Financial Accounting: An Integrated Approach 0170349683, 9780170349680
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6TH EDITION
r
Fin an cial Accounting
An I n t e g r a t e d
Approach
Ken Trotman E l i z a b e t h Carson Michael Gibbins
CENGAGE Learning' Financial accounting: an integrated approach 6th Edition Ken Trotman Elizabeth Carson Michael Gibbins
Publishing manager: Dorothy Chiu Publishing editor: Geoff Howard Developmental editors: Duncan Campbell-Avenell; James Cole; Lydia Crisp Senior project editor: Tanya Simmons Art direction: Danielle Maccarone Permissions/Photo researcher: Helen Mammides Editor: Pete Cruttenden Proofreader: Penelope Goodes Indexer: Julie King Text designer: Christina Neri; Fiona Byrne Cover designer: Chris Starr (MakeWork) Cover: Chris Starr (MakeWork) Typeset by Cenveo Publisher Services Any URLs contained in this publication were checked for currency during the production process. Note, however, that the publisher cannot vouch for the ongoing currency of URLs.
© 2016 Cengage Learning Australia Pty Limited Copyright Notice This Work is copyright. No part of this Work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without prior written permission of the Publisher. Except as permitted under the Copyright Act 1968, for example any fair dealing for the purposes of private study, research, criticism or review, subject to certain limitations. These limitations include: Restricting the copying to a maximum of one chapter or 10% of this book, whichever is greater; providing an appropriate notice and warning with the copies of the Work disseminated; taking all reasonable steps to limit access to these copies to people authorised to receive these copies; ensuring you hold the appropriate Licences issued by the Copyright Agency Limited (“CAL”), supply a remuneration notice to CAL and pay any required fees. For details of CAL licences and remuneration notices please contact CAL at Level 15, 233 Castlereagh Street, Sydney NSW 2000, Tel: (02) 9394 7600, Fax: (02) 9394 7601 Email: [email protected] Website: www.copyright.com.au For product information and technology assistance, in Australia call 1300 790 853; in New Zealand call 0800 449 725 For permission to use material from this text or product, please email [email protected] National Library of Australia Cataloguing-in-Publication Data Trotman, K. T. (Kenneth Thomas), author. Financial accounting : an integrated approach/Ken Trotman, Elizabeth Carson, Michael Gibbins. Sixth edition. 9780170349680 (paperback) Includes index. Subjects: Accounting-Textbooks. Other Creators/Contributors: Carson, Elizabeth, author. Gibbins, Michael, 1942-author. 657.044
Cengage Learning Australia Level 7, 80 Dorcas Street South Melbourne, Victoria Australia 3205 Cengage Learning New Zealand Unit 4B Rosedale Office Park 331 Rosedale Road, Albany, North Shore 0632, NZ For learning solutions, visit cengage.com.au Printed in China by 1010 Printing International Limited. 1 2 3 4 5 6 7 19 18 17 16 15
1
Intro du ction to financial accounting
2
M easuring and evaluating financial position and financial perform ance
1 41
A P P E N D IX T O C H A P T E R 2 : B ackground: sole tra d e rs , p a rtn e rs h ip s , com p a n ie s an d Financing
3
80
The d o u b le -e n try system
85
A P P E N D IX T O C H A P T E R 3 : A b rie f h is to ry o f e a rly ac c o u n tin g
133
4
R ecord-keeping
139
5
Accrual accounting a d justm e nts
183
6
Financial repo rting principles, accounting standards and au d itin g
235
7
Internal control and cash
283
8
Accounts receivable and fu rth e r reco rd -kee ping
315
9
Inventory
357
10
N oncurrent assets
385
11
Liabilities
423
A P P E N D IX T O C H A P T E R 11: F u tu re cash flow s: p re s e n t va lu e an alysis
458
12
C om pleting the balance sheet
463
13
Revenue and expense recognition: additiona l concepts
491
14
The sta te m e n t o f cash flow s
527
15
Financial sta te m e n t analysis
575
16
A ccounting policy choices
635
17
S u staina bility repo rting
657
Appendix: W oolw orths Lim ited Annual R eport 2014
687
Glossary
734
Index
745
P reface
xiii
G uide to th e te x t
xiv
G uide to th e on lin e resources
xvi
A b o u t th e a u th o rs A c k n o w le d g e m e n ts
xviii xx
CHAPTER 1 In tro du ction to financial accounting
1
Chapter overview
1
1.1 1.2
Use and preparation of accounting
2
Financial accounting
2
1.3 1.4
Who uses financial accounting information?
3
The people involved in financial accounting
5
1.5
Accrual accounting
8
1.6 1.7
The key financial statements
12
Relationships between the financial statements
17
1.8
Financial statement assumptions
21
1.9
Is accounting really important?
22
Practice problems Key terms Flomework and discussion to develop understanding
26 27 27
CHAPTER 2 M easuring and evaluating financial position and financial perform ance
41
Chapter overview
41
2.1 2.2
Introduction to the balance sheet
43
Explanations of the three balance sheet categories: assets, liabilities and eguity
45
2.3 2.4
Some preliminary analysis of the Sound and Lightbalance sheet
48
A closer look at the balance sheet
50
2.5
Maintaining the accounting eguation
54
2.6 2.7
Managers and the balance sheet
56
The income statement
57
2.8
Connecting balance sheets and income statements
60
2.9 2.10
A closer look at the income statement
63
Capital markets, managers and performance evaluation
65
Practice problems Key terms Homework and discussion to develop understanding
67 68 68
Contents
APPENDIX TO CHAPTER 2: B ackground: sole tra d ers, p artnerships, com panies and financing A2.1 Four kinds of business organisation A2.2
Business financing
CHAPTER 3 The d o u b le -e n try system
v ii
80 80 83
85
Chapter overview
85
3.1 3.2
Transaction analysis
86
Transaction analysis extended
88
3.3
Recording transactions: double-entry bookkeeping
94
3.4 3.5
More about accounts
98
How debits and credits work
99
3.6
Debits and credits, revenues and expenses
102
3.7 3.8
Arranging accounts on the balance sheet
108
More journal entries
110
3.9
Cash versus accrual accounting revisited
112
3.10
Example: Simone's jewellery business
114
Practice problems Key terms Homework and discussion to develop understanding
APPENDIX TO CHAPTER 3: A b rie f history o f early accountin g A3.1 Mesopotamia to Rome: 4500 BC to AD 400
117 119 119
133 134
A3.2
The Middle Ages to the Renaissance: AD 4 0 0 -5 0 0
134
A3.3 A3.4
Britain: 1500 to the early 1800s
135
Financial accounting's recent history
136
Notes
138
CHAPTER 4 R ecord-keeping
139
Chapter overview
139
4.1 4.2
The importance of good records
140
Financial accounting's transactional filter
140
4.3 4.4
Accounting's 'books' and records
143
Example: Northern Star Theatre Company
155
4.5
Another illustrative example
164
4.6
Electronic commerce
169
4.7
Managers, bookkeeping and control
170
Practice problems Key terms Homework and discussion to develop understanding Note
171 172 172 182
v iii
Contents
CHAPTER 5 Accrual accounting adjustm e nts Chapter overview
183 183
5.1
Conceptual foundation of accrual accounting
185
5 .2
Accrual accounting adjustments
192
5 .3
Multi-colum n worksheets
200
5 .4
The financial period
204
5 .5
Contra accounts
204
5 .6
Illustrative example
207
5 .7
Managers and accrual accounting assumptions
213
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 6 Financial re p o rtin g principles, accounting standards and au d itin g Chapter overview
215 217 217
235 235
6.1
Introduction: accounting standards and principles
236
6 .2
Accounting principles and the use of accounting information
236
6 .3
Framework for the preparation and presentation of financial statements
238
6 .4
Assets and liabilities: valuation and measurement
245
6 .5
Accounting regulation in Australia
249
6.6
International financial reporting standards
251
6 .7
The annual report and financial statements
252
6.8
The external auditor's report
254
6 .9
The nature of a profession and professional ethics
257
6 .1 0
Capital markets
260
6.11
Contracts and financial accounting information
265
6 .1 2
Managers and financial accounting standards
267
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 7 Internal control and cash Chapter overview Internal control
7.1
269 269 270 281
283 283 284
7 .2
Internal control of cash
287
7 .3
Bank reconciliations
290
7 .4
Performing a bank reconciliation from information in cash journals
294
7 .5
Petty cash
297
7 .6
Disclosure of internal control in annual reports
298
7 .7
Managers and internal control
299
Contents
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 8 Accounts receivable and fu rth e r reco rd -kee ping Chapter overview
IX
300 301 301 314
315 315
8 .1
Receivables
316
8 .2
Control accounts and contra accounts
317
8 .3
Accounts receivable and contra accounts
317
8 .4
Illustrative example
323
8 .5
Trade discount and cash discount
327
8.6
Detailed recording using special journals, subsidiary ledgers and control accounts
328
8 .7
Prime entry records: special journals
330
8.8
Subsidiary ledgers and control accounts
330
8 .9
Operation of special journals and subsidiary ledgers
331
8 .1 0
Role of general journal and general ledger
337
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 9 Inventory Chapter overview 9.1 Inventory control
338 340 340 355
357 357 358
9 .2
Accounting entries for perpetual and periodic inventory
360
9 .3
Inventory valuation and cost of goods sold
364
9 .4
More about inventory cost flow assumptions
366
9 .5
An example: Meeix Ltd
368
9 .6
Lower of cost and net realisable value rule
371
9 .7
Retail inventory and standard costs
372
9 .8
Disclosure of inventory accounting policies
373
9 .9
Managers and the valuation of inventory
Practice problems Key terms Homework and discussion to develop understanding Note
CHAPTER 10 N oncurrent assets Chapter overview 1 0 .1
The cost of an asset: basic components
374 375 376 376 384
385 385 386
1 0 .2
Depreciation of assets and depreciation expense
387
1 0 .3
Depreciation bases and methods
390
X
Contents
10.4 10.5
Depreciation example
395
Gains and losses on noncurrent asset disposals
397
10.6
Asset impairment
398
10.7 10.8
Asset revaluations
401
Intangible assets
403
10.9
Goodwill
406
10.10 Finance leases 10.11 Managers and noncurrent assets
408
Practice problems Key terms Homework and discussion to develop understanding
409 409 410
CHAPTER 11 Lia bilities
407
423
Chapter overview
423
11.1
What is a liability?
424
11.2
General measurement principles
425
11.3 11.4
Financial statement presentation of liabilities
426
Payables
428
11.5
Interest-bearing liabilities - short-term
429
11.6 11.7
Interest-bearing liabilities - long-term
431
Tax liabilities
433
11.8
Provisions
433
11.9 11.10
Contingent liabilities
437
'Off balance sheet' financing
439
11.11
Goods and services tax
439
Practice problems Key terms Homework and discussion to develop understanding
APPENDIX TO CHAPTER 11: F u tu re cash Flows:p resen t value analysis A11.1 Future cash flows A11.2 Interest and present value Notes
458 458 459 462
CHAPTER 12 C om pleting the balance sheet Chapter overview Intercorporate investments and corporate groups
12.1 12.2
444 445 445
463 463 464
Consolidations
467
12.3 12.4
Shareholders' eguity
470
Share capital
471
12.5
Reserves
474
12.6 12.7
Retained profits and dividends
475
Cash dividends
476
Contents
12.8 12.9
XI
Bonus issues and share splits
477
Managers, investments and shareholders' equity
479
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 13 Revenue and expense recognition: additiona l concepts
480 481 481
491
Chapter overview
491
13.1
Revenues
492
13.2
Revenue recognition
493
13.3 13.4
The expenses concept: the Framework
501
Statement of profit or loss and other comprehensive income
502
13.5
Statement of changes in equity
507
13.6 13.7
'What if'(effects) analysis
508
Managers and the recognition of revenues and expenses
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 14 The sta te m e n t o f cash flow s
511 512 513 513
527
Chapter overview
527
14.1
The purpose of cash flow analysis
528
14.2
Overview of the statement of cash flows
529
14.3 14.4
Preparation using the direct method
533
Interpreting a statement of cash flows (direct method)
543
14.5
Preparation using the indirect method
545
14.6 14.7
Interpreting a statement of cash flows (indirect method)
548
Cash flow and the manager
Practice problems Key terms Homework and discussion to develop understanding Note
CHAPTER 15 Financial sta te m e n t analysis
549 550 552 552 573
575
Chapter overview
575
15.1
Investment and relative return
576
15.2 15.3
Introduction to financial statement analysis
576
Common size statements
578
15.4
Woolworths Limited: an example company
579
15.5 15.6
Financial statement ratio analysis
581
Integrative ratio analysis
591
15.7
Financial statement ratio analysis example
594
x ii
Contents
15.8
Interpretation of cash flow information
605
15.9 'What if' effects, ratios and cash flow 15.10 Measuring a manager's performance
607
Practice problems Key terms Homework and discussion to develop understanding
612 613 614
CHAPTER 16 A ccounting policy choices
610
635
Chapter overview
635
16.1
Introduction
636
16.2 16.3
Background to accounting policy choices
636
Inventory valuation and COGS: effects
640
16.4
Depreciation effects analysis
641
16.5 16.6
Intangibles effects analysis
642
Accounting policy disclosure
643
16.7
Accounting policy choices: management's objectives
643
Practice problems Key terms Homework and discussion to develop understanding
645 645 645
CHAPTER 17 S u staina bility repo rting
657
Chapter overview
657
17.1
What is sustainability reporting?
658
17.2
What is reported in sustainability reports?
659
17.3
Do stakeholders require more than financial reporting?
661
17.4
Why do organisations produce sustainability reports?
662
17.5 17.6
Criteria for sustainability reporting
664
Trends in sustainability reporting
667
17.7
Energy efficiency as an im portant example of sustainability
669
17.8
Integrated reporting
676
Practice problems Key terms Homework and discussion to develop understanding Notes
APPENDIX W oolw orths Lim ited Annual R eport 2014
682 682 682 686
687
G lossary
734
In dex
745
O n e q u e s tio n I h a v e b e e n fre q u e n tly a s ke d s in ce w ritin g the first e d itio n o f this b o o k is: w h y w rite a n in tro d u c to ry a c c o u n tin g te x tb o o k ? First, I h a v e b e e n in v o lv e d in te a c h in g in tro d u c to ry fin a n c ia l a c c o u n tin g fo r o v e r 3 5 y e a rs . I e n jo y try in g to g e t a cro ss the in tro d u c to ry c o n c e p ts . S e c o n d , I h a v e b e e n s u rp rise d a t th e d iffe re n c e s b e tw e e n h o w in tro d u c to ry a c c o u n tin g is ta u g h t in m ost u n d e rg ra d u a te p ro g ra m s a n d h o w it is ta u g h t in M B A courses in the U n ite d States a n d A u s tra lia . T h irty y e a rs a g o th e re w e re g o o d re a so n s fo r the d iffe re n c e s , as m ost o f o u r firsty e a r u n d e rg ra d u a te students w e re a c c o u n tin g m a jo rs . This is n o t th e c a s e to d a y . T h ird , w h e n I a s k a tte n d e e s a t e x e cu tive e d u c a tio n p ro g ra m s w h a t th e ir a c c o u n tin g b a c k g ro u n d is, m a n y re s p o n d th a t th e y d id first-year a c c o u n tin g 10 -p lu s y e a rs a g o b u t fo u n d it b o rin g ! W ith this in m in d , I trie d to a d d to a n u n d e rg ra d u a te b o o k s o m e o f the fea tu re s th a t M B A s a n d e xe cu tive s seem to e n jo y . W e d o n 't w a n t o u r students re tu rn in g in 1 0 y e a rs a n d s u g g e s tin g o u r courses a re b o rin g ! T a lk in g a b o u t c o m p a n ie s a n d re la tin g the m a te ria l to a n n u a l reports a n d n e w s p a p e r a rtic le s helps students to g e t interested. W ith a ll o f th e a b o v e in m in d , w e set a b o u t in c o rp o ra tin g the fo llo w in g in th e b o o k . First, w e h a v e tried to m a ke c le a r to students the im p o rta n c e o f a c c o u n tin g in fo rm a tio n b y fre q u e n t re fe re n ce to cu rre n t m a te ria l. S e c o n d , as c o m p a n ie s a re the m ost c o m m o n business o rg a n is a tio n s in A u s tra lia to d a y , w e start b y w ritin g a b o u t c o m p a n ie s , ra th e r th a n s p e n d in g m a n y in tro d u c to ry c h a p te rs c o n c e n tra tin g o n so le tra d e rs. T h ird , to k e e p this b o o k 's m a te ria l in te re stin g a n d re le va n t, w e h a v e m a d e fre q u e n t re fe re n ce s to th e c o n te n t o f a n n u a l reports. S tudents le a rn a b o u t real c o m p a n ie s a n d c a n fo llo w th e ir p e rfo rm a n c e in the n e w s p a p e rs o r the s h a re m a rke t if th e y w is h . Fourth, w e b e lie v e th a t th e d e p th o f te c h n ic a l k n o w le d g e in this b o o k w ill c h a lle n g e b o th a c c o u n tin g a n d n o n -a c c o u n tin g m a jo rs. The first e d itio n o f this te x tb o o k w a s a d a p te d from the s e co n d e d itio n o f the best-selling C a n a d ia n in tro d u c to ry fin a n c ia l a c c o u n tin g te x tb o o k o f the s a m e n a m e w ritte n b y M ic h a e l G ib b in s . In the A u s tra lian e d itio n , w e h a ve a d d e d e ig h t c h a p te rs as w e ll as re o rie n tin g the m a te ria l to w a rd s the A u s tra lia n c o n te xt. O u r sixth e d itio n in c o rp o ra te s a n e w C h a p te r 8 o n re ce iva b le s. P reviously the re ce iv a b le s m a te ria l w a s p a rt o f the e a rly c h a p te rs o n a c c ru a l a c c o u n tin g (p a rtic u la rly C h a p te r 5 ). B y m o v in g it to C h a p te r 8 w e h a ve m a d e C h a p te r 5 m o re m a n a g e a b le ; it a ls o a llo w e d us to a d d re ss re ce iv a b le s in m o re d e ta il, in c lu d in g the use o f s u b s id ia ry le d g e rs. In a d d itio n , s u sta in a b ility re p o rtin g has b e e n m o ve d to C h a p te r 1 7 a n d linked w ith in te g ra te d re p o rtin g . These s u sta in a b ility reports h a ve b e c o m e v e ry c o m m o n a n d a re in c re a s in g ly im p o rta nt. The m ost a ttra c tiv e fea tu re s o f the fifth e d itio n h a v e b e e n re ta in e d : a n e a sy-to -re a d style w ith a w e a lth o f extra cts from c o m p a n y a n n u a l re p o rts, n e w s p a p e rs a n d m a g a z in e s , 'H o w 's y o u r u n d e rs ta n d in g ? ' a c tiv ity q u e stio n s th ro u g h o u t e a c h c h a p te r, q u e stio n s a t th e e n d o f e a c h c h a p te r re la tin g to real a n n u a l re p o rts, as w e ll as a set o f ca se s w ith q u e stio n s re la tin g to the W o o lw o rth s Lim ited A n n u a l R eport 2 0 1 4 (a p p e n d ix a t the e n d o f the b o o k ). S tudents sh o u ld ta k e a d v a n ta g e o f th e a n c illa ry m a te ria l th a t g o e s w ith this b o o k , in p a rtic u la r the C o u rs e M a te w e b s ite , w h ic h in c lu d e s re visio n q u iz z e s , p ra c tic e q u e s tio n s , a n n o ta te d w e b lin k s a n d m uch in te ra c tiv e m a te ria l. A ls o , the p u b lis h e r has m a d e a v a ila b le a suite o f a d d itio n a l resources fo r instructors. S tudents m a y like to a ls o o b ta in th e a c c o m p a n y in g S tu d y G u id e , w h ic h p ro v id e s num erous a d d itio n a l que stio n s. W e trust th a t y o u w ill e n jo y the b o o k . Ken T rotm an
XIV
Guide to the text A s you re a d th is te x t you w ill fin d a n u m b e r of fe a tu r e s in e v e ry c h a p te r to e n h a n c e y o u r s tu d y of a c c o u n tin g an d h e lp you u n d e rs ta n d h o w th e th e o r y is a p p lie d in th e r e a l w o rld .
C H A P T E R O P E N IN G FE A TURES
The learning objectives and chapter overview give you a clear sense of what topics each chapter will cover and what you should be able to do after reading the chapter
F EA TURES W I T H I N C H A P T E R S
The three m ain e lem ents o f a b a la n c e sheet a re assets, lia b ilitie s a n d shareholders'equity.
Key term s in bold highlight important accounting terminology. Definitions for these terms can be found at the end of the book in the glossary.
H O W 'S Y O U R U N D E R S T A N D IN G ?
How ’s your understanding activity questions throughout each chapter help you to reinforce your understanding of key concepts as you progress through the text, providing you with the opportunity to reflect and revise important material. H O W 'S Y O U R U N D E R S T A N D IN G ? H ere is a question you should be able to answer, based on what you have ju st read. If you can't answer it, it would be best to re-read the material. What are the two main things that financial accounting measures? Your answer should be: financial performance and financial position.
s
A t th e en d of ea c h c h a p te r y o u ’ll fin d s e v e r a l to o ls to h e lp you to re v ie w , p ra c tic e an d e x te n d y o u r k n o w le d g e of th e key le a rn in g o u tc o m e s . Practice problems give you the opportunity to test your knowledge and consolidate your learning. A list of key terms from the chapter have been provided to help with your revision. The homework and discussion to develop understanding section provides you with discussion questions, problems, and cases to help you with your revision.
xvi
Guide to the ontine resources FOR T H E IN S T R U C T O R C e n g a g e L e a rn in g is p le a s e d to p ro v id e you w ith a s e le c tio n of re s o u rc e s th a t w ill h e lp you p re p a re y o u r le c tu r e s an d a s s e s s m e n ts . T h e s e te a c h in g to o ls a re a c c e s s ib le via h ttp ://lo g in .c e n g a g e .c o m .
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FOR T H E S T U D E N T N e w c o p ie s of th is te x t c o m e w ith an a c c ess cod e th a t gives you a 1 2 -m o n th s u b s c rip tio n to th e C o u rs e M a te E x p re s s W e b s ite . V is it h ttp ://lo g in .c e n g a g e b r a in .c o m an d lo g in u sin g th e cod e c a rd .
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h e l p s y o u b u ild a f u l l y i n t e g r a t e d u n d e rs ta n d in g of fin a n c ia l a c c o u n tin g a n d m a n a g e m e n t a c c o u n t i n g . You ca n buy th e M a n a g e m e n t A c c o u n tin g e B o o k d ire c t fr o m C e n g a g e B ra in .
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About the authors Ken Trotman is S c ie n tia Professor in th e S ch o o l o f A c c o u n tin g a t the U n ive rsity o f N e w S outh W a le s . H e has a n M C o m (H o n s ) from th e U n ive rsity o f N e w S outh W a le s a n d a PhD fro m th e A u s tra lia n G ra d u a te S ch o o l o f M a n a g e m e n t (U N S W ). H e is a F e llo w o f b o th C h a rte re d A c c o u n ta n ts A u s tra lia a n d N e w Z e a la n d a n d C P A A u s tra lia . K en's m a jo r re se a rch interests in c lu d e e x a m in in g th e p ro c e s s in g o f in fo rm a tio n b y users o f a c c o u n tin g reports a n d a u d ito rs , a n d the fa cto rs th a t a ffe c t the q u a lity o f th e ir d e c is io n s . H e has re ce iv e d the fo llo w in g a w a rd s fro m th e A m e ric a n A c c o u n tin g A s s o c ia tio n : 2 0 0 1 O u ts ta n d in g E d u c a to r A w a r d b y the A u d it S e c tio n , 2 0 0 8 C o n trib u tio n A w a r d
N o ta b le C o n trib u tio n to the A u d itin g Literature A w a r d , 2 0 0 9 N o ta b le (Lifetime) in B e h a v io ra l A c c o u n tin g Literature, a n d 2 0 1 4
B e h a v io ra l O u ts ta n d in g D o c to ra l
D issertation S u p e rv iso r A w a r d . H e re c e iv e d the O u ts ta n d in g C o n trib u tio n to the A c c o u n tin g R esearch Literature A w a r d b y the A c c o u n tin g A s s o c ia tio n o f A u s tra lia a n d N e w Z e a la n d (A A A N Z ) in 1 9 9 9 . H is research has resulted in him b e in g m a d e a F e llo w o f th e A c a d e m y o f S o c ia l S c ie n c e s in A u s tra lia . H e is a fo rm e r p re s id e n t o f the A A A N Z , a fo rm e r C o o p e rs & L y b ra n d v is itin g re se a rch p ro fe s so r a n d D ire c to r o f R esearch fo r th e a u d it se ctio n o f th e A m e ric a n A c c o u n tin g A s s o c ia tio n . H e has o v e r 4 0 y e a rs o f u n ive rsity te a c h in g e x p e rie n c e , m uch o f w h ic h has c o v e re d in tro d u c to ry a c c o u n tin g . In a d d itio n to te a c h in g in the S ch o o l o f B usiness, U N S W , he has ta u g h t a t the U n ive rsity o f Illin o is a t U rb a n a - C h a m p a ig n , C o rn e ll U n ive rsity a n d th e U n ive rsity o f M ic h ig a n . H e has e x te n sive c o n s u ltin g e x p e rie n c e a n d has c o n d u c te d m a n y e x e c u tiv e tra in in g p ro g ra m s in b o th the p riv a te a n d p u b lic sectors. H e has p u b lis h e d w id e ly in A u s tra lia n a n d in te rn a tio n a l re se a rch jo u rn a ls a n d is o n th e e d ito ria l b o a rd s o f num erous le a d in g in te rn a tio n a l research jo u rn a ls. In 2 0 1 1 he w a s in d u c te d in to the A u s tra lia n A c c o u n tin g H a ll o f Fam e.
Elizabeth Carson is a P rofessor in fin a n c ia l a c c o u n tin g a n d a u d itin g a t th e U n ive rs ity o f N e w S outh W a le s . E liz a b e th 's rese a rch interests in c lu d e e c o n o m ic s o f g lo b a l a n d n a tio n a l a u d it m arkets, in d u stry s p e c ia lis a tio n b y a u d ito rs a n d a u d it re p o rtin g . H e r PhD in v e s tig a tin g g lo b a l a u d it firm n e tw o rks a n d g lo b a l in d u stry s p e c ia lis a tio n
b y a u d it firm s w a s a w a rd e d
the A m e ric a n A c c o u n tin g A s s o c ia tio n A u d itin g
S ectio n
O u ts ta n d in g D isse rta tio n A w a r d in 2 0 0 8 . H e r w o rk has a p p e a re d in le a d in g a c a d e m ic jo u rn a ls in c lu d in g The A c c o u n tin g R e vie w , A u d itin g : A J o u rn a l o f P ra c tic e a n d T h e o ry a n d A c c o u n tin g a n d F in a n ce . E liza b e th te a c h e s a t p o s tg ra d u a te level in fin a n c ia l a c c o u n tin g a n d a u d itin g , as w e ll as s u p e rv is in g re se a rch students in the H o n o u rs , M P h il a n d PhD p ro g ra m s . S he re c e iv e d the Pearson E d u c a tio n A c c o u n tin g Lecturer o f the Y e a r a w a rd fo r her d e v e lo p m e n t o f the 'A c c o u n tin g : A U ser P ersp e ctive ' s u b je c t in th e M a s te rs o f C o m m e rc e p ro g ra m . P rior to jo in in g a c a d e m ia , she w o rk e d w ith P ric e w a te rh o u se C o o p e rs (P w C ) a n d is q u a lifie d as a c h a rte re d a c c o u n ta n t.
M ichael G ibbins is th e W in s p e a r Professor o f A c c o u n tin g in th e Fa cu lty o f Business, U n ive rsity o f A lb e rta . H e has a B C o m fro m the U n ive rs ity o f British C o lu m b ia , a n M B A fro m Y o rk U n ive rsity a n d a PhD in a c c o u n tin g a n d p s y c h o lo g y fro m C o rn e ll U n ive rsity. H e o b ta in e d his c h a rte re d a c c o u n ta n c y d e s ig n a tio n in the P rince G e o r g e o ffic e o f w h a t is n o w D e lo itte & T o u ch e . H e has he ld a p p o in tm e n ts a t Q u e e n s U n ive rsity S ch o o l o f Business, th e C a n a d ia n Institute o f C h a rte re d A c c o u n ta n ts a n d th e U n ive rsity o f British C o lu m b ia . H is research a n d te a c h in g interests lie in h o w p e o p le m a ke d e c is io n s a n d ju d g e m e n ts, a n d in th e w a y a c c o u n tin g in fo rm a tio n is used in m a k in g im p o rta n t d e c is io n s in business a n d o th e r e c o n o m ic spheres. A p a rtic u la r interest is in the p ro fe s sio n a l ju d g e m e n t o f p u b lic a c c o u n ta n ts , m a n a g e rs a n d o th e r p ro fe s sio n a ls w h o c o p e w ith th e pressures a n d risks o f m o d e rn business life. H e has p u b lis h e d w id e ly o n ju d g e m e n t,
About the authors
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a c c o u n tin g , fin a n c ia l d is c lo s u re a n d e d u c a tio n a l su b je cts; is a fo rm e r e d ito r o f the C a n a d ia n a c c o u n tin g resea rch jo u rn a l C o n te m p o ra ry A c c o u n tin g R esearch; has b e e n o n th e e d ito ria l b o a rd s o f num erous a c a d e m ic jo u rn a ls; a n d is a c tiv e in th e C a n a d ia n A c a d e m ic A c c o u n tin g A s s o c ia tio n , the A m e ric a n A c c o u n tin g A s s o c ia tio n a n d o th e r p ro fe s s io n a l b o d ie s . H e has re c e iv e d a n u m b e r o f e d u c a tio n a n d te a c h in g a w a rd s a n d in 1 9 8 8 he re c e iv e d th e h o n o u r o f b e c o m in g a F e llo w o f b o th th e A lb e rta a n d British C o lu m b ia Institutes o f C h a rte re d A c c o u n ta n ts . M ik e is n o w retired a n d lives in E d m o n to n , C a n a d a .
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Acknowledgem ents The c o m p le tio n o f this b o o k w a s o n ly a c h ie v e d w ith th e h e lp o f m a n y in d iv id u a ls . M y g re a te s t thanks g o to m y fo rm e r c o lle a g u e , the late G o r d o n H o w itt. O v e r 4 0 y e a rs a g o G o rd o n
in s p ire d m y interest in
a c c o u n tin g . H e ta u g h t m e first-ye a r a c c o u n tin g a n d su b se q u e n tly as a sta ff m e m b e r p ro v id e d m e w ith g u id a n c e a n d s u p p o rt. W ith o u t his h e lp I c o u ld n o t h a v e w ritte n this b o o k . D u rin g the first e d itio n he e n c o u ra g e d m e, re g u la rly c h e c k e d o n p ro g re s s, c o n tin u a lly re a d d ra fts, p ro v id e d m a n y q u e s tio n s , a u th o re d the s o lutions m a n u a l a n d g e n e ra lly o ffe re d frie n d s h ip a n d su p p o rt. This s u p p o rt c o n tin u e d w ith th e re v ie w in g o f the s e c o n d e d itio n . For 5 0 y e a rs he m a d e a n o u ts ta n d in g c o n trib u tio n to a c c o u n tin g e d u c a tio n a t the U n ive rsity o f N e w S outh W a le s . I c e rta in ly h a v e n e ve r m et a m o re d e d ic a te d a c c o u n tin g te a c h e r. It has b e e n a p riv ile g e to w o rk w ith him a n d w e a ll miss his in s p ira tio n . M y c o -a u th o r M ik e G ib b in s w a s kin d e n o u g h to in v ite m e to a d a p t his o rig in a l C a n a d ia n te x tb o o k . M ik e has a n o u ts ta n d in g re p u ta tio n as a re se a rc h e r a n d I like d his v e rs io n o f the b o o k so m uch th a t I d e c id e d to ta k e o n the task o f c o -a u th o r. M y n e w c o -a u th o r, Professor E liza b e th C a rs o n , has p ro v id e d m e w ith m a n y he lp fu l s u g g e stio n s o n p re vio u s e d itio n s o f the b o o k a n d has h e lp e d to re s h a p e m a n y parts o f this n e w e d itio n o f the b o o k . M y life has b e e n m a d e m uch e a s ie r w ith the h e lp o f s o m e v e ry c a p a b le re se a rch assistants. S ta ff a t the U n ive rsity o f N e w S outh W a le s a n d s o m e o th e r universities h a v e b e e n g e n e ro u s in p ro v id in g m e w ith m a te ria l. M ic h a e l Pennisi p ro v id e d m a te ria l o n G S T a n d m a te ria l o n s u b s id ia ry le d g e rs , n o w in C h a p te r 8. A th o l C a rrin g to n a n d G o rd o n H o w itt p ro v id e d m e w ith s o m e m a te ria l in C h a p te r 5 , as w e ll as num erous q u e stio n s, a n d M a lc o lm M ille r w ith s o m e m a te ria l in C h a p te r 8 . R osina M la d e n o v ic p ro v id e d s o m e m a te ria l fo r C h a p te rs 8 a n d 9 as w e ll as num erous c o m m e n ts o n the b o o k . G e rry G a lle y w ro te s u b sta n tia l s e ctio n s o f C h a p te r 1 1. N o e l H a rd in g p ro v id e d m a te ria l fo r C h a p te r 8 . C h a p te r 1 7 w a s la rg e ly w ritte n b y A n d re w T rotm an w ith e x c e lle n t inputs fro m T a n y a F ie d le r a n d S a ra h A d a m s as w e ll as a d v ic e fro m R o g e r S im nett a n d P atricia S tro n g . K ate M o r g a n has re w ritte n C h a p te r 1 7 fo r the sixth e d itio n as w e ll as p ro v id in g m a te ria l fo r m a n y c h a p te rs. Q u e s tio n s w e re a ls o p ro v id e d b y K evin C la rk e , V ic to ria C lo u t, C la u d ia G o rm ily , D e a n H a n lo n , N o e l H a rd in g , C a m e ro n H o o p e r, A n d r e w J a ck so n , H e le n K a n g , Je ffre y K n a p p , C h ris P oullaos, P atricia S tro n g a n d Per Tronnes. M a lc o lm M ille r a n d D ia n e M a y o r g a h a v e p ro v id e d a d v ic e o n te c h n ic a l issues o v e r the y e a rs . O th e r useful c o m m e n ts w e re p ro v id e d b y pre se n t a n d e x -U N S W staff in c lu d in g K a r M in g C h o n g , R obert C z e rn k o w s k i, N e il F a rg h e r, R oger G ib s o n , W e n d y G re e n , N o e l H a rd in g , A n d r e w J a ck so n , A m n a K h a lifa , J a n ic e Loftus, D ia n e M a y o r g a , R ich a rd Petty, B a ljit S id h u a n d R oger S im nett. O v e r v a rio u s e d itio n s , a d v ic e fro m S te p h e n B ah (U n ive rsity o f N e w c a s tle ), Peter C a re y (M o n a s h U nive rsity), Peter C o lle tt (U n ive rsity o f T a s m a n ia ), Russell C ra ig , Linda E nglish (U n ive rsity o f S yd n e y ), V ic Fatseas (C h a rle s Sturt U n ive rsity), J a ck F la n a g a n , D e a n H a n lo n (M o n a s h U n ive rsity), Jan H o llin g d a le (B ond U niversity) a n d G re g W h ittre d (U n ive rsity o f A u c k la n d ) w a s a p p re c ia te d . C e n g a g e Learning a ls o a rra n g e d fo r use o f s o m e m a te ria l in C h a p te r 6 fro m the US b o o k b y I. S o lo m o n , L. W ith e r , P. V a rg o a n d L. Plunkett. K en Tro tm a n
Acknowledgements
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C e n g a g e Learning w o u ld a ls o like to th a n k the fo llo w in g re v ie w e rs , w h o p ro v id e d h e lp fu l a n d useful c o m m e n ts w h ile this e d itio n w a s b e in g d e v e lo p e d : A b d e l H a la b i, M o n a sh University Dean H anlon, M o n a sh University C hristina James-Overheu, University o f Southern Q ueensland Y ou n g d e o k Lim, University o f N e w South W a le s M a ria M u c c ia ro n e , M u rd o ch University Karen N ic ita , N orth S ydney Institute o f TAFE (M e a d o w b a n k) Dr A fza lu r Rashid, University o f Southern Q ueensland Jackie Y ong, University o f N e w ca stle .
Introduction to Financial accounting ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: describe the basic purpose of financial accounting identify the users o f accounting inform ation a n d the decisions they m ake that require accounting inform ation identify the people w h o a re involved in financial accounting describe how accrual accounting differs from cash accounting calculate accrual profit for an organisation explain the basic contents of the three key financial statements and describe the purpose of each statement describe the basic principles an d assumptions o f accounting explain w h y accounting is im portant.
C H A PTER O VE R VIEW A c c o u n tin g has b e e n d e s c rib e d as th e 'la n g u a g e o f b u sin e s s '. It p ro v id e s m a n a g e rs w ith in o rg a n is a tio n s a n d th ose o u ts id e th e o rg a n is a tio n (e .g . in ve sto rs a n d c re d ito rs ) w ith in fo rm a tio n a b o u t th e fin a n c ia l p e rfo rm a n c e a n d fin a n c ia l p o s itio n o f th e business. R e g ardless o f w h a t ty p e o f c a re e r y o u pu rsu e , a c c o u n tin g in fo rm a tio n w ill h a ve im p o rta n t effe cts on y o u . This c h a p te r in tro d u c e s y o u to fin a n c ia l a c c o u n tin g a n d illu s tra te s som e useful a c c o u n tin g c o n c e p ts a n d te c h n i qu es. It o u tlin e s a w a y o f th in k in g a b o u t fin a n c ia l a c c o u n tin g th a t w ill be im p o rta n t to y o u r c a re e r, w h e th e r y o u b e c o m e a n a c c o u n ta n t o r a user o f a c c o u n tin g in business o r in o th e r w a lk s o f life . Y ou a re in tro d u c e d to th e s o c ia l se ttin g o f fin a n c ia l a c c o u n tin g a n d som e o f th e p e o p le in v o lv e d . F in a n c ia l a c c o u n tin g is c o m p le x a n d re q u ire s s o u n d ju d g e m e n t b e ca u s e it a tte m p ts to serve th e ne ed s o f a ll these p e o p le , n o t a ll o f w h o m n e c e s s a rily see th in g s th e sa m e w a y . Y ou a re then in tro d u c e d to o n e o f th e c o rn e rs to n e s o f h o w fin a n c ia l a c c o u n tin g w o rk s : a c c ru a l a c c o u n tin g , th e b ro a d fra m e w o rk w ith in w h ic h fin a n c ia l a c c o u n tin g re p o rts a re p re p a re d . Y ou a re a ls o in tro d u c e d to th e th re e k e y fin a n c ia l state m e nts a n d th e b a s ic fin a n c ia l sta te m e n t a s su m p tio n s . E x a m p le s fro m th e fin a n c ia l press w ill h e lp c o n v in c e y o u o f th e im p o rta n c e o f a c c o u n tin g in fo rm a tio n .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
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1.1
Use and preparation of accounting
Use Financial accounting has value because the inform ation it produces is used in a variety o f w a ys. Users include m anagers, investors, bankers, fin a n cia l analysts a n d m any others. Such p e o p le study accounting to learn h o w to use inform ation effectively a n d to d o their jobs better. For accountants, this inform ation is essential to the services they provide.
P reparation A ccounting is a co m p le x human activity. A ccounting inform ation doesn't just happen: it is produced by a large set of people, activities a n d computers. To be effective users o f the inform ation, p e o p le need to kn o w som ething a b o u t h o w and w h y the inform ation is prepared. Accountants' expertise is all a b o u t the h o w a nd the w h y. The dem and for useful inform ation shapes h o w fin a n cia l accounting inform ation is prepared; for exam ple, w hen producing annual o r monthly perform ance reports. H o w it is prepared shapes its use; for exam ple, in financial analysis a n d m anagerial decisions.
FOR YOUR INTEREST L e a rn in g te r m in o lo g y is im p o rta n t. T o h e lp y o u w ith th a t, th is b o o k has a g lo s s a ry o f te rm s a t th e b a c k on pa ge 7 3 4 . I f y o u ’re n o t s u re w h a t a te r m m e a n s , lo o k it u p rig h t aw ay. A c c o u n tin g is a c h a lle n g in g d is c ip lin e th a t in v o lv e s m a n y c a p a b ilitie s : a s s ig n in g n u m b e rs t o re p re s e n t fin a n c ia l p h e n o m e n a ; p ro v id in g e x p la n a tio n s o f th o s e n u m b e rs ; a n a ly s in g and v e rify in g th e in fo rm a tio n p re p a re d b y o th e rs ; u n d e rs ta n d in g th e n e e d s o f th o s e w h o use a c c o u n tin g ’s re p o rts to m a k e d e c is io n s ; e n g a g in g in o ra l, w r itte n an d e le c tro n ic c o m m u n ic a tio n w ith th e m a n y p e o p le in v o lv e d in an o rg a n is a tio n ’s fin a n c ia l a c tiv itie s ; an d m a in ta in in g ju d g e m e n t th a t is s o u n d , o b je c tiv e and e th ic a l. M u c h o f th e c h a lle n g e o f a c c o u n tin g is in fig u rin g o u t w h ic h n u m b e rs t o use and d e c id in g w h a t th e n u m b e rs te ll us. A d d in g an d s u b tra c tin g th e n u m b e rs is o fte n th e ea sy p a rt. T h is m a ke s a c c o u n tin g b o th e a sie r and h a rd e r t o le a rn th a n y o u m ig h t ha ve th o u g h t. A c c o u n t in g is ro o te d in th e fin a n c ia l s e ttin g , an d has its o w n v o c a b u la ry , so d o n ’t e x p e c t it all t o m a k e p e r fe c t sense a t th e b e g in n in g . It w ill ta k e a w h ile f o r y o u t o a c q u ire th e k n o w le d g e th a t c re a te s an u n d e rs ta n d in g o f bu siness an d a c c o u n tin g as th e y re a lly a re in o u r w o rld . T h is u n d e rs ta n d in g w ill be based o n y o u r k n o w le d g e o f b o th c o n c e p ts and te c h n iq u e s , and o f th e v ie w p o in ts o f b o th a c c o u n ta n ts an d th e users o f a c c o u n tin g . T h e g o in g w ill n o t all be easy, b u t i f y o u g iv e it y o u r b e s t e f f o r t , y o u m a y be s u rp ris e d a t th e h ig h level o f s o p h is tic a tio n y o u w ill re a c h . H e re is o n e im p o r ta n t s u g g e s tio n . T h e o n ly w a y to le a rn a c c o u n tin g is t o do p ro b le m s . It is v ita l th a t y o u d o m o re th a n ju s t rea d th e e x a m p le s . A f t e r re a d in g th e c h a p te r, c o m e b a c k and d o th e e x a m p le s t o c h e c k y o u r u n d e rs ta n d in g .
1.2
Financial accounting
A ccounting is a process o f identifying, measuring a nd com m unicating e conom ic inform ation to a llo w inform ed decisions by the users o f that inform ation. A ccounting systems are often described as either fin a n cia l accounting systems (w here p e rio d ic Financial statements are p rovided to external decision-m akers, such as investors, creditors and customers) o r m anagem ent accounting systems (including inform ation for planning an d perform ance reports to m anagers throughout the o rganisation; that is, internal decision-makers).
CHAPTER 1 Introduction to Financial accounting
3
Financial accounting measures an enterprise's perform ance over time an d its position (status) at a point in time, and does so in Australian dollars, US dollars, yen, euros o r w h a te ve r currency is ju dged relevant to the enterprise. This m easurem ent o f financial perform ance a nd financial position is d o n e for all sorts o f enterprises: large and small businesses, governments from local to national levels, universities, charities, churches, clubs, international associations an d m any others. The fin a n cia l statements, w h ich a re fin a n cia l accounting's reports, summarise the measurements o f fin a n cia l perform ance a nd fin a n cia l position in standard w a ys thought to be useful in evaluating w hether the enterprise has d o n e w e ll a n d is in g o o d shape. These fin a n cia l statements include notes, w h ich contain m any w o rd s (sometimes dozens o f pages) o f e xplanation a nd interpretation, in a d d itio n to the numbers. The statements report on the e co n o m ic an d fin a n cia l matters a nd are largely for the use o f p e o p le outside the enterprise, such as investors, lenders, club members, regulatory agencies a nd taxation authorities. In summary: •
F inancial perform ance is the generation o f n e w resources from day-to-day operations over a p eriod o f time.
•
F inancial position is the enterprise's set o f fin a n cia l resources a nd o b lig a tio n s at a point in time.
•
F inancial statements are the reports describing fin a n cia l perform ance a nd position (e.g. the b a la n ce sheet an d the incom e statement).
•
N o te s are part o f the statements, a d d in g explanations to the numbers. As w e w ill see throughout this book, fin a n cia l perform ance a nd position are highly related. G o o d perform ance is
likely to lead to a healthy fin a n cia l position; if a c o m p a n y has been m aking profits, it w ill p ro b a b ly build up resources. O n the other hand, a healthy fin a n cia l position facilitates perform ance; if you have lots o f resources com p a red to o b lig a tio n s, the c o m p a n y can undertake activities that lead to g o o d perform ance. A nother branch o f a ccounting, m anagem ent acco u n tin g , is oriented to w a rd s helping m anagers a nd others inside the enterprise, in contrast to fin a n cia l accounting's m ore external focus. W h ile m anagem ent accounting is not exam ined in this book, students interested in h o w fin a n cia l accounting measures m anagerial perform ance w ill find frequent references to the relationship betw een m anagers a nd fin a n cia l a ccounting. In the end, all forms of accounting exist to help p e o p le such as m anagers, investors, bankers, legislators an d the public make fin a n cial decisions.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le t o a n s w e r, based o n w h a t y o u ha ve ju s t rea d. I f y o u c a n ’t a n s w e r it, it w o u ld be b e s t to r e -re a d th e m a te ria l. W h a t a re th e tw o m a in th in g s th a t fin a n c ia l a c c o u n tin g m e a s u re s ? Y o u r a n s w e r s h o u ld be : fin a n c ia l p e rfo rm a n c e an d fin a n c ia l p o s itio n .
1.3
Who uses financial accounting inform ation?
This b o o k w ill sh o w you the m any w a ys in w h ich fin a n cia l accounting has been shaped by the developm ent of business an d society. Financial accounting helps: •
stock market investors d e c id e w hether to buy, sell o r hold shares o f com panies
•
banks a nd other lenders d e c id e w hether or not to lend
•
m anagers run enterprises on b ehalf o f ow ners, members o r citizens (in a d d itio n to the help pro vid e d by m anagem ent accounting a nd other sources of inform ation)
•
m anagem ent b y p ro vid in g basic fin a n cia l records for the purposes o f day-to-day m anagem ent, control, insurance an d fraud prevention
•
governm ents in m onitoring the actions of enterprises an d in assessing taxes, such as incom e tax an d the g o ods an d services tax (GST).
4
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W h o le books can be, a nd have been, w ritten a b o u t each of these functions. Though this b o o k em phasises externally oriented fin a n cia l accounting for business firms, d o n 't forget that there are m any other organisations that use, and are affected by, acco u n tin g . W h e n w o rd s like 'o rg a n isa tio n ', 'c o m p a n y ' o r 'enterprise' are used, the im plications often g o w e ll beyond business firms. The centre o f our interest in this b o o k - fin a n cia l accounting for the enterprise - operates w ith in a nd serves a com plex social setting. It seeks to m onitor a n d report on fin a n cia l events initiated by o r h a p p e n in g to the enterprise. A ccounting is not a passive force w ithin the social setting: it tells us w h a t is g o in g on, but in so d o in g it affects our decisions and actions a n d , therefore, also affects w h a t is g o in g on. The social setting is com posed of m any people, including groups, com panies, institutions a n d other parties interested in, o r having an influence on, the com pany's fin a n cia l acco u n tin g . As w e w ill see m any times in this book, these parties d o not share the sam e interest in the com pany's a ccounting, a nd m ay even be in com petition o r conflict w ith each other. M o s t w ill be in the same country as the c o m p a n y an d its m anagem ent but, increasingly, com panies and other enterprises are op e ra tin g internationally. The other groups interested in, a nd affecting, the com pany's financial accounting m ay be located a n yw h e re on the planet. Let's consider some possible users o f the fin a n cia l statements o f a listed com pany: •
A com pany's bo a rd o f directors m anages the c o m p a n y on behalf o f its shareholders. O n e function o f the b oard, w h ich involves the fin a n cia l statements, is hiring the com pany's to p op e ra tin g m anagem ent - e sp e cia lly the chief executive office r (CEO). Suppose you are a mem ber o f the b o a rd a n d are preparing for a discussion at the next board m eeting. The bo a rd evaluates the C E O 's perform ance continuously, w h ich is its responsibility. The financial statements have been p rovided to the bo a rd prior to the m eeting, a nd w ill be a m ajor contribution to this evaluation.
•
A com pany's shares a re listed (i.e. can be bought a nd sold) on the Australian Stock Exchange (ASX). Suppose you are a fin a n cia l analyst for an investment d e a le r an d a re preparing a report projecting future earnings and m aking recom m endations a b o u t w hether the com pany's shares are w orth buying, keeping if a lre a d y held, or instead should be sold. You have the fin a n cia l statements an d w ill use them to support yo u r report.
•
A c om pany has several hundred m illion dollars in bank bo rro w in g s, a nd lines o f credit (pre-authorised b o rro w in g capability) for millions o f dollars m ore. Suppose you are a com m ercial lending o ffice r for a bank, conducting a regular review o f the com pany's b o rro w in g status. You must consider the q u a lity of the com pany's financial perform ance a nd assets (m any o f w h ich have been assigned as security on bank loans, an d therefore could be seized if the c o m p a n y doesn't p a y its loans b a ck on schedule). Financial perform ance is im portant because net profit generates cash to p a y loans, a nd a g o o d past record suggests that the c o m p a n y is likely to be a b le to earn profit in the future. You have requested the fin a n cia l statements to use in your review .
•
A c o m p a n y depends on a large num ber o f suppliers to o b ta in g o o d s a nd services. Suppose you a re the sales m anager of a stationery supplier an d are considering signing a long-term contract to supply the com p a n y. You w a n t to sign the contract because yo u r c o m p a n y needs the business, but you have to be satisfied that your shipments w ill be p a id for. M o re positively, you hope that if you d o a g o o d jo b , you w ill have an opportunity to g ro w w ith the com pany. M o s t of the inform ation you need has been received a lre a d y, but you have o b ta in e d the financial statements an d are review ing them as you make yo u r final decisions a b o u t the contract. In summary, these scenarios in d ica te the fo llo w in g reasons for using the com pany's fin a n cia l statements:
•
evaluation o f the C E O 's perform ance by a mem ber o f the b o a rd o f directors
•
preparation o f 'b u y ', 'sell' o r 'h o ld ' recom m endations b y a fin a n cia l analyst
•
review of the com pany's b o rro w in g status by a ba n k lending officer
•
developm ent o f a supply contract w ith the c o m p a n y by a stationery supplier's sales m anager. These scenarios have been chosen to a d d to your insight into the use o f fin a n cia l accounting inform ation. They
are not com plete. In all cases, the fin a n cia l statements w o u ld be o nly part o f the inform ation used in the d e cisio n making process. A lso, there are m any other uses for fin a n cia l statements, some o f w h ich m ight make different dem ands on the q u a lity o f the inform ation from those discussed here.
CHAPTER 1 Introduction to Financial accounting
5
FOR YOUR INTEREST A b o v e w e n o te d th a t fin a n c ia l s ta te m e n ts w o u ld be o n ly p a rt o f th e in fo r m a tio n used b y v a rio u s g ro u p s s u ch as in v e s to rs an d m a n a g e m e n t in d e c is io n -m a k in g . A n o th e r im p o r ta n t ty p e o f in fo r m a tio n is s u s ta in a b ility re p o rtin g . T h e se re p o rts in c lu d e in fo r m a tio n o n e c o n o m ic , e n v iro n m e n ta l, s o cia l and s a fe ty p e rfo rm a n c e . F o r e x a m p le , th e y c o u ld in c lu d e in fo rm a tio n o n c a rb o n e m is s io n s , e n e rg y usage, e m p lo y e e s a fe ty , c o m m u n ity in v o lv e m e n t, e tc . W e in tro d u c e th is m a te ria l in C h a p te r 17, as m a n y c o m p a n ie s n o w in c lu d e th is in fo rm a tio n in th e ir a n n u a l re p o rts o r s e p a ra te s u s ta in a b ility re p o rts .
1.4 The people involved in financial accounting The main participants in the art o f fin a n cia l accounting are: •
the inform ation users (the decision-makers)
•
the inform ation preparers, w h o put together the inform ation to fa cilita te the users' decision-m aking
•
the auditors, w h o assist the users by enhancing the c re d ib ility o f the inform ation, p roviding a professional opin ion a b o u t the fairness an d appropriateness o f the inform ation.
Users (decision-m akers) In fin a n cia l acco u n tin g , a user o r decision-m aker is som eone w h o makes decisions on the basis o f the fin a n cial statements, on his or her o w n behalf, o r on behalf o f a com p a n y, bank o r other o rganisation. Ultim ately, the nature and contents o f fin a n cia l statements a re functions o f the dem and for decision inform ation from users. If user de m a n d is the fundam ental reason for fin a n cia l statements, understanding the de m a n d is important. A user's main de m a n d is for the c re d ib le p e rio d ic reporting o f an enterprise's fin a n cia l position a nd perform ance: •
C re d ib le means that the inform ation in the reports (the fin a n cia l statements) app e a rs to be sufficiently trustworthy an d com petently prepared for it to be used to make decisions. There is a co st-b e n e fit issue here: huge am ounts of m oney could be spent trying to make the reports absolutely perfect, but since that m oney w o u ld have to com e out o f the enterprise's funds, spending it w o u ld make its perform ance a nd position poorer. Users, such as ow ners and m anagers, m ay not w a n t that to h appen, so cre d ib ility is a relative co n d itio n , not an absolute one. A ccounting inform ation has to be w orth its cost.
•
P eriodic means that users can expect reports on some regular basis (such as ye a rly o r quarterly). The longer the w a it, the m ore solid is the inform ation. But w a itin g a long tim e for inform ation is not desirable: users are w illin g to a c ce p t some im precision in the inform ation in return for p e rio d ic reports w ith timely, decision-relevant inform ation. The main groups o f users a re as follow s:
•
O w n e rs are individual business ow ners, such as proprietors, partners a nd other entrepreneurs; in dividual investors (shareholders) in shares on stock markets w h o can vote on c o m p a n y affairs; com panies that invest in other com panies; superannuation funds an d other institutions that invest in com panies; a nd p e o p le w ith quasi-ow nership interests, such as members o f clubs o r voters in local councils. In respect o f com panies, shareholders o w n portions o f the co rp o ra tio n - shares that can be bought an d sold - but the co rp o ra tio n is a legal entity existing separately from its shareholder ow ners. Investors purchase shares in a c o m p a n y w ith the hope o f g a in in g in tw o w a ys: receiving a portion o f the co m p a n y's p rofit in the form o f dividends, a n d being a b le to sell their shares in the future a t a price higher than they p a id .
•
Potential ow ners are p e o p le o f the same sort as the ow ners listed a b o ve , w h o d o not at present have funds invested in the enterprise but m ay be considering m aking such an investment. Because potential ow ners often buy shares from present ow ners - fo r exam ple, b y trading shares on the stock market - rather than investing directly,
6
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
there is often a sig n ifica n t difference in outlook betw een present ow ners, w h o m ay w ish to sell their shares for as much as possible, an d potential ow ners, w h o w o u ld like to p a y as little as possible. •
C reditors a n d p o te n tia l creditors are suppliers, banks, bondholders, em ployees an d others w h o have lent m oney to the enterprise, w h o are o w e d funds in return for supplying som ething o f value, o r w h o a re considering taking on such a role. C reditors d o not have the legal control o f the enterprise that ow ners have, but they often have a large say in enterprise decisions, e sp e cia lly if the enterprise gets into difficulty. In cases o f extreme difficulty, creditors m ay have the right to take over control o f the enterprise from the ow ners. Sometimes the difference betw een creditors an d ow ners is hard to discern because it m ay d e p e n d on subtle legalities a b o u t w h o has w h a t rights, and some p e o p le m ay p la y both roles for a given enterprise. For exam ple, an o w n e r invests m oney in a business, but in a d d itio n m ay lend the business further money, becom ing a creditor as w e ll as an ow ner. C reditors need to d e c id e w hether to supply g o o d s o r services to the firm on credit.
•
M a n a g e rs a re those w h o run the enterprise on b ehalf o f the ow ners. They have a g re a t interest in the w a y accounting reports on their activities an d results. They use the inform ation for p la n n in g , controlling a nd organising the activities o f the entity. O ften m anagers' salaries an d bonuses, a nd the likelihood of staying in their jobs, are directly affected by the contents o f the fin a n cia l statements. In small businesses in particular, the o w n e r m ay also be the main m anager.
•
Em ployees a n d their unions o r other associations are interested in the enterprise's a b ility to p a y w a g e s, m aintain em ploym ent levels a nd keep such promises as p a yin g superannuation contributions. Financial inform ation can be used to assess jo b security.
•
Regulators a n d other governm ent b o d ie s a n d agencies a re groups that m ay use the fin a n cia l statements as a basis to evaluate w h e th e r the enterprise is fo llo w in g various rules an d agreem ents.
•
F inancial a n d m arket analysts a re p e o p le w h o study com panies' perform ances a nd prepare reports for others by analysing those com panies. Analysts often make recom m endations a b o u t w hether to invest, sell o r d o neither.
•
C om petitors m ay use the fin a n cia l statements to try to understand the enterprise's operations for the purpose of m aking life m ore difficu lt for the enterprise. Sometimes, for exam ple, m anagers are reluctant to disclose inform ation to shareholders, because com petitors can then also o btain it an d act to reduce the enterprise's prospects.
•
A cco u n tin g researchers are p e o p le - mostly university academ ics, but also some based in accounting firms and other organisations - w h o study accounting w ith the o b je ctive o f understanding it a nd contributing to its im provem ent.
•
Customers need to consider if the entity is fin a n cia lly sound. This is particularly im portant w hen customers are required to p a y am ounts in a d va n ce . It is also im portant if customers rely on the w arranties p rovided by the entity.
•
M iscellaneou s third parties a re various other p e o p le w h o m ay get access to an enterprise's fin a n cia l statements and use them in various w a ys . O n c e statements have been issued, m any p e o p le m ay make use o f them. For exam ple, politicians m ay make judgem ents a b o u t industry e fficie n cy o r taxation levels, journalists m ay w rite stories a b o u t em ploym ent practices, a nd judges m ay evaluate the enterprise's a b ility to p a y if it loses a lawsuit. Think about all these users a nd decisions! It is a gre a t c h a lle n g e to d e ve lo p one set o f p e rio d ic financial
statements for an enterprise so that it can be useful for all. Perhaps you w ill not be surprised to kn o w that there is much controversy a b o u t w hether fin a n cia l statements d o this w e ll, a nd w h e th e r fin a n cia l accounting methods serve some users o r decisions better than others. F low likely is it that you, the reader, w ill use accounting inform ation in the future? If you plan to be an accountant, the value of studying fin a n cia l accounting is clear. It m ay not be so clear, how ever, if you have other plans, such as a career in m anagem ent, m arketing, finance, e n gineering, la w , human resources o r production. To pro vid e some perspective to those o f you not planning an accounting career, an d to help you understand the m anagers you w ill w o rk w ith if you d o becom e an accountant o r auditor, comments w ill be m ade frequently about m anagers an d fin a n cia l a ccounting.
CHAPTER 1 Introduction to Financial accounting
7
Financial accounting is directly relevant to m anagers because it reports on the m anagers' perform ance as decision-m akers, caretakers o f the enterprise, representatives o f the ow ners, legal officers o f the enterprise, a nd so on. A ny m anager cannot help but be interested in h o w her or his perform ance is being measured a nd in h o w that perform ance is analysed, projected a nd otherw ise evaluated. M a n a g e rs ' bonuses, prom otions, dismissals, transfers and other rew ards an d penalties are often directly based on the numbers an d com m entaries prepared by accountants. Every m anager should have an intim ate understanding o f h o w accounting is measuring his o r her perform ance a n d should be a b le to conduct a 'reasonableness check' o f the inform ation being p ro vid e d . It is critical for m anagers to understand the im p a ct o f every decision they are m aking on accounting numbers as these numbers w ill measure their perform ance. H ere are a fe w exam ples o f h o w non-accounting m anagers m ay use accounting inform ation. M a rke tin g m anagers need to understand the fin a n cia l statements of potential customers to determ ine w hich customers to focus on an d w h ich ones to extend credit to. Purchasing m anagers need to understand suppliers' finan cia l statements to make sure they have the c a p a city to supply in the long term. Human resources m anagers use accounting inform ation in salary negotiations, an d inform ation systems designers need to include the accounting inform ation system in their design. If you are extrem ely talented a nd have d e c id e d to make your fortune as a sports star or m usician, you still need to know a b o u t acco u n tin g . W e suggest that understanding the fin a n cia l statements o f the S ydney C ricket G ro u n d or the O p e ra House w o u ld be o f benefit in negotiating w ith those organisations.
Preparers (decision facilita tors) T w o main groups are responsible for the inform ation in the fin a n cia l statements: •
M a n a g e rs are responsible for running an enterprise, including issuing accounting an d other inform ation, and controlling its fin a n cia l affairs. The fact that m anagers are also users, a n d a re vita lly interested in the results, has created a fundam ental conflict o f interest fo r them a nd has led to the developm ent o f the aud itin g function (see below ). M a n a g e rs are often referred to, as a g roup, as m anagem ent.
•
A ccountants have the jo b o f shaping the fin a n cia l statements by a p p ly in g the principles o f accounting to the enterprise's records, under the direction o f m anagem ent. M a n y accountants a re members o f professional societies, such as C PA A ustralia, C hartered A ccountants in A ustralia a n d N e w Z e a la n d , an d the H ong Kong Society of A ccountants. A ccountants an d their professional bodies also often have a u d itin g experience and interests, a nd sometimes aud itin g roles, but the task of p reparing the fin a n cia l statements is quite different in p rin ciple from the task o f verifying those statements once they are prepared.
A u ditors (cre d ib ility enhancers) Auditors report on the c re d ib ility o f the enterprise's fin a n cia l statements, on b e h a lf o f ow ners an d others. Auditors have the jo b of assisting the users by verifying that the fin a n cia l statements have been prepared fairly, com petently an d in a m anner consistent w ith acce p te d accounting principles. The aud itin g role is a very o ld one, arising because users dem a n d e d some assurance that m anagers' reports on their perform ance w e re not self-serving, biased o r d o w n rig h t untruthful. This b o o k refers frequently to external auditors, w h o report on the fin a n cia l statements on b ehalf o f external users, but there are also internal auditors, w h o w o rk w ithin the enterprise to support the c re d ib ility of inform ation being used b y m anagem ent, an d other auditors (such as tax auditors, w h o verify taxpayers' com putation o f tax). W h ile external auditors m ay be asked for a d v ice in p re paring the statements, e sp e cia lly for small com panies, they must a vo id responsibility for the statements because their role is to scrutinise the preparation process. They cannot cre d ibly a udit statements they have prepared! (Professional accountants often d o prepare fin a n cia l statements, but in so d o ing they are not acting as external auditors, a nd they make this cle a r in covering letters an d footnotes attached to the statements.) The external auditors are form ally a p p o in te d by the ow ners; for exam ple, at the annual shareholders' m eeting. But an enterprise's external a u d ito r is not perm itted to be an o w n e r or m anager o f the enterprise. For exam ple, they cannot o w n shares in the c o m p a n y an d they cannot a ct as a director o r m anager of the co m p a n y, even for a small
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
8
part o f the year. This is to ensure that the a u d ito r is fin a n cia lly an d ethically independent a n d can therefore be objective a b o u t the enterprise's fin a n cia l affairs. Independence a nd o b je ctivity a re fundam ental ideas that you w ill encounter frequently in this book. External auditors m ay w o rk a lo n e o r in partnership w ith other auditors in accounting firms. Som e o f these firms are very large, having thousands of partners an d tens o f thousands o f em ployees, a nd offices in m any cities and countries. A ccounting firms offer their clients not o nly external aud itin g but also a d vice on incom e tax, accounting, com puter systems an d m any other fin a n cia l an d business topics. H ow ever, if they conduct the a u d it there are rules in place a bout w h a t other services they can p rovide, as auditors cannot be involved in aud itin g their o w n w o rk, or creating a n y conflict-of-interest problem s. M a n a g in g this requires co n sid e ra b le professional skill a nd attention to the ethics and rules o f professional conduct. W h e th e r this is being d o n e successfully is a matter o f much controversy at present. In Australia, as w e ll as in m any overseas countries, there has been a d d itio n a l regulation a im e d a t im proving the independen ce o f auditors. The large accounting firms annually spend m any millions o f dollars on their independence a nd quality-control systems.
People and ethics Ethics, m entioned a b o ve , w ill be raised throughout this book. Ethical issues can arise in just a b o u t a n y area of accounting. H ere a re some exam ples, all o f them real: •
An enterprise has been sued by a recently fired e m ployee w h o claim s that the dismissed w a s based on the em ployee's a g e , a nd therefore broke em ploym ent law s. The enterprise's general m anager denies any im propriety. The enterprise's chief accountant, w h o personally feels that the form er em ployee's claim is justified, has suggested to the boss that the law suit should be m entioned in a note to the fin a n cia l statements, so that users o f the statements w ill kn o w there is a potential for loss if the form er em ployee w ins. The general m anager feels that the chief accountant should ignore the law suit in p re paring the fin a n cia l statements, to a v o id em barrassm ent and the a p p e a ra n c e o f adm itting guilt. The general m anager fears that such an a p p a re nt adm ission could be used against the enterprise in court an d so could cause the enterprise to lose the lawsuit. W h a t should the chief accountant d o ?
•
W h ile d o in g an audit, the external a u d ito r learns that the enterprise m ay have been cheating o ne o f its customers. The customer, w h o is un a w a re o f this a nd quite h a p p y w ith things, is another client o f the auditor. The auditor, w h o is bound by rules o f conduct designed to protect the c o n fid e n tia lity o f inform ation g a in e d during the audit, knows that saying anything to a n yo n e could result in m ajor lawsuits. Should the a u d ito r just keep quiet a b o u t w h a t w a s found?
•
A third enterprise's general m anager is p a id a bonus each year, calculated as a percentage o f profit. The general m anager is considering a proposed ch a n g e o f depreciation method that w ill reduce d e p re cia tio n expense and therefore raise accrual profit an d increase the general m anager's bonus. Should the general m anager refuse to im plem ent the accounting ch a n g e, request that the bonus calculation ignore the change, o r just g o a h e a d and e n jo y the higher bonus? These illustrative problem s d o not have easy answers, so none are offered here. They are dilem m as for the chief
accountant, the a u d ito r an d the general m anager. This b o o k w ill address ethical issues from tim e to time, helping you to sharpen your ethical sense a lo n g w ith your accounting kn o w le d g e - the tw o are inseparable.
1.5
Accrual accounting
Financial accounting's task of p ro ducing fin a n cia l statements is a co m p le x one. For even a small business, thousands o f events (transactions) have to be recorded an d their fin a n cia l effects evaluated. For large corporations such as BHP Billiton, Lend Lease, Rio Tinto, W o o lw o rth s , A M P , Q a n ta s an d W e s tp a c , o r organisations such as the University of N e w South W a le s , Brisbane C ity C o u n cil o r the Red Cross, the num ber o f annual transactions runs into the m illions or billions. Frequently, w hen the tim e comes to prepare the fin a n cia l statements, some transactions have not been com pleted, are in dispute o r have an otherw ise unclear status. Here a re exam ples in w h ich a p p ro p ria te figures m ay be difficult to determ ine:
CHAPTER 1 Introduction to Financial accounting
•
9
The value o f W e s tp a c 's overseas loans (i.e. the m oney actu a lly to be received b a ck from those loans) depends on the health o f the b o rro w in g countries' econom ies, stability in international money-transfer arrangem ents (often disrupted by w ars, politics a nd natural disasters) an d the relative values of various countries' currencies, w h ich , like nickel prices, can ch a n g e a lot from d a y to d a y.
•
The value of donations prom ised to the Red Cross but not yet received depends on h o w com m itted donors a re to actu a lly producing the cash. This com m itm ent can be affected by unem ploym ent, rising prices for fo o d a nd other g o o d s the donors need, an d other factors beyond the Red Cross's control.
•
The am ount o f profit that should be recognised during the ye a r by Leighton H oldings for the construction o f a m ajor b rid g e that w ill take tw o years to com plete w ill d e p e n d on future expenses. To c o p e w ith these com plexities, fin a n cia l accounting for most businesses an d organisations uses the accrual
accounting a p p ro a ch . U nder an accrual accounting system, the im pact of transactions on the fin a n cia l statements is recognised in the tim e periods during w h ich revenues an d expenses occur, rather than w hen the cash is received or p a id . Formal definitions o f revenues a nd expenses can be quite c o m p lica te d , a nd a re left to C h a p te r 2. A t this stage, w e w ill pro vid e exam ples o f the main types o f revenues an d expenses. The main form o f revenue is usually the sale o f g o o d s or services; for exam ple, the sale o f coffee m achines for $ 4 5 0 0 0 o r carrying out the installation o f a n ew com puter system for $ 3 0 0 0 0 0 . O th e r revenues include interest on investments held, dividends received on shares an d rent from premises o w n e d by the com pany. Expenses include the costs of services an d resources consum ed in the process o f generating revenues. Examples o f costs incurred are w a g e s, electricity, travel an d rent. An exam ple o f resources consum ed is de p re cia tion. O rga n isa tio n s d e p re cia te the cost o f an asset (such as a m otor vehicle o r a printing machine) over the useful life o f the asset; that is, each ye a r a percentage o f the cost of the asset becom es an expense. These assets are helping in generating revenue; therefore, a share o f the cost should be treated as an expense in each accounting period during w h ich the asset helps generate revenue. W h y d o w e d e p re cia te the cost of an asset over its useful life rather than treat the cost o f the asset as an expense in the first year? The reason is that the asset is used over m any years an d helps generate revenue over m any periods. This de p re cia tio n expense is m atched to the revenues earned during the p e riod. N o te that estimates need to be m ade. For exam ple, a printing m achine that cost $ 4 8 0 0 0 0 w o u ld have annual dep re cia tio n o f $ 1 2 0 0 0 0 , $ 9 6 0 0 0 o r $ 8 0 0 0 0 , d e p e n d in g on w hether its estim ated life is four, five o r six years; that is, the judgem ent on the useful life o f the m achine has an im pact on p rofit each year.
HOW'S YOUR UNDERSTANDING? L is t th e m a in re v e n u e s an d e x p e n s e s f o r a c o ffe e c a r t y o u see o n c a m p u s o r in th e c ity . Y o u r a n sw e rs s h o u ld be as fo llo w s . T h e m a in re v e n u e w ill c o m e fr o m c o ffe e sales. I f all sales a re cash sales it w o u ld be th e cash re c e iv e d f o r th e c o ffe e s sold . B u t n o te th a t s o m e c u s to m e rs m a y ha ve an a c c o u n t w h e re all c o ffe e s sold t o th e m are re c o rd e d an d th e n th e y pa y th e w h o le a m o u n t th e fo llo w in g m o n th o n re c e ip t o f an in v o ic e . N o te th a t u n d e r a c c ru a l a c c o u n tin g it is th e d e liv e ry o f th e s e rv ic e (i.e . h a n d in g o v e r th e c u p o f c o ffe e ) th a t re s u lts in re v e n u e b e in g re c o g n is e d . L ik e ly e x p e n s e s in c lu d e : •
th e c o s t o f c o ffe e
•
th e c o s t o f c u p s
•
w ag es
•
r e n t o f sp a c e (e .g . t o th e u n iv e rs ity )
•
d e p re c ia tio n o n th e c o ffe e m a c h in e .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
10
Accrual accounting versus cash accounting Before considering these com plexities, let's consider the basic differences betw een cash accounting an d accrual accounting. •
C ash a ccou n tin g involves recording revenues an d expenses a t the tim e the cash is received o r p a id . This is reasonably precise, because the accountant knows w h e th e r cash has been p a id o r received an d the exact am ount is easily determ ined (from accounting books o r bank statements).
•
H ow ever, often the tim ing o f cash flo w is in a different accounting period from the substance o f the transaction. Examples include selling inventory on credit; w hen a contractor fixes m achinery but w ill not be p a id until a later accounting p e riod; o r the use o f m achinery, w h ich reduces its future useful life. As noted a b o v e (but w orth repeating), a ccru a l a ccounting incorporates these com plexities b y re co rd in g revenues a n d expenses a t the time they occur, not w hen cash is received. To c om pare cash profit w ith accrual profit, consider the fo llo w in g :
•
A c o m p a n y makes credit sales o f $ 1 0 0 0 0 0 in June, w h ich w ill be collected in July. U nder an accrual system, $ 1 0 0 0 0 0 revenue w o u ld be included in June, w hereas under a cash system the am ount w o u ld be recognised in July.
•
A contractor carries out repair w o rk for your c o m p a n y in June for $ 2 0 0 0 0 , but the bill w ill not be p a id until July. U nder an accrual system, the expense w o u ld be recognised in June, but under a cash system it w o u ld not be recognised until July.
•
U nder accrual accounting there w ill be an a llo ca tio n o f the cost o f equipm ent to expenses over several accounting periods to recognise the consum ption o f the equipm ent's future e co n o m ic value. This is ca lle d d e p re cia tio n . If some new equipm ent cost $ 8 0 0 0 0 a nd has a life of e ig h t years, $ 1 0 0 0 0 de p re cia tio n w o u ld be included in expenses each year.
HOW'S YOUR UNDERSTANDING? In J u n e , a c o m p a n y m a ke s cash sales o f $ 1 0 0 0 0 and c re d it sales o f $ 2 0 0 0 0 (a ll t o be c o lle c te d in J u ly J. It pays w ag es o f $ 6 0 0 0 and o w e s $ 1 0 0 0 f o r J u n e e x p e n s e s ( t o be paid in J u ly J.
1 2
W h a t is p r o fit u s in g cash a c c o u n tin g ? W h a t is p r o fit u s in g a c c ru a l a c c o u n tin g ? Y o u r a n sw e rs s h o u ld be:
1
$10 0 0 0 - $ 6 0 0 0 = $ 4 0 0 0
2
$10 0 0 0 + $ 2 0 0 0 0 - $ 6 0 0 0 - $ 1 0 0 0 = $ 2 3 0 0 0 .
Using accrual accounting to prepare financial statem ents Using the accrual accounting a p p ro a ch in p re paring the fin a n cia l statements, attempts are m ade to: •
include all the cash receipts a nd payments that have a lre a d y happe n e d ; for exam ple, cash sale a n d cash paym ent fo r w a g e s
•
incorporate future cash receipts a nd payments that should be expected, based on existing transactions; for exam ple, it is necessary to include the credit sale n o w , although the cash w ill not arrive until the next period
•
measure the value o f incom plete transactions; for exam ple, estim ate the likely am ount o f accounts receivable that w ill not be collected, a nd treat the am ount as an expense o f this ye a r
•
estim ate figures w hen exact amounts are unknow n; for exam ple, estim ate the am ount o f interest due from the bank at year-end, even though the b a n k does not a d d the interest to yo u r account for another tw o months - the am ount is interest revenue
CHAPTER 1 Introduction to Financial accounting
•
11
make an e co n o m ica lly m eaningful overall assessment of a w k w a rd problem s; for exam ple, a customer is suing you for $ l m illion because o f a faulty product. You a g re e to p a y $ 2 0 0 0 0 0 in settlement now , but the client takes the matter to court, w ith the case to be held next year. You need to determ ine if there is an expense in this year. C o m p lica tio n s such as this can be left to later chapters, but it is im portant to realise early that there are com plications in determ ining profit.
Estim ates and assessm ents N o tic e the use o f the w o rd s 'estim ate' an d 'assessment' a b o ve . This illustrates the need for judgem ents w hen preparing fin a n cia l statements. Further exam ples o f estimates for the situations described earlier for W e s tp a c , Red Cross a nd Leighton H o ld in g s a re as follow s. •
In ord e r to ju d g e the value o f W e s tp a c 's uncollected loans, som eone studies the loan repaym ent record o f various countries for W e s tp a c a nd estimates h o w much m oney the bank w ill be a b le to collect.
•
To help the Red Cross make its spending plans, som eone advises the Red Cross on h o w much o f the prom ised donations is likely to be received.
•
Som eone calculates the costs involved in bu ild in g the b rid g e to this point. Based on such estimates as the percentage o f the jo b com pleted, he o r she also estimates the total likely profit o f bu ild in g the b rid g e and determines the percentage o f profit to be included in this period.
•
All com panies have to estim ate the am ount o f m oney o w in g to em ployees at the end o f each year.
The im portance o f good ju d g e m e n t A ccrual accounting has been d e ve lo p e d because fin a n cia l statements cannot be based on merely the routine accounting records o f w h a t has h a p pened. M e a su rin g e conom ic perform ance is m ore co m p le x than that, an d the a p p ro p ria te measures can be elusive o r can d e p e n d on one's point o f v ie w . M a n y augm entations to the transactional record (estimates, adjustments, judgem ents a nd verbal explanations) must be m ade so that the statements w ill be m eaningful. The resulting statements, therefore, d e p e n d to a g re a t extent on the q u a lity a nd fairness of such augm entations. M a n a g e rs, accountants a nd auditors must use their judgem ent constantly. Financial a ccounting, because it relies on m any judgem ents, is fa r more im precise than most p e o p le (even many regular users of fin a n cia l statements) realise. To help students understand the reality o f modern fin a n cia l accounting, this b o o k spends much space on the real-life im precisions o f p reparing a nd using fin a n cia l statements. A ccrual accounting is therefore the presumed method in this book, though there w ill be some com parisons betw een it and sim ple cash-based a ccounting. M o d e rn fin a n cia l accounting starts w ith cash receipts an d paym ents, then builds a very large accrual accounting process in a d d itio n to the cash records in o rd e r to pro vid e the sophisticated measures o f fina n cia l perform ance an d position that to d a y's w o rld dem ands.
FOR YOUR INTEREST M a n y o f y o u w ill e n d u p w o rk in g as a c c o u n ta n ts o r m a n a g e rs f o r o rg a n is a tio n s th a t o p e ra te in m a n y c o u n trie s . T h is b o o k s h o u ld e q u ip y o u t o u n d e rs ta n d th e fin a n c ia l s ta te m e n ts p re p a re d in m o s t c o u n trie s , in c lu d in g A u s tra lia , th e U n ite d S ta te s , th e U n ite d K in g d o m , C a n a d a , N e w Z e a la n d , C h in a , S in g a p o re , FHong K o n g , In d o n e s ia , M a la y s ia and m a n y o th e rs . T h e m e th o d s o f p re p a rin g fin a n c ia l s ta te m e n ts in th e s e c o u n trie s are v e ry s im ila r. A ll use th e a c c ru a l a c c o u n tin g s y s te m in tro d u c e d in th is c h a p te r. W it h th e in tr o d u c tio n o f In te rn a tio n a l F in a n c ia l R e p o rtin g S ta n d a rd s (IF R S ) in 2 0 0 5 , d iffe re n c e s b e tw e e n fin a n c ia l r e p o rtin g in th e s e c o u n trie s a re lik e ly to be v e ry sm all.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
12
1.6
The key financial statem ents
O rganisations are required to p ro vid e the fo llo w in g types o f inform ation that are relevant to user needs: financial position, fina n cia l perform ance, fin a n cin g activities a nd investing activities. The key finan cia l statements that p ro vid e this inform ation are: a balance sheet, w h ich shows the fin a n cia l position at a point in time; an income statem ent, w h ich measures fin a n cia l perform ance over a d e fined p eriod (such as a month o r a year) b y deducting expenses from revenues during the p eriod to o btain profit for the p e riod; a nd a statem ent of cash flows, w h ich shows the sources a n d uses o f cash during the p e riod. Both fin a n cin g a nd investing activities are included in this statement.
Balance sheet Exhibit 1.1 provides an exam ple o f a sim ple b a la n ce sheet. The b a la n ce sheet shows an o rg anisation's resources and claim s on resources a t a particular point in time. The hea d in g provides the c o m p a n y name, the title o f the report and the date a t w h ich the fin a n cia l position is show n. The three main elements o f a b a la n ce sheet are assets, liabilities and shareholders' equity. In this case, the o rganisation is a co m p a n y, a n d shareholders' equity is described as shareholders' equity. If the organisation w e re a sole trader o r partnership, it w o u ld be ca lle d proprietor's equity or partners' equity, respectively.
ASSETS Assets are the future e conom ic benefits that are controlled by an organisation as a result o f past transactions o r other past events. The value o f every asset needs to be m easurable in m onetary terms. A brief discussion o f the assets in Exhibit 1.1 w ill make you fa m ilia r w ith the term inology.
CHAPTER 1 Introduction to Financial accounting
13
•
The cash at bank a ccount records deposits an d w ith d ra w a ls from a bank.
•
A ccounts receivable (also ca lle d debtors) represents am ounts o w in g from customers for g o o d s o r services pro vid e d to them. Accounts receivable is shown net, w h ich indicates the am ount that m anagem ent expects to co lle ct from customers after a llo w a n ce s have been m ade for likely uncollectable amounts.
• •
Inventory g e n e ra lly represents the cost o f stock on hand; that is, unsold products. Property, plant an d equipm ent includes items such as land, buildings, equipm ent, motor vehicles, com puters and furniture. Assets can be financed in one o f tw o w a ys: liabilities a n d /o r shareholders' equity: Assets = Liabilities + S h areh o ld ers' eq u ity
LIABILITIES L ia b ilitie s a re the future sacrifices o f econom ic benefits that an organisation is presently o b lig e d to make to other organisations o r individuals as a result o f past transactions or events. For exam ple, suppliers providing goods on credit and em ployees carrying out w o rk are exam ples o f past transactions that lead to liabilities. Liabilities can be legally o w e d debts, such as loans from the bank, m ortgages or amounts due to suppliers. H ow ever, they also can be estimates o f future payments based on past agreements, such as those arising from promises o f future benefits to employees for long service leave, or o f w arranty repairs for customers w hen products break d o w n . Liabilities involve the future use of assets, usually cash, o r the perform ance of future services. An exam ple o f the form er is paying cash to reduce a liability. An exam ple of providing a future service w o u ld be carrying out w arranty repairs on products previously sold. Four exam ples o f liabilities in Exhibit 1.1 a re a cco u n ts p ayable, w a g e s p a ya b le , provision for em ployee entitlements an d long-term loans. •
A ccounts p a y a b le (often c a lle d trade creditors) is the am ount o w e d to various suppliers for g o o d s o r services they have pro vid e d to an organisation.
•
W a g e s p a y a b le (also called accrued w ages) is for w o rk done by employees, but for w hich they have not been paid.
•
Provision for e m ployee entitlements refers to entitlements em ployees accum ulate as a result of past w o rk , such as h o lid a y leave, sick leave, long service leave a nd superannuation.
•
Long-term loans a re loans that are not re p a ya b le w ithin a year.
SH A R EH O LD ER S' E Q U ITY Shareholders' equity is the excess o f assets over liabilities. It is a residual claim o f the shareholders on the assets o f the organisation. S hareholders' equity consists o f tw o main elements: share c a p ita l an d re ta in e d p ro fits . • •
Share c a p ita l is the am ount that ow ners have directly invested in the com pany. R etained profits represent the total cum ulative amounts o f profits that the c o m p a n y has retained in the business rather than distributed as dividends. The relationship betw een assets, liabilities an d shareholders' equity can be expressed in the fo llo w in g a cco u n tin g
e q u a tio n : Assets = Liabilities + S h areh o ld ers' eq u ity This equation shows that the resources o f an enterprise are funded from tw o types o f sources: d e b t o r equity. The effects o f transactions on this equation are discussed in C h a p te r 2 . A t this point you should note that the equation balances a t every point in time.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
14
HOW'S YOUR UNDERSTANDING? F o r e a ch o f th e fo llo w in g ite m s s ta te w h e th e r th e y are assets ( A ) , lia b ilitie s (L ), s h a re h o ld e rs ’ e q u ity (S E ) o r n o t lis te d in th e b a la n c e s h e e t:
1 a c c o u n ts re c e iv a b le 2 a c c o u n ts p a ya b le 3
sales re v e n u e
4 s h a re c a p ita l 5 e q u ip m e n t 6 loans Y o u r a n sw e rs s h o u ld be: 1
A
2
L
3
N o t lis te d in th e b a la n c e s h e e t
4 SE 5 A 6 L
C om parative balance sheets N o te that the b a la n ce sheet in Exhibit 1.1 shows numbers for 2 0 1 5 an d 2 0 1 6 . The changes from 2 0 1 5 to 2 0 1 6 provide the reader w ith inform ation a b o u t w h a t is h ap p e n in g to various a ccount balances; for exam ple, cash a t bank has increased from $ 1 4 0 0 to $ 2 0 0 0 . The statement does not tell us the reasons for the ch a n g e, but it is possible to obtain inform ation on the c h a n g e in this a ccount in the statement o f cash flow s p rovided in Exhibit 1.3 (to be discussed later). W h ile some o f the reasons for the changes in other balances a re too c o m p lica te d for this introductory chapter, you w ill be a b le to understand the changes after you have com pleted the next tw o chapters (w e w ill return to Exhibit 1.1 in C h a p te r 2). For no w , consider some prelim inary ideas: •
W h a t w o u ld be a likely e xplanation for the increase in accounts receivable? M o s t likely credit sales (this w o u ld increase accounts receivable) are greater than cash received from customers related to credit sales (this w o u ld decrease accounts receivable).
•
W h a t does the increase in share ca p ita l m ean? This norm ally indicates that there have been shares issued during
•
The long-term loans have decreased from $ 3 3 6 0 0 to $ 3 0 0 0 0 , in d ica tin g the c o m p a n y has b o rro w e d less than
the year.
it has repaid on the loans.
HOW'S YOUR UNDERSTANDING? 1
I f th e balances o f to ta l assets and sh a re h o ld e rs’ e q u ity are $ 1 0 0 0 0 0 and $ 4 0 0 0 0 , re sp e ctive ly, w h a t is th e balance o f to ta l liabilities?
2
I f th e balances o f to ta l liabilities and sh a re h o ld e rs’ e q u ity are $ 2 0 0 0 0 0 and $ 3 0 0 0 0 0 , re sp e ctive ly, w h a t is th e balance o f to ta l assets?
3
G ive n th e balances o f assets $ 3 0 0 0 0 0 , liabilities $ 2 0 0 0 0 0 and share capital $ 6 0 0 0 0 , w h a t is th e balance o f re ta in e d p ro fits ? Y o u r answers should be: $ 6 0 0 0 0 , $ 5 0 0 0 0 0 and $ 4 0 0 0 0 .
CHAPTER 1 Introduction to Financial accounting
15
Income sta te m e n t In previous years, the incom e statement w a s called the profit a nd loss statement. Som e com panies m ay continue to use that term inology w ithin their internal reports, so you should at least be a w a re o f it. The incom e statement provides inform ation on an o rg a nisation's p ro fita b ility for a period o f time. It matches revenues during a p eriod aga in st expenses incurred in earning the revenues. The difference is the p ro fit (revenue greater than expenses) o r loss (expenses greater than revenue). Recall that under an accrual accounting system, the cash related to the revenue o r expense does not have to be received o r p a id in o rd e r for the revenue o r expense to be included in the incom e statement. Discussion of w hen revenue a nd expenses are recognised is included in C h a p te r 2. Exhibit 1 .2 provides an exam ple of a sim plified incom e statement. Sales is the o nly revenue item listed. The next item in the incom e statement is co st o f goods sold (COGS). For a retailer, this w o u ld be the purchase price of the g o o d s that a re sold. For exam ple, if a retailer sells 1 0 0 items at $ 2 0 each a nd the cost price of each o f the items is $ 8 , sales revenue w o u ld be $ 2 0 0 0 ($ 2 0 x
1 0 0 ) a nd cost o f g o o d s sold w o u ld be
$ 8 0 0 ($ 8 x 1 0 0 ). The difference betw een sales revenue a nd cost o f g o o d s sold is called gross p r o fit (also gross m argin).
EXHIBIT 1.2 IN C O M E S T A T E M E N T FOR TH E YEAR ENDED 3 0 JUNE 2 0 1 6
$000 Sales revenue
$000 21 000
Less Cost of goods sold
8 000
Gross profit
13 000
Less Operating expenses Salaries
2 500
Depreciation
500
Electricity
300
Travel
300
Other
400
Operating profit before tax
4000 9 000
Less Income tax expense
3 000
Operating profit after tax
6 000
The incom e statement also lists various o perating expenses, as show n in Exhibit 1 .2 . These costs relate to the dayto-day running o f the business. M a n y other op e ra tin g expenses, such as advertising, staff training, m aintenance, telephone an d motor vehicle expenses, could also be included. Deducting these op e ra tin g expenses from gross p rofit gives op e ra tin g p ro fit b e fo re ta x. Tax is then deducted to g ive o p erating profit after tax. The p rofit figure o f $ 6 m illion can be p a id out in d ividends to shareholders o r retained in the business. This is the connecting link betw een the b a la n ce sheet a nd the incom e statement. The ope n in g b a la n ce o f retained profits plus the profit fo r the ye a r minus dividends equals the closing b a la n ce o f retained profits as shown in the bala nce sheet.
16
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C om panies pro vid e a separate statement o r note to the accounts sh o w in g the ch a n g e in retained p rofit for the year. For exam ple, if XYZ's o p e n in g retained profits w e re $ 2 4 m illion, net p rofit for the ye a r w a s $ 6 m illion and dividends o f $ 3 m illion w e re d e cla re d a nd p a id , w e w o u ld see the fo llo w in g statement in the notes to the accounts for retained profits. $ million 1 Opening balance
24
+ Net profit
_6
- Dividends declared and paid
_3
Closing balance
27
30
S tate m ent o f cash flow s Because revenues reported usually d o not equal cash collected a nd expenses d o not equal cash p a id , net profit is different from the ch a n g e in cash for the p e riod. The statement o f cash flow s shows the changes during the period in one b alance sheet account, nam ely cash. It shows the receipt o f cash a nd the paym ent o f cash. A cco u n tin g sta n d a rd s require com panies to present this statement in their published fin a n cia l statements. Individual transactions are norm ally split into the fo llo w in g three categories: 1 2
o p e ra tin g a c tiv itie s : related to the provision o f g o o d s a nd services in v e stin g a c tiv itie s : related to the acquisition an d disposal o f certain noncurrent assets, including property, plant and equipm ent
3
Financing a c tiv itie s : related to c h a n g in g the size a nd com position o f the fin a n cia l structure o f the entity, including equity and certain b orrow ings. Exhibit 1 .3 provides an exam ple o f a statement o f cash flow s. U nder cash flow s from o p erating activities, it shows
that the c o m p a n y received $ 1 7 m illion from customers, an d p a id $ 7 .7 m illion an d $ 2 .5 m illion to suppliers and em ployees respectively, as w e ll as p a yin g $ 4 .3 m illion in other op e ra tin g costs.
CHAPTER 1 Introduction to Financial accounting
17
N o te that these figures are not the sam e as those in the incom e statement. For exam ple, the c o m p a n y could have m ade $ 21 m illion in credit sales, but o n ly collected $ 1 7 m illion from customers by the end o f the year. There w a s only on e investing item, being the cash p a id for a n e w m achine. C ash flow s from fin a n cin g activities sh o w that the c o m p a n y received $ 4 m illion from an issue o f shares, but p a id b a ck a $ 3 .6 m illion ba n k loan. The net effect on cash o f all of the a b o v e transactions w a s an increase o f $ 6 0 0 0 0 0 . W h e n a d d e d to the o p e n in g b a la n ce of $ 1 .4 m illion, it shows a closing b a la n ce o f $ 2 m illion, w h ich is also the figure shown under cash in the bala nce sheet. Statements o f cash flow s w ill be discussed in detail in C h a p te r 14.
FOR YOUR INTEREST J u s t a re m in d e r th a t in th e s e e a rly c h a p te rs m a k e s u re y o u g o to th e g lo s sa ry w h e n y o u e n c o u n te r a n e w te rm .
1.7
Relationships between the financial statem ents
Exhibit 1 .4 shows the main relationships betw een the various fin a n cia l statements. W e have a b b re via te d the bala nce sheet, the incom e statement a nd the cash flo w statement in Exhibits 1 .1 , 1 .2 an d 1.3 to make the relationship clearer. The cash flo w statement explains the ch a n g e in cash in the b a la n ce sheet from $ 1 4 0 0 to $ 2 0 0 0 . This ch a n g e w ill be from cash flow s from o p e ra tin g , investing a nd financing activities, a nd a closer exam ination o f Exhibit 1.3 w ill sh o w w h ich cash flow s have the m ajor im pact. N e t p rofit o f $ 6 0 0 0 for the ye a r app e a rs in the incom e statement, a n d this am ount increases retained profits. H o w this w orks can be seen in the note on retained profits, w h ich has increased from $ 2 4 0 0 0 to $ 2 7 0 0 0 , du e to the net profit for the ye a r less the dividends d e cla re d and p a id ; that is, the am ount o f net p rofit not used for d ividends increases the b a la n ce of retained profits.
EXHIBIT 1.4 R ELA TIO N SH IP S B ETW EEN TH E STA TE M E N TS (BASED ON EXHIBITS 1.1 TO 1.3)
Balance Sheet Cash
2016
Cash Flow Statement
2015
2,000
1,400
Other assets
11 8,000
114,000
Total assets
1 ,4 0 0 — > 2 ,0 0 0
115,400
Income statement 24,000 6 ,00 0 30,000
— Dividends
From financing activities
Revenues
21,000
Expenses*
15,000
Net profit
3,000 27,000 6 ,0 0 0
18
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? I f th e o p e n in g b a la n c e in re ta in e d p r o fits is $ 1 0 0 0 0 0 , n e t p r o fit a fte r ta x is $ 6 0 0 0 0 an d d iv id e n d s d e c la re d and pa id is $ 4 0 0 0 0 , w h a t is th e b a la n c e o f re ta in e d p ro fits a t y e a r-e n d ? Y o u r a n s w e r s h o u ld be : $ 1 0 0 0 0 0 + $ 6 0 0 0 0 — $ 4 0 0 0 0 = $ 1 2 0 0 0 0 .
Dem ands on the qu a lity o f financial accounting in fo rm a tio n Let's think about w h a t the users o f fin a n cia l inform ation (such as the board o f directors, the analyst, the banker a nd the supplier discussed in section 1 .3 ] m ight reasonably expect o f the fin a n cia l statements. The im portant accounting concepts and principles involved are described in italics. 1
The financial statements need to contain inform ation that is useful to those w h o are making the decisions. The inform ation must have value in helping the financial analyst o r the bank lending officer make their recom m endation. In addition, the inform ation to be provided needs to be supplied in a tim ely manner. For exam ple, some o f the decisions by the board o f directors, the analyst, an d the banker an d the supplier noted earlier need to be m ade at a certain point in time. W h ile the outcom e o f a particular contract m ay be relevant inform ation, the decisions often cannot w a it until that contract has been finalised. This is the c o n ce p t o f relevance, tf inform ation is to assist users in m aking decisions a b o u t the a llo ca tio n o f scarce resources, it should help them make, confirm o r correct pre d ictio n s a b o u t the outcom es o f past, present or future events.
2
The financial statements should not be d e lib e ra te ly m isleading. They should be free from bias. They should not be designed to lead users tow ards conclusions that are desired by the preparers. If accounting inform ation is to tell p eople a b o u t the e co n o m ic forces affecting the co m p a n y, an d the business arrangem ents the c o m p a n y has m ade to deal w ith those forces, it should connect to such im portant underlying phenom ena. The ba n k loans officer w o u ld w a n t to feel confident that the statements w e re not prepared in such a w a y as to make the co m p a n y a p p e a r to be a better lending risk than it is. Sim ilarly, the b o a rd o f directors w o u ld w a n t the statements to provide an objective portrayal o f the C E O 's perform ance in running the com p a n y. This is the criterion o f 'faithful representation', previously referred to as reliability. The fin a n cia l statements should report the eco n o m ic substance o f events h a p p e n in g to the com pany, a n d the numbers should measure the events neutrally, neither overstating n o r understating their im pact. Reliable inform ation w ill, w ith o u t bias o r undue error, faithfully represent those transactions a n d events that have occurred. To have p e rfe ct faithful representation the fin a n cia l inform ation needs to be com plete, neutral a n d free from error. W h ile such perfection is seldom com pletely a c h ie va b le , the b o a rd o f d irectors' o b je ctive is to m axim ise these qualifies.
3
Preparing fin a n cia l statements, like a n y other activity, costs m oney an d takes time. M o s t p e o p le w o u ld be satisfied if the statements w e re fa ir in relation to the im portant things an d w o u ld not mind a fe w m inor errors in them, e specially if preventing small errors w o u ld cost the c o m p a n y m oney (reducing the com pany's p rofit an d cash flow ) o r d e la y the release o f the statements. A sales m anager w o u ld not w a n t to w a it for the statements w h ile accountants c h a n g ed the cost o f the com pany's inventory o f unsold items (part of the m ulti-m illion-dollar inventory account) from $ 1 1 8 9 to $ 1 1 9 9 . This is the criterion o f m a te ria lity (significance). The m ateriality c o n ce p t is c o n ce rn e d w ith assessing w hether om ission, misstatement o r non-disclosure o f a p ie c e o f inform ation w o u ld a ffe ct the decisions o f users o f the a ccounting reports. Just w h a t is o r is no t m aterial is a m atter o f judgem ent, a n d has been the subject o f considerable research a n d study b y accountants a n d auditors. Usually, p e o p le ju d g e m ateriality b y considering the size o f a possible error c o m p a re d to the net p ro fit o r the to ta l assets. For exam ple, an acco u n ta n t o r a u d ito r m ight ju d g e that an error o ver 5 p e r cent o f net p ro fit o r 1 p e r cent o f total assets is m aterial a n d a sm aller one is not. But, as you m ight expect, the m ateriality jud ge m e n t dep e n d s on a n y p a rticu la r uses o f the inform ation that are expected, a n d on w hether the error moves the p ro fit to a loss o r violates some loan co ndition.
CHAPTER 1 Introduction to Financial accounting
19
4 There needs to be some standard a g a in st w h ich an accounting method o r num ber can be jud g e d . The fin a n cial analyst w o u ld like to kn o w that the com pany's fin a n cia l statements w e re presented fairly, in all m aterial respects, given acce p te d current methods. In the incom e statement, for exam ple, sales revenue should mean w h a t a kn o w le d g e a b le analyst o r other user w o u ld expect for such a com pany. The c o m p a n y is actually a g ro u p of com panies, so its fin a n cia l statements are co n so lid a te d , a n d it w o u ld be reasonable to expect that the com pany's method of ca lculating co n so lid a te d figures w a s proper. This is w here generally accepted accounting principles (GAAP) com e in. To assure the users that a cce p te d m ethods have been fo llo w e d , the auditor's report also says that the auditor's o p in io n is that the statements have been p re p a re d in a cco rd a n ce w ith g e n e ra lly a c ce p te d a cco u n tin g principles. This does not m ean that on e p a rticular m ethod has been fo llo w e d : G A A P often include several a cce p ta b le methods, d e p e n d in g on the circumstances. Therefore, the a u d ito r is saying that the co m p a n y's a cco u n tin g methods, a n d the resulting figures, are a p p ro p ria te to its circumstances. 5
The previous criteria in d ica te that the fin a n cia l statements necessarily reflect judgem ent on the part o f the preparers. A lso, the figures in the statements are summaries o f m any accounts; for exam ple, 'accounts receivable' an d 'long-term d e b t' m ay include dozens o r thousands o f different customers o r debts. The bank loan officer m ay w a n t to kn o w w h a t sort o f long-term debts the c o m p a n y has, so that they m ay be evaluated a g a in st the bank b o rro w in g by the co m p a n y. The bank w o u ld not w a n t other creditors to interfere w ith the co m p a n y's a b ility to pay b a ck the bank. The fin a n cia l analyst m ay w a n t to kn o w if the c o m p a n y has m ade commitments to issue more shares (such as in a plan to m otivate senior m anagem ent b y issuing shares to them ch e a p ly if they perform w ell), because those m ight reduce the equity o f a n yo n e buying the shares now . This raises the p rin cip le o f disclosure. The fin a n cia l statements include a la rg e num ber o f notes a n d account descriptions intended to m ake it cle a r to the re a d e r w hich im portant a cco u n tin g methods have been fo llo w e d (especially if those methods are no t w h a t m ight be expected) a n d to p ro vid e supplem entary inform ation on debts, share ca p ita l, commitments, la w suits a n d other things thought to b e helpful, o r necessary, in understanding the statements. Disclosure b e y o n d the a cco u n tin g figures is b e co m in g increasingly extensive: m a n y p a g e s o f notes often a c co m p a n y the set o f statements, a n d com panies disclose a d d itio n a l inform ation to taxation authorities, to securities regulators (such as the A ustralian Securities a n d Investments C om m ission a n d the US Securities a n d E xchange Com m ission) a n d to im portant other parties w h o have a reason to g e t the inform ation (such as the bank loan o ffice r a n d the fin a n cia l analyst).
6
The b o a rd , the banker, the analyst an d the supplier w o u ld like inform ation they can understand. U ndoubtedly, their a b ility to understand w ill depe n d on their kn o w le d g e o f a ccounting, as fin a n cia l reports are p repared for users w h o have a reasonable kn o w le d g e o f business including acco u n tin g . H opefully this w ill be you in a fe w years. This p rin cip le is c a lle d understandability. Reports should b e p re p a re d h a vin g re g a rd to the interests o f users w h o are w illin g to exercise d ilig e n c e in e xa m in in g the reports, a n d w h o possess the skills a n d a b ility to co m p re he n d co n te m p o ra ry a cco u n tin g practices.
7
The banker an d the fin a n cia l analyst are also involved w ith other com panies. They w o u ld like to be a b le to c o m p a re the co m p a n y's fin a n cia l statements w ith those o f sim ilar com panies. It m ay be difficult to be sure that a c o m p a n y is perform ing w e ll o r b a d ly in an absolute sense, but it can a lw a ys be co m p a red to others, as long as the fin a n cia l statements have been prepared in a c o m p a ra b le w a y . You w ill not b e surprised that this p rin cip le is c a lle d comparability. It w ill b e im portant w hen w e re view techniques fo r fin a n cia l statement analysis in C h a p te r 15 .
8 The banker, the analyst a nd the bo a rd o f directors w ill also w a n t to study the trend in fin a n cia l perform ance and position over time. Is the net profit im proving over time, o r d e te riorating? H o w a b o u t liquidity? O r the ratio of debt-to-equity fin a n cin g ? It is im portant to kn o w if sig n ifica n t events have h a p pened to make com parisons over tim e difficult o r even im possible. It is also im portant to kn o w if the c o m p a n y has ch a n g ed its accounting methods over time, because such changes m ay affect the c o m p a ra b ility o f the accounting figures from y e a r to year.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
20
K eeping the same accounting methods over tim e is ca lle d consistency. If the c o m p a n y is fo llo w in g G A AP , consistent methods w ill be used, o r the reader o f the statements w ill be told if a ch a n g e has been m ade, an d w h a t the effects o f changes in accounting methods a re (if they are material). N o te that consistency does not mean that a c o m p a n y has to use the sam e accounting method in all parts o f the co m p a n y. For exam ple, different d epreciation methods can be used for different assets. W e can form alise some o f the a b o v e ideas by relating them to the conceptual fram ew ork put out by the Australian A ccounting Standards B oard (AASB) in its docum ent Fram ew ork for the P reparation a n d Presentation o f Financial Statements (hereafter c a lle d the Framework). The Fram ework, w h ich w a s revised in D ecem ber 20 1 3, notes that these qualitative characteristics a re the attributes that make the inform ation in the fin a n cia l reports useful to users. It lists tw o fundam ental qualitative characteristics: relevance a n d faithful representation. In a d d itio n , it notes that c o m p a rab ility, verifiability, timelines a n d understandability are characteristics that enhance the tw o fundam ental characteristics. In summary, the qualitative characteristics set out in the Fram ew ork are: 1
2
Fundamental q u alitative characteristics: -
relevance
-
faithful representation.
Enhancing qualitative characteristics: -
c o m p a ra b ility
-
ve rifiability
-
timeliness
-
understandability.
The terms 'relevance' a nd 'faithful representation' w e re discussed earlier. If you are not sure o f their m eaning, you should g o back a nd re-read those descriptions. B elo w w e e la b o ra te on the four enhancing q u alitative characteristics (based on the Framework). •
C o m p a ra b ility : inform ation a b o u t o ne organisation is m ore useful w hen it can be co m p a red w ith sim ilar inform ation from another organisation an d also is co m p a ra b le over time w ithin the same organisation.
•
V erifiability: the numbers in the fin a n cia l statements can be verified directly by looking a t docum entation (e.g. the cost price o f equipm ent) o r through direct observation (e.g. counting cash o r inventory). They can also be verified indirectly by checking inputs to a model form ula a nd recalculating the outputs.
• •
Timeliness: p ro vid in g inform ation in tim e for the user to incorporate the inform ation in their decisions. U nderstandability: inform ation is m ore useful if it is understandable to inform ed decision-m akers. U nderstandability can be increased b y presenting inform ation in a cle a r an d concise manner.
