Accounting and Finance Management for Non-Specialist (Custom Edition EBook) 9780655703204, 0655703209

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A CUSTOM EDITION

ACCOUNTING AND FINANCE MANAGEMENT FOR NON-SPECIALISTS

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ACCOUNTING AND FINANCE MANAGEMENT FOR NON-SPECIALISTS

Compiled by Dr Anton Jordaan

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A PEARSON AUSTRALIA CUSTOM BOOK

Accounting and Finance Management for Non-Specialists

Compiled by Dr Anton Jordaan Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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Pearson Australia 707 Collins Street Melbourne VIC 3008 Ph: 03 9811 2400 www.pearson.com.au Copyright © 2020 This Custom Book Edition, Pearson Australia (a division of Pearson Australia Group Pty Ltd) Copyright © 2019 by Pearson Australia for Financial Management: Principles and Applications by Titman, Martin, Keown and Martin Copyright © 2018 by Pearson Australia for Accounting for Non-Specialists by Peter Atrill & Eddie McLaney All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the written permission of the publisher. Project Management Team Leader: Production Manager: Education Consultant: Courseware Associate: Production Controller:

Jill Gillies Katie Young Leanne Lavelle Jessica Darnell Yoke Lian Yong

ISBN: 978 0 6557 0320 4

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How to use this custom book Welcome to Accounting and Finance Management for Non-Specialists. Your Course Coordinator has created this custom book by choosing content that meets the specific requirements of your course. The chapters in this custom book come from Accounting for Non-Specialists by Atrill and McLaney and Financial Management: Principles and Applications by Titman, Martin, Keown and Martin. This custom book contains the original page numbering of the source materials, with the chapters from Financial Management: Principles and Applications following the chapters from Accounting for Non-Specialists. We wish you well with your course and hope that you will find reading this text easy and enjoyable.

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CONTENTS How to use this custom book Chapters from Accounting for Non-Specialists Chapter 1 Introduction to accounting Chapter 2 Measuring and reporting financial position Chapter 3 Measuring and reporting financial performance Chapter 4 Introduction to limited companies Chapter 5 Regulatory framework for companies Chapter 6 Measuring and reporting cash flows Chapter 7 Corporate social responsibility and sustainability accounting Chapter 8 Analysis and interpretation of financial statements Chapter 9 Cost–volume–profit analysis and relevant costing Chapter 12 Capital investment decisions Chapter 13 The management of working capital Chapter 14 Financing the business

1 40 86 142 177 211 257 297 346 476 522 559

Chapters from Financial Management: Principles and Applications Chapter 1 Getting started—Principles of finance Chapter 4 Financial analysis—Sizing up firm performance Chapter 5 The time value of money—The basics Chapter 8 Risk and return—Capital market theory Chapter 11 Investment decision criteria Chapter 12 Analysing project cash flows Chapter 13 Risk analysis and project evaluation Chapter 14 The cost of capital Chapter 15 Analysis and impact of leverage Chapter 16 Capital-structure policy Chapter 18 Financial Forecasting and Planning Chapter 19 Working capital management Chapter 21 Corporate risk management

2 86 138 228 334 379 415 458 496 532 602 624 685

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Chapters from Accounting for Non-Specialists Chapter 1 Introduction to accounting Chapter 2 Measuring and reporting financial position Chapter 3 Measuring and reporting financial performance Chapter 4 Introduction to limited companies Chapter 5 Regulatory framework for companies Chapter 6 Measuring and reporting cash flows Chapter 7 Corporate social responsibility and sustainability accounting Chapter 8 Analysis and interpretation of financial statements Chapter 9 Cost–volume–profit analysis and relevant costing Chapter 12 Capital investment decisions Chapter 13 The management of working capital Chapter 14 Financing the business

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CHAPTER 1

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

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

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

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

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

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

People need economic information to help them make decisions and judgements about businesses. Whether we are talking about a business manager making decisions about the most appropriate level of production, a bank manager responding to a request from the business for a bank loan, or trade unionists deciding how much pay increase to seek for their members, accounting information should help them with their decision. In this opening chapter we begin by considering the roles of accounting. As we shall see, accounting can be a valuable tool in the decision-making, planning and control process. We shall identify those people who are VJGOCKPWUGTUQHCEEQWPVKPICPFƂPCPEKCNKPHQTOCVKQPCPFFKUEWUUVJGYC[UKPYJKEJVJKUKPHQTOCVKQPECP improve the quality of decisions that they make. In subsequent chapters, we develop this decision-making VJGOGD[EQPUKFGTKPIKPUQOGFGVCKNVJGMKPFUQHƂPCPEKCNTGRQTVUCPFOGVJQFUWUGFVQCKFFGEKUKQPOCMKPI 5KPEGVJKUDQQMKUOCKPN[EQPEGTPGFYKVJCEEQWPVKPICPFƂPCPEKCNFGEKUKQPOCMKPIHQTRTKXCVGUGEVQT businesses, we shall devote some time to examining the business environment. We shall, therefore, EQPUKFGTVJGMG[ƂPCPEKCNRWTRQUGQHCRTKXCVGUGEVQTDWUKPGUUVJGOCKPHQTOUQHDWUKPGUUGPVGTRTKUG and the ways in which a business may be structured, organised and managed. These are all important CUVJG[JGNRVQUJCRGVJGMKPFQHCEEQWPVKPICPFƂPCPEKCNKPHQTOCVKQPVJCVKURTQFWEGF Finally, we shall consider how business is changing and identify key issues regarding stakeholder interests, ethics and sustainability. These issues have considerable implications for the public perception of business, for businesses themselves, and for accountants and their measurement and reporting systems. Some of VJGUGKUUWGUCTGFKHƂEWNVCPFPQVGCUKN[TGUQNXGFDWVVJG[CTGKUUWGUVJCV[QWPGGFVQDGCYCTGQH

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

• • • •

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

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

• •

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

• •

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

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

All of these decisions will require you to collect information, much of which can be classified as economic. Economic information is largely quantitative. The typical economic decision involves choosing the best outcome for you, given that your resources are scarce. None of what has been said to date should imply that decisions are made solely on economic lines. Many decisions are based on things such as personal preference, family considerations, a sense of duty or aesthetics, with a few people even using the stars to assist! However, many decisions have a clear economic orientation, and accounting can help with these decisions. So what information do you need to keep your expenditure in line with income? You will probably need a clear understanding of your income, its amount and nature. You will also need to have a clear understanding of your spending patterns, and you will almost certainly need to differentiate between ongoing regular expenditure and one-off expenditure. Decisions to buy new things may be relatively easy, such as buying a new phone, which may well be bought out of normal spending. Decisions about major assets, such as the purchase of a home, will require much more careful information gathering and analysis. This analysis will probably include ideas around how the asset will be funded. Decisions regarding potential business ventures also require substantial data collection and analysis. Your future lifestyle is likely to be substantially influenced by the success or failure of a venture of this type. The analysis will need to contain information about markets and competition, as well as specifics regarding the particular business. Decisions regarding the possible purchase of new shares or bonds will require the collection of relevant data. In the case of shares, this will probably mean detailed information about the past performance of the company and estimates of its future prospects. Clearly, any decision that has an economic element will require substantial economic information. Basically, the role of the accounting system is to provide much of that information. The system cannot and does not attempt to cover all economic input, but essentially focuses on the collection, recording and reporting of key economic data as they relate to a particular individual or entity. Just what information is covered is the subject of this book. You may not be comfortable with numbers and quantified information. However, it is difficult for an entity to be successful without having someone who does understand and can communicate such information. So good luck with your studies.

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NATURE AND ROLE OF ACCOUNTING Accounting is concerned with the collection, analysis and communication of economic information.

Such information can be used as a tool of decision-making, planning and control. This is to say that accounting information is useful to those who need to make decisions and plans about businesses, and for those who need to control those businesses. Examples of the kind of decisions for which the managers of businesses may need accounting information include the following: • decisions to develop or terminate new products or services • decisions to change the price or quantity of existing products • decisions to borrow money to help finance the business • decisions relating to the scale of the business, and • decisions to change the methods of purchasing, production or distribution. You might spend a few moments reflecting on the implications of some of these. Some decisions have far-reaching consequences; for example, moves to take activities offshore have the potential to impact substantially on the business, its workforce, and the local and regional communities. Although managers working in a particular business are likely to be significant users of accounting information, they are by no means the only people who are likely to use accounting information about that particular business. People outside the business (whom we shall identify later) may need information to help make decisions such as whether to invest in the business—as owner or lender—whether to grant credit for goods provided, or whether to enter into a major contract with the particular business. It is generally recognised that accounting fulfils two distinct roles: a ‘stewardship’ role and a ‘decision-usefulness’ role. Traditionally, accounting focused more on providing a stewardship, or accountability, report on the status of transactions for the period; that is, what was the position at the beginning of the period, what happened during the period, and what the position was at the end of the period. More recently, accounting has been seen as a way of assisting a wide range of users to make informed choices about the allocation of scarce resources. Sometimes, the impression is given that the purpose of accounting is simply to prepare financial reports on a regular basis. While it is true that accountants do this kind of work, it does not represent an end in itself. The ultimate purpose of accountants’ work is to discharge the accountability function of management and to influence the decisions of those who use the information produced. This decision-making perspective of accounting is central to the theme of this book and shapes the way we deal with each chapter.

LO1 Explain the nature and role of accounting

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

Accounting as a service function Accounting can be seen as a form of service. Accountants provide financial information to their ‘clients’. These clients are the various users identified in the next main section of the chapter. The quality of the service provided will be determined by the extent to which it meets the information needs of the various user groups. To be useful to users, the information must possess certain qualities. In particular, it must be relevant and it must faithfully represent what it is supposed to represent. These two qualities, which are regarded as fundamental qualities, are covered in more detail below. • Relevance. Accounting information must be able to influence decisions—otherwise, there really is no point in producing it. To do this, it must be relevant to the prediction of future events (such as estimating next year’s profit) or to the confirmation of past events (such as establishing last year’s profit), or to both. By confirming past events, users can check on the accuracy of their earlier predictions. This can, in turn, help them to improve the ways in which they make predictions in the future. To be relevant, accounting information must cross a threshold of materiality. A key question to be asked is whether its omission or misrepresentation would alter the decisions that users make. If the answer is no, the information is not material. This means that it should

fundamental qualities These are the two most important qualities which underline the preparation of accounting reports; namely relevance and faithful representation. relevance A quality that states that, in order to be relevant, accounting information must DGCDNGVQKPƃWGPEGFGEKUKQPU materiality The quality of information which has the potential to alter the decisions that users make.

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

•

not be separately included within accounting reports, as it will merely clutter them up and, perhaps, interfere with the users’ ability to interpret them. All figures need to be included in the accounts: the question is whether a particular figure needs to be separately identified or whether it can be included elsewhere, under a more general heading. The threshold of materiality will vary from one business to the next. To identify the threshold, the nature of the information and the amounts involved must be considered within the context of the accounting reports of the particular business. Faithful representation. Accounting information should represent what it is supposed to represent. This means that it should be complete, by providing all of the information needed to understand what is being portrayed. It should also be neutral, which means that it should be presented and selected without bias. Finally, it should be free from error. This is not the same as saying that it must always be perfectly accurate; this is not really possible. Estimates may have to be made which eventually turn out to be inaccurate. It does mean, however, that there should be no errors in the way in which these estimates have been prepared and described. In practice, a piece of information may not perfectly represent these three aspects of faithful representation. It should try to do so, however, insofar as possible.

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

Further qualities

comparability A quality which helps users identify similarities and differences between items of information.

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

Where accounting information is both relevant and faithfully represented, there are other qualities that, if present, can enhance its usefulness. These are comparability, verifiability, timeliness and understandability. Each of these qualities is now considered. • Comparability. This quality helps users to identify similarities and differences between items of information. It may help them, for example, to identify changes in the business over time (such as the trend in sales revenue over the past five years). It may also help them to evaluate the performance of the business in relation to similar businesses. Comparability is enhanced by treating items that are basically the same in the same manner for accounting purposes. It is also enhanced by making clear the policies that have been adopted in measuring and presenting the information. • 8GTKƂCDKNKV[ This quality provides assurance to users that the accounting information provided faithfully represents what it is supposed to represent. Accounting information is verifiable where different, independent experts would be able to reach a consensus that it provides a faithful portrayal. Verifiable information tends to be supported by evidence. • Timeliness. Accounting information should be produced in time for users to make their decisions. A lack of timeliness will undermine the usefulness of the information. Normally, the later accounting information is produced, the less useful it becomes. • Understandability. Accounting information should be set out as clearly and concisely as possible. It should also be able to be understood by those at whom the information is aimed.

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

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

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Costs and benefits of accounting information Beside the characteristics described above, there is also a seventh key characteristic which is at least as important as any of these six. In theory, a particular piece of accounting information should be produced only if the cost of providing it is less than the benefits, or value, to be derived from its use. This cost–benefit issue will limit the amount of accounting information provided. In practice, however, these costs and benefits are difficult to assess. There are no easy answers to the problem of weighing costs and benefits. Although it is possible to apply some ‘science’ to the problem, a lot of subjective judgement is normally involved. The qualities, or characteristics, influencing the usefulness of accounting information, which have been discussed above, are summarised in Figure 1.1.

COST CONSTRAINT

Qualities

Fundamental

Enhancing

Faithful representation

Relevance

Predictive value

%QPƂTOCVQT[ value

Completeness

Neutrality

Freedom from error

Materiality threshold Comparability

Timeliness

8GTKƂCDKNKV[

Understandability

FIGURE 1.1 6JGEJCTCEVGTKUVKEUVJCVKPƃWGPEGVJGWUGHWNPGUUQHCEEQWPVKPIKPHQTOCVKQP Two fundamental qualities determine the usefulness of accounting information. In addition, four qualities enhance the usefulness of accounting KPHQTOCVKQP6JGDGPGƂVUQHRTQXKFKPIVJGKPHQTOCVKQPJQYGXGTUJQWNFQWVYGKIJVJGEQUVU

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

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Information KFGPVKƂECVKQP

Information TGEQTFKPI

Information analysis

Information TGRQTVKPI

FIGURE 1.2 6JGCEEQWPVKPIKPHQTOCVKQPU[UVGO 6JGƂIWTGUJQYUVJGHQWTUGSWGPVKCNUVCIGUQHCPCEEQWPVKPIKPHQTOCVKQPU[UVGO6JGƂTUVVYQUVCIGUCTGEQPEGTPGFYKVJRTGRCTCVKQPCPFVJG last two stages are concerned with using the information collected.

3 analysing and interpreting the information collected 4 reporting the information in a manner that suits the needs of users.

Given the decision-making emphasis of this text, we shall concentrate on the final two elements of the process—the analysis and reporting of financial information. We are concerned with how information is used by, and is useful to, decision-makers rather than with how it is collected and recorded.

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

Provide information to assist users’ decision-making Report on the status of transactions for the period 2TGRCTGƂPCPEKCNTGRQTVUQPCTGIWNCTDCUKU 2TQXKFGƂPCPEKCNKPHQTOCVKQPVQENKGPVU None of the above are true.

Concept check 2 The two most important qualities for accounting information are: A B C D E

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

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

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

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

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

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

FIGURE 1.3 Owners

Customers

Competitors

Employees and their representatives

Managers

Business organisation Lenders

Suppliers

/CKPWUGTUQHƂPCPEKCNKPHQTOCVKQPTGNCVKPIVQC DWUKPGUUQTICPKUCVKQP 6JGƂIWTGUJQYUVJCVUGXGTCNWUGTITQWRUJCXGCPKPVGTGUV KPVJGƂPCPEKCNKPHQTOCVKQPTGNCVKPIVQCDWUKPGUU organisation. Most of them are outside the business but, nevertheless, have a stake in it. This is not meant to be an exhaustive list of potential users, but the user groups KFGPVKƂGFJGTGCTGPQTOCNN[VJGOQUVKORQTVCPV

Government

Investment analysts

Community representatives

Activity 1.2 illustrates that each user group looks at the business from a different perspective and has its own particular interest. Inevitably there will be occasions when these perspectives and interests may clash. One of the more likely causes relates to the way in which the wealth of the business is generated and distributed. Recent years have seen considerable debate as to the salary level of management teams, especially that of the chief executive officer (CEO). High bonus payments in a year in which performance has not been judged to be good do not sit well with investors. Another area of potential conflict is likely to be between investors and lenders, with lenders wishing to be sure that the money lent has been invested appropriately and with due regard to their interests, while borrowers are likely to want to be able to have maximum flexibility. Stakeholder theory uses a similar approach to that set out above, but additionally provides some useful insights into just what makes a successful business, and illustrates how the various user groups can interact. User groups can clearly be thought of as stakeholders in a business. Stakeholder theory was effectively introduced by R. Edward Freeman in 1984 in his book, Strategic Management: A Stakeholder Approach. Freeman’s main point was that, at that time, business pretty much saw managerial self-interest and shareholder profit as the driving force of business. Freeman argued that this wasn’t the view of the people who actually did business. They had other

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

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motivations and responded to other people—employees, customers, suppliers, regulators, industry bodies, trade unions, community groups—which Freeman called stakeholders. We shall come back to stakeholder theory later in the chapter.

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

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

Concept check 5 Stakeholder theory: A B C D E

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

FINANCIAL AND MANAGEMENT ACCOUNTING LO3 Compare and contrast financial and management accounting

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

In providing information for the various user groups identified, accounting has divided into two main areas: management accounting and financial accounting. Management accounting, as the name suggests, is concerned with providing managers with the information they require for the day-to-day running of the organisation. Financial accounting is concerned with providing the other users with useful information. The main differences between the two types of accounting reflect the range of recipients, as follows: • Nature of the reports produced. Financial accounting tends to produce general-purpose financial reports; that is, they contain financial information that will be useful for a broad range of users and decisions. Management accounting reports, on the other hand, are often specific-purpose reports, designed either a particular decision or manager in mind. • Level of detail. Financial accounting reports provide users with a broad overview of the position, performance and cash flows of the business for a period. As a result, information is aggregated and detail is often lost. Management accounting reports, however, often provide managers with considerable detail to help them with a particular decision. • Restrictions. Financial reporting for many businesses is subject to legal and accounting regulations that seek to ensure that specified content is presented in a fairly standard form. Because management accounting reports are for internal use only, there are no restrictions on the form and content of the reports. • Reporting interval. For most businesses, financial accounting reports are produced on an annual basis. However, large companies may produce half-yearly reports and a few produce quarterly reports. Management accounting reports may be produced as frequently as required by managers. In many businesses, managers are provided with certain weekly or monthly reports to allow them to check progress on a regular basis. In addition, special-purpose reports will be prepared when required (e.g. to evaluate a proposal for a piece of equipment).

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• Time horizon. Financial accounting reports reflect the performance and position of the

•

business to date. In essence, they are backward-looking. Management accounting reports, on the other hand, often provide information on expected future performances as well as past performance. It is an oversimplification, however, to suggest that financial accounting reports never incorporate expectations concerning the future. Occasionally, businesses will release forecast information to other users in order to raise capital or to fight off unwanted takeover bids. Even preparation of the routine financial reports typically requires making some judgements about the future, as we shall see in Chapter 3. Range of information. Financial accounting reports concentrate on information that can be quantified in monetary terms. Management accounting produces such reports, too, but is also more likely to produce additional reports on non-financial matters, such as measures of physical quantities of inventory (stocks) and output. Financial accounting places greater emphasis on objective, verifiable evidence when preparing reports. Management accounting reports intended for managers may use information that is less objective and verifiable, but which nevertheless provides managers with the information they need. So the basic accounting statements will be used historically by the financial accountant, where the emphasis is on information which is as reliable and as objective as possible, whereas the management accountant may well use the same format to assist in some decisions, but will inevitably also use estimates which are clearly less reliable. This does not detract from the usefulness of the forecasts.

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

ACTIVITY 1.3 Can you think of any areas of overlap between the information needs of managers and those of other users? (Hint: Think about the time orientation and the level of detail of accounting information.)

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

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

D E

Financial accounting provides greater detail than management accounting. /CPCIGOGPVCEEQWPVKPIKUUWDLGEVVQVJGUCOGUVCPFCTFUCUƂPCPEKCNCEEQWPVKPI 6JGƂPCPEKCNCEEQWPVCPVECPRNCPVJGKTCPPWCNVYQYGGMXCECVKQPOQTGTGNKCDN[VJCP the management accountant. Financial accounting is forward-looking. None of the above.

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Concept check 7 Which of the following is false? A

B

C

D E

/CPCIGOGPVCEEQWPVKPIRTQXKFGUOQTGUEQRGHQTETGCVKXKV[VJCPƂPCPEKCN accounting. 6JGTGCTGOQTGTWNGUVQHQNNQYKPƂPCPEKCNCEEQWPVKPIVJCPKPOCPCIGOGPV accounting. Management accounting reports tend to provide a wider range of information than that RTQXKFGFD[ƂPCPEKCNCEEQWPVKPI All of the above are false. None of the above are false.

WHAT IS THE FINANCIAL OBJECTIVE OF A BUSINESS? LO4 Identify the main purpose of a business (while recognising a range of other influences), and explain the traditional risk– return relationship

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

Stakeholder theory Stakeholder theory was introduced in the section on users of accounting information, but the theory now goes way beyond what users might need from accounting. Freeman has been developing his theory for the last 30 years. A sense of his current thinking is summarised in Real World 1.2. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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REAL WORLD 1.1 Short-term gains, long-term problems For many years, under the guise of defending capitalism, we have been allowing ourselves to degrade it. We have been poisoning the well from which we have drawn wealth. We have misunderstood the importance of values to capitalism. We have surrendered to the idea that success is pursued by making as much money as the law allowed without regard to how it was made. Thirty years ago, retailers would be quite content to source the shoes they wanted to sell as cheaply as possible. The working conditions of those who produced them was not their concern. Then headlines and protests developed. Society started to hold them responsible for previously invisible working conditions. Companies like Nike went through a transformation. They realised they were polluting their brand. Global sourcing became visible. It was no longer viable to define success simply in terms of buying at the lowest price and selling at the highest. Financial services and investment are today where footwear was thirty years ago. Public anger at the crisis will make visible what was previously hidden. Take the building up of huge portfolios of loans to poor people on US trailer parks. These loans were authorised without proper scrutiny of the circumstances of the borrowers. Somebody else then deemed them fit to be securitised and so on through credit default swaps and the rest without anyone seeing the transaction in terms of its ultimate human origin. Each of the decision makers thought it okay to act like the thoughtless footwear buyer of the 1970s. The price was attractive. There was money to make on the deal. Was it

responsible? Irrelevant. It was legal, and others were making money that way. And the consequences for the banking system if everybody did it? Not our problem. The consumer has had a profound shock. Surely we could have expected the clever and wise people who invested our money to be better at risk management than they have shown themselves to be in the present crisis? How could they have been so gullible in not challenging the bankers whose lending proved so flaky? How could they have believed that the levels of bonuses that were, at least in part, coming out of their savings could have been justified in ‘incentivising’ a better performance? How could they have believed that a ‘better’ performance would be one that is achieved for one bank without regard to its effect on the whole banking system? Where was the stewardship from those exercising investment on their behalf? The answer has been that very few of them do exercise that stewardship. Most have stood back and said it doesn’t really pay them to do so. The failure of stewardship comes from the same mindset that created the irresponsible lending in the first place. We are back to the mindset that has allowed us to poison the well: never mind the health of the system as a whole, I’m making money out of it at the moment. Responsibility means awareness for the system consequences of our actions. It is not a luxury. It is the cornerstone of prudence. Source: Extract from Goyder, M. (2009) ‘How we’ve poisoned the well of wealth’, Financial Times, 15 February. © The Financial Times Limited 2009. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

REAL WORLD 1.2 Stakeholder theory—current thinking As we saw earlier, Freeman argued strongly that managerial self-interest and shareholder profits, which he described as ‘the old story’, were not the driving force of business. He felt that people were interested in, and motivated by, far more than profit, and that all of their interests needed to be given appropriate recognition. Of course, profits were part of the story, but profits were seen as the outcome rather than the aim. So, what makes a successful business? Obvious elements include good products or services, a good and committed workforce, reliable suppliers who provide goods and services at the right quality, and a good relationship with the community at large. Freeman now talks about working to ‘harmonise’ the various stakeholders’ interests. There will of course be some

conflict between some stakeholders, but such conflict should be seen as an opportunity to value-create. Value is perceived by Freeman as much broader than simply financial value. He believes ‘we create value when we do things that people find valuable’. The traditional approach is reasonably easily associated with measurement. Most businesses know how to measure customer satisfaction and whether they are creating value for their customers. Other areas, such as value for employees and the community, are less commonly addressed—and these need to be worked on. Source: Eva Tsahuridu & David Walker, ‘R. Edward Freeman—The Stakeholder Revolutionary’, InTheBlack, 1 April 2015.

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It is recommended that you read the entire article. Clearly stakeholder theory has had considerable influence over time, but whether accounting is doing enough in this area remains debatable. What is not in doubt is that social and environmental accounting has become much more important in assessing performance. Freeman believes that the way in which these have been ‘bolted on’ to the old business model of financial accounting suggests that there is a long way to go. We shall see in Chapter 7 just how many improvements have been made in reporting on social and environmental aspects and impacts, more commonly now called sustainability reporting or integrated reporting. There also remains scope for considerably more work to be carried out to deal with some of the issues implicit in Freeman’s theory. Just how easy it will be to find appropriate ways of dealing with the issues he raises remains to be seen.

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

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

FIGURE 1.4

Return

4GNCVKQPUJKRDGVYGGPTKUMCPFTGVWTP Even at zero risk, a certain level of return will be required. This will increase as the level of risk increases.

0

Risk

ACTIVITY 1.4 Look at Figure 1.4 above and state, in broad terms, where an investment in: (a) a government savings account, and (b) a lottery ticket should be placed on the risk–return line.

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

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

Provision of good working conditions for employees Conservation of the environment 'CTPKPIQHRTQƂVUKPVJGUJQTVVGTO Enhancement of the wealth of its owners The need to be an industry leader.

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

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

THE MAIN FINANCIAL REPORTS—AN OVERVIEW

Financial accounting Financial accounting grew from the old idea of stewardship accounting where stewards (managers/ representatives) gave an accounting of how they had fulfilled their responsibilities. When you remember that this was happening throughout the Industrial Revolution, you should realise that these statements were all about wealth. There was little concern about staff (workers), social issues or the environment. Human rights was not a term even thought about, other than as it related to the bosses! Times have changed, as we shall see as we progress through the book. However, the need for basic financial statements remains. A very simple illustration is given next. You will find that the rules and regulations surrounding these statements have become more rigorous as time has passed and business has become more complicated. The main financial statements are designed to provide a picture of the overall financial position and performance of the business. To do this, the accounting system normally produces three main financial reports on a recurring basis. These financial statements are concerned with answering the following questions: • What cash movements (i.e. cash in and cash out) took place over a particular period? • How much did wealth increase over a particular period as a result of operating and other activities? In other words, how much profit did the business generate from its overall activities? • What is the financial position of the business at the end of a particular period? These questions are all addressed by the three main financial reports listed below: 1 the UVCVGOGPVQHECUJƃQYU for the period 2 the UVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG for the period, commonly known as the income statement. It is often also referred to as the RTQƂVCPFNQUUUVCVGOGPV, especially when used internally in a business. For limited companies, the annual published statement is now called a statement of comprehensive income, and formats and requirements will be dealt with in Chapters 3 and 5.

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

statement of cash flows The statement that shows the sources and uses of cash for a period. statement of financial performance/income statement The statement which measures and reports how OWEJYGCNVJ RTQƂVJCU been generated in a period. statement of comprehensive income A statement that presents all items of income and expense recognised in a period, either in a single statement of comprehensive income, or KPVYQUVCVGOGPVUVJGƂTUV being a statement displaying EQORQPGPVUQHRTQƂVCPFNQUU

PQTOCNKPEQOGUVCVGOGPV and a second which begins YKVJRTQƂVQTNQUUCPF displays components of other comprehensive income. From January 2018 the twostatement approach will need VQDGOQFKƂGFVQCVYQ section approach, with the income statement preceding the other comprehensive income section. statement of financial position A statement that shows the assets of a business and the claim on those assets at a point in time. balance sheet A statement that shows the assets of a business and the claims on the business. Assets must always equal claims. Claims will relate to external liabilities and owner’s claims

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statement of changes in equity The statement that shows all changes in the owners’ interest in the net assets of the business as a result of transactions and events during a period. This includes total comprehensive income for the period, KPENWFKPIRTQƂVQTNQUUCPF transactions with owners in their capacity as owners, showing contributions by and distributions to owners. equity The share of the business which represents the owners’ interests.

1.1

3 the UVCVGOGPVQHƂPCPEKCNRQUKVKQP as at the end of the period, commonly known as the balance sheet.

In due course we will also introduce a fourth statement, the statement of changes in equity, but this statement is really only important for limited companies and we will leave discussion until the appropriate later chapter. Basically, equity is the term used to indicate the share of the business which represents the owners’ interests. Taken together, the three main statements provide an overall picture of the financial health of the business. Perhaps the best way to introduce the financial reports is to look at an example of a very simple business. From this we shall be able to see what sort of useful information each of the statements can provide. We can see from the financial reports in Example 1.1 that each provides part of the picture of the financial performance and position of the business. We begin by showing the cash movements. Cash is vital for any business to function effectively: to meet obligations, to acquire other resources (such as stock/inventory), to satisfy operating expenses, and to meet ownership distributions. Cash has been described as the ‘life blood’ of a business, and movements in cash are usually given close scrutiny by users of financial statements.

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1.1 continued

It is clear that reporting cash movements alone would not be enough to portray the financial health of the business. The changes in cash over time do not fully reveal the profit generated. The statement of financial performance provides an insight into this aspect of performance. For day 1, for example, we saw that the cash balance increased by $60 but the profit generated, as shown in the statement of financial performance, was $210. The increase in wealth ($210) was represented by $60 cash and $150 in the form of stock (inventory). To determine the total wealth of the business, a statement of financial position is drawn up at the end of the day. Cash is only one form in which wealth can be held. In the case of this business, wealth is also held in the form of inventory (stock of goods for resale). Drawing up the statement of financial position involves listing both forms of wealth held. In the case of a large business, there may be many other forms of holding wealth, such as land and buildings, equipment and motor vehicles. Let us now continue with our example. 1PVJGUGEQPFFC[QHVTCFKPI2CWNRWTEJCUGFOQTGYTCRRKPIRCRGTHQTECUJ*GOCPCIGFVQUGNN CNNVJGPGYYTCRRKPIRCRGTCPFJCNHQHVJGGCTNKGTUVQEMHQTCVQVCNQH 6JGUVCVGOGPVQHECUJƃQYUQPFC[KUCUHQNNQYU $ 5VCVGOGPVQHECUJƃQYUHQTFC[ 1RGPKPIDCNCPEG KGENQUKPIDCNCPEGHTQOFC[ 5CNGQHYTCRRKPIRCRGT 2WTEJCUGQHYTCRRKPIRCRGT %NQUKPIDCNCPEG

        

1.1 continued

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

The solution to Activity 1.5 shows that the total business wealth increased by $52.50 (i.e. the amount of the day’s profit) even though the cash balance declined. This is due to the fact that the business is holding more of its wealth in the form of inventory rather than cash, compared with at the end of day 2. Note that the statement of financial performance and the statement of cash flows are both concerned with measuring flows (of wealth and cash, respectively) over time. The period of time may be one day, one month, one year, etc. The statement of financial position (balance sheet), however, is concerned with the financial position (or wealth) at a particular moment in time (the end of one day, one week, etc). Figure 1.5 illustrates this point. The statement of financial performance, statement of cash flows and statement of financial position, when taken together, are often referred to as the ‘final accounts’ of the business.

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For external users of the accounts, these reports are normally backward-looking and are based on records of past events and transactions. This can be useful as feedback on past performance and for identifying trends and clues to future performance. However, the reports can also be prepared using projected data in order to help assess likely future profits, cash flows, etc. The financial reports are normally prepared on a projected basis for internal decision-making purposes only. Managers are usually reluctant to publish these projected figures for external users.

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Nevertheless, as external users have to make decisions about the future, projected financial reports prepared by managers are likely to be useful for this purpose. Managers are, after all, in a good position to assess future performance, and so their assessments are likely to provide valuable information. In certain circumstances, such as raising fresh capital or resisting a hostile takeover bid, managers are prepared to depart from normal practice and issue projected figures to external users. Where publication does occur, some independent verification of the assumptions underlying the forecasts is often provided by a firm of accountants to lend credibility to the figures produced.

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

Concept check 10 6JGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEGKUCNUQMPQYPCU A B C D E

5VCVGOGPVQHƂPCPEKCNRQUKVKQP The income statement 6JGRTQƂVCPFNQUUUVCVGOGPV The balance sheet Statement of comprehensive income.

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

The statement of changes in equity The balance sheet 6JGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG The statement of comprehensive income 6JGUVCVGOGPVQHECUJƃQYU

Concept check 12 9JKEJƂPCPEKCNUVCVGOGPVUCTGXKFGQUTCVJGTVJCPUPCRUJQVU! A B C D E

Income statement and balance sheet 5VCVGOGPVQHECUJƃQYUCPFUVCVGOGPVQHƂPCPEKCNRQUKVKQP $CNCPEGUJGGVCPFUVCVGOGPVQHECUJƃQYU 5VCVGOGPVQHƂPCPEKCNRGTHQTOCPEGCPFUVCVGOGPVQHECUJƃQYU None of the above.

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SELF-ASSESSMENT QUESTION

1.1

While on holiday on the Gold Coast, Helen had her credit cards and purse stolen from a beach where she was swimming. She was left with only $120, which she had left in her hotel room. There were three days of her holiday remaining. She was determined to continue her holiday and so decided to make some money in order to be able to complete her holiday. She decided to sell orange juice to holiday-makers on the local beach. On day 1 she purchased 80 cartons of orange juice at $1.50 each for cash, and sold 70 of these for $2.40 each. On the following day she RWTEJCUGFECTVQPUHQTECUJCPFUQNFCVGCEJ1PVJGVJKTFCPFƂPCNFC[UJGRWTEJCUGFCPQVJGTECTVQPU for cash. However, it rained and, as a result, business was poor. She managed to sell 20 at $2.40 each, but was forced to sell the rest of her stock at $1.20 each. 2TGRCTGCUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG KPEQOGUVCVGOGPVCPFCUVCVGOGPVQHECUJƃQYUHQTGCEJFC[oU VTCFKPICPFCUVCVGOGPVQHƂPCPEKCNRQUKVKQPCVVJGGPFQHGCEJFC[oUVTCFKPI

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

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

What kinds of business ownership exist? The particular form of business ownership has important implications for accounting purposes, and so it is useful to be clear about the main forms of ownership that can arise. There are basically three arrangements: • sole proprietorship (also known as sole trader) • partnership, and • limited company. We shall now consider the first two in reasonable detail, and limited companies in outline. Chapters 4 and 5 will provide more detail for limited companies.

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

Sole proprietorship (also known as sole trader), as the name suggests, is where an individual is the sole owner (known as the proprietor) of a business. This type of business is often quite small in terms of total income or profits, or number of employees. However, the number of businesses that operate as sole proprietors is very large, far greater than the number of businesses that operate as companies. Examples of sole proprietor businesses can be found in most sectors, but the service sector predominates. Hence, services such as electrical repairs, plumbing, picture framing, photography, driving instruction, retail shops and hotels have a large proportion of sole proprietor businesses. A sole proprietor business is easy to set up, with no formal procedures being required. Operations can generally commence immediately (unless special permission is required because of the nature of the trade or service, such as running licensed premises). The owner has considerable discretion as to how the business is to be conducted, and is able to restructure or dissolve the business whenever it suits. A sole proprietorship has no separate legal identity. From a legal perspective there is no distinction between the owner (Bill Bloggs) and the business (Bill’s Diner). However, from an accounting perspective we distinguish clearly between the owner (Bill Bloggs) and the business (Bill’s Diner). The accounting entity (Bill’s Diner) will recognise transactions between the owner (Bill Bloggs) and the business. These transactions concern capital (funds) contributed to the business by the owner, profit

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earned by the business and not distributed to the owner, and distributions to the owner. Distributions to the owner, which are often labelled ‘drawings’, may be any of the following: • cash taken out of the business on a regular (weekly) or irregular basis • other assets taken out of the business for personal consumption or use (e.g. merchandise or equipment) • personal accounts paid by the business (e.g. insurance, rent, electricity) • personal benefits derived from business assets (e.g. accommodation, use of motor vehicle). Another consequence of the fact that the law does not recognise the sole proprietor business as being separate from the owner is that the business will cease on the death of the owner. A sole proprietor has unlimited liability, and no distinction is made between the proprietor’s personal wealth and that of the business if there are business debts to be paid. The important characteristics of the sole proprietorship entity structure from the perspective of both the owner and other people or other entities dealing with this business are summarised in Table 1.1.

TABLE 1.1 CHARACTERISTICS OF A SOLE PROPRIETORSHIP 0QUGRCTCVGNGICNGPVKV[ While the business is a separate accounting (recording/reporting) entity, it is not a separate legal entity. It cannot enter into contractual arrangements (borrow, lend, purchase, sell, sue or be sued) in its own right; rather, the legal owner must negotiate such contracts. .KOKVGFNKHG The sole proprietorship structure has a limited life. The life of the business is restricted to the period in which the owner continues in that position. This does not mean that the activity of the business necessarily stops when the owner dies, retires or leaves the business, but that sole proprietorship business ceases and possibly another commences (e.g. new owner, new name). 7PNKOKVGFNKCDKNKV[ The owner of a sole proprietorship has unlimited liability with respect to the activities of the business. That is, he or she is fully responsible for the obligations and debts of the business. /KPKOWOTGRQTVKPITGIWNCVKQPU4GIWNCVKQPUHQTƂPCPEKCNTGEQTFKPICPFTGRQTVKPICTGOKPKOCNEQORCTGFYKVJVJQUGHQTQVJGTGPVKV[ structures. However, the introduction of the Goods and Services Tax (GST) has increased the requirement for regular detailed reports. .KOKVGFCEEGUUVQHWPFU Access to funds is potentially limited. With a sole proprietorship, the ownership funding is restricted to the personal resources of a single owner. Additionally, certain forms of borrowing are not available to sole proprietors that may be available to companies, and lenders may be more reluctant to provide credit or funds to sole proprietorships. 6JGEQUVUVQGUVCDNKUJCUQNGRTQRTKGVQTUJKRUVTWEVWTGCTGPQTOCNN[OWEJNQYGTVJCPHQTQVJGTGPVKV[UVTWEVWTGU By costs we are referring to those involved in setting up the business entity, not the costs to make the business operational (e.g. the necessary resources, property, plant, equipment, inventories, staff and other expenditure).

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

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• ownership and management are normally combined • the financial rewards flow directly to the owner • timely decision-making is possible. Potential disadvantages of the sole proprietorship structure when compared to other structures include: • the liability of the owner is unlimited, and personal assets may have to be used to satisfy business debts access to ownership funds is restricted to the personal resources of the proprietor • • experience and knowledge is limited to the extent that the sole owner is frequently the sole manager • access to non-ownership funding (suppliers of goods and services on credit, external loans) is often limited.

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

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

TABLE 1.2 CHARACTERISTICS OF A PARTNERSHIP 0QUGRCTCVGNGICNGPVKV[ While the partnership is a separate accounting entity, there is no legal distinction between the business and the partners. As with a sole proprietorship, it is the partners, not the partnership, who enter into all contractual arrangements (e.g. borrow, lend, buy, sell, employ, dismiss, sue, be sued). .KOKVGFNKHG The partnership has a limited life, as each time there is a change in ownership (partners leave, new partners are introduced), the current partnership concludes and a new partnership commences. 7PNKOKVGFNKCDKNKV[ The liability of partners jointly and separately is unlimited with respect to the debts of the business. This means that each partner’s personal assets can be called upon to satisfy the claims of business creditors, well beyond the amount of the individual partner’s share of the business. /WVWCNCIGPE[ Each partner is responsible for the business actions of all other partners as if they had taken the action themselves. %QQYPGTUJKRQHCUUGVU The partnership assets are owned by the partners in aggregate rather than individually. %QQYPGTUJKRQHRTQƂVU6JGRCTVPGTUJKRRTQƂVUDGNQPIVQVJGRCTVPGTUGSWCNN[QTKPQVJGTYKUGCITGGFRTQRQTVKQPU .KOKVGFOGODGTUJKR There are certain restrictions on how many partners can belong to a partnership entity structure. While this is normally limited to 20, there are some exceptions in certain professions (e.g. accounting practices). Given the expanded number of owners, the access to ownership funds is normally much greater than for a sole proprietorship. +PETGCUGFTGIWNCVKQP Most states have Partnership Acts which provide direction for the activities of partnerships and the rights and responsibilities of partners.

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It is worth noting that, because of the fact that a partnership is not a separate legal entity, the partnership will pay no tax. The partnership profit or loss will be distributed to each partner, who will then include it in his or her tax return (just like a sole trader). The potential advantages of partnerships might include the following: • there would normally be greater access to capital since there are two or more owners • the partners normally bring different skills to the partnership (professional, administrative, technical) • greater management flexibility is gained by having more than one owner • taxation advantages often arise when the partnership income can be spread among the partners; this applies particularly to ‘husband and wife’ activities. When considering the potential disadvantages of partnerships, it is important to identify the entity structure with which the partnership is being compared. In comparison with a sole proprietorship, the disadvantages could include: • a higher level of regulation • giving up profit share to other owners (co-ownership) • giving up individual asset ownership (co-ownership) • reduced decision-making authority (shared management) • mutual agency imposes extra responsibility for the business actions of other partners. In comparison with a limited company, the disadvantages could include: • a limited life may affect long-term planning • unlimited liability creates greater risk for ownership investment • absence of a specialist management team • mutual agency imposes extra responsibility for the business actions of the partners • access to both ownership funds and debt funds is limited. While not legally necessary, it is sensible for partners to have a formal and detailed partnership agreement in order to avoid the problems that invariably arise over the operation of the partnership and the relations between partners. When problems between partners cannot be resolved without recourse to the law, the requirements of the relevant Partnership Act will apply. On the distribution of partnership profit, most Partnership Acts indicate the following: • partners are not entitled to a ‘salary or wage equivalent’ related to their input (physical or mental) into the business operations • partners are not entitled to an ‘interest equivalent’ on the capital contributions they make to the business • the profit or loss is to be divided equally among the partners. However, these rules apply only in the absence of an agreement. Partners can (and should) agree to share profits in any way they choose, including payment of interest on capital and the equivalent of a wage to partners. With regard to the accounting requirements of a partnership, the only major difference between this and a sole proprietorship is that there is more than one owner. This means that the income figure will need to be divided between the partners as will the calculation of owners’ wealth (equity). Typically, the partnership maintains individual records of each partner’s transactions with the partnership, as follows: • resource contributions (capital) • resource withdrawals (drawings) • share of undistributed profits (either current or retained earnings—earnings made in earlier periods but not withdrawn by the owners).

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

share of the company. Hence the owners of a limited company are often known as ‘shareholders’. Limited companies can range in size from quite small to very large. The number of individuals who

limited company #PCTVKƂEKCNNGICNGPVKV[ which has an identity separate from that of those who own and manage it.

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limited liability The situation in which an investor in a business (a NKOKVGFEQORCP[JCUJKU or her liability limited to a OCZKOWOURGEKƂGFCOQWPV namely, the maximum that he or she has agreed to subscribe to the business. Australian Securities and Investments Commission (ASIC) The government body responsible for regulating companies, company borrowings, and investment advisers and dealers. audit A process in which a range of activities are checked to ensure that the activities have been completed in accordance with a set of rules or guidelines.

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

invest in the company and become part-owners (known as ‘subscribing capital’) may be unlimited, which provides the opportunity to create a very large-scale business, although many are quite small. The liability of owners, however, is limited (hence ‘limited’ company), which means that those individuals subscribing capital to the company are liable only for debts incurred by the company up to the amount that they have agreed to invest. This cap on the liability of the owners is designed to limit risk and to produce greater confidence to invest. Without such limits on owner liability, it is difficult to see how a modern capitalist economy could operate. In many cases, the owners of a limited company are not involved in the day-to-day running of the business and will, therefore, invest in a business only if there is a clear limit set on the level of investment risk. The benefit of limited liability, however, imposes certain obligations on such companies. To start up a limited company an application must be made to the Australian Securities and Investments Commission (ASIC) for registration of the company, and every person who agrees to be a shareholder, director or company secretary must register. The company will be allocated an Australian Company Number, which acts as an identifier. The company must also register for an ABN, a number which assists in transactions relating to various aspects of taxation. The Corporations Act, which covers most companies, provides a framework for company procedures and the way in which companies conduct their affairs, including the accounting and reporting requirements. Part of this regulatory framework requires annual financial reports to be made available to owners and lenders, and usually an annual general meeting of the owners has to be held to approve the reports. In addition, a copy of the annual financial reports must be lodged with the ASIC for public inspection. In this way, the financial affairs of a limited company enter the public domain. With the exception of small proprietary companies, there is also a requirement for the annual financial reports to be subject to an audit. This involves an independent firm of accountants examining the annual reports and underlying records to see whether the reports provide a true and fair view of the financial health of the company, and whether they comply with the relevant accounting rules established by law and by accounting rule-makers. Limited companies are considered in more detail in Chapters 4 and 5. All of the large household-name Australian businesses (BHP Billiton, Woolworths, Telstra, IAG and so on) are limited companies. This book concentrates on the accounting aspects of limited liability companies, because this type of business is by far the most important in economic terms. However, there are a number of complications associated with limited companies that do not exist with sole proprietorships or partnerships. Some of these relate to the structure of limited companies, and some relate to the increased regulation associated with companies. The next two chapters will introduce you to the basic accounting concepts with reference to sole proprietorships and partnerships, together with some very simple company structures. Once we have dealt with the basic accounting principles, which are the same for all three types of business, we can then go on to see how they are applied in more detail to limited companies. It must be emphasised that there are no differences in principle in the way these three forms of business keep their day-to-day accounting records. However, in preparing their periodic financial statements, there are certain differences that need to be considered. These differences are not ones of principle, however, but of detail. Nearly all businesses that involve more than a few owners and/or employees are set up as limited companies. Finance will come from the owners (shareholders) in the form of a cash investment in the company or by leaving in the business profits to which they are entitled. Finance can also come from lenders who earn interest on the amount lent to the business, or from suppliers who provide goods on credit. Credit means that goods and services are provided with a payment date agreed for some time in the future (typically one to three months). In larger limited companies, the owners (shareholders) tend not to be involved in the daily running of the business. They appoint a board of directors to manage the business on their behalf. The board is charged with three major tasks: 1 setting the overall direction and strategy for the business 2 monitoring and controlling the activities of the business, and 3 communicating with shareholders and others connected with the business.

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Each board has a chairman, elected by the directors, who is responsible for running the board in an efficient manner. In addition, each board has a chief executive officer (CEO) (sometimes referred to as the ‘managing director’) who is responsible for running the business on a day-to-day basis. Occasionally, the roles of chairman and CEO are combined, although it is usually considered to be a good idea to separate them in order to prevent a single individual having excessive power. The board of directors represents the most senior level of management. Below this level, managers are employed, with each manager typically being given responsibility for a particular part of the business’s operations. Just how a particular business organises its operations is up to the board. Possibilities include: • the splitting up into separate departments, often on functional lines (e.g production, finishing, distribution, marketing, personnel and finance) • running the business on geographical lines, or • any number of combinations of these and others. The implications of complicated organisations of this type are considerable for both the user and the accountant. There is a need to consider just how best to provide relevant information to help in the management process, and management accounting reports will be appropriately detailed. In the area of financial accounting we need to consider how to best provide general-purpose accounting information that provides relevant information to assess performance of the business.

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

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

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

Steps in the planning process Planning is usually broken down into three stages: 1 Setting the objectives or mission of the business. This is what the particular business is basically trying to achieve. The objectives are likely to reflect the attitudes of owners (shareholders) and managers. They tend to be framed in broad, generalised, non-numerical terms. Once the objectives have been established, they are likely to remain in force for the long term—for example, 10 years. For most private-sector organisations, wealth generation is likely to be the main financial/economic objective. However, businesses typically have objectives other than the financial ones—for example, being environmentally friendly or providing employment for the family. In practice, therefore, any decision is likely to be the result of a compromise between more than one objective. 2 Setting long-term plans. These are plans setting out how the business will aim to achieve its objectives over a period of, say, five years. They are likely to deal with such matters as: • type of products or services to be offered by the business • amounts and sources of finance required by the business

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• capital investments (e.g. in new plant and machinery) required • sources of raw materials • labour requirements. In the case of each of these, the pursuit of the established objectives of the business over the planning horizon (perhaps five years) will lay the foundation for the plans. Long-term plans tend to be stated in financial terms. budget #ƂPCPEKCNRNCPHQTVJGUJQTV term, typically one year.

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

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

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

Control control To compel events to conform to the plan.

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

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Step 1

Identify business objectives

25

FIGURE 1.6 6JGRNCPPKPICPFEQPVTQNRTQEGUU

Step 2

Consider options

Step 3

Evaluate options and make a selection

Step 4

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

Step 5

Prepare short-term plans (budgets)

Step 6

Perform and collect information on actual performance

Step 7

Respond to divergences between plans and actuals, and exercise control

Step 8

Revise plans (and budgets) if necessary

6JGƂIWTGUJQYUVJGMG[UVGRUKPVJGRNCPPKPICPFEQPVTQN process as described in this chapter.

absorbed. In practice, this may mean that information is produced in summarised form and that only a restricted range of options will be considered.

Not-for-profit organisations Although the focus of this book is accounting as it relates to private-sector businesses, there are many PQVHQTRTQƂVQTICPKUCVKQPU that do not exist mainly for the pursuit of profit. Examples include: • charities • clubs and associations • universities • local government authorities • national government departments and associated agencies • churches, and • trade unions.

not-for-profit organisation An organisation whose main CKOKUPQVVQOCMGCRTQƂV but to achieve some other clear goal, usually of a social nature.

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

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Concept check 13 ;QWoXGFGEKFGFVQHQNNQY$KNN)CVGUCPFFWORWPKXGTUKV[VQIQKPVQDWUKPGUU You will probably set up your business initially as a: A B C D E

Limited company Partnership 0QPRTQƂVQTICPKUCVKQP 021 Sole trader Any of the above.

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

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

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

Not a separate legal entity Increased regulation (Partnership Acts) Unlimited liability *CXGVQUJCTGRTQƂVUYKVJRCTVPGTU All of the above.

THE CHANGING FACE OF BUSINESS AND ACCOUNTING LO7 Identify ways in which business and accounting have been changing, together with some current issues confronting businesses and their associated reporting, including current thinking on ethics in business

Over the past 40 years, the environment within which businesses operate has become increasingly turbulent and competitive. Various reasons have been identified to explain these changes, including: • increasingly sophisticated and demanding customers • the development of a global economy where national frontiers become less important • rapid changes in technology • the deregulation of domestic markets (e.g. electricity, water and gas) • increasing pressure from owners (shareholders) for competitive economic returns • the increasing volatility of financial markets, and • substantially increased awareness of the need to recognise the implications of the actions of business on the environment and society at large. This new, more complex environment has brought new challenges for managers and other users of accounting information. Their needs have changed, and both financial accounting and management accounting have had to respond. To meet the changing needs of users there has been a radical review of the kind of information to be reported.

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The internationalisation of businesses has created a need for accounting rules to have an international reach. It can no longer be assumed that users of accounting information relating to a particular business are based in the country in which the business has its base, or are familiar with the accounting rules of that country. Thus, there has been increasing harmonisation of accounting rules across national frontiers. A more detailed review of these developments is included in Chapter 5. As a result of criticisms that the financial reports of some businesses are not clear enough to users, accounting rule-makers have tried to improve reporting rules to ensure that the accounting policies of businesses are more comparable and more transparent, and that they portray economic reality more faithfully. The importance of this work has been reinforced by a number of scandals over the past couple of decades, typically relating to the financial reports prepared for general-purpose external users. These scandals have become front-page news in Australia, and a major talking point among those connected with the world of business. Unfortunately, all this attention has been for all the wrong reasons. We have seen that investors rely on financial reports to help keep an eye on their investment and on the managers. However, these scandals clearly indicate that cases have arisen where managers have been providing misleading information to their investors. Two of the most notorious cases have been those of Enron, a Texas-based energy-trading business accused of making complicated financial arrangements to obscure losses and to inflate profits, and HIH Insurance Group, where mismanagement and an inadequate response to emerging pressures in international insurance markets led to Australia’s greatest corporate collapse, with losses of up to $5.3 billion. In the wake of these scandals, there was much closer scrutiny of businesses’ financial reports by investment analysts and investors. This has led to further businesses, in Australia and worldwide, being accused of using dubious accounting practices to bolster profits. Various reasons have been put forward to explain this spate of scandals. Some may have been caused by the pressures on managers to meet investors’ unrealistic expectations of continually rising profits; others by the greed of unscrupulous executives whose pay is linked to financial performance. However, they may all reflect a particular economic environment. The Australian legal system has made it plain that it deplores the actions of unscrupulous executives. In 2005, Ray Williams and Rodney Adler, former chiefs of HIH, were sentenced to four and a half years in prison for their part in the fraud.

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

Whatever the causes, the result of these accounting scandals has been to undermine the credibility of financial statements and to introduce much stricter regulations concerning the quality of financial information. More recently, the global financial crisis has further highlighted, among many other things, inadequacies and inconsistencies in financial reporting regulations and reporting practices. Parallel to this work are major efforts to improve corporate governance. Increasingly, concern with the environment—particularly via climate change—has led to considerably more focus being directed to environmental and social factors, typically wrapped up together under a generic heading of ‘sustainability reporting’. Many companies, especially the larger ones, now use sustainability as a core part of their business’s approach and associated planning. More recently, the idea of integrated accounting, which is all about value creation, has been developed. These topics will be considered in more detail in Chapter 7. Management accounting has also changed by becoming more outward-looking and more customer-focused. In the past, information provided to managers has been largely restricted to that collected within the business. However, the attitude and behaviour of customers and rival businesses have now become the object of much information gathering. Increasingly, successful businesses are those that are able to secure and maintain competitive advantage over their rivals. In addition, information about the costs and profits of rival businesses, which can be used as ‘benchmarks’ by which to gauge competitiveness, is gathered and reported.

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To compete successfully, businesses must also find ways of managing costs. The cost base of modern businesses is under continual review, and this in turn has led to the development of more sophisticated methods of measuring and controlling costs.

Ethics and ethical behaviour in business ethics A code of behaviour considered correct, especially that of a particular group, organisation or individual.

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

It is now clearly recognised that in free societies businesses need to be good corporate citizens. Also, the idea discussed in an earlier section, that businesses need to harmonise stakeholders’ interests, implies that there is a need for ethics and ethical behaviour. As we have already seen, the last couple of decades have witnessed a number of scandals in which behaviour has been identified as both illegal and unethical. The regulatory framework has been tightened as a result, as have the codes of ethics of various professional organisations. By way of illustration, the International Federation of Accountants (IFAC), an independent worldwide organisation, with a stated purpose ‘to develop and enhance a coordinated worldwide accountancy profession with harmonised standards’, has developed a code of ethics for accountants in each country to use as the basis for founding their own codes of ethics. The major Australian accounting bodies have developed a ‘Code of Ethics for Professional Accountants’ based on the IFAC code. A considerable amount of work on ethics has been done over the years. For example, the Institute for Global Ethics (www.globalethics.org), a non-profit organisation, uses the same kind of values-driven ethos implicit in Freeman’s work on stakeholder theory. Rewards identified include: increased shareholder confidence; enhanced productivity; attraction and retention of a quality workforce; protection of customer trust; improved efficiency; and expansion of compliance efforts (i.e. ensuring rules and regulations are followed). Guiding principles include: honesty and truthfulness in all dealings; responsibility and accountability in every transaction; fairness and equity in each relationship; respect and mindfulness of the dignity of every individual; and compassion and caring in each situation. The Institute’s research suggests that these principles transcend national and cultural borders, economic stratification, language, gender and religion. These principles are also important in developing a set of corporate ethical values, or ideology (the way in which a corporation actually does business). This set of values is not necessarily the same as business ethics. Business ethics has been defined as ‘The study of proper business policies and practices regarding potentially controversial issues, such as corporate governance, insider trading, bribery, discrimination, corporate social responsibility and fiduciary responsibilities. Business ethics are often guided by law, while other times provide a basic framework that a business may choose to follow in order to gain public acceptance’ (www.investopedia.com/terms/b/businessethics.asp). Conversion of this definition to what actually happens on the ground can still vary tremendously. There is undoubtedly a real concern about behaviour being ethically sound, and the general public is increasingly critical of failures in this arena. Examples of clear failures can be seen in Real World 1.3. Real World 1.3 provides some extreme illustrations, but there are many other examples of breakdowns or failures that range from minor moral misjudgements through sloppiness in the way business is transacted and general sharp practice, to plain fraud. Also, thinking back to the section on stakeholder theory, Freeman’s ‘new story’ clearly has not reached parts of the business community (and possibly the entire community). Do we accept that this is reality, or try to do something more positive? In fact, the impact of ethical considerations is now well recognised. There have been substantial improvements in corporate governance—the system by which corporations are directed and controlled—and compliance and other regulatory requirements are more rigorous. Many superannuation funds now have investment categories with names such as ‘ethically based investments’, which enable investors to choose investments with a sound ethical (or green) underpinning. Consumers seem to be increasingly turning to businesses or industries which engage in ethical trading, such as Fairtrade coffee.

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REAL WORLD 1.3 Ethical failures Volkswagen’s emission-cheating scandal beggars belief. Volkswagen admitted to cheating on emissions tests for nearly half a million diesel-powered cars sold since 2008. Volkswagen says that as many as 11 million vehicles worldwide use what authorities call defeat devices, or soware that can make cars appear cleaner than they are during regulatory tests and disable emissions controls during normal driving. Volkswagen apologised and asked for patience, while setting aside US$7.3 billion to cover fallout from the scandal. Since that time the US Justice Department has sued Volkswagen in an action that could cost Volkswagen US$18 billion. The final direct cost in the US was around $15 billion, plus a further US$4.7 billion. VW subsequently made clear that it had no intention of offering equal compensation to Europeans who had bought tainted diesel vehicles. This claim was based on differing emissions standards. VW reported a 20% slump in pre-tax profits in the first three months of 2016. Sources: Mike Spector, ‘Volkswagen facing barrage of litigation’, The Australian, 30 September 2015. Arona Viswanatha & Mike Spector, ‘VW faces $25bn payout in US emissions lawsuit’, The Australian, 6 January 2016. William Boston, ‘VW rejects cash offer for owners in Europe’, The Australian, 5 July 2016. Kate Palmer, ‘VW profit sharply lower as effects of emissions-rigging scandal continues’, The Daily Telegraph (UK), 1 June 2016.

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

In China, authorities accused an online financing platform of deceiving mostly small investors out of more than 50 billion

yuan. Ezubo and its parent, Yucheng International Holdings Group, were charged with illegally soliciting funds from the public, and fraud. The companies had allegedly lured investors with promises of high-interest payouts from leasing projects. It was also alleged that 95% of the projects were false. Source: Chuin-Wei Yap, ‘Ezubo a $10bn “Ponzi scheme”, says Bejing’, The Australian, 3 February 2016.

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

In the course of this text we shall see that accountants play a very important role in compliance and certain ethical issues. Increasingly, as community expectations change, so will compliance needs. The increased emphasis in recent years on sustainability has led to substantially expanded reports, which are discussed in Chapter 7. The ideas of Freeman regarding stakeholder theory’s ‘new story’ are likely to lead to a range of new measurement systems over the next few decades.

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Eva Tsahuridu, in a regular piece on ethics in InTheBlack (‘How do you stop bad apples?’, May 2015) asked how we might move from a compliance-based approach to one which focuses on shared values and benefit creation. The article suggests that we need to develop a positive ethical organisation, in which doing the right thing is the normal thing to do. Such an organisation will require attention to: • leadership that is visibly ethical, with explicit commitment to ethics • culture and informal systems that include values, role models, language, norms, symbols and heroes • formal systems that include codes of conduct, policies and rules, structure, performance management and reward systems, and decision-making processes. There is considerable overlap between the ideas covered in the section on stakeholder theory and this one on ethics. The use of the term ‘values driven’ is increasingly common. Accounting has led the field in terms of measurement. It remains the principal discipline for measurement. However, many of the ideas raised in this chapter are difficult to measure. Considerable work remains to be done.

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

Advances in technology Deregulation of utility providers (e.g. electricity, water) Breakdown of political barriers None of the above 6JGƂTUVVJTGG

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

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

Accounting standards that meet the unique needs of a particular country +PETGCUGFENCTKV[QHƂPCPEKCNTGRQTVU Harmonisation of accounting rules across countries and continents )TGCVGTVTCPURCTGPE[KPƂPCPEKCNTGRQTVKPI )TGCVGTEQORCTCDKNKV[KPƂPCPEKCNTGRQTVKPI

HOW USEFUL IS ACCOUNTING INFORMATION? No-one would seriously claim that accounting information fully meets all of the needs of each of the various user groups. Accounting is still a developing subject, and we still have much to learn about user needs and the ways in which these needs should be met. Nevertheless, the information contained in accounting reports should help users make decisions relating to the business. The information should reduce uncertainty about the financial position and performance of the business. It should help to answer questions concerning the availability of funds to pay owners a return, to repay loans, to reward employees and so on. While we cannot be sure just how useful accounting information actually is to users, there is little doubt that accounting is perceived as being useful. Several studies have attempted to rank the

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importance of accounting information in relation to other sources of information. Generally these studies have found that accounting information is ranked more highly than other sources of information. The impact on share prices of accounting information is one area where some clear evidence can be seen to support these views. Real World 1.4 provides examples of the impact on share prices of announcements regarding current or anticipated profits.

REAL WORLD 1.4 Impact of financial results on share price CBA reported a better than expected profit amounting to $4.8 billion. It held the dividend steady. At this time the investor market was best described as ‘rattled’. The overall stock market was close to being in ‘bear’ territory, having lost around 20% over the last six months. Shares rose by 1.8%, a remarkably good performance under the circumstances. Source: Michael Bennet, ‘CBA posts $5bn profit but dividend frozen’, The Australian, 11 February 2016.

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

The Reject Shop smashed profit forecasts by reporting halfyearly profit of $18.3 million, on a 5.6% li in sales to $424.7 million. This represented a 43% increase in profit. Its share price increased by 26%.

AGL fl agged a fall in profits of $100 million, aer being caught short of lower priced gas. AGL share price went lower by 6%, but recovered to only 2% lower aer it became clear that it still expected to deliver higher earnings for 2017.

Source: Eli Greenblat, ‘Super profit for Reject Shop’, The Australian, 18 February 2016.

Source: Barry Fitzgerald, ‘AGL flags $100m fall in gas profit’, The Australian, 8 July 2016.

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

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

Why do I need to know anything about accounting and finance? At some stage of your study you have probably asked yourself: ‘Why do I need to study accounting? I don’t intend to become an accountant!’ Well, from the explanation of what accounting is about, which has broadly been the subject of this chapter, it should be clear that the accounting function within a business is a central part of its management information system. On the basis of information provided by the system, managers make decisions concerning the allocation of resources. As we have seen, these decisions may concern whether to: • continue with or expand certain business operations • invest in particular projects, or • sell particular products.

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Such decisions can have a profound effect on all those connected with the business. It is important, therefore, that all of those who intend to work in a business should have a fairly clear idea of certain important aspects of accounting and finance. These aspects include: • how financial reports should be read and interpreted • how financial plans are made • how investment decisions are made, and • how businesses are financed. Many, perhaps most, students have a career goal of being a manager within a business—perhaps a personnel manager, a production manager, a marketing manager or an IT manager. If you are one of these students, an understanding of accounting and finance is very important. When you become a manager, even a junior one, it is almost certain that you will have to use financial reports to help you to carry out your role. It is equally certain that it is largely on the basis of financial information and reports that your performance as a manager will be judged. As part of your management role, it is likely that you will be expected to help in forward planning for the business. This will often involve the preparation of projected financial statements and the setting of financial targets. If you do not understand what the financial statements really mean and the extent to which the financial information is reliable, you will find yourself at a distinct disadvantage to others who know their way around the system. Along with other managers, you will also be expected to help decide how the limited resources available to the business should be allocated between competing options. This will require an ability to evaluate the costs and benefits of the different options available. Once again, an understanding of accounting and finance is important to carrying out this management task. This is not to say that you cannot be an effective and successful personnel, production, marketing or IT manager unless you are also a qualified accountant. It does mean, however, that you need to become a bit ‘streetwise’ in accounting and finance if you are to succeed. This book should give you that street wisdom.

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

B C

D E

9GNNRTGRCTGFƂPCPEKCNUVCVGOGPVUYKNNOGGVCNNQHVJGPGGFUQHOQUVDWVPQVCNN user groups. Accounting information is useful only to those trained in accounting. 6JGCDKNKV[VQWPFGTUVCPFƂPCPEKCNUVCVGOGPVUKUKORQTVCPVCPFGXGPETKVKECNHQTOCP[ non-accounting managers in business. All of the above. None of the above.

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

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

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

OBJECTIVE

METHOD ACHIEVED

Explain the nature and role of accounting

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

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

• +FGPVKƂGFVJGHQNNQYKPIITQWRU • owners • managers • lenders • suppliers • investment analysts • customers • competitors • employees and their representatives • government • community representatives • Discussed uses made of accounting through an activity • Introduced stakeholder theory

%QORCTGCPFEQPVTCUVƂPCPEKCNCPF management accounting

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

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

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

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

• +FGPVKƂGFYGCNVJGPJCPEGOGPVCUVJGOCKPQDLGEVKXGQHCDWUKPGUU • &KUEWUUGFCTCPIGQHQVJGTUGEQPFCT[QDLGEVKXGUVJCVOC[KPƃWGPEGVJGYC[KP which a business is run • Explained the need to retain a balance between risk and return

2TQXKFGCPQXGTXKGYQHVJGOCKPƂPCPEKCN reports prepared by a business

• +NNWUVTCVGFVJGPGGFHQTCPFFGXGNQROGPVQHVJGUVCVGOGPVQHECUJƃQYUVJG UVCVGOGPVQHƂPCPEKCNRQUKVKQPCPFVJGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG RTQƂV CPFNQUUCEEQWPV • +FGPVKƂGFVJGV[RKECNOCPCIGOGPVCEEQWPVKPITGRQTVURTGRCTGF

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

• +FGPVKƂGFCPFQWVNKPGFVJGOCKPMKPFUQHDWUKPGUUQYPGTUJKR • sole proprietorship • partnership • limited company • Outlined the ways in which a business is typically managed • +FGPVKƂGFYC[UKPYJKEJCEEQWPVKPIKUNKMGN[VQDGWUGF • +FGPVKƂGFCTCPIGQHPQVHQTRTQƂVQTICPKUCVKQPUCPFGZRNCKPGFVJCVVJGKT KPHQTOCVKQPPGGFUCTGUKOKNCTVQVJQUGQHHQTRTQƂVQTICPKUCVKQPU

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

• +FGPVKƂGFVJGYC[UKPYJKEJDWUKPGUUJCUDGEQOGKPETGCUKPIN[EQORNGZCPF turbulent • Explained how internationalisation of business has led to harmonisation of accounting rules • +FGPVKƂGFCTGCUQHEQPEGTPCPFEWTTGPVCEVKXKV[KPCEEQWPVKPICUCTGUWNVQHVJG greater complexity • Outlined the importance of ethics in business

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

• Explained that accounting is central to all businesses, and that a basic knowledge is GUUGPVKCNKH[QWCTGVQHWNƂNCOCPCIGTKCNTQNGKPCDWUKPGUU

DISCUSSION QUESTIONS EASY 1.1

LO1

What is the purpose of producing accounting information?

1.2

LO6

Why is it important to have a partnership agreement specifying the arrangement for allocating

FKXKFKPIRTQƂVUDGVYGGPVJGRCTVPGTU!

1.3

LO3

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

1.4

LO4

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

1.5

LO5

+FGPVKH[VJGUKOKNCTKVKGUCPFFKHHGTGPEGUDGVYGGPVJGVJTGGOCLQTGZVGTPCNƂPCPEKCNTGRQTVU UVCVGOGPV QHƂPCPEKCNRQUKVKQPUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEGUVCVGOGPVQHECUJƃQYU

1.6

LO6

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

1.7

LO7

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

1.8

LO8

n7PFGTUVCPFCDKNKV[oKUKFGPVKƂGFKPVJGVGZVCUCMG[EJCTCEVGTKUVKEQHCEEQWPVKPIKPHQTOCVKQP$[ YJQOUJQWNFVJGƂPCPEKCNTGRQTVUDGTGCFKN[WPFGTUVQQF!

1.9

LO3/4/6

Distinguish between ‘planning’ and ‘control’.

1.10 LO3/4/6

Within a business, how can accounting facilitate control?

1.11 LO3/4/6

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

INTERMEDIATE 1.12 LO1

‘Relevance’ and ‘reliability’ represent two key qualitative characteristics of accounting information. 9JCVFQVJGUGVYQVGTOUOGCPKPCPCEEQWPVKPIEQPVGZV!#TGVJG[KPEQPƃKEV!

1.13 LO2

#UCPQYPGTQHCUOCNNDWUKPGUUYJCVCTGVJTGGMG[ƂPCPEKCNCVVTKDWVGUQHVJGDWUKPGUU[QWYQWNF YKUJVQCUUGUUYJGP[QWTGXKGYƂPCPEKCNTGRQTVU!

1.14 LO3

4GEQPEKNGƂPCPEKCNCEEQWPVKPIYKVJOCPCIGOGPVCEEQWPVKPI;QWTVGZVDQQMENGCTN[FKUVKPIWKUJGU between them. What are the similarities?

1.15 LO4

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

1.16 LO6

Describe two advantages for each type of business organisation.

1.17 LO7

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

1.18 LO8

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

1.19 LO5/6

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

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1.20 LO6

35

%QPVTQNKPCEEQWPVKPIKUNKPMGFVQVKOGN[EQORCTKUQPDGVYGGPCEVWCNCPFDWFIGVƂIWTGU9JCVCTG the implications of this relationship for: (a) the budgeting process, and





D VJGƂPCPEKCNTGRQTVKPIRTQEGUU!

CHALLENGING 1.21 LO1

(KPCPEKCNCEEQWPVKPIUVCVGOGPVUVGPFVQTGƃGEVRCUVGXGPVU+PXKGYQHVJKUJQYECPVJG[JGNRCWUGT make a decision when decisions, by their very nature, can only be made about future actions?

1.22 LO2/6

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

What are the different types of business structure?

•

What is meant by the term ‘stakeholder’?

•

Who are the stakeholders for each type of business?

•

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

•

Will stakeholder demands affect the choice of business structure?

1.23 LO3

;QWJCXGLWUVITCFWCVGFHTQOWPKXGTUKV[YKVJCPCEEQWPVKPIFGITGGCPFCTGCDQWVVQUVCTVLQD JWPVKPI;QWYCPVVQJCXGCLQDVJCVYKNNCNNQY[QWVQWUG[QWTETGCVKXGUVTGCM&KUEWUUJQY ETGCVKXKV[YKNNGPJCPEGQTKPJKDKV[QWTRGTHQTOCPEGCUCƂPCPEKCNCEEQWPVCPVCPFCUCOCPCIGOGPV accountant.

1.24 LO4

6JGINQDCNƂPCPEKCNETKUKUUJQYGFWUVJCVTKUMKUDCF&Q[QWCITGG!

1.25 LO5

n6JGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEGTGƃGEVUVJGƂPCPEKCNRGTHQTOCPEGHQTVJGRGTKQFCPF GZRNCKPUVJGEJCPIGUKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPo&Q[QWCITGGQTFKUCITGGYKVJVJKU statement? Why?

1.26 LO7

+VJCUDGGPUWIIGUVGFVJCVVJGINQDCNƂPCPEKCNETKUKUOKIJVJCXGDGGPCXQKFGFKHYGJCFWUGFECUJ based accounting. Discuss.

1.27 LO8

9JKEJƂPCPEKCNKPHQTOCVKQPYQWNFDGWUGHWNKH[QWYGTGTWPPKPIVJGUCNGUFGRCTVOGPVQHCNCTIG DWUKPGUU!%CP[QWVJKPMQHCP[PQPƂPCPEKCNKPHQTOCVKQPVJCV[QWOKIJVYCPVVQJCXG!

1.28 LO1/8

If you were to consider starting a business, what information would you be seeking before commencing?

1.29 LO4

Refer back to Real World 1.1. How do you feel about the idea, ‘it was legal and others were making money that way’? How might we best move away from this attitude, and what should our approach be?

1.30 LO4

'UVKOCVKPIRTQƂVCUKVTGNCVGUVQCRCTVKEWNCTDWUKPGUUKUOCPCIGCDNG$WVOGCUWTGOGPVQHUQEKCNCPF GPXKTQPOGPVCNKUUWGUKUOQTGFKHƂEWNV*QYOKIJV[QWCRRTQCEJVJKUKUUWG!

1.31 LO1/5

What do you understand by stewardship? Does the traditional approach to stewardship accounting CEEQTFYKVJ[QWTXKGY!+FGPVKH[TGCUQPUYJ[VJGOCKPƂPCPEKCNTGRQTVURTGRCTGFHQTGZVGTPCNWUGCTG UVKNNNCTIGN[ƂPCPEKCNN[QTKGPVGF!

1.32 LO5/7/8

Do you think, from your own experience, that the ideas of stakeholder theory, as compared with the VTCFKVKQPCNUGCTEJHQTRTQƂVCTGICKPKPIOWEJITQWPFCPFKHUQKPYJKEJCTGCUCPFYC[U!

1.33 LO7

In the light of the examples included in Real World 1.3, do you believe that ethics in today’s business world are improving?

1.34 LO1/8

#EEQWPVKPIKUPQTOCNN[FGƂPGFKPVGTOUQHnTGEQTFKPIENCUUKH[KPIUWOOCTKUKPICPFEQOOWPKECVKPI economic information about a reporting entity’. Explain and provide an example of the following key VGTOUKPUWEJCFGƂPKVKQP •

Classifying

•

Summarising

•

Communicating

•

Economic information.

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CHAPTER 1 CASE STUDY Characteristics of successful business people A supplement entitled Psychology of success, sponsored by NAB, appeared in The Australian on 9 October 2015. This supplement included a range of

pieces relating to a number of very successful, quite young entrepreneurs. The content of these is broadly summarised in Table 1.3.

TABLE 1.3 CHARACTERISTICS OF SUCCESSFUL BUSINESS PEOPLE • Being able to break down challenges into bite-sized chunks, and resisting looking too far into the future • $GKPICDNGVQMGGRQPGoUPGTXGCPFCXQKFCETKUKUQHEQPƂFGPEG • Having self-belief and being able to spot it in others • Being able to crash through your comfort zones • Avoiding the temptation to believe that the problem is external. What sets apart those who are able to conquer challenges to self-belief is a willingness to face up to fear and the possibility of failure • Being comfortable with feeling uncomfortable, and understanding that emotional fortitude is something that develops • Recognising that the early days of any business are going to be something of a roller coaster ride • Not comparing yourself with others • Recognising that persistence, determination and a never-say-die attitude are vital, but not the only ingredients for business success • Having a need for self-awareness and balance • Avoiding the pitfall that people with a lot of drive and determination can get caught up in the business and become obsessive • Recognising, though, that obsession creates a source of energy, and when focused and aligned with persistence, can be a mechanism for success • Never taking rejection or negative feedback personally, but deal with the rejections • Recognising that a defensive reaction to criticism and negative feedback can be disastrous. There is a need to view negative feedback as a gift • Recognising your own strengths and weaknesses. It is rare that one person is great at running every part QHCDWUKPGUU4GEQIPKUG[QWTQYPWPKSWGVCNGPVUCPFƂPFRGQRNGYJQGZEGNYJGTG[QWFQPoV • Recognising the need for sheer determination, hard work and a burning desire to succeed Source: ‘Psychology of success’, The Australian, 9 October 2015.

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

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

a)

discuss the kind of skill set required for a successful career in business in the future

b)

identify just how accounting can link with these characteristics.

37

Concept check answers %% %% CC3 CC4 CC5

A C D D A

CC6 CC7 CC8 CC9 %%

C E D B B

%% %% %% %% %%

A D D B E

%% %% %% %%

E A C E

SOLUTIONS TO ACTIVITIES ACTIVITY 1.1 It would be very useful if accounting reports could be understood by everyone. This, however, is unrealistic, as complex ƂPCPEKCNGXGPVUCPFVTCPUCEVKQPUECPPQVPQTOCNN[DGGZRTGUUGFKPUKORNGVGTOU+VKURTQDCDN[DGUV VJCV YG TGICTF accounting reports in the same way that we regard a report written in a foreign language. To understand either of these, we need to have had some preparation. When producing accounting reports, it is normally assumed that the user not only has a reasonable knowledge of business and accounting, but is also prepared to invest some time in studying the reports.

ACTIVITY 1.2 ;QWTCPUYGTOC[DGCNQPIVJGHQNNQYKPINKPGU 7UGTITQWR

&GEKUKQP

Customers

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

Competitors

How best to compete against PI or, perhaps, whether to leave the market on the grounds that it is PQVRQUUKDNGVQEQORGVGRTQƂVCDN[YKVJ2+6JKUOKIJVKPXQNXGEQORGVKVQTUWUKPI2+oURGTHQTOCPEGKP various aspects as a ‘benchmark’ when evaluating their own performance. They might also try to CUUGUU2+oUƂPCPEKCNUVTGPIVJCPFKFGPVKH[UKIPKƂECPVEJCPIGUVJCVOC[UKIPCN2+oUHWVWTGCEVKQPU GI raising funds as a prelude to market expansion).

Employees

Whether to continue working for PI and, if so, whether to demand higher rewards for doing so. The HWVWTGRNCPURTQƂVUCPFƂPCPEKCNUVTGPIVJQHVJGDWUKPGUUCTGNKMGN[VQDGQHRCTVKEWNCTKPVGTGUVYJGP making these decisions.

Government

Whether PI should pay tax and, if so, how much, whether it complies with agreed pricing policies, YJGVJGTƂPCPEKCNUWRRQTVKUPGGFGFCPFUQQP+POCMKPIVJGUGFGEKUKQPUCPCUUGUUOGPVQH2+oU RTQƂVUUCNGUTGXGPWGUCPFƂPCPEKCNUVTGPIVJYQWNFDGOCFG

Community

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

Investment

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

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ACCOUNTING FOR NON-SPECIALISTS

Suppliers

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

Lenders

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

Managers

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

Owners

Whether to invest more in PI or to sell all, or part, of the investment currently held. This would involve an assessment of the likely risks and returns associated with PI. Owners may also be involved YKVJFGEKUKQPUQPTGYCTFKPIUGPKQTOCPCIGTU6JGƂPCPEKCNRGTHQTOCPEGQHVJGDWUKPGUUYQWNF normally be considered when making such a decision.

#NVJQWIJVJKUCPUYGTEQXGTUOCP[QHVJGMG[RQKPVU[QWOC[JCXGKFGPVKƂGFQVJGTFGEKUKQPUCPFQTQVJGTHCEVQTUVQDG taken into account by each group.

ACTIVITY 1.3 We thought of two points: • Managers will, at times, be interested in receiving an historical overview of business operations of the sort provided to other users. • Other users would be interested in receiving information relating to the future, such as the planned level of RTQƂVUCPFPQPƂPCPEKCNKPHQTOCVKQPUWEJCUVJGUVCVGQHVJGUCNGUQTFGTDQQMCPFVJGGZVGPVQHRTQFWEV innovations.

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

ACTIVITY 1.5 5VCVGOGPVQHECUJƃQYUHQTFC[



Opening balance (from day 2)

900

Sale of wrapping paper

390 1290

Purchase of wrapping paper

600

Closing balance

690

5VCVGOGPVQHƂPCPEKCNRGTHQTOCPEGHQTFC[



Sales

390.00

Cost of goods sold (½ of $(600 + 75))

337.50

2TQƂV 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCVVJGGPFQHFC[

52.50 

Cash

690.00

Inventory (½ of $(600 + 75))

337.50

Total assets

1027.50

= Paul’s wealth in the business – equity

1027.50

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CHAPTER 1 INTRODUCTION TO ACCOUNTING

39

ACTIVITY 1.6 +PRTCEVKEGFGEKUKQPOCMGTUOC[PQVDGCUTCVKQPCNCPFECRCDNGCUKORNKGFKPVJGRNCPPKPIRTQEGUU+PFKXKFWCNUOC[ƂPFKV FKHƂEWNVVQJCPFNGNCTIGCOQWPVUQHKPHQTOCVKQPCDQWVCYKFGTCPIGQHQRVKQPU#UCTGUWNVVJG[OC[TGUVTKEVVJGKTTCPIG of options or discard some information to avoid becoming overloaded. They may also adopt rather simple approaches to GXCNWCVKPIUWEJCOCUUQHKPHQTOCVKQP(QTGZCORNGVJG[OKIJVKIPQTGCP[KPHQTOCVKQPVJCVFQGUPQVƂVYGNNYKVJVJG decision-makers’ desired outcome.

ACTIVITY 1.7 6JGTGJCXGDGGPCPWODGTQHEQTRQTCVGETCUJGUD[HCTVJGOQUVUKIPKƂECPVDGKPI*+*+PUWTCPEG1VJGTUVJCVJCXGJCF wide press coverage include OneTel, ABC Learning Centres, Allco, Timbercorp and Great Southern Plantations. Recently we have had Dick Smith.

ACTIVITY 1.8 Other sources of information available include: • meetings with managers of the business • public announcements made by the business • newspaper and magazine articles • websites, including the website of the business • radio and TV reports • information-gathering agencies (e.g. agencies that assess businesses’ creditworthiness or credit ratings) • industry reports, and • economy-wide reports. These sources can provide information on various aspects of the business, such as new products or services being offered, management changes, new contracts offered or awarded, the competitive environment within which the business QRGTCVGUVJGKORCEVQHPGYVGEJPQNQI[EJCPIGUKPNGIKUNCVKQPEJCPIGUKPKPVGTGUVTCVGUCPFHWVWTGNGXGNUQHKPƃCVKQP *QYGXGTVJGXCTKQWUUQWTEGUQHKPHQTOCVKQPKFGPVKƂGFCTGPQVTGCNN[UWDUVKVWVGUHQTCEEQWPVKPITGRQTVU4CVJGTVJG[CTG DGUVWUGFKPEQPLWPEVKQPYKVJVJGTGRQTVUKPQTFGTVQQDVCKPCENGCTGTRKEVWTGQHVJGƂPCPEKCNJGCNVJQHCDWUKPGUU

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CHAPTER 2

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

L01

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

L02 Explain the accounting equation, and use it to build up a statement of financial position at the end of a period

L03 Classify assets and claims L04 Apply the different possible formats for the statement of financial position L05 Identify the main factors that influence the content and values in a statement of financial position

L06 Explain the main ways in which the statement of financial position can be useful for users of accounting information

L07 Identify the main deficiencies or limitations in the statement of financial position.

6JGPGZVƂXGEJCRVGTUGUUGPVKCNN[FGCNYKVJVJGCTGCMPQYPCUƂPCPEKCNCEEQWPVKPI+PVJKUEJCRVGTYG GZCOKPGVJGƂTUVQHVJGOCLQTƂPCPEKCNTGRQTVUtVJCVYJKEJKUEQPEGTPGFYKVJGUVCDNKUJKPIƂPCPEKCN RQUKVKQP6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPVTCFKVKQPCNN[NCDGNNGFVJGnDCNCPEGUJGGVoTGRTGUGPVUVJG CUUGVUQHCPGPVKV[CPFVJGENCKOUCICKPUVVJQUGCUUGVUCVCIKXGPRQKPVKPVKOG6JGKPVGTGUVUKPQTENCKOU CICKPUVVJGCUUGVUCTGFKXKFGFKPVQGZVGTPCN NKCDKNKV[CPFKPVGTPCN QYPGTUoKPVGTGUVU9GYKNNUGGJQY VJGUVCVGOGPVKUOCFGWRCPFJQYVJGTGRQTVKURTGRCTGF9GYKNNCNUQEQPUKFGTVJGDCUKUQPYJKEJ CEEQWPVU CTG KPENWFGF OGCUWTGF CPF TGRQTVGF (KPCNN[ KVU WUGHWNPGUU KP FGEKUKQPOCMKPI YKNN DG EQPUKFGTGFCPFRQUUKDNGFGƂEKGPEKGUJKIJNKIJVGF +PQTFGTVQGPCDNGWUVQHQEWURTKOCTKN[QPVJGPCVWTGQHVJGCEEQWPVKPIRTQEGUUKPVJKUEJCRVGTCPF %JCRVGTYGYKNNEQPEGPVTCVGQPTGNCVKXGN[UKORNGDWUKPGUUUVTWEVWTGUOCKPN[UQNGRTQRTKGVQTUJKRUCPF RCTVPGTUJKRU CNVJQWIJ VJG UCOG RTKPEKRNGU CRRN[ VQ NKOKVGF EQORCPKGU *QYGXGT IKXGP VJG UK\G EQORNGZKV[CPFTCPIGQHTGIWNCVQT[KUUWGUVJCVEQPHTQPVNCTIGTEQORCPKGUYGJCXGFGNKDGTCVGN[NGHV FGVCKNGFEQORCP[CEEQWPVKPIVQ%JCRVGTUCPF

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

41

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

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

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

•

•

•

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

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

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

tangible assets Those assets that have a physical substance (e.g. plant and machinery, motor vehicles). intangible assets Assets which, while providing expected future DGPGƂVUJCXGPQRJ[UKECN substance (e.g. copyrights, patents).

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ACCOUNTING FOR NON-SPECIALISTS

Is there a probable future GEQPQOKEDGPGƂV!

FIGURE 2.1

No

Decision chart for identifying an accounting asset An item must possess each of the four characteristics KFGPVKƂGFVQDGTGICTFGFCUCPCUUGV

Yes

&QGUVJGDGPGƂVCTKUGHTQOCRCUV VTCPUCEVKQPQTGXGPV!

No

Yes

Is there a right to EQPVTQNVJGTGUQWTEG!

No

Yes

Can the resource be reliably OGCUWTGFKPƂPCPEKCNVGTOU

No

Yes

Accounting asset

claim An obligation on the part of the business to provide cash QTUQOGQVJGTDGPGƂVVQCP outside party. liabilities Claims of individuals and organisations, apart from the owner(s), that have arisen from past transactions or events, such as supplying goods or lending money to the business. owners’ equity The claim of the owner(s) on the assets of the business. equity/capital The share of the business which represents the owners’ interests.

Not an accounting asset

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

Liabilities Liabilities represent the claims of individuals and organisations, apart from those of the owner(s), which have arisen from past transactions or events, such as supplying goods and services or lending money to the business. Examples include accounts payable (creditors), bank overdrafts, personal loans, mortgages and provisions (estimates) for warranty, long-service leave, holiday pay, and taxation. In order to be recognised as a liability, the same kinds of recognition criteria that apply to assets also apply, which means the probability of occurrence and reliability of measurement need to be considered. Most liabilities represent legal claims by external parties against the entity for satisfaction in cash (e.g. bills or accounts payable) or for the provision of goods and services (e.g. subscriptions received in advance). Another type of liability is generally classified as provisions.

