ACC 101 Introduction to Financial Accounting
CHAPTER 1: INTRODUCTION TO FINANCIAL
ACCOUNTING
1.1 USE, PREPARATION AND CONCEPTS
* Use: The information derived from financial accounting is used by managers, investors, bankers, financial analysts and accountants, helping them to learn how to use information effectively and to do their jobs better. This information is essential to accountants for the services they provide. * Preparation: to be effective users of accounting information, people need to know something about how and why the information is prepared. Accountants’ expertise is about the how and why. * Concepts: Users, accountants and accounting form a connected system. The demand for useful information shapes how financial accounting information is prepared. Tying it all together are the whys: the reasons it is used and prepared, the principles that lie behind it. The hows (preparation procedures and techniques), whys (concepts and principles) and uses (analysis and decisions) of financial accounting are all tied together.
1.2 FINANCIAL ACCOUNTING
* Accounting: a process of identifying, measuring, and communicating economic information to allow the users of that information to make informed decisions. * Accounting systems are usually described as either financial accounting systems (periodic financial statements are provided to external decision makers e.g. investors, creditors, customers), or management accounting systems (information for planning and performance reports to internal decision makers e.g. manager of an organisation). * Financial accounting measures an enterprise’s performance over time, and its position at a point in time, in whatever currency is relevant to the enterprise; from small to large businesses, and other enterprises including local or national governmental bodies, charities, churches etc. * Financial statements (financial accounting’s reports) summarises measurements of financial performance and position in standards thought to be useful for the enterprise’s evaluation. These statements include notes, which add an explanation to the numbers. * Financial performance: means generating new resources from day-to-day operations over a period of time. * Financial position: is the enterprise’s set of financial resources and obligations at a point in time. * Financial performance and position are highly related; strong financial performance (large profits) will lead to a build-up of resources. Healthy financial position facilitates performance; if one holds more resources than obligations, it gives more scope to be able to take activities that lead to better performance.
1.3 THE SOCIAL SETTING OF FINANCIAL ACCOUNTING
* Functions of financial accounting includes: helping stock market investors decide whether or not to buy, sell or hold shares of companies, help banks/lenders decide whether or not to lend, used by governments to monitor actions of enterprises and for tax purposes, providing basic financial records for day-to-day management etc. * Financial accounting for the enterprises seeks to monitor and report on financial events initiated, or happening to the enterprise. Accounting is not passive within social settings: it tells us what’s going on, but in doing so, also affects our decisions and actions, and therefore, affects what’s going on. * In the social setting, the parties interested in an enterprise’s financial accounting may have differing interests or purposes for the information e.g. they may be in competition or conflict with one another, or they may be operating internationally.
1.4 THE PEOPLE INVOLVED IN FINANCIAL ACCOUNTING
1) USERS (DECISION MAKERS)
* In financial accounting, a user is someone who makes decisions on their own, or a company’s behalf based on information from the financial statements. The nature and contents of financial statements are functions of the demand for decision information from users. If user demand is the fundamental reason for financial statements, understanding the demand is important. * A user’s main demand is for the credible periodic reporting of an enterprise’s financial position and performance. * Credible means that the information in the financial statements appears to be sufficiently trustworthy and competent. Credibility is a relative condition as there is a cost-benefit issue here: attempting to perfect the report is costly and may affect an enterprise’s performance and position if they strived to achieve this perfection. * Periodic means the users can expect report on some regular basis. Usually, the longer the wait, the more solid the information. But imprecision is accepted in return for reports with timely, decision-relevant information. MAIN GROUPS OF USERS
* Owners: individual business owners, individual investors (shareholders), people with quasi-ownership interests. Investors purchase shares in hopes of gaining in two ways: receiving a portion of the company’s profit in dividends, and selling the shares at a later time for a higher price than they paid. * Potential owners: the same sort of people as owners, but do not have funds invested in the enterprise at the moment, but are considering to do so. * Creditors and potential creditors: suppliers, banks, bondholders, employees and others who have lent money to the enterprise, who are owed funds in return for supplying something of value, or who are considering taking on such a role. Creditors do not have the legal control of the enterprise that owners have, but may have a large say in enterprise decisions in times of difficulty. One is able to be both an owner and a creditor. Creditors need to decide whether to supply goods and services to the firm on credit. * Managers: those who run the enterprise on behalf of the owners. They use the information in accounting reports to plan, control and organise the activities of the entity. Their salaries and bonuses are also directly affected by the contents of the financial statements. * Employees and their unions: financial information could be used by them to assess job security. E.g. ability to pay wages, superannuation contributions, maintain employment. * Regulators and other government bodies: using financial statements to evaluate whether the enterprise is following various rules and agreements. * Financial and market analysts: those who study companies’ performances and prepare reports for others by analysing those companies, advising whether to invest, buy or sell. * Competitors: attempting to understand an enterprise’s operations to harm an enterprise’s prospects. * Accounting researchers: mostly university academics, and those who study accounting with the objective of understanding it and contributing to its improvement. * Customers: need to consider if the entity is financially sound. This is especially the case if large advance payments are required of them. Also reliance on warranties. * Miscellaneous third parties: politicians may make judgements about industry efficiency or taxation levels, journalists may write articles about employment practices etc. 2) PREPARERS (DECISION FACILITATORS)
* Three main groups are responsible for the information in financial statements * Managers: responsible for running the enterprise, including issuing accounting and other information, and controlling its financial affairs. As managers are also users vitally interested in the results, there is a level of conflict here, and has created the need for the auditing function. * Bookkeepers and clerks: working under the direction of managements to create transactional data from which accounting reports are built. * Accountants: have the job of shaping the financial statements by applying the principles of accounting to the enterprise’s records, under the direction of management. 3) AUDITORS (CREDIBILITY ENHANCERS)
* Auditors report on the credibility of an enterprise’s financial statements on behalf of owners (internal auditors who support the credibility of information used by management), and others (external auditors, reporting on financial statements on behalf of external users). * Auditors have the job of assisting users, by verifying that financial statements have been prepared fairly, competently and in a manner consistent with accounting principles. * External auditors may be asked at times to prepare financial statements for small companies, however, they must avoid responsibility for statements because their role is to scrutinise the preparation process. * External auditors are formally appointed in shareholder’s meetings, and are not permitted to be the owner or the manager. This is to ensure that the auditor is financially and ethically independent, and can therefore be objective about the enterprise’s financial affairs. * Large accounting firms who not only offer external auditing, but other services such as accounting spend large sums of money on their independence and quality control systems.