FOR YOUR INTEREST T h e a c c o u n tin g p ro fe s s io n has b e e n c ritic is e d f o r th e in c re a s e d c o m p le x ity o f fin a n c ia l re p o rts , w h e re th e n o te s to th e a c c o u n ts c an e x c e e d 5 0 pages. O n e re a so n is th e in c re a s e d c o m p le x ity o f tra n s a c tio n s an d th e in c re a s e d n e e d f o r e s tim a te s . F o r e x a m p le , w h e n s e n io r e x e c u tiv e s are o n ly p a id a sala ry, r e p o rtin g o f e x e c u tiv e re m u n e ra tio n is m u c h e a s ie r th a n w h e n th e y g e t a d d itio n a l sh a re o p tio n s an d v a rio u s in c e n tiv e s based o n a c c o u n tin g n u m b e rs . A ls o , g iv e n th e legal c o n s e q u e n c e s and p e n a ltie s f o r o m is s io n o f re q u ire d d a ta , it is lik e ly f o r m a n a g e m e n t to o v e r - r e p o r t r a th e r th a n u n d e r - r e p o r t w h e n th e r e is u n c e rta in ty . T h e re are ta s k fo rc e s and c o m m itte e s c o n s id e rin g th e s e issues a t p re s e n t.
CHAPTER 1 Introduction to Financial accounting
21
T ra d e -o ffs am ong accounting principles If you think a b o u t the criteria a nd principles m entioned a b o ve (i.e. relevance, reliability, m ateriality, conform ance w ith G A A P , disclosure, understandability, c o m p a ra b ility a n d consistency), you m ay see that they d o not a lw a ys fit together w e ll. For exam ple, it w o u ld seem sensible to propose that the m ore faithfully representative the accounting inform ation is, the better. You can achieve this by being very careful a b o u t h o w you prepare it, checking it carefully a nd having the auditors com e in a nd verify it, a nd m aybe even w a itin g until some m ajor uncertainties are resolved, so you d o not have to estim ate them. It also seems sensible that decision-m akers need inform ation that is relevant to their decisions w hen they are making them. This means that inform ation should be timely: p e o p le should not have to w a it for the inform ation they need. In this light, let's consider a c o m p a n y trying to report on its lia b ility to em ployees for long service leave. It has thousands o f em ployees w h o w ill take this tim e o ff over the next 4 0 years, if they d o not leave (voluntarily or involuntarilyl). The d o lla r am ount of long service leave p a id w ill d e p e n d on h o w much the em ployees earn w hen they take the leave, an d that is not yet know n for most o f them. The am ount of leave depends on h o w long the em ployees have been w ith the firm. U nder most a w a rd s, it starts to accum ulate after 1 0 o r 15 years o f service. For each extra ye a r o f service it increases a t different rates. If the em ployee leaves before 1 0 years o f service, no am ount norm ally needs to be p a id unless the em ployee's leaving w a s involuntary. F lo w is that for a mass o f uncertainty? A n y num ber you com e up w ith for the long service leave lia b ility w ill be based on all sorts o f estimates o f unknown future events. Therefore, to ge t a lia b ility figure that faithfully represents the liability, you really have to w a it 2 0 o r 3 0 years until most o f the em ployees have retired or taken their leave. You can a lw a ys expect to get m ore reliable da ta b y just w a itin g a w h ile , even years, to see h o w things turn out. But w a itin g 2 0 or 3 0 years w ill hardly p ro vid e tim ely inform ation that is relevant to decisions such as those being m ade by the board o f directors, the investment analyst, the banker a nd the supplier m entioned a b o ve . Such decisions require the best inform ation w e can com e up w ith no w , even if it is necessarily based on estimates a nd assumptions. As time passes, faithful representation rises an d relevance falls, so w e have to try to find some m id p o in t w h e re there is enough o f both, even though w e m ay prefer even m ore o f o ne o r both of these attributes.
1.8
Financial statem ent assumptions
N o w that you have seen the fin a n cia l statements an d the basic principles upon w h ich accounting relies, it is im portant to understand some basic assumptions underlying current accounting practice an d the preparation o f fin a n cial statements. The fo llo w in g concepts (or assumptions) are discussed b e lo w : accrual basis, g o in g co n ce rn , a cco u n tin g e n tity , accounting p e riod, m onetary a nd historical cost. •
A cc ru a l basis: fin a n cia l reports are prepared on the accrual basis o f acco u n tin g ; that is, the effects o f transactions an d other events a re recognised as they occur, regardless o f w hether cash is received o r p a id at that time.
•
G o in g concern: fin a n cia l statements are prepared on the premise that the organisation w ill continue operations as a g o in g concern in the foreseeable future. If this is not the case, it is necessary to report the liq uidation values of an o rg anisation's assets.
•
A cco u n tin g entity: under this concept, the accounting entity is separate an d distinguishable from its ow ners. For exam ple, the accounting entity o f a sole trader is differentiated from the fin a n cia l affairs of the o w n e r. Sim ilarly, a c o m p a n y is a separate entity from its shareholders. If either the sole trader o r a shareholder o f a c o m p a n y goes out a nd buys a n e w set o f g o lf clubs, it m ay affect his o r her personal finances but does not affect the accounting entity. A ccounting entities d o not necessarily correspond to legal entities. For exam ple, as noted a b o ve , the personal fin a n cia l affairs o f the sole trader can be separated from the finances o f the business, although there is no legal distinction. This co n ce p t puts a b o u n d a ry on the transactions that are to be recorded for a n y particular accounting entity. It also a llo w s the o w n e r to evaluate the perform ance o f the business.
•
A cco u n tin g p e rio d : the life o f a business needs to be d iv id e d into discrete periods to evaluate perform ance for that period. D ividing the life o f an organisation into equal periods to determ ine profit o r loss for that period is know n as the accounting period concept. The time periods are arbitrary, but most organisations report at least
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
22
annually, w ith large com panies preparing half-yearly a nd quarterly fin a n cia l statements for outside purposes (in some countries) an d at least m onthly (sometimes m ore frequently) fin a n cia l statements for m anagem ent purposes. •
M o n e ta ry : accounting transactions need to be m easured in a com m on denom inator, w h ich in A ustralia is, not surprisingly, the Australian d o lla r. This a llo w s com parisons across periods an d across different com panies. Transactions that cannot be reasonably assigned a d o lla r value are not included in the accounts. This concept also assumes that the value o f the m onetary unit is constant over time, w h ich ignores inflation.
•
H istorical cost: under the historical cost concept, assets are initially recorded at cost. As you w ill see in later chapters, m any assets, such as inventory, w ill still be recorded at cost in the balance sheet in subsequent periods although their value has increased. Some other assets - such as property, plant a nd equipm ent - can be revalued periodically. Thus, in reading a balance sheet it is important to note at w h a t valuation the assets are being recorded. Some o f these basic concepts have a lre a d y been briefly m entioned e arlier in this chapter, a n d all w ill be referred
to a g a in throughout the book.
1.9
Is accounting really im portant?
The econom y as a w hole Financial accounting is perceived b y m any to have contributed to our most recent w o rld w id e fin a n cia l crisis. C o n sid e r the introduction to 'H o w D id Financial Reporting C ontribute to the Financial C risis?' by M a ry Barth an d W a y n e Landsman, European A cco u n tin g Review, VoL 19, N o . 3 , 2 0 1 0 : T h e F in a n cia l C ris is th a t began m id w a y th ro u g h 2 0 0 7 a n d c o n tin u e d th ro u g h th e e n d o f 2 0 0 8 re s u lte d in th e c o lla p s e o f n u m e ro u s c o m m e rc ia l an d in v e s tm e n t ba nks . . . T h e n e a r c o lla p se o f th e fin a n c ia l s e c to r has re s u lte d in th e g re a te s t e c o n o m ic c o n tra c tio n th a t th e U S an d E u ro p e have seen sin c e th e e n d o f th e S e c o n d W o rld W a r . . . C a lls f o r a c tio n to p re v e n t a re p e a t o f th e F in a n cia l C ris is have also to u c h e d o n a c c o u n tin g sta n d a rd s e ttin g a n d th e w a y in w h ic h a c c o u n tin g in fo rm a tio n ( o r la ck t h e r e o f) c o n trib u te d to th e F in a n cia l C risis.
The authors pro vid e insights into w hether inform ation a v a ila b le to investors w a s sufficiently transparent to make a p p ro p ria te judgem ents re garding the values a nd riskiness o f bank assets a nd liabilities. In case you a re not convinced that accounting numbers (profit a n d b a la n ce sheet figures) are im portant, w e hope the fo llo w in g ne w spaper extracts m ay convince you. Q uotes o f this type a p p e a r in the fin a n cia l section o f most new spapers every d a y. The quotes are ones w e thought you m ight find interesting. They clearly sh o w that a lot of em phasis is placed on accounting figures (especially profits) in decision-m aking b y m anagem ent a nd by users such as shareholders and creditors, co rp o ra te boards a nd consum er groups, as w e ll as their im pact on a range o f other com m unity groups.
Used by m anagem ent in m aking business decisions The fo llo w in g exam ples illustrate the im portance accounting numbers have on m anagem ent decisions to contract and expand the business, w h ich in turn affect em ployees, suppliers, contractors a nd the econom y. The a v a ila b ility o f large sums o f cash, undraw n d e b t facilities, a nd g ro w in g cash flow s e n a b le com panies take a d va n ta g e of opportunities as they em erge. O n the other hand, businesses a re often put up for sale w hen they cannot provide the fin a n cia l perform ance (as measured by accounting numbers) to g ive investors the return they w a n t. C onsider the fo llo w in g tw o exam ples: •
'Earnings before interest a nd tax soared 8 6 per cent to $1 14.1 m illion. The strong result helped push CSR into a net cash position o f $ 5 .7 m illion. G iven its pristine b a la n ce sheet, C re d it Suisse analyst A n d re w Peros estimates CSR has up to $ 3 5 0 m illion o f fire p o w e r to spend on acquisitions' ('CSR profits soar as house bu ild in g gathers momentum, A ustralian Financial Review, 6 N o ve m b er 2 0 1 4 ).
•
'Q a n ta s has announced plans to cut 1 0 0 0 jobs an d defer c a p ita l spending. The a irlin e has also raised the prospect o f selling assets, such as a irp o rt terminal leases a nd a m inority stake in its frequent flyer business, to help raise m ore cash' ('M o o d y 's d o w n g ra d e s Q a n ta s to junk', A ustralian Financial Review, 1 O January 2 0 1 4 ).
CHAPTER 1 Introduction to Financial accounting
23
Used by shareholders for de cisio n-m akin g purposes (and im pact on shareholders) Both g o o d an d ba d accounting news often has a b ig im pact on the share market (see C h a p te r 6 for a more sophisticated discussion). In particular, w hen com panies announce ba d news their share prices are usually adversely affected, as show n by the fo llo w in g illustrations. •
'The tremors from C entro's adm issions shook the stock market. A lre a d y spooked by higher than expected US inflation numbers, it lost $ 4 4 billion in its largest one-day slide since A ugust 1 0 ... A t the sam e time, forecast earnings have been slashed' (R. H arley a nd M . Dunckley, 'C re d it Crisis S avages C e n tro ', A ustralian Financial Review, 1 8 D ecem ber 2 0 0 7 ).
•
'Investors in surfwear g ro u p B illabong have lost more than $ 4 0 0 million after the co m p a n y issued a shock earnings d o w n g ra d e that prom pted a 4 4 per cent plunge in the com pany's share price and rattled an a lre a d y fragile retail sector' (Blair Speedy, 'B illabong profit w ip e o u t costs investors $ 4 1 3 m ', The Australian, 2 0 Decem ber 201 1).
•
'U G L's share price, w h ich fell alm ost 15 per cent on Thursday fo llo w in g an announcem ent the p o w e r plant had cost blow outs o f alm ost $ 2 0 0 m illion, fell 4 3 c to $ 5 .4 6 on Friday as analysts slashed earnings forecasts' ('UGL faces scrutiny over disclosure', S ydney M o rn in g H erald, 8 - 9 N o ve m b e r 2 0 1 4 ).
•
'The shares w e n t into freefall after the c o m p a n y fin a lly announced to the market on O c to b e r 2 7 it w o u ld be stripped o f $1 9 .6 m illion in funding a nd w o u ld take a $ 5 m illion hit to its bottom-line profits in 2 0 1 4 - 1 5 ' ('U nder fire V ocation chief buys as restructure loom s', A ustralian Financial Review, 4 N o ve m b e r 2 0 1 4 ).
Used by bankers and o th e r cre d ito r groups Bankers use accounting numbers to d e c id e w hether to lend, to determ ine the level o f risk an d often the interest rate to charge. Rating agencies such as S tandard & Poor's a nd M o o d y 's use accounting numbers to g ive their credit ratings, w h ich have an im pact on the interest rates com panies have to pay. •
'[S]hares in C entro a nd the associated C entro Retail Trust both plunged 2 6 b yesterday ... as the g ro u p w a s forced to a d m it more b ad news a b o u t its d e b t a nd foreign e xch a n g e positions ... The co m p a n y's lenders g a ve it until February 15 to com e up w ith a refinancing plan ... the c o m p a n y announced another asset sale as it tries to bolster its b a la n ce sheet' (M . Dunckley an d B. W ilm o t, 'C entro acts to a p p e a se banks', A ustralian Financial Review, 16 J a n u a ry 2 0 0 8 ).
•
'S tandard & Poor's said Q ueensland's strong b a la n ce sheet ensured it kept its A A A credit rating yesterday, but it w a rn e d o f a w e a ke n in g o f underlying governm ent finances over the next fe w years as it rolls out its multibilliond o lla r infrastructure p rogram ' (M . Ludlow, 'Resource states w id e n revenue g a p ', A ustralian F inancial Review, 1 1 January 2 0 0 7 ).
•
'Ratings a g e n c y M o o d y 's has stripped W estern A ustralia o f its A A A rating, w a rn in g o f vo la tility in its revenue base an d an "optim istic" forecast for iron o re prices ... blam ing the state's o n g o in g d e ficit position, the deterioration in its d e b t metrics a nd a g ro w in g risk this trend m ay not be reversed soon' ( 'W A loses A A A rating', The Australian, 2 5 August 2 0 1 4 ).
Used by corporate boards in rew arding and rem oving executives M o s t executive com pensation schemes include perform ance bonuses, an d accounting numbers a re key com ponents o f these perform ance hurdles. •
'M r N orris's remuneration has rocketed from a b o u t $ 9 .2 m illion in 2 0 0 9 . The bulk o f the increase is du e to incentive-based perform ance rights, w h ich rose to $ 6 .4 m illion from $ 1 .9 m illion. The ba n k met targets for profits an d customer satisfaction' (Vesna Poljak an d John Kehoe, 'C B A chief's $ 1 6 .2 m w a g e tips the scales', W e e ke n d A ustralian F inancial Review, 1 8 - 1 9 S eptem ber 2 0 1 0 ).
•
'The most notable ch a n g e w a s in bonuses, w ith all executives forfeiting a t least 15 per cent o f their short-term incentive payments after net profit fell 9 8 per cent in 2 0 0 9 - 1 0 ' (Luke Forrestal, 'D o w n e r cuts p a y cheques', A ustralian F inancial Review, 2 8 Septem ber 2 0 1 0 ).
24
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
'Treasury W in e s Estates is seeking shareholder a p p ro va l to g ra n t chief executive M ic h a e l C la rk rights to acq u ire up to 7 6 4 0 0 0 shares a t no cost if the w in e m a ke r meets perform ance hurdles ... earnings must g ro w m ore than 15 per cent' ('Stocks to w a tch at close on Friday', S ydney M o rn in g H erald, 7 N o ve m b e r 2 0 1 4 ).
•
'A lan Joyce is the latest high-profile C E O to g ive up a bonus a nd p a y rise ... "It's absolutely a p p ro p ria te that w hen c om pa n y returns g o d o w n executive p a y should g o d o w n as w e ll," M r Joyce said. "It has been an extrem ely tough ye a r for Q a n ta s shareholders an d w h a t w e w a n t to sh o w is that my p a y has to have a huge correlation w ith the p ro fita b ility o f the c o m p a n y"' ('N o bonus o r p a y rise for Joyce at Q a n ta s', A ustralian Financial Review, 2 0 A ugust 2 01 2).
•
'The take-home p a y for Q a n ta s chief executive A lan Joyce has risen b y just over $1 m illion to $ 3 .3 m illion this ye a r ... His latest p a cka g e included $ 2 .1 m illion in base pay, a cash bonus o f $ 7 7 5 0 0 0 an d a further $ 3 8 8 0 0 0 in deferred shares ... The shortterm bonus is m easured on a range o f factors including underlying pre tax profit' ('Q a n ta s chief A la n Joyce gets $ 1 m raise', The A g e , 6 Septem ber 2 01 3).
•
'RIO Tinto chief executive Tom A lbanese's remuneration rose 3 1 .4 per cent in 2 0 1 0 after exce e d in g his targets on various fronts including the com pany's stellar earnings results' ('Rio Tinto C E O Tom A lbanese's p a y jumps 31 pc in 2 0 1 0 ', The Australian, 1 6 M a rc h 2 0 1 1).
Used by unions and m an ag em e nt in ne go tia tin g w age agreem ents In p a y disputes, both m anagers a nd unions often use accounting numbers to support their case. For exam ple, the higher the profits, the m ore likely the p a y increases. •
'The union representing S ydney bus drivers a p o lo g is e d to commuters for c a llin g a 2 4 -hour strike. The union argued that negotiations had broken d o w n a nd pointed out that the State Transit A uthority "posted a profit o f more than $ 4 5 m illion last fin a n cia l ye a r but bus drivers w e re being asked to a c ce p t cuts to basic conditions before they could get a fa ir p a y rise"' ('Sydney bus strike c a lle d ', S ydney M o rn in g H erald, 1 7 D ecem ber 2 0 0 9 ).
Im pact on the co m m u n ity and consum ers In relation to moving the Australian G ra n d Prix: •
'The d w in d lin g lure o f the race a m ong the co rp o ra te set can also be seen in sales revenues, w h ich fell from $ 4 0 m illion in 1 9 9 6 to $ 2 4 .5 m illion last y e a r' (B. Butler an d M . H aw thorne, 'Race d ro w n in g in a sea o f red', S ydney M o rn in g H erald, 1 9 M a rc h 20 1 1). W h a t w e w a tch on television:
•
'Ten N e tw o rk H o ld in g s says it w ill relaunch its d ig ita l sports channel "O n e " w ith general content in M a y , as it released results sh o w in g a 1 6 per cent fall in first half net profit' ('Ten's profit d ro p is unacceptable: M u rd o c h ', S ydney M o rn in g H erald, 7 A pril 2 0 1 1).
•
'$ 2 5 4 m illion to be slashed from A B C 's b u dget ... staff w ill be told on M o n d a y w h a t program s a nd services w ill be a x e d ' ('A B C boss w arns o f "sig n ifican t" jo b losses, program m ing cuts', S ydney M o rn in g H erald, 21 N o ve m b e r 2 0 1 4 ). O n customers:
•
'The w id e r im pact o f the co lla p se o f kitchen supplier K leenm aid last w e e k is expected to be even more d a m a g in g than the $ 7 6 m illion it ow es to banks, customers, em ployees, suppliers, franchisee ow ners a nd the adm inistrators ... U p to 4 5 0 0 customers are collectively o w e d $ 2 7 m illion for fully o r p a rtia lly p a id kitchens' (M ichelle Singer, 'K leenm aid: M o re pain on the w a y ', A ustralian F inancial Review, 2 4 A pril 2 0 0 9 ).
•
'despite the a irlin e hours earlier announcing the $ 2 5 2 m illion half-year underlying loss a nd plans to cut 5 0 0 0 jobs a n d close routes' (M att O 'S u lliva n a nd James M a ssola , 'Q a n ta s cuts 5 0 0 0 jobs, posts $ 2 5 2 m illion first half loss', S ydney M o rn in g H erald, 2 7 February 2 0 1 4 ).
CHAPTER 1 Introduction to Financial accounting
25
Im pact on em ployees and jobs A ccounting numbers can lead to co rp o ra te failure, w ith resulting consequences for w orkers. •
'Telstra w ill slash at least 6 0 0 0 jobs, o r 15 per cent of its w orkforce, over three years as it seeks to return earnings to last year's levels an d revive its share price despite uncertainty a b o u t its $1 1 billion de a l w ith Labor's national b ro a d b a n d netw ork' (Dom inic W h ite , 'Telstra to slash a t least 6 0 0 0 jobs', A ustralian Financial Review, 3 0 S eptem ber 2 0 1 0 ).
•
'In Q a n ta s's case, this resulted in last w e e k's announcem ent to slash 1 0 0 0 jobs an d record a pre-tax loss of betw een $ 2 5 0 m illion an d $ 3 0 0 m illion for the first half of this fin a n cia l y e a r' ('Q antas needs to make radical changes o r b o o k a ticket to a irline heaven', A ustralian F inancial Review, 9 D ecem ber 2 0 1 3).
•
'D evereux said H olden's parent, G e n e ra l M o to rs, had all the inform ation needed to d e c id e that a business case for m anufacturing in A ustralia no longer existed ... A total o f 2 9 0 0 jobs to g o at H olden, multiples o f that likely to g o in Australian supplier co m p a n ie s' ('H olden loss shows need for reform ', S ydney M o rn in g H erald, 1 2 D ecem ber 2 0 1 3).
26
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A C lassification o f item s Listed b e lo w a re b a la n ce s a t 3 0 June 2 0 1 6 .
$ Cash at bank Inventory Sales Wages Cost of goods sold Share capital Accounts payable
1
C la s s ify e a ch a c c o u n t as a n asset, lia b ility , reven ue , e x p e n s e o r e q u ity .
2
P re p a re an in c o m e state m e nt fo r th e p e rio d e n d in g 3 0 June 2 0 1 6 .
3
P re p a re a b a la n c e sheet a t 3 0 June 2 0 1 6 .
210000 60000 210000 40000 70000 140 00 0 30000
PRACTICE PROBLEM B A ccrual p ro fit 1
D u rin g th e a c c o u n tin g p e rio d , G re e n Lim ited re c e ive d $ 7 5 0 0 0 0 fro m sales a n d p a id o u t $ 5 8 0 0 0 0 in w a g e s a n d o th e r expe nses. H o w e v e r, a n e x tra $ 2 6 0 0 0 0 w o rth o f sales w e re m a d e d u rin g th e y e a r b u t th e cash has n o t be en c o lle c te d y e t. The c o m p a n y a ls o o w e s $ 2 4 0 0 0 0 fo r v a rio u s expe nses. W h a t is th e a c c ru a l p ro fit?
2
G re e n Lim ited p u rc h a s e d 3 0 0 0 item s fo r $ 5 e a ch on c re d it a n d sells 2 0 0 0 o f these item s o n c re d it fo r $ 8 . W h a t is th e sales reven ue a n d c o st o f g o o d s sold fo r th e p e rio d ?
PRACTICE PROBLEM C Calculate share h o ld e rs' e q u ity G iv e n th e fo llo w in g in fo rm a tio n re la tin g to P enguin Ltd, w h a t is th e b a la n c e o f s h a re h o ld e rs ' e q u ity?
$ Property, plant and equipment
1500000
Accounts receivable
400000
Cash
100 00 0
Inventory
500000
Bank loan
250000
Wages payable
90000
CHAPTER 1 Introduction to Financial accounting
27
KEY TERMS Accountant Accounting Accounting entity Accounting eguation Accounting principles Accounting standards Accounts payable Accounts receivable Accrual accounting Accrual profit Balance sheet Comparability Cost of goods sold (COGS) Depreciation
Dividends Expense Financial performance Financial position Financial statements Financing activities Generally accepted accounting principles (GAAP) Going concern Gross profit Income statement Inventory Investing activities Investors
Liabilities Materiality Measurement Net profit Operating activities Profit Profit before tax Relevance Retained profits Revenues Share capital Statement of cash Flows Timeliness Understandability
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This section starts w ith simpler discussion questions that revise some o f the basic concepts, w hich are then follow ed by a set o f problems.
DISCUSSION QUESTIONS 1
W h a t is th e b a s ic p u rp o s e o f fin a n c ia l a c c o u n tin g ?
2
D istin g u ish b e tw e e n fin a n c ia l p e rfo rm a n c e a n d fin a n c ia l p o s itio n .
3
W h a t is th e d iffe re n c e b e tw e e n fin a n c ia l a n d m a n a g e m e n t a c c o u n tin g ?
4
W h o a re th e m a in p a rtie s th a t c o m p ris e th e s o c ia l setting o f a c c o u n tin g ?
5
W h a t is m e a n t b y c re d ib le p e rio d ic re p o rtin g ? W h a t prevents o rg a n is a tio n s fro m m a k in g fin a n c ia l statem ents in c re a s in g ly c re d ib le ? (C o n s id e r c o s t-b e n e fit im p lic a tio n s .)
6 List fo u r im p o rta n t users o f fin a n c ia l a c c o u n tin g a n d d e s c rib e th e use th a t e a ch user w o u ld m a ke o f the in fo rm a tio n . 7
D o a ll users o f fin a n c ia l a c c o u n tin g h a ve th e sam e in fo rm a tio n needs? W h y , o r w h y not?
8
List som e s im ila ritie s a n d d iffe re n c e s b e tw e e n the need fo r fin a n c ia l in fo rm a tio n b e tw e e n s h a re h o ld e rs a n d b a n ke rs.
9
List fiv e situ a tio n s in w h ic h ju d g e m e n t is re q u ire d b y th e p re p a re rs o f fin a n c ia l in fo rm a tio n .
1 0 W h a t do es an a u d it a c h ie v e ? 11 D e s crib e w h a t is m e a n t b y a c c ru a l a c c o u n tin g . H o w do es it d iffe r fro m cash a c c o u n tin g ? 12 W h o uses a c c ru a l a c c o u n tin g ? 13 W h ic h o f th e fo llo w in g term s w o u ld y o u see in fin a n c ia l statem ents p re p a re d u n d e r (a) a c c ru a l a c c o u n tin g a n d (b) cash a c c o u n tin g : a cco u n ts p a y a b le , a c co u n ts re c e iv a b le , cash a n d in ve n to ry? 14 W h a t a re th e th re e key fin a n c ia l statem ents, a n d w h a t re le v a n t in fo rm a tio n d o th e y p ro v id e to users o f a c c o u n tin g reports? 15 E x p la in , in s im p le term s, e a ch o f th e fo llo w in g fin a n c ia l a c c o u n tin g assu m p tio n s: a a c c o u n tin g e n tity
b
a c c o u n tin g p e rio d
c
m o n e ta ry
d
h is to ric a l cost
e
g o in g c o n c e rn
f
m a te ria lity .
28
16
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
D o y o u th in k le ctu rers sh o u ld h a ve th e rig h t to use th e ir o w n ju d g e m e n t in d e te rm in in g s u b je c t g ra d e s , o r sh o u ld those g ra d e s be b a se d o n o b je c tiv e ly set e xam s a d m in is te re d b y s om e on e o th e r th a n lecturers? W h y ? D o y o u th in k c o m p a n ie s ' m a n a g e m e n t sh o u ld h a ve th e rig h t to c h o o se th e a c c o u n tin g p o lic ie s a n d m e tho ds b y w h ic h th e ir p e rfo rm a n c e is m e a su re d ? W h y ? H o w d o these tw o cases d iffe r, if a t all?
PROBLEMS PROBLEM 1.1 C alculate accrual acco u n tin g p ro fit John S m ith set up his o w n c a te rin g business o n 1 July 2 0 1 5 . D u rin g th e 12 m onths up to 3 0 June 2 0 1 6 th e fo llo w in g tra n sa ctio n s o c c u rre d : 1
John p u t $ 1 0 0 0 0 o f his o w n m o n e y in to th e business.
2
H e b o rro w e d $ 2 0 0 0 0 fro m the b a n k fo r o n e y e a r a t 5 p e r c e n t p e r a n n u m , w ith in tere st to be p a id a t th e e n d o f th e lo a n .
3
H e p a id $ 1 0 4 0 0 in w a g e s a n d o w e d $ 3 0 0 0 in w a g e s fo r w o rk d o n e .
4
H e b o u g h t c a te rin g e q u ip m e n t fo r $ 6 0 0 0 , w h ic h has a n e x p e c te d useful life o f th re e y e a rs .
5
H e p a id o th e r expe nses o f $ 1 2 3 0 0 .
6 John sent b ills fo r $ 6 0 0 0 0 to custom ers fo r w o rk p e rfo rm e d b e tw e e n 1 July 2 0 1 5 a n d 3 0 June 2 0 1 6 . By 3 0 June he h a d re c e ive d $ 4 5 0 0 0 a n d e x p e c te d th e o th e r $ 1 5 0 0 0 b y A u g u s t. U sing th e c o n c e p ts o f a c c ru a l a c c o u n tin g , c a lc u la te J o h n 's p ro fit fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 1.2 Prepare a balance sheet and calculate p ro fit 1
G iv e n the fo llo w in g b a la n c e s , p re p a re a b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r Palm T ree Lim ited.
$ Bank loan Share capital Wages payable Accounts payable Inventory Cash at bank Buildings
2
40000 160 00 0 60000 80000 140 00 0 50000 200000
Retained profits
90000
Accounts receivable
40000
The c o m p a n y d id n o t d e c la re a n y d iv id e n d s d u rin g th e y e a r. Its b a la n c e in re ta in e d p ro fits a t th e start o f th e y e a r w a s $ 6 0 0 0 0 . W h a t is th e p ro fit fo r th e y e a r?
CHAPTER 1 Introduction to Financial accounting
29
PROBLEM 1.3 C ontent o f fin a n cia l sta te m e n ts C o n s id e r th e list o f a c co u n ts g iv e n a n d c a te g o ris e them as a n asset, lia b ility o r s h a re h o ld e rs ' e q u ity item th a t w o u ld a p p e a r on th e b a la n c e sheet o r a re ven ue o r e x p e n s e th a t w o u ld a p p e a r o n th e in c o m e state m e nt b y tic k in g the a p p ro p ria te co lu m n .
PROBLEM 1.4 W hat are various people's in te re sts in fin a n cia l accounting? B rie fly d e s c rib e w h a t e a ch o f th e fo llo w in g p e o p le w o u ld lik e ly w a n t to le a rn fro m th e fin a n c ia l statem ents o f B ran dX Ltd, a n d h o w e a ch m ig h t be a ffe c te d if th e statem ents s h o w e d g o o d o r b a d fin a n c ia l p e rfo rm a n c e o r fin a n c ia l p o s itio n . 1 The c h ie f e x e c u tiv e o ffic e r (C E O ) o f th e c o m p a n y 2
The c o m p a n y 's c h ie f a c c o u n ta n t
3
The c h a irp e rs o n o f th e c o m p a n y 's b o a rd o f d ire c to rs (the b o a rd e v a lu a te s th e p re s id e n t's p e rfo rm a n c e on b e h a lf o f th e s h a re h o ld e rs)
4 The p a rtn e r o f a u d itin g firm D im b le b y & C o ., fo r w h o m B ra n d X is a c lie n t 5
The lo c a l m a n a g e r o f ta x c o lle c tio n s fo r th e A u s tra lia n T a x a tio n O ffic e
6 John Flatstone, w h o o w n s 1 0 0 shares o f B ran dX 7
M ild re d Evans, w h o is th in k in g o f b u y in g som e shares o f th e c o m p a n y
8 The lo c a l m a n a g e r o f B ig B ank, w h ic h has m a d e a la rg e lo a n to B ran dX
PROBLEM 1.5 W hat are various people's in te re sts in fin a n cia l accounting? B rie fly d e s c rib e w h a t e a c h o f th e fo llo w in g g ro u p s w o u ld like to k n o w fro m th e fin a n c ia l statem ents o f th e S w an s F o o tb a ll C lu b . 1 The C E O 2
The p la y e rs
3
The s u p p o rte rs
4 The s u p p lie rs o f m e a t pies a n d b e e r fo r ho m e ga m e s
30
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.6 Users and th e ir needs A c c o u n tin g in fo rm a tio n is d e m a n d e d b y a w id e ra n g e o f users, in c lu d in g s h a re h o ld e rs , c o m p a n y m a n a g e m e n t, s u p p lie rs , b a n k e rs , tra d e un io ns, th e A u s tra lia n S ecuritie s a n d Investm ents C o m m is sio n (ASIC ) a n d th e A u s tra lia n T a x a tio n O ffic e (A T O ). W h ic h user is lik e ly to seek e a ch o f th e fo llo w in g types o f in fo rm a tio n ? 1 The lik e lih o o d o f th e c o m p a n y m e eting its in tere st pa ym e n ts o n tim e
2 The p ro fita b ility o f e a c h d iv is io n in th e c o m p a n y
3
The fin a n c ia l p o s itio n a n d p e rfo rm a n c e o f a c o m p a n y issuing shares to th e p u b lic fo r th e firs t tim e
4
The pro sp e c ts fo r fu tu re d iv id e n d pa ym e n ts
5
The p ro b a b ility th a t th e c o m p a n y w ill be a b le to p a y fo r its p u rch ases on tim e
6 The p ro fita b ility o f th e c o m p a n y b a se d o n th e ta x la w
7 The p ro fita b ility o f th e c o m p a n y since th e last c o n tra c t w ith e m p lo y e e s w a s s ig n e d .
PROBLEM 1.7 A ccrual p ro fit B rick Lim ited m a d e cash sales o f $ 5 5 0 0 0 0 a n d c re d it sales o f $ 3 7 0 0 0 0 ( $ 2 2 0 0 0 0 o f w h ic h h a d be en c o lle c te d b y y e a r-e n d ). It p a id $ 4 1 0 0 0 0 in expe nses a n d o w e d $ 2 3 0 0 0 0 a t y e a r-e n d . W h a t w a s th e a c c ru a l p ro fit?
PROBLEM 1.8 A ccrual p ro fit 1
D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , French H o rn Ltd m a d e cash sales o f $ 1 0 0 0 0 0 , c re d it sales o f $ 2 0 0 0 0 0 ( $ 5 0 0 0 0 o f w h ic h w e re still to be c o lle c te d a t y e a r-e n d ), a n d re c e iv e d $ 2 5 0 0 0 o w in g fro m c re d it sales, w h ic h o c c u rre d in M a y 2 0 1 5 . W h a t is French H o rn 's sales reven ue fo r th e y e a r e n d e d 3 0 June 2 0 1 6?
2 A ls o d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , French H o rn p a id $ 6 0 0 0 0 a n d o w e d $ 1 0 0 0 0 in e m p lo y e e w a g e s . O f th e $ 6 0 0 0 0 p a id , $ 5 0 0 0 re la te d to w a g e s p a y a b le as a t 3 0 June 2 0 1 5 . W h a t is th e to ta l o f French H o rn 's a c c ru a l a c c o u n tin g expenses?
3
W h a t is French H o rn 's a c c ru a l a c c o u n tin g p ro fit fo r th e y e a r e n d e d 3 0 June 2 0 1 6?
PROBLEM 1.9 C alculate accrual acco u n tin g p ro fit Fred Jones s ta rte d a c o n s u ltin g business on 1 M a rc h 2 0 1 6 . D u rin g th e p e rio d up to 3 0 June 2 0 1 6 , th e fo llo w in g tra n sa ctio n s o c c u rre d : 1 Fred p u t $ 1 0 0 0 0 o f his o w n m o n e y in to th e business. 2
H e b o rro w e d $ 3 0 0 0 0 fro m th e b a n k a t 1 0 p e r c e n t p e r an n u m fo r o n e y e a r w ith in tere st to be re p a id a t th e en d o f the lo a n .
3
H e sent b ills fo r $ 3 5 0 0 0 to custom ers fo r w o rk p e rfo rm e d . By 3 0 June he h a d re c e ive d $ 3 0 0 0 0 a n d e x p e c te d th e o th e r $ 5 0 0 0 in July.
4
H e b o u g h t a c o m p u te r fo r $ 8 1 0 0 th a t has an e x p e c te d useful life o f th re e y e a rs .
5
H e p a id $ 1 2 0 0 0 in w a g e s .
6
H e p a id o th e r expe nses o f $ 2 0 0 0 0 .
7
H e re c e ive d a $ 5 0 0 b ill fo r a d v e rtis in g (a p p e a re d in n e w s p a p e rs in M a y ; w ill be p a id in July). U sing th e c o n c e p ts o f a c c ru a l a c c o u n tin g , c a lc u la te F red's p ro fit fo r th e fo u r m onths e n d in g 3 0 June 2 0 1 6 .
PROBLEM 1.10 Com paring n e t p ro fits and cash flo w K in g s fo rd C ustom s w a s fo u n d e d o n 1 July 2 0 1 6 . A t th e e n d o f firs t y e a r's o p e ra tio n s , th e fo llo w in g s u m m a ry o f its a c tiv itie s has be en p re p a re d b y th e o w n e r. 1
B o rro w e d cash o f $ 6 0 0 0 0 fro m C A A B ank.
2
E m p lo ye es e a rn e d $ 9 6 8 0 0 o f w a g e s , o f w h ic h $ 4 0 0 0 0 is to be p a id in th e ne xt a c c o u n tin g p e rio d .
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3
P erform e d custom ise d services th a t g e n e ra te d sales re ven ue o f $ 2 4 3 3 0 0 , o f w h ic h $ 1 0 0 0 0 0 re m a in e d u n co lle cte d a t th e e n d o f th e y e a r.
4
O th e r o p e ra tin g expe nses, in c lu d in g p h o n e b ills a n d e le c tric ity a m o u n tin g to $ 2 6 8 0 0 , w e re in c u rre d d u rin g the y e a r. O f this a m o u n t, $ 1 0 0 0 0 re m a in e d u n p a id a t th e e n d o f th e y e a r. S h o w the e ffe c t o n net p ro fit a n d cash o f e a ch o f th e a b o v e tra n s a c tio n s fo r this a c c o u n tin g p e rio d .
PROBLEM 1.11 C ontents o f fin a n c ia l sta te m e n ts M a tc h e a ch item w ith th e fin a n c ia l state m e nt it w o u ld a p p e a r in b y tic k in g th e a p p ro p ria te co lu m n . Item
Balance sheet
Income statement
Statement of cash flows
Wages expense Cash paid for equipment Cash at bank Equipment Cash flow from customers Accounts payable Cash paid to employees Sales revenue
PROBLEM 1.12 C ontents o f fin a n c ia l sta te m e n ts M a tc h e a ch item w ith th e fin a n c ia l state m e nt th a t it w o u ld a p p e a r in b y tic k in g th e a p p ro p ria te co lu m n .
32
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.13 C lassification o f item s Listed b e lo w a re b a la n ce s fo r 2 0 1 6 .
$ Accounts receivable Sales Electricity Retained profits Loan Transportation costs
1
C la s s ify e a ch a c c o u n t as a n asset, lia b ility , reven ue , e x p e n s e o r e q u ity .
2
P re p a re an in c o m e state m e nt fo r th e p e rio d e n d in g 31 D e c e m b e r 2 0 1 6 .
80000 250000 30000 50000 200000 1 0 0 00
PROBLEM 1.14 M atching fin a n cia l sta te m e n t item s to s ta te m e n t categories R a in d ro p H o ld in g s Ltd is a p u b lic c o m p a n y . B e lo w a re item s ta ke n fro m its re c e n t c o n s o lid a te d b a la n c e sheet a n d c o n s o lid a te d in co m e statem ent. N o te th a t d iffe re n t c o m p a n ie s use s lig h tly d iffe re n t titles fo r th e sam e item . M a rk e a ch item in th e fo llo w in g list as a n asset (A), lia b ility (L) o r s h a re h o ld e rs ' e q u ity (SE) th a t w o u ld a p p e a r on the b a la n c e sheet, o r reven ue (R) o r e x p e n s e (E) th a t w o u ld a p p e a r on th e in co m e statem ent. 1 P ro p e rty p la n t a n d e q u ip m e n t
2
Sales reven ue
3
T ra d e a n d o th e r p a y a b le s
4 A d v e rtis in g costs 5
P rovisions
6
In ve nto ries
7 8 9
R evenue re c e ive d in a d v a n c e
P rep aym e nts Reserves
1 0 C a s h a n d cash e q u iv a le n ts 11 D e p re c ia tio n 12 C o s t o f sales
PROBLEM 1.15 M atching cash flo w sta te m e n t item s to categories The fo llo w in g item s w e re ta ke n fro m a re c e n t cash flo w statem ent. N o te th a t d iffe re n t c o m p a n ie s use s lig h tly d iffe re n t titles fo r th e sam e item . M a rk e a ch item in th e list as a cash flo w fro m o p e ra tin g a c tiv itie s (O ), in ve stin g a c tiv itie s (I) o r fin a n c in g a c tiv itie s (F). 1 C a s h p a id to e m p lo y e e s
2 C a s h b o rro w e d fro m th e b a n k 3
C a s h p ro c e e d s re c e iv e d fro m sale o f investm ent in a n o th e r c o m p a n y
4
In co m e ta xe s p a id
5
R ep a ym e n t o f lo a n p rin c ip a l
CHAPTER 1 Introduction to Financial accounting
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6 C a s h re c e iv e d in return fo r issue o f sh a re c a p ita l
7 C a s h re c e iv e d fro m custom ers 8
Purchases o f p ro p e rty , p la n t a n d e q u ip m e n t
9 C a s h p a id to s u p p lie rs 10 C a s h p a id fo r d iv id e n d s to s h a re h o ld e rs 11 R ep a ym e n t o f lo a n interest
PROBLEM 1.16 A cco u n tin g equation M r Sm iles o p e n e d his fru it s h o p a t th e b e g in n in g o f last y e a r. By th e e n d o f th a t y e a r he h a d th e fo llo w in g assets a n d lia b ilitie s : $000 Assets Cash
350
Fruit
600
Total assets
950
Liabilities Suppliers payable
280
Wages payable
128
Total liabilities
408
1
W h a t is M r S m ile s' s h a re h o ld e rs ' e q u ity in his fru it s h o p a t th e e n d o f th e y e a r?
2
If M r S m ile s' in itia l in ve stm en t w a s $ 5 0 0 0 0 0 , w h a t w a s his p ro fit fo r th e y e a r?
PROBLEM 1.17 The a cco u n tin g equation C a rd ig a n Ltd has to ta l assets o f $ 1 5 0 0 0 0 a n d lia b ilitie s th a t a d d up to $ 7 0 0 0 0 as a t 3 0 June 2 0 1 5 . 1
W h a t is C a rd ig a n 's s h a re h o ld e rs ' e q u ity as a t 3 0 June 2 0 1 5 ?
2
D u rin g th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l assets in cre a s e b y $ 6 3 0 0 0 w h ile to ta l lia b ilitie s in cre a s e b y $ 2 5 0 0 0 . W h a t is th e a m o u n t o f C a rd ig a n 's s h a re h o ld e rs ' e q u ity on 3 0 June 2 0 1 6?
3
N o w assum e th a t in th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l lia b ilitie s in cre a s e b y $ 2 0 0 0 0 a n d its s h a re h o ld e rs ' e q u ity d e cre ases b y $ 1 2 0 0 0 . O n 3 0 June 2 0 1 6 , w h a t is th e level o f C a rd ig a n 's to ta l assets?
4 A ssum e th a t in th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l assets d o u b le w h ile its s h a re h o ld e rs ' e q u ity re m a in s u n c h a n g e d . W h a t a re its to ta l lia b ilitie s as a t 3 0 June 2 0 1 6?
PROBLEM 1.18 The a cco u n tin g equation Use th e a c c o u n tin g e q u a tio n to a n s w e r th e fo llo w in g qu e stio n s. 1
P illo w Ltd h a lv e d its lia b ilitie s d u rin g th e y e a r. A t th e b e g in n in g o f th e y e a r, th e a m o u n t o f to ta l assets w a s $ 8 0 0 0 0 a n d o w n e rs ' e q u ity w a s $ 5 0 0 0 0 . W h a t is th e a m o u n t o f P illo w 's to ta l lia b ilitie s a t th e e n d o f th e y e a r?
2
B u ffa lo Ltd b e g a n th e y e a r w ith assets o f $ 6 0 0 0 0 a n d lia b ilitie s o f $ 2 5 0 0 0 . N e t p ro fit fo r th e y e a r w a s $ 4 3 0 0 0 . W h a t is th e a m o u n t o f o w n e rs ' e q u ity a t th e e n d o f th e y e a r?
3
D u rin g th e last fin a n c ia l y e a r, S p a rk le Industries trip le d th e a m o u n t o f its assets. A t th e e n d o f th e y e a r, to ta l lia b ilitie s a m o u n te d to $ 5 7 0 0 0 w h ile o w n e rs ' e q u ity w a s $ 1 5 0 0 0 . W h a t w a s th e a m o u n t o f to ta l assets a t the b e g in n in g o f the y e a r?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.19 Incom e sta te m e n t G iv e n th e fo llo w in g in fo rm a tio n , p re p a re an in c o m e state m e nt fo r G e rk e Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
$ Rent expense
30000
Cost of goods sold
100000
Sales
250000
Wages
75 000
Advertising
25 000
Training expense
8 000
PROBLEM 1.20 Incom e sta te m e n t e an income statement for the year ended 3 0 .
$ Sales
48 000
Cost of goods sold
21 000
Wages
8 000
Electricity
4000
Travel
2 000
Advertising
1 000
PROBLEM 1.21 Prepare a balance sheet and calculate p ro fit 1
G iv e n the fo llo w in g b a la n c e s , p re p a re a b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r B ricks Ltd.
$ Bank loan
100000
Share capital
400000
Accounts payable
60000
Taxes payable
40000
Inventory Cash
2
150000 50000
Land and buildings
500000
Retained profits
200000
Accounts receivable
100000
The c o m p a n y d id n o t d e c la re a n y d iv id e n d s d u rin g th e y e a r. Its b a la n c e in re ta in e d p ro fits a t th e start o f th e y e a r w a s $1 2 0 0 0 0 . W h a t is th e p ro fit fig u re fo r th e y e a r?
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PROBLEM 1.22 Analysing revenues and expenses and preparing an incom e s ta te m e n t A ssum e y o u a re th e o w n e r o f D o u b le C a fe , a c o ffe e sh o p in S y d n e y 's C B D . A t th e e n d o f June 2 0 1 6 , y o u fin d (fo r June o n ly) th is in fo rm a tio n : 1 Sales, as p e r cash re g is te r re c o rd s, o f $ 4 7 0 0 0 , plus sales on c re d it (tw o b irth d a y p a rtie s) o f $ 7 5 0 . 2
The c o st o f g o o d s sold d u rin g June h a d c o st $ 1 6 0 0 0 co n s is tin g o f c o ffe e , cups a n d cake s.
3
D u rin g th e m o nth , a c c o rd in g to th e c h e q u e b o o k , y o u p a id $ 1 4 0 0 0 fo r s a la rie s , rent, a d v e rtis in g a n d o th e r exp e n se s; h o w e v e r, y o u h a ve no t y e t p a id th e $ 6 8 0 m o n th ly b ill fo r e le c tric ity fo r June.
O n th e basis o f th e d a ta g iv e n (d is re g a rd in co m e taxes), w h a t w a s th e a m o u n t o f net p ro fit fo r June? S h o w c o m p u ta tio n s .
PROBLEM 1.23 C alculate share h o ld e rs' e q u ity G o m e z Lim ited has th e fo llo w in g assets a n d lia b ilitie s .
$ Loan
180 00 0
Cash
90000
Accounts payable
110 00 0
Accounts receivable
170 00 0
Equipment
200000
1
C la s s ify e a ch b a la n c e as a n asset o r a lia b ility .
2
C a lc u la te s h a re h o ld e rs ' e q u ity .
PROBLEM 1.24 C alculate share h o ld e rs' e q u ity G iv e n th e fo llo w in g in fo rm a tio n re la tin g to S trip es Ltd, w h a t is th e b a la n c e o f s h a re h o ld e rs ' e q u ity?
$ Land and buildings
2 800000
Accounts payable
250000
Cash and cash equivalents
340000
Inventory
410000
Bank loan
600000
Taxes payable
104 00 0
PROBLEM 1.25 Id e n tity som e a cco u n tin g concepts and p rinciples Id e n tify th e a c c o u n tin g c o n c e p ts o r p rin c ip le s th a t re la te to e a ch o f th e fo llo w in g sentences a n d e x p la in w h a t e ffe c t th e c o n c e p ts o r p rin c ip le s h a ve on fin a n c ia l statem ents: 1
Users o f fin a n c ia l statem ents sh o u ld be a b le to b e lie v e th a t th e nu m b ers re p re s e n t re a l events.
2
F in a n c ia l statem ents sh o u ld a v o id un du e o p tim is m a b o u t th e fu ture .
3
It is h a rd to say a b s o lu te ly if a c o m p a n y is p e rfo rm in g w e ll o r b a d ly , b u t y o u c a n e v a lu a te its re la tive p e rfo rm a n ce .
4
F in a n c ia l a c c o u n tin g sh o u ld be h e lp fu l bo th in u n d e rs ta n d in g th e p a st a n d lo o k in g a h e a d to th e fu ture .
5
The c o n te n t o f fin a n c ia l statem ents sh o u ld no t d e p e n d o n w h o p re p a re s them .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
36
PROBLEM 1.26 A cco u n tin g assum ptions C o n s id e r th e fo llo w in g statem ents re la tin g to h o w w e m ig h t a c c o u n t fo r c e rta in tra n s a c tio n s o r events. W h a t a c c o u n tin g a s su m p tio n o r p rin c ip le u n d e rlie s e a ch ? 1 'In v e n to ry is re c o rd e d a t cost unless th e net re a lis a b le v a lu e o f in v e n to ry is b e lo w cost. In th a t case , in v e n to ry is w ritte n d o w n to th e net re a lis a b le v a lu e .'
2
'A c c o u n tin g fin a n c ia l statem ents a re p rim a rily b a se d on h is to ric a l costs. T h e y s h o u ld , h o w e v e r, be p rim a rily a b o u t th e c o n te m p o ra ry cash v a lu e o f a c o m p a n y 's net a sse ts.'
3
'A t th e e n d o f e a ch p e rio d , a c o m p a n y has to c a lc u la te a n y sa la rie s th a t h a ve a c c ru e d , a n d re c o g n is e an e x p e n s e a n d a lia b ility fo r th a t a m o u n t.'
4
'If a c o m p a n y c h a n g e s its d e p re c ia tio n p o lic y , it needs to d isc lo se (in th e notes to th e fin a n c ia l statem ents) the
5
'M a n y businesses d o no t re c o rd " fr e ig h t in " as p a rt o f th e a c q u is itio n cost o f in v e n to ry , b u t a n y fre ig h t c h a rg e s o f th e p e rio d , w h ic h a re n o rm a lly sm all a m ou nts, a re e x p e n s e d in th e gross p ro fit section o f th e in co m e s ta te m e n t.'
n a tu re o f th e c h a n g e , a n d its fin a n c ia l e ffe c ts.'
PROBLEM 1.27 Q ualitative characteristics The F ra m e w o r k f o r th e P re p a r a tio n a n d P re s e n ta tio n o f F in a n c ia l S ta te m e n ts e x a m in e s th e c h a ra c te ris tic s o f a c c o u n tin g in fo rm a tio n th a t m a ke this in fo rm a tio n useful fo r d e c is io n -m a k in g . It a ls o p o in ts o u t th a t v a rio u s lim ita tio n s , w h ic h a re in h e re n t in th e m e asure m en t a n d re p o rtin g pro ce ss, m a y necessitate tra d e -o ffs b e tw e e n these lim ita tio n s a n d th e p o s itiv e c h a ra c te ris tic s o f useful in fo rm a tio n . 1 B rie fly d e s c rib e th e fo llo w in g c h a ra c te ris tic s o f useful a c c o u n tin g in fo rm a tio n :
2
3
a
re le v a n c e
b
re lia b ility
c
u n d e rs ta n d a b ility
d
c o m p a ra b ility .
For e a ch o f th e fo llo w in g p a irs o f in fo rm a tio n c h a ra c te ris tic s , g iv e an e x a m p le o f a s itu a tio n in w h ic h o n e o f the c h a ra c te ris tic s m a y be s a c rific e d in return fo r a g a in in th e o th e r:
a
re le v a n c e a n d re lia b ility
b
re le v a n c e a n d c o m p a ra b ility
c
re le v a n c e a n d u n d e rs ta n d a b ility .
W h a t c rite rio n sh o u ld be used to e v a lu a te tra d e -o ffs b e tw e e n in fo rm a tio n c h a ra c te ris tic s ?
PROBLEM 1.28 Prim ary assum ptions made in prep a rin g fin a n cia l statem ents K e lly o p e n e d a p h o to g ra p h y business in a sm all s h o p th a t she re n te d fro m a la rg e re ta ile r, E astfield Lim ited . She p a id th e first m o n th 's ren t o f $ 4 0 0 b y w ritin g a c h e q u e fro m he r p e rso n a l a c c o u n t. K e lly to o k som e o f he r o w n p h o to g ra p h y e q u ip m e n t a n d m a te ria ls (w o rth $ 5 0 0 0 ) in to th e s h o p , a n d a ls o b o u g h t so m e n e w c a m e ra s so th a t she c o u ld ta k e p ictu re s o f he r custom ers w ith th e best a v a ila b le te c h n o lo g y . The c a m e ra s h a d a re c o m m e n d e d re ta il p ric e o f $ 2 5 0 0 b u t she w a s a b le to b u y them on sale fo r $ 2 2 0 0 , c h a rg in g them to he r p e rso n a l c re d it c a rd . K elly's first c u sto m e r p a id he r $ 9 0 0 fo r a set o f p o rtra its , so she o p e n e d a b a n k a c c o u n t fo r th e c o m p a n y . H e r o th e r custom ers h a ve no t y e t p a id her, o w in g a to ta l o f $ 3 1 0 0 . A t th e e n d o f th e first m o nth o f business, K e lly p re p a re d the fo llo w in g fin a n c ia l statem ents (see ne xt p a g e ).
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KELLY'S PROFESSIONAL PHOTOGRAPHY BALANCE SHEET AS AT 31 MAY 20 16 $ Cash Equipment
$
900 2 500
Shareholders' equity
3 400
3 400 3 400
KELLY'S PROFESSIONAL PHOTOGRAPHY INCOME STATEMENT FOR THE MONTH ENDED 31 MAY 2 0 1 6 Sales
4000
Rent Equipment
400 2 500
2 900
1 too
Net profit
Id e n tify th e a ssu m p tio n s th a t K e lly has v io la te d , a n d e x p la in h o w e a c h even t sh o u ld h a ve been h a n d le d . P rep are a c o rre c te d b a la n c e sheet a n d in co m e statem ent.
PROBLEM 1.29 Discuss e th ica l problem s Discuss th e e x a m p le s o f e th ic a l p ro b le m s g iv e n a t th e e n d o f s e ctio n 1 .4 . W h a t e th ic a l issues d o y o u see? W h a t d o y o u th in k th e c h ie f a c c o u n ta n t, th e a u d ito r a n d the g e n e ra l m a n a g e r s h o u ld do?
CASES CASE 1A
W oolworths Limited
Refer to th e e x tra c ts o f th e 2 0 1 4 a n n u a l re p o rt o f W o o lw o rth s Lim ited in th e b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to th e c o n s o lid a te d a cco u n ts. 1 P ro v id e in d ic a to rs th a t W o o lw o rth s uses a c c ru a l a c c o u n tin g .
2 W h a t w e re to ta l assets a t 2 9 June 2 0 1 4 ? 3 W h a t w e re to ta l lia b ilitie s a t 2 9 June 2 0 1 4 ? 4 W h a t w a s s h a re h o ld e rs ' e q u ity a t 2 9 June 2 0 1 4 ? 5
State th e a c c o u n tin g e q u a tio n in d o lla r fig u re s a t 2 9 June 2 0 1 4 .
6
W h a t w a s th e net p ro fit b e fo re ta x?
7
W h a t w a s th e net p ro fit a fte r ta x?
8
W h a t w e re th e la rg e s t cash in flo w a n d o u tflo w re la tin g to o p e ra tin g a c tiv itie s ?
9 G iv e tw o rea so ns w h y th e cash flo w fro m o p e ra tio n s is a d iffe re n t fig u re fro m o p e ra tin g p ro fit a fte r ta x. 10 D id its to ta l assets in cre a s e o r d e c re a s e o v e r th e last y e a r? 11 H o w m uch in v e n to ry (in d o lla rs) d id W o o lw o rth s h a ve as a t 2 9 June 2 0 1 4 ? 12 O n w h a t d a te do es W o o lw o rth s ' m ost re c e n t re p o rtin g y e a r e n d ? 13 For h o w m a n y y e a rs do es it pre se n t c o m p le te :
a
b a la n c e sheets?
b
in co m e statem ents?
c
cash flo w statem ents?
14 A re its fin a n c ia l statem ents a u d ite d b y an in d e p e n d e n t firm ? W h o is th e a u d ito r fo r th e c o m p a n y ?
38
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 1B________________ Accrual and cash profit in measuring performance W in g s Ltd is a n a irlin e services c o m p a n y w ith a p la n t n e a r S y d n e y A ir p o r t a n d se rvice centres in s eve ral states. It p ro v id e s m eals, serviettes a n d o th e r fo o d -re la te d item s, c le a n in g , in te rio r m a in te n a n c e a n d s eve ral o th e r services to v a rio u s a irlin e s . The c o m p a n y has be en fa irly successful, th o u g h recessions a n d th e d e re g u la tio n o f a ir service s ha ve p u t s ig n ific a n t pressure o n its o p e ra tio n s . W h e n th e c o m p a n y b e g a n in th e la te 1 9 7 0 s , it h a d a re la tiv e ly w e a k fin a n c ia l p o s itio n (m a in ly b e ca u s e o f b o rro w in g to g e t set up) a n d its fin a n c ia l p e rfo rm a n c e , w h ile s a tis fa c to ry , has no t e n a b le d it to re d u c e its d e b t lo a d v e ry m uch. It seem s th a t e v e ry tim e th e c o m p a n y gets a little a h e a d , n e w e q u ip m e n t m ust b e p u rc h a s e d o r n e w p ro d u c t lines d e v e lo p e d , a n d th e c o m p a n y fin d s itself b o rro w in g a g a in . A re c e n t y e a r p ro v id e s a g o o d e x a m p le . The c o m p a n y 's a c c ru a l p ro fit w a s $ 1 8 8 0 0 0 a n d its cash p ro fit w a s $ 2 4 1 0 0 0 . (The d iffe re n c e resulted b e ca u s e o f a d e p re c ia tio n e x p e n s e o f $ 9 6 0 0 0 a n d u n co lle cte d reven ue b e in g $ 4 3 0 0 0 h ig h e r a t th e e n d o f th e y e a r th a n a t th e b e g in n in g . In th e c o m p a n y 's fin a n c ia l statem ents, th e p h ra s e 'n e t p ro fit fo r th e y e a r' w a s used to d e s c rib e th e a c c ru a l p ro fit a n d 'c a s h g e n e ra te d b y o p e ra tio n s ' d e s c rib e d th e cash p ro fit.) The g e n e ra l m a n a g e r h a d lo o k e d fo rw a rd to using som e o f th e cash to p a y de bts, b u t la te in th e y e a r the c o m p a n y h a d to b u y n e w fo o d -h a n d lin g a n d w ra p p in g e q u ip m e n t fo r $ 2 0 6 0 0 0 to m eet revised s ta n d a rd s a n n o u n c e d b y its a irlin e custom ers. T h e re fo re , th e c o m p a n y e n d e d up o n ly a fe w th o u s a n d d o lla rs a h e a d in cash , no t e n o u g h to m a ke m uch o f a d e n t in its de bts. The g e n e ra l m a n a g e r has a re g u la r h a lf-y e a rly m e eting w ith th e c o m p a n y 's e x te rn a l a u d ito r to discuss a c c o u n tin g a n d a u d itin g issues. A fte r th e a b o v e results w e re k n o w n , th e g e n e ra l m a n a g e r p h o n e d th e a u d ito r a n d m a d e th e fo llo w in g c om m en ts: 'I th o u g h t I'd ask y o u to th in k a b o u t a fe w th in g s b e fo re o u r m e eting n e xt w e e k . W h e n it com es to o u r a c c o u n tin g , I th in k th e c o m p a n y has to o m a n y m asters a n d to o m a n y m easures. W h a t I m e an is first th a t to o m a n y p e o p le a re c o n c e rn e d w ith w h a t o u r fin a n c ia l statem ents say. W h y c a n 't w e just p re p a re fin a n c ia l statem ents th a t m eet m y needs as g e n e ra l m a n a g e r? W h y d o w e h a ve to w o rry a b o u t a ll th e o th e r p e o p le o u ts id e the c o m p a n y ? S om etim es I'm n o t even sure w h o a ll those o th e r p e o p le a re , since y o u a c co u n ta n ts a n d a u d ito rs often just ta lk a b o u t " u s e rs " w ith o u t b e in g to o c le a r w h a t y o u m e an . A ls o , I'm c o n fu se d b y th e e x is te n ce o f b o th a " n e t p ro fit" fig u re a n d a "c a s h g e n e ra te d b y o p e ra tio n s " fig u re in o u r fin a n c ia l statem ents. W h y c a n 't w e just h a ve o n e o r the o th e r to m e asure o u r p e rfo rm a n c e ? ' The g e n e ra l m a n a g e r ra is e d issues th a t w ill b e a d d re s s e d fre q u e n tly as this b o o k d e v e lo p s y o u r u n d e rs ta n d in g . But fo r n o w , w h a t w o u ld y o u s a y to th e g e n e ra l m a n a g e r?
CASE 1C
Audit and ethics issues
R ead th e fo llo w in g e x tra c t.
T h e o v e ra ll o b je c tiv e o f th e fin a n c ia l s ta te m e n t a u d it is t o a d d c r e d ib ility t o m a n a g e m e n t’s fin a n c ia l r e p o r ts . . .
Essential C om p on en t E v e ry fin a n c ia l m a r k e t, a n d s u b s e q u e n tly all fin a n c ia l re g u la to rs , re lie s o n th e e x is te n c e o f m e a n in g fu l an d re lia b le fin a n c ia l s ta te m e n ts . T h e external audit p ro v id e s t h e e s s e n tia l c o m p o n e n t o f in d e p e n d e n t a s s u ra n c e , w h ic h is n e c e s s a ry f o r t h e p ro v is io n o f re lia b le fin a n c ia l s ta te m e n ts . . . T h e h ig h q u a lity a u d it d e liv e re d in 2 0 0 9 is a t o t a lly d if fe r e n t s e rv ic e th a n th e a u d it t h a t w o u ld ha ve b e e n o f f e r e d as little as 1 0 y e a rs a g o . W h a t has re m a in e d c o n s ta n t o v e r th is tim e is th e v a lu e o f th e in d e p e n d e n t a s s u ra n c e p ro v id e d b y t h e a u d it p ro c e s s . . .
E xpe ctation Gap T h e re is a s e g m e n t o f th e m a r k e t t h a t sees an e x te rn a l a u d it as t h e g u a ra n te e a g a in s t p o o r m a n a g e m e n t b e h a v io u r, q u e s tio n a b le b u sin e ss d e c is io n s a n d , u ltim a te ly , a g a in s t c o r p o r a te fa ilu re . . . W e a re all w e ll a w a re t h a t a c o r p o r a te fa ilu re d o e s n o t a lw a y s e q u a te t o an a u d it fa ilu re . Source: Richard Deutsch, ‘A udits add C redibility’, Charter, Septem ber 2 0 0 9 .
CHAPTER 1 Introduction to Financial accounting
1
W h a t is m e a n t b y in d e p e n d e n t assu ran ce ?
2
G iv e som e e x a m p le s o f la c k o f in d e p e n d e n c e .
3
C o m m e n t on th e statem ents in th e p a ra g ra p h h e a d e d 'E x p e c ta tio n G a p '.
4
H o w d o m a n a g e m e n t's a n d a u d ito rs ' re s p o n s ib ilitie s d iffe r?
5
W h y is th e in te g rity o f m a n a g e m e n t im p o rta n t to th e fin a n c ia l re p o rtin g process?
COURSEMATE
WEBSITE RESOURCES
0 C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m
p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
39
Measuring and evaluating Financial position and Financial perFormance ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: describe the contents of a bala n c e sheet carry out prelim inary analysis based on the contents of a b a la n c e sheet determ ine w h a t business activities result in changes in a b a la n c e sheet determ ine w h ether an item should be included as an asset or a liability in the b a la n c e sheet show h o w specific activities affect each item in the b a la n c e sheet p re p a re a bala n c e sheet determ ine the effect o f transactions on revenue and expenses p re p a re an incom e statement explain the nature of each o f the items in the b a la n c e sheet a n d incom e statem ent for a public com pany describe the contents of the note reconciling opening an d closing retained profits explain the im portance of both financial statements to m anagers.
CHAPTER OVERVIEW C h a p te r 1 in tro d u c e d a c c ru a l a c c o u n tin g , th e k e y fin a n c ia l state m e nts a n d th e users a n d p re p a re rs o f these state m ents. N o w w e tu rn to th re e c h a p te rs th a t set o u t fin a n c ia l a c c o u n tin g 's results a n d o u tlin e th e re c o rd -k e e p in g system th a t le a d s to th ose results. This c h a p te r fo cu ses o n th e c o n te n t a n d use o f th e state m e nts m e a s u rin g fin a n c ia l p o s itio n a t a p a rtic u la r d a te (a b a la n c e sheet) a n d m e a s u rin g fin a n c ia l p e rfo rm a n c e (an in c o m e state m e nt) o v e r a p e rio d . C h a p te rs 3 a n d 4 c o n s id e r h o w th e d o u b le -e n try system p ro d u c e s a c c o u n ts a n d h o w these a c c o u n ts a re a s s e m b le d to g e th e r to fo rm fin a n c ia l state m e nts. The b a la n c e shee t is fin a n c ia l a c c o u n tin g 's o ld e s t a n d m ost b a s ic re p o rt. It m e asure s th e e n te rp ris e 's fin a n c ia l p o s itio n a t a p a rtic u la r d a te a n d is th e b a sis fo r m uch fin a n c ia l a n a ly s is . F ig u re 2 .1 o u tlin e s w h a t y o u w ill le a rn in th e n e xt th re e c h a p te rs :
•
p r o c e d u r e s a n d te c h n iq u e s : h o w th e doub le-entry accounting system p ro d u c e s a c c o u n ts , a n d h o w to a s se m b le
a b a la n c e sheet a n d a n in c o m e s ta te m e n t fro m th ose a c c o u n ts
•
c o n c e p ts a n d p r in c ip le s : w h y th e b a la n c e sheet a n d in c o m e s ta te m e n t a re im p o rta n t, w h y th e y a re a rra n g e d as
th e y a re , a n d som e in te re s tin g h is to ry a b o u t w h e re th e y c a m e fro m
•
a n a ly s is a n d d e c is io n s : u sin g th e fin a n c ia l state m e nts to u n d e rs ta n d h o w a n e n te rp ris e is p u t to g e th e r
fin a n c ia lly a n d h o w it d o e s its bu siness, a n d u sin g it to d o som e a n a ly s is o f th e e n te rp ris e 's fin a n c ia l h e a lth a n d p e rfo rm a n c e .
42
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FIGURE 2.1
The how, why and uses of accounting
The b a la n c e shee t s u m m arises, a t a p a rtic u la r d a te , th e e n te rp ris e 's fin a n c ia l p o s itio n as a c c o u n tin g m easures it, in th re e c a te g o rie s o f lists: •
re s o u rc e s (such a s c a sh , p ro d u c ts o n h a n d , la n d a n d b u ild in g s ) c a lle d assets
•
o b lig a t io n s (such as lo a n s o w in g a n d d e b ts to s u p p lie rs) c a lle d lia b ilitie s
•
o w n e r s ' in te re s ts (w h a t's le ft a fte r s u b tra c tin g th e o b lig a tio n s fro m th e resources) c a lle d e q u ity .
The in d iv id u a l item s in e a c h o f these lists a re c a lle d a c c o u n ts , so o v e r th e c e n tu rie s th e ta s k o f p re p a rin g them has b e e n n a m e d a c c o u n tin g , a n d th e p e o p le w h o d o it a re a c c o u n ta n ts . A ll these w o rd s a re d e riv e d fro m 'c o u n t', w h ic h is w h e re a c c o u n tin g b e g a n : just c o u n tin g th in g s a n d lis tin g th e m . The b a la n c e shee t p o rtra y s th e e n te rp ris e b y a rra n g in g its lists o f a c co u n ts so th a t th e assets sum to th e sam e to ta l a s th e o th e r tw o lists, a n d se ttin g th em b e s id e (o r b e lo w ) e a c h o th e r, s o m e th in g like this:
Assets
Liabilities and equity
Item a
$$
Item x
$$
Item b
_$$
Item y
_$$
Etc.
$$
Etc.
$$
Total
T$$
Total
T$$
B ecau se th e le ft to ta l e q u a ls th e rig h t to ta l, a c c o u n ta n ts s a y th a t th e y b a la n c e - h e n c e th e n a m e b a la n c e sheet. The u n d e rly in g a c c o u n tin g system m a in ta in s th is b a la n c e b y m a k in g sure th a t a n y c h a n g e s in o n e s id e o f th e b a l a n c e shee t a re m a tc h e d b y c h a n g e s in th e o th e r s id e . This re q u ire s th a t e a c h c h a n g e b e re c o rd e d tw ic e , so th e a c c o u n tin g system is c a lle d d o u b le -e n try . The b a la n c e shee t tu rns o u t to b e th e a c c u m u la tio n o f e v e ry th in g fin a n c ia l a c c o u n tin g has re c o rd e d a b o u t th e e n te rp ris e s in c e th e d a y th e e n te rp ris e b e g a n , so it is th e fu n d a m e n ta l c u m u la tiv e a c c o u n tin g re c o rd , a n d is th e a n c h o r to w h ic h a ll th e o th e r fin a n c ia l state m e nts a re tie d . The b a la n c e sheet p ro v id e s im p o rta n t in fo rm a tio n a b o u t th e e n te rp ris e 's fin a n c ia l stru c tu re a n d s tre n g th , b u t its d e s c rip tio n o f th e e n te rp ris e 's fin a n c ia l p o s itio n is n o t th e o n ly s to ry to be to ld . Its p ic tu re is sta tic: it tells us w h a t th e p o s itio n is. M o s t m a n a g e rs , o w n e rs a n d c re d ito rs a ls o w a n t to k n o w h o w w e ll th e e n te rp ris e is p e rfo rm in g a n d h o w it g o t to w h e re it is. To p ro v id e th a t e x p la n a tio n , w e ne ed to m e a s u re fin a n c ia l p e rfo rm a n c e . This is p ro v id e d b y a n in c o m e sta te m e n t (often c a lle d a p ro fit a n d loss s ta te m e n t in te rn a lly w ith in o rg a n is a tio n s ). C o rp o ra tio n s - w h ic h a re le g a lly in c o rp o ra te d c o m p a n ie s such as Q a n ta s , C o m m o n w e a lth B a n k, T e lstra, BHP B illito n , W o o lw o rth s a n d th o u s a n d s o f lo c a l, n a tio n a l a n d in te rn a tio n a l bu sinesses - p ro d u c e fin a n c ia l statem ents a t le a st a n n u a lly . S o d o m a n y o th e r k in d s o f o rg a n is a tio n s , such as th e C ity o f B ris b a n e , th e S a lv a tio n A rm y , th e G o v e rn m e n t o f A u s tra lia a n d y o u r u n iv e rs ity 's s tu d e n t u n io n . (W e m a in ly fo cu s o n businesses, e s p e c ia lly c o rp o ra tio n s , b u t o th e r k in d s o f o rg a n is a tio n s a re c o n s id e re d w h e re a p p ro p ria te .) For la rg e c o rp o ra tio n s , e s p e c ia lly p u b lic c o m p a n ie s w h o s e share s a re tra d e d o n stock m a rke ts, th e fin a n c ia l state ments a re in c lu d e d in a la rg e r d o c u m e n t c a lle d a n annual report. A n a n n u a l re p o rt ty p ic a lly b e g in s w ith n a rra tiv e m a te ria l o n the c o rp o ra tio n 's p e rfo rm a n c e a n d pro sp ects, m oves on to a n e xte n sive discussion a n d a n a ly s is b y m a n a g e m e n t, then turns to th e fin a n c ia l statem ents: th e b a la n c e sheet, th e in c o m e state m e nt a n d th e state m e nt o f cash flo w s . The first tw o a re discussed in this c h a p te r, a n d th e state m e nt o f cash flo w s is d iscusse d in C h a p te r 1 4 .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2.1
43
Introduction to the balance sheet
The balance sheet is only one o f the set o f financial statements, each of w hich is im portant for particular uses. H ow ever, as the summary of the double-entry system, the balance sheet is a critical part o f financial accounting. It balances, containing tw o lists that have the same d o lla r total and together describe the enterprise's financial position at a particular date. The first list is the enterprise's fin a n cia l resources at that d ate, as measured by the fin a n cia l accounting methods you w ill learn. These resources, called a s s e t s , include the enterprise's cash, accounts receivable (money customers have prom ised to pay), inventory (goods for sale), land, buildings, equipm ent a nd m any other resources that the enterprise has accum ulated an d can use in the future. The second list is the sources, o r fin a n cin g , o f those resources at that d a te - a g a in , as measured b y fin a n cial accounting methods. •
These fin a n cin g sources include existing o b lig a tio n s that w ill have to be p a id in the future, such as loans from the bank, amounts d ue to be p a id to em ployees a n d suppliers (w ages p a y a b le a nd accounts p a y a b le respectively), m ortgages an d other long-term b o rrow in g s, a n d m any other debts. Som e estimates o f future payments are also included, although they m ay not be le g a lly o w e d just yet, such as promises to p a y e m ployee long service leave an d estim ated future w a rra n ty costs based on the expected w a rra n ty expenses related to sales a lre a d y m ade. All these legal o b lig a tio n s a nd estimates together are c a lle d liabilities.
•
The list o f sources also includes amounts received from ow ners, w h ich norm ally involve perm anent fin a n cin g and d o not have to be re paid, plus a n y past accrual profits that have not been p a id out to the ow ners. O w n e rs can fin a n ce an enterprise b y contributing m oney to the enterprise, or by not taking profit out of the enterprise, as w e w ill see. The ow ners' investment is c a lle d ow ners' equity, o r just equity. (For corporations, w h ich a re o w n e d by shareholders, the term is usually shareholders' equity, w h ile for unincorporated businesses the terms ow ners' c a p ita l o r partners' c a p ita l are likely to be used. All o f these terms just mean ow ners' equity.) Because the b a la n ce sheet balances, the total am ount o f assets must equal the total o f liabilities plus equity.
Arithm etically, the accounting equation (often c a lle d the b a la n ce sheet equation) therefore is: Sum of assets = Sum of liabilities + Sum of eq u ity This gives us the accounting equation: Assets = Liabilities + S h areh o ld ers' eq u ity This equation is fundam ental to financial accounting. Accounting procedures are designed to create and m aintain this equality at all times. For exam ple, if you obtain $ 1 0 0 by b o rrow ing from the bank, your balance sheet w o u ld list the $ 1 0 0 cash you received as a resource and the $ 1 0 0 o b lig a tio n to repay as a liability. By m aintaining this equality, financial accounting ensures that all the financing sources that g o w ith the resources are identified, and vice versa. This balanced p a ir of lists is one of the main reasons for financial accounting's value as an inform ation system. The tw o lists are put side by side, o r the first a b o v e the second, as in the standard style show n in Figure 2 .2 . F o r m a t o f b a la n c e s h e e t
(all figures are as of a particular date) OR
Side-by-side style
Vertical style
A ss ets :
L ia b ilitie s :
A ss ets :
Useful financial resources
Obligations to be paid
Useful financial resources
E q u ity :
Obligations to be paid
L ia b ilitie s :
Owners' investment
E q u ity : In b o t h c a s e s , s u m A = s u m L + s u m E
FIGURE 2.2
Balance sheet
Owners’ investment
44
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Exhibit 2.1 is a sim ple exam ple o f a b a la n ce sheet using the side-by-side style to em phasise the e q u a lity o f the tw o lists, w ith assets on the left a n d liabilities a nd equity on the right. Explanations o f the terms used in the b a la n ce sheet fo llo w the exam ple.
EXHIBIT 2.1
SOUND AND LIGHT LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 6 (IN TH O U SA N D S OF DOLLARS)
* Equipment (net) = Cost —Accumulated depreciation = $272 000 —$122 000 = $150 000
Let's review some features o f this b a la n ce sheet: •
The title identifies the enterprise (Sound an d Light Ltd), the point in tim e a t w h ich it is d ra w n up (3 0 June 2 0 1 6 )
•
The b alance sheet balances! As at 3 0 June 2 0 1 6 , total assets of $ 4 9 5 0 0 0 are exactly equalled by the total
and the currency in w h ich am ounts a re m easured (thousands o f dollars). sources of these assets (i.e. liabilities an d shareholders' equity). It is a summary, so w e cannot tell exactly w hich source produced w h ich asset o r assets; for exam ple, the $ 5 0 0 0 0 o f cash cam e partly from bank b o rro w in g and partly from other sources, such as past profits. (M o re a b o u t sources shortly.) •
Assets are usually separated into shorter-term ones (current assets) an d longer-term ones (noncurrent assets). (M ore a bout these categories be lo w .)
•
Like assets, liabilities are usually separated into shorter-term ones (current liabilities) a nd longer-term ones (noncurrent liabilities).
•
The b a la n ce sheet shows several in dividual accounts, telling us a b o u t the com pany's particular fin a n cia l structure. For exam ple, the c o m p a n y expects to receive $ 7 5 0 0 0 from customers an d ow es $ 7 3 0 0 0 to its suppliers. The c o m p a n y ow es $ 3 0 0 0 0 to the b a n k but has chosen not to p a y it all back, keeping m ore than that ( $ 5 0 0 0 0 ) on hand as cash. (These accounts a re usually a g g re g ate s o f m any sm aller accounts; for exam ple, there is an account for each customer w h o ow es m oney to Sound an d Light.)
•
The $ 4 9 5 0 0 0 o f assets have been fin a n ce d by $ 1 9 0 0 0 0 ($ 1 0 3 0 0 0 + $ 8 7 0 0 0 ) of liabilities a nd $ 3 0 5 0 0 0 o f ow ners' equity.
•
N o te : the accounting equation a lw a ys balances: Assets = Liabilities + Equity
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
45
2.2 Explanations of the three balance sheet categories: assets, liabilities and equity Assets Assets are a mixture o f the resources that the c o m p a n y needs to d o business - for instance, products to sell a nd a buildin g to ope ra te from - a nd the resources that it has accum ulated as a result o f d o in g business, including amounts due from customers for past sales. You can think o f assets as e co n o m ic resources that have p ro b a b le future benefits that are controlled by the entity. M o re form ally, assets a re resources controlled by the entity as a result o f past events an d from w h ich future econom ic benefits a re expected to flo w to the entity. Based on this definition, assets need to have three essential characteristics: •
Future econom ic benefits because the assets are used to provide goods and services for exchange, w ith the objective of generating net cash flow s (e.g. through the sale o f the asset o r the sale o f the output produced through the use of the asset). C onsider the fo llo w in g exam ples o f assets and h o w they provide future econom ic benefits. Cash balances are beneficial because o f their com m and over the future econom ic benefits they provide. Assets such as accounts receivable are direct claims to cash inflows (receipt o f paym ent from accounts receivable); prepayments (e.g. prepaid rent) provide rights to receive services in the future; inventories can be exchanged for cash o r claims to cash, property, plant and equipment; a nd patents can provide goods o r services.
•
C o n tro l b y the entity relates to the c a p a c ity o f an entity to benefit from the asset in pursuing its objectives a nd to d e n y o r regulate the access o f others. For exam ple, if a c o m p a n y ow ns a truck it can prevent others from using it. Som e future e conom ic benefits w ill not be controlled b y an entity, because the entity cannot d e n y others access to the benefits o f the asset; for exam ple, a property d e ve lo p e r w h o builds units an d is required by the local council to put in a public park as part of the project. If the park is open to the general public w ith o u t charge, then the d e ve lo p e r does not have control over the asset a nd the public park w o u ld not be included as an asset for the property developer.
•
O ccurrence o f p a st transactions o r other p a st events means that the transaction or other event g ivin g the entity control over the future e conom ic benefits must have occurred. M o s t assets are o b ta in ed by an entity by using cash, credit (prom ise to p a y in the future) o r barter transactions. Sound a n d Light's assets include cash, accounts receivable, inventory, land an d equipm ent. O th e r 'assets' of
Sound a nd Light m ight include h a p p y em ployees, a safe w o rkin g environm ent an d the benefit o f some market research on w h ich products w ill be p o p u la r in the future - yet these d o not d irectly a p p e a r on its b a la n ce sheet. There is a distinction betw een the assets that accounting recognises a nd these other 'assets'. There are objective, standard measures for the e co n o m ic control o f the first g ro u p a nd for dem onstrating the p ro b a b ility o f future benefits that w ill eventuate for the first g roup, but not for the second g ro u p . For exam ple, in the first g roup, an inventory o f m achine parts is o w n e d by the enterprise a nd has a d o lla r cost that can be easily verified. The benefit w ill com e from future use o r selling the inventory. In the second g roup, a h a p p y e m ployee is, in theory, m ore productive than an unhappy em ployee, but it is difficult to measure re liably (with a n y consistency) h o w much m ore productive a very h a ppy em ployee is co m pared w ith an em ployee w h o is o n ly m ildly happy. M o re o ver, at least in our society, an enterprise does not o w n its em ployees! A ccounting g e n e ra lly records assets only w h e re there is econom ic control; that is, w h e re the value o f the asset can be re liably measured an d it is p ro b a b le the future benefits w ill eventuate. The expenditure for market research w ill not q u a lify as an asset because it is not possible, a t the d a te of expenditure, to establish that it is p ro b a b le that the future benefits w ill eventuate. This places limits on the scope of the fin a n cia l statements. In summary, an asset is o n ly recognised in the b a la n ce sheet w hen (a) it is p ro b a b le that future e co n o m ic benefits w ill eventuate, an d (b) the asset possesses a cost o r other value that can be re liably measured. W e w ill discuss these com plications in m ore detail in C h a p te r 6.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Assets are usually separated into shorter-term ones (current assets) a nd longer-term ones (noncurrent assets). Current assets a re those that are expected to be used, sold o r collected w ithin the next year. N oncurrent assets, therefore, are expected to have benefits for m ore than a y e a r into the future. Sound a nd Light has $ 2 4 5 0 0 0 in current assets a n d $ 2 5 0 0 0 0 in noncurrent assets.
HOW'S YOUR UNDERSTANDING? W h ic h o f th e fo llo w in g w o u ld n o t be in c lu d e d as assets in th e b a la n c e s h e e t: a c c o u n ts re c e iv a b le , e q u ip m e n t, s h a re c a p ita l, in v e n to ry an d a c c o u n ts p a ya b le ? Y o u r a n s w e r s h o u ld be : sh a re c a p ita l (S E ) and a c c o u n ts p a y a b le (L ).
Liabilities Liabilities are p ro b a b le debts o r o b lig a tio n s that result from an entity's past transactions (e.g. som eone p roviding them w ith a service) an d w ill be p a id for w ith assets (e.g. cash) o r services (e.g. p ro vid in g a service that som eone else has a lre a d y p a id the entity for). M o re form ally, liabilities are present o b lig a tio n s of the entity arising from past events, the settlements o f w h ich a re expected to result in an o u tflo w from the entity o f resources e m b o d yin g econom ic benefits. There are tw o essential characteristics o f liabilities. First, a present o b lig a tio n exists a nd the o b lig a tio n involves settlement in the future via the sacrifice o f future econom ic benefits. M o s t o b lig a tio n s a re le g a lly enforceable; for exam ple, they arise out o f contractual arrangem ents, including m oney b o rro w e d , amounts o w in g on assets purchased o r for services p ro vid e d , or o b lig a tio n s to pro vid e services to parties w h o have p a id in a d va n ce . O b lig a tio n s can also be im posed on the entity, including dam ages a w a rd e d by courts, w orkers' com pensation claim s and income tax payable. O b lig a tio n s can also arise from normal business practice, custom a nd a desire to m aintain g o o d business relations o r act in an eq u ita ble manner. If, for exam ple, an entity decides as a matter of p o licy to rectify faults in its products even w hen these becom e a p p a re nt after the w a rra n ty p eriod has e xpired, the w a rra n ty am ounts that a re expected to be e xpended in respect of g o o d s a lre a d y sold are liabilities. The other essential characteristic of a lia b ility is that it has adverse fin a n cia l consequences for the entity, in that the entity is o b lig e d to sacrifice e co n o m ic benefits to o ne o r m ore entities. Thus, the existence of a lia b ility depends on the present o b lig a tio n being such that the legal, social, p o litica l or econom ic consequences o f fa ilin g to honour the o b lig a tio n leave the entity little, if any, discretion to a vo id the future sacrifice o f e conom ic benefits to another entity. For exam ple, an entity p lacing an o rd e r for the purchase o f g o o d s w o u ld not norm ally g ive rise to a lia b ility, since the entity w o u ld norm ally have the discretion to a v o id the future sacrifice o f econom ic benefits by being a b le to cancel the order. The receipt o f the g o o d s w o u ld norm ally be the event that w o u ld create the liability. Liabilities include amounts o w e d to creditors, such as banks an d suppliers, o r am ounts estim ated to be due later, such as h o lid a y an d long service leave payments to em ployees, estim ated future incom e taxes o r interest bu ild in g up on a bank loan. For exam ple, if an electrician has d o n e repair w o rk on a c o m p a n y b u ild in g , the electrician w ill be o w e d m oney (accounts p a yable). The electrician has d o n e the w o rk (past transaction) a nd the c o m p a n y has a present o b lig a tio n . N o t all liabilities a re expected to be p a id in cash; some are 'p a id ' b y p ro vid in g g o o d s o r services. An exam ple is a deposit received from a customer for g o o d s to be shipped later. The enterprise has the m oney (an asset) and records a corresponding lia b ility for the deposit, but expects to g ive the customer the agreed-upon g o o d s to d ischarge the liability. In the m eantim e, the customer has a claim on the enterprise, expecting to get either the g o o d s o r the cash back if the g o o d s are not supplied. Sound an d Light's liabilities include am ounts o w in g to the bank (bank overdraft) and amounts o w in g to suppliers (accounts payable) a nd a long-term loan. Follow ing the same rule as for assets, liabilities g e n e ra lly include o nly o b lig a tio n s that can be re liably measured. If you are in d e b t to a friend fo r $ 1 0 , that w o u ld a p p e a r on yo u r b a la n ce sheet. H ow ever, if you are 'in d e b t' to a friend for saving your life, that w o u ld not a p p e a r on yo u r b a la n ce sheet. The requirem ent that the o b lig a tio n has
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arisen from a past transaction means that a prom ise to p a y is a lia b ility if the enterprise has a lre a d y received the benefit; for exam ple, if it has received cash from the bank o r g o o d s from a supplier or hard w o rk from an em ployee expecting a pension. An expectation to p a y later is not a liability if the transaction bringing the benefit has not happened. For exam ple, an agreem ent to b o rro w before the cash has been received is not a liability, nor is an order to purchase something before the goods have arrived. Because some o f these expected or possible future events m ay result in future payments, even if they d o not meet the definition o f a liability an d so d o not a p p e a r in the balance sheet, they are sometimes described in the notes to the financial statem ents so that the users o f the financial statement are a w a re of them. Like assets, liabilities a re usually separated into shorter-term ones (current liabilities) an d longer-term ones (noncurrent liabilities). C urrent liabilities are those that are due (expected to be p a id o r otherw ise discharged) w ithin the next year. N oncurrent liabilities, therefore, a re du e m ore than a ye a r into the future. Som e liabilities, such as many house m ortgages, extend for years into the future, but a re partly p a id each year, so the b a la n ce sheet w o u ld show both a current an d a noncurrent portion for them. Sound an d Light has $ 1 0 3 0 0 0 in current liabilities an d $ 8 7 0 0 0 in noncurrent liabilities.
HOW'S YOUR UNDERSTANDING? 1
W h ic h o f th e fo llo w in g are lia b ilitie s : a c c o u n ts re c e iv a b le , in v e n to ry , a c c o u n ts p a ya b le , w ag es p a ya b le and ta x e s p a ya b le ?
2
W o u ld an a g re e m e n t to b o rro w m o n e y fr o m th e b a n k in th r e e m o n th s ’ tim e a p p e a r in th e b a la n c e s h e e t?
Y o u r a n sw e rs s h o u ld be:
1 A c c o u n ts p a ya b le , w ag es p a y a b le and ta x e s pa ya b le . 2 N o , th e tra n s a c tio n b rin g in g th e b e n e fit has n o t h a p p e n e d .
Equity Equity is the ow ners' interest in the enterprise. •
Equity can be derived from direct contributions the ow ners have m ade, o r from the accum ulation o f profits that the ow ners have chosen not to w ith d ra w . For a com p a n y, this w o u ld mean profits that have not been distributed as dividends.
•
The details o f the ow ners' equity section o f the b a la n ce sheet d e p e n d on the legal structure o f the enterprise and
•
The b a la n ce sheet does not distinguish betw een assets w h o se sources are liabilities an d assets pro vid e d by
its ow n e rsh ip arrangem ents (exam ined later in this chapter).
ow ners. C o m p le x fin a n cia l events make this im practical, so the assets represent a pool o f resources p rovided by all sources. •
The ow ners' interest can also be considered as a 'residual' o f the sum o f the assets minus the o b lig a tio n s the enterprise has taken on. (If A = L + E, the equation can also be w ritten A — L = E.) Because the b a la n ce o f the shareholders' equity figure equals assets minus liabilities, this residual o r net concept
o f equity is often referred to as the b o o k value o f the w h o le enterprise. B ook value is an arithm etically va lid idea, as the equation on the previous p a g e shows. But it m ay not tell us very much. For exam ple, if Sound a nd Light suddenly w e n t out o f business, the ow ners w o u ld be unlikely to receive exactly the equity o f $ 3 0 5 0 0 0 , because n o b o d y knows w h a t the assets w o u ld fetch if they had to be sold o ff all at once, an d the liabilities perhaps w o u ld be settled for som ething other than the expected future payments used to record them. Sim ilarly, if the ow ners d e c id e d to sell the business, the price they w o u ld ge t w o u ld d e p e n d on their a nd the buyers' view s as to the future success o f the business, not just on the accum ulated assets an d liabilities recorded in the b a lan ce sheet. Thus, the am ount w o u ld be very unlikely to equal the b a la n ce sheet equity figure.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Shareholders' equity is g e n e ra lly based on historical transactions, a nd does not, except by c o in cid e n ce , equal the current m arket value o f the w h o le business. M a n y high-technology a n d internet com panies a t the start of this century had small equity am ounts in their b a la n ce sheets but huge stock market values (market ca p ita lisa tio n , o r the share price times the num ber o f shares outstanding). The stock market m ay have been considering all sorts o f 'assets' not included b y accounting, such as com petitive strength o r smart em ployees, a n d /o r expecting g o o d future perform ance. M a n y o f these share prices have subsequently d ro p p e d , but there often are differences betw een the shareholder equity section o f the b a la n ce sheet a nd the current market price o f the com pany. C ontributions from ow ners can com e in m any forms, including the issue o f share c a p ita l an d the o b ta in in g o f past profits (discussed below ). For a corp o ra tio n like Sound an d Light, the most usual is share ca p ita l: p e o p le g ive the corporation m oney in e xch a n g e for shares, w h ich are portions o f ow n e rsh ip interest. Sound an d Light ow ners (shareholders) have contributed $1 3 0 0 0 0 to the co rp o ra tio n . For exam ple, some ow ners p ro b a b ly contributed cash to get Sound and Light started, so they w o u ld be a m ong the sources o f the cash asset. M a n y co rp o ra tio n s' shares, also c alled stocks in some countries (such as the United States), are traded on stock markets (e.g. the Australian Stock Exchange). In such markets, shares are traded betw een ow ners; the corporations issuing the shares receive m oney only w hen the shares are issued by them to the first ow ners. Therefore, trades subsequent to the initial share issue are not reflected in the co rp o ra tio n 's share ca p ita l; these trades a re transactions for the ow ners, not fo r the co rp o ra tio n . Past profit retained, usually called retained profits (or retained earnings), represents past accrual p rofit not yet given to ow ners. (The terms 'e arnings', 'in co m e ' a nd 'p ro fit' a re used pretty much interchangeably, but they all refer to accrual profit, as described in C h a p te r 1.) As w e 'll see in later chapters, earning profit means that there w ill be more assets (such as cash) a n d /o r fe w e r liabilities, so profit is a source of assets. Sound a n d Light has $ 1 7 5 0 0 0 in retained profits, w h ich means it has $ 1 7 5 0 0 0 m ore in assets than it w o u ld have had if those profits had all been p a id out. The ow ners could have w ith d ra w n cash o r other assets from the c o m p a n y (for instance, by d e claring themselves a d ivid e n d , w h ich is a paym ent o f some o f the retained profits to the owners), but they have chosen instead to leave the assets in the c o rp o ra tio n . Thus, those assets are resources o f the co rp o ra tio n an d retained profits are their source. The corporation can use the assets to earn m ore profit in the future. Since E = A — L, it is arithm etically possible for equity to be negative. If the assets a re less than the liabilities, w hich w o u ld ind ica te an enterprise has m ore o b lig a tio n s than resources (not a g o o d position to be ini), the equity, and therefore the enterprise's b o o k value, w ill be negative. Such a situation is a sign o f serious fin a n cia l problems and is likely to be fo llo w e d by insolvency.
HOW'S YOUR UNDERSTANDING? I f asse ts are re s o u rc e s , w h a t are th e p o ss ib le s o u rc e s f o r th e s e assets? Y o u r a n s w e r s h o u ld be : L ia b ilitie s , s h a re c a p ita l an d re ta in e d p ro fits .
2.3 Some prelim inary analysis of the Sound and Light balance sheet From the Sound an d Light b a la n ce sheet, w e can an sw e r some questions a b o u t the co rp o ra tio n 's fin a n cia l co n d itio n : 1
Is the enterprise soundly fin a n ce d ? Sound an d Light has fin a n ce d its $ 4 9 5 0 0 0 in assets by b o rro w in g $ 1 0 3 0 0 0 short-term a nd $ 8 7 0 0 0 long-term, a nd b y getting $ 1 3 0 0 0 0 in contributions from ow ners a n d not p aying past earnings o f $ 1 7 5 0 0 0 out to ow ners. Its $ 4 9 5 0 0 0 in assets a re therefore financed by $ 1 9 0 0 0 0 (3 8 .4 per cent) from creditors a n d $ 3 0 5 0 0 0 (6 1 .6 per cent) from the ow ners. Its debt-to-equity ratio is $ 1 9 0 / $ 3 0 5 = 6 2 .3 per cent (often w ritten 0 .6 2 :1 ) . So, Sound a nd Light is not much in debt, proportionately. W h a t w o u ld you think if the creditors w e re o w e d $ 4 5 0 0 0 0 a n d the shareholders' equity w a s o n ly $ 4 5 0 0 0 ? This
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w o u ld be a debt-to-equity ratio o f $ 4 5 0 / $ 4 5 = 1 0 0 0 per cent (1 0 :1 ), much m ore risky for the creditors because a lot m ore o f their m oney than the ow ners' m oney w o u ld be a t risk if the c o m p a n y ran into trouble. 2
C a n the enterprise p a y its bills on tim e? Sound a n d Light ow es $ 1 0 3 0 0 0 in the short term an d has only $ 5 0 0 0 0 in cash. Therefore, to p a y its bills it w ill have to co lle ct cash from its customers, either by getting them to p a y w h a t they a lre a d y o w e o r by selling them some inventory for cash. There is likely no problem here: collections an d sales, a nd payments to creditors, are p ro b a b ly g o in g on continuously. The c o m p a n y has $ 2 4 5 0 0 0 of current assets that it should be a b le to turn into cash to p a y the $ 1 0 3 0 0 0 of current liabilities. It is said to have $ 2 4 5 0 0 0 — $ 1 0 3 0 0 0 = $ 1 4 2 0 0 0 in working capital an d a w o rkin g c a p ita l ratio (also ca lle d the current ratio) of $ 2 4 5 / $ 1 0 3 , o r 2 .3 8 . The w o rkin g ca p ita l is positive, an d the ratio indicates there is m ore than tw ice as much current assets as current liabilities, so Sound a nd Light app e a rs to be fine.
3
You can see that if the c o m p a n y had a slo w p eriod o f sales o r collections, it could have difficulty p a yin g its bills. But if you w e re concerned a b o u t the com pany's a b ility to sell inventory to p a y its bills, you could calculate the q u ick ratio (also c a lle d the a c id test ratio). It is like the w o rkin g c a p ita l ratio, but has o nly cash, very short-term investments that could be sold, a nd accounts receivable in its num erator. For Sound a nd Light, the q u ick ratio w o u ld be ( $ 5 0 0 0 0 + $ 7 5 0 0 0 ) / $ 1 0 3 0 0 0 = 1 .2 1 . The c o m p a n y could p a y its current liabilities w ithout having to sell inventory. W h a t w o u ld you think if the c o m p a n y had o nly $ 1 0 0 0 0 in cash an d $ 1 6 0 0 0 0 in inventory? In that case, though its w o rkin g c a p ita l a nd w o rkin g ca p ita l ratio w o u ld be the same, it w o u ld likely be overstocked an d short o f cash, an d m ight have trouble p a yin g bills. N o w the q u ick ratio w o u ld be ( $ 1 0 0 0 0 + $ 7 5 0 0 0 ) / $ 1 0 3 0 0 0 = 0 .8 3 . The c o m p a n y w o u ld have to sell some inventory to meet its current liabilities. All ratios are o n ly indicators. They require interpretation of the specific circumstances of each enterprise, so w e d o n 't kn o w from our calculations if the c o m p a n y is in trouble, but a lo w q u ick ratio w o u ld g ive a signal to look further into the situation.
4
Should the ow ners d e cla re themselves a d ivid e n d ? If so, h o w large should it be? Legally, the b o a rd o f directors (w ho m a n a g e the c o m p a n y on behalf o f the shareholders) a re a b le to d e cla re a d ivid e n d to shareholders of $ 1 7 5 0 0 0 , the full am ount o f the retained earnings. But there is not nearly enough cash fo r that. Those past earnings have been reinvested in inventory, land, equipm ent a nd so on, an d are therefore not sitting around in cash w a itin g to be p a id to ow ners. This is true o f nearly all com panies: they invest past earnings in o p erating assets, so d o not have a lot o f cash on hand. P robably a d ivid e n d o f m ore than a b o u t $ 2 5 0 0 0 , o n ly one-seventh o f the retained earnings, w o u ld cause Sound a nd Light some cash strain. W h a t w o u ld you think if the c o m p any had no land or equipm ent but $ 3 0 0 0 0 0 in cash instead? It w o u ld a p p e a r to be cash-rich in that case, and should either invest the cash productively o r p a y a d ivid e n d to the ow ners so they can d o w h a t they like w ith the m oney.
5
Equipm ent (net) of $ 1 5 0 0 0 0 is represented b y the cost o f the equipm ent $ 2 7 2 0 0 0 less accum ulated depreciation o f $1 2 2 0 0 0 . In calcu la tin g its profit, Sound an d Light has deducted dep re cia tio n on its equipm ent as an expense. The profit that is in the retained profits part o f the equity is, therefore, sm aller than it w o u ld have been w ith o u t this deduction. The accum ulated am ount o f that expense, built up over the years, is deducted from the assets in the b a la n ce sheet to sh o w h o w much o f the econom ic value o f the assets is estim ated to have been used up so far. Accum ulated d e p re cia tio n is therefore a 'n e g a tive asset' used to reduce the am ounts of other assets. In this case, the equipm ent cost $ 2 7 2 0 0 0 , a g a in st w h ich dep re cia tio n o f $1 2 2 0 0 0 has accum ulated, so the 'net' b o o k value o f the equipm ent is the rem ainder: $ 1 5 0 0 0 0 . (It is normal for the b a la n ce sheet to report o n ly the net am ount an d g ive cost a n d accum ulated de p re cia tio n am ounts in the notes.) C o m p a rin g the cost and the accum ulated dep re cia tio n tells us som ething a b o u t the a g e o f the equipm ent. The $1 2 2 0 0 0 accum ulated d e p re cia tio n is less than half the equipm ent's cost, so the c o m p a n y estimates that less than half the econom ic value o f the equipm ent has been used. W h a t w o u ld you think if the accum ulated d e p re cia tio n w e re $ 2 5 0 0 0 0 ? The equipm ent w o u ld be nearing the end o f its estim ated life.
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Common presentation styles for balance sheets So you see that the b a la n ce sheet provides interesting inform ation if you kn o w h o w to read it. Y our skill in reading it w ill g ro w as you w o rk w ith it. There are different styles o f presentation for the b a la n ce sheet; all sh o w the same inform ation, but they a re arra n g e d differently. Exhibit 2.1 show ed you the side-by-side form at for Sound a n d Light Ltd. In Exhibit 2 .2 , the vertical form at is show n, w h ich has becom e far m ore com m on. It shows assets less liabilities equals shareholders' equity.
2.4
A closer look at the balance sheet
To g a in further insights into the content of a b a la n ce sheet, w e w ill exam ine the content o f C h e z Ltd's b a la n ce sheet, shown in Exhibit 2 .3 . •
It is com parative: it contains figures both for the most recent ye a r an d for the preceding ye a r to help the users recognise changes. It is standard practice for the m ore recent figures to be to the left, closer to the w o rd s describing those figures.
•
For clarity, the figures a re show n in thousands o f dollars, not e xact am ounts to the cent.
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HOW'S YOUR UNDERSTANDING? A s s e m b le a b a la n c e s h e e t f o r N o r th e r n L td fr o m th e fo llo w in g in fo r m a tio n , and c o m m e n t o n th e c o m p a n y ’s fin a n c ia l p o s itio n a t th a t p o in t in tim e : •
sh a re c a p ita l $ 1 0 0 0
•
a c c o u n ts re c e iv a b le $ 1 1 0 0
•
a c c o u n ts p a ya b le $ 2 1 0 0
•
in v e n to ry $ 1 7 0 0
•
re ta in e d p ro fits $ 2 2 0 0
•
cash $ 5 0 0
•
e q u ip m e n t $ 2 0 0 0 . Y o u r a n s w e r s h o u ld be : c u r r e n t assets $ 3 3 0 0 , n o n c u r r e n t assets $ 2 0 0 0 ; to ta l assets $ 5 3 0 0 ; c u r r e n t
lia b ilitie s $ 2 1 0 0 , n o n c u r r e n t lia b ilitie s $ 0 ; c o n trib u te d c a p ita l $ 1 0 0 0 , re ta in e d p ro fits $ 2 2 0 0 ; and to ta l lia b ilitie s and e q u ity $ 5 3 0 0 . W o rk in g c a p ita l is $ 1 2 0 0 ; th e w o rk in g c a p ita l ra tio is 1 .5 7 , so it is n o t as s tro n g c u r r e n tly as S o u n d and L ig h t is. L ia b ilitie s o f $ 2 1 0 0 a re 3 9 .6 p e r c e n t o f to ta l s o u rc e s , w ith a d e b t - t o - e q u it y ra tio o f 6 5 .6 p e r c e n t, so th e c o m p a n y ’s fin a n c in g is s im ila r to S o u n d an d L ig h t’s, th o u g h all o f its lia b ilitie s are c u r r e n t, w h ic h is u n u s u a l. W ith $ 5 0 0 c a sh , it d o e s n o t ha ve e n o u g h cash t o p a y all o f its $ 2 2 0 0 re ta in e d p r o fits t o s h a re h o ld e rs as d iv id e n d s i f it w a n te d to . •
•
References are norm ally m ade to various notes. It is not possible to explain every im portant item on the fa ce o f the b a la n ce sheet, so extensive e xp la n a to ry notes are referred to a nd a p p e n d e d to most b a la n ce sheets. C hez's notes are not p rovided here because they raise issues w e have not yet covered. Remember to lo o k for notes w hen you are using fin a n cia l statements.
•
The co m p a n y has m any different kinds o f asset, liability and equity accounts. They are not necessarily easy to classify into the categories you sa w in the Sound a nd Light Ltd exam ple. You p ro b a b ly w o n 't understand all the accounts and h o w the co m p a n y has categorised them; that understanding w ill deve lo p as you w o rk through the book.
•
The b a la n ce d a te is 31 M a y , not 3 0 J u n e . The end o f the taxation year, 3 0 J u n e , is the most p o p u la r accounting year-end (financial year-end), but m any com panies choose other dates, particularly subsidiaries o f US com panies, am ong w h o m 31 D ecem ber is popular. Som e e xplanation of the deta ile d content o f b a la n ce sheets w ill be helpful no w , before some exam ples of
preparing b a la n ce sheets a re given. Som e o f C hez's assets w e re described in C h a p te r 1: cash, accounts receivable a nd inventory. Property, plant and equipm ent is split into land, buildings, equipm ent, a nd furniture a nd fittings. M a n y A ustralian com panies n o w show property, plant an d equipm ent as on e item on the fa ce of the b a la n ce sheet (e.g. equipm ent net = $ 1 0 0 0 0 ) , w ith the split-up in o ne o f the notes to the accounts (e.g. equipm ent — accum ulated d e p re cia tio n : $ 4 0 0 0 0 0 — $ 3 0 0 0 0 0 = $ 1 0 0 0 0 0 ). N o te that land is not d e p re cia te d , but buildings, equipm ent, an d furniture a n d fittings are shown net, m eaning that accum ulated d e p re cia tio n has been d educted. The e xact am ount o f the accum ulated d e p re cia tio n d educted w ill be show n in the notes. For exam ple, if plant an d equipm ent cost $1 m illion an d had an expected life o f five years, the am ount o f d e p re cia tio n each ye a r w o u ld be $ 2 0 0 0 0 0 . A fter three years, accum ulated d e p re cia tio n w o u ld be $ 6 0 0 0 0 0 ($ 2 0 0 0 0 0 + $ 2 0 0 0 0 0 + $ 2 0 0 0 0 0 ).