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

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

ACTIVITY 2.1 Indicate which of the following items could appear as an asset or a liability on the statement of financial position of business A. Explain your reasoning in each case. (a) (b)

(c) (d) (e) (f) (g) (h)

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

43

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

Owners’ equity (OE, or simply ‘equity’) This represents the claim of the owner(s) against the business, and is sometimes referred to as the ‘owners’ capital’. Equity can be defined as the ‘residual interest in the assets of the entity after deducting all of its liabilities’. Some find it hard to understand how the owner can make a claim against the business, particularly when we consider a sole proprietor-type business like Paul’s from Chapter 1, where the owner is, in effect, the business. However, for accounting purposes, a clear distinction is made between the business (whatever its size) and the owner(s). The business is viewed as being quite separate from the owner, irrespective of whether the business has a separate legal identity or not. This means that when financial reports are prepared, they are prepared for the business rather than the owner(s). From this perspective, therefore, any funds the owner contributes to help finance the business are regarded as a claim against the business in its statement of financial position. The equity section of the statement of financial position is broadly the same irrespective of the type of business concerned. We shall see in Chapter 4 that, with limited companies, the total equity figure must be analysed according to how each part of it first arose. For example, companies must make a distinction between the part of it that arose from retained earnings (or profits) and the part that arose from the owners putting in cash to start up the business, usually by buying shares in the company. Once a claim from the owners or outsiders has been incurred by a business, it will remain as an obligation until it is settled.

Concept check 1 6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQP A B C D E

+URTGRCTGFCVCRCTVKEWNCTRQKPVKPVKOG +UCNUQTGHGTTGFVQCUCDCNCPEGFUJGGV %QPUKUVUQHCUUGVUTGNKCDKNKVKGUCPFGSWKV[ #NNQHVJGCDQXGCTGVTWG 0QPGQHVJGCDQXGCTGVTWG

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ACCOUNTING FOR NON-SPECIALISTS

Concept check 2 9JKEJQHVJGHQNNQYKPIKUCOCKPEJCTCEVGTKUVKEQHCPCUUGV! A B C D E

2QUUKDNGHWVWTGGEQPQOKEDGPGƂV 'ZKUVUHTQOCHWVWTGVTCPUCEVKQPQTGXGPV 6JGDWUKPGUUJCUCPGZENWUKXGTKIJVVQEQPVTQNVJGDGPGƂV %CPPQVDGTGNKCDN[OGCUWTGFKPOQPGVCT[VGTOU #NNQHVJGCDQXGCTGMG[CUUGVEJCTCEVGTKUVKEU

Concept check 3 #RQVGPVKCNNKCDKNKV[GZKUVUVJCVOKIJVCTKUGQPVJGQEEWTTGPEGQHCRCTVKEWNCT GXGPVKUMPQYPCU A B C D

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

2.1

E

#RTQXKUKQP #ETGFKVQT #EQPVKPIGPVNKCDKNKV[ #FGDV #NNQHVJGCDQXG

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

Jerry and Co. deposits $20,000 in a bank account on 1 March to commence business. Let us assume that the cash is supplied by the owner ($6,000) and an outside party ($14,000). Raising the funds this way will give rise to a claim on the business by both the owner (capital) and the outside party

NKCDKNKV[+HCUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH,GTT[CPF%QKURTGRCTGFHQNNQYKPIVJGCDQXG transactions, the assets and claims of the business will appear as follows: Jerry and Co. 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Assets Cash at bank

$ 20,000

Total assets

20,000

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

$ 6,000 14,000 20,000

We have chosen a two-sided, traditional-style statement for our example. This is primarily because this links easily with the formal recording process, which will be outlined in Accounting and You, later in the chapter (page 49). At a later stage, we will discuss other formats that are in more common use for published reports. We can see from the statement that has been prepared that the total claims are the same as the total assets. Thus: Assets = Owners’ equity + Liabilities

The equation shown above—often referred to as the ‘accounting equation’—will always hold true. Whatever changes may occur to the business’s assets or the claims against it, compensating changes Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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45

GNUGYJGTGYKNNGPUWTGVJCVVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCNYC[UnDCNCPEGUo KGDQVJUKFGUCITGG For example, consider some further possible transactions for Jerry and Co. Assume that, after the $20,000 had been deposited in the bank, the following transactions took place: 2 March 3 March

Purchased a motor vehicle for $5,000 paying by cheque. Purchased inventory (stock-in-trade, goods to be sold) on one month’s credit for

2.1

$3,000. (This means that the inventories were bought on 3 March, but payment will 4 March 6 March

not be made until 3 April.) Repaid $2,000 of the loan from the outside party. Owner introduced another $4,000 into the business bank account.

continued

#UVCVGOGPVQHƂPCPEKCNRQUKVKQPOC[DGFTCYPWRCHVGTGCEJFC[KPYJKEJVTCPUCEVKQPUJCXGVCMGP place. In this way, the effect of each transaction on the assets and the claims against them can be UGGP6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJYKNNDGCUHQNNQYU Jerry and Co. 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Assets Cash at bank (20,000 – 5,000) Motor vehicle Total assets

$ 15,000 5,000 20,000

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

$ 6,000 14,000 20,000

As you can see, the effect of purchasing a motor vehicle is to decrease the balance at the bank by $5,000 and to introduce a new asset—a motor vehicle—onto the statement. The total assets remain unchanged; only the ‘mix’ of assets has changed. The claims against the business remain the same, as there has been no change in the funding arrangements for the business. 6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJHQNNQYKPIVJGRWTEJCUGQHKPXGPVQT[YKNNDGCU follows: Jerry and Co. 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Assets Cash at bank Motor vehicle Inventory Total assets

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

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

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

The effect of purchasing inventory has been to introduce another new asset (inventory) to the UVCVGOGPVQHƂPCPEKCNRQUKVKQP+PCFFKVKQPVJGHCEVVJCVVJGIQQFUJCXGPQV[GVDGGPRCKFHQTOGCPU that the claims against the business have been increased by the $3,000 owed to the supplier, who KUTGHGTTGFVQCUnCEEQWPVURC[CDNGoQPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP#EEQWPVURC[CDNGKUCNUQ known as ‘payables’ or ‘creditors’

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

Example 2.1 illustrates the point made earlier that the accounting equation (owners’ equity + liabilities = assets) will always hold true because the equation is based on the fact that, if a business wishes to acquire assets, it must raise funds equal to the cost of those assets. These funds must be provided by the owners (owners’ equity) or other outside parties (liabilities), or both. Hence, the total cost of assets acquired should always equal the total owners’ equity (capital) plus liabilities. It is worth pointing out that a business would not draw up a statement of financial position after each day of transactions, as shown in Example 2.1. Such an approach is likely to be impractical

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given even a relatively small number of transactions each day. A statement of financial position for a business is usually prepared at the end of a defined reporting period. Determining the length of the reporting period involves weighing up the costs of producing the information against its perceived benefits for decision-making purposes. In practice, the reporting period varies between businesses, and could be monthly, quarterly, half-yearly or annually. For external reporting purposes, an annual reporting cycle is the norm (although certain large companies report more frequently than this). However, for internal reporting purposes, many businesses produce monthly financial reports.

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

9GYKNNWUGVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPFTCYPWRHQT,GTT[CPF%QCUCV/CTEJKPVJG UQNWVKQPVQ#EVKXKV[ RCIG6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPYCUCUHQNNQYU

2.1 continued

Jerry and Co. 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Assets Cash at bank Motor vehicle Inventory Total assets

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

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

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

Let us assume that, on 7 March, the business managed to sell all of its inventory for $5,000 and TGEGKXGFCEJGSWGKOOGFKCVGN[HTQOVJGEWUVQOGTHQTVJKUCOQWPV6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQP on 7 March, after this transaction has taken place, will be as follows: Jerry and Co. 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Assets Cash at bank (17,000 + 5,000) Motor vehicles Inventory (3,000 – 3,000)

$ 22,000 5,000

Total assets

27,000

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

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

9GECPUGGVJCVVJGKPXGPVQT[ JCUPQYFKUCRRGCTGFHTQOVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP but the cash at bank has increased by the selling price of the inventory ($5,000). The net effect has, therefore, been to increase assets by $2,000 (i.e. $5,000 – $3,000). This increase represents the net KPETGCUGKPYGCNVJ RTQƂVYJKEJJCUCTKUGPHTQOVTCFKPI#NUQPQVGVJCVVJGQYPGTUoGSWKV[KPVJG business has increased by $2,000 in line with the increase in assets. This increase in owners’ equity TGƃGEVUVJGHCEVVJCVKPETGCUGUKPYGCNVJCUCTGUWNVQHVTCFKPIQTQVJGTQRGTCVKQPUYKNNDGVQVJG DGPGƂVQHVJGQYPGTCPFYKNNKPETGCUGJKUQTJGTUVCMGKPVJGDWUKPGUU

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47

It is appropriate to consider just what the effect would have been on the statement of financial position if the inventory had been sold on 7 March for $1,000 rather than $5,000. The statement of financial position on 7 March would be as follows:

JERRY AND CO. Statement of financial position as at 7 March Assets Cash at bank Motor vehicle

$ 18,000 5,000

Total assets

23,000

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

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

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

Any funds introduced by the owner(s), or withdrawn by the owner(s) for living expenses or other reasons, will further extend the accounting equation as follows: Assets at the end of the period = Owners’ equity at the beginning + 2TQƂV QTs.QUU1VJGTQYPGTUoGSWKV[EJCPIGU .KCDKNKVKGUCVVJGGPFQHVJGRGTKQF

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

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

If the drawings were in cash, then the balance of cash would decrease by $1,500 in the statement of financial position. It is highly unlikely that a statement of financial position will be required on a daily basis, but rather at the end of a specified period, typically at the end of a month or year. The same approach could theoretically be used to build up a statement of financial position at the end of a period. Self-assessment question 2.1 requires you to try to do this. An alternative to the system of pluses and minuses is a worksheet approach. Table 2.1 provides an illustration of how a worksheet can achieve the same result. It uses the content of Example 2.1.

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SELF-ASSESSMENT QUESTION

2.1

6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPQHCDWUKPGUUCVVJGUVCTVQHCYGGMKUCUHQNNQYU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV(GDTWCT[ Assets #EEQWPVUTGEGKXCDNG +PXGPVQT[ (WTPKVWTGCPFƂVVKPIU (TGGJQNFRTGOKUGU

$     

Claims #EEQWPVURC[CDNG $CPMQXGTFTCHV %CRKVCN 'SWKV[

$    _______ 

&WTKPIVJGPGZVYGGMVJGHQNNQYKPIVTCPUCEVKQPUVQQMRNCEG        

5QNFKPXGPVQT[HQTECUJ6JKUKPXGPVQT[JCFEQUV 5QNFKPXGPVQT[HQTQPETGFKV6JKUKPXGPVQT[JCFEQUV 4GEGKXGFECUJHTQOCEEQWPVUTGEGKXCDNGVQVCNNKPI 6JGQYPGTUQHVJGDWUKPGUUEQPVTKDWVGFQHVJGKTQYPOQPG[YJKEJYCURNCEGFKPCDWUKPGUUDCPM CEEQWPV 6JGQYPGTUEQPVTKDWVGFCUGEQPFJCPFOQVQTXGJKENGCVVJGUVCTVQHVJGDWUKPGUUXCNWGFCVVQDGWUGFKP VJGDWUKPGUUNo cashKUKPXQNXGFKPVJKUVTCPUCEVKQP $QWIJVKPXGPVQT[QPETGFKVHQT 2CKFCEEQWPVURC[CDNGQH 2CKFYCIGUQH

5JQYVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCHVGTCNNVJGUGVTCPUCEVKQPUJCXGDGGPTGƃGEVGF

TABLE 2.1 ACCOUNTING EQUATION AND EFFECTS OF TRANSACTIONS USING A WORKSHEET Assets Cash /CTEJ



/CTEJ

s

/CTEJ

Inventory

=

Liabilities

+

Motor vehicle

Accounts payable

Loan

Owners’ contribution





s

/CTEJ



/CTEJ



CPF

s 

Retained RTQƂV

Drawings





/CTEJ

Owners’ equity

 s



s

 –

–



 









5KPINGCEEQWPV KG s

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

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49

ACCOUNTING AND YOU DOUBLE-ENTRY BOOK-KEEPING In Chapter 1 we indicated that in this book we will not be focusing on the collection of accounting information or the actual preparation of financial reports. We have, for purposes of illustration and understanding, explained the nature of the accounting equation by use of a system of pluses and minuses. In practice, accounting systems are based on a system of recording known as double-entry book-keeping. Most systems are now computerised, but are essentially still based on double-entry book-keeping principles. With double-entry book-keeping every item that requires recording is effectively done via a system of individual accounts. Every item in the statement of financial position has its own account, in which entries are made. Historically, these accounts were typically held in a book known as a ‘ledger’; hence, the commonly used reference to ‘ledger accounts’. The form of a ledger account is essentially T-shaped; hence, the alternative name of ‘T accounts’. An example is set out below. This represents the recording in the cash account of Jerry and Co. up to 4 March. Debit side

Name of account (Cash)

Date

Detail

1 March

Equity/capital

1 March

Loan

Amount ($)

Credit side

Date

Detail

Amount ($)

6,000

2 March

Vehicle

5,000

14,000

4 March

Loan

2,000

4 March

Balance c/f

20,000 4 March

Balance b/f

13,000 20,000

13,000

Basically, for assets, entries made on the debit side increase the amount in an asset account, while a credit represents a reduction in the particular asset account. The date enables events to be tracked. The detail represents the other account that needs to be entered, given the dual aspect convention. For liability accounts, the increases are recorded on the credit side and the decreases on the debit side. When it comes to ledger accounts, this leads to the dual aspect convention becoming ‘for every debit there must be a credit’; hence, double-entry book-keeping. This means that the double entry to the first debit entry in the cash account for 1 March would be a credit to an account set up to keep track of the owners’ equity, as shown below. Debit side Date

Equity/Capital account Detail

Amount ($)

Credit side

Date

Detail

1 March

Cash

Amount ($) 6,000

Periodically, and certainly when a statement of financial position is needed, it will be necessary to summarise the position of every account, which leads to a balancing of individual accounts. This is shown in the Cash account used above. Note that ‘c/f’ stands for ‘carried forward’, and ‘b/f’ stands for ‘brought forward’. All that has happened in this case is that the two sides have been totalled (clearly $20,000 on the debit side and $7,000 on the credit side) which means that there is $13,000 le. This approach means that, during a period, all changes in the assets, liabilities and equities are recorded and, at the end of the period, balanced, which should leave the balance sheet equation in balance.

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ACCOUNTING FOR NON-SPECIALISTS

At this stage, the important point for you to recognise is that the statement of financial position is simply a summary of the account balances that are maintained in the individual ledger accounts; hence, the title of ‘balance sheet’, which is the traditional title for the statement of financial position. So why might it be useful for you to know this? Several reasons spring to mind.

• •

•

Many experienced business people still use (or refer to) the traditional terminology. There are examples where figures are represented using debits and credits (e.g. bank statements). Many people find it confusing that if their bank statement shows a credit balance on their account, it means that they have money in their account. How can that be, given what is said above? The answer is straightforward. The bank statement sent to the customer is prepared from the bank’s viewpoint. If you have cash in the bank, the bank would show this as a liability (credit) in its accounts. In the customer’s own ledger accounts, cash in hand would be shown as a debit. In practice, of course, manual ledger systems are rare, with most systems using computerised systems such as MYOB. Many of these still use traditional terminology, and a broad understanding of the systems might be useful. For example, many computer systems still refer to the ‘sales ledger’ or ‘debtors ledger’, which is simply the place where detailed individual records relating to customers are kept.

The situation gets a bit more complicated when we consider the income statement, but the principles remain valid.

Concept check 4 9JKEJQHVJGHQNNQYKPIKUHCNUG! A B C D E

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THE CLASSIFICATION OF ASSETS AND CLAIMS

The classification of assets Classify assets and claims

To help users of financial information easily locate items of interest on the statement of financial position, it is customary to group assets, liabilities and equities into categories. This is designed to help users, as a haphazard listing of those items could be confusing. Assets are normally categorised as either current or non-current. The distinction between current and non-current assets is as follows.

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FIGURE 2.2

51

Inventory

6JGEKTEWNCVKPIPCVWTGQHEWTTGPVCUUGVU Inventories may be sold on credit to customers. When the customers pay, the accounts receivable will be converted into cash, which can then be used to purchase more inventories, and so the cycle begins again Cash

Current assets are basically assets that are held for the short term. They include cash and other assets that are expected to be consumed or converted to cash, usually within the next 12 months or within the operating cycle. To be more precise, current assets are assets that meet any of the following conditions:

• • • •

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

The operating cycle normally represents the time between the acquisition of the assets (e.g. raw materials or finished goods) and their ultimate realisation in cash or cash equivalents. Current assets are normally held as part of the day-to-day trading activities of the business. The most common current assets are inventory (stock), accounts receivable (trade debtors), prepayments and cash itself: these are all interrelated and circulate in a business, as shown in Figure 2.2. It is worth making the point here that most sales made by most businesses are made on credit. This is to say that the goods pass, or the service is rendered, to the customer at one point but the customer pays later. Retail sales are the only significant exception to this general practice. We can see that cash can be used to purchase inventory, which is then sold on credit. When the customers pay, the business receives an injection of cash. For purely service businesses, the situation is similar, except that inventories are not involved. Non-current assets are simply assets which do not meet the definition of current assets. They tend to be held for long-term operations, so they are typically held for generating wealth rather than resale (although they may be sold when the business has no further use for them). They can be seen as the tools of the business. Non-current assets may be either tangible or intangible. Tangible non-current assets are normally categorised under a heading of ‘property, plant and equipment’. This is a rather broad term, which includes items such as land and buildings, motor vehicles, and fixtures and fittings. This distinction between assets that are continuously circulating within the business (current) and assets used for long-term operations (non-current) may be helpful when trying to assess the appropriateness of the mix of assets held. Most businesses will need a certain amount of both types of asset to operate effectively. It is important to appreciate that the classification of an asset may vary (i.e. between current and non-current) according to the nature of the business being carried out. This is because the purpose for which a particular type of business holds a certain asset may vary. For example, a motor vehicle manufacturer normally holds its motor vehicles for resale and would, therefore, classify them as inventory. On the other hand, a business that uses motor vehicles for transport would classify them as non-current assets. Assets should be classified as non-current when they do not satisfy any of the criteria for being classified as current. The accounting standard relating to presentation of financial statements also permits assets to be classified using the order of liquidity (i.e. the ability to turn the asset into cash), where appropriate. The vast majority of businesses use the current/non-current basis.

Accounts receivable

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

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

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ACTIVITY 2.3 (a)

The assets of Kunalun and Co., a large metalworking business, are shown below: cash at bank

fixtures and fittings

office equipment

motor vehicles

freehold factory premises

plant and machinery

computer equipment

stock of work-in-progress (i.e. partly completed goods)

short-term investments Which of the above should be defined as current assets, and which should be defined as non-current assets? (b)

Can you identify which sort of businesses may prefer to use the liquidity basis rather than the current/non-current basis for classifying assets?

The classification of liabilities current liabilities Amounts due for repayment to outside parties within 12 months of the statement of ƂPCPEKCNRQUKVKQPFCVGQT within the operating cycle.

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

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

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

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

Non-current liabilities represent amounts due that do not meet the definition of current liabilities

and so represent longer-term liabilities. Examples of current and non-current liabilities include: Current Non-current Accounts payable Mortgage loan Bank overdraft Long-term loans Bank loan (repayable within 12 months) Revenue received in advance (e.g. subscriptions) Unlike the case for assets, the purpose for which the liabilities are held is not an issue—only the period for which the liability is outstanding is important. Thus, a long-term liability will turn into a current liability when the settlement date comes within 12 months or one operating cycle of the statement of financial position date. For example, borrowings to be repaid 18 months after the date of a particular statement of financial position will appear as a non-current liability, but will appear as a current liability in the statement of financial position in the following year. This classification of liabilities between current and non-current helps to highlight those financial obligations that must shortly be met. Users can compare the amount of current liabilities with the amount of current assets (i.e. the assets that are cash or will turn into cash within the normal operating cycle). This comparison should indicate whether a business can cover its maturing obligations. The classification of liabilities between current and non-current should also help to indicate how long-term finance is raised. If a business relies on long-term borrowings to finance the business, the financial risks associated with the business will increase. This is because these borrowings will bring a commitment to make periodic interest payments and capital repayments. The business may be forced to stop trading if this commitment is not fulfilled. Thus, when raising long-term finance, a business must try to strike the right balance between non-current liabilities and owners’ equity. We shall consider this issue in more detail in Chapter 14.

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53

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

the case of partnerships, the profits and drawings are typically collected and shown in a separate current account for each partner. In the case of companies, withdrawals take the form of dividends. Retained earnings shown reflect the cumulative figure after including earnings and dividends. 3 Other reserves—profits that result from other events; for example, if an asset is revalued to a higher value, there will be a corresponding increase in the equity, and this increase is usually put in a revaluation reserve. This area will be dealt with a little later in the chapter, and further expanded in Chapters 4 and 5. It is now common for categories 2 and 3 to be combined: 1 owners’ equity 2 reserves: (a) retained profits (b) other reserves.

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

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

Partnership

Company

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FORMATS FOR STATEMENTS OF FINANCIAL POSITION LO4 Apply the different possible formats for the statement of financial position

Now that the classification of assets, liabilities and owners’ equity has been completed, it is time to consider the format of the statement of financial position. Although there is an almost infinite number of ways of presenting the same information, there are, in practice, two basic choices.

Horizontal format So far in the chapter we have used the traditional horizontal format (also referred to as the ‘T account format’) based on the ledger accounting system outlined earlier in Accounting and You (page 49). Figure 2.3 provides an overview of this perspective.

Current assets

Non-current assets

Current liabilities

Non-current liabilities

Owners’ equity

FIGURE 2.3 6JGJQTK\QPVCNNC[QWV 6JGGSWCVKQPHQTVJGJQTK\QPVCNHQTOQHUVCVGOGPVQHƂPCPEKCNRQUKVKQPNC[QWV

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The style we adopted with Jerry and Co. in Example 2.1 is in line with this approach. A more comprehensive example of this style is shown in Example 2.2.

+NNWUVTCVKQPQHJQTK\QPVCNUVCVGOGPVQHƂPCPEKCNRQUKVKQP Brie Manufacturing 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV&GEGODGT %WTTGPVCUUGVU Cash at bank Accounts receivable Inventory

$ 48,000 72,000 92,000

$

212,000 0QPEWTTGPVCUUGVU Motor vehicles Plant and machinery Property

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

Total assets

%WTTGPVNKCDKNKVKGU Accounts payable 0QPEWTTGPVNKCDKNKVKGU Loan Total liabilities 1YPGTUoGSWKV[ Opening balance #FFRTQƂV

$ 148,000

$

2.2

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

Less drawings Ending balance Total liabilities and owners’ equity

240,000 588,000

Note that within each category of asset (current and non-current), the items are listed with the most liquid (starting with cash) first, going down to the least liquid. This is standard practice, followed irrespective of the format used. Liquidity generally relates to cash or closeness to cash. Note also that this approach is not used in all countries. For example, in the United Kingdom the order is typically reversed: the list goes from the least liquid to the most liquid. Overall content is basically the same; only the order changes.

Vertical or narrative format In recent years, a more common form of layout for the statement of financial position is the ‘vertical’ or ‘narrative’ form of layout, which is really based on a rearrangement of the accounting equation. There are two possible approaches to presenting the vertical format: • the entity approach, and • the proprietary approach. The focus of the entity approach is on the entire entity, whereas that of the proprietary approach is on the proprietary interest. The only difference is that the two layouts will be arranged slightly differently as shown below. Entity approach Current assets + Non-current assets = Current liabilities + Non-current liabilities + Owners’ equity

Proprietary approach Current assets + Non-current assets – Current liabilities – Non-current liabilities = Owners’ equity

entity approach An approach to the layout QHVJGUVCVGOGPVQHƂPCPEKCN position which emphasises that the report is focusing on the entity as a whole. proprietary approach An approach to the layout QHVJGUVCVGOGPVQHƂPCPEKCN position which emphasises that the report is focusing on the proprietors (owners).

It should be clear that the entity approach simply rearranges the horizontal layout in a vertical format. The proprietary approach requires some readjustment, as can be seen in Example 2.3, which shows the information provided in Example 2.2 from a vertical, proprietary perspective.

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2.3

$

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Cash at bank Accounts receivable Inventory

$

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

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Motor vehicles Plant and machinery Property

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

Total assets Less liabilities %WTTGPVNKCDKNKVKGU

Accounts payable

148,000

0QPEWTTGPVNKCDKNKVKGU

Loan

200,000

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Net assets

240,000

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Opening balance #FFRTQƂV

200,000 56,000 256,000 (16,000) 240,000

Less drawings Total equity

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

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

ACTIVITY 2.4 The following information relates to the Simonson Engineering Company as at 30 September 2017: Plant and machinery Accounts payable Bank overdra Inventory Freehold premises Long-term loans Accounts receivable

$ 100,000 72,000 104,000 180,000 288,000 204,000 192,000

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Capital at 1 October 2016 Cash in hand Motor vehicles Fixtures and fittings Profit for the year to 30 September 2017 Drawings for the year to 30 September 2017

57

470,000 6,000 60,000 36,000 72,000 60,000

Prepare a statement of financial position in the vertical form.

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

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Concept check 11 9JKEJQHVJGHQNNQYKPIUVCVGOGPVUKUHCNUG! A B C D E

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

reporting entity An entity with users who rely on general-purpose ƂPCPEKCNUVCVGOGPVUHQTVJGKT information relating to that entity.

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

for decades 2 continued development of professional and statutory accounting standards. In Chapters 2 and 3 we focus on the first of these, but will deal with the second in more detail in the later chapters on limited companies. Our aim in chapters 2 and 3 is to provide a broadly based understanding of the statement of financial position and income statement without the additional complications involved in larger-scale businesses, which are subject to much more rigorous regulation and control in terms of their financial reporting. The notion of a reporting entity is relevant here, and provides a rationale for our approach. Essentially a reporting entity is one which has a range of external users who use the financial statements to make decisions. Just which decisions users wish to make, and exactly what information they think they need, is not known precisely by the reporting entity. Consequently, the aim is to provide general-purpose information that will be of use to a variety of users. These general-purpose reports are subject to increasing amounts of regulation through accounting standards, legislation, stock exchange requirements and a variety of other bodies. In Chapters 2 and 3 we focus on the basic accounting principles which apply to all organisations. In Chapters 4 and 5 we will deal with the major area of reporting entities, namely companies, at which stage we shall consider the development of accounting standards and their application.

Conventional accounting practice conventions Rules that have been devised over time in order to deal with practical problems experienced by preparers CPFWUGTUQHƂPCPEKCN reports.

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

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

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

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limited companies, on the other hand, there is a clear legal distinction between the business and its owners. For accounting purposes, these legal distinctions are irrelevant, and the business entity convention applies to all forms of business entity.

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

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

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

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

Prudence convention The prudence convention holds that caution should be exercised when making accounting judgements. The application of this convention normally involves recording all losses at once and in full; this refers to both actual losses and expected losses. Profits, on the other hand, are recognised only when they actually arise. Greater emphasis is, therefore, placed on expected losses than on expected profits. To illustrate the application of this convention, let us assume that certain inventories held by a business prove unpopular with customers and so a decision is made to sell them below their original cost. The prudence convention requires that the expected loss from future sales be recognised immediately rather than when the goods are eventually sold. If, however, these inventories could have been sold above their original cost, profit would be recognised only at the time of sale. The prudence convention evolved to counteract the excessive optimism of some managers, and is designed to prevent an overstatement of financial position and performance. Applying this convention, however, requires judgement. This means that the way in which it is applied by

prudence convention The convention which holds VJCVƂPCPEKCNTGRQTVUUJQWNF err on the side of caution, effectively anticipating losses CPFQPN[TGEQIPKUKPIRTQƂVU when they are realised.

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preparers of financial statements may differ over time and between businesses. Where excessive prudence is applied, it will lead to an understatement of profits and financial position. This will mean a consistent bias in the reporting of both financial performance and position. In recent years, the prudence convention has weakened its grip on accounting and has become a less dominant force. Nevertheless, it remains an important convention.

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

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

Dual aspect convention dual aspect convention The accounting convention which holds that each ƂPCPEKCNVTCPUCEVKQPJCUVYQ aspects and that each aspect must be recorded in the ƂPCPEKCNUVCVGOGPVU double-entry bookkeeping/accounting The formal system of recording using ledger CEEQWPVUYJKEJTGƃGEVVJG FWCNCURGEVQHƂPCPEKCN transactions. money measurement The accounting convention which holds that accounting should only deal with those items which are capable of being expressed in monetary terms.

The dual aspect convention states that each transaction has two aspects, both of which will affect the statement of financial position. Thus, the purchase of a car for cash results in an increase in one asset (car) and a decrease in another (cash). The repayment of a loan results in the decrease in a liability (loan) and the decrease in an asset (cash/bank). As we saw in Example 2.1 (page 44), recording the dual aspect of each transaction ensures that the statement of financial position will continue to balance. The ‘dual aspect’ is reflected in the system of double-entry book-keeping/accounting, which underpins the recording of information in the actual accounting records.

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

Goodwill and brands Some intangible non-current assets are similar to tangible non-current assets: they have a clear and separate identity, and the cost of acquiring the asset can be reliably measured. Examples normally include patents, trademarks, copyrights and licences. Other intangible non-current assets, however, are quite different. They lack a clear and separate identity and reflect a hotchpotch of attributes, which are part of the essence of the business. Goodwill and product brands are often examples of assets that lack a clear and separate identity. The term ‘goodwill’ is often used to cover various attributes, such as the quality of the products, the skill of employees and the relationship with customers. The term ‘product brands’ is also used

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to cover various attributes, such as the brand image, the quality of the product, the trademark, and so on. Where goodwill and product brands have been generated internally by the business, it is often difficult to determine their cost or to measure their current market value, or even to be clear that they really exist. They are, therefore, excluded from the statement of financial position. When they are acquired through an ‘arm’s length transaction’, however, the problems of uncertainty about their existence and measurement are resolved. (An arm’s length transaction is one that is undertaken between two unconnected parties.) If goodwill is acquired when taking over another business, or if a business acquires a particular product brand from another business, these items will be separately identified and a price agreed for them. Under these circumstances, they can be regarded as assets (for accounting purposes) by the business that acquired them, and included on the statement of financial position. To agree on a price for acquiring goodwill or product brands means that some form of valuation must take place, and this raises the question as to how it is done. Usually, the valuation will be based on estimates of future earnings from holding the asset—a process that is fraught with difficulties. Nevertheless, a number of specialist businesses now exist that are prepared to take on this challenge. Real World 2.1 shows how one specialist business ranked and valued the top 10 brands in the world for 2016.

REAL WORLD 2.1 Brand leaders Marketing services group Millward Brown Optimor, part of WPP plc, produces an annual report that ranks and values the top world brands. For 2016, the top 10 brands and their values are as follows. Ranking Brand 1 2 3 4 5 6 7 8 9 10

Google Apple Microso AT&T Facebook Visa Amazon Verizon McDonald’s IBM

Industry Technology Technology Technology Telecom provider Technology Payments Retail Telecom provider Fast food Technology

Value ($m) 229,198 228,460 121,824 107,387 102,551 100,800 98,988 93,220 88,684 86,206

We can see that the valuations placed on the brands owned are quite staggering. We can also see how technology businesses dominate the rankings. It is interesting to compare results year-on-year. Over the last year McDonald’s remained steady, while Facebook rose seven places to number 5. The report also lists the brand contribution, a measure of the influence of brand alone on financial value, on a scale of 1 to 5, with 5 being the highest. Source: Millward Brown Optimor, ‘2016 BrandZ™ Top 100 Most Valuable Global Brands’, http://www.millwardbrown.com/brandz/ top-global-brands/2016.

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

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REAL WORLD 2.2 Spurs players appear on the pitch and on the statement of financial position Tottenham Hotspur Football Club (Spurs) has acquired several key players as a result of paying transfer fees to other clubs. In common with most UK football clubs, Spurs reports the cost of acquiring the rights to the players’ services on its statement of financial position. The club’s statement as at 30 June 2015 shows the total cost of registering its squad of players at about £208 million. The club treats a proportion of each player’s transfer fee as an expense each year. The exact proportion depends on the length of the particular player’s contract. The £208 million does not include ‘home-grown’ players, because Spurs did not pay a transfer fee for them and so no clear-cut value can be placed on their services. During the year to 30 June 2015, the club spent around £37 million on

acquiring new players. Some players also le the club during the year, and £37 million was deducted from the cost of registrations. (Most years there is likely to be quite a difference between these figures.) The item of players’ registrations is shown as an intangible asset in the statement of financial position, as it is the rights to services, not the players, which are the assets. It is shown net of depreciation (or amortisation, as it is usually termed for non-current assets). The carrying amount at 30 June 2015 was just over £99 million and represented 25% of Spurs assets, as shown in the statement of financial position. Source: Based on Tottenham Hotspur Ltd Annual Report 2015.

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

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

Valuing assets We saw earlier that, when preparing the statement of financial position, the historic cost convention is normally applied for the reporting of assets. This point requires further explanation as, in practice, things are a little more complex than this. Large businesses throughout much of the world adhere to asset valuation rules set out in International Financial Reporting Standards. (These reporting standards will be discussed in more detail in Chapter 5.) The key valuation rules are considered below.

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

Non-current assets with finite lives Benefits from assets with finite lives will be used up over time as a result of market changes, wear and tear, and so on. Plant, equipment, motor vehicles and computers are examples of tangible

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assets that are normally considered to have a finite life. A patent, which gives the owner exclusive rights to use an invention, is an example of an intangible asset that has a finite life. (Many patents are granted for a period of 20 years.) The amount used up, which is referred to as depreciation (or amortisation, in the case of intangible non-current assets), must be measured for each reporting period for which the assets are held. Although we shall leave a detailed examination of depreciation until Chapter 3, we need to know that when an asset has been depreciated this must be reflected in the statement of financial position. The total depreciation that has accumulated over the period since the asset was acquired must be deducted from its cost. This net figure (i.e. the cost of the asset less the total depreciation to date) is referred to as the carrying amount. It is sometimes also known as net book value or written-down value. The procedure just described is not really a contravention of the historic cost convention. It is simply recognition of the fact that a proportion of the historic cost of the noncurrent asset has been allocated in the process of generating benefits for the business.

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

Fair values Although initially historic cost is the standard or ‘benchmark’ treatment for recording non-current assets of all types (tangible and intangible, finite or indefinite lives), an alternative is allowed. Noncurrent assets may be recorded using fair values, provided that these values can be measured reliably. The fair values, in this case, are the current market values (i.e. the exchange values in an arm’s length transaction). The use of fair values, rather than cost figures, whether depreciated or not, can provide users with more up-to-date information, which may well be more relevant to their needs. It may also place the business in a better light, as assets such as property may have increased significantly in value over time. Of course, increasing the statement of financial position value of an asset does not make that asset more valuable. Perceptions of the business, however, may be altered by such a move. One consequence of upwardly revaluing non-current assets with finite lives is that the depreciation charge will be increased. This is because depreciation is based on the new (increased) value of the asset. Refer back to Example 2.2 on page 55. What would be the effect of revaluing the property to a figure of $440,000 on the statement of financial position? The effect on the statement of financial position would be to increase the property to $440,000, and the gain on revaluation (i.e. $440,000 – $180,000 = $260,000) would be added to equity, as it is the owner(s) who will benefit from the gain. Typically, the revaluation ‘gain’ would be shown in a revaluation reserve. Once assets are revalued, the frequency of revaluation then becomes an important issue, as assets recorded at out-of-date revaluations can mislead users. Using such figures on the statement of financial position is the worst of both worlds. It lacks the objectivity and verifiability of historic cost; it also lacks the realism of current values. Where fair values are used, revaluations should therefore be frequent enough to ensure that the carrying amount of the revalued asset does not differ materially from its true fair value at the statement of financial position date. When an item of property, plant or equipment (a tangible asset) is revalued on the basis of fair values, all assets within that particular group must be revalued. Thus, it is not acceptable to revalue some items of property but not others. Although this provides some degree of consistency within a particular group of assets, it does not prevent the statement of financial position from containing a mixture of valuations. Intangible assets are not often revalued to fair values. This is because revaluations can be used only where there is an active market, thereby permitting fair values to be properly determined. Such markets, however, rarely exist for intangible assets.

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

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The impairment of assets

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

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

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

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

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

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

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

•

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

•

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

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

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

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

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

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

REAL WORLD 2.4 Myer: Non-current assets – valuation ‘Property, plant and equipment is stated at cost less depreciation. Cost includes expenditure that is directly attributable to the acquisition of the items’ (p. 75). ‘Goodwill and intangibles that have an indefinite life are tested annually for impairment, or more frequently if events or changes in circumstances indicate that they may be impaired … An impairment loss is recognised for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value to sell and value in use. ‘The useful life of brands are assessed on acquisition. The brands which are not considered to have foreseeable brand maturity dates have been assessed as having indefinite useful lives as there is a view that there is no foreseeable limit to the period over which key brands are expected to generate net cash inflows for the entity. These brands are therefore not amortised. Instead, these brand names are tested for impairment annually, or more frequently if events or changes in circumstances indicate that they might be impaired, and are carried at cost less accumulated impairment losses’ (p. 78). Source: Myer Annual Report 2016, pp. 75 & 78. © Myer Pty Ltd.

Harvey Norman ‘Plant and equipment assets are stated at historical cost less accumulated depreciation and any accumulated impairment losses. Land and buildings are measured at fair value less

accumulated depreciation on buildings and leasehold land and any impairment losses recognised at the date of the revaluation. Valuations are performed with sufficient frequency to ensure that the carrying amount of a revalued asset does not differ materially from its fair value’ (p. 69). For revaluations of owner-occupied properties ‘Fair value is determined by reference to market-based evidence, which is the amount for which the assets could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arm’s length transaction as at the valuation date’ (p. 69). For Investment properties ‘The fair value in respect of each investment property has been calculated using the income capitalisation method, against current market rental value, and having regard to, in respect of each property … A discounted cash flow valuation or a direct sale comparison valuation is undertaken in respect of all properties as a secondary check method of the capitalisation approach, excluding property for development’ (pp. 70–71). ‘The fair values of investments that are actively traded in organised financial markets are determined by reference to quoted market bid prices at the close of business at balance date. For investments with no active market, fair values are determined using valuation techniques’ (p. 72). Source: Harvey Norman Annual Report 2016. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

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

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USEFULNESS OF THE STATEMENT OF FINANCIAL POSITION The statement of financial position is the oldest of the three main financial statements, and many businesses prepare one on a regular basis, even though they may not be subject to regulations requiring it to be produced. This suggests that it is regarded as providing useful information. There are various ways in which the statement of financial position may help users, including the following: • It provides insights about how the business is financed and how its funds are deployed. The statement of financial position shows how much finance is contributed by the owners and how much is contributed by outside lenders. It also shows the different kinds of assets acquired and how much is invested in each kind. The relative proportion of total finance contributed by the owners and outsiders can be calculated to see whether the business depends heavily on outside financing. Heavy borrowing can incur a commitment to large interest payments and large capital repayments at regular intervals. Such legally enforceable obligations can be a real burden as they have to be paid irrespective of the financial position of the business. Funds raised from the owners of the business, on the other hand, do not impose such obligations on it. • It provides insights into the liquidity of the business. This is the ability of the business to meet its short-term obligations (current liabilities) from its liquid (cash and near-cash) assets. Liquidity is particularly important because business failures occur when the business cannot meet its maturing obligations, for whatever reason. • It can provide a basis for assessing the value of the business. Since the statement of financial position lists, and places a value on, the various assets and claims, it can provide a starting point for assessing the value of the business. It is, however, severely limited in the extent to which it can do this. We have seen earlier that accounting rules may result in assets being shown at their historic cost and that the restrictive definition of assets may exclude certain business resources from the statement of financial position. Ultimately, the value of a business will be based on its ability to generate wealth in the future. Because of this, assets need to be

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valued on the basis of their wealth-generating potential. Also, other business resources that do not meet the restrictive definition of assets, such as brand values, need to be similarly valued and included. • It provides insights into the ‘mix’ of assets held by the business. The relationship between current assets and non-current assets is important. Businesses with too much of their funds tied up in non-current assets could be vulnerable to financial failure, because non-current assets are seldom easy to turn into cash to meet short-term obligations. Converting many noncurrent assets into cash may well lead to substantial losses for the business, because such assets are not always worth on the open market what the business paid to acquire them or what they are worth to the business. For example, a specialised piece of equipment may have great value to one business, yet little to another. • It can help users in assessing performance. The effectiveness of a business in generating wealth can usefully be assessed against the amount of investment that was involved. Thus, the relationship between profit earned during a period and the value of the net assets invested can be helpful to many users, particularly owners and managers. The interpretation of the statement of financial position will be considered in more detail in Chapter 8.

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

$

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

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

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

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

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

Total liabilities and owners’ equity

252,000 1,060,000

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

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SELF-ASSESSMENT QUESTION

2.2

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

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STATEMENT OF FINANCIAL POSITION DEFICIENCIES ACTIVITY 2.7 The statement of financial position has been likened to a financial photograph or snapshot of a business at a point in time. If you think about the problems you have had with particular photos you have taken, these will provide some useful insights into potential deficiencies in statements of financial position. For example, when looking at a group photograph you have taken, you may have noted that:

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69

someone has been le out another person is obscured by an intervening object there is a person in the photo who was not part of your group another person moved and their image is blurred the picture is skewed to one side, or there is a problem with some of the group being in the light and others in the shade.

How can these problems with taking a group photograph relate to the possible deficiencies of a statement of financial position in presenting the financial position at a point in time?

Thinking along these lines enables us to identify some of the deficiencies or limitations that a statement of financial position has in presenting the financial position of an entity at a point in time. The statement of financial position represents the end product of the interpretation and application, by management, accountants and auditors, of the statutory and professional rules and principles of accounting and financial reporting. In interpreting and applying this body of knowledge, at least two situations may cause deficiencies in individual statements of the financial position of a given entity at a point in time. First, within this body of knowledge itself there are potential conflicts that may lead to such deficiencies. While this introductory text on accounting does not set out to review accounting theory in detail, a few examples may illustrate the possible conflicts. We stated earlier that an underlying assumption was a ‘stable monetary unit’: the economic reality is that since money is a good in its own right, subject to supply and demand fluctuations, it cannot be used accurately as a measuring unit for comparisons over time. Therefore, when accountants add building costs in 2000 to alteration costs in 2017, the aggregate makes no more sense than adding together Australian and US dollars without making some translation adjustment. That is, Australian dollars in 2000 do not have the same purchasing power significance as Australian dollars in 2017, so they cannot be added meaningfully. We also noted in Chapter 1 that financial information presented in the reports should be both relevant and reliable, yet these two qualities are often in conflict. Relevant information (useful in decision-making) is not always entirely reliable (faithfully representative), and if you wait for reliable information, it may not always be particularly relevant. What you paid for some equipment in 2005 can be reliably measured (external invoice and receipt), but this may not be relevant in 2017 when you have to decide whether to retain or dispose of the equipment. In 2017 you may want to know the value of that asset in use (present value of future cash flows attributable to that asset) or its value in exchange (estimated selling price less costs to sell). While these two current values are useful for decision-making, as measures they may not be reliable as they are subject to estimation error or personal bias. Second, the accounting principles and rules of the accounting body of knowledge allow management individuals considerable discretion when it comes to deciding how to record transactions. Many of these choices will be specifically discussed in Chapter 3 on the statement of financial performance, so you may find it useful to review this section after having read Chapter 3. These choices include: • Whether expenditure is to be recognised as giving rise to an immediate asset (statement of financial position) or expense (statement of financial performance). There are endless examples of this choice, but a few common examples are expenditure related to advertising, research, exploration and plant repairs. Of course, the treatment selected will immediately affect the statement of financial position for assets. • The requirement to make estimates or guesses about future events. Accountants are forever required to anticipate what will happen in the future. There are many examples of the estimation process. With inventory, estimates are made about their realisable value and possible losses from obsolescence, deterioration or theft. With accounts receivable, estimates are made about sales returns, discounts to be taken, the timing of the receipts, and how much will not be collected. With plant and equipment, estimates are made about useful lives, residual values, the pattern of using up the economic benefits, and their individual recoverable

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amount. Obviously, the results of all these estimates and guesses are reflected in the final numbers in the statement of financial position. The accountant nevertheless has a wide range of accounting methods or techniques for recording transactions in many areas related to the statement of financial position. In accounting for accounts receivable and bad debts, bad debts can be recognised when realised, or anticipated using a percentage of credit sales or based on the age of the debt. With inventory, the inventory on hand at the end of the period can be measured by different methods (first in, first out; last in, first out; weighted average; standard cost). With plant and equipment, various depreciation methods are acceptable (straight line; units of production; reducing balance; sum of the years’ digits). These few examples again highlight implications for the account balances in the statement of financial position.

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SUMMARY +PVJKUEJCRVGTYGJCXGCEJKGXGFVJGHQNNQYKPIQDLGEVKXGUKPVJGYC[UJQYP

OBJECTIVE

METHOD ACHIEVED

Explain the nature and purpose of the statement QHƂPCPEKCNRQUKVKQPCPFKVUEQORQPGPVRCTVU

• +FGPVKƂGFVJGRWTRQUGCUDGKPIVQUGVQWVVJGƂPCPEKCNRQUKVKQPQHCDWUKPGUU at a particular point of time • Explained that the statement included assets and claims, which consisted of external liabilities and owners’ equity • +FGPVKƂGFCPFCPCN[UGFVJGPCVWTGQHCUUGVU • +FGPVKƂGFCPFCPCN[UGFVJGPCVWTGQHNKCDKNKVKGU • +FGPVKƂGFCPFCPCN[UGFVJGPCVWTGQHQYPGTUoGSWKV[ • Used the accounting equation to illustrate the build-up of a statement of ƂPCPEKCNRQUKVKQPEQXGTKPICTCPIGQHVTCPUCEVKQPUKPENWFKPIVTCFKPI transactions

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• Explained the accounting equation • Illustrated by use of a practical example • Worked through an additional activity to enable us to prepare a statement of ƂPCPEKCNRQUKVKQPCHVGTCUGTKGUQHVTCPUCEVKQPU

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• +FGPVKƂGFVJGOQUVEQOOQPENCUUKƂECVKQPQHCUUGVUDGKPIDCUGFQPVJGVKOKPI QHTGEGKRVUQHDGPGƂVUQHQYPGTUJKR GIEWTTGPVPQPEWTTGPV • +FGPVKƂGFVJGEWTTGPVPQPEWTTGPVENCUUKƂECVKQPCUDGKPICRRTQRTKCVGHQT liabilities • Explained the difference between the various components of equity

Apply the different possible formats for the UVCVGOGPVQHƂPCPEKCNRQUKVKQP

• +NNWUVTCVGFVJGOCKPHQTOCVQHVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP • Examined the following formats: • horizontal (T account) • vertical (narrative) • Differentiated between the entity approach and the proprietary approach • +FGPVKƂGFVJGDCUKEGSWCVKQPCU • proprietary: OE = A – L • entity: A = L + OE

+FGPVKH[VJGOCKPHCEVQTUVJCVKPƃWGPEGVJG EQPVGPVCPFXCNWGUKPCUVCVGOGPVQHƂPCPEKCN position

+FGPVKƂGFCPFCPCN[UGFVJGHQNNQYKPIHCEVQTU • conventional accounting practice • business entity • historic cost • prudence • going concern • dual aspect • money measurement, including consideration of goodwill and brands and human resources • stable monetary unit • valuation of assets

+FGPVKH[VJGOCKPYC[UKPYJKEJVJGUVCVGOGPVQH +FGPVKƂGFVJGYC[UKPYJKEJVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPECPRTQXKFGWUGHWN insights into: ƂPCPEKCNRQUKVKQPECPDGWUGHWNHQTWUGTUQH • JQYVJGDWUKPGUUKUƂPCPEGFCPFJQYHWPFUCTGFGRNQ[GF CEEQWPVKPIKPHQTOCVKQP • the liquidity (ability to meet short-term obligations) of the business • the value of the business • the relationship between assets and claims • the asset mix (productive or unproductive) of the business • business performance

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IFGPVKH[VJGOCKPFGƂEKGPEKGUQTNKOKVCVKQPUKP VJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP

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DISCUSSION QUESTIONS GENERAL EASY 2.1

LO1

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2.2

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2.3

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2.4

LO3

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INTERMEDIATE 2.5

LO1/5/7

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2.6

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2.7

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2.8

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2.9

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2.10 LO6

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2.11 LO2/5

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CHALLENGING 2.12 LO1/5

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2.13 LO1/2/5

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2.14 LO1/2/5

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2.15 LO5/6/7

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2.16 LO2

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73

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2.18 LO5

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APPLICATION EXERCISES EASY 2.1a LO2

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Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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ACCOUNTING FOR NON-SPECIALISTS

2.2

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Amount

0QX

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

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ACCOUNTING FOR NON-SPECIALISTS

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Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

Account

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Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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CHAPTER 2 MEASURING AND REPORTING FINANCIAL POSITION

2.13 LO1/2/3

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ACCOUNTING FOR NON-SPECIALISTS

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CHAPTER 2 CASE STUDY Usefulness of the statement of financial position If you were to do an internet search on ‘balance sheet uses’, you would get a series of hits ranging from Wikipedia through a number of commercial and academic sites. Undertake a search of this type and summarise your findings. Your summary should include, but not necessarily be confined to, the following: 1 The balance sheet/statement of financial position provides a summary of the assets and liabilities controlled by the business. 2 It provides a snapshot of the assets and liabilities at a particular moment in time.

3 These assets and liabilities are broken down under appropriate categories. 4 It shows how the business is funded. 5 The amount of the owners’ equity can be clearly seen. 6 Equity can be broken down into contributed capital and other retentions. 7 The level of debt, and the type of debt, can be clearly seen. 8 Liquidity can be ascertained. 9 The balance sheet follows a fairly standard form.

QUESTIONS 1

Do you agree that the statement of financial position provides a summary of the assets and liabilities of the business? What kind of omissions can you think of? What limitations does the statement have?

2

How useful is this summary in terms of making economic decisions?

3

The snapshot analogy is a good one, but what are the limitations of an approach of this type?

4

How does the statement of financial position help in assessing the financial health of a business?

5

Can you think of any reasons why the figure shown under equity in a statement of financial position could be misleading?

6

What do you think about the use of debt in a business? Why and when might the use of debt be appropriate?

7

Why might the absence of debt in a business be seen as displaying a sound financial approach?

8

What do you think were the main issues arising from the global financial crisis and how have they impacted on the levels of debt deemed to be acceptable or appropriate?

9

How important might financial flexibility be to a business?

10

Explain the terms ‘current’ and ‘non-current’. Why do you think current and non-current items are separately classified? How might this distinction help you in assessing the appropriateness of funding the assets?

11

What can you learn from the statement of financial position about liquidity within the business? How might you decide what level of liquidity is appropriate?

12

How does the statement of financial position help in assessing the risk inherent in the business?

Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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81

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CHAPTER 3

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

LO1 Explain the nature and purpose of a statement of financial performance, usually referred to as an income statement, and its relationship with the statement of financial position

LO2 Understand the layout of a typical statement of financial performance, and describe its component parts

LO3 Demonstrate an understanding of income and expenses in relation to definition, recognition, classification and measurement

LO4 Explain the concept of depreciation and its impact on the financial statements LO5 Identify the main issues relating to inventory in the context of the income statement and the statement of financial position

LO6 Identify the main issues regarding receivables in terms of revenue and expense recognition, and explain their impact on the income statement and the statement of financial position

LO7 Prepare a simple income statement from relevant financial information LO8 Review and interpret the income statement.

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

THE STATEMENT OF FINANCIAL PERFORMANCE—ITS NATURE AND PURPOSE, AND ITS RELATIONSHIP WITH THE STATEMENT OF FINANCIAL POSITION In Chapter 2 we examined the nature and purpose of the statement of financial position. We saw that this statement was concerned with setting out the financial position of a business at a particular moment in time. However, most users need more than just the information on the amount of wealth held by a business at one moment in time. Businesses exist for the primary purpose of generating wealth, or profit, and the profit generated during a specific period is the primary concern of many users of financial reports. Although the amount of profit generated is of particular interest to the owners of a business, other stakeholder groups, such as managers, employees and suppliers, will also have an interest in the profit-making ability of the business. The purpose of the income statement is to measure and report how much profit (financial progress or wealth) the business has generated over a period. It also helps users to gain some impression of how that profit was made. As with the statement of financial position, the principles are the same irrespective of whether the income statement is for a sole proprietorship business, a partnership or a limited company. Profit (or loss) is the difference between the increases in owners’ equity (capital), known as income, and the decreases in owners’ equity, known as expenses. You should note that changes in equity due to additional contributions from the owner(s), or withdrawals in the form of drawings or distributions, will not form part of the profit calculation. The measurement of profit (or loss) for the period requires the calculation of the total income of the business generated during a particular period less the expenses incurred for that period. Income is defined as the increases in economic benefits through the inflow of assets (e.g. cash or amounts owed to a business by accounts receivable) or the reduction in liabilities, which will increase equity (other than those relating to owners’ equity contributions) for the particular reporting period. Income is comprised of both operating ‘revenues’ and ‘other gains/losses’. Revenues represent the gross inflows of future economic benefits gained from the different categories of operating activities (e.g. cash from sales). Other gains represent the net inflows from the non-operating activities; for example, the gain on sale of investments, or the gain on foreign currency transactions. Different forms of business enterprise will generate different forms of revenue. Some examples of the different forms that revenue can take are as follows:

• • • •

sales of goods (e.g. of a manufacturer) fees for services (e.g. of a solicitor) subscriptions (e.g. of a club) interest received (e.g. of an investment fund).

It is quite possible for a business to have more than one source of income.

87

LO1 Explain the nature and purpose of a statement of financial performance, usually referred to as an income statement, and its relationship with the statement of financial position

income Increases in economic DGPGƂVUHQTVJGCEEQWPVKPI RGTKQFKPVJGHQTOQHKPƃQYU QHCUUGVUQTFGETGCUGUKP NKCDKNKVKGUVJCVTGUWNVKP KPETGCUGUKPGSWKV[QVJGT VJCPVJQUGTGNCVKPIVQ QYPGTUJKREQPVTKDWVKQPU revenues +PETGCUGUKPVJGQYPGTUo ENCKOCUCTGUWNVQH QRGTCVKQPU other gains )CKPUHTQOPQPQRGTCVKPI CEVKXKVKGU

ACTIVITY 3.1 The following represent different forms of business enterprise: 1 2 3 4 5 6 7 8 9

accountancy practice squash club bus company newspaper finance company songwriter retailer magazine publisher a large soccer club, e.g. Arsenal or Manchester United.

Can you identify the main source(s) of revenue for each type of business enterprise?

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expense #OGCUWTGQHVJGQWVƃQY QHCUUGVU QTKPETGCUGKP NKCDKNKVKGUKPEWTTGFCUCTGUWNV QHIGPGTCVKPITGXGPWGU

The total expenses relating to each period must also be identified. Expense is really the opposite of revenue. An expense represents the outflow of assets (or increase in liabilities) incurred in the process of carrying on a business and generating income. The nature of the business will again determine the type of expenses incurred. Examples of some of the more common types of expense are: • the cost of buying goods which are subsequently sold—known as ‘cost of sales’ or ‘cost of goods sold’ • salaries and wages • rent and rates • motor vehicle running expenses • insurances • printing and stationery • heat and light, and • telephone and postage. The income statement for a period simply shows the total income generated during a particular period (revenues and other gains), from which is deducted the total of the expenses incurred in generating that income. The difference between the total income and the total expenses will represent either profit (if income exceeds expenses) or loss (if expenses exceed income). Thus, we have: 2TQƂV NQUUHQTVJGRGTKQF6QVCNKPEQOG +s6QVCNGZRGPUGU ' KPEWTTGFKPIGPGTCVKPIVJGKPEQOG

reporting period 6JGRCTVKEWNCTRGTKQFHQT YJKEJVJGCEEQWPVKPI KPHQTOCVKQPKURTGRCTGF

The period over which profit or loss is normally measured is usually known as the reporting period, but it is sometimes called the ‘accounting period’ or ‘financial period’.

The two major statements—statement of financial position and income statement—should not be viewed as substitutes for each other, but rather as performing different functions. The statement of financial position of a business is a report at a single point in time and is effectively a ‘snapshot’ of the stock of wealth held by the business. The income statement, on the other hand, is concerned with the generation of wealth over a period of time. The two statements are closely related. The income statement can be viewed as linking the statement of financial position at the beginning of the period with that at the end of the period. At the start of a new reporting period, the statement of financial position shows the opening wealth position of the business. After an appropriate period, an income statement is prepared to show the wealth generated over that period. A statement of financial position is then also prepared to reveal the new wealth position at the end of the period. This statement will reflect the changes in wealth that have occurred since the previous statement of financial position was drawn up. Thus, at the commencement of the business, a financial position statement will be produced to reveal the opening financial position: ADGIOEDGI LDGI

where Abeg = assets at the beginning of the period OEbeg = owners’ equity (capital) at the beginning of the period, and Lbeg = liabilities at the beginning of the period At the end of an appropriate period, an income statement will be prepared to show the wealth generated over the period: 2TQƂV NQUUIRGTKQFsERGTKQF

where Iperiod = the income for the period, and Eperiod = the expenses for the period At the end of the period, a revised statement of financial position will be prepared to incorporate the changes in wealth that have occurred since the beginning financial position statement was

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drawn up. This will include adjustments to capital, reflecting the amount of profit for the period and any other owners’ changes disclosed. This means that the accounting equation can be extended as follows: #UUGVUGPFOEDGI 2TQƂV QTs.QUU1VJGTOECFL .KCDKNKVKGUGPF

where Assetsend = the assets at the end of the period Other OEadj = other adjustments to equity (i.e. injections and drawings or distributions) Liabilitiesend = liabilities at the end of the period This equation can be further extended to: #UUGVUGPFOEDGI  +PEQOGs'ZRGPUGU1VJGTOECFL .KCDKNKVKGUGPF

In theory, it would be possible to calculate profit and loss for the period by making all adjustments for income and expenses through the equity section of the statement of financial position (the capital account), as was done in the solution to Self-assessment Question 2.1. However, this would be rather cumbersome with even a small business. A better solution is to have an ‘appendix’ to the owners’ equity (capital) account in the form of an income statement. By deducting expenses from the income for the period, the profit (loss) can be derived for adjustment to the capital account. This figure represents the net effect of operating and other activities for the period. Providing this ‘appendix’ means that a detailed and more informative view of financial performance is presented to users.

The stock approach to calculating profit It is worth noting that, as a result of the relationship between the income statement and two consecutive statements of financial position, it is possible to compute the total profit or loss for a period based on what is known as the stock approach. Total equity must equal assets less external liabilities (net assets). Therefore the difference between the opening figure and closing figure for net assets must equal the changes in equity that have occurred over the accounting period. If we know the opening equity figure, any other injections of additional capital, and any drawings by or distributions to owners, it should be relatively easy to calculate the profit for the year. This can be done as follows: Opening equity Plus new capital injected Less any drawings or distributions Plus profit Equals the closing equity

known known known or estimated calculate known

stock approach #ECNEWNCVKQPQHRTQƂV HQTCRGTKQFDCUGFQPC EQORCTKUQPQHPGVCUUGVU QXGTVJGRGTKQFCFLWUVGF HQTCP[MPQYPKPLGEVKQPU QTYKVJFTCYCNUQHGSWKV[ YKVJVJGTGUWNVKPIFKHHGTGPEG RTQXKFKPICPGUVKOCVGQH RTQƂVQTNQUUHQTVJGRGTKQF net assets 6JGFKHHGTGPEGDGVYGGP CUUGVUCPFGZVGTPCNNKCDKNKVKGU

This approach to working out profit is particularly useful: • where the accounting records are incomplete • where regulatory bodies (e.g. taxation office) need to determine profit or loss when records are unavailable • for insurance assessors or other parties to determine profit or loss where records have been destroyed.

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LO2 Understand the layout of a typical statement of financial performance, and describe its component parts





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THE FORMAT OF THE INCOME STATEMENT The format of the income statement will vary according to both the entity structure (e.g. non-profit entity, sole proprietorship, partnership, company) and the nature of its operations (e.g. manufacturing, retail, service). To illustrate an income statement, let us consider the case of a retail business (i.e. a business that buys goods in their completed state and resells them). Example 3.1 sets out a typical layout for the income statement of a retail business.

BETTER-PRICE STORES Income statement

3.1

for the year ended 31 October 2017 $ 5CNGUTGXGPWG %QUVQHUCNGU )TQUURTQƂV 5CNCTKGUCPFYCIGU 4GPVCPFTCVGU *GCVCPFNKIJV 6GNGRJQPGCPFRQUVCIG +PUWTCPEG 4GRCKTUCPFOCKPVGPCPEG /QVQTXGJKENGTWPPKPIGZRGPUGU &GRTGEKCVKQPtƂZVWTGUCPFƂVVKPIU &GRTGEKCVKQPtOQVQTXGJKENGU 1RGTCVKPIRTQƂV +PVGTGUVQPNQCP +PVGTGUVTGEGKXGFHTQOKPXGUVOGPVU 4GPVTGEGKXGFHTQORTQRGTV[ 2TQƂVHQTVJG[GCT

432,000

 178,000

















 86,000

 2,000 6,000 93,000

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Note that parentheses are used to denote when an item is to be deducted. This convention is used by accountants in preference to + or – signs, and this method will normally be used throughout the text. A clear understanding of the key terms used in this statement is important and these are explained below.

Key terms Gross profit The first part of the income statement is concerned with calculating the ITQUURTQƂV for the period. We can see that revenue, which arises from selling the goods, is the first item to appear. Deducted from this item is the cost of sales (also called ‘cost of goods sold’) during the period. This gives the gross profit, which represents the profit from buying and selling goods, without taking into account any other revenues or expenses associated with the business.

gross profit 6JGFKHHGTGPEGDGVYGGPVJG TGXGPWGUHTQOUCNGUCPFVJG EQUVQHVJQUGUCNGU

Operating profit From the gross profit, operating expenses (overheads) that have been incurred in operating the business (salaries and wages, rent and rates, and so on) are deducted. The resulting figure is known as the QRGTCVKPIRTQƂV for the reporting period. This represents the wealth generated during the period from the normal activities of the business. It does not take account of any income that the business may have from activities that are not included in its normal operations. Better-Price Stores in Example 3.1 is a retailer, so the interest on some spare cash that the business has invested is not part of its operating profit. Costs of financing the business are also ignored in the calculation of the operating profit.

operating profit 6JGKPETGCUGKPYGCNVJHQT CRGTKQFVJCVKUIGPGTCVGF HTQOPQTOCNQRGTCVKQPU

Profit for the period Having established the operating profit, we add any non-operating income (such as interest receivable) and deduct any non-operating expenses (in this example, interest payable on borrowings made by the business) to arrive at the RTQƂVHQTVJGRGTKQF. This is the income that is attributable to the owner(s) of the business, and will be added to the equity figure in the statement of financial position. As can be seen, profit for the period is a residual: that is, the amount remaining after deducting all expenses incurred in generating the sales revenue for the period and taking account of non-operating income.

profit for the period 6JGRTQƂVHQTVJG[GCTCHVGT CTGCUQPCDNGGUVKOCVGQHVCZ NKMGN[HQTVJG[GCT

Cost of sales The EQUVQHUCNGU (or ‘cost of goods sold’) figure for a period can be identified in different ways. In some businesses, the cost of sales amount for each individual sale is identified at the time of the transaction. Each item of sales revenue is closely matched with the relevant cost of that sale, and so identifying the cost of sales figure for inclusion in the income statement is not a problem. Many large retailers (e.g. supermarkets) have point-of-sale (checkout) devices that not only record each sale but also simultaneously pick up the cost of the goods that are the subject of the particular sale. Other businesses that sell a relatively small number of high-value items (e.g. an engineering business that produces custom-made equipment) also tend to match sales revenue with the cost of the goods sold, at the time of the sale. However, some businesses (e.g. small retailers) do not usually find it practical to match each sale to a particular cost of sales figure as the reporting period progresses. Instead, therefore, they identify the cost of sales figure at the end of the reporting period. To understand how this is done, we need to remember that the cost of sales figure represents the cost of goods that were sold by the business during the period rather than the cost of goods that were bought by that business during the period. Part of the goods bought during a particular period may remain in the business, as inventories, at the reporting period end. These will normally be sold in the next period. To derive the cost of sales for a period, we need to know the amount of opening and closing inventories for the period and the cost of goods bought during the period. Example 3.2 illustrates how the cost of sales is derived.

cost of sales 6JGEQUVCVVTKDWVCDNGVQVJG UCNGUTGXGPWGU

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$GVVGT2TKEG5VQTGUYJKEJYGEQPUKFGTGFKP'ZCORNGDGICPVJGTGRQTVKPIRGTKQFYKVJWPUQNF KPXGPVQTKGUQHCPFFWTKPIVJCV[GCTDQWIJVKPXGPVQTKGUCVCEQUVQH#VVJGGPF QH|VJG[GCTWPUQNFKPXGPVQTKGUQHYGTGUVKNNJGNFD[VJGDWUKPGUU

3.2

6JGQRGPKPIKPXGPVQTKGUCVVJGDGIKPPKPIQHVJG[GCTplusVJGIQQFUDQWIJVFWTKPIVJG[GCTYKNN TGRTGUGPVVJGVQVCNIQQFUCXCKNCDNGHQTTGUCNG6JWU

1RGPKPIKPXGPVQTKGU 2WTEJCUGU IQQFUDQWIJV )QQFUCXCKNCDNGHQTTGUCNG

$ 40,000 289,000 329,000

6JGENQUKPIKPXGPVQTKGUYKNNTGRTGUGPVVJCVRQTVKQPQHVJGVQVCNIQQFUCXCKNCDNGHQTTGUCNGVJCVTGOCKPU WPUQNFCVVJGGPFQHVJGRGTKQF6JWUVJGEQUVQHIQQFUCEVWCNN[UQNFFWTKPIVJGRGTKQFOWUVDGVJG VQVCNIQQFUCXCKNCDNGHQTTGUCNGlessVJGKPXGPVQTKGUTGOCKPKPICVVJGGPFQHVJGRGTKQF6JCVKU

)QQFUCXCKNCDNGHQTTGUCNG %NQUKPIKPXGPVQTKGU %QUVQHUCNGU QTEQUVQHIQQFUUQNF

$ 329,000

 

These calculations are sometimes shown on the face of the income statement as in Example 3.3.

3.3

5CNGUTGXGPWG %QUVQHUCNGU  1RGPKPIKPXGPVQTKGU  2WTEJCUGU IQQFUDQWIJV  %NQUKPIKPXGPVQTKGU )TQUURTQƂV

$ 432,000 40,000 289,000



 178,000

This is just an expanded version of the first section of the income statement for Better-Price Stores, as set out in Example 3.1. We have simply included the additional information concerning inventories balances and purchases for the year in Example 3.2.

Classifying expenses The classifications for the revenue and expense items—as with the classifications of various assets and claims in the statement of financial position—are often a matter of judgement by those who design the accounting system. Thus, the income statement set out in Example 3.1 (page 90) could have included the insurance expense with the telephone and postage expense under a single heading—say, ‘general expenses’. Such decisions are normally based on how useful a particular classification will be to users. This will usually mean that expense items of material size will be shown separately. For businesses that trade as limited companies, however, there are rules that dictate the classification of various items appearing in the financial statements for external reporting purposes. In this case, and in general, expenses are normally classified under four headings: 1 cost of sales 2 selling and distribution 3 administration and general, and 4 financial.

You should note that this classification applies only to external reporting. More detail would be required by managers in their day-to-day operations, and managerial reports would provide as much detail as was needed.

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ACTIVITY 3.2 The following information relates to the activities of H & S Retailers for the year ended 30 April 2018: $ Motor vehicle running expenses Closing inventory Rent and rates Rent received from sub-letting Motor vans Annual depreciation—motor vans Heat and light Telephone and postage Sales Goods purchased Insurance Loan interest payable Balance at bank Salaries and wages Opening inventory

4,800 12,000 20,000 8,000 25,200 6,000 3,600 1,800 389,600 273,400 3,000 2,480 19,120 41,600 16,000

Prepare an income statement for the year ended 30 April 2018. (Hint: Not all items listed should appear on this statement.)

The reporting period We have seen already that for reporting to those outside the business, a financial reporting cycle of one year is the norm, although some large businesses produce a half-yearly, or interim, financial statement to provide more frequent feedback on progress. For those who manage a business, however, it is mostly essential to have much more frequent feedback on performance. Thus it is quite common for income statements to be prepared on a quarterly, monthly, weekly or even daily basis in order to show how things are progressing.

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PROFIT MEASUREMENT AND THE RECOGNITION OF REVENUES AND EXPENSES

Recognition of revenues Demonstrate an understanding of income and expenses in relation to definition, recognition, classification and measurement

A key issue in the measurement of profit concerns the point at which income (revenue) is recognised. It is possible to recognise income at different points in the production/selling cycle, and the particular point chosen could have a significant effect on the total income reported for the period. Many business failures and corporate crashes happen when profit has been inflated by recognising income before it was realised, and in most of these cases it was never realised. By way of illustration of the problem, let us consider the situation where a motor car dealer receives an order for a new car from one of its customers. The associated revenue could be recognised by the dealer: • at the time that the order is placed by the customer • at the time that the car is collected by the customer, or • at the time that the customer pays the dealer. These three points could well be quite far apart, particularly where the order relates to a specialist car that is sold to the customer on credit. The point chosen is not simply a matter of academic interest: it can have a profound impact on the total revenues reported for a particular reporting period. This, in turn, could have a profound effect on profit. If the sales transaction straddled the end of a reporting period, the choice made between the three possible times for recognising the revenue could determine whether it is included as revenue of an earlier reporting period or a later one. Irrespective of whether we are dealing with the sale of goods or the provision of services, the main criteria for recognising revenue are that: • the amount of revenue can be measured reliably, and • it is probable that the economic benefits will be received. An additional criterion, however, must be applied where the revenue comes from the sale of goods, which is that: • ownership and control of the items should pass to the buyer. Implicit in these criteria is that the activities necessary to generate the revenue (e.g. delivery of goods, carrying out repairs) are substantially complete, and that any other related outstanding items (e.g. returns, warranty) can be determined with reasonable certainty. Referring back to the sale of a car by a motor dealer, all of the three criteria mentioned above will usually be fulfilled at the point when the goods are passed to, and accepted by, the customer. This is because: • the selling price and the settlement terms will have been agreed and therefore the amount of revenue can be reliably measured • delivery and acceptance of the goods leads to ownership and control passing to the buyer, and • transferring ownership gives the seller legally enforceable rights that make it probable that the buyer will pay.

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We can see that the effect of applying these criteria is that a sale on credit is usually recognised before the cash is received. This means that the total sales revenue figure shown in the income statement may include sales transactions for which the cash has yet to be received. The total sales revenue figure in the income statement for a period will often, therefore, be different from the total cash received from sales during that period. For cash sales (i.e. sales where cash is paid at the same time as the goods are transferred), there will be no difference in timing between reporting sales revenue and cash received. Particular issues arise in the context of long-term contracts and services. These are dealt with in more detail below.

Long-term contracts Some contracts, both for goods and services, can last for more than one reporting period. If the business providing the goods or service were to wait until the contract was completely fulfilled before recognising revenue, the income statement could give a misleading impression of the wealth generated in the various reporting periods covered by the contract. This is a particular problem for businesses that undertake major long-term contracts, where a single contract could represent a large proportion of their total activities. Construction contracts often extend over a long period of time. Suppose that a customer enters into a contract with a builder to have a new factory built that will take three years to complete. In such a situation, it is possible to recognise revenue before the factory is completed, provided that the building work can be broken down into a number of stages and each stage can be measured reliably. Let us assume that building the factory could be broken down into the following stages: • • • •

Stage 1: clearing and levelling the land and putting in the foundations Stage 2: building the walls Stage 3: putting on the roof Stage 4: putting in the windows and completing all of the interior work.

Each stage can be awarded a separate ‘staging’ price, with the total for all the stages being equal to the total contract price for the factory. This means that, as each stage is completed, the builder can recognise the price for that stage as revenue and bill the customer accordingly. This is provided that the outcome of the contract as a whole can be estimated reliably. If the builder were to wait until the factory was completed before recognising revenue, the income statement covering the final year of the contract would recognise all of the revenue on the contract, and the income statements for each preceding year would recognise no revenue. This would give a misleading impression, as it would not reflect the work done during each period.

Services There are certain kinds of services that may take years to complete. One example is where a consultancy business installs a new computer system for the government. Under these circumstances, if the contract can be broken down into stages, and each stage can be reliably measured, a similar approach to that used for long-term construction contracts can be adopted. This will allow revenue to be recognised at each stage of completion. In some cases, a continuous service may be provided to a customer. For example, a telecommunications business may provide open access to the internet for subscribers. Here, the benefits from providing the service are usually assumed to arise evenly over time and so revenue is recognised evenly over the subscription period. Where it is not possible to break down a service into particular stages of completion, or to assume that benefits from providing the service accrue evenly over time, revenue will not usually be recognised until the service is fully completed. The work done by a solicitor on a house purchase for a client would normally be one such example. When a service is provided, there will usually be a timing difference between the recognition of revenue and the receipt of cash. Revenue for providing services is often recognised before the cash is received, as with the sale of goods on credit. However, there are occasions when it is the other way around, usually because the business demands payment before providing the service. Examples Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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include: rent received from letting premises; telephone line rental charges; vehicle licences or TV subscription fees; and subscriptions received for the membership of clubs. Real World 3.1 provides an illustration of the difficulties and importance of determining exactly when a sale should be recognised for income purposes.

REAL WORLD 3.1 The Hewlett Packard/Autonomy takeover Hewlett-Packard (HP) bought British software company Autonomy for US$11 billion in 2011. HP subsequently argued that Autonomy included too much revenue upfront in deals selling both soware and continuing services to clients, and sued Autonomy. The issue surrounds the question as to when is a sale a sale? The problems identified earlier in this section on revenue recognition can be seen to be real issues in mainstream corporations. The issue seems to be based on just how the rules relating to revenue recognition are applied. Standard practice in this particular industry seems to be that a proportion is recognised upfront, with the balance being spread over the life of the service contract. Each company can determine the appropriate split for them, which then needs to be applied consistently over time. Obviously HP was unhappy with the split determined by Autonomy. HP wrote down the value of the Autonomy deal by US$8.8 billion in 2012, blaming US$5.5 million on ‘accounting improprieties’. It referred the case to the US Securities and Exchange Commission and the British Serious Fraud Squad. In 2015 Hewlett-Packard unveiled the details of its fraud case against Mike Leach, the founder of Autonomy. Essentially it boils down to the claim that Autonomy fraudulently inflated the revenues. ‘Its purpose was to ensure that the Autonomy group’s financial performance … appeared to be that of a rapidly growing pure soware company.’ HP’s allegations are based on Autonomy practices such as recognising sales to resellers rather than to the ultimate customer, and allegations of disclosure failures relating to sales of low-margin (even loss-making) computer hardware to support its more lucrative soware business.

In October 2015, Mike Lynch counter-claimed against Hewlett-Packard for more than US$160 million, for trashing his reputation and hampering his venture capital fundraising efforts. The UK Serious Fraud Squad closed its criminal investigation in January 2015 without bringing charges. Probes by the Securities Exchange Commission and the FBI appear to be continuing. Questions have been raised as to why, if there was jiggerypokery at Autonomy, it went unnoticed for so long by so many. The legal arguments continue and are not expected to be finalised until 2018. In September 2016, The Guardian reported that British firm Micro Focus will take on the remaining soware assets from HP’s 2011 acquisition. Sources: Andrew Peaple, ‘Accounting for Autonomy’, The Australian, 23 November 2012. ‘Fallen idols’, The Economist, 24 November 2012, www.economist.com/ news/business/21567080-we-were-duped-overpaying-british-sowarecompany-says-hp-fallen-idols. Arik Hesseldahl, ‘HP sues former Autonomy execs, seeking $5 billion in damages’, Recode, 31 March 2015, http://recode.net/2015/03/31/ hp-sues-former-autonomy-execs-seeking-5-billion-in-damages/. Arik Hesseldahl, ‘HP’s $5.5 billion fraud lawsuit against former Autonomy executive is now public’, Recode, 5 May 2015, http://recode/ net/2015/05/05/hps-5-billion-fraud-lawsuit-against-former-autonomyexecutives-is-now-public/. Christopher Williams, ‘Autonomy Founder Mike Lynch sues HP for $160m over fraud claims’, The Telegraph, 1 October 2015, http://www. telegraph.co/uk/finance/news/bysector/mediatechnologyandtelecoms/ electronics/11905834/Autonomy-founder-Mike-Lynch-sues-HP-for-160mover-fraud-claims. Angela Monaghan, Hewlett-Packard offloads last Autonomy assets in soware deal, The Guardian, 9 September 2016.

Cash versus accrual revenue recognition The application of these recognition criteria in accounting means that a sale on credit is usually recognised before the cash is ultimately received. The total sales figure in the income statement will, therefore, differ from the total cash received from sales. Alternatively, situations may also arise where an entity has received benefits (normally cash) in advance—that is, before providing all of the related goods and services. For example, customers often pay a deposit in advance, or pay for goods or services for a specified future time period

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(e.g. subscriptions, insurance premiums and service fees are regularly paid in advance). For such transactions the income recognition criteria are not fully satisfied, and the reporting entity receiving such advances should classify the advance receipts as a liability (known as ‘deferred revenue’) in the statement of financial position. They represent an obligation to provide the customer, member or client, goods or services (or a refund where goods or services are not provided) at some time in the future. It is important to note that the approach in this section (known as ‘accruals accounting’) recognises income on the basis that it has been earned irrespective of whether the cash receipt is in arrears or advance. For accounting purposes, we have deemed that income is earned when it is realised; realisation being closely linked to probability of occurrence and reliability of measurement. Real World 3.2 provides some examples of the way in which revenue is recognised in practice.

REAL WORLD 3.2 Revenue recognition Harvey Norman Sale of goods ‘Revenue is recognised when the significant risks and rewards of ownership have passed to the buyer and the costs incurred, or to be incurred, in respect of the transaction can be measured reliably. Risks and rewards are considered passed to the buyer at the time of delivery of the goods to the customer. Lay-by sales are recognised aer the final payment is received from the customer’ (p. 75).

Dividends

‘Revenue from contracting businesses is included in sale of goods and is recognised in proportion to the stage of completion of the contract. An expected loss is recognised immediately as an expense. ‘Revenue from the sale of services is recognised when the service has been provided to the customer and where there are no continuing unfulfilled service obligations. ‘Revenue from the sale of land development projects is recognised when all of the following conditions have been met: contracts are exchanged; an appropriate non-refundable deposit is received; and material conditions contained within the contract are met.’

‘Revenue is recognised when the shareholders’ right to receive the dividend is established’ (p. 75).

Source: Boral Limited Annual Report 2016, p. 85.

Rental income

Fletcher Building Group

‘Rental income arising on investment properties is accounted for on a straight-line basis over the lease terms and is included in revenue due to its operating nature’ (p. 76).

Fletcher Building Group is a New Zealand based building business which also operates in Australia and the rest of the world. A substantial part of its work involves construction. Revenue from construction contracts ‘requires estimates to be made of the outcomes under each contract, which requires assessments and judgements to be made on a range of factors such as: recovery of pre-contract costs, changes in the scope of work, contract programmes, maintenance and defects liabilities, and changes in costs’ (p. 62). ‘Earnings on construction contracts (including subcontracts) are determined using the percentage-of-completion method. Earnings are not recognised until the outcome can be reliably estimated. The company uses its professional judgement to assess both the physical completion and the forecast financial result of the contract. Provision is made for estimated future losses on the entire contract from the date it is first recognised that a contract loss may be incurred’ (p. 65).

Source: Harvey Norman Annual Report 2016, pp. 75, 76. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Boral Sales revenue is revenue earned from the provision of products or services, net of returns, discounts and allowances.

Significant accounting judgements, estimates and assumptions ‘Revenue from the sale of goods is recognised when the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is probable, the associated costs and possible return of the goods can be estimated reliably, there is no continuing management involvement with the goods and the amount of the revenue can be measured reliably.

Source: Fletcher Building Annual Report 2016, pp. 62 and 65. Fletcher Building Limited.

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Recognition of expenses matching convention 6JGCEEQWPVKPIEQPXGPVKQP YJKEJJQNFUVJCVKP OGCUWTKPIKPEQOGGZRGPUGU UJQWNFDGOCVEJGFVQ VJGTGXGPWGUVJG[JGNRGF IGPGTCVGKPVJGUCOG CEEQWPVKPIRGTKQFCUVJQUG TGXGPWGUYGTGTGCNKUGF

Having considered the recognition of revenue, let us now turn to the recognition of expenses. The matching convention provides guidance on this. This convention states that expenses should be matched to the revenue that they helped generate. In other words, the expenses associated with a particular item of revenue must be taken into account in the same reporting period as that in which the item of revenue is included. Applying this convention often means that an expense reported in the income statement for a period may not be the same as the cash paid for that item during the period. Accruals accounting clearly also applies to recognition of expenses. Also, as with revenues, for an item to be treated as an expense its occurrence must be probable (more likely than less likely) and it must be capable of being reliably measured. In recognising expenses in a specific period, three possibilities arise: 1 the cash payments are the same as the expenses incurred (benefits used up or consumed) 2 the cash payments are less than the expenses incurred, or 3 the cash payments exceed the expenses incurred.

The first possibility poses no problems, as the expense that is recognised on an accrual basis is the same as the cash paid. However, with the other possibilities, the expense recognised on an accrual basis is not the same as the cash paid. We will review these two in more detail. Remember that for the accrual method of recognising expenses, the expense is recognised when it is incurred (i.e. the economic benefits are used up).

Recognising expenses where the expense for the period is more than the cash paid during the period Consider Example 3.4.

3.4

&QOGUVKE.VFCTGVCKNGTUGNNUJQWUGJQNFGNGEVTKECNCRRNKCPEGU+VRC[UKVUUCNGUUVCHHCEQOOKUUKQPQH QHUCNGUTGXGPWGIGPGTCVGF6QVCNUCNGUTGXGPWGHQTNCUV[GCTCOQWPVGFVQ6JKUYKNNOGCP VJCVVJGEQOOKUUKQPVQDGRCKFKPTGURGEVQHVJGUCNGUHQTVJG[GCTYKNNDG*QYGXGTD[VJGGPF QHVJG[GCTVJGCOQWPVQHUCNGUEQOOKUUKQPVJCVJCFCEVWCNN[DGGPRCKFVQUVCHHYCUQPN[+HVJG DWUKPGUUTGRQTVGFLWUVVJGCOQWPVRCKFKVYQWNFOGCPVJCVVJGKPEQOGUVCVGOGPVYQWNFPQVTGƃGEV VJGHWNNGZRGPUGHQTVJG[GCT6JKUYQWNFEQPVTCXGPGVJGmatching conventionDGECWUGPQVCNNQHVJG GZRGPUGUCUUQEKCVGFYKVJVJGTGXGPWGQHVJG[GCTYQWNFJCXGDGGPOCVEJGFKPVJGKPEQOGUVCVGOGPV #NUQVJGLWUVKƂECVKQPHQTVJGEQOOKUUKQPKUENGCT DGVVGTVJCPRTQDCDNGCPFKVKUOGCUWTCDNGYKVJ CEEWTCE[5QVJGCFLWUVOGPVPGGFGFKUCUHQNNQYU r 5CNGUEQOOKUUKQPGZRGPUGKPVJGKPEQOGUVCVGOGPVYKNNKPENWFGVJGCOQWPVRCKFRNWUVJGCOQWPV QWVUVCPFKPI KG 

accrued expenses 'ZRGPUGUYJKEJCTG QWVUVCPFKPICVVJGGPFQH VJGCEEQWPVKPIRGTKQF

r 6JGCOQWPVQWVUVCPFKPI TGRTGUGPVUCPQWVUVCPFKPINKCDKNKV[CVVJGGPFQHVJG[GCTCPFYKNNDG KPENWFGFWPFGTVJGJGCFKPIaccrued expensesQTnCEETWCNUoKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP#U VJKUKVGOYKNNJCXGVQDGRCKFYKVJKPOQPVJUQHVJG[GCTGPFKVYKNNDGVTGCVGFCUCEWTTGPVNKCDKNKV[ r 6JGECUJYKNNCNTGCF[JCXGDGGPTGFWEGFVQTGƃGEVVJGEQOOKUUKQPRCKF FWTKPIVJGRGTKQF 6JGUGRQKPVUCTGKNNWUVTCVGFKP(KIWTG 9JGPVJGQWVUVCPFKPIUCNGUEQOOKUUKQPKURCKF RTQDCDN[KPVJGPGZVSWCTVGT r ECUJYKNNDGTGFWEGFCPF r VJGCOQWPVQHVJGCEETWGFGZRGPUGYKNNDGTGFWEGFGNKOKPCVGF

Ideally, all expenses should be matched to the income (e.g. sales) to which they relate, in the period in which they are reported. However, it is often difficult to match certain expenses closely to income in the same way that we have matched sales commission to sales. It is unlikely, for example, that electricity charges incurred can be linked directly to particular sales in this way. As a result, the electricity charges incurred will normally be recognised in (assigned or allocated to) the period to which they relate. Example 3.5 illustrates this.

