committee. It may not have occurred to you that many of the principles relating to corporate governance may also apply to the running of such a club or committee. Elements might include:

• • • •

Principle 1: What are the respective roles of the chair, committee members, coaches and players?

• •

Principle 5: The club’s need to report regularly on what is going on.

Principle 2: What is the optimal size and nature of the managing committee? Principle 3: What is the view of the club on equity and fairness in the sport? Principle 4: The club’s need to account for income from fees, subscriptions and charges, and to report on the financial condition of the club on a regular basis. Principles 6–8: These are not likely to be as important at this level, but the principles remain.

As you progress through life, there is a reasonable prospect that you may become a member of a school board/council, or a hospital/health service board. All of these will have governance requirements which are likely to follow similar lines to those set out above. By way of illustration, read the 2015 resource, ‘Welcome to the Board’, on the Victorian Public Sector Commission website, http://vpsc.vic.gov.au.

Class discussion points You have decided to become a member of a school council or board. 1 While the school is not formally a business, it will still need to keep financial records. What differences (if any) do you think you will find in terms of the financial records that are kept at the school as compared with a business? 2 What do you think the audit procedures might be? 3 Do you think there will be any specific profitability objectives? 4 What size do you think the board should be? 5 What skills should it aim to have? 6 How important is the relationship between the board, its chair and the head teacher?

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7 What kind of rules would you anticipate being applied regarding the presentation and assessment of financial results?

Concept check 6 The ASX Corporate Governance Principles do not include: A

Promotion of ethical and responsible decision-making

B C D E

Respecting the rights of stakeholders Recognising and managing risk None—all are included.

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Concept check 7 Which of the following is NOT true?

D

The Australian Securities Exchange (ASX) extends the accounting rules for those companies listed as eligible to have their shares traded on the exchange. The Corporations Act provides the basic framework for company accounting regulation. Corporate governance is the system by which corporations are directed and controlled. The ASX Corporate Governance Principles specify that companies should have a

E

None of the above. All are true.

A

B C

PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS LO4

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Identify the main requirements relating to the published annual report, including all of the financial and ancillary statements

Now that we have gained an impression of the sources of rules affecting limited companies, let us turn our attention to the main rules to be followed in the presentation of financial statements. We shall focus on the IASB rules and, in particular, those contained in AASB 101 Presentation of Financial Statements. This standard is very important as it sets out the structure and content of financial statements and the principles to be followed in preparing these statements. The standard states that these financial statements should normally cover a one-year period and should be accompanied by comparative information for the previous year. Thus, at the end of each reporting period, companies should normally produce two of each of the statements, plus the related notes. In practice, virtually all companies satisfy this requirement by showing the equivalent figures for the previous year in a separate column in the current year’s statements. Comparative narrative information should also be provided if necessary to obtain a better grasp of the current period results—for example, as background to an ongoing legal dispute. Before we consider the financial statements in detail, it is important to emphasise that the standard requires that they provide a fair representation of a company’s financial position, financial performance and cash flows. There is a presumption that this will be achieved where they are drawn up in accordance with the various AASB standards that are currently in force. It is only in very rare circumstances that compliance with a standard would not result in a fair representation of the financial health of a company. Where the financial statements have been prepared in accordance with AASB standards, this should be clearly stated in the notes. Accounting Standard AASB 101: Presentation of Financial Statements (the equivalent of IAS 1) applies to reporting and disclosing entities. The essence of the standard is set out below, and we will consider each of the financial statements in turn.

Statement of financial position AASB 101 does not prescribe the format (or layout) for this financial statement, but does set out the minimum information that should be presented on the face of the statement of financial position. This includes the following:

• • • • • • • •

property, plant and equipment investment property intangible assets financial assets (excluding trade and other receivables, cash and cash equivalents, and investments accounted for using the equity method) investments accounted for using the equity method biological assets inventories trade and other receivables

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• • • • • • • • • •

345

cash and cash equivalents the total of assets classified for sale trade and other payables provisions (a provision is a liability that is of uncertain timing or amount—such as a possible obligation arising from a legal case against the company that has yet to be determined) financial liabilities (other than payables and provisions shown above) liabilities and assets for current tax deferred tax liabilities and deferred tax assets liabilities included in disposal groups classified as for sale non-controlling interests—presented within equity issued share capital and reserves (equity) attributable to owners of the parent. (AASB 101: Presentation of Financial Statements, para 54. © Commonwealth of Australia (2017).)

Additional information should also be shown where it is relevant to an understanding of the financial position of the business. The standard requires that, on the statement of financial position, a distinction is normally made between current assets and non-current assets and between current liabilities and non-current liabilities. However, for certain types of businesses, such as financial institutions, the standard accepts that it may be more appropriate to order items according to their liquidity (i.e. their nearness to cash). Financial institutions, such as banks and insurance companies, frequently select the liquidity approach to classifying assets, to provide more relevant and reliable information to the report users. The nature of their business is largely linked to matching available funds with external claims over time, and classifying both assets and liabilities on a liquidity basis provides valuable insights into the entity’s ability to service such claims. Some of the classification groups identified above require further detailed breakdowns, generally to comply with a specific standard; for example, inventories and non-current assets, which typically have sub-classifications for property, plant and equipment. Other areas include equity and reserves, and provisions. Many of these sub-classifications can be handled by way of a series of notes to the main statements. In terms of published statements of financial position in Australia, the most commonly presented is the vertical format based on the entity equation. Irrespective of the format, or the equation, all of the statements of financial position contain the same information.

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Statement of comprehensive income The past two decades have seen a number of changes in the name given to the statement of financial performance and its presentation. The title has evolved from the ‘profit or loss statement’ to the ‘statement of financial performance’ to the ‘income statement’ and, more recently for disclosing entities, which includes limited companies, to the statement of comprehensive income. This last change is probably the only one of much significance. The statement of comprehensive income extends the conventional income statement to include certain other gains and losses that affect shareholders’ equity. It may be presented either in the form of a single statement or as two separate statements, comprising an income statement and a statement of comprehensive income. From January 2018, the two-statement approach will need to be modified to a two-section approach, with the income statement preceding the comprehensive income section. This new statement attempts to overcome a perceived weakness of the conventional income statement. In broad terms, the conventional income statement shows all realised gains and losses for the period. It also shows some unrealised losses. However, gains—and some losses—that remain unrealised (because the asset is still held) tend not to pass through the income statement, but go, instead, directly to a reserve. We saw in an earlier chapter an example of such an unrealised gain.

statement of comprehensive income

second which begins with

ACTIVITY 7.12 Can you identify this example? Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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This related to a situation in which a business revalued its land and buildings. The gain arising was not shown in the conventional income statement, but was transferred to a revaluation reserve, which forms part of equity. (See the section under ‘Fair values’ in Chapter 2, page 68.) Land and buildings are not the only assets to which this rule relates, but revaluations of these types of asset are, in practice, the most common examples of unrealised gains. An example of an unrealised gain, or loss, that has not been mentioned so far arises from exchange differences when the results of foreign operations are translated into Australian dollars. Any gain, or loss, bypasses the income statement and is taken directly to a currency translation reserve. Before going through the statement in detail, it is worth thinking about the kinds of incomegenerating transactions that might occur. A moment’s reflection should make you realise that the vast majority of transactions that occur will be in the nature of operating activities as a result of normal trading. For many small and medium businesses, there are likely to be very few other gains or losses. The most common would be increases in the value of non-current assets, an increase reflected in a revaluation reserve, which is of course part of equity. For larger, more complex businesses, revaluations would be common, but also a range of other gains or losses might occur. These will be discussed later in this section. Traditionally, income from operating activities has been recorded in an income statement or profit and loss statement, with the total profit or loss being transferred to equity. Other gains and losses have generally been adjusted through equity, via use of various reserve accounts. The income statement/profit and loss statement—which focuses on operating performance— provides details of the progress for the period and thereby an indication of future periods’ progress. As such, it is very important. However, there is little doubt that the approach of dealing with some transactions directly through reserves meant that it was possible to hide certain information, or at least to make it rather difficult to see exactly what was going on in total. As we saw earlier, revaluations of assets represent a gain to the owners, but this was typically not reflected in the income figure. This omission is understandable in that income measurement has usually been primarily concerned with operating profit. But this omission and others of a similar nature are now considered inappropriate. In response to the inconsistent treatment of income and expense and changes in owner’s equity that were not being reported in the income statement, the standard changed to require all changes in owners’ equity that are not directly a contribution of the owner or a distribution to the owner to now be shown in a statement of comprehensive income. The statement of comprehensive income can be seen as an attempt to include in the statement of financial performance many items that were either required to be excluded under the regulations (accounting standards) or were intentionally excluded by management from the profit and loss. The term ‘comprehensive’ is intended to mean the inclusion of all income—income here being used in the broader sense to include both ‘revenue’ and ‘other gains or losses’, together with ‘expenses’. It essentially means ‘all-inclusive income’. Thus, income is now categorised as ordinary or operating and simply labelled ‘income’, and ‘non-operating or other income’ is labelled as ‘other comprehensive income’. AASB 101 requires that the statement of comprehensive income presents the profit or loss, the total of other comprehensive income, and comprehensive income for the period, being the total of the profit and loss and other comprehensive income. Where appropriate, both the profit and loss for the period and the comprehensive income for the period are allocated between non-controlling interests and the owners of the parent company. The statement may be presented either in the form of an integrated statement or as one statement split into two sections, comprising an income statement and a statement of other comprehensive income. As from January 2018, both sections need to be presented together, with the income statement/profit and loss section being first, followed directly by the other comprehensive income section. A separate income statement/profit and loss may be presented, but if this is done, it must immediately precede the statement presenting comprehensive income. The following minimum information is to be presented in the profit or loss section of the statement:

• revenue • gains and losses arising from the derecognition of financial assets measured at amortised cost Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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• • • • • •

finance costs impairment costs share of profit or loss of associates and joint ventures accounted for using the equity method cumulative gains or losses from reclassification of financial assets tax expense a single amount comprising the total of discontinued operations. (Para 82, © Commonwealth of Australia (2017).)

In general, the standard requires all items that are relevant to an understanding of performance to be shown on the face of the statement of comprehensive income and that all material expenses should be separately disclosed. AASB 101 Presentation of Financial Statements specifies that in the profit or loss section itself, or in the notes attached to it, details of any material items of income or expense incurred by the following should be disclosed: (a) write-down of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write downs (b) restructuring activities (c) disposal of property, plant and equipment (d) disposal of investments (e) discontinued operations (f) litigation settlements (g) other reversals of provisions. (Para 98, © Commonwealth of Australia (2017).) In practice, other material expenses may require separate disclosure. The standard requires an analysis of expenses recognised in the profit or loss section. This can be done on the statement or in the notes. Expenses can be presented either according to their nature or function. The ‘nature’ of an item refers to its essential characteristic or unique attribute. Examples included in the standard are depreciation, purchase of materials, transport costs, employee benefits and advertising costs. The ‘function’ of an item refers to its role, purpose or rationale. The standard does not prescribe categories. However, in practice, there are four categories for retailers and three for other activities that are commonly used, but the categories tend not to be regulated and are decided upon by the individual entity’s management. The four most common categories are: 1 Cost of sales 2 Selling and distribution 3 Administration and general

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4 Financial.

The choice between the two possible ways of presenting expenses will depend on which one the directors believe will provide the more relevant and reliable information. ‘Other comprehensive income’ represents those items of income (revenue or other gains) and expenses not required to be included in income (ordinary or operating) by any of the accounting standards. Paragraph 7 of AASB 101 Presentation of Financial Statements specifically identifies the following transactions for inclusion as ‘comprehensive income’: (a) (b) (c) (d) (e) (f) (g) (h) (i)

changes in revaluation surplus remeasurements of defined benefit plans gains or losses arising from translating the financial statements of foreign operations gains and losses from investments in equity instruments designated at fair value through other comprehensive income gains and losses on financial assets measured at fair value through other comprehensive income the effective portion of gains or losses on hedging instruments in a cash flow hedge for particular liabilities designated as at fair value through profit or loss, the amount of the change that is attributable to changes in the liability’s credit risk changes in the value of the time value of options changes in the value of the forward elements of forward contracts.

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More generally, the ‘other comprehensive income’ section needs to include line items to cover:

• items of other comprehensive income classified by nature, split into those that will not need to • • • •

be reclassified subsequently to profit or loss, and those that will be reclassified when specific conditions are met the share of other comprehensive income of associates and joint ventures accounted for using the equity method, separated into those that will not be reclassified subsequently to profit or loss and those that will be reclassified subsequently when specific conditions are met when such presentation is relevant to an understanding of the entity’s financial performance the amount of income tax relating to each item of other comprehensive income, including reclassification adjustments reclassification adjustments relating to components of other comprehensive income (see below). (© Commonwealth of Australia (2017).)

You need to recognise that many of the unrealised gains included in the statement of comprehensive income will eventually be realised. At that later stage, realised gains will be recognised in operating income. To avoid double counting, when the subsequent gain or loss is recognised in the operating section of the statement of comprehensive income, an equivalent deduction will need to be made in the ‘other comprehensive income’ section of the report. The reclassification adjustments can be shown directly in the statement of comprehensive income in the ‘other comprehensive income’ section as offsets, or they can be shown in the notes to the statements. The overall intention of the statement of comprehensive income is to provide more useful information to enable users to distinguish between income and expense of a recurring or permanent nature from those of a non-recurring or temporary nature. There will still be some adjustments made directly to retained profits, such as those related to the correction of errors and those related to the retrospective application of accounting policies or new and changed accounting standards. These will continue to be reported in the statement of changes in equity, which is dealt with in the next section. The statement of comprehensive income ensures that all gains and losses, both realised and unrealised, are reported within a single statement. To do this, it extends the conventional income statement by including unrealised gains, as well as any unrealised losses not yet reported, immediately below the measure of profit for the year. An illustration of this statement is shown in Example 7.1.

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MALIK LTD Statement of comprehensive income

7.1

for the year ended 31 july 2017 $m 97.2 Cost of sales

Distribution expenses Administration expenses 11.5 Finance charges 9.7 Tax Other comprehensive income Foreign currency translation differences for foreign operations Tax on other comprehensive income

6.6 4.0 8.0

Total comprehensive income for the year

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This example adopts a single-statement approach to presenting comprehensive income. The alternative two-statement approach simply divides the information shown above into two separate parts. The income statement, which is the first statement, begins with the revenue for the year and ends with the profit for the year. The statement of comprehensive income, which is the second statement, begins with the profit for the year and ends with the total comprehensive income for the year. Real World 7.4 shows the consolidated statement of comprehensive income for department store chain, Myer, which uses a two-statement approach to reporting income. A traditional income statement (shown in the Chapter 6 Case Study, page 322) precedes the statement shown below.

REAL WORLD 7.4 Example of statement of comprehensive income Consolidated statement of comprehensive income For the period ended 30 July 2016 2016

2015 52 weeks

Notes 29,826

Exchange differences on translation of foreign operations

F2 F2

14,514

41,465

Source: Myer Holdings Limited, Myer Annual Report 2016, p. 61. © Myer Pty Ltd.

Class discussion points 1 What do you understand by a cash flow hedge? 2 Why does this appear in the statement of comprehensive income?

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3 Is a separate statement of comprehensive income really necessary? Wouldn’t it be as easy to revert to the situation where there is an income statement and a series of reserves which reflect movements in other comprehensive income?

4 Explain how a revaluation of property from $1 million to $2 million would appear in the financial statements. Suppose that next year the property was sold for $2.2 million. How would this appear in the financial statements at the end of the second year?

It is worth noting that all of the items listed in the above statement for Myer relate to ‘items that may be reclassified to profit and loss’. This means that they are the kind of items referred to in the preceding paragraph. You should recognise that further items can be found (e.g. in Harvey Norman’s 2016 annual report) that would be listed as ‘items that will not need to be reclassified subsequently to profit and loss’. Items include ‘Fair value revaluations of land and buildings’ and ‘Income tax effect on fair value revaluation of land and buildings’. A relevant question to ask at this stage is whether it matters whether gains or losses are shown directly in the income statement or indirectly in the balance sheet, as long as they are disclosed? Some behavioural research in accounting suggests that it does not matter where the information is located, as long as it is available to users. Report users and investors are assumed to be competent and diligent, and will, therefore, efficiently incorporate all publicly available information into their assessment of the entity. Other capital market research would indicate that where the information is placed by management is important in decision-making and in communicating management

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inside information to external stakeholders. Considerable concern still remains as to whether the introduction of the statement of comprehensive income adds value to users or whether it makes understanding more difficult.

SELF-ASSESSMENT QUESTION

7.1

December 2017: Finance charges

40

Cost of sales

460

Distribution expenses

110

Administration expenses

212 25

Gain on revaluation of property, plant and equipment

20 15 24

Tax on other components of comprehensive income

1

statement of changes in equity interest in the net assets of the business as a result of transactions and events

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transactions with owners

Statement of changes in equity The statement of changes in equity aims to help users to understand the changes in share capital and reserves that took place during the reporting period. It reconciles the figures for these items at the beginning of the period with those at the end. This is achieved by showing the effect on the share capital and reserves of total comprehensive income as well as the effect of share issues and purchases during the period. The effect of dividends during the period may also be shown in this statement, although dividends can be shown in the notes instead. To see how a statement of changes in equity may be prepared, let us consider Example 7.2.

7.2 Foreign currency translation reserve

$m 100 20 40 150

Total equity

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

This information for 2017 can be set out in a statement of changes in equity as follows:

MIRO LTD Statement of changes in equity

7.2

for the year ended 31 December 2017

Balance as at 1 January 2017 Changes in equity for 2017 Issue of ordinary shares

$m 100

$m 20

$m 40

$m 150

70

Total comprehensive income 170

$m

continued

70 120 140

42 165

152 505

1 We have chosen to show dividends in the statement of changes in equity rather than in the notes. They represent an appropriation of equity and are deducted from retained earnings. 2 The effect of each component of comprehensive income on the various elements of shareholders’ equity must be separately disclosed. The revaluation gain and the loss on translating foreign opera-

More generally, the statement of changes in equity may include the information shown in Table 7.3.

TABLE 7.3 TYPICAL COMPONENTS OF STATEMENT OF CHANGES IN EQUITY Opening balance

1/–

1/–

Comprehensive income

1/–

1/–

Accounting policy changes

1/–

1/–

Prior period error correction

1/–

1/–

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Share issues

–

Return of capital Dividends paid/declared Closing balance

–

–

1/–

1/–

1

1 1/–

1

1

–

– –

1

1

ACTIVITY 7.13 Manet Ltd had the following share capital and reserves as at 1 January 2017: Share capital (ordinary shares) Revaluation reserve Currency translation reserve Retained earnings Total equity

$m 300 120 15 380 815

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During the year to 31 December 2017, the company revalued property, plant and equipment upwards by $30 million and made a loss on foreign exchange translation of foreign operations of $5 million. The company made a profit for the year from normal operations of $160 million during the year and the dividend was $80 million. Prepare a statement of changes in equity for 2017 in accordance with the requirements of AASB 101.

Statement of cash flows The statement of cash flows should help users to assess the ability of a company to generate cash and to assess the company’s need for cash. The presentation requirements for this statement are set out in IAS 7/AASB 107: Statement of Cash Flows, which we shall consider in some detail in the next chapter.