1.5 ACCRUAL ACCOUNTING
* Enterprises have thousands of events/transactions to be recorded and their financial effects evaluated. Frequently, when the times comes to prepare financial statements, transactions have not been completed, are in dispute, or an unclear status. To cope with these complexities, financial accounting for most enterprises, use the accrual accounting approach. * Under the accrual accounting system, the impact of transactions on the financial statements are recognised in the time periods in which revenues and expenses occur, rather than when cash is received or paid. * The main form of revenue is usually the sales of g/s. Other revenues include interest on investments held, dividends received on shares and rent from premises owned by the company. * Expenses include the cost of services and resources consumed in the process of generating revenues. E.g. of costs incurred: labour, electricity, travel, commission. An example of resources consumed: depreciation. Organisations depreciate the cost of an asset, over the useful life of the asset, rather than treat the cost of the asset as an expense in the first year. Each year a percentage of the cost of the asset becomes an expense. We depreciate the cost of an asset over its useful life as assets are used over many years and help to generate revenue over many periods, and this depreciation expense is matched to revenues being earned during the period. The judgement on the useful life of the asset has an impact on profit each year. ACCRUAL ACCOUNTING VERSUS CASH ACCOUNTING
* Cash accounting: recording revenues and expenses at the time cash is received or paid. This is reasonably precise, and exact amounts may be determined (from accounting books and bank statements). * However, the timing of cash flow is often in a different accounting period to the substance of the transaction e.g. selling inventory on credit, when a contractor fixes machinery but will not be paid until a later accounting period, or the use of machinery. USING ACCRUAL ACCOUNTING TO PREPARE FINANCIAL STATEMENTS
When using the accrual accounting approach in preparing financial statements, attempts are made to: * Include all cash receipts and payments that have already happened e.g. cash sale * Incorporate future cash receipts and payments that should be expected, based on existing transactions e.g. credit sales * Measure the value of incomplete transactions e.g. estimating the amount of accounts receivable that will not be collected, and treat it as an expense for the year. * Estimate figures when exact amounts are unknown e.g. amount of interest due from the bank at year end: interest revenue. * Making economically meaningful assessments of awkward problems. E.g. being sued for $1mil for a faulty product, you agree to pay $200,000, but they decide to take the matter to court. ESTIMATES AND ASSESSMENTS
* There is a need to use judgements when preparing financial statements e.g. assessing the amount of uncollected loans a bank is able to receive by studying the loan repayment records of the countries owing money. THE IMPORTANCE OF GOOD JUDGEMENT
* Financial accounting is imprecise because it relies on many judgements, and because many augmentations must be made to the transactional records so that the statements will be meaningful. * Modern financial accounting starts with cash receipts and payments, then builds a very large accrual accounting process in addition to the cash records in order to provide a sophisticated measure of financial performance and position.
1.6 THE KEY FINANCIAL STATEMENTS
* Organisations are required to provide information regarding: financial position, financial performance, financial activities and investing activities which are relevant to user needs. * Key financial statements that provide this information include: balance sheets which shows the financial position at a point in time, income statements which measures financial performance over a defined period by deducting expenses from revenues during the period to obtain profit for that period, and a statement of cash flows which shows the sources and uses of cash during the period. Financial and investing activities are included in this statement.
BALANCE SHEET
* Shows an organisation’s resources and claims on resources at a particular point in time. * The heading provides the company name, title of the report, and date at which the financial position is shown. * Three main elements of a balance sheet: assets, liabilities, and shareholder’s equity (if organisation were a sole trader or partnership, it would be proprietor’s equity or partner’s equity respectively). ASSETS
* Future economic benefits that are controlled by an organisation as a result of past transactions or past events. The value of assets needs to be measured in monetary terms. * Assets include cash, accounts receivable/debtors (amounts owing from customers for g/s provided to them. A.R is shown in net, which is the amount expected to be collected after allowances have been made for likely uncollectable amounts), inventory (cost of stock on hand, unsold products), and property, plant & equipment. * Assets can be financed in one of two ways: assets = liabilities + shareholder’s equity. LIABILITIES
* Future sacrifices of economic benefits that an organisation is presently obliged to make to other organisations/individuals as a result of past transactions or events. E.g. suppliers providing goods on credit, employees carrying out work. * Liabilities can be legally owed debts e.g. loans & mortgages, however they can also be estimates of future payments based on past agreements e.g. future benefits for employees for long service leave or warranty repairs. Liabilities involve the future use of assets (usually cash) or performance of future services.