52
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 2.3 • BALANCE SH EET AS A T 31 M A Y (IN TH O U SA N D S OF DOLLARS)
2016
2015
$
$
8 952
6 336
Assets Current assets Cash and cash equivalents Investments
1 8516
5179
Accounts receivable
26 396
18 069
Inventory
22 831
20427
Prepayments
3586
2015
80281
52 026
Land
23 205
23 205
Buildings (net)
26282
25911
Equipment (net)
35 120
36 630
4 864
4140
Total current assets
Noncurrent assets
Furniture and fittings (net) Intangibles (net)
2 398
3 586
91 869
93472
172 15 0
145498
Accounts payable
7984
6443
Accrued expenses
5 740
3491
Income taxes payable
3 248
2 756
Provision for employee entitlements
4 898
1 598
Dividends payable
5 925
2 883
27795
17171
Long-term loans
23 856
21 805
Provision for employee entitlements
1 4006
13 647
Total noncurrent liabilities
37 862
35452
Total noncurrent assets
Total assets Liabilities and shareholders' equity Current liabilities
Total current liabilities
Noncurrent liabilities
Total liabilities
65 657
52 623
106493
92 875
Share capital
23 961
23 961
Retained profits
8 2 5 32
68914
106493
92 875
Net assets Shareholders' equity
Total shareholders' equity
C h e z Ltd also has some other assets that w e re not introduced in C h a p te r 1, including investments, prepaym ents, property, plant a nd equipm ent (net), a n d intangibles. •
Investments are short-term; that is, included under current assets - a nd could be shares in other com panies (such as the C om m onw ealth Bank o r W o o lw o rth s), w h ich C h e z intends to convert to cash w ithin a year.
•
Prepaym ents (or p re p a id expenses) a re amounts that have been p a id in a d va n ce but for w h ich the benefits have not yet been received. For exam ple, if w e p a y a 12-month insurance premium on 1 A pril 2 0 1 5 , at 31 M a y
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
53
2 0 1 5 w e w ill have a prepaym ent equal to ten-twelfths o f the am ount p a id . Prepayments are assets because they represent future e co n o m ic benefits. •
The property, plant an d equipm ent (PPE) w ill be recorded at cost net o f accum ulated d e p re cia tio n . Each ye a r d e p re cia tio n expense is calculated an d the sum o f these d e p re cia tio n expenses is ca lle d accum ulated d e p re cia tio n . D epreciation expense an d accum ulated de p re cia tio n are discussed in m ore detail in C h a p te r 5 . W h e n you see the w o rd 'net' after PPE it means accum ulated d e p re cia tio n has been deducted from cost.
•
Intangible assets a re noncurrent assets that have no physical substance, such as copyrights, patents, tradem arks, brand names a n d g o o d w ill. They a re discussed in C h a p te r 10. C h e z Ltd includes m any liabilities that have not yet been discussed. Accounts p a y a b le a nd long-term loans w e re
described in C h a p te r 1. T w o others are accrued expenses a nd provision for em ployee entitlements. •
Accrued expenses relate to expenses that have been incurred during the ye a r but not yet p a id . C o n sid e r tw o exam ples. Assume C h e z Ltd pays salaries an d w a g e s every tw o w eeks for w o rk d o n e in the previous tw o w eeks. If the last p a y d a y w a s 1 9 M a y , the c o m p a n y w o u ld o w e em ployees salaries an d w a g e s from 2 0 M a y to 31 M a y . This is ca lle d accrued w a g e s o r w a g e s p a ya b le . A nother exam ple o f accrued expenses could be the am ount o w in g to the electricity co m p a n y. If it bills you quarterly a nd the last bill w a s for the p eriod e n ding 3 0 A p ril, you w o u ld o w e the c o m p a n y for one month's electricity at the end o f the accounting p e riod. This w o u ld also form part of accrued expenses. Income taxes p a y a b le is the am ount p a y a b le to the tax o ffice in the next year.
•
Provision for e m ployee entitlements relates to long service leave, h o lid a y p a y a nd some superannuation. It is an estim ate, based on years o f service, o f the am ounts o w in g to em ployees that w ill have to be p a id in future periods. The provision for e m ployee entitlements has both current a nd noncurrent proportions, d e p e n d in g on w hen the am ounts a re likely to be p a id .
W here do the figures come from ? A full understanding o f w h a t assets a nd liabilities are an d h o w to measure them w ill take time an d m any exam ples. O n e thing you m ay be w o n d e rin g a b o u t is w h e re the figures used to measure these things com e from. This is a d e e p and controversial question indeed. O n ly a superficial an sw e r can be given now , but after a fe w m ore chapters you w ill have a d e e p e r understanding o f it. A ccounting is g e n e ra lly a historical measurement system: it records w h a t has h a p pened, not w h a t w ill happen o r w o u ld have h a p pened if conditions had been different. Therefore, asset a n d lia b ility values are derived from the past. Assets are g e n e ra lly valued at w h a t they cost w hen they w e re a cquired, a nd liabilities are g e n e ra lly valued at w h a t w a s p ro m ise d w hen the o b lig a tio n arose. In most countries, assets a nd liabilities a re not valued at the current prices they m ight fetch if sold right no w . This is som ething that confuses m any users: looking at a b a la n ce sheet in the United States, for exam ple, a user m ight think that assets such as land an d buildings are shown a t w h a t those assets w o u ld be w orth right n o w if they w e re sold. They are, instead, valued at w h a t they cost w hen they w ere acquired. The differences in these values can be large. For exam ple, a c o m p a n y m ay have bought land in the d o w n to w n area o f a city 2 0 years a g o for $ 1 0 0 0 0 0 . The land m ay n o w be w orth millions o f dollars. But the b a la n ce sheet norm ally w ill sh o w the land asset at a figure o f $ 1 0 0 0 0 0 , its o rig in a l cost. This is because the o n ly thing that has happened is that the land w a s a cq u ire d 2 0 years a g o , a nd the cost incurred then can be verified. N o th ing further has h a p pened: the land has not been sold, so its current value is hypothetical an d difficult to verify. H ow ever, in A ustralia certain assets can be revalued in the b a la n ce sheet to current market prices. They are show n at either independent valuation or directors' valuation. This im portant valuation issue is discussed in m ore detail in C h a p te r 10. The b a la n ce sheets o f most Australian com panies actu a lly sh o w a little less detail than our C h e z Ltd exam ple. For exam ple, under liabilities it is quite normal to have a heading 'p a y a b le s', w h ich includes accounts p a y a b le and accrued expenses. The split-up o f these amounts is then given in the notes to the accounts.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
54
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n y o u r re a d in g o f th is c h a p te r:
1 2
C o m m e n t o n th e s h o r t- t e r m fin a n c ia l p o s itio n o f C h e z L td . P re p a re th e b a la n c e s h e e t o f M ik e ’s T y re R e p a ir (o w n e r, M ik e ) fr o m th e fo llo w in g a c c o u n t ba la n ce s: b a n k o v e rd ra ft, $ 2 5 0 ;
a c c o u n ts
re c e iv a b le , $ 6 4 0 ;
in v e n to ry o f s u p p lie s, $ 2 1 0 ; e q u ip m e n t c o s t, $ 8 9 0 ;
a c c u m u la te d d e p re c ia tio n o n e q u ip m e n t, $ 4 7 0 ; a c c o u n ts p a ya b le , $ 3 6 0 ; s h a re h o ld e rs ’ e q u ity , $ 6 6 0 . Y o u r a n sw e rs s h o u ld be:
1
W o rk in g c a p ita l is $ 5 2 4 8 6 0 0 0 ; c u r r e n t ra tio is 2 .8 9 :1 . T h e in te r p r e ta tio n o f th e w o rk in g c a p ita l ra tio d e p e n d s v e ry m u c h on th e n a tu re o f th e e n te rp ris e an d its w a y o f d o in g bu siness. H o w e v e r, y o u c an see th a t C h e z L td is in q u ite a s tro n g p o s itio n ; c u r r e n t assets a re a lm o s t th r e e tim e s c u r r e n t lia b ilitie s .
2 T o ta l assets o f $ 1 2 7 0 ( 6 4 0 + 2 1 0 + 8 9 0 — 4 7 0 ) an d to ta l lia b ilitie s o f $ 6 1 0 ( 2 5 0 + 3 6 0 ) , g iv in g n e t assets o f $ 6 6 0 an d o w n e rs ’ e q u ity also o f $ 6 6 0 .
2.5
M aintaining the accounting equation
In sections 2.1 a nd 2 .2 the accounting equation w a s introduced: Assets = Liabilities + S h areh o ld ers' equity An understanding o f this equation is fundam ental to your understanding o f the b a la n ce sheet an d the w h o le accounting recording process. Financial accounting is said to use the double-entry system, w h e re b y the accounting equation is a lw a ys kept in ba la n ce . If an asset goes up, a lia b ility or equity must g o up too (or another asset must g o d ow n). If a lia b ility goes up, an asset must g o up too, o r an equity o r another lia b ility must g o d o w n . H ere a re some exam ples, using the b a la n ce sheet descriptions in the Sound an d Light exam ple in section 2.1 a nd the equation A ] = Li + Ei to represent the b a la n ce sheet before the events: •
cash o f $ 1 0 0 o b ta in e d from an o w n e r for shares: 'cash' asset up, 'share c a p ita l issued' equity up, so A i + $ 1 0 0 = Li + E , + $ 1 0 0
•
$ 1 2 0 collected from a customer: 'cash' asset up, 'accounts receivable' asset d o w n , so A i + $ 1 0 0 + $ 1 2 0 —
•
g o o d s for sale costing $1 3 0 received from a supplier: 'inventory' asset up, 'accounts p a y a b le ' lia b ility up, so A i
$ 1 2 0 = Li + E i + $ 1 0 0
+ $ 1 0 0 + $ 1 2 0 — $ 1 2 0 + $ 1 3 0 = Ln + $ 1 3 0 + Ei + $ 1 0 0 . A fter these three events, the n ew b a la n ce sheet is $ 2 3 0 higher on both sides a nd so still in balance: A , + $ 2 3 0 (net) = L, + $ 1 3 0 + E, + $ 1 0 0 The key point is that the equation w ill a lw a ys be in ba la n ce . The equation w o u ld b a la n ce before recording these transactions a n d w ill b a la n ce after the transactions have been recorded. W e cover transaction analysis in more detail in C h a p te r 3 , including e x p a n din g the equation to incorporate revenue and expenses. So at this point w e w ill just consider transactions that o n ly have an im pact on the bala n ce sheet. Assume that, at 3 0 June 2 0 1 6 , FGH Ltd had cash o f $ 2 0 0 0 0 0 an d share c a p ita l o f $ 2 0 0 0 0 0 . N o te that the accounting equation balances at this point. In fact, the equation w ill b a la n ce after w e record every transaction. C onsider the im pact o f each o f the fo llo w in g transactions: 1
The c o m p a n y receives $ 4 0 0 0 0 0 from the issue o f shares ( 2 0 0 0 0 0 shares at $ 2 each). This transaction increases an asset (cash at bank) a nd increases shareholders' equity account (share capital).
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2
55
The c o m p a n y purchases n e w equipm ent fo r $ 5 0 0 0 0 0 , p a yin g cash to the supplier. This transaction increases on e asset (equipment) a nd decreases another asset (cash).
3
The c o m p a n y borrow s $ 2 0 0 0 0 0 from the bank. This transaction increases an asset (cash a t bank) a nd increases a lia b ility (loan).
4
The c o m p a n y purchases inventory on credit for $ 1 5 0 0 0 0 . This transaction increases a lia b ility (accounts payable) a nd increases an asset (inventory).
5
The c o m p a n y pays $ 5 0 0 0 0 to accounts p a ya b le . This transaction decreases an asset (cash) an d a lia b ility (accounts payable). Each of the a b o v e transactions is recorded in Exhibit 2 .4 an d the n e w b a la n ce sheet a t 31 July 2 0 1 6 app e a rs in
Exhibit 2 .5 .
EXHIBIT 2 .5 BALANCE SH EET AS A T 31 JULY 2 0 1 6
Assets
$
Current assets Cash
250000
Inventory
150 00 0 400000
Noncurrent assets Equipment at cost
Liabilities
500000
Accounts payable
Long-term loans
200000
Total liabilities
300000
Shareholders' equity
Retained profits
900000
100000
Noncurrent liabilities
Share capital
Total assets
$
Current liabilities
600000 0
Total shareholders' equity
600000
Total liabilities and shareholders' equity
900000
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
56
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be a b le to c o m p le te , based o n w h a t y o u ha ve rea d. W h a t is th e e f fe c t o f e a ch o f th e fo llo w in g tra n s a c tio n s on to ta l assets?
1 2 3 4 5
P u rc h a s e d e q u ip m e n t f o r $ 2 0 0 0 0 0 cash. P u rc h a s e d in v e n to ry f o r $ 3 0 0 0 0 o n c re d it. R e c e iv e d a loan o f $ 5 0 0 0 0 fr o m th e ba nk. R e c e iv e d $ 2 0 0 0 0 fr o m a c c o u n ts re c e iv a b le . Issued a d d itio n a l share s o f $ 3 0 0 0 0 0 . Y o u r a n sw e rs s h o u ld be:
1 2 3 4 5
N o e f fe c t: e q u ip m e n t in c re a s e s b u t cash d e cre a s e s . In cre a se s b y $ 3 0 0 0 0 (in v e n to ry ). In cre a se s b y $ 5 0 0 0 0 (c a s h ). N o e f fe c t: ca sh in c re a s e s b u t a c c o u n ts re c e iv a b le d e cre a s e s . In cre a se s b y $ 3 0 0 0 0 0 (c a s h ).
2.6
Managers and the balance sheet
W h y d o m anagers care a b o u t their co m p a n ie s' b a la n ce sheets? The basic reason is that m any outsiders do, including ow ners, creditors, tax authorities an d unions. Read a n y issue of a business new sp a p e r o r m a g a zin e and you w ill see frequent references to the im portance o f the b a la n ce sheet a n d levels o f d ebt. For exam ple: R o b L td w a s an a ttr a c tiv e p r o s p e c t b e c a u s e it ha d a s tro n g b a la n c e s h e e t. T h in n L td has a w e a k fin a n c ia l s tru c tu re . M a n a g e m e n t m u s t so lv e th is p ro b le m b e fo re r is k -s h y in v e s to rs ca n be e x p e c te d t o ta k e an in te r e s t in th e c o m p a n y . H u g e L td has la rg e ca sh re s e rv e s , so o n e ca n o n ly g u e ss t h a t m a n a g e m e n t is lo o k in g t o b u y a n o th e r c o m p a n y t o a d d t o H u g e ’s c o n s o lid a te d g ro u p . X L td ’s d e b t - t o - e q u it y ra tio is h ig h f o r th e in d u s try . T h e u n d e rly in g s tre n g th o f P B ’s b a la n c e s h e e t is h a rd t o ig n o re . T h e a d v a n ta g e o f Q u e e n s la n d ’s s tro n g b a la n c e s h e e t w as t h a t it e n a b le d th e s ta te t o w ith s ta n d a n y u n e x p e c te d s h o ck s. W e s tfie ld has g ro w n b e c a u s e it has a v e r y c o n s e rv a tiv e b a la n c e s h e e t t h a t p ro v id e s o p p o r tu n itie s .
The b a lance sheet reports w h a t the organisation's position (assets, liabilities a nd shareholders' equity) is a t a point in tim e (the fin a n cia l year-end o r a n y other da te on w h ich the b a la n ce sheet is prepared). It shows the assets (resources) that m anagem ent has chosen to a cq u ire for the o rganisation, a nd h o w m anagem ent has d e c id e d to finance those assets. Therefore, it provides a useful picture o f the state o f the c o m p a n y a nd is used b y m any outsiders to evaluate the q u a lity o f m anagem ent's decisions on o b ta in in g , d e p lo y in g a nd fin a n cin g assets. For better o r w orse, it is the summary o f all the inform ation recognised by accounting a nd is, to m any peo p le , the basic score ca rd of m anagem ent's stewardship o f the com p a n y. The b a lance sheet does not directly state h o w m anagem ent has perform ed in using assets to earn profit. Such inform ation is contained in the incom e statement, but all o f it correlates w ith the basic double-entry inform ation contained in the b a la n ce sheet. G o o d p rofit perform ance, for exam ple, is reflected in increased assets and shareholders' equity (retained profits). The strengths an d weaknesses o f the b a la n ce sheet, w h ich w ill be explored throughout this book, are therefore fundam entally im portant to m anagers, w h o are responsible for m anaging com panies' assets a n d liabilities. M a n a g e rs ' o w n salaries, prom otions, careers a nd reputations d e p e n d on other people's decisions (such as investors' decisions to buy an d sell shares) w h ich , in turn, rest to some extent on b a la n ce sheet inform ation.
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2.7
57
The income statem ent
A business exists over a period o f time. If the ow ners a nd m anagers a re successful, it m ay prosper for a long time. Suppose a measure o f the co m p a n y's fin a n cia l perform ance is desired for com parison w ith other com panies, for assessing incom e tax, for help in d e c id in g h o w much to sell the c o m p a n y for, o r for m any other reasons w e w ill com e to. H o w could such perform ance be m easured? W e m ight measure the com pany's fin a n cia l perform ance by closing it d o w n , selling off all its assets, p a yin g off all its liabilities an d discovering h o w much is left for the ow ners. G o o d perform ance w o u ld be in d ica te d if the m oney left for the ow ners plus the am ounts they w ith d re w over the years w e re greater than the am ount they put in w hen they founded the com p a n y, perhaps adjusted for inflation over that tim e an d for the ow ners' costs in raising the m oney they put in. But killing the business to measure h o w w e ll it has been d o in g is a little drastic! W a itin g until it dies o f natural causes hardly seems a n y better: m any com panies have outlasted m any generations o f ow ners a n d m anagers. It w o u ld be m ore useful to measure perform ance over selected shorter periods o f time: annually, every three months (quarterly) o r on a m onthly basis. People could then make their decisions a b o u t investing in the c o m p a n y o r getting out, a nd hiring m anagers or firing them, w hen they w a n te d to d o so. This is w h e re the incom e statement becom es useful. This statement uses accrual accounting to measure fin a n cial perform ance over a period o f time, usually a year, six months, three months o r o ne month, in d ica tin g the bottom line net p rofit fo r the p e riod, calculated as revenues minus expenses. N e t pro fit fo r the period = Revenues - Expenses fo r the period
Revenues and expenses Recall that in section 1 .5 the concepts o f revenues a nd expenses w e re introduced. As part o f the conceptual fram ew ork o f acco u n tin g , o fficia l pronouncem ents d e ve lo p e d definitions o f revenues an d expenses. They w e re deve lo p e d to be a p p lic a b le to a range o f measurement models an d to include some transactions unique to the public sector. C onsequently, the definitions are difficult to fo llo w , especially for students in their second w e e k o f an accounting course. As a result, w e w ill defer discussion o f these definitions until C h a p te r 13. B elow are some fundam ental definitions that cover most revenues a nd expenses.
R EVENUES Revenues a re described here as increases in the com pany's w ealth arising from the provision o f services o r the sale of g o o d s to customers. W e a lth increases because customers: •
p a y cash for g o o d s o r services
•
prom ise to p a y cash (such promises a re c a lle d accounts receivable for g o o d s an d services)
•
(more rarely) p a y w ith other forms o f w e a lth , such as by p roviding other assets to the c o m p a n y o r fo rg ivin g debts o w e d by the c o m p a n y for g o o d s a nd services. If, in return for services o r g o o d s, a customer p a id $ 1 0 0 0 in cash, another customer prom ised to p a y $ 1 0 0 0
later, another g a ve the c o m p a n y $ 1 0 0 0 in equipm ent, o r another fo rg a ve a $ 1 0 0 0 d e b t the c o m p a n y had o w e d the customer, each w o u ld be ca lle d a revenue o f $ 1 0 0 0 . Interest a nd dividends received a re also exam ples o f revenue because they are increases in w ealth as a result of provid in g a service (lending o r investing m oney in another organisation). The key test for revenue recognition is w hether the g o o d s o r services have been rendered (e.g. delivery to customers o r the provision of a service). Revenue recognition can becom e quite c o m p lica te d for some com panies. For exam ple, if a c o m p a n y received a contract to build a n e w h ig h w a y from Brisbane to M e lb o u rn e , w hen w o u ld revenue be recognised? This a n d other m ore c o m p lica te d questions concerning revenue recognition w ill be addressed in C h a p te r 1 3.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
58
EXPENSES Expenses are the opposite o f revenues. They are decreases in the com pany's w ealth that are incurred in order to earn revenue. W e a lth decreases because operating costs have to be p a id ; customers have to be given the goods they have paid for; long-term assets w e a r out as they are used to earn revenue; a nd liabilities m ay be incurred as part o f the process. If, as p a rt o f its attem pt to earn revenues, the c o m p a n y p a id $ 6 0 0 in rent, o r the g o o d s bought by a customer cost the c o m p a n y $ 6 0 0 to provide, the equipm ent d e p re cia te d b y $ 6 0 0 , o r the c o m p a n y prom ised to p a y an em ployee $ 6 0 0 in w a g e s later on for w o rk a lre a d y com pleted, each o f these w o u ld be c a lle d an expense o f $ 6 0 0 . A m ajor expense c a te g o ry that sometimes causes confusion is the cost of g o o d s sold (C O G S ) expense. In the exam ples a bove , if the g o o d s bought by the customer cost the c o m p a n y $ 6 0 0 to p rovide, $ 6 0 0 is the cost o f the goods sold that earned revenue o f $ 1 0 0 0 . The revenue is w h a t the customer agrees to pay; the cost o f g o o d s sold is w h a t it costs the enterprise to pro vid e those g o o d s. Therefore, a transaction w ith a customer w h o is buying g o o d s has tw o aspects: •
the enterprise is better off because o f the revenue g a in e d
•
the enterprise is w orse off because o f the cost o f the g o o d s that the customer takes a w a y . W h e n the enterprise buys the goods for sale, they begin on the balance sheet in the asset account 'inventory of unsold
g o o d s'. W h e n they are sold, their cost is transferred from the asset account to the expense account 'cost o f g o o d s sold'. This is done as a separate accounting activity from recording the revenue, because it is a separate econom ic event. W h e th e r the enterprise makes m oney on the deal depends on w hether the revenue g a in e d is greater than the cost o f goods sold (plus any other expenses incurred to make the sale, such as sales commissions and shipping costs).
PROFIT Both revenues a n d expenses a re measured by fo llo w in g the concepts o f accrual acco u n tin g ; therefore, they represent increases o r decreases in w e a lth , w hether o r not cash receipts o r payments occur at the same time. As net p rofit is the difference betw een revenues a n d expenses, it represents the net in flo w o f w ealth to the c o m p a n y during the period. The reporting o f net p rofit means that the c o m p a n y has becom e w e a lth ie r during the p e riod. If net profit is negative; that is, if revenues a re less than expenses - it is instead called n e t loss, a nd represents a net o u tflo w o f w ealth. In this case, the c o m p a n y has becom e less w e a lth y. Expenses include all the costs o f earning the revenues, including incom e an d other taxes, but they d o not include paym ent o f returns to ow ners (w ithdraw als by sole traders o r partners, o r dividends to shareholders of com panies). Payments, o r promises o f paym ent, o f returns to ow ners (such as w hen a co m p a n y's b o a rd o f directors declares - or promises - a dividend) are considered to be distributions o f net profit to ow ners. The undistributed rem ainder is kept in the c o m p a n y as retained profits.
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be a b le to c o m p le te , based o n w h a t y o u ha ve rea d. C a lc u la te th e to ta l re v e n u e and e x p e n s e s f o r th e m o n th o f J u n e 2 0 1 6 , g iv e n th e fo llo w in g :
1 2 3 4
C r e d it sales o f $ 2 0 0 0 0 0 m a d e in J u n e ; 5 0 p e r c e n t to be c o lle c te d in J u n e . C a s h sales o f $ 3 0 0 0 0 0 . R e c e iv e d $ 2 0 0 0 0 as a d e p o s it fr o m a c u s to m e r in J u n e f o r a j o b to be c a rrie d o u t in J u ly . P aid salaries o f $ 4 0 0 0 0 ; $ 1 0 0 0 0 re la te d to w o rk c a rrie d o u t in M a y and $ 3 0 0 0 0 re la te d to J u n e w o rk .
5 P aid r e n t f o r th e m o n th o f J u n e o f $ 6 0 0 0 o n 7 J u n e . 6 R e c e iv e d a bill f o r $ 1 5 0 0 fr o m an e le c tric ia n f o r w o rk d o n e o n 2 0 J u n e . T h is w ill be paid n e x t m o n th . Y o u r a n sw e rs s h o u ld be : re v e n u e $ 2 0 0 0 0 0 + $ 3 0 0 0 0 0 ; e x p e n s e s $ 3 0 0 0 0 + $ 6 0 0 0 + $ 1 5 0 0 .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
59
The relationship o f p ro fit for the period to retained profits Retained profits is the sum o f past net profits, measured since the c o m p a n y b e gan, minus dividends d e cla re d (even if not yet paid) to ow ners since the b e g in n in g . Retained profits from the end o f the preceding p eriod (year, quarter, month or w hatever) a re therefore increased b y profits for the p eriod an d reduced b y a n y dividends. Retained profits at end of period
= Retained profits at beginning of period + Net profit (or - Net loss) for the period — Dividends declared during the period
An alternative form at to sh o w the ch a n g e in retained profits is: Start with retained profits, beginning of period (end of previous period)
XXXX
Add net profit for the period
XXXX
Deduct dividends declared during the period
(XXXX)
Equals retained profits, end of period
XXXX
In the a b o ve exam ple, the co m p a n y earned a profit. If the co m p a n y performed badly, the profit could be negative (expenses greater than revenues, producing a net loss instead), an d in that case, the net loss is deducted from the beginning retained profits. If things get really ba d , retained profits can also be negative (losses having overw helm ed profits). You m ight be interested to know that you can, if you have the pa st records, g o b ack year by year, figuring out how much profit w a s a d d e d to retained profits each year an d h o w much in dividends w a s deducted. You could g o all the w a y b ack to the first d a y of the com pany, w hen there had not yet been a ny profit and, therefore, not yet any retained profits. Retained profits is therefore like an onion: you can keep peeling a w a y each year's layer until you have peeled it all a w a y and a re back to zero. You can sim ilarly peel a w a y each year's transactions in every balance sheet account; for exam ple, you can trace all the changes in cash back to the very beginning. For this reason, the balance sheet can be said to reflect everything that has ever been recorded in the accounts: it is the accum ulation o f everything that has happened from w hen the co m p a n y began until now . A ccounting really is a historical inform ation system! In a co m p a n y, the bo a rd o f directors is the senior level o f m anagem ent, op e ra tin g the c o m p a n y on behalf o f the ow ners. W h e n the b o a rd declares a d ivid e n d , the am ount is deducted from retained profits at that time. A t that point, the c o m p a n y has a lia b ility to the ow ners, w h ich it pays o ff later by sending the ow ners the prom ised cash. This involves tw o principles o f fin a n cia l accounting: 1
Transactions w ith ow ners, o f w h ich the main exam ple is dividends, are taken out o f retained profits. They are not an expense, an d therefore are not deducted in calculating profit for the period.
2
O w n e rs can be creditors too, if they a re o w e d d ividends o r have lent the c o m p a n y m oney in a d d itio n to the shares they bought.
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be ab le to c o m p le te , based o n w h a t y o u ha ve rea d. T h e fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 6 :
a
Issued s hare s to in v e s to rs f o r $ 1 0 0 0 0 0 cash,
b
B o rro w e d $61 0 0 0 fr o m th e bank,
c
P u rc h a s e d e q u ip m e n t f o r $17 0 0 0 cash,
d
P u rc h a s e d $ 7 2 3 0 0 0 o f a d d itio n a l in v e n to ry o n c re d it.
e
S o ld $1 141 9 0 0 o f p ro d u c ts t o c u s to m e rs on c re d it; c o s t o f th e g o o d s w as $ 7 0 0 0 0 0 .
f
In c u rre d $ 2 1 8 2 0 0 in s e llin g e x p e n s e s , p a y in g 8 0 p e r c e n t in cash an d o w in g th e re s t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
g
Paid cash dividends o f $16 0 0 0
h
E arned $ 4 0 0 0 in te re s t on in v e stm e n ts, re ce ivin g 7 5 p e r c e n t in cash,
i 1 2 3
In c u rre d $ 2 9 0 0 in in te re s t expense to be paid a t th e b e g in n in g o f n e x t year. W h a t was re ve n u e fo r th e year? W h a t are expenses fo r th e year? W h a t is th e n e t p ro fit? Y o u r answers should be:
1 2 3
$1 141 9 0 0
+ $ 4 0 0 0 = $1
1 45 9 0 0
$ 7 0 0 0 0 0 + $ 2 1 8 2 0 0 + $ 2 9 0 0 = $921 1 0 0 $1 1 4 5 0 0 0 - $921 1 0 0 = $ 2 2 3 9 0 0 .
2.8 Connecting balance sheets and income statements The b a la n ce sheet shows all assets, liabilities an d shareholders' equity accounts at a point in time. Usually the b alance sheet is com parative, show ing the accounts a t both the b e g inning o f the incom e statement's p eriod (i.e. the end o f the previous period) an d a t the end o f the incom e statement's p e riod, a nd therefore show ing both the beginning retained profits an d the e n ding retained profits. Assets at beginning
=
Liabilities + equity (including retained profits) at beginning
Assets at end
=
Liabilities + equity (including retained profits) at end
Change in assets
=
Change in liabilities + change in equity (including retained profits)
Suppose a co rp o ra tio n had assets of $1 2 0 0 at the b e g inning o f a ye a r a nd $ 1 4 5 0 at the end, an d liabilities of $ 7 5 0 at the beg in n in g a n d $ 9 0 0 at the end. W e can d e d u ce that its equity w a s $ 4 5 0 a t the b e ginning an d $ 5 5 0 at the end (i.e. Assets — Liabilities = Equity). These d a ta p roduce the fo llo w in g calculation o f the changes in the b alance sheet categories: Assets
1
Equity 1
Liabilities
Beginning:
$1 200
=
$750
+
$450
Ending:
$1 450
=
$900
+
$550
Changes:
$ 250
=
$150
+
$100
W h e re d id the ch a n g e in equity com e from ? Upon investigation, w e find out that the c o m p a n y issued m ore share c apital o f $ 4 0 , earned profit of $ 1 8 5 an d d e cla re d a d ivid e n d o f $ 1 2 5 . Thus: $
71
Share capital change: Equity increase due to issued share capital
40
Retained profits change: Equity increase due to profit Equity decrease due to declaration of dividend Change in equity between the two balance sheets
185 (125)
60 100
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61
W e know w h a t the profit w a s, but not w h a t the c o m p a n y d id to earn it. This is w h a t the profit an d loss com ponent o f the incom e statement is for: describing the revenues a nd expenses that produced the $1 8 5 profit. But once w e have that, it is useful to kn o w h o w that factors in to the b a la n ce sheet. The net profit is part o f the ch a n g e in retained profits, w h ich in turn is part of the c h a n g e in the b a la n ce sheet over that p e riod. The statement (or note) show in g changes in retained profits therefore 'knits' the b a la n ce sheet a nd the incom e statement together by show ing that the net profit is part o f the ch a n g e in the b a la n ce sheet over the p e riod. (Accountants refer to this knitting together as the articulation o f the tw o statements.) Profit is part o f the ch a n g e in retained profits fo r the p e riod, therefore: P rofit is p a rt o f the e q u ity com ponent of the accounting eq u atio n M a k e sure you understand h o w this w orks: •
A revenue increases w e a lth , so it either increases assets o r decreases liabilities, an d therefore increases equity.
•
An expense decreases w e a lth , so it either decreases assets o r increases liabilities, a nd therefore decreases equity.
•
Positive net p ro fit has the overall effect o f increasing assets a n d /o r decreasing liabilities, an d therefore increases equity (increases due to revenues exceed decreases due to expenses).
•
A net loss, w h ich is negative net profit, does the o pposite, decreasing equity (decreases due to expenses exceed increases d ue to revenues). A t this stage make sure you g ra sp the idea that p rofit is part o f equity through retained profits. N o te that in
C h a p te r 1 3 you w ill see that the full incom e statement includes other equity changes that articulate through to the b a lan ce sheet.
FOR YOUR INTEREST P eople s o m e tim e s th in k th a t th e w h o le balance o f re ta in e d p ro fits is available to pay dividends. Legally th a t m ay be tru e , b u t p ra c tic a lly it is v e ry u n lik e ly to be tru e , because p r o fit co m e s fro m changes in all th e fo rm s o f w e a lth on th e balance sheet. A c o m p a n y th a t has m ade go o d p ro fits and used th e m o n e y earned to invest in new p la n t and e q u ip m e n t, fo r exam ple, w o u ld have to sell th e p la n t and e q u ip m e n t i f it w e re to pay o u t all th e re ta in e d p ro fits as dividends. A lso , since p r o fit is based on accrual a c co u n tin g , it is re p re se n te d by changes in n o n -c a s h a c co u n ts such as a c co u n ts receivable (u n c o lle c te d revenues) and a c co u n ts payable (u n p aid expenses), so th e p ro fit in re ta in e d p ro fits is n o t all cash, and th e c o m p a n y m ig h t have to cle a r up all its receivables and payables to g e t th e cash to pay a big d ividend. The ow n e rs m ay n o t even w a n t a d ividend: m any co m p a n ie s th a t pay sm all o r no dividends have e x c e lle n t share prices on th e s to c k m a rk e t, because shareholders believe th a t th e co m p a n ie s w ill g ro w and p ro sp e r i f th e m o n e y th a t co u ld have been paid as dividends is instead k e p t inside th e c o m p a n y and used to m ake p ro fita b le business in v e stm e n ts.
An exam ple o f a rtic u la tio n betw een the balance sheet and the incom e sta te m e n t Bratwurst Ltd had the fo llo w in g b a la n ce sheet at the end o f 2 0 1 5 (beginning o f 2 0 1 6 ): assets $ 5 0 0 0 , liabilities $ 3 0 0 0 a nd equity $ 2 0 0 0 . •
The b e ginning equity figure w a s m ade up o f the shareholders' invested share c a p ita l o f $ 5 0 0 plus retained profit accum ulated to the end o f 2 0 1 5 o f $ 1 5 0 0 . (That $ 1 5 0 0 w a s therefore the sum o f all the net profits the c o m p any had ever had up to the end o f 2 0 1 5 minus all the d ividends ever d e cla re d to ow ners up to that point.)
•
During 2 0 1 6 , the c o m p a n y had revenues o f $1 1 0 0 0 a nd expenses o f $ 1 0 0 0 0 , a nd d e cla re d d ividends to ow ners o f $ 3 0 0 .
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•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A t the end of 2 0 1 6 , the c o m p a n y had assets o f $ 5 9 0 0 , liabilities o f $ 3 2 0 0 a nd equity o f $ 2 7 0 0 , m ade up o f the shareholders' invested share ca p ita l o f $ 5 0 0 plus retained profits of $ 2 2 0 0 . Exhibit 2 .6 shows the relationship.
You can see several things from this exam ple: •
W e have used the term 'retained profits' instead o f 'retained earnings'. Both are used in A ustralia, but the former is m ore com m on. In the United States a nd C a n a d a , 'retained earnings' is much m ore com m on.
•
The incom e statement's bottom line is transferred to the statement of retained profits, w h ich is g e n e ra lly shown as a note to the b a la n ce sheet.
•
The retained profits note's bottom line is transferred to the b a la n ce sheet, show ing that the statements tie together (articulate) through retained profits. In a d d itio n , asset a n d /o r lia b ility accounts in the b a la n ce sheet also have to ch a n g e to reflect the w ealth changes
that revenues and expenses involve. These changes keep the b a la n ce sheet in b a la n ce w ith the ch a n g e in retained profits. This is true for all com panies, not just sim ple ones like Bratwurst Ltd. The Bratwurst exam ple also shows that the profit inform ation an d the retained profit note could be said to be detailed explanations o f the c h a n g e in the b a la n ce sheet's retained profits figure. But the b a la n ce sheet could instead have had the fo llo w in g form at under the retained profits part o f shareholders' equity:
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63
Retained profits Beginning balance A dd Revenues
1 500 1 1 000 12 500
D e d u c t Expenses
1 0000 2
D e d u c t Dividends declared
Ending balance
500 300
2 200
The inform ation is there, but putting all this on the b a la n ce sheet w o u ld make it rather cluttered, a nd there w o u ld hardly be room to pro vid e a n y details a b o u t the various revenues, expenses an d d ividends. A lso, the co n ce p t o f profit as a measure o f perform ance w o u ld be obscured.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
In fin a n cia l a c c o u n tin g , w h a t is a re ve n u e and w h a t is an expense?
2
S uppose B ra tw u rs t L td ’s a c c o u n tin g re co rd s show ed th e fo llo w in g fo r th e n e x t year, 2 0 1 7 : revenues earned $ 1 4 2 0 0 , cash c o lle c te d fro m c u s to m e rs $13 8 0 0 , expenses in c u rre d $12 9 0 0 , dividends declared $ 6 0 0 and dividends paid in cash $ 5 0 0 . (R e m e m b e r, re ta in e d p ro fits equalled $ 2 2 0 0 a t th e end o f 2 0 1 6 .) W h a t was B ra tw u rs t’s n e t p r o fit fo r 2 0 1 7 and its re ta in e d p ro fits as a t th e end o f 2017? Y o u r answers should be: $14 2 0 0 - $12 9 0 0 = $ 1 3 0 0 ; and $ 2 2 0 0 + $ 1 3 0 0 - $ 6 0 0 = $ 2 9 0 0 .
2.9
A closer look at the income statem ent
S ocial an d e co n o m ic forces have helped to produce an incom e statement that is m ore co m p le x than the sim ple Bratwurst Ltd exam ple you s a w earlier. See Exhibit 2 .7 for T a b co rp H o ld in g s' Income statement. A m ong the things you m ay notice as you review the tw o statements are: •
The incom e statement covers a p eriod o f tim e (years e n ding 3 0 June in this case), not a point in time, as the b a la n ce sheet does. It also is shown in millions o f dollars.
•
As you a lre a d y s a w w ith the b a la n ce sheets, extensive e xp lanatory notes a re norm ally referred to on the incom e statement a nd a p p e n d e d to them. The notes a re not attached here. The content of such notes is important, how ever, so some comments are m ade a b o u t that b e lo w , a nd further attention w ill be p a id to it in later chapters.
• •
A t the to p o f the statement, the total revenue fo r the ye a r is disclosed as $ 2 0 3 9 .8 million. Expenses (including em ploym ent costs o f $ 1 6 5 .1 m illion an d com m issions/fees of $ 7 7 0 .8 million) are then deducted to ge t o p erating profit before incom e tax.
•
Incom e tax is levied on a com pany's profit because it is le g a lly separate from its ow ners. Such tax is usually a percentage of profit before incom e tax (though there are m any com plications). Income tax expense o f $ 7 5 .1 m illion a n d loss from discontinued operations, net o f tax ($ 1 9 .5 million), are deducted to ge t 'o p e ra tin g profit after incom e tax' o f $ 1 2 9 .9 million.
•
Loss on profits from discontinued operations (parts of the business that are no longer in operation) are norm ally deducted to g ive a clearer indication o f profits from continuing operations, w h ich is m ore useful for predicting future profits.
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•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o te that the governm ent taxes a nd levies ( $ 3 4 9 .5 million) are not incom e tax. There a re separate taxes related to the g a m ing industry.
•
In 201 3 there w a s mention o f im pairm ent. This is w h e re com panies need to reduce the value o f some o f their assets b e lo w cost a nd is e xp la in e d in C h a p te r 10.
EXHIBIT 2.7
TABCORP HOLDINGS LIMITED IN C O M E S T A T E M E N T FOR TH E YEAR ENDED 3 0 JUNE 2 0 1 4
2014
Revenue
2013
$m
$m
2 0 3 9 .8
2 003.2
0 .7
8.5
Government taxes and levies
(349.5)
(334.1)
Commissions and fees
(770.8)
(763.1)
Employment costs
(165.1)
(154.2)
Other income
Communications and technology costs Depreciation and amortisation Impairment Property costs
(75.9)
(85.2)
(164.4)
(151.1)
-
(18.6)
(41.3)
(40.3)
(38.1)
(36.8)
Other expenses
(113.7)
(106.2)
Profit before income tax expense and net finance costs
3 2 1 .7
322.1
Advertising and promotions
3.4
Finance income
3.1
Finance costs
(100.6)
(106.8)
Profit from continuing operations before income tax expense
22 4.5
218.4
Income tax expense
(75.1)
Profit from continuing operations after income tax
149.4
(70.8) 147.6
Discontinued operations Loss from discontinued operations, net of tax
(19.5)
(21.0)
N et profit after tax
129.9
126.6
S ou rce : T a b c o rp H o ld in g s Lim ited, A n n u a l R ep ort 2 0 1 4 .
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: I f th e o p e n in g balance o f re ta in e d p ro fits is $ 8 5 0 0 0 0 , n e t p r o fit b e fo re ta x $ 1 5 0 0 0 0 , n e t p r o fit a fte r ta x $ 1 2 0 0 0 0 , and $ 7 0 0 0 0 o f dividends w e re d e cla re d , w h a t is th e clo sing balance o f re ta in e d p ro fits ? Y o u r answ er should be: $ 9 0 0 0 0 0 ( 8 5 0 0 0 0 + 1 2 0 0 0 0 - 7 0 0 0 0 ) .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
65
FOR YOUR INTEREST B o th in A u s tra lia and in te rn a tio n a lly th e label fo r th e s ta te m e n t th a t provides th e p r o fit fig u re has changed o fte n o v e r re c e n t decades; exam ples in c lu d e p r o fit and loss s ta te m e n t, s ta te m e n t o f fin a n cia l p e rfo rm a n c e and in c o m e s ta te m e n t. Y o u should be aw are o f th e se nam e changes as som e co m p a n ie s m ay re ta in th e o ld e r nam es fo r in te rn a l d o c u m e n ts because o f m anagers’ fa m ilia rity w ith th e m . F o r exam ple, th e use o f th e te rm ‘p r o fit and loss s ta te m e n t’ is still c o m m o n in m a n y com panies.
2.10 Capital markets, managers and performance evaluation The profit figure, as disclosed in the incom e statement, has m ajor im pacts on m anagers' salaries, prom otions, careers and reputations - e sp e cia lly w h e re c a p ita l markets such as stock markets a re concerned. M a n a g e rs o f large, publicly traded com panies a re under constant pressure because o f the spotlight on profits an d its com ponents. Business and social observers often com m ent that this spotlight is too intense; that there is m ore to m anagerial perform ance than the profit figure. An indication o f the im portance p laced on the 'bottom line' can be found in alm ost a n y issue of a financial new spaper, such as The A ustralian o r the A ustralian F inancial Review, in their regular announcem ents o f com panies' annual a n d /o r half-yearly profits. These announcem ents presum ably are meant to focus on the crucial bits of inform ation. The emphasis is on profit. There is alm ost never a n y d a ta a b o u t non-financial perform ance, longer-term issues o r other aspects o f m anagers' efforts. This is not to say that these other factors a re not considered a t some point, but w hen announcem ents tend to stress earnings, other things can be overlooked. The announcem ents sh o w sales, profits before tax (pre-tax), net p rofit after tax (net), earnings per share (EPS), interim a nd final dividends per share (which includes the d a te o f paym ent; 'ff' signifies the d ivid e n d is fully franked, m eaning that tax has a lre a d y been p a id on the profits by the co m p a n y; 'p ' means it is partly franked) a nd the present share price, w h ich includes the ch a n g e from the previous d a y (shares last). Som e figures are converted to per-share da ta (roughly, these a re the profit figure d iv id e d by the num ber of o rd in a ry shares issued by the com pany). Per-share amounts are thought to be helpful to the user w h o ow ns o r is thinking o f buying a particular num ber o f shares a nd w o n d e rs w h a t portion o f the co m p a n y's results can be related to that num ber of shares. If you o w n n shares of X Limited, you can say that your shares earned $ 0 ,5 5 5 p e r share in the 2 0 1 6 fin a n cia l year, up from $ 0 .4 8 1 per share in the previous fin a n cia l year. Share price inform ation is given for the current period. For exam ple, it shows that the share price o f X Limited at the last sale the previous d a y w a s $ 5 .3 6 , w h ich w a s d o w n 4 .2 cents on the previous d a y's closing price. W h e n the fin a n cia l statements are p roduced, a nd announcem ents like Exhibit 2 .8 are m ade from them, the statements w ill reflect the sam e things, the same m anagem ent decisions. Therefore, share prices w ill g o up o r d o w n w hen investors receive news a b o u t a c o m p a n y that changes the attractiveness o f its shares. If this news comes out before the fin a n cia l statements a nd the a b o v e announcem ents (which is usually the case, e sp e cia lly for w ell-know n com panies that are frequently in the news), then the share price w ill a lre a d y have ch a n g ed in the m anner to be expected from the announcem ents. If an announcem ent (surprisingly g o o d o r b a d results) is not expected, then the share prices w ill ch a n g e w hen the announcem ent is m ade, because the announcem ent is the news. In either case, share market prices an d p rofit announcem ents tend to end up m oving in the same direction, an d therefore are correlated.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
M a n a g e rs o f com panies w ith traded shares a re therefore keenly a w a re o f a ccounting's profit measurement, because accounting is tracking factors that investors are concerned about. If the investors d o not learn a b o u t these factors from other sources, they w ill certainly learn a b o u t them from the accounting statements. The incom e statement is also im portant for managers of smaller com panies o r private com panies. W h ile their shares are not traded, managers and o w n e r-m a n a g e rs o f smaller com panies are as concerned as managers of larger com panies are a bout m anagem ent bonuses, incom e tax a nd other effects o f profit figures. M a n a g e rs o f m any com panies - e specially, but not only, larger corporations - g o to great lengths to explain their perform ance to investors an d to p e o p le on w hom investors rely, such as share market analysts a n d business journalists. Therefore, every m anager should be conversant w ith h o w her o r his perform ance is measured in the incom e statement - because a lot o f other p e o p le are!
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
67
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A C alculate n e t p ro fit A ssum e this is th e firs t y e a r o f o p e ra tio n s fo r the c o m p a n y . U sing th e fo llo w in g in fo rm a tio n c a lc u la te net p ro fit b e fo re ta x.
$ Credit sales
300000
Cash sales
100 00 0
Cash received from accounts receivable
160 00 0
Cost of goods sold
70000
Cash purchases of inventory
90000
Operating expenses paid
80000
Operating expense incurred during the year but owing at year-end
30000
PRACTICE PROBLEM B Prepare a balance sheet a p p ro p ria te ly classified From th e fo llo w in g in fo rm a tio n , p re p a re a b a la n c e sheet, a p p ro p ria te ly c la s s ifie d , as a t 3 0 June 2 0 1 6 fo r PSM Lim ited. $000 Share capital
108518
Cash
11 636
Accounts payable
43 091
Investments ($3 371 000 held for short-term investment) Retained profits Prepayments
5 458 28 546 3 958
Accounts receivable
47515
Long-term borrowings
30 866
Inventory
66479
Provisions for employee entitlements ($30 9 1 9 0 0 0 due within one year)
34888
Property, plant and equipment
67760
Other long-term assets
42 742
Other receivables (due in more than one year)
PRACTICE PROBLEM C Revenues and expenses The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 6 . 1 Issued shares to investors fo r cash . 2
P ro v id e d services to custom ers, re c e iv in g p a rt in cash a n d th e rest on c re d it.
3
In cu rre d a d v e rtis in g e x p e n s e , p a id in cash .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
68
4
C o lle c te d cash fro m a c co u n ts re c e iv a b le .
5
R e p a id a b a n k lo a n .
6
P urchased e q u ip m e n t on c re d it.
7
B o u g h t in v e n to ry fo r cash .
8
S old g o o d s on c re d it (C O G S e q u a ls 6 0 p e r c e n t o f sales).
9
P aid w a g e s e x p e n s e fo r th e p e rio d .
10 R eceived a lo a n fro m th e b a n k . 11 In cu rre d m a in te n a n c e ex p e n s e , p a id cash .
12 D e c la re d a n d p a id a cash d iv id e n d to investors. For e a c h o f th e tra n s a c tio n s , in d ic a te th e e ffe c t (+ fo r in cre a s e a n d — fo r de cre a s e ) o f e a ch tra n s a c tio n on revenues, expe nses a n d net p ro fit. W r ite N E if th e re is no effect.
PRACTICE PROBLEM D Incom e sta te m e n t and balance sheet Isa b e lle Lim ited sta rte d business o n 1 S e p te m b e r 2 0 1 6 . D u rin g th e first m o nth in business th e fo llo w in g tra n s a c tio n s o c c u rre d . a Issued s h a re c a p ita l, $ 1 0 0 0 0 0 .
b
P aid o n e m o n th 's ren t o f $ 2 0 0 0 .
c
P ro v id e d services to custom ers on c re d it, $ 3 0 0 0 0 ; $ 1 1 0 0 0 o f this a m o u n t h a d been re c e ive d b y th e e n d o f the m onth.
d
P aid w a g e s o f $ 7 0 0 0 .
e
R eceived a $ 1 0 0 0 b ill fo r c le a n in g services o n th e n e w ly re n te d p ro p e rty fo r th e c le a n in g d o n e . The b ill w ill be p a id in O c to b e r.
Required: 1
P re p a re an in c o m e state m e nt fo r th e m onth o f S e p te m b e r 2 0 1 6 .
2
P re p a re a b a la n c e sheet a t 3 0 S e p te m b e r 2 0 1 6 .
KEY TERMS Accounts Accrued expenses Accumulated depreciation Annual report Assets Bank overdraft Current assets Current liabilities
Current ratio Double-entry accounting Income tax expense Income tax payable Intangible assets Market value Net loss Noncurrent assets
Noncurrent liabilities Notes to the Financial statements Prepayments (prepaid expenses) Provision Statement of retained profits Stewardship Working capital
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
D e fin e th e fo llo w in g term s in y o u r o w n w o rd s :
a
re ven ue
b
expense
c
net p ro fit
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
d
d iv id e n d
e
re ta in e d p ro fits
f
s h a re h o ld e rs ' e q u ity .
2
W h a t is th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t assets?
3
W h a t is th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t lia b ilitie s ?
4
D o lia b ilitie s a lw a y s in v o lv e fu tu re pa ym e n ts o f cash?
5
S u g g e st tw o w a y s re ta in e d p ro fits m a y d e cre a s e .
6
H o w c a n a b a la n c e sheet a n s w e r th e fo llo w in g qu estio ns: a Is a c o m p a n y fin a n c ia lly sound?
7
69
b
C a n a c o m p a n y p a y its bills on tim e?
c
S ho uld th e b o a rd o f d ire c to rs d e c la re a d iv id e n d ?
d
H o w o ld is th e e q u ip m e n t?
E x p la in th e m a in d iffe re n c e s b e tw e e n th e a lte rn a tiv e m e tho ds o f setting o u t a b a la n c e sheet: th e side -by-sid e style a n d th e v e rtic a l style.
8
List fo u r lia b ilitie s th a t c a n be e ith e r c u rre n t o r n o n c u rre n t lia b ilitie s . W h a t d e te rm in e s th e ir c a te g o ris a tio n ?
9
The C E O o f a la rg e A u s tra lia n c o m p a n y a n n o u n c e d a t a recen t s h a re h o ld e rs ' m e e tin g : 'O u r p e o p le a re o u r g re a te s t a sse ts.' If this is th e case , w h y a re th e y n o t in c lu d e d in th e b a la n c e sheet?
10 E x p la in th e fo llo w in g in n o n -te ch n ic a l la n g u a g e th a t a business p e rso n w h o has n o t re a d this te xt w o u ld u n d e rsta n d : a W h y is net p ro fit p a rt o f s h a re h o ld e rs ' e q u ity?
b
If net p ro fit is p a rt o f s h a re h o ld e rs ' e q u ity , w h y is it ne ce ssary to h a ve a s e p a ra te in c o m e statem ent? W h y not just re p o rt net p ro fit o n th e b a la n c e sheet?
c
W h y a re d iv id e n d s to s h a re h o ld e rs no t c o n s id e re d to be an e x p e n s e in c a lc u la tin g net p ro fit? E m p lo ye e w a g e s a re c o n s id e re d to be an e x p e n s e , as is th e cost o f p ro d u c ts d e liv e re d to custom ers, a n d s h a re h o ld e rs m ust be k e p t h a p p y , as m ust e m p lo y e e s a n d custom ers.
11 W h y a re in v e n to ry a n d acco un ts re c e iv a b le n o rm a lly c u rre n t ra th e r th a n n o n c u rre n t assets? W h e n w o u ld th e y be n o n c u rre n t assets?
12 P ro v id e o n e e x a m p le e a ch o f investm ents, in ta n g ib le s , p re p a ym e n ts a n d a c c ru e d expe nses. 13 P ro v id e an in d ic a to r o f w h e th e r a c o m p a n y is fin a n c ia lly soun d. 14 P ro v id e an in d ic a to r o f w h e th e r a c o m p a n y c a n p a y its b ills on tim e. 15 C o n s id e r a n y c o m p a n y y o u a re fa m ilia r w ith o r in tere ste d in a n d m a ke a list o f a ll th e p e o p le w h o m ig h t be in tere ste d in its b a la n c e sheet. M a k e y o u r list using th e fo llo w in g h e a d in g s :
Person (decision-maker)
Use (decision to be made)
T ry to th in k a b o u t th e 'u s e ' issue b ro a d ly : y o u r list c o u ld e a s ily be a lo n g o n e . Y ou m ig h t m a ke it even m o re b ro a d b y in c lu d in g p e o p le y o u th in k m ig h t like to use th e b a la n c e shee t b u t w h o s e needs a re no t served b y it as y o u u n d e rsta n d it, o r w h o d o n o t h a ve tim e ly access to it. 16 'F in a n c ia l re p o rts a re no lo n g e r tim e ly to d a y .' D iscuss. 1 7 W r ite a p a ra g ra p h in w h ic h y o u id e n tify a n o n -a cc o u n tin g c a re e r y o u o r s o m e o n e y o u k n o w m a y pursue, a n d e x p la in th e in tere st in b a la n c e sheet in fo rm a tio n th a t this c a re e r m ig h t e n ta il. If y o u re a lly c a n n o t see a n y re la tio n s h ip b e tw e e n th a t c a re e r a n d a n y th in g re p o rte d in a b a la n c e sheet, e x p la in w h y not. 18 C a n a s in g le b a la n c e sheet e v e r satisfy a ll th e users o f a c o m p a n y 's fin a n c ia l statem ents, o r sh o u ld th e re be d iffe re n t b a la n c e sheets p re p a re d to m eet th e d iffe rin g needs o f users? W r ite a p a ra g ra p h g iv in g y o u r c o n s id e re d v ie w s .
19 'Y o u c a n h a ve a p e rfe c tly a c c u ra te b a la n c e sheet 5 0 y e a rs a fte r y e a r-e n d .' D iscuss. 2 0 E x p la in w h y th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t lia b ilitie s is im p o rta n t to a c o m p a n y . 21 E x p la in th e d iffe re n c e b e tw e e n an a c c ru a l a n d a p ro v is io n .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
70
PROBLEMS PROBLEM 2.1 Classifying accounts on a balance sheet B e lo w a re som e o f th e acco un ts o f M o n e y M a k in g Ltd: 1 W a g e s p a y a b le
2
S h a re c a p ita l
3
C a s h a n d cash e q u iv a le n ts
4
In ve n to ry
5
B o rro w in g s
6
P rovision fo r e m p lo y e e en titlem en ts (cu rre n t p o rtio n )
7
In co m e ta xe s p a y a b le
8
E q u ip m e n t
9
P rep aym e nts State w h e th e r e a ch w o u ld be c la s s ifie d as a n asset, a lia b ility o r s h a re h o ld e r e q u ity .
PROBLEM 2.2 In te rp re tin g balance sheets 1
'T he c o m p a n y is in a p o s itio n to u tilise a s trong b a la n c e sheet to m a ke a c q u is itio n s th a t sh o u ld b o o s t its e a rn in g s p e r s h a re .'
2
'T he c o m p a n y has m a in ta in e d a s trong b a la n c e sheet a n d h a d a m p le c a p a c ity to e x p a n d its b u siness.'
3
'T he a b ility to g e a r th e c o m p a n y 's b a la n c e sheet to p ro d u c e a m o re e ffic ie n t c a p ita l structure is a key to a successful fu tu re .'
Discuss th e im p lic a tio n s o f e a ch o f th e statem ents fro m th e p o in t o f v ie w o f th e com m en ts m a d e on th e ir b a la n c e sheets.
PROBLEM 2.3 Prepare a classified balance sheet From th e fo llo w in g in fo rm a tio n , p re p a re a b a la n c e sheet, a p p ro p ria te ly c la s s ifie d , as a t 3 0 June 2 0 1 6 fo r In co b Ltd.
1
T
Share capital
161 000
Property, plant and equipment, at cost
550000
Accounts payable
61 000
Accounts receivable
68 000
Cash and cash equivalents
43 000
Notes payable
30000
Prepayments
1 0000
Long-term debt, excluding current portion
200000
Long-term investments
110 00 0
Provision for employee entitlements (noncurrent) Retained profits Income taxes payable
34000 184000 32 000
Inventory
81 000
Patents and trademarks
55 000
Current portion of long-term debt Accumulated depreciation
25 000 190000
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
71
PROBLEM 2 .4 Prepare a classified balance sheet Based on the fo llo w in g in fo rm a tio n , p re p a re an a p p ro p ria te ly c la s sifie d b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r JKL Lim ited. 1
$000 Share capital Cash Accounts payable
45 092 63 382 105344
Retained profits
39 346
Accounts receivable
98 264
Interest-bearing liabilities (current)
192370
Inventories
110234
Provisions (current) Property, plant and equipment
70 876 181148
PROBLEM 2 .5 Explain balance sheet ideas to a business executive Y ou a re the e x e c u tiv e assistant to S te p h a n e S o ld e n , a p a rtic u la rly h a rd -d riv in g a n d successful o w n e r o f a c h a in o f re stau ran ts. N o t lo n g a g o , S olde n a n d y o u w e re fly in g to a n o th e r c ity , a n d th e in flig h t film w a s so b a d th e tw o o f y o u e n d e d up ta lk in g a b o u t a ll sorts o f th in g s. O n e s u b je c t w a s S o ld e n 's im p a tie n c e w ith a c c o u n ta n ts a n d a c c o u n tin g w h ic h , p ro b a b ly be ca u se the a n n u a l a u d it o f th e c o m p a n y 's a c co u n ts w a s then ta k in g p la c e , seem ed p a rtic u la rly s tro n g . H o w w o u ld y o u re s p o n d to th e fo llo w in g q u e s tio n s fro m S olde n? 1 'T he m a in th in g th a t sticks in m y m in d a b o u t th e b a la n c e sheet is th a t th e th in g b a la n c e s ! W h o cares? W h y sh o u ld it m a tte r? ' 2
3
'M y a u d ito r keeps w a n tin g to ta lk to m e a b o u t w h a t th e b a la n c e sheet says a b o u t th e c o m p a n y 's fin a n ce s a n d h o w I've m a n a g e d th em . But I a lw a y s lo o k to th e fu tu re - w h y sh o u ld I c a re a b o u t th e b a la n c e shee t w h e n it's just a " s n a p s h o t" o f h is to ry ? ' 'Last y e a r, I h a d a re a lly g o o d id e a a b o u t th e b a la n c e sheet. Y ou k n o w , I c o n s id e r o u r re s ta u ra n t m a n a g e rs to be th e m ost im p o rta n t asset th e c o m p a n y has. I w a s g o in g to h a ve th e m a n a g e rs a d d e d to th e b a la n c e sheet as assets, so it w o u ld s h o w a ll o u r assets. But th e a c c o u n ta n ts a n d a u d ito rs d id n 't seem in tere ste d in m y id e a . W h y no t? '
4
'S o m e o n e to ld m e o n c e th a t th e b a la n c e sheet is a p h o to g ra p h o f th e business a t a p a rtic u la r in sta n t in tim e , a n d th a t y o u h a ve to be c a re fu l b e ca u s e som e a c c o u n ta n t m ig h t h a ve to u c h e d up th e p h o to , a irb ru s h e d a w a y the w a rts . W h a t d id th e y m e an ? Isn't th e b a la n c e sheet an e x a c t list o f a ll th e c o m p a n y 's assets a n d lia b ilitie s ? '
C la s s ify e a ch item as it w o u ld be re p o rte d on a b a la n c e sheet using th e fo llo w in g c a te g o rie s : c u rre n t asset, no n c u rre n t asset, c u rre n t lia b ility , n o n c u rre n t lia b ility a n d s h a re h o ld e rs ' e q u ity .
PROBLEM 2 .6 Prepare sim ple balance sheet, notes, 'w hat i f analysis S c a llo p s G a lo re Ltd is a s e a fo o d e a te ry s p e c ia lis in g in shellfish a n d soups. The prem ises a re ren ted a n d a ll sales a re fo r cash , so th e c o m p a n y has o n ly a fe w b a la n c e sheet a c co u n ts. The a c co u n ts, as a t 3 0 June 2 0 1 6 , a re as fo llo w s .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Food supplies cost Equipment cost Other supplies cost
2 100 64900 4500
Cash at bank
2 200
Payable to suppliers
5 300
Long-term loan Wages payable
25 000 900
Share capital
1 0000
Accumulated depreciation
27400
Retained profits
5 100
Required: 1
P re p a re a b a la n c e sheet fo r S c a llo p s G a lo re Ltd as a t 3 0 June 2 0 1 6 . In clu de a n y notes to th e b a la n c e sheet th a t y o u th in k m ig h t be useful.
2
C o m m e n t on th e c o m p a n y 's fin a n c ia l p o s itio n as s h o w n b y y o u r b a la n c e sheet.
3
S u p p o se , w h e n y o u w e re re v ie w in g th e c o m p a n y 's a cco u n ts a fte r p re p a rin g th e b a la n c e sheet, y o u fo u n d an e rro r in th e re c o rd s. The c o m p a n y h a d p a id a s u p p lie r $ 2 9 0 0 , b u t th a t p a y m e n t h a d in a d v e rte n tly no t been d e d u c te d fro m th e c o m p a n y 's b a n k a c c o u n t re c o rd o r fro m its re c o rd o f a c co u n ts p a y a b le to s u p p lie rs . Y ou d e c id e d to re c o rd th a t p a y m e n t. W h a t ch a n g e s resulted in th e b a la n c e sheet y o u p re p a re d in q u e s tio n 1 a n d in y o u r com m en ts in q u e s tio n 2?
PROBLEM 2.7 Prepare a classified balance sheet From th e fo llo w in g in fo rm a tio n , p re p a re a n a p p ro p ria te ly c la s s ifie d b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r M S P O Lim ited.
$000 Share capital
67358
Cash
31 691
Accounts payable
52 672
Retained profits
39 346
Receivables ($1 549 000 due in more than one year)
49132
Interest-bearing liabilities ($8 732 000 due this year)
96185
Intangibles
49 053
Deferred tax liabilities
4962
Inventories
55 117
Provisions ($31 704 000 due within one year)
35 438
Property, plant and equipment
90574
Reserves Deferred tax assets
7 320 16 974
Other long-term assets (financial assets)
2416
Other current assets (prepayments)
8 324
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PROBLEM 2 .8 C orrecting a balance sheet F in ew in es Lim ited b e g a n business on 1 J u ly 2 0 1 5 , p ro d u c in g a n d s e llin g w in e . O n e y e a r la te r, th e c o m p a n y 's n e w ly a p p o in te d a c c o u n ta n t, A l Beer, needs to p ro d u c e a b a la n c e sheet fo r a m e eting o f c o m p a n y executive s. U n fo rtu n a te ly , A l is m o re s kille d a t w in e m a k in g th a n he is a t a c c o u n tin g , a n d has req ue ste d y o u r a d v ic e . H e show s y o u th e fo llo w in g b a la n c e sheet he has p re p a re d . FINEWINES LIMITED BALANCE SHEET AS AT 3 0 JUNE 20 16 Assets
Liabilities and shareholders' equity
Cash
4 340
Net profit for the year Inventory of grapes
24720 9 800
Accounts payable
Accounts receivable
10460
Share capital
40000
Kitchen equipment
50 800
10680
A ssum e th a t th e a c c o u n t b a la n c e s A l has used a re c o rre c t. P rep are a c o rre c te d b a la n c e sheet. P ro v id e an e x p la n a tio n o f th e m a in d iffe re n c e s b e tw e e n y o u r b a la n c e sheet a n d th e o n e A l p re p a re d .
PROBLEM 2 .9 Basic balance sheet, n e t p ro fit and retained p ro fits ideas LB Ltd h a d th e fo llo w in g recen t b a la n c e sheet as a t 3 0 S e p te m b e r 2 0 1 6 : Cash Inventory Land
1 642 480 3 100
Mortgage Share capital Retained profits
5 222
500 3 500 1 222 5 222
1
W h y is 'la n d ' on th e b a la n c e sheet, a n d w h a t do es it represent?
2
O n 5 O c to b e r 2 0 1 6 , th e c o m p a n y b o rro w e d $ 2 4 1 0 fro m th e b a n k a n d used th e m o n e y im m e d ia te ly to b u y m o re la n d . W h a t w a s th e to ta l d o lla r fig u re o f th e c o m p a n y 's assets a fte r this p o in t?
3
W h y d id th e c o m p a n y no t just use th e $ 3 5 0 0 s h a re c a p ita l to b u y m o re la n d in ste a d o f b o rro w in g fro m the bank?
4
E x p la in w h a t 're ta in e d p ro fits ' represents.
5
For th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e c o m p a n y 's revenues w e re $ 1 0 1 1 6 a n d its expe nses (in c lu d in g in c o m e tax) w e re $ 9 8 8 1 . D u rin g th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e c o m p a n y d e c la re d d iv id e n d s o f $1 2 0 . W h a t w a s th e b a la n c e in re ta in e d p ro fits a t th e b e g in n in g o f th a t y e a r (1 O c to b e r 2 0 1 5 )?
6
If the 2 0 1 6 expe nses w e re $1 1 6 0 0 in ste a d o f th e fig u re in p o in t 5 , a n d th e c o m p a n y d id n o t d e c la re a n y d iv id e n d s , w h a t w o u ld th e re ta in e d p ro fits be a t 3 0 S e p te m b e r 2 0 1 6 ? H o w w o u ld y o u in te rp re t this nu m b er?
PROBLEM 2.10 Incom e s ta te m e n t and balance sheet The fo llo w in g a c c o u n t b a la n c e s a re ta ke n fro m th e b o o ks o f C e n tu ry C in e m a s on 31 D e c e m b e r 2 0 1 6 . R evenues a n d expe nses a re fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . The re ta in e d p ro fits b a la n c e is as a t 1 J a n u a ry 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
$ Accounts receivable
13 450
Accounts payable
1 3 9 10
Advertising expense
42 780
Cash
4610
Confectionery sales
12 300
Cost of confectionery sold
1 0 5 00
Electricity expense
5 090
Furniture and fittings
34000
Inventory
18 000
Land and buildings
60000
Loan payable
35 000
Projection equipment
41 000
Rent expense
33 200
Retained profits, 1 January 2016
59 720
Share capital
60000
Ticket revenue
81 700
1
P re p a re an in c o m e state m e nt fo r C e n tu ry C in e m a s fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
2
P re p a re a note fo r re ta in e d p ro fits fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
P re p a re a b a la n c e sheet as a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 2.11 Com paring p ro fit w ith cash Flow G o ld C o a s t C ustom s w a s o rg a n is e d o n 1 July 2 0 1 6 . A t th e en d o f th e firs t y e a r o f o p e ra tio n s th e o w n e r p re p a re d th e fo llo w in g s u m m a ry o f its a c tiv itie s . 1 C u s to m is e d c a r services p e rfo rm e d fo r custom ers, $1 3 7 7 5 0 , o f w h ic h $ 2 2 4 0 0 re m a in e d u n co lle cte d a t th e en d o f the y e a r. 2
C a s h b o rro w e d fro m th e b a n k , $ 8 0 0 0 0 .
3
E q u ip m e n t p u rc h a s e d fo r $ 4 5 0 0 0 cash a t th e e n d o f th e y e a r to be used in th e business fo r tw o y e a rs s ta rtin g th e ne xt y e a r.
4
W a g e s e a rn e d b y e m p lo y e e s , $ 6 7 6 0 0 , o f w h ic h 2 0 p e r c e n t re m a in e d u n p a id a t th e e n d o f th e y e a r.
5
O th e r o p e ra tin g expe nses, $ 4 6 0 2 0 , o f w h ic h $1 2 0 0 0 re m a in e d u n p a id a t th e e n d o f th e y e a r. S h o w th e e ffe c t on net p ro fit a n d cash o f e a ch o f th e a b o v e tra n sa ctio n s.
PROBLEM 2.12 Indicate the e ffe cts o f tra n sa ctio n s W ith re sp e ct to th e c u rre n t a c c o u n tin g p e rio d , s h o w th e e ffe c t o f th e fo llo w in g tra n s a c tio n s on net p ro fit a n d cash fo r th e p e rio d . 1 P urchase in v e n to ry on cash fo r $ 4 0 0 0 0 . 2
R e c o rd in g d e p re c ia tio n o f $ 1 0 0 0 0 .
3
C re d it sale o f a s ervice fo r $ 3 0 0 0 0 .
4
P aym e nt o f a cash d iv id e n d o f $ 8 0 0 0 .
5
P aym e nt o f s a la ry fo r th e c u rre n t p e rio d o f $ 2 0 0 0 0 .
6
Interest p a y m e n t on a lo a n o f $ 7 0 0 0 .
7
R ep a ym e n t o f a lo a n o f $ 1 0 0 0 0 0 .
8
P aym e nt o f a n in v o ic e fo r a d v e rtis in g o f $ 1 3 0 0 0 th a t h a d been re c o rd e d as a n e x p e n s e in th e p re vio u s p e rio d .
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PROBLEM 2.13 E ffe ct o f tra n sa ctio n s on assets, lia b ilitie s and shareholders' e q u ity W h a t is th e e ffe c t on assets, lia b ilitie s a n d s h a re h o ld e rs ' e q u ity o f e a ch o f th e fo llo w in g tra n sa ctio n s? 1 C o n trib u te cash to th e c o m p a n y in return fo r shares.
2
B o rro w m o n e y fro m th e b a n k .
3
R eceive p a y m e n t fro m a d e b to r.
4
P urchase in v e n to ry o n c re d it.
5
P urchase in v e n to ry fo r cash.
6
Pay a c co u n ts p a y a b le .
7
R eceive in tere st th a t w a s d u e fro m th e p re vio u s a c c o u n tin g p e rio d .
8
P urchase fu rn itu re a n d fittin g s on c re d it.
9
A n o w n e r's c o n trib u tio n o f his m o to r v e h ic le to th e c o m p a n y in return fo r a d d itio n a l shares.
PROBLEM 2.14 E ffects o f tra n sa ctio n s on assets, lia b ilitie s and shareholders' e q u ity W h a t is th e e ffe c t on assets, lia b ilitie s a n d s h a re h o ld e rs ' e q u ity o f e a ch o f th e fo llo w in g tra n sa ctio n s? Use the n o ta tio n s 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t'. 1
O w n e rs o f th e c o m p a n y c o n trib u te m o to r ve h icle s in return fo r a d d itio n a l shares.
2
R eceive p a y m e n t fro m a c co u n ts re c e iv a b le .
3
P urchase e q u ip m e n t fo r cash .
4
Issue shares to p a y o ff a long -term lo a n .
5
Pay am o u n ts o w e d to a cco u n ts p a y a b le .
6
Sell in v e n to ry fo r cash a t a p ric e h ig h e r th a n its cost.
7
P urchase in v e n to ry o n c re d it.
8
Pay s a la rie s to e m p lo y e e s .
PROBLEM 2.15 Balance sheet and incom e s ta te m e n t e ffects o f Failure to record transactions U sing th e n o ta tio n s 'in c re a s e ', 'd e c re a s e ' a n d 'n o e ffe c t', in d ic a te th e e ffe c t on assets, lia b ilitie s , s h a re h o ld e rs ' e q u ity a n d ne t p ro fit b e fo re ta x o f fa ilin g to re c o rd e a ch o f th e fo llo w in g in d e p e n d e n t tra n sa ctio n s o r events: 1 A $ 2 0 0 0 0 0 p ie c e o f e q u ip m e n t p u rc h a s e d o n c re d it.
2
In ve n to ry o f $ 3 0 0 0 0 p u rc h a s e d on a c co u n t.
3
S ale o f in v e n to ry (co sting $ 3 0 0 0 0 ) on c re d it fo r $ 5 0 0 0 0 .
4
A lo a n re c e ive d fro m th e b a n k fo r $ 8 0 0 0 0 .
5
P aym e nt o f w a g e s o f $ 1 0 0 0 0 0 fo r th e p e rio d .
PROBLEM 2.16 Recording o f assets State w h e th e r o r n o t an asset sh o u ld be re c o rd e d in th e b a la n c e sheet o f XYZ Ltd as a t 3 0 June 2 0 1 6 in e a ch o f the fo llo w in g s itu a tio n s . State th e a m o u n t (if an y) o f th e asset, a n d a n y a s su m p tio n s m a d e . 1 O n 15 M a y 2 0 1 6 , X YZ Ltd p a id In su ra nce Ltd $ 2 0 0 0 0 fo r an in su ra n c e p re m iu m . The p re m iu m cove rs losses in c u rre d du e to fire , th eft o r o th e r causes up to 1 4 M a y 2 0 1 7 .
2
X YZ Ltd p a id $ 1 5 0 0 0 fo r a p a te n t in A p r il 2 0 1 6 .
3
X YZ Ltd has just h ire d a n e w g e n e ra l m a n a g e r w h o is an e x p e rt in th e business c a rrie d on b y X YZ Ltd. W ith the h e lp o f this p e rso n , th e c o m p a n y is e x p e c te d to in cre a s e its a n n u a l p ro fits b y $ 5 0 0 0 0 0 . The g e n e ra l m a n a g e r's s a la ry is $ 3 0 0 0 0 0 p e r an n u m .
4
X YZ Ltd p u rc h a s e d la n d in 2 0 0 9 fo r $ 1 0 0 0 0 0 . The m a rke t v a lu e o f this la n d is $ 1 5 0 0 0 0 as a t 3 0 June 2 0 1 6 .
5
A m a c h in e is p u rc h a s e d fo r $1 m illio n a n d costs a n a d d itio n a l $ 4 0 0 0 0 0 to in sta ll.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 2.17 Recording o f lia b ilitie s State w h e th e r o r n o t e a c h o f th e fo llo w in g events w o u ld result in a lia b ility b e in g re c o g n is e d in th e a cco u n ts a t 3 0 June. 1 Taxes fo r th e y e a r e n d e d 3 0 June, w h ic h a re no t p a y a b le until O c to b e r. 2
W a g e s to be p a id on 2 July to c o v e r th e tw o -w e e k p e rio d up to 3 0 June.
3
The c o m p a n y sells w a s h in g m a ch in e s a n d g ive s a o n e -y e a r w a rra n ty to re p a ir o r re p la c e a n y fa u lty m a ch in es.
4
A c o n s tru c tio n c o m p a n y receives a $ 1 0 m illio n a d v a n c e in June o n a c o n tra c t. The w o rk w ill c o m m e n ce in July.
5
The c o m p a n y has s ig n e d a c o n tra c t to p a y its m a n a g in g d ire c to r $1 m illio n p e r a n n u m (in fla tio n a d ju ste d ) fo r the n e xt fo u r y e a rs .
PROBLEM 2.18 Recognise revenue C a lc u la te th e to ta l reven ue fo r th e m o nth o f F e b ru a ry 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 C re d it sales o f $ 1 0 0 0 0 0 m a d e in F e b ru a ry ; 5 0 p e r c e n t to be c o lle c te d in F e b ru a ry. 2
C a s h sales o f $ 1 5 0 0 0 0 .
3
R eceived re n ta l reven ue o f $ 5 0 0 0 fo r th e m o nth o f F e b ru a ry.
4
Interest o f $ 8 0 0 0 is c re d ite d to th e c o m p a n y b a n k statem ent. It relate s to in tere st e a rn e d fo r th e six m onths fro m 1 A u g u s t 2 0 1 5 to 31 J a n u a ry 2 0 1 6 .
5
R eceived $ 1 0 0 0 0 as a d e p o s it fro m a c u sto m e r fo r a jo b to b e c a rrie d o u t in M a rc h .
PROBLEM 2.19 Recognise revenue C o p ie r Ltd m a n u fa c tu re s a n d sells sm all ho m e p h o to c o p ie rs to hom es a n d sm all businesses; it a ls o sells c a rtrid g e s to g o in th e c o p ie rs a n d m o n th ly m a g a z in e s on ru n n in g a sm all business. C o n s id e r th e fo llo w in g tra n sa ctio n s: 1 It d e liv e rs 1 0 p h o to c o p ie rs ; th e c u sto m e r p ro m ises to p a y $ 2 0 0 0 0 w ith in tw o m onths. 2
It bu ys a m o to r v e h ic le w ith a list (o r 's tic k e r') p ric e o f $ 4 1 0 0 0 fo r $ 3 1 2 0 0 cash.
3
It receives o rd e rs fo r 1 0 0 0 in k c a rtrid g e s fro m custom ers fo r $ 1 8 e a ch fo r fu tu re d e liv e ry . The term s re q u ire p a y m e n t in fu ll w ith in 3 0 d a y s o f d e liv e ry .
4
It c o m p le te s p ro d u c tio n o f th e in k c a rtrid g e s d e s c rib e d in p o in t 3 a n d d e liv e rs th e o rd e r.
5
It issues $ 2 m illio n in n e w shares.
6
It receives a to ta l o f $ 3 6 0 0 fro m su b s crib e rs to th e m a g a z in e . The s u b s c rip tio n s c o v e r a fu ll 1 2 e d itio n s fo r the y e a r. O n ly th e firs t e d itio n has be en po ste d to custom ers.
For e a ch o f th e a b o v e tra n s a c tio n s , state if reven ue is to be re c o g n is e d in th e c u rre n t fin a n c ia l y e a r, a n d in d ic a te the reven ue a c c o u n t title a n d a m o u n t. If reven ue is no t to be re c o g n is e d this y e a r, e x p la in w h y .
PROBLEM 2 .2 0 Recognise expenses C a lc u la te th e to ta l expe nses fo r th e m o nth o f F e b ru a ry 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 P aid s a la rie s o f $ 2 0 0 0 0 ; $ 5 0 0 0 re la te d to w o rk c a rrie d o u t in J a n u a ry a n d $ 1 5 0 0 0 re la te d to F e b ru a ry w o rk . 2
P aid c o m m is sio n expe nses o f $ 1 0 0 0 0 in F e b ru a ry. The c o m m is sio n re la te d to J a n u a ry sales.
3
P aid re n t fo r th e m onth o f F e b ru a ry o f $ 3 0 0 0 o n 9 F e b ru a ry.
4
R eceived a b ill fo r $ 7 5 0 fro m a p lu m b e r fo r re p a ir w o rk d o n e on 2 5 F e b ru a ry. This w ill be p a id n e xt m o nth.
5
P aid a n $ 8 0 0 0 0 d e p o s it o n a b lo c k o f la n d .
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PROBLEM 2.21 R ecognising expenses C a lc u la te th e to ta l expe nses fo r th e m onth o f June 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 P aid sa la rie s o f $ 6 0 0 0 0 ; $ 5 0 0 0 0 re la te d to w o rk c a rrie d o u t in M a y 2 0 1 6 a n d $ 1 0 0 0 0 re la te d to June 2016.
2 A p h o n e b ill fo r $ 1 2 0 0 w a s re c e ive d fo r th e u sag e on June. This a m o u n t w ill be p a id o n 1 July 2 0 1 6 . 3
A $ 6 5 0 0 0 d e p o s it w a s p a id fo r a b lo c k o f la n d .
4
P aid rent fo r th e m onth o f June o f $ 6 0 0 0 on 1 June 2 0 1 6 .
5
A c o m m is sio n e x p e n s e o f $ 8 0 0 0 w a s p a id in June. The c o m m is sio n re la te d to A p r il sales.
PROBLEM 2 .2 2 When is revenue earn e d ? Is reven ue e a rn e d fro m th e fo llo w in g tra n sa ctio n s? G iv e reasons fo r y o u r an sw e rs. 1 G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 9 5 0 0 .
2 G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 6 0 0 0 . 3
G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 4 5 0 0 .
4 A s u rv e y o r sends an a c c o u n t fo r $ 1 5 0 0 0 to a b u ild e r fo r w o rk in c o n n e c tio n w ith a s u b d iv is io n o f a b lo c k o f la n d . 5
A n e le c tric a l store p ro v id e s a fre e s ervice o n a te le v is io n set d u rin g th e w a rra n ty p e rio d . The cost to th e store w a s $250.
6 A n in ve stm en t c o m p a n y receive s a d iv id e n d o f $ 8 0 0 0 o n o n e o f its investm ents.
7 G o o d s c o stin g $ 1 0 0 a re s o ld fo r $ 1 6 0 . Instead o f p a y in g fo r th e g o o d s , th e c u stom er c le a n s th e store's w in d o w s . This c le a n in g is n o rm a lly c a rrie d o u t b y an o u ts id e c o n tra c to r a t a cost o f $1 6 0 .
PROBLEM 2 .2 3 A ccountants, ethics and the balance sheet A s has been in d ic a te d seve ral tim es so fa r (in s ection 2 .7 , fo r e x a m p le ), m a n a g e rs o f businesses a n d o th e r o rg a n is a tio n s a re v e ry c o n c e rn e d a b o u t h o w th e b a la n c e sheet reflects th e ir m a n a g e m e n t o f th e e n te rp ris e . This is v e ry u n d e rs ta n d a b le , a n d g e n e ra lly a p p ro p ria te to o , b e ca u s e such c o n c e rn is lik e ly to m a ke m a n a g e rs w a n t to d o a g o o d jo b o f m a n a g in g . But it c a n a ls o le a d to a te m p ta tio n to a lte r th e in fo rm a tio n in a m a n a g e r's fa v o u r. The p o s s ib ility o f such a te m p ta tio n is p a rt o f th e rea so n a u d ito rs a re e m p lo y e d to e x a m in e fin a n c ia l statem ents, in c lu d in g th e b a la n c e sheet. This te m p ta tio n c a n a ls o p ro d u c e e th ic a l p ro b le m s fo r p ro fe s s io n a l a c co u n ta n ts e m p lo y e d b y th e e n te rp ris e . O n th e o n e h a n d , such an a c c o u n ta n t is b o u n d b y th e e th ic a l rules o f th e p ro fe s sio n to see th a t p ro p e r a c c o u n tin g m e tho ds a re fo llo w e d in p re p a rin g th e c o m p a n y 's b a la n c e sheet, w h ic h w o u ld im p ly th a t th e in fo rm a tio n sh o u ld no t be a lte re d in m a n a g e m e n t's fa v o u r. O n th e o th e r h a n d , such an a c c o u n ta n t w o rk s fo r s e n io r m a n a g e m e n t a n d is lik e ly to b e b o u n d b y th e c o n tra c t o f e m p lo y m e n t to p u t th e e n te rp ris e 's interests first. W h a t do es such an a c c o u n ta n t (such as th e c h ie f a c c o u n ta n t re s p o n s ib le fo r p re p a rin g th e e n te rp ris e 's fin a n c ia l statem ents) d o if s e n io r m a n a g e m e n t (such as th e g e n e ra l m a n a g e r) w a n ts to a lte r th e b a la n c e sheet to m a ke th in g s lo o k be tte r a n d m akes a g o o d c a se th a t such an a c tio n w ill h e lp th e e n te rp ris e g e t b a n k lo a n s a n d th e o th e r a ssista n ce it needs? Discuss th is s itu a tio n fro m th e v ie w p o in t o f bo th th e g e n e ra l m a n a g e r a n d th e c h ie f a c c o u n ta n t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASES CASE 2A
W oolworths Limited
Refer to th e e x tra c ts o f th e 2 0 1 4 a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to th e c o n s o lid a te d acco un ts. 1 A t w h a t p o in t in tim e is th e b a la n c e sheet d ra w n up? 2
W h a t is th e c u rre n c y in w h ic h a c co u n ts in th e b a la n c e sheet a re m e asure d?
3
Illustrate h o w th e 2 0 1 4 b a la n c e sheet o f W o o lw o rth s Lim ited b a la n ce s.
4
H o w w e re th e assets fin a n c e d ?
5
H o w is th e 'n e t assets' fig u re d e te rm in e d ?
6
W h a t a re th e b a la n c e s o f c u rre n t assets, c u rre n t lia b ilitie s , n o n c u rre n t assets a n d n o n c u rre n t lia b ilitie s a t 2 9 June 2014?
7
W h a t is th e b a la n c e o f w o rk in g c a p ita l a t 2 9 June 2 0 1 4 ?
8 W h a t d iv id e n d s w e re p a id d u rin g th e y e a r? 9
W h a t is th e a m o u n t o f s h a re c a p ita l issued?
1 0 W h a t c o m p a n ie s w o u ld be in c lu d e d in th e c o n s o lid a te d fig u re s? 11 W h a t is c o st o f g o o d s s o ld fo r W o o lw o rth s in 2 0 1 4 ? 12 For W o o lw o rth s in 2 0 1 4 , a re th e net p ro fits fro m o rd in a ry a c tiv itie s a fte r ta x a n d th e c h a n g e in th e cash b a la n c e th e sam e am ounts? 13 W h a t is th e a m o u n t o f net p ro fit fo r 2 0 1 4 ? 14 W h a t a m o u n t o f reven ue w a s e a rn e d in 2 0 1 4 ? 15 H o w m uch in v e n to ry (in d o lla rs) do e s th e c o m p a n y h a ve as a t 2 9 June 2 0 1 4 ? 16 By w h a t a m o u n t d id cash a n d cash e q u iv a le n ts c h a n g e d u rin g th e m ost recen t y e a r?
CASE 2B___________________________ Interpreting balance sheets 1
'Q a n ta s A irw a y s . . . la u n c h in g a $ 5 0 0 m illio n c a p ita l ra is in g to stre n g th e n its b a la n c e sheet a n d c o n tin u e fu n d in g a fle e t u p g ra d e b e fo re c o n d itio n s w o rs e n . . . " A s trong b a la n c e sheet fo r us w ill be c ritic a l g o in g fo r w a r d ," s a id M r J o yce . . . A irlin e s g lo b a lly a re stee lin g fo r $ U S 5 b illio n ($ 7 .8 b illio n ) in losses this y e a r a lo n e as th e y g ra p p le w ith p lu n g in g d e m a n d . . . ' (A u s tr a lia n F in a n c ia l R e v ie w , 5 F e b ru a ry 2 0 0 9 ) .
2
'A N Z last n ig h t ru le d o u t a c a p ita l-ra is in g in th e s h o rt te rm , d e c la rin g its b a la n c e shee t w a s a m o n g th e s trong est o f th e m a jo r A u s tra lia n b a n k s. S p e c u la tio n h a d m o u n te d th a t A N Z w o u ld ta p s h a re h o ld e rs fo r e x tra fu nds to b o o s t c a p ita l ra tio s . . . ' (A u s tr a lia n F in a n c ia l R e v ie w , 1 3 F e b ru a ry 2 0 0 9 ) .
3
'A M P has jo in e d th e e v e r-g ro w in g list o f c o m p a n ie s to cu t d iv id e n d s d u rin g th e e a rn in g s season . . . to s treng th en its b a la n c e sheet as its cash flo w c o n tin u e s to be b a tte re d . . . The c ritic a l p rio rity is to m a in ta in b a la n c e sheet streng th to c o n tin u e w ith s ta n d in g th e o n g o in g v o la tility . . . ' ( W e e k e n d A u s tr a lia n F in a n c ia l R e v ie w , 1 4 - 1 5 F e b ru a ry 2 0 0 9 ) .
4
'M s W e s tw a te r s a id th e a d v a n ta g e o f Q u e e n s la n d 's stro n g b a la n c e sheet w a s th a t it e n a b le d th e state to w ith s ta n d a n y u n e x p e cte d sh o c ks ' (A u s tr a lia n F in a n c ia l R e v ie w , 11 J a n u a ry 2 0 0 7 ) .
Required: Discuss th e im p lic a tio n s o f e a ch o f th e qu ote s fro m th e p o in t o f v ie w o f th e com m en ts m a d e o n th e ir b a la n c e sheets.
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
79
CASE 2C______________The importance of balance sheets in making decisions R ead th e fo llo w in g e x tra c t.
T e lstra talks dow n T3 buyback b y C o lin K r u g e r T e ls tra . . . has p o u re d c o ld w a te r o n t h e p r o s p e c t o f a s ig n ific a n t s h a re b u y b a c k . . . ‘W e ’v e g o t a s tro n g b a la n c e s h e e t b u t w e d o n ’t w a n t t o w e a k e n t h a t b a la n c e s h e e t . . .’ B r o k e r r e p o r ts h a ve e s tim a te d T e ls tra c o u ld b u y b a c k $ 1 0 b illio n in [s h a re s ] . . .
w ith o u t h a v in g a
s ig n ific a n t e f f e c t o n th e c o m p a n y ’s d e b t ra tin g . . .’ Source: C. Kruger, Telstra Talks Down T3 Buyback’, Sydney Morning Herald, 2 2 M arch 2 0 0 5 .
Required: 1 W h a t is m e a n t b y a s h a re b u y b a c k ? 2
W h a t is m e a n t b y a d e b t ra tin g ? W h y is it im p o rta n t?
3
W h a t ro le do e s th e b a la n c e sheet p la y in th e d e c is io n s fo r Telstra d iscusse d in this a rtic le ?
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m
p r e p a r a tio n to o ls . >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
>
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
80
APPENDIX TO CHAPTER 2
Background: sole traders, partnerships, companies and Financing To help you further understand the b a la n ce sheet, read the fo llo w in g background m aterial. This section focuses on the right-hand side o f the accounting equation, exam ining h o w the form o f business organisation determines the w a y ow ners' equity is shown on the b a la n ce sheet a nd outlining h o w both right-hand terms in d ica te h o w the assets are financed. This book's glossary w ill also help you to understand the term inology. There are m any im portant forms o f o rganisation, such as businesses organised as partnerships, com panies or cooperatives, an d non-business organisations such as clubs, charities, governments an d p o litica l parties. H ow ever, they cannot all be described here. Instead, w e w ill focus on four main kinds of business organisations a n d their main methods of financing.
A2.1
Four kinds of business organisation
You have seen that each b a la n ce sheet has an ow ners' equity section. The exam ples o f Sound an d Light Ltd and C h e z Ltd indicated that the equity could be considered to be o f tw o general kinds for a business enterprise: •
directly contributed equity, in w h ich ow ners have p rovided m oney o r other assets to the enterprise
•
indirectly contributed equity (retained profits), in w h ich ow ners have a llo w e d profits earned b y the enterprise to remain there, to help earn m ore profits in the future. The legal m eaning o f being an o w n e r depends on w h a t kind o f organisation exists. The equity section o f the
b alance sheet reflects that legal m eaning, so that ow ners an d other users w ill understand the status o f their equity. Four main kinds o f business organisations are the sole trader, the partnership, the c o m p a n y an d the co rp o ra te group.
Sole trader A sole trader (sole proprietorship) is a business o w n e d by o ne person (the proprietor). It does not le g a lly exist separately from the ow n e r. Because the business does not exist as a separate legal entity, it is said to be unincorporated. If S im one, a jew eller, just starts up a business o ne d a y on her o w n w ith o u t further legal steps, the business is a sole trader. Legally, such a business is not distinguishable from Sim one's non-business affairs. If she w ishes, she can use the business cash to buy groceries (although separate records of business transactions must be kept for tax purposes), a nd if she does not p a y her business bills, her creditors can claim aga in st a n y non-business assets she has. Because a sole trader has no separate legal existence, the equity section o f the b a la n ce sheet does not necessarily distinguish betw een the o w n e r's direct contributions to the business a nd the indirect contributions by retained profits. Both kinds o f equity are sim ply lum ped together as ow ners' c a p ita l. The ow ners' equity section o f the b alance sheet just says: I O w ners'equity Owners' capital
I $xxxx
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
81
Partnership A partnership is also unincorporated, but it has m ore than one ow n e r. Partnerships are not separate legal entities, and all partners a re personally responsible for the debts o f the partnership. A g a in , the ow ners' personal assets can be claim e d b y business creditors, so there is the same, som ew hat arbitrary, distinction betw een business affairs and personal affairs. The fact that there is m ore than one o w n e r introduces some form ality into the business. For exam ple, there is (or should be) an agreem ent a b o u t h o w the profits o f the business are to be split am ong the partners an d a b o u t h ow much each partner can w ith d ra w from the business. Because stress can d e ve lo p in partnerships, states an d countries have partnership law s that pro vid e some structure if the partners d o not d o so themselves. A partnership's ow ners' equity section of the b a la n ce sheet, like that for a sole trader, does not necessarily distinguish betw een ow ners' direct contributions a nd retained profits. The o n ly difference is that each o w n e r's total c a p ita l is identified on the fa ce o f the b a lan ce sheet (or, if there are m any partners, as in firms o f law yers, accountants o r engineers, in a separate schedule). Therefore, the ow ners' equity section o f the partnership's b a la n ce sheet shows: I O w ners'equity
$
Partners' capital: Partner A
xxxx
Partner B
xxxx
Partner C
xxxx
Total capital
xxxx
W h e n an individual w ishes to leave the partnership, it is necessary to o btain the permission o f existing partners to transfer o w nership to a n ew partner. As w ith sole traders, partnerships a re not legal entities, but for accounting purposes they are considered as a separate entity from the partners.
Company C om p a n ie s a re legal entities established under C o rporations Law. The co m p a n y's c a p ita l is d iv id e d into shares, and the ow ners are called shareholders. C o m p a n ie s are separate legal entities; therefore, they can buy, o w n a nd sell assets, enter into contracts in their o w n right, an d sue an d be sued. The m ajor a d va n ta g e o f a c o m p a n y structure is that a c o m p a n y has lim ited lia b ility in the event o f its failure. This means that shareholders are not lia b le for debts incurred by a c o m p a n y once their shares have been p a id for in full; that is, their lia b ility is lim ited to the u n paid am ount on a n y shares bought. A ll com panies that have lim ited lia b ility have the w o rd 'Lim ited' o r 'Ltd' after their name. O th e r advantages o f a c o m p a n y structure include the ease o f transfer of o w n e rsh ip an d increased b o rro w in g pow e r. The shares o f public com panies can g e n e ra lly be sold freely, a n d transfer o f o w nership does not affect the continuity o f operations. Stock exchanges pro vid e a convenient means for the disposal an d acquisition o f shares and for m aking known the prices that sellers a re w illin g to a cce p t an d that buyers are prepared to offer. In the case o f the death o f a shareholder in a co m p a n y, ow n e rsh ip o f the share norm ally passes to the beneficiary o f the deceased shareholder, w ith o u t interruption to the activities of the com pany. A c o m p a n y has a v a ila b le to it a num ber o f sources o f funds that a re d e nied to a sole proprietorship o r a partnership. Debentures or unsecured notes m ay be issued b y a co m p a n y. A debenture is a docum ent that evidences an undertaking by a c o m p a n y to repay a particular am ount a t o r before an a g re e d d ate, a n d to p a y interest a t an a gree d rate at specified intervals. The d e b t m ay be secured by a specific c h a rg e over certain assets, o r by a 'flo a ting
82
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
c harge' over all the assets o f the com p a n y. H ig h ly regarded com panies m ay be a b le to o btain funds w ith o u t p le d g in g assets; that is, b y the issue o f unsecured notes o r the a cce p ta n ce o f deposits. Because o f these advantages, particularly lim ited lia b ility, most business enterprises are com panies. Even your local new sagent, chemist o r corner shop is likely to have a d o p te d a c o m p a n y structure. C om panies can be either public o r private com panies. The main difference is that public com panies can invite the public to subscribe to their share ca p ita l using a docum ent c a lle d a prospectus. A private c o m p a n y (denoted b y 'Pty' in the name) cannot invite the public to subscribe for shares. They also have limits on the num ber of shareholders (maximum 5 0 ) a nd other restrictions on the transferability of the shares. Private com panies have certain exem ptions regarding requirements to pro vid e full fin a n cia l statements an d the a ppointm ent o f auditors. Listed public com panies are those public com panies that have chosen to be listed on the Australian Stock Exchange. This listing assists trading in the com pany's shares a nd helps in the raising o f funds. H ow ever, it does involve a d d itio n a l disclosure to the stock exchange. C om panies can be very com plex; just tw o com plexities w ill be m entioned here.
Forms o f share capital People becom e ow ners o f a c o m p a n y b y buying shares that g ive them voting pow ers o r other rights. W h e n a share is first issued by a com p a n y, the m oney received for it is put in the com pany's b a n k account a n d the source of that asset is called share ca p ita l, w h ich is an ow ners' equity item. If the person w h o p a id the c o m p a n y for that share later sells it to som eone else, the m oney for that sale goes to the person w h o o w n e d the share, not to the co m p a n y. Therefore, the com pany's share c a p ita l shows o n ly the am ount received b y it the first tim e the share is sold. M o s t o f the m illions of share sales and purchases that take p la ce on the w o rld 's stock exchanges every d a y have no effect on com panies' b alance sheet accounts for share c a p ita l, because they are trades a m ong ow ners, not issues b y the com panies. There are several classes o f shares, including: •
o rd in a ry shares: ow ners o f these vote; they a re the com pany's basic (residual) ow ners, the ones w h o d e c id e w h o w ill be on the b o a rd o f directors that m anages the c o m p a n y for the ow ners an d declares d ividends to ow ners
•
preference shares o r otherw ise s p e cia l shares: ow ners usually d o not vote, but in return they have rights, such as receiving a fixed d ivid e n d each ye a r a n d , in some cases, a preference in asset distributions if the c o m p a n y liquidates
•
Class A , C lass B a n d other such categorisations: w hether these are m ore like o rd in a ry shares or preference shares depends on the specific rights they carry. M a n y com panies use these va g u e terms because the com plexity of rights often prevents a sim ple categorisation such as o rd in a ry o r preference. The face of the balance sheet or the notes to the accounts w ill list all the kinds o f shares the com pany is authorised to issue,
specify any special rights and show the amount of share capital issued so far for each kind of share. The cash received for such share capital is the property of the com pany: the owners (i.e. shareholders, or stockholders as they are often also called, especially in the United States) have no right to get the money b a c k - except in specific circumstances.
Retained profits Profits o f a c o m p a n y can be p a id to the ow ners in the form of a d ivid e n d o r retained w ithin the com p a n y. The b alance sheet shows the am ount of a n y retained profits (past profits minus past dividends) as a separate ow ners' equity item. Thus, in a d d itio n to its lists o f assets an d liabilities, a com pany's b a la n ce sheet has an ow ners' equity section show ing various legal details to assist current a n d future ow ners:
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
I Shareholders'equity
83
$
Share capital: Class A shares (for example)
xxxx
Class B shares (for example)
xxxx
Total issued capital
xxxx
Retained profits
xxxx
Total shareholders' equity
xxxx
Items other than issued c a p ita l an d retained profits m ay a p p e a r in a com pany's ow ners' equity. Such items reflect legal a nd accounting com plexities that a re not im portant at this point. These items (including reserves) w ill be discussed in C h a p te r 1 2.
Corporate group M a n y com panies you are fa m ilia r w ith , such as BHP Billiton, CSR, the C o m m onw ealth Bank an d W o o lw o rth s , are not single com panies but are rather groups o f many, often hundreds, o f com panies. The b a la n ce sheet o f such a corpo ra te g ro u p attempts to represent w h a t that g ro u p looks like as a 'c o n so lid a te d ' e conom ic entity, although there is no such entity legally. D oing this requires co m p le x accounting techniques that a re mostly beyond the scope o f this book. The b a la n ce sheet o f a co rp o ra te g ro u p looks like that o f a single co m p a n y, w ith the shareholders' equity section representing the equity of the prim ary, o r parent, c o m p a n y in the g roup. In C h a p te r 1 0 , a brief exam ination w ill be m ade of the assumptions behind fin a n cia l statements for co rp o ra te groups. For no w , rem em ber that such consolidated fin a n cia l statements are a g g re g ate s o f m any le g a lly separate com panies. A summary o f the different kinds o f business organisations is given in Exhibit A 2 . 1.
EXHIBIT A2.1
KINDS OF BUSINESS ORGANISATIONS
Kind
Legality
Owner(s)
Equity accounts
Sole trader
Not separate from owner
One proprietor
Capital and retained profits are combined
Partnership
Not separate from owners
Several or many partners
Capital and retained profits are combined but each partner's total is calculated separately
Company
Separate from owners
Usually several or many shareholders
Legal share capital is disclosed separately from retained profits
Corporate group
Consists of legally separate companies
Usually several or many shareholders
Legal share capital of parent company is disclosed separately from retained profits
A2.2
Business financing
The b a la n ce sheet's right side lists the sources o f the assets listed on its left side. As this b o o k proceeds, m any details a bou t both sides o f the b a la n ce sheet w ill be e xp la in e d . For n o w , here is a list o f the main sources:
C urrent lia b ilitie s (due w ith in a year) •
Loans from banks d ue on de m a n d o r otherw ise, at least potentially p a y a b le sooner rather than later.
•
Financing p rovided by suppliers a nd other trade creditors b y a llo w in g the enterprise to o btain credit for its purchases a nd p a y for them later
84
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W a g e s earned by, but not yet p a id to, em ployees a nd taxes w ith h e ld from them that are to be turned over to the taxation authorities
•
O th e r am ounts that w ill be p a id in the next ye a r related to such em ployee benefits as h o lid a y p a y a nd long service leave
•
Estimates of am ounts o w in g for things such as po w e r, interest charges, legal costs a nd other debts bu ild in g up, but not yet actu a lly billed to the enterprise
•
Incom e and other taxes o w e d b y the enterprise
•
D ividends o w e d b y the enterprise (if it is a com pany), d e cla re d by the board o f director, but not yet p a id to the shareholders
•
Short-term portions o f longer-term debts, such as the prin cipa l payments due over the next ye a r on long-term m ortgages.
N oncurrent lia b ilitie s (debts due m ore than a year in the future) •
M o rtg a g e s a n d other debts extending over several years
•
C ertain long-term liabilities, such as special loans from ow ners in a d d itio n to their share c a p ita l, long-term tax estimates and estim ated liabilities for amounts to be p a id to em ployees in the future.
O wners' equity •
For a sole trader: ow ner's c a p ita l (contributed c a p ita l a nd profit not w ith d ra w n b y the ow ner)
•
For a partnership: ow ners' c a p ita l (contributed c a p ita l a nd profits not w ith d ra w n b y the owners)
•
For a co m p a n y: share ca p ita l received for each kind of share plus retained profits (plus some other items if legal or accounting com plexities require them).
The double-entry system ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO carry out transaction analysis a n d determ ine the im pact of transactions on elements of bala n c e sheets an d incom e statements describe how debits a n d credits w o rk in the double-entry accounting system record transactions using debits an d credits p re p a re journal entries determ ine the bala n c e of an account after a series o f transactions describe the norm al b a la n c e for the follow ing types of accounts: assets, liabilities, equity, revenues a n d expenses explain w h y financial accounting has becom e m ore sophisticated over the centuries
C H A PTER O VE R VIEW In C h a p te r 2 w e d isc u s se d th e im p o rta n c e o f th e b a la n c e sheet a n d in c o m e sta te m e n t to m a n a g e rs . It is th e re fo re c ritic a l th a t e v e ry m a n a g e r u n d e rs ta n d s th e im p a c t o f tra n s a c tio n s o n these fin a n c ia l re p o rts . This c h a p te r p ro v id e s th ose skills b y e x te n d in g tra n s a c tio n a l a n a ly s is , w h ic h c o n s id e rs th e im p a c t o f s p e c ific tra n s a c tio n s o n th e a c c o u n t in g e q u a tio n . A g o o d u n d e rs ta n d in g o f tra n s a c tio n a l a n a ly s is w ill m a k e th e rest o f th is b o o k e a s ie r to fo llo w . A s w e ll a s b e in g c ritic a l fo r m a n a g e rs a n d o th e r users o f a c c o u n tin g re p o rts , tra n s a c tio n a l a n a ly s is is im p o rta n t to p re p a re rs o f fin a n c ia l in fo rm a tio n , a s it fo rm s th e b a sis o f th e d o u b le -e n try system . The d o u b le -e n try system in v o lv in g d e b its a n d c re d its - w h ic h fo rm s th e b a sis o f m o d e rn a c c o u n tin g - is then d e s c rib e d . W e use th is system to p re p a re jo u rn a l e n trie s a n d (via th e use o f spre a d s h e e ts ) to p re p a re fin a n c ia l statem ents. P re p a rin g fin a n c ia l state m e nts b y th e fu ll a c c o u n tin g p ro ce ss is le ft to C h a p te r 4 . W ith th e e x te n d e d k n o w le d g e o f tra n s a c tio n a n a ly s is , w e w ill illu s tra te th e d iffe re n c e s b e tw e e n a c c ru a l a n d ca sh a c c o u n tin g .
86
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FOR YO UR
IN T E R E S T
B e lo w is an o b s e rv a tio n fr o m an e x p e rie n c e d p r a c titio n e r c o n c e rn in g d o u b le e n try : I p e rs o n a lly b e lie ve th a t i f y o u c a n ’t u n d e rs ta n d th e d e b its an d c re d its o f a c lie n t’s bu sin e ss, y o u c a n ’t
p o ss ib ly
u n d e rs ta n d
w h e re
issues
in
th e ir
bu siness
or
p ro ce ss e s
c an
o c c u r.