Notes The notes play an important role in helping users to understand the financial statements. Most financial statements are prepared in a form which summarises a considerable amount of detail. This detail then needs to be shown elsewhere in the form of notes to the accounts. Careful reading of the notes should be an essential part of any review of an annual report. AASB 101 states that the notes shall: (a) Present information about the basis of preparation of the financial statements and the specific accounting policies used . . . (b) Disclose the information required by Australian Accounting Standards that is not disclosed elsewhere in the financial statements. (c) Provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding of any of them. (Para 112, © Commonwealth of Australia (2017).) The notes should be prepared in a systematic way, consider understandability and comparability, and be cross-referenced. The notes play an important role in helping users to understand the financial statements. The notes typically include:

• a confirmation that the financial statements comply with relevant accounting standards • explanations of the measurement bases and accounting policies used (e.g. the basis of inventories valuation or depreciation)

• details relating to any sub-classifications in the statements (e.g. breakdown of current and

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• •

non-current assets) supporting information relating to items appearing on the four major financial statements other significant disclosures, including contingent liabilities. (© Commonwealth of Australia (2017).)

General points AASB 101 provides support for three key accounting conventions when preparing the financial statements. These are:

• the going concern convention • the accruals convention (except for the statement of cash flows) • the consistency convention. These conventions were discussed in Chapters 2 and 3. Finally, to improve the transparency of financial statements, the standard states that:

• Offsetting liabilities against assets, or expenses against income, is not allowed. Thus, it is not •

acceptable, for example, to offset a bank overdraft against a positive bank balance (where a company has both). Material items must be shown separately.

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Concept check 8 Which statement is false? A

AASB 101 does not prescribe the format but it does set out the minimum information

B

AASB 101 requires no distinction be made between current assets and non-current assets and between current liabilities and non-current liabilities.

C

further detailed breakdowns. D

E

presented is the vertical format based on the entity equation. None of the above are false.

Concept check 9 The statement of comprehensive income: A

B

C

D E

Extends the conventional income statement to include certain other gains and losses that affect shareholders’ equity Overcomes a weakness of conventional accounting whereby there is no robust principle Ensures that all gains and losses, both realised and unrealised, are reported within a single statement All of the above A and C only.

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SEGMENTAL FINANCIAL REPORTS Most large businesses are engaged in a number of different operations or lines of business, with each having its own levels of risk, growth and profitability. Information relating to each type of business operation, however, is normally added together (aggregated) in the financial statements so as to provide an overall picture of the financial performance and position of the business as a whole. For example, the revenue figure at the top of the income statement represents all of the business’s revenues added together. This will be true even where the revenues come from quite different activities. Although this aggregation of information can help to provide a clearer broad picture, it can make it difficult to undertake comparisons over time or between businesses. Some idea of the range and scale of the various types of operation must be gained for a proper assessment of financial health. Thus, to undertake any meaningful analysis of financial performance and position, it is usually necessary to disaggregate the information contained within the financial statements. This disaggregated information is disclosed in segmental financial reports. By breaking down the financial information according to each type of business operation, or operating segment, the relative risks and profitability of each segment can be evaluated and useful comparisons with other businesses or other operating segments can be made. The trend of performance for each operating segment over time can be seen, which helps determine more accurately the likely growth prospects for the business as a whole. It should also be easier to assess the impact on the overall business of changes in market conditions relating to particular operating segments. Disclosure of information relating to the performance of each segment may also help to improve the efficiency of the business by keeping managers on their toes. Operating segments that are

LO5 Explain the rationale for preparing segment reports and describe the reporting requirements

segmental financial reports

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performing poorly will be revealed and this should put pressure on managers to take corrective action. Finally, where an operating segment has been sold, the shareholders will be better placed to assess the wisdom of the managers’ decision to sell it.

Segmental reporting rules AASB 8 Operating Segments requires listed companies to disclose information about their various operating segments. Defining an operating segment, however, can be a tricky business. The AASB has opted for a ‘management approach’, which means that an operating segment is defined by reference to how management has segmented the business for internal reporting and monitoring purposes. Thus, how the business is divided into segments, for the purposes of managing them, defines a segment, under the standard, for that particular business. An operating segment is, therefore, defined as a part of the business: (a) that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), (b) whose operating results are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and (c) for which discrete financial information is available. (AASB 8 Operating Segments, para 5, © Commonwealth of Australia (2017).) Not all parts of the business will meet the criteria identified. The headquarters of the business (‘head office’) and some other functional departments, for example, are unlikely to do so.

ACTIVITY 7.14 What do you think are the main advantages of adopting the management approach to segment identification?

There are, of course, other ways of identifying an operating segment. One approach would be to define a segment according to the industry to which it relates. This, however, may lead to endless definition and classification problems. To be reported separately, an operating segment must be of significant size. This normally means that it must account for 10% or more of the combined revenue, profits or assets of all operating segments. A segment that does not meet this size threshold may be combined with other similar segments to produce a reportable segment, or separately reported despite its size at the directors’ discretion. If neither of these options is chosen, it should be reported with other segments under a separate category of ‘all other segments’.

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Segmental disclosure Financial information to be disclosed includes some profit (loss) measure (e.g. operating profit) for each segment, along with the following income statement items, provided that they are regularly reported to management:

• revenue, distinguishing between revenue from external customers and revenue from other • • • • • •

segments of the business interest revenue and interest expense depreciation and amortisation material items of income and expense any profit (loss) from associate companies or joint ventures income tax expense material non-cash items other than depreciation or amortisation. (AASB 8 Operating Segments, © Commonwealth of Australia (2017).)

The business must also disclose the total assets and liabilities for each reportable segment if such amounts are regularly provided to the chief operating decision-maker. Any additions to non-current assets during the period must also be reported. Where these items are not regularly reported to Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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355

management, they need not be included in the segmental report that appears in the business’s annual report. Example 7.3 provides an illustrative segmental financial report for a business.

Inter-segment revenue Interest revenue Interest expense Depreciation

$m 150 20 10

Expenditures for reportable segment non-current assets

40 15 60 12 25

$m 200 10 15 20 19 10 80 18

$m 25

5 4 12 2 4

$m

7.3

10 15 65 10 152 61

We can see that information relating to each segment as well as a combined total for all operating segments is shown. Key items, which include revenues, profits, assets and liabilities, must be reconciled with the corresponding amounts for the business as a whole. For example, Goya Ltd’s income statement should show revenue of $375 million for the business as a whole. When carrying out a reconciliation, we should bear in mind the following:

• Inter-segment revenues should be eliminated as no transaction with external parties occurs—

only sales to customers outside the business are deemed to be sales of the business as a whole.

• Any profit arising from inter-segment transfers should also be eliminated. • Assets and liabilities that have not been allocated to a particular segment should be taken into

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account.

The last item normally refers to assets and liabilities relating to business-wide activities. Thus, head office buildings may provide an example of unallocated assets and staff pension liabilities may provide an example of unallocated liabilities. AASB 8 requires certain non-financial information concerning segments to be disclosed, including the basis for identifying operating segments and the types of products and services that each segment provides. It also requires disclosure of business-wide information such as geographical areas of operations and reliance on major customers. Real World 7.5 provides a summary of the information provided by Harvey Norman and Origin Energy on operating segments.

REAL WORLD 7.5 Segment reporting Harvey Norman Holdings Limited Harvey Norman provided the following information in its 2016 annual report. Operating segment figures for the current and previous years, covering

i) Revenue ii) Segment Result Before Interest, Taxation, Depreciation, Impairment & Amortisation; Interest Expense; Depreciation Expense; Amortisation & Impairment Expense; Segment Result Before Tax

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iii) Operating Segment Assets and Liabilities; Segment Assets; Inter-company Eliminations; Segment Assets A#er Eliminations; Segment Liabilities; Inter-company Eliminations; Segment Liabilities A#er Eliminations for the following segments: Franchising operations Retail—New Zealand Retail—Singapore and Malaysia Retail—Slovenia and Croatia Retail—Ireland and Northern Ireland Other Non-Franchised Retail Total retail Retail Property Property Developments for Resale Total property Equity Investments Other Inter-company Eliminations Total segment

•

Integrated gas—gas and oil exploration and production in Australia and New Zealand Contact energy—includes the group’s 53.09% controlling interest in Contact Energy Limited.

Various business development and support activities not allocated to segments are combined under a ‘Corporate’ heading in the segments report. Detail provided includes:

• • •

a segment result indicating the underlying earnings before interest and taxes, followed by a section for items excluded from underlying profit a listing of segment assets and liabilities a section on geographical information.

Source: Origin Energy Limited Annual Report 2016.

Class discussion points

The report then describes the various operating segments, clearly setting out the geographical locations of the main segments. Source: Harvey Norman Holdings Limited Annual Report 2016, pp. 82–85. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Origin Energy Ltd In its 2016 annual report Origin Energy provides segment reports for:

•

•

Energy markets—energy retailing, power generation and LPG operations predominantly in Australia

1 Access the segment report for Harvey Norman. What does this reveal about profitability of the various segments? 2 Did the listing of segment descriptions give you any surprises? 3 Access the segment report for Origin. What do you think is meant by the term ‘underlying profit’? 4 Access the segment reports of Wesfarmers, which is more of a conglomerate than the two entities used in Real World 7.5? How important is segment reporting in assessment of performance of a company of this type?

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Segmental reporting problems

transfer price The price at which sales are

When preparing segmental reports, various problems can arise, not least of which is that of identifying a segment. We have already seen that the relevant AASB/IFRS identifies operating segments according to the internal reporting and monitoring procedures of the business. While this may be the most practical course of action, comparisons between segments in other businesses may be impossible because of the different ways in which they are defined. Another problem may arise where there is a significant amount of sales between operating segments. Where this occurs, the transfer price of the goods or services between segments can have a substantial impact on the reported profits of each segment. A potential risk is that revenues and profits will be manipulated for each segment through the use of particular transfer pricing policies. Tax authorities around the world are taking an increasingly hard line towards the transfer pricing policies that businesses adopt.

ACTIVITY 7.15 (a)

Why might a business wish to manipulate the transfer price between segments?

(b)

Can you provide any examples of where authorities are putting pressure on business regarding tax?

AASB/IFRS 8 recognises the impact of transfer pricing policies on segmental revenues and profit by stating that the basis for accounting for transactions between segments must be disclosed. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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357

A third problem is that some expenses and assets may relate to more than one operating segment and their allocation between segments may vary between businesses. Again, this may hinder comparisons of segmental profits and profitability between businesses. In spite of these issues, segment reporting provides considerable assistance to investors and other stakeholders in evaluating performance and prospects. However, it is difficult to see just how thorough evaluation could be without disclosure of the type described in this section.

Concept check 10

A B C

D

A division based on geography A division based on types of business A division based on how management chooses for internal reporting and monitoring purposes Any segment which accounts for 20% or more of the total revenue or assets of the business

E

Concept check 11 Which of the following statements relating to segment reporting is not true? A

Inter-segment revenues should be eliminated.

B C

D

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E

Segments below a certain size should be grouped together under a heading of ‘all other segments’. Segment reporting ensures investors can understand the segment and compare it with segments of other businesses. Segment reporting is necessary to enable investors in conglomerates to understand what is going on in the business.

SELF-ASSESSMENT QUESTION

7.2

authorised for publication, which relate to the reporting period just ended, should be treated as a liability in the 2 ‘AASB 101 provides support for three key accounting conventions—accruals, historic cost and consistency.’ 3 ‘AASB 101 permits bank overdrafts to be offset against positive bank balances when preparing the statement Critically comment on each of the statements.

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(b) Segmental information relating to Dali Ltd for the year to 31 May 2017 is as follows:

Inter-segment revenues Interest revenue Interest expense Depreciation

210 40

85

655

95

80 20

28 55 24

8 15 18

150 62

170 28

125

44 26

77

85

67

22

174

Impairment of assets Expenditures for reportable segment non-current assets

Analyse the performance of each of the three main business segments of Dali Ltd for the year and comment

CREATIVE ACCOUNTING LO6 Define the term creative accounting, describe the kind of methods used and identify steps that might be used to prevent it occurring

creative accounting Creative accounting consists of accounting practices that

Despite the proliferation of accounting rules and the independent checks that are imposed, concerns over the quality of published financial statements surface from time to time. There are occasions when directors apply particular accounting policies, or structure particular transactions, in such a way as to portray a picture of financial health that is in line with what they want users to see, rather than what is a true and fair view of financial position and performance. Misrepresenting the performance and position of a business in this way is often called creative accounting and it poses a major problem for accounting rule-makers and for society generally.

ACTIVITY 7.16 Why might the directors of a company engage in creative accounting? Try to think of at least two reasons.

Reasons given for manipulation of financial statements by management include: what those standards intend

• The link between management remuneration and financial performance provides an incentive

loopholes in the accounting

• Accounting standards still provide some flexibility of interpretation. • The relationship between the independent auditor and the corporate client may act as an

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to try to make the picture of performance as good as it can be.

accounting practices are to prevent such behaviors

inhibitor to finding creative accounting at work (see the Class Discussion Points for Real World 7.1).

Creative accounting methods There are many ways in which unscrupulous directors can manipulate the financial statements. They usually involve adopting novel or unorthodox practices for reporting key elements of the financial statements, such as revenue, expenses, assets and liabilities. They may also involve the use of complicated or obscure transactions in an attempt to hide the underlying economic reality. The manipulation carried out may be designed either to bend the rules or to break them. We shall now consider some of the more important ways in which rules may be bent or broken. Some creative accounting methods are designed to overstate the revenue for a period. These methods often involve the early recognition of sales revenue or the reporting of sales transactions that have no real substance. The manipulation of revenue has been at the heart of many of the accounting scandals recently exposed. Given its critical role in the measurement of performance,

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this is perhaps not surprising. We saw earlier in Chapter 3, in Real World 3.1, the problems caused by accusations of Hewlett Packard against Autonomy and in Chapter 6 in Real World 6.2 how Target manipulated its income figures. Types of revenue manipulation include:

• Reporting the sale of goods as soon as an order has been placed, rather than when the goods • •

are delivered to, and accepted by, the customer. Putting pressure on distributors to accept more goods than they can sell. This is known as ‘channel stuffing’ or ‘trade loading’. Engaging in artificial trading, which involves businesses in the same industry selling the same items between themselves to boost sales revenue. One example is where telecom businesses sell unused fibre optic capacity to each other. This is known as ‘hollow swaps’. Another example is where energy businesses sell energy between themselves for the same price and at the same time. This is known as ‘round tripping’ or ‘in and out trading’.

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The first two will lead to both revenue and profits being overstated. Artificial trading between similar businesses will inflate the sales revenue for a period but will not inflate reported profits. Nevertheless, this may still benefit the business, and certainly management, where pay and bonuses are based on performance (with performance being measured by revenue). Sales revenue growth has become an important yardstick of performance for some investors and can affect the value they place on the business. Revenue reduction, making a company look worse off than it is, can be a useful ploy in warding off potential takeovers. Indeed, creative accounting at the time of potential takeovers and mergers is almost certainly alive and well. Some creative accounting methods focus on the manipulation of expenses. Those expenses that rely on directors’ estimates of the future or their choice of accounting policy are particularly vulnerable to manipulation. By changing estimates about the future (e.g. the useful life or residual value of an asset), or by changing accounting policies (e.g. switching from FIFO to AVCO), it may be possible to derive an expense figure and, consequently, a profit figure that suits the directors. Adjustments in bad debts and doubtful debts provisions provide another easy target. The incorrect ‘capitalisation’ of expenses may also be used as a means of manipulation. This involves treating expenses as if they were amounts incurred to acquire or develop non-current assets, rather than amounts consumed during the period. The net effect of this is that the expenses will be unfairly understated and profit will, therefore, be unfairly boosted. Businesses that build their own assets are often best placed to undertake this form of malpractice. An approach often used by a new management team is to load the expenses in the early years so as to increase the likelihood of an improving financial result in the later years, giving a good growth record. Loading bad debts into the current year is also common.

ACTIVITY 7.17 (a) (b)

Can you identify the kind of expenses for which the directors make estimates or choices in the ways described? What would be the effect on the profits and total assets of a business of incorrectly capitalising expenses?

Some creative accounting methods focus on the concealment of losses or liabilities. The financial statements can look much healthier if these can somehow be eliminated. One way of doing this is to create a ‘separate’ entity that will take over the losses or liabilities. Other areas which can be manipulated are pension obligations and contingent liabilities. There are various ways in which assets can be misstated. These include: using asset values that are higher than the assets’ fair market values capitalising costs that should have been written off as expenses, as described earlier recording assets that are not owned or which do not exist.

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ACCOUNTING FOR BUSINESS STUDENTS

Directors may misrepresent or try to conceal certain information. This may relate to commitments made, key changes in accounting policies or estimates, significant events and so on. The information may also relate to financial transactions between the directors and the business. There is a fine line between creative accounting and fraud or cheating. Many of the significant scandals that have occurred over the last 20 or so years can be seen to have started with some minor variations on accounting judgements, then moved into full-blown creative accounting, and later into fraud. Recording fictitious revenues is an example of this. This cannot technically be called creative accounting. It is cheating. Real World 7.6 briefly summarises some examples of the various ways in which creative accounting has been implemented.

REAL WORLD 7.6 Examples of creative accounting (a) Dairy group Murray Goulburn has been accused of overstating its profits by about $150 million (see Real World 7.1 as well). A forensic accountant has claimed that the way in which the company used its milk price support program, ‘under which farmers would be paid a higher price immediately but the extra money would be clawed back from payments for milk in the future’ was ‘an accounting nonsense’. The end result was that the extra amount paid out was then recognised as an asset. Source: Ben Butler & Daniel Palmer, ‘MG used debt to overstate profit’, The Australian, 21 October 2016.

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(b) One particularly notorious case of capitalising expenses is alleged to have occurred in the financial statements of WorldCom (now renamed MCI). This company, which is a large US telecommunications business, is alleged to have overstated profits by treating certain operating expenses, such as basic network maintenance, as capital expenditure. This happened over a 15-month period during 2001 and 2002. To correct for this overstatement, profits had to be reduced by a massive $3.8 billion. Sources: Multiple web sources. For more detail use the reference in the Classroom Discussion Points below on ‘The 10 worst accounting scandals of all time’.

(c) Perhaps the best known case of concealment of losses and liabilities concerned the Enron Corporation. This was a large US energy business that used ‘special purpose entities’ (SPEs) as a means of concealment. SPEs were used by Enron to rid itself of problem assets that were falling in value, such as its broadband operations. In addition, liabilities were transferred to these entities to help Enron’s statement of financial position look healthier. The company had to keep its gearing ratios (the relationship between borrowing and equity) within particular limits to satisfy credit-rating agencies, and SPEs were used to achieve this. The SPEs used for concealment purposes were not independent of the company and should have

been consolidated in the statement of financial position of Enron, along with their losses and liabilities. When these, and other accounting irregularities, were discovered in 2001, there was a restatement of Enron’s financial performance and position to reflect the consolidation of the SPEs which had previously been omitted. As a result of this restatement, the company recognised $591 million in losses over the preceding four years and an additional $628 million worth of liabilities at the end of 2000. The company collapsed at the end of 2001. Source: Based on C. William Thomas, ‘The rise and fall of Enron’, Journal of Accountancy, vol. 194, no. 3, 1 April 2002. This article represents the opinions of the author, which are not necessarily those of the Texas Society of Certified Public Accountants.