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Income statement

Statement QHECUJƃQYU

Sales commission expense $6,000

Statement of ƂPCPEKCNRQUKVKQP at year’s end

Cash $5,000

Accrual $1,000

FIGURE 3.1 Accounting for sales commission 6JKUKNNWUVTCVGUVJGOCKPRQKPVUQH'ZCORNG9GECPUGGVJCVVJGUCNGUEQOOKUUKQPGZRGPUGQH YJKEJCRRGCTUKPVJGKPEQOGUVCVGOGPVKU OCFGWRQHCECUJGNGOGPVQHCPFCPCEETWGFGNGOGPVQH6JGECUJGNGOGPVCRRGCTUKPVJGUVCVGOGPVQHECUJƃQYUCPFVJGCEETWGF GNGOGPVYKNNCRRGCTCUC[GCTGPFNKCDKNKV[KPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP

&QOGUVKE.VFJCUTGCEJGFVJGGPFQHKVUTGRQTVKPIRGTKQFCPFJCURCKFHQTGNGEVTKEKV[HQTQPN[VJG ƂTUVVJTGGSWCTVGTUQHVJG[GCT COQWPVKPIVQ6JKUKUUKORN[DGECWUGVJGGNGEVTKEKV[EQORCP[ JCUQPN[LWUVUGPVQWVDKNNUHQTVJGSWCTVGTVJCVGPFUQPVJGUCOGFCVGCU&QOGUVKE.VFoU[GCTGPF 6JGCOQWPVQH&QOGUVKE.VFoUDKNNHQTVJKUNCUVSWCTVGTKU+PVJKUUKVWCVKQPVJGCOQWPVQHVJG GNGEVTKEKV[GZRGPUGQWVUVCPFKPIKUFGCNVYKVJCUHQNNQYU • 'NGEVTKEKV[GZRGPUGKPVJGKPEQOGUVCVGOGPVYKNNKPENWFGVJGCOQWPVRCKFRNWUVJGCOQWPVQHVJG DKNNHQTVJGNCUVSWCTVGT KG KPQTFGTVQEQXGTVJGYJQNG[GCT

3.5

r 6JGCOQWPVQHVJGQWVUVCPFKPIDKNN TGRTGUGPVUCNKCDKNKV[CVVJGGPFQHVJG[GCTCPFYKNNDG KPENWFGFWPFGTVJGJGCFKPInCEETWCNUoQTnCEETWGFGZRGPUGUoKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP 6JKUKVGOYQWNFPQTOCNN[JCXGVQDGRCKFYKVJKPOQPVJUQHVJG[GCTGPFCPFYKNNVJGTGHQTGDG VTGCVGFCUCEWTTGPVNKCDKNKV[ r 6JGECUJYKNNCNTGCF[JCXGDGGPTGFWEGFVQTGƃGEVVJGCOQWPV RCKFHQTGNGEVTKEKV[FWTKPI VJGRGTKQF 6JKUVTGCVOGPVYKNNOGCPVJCVVJGEQTTGEVƂIWTGHQTVJGGNGEVTKEKV[GZRGPUGHQTVJG[GCTYKNNDG KPENWFGFKPVJGKPEQOGUVCVGOGPV+VYKNNCNUQJCXGVJGGHHGEVQHUJQYKPIVJCVCVVJGGPFQHVJG TGRQTVKPIRGTKQF&QOGUVKE.VFQYGFVJGCOQWPVQHVJGNCUVSWCTVGToUGNGEVTKEKV[DKNN&GCNKPIYKVJ VJGQWVUVCPFKPICOQWPVKPVJKUYC[TGƃGEVUVJGFWCNCURGEVQHVJGKVGOCPFYKNNGPUWTGVJCVVJG CEEQWPVKPIGSWCVKQPKUOCKPVCKPGF

Domestic Ltd may wish to draw up its income statement before it is able to discover how much it owes for the last quarter’s electricity. In this case it is quite normal to make a reasonable estimate of the amount of the bill, and to use this estimated amount as described above. Examples of other expenses for a retailer that cannot be linked directly to sales revenue, and for which matching will therefore be done on a time basis, include rent and rates, insurance, interest payments and licence fees.

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Recognising expenses where the amount paid during the year is more than the full expense for the period Consider Example 3.6.

3.6

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prepaid expenses 'ZRGPUGUVJCVJCXGDGGP RCKFKPCFXCPEGCVVJGGPF QHVJGTGRQTVKPIRGTKQF

r 5JQYVJGSWCTVGToUTGPVRCKFKPCFXCPEG CUCprepaid expenseWPFGTCUUGVUKPVJGUVCVGOGPV QHƂPCPEKCNRQUKVKQP+VKUCPCUUGVDGECWUGKVTGRTGUGPVUHWVWTGGEQPQOKEDGPGƂVUKPVGTOUQHVJGTKIJV VQWUGVJGTGPVGFRTGOKUGUHQTVJGƂTUVVJTGGOQPVJUQHVJGPGZV[GCT2NGCUGPQVGVJCVVJKUGZCORNG KIPQTGU)56YJKEJYQWNFCRRN[VQEQOOGTEKCNTGPVCNU6JGRTGRCKFGZRGPUGYKNNCRRGCTCUCEWTTGPV CUUGVKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPWPFGTVJGJGCFKPInRTGRCKFGZRGPUGUoQTnRTGRC[OGPVUo +PVJGPGZVRGTKQFVJKURTGRC[OGPVYKNNEGCUGVQDGCPCUUGVCPFDGEQOGCPGZRGPUGKPVJGKPEQOG UVCVGOGPVQHVJCVRGTKQFYJGPVJGVJTGGOQPVJUoWUCIGGZRKTGU6JKUKUDGECWUGVJGTGPVRTGRCKF TGNCVGUVQVJCVRGTKQFCPFYKNNDGnWUGFWRoFWTKPIKV 6JGUGRQKPVUCTGKNNWUVTCVGFKP(KIWTG

Income statement

Statement QHECUJƃQYU

Rent payable expense $12,000

Statement of ƂPCPEKCNRQUKVKQP at year’s end

Cash $15,000

Prepaid expense $3,000

FIGURE 3.2 Accounting for rent payable 6JKUKNNWUVTCVGUVJGOCKPRQKPVUQH'ZCORNG9GECPUGGVJCVVJGTGPVGZRGPUGQH YJKEJCRRGCTUKPVJGKPEQOGUVCVGOGPVKUOCFGWRQH HQWTSWCTVGTUQHTGPVCVCSWCTVGT6JKUKUVJGCOQWPVVJCVTGNCVGUVQVJGRGTKQFCPFKUnWUGFWRoKPVJGRGTKQF6JGECUJRCKFQH

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In practice, the treatment of accruals and prepayments will be subject to the OCVGTKCNKV[ convention in accounting. This convention states that, where the amounts involved are immaterial (insignificant), we should consider only what is expedient. This may mean that an item will be treated as an expense in the period in which it is paid, rather than being strictly matched to the income to which it relates. For example, a business may find that, at the end of an accounting period, there is a bill of $5 owing for stationery used during the year. The time and effort involved in recording this as an accrual would have little effect on the measurement of profit or financial position for a business of any size, and so it would be ignored when preparing the income statement for the period. Presumably the bill would be paid in the following period and therefore it would be treated as an expense of that period.

101

materiality convention 6JGEQPXGPVKQPYJKEJ UC[UVJCVKVGOUPGGFVQDG UGRCTCVGN[FKUENQUGFKHVJG[ YKNNDGUGGPCUKORQTVCPV

OCVGTKCND[WUGTU+VGOU PQVFGGOGFVQDGKORQTVCPV GPQWIJVQLWUVKH[UGRCTCVG FKUENQUWTGECPDGITQWRGF VQIGVJGT

ACTIVITY 3.3 A business commences on 1 January. During the course of the first six months the following transactions occurred. 1

Sales of $200,000 were made, of which 80% were paid in cash by the end of the period.

2

Rent of $21,000 was paid, covering the period to the end of July.

3

Insurance, amounting to $2,000, was paid for the year.

4

Loan interest of $5,000 was paid, covering the first five months of the year.

5

Electricity bills, amounting to $800, were received and paid for during the period ending on 30 April. No other bills were received by the end of the six months.

6

A number of subscriptions covering the entire year were received, amounting to $2,000.

Show how these transactions will appear in the income statement for the first six months of business, and on the statement of financial position as at 30 June.

Profit, cash and accruals accounting—a review The previous sections on revenues and expenses show that, for a particular reporting period, total revenue does not usually represent cash received, and total expenses are not the same as cash paid. As a result, the profit figure (i.e. total revenue minus total expenses) does not normally represent the net cash generated from operations during a period, so it is important to distinguish between profitability and liquidity. Profit is a measure of achievement, or productive effort, rather than a measure of cash generated. Although making a profit will increase wealth, we have already seen in the previous chapter that cash is only one form in which that wealth may be held. These points are reflected in the CEETWCNUEQPXGPVKQP of accounting, which asserts that profit is the excess of revenue over expenses for a period, not the excess of cash receipts over cash payments. Leading on from this, the approach to accounting that is based on the accruals convention is frequently referred to as CEETWCNUCEEQWPVKPI. The statement of financial position and the income statement are both prepared on the basis of accruals accounting.

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Concept check 7 4GXGPWGKUIGPGTCNN[TGEQIPKUGFYJGP A B C D E

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Concept check 9 9JKEJQHVJGHQNNQYKPIDWUKPGUUGUYKNNJCXGVJGNGCUVRTQDNGOU YKVJTGXGPWGTGEQIPKVKQP! A B C D E

LO4 Explain the concept of depreciation and its impact on the financial statements

depreciation #OGCUWTGQHVJCVRQTVKQPQH VJGEQUV NGUUTGUKFWCNXCNWG QHCƂZGFCUUGVYJKEJJCU DGGPGZRGPUGFFWTKPICP CEEQWPVKPIRGTKQF amortisation 6JGYTKVKPIFQYPQHCP CUUGVtWUWCNN[CPKPVCPIKDNG CUUGVtCUKVUDGPGƂVKU WUGFWRVJGGSWKXCNGPV QHFGRTGEKCVKQPHQTCPQP EWTTGPVCUUGV

#HCUVHQQFTGUVCWTCPV An airline An accountant #YKPGT[ #VQQVJRCUVGOCPWHCEVWTGT

PROFIT MEASUREMENT AND THE CALCULATION OF DEPRECIATION The expense of depreciation, which appeared in the income statement for Better-Price Stores, is an example of a deferred expense, where the cash is paid in advance of the expense being recognised. Non-current assets (normally with the exception of freehold land) do not have a perpetual existence. They are eventually used up in the process of generating income for the business. This ‘using up’ may relate to physical deterioration (as with a motor vehicle). It may, however, be linked to obsolescence (as with some IT software that is no longer useful) or the mere passage of time (as with a purchased patent, which has a limited period of validity). In essence, depreciation is an attempt to measure that portion of the cost (or fair value) of a non-current asset that has been depleted in generating the revenue recognised during a particular period. Depreciation tends to be relevant both to tangible non-current assets (property, plant and equipment) and to intangible non-current assets (e.g. a licence to operate a mobile phone business). We should be clear that the principle is the same for both of these types of non-current asset. Some non-current assets could have perpetual useful lives. These might include land and acquired goodwill. These assets are typically not depreciated. In the case of intangibles, we usually refer to the expense as amortisation, rather than ‘depreciation’. In the interests of brevity, however, we shall use the word ‘depreciation’ for both tangibles and intangibles. In effect, depreciation is a cost allocation process, as the appropriate portion of cost that has been used up can only be an estimate. Management estimates how much of the economic benefits of the related asset have been used up during the period. The depreciation charge (the measure of the economic benefits used up) is considered to be an expense of the period to which it relates.

Calculating depreciation To calculate a depreciation expense for a period, four factors have to be considered: 1 the cost (or fair value) of the asset 2 the useful life of the asset

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3 the estimated residual value of the asset to the entity at the end of the useful life of the asset, and 4 the depreciation method used.

The cost (or fair value) of the asset This includes all costs incurred by the business to bring the asset to its required location and to make it ready for use. Thus, in addition to the costs of acquiring the asset, any delivery costs, installation costs (e.g. setting up a new machine) and legal costs incurred in the transfer of legal title (e.g. freehold property) are included as part of the total cost of the asset. Similarly, any costs incurred in improving or altering an asset to make it suitable for its intended use in the business are also included as part of the total cost. Example 3.7 provides an illustration.

&CNVQP'PIKPGGTKPI.VFRWTEJCUGFCPGYECTHQTKVUOCTMGVKPIFKTGEVQT6JGKPXQKEGTGEGKXGFHTQOVJG ECTUWRRNKGTTGXGCNGFVJGHQNNQYKPI $ 0GY*QNFGP%TW\G &GNKXGT[EJCTIG #NNQ[YJGGNU 5WPTQQH 2GVTQN 4GIKUVTCVKQP 2NCVGU

$ 24,000

 660 200 30  200

3.7

2,090 26,090 14,000 12,090

6TCFGKP%QOOQFQTG #OQWPVQWVUVCPFKPI

6JGEQUVQHVJGPGYECTYKNNDGCUHQNNQYU $ 0GY*QNFGP%TW\G &GNKXGT[EJCTIG #NNQ[YJGGNU 5WPTQQH 2NCVGU

$ 24,000

 660 200 200  

6JGUGEQUVUKPENWFGVJGFGNKXGT[EQUVUCPFRNCVGUCUVJG[CTGCPKPVGITCNRCTVQHVJGCUUGV +ORTQXGOGPVU CNNQ[YJGGNUCPFUWPTQQHCTGCNUQTGICTFGFCURCTVQHVJGVQVCNEQUVQHVJGECT6JG RGVTQNEQUVUCPFTGIKUVTCVKQPJQYGXGTTGRTGUGPVCEQUVQHQRGTCVKPIVJGCUUGVTCVJGTVJCPCRCTVQH VJGVQVCNEQUVQHCESWKTKPIVJGCUUGVCPFOCMKPIKVTGCF[HQTWUGUQVJGUGCOQWPVUYKNNDGEJCTIGFCU CPGZRGPUGKPVJGRGTKQFKPEWTTGF CNVJQWIJRCTVQHVJGEQUVQHVJGTGIKUVTCVKQPOC[DGTGICTFGFCUC RTGRCKFGZRGPUGKHVJGRGTKQFQHVJGTGIKUVTCVKQPIQGUDG[QPFVJGGPFQHVJGEWTTGPVƂPCPEKCN[GCT 6JGVTCFGKPƂIWTGUJQYPKURCTVRC[OGPVQHVJGVQVCNCOQWPVQWVUVCPFKPICPFKUPQVTGNGXCPVVQC EQPUKFGTCVKQPQHVJGVQVCNEQUV

The fair value of an asset was defined in Chapter 2 as the exchange value that could be obtained in an arm’s length transaction. Revaluations upwards from cost only occur if the fair value can be measured reliably. They are quite common with regard to certain types of assets (e.g. buildings), but are rare with regard to intangible non-current assets. Where fair values have been used, the depreciation expense should be based on those fair values, rather than on the historic costs.

The useful life of the asset A non-current asset has a physical life, an economic life and a useful life to the entity. The physical life of an asset becomes exhausted by wear and tear and the passage of time, although careful maintenance and improvements can extend this. The economic life of an asset is determined by the Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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effects of technological progress and commercial realities (e.g. changes in demand). The benefits provided by the asset are eventually outweighed by the costs as it becomes unable to compete with newer assets, or becomes irrelevant to the needs of the business. The economic life of a business asset may be much shorter than its physical life. For example, a computer may have a physical life of eight years and an economic life of three years. It is the economic life of an asset that will determine its expected useful life for the purpose of calculating depreciation. Forecasting this, however, may be extremely difficult in practice, as technological progress and shifts in consumer tastes can be swift and unpredictable.

Estimated residual value (disposal value) residual value 6JGGZRGEVGFXCNWGCVVJG GPFQHVJGWUGHWNNKHGQHC PQPEWTTGPVCUUGV

When a business disposes of a non-current asset it may still be of value to others, and some payment may be received. This payment will represent the asset’s TGUKFWCNXCNWG or ‘disposal value’. To calculate the total amount to be depreciated, the estimated residual value of the asset must be deducted from its cost. The likely amount to be received on disposal is, once again, often difficult to predict. The best guide is often past experience of similar assets sold.

Depreciation method Once the amount to be depreciated (i.e. the cost or fair value of the asset less any residual value) has been estimated, the business must select a method of allocating this depreciable amount between the reporting periods covering the asset’s useful life. There are various ways in which this can be done. The two most common methods are: straight-line depreciation #OGVJQFQHCEEQWPVKPI HQTFGRTGEKCVKQPYJKEJ CNNQECVGUVJGCOQWPVVQDG FGRTGEKCVGFGXGPN[QXGTVJG WUGHWNNKHGQHVJGCUUGV

• straight-line depreciation—with equal depreciation expense in each period • accelerated depreciation—with systematically higher depreciation expense in the earlier periods of the asset’s useful life, and systematically smaller depreciation expense in the later periods of its useful life. 5VTCKIJVNKPGFGRTGEKCVKQP simply allocates the amount to be depreciated evenly over the useful

life of the asset. In other words, there is an equal depreciation expense for each year that the asset is held. Example 3.8 illustrates how this works.

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3.8

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QTHCKTXCNWGNGUUVJGTGUKFWCNXCNWG6JKUCEEWOWNCVGFFGRTGEKCVKQPƂIWTGYKNNKPETGCUGGCEJ[GCTCU CTGUWNVQHVJGCPPWCNFGRTGEKCVKQPGZRGPUGKPVJGKPEQOGUVCVGOGPV6JKUCEEWOWNCVGFCOQWPVYKNN DGFGFWEVGFHTQOVJGEQUV QTHCKTXCNWGQHVJGCUUGVQPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP6JWUHQT GZCORNGCVVJGGPFQHVJGUGEQPF[GCTVJGCEEWOWNCVGFFGRTGEKCVKQPYKNNDG³CPF VJGCUUGVFGVCKNUYKNNCRRGCTQPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUHQNNQYU /CEJKPGCVEQUV .GUUCEEWOWNCVGFFGRTGEKCVKQP

$ 40,000 19,488

$



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The balance of $20,512 shown in Example 3.8 is referred to as the YTKVVGPFQYPXCNWG or PGVDQQMXCNWG or ECTT[KPICOQWPV of the asset. It represents that portion of the cost (or fair value) of the asset which has still to be written off (or allocated against future income generated from using the asset). This figure does not represent the current market value, which may be quite different. The only point at which the carrying amount is intended to equal the market value of the asset is immediately before it is to be disposed of. Thus, in Example 3.8, at the end of the four-year life of the machine, the carrying amount would be $1,024—its estimated disposal value. Disclosure of the two component parts of the writtendown value is generally considered to provide useful information as compared with disclosure of just a single figure. The straight-line method derives its name from the fact that the written-down value of the asset at the end of each year, when graphed against time, will result in a straight line, as shown in Figure 3.3.

105

written-down value 6JGEQUVQTHCKTXCNWGQHCP CUUGVNGUUVJGCEEWOWNCVGF COQWPVYTKVVGPQHHCU FGRTGEKCVKQPVQFCVG net book value #PQVJGTVGTOHQTYTKVVGP FQYPXCNWG carrying amount 6JGPGVDQQMXCNWGUJQYP KPVJGUVCVGOGPVQHƂPCPEKCN RQUKVKQPCVCRQKPVQHVKOG

FIGURE 3.3

Written-down 40 value ($000)

Graph of written-down value against time using the straight-line depreciation method

30

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20

10

0

1

2

3

4

Asset life (years)

The second approach to calculating depreciation for a period is referred to as CEEGNGTCVGF depreciation. The most common accelerated depreciation method is known as the reducingDCNCPEG OGVJQF (or declining-balance method), which applies a fixed percentage rate of depreciation to the written-down value of an asset each year. The effect of this will be higher annual depreciation charges in the early years and lower charges in the later years. Deriving the fixed percentage to be applied requires the use of the following formula: Pas

Î

n

where P = the depreciation percentage n = the useful life of the assets (in years) R = the residual value of the asset C = the cost of the asset

R b3 C

accelerated depreciation #PCRRTQCEJVQVJG ECNEWNCVKQPQHFGRTGEKCVKQP GZRGPUGYJKEJTGUWNVUKP FGRTGEKCVKQPGZRGPUGUDGKPI JKIJGTKPVJGGCTN[[GCTUQH CPCUUGVoUNKHGVJCPKPNCVGT [GCTU reducing-balance method #OGVJQFQHFGRTGEKCVKQPKP YJKEJCƂZGFRGTEGPVCIGKU CRRNKGFVQVJGYTKVVGPFQYP XCNWGQHVJGCUUGV

In practice an estimated approximate rate is often used. The fixed percentage rate will be given in all examples used in this text.

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To illustrate this method, let us take the same information used in Example 3.8, but this time use a fixed percentage (60%) of the written-down value to determine the annual depreciation charge. The calculations are shown in Example 3.9.

3.9

$ 40,000 24,000 16,000 9,600 6,400 3,840   1,024

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We can see that the pattern of depreciation is quite different between the two methods. If we plot the written-down value of the asset derived by using the reducing-balance method against time, the result will be as shown in Figure 3.4.

FIGURE 3.4

Written-down 40 value ($000)

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30

20

10

0

1

2

3

4

Asset life (years)

Other methods are clearly available. One interesting method is use of units of production based depreciation—the depreciation expense allocated to each period reflects the portion of the asset’s total available capacity that has been ‘used up’ in the current period (e.g. kilometres travelled, units produced, hours of operation). Under this method, the useful life of the asset changes from ‘time’ to ‘output’. At this point it is probably useful to consider the impact that use of the different depreciation methods has on profit. Let us assume that the machine used in the last two examples was owned by a business that made a profit before depreciation of $20,000 for each of the four years in which the asset was held. The impact on profit is shown below.

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107

STRAIGHT-LINE METHOD 2TQƂVDGHQTG FGRTGEKCVKQP $

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Year 1

20,000

9,744



Year 2

20,000

9,744



Year 3

20,000

9,744



Year 4

20,000

9,744





41,024

REDUCING-BALANCE METHOD PTQƂVDGHQTG FGRTGEKCVKQP $

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Year 1

20,000

24,000



Year 2

20,000



10,400

Year 3

20,000

3,840



Year 4

20,000







41,024

The above calculations reveal that the straight-line method of depreciation results in a constant net profit figure over the four-year period. This is because both the profit before depreciation and the depreciation charge are constant over the period. The reducing-balance method, however, results in a changing profit figure over time. In the first year a net loss is reported, and thereafter a rising net profit is reported. Although the pattern of profit over the individual periods will be quite different, depending on the depreciation method used, the total profit for the four-year period will remain the same. This is because the two methods of depreciation will allocate the same amount of total depreciation over the four-year period. It is only the amount allocated between years that will differ. In practice, the use of different depreciation methods may not have such a dramatic effect on profits as suggested above. This is because businesses typically have more than one depreciating non-current asset. Where a business replaces some of its assets each year, the total depreciation charge calculated under the reducing-balance method (or the units of production approach mentioned above) will reflect a range of charges (from high through to low), as assets will be at different points in the replacement cycle. This could mean that the total depreciation charge under these methods may not significantly differ from the total depreciation charge that would be derived under the straight-line method.

Selecting a depreciation method How does a business choose which depreciation method to use for a particular asset? The most appropriate method is the one that best matches the depreciation expense to the income it helped generate. The business may, therefore, decide to examine the pattern of benefits flowing from the asset. Where the benefits are likely to remain fairly constant over time (e.g. buildings), the straight-line method may be most appropriate. Where assets lose their efficiency over time and the benefits decline as a result (e.g. certain types of machinery), the reducing-balance method may be more appropriate. The units of production method mentioned above is particularly relevant where depreciation relates more to use than to time, or to technological or commercial factors. Where the pattern of economic benefits provided by the asset is uncertain, the straight-line method is normally chosen.

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There is an International Financial Reporting Standard (or International Accounting Standard) to deal with the depreciation of property, plant and equipment. As we shall see in Chapter 5, the purpose of accounting standards is to narrow areas of accounting difference and to try to ensure that information provided to users is transparent and comparable. The relevant standard endorses the view that the depreciation method chosen should reflect the pattern of economic benefits provided, but does not specify particular methods to be used. It states that the useful life, depreciation method and residual values of non-current assets should be reviewed at least annually and adjustments made where appropriate. Figure 3.5 provides an overview of the depreciation process related to non-current assets.

Cost (or fair value) less Residual value equals Depreciable amount

Year 1

Year 2

Year 3

Year 4

Depreciation

Depreciation

Depreciation

Depreciation

Asset life (Number of years)

FIGURE 3.5 Calculating the annual depreciation charge 6JGEQUV QTHCKTXCNWGQHCPCUUGVNGUUVJGTGUKFWCNXCNWGTGRTGUGPVUVJGCOQWPVVQDGFGRTGEKCVGF6JKUCOQWPVKUFGRTGEKCVGFQXGTVJGWUGHWNNKHG

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Impairment and depreciation We saw in Chapter 2 that all non-current assets could be subjected to an impairment test. Where a non-current asset with a finite life has its carrying amount reduced as a result of an impairment test, depreciation expenses for future reporting periods should be based on the impaired value of that asset.

Depreciation and the replacement of fixed assets Some people appear to believe that the purpose of depreciation is to provide the funds for the replacement of a non-current asset when it reaches the end of its useful life. However, this is not

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the case. It was mentioned earlier that depreciation represents an attempt to allocate the cost or fair value (less any residual value) of a non-current asset over its expected useful life. The depreciation expense for a particular reporting period is used in calculating profit for that period. If a depreciation charge is excluded from the income statement, we will not have a fair measure of financial performance. Whether or not the business intends to replace the asset in the future is irrelevant. Where an asset is to be replaced, the depreciation expense in the income statement will not ensure that liquid funds are set aside specifically for this purpose. Although the depreciation expense will reduce profit, and therefore reduce the amount that the owners may decide to withdraw, the amounts retained within the business as a result may be invested in ways that are unrelated to the replacement of the asset.

Depreciation and judgement When reading the above sections on depreciation it may have struck you that accounting is not as precise and objective as is sometimes suggested. There are areas where judgement is required, and depreciation provides a good illustration of this. Examples include: the expected residual or disposal value of the asset; the expected useful life of the asset; and the choice of depreciation method. Making different judgements on these matters will produce a different pattern of depreciation expense over the life of the asset and, therefore, a different pattern of reported profits. However, any under- or over-estimations made in this context will be adjusted for in the final year of an asset’s life (as a gain or loss on disposal), so the total depreciation charge (and total profit) over the asset’s life will not be affected by estimation errors.

ACTIVITY 3.4 Sally Dalton (Packaging) Ltd bought a machine for $40,000. At the end of its useful life of four years, the amount received on sale was $4,000. When the asset was bought, the business received two estimates of the likely residual value of the asset, which were: (a) $8,000 and (b) zero. Show the pattern of annual depreciation expenses over the four years and the total depreciation expenses for the asset under each of the two estimates. The straight-line method should be used to calculate the annual depreciation expenses.

The final adjustment for under-depreciation of an asset is often referred to as ‘loss (or deficit) on sale of non-current asset’, as the amount actually received is less than the residual value. Similarly, the adjustment for over-depreciation is often referred to as ‘profit (or surplus) on sale of non-current asset’. These final adjustments are normally made as an addition to the expense (or a reduction in the expense) for depreciation in the reporting period of disposal of the asset.

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PROFIT MEASUREMENT AND THE VALUATION OF INVENTORY LO5 Identify the main issues relating to inventory in the context of the income statement and the statement of financial position

As with non-current assets, inventory represents another example of a deferred expense, where the payment for the inventory precedes the recognition of the expense. The valuation of inventory and its impact on profit measurement raises the following issues: • • • •

What is inventory? What is the cost of inventory? What is the basis for transferring the inventory cost to cost of sales? What is the net realisable value of inventory?

What is inventory? Inventory for accounting purposes consists of finished goods (e.g. merchandise for a retailer), raw materials (e.g. inputs to the manufacturing process—metal, paint, timber), stores or supplies (e.g. consumables—paper, cleaning liquid), and work-in-progress (e.g. partly finished goods of a manufacturer).

What is the cost of inventory? All costs directly related to bringing the inventory into a saleable state (ready to sell) should be included as part of the cost of inventory. These include: • cost of purchase—which would include the purchase price, government taxes and duties, and freight-inwards costs • costs of conversion—which would largely concern goods being manufactured, including both costs that can be readily or physically traced to the product and others that cannot be obviously traced to the product (these latter costs are referred to as ‘indirect costs’ or ‘overheads’), and • other costs incurred to bring the inventories to their present location and condition—which could include things such as storage, security and display. The ‘cost of inventory’ for profit measurement implies that any costs included in inventory will be deferred as an asset (inventory), and not recognised as an expense until the inventory is sold (cost of goods sold) or written down (inventory write-down). Costs that are not included in inventory will be recognised immediately as expenses.

What is the basis for transferring the inventory cost to cost of sales? The cost of inventories is important in determining financial performance and position. The cost of inventories sold during a reporting period will affect the calculation of profit, and the cost of inventories held at the end of the reporting period will affect the portrayal of assets held.

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111

To calculate the cost of inventories, an assumption must be made about the physical flow of inventories through the business. This assumption need not have anything to do with how inventories actually flow through the business; it is concerned only with providing useful measures of performance and position. Three common assumptions used are:

FIFO #OGVJQFQHKPXGPVQT[ XCNWCVKQPDCUGFQPVJG CUUWORVKQPVJCVVJGƂTUV KPXGPVQT[TGEGKXGFKUVJGƂTUV VQDGWUGF

1 ƂTUVKPƂTUVQWV (+(1—the earliest inventories held are the first to be used

LIFO #OGVJQFQHKPXGPVQT[ XCNWCVKQPDCUGFQPVJG CUUWORVKQPVJCVVJGNCUV KPXGPVQT[TGEGKXGFKUVJG ƂTUVVQDGWUGF

2 NCUVKPƂTUVQWV .+(1—the latest inventories held are the first to be used 3 YGKIJVGFCXGTCIGEQUV #8%1—inventories entering the business lose their separate identity

and go into a ‘pool’; any issues with inventories then reflect the average cost of the inventories that are held. During a period of changing prices, the choice of assumption used in costing inventories can be important. Example 3.10 provides a simple illustration of how each assumption is applied and the effect of each on financial performance and position. Let us now use this information to calculate the cost of goods sold and closing inventory figures for the business. The example shows that purchases of 14,000 tonnes were made, that 9,000 tonnes were used up and sold, and 5,000 tonnes remained as closing inventory. The question is, what value do we put on the 9,000 tonnes which were sold, and what value on the closing inventory?

weighted average cost #OGVJQFQHKPXGPVQT[ XCNWCVKQPYJKEJOCMGU VJGCUUWORVKQPVJCVVJG XCNWCVKQPCVVCEJGFVQEQUV QHUCNGUKUDCUGFQPCP CXGTCIGEQUVQHKPXGPVQT[

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6QPPGU 1,000  8,000 14,000 9,000 

%QUVRGTVQPPG   

3.10

First in, first out Using FIFO, the first 9,000 tonnes of the purchases are assumed to be those that were sold and the remainder to comprise the closing inventory. Thus we have:

CLOSING INVENTORY

COST OF SALES NO. OF TONNES

COST PER TONNE $

TOTAL $

/C[

1,000

10

10,000

2



11



3

3,000

12



%QUVQHUCNGU

101,000

NO. OF TONNES

COST PER TONNE $

TOTAL $



12



%NQUKPIKPXGPVQT[

60,000

Last in, first out Using this approach, the later purchases are assumed to be the first to be sold and the earlier purchases to comprise the closing inventory. Thus we have:

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CLOSING INVENTORY

COST OF SALES NO. OF TONNES

COST PER TONNES $

TOTAL $

11,000

4,000

11

44,000

–

1,000

10

10,000

NO. OF TONNES

COST PER TONNE $

TOTAL $

/C[

8,000

12



2

1,000

11

1

– %QUVQHUCNGU

107,000

54,000

%NQUKPIKPXGPVQT[

Weighted average cost Using this approach, a weighted average cost will be determined, to derive both the cost of sales and the cost of the remaining inventory held. Thus we have: PURCHASES NO. OF TONNES

COST PER TONNE $

TOTAL $

/C[

1,000

10

10,000

2



11



3

8,000

12



14,000



#XGTCIGEQUV RGTVQPPG COST OF SALES

CLOSING INVENTORY

NO. OF TONNES

COST PER TONNE $

TOTAL $

9,000





NO. OF TONNES

COST PER TONNE $

TOTAL $







ACTIVITY 3.5 Suppose that the 9,000 tonnes of inventory (coal) were sold for $15 per tonne. a b c

Calculate the gross profit for the period under each of the three methods. How is the financial position affected by each method when prices are rising? Assume that prices are falling rather than rising. How would the financial performance and position differ under the various inventory valuation methods?

It is important to recognise that the different inventory cost allocation methods will affect only the reported profit between years. The figure derived for closing inventory will be carried forward and matched with sales in a later period. Thus, if the cheaper purchases of inventory are matched to sales in the current period, it will mean that the dearer purchases will be matched to sales in a later period. Over the life of the business, therefore, the total profit will be the same whichever cost allocation method has been used. In reviewing the different cost allocation methods, we have used a very simple method under which all inventory purchases occur before any sales arise. In reality, the sales and purchases will

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be interspersed over the period. This leads us to consider briefly the two main inventory recording systems: 1 the perpetual inventory system, and 2 the physical or periodic inventory system.

Perpetual inventory system The RGTRGVWCNKPXGPVQT[U[UVGO maintains continuous records of all inventory movements at both cost and selling price. The following summarises these records of inventory and cost of sales. Accounts Transaction

Inventory

Purchase

Increase (+)

Purchase returns

Decrease (–)

Sales (at cost price)

Decrease (–)

Increase (+) Decrease (–)

Sales returns (at cost price)

Increase (+)

Owners’ drawings of inventory

Decrease (–)

Stock count losses

Decrease (–)

Cost of sales

perpetual inventory system #U[UVGOQHTGEQTFKPI KPXGPVQT[KPFGVCKNUQCU VQCNYC[UDGCYCTGQHVJG EWTTGPVNGXGNCPFXCNWG QHKPXGPVQT[CPFYJKEJ CNUQGPCDNGUKOOGFKCVG ECNEWNCVKQPQHVJGVTCPUHGTVQ EQUVQHUCNGU

The advantage of the perpetual system is that at any point in time the business knows what inventory should be on hand and what the cost of sales for the period to date has been. Physical inventory counts are still undertaken to confirm the inventory balances and to assess inventory losses. The implication of the perpetual inventory system for cost allocation is that for the LIFO and average approaches the appropriate costing is determined progressively over time and not at the end of the period.

Physical or periodic inventory system The physical or periodic KPXGPVQT[ U[UVGO is much simpler and does not maintain detailed records of the cost of inventory sold. Essentially the cost of sales is determined using a summary report as follows: (+) (+) (–) (=) (–) =

Inventory at the beginning Purchases Freight inward Purchase returns Inventory available Inventory at the end Cost of sales

x x x (x) x (x) x

periodic inventory system #U[UVGOQHKPXGPVQT[ TGEQTFKPIYJKEJKUOWEJ UKORNGTVJCPVJGRGTRGVWCN OGVJQFYJGTGKVKU PGEGUUCT[VQEQWPVVJGUVQEM CVVJGGPFQHVJGRGTKQFKP QTFGTVQECNEWNCVGEQUVQH UCNGUHQTVJGRGTKQF

The closing inventory is found by a physical stocktake. All the other figures will be collected in the course of the year, and used alongside the physical stocktake to calculate the cost of sales. Under this system it is not directly possible to determine stock losses, as the assumption is that stock not on hand must have been sold (i.e. is in cost of sales).

The net realisable value of inventory We saw in Chapter 2 that the convention of prudence requires that inventories be valued at the lower of cost and net TGCNKUCDNGXCNWG. In theory, this means that the valuation method applied to inventories could switch each year, depending on which of cost and net realisable value is the lower. In practice, however, the cost of the inventories held is usually below the current net realisable value—particularly during a period of rising prices. It is, therefore, the cost figure that will normally appear in the statement of financial position. Examples of circumstances where the net realisable value will be lower than the cost of inventories held include: where goods have deteriorated or become obsolete; where there has been a fall in the market price of the goods; the goods are being used as a ‘loss leader’; or where bad buying decisions have been made.

net realisable value (NRV) 6JGGUVKOCVGFUGNNKPI RTKEGNGUUCP[HWTVJGTEQUVU VJCVOC[DGPGEGUUCT[VQ EQORNGVGVJGIQQFUCPFCP[ EQUVUKPXQNXGFKPUGNNKPICPF FKUVTKDWVKPIVJQUGIQQFU

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consistency convention 6JGCEEQWPVKPIEQPXGPVKQP YJKEJJQNFUVJCVYJGP CRCTVKEWNCTOGVJQFQH CEEQWPVKPIKUUGNGEVGFVQ FGCNYKVJCVTCPUCEVKQPVJKU OGVJQFUJQWNFDGCRRNKGF EQPUKUVGPVN[QXGTVKOG

There is an International Financial Reporting Standard that deals with inventories. It states that, when preparing financial statements for external reporting, the cost of inventories should normally be determined using either FIFO or AVCO. The standard also requires the ‘lower of cost and net realisable value’ rule to be used, and so endorses the application of the prudence convention. The LIFO assumption is not acceptable for external reporting. Inventory valuation provides a further example of the judgement required to derive the figures for inclusion in the financial statements. The main areas are: the choice of cost method (FIFO, LIFO, AVCO); deciding which items should be included in the cost of inventory (particularly for work-in-progress and the finished goods of a manufacturing business); and deriving the net realisable value figures for inventory held. Inventory valuation and depreciation provide two examples of where the EQPUKUVGPE[ convention should be applied. This convention holds that when a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time. Thus, it would not be usual to switch from, say, FIFO to AVCO between periods. The purpose of this convention is to try to ensure that users can make valid comparisons between periods. Where changes of this type do occur, appropriate disclosures regarding reasons and effects are required.

Concept check 12 9JKEJQHVJGHQNNQYKPIYQWNF016DGKPENWFGFCUCEQUVQHKPXGPVQT[! A B C D E

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Concept check 14 (KEMNG%QORCP[YKUJGUVQEJCPIGVJGKTKPXGPVQT[ƃQYCUUWORVKQP 9JKEJCEEQWPVKPIEQPXGPVKQPQTRTKPEKRNGNKOKVUVJGKTCDKNKV[VQFQUQ! A B C D E



*KUVQTKECNEQUV /CVEJKPI 2TWFGPEG %QPUKUVGPE[ %QPUGTXCVKUO

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PROFIT MEASUREMENT AND THE PROBLEM OF BAD AND DOUBTFUL DEBTS

The traditional approach The recognition of bad and doubtful debts is associated with accruals accounting in general and specifically the matching principle. Most businesses sell goods on credit. When credit sales are made, the revenue is usually recognised as soon as the goods are passed to, and accepted by, the customer. Recording the dual aspect of a credit sale will involve: • increasing the sales, and • increasing accounts receivable by the amount of the credit sale. However, with this type of sale there is always the risk that the customer will not pay the amount due. When it is reasonably certain that the customer will not pay, the debt is considered to be ‘bad’, and this must be taken into account when preparing the financial statements. If the bad debt were not taken into account, the effect would be to overstate the assets (receivables) on the statement of financial position and the profit in the income statement, as the sale (which has been recognised) will not result in any future benefits arising. To provide a more realistic picture of financial performance and financial position, any bad debts must be ‘written off’. This will involve: • reducing accounts receivable (debtors), and • increasing expenses (by creating an expense known as ‘bad debts written off’)

115

LO6 Identify the main issues regarding receivables in terms of revenue and expense recognition, and explain their impact on the income statement and the statement of financial position

bad debts #OQWPVUQYGFVQCDWUKPGUU VJCVCTGEQPUKFGTGFVQDG KTTGEQXGTCDNG

by the amount of the bad debt. The matching convention requires that, where possible, the bad debt be written off in the same period as that of the sale that gave rise to the debt. Note that when a debt is bad, the accounting response is not simply to cancel the original sale. If we did this, the income statement would not be so informative. Reporting the bad debts as an expense can be extremely useful in evaluating management performance, particularly credit-granting policies. At the end of the accounting period it may not be possible to identify, with reasonable certainty, all the bad debts that have been incurred during the period. It may be that some debts are unlikely to be collected, but only at some later point in time will the true position become clear. Such uncertainty does not mean that, when preparing the financial reports, we should ignore the possibility that some of the accounts receivable outstanding will eventually prove to be bad. It would not be prudent to do so, nor would it comply with the need to match expenses to the period in which the associated sale is recognised. As a result, the business will normally try to identify all those debts that, at the end of the period, can be classified as ‘doubtful’ (i.e. they may eventually prove to be bad). The determination of doubtful debts is normally achieved either on the basis of the credit sales or by analysing the balances outstanding from accounts receivable. With a credit sales approach, a given percentage based on past experience and current expectations is often applied to the credit sales figure to determine the doubtful debts expense. Analysis of the balances outstanding in accounts receivable may involve making an account-byaccount analysis of individual accounts receivable, or categorising the total ‘accounts receivable outstanding’ balance in terms of how long the amounts have been outstanding. This will be dealt with in more detail in Chapter 13. Analysis using either the percentage of credit sales or the aged listing of accounts receivable will determine the amount of the accounts receivable balance that is not expected to be received. This will be recorded as: • an expense labelled ‘doubtful debts expense’ to be included in the income statement, and • a deduction from the accounts receivable account labelled ‘allowance for doubtful debts’ to be included in the statement of financial position.

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By recognising doubtful debts we take full account, in the appropriate accounting period, of those accounts receivable for which there is a risk of non-payment. This accounting treatment of doubtful debts will occur in addition to the treatment of bad debts described earlier. Example 3.11 illustrates the reporting of bad and doubtful debts.

$QUVQP'PVGTRTKUGUJCUCEEQWPVUTGEGKXCDNGQHCVVJGGPFQHVJGCEEQWPVKPI[GCTVQ,WPG +PXGUVKICVKQPQHVJGUGCEEQWPVUTGEGKXCDNGTGXGCNUVJCVKUNKMGN[VQRTQXGKTTGEQXGTCDNG CPFVJCVTGEQXGT[QHCHWTVJGTKUFQWDVHWN

3.11

'ZVTCEVUHTQOVJGƂPCPEKCNUVCVGOGPVUYQWNFDGCUUJQYPDGNQY +PEQOGUVCVGOGPV GZVTCEVUHQTVJG[GCTGPFGF,WPG $CFFGDVUYTKVVGPQHH &QWDVHWNFGDVUGZRGPUG

$ 10,000 30,000

5VCVGOGPVQHƂPCPEKCNRQUKVKQP GZVTCEVUCUCV,WPG #EEQWPVUTGEGKXCDNG .GUUCNNQYCPEGHQTFQWDVHWNFGDVU

$ 340,000* 30,000 310,000

KGs 6JGCNNQYCPEGHQTFQWDVHWNFGDVUKUQHEQWTUGCPGUVKOCVGCPFKVKUSWKVGNKMGN[VJCVVJGCEVWCNCOQWPV QHFGDVUVJCVWNVKOCVGN[RTQXGVQDGDCFYKNNDGFKHHGTGPVHTQOVJGGUVKOCVG#P[FKHHGTGPEGYKNN PQTOCNN[DGCFLWUVGFKPVJGHQNNQYKPI[GCToUCEEQWPVU

ACTIVITY 3.6 Clayton Conglomerates had debts outstanding at the end of the accounting year to 30 June 2017 of $870,000. The chief accountant believed that $40,000 of those debts were irrecoverable, and that a further $60,000 were doubtful. In the subsequent period, it was found that an over-estimate had been made and that only a further $45,000 of debts actually proved to be bad. Show the relevant extracts in the income statement for both 2017 and 2018 to report the bad debts written off and the allowance for doubtful debts. Also show the relevant statement of financial position extract as at 30 June 2017.

Bad and doubtful debts represent a further area where judgement is required for deriving expenses figures for a particular period. Judgement is often required to derive a figure for bad debts incurred during a period. Views may differ over whether or not a debt is irrecoverable. The decision whether or not to write off a bad debt will affect the expenses for the period and, hence, the reported profit.

The impairment of assets approach Since the harmonisation of Australian accounting standards with international accounting standards, an overall impairment test has been applied to many of the assets held by business entities. The standard relating to ‘impairment of assets’ stipulates that assets should not be carried at amounts exceeding the future cash flow expected to be recovered from the use and/or disposal of the particular asset. Where the recoverable amount is less than the carrying amount, the assets are to be written down to the recoverable amount, and the write-down will be labelled ‘impairment loss’.

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The implications of this for accounting for bad and doubtful debts are: • in calculating the bad and doubtful debts expense, consideration will be given to the amount expected to be recovered—this is essentially the same as what has already been discussed under the traditional approach • the name of the bad and doubtful debts expense may be changed to ‘impairment loss’ on accounts receivable • the reduction in receivables, typically called ‘allowance for doubtful debts’, may be changed to ‘allowance for impairment loss’, and • the asset (accounts receivable) will be said to be recorded on the basis of unimpaired cost; that is, it will be recorded on the basis of cost that has not been written down for impairment. Real World 3.3 provides some examples of accounting policies that relate to depreciation, inventory, and bad and doubtful debts.

REAL WORLD 3.3 Accounting policies relating to this chapter Boral Depreciation ‘Depreciation is calculated to expense the cost of items of property, plant and equipment (excluding freehold land) less their estimated residual values on a straight-line basis over their estimated useful lives’ (p. 94). ‘Estimation of useful lives has been based on historical experience. In addition, the condition of the assets is assessed at least annually and considered against the remaining useful life. Adjustments to useful lives are made when considered necessary’ (p. 94). Depreciation and amortisation rates used are: buildings 1–10%; mineral reserves and licences 1–5%; plant and equipment 5–33.3%.

Receivables ‘Trade and other receivables are initially recognised at the value of the invoice issued to the customer and subsequently at the amount considered recoverable from the customer (amortised cost using the effective interest rate method)’ (p. 93). ‘The group has considered the collectability and recoverability of trade receivables. An allowance for doubtful debts has been made for the estimated irrecoverable trade receivable amounts arising from past rendering of services, determined by reference to past default experience’ (p. 93).

Inventories ‘Inventories are valued at the lower of cost and net realisable value. Net realisable value represents the estimated selling price less all estimated costs of completion and costs incurred in marketing, selling and distribution’ (p. 94). Land development projects are stated at the lower of cost and net realisable value. ‘Cost includes the cost of acquisition,

development and holding costs during development. Costs incurred aer completion of development are expensed as incurred’ (p. 94). Source: Boral Annual Report 2016, Boral Limited, pp. 91, 93 and 94.

Harvey Norman Depreciation ‘Depreciation is calculated on a straight-line basis over the estimated life of the asset as follows:

• • • • • •

Land—not depreciated Leasehold land—lease term Buildings under construction—not depreciated Buildings—20 to 40 years Owned plant and equipment—3 to 20 years Plant and equipment under finance lease—1 to 20 years.

The assets’ residual values, useful lives and amortisation methods are reviewed, and adjusted if appropriate, at each financial year end (p. 69)’.

Allowance for impairment loss on trade receivables ‘Where receivables are outstanding beyond the normal trading terms or beyond the terms specified in the loan agreement, the likelihood of the recovery of these receivables are assessed by management. ‘Due to the large number of debtors, trade receivables are assessed based on supportable past collection history and historical bad debt write-offs. Non-trade debts receivable are assessed on an individual basis if impairment indicators are present’ (p. 68).

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Inventories

Inventories

‘Inventories are valued at the lower of cost and realisable value and are recorded net of all volume rebates, marketing and business development contributions and settlement discounts. Costs are on a weighted average basis and include the acquisition cost, freight, duty and other inward charges. Net realisable value is the estimated selling price in the ordinary course of business, less any estimated costs necessary to make the sale’ (p. 73).

‘Inventories are valued at the lower of cost or net realisable value, determined principally on the first-in, first-out basis. Cost includes direct manufacturing costs and manufacturing overheads at normal operating levels. ‘Land and developments are stated at the lower of cost and net realisable value. Cost includes the cost of acquisition and development. Costs incurred after completion of development are expensed as incurred’ (p. 63).

Source: Harvey Norman 2016 Annual Report, pp. 68, 69 and 73. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Depreciation

Fletcher Building Group Debtors ‘Debtors are valued at estimated net realisable value. The valuation is net of a specific provision maintained for doubtful debts. All known losses are written off to earnings in the period in which it becomes apparent that the debts are not collectable. Trade debtors normally have 30 to 90 day terms’ (p. 63).

‘Depreciation of property, plant and equipment and amortisation of definite lived intangible assets are calculated on the straight-line method. Expected useful lives, which are regularly reviewed on a weighted average basis are: Buildings Plant & machinery Fixtures and equipment Leased assets capitalised Intangible assets

30 years 13 years 5 years 10 years 5 to 10 years’ (p. 65)

Source: Fletcher Building Annual Report 2016, pp. 63 and 65. Fletcher Building Limited.

Concept check 15 6JGRTKOCT[KUUWGYKVJCEEQWPVKPIHQTWPEQNNGEVCDNGETGFKVUCNGUKU A B C D E



*QYOWEJGZRGPUGVQTGEQIPKUG &GVGTOKPKPIYJ[VJGUCNGYCUOCFG &GVGTOKPKPIYJGPVQTGEQIPKUGVJGDCFFGDVGZRGPUG &GVGTOKPKPIYJKEJCEEQWPVUCTGnDCFo #NNQHVJGCDQXG

Concept check 16 6JGn#NNQYCPEGHQTFQWDVHWNFGDVUoCEEQWPVKUYJCVMKPFQHCEEQWPV! A B C D E

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LO7 Prepare a simple income statement from relevant financial information

PREPARING AN INCOME STATEMENT FROM RELEVANT FINANCIAL INFORMATION Given that this book is targeted at non-specialists, we do not expect you to be especially proficient in preparing accounts from a list of transactions. However, this section provides an opportunity for you to work through a small number of practical activities and exercises which have the aim of

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reinforcing your understanding of the basic principles. This should enable you to better understand the end products, the final income statement and the statement of financial position. It is suggested that you work through Activity 3.7. Giving yourself plenty of paper to work on, set out a statement of financial position and an income statement, and work through each transaction, noting the impact of each transaction on the face of the statements. You will probably find it useful to record items in two columns—a ‘+’ column and a ‘–’ column—for each item in each statement. When you have completed this, total the items and the end result should be clear. If necessary, use the approach in the solution to assist you with other exercises.

ACTIVITY 3.7 TT Motors is a new business which started trading on 1 January 2016. The following is a summary of transactions that occurred during the first year of trading: 1 The owners introduced $70,000 of capital, which was paid into a bank account opened in the name of the business. 2 Premises were rented from 1 January 2016 at an annual rental of $20,000. During the year, rent of $25,000 was paid to the owner of the premises. 3 Rates on the premises were paid during the year as follows: For the period 1 January 2016 to 31 March 2016, $500. For the period 1 April 2016 to 31 March 2017, $1,200. 4 A delivery vehicle, bought on 1 January for $32,000, is expected to be used in the business for four years and then sold for $16,000. 5 Wages totalling $33,500 were paid during the year. At the end of the year, the business owed $630 of wages for the last week of the year. 6 Electricity bills for the first three quarters of the year were paid, totalling $1,650. Aer 31 December 2016, but before the accounts had been finalised for the year, the bill for the last quarter arrived showing a charge of $620. 7 Inventory totalling $143,000 was bought on credit. 8 Inventory totalling $12,000 was bought for cash. 9 Sales on credit totalled $152,000 (cost $74,000). 10 Cash sales totalled $35,000 (cost $16,000). 11 Receipts from accounts receivable totalled $132,000. 12 Payments to accounts payable totalled $121,000. 13 Vehicle running expenses paid totalled $9,400. At the end of the year it was clear that an accounts receivable of $400 would not be paid. Prepare a statement of financial position as at 31 December 2016 and an income statement for the year to that date.

Concept check 17 6JGQYPGTUoEQPVTKDWVKQPQHECRKVCNVQQRGPVJGDWUKPGUUDCPMCEEQWPV YKNNTGUWNVKPYJKEJQHVJGHQNNQYKPI! A B C D E

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Concept check 18 +PXGPVQT[RWTEJCUGFQPETGFKV A B C D E

Increases the amount of assets Increases the amount of liabilities +PETGCUGUVJGCOQWPVQHGSWKV[ 5QOGQHVJGCDQXG 0QPGQHVJGCDQXG

SELF-ASSESSMENT QUESTION 3.1 6JGHQNNQYKPIKUVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH66/QVQTUCVVJGGPFQHKVUƂTUV[GCTQHVTCFKPI HTQO#EVKXKV[ TT Motors Statement of financial position as at 31 December 2017 $ Current assets %CUJCVDCPM #EEQWPVUTGEGKXCDNG 2TGRCKFGZRGPUGU +PXGPVQT[

$

    

Non-current assets /QVQTXGJKENGUtEQUV

32,000

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28,000   22,000 

Owners’ equity 1TKIKPCN 4GVCKPGFRTQƂV 6QVCNNKCDKNKVKGUCPFQYPGTUoGSWKV[

70,000   

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121

5 Wages totalling $36,700 were paid during the year. At the end of the year, the business owed $860 of wages for the last week of the year.  'NGEVTKEKV[DKNNUVQVCNNKPIHQTVJGƂTUVVJTGGSWCTVGTUQHVJG[GCTYGTGRCKF#HVGT&GEGODGTDWV DGHQTGVJGCEEQWPVUJCFDGGPƂPCNKUGFHQTVJG[GCTVJGDKNNHQTVJGNCUVSWCTVGTCTTKXGFUJQYKPICEJCTIGQH  +PXGPVQT[VQVCNNKPIYCUDQWIJVQPETGFKV  +PXGPVQT[VQVCNNKPIYCUDQWIJVHQTECUJ  5CNGUQPETGFKVVQVCNNGF EQUV  %CUJUCNGUVQVCNNGF EQUV  4GEGKRVUHTQOCEEQWPVUTGEGKXCDNGVQVCNNGF  2C[OGPVUVQCEEQWPVURC[CDNGVQVCNNGF 13 Vehicle running expenses paid totalled $16,200. 2TGRCTGCUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV&GEGODGTCPFCPKPEQOGUVCVGOGPVHQTVJG[GCTVQVJCVFCVG

USES AND USEFULNESS OF THE INCOME STATEMENT The income statement, like the statement of financial position, has been around for a long time, and most major businesses seem to prepare an income statement on a frequent basis (monthly or even more frequently). This clearly suggests that the income statement is regarded as providing useful information. In particular, this statement should help in providing information on how effective the business has been in generating wealth and how the profit was derived. Since wealth generation is the primary reason for most businesses to exist, assessing how much wealth has been created is an important issue. The income statement reveals the profit for the period, or the ‘bottom line’, as it is sometimes called. This provides a measure of the wealth created for the owners. Gross profit and operating profit are also useful measures of wealth creation. In addition to providing various measures of profit, the income statement provides other information needed for a proper understanding of business performance. It reveals the level of sales revenue, and the nature and amount of expenses incurred, which can help in understanding how profit was derived. Example 3.12 provides an illustration of the above points.

LO8 Review and interpret the income statement

Consider the income statement set out below:

PATEL WHOLESALERS Income statement for the year ended 31 March 2018 Sales Less cost of sales )TQUURTQƂV Less Salaries and wages Rent and rates Telephone and postage Motor vehicle expenses Depreciation—motor vehicle &GRTGEKCVKQPtƂZVWTGUCPFƂVVKPIU 1RGTCVKPIRTQƂV Loan interest 2TQƂVHQTVJG[GCT

$ 460,500 (345,800) 114,700

3.12

(45,900) (15,300) (1,400) (3,900) (2,300) (2,200) 43,700 (4,800) 38,900

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6QGXCNWCVGƂPCPEKCNRGTHQTOCPEGVJGHQNNQYKPIRQKPVUOKIJVDGEQPUKFGTGF

3.12 continued

r 6JGUCNGUƂIWTGTGRTGUGPVUCPKORQTVCPVOGCUWTGQHRTQFWEVKQPCPFECPDGEQORCTGFYKVJ UCNGUƂIWTGUQHGCTNKGTRGTKQFUCPFVJGRNCPPGFUCNGUƂIWTGHQTVJGEWTTGPVRGTKQFVQCUUGUUVJG CEJKGXGOGPVQHVJGDWUKPGUU r 6JGITQUURTQƂVƂIWTGECPDGTGNCVGFVQVJGUCNGUƂIWTGVQƂPFQWVVJGRTQƂVCDKNKV[QHVJGIQQFU UQNF6JGUVCVGOGPVCDQXGUJQYUVJCVVJGITQUURTQƂVKUCDQWVQHVJGUCNGUƂIWTGQTVQRWVKV CPQVJGTYC[HQTGXGT[QHUCNGUIGPGTCVGFVJGITQUURTQƂVKU~6JKUNGXGNQHRTQƂVCDKNKV[OC[ DGEQORCTGFYKVJRCUVRGTKQFUYKVJRNCPPGFNGXGNUQHRTQƂVCDKNKV[QTYKVJEQORCTCDNGƂIWTGUQH UKOKNCTDWUKPGUUGU r 6JGGZRGPUGUQHVJGDWUKPGUUOC[DGGZCOKPGFCPFEQORCTGFYKVJRCUVRGTKQFUVQGXCNWCVG QRGTCVKPIGHƂEKGPE[+PFKXKFWCNGZRGPUGUECPDGTGNCVGFVQUCNGUVQCUUGUUYJGVJGTVJGNGXGN QHGZRGPUGUKUCRRTQRTKCVG6JWUHQTGZCORNGKPVJGCDQXGUVCVGOGPVVJGUCNCTKGUCPFYCIGU TGRTGUGPVCNOQUVQHUCNGUQTHQTGXGT[QHUCNGUIGPGTCVGF~KUCDUQTDGFD[GORNQ[GG EQUVU r 2TQƂVECPCNUQDGTGNCVGFVQUCNGU+PVJGUVCVGOGPVUJQYPCDQXGRTQƂVKUCDQWVQHUCNGU6JWU HQTGXGT[QHUCNGUVJGQYPGTUQHVJGDWUKPGUUDGPGƂVD[~9JGVJGTQTPQVVJKUKUCEEGRVCDNG YKNNCICKPFGRGPFQPOCMKPIVJGMKPFQHEQORCTKUQPUTGHGTTGFVQGCTNKGT2TQƂVCUCRGTEGPVCIG QHUCNGUECPXCT[UWDUVCPVKCNN[DGVYGGPFKHHGTGPVV[RGUQHDWUKPGUUGU7UWCNN[CVTCFGQHHECPDG OCFGDGVYGGPRTQƂVCDKNKV[CPFUCNGUXQNWOG5QOGDWUKPGUUGUCTGRTGRCTGFVQCEEGRVCNQYRTQƂV RGTEGPVCIGKPTGVWTPHQTIGPGTCVKPICJKIJXQNWOGQHUCNGU#VVJGQVJGTGZVTGOGUQOGDWUKPGUUGU OC[RTGHGTVQJCXGCJKIJRTQƂVRGTEGPVCIGDWVCEEGRVCTGNCVKXGN[NQYXQNWOGQHUCNGU(QT GZCORNGCUWRGTOCTMGVOC[HCNNKPVQVJGHQTOGTECVGIQT[YJKNGCVTCFGTKPNWZWT[ECTUOC[HCNNKPVQ VJGNCVVGTECVGIQT[

Concept check 19 #PCN[UKUQHVJGKPEQOGUVCVGOGPVYKNN016RTQXKFG A B C D E

Useful information #PKPFKECVKQPQHJQYRTQƂVYCUFGTKXGF #PKPFKECVKQPQHVJGEQORCP[oUƂPCPEKCNRQUKVKQP +PHQTOCVKQPCDQWVUQWTEGUQHTGXGPWG +PHQTOCVKQPCDQWVV[RGUQHGZRGPUGU

Concept check 20 6JGnDQVVQONKPGoTGHGTUVQ A B C D E

)TQUURTQƂV 1RGTCVKPIRTQƂV )TQUUOCTIKP 2TQƂVHQTVJG[GCT #NNQHVJGCDQXG

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123

ACTIVITY 3.8 Chan Exporters provides the following income statement:

CHAN EXPORTERS Income statement for the year ending 31 May 2017 $ 840,000 (620,000)

Sales Less cost of sales Gross profit Less Salaries and wages

220,000

Selling and distribution expenses Rent and rates Bad debts written off Telephone and postage Insurance Motor vehicle expenses Loan interest Depreciation—motor vehicle Depreciation—fixtures and fittings Loss for the year

(44,000) (30,000) (86,000) (4,000) (2,000) (8,000) (5,000) (3,000) (4,000) (58,000)

(92,000)

In the previous year, sales were $640,000. The gross profit was $200,000 and the net profit was $37,000. Analyse the performance of the business for the year to 31 May 2017 as far as the information allows.

SELF-ASSESSMENT QUESTION

3.2

6JGHQNNQYKPIKUCFTCHVUGVQHUKORNKƂGFCEEQWPVUHQT2GCT.VFHQTVJG[GCTGPFGF5GRVGODGT PEAR LTD Income statement for the year ended 30 September 2017 5CNGU %QUVQHUCNGU )TQUURTQƂV .GUUGZRGPUGU 5CNCTKGU &GRTGEKCVKQP 1VJGTQRGTCVKPIGZRGPUGU 1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG 2TQƂVDGHQTGVCZCVKQP 6CZCVKQPt 2TQƂVCHVGTVCZCVKQP

$’000 

 688





 88

 73

 

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PEAR LTD Statement of financial position as at 30 September 2017 $’000 Current assets %CUJCVDCPM #EEQWPVUTGEGKXCDNG +PXGPVQT[ Non-current assets %QUV #EEWOWNCVGFFGRTGEKCVKQP Total assets %WTTGPVNKCDKNKVKGU $CPMQXGTFTCHV 6CZRC[CDNG #EEQWPVURC[CDNG 1VJGTCEEQWPVURC[CDNG 0QPEWTTGPVNKCDKNKVKGU NQCPtTGRC[CDNG 6QVCNNKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN 4GVCKPGFRTQƂV 6QVCNNKCDKNKVKGUCPFUJCTGJQNFGTUoGSWKV[

21 182 207 410 

 880 1,290  22 88 20  300  600   1,290

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ACCOUNTING AND YOU INCOME TAX In this chapter we have been concerned with the measurement and reporting of income. One important aspect from a personal perspective is income tax. Given below is a summary of the main factors affecting the amount of tax you pay as an individual.

Income tax assessment If you’ve been living in Australia and earning money, you will most likely have paid tax to the Australian government. Aer lodging your yearly tax return, you would have received a tax assessment from the Australian Taxation Office (ATO). But have you ever wondered what all those items on your tax assessment actually refer to? Given below is a brief summary of each item at the time of writing. You should check the website of the Australian Taxation Office to ensure that you are working with current information. Taxable income

Represents the net of assessable income and allowable deductions.

Assessable income*

Represents the ordinary and statutory income items that are classified as income within the Income Tax Assessment Act 1997. This would include such things as salary and wages, share of partnership profits, interest, grossed-up dividends, rent, fees for services, taxable capital gains, etc.

Allowable deductions*

Generally you can claim for expenses that you incur in earning your assessable (taxable) income, but not private, domestic or capital expenses. Deductions might include: certain vehicle and travel expenses; gifts and donations; home office expenses; self-education expenses; tools, equipment and other assets; and expenses incurred in earning investment income. You should note that these will depend on your particular circumstances and the conditions under which payment for these items was made. Basically, a deduction is an amount that can be taken off your assessable income, thus reducing your tax liability. Deductions provide greater benefits to taxpayers with the higher marginal tax rates.

Tax payable

This is determined by applying the applicable tax scales to the taxable income. For residents, the tax scales for the year ended 2017 were:

    

sPKN s s s  

Levies

These represent additional amounts to be paid related to specific benefits received by the taxpayer—the main one being ‘Medicare’,

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which is based on 2% of the taxable income, although some reductions are available in certain cases. There is also a Temporary Budget Repair Levy, payable at a rate of 2% for taxable incomes over $180,000. Another levy is the HELP or HECS repayment levy based on the level of the debt and the income earned. Tax offsets (also known as ‘rebates’)

Tax offsets provide a direct reduction of the tax payable. A whole range of offsets are available, but some of the more common ones relate to: spouse or dependent relatives; health insurance; medical expenses; seniors and pensioners; superannuation; and low-income earners.

Adjusted tax payable

The initial tax payable plus levies minus offsets.

Pay as you go (PAYG) withholding tax

The tax paid on the employee’s behalf by the employer during the year. The difference between the adjusted tax payable and the total paid under PAYG will give the net tax payable (or the refund due).

Franking credits

When companies pay dividends out of taxed profits, the tax credit is passed on to the shareholder receiving the dividend. Normally, tax has been paid on all of the profit out of which the dividend is paid. This is called ‘fully franked’. Thus (assuming an income tax rate for companies of 30%), a fully franked dividend of $2,800 needs to be recorded by the taxpayer as: Assessable income: Dividends  ³ (i.e. the dividend received is net of tax, so the gross dividend is scaled up by 100/70, 30% being the expected income tax rate for companies). Tax credit:  ³

Net tax payable

The amount still owing by the taxpayer.

*These items make up the taxable income but are not actually shown on the assessment. In arriving at the profit for the year for a business, most normal expenses would be treated as deductions, although in some cases the ATO applies its own rules; for example, it uses its own figures for calculating depreciation for tax purposes. Any profits made by individuals through a sole proprietorship or a partnership will be dealt with as part of the individual tax assessment of the owner. Profits made by a corporation will be taxed at a rate applying to companies. At the time of writing this was 30%.

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SUMMARY +PVJKUEJCRVGTYGJCXGCEJKGXGFVJGHQNNQYKPIQDLGEVKXGUKPVJGYC[UJQYP

OBJECTIVE

METHOD ACHIEVED

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DISCUSSION QUESTIONS EASY 3.1

LO1/2

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3.2

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3.3

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3.4

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3.5

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INTERMEDIATE 3.6

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3.7

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3.8

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3.9

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Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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129

CHALLENGING 3.15 LO3

9JGPUJQWNFKPEQOGQTTGXGPWGDGTGEQIPKUGFCUDGKPIGCTPGFCPFTGEQTFGFKPVJGCEEQWPVU! 2TQXKFGFKUEWUUKQPCPFGZCORNGUQHFKHHGTGPVV[RGUQHKPEQOGCPFTGXGPWGYJGTGVJGTGEQIPKVKQP FCVGKUPQVCUENGCTEWVCUKVYQWNFDGHQTCECUJUCNGYKVJKOOGFKCVGFGNKXGT[

3.16 LO4

%TKVKECNN[GZCOKPGVJGHQNNQYKPIUVCVGOGPVUCDQWVFGRTGEKCVKQP

C&GRTGEKCVKQPKUCXCNWCVKQPCFLWUVOGPV

D&GRTGEKCVKQPGSWCNURJ[UKECNYGCTCPFVGCT

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F6JGTGKUPQRQKPVKPFGRTGEKCVKPIDWKNFKPIUDGECWUGVJGKTXCNWGKUKPETGCUKPI

3.17 LO3

*QYOKIJVVJGKUUWGTGICTFKPIVJGRTKPEKRNGUQHTGXGPWGTGEQIPKVKQPKP4GCN9QTNFHQT#WVQPQO[ JCXGDGGPCFFTGUUGFCPFRQUUKDN[CXQKFGF!

3.18 LO3

9JCVMKPFQHOGCUWTGOGPVFKHƂEWNVKGUFQ[QWVJKPMVJCV(NGVEJGT$WKNFKPI)TQWR UGG4GCN9QTNF OKIJVJCXGKPVGTOUQHKVUTGEQIPKVKQPETKVGTKCTGNCVKPIVQNQPIVGTOEQPVTCEVU!

3.19 LO1/2/8

%CP[QWKFGPVKH[TGCUQPUYJ[[QWOKIJVHGGNVJGPGGFVQGPICIGKPVCZRNCPPKPI!

3.20 LO2/8

+H[QWYGTGEQPUKFGTKPIUGVVKPIWRCDWUKPGUUYJCVCTGVJGVCZCVKQPHCEVQTUVJCVOKIJVKPƃWGPEG[QWT EJQKEGQHWUKPICUQNGRTQRTKGVQTUJKRCRCTVPGTUJKRQTCEQORCP[!

APPLICATION EXERCISES EASY 3.1

LO2

(QTCTGUVCWTCPVRTQXKFGGZCORNGUQHGZRGPUGUVJCVTGNCVGVQVJGHQNNQYKPIHWPEVKQPU Cost of sales

3.2

LO3/5

Selling and distribution

Administration and general

Financial

C $GTV'TPKG%QORCP[DGIKPVJG[GCTYKVJKPXGPVQT[QH&WTKPIVJG[GCTVJG[RWTEJCUG IQQFUHQTCPFJCXGUCNGUVQVCNNKPI6JGDWUKPGUUOCMGUCWPKHQTOITQUURTQƂV QHQPUCNGU 

9JCVKUVJGKTENQUKPIKPXGPVQT[XCNWGHQTVJG[GCT!

D /WNFGT5EWNN[%QORCP[DGIKPVJG[GCTYKVJKPXGPVQT[QH&WTKPIVJG[GCTVJG[ CEJKGXGUCNGUVQVCNNKPIGCTPKPIRTQƂVCVCWPKHQTOITQUURTQƂVTCVGQHQPUCNGU +PXGPVQT[CVVJGGPFQHVJG[GCTCOQWPVGFVQ  3.3

LO3

9JCVYGTG/WNFGT5EWNN[oURWTEJCUGUHQTVJG[GCT!

C Jan

Feb

Rent expense



2TGRCKF4GPVtUVCTVQHOQPVJ





2TGRCKF4GPVtGPFQHOQPVJ





4GPVRCKF



Mar

Apr





  



2TQXKFGCPUYGTUKPVJGUJCFGFEGNNU

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130

ACCOUNTING FOR NON-SPECIALISTS

D Jan

Feb

9CIGGZRGPUG



9CIGURC[CDNGtUVCTVQHOQPVJ





9CIGURC[CDNGtGPFQHOQPVJ





9CIGURCKF

Mar

Apr





 







2TQXKFGCPUYGTUKPVJGUJCFGFEGNNU 3.4

LO4

C +VoUVJTGGOQPVJUDGHQTGVJGGPFQHVJGƂPCPEKCN[GCTCPF.GQ/WTRJ[QYPGTCPFQRGTCVQTQH /WTRJoU6TWEMKPIJCULWUVRWTEJCUGFCPGYVTWEMHQTJKUECVVNGCPFJC[JCWNKPIDWUKPGUU 

%QUVUKPEWTTGFCTGCUKPFKECVGFDGNQY

&GCNGTEJCTIG



+PUVCNNCVKQPQH)25UCHGV[FGXKEGUGVE



&GNKXGT[EJCTIGU



Import taxes



(WGNEQUV ƂTUVƂNNWR





/WTRJGUVKOCVGUCWUGHWNNKHGHQTVJGVTWEMQH[GCTUCVYJKEJVKOGKVEQWNFDGUQNFHQT JGTGEMQPU/WTRJoURNCPJQYGXGTKUVQWRITCFGVQCPGYOQFGNKPVYQ[GCTU*GGUVKOCVGU TGUCNGXCNWGKPVYQ[GCTUVQDG



%CNEWNCVG/WTRJoUUVTCKIJVNKPGFGRTGEKCVKQPGZRGPUGHQTVJGEWTTGPV[GCT

D +VoUPQYVJGGPFQHVJGPGZVƂPCPEKCN[GCTCHVGTRWTEJCUGQHVJGPGYVTWEM6JCVKU/WTRJoUDGGP WUKPIJKUPGYVTWEMHQTOQPVJU0QVJKPIoUEJCPIGFDWVPQY.GQYCPVUVQUGGJQYJKUVTWEM YKNNDGUJQYPQPJKUDCNCPEGUJGGV 

3.5

LO3

5JQYJQY/WTRJoUVTWEMYKNNCRRGCTQPVJGDCNCPEGUJGGVCHVGTOQPVJUoWUG4GOGODGTVJCV JGoUWUKPIUVTCKIJVNKPGFGRTGEKCVKQP

6JGHQNNQYKPIKPEQOGUVCVGOGPVKPHQTOCVKQPTGNCVGUVQCVTCFKPIGPVGTRTKUGCPFEQXGTUHQWT KPFGRGPFGPVUKVWCVKQPU%CNEWNCVGVJGOKUUKPIƂIWTGU (a)

(d)

$

$

$

$



800,000

!



120,000

!

230,000

Net purchases

130,000

!



!

#XCKNCDNGKPXGPVQT[

184,000

!

!

!

44,000







!

390,000

!



1RGPKPIKPXGPVQT[

%NQUKPIKPXGPVQT[ %QUVQHUCNGU )TQUURTQƂV



210,000



240,000

1RGTCVKPIGZRGPUGU

70,000





!

!

!

!



2TQƂV .QUU LO3

(c)

200,000

Net sales

3.6

(b)

(KNNKPVJGXCNWGU CVQ HKPVJGHQNNQYKPIVCDNGQPVJGCUUWORVKQPVJCVVJGTGYGTGPQQRGPKPI DCNCPEGUKPXQNXGF Relating to period

4GPVRC[CDNG 4CVGUCPFKPUWTCPEG

At end of period

Paid/ Received $

Expense/Revenue for period $

Prepaid $

10,000

C

1,000



D

Accruals/Deferred revenues $ 1,000

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General expenses

E



1,000

3,000



F

Salaries

G

9,000

3,000

4GPVTGEGKXCDNG

H





+PVGTGUVRC[CDNGQPDQTTQY KPIU

131

INTERMEDIATE 3.7

LO4

(QNNQYKPIQPHTQO'ZGTEKUG/WTRJoUGZRCPFKPIJKUDWUKPGUUCPFJCULWUVDQWIJVCPQVJGTVTWEM

UGGFGVCKNUDGNQY &GCNGTEJCTIG



+PUVCNNCVKQPQH)25UCHGV[FGXKEGUGVE



&GNKXGT[EJCTIGU



Import taxes



/WTRJoUDGGPVCNMKPIVQUQOGQHJKUVTWEMKPIDWFFKGUCPFJCUDGGPCFXKUGFVJCVJGUJQWNFDGWUKPI nMOFTKXGPoCUVJGDCUKUHQTFGVGTOKPKPIJKUFGRTGEKCVKQPGZRGPUG/WTRJGUVKOCVGUVJCVJGoNNIGV MOHTQOVJGVTWEMCVYJKEJVKOGJGoNNDGCDNGVQUGNNKVHQT 1%CNEWNCVGVJGFGRTGEKCVKQPEJCTIGHQTMOQHWUGKP[GCT 2%CNEWNCVGVJGFGRTGEKCVKQPEJCTIGHQTMOQHWUGKP[GCT 35JQYJQY/WTRJoUVTWEMYKNNCRRGCTQPVJGDCNCPEGUJGGVCVVJGGPFQH[GCT 3.8

LO1/2/3

,QGoURTQƂVCPFNQUUTGEQTFUHQTVJG[GCTGPFGF,WPGJCXGDGGPNQUV*QYGXGT[QWCTG CDNGVQGZVTCEVVJGHQNNQYKPIUVCVGOGPVQHƂPCPEKCNRQUKVKQPKPHQTOCVKQPVQIGVJGTYKVJVJGQYPGToU EQPVTKDWVKQPUCPFFTCYKPIUHQTVJG[GCT Beginning

End

%CUJ



3,700

#EEQWPVUTGEGKXCDNG

7,900

8,700

+PXGPVQT[





800



.CPF

20,000

20,000

$WKNFKPI





2NCPVCPFGSWKROGPV

18,000



/QVQTXGJKENGU

23,000

31,000

9,000



Current assets

2TGRC[OGPVU Non-current assets

%WTTGPVNKCDKNKVKGU #EEQWPVURC[CDNG $CPMQXGTFTCHV Accruals

Nil

7,400

1,300



40,000



0QPEWTTGPVNKCDKNKVKGU $CPMNQCP

#FFKVKQPCNKPHQTOCVKQP6JGQYPGTFKFPQVOCMGCP[HWTVJGTEQPVTKDWVKQPUFWTKPIVJG[GCTDWVFKF YKVJFTCYECUJQH %CNEWNCVGVJGRTQƂVOCFGD[,QGoUUQNGRTQRTKGVQTUJKRFWTKPIVJG[GCTGPFGF,WPG 3.9

LO7/8

C 2TGRCTGCPKPEQOGUVCVGOGPVHQT/QUV[P%QORCP[HQTVJG[GCTGPFGF,WPGIKXGPVJG HQNNQYKPICEEQWPVDCNCPEGU Note: 5QOGCEEQWPVUOC[PQVDGTGNGXCPV

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ACCOUNTING FOR NON-SPECIALISTS

$ 4,420

#EEQWPVKPICPFCWFKV #EEQWPVURC[CDNG

11,830

#EEQWPVUTGEGKXCDNG

 124,800

#EEWOWNCVGFFGRTGEKCVKQPtGSWKROGPV

83,200

#EEWOWNCVGFFGRTGEKCVKQPtOQVQTXGJKENGU #NNQYCPEGHQTFQWDVHWNFGDVU

 10,400

$CFCPFFQWDVHWNFGDVU

3,900

%CUJ

208,000

%QUVQHUCNGU &GRTGEKCVKQPtGSWKROGPV



&GRTGEKCVKQPtOQVQTXGJKENGU



'SWKROGPVTGRCKTU

2,080

*GCVCPFNKIJV

4,810

Insurance



+PXGPVQT[

14,300

Loan



Loan interest



/QVQTXGJKENGTWPPKPIEQUVU

2,210

/QVQTXGJKENGU



2JQPGCPFKPVGTPGV



4GPVCPFTCVGU

 2,210

4Q[CNVKGUTGEGKXGF

48,100

5CNCT[CPFYCIGU Sales



D%QPUKFGTVJGTGUWNVKPIUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG2TQXKFGCTGXKGYCPFKPVGTRTGVCVKQPQH VJKUUVCVGOGPVIKXKPIKPFKECVKQPUQHYJCVHWTVJGTKPHQTOCVKQPKUTGSWKTGFVQEQPFWEVCRTQRGTTGXKGY

E 9JCVSWGUVKQPUOKIJVDGTCKUGFTGICTFKPIVJGCEEQWPVKPIVTGCVOGPVEJQUGPHQT KPUWTCPEGCPF

GSWKROGPVTGRCKTU! 3.10 LO5

5RTCVNG[.VFKUCDWKNFGTUoOGTEJCPV1P5GRVGODGTVJGDWUKPGUUJCFVQPPGUQHUCPFKPUVQEM CVCEQUVQHRGTVQPPGCVQVCNEQUVQH&WTKPIVJGƂTUVYGGMKP5GRVGODGTVJGDWUKPGUU RWTEJCUGFVJGHQNNQYKPICOQWPVUQHUCPF September

Tonnes

Cost per tonne

2

48



4







10



1P5GRVGODGTVJGDWUKPGUUUQNFVQPPGUQHUCPFVQCNQECNDWKNFGT %CNEWNCVG

C6JGEQUVQHIQQFUUQNFDCUGFQPRGTRGVWCNKPXGPVQT[CPF(+(1EQUVCNNQECVKQP

D6JGENQUKPIKPXGPVQT[DCUGFQPRGTKQFKEKPXGPVQT[CPFYGKIJVGFCXGTCIGEQUVCNNQECVKQP 3.11 LO3–6

1PYJCVDCUKUYQWNFVJGHQNNQYKPIGZRGPUGUDGOGCUWTGFQTECNEWNCVGF KGYJCVFQGUVJGCOQWPV HQTGCEJTGRTGUGPV! Expense account

Amount $

A Insurance

2,400

$ &GRTGEKCVKQPtDWKNFKPIU



Basis of measurement

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CHAPTER 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

% %QUVQHIQQFUUQNF

3.12 LO7

133



D $CFCPFFQWDVHWNFGDVU

4,700

'

.QPIUGTXKEGNGCXG



F

9CTTCPV[



G 9TKVGFQYPQHNCPF



* +ORCKTOGPVQHIQQFYKNN

23,000

%CNEWNCVGFGRTGEKCVKQPGZRGPUGHQTGCEJCUUGVITQWRHQTVJG[GCTGPFGF,WPG Asset

Delivery trucks

1HƂEGGSWKROGPV

Computers

#ESWKUKVKQPEQUV







7UGHWNNKHGWPKVU  MKNQOGVTGUHQTVTWEMU [GCTUHQTTGUV

200,000

10

3

30

'UVKOCVGFTGUKFWCN XCNWG









Units of RTQFWEVKQP#

5VTCKIJVNKPG

4GFWEKPI balance*

5VTCKIJVNKPG

!

!

!

!

Depreciation OGVJQF Depreciation expense

Building

#

6JGVTWEMUYGTGFTKXGPMOFWTKPIVJG[GCT

6JGEQORCP[WUGUCPCRRTQZKOCVGFTGFWEKPIDCNCPEGTCVGQH1PG[GCTQHFGRTGEKCVKQPJCU DGGPTGEQTFGFRTKQTVQVJGEWTTGPV[GCT

CHALLENGING 3.13 LO3/4 



 

 





#HVGTVJGCEEQWPVCPVQH5COCTCU%QJCFRTGRCTGFVJGƂPCPEKCNUVCVGOGPVUHQTVJG[GCTGPFGF ,CPWCT[VJGHQNNQYKPIGTTQTUECOGVQNKIJV  #OQVQTXCPRWTEJCUGFCVCEQUVQHYKVJCEEWOWNCVGFFGRTGEKCVKQPCVVJGDGIKPPKPI QHVJG[GCTQHJCFDGGPFGRTGEKCVGFCVWUKPIVJGTGFWEKPIDCNCPEGOGVJQFTCVJGT VJCPVJGUVTCKIJVNKPGOGVJQFQHFGRTGEKCVKQP  6JGRC[OGPVQHHQTCVTCFGRC[CDNGJCFDGGPVTGCVGFCUCECUJRWTEJCUG  9KVJFTCYCNUD[VJGQYPGTQHFWTKPIVJG[GCTJCFDGGPVTGCVGFCURCTVQHVJGUCNCTKGU CPFYCIGUGZRGPUG  $CPMEJCTIGUQHFWTKPIVJG[GCTJCFDGGPVTGCVGFCUKPVGTGUVEJCTIGU  6JGRTQƂVHQTVJG[GCTDGHQTGVJGUGGTTQTUYGTGFKUEQXGTGFYCU 9JCVKUVJGRTQƂVHQTVJG[GCTCHVGTCFLWUVKPIHQTVJGUGGTTQTU!

3.14 LO6

&KCZQP5WRRNKGU%QJCUTGEGPVN[RTGRCTGFFTCHVƂPCPEKCNUVCVGOGPVUHQTVJGOQUVTGEGPV[GCT# RTQƂVHQTVJG[GCTQHYCUTGRQTVGF5WDUGSWGPVKPXGUVKICVKQPHQWPFVJCVQPGKVGOQH VJGKPXGPVQTKGU +:.JCFDGGPXCNWGFWUKPIVJG.+(1DCUKUYJGTGCUVJGRQNKE[QHVJGDWUKPGUU KUVQWUGVJG(+(1DCUKUHQTCNNKPXGPVQTKGU6JGDWUKPGUUJCFVJGHQNNQYKPIVTCPUCEVKQPUFWTKPIVJG [GCTHQTVJKUKVGO IXL 205 ,CP /C[ 21 Sept

1RGPKPIKPXGPVQTKGU $QWIJV $QWIJV

Units  2,800 1,100

0QX

5QNF

 3,700

Cost/unit   

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ACCOUNTING FOR NON-SPECIALISTS

+VYCUCNUQFKUEQXGTGFCHVGTVJGFTCHVƂPCPEKCNUVCVGOGPVUYGTGRTGRCTGFVJCVVJGPGVTGCNKUCDNG XCNWGQHKPXGPVQTKGUQHKVGO+:.YCU %CNEWNCVGVJGTGXKUGFRTQƂVHQTVJG[GCTCHVGTVJGKPXGPVQTKGUHQTKVGO+:.JCXGDGGPCRRTQRTKCVGN[ XCNWGF 3.15 LO7/8

6JGHQNNQYKPIKUVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH99#UUQEKCVGUCUCV&GEGODGT

WW ASSOCIATES Statement of financial position as at 31 December 2016 $ ASSETS Current assets %CUJ 2TGRCKFGZRGPUGU TCVGU 6TCFGTGEGKXCDNGU +PXGPVQTKGU Non-current assets /CEJKPGT[ 6QVCNCUUGVU EQUITY AND LIABILITIES %WTTGPVNKCDKNKVKGU #EEQWPVURC[CDNG #EETWGFGZRGPUGU YCIGU Equity Share capital 4GVCKPGFGCTPKPIU 6QVCNGSWKV[CPFNKCDKNKVKGU

 800  24,400 84,400   33,800 3,400 37,200  47,800 97,800 

&WTKPIVJGHQNNQYKPIVTCPUCEVKQPUVQQMRNCEG  

 













       

       

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ƂPCPEKCN RQUKVKQPCUCVVJCVFCVG

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3.16 LO3–7

135

#ODTQUGRTGRCTGUJKUKPEQOGUVCVGOGPVQPCECUJDCUKU Sales .GUUKPXGPVQT[RWTEJCUGU 'SWCNUITQUURTQƂV Less expenses 5CNCT[CPFYCIGU Rent Insurance #FXGTVKUKPI 1VJGT 'SWCNUPGVRTQƂV

100,000 30,000 70,000 20,000  2,000 3,000 4,000

44,000 

1PHWTVJGTKPXGUVKICVKQP[QWƂPFVJGHQNNQYKPICEETWCNDCNCPEGU $GIKPPKPI  700 8,400 3,000 800 Nil

#EEQWPVUTGEGKXCDNG #EEQWPVURC[CDNG HQTKPXGPVQT[ +PXGPVQT[ 2TGRCKFTGPV 2TGRCKFKPUWTCPEG #EETWGFCFXGTVKUKPI

'PFKPI  4,100  1,200 1,000 

#NUQVJGTGUJQWNFDGFGRTGEKCVKQPQHRNCPVCPFGSWKROGPVQHCPFDCFCPFFQWDVHWN FGDVUQH 2TGRCTGCPCEETWCNDCUGFKPEQOGUVCVGOGPV

CHAPTER 3 CASE STUDY Paul is a fine arts graduate, who has several years’ experience working on games graphics. Recently he has been made redundant, mainly due to the strength of the Australian dollar. He has now turned back to his main love, which is painting and printing, but is finding freelance work financially unproductive at the moment. While Paul is not someone who needs a huge amount of money to be content, he has realised that he needs a certain amount of regular income to enable him to survive, and also to be able to purchase materials needed for his preferred activities. Recently an opportunity has arisen which looks as though it might enable him to achieve what he wants, which is essentially a base level of income, but with enough time to devote to his main interest. There is a small motel available for sale in a small country town, which has a reputation for being something of an ‘arty’ town. There is already an art gallery there, together with a choir and a hall which is used for visiting performers. The location is close to a very popular national park, with a good prospect of high occupancy rates. As against this, occupation rates are likely to be low in the non-school holiday times.

The motel is offered as a ‘walk in, walk out’ (WIWO) facility, and is fully equipped. The purchase price for the business is $50,000. However, the buildings are not owned, but leased. The current lease expires in three years, but there are options for at least two further five-year terms in place. The current lease costs $40,000 per annum in rent. The motel has 15 rooms, 10 of which are double or twin rooms. There are a further three rooms with a third single bed, and the remaining two rooms are family rooms that will take four to five people. The motel is graded as a three-star facility, with tariffs for a double room being around $90 per night. There is a two-bedded residence for the manager as well. A full breakfast menu is provided at a charge as part of the motel service. The statement that is provided by the real estate agent includes the following information: 1 The business has been in operation for 10 years. 2 Total gross income recorded for the last year is $150,000. 3 Gross profit for the year is $125,000. 4 Total operating expenses for the year are $100,000.