* E.g. of liabilities: accounts payable/trade creditors (amount owed to suppliers for g/s they have provided to an organisation), wages payable/accrued wages (work done by employees, for which they have not yet been paid), provision for employee entitlements (that employees accumulate as a result of past work e.g. holiday leave), and long-term loans (loans not repayable within a year). SHAREHOLDER’S EQUITY
* The excess of assets over liabilities; the residual claim of the shareholders on the assets of the organisation. Shareholder’s equity consists of two main elements: share capital and retained profits. * Share capital is the amount that owners have directly invested in the company * Retained profits represent the total cumulative profits that the company has retained in the business rather than distributed in dividends. * The equation assets = liabilities + owner’s equity shows that resources of an enterprise are funded by either debt or equity. The equation balances in every point in time. COMPARATIVE BALANCE SHEETS
* While the changes from year to year on the balance sheet provides readers with information about what is happening to various account balances, the statement does not account for the change. However, it is possible to obtain this information on the change in this account in the statement of cash flows.
INCOME STATEMENT
* In previous years, income statements were called profit and loss statements. * Provides information on an organisation’s profitability for a period of time, matching revenues during a period against expenses incurred in earning the revenue. The difference is the profit or loss. Remembering that under an accrual accounting system, the revenue or expense does not have to be received or paid for the revenue or expense to be recorded in the income statement. * From an e.g., the difference between sales revenue and the cost of goods sold in the gross profit/gross margin. * Income statement also lists various day-to-day operating expenses. Deducting operating expenses from gross profit gives operating profit before tax. Tax is then deducted to give operating profit after tax. * The profit figure can then either be paid out in dividends to shareholders or retained in the business. This is the connecting link between the balance sheet and the income statement. The opening balance of retained profits plus the profit for the year minus dividends equals the closing balance of retained profits as shown in the balance sheet. * Companies provide a separate statement or note to the accounts showing the change in retained profit for the year.
STATEMENT OF CASH FLOWS
* Because revenues reported usually do not equal cash collected and expenses do not equal cash paid, net profit is different from the change in cash for the period. * The statement of cash flows shows the changes during the period in one balance sheet, namely, the receipt and payment of cash. Accounting standards require companies to present this statement in their published financial statements. * Individual transactions are usually split into three categories: operating activities related to the provision of g/s, investing activities related to the acquisition and disposal of non-current assets including property, plant and equipment, and financing activities related to the changing size and composition of the financial structure of the entity including equity and certain borrowings. * The closing balance of the statement of cash flows is the figure shown under cash in the balance sheet.
1.7 RELATIONSHIPS BETWEEN THE FINANCIAL STATEMENTS
* The opening balance in the cash flow statement is obtained from the cash figure of year 1 on the balance sheet. We must then add the total net cash flows of this year to the opening balance to obtain the cash figure for year 2 for the balance sheet. * The net profit figure derived from the income statement is then added to the retained profits of year 1 from the balance sheet in the retained profits note. To obtain retained profits for year 2 in the balance sheet, dividends must then be deducted from this figure.
1.8 INFORMATION USE SCENARIOS
DEMANDS ON THE QUALITY OF FINANCIAL ACCOUNTING INFORMATION (ACCOUNTING PRINCIPLES) 1) The concept of relevance: if information is to assist users in making decisions about the allocation of scarce resources, it should help them make, confirm or correct predictions about the outcomes of past, present or future events. Timelessness refers to the need to provide relevant information in enough time for the decision to be made. 2) The criterion of reliability: financial statements should report the economic substance of events happening to the company, and the numbers should measure the events neutrally, neither overstating nor understating their impact. Reliable information will, without bias or undue error, faithfully represent those transactions and events that have occurred. 3) The criterion of materiality (significance): concerned with assessing whether omission, misstatement or non-disclosure of a piece of information would affect the decisions of users of the accounting reports. What is or what isn’t material is a matter of judgement. Usually, people judge materiality by considering the size of a possible error compared to the net profit or the total assets. The materiality judgement depends on any particular uses of information that are expected and on whether the error moves the profit to a loss or violates some loan condition. 4) GAAP (generally accepted accounting principles): to assure users that accepted accounting standards have been followed, the auditor’s report will contain the auditor’s opinion about whether or not the financial statement has complied with GAAP. GAAP does not mean one particular method has been followed, but rather, the company’s accounting methods and figures are appropriate to their circumstances. 5) Another criterion prudence: if there is uncertainty, assets, revenues and profit should not be overstated and liabilities, expenses and losses should not be understated. Prudence should involve being cautious, not deliberately biasing important numbers, although where prudence begins and ends is a matter of judgement. 6) Principle of disclosure: financial statements include large number of notes and account descriptions intended to make it clear to the reader which important accounting methods have been followed, and to provide supplementary information on debts, share capital, commitments, law suits and other things thought to be helpful, or necessary in understanding the statements. Disclosure beyond the accounting figures is becoming increasingly extensive. Companies disclose information to those such as taxation authorities, securities regulators and other parties such as a bank loan officer. 7) Principle of understandability: reports should be prepared having regard to the interests of users who are willing to exercise diligence in examining reports, and who possess the skills and ability to comprehend contemporary accounting practices. 8) Principle of comparability: financial statements have been prepared in a comparable way (across different time periods, and across similar companies). 9) Consistency: using the same accounting methods over time. Consistency does not mean that a company has to use the same accounting methods in all parts of the company. * The above ideas may be formalised by the framework put out by the Australian Accounting Standards Board (AASB). It lists 4 qualitative characteristics with subheadings in brackets that make information in financial reports useful to users: understandability, relevance (materiality), reliability (faithful representation, substance over form, neutrality, prudence and completeness), and comparability. * Faithful representation: the accounting information represents what really existed or happened. * Substance and form: transactions and events must be presented in accordance with their substance and economic reality, not merely the legal or technical requirements for reporting. * Neutrality: freedom from bias. The situation and presentation of information should not be made to achieve a predetermined result or outcome. * Prudence: a degree of caution in the exercise of judgements involved in making estimates. * Completeness: material information is not omitted, as this can be misleading.