(d) China Media Express, a supplier of television advertising services on buses, became part of a growing list of Chinese companies accused of fraudulently misleading investors about their financial condition. The company, which is quoted on the US Stock Exchange, was accused by the Securities and Exchange Commission (SEC) of falsely reporting significant increases in its business operations, financial condition and profits almost immediately upon becoming a publicly traded company. In addition to grossly overstating its cash balances, China Media Express is also accused of falsely stating that two multi-national corporations were its advertising clients when, in fact, they were not. The SEC alleged that, beginning in at least November 2009 and continuing therea#er, China Media materially overstated its cash balances by a range of approximately 452% to over 40,000%. For example, on 31 March 2010, China Media reported $57 million in cash on hand for the fiscal year ended 31 December 2009 when it actually had a cash balance of only $141,000. On 9 November 2010, the company issued a press release announcing a cash balance of $170 million for the period ended 30 September 2010

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

when it actually had a cash balance of merely $10 million. In addition to massively overstating its cash balances, China Media was alleged to have materially misrepresented the nature of its business relationships with two multinational corporations, claiming they were its advertising clients when, in fact, they were not. China Media’s falsely reported increases in its cash balances allowed the company to attract investors and raise money from share sales. Between January 2010 and December 2010, a hedge fund paid China Media $53 million to purchase millions of shares in the company. Source: Adapted from ‘Another Chinese company gets charged with fraud’, The Financial Times, 20 June 2013 (Kwan Yuk, P.), © The Financial Times Limited 2013. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

Class discussion points 1 Find out more about a range of scandals, including: (a) How was the scandal discovered? (b) How was it perpetrated? (c) Was the issue one of creative accounting or fraud? (d) What penalties resulted? (e) Was there any criticism of the auditors? 2 Do a web search on Enron and its auditors Arthur Andersen and summarise your findings. To get you started you might look at ‘The 10 worst accounting scandals of all time’, www.accounting-degree. org/scandals. 3 Update the situation regarding Murray Goulburn?

Checking for creative accounting When the financial statements of a business are being examined, a number of checks may be carried out on them to help gain a feel for their reliability. These can include checks to see whether:

• the reported profits are significantly higher than the operating cash flows for the period (as • • • • • •

shown in the business’s statement of cash flows), which may suggest that profits have been overstated the tax charge is low in relation to reported profits, which may suggest, again, that profits have been overstated, although there may be other, more innocent, explanations the valuation methods used for assets held are based on historic cost or fair values and, if the latter approach has been used, why and how the fair values were determined there have been changes in accounting policies over the period, particularly in key areas such as revenue recognition, inventories valuation and depreciation the accounting policies adopted are in line with those adopted by the rest of the industry the auditors’ report gives a ‘clean bill of health’ to the financial statements the ‘small print’ (that is the notes to the financial statements) is being used to hide significant events or changes.

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361

• the business is paying increased dividends; and/or • the directors are buying shares in the business. Although the various checks described are useful, they cannot be used to guarantee the reliability of the financial statements. Some creative accounting practices may be very deeply seated and may go undetected for years.

ACTIVITY 7.18 Can you suggest checks that might be useful to get a feel for the reliability of a set of financial statements?

Creative accounting and economic growth Some years ago there was a wave of creative accounting scandals, particularly in the US but also in Europe; however, it seems that this wave has now subsided. The quality of financial reporting Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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is improving and it is to be hoped that trust among investors and others is being restored. As a result of the actions taken by various regulatory bodies and by accounting rule-makers, creative accounting has become a more risky and difficult process for those who attempt it. However, it will never disappear completely, and a further wave of creative accounting scandals may occur in the future. The last wave coincided with a period of strong economic growth, and during good economic times investors and auditors become less vigilant so it becomes easier to manipulate the figures. We must not, therefore, become too complacent. Things may change again when we next experience a period of strong growth.

Concept check 12 Which of the following statements about creative accounting is true? A

Flexibility in accounting standards prevent creative accounting.

B

C

D

motivation for creative accounting. The relationship between the independent auditor and the corporate client does not usually act as an inhibitor to creative accounting. During good economic times investors and auditors become less vigilant so it becomes

E

with what manipulators want users to see, rather than what is a true and correct view

Concept check 13 Which of the following is a useful check for creative accounting? A B

C D

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E

Check the valuation methods used, particularly whether fair value has been used, and if it has, what the basis is for the valuation Check whether the accounting policies used are in line with the rest of the industry. All of the above. None of the above.

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SUMMARY In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Explain the importance of company law in relation to the directors’ duty to account, and discuss the role of the auditor in this process

• •

LO2: Explain why there is a need for accounting rules, explain the importance of accounting standards and map the development of accounting standards through to the development of international standards

• Explained the need for accounting rules • • Discussed the internationalisation of business and the growth of •

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• • LO3: Outline the role of the Australian Securities Exchange in regard to company reporting and management, with particular reference to corporate governance

• •

LO4: Identify the main requirements relating to the published annual report, including all of the financial and ancillary statements

•

LO5: Explain the rationale for preparing segment reports and describe the reporting requirements

• • • •

LO6: Define the term creative accounting, describe the kind of methods used and identify steps that might be used to prevent it occurring

• • • • •

Presentation of Financial Statements relating to: • • • • • notes

DISCUSSION QUESTIONS EASY 7.1

LO1

7.2

LO2

What is the role of a company director? that companies should be allowed to adopt methods and procedures that are best suited for them.

7.3

LO3

What is meant by the term ‘corporate governance’? What would be included in corporate governance activities?

7.4

LO4

Describe the key components of the annual report, including an explanation of the purpose of each report element.

7.5

LO5

How important do you think segment reporting is for a public company?

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INTERMEDIATE 7.6

LO1

7.7

LO2

The Australian Accounting Standards Board (AASB) has adopted International Accounting Standards standard where strict compliance will not provide true and fair reporting? Explain.

7.8

LO4

Discuss the purpose of the statement of comprehensive income from an accounting concept

7.9

LO4

The empirical research into the usefulness of the new statement of comprehensive income is mixed. (i.e. in the statement of comprehensive income)?

7.10 LO4

They’re showing a value for goodwill, and you know that unrealised assets such as human capital, a strong customer base and good supplier relationships cannot be shown as assets. What should you do?

7.11 LO2

Explain why corporate governance is currently a ‘hot topic’ for organisations and standard setters.

7.12 LO1/3

Explain what you understand by ‘true and fair’ in the context of company reporting.

7.13 LO2

that of the Australian Accounting Standards Board?

CHALLENGING 7.14 LO1

earned money in another HIH Insurance? What other safeguards exist in company law to provide such assurance?

7.15 LO2 7.16 LO2

Distinguish between ‘corporate governance’ and ‘enterprise governance’.

7.17 LO5

What problems does a user of segment reports face when seeking to make comparisons between businesses?

7.18 LO1

(a) What is to be included in audit reports? (b) Why do small proprietary companies not need to have their reports audited? (c) What is the main function of an audit report? (d) Why do companies have to report on the extent of non-audit services provided to them by the auditing business?

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7.19 LO2

Over the past two decades Australia has moved through the following stages: Producing its own standards with reference to differences between these and the equivalent international standards Changing its standards to be compatible with the equivalent international accounting standards. The process was labelled ‘harmonisation’ and involved adapting international standards for use in Australia. Changing its standards to be consistent with the equivalent international accounting standards. The process was labelled ‘convergence’ and involved adopting the international accounting standards for use in Australia. (a) Why would Australia give up its standards in favour of international accounting standards? (b) What could disadvantage Australia in giving up setting its own individual accounting standards?

7.20 LO6

From your study of creative accounting, do you think that it is possible to see how a path might emerge that takes someone from a mild tweak of an accounting judgement to a complete fraud?

7.21 LO1–3

The size of annual reports published by limited companies has increased steadily over the years. Can you think of any reasons, apart from the increasing volume of accounting regulation, why this has occurred?

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7.22 LO1–4

It has been suggested that too much information may be as bad as too little information for users of annual reports. Explain.

7.23 LO1–4

The system of corporate governance for stock exchange companies adopts an ‘if not, why not’ approach, also described as a ‘comply or explain’ approach. What does this mean? Set out one advantage and one disadvantage of this approach.

APPLICATION EXERCISES EASY 7.1

LO3

How would you classify the following expenses?

Freight inward Freight outward Sales staff salaries Interest Rates Depreciation—showcase Depreciation—building Repairs and maintenance—cash register Cleaning Bad debts Discounts given Telephone and postage Insurance—inventory Audit fee Administration—staff salaries Advertising

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7.2

LO3

found on a conventional income statement.

1 2 3 4 5 7.3

LO3

Which of the following are examples of ‘other comprehensive income’? Yes Correction of prior period errors Gains or losses on foreign exchange transactions Changes in the fair value of available-for-sale assets

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Changes in accounting policy Impairment loss (goodwill) Asset revaluation Foreign currency translation gains or losses related to foreign operations Gain or loss on the sale of revalued land

INTERMEDIATE 7.4

LO2

corporate governance principles. These were revised in 2010 into eight principles. Complete the table below.

1 2 3 4 5 6 7 8 7.5

LO1

blank for each by making a selection from the list below. 1

Company directors are responsible for the preparation of _________ that provide a _________ representation of the _________ and _________ of the business.

2

4

checked by an _________ and reported on (unless the company is a small proprietary company. _________ are rules established by the professional or statutory accounting bodies, which should be followed by preparers of the annual accounts of companies.

5

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auditor’s report tends to be _________.

7.6

LO1

fairly short

auditor

performance

fair

accounting standards

accounting standards

auditor’s report

fair

true

blank for each by making a selection from the list below. 1 2

The _________ report is generally much longer than their statement, and contains an increasing level of _________ disclosures. The _________ typically includes an indication that the audit was conducted in accordance with _________.

4 5

An audit report gives an _______, not a _________.

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

7.7

LO2

Australian Auditing Standards

Australian Accounting Standards

opinion

directors

auditor’s report

guarantee

voluntary

below. 1 2

4 5

The setting of ________ ________ in Australia is the responsibility of the Australian Accounting Standards Board (AASB). Companies are ________ to comply with the accounting standards. If company directors disagree with an accounting standard they ________ and may express their concerns in the _______. Australian Securities Exchange (ASX) listed companies must include summarised ________ accounts in addition to the statutorily required ________ accounts. The ________ provides the basic framework of company accounting regulation. This is augmented by _______ which have virtually the force of law.

accounting standards

accounting standards

annual

Corporations Act

required by law

half-year

still must comply 7.8

LO3

The accounts of NuFarm Ltd as at 30 June 2017 included the following:

Sales Interest income Gain on sales of equipment Gain on valuation of investments Dividend income

1,340,000 17,400 5,700 12,500 7,800

Cost of sales

700,700

Selling and distribution

127,300

Administration and general expenses

56,400

Finance expenses

13,500

Income tax expense

132,900

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Additional information: There is a gain on valuation of available-for-sale investments of $12,300. Prepare a single statement of comprehensive income for the year ended 30 June 2017.

CHALLENGING 7.9

LO2

below. 1 2

4

The need for accounting rules arises largely because of the separation of ________ from _______. Accounting rules (or standards) seek to achieve ________ and _______, to help to ensure that similar transactions are treated and reported in the same way. Today’s global economy has provided the impetus for the ________ ________ of accounting rules. In this regard the International Accounting Standards Board (IASB) has the goal of developing a ________ of high-quality, global ________.

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ACCOUNTING FOR BUSINESS STUDENTS

5

These rules are known as ________ and deal with key issues such as: What information should be ________ How information should be ________ How assets should be ________ How ________ should be measured. single set management

comparability

accounting rules

ownership

international harmonisation

consistency

presented

disclosed valued

International Financial Reporting Standards (IFRS)

7.10 LO3

Murphy Ltd provides the following equity accounts as at 1 January 2017.

$m

Share capital—ordinary shares issued at $5 Revaluation reserve Actuarial gain reserve Retained earnings Total equity

500 100 50 250 900

Income tax at a rate of 30% has not yet been paid. Murphy reported an upward revaluation of land and buildings of $80 million (before any tax that would be payable were the unrealised gains to be realised). The company issued 10 million ordinary shares during the year at a price of $3.00. Dividends Prepare a statement of changes in equity for the 2017 calendar year. 7.11 LO4

There are a number of items included on the statement of comprehensive income that are not found of the conventional recognition/reporting for each item.

1 2 3

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4 5

7.12 LO4 Administrative expenses Cost of sales Distribution expenses

$150,000 $2,500,000 $250,000

Interest charges

$50,000

Other expenses

$100,000

Prepaid expenses

$350,000

Realised gain on plant and equipment

$200,000

Revenue

$4,000,000

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

Tax on comprehensive income

$100,000 $350,000

Unearned revenue (i.e. revenue received in advance)

$200,000

Unrealised gain on foreign currency translations on foreign operations

$100,000

Unrealised gain on revaluation of plant and equipment

$200,000

Ortiz’s accountant has asked for your assistance with her preparation of a statement of comprehensive income as she has never prepared one. 7.13 LO3

The following were extracted from the accounts of HiLite Ltd as at 30 June 2017: $ Sales Rent income

867,300 9,700 23,600

Loss on sale of available-for-sale assets

28,700

Gain on valuation of investments

12,400

Raw materials and supplies used

345,800

Employee expenses

215,700

9,600

24,200 Depreciation of plant and equipment

34,800 13,600

Impairment goodwill

15,000

Finance expenses

23,400

Other expenses Income tax expense

7,200 65,400

Additional information provided: (a) Loss on sale of available-for-sale investments recognised as ordinary income. It had previously been revalued down by $10,000.

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Prepare a single statement of comprehensive income for the year ended 30 June 2017. Expenses are 7.14 LO1–4 (b) ‘International Accounting Standards (IAS) apply to all Australasian companies, but Stock Exchange listed companies must also adhere to International Financial Reporting Standards (IFRS).’ (c) ‘All listed companies in Australasia must follow IASs and IFRSs.’ of what they purport to show.’ (e) ‘IAS 1 leaves it to individual companies to decide the format that they use in the statement of

upward revaluation of a non-current asset.’ (g) ‘If a majority of the shareholders of a listed company agrees, the company need not produce a Critically comment on each of these statements.

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ACCOUNTING FOR BUSINESS STUDENTS

7.15 LO5

Segmental information relating to Turner Ltd for the year to 30 April 2017 is: $m

$m

$m

$m

250

230

52

532

Inter-segment revenues

45

25

–

70

Interest revenue

18

–

–

18

Interest expense

–

25

–

25

Depreciation

60

35

10

105

10

34

12

56

–

5

–

5

Revenues from external customers

Other material non-cash items: Impairment of assets Reportable segment assets

140

90

34

264

Expenditures for reportable segment non-current assets

22

12

10

44

Reportable segment liabilities

55

38

4

97

Analyse the performance of each of the three main business segments for the year and comment on your results.

CHAPTER 7 CASE STUDY

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How boards can be more effective and challenge management more effectively Given below is a summary of a paper. Read this summary and answer the questions that follow. The Chartered Institute of Management Accountants released a discussion paper in January 2010 entitled ‘Enterprise governance: restoring boardroom leadership’. The paper quotes the president of IFAC, Robert Bunting, as saying: ‘Regardless of who is to blame, the [global financial] crisis was unquestionably exacerbated by corporate governance failures.’ He specifically identified the lack of proper risk management processes, and governance systems which did not provide adequately for risky strategies. The discussion paper sets out a range of related factors which leads to a board’s effectiveness, which include frameworks relating to processes and structures, and people and behaviours. Much of the work to date focuses on the first group, with limited work on the second. Points of relevance in the paper relating to people and behaviours include the following: • It is important not to make too rigid a distinction between structure and culture in shaping behaviour. • Composition of the board is important: members need to work together as a team; diversity is important.

• Professional behaviour between board members and between board members and the executive management team is important, as is mutual respect. • It is important to understand and manage the human aspects of the business. • The prevalence of emotional factors in corporate success and failure means that they should be recognised as being at the heart of boardroom leadership and effectiveness. • There is a need to develop a culture of ‘effective challenge’, in which decisions are thoroughly debated and subject to proper scrutiny. All too o#en, boards develop a ‘group think’ approach, in which all members think the same way, leading to less rigour in the analysis. • In spite of containing very able members, some boards do not work well together, or do not have the collective desire to do what is necessary to challenge the status quo. • In some cases, the CEO has tight control over the workings of the board, with the result that awkward questions become too hard to ask. • Talent development and reward, and sound succession planning, both at board level and at executive level, are important.

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With regard to frameworks, processes and structures, the following are particularly noteworthy: • Boards must properly understand risk and integrate it into strategic thinking. Simply ticking boxes in a risk framework is not enough. • Organisations tend to oscillate between underscrutiny in good times and over-scrutiny in bad times. • Greed reflects a failure of leadership. It is o#en associated with ‘disaster myopia’, which is the tendency to underestimate the probability of adverse outcomes that have not occurred in recent memory.

The discussion paper recognises that implementing some of these ideas is not easy. However, they point us in a direction which expands the ideas on more traditional corporate governance. We recommend you read the whole paper. It includes a number of examples of behaviour and attitudes that relate to the global financial crisis that are very revealing. Source: Adapted from Gillian Lees, ‘Enterprise governance: restoring boardroom leadership’, January 2010, pp. 5–7. C.I.M.A. © 2010, Chartered Institute of Management Accountants. All rights reserved. Used by permission..

QUESTIONS 1

Do you think that the regulatory framework discussed in this chapter provides an adequate foundation for management and oversight?

2

How might a company strive to safeguard the integrity of its financial reporting?

3

What is the role and effectiveness of the auditor?

4

Is the division of corporate governance between conformance and performance useful?

5

The discussion paper summarised above identifies processes and structures as a key part of governance. List the range of processes and structures mentioned in the ASX Corporate Governance Principles.

6

The discussion paper talks about the importance of people and behaviours on board effectiveness. (a) What do you think is meant by ‘board culture’? (b) Do you think it is important that board members behave in a professional manner to each other? Why/why not? (c) Do you agree that diversity is an important component of a good board? (d) Why do you think that mutual respect between board members is important? What kinds of issues are likely to arise if mutual respect is lost? (e) What do you understand by the term ‘group think’, and how might it be prevented? How might a culture of ‘effective challenge’ be developed? (f) What reasons can you think of that might prevent a board working effectively as a team? (g) Is there an optimal size and composition for a board? Explain your answer. (h) How might a board encourage ethical and responsible decision-making? (i)

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7

What kind of relationship should a CEO seek to build with the board?

With regard to frameworks, processes and structures, answer the following. (a) What kind of risks might a company face? You may find it easier to think of a particular business and think about the particular risks associated with that business. (b) How best should risk be managed? (c) What do you understand by ‘disaster myopia’, and how might you guard against it? (d) Comment on the statement ‘Greed reflects a failure of leadership’.

Concept check answers CC3 CC4

C B E D

CC5 CC6 CC7 CC8

E C D B

CC9

D C D D&E

D

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SOLUTIONS TO ACTIVITIES ACTIVITY 7.1 (a) If shareholders do not receive information about the performance and position of their investment, they will have problems in appraising their investment. Under these circumstances, they would probably be reluctant to invest. Furthermore, individuals and organisations would be reluctant to engage in commercial relationships, health.

disinvestment) decisions. When coupled with limited liability and an active market for shares and other securities,

ACTIVITY 7.2

ACTIVITY 7.3 • the valuation and impairment of assets • the depreciation and impairment of non-current assets • the valuation of inventories.

ACTIVITY 7.4 (a) While many reasons could be given for the pressure to standardise accounting practices globally, it would appear that the major pressure groups were the stock exchange bodies across many countries and the major corpora(b) The arguments in favour of harmonisation/standardisation of accounting rules and reporting practices would include:

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• • reduced accounting and reporting costs for multinational enterprises as fewer separate reports would need to be produced; lower aggregate costs to prepare accounting standards • • lower costs of capital for organisations • • greater accountability of regulatory bodies. (c) The following are potential disadvantages of adopting international standards: • International standards, by their very nature, must be general and involve compromise to gain broad acceptance. information. It is interesting that the Australian standard-setting body has, in adopting the international standards, made changes that further restrict the choices available to Australian companies and also require additional disclosure. • In general it will be more expensive for purely domestic companies to comply with new international accounting standards because there are more standards and present practices may need to be changed. A single set of accounting standards for worldwide use cannot take into account the wide divergence in the economic, political, legal and cultural attributes of different countries.