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5 Interest and financing costs were $2,000. 6 Depreciation was $5,000. 7 Net profit was $18,000. On investigation you are given more detail relating to the operating expenses for the last year, as follows: Bank charges Carpet cleaning Council registration fees New towels and curtains Interest Insurance Repairs and maintenance Pool chemicals and cleaning Newsagents Accountancy fee Electricity

1,600 800 900 1,500 700 4,000 5,000 800 1,500 1,500 12,000

Water Donations Miscellaneous expenses Soware, internet and computers Advertising and memberships Telephone Car expenses Rent Rates

1,000 1,200 7,000 3,500 8,000 2,000 3,000 40,000 4,000

Following detailed discussions with the vendor, you discover that: • No attempt has been made to segregate personal and business expenses. • Food is purchased from cash receipts. • The vendor estimates that he takes out about $300 every week from the cash takings. • The car expenses are paid by the business.

QUESTIONS 1

Advise Paul on whether or not he should proceed with the purchase.

2

Advise Paul as to whether the price is appropriate.

3

Explain why not separating the figures into those relating to personal or business aspects may cause problems for decision-making.

4

Attempt to summarise the above information in such a way as to calculate a profit figure for the business.

5 6

Summarise the aspects of the decision that relate to Paul’s artistic leanings. What other factors might be worth considering by Paul in reaching a final decision?

Concept check answers CC1 CC2 CC3 CC4 CC5

% $ $ ' '

CC6 CC7 CC8 CC9 CC10

D % D A '

CC11 CC12 CC13 CC14 CC15

' A A D %

CC16 CC17 CC18 CC19 CC20

$ D D % D

SOLUTIONS TO ACTIVITIES ACTIVITY 3.1 ;QWTCPUYGTUJQWNFDGCNQPIVJGHQNNQYKPINKPGU         

CEEQWPVCPE[RTCEVKEGtHGGUHQTUGTXKEGU USWCUJENWDtUWDUETKRVKQPUEQWTVHGGU DWUEQORCP[tVKEMGVUCNGUCFXGTVKUKPI PGYURCRGTtPGYURCRGTUCNGUCFXGTVKUKPI ƂPCPEGEQORCP[tKPVGTGUVTGEGKXGFQPNQCPU UQPIYTKVGTtTQ[CNVKGUEQOOKUUKQPHGGU TGVCKNGTtUCNGQHIQQFU OCIC\KPGRWDNKUJGTtOCIC\KPGUWDUETKRVKQPUUCNGUCPFCFXGTVKUKPI )CVGVCMKPIU TGNCVKXGN[OKPQTVTCPUHGTUQHRNC[GTUURQPUQTUJKRUCNGUQHOGTEJCPFKUG68TKIJVUGVE

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ACTIVITY 3.2 ;QWTCPUYGTUJQWNFDGCUHQNNQYU

H & S RETAILERS Income statement for the year ended 30 April 2018 $

Sales Less cost of sales 1RGPKPIKPXGPVQT[ 2WTEJCUGU %NQUKPIKPXGPVQT[ )TQUURTQƂV Less 5CNCTKGUCPFYCIGU 4GPVCPFTCVGU *GCVCPFNKIJV 6GNGRJQPGCPFRQUVCIG Insurance /QVQTXGJKENGTWPPKPIGZRGPUGU &GRTGEKCVKQPtOQVQTXCPU 1RGTCVKPIRTQƂV 4GPVTGEGKXGF Loan interest 2TQƂVHQTVJG[GCT

  273,400 289,400



 112,200













 31,400 8,000

 

6JGVYQKVGOUPQVKPENWFGFKPVJGKPEQOGUVCVGOGPVCTGKPHCEVCUUGVU OQVQTXCPUCPFECUJCPFYQWNFCRRGCTKP VJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP

ACTIVITY 3.3  5CNGUYKNNCRRGCTKPVJGKPEQOGUVCVGOGPVCU%CUJYKNNKPETGCUGKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP D[YKVJDGKPICFFGFVQTGEGKXCDNGU ;QWUJQWNFPQVGVJCVVJGTGYKNNDGCPGZRGPUGVQTGƃGEVVJGEQUVQHUCNGUCUYGNN  6JGTGPVRCKFEQXGTGFUGXGPOQPVJUUQVJGGZRGPUGKPVJGKPEQOGUVCVGOGPVHQTVJGUKZOQPVJUGPFKPI,WPG YKNNDGEQPƂPGFVQYKVJVJGGZVTCRCKFDGKPIUJQYPCUCRTGRC[OGPV  +PUWTCPEGEQXGTUVJGGPVKTG[GCT6JGKPEQOGUVCVGOGPVEQXGTUQPN[VJGƂTUVUKZOQPVJUUQVJGGZRGPUGYKNNDG JCNHQH YKVJVJGTGOCKPKPICRRGCTKPIKPVJGDCNCPEGUJGGVCUCV,WPGCUCRTGRC[ OGPV  6JGNQCPKPVGTGUVRCKFCNNTGNCVGUVQVJGCEEQWPVKPIRGTKQFEQXGTKPIVJGƂTUVUKZOQPVJUUQCNNYKNNDG KPENWFGFKPVJGKPEQOGUVCVGOGPV*QYGXGTVJGCOQWPVQHKPVGTGUVHQT,WPGKUPQV[GVRCKFUQVJKUYKNNPGGFVQ DGCFFGFVQVJGGZRGPUGKPVJGKPEQOGUVCVGOGPV OCMKPIVJGNQCPKPVGTGUVHQTVJGUKZOQPVJRGTKQF CPFVQCNKCDKNKV[KPVJGDCNCPEGUJGGVCEETWGFNQCPKPVGTGUV   6JGGNGEVTKEKV[DKNNCNNTGNCVGUVQVJGUKZOQPVJN[CEEQWPVKPIRGTKQFUQYKNNHQTORCTVQHVJGGNGEVTKEKV[ GZRGPUGKPVJGKPEQOGUVCVGOGPVHQTVJGRGTKQF*QYGXGT/C[CPF,WPGTGOCKPWPRCKF+VYKNNDGPGEGUUCT[VQ GUVKOCVGVJGNKMGN[GZRGPUGHQTVJGUGVYQOQPVJUCPFCFFVJGGUVKOCVGFCOQWPVVQVJGGZRGPUGKPVJGKPEQOG UVCVGOGPVCPFVQCNKCDKNKV[ CEETWGFGNGEVTKEKV[KPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP)KXGPVJCVVJGGZRGPUGHQT VJGƂTUVHQWTOQPVJUYCUCPGUVKOCVGQHCTQWPFRGTOQPVJUGGOUTGCUQPCDNG5QVJGGZRGPUGHQT VJGRGTKQFYKNNDGYJKNGVJGTGYKNNCNUQDGCPCEETWCNQH  6JGUWDUETKRVKQPUTGEGKXGFEQXGTVJGGPVKTG[GCT5QPQVCNNQHVJGCOQWPVTGEGKXGFUJQWNFCRRGCTCUTGXGPWGKP VJGKPEQOGUVCVGOGPV1PN[JCNHUJQWNFDGTGEQTFGFCUTGXGPWGYKVJVJGQVJGTJCNHDGKPIUJQYPCUCNKCDKNKV[

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FGHGTTGFTGXGPWGKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP6JGFGHGTTGFTGXGPWGKUCRC[OGPVKPCFXCPEGtVQVJG DWUKPGUUtCPFVJKUTGOCKPUCNKCDKNKV[WPVKNVJGUWDUETKRVKQPKUWUGFWR

ACTIVITY 3.4 6JGFGRTGEKCVKQPGZRGPUGCUUWOKPIGUVKOCVG CYKNNDGC[GCT KG s6JGFGRTGEKC VKQPGZRGPUGCUUWOKPIGUVKOCVG DYKNNDGC[GCT KG#UVJGCEVWCNTGUKFWCNXCNWGKU GUVKOCVG CYKNNNGCFVQWPFGTFGRTGEKCVKQPQH KGsQXGTVJGNKHGQHVJGCUUGVCPFGUVKOCVG

DYKNNNGCFVQQXGTFGRTGEKCVKQPQH KGs6JGUGWPFGTCPFQXGTGUVKOCVKQPUYKNNDGFGCNVYKVJKP [GCTHQWT 6JGRCVVGTPQHFGRTGEKCVKQPCPFVQVCNFGRTGEKCVKQPGZRGPUGUYKNNVJGTGHQTGDG Estimate Year

(a) $

(b) $

1

#PPWCNFGRTGEKCVKQP

8,000

10,000

2

#PPWCNFGRTGEKCVKQP

8,000

10,000

3

#PPWCNFGRTGEKCVKQP

8,000

10,000

4

#PPWCNFGRTGEKCVKQP

8,000

10,000

32,000

40,000

4

7PFGT QXGTFGRTGEKCVKQP 6QVCNFGRTGEKCVKQP

4,000







ACTIVITY 3.5 ;QWTCPUYGTUJQWNFDGCNQPIVJGHQNNQYKPINKPGU

)TQUURTQƂVECNEWNCVKQP

FIFO $’000

LIFO $’000

AVCO $’000

5CNGU "







%QUVQHUCNGU







)TQUURTQƂV







%NQUKPIKPXGPVQT[ƂIWTG







6JGCDQXGƂIWTGUTGXGCNVJCV(+(1YKNNIKXGVJGJKIJGUVITQUURTQƂVFWTKPICRGTKQFQHTKUKPIRTKEGU6JKUKUDGECWUG UCNGUCTGOCVEJGFYKVJVJGGCTNKGT CPFEJGCRGTRWTEJCUGU.+(1YKNNIKXGVJGNQYGUVITQUURTQƂVCUUCNGUCTG OCVEJGFCICKPUVVJGOQTGTGEGPV CPFFGCTGTRWTEJCUGU6JG#8%1OGVJQFYKNNPQTOCNN[IKXGCƂIWTGVJCVKUDG VYGGPVJGUGVYQGZVTGOGU 6JGENQUKPIKPXGPVQT[HKIWTGKPVJGUVCVGOGPVQHHKPCPEKCNRQUKVKQPYKNNDGJKIJGUVYKVJVJG(+(1OGVJQF6JKU KUDGECWUGVJGEQUVQHIQQFUUVKNNJGNFYKNNDGDCUGFQPVJGOQTGTGEGPV CPFFGCTGTRWTEJCUGU.+(1YKNNIKXG VJGNQYGUVENQUKPIKPXGPVQT[HKIWTGCUVJGIQQFUJGNFKPUVQEMYKNNDGDCUGFQPVJGGCTNKGT CPFEJGCRGT KPXGPVQT[RWTEJCUGF1PEGCICKPVJG#8%1OGVJQFYKNNPQTOCNN[IKXGCHKIWTGVJCVKUDGVYGGPVJGUGVYQ GZVTGOGU 9JGPRTKEGUCTGHCNNKPIVJGRQUKVKQPQH(+(1CPF.+(1KUTGXGTUGF(+(1YKNNIKXGVJGNQYGUVITQUURTQƂVCUUCNGU CTGOCVEJGFCICKPUVVJGGCTNKGT CPFFGCTGTIQQFURWTEJCUGF.+(1YKNNIKXGVJGJKIJGUVITQUURTQƂVCUUCNGUCTG OCVEJGFCICKPUVVJGOQTGTGEGPV CPFEJGCRGTIQQFURWTEJCUGF#8%1YKNNIKXGCEQUVQHUCNGUƂIWTGDGVYGGP VJGUGVYQGZVTGOGU6JGENQUKPIKPXGPVQT[ƂIWTGKPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPYKNNDGNQYGUVWPFGT(+(1CU VJGEQUVQHKPXGPVQT[YKNNDGDCUGFQPVJGOQTGTGEGPV CPFEJGCRGTUVQEMURWTEJCUGF.+(1YKNNRTQXKFGVJGJKIJGUV ENQUKPIKPXGPVQT[ƂIWTGCPF#8%1YKNNRTQXKFGCƂIWTGDGVYGGPVJGVYQGZVTGOGU

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ACTIVITY 3.6 ;QWTCPUYGTUJQWNFDGCUHQNNQYU

CLAYTON CONGLOMERATES Income statement (extracts) for the year ended 30 June 2017 $ 40,000 

$CFFGDVUYTKVVGPQHH &QWDVHWNFGDVUGZRGPUG

CLAYTON CONGLOMERATES Income statement (extracts) for the year ended 30 June 2018 $ 

&QWDVHWNFGDVUGZRGPUGYTKVVGPDCEM

CTGXGPWGQTCTGFWEVKQPKPVJGGZRGPUG

CLAYTON CONGLOMERATES Statement of financial position (extract) as at 30 June 2017 #EEQWPVUTGEGKXCDNG .GUUCNNQYCPEGHQTFQWDVHWNFGDVU

$ 830,000**  770,000

6JKUƂIWTGYKNNWUWCNN[DGPGVVGFQHHCICKPUVCP[CNNQYCPEGETGCVGFHQTFQWDVHWNFGDVUKPTGURGEVQH s

ACTIVITY 3.7 +PCPGZGTEKUGNKMGVJKUQPGYJGTG[QWCTGKPGHHGEVVT[KPIVQTGEQTFFGVCKNGFVTCPUCEVKQPUFKTGEVN[KPVQVJGƂPCNCE EQWPVU KGKPEQOGUVCVGOGPVCPFUVCVGOGPVQHƂPCPEKCNRQUKVKQP[QWOC[ƂPFKVWUGHWNVQNKUVVTCPUCEVKQPUCU UJQYPKPCVYQUKFGFHQTOCVYKVJEQNWOPUHQTRNWUGUCPFOKPWUGU6JKUGHHGEVKXGN[FWRNKECVGUVJGFQWDNGGPVT[RTQ EGUUVJCVYQWNFDGECTTKGFQWVKPRTCEVKEGKPCUGVQHNGFIGTCEEQWPVU+PVJKURCTVKEWNCTGZCORNGVJGTGCTGPQOKPWU VTCPUCEVKQPUKPVJGKPEQOGUVCVGOGPVWPNKMGVJGGZGTEKUGUCVVJGGPFQHVJGEJCRVGT%NGCTN[VJGGPFRTQFWEVHQTDQVJ UVCVGOGPVUOC[VJGPPGGFVQDGTGHQTOCVVGFKPVQCXGTVKECNHQTOCVQPEQORNGVKQP

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TT MOTORS Statement of financial position as at 31 December 2017 + Current assets %CUJ

#EEQWPVUTGEGKXCDNG 2TGRC[OGPVU

+PXGPVQT[ Non-current assets &GNKXGT[XGJKENG 6QVCNCUUGVU

70,000  132,000



–

Net

  1,200 32,000   12,000 121,000 9,400 132,000 400

 300





%WTTGPVNKCDKNKVKGU #EEQWPVURC[CDNG

Accruals

 %CRKVCN 2TQƂV

143,000 12,000

74,000 



32,000

4,000

28,000 

+

–

143,000

121,000

Net 22,000

 



70,000 



6QVCNNKCDKNKVKGUCPF owners’ equity



TT MOTORS Income statement for the year ended 31 December 2017 %QUVQHUCNGU Rent Rates 9CIGU 'NGEVTKEKV[ $CFFGDVU 8GJKENGFGRTGEKCVKQP Vehicle expenses 0GVRTQƂV

+ 74,000  20,000*  900**     400 4,000 9,400

–

Net 90,000 20,000 1,400

Sales

+  

–

Net 187,000

34,130 2,270 400 4,000 9,400   187,000

187,000

#PCNVGTPCVKXGCRRTQCEJYQWNFJCXGDGGPVQUJQYVJGKPKVKCNN[CUCPGZRGPUGCPFCVVJG[GCTGPF VTCPUHGTQHVJKUVQVJGRTGRC[OGPV #PCNVGTPCVKXGCRRTQCEJYQWNFJCXGDGGPVQUJQYVJGCPFUWDUGSWGPVN[VTCPUHGTVQVJG RTGRC[OGPV

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141

This could then be presented in a vertical or narrative format as follows: $ Current assets Cash Accounts receivable Prepayments Inventory

750 19,600 5,300 65,000 90,650

Non-current assets Delivery vehicle cost Accumulated depreciation

32,000 (4,000) 28,000

Total assets

118,650

Current liabilities Accounts payable Accruals

22,000 1,250 23,250

Capital/Equity Contributed

70,000

0GVRTQƂV

25,400 95,400

Total liabilities and equity

118,650 $

Sales

187,000

Less cost of sales

(90,000)

)TQUURTQƂV

97,000

Less expenses Rent

(20,000)

Rates

(1,400)

Wages

(34,130)

Electricity Bad debts

(2,270) (400)

Depreciation

(4,000)

Vehicle expenses

(9,400)

2TQƂVHQTVJG[GCT

25,400

ACTIVITY 3.8 5CNGUKPETGCUGFD[OQTGVJCPQXGTVJGRTGXKQWU[GCTDWVVJGnDQVVQONKPGoHGNNHTQOCRTQƂVQHVQCNQUUQH 6JGTCRKFGZRCPUKQPQHVJGDWUKPGUUJCUENGCTN[DTQWIJVRTQDNGOUKPKVUYCMG+PVJGRTGXKQWURGTKQFVJGDWUKPGUU YCUOCMKPICITQUURTQƂVQHOQTGVJCP~HQTGXGT[QHUCNGUOCFG6JKUTGFWEGFKPVJG[GCTGPFKPI|/C[VQ CTQWPF~HQTGXGT[QHUCNGUOCFG6JKUUGGOUVQUWIIGUVVJCVVJGTCRKFGZRCPUKQPYCUHWGNNGFD[CTGFWEVKQPKPRTKEGU 6JGITQUURTQƂVKPETGCUGFKPCDUQNWVGVGTOUD[JQYGXGTVJGTGYCUCFTCUVKEFGENKPGKPPGVRTQƂVUFWTKPIVJGRGTKQF +PVJGRTGXKQWURGTKQFVJGDWUKPGUUYCUOCMKPICRTQƂVHQTVJG[GCTQHPGCTN[~HQTGXGT[QHUCNGUYJGTGCUHQTVJG[GCT GPFKPI/C[VJKUTGFWEGFVQCNQUUQHPGCTN[~HQTGXGT[QHUCNGUOCFG6JKUOGCPUVJCVQXGTJGCFGZRGPUGU JCXGKPETGCUGFEQPUKFGTCDN[5QOGKPETGCUGKPQXGTJGCFGZRGPUGUOC[DGGZRGEVGFKPQTFGTVQUGTXKEGVJGKPETGCUGFNGXGNQH CEVKXKV[*QYGXGTVJGKPETGCUGCRRGCTUVQDGGZEGRVKQPCN+HYGNQQMCVVJGNKUVQHQXGTJGCFGZRGPUGUYGECPUGGVJCVVJG ƂIWTGHQTDCFFGDVUYTKVVGPQHHUGGOUXGT[JKIJ OQTGVJCPQHVQVCNUCNGU6JKUOC[DGCHWTVJGTGHHGEVQHVJGTCRKF GZRCPUKQPVJCVJCUVCMGPRNCEG+PQTFGTVQIGPGTCVGUCNGUKPUWHƂEKGPVTGICTFOC[JCXGDGGPRCKFVQVJGETGFKVYQTVJKPGUU QHEWUVQOGTU#EQORCTKUQPQHQXGTJGCFGZRGPUGUYKVJVJQUGQHVJGRTGXKQWURGTKQFYQWNFDGWUGHWN Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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CHAPTER 4

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

LO1 Identify and discuss the main features of companies LO2 Explain equity and borrowings in a company context LO3 Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

LO4 Explain and discuss the main financial statements prepared by a limited company.

Most businesses in Australia and New Zealand, including some of the very smallest, operate in the form of limited companies, and they account for the majority of business activity and employment. The GEQPQOKEUKIPKƂECPEGQHVJKUV[RGQHDWUKPGUUKUPQVEQPƂPGFVQ#WUVTCNCUKCKVECPDGUGGPKPOQUVQH the world’s developed countries and in many developing countries. In this chapter we consider the nature of limited companies and how they differ from sole proprietorship businesses and partnerships. This expands the brief discussion of various business forms in Chapter 1. 9GGZCOKPGVJGYC[UKPYJKEJVJGQYPGTURTQXKFGƂPCPEGCPFQWVNKPGVJGV[RGQHDQTTQYKPIUVJCV companies can engage in, and then explain the constraints imposed on limited companies regarding distributions and reductions in capital. 9GUJCNNCNUQUGGJQYVJGDCUKEƂPCPEKCNUVCVGOGPVUYJKEJYGTGFKUEWUUGFKPVJGRTGXKQWUVYQEJCRVGTU are prepared for this type of business. The particular formats required by the regulators will be dealt with in Chapter 5.

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143

THE MAIN FEATURES OF COMPANIES There is a wide range of company types, but the most common in Australia is the company limited by share capital. In this book we will largely restrict our focus to this entity structure. A limited company may be owned by just one person, but most have more than one owner and some have many owners. The owners are usually known as members or shareholders. The ownership of a company is normally divided into a number, frequently a large number, of shares, each of equal size. Each owner, or shareholder, owns one or more shares in the company. Limited companies have a number of distinguishing features, which are dealt with below.

LO1 Identify and discuss the main features of companies

Legal nature A limited company has the legal capacity of a person and has a separate legal status from those who own the entity (the shareholders). Thus, a company is able to enter into contracts with external parties (buy, sell, borrow, lend, employ, sue, be sued) in its own right. This means that the company assets are owned by the company in its own right as a legal person. This contrasts sharply with other types of businesses, such as sole proprietorships and partnerships (i.e. unincorporated businesses), where it is the owner(s) rather than the business that must sue, enter into contracts and so on, because the business has no separate legal identity. An Australian company comes into existence as a ‘body corporate’ when it is registered under the Corporations Act 2001 and is issued a certificate of registration. Since a limited company has its own legal identity, it is regarded as being quite separate from those who own and manage it. It is worth emphasising that this legal separateness of owners and the company has absolutely no connection with the business entity convention of accounting, which we discussed in Chapter 2. This accounting convention applies equally well to all business types, including sole proprietorships and partnerships where there is certainly no legal distinction between the owner(s) and the business. Another consequence of the legal separation of the limited company from its owners is that companies must be accountable to the tax authorities for tax on their profits and gains. This leads to the reporting of tax in the financial statements of limited companies. The charge for tax is shown in the income statement (the profit and loss account). The tax charge for a particular year is based on that year’s profit. Any tax due but unpaid will also appear in the end-of-year statement of financial position (the balance sheet) as a current liability. The tax position of companies contrasts with that of sole proprietorships and partnerships, where tax is levied not on the business but on the owner(s). Thus tax does not impact on the financial statements of unincorporated businesses, but is an individual matter between the owner(s) and the tax authorities. Companies are charged income tax on their profits and gains. The rate of tax is levied on the company’s taxable profit, which is not necessarily the same as the profit shown on the income statement. This is because tax law does not, in every respect, follow the normal accounting rules. Generally, however, the taxable profit and the company’s accounting profit are pretty close to one another. There can be tax advantages to trading as a limited company rather than as a sole proprietor or a partner. This may partly explain the rise in popularity of private limited companies over recent years.

income tax An amount levied on income, which is payable to the government.

Unlimited (perpetual) life A company is normally granted a perpetual existence, which means it will continue even where an owner of some, or even all, of the shares in the company dies. The shares of the deceased person will simply pass to the beneficiary of his or her estate. The granting of perpetual existence means that the life of a company is quite separate from the lives of those individuals who own or manage it. It is not, therefore, affected by changes in ownership that arise when individuals buy and sell shares in the company. Although a company may be granted a perpetual existence when it is first formed, it is possible for either the shareholders or the courts to bring this existence to an end. When this is done, the

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voluntary liquidation A situation in which a business is closed on a voluntary basis.

assets of the company are usually sold to generate cash to meet the outstanding liabilities. Any surplus arising after all liabilities have been met will then be used to pay the shareholders. Shareholders may agree to end the life of a company where it has achieved the purpose for which it was formed or where they feel that the company has no real future. The courts may bring the life of a company to an end where creditors have applied to the courts for this to be done because they have not been paid amounts owing. Where shareholders agree to end the life of a company, it is referred to as a voluntary liquidation.

Limited liability Since the company is a legal person in its own right, it must take responsibility for its own debts and losses. This means that once the shareholders have paid what they have agreed to pay for the shares, their obligation to the company, and to the company’s creditors, is satisfied. Thus shareholders can limit their losses to the amount that they have paid, or agreed to pay, for their shares. This is of great practical importance to potential shareholders, since they know that what they can lose, as part-owners of the business, is limited. Contrast this with the position of sole proprietors or partners. They cannot ‘ring-fence’ assets that they do not want to put into the business. If a sole proprietorship or a partnership business finds itself in a position where liabilities exceed the business assets, the law gives unsatisfied creditors the right to demand payment out of what the sole proprietor or partner may have regarded as ‘non-business’ assets. Thus the sole proprietor or partner could lose everything—house, car, the lot. This is because the law sees Jill, the sole proprietor, as being the same as Jill, the private individual. The shareholder, by contrast, can lose only the amount committed to that company. Legally, the business operating as a limited company, in which Jack owns shares, is not the same as Jack himself. This is true even if Jack were to own all of the shares in the company. Although limited liability has this advantage to the providers of equity finance (the shareholders), it is not necessarily to the advantage of all of the others who have a stake in the business. Limited liability is attractive to shareholders because they can, in effect, walk away from the unpaid debts of the company if their contribution has not been sufficient to meet those debts. This is likely to make any individual, or another business, wary of entering into a contract with a limited company. This can be a real problem for smaller, less established companies. Suppliers may insist on cash payment before delivery of goods or the rendering of a service. Alternatively, they may require a personal guarantee from a major shareholder that the debt will be paid before allowing trade credit. In the latter case, the supplier circumvents the company’s limited liability status by demanding the personal liability of an individual. Larger, more established companies, on the other hand, tend to have built up the confidence of suppliers.

Legal safeguards Various safeguards exist to protect individuals and businesses contemplating dealing with a limited company. These include the requirement to indicate limited liability status in the name of the company. By doing this, a warning is issued to prospective suppliers and lenders. A further safeguard is the restriction placed on the ability of shareholders to withdraw their equity from the company. These restrictions are designed to prevent shareholders from protecting their own investment and, as a result, leaving lenders and suppliers in an exposed position. We shall consider this point in more detail later in the chapter. Finally, public and large limited companies are required to produce annual financial statements (income statements, statements of financial position and statements of cash flows) and make these publicly available. This means that anyone interested can gain an impression of the financial performance and position of the company. The form and content of the first two of these statements are considered in some detail later in this chapter and in Chapter 5. Chapter 6 is devoted to the statement of cash flows. Clearly, while limited liability is an advantage to the owners, it can pose a problem to the external parties providing goods and services to the company.

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Public and proprietary (private) companies Several different types of companies operate under the Corporations Act. A limited company uses the word ‘Limited’ (‘Ltd’) in its name. The two main categories are public companies and proprietary (private) companies. Public companies can offer their shares for sale to the general public; proprietary companies cannot. There is no maximum number of shareholders required for public companies, so ownership can be very widely spread. Many public companies, provided that they meet the requirements of the Australian Securities Exchange (ASX), have their shares listed on the exchange. This means that they can be freely traded, and that shareholders can sell their shares at the going market price, or existing shares can be purchased. Public companies are more rigorously regulated than proprietary companies. Proprietary companies tend to be smaller businesses where the ownership is divided between relatively few shareholders who are usually fairly close to one another (e.g. a family company). Numerically, there are more private limited companies in Australia and New Zealand than there are public ones. However, since the public ones tend to be individually larger, they represent a much more important group economically. Many proprietary companies are no more than a vehicle for operating businesses that are effectively little more than sole proprietorships or small partnerships. Proprietary companies have the words ‘Proprietary Limited’ (‘Pty Ltd’) in their name. They are restricted to no more than 50 (non-employee) shareholders, and have restricted ability to raise money from the public. Proprietary companies generally are less regulated than public companies. Small proprietary companies are relieved of many of the reporting requirements of large proprietary companies or public companies. A company is deemed to be small if it satisfies at least two of the following three requirements:

public company A company that can offer shares to the general public. Shares can be traded on a public stock exchange.

proprietary (private) company A limited company for which the directors can restrict the ownership of its shares. Shares cannot be traded on a public stock exchange.

1 It has consolidated gross operating revenue of less than $25 million. 2 Its consolidated gross assets at the end of the financial year are less than $12.5 million. 3 It employs fewer than 50 employees at the end of the financial year.

While for some forms of companies the membership may be restricted, for public companies the number of shareholders can be very large. In several significant cases in which government-owned businesses became companies (e.g. Commonwealth Bank, Telstra), the initial number of owners exceeded 250,000. With such a large number of owners, corporate entity structures can raise significant amounts of ownership funds. Also, public companies have access to certain types of debt funding that are not available to other entity structures. This will be discussed further in Chapter 14. Large companies typically have a very large number of shareholders. Real World 4.1 illustrates the scale and range of shareholdings for two companies.

Transferring share ownership—the role of the stock exchange We have made the point that shares in companies may be transferred from one owner to another without this change of share ownership having any direct impact on the company’s business, or on the shareholders not involved with the particular transfer. With major companies, the desire of some shareholders to sell their shares, and the desire of others to buy those shares, has given rise to a formal market, or stock exchange, in which the shares can be bought and sold. The ASX, and similar organisations around the world, are marketplaces where shares in major companies are bought and sold. Prices are determined by the law of supply and demand. Supply and demand are themselves determined by investors’ perceptions of the future economic prospects of the companies concerned. This of course raises the question: if the change in ownership of a company’s shares does not directly affect that company, why would it welcome the fact that the shares are traded in a recognised market? The main reason is that investors are generally very reluctant to pledge their money unless they can see some way to turn their investment back into cash. In theory, the shares of a particular company may be very valuable if the company has a very bright economic future, but, unless this

stock exchange A market where ‘secondhand’ shares may be bought and sold and new capital raised.

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REAL WORLD 4.1 1. Distribution of listed shares in Telstra as disclosed in the 2016 annual report Size of holding

Number of shareholders

%

Number of shares

%

1–1,000

644,700

46.24

356,247,077

2.91

1,001– 5,000

513,876

36.86

1,234,223,169

10.10

5,001–10,000

126,240

9.06

901,087,894

7.37

10,001–100,000

105,610

7.58

2,508,160,462

20.52

3,718

0.27

7,225,937,234

59.10

1,394,146

100.00

12,225,655,836

100.00

100,001 and over Total

Source: Telstra Annual Report 2016, p. 159.

2. Distribution of listed shares in New Zealand Oil and Gas Limited as disclosed in the 2016 annual report As at 24 August 2016 New Zealand Oil and Gas Limited had 12,157 listed ordinary shareholders owning 336 million shares. Almost 50% of these were held by only 20 shareholders.

JP Morgan Chase Bank held the largest holding at just over 16%. Source: New Zealand Oil and Gas Limited Annual Report 2016, p. 50.

value can be realised in cash, the benefit to the shareholders is dubious. After all, you cannot spend shares; you generally need cash. This means that potential shareholders are much more likely to be prepared to buy new shares from the company (thus providing the company with new finance) where they can see a way of liquidating their investment (turning it into cash). The stock exchanges provide the means of liquidation. Although the buying and selling of ‘secondhand’ shares does not provide the company with cash, the fact that the buying and selling facility exists will make it easier for the company to raise new share capital as and when it wishes to do so.

Separation of ownership and management

directors Individuals who are elected to act as the most senior level of management of a company.

A limited company may have legal personality, but it is not a human being capable of making business decisions and plans and exercising control over it. People must take on these management tasks. The most senior level of management of a company is the board of directors. The shareholders elect directors (by law there must be at least one director) to manage the company on a day-to-day basis on their behalf. In a small company, the board may be the only level of management and consist of all of the shareholders. In larger companies, the board may consist of 10 or so directors out of many thousands of shareholders. Indeed, directors are not even required to be shareholders. Below the board of directors of the typical large company could be several layers of management. With sole proprietorships and partnerships, the owner(s) and manager(s) are, by and large, the same people. However, companies (other than quite small ones) will generally have a separate specialist management team outside the ownership interest. There is a growing trend for key personnel in a management team to be allocated shares (ownership interests) on the basis of the company’s performance, so they may become managers and owners at the same time.

Extensive regulation The corporate entity will be subject to much stricter regulation than the partnership and sole proprietorship entity structure, due to the ‘limited liability’ benefit granted to owners (shareholders) and the fact that most shareholders are widely removed from the day-to-day activities of the business and its management.

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The additional regulations that apply to the limited liability company depend on the classification of that company. However, these regulations may relate to:

• company registration requirements before a company is granted a certificate of incorporation • the requirement to submit annual accounts to the Australian Securities and Investments • • •

Commission (ASIC) the requirement to have accounts audited by registered auditors the requirement to prepare reports in conformity with statutory Australian Accounting Standards, and reporting and other obligations imposed on the company management (directors).

These will be discussed in more detail in Chapter 5. In recent years, the issue of corporate governance has generated much debate. The term is used to describe the ways in which companies are directed and controlled. The issue of corporate governance is important because, in companies of any size, those who own the company (the shareholders) are usually divorced from the day-to-day control of the business. Since the shareholders employ the directors to manage the company for them, it seems reasonable to assume that the best interests of shareholders will guide the directors’ decisions. However, in practice this does not always occur. The directors may be more concerned with pursuing their own interests, such as increasing their pay and ‘perks’ (expensive motor cars, overseas visits and so on) and improving their job security and status. As a result, the interests of shareholders and the interests of directors may conflict. Directors who pursue their own interests at the expense of the shareholders pose a problem for the shareholders. However, they may also cause a problem to society as a whole. If shareholders feel their funds are likely to be mismanaged, they will be reluctant to invest. A shortage of funds will restrict investment choices, and the costs of funds will increase as businesses compete for available funds. Thus, a lack of concern for shareholders can profoundly affect the performance of the economy. To avoid these problems, most competitive market economies have a framework of rules to help monitor and control the behaviour of directors. These rules are usually based on three guiding principles:

corporate governance The system by which corporations are directed and controlled.

• Disclosure. This lies at the heart of good corporate governance. Adequate and timely

•

•

disclosure can help shareholders judge the performance of the directors. Where performance is considered unsatisfactory, this will be reflected in the price of shares. Changes should then be made to ensure the directors regain the confidence of shareholders. Accountability. This involves defining the roles and duties of the directors and establishing an adequate monitoring process. In Australia, company law requires the directors of a business to act in the best interests of the shareholders. This means, among other things, that they must not try to use their position and knowledge to make gains at the expense of the shareholders. The law also requires larger companies to have their annual financial statements independently audited. An independent audit lends credibility to the financial statements prepared by the directors. An audit is effectively a checking of the financial reports so that the auditors can make a judgement as to whether the accounts show a true and fair view of the financial performance and position of the organisation. Fairness. Directors should not be able to benefit from ‘inside’ information that is not available to shareholders. As a result, both the law and the Australian Securities Exchange (ASX) place restrictions on the ability of directors to buy and sell the shares of the business. For example, the directors cannot buy or sell shares immediately before the announcement of the annual trading results of the business, or before the announcement of a significant event, such as a planned merger or the loss of the chief executive.

The number of rules designed to safeguard shareholders has increased considerably over the years. This has been in response to weaknesses in corporate governance procedures, which have been exposed through well-publicised business failures and frauds, excessive pay increases to directors, and evidence that some financial reports were being ‘massaged’ so as to mislead shareholders. Real world 4.2 provides an example of how one subsidiary tried to hide sliding profitability.

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REAL WORLD 4.2 Target inflates profit ‘Wesfarmers boss Richard Goyder has recognised that the conglomerate has taken a knock to its most prized possession, its reputation, aer what he called a “mind blowingly stupid” decision by a clique of Target (owned by Wesfarmers) executives to hide sliding profitability, using $21 million in improper payments from suppliers’ (Durie). ‘The rebate was paid with the promise that second-half price rises would offset the payment, which was treated in the accounts as profit, contrary to Wesfarmers stated policy’ (Greenblat). Target reported increased earnings before interest

and tax of $74 million, a rise of 5.6% from $70 million. Without the adjustment they would have fallen to about $60 million. Target’s boss resigned. Wesfarmers went into damage control, assuring investors that the accounting regularities were confined to Target. The impact on the Wesfarmers overall results was relatively insignificant. Sources: John Durie, ‘Governance off target’, The Australian, 5 April, 2016. Eli Greenblat, ‘Wesfarmers takes hit from “stupid” Target’, The Australian, 12 April 2016.

Chapter 5 deals with corporate governance in more detail.

ACTIVITY 4.1 (a) The fact that shareholders can limit their losses to that which they have paid, or have agreed to pay, for their shares, is of great practical importance to potential shareholders. Can you think of any practical benefit to a private-sector economy, in general, of this ability of shareholders to limit losses? Consider how suppliers of goods and services might be protected, given that the liability of company owners is limited to their agreed contributions. (b) Can you think of ways in which the shareholders themselves may try to ensure that the directors always act in the shareholders’ best interests?

The ways in which unscrupulous directors can manipulate the financial statements are many and varied. Before leaving this section, however, it is worthwhile reminding ourselves of the importance of sound internal control, which can be described as the systems and policies adopted by an entity to safeguard assets, promote efficiency and ensure reliable and accurate accounting records. The Accounting and You section that follows raises issues of fraud and embezzlement.

Advantages and disadvantages of the company entity structure Having highlighted some key features of the company entity structure, we can compare its potential advantages and disadvantages with those of the other common entity structures. The advantages normally include: • the separation of ownership and management, and the existence of a specialist management team • the perpetual existence of the entity, ensuring the stability of operations and long-term planning • the existence of a separate legal entity, which gives the entity operational and financial freedom • the limited liability for the owners (shareholders), which removes significant barriers to investment greater access to ownership funding, enhancing the business’s ability to operate and expand • Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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ACCOUNTING AND YOU FRAUD AND EMBEZZLEMENT The ideas of corporate governance and the role of directors introduced you to some of the issues that need to be confronted regarding the ways in which companies and directors should behave, and also provided examples of ways in which they should not behave. While the section covered issues such as disclosure, accountability and fairness, there is a ra of ways in which results can be manipulated and businesses cheated out of significant sums. The two most typical methods used are management fraud and employee embezzlement. Management fraud oen aims to increase share price by overstating revenues or understating expenses. This is oen associated with increases in staff bonuses. In the extreme, we can find examples of fraud on a vast scale, such as Bernard Madoff’s infamous ponzi scheme. A ponzi scheme is a fraudulent investment scheme that pays returns to investors from their own money, or money paid by subsequent investors, rather than from any actual profit earned. In the case of Madoff’s business, the amount missing from client accounts, including fabricated gains, ran into billions of dollars. Note also Real World 1.3 for more recent examples. Employee embezzlement typically involves the misappropriation of business assets. Ways in which this can occur include:

• • • • •

direct stealing of cash, inventory or other assets cheque tampering, or manipulating the system so that cheques are sent to the employee inappropriately fraud associated with cash registers travel and other expense rorts, and the taking of bribes and kickbacks.

Clearly, good systems of internal control are necessary. It is important to note that, in many cases, it is perceived pressure that creates the environment in which fraud and embezzlement are likely to happen. If pressure is coupled with a perceived opportunity, the likelihood increases. Interestingly, people who commit these offences oen have a rationalisation process, which they use as a justification. These kinds of events also mean that some degree of external regulation can be justified. The next chapter covers the more important aspects. You need to understand, though, that even close regulation is not guaranteed to find all these crimes, and certainly not quickly. It is worth noting that the US Securities and Exchange Commission had conducted investigations into Madoff’s business practices over several years but did not uncover the fraud. The message is clear. Some regulation is appropriate, but you should not rely on this to deal with all possible events. You must have sound systems of internal control. You always need to be observant and questioning. If good internal control systems are absent, the chances of you experiencing fraud or embezzlement in your workplace increase substantially. It would be a useful exercise for you to try to identify possible gaps in internal control in your workplace just to see whether the system is as sound as possible.

• potentially greater access to debt funding • potential taxation advantages, given that the company tax rate is less than the maximum •

personal taxation rate (at the time of writing the company tax rate was at 30% compared with a maximum personal tax rate of 45%), and potential increases in share values where shares are listed on the stock exchange.

Potential disadvantages include:

• more expensive to establish • more extensive regulatory requirements Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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• • • • •

less management flexibility potential loss of control by the original owners greater scrutiny by analysts and other special interest groups greater pressure to perform over the short term by external (non-management) investors, and potential taxation disadvantages as tax is paid at 30% on all profit (from the first $1).

Note that you should check the latest figures. The above rates are correct at the time of writing.

Concept check 1 Which of the following is NOT a feature of a company? A B C

D

E

Public companies are more rigorously regulated than proprietary companies. The two main categories are public companies and proprietary (private) companies. Many proprietary companies are no more than a vehicle for operating businesses that are effectively little more than sole proprietorships or small partnerships. Small proprietary companies are relieved of many of the reporting requirements of large proprietary companies or public companies. A proprietary company’s shares can be traded on a public stock exchange.

Concept check 2 Which of the following is NOT one of the two requirements that proprietary companies must satisfy to be deemed to be small? A B C D E

%QPUQNKFCVGFPGVCUUGVUCVVJGGPFQHVJGƂPCPEKCN[GCTCTGNGUUVJCPOKNNKQP %QPUQNKFCVGFITQUUQRGTCVKPITGXGPWGOWUVDGNGUUVJCPOKNNKQP +VGORNQ[UHGYGTVJCPGORNQ[GGUCVVJGGPFQHVJGƂPCPEKCN[GCT %QPUQNKFCVGFITQUUCUUGVUCVVJGGPFQHVJGƂPCPEKCN[GCTCTGNGUUVJCPOKNNKQP None of the above.

Concept check 3 Advantages of the company entity structure do NOT include … A B C D E

LO2 Explain equity and borrowings in a company context

permanent existence. limited liability of shareholders. more extensive regulatory requirements. potential tax advantages. None of the above. All are advantages.

EQUITY AND BORROWINGS IN A COMPANY CONTEXT

Equity/capital (owners’ claim) of limited companies Our simple statement of financial position (balance sheet) in Chapter 1, which was covered in more detail in Chapter 2, was effectively a statement of wealth. In practice, this statement sets out the things that are owned, and deducts from this figure the amounts owed to outsiders. The

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difference represents the wealth of the business. Since the business is run for the owners’ benefit, this wealth can be seen as a measure of the owners’ claim. As a business makes more profit and increases its wealth, so the owners’ claim increases. If the business pays out some of its profits, the wealth will decrease, as will the owners’ claim. As we have seen, the owners’ claim of a sole proprietorship is normally encompassed in one figure relating to equity on the statement of financial position, usually labelled capital. This figure can be increased by further injections of funds or by making profits, or reduced by incurring losses or by drawings made by the owners. With companies, this is usually a little more complicated, although in essence the same broad principles apply. With a company, the owners’ claim is divided between shares (i.e. the original investment) on the one hand, and reserves (i.e. profits and gains subsequently made) on the other. Capital and reserves are generally referred to as ‘shareholders’ equity’. There may also be shares of more than one type and reserves of more than one type, so within the basic divisions of share capital and reserves there may well be further subdivisions. This probably seems quite complicated. Shortly we shall consider the reasons for these subdivisions and all should become clearer. When a company is first formed, those who take steps to form it (usually known as its ‘promoters’) decide how much has to be raised by the potential shareholders to set up the company with the necessary assets to operate. Example 4.1 illustrates such a case and how this is reflected in a statement of financial position.

151

capital Another name for owners’ equity, often associated with sole proprietorships or partnerships. The owner’s claim on the assets of the business.

Let us imagine that several friends decide to form a company to operate a particular business. They estimate that the company will need $50,000 to obtain the necessary assets to operate the business. Between them they raise the cash to buy shares in the company, which issues 50,000 shares at $1 each.

4.1

#VVJKURQKPVVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP DCNCPEGUJGGVQHVJGEQORCP[YQWNFDG 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ $ Net assets CNNKPECUJ Shareholders’ equity 5JCTGECRKVCN UJCTGU

50,000 50,000

continued

(QTUKORNKEKV[KPVJKUCPFUWEEGGFKPIUVCVGOGPVUQHƂPCPEKCNRQUKVKQPRTGUGPVGFVQKNNWUVTCVGRQKPVU about shareholders’ equity, we have simply added together current and non-current assets and FGFWEVGFGZVGTPCNNKCDKNKVKGUIKXKPIPGVCUUGVU6JKUƂIWTGOWUVGSWCNUJCTGJQNFGTUoGSWKV[ The company now buys the necessary non-current assets and inventory and starts to trade. During VJGƂTUV[GCTKVOCMGUCRTQƂVQH6JKUD[FGƂPKVKQPOGCPUVJCVDQVJVJGPGVCUUGVUCPF VJGQYPGTUoENCKOGZRCPFD[ 4GOGODGTVJCVEQORCP[RTQƂVUDGNQPIVQVJGUJCTGJQNFGTU &WTKPIVJG[GCTVJGUJCTGJQNFGTU QYPGTUOCMGPQFTCYKPIUQHVJGKTECRKVCN UWEJFTCYKPIUCTG MPQYPCUnFKXKFGPFUoYJGPCRRNKGFVQEQORCPKGUUQCVVJGGPFQHVJG[GCTVJGUWOOCTKUGFUVCVGOGPV QHƂPCPEKCNRQUKVKQPNQQMUNKMGVJKU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Net assets XCTKQWUCUUGVUNGUUNKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN UJCTGU 4GUGTXGU TGVCKPGFRTQƂVU

$ 60,000 50,000 10,000 60,000

6JGRTQƂVKUUJQYPKPCnTGUGTXGoMPQYPCUnTGVCKPGFRTQƂVUo QTnTGVCKPGFGCTPKPIUo0QVGVJCVYGFQ PQVUKORN[CFFVJGRTQƂVVQVJGUJCTGECRKVCN9GOWUVMGGRVJGVYQCOQWPVUUGRCTCVG VQUCVKUH[VJG %QTRQTCVKQPU#EVDGECWUGVJGTGKUCNGICNTGUVTKEVKQPQPVJGOCZKOWOFTCYKPIUQHECRKVCN QTnFKXKFGPFUo VJCVVJGQYPGTUECPOCMG6JKUKUFGƂPGFD[VJGCOQWPVQHFKUVTKDWVCDNGTGUGTXGUUQKVKUJGNRHWNVQUJQY VJGUGUGRCTCVGN[9GUJCNNNQQMCVYJ[VJGTGKUVJKUTGUVTKEVKQPCPFJQYKVYQTMUNCVGTKPVJGEJCRVGT

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ordinary shares Shares of a company owned by those who are due the DGPGƂVUQHVJGEQORCP[oU activities after all other stakeholders have been UCVKUƂGF dividends Transfers of assets (usually cash) made by a company to its shareholders.

Shares represent the basic units of ownership of the business. All companies issue ordinary shares, the main risk-bearing shares issued by companies (see Example 4.1). These are often referred to as ‘equities’. All other claims on the business have a higher priority in terms of repayment. Ordinary shareholders’ returns will come from distributions of profit (known as dividends) or from increases in the value of the shares. Under normal circumstances, retaining profits is likely to produce such increases. Until recently, each share had a value, known as ‘par value’, attached to it. The Company Law Review Act 1998 eliminated this, and shares are now deemed to have no par value. Shares can be issued fully or partly paid, as illustrated in Example 4.2.

Suppose a company wishes to raise $250,000 in cash and issues 250,000 ordinary shares at a price of $1 a share.

4.2

6JGTGUWNVKPIUVCVGOGPVQHƂPCPEKCNRQUKVKQPYKNNDG Net assets Cash

$250,000

Shareholders’ equity 2CKFWRUJCTGECRKVCN QTFKPCT[UJCTGUKUUWGFCV

$250,000

These shares are fully paid as there is no further payment required of the shareholders. partly paid shares Shares on which the full issue price of the share has not been paid as at reporting date. This would normally relate to shares that are to be paid in instalments or a series of calls, and not all of the total share issue price is required to be paid (or has been called up) as at the reporting date.

fully paid shares Shares on which the shareholders have paid the full issue price.

A company can issue partly paid shares. Suppose that instead of issuing 250,000 shares at $1, the EQORCP[FGEKFGUVQTCKUGVJGKVPGGFUD[KUUWKPIRCTVN[RCKFUJCTGUDWVCUMUHQT ECNNU only 50¢ per share now, with the remaining 50¢ per share to be called and collected at some future date. 6JGTGUWNVYKNNDG Net assets Cash

$250,000

Shareholders’ equity 5JCTGECRKVCN QTFKPCT[UJCTGUKUUWGFCVtECNNGFVQ~

$250,000

The shareholders, in agreeing to buy shares issued at $1, have agreed to commit $1 when required. #VVJKUUVCIGVJGEQORCP[JCUQPN[CUMGFHQTJCNHQHVJKUUQVJGHWTVJGTNKCDKNKV[QHVJGUJCTGJQNFGTU is restricted to 50¢ per share. Once this has been paid, the shares become fully paid shares and the shareholders have no further liability to the company. 9JGTGECNNUCTGWPRCKFVJKUYKNNDGTGƃGEVGFQPVJGDCNCPEGUJGGV+HHQTGZCORNGVJGECNNYCUWPRCKF QPUJCTGUVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPYQWNFCRRGCTCUHQNNQYU $ Net assets Cash Shareholders’ equity 5JCTGECRKVCN QTFKPCT[UJCTGUKUUWGFCVtECNNGFVQ~ .GUUECNNUKPCTTGCTU UJCTGUCV~

$247,500 250,000

 $247,500

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ACTIVITY 4.2 (a) Show the statement of financial position of a company aer each of the following transactions: • The issue of 100,000 shares at an issue price of $2, of which $1 is payable immediately. • Aer a further call of 50¢ per share. (b) A company issues 100,000 shares on formation at $1 per share. Five years later its statement of financial position is as shown below: Net assets

$170,000

Shareholders’ equity Capital 4GVCKPGFRTQƂVU

100,000 70,000 $170,000

The current market price of the shares is $2. A further 100,000 shares are issued at market price. Show the statement of financial position, assuming the issue is successful.

Some companies also issue other classes of shares, preference shares being the most common. These usually guarantee that if a dividend is paid, the preference shareholders will be entitled to the first part of it up to a maximum value. This maximum is normally defined as a fixed percentage of the preference shares. If, for example, a company issues 100,000 preference shares at $1 each with a dividend rate of 6%, this means that the preference shareholders are entitled to receive the first $6,000 of any dividend paid by the company for a year. The profit in excess of the preference dividend is the entitlement of the ordinary shareholders, although this amount is not necessarily (or even normally) paid out as a cash dividend. Normally, any undistributed profits and gains accrue to the ordinary shareholders. Thus, the ordinary shareholders are the primary risk-takers. Their potential rewards reflect this risk. Power normally resides in the hands of the ordinary shareholders. Generally, only the ordinary shareholders are able to vote on issues that affect the company, such as who the directors should be. One ordinary share usually carries with it one vote. It is open to the company to issue shares of various classes, perhaps with some having unusual conditions, but it is rare to find other than straightforward ordinary and preference shares. Although a company may have different classes of shares whose holders have different rights, within each class all shares must be treated equally. The rights of the various classes of shareholders, as well as other matters relating to a particular company, are contained in that company’s constitution, or in the special resolution approving the issue. Example 4.3 illustrates the importance of ensuring that new shares are issued at an appropriate price so as to preserve the rights of existing shareholders.

preference shares 5JCTGUYJKEJJCXGCƂZGF rate of dividend that must be paid before any ordinary dividend can be paid. Often preference shares have higher priority than ordinary shares in the event of the company going into liquidation.

6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPQHCEQORCP[KUCUHQNNQYU Net assets Shareholders’ equity %CRKVCN OKNNKQPUJCTGU 4GVCKPGFRTQƂVU

$1,500,000 1,000,000 500,000 $1,500,000

4.3

#UUWOKPIVJCVVJGOCTMGVXCNWGQHVJGUJCTGUKUVJGUCOGCUVJGDQQMXCNWGVJGUJCTGRTKEGYQWNFDG 6JGEQORCP[JCUFGEKFGFVQTCKUGCPGZVTCECUJHQTGZRCPUKQPD[KUUWKPIPGYUJCTGU+H the shares are issued for $1.50 each, 400,000 shares must be issued, producing the following statement QHƂPCPEKCNRQUKVKQP

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4.3 continued

Net assets Shareholders’ equity %CRKVCN OKNNKQPUJCTGU 4GVCKPGFRTQƂVU

$2,100,000 1,600,000 500,000 $2,100,000

This should maintain the share price at $1.50. +HVJGPGYKUUWGQHUJCTGUYCUCVCRTKEGNGUUVJCPUC[VJGGPFTGUWNVYQWNFDGCU HQNNQYU Net assets Shareholders’ equity %CRKVCN OKNNKQPUJCTGU 4GVCKPGFRTQƂVU

$1,900,000 1,400,000 500,000 $1,900,000

+HYGEQPVKPWGQWTCUUWORVKQPVJCVDQQMXCNWGCPFOCTMGVXCNWGCTGVJGUCOGVJGOCTMGVXCNWG per share will change to $1.9 million/1.4 million shares = $1.36 per share. The old shareholders are disadvantaged, whereas the new ones are better off. +PRTCEVKEGVJGUKVWCVKQPKUOQTGEQORNKECVGFVJCPVJKUYKVJDQQMXCNWGCPFOCTMGVXCNWGCNOQUV never being the same, but the principles remain the same.

A company can issue more share capital at a later date. Given that the value of the company (and therefore of the shares) is likely to increase over time as profits are retained, the asking price for the new shares is likely to be higher than the original asking price. Generally we would expect new shareholders to buy new shares at a price very close to the current market value of the shares. The proceeds will be added to cash and capital. You need to understand why it is important that any new issues are at a price close to market price. Since the new shareholders have the same rights as the old, the new shareholders must ‘buy in’ their share of any increases in value since the initial share purchase. If this does not occur, then new shareholders will benefit at the expense of the old shareholders.

Reserves reserves #OQWPVUTGƃGEVKPIKPETGCUGU in owners’ claims.

Reserves are profits and gains that have been made by the company and that still form part of the

shareholders’ (owners’) claim. Profits and gains tend to lead to cash flowing into the company. Note that retained profits represent the largest source of new finance for Australian companies, more than share issues and borrowings combined for most companies. These ploughed-back profits create most of the typical company’s reserves. Retained profits can be held in an account with the same name, ‘retained profits’, or in an account labelled ‘general reserve’. Reserves will be reduced by distributions (typically dividends) or by any losses incurred. You should note that reserves are not cash. Reserves represent a claim by the owners on the business. In everyday usage, we tend to talk about reserves being things held as a back-up, and these tend to relate to assets (e.g. cash, minerals). You must recognise that an accounting reserve represents something other than this—it is a claim. Not all reserves result from profits earned and, therefore, some reserves may not be distributable as a cash dividend. For example, a company might revalue (upwards) non-current assets, such as property bought several years ago for $250,000, now revalued to reflect its current value of, say, $400,000. The property value would be increased by $150,000 and a revaluation reserve would be increased by the same amount. Note that such capital gains can be distributed if they result from a bona fide revaluation of all assets, but such distributions are relatively rare.

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Bonus shares It is always open to the company to take reserves of any kind and turn them into share capital. The new shares are known as bonus shares as they involve no cost to the shareholders. They are also known as a share dividend. Issues of bonus shares occur quite frequently. Example 4.4 illustrates how bonus shares work.

bonus shares Reserves which are converted into shares and given ‘free’ to shareholders.

6JGUWOOCT[UVCVGOGPVQHƂPCPEKCNRQUKVKQPQHCEQORCP[KUCUHQNNQYU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Net assets XCTKQWUCUUGVUNGUUNKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GUGTXGU

$ 128,000 50,000 78,000 128,000

The company decides that it will issue, to existing shareholders, one new $1 share for every share QYPGFD[GCEJUJCTGJQNFGT6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPKOOGFKCVGN[HQNNQYKPIVJKUYKNN CRRGCTCUHQNNQYU

4.4 continued

5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJ Net assets XCTKQWUCUUGVUNGUUNKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GUGTXGU s

$ 128,000 100,000 28,000 128,000

9GECPUGGVJCVVJGTGUGTXGUJCXGFGETGCUGFD[CPFUJCTGECRKVCNJCUKPETGCUGFD[VJGUCOG COQWPV5JCTGEGTVKƂECVGUHQTVJGQTFKPCT[UJCTGUQHGCEJYJKEJJCXGDGGPETGCVGFHTQO reserves, will be issued to the existing shareholders to complete the transaction.

Assume now that a shareholder of the company in Example 4.4 owned 100 shares in the company before the bonus issue. How will things change for this shareholder, as a result of the bonus issue, with regard to the number of shares owned and to the value of the shareholding? The answer should be that the number of shares will double from 100 to 200. Now the shareholder owns one five-hundredth of the company (200/100,000). Before the bonus issue the shareholder also owned one five-hundredth of the company (100/50,000). The company’s assets and liabilities have not changed one bit as a result of the bonus issue, so, logically, one fivehundredth of the value of the company should be identical to what it was before. Thus, each share is worth half as much, but the shareholder now owns twice as many shares. In practice, events are not likely to take place with quite the precision implied above. One of the arguments used to support a bonus issue is that a reduction in share price might lead to higher levels of activity in the market for shares, with the result that the price might not fall as much as logic would expect, with the end result being an increase in the market value of the company. Referring to Example 4.4, such a result might leave the shares trading at a value slightly higher than 50% of the prebonus share price. Such a reaction may be short term if the fundamental value of the business, based on future earnings, has not changed. However, the fact that a firm undertakes a bonus issue may indicate that management has reason to believe that future earnings will improve, and if the market supports this position, then the bonus issue may be associated with increased overall share value. However, if the share value increases overall after the bonus issue, it is not possible to determine whether the share value may have increased anyhow, had the bonus not taken place. A bonus issue simply takes one part of the owners’ claim (part of a reserve) and puts it into another part of the owners’ claim (share capital).

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This inevitably raises the question: why bother? Three possible reasons are:

• Share price—to lower the value of each share, without reducing the shareholders’ collective or individual wealth.

• Shareholder confidence—to provide the shareholders with a ‘feel good factor’. Apparently •

shareholders like bonus issues, because it seems to make them better off, although in practice it should not affect their wealth. Lender confidence—where reserves arising from operating profits and/or realised gains on the sale of non-current assets are used to make the bonus issue, it has the effect of taking part of that portion of the owners’ claim which could be drawn by the shareholders as drawings (or dividends), and locking it up. There are severe restrictions on the extent to which shareholders may make drawings from their capital. An individual or organisation contemplating lending money to the company may insist that the dividend payment possibilities are restricted as a condition of making the loan.

Raising share capital A company may decide to raise additional funds by making further issues of new shares. These may be by:

• Rights issues—issues made to existing shareholders, in proportion to their existing

rights issue An issue of shares for cash to existing shareholders on the basis of the number of shares already held, at a price that is usually lower than the current market price.

shareholding. To encourage existing shareholders to take up their ‘rights’ to buy some new shares, those shares are virtually always offered at a price below the current market price of the existing ones. Rights to buy shares can be sold, so shareholders who do not wish to take up their rights can sell them and benefit accordingly. Note, however, that in the case of proprietary companies the directors may have the discretion to refuse to register transfers. Remember that a rights issue is a totally different thing from a bonus issue. Rights issues result in an asset (cash) being transferred from shareholders to the company. Bonus issues involve no transfer of assets in either direction.

• Public issues—issues made to the general investing public (only public companies). • Private placings—issues made to selected individuals or institutions who are usually approached and asked whether they would be interested in taking up new shares. During its lifetime, a company may use any or all of these approaches to raising funds through issuing new shares. These approaches will be discussed in detail in Chapter 14.

Borrowings

loan notes Long-term borrowings usually made by limited companies.

Most companies borrow to supplement the funds raised from share issues and retained profits. Ways in which borrowing typically occurs are covered in Chapter 14. In the statement of financial position, long-term loans will be categorised as non-current liabilities, while short-term loans will be categorised as current liabilities. Usually, long-term loans are secured on assets of the company. This would give the lender the right to seize the assets concerned, sell them and satisfy the repayment obligation, should the company default on either its interest payments or the repayment of the loan. A common form of borrowing is through the issue of loan notes. Where a large issue of loan notes is made, it can sometimes be taken up in small slices, by private investors, or in large slices, by investing institutions such as pension funds and insurance companies. These slices of loans can also, at times, be bought and sold through the stock exchange. This means that investors need not wait the full term of the loan to obtain repayment, but can sell their slice of it to another investor at any point. Loan notes are often known as ‘loan stock’, ‘debentures’ or ‘corporate bonds’. The fact that loan notes may be traded on the stock exchange can lead to confusing loan notes with shares. They are, however, quite different. Holders of shares own the company, and share in its losses and profits. Holders of loan notes simply lend money to the company under a legally binding contract. It is important to the prosperity and stability of a company that it strikes a suitable balance between finance provided by the shareholders (equity) and finance from borrowing. This topic will be explored in Chapters 8 and 14.

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Concept check 4 Which of the following statements is false? A B C

D

E

Capital is the term used for owners’ equity in proprietorships and partnerships. Shares represent the basic units of ownership of a company. Partly paid shares are shares on which the full issue price of the share has not been paid as at reporting date. Preference shares generally have lower priority than ordinary shares in the event of the company going into liquidation. A company may have different classes of shares with different rights.

Concept check 5 Which of the following statements is true? A

B C

D E

 GUGTXGUCTGRTQƂVUCPFICKPUVJCVJCXGDGGPOCFGD[VJGEQORCP[CPFVJCV 4 still form part of the shareholders’ (owners’) claim. Reserves are usually in the form of cash. 4GVCKPGFRTQƂVU TGVCKPGFGCTPKPIUKUCTGUGTXGQHRTQƂVUVJCVJCUDGGPRCKF out to shareholders. Reserves represent a claim by the lenders to the business. None of the above.

Concept check 6 Which of the following is NOT a characteristic of bonus share issues? A B C D E

They convert a reserve into share capital. They are also known as share dividends. They lower the value of an individual share. They lower overall shareholder wealth. They provide shareholders with a ‘feel good factor’.

LO3 RESTRICTIONS ON THE RIGHTS OF SHAREHOLDERS TO MAKE DRAWINGS OR REDUCTIONS OF CAPITAL Limited companies are required by law to distinguish between that part of their capital (shareholders’ claim) which may be withdrawn by the shareholders and that part which may not be. The distributable (withdrawable) part, which has arisen from operating profits and from realised profits on the disposal of fixed assets (both on an after-tax basis), is called TGVCKPGFRTQƂV. As mentioned earlier, unrealised capital profits obtained by a bona fide revaluation of all assets are also distributable. The non-distributable part (which cannot be withdrawn) normally consists of what arose from funds injected by shareholders buying shares in the company. In fact, many companies treat unrealised capital gains obtained by a revaluation as, effectively, a non-distributable revaluation reserve. The reason why limited companies are required to distinguish different parts of their equity relates to limited liability, which company shareholders enjoy, but which owners of unincorporated businesses do not. If a sole trader withdraws all of the owner’s claim, or even

Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

retained profit 6JGCOQWPVQHRTQƂVOCFG over the life of a business which has not been taken out by owners in the form QH|FTCYKPIUQTFKXKFGPFU

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more than this, the position of the business’s creditors is not weakened since they can legally enforce their claims against the sole trader as an individual. With a limited company, in which the business and the owners are legally separated, such legal right does not exist. However, to protect the company’s creditors the law insists that a specific part of the capital of a company cannot legally be withdrawn by the shareholders. The law does not specify how large the non-distributable part of a particular company’s capital should be. It simply requires that anyone dealing with the company must be able to tell how large it is by looking at the company’s statement of financial position. In the light of this, a particular prospective lender, or supplier of goods or services on credit, can make a commercial judgement as to whether or not to deal with the company. Example 4.5 illustrates both the extent to which external claims can be protected, and also the limits.

6JGUWOOCT[UVCVGOGPVQHƂPCPEKCNRQUKVKQPQHCEQORCP[KUCUHQNNQYU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV,WPG

4.5

$ Net assets Current and non-current assets less short-term liabilities Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GVCKPGFRTQƂVU

43,000 20,000 23,000 43,000

6JGEQORCP[JCUCUMGFCDCPMVQOCMGKVCNQPIVGTONQCP+HVJGDCPMCITGGUUVTCKIJVCYC[ VJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPYKNNCRRGCTCUHQNNQYU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV,WPG $ Net assets %WTTGPVCPFPQPEWTTGPVCUUGVUNGUUUJQTVVGTONKCDKNKVKGU   .GUUPQPEWTTGPV NQPIVGTONKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GVCKPGFRTQƂVU

68,000 25,000 43,000 20,000 23,000 43,000

#UVJKPIUUVCPFVJGTGCTGCUUGVUQHVQOGGVVJGDCPMoUENCKOQH*QYGXGTVJG EQORCP[EQWNFRC[CFKXKFGPFQHRGTHGEVN[NGICNN[+HKVFKFVJGUVCVGOGPVQHƂPCPEKCN RQUKVKQPYQWNFCRRGCTCUHQNNQYU Net assets %WTTGPVCPFPQPEWTTGPVCUUGVUNGUUUJQTVVGTONKCDKNKVKGU s Less non-current liabilities Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GVCKPGFRTQƂVU s

45,000 25,000 $20,000 20,000 s $20,000

6JKUNGCXGUVJGDCPMKPCOWEJYGCMGTRQUKVKQPDGECWUGPGVCUUGVUCTGPQYUJQYPCUJCXKPICXCNWG QHVQOGGVCENCKOQH0QVGVJCVVJGFKHHGTGPEGDGVYGGPVJGCOQWPVQHVJGDCPMNQCP CPFVJGQVJGTPGVCUUGVUCNYC[UGSWCNUVJGECRKVCNCPFTGUGTXGUVQVCN6JGECRKVCNTGRTGUGPVUCnOCTIKP of safety’ for creditors. The larger the amount of the owners’ claim that is withdrawable by the shareholders, the smaller the potential margin of safety for creditors.

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The law is quite specific that it is illegal, under normal circumstances, for shareholders to withdraw that part of their claim which is represented by capital. This means that potential creditors of the company know the maximum amount of the shareholders’ claim that can be drawn or withdrawn by the shareholders. It is important to remember that company law says nothing about how large this margin of safety must be. What is desirable is left as a matter of commercial judgement by the company concerned. The larger it is, the easier the company will find it to persuade potential lenders to lend and suppliers to supply goods and services on credit. Sometimes, a potential creditor may insist that some of the retained profits are converted to bonus shares (or ‘capitalised’) to increase the margin of safety, as a condition of granting the loan. Also, most potential long-term lenders try to secure their loan against one of the company’s assets, such as freehold property. This gives them the right to seize the specific asset concerned, sell it and satisfy their claim should the company default. Lenders often place restrictions or covenants on the borrowing company’s freedom of action as a condition of granting the loan. These covenants typically restrict the level of risk to which the company, and thus the lender’s asset, is exposed. Also, it would be quite rare for a company to pay out all of its revenue reserves as a dividend: a legal right to do so does not necessarily make it a good idea. Most companies see ploughed-back profits as a major—usually the major—source of new finance. The factors that influence the dividend decision are likely to include:

• the availability of cash to pay a dividend—it would not be illegal to borrow to pay a dividend, • •

but it would be unusual and, possibly, imprudent the needs of the business for finance for investment possibly a need for the directors to create good relations with investors, who may regard a dividend as a positive feature.

Large companies tend to have a clear and consistent policy towards the payment of dividends, and any change in the policy provokes considerable interest. It is usually interpreted by shareholders as a signal of the directors’ views concerning the future. For example, an increase in dividends may be taken as a signal from the directors that future prospects are bright: a higher dividend is seen as tangible evidence of their confidence. Real World 4.3 provides an example of how commercial realities led to a change in the level of dividends paid by two very large companies, as well as providing a rare example of non-compliance regarding distributions.

REAL WORLD 4.3 Dividend policy and distributions a) Dividend policy Rio Tinto and BHP Billiton, probably the two biggest resources companies in the world, have both changed their dividend policies as a result of the crash in commodity prices and the associated impact on their results and future prospects. Each has had a progressive policy, i.e. always increasing. For 2015 Rio maintained its final dividend, but foreshadowed a potential near halving of dividends for 2016, with a payout ratio of between 40% and 60% aerwards. BHP also slashed its interim dividend (from US62¢ per share to US16¢), the first time the dividend had been cut since the very early days of the company. It flagged that, in the future, the dividend would be a minimum of 50% of underlying profit for the

period. Both companies recognised that they were in danger. Concerns were generally about the levels of costs, capital expenditure, debt and productivity, alongside dramatic reductions in selling prices. Rio’s full year underlying profit fell 51%, in spite of a reduction in its global wages bill of $US1.2 billion. After impairments, the full year loss was US$866 million. Source: Stephen Bartholomeusz, ‘Rio Tinto snookers BHP by dumping progressive dividend policy’, The Weekend Australian, 13–14 February 2016. Robert Gottliebsen, ‘BHP’s management lesson for all Australian companies’, The Australian, 24 February 2016. Matt Chambers, ‘Rio Tinto shrinks its wages bill by $US1.2bn’, The Australian, 4 March 2016.

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The final result for BHP Billiton for 2016 was a loss from operations of $US6.235 billion, but an underlying figure of earnings before interest and tax, depreciation and amortisation (EBITDA) of US$12.3 billion. A final dividend of 14 cents per share was agreed, making the total for the year US30¢. In accordance with the Group dividend policy, this comprises the minimum payout of US8¢ per share and an additional US6¢ per share, reflecting continued balance sheet strength and strong, free cash flow during the period. In the first half of 2016 Rio paid a dividend per share of US45¢ per share compared with US107.5¢ for the equivalent period of 2015. Sources: Rio Tinto, ‘Half year results 2016’. BHP Billiton, ‘Reports and presentations’, 2016.

b) Distributability of dividends In the United Kingdom, Betfair returned £80 million to investors in violation of accounting rules, the gambling company admitted. The embarrassing breach—which occurred in 2011, 2012 and 2013 before being noticed—involved Betfair paying out more in dividends and share buybacks than it was legally permitted to.

Betfair announced its first dividend as a public company in June 2011, partly to reassure investors who had seen the company’s shares halve since its flotation six months earlier. It paid out £30 million in relation to the 2011, 2012 and 2013 financial years, and also bought back £50 million in shares. However, the payments did not comply with a rule change on how a company’s realised profits and distributable reserves are defined. Betfair said in its latest annual report that, ‘as a result of certain changes to the technical guidance issued by the Institute of Chartered Accounts [sic] in England and Wales (the “ICAEW”) in October 2010, the Company did not have sufficient distributable reserves to make those distributions and so they should not have been paid by the Company to its shareholders’. Deed polls have now been used to ensure that investors do not have to repay the dividends, and the company’s annual general meeting in September will be asked to approve the cancellation of ordinary shares affected by the buyback. Source: Extract from Mance, H. (2014) ‘Betfair admits to £80m payouts mistake’, .com, 3 August. © The Financial Times Limited 2014. All Rights Reserved. FT and 'Financial Times’ are trademarks of The Financial Times Ltd.

It is possible for certain preference shares (called ‘redeemable preference shares’) to be redeemed (repurchased by the company). Where any such preference shares redeemed are replaced by new shares there is no real problem, as the creditor’s position relative to shareholders is unchanged. However, where preference shares are redeemed without any new capital issue, there seems to be a direct contradiction of what has been said so far in this section, as the shareholders’ equity would be reduced. It is, therefore, necessary for an amount equivalent to the amount of preference capital redeemed to be transferred from retained profits directly to capital, thus maintaining the total capital of the business. Without this proviso, unscrupulous directors could redeem capital and pay out retained profits, disadvantaging creditors and lenders. A company is not allowed to acquire and hold its own shares, but it can buy them back and cancel them, so long as the buyback does not materially prejudice the creditors.

ACTIVITY 4.3 Why might a company wish to buy back its shares? What advantages might result for shareholders?

SELF-ASSESSMENT QUESTION

4.1

6JGUWOOCTKUGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH$QPCP\C.VFKUCUHQNNQYU BONANZA LTD Statement of financial position as at 31 December 2017 Net assets XCTKQWUCUUGVUNGUUNKCDKNKVKGU Shareholders’ equity 5JCTGECRKVCN UJCTGUKUUWGFCVGCEJ 4GXCNWCVKQPTGUGTXG 4GVCKPGFRTQƂVU

$ 235,000 130,000 37,000 68,000 235,000

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161

 9KVJQWVCP[QVJGTVTCPUCEVKQPUQEEWTTKPICVVJGUCOGVKOGVJGEQORCP[OCFGCQPGHQTƂXGTKIJVUUJCTGKUUWGCV RGTUJCTGRC[CDNGKPECUJ CNNUJCTGJQNFGTUVQQMWRVJGKTTKIJVUCPFKOOGFKCVGN[CHVGTOCFGCQPGHQTHQWT DQPWUKUUWGCVCPKUUWGRTKEGQH 5JQYVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPKOOGFKCVGN[HQNNQYKPIVJGDQPWUKUUWGCUUWOKPIVJCVVJGFKTGEVQTU want to retain the maximum dividend payment potential for the future.  'ZRNCKPYJCVGZVGTPCNKPƃWGPEGOKIJVECWUGVJGFKTGEVQTUVQEJQQUGPQVVQTGVCKPVJGOCZKOWOFKXKFGPFRC[OGPV possibilities.  5JQYVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPKOOGFKCVGN[HQNNQYKPIVJGDQPWUKUUWGCUUWOKPIVJCVVJGFKTGEVQTUYCPV to retain the minimum dividend payment potential for the future. (For the purposes of questions 3 and 4, assume that the company does not consider the revaluation reserve to be distributable as a cash dividend.) 4 What maximum dividend could be paid before and after the events described in question 1 if the minimum dividend payment potential is achieved?  .GGQYPGFUJCTGUKP$QPCP\C.VFDGHQTGVJGGXGPVUFGUETKDGFKPSWGUVKQP#UUWOKPIVJCVVJGEQORCP[oUPGV CUUGVUJCXGCXCNWGGSWCNVQVJCVUJQYPKPVJGCEEQWPVUUJQYJQYVJGUGGXGPVUYKNNCHHGEV.GGoUYGCNVJ

Concept check 7 Which statement is false? A

B

C

D E

 GVCKPGFRTQƂVUCTGRTQƂVUOCFGQXGTVJGNKHGQHCDWUKPGUUYJKEJJCXGPQV 4 been taken out by owners in the form of drawings or dividends. +VKUNCYVJCVCURGEKƂERCTVQHVJGECRKVCNQHCEQORCP[ECPPQVNGICNN[DG withdrawn by the shareholders. .CTIGEQORCPKGUVGPFVQJCXGCPQRCSWGCPFEJCPIKPIRQNKE[VQYCTFUVJGRC[OGPVQH dividends. The availability of cash is quite possibly a factor in a dividend payment decision. None of the above.

Concept check 8 Which of the following is false? A

B

C D E

Many companies treat unrealised capital gains obtained by a revaluation as a non-distributable revaluation reserve. 6QRTQVGEVVJGEQORCP[oUETGFKVQTUVJGNCYKPUKUVUVJCVCURGEKƂERCTVQHVJG capital of a company cannot legally be withdrawn by the shareholders. /CP[EQORCPKGUVTGCVTGVCKPGFRTQƂVUCUCUQWTEGQHƂPCPEG It is illegal for a company to borrow money to pay a dividend. None of the above are false.

THE MAIN FINANCIAL STATEMENTS The financial statements of a limited company are, in principle, the same as those of a sole proprietorship or a partnership. There are, however, differences in detail, which we shall now consider. Example 4.6 sets out the income statement and statement of financial position of a limited company.

LO4 Explain and discuss the main financial statements prepared by a limited company

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DA SILVA LTD Income statement

4.6

for the year ending 31 December 2017 $m 840

 320















 95

 85

 61

4GXGPWG Cost of sales )TQUURTQƂV 9CIGUCPFUCNCTKGU *GCVCPFNKIJV 4GPVCPFTCVGU Motor vehicle expenses +PUWTCPEG Printing and stationery Depreciation Audit fee 1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG 2TQƂVDGHQTGVCZCVKQP Taxation 2TQƂVHQTVJG[GCT

DA SILVA LTD Statement of financial position as at 31 December 2017 $m Current assets Cash Accounts receivable +PXGPVQTKGU Non-current assets Property, plant and equipment +PVCPIKDNGCUUGVU Total assets Current liabilities Accounts payable Taxation Non-current liabilities Borrowings Equity Ordinary shares issued at $0.50 each Other reserves 4GVCKPGFGCTPKPIU Total equity and liabilities

36 112 65 213 203 100 303 516 99 12 111 100 200 80 25 305 516

.GVWUPQYIQVJTQWIJVJGUGUVCVGOGPVUCPFRKEMWRVJQUGCURGEVUVJCVCTGWPKSWGVQNKOKVGF companies.

The income statement The main points for consideration in the income statement are as follows.

Profit Following the calculation of operating profit, two further measures of profit are shown. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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CHAPTER 4 INTRODUCTION TO LIMITED COMPANIES

The first of these is the RTQƂVDGHQTGVCZCVKQP. Interest charges are deducted from the operating profit to derive this figure. In the case of a sole proprietor or a partnership business, the income statement would end here. The second measure of profit is the RTQƂVHQTVJGRGTKQF (usually a year). As the company is a separate legal entity, it is liable to pay tax on the profits generated. (This contrasts with the sole proprietor business where it is the owner rather than the business who is liable for the tax on profits, as we saw earlier in the chapter.) This measure of profit after tax represents the amount that is available for the shareholders.

Audit fee Companies beyond a certain size are required to have their financial statements audited by an independent firm of accountants, for which a fee is charged. As we shall see in Chapter 5, the purpose of the audit is to lend credibility to the financial statements. Although it is also open to sole proprietorships and partnerships to have their financial statements audited, relatively few do, so this is an expense that is most often seen in the income statement of a company.

163

profit before taxation The result when all of the appropriately matched expenses of running a business have been deducted from the revenue for the year, but before the taxation charge has been deducted. profit for the period 6JGRTQƂVHQTVJG[GCTCHVGT a reasonable estimate of tax likely for the year.

The statement of financial position The main points for consideration in the statement of financial position are as follows.

Taxation The amount that appears as part of the current liabilities represents any income tax due in the next 12 months.

Other reserves This will include any reserves that are not separately identified on the face of the statement of financial position. It may include a general reserve, which normally consists of trading profits that have been transferred to this separate reserve for reinvestment (‘ploughing back’) into the operations of the company. It is not at all necessary to set up a separate reserve for this purpose. The trading profits could remain unallocated and still swell the retained earnings of the company. It is not entirely clear why directors decide to make transfers to general reserves, since the profits concerned remain part of the revenue reserves, and as such they still remain available for dividend. The most plausible explanation seems to be that directors feel that placing profits in a separate reserve indicates an intention to invest the funds, represented by the reserve, permanently in the company and, therefore, not to use them to pay a dividend or to fund a share repurchase. Of course, the retained earnings appearing on the statement of financial position are also a reserve, but that fact is not indicated in its title. Real World 4.4 on page 164 provides an illustration of the range of reserves found in practice. Many large companies use similar approaches, as revaluations, foreign currency translations and cash flow hedges are reasonably common.

Dividends Dividends represent drawings by the shareholders of the company. They are paid out of the revenue reserves and should be deducted from these reserves (usually retained earnings) when preparing the statement of financial position. Shareholders are often paid an annual dividend, perhaps in two parts. An ‘interim’ dividend may be paid part-way through the year, and a ‘final’ dividend shortly after the year-end. Those dividends declared by the directors during the year but still unpaid at the year-end may appear as a liability in the statement of financial position. To be recognised as a liability, however, they must be properly authorised before the year-end date. This normally means that the shareholders must approve the dividend.

ACTIVITY 4.4 Assume that a company has a profit before taxation of $10 million and expects to pay income tax at the rate of 30%. It has paid an interim dividend of 10¢ per share and expects to pay a final dividend of 10¢ per share. There are 20 million shares issued at a price of $1.50 each. Opening retained profits were $15 million. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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Show your calculation of the retained profits at the end of the year, the equity section of the statement of financial position at the end of the year, and any other current liabilities that will be shown in the closing statement of financial position.

REAL WORLD 4.4 Reserves and retained profits Harvey Norman, in its annual report for 2016, included the following reserves, as well as retained profits. Asset revaluation reserve This reserve is used to record increases in the fair value of ‘owner occupied’ land and buildings and decreases to the extent that such decreases relate to an increase on the same asset previously recognised in equity. Foreign currency translation reserve This reserve is used to record exchange differences arising from the translation of the financial statements of foreign subsidiaries. Available for sale reserve This reserve is used to record fair value changes on available-for-sale investments.

Cash flow hedge reserve This reserve is used to record the portion of the gain or loss on a hedging instrument in a cash flow hedge that is determined to be an effective hedge. Employee equity benefit reserve This reserve is used to record the value of equity benefits provided to executive directors as part of their remuneration. Acquisition reserve This reserve is used to record the consideration paid in excess of carrying value of non-controlling interests. Some of these reserves will actually be negative and clearly will reduce total equity. Source: Harvey Norman Annual Report 2016, p. 109. © Harvey Norman Holdings Limited A.C.N. 104 215 241.

Concept check 9 Which of the following is false? A

B

C D E

6JGƂPCPEKCNUVCVGOGPVUQHCNKOKVGFEQORCP[CTGHWPFCOGPVCNN[VJGUCOGCU those of a sole proprietorship. 6JGƂPCPEKCNUVCVGOGPVUQHCNKOKVGFEQORCP[CTGHWPFCOGPVCNN[VJGUCOGCU those of a partnership. 6CZGZRGPUGKUTGEQIPKUGFD[CEQORCP[YJGPRTQƂVUCTGGCTPGF Unpaid taxes will be part of a company’s current liabilities. None of the above. All are true.

Concept check 10 Which of the following statements is false? A

B C D E

The asset revaluation reserve account is used to record increases in the fair value of ‘owner occupied’ land and buildings. Dividends are the corporate version of drawings. The creation of a general reserve is a sensible business decision in many contexts. The creation of a general reserve does not affect the ability of the company to pay dividends. None of the above. All are true.

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

OBJECTIVE

METHOD ACHIEVED

Identify and discuss the main features of companies

• • • • • •

Explain equity and borrowings in a company context

• • • • •

Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital

• +FGPVKƂGFVJGNGICNRQUKVKQPTGICTFKPIUJCTGJQNFGTUoCDKNKV[VQOCMGFTCYKPIUQT reductions in capital • Illustrated the basic reason for the restrictions

'ZRNCKPCPFFKUEWUUVJGOCKPƂPCPEKCN statements prepared by a limited company

• +FGPVKƂGFVJGOCLQTFKHHGTGPEGUDGVYGGPVJGƂPCNCEEQWPVUQHCNKOKVGFEQORCP[CU distinct from a sole proprietorship or a partnership

Explained the importance and implications of corporate separate legal entity 'ZRNCKPGFVJGUKIPKƂECPEGQHRGTRGVWCNNKHGHQTCEQORCP[ Explained limited liability and its consequences Distinguished between private companies and public companies Explained the role of the stock exchange in transferring share ownership Explained the separation of ownership and management that is implicit in companies • +FGPVKƂGFTGCUQPUHQTITGCVGTTGIWNCVKQPCUUQEKCVGFYKVJEQORCPKGU • Outlined the concept of corporate governance • Listed and explained the advantages and disadvantages of limited companies +FGPVKƂGFCPFGZRNCKPGFVJGDCUKEnENCUUKƂECVKQPoQHGSWKV[HQTCNKOKVGFEQORCP[ Explained the nature of reserves Explained and illustrated bonus shares +FGPVKƂGFVJGOCKPYC[UKPYJKEJECRKVCNECPDGTCKUGF +FGPVKƂGFVJGV[RGUQHDQTTQYKPIRQUUKDNGHQTEQTRQTCVGGPVKVKGUCPFVJGKT importance

DISCUSSION QUESTIONS EASY 4.1

LO1

What is meant by a company having ‘perpetual life’? Is this ‘life’ different for a limited company as compared to a proprietary company?

4.2

LO1/2/3

In what sense do preference shares have an ‘advantage’ or ‘priority’ over ordinary shares?

4.3

LO2

5KZHTKGPFUFGEKFGVQHQTOCEQORCP[VQUVCTVCDWUKPGUU6JG[CITGGVQUWRRN[GCEJVQ provide the initial capital. They are thinking of having a share capital of six shares each issued at CRTKEGQH6JGKTCEEQWPVCPVJCUCFXKUGFVJGOVQJCXGUJCTGUCVCPKUUWGRTKEG QHRGTUJCTG%CP[QWVJKPMYJ[VJGCEEQWPVCPVICXGVJGOVJKUCFXKEG!

INTERMEDIATE 4.4

LO1

Does the distribution of Telstra shares shown in Real World 4.1 surprise you? Why do you think that VJGOCLQTKV[QH6GNUVTCUJCTGJQNFGTUƂVKPVQVJGƂTUVVYQECVGIQTKGU!

4.5

LO1

*QYFQ[QWFGVGTOKPGYJGVJGTCEQORCP[ECPDGENCUUKƂGFCUnUOCNNoWPFGTVJG#WUVTCNKCP Corporations Act?

4.6

LO1

What are the main areas that directors need to disclose in their report?

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4.7

LO1/2

Why would a business choose to make the following entity structure changes? (a) From a sole proprietorship or partnership to a private company. (b) From a public company to a private company.

4.8

LO1

+UnNKOKVGFNKCDKNKV[oCIQQFVJKPI!'ZRNCKP

4.9

LO2

What is the difference between a share issued as a ‘bonus share’ and a ‘rights share’ from the RGTURGEVKXGQHVJG (a) shareholder? (b) company issuing the shares? (c) unsecured creditor?

4.10 LO3

Why is the Corporations Act particularly interested in distinguishing between ‘a return on capital’ and ‘a return of capital’?

4.11 LO1/2

Can reserve accounts have a negative balance? If yes, provide an example.

4.12 LO4

&KUEWUUVJGVJTGGIWKFKPIRTKPEKRNGUTGNCVKPIVQOQPKVQTKPICPFEQPVTQNQHVJGDGJCXKQWTQHFKTGEVQTU namely, disclosure, accountability and fairness.

4.13 LO1/2

Can you think of any reason why the price at which shares are transferred from one person to another may be different from the amount originally invested in the company?

4.14 LO3

How can a company’s supplier minimise the risk carried by the limited liability of shareholders?

CHALLENGING 4.15 LO2/3

Your non-accountant friend has asked you to explain what is represented by the ‘Reserve for Future 4GUGCTEJ&GXGNQROGPVoCEEQWPVQP2*$.VFoUDCNCPEGUJGGV'ZRNCKPYJCVVJKUCEEQWPVTGRTGUGPVU and why it might have been created.

4.16 LO4

&GUETKDGVJGUKOKNCTKVKGUCPFFKHHGTGPEGUDGVYGGPVJGOCKPƂPCPEKCNUVCVGOGPVURTGRCTGFHQTCNKOKVGF company and those for a sole proprietorship or partnership.

4.17 LO3

What is a chief means by which the Corporations Act protects the interests of creditors and other external lenders?