TRADE-OFFS AMONG ACCOUNTING PRINCIPLES
* The criteria and principles mentioned above may not always fit well together. * Prudence is a bias that interferes with reliability.
* If one company that is likely to be compared with another company changes their accounting methods, the other company may match their accounting methods to theirs for the sake of comparability, however, there will be inconsistency with their own figures over time. * There is almost never a solution that produces the most reliable and timeliest, relevant accounting information. As time passes, reliability rises and timely relevance falls, so we must try to find a midpoint where there is enough of both, but not as much as we would like of either.
1.9 FINANCIAL STATEMENT ASSUMPTIONS
* Below are some basic assumptions underlying accounting practice and the preparation of financial statements. * Accrual basis: financial reports are prepared on the basis of accrual accounting; effects of transactions and other events are recognised as they occur. * Going concern: financial statements are prepared on the premise that the organisation will continue operations as a going concern in the foreseeable future. If this is not the case, it is necessary to report liquidation values of an organisation’s assets. * Accounting entity: the accounting entity is separate and distinguished from its owners. E.g. the accounting entity of a sole trader is differentiated from the financial affairs of the owner, and a company is a separate entity from its shareholders. This concept puts a boundary on the transactions that are to be recorded for any particular accounting entity, allowing the owner to evaluate the performance of the business. * Accounting period: Dividing the life of an organisation into equal periods to evaluate performance (profit or loss) for that period is known as the accounting period concept. The time periods are arbitrary, but most organisations report at least annually, with many companies preparing half-yearly and quarterly financial statements, with others doing so more frequently (monthly) for management purposes. * Monetary: accounting transactions need to be measured in a common denominator, which in Australian, is the Australian dollar, allowing comparisons across different time periods, and companies. This also assumes that the value of the monetary unit is constant over time, ignoring inflation. Transactions that are unable to be assigned a dollar amount are not included in the accounts. * Historical cost: assets are initially recorded at cost. Many assets such as inventory will still be recorded at cost in the balance sheet in subsequent periods although their value has increased. Some other assets such as property, plant and equipment can be revalued periodically. It is important to notes at what valuation the assets are being recorded in the balance sheet.
1.10 IS ACCOUNTING REALLY IMPORTANT?
* Used by management in making business decisions: accounting numbers have huge impacts on management decisions to contract and expand the business, which in turn affects employees, suppliers, contractors and the economy. E.g. Southcorp, Australia’s largest publicly traded winemaker, has signalled its willingness to close some of its vineyards, if it can’t make them profitable, as part of an ongoing asset review that has already seen the closure of several winemaking and distribution facilities. It has launched a detailed review of profitability of its vineyards, as it strives for a better return on capital employed. * Used by people such as shareholders for decision-making purposes: both good and bad accounting news often has a big impact on the share market * Used by boards in takeover battles: accounting numbers are used to decide which companies to make takeover offers for, to convince shareholders to accept the offer, and by defending boards to try to stop the takeover. * Used by bankers and other credit groups: bankers use accounting numbers to decide whether to lend, to determine the level of risk and often the interest to charge. Rating agencies such as Standard and Poor’s and Moody’s use accounting numbers to give their credit rating, which has impact on the interest rates companies have to pay. * Used by corporate boards in rewarding and removing executives: most executive compensation schemes include performance bonuses and accounting numbers are key components of these performance hurdles. * Used by unions and management in negotiating wage agreements: in pay disputes, both managers and unions often use accounting numbers to support their case. For example, the higher the profits, the more likely the pay increases. * Impact on the economy and employment
* Impact on the community and consumers: poor accounting numbers can lead to the discontinuing of community and customer services * Impact on workers: accounting numbers can lead to corporate failure, with resulting consequences for workers. * Legal Impact: False accounting reports can lead to major legal battles and accounting numbers can be used in compensation settlements. * Penalties for misleading accounting: recent corporate collapses involving misleading accounting reports have led to major penalties both in Australia and overseas.
1.11 PUBLIC SECTOR ISSUES
* There has been a move from cash accounting to accrual accounting in the three tiers of government. * Users including departmental managers, policy advisors, Members of Parliament etc., require information about departments and councils for the purposes of making and evaluating decisions regarding the allocation of scarce resources. They may use this information to determine, for e.g., whether a department is: achieving its objectives, operating economically and efficiently in achieving its objectives, using its resources for the purposes intended, worthy of continued support of their activities, and if so how much, and if they’re able to continue to provide g/s in the future. * Government departments and local government authorities are required to prepare financial reports including a balance sheet, income statement and statement of cash flows. * Governments are required to provide whole-of-government accounts. The financial reports of governments encompass the assets they control, the liabilities they have incurred and the related revenues and expenses. Users of these government reports include parliamentarians, the public, and providers of finance, media and other analysts. The financial reports also assist governments in discharging their obligation of financial accountability. * An increasingly important area of the public sector is the performance of government trading enterprises (GTEs). GTEs have become an increasing source of revenue, via dividends and taxation for both the State and Commonwealth governments. * Many GTEs have recently undergone reforms and structural changes including industry restructuring, improved accountability, commercialism and corporatisation, privatisation and pricing reforms. Accounting reports and the development of accounting performance measures have been necessary to ensure focus on these reforms.