ACTIVITY 7.5 Some issues may be resolved by reference to the application of general principles rather than by the generation of further rules.

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

ACTIVITY 7.6 and understandability. These are regarded as desirable, but not critical, characteristics. In the absence of relevance and faithful representation, they cannot make information useful.

ACTIVITY 7.7 Accounting can never really be said to be ‘correct’ or ‘accurate’ as these words imply that there is a precise value that an asset, claim, revenue or expense could have. This is simply not true in many, if not most, cases. Depreciation provides a good example of where ‘correct’ or ‘accurate’ would not be appropriate. The annual depreciation expense is based on judgements about the future concerning the expected useful life and residual value of an asset. If all relevant factors are taken into account and reasonable judgements are applied, it may be possible to achieve a fair representation of the for depreciation for a period cannot be achieved.

ACTIVITY 7.8 (a) If shareholders feel that their funds are likely to be mismanaged, they will be reluctant to invest. This can have severe economic repercussions. (b) Various arguments can be made in favour of greater accountability from such companies. As their shares are frequently traded, greater transparency concerning their business operations should help investors to make more the smooth functioning of capital markets. In addition, Stock Exchange listed companies tend to be larger and have more economic power and more stakeholders than other companies. Their impact on the economy and society as a whole, therefore, tends to be greater. This, in turn, creates an obligation for them to account more fully for their operations and actions.

ACTIVITY 7.9 No, because rules and regulations do not eliminate mismanagement, and more time would be spent on trying to get around them.

ACTIVITY 7.10 practices and for a set of reasonable governance guidelines.

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ACTIVITY 7.11 Several fundamental questions arise: • What are the information needs of a modern investment community? It is likely that conventional reporting requirements will be expanded to include sustainability reporting in the future, particularly accounting for carbon and water. • How do we deal with the broadening range of stakeholders and changing priorities? • What information does an extended stakeholder group need? Debates are likely to continue, due to concerns about over-regulation and the broadening of stakeholder interests.

ACTIVITY 7.12 The example that we met earlier is where a business revalues its land and buildings. The gain arising is not shown in the conventional income statement, but is transferred to a revaluation reserve, which forms part of equity. Land and buildings are not the only assets to which this relates, but these types of assets, in practice, are the most common examples of unrealised gains.

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ACTIVITY 7.13 Statement of changes in equity for the year ended 31 December 2017 $m Balance as at 1 January 2017 Changes in equity for 2017

120

Total comprehensive income 150

$m 815

15

10

160

185

460

920

1

Dividends are shown in the statement of changes in equity. They are deducted from retained earnings. An alternative

2

The effect of each component of comprehensive income on the various components of shareholders’ equity must be separately disclosed. The revaluation gain and the loss on foreign exchange transactions are each allocated to a

ACTIVITY 7.14 Under the management approach, shareholders will receive reports that are similar to the internal reports produced for management. This means that they can assess business performance from the same viewpoint as management. It should also mean that businesses would avoid additional, perhaps heavy, reporting costs as the information would already have been produced.

ACTIVITY 7.15 (b) ‘The French tax authorities have embarked on a €1 billion tax claim against Google following an investigation of tax country. Source: Extract from Calum Fuller, ‘Google hit with €1 billion French tax bill’, Accountancy Age, 7 February 2014. In September 2016 the European Union claimed €13 billion in back taxes from Apple that it said were owing. The Irish Government and Apple appealed this decision. The US government feels that the revenue should be taxed in the USA.

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ACTIVITY 7.16 There are many reasons, including: • • • to hide poor management decisions • • • to satisfy the demands of major investors concerning levels of return.

ACTIVITY 7.17 (a) These include certain expenses that we discussed in Chapter 3, such as: • • • •

depreciation of property, plant and equipment amortisation of intangible assets, such as goodwill inventories (cost of sales) allowances for trade receivables.

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CHAPTER 7 REGULATORY FRAMEWORK FOR COMPANIES

assets would be increased because the expenses would be incorrectly treated as non-current assets.

ACTIVITY 7.18 See the text. It is worth taking on board the emphasis that one analyst places on careful examination of the notes. Alistair Hodgson, investment manager at private client stockbroker Pilling and Co, says, ‘The notes tend to hold the key to anything that looks strange. I look to pick out things that the auditor has told the company to declare—the kind of thing they might not want to declare, but they have got to do so in order to make the accounts honest.’

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Source: ‘It pays to read between the lines’, The Financial Times, 17 September 2005 (Sharon Smith), © The Financial Times Limited 2013. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

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MEASURING AND CHAPTER REPORTING NAME CASH FLOWS LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain why cash and cash flows are important to the reporting entity LO2 Explain the nature, purpose and layout of the statement of cash flows LO3 Prepare a simple statement of cash flows LO4 Prepare a reconciliation of profit with cash flow from operating activities, and explain how useful this is in decision-making

LO5 Identify some of the potential complexities that arise with statements of cash flows LO6 Explain what the statement tells us, and illustrate how the statement of cash flows can be useful for identifying cash flow management strengths, weaknesses and opportunities, both historically and in forecasting and planning.

company’s operating or trading activities affect its wealth, it has been acknowledged that the accrualThis is principally because large expenditures on such things as non-current assets and inventories do because, in practice, without it no organisation can operate. Companies are required to produce a

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interpreted, and also how the accounting statements can be used for planning and decision-making, by

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ACCOUNTING AND YOU MANAGING YOUR CASH

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How o#en have you run out of cash over a long weekend when there is no ATM nearby? ‘Regularly,’ I hear you say. Why do you think this is? Typical reasons might include lack of planning, laziness, unplanned spending or unforeseen events throwing your calculations out—did a friend not pay you the money owed? There are clearly lessons to be learned from something like this, but when an individual runs out of cash on a short-term basis, the knock-on effects are relatively limited. The same may not be true when it happens to your business. There are many pitfalls waiting for you in running your own business, especially in the early years. We frequently hear of a business that seems to be going very well, with the volume of trade growing quickly. Everything looks great, but then the wheels come off. Usually this is because of a lack of appropriate attention to issues that relate to cash management. A common issue is too rapid expansion, commonly referred to as ‘overtrading’. Why should this be a problem? There are several reasons:

• •

the need for more non-current assets, which means a cash outflow or an increase in debt

•

an expanded customer base, with more uncertainty regarding the payment of accounts receivable, and possibly an increase in bad debts

• •

difficulty in obtaining larger amounts of credit from suppliers, or

the need for a rapid increase in inventories, which means increases in cash outflows or an increase in accounts payable or, more likely, both

insufficient equity to support a larger than planned for business.

All of these have the potential to impact negatively on the cash balance. As well as these factors, which can impact on cash flows directly, there is also the personal stress on the owners/managers from a degree of unplanned expansion, which consequently impacts on efficiency. Casualness in cash management, or insufficient attention to what is going on, can be the final straw for a business, particularly one that is growing. Another major cause of problems is lack of realistic planning. It is easy to get carried away with the idea of a new venture and make assumptions that prove to be invalid. A major problem that frequently arises relates to the period that it takes your customers to pay you. In practice, periods of 50 days are common, and many small businesses fail simply because of this. Great care needs to be taken to develop realistic assumptions for planning, and follow this up with sound systems of working capital management. It is also worth exploring opportunities for developing an overdra# or line of credit facility with your bank. The message is that cash management does not look a#er itself. It is an important part of running a business. You might find it useful to review some of the material available on the internet regarding the failure of Pie Face and its subsequent revival plan. Pie Face was an Australian fast-food chain, notable for the face drawings on its pies. A#er about 11 years of rapid expansion, the firm appointed administrators in late 2014. Its story has all the hallmarks of a typical over-ambitious growth plan. It has subsequently commenced a revival program. Possible useful sites include: http://theconversation.com/pie-face-collapse-a-lesson-in-biting-off-more-than-you-canchew-34656 www.smh.com.au/business/retail/how-pie-face-cooked-its-own-goose-20141127-11vbpq.html http://expert360.com/blog/can-learn-pie-face-fiasco www.franchisebusiness.com.au/news/the-truth-about-pie-face-and-its-revival-plan.

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Class discussion points 1 What are the likely personal costs of running out of cash in the way outlined above? 2 Summarise the main reasons for the failure of Pie Face. How might these reasons impact on cash flow? 3 If you were just starting your own business, what steps might you take to minimise the possibility of failure through overtrading? 4 How might you address the questions as to how much credit you would give and what payment terms you would allow customers? What would this imply for the cash resources needed to set up your business? 5 How important do you regard this last decision?

THE IMPORTANCE OF CASH AND CASH FLOW LO1 Explain why cash and cash flows are important to the reporting entity

Simple organisations, such as small clubs and other not-for-profit associations, often limit their accounting activities to a record of cash receipts and cash payments. Periodically (normally annually), a summary of all cash transactions for the period is produced for the members, showing one single figure for each category of payment or receipt; for example, membership subscriptions. This summary usually forms the basis of the club’s decision-making and is the main means for the committee to fulfil its moral duty to account to the club members. This is normally sufficient for such organisations. Table 8.1 illustrates such a report

TABLE 8.1 TYPICAL RECEIPTS AND PAYMENTS STATEMENT XYZ SOCIAL CLUB Statement of receipts and payments

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$ Cash at bank 1/7/16 Receipts Members’ subscriptions Fundraising Government grants Interest Other Payments Administration and accounting Functions Insurance Repairs and maintenance Telephone and postage Utilities Other Cash at bank 30/6/17

$ 10,320

4,370 3,190 2,500 470 380

1,360 3,410 920 2,670 1,290 1,430 670

10,910 21,230

11,750 9,480

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As we have seen in earlier chapters, organisations that are more complicated than simple clubs have to produce statements that reflect movements in wealth and the net increase (profit) or decrease (loss) for the period concerned. The statement of cash flows is a fairly late addition to the annual published financial statements. At one time, companies were only required to publish an income statement and a statement of financial position. It seems the prevailing view was that all the financial information needed by users would be contained within these two statements. This view may have been based partly on the assumption that, if a business were profitable, it would also have plenty of cash. While in the long run this is likely to be true, it is not necessarily true in the short to medium term. In practice, unless a business’s cash flows are monitored in the short to medium term, there may not be a long term for that business. We saw in Chapter 3 that the income statement sets out the revenue and expenses for the period, rather than the cash inflows and outflows. This means that the profit (or loss), which represents the difference between the revenue and expenses for the period, may have little or no relation to the cash generated for the period. To illustrate this point, let us take the example of a business making a sale (generating revenue). This may well lead to an increase in wealth that will be reflected in the income statement. However, if the sale is made on credit, no cash changes hands—at least, not at the time of the sale. Instead, the increase in wealth is reflected in another asset: an increase in trade receivables. Furthermore, if an item of inventory is the subject of the sale, wealth is lost to the business through the reduction in inventories. This means that an expense is incurred in making the sale, which will also be shown in the income statement. Once again, however, no cash changes hands at the time of sale. For such reasons, the profit and the cash generated during a period rarely go hand in hand. Activity 8.1 helps to underline how particular transactions and events can affect profit and cash for a period differently.

ACTIVITY 8.1

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The following is a list of business/accounting events. In each case, state the effect (i.e. increase, decrease or no effect) on both cash and profit. Event Repayment of a loan Making a sale on credit Buying a non-current asset for cash Depreciating a non-current asset Receiving cash from accounts receivable Buying some inventory for cash Making a share issue for cash

Effect On profit On cash .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... .......... ..........

From what we have seen so far, it is clear that the income statement is not the place to look if we are to gain insights about cash movements over time. We need a separate financial statement. In 1991, a new accounting standard required entities to produce and publish, as well as the income statement and the balance sheet, a cash flow statement reflecting movements in cash. The reason for this was the growing belief that, despite their usefulness, the income statement and the balance sheet did not concentrate sufficiently on liquidity. It was believed that the ‘accrual-based’ nature of the income statement tended to obscure the question of how and where a company was generating the cash it needed to continue its operations. The standard has been updated several times and the title of the statement has subsequently been changed to ‘statement of cash flows’. Why is cash so important to businesses pursuing profit/wealth? The solution to Activity 8.1 illustrates the fact that cash and profit do not go hand in hand, so why the current preoccupation

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with cash? After all, cash is just an asset that a business needs to help it to function. The same could be said of inventory or non-current assets. Cash is important because people and organisations will not normally accept any other way of settling their claims against the business. If a business wants to employ people, it must pay them in cash. If it wants to buy a new asset to exploit a business opportunity, the seller of the asset will normally insist on being paid in cash, probably after a short period of credit, usually a month or two. When businesses fail, it is their inability to find cash to pay claimants that really drives them under. These factors make cash the pre-eminent business asset and, therefore, the one that analysts and others watch carefully in trying to assess the ability of the business to survive and to take advantage of commercial opportunities as they arise. During an economic downturn, the ability to generate cash takes on even greater importance. Banks become more cautious in their lending, and businesses with weak cash flows often find it difficult to obtain finance. The importance of cash and cash flow can be seen in two UK examples in Real World 8.1. Part (a) is taken from an article by Luke Johnson who is a ‘serial entrepreneur’. This article was written just after the tennis at Wimbledon had finished and covered his views on major self-inflicted mistakes that can undermine a career. The article covered a range of mistakes, but the one given in Real World 8.1 relates specifically to the inability to distinguish profit from cash. Part (b) is taken from a column written by John Timpson, which appeared in the Daily Telegraph. Timpson is the chief executive of the successful British high street shoe-repairing and key-cutting business that bears his name. In the column he highlights the importance of cash reporting in managing the business.

REAL WORLD 8.1

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(a) Wise entrepreneurs learn that profits are not necessarily cash. But many founders never understand this essential accounting truth. A cash flow projection is a much more important document than a profit and loss (income) statement. A lack of liquidity can kill you, whereas a company can make paper losses for years and still survive if it has sufficient cash. It is amazing how financial journalists, fund managers, analysts, bankers and company directors can still focus on the wrong numbers in the accounts – despite so many high-profile disasters over the years. Source: Extract from Johnson, L., ‘The most dangerous unforced errors’, #.com, 9 July 2013. © The Financial Times Limited 2013. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

(b) I look at our cash balance every day (not Saturdays and Sundays). It is the best way to test the financial temperature of our business. The trick is to compare with the same day last year, thus showing cash flow for the past 12 months. It is not a perfect system (never forget that your finance department may secretly massage the cash by paying suppliers sooner or later than you anticipate) but a glance at the daily cash is more transparent than management accounts that are full of provisions and only appear once a month.

Finance and IT take a delight in producing a deluge of data. But being in possession of too many statistics is counterproductive. This daily cash report helps to clear the clutter created by computers – it’s a simple report that helps you pose the right questions. Why have things suddenly got worse? Are we in danger of breaking our bank borrowing limit? Why does the cash flow look so much better than in the management accounts? This cash report can also give  you an early warning of changing financial circumstances. It came to my rescue in 2004 when, through a major acquisition, the business doubled in size overnight and was going through a great deal of change. Our financial control suffered but I didn’t realise how bad things were until I was waiting to board a plane to go on a Caribbean holiday. A quick look at my Blackberry (when my wife wasn’t looking) showed an unexpected £500,000 deterioration in our overdraft. It wasn’t a great start to the holiday and my wife was upset when I spent the first day on the telephone. However, we were able to tackle the problem six weeks before it would have been revealed in the management accounts. Source: Timpson, J., ‘The management column’, The Daily Telegraph Business, 14 June 2010. © Telegraph Media Group Limited 2010.

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Class discussion points 1 How can a company make a paper loss and survive? 2 How frequently do you check your own personal bank account? 3 What kind of information about cash flows would you require for your own business? How frequently would you wish this information to be available?

4 Do you agree that you can have too many statistics? Do accounting statements run the risk of causing information overload? 5 Do you think that information on cash flows is more useful than the income statement and balance sheet?

Concept check 1 Which of the following statements is true? A

B

sheet and income statement. The income statement and balance sheet provide all of the information needed by most

C D E

None of the statements are true.

Concept check 2 A B C D

Cash sales Credit sales Payment of rates Receipts from debtors/receivables.

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Concept check 3 A B C D

Depreciation Wages paid in the current period Payment of creditors/payables Sale of a non-current asset.

Differences between the four external financial reports It is probably timely to remind ourselves of the four external financial reports required to be produced by regulated reporting entities. These are: 1 the statement of financial position (balance sheet) 2 the statement of comprehensive income (income statement/profit and loss) 3 the statement of cash flows 4 the statement of changes in equity.

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The statement of financial position (balance sheet) is a static financial report made at a given point in time and based on the balances in assets, liabilities and owners’ equity (capital). It is normally based on accrual transactions (recognising accounts and changes in account balances on the basis of economic reality rather than changes in cash). The statement of comprehensive income (income statement or profit or loss statement) is a financial report measuring the financial performance over a period of time (usually one year). It is normally based on accrual transactions related to income (revenues) earned less expenses incurred. The statement of cash flows is a financial report identifying all cash receipts and cash payments for the period. It is, therefore, based on cash, not accrual, transactions and incorporates all account types (assets, liabilities, owners’ equity, revenues, expenses and distributions). The differences between the statement of comprehensive income and the statement of cash flows must be understood and recognised. The statement of changes in equity is a financial report identifying all changes in equity for the period related both to comprehensive income, owners’ contributions and withdrawals, and all other changes in equity that are not processed through the statement of comprehensive income (e.g. correction of prior period errors, changes in accounting policy, or the retrospective application of a new accounting standard). The relationship between these four statements is shown in Figure 8.1.

Owners’ claim Statement of financial position at the start of the accounting period Cash

Income statement/ statement of comprehensive income

Owners’ claim

Statement of changes in equity

Statement of financial position at the end of the accounting period

Statment of cash flows

Cash

FIGURE 8.1

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the business’s assets and claims against those assets. The statement of comprehensive income and the statement of changes in equity explain how, over a period between two statements of also looks at changes over the accounting period, but this statement explains the alteration in the

THE STATEMENT OF CASH FLOWS LO2 Explain the nature, purpose and layout of the statement of cash flows

The statement of cash flows is, in essence, a summary of the cash inflows and outflows over the period concerned. To aid understanding, these cash flows are divided into categories (e.g. those relating to investment in non-current assets). Cash inflows and outflows falling within each category are added together to provide a total for that category. These totals are shown on the statement of cash flows and, when added together, reveal the net increase or decrease of the cash (and cash equivalents) of the business over the period. The statement is basically an analysis of the business’s cash movements for the period.

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The standard layout for the statement of cash flows in Australia is shown in Table 8.2.

TABLE 8.2 LAYOUT FOR THE STATEMENT OF CASH FLOWS XYZ LTD Statement of cash flows for the financial year ended 30 June 2017 Cash flows from operating activities Cash receipts from customers Cash paid to suppliers Cash paid to employees Interest paid Income taxes paid

x

Cash flows from investing activities Purchase of property, plant and equipment Acquisition of subsidiary, net of cash acquired Proceeds from sale of property, plant and equipment Interest received Dividends received

x x x

Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings

x x

Dividends paid

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Net increase (decrease) in cash and cash equivalents held

The Accounting Standard AASB 107: Statement of Cash Flows defines operating activities as ‘the principal revenue producing activities of the entity and other activities that are not investing or financing’ (© Commonwealth of Australia (2017)). Interest received would normally be classified as an operating activity cash inflow for financial institutions, but there is no agreement on its treatment for other organisations. It has long been debated whether interest received relates to operating activities or investing activities, and the current accounting standard allows firms to choose based on their individual circumstances. The headings in italics are the primary categories into which cash payments and receipts for the period must be placed.