4.18 LO4

In light of the various corporate collapses and scandals in recent years (e.g. HIH Insurance), you’re EQPEGTPGFCDQWVVJGCEEWTCE[QHEQTRQTCVGƂPCPEKCNUVCVGOGPVU9JCVKU[QWTEJKGHCUUWTCPEGVJCV VJGƂPCPEKCNUCTGnCEEWTCVGo!

4.19 LO1/2/3

Summarise the rules relating to payment of dividends. Do these rules adequately protect creditors and lenders?

4.20 LO1

+UCRTQITGUUKXGFKXKFGPFRQNKE[TGCNKUVKE!1PVJGDCUKUQH4GCN9QTNFFQ[QWVJKPMVJCVGKVJGT$*2 or Rio had any real choice other than a reduction in dividends?

4.21 LO1

From your own experience, which of the ways of committing fraud have you found to be most common? If you have no such experience, which of the ways do you think is most likely? Why do you think this? How might this be prevented? What kind of pressures might lead to someone engaging in fraud? What do you consider are the key elements of internal control?

APPLICATION EXERCISES EASY 4.1

LO1

Test your knowledge of various aspects of limited liability companies. Match the terms in 1–10 in the ƂTUVNKUVYKVJVJGEQTTGURQPFKPIFGƂPKVKQPU#s,KPVJGUGEQPFNKUV 1. Share





 .VF





 2V[.VF





 'SWKV[

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5. Dividend 



 4GUGTXGU 7. Preference shares 8. Rights issue





 $QPWUKUUWG 10. Audit A. Shares distributed by the company to shareholders ‘for free’





$ +PFGRGPFGPVGZCOKPCVKQPQHCEQORCP[oUƂPCPEGU





% 5KIPKƂGUCRWDNKENKOKVGFEQORCP[





' +PENWFGURTQƂVUDWKNVWRQXGTVKOGYKVJKPVJGEQORCP[





( 5KIPKƂGUCRTKXCVGNKOKVGFEQORCP[

D. Shares given preference when dividends are distributed

G. Opportunity for shareholders to buy more shares H. The sum of all the reserves and ordinary share capital I.

Part of reserves distributed to shareholders





, 1PGWPKVQHCEQORCP[oUQYPGTUJKR

4.2

LO2

2KNNCT.KOKVGFKUUWGFQTFKPCT[UJCTGUCVCPFOCFGCECNNCV%CNNUCTGKPCTTGCTUCV balance day for 500 shares. %CNEWNCVG2KNNCT.KOKVGFoUUJCTGECRKVCNDCNCPEG

4.3

LO2

C 5JQYVJGGHHGEVQPVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPQHVJGHQNNQYKPIVTCPUCEVKQPU







K UJCTGUKUUWGFCVCRTKEGQHRGTUJCTGDWVQPN[~RGTUJCTGKUECNNGF







KK CHVGTVJGTGOCKPKPI~KUECNNGF





D 6JGUWOOCTKUGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPQHCEQORCP[KUCUHQNNQYU 5,000,000

0GVCUUGVU Equity Ordinary share capital issued at $1 per share

3,000,000

4GVCKPGFRTQƂVU

2,000,000 5,000,000

6JGEQORCP[KURNCPPKPIVQTCKUGCHWTVJGTOKNNKQPXKCCPGYKUUWGQHUJCTGU#FXKUGVJGEQORCP[ as to the price at which the shares should be issued. 4.4

LO2

#EQORCP[JCUVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPIKXGPDGNQY

0GVCUUGVU

200,000

Ordinary share capital issued at $1 per share

100,000

4GVCKPGFRTQƂVU

100,000 200,000

6JGOCTMGVXCNWGRGTUJCTGKU (a) What is the book value per share? (b) The company intends to issue 100,000 more shares at the market price. Show the statement of ƂPCPEKCNRQUKVKQPCHVGTVJKUKUUWG (c) What is the book value per share after the new issue? (d) What reasons may exist for the book value per share to differ from the market price per share? 4.5

LO1/2

C (TQVJ[.VFUVCTVGFVTCFKPIKPCPFKVOCFGCNQUUHQTVJG[GCTQH+PKV OCFGCRTQƂVQH9JCVKUVJGOCZKOWOFKXKFGPFVJCVKVECPRC[CVVJGGPFQH!





D $WDDN[.VFUVCTVGFVTCFKPIKPCPFOCFGCRTQƂVHQTVJG[GCTQH+PKV OCFGCNQUUQH9JCVKUVJGOCZKOWOFKXKFGPFVJGEQORCP[EQWNFRC[CVVJGGPFQH CUUWOKPIVJCVPQFKXKFGPFUYGTGRCKFKP!

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E #UYGNNCUVJGTGUWNVUIKXGPKP D[QWƂPFVJCV$WDDN[.VFUQNFCRNQVQHNCPFYJKEJJCFEQUV HQTCPFJCFTGXCNWGFCPQVJGTUKOKNCTRNQVYJKEJJCFEQUVVQ 9JCVKUVJGOCZKOWOFKXKFGPFVJCVVJGEQORCP[EQWNFRC[CVVJGGPFQH!

INTERMEDIATE 4.6

LO1/3

;QWTRCTVPGTJCULWUVIKXGP[QW[QWTUVDKTVJFC[RTGUGPVnPQPTGFGGOCDNGRCTVKEKRCVKPI cumulative, non-voting, 10% preference shares’. Complete the table below, explaining the meaning of each of the descriptive terms (top row of table), and indicate whether that feature of the share is (a) ‘really good’, (b) ‘good’, (c) ‘not so good’ or (d) ‘doesn’t really matter’ for each of the share features (bottom row of table). Non-redeemable

Participating

Cumulative

Non-voting

10% Preference shares

Explanation of feature Evaluation 4.7

LO1/2

%QOOGPVQPVJGHQNNQYKPISWQVG .KOKVGFEQORCPKGUECPUGVCNKOKVQPVJGCOQWPVQHFGDVUVJCVVJG[YKNNOGGV6JG[VGPFVQJCXG reserves of cash, as well as share capital, and they can use these reserves to pay dividends to the shareholders. Many companies have preference as well as ordinary shares. The preference shares give a guaranteed dividend. The shares of many companies can be bought and sold on the stock GZEJCPIG5JCTGJQNFGTUUGNNKPIVJGKTUJCTGUECPTGRTGUGPVCWUGHWNUQWTEGQHPGYƂPCPEGVQVJG company.

4.8

LO2

#EQORCP[JCFVJGHQNNQYKPIGXGPVUFWTKPIKVUOQUVTGEGPVƂPCPEKCN[GCT

   

   

   

#PQPEWTTGPVCUUGVYCUUQNFHQTCRTQƂVQH #RTQƂVQHYCUOCFGQPVTCFKPIQRGTCVKQPU #PKUUWGQHQTFKPCT[UJCTGUTCKUGF 2TQRGTV[YCUTGXCNWGFCVCDQXGKVUEWTTGPVTGEQTFGFXCNWG

Which of the above will lead to the creation of a capital reserve? 4.9

LO2

%JGUJKTG.VFJCUCIGPGTCNTGUGTXGQHCPFCDCPMQXGTFTCHVQH6JGEJKGH executive would like to distribute all of the general reserves in the form of a dividend. He therefore proposes to increase the overdraft to pay for the dividend distribution. However, the operations FKTGEVQTJCUCTIWGFVJCVVJKUECPPQVDGFQPGHQTVYQTGCUQPUYJKEJCTG 1. The general reserve is regarded in law as a non-distributable reserve.





 6JGNCYUVCVGUVJCVFKXKFGPFUECPPQVDGRCKFD[WUKPIDQTTQYGFHWPFU 9JKEJQHVJGCDQXGUVCVGOGPVUKUEQTTGEV VTWGHCNUG!'ZRNCKP

4.10 LO3

%QPUKFGTVJGHQNNQYKPIUVCVGOGPVU A limited company cannotRC[FKXKFGPFUVQQTFKPCT[UJCTGJQNFGTUYJGTG





1. An operating loss is made in the period to which the proposed dividends relate.  #FGEKUKQPJCUDGGPOCFGPQVVQRC[CFKXKFGPFVQRTGHGTGPEGUJCTGJQNFGTU #TGVJGCDQXGUVCVGOGPVUVTWGQTHCNUG!'ZRNCKP

4.11 LO4

;CPMGGU.KOKVGFGCTPGFCRTQƂVDGHQTGVCZCVKQPQHOKNNKQPCPFGZRGEVUVQRC[KPEQOGVCZCV VJGTCVGQH6JGEQORCP[RCKFCPKPVGTKOFKXKFGPFQHRGTUJCTGCPFGZRGEVUVQRC[CƂPCN FKXKFGPFQHRGTUJCTG6JGTGCTGOKNNKQPUJCTGUKUUWGFCVCRTKEGQHGCEJ1RGPKPITGVCKPGF GCTPKPIUYGTGOKNNKQP Show your calculation of year-end retained earnings.

4.12 LO2

C 6JGUWOOCTKUGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH.GQP.VFKUUJQYPDGNQY

0GVCUUGVU

2,000,000

Ordinary share capital issued at $1

1,200,000

Preference share capital issued at $1 4GVCKPGFRTQƂVU

300,000 500,000 2,000,000

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The directors decide to redeem the preference share capital. This is to be replaced by a further issue QHQTFKPCT[UJCTGUCVRGTUJCTG 5JQYVJGTGXKUGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPCHVGTVJKUJCUQEEWTTGF 



4.13 LO2

(b) What would you have needed to do if the replacement issue had not taken place?

E 'ZRNCKPVJGTCVKQPCNGHQT[QWTCPUYGTVQ D 6JGUWOOCTKUGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPQH%(.VFKUCUHQNNQYU 1,600,000

0GVCUUGVU Ordinary share capital issued at $1

800,000

4GXCNWCVKQPTGUGTXG

400,000

4GVCKPGFRTQƂVU

400,000 1,600,000

%(.VFFGEKFGUVQOCMGCDQPWUKUUWGQPCQPGHQTHQWTDCUKUHQNNQYGFD[CTKIJVUKUUWGQPCQPGHQT ƂXGDCUKUCVCRTKEGQHRGTUJCTG 5JQYVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQPCHVGTVJGUGKUUWGU 'ZRNCKPVJGOQXGOGPVUKPTGUGTXGU

CHALLENGING 4.14 LO3

9QQNYGNN.VFJCUVJGHQNNQYKPIGSWKV[ECRKVCNCVVJG[GCTGPF

Ordinary shares of $0.25 each 4GXCNWCVKQPTGUGTXG

$400,000 160,000

General reserve

40,000

4GVCKPGFRTQƂVU

50,000 $650,000

+PCFFKVKQPVJGEQORCP[JCURTGHGTGPEGUJCTGUKPKUUWG6JGDQCTFQHFKTGEVQTU wishes to eliminate the company’s reserves. It has decided to make an immediate 1-for-4 bonus issue of ordinary shares. Following the issue, an annual dividend will be paid to shareholders. The board would like the amount paid to ordinary shareholders to be the maximum possible. 9JCVYKNNDGVJG (a) total reserves of the company following the above transaction? (b) dividend per share to ordinary shareholders? 4.15 LO3

'HHQTF.VFJCUVJGHQNNQYKPIGSWKV[ECRKVCNCV[GCTGPF

Ordinary shares of $0.50 each

$200,000

4GXCNWCVKQPTGUGTXG

50,000

General reserve

80,000

4GVCKPGFRTQƂVU

62,000 $392,000

+PCFFKVKQPVJGEQORCP[JCURTGHGTGPEGUJCTGUKPKUUWG6JGDQCTFQHFKTGEVQTU YKUJGUVQGNKOKPCVGVJGEQORCP[oUTGUGTXGU+VJCUFGEKFGFVQOCMGCPKOOGFKCVGHQTDQPWUKUUWG of ordinary shares. Following the issue, an annual dividend will be paid to shareholders. 9JCVYKNNDGVJGTGSWKTGF (a) transfer from revenue reserves to effect the bonus issue? (b) dividend per ordinary share?

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4.16 LO4

2TGUGPVGFDGNQYKUCFTCHVUGVQHƂPCPEKCNUVCVGOGPVUHQT%JKRU.VF

CHIPS LTD Income statement for the year ended 30 June 2017 $’000 1,850

 810

   215   180   120

4GXGPWG Cost of sales )TQUURTQƂV Depreciation Other operating costs 1RGTCVKPIRTQƂV +PVGTGUVRC[CDNG 2TQƂVDGHQTGVCZCVKQP Taxation 2TQƂVHQTVJG[GCT

CHIPS LTD Statement of financial position as at 30 June 2017 Cost $’000

Depreciation $’000

ASSETS Current assets %CUJCVDCPM Accounts receivable +PXGPVQTKGU Non-current assets Motor vehicles Plant and equipment Buildings Total assets LIABILITIES AND EQUITY Current liabilities Accounts payable Other payables Tax Non-current liabilities $QTTQYKPIU UGEWTGFPQVGU Equity Ordinary shares issued at $1, fully paid 4GUGTXGUCVDGIKPPKPIQHVJG[GCT 2TQƂVHQTVJG[GCT Total liabilities and equity

$’000

16 420 950 1,386 102 650 800 1,552



    

49 283 688 1,020 2,406

361 117 60 538 700 800 248 120 1,168 2,406

6JGHQNNQYKPICFFKVKQPCNKPHQTOCVKQPKUCXCKNCDNG 



 2 WTEJCUGKPXQKEGUHQTIQQFUTGEGKXGFQP,WPGCOQWPVKPIVQJCXGPQVDGGP KPENWFGF6JKUOGCPUVJCVVJGEQUVQHUCNGUƂIWTGKPVJGKPEQOGUVCVGOGPVJCUDGGPWPFGTUVCVGF





 #  OQVQTXGJKENGEQUVKPIYKVJFGRTGEKCVKQPCOQWPVKPIVQYCUUQNFQP,WPG HQTRCKFD[EJGSWG6JKUVTCPUCEVKQPJCUPQVDGGPKPENWFGFKPVJGEQORCP[oUTGEQTFU





 0QFGRTGEKCVKQPQPOQVQTXGJKENGUJCUDGGPEJCTIGF6JGCPPWCNTCVGKUQHEQUVCV[GCTGPF





 #  UCNGQPETGFKVHQTOCFGQP,WN[JCUDGGPKPENWFGFKPVJGƂPCPEKCNUVCVGOGPVU KPGTTQT6JGEQUVQHUCNGUƂIWTGKUEQTTGEVKPTGURGEVQHVJKUKVGO

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 #JCNH[GCTN[RC[OGPVQHKPVGTGUVQPVJGUGEWTGFNQCPFWGQP,WPGJCUPQVDGGPRCKF





 6 JGVCZEJCTIGUJQWNFDGQHVJGTGRQTVGFRTQƂVDGHQTGVCZCVKQP#UUWOGVJCVKVKURC[CDNG in full, shortly after year-end.

171

2TGRCTGCTGXKUGFUGVQHƂPCPEKCNUVCVGOGPVUKPEQTRQTCVKPIVJGCFFKVKQPCNKPHQTOCVKQPKPs

9QTMVQVJGPGCTGUV 4.17 LO4

4QUG.VFQRGTCVGUCUOCNNEJCKPQHTGVCKNUJQRUYJKEJUGNNJKIJSWCNKV[VGCUCPFEQHHGGU#RRTQZKOCVGN[ half of the sales are on credit. Abbreviated and unaudited accounts are given below.

ROSE LTD Income statement for the year ended 31 March 2017 $’000 Sales Cost of sales )TQUURTQƂV Labour costs Depreciation Other operating costs

$’000 12,080

 5,798







 1,512   1,446   1012   712 756 1,468

1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG 2TQƂVDGHQTGVCZ Tax expense 2TQƂVCHVGTVCZ Dividend declared 4GVCKPGFRTQƂVHQTVJG[GCT 4GVCKPGFRTQƂVDTQWIJVHQTYCTF 4GVCKPGFRTQƂVECTTKGFHQTYCTF

ROSE LTD Statement of financial position as at 31 March 2017 $’000 Current assets %CUJCVDCPM Accounts receivable +PXGPVQT[

26 996 1,583 2,605 2,728 5,333

Non-current assets Total assets Current liabilities $CPMQXGTFTCHV Tax payable Dividend payable Accounts payable Other payables

$’000

296 434 300 1,118 417 2,565

Non-current liabilities &GDGPVWTGtTGRC[CDNG Total liabilities Shareholders’ equity Ordinary share capital 4GVCKPGFRTQƂVU Total liabilities and shareholders’ equity

300 2,865 1,000 1,468 2,468 5,333

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5KPEGVJGWPCWFKVGFCEEQWPVUHQT4QUG.VFYGTGRTGRCTGFVJGHQNNQYKPIKPHQTOCVKQPJCUDGEQOG CXCKNCDNG 



 #PCFFKVKQPCNQHFGRTGEKCVKQPUJQWNFJCXGDGGPEJCTIGFQPƂZVWTGUCPFƂVVKPIU





 +PXQKEGUHQTETGFKVUCNGUQP/CTEJCOQWPVKPIVQJCXGPQV[GVDGGPKPENWFGF cost of sales is not affected.





 $CFFGDVUUJQWNFDGRTQXKFGFCVCNGXGNQHQHFGDVQTUCV[GCTGPF





 +PXGPVQT[RWTEJCUGFHQTYCUFCOCIGFCPFKUPQYWPUCNGCDNG





 ( KZVWTGUCPFƂVVKPIUVQVJGXCNWGQHYGTGFGNKXGTGFLWUVDGHQTG/CTEJDWVVJGUG assets were not included in the accounts and the purchase invoice has not been processed.





 9  CIGUHQT5CVWTFC[QPN[UVCHHCOQWPVKPIVQJCXGPQVDGGPRCKFHQTVJGƂPCN5CVWTFC[QH the year.





 6JGCWFKVHGGQHKUFWG





 6CZKURC[CDNGCVQHPGVRTQƂV 2TGRCTGCUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV/CTEJCPFCPKPEQOGUVCVGOGPV

CHAPTER 4 CASE STUDY The statement of financial position and the income statement for the large department store chain Myer are shown below.

Consolidated balance sheet As at 30 July 2016

ASSETS Current assets %CUJCPFECUJGSWKXCNGPVU 6TCFGCPFQVJGTTGEGKXCDNGUCPFRTGRC[OGPVU +PXGPVQTKGU >KXCVKXGƂPCPEKCNKPUVTWOGPVU Total current assets Non-current assets 2TQRGTV[RNCPVCPFGSWKROGPV +PVCPIKDNGCUUGVU &GHGTTGFVCZCUUGVU >KXCVKXGƂPCPEKCNKPUVTWOGPVU +PXGUVOGPVKPCUUQEKCVG 1VJGTPQPEWTTGPVCUUGVU 6QVCNPQPEWTTGPVCUUGVU 6QVCNCUUGVU LIABILITIES Current liabilities 6TCFGCPFQVJGTRC[CDNGU 2TQXKUKQPU &GHGTTGFKPEQOG %WTTGPVVCZNKCDKNKVKGU >KXCVKXGƂPCPEKCNKPUVTWOGPVU Other liabilities 6QVCNEWTTGPVNKCDKNKVKGU

2016

2015

Notes

$’000

$’000

& $ $ '

    479.738

    480,804

% % # ' )   

       

   s s   

$ % %  '

     795 

     871 



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CHAPTER 4 INTRODUCTION TO LIMITED COMPANIES

Non-current liabilities $QTTQYKPIU 2TQXKUKQPU &GHGTTGFKPEQOG >KXCVKXGƂPCPEKCNKPUVTWOGPVU 6QVCNPQPEWTTGPVNKCDKNKVKGU 6QVCNNKCDKNKVKGU 0GVCUUGVU

& % % '   

      

      

EQUITY %QPVTKDWVGFGSWKV[ 4GVCKPGFGCTPKPIU 4GUGTXGU Total equity

( ( ( 

 

 

   

173

Consolidated income statement For the period ended 30 July 2016

Notes Total sales value %QPEGUUKQPUCNGU Sale of goods  5CNGUTGXGPWGFGHGTTGFWPFGTEWUVQOGTNQ[CNV[RTQITCO Revenue from sale of goods  1VJGTQRGTCVKPITGXGPWG %QUVQHIQQFUUQNF 1RGTCVKPIITQUURTQƂV Other income 5GNNKPIGZRGPUGU #FOKPKUVTCVKQPGZRGPUGU 5JCTGQHPGVRTQƂV NQUUQHGSWKV[CEEQWPVGFCUUQEKCVG Strategic review, restructuring, store and brand exit costs CPFKORCKTOGPVQHCUUGVU Earnings before interest and tax (KPCPEGTGXGPWG (KPCPEGEQUVU 0GVƂPCPEGEQUVU 2TQƂVDGHQTGKPEQOGVCZ +PEQOGVCZGZRGPUG 2TQƂVHQTVJGRGTKQFCVVTKDWVCDNGVQQYPGTUQH/[GT*QNFKPIU.KOKVGF

# #   # 

Earnings per share attributable to the ordinary equity holders of the Company: $CUKEGCTPKPIURGTUJCTG Diluted earnings per share

# A5

#  #  # #      #

2016

2015

53 weeks

52 weeks

$’000

$’000



 

  

  71









 

  

  108



 s

  



 

  Cents

  



 

  Cents

 7.7

 5.1

Source: Myer Annual Report 2016. pp. 60 and 62. © Myer Pty Ltd.

Use the information provided above, together with a review of the notes to the accounts found on the web, to answer the following questions.

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QUESTIONS 1

What do you understand by the term ‘cash and cash equivalents’ in the consolidated balance sheet (statement of financial position)?

2

What is the basis of valuation of trade and other receivables and inventories for 2016?

3

What do you think are likely to be the main components in the figure for ‘property, plant and equipment’ in the balance sheet (statement of financial position)?

4

What do you understand by ‘fair value’?

5

What items do you think might be covered under the heading ‘intangible assets’ in the balance sheet (statement of financial position)? How do you think the various items might be valued and subsequently amortised?

6

What items are likely to be covered under the heading ‘borrowings’? How might these borrowings be secured?

7

The ‘provisions’ in the current liabilities are mainly made up of employee benefits, leased premises and restructuring. Those in the non-current liabilities include employee benefits and leased premises. Can you suggest what these might relate to?

8

‘Reserves’ in the balance sheet (statement of financial position) are negative. What does this mean?

9

What are the main reasons for the differing performances regarding normal profit in the two years covered by the income statement?

Concept check answers CC1 CC2 CC3

' A C

CC4 CC5 CC6

D A D

CC7 CC8 CC9

C D '

CC10 C

SOLUTIONS TO ACTIVITIES ACTIVITY 4.1

C $WUKPGUUKUCTKUM[XGPVWTGtKPUQOGECUGUXGT[TKUM[2GQRNGYKNNWUWCNN[DGJCRRKGTVQKPXGUVOQPG[YJGPVJG[MPQY the limit of their liability. If investors are given limited liability, new businesses are more likely to be formed and GZKUVKPIQPGUCTGNKMGN[VQƂPFKVGCUKGTVQTCKUGOQTGƂPCPEG6JKUKUIQQFHQTVJGRTKXCVGUGEVQTGEQPQO[CPFOC[ ultimately lead to the generation of greater wealth for society as a whole. Obviously not all suppliers of goods and services are protected, as we read regularly that they lose all or part of what is owed to them when companies are liquidated (e.g. Harris Scarfe, Ansett, HIH). However, certain factors, requirements QTCEVKQPUCTGKPRNCEGVQRTQXKFGRTQVGEVKQPKPENWFKPI • VJGNGICNTGSWKTGOGPVHQTEQORCPKGUVQRTGRCTGƂPCPEKCNTGRQTVUKPEQPHQTOKV[YKVJUVCVWVQT[CEEQWPVKPI standards • suppliers may require payment to be made in advance • creditors may require personal guarantees by the owners or management • NGPFGTUOC[VCMGQWVCURGEKƂEENCKOCICKPUVVCPIKDNGCUUGVUQHVJGEQORCP[ OQTVICIGDKNNQHUCNG • NGPFKPICITGGOGPVUOC[TGUVTKEVVJGƂPCPEKCNRTCEVKEGU tOCZKmum level of debt to assets tminimum required return on assets tNKOKVCVKQPUQPRTQƂVFKUVTKDWVKQPU trestrictions on asset sales tspeciƂECVKQPQHCEEQWPVKPIOGVJQFUVJCVECPDGWUGF

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CHAPTER 4 INTRODUCTION TO LIMITED COMPANIES

175

• the creditors rank before the shareholders in the distribution of assets in the event of a liquidation of the company.

D 6YQYC[UCTGEQOOQPN[WUGFKPRTCEVKEG • The shareholders may insist on monitoring closely the actions of the directors and the way in which they use the resources of the company. • The shareholders may introduce incentive plans for directors that link their pay to the share performance of the company. In this way, the interests of the directors and shareholders will become more closely aligned.

ACTIVITY 4.2 6JGCPUYGTUCTGCUHQNNQYU (a)

Net assets Cash

$100,000

Shareholders’ equity 5JCTGECRKVCN QTFKPCT[UJCTGUKUUWGFCVtECNNGFVQ

$100,000

Net assets Cash

$150,000

Shareholders’ equity 5JCTGECRKVCN QTFKPCT[UJCTGUKUUWGFCVtECNNGFVQ

$150,000

6JGUVCVGOGPVQHƂPCPEKCNRQUKVKQPYQWNFCRRGCTCUHQNNQYU (b)

Net assets %CRKVCN UJCTGU 4GVCKPGFRTQƂVU

$370,000 300,000

KGKUUWGFCVRNWUKUUWGFCV

70,000 $370,000

ACTIVITY 4.3 4GCUQPUOKIJVKPENWFGVJGHQNNQYKPI • Where surplus funds cannot be invested to yield returns in excess of the return being paid to shareholders, it makes economic sense to buy back shares rather than to invest surplus funds. • 5JCTGECRKVCNTGRTGUGPVURGTOCPGPVHWPFUQPYJKEJVJGEQORCP[YKNNRC[FKXKFGPFUKPFGƂPKVGN[9JGTG the current level of permanent funds is excessive, it makes sense to reduce that funding and replace it with short-term funds as required (debt). • The repurchase of shares may lower the average cost of funds to the company (cost of capital), and this will mean that more potential projects will be deemed acceptable. • The company’s activity in the market will increase demand for shares and potentially increase or sustain the share price, which will normally be an advantage to the company. • When the share price falls, it is a good time for the company to repurchase shares. (TQOVJGXKGYRQKPVQHVJGUJCTGJQNFGTRQUUKDNGCFXCPVCIGUKPENWFG • The activity of the company in buying its own shares will create additional demand, and this will have a positive impact on the share price. • The repurchase of shares reduces the number of shares available for trading, and this also will have a positive impact on the share price. • 6JGTGRWTEJCUGQHUJCTGUYKNNPQTOCNN[NQYGTVJGƂTOoUEQUVQHHWPFUCPFRQVGPVKCNN[KPETGCUGTGVWTPUQP remaining shares. • The earnings and dividends per share should increase given there are now fewer shares.

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ACTIVITY 4.4 $m Calculation of retained earnings 2TQƂVDGHQTGVCZCVKQP



Income taxation (30%)

3

#HVGTVCZRTQƂV



.GUUFKXKFGPFU

4

Added to reserves

3

4GVCKPGFRTQƂVUCVUVCTVQH[GCT

15

%NQUKPIDCNCPEGQHTGVCKPGFRTQƂVU

18

Equity section 5JCTGECRKVCN OKNNKQPUJCTGUKUUWGFCV



4GVCKPGFRTQƂVU

18

Total equity

48

Current liabilities Income tax

3

Final dividends due

 5

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CHAPTER 5

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

L01

Explain the importance of company law in relation to the directors’ duty to account, and discuss the role of the auditor in this process

L02 Explain why there is a need for accounting rules, identify the main sources of accounting rules, and outline the role of the Australian Securities Exchange with regard to company reporting and management, with particular reference to corporate governance

L03 Identify the main requirements relating to the published annual report, including all of the financial and ancillary statements

L04 Explain the concept of group or consolidated accounts.

6JKUEJCRVGTEQPVKPWGUQWTGZCOKPCVKQPQHVJGƂPCPEKCNUVCVGOGPVUQHNKOKVGFEQORCPKGU6JGOCKP HGCVWTGUQHNKOKVGFEQORCPKGUYGTGKFGPVKƂGFKP%JCRVGT6JKUEJCRVGTHQEWUGUNCTIGN[QPVJGTGIWNCVQT[ CURGEVUQHEQORCP[CEEQWPVKPI9GDGIKPD[KFGPVKH[KPIVJGNGICNTGURQPUKDKNKVKGUQHFKTGEVQTU9GVJGP IQ QP VQ FKUEWUU VJG OCKP UQWTEGU QH CEEQWPVKPI TWNGU IQXGTPKPI RWDNKUJGF ƂPCPEKCN UVCVGOGPVU #NVJQWIJCFGVCKNGFEQPUKFGTCVKQPQHVJGUGCEEQWPVKPITWNGUKUDG[QPFVJGUEQRGQHVJKUDQQMVJGMG[ TWNGUVJCVUJCRGVJGHQTOCPFEQPVGPVQHVJGRWDNKUJGFƂ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ƂFGPEGKPCRCTVKEWNCTDWUKPGUUCPFFGEKUKQPOCMGTUPGGFVQDGXGT[CYCTGQH VJGFGITGGQHEQPƂFGPEGCUUQEKCVGFYKVJCRCTVKEWNCTDWUKPGUU 9GVJGPOQXGVQCEQPUKFGTCVKQPQHJQYVJGXCTKQWUTWNGUCPFNGICNTGSWKTGOGPVUCTGTGƃGEVGFKPVJG CPPWCNTGRQTVUQHEQORCPKGUKPENWFKPIVJGUVCVGOGPVQHEQORTGJGPUKXGKPEQOGCPFVJGUVCVGOGPVQH EJCPIGUKPGSWKV[+VKUKORQTVCPVVJCVFGEKUKQPOCMGTUCTGCDNGVQnTGCFo CPFWPFGTUVCPFCUGVQH CEEQWPVUCURWDNKUJGFKPCEQORCP[CPPWCNTGRQTVCUVJKURTQXKFGURTQDCDN[VJGOQUVEQORTGJGPUKXG RKEVWTGCXCKNCDNGVQOQUVWUGTUQHƂPCPEKCNKPHQTOCVKQP6JGUGWUGTUOC[DGKPXGUVQTUUGGMKPIKPHQTOCVKQP CDQWVEQORCPKGUKPYJKEJVJG[JCXGCPKPVGTGUVQTKPFGGFQPGYKVJYJKEJVJG[EQORGVG (KPCNN[YGRTQXKFGCPQWVNKPGQHVJGTGCUQPUYJ[CPFVJGYC[KPYJKEJCITQWRQHEQORCPKGUPGGFUVQ RTGRCTGCUGVQHEQPUQNKFCVGFCEEQWPVU

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LO1 Explain the importance of company law in relation to the directors’ duty to account, and discuss the role of the auditor in this process

reporting entity An entity with users who rely on general-purpose ƂPCPEKCNUVCVGOGPVUHQTVJGKT KPHQTOCVKQPTGNCVKPIVQVJCV entity. disclosing entity An entity that issues UGEWTKVKGUVJCVCTGSWQVGFQP CUVQEMGZEJCPIGQTOCFG CXCKNCDNGVQVJGRWDNKEXKCC RTQURGEVWU

THE DIRECTORS’ DUTY TO ACCOUNT—THE ROLE OF COMPANY LAW (CORPORATIONS ACT) As we have already seen, it is not usually possible for all of the shareholders to be involved in the general management of the company, nor do most of them wish to be involved, so they elect directors to act on their behalf. It is both logical and required by company law that directors are accountable for their actions as stewards of the company’s assets. The directors must therefore prepare (or have prepared on their behalf) financial statements that provide a fair representation of the financial position and performance of the business. This requires that they select appropriate accounting policies, make reasonable accounting estimates, and adhere to all relevant accounting rules when preparing the statements. The directors are also expected to maintain appropriate internal control systems. In this context, directors of all reporting entities and disclosing entities, all public companies and all large proprietary companies are required to prepare true and fair financial statements. (Disclosing entities include companies listed on the stock exchange and companies raising funds through a prospectus—i.e. public issue.) Small proprietary companies are not required to prepare formal financial statements or to have them audited, unless directed to by at least 5% of their shareholders or by the Australian Securities and Investments Commission (ASIC). They must, however, maintain sufficient accounting records to allow annual accounts to be prepared and audited. The financial statements are to include the statement of financial position, the statement of financial performance (in the case of companies, this is a statement of comprehensive income), the statement of changes in equity, the statement of cash flows and related notes. ‘True and fair’ has not been specifically defined, nor tested in court. However, it is normally interpreted as requiring the provision of all necessary financial information of a material nature related to both the directors’ stewardship role and financial information (decision-making) role. Information is material if its omission, misstatement or non-disclosure has the potential, individually or collectively, to: • influence the economic decisions of the users taken on the basis of the financial report, or • affect the discharge of accountability by the management or governing body of the entity.

accounting standards 4WNGUGUVCDNKUJGFD[VJG RTQHGUUKQPCNQTUVCVWVQT[ CEEQWPVKPIDQFKGUYJKEJ UJQWNFDGHQNNQYGFD[ RTGRCTGTUQHVJGCPPWCN CEEQWPVUQHEQORCPKGU auditors 2TQHGUUKQPCNUYJQUGOCKP FWV[KUVQOCMGCTGRQTVCU VQYJGVJGTKPVJGKTQRKPKQP VJGCEEQWPVKPIUVCVGOGPVU QHCEQORCP[FQYJCVVJG[ CTGUWRRQUGFVQFQPCOGN[ VQUJQYCVTWGCPFHCKTXKGY CPFEQORN[YKVJUVCVWVQT[ CPFCEEQWPVKPIUVCPFCTF TGSWKTGOGPVU

The Corporations Act also requires directors of disclosing entities to accompany the financial statements with a ‘directors’ declaration’ and a ‘directors’ report’. In the directors’ declaration, the directors must state whether, in their opinion, the financial statements comply with the applicable accounting standards and represent a ‘true and fair’ view of both the financial performance and the financial position of the company. They must also state whether, in their opinion, at the date of the declaration, there are reasonable grounds to believe that the company can meet its debts as and when they fall due. The directors’ report is generally much longer, and contains certain required information together with an increasing level of voluntary disclosures. Such disclosures include the names of directors, the emoluments of directors, the principal activities of the company, a review of the operations for the year, details of significant changes in the state of affairs of the company, the financial significance of probable future events, details of significant events that have occurred after the balance date that may affect the company, and details of compliance with environmental regulations. Obviously, the voluntary disclosures extend beyond the required disclosures, and may include financial forecasts, details of human resource management strategies, significant contributions to community life, and additional environmental initiatives. When one company owns a controlling interest in another so that management of the controlled company is effectively carried out by the controlling company, ‘consolidated accounts’ (‘group accounts’) must be prepared in addition to the individual company accounts. The financial reports must comply with accounting standards. Companies’ financial reports should be checked by an auditor and reported on (unless the company is a small proprietary company—and even then shareholders or ASIC may require an audit).

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179

Auditors Shareholders are required to appoint a qualified and independent person or, more usually, a firm to act as auditor. The main duty of auditors is to make a report declaring whether or not the statements do what they are supposed to do: that is, whether they fairly reflect the entity’s financial performance, financial position and liquidity, and whether they comply with statutory requirements and accounting standards. This requires the auditors to critically examine the annual accounting statements prepared by the directors, and the evidence on which they are based. The auditors’ opinion must be included with the accounting statements that are sent to the shareholders and to the ASIC. The auditor’s report provides a check on the credibility and reliability of the financial reports, and indicates whether or not the report complies with the Corporations Act. The auditor’s report tends to be fairly short and normally includes: • the identification of the financial reports covered by the audit report, together with responsibilities • a statement that the audit (the check) was carried out in accordance with Australian Auditing Standards • a statement that the financial statements comply with Australian Accounting Standards • an opinion section, in which the auditor concludes whether or not the financial reports fairly represent the company’s financial performance, financial position and cash flows—if the auditor does not think that this is the case, the report will be ‘qualified’ with a section explaining why, and the extent to which, the statements do not comply with the statements and tests reviewed above. Note that an audit report gives an opinion but no guarantees. In general, however, given the number of legal cases made against auditors, it is true to say that with all the care and attention to detail involved in audit work, an unqualified audit report should reassure the investing public. Even qualified reports rarely pose problems when the rationale for the qualification is understood. Overall, the onus on the directors of limited companies to report on the activities is extensive. Originally, the prime motivation was a ‘stewardship’ report, in which the directors reported to the shareholders on their stewardship of the resources entrusted to them. Over the past 30 years the stewardship report has developed into a general-purpose report of use to a variety of users and potential users, such as shareholders, potential shareholders, lenders, creditors, employees, social activists and environmentalists. The relationship between the shareholders, the directors and the auditors is illustrated in Figure 5.1.

FIGURE 5.1 Directors

account elect

The relationship between the shareholders, the directors and the auditors review report

Shareholders

elect

Auditors

6JGFKTGEVQTUCTGCRRQKPVGFD[VJGUJCTGJQNFGTUVQOCPCIGVJGEQORCP[QP VJGUJCTGJQNFGTUoDGJCNH6JGFKTGEVQTUCTGTGSWKTGFVQTGRQTVGCEJ[GCTVQ VJGUJCTGJQNFGTURTKPEKRCNN[D[OGCPUQHƂPCPEKCNUVCVGOGPVUQPVJG EQORCP[oURGTHQTOCPEGCPFRQUKVKQP6QNGPFITGCVGTETGFKDKNKV[VQVJG ƂPCPEKCNUVCVGOGPVUVJGUJCTGJQNFGTUCNUQCRRQKPVCWFKVQTUVQKPXGUVKICVG VJGUVCVGOGPVUCPFVQGZRTGUUCPQRKPKQPQPVJGKTTGNKCDKNKV[

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In spite of all of these rules, there is evidence of some dissatisfaction, as can be seen from Real World 5.1.

REAL WORLD 5.1 ASIC comments on recent audits In December 2015 ASIC released a regular audit inspection report, which included the following: 1

2 3

4

In 19% of audit areas auditors did not obtain reasonable assurance that the financial report as a whole was free of material misstatement. The findings are similar to those of audit oversight regulators in other countries. There is a continued need for audit firms to improve audit quality and the consistency of audit execution. While firms continue to make good efforts to improve audit quality, these are yet to be reflected in the riskbased inspection findings. ASIC’s findings do not necessarily mean that audited financial statements were materially misstated, rather that the auditor did not have a sufficient basis to support their opinion on the financial report.

5

Audit inspections suggest improvements are needed in: ● the sufficiency and appropriateness of audit evidence obtained by the auditor ● the level of auditors’ professional scepticism, and ● appropriate use of the work of experts and other auditors.

6 7

8

Many of the findings related to accounting estimates (including impairment) and accounting policy choices. The report outlines areas auditors should continue to focus on to improve audit quality and consistency of audit execution. The report encourages firms to consider reviewing staffing to ensure sufficient and appropriate experience and expertise is available for auditing increasingly complex entities and audits that require significant judgement.

Source: 15-385MR ASIC audit inspection findings for 2014–15, 15 December 2015, ASIC. © Australian Securities & Investments Commission. Reproduced with permission.

ACTIVITY 5.1 (a) What are the possible consequences of failing to make financial statements available to shareholders, lenders and suppliers on the ability of the business to operate? (b) How important is the publication of well-regulated annual reports to the efficiency of the private sector? (c) How important is the role of the auditor in this area?

Concept check 1 Which of the following is NOT true? A

B

C D E

+VKUPQVWUWCNN[RQUUKDNGHQTCNNQHCEQORCP[oUUJCTGJQNFGTUVQDGKPXQNXGFKP VJGIGPGTCNOCPCIGOGPVQHVJGEQORCP[KPYJKEJVJG[QYPUJCTGU /QUVUJCTGJQNFGTUFQPQVYKUJVQDGKPXQNXGFKPVJGIGPGTCNOCPCIGOGPV QHVJGEQORCP[KPYJKEJVJG[QYPUJCTGU 6JGUJCTGJQNFGTUCTGGZRGEVGFVQOCKPVCKPCRRTQRTKCVGKPVGTPCNEQPVTQNU[UVGOU &KTGEVQTUCTGCEEQWPVCDNGHQTVJGCEVKQPUQHVJGEQORCP[ &KTGEVQTUCEVCUUVGYCTFUQHVJGEQORCP[oUCUUGVU

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Concept check 2 Which of the following is NOT true? A

B C

D

E

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Concept check 3 Public companies and all large proprietary companies are required VQRTGRCTGVTWGCPFHCKTƂPCPEKCNUVCVGOGPVUKPENWFKPI A B C D E

+PEQOGUVCVGOGPV $CNCPEGUJGGV 5VCVGOGPVQHECUJƃQYU #CPF$ #$CPF%

SOURCES OF RULES AND REGULATION

The need for accounting rules If we accept the need for directors to prepare and publish financial statements, we should also accept the need for rules about how they are prepared and presented. Without rules, there is a much greater risk that unscrupulous directors will adopt accounting policies and practices that portray an unrealistic view of financial health. There is also a much greater risk that the financial statements will not be comparable over time or with those of other businesses. Accounting rules can narrow areas of differences and reduce the variety of accounting methods. This can help ensure that similar transactions are treated in a similar way. Although accounting rules should help to provide confidence in the integrity of financial statements, users must be realistic about what can be achieved. Problems of manipulation and of concealment can still occur even within a highly regulated environment. The scale of these problems, however, should be reduced where there is a practical set of rules. Problems of comparability can also still occur, as judgements and estimates must be made when preparing financial statements. There is the added problem that no two companies are identical, and so accounting policies may vary between companies for entirely valid reasons.

LO2 Explain why there is a need for accounting rules, identify the main sources of accounting rules, and outline the role of the Australian Securities Exchange with regard to company reporting and management, with particular reference to corporate governance

Sources of accounting rules In recent years there have been increasing trends towards the internationalisation of business and the integration of financial markets. These trends have helped to strengthen the case for the international harmonisation of accounting rules. By adopting a common set of rules, users of financial statements should be better placed to compare the financial health of companies based in different countries. It should also relieve international companies of some of the burden of preparing multiple financial statements, as different financial statements would no longer be required to comply with the rules of the different countries in which a particular company operates.

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International Financial Reporting Standards 6TCPUPCVKQPCNCEEQWPVKPI rules that have been CFQRVGFQTFGXGNQRGFD[ VJG+PVGTPCVKQPCN#EEQWPVKPI 5VCPFCTFU$QCTFCPF YJKEJUJQWNFDGHQNNQYGF KPRTGRCTKPIVJGRWDNKUJGF ƂPCPEKCNUVCVGOGPVUQHNKUVGF NKOKVGFEQORCPKGU International Accounting Standards See+PVGTPCVKQPCN(KPCPEKCN 4GRQTVKPI5VCPFCTFU Australian Accounting Standards Board (AASB) #WUVTCNKCPDQF[TGURQPUKDNG HQTFGXGNQRKPICEEQWPVKPI UVCPFCTFUHQTCRRNKECVKQPVQ Australian entities.

The International Accounting Standards Board (IASB) is an independent body that is dedicated to developing a single set of high-quality, global accounting rules. These rules are known as International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS), and deal with key issues such as: • • • •

what information should be disclosed how information should be presented how assets should be valued, and how profit should be measured.

Over the years, the IASB has greatly extended its influence and authority. The point has now been reached where all major economies adopt IFRS or have set timelines to adopt, or to converge with, IFRS.

Australia and the International Accounting Standards The setting of accounting standards in Australia is the responsibility of the Australian Accounting Standards Board (AASB) . In recent years the AASB has adopted International Accounting Standards in respect of for-profit organisations. However, there are some minor differences in wording. The Australian standards still have their own numbers, but these can be matched clearly with the International Accounting Standards. Accounting standards narrow management’s range of methods for recording and reporting transactions, which means there is greater consistency and comparability in application and assessment. Companies are required by law to comply with the accounting standards. If management considers that complying with a particular accounting standard will prevent a true and fair view of the financial position or performance, they still must adhere to the standard. They can then, if they choose, provide additional information in the notes about their concerns over applying that standard.

The role of the Australian Securities Exchange (ASX) in company accounting The Australian Securities Exchange (ASX) extends the accounting rules for those companies listed as eligible to have their shares traded on the exchange. These extensions include summarised interim (half-year) accounts in addition to the statutorily required annual accounts, along with several specific requirements for matters such as takeovers, capital, options and sundry administrative concerns. Figure 5.2 illustrates the sources of accounting rules with which listed Australian companies must comply.

Corporate governance Generally, all the issues covered until now relate to the idea of developing sound systems of corporate governance, the system by which corporations are directed and controlled. As such, it typically details

FIGURE 5.2 Company law

External accounting rules

International accounting standards

Sources of accounting regulations for an Australian company listed on the Australian Securities Exchange 6JG%QTRQTCVKQPU#EVRTQXKFGUVJGDCUKEHTCOGYQTMQHEQORCP[ CEEQWPVKPITGIWNCVKQP6JKUKUCWIOGPVGFD[CEEQWPVKPI UVCPFCTFUYJKEJJCXGXKTVWCNN[VJGHQTEGQHNCY6JG#5:KORQUGU CFFKVKQPCNTWNGUHQTEQORCPKGUNKUVGFQPVJGGZEJCPIG

Stock exchange rules imposed by ASX

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the rights and responsibilities of the corporation’s different participants. This explains the prevailing emphasis on such things as rules for directors, matters relating to the board as a whole, different types of shareholders, and other stakeholders. Governance also typically requires some detailed rules and procedures for decision-making, including objective-setting and performance evaluation. In spite of this, corporate governance remains an ongoing issue. It became a serious concern in the late 1980s, when the global share market collapsed. Certain high-profile corporate failures, such as Bond Corporation and Quintex Corporation (Christopher Skase), added fuel to the debate and led to some changes. More recently, in the early years of this century, the collapse of Enron, Ansett, One.Tel and HIH led to something of a crisis of confidence. The collapse of Arthur Andersen, a major auditor with a worldwide reputation, added fuel to the fire. The reactions in different parts of the world were not the same. In the United States, the resulting legislation (the Sarbanes-Oxley Act of 2002) aimed to curtail the misbehaviour and excesses of senior managers and to ensure the correctness of the financial statements. In Australia, the following occurred: • a Royal Commission was held over the HIH collapse • the ASX set up a council on corporate governance, and • the Corporate Law Economic Reform Program (CLERP) gave the Australian Securities and Investments Commission (ASIC) power to fine companies for breaches of the disclosure rules. The HIH Royal Commission basically found that HIH was mismanaged, that decisions were illconceived, and that the management culture was unsound. In general, the Royal Commission’s report found that imposing highly prescriptive governance systems and structures is fraught with danger. A ‘one size fits all’ approach will not work. The report focused more on the role of boards and directors, and the associated cultures. The culture of HIH and its board was considered to have major shortcomings. There were no significant recommendations for change. The ASX set up the Corporate Governance Council in 2002, and Principles of Good Corporate Governance and Best Practice Recommendations was published in 2003 (© 2016 ASX Corporate Governance Council). The main mission identified in the 2003 publication was ‘to develop and deliver an industry-wide, supportable and supported framework for corporate governance which could provide a practical guide for listed companies, their investors, the wider market and the Australian community’ (‘Foreword’). The Council requires that the guidelines are applied, arguing that ‘maintaining an informed and efficient market and preserving investor confidence remain the constant imperatives’ (‘Foreword’). The 2003 document identified the essential corporate governance principles. Ten such principles were identified. In August 2007 the principles and recommendations were reviewed and revised into eight principles. A minor revision was made in 2010. Following a comprehensive review in 2012–13, the third edition of the Principles and Recommendations was approved. Changes reflect global developments in corporate governance, and enhanced risk recommendations. The structure has also been simplified and greater flexibility provided in terms of where governance disclosures are made. The revised principles identified by the ASX Corporate Governance Council are set out in Table 5.1. Each principle is supported by several recommendations. For example, Principle 4, ‘Safeguard integrity in financial reporting’, is supported as follows: Recommendation 4.1 The board of a listed entity should: (a) have an audit committee which: 1) has at least three members, all of whom are non-executive directors and a majority of whom are independent directors; and 2) is chaired by an independent director, who is not the chair of the board; and disclose 3) the charter of the committee; 4) the relevant qualifications and experience of the members of the committee; and 5) in relation to each reporting period, the number of times the committee met throughout the period and the individual attendances of the members at those meetings.

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TABLE 5.1 THE ASX CORPORATE GOVERNANCE PRINCIPLES Principle 1 Lay solid foundations for management and oversight #NKUVGFGPVKV[UJQWNFGUVCDNKUJCPFFKUENQUGVJGTGURGEVKXGTQNGUCPFTGURQPUKDKNKVKGUQHKVUDQCTFCPFOCPCIGOGPVCPFJQYVJGKT RGTHQTOCPEGKUOQPKVQTGFCPFGXCNWCVGF Principle 2 Structure the board to add value #NKUVGFGPVKV[UJQWNFJCXGCDQCTFQHCPCRRTQRTKCVGUK\GEQORQUKVKQPUMKNNUCPFEQOOKVOGPVVQFKUEJCTIGKVUFWVKGUGHHGEVKXGN[ Principle 3 Act ethically and responsibly #NKUVGFGPVKV[UJQWNFCEVGVJKECNN[CPFTGURQPUKDN[ 2TKPEKRNG5CHGIWCTFKPVGITKV[KPƂPCPEKCNTGRQTVKPI #NKUVGFGPVKV[UJQWNFJCXGHQTOCNCPFTKIQTQWURTQEGUUGUVJCVKPFGRGPFGPVN[XGTKH[CPFUCHGIWCTFVJGKPVGITKV[QHKVUEQTRQTCVGTGRQTVKPI Principle 5 Make timely and balanced disclosure #NKUVGFGPVKV[UJQWNFOCMGVKOGN[CPFDCNCPEGFFKUENQUWTGQHCNNOCVVGTUEQPEGTPKPIKVVJCVCTGCUQPCDNGRGTUQPYQWNFGZRGEVVQ JCXGCOCVGTKCNGHHGEVQPVJGRTKEGQTXCNWGQHKVUUGEWTKVKGU Principle 6 Respect the rights of security holders #NKUVGFGPVKV[UJQWNFTGURGEVVJGTKIJVUQHKVUUGEWTKV[JQNFGTUD[RTQXKFKPIVJGOYKVJCRRTQRTKCVGKPHQTOCVKQPCPFHCEKNKVKGUVQCNNQY VJGOVQGZGTEKUGVJQUGTKIJVUGHHGEVKXGN[ Principle 7 Recognise and manage risk #NKUVGFEQORCP[UJQWNFGUVCDNKUJCUQWPFTKUMOCPCIGOGPVHTCOGYQTMCPFRGTKQFKECNN[TGXKGYVJGGHHGEVKXGPGUUQHVJKUHTCOGYQTM Principle 8 Remunerate fairly and responsibly #NKUVGFGPVKV[UJQWNFRC[FKTGEVQTTGOWPGTCVKQPUWHƂEKGPVVQCVVTCEVCPFTGVCKPJKIJSWCNKV[FKTGEVQTUCPFFGUKIPKVUGHHGEVKXG TGOWPGTCVKQPVQCVVTCEVTGVCKPCPFOQVKXCVGJKIJSWCNKV[UGPKQTGZGEWVKXGUCPFVQCNKIPVJGKTKPVGTGUVUYKVJVJGETGCVKQPQHXCNWG HQTUGEWTKV[JQNFGTU Source: ASX Corporate Governance Council%QTRQTCVG)QXGTPCPEG2TKPEKRNGUCPF4GEQOOGPFCVKQPUTF|'FKVKQPR…#5: %QTRQTCVG)QXGTPCPEG%QWPEKN

(b) If it does not have an audit committee, disclose that fact and the processes it employs that

independently verify and safeguard the integrity of its corporate reporting, including the processes for the appointment and removal of the external auditor and the rotation of the audit engagement partner. Recommendation 4.2 The board of a listed entity should, before it approves the entity’s financial statements for a financial period, receive from its CEO and CFO a declaration that, in their opinion, the financial records of the entity have been properly maintained and that the financial statements comply with the appropriate accounting standards, and give a true and fair view of the financial position and performance of the entity and that the opinion has been formed on the basis of a sound system of risk management and internal control which is operating effectively. Recommendation 4.3 A listed entity that has an AGM should ensure that its external auditor attends its AGM and is available to answer questions from security holders relevant to the audit. Source: ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 3rd Edition, 2014, pp. 21 and 22. © 2016 ASX Corporate Governance Council. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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We recommend that you read the third edition of Corporate Governance Principles and Recommendations, which can be found at www.asx.com.au/documents/asx-compliance/cgcprinciples-and-recomendations-3rd-edn.pdf. The board of a listed company can decide that a recommendation is not appropriate for them. If it decides that this is so, then it must explain why it has not adopted the recommendation. The principles adopt an ‘if not, why not’ approach. Failure to do one or other of these can lead to the company’s shares being suspended from listing. This is an important sanction against non-compliant directors. A major advantage of a stock exchange listing is that it enables investors to sell their shares whenever they wish. A company that is suspended from listing would find it hard—and, therefore, expensive—to raise funds from investors, because there would be no ready market for the shares. A corporate governance statement is now part of the annual report of listed companies. Real World 5.2 provides a summary of such a statement from the 2016 Annual Report for New Zealand Oil and Gas Limited, a company which is quoted on the New Zealand Stock Exchange.

REAL WORLD 5.2 Corporate governance statement of New Zealand Gas and Oil Limited summary New Zealand Oil and Gas Limited has a nine-page section on corporate governance in its 2016 annual report, which covers: ● Board of Directors: responsibilities, constitution, details of Board members, when appointed, qualifications, independent directors, and Board proceedings. ● Board Committees: Audit Committee, Nomination and Remuneration Committee, and HSSE (health, safety, security and environment) Sustainability and Operational Risk Committee. ● Responsibilities of the Board: approval of corporate strategy and performance objectives; establishing policies appropriate for the Company; oversight of the Company, including its control and accountability systems; approving major investments and monitoring their return on investment; overall risk management and control framework; appointing, removing and evaluating the performance of the CEO; reviewing performance of senior management; appointing and removing the Company secretary; setting broad remuneration policy; nominating and appointing new directors to the Board; evaluating the performance of the Board, committees of the Board, and individual directors; reviewing systems of risk management, internal compliance and control, codes of conduct, and legal compliance; approving and monitoring the progress of any major capital expenditure, capital management, and acquisitions and divestures; reviewing and ratifying HSSE Sustainability and

Operational Risk policies and the HSSE Sustainability and Operational Risk Management System, and monitoring its implementation and performance; approving and monitoring financial and other reporting; ensuring that the Company provides continuous disclosure of information such that shareholders and the investment community have available all information to enable them to make informed assessments of the Company’s prospects; ensuring overall corporate governance of the consolidated entity; determining the key messages that the Company wishes to convey to the market from time to time; and monitoring information commitments and continuous disclosure obligations. ● Delegation to management: a range of policies relating to Health and Safety; Environment; Code of Conduct and Ethics; Communications, Market and Social Media Disclosure; Securities Trading; Directors Interests; Whistleblowers; Diversity; Delegated Authorities Manual; Remuneration and Performance Appraisal; Treasury; ETS Obligations and Carbon Liability; Email and Internet Use; Anti-Harassment; and Drugs and Alcohol. ● Corporate Governance Best Practice Code. This is effectively a comparison of Company practice with that implicit in the NZX code of practice. This section therefore identifies those areas where Company practice differs from that found in the NZX code of practice. Source: New Zealand Oil and Gas Limited Annual Report 2016, pp. 41–49.

The existence of the ASX Corporate Governance Principles has generally been agreed to have improved the quality of information available to shareholders, resulted in better checks on the powers of directors, and provided greater transparency in corporate affairs. However, rules can only be a partial answer. A balance must be struck between the need to protect shareholders and the need to encourage the entrepreneurial spirit of directors, which could be stifled under a welter Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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of rules. This implies that rules should not be too tight, but tight enough to limit unscrupulous directors’ attempts to find ways around them. It is interesting to note that the revised (2010) version of the Principles did not change any of the basic principles. Yet the world had been through the global financial crisis, which surely must rank as a failure of leadership. The third edition has taken on board a number of issues raised by the global financial crisis, notably in the area of risk management, but it still seems reasonable to ask the question: are the basic principles sufficient? The International Federation of Accountants (IFAC) prepared a study on enterprise governance (CIMA & IFAC, 2004). Enterprise governance was defined as ‘the set of responsibilities and practices exercised by the board and executive management with the goal of providing strategic direction, ensuring that objectives are achieved, ascertaining that risks are managed appropriately and verifying that the organisation’s resources are used responsibly’. What was particularly interesting about this study was that it identified two aspects of enterprise governance— conformance and performance—and argued that these two need to be in balance. Basically, corporate governance was identified with conformance (namely, accountability and assurance), while business governance was associated with performance (namely, value creation and resource utilisation). Central to the argument was the idea that good corporate governance on its own cannot make a company successful. Good corporate governance needs to be linked strategically with good performance management systems that focus on the key drivers of business success. The Chapter 5 Case Study (page 207) provides a summary of an interesting discussion paper with some observations that have been made on corporate governance recently. We recommend you read the whole paper. It includes a number of examples of behaviour and attitudes that relate to the global financial crisis that are very revealing. Good governance is clearly important, but care is necessary to ensure that the process doesn’t become more important than the substance.

ACTIVITY 5.2 (a) We came across some IAS and IFRS earlier in the book. Try to recall at least two topics where financial reporting standards were mentioned. (b) What do you think might have been the main reasons for recent pressure towards international harmonisation of accounting practices? (c) What benefits could be gained by harmonising Australian Accounting Standards with the International Accounting Standards? (d) Do you think that mismanagement can be avoided by imposing highly prescriptive governance systems and structures? Why/why not? (e) What does this imply about the difficulties in ensuring that reports are sound, in terms of setting in place detailed rules of corporate governance? (f) What do you see as the likely future of corporate governance? What about ongoing issues?

ACCOUNTING AND YOU You may not aspire to become a board member of a corporation. However, you are quite likely to become a member of a club, such as a sports club, and may well become a key member of the organising committee. It may not have occurred to you that many of the principles relating to corporate governance may also apply to the running of such a club or committee. Elements might include:

• •

Principle 1: What are the respective roles of the chair, committee members, coaches and players? Principle 2: What is the optimal size and nature of the managing committee?

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• •

Principle 3: What is the view of the club on equity and fairness in the sport?

• •

Principle 5: The club’s need to report regularly on what is going on.

187

Principle 4: The club’s need to account for income from fees, subscriptions and charges, and to report on the financial condition of the club on a regular basis. Principles 6–8: These are not likely to be as important at this level, but the principles remain.

As you progress through life, there is a reasonable prospect that you may become a member of a school board/council, or a hospital/health service board. All of these will have governance requirements which are likely to follow similar lines to those set out above. By way of illustration, read the 2015 publication, ‘Welcome to the Board’, on the Victorian Public Sector Commission website, http:// www.vpsc.vic.gov.au.

Concept check 4 #EEQWPVKPITWNGU QTUVCPFCTFUCTGPGGFGFVQ A

B C D E

2TGXGPVWPUETWRWNQWUFKTGEVQTUHTQOCFQRVKPICEEQWPVKPIRQNKEKGUCPFRTCEVKEGU VJCVRQTVTC[CPWPTGCNKUVKEXKGYQHƂPCPEKCNJGCNVJ #NNQYEQORCTKUQPDGVYGGPEQORCPKGU 2TQXKFGEQPƂFGPEGKPVJGKPVGITKV[QHƂPCPEKCNUVCVGOGPVU #NNQHVJGCDQXG 5QOGQHVJGCDQXG

Concept check 5 +PVGTPCVKQPCN(KPCPEKCN4GRQTVKPI5VCPFCTFU +(45 A

B

C D E

#TGVTCPUPCVKQPCNCEEQWPVKPITWNGUCFQRVGF QTFGXGNQRGFD[VJG +PVGTPCVKQPCN#EEQWPVKPI5VCPFCTFU$QCTF +#5$ #TGVTCPUPCVKQPCNCEEQWPVKPITWNGUVJCVUJQWNFDGHQNNQYGFKPRTGRCTKPI VJGRWDNKUJGFƂPCPEKCNUVCVGOGPVUQHNKUVGFNKOKVGFEQORCPKGU #TGPQYCFQRVGFQTYKNNDGCFQRVGFD[CNNOCLQTGEQPQOKGU *CXGOKPQTYQTFKPIFKHHGTGPEGUVQ#WUVTCNKCP#EEQWPVKPI5VCPFCTFU #NNQHVJGCDQXG

Concept check 6 Which of the following is NOT true? A

B C D

E

6JG#WUVTCNKCP5GEWTKVKGU'ZEJCPIG #5:GZVGPFUVJGCEEQWPVKPITWNGUHQT VJQUGEQORCPKGUNKUVGFCUGNKIKDNGVQJCXGVJGKTUJCTGUVTCFGFQPVJGGZEJCPIG 6JG%QTRQTCVKQPU#EVRTQXKFGUVJGDCUKEHTCOGYQTMHQTEQORCP[CEEQWPVKPITGIWNCVKQP %QTRQTCVGIQXGTPCPEGKUVJGU[UVGOD[YJKEJEQTRQTCVKQPUCTGFKTGEVGFCPFEQPVTQNNGF 6JG#5:%QTRQTCVG)QXGTPCPEG2TKPEKRNGUURGEKH[VJCVEQORCPKGUUJQWNFJCXGCUVTWEVWTG VQUCHGIWCTFVJGKTƂPCPEKCNUWEEGUU 0QPGQHVJGCDQXG#NNCTGVTWG

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PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS LO3 Identify the main requirements relating to the published annual report, including all of the financial and ancillary statements

Accounting Standard AASB 101: Presentation of Financial Statements (the equivalent of IAS 1), applies to reporting and disclosing entities. The essence of the standard is set out below.

Statement of financial position AASB 101 does not prescribe the format (or layout) for this financial statement, but does set out the minimum information that should be presented on the face of the statement of financial position. This includes the normal kind of things that we have seen in statements of this type so far in the book, together with a few others that are less obvious, including investment property, biological assets, total of assets for sale, and non-controlling interests (also known as minority interests). Additional information should also be shown where it is relevant to an understanding of the financial position of the business. The standard requires that, on the statement of financial position, a distinction is normally made between current assets and non-current assets and between current liabilities and non-current liabilities. However, for certain types of businesses, such as financial institutions, the standard accepts that it may be more appropriate to order items according to their liquidity (i.e. their nearness to cash). Financial institutions, such as banks and insurance companies, frequently select the liquidity approach to classifying assets, to provide more relevant and reliable information to the report users. The nature of their business is largely linked to matching available funds with external claims over time, and classifying both assets and liabilities on a liquidity basis provides valuable insights into the entity’s ability to service such claims. Some of the classification groups identified above require further detailed breakdowns, generally to comply with a specific standard; for example, inventories and non-current assets, which typically have sub-classifications for property, plant and equipment. Other areas include equity and reserves, and provisions. Many of these sub-classifications can be handled by way of a series of notes to the main statements. In terms of published statements of financial position in Australia, the most commonly presented is the vertical format based on the entity equation. Irrespective of the format, or the equation, all of the statements of financial position contain the same information.

Statement of comprehensive income The statement of comprehensive income extends the conventional income statement to include certain other gains and losses that affect shareholders’ equity. It may be presented either in the form of a single statement or as two separate statements, comprising an income statement and a statement of comprehensive income. From January 2018, the two-statement approach will need to be modified to a two-section approach, with the income statement preceding the comprehensive income section. This new statement attempts to overcome a perceived weakness of the conventional income statement. In broad terms, the conventional income statement shows all realised gains and losses for the period. It also shows some unrealised losses. However, gains—and some losses—that remain unrealised (because the asset is still held) tend not to pass through the income statement, but will go, instead, directly to a reserve. We saw, in an earlier chapter, an example of such an unrealised gain. This related to the situation in which a business revalued its land and buildings. The gain arising was not shown in the conventional income statement, but was transferred to a revaluation reserve, which forms part of the equity. (See the section under ‘Fair values’ in Chapter 2, page 63.) Land and buildings are not the only assets to which this rule relates, but revaluations of these types of asset are, in practice, the most common examples of unrealised gains. An example of an unrealised gain, or loss, that has not been mentioned so far arises from exchange differences when the results of foreign operations are translated into Australian dollars. Any gain, or loss, bypasses the income statement and is taken directly to a currency translation reserve. A weakness of conventional accounting is that there is no robust principle that we can apply to determine precisely what should, and what should not, be included in the income statement. Thus, on the one hand, losses arising from the impairment of non-current assets normally appear in the

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income statement. On the other hand, losses arising from translating the carrying value of assets expressed in an overseas currency (because they are owned by an overseas branch) do not. This difference in treatment, which is ingrained in conventional accounting, is difficult to justify. The statement of comprehensive income ensures that all gains and losses, both realised and unrealised, are reported within a single statement. To do this, it extends the conventional income statement by including unrealised gains, as well as any unrealised losses not yet reported, immediately below the measure of profit for the year. An illustration of this statement is shown in Example 5.1.

MALIK LTD Statement of comprehensive income for the year ended 31 July 2017 Revenue Cost of sales )TQUURTQƂV Other income Distribution expenses Administration expenses Other expenses 1RGTCVKPIRTQƂV Finance charges 2TQƂVDGHQTGVCZ Tax 2TQƂVHQTVJG[GCT Other comprehensive income 4GXCNWCVKQPQHRTQRGTV[RNCPVCPFGSWKROGPV (QTGKIPEWTTGPE[VTCPUNCVKQPFKHHGTGPEGUHQTHQTGKIPQRGTCVKQPU Tax on other comprehensive income 1VJGTEQORTGJGPUKXGKPEQOGHQTVJG[GCTPGVQHVCZ 6QVCNEQORTGJGPUKXGKPEQOGHQTVJG[GCT

$m 97.2 (59.1) 38.1 3.5 (16.5) (11.2) (2.4) 11.5 (1.8) 9.7 (2.4) 7.3

5.1

6.6 4.0 (2.6) 8.0 15.3

This example adopts a single-statement approach to presenting comprehensive income. The alternative two-statement approach simply divides the information shown above into two separate parts. The income statement, which is the first statement, begins with the revenue for the year and ends with the profit for the year. The statement of comprehensive income, which is the second statement, begins with the profit for the year and ends with the total comprehensive income for the year. ‘Other comprehensive income’ represents those items of income (revenue or other gains) and expenses not required or permitted to be included in profit or loss (ordinary or operating) by any of the accounting standards. Paragraph 7 of AASB 101: Presentation of Financial Statements specifically identifies the following transactions for inclusion as ‘comprehensive income’: (a) changes in revaluation surplus (b) actuarial gains and losses on defined benefit plans (c) gains or losses arising from translating the financial statements of foreign operations (d) gains or losses on remeasuring available-for-sale financial assets, and (e) the effective portion of gains or losses on hedging instruments in a cash flow hedge.

The intention of AASB 101 is to provide more useful information so as to enable users to distinguish between income and expense of a recurring or permanent nature from those of a non-recurring or temporary nature. Real World 5.3 shows the consolidated statement of comprehensive income for department store chain, Myer, which uses a two-statement approach to reporting income. A traditional income statement (shown in the Chapter 4 Case Study, page 172) precedes the statement shown below. The meaning of the terms ‘consolidated’ and ‘non-controlling interest’ will become clear in the next section.

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REAL WORLD 5.3 Example of statement of comprehensive income Consolidated statement of comprehensive income for the period ended 30 July 2016

Notes Profit for the period Other comprehensive income Items that may be reclassified to profit and loss Cash flow hedges Exchange differences on translation of foreign operations Other comprehensive income for the period, net of tax Total comprehensive income for the period attributable to owners of Myer Holdings Limited

F2 F2

2016 52 weeks $’000 60,543

2015 53 weeks $’000 29,826

(14,486) (221) (14,707) 45,836

14,514 (2,875) 11,639 41,465

Source: Myer Annual Report 2016, p. 61. © Myer Pty Ltd.

You need to recognise that many of the unrealised gains included in the statement of comprehensive income will eventually be realised. At that later stage, realised gains will be recognised in operating income. To avoid double counting, when the subsequent gain or loss is recognised in the operating section of the statement of comprehensive income, an equivalent deduction will need to be made in the ‘other comprehensive income’ section of the report. The reclassification adjustments can be shown directly in the statement of comprehensive income in the ‘other comprehensive income’ section as offsets, or they can be shown in the notes to the statements. It is worth noting that all of the items listed in the above statement for Myer relate to ‘items that may be reclassified to profit and loss’. This means that they are the kind of items referred to in the preceding paragraph. You should recognise that further items can be found (e.g. in Harvey Norman’s 2016 annual report) that would be listed as ‘items that will not need to be reclassified subsequently to profit and loss’.

SELF-ASSESSMENT QUESTION

5.1

6JGHQNNQYKPIKPHQTOCVKQPYCUGZVTCEVGFHTQOVJGƂPCPEKCNUVCVGOGPVUQH+%JKPI $QQMUGNNGTU.VFHQTVJG[GCTVQ &GEGODGT Finance charges Cost of sales Distribution expenses Revenue Administration expenses Other expenses )CKPQPTGXCNWCVKQPQHRTQRGTV[RNCPVCPFGSWKROGPV .QUUQPHQTGKIPEWTTGPE[VTCPUNCVKQPUQPHQTGKIPQRGTCVKQPU 6CZQPRTQƂVHQTVJG[GCT Tax on other components of comprehensive income

$m 40 460 110 943 212 25 20 15 24 1

Prepare a statement of comprehensive income for the year ended 31 December 2017.

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Items include ‘Fair value revaluations of land and buildings’ and ‘Income tax effect on fair value revaluation of land and buildings’.

Statement of changes in equity The statement of changes in equity aims to help users to understand the changes in share capital and reserves that took place during the reporting period. It reconciles the figures for these items at the beginning of the period with those at the end. This is achieved by showing the effect on the share capital and reserves of total comprehensive income as well as the effect of share issues and purchases during the period. The effect of dividends during the period may also be shown in this statement, although dividends can be shown in the notes instead. To see how a statement of changes in equity may be prepared, let us consider Example 5.2.

191

statement of changes in equity 6JGUVCVGOGPVVJCVUJQYU CNNEJCPIGUKPVJGQYPGTUo interest in the net assets QHVJGDWUKPGUUCUCTGUWNV QHVTCPUCEVKQPUCPFGXGPVU FWTKPICRGTKQF6JKU KPENWFGUVQVCNEQORTGJGPUKXG KPEQOGHQTVJGRGTKQF KPENWFKPIRTQƂVQTNQUUCPF VTCPUCEVKQPUYKVJQYPGTU KPVJGKTECRCEKV[CUQYPGTU UJQYKPIEQPVTKDWVKQPUD[ CPFFKUVTKDWVKQPUVQQYPGTU

#V,CPWCT[/KTQ.VFJCFVJGHQNNQYKPIGSWKV[ Miro Ltd

5.2

$m 100 20 40 150 310

5JCTGECRKVCNtQTFKPCT[UJCTGUKUUWGFCV Revaluation reserve (QTGKIPEWTTGPE[VTCPUNCVKQPTGUGTXG Retained earnings 6QVCNGSWKV[

&WTKPIVJGEQORCP[OCFGCRTQƂVHQTVJG[GCTHTQOPQTOCNDWUKPGUUQRGTCVKQPUQHOKNNKQP CPFTGRQTVGFCPWRYCTFTGXCNWCVKQPQHRTQRGTV[RNCPVCPFGSWKROGPVQHOKNNKQP PGVQHCP[ VCZVJCVYQWNFDGRC[CDNGYGTGVJGWPTGCNKUGFICKPUVQDGTGCNKUGF#NQUUQPGZEJCPIGFKHHGTGPEGU QPVTCPUNCVKPIVJGTGUWNVUQHHQTGKIPQRGTCVKQPUQHOKNNKQPYCUCNUQTGRQTVGF6QUVTGPIVJGPKVU ƂPCPEKCNRQUKVKQPVJGEQORCP[KUUWGFOKNNKQPQTFKPCT[UJCTGUFWTKPIVJG[GCTCVCRTKEGQH &KXKFGPFUHQTVJG[GCTYGTGOKNNKQP 6JKUKPHQTOCVKQPHQTECPDGUGVQWVKPCUVCVGOGPVQHEJCPIGUKPGSWKV[CUHQNNQYU

MIRO LTD Statement of changes in equity for the year ended 31 December 2017

$CNCPEGCUCV,CPWCT[ %JCPIGUKPGSWKV[HQT +UUWGQHQTFKPCT[UJCTGU Dividends (Note 1) Total comprehensive income HQTVJG[GCT 0QVG Balance at 31 December 2017

Share capital $m 100

Revaluation reserve $m 20

70 –

– –

– 170

120 140

Translation reserve $m 40

Retained earnings $m 150

Total $m 310

– –

– (27)

70 (27)

(10) 30

42 165

152 505

Notes:  9GJCXGEJQUGPVQUJQYFKXKFGPFUKPVJGUVCVGOGPVQHEJCPIGUKPGSWKV[TCVJGTVJCPKPVJGPQVGU 6JG[TGRTGUGPVCPCRRTQRTKCVKQPQHGSWKV[CPFCTGFGFWEVGFHTQOTGVCKPGFGCTPKPIU 2 The effect of each component of comprehensive income on the various elements of shareholders’ GSWKV[OWUVDGUGRCTCVGN[FKUENQUGF6JGTGXCNWCVKQPICKPCPFVJGNQUUQPVTCPUNCVKPIHQTGKIPQRGTCVKQPU CTGGCEJCNNQECVGFVQCURGEKƂETGUGTXG6JGRTQƂVHQTVJG[GCTKUCFFGFVQTGVCKPGFGCTPKPIU

More generally, the statement of changes in equity may include the information shown in Table 5.2.

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TABLE 5.2 TYPICAL COMPONENTS OF STATEMENT OF CHANGES IN EQUITY Equity accounts

4GVCKPGFRTQƂV

Reserves

Share capital

Total

1RGPKPIDCNCPEG

+/–

+/–

+

+

%QORTGJGPUKXGKPEQOG

+/–

+/–

#EEQWPVKPIRQNKE[EJCPIGU

+/–

+/–

2TKQTRGTKQFGTTQTEQTTGEVKQP

+/–

+/–

+/–

–

5JCTGKUUWGU 4GVWTPQHECRKVCN &KXKFGPFURCKFFGENCTGF %NQUKPIDCNCPEG

–

–

+/–

+/–

+

+

–

– –

+

+

ACTIVITY 5.3 Manet Ltd had the following share capital and reserves as at 1 January 2017: Share capital (ordinary shares) Revaluation reserve Currency translation reserve Retained earnings Total equity

$m 300 120 15 380 815

During the year to 31 December 2017, the company revalued property, plant and equipment upwards by $30 million and made a loss on foreign exchange translation of foreign operations of $5 million. The company made a profit for the year from normal operations of $160 million during the year and the dividend was $80 million. Prepare a statement of changes in equity for 2017.

Statement of cash flows The statement of cash flows should help users to assess the ability of a company to generate cash and to assess the company’s need for cash. The presentation requirements for this statement are set out in IAS 7/AASB 107: Statement of Cash Flows, which we shall consider in some detail in the next chapter.

Notes Most financial statements are prepared in a form which summarises a considerable amount of detail. This detail then needs to be shown elsewhere in the form of notes to the accounts. Careful reading of the notes should be an essential part of any review of an annual report. The notes typically include: • a confirmation that the financial statements comply with relevant accounting standards • explanations of the measurement bases and accounting policies used (e.g. the basis of inventories valuation or depreciation) • details relating to any sub-classifications in the statements (e.g. breakdown of current and non-current assets) • supporting information relating to items appearing on the four major financial statements, and • other significant disclosures.

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193

Concept check 7 Which statement is false? A

B

C

D

E

##5$FQGUPQVRTGUETKDGVJGHQTOCVDWVKVFQGUUGVQWVVJGminimum KPHQTOCVKQPVJCVUJQWNFDGRTGUGPVGFQPVJGHCEGQHVJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP ##5$TGSWKTGUPQFKUVKPEVKQPDGOCFGDGVYGGPEWTTGPVCUUGVUCPF PQPEWTTGPVCUUGVUCPFDGVYGGPEWTTGPVNKCDKNKVKGUCPFPQPEWTTGPVNKCDKNKVKGU ##5$TGEQIPKUGUVJCVUQOGQHVJGENCUUKƂECVKQPITQWRUKFGPVKƂGFKP$CDQXGTGSWKTG HWTVJGTFGVCKNGFDTGCMFQYPU +PVGTOUQHRWDNKUJGFUVCVGOGPVUQHƂPCPEKCNRQUKVKQPKP#WUVTCNKCVJGOQUVEQOOQPN[ RTGUGPVGFKUVJGXGTVKECNHQTOCVDCUGFQPVJGGPVKV[GSWCVKQP 0QPGQHVJGCDQXGCTGHCNUG

Concept check 8 6JGUVCVGOGPVQHEQORTGJGPUKXGKPEQOG A

B

C

D E

'ZVGPFUVJGEQPXGPVKQPCNKPEQOGUVCVGOGPVVQKPENWFGEGTVCKPQVJGTICKPU CPFNQUUGUVJCVCHHGEVUJCTGJQNFGTUoGSWKV[ 1XGTEQOGUCYGCMPGUUQHEQPXGPVKQPCNCEEQWPVKPIYJGTGD[VJGTGKUPQTQDWUV RTKPEKRNGVJCVRTGEKUGN[URGEKƂGUYJCVVQKPENWFGKPVJGKPEQOGUVCVGOGPV 'PUWTGUVJCVCNNICKPUCPFNQUUGUDQVJTGCNKUGFCPFWPTGCNKUGFCTGTGRQTVGFYKVJKP CUKPINGUVCVGOGPV #NNQHVJGCDQXG #CPF%QPN[

ACCOUNTING FOR GROUPS OF COMPANIES The treatment of companies so far has dealt with single companies. In fact, many companies acquire shares in other companies to obtain a controlling interest in these companies. There are a number of reasons for this, including: • • • •

the elimination of, or at least reduction in, competition safeguarding of sources of supply or sales outlets risk reduction through diversification, and access to economies of scale.

Control can normally be achieved by ownership of at least 50% of the ordinary share capital. The controlling company is known as the parent company (or holding company), and the (partly) owned company is known as a subsidiary company. Many large companies control multiple subsidiaries. Just how these operate together varies tremendously, but they are nevertheless seen to operate as a group, and this has certain consequences. It is important to note that, even in the case where a subsidiary is 100% owned, there may be good reasons to retain a separate identity. Reasons might include: • the subsidiary might have a market identity which is important to maintain, and this can best be achieved through retention of its current corporate status • the staff of the subsidiary might feel that they have greater autonomy and independence if it retains its separate identity, or • the directors of the parent might prefer to retain the limited liability status of each company individually.

LO4 Explain the concept of group or consolidated accounts

parent/holding company #EQORCP[YJKEJKPXGUVU KPCPQVJGTEQORCP[D[ RWTEJCUKPIUWHƂEKGPVUJCTGU VQQDVCKPCEQPVTQNNKPI interest. subsidiary company #EQORCP[YJKEJKU EQPVTQNNGFD[CPQVJGTD[VJG HCEVVJCVVJKUQVJGTEQORCP[ QYPUCEQPVTQNNKPIKPVGTGUVKP VJGEQORCP[EQPEGTPGF

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group or consolidated accounts #PCOCNICOCVKQPQHUGVU QHCEEQWPVUHQTCITQWRQH EQORCPKGUUWEJVJCVVJG ITQWRCEEQWPVUCRRGCTCU KHVJGGPVKTGITQWRYCUQPG entity.

goodwill on consolidation 6JGCOQWPVRCKFD[CP KPXGUVKPIEQORCP[HQT RWTEJCUGQHUWHƂEKGPVUJCTGU VQCESWKTGCEQPVTQNNKPI KPVGTGUVKPCPQVJGTEQORCP[ NGUUVJGXCNWGQHVJGGSWKV[ QTPGVCUUGVUWUWCNN[ ECNEWNCVGFQPCHCKTXCNWG basis. non-controlling interests/minority interests 6JGRTQRQTVKQPQHC UWDUKFKCT[EQORCP[VJCVKU QYPGFD[QVJGTVJCPVJG RCTGPVEQORCP[

In most cases each individual company is still required to prepare its own accounts, but in addition the parent company is also required to prepare a set of group or consolidated accounts. These group accounts amalgamate the financial statements of all of the group members. Thus the group accounts will include all of the revenues and expenses incurred by the individual members of the group, and all of the assets and liabilities of the members of the group, subject to some adjustments dealt with below. The overall aim of a set of group or consolidated accounts is to show the accounts as if the parent had owned and operated all of the assets of the business directly, rather than via a set of subsidiaries. The parent company is required to provide financial accounts that relate to its own performance as a single company, but also to provide a set of group accounts. In principle, the process of consolidation is relatively straightforward. In essence all that is needed is to add up the various revenues and expenses that appeared in the individual company income statements to obtain the group income statement, and all of the assets and claims in the various statements of financial position to obtain the group statement of financial position. However, while this is the case in principle, a number of complications usually occur, the most important of which are dealt with below. • Goodwill arising on consolidation. When the amount paid by the parent is more than the book value associated with a subsidiary, the extra amount paid will need to appear on the group statement of financial position as an asset, called goodwill on consolidation. • Non-controlling interests (also known as minority interests). As stated above, all revenue, expenses, assets and liabilities must be reflected to their full extent in the group financial statements. This must be the case whether the parent owns 100% of the subsidiary company’s shares, or less. The critical question relates to control. Where the ownership is less than 100%, then part of any net income and net assets must be attributable to interests other than that of the parent, namely non-controlling interests. Outside shareholders have financed part of the group’s activities and are entitled to part of any group income. Example 5.3 shows how the statement of financial position for the group owned by Parent Ltd, a company which controls a subsidiary, Sub Ltd, is built up.

2CTGPV.VFQYPUQHVJGQTFKPCT[UJCTGECRKVCNQH5WD.VF2CTGPV.VFRCKFOKNNKQPHQTVJG controlling interest.

5.3 takeover 9JGTGQPGEQORCP[DW[U enough shares in another VQQDVCKPCEQPVTQNNKPI interest.

6JGUVCVGOGPVUQHƂPCPEKCNRQUKVKQPQHVJGVYQEQORCPKGUKOOGFKCVGN[CHVGTVJGtakeoverD[2CTGPV .VFQHEQPVTQNQXGT5WD.VFCTGCUHQNNQYU 5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV&GEGODGT

Current assets Cash Accounts receivable Inventories Non-current assets 2TQRGTV[RNCPVCPFGSWKROGPV Investments in Sub Ltd—20m shares in Sub Ltd Total assets Current liabilities #EEQWPVURC[CDNG Non-current liabilities Debentures

Parent Ltd

Sub Ltd

$m

$m

8 12 19 39

5 7 8 20

38 32 70 109

30

10

5

24

10

50

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Equity 1TFKPCT[UJCTGUKUUWGFCVGCEJ Reserves

50 25 75 109

6QVCNGSWKV[CPFNKCDKNKVKGU

25 10 35 50

7PFGTEKTEWOUVCPEGUUWEJCUCVCMGQXGTYGYQWNFTGCUQPCDN[GZRGEVVJCVVJGƂIWTGUUJQWNFDGDCUGF on current fair value. 6JGIQQFYKNNQPEQPUQNKFCVKQPYQWNFDGECNEWNCVGFCUHQNNQYU6JGKPXGUVOGPVKPUJCTGUIKXGU2CTGPV .VFCPJQNFKPIYJKEJKUENGCTN[CEQPVTQNNKPIKPVGTGUVUQITQWRCEEQWPVUCTGTGSWKTGF6JGEQUV QHVJKUJQNFKPIKUOKNNKQP6JGPGVCUUGVUCESWKTGFCOQWPVVQQHVJGGSWKV[CVVJGVKOGQH RWTEJCUGYJKEJKUOKNNKQP³OKNNKQP6JKUOGCPUVJCVVJGCOQWPVRCKFGZEGGFUVJG HCKTXCNWGQHVJGPGVCUUGVUD[OKNNKQPCPFVJKUOWUVCRRGCTKPVJGITQWRUVCVGOGPVQHƂPCPEKCN position.

195

5.3 continued

6JGPQPEQPVTQNNKPIKPVGTGUVUCOQWPVVQQHVJGGSWKV[QH5WD.VFYJKEJCOQWPVUVQOKNNKQP³ OKNNKQP 6JGITQWRUVCVGOGPVQHƂPCPEKCNRQUKVKQPECPVJGPDGEQPUVTWEVGFCUHQNNQYU %QPUQNKFCVGFUVCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV&GEGODGT $m Current assets Cash Accounts receivable Inventories Non-current assets 2TQRGTV[RNCPVCPFGSWKROGPV )QQFYKNNQPEQPUQNKFCVKQP Total assets Current liabilities #EEQWPVURC[CDNG Non-current liabilities Debentures Equity 1TFKPCT[UJCTGUKUUWGFCVGCEJ Reserves 'SWKV[CVVTKDWVCDNGVQVJGRCTGPV Non-controlling interests 6QVCNGSWKV[CPFNKCDKNKVKGU

(8 + 5) (12 + 7) (19 + 8)

13 19 27 59

(38 + 30)

68 4 72 131

(10 + 5)

15

(24 + 10)

34 50 25 75 7 82 131

You should note that all of the figures but two—the goodwill on consolidation and the noncontrolling interest—are simply the sum of the various parts relating to the parent and subsidiary. Goodwill on consolidation is usually shown under intangible assets in the statement of financial position. In the year that follows the takeover, the summarised income statements of Parent Ltd and Sub Ltd are as shown in Example 5.4 together with a consolidated income statement and workings. A further complication, beyond the scope of this book, relates to intra-group transactions; that is, transactions that take place between the companies within the group. This might include loans from one member of the group to another. These need to be eliminated in the group accounts, as do any profits recognised by one company within the group that are not realised by ongoing sale

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+PEQOGUVCVGOGPVHQTVJG[GCTGPFKPI&GEGODGT

5.4

Parent Ltd $m 40 (20) 20 (8) (2) 10 (3) 7

Revenue Cost of sales )TQUURTQƂV Administration expenses Distribution expenses 2TQƂVDGHQTGVCZ Taxation 2TQƂVHQTVJG[GCT

Sub Ltd $m 20 (8) 12 (4) (2) 6 (1.8) 4.2

6JGEQPUQNKFCVGFKPEQOGUVCVGOGPVKUCUHQNNQYU +PEQOGUVCVGOGPVHQTVJG[GCTGPFKPI&GEGODGT Revenue Cost of sales )TQUURTQƂV Administration expenses Distribution expenses 2TQƂVDGHQTGVCZ Taxation 2TQƂVHQTVJG[GCT Attributable to 'SWKV[JQNFGTUQHVJGRCTGPV Non-controlling interests

(40 + 20) (20 + 8) (8 + 4) (2 + 2) (10 + 6) (3 + 1.8)

  Z

Z

$m 60 (28) 32 (12) ( 4) 16 (4.8) 11.2 10.36 0.84 11.2

6JGPQPEQPVTQNNKPIKPVGTGUVoUUJCTGQHRTQƂVUKUQHVJGRTQƂVQH5WD.VFYKVJVJGTGOCKPFGT being all the entitlement of Parent Ltd.

outside of the group. For example, if a subsidiary company sells goods to a parent at a price which yields a profit of, say, $100,000, and these goods are not sold on beyond the group, we have a profit that is realised by the subsidiary, but which has not been realised as a group.