* Use: The information derived from financial accounting is used by managers, investors, bankers, financial analysts and accountants, helping them to learn how to use information effectively and to do their jobs better. This information is essential to accountants for the services they provide. * Preparation: to be effective users of accounting information, people need to know something about how and why the information is prepared. Accountants’ expertise is about the how and why. * Concepts: Users, accountants and accounting form a connected system. The demand for useful information shapes how financial accounting information is prepared. Tying it all together are the whys: the reasons it is used and prepared, the principles that lie behind it. The hows (preparation procedures and techniques), whys (concepts and principles) and uses (analysis and decisions) of financial accounting are all tied together.
1.2 FINANCIAL ACCOUNTING
* Accounting: a process of identifying, measuring, and communicating economic information to allow the users of that information to make informed decisions. * Accounting systems are usually described as either financial accounting systems (periodic financial statements are provided to external decision makers e.g. investors, creditors, customers), or management accounting systems (information for planning and performance reports to internal decision makers e.g. manager of an organisation). * Financial accounting measures an enterprise’s performance over time, and its position at a point in time, in whatever currency is relevant to the enterprise; from small to large businesses, and other enterprises including local or national governmental bodies, charities, churches etc. * Financial statements (financial accounting’s reports) summarises measurements of financial performance and position in standards thought to be useful for the enterprise’s evaluation. These statements include notes, which add an explanation to the numbers. * Financial performance: means generating new resources from day-to-day operations over a period of time. * Financial position: is the enterprise’s set of financial resources and obligations at a point in time. * Financial performance and position are highly related; strong financial performance (large profits) will lead to a build-up of resources. Healthy financial position facilitates performance; if one holds more resources than obligations, it gives more scope to be able to take activities that lead to better performance.
1.3 THE SOCIAL SETTING OF FINANCIAL ACCOUNTING
* Functions of financial accounting includes: helping stock market investors decide whether or not to buy, sell or hold shares of companies, help banks/lenders decide whether or not to lend, used by governments to monitor actions of enterprises and for tax purposes, providing basic financial records for day-to-day management etc. * Financial accounting for the enterprises seeks to monitor and report on financial events initiated, or happening to the enterprise. Accounting is not passive within social settings: it tells us what’s going on, but in doing so, also affects our decisions and actions, and therefore, affects what’s going on. * In the social setting, the parties interested in an enterprise’s financial accounting may have differing interests or purposes for the information e.g. they may be in competition or conflict with one another, or they may be operating internationally.
1.4 THE PEOPLE INVOLVED IN FINANCIAL ACCOUNTING
1) USERS (DECISION MAKERS)
* In financial accounting, a user is someone who makes decisions on their own, or a company’s behalf based on information from the financial statements. The nature and contents of financial statements are functions of the demand for decision information from users. If user demand is the fundamental reason for financial statements, understanding the demand is important. * A user’s main demand is for the credible periodic reporting of an enterprise’s financial position and performance. * Credible means that the information in the financial statements appears to be sufficiently trustworthy and competent. Credibility is a relative condition as there is a cost-benefit issue here: attempting to perfect the report is costly and may affect an enterprise’s performance and position if they strived to achieve this perfection. * Periodic means the users can expect report on some regular basis. Usually, the longer the wait, the more solid the information. But imprecision is accepted in return for reports with timely, decision-relevant information. MAIN GROUPS OF USERS
* Owners: individual business owners, individual investors (shareholders), people with quasi-ownership interests. Investors purchase shares in hopes of gaining in two ways: receiving a portion of the company’s profit in dividends, and selling the shares at a later time for a higher price than they paid. * Potential owners: the same sort of people as owners, but do not have funds invested in the enterprise at the moment, but are considering to do so. * Creditors and potential creditors: suppliers, banks, bondholders, employees and others who have lent money to the enterprise, who are owed funds in return for supplying something of value, or who are considering taking on such a role. Creditors do not have the legal control of the enterprise that owners have, but may have a large say in enterprise decisions in times of difficulty. One is able to be both an owner and a creditor. Creditors need to decide whether to supply goods and services to the firm on credit. * Managers: those who run the enterprise on behalf of the owners. They use the information in accounting reports to plan, control and organise the activities of the entity. Their salaries and bonuses are also directly affected by the contents of the financial statements. * Employees and their unions: financial information could be used by them to assess job security. E.g. ability to pay wages, superannuation contributions, maintain employment. * Regulators and other government bodies: using financial statements to evaluate whether the enterprise is following various rules and agreements. * Financial and market analysts: those who study companies’ performances and prepare reports for others by analysing those companies, advising whether to invest, buy or sell. * Competitors: attempting to understand an enterprise’s operations to harm an enterprise’s prospects. * Accounting researchers: mostly university academics, and those who study accounting with the objective of understanding it and contributing to its improvement. * Customers: need to consider if the entity is financially sound. This is especially the case if large advance payments are required of them. Also reliance on warranties. * Miscellaneous third parties: politicians may make judgements about industry efficiency or taxation levels, journalists may write articles about employment practices etc. 2) PREPARERS (DECISION FACILITATORS)
* Three main groups are responsible for the information in financial statements * Managers: responsible for running the enterprise, including issuing accounting and other information, and controlling its financial affairs. As managers are also users vitally interested in the results, there is a level of conflict here, and has created the need for the auditing function. * Bookkeepers and clerks: working under the direction of managements to create transactional data from which accounting reports are built. * Accountants: have the job of shaping the financial statements by applying the principles of accounting to the enterprise’s records, under the direction of management. 3) AUDITORS (CREDIBILITY ENHANCERS)
* Auditors report on the credibility of an enterprise’s financial statements on behalf of owners (internal auditors who support the credibility of information used by management), and others (external auditors, reporting on financial statements on behalf of external users). * Auditors have the job of assisting users, by verifying that financial statements have been prepared fairly, competently and in a manner consistent with accounting principles. * External auditors may be asked at times to prepare financial statements for small companies, however, they must avoid responsibility for statements because their role is to scrutinise the preparation process. * External auditors are formally appointed in shareholder’s meetings, and are not permitted to be the owner or the manager. This is to ensure that the auditor is financially and ethically independent, and can therefore be objective about the enterprise’s financial affairs. * Large accounting firms who not only offer external auditing, but other services such as accounting spend large sums of money on their independence and quality control systems.