It is
fu n d a m e n ta l to b e in g a g o o d a c c o u n ta n t, a u d ito r o r bu siness a d viso r. Source: Fiona Campbell, Partner, A u d it Services, Ernst & Young
3.1 Transaction analysis The purpose o f this section is to extend your k n o w le d g e o f h o w various transactions affect the accounting e quation. In this section w e concentrate on transactions that affect the b a la n ce sheet. In section 3 .2 , the accounting equation is e x p anded to sho w the effect on the incom e statement. Transaction analysis is a useful w a y o f understanding h o w any transaction o r event affects a co m p a n y's fin a n cia l statements. Recall that the basic accounting equation is: Assets = Liabilities + S h areh o ld ers' equity A fter each transaction, the total assets must a lw a ys equal the total liabilities a nd shareholders' equity. This equality remains regardless o f the type o f transaction. To illustrate, consider the fo llo w in g transactions for LRM Ltd for M a rc h 2 0 1 6 . 1
Shareholders invested $ 2 0 0 0 0 0 cash in the business. The effect o f this transaction is to increase cash (an asset) and increase share c a p ita l (a shareholders' equity account).
2
Land a n d bu ild in g s w e re p u rch a se d for $ 3 0 0 0 0 0 , w h ich is fin a n ce d b y a loan from the seller re p a ya b le in five years. For this transaction, land a nd buildings (an asset) is increased. This is financed through a loan, so loan (a lia b ility account) is also increased. N o te that this transaction does not affect shareholders' equity. The shareholders d o not have a n y m ore o r less equity in the com pany, as assets an d liabilities increased by the same am ount. N o te that after these first tw o transactions the accounting equation is still in ba la n ce , as w ill be the case after every transaction.
3
Inventory w orth $ 5 0 0 0 0 w as b o u g h t on credit. Inventory is purchased for $ 5 0 0 0 0 , w ith an agreem ent to pay the suppliers at a later d a te (usually 3 0 days after the da te o f sale). A g a in , both an asset an d a lia b ility are increased. In this case they a re inventory (asset) a nd accounts p a y a b le (liability).
4
E quipm ent w orth $ 9 0 0 0 0 w as p u rch a se d b y p a y in g $ 2 0 0 0 0 cash a n d signing an agreem ent to p a y the rem ainder in 9 0 days. This involves the purchase o f equipm ent (increase in an asset), w h ich is financed by both p aying out cash (an asset) a nd incurring a lia b ility, w h ich in this case is notes p a ya b le . N otes p a y a b le differs from accounts p a y a b le because the lia b ility is evidenced by a prom issory note o r bill o f exchange. N otes p a y a b le increased by $ 7 0 0 0 0 .
5
D a m a g e d inventory that w as p u rch a se d on cre dit a t a cost o f $ 5 0 0 0 w as returned to the supplier. This reverses part of transaction 3. The d a m a g e d inventory is returned to the supplier, thus decreasing inventory (an asset). As less m oney is n o w o w e d to the suppliers, accounts p a y a b le (a liability) is also reduced.
6
P aid $ 3 0 0 0 0 on accounts p a y a b le . This results in the lia b ility (accounts payable) being reduced b y a paym ent that reduces an asset (cash).
7
Purchased $ 1 0 0 0 0 inventory using cash. All o f the a b o ve six transactions have affected both sides o f the equation. H ow ever, this transaction affects o nly the asset side. It results in one asset (inventory) increasing a nd another asset (cash) decreasing. A g a in , after all transactions have been recorded, the accounting equation balances.
CHAPTER 3 The d o u b le -e n try system
87
A summary o f the effect o f each o f these transactions is shown in Exhibit 3 .1 . Based on the totals o f the accounting equation in Exhibit 3 .1 , a b a la n ce sheet is produced in Exhibit 3 .2 . As this is a n e w organisation and none o f the transactions affected revenues o r expenses, there is a z e ro b a la n ce for retained profits. N o te that at this stage neither interest on the loan nor d e p re cia tio n on the buildings a n d o ffice equipm ent has been included.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
88
H O W 'S Y O U R
U N D E R S T A N D IN G ?
H e re a re th r e e q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
I f a c o m p a n y re c e iv e s $ 1 0 0 0 0
2
Y o u p u rc h a s e $ 5 0 0 0 o f in v e n to ry on c re d it. W h a t e f f e c t w ill it ha ve o n th e a c c o u n tin g e q u a tio n ?
cash fr o m
its a c c o u n ts re c e iv a b le , w h a t e f fe c t w ill it ha ve o n th e
a c c o u n tin g e q u a tio n ?
3
D id e ith e r o f th e a b o v e tra n s a c tio n s a f fe c t p r o fit f o r th e p e rio d ? Y o u r a n sw e rs s h o u ld be:
1
C a s h a t b a n k (a n a s se t) in c re a s e s and a c c o u n ts re c e iv a b le (a n a s se t) d e cre a s e s .
2
In v e n to ry (a n a s se t) in c re a s e s and a c c o u n ts p a ya b le (a lia b ility ) in cre a s e s.
3
N o , b e c a u s e n e ith e r tra n s a c tio n a ffe c te d re v e n u e s o r ex p e n s e s .
3.2
Transaction analysis extended
W e w ill n o w e xp a n d the LRM transaction analysis exam ple in section 3.1 to include some revenue a nd expense transactions. To d o this w e w ill e xp a n d the accounting equation as follow s: A ssets = L ia b ilitie s + S h a re h o ld e rs ' e q u ity A ssets = L ia b ilitie s + Issues c a p ita l + O p e n in g re ta in e d p ro fits + N e t p r o fit - D iv id e n d s A ssets = L ia b ilitie s + Issues c a p ita l + O p e n in g re ta in e d p ro fits + R e ve n u e - E xpenses - D iv id e n d s Recall from section 3.1 that, after the initial transactions w e re recorded, the closing balances w e re as follow s as at 31 M a rc h 2 0 1 6 for LRM Ltd: $ Cash Inventory Land and buildings Equipment
140 00 0 5 5 000
300000 90000
Accounts payable
15 000
Notes payable
70000
Loans
300000
Share capital
200000
C onsider the fo llo w in g a d d itio n a l transactions for the month o f A pril 2 0 1 6 : 8
C ash sales o f $ 3 0 0 0 0 w ere m ade. The cost o f the g o o d s that w e re so ld a m ounted to $ 1 2 0 0 0 . This transaction has tw o effects: o ne to recognise revenue a nd increase assets; the other to recognise an expense and decrease assets. A cash sale o f $ 3 0 0 0 0 w a s m ade. This increases a revenue account (sales revenue) and increases an asset (cash). W e are also told that cost o f g o o d s sold, often a b b re via te d as C O G S , am ounted to $1 2 0 0 0 . C ost of g o o d s sold is w h a t the c o m p a n y pays to a cq u ire the g o o d s that customers buy. It is not the same as sales revenue, but is rather an expense the c o m p a n y incurs to ge t sales revenue. In this case the expense (C O G S ) increases by $ 1 2 0 0 0 an d inventory (an asset) decreases by $ 1 2 0 0 0 ; that is, the goods w hen purchased w e re a d d e d to inventory, a n d n o w that they are sold, inventory is decreased.
CHAPTER 3 The d o u b le -e n try system
9
89
C re d it sales o f $ 4 0 0 0 0 w e re m ade. The C O G S w a s $ 1 6 0 0 0 . This transaction has the sam e effect on the accounting equation as transaction 8, except that accounts receivable (an asset) is increased instead o f cash (another asset). Because it w a s a credit sale, paym ent w ill be received in the future rather than now . Sales revenue a nd accounts receivable increase by $ 4 0 0 0 0 , inventory decreases by $ 1 6 0 0 0 an d cost o f g o ods sold increases by $ 1 6 0 0 0 .
10
Payments o f $ 8 0 0 0 w e re m ade to suppliers. In this transaction, a paym ent w a s m ade an d therefore cash (an asset) decreases. In a d d itio n , the paym ent to creditors reduces accounts p a ya b le , a lia b ility account.
11
P aid w a g e s o f $ 2 0 0 0 0 for the first tw o weeks o f A p ril. W a g e s a re an expense for the p e riod. The paym ent of w a g e s in this transaction increases this expense an d reduces the cash a ccount (an asset).
12
R eceived an advertising invoice fo r $ 2 0 0 0 for a ra d io advertisem ent b ro a d ca st on 5 A pril. The b ill w ill b e p a id next month. The c o m p a n y receives an invoice for services that have a lre a d y been pro vid e d to it. The expense should be recognised in the period w hen the service w a s received. Therefore, an expense account (advertising) w ill be increased by $ 2 0 0 0 a nd a lia b ility account (accounts payable) w ill increase by $ 2 0 0 0 , as the am ount has not yet been p a id .
13
R eceived $ 2 5 0 0 0 from accounts receivable. This results in o ne asset (cash) increasing an d another asset (accounts receivable) d ecreasing. N o revenue is recognised as that occurred e arlier w hen the sale w a s m ade (see transaction 9).
14
A t the e n d o f the month $ 18 0 0 0 is o w in g in w a g e s for the last tw o w eeks o f the month. It is due to be p a id on 1 M a y . The em ployees have carried out the w o rk but have not yet been p a id because the next p a y d a y falls on the first d a y of the fo llo w in g month. As they have d o n e the w o rk , an expense account (wages) increases by $ 1 8 0 0 0 . A lso, as the am ount is o w e d to them, a lia b ility acco u n t (w ages payable) increases b y $ 1 8 0 0 0 . A summary o f the effect o f these transactions is p rovided in Exhibit 3 .3 . Based on the totals o f the columns in
Exhibit 3 .3 , an incom e statement an d a b a la n ce sheet w e re p repared, as show n in Exhibits 3 .4 a nd 3 .5 . The incom e statement is based on the revenue an d expense columns in Exhibit 3 .3 . The retained profits figure (same as profit for the p eriod as there is no o p e n in g b a la n ce o f retained profits a nd no d ividends declared), together w ith the share c a p ita l account a nd the other assets a nd liabilities accounts, pro vid e the inform ation for the b a la n ce sheet.
R einforcing the relationship betw een three principal financial statem ents W o rk through this next exam ple slo w ly to make sure you understand basic transaction analysis an d h o w it im pacts the three fin a n cia l statements: incom e statement, b a la n ce sheet a nd statement o f cash flow s. Assume all o p e n in g balances are zero. 1
Issue shares for cash, $ 8 0 0 0 0 .
2
B orrow cash from the bank, $ 2 0 0 0 0 .
3
Purchase inventory on credit, $ 3 5 0 0 0 .
4
Sell inventory (costing $ 3 0 0 0 0 ) for $ 7 0 0 0 0 on credit.
5
Pay accounts p a ya b le , $ 2 0 0 0 0 .
6
Receive $ 4 0 0 0 0 from accounts receivable.
7
Pay rent, $ 5 0 0 0 .
8
Pay w a g e s of $ 2 0 0 0 0 a nd o w e $ 4 0 0 0 in w a g e s a t the end o f the month.
9
Purchase equipm ent for cash, $ 5 0 0 0 0 .
10 Pay d ividends o f $ 3 0 0 0 . First, let's consider the full transaction analysis in Exhibit 3 .6 . Then in Exhibit 3 .7 the headings have been condensed into C ash, O th e r Assets, Liabilities a n d S hareholders' Equity to sh o w h o w all this inform ation is used to construct the b a la n ce sheet, incom e statement an d the statement o f cash flo w . Take your tim e an d fo llo w through each transaction.
o
LRM LTD TRANSACTION ANALYSIS
B
Assets Transaction Balance 8
Cash
Accounts receivable
Inventory
Land and buildings
Accounts payable
200000
Expenses
30000
-1 2 0 0 0
40000
-1 6 0 0 0
- 8 000
- 8 000
-20000
12
- 2 000
2 000 25 000
- 2 5 000
167000
15 000
14 Total
300000
Revenues
-1 6 0 0 0
-2 0 0 0 0
13
Share capital
55 000
11
70000
Loans
- 1 2 000
10
15 000
W ages payable
30000 40000
90000
Notes payable
140000
9
300000
Equipment
Liabilities + shareholders' equity
27000
300000
90000
$599000
9000
=
$599000
70000
18 000
_______
_______
______
-1 8 0 0 0
1 8 0 00
300000
200000
70000
-6 8 0 0 0
Dividend
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 3.3
CHAPTER 3 The d o u b le -e n try system
91
EXHIBIT 3.5 BALANCE SHEET AS AT 3 0 A P R IL 2 0 1 6
Assets
$
Current assets Cash Accounts receivable Inventory
Liabilities and shareholders' equity Current liabilities
167000
Accounts payable
15 000
Notes payable
27000
Wages payable
Noncurrent assets Land and building
18 000
Noncurrent liabilities 300000 90000 390000
Loans
300000
Total liabilities
397000
Shareholders' equity Share capital Retained profits*
Total assets
9 000 70000
97000
209000
Office equipment
$
599000
200000 2 000
Total shareholders' equity
202000
Total liabilities and SE
599000
* Retained profits = opening retained profits (0) + profit (2000) - dividends declared (0) = 2000
co t>o
TRANSACTION ANALYSIS
Liabilities + shareholders' equity
Assets Transaction
Cash
1
80000
2
20000
Accounts receivable
Accounts payable
70000
5
(20000)
6
40000
7
(5 000)
8
(20000)
9
(50000)
Accrued expenses
Expenses
Dividend
35 000
(30000)
70000 (
(30000)
20000 )
(40000) (5 000) (24000)
4000 50000
(3 000) 42 000
Revenues 80000
35 000
4
10
Equipment
20000
3
Total
Inventory
30000
5 000
50000
127000 :
15 000 127000
4 000
______
______
______
______
(3 000)
20000
80000
70000
(59 000)
(3 000)
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 3.6
EXHIBIT 3.7
LRM LTD RELATIONSHIP OF TRANSACTION ANALYSIS TO THE FINANCIAL STATEMENTS
Source data for cash flow statement
Source data for income statement
l Balance Sheet Current assets
- (20 000] + 40 000 + (5000] + (20 000] b 80 000 + 20 000 + (3000)
Cash Receivables Inventory
$
Accounts payable Accrued expense Bank loan
50 000
Issued capital Retained profits Total
N o n c u r r e n t a s s e ts
Equipment Total
Liabilities
42 000 30 000 5 000
$ 15 4 20 39
000 000 000 000
S h a r e h o ld e r s 'e q u it y
127 000
80 000 8 00 0 • 127 000
CHAPTER 3 The double-entry system
Source data for balance sheet
(X)
OJ
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
94
HOW'S YOUR UNDERSTANDING? W h a t im p a c t w ill each o f th e fo llo w in g have on p r o fit fo r th e perio d ?
1 2 3 4 5
P urchase in v e n to ry on c re d it fo r $ 2 0 0 0 0 . Sell goods on c re d it fo r $ 3 0 0 0 0 (c o s t o f goods sold was $14 0 0 0 ) . Pay a cco u n ts payable o f $ 2 0 0 0 0 . R eceive $ 3 0 0 0 0 fro m a c co u n ts receivable. Pay $ 1 0 0 0 0 fo r wages d u rin g th e p e rio d , and ow e $ 2 0 0 0 fo r o th e r w o rk do n e d u rin g th is p e rio d th a t will n o t be paid to n e x t period. Y o u r answers should be: 0 ; $16 0 0 0 ; 0 ; 0 ; and $12 0 0 0 .
3.3
Recording transactions: double-entry bookkeeping
The accounting equation discussed in section 3 .2 is a useful technique for understanding h o w transactions can affect financial statements. H ow ever, it can be very u n w ie ld y w hen there are m any accounts an d a large num ber of transactions. A system o f accounting involving debits an d credits w a s invented centuries a g o an d is still used today. O n e w a y to understand this double-entry system is to start w ith the b a la n ce sheet. As noted in the previous section, the statement balances (this is w h y it is ca lle d a b a la n ce sheet); that is, the d o lla r value o f all the resources on the left is equal to the d o lla r value o f all the sources on the right. If the b a la n ce sheet is to ba la n ce , every transaction and a d ju s tm e n t must also ba la n ce ; that is, their effects on the tw o sides o f the statement must be e qual. To reinforce the earlier discussion on transaction analysis, consider the fo llo w in g : •
If a resource (asset) is increased, (a) a source (lia b ility o r equity) must be increased by the sam e amount; o r (b) another resource decreased by the sam e am ount; o r (c) there must be some mixture o f source increases a nd other resource decreases that equals the o rig in a l resource's increase. For exam ple, if the asset increased w a s inventory by $ 2 0 0 , (a) there could be an increase in accounts p a y a b le of $ 2 0 0 ; (b) there could be a decrease in cash of $ 2 0 0 ; and (c) there could be an increase in accounts p a y a b le o f $ 1 5 0 an d a decrease in cash o f $ 5 0 .
•
C onversely, if a resource is decreased, (a) a source must be decreased b y the same am ount; o r (b) another resource increased by the sam e amount; o r (c) some mixture o f source increases/decreases an d other resource increases that equals the o rig in a l resource's decrease. For exam ple, if cash is the resource that decreases by $ 5 0 0 , (a) there could be a loan decreasing by $ 5 0 0 ; (b) there could be equipm ent increasing by $ 5 0 0 ; an d (c) there could be equipm ent increasing by $ 4 5 0 0 an d loan increasing b y $ 4 0 0 0 . This is just arithm etic. D ouble entry is a form o f a lg e b ra ic notation, in w h ich an equation (the accounting equation)
must be m aintained. For reasons that a re n o w largely lost in the mists o f time, increases to resources (assets), on the left side, a re called debits, and increases to sources (liabilities a nd equity), on the right side, are c a lle d credits. Perhaps confusingly, decreases on the left side a re also ca lle d credits, an d decreases on the right side a re also ca lle d debits. Financial accounting uses o nly tw o names to cover the four kinds o f effects, w h ich w ill turn out to have some advantages as w e learn m ore a b o u t the w a y accounting w orks. Thus, the b a la n ce sheet looks like this: Left side: Resources (Assets)
Right side: Sources (Liabilities, Equity)
Increases: debits
Increases: credits
Decreases: credits
Decreases: debits
Sum of resources
= Sum of sources
Assets
= Liabilities + Equity
Debits
= Credits
CHAPTER 3 The d o u b le -e n try system
95
M o s t students a re confused b y these terms, debits an d credits. To a v o id this confusion, sim ply think o f a d e b it as a left-hand-side entry an d a credit as a right-hand-side entry. An a n a lo g y m ay assist. W h e n you drive, you stop a t red lights an d g o on green. This is a convention. If it had been set up the op p o site w a y , the system w o u ld still w ork. H ow ever, c h a n g in g the system n o w o r d o in g the op p o site has some disastrous effects. The sam e a p plies w ith debits and credits. They could have been set up the o p p o site w a y around, but they w eren't. C o n sid e r the fo llo w in g summary: Type of account
Normal balance
Increases result in
Decreases result in
Assets
Debit
Debit
Credit
Liabilities
Credit
Credit
Debit
Shareholders' equity
Credit
Credit
Debit
expressed in terms o f the accounting equation as follow s: Assets Debit to increase
Credit to decrease
=
Liabilities Debit to decrease
+
Credit to increase
Shareholders' equity Debit to decrease
Credit to increase
Every transaction, w ith o u t exception, has tw o (or more) effects. O n e requires a d e b it entry an d on e requires a credit entry. The recording of increases to assets on the d e b it side a nd decreases on the credit side is the op p o site to that o f liabilities a nd shareholders' equity. It therefore provides the a d d itio n a l control on a ccuracy, in that the sum of the d e b it balances must equal the sum o f the credit balances. To understand this process, you need to be a w a re o f some terms: •
A ccounting records certain kinds o f events m easured in the country's currency (dollars in Australia). W e w ill call those events transactions, a w o rd used a fe w times a lready.
•
A cco u n tin g 's w a y o f recording transactions is c a lle d the 'entry', an d the method follow s the double-entry record keeping system described b y Pacioli 5 0 0 years a g o . (Entries are summarised in records usually ca lle d journals, so they a re also c a lle d jo u rn a l entries.)
•
The entries are transferred to an d summarised in accounts, w h ich lie behind all the amounts an d descriptions show n on the b a la n ce sheet. Each account has a num erical b a la n ce that is either a d e b it o r a credit. (All the accounts collected together are usually referred to as a ledger.)
•
As you know , it is im portant that all the accounts together p roduce a ba la n ce d b a la n ce sheet. Before preparing the b a la n ce sheet from the accounts, accountants usually make a list o f the account balances from the ledger and make sure that the sum o f all the d e b it balances equals the sum o f all the credit balances. Because you never kn o w for sure if it w ill w o rk, this list is ca lle d the tria l balance!
•
Finally, the fin a n cia l statements a re prepared. In this chapter, w e concentrate on mastering journal entries a nd pro vid e a sim ple spreadsheet method of
m aintaining a ccount balances. The use o f such tools as ledgers a nd trial balances is left to C h a p te r 4 , w hen w e describe the full accounting process.
Two sim ple exam ples o f double en try P U R C H A S IN G , O N CREDIT, G O O D S FO R RESALE •
The resource (an asset) is an a d d itio n to the enterprise's in ve n to r/ (unsold products).
•
The source (a liability) is that an o b lig a tio n is created to p a y the supplier.
96
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
If the g o o d s cost, say, $ 4 5 2 , w e have: •
a d e b it o f $ 4 5 2 : an a d d itio n to the account for the resource, in this case the inventory o f unsold products
•
a credit o f $ 4 5 2 : an a d d itio n to the account for the source, in this case the o b lig a tio n to the supplier, usually called accounts pa ya b le . The b a lance sheet stays in b a la n ce because of this d o u b le entry, because both resources an d sources are
increased (are 'up') b y $ 4 5 2 : Resources
Sources
Up (debit) $452
Up (credit) $452
Assets up $452
Liabilities up $452 (no change in equity)
B O R R O W IN G M O N E Y F R O M THE B A N K O N A L O N G -T E R M L O A N •
The resource (asset) is an a d d itio n to the am ount o f cash on hand.
•
The source (a lia b ility a g a in ) is that an o b lig a tio n is created to repay the bank.
If the b o rrow ed cash is, say, $ 1 0 0 0 , w e have: •
an ad d itio n to the asset 'cash', so total resources g o up $ 1 0 0 0
•
an ad d itio n to the lia b ility 'long-term bank lo a n ', so the total sources also g o up $ 1 0 0 0 . A g a in , the b a la n ce sheet stays in balance: Resources
Sources
Up (debit) $1000
Up (credit) $1000
Assets up $ 1000
Liabilities up $ 1000 (no change in equity)
These transactions w o u ld be recorded as follow s: DR CR DR CR
Inventory
452
Accounts payable Cash
452 1 000
Bank loan
1 000
N o te that debits a re a b b re via te d to DR an d credits to CR, as is customary.
SUMMARY These are sim ple exam ples, but they illustrate several features o f the bookkeeping system. (For hundreds o f years, accounting records w e re kept in bound books. In spite o f the advent o f computers, 'b o o ks' are still used by m any enterprises, as w e w ill see.) Som e features illustrated by the exam ples include the fo llo w in g : •
Each double-entry record names on e (or more) accounts that are de b ite d, an d on e (or more) that are credited. Accounts contain all the transaction records an d a n y adjustments, an d therefore reflect everything recorded in the system. The cash account, for exam ple, lists all transactions a n d adjustments that have affected cash. Accounts are used directly in p reparing the b a la n ce sheet a n d the incom e statement.
•
The double-entry records shown in the exam ple are c a lle d journal entries. A journal entry can list as many accounts as a re needed to record the transaction, but for each journal entry, the sum o f the debits must e q u a l the sum o f the credits. If not, the accounting equation w ill not be m aintained (the 'b o o ks' w ill not balance).
CHAPTER 3 The d o u b le -e n try system
97
FOR YOUR INTEREST A n in te re s tin g a s p e c t o f a tra n s a c tio n is th a t, b e c a u s e it is an e x c h a n g e , b o th p a rtie s t o th e e x c h a n g e w o u ld re c o rd it, e a ch fr o m th a t p a rty ’s p o in t o f v ie w . I f E n te rp ris e A ga in s cash f o r a lo an fr o m
E n te rp ris e B,
E n te rp ris e A w o u ld re c o rd an in c re a s e in cash (a d e b it) an d in a lo a n lia b ility (a c re d it) , w h ile E n te rp ris e B w o u ld re c o rd a d e c re a s e in cash (a c re d it) an d an in c re a s e in an a s se t f o r th e lo an re c e iv a b le , to be c o lle c te d (a d e b it). H e re are e x a m p le s o f s o m e e x c h a n g e s and h o w b o th p a rtie s w o u ld re c o rd th e tw o a s p e c ts o f e a c h . T h e re is a tr a d itio n o f re c o rd in g th e d e b its f ir s t in th e d o u b le e n try . T h a t is s o m e tim e s d is re g a rd e d h e re , so th a t y o u c an see th e p a rallels b e tw e e n P a rty A ’s an d P a rty B ’s re c o rd s .
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
W h a t are th e e ffe c ts o n th e b a la n c e s h e e t o f th e fo llo w in g tra n s a c tio n ? W h a tz is L td re c e iv e d $ 2 0 0 0 0 cash fr o m a s h a re h o ld e r in re tu rn f o r $ 5 0 0 0 in n e w ly issu ed share s an d p ro m is e d t o p a y th e s h a re h o ld e r th e o t h e r $ 1 5 0 0 0 b a c k a t th e e n d o f th r e e years.
2
W h a t is th e jo u r n a l e n tr y to re c o rd th e fo llo w in g tra n s a c tio n , in w h ic h W h a tz is used th e cash fr o m th e s h a re h o ld e r? T h e c o m p a n y b o u g h t a la rg e tr u c k , w h ic h c o s t $ 8 9 0 0 0 , b y p u ttin g $ 2 0 0 0 0 d o w n in cash an d fin a n c in g ( b o rro w in g ) th e re s t fr o m th e t r u c k d e a le r’s fin a n c e c o m p a n y .
Y o u r a n sw e rs s h o u ld be:
1
C a s h up $ 2 0 0 0 0 , sh a re c a p ita l up $ 5 0 0 0 an d lo n g - t e r m lo an up $ 1 5 0 0 0 . T h e re s u lt is to ta l in c re a s e to assets $ 2 0 0 0 0 , and to ta l in c re a s e to s o u rc e s o f assets $ 2 0 0 0 0 .
2
D R T ru c k $ 8 9 0 0 0 , C R C a s h $ 2 0 0 0 0 and C R T ru c k lo an $ 6 9 0 0 0 . T h e re s u lt is n e t to ta l in c re a s e to assets $ 6 9 0 0 0 , an d to ta l in c re a s e to s o u rc e s o f asse ts $ 6 9 0 0 0 ; to ta l d e b its $ 8 9 0 0 0 an d to ta l c re d its $89 00 0.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
98
3.4
More about accounts
The b a lance sheet an d the incom e statement are prepared from the underlying accounts, w h ich have been recorded using the double-entry system so that the sum o f the dollars in all the d e b it accounts equals the sum in all the credit accounts. But w h a t is an account, exactly? H ere's a w o rkin g d e finition: an a cco u n t is a re co rd o f the d o lla r am ounts com prising a p a rticu la r asset, lia b ility, equity, revenue o r expense. The net effect o f these am ounts is a d e b it o r credit, and is c alled the account's balance. B elow are some exam ples of h o w account balances a re ca lculated. M o d e rn com puterised accounting systems can produce accounts in various formats thought to be useful, but they all use the arithm etic illustrated b e lo w . •
If the enterprise's cash b egan at $ 5 0 0 a n d there w a s a receipt o f $ 4 0 0 a nd o ne o f $ 7 5 0 , a n d a paym ent of $ 3 0 0 and one o f $ 5 2 5 , the cash asset account w o u ld sh o w a b a la n ce o f $ 8 2 5 (a d e b it because there is a positive b a la n ce in this asset account). Cash = $ 5 0 0 D R + $ 4 0 0 D R + $ 7 5 0 D R - $ 3 0 0 C R - $ 5 2 5 C R = $ 8 2 5 D R
•
If share c a p ita l b egan a t $ 1 0 0 0 an d m ore shares w e re sold for $ 4 0 0 (w hich, let's say, caused the cash receipt above), the share c a p ita l equity a ccount w o u ld sh o w a b a la n ce of $ 1 4 0 0 (a credit because there is a positive b alance in this equity account). S h are capital = S 1 0 0 0 C R + S 4 0 0 C R = S 1 4 0 0 C R
•
If am ounts o w in g to trade creditors b egan at $ 9 5 0 a n d a cre d ito r w a s p a id $ 3 0 0 (the first paym ent above), the accounts p a y a b le lia b ility a ccount w o u ld sh o w a b a la n ce o f $ 6 5 0 (a credit because there is a positive b a la n ce in this lia b ility account). Accounts p a y a b le = S 9 5 0 C R - S 3 0 0 D R = S 6 5 0 C R
•
If a cash collection from a customer w a s m ade for $ 7 5 0 (the second cash receipt above), the accounts receivable account, w ith a b a la n ce of, say, $ 2 0 0 0 before the collection, w o u ld reduce by an am ount o f $ 7 5 0 (a credit because this reduces the accounts receivable asset, w h ich has been transformed into cash through the collection transaction). Accounts receivab le = $ 2 0 0 0 D R - $ 7 5 0 C R = $ 1 2 5 0 D R
•
If a $ 5 2 5 cash paym ent (the second cash paym ent above) w a s m ade on the com pany's b a n k loan, a lia b ility account w ith a nam e like 'b a n k lo a n ' w o u ld be d e b ite d w ith this paym ent. Suppose the loan had a b a la n ce of $ 15 0 0 0 before the paym ent. The account b ala n ce w o u ld then be calculated to sh o w the deduction of the paym ent. B ank lo an (p a rt of liabilities) = $ 1 5 0 0 0 C R - $ 5 2 5 D R = $ 1 4 4 7 5 C R
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HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
G a r f L td had a c c o u n ts re c e iv a b le a t th e b e g in n in g o f th e y e a r o f $ 5 2 9 0 . D u rin g th e y e a r, it had re v e n u e fr o m sales o n c re d it o f $ 3 9 6 2 0 an d c o lle c te d $41 0 8 0 fr o m its c u s to m e rs . W h a t w as th e b a la n c e o f a c c o u n ts re c e iv a b le a t th e e n d o f th e y e a r?
2
G a r f L td ’s n e t p r o fit f o r th is y e a r w as $ 2 9 4 0 , an d it d e c la re d $ 9 0 0 in d iv id e n d s to its s h a re h o ld e rs d u rin g th e y e a r. R e ta in e d p ro fits w e re $ 7 4 1 0 a t th e b e g in n in g o f th e y e a r. W h a t is th e b a la n c e o f re ta in e d p ro fits a c c o u n t a t th e e n d o f th e y e a r?
Y o u r a n sw e rs s h o u ld be:
1
$ 3 8 3 0 ( r e m e m b e r a c c o u n ts re c e iv a b le g o up via c re d it sales an d d o w n b y re c e ip ts fr o m
2
$ 9 4 5 0 ( r e m e m b e r re ta in e d p r o fits g o up w h e n th e r e is a p r o fit b u t g o d o w n w h e n a d iv id e n d is d e c la re d
a c c o u n ts
re c e iv a b le )
b e c a u s e it is a d is trib u tio n o f p r o fit to s h a re h o ld e rs .)
3.5
How debits and credits work
Let's consider an exam ple: C a p p u M a n ia Ltd, a small c o m p a n y that operates a coffee shop on the ground flo o r o f an office b u ild in g . Exhibit 3 .8 shows the com pany's b a la n ce sheet at the end o fju n e 2 0 1 5 . EXHIBIT 3 .8
CAPPUMANIA LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 5
Assets
$
Current assets
Liabilities and shareholders' equity
$
Current liabilities
Cash
4000
Inventory of unsold food Inventory of supplies
Accounts payable
1 200
800
Taxes payable
600
1 900
Total liabilities
1 800
6700
Noncurrent liabilities
Noncurrent assets
Loan
5 000
Total liabilities
6 800
Equipment
9000
Shareholders' equity
Accumulated depreciation
(1 500)
Share capital
3 000
7500
Retained profits
4400
Total shareholders' equity
Total assest
14 200
Total liabilities and shareholders' equity
7400 14 200
N o w let's see h o w the fo llo w in g four transactions, all h a p p e n in g on 1 July 2 0 1 5 , are recorded using accounting's double-entry method (ignoring the details o f the particular com puter or m anual record-keeping system): 1
C a p p u M a n ia pays $ 5 0 0 o f its taxes o w in g .
2
C a p p u M a n ia buys $ 4 5 0 m ore supplies, p aying $ 1 0 0 cash a n d o w in g the rest.
3
A shareholder is given m ore shares in return for personally p aying $ 1 1 0 0 on the equipm ent loan.
4
C a p p u M a n ia buys a n e w coffee m achine for $ 2 0 0 cash.
100
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Let's look at the entries. 1
Resource effect: C ash is reduced. Cash is an asset, so a decrease in an asset w o u ld be a credit. S ource effect: Tax lia b ility is reduced. A lia b ility is reduced, so the effect w o u ld be a debit. Entry:
1
$ DR
Taxes payable (liability)
CR
$
500
Cash (asset)
500
Double-entry m ethod: There is both a DR a nd a CR a nd the tw o are the same. (The tradition is to list the DR(s) first in an entry.) 2
Resource effects: Inventory is increased by $ 4 5 0 . It is an asset, an d an increase in asset is a d e b it. C ash is decreased by $ 1 0 0 so this is a credit, as a bove. S ource effect: The lia b ility to suppliers is increased by $ 3 5 0 . An increase in a lia b ility results in a credit. Entry:
D ouble-entry m ethod: There are both DRs a nd CRs, an d the sum o f the DRs equals the sum o f the CRs. (An entry can have a n y num ber o f DRs an d CRs as long as the sums o f each a re equal.) N o te that this d e b it entry could have been achieved b y tw o entries:
3
Resource effect: N o n e . S ource effects: The equipm ent loan, a lia b ility, is decreased $1 1 0 0 , so this is a debit. The share ca p ita l, an equity, is increased $1 1 0 0 , so this is a credit. Entry:
1
$ DR CR
Loan (liability)
$
1 to o
Share capital (equity)
1 to o
D ouble-entry m ethod: This transaction affects o nly the right side of the b a la n ce sheet, but the statement stays in b alance because on e a ccount on the right side goes up a nd another goes d o w n .
CHAPTER 3 The d o u b le -e n try system
4
101
Resource effects: Equipment, an asset, is increased $ 2 0 0 , so this is a debit. C ash is decreased $ 2 0 0 , w h ich is a credit as in transactions l an d 2. S ource effect: N o n e . Entry:
I
$ DR
Equipment (asset)
CR
Cash (asset)
s|
200 200
Double-entry m ethod: This transaction also affects o n ly o ne side o f the b a la n ce sheet - this time, the assets side - but a g a in the b a la n ce d entry keeps the b a la n ce sheet in balance. These journal entries form part o f the accounting cycle, w h ich records accounting transactions. The sequences of procedures by w h ich these transactions enter the fin a n cia l statements are discussed in C h a p te r 4 . For an illustration of h o w a journal entry affects the b a la n ce sheet, these entries are recorded here b y a d d in g them to, o r subtracting them from, the previous (3 0 June) balances in the accounts. This is d o n e in Exhibit 3 .9 , using a com puter spreadsheet form at (in this case, M ic ro so ft Excel, but the particular spreadsheet does not matter). A rbitrarily, the debits are recorded as positive an d the credits as negative. This does not mean debits a re g o o d a nd credits a re b a d ! It is sim ply an accounting convention. You can see from the spreadsheet that at 3 0 J u n e the total o f a d d in g all the debits a nd subtracting all the credits is zero. The transaction entries a re in b a la n ce because the sum o f the debits equals the sum o f the credits. The l July d e b it balances also equal the credit balances.
EXHIBIT 3.9
CAPPUMANIA LTD EXAM PLE IN SPR EA D SH EET FORM
* The numbers in brackets have been added to the spreadsheet printout to refer to the events and transactions described in the text.
102
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
It w o u ld be unlikely that another b a la n ce sheet w o u ld be p repared, just one d a y after the 3 0 June one, but to com plete the exam ple, let's see h o w the d e b it balances w o u ld also equal the credit balances, after recording the four transactions (see Exhibit 3 .1 0 ).
EXHIBIT 3.10
CAPPUMANIA LTD BALANCE SHEET AS A T 1 JULY 2 0 1 5
HOW'S YOUR UNDERSTANDING? S uppose th a t on 1 J u ly 2 0 1 5 a fift h tra n s a c tio n had o c c u rre d : C a p p u M a n ia repaid $ 8 0 0 on its loan to th e bank. W h a t w o u ld th e fo llo w in g revised fig u re s have been on th e 1 J u ly 2 0 1 5 balance s h e e t: cash, c u rre n t assets, to ta l assets, to ta l liabilities and sh a re h o ld e rs’ e q u ity? Y o u r answers should be: $ 2 4 0 0 , $ 5 5 5 0 , $13 2 5 0 , $ 4 7 5 0 and $ 8 5 0 0 .
3.6
Debits and credits, revenues and expenses
In section 3 .5 , you s a w h o w entries a n d accounts w e re used to record events as transactions in the double-entry accounting system. In the C a p p u M a n ia Ltd exam ple, this w a s lim ited to b a la n ce sheet accounts. Let's e xp a n d the exam ple to bring in revenue a nd expense accounts. To keep the exam ple uncluttered, w e g ro u p all the co m p a n y's activities for the ye a r ended 3 0 J u n e 2 0 1 6 into the fo llo w in g summary list. First, the econom ic events to be recorded: 1
Revenue for 2 0 1 6 w a s $ 8 9 7 4 0 . The coffee b ar does mostly cash business, so o f this, $ 8 5 2 5 0 w a s in cash and the rest w a s on credit.
2
G eneral expenses for 2 0 1 6 , not including dep re cia tio n o r incom e tax, totalled $ 6 7 2 3 0 . M o s t o f the expenses w e re on credit, for coffee supplies an d so on, so o f this, o n ly $ 21 2 0 w a s in cash.
CHAPTER 3 The d o u b le -e n try system
3
103
A t the end of the year, it turned out that unsold food on hand cost $ 5 5 0 and supplies on hand (mainly paper cups and plastic spoons) cost $ 1 7 4 0 . Therefore, the food inventory account has to be reduced by $ 2 5 0 ($ 8 0 0 - $ 5 5 0 ) and the supplies inventory account has to be reduced by $ 6 1 0 ($ 2 3 5 0 - $ 1 7 4 0 ). Using up these inventories is part of the cost of earning revenue, so these reductions w ill be included in the com pany's general expenses. W e could have described these expenses here as a C O G S expense and put them as a separate expense category.
4
D epreciation expense for the ye a r w a s $ 2 3 8 0 .
5
The co m p a n y's incom e tax expense for 2 0 1 6 w a s estim ated as $ 4 4 6 0 . (This is an estim ate because, until the incom e tax authorities issue a form al assessment o f tax, the c o m p a n y does not kn o w for sure w h a t its tax w ill be for the year.)
6
The com pany's b o a rd o f directors d e cla re d a d ivid e n d o f $ 1 0 0 0 . C ash inflow s an d outflow s b y 3 0 J u n e 2 0 1 6 not a lre a d y m entioned:
7
C ollections o f the revenue on credit totalled $ 3 3 3 0 .
8
Payments to suppliers totalled $ 5 9 4 2 0 .
9
The c o m p a n y p a id $ 3 0 0 0 tow ards its incom e tax.
10 O n ly $ 8 0 0 o f the d ivid e n d had been p a id . Before recording these transactions, w e w ill extend the d e b it/c re d it rules to revenue a n d expense items. To help you understand the entries, rem em ber that because profit is a part o f retained profits, w h ich is an equity a ccount and therefore a credit account on the b a la n ce sheet, anything that helps p rofit is a credit. A revenue is therefore a credit b a lan ce account. C onversely, anything that reduces profit reduces retained profits a nd equity, a n d is therefore a d ebit. An expense is therefore a d e b it b a la n ce account. W h e n d ividends are d e cla re d , they are deducted from retained profits, therefore such deductions are debits because they reduce equity. All this produces the fo llo w in g table o f double-entry a ccounting's debits a nd credits: Debits
Credits
Increases in assets
Decreases in assets
Decreases in liabilities
Increases in liabilities
Decreases in equity:
Increases in equity:
Dividends declared
Contributed capital
Expenses
Revenues
For com pleteness, the summary pro vid e d in section 3 .3 is extended as shown b e lo w :
N o te that one w a y o f decreasing retained profits is to d e cla re a d ivid e n d , w h ich results in a d e b it entry. To further dem onstrate this, the accounting equation can be rewritten in T-account form at as follow s: Assets Debit to increase
Credit to decrease
Liabilities Debit to decrease
Credit to increase
M
Shareholders' equity Debit to decrease
Credit to increase
104
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Increases in assets a re debits; increases in liabilities o r shareholders' equity a re credits. As noted earlier, shareholders' equity accounts include share c a p ita l, retained profits, revenue a nd expenses. Remember, increases in expenses reduce shareholders' equity a nd are, therefore, debits, w h ile an increase in revenue increases shareholders' equity and is, therefore, a credit. The revenue an d expense accounts can thus be show n as: Revenue Debit to decrease
Credit to increase
Expenses Debit to increase
Credit to decrease
H ere are the journal entries for the 10 items given earlier:
Revenue Cash (assets increased) Accounts receivable (assets increased)
85 250 4490
Revenue (equity increased)
2
89740
General expenses General expenses (equity decreased)
67230
2 120
Cash (assets decreased) Accounts payable (liabilities increased)
3
65 110
Using up of inventories General expenses (equity decreased)
250
Inventory of unsold food (assets decreased) General expenses (equity decreased)
250 610
Inventory of supplies (assets decreased)
4
610
Depreciation of equipment Depreciation expense (equity decreased)
2 380
Accumulated depreciation (assets decreased)
5
2 380
Estimated income tax expense Income tax expense (equity decreased)
4460
Taxes payable (liabilities increased)
6
4460
Dividend declared Retained profits (equity decreased)
1000 1000
Dividend payable (liabilities increased)
7
Collections of accounts receivable Cash (assets increased)
3 330
Accounts receivable (assets decreased)
8
3 330
Payments of accounts payable Accounts payable (liabilities decreased)
59420
Cash (assets decreased)
9
59420
Payments towards income tax Taxes payable (liabilities decreased)
3 000
Cash (assets decreased)
10
3 000
Payment towards dividend Dividend payable (liabilities decreased) Cash (assets decreased)
800
800
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105
W e can enter these 10 entries into the co m p a n y's accounts, using the spreadsheet basis you s a w in section 3 .5 . The resulting spreadsheet is shown in Exhibit 3 .1 1 . N o te that the 1 July 2 0 1 5 figures, w h ich are w h a t w e e nded up w ith in Exhibit 3 .9 , are n o w in the first colum n, as the starting figures. Some n ew accounts (such as accounts receivable an d revenue) are needed to record the entries: the titles o f these are show n in italics.
EXHIBIT 3.11
CAPPUMANIA LTD EXAMPLE IN SPREADSHEET FORM (CONTINUED FROM EXHIBIT 3.9)
* The numbers in brackets have been added to the spreadsheet printout to refer to the 10 events and transactions described in the text.
You can see that everything is still in ba la n ce . The sums o f the debits an d credits in the 1 0 entries a re $ 2 3 2 2 2 0 , and the 3 0 June 2 0 1 6 accounts a d d up to ze ro (rem ember that, a rbitrarily, debits are show n as positive am ounts and credits as negative ones).
106
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
To highlight the calculation o f profit from the e x p a n de d set o f accounts, a second version o f the spreadsheet is shown in Exhibit 3 . 1 2 . It is the sam e as in Exhibit 3 . 1 1, except that the b a la n ce sheet accounts an d the profit and loss accounts (part o f the incom e statement) are n o w separately subtotalled. You w ill see that profit (the difference betw een the revenue an d expense accounts) equals $ 1 4 8 1 0 . It is a credit, w h ich is w h a t equity is. A lso note that, w ithout the revenue a nd expense accounts, the b a la n ce sheet accounts are out o f b a la n ce by the sam e $ 1 4 8 1 0 . In C h a p te r 4 , you w ill see h o w these revenue a nd expense accounts are closed off. A separate note w ill sh o w that the profit figure w ill be transferred to retained profits; that is, o p e n in g retained profits plus net profit for the ye a r minus d ivid e n d declare d equals closing retained profits (4 4 0 0 + 1 4 8 1 0 — 1 0 0 0 = 1 8 2 1 0 ). A figure o f $ 1 8 2 1 0 w ill a p p e a r as the b a la n ce o f the retained profits a ccount in the b a la n ce sheet.
EXHIBIT 3.12
CAPPUMANIA LTD
EXA M PLE IN SPR EA D SH EET FORM (C O N TIN U E D ) (W IT H SUBTO TALS TO SHO W PROFIT C A LC ULATIO N)
CHAPTER 3 The d o u b le -e n try system
107
The com pany's incom e statement sh ow in g profit for the y e a r is show n in Exhibit 3 . 1 3. The b a la n ce sheet is given in Exhibit 3 . 14 .
EXHIBIT 3.14
CAPPUMANIA LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 6
* Opening balance + Net profit — Dividends declared = Closing balance 4 4 0 0 + 14 81 0 - 1000 = 18 210
This exam ple has illustrated h o w accounting accum ulates inform ation a b o u t activities a nd h o w the fin a n cial statements are prepared from the accounts that are p roduced as the inform ation is accum ulated. You can see h o w the tw o fin a n cia l statements fit together (articulate) because they a re all based on the d o u ble entry accounting system: •
A set o f accounts is created w h ich is in b a la n ce (sum o f all the d e b it a ccount balances = sum o f all the credit a ccount balances). From these accounts a re produced: -
the incom e statement, the bottom line (net profit after tax) o f w h ich is transferred to a note to the accounts sh o w in g a statement o f retained profits, the bottom line (ending retained profits) of w h ich is transferred to
-
the b a la n ce sheet, w h ich summarises all the accounts.
108
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A ctivities affecting profit therefore affect the b a la n ce sheet through the double-entry system. Looking b ack a t the entries a bove, for exam ple: •
Entry 1 increased the b a la n ce sheet's assets an d increased revenue on the incom e statement (thereby also increasing profit, w h ich is transferred to retained profits, therefore increasing equity, w h ich keeps the bala n ce sheet in balance).
•
Entry 2 decreased the b a la n ce sheet's assets a nd increased its liabilities a nd increased expenses on the incom e statement (thereby also decreasing profit, therefore decreasing equity, w h ich keeps the b a la n ce sheet in balance). You w ill see this sort o f relationship a m ong the fin a n cia l statements m any times. It is the basis o f one o f the most
im portant uses o f fin a n cia l statements: analysing the fin a n cia l statements in o rd e r to evaluate fin a n cia l perform ance and financial position.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
A t th e end o f 2 0 1 5 , H in to n H a ts Ltd had retained p ro fits o f $ 2 9 4 9 0 . D u rin g 2 0 1 6 , it had revenue o f $112 3 5 0 , general expenses o f $ 9 1 1 7 0 , depreciation expense o f $ 6 2 1 0 and in co m e tax expense o f $ 3 4 2 0 . D ividends o f $ 5 0 0 0 w ere declared d uring 2 0 1 6 . W h a t was th e balance o f retained p ro fits at th e end o f 2 0 1 6 ?
2
I f th e c o m p a n y paid $ 1 2 0 0 cash fo r th e re n t on its shop fo r th e last m o n th o f 2 0 1 6 , w h a t w o u ld this e v e n t do to : assets, liabilities, p r o fit fo r 2 0 1 6 , re ta in e d p ro fits and e q u ity?
Y o u r answers should be: 1
$36 0 4 0
2
D o w n $ 1 2 0 0 ; no e ffe c t; dow n $ 1 2 0 0 ; dow n $ 1 2 0 0 ; and do w n $ 1 2 0 0 .
3.7
Arranging accounts on the balance sheet
In the Sound and Light exam ple (C hapter 2) an d the C a p p u M a n ia exam ple (this chapter), you s a w that accounts w e re organised into the statement's main categories: current assets, noncurrent assets, current liabilities, noncurrent liabilities and equity. This w a s d o n e because the arrangem ent o f accounts is m eant to convey inform ation beyond the account balances themselves. The placem ent o f each a ccount tells the reader o f the b a la n ce sheet w h a t kind of account it is: a short-term asset o r a long-term one; a short-term lia b ility o r a long-term one; o r an equity. This enables the calculation o f m eaningful ratios an d other analyses. The b a la n ce sheet is said to be classified, because accounts are classified into m eaningful categories. This means that the accountant p reparing the b a la n ce sheet has to look into an account w ith a title like 'b a n k lo a n ', for exam ple, an d determ ine w hether it should be included in current liabilities o r noncurrent liabilities. M o v in g items around w ith in the b a la n ce sheet (or w ithin other fin a n cia l statements) is called redassiFication, an d is d o n e by accountants w h enever it is thought to im prove the inform ativeness o f the financial statement.
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109
Three exam ples o f account classification C U R R EN T A N D N O N C U R R E N T P O R T IO N S O F N O N C U R R E N T LIABILITIES M a n y noncurrent liabilities, such as m ortgages, bonds an d debentures, require regular payments, so although most of the d e b t is noncurrent, not all o f it is. Accountants therefore reclassify the am ount to be p a id on the prin cipa l o f the d e b t w ith in the next ye a r into current liabilities, an d sh o w o n ly the residual (due more than a ye a r a w a y) as noncurrent. (Any interest o w in g but not yet p a id w o u ld be treated as a separate lia b ility. If it is due to be p a id w ithin the y e a r it is a current liability.)
B A N K O VER D RA FTS Suppose a c o m p a n y has a b a n k overdraft o f $ 5 0 0 , w h ich means that its cash-in-bank asset is negative (the ba n k has a llo w e d the c o m p a n y to remove $ 5 0 0 m ore cash from the account than there w a s in it, in effect lending the c o m p a n y the $ 5 0 0 ). The co m p a n y's other assets total $ l 2 4 0 0 . Its net assets are therefore $ l 1 9 0 0 , an d this is also the total o f its liabilities an d shareholders' equity. There a re at least tw o w a ys o f presenting this inform ation: Other assets of $ 12 4 00 minus bank overdraft of $500
=
Liabilities and shareholders' equity of $1 1 900
=
Liabilities and shareholders'equity of $1 1 900 plus bank overdraft of $500
or Other assets of $ 12 4 00
For bank overdrafts, it is custom ary to use the second method, to move the negative ba n k am ount to the other side o f the b a la n ce sheet. Even if the c o m p a n y norm ally has cash in the bank so that the a ccount is norm ally an asset, the a ccount is a lia b ility at this point because the bank has, in effect, lent the c o m p a n y $ 5 0 0 an d w ill w a n t the m oney back.
N E G A T IV E A M O U N T S LEFT A S D E D U C T IO N S Som e ne g a tive am ounts are left as d eductions, not m oved to the other side to m ake them positive, as w a s d o n e w ith the overdraft. A ccum ulated d e p re cia tio n is an im portant e x a m p le o f a n e g a tive -b a la n ce acco u n t. (In practice , this is often ca lle d a contra asset an d is discussed further in C h a p te r 5 .) It is the am ount o f all the d e p re cia tio n c a lcu la te d to d a te on assets such as b u ild in g s a n d equipm ent. For a ccum ulated d e p re cia tio n , there are a t least tw o a p p ro p ria te w a ys o f presenting the inform ation, all o f w h ich m aintain the b a la n c e sheet equa tion : 1
It could be disclosed separately as a deduction on the left side o f the b a la n ce sheet, as w a s used in the Sound an d Light an d C a p p u M a n ia b a la n ce sheets. This is sometimes used, but if there a re a lot of different kinds of assets a nd d e p re cia tio n am ounts, it can make the b a la n ce sheet a little cluttered.
2
It could be d educted from the assets' cost, a nd just the net b o o k value could be disclosed on the b a la n ce sheet, so that accum ulated de p re cia tio n is not m entioned on the fa ce o f the statement. This method, w h ich is most com m on, w o u ld be a c co m p a n ie d b y a note to the fin a n cia l statements, listing the cost an d accum ulated d e p re cia tio n amounts separately, so keeping the b a la n ce sheet uncluttered a nd a llo w in g some a d d itio n a l explanations o f the figures if that w e re thought useful.
110
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: P re p a re th e asse t side o f a b a la n c e s h e e t f o r M ik e ’s T y re R e p a ir L td fr o m th e fo llo w in g a m o u n ts : cash on h a n d $ 9 0 , a c c o u n ts re c e iv a b le $ 6 4 0 , in v e n to ry $ 2 1 0 , e q u ip m e n t c o s t $ 8 9 0 an d a c c u m u la te d d e p re c ia tio n o n e q u ip m e n t $ 4 7 0 . Y o u r a n s w e r s h o u ld be: $
$
Current assets
90
Cash at bank Accounts receivable
640
Inventory
210
940 Noncurrent assets Equipment
890
Accumulated depreciation
(470)
Total assets
3.8
420 1 360
More journal entries
You w ill discover further in C h a p te r 4 that the accounting process is reasonably m echanical on ce you have created your journal entries. C re a tin g journal entries is critical to your general understanding o f a ccounting. The better you understand this (and the earlier sections that g a v e you the k n o w le d g e to d o this section), the easier you w ill find the rest o f the course. A fe w extra hours on this m aterial w ill save you m any m ore hours later in this subject and subsequent subjects. Let's g o b a ck to the LRM exam ple from sections 3.1 a n d 3 .2 an d prepare the journal entries. The 1 4 transactions are repeated here for convenience. 1 2
Shareholders invest $ 2 0 0 0 0 0 cash in the business. Land and bu ild in g is purchased for $ 3 0 0 0 0 0 , w h ich is fin a n ce d by a loan from the seller re p a ya b le in five years.
3 4
Inventory w orth $ 5 0 0 0 0 is bought on account. Equipm ent w orth $ 9 0 0 0 0 is purchased by p a yin g $ 2 0 0 0 0 cash an d signing an agreem ent to p a y the rem ainder in 9 0 days.
5
D am aged inventory that w a s purchased on credit at a cost o f $ 5 0 0 0 w a s returned to the supplier.
6 $ 3 0 0 0 0 is p a id on accounts p a ya b le . 7
$ 1 0 0 0 0 o f inventory is purchased using cash.
8 C ash sales of $ 3 0 0 0 0 w e re m ade. The cost o f the g o o d s that w e re sold am ounted to $ 1 2 0 0 0 . 9
C re d it sales o f $ 4 0 0 0 0 w e re m ade. The cost o f g o o d s sold w a s $ 1 6 0 0 0 .
10 Payments o f $ 8 0 0 0 w e re m ade to suppliers. 11 Paid w a g e s o f $ 2 0 0 0 0 for the first tw o w eeks o f A pril. 12 Received an advertising invoice for $ 2 0 0 0 for a ra d io advertisem ent broadcast on 5 A p ril. The bill w ill be p a id next month.
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111
13 Received $ 2 5 0 0 0 from accounts receivable. 1 4 A t the end o f the month, $1 8 0 0 0 is o w in g in w a g e s for the last tw o w eeks o f the month. It is due to be p a id on 1 M ay. B elow are the relevant journal entries an d the reasons for the d e b it an d credit entries. Before looking at these journal entries, try to d o them yourself. If you are not getting them correct, g o b a ck to sections 3.1 a nd 3 .2 for further detail on h o w the transactions affect the specific accounts. JOURNAL ENTRIES FOR LRM LTD $ 1
DR CR
Reason: 2
Reason:
$
200000
Share capital
200000
Cash (asset) increases; share capital (shareholders' equity) increases DR CR
3
Cash
Land and buildings
300000
Long-term loan
300000
Land and buildings (asset) increases; long-term loan (liability) increases DR CR
Inventory
50000
Accounts payable
50000
Reason:
Inventory (asset) increases; accounts payable (liability) increases
4
DR
Equipment
CR
Cash
20000
CR
Notes payable
70000
Reason: 5
Equipment (asset) increases; cash (asset) decreases; notes payable (liability) increases DR CR
Accounts payable
Reason:
Accounts payable (liability) decreases; inventory (asset) decreases DR
Reason:
Accounts payable (liability) decreases; cash (asset) decreases
CR
DR CR
Accounts payable
Inventory
Inventory (asset) increases; cash (asset) decreases DR
CR
Cash
9
DR
CR Reason:
10000 10000
30000 30000 12 000
Inventory
Cash (asset) increases; sales revenue (revenue) increases; COGS (expense) increases; inventory (asset) decreases
DR
30000
Sales revenue Cost of goods sold
Reason:
CR
30000
Cash
8
DR
5 000
Cash
Reason:
CR
5 000
Inventory
6
7
90000
Accounts receivable
12 000
40000
Sales revenue Cost of goods sold Inventory
Accounts receivable (asset) increases; sales revenue (revenue) increases; cost of goods sold (expense) increases; inventory (asset) decreases
40000 16000 16000
»
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
112
10
DR CR
Accounts payable
8 000
Reason:
Accounts payable (liability) decreases; cash (asset) decreases
11
DR
Reason:
Wages expense (expense) increases; cash (asset) decreases
CR
12
DR CR
Wages expense
20000
Advertising expense
13
DR
14
Cash
2 000
25 000
Accounts receivable
25 000
Cash (asset) increases; accounts receivable (asset) decreases DR CR
Reason:
2 000
Accounts payable
Advertising expense (expense) increases; accounts payable (liability) increases
CR
20000
Cash
Reason:
Reason:
8 000
Cash
Wages expense
18 000
Wages payable
18 000
Wages expense (expense) increases; wages payable (liability) increases
HOW'S YOUR UNDERSTANDING? T o re v is e th e a b o v e p o in t c o n s id e r th e fo llo w in g in fo r m a tio n . W h ic h o f th e fo llo w in g tra n s a c tio n s w o u ld in c re a s e o r d e c re a s e p r o fit in J u n e :
1
C r e d it sales o f $ 5 0 0 in J u n e w ith cash re c e iv e d in A u g u s t.
2
R e c e iv e d $ 3 0 0 cash in J u n e fr o m a c c o u n ts re c e iv a b le a t th e e n d o f M a y .
3
R e c e iv e d an e le c tric ity bill in J u n e fo r $ 1 6 0 w h ic h relates to e le c tric ity used in J u n e ; th e bill w ill be paid in J u ly ).
Y o u r a n sw e rs s h o u ld be:
1
In cre a se s p ro fit.
2
D o e s n o t im p a c t p r o fit (i.e . in c re a s e s c a sh , d e c re a s e s a c c o u n ts re c e iv a b le ).
3
D e c re a s e s p ro fit.
3.9
Cash versus accrual accounting revisited
In C h a p te r 1 you learnt that the predom inant method o f accounting is ca lle d accrual acco u n tin g . It is used b y all large businesses, an d in the last d e c a d e has also been used b y public sector organisations an d not-for-profit organisations. U nder an accrual accounting system, the im pact o f transactions is recognised in the p eriod w hen revenues and expenses occur - w h ich m ay or m ay not be the sam e p eriod in w h ich the cash is received. For exam ple, a cash sale o f $ 1 0 0 0 w o u ld increase both sales revenue (and therefore accrued profit) a nd cash (increase cash; increase sales revenue). H ow ever, a credit sale o f $ 1 0 0 0 in M a y w ith cash collected in July w o u ld increase sales revenue in M a y , but not increase cash until July (increase accounts receivable; increase sales revenue). W h e n the m oney is received in July, cash w o u ld increase but it w o u ld have no im pact on revenue (increase cash; decrease accounts receivable).
CHAPTER 3 The do u b le -e n try system
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Figure 3.1 summarises the w a y accrual fin a n cia l accounting inform ation is assem bled, an d gives exam ples. •
The foundation is cash transactions, w h ich even the simplest accounting records include.
•
M o s t accounting systems also include credit transactions, because most enterprises extend credit to customers a n d /o r use cre d it from their suppliers an d em ployees.
L e v e ls o f fin a n c ia l a c c o u n t in g
Often uncertain, complex and unclear
S o m e e x a m p le s
Debt and share contract details Possible lawsuit outcomes Choices of accounting methods
Estimated pension payments Wear and tear on building Future income taxes
Unsold goods expected to be sold Estimated income tax payable Insurance paid in advance
Amounts due from customer Amounts due to suppliers Unpaid employee wages
Usually certain, verifiable and clear
FIGURE 3.1
•
Cash or cheques received Cash or cheques paid Direct bank transactions
Levels of accrual accounting•
Short-term a nd long-term adjustments a re needed in preparing fin a n cia l statements, unless the com pany's accounting system is sophisticated enough to have a lre a d y built them in (some are, though there are a lw a ys new issues to be d e a lt w ith as the w o rld keeps changing).
•
Extensive narrative an d supplem entary disclosures (especially the notes to the fin a n cia l statements) are m ade, sometimes using m any m ore pages than the statements themselves do. The result is that accrual accounting is a very co m p le x inform ation system, a nd it w ill take the rest o f this b o o k to
introduce you to it properly. H ow ever, n o w that you have covered transaction analysis, it should start to becom e easier to fo llo w . So let's review some key points a b o u t accrual a ccounting. •
Revenue is recognised in the period in w h ich the g o o d is delivered o r the service is p rovided. Revenue can be recorded regardless o f w hen cash is received.
• •
C ash can be received in the sam e period as revenue is recognised (e.g. cash sales). Revenue can be recognised in o ne p e riod, an d the cash is not received until the fo llo w in g period (e.g. credit sales).
114
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C ash can be received in one p e riod, but the service is not p rovided until a later p eriod an d , therefore, revenue w ill not be recognised until the later p eriod (e.g. customer pays a dep o sit on services to be pro vid e d in a later period).
•
Expenses are recognised in the p eriod in w h ich the expense is incurred. A g a in this is regardless o f w hen cash is p a id . For exam ple, if an em ployee w orks 10 days in a month a nd the w a g e rate is $ 2 0 0 a d a y, the expense is $ 2 0 0 0 for the month. This is regardless o f w hether all or part o f the $ 2 0 0 0 is p a id in this month, a future month o r a previous month.
3.10
Example: Simone's jew ellery business
H ere is an exam ple of h o w accrual accounting w orks. The exam ple is o f a small business, one you should be a b le to im agine easily, but the accounting issues it raises are exactly the same as those fa ce d by b ig businesses. Sim one w orks in an o ffice during the d a y, but in the evenings a n d on w eekends she makes silver jew ellery in a studio she has set up in her basement. The jew ellery is sold in local craft shops, an d Sim one keeps a separate bank account to deposit the cash from her sales an d to p a y the bills for supplies. A ccounting is a w a y o f portraying an enterprise; another w a y , a visual im age, m ay help you. Try to picture Sim one w orking in her studio, d riving around to craft shops to d eliver her products a nd collect cash, a n d relaxing w ith her friends w hen things are g o in g w e ll. It is im portant that accounting's reports be consistent w ith the reality o f her business, so keep the im age in mind as this exam ple develops.
2016 as first year in business For 2 0 1 6 , her first ye a r in business, Sim one received $ 4 3 5 0 in cash from the craft shops for sales o f her jew ellery and p a id $ 1 6 7 0 in cash for silver an d other supplies an d expenses. H o w much m oney d id she make from her business in 2 0 1 6 ? The sim ple answ er is that she m ade a cash p rofit of $ 2 6 8 0 ( $ 4 3 5 0 cash collected minus $ 1 6 7 0 cash p a id out). H er bank b a lance increased by that am ount during the year. This is a sim ple, understandable calculation. The notion behind accrual accounting is that m aybe the sim ple calculation is to o sim ple; that it really does not properly measure w h a t Sim one a ccom plished during the year. A ccrual accounting tries to take into account a number o f things. •
A t the end of the year, Sim one w a s still o w e d $ 3 1 0 for sales by on e craft shop because the o w n e r had been out w hen she stopped by. The shop p a id her a fe w w eeks later, but shouldn't that am ount be counted as revenue for the ye a r the sales w e re m ade? It w a s a credit transaction in that year, not a cash transaction yet. The am ount w as legally o w e d to Sim one at the end o f the ye a r a nd she expected to collect the cash.
•
A t the end o f the year, Sim one had some u n paid bills for business expenses totalling $ 8 5 . She p a id those early in the next year, but a ren't they really expenses for the ye a r in w h ich she incurred them, rather than for the y e a r in w h ich she p a id them ? She has bills for these, so they represent other credit transactions, but this time involving promises by Sim one to p a y rather than b y her customers to p a y her.
•
In m aking the jew ellery, she used some equipm ent she had bought earlier for $ 1 2 0 0 . If the equipm ent is expected to last a b o u t 1 0 years, shouldn't the w e a r a n d tear on it during the ye a r be counted as an expense? It is not easy to figure out h o w much w e a r a n d tear results from a particular p e riod, but say that Sim one feels that the ye a r w a s a normal one o f the 1 0 years the equipm ent should last for. The cost o f the w e a r a nd tear, therefore, w a s about 1 0 per cent of the o rig in a l cost o f the equipm ent, o r $ 1 2 0 . (This $ 1 2 0 figure is w h a t accountants call d e p reciation. It can be calculated in several w a ys, as w e w ill see later on.) This is an exam ple o f a long-term estim ate o r expectation. People have all sorts o f disagreem ents a b o u t d e p re cia tio n because it involves the prediction o f an uncertain future (along w ith other reasons w e 'll lo o k at).
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By using these three a d d itio n a l pieces o f inform ation, accrual accounting w o u ld calculate Sim one's accrual profit for the ye a r 2 0 1 6 (her first ye a r in business) in the fo llo w in g w a y , taking into a ccount the various estimates and incom plete transactions described: SIMONE'S JEWELLERY BUSINESS CALCULATION OF ACCRUAL PROFIT FOR THE YEAR 2 0 1 6 Revenue ($4350 collected plus $310 still to be received)
$4 660
Expenses ($1670 paid plus $85 unpaid plus $ 120 estimated depreciation)
Accrual profit based on the information provided
1 875 $2 785
A ccrual accounting can an d does handle m any m ore com plexities than the three included a b o ve . Even w ith this uncom plicated exam ple, you can see that the $ 2 7 8 5 accrual profit is a m ore com plete measure o f Sim one's business perform ance than is the cash profit o f $ 2 6 8 0 , w h ich is the ch a n g e in cash b a la n ce a lone. (Accrual profit is not necessarily higher than cash profit - it just happens to be so in this exam ple.) •
N o te that there are m ore items w e d id not consider at this early stage of the book. W h a t a b o u t the costs of using the room in her basem ent for her studio a n d her ca r for deliveries? Should some calculation o f such costs be m ade, although it w o u ld be difficult to be exact a b o u t them ? W h a t a b o u t incom e tax? If she has to p a y incom e tax on w h a t she earns from her business, should that tax also be deducted as a business expense? W h a t a bout unused supplies at the end o f the p e rio d ? H o w a re g o o d s a nd services taxes (GST) handled? For no w , let's not becom e mired in such com plexities! Remember that accrual accounting tries to pro vid e a more
thorough measurement o f fin a n cia l perform ance an d other aspects o f an enterprise than sim ple cash-based accounting. In o rd e r to d o so, it incorporates m ore co m p le x ideas, as w e ll as estimates a nd judgem ents. M u ch of your task is to understand the com plexities, estimates a nd judgements so that you w ill be a b le to understand the resulting fin a n cia l statements an d w h a t they say a b o u t the enterprise.
Impact o f opening balances on the Simone example To finish the exam ple o f Sim one's business, let's extend it to the case in w h ich 2 0 1 6 w a s not her first ye a r in business; that is, 2 0 1 6 w a s just a normal business year. That means she m ay have had uncollected sales an d u n paid bills at the end o f 2 0 1 5 (beginning o f 2 0 1 6 ). W o u ld those o p e n in g balances make a n y difference to the cash profit calculation for 2 0 1 6 ? N o , they w o u ld n 't - they d o n 't involve a n y ch a n g e in cash receipts o r payments during the year. W o u ld they make a n y difference to the accrual profit calculation for 2 0 1 6 ? Yes, they w o u ld . Let's see how . To keep the exam ple uncluttered, let's use exactly the sam e numbers a g a in , but a d d tw o n e w items as at the end o f 2 0 1 5 : accounts receivable (credit sales m ade for w h ich the cash has not yet been received), $ 2 4 0 ; an d accounts p a y a b le (unpaid bills), $ 5 0 . W h a t effect d o these have on the accrual profit calculation? Som e o f the $ 4 3 5 0 cash received in 2 0 1 6 w a s not for that year's sales, but rather covered collecting $ 2 4 0 revenue that w a s part o f the accrual profit calculation in the previous year, 2 0 1 5 . That am ount has to be subtracted from $ 4 3 5 0 in the 2 0 1 6 accrual p rofit calculation because it w a s a lre a d y in the 2 0 1 5 accrual profit a nd shouldn't be counted tw ice. The $ 5 0 o f u n paid bills at the end o f 2 0 1 5 w e re included in the cash payments in 2 0 1 6 ; therefore, they w e re counted in the 2 0 1 6 expenses a b o ve , although they had a lre a d y been included in the 2 0 1 5 expenses. C onsequently, they a re deducted from the 2 0 1 6 expenses because they d o n 't belong in 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o w here's Sim one's accrual profit if 2 0 16 w a s not her first year: SIMONE'S JEWELLERY BUSINESS REVISED CALCULATION OF ACCRUAL PROFIT FOR THE YEAR 20 16 Revenue ($4350 collected, minus $240 from 2015, plus $310 still to be received)
$4420
Expenses ($1670 paid, minus $50 from 2015, plus $85 unpaid at the end of 2015, plus $120 estimated depreciation for 2015)
1 825 ______
Accrual profit based on the information provided
$2 595
C ash profit is still $ 2 6 8 0 - unaffected b y the n e w inform ation. But accrual p rofit is ch a n g ed , as it a lw a ys is, by non-cash items existing at both the b e ginning a nd the end o f the year.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve j u s t re a d , b u t n o te it is a b it m o re d iffic u lt b e ca u s e it has o p e n in g ba la n ce s o f a c c o u n ts re c e iv a b le and a c c o u n ts p a ya b le . I f y o u c a n ’t a n s w e r th e m , it w o u ld be b e s t t o re -re a d th e m a te ria l. F re d s ta rte d his d e liv e ry b u sin e ss a fe w y e a rs ag o. T h is y e a r, he c o lle c te d $ 4 7 0 0 0 fr o m his c u s to m e rs and paid $21 0 0 0
in ex p e n s e s . A t th e b e g in n in g o f th is y e a r, his c u s to m e rs o w e d $ 3 5 0 0 an d he o w e d his
s u p p lie rs $ 7 0 0 . A t th e e n d o f th is y e a r, his c u s to m e rs o w e h im $ 3 2 0 0 ; he o w e s his s u p p lie rs $ 1 4 5 0 ; and his tr u c k d e p re c ia tio n f o r th e y e a r w as $ 4 6 0 0 . U s in g ju s t th is in fo rm a tio n :
1
W h a t is th is y e a r’s cash p r o fit?
2
W h a t is th is y e a r’s a c c ru a l p r o fit?
Y o u r a n sw e rs s h o u ld be:
1
C a s h p r o fit is $ 2 6 0 0 0 ( $ 4 7 0 0 0 cash re c e ip ts - $21 0 0 0 cash p a y m e n ts ).
2
A c c ru a l p r o fit is $ 2 0 3 5 0 (re v e n u e o f $ 4 7 0 0 0 - $ 3 5 0 0 + $ 3 2 0 0 = $ 4 6 7 0 0 ; e x p e n s e s o f $21 0 0 0 $ 7 0 0 + $ 1 4 5 0 + $ 4 6 0 0 = $ 2 6 3 5 0 ).
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117
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Transaction analysis Flashy Fashions Ltd is a sm all c o m p a n y in a c o a s ta l to w n . It rents its pre m ises a n d its sales a re a ll o n c re d it. It has o n ly th re e expe nses: cost o f g o o d s s o ld , rent a n d in c o m e ta x. A t th e e n d o f its p re v io u s fin a n c ia l y e a r, 3 0 S e p te m b e r 2 0 1 5 , Flashy's b a la n c e shee t w a s as fo llo w s : FLASHY FASHIONS LTD BALANCE SHEET AS AT 3 0 SEPTEMBER 20 16 Assets
$
Current assets
Equities Current liabilities
Cash
800
Accounts payable
600
Accounts receivable
400
Rent payable
300
Inventory
900
Shareholders' equity Share capital
500
Retained profits
700
2 100
2100
a
D u rin g th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , the fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's ac co u n ts, R evenue fro m c re d it sales $ 1 0 0 0 0 .
b
C o lle c tio n s fro m custom ers $ 9 6 0 0 .
c
Purchases o n c re d it o f in v e n to ry fo r sale $ 6 1 0 0 .
d
Paym ents to s u p p lie rs $ 6 3 0 0 .
e
C o s t o f g o o d s sold $ 6 4 0 0 .
f
Rent c h a rg e d b y th e la n d lo rd $ 2 4 0 0 .
g
Rent p a id to th e la n d lo rd $ 2 9 0 0 (d e cre a s in g th e lia b ility ),
h
In co m e ta x p a y a b le fo r th e y e a r $ 3 5 0 .
i
C a s h d iv id e n d s d e c la re d a n d p a id to s h a re h o ld e rs $ 4 5 0 .
R e q u ire d : 1 P re p a re tra n s a c tio n a n a lys is fo r e a c h o f th e a b o v e item s.
2
P re p a re an in co m e state m e nt a n d a b a la n c e sheet.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEM B Com plete the expanded acco u n tin g equation C a lc u la te th e m issing fig u re in e a c h o f th e fo llo w in g s itu a tio n s : Current assets
Noncurrent assets
Current liabilities
Noncurrent liabilities
Share capital
Opening retained profits
Revenue
Expense
Dividend
1
50000
200000
25 000
50000
?
5 000
25 000
15 000
0
2
150 00 0
600000
75 000
150 00 0
450000
30000
150 00 0
?
0 0 0
3
150 00 0
600000
75 000
150 00 0
450000
120000
135 000
?
4
?
250000
25 000
50000
250000
50000
45 000
30000
PRACTICE PROBLEM C Transaction analysis and jo u rn a l entries B e lo w is th e a b rid g e d b a la n c e sheet fo r N e w c o m b e Ltd as a t 31 M a y 2 0 1 6 . 1 Assets Cash
$ 90000
1
Liabilities and shareholders' equity Accounts payable
110 00 0
Accounts receivable
106000
Long-term loan
240000
Inventory
118 000
Share capital
200000
Prepayments
45 000
Equipment
400000
Accumulated depreciation
(125 000)
Retained profits
634000
84000
634000
The fo llo w in g tra n s a c tio n s o c c u r d u rin g June: a R eceived $ 2 3 0 0 0 fro m a c co u n ts re c e iv a b le , b
A d d itio n a l shares w o rth $ 8 0 0 0 0 a re issued,
c
In ve n to ry (co sting $ 3 2 0 0 0 ) is s o ld o n c re d it fo r $ 7 6 0 0 0 .
d
R e c o g n itio n o f $ 4 0 0 0 o f d e p re c ia tio n e xpe nse,
e
O f th e lo a n , $ 6 0 0 0 0 is re p a id ,
f
A d m in is tra tiv e expe nses o f $ 7 0 0 0 a re p a id ,
g
A to ta l o f $ 9 0 0 0 o f p re p a ym e n ts a re used up.
h
P aym e nt o f w a g e s o f $ 1 3 0 0 0 .
i
P urchase o f $ 2 8 0 0 0 w o rth o f in v e n to ry fo r cash,
j
D iv id e n d s o f $ 6 0 0 0 a re p a id ,
k
P aym e nt o f $ 3 6 0 0 0 o f a c co u n ts p a y a b le .
R e q u ire d : 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n s a c tio n s o n th e a c c o u n tin g e q u a tio n . 2
P re p a re an in c o m e state m e nt fo r th e m onth o f June a n d a b a la n c e sheet fo r N e w c o m b e Ltd a t 3 0 June 2 0 1 6 .
3
For e a ch o f th e a b o v e tra n sa ctio n s, w h a t is th e e ffe c t o n net p ro fit, to ta l assets, to ta l lia b ilitie s a n d s h a re h o ld e rs ' e q u ity ? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
4
P re p a re jo u rn a l en trie s fo r e a ch o f th e 11 tra n sa ctio n s a b o v e .
CHAPTER 3 The d o u b le -e n try system
Adjustment(s) Ratios
119
Reclassification Trial balance
This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
1
If a n asset in cre ases, list w h a t else m a y h a ve h a p p e n e d to th e a c c o u n tin g e q u a tio n .
2
W h ic h o f th e fo llo w in g is n o t p o ssib le? a
O n e lia b ility in cre ases a n d a n o th e r lia b ility in cre ases,
b
S h a re h o ld e rs ' e q u ity in cre ases a n d lia b ilitie s d e cre a s e ,
c
Assets in cre a s e a n d lia b ilitie s d e cre a s e .
3
W h y do es an in cre a s e in revenues result in an in cre a s e in s h a re h o ld e rs ' e q u ity ? W h a t o th e r p a rt o f the a c c o u n tin g e q u a tio n is lik e ly to be a ffe c te d ?
4
W h y d o e s an in cre a s e in expe nses result in a d e cre a s e in s h a re h o ld e rs ' e q u ity ? W h a t o th e r p a rt o f the a c c o u n tin g e q u a tio n is lik e ly to be a ffe c te d ?
5
G iv e th re e e x a m p le s o f a n asset th a t c o u ld d e cre a s e w h e n an e x p e n s e is in cre a s e d .
6 W h ic h a c co u n ts n o rm a lly h a ve a d e b it b a la n c e a n d w h ic h n o rm a lly h a ve a c re d it b a la n c e ? 7
C h o o s e five tra n s a c tio n s a n d s h o w bo th th e resou rce e ffe c t a n d th e so u rce effect.
8
E x p la in h o w th e b a la n c e sheet a n d th e in c o m e state m e nt a rtic u la te .
9
List som e o f th e la rg e r expe nses y o u w o u ld e x p e c t to see in th e in co m e statem ents fo r th e fo llo w in g o rg a n is a tio n s : a W o o lw o rth s b
C o m m o n w e a lth B ank
c
Red C ross
d
A u s tra lia n N a v y
PROBLEM 3.1 Transactions P ro v id e illu s tra tio n s o f th e fo llo w in g tra n sa ctio n s re la tin g to a lo c a l re ta ile r: 1
O n e asset is e x c h a n g e d fo r a n o th e r.
2
A n asset a n d a lia b ility in cre a s e b y th e sam e a m o u n t.
3
A n asset a n d re ven ue in cre a s e b y th e sam e a m o u n t.
4
O n e lia b ility is e x c h a n g e d fo r a n o th e r.
5
A n asset a n d a lia b ility a re re d u c e d b y th e sam e a m o u n t.
6 A lia b ility a n d a n e x p e n s e a re in c re a s e d b y th e sam e a m o u n t. 7
A n asset a n d s h a re h o ld e rs ' e q u ity a re in cre a s e d b y th e sam e a m o u n t.
8 A n asset is re d u c e d a n d an e x p e n s e is in cre a s e d b y th e sam e a m o u n t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3.2 Com plete tra n sa ctio n analysis and prepare fin a n cia l statem ents The fo llo w in g tra n s a c tio n s o c c u rre d fo r th e m o nth o f N o v e m b e r 2 0 1 6 fo r H o a d Ltd: a The c o m p a n y w a s in c o rp o ra te d , w ith s h a re h o ld e rs in ve stin g $ 2 0 0 0 0 0 in cash , b
P urchased in v e n to ry fo r cash , $ 2 0 0 0 0 .
c
P aid $ 4 0 0 0 fo r a m o n th 's rent on th e prem ises,
d
P urchased in v e n to ry on c re d it, $ 3 0 0 0 0 .
e
R eceived an a d v e rtis in g b ill fo r a n e w s p a p e r a d ve rtis e m e n t to p ro m o te th e n e w c o m p a n y . The $ 1 0 0 0 b ill w ill be p a id in D e c e m b e r.
f
In ve n to ry w ith a c o st o f $ 4 0 0 0 0 w a s s o ld o n c re d it fo r $ 9 0 0 0 0 .
g
P aid $ 2 5 0 0 0 o f a c co u n ts p a y a b le ,
h
R eceived $ 3 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
i
P aid w a g e s o f $ 1 5 0 0 0 .
j
P aid sales c o m m is sio n a t th e ra te o f 1 p e r c e n t o n sales m a d e d u rin g th e m o nth,
k
P urchased a n e w c o m p u te r fo r $ 6 0 0 0 ; p a id $ 3 0 0 0 in cash a n d $ 3 0 0 0 to be p a id in 15 m onths tim e.
I
O w e d e m p lo y e e s $ 2 0 0 0 in w a g e s a t th e e n d o f th e m onth.
R e q u ire d : 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n s a c tio n s o n th e a c c o u n tin g e q u a tio n . 2
P re p a re an in c o m e state m e nt a n d a b a la n c e sheet a t 3 0 N o v e m b e r 2 0 1 6 .
3
P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n a n d d e te rm in e th e b a la n c e fo r e a c h a c c o u n t.
4
For e a c h tra n s a c tio n a to I, w h a t is th e e ffe c t on net p ro fit a n d to ta l assets? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
PROBLEM 3.3 E ffe ct o f tra n sa ctio n s The fo llo w in g tra n sa ctio n s o c c u rre d fo r G ilc h re s t Ltd (assum e a ll b e g in n in g b a la n ce s = 0) d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . a Issued shares fo r $ 7 0 0 0 0 0 cash . b
S ig n e d a c o n tra c t on 1 O c to b e r 2 0 1 6 fo r $ 2 0 0 0 0 0 to s u p p ly c o n s u ltin g a d v ic e . R eceived an a d v a n c e o f $ 3 0 0 0 0 . A t 31 D e c e m b e r n o n e o f th e c o n s u ltin g a d v ic e h a d y e t be en p ro v id e d ,
c
P urchased $ 2 0 0 0 0 0 o f in v e n to ry ; p a id $ 9 0 0 0 0 cash w ith th e re m a in d e r on a c c o u n t,
d
S old $ 3 0 0 0 0 0 o f p ro d u cts to custom ers o n a c c o u n t; cost o f p ro d u c ts w a s $ 1 4 0 0 0 0 .
e
C o lle c te d $1 2 0 0 0 0 cash fro m custom ers in p o in t (d).
f
P aid $ 7 0 0 0 0 in w a g e s to e m p lo y e e s d u rin g th e y e a r; a t y e a r-e n d w a g e s o f $ 8 0 0 0 a re o w e d to e m p lo y e e s fo r w o rk d o n e in D e c e m b e r 2 0 1 6 , to be p a id in 2 0 1 7 .
g
E arn ed $ 1 0 0 0 0 in tere st o n investm ents, re c e iv in g 7 0 p e r c e n t in cash .
h
R eceived an e le c tric ity b ill in D e c e m b e r 2 0 1 6 fo r $ 4 0 0 0 c o v e rin g e le c tric ity c h a rg e s fo r D e c e m b e r 2 0 1 6 . The b ill w ill be p a id in J a n u a ry 2 0 1 7 .
i
P aid $ 2 0 0 0 0 cash fo r s u p p lie s re c e ive d d u rin g 2 0 1 6 . A t y e a r-e n d $ 7 0 0 0 o f su p p lie s w e re still o n h a n d (i.e. h a d n o t be en used up).
j
D e c la re d a n d p a id $ 3 0 0 0 0 in cash d iv id e n d s to s h a re h o ld e rs.
CHAPTER 3 The d o u b le -e n try system
121
For e a ch o f th e a b o v e tra n s a c tio n s , events o r fa cts, in d ic a te th e im p a c t on revenues, exp e n se s, assets a n d lia b ilitie s d u rin g 2 0 1 6 b y p la c in g a + o r - s ig n (+ fo r in cre a s e a n d - fo r de cre ase) to in d ic a te d ire c tio n in th e a p p ro p ria te b o x . W r ite N E if th e re is no effect. In clu d e d o lla r a m ou nts.
PROBLEM 3.4 N et p ro fit and to ta l assets D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , th e fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's a cco u n ts o f B org Lim ited. a Issue s h a re c a p ita l o f $ 5 0 0 0 0 0 . b
C re d it sales, $ 3 0 0 0 0 0 .
c
C a s h sales, $1 2 0 0 0 .
d
C o lle c tio n s fro m a c co u n ts re c e iv a b le , $ 3 0 0 0 0 0 .
e
Purchases o f in v e n to ry on c re d it, $ 1 4 0 0 0 0 .
f
Paym ents o f a cco u n ts p a y a b le , $ 1 0 0 0 0 0 .
g
C o s t o f g o o d s sold , $ 1 6 0 0 0 0 .
h
W a g e s e x p e n s e , $ 1 8 0 0 0 0 , n o t y e t p a id ,
i
W a g e s p a id , $ 4 4 0 0 0 (re d u c e w a g e s p a y a b le ),
j
C a s h d iv id e n d s , $ 4 0 0 0 0 , d e c la re d a n d p a id .
W h a t is th e s e p a ra te e ffe c t o f e a ch o f th e tra n sa ctio n s on net p ro fit a n d to ta l assets?
PROBLEM 3.5 Com plete the expanded a cco u n tin g equation C a lc u la te th e m issing fig u re in e a ch o f th e fo llo w in g situ a tio n s : Current assets 1
100000
Noncurrent assets 400000
Current liabilities 50000
Noncurrent liabilities 100000
Share capital
Opening retained profits ?
Revenue
10000
Expenses
Dividends
50000
30000
0 0 0
2
100000
400000
50000
100000
300000
20000
100000
?
3
100000
400000
50000
100000
300000
80000
90000
?
4
?
500000
50000
100000
500000
100000
90000
60000
0
5
100000
400000
50000
100000
300000
20000
100000
50000
?
6
100000
500000
50000
100000
300000
?
100000
50000
20000
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3 .6 A scertain the unknow ns in the acco u n tin g equation Find th e u n kn o w n s fo r LAP Ltd g iv e n th e fo llo w in g in fo rm a tio n : $m Assets 1 July 2015
$m
600
Liabilities 1 July 2015
Assets 30 June 2016
?
?
Liabilities 30 June 2016
300
Share capital 1 July 2015
180
Share capital 30 June 2016
190
Retained profits 1 July 2015
200
Retained profits 30 June 2016
Revenues for the year
800
Expenses for the year
650
Dividends
?
50
PROBLEM 3 .7 Prepare a balance sheet trom sim ple tran sa ctions South S h o re M a n u fa c tu rin g Ltd h a d this b a la n c e sheet: BALANCE SHEET AS AT 3 0 JUNE 2 0 1 6 | Assets
$
Current assets
Liabilities and shareholders' equity
$
Current liabilities
Cash
24000
Bank overdraft
53 000
Accounts receivable
89000
Accounts payable
78 000
Taxes payable
13 000
Current part of mortgage
18 000
Inventories, cost
111 00 0
Prepayments
7000 231000
Noncurrent assets
162 00 0
Noncurrent liabilities
Land, cost
78000
Factory and equipment, cost
584000
Accumulated depreciation
(198 000)
386000
Mortgage, less current
214000
Employee entitlements
66 000
Loan from shareholders
100 00 0 380000
Shareholders' equity Share capital
55 000
Retained profits
98 000 153 000
695000
D u rin g J u ly 2 0 1 6 , S outh S h o re M a n u fa c tu rin g e x p e rie n c e d th e fo llo w in g tra n sa ctio n s: a A n a m o u n t o f $ 1 0 0 0 0 o f th e s h a re h o ld e rs ' lo a n w a s re p a id , b
A c u stom er p a id o n e o f th e a c co u n ts re c e iv a b le , $1 1 2 4 0 .
c
A d d itio n a l in v e n to ry c o stin g $ 5 3 2 0 w a s p u rc h a s e d o n c re d it,
d
The c o m p a n y issued n e w shares fo r $ 2 2 0 0 0 cash .
695 000
CHAPTER 3 The d o u b le -e n try system
e
123
The p ro ce e d s o f th e sh a re issue w e re used to re d u c e th e b a n k o v e rd ra ft.
f
M o re la n d c o stin g $ 5 2 0 0 0 w a s p u rc h a s e d fo r $1 2 0 0 0 cash plus a n e w long -term m o rtg a g e fo r th e rest,
g
M o re fa c to ry e q u ip m e n t c o stin g $ 3 1 9 0 0 w a s p u rc h a s e d o n c re d it, w ith $1 3 9 0 0 d u e in six m onths a n d th e rest d u e in 2 4 m onths.
Required: 1 P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n . 2
P re p a re a n e w b a la n c e sheet fo r th e c o m p a n y as a t 31 J u ly 2 0 1 6 .
PROBLEM 3 .8 Prepare a balance sheet from sim ple transactions N o rth S ho re M a n u fa c tu rin g Ltd h a d this b a la n c e sheet: BALANCE SHEET AS AT 3 0 JUNE 20 16 Assets
$
Current assets
Liabilities and shareholders' equity Current liabilities
Cash
20 000
Accounts payable
80000
Accounts receivable
70 000
Taxes paya ble
20000
Inventories, cost
1 10 000
Wages payable
200000
Noncurrent assets
1 0 0 00 110 00 0
Noncurrent liabilities
Land, cost
200000
Mortgage, loan
200000
Plant and equipment
400 000
Provision for employee entitlements
100000
Accum. depreciation
(100 000)
600000
300000
Shareholders' equity Share capital Retained profits
200000 90000 290000
700000
700000
D u rin g July 2 0 1 6 , N o rth S h o re M a n u fa c tu rin g e x p e rie n c e d th e fo llo w in g tra n sa ctio n s: a A n a m o u n t o f $ 8 0 0 0 o f a c co u n ts p a y a b le w a s p a id , b
A c u sto m e r p a id o n e o f th e a c co u n ts re c e iv a b le , $ 13 2 8 0 .
c
A d d itio n a l in v e n to ry c o stin g $ 8 0 0 0 w a s p u rc h a s e d o n c re d it,
d
The c o m p a n y issued n e w shares fo r $ 5 0 0 0 0 cash,
e
The p ro ce e d s o f th e sh a re issue w e re used to re d u c e th e m o rtg a g e lo a n .
f
M o re la n d c o stin g $ 5 4 0 0 0 w a s p u rc h a s e d fo r $ 1 4 0 0 0 cash plus a n e w long -term m o rtg a g e fo r th e rest,
g
M o re e q u ip m e n t c o stin g $ 3 3 9 0 0 w a s p u rc h a s e d on c re d it, w ith $1 3 9 0 0 d u e in tw o m onths.
Required: 1 P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n . 2
P re p a re a n e w b a la n c e sheet fo r th e c o m p a n y as a t 31 J u ly 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3 .9 Com plete tra n sa ctio n analysis and show e ffe c t on n e t p r o fit/to ta l assets The a b rid g e d b a la n c e sheet fo r R oche Ltd a t 31 A u g u s t 2 0 1 6 w a s as fo llo w s : Assets
$
Liabilities and shareholders' equity
1 10 000
Accounts receivable
410000
Long-term loan
310000
Inventory
610000
Share capital
910000
Retained profits
250000
Prepayments Equipment Accumulated depreciation
80000
Accounts payable
$
Cash
210000
610000 140000 1 680000
1680000
The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g S e p te m b e r: a P aid $ 1 0 0 0 0 0 o f a cco u n ts p a y a b le , b
R eceived $ 3 0 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
c
P urchased in v e n to ry on c re d it fo r $ 2 0 0 0 0 0 .
d
M a d e c re d it sales o f $ 7 0 0 0 0 0 (C O G S w a s $ 4 5 0 0 0 0 ) .
e
A d m in is tra tiv e expe nses o f $ 3 0 0 0 0 w e re p a id in cash,
f
D e p re c ia tio n o f $ 1 0 0 0 0 w a s re c o g n is e d ,
g
P rep aym e nts o f $ 1 0 0 0 0 e x p ire d d u rin g th e m onth,
h
D iv id e n d s o f $ 2 0 0 0 0 w e re p a id ,
i
P aid b a c k $ 1 0 0 0 0 0 on th e lo a n ,
j
Issued a d d itio n a l shares w o rth $ 5 0 0 0 0 0 .
k
P aid th e w a g e s b ill o f $ 5 0 0 0 0 .
Required: 1 S h o w th e e ffe c t o f the a b o v e tra n sa ctio n s on th e a c c o u n tin g e q u a tio n . 2
P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n a n d d e te rm in e th e b a la n c e s o f the a cco u n ts.
3
W h a t is th e e ffe c t on net p ro fit a n d to ta l assets? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
PROBLEM 3.1 0 Transaction analysis The fo llo w in g tra n s a c tio n s p e rta in to R osew all Ltd fo r N o v e m b e r 2 0 1 5 . 1 The c o m p a n y w a s in c o rp o ra te d , w ith s h a re h o ld e rs in ve stin g $ 2 5 0 0 0 0 in cash . 2
P urchased $ 4 3 0 0 0 w o rth o f in v e n to ry on c re d it.
3
Rent o f $ 8 0 0 0 w a s p a id .
4
M a d e c re d it sales o f $ 1 1 0 0 0 0 (C O G S w a s $ 4 5 0 0 0 ).
5
R eceived th e $ 2 0 0 0 b ill fo r a n a d v e rtis in g c a m p a ig n to p ro m o te th e n e w c o m p a n y . This a m o u n t w ill be p a id in D e c e m b e r.
6
In ve n to ry w a s p u rc h a s e d fo r $ 2 7 0 0 0 cash .
7
P aid $ 3 0 0 0 0 o f a c co u n ts p a y a b le .
8 W a g e s o f $ 2 4 0 0 0 w e re p a id (w a g e s e xpe nse). 9
R eceived $ 4 5 0 0 0 fro m a c co u n ts re c e iv a b le .
1 0 Sales c o m m is sio n w a s p a id a t th e ra te o f 1 p e r c e n t o f to ta l m o n th ly sales. 11 P urchased n e w m a c h in e ry a t a cost o f $ 9 0 0 0 . O f this, $ 4 0 0 0 w a s p a id in cash w ith th e re m a in d e r to be p a id in 1 5 m o n th s' tim e. 12 O w e d e m p lo y e e s $ 3 5 0 0 in w a g e s a t th e e n d o f N o v e m b e r. 13 D e p re c ia tio n o n th e n e w e q u ip m e n t e q u a lle d $ 1 0 0 0 .
CHAPTER 3 The d o u b le -e n try system
125
14 Interest o f $ 6 0 0 0 is o w e d b y th e b a n k a t th e e n d o f N o v e m b e r. It w ill be re c e iv e d in J a n u a ry 2 0 1 6 . 15 R eceived $ 8 0 0 0 fro m a c lie n t. S ervices to th e c lie n t w ill be p ro v id e d in D e c e m b e r. 16 S evera l investors s o ld th e ir shares to o th e r investors. S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n sa ctio n s on th e a c c o u n tin g e q u a tio n .
PROBLEM 3.11 Examples o f tran sa ctio n s P ro v id e a n e x a m p le o f a tra n s a c tio n w h e re : 1 o n e asset in cre ases a n d a n o th e r asset de cre a se s
2
an asset in cre ases a n d a lia b ility in cre ases
3
an asset in cre ases a n d s h a re h o ld e rs ' e q u ity in cre ases
4
s h a re h o ld e rs ' e q u ity in cre ases a n d lia b ilitie s d e cre a s e
5
an asset d e cre a s e s a n d a lia b ility de cre ases
6 o n e lia b ility in cre ases a n d a n o th e r lia b ility de cre ases 7
an asset d e cre a s e s a n d s h a re h o ld e rs ' e q u ity d e cre ases.
PROBLEM 3.12 Transaction analysis - revenue and expenses UL starte d business on 1 July 2 0 1 6 , a n d h a d th e fo llo w in g tra n s a c tio n s o n 1 July: a Issued 3 0 0 0 0 0 shares o f $1 fo r $ 3 0 0 0 0 0 cash .
b
B o u g h t e q u ip m e n t fo r $ 2 0 0 0 0 0 , p a y in g cash . The e q u ip m e n t has a fiv e -y e a r life,
c
B o u g h t $ 5 0 0 0 0 w o rth o f in v e n to ry o n c re d it,
d
P aid $ 8 0 0 0 fo r a y e a r's rent on a b u ild in g .
e
T o o k o u t a tw o -y e a r $ 2 0 0 0 0 0 b a n k lo a n a t an in tere st ra te o f 1 0 p e r c e n t p e r a n n u m . The in tere st is not p a y a b le until th e e n d o f th e lo a n . B etw e en 1 July a n d 31 D e c e m b e r, th e fo llo w in g tra n s a c tio n s o c c u rre d :
f
S old in v e n to ry th a t c o st $ 3 0 0 0 0 fo r $ 7 0 0 0 0 . A ll sales w e re on c re d it,
g
P aid $ 4 0 0 0 0 to s u p p lie rs o f in v e n to ry fo r th e c re d it pu rch ases in p o in t (c), a b o v e ,
h
C o lle c te d $ 5 0 0 0 0 fro m custom ers,
i
P aid sa la rie s o f $ 1 0 0 0 0 .
j
R eceived $ 4 0 0 0 fo r a jo b to be c o m p le te d in F e b ru a ry 2 0 1 7 . O n 31 D e c e m b e r:
k
S a la rie s o f $ 3 0 0 0 w e re o w in g to staff.
I
O w e d $ 8 0 0 0 b y th e b a n k fo r interest.
For th e p e rio d 1 J u ly to 31 D e c e m b e r 2 0 1 6 : 1 List a ll revenues (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent. 2
List a ll expe nses (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent.
PROBLEM 3.13 Id e n tify in g a cco u n t title s B e lo w a re som e in d e p e n d e n t h y p o th e tic a l s itu a tio n s . 1 A c o m p a n y pa ys its s h a re h o ld e rs a $ 9 0 0 0 0 cash d iv id e n d . 2
A c o m p a n y b o rro w s $ 2 5 0 0 0 fro m th e lo c a l b a n k a n d sign s a six-m onth note fo r th e lo a n .
3
A c o m p a n y pu rch ases 5 0 0 o rd in a ry shares o f W o o lw o rth s Lim ited fo r $ 1 5 0 0 0 .
4
A c o m p a n y pu rch ases a b lo c k o f la n d fo r $ 4 0 0 0 0 0 cash . A n a p p ra is e r fo r th e b u y e r v a lu e d th e la n d a t $425 000.
5
A c o m p a n y bu ys th re e fa x m a ch in e s fo r o ffic e use, fo r w h ic h it sign s a no te p ro m is in g to p a y $ 1 5 0 0 w ith in six m onths.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6 A c o m p a n y signs a lease a g re e m e n t fo r a w a re h o u s e ; the rent is $ 1 5 0 0 0 p e r m o nth . U p o n s ig n in g the d o c u m e n t, th e re ta ile r p a ys $ 4 5 0 0 0 to th e o w n e r o f th e b u ild in g (assum e no s e cu rity d e p o sit).
7
A c o m p a n y pu rch ases a n e w d e liv e ry tru ck fo r $ 6 3 0 0 0 cash th a t has a list p ric e o f $ 6 9 0 0 0 .
8 A c o m p a n y a c q u ire s a p a te n t on a n e w d ig ita l te c h n o lo g y , p a y in g $ 3 0 0 0 0 0 cash a n d s ig n in g a $ 6 0 0 0 0 0 note p a y a b le d u e in tw o y e a rs . In d ic a te th e a p p ro p ria te a c c o u n t titles, if a n y , a ffe c te d b y e a ch o f th e events d e s c rib e d a b o v e . A n s w e r in term s o f ch a n g e s in a c c o u n t b a la n c e s (in c re a s e /d e c re a s e ). In clu de th e d o lla r a m o u n t.
PROBLEM 3.14 Id e n tify in g a cco u n t title s B e lo w a re som e tra n s a c tio n s fo r a re ta ile r. 1
The c o m p a n y o rd e rs 2 0 d is p la y stands fo r $ 3 0 0 e a c h , to be d e liv e re d n e xt m onth.
2
The c o m p a n y re p a y s $ 4 0 0 0 p rin c ip a l o n its lo a n (ig n o re interest).
3
The c o m p a n y sells 1 0 0 0 0 0 shares fo r $ 1 2 p e r sh a re to investors.
4
The c o m p a n y signs a c o n tra c t fo r c o n s tru c tio n o f a n e w re s id e n tia l b u ild in g fo r $ 6 0 0 0 0 0 a n d p a ys $ 5 0 0 0 0 as th e in itia l p a y m e n t fo r c o n s tru c tio n .
5
The c o m p a n y hires a n e w C F O . The C F O 's re m u n e ra tio n p a c k a g e in clu d e s s a la ry o f $ 3 0 0 0 0 0 p e r a n n u m plus s u p e ra n n u a tio n . The C F O starts w o rk in tw o m o n th s' tim e.
6 The c o m p a n y p u rch ases a w e ll-e s ta b lis h e d b ra n d na m e fo r $ 1 7 0 0 0 0 cash . In d ic a te th e a p p ro p ria te a c c o u n t titles, if a n y , a ffe c te d b y e a ch o f th e events d e s c rib e d a b o v e . A n s w e r in term s o f ch a n g e s in a c c o u n t b a la n c e s (in c re a s e /d e c re a s e ). In clu de th e d o lla r a m o u n t.
PROBLEM 3.15 N orm al balances o f accounts W h a t w o u ld be th e n o rm a l b a la n c e (DR o r CR) fo r e a ch o f th e fo llo w in g a c c o u n t titles? 1 A c co u n ts re c e iv a b le 2
A c co u n ts p a y a b le
3
In ve n to ry
4
P rovision fo r e m p lo y e e en titlem en ts
5
Taxes p a y a b le
6
R eta in ed p ro fits
7
S h a re c a p ita l
8
Investm ents
9
P lant a n d e q u ip m e n t
1 0 A c c ru e d expe nses 11 P rep aym e nts
PROBLEM 3.16 A cco u n t cla ssifica tio n and D r/C r rules Select H arvests Lim ited is a n a g ric u ltu ra l c o m p a n y , th e c o re o p e ra tio n s o f w h ic h in vo lv e o rc h a rd d e v e lo p m e n t a n d , o rc h a rd m a n a g e m e n t, as w e ll as s u p p ly o f a lm o n d s to th e A u s tra lia n a n d o ve rse a s m arkets. The fo llo w in g a re a c co u n ts fro m a b a la n c e sheet fo r th e y e a r e n d e d 3 0 June 2 0 1 4 o f S elect H arvests Lim ited. 1 P rop erty, p la n t a n d e q u ip m e n t
2
In tere st-b earing lia b ilitie s (long-term )
3
In ve nto ries
4
R eta in ed p ro fits
5
C a s h a n d cash e q u iv a le n ts
6
P rovisions (long-term )
7
C u rre n t ta x lia b ilitie s
CHAPTER 3 The d o u b le -e n try system
127
8 T ra d e a n d o th e r re c e iva b le s 9
In ta n g ib le assets
1 0 T ra d e a n d o th e r p a y a b le s (short-term ) 11 B io lo g ic a l assets - a lm o n d trees 12 C o n trib u te d e q u ity . For e a ch a c c o u n t, in d ic a te h o w it n o rm a lly sh o u ld be c a te g o ris e d on a c la s s ifie d b a la n c e sheet. A ls o s h o w w h e th e r th e a c c o u n t n o rm a lly has a d e b it (DR) o r c re d it b a la n c e (CR).
PROBLEM 3.17 Id e n tify d e b it and cre d it balances, and prepare a balance sheet BM L P roducts Ltd m a n u fa c tu re s a n d sells c h ild re n 's to ys. H e re a re th e c o m p a n y 's b a la n c e sheet a cco u n ts as a t 3 0 June 2 0 1 6 , in a lp h a b e tic a l o rd e r.
s1
$ Accumulated depreciation
63 700
Owing from customers
Bank account balance
14 300
Owing to suppliers
21 900
Retained earnings
47500
Share capital issued
25 000
Bank loan Building Cash on hand
21 200 102 10 0
Short-term part of mortgage
8 000
600
Unpaid employee wages
1 800
Fixtures and equipment
37900
Unsold finished products
29600
Land
48 000
Unused office supplies
Long-term part of mortgage owing
71 000
Unused product raw materials
Employees' tax not yet remitted
2 500
6 200
1 400 18 700
1
D e c id e w h ic h a c co u n ts h a ve d e b it b a la n c e s a n d w h ic h h a ve c re d it b a la n c e s . A c c o rd in g to th e c o m p a n y 's a c c o u n tin g system , to ta l d e b its = to ta l c re d its = $ 2 6 0 7 0 0 .
2
Based on y o u r a n s w e r to q u e s tio n 1, p re p a re th e c o m p a n y 's 3 0 June 2 0 1 6 b a la n c e sheet fro m th e a b o v e a c co u n ts.
3
R ew rite th e b a la n c e sheet using a c c o u n t titles th a t y o u a re m o re lik e ly to see in a c tu a l fin a n c ia l statem ents.
4
C o m m e n t b rie fly on th e c o m p a n y 's fin a n c ia l c o n d itio n , as s h o w n b y the b a la n c e sheet.
PROBLEM 3.1 8 Explain and w rite entries For changes in account balances H e re a re som e a c c o u n t ch a n g e s th a t h a ve o c c u rre d to Lotus Ltd. For e a ch o f th e item s, w rite in a fe w w o rd s w h a t w o u ld h a ve c a u s e d th e c h a n g e s a n d w rite a jo u rn a l e n try to a c c o u n t fo r them . 1 C a s h up $ 1 0 0 0 0 ; s e rvice reven ue up $ 1 0 0 0 0 . 2
W a g e s e x p e n s e up $ 8 0 0 0 ; cash d o w n $ 1 0 0 0 0 ; w a g e s p a y a b le d o w n $ 2 0 0 0 .