• Cash flows from operating activities. This is the net inflow from operations. It is equal to the

•

sum of cash receipts from accounts receivable (and cash sales where relevant) less the sums paid to buy inventory, to pay rent, to pay wages, etc. Note that the amounts of cash received and paid, not the revenues and expenses, are what feature in the statement of cash flows. It is, of course, the income statement/statement of comprehensive income that deals with the expenses and revenues. Cash flows from investing activities. This part of the statement is concerned with cash payments made to acquire additional non-current assets and cash receipts from the disposal of such assets. These non-current assets could be tangible assets, such as plant and machinery, or

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•

•

such things as loans made by the business, shares in another company bought by the business, or other investments. Cash flows from financing activities. This part of the statement is concerned with financing the business, except to the extent of trade credit and other very short-term credit. So we are considering borrowings (other than very short term), and finance from share issues. This category is concerned with procuring long-term finance from debt and equity sources together with debt repayment/redemption and the returns to equity holders. Net increase in cash and cash equivalents held. Naturally, the total of the statement must be the net increase or decrease in cash over the period covered by the statement.

The Australian Accounting Standard AASB 107: Statement of Cash Flows incorporates a broad concept of cash in terms of both ‘cash’ and ‘cash equivalents’. Cash represents ‘cash on hand’ and ‘demand deposits’, while cash equivalents represent short-term, highly liquid investments that can readily be converted to a fixed amount of cash. Details of the statement of financial position accounts making up the ‘cash and cash equivalent’ balance in the statement of cash flows must be separately disclosed. Examples of such accounts would include ‘cash on hand’, ‘cash deposits at the bank’, ‘bank overdrafts’, ‘short-term money market deposits’ and ‘bank bills’.

ACTIVITY 8.2 At the end of its reporting period, Zeneb Ltd’s statement of financial position included the following items: 1 2 3 4

a bank deposit account where one month’s notice of withdrawal is required ordinary shares in Jones Ltd (a stock exchange listed business) a high-interest bank deposit account that requires six months’ notice of withdrawal an overdra& on the business’s bank account.

Which, if any, of these four items would be included in the figure for cash and cash equivalents?

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Under normal circumstances, we would expect (or at least hope) that the cash flows from operations would be positive. Since the cash flows do not include non-cash expenses such as depreciation, the cash flow from operations will normally be higher than the profit recorded. Interest and tax payments are separately identified. Companies pay tax on profits, so if the company is profitable, the cash flow will move from the company to the tax authority. There will not normally be a cash outflow relating to tax if the company is not profitable. The cash flow from operating activities gives users a reasonable understanding of the trends over the years and of likely sustainability in the future. Given that a high proportion of the funding for expansion comes from retained profits, which is approximately the cash flow from operating activities less dividends, a full understanding of the cash flow from operating activities is important.

ACTIVITY 8.3 Assume that last year’s statement of cash flows for Angus Ltd showed a ‘negative’ cash flow from operating activities. What could be the reason for this? Should the company’s management be alarmed by it? free cash flow

An important variation to this is what is known as free cash flow. ‘Free cash flow represents the cash flow that a company is able to generate after spending the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value’ (Investopedia). Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. Some people feel that there is too much emphasis on earnings, which can be manipulated, whereas it is difficult to fake cash flow. You can read more on free cash flow at www.investopedia.com/terms/f/freecashflow. asp#ixzz4VgXt11ds, or follow Investopedia on Facebook.

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385

Operating cash flow is an important part of many businesses’ key performance indicators. Real World 8.2 provides evidence of this.

REAL WORLD 8.2 (a) Energy business BP plc frames one of its key financial performance targets in terms of operating cash flows. Its performance over the five years ending 31 December 2015 is set out in Figure 8.2. For 2016, operating cash flows—excluding amounts relating to the Gulf of Mexico—totalled $17.583 billion. Net cash flow provided by operations was $8.4 billion lower than for 2015. Of this, $7.1 billion was associated with Gulf of Mexico spending.

It also included ‘Operating cash flow per share’ and ‘Free cash flow per share’ in its ‘Key share data’.

Class discussion points 1 Why do you think that BP considers operating cash flow a key performance indicator? 2 Would you expect operating cash flows to be of a similar magnitude each year? If not, why not? What might explain variations?

Source: B.P. p.l.c. Annual Report 2016, p. 22.

3 How important do you regard free cash flow?

(b) Wesfarmers included ‘Operating cash flows’ and ‘Free cash flows’ under the heading ‘Key financial data’ in the ‘Highlights Summary’ of its 2016 Annual Report (p. 6).

4 What factors do you think need particular attention when planning for next year’s operating cash flows?

FIGURE 8.2

Note: Environmental issues, including the Gulf of Mexico issue referred to above, are discussed in more detail in Chapter 9.

40 32.8

30

Source: Our key performance indicators, 2015, B.P. p.l.c.

20

22.2

20.5

21.1

2012

2013

19.1

10

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0

2011

2014

2015

The section on investing activities needs to be linked with the other two sections, since we would normally expect long-term assets to be paid for (funded) by either operations or other financing. Of course, sometimes asset sales can fund further asset purchases. Because most types of fixed assets wear out and because companies tend to seek to expand their asset base, the normal direction of cash in this area is out of the company (i.e. negative). The section on financing indicates what cash has been raised and repaid in financing transactions. Normally, a company pays out more to service its finance than it receives from its own financial investments (loans made and shares owned). Financing can go in either direction, depending on the financing strategy at the time. Since companies seek to expand, there is a general tendency to associate this area with cash coming into the business rather than leaving it. Figure 8.3 provides a diagrammatic representation of the statement of cash flows showing likely directions of cash flows.

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FIGURE 8.3 Operating activities

Various activities of the business each have their own effect on its cash and cash equivalent balances, either positive (increasing them) or negative (reducing them). The net increase or decrease in the cash and cash equivalent balances over a period will be the sum of these individual effects, taking account of the direction (cash in or cash out) of each activity. Note that the direction of the arrow shows the

Cash and cash equivalent balances

Investing activities

Financing activities

activity. In certain circumstances, each of these arrows could be reversed in direction.

A comparison of statements of cash flows over time enables us to identify trends and make comparisons with other companies.

Concept check 4 Which of the following statements is false? A

B

received from customers and cash paid to suppliers. C

non-current assets, their depreciation, and sale proceeds from any such assets sold. D

E

such things as loans raised or repaid, and rights issues. None of the above. They are all true.

Concept check 5 Copyright © 2017. P.Ed Australia. All rights reserved.

What do you think are the most likely patterns to be found in the cash

A B C D

LO3 Prepare a simple statement of cash flows

PREPARATION OF THE STATEMENT OF CASH FLOWS—A SIMPLE EXAMPLE The statement of cash flows is based on an analysis and classification of cash receipts and cash payments for the period into three activity sets (operating, investing, financing) and several categories within each activity (see Figure 8.3, and Table 8.2 on page 383).

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

While your chosen career might not require you to be able to prepare a statement of cash flows yourself, a broad understanding of the approach needed to prepare such a statement will give you a better understanding of the statement itself. Also, when the statement is turned around and used in a forward-looking or forecast mode, it can become an extremely powerful aid in strategic planning. With this in mind, we shall use Example 8.1 to illustrate the preparation of a statement of cash flows.

$m 100

Sales Cost of sales

8.1

40 Depreciation 18 Interest expense 15 Tax 10 40 20 20

Proposed dividend on ordinary shares

Current assets Cash at bank and in hand Accounts receivable Inventory

$m

$m

12 15 22 49

5 20

40

50

50 80 129

60 95 150

10 4 15 29

15 5 20 40

20

25

50

65 20 85 150

55

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Non-current assets

Total assets Current liabilities Accounts payable Income tax payable Dividend proposed Non-current liabilities Debenture loans Shareholders’ equity Paid-up ordinary capital

Total liabilities and shareholders’ equity

80 129

additional plant and machinery. There were no other non-current asset acquisitions or disposals.

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ACCOUNTING FOR BUSINESS STUDENTS

Deducing cash flows from operating activities

direct method

The first category of cash flows that appears in the statement—the most important one for most businesses—is the cash flow from operations. Basically, this requires an analysis of the records of the business for the period, so as to calculate all payments and receipts relating to operating activities. These are summarised to give the net figure for inclusion in the statement of cash flows. There are two approaches that can be taken to deriving this figure: the direct method and the indirect method. The direct method involves an analysis of the cash records of the business for the period, identifying all payments and receipts relating to operating activities. These are summarised to give the total figures for inclusion in the statement of cash flows. The indirect method uses accounting information from the income statement and the statement of financial position to convert the profit figure to a cash figure. It relies on the fact that, sooner or later, sales revenue will give rise to cash inflows and expenses will give rise to outflows. This means that the figure for profit for the year will be linked to the net cash flows from operating activities. Since businesses have to produce an income statement, the information that it contains can be used as a starting point to deduce the cash flows from operating activities. In fact, the accounting standard encourages entities to use the direct method, as it provides information that may be useful in estimating future cash flows, which is not available under the indirect method. However, entities which use the direct method are required to provide a reconciliation of cash flows arising from operating activities to profit or loss. Given this, the next section will deal with the direct method, while a later section will illustrate how the reconciliation statement is prepared, and there, the indirect method will be used. Remember that the layout for the operating section is as shown below. Cash flows from operating activities

x

Cash receipts from customers Cash paid to suppliers Cash paid to employees Interest paid Income taxes paid

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The first stage in the preparation of the statement is to calculate the cash receipts from customers. Basically, we would expect the following relationship to be true: x plus sales for the period

x

gives the amount we might expect to receive for the period

x

This amount has either been received or not (in which case it will be reflected in a figure for accounts receivable at the end of the period). Hence, cash received from customers can be calculated as follows: x plus sales for the period

x

gives the amount we might expect to receive for the period

x

equals the cash received from customers

x

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

The first stage is to calculate the cash receipts from customers. Using the figures in Example 8.1, cash received from customers can be calculated as follows: 15 plus sales for the period

100

gives the amount we might expect to receive for the period

115

less closing balance of accounts receivable 95

equals the cash received from customers

The same kind of approach can be used to calculate cash paid to suppliers and employees, although the process is generally a little more complicated, as this requires knowledge of the purchases figure. The first stage is therefore to calculate this figure. The calculation of payments relating to accounts payable for inventory purchases can be derived as follows: x plus purchases of inventory for the period

x

gives the amount we might expect to pay for the period

x

equals the cash paid to accounts payable

x

This requires knowledge of the purchases figure, which can be derived as follows: x plus purchases

x

equals the amount available for sale

x x

Using Example 8.1, and inserting the known figures, we get: 22 plus purchases

x

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equals the amount available for sale

22 1 x 60

The figure for purchases x can be calculated by solving: 22 1 x 2

= 60, so x = 60 1

2 22 = 68

This figure can then be inserted in the table for accounts payable to enable us to work out the cash paid relating to accounts payable. 10 plus purchases of inventory for the period

68

gives the amount we might expect to pay for the period

78

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Payments of other expenses may be presumed to have been paid in cash, as they reflect expenses of the year, and if there are no prepayments or accruals at either the beginning or end of the year. Depreciation will not involve a cash outflow. Interest paid is usually fairly straightforward, but where there is an associated interest payable or interest prepaid (or indeed, if there are prepaid or accrued expenses), a calculation process similar to the one above for accounts payable will be required. The calculation of interest paid relating to interest payable can be derived as follows: x plus interest expense for the period

x

gives the amount we might expect to pay for the period

x

equals the interest paid

x

The calculation of interest paid relating to prepaid interest can be derived as follows: 0 plus interest expense for the period gives the amount we might expect to pay for the period less closing balance of interest payable equals the interest paid

With regard to payments of tax, we have already noted that the actual payment of tax tends to lag behind profits, so we would expect payments in the current year to reflect last year’s (possibly adjusted) tax liability. In the case of Example 8.1, it should be clear that the figure for tax due at the end of 2016 will be paid in 2017, and the amount included against profit for 2017 will remain outstanding at the end of 2017, presumably to be paid in 2018. Alternatively, it can be calculated in the same way that we calculated interest paid where there was tax payable at the beginning and end of the period. The ‘operating’ section can now be completed for Example 8.1 as follows: Cash flows from operating activities Cash receipts from customers

95

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Cash paid to suppliers and employees 1 Interest paid 8

Deducing cash flows from investing activities The basis of this section is as set out below: Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of property, plant and equipment

x

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

We need to know how much has been spent on non-current assets, and any sale proceeds from non-current asset sales. In Example 8.1 we are told that the company spent $10 million on additional land and buildings, and $10 million on additional plant and machinery; also, that there were no other non-current asset acquisitions or disposals. There was no investment income and, therefore, no cash received from dividends or interest. If there was income from either of these investments, then the cash received would be calculated in the same way that cash from customers was calculated. The ‘investing’ section for Example 8.1 would appear as follows:

Cash flows from investing activities 1

Deducing cash flows from financing activities A comparison of the opening and closing capital figures should enable us to calculate the amount of new share capital issued. In the case of Example 8.1, ordinary share capital increased by $15 million ($50 million to $65 million) over the year. A comparison of the long-term liabilities at the beginning and end of the year should indicate the net cash flows from borrowings. In Example 8.1 (page 387), we assume that there was new borrowing of $5 million as the loans figure increased by that amount over the year. As for dividends, we would usually expect to see final dividends for the year as a current liability in the year-end statement of financial position, to be paid early in the following year. In Example 8.1, this means that the $15 million dividends proposed at the end of 2016 will be paid in 2017. The proposed dividends shown in the statement of comprehensive income for the year ended 30 June 2017 are also shown as outstanding in the year-end statement of financial position, so clearly they cannot have been paid. The ‘financing’ section can now be completed for Example 8.1 as follows:

Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings

15 5

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5

AASB 107 requires disclosure for transactions and other events which do not result in cash flows but which affect assets and liabilities. These are known as non-cash investing and financial activities and are reported in a note to the statement of cash flows if significant. Examples of non-cash investing and financing activities include the following: 1 the acquisition of non-cash assets (e.g. a building) by an exchange with other non-cash assets

(e.g. land), by issuing debt securities (e.g. debentures) or by issuing shares directly to the vendor 2 the reduction in non-current debt by settlement with non-cash assets (e.g. equipment) by

exchange with another debt instrument (e.g. debentures or notes) or by issuing shares directly to the creditor 3 internal changes or transfers within the equity section of the statement of financial position (e.g. bonus issue of shares from reserves).

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Putting the above sections together enables us to complete the statement of cash flows for Example 8.1 as follows: Statement of cash flows for the year ended 30 June 2017 $m Cash flows from operating activities Cash receipts from customers

95 1

Interest paid 8 Cash flows from investing activities 1 Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid

15 5 5

Net decrease in cash and cash equivalents held Cash and cash equivalents at the beginning of the financial year Cash and cash equivalents at the end of the financial year

12 5

A legitimate question to ask is: what does this statement add? Chapter 10 deals specifically with financial analysis. However, the statement of cash flows should be linked with this analysis, with the following points being relevant. The statement clearly shows that cash decreased by $7 million over the course of the year, and it clearly identifies the factors that contributed to this decrease. This enables users of the financial reports to assess the efficiency of liquidity management. The following might be considered:

• • • • •

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•

•

Is a decline in cash resources to $5 million acceptable? Does it pose any problems regarding liquidity in the future? Will it signal any problem with creditworthiness/credit ratings? The cash flow from operating activities is positive, but is it enough? Could it be increased? $20 million has been spent on new property, plant and equipment, $15 million has been raised by a new share issue, and $5 million has been borrowed. Are these levels of acquisitions and funding appropriate? Rather strangely, $15 million in dividends has been paid out, a figure that is higher than the after-tax profit for the year. The logic of this should be questioned since a new share issue has been made. Normally, new asset purchases (investing activities) are associated with similar sized inputs in the financing section. The dividends payment appears to be an aberration. Have the new shares affected the control of the company, and is this a current or potential issue?

The statement of financial position also raises further issues, to be reviewed after studying Chapter 10.

• Accounts receivable have increased by one-third, or $5 million—is this increase justified • •

relative to sales, or is it due to tighter trading conditions or an inefficient debt collection and credit policy? Inventory has increased by just over one-third, or $8 million—is this justified, or does it reflect poor inventory control? Accounts payable have increased by 50%, or $5 million. To some extent this may offset the increase in inventory. It could also reflect a lengthening of the time the business takes to pay its debts. Whether the new time is appropriate is a question that has to be considered in the context of the industry.

The statement of cash flows highlights the main liquidity issues. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

Real World 8.3 provides an example of a statement of cash flows for department store chain Myer from its 2016 annual report.

REAL WORLD 8.3 Example of a statement of cash flows Consolidated statement of cash flows for the period ended 30 July 2016

Notes

185,682 71

149,847 108

149,490

96,915

1,856

18,225 800

Interest paid Tax paid

Payments for property, plant and equipment Net investment in associate Payment for brands acquisition Payments for intangible assets Interest received

17,927 Proceeds from the issue of shares, net of transaction cocsts Dividends paid to equity holders of the parent

212,011 F3 60

455

45,207

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Source: Myer Annual Report 2016, © Myer Pty Ltd., p. 64.

Class discussion points 1 The importance of operating flows is clear. What questions arise for you when considering just the first two lines of the statement relating to receipts from customers and payments to suppliers and employees for the two years covered by the statement? 2 Do you see anything else of interest regarding other items in the operating flows?

4 Why are the financing flows so different over the two years? 5 What are your initial thoughts regarding the level of dividends paid? You will need to access the annual report on the website to provide clear answers to these questions.

3 Identify the main differences between the figures for cash flows from investing activities over the two years covered by the statement?

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Concept check 6

How much cash was received from receivables in the year? A B C D

$102,000 $105,000 $95,000 $99,000.

Concept check 7

purchases made on credit for the year? A B C D

$74,000 $62,000 $60,000 $58,000.

Concept check 8 What was the amount paid for wages in the year? Copyright © 2017. P.Ed Australia. All rights reserved.

A B C D

$225,000 $219,000 $221,000 $215,000.

ACTIVITY 8.4 Chen Ltd’s income statements for the years ended 31 December 2016 and 2017 and the statements of financial position as at 31 December 2016 and 2017 are as follows:

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

CHEN LTD Income statement for the year ended December $m 207

$m

Cost of sales 106

77

64

29

60

25

44

19

Distribution expenses Administrative expenses Interest payable Taxation

CHEN LTD Statements of financial position as at 31 December

ASSETS Current assets Cash Accounts receivable Inventories

19 26 24 69

Non-current assets Plant and machinery

62 110 172 241

Total assets

25 25 50 56 186

Current liabilities 2 Trade payables Income tax

8 45

Non-current liabilities 40

40

100 56 156 241

100 57 157

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Equity

Total equity and liabilities

Included in ‘cost of sales’, ‘distribution expenses’ and ‘administrative expenses’, depreciation was as follows: 2016 2017 $m $m Land and buildings Plant and machinery

6 10

10 12

There were no non-current asset disposals in either year. The amount of cash paid for interest equalled the expense in each year. Dividends were paid totalling $18 million in each year. Prepare a statement of cash flows for the business for 2017. Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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LO4 Prepare a reconciliation of profit with cash flow from operating activities, and explain how useful this is in decisionmaking

RECONCILING PROFIT FOR THE YEAR WITH CASH FROM OPERATING ACTIVITIES The accounting standard also requires a note that reconciles the profit or loss after tax with the cash flows from operating activities. The reconciliation uses a system of calculating cash flows from operating activities which is known as the indirect method. Reconciling the profit after tax with operating cash flows involves a number of stages. The first is to adjust for any items which are clearly non-operating items, and which will appear in the investing or financing sections. The second is to add back any non-cash expenses (such as depreciation). The final step is to adjust for any changes in current assets and current liabilities. The process works broadly as set out in Table 8.3.