1.5 ACCRUAL ACCOUNTING
* Enterprises have thousands of events/transactions to be recorded and their financial effects evaluated. Frequently, when the times comes to prepare financial statements, transactions have not been completed, are in dispute, or an unclear status. To cope with these complexities, financial accounting for most enterprises, use the accrual accounting approach. * Under the accrual accounting system, the impact of transactions on the financial statements are recognised in the time periods in which revenues and expenses occur, rather than when cash is received or paid. * The main form of revenue is usually the sales of g/s. Other revenues include interest on investments held, dividends received on shares and rent from premises owned by the company. * Expenses include the cost of services and resources consumed in the process of generating revenues. E.g. of costs incurred: labour, electricity, travel, commission. An example of resources consumed: depreciation. Organisations depreciate the cost of an asset, over the useful life of the asset, rather than treat the cost of the asset as an expense in the first year. Each year a percentage of the cost of the asset becomes an expense. We depreciate the cost of an asset over its useful life as assets are used over many years and help to generate revenue over many periods, and this depreciation expense is matched to revenues being earned during the period. The judgement on the useful life of the asset has an impact on profit each year. ACCRUAL ACCOUNTING VERSUS CASH ACCOUNTING
* Cash accounting: recording revenues and expenses at the time cash is received or paid. This is reasonably precise, and exact amounts may be determined (from accounting books and bank statements). * However, the timing of cash flow is often in a different accounting period to the substance of the transaction e.g. selling inventory on credit, when a contractor fixes machinery but will not be paid until a later accounting period, or the use of machinery. USING ACCRUAL ACCOUNTING TO PREPARE FINANCIAL STATEMENTS
When using the accrual accounting approach in preparing financial statements, attempts are made to: * Include all cash receipts and payments that have already happened e.g. cash sale * Incorporate future cash receipts and payments that should be expected, based on existing transactions e.g. credit sales * Measure the value of incomplete transactions e.g. estimating the amount of accounts receivable that will not be collected, and treat it as an expense for the year. * Estimate figures when exact amounts are unknown e.g. amount of interest due from the bank at year end: interest revenue. * Making economically meaningful assessments of awkward problems. E.g. being sued for $1mil for a faulty product, you agree to pay $200,000, but they decide to take the matter to court. ESTIMATES AND ASSESSMENTS
* There is a need to use judgements when preparing financial statements e.g. assessing the amount of uncollected loans a bank is able to receive by studying the loan repayment records of the countries owing money. THE IMPORTANCE OF GOOD JUDGEMENT
* Financial accounting is imprecise because it relies on many judgements, and because many augmentations must be made to the transactional records so that the statements will be meaningful. * Modern financial accounting starts with cash receipts and payments, then builds a very large accrual accounting process in addition to the cash records in order to provide a sophisticated measure of financial performance and position.
1.6 THE KEY FINANCIAL STATEMENTS
* Organisations are required to provide information regarding: financial position, financial performance, financial activities and investing activities which are relevant to user needs. * Key financial statements that provide this information include: balance sheets which shows the financial position at a point in time, income statements which measures financial performance over a defined period by deducting expenses from revenues during the period to obtain profit for that period, and a statement of cash flows which shows the sources and uses of cash during the period. Financial and investing activities are included in this statement.
BALANCE SHEET
* Shows an organisation’s resources and claims on resources at a particular point in time. * The heading provides the company name, title of the report, and date at which the financial position is shown. * Three main elements of a balance sheet: assets, liabilities, and shareholder’s equity (if organisation were a sole trader or partnership, it would be proprietor’s equity or partner’s equity respectively). ASSETS
* Future economic benefits that are controlled by an organisation as a result of past transactions or past events. The value of assets needs to be measured in monetary terms. * Assets include cash, accounts receivable/debtors (amounts owing from customers for g/s provided to them. A.R is shown in net, which is the amount expected to be collected after allowances have been made for likely uncollectable amounts), inventory (cost of stock on hand, unsold products), and property, plant & equipment. * Assets can be financed in one of two ways: assets = liabilities + shareholder’s equity. LIABILITIES
* Future sacrifices of economic benefits that an organisation is presently obliged to make to other organisations/individuals as a result of past transactions or events. E.g. suppliers providing goods on credit, employees carrying out work. * Liabilities can be legally owed debts e.g. loans & mortgages, however they can also be estimates of future payments based on past agreements e.g. future benefits for employees for long service leave or warranty repairs. Liabilities involve the future use of assets (usually cash) or performance of future services.