3
A c c o u n ts p a y a b le d o w n $ 3 2 2 0 , cash d o w n $ 3 2 2 0 .
4
In co m e ta x e x p e n s e up $ 5 9 0 0 , cash d o w n $ 5 0 0 0 , in co m e ta x p a y a b le up $ 9 0 0 .
5
C a s h up $ 3 5 0 , c u sto m e r d e p o s its lia b ility up $ 3 5 0 .
6 A u d itin g e x p e n s e up $ 3 0 0 0 , a c co u n ts p a y a b le up $ 2 4 0 0 , cash d o w n $ 6 0 0 . 7
E q u ip m e n t up $ 5 2 0 0 , s h a re c a p ita l up $ 5 2 0 0 .
8 C a s h up $ 2 4 0 0 , a c co u n ts re c e iv a b le up $ 6 6 0 0 , reven ue up $ 9 0 0 0 , in v e n to ry d o w n $ 5 5 0 0 , C O G S exp e n se up $ 5 5 0 0 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3.19 Prepare sim ple jo u rn a l entries P re p a re jo u rn a l en trie s fo r th e fo llo w in g tra n s a c tio n s in June 2 0 1 6 . 1 B o rro w e d $ 1 0 0 0 0 0 cash fro m th e b a n k a n d s ig n e d a note d u e in tw o ye a rs . 2
P urchased in v e n to ry c o s tin g $ 1 5 0 0 0 on c re d it.
3
S old in v e n to ry c o stin g $ 1 2 0 0 0 to custom ers fo r $ 2 0 0 0 0 on a c co u n t.
4
R eceived a $ 5 0 0 0 d e p o s it o n a re n ta l p ro p e rty to be re n te d fo r th e m onth o f J a n u a ry 2 0 1 7 .
5
R eceived $ 1 0 0 0 0 fro m a c u sto m e r in q u e s tio n 3 .
PROBLEM 3 .2 0 Prepare jo u rn a l entries DRAGONS LTD BALANCE SHEET AS AT 3 0 JUNE 20 15
D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , th e fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's ac co u n ts: 1 C re d it sales, $ 2 0 0 0 0 0 . 2
C a s h sales, $ 6 0 0 0 .
3
C o lle c tio n s fro m custom ers, $ 1 5 0 0 0 0 .
4
Purchases o f in v e n to ry on c re d it, $ 7 0 0 0 0 .
5
Paym ents o f a cco u n ts p a y a b le , $ 5 0 0 0 0 .
6 C o s t o f g o o d s so ld , $ 8 0 0 0 0 . 7
W a g e s ex p e n s e , $ 9 0 0 0 0 , n o t y e t p a id .
8 W a g e s p a id , $ 2 2 0 0 0 . 9
P aid ta x p a y a b le , $ 6 0 0 0 .
1 0 C a s h d iv id e n d s o f $ 2 0 0 0 0 , d e c la re d a n d p a id . P rep are jo u rn a l en trie s, an in co m e state m e nt fo r th e y e a r e n d e d 3 0 June 2 0 1 6 a n d a b a la n c e sheet as a t 3 0 June 2016.
PROBLEM 3.21 Prepare a s ta te m e n t o f reta in e d p ro fits The a c co u n ts fo r A u s tra lia n RST Lim ited fo r 3 0 June 2 0 1 6 in c lu d e d th e fo llo w in g (in a lp h a b e tic a l o rd e r):
$000 Dividends declared
49444
DR
Income tax expense
571
DR
Operating profit before tax
58 884
CR
Retained profits, beginning of year
35 697
CR
P rep are a state m e nt s h o w in g c lo s in g re ta in e d p ro fits.
CHAPTER 3 The d o u b le -e n try system
129
PROBLEM 3 .2 2 Retained p ro fits The a c co u n ts fo r P rentice R etail Ltd fo r last y e a r in c lu d e d th e fo llo w in g (in a lp h a b e tic a l o rd e r):
$ Dividends declared
87000
Income tax expense
145210
DR
23 570
CR
Miscellaneous revenue from investments Operating expenses
1 703470
DR
354290
CR
2 111 480
CR
Retained profits, beginning of year Revenue from sales
DR
C a lc u la te net p ro fit, a n d p re p a re a no te to s h o w th e c h a n g e in re ta in e d p ro fits fo r th e y e a r.
PROBLEM 3 .2 3 Cash balance and accrual acco u n tin g p ro fit U sing th e fo llo w in g in fo rm a tio n fo r D a v id T ours, c a lc u la te : 1 th e cash in b a n k as a t th e e n d o f 2 0 1 6
2 th e 2 0 1 6 a c c ru a l a c c o u n tin g p ro fit.
s Owing from customers as at the end of 2015 (collected in 2016)
1 000
Owing from customers as at the end of 201 6 (collected in 201 7)
850
Cash collected from customers during 2016 for 2016 trips
68 990
Payable to suppliers as at the end of 2015 (paid in 2016)
1 480
Cash paid to suppliers during 2016 for 2016 expenses
36910
Payable to suppliers as at the end of 2016 (payable in 2017)
2 650
Depreciation on equipment during 2016
3 740
Cash in bank as at the end of 2015
1 2430
PROBLEM 3 .2 4 R econciliation o f cash p ro fit and accrual p ro fit Turku S ervices C o m p a n y h a d a cash p ro fit fo r its first y e a r in business o f $ 6 7 4 5 0 a n d an a c c ru a l p ro fit o f $ 4 9 8 6 0 . S h o w h o w th e tw o am ou nts re c o n c ile , using th e fo llo w in g in fo rm a tio n : 1 U n c o lle c te d reven ue a t th e e n d o f th e y e a r w a s $ 1 8 7 3 0 . 2
U n p a id b ills fo r expe nses a t th e e n d o f th e y e a r to ta lle d $ 2 4 8 8 0 .
3
Expenses fo r th e n e xt y e a r, p a id a lre a d y , to ta lle d $ 2 3 0 0 .
4
D e p re c ia tio n o n th e c o m p a n y 's e q u ip m e n t w a s $1 3 7 4 0 fo r th e y e a r.
PROBLEM 3 .2 5 C alculate accrual p ro fit and change in cash 'I just d o n 't u n d e rsta n d it!' B a rry h a d re c e ive d his a c c o u n ta n t's c a lc u la tio n o f his business p ro fit, s h o w in g a n a c c ru a l p ro fit fo r his firs t y e a r in business o f $ 4 5 2 9 0 . 'If I m a d e so m uch m o n e y, w h y d o n 't I h a ve it in th e b a n k ? M y b a n k a c c o u n t show s o n ly $ 1 5 0 4 0 on h a n d !'
130
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
B a rry o p e ra te s B a rry S u p p ly , w h ic h p ro v id e s s ta tio n e ry a n d o ffic e su p p lie s to business custom ers. H e has no store, just a sm all re n te d w a re h o u s e , a n d o n ly o n e e m p lo y e e . H e re a re th e d a ta th a t B a rry a n d his a c c o u n ta n t used. E x p la in c le a rly to B a rry : 1
H o w th e a c c o u n ta n t c a lc u la te d th e $ 4 5 2 9 0 p ro fit.
2
W h y th e re is o n ly $ 1 5 0 4 0 on h a n d .
Collected from customers during the year
143 710
Still owing from customers at the end of the year (collected next year) Paid for products to resell and for other expenses, including wages, during the year
15 220 128 670
Owing for products and other expenses at the end of the year (paid next year)
9 040
Cost of unsold products on hand at the end of the year (all sold next year)
26 070
Depreciation on equipment during the year
2 000
PROBLEM 3 .2 6 Prepare Financial sta te m e n ts From accounts
»
$ Salaries expense
71 000
DR
Dividends declared
1 1000
DR
2 800
CR
Accumulated depreciation
94000
CR
Land
63 000
DR
Cash at bank
18 000
DR
Employee benefits expense
13 100
DR
Income tax expense
6900
DR
5 400
CR
Credit sales revenue
346200
CR
Income tax payable
Tax deductions payable Accounts receivable
1 6400
DR
Inventory on hand
68 000
DR
Cash sales revenue
21 600
CR
Prepaid insurance
2 400
DR
Dividends payable
5 500
CR
Beginning retained profits
92 800
CR
26 700
DR
Accounts payable
41 000
CR
Cost of goods sold
161 600
DR
Interest revenue
1 700
CR
Insurance expense
11 200
DR
Building
243 000
DR
200000
CR
Trucks and equipment
182500
DR
31 100
DR
Salaries payable
4100
CR
114000
CR
Miscellaneous expenses
8 200
DR
21 800
CR
Interest expense
16 800
DR
Depreciation expense
Share capital Office expenses Mortgage payable Bank loan owing
1
Look a t th e list o f a c co u n ts (in no p a rtic u la r o rd e r) o f G e e w h iz P rod uctio ns a t 3 0 N o v e m b e r 2 0 1 5 a n d d e c id e w h ic h ones a re in co m e state m e nt acco un ts.
2
C a lc u la te net p ro fit b a se d o n y o u r a n s w e r to q u e s tio n 1.
3
C a lc u la te e n d in g re ta in e d p ro fits b a se d on y o u r a n s w e r to q u e s tio n 2 .
4
5
P re p a re th e fo llo w in g fin a n c ia l statem ents, d e m o n s tra tin g th a t y o u r a n sw e rs to q u e s tio n s 2 a n d 3 a re c o rre c t, a
In co m e state m e nt fo r th e y e a r e n d e d 3 0 N o v e m b e r 2 0 1 5 .
b
A note c a lc u la tin g re ta in e d p ro fits fo r th e y e a r e n d e d o n th a t d a te ,
c
B a la n c e sheet a t 3 0 N o v e m b e r 2 0 1 5 .
C o m m e n t b rie fly o n w h a t th e fin a n c ia l statem ents s h o w a b o u t th e c o m p a n y 's p e rfo rm a n c e fo r 2 0 1 5 , a n d its fin a n c ia l p o s itio n a t 3 0 N o v e m b e r 2 0 1 5 .
CHAPTER 3 The d o u b le -e n try system
131
PROBLEM 3 .2 7 P ro fit and loss sm o o th in g and ethics In co m e (p ro fit) s m o o th in g is a w a y o f m a n ip u la tin g a c o m p a n y 's net p ro fit in o rd e r to c re a te a d e s ire d im p re ss io n o f m a n a g e m e n t's c a p a b ility a n d p e rfo rm a n c e . O th e r kind s o f p ro fit m a n ip u la tio n b y m a n a g e m e n t h a ve a lso been a lle g e d . D o y o u th in k it is e th ic a l fo r m a n a g e m e n t to m a n ip u la te th e fig u re s b y w h ic h its p e rfo rm a n c e is m easure d? W h y o r w h y not?
CASES CASE 3A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 W h a t p e rio d is c o v e re d b y th e in c o m e statem ent? 2
List th e m a in type s o f revenues.
3
List som e o f th e la rg e r expe nses in c u rre d in e a rn in g reven ue .
4
W h a t a re in tere st e x p e n s e a n d in tere st re ven ue fo r th e y e a r?
5
W h a t is c o st o f g o o d s s o ld fo r th e y e a r?
6
W h a t is to ta l d e p re c ia tio n a n d a m o rtis a tio n fo r th e y e a r?
7
E x p la in th e c h a n g e in re ta in e d p ro fits fro m 2 0 1 3 to 2 0 1 4 .
8 W h a t is in c o m e ta x e x p e n s e fo r th e y e a r? 9
W h a t a re th e b a s ic e a rn in g s p e r s h a re fo r 2 0 1 4 ?
1 0 W h a t w o u ld be th e n o rm a l b a la n c e (DR o r CR) o f e a ch o f th e fo llo w in g a c co u n ts in c lu d e d in th e W o o lw o rth s Lim ited b a la n c e sheet o r th e re le v a n t notes: tra d e d e b to rs , in v e n to ry , investm ents, la n d a n d b u ild in g s , a d v a n c e s to e m p lo y e e s , tra d e c re d ito rs , p ro v is io n fo r in c o m e ta x , p ro v is io n fo r d iv id e n d s a n d re ta in e d pro fits? 11 In W o o lw o rth s ' 2 0 1 4 b a la n c e sheet, w h a t w o u ld be th e n o rm a l b a la n c e (d e b it o r c re d it) fo r in ve n to rie s , re c e iv a b le s , in ta n g ib le s , a c co u n ts p a y a b le a n d re ta in e d p ro fit?
CASE 3B_______________________ Financial reporting on the internet This b o o k m e ntion s th e w e b p a g e s fo r m a n y c o m p a n ie s . In cre a s in g ly , c o rp o ra tio n s a n d o th e r o rg a n is a tio n s a re p u ttin g o u t d e ta ile d in fo rm a tio n a b o u t them selves on th e in te rn e t. But h o w g o o d is th a t in fo rm a tio n ? Is it e a s y to fin d in th e c o m p a n y 's w e b m a te ria l? Is it up to d a te ? Is it d is p la y e d usefully? C a n it be d o w n lo a d e d e a s ily ? This is a case y o u c a n c o n s tru c t fo r y o u rs e lf, a n d discuss in class e ith e r b y c o m p a rin g v a rio u s c o m p a n ie s o r b y c o m p a rin g v a rio u s p e o p le 's re a ctio n s to th e sam e c o m p a n y . Pick a c o m p a n y th a t interests y o u o r th a t is a s s ig n e d b y y o u r in stru cto r. G o to its w e b s ite a n d see w h a t is th ere re g a rd in g th e c o m p a n y 's fin a n c ia l statem ents. If y o u d o n 't k n o w th e c o m p a n y 's w e b a d d re ss , ty p e th e c o m p a n y na m e in to y o u r search e n g in e a n d y o u 'll lik e ly g e t to it e a s ily . O n c e y o u g e t to th e c o m p a n y 's w e b p a g e , s ta rt y o u r e x a m in a tio n a n d c o n s id e r q u e s tio n s such as th ose b e lo w , w h ic h c o u ld be a d d re s s e d in a re p o rt o r in a class discu ssio n : 1
H o w a ttra c tiv e a n d us e r-frie n d ly is th e in itia l w e b p a g e ? Does it c o n c e n tra te on m a rk e tin g th e c o m p a n y 's p ro d u cts , p ro v id in g g e n e ra l in fo rm a tio n , te llin g y o u a b o u t re c e n t m e d ia a tte n tio n d ire c te d to w a rd s th e c o m p a n y , o r o th e r pu rpo se s?
2
H o w e a s y is it to fin d th e c o m p a n y 's fin a n c ia l in fo rm a tio n , if it is th e re a t a ll? (M a n y w e b p a g e s d ire c t y o u to 'In v e s to r in fo rm a tio n ' o r som e such a re a fo r fin a n c ia l in fo rm a tio n , others s p e c ify th e fin a n c ia l rep orts d ire c tly , w h ile others m a ke it q u ite h a rd to fin d .)
3
H o w m uch do es th e c o m p a n y tell y o u a b o u t itself to h e lp y o u p u t th e fin a n c ia l in fo rm a tio n in co n te xt? C a n y o u e a s ily re la te th e b a c k g ro u n d to th e fin a n c ia l m a te ria l, o r d o y o u h a ve to ju m p a ll o v e r th e w e b s ite to fin d it a ll?
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4
H o w useful d o y o u fin d th e fin a n c ia l statem ents to be? A re th e y up to d a te , a re th e y a n a ly s e d o r c o m m e n te d u p o n b y th e c o m p a n y , a n d a re th e y re la te d to recen t events a ffe c tin g th e c o m p a n y o r just p lu n k e d on th e w e b as is? (You c o u ld lo o k fo r a m a n a g e m e n t disc u s sio n a n d a n a lys is section if th e b a la n c e sheet is just in c lu d e d in the c o m p a n y 's c u rre n t a n n u a l re p o rt, po ste d as is on the w e b .)
5
A re th e b a la n c e sheet, in c o m e state m e nt a n d s u p p o rtin g m a te ria l e a s y to d o w n lo a d a n d / o r p rin t? W o u ld th e y be re a d ily a v a ila b le fo r in se rtio n in an a n a lys is o f th e c o m p a n y ?
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APPENDIX TO CHAPTER 3
A brief history of early accounting W ith the o ve rvie w o f the double-entry accounting system taken ca re of, w e can n o w pro vid e a historical review , because understanding h o w w e g o t to w h e re w e are helps in understanding w h y w e d o w h a t w e d o n o w (and h o w to d o it). Financial accounting is an ancient inform ation system, w ith m any of its ideas o rig in a tin g hundreds of years a g o . Like other co m p le x human inventions, fin a n cia l accounting d id not just a p p e a r one d a y fully form ed. It has deve lo p e d over thousands o f years a nd has been thoroughly intertw ined w ith the developm ent o f civilisation. A science w riter, quoting a b re w e ry ow n e r, had this to say on the to p ic o f accounting a n d beer: Whatever the reason, [the early farmers in Mesopotamia] grew grain [and] ‘if you have grain, you need storehouses; if you have storehouses, you need accountants; if you have accountants, bang - you’re on the road to civilisation’ (or the world’s frst audit).
O u r focus here is on a ccounting, not on history. N evertheless, the past has a bearing on a ccounting, in that accounting evolves as business, governm ent a nd other institutions in society evolve. As the needs for inform ation chan g e, accounting changes to meet those needs. A ccounting's evolution is not a lw a ys smooth, a n d not a lw ays efficient. A t a n y given time there a re aspects o f accounting that m ay not seem to fit current needs w e ll, but over time w e can expect that accounting w ill, as it has in the past, meet those needs if they persist. W h e n com m erce consisted m ainly o f trading a m ong fam ilies o r tribal units, inform ation dem ands w e re not c o m p lica te d . M o n e y had not been invented, so even the sim ple fin a n cia l reports you s a w in C h a p te r l could not have been prepared. People w o u ld w a n t to kn o w w h a t they had on hand, a nd w o u ld need some sort of docum entation to a cco m p a n y shipments, so that they an d their customers w o u ld a g re e on w h a t w a s being tra d e d . To meet such needs, accounting began as sim ple list-making. Lists o f the fam ily's o r tribe's resources w e re particularly im portant a n d , later, lists o f debts to other tribes o r fam ilies. Later still, as com m ercial activities becam e m ore com plex, fam ilies b egan to e m p lo y others to run aspects of their businesses an d began also to create large business units w ith several locations. A ccounting also had to becom e m ore com plex, p ro vid in g records that could be used to m onitor the activities o f em ployees a nd businesses in far-flung locations. People found that they needed to be a b le to verify w h a t em ployees an d traders said w a s h a p p e n in g . Because o f these needs, the practice o f having systematic records that could be a u dited later w a s begun. To help you understand h o w present-day fin a n cia l accounting concepts a n d techniques arose, w e start w ith a brief history taking us from a b o u t 4 5 0 0 BC in M e s o p o ta m ia to the early 1 8 0 0 s in England. W e then cover the tw o succeeding centuries, brin g in g the history up to the present. Keep in mind that the purpose o f this review is to help you understand a ccounting, not to explain general history. Because m odern accrual a ccounting, as practised in A ustralia a nd much o f the rest o f the w o rld , has its roots in the developm ent o f W estern civilisation, our review o f accounting history is oriented to that developm ent. The interesting stories o f the developm ent o f accounting in other parts o f the w o rld , such as C h in a , India a nd A frica , are therefore not included. The comments b e lo w are necessarily brief. If you w o u ld like to read further, some reading suggestions on accounting history are pro vid e d a t the end o f the a p p e n d ix .2
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A3.1
Mesopotamia to Rome: 4500 BC to AD 400
For a society to de m a n d acco u n tin g , it must have active trade an d com m erce, a basic level o f w ritin g , methods of measuring and ca lcu la tin g , a nd a medium o f e xchange or currency.3 The earliest known civilisation w ith an active record-keeping system flourished in M e so p o ta m ia (n o w Iraq a nd Syria). G e n e ra lly, a com m on la n g u a g e (such as B abylonian) existed for business, a nd there w a s also a g o o d system o f numbers an d currency, a nd record-keeping using c la y tablets. As fa r as w e know , o rd in a ry merchants an d general traders d id not keep o fficia l records. O ffic ia ls o f the governm ent a n d religious leaders o f the temples d e c id e d w h a t records w e re to be m aintained for o fficia l purposes, and scribes d id the record-keeping. A scribe w a s a p p re n tice d for m any years to master the craft o f recording taxes, customs duties, tem ple offerings an d trade betw een governments an d tem ples. Records consisted o f counts a nd lists of grain, cattle and other resources, an d o f o b lig a tio n s arising from trade. W e can still see that to d a y: the b a la n ce sheet o f a n y enterprise includes items such as unsold products a n d equipm ent, a nd trade o b lig a tio n s such as am ounts due from customers a nd due to suppliers. All these figures are summaries supported by d e ta ile d lists. W h e n a scribe determ ined that a particular record w a s com plete a nd correct, the scribe's seal w a s pressed into a c la y tablet to certify that this w a s so, an d the tablet w a s baked to prevent alteration. The scribe w a s a forerunner of today's accountants a nd auditors. (H ow ever, to d a y's auditors d o not use seals; instead, they sign an a u d it report to indicate that the fin a n cia l statements a re fa irly presented.) This scribe-based form o f record-keeping w a s used for m any years, spreading across lands an d tim e to Egypt, G re e ce a nd Rome. M e d ia other than c la y tablets, such as papyrus, w e re used as tim e passed.5 (Do you suppose p e o p le accustom ed to c la y tablets w o u ld have resisted the introduction o f papyrus, just as some p e o p le accustom ed to pencil an d p a p e r resisted the introduction o f computers for accounting?) Trade and com m erce g re w over thousands o f years, from small fa m ily operations to very large activities involving kings, religious leaders a n d various levels o f governm ent. For exam ple, as G re e k civilisation spread a nd then the Roman Empire e xp a n de d greatly, adm inistrative regions w e re o rganised in conquered lands in o rd e r to sim plify governing them. These regions w e re m anaged by local adm inistrators o r governors, w h o generally could neither read nor w rite. W h e n accounting o f their m anagem ent w a s required, an o fficia l o f the central governm ent w o u ld com e out and listen to an oral report. This event w a s, therefore, a 'h e a rin g ', a n d the listening o fficia l w a s there to 'a u d it' (from the Latin w o rd for 'h e a r'). Today, the person w h o comes to inspect an d a p p ro ve the fin a n cia l statements o f an enterprise is calle d an auditor, though a lot m ore goes on to d a y than just listening.
A3.2 The Middle Ages to the Renaissance: AD 4 0 0 -5 0 0 W ith the fall o f the Roman Empire in a b o u t the fifth century A D , both trade an d associated record-keeping becam e stagnant in Europe, though activities still continued in C onstantinople, the M id d le East, India, C h in a an d elsewhere. In Europe, a greater stimulus to trade b egan w ith the p eriod of the C rusades, around the eleventh century, w hen kings and princes could not themselves pro vid e the material to support their retinues o f crusaders bound for the H o ly Land. This w a s a prosperous time for the lesser nobles a nd private merchants, w h o supplied the crusaders from ports such as Venice. A shift o f supply an d e conom ic p o w e r from governments to the private sector b e gan, a nd large merchant banks deve lo p e d , such as those of the M e d ic i in Florence. These banks becam e heavily involved in the businesses and governments they helped to finance. Because o f all these activities, a m ore exact system of record-keeping w a s d e ve lo p e d in ord e r to keep track of materials supplied, cash received a nd spent a n d , especially, w h o o w e d w hom h o w much m oney.6 For the traders, merchants and bankers, the stimulus pro vid e d by the C rusades set record-keeping o ff in a m ore o rganised and systematic direction. The n e w direction w a s m ade possible also by refinements in the use o f numbers an d arithm etic
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that had taken p la ce in A ra b countries during Europe's M id d le A ges. The num ber system w e use in accounting an d in our d a ily lives o rig in a te d from these refinements. The exact w a y in w h ich accounting or, m ore precisely, the record-keeping basis o f accounting w e call bookkeeping, evolved during this busy time is a subject o f d e b a te am ong accounting historians. A m ajor event, how ever, w a s the publication in 14 9 4 of a treatise on 'double-entry' b o okkeeping b y Friar Pacioli o f Venice. In the book, he referred to the method as an established procedure that had been in use in the M e d ic i banks o f Italy an d in other businesses for some time. Pacioli's b o o k w a s an im portant contribution to the kn o w le d g e of a lg e b ra and arithm etic, a nd o f value sp e cifica lly because o f its deta ile d description an d c o d ifica tio n o f the double-entry system. It w a s ra p id ly translated into all the m ajor European languages an d , using these translations, European scholars extended Pacioli's ideas.
D o u b le -e n try bookkeeping Pacioli's concepts w e re revolutionary but sound: they form the fundam ental basis of m odem fin a n cia l accounting, provid in g a method of pulling together all the lists o f resources a nd o b lig a tio n s in a w a y that helps to prevent errors. The id e a is that each trade o r other com m ercial transaction is recorded (entered) tw ice , hence the descriptor 'double-entry': •
o n ce to recognise the resource involved in the transaction
•
o n ce to recognise the source o r effect o f that resource change. Instead o f the disconnected lists that existed before double-entry bookkeeping w a s invented, the lists of resources
and sources w e re n o w connected to each other. N o w a b a la n ce sheet o f the modern kind could be prepared. Double-entry b o o kkeeping, w h ich m ight be seen as a pretty humdrum sort o f activity, turns out to have a solid conceptual basis an d a long a nd im portant history. If a d o lla r am ount (or an am ount in a n y other medium o f e xch a n g e - pounds, francs, yen, marks an d so on) can be assigned to each transaction, that am ount can be used to record both the resources an d sources sides o f each. Then, by a d d in g up all the resources amounts a nd all the sources amounts, the tw o sides a ct as a check on each other. If errors are m ade, they are likely to be found because the tw o sides w ill not a d d up to the sam e amount. If they d o a d d up, w e say they 'b a la n c e '. H ence, the 'b a la n c e sheet', w h ich shows that the tw o sides d o a d d up. The record-keeping system Pacioli described to the w o rld is one o f the most far-reaching o f human inventions.
A3.3
Britain: 1500 to the early 1800s
Before Pacioli, English record-keeping had much in com m on w ith Roman methods used hundreds o f years earlier. 'S tew ards' w e re e m ployed to m anage the properties o f the English aristocracy, much as local governors had been in Roman-held areas. In 1 3 0 0 , O x fo rd University offered an accounting course: Roman record-keeping for stew ards.7 The co n ce p t o f stew ardship - o f a person m a naging som ething on behalf o f som eone else - is still an im portant aspect o f acco u n tin g . It is often said, for exam ple, that an enterprise's fin a n cia l statements dem onstrate the q u a lity of m anagem ent's stew ardship o f the enterprise on b ehalf of its ow ners. In the several hundred years after Pacioli's treatise, accounting d e ve lo p e d to suit the social an d business circumstances o f each country. France, for exam ple, had a strong, centralised governm ent a nd d e ve lo p e d a national accounting system w ritten b y a central bo a rd o f adm inistrators. O n the other hand, England (w hich in com bination w ith its neighbours becam e G re a t Britain) had less governm ent involvem ent in com m erce an d trade, a nd a smaller civil service, an d relied m ore heavily on the initiatives o f the private sector a nd the courts.8 The fin a n cia l accounting system n o w used in A ustralia, N e w Z e a la n d , the United Kingdom , C a n a d a , the United States a nd m any other countries relies heavily on the precedents set in England during this p e riod. The English a p p ro a ch used Pacioli's double-entry system for record-keeping a nd built the fin a n cia l statements' reporting system on that. O th e r countries, including A ustralia, have d e ve lo p e d that further.
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Financial accounting in continental Europe d e ve lo p e d on a som ew hat different path, as it d id in Russia, C hina, Japan and m any other countries. H ow ever, the B ritish-A m erican-A ustralian a p p ro a ch is still g a in in g popularity w o rld w id e ; for exam ple, C h in a a d o p te d it for much of its fin a n cia l reporting in the early 1 9 9 0 s . Efforts are being m ade w o rld w id e to 'harm onise' fin a n cia l accounting to assist international trade, an d the sort o f fin a n cia l accounting set out in this b o o k seems likely to becom e the international standard.
FOR YOUR INTEREST J o h n C r o a k e r ( 1 7 8 8 - 1 8 2 4 ) w as an E n g lis h -b o rn
b a n k c le rk w h o w as c o n v ic te d o f e m b e z z le m e n t and
s e n te n c e d t o tra n s p o rta tio n f o r 14 y e a rs to th e c o lo n y o f N e w S o u th W a le s . H e w as g ra n te d an im m e d ia te t ic k e t o f leave b y G o v e r n o r M a c q u a rie and w as e m p lo y e d as a c le rk in th e ju d ic ia r y . H is a rriva l in N e w S o u th W a le s c o in c id e d w ith th e e s ta b lis h m e n t o f th e B a n k o f N e w S o u th W a le s (n o w k n o w n as W e s tp a c ), and C ro a k e r s e t up its b o o k k e e p in g p ro c e d u re s a c c o rd in g to th e s y s te m o f d o u b le e n try . N o t o n ly d id he in tr o d u c e d o u b le - e n tr y b o o k k e e p in g t o th e b a n k b u t ‘th e r e are g o o d re a so n s f o r b e lie v in g th a t he in tro d u c e d th e s y s te m t o th e c o lo n y as a w h o le ’. Source: J. Booker and R. Craig, John Croaker: Convict Embezzler, M elbourne University Press, 2 0 0 0 , p. 19.
Until the m id -1 6 0 0 s , accounting a nd record-keeping (bookkeeping) w e re largely synonym ous. Records w e re a private matter for the attention o f the lord, m erchant or banker. But then a sig n ifica n t developm ent occurred: the advent o f com panies that sold shares o f o w n e rsh ip to private citizens. These citizens could not all c ro w d into the com pany's o ffice to inspect the records, even if they could understand them. This produced a dem and for some form o f reporting to the shareholders; for fin a n cia l statements that could be relied on as accurate summaries o f the records. There w a s a dem and that the b a la n ce sheet be m ore deta ile d in its description o f the ow ners' equity an d the changes in it than had been necessary before there had been such dispersed ow nership. There w a s even some dem and for regulation o f such reports. For exam ple, in 1 6 5 7 O liv e r C ro m w e ll, as Regent o f England, requested that the East India C o m p a n y publish its b a la n ce sheet.9 A ccounting w a s on its w a y to d e ve lo p in g the standards o f calculation and disclosure that are very im portant in m odern accounting a nd distinguish accounting from the underlying practice of record-keeping. Progress in this direction w a s not ra p id , but it g a in e d momentum w ith the Industrial Revolution. The d e velopin g Industrial Revolution o f the late 1 7 0 0 s a nd early 1 8 0 0 s helped to fuel the em erging com m ercial sector of Britain, a nd accounting practices becam e an im portant part o f this. In 1 8 2 5 , the British Parliament eased hundred-year-old prohibitions on trading shares in com panies, a nd the modern era o f share markets a nd publicly o w n e d com panies b egan in earnest. A fe w years later, Parliament required annual audits o f the b a la n ce sheets of such com panies. A ccounting a nd aud itin g continued to d e ve lo p in response to the c h a n g in g needs o f the society of w hich they w e re a part. From then on, accounting's emphasis shifted from record-keeping to the ch o ice of accounting method, professional ethics an d the various standards a nd law s governing fin a n cia l reporting a nd fin a n cia l disclosure.
A3.4
Financial accounting's recent history
D evelopm ents in the nin etee nth ce ntu ry10 Until the early 1 8 0 0 s , most business enterprises w e re form ed for specific ventures, w e re fin a n ce d by a fe w w e a lth y ow ners and w e re d isb a n d e d w hen the ventures w e re com pleted. The sharing o f profits am ong the ow ners o f the enterprise o r venture to o k p la ce a t the end, w hen all the assets w e re sold, the liabilities w e re p a id o ff a nd the net am ount rem aining w a s then distributed. As industrialisation increased, large industrial plants began replacing
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short-term ventures as the m ajor form of business enterprise, a n d the traditional method o f fin a n cin g a nd profit-sharing w a s no longer a cce p ta b le . The large cost o f constructing an d m aintaining these m ore capital-intensive enterprises w a s often m ore than a fe w ow ners could afford, an d the long life o f the assets m ade w a itin g for the w in d in g up o f the enterprise before sharing profits an unsatisfactory o ption. Various pieces o f co m p a n ie s' legislation w e re introduced in Britain in the 1 8 3 0 s , 1 8 4 0 s an d 1 8 5 0 s . This legislation a llo w e d com panies to sell shares in stock markets (w hich, because the initial issuing o f shares provides c a p ita l - that is, equity funds for the com panies - are also called c a p ita l markets). The legislation also characterised a m ajor feature o f com panies: lia b ility o f the com pany's ow ners to the com pany's creditors w a s, an d still is, lim ited to the am ount o f the ow ners' u n paid ca p ita l in the co m p a n y. The justification for the lim ited lia b ility feature w a s that individual investors could not a lw a ys be a w a re of the actions o f the directors they elected o r the m anagers w h o w ere, in turn, e n g a g e d by the directors. Therefore, investors should not be lia b le for a n y more than the am ount o f m oney they invested in the enterprise. But no investors w o u ld w a n t to lose even that, so as c a p ita l markets d e ve lo p e d , the dem and for inform ation a b o u t the corporations involved g re w . The lim ited lia b ility o f its ow ners, a nd an existence separate from its ow ners, are tw o factors that largely d efine the c orpo ra tio n . M o d e rn law s a nd business practices co m p lica te the o peration o f c a p ita l markets an d can reduce the protection o f lim ited lia b ility, but the idea that a co rp o ra tio n is a 'le g a l person', a b le to act on its o w n and survive changes in its ow ners, is still central to business. In fin a n cia l acco u n tin g , the focus is on the e conom ic entity that is exch a n g in g physical an d fin a n cia l g o o d s a nd promises w ith other e conom ic entities, but since law s began to define w h a t corporations are (and sometimes w h a t proprietorships, partnerships an d co rp o ra te groups are, too), accounting also must reflect the legal nature of econom ic exchanges a nd the structure o f the organisation. An im portant legal issue is the sharing o f profits. The problem of h o w to ensure the fa ir calculation a nd sharing of ow ne rsh ip interests led legislators to require that a corporation present its b a la n ce sheet annually to its shareholders and that an a u d ito r be present to report to the shareholders on the v a lid ity of that fin a n cia l statement. Legislation also required that a n y annual payments to shareholders should not com e out o f the sale of, o r a decrease in the value of, a corpo ra tio n 's long-term c a p ita l assets. Such payments should be m ade out o f monies earned ye a rly from these assets after all y e a rly debts a re p a id . W e can think o f 'm onies earned ye a rly' as revenues, a nd 'ye a rly debts' as expenses, so this meant, roughly, that payments to shareholders should com e out o f ye a rly profit. This is close to the d ivid end requirem ent p la ce d on most corporations to d a y (dividends can norm ally o nly be p a id out o f net profit). C o rporations began to com pute profit in statements o r schedules separate from the b a la n ce sheet, so that they could dem onstrate that they had perform ed w e ll enough to perm it the distribution o f d ividends or the issuing o f m ore shares. As businesses g re w in size a nd com plexity, the de m a n d for inform ation on fin a n cia l perform ance increased. The static picture presented b y the b a la n ce sheet w a s not g o o d enough for the em erging stock markets, for the increasingly large g ro u p o f non-ow ner professional m anagers, o r for governm ents that w ish e d to evaluate (and tax!) businesses' perform ance (to mention just a fe w o f the groups interested in evaluating perform ance). The profit a nd loss statement (n o w c a lle d an incom e statement in Australia) has com e into its o w n as a central part o f fin a n cia l reporting in the last 1 0 0 years, a nd its measurement o f fin a n cia l perform ance is central to e conom ic activity an d perform ance evaluation in most o f the w o rld . In responding to these dem ands for better perform ance inform ation, accountants w e re lim ited by a lack of accounting theories o r conventions to illustrate a nd d efine h o w to prepare b a la n ce sheets a n d incom e statements. There w a s no n a tio n ally o rg anised association o f accountants in Britain until the end o f the 1 8 0 0 s (although the Accountants' Society o f Edinburgh received a royal charter in 1 8 5 4 , an event that led to the term 'chartered accountant'). Financial accounting methods d e ve lo p e d on a case-by-case basis, w ith no overall plan o r concepts throughout this period. Some m odel fin a ncia l statements a nd exam ples from legislation w e re being used, an d incom e statements w e re becom ing established. H ow ever, as business an d com m ercial activity continued to increase, it w a s becom ing necessary to establish a rational basis (principles) for preparing fin a n cia l statements a nd for extending these principles to n ew settings.
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Tow ards the end o f the 1 8 0 0 s , several British court cases had established that accountants a nd auditors had to d e c id e w h a t w e re p roper an d fa ir fin a n cia l statements, an d could not expect courts an d legislatures to d e c id e for them. A prom inent accountant, Ernest C o o p e r, v o ice d his concern in 1 8 9 4 : 'The a lre a d y sufficient responsibilities and anxieties of an A ud ito r w ill be extended beyond those known o f a n y trade o r p ro fe s sio n .'11 A ccounting w a s on its w a y to form ulating the professional rights, responsibilities a nd criteria for com petence, as had the a lre a d y established professions o f la w , engineering a nd m edicine.
FOR YOUR INTEREST S e rg e a n t J e re m ia h M u r p h y h o ld s a u n iq u e p la c e in A u s tra lia n c o m m e rc ia l h is to ry as b e in g th e f ir s t p e rs o n in A u s tra lia [w h o s e a ffa irs w e re re c o rd e d as a le d g e r a c c o u n t p re p a re d w ith in a d o u b le - e n tr y a c c o u n tin g s y s te m ]. H is b a n k d e p o s it on 5 A p r il 1817 w as th e f ir s t d e p o s it ta k e n b y th e B a n k o f N e w S o u th W a le s . T h e re c o rd in g o f th is d e p o s it a p p e a rs t o p ro v id e th e e a rlie s t a r te fa c t th a t has s u rv iv e d o f th e o p e ra tio n o f a d o u b le - e n tr y a c c o u n tin g s y s te m in c o lo n ia l A u s tra lia . Source: R. Craig, ‘Jeremiah M urphy: Bank A cco u n t N o. V, Australian CPA, D ecem ber 1998, pp. 6 8 - 9 .
N O TES 1
Stone, J., 'B ig B rewhaha o f 1 8 0 0 B C ', D isco ver, January 1 9 9 1 , p. 14. (The w ords quoted in the excerpt are those o f Fritz M a y ta g , o w n e r o f the A nchor Brewing C o m p a n y o f San Francisco.) 2 Information a b o ut the history o f accounting and business is published in m any places. A variety o f professional a n d a ca d e m ic journals have show n an interest in such m aterial, and there is a journal devoted sp ecifically to it: the A c c o u n tin g H isto ria n s Jo urnal. See also the references below . 3 Coustourous, G . J., A c c o u n tin g in the G o ld e n A g e o f G re e c e : A Response to S o c io e c o n o m ic C h a n g e s , C enter for International Education and Research in A ccounting, University o f Illinois, C h a m p a ig n , 1 9 7 9 . 4 Keister, O . R., T h e M ech a nics o f M eso p ota m ia n Record-Keeping', in C hatfield, M . (e d .), C o n te m p o ra ry S tudies in the E vo lu tion o f A c c o u n tin g Thought, Dickenson Publishing C o m p a n y Ltd, Belmont, 1 9 6 8 , pp. 1 2 - 2 0 . 5 O . ten H ave, The H is to ry o f A c c o u n tin g , B ay Books, Palo A lto, 1 9 7 6 , pp. 2 7 - 3 0 . 6 Ibid., pp. 3 0 - 4 6 . 7 C hatfield, M ., 'English M e d ie va l Book-keeping: Exchequer and M a n o r', C o n te m p o ra ry S tudies in the E vo lu tion o f A c c o u n tin g Thought, p. 3 6 . 8 Ibid., pp. 5 6 - 7 4 . 9 O . ten H ave, H istory, p. 6 7 . 1 0 Some o f the ideas in this section w ere developed w ith reference to Ross Skinner's A c c o u n tin g S tand ard s in Evolution, Holt, Rinehart & W inston, Toronto, 1 9 8 7 . For a com prehensive treatment o f the developm ent o f accounting standards, see part 1 o f Skinner's book. 11 Ibid., p. 2 3 .
Record-keeping ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO describe the im portance of goo d record-keeping describe the criteria used to determ ine if an event involves an accounting transaction identify accounting transactions explain the various steps in the accounting cycle describe w h a t source documents exist and how they provide d a ta for the accounting system p re p a re journal entries post to ledg er accounts a n d calculate the closing balances p re p a re a trial balance p re p a re closing entries a n d explain the need for these closing entries p re p a re financial statements from the trial balance.
C H A PTER O VE R VIEW This c h a p te r c o ve rs th e pro ce sses b y w h ic h tra n s a c tio n s a re re c o rd e d in th e a c c o u n tin g system . It d e s c rib e s th e c ri te ria th a t a re used to d e te rm in e if a n a c c o u n tin g tra n s a c tio n o c c u rs . It th en c o n s id e rs th e b a s ic steps in th e a c c o u n t in g c y c le : so u rce d o c u m e n ts , jo u rn a l e n trie s, p o s tin g to le d g e rs , tria l b a la n c e s , a d ju s tin g e n trie s, c lo s in g e n trie s a n d th e p re p a ra tio n o f fin a n c ia l statem ents.
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4.1
The importance of good records
This chapter em phasises a very basic part o f a ccounting: the record-keeping (bookkeeping) procedures that form the records on w h ich accounting inform ation is built. C om plete and accurate records are im portant: they pro vid e the observations a nd the history o f the enterprise. W ith o u t know ing w h a t has happe n e d , investors an d m anagers cannot make plans for the future, evaluate alternatives properly or learn from past actions. In to d a y's com plex business environm ent - e sp e cia lly since enterprises have becom e very large - the num ber o f events (or transactions, as w e w ill call them) is much too g re a t for a n yo n e to keep track o f w ithout keeping accurate records (written or, these days, mostly on com puter). Records pro vid e the basis for extrapolations into the future, the inform ation for evaluating an d re w a rd in g perform ance, a nd a basis for internal control over the existence an d q u a lity o f an enterprise's assets. R ecord-keeping, how ever, does cost money; therefore, records should be w orth their cost. H o w co m p le x a nd sophisticated to make one's records is a business decision, much like decisions such as h o w to price o r market one's product.
4.2
Financial accounting's transactional filter
A ccounting is an inform ation system to filter an d summarise d a ta . Inform ation systems select observations from the w o rld , collect those results into d a ta banks, an d org a n ise a nd summarise the d a ta to produce specific kinds of inform ation. This is useful because decision-m akers cannot c o p e w ith masses o f ra w , unorganised observations, and it is econ o m ica lly efficient to have one system o rganise da ta into inform ation on behalf o f the various users. The d a ily new sp a p e r is an e ve ryd a y exam ple o f o rg anising an d sum m arising. The editors g ro u p stories and features so that you kn o w w h e re to look for w h a t you w a n t. There is a sports section, an entertainm ent section, a p a g e fo r letters to the editor, a nd so on. W h ile no n e w sp a p e r contains exactly w h a t you w a n t, it gets close enough to w h a t most p e o p le w a n t so that it can be published a t a lo w cost co m p a red w ith w h a t it w o u ld cost you to hire reporters to get inform ation just for you. In ord e r to make this w o rk, every inform ation system has to be choosy: it must filter all the a v a ila b le d a ta a nd pick w h a t is relevant to its purpose. You d o n 't expect the n e w spaper to contain glossy reproductions o f Rembrandt paintings suitable for fram ing, or to print the grades you received in your university courses: you g o to other inform ation sources for such things. An inform ation system such as fin a n cia l accounting is inherently lim ited. It can report o nly w h a t its sensors p ick up as it seeks out da ta or filters d a ta from the mass o f o n g o in g events. N o inform ation system tells you 'the truth', and certainly not 'the w h o le truth', because it can o n ly pass a lo n g inform ation based on w h a t it has been designed or perm itted to gather as d a ta . Figure 4 .1 represents the situation. The g a p in the w a ll is the system's filter o r 'w in d o w on the w o rld '. O n c e a p ie ce o f ra w d a ta is adm itted, recording activity takes p la ce an d it is stored in a bank o f d a ta (in accounting: stored in m anual o r com puterised accounts, ledgers, journals ['the b o o ks'] an d supporting records). The data in this bank are then o rg anised to p roduce usable inform ation (in acco u n tin g : fin a n cia l statements a nd reports). In accounting , w e g e n e ra lly refer to the left part o f the d ia g ra m - the d a ta recording an d some routine classifying and summarising - as b o o kkeeping. W e refer to the right part, the turning o f d a ta into inform ation for users, as accounting o r reporting. Financial accounting inform ation is co ntained in the system's final product, the financial statements a n d notes.
Ongoing events in the world
FIGURE 4.1
Steps in the accounting information system
*
Classifying Summarising Organising
-------► Information
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A ccounting reports a re based on, a nd are lim ited by, the d a ta that is collected. Therefore, if you are to understand the reports, you have to understand h o w accounting filters, notices an d chooses events to record into its d a ta bank. Financial accounting's filter, its w in d o w on the w o rld , is the transaction. G en e ra lly, if an event is a transaction, it is recorded in fin a n cia l a ccounting's d a ta b a se ; if it is not, the routine accounting system ignores the event. (You'll see in C h a p te r 5 that o ne o f the reasons for accrual accounting techniques is to pro vid e for events that the transaction-based record-keeping system has ignored o r treated im properly.) The fo llo w in g are exam ples o f external accounting transactions. They should be recorded routinely by the accounting system: 1
The payroll departm ent pays em ployees b y deposits to their b a n k accounts.
2
A customer pays, in cash, an a ccount o w in g since last month a nd gets a receipt.
3
A sales clerk prepares an invoice for a customer for the sale o f g o o d s the customer is taking w ith her a nd promises to p a y for.
4
The bank charges b a n k fees on an account.
5
The storeroom receives a shipm ent o f spare parts for the delivery trucks, a lo n g w ith an invoice from the parts supplier. There is no lim it to the num ber o r kinds o f transactions that human ingenuity can devise. A ccounting has to deal
w ith them, an d must ch a n g e as they ch a n g e. N o w a d a y s , m any com panies have to handle internet transactions and those h a p p ening through w e b pages an d other areas o f e-com merce, all o f w h ich have fundam entally ch a n ged m any accounting systems. Transactions a re partly d e fined b y the legal an d e co n o m ic system. In our society, promises to p a y can be enforced in the courts, so they are considered transactions, as in exam ple 3 a b o ve . In general, there a re tw o main kinds o f transactions im portant in a ccounting: cash transactions, w h ich feature the concurrent e xch a n g e o f cash, and credit transactions, w h ich feature (partially o r fully) promises to e xchange cash in the future. The fo llo w in g a re exam ples of events that are not accounting transactions an d that w ill therefore not be recorded routinely, if at all, by the accounting system: 1
The chief executive officer (CEO) o f the c o m p a n y breaks her leg w h ile skiing.
2
The credit departm ent m anager decides that a particular customer is p ro b a b ly never g o in g to p a y the account he ow es.
3
The main w arehouse burns to the ground overnight.
4
A customer orders a m achine to be delivered next month.
5
Real estate reports in d ica te the com pany's land has g o n e up in value by 1 4 per cent since last year. Som e such events m ay be brought into the system by special adjustments to the routine recording system that w e
w ill learn a b o u t later. Events 2 a n d 3 are exam ples. But m any are never included in fin a n cia l accounting's inform ation system. Event 1 is an exam ple. O th e r events a re recorded o n ly after som ething m ore has happe n e d . Event 4 is recorded by the accounting system o nly w hen the m achine is delivered, an d in Australian acco u n tin g , event 5 is recorded o n ly if directors d e c id e to revalue land. Human ingenuity comes in here a g a in : some large o r innovative com panies have accounting systems that routinely record events that are not transactions and that other (or smaller) com panies w o u ld ignore o r leave to be done as special adjustments. Some exam ples are internal transfers of goods from departm ent to departm ent in the com pany, monthly changes in the market values o f investments, estimated profit earned on partly com pleted construction contracts, and revisions in estimates for future w arranty payments. These m ay be included for various reasons; for instance, because other inform ation systems in the com pany provide the necessary data so they can be used easily, or because m anagem ent believes more finely tuned accounting inform ation to be useful in decision-m aking.
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W h a t distinguishes accounting transactions, such as in the first list a b o ve , from the sorts o f events in the second list? All of those in the second list m ay be im portant e co n o m ica lly, but they are not routinely recorded by the accounting system. In order to q u a lify as a fin a n cia l accounting transaction, an event must norm ally have all five of the fo llo w in g characteristics: •
Three fundam ental e co n o m ic a nd legal characteristics: -
exchange: the event must involve an e xch a n ge o f g o o d s, money, fin a n cia l instruments (such as cheques), legal
-
past: the e xch a n g e must have happe n e d , even if just seconds a g o (financial accounting is essentially a histori
promises o r other items o f e co n o m ic value c a l inform ation system) -
external: the e xchange must have been betw een the entity being accounted for a nd som eone else, such as a customer, an o w n e r, a supplier, an em ployee, a banker o r a tax collector (the e xch a n g e must have been across the entity's boundary, so to speak).
•
T w o supplem entary characteristics: -
evidence: there must be some docum entation o f w h a t has h a p pened (recorded on p a p e r or electronically) dollars: the event must be m easurable in dollars o r the currency unit relevant in the country w h e re the transac tion happe n e d .
The fo llo w in g transaction characteristics d e fin e the nature an d value o f fin a n cia l accounting inform ation. •
First, transactions are linked to the legal a nd e conom ic co n ce p t o f an exchange: com pleting a contract b y giving o r receiving consideration in return for the g o o d s or services that ch a n g e hands. The transactional basis of fina n cia l accounting thus has roots in the fundam ental legal a nd e conom ic processes by w h ich society and business operate. It is no a c cid e n t that accounting recognises, as transactions, events that have a b ro a d e r legal and business im portance too.
•
S econd, they constitute a large part o f the underlying rationale for the historical cost basis o f a ccounting, w h ich is firm ly founded on the transaction. If a transaction has h a p p e n e d , it should be in the accounting system a nd in the fina n cia l statements. It is history. If it has not yet h a p p e n e d , it is not yet the sam e sort of legal event a nd w ill not yet be in the historical accounting system. W e can figure out h o w to get some events that have not h a p pened into accounting a n y w a y , but they often d o not fit in w e ll, a nd can be controversial, because reasonable p e o p le often disagree on w hether to bring them in a nd h o w to bring them in.
•
Third, the characteristics of the transaction pro vid e the basis on w h ich the records can be verified (audited) later as part of the process o f ensuring that the accounting inform ation is cre d ib le . Events that d o not have these characteristics are difficult to verify later, an d therefore inevitably lack c re d ib ility as measures o f financial perform ance o r position. Let's look at the five events from the list o f accounting transactions on p a g e I 4 l (1 to 5) a nd see that they fit the
set o f transaction characteristics: Exchange
Past exchange
External party
Evidence
1
Money
2
Money
Dollars
Yes
Employee
Direct deposit
Direct deposit
Yes
Customer
Receipt
Cash
3
Goods, promise
Yes
Customer
Invoice
Price
4
Money
Yes
Bank
Bank statement
Cash
5
Goods, promise
Yes
Supplier
Invoice
Price
The five events in the subsequent list on p a g e 1 4 1 , w h ich a re no t accounting transactions, lack several characteristics, especially that o f being a past e co no m ic exchange. (Event 4 , for exam ple, is not yet an e xchange because the m achine hasn't yet been delivered.) W h a t if an accountant is not satisfied w ith the set o f d a ta recorded b y an accounting system a nd w ishes to adjust those d a ta to reflect some event he o r she thinks is im portant in measuring fin a n cia l perform ance o r position? This can
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be d o n e by recording special alterations to the da ta b a n k ca lle d 'adjustm ents' o r adjusting journal entries, w hich introduce n e w da ta or alter the recording o f previous d a ta . D eciding w hether to make such adjustments and determ ining the d o lla r am ounts to use in them require expertise a n d g o o d judgem ent, since they involve events that are not exchanges, are not a lw a ys a cco m p a n ie d by normal evidence, or are not readily m easurable in dollars. Y ou'll see much m ore a b o u t adjustments in the discussion o f accrual accounting in C h a p te r 5 . M o s t o f this b o o k involves the accounting (right-hand) side o f the e arlier inform ation system d ia g ra m : d e c id in g on adjustments, d e c id in g on reporting form at, m aking supplem entary notes an d other such activities. D on't forget that the basic transactional recording system underlies the w h o le process, an d the p receding definition o f w h a t is and isn't an external transaction gives the accounting system much o f its va lu a b le objectivity. H ow ever, also note that accrual accounting is designed to g o beyond external transactions an d a d d a further layer o f inform ation related to internal transactions such as d e p re cia tio n , u n p a id w a g e s an d prepaym ents. These are discussed in m ore detail in C h a p te r 5 .
HOW'S YOUR UNDERSTANDING? W h ic h o f th e fo llo w in g tra n s a c tio n s w o u ld be re c o rd e d in th e a c c o u n tin g s y s te m f o r O ra n g e L im ite d ?
1 2 3 4
Issue o f sh a re s b y O ra n g e L im ite d to th e p u b lic . S ale o f s hare s fr o m s o m e s h a re h o ld e rs o f O ra n g e L im ite d t o n e w s h a re h o ld e rs . O ra n g e L im ite d re c e iv e d a p u rc h a s e o r d e r f o r th e s u p p ly o f 1 0 0 m e tre s o f w ire . O ra n g e L im ite d d e liv e re d th e a b o v e o rd e re d w ire to th e c u s to m e r. Y o u r a n s w e r s h o u ld be : 1 an d 4 .
4.3
Accounting's 'books' and records
A ccounting cycle Figure 4 .2 shows the sequence o f accounting procedures from the o rig in a l docum entary e vidence of a transaction (source documents) to the preparation o f fin a n cia l statements. The source docum ents are the basis for journal entries, w h ich in turn a re posted to the general ledger accounts as a means o f summarising the transactions. A trial b a la n ce is then taken out to ensure that the total o f the debits equals the total o f the credits. End-of-period accruals, corrections a nd other adjustments (covered in detail in C h a p te r 5) are then incorporated via a d d itio n a l journal entries. A post-adjustment trial b a la n ce is taken out to ensure the total o f the debits still equals the total o f the credits. Further journal entries then close the revenue, expenses a nd d ivid e n d amounts to retained profits to make all o f those accounts' balances ze ro in preparation for the next period's step 1. (The b a lan ce sheet accounts continue into the next period an d so are not closed.) Financial statements are then prepared.
The un de rlyin g accounting system This section summarises some o f the m echanics of the accounting system behind steps 1 to 9 in Figure 4 .2 , to show you h o w transactions are summarised into the fin a n cia l statements. Keep in m ind, though, that this is a basic description: much has been left out in orde r to keep the portrayal clear. These days, for most com panies, m any o f the 'books' referred to b e lo w a re a ctually electronic records in com puter systems.
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FIGURE 4.2
Steps in the accounting cycle
Source docum ents and the tra nsactional cycle A ccounting record-keeping depends upon sets o f docum ents to sh o w that transactions have occurred. Such docum ents are kept so that the accounting records can be checked a nd verified to correct errors. They also permit a u d iting, and can be used if there is a dispute or to support incom e tax claim s a nd other legal actions. The transactions themselves reflect various events in op e ra tin g a business. H ere are some exam ples from a real com pany, Labelcraft Pty Ltd.1 1
Labelcraft, a manufacturer o f self-adhesive labels an d cartons, is located in S ydney. To manufacture these products it orders ink, p a p e r an d c a rd b o a rd , am ong other things. O rd e rin g the kinds o f m aterials it needs to produce products customers w ill w a n t is an im portant early step. O rd e rin g is not an accounting transaction, so orders are not recorded in the accounts, but docum enting an d keeping track o f them is very im portant to Labelcraft, so it uses purchase order forms for this through its o nline system for ordering (this is very sim ilar to w hen you order online an d items g o to a shopping cart). The items ordered are listed in detail so they can be checked against w h a t actu a lly arrives from the supplier. The am ount o f g o o d s a nd services tax (GST) is a d d e d . The accounting entries for G ST a re covered in C h a p te r 1 1.
2
W h e n ordered items arrive, they are checked aga in st purchase orders an d the supplier's packing slips, to ensure all is correct. W h e n Labelcraft accepts a delivery, this is an accounting transaction, a nd a purchases record is created to support the transaction d e b it Inventory (asset] a n d c re d it A ccounts p a y a b le (liability!. If the c o m p a n y needed to return some g o o d s to suppliers, it is recorded as w e ll, in just the o p p o site w a y : c re d it Inventory and d e b it A ccounts p a y a b le .
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W h e n Labelcraft pays the supplier, it is usually by electronic transfer o f funds (or for some small suppliers a cheque is w ritten). A c o p y o f that is the source docum ent for recording the transaction d e b it A ccounts p a y a b le a nd credit C ash (bank).
4
Selling the products is w h a t Labelcraft is in business to d o . W h e n a sale is m ade, a sales invoice is prepared, specifying various useful details. A c o p y o f this invoice supports the transaction d e b it A ccounts receivable and c re d it Sales revenue. (Through the com pany's com puterised inventory system, the sales invoice also supports recording the cost o f the g o o d s taken by the customer, d e b it C ost o f g o o d s so ld expense a nd cre d it Inventory.) You w ill cover the cost o f g o o d s sold calculation for a m anufacturing firm in a later part o f the course on m anagem ent accounting (for m ore inform ation on m anagem ent a ccounting, log on to C o u rse M a te a nd see this text's M a n a g e m e n t A ccounting supplement). It is determ ined based on the am ount o f m aterial, labour and overhead incurred in the production process. The am ount on the invoice w ill include GST. For exam ple, if the total am ount c h a rg e d is $ 7 0 7 .3 0 , it includes $ 6 4 .3 0 GST. In effect, Labelcraft is collecting this am ount on b ehalf of the governm ent. W h ile the entries w ill be show n in m ore detail in C h a p te r 11, the journal entry w ill be: d e b it A ccounts receivable $ 7 0 7 .3 0 (i.e. the am ount o w e d by the debtor), c re d it Sales revenue b y $ 6 4 3 .0 0 (i.e. revenue earned by the com pany) an d cre d it G S T lia b ility a cco u n t w ith $ 6 4 .3 0 (i.e. the am ount being collected in G ST on b ehalf o f the governm ent). The paym ent is for the am ount Labelcraft is being ch a rg e d by the supplier, even if this is less than the 'list p rice '. If the terms o f paym ent a llo w a discount for early paym ent, this requires a d d itio n a l entries w h ich a re covered in C h a p te r 8.
5
C ollecting from customers is the last event w e illustrate. W h e n a customer pays Labelcraft, the paym ent is listed in the d a y's collections. That list is the source docum ent to support the transaction d e b it Cash (bank) an d cre d it Accounts receivable. It also supports the bank deposit m ade that d a y, so that if there are problems, som eone can start w ith the monthly bank statement a nd trace the deposits shown on it b a ck to the payments by individual customers.
6 Labelcraft, like m any businesses, relies on credit cards an d electronic funds transfer for customers' payments on some sales. W h e n a customer pays by credit ca rd , the credit ca rd slip is d eposited into the ba n k just like cash or a cheque (the credit ca rd c o m p a n y bills Labelcraft for its fee monthly). Some customers p a y Labelcraft by electronic funds transfer (EFT) w h ich has becom e very com m on for m any organisations, both large an d small. W ith o u t keeping track of EFTs an d credit ca rd paym ents, Labelcraft w o u ld have little idea o f w h a t its bank balances should be. Labelcraft also uses other kinds o f docum ents. It has m ore electronic transfers; for exam ple, p a yin g all em ployees by direct dep o sit into their b a n k accounts. There are m any kinds o f docum ents used by various com panies. Each c o m p a n y a dapts docum ents to its o w n needs, e sp e cia lly to pro vid e legal an d taxation e vidence an d to support accounting transactions records. You can count on tw o things re garding a n y co m p a n y, governm ent, sports clu b or other org a n isa tio n : (1 ) it w ill have various docum ents to b ack up its accounting system; an d (2) those docum ents w ill be suited to that organisation a n d so m ight not be quite like those o f a n y other organisations.
Journal entries Based on source docum ents, accounting transactions are recorded by p reparing journal entries. Because this is w hen the business event is first recorded by the accounting system, these basic transactional records a re often called books o f o rig in a l entry. Journal entries w e re introduced in C h a p te r 3 to illustrate the use of debits a nd credits. Journal entries p rovide, in chro n o lo g ica l order, a record o f all the transactions recorded by an org a n isa tio n . Journal entries can take many different forms, d e p e n d in g on such factors as the size o f the o rganisation, the frequency of transactions an d the frequency of p ro vid in g reports. In this section w e describe the simplest form, known as a general journal entry. You had some practice in p re paring journal entries in C h a p te r 3 , but it is w orth reinforcing here. C o n sid e r the fo llo w in g transactions: • •
A consulting c o m p a n y provides services to a client a nd sends it an invoice (source docum ent) for $ 1 0 0 0 0 . The c o m p a n y buys a motor vehicle for $ 3 0 0 0 0 , p a yin g $1 2 0 0 0 cash an d o w in g $1 8 0 0 0 to be p a id in tw o years.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
These w o u ld be recorded as follow s:
N o te that an alternative form at for the journal entries often puts the d e b it (DR) a nd credit (CR) before each account rather than as headings to the right-hand colum n. For exam ple: DR CR
Accounts receivable Consulting revenue
10000 1 0 0 00
Both methods are a cce p ta b le . From the a b o ve journal entries, the fo llo w in g should be noted: •
All journal entries have one o r m ore accounts d e b ite d a nd one o r m ore accounts credited. A journal entry can list as m any accounts as a re needed to record the transaction, but each journal entry must be recorded so that the sum o f the debits equals the sum o f the credits for that entry. If not, the accounting equation w ill not be m aintained (the books w ill not balance).
•
It is traditional for the debits to be listed first in each journal entry a nd for the debits to be w ritten to the left a nd the credits to the right. N e ith e r of these is arithm etically necessary, but keeping a consistent style helps keep the records understandable.
•
It is custom ary to om it the d o lla r signs in w ritin g the entries. The transaction has to be m easurable in dollars, so putting in d o lla r signs is thought to be redundant.
•
It is also traditional to w rite a short e xplanation called a narration b e lo w each entry as a m em orandum of w h a t the recorded transaction w a s about. A g a in , this is not necessary, but it helps to make the record understandable.
•
Every journal entry should also be d a te d , an d is usually num bered, so there is no d o u b t a b o u t w hen the transaction w a s recorded. The d a te can have im portant legal an d tax im plications, an d , o f course, it is necessary to know w h ich fin a n cia l p eriod a transaction belongs to w hen fin a n cia l statements are being prepared.
•
A posting reference is given to indicate the ledger account to w hich each journal entry is posted. This number can be obtained from the com pany's chart of accounts. In d e cid in g w h a t accounts to use, accountants deve lo p a chart o f accounts an d use it to determine the nam e of the account that is affected by a transaction. A chart of accounts is a listing of the titles o f all accounts. For exam ple, assets m ay be numbered 1 to 9 9 , liabilities 1 0 0 to 1 9 9 , shareholders' equity 2 0 0 to 2 9 9 , revenues 3 0 0 to 3 9 9 and expenses 4 0 0 to 4 9 9 . This allow s room for expansion over time as new account titles are required for new types o f transactions. An illustration is provided in section 4 .5 . Enterprises w ith m any transactions to record - this is most enterprises - d o not create a separate journal entry
for each transaction, but instead use special records for each frequent, routine kind o f transaction, such as a sales journal, a cash receipts journal, a cash payments journal an d a purchases journal. These are illustrated in C h a p te r 8.
CHAPTER 4
Record-keeping
147
Alm ost all bookkeeping systems a re com puterised. These systems m ay o r m ay not produce records that look like the preceding exam ples, but they have the sam e arithm etical o b je ctive o f keeping all the debits equal to all the credits. You s a w spreadsheet printout exam ples in C h a p te r 3 , but spreadsheets a re a little cum bersom e for handling large numbers o f transactions, so most enterprises use special accounting softw are.
HOW'S YOUR UNDERSTANDING? W h a t is th e jo u r n a l e n tr y f o r th e sale o f g o o d s o n c re d it f o r $ 8 0 0 0 0 th a t c o s t $ 5 0 0 0 0 ? Y o u r a n s w e r s h o u ld be: DR
Accounts receivable
CR
Sales revenue
DR CR
COGS
$80000 $80000 $50000
Inventory
$50000
Posting to ledgers C onsid e r a situation w h e re , during the month, thousands o f journal entries w e re w ritten, o f w h ich 2 0 per cent included either a d e b it o r credit to the cash account. If you w e re asked the b a la n ce o f the cash account a t the end of the month, h o w w o u ld you find out? O n e o ption is to get the o p e n in g ba la n ce , a d d on all d e b it entries affecting cash and d educt all credit entries affecting cash. But d o in g this is time-consuming, an d it w o u ld be preferable to have a source that w ill g ive you the b a la n ce o f the account at a n y point in time. Such a source is a ledger. Ledgers are books (or com puter records) that have a separate p a g e o r a ccount c o d e for each in dividual a ccount referred to in the books o f o rig in a l entry. Each area o r p a g e contains a summary o f all the transactions relating to that particular account and, therefore, posted to it. H ere is an exam ple o f the 'cash in bank' a ccount for a com p a n y: Cash in bank Date
Description
Entry no.
Debits
Credits
Balance
0 2 /1 2 /1 6
First deposit
1
10000
1 0 0 00 DR
0 2 /1 2 /1 6
Deposit
3
1 146
11 146 DR
0 2 /1 2 /1 6
Cheque
7
678
10468 DR
0 2 /1 2 /1 6
Cheque
8
2 341
8 127 DR
You see the id e a . Each a ccount is really just a convenient summary o f the entries affecting it. In turn, the bala nce sheet is a summary o f all the a ccount balances. The general ledger is the com plete set o f all the accounts (assets, liabilities, equity accounts, revenues an d expenses) that lie behind the fin a n cia l statements. You m ight w a n t to think o f the ledger as a set o f a ccount pages (real pages, such as in the bound books the bookkeepers o f o ld used, o r representations in a com puter system), such as the o ne a b o ve , in w h ich the sum o f all the d e b it b a la n ce accounts equals the sum o f all the credit b a la n ce accounts. The picture in Figure 4 .3 , using the accounting equation form at a nd including the cash in bank account a b o ve , m ight be useful.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A s s e ts
FIGURE 4.3
L ia b ilitie s a n d E q u ity
Ledgers
For dem onstration an d analysis purposes, accountants a nd accounting instructors often use a sim plified version of an account c alle d a T-account, w h ich includes o nly the debits a nd credits columns o f the account, w ith o u t calculating the b a la n ce after every entry. A T-account version o f the a b o v e cash account exam ple w o u ld look like this: Cash in bank DR
CR
1 0000
678
1 146
2 341
8 127
The b a lance o f $ 8 1 2 7 is sim ply the am ount by w h ich the d e b it entries exceed the credit entries. N o te that the normal b a la n ce o f asset accounts is a d e b it an d the normal b a la n ce o f liabilities a nd equity accounts is a credit balance. (Also note that, as revenues increase equity, their normal b a la n ce is a credit a n d , as expenses reduce equity, their normal b a la n ce is a debit.) By convention, left-hand entries to ledgers are ca lle d debits an d right-hand entries are ca lle d credits. H ere is an exam ple o f some ledger accounts: Cash DR
Loans CR
DR
CR
CHAPTER 4
Record-keeping
149
Recall our e arlier d e b it/c re d it conventions from C h a p te r 3: •
For asset accounts, increases are recorded on the left-hand side (i.e. debit) a nd decreases are recorded on the right-hand side (i.e. credit).
•
For liabilities a nd shareholders' equity accounts, the o p p o site occurs. Increases are recorded on the right-hand side (credit) a nd decreases are recorded on the left-hand side (debit). General journal DR Accounts receivable
CR
10 000
Consulting revenue
Accounts receivable
10000
2
Consulring revenue
DR
CR
31 6
DR
1 CR
10000
1 0 0 00
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TE 1
W e th a n k Terry R ow ne y, C E O o f La belcraft, fo r p ro v id in g these e x a m p le s.
Accrual accounting adjustments ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: explain how the tim ing of revenue an d expense recognition differs from cash inflows a n d outflows explain the purpose of accrual accounting adjustments describe prepaym ents, accrued revenue, accrued expenses, revenue received in a d v a n c e , d e p re ciatio n , doubtful debts a n d contra accounts calculate the im pact on the financial statements of accrual accounting adjustments p re p a re journal entries for accrual accounting adjustments show the im pact on the financial statements and p re p a re journal entries for the depreciation of assets a n d the sale of assets
CHAPTER OVERVIEW A c c ru a l a c c o u n tin g e xists b e c a u s e ca sh flo w in fo rm a tio n is n o t c o m p le te e n o u g h to assess fin a n c ia l p e rfo rm a n c e o r fin a n c ia l p o s itio n . K e e p in g tra c k o f ca sh flo w is c ru c ia l fo r bu siness success, b u t it is n o t e n o u g h . W e h a v e to g o b e y o n d ca sh flo w to assess e c o n o m ic p e rfo rm a n c e m o re b ro a d ly a n d to assess non-cash re so u rce s a n d o b lig a tio n s . W e d o th is a lth o u g h it fo rc e s us to m a ke estim a te s, ju d g e m e n ts a n d o th e r a c c o u n tin g c h o ic e s th a t, in tu rn , m a ke th e results less p re c is e th a n w e w o u ld w is h , a n d m o re s u b je c tiv e th a n tra n s a c tio n -b a s e d ca sh flo w fig u re s . Im a g in e th e fo llo w in g c o n v e rs a tio n b e tw e e n a s tu d e n t a n d a re la tiv e , w h o is a ls o a p ro fe s s io n a l a c c o u n ta n t: A c c o u n ta n t:
W e ll, y o u s p e n t th e s um m er w o rk in g a t H ig h -cla s s B o u tiq u e . H o w d id y o u d o ?
S tu d e n t:
I h a d a g re a t tim e . M e t som e g re a t p e o p le , le a rn e d a lo t a b o u t re ta ilin g , a n d h a ve d e c id e d to
A c c o u n ta n t:
N o , I m e a n t h o w d id y o u d o fin a n c ia lly ?
S tu d e n t:
Let's see. I re c e iv e d $ 4 2 6 0 o v e r th e th re e m onths. I h a ve $ 2 3 3 0 left in th e b a n k , so I gu ess I m ust
m a jo r in m a rk e tin g .
h a ve s p e n t $ 1 9 3 0 . G e e , $ 2 3 3 0 d o e s n 't seem m uch fo r a s u m m e r's w o rk ! But th e b o u tiq u e still o w e s m e fo r m y last w e e k o f w o rk . A c c o u n ta n t:
W h a t d id y o u s p e n d th e $ 1 9 3 0 on?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
S tu d e n t:
I b le w so m e o f th e m o n e y on b e e r a n d e n te rta in m e n t, a n d on th a t trip to th e G o ld C o a s t. But I a lso b o u g h t n e w c lo th e s fo r sem ester o n e , a n d I h a ve th e n e w c o m p u te r, a n d th e iP a d I g o t so th a t I m ig h t be a b le to ta k e b e tte r no tes in class a n d pa ss a c c o u n tin g .
A c c o u n ta n t:
D o n 't fo rg e t y o u h a ve to p a y y o u r U n c le A l b a c k th e m o n e y he le nt y o u in N o v e m b e r. T h a t's in y o u r b a n k a c c o u n t to o . Y o u p ro m is e d to p a y h im , plus in tere st, a t th e e n d o f th e sum m er. A n d then th e re 's y o u r u n iv e rs ity fees fo r n e xt y e a r; som e o f th ose h a ve b e e n p a id . A n d d id n 't y o u s a y th a t y o u o w e d a frie n d s o m e th in g fo r p e tro l fo r th a t tr ip to th e G o ld C o a s t a n d y o u h a d a lre a d y b o u g h t b o o k s in a d v a n c e b e c a u s e th e a c c o u n tin g o n e lo o k e d so in te re stin g ?
S tu d e n t:
I d o n 't th in k w e s h o u ld c o u n t th e fees b e ca u s e it d o e s n 't re a lly a p p ly un til I e n ro l. A lth o u g h I guess th a t's w h y I w a s w o rk in g . N o w I'm n o t sure if I h a d a g o o d s um m er o r not!
This e x a m p le illu s tra te s m a n y o f th e issues a c c ru a l a c c o u n tin g trie s to d e a l w ith , in c lu d in g th e fo llo w in g : •
The m o re y o u th in k a b o u t it, th e m o re c o m p le x m e a s u rin g p e rfo rm a n c e a n d p o s itio n seem s to b e , a n d th e less s a tis fa c to ry ca sh b y itse lf seem s to be a s a m e a su re .
•
S om e o f w h a t is e a rn e d m a y n o t y e t h a ve b e e n re c e iv e d in ca sh (p a y m e n t fo r th e la st w e e k o f w o rk ).
•
S im ila rly , so m e costs in c u rre d m a y n o t y e t h a ve b e e n p a id (the p e tro l fo r th e trip ).
•
S om e c a sh p a y m e n ts result in re so u rce s still h a v in g e c o n o m ic v a lu e a t th e e n d o f th e p e rio d (the iP a d , th e c o m p u te r a n d m a y b e th e clo th e s).
•
S om e c a sh re c e ip ts result in o b lig a tio n s still o u ts ta n d in g a t th e e n d o f th e p e rio d (U n cle A l's lo a n ).
•
The lo n g e r-te rm re so u rce s m a y h a ve d e te rio ra te d d u rin g th e p e rio d (n o t a ll th e c lo th e s p u rc h a s e d d u rin g th e s u m m er w ill still b e v a lu a b le b e c a u s e fa s h io n s c h a n g e , a n d th e iP a d a n d th e c o m p u te r a re n o w used item s).
•
O b lig a tio n s m a y b u ild up d u rin g th e p e rio d (the in te re st o n U n c le A l's lo a n ).
•
T h e re is o fte n d o u b t a b o u t w h e th e r som e th in g s s h o u ld b e in c lu d e d in m e a s u rin g p e rfo rm a n c e fo r a g iv e n
•
G e n e ra lly , h o w d o w e re la te th e tim in g o f c a sh flo w s to th e p e rio d w e 'r e c o n c e rn e d w ith ? M o s t o f th e a b o v e
p e rio d o r p o s itio n a t a g iv e n p o in t in tim e (the u n iv e rs ity fees). item s in v o lv e cash flo w s s o o n e r o r la te r; th e a w k w a rd case s a re u s u a lly th ose w h e n th e p e rio d in w h ic h th e ca sh m oves a n d th e p e rio d fo r w h ic h w e 'r e m e a s u rin g p e rfo rm a n c e d o n 't m a tch . T h in k o f a c c ru a l a c c o u n tin g as a n a tte m p t to m e a s u re e c o n o m ic p e rfo rm a n c e a n d fin a n c ia l p o s itio n in a m o re c o m p le x w a y th a n just b y u s in g c a sh . T h e re is a lw a y s a tra d e -o ff h e re : th e c lo s e r to c a s h , th e m o re p re c is e th e m e a su re , b u t a ls o th e m o re lim ite d a n d less in fo rm a tiv e th e in fo rm a tio n . The m o re a c c o u n ta n ts try to m a ke th e fin a n c ia l state m e nts e c o n o m ic a lly re le v a n t, th e m o re th e y m ust in c lu d e e s tim a te s a n d o th e r sources o f im p re c is io n o r e rro r.
CHAPTER 5 Accrual accounting adjustm ents
185
HOW'S YOUR UNDERSTANDING? A s re v is io n o f th e ba sic c o n c e p ts o f cash an d a c c ru a l a c c o u n tin g , c o m p le te th e fo llo w in g p ro b le m . W ith
re s p e c t to
th e
c u r r e n t a c c o u n tin g
p e rio d , s ta te w h e th e r e a ch
o f th e fo llo w in g
in d e p e n d e n t
tra n s a c tio n s : (a ) in c re a s e s e x p e n s e s ; ( b ) d e c re a s e s c a sh ; o r ( c ) b o th .
1
R e c o g n itio n o f d e p re c ia tio n
2
R e p a y m e n t o f a loan
3
P a y m e n t o f a cash d iv id e n d
4
P a y m e n t o f an a d v e rtis in g in v o ic e th a t w as re c o rd e d as an e x p e n s e in th e p re v io u s p e rio d
5
P a y m e n t o f w ag es f o r th e p e rio d
6 P u rc h a s e o f a b lo c k o f land f o r cash Y o u r a n sw e rs s h o u ld be:
1 in c re a s e s e x p e n s e s 2 d e c re a s e s cash 3
d e c re a s e s cash
4
d e c re a s e s cash
5
b o th
6 d e c re a s e s cash
5.1
Conceptual foundation of accrual accounting
A ccrual accounting is the d o m in a n t form o f fin a n cia l accounting in the w o rld to d a y. This cha p te r builds on the foundation la id in e arlier chapters; it explains w h y accrual accounting exists a n d distinguishes the accrual-basis from cash-basis a ccounting. A ccrual accounting is based on the id e a that events, estimates an d judgem ents that are im portant to the measurement o f fin a n cia l perform ance a n d position should be recognised by entries in the accounts (and therefore reflected in the fin a n cia l statements). This is regardless o f w hether o r not they are yet to be, o r a lre a d y have been, realised b y cash received o r p a id out. To slightly oversim plify, w e m ight say that the o b je ctive is to recognise e conom ic flow s in a d d itio n to cash flow s. To c la rify this id e a , w e w ill focus on revenue a nd expense recognition. Let's build the accrual accounting a p p ro a ch from some basics. These three cornerstones have com e up a lre a d y in this book, but w e ll g ive them brief definitions a g a in , then build from there. W e w ill com e b a ck to these concepts in C h a p te r 1 3 to p ro vid e the m ore inclusive concepts outlined in the revised International A ccounting Standards. •
Revenues are inflow s o f e co n o m ic resources from customers, earned through p ro vid in g g o o d s o r services. You m ight say that com panies are in business to earn revenues.
•
Expenses are outflow s o f econom ic resources to em ployees, suppliers, taxation authorities an d others, resulting from business activities, to generate revenue a nd serve customers. You m ight say that incurring expenses is the cost o f earning revenues.
•
N e t p ro fit is the difference betw een revenues a nd expenses over a period o f time, such as a month, a quarter o r a year. You m ight say that net profit is the measure o f success in generating m ore revenues than it costs to d o so. N o te some features o f these cornerstones:
•
Revenues an d expenses refer to inflow s a nd outflow s o f e conom ic resources. These flow s m ay be represented by the kinds o f events recognised by the transactional record-keeping system described in C h a p te r 4 , but they m ay also involve other phenom ena such as those discussed in section 5 .2 . In particular, they m ay involve phenom ena that arise before o r after cash changes hands, as w e ll as a t the point o f the cash flo w .
186
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N e t profit is depen d e n t on h o w revenues a nd expenses are measured. A ccountants d o n 't (or shouldn't) choose the profit num ber first, then force revenues a nd expenses to result in that number, but instead measure revenues and expenses as best they can, then let net profit be w h a te ve r the difference is betw een properly measured revenues and expenses.
A conceptual system for accrual p ro fit m easurem ent A ccrual accounting's purpose is to extend the measurement o f fin a n cia l perform ance an d fin a n cia l position by recognising phenom ena before an d after cash flow s, as w e ll as a t the p o in t o f cash flow s (which cash basis accounting a lre a d y does). W e need a system, therefore, that covers the fo llo w in g types o f events: 1
re c o g n itio n o f revenue (resource inflow ) o r expense (resource outflow ) a t the sam e tim e as cash in flo w o r o utflow
2
recognition o f revenue (resource inflow) o r expense (resource outflow ) before cash in flo w o r o utflow
3
recognition o f revenue (resource inflow) o r expense (resource outflow ) after cash in flo w o r outflow . A ccrual accounting derives its value from recognising transactions in categories 2 a n d 3 . These a llo w
measurement o f perform ance a n d position to be spread out over time. C a te g o ry 2 extends the tim e horizon out prior to the cash flo w , a nd c a te g o ry 3 extends the time horizon out subsequent to the cash flo w . C a te g o ry 1 a lre a d y exists in the cash basis o f a ccounting, so the accrual method includes the cash basis. As w ill be illustrated b e lo w , it also does much more.
Im plem enting the accrual fra m ew o rk As you review the fo llo w in g exam ples, try to think a b o u t the general accrual accounting fram ew ork they represent. They are not the o n ly exam ples that could be listed, but they w ill help you understand the concept, so that you can choose o r understand an accounting entry o r fin a n cia l statement item that you m ight not have seen before. Think about the patterns rather than trying to memorise the entries. Think a b o u t h o w accrual accounting recognises revenue w hen it is earned a nd recognises expenses w hen they are incurred, regardless o f w hen the cash is collected. In the fo llo w in g illustration, w e first sh o w the effect o f the transactions on the accounting e q uation, then sh o w the journal entry b elo w . This should reinforce your understanding o f journal entries. In considering each o f the entries b e lo w , rem em ber the accounting equation must a lw a ys ba la n ce : A = L + SE. An increase in revenue increases SE w h ile an increase in an expense decreases SE.
1 RECOGNITION OF REVENUE OR EXPENSE AT THE SAME TIME AS CASH INFLOW OR OUTFLOW These exam ples are sim ple cash-basis revenue a n d expense transactions, w h ich you have seen in earlier chapters. W e present them a g a in here to pro vid e a com plete picture of revenue a nd expense accounting under the accrual basis. R evenues
•
A retail shop records a cash sale to a customer. T C ash
$48
T Sales revenue
$48 $ DR CR
Cash Sales
$
48 48
CHAPTER 5 Accrual accounting adjustm ents
187
An investor records a d ivid e n d cheque received from BHP Billiton. T Cash
$150
T D ividend revenue
$150 $
DR CR
Cash
$
150
Dividend revenue
150
E x p e n se s
•
A c o m p a n y pays A cm e Rug C leaners to sham poo the carpets in its customer w a itin g area. T O ffic e expenses
$245
$ Cash
$245
N o te that increasing an expense reduces equity. $ DR CR
•
Office expense
$
245
Cash
245
A c o m p a n y makes a d onation to the accounting departm ent o f the local university to sup research. T D onation expense
$10000
$ Cash
$10000 $ DR CR
Donation expense
$
10000
Cash
10000
2 RECOGNITION OF REVENUE OR EXPENSE PRIOR TO CASH FLOW In the fo llo w in g situations, the revenue or expense is recognised before the cash in flo w o r ou tflo w . U nder accrual accounting, the revenue should be recognised (recorded in the accounting records) w hen it is earned, not w hen the cash is collected. Sim ilarly, expenses should be recognised in the period in w h ich the expense is incurred, not w hen the cash is p a id . Assume the year-end is 3 0 Ju n e. R evenues
•
A la w ye r performs services for a client in June 2 0 1 6 a nd bills the client $ 5 0 0 to be p a id w ithin 3 0 days. T Accounts receivable
$500
T Fee revenue
$500
$ DR
Accounts receivable
CR
Fee revenue
$
500 500
188
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
E x p e n se s
A c o m p a n y receives a $ 2 4 0 0 advertising bill on 1 0 June 2 0 1 6 , p a y a b le w ithin 3 0 days. T A dvertising expense
$2400
T Accounts p a ya b le
$2400 $
DR CR
Advertising expense
$
2400
Accounts payable
2400
A manufacturer estimates that it w ill incur future w a rra n ty costs o f $ 3 0 0 0 in the 2 0 1 6 financial sold in the 2 0 1 6 fin a n cia l year. (The w a rra n ty expense should be recognised in 2 0 1 6 , since w h ich the sales revenue w a s recognised a nd the w a rra n ty expense relates to that sale.) T W a rra n ty expense
$3000
T W a rra n ty lia b ility
$3000
(W a rra n ty lia b ility is sometimes c a lle d provision fo r w a rra n ty expense.) $ DR CR
Warranty expense
$
3 000
Warranty liability
3 000
O n 3 0 June 2 0 1 6 , a c o m p a n y calculates that its 2 0 1 6 incom e taxes are $ 1 8 5 0 . The com taxes b y 1 0 O c to b e r 2 0 1 6 T Income tax expense
$1850
T Income tax p a y a b le
$1850 $
DR CR
Income tax expense
$
1 850
Income tax payable
1 850
In the a b o v e exam ples, revenue an d expenses a re recognised before the cash flo w transactions. W h e n the cash flow s occur, there is no longer a need to recognise revenue or expense. The cash flow s w ill be recorded as offsets to the assets and liabilities created w hen the revenues an d expenses w e re initially recorded. For exam ple, the paym ent o f the tax bill w ill decrease cash an d decrease incom e tax p a ya b le . These entries a re illustrated b e lo w .
3 CASH COLLECTIONS OR PAYMENTS RELATED TO PREVIOUSLY RECOGNISED REVENUES AN D EXPENSES R evenues
•
The law yer receives full paym ent from her client in July 2 0 1 6 . T C ash
$500
i Accounts receivable
$500 $
DR CR
Cash Accounts receivable
$
500 500
CHAPTER 5 Accrual accounting adjustm ents
189
E x p e n se s
•
The advertising expense is p a id on 1 0 July 2 0 1 6 . i Accounts p a y a b le
$2400
i C ash
$2400 $ DR CR
Accounts payable
$
2400
Cash
2400
The manufacturer makes payments under the w a rra n ty in July 2 0 1 6 $ W a rra n ty lia b ility
$3000
$ Cash
$3000 $ DR CR
Warranty liability
$
3 000
Cash
3 000
The c o m p a n y pays a cheque to the A ustralian Taxation O ffic e on 10 O c to b e r 2 0 1 6 . 1 Income tax p a y a b le
$1850
$ Cash
$1850 $ DR CR
4
Income tax payable
$
1 850
Cash
1 850
CASH INFLOW OR OUTFLOW BEFORE REVENUE AND EXPENSE RECOGNITION
In the fo llo w in g situations, the revenue o r expense is recognised after the cash in flo w o r ou tflo w . U nder accrual accounting, the revenue should be recognised w hen it is earned, not w hen the cash is collected. Sim ilarly, expenses should be recognised in the p eriod in w h ich the expense is incurred, not w hen the cash is p a id . R evenues
•
A la w ye r receives an a d va n ce o f $ 2 5 0 0 from a client for future services. The revenue w ill not be earned until a later d a te w hen services are perform ed. R ecognition o f revenue is deferred until the service has been perform ed. T C ash
$2500
T Custom er d e p o sits*
$2500
* (This is also called 'unearned revenue' o r 'revenue received in a d va n ce '.) $
DR CR
Cash Customer deposits
$
2 500 2 500
190
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Expenses •
In June 2 0 1 6 , D o g w o o d Limited pays $ 4 0 0 for a one-year fire insurance p o licy that becom es effective l July 2 0 1 6 . The insurance premium provides co ve ra ge for one year, a nd should be recognised as a 2 0 1 7 expense. Expense recognition is deferred until 2 0 1 7 . T Prepaid insurance
$400
i C ash
$400 $ DR CR
•
Prepaid insurance
$
400
Cash
400
In July 2 0 16 , D o g w o o d Lirrlited purchases, for $ 4 0 0 0 0 0 in cash, a n ew building to be used as a retail location. D o g w o o d estimates that thi3 building w ill be useful for 101years. The building w ill be used to p roduce revenues over 1 0 future years. Recognition o f an expense for the cost o f using the building (depreciation expense) w ill be d e fe rre d . T Building
$400000
$ Cash
$400000 $
•
DR
Building
CR
Cash
$
400000 400000
D o g w o o d Limited purchases $ 5 0 0 0 w orth o f stereo com ponents from a supplier for cash. D o g w o o d intends to resell these items to its customers. The purchases represent an asset (inventory), an d recognising the cost as an expense is deferred until revenue is recognised through sales to customers. T Inventory
$5000
$ Cash
$5000 $ DR CR
Inventory
$
5 000
Cash
5 000
5 RECOGNITION OF REVENUE OR EXPENSE AFTER CASH INFLOW OR OUTFLOW Revenues •
The la w ye r com pletes the w o rk prom ised for the client. The revenue has n o w been earned a nd should be recognised. i Custom er deposits
$2500
T Fee revenue
$2500 $ DR
Customer deposits
CR
Fee revenue
$
2 500 2 500
CHAPTER 5 Accrual accounting adjustm ents
191
Expenses •
D o g w o o d 's fire insurance p o licy expires in June 2 0 17 . C o ve ra g e has been used during the ye a r e nded 3 0 June 2 0 1 7 ; therefore, the cost o f insurance used up should be recognised as an expense. T Insurance expense
$400
i Prepaid insurance
$400 $
DR CR
Insurance expense
$
400
Prepaid insurance
400
D o g w o o d recognises a portion o f the cost o f the bu ild in g as an op e ra tin g expense. T D epreciation expense
$4000
T Accum ulated d epreciation
$4000 $
DR CR
Depreciation expense
$
4000
Accumulated depreciation
4000
D o g w o o d sells all o f the stereo com ponents to customers. The cost o f the inventory sold is an revenue from the sale. T C ost of g o o d s sold
$5000
1 Inventory
$5000 $ DR CR
Cost of goods sold Inventory
$
5 000 5000
SUMMARY Based on the a bove: •
You can say that accrual accounting makes much o f the b a la n ce sheet into a sort o f 'h o ld in g a re a ' for incom plete revenue an d expense events. For exam ple, w e record a credit sale as revenue a nd set up the related accounts receivable until cash is subsequently collected.
•
You can see h o w accrual accounting spreads out these events over time. For exam ple, a building is o rig in a lly recorded as an asset, a nd the cost is p e rio d ica lly recognised as a dep re cia tio n expense over the useful life of the asset. There a re com plications, but the general pattern behind accrual accounting's revenue a nd expense recognition
system is as follow s: •
The recognition o f revenue before cash collection is d o n e by creating an asset account (accounts receivable, usually), w h ich stands in for the e conom ic value g a in e d until the cash has been collected.
•
The recognition o f an expense before cash paym ent is d o n e b y creating a lia b ility account (such as accounts p a ya b le , w a g e s p a y a b le o r tax payable), w h ich stands in for the e co n o m ic value lost until the cash is p a id .
•
R ecognition o f unearned revenue w hen cash is collected is pro vid e d for by creating a lia b ility a ccount (called 'unearned revenue' o r 'revenue received in a d va n ce '), w h ich represents the com m itm ent to the customer until the e co n o m ic value is g a in e d by p ro vid in g the g o o d s o r services the customer has p a id for. Revenue is later recognised w hen the g o o d s o r services are actu a lly p rovided.
192
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
An asset account (such as prepaym ents, inventory or machinery) is created w hen cash is p a id . These assets represent the a v a ila b le resource until the econom ic value is lost b y consum ing the asset. Assets can be acquired by promises to pay, not just b y cash; therefore, journal entries m ight credit accounts p a ya b le , m ortgage p a y a b le o r other liabilities rather than cash. But you can see that the 'asset' side o f these entries still represents resources that are to be consum ed later. A ccrual accounting recognises the expense w hen the consum ption happens, not w hen the asset is a cq u ire d , no matter h o w it is a cquired.
•
N o t all cash flow s involve revenues o r expenses. Such flow s have to be included in the accounts, but as they d o not affect profit, they are lim ited to b a la n ce sheet accounts. There are other events even further rem oved from the profit calculation. Some exam ples o f these a re the receipt o f cash from an issue o f share ca p ita l, the disbursement o f cash to make a m ortgage paym ent, the disbursem ent of cash to p a y for an investment in another com pany, and the receipt o f cash from a b a n k loan. These exam ples w e re intended to help you think a b o u t w h a t is g o in g on, an d see that there is a pattern behind
the great variety of entries used in accrual acco u n tin g . For exam ple, the fo llo w in g are all exam ples o f asset consum ption: •
reduction in the e conom ic value o f a building (credit accum ulated d e p re cia tio n ; d e b it d e p re cia tio n expense)
•
reduction in inventory as g o o d s a re sold (credit inventory; d e b it cost o f g o o d s sold)
•
reduction in supplies assets as supplies a re used (credit supplies inventory; d e b it supplies expense)
•
reduction o f p re p a id insurance asset as the c o ve ra g e is used (credit p re p a id insurance; d e b it insurance expense).
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1 2
P rovide an exam ple w h e re th e cash received is equal to , g re a te r th a n o r less th a n th e re ve n u e earned. In w h a t w ay can it be said th a t d e p re cia tio n expense and c o s t o f goods sold expense are exam ples o f th e sam e th in g ? Y o u r answers should be:
1
C ash sale; re c e ip t o f p a y m e n t by a c o m p a n y such as an airline w ith th e service to be d e live re d in n e xt
2
T h e y b o th re su lt in an expense w hen assets are used up (e.g. e q u ip m e n t and in v e n to ry ).
fin a n cia l year; and c re d it sale.
5.2
Accrual accounting adjustm ents
The transactional records pro vid e the foundation o f the fin a n cia l accounting system. In order to im plem ent the accrual accounting system outlined a b o ve , such records usually require adjustments. Adjustments involve the im plem entation o f routine accruals, such as those in d ica te d in section 5 .1 : revenues earned but not yet collected, expenses incurred but not yet p a id , cash received from customers before the related revenues have been earned, a nd consum ption of assets. The degree to w h ich accrual adjustments are needed in a n y accounting system depends on the sophistication of the system: sophisticated accounting systems m ay g o beyond the transactional records a nd routinely include many adjustments that, for sim pler systems, a re m ade at year-end in a special set o f journal entries. M a n y large com panies have monthly accruals for interest expenses an d other expenses as they build up, a nd m onthly adjustments for depreciation and other consum ptions o f assets. M a n y small com panies d o n 't bother until annual fin a n cia l statements are needed.
CHAPTER 5 Accrual accounting adjustm ents
193
A ccrual accounting adjustments fo llo w the sam e double-entry form at as d o the transactional records: •
A fter each adjustm ent, the accounting equation w ill still balance.
•
Som e a c c o u n t/s must be de b ite d.
•
Som e a c c o u n t/s must be credited.
•
The sum of the debits must equal the sum o f the credits. A ccountants call such adjustments 'adjusting journal entries'. Their purpose is to a ugm ent the transaction-based
(especially cash-based) figures (outlined in C h a p te r 4) to a d d to the story told by the transactional records. They im plem ent accrual accounting. The o b je ctive o f accrual accounting is to im prove the measurement o f fin a n cia l perform ance a n d position. H ow ever, because different choices can be m ade a b o u t w h a t accounts need to be adjusted an d by h o w much, accrual accounting can be a mechanism for m anipulating results an d p ro ducing m isleading reports. Therefore, the auditors g ive particular attention to the kinds o f accrual adjustments a c o m p a n y makes. M o s t o f the criticism of finan cia l reporting is directed at subjective accrual adjustments - m ade using judgem ent - rather than at the more objective, ve rifia b le transactional records. In spite o f this subjectivity a nd criticism , most accountants believe the accrual accounting basis to be superior to the cash basis, because it provides a m ore com plete record that is also m ore representative o f e conom ic perform ance than the cash basis. There a re four main types of routine adjustments that need to be accounted for: •
expiration o f assets
•
unearned revenues
•
accrual o f unrecorded expenses
•
accrual o f unrecorded revenues.
Expiration o f assets Prepaym ents (prepaid expenses) are assets that arise because an expenditure has been m ade, but there is still value extending into the future. They are usually classified as current assets because the Future value usually continues only into the next year. H ow ever, sometimes the value extends beyond a year, a nd the c o m p a n y m ay then a p p ro p ria te ly show a noncurrent p re p a id expense. Prepaid expenses arise w h enever the paym ent schedule for an expense does not match the com pany's fin a n cia l p e riod, such as for annual insurance premiums w hen the p o licy da te is not the financia l year-end, o r council rates that are based on the council's rate assessment schedule rather than on the com pany's fin a n cia l period. Prepayments are not assets in the same w a y as are receivables (to be collected in cash) or inventories (to be sold for cash). They arise from accrual acco u n tin g , in cases w h e re the expense recognition follow s the cash flo w . This is conce p tu a lly the sam e reason inventories a n d equipm ent a re on the b a la n ce sheet: som ething o f value exists; therefore, its cost should not yet be deducted as an expense. Here, the value is in the fact that, having spent the m oney alre a d y, the c o m p a n y w ill not have to spend it in the next p e riod. Alternatively, the value can be considered to be the fa ct that they a re entitled to a service in the future for w h ich they have a lre a d y p a id . So, p re p a id expenses d o not necessarily have a n y market value, but they have an e conom ic value because future resources w ill not have to be expe n de d . As the assets are consum ed in the process o f earning revenue, a portion o f the cost is w ritten o ff in each period as an expense. For exam ple, in the case o f prepaym ents, such as p re p a id insurance, one-twelfth o f the premium w o u ld be used up each month, resulting in a reduction in an asset (prepayments) a nd an increase in an expense (insurance expense). The accounting for prepaym ents w orks as fo llo w s. W h e n an am ount is p a id - for, say, an insurance premium prepaym ents (an asset) is increased a nd cash (an asset) decreases. A t the end o f the accounting p e riod, some o f the prepaym ent w ill have been used up. Therefore, the am ount o f the asset is reduced an d the expired portion o f the asset is treated as an expense. C o n sid e r the fo llo w in g exam ple.
194
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
O n 1 June 2 0 1 6 , a c o m p a n y pays $ 2 4 0 0 0 for a one-year insurance po licy. The accounts w o u ld be affected as follow s.
As one-twelfth o f the asset w a s used up in June (i.e. an expense o f $ 2 0 0 0 ), the closing b a la n ce of the asset is $ 22000 . The journal entry w o u ld be:
These accounts n o w a p p e a r as follow s: Insurance expense
Prepayments 24000
1 /6 Bal.
3 0 /6
2 000
3 0 /6
2 000
22 000
The prepaym ent b a la n ce o f $ 2 2 0 0 0 represents 1 1 months o f insurance that is p re p a id a nd w o u ld be shown in the b a lance sheet at 3 0 June 2 0 1 6 as a current asset. The insurance expense a ccount w o u ld a p p e a r on the June incom e statement. The transfer from the asset a ccount (prepayments) to the expense account (insurance expense) w ill continue each month for the next 1 1 months, b y w h ich time the asset w ill have a ze ro balance. You should note that there is an alternative w a y o f treating prepaym ents, w h ich m any com panies also use. In this case they treat the initial cash paym ent as an expense, then at the end o f the period reduce the expense by the am ount that has not been used up, thus creating an asset (prepayments). The effect on the accounting equation w o u ld be as follow s:
The journal entries w o u ld a p p e a r as follow s: $ 1 June
30 June
DR
Insurance expense
CR
Cash
DR
Prepayments
CR
Insurance expense
s|
24000 24000 22000 22 000
CHAPTER 5 Accrual accounting adjustm ents
195
These accounts n o w a p p e a r as follow s: Prepayments 3 0 /6
Bal.
22 000
Insurance expense 1 /6 3 0 /6 Bal.
24000
3 0 /6
22 000
2 000
As you can see, the balances in the prepaym ents an d the insurance expense at 3 0 June are identical under both methods. In this b o o k w e w ill g e n e ra lly use the first method. Prepayments a re sometimes show n on the fa ce of the b a la n ce sheet (the Telstra exam ple) o r included in other assets an d disclosed separately in the notes to the accounts (theJB Hi-Fi exam ple). Exhibit 5 . 1 shows that Telstra has $ 3 2 9 m illion of prepaym ents classified as current assets a nd shown on the fa ce of its 2 0 14 b a la n ce sheet. In contrast, JB Hi-Fi Limited, in its 2 0 1 4 annual report, shows prepaym ents in the notes as part o f 'other current assets'.
196
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A nother exam ple of the expiration o f assets is the using up o f supplies. For exam ple, on 3 June a c o m p a n y purchases supplies costing $ l 0 0 0 0 , w h ich it pays cash for. A t 3 0 J u n e , it is ascertained that $ 3 0 0 0 o f the supplies remains unused. Therefore, the b a la n ce o f the asset account (supplies) needs to be reduced b y $ 7 0 0 0 ( $ 1 0 0 0 0 $ 3 0 0 0 ). The fact that $ 7 0 0 0 o f supplies has been used up results in an expense.
The supplies expense b a la n ce o f $ 7 0 0 0 w o u ld a p p e a r in the June incom e statement. The supplies b a la n ce o f $ 3 0 0 0 w o u ld a p p e a r as a current asset in the b a la nce sheet as at 3 0 Ju n e. The journal entries w o u ld a p p e a r as follow s: $ 3 June
30 June
DR
Supplies
CR
Cash
DR CR
$
1 0 0 00 1 0000
Supplies expense
7000
Supplies
7000
A nother exam ple o f reducing the b a la n ce o f an asset a nd treating it as an expense upon consum ption is d e p reciation. This co n ce p t has been introduced earlier, an d w ill be discussed in section 5 .5 o f this cha p te r a n d , in m ore detail, in C h a p te r 10.
U nearned revenues Unearned revenue is future revenue w h e re the cash has been received in a d va n ce o f earning revenue. Alternative names for the unearned revenue account include 'revenue received in a d v a n ce ', 'advances from customers' and 'custom er deposits'. They relate to collections from customers for g o o d s o r services not yet p ro vid e d ; therefore, the revenue cannot yet be recognised. Examples include deposits from customers for jobs, insurance premiums received, yearly m aga zin e subscriptions received, g o lf club m em bership fees a nd rental incom e received in a d va n ce . For exam ple, a c o m p a n y that sells m agazines by subscription w o u ld usually receive these am ounts in a d va n ce , then send out m agazines each month. Assume that at the start o f the ye a r the c o m p a n y receives subscriptions o f $ 2 4 0 0 0 0 and has prom ised to send out m agazines for 1 2 months. A t the time o f collection, the am ount received w o u ld be a lia b ility because g o o d s o r services are o w in g to the subscriber. As each m a g a zin e is delivered, the lia b ility is reduced and revenue can be recognised.
January
+240000
Monthly
The journal entries w o u ld be as follow s:
+ 2 40 0 0 0 -2 0 0 0 0
+20000
CHAPTER 5 Accrual accounting adjustm ents
197
Each month, as the m a g a zin e is sent out, the fo llo w in g journal entry w o u ld be posted:
Q a n ta s A irw a ys Limited, in its 'Statement o f S ignificant A ccounting Policies' in its 2 0 1 4 A n n u a l Report, provides the fo llo w in g details on unearned revenue (described as 'revenue received in adva n ce '): P a s s e n g e r re v e n u e an d f r e ig h t re v e n u e is re c o g n is e d w h e n p a s s e n g e rs o r f r e ig h t a re u p lifte d . . . . R e c e ip ts f o r a d v a n c e d p a s s e n g e r t ic k e t sales o r f r e ig h t sales w h ic h ha ve n o t y e t b e e n a v a ile d o r re c o g n is e d as re v e n u e a re d e fe rre d o n th e b a la n c e s h e e t as re v e n u e re c e iv e d in a d v a n c e . Source: Q antas Airways Lim ited, Annual Report 2014.
This note indicates that w hen the cash is received, cash (an asset) w ill be d e b ite d a nd revenue received in a d va n ce (a liability) w ill be credited. W h e n passengers take their flight o r their ticket expires, the revenue received in a d va n ce account w o u ld be reduced (debited) an d revenue increased (credited). Q antas, like many other com panies including Telstra, refers to 'unearned revenue' as 'revenue received in advance'; that is, both terms can be used interchangeably. N o te that revenue received in advance is its largest current liability. In its 2 0 1 4 A nnual Report, Q antas has $ 3 4 0 6 million in current liabilities under the heading 'Revenue received in advance'. Qantas Group Note
2014
2013
$m
$m
18
1 851
1 844
Revenue received in advance
19
3 406
3 047
Interest-bearing liabilities
20
1 210
835
Other financial liabilities
25
182
86
Provisions
21
876
835
7525
6647
Current liabilities Payables
Total current liabilities
Source: Q a n ta s A irw a ys Limited,
A n n u a l R eport 2 0 1 4 .
Unearned revenue is also large in some service industries such as telecom m unications. As an exam ple, w hen you p a y your phone rental in a d va n ce , the paym ent received by Telstra w o u ld increase cash an d increase revenue received in a d va n ce . As it provides the service, the revenue w o u ld be increased a nd the lia b ility decreased. In previous annual reports, Telstra has noted that revenue received in a d va n ce consists m ainly o f revenue from p roviding access to the fixed a nd m obile netw ork a nd directories advertising revenue. This revenue is initially recorded as a lia b ility an d then transferred to earned revenue in line w ith its revenue recognition policies. The Institute o f C hartered A ccountants A ustralia (ICAA), in its 2 0 1 4 fin a n cia l statements, includes fees in a d va nce o f $ 3 6 0 6 4 . In note 1 0 , it describes them as follow s:
Source: The Institute o f C hartered Accountants Australia (ICAA),
2 0 1 4 F in a n c ia l Statem ents.
198
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o te that these items a re included in the lia b ility section because, a t year-end, the IC A A has not yet p rovided the service. They are recognised as revenue in the fo llo w in g year; that is, the ye a r the IC A A provides the service. Similarly, CPA Australia, in the notes to its financial statements for the ye a r ended 3 1 Decem ber 2 01 3, states that: T h e s u b s c rip tio n y e a r ru n s f r o m 1 J a n u a ry t o 31 D e c e m b e r . S u b s c r ip tio n s a re p a ya b le a n n u a lly in a d v a n c e . O n ly th o s e m e m b e rs h ip fe e s a n d s u b s c rip tio n p a y m e n ts t h a t a re a ttrib u ta b le t o th e c u r r e n t fin a n c ia l y e a r a re re c o g n is e d
as re v e n u e . F e e s a n d s u b s c rip tio n
p a y m e n ts t h a t re la te t o
fu tu re
p e rio d s a re s h o w n
in th e S ta te m e n t o f fin a n c ia l p o s itio n as s u b s c rip tio n s a n d fe e s in a d v a n c e u n d e r t h e h e a d in g o f C u r r e n t lia b ilitie s - o th e r. Source: C P A Australia, 2013 Annual Report.