TABLE 8.3 THE INDIRECT METHOD OF DEDUCING THE NET CASH FLOW FROM OPERATING ACTIVITIES

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x

indirect method An approach to deducing

This reconciliation is based on the following logic. The starting point of the reconciliation is the profit after tax, the bottom line of the income statement. In order to convert the profit figure to an operating cash flow, we first need to reduce the profit figure by any items which are clearly nonoperating, and which will appear in either the investing or financing sections. By way of illustration, investment income would be part of profit, but not of operating profit (it is clearly not an operating cash flow), and so any amount relating to investment income would need to be deducted in arriving at operating profit. This figure would normally appear in the investing section. The next stage is to add back any non-cash expenses. So, if for example there was a foreign exchange loss taken in calculating the profit figure, the amount of that loss would need to be added back. Depreciation is the prime example of a non-cash expense which clearly relates to operating activities. It is not associated with any movement in cash during the accounting period, but rather

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

represents an estimate of service potential or economic benefits of property, plant and equipment used up during the period. The remaining adjustments all relate to the operating profit after income tax. Broadly, we would expect sales to give rise to cash inflows, and expenses to give rise to outflows. We have already seen that this relationship does not follow precisely within a particular accounting period. It is not strictly true that profit equals the net cash inflow from operating activities. In Example 8.1 (page 387) we saw a difference between the sales figure in the statement of comprehensive income and the cash received from customers calculated as follows:

15 plus sales for the period

100

gives the amount we might expect to receive for the year

115

less closing balance of accounts receivable equals the cash received from customers

95

Put another way, the cash from customers can be arrived at as follows:

Sales for the period

100

less the increase or plus the decrease in accounts receivable over the year

Copyright © 2017. P.Ed Australia. All rights reserved.

Cash received from customers

95

An increase in accounts receivable over the year means that the cash received will be less than the amount included as revenue over the year, by the amount of the increase. A reduction in accounts receivable over the year means that the cash received will exceed the amount included as revenue over the year, by the amount of the decrease. Basically, the accounts receivable figure is affected by sales and cash receipts. It is increased when a credit sale is made, and decreased when cash is received from a debtor. If, over the year, the sales and the cash receipts had been equal, the accounts receivable figures would have remained the same. Since the accounts receivable figure increased, it must mean that less cash was received than the figure for sales included in the statement of comprehensive income. Thus, the cash receipts from sales must be $95 million (i.e. 100 – (20 – 15)). Put slightly differently, we can say that, as a result of sales, assets of $100 million flowed into the business during the year. If $5 million of this went to increasing the asset of accounts receivable, this leaves $95 million to increase cash. The same general point is true in respect of nearly all of the other items taken into account when deducing the operating profit figure. The exception is depreciation, which was covered earlier. Using Example 8.1 (page 387), we see that this would result in a reconciliation as shown below: $m 10 Depreciation

5

Increase in inventory Increase in accounts receivable Increase in accounts payable

5

Increase in tax payable

1 8

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The net cash inflow of $8 million from operating activities is the same as shown on the statement of cash flows. Basically, this reconciliation starts with the assumption that the profit equals the cash generated. We know that this is not true, because the following things happen to prevent it being true:

• Depreciation does not involve a cash outflow, so the cash flow from operations will be higher •

•

Copyright © 2017. P.Ed Australia. All rights reserved.

•

than the profit by the amount of the depreciation. Any increase in current assets (accounts receivable, prepayments or inventory) over the course of the year can be seen as representing a drain of cash (accounts receivable—cash not collected from sales during the period; inventory and prepayments—cash paid related to inventory and other expenses exceeds the cost of goods sold and expense amounts). So increases can be seen as an effective decrease in cash flow. Any decrease in current assets means that these assets over the course of the year can be seen as releasing cash (accounts receivable—cash collected exceeds the sales; inventory and prepayments—cash paid for inventory and other expenses is less than the cost of goods sold and expense amounts). So reductions represent an effective increase in cash flow. Any increase in current liabilities (accounts payable, income tax payable, deferred tax payable and accruals) must mean that less cash has been paid out over the course of the year than one might have expected on the basis of the expenses included in the statement of comprehensive income. This means that an increase in such liabilities over the year can be seen to represent an effective increase in cash flow, over and above those included from profit. Any decrease in these current liabilities must mean that more has been paid out over the course of the year than one might have expected on the basis of the expenses included in the statement of comprehensive income. This means that a decrease in such liabilities over the year (they have been paid off) can be seen to represent an effective decrease in cash flow compared with profit. Any gain or loss on the disposal of non-trading assets (e.g. property, plant and equipment; investments; intangibles) needs to be adjusted for. Both the gain and the loss are non-cash in nature and simply represent the difference between the proceeds on disposal and the carrying amount of the asset sold. The cash proceeds are included as a cash inflow in the investing activities section of the statement of cash flow. Therefore, the loss is added back in the reconciliation and the gain is deducted.

All of this means that if we take the profit for the year, adjust it to eliminate any items relating to investing and financing, add back the depreciation charged and any other non-cash expenses, and adjust this total by movements in non-cash current asset and current liability accounts (e.g. inventory, accounts receivable, accounts payable, prepayments and accruals, and income tax), we have the net cash from operating activities. In many ways the reconciliation provides more useful information than the statement of cash flows using the direct method. Cash can be positively or negatively affected by changes in working capital. These are not obvious in the statement of cash flows, but the reconciliation focuses on them. Certainly, inefficient working capital management can more easily be identified by the reconciliation. The reconciliation enables a clearer focus on the working capital components; namely, inventory, credit control relating to receivables, and control of payables. Unless someone in an organisation is given control and responsibility for each of these areas (and they can be under the control of different people), the chances are that the end cash result will be a residual or unplanned result. All of these areas need to be continually worked on. Working capital management needs to be positively managed, not left to chance. Real World 8.4 provides an example of the reconciliation of net (deficit)/surplus after tax to net cash flows from operations relating to Myer, which complements Real World 8.3.

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

399

REAL WORLD 8.4 Example of reconciliation of net (deficit)/surplus a"er tax to net cash flows from operations

Depreciation and amortisation, including lease incentives and contributions Interest income Interest expense Share-based payments expense Net exchange differences Change in operating assets and liabilities (Increase)/decrease in trade and other receivables (Increase)/decrease in inventories Decrease/(increase) in deferred tax asset (Decrease)/increase in trade and other payables (Decrease)/increase in current tax payable Increase/(decrease) in provisions (Decrease)/increase in other liabilities

60,543 93,896 (906) 1,094 1,080 620 (221)

29,826 101,697 (753) 1,221 1,445 – (2,875)

(3,457) (14,622) (6,792) 5,717 (964) 6,521 7,057 (76) 149,490

(4,107) (6,615) (4,437) (2,797) (19,494) (6,809) 10,720 (107) 96,915

Source: Diagrammatic representation of the statement of cash flows, Myer Annual Report 2016, p. 83. © Myer Pty Ltd.

Class discussion points

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1 Comment on just what the reconciliation statement tells you about working capital management.

2 Discuss the usefulness of this statement.

Concept check 9 method is true? A

AASB107 requires preparation of this reconciliation.

B C D

All of the above are true.

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Concept check 10 Your company has increased its accounts receivable balance from start

A

B

C

D

Increase in receivables Increase in payables Increase in receivables Increase in payables Increase in receivables Increase in payables Increase in receivables Increase in payables

$5,000 $17,000 ($5,000) ($17,000) ($5,000) $17,000 $5,000 ($17,000).

ACTIVITY 8.5 The relevant information from the accounts of Dido Ltd for last year is as follows: $m Sales 500 Cost of sales (300) Depreciation (34) Other expenses (44) Profit for the year 122 At the beginning of the year Inventory 15 Accounts receivable 24 Accounts payable 18 At the end of the year Inventory 17 Accounts receivable 21 Accounts payable 19

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1 2

Prepare a statement of cash flows from operating activities. Prepare a statement reconciling the profit for the year with the cash flows from operating activities.

The example to date relates to a company which is required to prepare a statement of financial performance in the form of a statement of comprehensive income. All of the principles outlined are equally applicable to other entities, although the statement of financial performance may be in the form of a traditional income statement or profit and loss account.

SOME COMPLEXITIES IN STATEMENT PREPARATION LO5 Identify some of the potential complexities that arise with statements of cash flows

So far we have used only relatively simple examples, and there is obviously a range of potential complications, many of which are beyond the scope of this book. The main complications relate to additional non-cash transactions and generally, though not exclusively, apply to the sections on investing and financing.

ACTIVITY 8.6 Can you think of other non-cash business transactions that must be adjusted for in preparing the statement of cash flows?

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

The investing section We need to know how much has been spent on non-current assets, and any proceeds relating to non-current asset sales. We also need to find the cash receipts from investments in terms of interest and dividends received. It is worth noting the movements in non-current assets over the year. These can generally be summarised as in Table 8.4:

TABLE 8.4 MOVEMENTS IN NON-CURRENT ASSETS Asset

Cost

Net

Balance at the start of the year

x

(x)

x

less any disposals

(x)

x

(x)

x

(x)

x

plus new acquisitions

x

–

x

plus any revaluations

x

–

x

less depreciation for the year

–

(x)

(x)

equals closing balance

x

(x)

x

The following points are important:

• Proceeds of asset sales are reflected in the investing section. • Only when an asset is sold can we calculate the actual depreciation incurred with complete

•

accuracy. Depreciation charged previously is only an estimate. Profits or losses on disposal reflect an under-provision (too little) or over-provision (too much) of depreciation. A loss on disposal represents additional depreciation and would be a non-cash expense. A profit on disposal offsets the depreciation. Any revaluations of assets are reflected in an increase in the asset and an increase in shareholders’ equity—shown in asset revaluation reserve.

Setting out a table of this sort enables us to follow through movements in assets relatively easily.

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ACTIVITY 8.7 The following are the extracts from a statement of financial position as at 1 January and 31 December.

Statement of financial position at 1 January and 31 December $ Cost Accumulated depreciation Net Plant and machinery Cost Accumulated depreciation Net

20,000

$ 25,000

10,000 80,000

100,000

60,000 150,000

70,000 200,000

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ACCOUNTING FOR BUSINESS STUDENTS

You are told that: • •

land and buildings were revalued upwards by $20,000 fixtures and fittings, which had cost $5,000, and which had been depreciated by $3,000, were sold for $1,000. (a) (b)

Calculate the depreciation for the year. Show the relevant extracts from the statement of cash flows.

The financing section Problems can arise in establishing the cash flow from owners’ contribution. Generally, by comparing the opening and closing capital figures (‘paid-up capital’ for companies) we should be able to calculate the amount of owners’ contributions received (new share capital issued for companies). However, problems can arise with:

• bonus issues (which result in an increase in share capital without any cash inflow) • issue of shares directly for non-cash assets or to extinguish debt • repurchase or redemption of shares. It is not usually difficult to see that called-up share capital increased over a period. Of course, if we were told that some of this was in the form of a bonus issue, the cash proceeds from shares would need to be adjusted. Suppose that in the course of the year, share capital of a company increased by $90 million, from $150 million to $240 million, but that the first tranche of the increase was in the form of a bonus issue of $30 million, so that the cash issue could have been only $60 million ($90 million – $30 million). A comparison of the long-term liabilities at the beginning and the end of the year should indicate the net cash flows from borrowings. However, as with the issue of shares, the calculation of cash received from long-term liabilities (or cash repaid on long-term loans) may be more complicated than just computing the change for the year in the liability balance. These problems include:

• The issue of debt directly for non-monetary assets (e.g. debentures issued in exchange for a •

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•

building). In this case, the increase in the liability does not represent a cash inflow. The conversion of debt directly into shares (e.g. convertible notes). In this case, the reduction of the liability does not represent a cash outflow. The accounting standard requires that the gross borrowing and gross repayments are shown. The change in the long-term liability for the period shows only the net change.

For dividends, we usually expect final dividends for the year to be shown as a current liability in the year-end statement of financial position, and to be paid early in the following year. Care must be taken when interim dividends are paid part-way through the year as these will also be paid in the year. Generally, we expect the cash outflow for dividend payments to include any proposed dividends outstanding from the preceding year, plus interim dividends (if any) declared in the current year. Some of these issues are covered in Self-assessment Question 8.1. You should work through this question carefully and then check the answer, which provides detailed explanations of the various stages.

Concept check 11 Which of the following is the most straightforward in calculating cash A B C D

Long-term asset acquisition is done using the historical cost assumption. Long-term assets may be revalued at the end of the accounting period. The gain or loss on disposal of a long-term asset is not obvious. There is a trade-in of an asset similar to the one being purchased.

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

403

Concept check 12 Calculation of the change in long-term liabilities from start of year to Which of the following will cause you problems when using this method? A B C D

Both borrowings and repayments occur in the same accounting period. Debt is paid by issuing shares to the lender. Debt is issued in direct exchange for long-term assets. All of the above will cause problems.

SELF-ASSESSMENT QUESTION

8.1

Torbryan Ltd’s statement of comprehensive income for the year ended 31 December 2016 and the statement of

TORBRYAN LTD Statement of comprehensive income for the year ended 31 December 2016 $m 591

Sales Cost of sales

284 21 214

147 16

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Transfer to reserves Proposed dividend on ordinary shares

TORBRYAN LTD Statement of financial position as at 31 December

Current assets Cash at bank and in hand Accounts receivable Prepaid expenses Inventory

$m

$m

2 115 6 44 167

17 16 41 197

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ACCOUNTING FOR BUSINESS STUDENTS

Non-current assets Plant and machinery Intangible assets: patents and trademarks Total assets Current liabilities Bank overdraft Accounts payable Income tax payable Dividend payable Accrued expenses Non-current liabilities Debenture loans Shareholders’ equity Paid-up ordinary capital Asset revaluation reserve

Total liabilities and shareholders’ equity

155 110 241 44 550 717

125

14 44 40 11 141

46 50 15 150

400

250

150

240 69 70

10 16 176 717

no other non-current asset acquisitions or disposals. A new issue of shares occurred. The land and buildings were revalued. At the end of 2015 there were 150,000 shares on issue.

WHAT DOES THE STATEMENT OF CASH FLOWS TELL US?

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LO6 Explain what the statement tells us, and illustrate how the statement of cash flows can be useful for identifying cash flow management strengths, weaknesses and opportunities, both historically and in forecasting and planning

The statement tells us how the business has generated cash during the period and where that cash has gone. Since cash is properly regarded as the life blood of just about any business, this is potentially very useful information. Tracking the sources and uses of cash over several years might show financing trends that a reader of the statements could find useful for predicting the company’s future behaviour. Looking specifically at the statement of cash flows for Torbryan Ltd Self-assessment Question 8.1, we can see the following:

• Net cash flow from operations was strong, much larger than the profit figure. This would be •

• • • •

expected, because depreciation is deducted in arriving at profit. Working capital tended to absorb some cash—not surprising if activity (sales output) had expanded over the year. The information supplied did not show whether there was an expansion or not. If there was not, questions would arise about working capital management. There were net outflows of cash in servicing of finance, payment of tax and purchasing non-current assets. There seemed to be a healthy figure of net cash inflows before financing. There was a fairly major outflow of cash to redeem some debt finance, which was partly offset by the proceeds of a share issue. The net effect was a rather healthier looking cash position in 2016 than the one in 2015.

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

ACTIVITY 8.8 Explain how the reconciliation statement can be useful in working capital management.

We have already seen that the reconciliation of operating profit and operating cash flows can be extremely useful in focusing on working capital management issues. Each component of working capital needs to be managed, but the reconciliation statement clearly identifies the impact of decisions (possibly non-decisions) on cash flows. The operating flows section probably identifies the most sustainable part of the organisation’s cash flows. The investing and financing flow sections clarify the situation that the organisation faces in these two areas. When turned around and used for forecasting purposes, the statement of cash flows, in conjunction with the other financial statements, becomes an integral part of the planning and decision-making process.

Concept check 13 Which of the following statements is more likely to be false? A B C D

Concept check 14 Which of the following statements is false? A

and cash equivalents.

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B

C

represents the expenditure on resources intended to generate future income D

E

None. All are true.

ACTIVITY 8.9 (a) (b)

Do you see any particular difficulties in using the financial reporting framework for forecasting purposes? How do you think that a forecast statement of cash flows might help in planning and decision-making?

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ACCOUNTING FOR BUSINESS STUDENTS

SELF-ASSESSMENT QUESTION 8.2 The management of your company is perplexed as to why the company’s bank balance has gone down in the last year,

Statement of financial position as at 2017

Current assets Cash Accounts receivable Inventory

50 60 70 180

10 80 100 190

Non-current assets 25 50

70

Premises

110

120 175

Total assets Current liabilities Accounts payable Dividends proposed Income tax payable

100 10 20

80 15 25 120

80

50

80

100 95 195

Non-current liabilities Shareholders’ equity Paid-up ordinary capital

Total liabilities and shareholders’ equity

Statement of comprehensive income for the year ending 31 December 2017 Sales

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Purchases

70 250

Cost of sales 159 Depreciation

109 102 Income tax Income after tax Dividends 62

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

407

During the year, vehicles that had cost $10,000 and had been depreciated by $6,000 were sold for $7,000. Sales in the previous year had been $350,000.

3 The company is now considering its plans for the next year and thinks that it can achieve a 20% increase in sales, with similar increases in cash expenses. It is very concerned about the liquidity of the business. It estimates that a further $30,000 will need to be spent on plant at the start of the new year, and at the same time a new vehicle will be needed, costing $25,000. Depreciation of plant and vehicles will be based on 10% and 20% straight-line,

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take to ensure appropriate liquidity is maintained or improved?

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ACCOUNTING FOR BUSINESS STUDENTS

SUMMARY In this chapter we have achieved the following objectives in the way shown.

OBJECTIVE

METHOD ACHIEVED

LO1: Explain why cash and cash flows are important to the reporting entity

•

LO2: Explain the nature, purpose and layout of the statement of cash flows

• • • • disposal • •

LO3: Prepare a simple statement of cash flows

• •

LO4: Prepare a reconciliation of profit with cash flow from operating activities, and explain how useful this is in decision-making

• •

LO5: Identify some of the potential complexities that arise with statements of cash flows

•

LO6: Explain what the statement tells us, and illustrate how the statement of cash flows can be useful for identifying cash flow management strengths, weaknesses and opportunities, both historically and in forecasting and planning

•

• • bonus shares • non-cash transactions • • • • • •

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DISCUSSION QUESTIONS EASY 8.1

LO1

8.2

LO2

8.3

LO3

8.4

LO1

8.5

LO4

8.6

LO5

8.7

LO6

respect? How is it different?

separate activities? has been prepared correctly? In accordance with Australian Accounting Standards, you have revalued your land and buildings

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

INTERMEDIATE 8.8

LO1 (a) an increase in the land account (b) an increase in share capital (issued) (c) a decrease in the long-term liabilities (d) a decrease in inventory (e) a decrease in accounts receivable.

8.9

LO1 direction in her opinion. Help Irene with her dilemma.

8.10 LO2

How does the accountant decide whether to classify an interest payment or receipt as an operating activity?

8.11 LO4 (a) Explain the difference between the two methods. (b) Which method is required by the Australian Accounting Standards? (c) Which method is preferable? Why? 8.12 LO5

determined through a comparison of the long-term liabilities at the beginning and end of the year. Describe two potential complications with this comparison.