* E.g. of liabilities: accounts payable/trade creditors (amount owed to suppliers for g/s they have provided to an organisation), wages payable/accrued wages (work done by employees, for which they have not yet been paid), provision for employee entitlements (that employees accumulate as a result of past work e.g. holiday leave), and long-term loans (loans not repayable within a year). SHAREHOLDER’S EQUITY
* The excess of assets over liabilities; the residual claim of the shareholders on the assets of the organisation. Shareholder’s equity consists of two main elements: share capital and retained profits. * Share capital is the amount that owners have directly invested in the company * Retained profits represent the total cumulative profits that the company has retained in the business rather than distributed in dividends. * The equation assets = liabilities + owner’s equity shows that resources of an enterprise are funded by either debt or equity. The equation balances in every point in time. COMPARATIVE BALANCE SHEETS
* While the changes from year to year on the balance sheet provides readers with information about what is happening to various account balances, the statement does not account for the change. However, it is possible to obtain this information on the change in this account in the statement of cash flows.
INCOME STATEMENT
* In previous years, income statements were called profit and loss statements. * Provides information on an organisation’s profitability for a period of time, matching revenues during a period against expenses incurred in earning the revenue. The difference is the profit or loss. Remembering that under an accrual accounting system, the revenue or expense does not have to be received or paid for the revenue or expense to be recorded in the income statement. * From an e.g., the difference between sales revenue and the cost of goods sold in the gross profit/gross margin. * Income statement also lists various day-to-day operating expenses. Deducting operating expenses from gross profit gives operating profit before tax. Tax is then deducted to give operating profit after tax. * The profit figure can then either be paid out in dividends to shareholders or retained in the business. This is the connecting link between the balance sheet and the income statement. The opening balance of retained profits plus the profit for the year minus dividends equals the closing balance of retained profits as shown in the balance sheet. * Companies provide a separate statement or note to the accounts showing the change in retained profit for the year.
STATEMENT OF CASH FLOWS
* Because revenues reported usually do not equal cash collected and expenses do not equal cash paid, net profit is different from the change in cash for the period. * The statement of cash flows shows the changes during the period in one balance sheet, namely, the receipt and payment of cash. Accounting standards require companies to present this statement in their published financial statements. * Individual transactions are usually split into three categories: operating activities related to the provision of g/s, investing activities related to the acquisition and disposal of non-current assets including property, plant and equipment, and financing activities related to the changing size and composition of the financial structure of the entity including equity and certain borrowings. * The closing balance of the statement of cash flows is the figure shown under cash in the balance sheet.
1.7 RELATIONSHIPS BETWEEN THE FINANCIAL STATEMENTS
* The opening balance in the cash flow statement is obtained from the cash figure of year 1 on the balance sheet. We must then add the total net cash flows of this year to the opening balance to obtain the cash figure for year 2 for the balance sheet. * The net profit figure derived from the income statement is then added to the retained profits of year 1 from the balance sheet in the retained profits note. To obtain retained profits for year 2 in the balance sheet, dividends must then be deducted from this figure.
1.8 INFORMATION USE SCENARIOS
DEMANDS ON THE QUALITY OF FINANCIAL ACCOUNTING INFORMATION (ACCOUNTING PRINCIPLES) 1) The concept of relevance: if information is to assist users in making decisions about the allocation of scarce resources, it should help them make, confirm or correct predictions about the outcomes of past, present or future events. Timelessness refers to the need to provide relevant information in enough time for the decision to be made. 2) The criterion of reliability: financial statements should report the economic substance of events happening to the company, and the numbers should measure the events neutrally, neither overstating nor understating their impact. Reliable information will, without bias or undue error, faithfully represent those transactions and events that have occurred. 3) The criterion of materiality (significance): concerned with assessing whether omission, misstatement or non-disclosure of a piece of information would affect the decisions of users of the accounting reports. What is or what isn’t material is a matter of judgement. Usually, people judge materiality by considering the size of a possible error compared to the net profit or the total assets. The materiality judgement depends on any particular uses of information that are expected and on whether the error moves the profit to a loss or violates some loan condition. 4) GAAP (generally accepted accounting principles): to assure users that accepted accounting standards have been followed, the auditor’s report will contain the auditor’s opinion about whether or not the financial statement has complied with GAAP. GAAP does not mean one particular method has been followed, but rather, the company’s accounting methods and figures are appropriate to their circumstances. 5) Another criterion prudence: if there is uncertainty, assets, revenues and profit should not be overstated and liabilities, expenses and losses should not be understated. Prudence should involve being cautious, not deliberately biasing important numbers, although where prudence begins and ends is a matter of judgement. 6) Principle of disclosure: financial statements include large number of notes and account descriptions intended to make it clear to the reader which important accounting methods have been followed, and to provide supplementary information on debts, share capital, commitments, law suits and other things thought to be helpful, or necessary in understanding the statements. Disclosure beyond the accounting figures is becoming increasingly extensive. Companies disclose information to those such as taxation authorities, securities regulators and other parties such as a bank loan officer. 7) Principle of understandability: reports should be prepared having regard to the interests of users who are willing to exercise diligence in examining reports, and who possess the skills and ability to comprehend contemporary accounting practices. 8) Principle of comparability: financial statements have been prepared in a comparable way (across different time periods, and across similar companies). 9) Consistency: using the same accounting methods over time. Consistency does not mean that a company has to use the same accounting methods in all parts of the company. * The above ideas may be formalised by the framework put out by the Australian Accounting Standards Board (AASB). It lists 4 qualitative characteristics with subheadings in brackets that make information in financial reports useful to users: understandability, relevance (materiality), reliability (faithful representation, substance over form, neutrality, prudence and completeness), and comparability. * Faithful representation: the accounting information represents what really existed or happened. * Substance and form: transactions and events must be presented in accordance with their substance and economic reality, not merely the legal or technical requirements for reporting. * Neutrality: freedom from bias. The situation and presentation of information should not be made to achieve a predetermined result or outcome. * Prudence: a degree of caution in the exercise of judgements involved in making estimates. * Completeness: material information is not omitted, as this can be misleading.