ACTIVITY 5.4 The following summary statements of financial position relate to H Ltd and S Ltd as at 31 December 2017, immediately aer H Ltd had acquired 60% of the share capital of S Ltd for $4 million.

H LTD AND S LTD Statement of financial position as at 31 December 2017

Current assets Non-current assets Investment in S Ltd Total assets

H Ltd

S Ltd

$m 4 6 4 14

$m 2 4 _ 6

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Liabilities 'SWKV[ 1TFKPCT[UJCTGU HWNN[RCKF Reserves 6QVCNGSWKV[ 6QVCNGSWKV[RNWUNKCDKNKVKGU

3

1

6 5 11 14

3 2 5 6

197

In the course of the next year, H Ltd made profits aer tax of $3 million and S Ltd $1.5 million. Prepare a consolidated statement of financial position as at 31 December 2017, and show how the profit aer tax for 2018 would be allocated to H Ltd and to the non-controlling interests in the group income statement for 2018.

This brief overview of group accounts is intended to help you understand the final accounts of groups of companies. Group structures and accounts can be very complicated. It is worth noting that investment in shares of another company does not always involve acquisition of a controlling interest. Frequently, a smaller amount of ownership will still enable the investing company to be able to exert an influence on the company whose shares are owned. Typically, companies that are between 20% and 50% owned by an investor company are known as associate companies of the investor company. In cases like this, the consolidated accounts also need to show: • the share of profits or losses of the associate company • the share of tax attributable to the associate company, and • the share of retained profit in the associate company.

associate company #EQORCP[YJKEJKURCTVN[ QYPGFD[CPQVJGTEQORCP[ UWEJVJCVVJGQYPGTUJKR FQGUPQVIKXGVJGKPXGUVQT EQORCP[EQPVTQNDWVFQGU give it the opportunity to GZGTVEQPUKFGTCDNGKPƃWGPEG 6[RKECNN[VJGQYPGTUJKRKU DGVYGGPCPF

Concept check 9 Which of the following is false? A

B C

D E

#EQORCP[VJCVCESWKTGUCEQPVTQNNKPIKPVGTGUVQHUJCTGUKPCPQVJGT EQORCP[KUMPQYPCUVJGRCTGPVQTJQNFKPIEQORCP[ 6JGQYPGF QTRCTVN[QYPGFEQORCP[KUMPQYPCUVJGUWDUKFKCT[ )QQFYKNNQPEQPUQNKFCVKQPCTKUGUYJGPVJGCOQWPVRCKFD[VJGRCTGPVKU OQTGVJCPVJGDQQMXCNWGCUUQEKCVGFYKVJVJGUWDUKFKCT[ +VKUIGPGTCNN[KPCRRTQRTKCVGVQTGEQIPKUGIQQFYKNNGZEGRVKPURGEKCNEKTEWOUVCPEGU 0QPGQHVJGCDQXG#NNCTGVTWG

Concept check 10 Which of the following statements is false? A

B C

D

E

6JGOKPQTKV[KPVGTGUVKUVJGRTQRQTVKQPQHCUWDUKFKCT[EQORCP[VJCVKUQYPGF D[QVJGTVJCPVJGRCTGPVEQORCP[ 6JGTGKUPQOKPQTKV[KPVGTGUVKHVJGUWDUKFKCT[KUQYPGFD[VJGRCTGPV #HWTVJGTEQORNKECVKQPYKVJEQPUQNKFCVGFCEEQWPVUTGNCVGUVQVTCPUCEVKQPUVJCVVCMGRNCEG DGVYGGPVJGEQORCPKGUYKVJKPCITQWR 6JGQXGTCNNCKOQHCUGVQHEQPUQNKFCVGFCEEQWPVUKUVQUJQYVJGCEEQWPVUCUKHVJGRCTGPV JCFQYPGFCPFQRGTCVGFallQHVJGCUUGVUQHVJGDWUKPGUUFKTGEVN[ 0QPGQHVJGCDQXG#NNCTGVTWG

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

OBJECTIVE

Explain the importance of company law in relation to the directors’ duty to account, and discuss the role of the auditor in this process

METHOD ACHIEVED

• +FGPVKƂGFCTCPIGQHNGICNTGSWKTGOGPVUTGNCVKPIVQFKUENQUWTG • 'ZCOKPGFVJGTQNGQHVJGCWFKVQT

Explain why there is a need for accounting rules, identify the • 'ZRNCKPGFVJGPGGFHQTCEEQWPVKPITWNGU main sources of accounting rules, and outline the role of the • &KUEWUUGFVJGKPVGTPCVKQPCNKUCVKQPQHDWUKPGUUCPFVJGITQYVJQH +PVGTPCVKQPCN#EEQWPVKPI5VCPFCTFU Australian Securities Exchange in regard to company • +FGPVKƂGFVJGTGNCVKQPUJKRDGVYGGP#WUVTCNKCP#EEQWPVKPI5VCPFCTFU reporting and management, with particular reference to CPFVJG+PVGTPCVKQPCN#EEQWPVKPI5VCPFCTFU corporate governance • +FGPVKƂGFVJGOCKPGZVGPUKQPUVQFKUENQUWTGTGSWKTGOGPVUTGNCVKPIVQ NKUVGFEQORCPKGU • 'ZCOKPGFCPFFGUETKDGFVJG#5:%QTRQTCVG)QXGTPCPEG2TKPEKRNGU • 'ZCOKPGFHCKTN[ETKVKECNN[VJGEQPEGRVQHEQTRQTCVGIQXGTPCPEG Identify the main requirements relating to the published CPPWCNTGRQTVKPENWFKPICNNQHVJGƂPCPEKCNCPFCPEKNNCT[ statements

• 1WVNKPGFVJGTGSWKTGOGPVUQH##5$Presentation of Financial StatementsTGNCVKPIVQ • VJGUVCVGOGPVQHƂPCPEKCNRQUKVKQP • VJGUVCVGOGPVQHEQORTGJGPUKXGKPEQOG • VJGUVCVGOGPVQHEJCPIGUKPGSWKV[ • VJGUVCVGOGPVQHECUJƃQYU • PQVGU

Explain the concept of group or consolidated accounts

• 1WVNKPGFVJGOCKPKUUWGUTGNCVKPIVQCRCTGPVsUWDUKFKCT[TGNCVKQPUJKR CPFKVUKORNKECVKQPUHQTCUGVQHITQWRCEEQWPVU

DISCUSSION QUESTIONS EASY 5.1

LO1

What is the role of a company director?

5.2

LO2

You have heard that management accounting is not regulated by accounting rules, under the premise that companies should be allowed to adopt methods and procedures that are best suited for VJGO9J[FQGUƂPCPEKCNCEEQWPVKPIPQVJCXGVJGUCOGFGITGGQHHTGGFQO!

5.3

LO2

What is meant by the term ‘corporate governance’? What would be included in corporate governance activities?

5.4

LO3

Describe the key components of the annual report, including an explanation of the purpose of each report element.

5.5

LO4

When are group or consolidated accounts required and what is the purpose of their preparation?

INTERMEDIATE 5.6

LO1

*QYFQGUVJGCWFKVQTCUUKUVVJGFKTGEVQTKPHWNƂNNKPIVJGKTFKTGEVQTUJKRTQNG!

5.7

LO2

The Australian Accounting Standards Board (AASB) has adopted International Accounting Standards

+#5HQTƂPCPEKCNTGRQTVKPI/WUV[QWTOCTIKPCNN[RTQƂVCDNGRTQRTKGVCT[EQORCP[YKVJCDUQNWVGN[PQ FGCNKPIUQWVUKFGQH#WUVTCNKCEQORN[YKVJ+#5!+H[QWJCXGVQEQORN[FQ+#5CNNQYƂTOUVQCFLWUVVJG standard where strict compliance will not provide true and fair reporting? Explain.

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5.8

LO3

Discuss the purpose of the statement of comprehensive income from an accounting EQPEGRVXKGYRQKPV&GUETKDGVJGCRRNKECDKNKV[QHURGEKƂECEEQWPVKPIRTKPEKRNGUKP[QWTFKUEWUUKQP

5.9

LO1

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5.10 LO4

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5.11 LO2

'ZRNCKPYJ[EQTRQTCVGIQXGTPCPEGKUEWTTGPVN[CnJQVVQRKEoHQTQTICPKUCVKQPUCPFUVCPFCTFUGVVGTU

5.12 LO1/3

'ZRNCKPYJCV[QWWPFGTUVCPFD[nVTWGCPFHCKToKPVJGEQPVGZVQHEQORCP[TGRQTVKPI

5.13 LO2

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199

CHALLENGING 5.14 LO1

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5.15 LO2

9JCVVYQEQTRQTCVGUVTWEVWTGHGCVWTGUOWUVGZKUVKHCEQORCP[KUUJQYKPICnOKPQTKV[KPVGTGUVo account on its balance sheet?

5.16 LO2

&KUVKPIWKUJDGVYGGPnEQTRQTCVGIQXGTPCPEGoCPFnGPVGTRTKUGIQXGTPCPEGo

5.17 LO1

#HVGTTGCFKPI4GCN9QTNFJQYKORQTVCPVFQ[QWVJKPMCWFKVQTUCTGKPCUUWTKPIKPXGUVQTUVJCVVJG[ CTGFGCNKPIYKVJCEQPƂFGPVCPFKPHQTOGFOCTMGV!

5.18 LO1

#FGNG(GTIWUQPKPCPCTVKENGGPVKVNGFn%QPƃKEVQHKPVGTGUVCVVJGJGCTVQHCWFKVFKUCUVGTUo (The Age&GEGODGTTGNCVKPIVQCPGCTNKGT#5+%CWFKVTGRQTVCTIWGFVJCVVJGTG KUCTGCNQTRGTEGKXGFEQPƃKEVQHKPVGTGUVDGECWUGCWFKVQTUIGVRCKFD[VJGEQORCP[VJG[ JCXGDGGPJKTGFVQKPFGRGPFGPVN[CWFKV5JGCTIWGFVJCVCPQVJGTQRVKQPOKIJVDGHQTVJG TGIWNCVQTVQCRRQKPVCPCWFKVQTTCVJGTVJCPNGCXGKVVQVJGEQORCP[&Q[QWVJKPMVJCV she is correct?

5.19 LO3

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5.20 LO1

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5.21 LO2

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•

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•

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(C 9J[YQWNF#WUVTCNKCIKXGWRKVUUVCPFCTFUKPHCXQWTQH+PVGTPCVKQPCN#EEQWPVKPI5VCPFCTFU! (D 9JCVEQWNFFKUCFXCPVCIG#WUVTCNKCKPIKXKPIWRUGVVKPIKVUQYPKPFKXKFWCNCEEQWPVKPIUVCPFCTFU!

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ACCOUNTING FOR NON-SPECIALISTS

APPLICATION EXERCISES EASY 5.1

LO3

*QYYQWNF[QWENCUUKH[VJGHQNNQYKPIGZRGPUGU! Cost of sales

Selling and distribution

Administration and general

Financial

(TGKIJVKPYCTF (TGKIJVQWVYCTF 5CNGUUVCHHUCNCTKGU +PVGTGUV 4CVGU &GRTGEKCVKQPtUJQYECUG &GRTGEKCVKQPtDWKNFKPI 4GRCKTUCPFOCKPVGPCPEGtECUJTGIKUVGT %NGCPKPI $CFFGDVU &KUEQWPVUIKXGP 6GNGRJQPGCPFRQUVCIG +PUWTCPEGtKPXGPVQT[ #WFKVHGG #FOKPKUVTCVKQPUVCHHUCNCTKGU #FXGTVKUKPI 5.2

LO3

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5.3

LO3

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No

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CHAPTER 5 REGULATORY FRAMEWORK FOR COMPANIES

5.4

LO4

201

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5.5

LO4

)KDDQPU.VFRWTEJCUGFQHVJGUJCTGUQHQPGQHVJGKTEQORGVKVQTU 2,$.VFCVCVQVCN EQUVQH#VVJGRWTEJCUGFCVG)KDDQPU.VFJCFVQVCNCUUGVUQH CPF|NKCDKNKVKGUQHYJKNG2,$.VFJCFCUUGVUQHCPFNKCDKNKVKGUQH 

C 9JCVCOQWPVQHIQQFYKNNQPEQPUQNKFCVKQP KHCP[YKNN)KDDQPUTGEQTF!

D 9JCVKUVJGCOQWPVQHOKPQTKV[KPVGTGUV KHCP[VJCV)KDDQPUYKNNTGEQTF!

5.6

LO4

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Net assets

H Ltd $’000

S Ltd $’000







–





5JCTGUKUUWGFCVHWNN[RCKF





4GUGTXGU









+PXGUVOGPVUKP5.VF 1TFKPCT[UJCTGECRKVCN

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INTERMEDIATE 5.7

LO2

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Full principle name

Principle name in three words or less

Appropriateness of principle for a sports club (Yes or No, and explain)

       

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ACCOUNTING FOR NON-SPECIALISTS

5.8

LO1

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4 5

%QORCP[FKTGEVQTUCTGTGURQPUKDNGHQTVJGRTGRCTCVKQPQHAAAAAAAAAVJCVRTQXKFGCAAAAAAAAA TGRTGUGPVCVKQPQHVJGAAAAAAAAACPFAAAAAAAAAQHVJGDWUKPGUU &KTGEVQTUCTGTGSWKTGFVQRTGRCTGAAAAAAAAACPFAAAAAAAAAƂPCPEKCNUVCVGOGPVU 6JGƂPCPEKCNTGRQTVUOWUVEQORN[YKVJAAAAAAAAA%QORCPKGUoƂPCPEKCNTGRQTVUUJQWNFDG EJGEMGFD[CPAAAAAAAAACPFTGRQTVGFQP WPNGUUVJGEQORCP[KUCUOCNNRTQRTKGVCT[ EQORCP[ AAAAAAAAACTGTWNGUGUVCDNKUJGFD[VJGRTQHGUUKQPCNQTUVCVWVQT[CEEQWPVKPIDQFKGUYJKEJ UJQWNFDGHQNNQYGFD[RTGRCTGTUQHVJGCPPWCNCEEQWPVUQHEQORCPKGU 6JGAAAAAAAAARTQXKFGUCEJGEMQPVJGETGFKDKNKV[CPFTGNKCDKNKV[QHVJGƂPCPEKCNTGRQTVU6JG CWFKVQToUTGRQTVVGPFUVQDGAAAAAAAAA

List ƂPCPEKCNUVCVGOGPVU

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performance

fair

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CEEQWPVKPIUVCPFCTFU

CWFKVQToUTGRQTV

fair

true

ƂPCPEKCNRQUKVKQP

5.9

LO1

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6JGAAAAAAAAATGRQTVKUIGPGTCNN[OWEJNQPIGTVJCPVJGKTUVCVGOGPVCPFEQPVCKPUCP KPETGCUKPINGXGNQHAAAAAAAAAFKUENQUWTGU 6JGAAAAAAAAAV[RKECNN[KPENWFGUCPKPFKECVKQPVJCVVJGCWFKVYCUEQPFWEVGFKPCEEQTFCPEG YKVJAAAAAAAAA 6JGTGRQTVYKNNCNUQKPENWFGCUVCVGOGPVVJCVVJGƂPCPEKCNUVCVGOGPVUEQORN[YKVJAAAAAAAAA +HVJGCWFKVQTEQPENWFGUVJCVVJGƂPCPEKCNTGRQTVUFQ016HCKTN[TGRTGUGPVVJGEQORCP[oU ƂPCPEKCNUKVWCVKQPVJG[YKNNKUUWGCAAAAAAAAACWFKVTGRQTV #PCWFKVTGRQTVIKXGUCPAAAAAAAPQVCAAAAAAAAA

List #WUVTCNKCP#WFKVKPI5VCPFCTFU

5.10 LO2

#WUVTCNKCP#EEQWPVKPI5VCPFCTFU

Opinion

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CHAPTER 5 REGULATORY FRAMEWORK FOR COMPANIES

203

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5.12 LO4

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5.13 LO4

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H LTD AND S LTD Statement of financial position as at 31 December 2017

Net assets +PXGUVOGPVUKP5.VF 1TFKPCT[UJCTGECRKVCN 5JCTGUKUUWGFCVHWNN[RCKF 4GUGTXGU

H Ltd

S Ltd

$’000

$’000

  

 

  

  

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ACCOUNTING FOR NON-SPECIALISTS

CHALLENGING 5.14 LO2

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Conventional treatment

    

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5.17 L03

205

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207

CHAPTER 5 CASE STUDY How boards can be more effective and challenge management more effectively Given below is a summary of a paper. Read this summary and answer the questions that follow. The Chartered Institute of Management Accountants released a discussion paper in January 2010 entitled ‘Enterprise governance: restoring boardroom leadership’. The paper quotes the president of IFAC, Robert Bunting, as saying: ‘Regardless of who is to blame, the [global financial] crisis was unquestionably exacerbated by corporate governance failures.’ He specifically identified the lack of proper risk management processes, and governance systems which did not provide adequately for risky strategies. The discussion paper sets out a range of related factors which lead to a board’s effectiveness, which include frameworks relating to processes and structures, and people and behaviours. Much of the work to date focuses on the first group, with limited work on the second. Points of relevance in the paper relating to people and behaviours include the following: • It is important not to make too rigid a distinction between structure and culture in shaping behaviour. • Composition of the board is important: members need to work together as a team; diversity is important. • Professional behaviour between board members and between board members and the executive management team is important, as is mutual respect. • It is important to understand and manage the human aspects of the business. • The prevalence of emotional factors in corporate success and failure means that they should be recognised as being at the heart of boardroom leadership and effectiveness. • There is a need to develop a culture of ‘effective challenge’, in which decisions are thoroughly debated and subject to proper scrutiny. All too oen, boards develop a ‘group think’ approach, in

which all members think the same way, leading to less rigour in the analysis. • In spite of containing very able members, some boards do not work well together, or do not have the collective desire to do what is necessary to challenge the status quo. • In some cases, the CEO has tight control over the workings of the board, with the result that awkward questions become too hard to ask. • Talent development and reward, and sound succession planning, both at board level and at executive level, are important. With regard to frameworks, processes and structures, the following are particularly noteworthy: • Boards must properly understand risk and integrate it into strategic thinking. Simply ticking boxes in a risk framework is not enough. • Organisations tend to oscillate between underscrutiny in good times and over-scrutiny in bad times. • Greed reflects a failure of leadership. It is oen associated with ‘disaster myopia’, which is the tendency to underestimate the probability of adverse outcomes that have not occurred in recent memory. The discussion paper recognises that implementing some of these ideas is not easy. However, they point us in a direction which expands the ideas on more traditional corporate governance. We recommend you read the whole paper. It includes a number of examples of behaviour and attitudes that relate to the global financial crisis that are very revealing. Source: Adapted from Gillian Lees, ‘Enterprise governance: restoring boardroom leadership’, January 2010, pp. 5–7. C.I.M.A. © 2010, Chartered Institute of Management Accountants. All rights reserved. Used by permission.

QUESTIONS 1

Do you think that the regulatory framework discussed in this chapter provides an adequate foundation for management and oversight?

2

How might a company strive to safeguard the integrity of its financial reporting?

3

What is the role and effectiveness of the auditor?

4

Is the division of corporate governance between conformance and performance useful?

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5

The discussion paper summarised above identifies processes and structures as a key part of governance. List the range of processes and structures mentioned in the ASX Corporate Governance Principles.

6

The discussion paper talks about the importance of people and behaviours on board effectiveness. (a) What do you think is meant by ‘board culture’? (b) Do you think it is important that board members behave in a professional manner to each other? Why/why not? (c) Do you agree that diversity is an important component of a good board? (d) Why do you think that mutual respect between board members is important? What kinds of issues are likely to arise if mutual respect is lost? (e) What do you understand by the term ‘group think’, and how might it be prevented? How might a culture of ‘effective challenge’ be developed? (f) What reasons can you think of that might prevent a board working effectively as a team? (g) Is there an optimal size and composition for a board? Explain your answer. (h) How might a board encourage ethical and responsible decision-making? (i)

7

What kind of relationship should a CEO seek to build with the board?

With regard to frameworks, processes and structures, answer the following. (a) What kind of risks might a company face? You may find it easier to think of a particular business and think about the particular risks associated with that business. (b) How best should risk be managed? (c) What do you understand by ‘disaster myopia’, and how might you guard against it? (d) Comment on the statement ‘Greed reflects a failure of leadership’.

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ACTIVITY 5.2

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– –

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Retained earnings $m 

Total $m 

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Notes  

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CHAPTER 6

MEASURING AND REPORTING CASH FLOWS LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

LO1 Explain why cash and cash flows are important to the reporting entity LO2 Explain the nature, purpose and layout of the statement of cash flows LO3 Prepare a simple statement of cash flows LO4 Prepare a reconciliation of profit with cash flow from operating activities, and explain how useful this is in decision-making

LO5 Identify some of the potential complexities that arise with statements of cash flows LO6 Explain what the statement tells us, and illustrate how the statement of cash flows can be useful for identifying cash flow management strengths, weaknesses and opportunities, both historically and in forecasting and planning.

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ACCOUNTING AND YOU MANAGING YOUR CASH How oen have you run out of cash over a long weekend when there is no ATM nearby? ‘Regularly,’ I hear you say. Why do you think this is? Typical reasons might include lack of planning, laziness, unplanned spending or unforeseen events throwing your calculations out—did a friend not pay you the money owed? There are clearly lessons to be learned from something like this, but when an individual runs out of cash on a short-term basis, the knock-on effects are relatively limited. The same may not be true when it happens to your business. There are many pitfalls waiting for you in running your own business, especially in the early years. We frequently hear of a business that seems to be going very well, with the volume of trade growing quickly. Everything looks great, but then the wheels come off. Usually this is because of a lack of appropriate attention to issues that relate to cash management. A common issue is too rapid expansion, commonly referred to as ‘over-trading’. Why should this be a problem? Several reasons can be found:

• •

the need for more non-current assets, which means a cash outflow or an increase in debt

•

an expanded customer base, with more uncertainty regarding the payment of accounts receivable, and possibly an increase in bad debts

• •

difficulty in obtaining larger amounts of credit from suppliers, or

a rapid increase in inventories is needed, which means increases in cash outflows or an increase in accounts payable or, more likely, both

insufficient equity to support a larger-than-planned-for business.

All of these have the potential to impact negatively on the cash balance. As well as these factors, which can impact on cash flows directly, there is also the personal stress on the owners/managers from a degree of unplanned expansion, which consequently impacts on efficiency. Casualness in cash management, or insufficient attention to what is going on, can be the final straw for a business, particularly one that is growing. Another major cause of problems is lack of realistic planning. It is easy to get carried along in the enthusiasm of a new venture and make assumptions that prove to be invalid. A major problem that arises frequently relates to the period that it takes your customers to pay you. You will see in Chapter 13 that periods of 50 days are common, and that many small businesses fail simply because of this. Great care needs to be taken to develop realistic assumptions for planning, and follow this up with sound systems of working capital management (dealt with in Chapter 13). Also, it is worth exploring opportunities for developing an overdra or line of credit facilities with your bank. The message is that cash management does not look aer itself. It is an important part of running a business. You might find it useful to review some of the material available on the internet regarding the failure of Pie Face and its subsequent revival plan. Pie Face was an Australian fast-food chain, notable for the face drawings on its pies. Aer about 11 years of rapid expansion, the firm appointed administrators in late 2014. Its story has all the hallmarks of a typical over-ambitious growth plan. It has subsequently commenced a revival program. Possible useful sites include: http://theconversation.com/pie-face-collapse-a-lesson-in-biting-off-more-than-you-can-chew-34656 www.smh.com.au/business/retail/how-pie-face-cooked-its-own-goose-20141127-11vbpq.html http://expert360.com/blog/can-learn-pie-face-fiasco/ www.franchisebusiness.com.au/news/the-truth-about-pie-face-and-its-revival-plan.

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213

THE IMPORTANCE OF CASH AND CASH FLOW Simple organisations, such as small clubs and other not-for-profit associations, often limit their accounting activities to a record of cash receipts and cash payments. Periodically (normally annually), a summary of all cash transactions for the period is produced for the members, showing one single figure for each category of payment or receipt; for example, membership subscriptions. This summary usually forms the basis of the club’s decision-making, and is the main means for the committee to fulfil its moral duty to account to the club members. This is normally sufficient for such organisations. Table 6.1 illustrates such a report:

LO1 Explain why cash and cash flows are important to the reporting entity

TABLE 6.1 TYPICAL RECEIPTS AND PAYMENTS STATEMENT XYZ SOCIAL CLUB Statement of receipts and payments for the year ended 30 June 2017 $ %CUJCVDCPM Receipts /GODGTUoUWDUETKRVKQPU (WPFTCKUKPI )QXGTPOGPVITCPVU +PVGTGUV 1VJGT Payments #FOKPKUVTCVKQPCPFCEEQWPVKPI (WPEVKQPU +PUWTCPEG 4GRCKTUCPFOCKPVGPCPEG 6GNGRJQPGCPFRQUVCIG Utilities 1VJGT %CUJCVDCPM

$ 

    

      

 

 

As we have seen in earlier chapters, organisations that are more complicated than simple clubs have to produce statements that reflect movements in wealth and the net increase (profit) or decrease (loss) for the period concerned. The statement of cash flows is a fairly late addition to the annual published financial statements. At one time, companies were only required to publish an income statement and a statement of financial position. It seems the prevailing view was that all the financial information needed by users would be contained within these two statements. This view may have been based partly on the assumption that, if a business were profitable, it would also have plenty of cash. While in the long run this is likely to be true, it is not necessarily true in the short to medium term. In practice, unless a business’s cash flows are monitored in the short to medium term, there may not be a long term for that business. We saw in Chapter 3 that the income statement sets out the revenue and expenses for the period, rather than the cash inflows and outflows. This means that the profit (or loss), which represents the difference between the revenue and expenses for the period, may have little or no relation to the cash generated for the period.

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To illustrate this point, let us take the example of a business making a sale (generating revenue). This may well lead to an increase in wealth that will be reflected in the income statement. However, if the sale is made on credit, no cash changes hands—at least, not at the time of the sale. Instead, the increase in wealth is reflected in another asset: an increase in trade receivables. Furthermore, if an item of inventory is the subject of the sale, wealth is lost to the business through the reduction in inventories. This means that an expense is incurred in making the sale, which will also be shown in the income statement. Once again, however, no cash changes hands at the time of sale. For such reasons, the profit and the cash generated during a period rarely go hand in hand. Activity 6.1 helps to underline how particular transactions and events can affect profit and cash for a period differently.

ACTIVITY 6.1 The following is a list of business/accounting events. In each case, state the effect (i.e. increase, decrease or no effect) on both cash and profit. Effect Event

On profit

On cash

Repayment of a loan

..........

..........

Making a sale on credit

..........

..........

Buying a non-current asset for cash

..........

..........

Depreciating a non-current asset

..........

..........

Receiving cash from accounts receivable

..........

..........

Buying some inventory for cash

..........

..........

Making a share issue for cash

..........

..........

..........

..........

From what we have seen so far, it is clear that the income statement is not the place to look if we are to gain insights about cash movements over time. We need a separate financial statement. In 1991, a new accounting standard required entities to produce and publish, as well as the income statement and the balance sheet, a cash flow statement reflecting movements in cash. The reason for this was the growing belief that, despite their usefulness, the income statement and the balance sheet did not concentrate sufficiently on liquidity. It was believed that the ‘accrualbased’ nature of the income statement tended to obscure the question of how and where a company was generating the cash it needed to continue its operations. The standard has been updated several times and the title of the statement has subsequently been changed to ‘statement of cash flows’. Why is cash so important to businesses pursuing profit/wealth? The solution to Activity 6.1 illustrates the fact that cash and profit do not go hand in hand, so why the current preoccupation with cash? After all, cash is just an asset that a business needs to help it to function. The same could be said of inventory or non-current assets. Cash is important because people and organisations will not normally accept any other way of settling their claims against the business. If a business wants to employ people, it must pay them in cash. If it wants to buy a new asset to exploit a business opportunity, the seller of the asset will normally insist on being paid in cash, probably after a short period of credit, usually a month or two. When businesses fail, it is their inability to find cash to pay claimants that really drives them under. These factors make cash the pre-eminent business asset and, therefore, the one that analysts and others watch carefully in trying to assess the ability of the business to survive and to take advantage of commercial opportunities as they arise. During an economic downturn, the ability to generate cash takes on even greater importance. Banks become more cautious in their lending, and businesses with weak cash flows often find it difficult to obtain finance. The importance of cash and cash flow can be seen in two UK examples in Real World 6.1. Part (a) is taken from an article by Luke Johnson who is a ‘serial entrepreneur’. This article was written just after the tennis at Wimbledon had finished and covered his views on major self-inflicted

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mistakes that can undermine a career. The article covered a range of mistakes, but the one given in Real World 6.1 relates specifically to the inability to distinguish profit from cash. Part (b) is taken from a column written by John Timpson, which appeared in the Daily Telegraph. Timpson is the chief executive of the successful British high street shoe-repairing and key-cutting business that bears his name. In the column he highlights the importance of cash reporting in managing the business.

REAL WORLD 6.1 a) Wise entrepreneurs learn that profits are not necessarily cash. But many founders never understand this essential accounting truth. A cash flow projection is a much more important document than a profit and loss (income) statement. A lack of liquidity can kill you, whereas a company can make paper losses for years and still survive if it has sufficient cash. It is amazing how financial journalists, fund managers, analysts, bankers and company directors can still focus on the wrong numbers in the accounts – despite so many high-profile disasters over the years. Source: Extract from Johnson, L., ‘The most dangerous unforced errors’, .com, 9 July 2013. © The Financial Times Limited 2013. All Rights Reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.

b) I look at our cash balance every day (not Saturdays and Sundays). It is the best way to test the financial temperature of our business. The trick is to compare with the same day last year, thus showing cash flow for the past 12 months. It is not a perfect system (never forget that your finance department may secretly massage the cash by paying suppliers sooner or later than you anticipate) but a glance at the daily cash is more transparent than management accounts that are full of provisions and only appear once a month.

Finance and IT take a delight in producing a deluge of data. But being in possession of too many statistics is counterproductive. This daily cash report helps to clear the clutter created by computers – it’s a simple report that helps you pose the right questions. Why have things suddenly got worse? Are we in danger of breaking our bank borrowing limit? Why does the cash flow look so much better than in the management accounts? This cash report can also give you an early warning of changing financial circumstances. It came to my rescue in 2004 when, through a major acquisition, the business doubled in size overnight and was going through a great deal of change. Our financial control suffered but I didn’t realise how bad things were until I was waiting to board a plane to go on a Caribbean holiday. A quick look at my Blackberry (when my wife wasn’t looking) showed an unexpected £500,000 deterioration in our overdraft. It wasn’t a great start to the holiday and my wife was upset when I spent the first day on the telephone. However, we were able to tackle the problem six weeks before it would have been revealed in the management accounts. Source: Timpson, J., ‘The management column’, The Daily Telegraph Business, 14 June 2010. © Telegraph Media Group Limited 2010.

Concept check 1 Which of the following statements is true? A

B

C D E

%CUJƃQYUVCVGOGPVURTQXKFGKPHQTOCVKQPVJCVECPGCUKN[DGQDVCKPGFHTQOVJG DCNCPEGUJGGVCPFKPEQOGUVCVGOGPV 6JGKPEQOGUVCVGOGPVCPFDCNCPEGUJGGVRTQXKFGCNNQHVJGKPHQTOCVKQPPGGFGF D[OQUVƂPCPEKCNUVCVGOGPVWUGTU 2TQƂVCPFECUJIGPGTCNN[IQWRQTFQYPUKOWNVCPGQWUN[ 2TGRCTCVKQPQHCECUJƃQYUVCVGOGPVKUPQVCVOCPCIGOGPVoUFKUETGVKQP 0QPGQHVJGUVCVGOGPVUCTGVTWG

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Concept check 2 9JKEJQHVJGHQNNQYKPIYKNNEJCPIGVJGƂTOoURTQƂVDWVPQVKVUECUJ! A B C D

%CUJUCNGU %TGFKVUCNGU 2C[OGPVQHTCVGU 4GEGKRVUHTQOFGDVQTUTGEGKXCDNGU

Concept check 3 9JKEJQHVJGHQNNQYKPIYKNNUKOWNVCPGQWUN[CNVGTVJGƂTOoURTQƂVCPFECUJNGXGNU! A B C D

&GRTGEKCVKQP 9CIGURCKFKPVJGEWTTGPVRGTKQF 2C[OGPVQHETGFKVQTURC[CDNGU 5CNGQHCPQPEWTTGPVCUUGV

THE STATEMENT OF CASH FLOWS LO2 Explain the nature, purpose and layout of the statement of cash flows

The statement of cash flows is, in essence, a summary of the cash inflows and outflows over the period concerned. To aid understanding, these cash flows are divided into categories (e.g. those relating to investment in non-current assets). Cash inflows and outflows falling within each category are added together to provide a total for that category. These totals are shown on the statement of cash flows and, when added together, reveal the net increase or decrease of the cash (and cash equivalents) of the business over the period. The statement is basically an analysis of the business’s cash movements for the period. The standard layout for the statement of cash flows in Australia is shown in Table 6.2. The Accounting Standard AASB 107: Statement of Cash Flows defines operating activities as ‘the principal revenue producing activities of the entity and other activities that are not investing or financing’. Interest received would normally be classified as an operating activity cash inflow for financial institutions, but there is no agreement on its treatment for other organisations. It has long been debated whether interest received relates to operating activities or investing activities, and the current accounting standard allows firms to choose based on their individual circumstances. The headings in italics are the primary categories into which cash payments and receipts for the period must be placed. • Cash flows from operating activities. This is the net inflow from operations. It is equal to the sum of cash receipts from accounts receivable (and cash sales where relevant) less the sums paid to buy inventory, to pay rent, to pay wages, etc. Note that the amounts of cash received and paid, not the revenues and expenses, are what feature in the statement of cash flows. It is, of course, the income statement/statement of comprehensive income that deals with the expenses and revenues. • Cash flows from investing activities. This part of the statement is concerned with cash payments made to acquire additional non-current assets and cash receipts from the disposal of such assets. These non-current assets could be tangible assets, such as plant and machinery, or such things as loans made by the business, shares in another company bought by the business, or other investments. • Cash flows from financing activities. This part of the statement is concerned with financing the business, except to the extent of trade credit and other very short-term credit. So we are considering borrowings (other than very short term), and finance from share issues. This

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TABLE 6.2 LAYOUT FOR THE STATEMENT OF CASH FLOWS XYZ LTD Statement of cash flows for the financial year ended 30 June 2017 %CUJƃQYUHTQOQRGTCVKPICEVKXKVKGU Cash receipts from customers Cash paid to suppliers Cash paid to employees Interest paid Income taxes paid Net cash provided by (used in) operating activities %CUJƃQYUHTQOKPXGUVKPICEVKXKVKGU Purchase of property, plant and equipment Acquisition of subsidiary, net of cash acquired Proceeds from sale of property, plant and equipment Interest received Dividends received Net cash provided by (used in) investing activities %CUJƃQYUHTQOƂPCPEKPICEVKXKVKGU Proceeds from issue of share capital Proceeds from long-term borrowings Repayment of long-term borrowings 2C[OGPVQHƂPCPEGNGCUGNKCDKNKVKGU Dividends paid 0GVECUJRTQXKFGFD[ WUGFKPƂPCPEKPICEVKXKVKGU 0GVKPETGCUG FGETGCUGKPECUJCPFECUJGSWKXCNGPVUJGNF %CUJCPFECUJGSWKXCNGPVUCVVJGDGIKPPKPIQHVJGƂPCPEKCN[GCT %CUJCPFECUJGSWKXCNGPVUCVVJGGPFQHVJGƂPCPEKCN[GCT

x (x) (x) (x) (x) x(x) (x) (x) x x x x(x) x x (x) (x) (x) x(x) x(x) x(x) x(x)

category is concerned with procuring long-term finance from debt and equity sources together with debt repayment/redemption and the returns to equity holders. • Net increase in cash and cash equivalents held. Naturally, the total of the statement must be the net increase or decrease in cash over the period covered by the statement. The Australian Accounting Standard AASB 107: Statement of Cash Flows incorporates a broad concept of cash in terms of both ‘cash’ and ‘cash equivalents’. Cash represents ‘cash on hand’ and ‘demand deposits’, while cash equivalents represent short-term, highly liquid investments that can readily be converted to a fixed amount of cash. Details of the statement of financial position accounts making up the ‘cash and cash equivalent’ balance in the statement of cash flows must be separately disclosed. Examples of such accounts would include ‘cash on hand’, ‘cash deposits at the bank’, ‘bank overdrafts’, ‘short-term money market deposits’ and ‘bank bills’. Under normal circumstances, we would expect (or at least hope) that the cash flows from operations would be positive. Since the cash flows do not include non-cash expenses such as depreciation, the cash flow from operations will normally be higher than the profit recorded. Interest and tax payments are separately identified. Companies pay tax on profits, so if the company is profitable, the cash flow will move from the company to the tax authority. There will not normally be a cash outflow relating to tax if the company is not profitable. The cash flow from operating activities gives users a reasonable understanding of the trends over the years and of likely sustainability in the future. Given that a high proportion of the funding for expansion comes from retained profits, which is approximately the cash flow from operating activities less dividends, a full understanding of the cash flow from operating activities is important.

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free cash flow (TGGECUJƃQYTGRTGUGPVUVJG ECUJƃQYVJCVCEQORCP[KU CDNGVQIGPGTCVGCHVGTNC[KPI QWVVJGOQPG[TGSWKTGFVQ OCKPVCKPQTGZRCPFKVUCUUGV base.

An important variation to this is what is known as HTGGECUJƃQY. ‘Free cash flow represents the cash flow that a company is able to generate after spending the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value’ (Investopedia; Definition). Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. Some people feel that there is too much emphasis on earnings, which can be manipulated, whereas it is difficult to fake cash flow. You can read more on free cash flow at www.investopedia.com/terms/f/freecashflow. asp#ixzz4VgXt11ds, or follow Investopedia on Facebook. Operating cash flow is an important part of many businesses’ key performance indicators. Real World 6.2 provides evidence of this.

REAL WORLD 6.2 a) Energy business BP plc frames one of its key financial performance targets in terms of operating cash flows. Its performance over the five years ending December 2015 is set out in Figure 6.1. Operating cash flow was lower in 2015, largely reflecting the impact of the lower oil price environment.

b) Wesfarmers included ‘Operating cash flows’ and ‘Free cash flows’ under the heading ‘Key financial data’ in the ‘Highlights Summary’ of its 2016 Annual Review (p. 6). It also included ‘Operating cash flow per share’ and ‘Free cash flow per share’ in its ‘Key share data’.

Source: Our key performance indicators, 2015, B.P. p.l.c. www.bp.com/en/ global/corporate/about-bp/our-strategy/key-performance-indicators.html.

FIGURE 6.1

40

1RGTCVKPIECUJƃQYHQT$2RNE DKNNKQP

32.8

30

20

22.2

20.5

21.1

2012

2013

19.1

10

0

2011

2014

2015

The section on investing activities needs to be linked with the other two sections, since we would normally expect long-term assets to be paid for (funded) by either operations or other financing. Of course, sometimes asset sales can fund further asset purchases. Because most types of fixed assets wear out and because companies tend to seek to expand their asset base, the normal direction of cash in this area is out of the company (i.e. negative). The section on financing indicates what cash has been raised and repaid in financing transactions. Normally, a company pays out more to service its finance than it receives from its own financial investments (loans made and shares owned). Financing can go in either direction, depending on the financing strategy at the time. Since companies seek to expand, there is a general tendency to associate this area with cash coming into the business rather than leaving it. Figure 6.2 provides a diagrammatic representation of the statement of cash flows showing likely directions of cash flows.

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FIGURE 6.2 &KCITCOOCVKETGRTGUGPVCVKQPQHVJG UVCVGOGPVQHECUJƃQYU

Operating activities

Cash and cash equivalent balances

8CTKQWUCEVKXKVKGUQHVJGDWUKPGUUGCEJJCXGVJGKTQYPGHHGEVQPKVU ECUJCPFECUJGSWKXCNGPVDCNCPEGUGKVJGTRQUKVKXG KPETGCUKPI VJGOQTPGICVKXG TGFWEKPIVJGO6JGPGVKPETGCUGQTFGETGCUG KPVJGECUJCPFECUJGSWKXCNGPVDCNCPEGUQXGTCRGTKQFYKNNDGVJG UWOQHVJGUGKPFKXKFWCNGHHGEVUVCMKPICEEQWPVQHVJGFKTGEVKQP

ECUJKPQTECUJQWVQHGCEJCEVKXKV[ 0QVGVJCVVJGFKTGEVKQPQHVJGCTTQYUJQYUVJGPQTOCN FKTGEVKQPQHVJGECUJƃQYKPTGURGEVQHGCEJCEVKXKV[+PEGTVCKP EKTEWOUVCPEGUGCEJQHVJGUGCTTQYUEQWNFDGTGXGTUGFKP FKTGEVKQP

219

Investing activities

Financing activities

A comparison of statements of cash flows over time enables us to identify trends and make comparisons with other companies.

Concept check 4 Which of the following statements is false? A

B

C

D

E

6JGUVCVGOGPVQHECUJƃQYUUWOOCTKUGUECUJƃQYUD[ECVGIQT[CPFEQXGTU QRGTCVKPIKPXGUVKPICPFƂPCPEKPIƃQYU 1RGTCVKPIƃQYUCTGV[RKECNN[ECUJƃQYUVJCVTGNCVGVQPQTOCNQRGTCVKQPUKPENWFKPI ECUJTGEGKXGFHTQOEWUVQOGTUCPFECUJRCKFVQUWRRNKGTU +PXGUVKPIƃQYUCTGECUJƃQYUTGNCVKPIVQKPXGUVOGPVUCPFKPENWFGRWTEJCUGQHPGY PQPEWTTGPVCUUGVUVJGKTFGRTGEKCVKQPCPFUCNGRTQEGGFUHTQOCP[UWEJCUUGVUUQNF (KPCPEKPIƃQYUCTGECUJƃQYUTGNCVKPIVQJQYVJGDWUKPGUUKUƂPCPEGFKPENWFKPIUWEJ VJKPIUCUNQCPUTCKUGFQTTGRCKFCPFTKIJVUKUUWGU 0QPGQHVJGCDQXG6JG[CTGCNNVTWG

Concept check 5 9JCVFQ[QWVJKPMCTGVJGOQUVNKMGN[RCVVGTPUVQDGHQWPFKPVJGECUJƃQYU HTQOQRGTCVKPICPFKPXGUVKPICEVKXKVKGUHQTCTGNCVKXGN[PGYEQORCP[ (e.g. in the growth phase)? A B C D

1WVƃQYUQHQRGTCVKPIECUJƃQYUQWVƃQYUQHKPXGUVKPIƃQYU +PƃQYUQHQRGTCVKPIECUJƃQYUQWVƃQYUQHKPXGUVKPIECUJƃQYU 1WVƃQYUQHQRGTCVKPIECUJƃQYUKPETGCUGKPKPXGUVKPIƃQYU +PƃQYUQHQRGTCVKPIECUJƃQYUKPƃQYUQHKPXGUVKPIƃQYU

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ACTIVITY 6.2 (a) Assume that last year’s statement of cash flows for Angus Ltd showed a ‘negative’ cash flow from operating activities. What could be the reason for this? Should the company’s management be alarmed by it? (b) At the end of its reporting period, Zeneb Ltd’s statement of financial position included the following items: i. a bank deposit account where one month’s notice of withdrawal is required ii. ordinary shares in Jones Ltd (a stock exchange listed business) iii. a high-interest bank deposit account that requires six months’ notice of withdrawal iv. an overdra on the business’s bank account. Which, if any, of these four items would be included in the figure for cash and cash equivalents?

LO3 Prepare a simple statement of cash flows

PREPARATION OF THE STATEMENT OF CASH FLOWS— A SIMPLE EXAMPLE The statement of cash flows is based on an analysis and classification of cash receipts and cash payments for the period into three activity sets (operating, investing, financing) and several categories within each activity (see Figure 6.2 and Table 6.2 on page 217). Given that the emphasis of this book is on the user rather than the preparer, a section on preparing a statement of cash flows might seem redundant. However, a broad understanding of the approach needed to prepare such a statement will give you a better understanding of the statement itself. Also, when the statement is turned around and used in a forward-looking or forecast mode, it can become an extremely powerful aid in strategic planning. With this in mind, we shall use Example 6.1 to illustrate the preparation of a statement of cash flows.

)KXGPDGNQYKUCUVCVGOGPVQHEQORTGJGPUKXGKPEQOGCPFCUVCVGOGPVQHƂPCPEKCNRQUKVKQPHQTC EQORCP[6JKUYKNNHQTOVJGDCUKUHTQOYJKEJYGUJCNNRTGRCTGCUVCVGOGPVQHECUJƃQYU

6.1

5VCVGOGPVQHEQORTGJGPUKXGKPEQOGHQTVJG[GCTGPFGF&GEGODGT Sales Cost of sales )TQUURTQƂV Depreciation Other expenses 1RGTCVKPIRTQƂV Interest expense 2TQƂVDGHQTGVCZ Tax 2TQƂVCHVGTVCZCVKQP 4GVCKPGFRTQƂVDTQWIJVHQTYCTFHTQONCUV[GCT Proposed dividend on ordinary shares 4GVCKPGFRTQƂVECTTKGFHQTYCTF

$m 100 (60) 40 (5) (17) 18 (3) 15 (5) 10 30 40 20 20

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221

5VCVGOGPVQHƂPCPEKCNRQUKVKQPCUCV&GEGODGT

%WTTGPVCUUGVU Cash at bank and in hand Accounts receivable Inventory 0QPEWTTGPVCUUGVU Plant and machinery—cost —accumulated depreciation Land and buildings Total assets %WTTGPVNKCDKNKVKGU Accounts payable Income tax payable Dividend proposed 0QPEWTTGPVNKCDKNKVKGU Debenture loans 5JCTGJQNFGTUoGSWKV[ Paid-up ordinary capital 4GVCKPGFRTQƂVU Total liabilities and shareholders’ equity

2016 $m

2017 $m

12 15 22 49

5 20 30 55

40 (10) 50 80 129

50 (15) 60 95 150

10 4 15 29

15 5 20 40

20

25

50 30 80 129

65 20 85 150

6.1 continued

During 2017 the company spent $10 million on additional land and buildings, and $10 million on additional plant and machinery. There were no other non-current asset acquisitions or disposals. A new issue of shares occurred.

Deducing cash flows from operating activities The first category of cash flows that appears in the statement—the most important one for most businesses—is the cash flow from operations. Basically, this requires an analysis of the records of the business for the period, so as to calculate all payments and receipts relating to operating activities. These are summarised to give the net figure for inclusion in the statement of cash flows. There are two approaches that can be taken to deriving this figure: the direct method and the indirect method. The FKTGEVOGVJQF involves an analysis of the cash records of the business for the period, identifying all payments and receipts relating to operating activities. These are summarised to give the total figures for inclusion in the statement of cash flows. The KPFKTGEVOGVJQF uses accounting information from the income statement and the statement of financial position to convert the profit figure to a cash figure. It relies on the fact that, sooner or later, sales revenue will give rise to cash inflows and expenses will give rise to outflows. This means that the figure for profit for the year will be linked to the net cash flows from operating activities. Since businesses have to produce an income statement, the information that it contains can be used as a starting point to deduce the cash flows from operating activities. In fact, the accounting standard encourages entities to use the direct method, as it provides information that may be useful in estimating future cash flows, which is not available under the indirect method. However, entities which use the direct method are required to provide a reconciliation of cash flows arising from operating activities to profit or loss. Given this, the next section will deal with the direct method, while a later section will illustrate how the reconciliation statement is prepared, and there, the indirect method will be used.

direct method 6JGOGVJQFQHECNEWNCVKPI QRGTCVKPIECUJƃQYUD[ CPCN[UKPIVJGECUJTGEQTFUVQ KFGPVKH[ECUJRC[OGPVUCPF TGEGKRVUD[V[RG indirect method #PCRRTQCEJVQFGFWEKPI VJGECUJƃQYUHTQO QRGTCVKPICEVKXKVKGUKPCECUJ ƃQYUVCVGOGPVD[CPCN[UKPI VJGDWUKPGUUoUƂPCPEKCN UVCVGOGPVU

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The first stage is to calculate the cash receipts from customers. Using the figures in Example 6.1, cash received from customers can be calculated as follows: Opening balance of accounts receivable

15

plus sales for the period

100

gives the amount we might expect to receive for the period

115

less closing balance of accounts receivable

(20) 95

equals the cash received from customers

The same kind of approach can be used to calculate cash paid to suppliers and employees, although the process is generally a little more complicated, as this requires knowledge of the purchases figure. The first stage is therefore to calculate this figure. Using Example 6.1, and inserting the known figures, we get: Opening inventory

22

plus purchases

x

equals the amount available for sale less closing inventory (the amount unsold) equals the cost of sales (the cost of the amount sold)

22 + x (30) 60

The figure for purchases x can be calculated by solving: 22 1 x 2 30 5 60, so x 5 60 1 30 2 22 5 68.

This figure can then be inserted in the table for accounts payable to enable us to work out the cash paid relating to accounts payable. Opening balance of accounts payable

10

plus purchases of inventory for the period

68

gives the amount we might expect to pay for the period

78

less closing balance of accounts payable

(15)

equals the cash paid to accounts payable

63

Payments of other expenses may be presumed to have been paid in cash, as they reflect expenses of the year, and if there are no prepayments or accruals at either the beginning or end of the year depreciation will not involve a cash outflow. Interest paid is usually fairly straightforward, but where there is an associated interest payable or interest prepaid (or indeed, if there are prepaid or accrued expenses), a calculation process similar to the one above for accounts payable will be required. The calculation of interest paid relating to interest payable can be derived as follows: Opening balance of interest payable

0

plus interest expense for the period

3

gives the amount we might expect to pay for the period less closing balance of interest payable equals the interest paid

3 (0) 3

With regard to payments of tax, we have already noted that the actual payment of tax tends to lag behind profits, so we would expect payments in the current year to reflect last year’s (possibly adjusted) tax liability. In the case of Example 6.1, it should be clear that the figure for tax due at the end of 2016 will be paid in 2017, and the amount included against profit for 2017 will remain

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outstanding at the end of 2017, presumably to be paid in 2018. Alternatively, it can be calculated in the same way that we calculated interest paid where there was tax payable at the beginning and end of the period. The ‘operating’ section can now be completed for Example 6.1 as follows: %CUJƃQYUHTQOQRGTCVKPICEVKXKVKGU Cash receipts from customers

95

Cash paid to suppliers and employees (63 + cash payments for other expenses of 17)

(80)

Interest paid

(3)

Income taxes paid (2016 liability)

(4)

Net cash provided by operating activities

8

Deducing cash flows from investing activities We need to know how much has been spent on non-current assets, and any sale proceeds from non-current asset sales. In Example 6.1 we are told that the company spent $10 million on additional land and buildings, and $10 million on additional plant and machinery; also, that there were no other non-current asset acquisitions or disposals. There was no investment income and, therefore, no cash received from dividends or interest. If there was income from either of these investments, then the cash received would be calculated in the same way that cash from customers was calculated. The ‘investing’ section for Example 6.1 would appear as follows: %CUJƃQYUHTQOKPXGUVKPICEVKXKVKGU Purchase of property, plant and equipment (10 + 10)

(20)

Net cash used in investing activities

(20)

Deducing cash flows from financing activities A comparison of the opening and closing capital figures should enable us to calculate the amount of new share capital issued. In the case of Example 6.1, ordinary share capital increased by $15 million ($50 million to $65 million) over the year. A comparison of the long-term liabilities at the beginning and end of the year should indicate the net cash flows from borrowings. In Example 6.1 (page 220), we assume that there was new borrowing of $5 million as the loans figure increased by that amount over the year. As for dividends, we would usually expect to see final dividends for the year as a current liability in the year-end statement of financial position, to be paid early in the following year. In Example 6.1, this means that the $15 million dividends proposed at the end of 2016 will be paid in 2017. The proposed dividends shown in the statement of comprehensive income for the year ended 30 June 2017 are also shown as outstanding in the year-end statement of financial position, so clearly they cannot have been paid. The ‘financing’ section can now be completed for Example 6.1 as follows:

%CUJƃQYUHTQOƂPCPEKPICEVKXKVKGU Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid 0GVECUJRTQXKFGFD[ƂPCPEKPICEVKXKVKGU

15 5 (15) 5

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Putting the above sections together enables us to complete the statement of cash flows for Example 6.1 as follows:

Statement of Cash flows for the year ended 30 june 2017 $m %CUJƃQYUHTQOQRGTCVKPICEVKXKVKGU Cash receipts from customers Cash payments to suppliers and employees (63 + other expenses of 17) Interest paid Income taxes paid (2016 liability) Net cash provided by operating activities %CUJƃQYUHTQOKPXGUVKPICEVKXKVKGU Purchase of property, plant and equipment (10 + 10) Net cash used in investing activities %CUJƃQYUHTQOƂPCPEKPICEVKXKVKGU Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid 0GVECUJRTQXKFGFD[ƂPCPEKPICEVKXKVKGU 0GVFGETGCUGKPECUJCPFECUJGSWKXCNGPVUJGNF %CUJCPFECUJGSWKXCNGPVUCVVJGDGIKPPKPIQHVJGƂPCPEKCN[GCT %CUJCPFECUJGSWKXCNGPVUCVVJGGPFQHVJGƂPCPEKCN[GCT

95 (80) (3) (4) 8 (20) (20) 15 5 (15) 5 (7) 12 5

A legitimate question to ask is: what does this statement add? Chapter 8 deals specifically with financial analysis. However, the statement of cash flows should be linked with this analysis, with the following points being relevant. The statement clearly shows that cash decreased by $7 million over the course of the year, and it clearly identifies the factors that contributed to this decrease. This enables users of the financial reports to assess the efficiency of liquidity management. The following might be considered:

• • • • • •

•

Is a decline in cash resources to $5 million acceptable? Does it pose any problems regarding liquidity in the future? Will it signal any problem with creditworthiness/credit ratings? The cash flow from operating activities is positive, but is it enough? Could it be increased? $20 million has been spent on new property, plant and equipment, $15 million has been raised by a new share issue, and $5 million has been borrowed. Are these levels of acquisitions and funding appropriate? Rather strangely, $15 million in dividends has been paid out, a figure that is higher than the after-tax profit for the year. The logic of this should be questioned since a new share issue has been made. Normally, new asset purchases (investing activities) are associated with similarsized inputs in the financing section. The dividends payment appears to be an aberration. Have the new shares affected the control of the company, and is this a current or potential issue?

The statement of financial position also raises further issues, to be reviewed after studying Chapter 8.

• Accounts receivable have increased by one-third, or $5 million—is this increase justified relative • •

to sales, or is it due to tighter trading conditions or an inefficient debt collection and credit policy? Inventory has increased by just over one-third, or $8 million—is this justified, or does it reflect poor inventory control? Accounts payable have increased by 50%, or $5 million. To some extent this may offset the increase in inventory. It could also reflect a lengthening of the time the business takes to pay its debts. Whether the new time is appropriate is a question that has to be considered in the context of the industry.

The statement of cash flows highlights the main liquidity issues. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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Real World 6.3 provides an example of a statement of cash flows for department store chain Myer from its 2016 annual report.

REAL WORLD 6.3 Example of a statement of cash flows Consolidated statement of cash flows for the period ended 30 July 2016 2016

2015

53 weeks

52 weeks

$’000

$’000

3,101,149 (2,915,467) 185,682 71 (15,894) (20,369) 149,490

3,096,099 (2,946,252) 149,847 108 (22,601) (30,439) 96,915

(40,479) (8,680) – (11,891) 1,856 943 (58,251)

(63,099) – (1,000) (17,276) 18,225 800 (62,350)

(295,000) 212,011 (16,426) 60 (99,355) (8,116) 53,323 45,207

17,927 23 (73,211) 455 (54,806) (20,241) 73,564 53,323

Notes %CUJƃQYUHTQOQRGTCVKPICEVKXKVKGU Receipts from customers (inclusive of goods and services tax) Payments to suppliers and employees (inclusive of goods and services tax) Other income Interest paid Tax paid 0GVECUJKPƃQYHTQOQRGTCVKPICEVKXKVKGU %CUJƃQYUHTQOKPXGUVKPICEVKXKVKGU Payments for property, plant and equipment Net investment in associate Payment for brands acquisition Payments for intangible assets Lease incentives and contributions received Interest received 0GVECUJ QWVƃQYKPƃQYHTQOKPXGUVKPICEVKXKVKGU %CUJƃQYUHTQOƂPCPEKPICEVKXKVKGU Repayment of borrowing net of transaction costs Proceeds from the issue of shares, net of transaction cocsts Dividends paid to equity holders of the parent Other 0GVECUJ QWVƃQYHTQOƂPCPEKPICEVKXKVKGU 0GV FGETGCUGKPETGCUGKPECUJCPFECUJGSWKXCNGPVU %CUJCPFECUJGSWKXCNGPVUCVVJGDGIKPPKPIQHVJGƂPCPEKCNRGTKQF %CUJCPFECUJGSWKXCNGPVUCVGPFQHRGTKQF Source: Myer Annual Report 2016, p. 64. © Myer Pty Ltd.

Concept check 6 #ƂTOJCUCPQRGPKPIDCNCPEGQHTGEGKXCDNGUCOQWPVKPIVQ&WTKPI VJG[GCTVJGƂTOJCUUCNGUVQVCNNKPI+VYTKVGUQHHKPDCFFGDVU #V[GCTGPFKVKUQYGFD[EWUVQOGTU *QYOWEJECUJYCUTGEGKXGFHTQOTGEGKXCDNGUKPVJG[GCT! A B C D

   

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Concept check 7 #EQORCP[JCUCDCNCPEGQPKVURC[CDNGUCEEQWPVQHCVVJGUVCTVQHVJG [GCT&WTKPIVJG[GCTKVRC[UCPFTGEGKXGUCFKUEQWPVCOQWPVKPIVQ #V[GCTGPFVJGEQORCP[QYGU9JCVYCUVJGCOQWPVQH purchases made on credit for the year? A B C D

   

Concept check 8 #VVJGUVCTVQHVJG[GCTCƂTOQYGUYCIGUQH+VKPEWTUCYCIGUGZRGPUG QHHQTVJG[GCT#VVJGGPFQHVJG[GCTKVJCUQWVUVCPFKPI What was the amount paid for wages in the year? A B C D

   

ACTIVITY 6.3 Chen Ltd’s income statements for the years ended 31 December 2016 and 2017 and the statements of financial position as at 31 December 2016 and 2017 are as follows:

CHEN LTD Income statement for the year ended December

Revenue Cost of sales )TQUURTQƂV Distribution expenses Administrative expenses 1RGTCVKPIRTQƂV Interest payable 2TQƂVDGHQTGVCZCVKQP Taxation 2TQƂVHQTVJG[GCT

2016 $m 207 (101) 106 (22) (20) 64 (4) 60 (16) 44

2017 $m 153 (76) 77 (20) (28) 29 (4) 25 (6) 19

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CHEN LTD Statements of financial position as at 31 December 2016 $m

2017 $m

19 26 24 69

– 25 25 50

62 110 172 241

56 130 186 236

– 37 8 45

2 34 3 39

40

40

100 56 156 241

100 57 157 236

ASSETS Current assets Cash Accounts receivable Inventories Non-current assets Plant and machinery Land and buildings Total assets EQUITY AND LIABILITIES Current liabilities Overdraft Trade payables Income tax Non-current liabilities Borrowings loan notes (10%) Equity Ordinary share capital Retained earnings Total equity and liabilities

Included in ‘cost of sales’, ‘distribution expenses’ and ‘administrative expenses’, depreciation was as follows:

Land and buildings Plant and machinery

2016 $m 6 10

2017 $m 10 12

There were no non-current asset disposals in either year. The amount of cash paid for interest equalled the expense in each year. Dividends were paid totalling $18 million in each year. Prepare a statement of cash flows for the business for 2017.

RECONCILING PROFIT FOR THE YEAR WITH CASH FROM OPERATING ACTIVITIES The accounting standard also requires a note that reconciles the profit or loss after tax with the cash flows from operating activities. The reconciliation uses a system of calculating cash flows from operating activities which is known as the indirect method. Reconciling the profit after tax with operating cash flows involves a number of stages. The first is to adjust for any items which are clearly non-operating items, and which will appear in the investing or financing sections. The second is to add back any non-cash expenses (such as depreciation). The final step is to adjust for any changes in current assets and current liabilities. The process works broadly as set out in Table 6.3 on page 228.

LO4 Prepare a reconciliation of profit with cash flow from operating activities, and explain how useful this is in decisionmaking

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TABLE 6.3 THE INDIRECT METHOD OF DEDUCING THE NET CASH FLOW FROM OPERATING ACTIVITIES 2TQƂVCHVGTVCZ

Z

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Z Z

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Z

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Z Z

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Z Z

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Z Z

tCEEQWPVURC[CDNG ETGFKVQTU

Z Z

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Z Z

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Z Z Z

This reconciliation is based on the following logic. The starting point of the reconciliation is the profit after tax, the bottom line of the income statement. In order to convert the profit figure to an operating cash flow, we first need to reduce the profit figure by any items which are clearly nonoperating, and which will appear in either the investing or financing sections. By way of illustration, investment income would be part of profit, but not of operating profit (it is clearly not an operating cash flow), and so any amount relating to investment income would need to be deducted in arriving at operating profit. This figure would normally appear in the investing section. The next stage is to add back any non-cash expenses. So, if for example there was a foreign exchange loss taken in calculating the profit figure, the amount of that loss would need to be added back. Depreciation is the prime example of a non-cash expense which clearly relates to operating activities. It is not associated with any movement in cash during the accounting period, but rather represents an estimate of service potential or economic benefits of property, plant and equipment used up during the period. The remaining adjustments all relate to the operating profit after income tax. Broadly, we would expect sales to give rise to cash inflows, and expenses to give rise to outflows. We have already seen that this relationship does not follow precisely within a particular accounting period. It is not strictly true that profit equals the net cash inflow from operating activities. In Example 6.1 (page 220) we saw a difference between the sales figure in the statement of comprehensive income and the cash received from customers calculated as follows: Opening balance of accounts receivable

15

plus sales for the period

100

gives the amount we might expect to receive for the year

115

less closing balance of accounts receivable

(20)

equals the cash received from customers

95

Put another way, the cash from customers can be arrived at as follows: Sales for the period

100

less the increase or plus the decrease in accounts receivable over the year

(5)

Cash received from customers

95

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An increase in accounts receivable over the year means that the cash received will be less than the amount included as revenue over the year, by the amount of the increase. A reduction in accounts receivable over the year means that the cash received will exceed the amount included as revenue over the year, by the amount of the decrease. Basically, the accounts receivable figure is affected by sales and cash receipts. It is increased when a credit sale is made, and decreased when cash is received from a debtor. If, over the year, the sales and the cash receipts had been equal, the accounts receivable figures would have remained the same. Since the accounts receivable figure increased, it must mean that less cash was received than the figure for sales included in the statement of comprehensive income. Thus, the cash receipts from sales must be $95 million (i.e. 100 – (20 – 15)). Put slightly differently, we can say that, as a result of sales, assets of $100 million flowed into the business during the year. If $5 million of this went to increasing the asset of accounts receivable, this leaves $95 million to increase cash. The same general point is true in respect of nearly all of the other items taken into account when deducing the operating profit figure. The exception is depreciation, which was covered earlier. Using Example 6.1 (page 220), we see that this would result in a reconciliation as shown below: $m 2TQƂVCHVGTVCZ Depreciation

10 5

Increase in inventory

(8)

Increase in accounts receivable

(5)

Increase in accounts payable

5

Increase in tax payable

1

0GVECUJƃQYRTQXKFGFD[QRGTCVKPICEVKXKVKGU

8

The net cash inflow of $8 million from operating activities is the same as shown on the statement of cash flows. Basically, this reconciliation starts with the assumption that the profit equals the cash generated. We know that this is not true, because the following things happen to prevent it being true:

• Depreciation does not involve a cash outflow, so the cash flow from operations will be higher •

•

than the net profit by the amount of the depreciation. Any increase in current assets (accounts receivable, prepayments or inventory) over the course of the year can be seen as representing a drain of cash (accounts receivable—cash not collected from sales during the period; inventory and prepayments—cash paid related to inventory and other expenses exceeds the cost of goods sold and expense amounts). So increases can be seen as an effective decrease in cash flow. Any decrease in current assets means that these assets over the course of the year can be seen as releasing cash (accounts receivable—cash collected exceeds the sales; inventory and prepayments—cash paid for inventory and other expenses is less than the cost of goods sold and expense amounts). So reductions represent an effective increase in cash flow. Any increase in current liabilities (accounts payable, income tax payable, deferred tax payable and accruals) must mean that less cash has been paid out over the course of the year than one might have expected on the basis of the expenses included in the statement of comprehensive income. This means that an increase in such liabilities over the year can be seen to represent an effective increase in cash flow, over and above those included from profit. Any decrease in these current liabilities must mean that more has been paid out over the course of the year than one might have expected on the basis of the expenses included in the statement of comprehensive income. This means that a decrease in such liabilities over the year (they have been paid off) can be seen to represent an effective decrease in cash flow compared with profit.

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• Any gain or loss on the disposal of non-trading assets (e.g. property, plant and equipment; investments; intangibles) needs to be adjusted for. Both the gain and the loss are non-cash in nature and simply represent the difference between the proceeds on disposal and the carrying amount of the asset sold. The cash proceeds are included as a cash inflow in the investing activities section of the statement of cash flow. Therefore, the loss is added back in the reconciliation and the gain is deducted. All of this means that if we take the profit for the year, adjust it to eliminate any items relating to investing and financing, add back the depreciation charged and any other non-cash expenses, and adjust this total by movements in non-cash current asset and current liability accounts (e.g. inventory, accounts receivable, accounts payable, prepayments and accruals, and income tax), we have the net cash from operating activities. In many ways the reconciliation provides more useful information than the statement of cash flows using the direct method. Cash can be positively or negatively affected by changes in working capital. These are not obvious in the statement of cash flows, but the reconciliation focuses on them. Certainly, inefficient working capital management can more easily be identified by the reconciliation. The reconciliation enables a clearer focus on the working capital components; namely, inventory, credit control relating to receivables, and control of payables. Unless someone in an organisation is given control and responsibility for each of these areas (and they can be under the control of different people), the chances are that the end cash result will be a residual or unplanned result. All of these areas need to be continually worked on. As we shall see in Chapter 13, working capital management needs to be positively managed, not left to chance. Real World 6.4 provides an example of the reconciliation of net (deficit)/surplus after tax to net cash flows from operations relating to Myer, which complements Real World 6.3.

REAL WORLD 6.4 Example of reconciliation of net (deficit)/surplus aer tax to net cash flows from operations 4GEQPEKNKCVKQPQHRTQƂVCHVGTKPEQOGVCZVQPGVECUJƃQYHTQOQRGTCVKPICEVKXKVKGU

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+PETGCUGFGETGCUGKPVTCFGCPFQVJGTTGEGKXCDNGU

+PETGCUGFGETGCUGKPKPXGPVQTKGU &GETGCUG KPETGCUGKPFGHGTTGFVCZCUUGV &GETGCUG KPETGCUGKPFGTKXCVKXGƂPCPEKCNKPUVTWOGPVU

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&GETGCUGKPETGCUGKPQVJGTNKCDKNKVKGU 0GVECUJKPƃQYHTQOQRGTCVKPICEVKXKVKGU

2016 53 weeks $’000  

   



2015 52 weeks $’000  

   –







 

  

 











 

 

Source: Myer Annual Report 2016, p. 83. © Myer Pty Ltd.

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Concept check 9 9JKEJQHVJGHQNNQYKPIUVCVGOGPVUCDQWVVJGKPFKTGEVRTQƂVTGEQPEKNKCVKQP method is true? A B C D

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B

C

D

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ACTIVITY 6.4 The relevant information from the accounts of Dido Ltd for last year is as follows: $m Sales Cost of sales

500 (300)

Depreciation

(34)

Other expenses

(44)

Profit for the year

122

At the beginning of the year Inventory

15

Accounts receivable

24

Accounts payable

18

At the end of the year Inventory

17

Accounts receivable

21

Accounts payable

19

1 Prepare a statement of cash flows from operating activities. 2 Prepare a statement reconciling the profit for the year with the cash flows from operating activities.

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The example to date relates to a company which is required to prepare a statement of financial performance in the form of a statement of comprehensive income. All of the principles outlined are equally applicable to other entities, although the statement of financial performance may be in the form of a traditional income statement or profit and loss account.

SOME COMPLEXITIES IN STATEMENT PREPARATION LO5 Identify some of the potential complexities that arise with statements of cash flows

So far we have used only relatively simple examples, and there is obviously a range of potential complications, many of which are beyond the scope of this book. The main complications relate to the sections on investing and financing.

The investing section We need to know how much has been spent on non-current assets, and any proceeds relating to non-current asset sales. We also need to find the cash receipts from investments in terms of interest and dividends received. It is worth noting the movements in non-current assets over the year. These can generally be summarised as in Table 6.4:

TABLE 6.4 MOVEMENTS IN NON-CURRENT ASSETS Cost

#EEWOWNCVGF depreciation

Net

$CNCPEGCVVJGUVCTVQHVJG[GCT

Z

Z

Z

NGUUCP[FKURQUCNU

Z

Z

Z

Z

Z

Z

Z

–

Z

Asset

RNWUPGYCESWKUKVKQPU RNWUCP[TGXCNWCVKQPU

Z

–

Z

NGUUFGRTGEKCVKQPHQTVJG[GCT

–

Z

Z

GSWCNUENQUKPIDCNCPEG

Z

Z

Z

The following points are important:

• Proceeds of asset sales are reflected in the investing section. • Only when an asset is sold can we calculate the actual depreciation incurred with complete

•

accuracy. Depreciation charged previously is only an estimate. Profits or losses on disposal reflect an under-provision (too little) or over-provision (too much) of depreciation. A loss on disposal represents additional depreciation and would be a non-cash expense. A profit on disposal offsets the depreciation. Any revaluations of assets are reflected in an increase in the asset and an increase in shareholders’ equity—shown in asset revaluation reserve.

Setting out a table of this sort enables us to follow through movements in assets relatively easily.

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ACTIVITY 6.5 The following are the extracts from a statement of financial position as at 1 January and 31 December.

Statement of financial position at 1 January and 31 December

(KZVWTGUCPFƂVVKPIU Cost Accumulated depreciation Net Plant and machinery Cost Accumulated depreciation Net Land and buildings—cost or valuation

1 January

31 December

$

$

20,000 (10,000) 10,000

25,000 (12,000) 13,000

80,000 (20,000) 60,000 150,000

100,000 (30,000) 70,000 200,000

You are told that: • land and buildings were revalued upwards by $20,000 • fixtures and fittings, which had cost $5,000, and which had been depreciated by $3,000, were sold for $1,000. (a) Calculate the depreciation for the year. (b) Show the relevant extracts from the statement of cash flows.

The financing section Problems can arise in establishing the cash flow from owners’ contribution. Generally, by comparing the opening and closing capital figures (‘paid-up capital’ for companies) we should be able to calculate the amount of owners’ contributions received (new share capital issued for companies). However, problems can arise with:

• bonus issues (which result in an increase in share capital without any cash inflow) • issue of shares directly for non-cash assets or to extinguish debt • repurchase or redemption of shares. It is not usually difficult to see that called-up share capital increased over a period. Of course, if we were told that some of this was in the form of a bonus issue, the cash proceeds from shares would need to be adjusted. Suppose that in the course of the year, share capital of a company increased by $90 million, from $150 million to $240 million, but that the first tranche of the increase was in the form of a bonus issue of $30 million, so that the cash issue could have been only $60 million ($90 million – $30 million). A comparison of the long-term liabilities at the beginning and the end of the year should indicate the net cash flows from borrowings. However, as with the issue of shares, the calculation of cash received from long-term liabilities (or cash repaid on long-term loans) may be more complicated than just computing the change for the year in the liability balance. These problems include:

• The issue of debt directly for non-monetary assets (e.g. debentures issued in exchange for a building). In this case, the increase in the liability does not represent a cash inflow.

• The conversion of debt directly into shares (e.g. convertible notes). In this case, the reduction •

of the liability does not represent a cash outflow. The accounting standard requires that the gross borrowing and gross repayments are shown. The change in the long-term liability for the period shows only the net change.

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For dividends, we usually expect final dividends for the year to be shown as a current liability in the year-end statement of financial position, and to be paid early in the following year. Care must be taken when interim dividends are paid part-way through the year as these will also be paid in the year. Generally, we expect the cash outflow for dividend payments to include any proposed dividends outstanding from the preceding year, plus interim dividends (if any) declared in the current year. Some of these issues are covered in Self-assessment Question 6.1.

Concept check 11 Which of the following is the most straightforward in calculating ECUJƃQYHTQOKPXGUVKPICEVKXKVKGU! A B C D

.QPIVGTOCUUGVCESWKUKVKQPKUFQPGWUKPIVJGJKUVQTKECNEQUVCUUWORVKQP .QPIVGTOCUUGVUOC[DGTGXCNWGFCVVJGGPFQHVJGCEEQWPVKPIRGTKQF 6JGICKPQTNQUUQPFKURQUCNQHCNQPIVGTOCUUGVKUPQVQDXKQWU 6JGTGKUCVTCFGKPQHCPCUUGVUKOKNCTVQVJGQPGDGKPIRWTEJCUGF

Concept check 12 %CNEWNCVKQPQHVJGEJCPIGKPNQPIVGTONKCDKNKVKGUHTQOUVCTVQH[GCTVQGPF QH[GCTQHVGPRTQXKFGU[QWYKVJVJGPGVECUJƃQYHTQODQTTQYKPIU9JKEJ QHVJGHQNNQYKPIYKNNECWUG[QWRTQDNGOUYJGPWUKPIVJKUOGVJQF! A B C D

$QVJDQTTQYKPIUCPFTGRC[OGPVUQEEWTKPVJGUCOGCEEQWPVKPIRGTKQF &GDVKURCKFD[KUUWKPIUJCTGUVQVJGNGPFGT &GDVKUKUUWGFKPFKTGEVGZEJCPIGHQTNQPIVGTOCUUGVU #NNQHVJGCDQXGYKNNECWUGRTQDNGOU

SELF-ASSESSMENT QUESTION

6.1

6QTDT[CP.VFoUUVCVGOGPVQHEQORTGJGPUKXGKPEQOGHQTVJG[GCTGPFGF&GEGODGTCPFVJGUVCVGOGPVQH ƂPCPEKCNRQUKVKQPCUCV&GEGODGTCPFCTGCUHQNNQYU TORBRYAN LTD Statement of comprehensive income for the year ended 31 December 2017 Sales Cost of sales )TQUURTQƂV Other expenses (including amortisation and depreciation of $79 million) Other operating income 1RGTCVKPIRTQƂV Interest expense (and similar charges) 2TQƂVHQT[GCTDGHQTGVCZ 6CZQPRTQƂV 2TQƂVCHVGTVCZCVKQP 4GVCKPGFRTQƂVDTQWIJVHQTYCTFHTQONCUV[GCT Transfer to reserves Proposed dividend on ordinary shares 4GVCKPGFRTQƂVECTTKGFHQTYCTF

$m 591 (307) 284 (91) 21 214 ( 21) 193 (46) 147 16 163 (60) (50) 53

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TORBRYAN LTD Statement of financial position as at 31 December

%WTTGPVCUUGVU Cash at bank and in hand Accounts receivable Prepaid expenses Inventory 0QPEWTTGPVCUUGVU (KZVWTGUƂVVKPIUVQQNUCPFGSWKROGPV Plant and machinery Land and buildings Intangible assets: patents and trademarks 6QVCNCUUGVU %WTTGPVNKCDKNKVKGU Bank overdraft Accounts payable Income tax payable Dividend payable Accrued expenses 0QPEWTTGPVNKCDKNKVKGU Debenture loans 5JCTGJQNFGTUoGSWKV[ Paid-up ordinary capital Asset revaluation reserve Other reserves 4GVCKPGFRTQƂVU 6QVCNNKCDKNKVKGUCPFUJCTGJQNFGTUoGSWKV[

2016 $M

2017 $M

2 115 6 44 167

17 123 16 41 197

155 110 241 44 550 717

163 125 310 37 635 832

14 44 32 40 11 141

– 39 46 50 15 150

400

250

150 – 10 16 176 717

240 69 70 53 432 832

&WTKPIVJGEQORCP[URGPVOKNNKQPQPCFFKVKQPCNRNCPVCPFOKNNKQPQPCFFKVKQPCNƂZVWTGU+VOCFGPQQVJGT PQPEWTTGPVCUUGVCESWKUKVKQPUQTFKURQUCNU#PGYKUUWGQHUJCTGUQEEWTTGF6JGNCPFCPFDWKNFKPIUYGTGTGXCNWGF#VVJG GPFQHVJGTGYGTGUJCTGUQPKUUWG 2TGRCTGCUVCVGOGPVQHECUJƃQYUHQTVJGEQORCP[HQTCPFCTGEQPEKNKCVKQPUVCVGOGPVDGVYGGPQRGTCVKPI RTQƂVCPFQRGTCVKPIECUJƃQYU

WHAT DOES THE STATEMENT OF CASH FLOWS TELL US? The statement tells us how the business has generated cash during the period and where that cash has gone. Since cash is properly regarded as the life blood of just about any business, this is potentially very useful information. Tracking the sources and uses of cash over several years might show financing trends that a reader of the statements could find useful for predicting the company’s future behaviour. Looking specifically at the statement of cash flows for Torbryan Ltd (Self-assessment Question 6.1), we can see the following:

• Net cash flow from operations was strong, much larger than the profit figure. This would be expected, because depreciation is deducted in arriving at profit. Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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• Working capital tended to absorb some cash—not surprising if activity (sales output) had

LO6 Explain what the statement tells us, and illustrate how the statement of cash flows can be useful for identifying cash flow management strengths, weaknesses and opportunities, both historically and in forecasting and planning

• • • •

expanded over the year. The information supplied did not show whether there was an expansion or not. If there was not, questions would arise about working capital management. There were net outflows of cash in servicing of finance, payment of tax and purchasing non-current assets. There seemed to be a healthy figure of net cash inflows before financing. There was a fairly major outflow of cash to redeem some debt finance, which was partly offset by the proceeds of a share issue. The net effect was a rather healthier looking cash position in 2017 than the one in 2016.

We have already seen that the reconciliation of operating profit and operating cash flows can be extremely useful in focusing on working capital management issues. Each component of working capital needs to be managed, but the reconciliation statement clearly identifies the impact of decisions (possibly non-decisions) on cash flows. The operating flows section probably identifies the most sustainable part of the organisation’s cash flows. The investing and financing flow sections clarify the situation that the organisation faces in these two areas. When turned around and used for forecasting purposes, the statement of cash flows, in conjunction with the other financial statements, becomes an integral part of the planning and decision-making process.

Concept check 13 9JKEJQHVJGHQNNQYKPIUVCVGOGPVUKUOQTGNKMGN[VQDGHCNUG! A B C D

%CUJƃQYKULWUVCUKORQTVCPVCURTQƂV &GRTGEKCVKQPNGCFUVQECUJƃQYHTQOQRGTCVKQPUDGKPIOQTGVJCPRTQƂV #RTQƂVCDNGEQORCP[UJQWNFJCXGCRQUKVKXGECUJƃQYHTQOƂPCPEKPI #ITQYKPIEQORCP[YKNNRTQDCDN[JCXGCPGICVKXGECUJƃQYHTQOKPXGUVKPI

Concept check 14 Which of the following statements is false? A

B

C

D

E

%NCUUKƂECVKQPD[CEVKXKV[RTQXKFGUKPHQTOCVKQPVJCVCNNQYUWUGTUVQCUUGUUVJGKORCEV QHVJQUGCEVKXKVKGUQPVJGƂPCPEKCNRQUKVKQPQHVJGGPVKV[CPFVJGCOQWPVQHKVUECUJ CPFECUJGSWKXCNGPVU %CUJƃQYHTQOQRGTCVKPICEVKXKVKGUKUCMG[KPFKECVQTQHVJGGPVKV[oUCDKNKV[VQIGPGTCVG UWHƂEKGPVECUJVQTGRC[NQCPUOCKPVCKPQRGTCVKPIECRCEKV[RC[FKXKFGPFUCPFOCMGPGY KPXGUVOGPVUYKVJQWVTGEQWTUGVQGZVGTPCNUQWTEGUQHƂPCPEG 5GRCTCVGFKUENQUWTGQHKPXGUVKPIƃQYUKUKORQTVCPVDGECWUGVJGƂIWTGTGRTGUGPVUVJG GZRGPFKVWTGQPTGUQWTEGUKPVGPFGFVQIGPGTCVGHWVWTGKPEQOGCPFECUJƃQYU 5GRCTCVGFKUENQUWTGQHƂPCPEKPIƃQYUKUKORQTVCPVDGECWUGKVJGNRURTGFKEVENCKOUQPHWVWTG ECUJƃQYUD[RTQXKFGTUQHECRKVCN 0QPG#NNCTGVTWG

ACTIVITY 6.6 (a) Explain how the reconciliation statement can be useful in working capital management. (b) Do you see any particular difficulties in using the financial reporting framework for forecasting purposes? (c) How do you think that a forecast statement of cash flows might help in planning and decision-making?

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237

SELF-ASSESSMENT QUESTION 6.2 6JGOCPCIGOGPVQH[QWTEQORCP[KURGTRNGZGFCUVQYJ[VJGEQORCP[oUDCPMDCNCPEGJCUIQPGFQYPKPVJGNCUV[GCT GXGPVJQWIJRTQƂVUJCXGDGGPUCVKUHCEVQT[4GNGXCPVKPHQTOCVKQPKUIKXGPDGNQY Statement of financial position as at 2017 1 JANUARY $’000

31 DECEMBER $’000

50 60 70 180

10 80 100 190

25 (12) 50 (30) 110 143 323

30 (10) 70 (35) 120 175 365

100 10 20 130

80 15 25 120

80

50

80 33 113 323

100 95 195 365

$’000

$’000 379

%WTTGPVCUUGVU Cash Accounts receivable Inventory 0QPEWTTGPVCUUGVU Vehicles—cost —accumulated depreciation Plant—cost —accumulated depreciation Premises 6QVCNCUUGVU %WTTGPVNKCDKNKVKGU Accounts payable Dividends proposed Income tax payable 0QPEWTTGPVNKCDKNKVKGU Loans 5JCTGJQNFGTUoGSWKV[ Paid-up ordinary capital 4GVCKPGFRTQƂVU 6QVCNNKCDKNKVKGUCPFUJCTGJQNFGTUoGSWKV[

Statement of comprehensive income for the year ending 31 December 2017 Sales Opening inventory Purchases Less closing inventory Cost of sales )TQUURTQƂV Depreciation —Plant —Vehicles 2TQƂVQPFKURQUCNQHXGJKENGU Other expenses 1RGTCVKPIRTQƂV Loan interest 2TQƂVDGHQTGVCZ Income tax Income after tax Dividends #FFGFVQTGVCKPGFRTQƂVU

70 250 320 (100) (220) 159 (5) (4) 3 (44)

(50) 109 (7) 102 (25) (77) (15) 62

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&WTKPIVJG[GCTXGJKENGUVJCVJCFEQUVCPFJCFDGGPFGRTGEKCVGFD[YGTGUQNFHQT5CNGUKP VJGRTGXKQWU[GCTJCFDGGP  2TGRCTGVJGUVCVGOGPVQHECUJƃQYUHQTVJG[GCTVQIGVJGTYKVJVJGTGEQPEKNKCVKQPQHQRGTCVKPIECUJƃQYUCPF RTQƂV  %QOOGPVQPVJGECUJƃQYUCPFUWIIGUVYC[UQHTGUQNXKPIVJGRTQDNGO  6JGEQORCP[KUPQYEQPUKFGTKPIKVURNCPUHQTVJGPGZV[GCTCPFVJKPMUVJCVKVECPCEJKGXGCKPETGCUGKPUCNGU YKVJUKOKNCTKPETGCUGUKPECUJGZRGPUGU+VKUXGT[EQPEGTPGFCDQWVVJGNKSWKFKV[QHVJGDWUKPGUU+VGUVKOCVGUVJCVC HWTVJGTYKNNPGGFVQDGURGPVQPRNCPVCVVJGUVCTVQHVJGPGY[GCTCPFCVVJGUCOGVKOGCPGYXGJKENGYKNN DGPGGFGFEQUVKPI&GRTGEKCVKQPQHRNCPVCPFXGJKENGUYKNNDGDCUGFQPCPFUVTCKIJVNKPG TGURGEVKXGN[.QCPKPVGTGUVKUNKMGN[VQDGCTQWPF%CNEWNCVGVJGRTQƂVVJCVOKIJVTGUWNVCPFRTGRCTGCUVCVGOGPV QHƂPCPEKCNRQUKVKQPCPFCUVCVGOGPVQHECUJƃQYUHQTVJGPGZV[GCTWUKPIVJGTGEQPEKNKCVKQPCRRTQCEJVQQRGTCVKPI ƃQYU5VCVGCNNQH[QWTCUUWORVKQPU&Q[QWVJKPMVJCVVJGNKSWKFKV[EQPEGTPUCTGLWUVKƂGF!9JCVUVGRUYQWNF[QW VCMGVQGPUWTGCRRTQRTKCVGNKSWKFKV[KUOCKPVCKPGFQTKORTQXGF!