8.13 LO6 8.14 LO3

CHALLENGING 8.15 LO4 Set him straight. Be gentle. 8.16 LO4/6

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8.17 LO6

APPLICATION EXERCISES EASY 8.1

LO1 (a) cash on hand (b) cash at the bank (c) accounts receivable (d) inventory (e) accounts payable (f) prepayments (g) bank overdraft

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410

ACCOUNTING FOR BUSINESS STUDENTS

(h) debentures (i) deposits at call (j) bill receivable (60 days) (k) loan receivable (three months) (l) gold bullion 8.2

8.3

LO1

LO1/2

1

Increase

No effect

2

Decrease

No effect

3

No effect

Increase

4

No effect

Decrease

nature:

(a)

Dividends received

(b)

Taxation paid

(c)

Payments to suppliers and employees

(d)

Interest paid

(e)

Purchase of property, plant and equipment

(f)

Bonus issue of shares

(g)

Dividends paid

(h)

Proceeds on sale of investments

(i)

Interest received

(j)

Long-term borrowing

(k)

Goodwill write-down (impairment)

(l) 8.4

LO3

Determine the values of the missing amounts.

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Jan Sales revenue

1,000

1,200

?

1,600

1,800

Opening accounts receivable

400

100

55

?

180

Closing accounts receivable

100

55

160

180

?

?

?

1,295

1,580

1,920

Cash receipts from customers 8.5

LO3

Mar

Determine the values of the missing amounts. Jan

Mar

Interest expense

44

55

?

Opening interest expense

10

12

Closing interest expense

12

8

?

?

Interest paid

67

75

8

?

15

5

15

?

63

57

88

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

8.6

LO1/3

Justine Ltd has the following account balances:

Cost of sales

789,600

Discount received

23,500

Accounts payable

123,500

117,900

Inventory

143,500

156,700

What is the cash paid to suppliers for the period?

INTERMEDIATE 8.7

LO2/3

Classify each of the following items as: (a) cash or non-cash

A

Credit sales to customers

B

Cash received from customers

C

Interest paid

D

Increase in long-term loan

E

Advance to employees

F

Bonus issue of shares

G H

Purchase of equipment

I

Depreciation of equipment

J

Revaluation upwards of land Proceeds on sale of equipment

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8.8

L

Cash paid to suppliers

M

Interest received

LO3

Increase Increase in debtors

Cash received from customers

☑

(a) Increase in prepayments (b) Decrease in provision for tax (c) Increase in interest receivable (d) Bad debts expense (e) Decrease in inventory (f) Decrease in accrued expenses (g) Increase in accounts payable (h) Discounts given (i) Discounts received (j) Increase in provision for doubtful debts.

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412

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8.9

LO5

Identify the effects of the following non-cash transactions on the accounts listed in the following table: Assets (a) Revaluation upwards of land (b) Bonus issue of shares (c) Write-down of inventory (d) Depreciation of equipment (e) Issue of debentures in exchange for buildings (f) Conversion of notes (debt) into shares (g) Write-down of goodwill (h) Recognising doubtful debts (i) Receiving early settlement discount from supplier.

8.10 LO3

Assets: Non-current plant and equipment Accumulated depreciation

Year 1

Year 2

67,293

76,937

(27,961)

(32,411)

Statement of comprehensive income Loss on sale of plant and equipment

3,764

Depreciation expense—plant and equipment

8,216

Other: The book value of the plant and equipment sold was $6,179. Calculate for the period (Period 2): (a) cash purchase of plant and equipment (b) proceeds on sale of plant and equipment. 8.11 LO3/5

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Owners’ equity: Paid-up capital Reserves Liabilities: Provision for dividends Debentures

Year 1

Year 2

100,000

150,000

50,000

60,000

30,000

45,000

5,000

8,000

70,000

110,000

Statement of comprehensive income Year 2 32,000 Dividends appropriated*

12,000

*Allocated

Other: There was a 1 for 4 bonus issue of shares during the year. Assets were revalued upwards by $30,000. $20,000 in debentures was directly exchanged for land acquisition.

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

— borrowing

8.12 LO3/5

______________

The following information concerns the non-current assets of TAO Ltd for the years ended 30 June 2017 and 2016:

Land

231

93

Buildings

237

212

69

63

Plant and equipment

30 June 2017: Land

• Revalued upwards by $15 million • Direct issue of debentures for land $80 million

Buildings

• Depreciation of $8 million

Plant and equipment

• Depreciation $13 million • Sale of plant and equipment at a gain of $3 million (carrying amount $9 million)

30 June 2017. 8.13 LO3

MORGAN TRADING LTD Statement of comprehensive income for the year ended 30 June 2017 $ Sales Cost of sales

$ 156,900

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81,100 Depreciation expense Interest expense 27,800 41,400 Income tax expense 28,980

Statement of financial position extract at 30 June 2016 and 2017

Current assets

Current liabilities

Accounts receivable Inventory Accounts payable Accrued interest Income tax payable

$ 450 8,760 14,770 950 9,800

$ 780 7,990 21,750 12,980 12,420

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ACCOUNTING FOR BUSINESS STUDENTS

year ended 30 June 2017: (a) cash receipts from customers (b) cash paid to suppliers and employees (c) interest paid (d) income tax paid (e) net cash provided by operating activities. 8.14 LO1/3

Heins Ltd had an $11,000 loss from operations for 2017. Depreciation expense for 2017 was $5,700, and a dividend of $5,000 was declared and paid. The balances in the working capital accounts at the start and end of the year are shown below: Start Cash

3,700

Accounts receivable

5,100

7,400

6,300

21,300

17,200

Prepayments

1,900

700

Accounts payable

8,300

11,500

Accrued expenses

700

1,500

Inventory

(a) Calculate the ‘cash from operating activities’ in 2017. Show workings. capital changes that have occurred. Are these changes likely to be sustainable? 8.15 LO3/4

The following information has been taken from the accounts of Juno Ltd for last year and the year before last:

JUNO LTD Summary of the statement of comprehensive income

Sales Cost of sales

$m 572

$m 505 270

272 Interest expense

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187 55 Inventory held at the end of period Accounts receivable at the end of period Accounts payable at the end of period

17

156 47 27 24 15

Using the above information, prepare for Juno Ltd:

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

CHALLENGING 8.16 LO3/5

Nu Bold Ltd’s statement of comprehensive income for the years ended 31 December 2016 and 2017

NU BOLD LTD Statement of comprehensive income for the years ended 31 December 2016 and 2017

Sales Cost of sales

$m 170

$m 190

80

90

49 Interest revenue 49 Interest expense 44

46

25 60

44 80

44

62

$m

$m

17 24 12

21 18 17 56

Proposed dividend on ordinary shares

NU BOLD LTD Statement of financial position as at 31 December 2016 and 2017

Current assets Inventory Debtors Cash at bank and in hand Non-current assets

Copyright © 2017. P.Ed Australia. All rights reserved.

Plant and machinery Total assets Current liabilities Trade creditors Income tax payable Dividend payable

61 191 244

157 55 212 268

15 9 10

16 10 12

66

68

100 44 144 244

100 62 162 268

Non-current liabilities Shareholders’ equity Paid-up share capital

Total liabilities and shareholders’ equity

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ACCOUNTING FOR BUSINESS STUDENTS

In ‘other expenses’, depreciation was included as follows:

Buildings

11

10

Plant and machinery

12

11

There were no non-current asset disposals in either year. In both years an interim dividend was paid and cash from operations. 8.17 LO3–5

The following information has been taken from the accounts of Tuna Ltd for the last two years (year ending 30 June):

Statement of comprehensive income Sales

627

591

Cost of sales

411

382

216

209

Interest expense Other expenses (excluding depreciation) Depreciation

Accounts receivable Inventories Prepayments

19

13

126

109

27

32

44

55

95

72

103

81

5

7

84

57

Accruals

9

5

Interest payable

7

3

Accounts payable

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Using the information provided, prepare for Tuna Ltd for the year ending 30 June 2017:

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

8.18 LO3–5

Hi View Ltd’s statement of comprehensive income for the years ended 31 December 2016 and 2017

HI VIEW LTD Statement of comprehensive income for years ended 2016 and 2017 $m 207 101 106

Sales Cost of sales

$m

77

4 62 2 64

Interest revenue and similar income

29 29

Interest expense and similar charges 60

25

44 74

19 56 75

56

57

Dividend on ordinary shares

HI VIEW LTD Statement of financial position at 31 December 2016 and 2017

Current assets Inventory Accounts receivable Cash at bank and in hand

$m

$m

24 26 27 77

25 25 1 51

110 62 172 249

56 186

16 14

20 6 14 40

40

40

100 56 156 249

100 57 157

Non-current assets

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Plant and machinery

Current liabilities Accounts payable Income tax payable Dividend payable Non-current liabilities

Shareholders’ equity Paid-up share capital

Total liabilities and shareholders’ equity

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ACCOUNTING FOR BUSINESS STUDENTS

In ‘other expenses’, depreciation was included as follows:

Land and buildings Plant and machinery

6

10

10

12

There were no non-current asset disposals in either year. In both years an interim dividend was paid

8.19 LO1–6

Torbryan Ltd’s statement of comprehensive income for the year ended 31 December 2017 and the

TORBRYAN LTD Statement of comprehensive income for the year ended 31 December 2017 $m

$m

Sales Cost of sales 270 169

Interest revenue and similar income

182 4 186

Interest expense and similar charges 170

188 Transfer to general reserve Proposed dividend on ordinary shares

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88

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

TORBRYAN LTD Statements of financial position as at 31 December 2016 and 2017

Current assets Cash at bank and in hand Accounts receivable Prepayments and accrued income Inventory

$m

$m

17

5

16 41 197

185

Non-current assets Intangible assets Patents and trademarks Tangible assets Plant and machinery

125

102 180 624 809

_

16

46 50 15 150

60 11 152

250

150

Total assets Current liabilities Bank overdraft Accounts payable Income tax payable Dividends payable Accrued expenses Non-current liabilities Debenture loans Shareholders’ equity Paid-up share capital Asset revaluation reserve

240 69 70

Total liabilities and shareholders’ equity

9 110 88 507 809

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current asset acquisitions or disposals. There was no share issue for cash during the year. Prepare

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ACCOUNTING FOR BUSINESS STUDENTS

8.20 LO1–5

Touchstones Ltd’s statements of comprehensive income for the years ended 31 December 2016 and

TOUCHSTONES LTD Statement of comprehensive income for the year ended 31 December 2016 and 2017 $m

$m 207

77

106

Sales Cost of sales

Interest revenue and similar income

58 4 62 2 64

1

Interest expense and similar charges 60 28 16 44

44 74

Proposed dividend on ordinary shares 56

Statements of financial position as at 31 December 2016 and 2017 $m Current assets Inventory Accounts receivable Cash at bank and in hand

$m

25 16 8 49

24 26 27 77

94

110 62 172 249

Non-current assets

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Plant and machinery 147 196

Total assets Current liabilities Accounts payable Income tax payable Dividend payable

26 8 12 46

16 14

Non-current liabilities 20

40

Shareholders’ equity Paid-up share capital

100

Total liabilities and shareholders’ equity

196

100 56 156 249

In ‘other expenses’, depreciation was included as follows:

Land and buildings

5

6

Plant and machinery

6

10

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

There were no non-current asset disposals in either year. In both years an interim dividend was paid

8.21 LO4

Note: It may not all be relevant.

Bad and doubtful debts

(1,300)

Depreciation expense—equipment

(5,300)

Impairment of goodwill

(2,500)

Gain on sale of equipment

2,500

Accounts receivable

4,300

Increase

Bank overdraft

4,500

Increase

Inventory

1,500

Increase

Equipment

9,900

Increase

Goodwill

2,500

Decrease

Accounts payable

1,200

Decrease

Prepaid expenses

700

Increase

4,700

Increase

Provision for taxation 8.22 LO6

Statement of comprehensive income extract for the year ended 30 June 2017 $

$ 545,700

Sales Cost of sales

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Depreciation expense Interest expense

18,700 156,900 46,900 14,070

Income tax expense

Statement of financial position extract as at 30 June 2016 and 2017 $ Current assets

Current liabilities

Accounts receivable Inventory Accounts payable Deposits received in advance Accrued interest Income tax payable

6,940 17,720 11,790 4,500 950 9,800

$ 590 7,980 12,950 7,900 12,420

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ACCOUNTING FOR BUSINESS STUDENTS

the direct and indirect methods:

Cash flows from operating activities Cash receipts from customers

544,660

Cash paid to suppliers and employees

(478,830)

Interest paid

(3,480) (11,450)

Income tax paid Net cash provided by operating activities

59,000

32,830 Add

Deduct

Add non-cash expenses related to non-current assets Depreciation

17,800

Adjust for changes over the period in non-cash current assets and liabilities Prepaid expenses

220

Inventory

2,350

Accounts receivable

940

Accounts payable

1,160

Accrued interest

220

Deposit received in advance

3,400

Income tax payable

2,620 28,390

2,220

59,000

30 June 2017. 8.23 LO6

Statement of financial position extract Copyright © 2017. P.Ed Australia. All rights reserved.

as at 30 June 2016 and 2017

Current assets

Current liabilities

Accounts receivable Inventory Accounts payable Deposits received in advance Accrued interest Income tax payable

$ 420 8,650

6,400 560 8,900

$ 590 7,980 12,950 7,900 12,420

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

Statement of cash flows extract for the year ended 30 June 2017 $ Cash flows from operating activities Cash receipts from customers Cash paid to suppliers Cash paid for other expenses Interest paid Income tax paid Net cash provided by operating activities

$

654,660

Reconstruct the statement of comprehensive income for the year ended 30 June 2017. 8.24 LO3/4/6

The directors of Sonya Ltd are considering their plans for the next year. The company’s statement of

SONYA LTD Statement of financial position at end of the current year Current assets Inventory Accounts receivable Cash

190 10 500

Non-current assets Freehold buildings 200 Aggregate depreciation Total assets Current liabilities Accounts payable Dividends proposed

200

Capital and reserves

700

The current plans are based on the following expectations for next year:

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1 2 3 4

5 6

New equipment will be purchased at the start of the year for $50,000 cash. The proposed dividends will be paid early in the year, and dividends amounting to $35,000 will be proposed for next year. Inventory at the end of the year will be $220,000. The following trading transactions will occur evenly over the year: Sales

$1,980,000

Purchases

$1,520,000

General expenses

$50,000

Directors’ salaries

$100,000

The period of credit given to customers will be two calendar months, and the period of credit taken from suppliers will be 1.5 months. No prepayments or accruals are anticipated. Depreciation on equipment is calculated at 10% per annum on cost.

(b) Comment on the changes in cash implicit in the plans. How might the result be improved?

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ACCOUNTING FOR BUSINESS STUDENTS

CHAPTER 8 CASE STUDY The management of Enviro Ltd is planning a fairly significant expansion policy for the forthcoming year (2018). You have been asked to look at the financial implications of its plans. You have asked for a clear identification of the underlying assumptions and estimates, and these are given below.

Care has been taken with regard to working capital management, and the business plans to maintain its working capital in the following proportions through both 2017 and 2018: Inventory Accounts receivable

Market position The total estimated market for 2017 is $600 million. Sales during 2017 are expected to be around $30 million. However, the business is looking to achieve an improved market share (currently 5%) in 2018 due to more aggressive marketing. A 25% increase in sales volume is expected. Given product price elasticity, prices will need to be maintained at the 2017 levels in order to achieve the planned volumes.

Economic environment The current rate of inflation is 4% and this rate is likely to continue through 2018. The business thinks that this reflects a reasonably close estimate of its specific cost inflation and is happy to proceed on this assumption. Tax is expected to be charged at 30%.

Dividend policy The dividends to be recommended for 2017 total $1 million. The business would like to increase this to $1.25 million to cover inflation and to share in the hoped for increase in profitability.

Financial structure of the company Share capital amounts to $10 million at the end of 2017, with reserves amounting to $2.5 million.

Cash Accounts payable

10% of sales for the year One-sixth of sales for the year (i.e. a two-month credit period) 3% of sales for the year One-twel#h of sales for the year (i.e. a one-month credit period)d)

Other current liabilities at the end of 2017 are estimated to be dividends and tax of $900,000. Variable costs in 2017 are expected to be 60% of sales. Fixed costs for 2017 are expected to be $9 million, including $1 million for depreciation. An extra amount of approximately $1 million will be spent on advertising in 2018 in order to capture the increased market share.

Capital expenditure/non-current assets The company currently has non-current assets which had cost $12 million, with an associated aggregate depreciation which is expected to amount to $4 million at the end of 2017. Depreciation is 10% straight line. In order to support the expansion, new equipment will need to be purchased at a cost of $4 million. This is planned to occur at the start of 2018. Depreciation on this will also be at 10% straight line. Some existing assets will be sold for $60,000. These had originally cost $400,000 and had been depreciated to date by $300,000.

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QUESTIONS 1

Explain why preparation of a set of projected financial statements might be useful.

2

Make the necessary computations to reflect the plans outlined above, clearly stating any assumptions.

3

Comment on the feasibility of the plans, and suggest any courses of action that management might take.

4

Evaluate the use of the projected financial statements in terms of efficiency of planning and decisionmaking in the context of this particular business.

5

State what advantages there might be in using spreadsheets to prepare statements of this type.

6

Sensitivity analysis is an analysis in which variables in a decision are changed one at a time, with the view to identifying which variables are most important to the success of the decision, plan or project. In what ways might an analysis of this type improve your decision-making ability? What kind of variables might you examine critically?

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

Concept check answers CC3 CC4

D B B C

CC5 CC6 CC7 CC8

B D B B

CC9

D C A D

C E

SOLUTIONS TO ACTIVITIES ACTIVITY 8.1

Event

On cash

Repayment of a loan

None

Decrease

Making a sale on credit

Increase

None

Buying a non-current asset for cash

None

Decrease

Depreciating a non-current asset

Decrease

None

Receiving cash from accounts receivable

None

Increase

Buying some inventory for cash

None

Decrease

Making a share issue for cash

None

Increase

The reasons for these answers are as follows:

point, however.

paid or received. 5 Receiving cash from a credit customer increases the cash balance and reduces the credit customer’s balance. Both of

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6 Buying some inventories for cash means that the value of the inventories will increase and the cash balance will

affected.

ACTIVITY 8.2 1 A cash equivalent. It is readily withdrawable. 2 Not a cash equivalent. It can be converted into cash because it is listed on the stock exchange. There is, however, a 3 Not a cash equivalent, because it is not readily convertible into liquid cash. than negative cash.

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ACCOUNTING FOR BUSINESS STUDENTS

ACTIVITY 8.3 • etc. than is being received from operating revenues. This would be alarming because a major expense for most

• The other reason might be less alarming. A business that expands its activities (level of sales) tends to spend quite a lot of cash relative to the amount of cash coming in from sales, usually because it is expanding its inventory before additional sales can be made. Even when the additional sales are made, these are normally made on

ACTIVITY 8.4 Opening receivables

26

Revenues for 2017

153

Total collectable

179

Closing balance receivables

(25)

Cash collected

154

Cost of sales Opening inventory

24

Purchases

x 24 1 x

Less closing inventory Equals cost of sales

(25) 76

So Purchases 5 77 Cash associated with payables for year Opening balance payables Purchases

37 77 114

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Less closing payables 5 cash paid

(34) 80

Tax paid Opening liability Tax due for year

8 6

Total due

14

Unpaid at end of year

(3)

Tax paid

11

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

CHEN LTD Statement of cash flows for the year ending 31 December 2017 $m Cash from customers Cash paid for goods + Tax paid

$m

154

+ +

Dividends Interest paid

19

ACTIVITY 8.5 Cash received from customers Opening balance of accounts receivable

24

plus sales for the period

500

gives the amount we might expect to receive for the year

524

less closing balance of accounts receivable

(21)

equals the cash received from customers

503

Cash paid to suppliers, etc. Opening balance of accounts payable

18

plus purchases of inventory for the period (see below)

302

gives the amount we might expect to pay for the year

320

less closing balance of accounts payable

(19)

equals the cash paid to accounts payable

301

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Calculation of purchases figure Opening inventory plus purchases equals the amount available for sale

15 x x 115

less closing inventory—the amount unsold

(17)

equals the cost of sales—the cost of the amount sold

300

Therefore, 15 1 x – 17 5 300 or x 5 300 1 17 – 15 5 302. Cash flows from operating activities Cash received from customers

503

Cash paid to suppliers and employees (301 1 other expenses of 44)

(345)

Net cash provided by operating activities

158

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ACCOUNTING FOR BUSINESS STUDENTS

The reconciliation is as follows: 122 34

Add depreciation

156 Less increase in inventory

(2)

Add decrease in accounts receivable

3

Increase in accounts payable

1 158

Thus, the net increase in working capital was $156 million. Of this, $2 million went into increased inventory. More cash was received from accounts receivable than sales were made, and less cash was paid to accounts payable than purchases were made of goods and services on credit. Both of these had a favourable effect on cash.