TRADE-OFFS AMONG ACCOUNTING PRINCIPLES
* The criteria and principles mentioned above may not always fit well together. * Prudence is a bias that interferes with reliability.
* If one company that is likely to be compared with another company changes their accounting methods, the other company may match their accounting methods to theirs for the sake of comparability, however, there will be inconsistency with their own figures over time. * There is almost never a solution that produces the most reliable and timeliest, relevant accounting information. As time passes, reliability rises and timely relevance falls, so we must try to find a midpoint where there is enough of both, but not as much as we would like of either.
1.9 FINANCIAL STATEMENT ASSUMPTIONS
* Below are some basic assumptions underlying accounting practice and the preparation of financial statements. * Accrual basis: financial reports are prepared on the basis of accrual accounting; effects of transactions and other events are recognised as they occur. * Going concern: financial statements are prepared on the premise that the organisation will continue operations as a going concern in the foreseeable future. If this is not the case, it is necessary to report liquidation values of an organisation’s assets. * Accounting entity: the accounting entity is separate and distinguished from its owners. E.g. the accounting entity of a sole trader is differentiated from the financial affairs of the owner, and a company is a separate entity from its shareholders. This concept puts a boundary on the transactions that are to be recorded for any particular accounting entity, allowing the owner to evaluate the performance of the business. * Accounting period: Dividing the life of an organisation into equal periods to evaluate performance (profit or loss) for that period is known as the accounting period concept. The time periods are arbitrary, but most organisations report at least annually, with many companies preparing half-yearly and quarterly financial statements, with others doing so more frequently (monthly) for management purposes. * Monetary: accounting transactions need to be measured in a common denominator, which in Australian, is the Australian dollar, allowing comparisons across different time periods, and companies. This also assumes that the value of the monetary unit is constant over time, ignoring inflation. Transactions that are unable to be assigned a dollar amount are not included in the accounts. * Historical cost: assets are initially recorded at cost. Many assets such as inventory will still be recorded at cost in the balance sheet in subsequent periods although their value has increased. Some other assets such as property, plant and equipment can be revalued periodically. It is important to notes at what valuation the assets are being recorded in the balance sheet.
1.10 IS ACCOUNTING REALLY IMPORTANT?
* Used by management in making business decisions: accounting numbers have huge impacts on management decisions to contract and expand the business, which in turn affects employees, suppliers, contractors and the economy. E.g. Southcorp, Australia’s largest publicly traded winemaker, has signalled its willingness to close some of its vineyards, if it can’t make them profitable, as part of an ongoing asset review that has already seen the closure of several winemaking and distribution facilities. It has launched a detailed review of profitability of its vineyards, as it strives for a better return on capital employed. * Used by people such as shareholders for decision-making purposes: both good and bad accounting news often has a big impact on the share market * Used by boards in takeover battles: accounting numbers are used to decide which companies to make takeover offers for, to convince shareholders to accept the offer, and by defending boards to try to stop the takeover. * Used by bankers and other credit groups: bankers use accounting numbers to decide whether to lend, to determine the level of risk and often the interest to charge. Rating agencies such as Standard and Poor’s and Moody’s use accounting numbers to give their credit rating, which has impact on the interest rates companies have to pay. * Used by corporate boards in rewarding and removing executives: most executive compensation schemes include performance bonuses and accounting numbers are key components of these performance hurdles. * Used by unions and management in negotiating wage agreements: in pay disputes, both managers and unions often use accounting numbers to support their case. For example, the higher the profits, the more likely the pay increases. * Impact on the economy and employment
* Impact on the community and consumers: poor accounting numbers can lead to the discontinuing of community and customer services * Impact on workers: accounting numbers can lead to corporate failure, with resulting consequences for workers. * Legal Impact: False accounting reports can lead to major legal battles and accounting numbers can be used in compensation settlements. * Penalties for misleading accounting: recent corporate collapses involving misleading accounting reports have led to major penalties both in Australia and overseas.
1.11 PUBLIC SECTOR ISSUES
* There has been a move from cash accounting to accrual accounting in the three tiers of government. * Users including departmental managers, policy advisors, Members of Parliament etc., require information about departments and councils for the purposes of making and evaluating decisions regarding the allocation of scarce resources. They may use this information to determine, for e.g., whether a department is: achieving its objectives, operating economically and efficiently in achieving its objectives, using its resources for the purposes intended, worthy of continued support of their activities, and if so how much, and if they’re able to continue to provide g/s in the future. * Government departments and local government authorities are required to prepare financial reports including a balance sheet, income statement and statement of cash flows. * Governments are required to provide whole-of-government accounts. The financial reports of governments encompass the assets they control, the liabilities they have incurred and the related revenues and expenses. Users of these government reports include parliamentarians, the public, and providers of finance, media and other analysts. The financial reports also assist governments in discharging their obligation of financial accountability. * An increasingly important area of the public sector is the performance of government trading enterprises (GTEs). GTEs have become an increasing source of revenue, via dividends and taxation for both the State and Commonwealth governments. * Many GTEs have recently undergone reforms and structural changes including industry restructuring, improved accountability, commercialism and corporatisation, privatisation and pricing reforms. Accounting reports and the development of accounting performance measures have been necessary to ensure focus on these reforms.
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