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239

SUMMARY +PVJKUEJCRVGTYGJCXGCEJKGXGFVJGHQNNQYKPIQDLGEVKXGUKPVJGYC[UJQYP

OBJECTIVE

METHOD ACHIEVED

'ZRNCKPYJ[ECUJCPFECUJƃQYUCTGKORQTVCPV • 'ZRNCKPGFVJCVECUJKUVJGNKHGDNQQFQHDWUKPGUUCPFVJGOGFKWOD[YJKEJ VQVJGTGRQTVKPIGPVKV[ CUUGVUCTGCESWKTGFGZRGPUGUCTGOGVFGDVUCTGRCKFCPFQYPGTUTGEGKXG TGVWTPU 'ZRNCKPVJGPCVWTGRWTRQUGCPFNC[QWVQHVJG UVCVGOGPVQHECUJƃQYU

• +NNWUVTCVGFVJGV[RKECNNC[QWV • +FGPVKƂGFVJGOCKPEQORQPGPVUQHVJGUVCVGOGPVQHECUJƃQYUCU • QRGTCVKPICEVKXKVKGUtEQOOGTEKCNQTVTCFKPICEVKXKVKGU • KPXGUVKPICEVKXKVKGUtPQPEWTTGPVQTPQPVTCFKPICUUGVCESWKUKVKQPCPF FKURQUCN • ƂPCPEKPICEVKXKVKGUtPQPEWTTGPVƂPCPEKPIHTQOQYPGTUCPFNGPFGTU • 'ZRNCKPGFVJGRWTRQUGQHVJGUVCVGOGPVQHECUJƃQYU

2TGRCTGCUKORNGUVCVGOGPVQHECUJƃQYU

• +FGPVKƂGFVJGOCKPEQORQPGPVUNKUVGFCDQXGCPFYQTMGFVJTQWIJCPGZCORNG • #UMGFSWGUVKQPUCUVQYJCVVJGUVCVGOGPVCFFU

2TGRCTGCTGEQPEKNKCVKQPQHRTQƂVYKVJECUJƃQY • +FGPVKƂGFCPFYQTMGFVJTQWIJVJGPGEGUUCT[UVGRU HTQOQRGTCVKPICEVKXKVKGUCPFGZRNCKPJQY • &KUEWUUGFVJGCFXCPVCIGUVQFGEKUKQPOCMGTUQHVJGTGEQPEKNKCVKQPUVCVGOGPV WUGHWNVJKUKUKPFGEKUKQPOCMKPI +FGPVKH[UQOGQHVJGRQVGPVKCNEQORNGZKVKGUVJCV • +FGPVKƂGFCTCPIGQHEQORNGZKVKGU CTKUGYKVJUVCVGOGPVUQHECUJƃQYU • OQXGOGPVUKPPQPEWTTGPVCUUGVU • DQPWUUJCTGU • PQPECUJVTCPUCEVKQPU 'ZRNCKPYJCVVJGUVCVGOGPVVGNNUWUCPF KNNWUVTCVGJQYVJGUVCVGOGPVQHECUJƃQYUECP DGWUGHWNHQTKFGPVKH[KPIECUJƃQY OCPCIGOGPVUVTGPIVJUYGCMPGUUGUCPF QRRQTVWPKVKGUDQVJJKUVQTKECNN[CPFKP HQTGECUVKPICPFRNCPPKPI

• #PCN[UGFVJGOCKPWUGUQHVJGUVCVGOGPVQHECUJƃQYU • +FGPVKƂGFQRGTCVKPIECUJƃQYUYJKEJUJQWNFDGRQUKVKXG • +FGPVKƂGFOCKPKPXGUVKPICEVKXKVKGUYJKEJCTGPQTOCNN[PGICVKXG • #UUGUUGFƂPCPEKPICEVKXKVKGUYJKEJUJQWNFDGDCNCPEGFQXGTVKOG • +FGPVKƂGFCPFQDUGTXGFEJCPIKPIRCVVGTPUQHECUJƃQYU • 4GXKGYGFTGEQPEKNKCVKQPHQTGHƂEKGPVWUGQHYQTMKPIECRKVCN • +NNWUVTCVGFVJTQWIJCUGNHCUUGUUOGPVSWGUVKQPJQYWUGQHCHQTGECUV UVCVGOGPVQHECUJƃQYUECPCUUKUVKPRNCPPKPI

DISCUSSION QUESTIONS EASY 6.1

LO1

6JGUVCVGOGPVQHECUJƃQYUKUUKOKNCTVQVJGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEGKPYJCVDCUKE TGURGEV!*QYKUKVFKHHGTGPV!

6.2

LO2

9JCVKUVJGECUJƃQYUVCVGOGPVGSWKXCNGPVVQVJGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEGnDQVVQONKPGo!

6.3

LO3

+FGPVKH[VJGVJTGGECVGIQTKGUQHVJGUQWTEGU WUGUQHECUJWUGFKPVJGUVCVGOGPVQHECUJƃQYU

6.4

LO1

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6.5

LO4

&QGUVJGTGEQPEKNKCVKQPQHRTQƂVVQECUJƃQYHTQOQRGTCVKQPURTQXGVJCVVJGUVCVGOGPVQHECUJƃQYU JCUDGGPRTGRCTGFEQTTGEVN[!

6.6

LO5

+PCEEQTFCPEGYKVJ#WUVTCNKCP#EEQWPVKPI5VCPFCTFU[QWJCXGTGXCNWGF[QWTNCPFCPFDWKNFKPIU WRYCTFUD[9JGTGFQGUVJKUTGXCNWCVKQPUJQYQPVJGUVCVGOGPVQHECUJƃQYU!

6.7

LO6

9JCVKPHQTOCVKQPFQGUVJGECUJƃQYUVCVGOGPVRTQXKFGVJCVKUPQVCXCKNCDNGHTQOVJGUVCVGOGPVQH ƂPCPEKCNRQUKVKQPQTVJGUVCVGOGPVQHƂPCPEKCNRGTHQTOCPEG!

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INTERMEDIATE 6.8

LO1

'ZRNCKPJQYVJGHQNNQYKPICEEQWPVUEQWNFEJCPIGCUKPFKECVGFYKVJQWVCECUJƃQYEQPUGSWGPEG

C CPKPETGCUGKPVJGNCPFCEEQWPV

D CPKPETGCUGKPUJCTGECRKVCN KUUWGF

E CFGETGCUGKPVJGNQPIVGTONKCDKNKVKGU

F CFGETGCUGKPKPXGPVQT[

G CFGETGCUGKPCEEQWPVUTGEGKXCDNG

6.9

LO1

#UCƂTUV[GCTCEEQWPVKPIUVWFGPV+TGPGKUEQPHWUGF5JGVJQWIJVUJGYCUNGCTPKPIVJCVCEETWCN CEEQWPVKPIRTQXKFGFOQTGWUGHWNKPHQTOCVKQPCDQWVVJGƂPCPEKCNRGTHQTOCPEGCPFRQUKVKQPQHCP QTICPKUCVKQPVJCPVJGUVCVGOGPVQHECUJƃQYU6JGUVCVGOGPVQHECUJƃQYUKUCUVGRKPVJGYTQPI FKTGEVKQPKPJGTQRKPKQP*GNR+TGPGYKVJJGTFKNGOOC

6.10 LO2

*QYFQGUVJGCEEQWPVCPVFGEKFGYJGVJGTVQENCUUKH[CPKPVGTGUVRC[OGPVQTTGEGKRVCUCPQRGTCVKPI CEVKXKV[!

6.11 LO4

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C 'ZRNCKPVJGFKHHGTGPEGDGVYGGPVJGVYQOGVJQFU

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E 9JKEJOGVJQFKURTGHGTCDNG!9J[!

6.12 LO5

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6.13 LO6

*QYFQRTQLGEVGFƂPCPEKCNUVCVGOGPVUCUUKUVKPVJGFGEKUKQPOCMKPIRNCPPKPICPFEQPVTQNRTQEGUUGU!

6.14 LO3

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CHALLENGING 6.15 LO4

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6.16 LO4/6

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6.17 LO6

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6.18 LO1/6

+H[QWYGTGLWUVUVCTVKPI[QWTQYPDWUKPGUUYJCVUVGRUOKIJV[QWVCMGVQOKPKOKUGVJGRQUUKDKNKV[QH HCKNWTGVJTQWIJQXGTVTCFKPI!

6.19 LO1/6

#HVGTTGCFKPI4GCN9QTNFYJCVMKPFQHKPHQTOCVKQPCDQWVECUJCPFECUJƃQYUYQWNF[QWTGSWKTG HQT[QWTQYPDWUKPGUU!*QYHTGSWGPVN[YQWNF[QWYKUJVJKUKPHQTOCVKQPVQDGCXCKNCDNG!

6.20 LO2

5GG4GCN9QTNF9J[FQ[QWVJKPMVJCVDQVJ$2CPF9GUHCTOGTUEQPUKFGTQRGTCVKPIECUJƃQYCU CMG[ƂPCPEKCNKPFKECVQT!

APPLICATION EXERCISES EASY 6.1

LO1

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CHAPTER 6 MEASURING AND REPORTING CASH FLOWS

6.8

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ACCOUNTING FOR NON-SPECIALISTS

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CHAPTER 6 MEASURING AND REPORTING CASH FLOWS

6.13 LO3

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(8,500) (3,400) (27,800)

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ACCOUNTING FOR NON-SPECIALISTS

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NU BOLD LTD Statement of financial position as at 31 December 2016 and 2017

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2017 $m 153 (76) 77 (48) – 29 – 29 (4) 25 (6) 19 56 75 (18) 57

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HI VIEW LTD Statement of financial position at 31 December 2016 and 2017

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CHAPTER 6 CASE STUDY The management of Enviro Ltd is planning a fairly significant expansion policy for the forthcoming year (2018). You have been asked to look at the financial implications of its plans. You have asked for a clear identification of the underlying assumptions and estimates, and these are given below.

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

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

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

Financial structure of the company Share capital amounts to $10 million at the end of 2017, with reserves amounting to $2.5 million. Care has been taken with regard to working capital management, and the business plans to maintain its working capital in the following proportions both through 2017 and 2018: Inventory Accounts receivable Cash Accounts payable

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

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

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

QUESTIONS 1

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

2

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

3

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

4

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

5

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

6

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

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CHAPTER 7

CORPORATE SOCIAL RESPONSIBILITY AND SUSTAINABILITY ACCOUNTING LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

L01 Outline and discuss a range of social and environmental issues, and the way in which accounting can contribute

L02 Explain what is meant by corporate social responsibility and the Ceres Principles

L03 Outline the major studies that have occurred on accounting for corporate social responsibilities

L04 Explain triple bottom line reporting L05 Outline the Global Reporting Initiative, and discuss its main framework in broad terms and its linkage with ideas of integrated accounting

L06 Explain the balanced scorecard approach and its advantages.

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SOCIAL ISSUES IN ACCOUNTING LO1 Outline and discuss a range of social and environmental issues, and the way in which accounting can contribute

General background In Chapter 1, we identified a range of groups that use accounting information. These included owners and managers, plus a variety of others, such as employees, community groups, governments and other interest groups. Over many years, accounting has moved its focus from stewardship to decision-usefulness. In more recent years, the idea of decision-usefulness has broadened considerably, with much more emphasis on providing information that is useful to a wider range of interested parties. Of particular significance is the far greater interest and involvement in issues that go beyond the confines of a particular business and affect society at large. Examples include working conditions and prospects for employees, the impact of pollution on the environment, and the use of energy. Ever since the Industrial Revolution, there have been conflicts between entrepreneurs and the broader society. Books such as Richard Llewellyn’s How Green Was My Valley, a story set in South Wales in the late 19th and early 20th centuries, depicts unashamed greed and excessive use of economic power and wealth, and the appalling working and living conditions of employees (encompassing health and safety and environmental issues). In this book, the valley became a huge slag heap, one of many which affected (and still affects) life in the valleys of South Wales. As wealth and power become more widespread, so perspectives change, and accounting information has slowly adapted to these changes. The stakeholder concept provides a useful framework to explain the broadening of needs.

Stakeholder concept The notions of stewardship accounting and decision-usefulness for owners and managers were the driving forces of accounting until the past 20 or so years. This meant that accounting focused mainly on providing information that enabled owners to make money. The stakeholder concept, on the other hand, recognises that other interested parties also have a legitimate interest or stake in the business. Chapter 1 identified the following user groups:

• • • • • • • • • •

owners/shareholders managers employees and their representatives customers government lenders suppliers investment analysts competitors, and community representatives.

Some of these user groups have clear and undeniable stakes. For example, many employees have a big stake in the business, its profitability, its attitude to things such as health and safety, and its long-term success. This is particularly true if the business employs a large part of a town or city’s workforce. Others have legitimate interests in relatively small parts of the business. Clearly, not all of these groups have equal, or even similar, interests, and there may well be different opinions over the idea that competitors have any legitimate interests. The importance of the particular business to the various groups of stakeholders might differ considerably, and might change over time for a particular stakeholder group, but generally the stakeholder concept is useful. Additions to the list might include potential customers, socially oriented action groups, including environmentalists and other pressure groups. Businesses ignore the views and needs of these groups at their peril. Even if we assume that the underlying objective of businesses is still wealth enhancement, businesses must be very conscious

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of stakeholders’ views and the possible impact on their future if they ignore them. An early example was the boycott on tuna products instigated by the Dolphin Coalition. This was directed against an industry-wide fishing practice that netted and killed large numbers of dolphins. Changes were made to the fishing practice and cans of tuna were labelled ‘dolphin safe’. Health issues raised over the past few years have also led to pressure from interested groups and considerable changes in products, and in their labelling and packaging. However, the major issues confronting us all are climate change and global warming. Sales of large cars, for example, have slumped, and the use of hybrids or more eco-friendly/fuel-efficient/electric vehicles has grown. Real World 7.1 provides a recent example of how public and consumer interests can impact on business.

REAL WORLD 7.1 The milk wars In January 2011 Coles cut the milk price to $1 a litre for some home-brand lines as part of its ‘down, down, prices are down’ campaign. Concerns were expressed that Coles and Woolworths, as well as competing against each other, were trying to wipe out smaller convenience stores and apply the blowtorch to other leading chains such as Aldi, Franklins and Costco. Nervous farmers were quick to express their concerns about their margins, noting that even Woolworths admitted that low prices, not seen since 1992, were unsustainable. Several years on, in 2016, Murray Goulbourn and Fonterra, two of the largest milk buyers, dropped the price from $5.60 per kilogram of milk solids to between $4.75 and $5. The impact on farmers’ incomes was dramatic, with many deciding to get out of the industry. There was an increase in depression and suicide amongst farmers. A campaign resulted, encouraging consumers to buy branded (i.e. more expensive) milk in order to preserve the industry. This was successful and resulted in stocks of branded milk running out; it was thought that this was the result of the policies of the two main supermarkets not to stock branded milks. Coles and Woolworths denied this. Coles said that they wanted to help dairy farmers and so were launching a new milk brand that would deliver an extra 20 cents per litre to a fund to help support dairy farmers in Victoria, New South Wales and Tasmania. This was viewed by farmers with real cynicism. Council of Small Business of Australia CEO Peter Strong questioned the move, telling the ABC that it was low supermarket prices that had effectively ‘destroyed’ the industry. The actions of the two major supermarkets led to them facing a PR nightmare.

The situation for Murray Goulburn was probably worse. Not only did Murray Goulburn drop the price, but it backdated it, so that farmers had to pay back large sums over time. Questions were raised as to whether Murray Goulburn knew for many months that the milk price was unsustainable, and never told the farmers, who went on with their business as normal. Remember that Murray Goulburn is a cooperative, though it went to the market for external funds in 2015, and farmers felt badly let down. Many believed that investors had been given a higher priority than farmers, even though the interest of farmers was the reason Murray Goulburn was established. The Managing Director resigned, and in August 2016 Murray Goulburn was the sole topic for a Four Corners episode. Anyone who doubts the bad feeling in the industry should read ‘The dairy disaster and Murray Goulbourn’, an article written just aer the 2016 results for Murray Goulburn were published. Sources: Waleed Aly, ‘Dairy farmers being milked dry’, The New Daily,17 May 2016, Charis Chang, ‘Shoppers furious over milk shortage’, news.com.au, 25 May 2016, . UNSW Business School, ‘Milking the market: what’s behind the Coles Woolworths price war’, Business Think, 29 March 2011, . John Crosby, ‘The dairy disaster and Murray Goulburn’, Stock & Land, September 2016, .

Probably the main effect the various stakeholder groups have had are:

• greater emphasis on social responsibility • greater understanding that the direct costs of the actions of a particular business can represent only a small part of the total costs, with the rest being borne by the community at large—this has highlighted environmental or ‘green’ issues

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• recognition that the workforce and its quality are major contributors to the success (or failure) •

of a business, and recognition that climate change is a human-made phenomenon and that we must take steps to cut emissions and do whatever is necessary to deal with this issue.

This has led to the development of corporate social reporting, environmental accounting (really a subset of corporate social reporting), triple bottom line reporting and reporting for sustainability.

What is social responsibility? As pointed out earlier, many businesses and business people have been criticised for their lack of social responsibility. Real World 7.2 provides some examples.

REAL WORLD 7.2 Social responsibility issues James Hardie has been severely criticised over the years for its apparent lack of support for those of its employees who became ill due to exposure to asbestos, a product made by the company. The pressure eventually led to an agreement being reached which provided compensation to the victims. There is little doubt, however, that a stigma remains associated with the company, which may take many years to be forgotten. The same is true of BP aer the major Deepwater Horizon oil disaster in the Caribbean that occurred in 2010. The issues of safety and the adequacy of safety precautions are particularly important in situations of this type. The consequences of such failures can be very far-reaching, affecting many other businesses, thousands of people, and the wildlife and ecology of a vast area. It should be recognised, however, that for many years BP had been seen as a leader in the general arena of sustainability and a standout among oil companies. The costs of a disaster of this type are enormous, and the downside risks of getting something like this wrong are huge.

More recently, the big banks have come under scrutiny. ANZ and Westpac have both been accused of rigging market benchmarks. CommInsure bribery allegations led to the resignation of the head of the ASX. Australian Securities and Investments Commission Chairman Greg Medcra recently put on notice banks’ senior executives to ‘ensure that efforts to improve culture and conduct do not become “white noise” for staff below them’ (Bennet). This was in the context of a study that was critical of ethical standards in the banks. He referred to the allegation relating to the rigging of the bank swap rate as ‘like polluting the water system’. He felt that ‘management and boards’ views on culture may be too rosy’. More generally, a survey of 1,000 people in May and June 2016 showed that most respondents saw senior administrators in business as unethical. Of course, this reaction is based on perception, but even if the reality is different, much work clearly needs to be done. Source: Michael Bennet, ‘Banks told to raise the bar on culture’, The Australian, 21 July 2016.

By and large, social responsibility is defined in a fairly broad manner. There is a growing expectation that a business will consider how its actions affect society at large, especially when pollution, health and safety issues, and job creation or destruction are involved. Of course, sometimes one objective conflicts with another. For example, it can be argued that coal-fired power stations pollute more than nuclear-powered stations do, but nuclear power brings its own dilemmas, many of which are reinforced by the problems associated with the nuclear industry in Japan following the earthquake and tsunami in 2011. Also, it is often the case that areas with huge coal deposits tend to have most of the power stations. One such area is the La Trobe Valley, in Gippsland, which has vast areas of brown coal, and is capable of producing cheap power for a considerable time into the future. However, the power stations in the valley are among the highest polluting stations in the country. Yet they are also the biggest employers in the area. To close the stations down quickly without taking steps to set up alternative job opportunities has the potential to consign the area to recession and depression.

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Being socially responsible involves setting policies and practices that will ensure that an entity (business or other organisation) acts as a good citizen, and that each particular entity must consider the social costs and benefits that result from its actions. This view is not, however, shared by all. The objective of shareholder wealth enhancement can be interpreted in a way that totally ignores any social costs that do not directly affect business returns—‘it’s okay as long as you can get away with it’. How does a business justify, in financial terms, to its shareholders the choice of a more expensive production process that will yield lower pollution levels but also lower profits? If a competitor goes down the lower-cost, higher-pollution route, it will probably be able to sell at a lower price and threaten that competitor’s position. There are clearly some inherent conflicts in this area.

ACTIVITY 7.1 (a) (b) (c)

Can you think of a town, city or region where prosperity and/or employment is, or has been, dependent on one employer? Can you think of businesses that seem to have behaved in a way that you do not regard as socially responsible? What are the reasons for your belief? Can you think of reasons why a business might still pursue activities that are less profitable but socially beneficial?

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

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

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

Concept check 1 Which of the following statements is false? A B

C D E

$WUKPGUUVQFC[ECPPQVUQNGN[HQEWUQPYGCNVJOCZKOKUCVKQP 5QEKCNCPFGPXKTQPOGPVCNKUUWGUUJQWNFDGIKXGPUGTKQWUEQPUKFGTCVKQPD[ VQFC[oUDWUKPGUUGU 6QFC[oUDWUKPGUUOCPCIGTUOWUVEQPUKFGTCOWEJDTQCFGTTCPIGQHKUUWGUVJCPKPVJGRCUV $WUKPGUUGUVQFC[WPCPKOQWUN[CEEGRVUWUVCKPCDKNKV[CUVJGKTRTKOCT[IQCN #NNQHVJGCDQXGCTGVTWG

Concept check 2 Which of the following statements is true? A B C D E

5QOGUVCMGJQNFGTUJCXGNGIKVKOCVGKPVGTGUVUKPCNNRCTVUQHCDWUKPGUU 5QOGUVCMGJQNFGTUJCXGNGIKVKOCVGKPVGTGUVUKPQPN[CEGTVCKPRCTVQHCDWUKPGUU 'PXKTQPOGPVCNKUVUCTGUGGPCUCTGNCVKXGN[PGYUVCMGJQNFGTKPDWUKPGUU 2QVGPVKCNEWUVQOGTUUJQWNFDGEQPUKFGTGFCUUVCMGJQNFGTU #NNQHVJGCDQXG

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

LO2 Explain what is meant by corporate social responsibility and the Ceres Principles

corporate social responsibility How companies manage the business process to produce an overall positive impact on society.

1YPGTUUJCTGJQNFGTUCPFOCPCIGTU 'ORNQ[GGUCPFEWUVQOGTU )QXGTPOGPVNGPFGTUCPFUWRRNKGTU +PXGUVOGPVCPCN[UVU #NNQHVJGCDQXG

CORPORATE SOCIAL RESPONSIBILITY (CSR)— WHAT DOES IT MEAN? While definitions can vary slightly, the following definition provides a useful starting point: CSR is about how companies manage the business processes to produce an overall positive impact on society. This definition is from Mallen Baker, and can be found at . (Mallen Baker Respectful Business blog. Reproduced with permission of Mallen Baker.) This website provides interesting insights into the whole area of corporate social responsibility and is recommended reading. This frequently updated site is issues-based, has an international focus, and is a potential agent for change. Mallen Baker goes on to say that companies need to consider two aspects of their operations: 1 the quality of their management—both in terms of people and practices 2 the nature and quantity of their impact on society in the various areas.

He argues that outside stakeholders are taking a far greater interest in companies’ activities—for instance, what they have done, good or bad, in terms of their products and services, in terms of their impact on the environment and local communities, and in their treatment and development of their workforce. The World Business Council for Sustainable Development defined CSR as follows: ‘Corporate Social Responsibility is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society at large’ (Holme & Watts, 2000, p. 8). This approach tends to be associated with capacity-building for sustainable livelihoods, respect for different cultures, and skill development. Mallen Baker has argued that definitions of this sort are much more inclusive than the typical approach found in the United States, where CSR is defined more in terms of a philanthropic model. In Europe, the emphasis seems to be more on operating in a socially responsible way, while still investing in communities for solid business reasons. This latter approach is probably more sustainable, in that it:

• inextricably links social responsibility with wealth creation • is likely to continue when times are hard, whereas philanthropy is likely to be the first to go.

Ceres Principles A set of principles which is effectively a 10-point code of environmental conduct.

There is little doubt that people will continue to put pressure on businesses to play a role in social issues. This is particularly true for transnational companies, such as BP and BHP Billiton, which are economic giants with more economic power than many nation states. An early example of this pressure came from the Coalition for Environmentally Responsible Economies(Ceres) (set up in 1989 immediately after the Exxon Valdez disaster in Alaska), a USbased coalition of environmental, investor and advocacy groups working together for a sustainable future, with a mission to move businesses, capital and markets to advance lasting prosperity by valuing the health of the planet and its people (see ). The aim is to find solutions to today’s environmental challenges. In 1989 Ceres developed a set of principles, which is effectively a 10-point code of environmental conduct. The Ceres Principles cover the areas set out in Table 7.1.

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TABLE 7.1 THE CERES PRINCIPLES 1) Protection of the Biosphere 9GYKNNTGFWEGCPFOCMGEQPVKPWCNRTQITGUUVQYCTFUGNKOKPCVKPIVJGTGNGCUGQHCP[UWDUVCPEGVJCVOC[ECWUGGPXKTQPOGPVCNFCOCIGVQ VJGCKTYCVGTQTVJGGCTVJQTKVUKPJCDKVCPVU9GYKNNUCHGIWCTFCNNJCDKVCVUCHHGEVGFD[QWTQRGTCVKQPUCPFYKNNRTQVGEVQRGPURCEGUCPF YKNFGTPGUUYJKNGRTGUGTXKPIDKQFKXGTUKV[ 2) Sustainable Use of Natural Resources 9GYKNNOCMGUWUVCKPCDNGWUGQHTGPGYCDNGPCVWTCNTGUQWTEGUUWEJCUYCVGTUQKNUCPFHQTGUV9GYKNNEQPUGTXGPQPTGPGYCDNGPCVWTCN TGUQWTEGUVJTQWIJGHƂEKGPVWUGCPFECTGHWNRNCPPKPI 3) Reduction and Disposal of Wastes 9GYKNNTGFWEGCPFYJGTGRQUUKDNGGNKOKPCVGYCUVGVJTQWIJUQWTEGTGFWEVKQPCPFTGE[ENKPI#NNYCUVGYKNNDGJCPFNGFCPFFKURQUGFQH VJTQWIJUCHGCPFTGURQPUKDNGOGVJQFU 4) Energy Conservation 9GYKNNEQPUGTXGGPGTI[CPFKORTQXGVJGGPGTI[GHƂEKGPE[QHQWTKPVGTPCNQRGTCVKQPUCPFQHVJGIQQFUCPFUGTXKEGUYGUGNN9GYKNNOCMG GXGT[GHHQTVVQWUGGPXKTQPOGPVCNN[UCHGCPFUWUVCKPCDNGGPGTI[UQWTEGU 5) Risk Reduction 9GYKNNUVTKXGVQOKPKOK\GVJGGPXKTQPOGPVCNJGCNVJCPFUCHGV[TKUMUVQQWTGORNQ[GGUCPFVJGEQOOWPKVKGUKPYJKEJYGQRGTCVGVJTQWIJ UCHGVGEJPQNQIKGUHCEKNKVKGUCPFQRGTCVKPIRTQEGFWTGUCPFD[DGKPIRTGRCTGFHQTGOGTIGPEKGU 6) Safe Products and Services 9GYKNNTGFWEGCPFYJGTGRQUUKDNGGNKOKPCVGVJGWUGOCPWHCEVWTGQTUCNGQHRTQFWEVUCPFUGTXKEGUVJCVECWUGGPXKTQPOGPVCNFCOCIGQT JGCNVJQTUCHGV[JC\CTFU9GYKNNKPHQTOQWTEWUVQOGTUQHVJGGPXKTQPOGPVCNKORCEVUQHQWTRTQFWEVUQTUGTXKEGUCPFVT[VQEQTTGEV WPUCHGWUG 7) Environmental Restoration 9GYKNNRTQORVN[CPFTGURQPUKDN[EQTTGEVEQPFKVKQPUYGJCXGECWUGFVJCVGPFCPIGTJGCNVJUCHGV[QTVJGGPXKTQPOGPV6QVJGGZVGPV HGCUKDNGYGYKNNTGFTGUUKPLWTKGUYGJCXGECWUGFVQRGTUQPUQTFCOCIGYGJCXGECWUGFVQVJGGPXKTQPOGPVCPFYKNNTGUVQTGVJG GPXKTQPOGPV 8) Informing the Public 9GYKNNKPHQTOKPCVKOGN[OCPPGTGXGT[QPGYJQOC[DGCHHGEVGFD[EQPFKVKQPUECWUGFD[QWTEQORCP[VJCVOKIJVGPFCPIGTJGCNVJ UCHGV[QTVJGGPXKTQPOGPV9GYKNNTGIWNCTN[UGGMCFXKEGCPFEQWPUGNVJTQWIJFKCNQIWGYKVJRGTUQPUKPEQOOWPKVKGUPGCTQWTHCEKNKVKGU 9GYKNNPQVVCMGCP[CEVKQPCICKPUVGORNQ[GGUHQTTGRQTVKPIFCPIGTQWUKPEKFGPVUQTEQPFKVKQPUVQOCPCIGOGPVQTVQCRRTQRTKCVG CWVJQTKVKGU 9) Management Commitment 9GYKNNKORNGOGPVVJGUGRTKPEKRNGUCPFUWUVCKPCRTQEGUUVJCVGPUWTGUVJCVVJG$QCTFQH&KTGEVQTUCPF%JKGH'ZGEWVKXG1HƂEGTCTGHWNN[ KPHQTOGFCDQWVRGTVKPGPVGPXKTQPOGPVCNKUUWGUCPFCTGHWNN[TGURQPUKDNGHQTGPXKTQPOGPVCNRQNKE[+PUGNGEVKPIQWT$QCTFQH&KTGEVQTUYG YKNNEQPUKFGTFGOQPUVTCVGFGPXKTQPOGPVCNEQOOKVOGPVCUCHCEVQT 10) Audits and Reports 9GYKNNEQPFWEVCPCPPWCNUGNHGXCNWCVKQPQHQWTRTQITGUUKPKORNGOGPVKPIVJGUG2TKPEKRNGU9GYKNNUWRRQTVVJGVKOGN[ETGCVKQPQH IGPGTCNN[CEEGRVGFGPXKTQPOGPVCNCWFKVRTQEGFWTGU9GYKNNCPPWCNN[EQORNGVGVJG%GTGU4GRQTVYJKEJYKNNDGOCFGCXCKNCDNGVQVJG RWDNKE Source:n6JG%GTGU2TKPEKRNGUoCeres, 2010, , reproduced with permission.

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The main work carried out by Ceres in recent years covers:

• Issues relating to climate change, including investment in clean energy, carbon asset risk, the Global Reporting Initiative (GRI) A multi-stakeholder institution whose mission is to develop and disseminate globally applicable Sustainability Reporting Guidelines. sustainability reporting A system of reporting that attempts to report on key issues that impact on environmental and social sustainability.

•

•

environmental, social and economic risks of the energy sources we use to power our economy, water, and supply chains. Corporate environmental reporting. As part of this work, Ceres launched the Global Reporting Initiative (GRI). The Sustainability Reporting Guidelines prepared by the GRI are among the world’s most widely accepted standards for corporate sustainability reporting. We will return to them later. In 2010, Ceres released a roadmap for sustainability, which was effectively updated in 2013 in a further report entitled The 21st Century Investor: Ceres Blueprint for Sustainable Investing. The 21st century economy will be shaped by powerful forces such as climate change, population growth, rising demand for energy, declining supplies of fresh water and other natural resources, and protection of human rights and worker health and safety.

The Ceres Principles might seem to represent one end of a fairly wide spectrum, and not all agree with them. Typical arguments that might be used against corporate social responsibility include the following:

• Businesses are owned by the shareholders—any money they choose to spend on so-called • • •

social responsibility reduces the amount available to them. Shareholders can choose for themselves whether or not to be philanthropic. Many companies don’t have time for this—they are too busy running their main business activity. It’s not the responsibility of individual businesses: it is up to politicians and governments. Corporations do not really care about CSR.

Of course, some of these arguments against CSR are not strong, and many are based on an incomplete understanding of CSR. For example, it can be argued that an emphasis on philanthropy as an appropriate reaction to CSR illustrates a complete misunderstanding of CSR and, indeed, of the nature of business. If business is about building a relationship with a range of stakeholders, the case for a broader approach to CSR is clear. Arguments about ‘not having time’ also fail. If you don’t have time to look at the wider issues, you may be missing opportunities and (possibly more important in this context) overlooking threats. When the role is largely political or governmentbased, problems arise when a business presumes that issues are being dealt with when they are not, and when it realises that it has not kept its eye on the ball. In some cases, given the size and nature of the industry and associated companies, better progress will be achieved by full involvement with the main corporate players than with national governments. Many companies spend a lot of time and money on activities that shape public policy, for good or evil. It is significant that quite a number of the most respected companies are respected because of their role in CSR.

ACTIVITY 7.2 Identify several companies that are currently in the news and what makes them newsworthy. What kind of CSR issues emerge? (You might find the Mallen Baker website useful and interesting.)

The whole area of corporate social responsibility is particularly challenging. Although a company must not ignore its responsibilities, there is no clear checklist to determine these. The public view is continually changing, as shown in Real World 7.3. Just how shareholders may see the balance between profitability and corporate social responsibility remains unclear, but the attitudes revealed by the first section of Real World 7.3 probably represent a significant shift over the previous 20 years or so. The Ceres Principles might appear to be optimistic, but the changes in attitude emerging from the developed world all seem to indicate a greater acceptance of social responsibility. The second part of Real World 7.3 provides guidance on the growth in responsible investing.

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REAL WORLD 7.3 Putting trust in ethical companies The Australian Crosby Textor Shareholder Jury was the first major public qualitative research done on the views of Australia’s growing number of retail shareholders. The survey found that concern about the environment and other issues of corporate social responsibility are important to retail investors looking for companies they can trust. However, these issues cannot be used to offset poor performance. Corporate social responsibility is a minimum standard investors require before investing in a company. Investors expect it of business now and in the future, realising that unethical behaviour could eventually hurt the company. Companies must do the right thing by their staff, and for health, safety and the environment. However, the concern with profitability remains strong. Ultimately, investors need faith that the companies can deliver on their promises and that senior management is to be trusted. Source: Glenda Korpraal, ‘Putting trust in ethical companies’, The Weekend Australian, 4–5 August 2007.

Responsible investing in Australia Responsible investment is an approach to investing that aims to incorporate environmental, social and governance (ESG) factors into investment decisions, to better manage risk and generate sustainable long-term returns. Just exactly what

this means can sometimes be somewhat ambiguous, and care is needed in interpreting figures. The Responsible Investment Association Australasia, in its Responsible Investment Benchmark Report for 2015, found the following:

•

•

•

Total assets managed under responsible investment strategies grew to encompass 50% of Australian total assets under management, at $629.5 billion as at 31 December 2014. Investments managed under core responsible investment—those traditionally referred to as ethically or socially responsible investments—rose again by 24% to $31.6 billion. The previous year the increase had been 50%. Investments undertaking integration of environmental, social and governance— referred to as broad responsible investment—were assessed differently this year, and represent $597.9 billion, reflecting the strong take up of ESG integration by many of Australia’s largest asset managers.

Source: Responsible Investment Association Australasia, Responsible Investment: Benchmark Report 2015 Australia.

Concept check 4 %QTRQTCVGUQEKCNTGURQPUKDKNKV[ %54TGRQTVKPIGZVGPFUVJGVTCFKVKQPCNƂPCPEKCN reporting into new areas. Which of the following are CSR areas? A B C D E F

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Concept check 5 Which of the following statements about Corporate Social Responsibility (CSR) would you dispute? Why? A

B

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C

D E

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ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITIES LO3 Outline the major studies that have occurred on accounting for corporate social responsibilities

Australia has no accounting standards for social responsibility accounting. However, there has been a move towards voluntary disclosure, especially by large listed companies. Reasons for voluntary disclosure include the following:

• In making decisions that affect perceived social responsibilities, a business must be aware of •

•

the costs and benefits, at least in broad terms, before it can make informed decisions. There could be advantages in sharing such information. As mentioned earlier, companies may achieve a competitive advantage by appearing to act as a good, socially responsible corporate citizen deserving of support. Voluntary disclosure provides a means by which a good marketing and public relations team can put pressure on non-disclosing competitors. It highlights what the team is doing compared to what might or might not be being done by the non-disclosing competitor. Cultivation of the ‘green’ and ‘ethical’ consumer markets.

Voluntary reporting has grown considerably over time. In 1979, when Trotman surveyed the annual results of the 100 largest companies listed in Australia, 69 of them made disclosures about social responsibility. Most of these related to human resources (including health and safety, working conditions and training) and the environment (including pollution control, protecting and improving the environment, and recycling products). A few disclosures included community (e.g. philanthropy and opening facilities to the public), energy (e.g. reduction of energy consumption and use of waste resources) and products (making products safer and reducing pollution). Under the heading of ‘others’ came work experience programs and use of local suppliers. To summarise some later studies:

• Trotman and Bradley (1981) examined the characteristics of the companies that provided • •

•

information of a socially responsible nature. They found that such companies were larger and placed greater emphasis on the long term. Guthrie and Parker (1990) found that disclosure was greater in the United Kingdom and the United States than in Australia. They also found that no company provided ‘bad news’, suggesting a desire to counter any potential criticism. This was reinforced by Gray, Owen and Adams (1996), who summarised research in the United Kingdom and showed that the percentage of companies making voluntary and mandatory disclosures on the environment and energy had grown significantly between 1986 and 1991. Over 70% of UK companies had provided information about the environment by 1991 (pp. 173–4). Deegan and Gordon (1996) reviewed the 1991 accounts of 197 Australian companies. They discovered that disclosures had markedly increased during the period 1988–91, that they were more positive than negative, and that they were mainly qualitative. Disclosures seemed to reflect the general increase in public interest in several issues that were no longer the sole domain of fringe groups. The research tended to reinforce the idea that disclosures of this type had become part of the company’s public relations effort. It also provided a good range of examples of environmental disclosures, both positive and negative, including the following:

Positive

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• • • • • • • • • • •

267

control of pollution or waste in the manufacturing process maintenance or implementation of a strategy to protect the environment rehabilitation of mining sites implementation of tree-replanting schemes positive outcomes from government inquiries introduction of environmental audits recycling of materials use of environmentally safe products in manufacturing undertaking of environmental impact or assessment studies sponsoring or receiving environmental achievement awards, and evidence of public support/approval of the company’s environmental activities.

Negative

• company in conflict with government view of its environmental activities • company’s admission of causing environmental, including health-related, problems for residents through its activities

• explicit admission of excessive pollution emissions • government investigation into, and court action over, the company’s environmental activities, and • non-compliance with regulations.

ACTIVITY 7.3 (a) (b) (c) (d)

Why do you think that there has been a growth in voluntary reporting of social and environmental factors? What kind of issues have raised the interest of the stakeholders? What are the advantages to a business of reporting on these kind of issues? What are the disadvantages?

In recent years, attention has focused more closely on triple bottom line (TBL) reporting and the Global Reporting Initiative (GRI), both of which are dealt with in more detail below. It is also worth noting that under the new corporate governance guidelines discussed earlier (page 183), all publicly listed companies must address their companies’ exposure to economic, environmental and social sustainability risks. http://theconversation.com/new-asx-guidelines-to-force-sustainability-reporting-24885

Concept check 6 There have been a number of studies conducted around the world as to voluntary reporting practice. These studies have provided a good range of examples of environmental disclosures, both positive and negative. (QTGCEJKVGOKPVJGHQNNQYKPINKUVKPFKECVGYJGVJGTVJGKVGOKU CPositive

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TRIPLE BOTTOM LINE REPORTING LO4 Explain triple bottom line reporting

triple bottom line reporting A system of reporting which focuses on economic performance, environmental performance and social performance.

The problems identified above highlighted the need for a reporting framework that was more comprehensive than the traditional reporting framework; that is, a new form of disclosure to integrate financial, environmental and social reporting. Triple bottom line reporting emerged in the late 1990s. The phrase ‘triple bottom line’ was coined by John Elkington in his book Cannibals with Forks: The Triple Bottom Line of 21st Century Business (1997). The essence of triple bottom line reporting is sustainable development, which requires much greater collaboration between industry, government and society at large. In reporting on a particular entity (which might include business corporations, governments and local governments), we need to devise a reporting system that embraces sustainable development, or at least shows us how to move towards this ideal. Such a report would focus on three areas:

• economic prosperity • environmental quality • social justice. So far in this book we have tended to deal with things which can be measured. However, not everything in the triple bottom line agenda falls easily into this category. We need a set of performance indicators for these three elements. Companies generally aim to create wealth, primarily for their shareholders. Typically, they want to do this for the long term, so they should be interested in what has been described as ‘sustainable value creation’. This is likely to mean that companies should meet society’s need for goods and services without destroying natural or social capital. It has been argued that this approach increases the time over which performance should be measured. Basically, the triple bottom line focuses on three components which together give total value added:

• economic value added • environmental value added • social value added. Of course, the impact of some activities on the environment or society is often negative and seldom easily measured, as we have said before. The major challenge of triple bottom line reporting is not the production of each of the three parts but their integration. In spite of this, triple bottom line reporting has gained in support and sophistication. Many companies see obvious benefits in its use and development, such as:

• embedding good corporate governance and ethics systems, which can produce a values-driven, • • • • •

integrated culture better management of risk and resource allocation formalising and enhancing communication with key stakeholders attracting better staff better benchmarking, enhancing the scope for competitive advantage, and better access to financial markets.

A KPMG survey carried out in 2002 found that 45% of the world’s top 250 companies produced a separate corporate report with details of social and environmental performance, an increase from 35% in 1999. There were substantial differences by country, with Japan having the largest proportion at 72%. Australia was ranked 12th at 14%. At about the same time, PricewaterhouseCoopers collected historical data to examine the nature, extent and quality of triple bottom line performance reporting by 40 of Australia’s largest listed companies. The report suggested the following:

• The triple bottom line is very important to some companies. • There is greater emphasis on the social bottom line than the environmental bottom line. • Companies report high levels of favourable news.

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The report questioned whether the motivation for reporting was to influence market perceptions regarding quality of management, and its ability to create innovative solutions and resolve conflicts between economic, environmental and social considerations. In June 2003, the Australian Department of Environment and Heritage published ‘Triple bottom line reporting in Australia: a guide to reporting against environmental indicators’. This linked with the Global Reporting Initiative. You should note that triple bottom line reporting has not been limited to companies. For example, Maroochy Shire Council prepared triple bottom line reports for some time, with sections covering a financial report card, an environmental report card and a social report card. The council was subsequently merged with other councils to form the Sunshine Coast Regional Council. For many years the council has maintained a commitment to reporting of this type. The council sets out a clear vision: ‘To be Australia’s most sustainable region—vibrant, green, diverse’. In the 2014–15 annual report, the council’s purpose is identified as ‘to serve the community well and position the region for the future’. Corporate goals for the period 2014– 2019 are identified as:

• • • • •

A new economy A strong community An enviable lifestyle and environment Service excellence A public sector leader.

The report then highlights a range of outcomes relating to each of these goals. It is interesting to map the development of the report (and presumably the underlying thinking of the council). The approach appears to have developed through financial reporting to triple bottom line reporting to an approach where these elements seem to be dealt with in a completely integrated way. The council’s annual report makes for interesting reading. The next section, on the Global Reporting Initiative, takes the concept of triple bottom line reporting into a new phase. Triple bottom line reporting seems likely to be absorbed as part of the move to full-scale sustainability reporting.

Concept check 7 Which of these statements do you think is false? 6JGGUUGPEGQHVTKRNGDQVVQONKPGTGRQTVKPIKUUWUVCKPCDNGFGXGNQROGPVYJKEJ TGSWKTGUOWEJITGCVGTEQNNCDQTCVKQPDGVYGGPKPFWUVT[IQXGTPOGPVCPFUQEKGV[ CVNCTIG 0QVGXGT[VJKPIKPVJGVTKRNGDQVVQONKPGCIGPFCECPDGOGCUWTGFGCUKN[ 6JGVTKRNGDQVVQONKPGTGRQTVHQEWUGUQPGEQPQOKERTQURGTKV[GPXKTQPOGPVCNSWCNKV[CPF UQEKCNLWUVKEG %QORCPKGUUJQWNFOGGVUQEKGV[oUPGGFHQTIQQFUCPFUGTXKEGUYKVJQWVFGUVTQ[KPIPCVWTCN QTUQEKCNECRKVCN 0QPGCTGHCNUG6JG[CTGCNNVTWG

A

B C

D

E

ACTIVITY 7.4 (a) (b) (c)

What are the three components of a triple bottom line report? What benefits might accrue to a business by use of triple bottom line reporting? What do you see as the possible motives for using triple bottom line reporting?

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THE GLOBAL REPORTING INITIATIVE (GRI) LO5 Outline the Global Reporting Initiative, and discuss its main framework in broad terms and its linkage with ideas of integrated accounting

General background The Global Reporting Initiative (GRI) (see ) is ‘an international, independent organisation that helps businesses, governments and other organisations understand and communicate the impact of business on critical sustainability issues such as climate change, human rights, corruption and many others’. It has been a leader in the development of detailed guidelines for sustainability reporting (and development), culminating in the issuing of the first recognised standards for sustainability reporting, in October 2016. As the approach using guidelines has changed to one using standards, there have been some changes to the mission and vision of the GRI. These are identified later in this section. The next section outlines the history and development of the GRI and its guidelines, and this is followed by a section on the new standards. It is interesting to note that, as new guidelines and now standards have been introduced, there has been a tendency for the documents to become more technical with less concentration on the principles underlying the guidelines. For this reason the next section will spend some time discussing an earlier set of guidelines (G3), which has a good balance between principles and practice, thus providing an excellent starting point for those readers new to the topic. You should note that all we can do in a book of this type is to make you aware of the key issues relating to sustainability reporting, and give you a broad understanding of the approach used by the GRI. At a later stage in your studies and career, there is little doubt that you will need to confront these issues, either as a manager, trying to balance the various components of a difficult decision, or as an accountant, seeking to measure the various aspects of the areas covered by the sustainability standards.

Background and development of the GRI Guidelines GRI promotes the use of sustainability reporting as a way for organisations to become more sustainable and contribute to a sustainable global economy. GRI’s original mission was to make sustainability reporting standard practice. To enable all companies and organisations to report their economic, environmental, social and governance performance, GRI produced free Sustainability Reporting Guidelines. GRI is a not-for-profit, network-based organisation; its activity involves thousands of professionals and organisations from many sectors, constituencies and regions. Launched in 1997, the GRI issued its first guidelines in 2000, while still a department of Ceres. It became independent in 2002, in which year it released the second version of its Sustainability Reporting Guidelines, known as G2. In doing so, it recognised that developing a globally accepted reporting framework was a long-term endeavour. The GRI’s G2 Guidelines document was very comprehensive, and the trends it identified are listed below (pp. 1–3):

• expanding globalisation—with corporate activity remaining the driving force, but all parties • • • • • • • •

‘seeking new forms of accountability that credibly describe the consequences of business activities wherever, whenever and however they occur’ a search for new forms of global governance—a key theme is greater transparency reform of corporate governance—expecting higher standards of ethics, transparency, sensitivity and responsiveness the global role of emerging economies, particularly those of Brazil, India and South Africa rising visibility of, and expectations for, organisations the measurement of progress towards sustainable development—‘a need to align future goals with a complex range of external factors and partners’, and more urgency in ‘defining broadly accepted sustainability performance indicators’ governments’ interest in sustainability reporting financial markets’ interest in sustainability reporting emergence of next-generation accounting.

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The last section is particularly interesting as it pointed to the future directions of accounting and set them firmly in context: The late 20th century saw worldwide progress in harmonizing financial reporting. Indeed, the rich tradition of financial reporting, continually evolving to capture and communicate the financial condition of the organization, has inspired GRI’s evolution. Yet today, many observers, including accountants themselves, recognise that characterizing the ‘bricks and mortar’ economy of the past will not suffice as a basis for characterizing today’s information economy. Valuing intangible assets—human capital, environmental capital, alliances and partnerships, brand and reputation— must complement the valuation of conventional tangible assets—factories, equipment, and inventory. Under the rubric of ‘business reporting’, ‘intangible assets analysis’, and ‘value reporting’, a number of accounting groups have launched programmes to explore how accounting standards should be updated to enhance such value drivers. New concepts of risk, opportunity, and uncertainty are likely to emerge (p. 3). Subsequent versions have been developed, with version 3 (known as the G3 Guidelines) being introduced in 2006, and an update and completion of G3 (known as G3.1)being produced in March 2011. The expanded guidelines covered reporting on gender, community and human rights related performance. Both versions defined sustainability reporting as follows: Sustainability reporting is the practice of measuring, disclosing, and being accountable to internal and external stakeholders for organisational performance towards the goal of sustainable development. ‘Sustainability reporting’ is a broad term considered synonomous with others used to describe reporting on economic, environmental, and social impacts (e.g., triple bottom line, corporate responsibility reporting, etc.) (G3.1, p. 3). The G3 Guidelines considered that the goal of sustainable development was to ‘meet the needs of the present without compromising the ability of future generations to meet their own needs’ (G3.1, p. 2). Key issues identified in G3.1 (p. 2) include the following:

• Achieving this goal may seem more of an aspiration than a reality, with opportunities not • • • • • •

being evenly distributed. Many improvements in the quality of life for some people are counter-balanced by alarming information about the state of the environment and the continuing burden of poverty and hunger. Developments of technical knowledge and improvements have the potential to solve many current problems. These developments also have the potential to help resolve the risks and threats to sustainability. Organisations are increasingly challenged to make new choices in the way in which their activities impact the earth, people and economies. Transparency relating to economic, environmental and social impacts is seen as fundamental to achieving effective stakeholder relations, investment decisions and other market relations. Transparency about the sustainability of organisational activity is of interest to a wide range of stakeholders.

A globally shared framework was required, which was seen as being provided by the GRI. All of the above points remain valid. As we shall see next, G4, by focusing on these basic issues, aimed to improve the way in which these issues could be addressed in a practical way. In May 2013, G4 was introduced. G4 made the following observations. An ever-increasing number of companies and other organisations want to make their operations sustainable. Moreover, expectations that long-term profitability should go handin-hand with social justice and protecting the environment are gaining ground. These expectations are only set to increase and intensify as the need to move to a truly sustainable economy is understood by companies and organisational financiers, customers and other stakeholders. Sustainability reporting helps organisations to set goals, measure performance, and manage change in order to make their operations more sustainable. A sustainability report conveys disclosures on an organisation’s impacts—be they positive or negative—on the environment,

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society and the economy. In doing so, sustainability reporting makes abstract issues tangible and concrete, thereby assisting in understanding and managing the effects of sustainability developments on the organisation’s activities and strategy’ (G4, p. 3). G4 recognised that there had been strong growth in sustainability reporting, an increased interest in critical sustainability topics by report users, an increased need for harmonisation between systems, and an increased integration between financial and sustainability reporting. The objectives of G4 were identified as follows:

• • • • • •

to be user-friendly to improve technical quality to align with other international reporting references or frameworks to ensure coverage of material topics to offer guidance on how to link sustainability and integrated reporting (covered later), and to improve data access.

The following extracts from G4 provide an indication of the direction that G4 took. Internationally agreed disclosures and metrics enable information contained within sustainability reports to be made accessible and comparable, providing stakeholders with enhanced information to inform their decisions. In this context G4 was planned and developed. The GRI Sustainability Reporting Guidelines were periodically reviewed to provide the best and most up-to-date guidance for effective sustainability reporting. The aim of G4, the fourth such update, is simple: to help reporters prepare sustainability reports that matter, contain valuable information about the organisation’s most critical sustainability-related issues, and make such sustainability reporting standard practice (G4 Preface, p. 3). In essence, G4 moved firmly in the direction of standard ways of reporting, and provided encouragement that sustainability reporting could become standard practice for all businesses, whether large or small. In doing so, it would become a rather more technical and potentially more prescriptive approach in the future. The G4 Sustainability Reporting Guidelines… offer Reporting Principles, Standard Disclosures and an Implementation Manual for the preparation of sustainability reports by organisations, regardless of their size, sector or location. The guidelines also offer an international reference for all those interested in disclosure of governance approach and of the environmental, social and economic performance and impacts of organizations (G4, p. 5). Many organisations have declared their voluntary adoption of the guidelines. Over the past few years, the guidelines have effectively become the global standard for sustainability reporting. The G4 Guidelines provided extremely comprehensive guidance and undoubtedly provided a thorough groundwork for the final stage of development—the setting of sustainability standards. Much of the detailed content of the new standards had its origin in G4.

Current position—the GRI Standards In October 2016 the GRI issued its new standards, which ‘are the latest evolution of GRI’s reporting disclosures, which have been developed through more than 15 years of a robust multi-stakeholder process. The standards are based on the GRI G4 guidelines, the world’s most widely used sustainability reporting disclosures, and feature an improved format and a new modular structure. The new GRI standards definitively replace the G4 guidelines, which will be phased out by 1 July 2018’ (see ). Early adoption is encouraged. Note that the claim above about ‘the world’s most widely used sustainability reporting’ usage is based on a survey carried out by KPMG. A major advantage of the new standards is that they provide a common language to cover the wide range of issues that

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come under the umbrella of ‘sustainability’. The new standards, by using a well-understood shared language, are expected to make sustainability much easier to report on and understand. The standards have been developed by a new Global Sustainability Standards Board (GSSB), a fully independent standard-setting body, with input from a wide variety of different sources, representing the GRI’s commitment to a multi-stakeholder approach. The GRI Standards comprise 36 modules that cover a range of topics outlined below. One aim of the new modular approach is to facilitate updates on a topic by topic basis rather than requiring a new set of guidelines, which is seen as a major advantage. This is also likely to mean that the standard-setting process for sustainability reporting will develop to be much more in line with the process used by the Accounting Standards Board. The standards contain all of the main content and disclosures from G4. A clear distinction is made in the standards between requirements, recommendations and guidance. In the introduction to the Consolidated Set of GRI Sustainability Reporting Standards 2016, in the overview section on page 3, the standards were identified as being:

• ‘designed to be used by organisations to report about their impacts on the economy, the • •

environment, and/or society’ ‘structured as a set of interrelated documents’ ‘developed primarily to be used … to help an organisation prepare a sustainability report which is based on the Reporting Principles and focuses on material topics’.

A report prepared in accordance with the standards ‘demonstrates that the report provides a full and balanced picture of an organisation’s material topics and related impacts, as well as how these impacts are managed’ (p. 4). The report can be completed as a stand-alone sustainability report, an example of which will be discussed later, or ‘can reference information disclosed in a variety of locations’ (p. 4). If the latter approach is used a GRI content index is required. The standards are structured as shown in Figure 7.1.

FIGURE 7.1

Foundation

Overview of the set of GRI Standards

GRI

Source: Consolidated Set of GRI Sustainability Reporting Standards, Figure 1, page 3, Overview of the set of GRI Standards. Reproduced with permission of The Global Reporting Initiative (GRI). GRI is an independent, international organisation that has pioneered corporate sustainability reporting since 1997. It helps businesses, governments and other organisations understand the impact of business on issues like climate change, human rights and corruption. With thousands of reporters in over 90 countries, GRI offers the world’s most trusted and widely used standards on sustainability reporting. This helps organizations and their stakeholders make better decisions using information that matters. Currently, over 42 countries and regions reference GRI in their policies. GRI is built on a unique multi-stakeholder approach, which ensures participation from diverse stakeholders in the development of its standards. GRI’s mission is to empower decision-makers to build a more sustainable economy and world.

Starting point for using the GRI standards

101 Universal standards

General disclosures

Management approach

GRI

GRI

102

To report contextual information about an organization

Topicspecific standards

103

To report the management approach for each material topic

Economic

Environmental

Social

GRI

GRI

GRI

200

300

400

Select from these to report specific disclosures for each material topic

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A brief summary of the standards follows. (All extracts are reproduced with permission of The Global Reporting Initiative (GRI).)

Foundation GRI 101: Foundation:

• sets out the reporting principles for defining report content and quality • explains the basic process for using the standards • sets out the ways in which the standards can be used. The reporting principles regarding report content are:

• • • •

Stakeholder inclusiveness—stakeholders must be identified and an explanation given as to how the organisation has responded to their reasonable expectations and interests (GR101: Foundation 2016, p. 8) Sustainability context—the organisation’s performance in the wider context of sustainability must be presented (p. 9) Materiality—the report must include topics that reflect the organisation’s significant economic, environmental and social impacts, or that substantively influence the assessments and decisions of stakeholders (p. 10) Completeness—the report must include coverage of material topics and their boundaries, in such a way that significant sustainability impacts are reflected, to enable stakeholders to assess performance (p. 12). The question as to where the boundaries are is an interesting and quite difficult one. Impacts may occur in a variety of ways, through direct action by the organisation, through indirect contributions to impacts, or through an organisation’s business relationships. Timeliness is seen as an aspect of completeness.

Those regarding report quality are:

• Accuracy—information should be accurate and sufficiently detailed to enable stakeholders to • • • • •

assess performance (p. 13) Balance—information should reflect both positive and negative aspects of performance to enable a reasoned assessment to be made (p. 13) Clarity—information should be understandable and accessible (p. 14) Comparability—information should be presented in a manner that enables comparisons over time and with other organisations (p. 14) Reliability—information should be collected and reported in a way that can be checked, and that establishes its quality and materiality (p. 15) Timeliness—information should be available in time for stakeholders to make informed decisions (p. 16).

The module provides considerable guidance on these issues, and in due course you may need to look at it in more detail. At this stage our aim is to alert you to an important area of reporting and decision making that is likely to become of far greater significance in years to come. There are two basic approaches to using the standards:

• preparation of a sustainability report in accordance with the standards • use of selected standards, or parts thereof, to report specific information, known as a GRI-referenced claim. The first of these can be further subdivided into:

• Core—requires ‘the minimum information needed to understand the nature of the •

organisation, its material topics and related impacts, and how these are managed’ (p. 21) Comprehensive—‘This builds on the core option by requiring additional disclosures on the organisation’s strategy, ethics and integrity and governance. In addition, the organisation is required to report more extensively on its impacts by reporting all of the topic-specific

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disclosures for each material topic covered by the GRI standards’ (p. 21). These will be covered next. In order to claim that a report has been prepared in accordance with the GRI Standards, the organisation must comply with all criteria for the respective option (see p. 23).

General Disclosures GR1 102: General Disclosures is used ‘to report contextual information about an organisation and its sustainability reporting practices. This includes information about an organization’s profile, strategy, ethics and integrity, governance, stakeholder engagement practices, and reporting process’. The details required are summarised below:

• Organisational profile—this covers a wide range of things, including detail on: the

• • •

•

•

organisation’s ownership and legal form, and name and location of head office; the range of activities, brands, products and services; markets served and location of activities; scale of the organisation; information on employees and other workers; information about its supply chain; significant changes to the organisation and its supply chain; external initiatives; membership of associations; and reference to the ‘precautionary principle’. This last point is an approach to risk management which states that, if an action has a possible risk of causing harm to the public, or to the environment, in the absence of scientific consensus that the action is not harmful, the burden of proof that it is not harmful rests with those taking the action (pp. 7–13). Strategy—this requires key impacts, risks and opportunities to be described, together with a statement from the senior decision-maker about the relevance of sustainability to the organisation and its strategy (pp. 14–15). Ethics and integrity—requires a description of the organisation’s values, principles, standards and norms of behaviour, and mechanisms for advice and concern about ethics (pp. 16–17). Governance—requires disclosure of governance structure, including details of committees responsible for decision-making on economic, environmental and social topics; delegating authority from the highest governance body to senior executives and employees, executivelevel responsibility, and processes for consulting stakeholders, all on economic, environmental and social topics; composition of the highest governance body and its committees, in quite a high degree of detail; chair of the highest governance body; nomination and selection processes for the highest governance body; processes regarding possible conflicts of interest; role of highest governance body in setting purpose, values and strategy, measures taken to develop and enhance the collective knowledge of the highest governance body, and evaluating the highest governance body’s performance, all with regard to economic, environmental and social topics; identifying and managing economic, environmental and social impacts; effectiveness of risk management process; review of economic, environmental and social topics; highest governance body’s role in sustainability reporting and ensuring that all material topics are covered; the process for communicating critical concerns and the nature and total number of critical concerns; remuneration policies and the process for determining remuneration, in quite some detail; stakeholders involvement in determining remuneration and how stakeholders views are sought; determining the annual compensation ratio and the percentage increase in annual total compensation ratio. The annual compensation ratio is the ‘ratio of the annual total compensation for the organisation’s highest-paid individual in each country of significant operations to the median annual total compensation for all employees (excluding the highest-paid individual) in the same country’. Consideration of this ratio is seen as significant to value creation generally (pp. 18–28). Stakeholder engagement—disclosures required include: a list of stakeholder groups; details of the percentage of total employees covered by collective bargaining agreements; the basis for identifying and selecting stakeholders; details of the approach to stakeholder engagement; and details of the key topics and concerns raised through stakeholder engagement (p. 32). Reporting practice—these disclosures provide an overview of the process followed to determine the content of the sustainability report, and the identification of material topics and boundaries. They include: a list of entities included in the consolidated financial statements; an

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explanation of the process for defining report content and topic boundaries; a list of material topics; the effects of any restatements of information given in previous reports; significant changes in reporting from a previous period in the list of material topics and boundaries; the reporting period, the date of the most recent report, and the reporting cycle; a contact point for questions regarding the report; the basis that the report is in accordance with the GRI Standards; the GRI content index; and a description of the organisation’s policy and practice with regard to seeking external assurance for the report (pp. 33–42).

Management approach Disclosures under GRI 103: Management Approach ‘enable an organisation to explain how it manages the economic, environmental, and social impacts related to material topics. This provides narrative information about how the organisation identifies, analyses, and responds to its actual and potential impacts’ (p.4). Disclosures cover the following areas.

• Material topic and their boundaries—for each material topic the boundary should be •

•

identified, by describing where the impacts occur and the organisation’s involvement with the impacts. The management approach and its components—for each material topic, information must be disclosed relating to: an explanation of how the topic is managed, together with the purpose of the management approach, and a description of a range of issues including policies, commitments, goals and targets, responsibilities, resources and grievance mechanisms (p. 8). Evaluation of the management approach—for each material topic the organisation must provide an explanation as to how the management approach is evaluated. This typically includes things such as assessing performance against goals and targets, and explaining how results are communicated and obstacles dealt with (p. 11).

Note that disclosures about the management approach are required in all of the GRI 200, 300 and 400 series, together with topic-specific disclosures.

Economic performance ‘In the context of the GRI Standards, the economic dimension of sustainability concerns an organization’s impacts on the economic conditions of its stakeholders, and on economic systems of local, national, and global levels’ (GRI 201: Economic Performance, p.4). It is important to note that the GRI does not focus on the financial condition of an organisation. These last two points are central to understanding the role of sustainability reporting. The related standards are as shown below.

• GRI 201deals with economic performance generally, and includes the economic value • • • •

•

generated, its defined benefit plan obligations, financial assistance from government, and the impact of climate change. GRI 202 deals with market presence, which covers the contribution of the organisation to economic development in its local areas. GRI 203 deals with indirect economic impacts. These can be easily hidden when major decisions are made by organisations. The closing of the Hazelwood plant in the Latrobe Valley provides an interesting case to consider. GRI 204 deals with procurement practices. This coverage includes the ‘support for local suppliers, or those owned by women or members of vulnerable groups’ (p. 4), lead times given to suppliers, and any negative impacts on the supply chain. GRI 205 addresses the topic of anti-corruption, which is typically linked with negative impacts, ‘such as poverty in transition economies, damage to the environment, abuse of human rights, abuse of democracy, misallocation of resources, and undermining of the rule of law’ (p. 4). GRI 206 deals with anti-competitive behaviour, which can include ‘unfair business practice, abuse of market position, cartels, anti-competitive mergers, and price-fixing’ (p. 4).

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Environmental impacts GRI 300: Environmental Impacts relates generally to environmental topics, as outlined below.

• GRI 301 deals generally with impacts related to use of materials, which can be renewable or •

•

•

• • • •

non-renewable, and some may be recycled. Specific disclosures include materials used, recycled materials used, and reclaimed products. GRI 302 deals with impacts related to use of energy. Efficient energy use and use of renewable energy are seen as important in lowering an organisation’s environmental footprint. The standard also deals with ‘upstream’ and ‘downstream’ activities related to the organisation’s activities. Specific disclosures required cover energy consumption, energy intensity, reduction of consumption, and reductions in energy requirements. GRI 303 deals with impacts of use of water. Use of water can impact on the water table and reduce available supply for others. Such changes have the potential for considerable economic and social consequences for local communities and others who are impacted. Disclosures are thus needed on water withdrawn, sources significantly affected, and water recycled and reused. GRI 304 deals with biodiversity. Impacts relate to living and non-living natural systems, including land, air, water and ecosystems. ‘Protection of biological diversity is important for ensuring the survival of plant and animal species, genetic diversity, and natural ecosystems’. Specific disclosures include details of sites in or adjacent to areas of high diversity value outside protected areas, significant impacts of activities, habitats protected or restored, and IUCN Red List species with habitats in areas affected by operations. GRI 305 deals with emissions. Specific disclosures include details of direct greenhouse gas emissions, indirect emissions, emissions intensity, reductions in greenhouse gas emissions intensity, and other specific emissions. GRI 306 deals with effluents and waste. Specific disclosures required include water discharge by quality and destination, waste by type and disposal method, significant spills, transport of hazardous waste, and water bodies affected by water discharges and/or runoff. GRI 307 deals with environmental compliance. Specific disclosures include any noncompliance with environmental laws and regulations. GRI 308 deals with supplier environmental assessment. This is about impacts that arise from an organisation’s business relationships. Specific disclosures include new suppliers screened using environmental criteria, and negative environmental impacts in the supply chain and related actions taken.

Social GRI 400: Social relates to social topics, which are outlined below.

• GRI 401 deals with employment, including job creation and working conditions. GRI 402–

• •

•

•

406 deal with specific aspects of employment, but topic disclosures required by GRI 401 include hiring of new employees and employee turnover, benefits provided to full-time employees but not to temporary or part-time ones, and parental leave. GRI 402 deals with labor/management relations, and ‘covers an organization’s consultative practices with employees…’ (p. 4). These are expected to be aligned with international standards. GRI 403 deals with Occupational Health and Safety. Topic-specific disclosures include types and rates of injury, occupational diseases, days lost, absenteeism, number of work-related fatalities, risk of diseases related to occupation, and health and safety issues covered in formal agreements with trade unions. GRI 404 deals with training and education. This ‘includes an organization’s approach to training and upgrading employee skills, and performance and career development reviews’ (p. 4). Specific disclosure requirements include average hours of training, programs for upgrading skills, and percentage of employees receiving regular performance and career development reviews. GRI 405 deals with diversity and equal opportunity. Diversity and equality at work are considered to provide significant benefits. Specific disclosures include diversity of governance bodies and employees, and ratio of basic salary and remuneration for women and men.

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• GRI 406 deals with non-discrimination. Each person should be treated fairly on the basis of • • • •

• •

• •

• • • • •

individual merit. Required disclosures include incidents of discrimination (including harassment) and corrective action taken. GRI 407 deals with freedom of association and collective bargaining. Specific topic disclosures include operations and suppliers in which freedom of association is at risk. GRI 408 deals with child labour. The topic is discussed in detail, and a topic-related disclosure is required relating to operations and suppliers at significant risk of incidents of child labour. GRI 409 deals with forced or compulsory labour. ‘Not to be subject to forced or compulsory labor is a fundamental human right’ (p. 4). GRI 410 deals with security practices. This focuses on the conduct of security staff towards others and the possible use of excess force. This is seen as having negative impacts on local people, with possible implications for the rule of law. A topic-specific disclosure relates to security staff trained in human rights policies and procedures. GRI 411 deals with rights of indigenous peoples. Indigenous peoples are frequently associated with historic injustices. A specific disclosure covers incidents of violations involving rights of indigenous peoples. GRI 412 deals with human rights assessment. The UN ‘Guiding Principles on Business and Human Rights’ is an assumed starting point. Topic-related disclosures include operations that have been subject to human rights reviews, employee training on human rights policies or procedures, and significant investment agreements and contracts that include human rights clauses or have undergone human rights screening. GRI 413 deals with local communities. Topic-specific disclosures include operations with local community engagement, impact assessments and development programs, and operations with significant actual and potential negative impacts. GRI 414 deals with supplier social assessment. ‘Due diligence is expected of an organisation in order to prevent or mitigate negative social impacts in the supply chain’ (p. 4). Topic-specific disclosures include new suppliers screened using social criteria, and negative social impacts in the supply chain and actions taken. GRI 415 deals with public policy. Disclosures include lobbying and making donations to political parties. GRI 416 deals with customer health and safety. Topic-specific disclosures include assessments of the health and safety impacts of product and service categories, and incidents of non-compliance. GRI 417 deals with marketing and labelling. Topic-related disclosures include requirements for product and service information and labelling, incidents of non-compliance relating to information and labelling, and marketing communication. GRI 418 deals with customer privacy. Topic-specific disclosure related to substantiated complaints concerning breaches is required. GRI 419 deals with socioeconomic compliance. ‘This includes an organization’s overall compliance record, as well as compliance with specific laws or regulations in the social and economic area’ (p. 4). Other elements include fraud, bribery and corruption, competition, labour issues etc. Non-compliance with laws and regulations in the social and economic area must be disclosed.

Just how far most companies are prepared to go in this whole area remains unclear. There is little doubt that over the years more companies, including many significant companies, such as BHP Billiton, Westpac, ANZ Bank and National Australia Bank, have become organisational stakeholders in the GRI. The G3 versions of the guidelines were clearer (and probably more general) than the first guidelines, probably reflecting the growth in stakeholders. The G4 Guidelines progressed the detailed application of the overall approach, and the GRI standards now provide both a common language for sustainability and a practical way for implementation. Questions can be asked as to whether all of the standards really relate to sustainability, or whether some reflect what has been seen as a desirable direction that is expected to result in improvement across the

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board that will improve things generally. Whether, in a new era of increased nationalism, antiglobalisation and concern for jobs at a local level, all of these standards will thrive, remains to be seen. In general, however, the aim of a sustainability report as a means of communicating sustainability performance and impacts—whether positive or negative—is both desirable and laudable. Real World 7.4 provides an example of an excellent approach to sustainability reporting.

REAL WORLD 7.4 Sustainability reporting at BHP BHP Billiton has prepared, for quite some time, extremely comprehensive annual reports in line with the GRI initiative. One of these is a sustainability report. The sustainability report aligns with the International Council on Mining and Metals Sustainable Development Framework and is prepared in accordance with the G4 comprehensive level reporting, including indicators from the GRI mining and metals sector. The 2015 sustainability report provided a comprehensive review of how BHP Billiton plans to resource its future. The company has developed a sustainability framework, with key components being the areas of governance, people, environment and society. The 2015 sustainability report tracked performance across a range of targets related to these areas. This report contained sections on:

• • • • • • •

BHP Billiton’s locations Chief Executive Officer’s review Our Charter Our sustainability approach Our sustainability performance Our material sustainability issues Governance — Doing what we say we will do, transparently and ethically — Operating with integrity — Climate change—sustainable growth requires an effective response to climate change

•

People — Keeping our people and operations safe — Focusing on the health and wellbeing of our people — Developing our workforce Environment—responsible stewards of the environment we all share — Biodiversity and land management — Water management

•

•

•

Society — Engaging effectively with communities — Respecting human rights — Making a positive contribution to society Appendix — Our stakeholders — Performance data — Independent assurance report to the Directors and management of BHP Billiton.

Source: BHP Billiton Sustainability Report, 2015. © BHP Billiton.

It is interesting to note that BHP Billiton has also produced a Sustainability Reporting Navigator, which indicates the sections in the various reports that specifically address what the organisation has done to address the GRI Guidelines and uphold the 10 principles of the UN Global Compact and the International Council on Mining and Metals. The 2016 Sustainability Report built on this, while at the same time reflecting current events. The Samarco tragedy in Brazil was a major focus, as was the development of the United Nations Sustainable Development Goals, launched in September 2015. These are 17 ambitious goals dedicated to improving the wellbeing of present and future generations and aiming to end poverty, protect the planet and ensure prosperity for all, as part of a new sustainable development agenda. Page 10 of the 2016 sustainability report indicates how BHP Billiton contributes to these goals and provides a framework for much of the report. The report ends with a number of appendices covering economic performance data, and performance data on people, society and the environment. The sustainability reports are available on the BHP Billiton website and are recommended reading. Other interesting reports you might like to look at include Wesfarmers and Nike’s responsibility report .

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There is little doubt that the work of the GRI represents a significant step forward in terms of the environmental and social information required. It will be interesting to see whether the introduction of sustainability standards, as compared with guidelines, increases use, and to what extent. It is worth pondering whether the GRI process, which is voluntary, indicates that business (at least some sections of it) is well ahead of governments in recognising the importance of sustainability. Of course, different countries and their governments have different economic, social, cultural and political conditions, and it is probably unrealistic to expect all countries to move forward at the same rate. However, there is little doubt that pressure for greater disclosure will continue to grow in the developed world, as will the rewards for being a good corporate citizen. One final point in this section on the GRI is that the point now reached, where GRI’s long-term aspiration and objective, namely a formal standard-setting process for sustainability reporting, has been achieved and has resulted in a revision of the GRI’s mission and vision. Real World 7.5 provides extracts from the GRI website, which contain the GRI’s current position.

REAL WORLD 7.5 GRI current position What we do ‘We produce the world’s most trusted and widely used standards for sustainability reporting, the GRI Standards, which enable organisations to measure and understand their most critical impacts on the environment, society and the economy.’ Who reports Sustainability reporting is carried out by companies and organisations of all types, sizes and sectors. Of the world’s largest corporations, 92% report on their sustainability performance and 82% of these use GRI Standards to do so. ‘Our vision is to create a future where sustainability is integral to every organisation’s decision-making process.

International Integrated Reporting Council (IIRC) A coalition that is currently working on systems to develop integrated reporting. integrated reporting A process that results in communication, most visibly in a periodic ‘integrated report’, about value creation over time. An integrated report is a concise communication about how an organisation’s strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term.

Our mission is to empower decision makers everywhere, through our sustainability standards and multi-stakeholder network, to take action towards a more sustainable economy and world. We believe: • In the power of a multi-stakeholder process and inclusive network • Transparency is a catalyst for change • Our standards empower informed decision making • A global perspective is needed to change the world • Public interest should drive every decision an organisation makes.’ Source: ‘About GRI’ . Reproduced with permission of The Global Reporting Initiative (GRI).

Integrated reporting It is interesting to note that the International Integrated Reporting Council (IIRC) , which is a global coalition of regulators, investors, companies, standard setters, the accounting profession and non-government organisations (NGOs), produced a framework for integrated reporting in December 2013. The framework states that: Integrated reporting promotes a more cohesive and efficient approach to corporate reporting and aims to improve the quality of information available to providers of capital to enable a more efficient and productive allocation of capital. The primary purpose of an integrated report is to explain to providers of financial capital how an organisation creates value over time. (IIRC, The International Integrated Reporting Framework, December 2013, p. 4.) Not surprisingly, there are many similarities between the framework and the GRI guidelines/ standards, which reinforces the view expressed earlier that extension of content in reporting is inevitable. There are, however, some subtle differences in emphasis. These are outlined below.

•

Integrated reporting appears to be targeted squarely at providers of financial capital, a much smaller target audience than that of the GRI standards.

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• While natural and social and relationship capital are identified as being relevant, it is easy to • • •

gain the impression that they are not seen as quite as important for integrated reporting as financial capital. The IIRC framework gives the impression that the focus is still very much on business, with seemingly less on the social and environmental factors. The guiding principles have much in common, but the framework is arguably closer to the more traditional accounting principles. The content elements of the prototype are more traditional than those of the GRI.

None of this should be seen as particularly critical of the framework. It represents a significant leap forward in reporting and may be better received by some organisations than the GRI standards. Whether it will lead to the ‘immersion’ of the organisation with all of its stakeholders remains a moot point. The GRI standards comment on the relationship between integrated reporting and sustainability reporting. Integrated reporting is seen as building on sustainability foundations, while sustainability reporting is seen as an intrinsic element of integrated reporting. However, the standards recognise that integrated reporting is primarily aimed at providers of financial capital, with an integrated representation of the key factors that are material to its present and future value creation.

Concept check 8 Which of these is a way in which sustainable reports should be similar VQEWTTGPVƂPCPEKCNTGRQTVU! A B C D

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Concept check 9 6JG)4+KFGPVKƂGUECVGIQTKGUQHUVCPFCTFFKUENQUWTGU6JGUGCTG A B C D E

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Concept check 10 Which of the following statements is most doubtful? Why? A

B

C

D

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ACTIVITY 7.5 (a) (b)

By reference to GRI 101, consider whether some of the reporting principles represent a shi away from those developed for financial reporting, in principle or in application. The GRI standards set out a range of disclosure requirements. Assess their usefulness. How many of these might you expect to find in a traditional financial report?

SELF-ASSESSMENT QUESTION

7.1

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LO6

THE BALANCED SCORECARD APPROACH

The final topic in this chapter, the balanced scorecard, provides an indication of the potential overlap of the roles of management and financial accountants. It also reinforces the view that the measurement role of the accountancy profession is likely to be expanded into new areas. Essentially, the balanced scorecard covers both a management system and a system for measuring and reporting performance, which integrates financial and operating performance measures in a way that highlights and communicates the company’s strategic goals. It was developed balanced scorecard in the 1990s by Kaplan and Norton in a series of articles in the Harvard Business Review. They Both a management system argued that, in today’s information age, companies must aim to create future value by investing in and a system for measuring and customers, suppliers, employees, processes, technology and innovation. The emphasis has changed reporting performance, which includes information relating to from production to customers, from tangible assets to intangible, from top–down management to ƂPCPEKCNCURGEVUQHVJGDWUKPGUU bottom–up, and incremental change has become transformational change. The changes are business processes, customers, significant in driving value. Intangible assets such as brands, intellectual property and people now and learning and growth, thus drive value in many companies. Explain the balanced scorecard approach and its advantages

giving a more comprehensive (and strategic) view of the business.

ACCOUNTING AND YOU It may have occurred to you that the changes implicit in the debates regarding social and environmental issues, and the development of sustainability reports, represent something of a watershed for capitalism, for associated approaches to business, and for the education that is appropriate for young entrepreneurs. There is little doubt that many businesses are now taking their social and environmental responsibilities far more seriously than was the case in earlier years. The move from a single-minded satisfaction of shareholder needs to a much more broadly based recognition of a range of stakeholder needs and interests has progressed significantly. Business models and strategies are now much broader. This raises the question as to whether the traditional business school education remains appropriate. Your answer to this question will depend on your particular interests and philosophy of business.

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An article by Dianna Middleton, ‘Demand for ethical routes to profits’, in The Australian, 2 December 2009, raised some interesting questions about attitudes of would-be entrepreneurs. These young entrepreneurs felt that ‘it was critical to create a product that was environmentally friendly and sustainable and whose sales could help support good causes’. The article suggested that young entrepreneurs are increasingly approaching business along these lines. Typical actions that result include accessing goods and materials from economically depressed parts of the world. One impact of this has been changes in business studies curricula, which now have an emphasis on ‘social entrepreneurship’. The article suggests that this move is a ‘generational progression’, as younger people have been brought up to be more socially aware. It is seen as something of a reaction to the perception that has existed for a time—the stigma of the ‘greedy MBA’. Of course, this may be a reaction to the fact that finding a job has become much more difficult and there is a sense of guilt about occurrences of recent years. Consequences of this movement include:

•

socially responsible concepts being included in business plans; for example, the building of a water-purifying plant in Africa, and the development of internet systems in regions with low technology backgrounds

• •

linking good business ideas with economically depressed areas businesses with a socially responsible backbone being seen as more attractive to nervous investors—risky investments are more likely to be supported if there is some social good resulting from them.

You might like to think about the implications that this movement might have on your ideas and training regarding your future career. In what could be seen as an interesting extension of this debate, a recent article by Mallen Baker listed 10 skills you need to work in the area of corporate social responsibility. The skills listed were:

• • • • • • • • • •

managing ambiguity know your subject (i.e. CSR) understand how to influence people communication mainstream business understanding sales listening skills project management research and analysis understanding metrics and reporting.

Many of these skills are common to many professions, but they probably need sharpening when you deal with the areas covered in this chapter. Source: Mallen Baker,‘10 skills you need to work in corporate social responsibility’, 5 March 2016, . Mallen Baker Respectful Business blog. 5 March 2016. Reproduced with permission of Mallen Baker.

The traditional accounting statements are not particularly useful as indicators of future value, if, in fact, value is driven differently. What we need is information that will assist strategy development, and also help users to make judgements about value, both now and in the future. The aim of the balanced scorecard approach is, therefore, to build management systems based on strategy.

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The balanced scorecard has been described as the ‘strategic chart of accounts’. It aims to capture both the financial and the non-financial elements of a company’s strategy, and to explain the relationships that drive the business results. It views the organisation from four perspectives: 1 financial 2 business process 3 customer 4 learning and growth.

It aims to provide and analyse data according to all four perspectives. One of its key components is measurement. Ways must be found to identify the key strategic drivers and then to find some criteria for measuring them. Another key part of the process is the examination of outcomes, as defined by agreed measures, followed by tracking these results and their feedback to further develop and refine strategy. Key components are:

• • • • •

strategic analysis of the present status of the company determination of appropriate measures of performance feedback on the performance measures analysis of trends in performance over time development of decision support tools and systems.

The financial perspective Financial information remains a core component of decision-making and strategy development. As the balanced scorecard system is established, we would expect a comprehensive corporate database to be developed, and more financial data to be centralised and automated. There is almost certainly going to be a need for some additional financial information, especially in the risk management area, and in the social and environmental areas, where cost–benefit information is likely to be needed. However, the essence of the balanced scorecard message is that reliance solely on financial data will risk an incomplete or unbalanced approach.

The business process perspective This perspective is all about how the business is running internally. Questions that should be asked include:

• Are the products and services appropriate to customer and market needs? If not, what could rectify the situation?

• Are the support services providing the desired support in a timely and efficient manner? How • •

can they be improved? How efficient are the production processes? How is the interaction with stakeholders organised?

The aim should be to identify which key elements of the business process affect strategy, and then to decide which measures could track performance in these areas. Measures include:

• percentage of systems automated • percentage of production completed within standard, and • production days lost for various reasons.

The customer perspective A focus on customers and customer satisfaction is vital to success. Dissatisfied customers will fairly quickly lead to the demise of a business. Poor performance in this area is a good indicator of future decline. This area requires detailed questions and measures for tracking and analysis. Such measures might include:

• some kind of customer satisfaction index • market share

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• number of new products • number of new customers, and • number of new markets, by type.

The learning and growth perspective In this modern information age, people are a key strategic asset. In some companies, people are the only asset of significance. Financial accounting has never really handled assets of this type well, yet this perspective is crucial to the strategy of many organisations, and requires focus on things such as:

• staff quality, experience and skills • systems for continuous training and development, professional updating and the development of a philosophy of life-long learning

• availability of technical and other specialist staff, and • time and support available for research and development. This key perspective then requires some measurable performance indicators. The balanced scorecard aims to link all four perspectives around vision and strategy. The management accountant is likely to become central to this process, primarily because of the emphasis on measurement, which is what accountants are good at. Several advantages are claimed:

• • • • •

Decisions are based on fact. Development of strategy occurs through a much broader staff base. Strategy is translated into operational reality. Because drivers are grounded in strategy, far more staff will grasp the big-picture strategy issues so that (hopefully) strategy will be improved. The organisation should then be better aligned to the strategy, and strategy will become part of everyone’s job. Continual feedback and review occurs in a strategic context, so strategy development will be better informed and become a continual process.

ACTIVITY 7.6 Identify the similarities in thinking between the GRI approach and the balanced scorecard approach.

Concept check 11 List the four perspectives used in the balanced scorecard approach. A B C D E

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Concept check 12 Which statement concerning the balanced scorecard is incorrect? A

B C D

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Concept check 13 Which statement concerning the balanced scorecard is not true? A B C

D

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OVERALL CONCLUSION From a variety of users there is a growing demand for a much broader source of information than that which has been provided in the past. A business can no longer focus solely on wealth enhancement for the shareholder group. Social and environmental concerns are now serious, and there is a great deal of emphasis on the sustainability demands that come from every sector— society, environmentalists, customers, employees and shareholders. It is becoming obvious that management itself must deal with a much broader set of questions and issues than it has in the past, to develop sound strategy. Whether all of this translates into broad acceptance of the GRI, with further development of measurement systems that will certainly expand the role of accountants, remains to be seen. As we have seen in discussing triple bottom line reporting, and more particularly the balanced scorecard, management has to expand its information base considerably if it is to compete in the information economy. It seems reasonable to suppose that both management and society at large are moving in the same direction. Just what pace both are going at is debatable. Whatever conclusion you reach, it seems inevitable that the issues raised in this chapter will not go away. Accountants will need to develop a set of expanded skills in these areas, and good business people will need to become much more familiar with wide-ranging measurement systems.