Accrual o f unrecorded expenses This adjustm ent involves determ ining w h ich expenses have been incurred b y the o rganisation (but not p a id in cash) during a particular period o f tim e - g e n e ra lly a month. This usually involves checking w h ich invoices have been received from suppliers, incorporating that inform ation into the accounting system as accounts p a ya b le , a nd making estimates for expenses for w h ich invoices have not yet been received (e.g. telephone, electricity a nd accounting fees). G e n e ra lly speaking, accounts p a y a b le includes trade suppliers, but accrued expenses include other expenses incurred in running the business. A ccrued expenses are expenses that have been incurred during the current period but w ill not be p a id until the fo llo w in g period. A com m on exam ple is w a g e s. Because the end o f the p a y p eriod a nd the end of the financial period occur on different days, it is necessary to include an accrual for w a g e s p a y a b le from the d a te o f last paym ent to the d a y on w h ich the accounting period finishes; that is, the em ployees have d o n e the w o rk but w ill not be p a id for this w o rk until after the end o f the fin a n cia l year. Therefore, at year-end, the organisation has a lia b ility. It is usually called 'accrued w a g e s ' o r 'w a g e s p a y a b le '. For exam ple, assume w a g e s are p a id w e e kly (on Thursday) to cover the previous five w o rkin g days before the Thursday. If 3 0 June falls on a Friday, tw o d a ys' w a g e s w ill be o w in g at 3 0 June. If the w e e kly w a g e s bill is $ 5 0 0 0 0 0 , then $ 2 0 0 0 0 0 (Thursday a nd Friday) w ill be o w in g .
30 June
+200000
-2 0 0 0 0 0
Total
+200000
-2 0 0 0 0 0
W a g e s expense is increased because it is an expense o f the p e riod, an d accrued w a g e s (or w a g e s payable) is increased because there is a lia b ility at the end of the p e riod. O th e r exam ples o f accruals w o u ld be interest expense and electricity charges o w in g at the end of a period. The journal entry w ill be: $ 30 June
DR CR
Wages expense Accrued wages
$
200000 200000
CHAPTER 5 Accrual accounting adjustm ents
199
The 2 01 3 annual report o f D avid Jones Limited shows the fo llo w in g :
Source: D avid Jones Ltd,
A n n u a l R eport 2 0 1 3 .
The a b o v e shows that for 2 0 1 3 , the $ 2 6 1 8 4 0 0 0 0 in payables includes other payables an d accruals of $ 1 3 2 4 2 7 0 0 0 . C o n sid e r the effect on p rofit for the p eriod a nd current liabilities if these items had not been included. Liabilities w o u ld sh o w $ 1 3 2 4 2 7 0 0 0 less, an d expenses w o u ld also be $ 1 3 2 4 2 7 0 0 0 less. You can see that these adjustments can have a m ajor im pact on the fin a n cia l statements. Consistent w ith the D avid Jones Limited exam ple a b o ve , accruals are norm ally included in the current liabilities section under the heading 'P ayables', a nd the am ount o f the accrual is show n separately in the notes to the accounts. H ow ever, if they are large enough, they a re show n on the fa ce o f the b a la n ce sheet.
Accrual o f unrecorded revenues The accrual o f unrecorded revenues occurs w hen a service has been p rovided but cash w ill not be received until the fo llo w in g p e riod. C om m on exam ples o f accrued revenues include interest receivable on loans, commissions earned and unbilled revenues. For exam ple, assume a c o m p a n y deposited $ 5 0 0 0 0 0 w ith a bank fo r on e ye a r at 4 per cent on 1 January 2 0 1 6 (interest p a y a b le at the end of the period). A t 3 0 June 2 0 1 6 , it w o u ld have earned $ 1 0 0 0 0 interest, although the total interest of $ 2 0 0 0 0 w o u ld not be received until 31 D ecem ber 2 0 1 6 . A ccrued interest (also ca lle d 'interest receivable'), w h ich is an asset, w o u ld be increased by $ 1 0 0 0 0 , and interest revenue w o u ld be increased by $ 1 0 0 0 0 .
A ccrued revenue (or interest receivable) is a current asset that w ill a p p e a r in the b a la n ce sheet, a nd interest revenue is a revenue account that w ill a p p e a r in the incom e statement for the y e a r e nded 3 0 J u n e 2 0 1 6 . The journal entry w o u ld be: $ 30 June
DR CR
Accrued revenue Interest revenue
*
1 0 0 00 10000
1
200
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
An interesting exam ple o f accrued revenue is p rovided in the 2 0 1 4 Telstra accounts. Telstra bills its customers either m onthly o r quarterly. W h e n it bills customers, it increases accounts receivable an d increases sales revenue. W h e n the cash is received, cash is increased a nd accounts receivable is decreased. H ow ever, at 3 0 J u n e there w ill be a lot o f telephone calls that have been m ade but not yet b illed. For exam ple, if you receive a bill on 1 June (and you are billed quarterly), you w ill not receive another bill until 1 Septem ber. As telephone calls have been m ade in June, Telstra has p rovided the service; therefore, it is entitled to recognise the revenue. Telstra's fin a n cia l statements (note 10) show accrued revenue of $1 1 5 5 m illion ($ 1 0 9 3 m illion in 2 01 3) under current assets. That is, at the end o f the year, it increased accrued revenue an d increased sales revenue.
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
W h a t e f f e c t w o u ld fa ilu re to m a k e a d ju s tm e n ts f o r a c c ru e d e x p e n s e s ha ve o n th e in c o m e s ta te m e n t and th e b a la n c e s h e e t?
2
A c o m p a n y has a $ 5 0 0 0 0 b a la n c e in th e c o m p a n y ’s u n e a rn e d s e rv ic e re v e n u e a c c o u n t. W h e re w o u ld th is a c c o u n t a p p e a r in th e b a la n c e s h e e t? Y o u r a n sw e rs s h o u ld be:
1
In c o m e s ta te m e n t: e x p e n s e s w o u ld be u n d e rs ta te d an d th e r e fo r e p r o fit o v e rs ta te d . B a la n c e s h e e t: lia b ilitie s w o u ld be u n d e rs ta te d an d re ta in e d p r o fits w o u ld be o v e rs ta te d (b e c a u s e p r o fit was o v e rs ta te d )).
2
L ia b ilitie s (p ro b a b ly c u r r e n t lia b ilitie s , a s s u m in g th a t th e s e rv ic e w ill be c a rrie d o u t w ith in a y e a r).
5.3
M ulti-colum n worksheets
M ulti-colum n worksheets are a useful d e vice to help you prepare fin a n cia l statements w h e re there a re m any adjusting entries. For exam ple, a 10-colum n adjusted w orksheet, start w ith the pre-adjusted trial b a la n ce (columns 1 a nd 2), then include adjusting entries (columns 3 a nd 4 ), fo llo w e d by the adjusted trial balance (columns 5 a nd 6), incom e statement numbers (columns 7 a n d 8) a nd b a la n ce sheet numbers (columns 9 an d 10). W h e re adjusting entries refer to a particular ledger a ccount in the pre-adjusted trial b a la n ce (e.g. prepayments), the am ount o f the adjusting entry should be entered in the a p p ro p ria te adjustm ent column o p p o site the relevant ledger account. W h e n the d e b it o r credit part of the adjusting entry refers to a ledger account that is not in the unadjusted trial balance, the nam e o f that le d g e r a ccount should be a d d e d to the bottom o f the trial b a la n ce a n d the am ount entered o p posite it in the a p p ro p ria te adjustm ent colum n. To further illustrate the a b o v e adjustments, consider the trial b a la n ce in Exhibit 5 .2 an d the fo llo w in g inform ation: •
The c o m p a n y prepares accounts annually.
•
Ending office supplies on hand w a s $ 1 3 m illion.
•
Prepayments related to insurance policies taken out on 1 O c to b e r 2 0 1 6 for on e year.
•
Unearned revenue relates to a six-month service agreem ent starting on 1 N ovem ber.
•
A t the end o f the year, w a g e s of $ 3 m illion w e re still o w in g .
•
An electricity bill w a s received on 1 O January show ing that electricity costs for D ecem ber 2 0 1 6 w e re $ 2 m illion.
•
O f the cash b alance, $ 2 7 m illion w a s on fixed dep o sit w ith the bank. The accrued interest at the end o f the year w a s $ l million.
CHAPTER 5 Accrual accounting adjustm ents
201
The fo llo w in g journal entries w o u ld be required:
1
$m Dec. 31
DR CR
Office supplies expense
$m
17
Office supplies
17
To record supplies used during the period Dec. 31
DR CR
Insurance expense
10
Prepayments
10
To record expiration of insurance coverage Dec. 31
DR
Unearned revenue
CR
Fees revenue
DR
Wages expense
10 10
Recognising revenue for fulfilling part of service contract Dec. 31
CR
3
Accrued expenses
3
To record accrued salaries a t year-end Dec. 31
DR CR
Electricity expense
2
Accrued expenses
2
To record accrued electricity a t year-end Dec. 31
DR CR
Accrued revenue
1
Interest revenue
1
To record accrued revenue a t year-end
A fter these entries have been posted to the ledger accounts, a multi-column w orksheet such as Exhibit 5 .3 could be used to p ro vid e an adjusted trial b a la n ce an d inputs for the incom e statement an d b a la n ce sheet in Exhibit 5 .4 .
1
202
EXHIBIT 5.3
WESTBANK LIMITED
Trial balance Account Nam e Cash
Debit
Adjustments
Credit
Debit
Adjusted trial balance
Credit
Debit
Income statement
Credit
Debit
Balance sheet
Credit
Debit
Credit
30
30
30
Accounts receivable
180
180
180
Inventory
220
220
220
Office supplies
30
17
13
13
Prepayments
40
10
30
30
Accrued revenue
0
1
Accounts payable
150
Unearned revenue
30
Accrued expenses
0
Loan Share capital Retained profits Sales Interest revenue Fees revenue
1
10 5
1 150
150
20
20
5
5
100
100
100
80
80
80
40
40
950
950
950
40
50
1
51
51
0
10
10
10
Cost of goods sold
300
Insurance expense
100
10
110
110
Wages expense
400
3
403
403
Electricity expense
20
2
22
22
Other expenses
80
80
80
Office supplies expense
300
0
17
300
17
17
Net profit
79 1400
1400
43
43
1 406
1 406
1011
79 1011
474
474
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
T R IA L BALANCE A T 31 DECEM BER 2 0 1 6
CHAPTER 5 Accrual accounting adjustm ents
EXHIBIT 5.4
WESTBANK LIMITED IN C O M E S TA T E M E N T FOR TH E M O NTH ENDING 31 DECEM BER 2 0 1 6
BALANCE SHEET AS AT 31 DECEM BER 2 0 1 6
* Closing retained profits = 4 0 + 79 = 119
203
204
5.4
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The financial period
Financial statements all have a tim e dim ension. Balance sheets are prepared as at specific points in time, a n d incom e statements cover specified periods o f time. Business, an d other e conom ic activities, carries on continuously. Therefore, if the financial statements are to be a t (or begin an d end at) particular dates, fin a n cia l accounting must som ehow find a w a y to separate all those activities into periods. M a k in g effective cut-offs for revenues an d expenses is a m ajor problem for accrual acco u n tin g . M u ch effort is put into determ ining w hether revenues are p laced in the a p p ro p ria te years, w hether there a re bills outstanding for expenses that should be taken into account, w hether inventories of g o o d s a nd supplies are actu a lly on hand, a nd so on. It is generally harder to d o this if an enterprise has larger an d less frequent revenue a nd expense transactions; and easier, therefore, if enterprises have m any short a nd sim ple transactions. But even then it can be difficult to keep track o f just w here the enterprise stands if there a re thousands o f transactions in process across a year-end. W h e n should the fin a n cia l (accounting) ye a r begin an d end? C om p a n ie s have an initial ch o ice , but once they make it, reasons relating to habit, an d legal an d tax rules, usually force them to stay w ith that c h o ice indefinitely. They m ay select a fin a n cia l year-end that is a relatively quiet time, so that there a ren't m any unfinished transactions in process, and the revenue an d expense cut-offs can be m ade more cleanly. A large m ajority o f Australian public com panies have 3 0 June as their fin a n cia l year-end. O n e reason for this is that it coincides w ith the end o f the tax year. H ow ever, this is certainly not the o n ly reason to use 3 0 June, as it is possible in A ustralia to use a substituted accounting p eriod for taxation purposes, p rovided permission is received from the Australian Taxation O ffic e . Financial year-ends va ry substantially betw een countries. For exam ple, in the United States, C a n a d a , S in g a p ore an d M a la y s ia , 31 D ecem ber is the most com m on date, w h ile in the United K ingdom , N e w Z e a la n d an d Japan, 31 M a rc h is most com m on. Examples o f A ustralian com panies w ith b a la n ce dates other than 3 0 J u n e include those show n b e lo w . Date
Company
31 March
James Hardie Industries Macquarie Bank
31 July
Washington H Soul Pattinson
31 August
Ten Network Holdings Limited
30 September
Orica Australia Australia and New Zealand Banking Group Westpac National Australia Bank
31 December
Coca-Cola Amatil Caltex
5.5
Contra accounts
Just about every b a la n ce sheet a ccount can be considered to be a control account. C ash is a record o f the cash that should be there if it w e re counted. A ccounts receivable is the sum o f all the individual customers' accounts. Inventory is the am ount that should be found if the c o m p a n y lists o r counts all the unsold g o o d s physically on hand. Accounts p a y a b le is the sum o f all the individual suppliers' accounts. The num ber o f shares outstanding should be tra ce a b le to the share c a p ita l account. (The particular ow ners m ay ch a n g e, for exam ple, because of trading on the stock market, but the c o m p a n y should a lw a ys kn o w h o w m any shares it has issued an d w h a t it o rig in a lly received for them.) Even the property, plant a nd equipm ent asset accounts are controls, as all the assets w h o se costs are included should be physically present. The value o f all these accounts as control accounts is that the am ounts in them should be supported by, or reconcilable to, d e ta ile d lists o r subsidiary ledgers, o r some such background d a ta . W h a t d o w e d o , then, w hen w e
CHAPTER 5 Accrual accounting adjustm ents
205
w a n t to make a ch a n g e in a b a la n ce sheet account w ith o u t ch a n g in g the underlying records a nd lists? H ere are some exam ples o f w hen w e m ight w a n t to ch a n g e an asset a ccount an d w h y, at the same time, w e m ight be reluctant to d o it: •
W e have becom e w o rrie d that w e m ight not collect all the accounts receivable, so, for conservatism a nd proper p rofit measurement, w e w a n t to recognise that w e have p ro b a b ly suffered some 'b a d debts' expense. H ow ever, w e d o not w a n t to ch a n g e the accounts receivable control account because it should correspond to the list of customers' accounts, a nd w e have not yet given up on collecting a n y accounts receivable, so the control feature is still useful. W e address this issue in C h a p te r 8.
•
The property an d plant assets are being used up e co n o m ica lly so w e w a n t to record d e p re cia tio n expense as part o f our profit measurement. H ow ever, w e d o not w a n t to ch a n g e the asset cost account balances because their costs a re not ch a n g in g , but rather their e conom ic values a re being used. W e address this issue b e lo w . In these examples, the financial statement objectives of proper asset valuation an d profit measurement seem to conflict
w ith m aintaining the accounts for control purposes. To address this problem a 'contra account' has been invented to a llo w us to recognise expenses and related value changes to assets w ithout changing the control account. It is useful both for profit measurement and to preserve the internal control aspects of the accounts. Therefore, it provides a bridge between accounting's role in internal control (which is outlined in C hapter 7) and in financial statement preparation. C ontra accounts have balances that are in the o p p o site direction to those o f the control a ccount w ith w h ich they are associated. For exam ple, contra asset accounts have credit balances that are 'co n tra ' the assets' d e b it balances. They are m ainly used fo r m a naging expense accruals separately from the asset accounts to w h ich they relate. Therefore, they keep the accruals from being m ixed into those accounts. C ontra accounts o n ly have m eaning in conjunction w ith the control accounts to w h ich they are m atched. W e ll see b e lo w h o w this works. H ere w e w ill focus o n ly on one very com m on use o f contra accounts: accum ulated dep re cia tio n (amortisation). Virtually all enterprises have this account. The a ccount illustrates h o w the accounting system can meet o ne o b je ctive (expense recognition) an d a vo id com prom ising another o b je ctive (control) by creating an account that recognises expenses but does not c h a n g e the control a ccount related to those expenses (asset costs).
A ccum ulated depreciation (am ortisation ) C ontra accounts are used to accum ulate d e p re cia tio n on fixed assets, such as buildings an d equipm ent. For exam ple, for equipm ent w h ich cost $ 5 0 0 0 0 0 a nd has a life o f 5 years, the annual dep re cia tio n c h a rg e of $ 1 0 0 0 0 0 w o u ld be recognised as follow s:
1 DR CR
$ Depreciation expense
s1
100000
Accumulated depreciation
100 00 0
The d e b it is an expense account in the incom e statement. The credit is a contra asset account. The credit side of the journal entry could have been to the asset a ccount 'B u ild in g '. Instead the contra a ccount is used, so that by leaving the asset cost a ccount a lone, the b a la n ce sheet presents the acquisition cost o f the asset a lo n g w ith the accum ulated am ount o f expense that has been recognised to d ate. S ho w in g both these items a llo w s users to make a rough guess as to h o w long the asset has been in service. Remember that accum ulated de p re cia tio n on the bala nce sheet is the am ount o f dep re cia tio n accum ulated over the life o f the asset to date, w hereas the am ount o f d epreciation charg e d this ye a r (to match the revenues the asset consum ption is presum ed to have helped generate) can be determ ined from the d e p re cia tio n expense acco u n t in the incom e statement. Let's lo o k a t a sim ple exam ple involving an electrician's purchase of a n ew truck. The truck cost $ 5 0 0 0 0 a nd an annual dep re cia tio n expense o f $ 8 0 0 0 w a s determ ined. Each year, the d e p re cia tio n expense a ccount w o u ld be increased by $ 8 0 0 0 a nd the contra asset a ccount (called 'accum ulated d e p re cia tio n ') w o u ld be increased by $ 8 0 0 0 . (In C h a p te r 1 0 w e discuss various d e p re cia tio n methods. H ere w e introduce the most im portant method c alled straight-line dep re cia tio n (see p a g e 3 9 1 ).)
206
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The journal entry w o u ld be:
1
s|
$
DR
Depreciation expense
CR
8000
Accumulated depreciation
8000
O n the b alan ce sheet, the asset a ccount for the truck's cost w o u ld continue to sh o w a b a la n ce o f $ 5 0 0 0 0 , but each ye a r the accum ulated dep re cia tio n contra asset a ccount w o u ld increase b y $ 8 0 0 0 . Deducting accum ulated depreciation from the long-term asset acco u n t leaves a figure known as the net book value. So w e w o u ld have: Cost
Accumulated depreciation
Net book value
$
$
$
Date of purchase
50000
0
50000
End of first year
50000
8 000
42 000
End of second year
50000
16 000
34000
If the truck w e re sold at a n y time, the cost w o u ld be rem oved from the ledger, but so w o u ld the contra account. The contra is m eaningful o n ly in com parison to the cost - w hen the truck is g o n e , neither a ccount is needed any more. Suppose the truck w e re sold fo r $ 3 7 0 0 0 at the end of the second year. A t this point, the accum ulated depreciation is $ 1 6 0 0 0 ( $ 8 0 0 0 + $ 8 0 0 0 ) an d the b o o k value is $ 3 4 0 0 0 ( $ 5 0 0 0 0 - $ 1 6 0 0 0 ) . If the c o m p a n y receives $ 3 7 0 0 0 , it makes a g a in of $ 3 0 0 0 . This g a in (usually called gain on sale o r profit on sale) is a revenue item. These effects a re shown as follow s: = Liabilities
Purchase
Cash
Truck
-5 0 0 0 0
+50000
Accumulated depreciation
Year 1
+ Equity Revenue
- 8 000
Year 2
Expense
- 8 000
- 8 000
- 8 000
Subtotal
-5 0 0 0 0
+50000
-1 6 0 0 0
-1 6 0 0 0
Sale of truck
+37000
-5 0 0 0 0
+16000
+3 000
The journal entry is:
The gain on sale is just the difference betw een the proceeds an d the net b o o k value at the d a te o f sale. If the proceeds had been $ 2 9 0 0 0 instead, the d e b it to cash w o u ld have been $ 2 9 0 0 0 a nd there w o u ld have been a d e b it to loss on sale (an 'other expense' account in the incom e statement) for $ 5 0 0 0 , the difference betw een the proceeds and the net b o o k value. W h e n non-physical assets, such as licences, patents a nd tradem arks, are am ortised, the accum ulated am ortisation account is used instead of accum ulated d e p re cia tio n . G a in s, losses an d write-offs on such assets are calculated just as for the physical assets illustrated a b o ve .
CHAPTER 5 Accrual accounting adjustm ents
5.6
207
Illustrative example
B elow , w e pro vid e an exam ple to reinforce the material covered in C hapters 4 a n d 5 . It covers journal entries, posting to the ledger, trial ba la n ce , adjustments, closing entries an d preparation o f fin a n cia l statements. Scanlon Limited had the fo llo w in g trial b a la n ce at 1 January 2 0 1 6 :
During January 2 0 1 6 , the fo llo w in g transactions occurred: a
C ash sales $ 7 0 0 0 0 0 .
b
C re d it sales $ 6 1 0 0 0 0 0 .
c
C ost o f g o o d s sold $ 3 0 0 0 0 0 0 .
d
Inventory purchased on credit $ 2 6 0 0 0 0 0 .
e
C ash collected from customers $ 5 8 0 0 0 0 0 .
f
C ash p a id to suppliers $ 2 8 0 0 0 0 0 .
g
Paid incom e tax liability.
h
Paid salaries $ 1 2 0 0 0 0 0 , com m ission $ 6 0 0 0 0 0 , other o perating expenses $ 1 0 0 0 0 0 .
i
Paid $ 4 0 0 0 0 for insurance.
j
Paid $ 3 0 0 0 0 in rent (the c o m p a n y debits p re p a id rent),
k
D epreciation expense is calculated a t 1 2 per cent per annum on cost.
I
C lo sin g balances in the p re p a id insurance a nd p re p a id rent accounts at the end o f January 2 0 1 6 should be $ 7 0 0 0 0 a nd $ 6 0 0 0 0 , respectively.
m The $ 1 0 0 0 0 0 revenue received in a d v a n ce related to a service contract that has n o w been fulfilled in w h o le , n
The bank ow es Scanlon Ltd $ 5 0 0 0 for interest a t the end o f January. The fo llo w in g steps w ill be carried out:
1
Prepare journal entries for the a b o ve transactions (Exhibit 5 .5 ).
2
Enter the o p e n in g balances in the ledger accounts a n d post the journal entries to the ledger (Exhibit 5 .6 ).
3
Prepare a trial b a la n ce at 31 January 2 0 1 6 (Exhibit 5 .7 ).
4
Prepare closing entries (Exhibit 5 .8 ).
5
Prepare a post-closing trial b a la n ce (Exhibit 5 .9 ).
6 Prepare an incom e statement for the month o f January 2 0 1 6 a n d a b a la n ce sheet as at 31 January 2 0 1 6 (Exhibits 5 .1 0 a nd 5.1 1).
208
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Before preparing the fin a n cia l statements, the revenue a n d expense accounts are closed via the closing journal entries (Exhibit 5 .8 ). They start w ith a ze ro b a la n ce in the next accounting p eriod to e n a b le profit for that period to be calculated. A fter posting these journal entries, a post-closing trial b a la n ce is prepared (Exhibit 5 .9 ). The incom e statement and the b a la n ce sheet are p rovided in Exhibits 5 .1 0 a n d 5 . 1 1 .
CHAPTER 5 Accrual accounting adjustm ents
209
» 1
31 Jan. 16
Insurance expense
30000
Prepaid insurance
30000
To record insurance expense for the month 1
31 Jan. 16
Rent expense
20000
Prepaid rent
20000
To record rent expense for the month m
31 Jan. 16
Revenue received in advance
100000
Service fee revenue
100 00 0
To record the earning of service fee revenue for the month n
31 Jan. 16
Accrued revenue
5 000
Interest revenue
5 000
To record the earning of interest revenue for month
EXHIBIT 5.6
SCANLON LIMITED LEDGER ACCOUNTS
Cash Bal. b /d
Accounts receivable
200000
f
2 800000
a
700000
g
500000
e
5 800000
h
1900000
i
40000
j
30000
Bal. c /d
1430000
Bal. b /d
700000
600000
Bal. c /d
2 600000
900000
Bal. b /d
60000
Prepaid insurance c
Bal. c /d
3 000000 300000
i
3 300000
300000
i
Bal. b /d
50000
3 1 /1 /1 2
30000
Bal. c /d
80000 Bal. b /d
40000
1 Bal. c /d
30000 70000
1 0 0 00 0
Prepaid rent Bal. b /d
6700000
6700000
3 300000 Bal. b /d
5 800000
900000
6 700000 Bal. b /d
Inventory
d
e
b 6100000
1430000
6700000 Bal. b /d
Bal. b /d
100 00 0
70000
Equipment 1
20000
Bal. b /d
1000000
60000 80000
60000
Accrued revenue n
5 000
Accumulated depreciation Bal. b /d
200000 k
10000 210000
»
210
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
» Accounts payable f
2 800000
Revenue received in advance
Bal. b /d
500000 d
Bal. c /d
m
300000
g
3100000
Bal. b /d
500000
300000
Bal. b /d
Bal. b /d
570000
Bal. b /d
n
Salaries expense m
100000
h 1200000
Cost of goods sold
600000
Insurance expense 1
30000
1
20000
O ther expenses
Commission expense
Depreciation expense k
10000
6100000 6 800000
2 265 000
h
700000
b
Interest revenue
Service fee revenue
100000
a
320000 1 945 000
h
420000
Sales
Retained profits
3 000000
500000
Bal. b /d
Loan
c
100000
Share capital
3100000 Bal. b /d
1 0 0 00 0
Income tax payable
2 600000
Rent expense
5 000
CHAPTER 5 Accrual accounting adjustm ents
Loan
570000
Share capital
420000
Retained profits
320000
Sales
6 800000
Service fee revenue
100 00 0
Interest revenue
5 000
Cost of goods sold
3 000000
Salaries expense
1 2 0 0000
Depreciation expense
1 0000
Insurance expense
30000
Rent expense
20000
Commission expense
600000
Other expenses
100000 8 725 000
8 725 000
211
212
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 5.10
SCANLON LTD IN C O M E S TA T E M E N T FOR TH E M O N TH ENDING 31 JANUARY 2 0 1 6
CHAPTER 5 Accrual accounting adjustm ents
5.7
213
Managers and accrual accounting assumptions
A ccrual a ccounting's purpose is to move beyond cash flow s to w a rd s a b ro a d e r e co n o m ic co n ce p t o f profit and financia l position. From a m anager's point o f v ie w , this has several im portant im plications: •
As a m ore inclusive w a y of measuring perform ance an d position, accrual accounting should reflect m ore o f w h a t a m anager is trying to d o than cash flo w can. This should make accrual accounting attractive to m anagers w h o w a n t to be evaluated fa irly an d w h o are interested in co m p a rin g their com panies w ith others.
•
This attractiveness depends on h o w com plete accrual accounting is in representing m anagers' perform ance. Here, there is a lim itation that often frustrates m anagers: accrual a ccounting, based on the historical transaction base o f record-keeping, is better suited to measuring past perform ance than to looking into the future, as m anagers are inclined to do .
214
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A ccounting runs into a fundam ental problem here. W h ile m anagers' expectations are a main reason for their actions, accounting cannot observe their expectations, but o n ly their actions. (Expectations are not observable in general, so this is not just a problem for accounting.) So, accounting reports the results of actions, not the reasons for those actions (except b y im plication). M a n a g e rs m ay therefore feel that the accounting statements are incom plete because they miss the 'w h y ' behind the revenues, expenses, assets a nd liabilities.
•
To m any peo p le , profits should be defined as changes in the value of the com p a n y. Econom ic earnings can be defined as increases in value. V alue changes are a function o f perform ance, but also o f expectations an d o f the market prices for assets a n d w h o le com panies. The evidence-based accounting procedures for revenue recognition a nd expense recognition, an d m atching them to measure profit, m ay not relate very w e ll to econom ic concepts o f earnings, o r to m anagers' struggles to increase the value o f their com panies.
•
A ccrual accounting's procedures require e vidence to support entries an d conservatism in estim ating the effects of future events (provide for expected losses, but not for expected gains until they occur). To m anagers seeking an even-handed evaluation o f their perform ance, accounting m ay seem overly sceptical a b o u t the future and d o w n w a rd ly biased in its measures. A ccrual accounting goes beyond cash flow s, a nd m anagers m ay w ish that it w e n t further, to recognise their optim ism a b o u t the future m ore than it does.
•
The criteria for w hen a nd h o w to recognise revenues an d expenses are in e sca p a b ly judgem ental, a nd therefore have both an a rb itra ry a nd a subjective aspect. Earlier chapters have suggested that some m anagers m ay be m otivated to m anipulate accounting results, a n d accrual accounting procedures can be a w a y o f d o in g this. H ow ever, it should also be said that m any m anagers find accrual accounting to o loose an d flexible an d w o u ld prefer less estim ation an d subjectivity. Prudence a nd conservatism a re also traits of m any m anagers, not just of accountants a nd auditors!
•
M o d e rn finan ce theory, w h ich is influential in the evaluations b y fin a n cia l markets, banks a nd takeover specialists, makes much o f cash flow s, but, as you have seen, cash flo w does not necessarily connect w e ll w ith accrual accounting's profit figure. This connection is w orse the shorter the period (e.g. cash flo w an d accrual profit are p ro b a b ly sim ilar over a l O-year p e riod, but a re unlikely to be sim ilar over a month). A nother reason, therefore, for m anagers to take fin a n cia l accounting seriously is so that they can kn o w w hen the
accounting measures seem a p p ro p ria te an d w hen they d o not. A ccrual accounting has m any adva n ta g e s a nd is very w id e ly used, but m anagers should not a c ce p t it uncritically. As a future m anager, you can be alm ost certain that accrual accounting numbers w ill affect your perform ance evaluation in your career. It is a lw a ys g o o d to know the rules by w h ich you are being evaluated a nd often rew a rd e d .
CHAPTER 5 Accrual accounting adjustm ents
215
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A A d ju s tin g jo u rn a l entries It is th e e n d o f In te rn a tio n a l F a brics Ltd's fin a n c ia l y e a r. Y ou a re w o rk in g on th e c o m p a n y 's fin a n c ia l statem ents, a n d h a ve d is c o v e re d th e item s a - f listed b e lo w . For e a ch item : 1 State w h e th e r o r no t th e item re q u ire s th a t an a d ju s tm e n t be m a d e in th e c o m p a n y 's a c co u n ts a c c o rd in g to the p rin c ip le s o f a c c ru a l a c c o u n tin g . 2
If th e a n s w e r to q u e s tio n 1 is yes, w rite a jo u rn a l e n try to a d ju s t th e c o m p a n y 's a c co u n ts. a
$ 3 2 0 0 o f sales m a d e on a c c o u n t just b e fo re th e e n d o f th e fin a n c ia l y e a r w a s n o t re c o rd e d until the b e g in n in g o f th e n e xt y e a r.
b
The cost o f g o o d s s o ld fo r those sales, to ta llin g $1 9 0 0 , has no t y e t be en re c o g n is e d .
c
D u rin g the y e a r, d e p o s its o f $ 5 3 0 0 w e re m a d e b y custom ers on s p e c ia l o rd e rs a n d w e re c re d ite d to the d e p o s it lia b ility a c c o u n t. D e p o sits o f $ 1 4 0 0 a re still b e in g h e ld , b u t a ll th e o th e r s p e c ia l o rd e rs h a ve been c o m p le te d a n d th e custom ers h a ve p a id th e rest o f th e p ric e fo r th ose o rd e rs (those p a ym e n ts a re in c lu d e d in sales revenue).
d
M a in te n a n c e expe nses seem ed ra th e r h ig h , a n d on in v e s tig a tio n it tu rn e d o u t th a t an a d d itio n to the c o m p a n y 's store, c o n s tru c te d o v e r a p e rio d o f seve ral m onths a t a cost o f $ 6 2 3 2 0 , h a d been in c lu d e d in the m a in te n a n c e expe nses.
e
The c o m p a n y 's a u d ito rs sent a b ill fo r $ 2 3 5 0 fo r th e y e a r's a u d it w o rk ,
f
Just b e fo re th e y e a r-e n d , the c o m p a n y b o u g h t a m o to r v e h ic le fo r $ 1 7 2 2 0 o n c re d it.
PRACTICE PROBLEM B Revenues as expenses The fo llo w in g tra n s a c tio n s o c c u rre d b e tw e e n 1 July 2 0 1 5 a n d 3 0 June 2 0 1 6 fo r A K H Lim ited, a
Issued sh a re c a p ita l fo r $ 6 0 0 0 0 0 cash,
b
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it,
c
P aid $ 5 6 0 0 0 to a c co u n ts p a y a b le .
d
S old in v e n to ry c o stin g $1 2 0 0 0 0 fo r $ 3 4 0 0 0 0 . A ll sales a re on c re d it,
e
R eceived $ 2 2 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
f
P aid d iv id e n d s o f $ 6 0 0 0 0 .
g
B o rro w e d $ 2 0 0 0 0 0 on 1 July 2 0 1 5 . The lo a n is d u e on 3 0 June 2 0 1 8 a n d c a rrie s a 1 0 p e r c e n t p .a . interest rate. P aid $ 8 0 0 0 in tere st on this lo a n d u rin g 2 0 1 6 .
h
P aid w a g e s o f $ 1 8 0 0 0 0 ; w a g e s o f $ 4 0 0 0 0 h a d be en e a rn e d b y e m p lo y e e s b u t n o t p a id a t y e a r-e n d .
i
O n 1 June re c e ive d a d e p o s it o f $ 8 0 0 0 0 fo r w o rk to be c a rrie d o u t in th e n e xt y e a r,
j
U sed $ 2 2 0 0 0 o f e le c tric ity d u rin g th e y e a r fo r w h ic h th e c o m p a n y has n o t y e t be en b ille d ,
k
P aid a $ 2 4 0 0 0 in su ra n c e p o lic y on 1 O c to b e r 2 0 1 5 , c o v e rin g 1 O c to b e r 2 0 1 5 to 3 0 S e p te m b e r 2 0 1 6 .
Required: 1
List a ll revenues fo r th e y e a r (in c lu d in g d o lla r a m ou nts).
2
List a ll expe nses fo r th e y e a r (in c lu d in g d o lla r am ou nts).
3
By h o w m uch d id th e cash b a la n c e in cre a s e d u rin g th e y e a r?
216
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEM C A cco u n tin g tra n sa ctio n s: re co n stru ctio n required The b a la n c e sheet a n d in co m e state m e nt o f R econ stru ction Lim ited a re re p ro d u c e d b e lo w . RECONSTRUCTION LIMITED BALANCE SHEET 3 1 /1 2 /2 0 1 6 Assets
$
Cash
Prepaid insurance
$ 5 000
-
Accounts receivable
3 1 /1 2 /2 0 1 5
40000
27000
3 000
2 000
Equipment
90000
90000
less Accumulated depreciation
(31 000)
(22 000)
Motor vehicle
25 000
25 000
less Accumulated depreciation
(10000)
Total assets
117000
122 000
500
1 000
Wages payable
6000
4000
Interest payable
2 500
3 000
(5 000)
Liabilities Accounts payable
Income tax payable
2 000
-
Long-term loan
50000
50000
Total liabilities
59000
60000
$ 58000
$ 62 000
Net assets
Shareholders' equity Share capital
39000
39 000
Retained profits
19000
23 000
$ 58000
$ 62 000
Total shareholders' equity
RECONSTRUCTION LIMITED INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20 16 $ Fees revenue Depreciation expense
(14000)
Electricity expense
(8 000)
Insurance expense
(17000)
Interest expense Rent expense Stationery expense Wages expense Profit/(loss) before tax
$ 105 000
(4500) (24000) (3 500) (38 000)
(109 000) (4000)
Income tax expense
0
Profit/(loss) aftertax
(4000)
CHAPTER 5 Accrual accounting adjustm ents
1
H o w m uch cash w a s p a id fo r in su ra n c e d u rin g th e y e a r?
2
H o w m uch cash w a s p a id fo r e le c tric ity d u rin g th e y e a r?
3
H o w m uch cash w a s p a id fo r in tere st d u rin g th e y e a r?
217
4
H o w m uch cash w a s p a id fo r in co m e ta x d u rin g th e y e a r?
5
The last m o n th ly rent p a y m e n t w a s m a d e on 1 5 D e c e m b e r 2 0 1 6 . M o n th ly rent is $ 2 0 0 0 p e r m o nth . H o w m uch re n t is o w in g as a t th e e n d o f th e y e a r?
6
R econ stru ction Lim ited d e p re c ia te s th e m o to r v e h ic le (the c o m p a n y o w n s o n e ve h icle ) using s tra ig h t-lin e d e p re c ia tio n w ith no re s id u a l v a lu e . O n w h a t d a te w a s th e m o to r v e h ic le p u rch a s e d ?
KEY TERMS Accrued revenues Adjusted trial balance Amortisation Contra account
Contra asset Expense recognition Gains Gain on sale
Loss on sale Net book value Recognition Revenue recognition
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
DISCUSSION QUESTIONS 1
E x p la in th e d iffe re n c e b e tw e e n a re ven ue a n d a cash re c e ip t.
2
G iv e e x a m p le s o f item s th a t a re re ven ue fo r a g iv e n p e rio d b u t n o t re c e ip ts fo r th a t p e rio d , item s th a t a re receipts b u t n o t reven ue , a n d item s th a t a re bo th reven ue a n d receipts.
3
E x p la in th e d iffe re n c e b e tw e e n an e x p e n s e a n d a cash d isb u rs e m e n t.
4
G iv e e x a m p le s o f item s th a t a re expe nses fo r a g iv e n p e rio d b u t n o t disb u rse m e n ts fo r th a t p e rio d , item s th a t a re d isb u rs e m e n ts b u t no t expe nses, a n d item s th a t a re b o th expe nses a n d d isb ursem e nts.
5
O u tlin e som e b a sic d iffe re n c e s b e tw e e n cash a c c o u n tin g a n d a c c ru a l a c c o u n tin g .
6
'T he c lo s e r to c a sh , th e m o re pre cise th e m e a s u re .' Discuss this state m e nt w ith respe ct to cash a n d a c c ru a l a c c o u n tin g .
7
'T he m o re th a t a c co u n ta n ts try to m a ke fin a n c ia l statem ents e c o n o m ic a lly re le v a n t, th e m o re th e y m ust in c lu d e estim ates a n d o th e r sources o f im p re c is io n o r e rro r.' D iscuss.
8 W h a t is th e p u rp o s e o f a c c ru a l a c c o u n tin g adju stm en ts? 9
For e a ch o f th e a c c ru a l a c c o u n tin g ad ju stm en ts, e x p la in th e im p a c t o n p ro fit fo r th e p e rio d a n d th e b a la n c e sheet.
10 Y o u r o ld sch o o l frie n d has jo in e d th e m a in te n a n c e g ro u p o f a la rg e a irlin e . H e asks y o u th e fo llo w in g q u e s tio n : 'O u r custom ers p a y us la rg e am o u n ts o f cash b u t w e c a ll this a lia b ility . S u re ly it has to in cre a s e p ro fits ? ' H o w w o u ld y o u a n sw e r? 11 The a c c o u n ta n t a t a la rg e m in in g c o m p a n y tells y o u th a t th e y h a ve som e c o n tra c to rs w h o d o th e w o rk b u t often d o n 't g e t a ro u n d to b illin g fo r a b o u t th re e m onths a fte r th e jo b is c o m p le te . She notes: 'It's g re a t fo r o u r cash flo w , b u t causes us lots o f w o rk a t y e a r-e n d .' E x p la in this com m en t.
12 W h a t is th e p u rp o s e o f d e p re c ia tin g n o n c u rre n t assets? 13 W h a t is th e d iffe re n c e b e tw e e n d e p re c ia tio n a n d a c c u m u la te d d e p re c ia tio n ?
14 For a m a n a g e r th in k in g a b o u t d is p o s in g o f som e assets, w h y is b o o k v a lu e im p o rta n t?
218
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
15 Discuss th e fo llo w in g : a
S p e a k in g p o s itiv e ly , it m ig h t be s a id th a t a c c ru a l a c c o u n tin g im p ro ve s o n th e cash flo w in fo rm a tio n . S p e a k in g n e g a tiv e ly , it m ig h t be s a id th a t a c c ru a l a c c o u n tin g messes up th e p ic tu re b y in tro d u c in g non-cash flo w fa cto rs. W h e th e r o r no t y o u like th e result th e y a c h ie v e , h o w d o a c c ru a l a c c o u n tin g en trie s w o rk to a lte r th e cash flo w story?
b
W h y c a n it be s a id th a t tim in g is a t th e c e n tre o f a c c ru a l a c c o u n tin g ?
16 R espond, in p o in t fo rm , to th e fo llo w in g c o m p la in t b y a bu sinessperson : 'I fin d m o d e rn fin a n c ia l a c c o u n tin g re a lly a n n o y in g . The ba sis o f fin a n c ia l streng th is th e a v a ila b ility a n d use o f re a l resources, such as cash a n d m a c h in e ry , y e t a c c ru a l a c c o u n tin g p ro d u ce s a p ro fit m e asure th a t is d e lib e ra te ly d iffe re n t fro m th e cash return e a rn e d b y th e business. W h y is this so? W h y sh o u ld a c c ru a l a c c o u n tin g d iv e rg e fro m th e m e a su re m e n t o f cash flo w ? ' 1 7 O n 31 D e c e m b e r, th e e n d o f th e a c c o u n tin g p e rio d o f U ltra C o rp ., the c o m p a n y a c c o u n ta n t is a b o u t to m a ke som e ad ju stm en ts. D e s crib e a set o f c ircu m s ta n ce s w h e re , in m a k in g th e ty p ic a l y e a r-e n d ad ju stm en ts: a a n e x p e n s e is d e b ite d a n d a lia b ility is c re d ite d b
a n e x p e n s e is d e b ite d a n d an asset c o n tra a c c o u n t is c re d ite d
c
a n asset is d e b ite d a n d reven ue is c re d ite d
d
a lia b ility is d e b ite d a n d reven ue is c re d ite d .
18 A business e x e c u tiv e re m a rk e d : 'A c c o u n ta n ts use a d u a l s ta n d a rd fo r m e a s u rin g assets. Som e a re on th e b a la n c e sheet be ca u se th e y h a ve re a l fu tu re e c o n o m ic v a lu e . O th e rs a re th e re o n ly be ca u se th e y 're left o v e r fro m the p ro fit m e asure m en t pro ce ss - sort o f expe nses w a itin g to be d e d u c te d . S im ila rly w ith lia b ilitie s : som e a re re a lly o w e d b u t som e a re just le fto vers o f th e a c c ru a l a c c o u n tin g pro ce ss fo r m e a s u rin g p ro fit'. Discuss this re m a rk , c itin g e x a m p le s o f assets a n d lia b ilitie s th a t m ig h t fit th e e x e c u tiv e 's fo u r c a te g o rie s . 1 9 N o w th a t y o u a re a fa m o u s b u sin e ssp e rso n , y o u a re fre q u e n tly a s ke d to m a ke a fte r-d in n e r spee ch es on business to p ic s . W ith o u t th in k in g a b o u t it to o m uch, y o u a g re e d to m a ke a spee ch o n a c c ru a l a c c o u n tin g to a class o f g ra d u a tin g business students. N o w y o u h a ve to th in k o f s o m e th in g to say, a n d y o u h a ve d e c id e d to e n title y o u r ta lk , 'W h y m a n a g e rs like m e like a c c ru a l a c c o u n tin g a n d w h y w e w o rry a b o u t it'. List th e to p ic s y o u p la n to ta lk a b o u t u n d e r this h e a d in g . 2 0 A businessperson y o u k n o w has just re c e iv e d th e fin a n c ia l statem ents o f a c o m p a n y in w h ic h th a t p e rso n o w n s share s. A n s w e r th e fo llo w in g qu e stio n s a s ke d b y th e pe rso n . T ry to a n s w e r w ith o u t ja rg o n , a n d use e x a m p le s th a t w ill m a ke y o u r a n sw e rs c le a r. a 'I'v e been to ld th a t these a c c ru a l a c c o u n tin g nu m b ers a re " m a in ly a m a tte r o f tim in g " . W h a t do es th a t m ean?' b
'I see th a t th e c o m p a n y has a no te in its fin a n c ia l statem ents d e s c rib in g its "re v e n u e re c o g n itio n " m e tho d. W h y w o u ld I w a n t to k n o w th a t? '
c
'I k n o w fro m m y business e x p e rie n c e th a t som etim es y o u c o lle c t cash so o n e r o r la te r th a n y o u e x p e ct. C ustom ers m a y h a ve c a sh , o r not, fo r a ll sorts o f reasons th a t h a ve n o th in g to d o w ith y o u . I u n d e rs ta n d th a t a c c ru a l a c c o u n tin g takes this in to a c c o u n t so th a t it d o e s n 't m a tte r w h e n cash is c o lle c te d , y o u g e t th e sam e re v e n u e fig u re a n y w a y . Is th is tru e ? '
d
'I u n d e rs ta n d th a t a c co u n ta n ts try to be sure th a t revenues a n d expe nses " m a tc h " , so th e p ro fit y o u g e t b y s u b tra c tin g expe nses fro m revenues m akes sense. It seems q u ite a p p ro p ria te . But w h a t e ffe c t, if a n y , d o e s this m a tc h in g p ro c e d u re h a ve on th e b a la n c e sheet fig u re s ? '
21 If m a n a g e m e n t w is h e d to o v e rs ta te p ro fit d u rin g th e y e a r, c o n s id e r th e im p lic a tio n s fo r e a c h o f th e fo llo w in g a d ju stm e n ts (that is, w h a t a c tio n s c o u ld be ta ke n b y fra u d u le n t m a n a g e m e n t to in cre a s e pro fits?): a p re p a y m e n ts b
u n e a rn e d reven ue
c
a c c ru e d expenses
d
a c c ru e d reven ue .
2 2 A c c ru a l-b a s e d fin a n c ia l re p o rts p re p a re d b y d e p a rtm e n ts o r g o ve rn m e n ts w ill d iffe r s ig n ific a n tly fro m c ash -ba se d re p o rts c o v e rin g th e sam e p e rio d . P ro v id e som e e x a m p le s o f th e in fo rm a tio n p ro v id e d in a c c ru a l-b a s e d fin a n c ia l re p o rts b u t n o t c ash -ba se d fin a n c ia l rep orts.
CHAPTER 5 Accrual accounting adjustm ents
219
PROBLEMS PROBLEM 5.1 Cash versus accrual acco u n tin g East H ills Ltd b e g a n business on 1 July 2 0 1 5 w ith e a ch o f th e tw o o w n e rs c o n trib u tin g $ 2 0 0 0 0 cash . The c o m p a n y p a id $ 2 2 0 0 in a d v a n c e fo r a tw o -y e a r le ase o f its re ta il pre m ises. In ve n to ry w o rth $ 3 5 0 0 w a s p u rc h a s e d in th e first m onth o f o p e ra tio n ; b y 3 0 June 2 0 1 6 , $ 1 2 0 0 o f th a t in v e n to ry re m a in e d . S ales reven ue o f $ 9 1 0 0 w a s in v o ic e d d u rin g th e y e a r, a lth o u g h $ 1 6 0 0 o f this a m o u n t is y e t to be c o lle c te d . D u rin g th e y e a r, w a g e s to ta llin g $ 1 3 0 0 w e re p a id to e m p lo y e e s a n d $ 9 0 0 w a s p a id fo r v a rio u s a d m in is tra tiv e expe nses. The c o m p a n y re c e ive d a n a d v e rtis in g in v o ic e fo r $1 1 0 0 as w e ll as a u tilitie s b ill fo r $ 3 8 5 ; these a re y e t to be p a id as a t 3 0 June 2 0 1 6 . 1
P re p a re a c ash -ba sis in co m e state m e nt fo r East H ills Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
2
P re p a re an a c cru a l-b a s is in co m e state m e nt fo r East H ills Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 5 .2 Cash versus accrual acco u n tin g G re e n fin g e rs Ltd o p e n e d a g a rd e n in g c o n s u ltin g c o m p a n y on 1 A u g u s t 2 0 1 6 w ith e a ch o f th e tw o o w n e rs c o n trib u tin g $ 1 0 0 0 0 cash . A o n e -y e a r b a n k lo a n o f $ 4 0 0 0 0 a t 12 p e r c e n t p e r an n u m w a s o b ta in e d fro m the b a n k o n 1 A u g u s t, w ith p rin c ip a l a n d in tere st to be re p a id a t th e e n d o f th e lo a n . A n in su ra n c e p o lic y fo r 12 m onths w a s ta ke n o u t o n 1 A u g u s t 2 0 1 6 fo r $ 6 0 0 . T h re e m o n th s' o ffic e re n ta l fo r $ 9 0 0 w a s p a id in a d v a n c e on 1 A u g u s t 2 0 1 6 . C o n s u ltin g re ven ue o f $ 1 0 0 0 0 w a s e a rn e d d u rin g th e m o nth , bu t $ 6 0 0 0 h a d n o t be en re c e iv e d a t th e en d o f A u g u s t. A tru ck th a t cost $ 3 6 0 0 0 w a s p a id fo r in cash on 1 A u g u s t. It h a d an e x p e c te d life o f th re e y e a rs a n d z e ro re s id u a l v a lu e . C a s h expe nses d u rin g th e m onth w e re : w a g e s , $ 6 0 0 ; o th e r expe nses, $ 4 0 0 . U n p a id b ills a t m o n th 's en d w e re : e le c tric ity , $ 1 0 0 ; w a g e s , $ 2 0 0 . P re p a re an in c o m e state m e nt fo r A u g u s t 2 0 1 6 u n d e r (a) an a c c ru a l ba sis a n d (b) a cash basis o f a c c o u n tin g .
PROBLEM 5 .3 Journal entries State E n te rta in m e n t (State) w ill be h o sting a c o n c e rt on 2 9 A u g u s t 2 0 1 4 . State has th e fo llo w in g tra n s a c tio n s in A u g u s t 2 0 1 4 a s s o c ia te d w ith th e c o n c e rt a n d its business. P re p a re th e jo u rn a l en trie s (fo r 1 -3 ) in g o o d fo rm using th e m ost a p p ro p ria te a c c o u n t titles (as re fe re n ce d in th e ta b le b e lo w ). A c c o u n ts P a y a b le
C o n c e rt E q u ip m e n t
P re p a id V e n u e E xp e n s e
A c c o u n ts R e c e iv a b le
C o n c e rt R evenue
R e ta in e d E a rn in g s
B u ild in g
L o ng-te rm In ve stm e n t
U n e a rn e d R evenue
C ash
N o te P a y a b le
V e n u e E xp e n s e
C o s t o f G o o d s S o ld
N o te R e c e iv a b le
W a g e s E xp e n s e
T ra n sa ctio n s: 1 State sold 1 0 0 0 0 tickets a n d c o lle c te d p a y m e n t on 1 A u g u s t fo r th e 2 9 A u g u s t c o n c e rt. T ickets w e re p ric e d a t $ 3 0 each. 2
State p a id $ 8 0 0 0 0 cash to TEK A re n a on 4 A u g u s t to host th e 2 9 A u g u s t c o n c e rt.
3
State p e rfo rm e d th e c o n c e rt on 2 9 A u g u s t. (N o te : th e re a re tw o tra n sa ctio n s ne ce ssary to be re c o rd e d fo r 'D ' (2 9 A u g u s t).
220
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5 .4 Revenue, expenses and cash P an am a Ltd p ro v id e s o n e -d a y tra in in g p ro g ra m s in a c c o u n tin g . It c h a rg e s $ 7 0 0 0 p e r d a y . The fo llo w in g events o c c u rre d fo r th e c o m p a n y in th e m o nth o f June 2 0 1 6 . a R eceived $ 3 0 0 0 0 fro m a c co u n ts re c e iv a b le fo r sales in p re vio u s m onths, b
P aid th re e m o n th s' ren t o f $ 3 6 0 0 0 c o v e rin g 1 June 2 0 1 6 to 3 0 A u g u s t 2 0 1 6 .
c
R eceived o rd e rs fo r 6 0 d a y s ' tra in in g d u rin g th e m o nth . D e liv e re d 5 0 d a ys o f th e tra in in g d u rin g th e m o nth a n d re c e iv e d p a y m e n t fo r 3 0 o f these d a ys .
d
S ig n e d a c o n tra c t to d e s ig n a s p e c ia l p ro g ra m fo r la w y e rs a t a p ric e o f $ 5 0 0 0 0 . D esign w ill c o m m e n ce in July. R eceived a $ 6 0 0 0 d e p o sit.
e
P aid $ 5 0 0 0 0 0 fo r n e w e q u ip m e n t on 1 June a n d $ 1 0 0 0 0 0 to in sta ll it. The e q u ip m e n t has a life o f 10 y e a rs ,
f
A c o n tra c t w a s s ig n e d w ith a n e w C E O fo r $1 0 0 0 0 0 0 p e r y e a r. The C E O w ill start o n 1 July,
g
P aid w a g e s d u rin g th e p e rio d o f $ 6 0 0 0 0 w ith a c c ru e d w a g e s o f $ 1 0 0 0 0 o w in g a t th e e n d o f th e m o nth,
h
D e c la re d a n d p a id a d iv id e n d o f $ 4 0 0 0 0 .
i
S old a p ie c e o f e q u ip m e n t th a t c o st $1 6 0 0 0 0 (a c c u m u la te d d e p re c ia tio n $ 1 2 0 0 0 0 ) fo r $ 3 2 0 0 0 .
j
W ro te d o w n th e v a lu e o f d a m a g e d in v e n to ry b y $ 3 6 0 0 .
k
B o rro w e d $ 2 4 0 0 0 o n 1 June fro m th e b a n k a t 1 0 p e r c e n t p e r a n n u m . Interest a n d p rin c ip a l re p a y a b le in 10 m onths.
Required: 1 D e te rm in e to ta l reven ue fo r th e m onth o f June 2 0 1 6 . 2
List a ll expe nses fo r th e m onth o f June 2 0 1 6 (in c lu d in g d o lla r am ou nts).
3
A ssum e an o p e n in g b a la n c e in th e cash a c c o u n t o f $ 6 0 0 0 0 0 . W h a t is th e c lo s in g b a la n c e o f th is a c co u n t?
PROBLEM 5 .5 Revenue and expenses R evesby Ltd starte d business on 1 July 2 0 1 6 a n d h a d th e fo llo w in g tra n s a c tio n s on 1 July: a Issued 5 0 0 0 0 0 shares o f $1 fo r $ 5 0 0 0 0 0 cash. b
B o u g h t e q u ip m e n t fo r $ 4 0 0 0 0 0 , p a y in g cash . The e q u ip m e n t has a fiv e -y e a r life,
c
B o u g h t $ 9 0 0 0 0 in v e n to ry on c re d it,
d
P aid $ 1 0 0 0 0 fo r a y e a r's re n t on a b u ild in g .
e
T o o k o u t a tw o -y e a r $ 4 0 0 0 0 0 b a n k lo a n a t an in te re st ra te o f 8 p e r c e n t p e r a n n u m . The in tere st is no t p a y a b le un til th e e n d o f th e lo a n .
B etw een 1 J u ly a n d 31 D e c e m b e r, th e fo llo w in g tra n s a c tio n s o c c u rre d : f
S old in v e n to ry th a t cost $ 8 0 0 0 0 fo r $ 1 4 0 0 0 0 . A ll sales w e re o n c re d it,
g
P aid $ 5 0 0 0 0 to s u p p lie rs o f in v e n to ry fo r th e c re d it pu rch ases in (c) a b o v e ,
h
C o lle c te d $ 9 0 0 0 0 fro m custom ers,
i
P aid s a la rie s o f $ 2 0 0 0 0 .
j
R eceived an $ 8 0 0 0 d e p o s it fro m a c u sto m e r fo r w o rk to b e c o m p le te d n e xt F e b ru a ry. O n 31 D e c e m b e r:
k
S a la rie s o f $ 6 0 0 0 h a d be en e a rn e d b u t n o t p a id .
I
O w e d $ 1 5 0 0 0 b y th e b a n k fo r interest.
1
List a ll revenues (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent.
2
List a ll expe nses (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in c o m e statem ent.
For th e p e rio d 1 J u ly to 31 D e c e m b e r 2 0 1 6 :
3
List a ll cash in flo w s a n d o u tflo w s . W h ic h o f them re fe r to o p e ra tio n s (refe r to C h a p te r 1)?
4
P re p a re a b a la n c e sheet a t 31 D e c e m b e r 2 0 1 6 .
CHAPTER 5 Accrual accounting adjustm ents
221
PROBLEM 5 .6 Revenues, expenses and lia b ilitie s PADSTOW LTD BALANCE SHEET AS AT 31 DECEMBER 2015 | Assets
$
C ash
168000
A c c o u n ts p a y a b le
A c c o u n ts re c e iv a b le
312000
W a g e s p a y a b le
In v e n to ry
320000
P re p a id re n t e x p e n s e
88 0 0 0
Total current assets
>1
Liabilities
200000 16000
U n e a rn e d re v e n u e
256000
Total current liabilities
472000
888000
L o ng-te rm d e b t
0
Land
1520000
Total liabilities
472000
E q u ip m e n t
3 200000
Shareholders' equity
Less a c c u m u la te d d e p re c ia tio n
Total noncurrent assets
T o ta l assets
(6 4 0 0 0 0 ) 4080000
4968000
S h a re c a p ita l
4 240000
R e ta in e d p ro fits
256000
Total shareholders' equity
4496000
Total liabilities and shareholders' equity
4968000
The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 fo r P a d sto w Ltd: a Issued sh a re c a p ita l fo r $ 3 0 0 0 0 0 cash. b
E x p ira tio n o f p re p a id ren t e x p e n s e (i.e . p re p a id re n t e x p e n s e b a la n c e to z e ro ),
c
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it,
d
P aid $ 5 6 0 0 0 to a c co u n ts p a y a b le .
e
S old in v e n to ry c o stin g $1 2 0 0 0 0 fo r $ 3 4 0 0 0 0 . A ll sales a re on c re d it,
f
C o lle c te d $ 1 0 6 0 0 0 fro m a c co u n ts re c e iv a b le .
g
D e p re c ia te d e q u ip m e n t fo r th e y e a r using th e s tra ig h t-lin e m e th o d (1 0 p e r c e n t p e r a n n u m ),
h
D iv id e n d s p a id to ta lle d $ 5 0 0 0 0 .
i
B o rro w e d $ 1 5 0 0 0 0 on 1 J a n u a ry 2 0 1 6 . The lo a n is d u e on 3 0 June 2 0 1 8 a n d c a rrie s a 1 0 p e r c e n t p e r an n u m in tere st rate. P aid $ 1 3 0 0 0 in tere st on this lo a n d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
j
O n 1 A p ril p a id $ 3 0 0 0 0 fo r a n in su ra n c e p o lic y c o v e rin g 1 A p ril 2 0 1 6 to 31 M a rc h 2 0 1 7 .
k
P aid w a g e s o f $ 1 6 0 0 0 0 ; w a g e s o f $ 3 0 0 0 0 h a d be en e a rn e d b u t n o t p a id to th e first p a y p e rio d in 2 0 1 7 .
I
Is o w e d $ 9 5 0 0 in in tere st fro m th e b a n k a t y e a r-e n d .
m A t 31 D e c e m b e r 2 0 1 6 th e u n e a rn e d reven ue a c c o u n t b a la n c e h a d re d u c e d to $ 5 0 0 0 . Required: 1 List a ll revenues (in c lu d in g d o lla r am ounts) th a t w ill a p p e a r in th e in c o m e state m e nt fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . 2
List a ll expe nses (in c lu d in g d o lla r a m ou nts, ig n o rin g ta x a tio n ) th a t w ill a p p e a r in th e in c o m e state m e nt fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
List a ll c u rre n t lia b ilitie s a t 31 D e c e m b e r 2 0 1 6 (in c lu d in g d o lla r a m ou nts).
PROBLEM 5 .7 E ffe ct on revenue, expenses, assets and lia b ilitie s The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 5 - 1 6 fo r S e d a n a Ltd, w h o s e y e a r-e n d is 3 0 June 2 0 1 6 . 1 Issued sh a re c a p ita l fo r $ 4 0 0 0 0 0 cash. 2
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it.
3
S old in v e n to ry c o stin g $ 6 0 0 0 0 fo r $ 1 9 0 0 0 0 . A ll sales a re o n c re d it.
4
R eceived $ 1 0 0 0 0 0 fro m a c co u n ts re c e iv a b le .
5
P aid d iv id e n d s o f $ 4 0 0 0 0 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6
P aid $ 3 2 OOO to a cco u n ts p a y a b le .
7
P aid w a g e s o f $ 9 0 0 0 0 ; w a g e s o f $ 1 0 0 0 0 h a d be en e a rn e d b y e m p lo y e e s b u t n o t p a id a t y e a r-e n d .
8 O n 1 June 2 0 1 6 re c e iv e d a d e p o s it o f $ 7 0 0 0 0 fo r w o rk to be c a rrie d o u t in th e ne xt y e a r. 9
U sed $ 1 5 0 0 0 o f e le c tric ity d u rin g th e y e a r fo r w h ic h th e c o m p a n y has n o t y e t be en in v o ic e d .
1 0 P urchased su p p lie s c o stin g $ 4 0 0 0 on c re d it; a t y e a r-e n d $ 8 0 0 o f these su p p lie s re m a in e d . 11 P aid a $ 2 4 0 0 0 in su ra n c e p o lic y on 1 O c to b e r 2 0 1 5 , c o v e rin g 1 O c to b e r 2 0 1 5 to 3 0 S e p te m b e r 2 0 1 6 . For e a ch o f the a b o v e tra n sa ctio n s, events o r facts, in d ic a te the im p a c t on revenues, expenses, assets a n d lia b ilitie s fo r the y e a r e n d e d 3 0 June 2 0 1 6 b y p la c in g a + o r — s ig n (+ fo r in cre a se a n d — fo r de cre ase) to in d ic a te d ire c tio n in the a p p ro p ria te b o x . W r ite N E if th ere is no effect. In clu de d o lla r am ou nts. Be sure to p la c e a n a n s w e r in e v e ry bo x.
PROBLEM 5 .8 A d ju stm e n ts The fin a n c ia l y e a r-e n d fo r R iv e rw o o d Ltd is 3 0 June. a P re p a id in su ra n c e as a t 1 July 2 0 1 5 w a s $ 4 0 0 0 . This rep resents th e cost o f a o n e -y e a r in su ra n c e p o lic y th a t e x p ire s o n 1 M a rc h 2 0 1 6 . b
F la m in g o w a s e n title d to a d iv id e n d re ven ue o f $ 5 0 0 0 w h ic h w ill no t be re c e iv e d until m id-July,
c
C o m m is sio n s to sales p e rso n n e l fo r th e fiv e -d a y w o rk in g w e e k e n d in g 2 J u ly 2 0 1 6 , to ta llin g $ 9 6 0 0 , w ill be p a id on 2 July.
d
Sales revenue fo r the y e a r in c lu d e d $ 5 7 0 o f custom er de po sits fo r p ro du cts th a t ha ve no t y e t been s h ip p e d to them ,
e
A to ta l o f $ 9 0 0 w o rth o f s ta tio n e ry w a s c h a rg e d to th e o ffic e s u p p lie s e x p e n s e d u rin g th e y e a r. O n 3 0 June, a b o u t $ 4 9 0 w o rth o f s ta tio n e ry is still c o n s id e re d useful fo r n e xt y e a r,
f
The c o m p a n y has a b a n k lo a n a n d p a ys in tere st a n n u a lly (in arre a rs) o n 31 D e c e m b e r. The e s tim a te d interest cost fo r th e c a le n d a r y e a r e n d e d 31 D e c e m b e r 2 0 1 6 is $ 5 0 0 .
Required: 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e o n th e a c c o u n tin g e q u a tio n a t 3 0 June 2 0 1 6 . 2
G iv e th e a d ju s tin g jo u rn a l e n try fo r e a ch o f th e a b o v e s itu a tio n s on 3 0 June 2 0 1 6 .
PROBLEM 5 .9 A d ju stm e n ts - acco u n tin g equation M o te ls Ltd o p e ra te s th re e m otels in la rg e c o u n try centre s. The a c co u n ts fo r th e y e a r e n d e d 3 0 June 2 0 1 6 h a ve been fin a lis e d , w ith th e e x c e p tio n o f a n y ad ju stm e n ts th a t m a y result fro m th e fo llo w in g : a Bonuses d u e to th e m otel m a n a g e rs to ta llin g $ 3 0 0 0 0 h a ve no t y e t be en re c o rd e d . b
O n 1 O c to b e r 2 0 1 5 , a c o m p re h e n s iv e in s u ra n c e p o lic y c o v e rin g b u ild in g a n d contents w a s ta ke n o u t fo r the y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e a n n u a l p re m iu m o f $ 2 4 0 0 b e in g p a id on 1 N o v e m b e r 2 0 1 5 .
c
Interest on investm ents a m o u n tin g to $ 6 0 0 is d u e b u t has no t y e t been re c e ive d ,
d
A p a y m e n t o f $ 9 0 0 fo r e m b o ss e d s ta tio n e ry w a s c h a rg e d , in e rro r, to th e a d v e rtis in g a c co u n t.
CHAPTER 5 Accrual accounting adjustm ents
223
e
A n a m o u n t o f $ 4 5 0 0 s p e n t o n a la p to p c o m p u te r w a s c h a rg e d to th e o ffic e expe nses a c c o u n t in ste a d o f the o ffic e e q u ip m e n t a c co u n t.
f
In M a y , c o m m is sio n o f $ 3 6 0 w a s re c e ive d in a d v a n c e fo r th e six m onths e n d in g 31 O c to b e r 2 0 1 6 .
g
A t 3 0 June 2 0 1 6 , a c c ru e d e le c tric ity c h a rg e s w e re $ 9 2 .
Required: 1 S h o w th e im p a c t o f e a ch tra n s a c tio n on th e a c c o u n tin g e q u a tio n . 2
P ro v id e jo u rn a l en trie s.
PROBLEM 5.1 0 Prepare a d ju stin g jo u rn a l entries i t necessary The a c c o u n ta n t fo r S u p e r O ffic e S u p p lie s Ltd (SO S) is re v ie w in g th e y e a r-e n d u n a d ju s te d tria l b a la n c e a n d c o n s id e rin g th e fo llo w in g item s o f in fo rm a tio n . For e a ch item , d e c id e if a n a d ju s tm e n t to th e a cco u n ts is necessary. If it is, w rite a jo u rn a l e n try to m a ke th e a d ju stm e n t. 1 A s h ip m e n t o f in v e n to ry th a t a rriv e d la te on th e last d a y o f th e y e a r w a s n o t re c o rd e d . The s h ip m e n t cost $ 1 3 1 0 0 , a n d w a s p a id fo r ro u tin e ly a b o u t th re e w e e ks la ter. 2
The a c c o u n ta n t d e te rm in e d th a t a m a jo r sales o rd e r h a d be en fille d on th e last d a y o f th e y e a r, a lth o u g h it w a s n o t re c o rd e d until th re e d a ys la te r. The o rd e r w a s fo r $ 7 2 0 0 , a n d th e g o o d s s u p p lie d h a d cost S O S $ 3 3 0 0 . The c u sto m e r p a id tw o w e e ks la ter.
3
In th e last fe w d a ys o f th e y e a r, th e c o m p a n y 's sh a re p ric e on th e A u s tra lia n S to ck E x ch a n g e fell a b o u t $ 0 .4 0 p e r share . The c o m p a n y has 5 0 0 0 0 0 shares issued.
4
T h ere has be en an e rro r in c a lc u la tin g d e p re c ia tio n e x p e n s e d u rin g th e y e a r. To c o rre c t th e e rro r, a n a d d itio n a l e x p e n s e o f $ 1 4 5 0 0 w o u ld ne ed to be re c o rd e d .
5
A re v ie w o f th e w a rra n ty lia b ility in d ic a te d th a t th e lia b ility sh o u ld be in c re a s e d b y $ 7 8 0 .
6 A t a b o a rd o f d ire c to rs m e eting on th e last d a y o f th e y e a r, th e c o m p a n y 's p re s id e n t a n d o th e r s e n io r executive s w e re a w a rd e d raises to ta llin g $ 1 1 1 0 0 a n n u a lly , to b e g in th e ne xt d a y . 7
The c o m p a n y b o u g h t 1 2 m o n th s' b u ild in g in su ra n c e tw o m onths b e fo re th e e n d o f th e y e a r, a t a c o st o f $ 2 4 0 0 , a n d d e b ite d th e cost to in su ra n c e ex p e n s e .
8 O n e o f th e cash re c e ip ts c re d ite d to sales reven ue tu rn e d o u t to be a d e p o s it o f $ 4 0 0 m a d e b y a c u sto m e r on an o rd e r th a t w ill b e fille d a w e e k a fte r th e e n d o f th e y e a r.
PROBLEM 5.11 Prepaym ents and accrued expense 1
In a recen t a n n u a l re p o rt th e fo llo w in g in fo rm a tio n is p ro v id e d :
P re p a y m e n ts
2016
2015
$m
$m
5 0 .8
5 2 .0
A ssum e th is a m o u n t a ll re la te d to in su ra n c e a n d th a t $ 7 0 m illio n cash w a s p a id d u rin g th e y e a r to the in su ra n c e c o m p a n y . W h a t is the in su ra n c e e x p e n s e fo r th e 2 0 1 6 fin a n c ia l y e a r? 2
A la rg e soft d rin k m a n u fa c tu re r, in a recen t a n n u a l re p o rt, in c lu d e d an a m o u n t o f $ 3 0 6 .7 m illio n in a c c ru e d c h a rg e s ($ 2 9 7 .1 m illio n in 2 0 1 5 ) . A ssum e th a t a ll these a c c ru e d c h a rg e s re la te d to w a g e s . If th e w a g e s p a id d u rin g th e y e a r w e re $ 5 0 0 m illio n , w h a t w a s th e w a g e s e x p e n s e fo r 2 0 1 6?
3
In note 1 0 o f its 3 0 S e p te m b e r 2 0 1 6 a n n u a l re p o rt, O K Lim ited show s th e fo llo w in g :
P re p a y m e n t a n d o th e r assets
2016
2015
$m
$m
3 6 .2
3 4 .4
A ssum e th a t this a m o u n t is a ll re la te d to in su ra n c e a n d th a t $ 3 0 m illio n cash w a s p a id d u rin g th e y e a r to the in su ra n c e c o m p a n y . W h a t is the in su ra n c e e x p e n s e fo r th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5.12 A d ju s tin g e n try to r accrued expenses 1
2
E m p lo ye es o f D o n o v a n Ltd a re p a id e v e ry F rid a y fo r th e fiv e -d a y w o rk in g w e e k fro m M o n d a y to F rid a y . The w e e k ly w a g e s e x p e n s e is $1 15 0 0 0 . The a c c o u n tin g y e a r-e n d is 31 D e c e m b e r. A ssum e this fa lls on a T h u rsd a y , a
P re p a re th e a d ju s tin g e n try fo r th e y e a r-e n d .
b
If no a d ju s tin g e n try is m a d e on 31 D e c e m b e r, w h a t w ill be th e im p a c t on net p ro fit? W h a t w ill th e e rro rs in th e b a la n c e sheet be?
c
W h a t is th e jo u rn a l e n try m a d e o n 1 J a n u a ry w h e n th e s ta ff a re p a id ?
O n 1 July 2 0 1 6 , D o n o v a n o b ta in e d a b a n k lo a n o f $ 1 0 0 0 0 0 a t 1 2 p e r c e n t interest, p a y a b le y e a rly in a rre a rs . The a c c o u n tin g y e a r-e n d is 31 D e c e m b e r. a
W h a t is th e a d ju s tin g e n try re q u ire d on 31 D e c e m b e r 2 0 1 6 ?
b
The c o m p a n y 's a c c o u n ta n t fo rg e ts to p re p a re th e a b o v e e n try. W h a t w ill th e e ffe c t o f this o m is sio n be on D o n o v a n 's fin a n c ia l statem ents?
c
P re p a re th e jo u rn a l e n try fo r 1 July 2 0 1 7 , w h e n th e firs t in tere st p a y m e n t is m a d e .
PROBLEM 5.13 Journal entries o f revenue received in advance In a re c e n t a n n u a l re p o rt o f Telstra, th e fo llo w in g a p p e a rs as th e fin a n c ia l p o lic y o n in s ta lla tio n a n d c o n n e c tio n fe e reven ue re c e iv e d in a d v a n c e : In s ta lla tio n a n d c o n n e c tio n fe e re v e n u e s t h a t a re n o t c o n s id e re d t o be s e p a ra te u n its o f a c c o u n tin g a re d e fe rre d a n d re c o g n is e d o v e r t h e a v e ra g e e s tim a te d c u s to m e r life . In c r e m e n ta l c o s ts d ir e c tly re la te d t o th e s e re v e n u e s a re a lso d e fe rre d an d a m o rtis e d o v e r th e c u s to m e r c o n t r a c t life in a c c o r d a n c e w ith n o te 2 .1 2 (d ). Source: Telstra C orporation Limited, 2014 Balance Sheet.
1
W h a t jo u rn a l en trie s w o u ld be p u t th ro u g h w h e n th e cash is re c e ive d ?
2
W h a t jo u rn a l e n try w o u ld be p u t th ro u g h w h e n th e reven ue is re c o g n is e d ?
PROBLEM 5.14 A d ju stm e n ts entries Parkes Ltd's a n n u a l a c c o u n tin g y e a r en ds on 3 0 June. It is 3 0 June 2 0 1 6 a n d a ll o f th e 2 0 1 6 en trie s e x c e p t the fo llo w in g a d ju s tin g en trie s h a ve be en m a d e . a O n 1 A p r il 2 0 1 6 th e c o m p a n y b o rro w e d $ 4 0 0 0 0 fro m a lo ca l b a n k a t 5 p e r c e n t p e r an n u m interest. The p rin c ip a l a n d in tere st a re p a y a b le on 3 0 June 2 0 1 7 . The b o rro w in g w a s c o rre c tly re c o rd e d bu t no a d ju stm e n t has be en m a d e fo r interest. b
O n 1 M a rc h 2 0 1 6 Parkes c o lle c te d s ix m o n th s 're n t o f $1 6 8 0 0 . A t th a t d a te Parkes d e b ite d C a s h a n d c re d ite d U n e a rn e d rent re ven ue fo r $ 1 6 8 0 0 .
c
O n 1 O c to b e r 2 0 1 6 Parkes p a id a o n e -y e a r p re m iu m fo r fire in su ra n c e , $ 1 8 0 0 0 , fo r c o v e ra g e s ta rtin g on th a t d a te . C a s h w a s c re d ite d a n d P re p a id in su ra n c e w a s d e b ite d fo r this a m o u n t.
d
A t 3 0 June 2 0 1 6 w a g e s e a rn e d b y e m p lo y e e s to ta lle d $ 3 8 0 0 0 . The e m p lo y e e s w ill be p a id in July 2 0 1 6 .
e
O n 3 0 June 2 0 1 6 th e c o m p a n y e s tim a te d it o w e d $ 6 0 0 0 fo r 2 0 1 6 e le c tric ity costs. The a m o u n t w ill be p a id w h e n th e in v o ic e is re c e ive d in July 2 0 1 6 .
f
O ffic e s u p p lie s o n h a n d a t 3 0 June 2 0 1 6 to ta lle d $ 1 4 0 0 . A d d itio n a l o ffic e su p p lie s c o s tin g $ 2 4 0 0 w e re p u rc h a s e d a n d d e b ite d to O ffic e su p p lie s (asset a c co u n t). The c o u n t o f su p p lie s o n h a n d a t y e a r-e n d w a s $ 8 0 0 .
CHAPTER 5 Accrual accounting adjustm ents
225
Required: 1
U sing th e fo llo w in g h e a d in g s , in d ic a te th e e ffe c t o f e a ch a d ju s tin g e n try a n d th e a m o u n t o f th e e ffe c t. Use + fo r in c re a s e , — fo r d e c re a s e a n d N E fo r no effect.
2
P re p a re th e a d ju s tin g jo u rn a l en trie s.
PROBLEM 5.15 A d ju s tin g jo u rn a l entries The a n n u a l a c c o u n tin g p e rio d fo r DEF Ltd en ds on 3 0 June. P re p a re a d ju s tin g e n trie s fo r e a ch o f th e fo llo w in g : 1 DEF w a s e n title d to a c o m m is sio n o f $ 2 0 0 0 d u rin g June, b u t th e c o m m is sio n w ill no t be re c e ive d un til July. 2
W a g e s o f $ 3 0 0 0 fo r th e fiv e -d a y w o rk p e rio d e n d in g 3 July w ill be p a id on 3 July. This is a F rid a y .
3
DEF Ltd has a $ 1 0 0 0 0 0 fix e d d e p o s it a t 12 p e r cent, w h e re in tere st is p a id in a rre a rs on 3 0 A p ril a n d 3 0 N o v e m b e r.
4
The o ffic e s u p p lie s a c c o u n t h a d an o p e n in g b a la n c e o f $ 1 0 0 0 on 1 J u ly 2 0 1 5 . S u p p lie s o f $ 8 0 0 0 w e re p u rc h a s e d d u rin g th e y e a r, a n d $ 9 0 0 o f s u p p lie s a re o n h a n d o n 3 0 June 2 0 1 6 .
PROBLEM 5.16 A d ju s tin g e n try to r pre p a id expense M N O Ltd p u rc h a s e d a o n e -y e a r in su ra n c e p o lic y on 1 A p r il. The e n tire p re m iu m o f $ 6 0 0 0 w a s re c o rd e d b y d e b itin g p re p a y m e n ts . Y e a r-e n d is 3 0 June. 1 G iv e th e 3 0 June a d ju s tin g e n try. 2
W h a t a m o u n t sh o u ld be re p o rte d in th e 3 0 June b a la n c e sheet fo r p re p a ym e n ts?
3
If no a d ju s tin g e n try w a s m a d e on 3 0 June, b y h o w m uch w o u ld net p ro fit be o v e rs ta te d o r u n d e rsta te d ? W o u ld assets be o v e rs ta te d o r u n d e rsta te d ?
4
W h a t w o u ld y o u r a d ju s tin g e n try in q u e s tio n 1 be if th e p re m iu m o f $ 6 0 0 0 w a s re c o rd e d b y d e b itin g in su ra n c e e xpe nse?
PROBLEM 5.17 A d ju s tin g e n try For accrued expense A B C Ltd p a y s its e m p lo y e e s e v e ry F rid a y fo r a fiv e -d a y w o rk in g w e e k fro m M o n d a y to F rid a y . The w e e k ly p a y ro ll am o u n ts to $ 1 5 0 0 0 0 . The a c c o u n tin g y e a r-e n d is 3 0 June. 1 A s su m in g th a t 3 0 June fa lls o n W e d n e s d a y , g iv e th e y e a r-e n d a d ju s tin g e n try. 2
If no a d ju s tin g e n try w a s m a d e on 3 0 June, b y h o w m uch w o u ld net p ro fit b e o v e rs ta te d o r u n d e rsta te d ? W h a t e rro rs w o u ld be in the b a la n c e sheet?
3
G iv e th e e n try to p a y th e s ta ff o n 2 July.
PROBLEM 5.1 8 A d ju s tin g e n try For revenue received in advance X YZ Ltd rents o n e o ffic e to a te n a n t w h o p a id th re e m o n th s' ren t in a d v a n c e o n 1 June. The firm c re d ite d u n e a rn e d re n ta l re ven ue to re c o rd th e $ 6 0 0 0 re c e iv e d . Y e a r-e n d is 3 0 June. 1 P re p a re th e a d ju s tin g e n try fo r 3 0 June. 2
W h a t w o u ld be th e effects o n th e firm 's fin a n c ia l statem ents if th e a d ju s tin g e n try w a s o m itte d ?
3
P re p a re th e e n try in th e n e xt p e rio d to re c o g n is e th e re m a in in g p o rtio n o f th e rent reven ue .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5.19 E ffects o f errors on the fin a n cia l sta te m e n ts C B D m a d e th e fo llo w in g e rro rs in a d ju s tin g th e a cco u n ts a t y e a r-e n d (3 0 June). a D id n o t a c c ru e $ 1 4 0 0 o w e d to th e c o m p a n y b y a n o th e r c o m p a n y re n tin g p a rt o f th e b u ild in g as a s to ra g e fa c ility . b
D id no t re c o rd $ 1 5 0 0 0 d e p re c ia tio n on e q u ip m e n t c o stin g $ 1 15 0 0 0 .
c
F a ile d to a d ju s t th e U n e a rn e d fe e re ven ue a c c o u n t to re fle c t th a t $ 1 5 0 0 w a s e a rn e d b y th e e n d o f th e y e a r.
d
R e co rd e d a full y e a r o f a c c ru e d in tere st e x p e n s e on a $ 1 7 0 0 0 , 9 p e r c e n t lo a n p a y a b le th a t has been o u ts ta n d in g o n ly since 31 M a y .
e
F a ile d to a d ju s t P re p a id in su ra n c e to re fle c t th a t $ 6 5 0 o f in su ra n c e c o v e ra g e has be en used.
Required: 1
U sing th e fo llo w in g h e a d in g s , in d ic a te th e e ffe c t o f e a ch e rro r a n d th e a m o u n t o f th e e ffe c t (i.e. th e d iffe re n c e b e tw e e n th e e n try th a t w a s o r w a s no t m a d e a n d th e e n try th a t sh o u ld h a ve be en m a d e ). Use 0 if th e e ffe c t overstates th e item , U if th e e ffe c t un derstates th e item , a n d N E if th e re is no effect.
Balance sheet Transaction
Assets
Liabilities
Shareholders' equity
Income statement Revenues
Expenses
Net profit
(a) (b) \CI (d) (e) 2
For e a ch e rro r, p re p a re th e a d ju s tin g jo u rn a l e n try: a
th a t w a s m a d e (if any)
b
th a t sh o u ld h a ve been m a d e a t y e a r-e n d .
PROBLEM 5 .2 0 A d ju stin g jo u rn a l entries J in d a b in e B oa t Ltd stores a n d c le a n s b o a ts fo r custom ers. It is c o m p le tin g th e a c c o u n t process fo r th e y e a r just e n d e d 3 0 June 2 0 1 6 . The tra n s a c tio n s d u rin g 2 0 1 6 h a ve be en jo u rn a lis e d a n d p o ste d . The fo llo w in g d a ta w ith re s p e ct to a d ju s tin g en trie s is a v a ila b le : 1 J in d a b in e c le a n e d th re e b o a ts fo r custom ers a t th e e n d o f June, b u t d id n o t re c o rd th e s ervice fo r $ 2 7 0 0 . 2
O n 1 M a y 2 0 1 6 , J in d a b in e p a id $ 1 2 0 0 to th e lo c a l n e w s p a p e r fo r a n a d ve rtis e m e n t to run e a ch T h u rsd a y fo r 1 2 w e e ks . A ll a d s h a ve be en run e x c e p t fo r th re e T h ursd ays in J u ly to c o m p le te th e 12 -w e e k c o n tra c t.
3
J in d a b in e b o rro w e d $ 2 5 0 0 0 0 a t 1 2 p e r c e n t a n n u a l in tere st ra te on 1 N o v e m b e r 2 0 1 6 to e x p a n d its s to ra g e fa c ility . The lo a n re q u ire s J in d a b in e to p a y th e in tere st q u a rte rly until th e note is re p a id in tw o y e a rs . J in d a b in e p a id q u a rte rly in tere st o n 1 F e b ru a ry a n d 1 M a y .
4
J in d a b in e re c e ive d $ 4 5 0 0 on 1 June 2 0 1 6 to store a s a ilb o a t fo r w in te r un til 1 N o v e m b e r 2 0 1 7 . J in d a b in e c re d ite d th e fu ll a m o u n t to U n e a rn e d s to ra g e reven ue on 1 June.
5
J in d a b in e 's b o a t-liftin g e q u ip m e n t cost $ 2 2 0 0 0 0 ; $ 2 2 0 0 0 w a s th e e s tim a te d d e p re c ia tio n in 2 0 1 6 .
6
B o a t-re p a ir su p p lie s on h a n d a t 1 J u ly 2 0 1 5 to ta lle d $1 6 5 0 0 . R e p a ir su p p lie s p u rc h a s e d d e b ite d to S u p p lie s on h a n d d u rin g th e y e a r a m o u n te d to $ 4 6 0 0 0 . The y e a r-e n d c o u n t s h o w e d $ 1 2 4 0 0 o f su p p lie s on h a n d .
7
W a g e s e a rn e d b y e m p lo y e e s d u rin g June 2 0 1 6 , u n p a id a n d u n re c o rd e d a t 3 0 June 2 0 1 6 , a m o u n te d to $ 3 8 0 0 . The n e xt p a y ro ll d a te w ill be 5 July 2 0 1 6 . P re p a re th e a d ju s tin g en trie s th a t sh o u ld be re c o rd e d fo r J in d a b in e a t 3 0 June 2 0 1 6 .
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227
PROBLEM 5.21 Classifying balance sheet item s A n a d ju s te d tria l b a la n c e a t 31 D e c e m b e r 2 0 1 6 fo r a to y m a n u fa c tu re r is g iv e n b e lo w :
Accounts receivable
Debit
Credit
$
$
295000
Accounts payable Property, plant and equipment
120000 1000000
Accumulated depreciation
400000
Income tax payable
40000
Revenue received in advance
10000
Prepaid expenses
20000
Accrued wages Inventory
25 000 200000
Cash
60000
Accrued revenue
20000
Long-term debt
100000
Share capital
700000
Retained profits at 1 January 2016
150000
Sales Cost of goods sold Depreciation expense Other operating expenses Income tax expense
800000 500000 20000 150000 80000 2345000
1
In th e b a la n c e sheet, p re p a re d a t 31 D e c e m b e r 2 0 1 6 : a
2
2345000
W h a t w o u ld be th e b a la n c e o f to ta l c u rre n t assets?
b
W h a t w o u ld be th e b a la n c e o f to ta l c u rre n t lia b ilitie s ?
c
W h a t w o u ld be th e b a la n c e o f to ta l n o n c u rre n t assets?
d
W h a t w o u ld be th e c lo s in g b a la n c e o f re ta in e d p ro fit?
W h a t w a s th e b a la n c e o f th e a c c u m u la te d d e p re c ia tio n a c c o u n t a t 31 D e c e m b e r 2 0 1 5 , a ssu m ing n o p ro p e rty , p la n t a n d e q u ip m e n t w a s d is p o s e d o f d u rin g th e y e a r?
PROBLEM 5 .2 2 A cco u n tin g cycle W a n C h a i Lim ited is a sm all w h o le s a le r o f e le c tro n ic c o m p o n e n ts lo c a te d n e a r H o n g K o n g 's c e n tra l business d is tric t. The firm has p ro v id e d a y e a r-e n d b a la n c e sheet a t 3 0 June 2 0 1 6 a n d a s u m m a ry o f a ll the tra n s a c tio n s th a t o c c u rre d in th e m onth o f July 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W A N CHAI LIMITED BALANCE SHEET AS AT 3 0 JUNE 20 16 7 Current assets Cash
324000
Accounts receivable Inventory
906000 1 332 000
Prepaid insurance
42 000
Prepaid rent Total current assets
144000 2 748 000
Noncurrent assets Buildings and equipment
324000
Accumulated depreciation
(804000)
Total noncurrent assets
2 436 000
Total assets
51 84000
Current liabilities Accounts payable
1620000
Accrued wages
264000
Unearned revenue
348 000
Total current liabilities
2 232 000
Noncurrent liabilities Loan
1 200000
Total noncurrent liabilities
1 200000
Shareholders' equity Share capital
1 420000
Retained profits
332 000
Total shareholders' equity
1 752 000
Total liabilities and shareholders' equity
51 84000
The tra n sa ctio n s a re as fo llo w s : a P aid w a g e s o u ts ta n d in g a t th e e n d o f June. b
M a d e c re d it sales o f $1 2 5 4 0 0 0 . (The cost o f th ose g o o d s s o ld w a s $ 7 5 0 0 0 0 . )
c
P aid $ 1 0 2 0 0 0 0 to a c co u n ts p a y a b le ,
d
P urchased $ 4 8 0 0 0 0 in v e n to ry on c re d it.
e
P aid cash fo r a n a n n u a l in su ra n c e p re m iu m o f $ 5 0 4 0 0 0 (1 2-m on th p o lic y c o m m e n c in g 1 A u g u s t 2 0 1 6 ) .
f
R eceived $1 6 8 0 0 0 0 fro m d e b to rs .
g
M a d e cash sales to ta llin g $ 2 7 0 0 0 0 . (The cost o f those g o o d s s o ld w a s $ 1 9 2 0 0 0 .)
h
Interest on th e lo a n is a t 1 0 p e r c e n t p e r an n u m a n d w ill be p a id in S e p te m b e r,
i
The w o rk re la te d to u n e a rn e d reven ue w a s c o m p le te d .
j
P aid w a g e s e x p e n s e o f $1 8 6 0 0 0 fo r July. W a g e s o w in g a t th e e n d o f July a re $ 6 0 0 0 0 .
k
P aid re n t fo r A u g u s t o f $ 1 4 4 0 0 0 . (Rent is p a y a b le m o n th ly in a d v a n c e , a t $ 1 4 4 0 0 0 p e r m onth.)
I
P aid a d m in is tra tiv e expe nses, in c u rre d d u rin g th e m o nth , o f $1 2 6 0 0 0 .
m
D e p re c ia tio n is c a lc u la te d m o n th ly a t 2 0 p e r c e n t p e r a n n u m fo r p la n t a n d e q u ip m e n t, b a se d o n cost,
n
C o m m is sio n s a re d e te rm in e d o n th e last d a y o f th e m onth a t $ 1 3 2 0 0 . T h e y w ill be p a id ne xt m onth,
o
The c o m p a n y is o w e d $ 1 0 0 0 0 in in tere st fro m th e b a n k a t th e e n d o f July.
CHAPTER 5 Accrual accounting adjustm ents
229
U sing W a n C h a i Lim ite d 's p re vio u s b a la n c e sheet as a s ta rtin g p o in t, p re p a re th e fo llo w in g d a ta fo r th e m onth e n d in g 31 J u ly 2 0 1 6 : 1 J o u rn a l en trie s a n d le d g e r a cco u n ts. 2
Post-adjustm ent tria l b a la n c e .
3
B a la n c e sheet a n d In co m e statem ent.
PROBLEM 5 .2 3 Recording a d ju s tin g entries and preparing a balance sheet and incom e s ta te m e n t SRP Ltd has th e fo llo w in g u n a d ju s te d tria l b a la n c e a t 31 D e c e m b e r 2 0 1 5 . Account titles
Cash
Debit
Credit
$
$
19 600
Accounts receivable
7000
Supplies
1 300
Prepaid insurance Equipment
900 27000
Accumulated depreciation Other assets
12 000 5100
Accounts payable
7500
Share capital (3000 shares outstanding all year)
16000
Retained profit
10 300
Service revenue COGS
48 000 32 900 93 800
93 800
D a ta no t y e t re c o rd e d a t 31 D e c e m b e r 2 0 1 5 in c lu d e th e fo llo w in g : a
D e p re c ia tio n e x p e n s e fo r 2 0 1 5 w a s $ 3 0 0 0 .
b
In su ra nce e x p ire d d u rin g 2 0 1 5 w a s $ 4 5 0 .
c
W a g e s e a rn e d b y e m p lo y e e s b u t no t y e t p a id on 31 D e c e m b e r 2 0 1 5 w a s $ 2 1 0 0 .
d
The su p p lie s c o u n to n 31 D e c e m b e r 2 0 1 5 re fle c te d $ 8 0 0 re m a in in g su p p lie s on h a n d to be used in 2 0 1 6 .
e
In co m e ta x e x p e n s e w a s $ 3 1 5 0 .
Required: 1 R ecord th e 2 0 1 5 a d ju s tin g e n trie s. 2
P re p a re a n in c o m e state m e nt a n d a c la s s ifie d b a la n c e sheet fo r 2 0 1 5 to in c lu d e th e effects o f th e p re c e d in g five tra n sa ctio n s.
3
P re p a re c lo s in g en trie s.
PROBLEM 5 .2 4 Ten-colum n w orksheet Refer to th e S c a n lo n e x a m p le in th e c h a p te r. C o m p le te a 10 -co lu m n w o rk s h e e t s e p a ra tin g o u t tra n s a c tio n k o n w a rd s as a d ju s tin g e n trie s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5 .2 5 Com prehensive exam ple in clu d in g a m u lti-c o lu m n w orksheet CANBERRA LIMITED BALANCE SHEET AS AT 31 DECEMBER 2 0 1 4 1 Assets
$
Current assets
Liabilities
s 1
Current liabilities
Cash
21 000
Account payable
27000
Accounts receivable
39000
Unearned revenue
32 000
Inventory
40000
Total current liabilities
59000
Prepaid rent
11 000
Total current assets
111000
Noncurrent assets
Noncurrent liabilities Long-term debt
0
Total noncurrent liabilities
0
Land
100000
Total liabilities
Property and equipment
400000
Net assets
Accumulated depreciation
(80000)
Intangible assets (net)
90000
Total noncurrent assets
510000
621000
562000
Shareholders' equity Share capital Retained profits
Total assets
59 000
Total shareholders' equity
520000 42 000 562000
The fo llo w in g tra n s a c tio n s o c c u rre d fo r C a n b e rra Lim ited in 2 0 1 5 : a Issued s h a re c a p ita l fo r $ 2 0 0 0 0 0 cash , b
P urchased $ 3 5 0 0 0 o f in v e n to ry on c re d it,
c
P aid $ 2 8 0 0 0 to a cco u n ts p a y a b le .
d
S old in v e n to ry c o stin g $ 6 0 0 0 0 fo r $ 2 7 0 0 0 0 . A ll sales a re on c re d it,
e
C o lle c te d $ 5 2 0 0 0 fro m custom ers.
f
P re p a id $1 2 0 0 0 ren t fo r th e y e a r c o m m e n c in g 1 J a n u a ry 2 0 1 5 .
g
D e p re c ia te d p ro p e rty a n d e q u ip m e n t fo r th e y e a r using th e s tra ig h t-lin e m e th o d (2 0 p e r c e n t p e r an n u m ),
h
D iv id e n d s d e c la re d a n d p a id to ta lle d $ 3 0 0 0 0 .
i
B o rro w e d $ 1 0 0 0 0 0 on 1 J u ly 2 0 1 4 . The lo a n is d u e on 3 0 June 2 0 1 6 a n d c a rrie s a 1 0 p e r c e n t p .a . interest rate. P aid $ 4 0 0 0 in tere st on th is lo a n d u rin g 2 0 1 5 .
j
On
k
P aid w a g e s o f $ 9 0 0 0 0 ; w a g e s o f $ 2 0 0 0 0 h a d be en e a rn e d b u t n o t p a id .
1 N ovem ber
I
R eceived in tere st o f $ 5 0 0 0 in cash fro m th e b a n k .
p a id $ 2 4 0 0 0 fo r a n in su ra n c e p o lic y c o v e rin g
1 N ovem ber 2 0 1 4
to 31 O c to b e r 2 0 1 5 .
O n 31 D e c e m b e r 2 0 1 5 : m The u n e a rn e d re ven ue a c c o u n t h a d a b a la n c e o f $ 5 0 0 0 . n
A c c ru e d in te re st reven ue h a d a b a la n c e o f $ 2 0 0 0 .
Required: 1
P re p a re jo u rn a l en trie s fo r th e a b o v e tra n sa ctio n s.
2
P re p a re le d g e rs.
3
P re p a re c lo s in g e n trie s.
4
P re p a re a 10 -c o lu m n w o rk sh e e t.
5
P re p a re an in c o m e state m e nt a n d b a la n c e sheet fo r C a n b e rra Lim ited fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 5 .
CHAPTER 5 Accrual accounting adjustm ents
231
PROBLEM 5 .2 6 Accrual versus cash acco u n tin g The b a la n c e sheet o f A B C Ltd as a t 31 D e c e m b e r 2 0 1 5 a n d th e cash re ce ip ts a n d pa ym e n ts fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 a re s h o w n b e lo w . ABC LTD BALANCE SHEET AS AT 31 DECEMBER 2015 $ Assets
$ Liabilities
Cash
5 000
Accounts payable
1 0000 80000
Accounts receivable
10000
Bank loan
Inventory
20000
Shareholders' equity
Plant and equipment
200000
Share capital
Land
100 00 0
Retained profits
Total
335 000
Total
200000 45 000 335000
CASH RECEIPTS A N D DISBURSEMENTS FOR THE YEAR ENDED 31 DECEMBER 20 16 $ Receipts
$ Disbursements
Cash sales
150 00 0
Salaries
65 000
Total collected from accounts receivable
100 00 0
Repairs
2 000
Rates and taxes
3 000
Interest
6000
Total payments to Accounts payable Insurance 250000
130 00 0 8 000 214000
A d d itio n a l in fo rm a tio n : a A s a t 31 D e c e m b e r 2 0 1 6 , th e b a la n c e o f a c co u n ts re c e iv a b le w a s $ 2 5 0 0 0 a n d th e b a la n c e o f a c co u n ts p a y a b le w a s $ 1 5 0 0 0 . b
S a la rie s a re n o w p a id m o n th ly o n th e s e co n d o f th e m o nth fo r th e p re c e d in g m o nth . W a g e s a n d s a la rie s to ta l $ 7 0 0 0 fo r th e m onth o f D e c e m b e r. This w a s p a id on 2 J a n u a ry 2 0 1 7 .
c
P lant a n d e q u ip m e n t is s h o w n net o f a c c u m u la te d d e p re c ia tio n o f $ 5 0 0 0 0 . D e p re c ia tio n e x p e n s e fo r th e y e a r is c a lc u la te d using th e s tra ig h t-lin e m e th o d a t 1 0 p e r c e n t p e r an n u m .
d
The b a n k lo a n a ccru e s in tere st a t a ra te o f 1 0 p e r c e n t p e r a n n u m , p a y a b le on 3 0 M a rc h a n d 3 0 S e p te m b e r. The lo a n w a s ta ke n o u t on 31 D e c e m b e r 2 0 1 5 .
e
A p h y s ic a l s to c kta ke , as a t 31 D e c e m b e r 2 0 1 6 , re v e a le d th a t in v e n to ry c o s tin g $ 2 3 0 0 0 w a s on h a n d . C o s t o f g o o d s s o ld fo r the y e a r w a s c a lc u la te d a s $ 1 3 2 0 0 0 .
f
The in su ra n c e p re m iu m o f $ 8 0 0 0 p ro v id e s c o v e r fo r th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 7 .
R e q u ire d : 1 C a lc u la te th e fo llo w in g : a
to ta l sales fo r th e p e rio d
b
gross p ro fit
c
sa la rie s e x p e n s e a n d a c c ru e d s a la rie s
d
in tere st e x p e n s e a n d a c c ru e d interest
e
in su ra n c e e x p e n s e a n d p re p a id in su ra n ce .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
2
W h a t w a s th e p ro fit/(lo s s ) fo r th e p e rio d ?
3
P re p a re th e b a la n c e sheet as a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 5 .2 7 C alculating accrual in fo rm a tio n From cash in fo rm a tio n The fo llo w in g in fo rm a tio n has be en e x tra c te d fro m th e a cco u n ts o f PQR Ltd. PQR LTD BALANCE SHEET AS AT 3 0 JUNE 20 15 Assets
$
$
Liabilities and shareholders' equity
Cash
25 000
Accounts payable
Accounts receivable
1 4000
Revenue received in advance
32 000
Accrued interest
Inventory Plant and equipment
150 00 0
Accumulated depreciation
40000
110 00 0
$ 19 000 8 000 1 000
Loan
25 000
Share capital
80000
Retained profits
48 000
181 000
181 00 0
CASH RECEIPTS FOR THE YEAR ENDED 3 0 JUNE 20 16 $ Cash sales
92 000
Receipts from accounts receivable
385000 477000
CASH PAYMENTS FOR THE YEAR ENDED 3 0 JUNE 20 16 $ Payments for accounts payable
172 00 0
Repayment of loan ($25 000) and interest ($2000)
27000
Administrative expenses
46000
Dividend payment
31 000 276000
A d d itio n a l in fo rm a tio n : a B alan ce s as a t 3 0 June 2 0 1 6 :
Inventory
$20000
Accounts receivable
$24000
b
C re d it pu rch ases o f in v e n to ry to ta lle d $ 1 7 6 0 0 0 fo r th e y e a r.
c
The services re la tin g to th e re ven ue re c e ive d in a d v a n c e a t 3 0 June 2 0 1 5 w e re p ro v id e d d u rin g th e y e a r,
d
N o a d d itio n s o r d is p o s a ls o f p la n t a n d e q u ip m e n t w e re m a d e d u rin g th e p e rio d . The d e p re c ia tio n ra te is 2 0 p e r c e n t p e r a n n u m . The s tra ig h t-lin e m e th o d is used.
CHAPTER 5 Accrual accounting adjustm ents
233
e
A d m in is tra tiv e expe nses in c lu d e d a p re p a y m e n t o f $ 4 0 0 0 fo r J u ly 2 0 1 6 .
f
A c c ru e d in tere st o n 3 0 June 2 0 1 5 re la te d to th e lo a n w h ic h w a s re p a id d u rin g th e y e a r. T here is no a c c ru e d in tere st as a t 3 0 June 2 0 1 6 .
R e q u ire d : 1 C a lc u la te to ta l reven ue fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . 2
List a ll expe nses fo r th e y e a r (in c lu d in g d o lla r a m ou nts).
3
C a lc u la te th e b a la n c e o f cash as a t 3 0 June 2 0 1 6 .
4
P ro v id e a b a la n c e sheet as a t 3 0 June 2 0 1 6 .
CASES CASE 5A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in th e a p p e n d ix a t th e b a c k o f th e b o o k . A ll qu e stio n s re la te to th e c o n s o lid a te d a cco u n ts. 1 Is th e re a n y in d ic a tio n o f th e fo llo w in g in th e a cco u n ts: a
p re p a ym e n ts?
b
u n e a rn e d revenue?
c
a c c ru e d expenses?
d
a c c ru e d revenues?
2
W h y w o u ld W o o lw o rth s Lim ited use 2 9 June 2 0 1 4 (3 0 June 2 0 1 3) ra th e r th a n 3 0 June as th e fin a n c ia l year-e nd?
3
W h a t is th e net b o o k v a lu e fo r: a
fre e h o ld la n d , w a re h o u s e s , re ta il a n d o th e r p ro p e rtie s ?
b
p la n t a n d e q u ip m e n t?
4
G iv e e x a m p le s fro m W o o lw o rth s ' fin a n c ia l statem ents to in d ic a te th a t it uses a c c ru a l a c c o u n tin g .
5
W h a t is th e d e p re c ia tio n fo r th e y e a r on p la n t a n d e q u ip m e n t a n d w h a t is th e b a la n c e o f a c c u m u la te d d e p re c ia tio n a t y e a r-e n d fo r p la n t a n d e q u ip m e n t?
CASE 5B_________________________Accrual accounting adjustm ents G o to th e fin a n c ia l statem ents o f Telstra Lim ited a n d fin d w h e re th e fo llo w in g item s a re lo c a te d (they w ill be on the b a la n c e sheet o r in o n e o f th e notes re la te d to th e b a la n c e sheet): 1 P rep aym e nts 2
A c c ru e d expe nses
3
U n e a rn e d reven ue
4
A c c ru e d reven ue .
State w h e re y o u fo u n d th e item s a n d th e d o lla r a m o u n t o f e a c h . If an item is listed u n d e r a d iffe re n t na m e , state w h a t it is.
CASE 5C________________________ Accrual accounting adjustm ents G o to th e fin a n c ia l statem ents o f JB Hi-Fi Lim ited a n d fin d w h e re th e fo llo w in g item s a re lo c a te d (they w ill be on the b a la n c e sheet o r in o n e o f th e notes re la te d to th e b a la n c e sheet): 1 P rep aym e nts 2
A c c ru e d expe nses
3
U n e a rn e d reven ue
4
A c c ru e d reven ue .
State w h e re y o u fo u n d th e item s a n d th e d o lla r a m o u n t o f e a c h . If an item is listed u n d e r a d iffe re n t na m e , state w h a t it is.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
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f C o u rs e M a te Go to h ttp ://lo g in .c e n g a g e b ra in .c o m to access CourseMate, your online study tool for Financial Accounting. CourseMate brings chapter concepts to life with interactive learning, study and exam preparation tools. >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Financial reporting principles, accounting standards and auditing ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE explain w h y financial accounting has authoritative standards and accounting principles (G AA P) explain G A A P and its com ponents describe the set of principles a n d concepts that g u id e the p rep aratio n o f financial reports explain the principles of financial accounting a n d h o w each directly affects the process of financial accounting define assets, liabilities and equity, a n d determ ine w h ether certain items m eet these definitions determ ine w h en an asset or liability is to be recognised list and explain the contents of annual reports in A ustralia explain the nature a n d purpose of an a u d it describe the types of a u d it reports issued m ake judgem ents on the a p p ro p ria te responses to certain ethical dilem m as describe the w a y in w hich c ap ital markets op e ra te describe the role o f financial accounting inform ation in c ap ital markets explain w h a t is m eant by an efficient c ap ital m arket explain the im plications for financial accounting for business contract arrangem ents.