ACTIVITY 8.6 Possible additional non-cash transactions: Management allocation expenses: • • • • •

amortisation or impairment of intangibles loss on sale of non-current assets write-down of inventory doubtful debts recognition discounts given

Management allocation revenues: • gain on sale of non-current assets • discounts received Asset increases: • • • •

donations revaluation upwards direct issue of shares or debt for assets self-constructed assets

Liability changes: • direct issue of debt for assets • forgiveness of debt • conversion of debt to equity

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Owners’ equity changes: • • • • •

revaluations transfers bonus issues direct issues for assets conversion of debt.

ACTIVITY 8.7 (a) Using the format on page 389 we get the following: Net Balance at the start of the year

150,000

–

150,000

–

–

–

150,000

–

150,000

plus new acquisitions

x 5 30,000

–

30,000

plus any revaluations

20,000

–

20,000

–

–

–

200,000

–

200,000

less any disposals

less depreciation for the year equals closing balance

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CHAPTER 8 MEASURING AND REPORTING CASH FLOWS

Net Balance at the start of the year less any disposals

80,000

(20,000)

60,000

–

–

–

80,000

(20,000)

60,000

plus new acquisitions

x 5 20,000

–

20,000

plus any revaluations

–

–

–

–

x 5 (10,000)

100,000

30,000

less depreciation for the year equals closing balance

(10,000) 70,000

The new acquisitions and the depreciation for the year are obtained by solving for x, as shown. Net Balance at the start of the year less any disposals

20,000 (5,000)

(10,000) 3,000

10,000 (2,000)

15,000

(7,000)

8,000

plus new acquisitions

x 5 10,000

–

10,000

plus any revaluations

–

–

–

x 5 (5,000)

(5,000)

(12,000)

13,000

less depreciation for the year equals closing balance

25,000

Note that the cost and accumulated depreciation of the asset being disposed of is what gets taken off. The fact that assets, which had cost $5,000 and had been depreciated by $3,000 (giving a book value of $2,000), were sold for $1,000 means that there will be a loss on disposal of $1,000, which will be a non-cash expense in the statement of

Cash flow from investing activities Purchase of land and buildings

(30,000)

Purchase of plant and machinery

(20,000) (10,000) 1,000

Net cash used in investing activities

(59,000)

Note that the reconciliation would include add-backs for depreciation totalling $15,000 plus $1,000 loss on disposal.

ACTIVITY 8.8

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etc.) on cash. Questions can be asked about management of each individual component. Greater clarity is obtained regarding the need for sound working capital management, and the consequences of poor management are clear.

ACTIVITY 8.9 (a) Once you get used to the idea that the aims are different, there are no real problems. Instead of using factual the consequences of our assumptions and judgements regarding the future. In this way we will be able to see the end results that will occur if all of our assumptions and judgements are correct. We may like what we see, which case we need to reassess and change our thinking. Surely, however, this is an important process in the development of our planning and thinking about our future. (b) They will illustrate what our cash situation is likely to be. This may require changes in plans. Areas that might want to buy, or do we need to scale things down?) and working capital management (do we need to run more

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C H A P T E R X9

CORPORATECHAPTER SOCIAL RESPONSIBILITY NAME AND SUSTAINABILITY ACCOUNTING LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Outline and discuss a range of social and environmental issues, and the way in which accounting can contribute

LO2 Explain what is meant by corporate social responsibility and the Ceres Principles LO3 Outline the major studies that have occurred on accounting for corporate social responsibilities

LO4 Explain triple bottom line reporting LO5 Outline the Global Reporting Initiative, and discuss its main framework in broad terms and its linkage with ideas of integrated accounting

LO6 Explain the balanced scorecard approach and its advantages.

assumption that the main objective of the owners is wealth enhancement. This objective may well still be the major driver, but, as we have seen, there are other stakeholders with a variety of interests. Their needs may not be particularly well served by the traditional accounting reports, and so there has been a continuing pressure to improve the information provided. This chapter introduces a range of improvements in the provision of accounting information concerning areas such as the social and

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and the Global Reporting Initiative, with its emphasis on sustainability. Finally, the chapter deals with the balanced scorecard approach, which covers both a management system and a system for measuring and reporting performance. At this stage, the disclosures and systems discussed in this chapter are voluntary. Just how long this remains the case is uncertain, as there are already steps being taken which may change this in the short number of major companies investing heavily in them. The role of the accountant seems destined to and the increased amount of information available to you as users of performance statements.

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SOCIAL ISSUES IN ACCOUNTING

General background In Chapter 1, we identified a range of groups that use accounting information. These included owners and managers, plus a variety of others, such as employees, community groups, governments and other interest groups. Over many years, accounting has moved its focus from stewardship to decision-usefulness. In more recent years, the idea of decision-usefulness has broadened considerably, with much more emphasis on providing information that is useful to a wider range of interested parties. Of particular significance is the far greater interest and involvement in issues that go beyond the confines of a particular business and affect society at large.

LO1 Outline and discuss a range of social and environmental issues, and the way in which accounting can contribute

ACTIVITY 9.1 Before reading on, try to think of three areas in which groups other than owners or managers might be interested.

Ever since the Industrial Revolution, there have been conflicts between entrepreneurs and the broader society. Books such as Richard Llewellyn’s How Green Was My Valley, a story set in South Wales in the late 19th and early 20th centuries, depicts unashamed greed and excessive use of economic power and wealth, and the appalling working and living conditions of employees (encompassing health and safety and environmental issues). In this book, the valley became a huge slag heap, one of many which affected (and still affects) life in the valleys of South Wales. As wealth and power become more widespread, so perspectives change, and accounting information has slowly adapted to these changes. The stakeholder concept provides a useful framework to explain the broadening of needs.

Stakeholder concept

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The notions of stewardship accounting and decision-usefulness for owners and managers were the driving forces of accounting until the past 20 or so years. This meant that accounting focused mainly on providing information that enabled owners to make money. The stakeholder concept, on the other hand, recognises that other interested parties also have a legitimate interest or stake in the business. Chapter 1 identified the following user groups:

• • • • • • • • • •

owners/shareholders managers employees and their representatives customers government lenders suppliers investment analysts competitors community representatives.

Some of these user groups have clear and undeniable stakes. For example, many employees have a big stake in the business, its profitability, its attitude to things such as health and safety, and its long-term success. This is particularly true if the business employs a large part of a town or city’s workforce. Others have legitimate interests in relatively small parts of the business. Clearly, not all

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of these groups have equal, or even similar, interests, and there may well be different opinions over the idea that competitors have any legitimate interests.

ACTIVITY 9.2 Can you think of a town, city or region where prosperity and/or employment is, or has been, dependent on one employer?

The importance of the particular business to the various groups of stakeholders might differ considerably, and might change over time for a particular stakeholder group, but generally the stakeholder concept is useful. Additions to the list might include potential customers, socially oriented action groups, including environmentalists, and other pressure groups. Businesses ignore the views and needs of these groups at their peril. Even if we assume that the underlying objective of businesses is still wealth enhancement, businesses must be very conscious of stakeholders’ views and the possible impact on their future if they ignore them. An early example was the boycott on tuna products instigated by the Dolphin Coalition. This was directed against an industry-wide fishing practice that netted and killed large numbers of dolphins. Changes were made to the fishing practice and cans of tuna were labelled ‘dolphin safe’. Health issues raised over the past few years have also led to pressure from interested groups and considerable changes in products, and in their labelling and packaging. However, the major issues confronting us all are climate change and global warming. Sales of large cars, for example, have slumped, and the use of hybrids or more eco-friendly/fuel-efficient/electric vehicles has grown. Real World 9.1 provides a recent example of how public and consumer interests can impact on business.

REAL WORLD 9.1

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The milk wars In January 2011 Coles cut the milk price to $1 a litre for some home-brand lines as part of its ‘down, down, prices are down’ campaign. Concerns were expressed that Coles and Woolworths, as well as competing against each other, were trying to wipe out smaller convenience stores and apply the blowtorch to other leading chains such as Aldi, Franklins and Costco. Nervous farmers were quick to express their concerns about their margins, noting that even Woolworths admitted that low prices, not seen since 1992, were unsustainable. Several years on, in 2016, Murray Goulbourn and Fonterra, two of the largest milk buyers, dropped the price from $5.60 per kilogram of milk solids to between $4.75 and $5. The impact on farmers’ incomes was dramatic, with many deciding to get out of the industry. There was an increase in depression and suicide amongst farmers. A campaign resulted, encouraging consumers to buy branded (i.e. more expensive) milk in order to preserve the industry. This was successful and resulted in stocks of branded milk running out; it was thought that this was the result of the policies of the two main supermarkets not to stock branded milks. Coles and Woolworths denied this. Coles said that they wanted to help

dairy farmers and so were launching a new milk brand that would deliver an extra 20¢ per litre to a fund to help support dairy farmers in Victoria, New South Wales and Tasmania. This was viewed by farmers with real cynicism. Council of Small Business of Australia CEO Peter Strong questioned the move, telling the ABC that it was low supermarket prices that had effectively ‘destroyed’ the industry. The actions of the two major supermarkets led to them facing a PR nightmare for a time, though this seems to have been relatively short-lived. The situation for Murray Goulburn was probably worse. Not only did Murray Goulburn drop the price, but it backdated it, so that farmers had to pay back large sums over time. Questions were raised as to whether Murray Goulburn knew for many months that the milk price was unsustainable, and never told the farmers, who went on with their business as normal. Remember that Murray Goulburn is a cooperative, though it went to the market for external funds in 2015, and farmers felt badly let down. Many believed that investors had been given a higher priority than farmers, even though the interest of farmers was the reason Murray Goulburn was

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established. The Managing Director resigned, and in August 2016 Murray Goulburn was the sole topic for a Four Corners episode. Anyone who doubts the bad feeling in the industry should read ‘The dairy disaster and Murray Goulbourn’, an article written just a#er the 2016 results for Murray Goulburn were published.

Class discussion points

Sources: Waleed Aly, ‘Dairy farmers being milked dry’, The New Daily, 17 May 2016, ,http://thenewdaily.com.au/news/national/2016/05/17 /waleed-aly-dairy-milked-dry/.. Charis Chang, ‘Shoppers furious over milk shortage’, news.com.au, 25 May 2016, ,www.news.com.au/finance/business/retail/shoppersfurious-over-milk-shortage/new-story/c8600a8a77678e2309489dca70 204c7a.. UNSW Business School, ‘Milking the market: what’s behind the Coles Woolworths price war’, BusinessThink, 29 March 2011, ,http:// businessthink.unsw.edu.au/Pages/Milking-the-MarketWhats-Behind-the-Coles-Woolworth-Price-War.aspx.. John Crosby, ‘The dairy disaster and Murray Goulburn’, Stock & Land, September 2016, ,www.stockandland.com.au/story/4139775 /the-dairy-disaster-and-murray-goulburn/..

3 Do you think that the issue has any long-term implications for the two supermarkets?

1 Why do you think that the public suddenly cut back savagely on purchases of supermarket branded milk? 2 Do you believe that the actions of Coles in launching a new milk brand that would contribute to a fund to help support dairy farmers in Victoria had any credibility?

4 Do you think that the two supermarkets have any responsibility for the wellbeing of their dairy suppliers? Should the consequences of the price war, in terms of both suppliers and consumers, have been seriously considered by the supermarkets before it was implemented? 5 Comment on the way in which Murray Goulburn has handled the dairy crisis. Try to find out how the cooperative has fared since late 2016. What lessons are there for us from this whole episode?

Probably the main effect the various stakeholder groups have had are:

• greater emphasis on social responsibility • greater understanding that the direct costs of the actions of a particular business can represent • •

only a small part of the total costs, with the rest being borne by the community at large—this has highlighted environmental or ‘green’ issues recognition that the workforce and its quality are major contributors to the success (or failure) of a business recognition that climate change is a human-made phenomenon and that we must take steps to cut emissions and do whatever is necessary to deal with this issue.

This has led to the development of corporate social reporting, environmental accounting (really a subset of corporate social reporting), triple bottom line reporting and reporting for sustainability.

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As pointed out earlier, many businesses and business people have been criticised for their lack of social responsibility. Real World 9.2 provides some examples.

REAL WORLD 9.2 Social responsibility issues James Hardie has been severely criticised over the years for its apparent lack of support for those of its employees who became ill due to exposure to asbestos, a product made by the company. The pressure eventually led to an agreement being reached which provided compensation to the victims. There is little doubt, however, that a stigma remains associated with the company, which may take many years to be forgotten.

The same is true of BP a#er the major Deepwater Horizon oil disaster in the Caribbean that occurred in 2010. The issues of safety and the adequacy of safety precautions are particularly important in situations of this type. The consequences of such failures can be very far-reaching, affecting many other businesses, thousands of people, and the wildlife and ecology of a vast area. It should be recognised, however, that for many

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years BP had been seen as a leader in the general arena of sustainability and a standout among oil companies. The costs of a disaster of this type are enormous, and the downside risks of getting something like this wrong are huge. More recently, the big banks have come under scrutiny. ANZ and Westpac have both been accused of rigging market benchmarks. CommInsure bribery allegations led to the resignation of the head of the ASX. Australian Securities and Investments Commission Chairman Greg Medcra# recently put on notice banks’ senior executives to ‘ensure that efforts to improve culture and conduct do not become “white noise” for staff below them’ (Bennet). This was in the context of a study that was critical of ethical standards in the banks. He referred to the allegation relating to the rigging of the bank swap rate as ‘like polluting the water system’. He felt that ‘management and boards’ views on culture may be too rosy’. More generally, a survey of 1,000 people in May and June 2016 showed that most respondents saw senior administrators in business as unethical. Of course, this reaction is based on perception, but even if the reality is different, much work clearly needs to be done. Source: Michael Bennet, ‘Banks told to raise the bar on culture’, The Australian, 21 July 2016.

Class discussion points 1 Use the web to find out more about the James Hardie asbestos issues. Then ask yourself, if you had been in charge of the company at that time, how would you have handled the issue? Do you think that a business facing this kind of concern now would handle it differently, and more speedily, than James Hardie did at the time? 2 Use the web to find out more about the Deepwater Horizon disaster. Do you believe that the risks were too great for a company like BP to take on? Comment on the way in which BP dealt with the disaster. 3 Use the web to find out more about BHP-Billiton and the Samarco catastrophe. Do you think that BHP-Billiton could reasonably have been expected to do any more than they did, both before and a#er the disaster? 4 Does examination of these cases make finding a balance between all sides of the enterprise easier for you? What are the main factors that you might consider if you were investing in a large enterprise in a poor country? 5 What are your views on the behaviour of company chairs, CEOs and senior executives?

ACTIVITY 9.3 Can you think of businesses that seem to have behaved in a way that you do not regard as socially responsible? What are the reasons for your belief?

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By and large, social responsibility is defined in a fairly broad manner. There is a growing expectation that a business will consider how its actions affect society at large, especially when pollution, health and safety issues, and job creation or destruction are involved. Of course, sometimes one objective conflicts with another. For example, it can be argued that coal-fired power stations pollute more than nuclear-powered stations do, but nuclear power brings its own dilemmas, many of which are reinforced by the problems associated with the nuclear industry in Japan following the earthquake and tsunami in 2011. Also, it is often the case that areas with huge coal deposits tend to have most of the power stations. One such area is the La Trobe Valley in Gippsland, which has vast areas of brown coal and is capable of producing cheap power for a considerable time into the future. However, the power stations in the valley are among the highest polluting stations in the country. Yet they are also the biggest employers in the area. To close the stations down quickly without taking steps to set up alternative job opportunities has the potential to consign the area to recession and depression. In spite of this, the French owners of the Hazelwood plant announced that the plant would close on 31 March 2017, with the loss of around 900 well-paid jobs. The cost to the local economy is in the order of $100 million. Government has promised to provide a considerable amount of support, but how that will (or even if it will) translate into more jobs is far from clear. There will be more pressure on the grid, and electricity prices will rise. On the other hand, there will be a considerable reduction in greenhouse emissions. It appears that the decision was made purely on commercial grounds. Being socially responsible involves setting policies and practices that will ensure that the entity (business or other organisation) acts as a good citizen, and that each particular entity must consider the social costs and benefits that result from its actions. However, this view is not shared by all. The objective of shareholder wealth enhancement can be interpreted in a way that totally ignores any social costs that do not directly affect business returns—‘it’s okay longEbook as you can get away with it’. How does a business justify, in financial Atrill, Peter, et al. Accounting for Business Students eBook, P.Ed Australia, 2017.as ProQuest Central, http://ebookcentral.proquest.com/lib/usyd/detail.action?docID=5220577. Created from usyd on 2018-03-05 19:39:35.

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CHAPTER 9 CORPORATE SOCIAL RESPONSIBILITY AND SUSTAINABILITY ACCOUNTING

terms, to its shareholders the choice of a more expensive production process that will yield lower pollution levels but also lower profits? If a competitor goes down the lower-cost, higher-pollution route, it will probably be able to sell at a lower price and threaten that competitor’s position. There are clearly some inherent conflicts in this area.

ACTIVITY 9.4 Can you think of reasons why a business might still pursue activities that are less profitable but socially beneficial?

So how might business as a whole be encouraged to engage in more socially responsible behaviour? There are several possibilities:

• Make shirking of responsibilities more costly, by regulation and law and public awareness. • Market the good citizen concept (e.g. the growth of ‘green’ consumerism), where consumers’ • •

decisions are strongly influenced by the nature of the business, product or production method. Combine businesses into groups to develop ways of dealing with aspects of their business in a socially responsible way. Promote government action, which might include legislation, penalties for non-compliance or subsidies.

Concept check 1 Which of the following statements is false? A B C D E

Business today cannot solely focus on wealth maximisation. Social and environmental issues should be given serious consideration by today’s businesses. Today’s business managers must consider a much broader range of issues than in the past. Businesses today unanimously accept sustainability as their primary goal. All of the above are true.

Concept check 2 Which of the following statements is true? A

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B C D E

Some stakeholders have legitimate interests in all parts of a business. Some stakeholders have legitimate interests in only a certain part of a business. Environmentalists are seen as a relatively new stakeholder in business. Potential customers should be considered as stakeholders. All of the above.

Concept check 3 The stakeholder concept recognises a number of parties with a legitimate A B C D E

Owners/shareholders and managers Employees and customers Government, lenders and suppliers Investment analysts All of the above.

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CORPORATE SOCIAL RESPONSIBILITY (CSR)— WHAT DOES IT MEAN?

LO2 Explain what is meant by corporate social responsibility and the Ceres Principles

corporate social responsibility business process to produce

While definitions can vary slightly, the following definition provides a useful starting point: CSR is about how companies manage the business processes to produce an overall positive impact on society. This definition is from Mallen Baker, and can be found at