CHAPTER OVERVIEW This is th e la st o f th e s ix c h a p te rs in tro d u c in g th e fin a n c ia l state m e nts. It has fe w n u m b e rs . (P erh ap s th e b re a k fro m n u m b e rs w ill h e lp th e p re v io u s m a te ria l settle in to y o u r u n d e rs ta n d in g !) In ste a d , th is c h a p te r fo cu ses on th e la rg e system o f s ta n d a rd s a n d p rin c ip le s th a t g o v e rn th e w a y a c c o u n ta n ts a s se m b le th e n u m b e rs . W e h a ve seen th a t a c c ru a l a c c o u n tin g a n d even tra n s a c tio n re c o rd in g re q u ire ju d g e m e n t a n d m a n a g e ria l d e c is io n s . N o w w e w ill d e lv e in to th e c o n c e p ts th a t g u id e th e a c c o u n ta n ts a n d th e a c c o u n tin g . Both d o in g a c c o u n tin g a n d usin g a c c o u n tin g in fo rm a tio n re q u ire a so lid c o n c e p tu a l u n d e rs ta n d in g , in a d d itio n to b e in g a b le to w o rk w ith th e n u m b ers. A c c o u n tin g in fo rm a tio n d o e s n 't just a p p e a r; it fo llo w s a c c e p te d s ta n d a rd s o f p re p a ra tio n , fo rm a t a n d disc lo su re , o r sh o u ld fo llo w th em . A c c o u n tin g s ta n d a rd s a n d p rin c ip le s a re n o t just 'th e o ry ': th e y a re a set o f v e ry p ra c tic a l g u id e lin e s th a t a c co u n ta n ts a n d m a n a g e rs fo llo w e v e ry d a y . This c h a p te r is a fo u n d a tio n fo r s u cc e e d in g c h a p te rs , w h ic h g e t in to th e s p e c ifics o f d o in g a c c o u n tin g a n d m a k in g a c c o u n tin g c h o ice s, a n d use th e p rin c ip le s fro m this c h a p te r c o n tin u o u s ly . If y o u a re g o in g to be a user o f a c c o u n tin g re p o rts, it is no t o n ly im p o rta n t to u n d e rsta n d the a b o v e b u t a ls o to be a w a re o f th e b ro a d e r c o n te n t o f a n a n n u a l re p o rt, h o w to in te rp re t a n a u d it re p o rt, a n d h o w a c c o u n tin g nu m b ers a re used in c a p ita l m a rke ts a n d c o n tra c tu a l a rra n g e m e n ts .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6.1 Introduction: accounting standards and principles B elow is a quote from a C a n a d ia n courtroom . It is a nice illustration o f just h o w im portant accounting standards are. La dies a n d g e n tle m e n o f th e j u r y , I p u t it t o y o u t h a t th e d e fe n d a n ts , M a r k e t D a r lin g In c .’s t o p m a n a g e rs o n tria l h e re , w ilfu lly c ir c u m v e n te d a c c o u n tin g s ta n d a rd s in p re p a rin g th e s e t o f fin a n c ia l s ta te m e n ts t h a t a re th e h e a rt o f th is law su it. W h e n in v e s to rs , o r d in a r y C a n a d ia n s lik e y o u rs e lv e s , b o u g h t M a r k e t D a r lin g sh a re s, t h e y w e re p u tt in g t h e ir fa ith in th e c o m p a n y as w e ll as t h e ir sa vin g s, a n d p a rt o f t h a t fa ith w as t h a t th e y w o u ld g e t h o n e s t in fo r m a tio n in th e c o m p a n y ’s fin a n c ia l re p o rts . T h a t fa ith w a s d e s tro y e d b y th e c o m p a n y ’s s e lf-s e r v in g a c c o u n tin g , a n d th e e v id e n c e s h o w s t h a t s u c h a c c o u n tin g also led t o t h e c o lla p s e o f th e w h o le b u sin e ss a n d th e loss o f in v e s to rs ’ m o n e y as w e ll as t h e ir fa ith . I’ll s u m m a ris e th e m a in p a rts o f th is sad s to ry : •
M a r k e t D a rlin g b e g a n te n y e a rs a g o w ith a so lid b u sin e ss c o n c e p t a n d g o o d e m p lo y e e s . B u t to p
•
T o fu e l th e ra p id g r o w th th o s e m a n a g e rs w a n te d , th e c o m p a n y n e e d e d la rg e a m o u n ts o f m o n e y , w h ic h it
m a n a g e rs , th e r e a t th e d e fe n d a n ts ’ ta b le , w a n te d fa s te r g r o w th .
g o t f r o m sh a re issu es a n d b a n k b o rr o w in g , a n d s p e n t o n in c re a s in g ly g ra n d io s e a n d d u b io u s in v e s tm e n ts a n d a c q u is itio n s o f o t h e r c o m p a n ie s . •
T o c o n v in c e in v e s to rs a n d le n d e rs t h a t it w as d o in g w e ll, a n d so ke e p t h e ir m o n e y c o m in g in , th e
•
T o p m a n a g e rs fo u n d a c c o u n tin g to o c o n s e rv a tiv e a n d c a u tio u s f o r t h e ir lik in g , so th e y s ta r te d t o fin d
c o m p a n y ha d t o s h o w s tro n g g r o w th in e a rn in g s .
w a y s o f r e p o r tin g re v e n u e s t h a t w e re n o t re al a n d d e la y in g e x p e n s e s , a n d so p ro d u c e d a r tific ia lly h ig h e a rn in g s , re ta in e d e a rn in g s a n d a s s e ts lik e re c e iv a b le s a n d in v e n to rie s . •
T h e c o n tin u o u s a n d in c re a s in g d e m a n d f o r e a rn in g s g r o w th b e c a m e a tre a d m ill. T h e c o m p a n y be g a n m a k in g b u sin e ss d e a ls a n d a c q u irin g o t h e r c o m p a n ie s b e c a u s e t h e y m a d e th e a c c o u n tin g n u m b e rs lo o k g o o d , n o t b e c a u s e th e y m a d e b u s in e s s se nse . T r u s tin g in v e s to rs s u p p o r te d th e c o m p a n y , a n d th e sh a re p ric e ro s e m o r e th a n te n fo ld in a fe w ye a rs .
•
G e t t in g in c re a s in g ly g o o d a c c o u n tin g re s u lts b e c a m e th e w h o le g o a l. B u t it w as a h o u s e o f c a rd s . T h e a c c o u n tin g w as u n fa ir, u n re lia b le , u n c o n v e n tio n a l, u n c o n s e rv a tiv e , a n d u ltim a te ly u n b e lie v a b le . W h e n in v e s to rs re a lis e d th is , th e y ran f o r c o v e r, a n d t h e sh a re p ric e c o lla p s e d . F a ith fu l in v e s to rs lo s t t h e ir s h irts , w h e n th e s h a re p ric e fe ll o v e r 9 5 p e r c e n t in a fe w w e e k s a n d t h e c o m p a n y w as fo r c e d in to b a n k ru p tc y .
•
La d ie s a n d g e n tle m e n , th is law s u it is fu n d a m e n ta lly a b o u t a c c o u n tin g s ta n d a rd s a n d th e c o m p a n y ’s fa ilu re t o fo llo w th e m . I f th e c o m p a n y ha d fo llo w e d a c c e p te d a c c o u n tin g s ta n d a rd s , in s te a d o f t r y in g to g e t a ro u n d t h e m , it w o u ld n o t ha ve g o tte n in to th is m e ss , in v e s to rs w o u ld n o t h a ve s u ffe r e d th e h u g e losses, a n d y o u w o u ld n o t be h e re t h in k in g a b o u t a c c o u n tin g o n th is fin e s u m m e r’s day.
N o d oubt m any of you reading this b o o k w ill one d a y be 'to p m anagers', but let's make sure you are not referred to as 'to p m anagers, there a t the defendants' ta b le '.
6.2 Accounting principles and the use of accounting inform ation H o w d o accountants d e c id e w h a t accounting is needed a nd then put their decisions into practice? This section outlines the conceptual background that guides accountants.
D oing accounting
takes expert know ledge,
considerable experience a n d continuous attention to n e w problem s an d solutions. C oncepts a nd principles are very im portant in accounting, because they form a lo g ica l structure that practising accountants use every d a y to consider problem s, make o r recom m end decisions a nd explain solutions.
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A p p lyin g accounting standards a nd principles depends on the particular accounting entity: the enterprise for w h ich the accounting is being d o n e . The local coffee shop is just as a p p ro p ria te an entity to be accounted fo r as are the groups o f corporations m aking up W o o lw o rth s or W e s tp a c , but decision criteria w o u ld im ply different accounting needs for the coffee shop entity, the retailer o r the bank, so g e n e ra lly a cce p te d accounting principles w o u ld be a p p lie d differently for these entities. (M o re a b o u t this in the 'For your interest' b ox a t the end of this section.) Financial accounting has a surprisingly large set o f concepts an d principles to g u id e accountants in preparing finan cia l statements, auditors in verifying them an d users in interpreting them. A very large am ount has been written a bou t the conceptual a nd theoretical side of acco u n tin g , a n d , as you s a w earlier, several groups are involved in setting fin a n cia l accounting standards a nd otherw ise regulating accounting inform ation. All this m aterial occupies m any metres o f library shelves an d much space in com puter databases. This section w ill g ive you a glim pse o f the conceptual structure behind fin a n cia l accounting b y focusing on some concepts of particular value to the users o f accounting inform ation. These concepts have been de d u ced by accountants, researchers an d standard-setters from lo g ic a nd the observation o f g o o d practices, a nd they a re used to g u id e everyone w h o prepares, audits, uses a nd studies fin a n cia l accounting. A phrase often used in relation to accounting's conceptual structure is 'g e n e ra lly acce p te d accounting principles' (GAAP). These a re the rules, standards a nd usual practices that com panies a re expected to fo llo w w hen p re paring their fin a n cia l statements. They a re a com bination o f the authoritative standards an d concept statements issued b y accounting standard-setters - such as the Australian A ccounting Standards B oard (AASB) and the Financial A ccounting Standards Board (FASB) in the United States - a nd the acce p te d w a ys of d o in g accounting that a re not included in such standards. Y ear by year, the set o f authoritative standards gets larger, but the w o rld continues to increase in com plexity, so the standards a re never extensive enough to include everything. Perhaps they should not try to cover everything, because if they d id , fin a n cia l accounting w o u ld be bound by a boring, inflexible set o f rules. The developm ent o f G A A P can be traced b a ck to the evolution o f fin a n cia l acco u n tin g , as w e ll as to the efforts of standard-setting bodies that attem pted to im prove accounting principles an d practices b y increasing the authoritative, docum ented part o f G A A P . Until the twentieth century w a s w e ll under w a y , authoritative accounting standards d id not exist. The catalyst that produced increased fin a n cia l disclosure a nd brought m ore rules governing it w a s the stock market crash o f 1 9 2 9 . Poor fin a n cia l reporting a nd disclosure w e re seen as contributing to the crash. It w a s argued that, had investors been better inform ed, they could have m ade sounder fin a n cia l decisions, thus preventing the stock market co lla p se an d its harmful e co n o m ic a n d social consequences. In A ustralia, the main G A A P consist of accounting standards a n d the conceptual fram ew ork. It all sounds a bit com plex, but if w e describe them o ne b y o ne it should becom e clearer. Think o f them as a p a c ka g e that together forms G A AP . W h ile , for m any years, there w e re significant differences in accounting standards betw een countries, recently the International A ccounting Standards Board (IASB) issued a w h o le series of accounting standards. The AASB uses the IASB pronouncem ents as the 'fo u n d atio n ' pronouncem ents, to w h ich it adds material d e ta ilin g the scope and a p p lic a b ility of a pronouncem ent in the Australian environm ent. A dd itio n s a re m ade, w h e re necessary, to broaden the content to cover sectors not addressed by an IASB pronouncem ent, an d dom estic, regulatory o r other issues. G e n e ra l concepts a nd principles to be used in preparing an d presenting fin a n cia l statements are set out in the Fram ew ork for the Preparation a n d Presentation o f F inancial Statements. (This is cited in the Australian A ccounting Standards an d in this b o o k as the Framework.) This Fram ew ork has im portant im plications, so w e n o w devote a com plete section to its coverage.
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FOR YOUR INTEREST W h ile w e ha ve G A A P , it is v e ry im p o r ta n t to c o n s id e r th e n e e d t o f i t th e a c c o u n tin g to th e c irc u m s ta n c e s o f th e p a rtic u la r a c c o u n tin g e n tity . H o w e v e r, i f y o u alw ays c h a n g e d e v e ry th in g to s u it e a ch e n te rp ris e , th e re w o u ld be n o s ta n d a rd s le ft an d n o c o m p a ra b ility to o t h e r e n te rp ris e s . I f e v e ry c o u rs e in th e u n iv e rs ity used a u n iq u e g ra d in g s y s te m , y o u c o u ld n ’t c o m p a re h o w y o u d id in d iffe r e n t c o u rs e s , o r c o m p u te a g r a d e - p o in t ave ra g e . H e re , v e ry b rie fly , a re th r e e e x a m p le s o f a c c o u n tin g d iffic u ltie s th a t fa c e a c c o u n ta n ts and m a n a g e rs . •
T h e A B C , as w e ll as c h a n n e ls N in e , T e n an d S e v e n , ha ve n a tio n a l T V n e tw o rk s in A u s tra lia . T h e A B C is p u b lic ly o w n e d , la rg e ly fin a n c e d b y th e g o v e r n m e n t o f A u s tra lia , an d is n o t g e n e ra lly s u p p o s e d to be tr y in g to m a k e a p r o fit, w h ile th e th r e e c o m m e rc ia l c h a n n e ls a re lis te d c o m p a n ie s an d a re d e fin ite ly tr y in g to m a k e a p r o fit. S h o u ld all f o u r use th e sa m e a c c o u n tin g m e th o d s , so th a t th e y m a y be c o m p a re d , o r do e s th e A B C ’s p u b lic o w n e rs h ip an d m a n d a te m e a n th a t its a c c o u n tin g s h o u ld be d iffe re n t? (T h e A B C ’s a c c o u n tin g w as v e ry d iffe r e n t 15 y e a rs ago fr o m th a t o f a p r o fit- m a k in g c o m p a n y , b u t its a c c o u n tin g has b e e n g e ttin g less an d less d iffe r e n t o v e r th e y e a rs .)
•
B e c a u s e c o m p a n ie s c a n n o t ‘o w n ’ th e ir e m p lo y e e s , all th o s e g re a t e m p lo y e e s a re n o t s h o w n o n th e b a la n ce s h e e t o f Q a n ta s , B H P o r U N S W A u s tra lia . B u t w h a t a b o u t a s p o rts te a m like th e S y d n e y S w an s o r M a n c h e s te r U n ite d ? T h e se te a m s o fte n p a y m illio n s o f d o lla rs f o r th e rig h t to ha ve p a rtic u la r p la y e rs play f o r th e m . H o w s h o u ld th e te a m a c c o u n t f o r s u c h s u m s ? A r e th e y assets o r e x p e n s e s ? I f th e y a re assets, h o w lo n g d o th e y la st? S h o u ld th e y be a m o rtis e d o v e r th e ‘u s e fu l life ’ o f th e p la y e r c o n c e rn e d ? T h a t w o u ld be to tr e a t th e p la y e r r a th e r like a m a c h in e o r a b u ild in g , b u t m a y b e , in an e c o n o m ic sense, t h a t ’s w h a t th e p la y e r is. (T h e a c tu a l p la y e rs a re n o t o n th e b a la n c e s h e e ts o f s o m e m a jo r s p o rtin g te a m s p a rtic u la rly in th e U n ite d S ta te s , b u t th e c o s ts to g e t th e m a re , and m a n y te a m s in d e e d a m o rtis e s u c h c o s ts o v e r th e le n g th o f tim e th e p la y e rs a re th o u g h t to be u s e fu l - an e x c e e d in g ly d iffic u lt e s tim a tio n to d o , w h e n an in ju ry , f o r e x a m p le , c a n re n d e r a s ta r p la y e r p r e tty w e ll useless lo n g b e fo re age w o u ld be e x p e c te d t o d o th e s a m e .)
•
H o w d o y o u fig u re o u t th e p ro fita b ility o f a b ig film like o n e o f th e S ta r W a rs s e rie s? S u c h a film s h o u ld a t tr a c t lo ts o f p e o p le t o th e th e a tr e s o o n a f te r it c o m e s o u t, b u t it w ill ( o r m ig h t) g e n e ra te o t h e r re v e n u e s f o r y e a rs , s u ch as d o w n lo a d s o r D V D sales, T V s c re e n in g s , p r o d u c t tie - in s an d b o o k s . (T h is is o n e o f a c c o u n tin g ’s h a rd e s t p ro b le m s . T h e re ha ve b e e n m a jo r la w s u its b e tw e e n p e o p le w h o are s u p p o s e d t o sh a re p r o fits fr o m film s an d d isa g re e a b o u t h o w s u c h p r o fits s h o u ld be c a lc u la te d , e s p e c ia lly h o w to fa c t o r in s u c h u n k n o w n s as fu tu r e re v e n u e s .)
6.3 Framework for the preparation and presentation of financial statem ents The Fram ew ork issued b y the AASB sets out the concepts that underlie the preparation o f fin a n cia l reports for external users. The Fram ew ork includes c o ve ra g e of: •
the objectives o f fin a n cia l reports
•
the assumptions underlying fin a n cia l reports
•
the qualitative characteristics that determ ine the usefulness o f fin a n cia l reports
•
the definition o f the elements from w h ich fin a n cia l reports are constructed: assets, liabilities, equity, incom e and expenses
•
recognition an d measurement o f the elements o f fin a n cia l statements.
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Some o f these items w ill sound fam iliar. For exam ple, in C hapter 1 w e discussed the basic qualitative characteristics that determ ine the usefulness o f financial reports, an d in C hapter 2 w e introduced you to definitions o f the key elements o f the financial statements, including assets a nd liabilities. These concepts w ill be e xp anded on here before w e take a more detailed look at the various bala n ce sheet, incom e statement a nd cash flo w elements in the later chapters. The Fram ew ork makes a distinction betw een general purpose fin a n cia l statements a nd special purpose financial statements. The Fram ew ork deals w ith general purpose fin a n cia l statements (as does this book). These general purpose fin a n cia l statements are a im ed at the com m on inform ation needs o f a w id e range o f users. These users gene ra lly have to rely on the fin a n cia l report as their m ajor source o f fin a n cia l inform ation. S pecial purpose reports, such as prospectuses for the issue o f shares, are outside the scope o f the Framework. In C h a p te r 1, you w e re introduced to the users o f fin a n cia l reports. These include: investors, em ployees, lenders, suppliers an d other trade creditors, customers, governments a nd their agencies, an d the public. The Framework takes the v ie w that investors, lenders and other creditors are the main users o f the financial reports, as the objective of general purpose financial reports is to provide information to existing and potential investors, lenders and other creditors to a llo w them to make decisions about providing resources to the organisation (Framework, 201 3, O B 2). The Fram ew ork also recognises that the users o f inform ation a b o u t not-for-profit organisations m ay be different and their resource a llo ca tio n decisions m ay differ. For exam ple, they include donors, taxpayers, recipients o f the services (e.g. the community) a n d parties p ro vid in g an oversight role (e.g. Parliament).
The objective o f financial reports The o b je ctive o f fin a n cia l reports is to pro vid e inform ation a b o u t fin a n cia l position, fin a n cia l perform ance a nd cash flow s that is useful to users in m aking e conom ic decisions. These econom ic decisions, w hich w ill vary depending on the user, generally require an evaluation of the ability of the entity to generate cash in the future. Users are interested in the timing of that cash generation and the level of certainty; that is, how likely it is that the cash w ill be generated. This future cash generation is an important determinant of the ability of the entity to pay dividends to shareholders, w ages to employees, interest to lenders and tax to the government. The Framework argues that decisions by potential users depend on the returns they expect (e.g. dividends, interest and capital gains/losses) and that expectations about returns depend on the assessments about the amount, timing and uncertainty of future cash flows. To help predict future cash flow s users need to kn o w about: •
the econom ic resources (e.g. land an d buildings, equipm ent a nd patents) that the entity controls
•
the claim s aga in st the entity (e.g. am ounts o w in g ) a n d h o w effectively a nd efficiently m anagem ent a nd the board have disch a rg e d their duties (Fram ework, 2 01 3 , O B 3 an d 4).
•
inform ation a b o u t the nature an d am ounts o f these resources a nd claim s related to the fin a n cia l position o f the entity. This inform ation helps users identify strengths a nd weaknesses, the entity's liq u id ity a nd solvency, a nd its need for a d d itio n a l fin a n ce a nd likelihood o f a ttaining it. In a d d itio n to kn o w in g a b o u t the present level o f resources a nd claim s, users also need to kn o w a b o u t changes in
these am ounts from both fin a n cia l perform ance a nd other transactions such as b o rro w in g m oney (e.g. bank loans) and issuing shares. Information on fin a n cia l perform ance (as measured by calculating the profit from the organisation) is useful for a num ber o f reasons: •
It helps users understand w h a t return shareholders get on their equity (return on equity) w h ich indicates h o w efficiently a n d effectively the organisation has used its resources.
•
Inform ation a b o u t the v a ria b ility o f this return a nd its com ponents (discussed in detail in C h a p te r 15 under ratios) helps assess future cash flow s (Fram ework, 2 0 1 3 , O B 15 -1 6 ).
U nderlying assum ptions T w o key assumptions in the preparation o f fin a n cia l statements are the use o f the accrual basis a nd the g o in g concern concept.
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A C C R U A L BASIS O F A C C O U N T IN G Financial reports are prepared on the accrual basis of accounting. As outlined earlier in the book, the accrual basis recognises the effects of transactions and events w hen they occur (which m ay or may not be w hen the cash is received). This use of accrual accounting probably does not surprise you, as w e have been using it since C hapter 1. The Framework emphasises that the use of accrual accounting provides a better basis for assessing an entity's past and future performance than information only related to cash receipts and cash payments during a period (Framework, 201 3, O B 17). Financial reports are norm ally prepared on the assumption that the entity w ill continue in o p eration for the foreseeable future. If this is not the case, a nd the entity intends o r needs to liquidate, it is necessary to prepare the financial reports on a basis other than historical cost. C o n sid e r the fo llo w in g exam ple. Assume last ye a r your university com pletely rem odelled yo u r classrooms w ith n ew carpet, tiered seating an d n e w inbuilt projection equipm ent. U nder historical cost, the cost o f all those renovations w o u ld be recorded as an asset a n d then d epreciated over the life o f the asset. If the costs w e re $ 1 0 m illion an d dep re cia tio n in ye a r 1 w a s $1 m illion, the b o o k value (cost — accum ulated depreciation) w o u ld be $ 9 m illion. This is the am ount that w o u ld a p p e a r on the b alance sheet. Frtowever, if the governm ent closed your university — that is, it is no longer a g o in g concern — the assets w o u ld need to be recorded a t liq uidation value. B asically, they w o u ld be recorded at w h a t they could be sold for. N o te that there is not much o f a secondhand market for tiered seating to fit a certain size of room , o r carpet that has been cut to fit that room . Liquidation value in this case w o u ld be a lot less than historical b o o k value. W h ile the Fram ew ork o n ly lists accrual accounting an d g o in g concern as the basic assumptions o f financial reporting, m any authors, including us, w o u ld also include the accounting entity, accounting period an d the monetary assumptions that w e described in C h a p te r 1 as key underlying assumptions. The Fram ew ork (201 3) also notes that fin a n cia l perform ance is reflected by past cash flow s a nd that these past cash flow s help users assess future cash flow s.
FOR YOUR INTEREST In th e pa st, g o v e rn m e n ts and g o v e rn m e n t d e p a rtm e n ts used cash r a th e r th a n a c c ru a l a c c o u n tin g . In 1991 th e N S W G o v e r n m e n t in tro d u c e d a c c ru a l a c c o u n tin g , an d in 1 9 9 8 th e C o m m o n w e a lth G o v e r n m e n t m o v e d to a c c ru a l a c c o u n tin g . A ll o t h e r s ta te s an d te r rito r ie s n o w also use a c c ru a l a c c o u n tin g .
Q ualitative characteristics o f financial repo rting Q u a lita tive characteristics are the attributes that make the inform ation p rovided in fin a n cia l reports useful to users. These qualitative attributes are categorised as fundam ental o r enhancing. The fundam ental q ualitative characteristics o f inform ation are: •
relevance
•
faithful representation. The enhancing q u alitative characteristics o f inform ation are:
•
c o m p a rab ility
•
verifia b ility
•
timeliness
•
understandability. The Fram ework states that the four characteristics enhance inform ation that is both relevant and faithfully represented.
You w ill recall (we hope) that these w e re discussed in C h a p te r 1. You should refer to section 1 .7 for the definitions of each. W ith the a d d itio n a l know ledge you have g a in e d from the last five chapters, some a d d itio n a l obseivations can be m ade at this stage a bout the four enhancing characteristics to make inform ation both relevant an d faithfully represented.
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In terms o f c o m p a rab ility, G A A P contains m any deta ile d rules w ith several industry exceptions a n d alternative accounting policies for the same transactions. This can result in com panies com ing to technically com petent conclusions that m ay be inconsistent w ith the underlying econom ic substance o f a particular transaction. All these exceptions a nd alternative treatments certainly lead to some difficulties in m aking com parisons across com panies. Analysts often com e up w ith their o w n standard w a y o f presenting accounting d a ta by taking published fin a n cial d a ta a n d converting it to their o w n requirements.
2
Verification relates to faithful representation of e co n o m ic phenom ena. V erification can be direct (e.g. counting inventory o r cash) o r indirect, through checking the inputs to a m odel, formula o r other techniques related to measurement (e.g. the calculation o f d epreciation).
3
Timeliness refers to having inform ation a v a ila b le w hen users need to make their decisions. H ow ever, having inform ation earlier rather than later can mean that it is less com plete. For exam ple, certain estimates becom e more accurate over time (e.g. the estim ate o f uncollectible accounts receivable, discussed in C h a p te r 8 , o r the obsolescence o f inventory, discussed in C h a p te r 9). Liabilities related to certain past acts m ay also becom e more accurately m easured as time passes. H ow ever, the characteristic o f timeliness incorporates the idea that it is im portant to have the inform ation w hen the decision is being m ade.
4
U nderstandabilily: The Fram ew ork states that users a re expected to have a reasonable kn o w le d g e o f business, eco n o m ic activities an d a ccounting, a n d a w illingness to study the inform ation w ith reasonable d ilig e n ce. H ow ever, there is a caveat: inform ation a b o u t co m p le x matters, if relevant to users, should not be excluded on the grounds that it is too difficult for users to understand. O v e r the last 1 0 years there have been m any claim s from sophisticated users o f accounting reports that the
com plexity in accounting has becom e so great that even experts have trouble understanding a published set of finan cia l reports. These concerns have been expressed in both A ustralia a nd overseas. O n e exam ple is the 2 0 0 8 Pozen Report, the Progress Report o f the A d v is o ry C om m ittee on Improvements to Financial R eporting to the U nited States Securities a n d Exchange Com m ission. The Pozen C om m ittee's o b je ctive w a s to exam ine the US fin a n cial reporting system a n d make recom m endations to increase the usefulness o f fin a n cia l reports to investors, creditors and other users w h ile reducing the com plexity o f the reporting system. The Pozen C om m ittee w a s particularly critical o f the com plexity caused b y m ore an d m ore deta ile d accounting standards, as a huge increase in com plexity makes it difficult for investors to understand the econom ic substance o f transactions a nd the entity's overall fin a n cia l position and perform ance. This also m ade it difficult for preparers to properly a p p ly G A A P an d com m unicate the econom ic substance o f transactions an d events; an d for others to audit, analyse an d regulate a co m p a n y's fin a n cia l reporting. W h a t does all this mean for you as an introductory accounting student? These accounting standards are continually being considered around the w o rld . Som e im portant changes in accounting have a lre a d y occurred and others are still em erging. A ccounting is not static; the better you understand the basic fundam entals o f a ccounting, the better you w ill be a b le to c o p e w ith these changes.
Elem ents o f financial statem ents The key elements of financial statements related to financial position are assets, liabilities and equity; those related to financial performance are income and expenses. These elements w ere introduced in earlier chapters, particularly C hapter 2. In earlier chapters w e referred to revenues, w hich, as you w ill see below , are one of the subelements of income.
ASSETS Assets are resources controlled by an entity as a result o f past events, a nd from w h ich future e conom ic benefits are expected to flo w to the entity. Let's consider some aspects o f the definition: •
The a b o ve definition specifies the essential features o f an asset, but not the criteria that need to be met before assets are recognised in the balance sheet; that is, the definition includes items that m ay not be included in the balance sheet because o f such factors as the reliability o f the measurement. These criteria are discussed later in this section.
•
'Future econom ic benefits' refers to the asset's potential to contribute to the flo w of cash (or cash equivalents) to the entity. This may be singly or in com bination w ith other assets. It m ay include assets (such as equipment) producing
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goods or services that are sold; it m ay be the ca p a city to reduce cash outflows (alternative manufacturing processes that reduce the cost of production); it m ay be resources that are convertible to cash (such as receivables or inventory). •
W h ile m any assets have physical form (such as property, plant a nd equipm ent [PPE]), this is not essential, as for
•
W h ile the right o f ow nership is com m on for m any assets (such as receivables or property), it is not essential; for
patents, tradem arks a nd copyrights (usually ca lle d intangibles).
exam ple, a lease o f equipm ent can be an asset if the entity controls the benefits that are expected to flo w to the entity. •
An asset must be as a result o f a past transaction o r other past events. This w ill norm ally be purchasing or producing the asset, but other exam ples could be the discovery o f mineral o r oil deposits, o r property given b y the governm ent as part o f a developm ent plan.
•
C ontrol by the entity relates to the ca p a city o f an entity to benefit from the asset in pursuing its objectives and to deny o r regulate the access o f others. The entity controlling the asset is the one that can exchange it, use it to provide goods or services, a nd charge others for its use. Although the a b ility to control the future econom ic benefits m ay be a result o f legally enforceable rights, this is not an essential characteristic o f an asset. For exam ple, under a lease agreem ent, the o w n e r (lessor) m ay transfer to the lessee control over the leased property for a certain period o f time. If the entity cannot d e n y others access to the benefits o f the asset, these future econom ic benefits w ill not be
controlled by the entity. For exam ple, consider a property de ve lo p e r w h o builds a series o f townhouses, a nd is required by the local council to put in road improvements o r a public park as part o f the project. If access to the road o r the park is open to the general public w ith o u t ch a rg e , then the de ve lo p e r does not have control over the asset.
ASSET R E C O G N IT IO N A further question addressed by the Fram ew ork is the criteria that should be used to recognise assets. Recognition refers to the reporting o f an item on the fa ce o f the fin a n cia l statements. For assets, the relevant fin a n cia l statement is the b a la n ce sheet. The Fram ew ork states that an asset should be recognised w hen an d o n ly w hen: •
It is p ro b a b le that a n y future econom ic benefits associated w ith the item w ill flo w to the entity.
•
The item has a cost o r value that can be measured w ith reliability. The term 'p ro b a b le ' means that the chance o f the future econom ic benefits arising is more likely rather than less
likely. For exam ple, a credit sale to a reputable customer still involves some p ro b a b ility that the am ount w ill not be collected. F-lowever, if the likelihood of non-receipt is remote at reporting date, the am ount o w in g to the entity w o u ld satisfy the criteria for recognition as an asset. For some expenditures, such as those on exploration, and research and developm ent, the degree o f certainty that the item w ill satisfy the criteria for recognition o f an asset often does not exist. For an asset to satisfy the recognition criteria, it is also necessary that it possess a cost o r other value that can be measured reliably. In most cases, assets have a cost that can be re liably measured; for exam ple, m otor vehicles, inventory o r equipm ent. An exam ple w h e re this is not the case is a m ining c o m p a n y that m ay have discovered, a t an imm aterial cost, some e vidence o f minerals on its exploration site, but a t the d a te o f reporting does not know the extent o f the minerals o r their value.
FOR YOUR INTEREST Y o u m a y have h e a rd C E O s say th a t th e ir s t a f f a re th e ir b ig g e s t a sse t. Y e t y o u w ill ha ve n o te d th a t s t a f f are n o t lis te d o n a n y b a la n c e s h e e t. O n e o f th e re a so n s is th e d iffic u lty o f p u ttin g a v a lu e o n s ta ff. In th e 1 9 7 0 s and 1 9 8 0 s , th e r e w as a lo t o f a c c o u n tin g re s e a rc h c a lle d h u m a n re s o u rc e a c c o u n tin g , w h ic h e x a m in e d th is q u e s tio n . S o m e s u g g e s tio n s f o r v a lu in g s ta ff in c lu d e d : •
all c o s ts s p e n t o n th e s t a f f m e m b e r (s u c h as th e c o s t o f tra in in g )
•
th e p re s e n t v a lu e o f th e fu tu r e cash th e s t a f f m e m b e r w ill g e n e ra te
•
th e c o s t o f tr a in in g a re p la c e m e n t.
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LIABILITIES A lia b ility is a present o b lig a tio n o f the entity arising from past events, the settlement o f w h ich is expected to result in an o u tflo w from the entity of resources e m b o d yin g e conom ic benefits. A g a in , w e should consider some o f the content o f this definition from the Framework: •
As w ith assets, this definition identifies essential features, but does not specify criteria for including the lia b ility on the b a la n ce sheet (this is covered below ).
•
Past transactions w o u ld include the a cq u irin g o f g o o d s a nd services (accounts p a yable), em ployees perform ing w o rk (w ages p a y a b le or provision o f e m ployee entitlements), the use o f m oney from the bank (interest payable), receipt o f a b a n k loan (bank loan), sale o f g o o d s (provision for w arranty) an d receipt o f cash in a d va n ce of p ro vid in g a service (revenue received in advance).
•
The existence o f a lia b ility depends on the present o b lig a tio n being such that the legal, social, p o litica l or e co n o m ic consequences o f fa ilin g to honour the o b lig a tio n leave the entity little, if any, discretion to a vo id the future sacrifice o f e co n o m ic benefits to another entity. For exam ple, an entity p la cin g an o rd e r for the purchase of g o o d s w o u ld not norm ally g ive rise to a liability, since the entity w o u ld norm ally have the discretion to a vo id the future sacrifice o f econom ic benefits by being a b le to cancel the order. The receipt o f the g o o d s w o u ld norm ally be the event that w o u ld create the lia b ility. F-lowever, if the g o o d s w e re to be m ade to the specifications o f the purchaser, it m ight not be possible to cancel the ord e r after the supplier com m enced manufacture o f the g oods, w ith o u t significant penalties. In these circum stances, a lia b ility w o u ld exist w hen the supplier com m enced manufacture o f the g oods.
•
Settlement o f a present o b lig a tio n can occur via: -
paym ent o f cash
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transfer o f other assets (e.g. a c o m p a n y has received a dep o sit on a p ie ce o f equipm ent it is p ro vid in g ; it later transfers that equipm ent to the person w h o p a id the deposit)
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provision o f services, w h e re am ounts have been received in a d va n ce o f services being p rovided (as w hen there has been a receipt o f cash for a future a irlin e flight), the lia b ility is later rem oved by p ro vid in g the service (i.e. p ro vid in g the flight for the passenger)
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replacem ent o f an o b lig a tio n w ith another o b lig a tio n (e.g. accrued expenses m ay later becom e accounts pay a b le w hen the c o m p a n y receives an invoice from the supplier)
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conversion o f the o b lig a tio n to equity (e.g. issuing shares to a c o m p a n y to extinguish a debt).
There a re tw o essential criteria for the recognition o f a liability: •
It is p ro b a b le that a n y future sacrifice o f econom ic benefits associated w ith the item w ill flo w to o r from the entity.
•
The item has a cost o r value that can be measured reliably. The term 'p ro b a b le ' means that the cha n ce o f the future sacrifice o f e conom ic benefits being required is more
likely rather than less likely. This p ro b a b ility can range from virtual certainty to highly unlikely. An exam ple o f virtual certainty w o u ld be that w a g e s during the month o f June are due to be p a id on 1 July. An exam ple o f it being highly unlikely w o u ld be that the c o m p a n y has guaranteed a loan from the b a n k to a highly pro fita b le subsidiary; the future sacrifice o f e co n o m ic benefits w o u ld o n ly occur if the subsidiary defaulted on the loan. W h ile the first exam ple w o u ld meet the criteria for recognition o f a lia b ility, the second exam ple w o u ld not. The second essential criterion is that the am ount o f the lia b ility can be re liably estim ated. V erifia b le e vidence of the am ounts to be p a id a nd the dates o f paym ent are a v a ila b le for m any liabilities (such as payments to creditors and repaym ents o f loans). FJowever, some p ro b a b le future sacrifices o f e co n o m ic benefits, such as lawsuits, cannot be reliably estim ated, a nd therefore a re not included as a lia b ility at this point in time. In betw een the a b o ve exam ples are future sacrifices related to future w a rra n ty expenses on products a lre a d y sold. These can norm ally be estim ated reliably based on previous experience w ith the products. Sim ilarly, estimates o f e m ployee entitlements can usually be estim ated on the basis o f past history a nd a ctuarial estimates.
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E Q U ITY Equity is defined in the Fram ew ork as the residual interest in the assets o f the entity after deduction o f its liabilities; that is, the difference betw een the am ounts assigned to its assets an d liabilities represents an elem ent o f the b a la n ce sheet that is referred to as equity (i.e. A = L + SE; SE = A - L). O th e r names b y w h ich equity is sometimes known include ow ners' equity, shareholders' equity a nd shareholders' funds. In the Fram ework, the a p p ro a ch taken o f defin in g equity as a residual is based on the v ie w that equity cannot be defined independently o f the other elements com prising the b a la n ce sheet. A cc o rd in g ly, the concepts o f assets and liabilities must be d e fined before a definition o f equity can be m ade ope ra tio n a l. Equity ranks after liabilities as a claim to the assets of an entity. In the event of the entity being w o u n d up, all liabilities must be met before a distribution can be m ade to the entity's owners. This characteristic implies that equity is a residual interest - it is the claim to the net assets o f the entity; that is, to the assets after liabilities have been deducted.
IN C O M E Income is defined in the Fram ew ork as 'increases in econom ic benefits during the accounting p eriod in the form of inflow s o r enhancem ents o f assets o r decreases in liabilities that result in increases in equity, other than relating to contributions from equity participants'. This tells you that such things as the issue o f shares w o u ld not be included. The above definition o f income has tw o components: revenue (which w e have discussed in earlier chapters) and gains. Revenue arises in the course of ordinary activities of the entity, such as sales, fees, interest, rent, royalties and commissions. G ains refer to other items that meet the definition of income. G ains include the sale of a noncurrent asset above book value (cost minus accumulated depreciation). G ains are normally reported separately in the incom e statement. The recognition o f incom e occurs sim ultaneously w ith the recognition o f increases in assets (such as an increase in assets from the sale o f g o o d s or services) an d decreases in liabilities (such as a decrease in liabilities because another party has w a iv e d a d e b t p ayable). The future e conom ic benefit related to the increase in asset o r decrease in lia b ility must be reliably measured. In earlier chapters w e noted that the specific recognition o f revenue occurred w hen the g o o d s o r services w e re provided. Policies such as this are a im ed at restricting the recognition o f revenue to those items that can be measured reliably.
EXPENSES U nder the Fram ework, expenses are defined as decreases in e co n o m ic benefits during the accounting p eriod in the form of outflow s o f assets (such as cash p a id for w a g e s), depletions o f assets (such as dep re cia tio n o f equipm ent or expiration o f prepayments) o r incurrences o f liabilities (such as increase in provision for em ployee entitlements) that result in decreases in equity (retained profits decrease), other than those resulting in distributions to equity holders (dividends are not expenses). This definition o f expenses includes expenses that arise in the o rd in a ry course o f the business as w e ll as losses. Examples of the form er include cost o f g o o d s sold (C O G S ), w a g e s a nd d e p re cia tio n . They usually take the form of depletion in assets such as cash (wages), inventory (C O G S ) o r PPE (depreciation). Losses include those resulting from disasters, such as fire o r flo o d , a nd from the disposal o f assets w h e re the asset is sold for less than its b o o k value (cost minus accum ulated depreciation). Expenses are recognised in the incom e statement w hen there is a decrease in future e conom ic benefits related to either a decrease in asset (such as de p re cia tio n o f equipm ent o r cash p a id for w a g e s) o r an increase in a lia b ility (increase in electricity p a y a b le or an increase in the provision for em ployee entitlements) that can be reliably measured. The recognition of the expense occurs at the same tim e - the other side of the double-entry system - w ith the recognition o f the decrease in asset or increase in liability. M a tch in g involves trying to line up measures of econom ic inflow s w ith outflow s. It involves the simultaneous recognition o f revenues w ith related expenses. For exam ple, the recognition o f cost of g o o d s sold expense a t the same time as the revenue from the sale (recall in e arlier chapters DR C O G S , CR Inventory, DR Accounts receivable and CR Sales revenue). Sim ilarly, sales commission w o u ld be taken up in the sam e p eriod as the sales revenue to w hich it relates.
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M easurem ent o f the elem ents o f financial statem ents The Fram ew ork describes measurement as the process o f determ ining the m onetary amounts that the elements o f the finan cia l statements a re to be recognised at a nd included in the b a la n ce sheet (assets, liabilities an d equity) an d the incom e statement (incom e an d expenses). The Fram ew ork sets out a num ber o f different measurement bases that are em ployed to different degrees, an d in varying com binations, in fin a n cia l reports. In p a ra g ra p h 1 0 0 o f the Fram ew ork the fo llo w in g are identified: •
H isto rica l cost: Assets are recorded a t the am ount o f cash o r cash equivalents p a id o r the fa ir value o f the consideration given to acq u ire them at the time of their acquisition. Liabilities a re recorded a t the am ount of proceeds received in e xch a n g e for the o b lig a tio n or, in some circumstances (e.g. incom e taxes), at the am ounts of cash o r cash equivalents expected to be p a id to satisfy the lia b ility in the normal course o f business.
•
C urrent cost: Assets a re carried at the am ount of cash o r cash equivalents that w o u ld have to be p a id if the same o r an equivalent asset w a s a cq u ire d currently. Liabilities are carried a t the undiscounted am ount o f cash o r cash equivalents that w o u ld be required to settle the o b lig a tio n currently.
•
Realisable (settlement) value: Assets are ca rried a t the am ount o f cash o r cash equivalents that could currently be o b ta in e d b y selling the asset in an o rderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted am ounts o f cash o r cash equivalents expected to be p a id to satisfy the liabilities in the normal course o f business.
•
Present value: Assets are carried at the present discounted value o f the future net cash inflow s that the item is expected to generate in the normal course o f business. Liabilities are ca rried at the present discounted value o f the future net cash outflow s that a re expected to be required to settle the liabilities in the normal course o f business.
6.4
Assets and liabilities: valuation and measurement
W h e n w e look a t fin a n cia l inform ation, w h a t d o the numbers (the numeric values assigned to assets a nd liabilities) m ean? The asset valuation question is both com plex a nd controversial. You m ay intuitively think that the assets should be valued at w h a t they are w orth, but w h a t does that m ean? There are five basic methods often suggested for measuring (valuing) assets an d liabilities: •
historical cost
•
price-level-adjusted historical cost
•
current or market value (value in exchange)
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value in use (or present value)
•
liq uidation value. As you read the description below of each measurement and valuation method, think about w hich one you believe is
appropriate, and in w hich circumstances. There is a lot of variety and personal judgement within generally accepted accounting principles, so no one method, even the main one (historical cost), is considered to be the best in all circumstances. Asset an d lia b ility valuation is often controversial, partly because o f a concern that the values should be useful in people's decision-m aking an d a suspicion that historical cost values are not as useful as those that look m ore to the future. W o u ld you drive yo u r ca r looking o n ly in the rear-view mirror to see w h e re you have been, an d not looking out the front w in d o w to see w h e re you are g o in g ? O n e w o rry is that historical cost valuation, the most com m on method, positions fin a n cia l statements to o much in the past, w hen there are e q u a lly im portant needs to recognise changes in market conditions an d to predict the future w hen making decisions. T w o controversies w ill serve as exam ples. For asset valuation, o ne issue is w hether market values m ay actu a lly be better than historical cost, at least in some cases, such as for the fin a n cia l an d m onetary assets of banks a nd sim ilar finan cia l institutions. For lia b ility valuation, an issue is w hether o b lig a tio n s due w e ll into the future, such as w a rra n ty o b liga tio n s, should be valued at the 'present value' o f the likely future payments (future cash flow s minus interest lost by w a itin g for the money), rather than just at the estim ated future cash o u tflo w itself, as is d o n e now . N o w let's turn to the five valuation methods.
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H istorical cost H istorical cost, otherw ise known as acquisition cost, values assets at the am ount p a id o r prom ised to a cq u ire the assets, and values liabilities a t the amounts of a n y associated promises. These amounts can g e n e ra lly be found by referring to transactional evidence, such as invoices, receipts o r contracts. The a b ility to docum ent the cost o f the asset is a m ajor reason w h y historical cost is the usual valuation method for most assets an d liabilities. A nother p rincipal reason is that an enterprise w ill rarely purchase assets o r make promises for their purchase for m ore than the enterprise believes them to be w orth. If you believe that an asset w ill pro vid e you w ith $ 1 0 0 0 0 w orth of productive ca p a city, you w ill not rationally p a y or prom ise m ore than $ 1 0 0 0 0 for it. U nder this method, an asset valued at historical cost is valued at its expected low est o r most conservative value o f future benefits at the d a te o f acquisition. In most cases, G A A P im ply the use of historical costs, unless some other valuation basis is m ore a p p ro p ria te and is sp e cifically disclosed in the fin a n cia l statements. For exam ple, note 1 o f BHP Billiton Pic's 2 0 1 4 financial statements states: 'entity accounts a re prepared ... using the historical cost convention, [w h ich has] been a p p lie d on a consistent basis w ith the ye a r e nded 3 0 J u n e 2 0 1 3 '. Some a d d itio n a l points in connection w ith this method are w orth noting: •
A t the point o f acquisition, historical cost = market value = value in use (present value), in most cases. W e assume that rational p e o p le w o u ld o nly p a y w h a t the asset is w orth to them in the future in their business, a nd that, in general, such use valuation w o u ld therefore tend to determ ine the market value of the asset.
•
M u ch o f the criticism o f historical cost has to d o w ith tim e issues. If a piece o f land w a s purchased 1 0 years a g o for $ 5 0 0 0 0 , this has little m eaning to d a y . Is the land w orth $ 2 0 0 0 0 0 o r $ 1 0 0 ? That is som ething you d o not know w ith historical cost.
•
If an asset's market value later falls b e lo w its original cost, the asset m ay be written d o w n to the market value. This violation o f strict historical cost accounting is very much part o f generally accepted accounting principles. It is behind tw o im portant accounting phenom ena: 'w riting d o w n ' o f unproductive assets an d the 'lo w e r o f cost o r market' rule used in valuing inventories and some other current assets. You w ill see more a bout these later in this book. C oncerns over h o w assets are valued using historical cost have led p e o p le to suggest alternative methods for
valuing assets an d liabilities on the b a la n ce sheet. Som e o f the m ore p o p u la r alternatives are show n b e lo w .
P rice -le ve l-a d ju ste d historical cost This a p p ro a ch , first proposed early in the tw entieth century, adjusts for changes in the value or purchasing p o w e r of the d o lla r (the measuring unit), rather than for changes in the values of particular assets. The historical cost values of the assets and liabilities a re adjusted for changes in the value of the d o lla r (using eco n o m y-w id e indices, such as the C onsum er Price Index) since the assets w e re a cq u ire d o r the liabilities w e re incurred. W h ile this method has been used in the past by some com panies a n d by some countries that had high inflation, it has not found much favour in A ustralia o r N orth A m erica. O n e reason for its lack o f p o p u la rity is that if historical cost is unsatisfactory co m pared to current values, adjusting the cost for inflation still makes it unsatisfactory, o nly n o w less understandable.
C urrent or m arket value (value in exchange) This a p p ro a ch records the individual assets an d liabilities a t their current particular market value. It focuses on the individual values o f the asset an d lia b ility items, not on changes in the d o lla r itself, as price-level-adjusted accounting does. It assumes that value is market-determined a n d that profit should be measured using changes over tim e in market values. The argum ent is that if, for exam ple, yo u r house's market w orth is greater to d a y than yesterday, you have m ade m oney on it to d a y, even if you have not sold it. If its market w orth is less, you have lost m oney on it, even if you have not sold it. This method has been the subject o f much w ritin g a n d experim entation, an d has some theoretical attraction. H ow ever, it does create difficulties a nd costs in estim ating current values. Current value accounting can use either input o r output values, o r a mixture of these. •
Input m arket value, o r entry value, refers to the am ount it w o u ld cost to bring the asset into the c o m p a n y if it w e re not currently in it. It is usually measured b y estim ating replacem ent cost, to purchase the asset a g a in , or reproduction cost, to make the asset a g a in . The same idea holds for the hypothetical re-borrow ing o f liabilities.
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O u tp u t m arket value, or exit value, is the am ount an asset is w orth if it w e re sold n o w (in other w o rd s, its net realisable value) o r the am ount that a lia b ility could be p a id o ff at now , usually m easured by quoted prices, app ra isa ls a nd sim ilar estimates.
•
Fair value is an alternative asset valuation method that you w ill see more an d more often. It is very sim ilar to market value, except it does not require a market value to exist. Fair value is the am ount of the consideration that w o u ld be agreed upon in an arm's-length transaction between know ledgeable, w illin g parties w h o are under no compulsion to act. This is a hypothetical am ount ('w ould be agreed'), but is supposed to represent a potential market transaction between tw o free agents, both know le d g e a b le and w illin g , a nd not related to each other ('arm's-length'). Fair value is being used increasingly internationally. Further reference to fa ir value is m ade in C h a p te r 10.
Value in use (present value) This a p p ro a ch considers that value flow s from the w a y the c o m p a n y w ill use the asset to generate future cash flow s. •
V alue in use is usually estim ated by ca lculating the net present value o f future cash inflow s (the cash flow s minus lost interest im plied by w a itin g for the cash) expected to be generated by the asset, o r cash outflow s it w ill make unnecessary.
•
Present value is the future cash flow s minus lost future interest im plied by w a itin g for the cash. For exam ple, suppose you are getting $ 1 in a year. If you had m oney now , you w o u ld be a b le to earn 1 0 per cent on it, but b y w a itin g a year, you g ive up that interest. The present value of the $ 1 is the am ount before the lost interest: the am ount that w o u ld build up to $1 in a ye a r at 1 0 per cent. That w o u ld be 91 cents. In a year, 91 cents at 1 0 per cent w o u ld earn 9 cents interest, bringing the total to the $1 you w ill get in a year. The present value (91 cents) is thus a lw a ys smaller than the future cash paym ent ($ 1 ), w h ich is said to be 'discounted' to a lo w er am ount to remove the effects o f future interest. Present value is covered further in the a p p e n d ix to C h a p te r 1 1. For exam ple, a m achine m ight be valued a cco rd in g to the products that it w ill make a nd that w ill be sold. M o d e rn
theories o f fin a n ce an d m anagem ent accounting presume that value in use, measured by the net present value, is an a p p ro p ria te method for m anagerial decisions a b o u t asset acquisition a nd fin a n cin g . M o re o ver, m any p e ople presume it underlies market values, but the a p p ro a ch has been little used in producing fin a n cia l accounting numbers.
FOR YOUR INTEREST T h e a b o v e d is c u s s io n o f fa ir v a lu e an d v a lu e in use is p a rtic u la rly im p o r ta n t f o r a c c o u n ta n ts in th e p re s e n t e n v iro n m e n t, as a c c o u n tin g s ta n d a rd s re q u ire d ire c to rs to e n s u re th e c a rry in g v a lu e o f an a s se t (c o s t m in u s a c c u m u la te d d e p re c ia tio n )) d o e s n o t e x c e e d its re c o v e ra b le a m o u n t. T h is re d u c tio n is c a lle d an im p a irm e n t loss an d is re c o g n is e d in th e in c o m e s ta te m e n t w ith th e e x p e n s e s . T h is is d isc u s se d in s e c tio n 1 0 .6 o f C h a p te r 1 0 . T h e re y o u w ill le a rn th a t ‘re c o v e ra b le a m o u n t’ re fe rs t o th e h ig h e r o f fa ir v a lu e less th e c o s t to sell th e asset an d th e a s s e t’s v a lu e in use. T h e re fo re , i f y o u are n o t s u re w h a t th e te rm s ‘fa ir v a lu e ’ and ‘v a lu e in u s e ’ m e a n , g o b a c k and re -re a d th e la st fe w pages.
Liquidation value Liquidation value is like output market value, but is used on a 'g o in g out o f business, sell it for w h a t you c a n ' basis. It is the value that the com pany's assets w o u ld bring upon being sold, a nd the value that liabilities w o u ld be p a id o ff for, if the w h o le c o m p a n y w e n t out o f business. It is used w hen the c o m p a n y is not felt to be a g o in g concern; that is, if its continued v ia b ility cannot be assumed. Therefore, the reader o f fin a n cia l statements that have been prepared on the historical cost basis should be entitled to presume that the c o m p a n y in question is a g o in g concern. This presum ption is an im portant part o f fin a n cial
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accounting, but every ye a r it turns out to be w ro n g for some com panies that unexpectedly fail. Such b a d outcomes remind us that g o o d judgem ent is required in selecting the valuation basis, as w ith other aspects o f financial accounting. The judgem ent that a c o m p a n y is a g o in g concern, an d should therefore use historical cost accounting, w ill turn out to be w ro n g if the c o m p a n y fails. C onversely, a judgem ent that a c o m p a n y is not a g o in g concern m ight be self-fulfilling: it m ight p a n ic creditors an d investors, a nd result in c o m p a n y failure.
An exam ple: cu rre n t m arket value as an a lterna tive to historical cost Let's look a t a realistic a nd relevant exam ple. In most countries, there are m any com panies that specialise in a cquiring and d e veloping real estate for o ffice buildings, shopping centres, industrial plants, housing developm ents a nd m any other uses. As you p ro b a b ly know , real estate values are highly va ria b le , w ith frequent boom s an d busts. Let's consider tw o fictional real estate developm ent com panies o perating in the S ydney market. They are c a lle d O x b rid g e and B ram view : •
O x b rid g e has undeveloped land, bought during a dow nturn in the S ydney real estate market, that cost $ 5 million and has an estim ated current market (output) value o f $ 8 m illion. The co m p a n y's net profit has been a bout $ 7 0 0 0 0 0 per ye a r in the last fe w years.
•
B ram view also has undeveloped land, c o m p a ra b le to O x b rid g e 's , except it w a s bought during an overheated period o f the S ydney market at a cost o f $1 1 m illion. Its estim ated current m arket value is also $ 8 m illion, and the com pany's net p rofit has also been a b o u t $ 7 0 0 0 0 0 per year. The tw o pieces o f land are a b o u t the same, but the com panies' historical-cost-based b a la n ce sheets certainly d o
not look the same: •
O x b rid g e : undeveloped land, at cost $ 5 million
•
B ram view : undeveloped land, at cost $1 1 million. A lso, O x b rid g e w ill sh o w a higher ratio o f net profit to total assets, in d ica tin g a p p a re ntly stronger perform ance
than Bram view , because its total assets w ill be lo w e r than B ram view 's. N o w , w e could argue that this is as it should be; that B ram view has not really d o n e as w e ll because, in hindsight, too much w a s p a id for the land. But another argum ent is that, since the tw o pieces of land are c o m p a ra b le econom ic assets, net profit should be related to the econom ic value (such as the market value) o f the assets, not to costs that d e p e n d on historical events rather than currently relevant econom ic conditions. Let's consider the id e a o f c h a n g in g both co m p a n ie s' asset valuations for the land to current market value. Using the concepts from e arlier in this book, w h a t m ight be some pros an d cons o f this idea? Pros include the fo llo w in g : •
m ore relevant valuation for users in assessing the com pany's value
•
m ore useful for co m p a rin g com panies w ith sim ilar e conom ic assets
•
fairer w a y o f relating perform ance (income) to the e co n o m ic value that m anagers a re m a naging on behalf of ow ners
•
m ore tim ely d a ta than the 'obsolete' cost figures
•
not costly to im plem ent (unless real estate appraisers have to be paid)
•
understandable to users w h o know som ething a b o u t real estate. C ons include the fo llo w in g :
•
less-reliable numbers, because they a re based on the estim ated selling value o f land that has not been sold
•
less-consistent b a la n ce sheet values, because real estate values tend to va ry a great d e a l over time
•
not transaction based, an d therefore not easily ve rifia b le
•
can be costly if valuations need to be p a id for
•
no effect on cash flo w directly o r through incom e tax, because the land has not been sold, so there m ight be d o u b t that m oving the fin a n cia l statement numbers around in the absence o f real econom ic effects w o u ld be very helpful to anyone.
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You can p ro b a b ly a d d m ore pros a nd cons. W e d o n 't kn o w the sig n ifica n ce (materiality) o f the land valuation issue to the co m p a n ie s' fin a n cia l statements, o r the incom e tax an d other consequences o f c h a n g in g the accounting numbers. But you should see that the accounting concepts are useful in figuring out w h a t the a p p ro p ria te accounting procedure to use w o u ld be.
6.5
Accounting regulation in Australia1
Earlier chapters have em phasised the im portance o f fin a n cia l accounting inform ation to various user groups. C re d ib le financia l reporting is hard to ach ie ve w ith o u t an accounting regulatory system. Effective regulation depends on the existence o f accounting rules based on the a p p ro p ria te concepts to g u id e inform ation processing an d disclosure. Also necessary is an enforcem ent mechanism that ensures sufficient c o m p lia n ce w ith the rules. The C o rp o ra te Law E conom ic Reform Program A c t 1 9 9 9 (CLERP A ct 1 9 9 9 ), w h ich cam e into effect on 1 January 2 0 0 0 , m odified the institutional arrangem ents for the setting o f accounting standards in A ustralia, recognising that fin a n cia l reporting requirements can p la y an im portant role in Australian com panies' a b ility to com pete effectively an d efficiently in a g lo b a l environm ent. The purpose o f this section is to pro vid e an o ve rvie w o f the A ustralian regulatory system as it relates to co rporate finan cia l reporting. Figure 6.1 depicts the main elements in the system.
The governm ent's role is highlighted in Figure 6 .1 . A fter an agreem ent w ith the states a n d the N orthern Territory in 1 9 9 0 , the Federal G overnm ent took over the responsibility for com panies an d securities la w in order to overcom e the constitutional obstacles. The b ro a d legal fram ew ork for co rp o ra te fin a n cia l reporting is set out in the C orp o ra tio ns A c t 2 0 0 1 , w ith subordinate detail contained in the C o rp o ra tio ns Regulations 2 0 0 1 . A lso show n in are tw o statutory bodies established by the A ustralian Securities a n d Investments Com m ission A c t 2 0 0 1 : the A ustralian Securities an d Investments Com m ission (ASIC) a nd the Financial Reporting C o u n cil (FRC). Both p la y an im portant role in the o peration a nd oversight o f fin a n cia l reporting in A ustralia. A S IC is the a g e n c y ch a rged w ith the adm inistration a nd enforcem ent o f the C o rp o ra tio ns A c t 2 0 0 1 , w h ile the FRC is responsible for b ro a dly overseeing the accounting a nd aud itin g standard-setting process in the private a nd public sectors.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The role of ASIC is to regulate and enforce laws that promote honesty and fairness in financial markets, products and services, and in Australian companies. In doing so, it underpins the strength, growth and international reputation of Australia's financial markets. As part of this role, it monitors com pliance w ith accounting standards and takes appropriate enforcement action w here necessary. ASIC's responsibilities include oversight of the audit function, including the registration of auditors and enforcing auditor independence. In this latter role it operates an auditor inspection program of all the large audit firms and some of the smaller ones. Each year it publicly reports on the findings of this inspection process. A SIC regulates Australian com panies, fin a n cia l markets, fin a n cia l services organisations an d professionals w h o deal and advise in investments, superannuation, insurance, deposit-taking a n d credit. Its roles include: •
t h e c o n s u m e r c r e d it re g u la to r: A S I C lic e n s e s a n d re g u la te s p e o p le a n d b u sin e ss e s e n g a g in g in c o n s u m e r
•
t h e m a rk e ts re g u la to r : A S I C assesses h o w e ffe c tiv e ly a u th o ris e d fin a n c ia l m a rk e ts a re c o m p ly in g w ith
c r e d it a c tiv itie s (in c lu d in g b a n ks , c r e d it u n io n s , fin a n c e c o m p a n ie s , a n d m o rtg a g e a n d fin a n c e b ro k e rs )
t h e ir legal o b lig a tio n s t o o p e ra te fa ir, o r d e r ly a n d tra n s p a re n t m a rk e ts . A S I C has re s p o n s ib ility f o r th e s u p e rv is io n o f tra d in g o n A u s tr a lia ’s d o m e s tic lic e n s e d e q u ity , d e riv a tiv e s a n d f u tu r e s m a rk e ts •
t h e fin a n c ia l s e rv ic e s re g u la to r: A S I C lic e n s e s a n d m o n ito rs fin a n c ia l s e rv ic e s b u sin e ss e s t o e n s u re t h a t th e y o p e ra te e ffic ie n tly , h o n e s tly a n d fa irly , f o r e x a m p le s u p e ra n n u a tio n , m a n a g e d fu n d s , s h a re s an d c o m p a n y s e c u ritie s , d e riv a tiv e s a n d in s u ra n c e . Source: Australian Securities and Investments Com m ission website ( http://w w w .asic.gov.aU /about-asic/w hat-w e-do/our-role/#w ho).
The other statutory b o d y, the FRC, is an a d viso ry council that sets the general strategic direction for the developm ent o f accounting standards. It reports to the Treasurer, w h o also ap p o in ts the members o f the FRC. M em bers' appointm ents are based on nom inations put fo rw a rd by key stakeholder groups: representatives from the business com m unity, the public sector, regulatory agencies a nd the professional accounting bodies. These groups all have an interest in the standard-setting process, a nd representation on the FRC a llo w s them an opportunity to provide input to the process, resulting in greater o w n e rsh ip o f the resulting standards. The FRC's mem bership, b ro a d ly based upon a variety o f stakeholder groups, enables the accounting standard-setting process to be m ore responsive to the needs o f the users an d preparers o f fin a n cia l statements. O n e of the key functions o f the FRC is to oversee the o peration o f the Australian A ccounting Standards Board (AASB). The AASB prepares, approves an d issues accounting standards for the purposes o f the C o rporations A c t 2 0 0 1 , and for the public an d not-for-profit sectors. It com prises a full-time chairperson, a p p o in te d by the Treasurer, and nine part-time members. M em bers a re a p p o in te d by the FRC, selected on the basis of their k n o w le d g e and experience in business, acco u n tin g , la w or governm ent. The FRC is also responsible for a p p ro vin g the priorities, business plan, budget a nd staffing arrangem ents o f the AASB. H ow ever, it cannot influence the A ASB's technical deliberations, an d , therefore, the content o f particular accounting standards. The FRC also oversees the A ud itin g an d Assurance Standards B oard (AUASB). The A UASB is responsible for the developm ent an d m aintenance o f aud itin g a nd assurance standards. It consists of 1 0 members a p p o in te d by the FRC, w ith the chairperson a p p o in te d by the Treasurer. In a d d itio n to this regulatory fram ew ork, accountants w ill belong to the accounting profession, represented in A ustralia b y C PA Australia, C hartered Accountants A ustralia a nd N e w Z e a la n d (C A A N Z ) a nd the Institute of Public A ccountants (IPA). The Australian professional accounting bodies have established the A ccounting Professional and Ethical Standards B oard (APESB). This b o d y issues standards to establish a n d m onitor the indepe n d e n ce a nd ethical behaviour of professional accountants. O f particular interest is APES 1 10 C o d e o f Ethics fo r Professional Accountants, w hich is discussed in section 6 .9 o f this chapter. C om panies that are listed on the Australian Securities Exchange Limited (ASX) must com ply w ith ASX listing rules if they wish to remain listed on the ASX. The listing rules may be enforced by the ASX's po w e r o f suspension o r delisting. M oreover, the rules have statutory backing in the C orporations A c t 2 0 0 1 , as a court order m ay be obtained to enforce them. Corporate governance is an im portant aspect o f ASX rules. The rules require a c o m p a n y to state w hether it has an audit com m ittee a n d , if it does not, to explain w h y not. In a d d itio n , com panies a re required to state, in their annual reports, the main co rp o ra te gove rn a n ce practices they had in p la ce during the reporting p e riod. To assist com panies, an indicative list o f co rp o ra te governance recom m endations are not in the ASX Listing Rules themselves - they are published by the ASX-convened C o rp o ra te G o ve rn a n ce C o u n cil, w h ich brings together various business shareholder
CHAPTER 6 Financial reporting principles, accounting standards and auditing
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and industry groups. U nder the ASX Listing Rules, ASX-listed entities are required to benchm ark their co rporate govern a n ce practices aga in st the C o u n cil's recom m endations a n d , w h e re they d o not conform , to disclose that fact and the reasons w h y (see Exhibit 6 . 1). EXHIBIT 6.1
THE ESSENTIAL CORPORATE GOVERNANCE PRINCIPLES
1
Lay solid foundations for management and oversight: A listed entity should establish and disclose the respective
2
Structure the board to add value: A listed entity should have a board of an appropriate size, composition, skills and
3
Act ethically and responsibly: A listed entity should act ethically and responsibly.
4
Safeguard integrity in corporate reporting: A listed entity should have formal and rigorous processes that
5
M ake timely and balanced disclosure: A listed entity should make timely and balanced disclosure of all matters
roles and responsibilities of its board and management and how their performance is monitored and evaluated. commitment to enable it to discharge its duties effectively.
independently verify and safeguard the integrity of its corporate reporting. concerning it that a reasonable person would expect to have a material effect on the price or value of its securities. 6
Respect the rights of security holders: 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.
7
Recognise and manage risk: A listed entity should establish a sound risk management framework and periodically review the effectiveness of that framework.
8
Remunerate fairly and responsibly: A listed entity should pay director remuneration sufficient to attract and retain high quality directors and design its executive remuneration to attract, retain and motivate high quality senior executives and to align their interests with the creation of value for security holders. Source: ASX C o rp o ra te G o vernance C ouncil,
C o rp o ra te G o v e rn a n c e P rincip le s a n d R eco m m e n da tio ns,
3rd Edition, ASX, Sydney, 2 0 1 4 , p. 3.
6.6
International financial reporting standards
Interna tio na l accounting standards As in business a n d econom ics generally, international issues have com e to the fore in fin a n cia l acco u n tin g . The grow th in com panies accessing d e b t a nd equity c a p ita l outside their national borders has substantially increased the need for a single set o f high-quality, understandable, enfo rce a b le an d g lo b a lly acce p te d accounting standards. In 1 9 7 3 , the International A ccounting Standards B oard w a s established to d e ve lo p a single set o f international accounting standards. The benefit o f establishing a single set o f g lo b a l accounting standards w a s that it enables c a p ita l providers to assess a nd c o m p a re intercom pany perform ance in a much m ore m eaningful, effective and efficient w a y than w a s possible w hen hundreds o f countries set their o w n accounting standards. These international fin a n cia l reporting standards (referred to as IFRSs) a re now , a lo n g w ith US G A AP , on e o f the tw o g lo b a lly recognised fin a n cia l reporting standards. W h ile the a d o p tio n of IFRSs in most m ajor c a p ita l markets except the United States represents a co nsiderable achievem ent for the IASB, there is still uncertainty a b o u t the a d o p tio n o f IFRSs by the USA. Since 2 0 0 1 , the IASB and the US Financial A ccounting Standards Board (FASB) have been a ctively w o rkin g tow ards convergence o f IFRSs and US G A AP . C on ve rg e n ce means that both fin a n cia l reporting fram ew orks w ill be a like so that international trade, stock markets, transfers o f funds a n d other international business could be assisted, or at least not im peded. Both boards have also a c kn o w le d g e d their com m itm ent to d e ve lo p in g high-quality, c o m p a tib le accounting standards that can be used for both dom estic a n d cross-border fin a n cia l reporting. Flow ever, progress on key convergence projects has been described as m ixed a nd has been slow er than a n ticip a te d . N evertheless, w h ile the US Securities an d Exchange Com m ission (SEC) continues to propose potential mechanisms that, if met, could lead to the use o f IFRSs in the US c a p ita l market, m any prom inent accountants suggest that it could be m any m ore years before fin a n cia l accounting standard-setting boards ach ie ve their g o a l o f a single g lo b a l set o f accounting standards.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6.7
The annual report and financial statem ents
Financial reporting is im portant for m any organisations. All incorporated com panies, a nd most other legally constituted organisations, are required to prepare a set o f fin a n cia l statements, at least annually, that explains their financial perform ance a nd position. Listed com panies, w h ich are those w h o se shares a re traded on a stock exchange, issue half-yearly fin a n cia l inform ation. M o s t sole traders an d partnerships also prepare annual financial statements, a t their bankers' request o r for inclusion w ith the proprietor's or partners' incom e tax returns, even if there are no other reasons for d o in g so. A ccounting standards require a com plete set o f fin a n cia l statements, w ith five com ponents: •
a statement o f fin a n cia l position at the end o f the period (com m only referred to as a b a la n ce sheet)
•
a statement o f p rofit or loss a nd other com prehensive incom e for the period (com m only referred to as an incom e statement)
•
a statement o f changes in equity for the period
•
a statement o f cash flow s for the period
•
notes to the fin a n cia l statements, com prising a summary of significant accounting policies a nd other explanatory inform ation. N o te that accounting standards n o w use the term 'a statement o f profit a nd loss an d other com prehensive incom e
for the p e rio d ', but state that other titles can be used. For exam ple, 'in co m e statement' an d 'statement of com prehensive incom e' a re com m only used b y m any com panies. B alance sheets have been discussed in e arlier chapters. The profit a nd loss com ponent o f the incom e statement w a s discussed in e arlier chapters, a nd other com prehensive incom e w ill be discussed in C h a p te r 1 3. The statement o f cash flow s w a s introduced in C h a p te r 1. Recall that the statement o f cash flow s depicts cash inflow s a n d cash outflow s under three categories: o p e ra tin g , investing a nd fin a n cin g . These categories w ill be covered in m ore detail in C h a p te r 14. The statement o f changes in equity reports changes in equity d ue to profit or loss, other com prehensive incom e (which w ill be referred to in C h a p te r 1 3) a n d transactions w ith ow ners related to the issue o f shares and dividends. Finally, notes to the fin a n cia l statements pro vid e a d d itio n a l detail on the items in the fin a n cia l statements. N o te 1 to the fin a n cia l report describes the entity's accounting policies (such as dep re cia tio n methods, w h a t is included in the costs o f assets, a nd h o w provisions for e m ployee entitlements are calculated). Subsequent notes provide m ore details on specific items in the fin a n cia l statements; for exam ple, there w ill be a note on revenues, expenses, receivables, inventory a nd PPE, a nd for each there w ill be a b re akdow n o f the content shown on the fa ce o f the incom e statement a nd the b a la n ce sheet. Public com panies an d other organisations include their set o f fin a n cia l statements in a much larger annual report. This report usually contains: 1
summary d a ta on the co m p a n y's perform ance for the ye a r - usually in a g ra p h ica l o r other easy-to-read form and com parisons g o in g b a ck five o r m ore years
2 a letter to the com pany's shareholders from the chairperson o f the board of directors; it often includes highlights of the perform ance fo r the ye a r a nd plans for the future 3
an often-extensive chief executive officer's report, including a description o f the e conom ic, fin a n cia l an d other factors behind the com pany's business, usually broken d o w n by its main products o r departm ents
4
for listed com panies, a co rp o ra te governance statement, w h ich is required under ASX regulations; this w o u ld include such items as the com position an d m em bership o f the bo a rd o f directors, the remuneration p o licy for directors, the a v a ila b ility o f independent professional a d v ice to directors, the com position o f the a u d it committee, procedures for identifying a nd m a naging business risks, a n d a statement o f ethical standards
5
the set o f fin a n cia l statements, co ntaining the statement o f fin a n cia l position (the b a la n ce sheet), the statement of profit and loss an d other com prehensive incom e (the incom e statement), the statement o f changes in equity, the statement o f cash flow s a nd notes to the accounts
CHAPTER 6 Financial reporting principles, accounting standards and auditing
6
253
a directors' statement, required by the C o rp o ra tio ns A c t 2 0 0 1 , w h ich includes a statement b y the directors that they have been given a w ritten a nd signed decla ra tio n by the C E O (or m a n a g in g director) a nd the chief financial o ffice r (CFO) that the fin a n cia l records o f the listed entity for the fin a n cia l ye a r have been properly m aintained in a cco rd a n ce w ith the C o rp o ra tio ns A c t 2 0 0 1 , that the fin a n cia l statements a n d notes to the accounts co m p ly w ith the accounting standards, that the fin a n cia l statements an d notes to the accounts present a true an d fa ir v ie w , and a n y other matter prescribed by regulations; the directors also pro vid e an o p in io n on w hether the c o m p a n y can p a y its debts as a nd w hen they fall due
7
An independent audit report: the auditor's report on the truth an d fairness o f the set o f fin a n cia l statements; the contents o f the statements a nd their notes a re the responsibility o f m anagem ent, a nd the auditor's report consists of the auditor's o p in io n a b o u t those statements an d notes (you should be sceptical o f fin a n cia l statements that have not been a u dited o r those w h o se a u d it report is not attached); the auditor's report is discussed in section 6 .8
8 a directors' report, w h ich includes such items as the names of the directors, the prin cipa l activities of the com pany, the op e ra tin g results, significant changes in the state o f affairs o f the co m p a n y, certain inform ation on directors, a report on dire cto r a nd executive rem uneration, a decla ra tio n by the directors that they have received a declaration b y the C E O /C F O a b o u t the entity's fin a n cia l records a nd fin a n cia l statements, an d inform ation a b o u t the entity's operations, fin a n cia l position an d business strategies a nd prospects for future fin a n cia l years 9
for listed com panies, inform ation on substantial shareholders, the distribution o f ow n e rsh ip o f shares, the 2 0 largest shareholders an d the voting rights o f shareholders
10 sustainability reporting: reports on sustainability perform ance including environm ental factors (e.g. e nergy usage, ca rbon emissions an d w a te r usage), safety (products an d workers), com m unity (contributions an d effect), labour policies etc.; sometimes there w ill be separate reports an d sometimes they w ill be included in the annual report, or sometimes in both (in C h a p te r 1 7 w e discuss sustainability in m ore detail). 11 other voluntary inform ation: -
graphs a nd other pictorial supplements
-
details a b o u t such matters as products, business policies a nd business objectives
-
lists o f senior m anagers a nd various policies, including training an d safety, a nd human resource m anagem ent.
If you have not seen an annual report, you m ight find it interesting to brow se through one. M o s t public com panies have their most recent annual reports (as w e ll as some m ore current fin a n cia l inform ation) on their w ebsite. In the a p p e n d ix o f this book, the 2 0 1 4 fin a n cia l statements a nd notes o f W o o lw o rth s Limited can be found, plus the auditor's report an d the directors' d eclaration.
Full versus concise financial reports T raditionally, in A ustralia, all o f the a b o v e inform ation w a s co ntained in on e set o f fin a n cia l statements. The C orp o ra tio ns A c t 2 0 0 1 n o w requires the publication o f both full general purpose financial reports (GPFR) and concise fin a n cia l reports. The full set o f fin a n cia l statements contains a b a la n ce sheet, an incom e statement, a statement o f c h a n g e in equity and a statement o f cash flow s. In a d d itio n , it contains all o f the notes to the fin a n cia l statements, the auditor's report and the directors' d e cla ra tio n . It m ay also contain various other pieces of inform ation the c o m p a n y decides to include. Shareholders can elect to receive this report. The concise fin a n cia l statements are sent to all shareholders, w ith a statement that the report is a concise report and that the GPFR w ill be sent to the shareholder if requested. The content o f the concise report is d ra w n up in a cco rd a n ce w ith the relevant accounting standards, an d all disclosures must be derived from the GPFR. W h ile there are minimum content requirements, there is scope for a d d itio n a l content, w h ich w ill va ry w ith regard to the particular circumstances o f the organisation a nd the expected needs o f the users. The concise fin a n cia l statements include a b a la n ce sheet, an incom e statement, a statement o f ch a n g e in equity and a statement o f cash flow s, as these must be presented, as in GPFR. In a d d itio n , there must be a discussion and analysis of these fin a n cia l statements to assist the user's understanding.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Examples o f the discussion a nd analysis include: Statement
Examples of discussion and analysis
Income statement
•
T rends in re v e n u e
•
The e ffe c ts o f s ig n ific a n t e c o n o m ic eve n ts, o r o th e r eve n ts, o n th e o p e ra tio n s o f th e e n tity
Balance sheet
Statement of changes in equity
Statement of cash flows
•
The m a in in flu e n c e s o n th e c o s t o f o p e ra tio n s
•
M e a s u re s o f f in a n c ia l p e rfo rm a n c e
•
C h a n g e s in th e c o m p o s itio n o f assets
•
S ig n ific a n t m o v e m e n ts in a c c o u n t b a la n c e s
•
The re la tio n s h ip b e tw e e n d e b t a n d e q u ity
•
C h a n g e s in th e c o m p o s itio n o f s h a re c a p ita l d u e to s h a re b u y b a c k s , s h a re d iv id e n d s a n d s h a re issu a n ce s
•
T re n d s in d iv id e n d s p a id to e q u ity h o ld e rs
•
The e ffe c ts o f c h a n g e s in a c c o u n tin g p o lic ie s
•
S ig n ific a n t c h a n g e s in re ta in e d p ro fits
•
C h a n g e s in c a s h flo w s fro m o p e ra tio n s
•
F in a n c in g o f c a p ita l e x p e n d itu r e p ro g r a m s
•
S e rv ic in g a n d re p a y m e n t o f b o r r o w in g
In a d d itio n , there w ill be a variety o f other disclosures, including segm ent inform ation (separate disclosures o f revenues, profits an d assets for the main segm ent o f the business).
6.8
The external auditor's report2
Several references to auditors w e re m ade a b o ve . The auditor's report is norm ally a routine statement b y the auditors that provides an o p in io n on w hether the fin a n cia l statements present a true a nd fa ir v ie w an d a re in a cco rd a n ce w ith accounting standards. H ow ever, if it is not routine, the auditors are trying to tell the users som ething they think is im portant. The auditor's report m ay be q u a lifie d in some w a y , in d ica tin g that the auditors have some concern a bout the statements. In extreme cases, the report m ay even 'd e n y ' the fairness o f the statements, saying that the auditors have some very serious objections. This is c a lle d an adverse o p in io n . W e discuss the various types o f a u d it reports b elow . W h ile you have p ro b a b ly heard o f the term 'a u d it', it w ill help to be a w a re o f the b ro a d e r term of 'assurance'. Assurance is an expression o f a conclusion on particular subject matter o r inform ation (e.g. fin a n cia l statements or levels o f greenhouse gas emissions) that is intended to increase the co n fid e n ce o f the users of that inform ation. Figure 6 .2 illustrates different levels o f assurance. As you can see, an a u d it of fin a n cia l statements is a reasonable assurance engagem ent. The a u d ito r provides an o p in io n on w hether the fin a n cia l statements p ro vid e a true a nd fair v ie w and w hether they are in a cco rd a n ce w ith accounting standards. The fact that an a u d it provides a reasonable level o f assurance rather than absolute assurance means that the a u d ito r is not guaranteeing the fin a n cia l statements are correct. This is the case because, as you have a lre a d y discovered, there are numerous estimates a nd judgements in the financial reports, an d some accounting numbers are contingent on future events (e.g. w hether inventory can be sold, and w hether accounts receivable can be collected). In a d d itio n , it is im practical for an a u d ito r to test every transaction. For exam ple, consider h o w m any transactions per ye a r com panies like W o o lw o rth s a nd the C om m onw ealth Bank w o u ld have. So external a u d itin g refers to the evaluation o f an o rg a nisation's fin a n cia l statements by an a u d ito r w h o should be independent o f the m anagem ent o f the o rganisation. The role o f the external a u d ito r has tw o fundam ental parts: •
to have an independent, unbiased a nd professional perspective
•
to render a com petent o p in io n on w hether the fin a n cia l statements present a true a nd fa ir vie w .
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More Absolute assurance - for example, a guarantee
Reasonable assurance - for example, an audit of financial statements Assurance obtained Limited assurance - for example, a review of financial statements
No assurance - for example, preparing financial statements on behalf of management (technically called a compilation engagement) Less Source: C PA Australia,
FIGURE 6.2
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Levels of assurance
Let's begin w ith independence. M a n a g e m e n t prepares the fin a n cia l statements a nd the a u d ito r provides an o pinio n on those fin a n cia l statements. The a u d ito r needs to be independent from m anagem ent. Auditors a re members o f professional associations, such as C P A A ustralia o r C hartered A ccountants A ustralia an d N e w Z e a la n d . O verseas equivalents include the Am erican Institute o f C ertified Public A ccountants, the C a n a d ia n Institute of C hartered A ccountants, the Institute of C hartered A ccountants o f E ngland an d W a le s , the H ong Kong S ociety o f A ccountants, the Institute o f C hartered Accountants o f N e w Z e a la n d , the Institute o f C ertified Public A ccountants o f S in g a p ore and the M a la y s ia n Institute o f A ccountants. A fundam ental objective of these professional associations is to protect society by ensuring the professionalism and independence of the external auditors w h o belong to them. Protecting society should be consistent w ith protecting the professional reputations o f the association's members. To this end, there are com plex rules o f professional ethics that prohibit the external auditor from having a financial interest - directly and in most indirect w a ys as w e ll - in the client com panies or other organisations being audited. These rules, and sim ilar ones related to other relationships between the auditor a nd the client, are intended to ensure that the auditor has no personal interest in w hether the financial statements report one kind o f perform ance o r another. In other w ords, the auditor should be an unbiased, professionally sceptical reviewer o f the financial statements and not som eone w h o w ants the result to turn out one w a y o r another. M a in ta in in g this indepe n d e n ce is not easy, because the auditors are business entrepreneurs themselves a nd their clients p a y them for d o in g the audit. The idea is that indepe n d e n ce is m aintained because the a u d ito r is a p p o in te d by, a n d reports to, the shareholders, not m anagem ent. Since the fin a n cia l statements are reports on m anagem ent's stew ardship perform ance, the a u d ito r is presumed to be w o rkin g for the shareholders in verifying m anagem ent's reports. In practice, how ever, external auditors must have a close w o rkin g relationship w ith their client's m anagem ent personnel in o rd e r to o btain the necessary inform ation to carry out the audit. Recent legislative changes overseas a n d in A ustralia (such as the S a rb a n e s -O x le y A c t 2 0 0 2 in the United States and CLERP 9 in Australia) have strengthened the indepe n d e n ce o f a u d it firms by such requirements as (a) the rotation o f au d it partners every five years; an d (b) banning the provision of m any non-audit services (such as consulting) b y the firm carrying out the audit. In a d d itio n , the large a u d it firms have spent m illions o f dollars recently im proving quality controls over indepe n d e n ce a nd the a u d it process. The second part o f the auditor's role is to render a com petent o p in io n on the fin a n cia l statements. If you refer to an a udit report, such as that for W o o lw o rth s Limited in the a p p e n d ix of this book, you w ill see that it says the auditors have reached an o p in io n as to w hether the fin a n cia l statements have been properly d ra w n up to g ive a true a nd fa ir v ie w in a cco rd a n ce w ith the provisions o f the C orp o ra tio ns A c t 2 0 0 1 a nd a p p lic a b le accounting standards. As
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noted a bove, it is an o p in io n , not a guarantee; nor does it say that the c o m p a n y has perform ed w e ll o r b a d ly. It sim ply says that the perform ance a nd the position have been m easured a nd presented in a g e n e ra lly a c ce p te d and unbiased w a y . G iven the com plexity o f a ccounting, aud itin g a n d business in general, the auditor's o p in io n is fundam entally a professional judgem ent. The a u d ito r not o nly must be com petent, but also must w e ig h all sorts o f factors in arriving at h is /h e r o p in io n . A ud itin g firms in N orth A m erica have sponsored a gre a t de a l o f research into the professional judgem ent o f auditors. The results of much of this research have been incorporated into international practices, including those in A ustralia. The form and content o f the auditor's report changes every fe w years as auditors rethink h o w best to com m unicate w ith the users o f fin a n cia l statements. Because the auditors are form ally reporting to the shareholders o f the com pany, not to m anagem ent, the report is usually sp e cifica lly addressed to the shareholders (the owners). The usual title o f the report is 'Independent auditor's report'. T yp ically an a u d it report w o u ld : 1
identify the co m p a n y, the set o f statements a nd their d ate, a nd state that the statements are the responsibility of m anagem ent
2 state that the directors a re responsible for p re paring the fin a n cia l statements an d for the internal controls (see C h a p te r 7) o f the c o m p a n y 3
include a statement that the auditors are responsible for aud itin g the fin a n cia l statements a nd that the audit involves perform ing procedures to o btain e vidence a b o u t the am ounts an d disclosures in the fin a n cia l report; and also that the e vidence o b ta in e d is sufficient a nd a p p ro p ria te to pro vid e a basis for the a u d it o p in io n
4 5
include a statement b y the a u d ito r confirm ing that they have met the required indepe n d e n ce standards present the auditor's o p in io n that the fin a n cia l statements g ive a true a nd fa ir v ie w , a nd that they a re in a cco rd a n ce w ith the provisions o f the C o rporations A c t 2 0 0 1 a nd accounting standards. You should expect most auditors' reports to be w o rd e d pretty much the same. This is called an unm odified report.
A ny nonstandard w o rd in g is likely to be a w a rn in g to a n yo n e p lanning to use the fin a n cia l statements in d e cisio n m aking. The auditor's report contains the auditor's o p in io n on the fin a n cia l statements. The most com m on type o f audit report is an unm odified report. An unm odified auditor's report indicates that the a u d ito r believes the financial statements present a true an d fa ir v ie w an d a re in a cco rd a n ce w ith accounting standards a nd relevant legislation. M o d ifie d auditor's reports a re issued w hen the a u d ito r believes the fin a n cia l statements contain a material misstatement, o r w hen the a u d ito r is unable to o btain enough e vidence to form an o p in io n . The fo llo w in g ta b le sets out the different types o f m odified auditor's reports that m ay be issued in these situations. Type of modified audit opinion
Description
Situations w here this type of report may be issued
Examples
Qualified or 'except for' opinion
The opinion states the financial statements present a true and fair view, and are in accordance with accounting standards except for the effect of a specific matter or matters.
A qualified opinion is issued when a specific part of the financial statements contains a material misstatement or adequate evidence cannot be obtained in a specific, material area, and the rest of the financial statements are found to present a true and fair view, in accordance with accounting standards.
The auditor has a different view on the valuation of an asset from that applied by management in the financial statements, but the rest of the financial statements were found to be free of material misstatements.
A disclaimer of opinion is issued when the auditor cannot obtain adequate evidence to form an opinion on the financial statements overall.
The company's financial reporting information system is damaged and key data is lost, meaning adequate evidence is not available to support the disclosures in the financial statements.
The issues are described in a separate paragraph within the report.
Disclaimer of opinion
The auditor cannot reach an opinion overall on the financial statements and therefore disclaims any opinion on it.
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Adverse opinion
The opinion states that the auditor believes the financial statements d o n o t present a true and fair view, and are n o t in accordance with accounting standards.
Source: CPA Australia,
An adverse opinion is issued when the auditor believes misstatements are so pervasive that the financial statements do not present a true and fair view, or are not in accordance with accounting standards.
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The auditor believes that management has applied an inappropriate financial reporting framework in preparing the financial statements.
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In certain, lim ited circumstances, the a u d ito r w ill issue an unqualified o p in io n , but w ill d ra w attention to or em phasise a matter that is relevant to the users o f the a u d it report, but is not o f such a nature that it affects the audit o p in io n . For exam ple, there m ay be a m ajor uncertainty that could affect the com pany's a b ility to remain a g o in g concern, but this uncertainty is a d e q u a te ly disclosed by the com pany. It is a p a ra g ra p h norm ally after the standard o pinio n p a ra g ra p h that highlights a matter affecting the fin a n cia l report, w h ich is included in a note to the financial statements that m ore extensively discusses it. The main idea is to alert the reader to the facts in this note.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1 T h e g e n e ra l m a n a g e r o f a s m a ll c o m p a n y re c e n tly said: ‘W e n e e d t o ha ve an e x te rn a l a u d ito r f o r o u r fin a n c ia l s ta te m e n ts so w e c a n g u a ra n te e th e ir a c c u ra c y to o u r b a n k .’ W ill th a t be th e re s u lt i f an a u d ito r is a p p o in te d ?
2 A n a u d ito r c a n n o t o b ta in s u ffic ie n t e v id e n c e as to th e v a lu a tio n o f an asset. T h e re s t o f th e fin a n c ia l s ta te m e n ts are fo u n d to p re s e n t a tr u e an d fa ir v ie w in a c c o rd a n c e w ith a c c o u n tin g s ta n d a rd s . W h a t ty p e o f a u d it r e p o r t w o u ld be issu ed ? Y o u r a n sw e rs s h o u ld be:
1 A n a u d ito r d o e s n o t g u a ra n te e th e a c c u ra c y o f fin a n c ia l s ta te m e n ts b u t p ro v id e s an o p in io n o n w h e th e r th e fin a n c ia l s ta te m e n ts s h o w a tr u e an d fa ir v ie w and a re in c o m p lia n c e w ith a c c o u n tin g s ta n d a rd s .
2 A n ‘e x c e p t f o r ’ o p in io n .
6.9 The nature of a profession and professional ethics M a n y o f the p e o p le involved in fin a n cia l accounting consider themselves to be professionals. Evolving systems of standards, such as G A A P , w o rk reasonably w e ll, partly because professionals, w h o are both expert a nd ethical, are involved. Ethical behaviour comes from personal standards plus various w ritten codes o f ethical conduct. For m any p e o p le to d a y, there is a strong concern w ith being professional. There are, how ever, certain occupations that have established status as 'the professions'. In to d a y's w o rld , some groups that have this status are physicians, law yers, engineers, architects an d professional accountants. Part o f the reason these groups stand out is that entry into each o f them requires a post-secondary education, including training an d exam ination by practitioners, a nd members are bound b y a c o d e of conduct o r professional ethics. M em bers o f each professional g ro u p usually e n jo y a m o n o p o ly in their particular area o f expertise. Associations o f architects, physicians, engineers, law yers a nd other members of le g a lly recognised professions can all prevent p e o p le from c a llin g themselves members o f their particular professions an d practising in that c a p a city. Such groups have to convince the public, as represented b y governm ents, for exam ple, that they have expertise and a p p ro p ria te codes o f ethical conduct, but also that entrance to their area o f expertise should be regulated for the public g o o d .
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In A ustralia, C hartered A ccountants A ustralia an d N e w Z e a la n d (CA), C PA A ustralia (CPA) an d the Institute of Public A ccountants (IPA) are the professional accounting bodies. There are no legal requirements governing the em ploym ent o f accountants in A ustralia, although some specialist accounting functions (such as a u d itin g , taxation and liquidation) are subject to statutory requirements. H ow ever, professional designations, such as C A , C P A an d IPA, are protected by la w , a n d can o n ly be attained if you meet the various requirements specified b y the relevant accounting body. For these accountants, there a re both pow ers an d restrictions (e.g. advertising must meet certain standards of content and decorum). The rights that a particular profession enjoys com e in return for promises m ade concerning the q u a lity an d ethics o f its mem bers' w o rk. If a professional accountant has not lived up to the standards o f conduct held by the profession, he o r she can be reprim anded o r expelled by the profession a n d /o r sued in court. (Anyone can be sued, o f course, but professionals are usually held to a higher standard o f perform ance than are non-professionals.) All told, being in a profession has m any advantages (including service to society, m o n o p o ly over an area of w ork, co lle g ia l support, social prestige a nd g o o d pay), but one must rem em ber that in return there is the social responsibility o f d isch a rg in g one's duties com petently an d in a cco rd a n ce w ith the profession's c o d e o f ethics. Professional codes o f ethics involve not o nly behaving in a professional m anner (i.e. w ith integrity an d objectivity), but also m aintaining the level o f expertise required in o rd e r to perform skilfully. This involves fo llo w in g procedures that w ill, o r should, ensure that high standards o f w o rk a nd perform ance are met, an d exercising inform ed judgem ent. For members o f the professional accounting bodies there are ethical standards, including APES 1 1 0 C o d e o f Ethics for Professional A ccountants. This C o d e notes that the m ark o f the accounting profession is its a cce p ta n ce o f the responsibility to act in the public interest. The C o d e sets out five fundam ental principles, w h ich are outlined b e lo w : 1
Integrity: an o b lig a tio n on accountants to be straightforw ard a nd honest in professional an d business relationships. This includes fa ir d e a lin g an d truthfulness.
2
O b je c tiv ity: an o b lig a tio n on accountants not to com prom ise their professional o r business judgem ent because of bias, conflict o f interest o r the undue influence o f others.
3
Professional com petence a n d du e care: the p rin ciple of professional com petence a nd d ue care, w h ich imposes the fo llo w in g o b lig a tio n s on accountants: -
to m aintain professional k n o w le d g e an d skill at the level required to ensure com petent professional service to act d ilig e n tly in a cco rd a n ce w ith a p p lic a b le technical an d professional standards w hen p ro vid in g their services.
4
C onfidentiality: an o b lig a tio n to refrain from: -
disclosing confidential inform ation a cq u ire d through business relationships w ith o u t p roper an d specific author
-
using confidential inform ation a cq u ire d as a result of professional an d business relationships to their
ity from the client o r em ployer adva n ta g e .
5
Professional behaviour: an o b lig a tio n on accountants to c o m p ly w ith relevant law s a nd a v o id actions that m ay discredit the accounting profession; for exam ple, m aking d isp a ra g in g references o r unsubstantiated com parisons to the w o rk o f others. C o m p lia n c e w ith the fundam ental principles m ay be affected by various threats, including the fo llo w in g :
•
self-interest threats, such as a fin a n cia l interest in the client, undue d e p e n d e n ce on the total fees of a client, o r a loan to o r from a client
•
self-review threats, such as aud itin g systems on reports in w h o se design o r developm ent you had been involved
•
a d v o c a c y threats, such as prom oting shares in a listed c o m p a n y w hen you are also a u d ito r of that co m p a n y
•
fam iliarity threats, such as having a close o r im m ediate fam ily relationship w ith a director o r officer o f a client, o r a
•
intim idation threats, such as being threatened w ith dismissal, o r being pressured to reduce the extent o f the w o rk
long association w ith senior personnel o f an a u d it client
perform ed in o rd e r to reduce fees (ad a p te d from APES I 10 C o d e o f Ethics for Professional Accountants).
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Various safeguards to elim inate o r reduce the threats to an a cce p ta b le level a re d e ve lo p e d b y the profession, by legislation an d in the w o rk environm ent. For exam ple, accounting firms involved in a u d it w o rk have a vast range of rules related to their staff o w n in g shares, an d e la b o ra te procedures to ensure that taking on a n ew client w ill not create indepe n d e n ce problem s; for exam ple, taking on an a u d it w hen another part o f the firm has d e ve lo p e d the inform ation system as part o f a consulting role.
Ethical issues H ere are exam ples o f ethical problem s that m ay be faced by professional accountants. W h a t w o u ld you, as a mem ber o f a professional b o d y or as som eone w h o m ay rely on accounting inform ation or auditors' reports, consider to be a p p ro p ria te ethical behaviour in each case? 1
M a ry w orks for a Big 4 accounting firm, an d is part o f the team d o in g the external a u d it o f W e s tw a rd Industries Ltd. Staff at W e s tw a rd a re all very friendly, a nd M a ry is offered the cha n ce to buy o ne o f the co m p a n y's highq u a lity sound systems for o n ly a b o u t half the usual price. Should she a c ce p t the d e a l?
2
A n d re w is also on the W e s tw a rd external a u d it team . H e is a mem ber o f a local foo tb a ll team . During drinks after a g am e, he hears a mem ber o f another team boast o f cheating W e s tw a rd system atically by over-billing on printing invoices. Should he tell W e s tw a rd ?
3
Lisa a n d Sean fall in love an d d e c id e to marry. Both are professional accountants: Lisa is the chief accountant of W e s tw a rd , responsible for p re paring all the com pany's fin a n cia l statements, a nd Sean is a partner of a Big 4 firm an d is in ch a rg e o f the external a u d it o f the co m p a n y. Should Sean turn the a u d it over to another partner, or perhaps even ask the accounting firm to resign as a u d ito r (because as a partner, he shares in the firm 's profits from all audits)?
4
M ic h e lle is another mem ber o f the W e s tw a rd external a u d it team . During some a u d it tests, she discovers that W e s tw a rd e n g a g e d in some business activities that a p p e a r to be ille g a l. Breaking that particular la w can bring large fines an d even jail terms. Should M ic h e lle g o to the p o lice?
5
Erin w orks for the same Big 4 firm. During the a u d it o f Basic Electronics Ltd, she discovers that an e m ployee of Basic is o vercharging W e s tw a rd by a p p ly in g too high a mark-up to services contracted w ith W e s tw a rd . Documents in d ica te that Basic's m anagem ent is a w a re o f this a nd is h a p p y to be getting a w a y w ith it, because it has a m aterial effect on Basic's profit. Should she tell the m anagem ent of Basic that she knows w h a t they are d o in g ? Should she tell Sean, the partner responsible for the W e s tw a rd a u d it? Should she tell W e s tw a rd ?
6 G e o rg e is a partner o f the sam e Big 4 firm. For years, his father has o w n e d a fe w shares o f W e s tw a rd , am ong a w h o le portfolio o f shares o f m any com panies. His father has just d ie d an d w ille d all the shares to G e o rg e . Should he sell the W e s tw a rd shares? O n e of the m ore interesting an d c h a lle n g in g aspects o f being a professional is d e a lin g w ith such ethical issues. Some o f these exam ples d o not have cle a r answers, but here are some ideas: 1
External auditors a re supposed to be independent scrutineers o f their clients' fin a n cia l affairs. M a ry should p ro b a b ly not a c ce p t the d e a l, unless it is a v a ila b le to a n yo n e w h o turns up at a retail store, because a c ce p tin g it w o u ld underm ine her independence. Being frie n d ly w ith clients is fine, but auditors also have to m aintain some distance from clients to protect their indepe n d e n ce an d integrity.
2
A n d re w should tell W e s tw a rd w h a t he heard a nd suggest that they look into their printing costs. W h e n d o in g their w o rk , auditors a cq u ire a g re a t deal o f confidential inform ation a b o u t their clients a nd must be very careful a b o u t h o w they use it. In this case, the inform ation w a s not a cq u ire d under circumstances o f confidentiality. A n d re w m ay find himself in court over the issue, how ever, so he m ay need to seek legal a d v ice before speaking to W e s tw a rd .
3
Sean needs to take some action to remove himself from the jo b o f aud itin g his w ife 's w o rk - to protect both her an d his integrity. The firm alm ost certainly has rules a b o u t such relationships. It is likely that these involve transferring the jo b to another partner a nd keeping Sean entirely ignorant o f the w o rk on the W e s tw a rd audit. The firm m ight have to resign the audit.
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M ic h e lle 's situation is very com plex. There is a mixture o f inform ation that w a s a cq u ire d c o n fid e n tia lly an d a duty to society. M u ch m ore has to be know n before a n y a d v ice could be offered to M ic h e lle . A t the very least, M ic h e lle and the firm w o u ld have to ge t legal a d vice im m ediately. The boards o f directors o f most large com panies have a u d it committees to g ive the auditors a w a y to bring criticisms o f m anagem ent to the board's attention. M ic h e lle 's firm w o u ld likely raise this w ith W e s tw a rd 's a u d it committee.
5
Erin's is another very com plex situation. Erin is responsible fo r protecting the c o n fid e n tia lity o f her client, Basic, and w o u ld get in trouble if she told another c o m p a n y w h a t she had learned on the audit. H ow ever, her firm is also responsible to both clients. A g a in , she an d the firm w o u ld need im m ediate legal ad vice .
6 M o s t firms have rules p ro hibiting members o f the firm from having an interest in a n y clients a u dited by the firm. G e o rg e w o u ld have to sell his shares in W e s tw a rd im m ediately.
6.10
Capital markets
Share m arkets and o th e r m arkets tor financial capital As business corporations d e ve lo p e d , o w n e rsh ip rights in them w e re sold m ore a n d m ore bro a d ly. The ow ners (shareholders) began to invest in several businesses at o n ce a n d to buy a n d sell their shares from a n d to each other. To facilitate the buying a nd selling (trading) o f shares am ong investors, share markets - organised as stock exchanges - deve lo p e d . T o d a y there are m any such exchanges, including the m ajor international ones in N e w York, London, Tokyo, Paris a nd Toronto. The A ustralian Securities Exchange (ASX) is also a large equities market, a nd the largest in the Southern Hem isphere. Brokers, investment banks, market analysts an d others conduct, assist in and advise on trading. Trading goes on in m ore than just the shares o f co m p a n ie s. For e xa m p le , there is a lso the tra d in g o f rights (using terms such as 'w a rra n t' o r 'o p tio n s') to buy o r sell shares in the future, to convert from o n e kind o f share to another, to receive d ivid e n d s a n d to perform a w id e va rie ty o f other future a ctions. N e w rights, a n d fin a n cia l instruments to co n ve y such rights, a re b e in g invented a n d tra d e d all the tim e. S pecial markets have been d e v e lo p e d fo r som e o f these, such as an o ptions e xch a n g e in C h ic a g o , but m any are tra d e d on regular stock exchanges, inclu d in g the ASX. C o rp o ra te a n d governm ent bonds a re also tra d e d , a n d there is such a va rie ty of fin a n cia l instruments that the distinction betw een o w n e rs h ip shares, cre d ito rsh ip bonds a n d other rights a nd instruments is often blurred. For e xa m p le , som e bonds ca rry the right to be converted into shares a t the o p tio n of the holder. M a n y exchanges an d over-the-counter markets use com puterised trading systems for the listed com panies w hose shares and other securities (the usual general nam e for all these shares, bonds an d other fin a n cia l instruments) are traded on the exchanges an d other markets. Furthermore, it is becom ing increasingly com m on for investors to buy or sell securities anyw h e re in the w o rld 2 4 hours a d a y. Taken together, all these exchanges, markets a nd buying and selling activities are usually c a lle d c a p ita l markets. They include both share trading an d trading o f all the other securities that corporations an d governm ents use to fin a n ce their assets. It is im portant to em phasise that these markets ope ra te quite separately from the organisations that initially issue the securities. For exam ple: •
W h e n a c o m p a n y decides to issue some shares, these securities a re offered to the market(s), a nd the c o m p a n y receives the proceeds o f the initial sale o f them (less commissions to brokers a nd others involved). A fter that, how ever, the c o m p a n y ceases to be a direct particip a n t. Investors buy the securities from each other a nd sell them to each other w ith no particip a tio n from the com p a n y.
•
Investors m ay even a ct in the fa ce o f o p p o sitio n from the com pany; for exam ple, an investor m ay try to get enough shares together to ge t voting control o f the c o m p a n y (a takeover). There is a lw a ys a risk fo r public com panies (com panies w h o se shares members o f the public are a b le to buy o r sell from each other w ithout permission o f the com panies) that the markets w ill behave in w a ys com panies d o not like.
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The c o m p a n y m ay announce a n ew m anagem ent team that it expects w ill im prove the com pany's perform ance, but its share price m ay fall because the p e o p le buying an d selling the shares d o not like the n e w team , a nd more p e o p le w a n t to sell their shares than w a n t to buy them, producing a fall in the share price.
•
The markets often create new securities out of the ones the co m p a n y initially issued, then trade those. For exam ple, a share m ay carry the right to buy another share in the future. That right m ay be bought an d sold separately on the market, so that you could ow n the share w ithout any such right, o r the right w ithout any such share. To prepare you for fin a n cia l accounting analysis, five particular aspects o f c a p ita l markets are outlined in this
section. These are: •
the w a y securities are traded an d security prices are established
•
the role o f inform ation (such as accounting reports) in such a market
•
the idea o f a 'risky return'
•
the fact that markets are 'a g g re g a te s'
•
the co n ce p t of 'm arket inform ational e fficiency'. These aspects, a m ong m any others, are d e a lt w ith in capital m arket theory. This theory is very down-to-earth,
and incorporates much p ractical kn o w le d g e o f h o w markets w o rk. It has been a pow erful impetus to econom ics, finance a nd accounting research, a nd to changes in the w a y c a p ita l markets are o perated.
Security trading and security prices C a p ita l markets w o rk in the sam e w a y as a n y market. People trade (buy a n d sell) w h a t they o w n for som ething else, usually m oney o r a prom ise o f it. •
There a re p e o p le w h o o w n securities, such as shares in BHP Billiton. Som e o f these a re w illin g to sell their shares, if the price is right. If no one w a s w illin g to sell at a n y price, there w o u ld be no trading!
•
There are p e o p le w h o d o n 't o w n a n y securities, but w h o are w illin g to buy them, if the price is right. If no one w a s w illin g to buy at a n y price, there w o u ld be no tra d in g ! Let's call the first g ro u p the sellers a nd the second g ro u p the buyers. Suppose w e had the fo llo w in g list o f possible prices of BHP shares: Price
Sellers' willingness to sell
Buyers' willingness to buy
$19
Everyone would sell
No one would buy
$18
Most would sell
A few would buy
$17
Half would sell
Half would buy
$16
Some would sell
Most would buy
$15
None would sell
All would buy
Y ou'll recognise from this hypothetical list o f prices that w e have a supply curve an d a de m a n d curve. C a p ita l market prices a re set by the interaction betw een those w a n tin g to sell an d those w a n tin g to buy. A t a price o f $ l 9, there w o u ld be lots o f shares for sale but no buyers; at a price o f $ 1 5 , there w o u ld be lots o f buyers but no sellers. Each d a y's market price fo r the shares is set by the b a la n ce betw een p e o p le w illin g to buy an d p e o p le w illin g to sell: •
If there a re m ore sellers than buyers, the price w ill fall, roughly d o w n to the level at w h ich there is an equal num ber o f buyers an d sellers (or at least, shares d e m a n d e d an d shares for sale).
•
If there a re m ore buyers than sellers, the price w ill rise, roughly up to the level at w h ich there is an equal num ber of sellers an d buyers (or shares for sale a nd shares dem anded). In the a b o ve exam ple, w e w o u ld expect the buyers a n d sellers to a g re e to trade (buy a nd sell) a t a price of
around $ 1 7 . So if w e looked up BHP Billiton's shares in the new spaper's listing o f ASX prices, w e w o u ld expect to see to d a y's price to be a b o u t $ 17 . But the d a ily price is set by the pressures o f supply an d de m a n d , so it w ill vary, d e p e n d in g on h o w m any buyers an d sellers make offers to buy o r sell. Therefore, it w ill va ry around $ 1 7 as those pressures vary.
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Role o f in fo rm a tio n in a capital m arket W h y w o u ld the pressures o f supply a nd dem and vary? B roadly speaking, there are three kinds o f reasons that are of interest in accounting analysis: •
N o inform ation-based tra d in g : The circumstances o f some buyers a nd sellers m ay require them to sell, o r even buy, alm ost regardless o f anything to d o w ith the particular c o m p a n y w h o se shares a re being traded. An o w n e r o f some shares m ay d ie a n d the estate m ay have to sell the shares in ord e r to distribute the m oney to the beneficiaries o f the o w n e r's w ill, o r an institutional investor, such as a superannuation fund, m ay need some cash to p a y superannuation o r other payments. A person m ay w in a lottery a nd buy shares in a m a naged fund (an investment consisting o f a sam ple o f shares of m any com panies), so that the mutual fund in turn has to buy some shares. Therefore, some trading is likely to be occurring continuously for reasons relating to raising o r spending a v a ila b le cash. Such trading is referred to as liq u id ity trading.
•
G e n e ra l inform ation-based tra d in g : C o m p a n ie s w h o se shares are traded a re part o f a general e conom ic system, and some general events m ay m odify people's view s on the w isd o m of investing in anything. As a result, this m ay cause changes in all o r most shares traded on an exchange. The share price o f com panies such as BHP Billiton m ay therefore ch a n g e, a lo n g w ith the rest. Examples o f such general events a re changes in national interest rates, announcem ents o f trends such as inflation o r consum er con fid e n ce , w ars, illness o r the death o f im portant people, and elections that ch a n g e the party in po w e r. If the Australian G overnm ent announced a n e w special tax on c o m p a n y profits, w e m ight expect pretty w e ll every com pany's share price to fall, including BHP Billiton's, because investors w o u ld see this as hurting every com pany's future profits an d , therefore, the returns investors w o u ld get from o w n in g shares in a n y com pany. M a rk e t-w id e price changes com ing from the e co n o m ic system are often c alle d systemic effects. Som e o f the trades m ay happen because investors think some com panies w ill be hurt o r helped m ore than others, an d some investors m ay be getting out o f that market altogether b y selling their shares and buying g o ld o r real estate instead.
•
S pecific inform ation-based tra d in g : Inform ation sp e cifica lly a b o u t BHP Billiton's future prospects m ay also cause changes in the w illingness of p e o p le to buy o r sell its shares. For exam ple, if BHP Billiton announced that it w a s g o in g to buy a m ining co m p a n y, some p e o p le m ay like that idea (and, w a n tin g to buy, increase the dem and for shares) and other p e o p le m ay dislike the id e a (and, w a n tin g to sell, increase the supply of shares). If most p e o p le think that BHP Billiton buying the other c o m p a n y is a g o o d idea, the share price w ill rise; if most p e o p le think it is a bad idea, the share price w ill fall. This phenom enon, in w h ich share prices are influenced by an d reflect a person's evaluation a b o u t the im pact o r m eaning o f an event (and their desire, therefore, to hold on to o r sell their shares), is very im portant for understanding share prices an d a ccounting's inform ation role. W e can say that the share market prices the inform ation, in that the ch a n g e in the trading price o f the shares (up, d o w n , o r not at all) is a measure o f the value o f the inform ation to the market. H arking b ack to the accounting concepts, w e m ight say that in a share market sense, decision-relevant inform ation is m aterial to the market if know ing a b o u t it changes, or w o u ld chang e, a security's market price or, perhaps, w o u ld prom pt trading (buying an d selling) even if the net effect on price w e re zero. A great am ount o f analysis an d research in acco u n tin g , fin a n ce a nd econom ics uses this idea to measure the
app a re nt value o f all sorts o f c o m p a n ^s p e c ific inform ation, such as a com pany's annual announcem ent o f its net profit (earnings announcem ent), announcem ents o f changes in m anagem ent an d news a b o u t other events initiated by o r affecting the com pany. (Presuming that a ch a n g e in share market prices is a measure o f inform ation's value requires some faith in the market system as a social g o o d a n d co n fid e n ce in the market's a b ility to respond appro p ria te ly, o r efficiently, to inform ation.)
Return and risk The return you earn by o w n in g a security (a share o r bond) is the sum of: •
the cash you get (from dividends o r interest payments) plus
•
the c hange (hopefully an increase) in the market price o f the security.
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You get a cash return plus a holding g a in o r c a p ita l g a in (or loss). C a p ita l market theory develops much o f its p o w e r from analysing the nature o f these tw o kinds o f returns, particularly the second kind. If the security you o w n varies in market price, that variation is, a cco rd in g to the theory, a measure o f the risk from o w n in g the security, since prices could g o up o r d o w n . Risk is calculated as the v a ria n ce o r standard deviation o f the prices around the a v e rage price - o r trend in a v e ra g e price - of that security. A risky security, therefore, is on e w h o se price varies all over the place. As described a b o ve , a security's price m ay v a ry because the w h o le share market o r bond m arket is g o in g up o r d o w n , o r because of inform ation that is specific to that security o r to the c o m p a n y issuing the security. So, a nalytica lly, the risk is separated into: • •
system atic risk: the portion o f the security's variation that relates to o r correlates w ith variation in the overall market unsystematic risk: the security's o w n residual variation not related to the market. Beta (a term com ing from the m athem atical model used to relate a firm 's returns to those o f the market overall) is a measure o f the security's relationship to overall market variations. Securities can be classified a cco rd in g to this relationship: a lo w beta security's prices va ry less than overall market prices d o , w h ile a high beta security's prices va ry m ore than the market does. Risk can be controlled to some extent b y holding a variety o f securities w ith different betas. M o re w ill be said
a bou t this in the section on agg re g ate s b e lo w . A natural question at this point m ight be: 'D oes accounting inform ation (especially profit o r cash flow ) help to predict security prices an d , therefore, risks an d returns?' M a rk e t prices a re pretty hard to predict, full stop. Therefore, accounting inform ation isn't much help, but neither is anything else. H ow ever, accounting inform ation can be helpful indirectly. W h e n im portant events that d o affect security prices are also represented in the accounting inform ation (perhaps later on, since accounting reports com e out o n ly quarterly o r annually), the accounting inform ation w ill indirectly be predictive, too. It depends on h o w w e ll accounting represents the o rig in a l event: it seems that if phenom ena reported in the accounting inform ation have a cle a r econom ic m eaning (such as w hen they represent an im pact on cash o r risk), they d o have some increm ental predictive value. A fter the fact, how ever, it is cle a r that accounting inform ation (especially profit) does correlate highly w ith market prices. The longer the a c c o u n tin g -p ric e relationship is measured, o rd in a rily the better it is: accounting profit, for exam ple, usually correlates better w ith share prices over several years than over a fe w months. A ccounting does relate to w h a te ve r affects markets, though c a llin g the shots in a d va n ce is hardl
A ggregates Security markets involve a g g re g a te behaviour. C a p ita l market theory proposes that a sensible investor w ill invest in a g ro u p of securities termed a po rtfo lio . By choosing a g ro u p w ith various in dividual betas (risk measured by variation in returns), the investor can assem ble a portfolio w ith w h a te ve r overall risk the investor w ishes. G e nerally, a portfolio is less risky than a n y individual security because, by a d d in g together a g ro u p o f securities w ith different unsystematic risks, the unique variations in each p a rtia lly cancel each other out. W h e n the price of on e goes up, another price m ay g o d o w n . Thus, a portfolio is a w a y of diversifying a w a y the unsystematic risk. Portfolio thinking has becom e pervasive in the investment com m unity. M o s t research on the im pact o f accounting inform ation assumes that investors have portfolios o f securities, a nd com panies accounting fo r their o w n investments (such as m arketable securities a nd superannuation funds) increasingly make the sam e assumption.
M arket in fo rm a tio n a l efficiency Efficiency o f inform ation use means that markets respond so q uickly a nd sm oothly to inform ation that o n ce the inform ation becom es public, its effects a re im m ediately reflected in prices through the trading o f securities. People w h o think the inform ation implies that they should buy, d o so, from p e o p le w h o think that they should sell. This fast response means that if the market is efficient, you c a n 't use p u b licly a v a ila b le inform ation (such as public fin a n cial statements everyone can read) to 'b e a t' the market; by the tim e you have the inform ation an d can act, the market w ill a lre a d y have reacted to the inform ation a nd p roduced a n ew trading price that reflects that inform ation. You, as an individual trader, d o n 't have the p o w e r to d o much a b o u t the price that the overall sum o f buys a nd sells has
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produced, so, unless you can trade on your inform ation before a n yone else knows it, you w ill find that the price a lre a d y reflects the value o f the inform ation. If everyone gets an accounting report at the same time, p ro b a b ly only those traders nim ble enough to act im m ediately w ill be a b le to take a d va n ta g e o f a n y news in the report. (M ore comments on w hether accounting reports a re likely to be news a re m ade below .) C a p ita l markets ope ra te on inform ation, but they d o so in light o f expectations a lre a d y form ed, in a c co rd a n ce w ith w h a t w a s a lre a d y know n. Therefore, the markets tend to respond to n ew inform ation o n ly if it is unexpected. The argum ent can be m ade that for an efficient capital m arket, o n ly the unexpected portion o f earnings (or o f a n y other such item o r announcem ent) is inform ation to the market. The market w ill not respond much to fin a n cia l results that are exactly as everyone expected. There a lw a ys is some response, though, because various market traders have different expectations and beliefs - these differences make the markets w ork! Research indicates that some markets (such as the N e w York Stock Exchange) are quite efficient w ith respect to publicly a v a ila b le inform ation, but exceptions have been found. The research is by no means conclusive, a n d the behaviour of m any markets is not w e ll understood (the Australian Securities Exchange, for exam ple, has been studied much less than the N e w Y ork Stock Exchange). Because inform ational e fficie n cy is a difficult phenom enon to dem onstrate conclusively, it is often called a hypothesis a b o u t h o w markets w o rk: the efficient m arket hypothesis. Securities commissions, such as the US Securities a n d Exchange Com m ission a n d the Australian Securities and Investments C om m ission, are responsible for ensuring that securities trading is as fa ir as possible. O n e problem securities commissions w o rry a b o u t is so-called asym m etric inform ation. Some market traders know m ore than others d o about a security a n d , therefore, could potentially take a d va n ta g e o f the m ore ignorant traders. If you kn o w that bad things are a h e a d , you sell to p e o p le w h o d o n 't know that the price w ill fall w hen everyone learns a b o u t the bad things, o r if you kn o w that g o o d things are a h e a d , you buy from p e o p le w h o d o n 't kn o w their shares are w orth m ore than they think. A m ajor role of fin a n cia l accounting is to reduce inform ation asymmetries b y producing inform ation that informs everyone. An exam ple o f the effects o f asym m etric inform ation is that p e o p le on the 'in sid e ' o f the c o m p a n y m ight use their private kno w le d g e to take a d va n ta g e o f other investors. Such insiders can buy or sell before other investors learn about som ething a n d , therefore, before the market can reach a n e w price based on the inform ation. If you w e re a senior executive o f a com pany, a n d you knew that to m o rro w the c o m p a n y w a s to release an unexpectedly g o o d earnings report that w o u ld cause the share price to rise, you could buy to d a y from share sellers w h o w e re ignorant of w h a t you knew. Securities com missions require that a n y significant inform ation be released q uickly an d to everyone at once, and they keep an eye on insider tra d in g , w h ich is illegal. Insider trading law s pro h ib it insider tra d in g , a n d it can result in very large fines as w e ll as jail sentences. Financial statements a re o ne o f the w a ys in w h ich com panies disclose inform ation a b o u t themselves to outsiders. Securities markets certainly p a y attention to fin a n cia l accounting inform ation, but in a w o rld in w h ich m any p e o p le buy a n d sell bonds, shares a nd options several times a d a y, half-yearly o r annual fin a n cia l statements o n ly provide part o f the picture. M u ch o f the inform ation in the fin a n cia l statements leaks out over the year, in press releases, announcem ents an d o fficia l inform ation filings w ith securities commissions o r stock exchanges. For exam ple, the audit o f a com pany's 3 0 June fin a n cia l statements m ay be com pleted in A ugust a n d the fin a n cia l statements printed and issued in N ovem b er, but throughout the prior y e a r there w ill have been announcem ents a b o u t im portant events. N o t surprisingly, accounting research shows that share price changes g e n e ra lly happen before the o fficia l earnings reports are released, a nd this is m ore likely to happen for larger firms a b o u t w h ich there tends to be m ore inform ation a v a ila b le betw een accounting reports. There is, therefore, a continual flo w o f financial-statem ent-related inform ation an d other significant inform ation from public com panies to securities markets. The general id e a is that inform ation should be released as soon as it is know n, so that general market traders a re not d isa d va n ta g e d , co m p a red w ith insiders. This helps to keep the system fa ir for all, but it should also assist the market's p ricing system to reflect inform ed evaluations o f co m p a n ie s' prospects, so that the market prices a re consistent w ith society's overall interest in the a p p ro p ria te a llo ca tio n o f econom ic resources. A cornerstone p o lic y for stock exchanges is that all persons investing in securities listed on the e xch a n g e have equal access to inform ation that m ay affect investment decisions. Investor co n fid e n ce in the integrity o f an e xchange
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requires tim ely disclosure o f m aterial inform ation concerning the com panies listed on the exchange, w ith the result that all participants in the market have equal opportunities concerning securities tra d in g . Trading on an e xch a n g e can be affected b y both m aterial inform ation a n d the existence o f rumours and speculation. In this case, an e xch a n g e m ay require an announcem ent from a c o m p a n y as to w hether such rumours and speculation are factual o r not.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
I f a p a rtic u la r c a p ita l m a rk e t is d e s c rib e d as b e in g e f fic ie n t, w h a t d o e s th a t im p ly a b o u t th e ro le and u s e fu ln e s s o f fin a n c ia l a c c o u n tin g in fo rm a tio n in th a t m a rk e t?
2
W h y is tim e ly d is c lo s u re o f fin a n c ia l a c c o u n tin g in fo r m a tio n an d o t h e r in fo r m a tio n im p o r ta n t to c a p ita l m a rk e ts ? Y o u r a n sw e rs s h o u ld be:
1
I f a p a rtic u la r m a rk e t is d e s c rib e d as b e in g e ffic ie n t, it im p lie s th a t p u b lic ly a vailab le in fo rm a tio n (s u c h as p u b lic fin a n c ia l s ta te m e n ts e v e ry o n e c an re a d ) c a n n o t be used to ‘b e a t’ th e m a rk e t. B y th e tim e an in v e s to r o b ta in s th e in fo r m a tio n an d c a n a c t on it, th e m a rk e t w o u ld a lre a d y ha ve re a c te d t o th e in fo r m a tio n and in c o rp o ra te d it in to sh a re p ric e s .
2
T im e ly d is c lo s u re o f in fo r m a tio n is im p o r ta n t to c a p ita l m a rk e ts in o rd e r to e lim in a te s o m e tra d e rs g a in in g an a d v a n ta g e o v e r o th e rs b y h a v in g th e in fo rm a tio n e a rlie r.
6.11
Contracts and financial accounting inform ation
Reporting to ca p ita l markets is not all that fin a n cia l accounting is g o o d for - o r that m anagers w o rry about. Financial accounting plays m any other roles that are im portant to m anagers an d other parties. Such accounting inform ation is used in resource-allocation decisions m ade b y governm ents, in assessing incom e taxes, in negotiations w ith a nd by labour unions, an d perhaps also in enhancing o r attacking the p o litica l p o w e r o f certain groups (such as the corpo ra te sector) in society. This section has some ideas a b o u t the contractual relationships am ong p e o p le involved in a business, a nd a bout a consequent role o f accounting inform ation in h o w such contracts w o rk . There has been much research on contracts, as on c a p ita l markets. The area goes b y several other names, w ith differences that are not im portant to this discussion, including agency theory, principal-agent theory an d positive accounting theory. In a contract, p e o p le a g re e to d o things on each other's behalf a nd to be com pensated for d o in g so properly. For exam ple, m anagers, auditors, law yers o r physicians are entrusted w ith acting on behalf o f on e or more other p e ople (the ow ners, creditors, defendants o r patients). C ontracts m ay be form ally w ritten ones (such as le g a lly bin d ing indentures p roviding protection to bondholders), less-formal em ploym ent contracts o r supplier agreem ents or inform al arrangem ents such as a handshake betw een partners. The person w h o is to d o som ething a nd be com pensated is often called the agent, an d the person w h o w ants it d o n e is the p rin cip a l. M a n y contracts involve both parties d o in g things for the other, a nd in a n y case, it is usually assumed that a va lid contract requires that both parties entered into it freely, because both expect to benefit. There is a fundam ental characteristic of contracts a m ong self-interested participants: the p e o p le are unlikely to have the same interests. C o n flict of interests is not v ie w e d as being b a d , but rather as being the natural state of affairs. For exam ple, if the a g e n t is to pro vid e effort on behalf o f the p rin cipa l, it w o u ld be natural for the a g e n t to w a n t to w o rk less hard than the prin cipa l w ishes. For the agent, effort is costly a nd m ight therefore be m inim ised, w hereas the prin cipa l w o u ld w a n t the agent's effort to be m axim ised.
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In the contract setting, accounting has a m ajor role in reporting on w h a t the a g e n t d id on behalf o f the p rincipal. This is the stew ardship role of accounting inform ation (in m onitoring the past stew ardship o f the agent, such as c o m p a n y m anagers, on behalf o f the prin cipa l, such as the ow ners or shareholders), as distinct from the futureoriented, decision-m aking role o f such inform ation in c a p ita l markets. N o w the focus is on h o w the m anagers behave, rather than on h o w the ca p ita l market (consisting o f shareholders a nd potential shareholders) behaves. You can think o f the inform ation produced by fin a n cia l accounting as resulting from the w ish b y the various parties to provide incentives and controls over each other's behaviour, especially agents' behaviour. This w ish exists because agents are assumed to w a n t to act in their o w n interests, a n d , in the absence o f a p p ro p ria te incentives an d controls, their interests are assumed not necessarily to co in cid e w ith those of their principals. From this point o f v ie w , accounting inform ation is a part o f the contract, a nd should serve the m onitoring an d other needs o f the contracting parties. Principals a nd agents specify w h a t they need a nd accounting serves that, so accounting is useful, a n d not in a n y sense 'right' o r 'w ro n g '. If conditions ch a n g e betw een various parties, accounting (and auditing) w ill ch a n g e to meet the n ew conditions. Principals an d agents w ill dem and w h a te ve r inform ation they require to m anag e the contractual relationship betw een them, a nd inform ation, therefore, can be ju dged o nly in terms o f that specific relationship. Is it w h a t they need, or isn't it? H ere is an exam ple. Suppose the shareholders of Lakewood Limited w a n te d m anagem ent to w o rk hard to m axim ise the price o f Lakew ood's shares, w h ich are traded on a stock exchange. The higher the price, the better the return w ill be to the ow ners from o w n in g the shares, an d the higher their w ealth w ill be. The ow ners might, through their representatives on Lakew ood's board o f directors, propose a m anagem ent contract that specifies that the top m anagers get no salary, but instead ge t 2 0 per cent o f the ch a n g e in the com pany's share price over each year. The to p m anagers m ight w e ll reply that this is too risky for them, because all sorts o f things m ight affect share price, including things over w h ich they have no control, such as w ars, recessions o r other unexpected problem s. The share price could g o up, but it m ight as likely g o d o w n . The m anagers m ay then propose that they should be p a id a flat salary o f $ 2 0 0 0 0 0 each, regardless o f changes in share price, believing that the ow ners should take the risks. This isn't w h a t the ow ners w a n t, because they a re concerned that the m anagers w ill not be sufficiently conscientious if they are guaranteed a salary regardless o f perform ance. Therefore, the tw o parties negotiate. Finally, a contract is a g re e d upon. Suppose it says that the m anagers w ill get $ 1 5 0 0 0 0 each, plus perform ance bonuses o f 5 per cent o f the annual net incom e a nd 3 per cent of the increase in share price, w ith no penalty for negative incom e or negative ch a n g e in share price, but w ith no bonuses then either. (The ow ners, interested in m axim ising the share price, a nd the m anagers, feeling that they have m ore control over net incom e than share price, w o u ld in this case have a g reed to include both factors in the bonus calculation.) M a n a g e m e n t com pensation contracts a re often very com plex, a nd a subcom m ittee of the b o a rd o f directors m ay be created sp e cifica lly to design an d m onitor such contracts. Securities commissions increasingly require public com panies to disclose the nature of such contracts a nd the com pensation that results from them, especially for the chief executive o ffice r an d other senior m anagers. M a n a g e m e n t com pensation contracts - in w h ich p a y depends on perform ance, and w h ich p a y o ff in shares o r options to buy shares ch e a p ly, in a d d itio n to cash - have becom e very com m on in recent years. The result is that the m anagers, as agents for the ow ners (the principals), have a g re e d to w o rk for the ow ners, and the ow ners have a g re e d to e m p lo y the m anagers. Both parties have entered into the contract for their o w n reasons, and both are satisfied w ith it (or they w o u ld not have agreed). N o w the ow ners can use fin a n cia l accounting inform ation to m onitor the m anagers' perform ance a nd to calculate their bonuses based on net incom e. Both parties, because o f their contract, are interested in the accounting inform ation, an d neither w o u ld be satisfied w ithout accounting. They m ay specify in their contract that G A A P be used to calculate net incom e, for the sake of convenience or because they prefer it that w a y . They also m ay specify other w a ys o f ca lculating net incom e that they think are to their mutual a d va n ta g e . If m any com panies have these sorts o f bonus arrangem ents o r other incentive contracts in w h ich financial accounting inform ation plays a role, there can be strong pressures on the developm ent of G A A P o r o fficia l accounting standards in directions that im prove the effectiveness o f such contracts. These pressures are likely to be in sim ilar directions to those of, say, ca p ita l markets, because the ow ners a re trading their shares on such markets. They w ill not
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be exactly the same, though, because the m anagers have to a g re e to the contracts too, a nd m ay not w a n t, for exam ple, to be a r as much risk as the c a p ita l market m ight like them to. There is also a cle a r role for auditors in the smooth functioning o f contracts. If the m anagers a re responsible for the accounting inform ation an d are being p a id on the basis o f it, the ow ners (w ho are perhaps some distance from the com pany's offices a nd in a n y case w o u ld not w a n t to have to sh o w up to ask questions a b o u t accounting) m ay not be inclined to trust the m anagers' figures, an d w o u ld prefer having an outside a u d ito r evaluate them. A d d in g c re d ib ility to m anagem ent's inform ation is the oldest reason for a u d itin g , a nd still central to it. There are m any kinds o f form al a nd inform al contracts, w ith m any parties other than m anagers (such as suppliers, associated com panies, foreign business partners an d governments) that m ay use fin a n cia l accounting inform ation. The parties to such contracts w ill necessarily have an interest in the fin a n cia l statements, in G A AP , in au d itin g , a n d in the other aspects o f fin a n cia l acco u n tin g . They w ill, therefore, act as part o f the system o f inform ation dem and and use that shapes acco u n tin g . Some o f the contracts that are likely to be o f interest from a fin a n cia l accounting point of v ie w include m anagem ent com pensation contracts (as illustrated above), labour contracts, contracts w ith suppliers a n d /o r customers, an d fin a n cia l contracts, such as those d ra w n up for issuance o f bonds, other d e b t o r equity. O n e reason for w ritten contracts is the co n flict of interests mentioned earlier. For exam ple, bondholders receive a claim on the co m p a n y, o r its assets, that has a higher legal priority than the shareholders' residual claim . A contract, such as a bond indenture, is w ritten specifying the e xact rights o f the bondholders. The indenture m ight say that if the com pany's w o rkin g c a p ita l falls b e lo w a certain level, the bondholders have the right to dem and e a rly paym ent o r some other penalty. This doesn't remove the conflict o f interests, but cla rifyin g the situation makes everyone's assessments o f the com pany's perform ance a nd prospects m ore inform ed.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le t o a n s w e r based o n w h a t y o u ha ve ju s t rea d. I f y o u c a n ’t a n s w e r it, it w o u ld be b e s t to re -re a d th e m a te ria l. G re e n L im ite d has a s e t o f m a n a g e m e n t b o n u s c o n tra c ts f o r its s e n io r e x e c u tiv e s , s p e c ify in g th a t th e ir pay w ill be based p a rtly o n h o w w e ll th e c o m p a n y p e rfo rm s . B ro w n L im ite d , h o w e v e r, j u s t pays its m a n a g e rs a fla t salary. W h a t d iffe re n c e s w o u ld y o u e x p e c t in th e a ttitu d e s o f th e tw o g ro u p s o f m a n a g e rs to th e ir c o m p a n y ’s fin a n c ia l s ta te m e n ts ? Y o u r a n s w e r s h o u ld be: Y o u w o u ld e x p e c t th e m a n a g e rs o f G re e n L im ite d t o be m o re in te re s te d in th e fin a n c ia l s ta te m e n ts r e fle c tin g p o s itiv e p e rfo rm a n c e , as th e ir re m u n e ra tio n is d ir e c tly re la te d to fin a n c ia l p e rfo rm a n c e o f th e c o m p a n y . T h is m a y in c re a s e th e c h a n c e s o f th e m s e le c tin g a c c o u n tin g p o lic ie s th a t in c re a s e th e c o m p a n y ’s p r o fit (s e e C h a p te r 1 6 ) and m a y also in c re a s e th e lik e lih o o d o f fin a n c ia l s ta te m e n t fra u d .
6.12
Managers and financial accounting standards
M a n a g e rs m ay be interested in accounting standards for several reasons. O n the positive side, standards should: •
make reports on m anagers' perform ance clearer
•
make it easier to make com parisons w ith other com panies
•
reduce the costs o f accounting (each c o m p a n y w o u ld not have to w o rk through an d invent accounting methods on its ow n)
• •
increase the co m p a n y's cre d ib ility in the eyes o f im portant users w h o utilise fin a n cia l statements in general help to evaluate the conceptual a nd numerical effects o f accounting choices a nd business decisions m anagers m ay have to make.
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O n the negative side: •
Standards m ay specify general methods that d o not w o rk w e ll for, o r even mismeasure, some specific com panies o r situations.
•
N o t all m anagers m ay w ish to be measured clearly o r have their com pany's perform ance easily co m p a red w ith that o f other com panies.
• •
Som e com ple x standards m ay be quite costly to fo llo w for some com panies. N e w standards m ay cause difficulty fo r loan agreem ents, bonus plans o r other arrangem ents that d e p e n d on accounting inform ation, an d w e re a g reed to before the im plem entation o f the n ew standards. W ith reasons like these, it should be no surprise that the senior m anagem ent o f m any com panies (and o f the firms
o f auditors w h o have the com panies as clients) take accounting standards very seriously. M a n y com panies seek to influence accounting standards through lo b b yin g standard-setters, lo b b yin g securities com missions a nd other governm ent agencies, a nd d o in g their o w n studies into the effects o f proposed standards. O n e o f the main reasons that top m anagers o f public com panies p a y close attention to their com panies' fin a n cia l statements, earnings announcem ents an d other disclosures is that share markets an d other securities markets respond q uickly to inform ation, and d o so in a cco rd a n ce w ith the value o f that inform ation to the market traders. The less a c o m p a n y is in the public eye o r the less it is involved in various securities markets, the less it is disciplined by such markets. H ow ever, even private com panies are not immune to such d iscipline, because they often com pete o r coop e ra te w ith , o r are suppliers to o r customers of, m ore d irectly affected com panies, an d also because even private ow ners often w ish to sell their com panies, b o rro w heavily o r take other action that brings their perform ance inform ation under scrutiny (e.g. com m on w a ys o f calculating the value of a private business make extensive use of fin a n cia l statements, a nd the perform ance an d trends they reveal). M a n a g e rs also p a y close attention to their co m p a n ie s' fin a n cia l statement figures, because im portant contracts are based on those, e xp licitly o r indirectly. M a n y to p m anagers are com pensated based on the p rofit shown in the financial statements, a nd m any o w n shares in their com panies. In a d d itio n , if the c o m p a n y is a public com p a n y, the to p m anagers m ay lose their jobs if stock market prices d e cline o r fail to rise as the bo a rd of directors wishes.
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PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Asset reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w g ive s rise to an asset u n d e r th e d e fin itio n a n d c h a ra c te ris tic s w ith in th e F ra m e w o rk . If so, s h o w th e a m o u n t o f th e asset. W h a t w o u ld th e asset be c a lle d ? 1 A te m p o ra ry excess o f cash is used to p u rch a s e shares in BHP B illito n fo r $ 8 5 0 0 .
2
A d e p o s it o f $ 5 0 0 0 is p a id on c u sto m -d e s ig n e d e q u ip m e n t to be c o m p le te d a n d d e liv e re d ne xt y e a r. The to ta l p u rch a s e p ric e o f this e q u ip m e n t w ill be $ 2 0 0 0 0 .
3
A s u p p lie r sends n o tic e th a t $ 9 0 0 w o rth o f ra w m a te ria ls has been s h ip p e d b y fre ig h t, w ith p a y m e n t d u e in 3 0 d a ys . The b u y e r o b ta in s title to th e g o o d s as soon as th e y a re s h ip p e d b y th e seller.
4
A c u sto m e r p laces an o rd e r fo r $ 6 0 0 w o rth o f g o o d s .
5
A p ro d u c tio n m a n a g e r has be en h ire d to ov e rs e e th e c o m p a n y 's o p e ra tio n s , w ith e m p lo y m e n t c o m m e n c in g next m o nth . O n e -tw e lfth o f th e a n n u a l s a la ry o f $ 9 6 0 0 0 is to be p a id a t th e e n d o f e a ch m o nth w o rk e d .
6
In ve n to ry is a c q u ire d a t a list p ric e o f $ 1 2 0 0 , w ith p a y m e n t m a d e in tim e to secure a 2 p e r c e n t d is c o u n t fo r p ro m p t settlem ent. C a s h d isc o u n ts a re tre a te d as a re d u c tio n in th e a c q u is itio n cost o f th e in ve n to ry.
PRACTICE PROBLEM B L ia b ility reco g n itio n In d ic a te w h e th e r o r no t e a ch o f th e fo llo w in g events im m e d ia te ly g ive s rise to th e re c o g n itio n o f a lia b ility . If a lia b ility is re c o g n is e d , state th e a c c o u n t title a n d th e a m o u n t. 1 A firm s ig n s a c o n tra c t to p u rch a s e a t least $ 4 0 0 0 0 w o rth o f m e rc h a n d is e d u rin g th e ne xt tw o m onths.
2
A c h e q u e fo r $ 2 4 0 fo r a tw o -y e a r s u b s c rip tio n to a m a g a z in e is re c e ive d .
3
A c o n s tru c tio n c o m p a n y a g re e s to b u ild a b rid g e fo r $ 2 m illio n . A d o w n p a y m e n t o f $ 2 0 0 0 0 0 is re c e iv e d u p o n s ig n in g th e c o n tra c t, a n d th e re m a in d e r is d u e w h e n th e b rid g e is c o m p le te d .
4
D u rin g th e last p a y p e rio d , e m p lo y e e s e a rn e d w a g e s a m o u n tin g to $ 2 4 5 0 0 fo r w h ic h th e y h a ve no t be en p a id . The e m p lo y e r is a ls o lia b le fo r p a y ro ll taxes o f 8 p e r c e n t o f th e w a g e s e a rn e d .
5
A c o m p a n y is in fo rm e d b y a p re vio u s e m p lo y e e th a t he is s uin g the c o m p a n y fo r $ 3 0 0 0 0 0 fo r w ro n g fu l d ism issa l.
KEY TERMS Accounting policies Agency theory Agent Audit committee Audit report Bonds Bond market
Capital market theory Corporate governance Current market value Current value accounting Efficient capital market Efficient market hypothesis Fair value
General purpose Financial reports Net present value Price-level-adjusted historical cost Principal-agent theory Replacement cost
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HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
D IS C U S S IO N Q U E S T IO N S 1
W h a t a re th e fu n d a m e n ta l q u a lita tiv e c h a ra c te ris tic s o f useful fin a n c ia l in fo rm a tio n a n d w h a t a re th e e n h a n c in g c h a ra c te ris tic s ?
2
P ro v id e an e x a m p le o f tra d e -o ffs a m o n g a c c o u n tin g p rin c ip le s .
3
The F ra m e w o rk states th a t u n d e rs ta n d a b ility is an e n h a n c in g q u a lita tiv e c h a ra c te ris tic . Is this co n s is te n t w ith the
4
D e fin e an asset. W h a t a re th e esse ntial c h a ra c te ris tic s o f an asset?
5
D e fin e a lia b ility . W h a t a re th e esse ntial c h a ra c te ris tic s o f a lia b ility ?
6
D e s crib e e a ch o f th e fo llo w in g m e thods fo r m e a s u rin g assets a n d lia b ilitie s : a h is to ric a l cost
h u g e c o m p le x ity in fin a n c ia l statem ents?
7
b
p rice -le v e l-a d ju s te d h is to ric a l cost
c
m a rk e t v a lu e
d
v a lu e in use
e
liq u id a tio n v a lu e
C o m p a re th e c o n ce p ts o f v a lu e in use a n d v a lu e in e x c h a n g e .
8 A rg u e bo th fo r, a n d a g a in s t, th e fo llo w in g p ro p o s itio n : 'H is to ric a l cost a c c o u n tin g is irre le v a n t to users' d e c is io n m a k in g .' 9
W h y is e th ics so im p o rta n t to a p ro fe s sio n ? Is th e re re a lly a ne ce ssity fo r e th ic a l g u id a n c e fo r m e m b ers o f a p ro fe ssio n ?
1 0 W r ite a p a ra g ra p h o r tw o d iscu ssin g th e fo llo w in g to p ic : 'T he o n ly th in g w o rs e th a n th e la rg e a n d c o m p le x set o f p ra c tic e s , s ta n d a rd s a n d th e o rie s th a t m a ke up G A A P w o u ld be if th e re w e re no such th in g as G A A P .' 11 W h a t statem ents a re in c lu d e d in a c o m p le te set o f fin a n c ia l statem ents? 12 W h a t is th e p u rp o s e o f th e notes to th e fin a n c ia l statem ents? 13 G o to th e w e b p a g e fo r a listed c o m p a n y , fin d its a n n u a l re p o rt a n d d e s c rib e th e c ontents o f th e C E O 's re p o rt. 14 W h a t p u rp o s e d o e s th e a u d ito r's re p o rt serve? 15 W h a t a re th e type s o f a u d it re p o rts , a n d w h a t do es e a ch in d ic a te to th e users o f fin a n c ia l statem ents? 16 In a d d itio n to th e fin a n c ia l statem ents, w h a t else is in c lu d e d in an a n n u a l re p o rt? 1 7 A u d ito rs p la y an im p o rta n t ro le in th e fin a n c ia l re p o rtin g system , a n d th e ir in d e p e n d e n c e fro m th e ir c lie n ts is an esse ntial fe a tu re o f this system . W h y is such in d e p e n d e n c e c o n s id e re d necessary? W h y is it d iffic u lt to m a in ta in ? 18 a b
T o a n in ve sto r, w h a t v a lu e has been a d d e d to th e fin a n c ia l statem ents b y th e a u d ito r's re p o rt? W h y ? S ug g e st som e lim ita tio n s re g a rd in g th e v a lu e o f th e a u d ito r's re p o rt th a t an in ve sto r sh o u ld be a w a re of.
1 9 D o y o u th in k n o t-fo r-p ro fit o rg a n is a tio n s sh o u ld fo llo w the sam e G A A P th a t business e n te rp rise s d o ? W h y , o r w h y not? 2 0 G iv e e x a m p le s o f cases w h e re th e re is a c o n flic t o f in tere st b e tw e e n p re p a re rs o f fin a n c ia l statem ents a n d users o f them . 21 S h o u ld a s e n io r fin a n c ia l m a n a g e r w h o w o rk s fo r a c o m p a n y , a n d is a p ro fe s s io n a l a c c o u n ta n t, h a ve to m eet the sam e s ta n d a rd s o f p ro fe s s io n a l ethics as d o e s a c o lle a g u e w h o is a n e x te rn a l a u d ito r in p u b lic p ra c tic e ? W h y , o r w h y not? 2 2 W h a t is th e ro le o f in fo rm a tio n in a c a p ita l m arket? 2 3 W h a t is m e a n t b y th e e ffic ie n t m a rke t h ypo the sis? 2 4 W h a t is th e m a jo r p u rp o s e o f a stock e x c h a n g e ? 2 5 E x p la in th e term s 'a g e n c y th e o ry ' a n d 's te w a rd s h ip '.
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2 6 B rie fly d e s c rib e tw o im p o rta n t im p lic a tio n s c a p ita l m a rke t th e o ry has fo r th e use o f a c c o u n tin g in fo rm a tio n . 2 7 B rie fly d e s c rib e tw o im p o rta n t im p lic a tio n s a g e n c y (co ntra ct) th e o ry has fo r th e use o f a c c o u n tin g in fo rm a tio n . 2 8 It a p p e a rs th a t som e to p m a n a g e rs a tte m p t to m a n a g e th e ir c o m p a n ie s ' fin a n c ia l disc lo su re , in c lu d in g th e ir fin a n c ia l a c c o u n tin g , to a lte r th e sto ry e a ch d isc lo su re tells. W h y m ig h t m a n a g e rs b e m o tiv a te d to d o this?
2 9 W h y sh o u ld th e s h a re h o ld e rs o f a la rg e , p u b lic ly tra d e d c o m p a n y w a n t to h a ve th e c o m p a n y 's fin a n c ia l statem ents a u d ite d ? 3 0 The a u d ito rs ' re p o rt is n o rm a lly w ritte n using s ta n d a rd w o rd in g . The id e a is th a t, if th in g s a re n o t a ll rig h t, v a ria tio n s fro m th e s ta n d a rd w o rd in g w ill a le rt users o f th e fin a n c ia l statem ents. Is th a t consisten t, o r in co nsistent, w ith c a p ita l m a rke t th e o ry ?
PROBLEMS PROBLEM 6.1 Can Financial sta te m e n ts m eet various needs? The c h a irp e rs o n o f th e b o a rd o f d ire c to rs o f a la rg e p u b lic c o m p a n y s a id in fru s tra tio n : 'T he c o m p a n y 's w ritte n a n d u n w ritte n c o n tra cts w ith its s h a re h o ld e rs a re so d iffe re n t fro m those w ith its m a n a g e rs th a t it's im p o s s ib le to d e s ig n fin a n c ia l statem ents th a t w ill m eet th e needs o f b o th s h a re h o ld e rs a n d m a n a g e rs '. W h a t d o y o u th ink?
PROBLEM 6 .2 Financial sta te m e n t assum ptions Listed b e lo w , in jo u rn a l e n try fo rm , a re c e rta in u n re la te d a c c o u n tin g s itu a tio n s a n d (w h e re a p p lic a b le ) the a c c o u n tin g tre a tm e n t th a t has be en fo llo w e d b y th e firm s c o n c e rn e d . 1 Y Z Ltd has p u rc h a s e d , fo r $ 2 m illio n , a c o m p u te r th a t it e xp e cts to use fo r th re e y e a rs . A t th e e n d o f this p e rio d , it p la n s to a c q u ire , fo r $ 4 .5 m illio n , a fa s te r c o m p u te r w ith g re a tly in cre a s e d s to ra g e c a p a c ity . The d ire c to rs d e c id e d to 'p ro v id e fo r o n e -th ird o f th e e s tim a te d cost o f a n e w c o m p u te r d u rin g th e c u rre n t y e a r'.
Accounting treatment: DR CR
2
Depreciation expense Accumulated depreciation
$1 5 0 0 0 0 0 $1 5 0 0 0 0 0
D u rin g th e c u rre n t y e a r, g e o lo g is ts a n d e n g in e e rs h ire d b y th e D uchess O il C o m p a n y re vised u p w a rd s the e s tim a te d v a lu e o f n a tu ra l g a s a n d o il on p ro p e rty le a se d b y th e c o m p a n y . The d ire c to rs in stru cted the a c c o u n ta n t to re c o rd g o o d w ill o f $ 5 m illio n , th e e s tim a te d v a lu e o f g a s a n d o il d e p o sits in excess o f p re vio u s estim ates.
Accounting treatment: DR CR
Goodwill Gain on revaluation of gas and oil deposits
$5 0 0 0 0 0 0 $5 0 0 0 0 0 0
3
The b o a rd o f d ire c to rs o f Ryan C o rp o ra tio n disp oses o f a m a jo r seg m e n t o f th e e n te rp ris e , b u t o m its a n y m e ntion o f this in th e a n n u a l re p o rt 'to p ro te c t th e interests o f s h a re h o ld e rs '. P rofit is c o rre c tly stated a n d to ta l fig u re s in the b a la n c e sheet a re c o rre c t in to ta l.
4
Z ig -Z a g Ltd c h a n g e s its m e th o d o f d e p re c ia tio n e v e ry th re e y e a rs , b u t c le a rly discloses th e c h a n g e in its p u b lis h e d fin a n c ia l statem ents.
5
The fin a n c ia l y e a r o f S a tu ra te d Ltd en ds o n 31 D e c e m b e r. It is n o w 21 J a n u a ry , a n d fin a n c ia l statem ents fo r the y e a r just e n d e d a re b e in g p re p a re d . O n 1 0 J a n u a ry , a c y c lo n e d e s tro y e d a w a re h o u s e s e rvicin g th e no rth e rn p a rt o f th e c o u n try , a n d m ost o f the in ve n to rie s sto re d in th e w a re h o u s e w e re re n d e re d w o rth le s s . B ecause th ere
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is som e d o u b t c o n c e rn in g th e p a y m e n t o f th e in su ra n c e p re m iu m b y th e d u e d a te , it re m a in s unsettled as to w h e th e r th e loss is in fa c t c o v e re d b y in su ra n c e . This p o s s ib le loss w a s re fle c te d in th e fin a n c ia l statem ents fo r the y e a r just e n d e d .
Accounting treatment: DR
Cyclone loss
$450000
CR
Inventory
$450000
6
It has be en c u s to m a ry fo r HPB Ltd, o n e o f th e c o u n try 's la rg e s t c o rp o ra tio n s , to c a p ita lis e a n d d e p re c ia te a ll n e w ly a c q u ire d assets c o stin g m o re th a n $ 2 0 0 . This y e a r, th e b o a rd o f d ire c to rs has in stru cted th a t, in fu ture , a ll a c q u is itio n s o f less th a n $ 5 0 0 a re to be im m e d ia te ly w ritte n o ff as expe nses.
7
B N M In su ra nce, b y a c tio n o f th e b o a rd o f d ire c to rs , w ro te d o w n th e v a lu e o f its h e a d o ffic e b u ild in g to a n o m in a l a m o u n t o f $ 1 . The o b je c tiv e w a s to b o lste r its p o lic y h o ld e rs ' c o n fid e n c e in th e fin a n c ia l streng th o f th e e n te rp ris e b y o b v io u s ly u n d e rsta tin g assets.
Accounting treatment: DR
Retained profits
$ 1 9 9 9 9 999
CR
Buildings
$ 1 9 9 9 9 999
In e a c h o f th e g iv e n s itu a tio n s , in d ic a te w h ic h b a sic a c c o u n tin g a ssu m p tio n s a re in v o lv e d , a n d w h e th e r th e y ha ve be en used a p p ro p ria te ly . In those s itu a tio n s w h e re y o u c o n s id e r th a t th e a c c o u n tin g a s su m p tio n s h a ve n o t be en used a p p ro p ria te ly , discuss th e e ffe c t o f this d e p a rtu re fro m n o rm a l p ra c tic e o n th e fin a n c ia l statem ents. The a c c o u n tin g a ssu m p tio n s w e re set o u t in s e ctio n 1 .8 o f C h a p te r 1.
PROBLEM 6 .3 A cco u n tin g concepts and econom ic agents 1
E x p la in w h y e a ch o f th e fo llo w in g c o n c e p ts is im p o rta n t in re la tio n to fin a n c ia l re p o rtin g to m arkets a n d o th e r e c o n o m ic a g e n ts th a t re ly on such re p o rtin g : a
2 3
e c o n o m ic e n tity assu m p tio n
b
h is to ric a l c o st ba sis o f a c c o u n tin g
c
fa ith fu l re p re s e n ta tio n
d
g e n e ra lly a c c e p te d a c c o u n tin g p rin c ip le s
e
p ro fe s s io n a l e th ics o f th e a c co u n ta n ts a n d / o r a u d ito rs in v o lv e d in p ro d u c in g fin a n c ia l statem ents.
H o w h a ve e a ch o f these c o n c e p ts be en in c o rp o ra te d in to th e fin a n c ia l statem ents o f a la rg e p u b lic c o m p a n y y ou k n o w a b o u t? G iv e s p e c ific e x a m p le s. N o w a p p ly these id e a s to a sm all p riv a te c o m p a n y , such as y o u r lo ca l T h ai ta k e a w a y , n e w s a g e n t o r p h a rm a c y . A re these c o n c e p ts still re levant? W h y o r w h y not?
PROBLEM 6 .4 U sefulness o f acco u n tin g concepts and p rinciples Jason is a h a rd -d riv in g , im p a tie n t business e x e c u tive . Y ou w o rk fo r h im , a n d c a n fe el th e g re y h a ir s p ro u tin g on y o u r h e a d fro m a ll th e pressure. O n e d a y , he returns fro m a lunch m e e tin g w ith his a c c o u n ta n t a n d says, 'T h a t a c c o u n ta n t to ld m e th a t th e re a re a c c o u n tin g c o n c e p ts a n d p rin c ip le s th a t tell m e im p o rta n t th in g s a b o u t w h y m y fin a n c ia l statem ents a re useful, w h y th e y a re w o rth a ll th e m o n e y th e y cost to p ro d u c e a n d a u d it. I'm n o t c o n v in c e d .' C h o o s e a n y fiv e o f th e c o n c e p ts a n d p rin c ip le s listed in section 6 .3 , a n d e x p la in to Jason w h y those five a re useful. M a k e y o u r e x p la n a tio n s b rie f a n d to th e p o in t: Jaso n hates lo n g w in d e d a n sw e rs!
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PROBLEM 6 .5 Id e n tify som e a cco u n tin g concepts and p rinciples Id e n tify th e a c c o u n tin g c o n c e p ts o r p rin c ip le s th a t re la te to e a ch o f th e fo llo w in g sentences, a n d e x p la in w h a t e ffe c t th e c o n c e p ts o r p rin c ip le s h a ve on fin a n c ia l statem ents: 1 Users o f fin a n c ia l statem ents sh o u ld be a b le to b e lie v e th a t th e nu m b ers re p re s e n t re a l events. 2
F in a n c ia l statem ents sh o u ld a v o id un du e o p tim is m a b o u t th e fu ture .
3
It is h a rd to s a y a b s o lu te ly if a c o m p a n y is p e rfo rm in g w e ll o r b a d ly , b u t y o u c a n e v a lu a te its re la tive p e rfo rm a n c e .
4
F in a n c ia l a c c o u n tin g sh o u ld be h e lp fu l bo th in u n d e rs ta n d in g th e p a st a n d lo o k in g a h e a d to th e fu ture .
PROBLEM 6 .6 Q ualitative characteristics The F ra m e w o r k f o r th e P re p a r a tio n a n d P re s e n ta tio n o f F in a n c ia l S ta te m e n ts e x a m in e s th e c h a ra c te ris tic s o f a c c o u n tin g in fo rm a tio n th a t m a ke this in fo rm a tio n useful fo r d e c is io n -m a k in g . It a ls o p o in ts o u t th a t v a rio u s lim ita tio n s , w h ic h a re in h e re n t in th e m e asure m en t a n d re p o rtin g process, m a y necessitate tra d e -o ffs b e tw e e n these lim ita tio n s a n d th e p o s itiv e c h a ra c te ris tic s o f useful in fo rm a tio n . 1 B rie fly d e s c rib e th e fo llo w in g c h a ra c te ris tic s o f useful a c c o u n tin g in fo rm a tio n :
2
a
re le v a n c e
b
fa ith fu l re p re s e n ta tio n
c
u n d e rs ta n d a b ility
d
c o m p a ra b ility
e
tim eliness
f
v e rific a tio n .
For e a ch o f th e fo llo w in g p a irs o f in fo rm a tio n c h a ra c te ris tic s , g iv e a n e x a m p le o f a s itu a tio n in w h ic h o n e o f the c h a ra c te ris tic s m a y be s a c rific e d in return fo r a g a in in th e o th e r: a
re le v a n c e a n d v e rific a tio n
b
fa ith fu l re p re s e n ta tio n a n d tim eline ss
c
c o m p a ra b ility a n d re le v a n c e
d
re le v a n c e a n d u n d e rs ta n d a b ility .
PROBLEM 6 .7 R ecognition in accordance w ith standards and th e Fram ew ork For e a c h o f item s 1 - 5 liste d b e lo w , state w h e th e r, in a c c o rd a n c e w ith e x is tin g a c c o u n tin g s ta n d a rd s a n d the F ra m e w o rk , it w o u ld be re c o g n is e d as: a an asset b
a lia b ility
c
a c o n tin g e n t lia b ility
d
reven ue
e
an exp e n se
f
n o n e o f th e a b o v e .
1
Items: a p ro v is io n fo r a n n u a l le ave
2
$1 m illio n p a y a b le u n d e r a g u a ra n te e in th e e v e n t o f a th ird p a rty b e in g u n a b le to p a y
3
p u rc h a s e d g o o d w ill
4
a p a te n t
5
th e excess o f re se a rch a n d d e v e lo p m e n t costs o v e r th e e x p e c te d fu tu re e c o n o m ic be ne fits o f th e p ro je c t.
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PROBLEM 6.8 R ecognition o f an asset The g e n e ra l m a n a g e r o f T e lco Lim ited is c o n s id e rin g s p e n d in g $ 1 5 m illio n on th e d e v e lo p m e n t o f a n e w m o b ile p h o n e th a t c a n a ls o be used as a te le v is io n . W h a t c o n d itio n s w o u ld ne ed to be m et b e fo re th e $ 1 0 m illio n c a n be re c o g n is e d as an asset on th e b a la n c e sheet?
PROBLEM 6.9 C onceptual com ponents o f asset cost The n e w a c c o u n ta n t fo r M a c ta g g a rt Industries is w o n d e rin g h o w to c a lc u la te th e cost o f a n e w m a c h in e th e c o m p a n y has just in sta lle d . E x p la in b rie fly w h e th e r o r no t y o u th in k e a ch o f th e fo llo w in g item s sh o u ld be p a rt o f th e m a c h in e 's cost, a n d w h y : 1 th e in v o ic e p ric e o f th e m a ch in e
2
sales ta x p a id o n th e m a ch in e
3
s h ip p in g c h a rg e s to g e t th e m a c h in e to th e c o m p a n y 's fa c to ry
4
th e cost o f th e fa c to ry m a n a g e r's trip to th e m a c h in e m a n u fa c tu re r's p la n t to c h o o se th e m a ch in e
5
th e cost o f p a in tin g th e m a c h in e lig h t g re e n , as o th e r m a ch in e s in th e fa c to ry a re p a in te d
6 e s tim a te d reven ue lost b e ca u s e th e m a c h in e a rriv e d late 7
th e cost o f s u b s ta n d a rd p ro d u c ts m a d e w h ile th e fa c to ry p e rso n n e l w e re le a rn in g h o w to o p e ra te th e m a c h in e (all th ro w n a w a y so as n o t to d a m a g e th e c o m p a n y 's re p u ta tio n fo r q u a lity pro du cts)
8
in tere st cost on th e b a n k lo a n used to fin a n c e th e m a c h in e 's p u rch a s e
9
th e cost o f m o vin g th re e o th e r m a ch in e s in th e fa c to ry to m a ke ro o m fo r th e n e w on e.
PROBLEM 6.10 D eterm ine asset costs from various possible com ponents D e te rm in e th e costs th a t w o u ld a p p e a r on th e b a la n c e sheet o f Sm ith C o . Ltd, in re la tio n to la n d a n d a b u ild in g , b a se d on th e fo llo w in g in fo rm a tio n : Purchase price of plant site
175 000
Building materials (includes $ 10 000 in materials wasted because of worker inexperience)
700 000
Machinery installation charges
40000
Grading and draining plant site
20000
Labour costs of construction (Smith Co. used its own workers to build the plant rather than laying them off because business was slack. However, the labour to build the plant cost $40000 more than outside contractors would have charged, because of inside workers' inexperience and inefficiency.) Machinery purchase cost
500 000
1000 000
Machinery delivery charges
10000
Parking lot grading and paving
60000
Replacement of building windows shot out by vandals before production start-up Architect's fees
7 000 40000
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PROBLEM 6.11 Asset reco g n itio n State w h e th e r o r no t a n asset sh o u ld be re c o rd e d in th e b a la n c e shee t o f LMR Ltd as a t 3 0 June 2 0 1 6 in e a ch o f the fo llo w in g s itu a tio n s . In d ic a te th e a m o u n t o f th e asset (if an y) a n d a n y a s su m p tio n s m a d e . 1 O n 1 5 M a y 2 0 1 6 , LMR Ltd p a id $ 1 0 0 0 0 fo r a n in su ra n c e p re m iu m . The p re m iu m co ve rs losses in c u rre d in the p e rio d up to 1 4 M a y 2 0 1 7 . 2
LMR Ltd p a id $ 1 0 0 0 0 0 fo r a p a te n t in A p r il 2 0 1 6 .
3
LMR Ltd has just h ire d a n e w g e n e ra l m a n a g e r w h o is an e x p e rt in th e business c a rrie d on b y LMR Ltd. W ith the h e lp o f this p e rso n , th e c o m p a n y is e x p e c te d to in cre a s e its a n n u a l p ro fits b y $ 8 5 0 0 0 0 . The g e n e ra l m a n a g e r's s a la ry is $ 4 5 0 0 0 0 p e r an n u m .
4
LMR Ltd p u rc h a s e d la n d in 1 9 9 4 fo r $ 5 0 0 0 0 0 . The m a rke t v a lu e o f this la n d is $ 7 5 0 0 0 0 as a t 3 0 June 2 0 1 6 .
5
O n 2 9 June 2 0 1 6 , LMR Ltd p a id $ 9 0 0 0 0 0 fo r a p rin tin g s ervice business c o n s is tin g o f m a ch in e s w o rth $ 5 0 0 0 0 0 a n d a list o f 7 5 e s ta b lis h e d clie nts.
6 O v e r th e y e a rs , LMR Ltd has c re a te d g o o d w ill a m o n g its c lie n ts so th a t it n o w e n jo ys g o o d re la tio n s w ith o v e r 2 0 0 0 custom ers. It is e s tim a te d th a t if th e business w a s sold , as a t 3 0 June 2 0 1 6 , LMR Ltd c o u ld d e m a n d an a d d itio n a l $ 4 0 0 0 0 0 a b o v e th e sale p ric e o f its p h y s ic a l assets. 7
A m a c h in e is p u rc h a s e d fo r $ 5 0 0 0 0 0 a n d costs a n a d d itio n a l $ 2 0 0 0 0 0 to in sta ll.
PROBLEM 6.12 R ecognition o f assets For e a ch s itu a tio n b e lo w , state w h e th e r an asset w o u ld be re c o g n is e d in th e b a la n c e sheet. If th e a n s w e r is no , state w h ic h o f th e esse ntial c h a ra c te ris tic s re la tin g to assets has n o t be en m et. 1 E q u ip m e n t is p u rc h a s e d on c re d it. 2
C a s h is re c e iv e d fro m a cash sale.
3
A y e a rly in su ra n c e p o lic y is p a id in a d v a n c e .
4
A d e p a rtm e n t store receive s g o o d s fro m a m a n u fa c tu re r on c o n s ig n m e n t. A c o n s ig n m e n t is a s e llin g a rra n g e m e n t w h e re b y a c o m p a n y (co n s ig n o r) ships g o o d s to a n a g e n t (the d e p a rtm e n t store), w h o a g re e s to sell th e g o o d s on b e h a lf o f th e c o m p a n y fo r a c o m m is sio n . U n d e r th e a g re e m e n t, title to th e g o o d s re m a in s w ith th e c o n s ig n o r until th e g o o d s a re sold to a th ird p a rty .
5
Land is d o n a te d to a s p o rtin g a s s o c ia tio n .
6 A s p o rtin g a s s o c ia tio n receives a g ra n t fro m th e lo c a l c o u n c il to b u ild a n e w te n n is c o u rt. 7
A p a te n t is p u rc h a s e d using cash .
8 M o n e y is spen t on resea rch a n d d e v e lo p m e n t th a t is u n lik e ly to le a d to a n y n e w p ro d u c t in th e n e a r fu ture , bu t has th e p o te n tia l to le a d to d e ve lo p m e n ts in th e lo ng term .
9 A c o m p a n y hires a n e w g e n e ra l m a n a g e r w h o has a re p u ta tio n fo r in c re a s in g p ro fits in he r first y e a r w ith a n y n e w e m p lo y e r. 1 0 BHP shares a re p u rc h a s e d fo r cash. 11 A c o u n c il s w im m in g p o o l o ffe rs fre e a d m is s io n to ra te p a y e rs w h o p ro v id e id e n tific a tio n . 12 A lu x u ry re so rt pa ve s a g ra v e l ro a d fro m th e h ig h w a y to th e resort. The ro a d c a n a ls o be used b y others to g e t to a n u m b e r o f s p o rtin g fa c ilitie s in th e a re a , in c lu d in g a g o lf co u rs e th a t is no t o w n e d b y th e resort. 13 A n e w p rin tin g press is a c q u ire d . 14 A p ie c e o f e q u ip m e n t has a w ritte n -d o w n v a lu e o f $ 1 0 0 0 0 0 , a n d is no lo n g e r used b y th e c o m p a n y . It has no s c ra p v a lu e .
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PROBLEM 6.13 Id e n tify item s as assets, lia b ilitie s o r ow ners' e q u ity State whether or not, and why, each of the following items is likely to be an asset, a liability or an owners' equity account (perhaps both an asset and a liability in some cases) of the company indicated: Company
Item
1
News Corporation
List of subscribers to a magazine
2
Qantas
Funds collected from employees, to be repaid to them after retirement as superannuation
3
Westpac
Westpac's satisfied customers
4
Any company
Lawsuit against the company by a builder who alleges the company failed to pay for work done on the company's premises
5
Any company
Land that the company has agreed to sell to a real estate developer once it has been surveyed
6
Westpac
Westpac's dissatisfied customers
7
Fairfax Media
Australian Financial Review's skilled group of editors and reporters
8
Ampolex
Oil discovered on Ampolex's property, but still underground and likely to stay there for many years
9
Sydney Football Club
Players under contract to the team
10
Harvey Norman
Deposits received from customers of Harvey Norman for furniture not yet delivered to them
11
Woolworths
Profits earned by Woolworths, but not yet paid out to the owners as dividends
12
FedEx
A fleet of delivery trucks leased by FedEx from several truck-leasing firms
13
Hertz
A car Hertz leases to a real estate salesperson
14
Telstra
Funds owing to Telstra by a customer who recently declared bankruptcy
15
Qantas
The phrase 'The Flying Kangaroo' and the logo, both registered trademarks
16
Westfield Holdings
The parking lot surrounding Roselands Shopping Mall, Sydney
17
Wesfarmers
A guarantee Wesfarmers has made on a bank loan owed by an associated company
18
New beer company
A newly developed beer with reduced calories that has yet to be approved by the government
PROBLEM 6.14 R ecognition o f lia b ility BRK Lim ited is b e in g sued fo r $ 3 .5 m illio n b y a c lie n t fo r d e fa m a tio n resultin g fro m statem ents m a d e in n e w s p a p e rs b y o n e o f its e x e c u tive s. In e a ch o f th e s itu a tio n s b e lo w , state w h e th e r a lia b ility sh o u ld be re c o g n is e d in th e b a la n c e sheet. 1 BRK receive s le g a l a d v ic e th a t it is u n lik e ly th a t th e c la im w ill be successful. 2
BRK receive s le g a l a d v ic e th a t th e c la im has a b o u t a 5 0 p e r c e n t c h a n c e o f b e in g successful.
3
BRK receives le g a l a d v ic e th a t th e c la im is lik e ly to be successful, w ith d a m a g e s s o m e w h e re b e tw e e n $ 5 0 0 0 0 0 a n d $ 3 m illio n .
4
BRK o ffers th e c lie n t $1 m illio n in full settlem ent, b u t th e c lie n t refuses.
5
A t y e a r-e n d , BRK is in fo rm e d th a t le g a l costs to d a te a re $ 4 0 0 0 0 0 , a n d th e y w ill in cre a s e s u b s ta n tia lly in the n e w y e a r, d e p e n d in g o n w h e th e r th e m a tte r g o e s to c o u rt o r not.
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PROBLEM 6.15 R ecognition o f lia b ilitie s in th e balance sheet State w h e th e r o r no t e a ch o f the fo llo w in g events w o u ld result in a lia b ility b e in g re co g n is e d in the acco un ts a t 3 0 June. If so, w h a t w ill the lia b ility be c a lle d ? If not, e x p la in the reasons w h y it w o u ld no t be re co g n is e d as a lia b ility . 1 Taxes fo r th e y e a r e n d e d 3 0 June, w h ic h a re no t p a y a b le until O c to b e r. 2
W a g e s to be p a id on 2 July to c o v e r th e tw o -w e e k p e rio d up to 3 0 June.
3 The c o m p a n y sells w a s h in g m a ch in e s a n d g ive s a o n e -y e a r w a rra n ty to re p a ir o r re p la c e a n y fa u lty m a ch in e s. 4 A c o n s tru c tio n c o m p a n y receives a $ 5 m illio n a d v a n c e in June fo r a c o n tra c t. The w o rk w ill c o m m e n ce in July. 5 6
The c o m p a n y has s ig n e d a c o n tra c t to p a y its m a n a g in g d ire c to r $ 5 0 0 0 0 0 p e r a n n u m (in fla tio n a d ju ste d ) fo r th e n e xt fo u r y e a rs . O n 1 June, th e c o m p a n y is in fo rm e d th a t it is b e in g sued fo r d a m a g e s o f $1 m illio n c a u s e d b y a fa u lty p ro d u c t. The c o m p a n y d e n ie s lia b ility .
7
The c o m p a n y w ill g o to a rb itra tio n in J u ly to d e te rm in e th e a m o u n t o f p a y m e n t to re p a ir e n v iro n m e n ta l d a m a g e c a u s e d b y o n e o f its fa cto rie s .
PROBLEM 6.16 R ecognition o f lia b ilitie s S a m a n th a is th e a c c o u n ta n t fo r P rio r Ltd. H o w w o u ld y o u a d v is e he r to a c c o u n t fo r th e fo llo w in g item s in th e fin a n c ia l statem ents, as a t 3 0 June 2 0 1 6? 1 A p ro d u c tio n m a n a g e r w a s a p p o in te d o n 1 M a y 2 0 1 6 u n d e r a tw o -y e a r c o n tra c t th a t specifies an a n n u a l s a la ry o f $ 5 0 0 0 0 fo r e a ch o f th e tw o y e a rs . The c o n tra c t c a n be te rm in a te d w ith s ix m o n th s' n o tic e fro m e ith e r p a rty . 2
The c o m p a n y p a ys , in to a b o n u s p o o l, 5 p e r c e n t o f th e p ro fits re p o rte d a t th e e n d o f June fo r d is trib u tio n to p a rtic ip a tin g e m p lo y e e s .
3 A s u b s id ia ry o f P rio r Ltd has just be en p la c e d in re c e iv e rs h ip . In A p r il 2 0 1 6 , P rio r Ltd s ig n e d as g u a ra n to r fo r an $ 8 0 0 0 0 0 tw o -y e a r lo a n fro m a fin a n c e c o m p a n y to th e s u b s id ia ry .
4
Based o n his e x p e rie n c e s in p re vio u s y e a rs , th e c u stom er se rvice m a n a g e r e xp e cts w a rra n ty c la im s a g a in s t sales m a d e d u rin g 2 0 1 6 to a m o u n t to $ 7 0 0 0 0 .
5
G o w e r a n d C o . is s uin g P rio r Ltd fo r b re a c h o f c o n tra c t. S a m a n th a th inks G o w e r a n d C o . w ill p ro b a b ly lose th e case.
PROBLEM 6.17 L ia b ility reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w results in a lia b ility u n d e r th e d e fin itio n s a n d c h a ra c te ris tic s w ith in th e F ra m e w o rk . If so, s h o w th e a m o u n t o f th e lia b ility . W h a t w o u ld th e lia b ility be c a lle d ? 1 A b a n k lo a n o f $ 1 0 0 0 0 is o b ta in e d , w ith th e c o m p a n y s ig n in g a n a g re e m e n t to re p a y th e a m o u n t in s ix m onths, to g e th e r w ith in tere st o f 8 p e r c e n t p e r an n u m . 2
E le ctricity used in th e pa st m o nth , w o rth $ 2 3 0 , has no t be en p a id fo r.
3 A $ 3 0 0 0 c h e q u e is re c e iv e d fro m a te n a n t fo r th re e m o n th s' ren t in a d v a n c e . 4 A c o m p a n y sign s a tw o -y e a r e m p lo y m e n t c o n tra c t w ith a m a rk e tin g m a n a g e r. E m p lo ym e n t b e g in s n e xt m onth, a t a c o n tra c t p ric e o f $ 1 5 0 0 0 0 p e r y e a r.
PROBLEM 6.18 E ffects o f an asset acco u n tin g change to m arket from cost B e a u p o rt Ltd o w n s s eve ral p a rce ls o f la n d in th e S y d n e y a re a . The a re a has been s u b je c t to w id e sw in g s in real estate v a lu e s , a n d th e g e n e ra l m a n a g e r is d o u b tfu l th a t th e h is to ric a l cost ba sis is a p p ro p ria te fo r use in a c c o u n tin g fo r th e c o m p a n y 's la n d a n d b u ild in g s . G iv e short b u t c a re fu l a n sw e rs to th e fo llo w in g q u e s tio n s a s ke d b y th e g e n e ra l m a n a g e r. 1 'If w e c h a n g e d to m a rk e t v a lu e s fo r th e re a l estate, in ste a d o f cost, w o u ld th a t m a ke o u r b a la n c e sheet lo o k be tte r o r w o rs e ? ' 2
'S im ila rly fo r p ro fit: w o u ld using m a rk e t v a lu e in ste a d o f cost m a ke us lo o k m o re p ro fita b le o r less p ro fita b le ? '
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3
'D o e s it m a tte r w h a t w e d o , as lo n g as w e d isc lo se bo th cost a n d m a rke t v a lu e s o m e w h e re in o u r fin a n c ia l state m e nts?'
4
In w h a t w a y d o th e g e n e ra l m a n a g e r's qu e stio n s re fle c t a c h o ic e b e tw e e n th e c o n c e p ts o f v a lu e in use a n d v a lu e in e x c h a n g e ?
5
W h a t o th e r bases fo r v a lu in g th e p a rce ls o f la n d a n d b u ild in g s w o u ld be a v a ila b le to th e c o m p a n y ?
PROBLEM 6.19 A u th o rita tiv e standards, ca p ita l m arkets and contracts M a n y o f th e a c c o u n tin g m e tho ds y o u a re s tu d y in g in this b o o k a re b a se d on a u th o rita tiv e s ta n d a rd s (such as A A S B S tatem ents), w h ic h a tte m p t to s p e c ify h o w c o m p a n ie s ' fin a n c ia l a c c o u n tin g sh o u ld be d o n e . Such s ta n d a rd s d o n 't c o v e r e v e ry th in g : c o m p a n ie s m ust still m a ke m a n y ch o ice s w h e n th e y a re p re p a rin g th e ir fin a n c ia l statem ents. W h y a re th e re a u th o rita tiv e s ta n d a rd s fo r c o m p a n ie s to fo llo w ? W h y d o n 't th e y c o v e r e v e ry th in g ? S h o u ld w e h a ve m o re o r fe w e r o f them ? S itu a te y o u r a n s w e r in th e c o n te x t o f th is c h a p te r's th e o rie s a b o u t in fo rm a tio n use.
PROBLEM 6.20 A u d ito rs and Forecast in fo rm a tio n R ecently, th e re has be en pressure to e x p a n d th e ro le o f a u d ito rs , b e ca u s e investors a n d o th e r g ro u p s a re d e m a n d in g m o re fo rw a rd -lo o k in g in fo rm a tio n . If these d e m a n d s a re m et, a u d ito rs m a y be e x p e c te d to re v ie w th e p la n s a n d fo re ca sts o f a c o m p a n y th a t w ill be re p o rtin g to th e p u b lic , a n d to d e te rm in e th e fa irn e ss o f such fo rw a rd -lo o k in g fin a n c ia l statem ents. Discuss th e im p lic a tio n s o f this e x p a n d e d ro le fo r a u d ito rs , using such c o n ce p ts as in d e p e n d e n c e , in fo rm a tio n v a lu e , c o m p a ra b ility , a g e n c y th e o ry , c a p ita l m a rk e t th e o ry , re le v a n c e , re lia b ility , o b je c tiv ity a n d a n y o th e r c o n c e p ts th a t y o u feel a re im p o rta n t.
PROBLEM 6.21 C apital m arkets, a u d ito rs and co n tra cts 1
O n 31 O c to b e r 2 0 1 5 , an a lys ts p re d ic te d th a t th e e a rn in g s p e r sh a re o f O a k e s Ltd w o u ld e q u a l $ 4 .8 0 fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 5 . A c tu a l results w e re a n n o u n c e d o n 2 7 F e b ru a ry 2 0 1 6 . E a rn in g s p e r s h a re fo r 2 0 1 5 c a m e to $ 3 .9 5 . C o n s id e r th e th re e da tes no te d a b o v e (31 O c to b e r 2 0 1 5 , 31 D e c e m b e r 2 0 1 5 a n d 2 7 F e b ru a ry 2 0 1 6 ) . O n w h ic h o f these da tes w o u ld y o u e x p e c t to see s h a re p rice s re a c t to e a rn in g s in fo rm a tio n ? W h y ? C a n y o u p re d ic t th e d ire c tio n in w h ic h s h a re p rice s w o u ld re a c t on a n y o f these dates? E x p la in w h y o r w h y not.
2
E x p la in th e im p o rta n c e o f th e a u d it fu n c tio n in th e c o n te x t o f a la rg e c o m p a n y w h e re th e o w n e rs h ip (co m p o s e d o f a la rg e n u m b e r o f p riv a te investors) a n d th e m a n a g e m e n t a re s e p a ra te d . T o w h o m a re th e a u d ito rs p rim a rily re s p o n s ib le ? By w h o m a re th e y h ire d ? W h a t w o u ld th e investors e x p e c t o f th e a u d ito rs ? D o y o u r a n sw e rs in d ic a te a n y th in g th a t is in co n s iste n t w ith th e a u d ito r's ro le as a n in d e p e n d e n t p a rty?
3
A g e n c y th e o ry d e sc rib e s th e p ro b le m s th a t a re in h e re n t w h e n o n e p a rty (the p rin c ip a l) hires a s eco nd p a rty (the a g e n t) to d o w o rk on th e fo rm e r's b e h a lf. C h o o s e o n e c o n tra c tu a l re la tio n s h ip e x is tin g b e tw e e n pa rtie s c o n n e c te d w ith a c o rp o ra tio n a n d d e s c rib e this re la tio n s h ip in an a g e n c y th e o ry co n te xt.
PROBLEM 6.22 Threats to an a u d ito r's independence Pat is th e p a rtn e r on th e a u d it o f H a rd w o o d E m p o riu m Ltd. C o m m e n t on w h e th e r o r not, a n d w h y , e a c h o f the fo llo w in g m a y b e a th re a t to Pat's in d e p e n d e n c e . 1 Pat a n d th e c h ie f fin a n c ia l o ffic e r o f H a rd w o o d E m p o riu m p la y g o lf to g e th e r e v e ry fe w w e e ks. 2
D u rin g th e a u d it, Pat no tices th a t th e c o m p a n y has a serious p ro b le m w ith its c o m p u te r system . P at's a c c o u n tin g firm is then h ire d b y H a rd w o o d E m p o riu m to d o a m a jo r re d e s ig n o f the system , fo r a la rg e fee.
3
A s p a rt o f th e c o m p le tio n o f th e a u d it, Pat w o rk s w ith th e c o m p a n y to d e te rm in e its lik e ly in c o m e ta x lia b ility fo r th e y e a r, in c lu d in g h e lp in g to p re p a re th e c o m p a n y 's in c o m e ta x returns. Pat b ills th e c o m p a n y fo r th e ta x a d v ic e s e p a ra te ly fro m th e a u d it fee.
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4
Pat's fo rm e r assistant on th e H a rd w o o d E m p o riu m a u d it is h ire d b y th e c o m p a n y as th e c h ie f fin a n c ia l a c c o u n ta n t, w h o is re s p o n s ib le fo r p re p a rin g a ll th e c o m p a n y 's fin a n c ia l statem ents.
5
Pat is a s ke d to s u b m it a b id on th e a u d it fe e fo r ne xt y e a r's H a rd w o o d E m p o riu m a u d it, in c o m p e titio n w ith s eve ral o th e r a c c o u n tin g firm s. Pat d e c id e s to s u b m it a v e ry lo w b id b e ca u s e th e reven ue fro m ta x a n d c o n s u ltin g services w o u ld m a ke up fo r th e lo w e r a u d it reven ue .
PROBLEM 6.23 Ethics For e a ch o f the fo llo w in g situ a tio n s , state w h ic h o f th e fu n d a m e n ta l p rin c ip le s h a ve be en b re a c h e d : 1 m a k in g a m a te ria lly fa lse state m e nt
2 tw o a c c o u n ta n ts on a p la n e a fte r a fe w beers d iscu ssin g fu tu re plan s o f a ta x a tio n c lie n t
3 o w n in g shares in an a u d it c lie n t 4
a d v e rtis in g th a t y o u r firm 's c lie n ts h a ve fe w e r ta x a u d its th a n clie nts o f o th e r firm s
5
n o t p ro v id in g a d e q u a te tra in in g fo r y o u r a u d it staff.
PROBLEM 6.24 Ethics From th e fo llo w in g list: a self-interest b
s e lf-re vie w
c
advocacy
d
fa m ilia rity
e
in tim id a tio n
state w h a t ty p e o f th re a t e a ch o f th e fo llo w in g s itu a tio n s p ro v id e s : 1 Y o u r c lie n t is s u ffe rin g fin a n c ia l h a rd s h ip , a n d has a d v is e d y o u th a t unless a u d it fees a re d ro p p e d b y 5 0 p e r cent th e c lie n t w ill p u t th e a u d it o u t to te n d e r. 2
A n a u d it c lie n t has te m p o ra ry s ta ff s h o rta g e s, a n d a n o th e r d iv is io n o f y o u r firm p ro v id e s s ta ff to h e lp o u t in p re p a rin g th e fin a n c ia l statem ents.
3 Y o u r m a jo r a u d it c lie n t is g ro w in g q u ic k ly , a n d n o w a c co u n ts fo r 4 0 p e r c e n t o f y o u r to ta l fees. 4
A n a u d it c lie n t in fo rm s y o u th a t th e C F O is re tirin g n e xt y e a r, a n d asks y o u to ta k e th e jo b a fte r c o m p le tio n o f this y e a r's a u d it.
PROBLEM 6.25 Ethics From th e fo llo w in g list: a self-interest b
s e lf-re vie w
c
advocacy
d
fa m ilia rity
e
in tim id a tio n
1
state w h a t ty p e o f th re a t e a ch o f th e fo llo w in g s itu a tio n s p ro v id e s : Y ou h a ve be en p a rtn e r on C K T Ltd fo r o v e r 2 0 y e a rs . The c lie n t has a re p u ta tio n fo r p ro d u c in g v e ry h ig h -q u a lity a c co u n ts.
2
Y ou c o m p le te d th e a u d it b e lo w b u d g e t this y e a r as y o u h a d th e b e n e fit o f a n e w s tre a m lin e d in fo rm a tio n system d e v e lo p e d b y y o u r firm .
3 Y ou a re e x c ite d b e ca u s e y o u g o on a m o n th 's h o lid a y th e n e xt d a y . Y ou fin d an unusual tra n s a c tio n b u t w h e n y o u m e n tio n it to y o u r s u p e rv is o r he re m in d s y o u to c o n s id e r th e need to fo llo w up , a n d th a t if y o u d o so y o u w ill ne ed to c o m p le te this b e fo re y o u g o on h o lid a y s . 4
Y ou in h e rit $ 2 0 0 0 0 o f shares in a c lie n t th a t y o u a u d it.
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PROBLEM 6 .2 6 C apital m arkets and c o n tra cts to r a corporation
Choose any large, well-known corporation you are interested in, and answer the following questions, based on your choice. 1 What kinds of capital markets are likely to be important to the company? 2 Suppose those capital markets are efficient, and an unexpected and important piece of information about the company is released. What is likely to happen? Would it make a difference if the markets expected the information? 3 List some of the explicit, implicit or even casual contractual relationships between the company and other internal or external parties that are likely to be important to the company's success.
CASES
Refer to th e fu ll fin a n c ia l statem ents o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to the c o n s o lid a te d a cco u n ts. 1 Find e a c h o f th e fo llo w in g a n d in d ic a te th e p a g e :
2
a
s u m m a ry d a ta on th e c o m p a n y 's p e rfo rm a n c e
b
a letter to s h a re h o ld e rs fro m th e c o m p a n y 's c h a irp e rs o n o f th e b o a rd o f d ire c to rs o r m a n a g in g d ire c to r
c
m a n a g e m e n t discussion a n d a n a lys is
d
a c o rp o ra te g o v e rn a n c e statem ent
e
th e d ire c to rs ' state m e nt
f
th e a u d ito r's re p o rt
g
th e d ire c to rs 'd e c la ra tio n
h
th e fiv e -y e a r su m m a ry.
W h o is th e a u d ito r?
3
W h a t a re th e m a in item s c o v e re d in th e a u d ito r's re p o rt?
4
W h a t a re th e m a in item s c o v e re d in th e d ire c to rs ' statem ent?
5
W h a t a re th e m a in item s a d d re s s e d in th e c o rp o ra te g o v e rn a n c e statem ent?
6
W h a t ris k-m a n a g e m e n t p o lic ie s a re discussed?
7
W h a t do es th e c o m p a n y s a y a b o u t c o rp o ra te e th ic a l sta n d a rd s?
8
P ro v id e e x a m p le s fro m th e a c co u n ts o f th e a c c o u n tin g p rin c ip le s o f m a te ria lity a n d c o m p a ra b ility fro m note 1 o f th e acco un ts.
9
Id e n tify tw o d iffe re n t g ro u p s o f users o f fin a n c ia l statem ents o f W o o lw o rth s Lim ited, a
W h a t d e cisio n s d o th e y m a ke b a se d on c o rp o ra te fin a n c ia l statem ents?
b
W h a t s p e c ific c o m p o n e n ts o f th e W o o lw o rth s Lim ited fin a n c ia l statem ents w o u ld th e y b e m ost in tere ste d in?
1 0 Peruse the list o f assets in th e b a la n c e sheet a n d th e re la te d notes. H o w a re th e assets v a lu e d ? A re th e re 'a s se ts' th a t a re left o u t th a t y o u w o u ld h a ve e x p e c te d to see? 11 H o w a re th e c o n c e p ts o f fa ir v a lu e a n d v a lu e in use used b y W o o lw o rth s ? 12 W o o lw o rth s Lim ited a ls o in clu d e s a section in its rep orts title d 'D o in g th e rig h t th in g '. W ith in this section o f the re p o rt th e m a n a g e m e n t o f W o o lw o rth s Lim ited suggests th e firm is c o m m itte d to 'm a x im is in g th e s o c ia l, e c o n o m ic a n d e n v iro n m e n ta l be ne fits o f its bu siness'. W h a t m easures o f p e rfo rm a n c e a re p ro v id e d to those s ta k e h o ld e rs o th e r th a n th e s h a re h o ld e rs a n d d e b t ho ld ers o f th e firm ? 13 W h a t stock e x c h a n g e is W o o lw o rth s Lim ited listed on? H o w m a n y shares a re issued? Look up a n e w s p a p e r o r o n lin e to d is c o v e r its sh a re p ric e . 14 List th re e a c c o u n tin g -re la te d events th a t a re lik e ly to in cre a s e th e c o m p a n y 's s h a re p ric e . 15 A re th e re a n y fo rm s o f in ce n tive c o n tra cts in p la c e fo r executive s (see W o o lw o rth s ' w e b p a g e )?
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CASE 6B
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Assets and liabilities
R ead th e fo llo w in g fa cts:
T h e m e r g e r b e tw e e n S o u th c o r p a n d R o s e m o u n t re s u lte d in la rg e losses f o r S o u th c o r p re s u ltin g in a $ 6 4 2 . 5 m illio n w rite d o w n o f g o o d w ill a n d a $ 2 4 0 m illio n w rite d o w n o f th e v a lu e o f th e R o s e m o u n t b ra n d . A ls o th e c o m p a n y re c o r d e d a $ 9 5 m illio n in o n e - o f f p ro v is io n s a n d re s tr u c tu r in g c o s ts .
1
U sing th e d e fin itio n o f an asset, e x p la in w h y th e assets d iscusse d w ith in this e x tra c t w o u ld be w ritte n d o w n .
2
W h a t a c c o u n tin g c o n c e p ts w o u ld h a ve been c o n s id e re d w h e n d e te rm in in g th e w rite d o w n o f assets?
3
U sing th e d e fin itio n o f a lia b ility , e x p la in w h y th e p ro v is io n d iscusse d w ith in th is e x tra c t m a y h a ve be en c re a te d .
4
S h o w th e e ffe c t on p ro fit o f e a ch o f th e am o u n ts o f $ 6 4 2 .5 m illio n , $ 2 4 0 m illio n a n d $ 9 5 m illio n . W h a t o th e r a c co u n ts w o u ld be a ffe c te d ?
5
P ro v id e p o ss ib le jo u rn a l en trie s fo r th e item s in q u e s tio n 4 .
CASE 6C
Executive compensation plans
Find som e n e w s p a p e r o r m a g a z in e a rticle s a b o u t e x e c u tiv e c o m p e n s a tio n . W ith c a p ita l m a rke t a n d a g e n c y (co ntra ct) th e o ry as a b a c k g ro u n d , discuss th e c o m p e n s a tio n used b y e a ch c o m p a n y . 1 W h a t fe a tu re s o f e a ch p la n re la te to th e p e rfo rm a n c e o f th e c o m p a n y 's shares on th e stock m arket? 2
W h a t fe a tu re s o f e a ch p la n re la te to m a n a g e m e n t's s te w a rd s h ip o f th e c o m p a n y on b e h a lf o f th e s h a re h o ld e rs?
3
W h a t ro le do es a c c o u n tin g in fo rm a tio n p la y in c o m p e n s a tio n fo r e a ch c o m p a n y ?
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Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TES 1 2
This section is heavily based on m aterial provided b y M alco lm M ille r. A d d itio n a l m aterial w as provided b y M ah ree n H asan, Roger S im nettand D iane M a y o rg a . Parts o f this section rely on inform ation in A G u id e to U n d e rs ta n d in g A u d itin g a n d A s s u ra n c e : Listed C o m p a n ie s 2 0 1 4 . W e thank A m ir G h a n d a r for his a d vice on this area.
Internal control and cash ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: outline the com ponents of a goo d internal control system describe m anagem ent's responsibilities for m aintaining control over an enterprise's assets pro vide inform ation for evaluating an internal control system a n d for purposes such as fraud prevention develop internal control procedures to protect cash explain the role o f bank reconciliations as p a rt o f an internal control system p re p a re a bank reconciliation statem ent explain the use o f petty cash as an internal control for cash.
C H A PTER O VE R VIEW This chapter looks at the importance of a good internal control system. The basic techniques for designing an inter nal control system are discussed. This chapter also considers the internal controls which exist for one important asset, cash. Some emphasis is given to the bank reconciliation, which is a key internal control over cash.
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7.1
Internal control
Internal control should be, a nd is, an im portant issue in most organisations. The reason is that internal controls increase e fficien cy a nd effectiveness o f operations, reduce risk o f asset loss, help ensure the re lia b ility o f financial statements and help ensure c o m p lia n ce w ith law s a nd regulations. These four items a re all critical for all enterprises, irrespective o f size. In te rn a l c o n t r o l is: a p ro c e s s , e f fe c te d b y an e n t it y ’s b o a rd o f d ire c to rs , m a n a g e m e n t a n d o t h e r p e rs o n n e l, d e s ig n e d t o p ro v id e re a s o n a b le a s s u ra n c e re g a rd in g th e a c h ie v e m e n t o f o b je c tiv e s in th e fo llo w in g c a te g o rie s : 1
e ffe c tiv e n e s s a n d e ff ic ie n c y o f o p e ra tio n s , in c lu d in g s a fe g u a rd in g a ssets a g a in s t loss
2
re lia b ility o f in te rn a l an d e x te rn a l fin a n c ia l a n d n o n - fin a n c ia l r e p o r tin g
3
c o m p lia n c e w ith a p p lic a b le law s a n d re g u la tio n s . Source: The Internal Control—Integrated Framework by th e C o m m itte e o f Sponsoring Organizations o f th e Treadway Com m ission C CO SO 2013).
Let's consider some o f the points in this d efinition. First, internal control is not one event o r circum stance but a process integrated w ith other basic m anagem ent processes, including planning a nd m onitoring. Its effectiveness is a state o r condition of the process at one o r more points in time; that is, particular parts o f the process w o rkin g on particular days. It is affected by the actions o f p e o p le in the organisation including m anagem ent, the b o a rd o f directors a nd other personnel. It has an im pact on p e o p le in the o rganisation; for exam ple, m anagem ent sets 'the tone at the to p ', w h ich affects integrity an d ethics a nd other positive control features. The chief executive o ffice r (CEO) is ultimately responsible for internal control. M a n a g e m e n t is a cco u n ta b le to the bo a rd o f directors, a nd this bo a rd provides governance, g u id a n c e an d oversight to the o rganisation. O th e r personnel a re also involved as they provide inform ation used in the internal control system a nd take actions needed to affect controls, such as authorising the paym ent o f an account. Internal control affects the w o rkin g life o f most personnel; for exam ple, having an im pact on w h a t responsibility they have a nd lim iting the authority they have (such as being authorised to make payments up to $ 5 0 0 0 ). Internal control, regardless o f h o w w e ll it is ope ra te d an d designed, can o n ly pro vid e reasonable assurance rather than absolute assurance to m anagem ent an d the board o f directors regarding the achievem ent o f an entity's objectives. All internal control systems have certain inherent lim itations. First, they are lim ited by the problem s of human judgem ent. Even if a control system is w e ll d esigned, individuals m ay make judgem ent mistakes, including misunderstanding instructions. S econd, m anagers m ay override effective internal control systems; that is, override prescribed policies o r procedures, such as increasing revenue to cover up falls in profits, enhancing reported profit to meet analysts' forecasts o r covering up breaches o f bank b o rro w in g conditions. Third, collusion betw een tw o or more individuals can result in control failures. Finally, internal controls cost money, a n d there are a lw a ys cost-versus-benefit discussions in im plem enting an d checking on controls; for exam ple, you w o u ld not spend $1 m illion a ye a r protecting inventory that w a s w orth $ 1 0 0 0 0 . Finally, internal control should be a d a p ta b le to the size a nd structure of the organisation. The internal controls you w o u ld expect at W o o lw o rth s w ill be very different from those you see a t your local family-run corner shop. Internal control covers three objectives: •
effectiveness an d efficiency of operations that relate to the entity's basic business objectives a n d sa feguarding of resources
•
reliability o f internal a n d external fin a n cia l a nd non-financial reporting, including published fin a n cia l statements, such as extracts of fin a n cia l d a ta from these statements (e.g. earnings announcem ents)
•
c o m p lia n ce w ith the law s a nd regulations to w h ich the entity is subject.
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Based on the a b o ve three objectives, internal controls can be considered to be effective for each o f the three categories if m anagem ent a nd the bo a rd o f directors have reasonable assurance that: •
they understand the extent to w h ich the organisation's objectives are being a chieved; for exam ple, particular returns on investment
•
fin a n cia l statements are being p repared reliably
•
there is co m p lia n ce w ith relevant law s a nd regulations.
1
C o n tro l environm ent: The control environm ent incorporates all the w ritten policies a nd procedures of the
Internal control consists o f the fo llo w in g five interrelated com ponents: organisation as w e ll as the unwritten practices o f those w ithin an o rganisation. The control environm ent sets the tone o f an o rganisation, influencing the control consciousness of its people. It is the foundation for all other com ponents of internal control, p roviding d isciplin e an d structure. C ontrol environm ent factors include the integrity, ethical values an d com petence o f the entity's peo p le ; m anagem ent's p h ilosophy an d o perating style; the w a y m anagem ent assigns authority a nd responsibility, a nd organises an d develops its peo p le ; an d the attention and direction p rovided by the bo a rd o f directors. 2
Risk assessment: Every entity faces a variety o f risks from external a nd internal sources that must be assessed. A precondition to risk assessment is establishm ent o f objectives, linked at different levels a nd internally consistent. Risk assessment is the identification a nd analysis o f relevant risks that m ay adversely im pact the achievem ent o f the org a nisation's objectives. This forms a basis for determ ining h o w the risks should be m ana g e d . Because eco n o m ic, industry, regulatory an d op e ra tin g conditions w ill continue to ch a n g e, mechanisms are needed to identify a nd d e a l w ith the special risks associated w ith ch a n g e, both internal a nd external.
3
C o n tro l activities: C ontrol activities are the policies an d procedures that help to ensure m anagem ent directives are carried out. They help to ensure that necessary actions are taken to address risks to achievem ent of the entity's objectives. C ontrol activities occur throughout the o rganisation, at all levels an d in all functions. They m ay be preventative o r detective in nature an d include both m anual a nd autom ated processes. They include a range of activities as diverse as approvals, authorisations, verifications, reconciliations, reviews of o p erating perform ance, security o f assets an d s e g re g a tio n o f d u tie s.
4 Inform ation a n d com m unication: Pertinent inform ation must be identified, captured a nd com m unicated in a form an d a tim efram e that e n a b le p e o p le to carry out their responsibilities. Inform ation systems p roduce reports co n ta in in g o p e ra tio n a l, fin a n cia l an d com pliance-related inform ation, w h ich make it possible to run a n d control the business. They de a l not o nly w ith internally generated d a ta but also inform ation a b o u t external events, activities an d conditions necessary to inform ed business decision-m aking an d external reporting. Effective com m unication also must occur in a b ro a d e r sense, flo w in g d o w n , across a nd up the o rganisation. All personnel must receive a cle a r message from to p m anagem ent that control responsibilities must be taken seriously. They must understand their o w n role in the internal control system, as w e ll as h o w individual activities relate to the w o rk of others. They must have a means o f com m unicating significant inform ation upstream. There also needs to be effective com m unication w ith external parties, such as customers, suppliers, regulators a n d shareholders.
5
M o n ito rin g : Internal control systems need to be m onitored - a process that assesses the q u a lity o f the system's perform ance over time. This is a ccom plished through o n g o in g m onitoring activities, separate evaluations o r a co m b in a tio n o f the tw o . O n g o in g m onitoring occurs in the course o f operations. It includes regular m anagem ent an d supervisory activities, an d other actions personnel take in perform ing their duties. The scope a nd frequency of separate evaluations w ill d e p e n d prim arily on an assessment o f risks an d the effectiveness o f o n g o in g m onitoring procedures. Internal control deficiencies should be reported upstream, w ith serious matters reported to top m anagem ent a nd the b o a rd (ad a p te d from C om m ittee o f Sponsoring O rg a n iza tio n s o f the T re a d w a y Com m ission [C O S O ] 2 0 1 3 , Internal C o n tro l - Integrated Fram ew ork). All the a b o v e five com ponents are relevant to each o f our previously stated three objectives. For each o b je ctive
(such as reliability of fin a n cia l reporting), all five com ponents must be present a nd function effectively to dem onstrate that internal control over the re lia b ility o f fin a n cia l reporting is effective.
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Control activities W h ile all o f the a b o v e com ponents o f internal control a re im portant, for illustration here w e pro vid e four exam ples of control activities: •
Toptlevel review s: M a n a g e rs carry out reviews o f actual perform ance co m pared to budgets, forecasts a n d prior period results. They assess w h ich targets are being a chieved. M a n a g e m e n t actions taken to analyse progress m ade and to fo llo w up on reporting actions are exam ples o f control activities.
•
Inform ation processing: C ontrols are used to check a ccuracy, completeness an d correct authorisation of transactions. Data entered is subject to e d it checks, such as no payroll am ount a b o v e $x. There is m atching to a p p ro ve d control files (e.g. a customer's order is acce p te d o nly after reference to an a p p ro ve d customer file) and a credit limit. N um erical sequences o f transactions are accounted for, such as a missing invoice number. File totals are co m p a red a nd reconciled w ith control accounts (e.g. the accounts receivable general ledger must reconcile w ith the accounts receivable subsidiary ledger).
•
S eparate record-keeping from h a n d lin g assets: An effective w a y of p roviding security over assets like cash, accounts receivable a n d inventories is to have records sh o w in g h o w much o f each asset is supposed to be on hand at a n y time. H ow ever, if the person w h o physically handles the asset (say, cash) also keeps the records o f it, errors o r fraud can be hidden by altering the records. A ccountants call the separation o f record-keeping and handling assets 'segregation o f duties'. O n e person collects the cash w h ile another person m aintains the cash records. If one o r the other makes a mistake, a difference w ill arise betw een the count o f cash on hand a nd w h a t the record shows should be on hand. This difference can then be investigated an d the cause corrected. S egregation o f duties can also be used w ithin the record-keeping system. For exam ple, o ne person can m aintain the general ledger, w ith the total accounts receivable account, a nd another can m aintain the accounts receivable subsidiary ledger, w ith the d e ta ile d list o f customer accounts. It is hard for smaller enterprises w ith fe w em ployees to spread the jobs around enough to segregate all the im portant tasks, but it should be d o n e as much as possible. If segregation o f duties do e sn 't exist, the boss needs to keep a close eye on im portant assets, such as cash and inventories.
•
Physically p ro te ct sensitive assets: This control method is rather obvious, but is easy to overlook. Sensitive assets, such as cash, inventories an d com puter equipm ent, should be behind lock an d key, kept in particular storage areas, or otherw ise protected from unauthorised o r casual access. M a n y enterprises a re slo p p y a b o u t access to their inventories, in particular, a nd sometimes protection is a g o o d id e a for assets you m ight not think of. For exam ple, m any manufacturers p roduce scrap as a by-product, a n d the scrap can be very valuable. O n e manufacturer put its scrap in the backyard an d found out later that thousands o f dollars' w orth had been lifted over the b a ck fence a nd sold on the scrap market. Examples o f physical controls include safes, locked storage areas, security guards a nd em ployee identification cards. Electronic devices a re being used w ith increased frequency; for exam ple, most university libraries have e lectronically co d e d their books so that an alarm goes o ff if a n yone tries to remove them w ith o u t first taking them to the front desk to have them checked out. There is much m ore to internal control than the points listed a b o ve . D esigning effective control systems requires an
understanding o f m anagem ent's objectives; a sensitivity to the co st-b e n e fit b a la n ce needed betw een tight, but costly, controls and loose, but cheap, controls; k n o w le d g e o f com puter systems a nd other record-keeping m ethods; and considerable insight into the subtleties o f human m otivation a n d behaviour. It also requires some com m on sense: com plete protection is not possible, a nd tying the enterprise up in red ta p e to g a in com plete protection is not w h a t a g o o d internal control system should do . Some specific exam ples o f internal control procedures include: •
independent a p p ro v a l a n d review : for exam ple, the authorisation o f purchase orders o r sales invoices; subsequent review o f large a nd unusual transactions; a n d a p p ro va l o f transactions over a certain limit (such as g ivin g credit over $ 1 0 0 0 0 0 )
•
m atching ind e pendently g e n e ra te d docum ents: for exam ple, m atching sales invoices a nd shipping docum ents to ensure all items shipped a re invoiced; m atching purchase orders an d receiving reports w ith paym ent vouchers to ensure goods w e re actu a lly ordered
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•
prenum bering a n d sequence checking o f docum ents: for exam ple, prenum bering shipping docum ents, sales
•
com parison w ith inde p e n d e n t third-party inform ation: for exam ple, ba n k re c o n c ilia tio n s o f ledger accounts w ith
•
can ce lla tio n o f docum entation: for exam ple, physically stam ping 'p a id ' on an invoice presented for paym ent;
invoices, cheques o r vouchers to prevent unauthorised use
b a n k statements (see section 7 .3 )
d e fa cin g spoiled o r cancelled cheques to prevent them being used •
segregation o f duties relating to transaction initiation, a p p ro v a l a n d re cording: for exam ple, the person w h o handles the physical asset (such as cash inventory) should not also be involved in the recording o f the transactions
•
d e m a n d in g timeliness o f operations: for exam ple, the prom pt dep o sit of cash receipts an d depositing cash intact; that is, not rem oving part o f it to p a y for small p e tty cash items.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: P ro v id e an e x a m p le o f e a ch o f th e fo llo w in g c o n tro ls :
1 in fo r m a tio n c o n tro ls 2 s e p a ra te r e c o r d - k e e p in g fr o m h a n d lin g o f assets 3
p h y s ic a l p r o te c tio n o f s e n s itiv e assets. Y o u r a n sw e rs s h o u ld be:
1
P a s sw o rd a c ce ss f o r a u th o ris e d users, e d it c h e c k s an d n o p a y m e n t g re a te r th a n $x.
2
T h e p e rs o n w h o re c o rd s cash tra n s a c tio n s d o e s n o t p h y s ic a lly h a n d le cash .
3
L o c k s , s w ip e -c a rd a c ce ss t o a p p ro v e d e m p lo y e e s , an d v id e o c a m e ra s in sh o p s.
7.2
Internal control of cash
C ash is the asset that is usually most susceptible to theft because o f its liquid, a nd g e n e ra lly anonym ous, nature.
A REAL CASE M ik e , a ju n io r a u d ito r, w as a ssign ed t o d o a s u rp ris e c o u n t o f th e cash o n h a n d a t a lo ca l c lo th in g s h o p . T h e cash c o u n te d w as s h o rt c o m p a re d w ith w h a t w as e x p e c te d , based o n th e a u d ito rs ’ p ro je c tio n s o f cash fr o m sales an d b a n k d e p o s it re c o rd s . M ik e w as a c c u s e d b y th e s h o p ’s a c c o u n tin g c le rk o f s te a lin g th e c a sh h im s e lf w h ile c o u n tin g it, an d he had to ca ll th e p o lic e an d in s is t th a t th e y s e a rc h h im an d so d e m o n s tra te th a t he had n o t s to le n it. It tu r n e d o u t th a t th e a c c o u n tin g c le rk had b e e n s te a lin g cash and c o v e rin g up th e th e fts b y c h a n g in g th e sales re c o rd s : a c la ssic case o f p o o r in te rn a l c o n tro l th ro u g h la ck o f s e g re g a tio n o f d u tie s , b e c a u s e th e c le rk had a cce ss to b o th th e cash an d th e re c o rd s o f th e cash . T h e t h e f t w as d is c o v e re d o n ly b e ca u s e M ik e ’s s u rp ris e cash c o u n t re fe rre d t o sales re c o rd s th a t th e c le rk had n o t y e t a lte re d to c o v e r u p th e s h o rta g e . T h e c le rk w as fire d an d p ro m is e d to m a k e re s titu tio n , th o u g h it w as d if f ic u lt to te ll h o w m u c h had b e e n ta k e n b e ca u s e sales re c o rd s had b e e n a lte re d f o r s eve ral years. T h e o w n e r o f th e s to re w as c ritic a l o f th e a u d ito rs f o r ‘n o t p re v e n tin g th e loss’, b u t th e a u d ito rs s h o w e d th a t th e y had in d e e d w a rn e d th e o w n e r, w h o had said th a t it w o u ld be to o e x p e n s iv e t o e m p lo y s o m e o n e else t o k e e p th e sales re c o rd s o r c o n tro l th e cash.
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For cash sales, a com m on control is to have locked-in sales registers o r other carefully controlled records. Registers (such as you w o u ld see a t a n y supermarket) usually print a consecutive num ber on the locked-in ta p e for each transaction. The access key is kept b y a single person, perhaps a supervisor, w h o balances cash to sale records. The proceeds that should have been received w ill be recorded on the tape. The person w h o keeps the key should count the cash w ith the cashier, c o m p a re it w ith the sales proceeds, a nd check that the ta p e numbers a re consecutive from one person's shift to that o f the next person. If this sort o f system is to w o rk, there has to be no collusion betw een the p eople controlling the cash an d checking the records - often, collusion is difficult to prevent, so having yet another person provide overall m onitoring o f the process is a g o o d id e a . W ith the greater use o f credit cards a nd the advent o f electronic com m erce, there are n o w m any forms o f 'cash' needing control attention, including currency, cheques, g ift cards, direct payments, credit cards a nd electronic funds transfers.
A REAL CASE A large c o m p a n y established a ‘p e tty cash’ fu n d in its fr o n t o ffic e to be used to pay fo r sm all purchases such as o ffic e supplies and c o u rie r charges. The re c e p tio n is t was given a fu n d o f $ 1 0 0 0 , in cash, and w hen m o s t o f th a t was s pent, s u b m itte d all th e re ce ip ts in an en ve lo p e and was re fu n d e d th e cash s p e n t, to b rin g th e p e tty cash fu n d back up to $ 1 0 0 0 . The in te rn a l c o n tro l, th e re fo re , was th a t, a t any tim e , th e re c e p tio n is t should have cash on hand plus re ce ip ts fo r p a ym e n ts to ta llin g $ 1 0 0 0 . W h a t th e c o m p a n y did n o t kn o w was th a t th e re c e p tio n is t was involved w ith th e d e live ry d riv e r fro m th e s to re fro m w h ich th e c o m p a n y g o t m o s t o f its o ffic e supplies, and nearly all invoices fro m th a t c o m p a n y paid th ro u g h p e tty cash w e re in fla te d . The c o m p a n y paid fa r m o re th a n it should have fo r th e supplies, b u t no one knew because th e people w h o g o t th e supplies did n o t see th e invoices, w h ich w e re k e p t by th e re c e p tio n is t as evidence o f cash payouts. The p e ople w h o re im b u rse d th e re c e p tio n is t had n o t seen th e o ffic e supplies, so did n o t know th e invoices w e re in fla te d . The th e fts and th e c o llu sio n b e tw e e n th e re c e p tio n is t and th e d riv e r w e re d isco ve re d lo n g a fte r th e tw o had m oved to a n o th e r c ity : s o m e o n e n o tic e d th a t o ffic e supplies co sts w e re lo w e r th a n th e y used to be! The c o m p a n y has no g o o d idea o f h o w m u c h was s to le n , b u t it believes th a t it was m a n y th o u sa n d s o f dollars o ve r th e years. Tw o points should be n o te d a b o u t th is fra u d . F irs t, overall m o n ito rin g o f p e tty cash su m m a rie s by a supervisor w ould p ro b a b ly have picked th is up. S eco n d , th e se are n o t th e typ e s o f expenses th a t should be paid fo r o u t o f p e tty cash.
A nother w a y to control cash from sales is to have m ulti-copied, prenum bered sales invoices. The invoice copies are then rem oved b y on e person. For cash sales, the amounts are cross-checked aga in st cash records, an d for credit sales, the am ounts are cross-checked aga in st accounts receivable records. A n y ga p s in the num erical continuity o f the invoices are investigated. For this control to w o rk, supervisors must ensure that an invoice is prepared for each sales transaction. An a d d itio n a l control is to regularly check inventory an d c o m p a re it w ith the sales records. This should prevent, o r at least detect, som eone selling inventory an d pocketing the cash. Take, for exam ple, the M a y fie ld Pro S hop, w h ich recorded sales o f g o o d s for the month that had a cost price of $ 1 0 0 0 0 a cco rd in g to the invoice copies in the locked box. If the inventory at the start o f the month w a s w orth $ 2 5 0 0 0 and a t the end o f the month w a s w orth $ 1 4 0 0 0 (based on the retail price of the goods), the sh