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SUMMARY +PVJKUEJCRVGTYGJCXGCEJKGXGFVJGHQNNQYKPIQDLGEVKXGUKPVJGYC[UJQYP

OBJECTIVE

METHOD ACHIEVED

Outline and discuss a range of social and environmental issues and the way in which accounting can contribute

• Provided a general background • Described and illustrated the stakeholder concept in the context of social and environmental issues

Explain what is meant by corporate social responsibility and the Ceres Principles

• • • • •

Outline the major studies that have occurred on accounting for corporate social responsibilities

• Outlined the major studies

Explain triple bottom line reporting

• Described and explained triple bottom line reporting

Outline the Global Reporting Initiative, and discuss its main framework in broad terms and its linkage with ideas of integrated accounting

• • • • • •

Explain the balanced scorecard approach and its advantages

• Described the rationale behind the balanced scorecard • 'ZRNCKPGFKVUDGPGƂVU • Indicated how it will expand the management accountant’s role

Explained social responsibility &GƂPGFEQTRQTCVGUQEKCNTGURQPUKDKNKV[ Illustrated by examples Set out the Ceres Principles Described context

Set the GRI in context 'ZRNCKPGFVJGDGPGƂVUQHVJG)4+RTQEGUU Described the purpose and form of a sustainability report Described and detailed the reporting principles +FGPVKƂGFCTCPIGQHUVCPFCTFFKUENQUWTGUCPFRGTHQTOCPEGKPFKECVQTU Illustrated by use of a real-world example how sustainability reporting can be carried out • Outlined the work of the International Integrated Reporting Council (IIRC)

REFERENCES #WUVTCNKCP&GRCTVOGPVQH'PXKTQPOGPVCPF*GTKVCIGn6TKRNG$QVVQO.KPG4GRQTVKPIKP#WUVTCNKC#)WKFGVQ 4GRQTVKPICICKPUV'PXKTQPOGPVCN+PFKECVQTUo#&'*%CPDGTTC %2##WUVTCNKCn#)WKFGHQT#UUWTCPEGQP5/'5WUVCKPCDKNKV[4GRQTVUo%2##WUVTCNKC/GNDQWTPG &GGICP%)QTFQP$n#UVWF[QHVJGGPXKTQPOGPVCNFKUENQUWTGRTCEVKEGUQH#WUVTCNKCPEQTRQTCVKQPUo Accounting & Business Research5WOOGTRRs 'NMKPIVQP,Cannibals with Forks: The Triple Bottom Line of 21st Century Business%CRUVQPG2WDNKUJKPI /CPMCVQ/0 )NQDCN4GRQTVKPI+PKVKCVKXG )4+Sustainability Reporting Guidelines)4+#OUVGTFCO6JG0GVJGTNCPFU YYYINQDCNTGRQTVKPIQTI )4+FQGUPQVGPFQTUGVJGVGZVQHVJGDQQMKPCP[YC[ )NQDCN4GRQTVKPI+PKVKCVKXG )4+Sustainability Reporting Guidelines XGTUKQP))4+#OUVGTFCO6JG 0GVJGTNCPFUYYYINQDCNTGRQTVKPIQTI )4+FQGUPQVGPFQTUGVJGVGZVQHVJGDQQMKPCP[YC[ )NQDCN4GRQTVKPI+PKVKCVKXG )4+Sustainability Reporting Guidelines XGTUKQP))4+#OUVGTFCO6JG 0GVJGTNCPFUYYYINQDCNTGRQTVKPIQTI )4+FQGUPQVGPFQTUGVJGVGZVQHVJGDQQMKPCP[YC[ )NQDCN4GRQTVKPI+PKVKCVKXG )4+Sustainability Reporting Guidelines XGTUKQP))4+#OUVGTFCO6JG 0GVJGTNCPFUYYYINQDCNTGRQTVKPIQTI )4+FQGUPQVGPFQTUGVJGVGZVQHVJGDQQMKPCP[YC[ )NQDCN4GRQTVKPI+PKVKCVKXG )4+Consolidated Set of GRI Sustainability Reporting Standards,)4+#OUVGTFCO 6JG0GVJGTNCPFUYYYINQDCNTGRQTVKPIQTI )4+FQGUPQVGPFQTUGVJGVGZVQHVJGDQQMKPCP[YC[ )TC[41YGP&#FCOU%Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting2TGPVKEG*CNN.QPFQP

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)WVJTKG,2CTMGT.&n%QTRQTCVGUQEKCNFKUENQUWTGRTCEVKEGCEQORCTCVKXGKPVGTPCVKQPCNCPCN[UKUo Advances in Public Interest AccountingXQNRRs *QNOG49CVVU2Corporate Social Responsibility: Making Good Business Sense9QTNF$WUKPGUU%QWPEKNHQT 5WUVCKPCDNG&GXGNQROGPV7-,CPWCT[ +PVGTPCVKQPCN+PVGITCVGF4GRQTVKPI%QWPEKNThe International Framework &GEGODGT -2/))NQDCN5WUVCKPCDKNKV[5GTXKEGUKPMG International Corporate Sustainability Reporting-2/)#OUVGTFCO 6TQVOCP-6n5QEKCNTGURQPUKDKNKV[FKUENQUWTGUD[#WUVTCNKCPEQORCPKGUoThe Chartered Accountant in Australia /CTEJRRs 6TQVOCP-6$TCFNG[)9n#UUQEKCVKQPUDGVYGGPUQEKCNTGURQPUKDKNKV[FKUENQUWTGUCPFEJCTCEVGTKUVKEUQHEQO RCPKGUoAccounting, Organisations and SocietyRRs

DISCUSSION QUESTIONS EASY 7.1

LO1

%QTRQTCVGUQEKCNTGURQPUKDKNKV[ %54TGRQTVKPIGZVGPFUVJGVTCFKVKQPCNƂPCPEKCNTGRQTVKPIKPVQPGY CTGCU&GUETKDGVJTGGQHVJGUGPGYCTGCU

7.2

LO2

9JCVKUOGCPVD[nEQTRQTCVGUQEKCNTGURQPUKDKNKV[o!

7.3

LO1/2/3

#VCRGTUQPCNNGXGNCTVKEWNCVG[QWTXKGYUQPGVJKECNIQXGTPCPEG+PVJGEQWTUGQHVJKUGZCOKPG[QWT XKGYUQPVJGGZVGPVVQYJKEJVJGUGCTEJHQTYGCNVJUJQWNFDGNKOKVGFD[OQTCNXCNWGUQTUQEKCN EQPUEKGPEG

7.4

LO3

&GUETKDGKPFGVCKNVJG#WUVTCNKCP#EEQWPVKPI5VCPFCTFUHQTEQTRQTCVGUQEKCNTGURQPUKDKNKV[ %54CEEQWPVKPI

7.5

LO4

.KUVVJGVJTGGEQORQPGPVUQHVTKRNGDQVVQONKPGTGRQTVKPI9JKEJEQORQPGPVKUEWTTGPVN[ CEEQOOQFCVGFD[ƂPCPEKCNCEEQWPVKPITGRQTVKPIUVCPFCTFU!9KVJYJCVOGCUWTG!

7.6

LO5

9JCVFQGUn)4+oUVCPFHQT!9JCVoUQPGYQTFVQFGUETKDGYJCVKVoUCNNCDQWV!9JQKUKVOGCPVVQDGPGƂV!

7.7

LO6

.KUVVJGHQWTRGTURGEVKXGUWUGFYKVJVJGDCNCPEGFUEQTGECTFCRRTQCEJ

INTERMEDIATE 7.8

LO1/2

%CP[QWVJKPMQHCP[EWTTGPVKUUWGUTGNCVKPIVQDWUKPGUUGUQTKPFWUVTKGUKP[QWTCTGCYJGTGDWUKPGUU KPVGTGUVUUQEKCNPGGFUCPFGPXKTQPOGPVCNEQPUGSWGPEGUCTGKPEQPƃKEV!*QYOKIJV[QWCVVGORVVQ DCNCPEGVJGUGEQPƃKEVUKPDQVJVJGUJQTVVGTOCPFVJGNQPIVGTO!

7.9

LO2

9J[OKIJVYGGZRGEVCXQNWPVCT[%54RQNKE[VQYQTM!

7.10 LO2

,WUVJQYOWEJTGURQPUKDKNKV[UJQWNFCPQTICPKUCVKQPVCMGHQTUQEKCNCPFGPXKTQPOGPVCNKUUWGU!

7.11 LO1/2/3

#UUWOGVJCV[QWCTGVJG%'1QHCEQORCP[VJCVKUVJGOCLQTGORNQ[GTKPCUOCNNVQYPKPTWTCN0GY 5QWVJ9CNGU9JCVTGURQPUKDKNKV[YQWNF[QWJCXGHQT[QWTGORNQ[GGU!9QWNF[QWTEQORCP[UK\G CHHGEV[QWTFGEKUKQP!

7.12 LO1/2/3

+UVJGTGCP[GXKFGPEGVJCVEQORCPKGUVJCVCTGUQEKCNN[TGURQPUKDNGKPVGTOUQHRQNNWVKQPCPFYCUVG CXQKFCPEGDGPGƂVKPVGTOUQHRTQƂVU!

7.13 LO1/2/3

6QYJCVGZVGPVCTGUQEKCNCPFGPXKTQPOGPVCNEQPEGTPUEQPUKUVGPVYKVJCUJCTGJQNFGTYGCNVJ OCZKOKUCVKQPQDLGEVKXG!

7.14 LO1/2/3

*QYYGNNGSWKRRGFKUVJGV[RKECNDWUKPGUURGTUQPVQWPFGTUVCPFVJGHWNNTCPIGQHKUUWGUEQXGTGFD[C HWNNUECNGUWUVCKPCDKNKV[TGRQTV!

7.15 LO1

9J[%54!&QPoVCEEQWPVCPVUJCXGGPQWIJVQFQYKVJVJGKTRTGRCTCVKQPQHVJGVTCFKVKQPCNƂPCPEKCN UVCVGOGPVU!

7.16 LO2

&KUEWUUVJGRQVGPVKCNHQTRTCEVKECNCRRNKECVKQPQHVJG%GTGU2TKPEKRNGU&GUETKDGRQVGPVKCNTQCFDNQEMUVQ VJGWUGQHVJGUGRTKPEKRNGUCUCRTCEVKECNIWKFG

7.17 LO6

*QYKUVJGDCNCPEGFUEQTGECTFCRRTQCEJUKOKNCTVQVJG)4+!

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289

CHALLENGING 7.18 LO5

+UVJGHQTOQHVJG)4+TGRQTVVQQEQORNGZ!9KNNKVNGCFVQKPHQTOCVKQPQXGTNQCF!

7.19 LO1/2/3

9JKNGOCP[EQTRQTCVGUQEKCNTGRQTVKPIKFGCUCTGUQWPFOCP[CTGUVKNNWPOGCUWTCDNG*QYOWEJFQGU VJKUFGVTCEVHTQOVJKUUV[NGQHTGRQTVKPI!

7.20 LO5

*QYTGCNKUVKEKUVJG)4+HQTCP[VJKPIQVJGTVJCPVJGNCTIGUVVTCPUPCVKQPCNEQORCPKGU!6QYJCVGZVGPV OKIJVVJGDCUKERTKPEKRNGUDGWUGFD[UOCNNGTFQOGUVKEEQORCPKGU!

7.21 LO1–6

%CP[QWVJKPMQHCP[EJCPIGUVQDWUKPGUUUVWFKGUEWTTKEWNCVJCVOKIJVDGTGSWKTGFVQUWRRQTVCPGY GTCQHDWUKPGUUYJGTGVJGGORJCUKUQPUWUVCKPCDKNKV[CPFUWUVCKPCDKNKV[TGRQTVKPIDGEQOGUVJGPQTO!

7.22 LO3

&KUEWUUVJGOCKPEJCNNGPIGUHQTVJGCEEQWPVKPIRTQHGUUKQPYKVJCP[CVVGORVVQFGXGNQRCEEQWPVKPI UVCPFCTFUHQTEQTRQTCVGUQEKCNTGURQPUKDKNKV[ %54CEEQWPVKPICPFTGRQTVKPI

7.23 LO4

9JCVKUVJGOCLQTEJCNNGPIGQHVTKRNGDQVVQONKPGTGRQTVKPI!9JCVCTGVJGDGPGƂVUQHOGGVKPIVJKU EJCNNGPIG!

7.24 LO6

'ZCEVN[JQYFQGUQPGIQCDQWVDCNCPEKPIVJGUEQTGECTF!

7.25 LO1

&Q[QWVJKPMVJCVVJGEQPEGTPYKVJRTQƂVCDKNKV[KFGPVKƂGFKPVJG%TQUD[6GZVQT5JCTGJQNFGT,WT[KP 4GCN9QTNFKUNKMGN[VQTGOCKPCUUVTQPIPQYCUKVYCUKP!9J[9J[PQV!

APPLICATION EXERCISES EASY 7.1

LO4

%QORNGVGVJGHQNNQYKPIVCDNGHQTVTKRNGDQVVQONKPGTGRQTVKPI

Component name

7.2

LO4

LO4

6TCFKVKQPCNƂPCPEKCNUVCVGOGPV HQEWUGZRNCPCVKQP

%QORNGVGVJGHQNNQYKPIVCDNGCUCPQWVNKPGQHVJGOCLQTUVWFKGUVJCVJCXGQEEWTTGFQPCEEQWPVKPIHQT EQTRQTCVGUQEKCNTGURQPUKDKNKVKGU

Year

7.3

6TCFKVKQPCNƂPCPEKCNUVCVGOGPV HQEWU

#WVJQT U

0WODGTQH EQORCPKGUUWTXG[GF

)GQITCRKECNHQEWU

/CKPƂPFKPI

6JGTGJCXGDGGPCPWODGTQHUVWFKGUEQPFWEVGFCUVQXQNWPVCT[TGRQTVKPIRTCEVKEGCTQWPFVJGYQTNF 6JGUGUVWFKGUJCXGRTQXKFGFCIQQFTCPIGQHGZCORNGUQHGPXKTQPOGPVCNFKUENQUWTGUDQVJRQUKVKXG CPFPGICVKXG

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(QTGCEJKVGOKPVJGHQNNQYKPINKUVKPFKECVGYJGVJGTVJGKVGOKU CPositive DNegative EBoth RQUKVKXGCPFPGICVKXGQT FNotCPGPXKTQPOGPVCNFKUENQUWTG  

IQXGTPOGPVKPXGUVKICVKQPKPVQVJGEQORCP[oUGPXKTQPOGPVCNCEVKXKVKGU

AAAAAA

 

KORNGOGPVCVKQPQHVTGGTGRNCPVKPIUEJGOGU

AAAAAA

 

KPVTQFWEVKQPQHGPXKTQPOGPVCNCWFKVU

AAAAAA

 

OCKPVGPCPEGQTKORNGOGPVCVKQPQHCUVTCVGI[VQRTQVGEVVJGGPXKTQPOGPV

AAAAAA

 

PQPEQORNKCPEGYKVJTGIWNCVKQPU

AAAAAA

 

RQUKVKXGQWVEQOGUHTQOIQXGTPOGPVKPSWKTKGU

AAAAAA

 

TGE[ENKPIQHOCVGTKCNU

AAAAAA

 

TGJCDKNKVCVKQPQHOKPKPIUKVGU

AAAAAA

 

EQORCP[oUCFOKUUKQPVQECWUKPIGPXKTQPOGPVCNKPENWFKPIJGCNVJTGNCVGF RTQDNGOUHQTTGUKFGPVUVJTQWIJKVUCEVKXKVKGU

AAAAAA



URQPUQTKPIQTTGEGKXKPIGPXKTQPOGPVCNCEJKGXGOGPVCYCTFU

AAAAAA



WPFGTVCMKPIQHGPXKTQPOGPVCNKORCEVQTCUUGUUOGPVUVWFKGU

AAAAAA



EQORCP[UGVUTGEQTFYKVJEQPUGEWVKXGKPLWT[HTGGFC[U

AAAAAA



WUGQHGPXKTQPOGPVCNN[UCHGRTQFWEVUKPOCPWHCEVWTKPI

AAAAAA



WUGQHGPXKTQPOGPVCNN[UGPUKVKXGOCPCIGOGPVVGEJPKSWGU

AAAAAA

INTERMEDIATE 7.4

LO2

%QORNGVGVJGHQNNQYKPI%GTGU2TKPEKRNGUVCDNG 2TKPEKRNGPCOGFGUETKRVKQP

$GPGƂEKCTKGUQHRTKPEKRNGCEJKGXGOGPV

                  

7.5

LO5

%QORNGVGtheHQNNQYKPIVCDNGCUCPQWVNKPGQHVJG)4+ VJG)NQDCN4GRQTVKPI+PKVKCVKXGKVUHTCOGYQTM CPFNKPMCIGUVQCEEQWPVKPI Stakeholders Mission Originally a department of ... ;GCTQHKUUWCPEGQHƂTUVIWKFGNKPGUMPQYPCU G3 Guidelines expanded to include ... Mandatory? Timeframe Types of general disclosure: Management approach Economic impacts Environmental impacts Social impacts

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7.6

LO1–5

291

7UGVJG+PVGTPGVVQƂPFGZCORNGUQHEQTRQTCVGUQEKCNTGURQPUKDKNKV[TGRQTVKPIUWOOCTKUGVJGOCPF EQOOGPVQPVJGO;QWOKIJVƂPFVJG/CNNGP$CMGTYGDUKVGQHCUUKUVCPEGJGTG

CHALLENGING 7.7

LO1–5

(KPFQWVCUOWEJCU[QWECPCDQWVVYQOCLQTVTCPUPCVKQPCNEQTRQTCVKQPUCPFEQOOGPVQPVJGKT UQEKCNCPFGPXKTQPOGPVCNRTCEVKEGUQXGTVKOG

7.8

LO1/2/3

#UVJGOC[QTQHCUOCNNVQYPKPTWTCN059[QWJCXGDGGPCRRTQCEJGFD[COWNVKPCVKQPCNOKPKPI EQORCP[VJCVYCPVUVQQRGPDQVJCNCTIGWPFGTITQWPFOKPGCPFCPQRGPRKVOKPGVYQMKNQOGVTGU QWVUKFGQH[QWTVQYP 6JGEQORCP[YKUJGUVQRTQXKFGCRRTQRTKCVG%54TGRQTVKPICPFJCUCUMGF[QWVQCFXKUGVJGOYKVJ TGICTFVQYJKEJITQWRUVJG[UJQWNFEQPUKFGTCPFVQRTQXKFGCNKUVCPFFGUETKRVKQPQHVJGKPHQTOCVKQP VJG[OKIJVRTQXKFG

7.9

LO2

9JKEJQHVJGUMKNNUKFGPVKƂGFD[/CNNGP$CMGTKP#EEQWPVKPICPF;QWFQ[QWVJKPMCTGTGSWKTGFD[ GCEJQHOCPCIGTUCEEQWPVCPVUCPFRGQRNGYQTMKPIKP%54!

7.10 LO5

6JG)4+RTQXKFGUIWKFCPEGTGICTFKPIDQWPFCTKGUHQTUWUVCKPCDKNKV[TGRQTVKPI*QYWUGHWNCTGVJGUG CPFYJCVFQ[QWUGGCUVJGOCLQTFKHƂEWNVKGUKPCRRN[KPIVJGO!+VKUUWIIGUVGFVJCV[QWWUGCP CRRTQRTKCVGTGRQTVGI$*2oUUWUVCKPCDKNKV[TGRQTVVQRTQXKFGCHQEWUHQT[QWTCPUYGT

7.11 LO1/2

9JCVFQGU4GCN9QTNFVGNN[QWCDQWVVJGFKHƂEWNVKGUQHDCNCPEKPIDWUKPGUUFGEKUKQPUYKVJ UQEKCNEQPUGSWGPEGU!'ZCOKPGVJGDCEMITQWPFVQVJGOKNMYCTUCPFVJGCEVKQPUVCMGPD[CNNVJG RCTVKEKRCPVU5JQWNFVJG[CNNJCXGUGGPVJGRTQDNGOUEQOKPI! 9JCVFQGUVJG/WTTC[)QWNDWTPDGJCXKQWTVGNN[QWCDQWVVJGPGGFHQTCRRTQRTKCVGFKUENQUWTG!

7.12 LO1/2

+FGPVKH[VJGMG[KUUWGUKPVJG,COGU*CTFKGCUDGUVQUECUGCPFFKUEWUUVJGO!

7.13 LO1/2

$2JCUDGGPCVVJGEGPVTGQHUQOGQHVJGYQTUVGPXKTQPOGPVCNFKUCUVGTUKPTGEGPVJKUVQT[YKVJVJG6GZCU %KV[4GƂPGT[GZRNQUKQPKPCPFVJG&GGRYCVGT*QTK\QPQKNDTGCEJKPVJG)WNHQH/GZKEQKP +UUWGUQHUCHGV[CPFCFGSWCE[QHUCHGV[RTGECWVKQPUNGCFKPIWRVQDQVJKPEKFGPVUYGTGHQWPFVQDG ƃCYGF6JGGHHGEVUQHVJGFKUCUVGTUCHHGEVGFDWUKPGUUGURGQRNGCPKOCNUCPFRNCPVUQHVJGUWTTQWPFKPI CTGCU+VECPDGCTIWGFVJCV$2UJCTGJQNFGTUUJQWNFJCXGPQVKEGFVJCVVJGEQORCP[YCUHCKNKPIVQ EQTTGEVUCHGV[JC\CTFUKPVJGKTTGƂPGTKGUCPFFTKNNKPIFGGRGTHQTQKNVJCPCP[QHKVUEQORGVKVQTUCPF VJGTGHQTGHCEGFITGCVGTTKUMU*QYGXGT$2JCFDGGPUGGPCUCNGCFGTKPUWUVCKPCDKNKV[HQTOCP[[GCTUD[ DGKPIQPGQHVJGƂTUVOCLQTEQTRQTCVKQPUVQCITGGYKVJVJGUEKGPVKƂEƂPFKPIUQPENKOCVGEJCPIG %QOOGPVQP$2oUUQEKCNCPFGPXKTQPOGPVCNRTCEVKEGU

7.14 LO2

4GXKGYCPFCRRTCKUGVJG%GTGUDNWGRTKPVHQTUWUVCKPCDNGKPXGUVKPI

7.15 LO2

6JG)4+)IWKFGNKPGUKPFKECVGFYKVJKPVJGƂTUVHGYRCIGUVJCV  VQFC[OCP[QDUGTXGTUKPENWFKPICEEQWPVCPVUVJGOUGNXGUTGEQIPKUGVJCVEJCTCEVGTK\KPIVJG e nDTKEMUCPFOQTVCToGEQPQO[QHVJGRCUVYKNNPQVUWHƂEGCUCDCUKUHQTEJCTCEVGTK\KPIVQFC[oUKP HQTOCVKQPGEQPQO[8CNWKPIKPVCPIKDNGCUUGVUtJWOCPECRKVCNGPXKTQPOGPVCNECRKVCNCNNKCPEGU CPFRCTVPGTUJKRUDTCPFCPFTGRWVCVKQPtOWUVEQORNGOGPVVJGXCNWCVKQPQHEQPXGPVKQPCN VCPIKDNGCUUGVUtHCEVQTKGUGSWKROGPVCPFKPXGPVQT[7PFGTVJGTWDTKEQHnDWUKPGUUTGRQTV KPIonKPVCPIKDNGCUUGVUCPCN[UKUoCPFnXCNWGTGRQTVKPIoCPWODGTQHCEEQWPVKPIITQWRUJCXG NCWPEJGFRTQITCOOGUVQGZRNQTGJQYCEEQWPVKPIUVCPFCTFUUJQWNFDGWRFCVGFVQGPJCPEG UWEJXCNWGFTKXGTU0GYEQPEGRVUQHTKUMQRRQTVWPKV[CPFWPEGTVCKPV[CTGNKMGN[VQGOGTIG Source: Global Reporting Initiative5WUVCKPCDKNKV[4GRQTVKPI)WKFGNKPGUR4GRTQFWEGFYKVJ RGTOKUUKQPQH6JG)NQDCN4GRQTVKPI+PKVKCVKXG )4+





C 9JCVRTQITGUUFQ[QWVJKPMJCUDGGPOCFGKPVJGUGCTGCU!





D 5QOGQHVJGVGTOUWUGFUGGOVQTGNCVGYGNNVQVJGKFGCQHKPVGITCVGFTGRQTVKPI9JCVFQ[QWUGGCU VJGTGNCVKQPUJKRDGVYGGPKPVGITCVGFTGRQTVKPICPFUWUVCKPCDKNKV[TGRQTVKPICURTQRQUGFD[VJG)4+!

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7.16 LO5

$*2$KNNKVQPKPKVUUWUVCKPCDKNKV[TGRQTVUGVQWVVCTIGVUCPFRGTHQTOCPEGHQTVJG[GCTKPVJG CTGCUQHUCHGV[JWOCPTKIJVUJGCNVJGPXKTQPOGPVCPFEQOOWPKV[&Q[QWVJKPMVJCVVJGVCTIGVUCTG TGCUQPCDNGCPFEQXGTCNNVJCVPGGFUVQDGEQXGTGF%QOOGPVQPVJGEQORCP[oURGTHQTOCPEG 5WOOCTKUGVJGYC[UKPYJKEJ$*2$KNNKVQPEQPVTKDWVGUVQVJG7PKVGF0CVKQPU5WUVCKPCDNG &GXGNQROGPV)QCNUCUKPFKECVGFKPKVUUWUVCKPCDKNKV[TGRQTV.

7.17 LO5

'ZVGTPCNCUUWTCPEGECPRTQXKFGDQVJTGRQTVTGCFGTUCPFKPVGTPCNOCPCIGTUYKVJKPETGCUGFEQPƂFGPEG KPVJGSWCNKV[QHUWUVCKPCDKNKV[RGTHQTOCPEGFCVC$GPGƂVUKPENWFGKPETGCUGFTGEQIPKVKQPVTWUVCPF ETGFKDKNKV[CUYGNNCUTGFWEGFTKUMCPFKPETGCUGFXCNWG1VJGTDGPGƂVUKPENWFGKORTQXGFDQCTFCPF %'1NGXGNGPICIGOGPVUVTGPIVJGPGFKPVGTPCNTGRQTVKPICPFOCPCIGOGPVU[UVGOUCPFKORTQXGF UVCMGJQNFGTEQOOWPKECVKQP *QYGXGTVJGSWCNKV[QHFCVCECPDGVTQWDNGUQOGHQTTGRQTVGTUCPFTGRQTVWUGTUCUVWF[HQWPF VJCVCVJKTFQHVJGNCTIGUVINQDCNEQORCPKGUPGGFGFVQKUUWGCTGUVCVGOGPVQHPQPƂPCPEKCN KPHQTOCVKQP#NUQCDQWVQHTGRQTVUNKUVGFQP)4+oU5WUVCKPCDKNKV[&KUENQUWTG&CVCDCUGKP KPFKECVGFVJGPGGFHQTUQOGHQTOQHGZVGTPCNCUUWTCPEG'ZVGTPCNCUUWTCPEGUGTXKEGRTQXKFGTUKPENWFG CEEQWPVCPE[ƂTOUGPIKPGGTKPIƂTOUCPFUWUVCKPCDKNKV[UGTXKEGUƂTOU &QCYGDUGCTEJWUKPInUWUVCKPCDKNKV[TGRQTVKPICUUWTCPEGoVQVT[VQKFGPVKH[VJGOCKPKUUWGUTGNCVKPIVQ UWUVCKPCDKNKV[TGRQTVUYKVJCRCTVKEWNCTGORJCUKUQPCUUWTCPEG

7.18 LO1/2

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CHAPTER 7 CASE STUDY This case study is based on an article written in 2010 in the CPA magazine InTheBlack. It is about the need for the principle of sustainability to drive business decisions and the importance of sustainability

reporting as a means of evaluating performance effectively. Read the article and answer the questions that follow.

Can accountants save the planet? Sustainability has become as valuable as the bottom line. Meet the man who’s helping drive change to financial reporting culture. If you still think that a company’s first duty— indeed, their only duty—is to maximise profits, then chances are you haven’t met South African corporate governance guru Mervyn King, who has lectured, consulted and advised companies, universities and institutions in 39 countries. ‘I’m on a crusade to change mindsets,’ he says. ‘I do it with passion, and I live in aeroplanes.’ King, 73, a retired judge who is now the chairman of the Global Reporting Initiative, has been talking about the importance of sustainability

reporting since the 2002 World Summit on Sustainable Development. Thanks in part to his advocacy, by 2015 all large and medium-sized companies in OECD countries will have to report on their environmental, social and governance performance (ESG) and, if they don’t, they must explain why. With good reason. While traditional financial statements are backward-looking, considering a company’s future sustainability is the only way stakeholders can make good investment

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decisions, King explains. Beverage manufacturers, such as SABMiller or CocaCola, for example, need to consider the potential risk of future water shortages to their business and be actively involved in reducing their water usage. And there’s another good reason, says King. ‘We owe a moral duty to those who come aer us, to leave them a sustainable world.’ Now he’s talking about integrated reporting and why companies should produce a single annual report that details the financial statements as well as future risks and strategies to ensure sustainable performance. ‘It’s going like wildfire,’ says King, who will speak on this issue at the World Congress of Accountants in Malaysia next month. By 2020, there should be a generally accepted and applied international standard that will effectively integrate financial and ESG reporting by all organisations. The International Integrated Reporting Committee, part of the Prince of Wales’ Accounting for Sustainability Project, aims to develop this global framework for sustainability reporting, with a report to be presented to the G20 next year. It’s clear this is a topic close to King’s heart. During our 90-minute interview, he talks quietly but almost continuously, fluently and articulately, about the importance of sustainability. In fact, it’s hard to slip in a question. Twenty years ago, King started thinking about how boards conduct themselves and the way companies report. South African law is derived from English law, but at that time the English Companies Act was silent on how companies should be governed and managed. King’s first report, published in 1994 as South Africa held its first democratic elections, aimed to fill that gap. ‘I became fascinated by corporate governance; how companies are directed and controlled,’ he says. He sees integrated reporting as the evolution of sustainability reporting and corporate governance, and wants integrated reporting to place decisions on sustainability in the mainstream and make them inseparable from considerations of strategy, risk and performance. His latest report on corporate governance, the King Code of Governance for South Africa 2009, has been adopted as a regulation by the Johannesburg Stock Exchange, although compliance with the report is not a legal requirement for South African companies. Integrated reporting ‘should set out the story of how that company has positively and negatively impacted on society and the environment, and how the company plans to ameliorate the negative impacts in the year ahead,’ King says. Without information on sustainability, it is impossible for investors to make a decision on future performance and possible risks.

293

A dyed-in-the-wool old school financier might still wonder whether sustainability is something only bunny huggers need worry about. Surely it’s the bottom line that rules the roost? But failing to examine a company’s future sustainability can have serious consequences. King notes that Nike lost 40 per cent of its share price in 1997 when word got out that its shoes were produced using child labour. More recently, perhaps BP shareholders should have noticed the company was drilling deeper for oil than any of its competitors, and thus faced greater risks. A company’s intangible assets—brand and reputation—now make up an ever greater part of its total economic value, oen dwarfing its market capitalisation. And it’s these intangible assets that are hardest hit in sustainability scandals. At the same time, consumers and investors are becoming more concerned about the impact of business on society and the environment. In 2006, Walmart, the world’s largest listed corporation by value, according to Forbes, was forced to re-examine its business strategy aer the Norwegian government pension fund—the second largest in the world, worth US$285 billion—dumped its 1.7 per cent shareholding because it was not happy with Walmart’s labour and environmental policies. Norway said investing in Walmart entailed an unacceptable risk that the fund might be complicit in serious violation of norms. That experience, says King, led Walmart to expand its ethical standards program to ensure it sourced products ethically and in a socially responsible way. Traceability, knowing where and how each product is manufactured, has become increasingly important to retailers, in order to prevent scandals and potential dumping of stock, and because consumers prefer to buy products that are perceived as more ethical. If suppliers want to sell to Walmart, they must comply with its conditions. King recalls that during the last US presidential election, The Wall Street Journal ran a story about a father asking his 12-year-old son which candidate—Obama or McCain—he’d choose. ‘Neither,’ said the boy, explaining that if he was able to vote he’d support Californian governor Arnold Schwarzenegger. ‘The Terminator?’ queried his father. ‘What does he know about being president?’ ‘Probably nothing,’ admitted the boy. ‘But he has done more to improve our air and the quality of our water than anyone else. And when I’m your age, those will be my problems.’ The article concluded: Take note, for this is your customer of tomorrow, says King, who believes these future customers are far more concerned about the state of the planet than their parents or grandparents.

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‘I have an eight-year-old grandson, and he is constantly saying to me, “You do so much flying, what is your carbon footprint?”’ he says, with evident fondness. ‘His mindset will be different to mine. We’ve got to start taking steps now. If you and I don’t do it, it won’t happen.’ All of this means that auditors are more critical than ever. ‘The auditing profession is the profession to give assurance,’ King says, ‘and they need to be upskilled.’ Business schools are starting to discuss adding environmental courses to accounting curricula, and big accounting firms, such as Deloitte, PricewaterhouseCoopers, Ernst & Young and KPMG, are beginning to hire environmental managers and scientists to help them in that assurance, says King, who wants to see assurance of sustainability as a mainstream, not a boutique, function.

King became socially active in the 1980s, a time of intense political upheaval in South Africa as apartheid repression became more heavy handed and the struggle for liberation intensified. During this decade, he resigned his judicial appointment in order to enter commerce. In 1981, he became chairman of Operation Hunger, which aims to feed children in rural areas of South Africa, where unemployment and poverty are oen endemic. He always wanted to be a lawyer. But if he were to start afresh as a 20th-century school leaver, King admits to a change of heart. ‘It’s a whole new world. I don’t think I’d be a corporate lawyer, I’d be an auditor—it’s fascinating.’ So accountants who are auditors save the planet? In King’s world, they can and they must.

Source: Jocelyn Newmarch, ‘Can accountants save the planet?’, InTheBlack, CPA Australia, October 2010.

QUESTIONS 1

Why does Mervyn King think that considering a company’s future sustainability is the only way stakeholders can make good investment decisions?

2

Do you agree with the idea that ‘we owe a moral duty to those who come aer us, to leave them a sustainable world’? What are the implications of this?

3

What are your views on the desirability of integrated reporting as outlined in the article?

4

What do you see as the main issues in moving towards integrated reporting?

5

King sees integrated reporting as ‘the evolution of sustainability reporting and corporate governance’. Do you see this as a natural evolution, or are there conflicts between governance and sustainability reporting?

6

Do you think that integrated reporting is primarily concerned with the sustainability of the business in the long term, or about ensuring that information is made available which will help society at large ensure that the society of the future is le with a sustainable world?

7

King points out that BP was drilling more deeply than any of its competitors and thus faced greater risks. Yet BP has for many years been seen as a leader in the whole area of sustainability. Consider how a ‘good’ company like BP can suddenly fall from grace so quickly. What steps might it have taken to reduce the risks it was taking? Would a fully integrated report have been likely to have made the issues clearer? In what way?

8

Use the internet to try to track the actions that Nike have taken over the past decade or so to retrieve the situation relating to the use of child labour.

9

What lessons did Walmart learn from their 2006 experience with the Norwegian pension fund?

10

What are your views regarding the implication in the article that future generations will have a different mindset to current generations? What areas do you think will be most important for the future, and how might they affect future business attitudes and practices?

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CHAPTER 8

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS LEARNING OBJECTIVES When you have completed your study of this chapter, you should be able to:

L01

Explain the importance of ratios in analysing financial performance, identify the possible bases for comparison, and identify the key aspects of financial performance and financial position that are evaluated by the use of ratios

L02 Identify the main ratios used to analyse profitability, and apply these ratios to a business

L03 Identify the main ratios used to analyse efficiency regarding usage of assets, and apply these ratios to a business

L04 Identify the main ratios used to analyse liquidity, and apply these ratios to a business

L05 Identify the main ratios used to analyse financial gearing (leverage), and apply these ratios to a business

L06 Identify the main ratios used to analyse investment performance, and apply these ratios to a business

L07 Identify a range of other issues relating to financial analysis, including the main limitations of ratio analysis.

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FINANCIAL RATIOS LO1 Explain the importance of ratios in analysing financial performance, identify the possible bases for comparison, and identify the key aspects of financial performance and financial position that are evaluated by the use of ratios

Financial ratios provide a quick and relatively simple means of examining the financial health of a business. A ratio simply expresses the relationship between one figure appearing in the financial statements and some other figure appearing in the financial statements (e.g. profit in relation to capital employed) or perhaps some resource of the business (e.g. profit per employee, sales per square metre of counter space). By calculating a relatively small number of ratios, it is often possible to build up a reasonably good picture of the financial position and performance of a business. Thus, it is not surprising that ratios are widely used by those who have an interest in businesses and business performance. Although ratios are not difficult to calculate, they can be difficult to interpret. For example, a change in the profit per employee of a business may be due to several possible reasons, such as: • a change in the number of employees without a corresponding change in the level of output • a change in the level of output without a corresponding change in the number of employees • a change in the mix of goods or services being offered, which in turn changes the level of profit. It is important to appreciate that ratios are really only the starting point for further analysis. They help to highlight the financial strengths and weaknesses of a business, but they cannot, by themselves, explain why certain strengths or weaknesses exist or why certain changes have occurred. Only a detailed investigation will reveal these underlying reasons. When comparing the financial health of different businesses, the differences that exist in the scale of operations pose a major problem. Thus, a direct comparison of (say) the profits of each business may be misleading due to differences in size. By expressing profit in relation to some other measure (e.g. sales) the ratio derived can be used as a basis for comparison with similarly derived ratios for other similar businesses. Ratios can be expressed in various forms; for example, as a percentage, as a fraction, as a proportion. The way a particular ratio is presented will depend on the needs of those who will use the information. Although it is possible to calculate a large number of ratios, only a relatively few, based on key relationships, may be required by the user. Many ratios that could be calculated from the financial statements (e.g. rent payable relative to current assets) may not be useful because there is no clear or meaningful relationship between the items. There is no generally accepted list of ratios that can be applied to the financial statements, nor is there a standard method of calculating many ratios. Variations in both the choice of ratios and their calculation will be found in the literature and in practice. However, it is important to be consistent in the way we calculate ratios for comparison purposes. The ratios discussed below are those which many consider to be among the more important for decision-making purposes.

Financial ratio classification Ratios can be grouped into certain categories, each one reflecting a particular aspect of financial performance or position. The following broad categories provide a useful basis for explaining the nature of the financial ratios to be dealt with: • Profitability. Businesses generally exist with the primary purpose of creating wealth for the owners. Profitability ratios reveal their degree of success: they express the profits made (or figures bearing on profit, such as sales revenue or overheads) in relation to other key figures in the financial statements or to some business resource. • Efficiency. Ratios may be used to measure how efficiently certain resources have been utilised by the business. Efficiency ratios are also referred to as ‘activity ratios’ or ‘turnover ratios’. • Liquidity. It is vital for the survival of a business to have sufficient liquid resources available to meet its maturing obligations, and there are specific ratios for examining the relationship between liquid resources held and accounts due for payment in the near future. • Financial gearing. This is the relationship between the contribution to financing the business made by the owners of the business and the amount contributed by others, in the form of loans. The level of gearing has an important effect on the degree of risk associated with a

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business, as we shall see. Gearing ratios tend to highlight the extent to which the business uses borrowings. • Investment. Certain ratios are concerned with assessing the returns and performance of shares in a particular business from the perspective of shareholders who are not involved with the management of the business. The categories of ratios outlined have a focus on the traditional financial statements. The increasing emphasis on sustainability and integrated reporting is likely to lead to the development of a number of ratios dealing with particular aspects of sustainability. Inevitably there will be convergence of both sets of ratios in time.

The need for comparison Calculating a ratio by itself will not tell you very much about the position or performance of a business. For example, if a ratio revealed that the business was generating $100 in sales per square metre of counter space, you could not deduce from this information alone whether this level of performance was good, bad or indifferent. It is only when you compare this ratio with some ‘benchmark’ that the information can be interpreted and evaluated. The most common benchmarks are described next.

Past periods By comparing the ratio that we have calculated with the same ratio, but for a previous period, it is possible to detect whether there has been an improvement or deterioration in performance. Indeed, it is often useful to track particular ratios over time (say, 5 or 10 years) to see whether it is possible to detect trends. The comparison of ratios from different periods brings certain problems, however. In particular, there is always the possibility that trading conditions were quite different in the periods being compared. There is the further problem that, when comparing the performance of a single business over time, operating inefficiencies may not be clearly exposed. For example, the fact that sales revenue per employee has risen by 10% over the previous period may at first sight appear to be satisfactory. This may not be the case, however, if similar businesses have shown an improvement of 50% for the same period or had much better sales revenue per employee ratios to start with. Finally, there is the problem that inflation may have distorted the figures on which the ratios are based. Inflation can lead to an overstatement of profit and an understatement of asset values, as will be discussed later in the chapter.

Similar businesses In a competitive environment, a business must consider its performance in relation to that of other businesses operating in the same industry. Survival may depend on its ability to achieve comparable levels of performance. A useful basis for comparing a particular ratio, therefore, is the ratio achieved by similar businesses during the same period. This basis is not, however, without its problems. Competitors may have different year-ends and so trading conditions may not be identical. They may also have different accounting policies, which can have a significant effect on reported profits and asset values (e.g. different methods of calculating depreciation or valuing inventories). Finally, it may be difficult to obtain the financial statements of competitor businesses. Sole proprietorships and partnerships, for example, are not obliged to make their financial statements available to the public. In the case of larger limited companies, there is a legal obligation to do so. However, a diversified business may not provide a breakdown of activities that is sufficiently detailed to enable analysts to compare the activities with those of other businesses.

Planned performance Ratios may be compared with the targets that management developed before the start of the period under review. The comparison of planned performance with actual performance may therefore be a useful way of revealing the level of achievement attained. However, the planned levels of performance must be based on realistic assumptions if they are to be useful for comparison purposes. Planned performance is likely to be the most valuable benchmark against which managers may assess their own business. Businesses tend to develop planned ratios for each aspect of their

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activities. When formulating its plans, a business may usefully take account of its own past performance and the performance of other businesses. There is no reason, however, why a particular business should seek to achieve either its own previous level of performance or that of other businesses. Neither may be an appropriate target. Analysts outside the business do not normally have access to the business’s plans. For these people, past performance and the performances of other, similar, businesses may provide the only practical benchmarks.

The key steps in financial ratio analysis When employing financial ratios, a sequence of steps is carried out by the analyst. The first step involves identifying which key indicators and relationships require examination. To carry out this step, the analyst must be clear who the target users are and why they need the information. Different types of users of financial information are likely to have different information needs, which will, in turn, determine which ratios they find useful. Managers should have an interest in all of the ratios, as they have an overall responsibility for the performance of the business. Shareholders are likely to be interested in their returns and the risk their investment carries. Thus, profitability, investment and gearing ratios will be of particular interest to them. Long-term lenders are concerned with the long-term viability of the business, and to help them to assess this, the profitability ratios and gearing ratios of the business are also likely to be of particular interest. Short-term lenders, such as suppliers, may be interested in how readily the business can repay the amounts owing in the short term. As a result, the liquidity ratios should be of interest to them. The second step in the process is to calculate the ratios identified in the first step as being appropriate for the particular users. The final step is to interpret and evaluate the ratios. Interpretation involves examining the ratios in conjunction with an appropriate basis for comparison and any other relevant information. The significance of the ratios calculated can then be established. Evaluation involves forming a judgement about the value of the information uncovered in the calculation and interpretation stage. While calculation is usually straightforward, the interpretation and evaluation stages are more difficult, and often require high levels of skill that can only really be acquired through much practice. The three steps described are shown in Figure 8.1.

Identify users and their information needs

Calculate appropriate ratios

Interpret and evaluate the results

FIGURE 8.1 Financial ratio analysis: the key steps

ACTIVITY 8.1 Review the main areas for which ratios can typically be usefully calculated, and explain the advantages of the three bases for comparison (i.e. past periods, similar businesses and planned performance).

The ratios calculated Probably the best way to explain financial ratios is to work through an example (see Example 8.1), which provides a set of financial statements from which we can calculate important ratios.

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6JGHQNNQYKPIƂPCPEKCNUVCVGOGPVUTGNCVGVQ#NGZKU.VFYJKEJQYPUCEJCKPQHYJQNGUCNGTGVCKN ECTRGVUVQTGU

ALEXIS LTD Statement of financial position

8.1

as at 31 March

Current assets $CPM #EEQWPVUTGEGKXCDNG +PXGPVQT[CVEQUV Non-current assets (KZVWTGUCPFƂVVKPIUCVEQUVNGUUCEEWOWNCVGFFGRTGEKCVKQP .CPFCPFDWKNFKPIU 6QVCNCUUGVU Current liabilities 5JQTVVGTODQTTQYKPIU CNNDCPMQXGTFTCHV #EEQWPVURC[CDNG +PEQOGVCZ Non-current liabilities $QTTQYKPIUNQCPPQVGU UGEWTGF Capital and reserves 2CKFWRQTFKPCT[ECRKVCN 0QVG

UJCTGUCNNKUUWGFCVEGPVUGCEJ 4GVCKPGFRTQƂV 6QVCNNKCDKNKVKGUCPFUJCTGJQNFGTUoGSWKV[

2016 $m

2017 $m

4 240 300 544

– 273 406 679

129 381 510 

160 427 587 

– 261 30 291

76 354 2 432

200

300

300

300

263 563 

234 534 

2016 $m 

 495

 243

 225

 165

2017 $m 

 409

 47

 15

 11

ALEXIS LTD Statement of comprehensive income for the year ended 31 March

4GXGPWG 0QVG %QUVQHUCNGU 0QVG )TQUURTQƂV 1RGTCVKPIGZRGPUGU 1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG 2TQƂVDGHQTGVCZ .GUUKPEQOGVCZ 2TQƂVHQTVJG[GCT

Notes  6JGOCTMGVRTKEGQHVJGUJCTGUQHVJGEQORCP[CVVJGGPFQHGCEJ[GCTYCUHQTCPF HQT  #NNUCNGUCPFRWTEJCUGUCTGOCFGQPETGFKV  6JGEQUVQHUCNGUƂIWTGECPDGCPCN[UGFCUHQNNQYU

1RGPKPIKPXGPVQTKGU 2WTEJCUGU 0QVG %NQUKPIKPXGPVQTKGU %QUVQHUCNGU

2016 $m 241  

 

2017 $m 300  

 

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8.1 continued

 #V/CTEJVJGCEEQWPVUTGEGKXCDNGUVQQFCVOKNNKQPCPFVJGCEEQWPVURC[CDNGCV OKNNKQP  #FKXKFGPFQHOKNNKQPJCFDGGPRCKFVQVJGUJCTGJQNFGTUKPTGURGEVQHGCEJ[GCT  6JGDWUKPGUUGORNQ[GFUVCHHCV/CTEJCPFCV/CTEJ  6JGDWUKPGUUGZRCPFGFKVUECRCEKV[FWTKPID[UGVVKPIWRCPGYYCTGJQWUGCPFFKUVTKDWVKQP EGPVTG  #V#RTKNVJGVQVCNQHGSWKV[UVQQFCVOKNNKQPCPFVJGVQVCNQHGSWKV[CPFPQPEWTTGPV NKCDKNKVKGUUVQQFCVOKNNKQP

As a general rule, when a ratio involves a comparison between two statements of financial position, we use year-end figures. However, if the ratio involves both the statement of financial position and the statement of financial performance (i.e. income statement and statement of comprehensive income), we would use the average of the two figures from the statement of financial position rather than the year-end figure, because it is more directly comparable with the figures from the statement of financial performance.

A brief overview Before we start our detailed look at the ratios for Alexis Ltd (in Example 8.1), it is helpful to take a quick look at what information is obvious from the financial statements. This will usually pick up some issues that ratios may not be able to identify. It may also highlight some points that could help us in our interpretation of the ratios. Starting at the top of the statement of financial position, the following points can be noted: • Reduction in the cash balance. The cash balance fell from $4 million (in funds) to a $76 million overdraft between 2016 and 2017. The bank may be putting the business under pressure to reverse this, which could raise difficulties. • Major expansion in the elements of working capital. Inventories increased by about 35%, trade receivables by about 14%, and trade payables by about 36% between 2016 and 2017. These are major increases, particularly in inventories and payables (which are linked because the inventories are all bought on credit—see Note 2). • Expansion of non-current assets. These have increased by about 15% (from $510 million to $587 million). Note 7 mentions a new warehouse and distribution centre, which may account for much of the additional investment in non-current assets. We are not told when this new facility was established, but it is quite possible that it was well into the year. This could mean that not much benefit was reflected in terms of additional sales revenue or cost saving during 2017. Sales revenue, in fact, expanded by about 20% (from $2,240 million to $2,681 million)—greater than the expansion in non-current assets. • Apparent debt capacity. Comparing the non-current assets with the long-term borrowings implies that the business may well be able to offer security on further borrowing. This is because potential lenders usually look at the value of assets that can be offered as security when assessing loan requests. Lenders seem particularly attracted to land and buildings as security. For example, at 31 March 2017, non-current assets had a carrying amount (the value at which they appeared in the statement of financial position) of $587 million, but long-term borrowing was only $300 million (although there was also an overdraft of $76 million). Carrying amounts are not normally, of course, market values. On the other hand, land and buildings tend to have a market value higher than their value as shown on the statement of financial position due to inflation in property values. • Lower operating profit. Although sales revenue expanded by 20% between 2016 and 2017, both cost of sales and operating expenses rose by a greater percentage, leaving both gross profit and, particularly, operating profit massively reduced. The level of staffing, which increased by about 33% (from 9,200 to 12,400 employees—see Note 6), may have greatly affected the operating expenses. (Without knowing when the additional employees were recruited during Copyright © 2020 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655703204 – Accounting and Finance Management for Non-Specialists

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2017, we cannot be sure of the effect on operating expenses.) Increasing staffing by 33% must put an enormous strain on management, at least in the short term. It is not surprising, therefore, that 2017 was not successful for the business—not, at least, in profit terms. Having had a quick look at what is fairly obvious, without calculating any financial ratios, we shall now go on to calculate and interpret some.

Concept check 1 Which of the following statements is false? A

B

C D E

6JGTGKUPQIGPGTCNN[CEEGRVGFNKUVQHTCVKQUVJCVECPDGCRRNKGFVQVJGƂPCPEKCN UVCVGOGPVU 9JGPEQORCTKPIVJGƂPCPEKCNJGCNVJQHFKHHGTGPVDWUKPGUUGUVJGFKHHGTGPEGUVJCV GZKUVKPVJGUECNGQHQRGTCVKQPURQUGCOCLQTRTQDNGO +VKUKORQTVCPVVQCRRTGEKCVGVJCVTCVKQUCTGTGCNN[QPN[VJGUVCTVKPIRQKPVHQTHWTVJGTCPCN[UKU 5VCPFCTFOGVJQFUQHECNEWNCVKQPGZKUVHQTGCEJQHVJGXCTKQWUTCVKQU 0QPGQHVJGCDQXGCTGHCNUG

Concept check 2 Which of the following provides a good benchmark, or basis for comparison, for ratio evaluation? A B C D E

+PFWUVT[CXGTCIG 2CUVRGTHQTOCPEG $WFIGVGFRGTHQTOCPEG 5KOKNCTDWUKPGUUGU #NNQHVJGCDQXG

Concept check 3 (KPCPEKCNTCVKQUCTGWUWCNN[FKXKFGFKPVQƂXGMG[ECVGIQTKGU%QPUKFGT the descriptions of those shown in list A and match them to the appropriate ECVGIQT[UJQYPKPNKUV$ List A 1 2 3 4

5

6JGUGTCVKQUCTGEQPEGTPGFYKVJTGVWTPUHTQOCPFVJGRGTHQTOCPEGQHUJCTGU 6JGUGTCVKQUKPENWFGECNEWNCVKQPUQHVJGVKOGVCMGPVQRC[UWRRNKGTU 6JGUGTCVKQUKPENWFGCEQORCTKUQPQHPQPEWTTGPVNKCDKNKVKGUCPFGSWKV[ 6JGUGTCVKQUCTGEQPEGTPGFYKVJVJGCXCKNCDKNKV[QHECUJQTPGCTECUJVQOGGVOCVWTKPI QDNKICVKQPU 6JGUGTCVKQUKPENWFGECNEWNCVKQPUQHVJGTGVWTPUHTQONQPIVGTOHWPFUKPXGUVGFKPVJG DWUKPGUU

List B 1 2 3 4 5

(KPCPEKCNIGCTKPITCVKQU 2TQƂVCDKNKV[TCVKQU +PXGUVOGPVTCVKQU .KSWKFKV[TCVKQU 'HƂEKGPE[TCVKQU

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PROFITABILITY RATIOS LO2 Identify the main ratios used to analyse profitability, and apply these ratios to a business

The following ratios may be used to evaluate the profitability of the business:

· · · ·

return on ordinary shareholders’ funds/return on equity return on capital employed operating profit margin, and gross profit margin.

We shall now look at each of these in turn.

Return on ordinary shareholders’ funds (ROSF) (also known as return on equity (ROE)) return on ordinary shareholders’ funds ratio (ROSF) #RTQƂVCDKNKV[TCVKQVJCV GZRTGUUGUVJGRTQƂVHQT VJGRGTKQFCXCKNCDNGVQ QTFKPCT[UJCTGJQNFGTUCUC RGTEGPVCIGQHVJGHWPFUVJCV VJG[JCXGKPXGUVGF

The return on ordinary shareholders’ funds ratio compares the amount of profit for the period available to the ordinary shareholders with the ordinary shareholders’ average stake in the business during that same period. For a limited company, the ratio (normally expressed in percentage terms) is as follows: ROSF =

2TQƂVCHVGTVCZCVKQPCPFCP[RTGHGTGPEGFKXKFGPF #XGTCIGQTFKPCT[UJCTGECRKVCNRNWUTGUGTXGU

× 100

The profit after taxation and any preference dividend is used in calculating the ratio, as this figure represents the amount of profit available to the owners. In the above equation, ‘reserves’ means all reserves, including general reserves, revaluation reserves and retained profits. In the case of Alexis Ltd, the ratio for the year ended 31 March 2016 is: 165 415(41' ³

 

Note that, when calculating the ROSF, the average of the figures for ordinary shareholders’ funds as at the beginning and at the end of the year has been used. This is because an average figure is normally more representative. The amount of shareholders’ funds was not constant throughout the year, yet we want to compare it with the profit earned during the whole period. We know, from Note 8, that the amount of shareholders’ funds at 1 April 2015 was $438 million. By a year later, however, it had risen to $563 million, according to the statement of financial position as at 31 March 2016. The easiest approach to calculating the average amount of shareholders’ funds is to take a simple average based on the opening and closing figures for the year. This is often the only information available, as is the case with Example 8.1 (page 301). Averaging is normally appropriate for all ratios that combine a figure for a period (such as profit for the year) with one taken at a point in time (such as shareholders’ funds). Where even the beginning-of-year figure is not available, it will be necessary to rely on just the year-end figure. This is not ideal, but, if this approach is consistently applied, it can produce ratios that are useful. Broadly, businesses seek to generate as high a value as possible for this ratio. This is provided that it is not achieved at the expense of potential future returns by, for example, taking on more risky activities. A return of 33% is a very good return. return on capital employed ratio (ROCE) #RTQƂVCDKNKV[TCVKQVJCV GZRTGUUGUVJGQRGTCVKPI RTQƂV KGRTQƂVDGHQTG KPVGTGUVCPFVCZCVKQPCU CRGTEGPVCIGQHVJGNQPI VGTOHWPFU GSWKV[CPF DQTTQYKPIUKPXGUVGFKPVJG DWUKPGUU

Return on capital employed (ROCE) The return on capital employed ratio is a fundamental measure of business performance. This ratio expresses the relationship between the operating profit generated during a period and the average long-term capital invested in the business during that period. The ratio is expressed in percentage terms and is as follows: 1RGTCVKPIRTQƂV 41%' × 100 5JCTGECRKVCN 4GUGTXGU 0QPEWTTGPVNKCDKNKVKGU

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Note in this case that the profit figure used is the operating profit (i.e. the profit before interest and taxation), because the ratio attempts to measure the returns to all suppliers of long-term finance before any deductions for interest payable to lenders, or payments of dividends to shareholders, are made. For the year to 31 March 2016, the ROCE ratio for Alexis Ltd is: 243 41%' ³

 

(The capital employed figure, which is the total equity plus non-current liabilities, at 1 April 2015 is given in Note 8.) Return on capital employed is considered by many to be a primary measure of profitability. It compares inputs (capital invested) with outputs (profit). This comparison is vital in assessing how effectively funds have been deployed. Once again, an average figure for capital employed may be used where the information is available.

Operating profit margin The QRGTCVKPIRTQƂVmargin ratio relates the operating profit for the period to the sales during that period. The ratio is expressed as follows: 1RGTCVKPIRTQƂV

1RGTCVKPIRTQƂVOCTIKP

5CNGU

× 100

operating profit margin ratio #RTQƂVCDKNKV[TCVKQVJCV GZRTGUUGUVJGQRGTCVKPI RTQƂVCUCRGTEGPVCIGQHVJG UCNGUTGXGPWGHQTVJGRGTKQF

The operating profit (profit before interest and taxation) is used in this ratio as it represents the profit from trading operations before any costs of servicing long-term finance are taken into account. This is often regarded as the most appropriate measure of operational performance for comparison purposes, as differences arising from the way a particular business is financed will not influence this measure. However, this is not the only way this ratio may be calculated in practice. The profit after taxation is also sometimes used as the numerator. For Alexis Ltd for the year ended 31 March 2016, the operating profit margin ratio is: 1RGTCVKPIRTQƂVOCTIKP

243 

³

This ratio compares one output of the business (operating profit) with another output (sales). The ratio can vary considerably between types of business. For example, a supermarket often operates on low operating profit margins to stimulate sales and, thereby, increase the total amount of profit generated. A jeweller, on the other hand, may have a high operating profit margin but a much lower level of sales volume. Factors such as the degree of competition, the type of customer, the economic climate, and industry characteristics (such as the level of risk) all influence the operating profit margin of a business. This point is picked up later in the chapter.

Gross profit margin The ITQUURTQƂV margin ratio relates the gross profit of the business to the sales revenue generated for the same period. Gross profit represents the difference between sales and the cost of sales. The ratio is, therefore, a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account. As cost of sales represents a major expense for retailing and manufacturing businesses, a change in this ratio can significantly affect the ‘bottom line’ (i.e. the profit for the year). The gross profit ratio is calculated as follows:

gross profit margin ratio #RTQƂVCDKNKV[TCVKQVJCV GZRTGUUGUVJGITQUURTQƂV CUCRGTEGPVCIGQHVJGUCNGU TGXGPWGHQTCRGTKQF

)TQUURTQƂV )TQUURTQƂVOCTIKP × 100 5CNGU

For Alexis Ltd for the year ended 31 March 2016, the ratio is as follows: 495 )TQUURTQƂVOCTIKP ³ 

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An adequate gross profit margin for a manufacturing and retail operation is essential to its success. An inadequate gross profit margin will mean that the business has little likelihood of success. The gross profit must cover the other expenses, and give the owners a satisfactory return. The adequacy of this margin depends on both the buying price (or manufactured cost) and the selling price.

ACTIVITY 8.2 Calculate the profitability ratios for Alexis Ltd for the year to 31 March 2017. Comment on these ratios. What do you learn from a comparison of the ratios over the two years? What needs to be done once the ratios have been examined?

Real World 8.1 sets out returns achieved by a variety of businesses.

REAL WORLD 8.1 Return on equity achieved by various companies Microso maintained a return on equity above 20% until the end of 2014. In 2015, due to goodwill and other impairment charges, this reduced to 14.36%. Over the 10 years to 2015 it achieved an average of 34.57%. Oracle, a major competitor of Microso, achieved a 10year average return on equity of 24.34%. Apple achieved a 10-year average return on equity of 34%. However, it has had higher returns than Microso over the last three years to 2015 due to higher income growth. Source: Steven Nickolas, ‘Analyzing Microso’s return on equity (ROE)’, Investopedia, 13 February 2016, .

Woolworths had a return on equity (before significant items) over the six-year period to 2016 that varied from 28.01% in 2011 to 14.43% in 2016. There were significant items relating to impairments in 2016. Interestingly, the gross profit

for the six-year period varied only slightly, from a minimum of 26.03% to 27.57%. Wesfarmers over the five-year period to 2015 achieved a return on average ordinary shareholders’ equity of between 7.7% and 10.5%. In 2016 it achieved a return before significant items of 9.6% which, aer significant items (impairments and restructuring of Target and Curragh), reduced to 1.7%. Sources: Annual Reports of Woolworths and Wesfarmers for 2016.

Toyota Motor Corp achieved a return on equity ranging from 2.69% to 12.95% over the period 2012–2015. Ford Motor Company achieved returns ranging from 12.85% to 35.52% over the same period. General Motors Company achieved figures ranging from 11.14% to 24.30%.

Other profit margins for the auto industry )TQUURTQƂVOCTIKP 6Q[QVC (QTF )GPGTCN/QVQTU 1RGTCVKPIRTQƂVOCTIKP 6Q[QVC (QTF )GPGTCN/QVQTU

2012   

2013   

2014   

2015   

  s

  

  

  

Source: .

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Concept check 4 Which of the following is not one of the main ratios used to assess RTQƂVCDKNKV[! A B C D E

1RGTCVKPIRTQƂVOCTIKP )TQUURTQƂVOCTIKP 4GVWTPQPVQVCNUJCTGJQNFGTUoGSWKV[ 4GVWTPQPECRKVCNGORNQ[GF #NNQHVJGCDQXGTCVKQUCTGWUGFVQCUUGUURTQƂVCDKNKV[

Concept check 5 9JKEJRTQƂVCDKNKV[TCVKQTGNCVGUVJGCOQWPVQHUCNGUTGXGPWGless the cost of sales to the total sales revenue for the period? A B C D E

1RGTCVKPIRTQƂVOCTIKP )TQUURTQƂVOCTIKP 4GVWTPQPUJCTGJQNFGTUoGSWKV[ 4GVWTPQPECRKVCNGORNQ[GF #NNQHVJGCDQXGTCVKQUCTGWUGFVQCUUGUURTQƂVCDKNKV[

Concept check 6 9JKEJRTQƂVCDKNKV[TCVKQGZRTGUUGUVJGTGNCVKQPUJKRDGVYGGPVJGQRGTCVKPI RTQƂVIGPGTCVGFFWTKPICRGTKQFCPFVJGCXGTCIGNQPIVGTOECRKVCN invested in the business during that period? A B C D E

1RGTCVKPIRTQƂVOCTIKP )TQUURTQƂVOCTIKP 4GVWTPQPUJCTGJQNFGTUoGSWKV[ 4GVWTPQPECRKVCNGORNQ[GF #NNQHVJGCDQXGTCVKQUCTGWUGFVQCUUGUURTQƂVCDKNKV[

EFFICIENCY RATIOS Efficiency ratios are used to try to assess how successfully the various resources of the business are managed. The following ratios consider some of the more important aspects of resource management: • • • • •

average inventories turnover period average settlement period for accounts receivable average settlement period for accounts payable sales revenue to capital employed, and sales revenue per employee.

LO3 Identify the main ratios used to analyse efficiency regarding usage of assets, and apply these ratios to a business

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Average inventories turnover period average inventories turnover period ratio #PGHƂEKGPE[TCVKQVJCV OGCUWTGUVJGCXGTCIGRGTKQF HQTYJKEJKPXGPVQTKGUCTG JGNFD[CDWUKPGUU

Inventory often represents a significant investment for a business. For some types of business (e.g. manufacturers), it may account for a substantial proportion of their total assets. The average inventories turnover period ratio measures the average period for which inventory is being held. The ratio is calculated thus: #XGTCIGKPXGPVQT[JGNF +PXGPVQTKGUVWTPQXGTRGTKQF × 365 %QUVQHUCNGU

The average inventory for the period can be calculated as a simple average of the opening and closing inventory levels for the year. However, in the case of a highly seasonal business, where inventory levels may vary considerably over the year, a monthly average may be more appropriate. For Alexis Ltd the inventories turnover period for the year ended 31 March 2016 is: +PXGPVQTKGUVWTPQXGTRGTKQF

  

³FC[U

(The opening inventories figure was taken from Note 3 to the financial statements.) This means that, on average, the inventory held is being ‘turned over’ every 56.6 days. So, a carpet bought by the business on a particular day would, on average, have been sold about eight weeks later. A business normally prefers a low inventories turnover period to a high period, as funds tied up in inventory cannot be used for other profitable purposes. In judging the amount of inventory to carry, the business must consider such things as the likely future demand, the possibility of future shortages, the likelihood of future price rises, the cost advantages of buying in larger quantities, the amount of storage space available and the perishability/susceptibility to obsolescence of the product. The management of inventory is explained in more detail in Chapter 13. This ratio is sometimes expressed in terms of months or weeks rather than days. Multiplying by 12 or 52, rather than 365, will achieve this.

Average settlement period for accounts receivable (debtors)

average settlement period for accounts receivable ratio #PGHƂEKGPE[TCVKQVJCV OGCUWTGUVJGCXGTCIGVKOG VCMGPHQTVTCFGTGEGKXCDNGUVQ RC[VJGCOQWPVUQYKPI

Selling on credit is the norm for most businesses, except for retailers. Trade receivables are a necessary evil. A business will naturally be concerned with the amount of funds tied up in trade receivables and try to keep this to a minimum. The speed of payment can have a significant effect on its cash flows. The average settlement period calculates how long, on average, credit customers take to pay the amounts they owe. The ratio is as follows: #XGTCIGUGVVNGOGPVRGTKQF

#XGTCIGCEEQWPVUTGEGKXCDNG %TGFKVUCNGUTGXGPWG

A business normally prefers a shorter average settlement period than a longer one, because funds that are not tied up may be used for more profitable purposes. Although this ratio can be useful, it is important to remember that it produces an average figure for the number of days debts are outstanding. This average may be badly distorted by, for example, a few large customers who are very slow payers. We are told that all sales made by Alexis Ltd are on credit, and so the average settlement period for accounts receivable for the year ended 31 March 2016 is: #XGTCIGUGVVNGOGPVRGTKQF

average settlement period for accounts payable ratio #PGHƂEKGPE[TCVKQVJCV OGCUWTGUVJGCXGTCIGVKOG VCMGPHQTCDWUKPGUUVQRC[ KVUVTCFGRC[CDNGU

× 365

  

³FC[U

Average settlement period for accounts payable (creditors) The average settlement period for accounts payable ratio measures how long, on average, the business takes to pay its accounts payable. The ratio is calculated as follows: #XGTCIGUGVVNGOGPVRGTKQF

#XGTCIGCEEQWPVURC[CDNG %TGFKVRWTEJCUGU

× 365

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This ratio provides an average figure which, like the average settlement period for accounts receivable, can be distorted by the payment period taken by one or two large suppliers. As accounts payable provides a free source of finance for the business, it is perhaps not surprising that some businesses attempt to increase their average settlement period for accounts payable. However, such a policy can be taken too far and result in a loss of suppliers’ goodwill. We will return to the issues of managing accounts receivable and accounts payable in Chapter 13. In the case of Alexis Ltd, for the year ended 31 March 2016 the average settlement period is:

  #XGTCIGUGVVNGOGPVRGTKQF ³FC[U 

Sales revenue to capital employed The sales revenue to capital employed ratio examines how effectively the assets of the business are being employed in generating sales revenue. The ratio is calculated as follows:



5CNGUTGXGPWG 5CNGUTGXGPWGVQECRKVCNGORNQ[GF 5JCTGECRKVCN 4GUGTXGU 0QPEWTTGPVNKCDKNKVKGU

sales revenue to capital employed ratio #PGHƂEKGPE[TCVKQVJCV TGNCVGUVJGUCNGUTGXGPWG IGPGTCVGFFWTKPICRGTKQFVQ VJGECRKVCNGORNQ[GF

Generally speaking, a higher sales revenue to capital employed ratio is preferred to a lower one. A higher ratio will normally suggest that assets are being used more productively in the generation of revenue. However, a very high ratio may suggest that the business is ‘over-trading on its assets’; that is, it has insufficient assets to sustain the level of sales revenue achieved. When comparing this ratio for different businesses, factors such as the age and condition of assets held, the valuation bases for assets, and whether assets are leased or owned outright can complicate interpretation. A variation of this formula is to use the total assets less current liabilities (which is equivalent to long-term capital employed) in the denominator (the lower part of the fraction). The identical result is obtained. This ratio is also sometimes known as the ‘asset turnover ratio’. For the year ended 31 March 2016, this ratio for Alexis Ltd is:  5CNGUTGXGPWGVQECRKVCNGORNQ[GF VKOGU

 

Sales revenue per employee The sales revenue per employee ratio relates sales revenue generated during a reporting period to a particular business resource that is, labour. It provides a measure of the productivity of the workforce. The ratio is: 5CNGUTGXGPWG 5CNGUTGXGPWGRGTGORNQ[GG 0WODGTQHGORNQ[GGU

sales revenue per employee ratio #PGHƂEKGPE[TCVKQVJCV TGNCVGUVJGUCNGUTGXGPWG IGPGTCVGFFWTKPICRGTKQF VQVJGCXGTCIGPWODGTQH GORNQ[GGUQHVJGDWUKPGUU

Generally, businesses would prefer a high value for this ratio, implying that they are using their staff efficiently. For the year ended 31 March 2016, the ratio for Alexis Ltd is: O 5CNGUTGXGPWGRGTGORNQ[GG  

ACTIVITY 8.3 Calculate the efficiency ratios for Alexis Ltd for the year to 31 March 2017. Comment on these ratios and their relationship to the ratios for the year ended 31 March 2016.

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Alternative formats The first three efficiency ratios have been expressed in terms of a turnover period (number of days). An alternative is to express them simply as the number of times that asset (or liability) turns over (repeats itself) on average during the year. The formula for such ratios is simply the appropriate figure from the statement of financial performance (e.g. cost of sales, credit sales and credit purchases) divided by the average statement of financial position figure (inventory, accounts receivable, accounts payable). If you know the ‘turnover’ figure (e.g. 3.2 times), you can get the ‘turnover period’ by dividing 365 days by the ‘turnover’ (e.g. 365 days/3.2 = 114 days). Similarly, if you know the ‘turnover period’ (e.g. 49 days), you can get the ‘turnover’ by dividing 365 days by the turnover period (e.g. 365 days/49 days = 7.45 times). For the worked examples the ‘turnovers’ would be:

2016

2017

VKOGU

VKOGU

#XGTCIGCEEQWPVUTGEGKXCDNGVWTPQXGT

VKOGU

VKOGU

#XGTCIGCEEQWPVURC[CDNGVWTPQXGT

VKOGU

VKOGU

Inventories turnover

The relationship between profitability and efficiency In our earlier discussions of profitability ratios, you will recall that return on capital employed (ROCE) is regarded as a key ratio by many businesses. The ratio is: 1RGTCVKPIRTQƂV 41%' × 100 .QPIVGTOECRKVCNGORNQ[GF

where long-term capital comprises share capital plus reserves plus long-term borrowings. This ratio can be broken down into two elements, as shown in Figure 8.2. Essentially, if we multiply the ROCE by Sales/Sales (which is obviously 1), we can split the ROCE ratio into its two component parts. The first ratio is the operating profit margin ratio, and the second is the sales revenue to capital employed (net asset turnover) ratio, both of which we discussed earlier.

FIGURE 8.2

1RGTCVKPIRTQƂV

The main elements comprising the ROCE ratio 6JG41%'TCVKQECPDGFKXKFGFKPVQVYQGNGOGPVUQRGTCVKPIRTQƂVVQ UCNGUTGXGPWGCPFUCNGUTGXGPWGVQECRKVCNGORNQ[GF$[CPCN[UKPI41%' KPVJKUYC[YGECPUGGVJGKPƃWGPEGQHDQVJRTQƂVCDKNKV[CPFGHƂEKGPE[ QPVJKUKORQTVCPVTCVKQ

Sales revenue multiplied by Sales revenue Long-term capital employed equals

Return on capital employed

By breaking down the ROCE ratio in this manner, we highlight the fact that the overall return on funds employed within the business will be determined both by the profitability of sales and by efficiency in the use of capital. Consider Example 8.2.

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%QPUKFGTVJGHQNNQYKPIKPHQTOCVKQPHQTNCUV[GCTEQPEGTPKPIVYQFKHHGTGPVDWUKPGUUGUQRGTCVKPIKPVJG UCOGKPFWUVT[ Antler Ltd $m 20 100 200

1RGTCVKPIRTQƂV #XGTCIGNQPIVGTOECRKVCNGORNQ[GF 5CNGUTGXGPWG

Baker Ltd $m 15 75 300

8.2

6JG41%'HQTGCEJDWUKPGUUKUKFGPVKECN *QYGXGTVJGOCPPGTKPYJKEJVJCVTGVWTPYCUCEJKGXGF D[GCEJDWUKPGUUYCUSWKVGFKHHGTGPV+PVJGECUGQH#PVNGT.VFVJGQRGTCVKPIRTQƂVOCTIKPKUCPF VJGUCNGUTGXGPWGVQECRKVCNGORNQ[GFTCVKQKUVKOGU UQ41%'³+PVJGECUGQH$CMGT .VFVJGQRGTCVKPIRTQƂVOCTIKPKUCPFVJGUCNGUTGXGPWGVQECRKVCNGORNQ[GFTCVKQKUVKOGU CPF UQ41%'³ 6JKUFGOQPUVTCVGUVJCVCTGNCVKXGN[JKIJUCNGUTGXGPWGVQECRKVCNGORNQ[GFTCVKQECPEQORGPUCVGHQT CTGNCVKXGN[NQYQRGTCVKPIRTQƂVOCTIKP5KOKNCTN[CTGNCVKXGN[NQYUCNGUTGXGPWGVQECRKVCNGORNQ[GF TCVKQECPDGQXGTEQOGD[CTGNCVKXGN[JKIJQRGTCVKPIRTQƂVOCTIKP+POCP[CTGCUQHTGVCKNCPF FKUVTKDWVKQP GIUWRGTOCTMGVUCPFFGNKXGT[UGTXKEGUQRGTCVKPIRTQƂVOCTIKPUCTGSWKVGNQYDWVVJG 41%'ECPDGJKIJRTQXKFGFVJCVVJGCUUGVUCTGWUGFRTQFWEVKXGN[ KGNQYOCTIKPJKIJUCNGUTGXGPWG VQECRKVCNGORNQ[GF

Example 8.3 illustrates how the ROCE of Alexis Ltd can be analysed into the two elements for each of the two years 2016 and 2017.

#NGZKU.VFoU41%'ECPDGCPCN[UGFCUUJQYPDGNQY ROCE 2016 2017

 

=

1RGTCVKPIRTQƂV

= =

OCTIKP  

×

Sales revenue to

× ×

capital employed  

8.3

%NGCTN[VJGOCKPKUUWGTGNCVGUVQVJGQRGTCVKPIRTQƂVOCTIKPTCVJGTVJCPUCNGUTGXGPWGVQECRKVCN GORNQ[GF6JGDWUKPGUUYCUOCTIKPCNN[OQTGGHHGEVKXGCVIGPGTCVKPIUCNGUTGXGPWG KGVJGUCNGU TGXGPWGVQECRKVCNGORNQ[GFTCVKQKPETGCUGFKPVJCPKP*QYGXGTKPVJGQRGTCVKPI RTQƂVOCTIKPHGNNUWDUVCPVKCNN[YKVJVJGTGUWNVVJCV41%'CNUQFGENKPGFFTCOCVKECNN[(WTVJGTCPCN[UKUKU PGGFGFCUVQYJGTGVJGKPGHƂEKGPEKGUTGNCVKPIVQQRGTCVKPIEQUVUCTQUG

Concept check 7 9JKEJGHƂEKGPE[TCVKQRTQXKFGUCPKPFKECVKQPQHVJGGHƂEKGPE[QHVJGƂTOoU collection department and/or appropriateness of customer credit policy? A B C D E

#XGTCIGKPXGPVQTKGUVWTPQXGTRGTKQF #XGTCIGUGVVNGOGPVRGTKQFHQTCEEQWPVUTGEGKXCDNG #XGTCIGUGVVNGOGPVRGTKQFHQTCEEQWPVURC[CDNG 5CNGUTGXGPWGVQECRKVCNGORNQ[GF 5CNGUTGXGPWGRGTGORNQ[GG

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Concept check 8 Which of the following ratios might be increased if the idea that credit RTQXKFGUCHTGGUQWTEGQHƂPCPEG GIKORTQXGFECUJƃQYHQTVJGDWUKPGUU YGTG|VCMGPKPVQCEEQWPV! A B C D E

#XGTCIGKPXGPVQTKGUVWTPQXGTRGTKQF #XGTCIGUGVVNGOGPVRGTKQFHQTCEEQWPVUTGEGKXCDNG #XGTCIGUGVVNGOGPVRGTKQFHQTCEEQWPVURC[CDNG 5CNGUTGXGPWGVQECRKVCNGORNQ[GF 5CNGUTGXGPWGRGTGORNQ[GG

Concept check 9 6JGFTCHVƂPCPEKCNUVCVGOGPVUQHSummerwine Ltd for the year ended 31 December 2017 include the following: 5CNGUTGXGPWG

OKNNKQP

)TQUURTQƂV

OKNNKQP

It is subsequently discovered that $30 million of this sales revenue relates to 2018 and that inventories valued at $10 million have been omitted from the closing inventories HQT&GEGODGT#HVGTEQTTGEVKQPQHVJGUGGTTQTUVJGITQUURTQƂVTCVKQYKNNDG A B C D

   

LIQUIDITY LO4 Identify the main ratios used to analyse liquidity, and apply these ratios to a business

Liquidity ratios assess how well the business can meet short-term commitments or claims against the assets when they fall due. This ratio is sometimes expressed in terms of the ability or speed with which assets can be converted to cash. The following ratios consider some of the more important aspects of the reporting entity’s liquidity position:

· current ratio, and · acid test (liquid or quick) ratio.

Current ratio current ratio #NKSWKFKV[TCVKQVJCVTGNCVGU VJGEWTTGPVCUUGVUQHVJG DWUKPGUUVQVJGEWTTGPV NKCDKNKVKGU

The current ratio compares the business’s ‘liquid’ assets (i.e. cash and those assets held that will soon be turned into cash) with the short-term liabilities (current liabilities). The ratio is calculated as follows: %WTTGPVCUUGVU

%WTTGPVTCVKQ

%WTTGPVNKCDKNKVKGU

Some texts suggest the notion of an ‘ideal’ current ratio (usually 2 times or 2:1) for a business. However, this fails to take into account the fact that different types of businesses require different current ratios. For example, a manufacturing business will often have a relatively high current ratio because it must hold stocks of finished goods, raw materials and work-in-progress. It will also

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normally sell goods on credit, thereby incurring accounts receivable. A supermarket chain, on the other hand, will have a relatively low current ratio as it will hold only fast-moving stocks of finished goods and will generate mostly cash sales. The higher the ratio, the more liquid the business is considered to be. As liquidity is vital to the survival of a business, a higher current ratio is normally preferred to a lower ratio. However, a business with a very high current ratio may have funds that are tied up in cash or other liquid assets, and so are not being used as productively as they might be. For the year ended 31 March 2016, the current ratio of Alexis Ltd is: 544 %WTTGPVTCVKQ VKOGU QT 291

The ratio reveals that the current assets cover the current liabilities by 1.9 times.

Acid test ratio The acid test ratio (also known as the ‘liquid ratio’ or ‘quick ratio’) represents a more stringent test of liquidity. It can be argued that, for many businesses, the inventory on hand cannot be converted into cash quickly. (Note that for Alexis Ltd the inventory turnover period was about 57 days in both years.) As a result, it may be better to exclude this particular asset from any measure of liquidity. The acid test ratio is based on this idea and is calculated as follows: #EKFVGUVTCVKQ



acid test ratio #NKSWKFKV[TCVKQVJCVTGNCVGU VJGNKSWKFCUUGVU WUWCNN[ FGƂPGFCUEWTTGPVCUUGVUNGUU KPXGPVQTKGUCPFRTGRC[OGPVU VQVJGEWTTGPVNKCDKNKVKGU

%WTTGPVCUUGVU GZENWFKPIKPXGPVQT[CPFRTGRC[OGPVU %WTTGPVNKCDKNKVKGU

The minimum level for this ratio is often stated as 1.0 times (or 1:1; i.e. current assets, excluding inventories, equal current liabilities). In some types of business, however, where cash flows are strong, it is not unusual for the acid test ratio to be below 1.0 without causing liquidity problems. The acid test ratio for Alexis Ltd for the year ended 31 March 2016 is:

s

#EKFVGUVTCVKQ

291

VKOGU QTVQ

We can see that the ‘liquid’ current assets do not quite cover the current liabilities, and so the business may have liquidity problems.

ACTIVITY 8.4 Calculate the liquidity ratios for Alexis Ltd for the year ended 31 March 2017. What do you deduce from these ratios for 2016 and 2017?

Both the current ratio and the acid test ratio derive the relevant figures from the statement of financial position. As this statement is simply a ‘snapshot’ of the financial position of the business at a single moment in time, care must be taken when interpreting the ratios. It is possible that the figures from the statement of financial position do not truly represent the liquidity position during the year. This may be due to exceptional factors or simply to the business being seasonal in nature, and these figures represent the cash position at one particular point in the seasonal cycle only.

Concept check 10 Which of the following is a ratio that is typically used to assess liquidity? A B C D E

3WKEMTCVKQ Current ratio Acid test .KSWKFTCVKQ #NNQHVJGCDQXG

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Concept check 11 Which ratio compares current assets with current liabilities? A B C D E

3WKEMTCVKQ Current ratio Acid test .KSWKFTCVKQ #NNQHVJGCDQXG

LO5 FINANCIAL GEARING (LEVERAGE) RATIOS Identify the main ratios used to analyse financial gearing (leverage), and apply these ratios to a business

financial gearing 6JGGZKUVGPEGQHƂZGF RC[OGPVDGCTKPIUQWTEGU QHƂPCPEG GIDQTTQYKPIU KPVJGECRKVCNUVTWEVWTGQHC DWUKPGUU

Financial gearing occurs when a business is financed, at least in part, by contributions from outside parties, typically borrowings. The level of gearing (i.e. the extent to which a business is financed by outside parties) is often an important factor in assessing risk. A business that borrows heavily is committed to pay interest charges and make capital repayments, a potential financial burden that can increase its risk of becoming insolvent. Nevertheless, it is the case that most businesses are geared to some extent. With such risks involved, you may wonder why a business would want to take on gearing. One reason may be that the owners have insufficient funds and, therefore, the only way to finance the business adequately is to borrow from others. Another reason is that gearing can be used to increase the returns to owners, as long as the returns generated from borrowed funds exceed the cost of paying interest. Example 8.4 illustrates this point.

6YQEQORCPKGU:.VFCPF;.VFEQOOGPEGDWUKPGUUYKVJVJGHQNNQYKPINQPIVGTOECRKVCNUVTWEVWTGU

8.4

2CKFWRQTFKPCT[ECRKVCN NQCP

X Ltd $   

Y Ltd $   

+PVJGƂTUV[GCTQHQRGTCVKQPUVJG[DQVJOCMGCPQRGTCVKPIRTQƂV RTQƂVDGHQTGKPVGTGUVCPFVCZCVKQP QH+PVJKUECUGVJGVCZTCVGKUCUUWOGFVQDGQHVJGRTQƂVDGHQTGVCZDWVCHVGTKPVGTGUV: .VFYQWNFDGEQPUKFGTGFJKIJN[IGCTGFCUKVJCUCJKIJRTQRQTVKQPQHDQTTQYGFHWPFUKPKVUNQPIVGTO ECRKVCNUVTWEVWTG;.VFJCUNQYGTNGXGNUQHIGCTKPI6JGRTQƂVCXCKNCDNGVQVJGUJCTGJQNFGTUQHGCEJ EQORCP[KPVJGƂTUV[GCTQHQRGTCVKQPUYKNNDG

1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG 2TQƂVDGHQTGVCZCVKQP 6CZCVKQP UC[ 2TQƂVCXCKNCDNGVQQTFKPCT[UJCTGJQNFGTU

X Ltd $ 

 

 

Y Ltd $ 

 

 

6JGTGVWTPQPUJCTGJQNFGTUoHWPFU 415(HQTGCEJEQORCP[YKNNDG X Ltd $ × 100 



Y Ltd $ × 100 



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9GECPUGGVJCV:.VFVJGOQTGJKIJN[IGCTGFEQORCP[JCUIGPGTCVGFCDGVVGTTGVWTPQP UJCTGJQNFGTUoHWPFUVJCP;.VF6JKUKUKPURKVGQHVJGHCEVVJCVVJGTGVWTPQPECRKVCNGORNQ[GFKU KFGPVKECNHQTDQVJDWUKPGUUGU KG ³ 0QVGVJCVCVVJGNGXGNQHQRGTCVKPIRTQƂVVJGUJCTGJQNFGTUQHDQVJ:.VFCPF;.VFDGPGƂV HTQOIGCTKPI9GTGVJGVYQDWUKPGUUGUVQVCNN[TGNKCPVQPGSWKV[ƂPCPEKPIVJGRTQƂVHQTVJG[GCT

CHVGTVCZCVKQPRTQƂVYQWNFDG KGNGUUVCZCVKQPIKXKPICP415(QH KG $QVJDWUKPGUUGUIGPGTCVGJKIJGT415(UVJCPVJKUCUCTGUWNVQHƂPCPEKCNIGCTKPI

8.4 continued

An effect of gearing is that returns to equity become more sensitive to changes in profits. For a highly geared company, a change in profits can lead to a proportionately greater change in the returns to equity, as illustrated in Example 8.5.

#UUWOGVJCVVJGRTQƂVDGHQTGKPVGTGUVCPFVCZYCUJKIJGTHQTGCEJEQORCP[KP'ZCORNGVJCP UVCVGF*QYYQWNFVJKUCHHGEVVJGTGVWTPQPQYPGTUoGSWKV[! 6JGTGXKUGFRTQƂVCXCKNCDNGVQVJGUJCTGJQNFGTUQHGCEJEQORCP[KPVJGƂTUV[GCTQHQRGTCVKQPUYKNNDG X Ltd $     

1RGTCVKPIRTQƂV +PVGTGUVRC[CDNG 2TQƂVDGHQTGVCZCVKQP 6CZCVKQP UC[ 2TQƂVCXCKNCDNGVQQTFKPCT[UJCTGJQNFGTU

Y Ltd $     

8.5

6JGTGVWTPQPUJCTGJQNFGTUoHWPFUHQTGCEJEQORCP[YKNNPQYDG :.VF

;.VF

 ³ 

 ³ 

We can see from Example 8.5 that for X Ltd, the higher geared company, the returns to equity have increased by one-third (from 21% to 28%), whereas for the lower geared company the benefits of gearing are less pronounced. The increase in the returns to equity for Y Ltd is onequarter (14% to 17.5%). The effect of gearing, of course, can work in both directions. Thus, for a highly geared company, a small decline in profits may bring about a much greater decline in the returns to equity. If the ROSF is less than the rate of interest charged on borrowings, the negative impacts of gearing become considerable. The reason that gearing tends to be beneficial to shareholders is that interest rates for borrowings are low by comparison with the returns that the typical business can earn. On top of this, interest expenses are tax-deductible, in the way shown in recent examples. This makes the effective cost of borrowing quite cheap. It can be argued that, since borrowing increases the risk to shareholders, there is a hidden cost of borrowing. Whatever your view of this, there is little doubt that there are benefits to the shareholders of the tax deductibility of interest on borrowings. Figure 8.3 illustrates the effects of gearing, with the movement of the larger cog (operating profit) causing a more than proportionate movement in the smaller cog (returns to ordinary shareholders).

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FIGURE 8.3 6JGGHHGEVQHƂPCPEKCNIGCTKPI 6JGVYQYJGGNUCTGNKPMGFD[VJGEQIUUQVJCVCTGNCVKXGN[ UOCNNEKTEWNCTOQXGOGPVKPVJGNCTIGYJGGN QRGTCVKPI RTQƂVNGCFUVQCTGNCVKXGN[NCTIGEKTEWNCTOQXGOGPVKPVJG UOCNNYJGGN TGVWTPUQPQTFKPCT[UJCTGJQNFGTUoHWPFU

Operating profit

Return on ordinary

shareholders’ funds

The following ratios may be used to evaluate the gearing or long-term financial stability (solvency) of a business: • gearing ratio, and • interest cover ratio.

Gearing ratio gearing ratio #TCVKQVJCVTGNCVGUVJG NQPIVGTOƂZGFTGVWTP ƂPCPEGEQPVTKDWVGF UWEJ CUDQTTQYKPIUVQVJGVQVCN NQPIVGTOƂPCPEGQHVJG DWUKPGUU

The gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a business: .QPIVGTONKCDKNKVKGU )GCTKPITCVKQ × 100 5JCTGECRKVCN 4GUGTXGU .QPIVGTONKCDKNKVKGU

The gearing ratio for Alexis Ltd as at 31 March 2016 is: )GCTKPITCVKQ

200

 

³

This ratio reveals a level of gearing that would not normally be considered as very high. Other variations of the gearing ratio focus mainly on the proportion of outside debt to owners’ equity. These are: • total liabilities to total assets • total liabilities to total owners’ equity, and • long-term liabilities to total owners’ equity. When comparing the gearing ratio calculated for a particular business with those calculated for other businesses (or industry averages), great care needs to be taken to ensure that the two sets of figures are comparable (i.e. use the same basis of calculation). The third ratio mentioned above is fairly commonly used (as in Real World 8.2, page 317). interest cover ratio #IGCTKPITCVKQVJCVFKXKFGU VJGQRGTCVKPIRTQƂV KG RTQƂVDGHQTGKPVGTGUVCPF VCZCVKQPD[VJGKPVGTGUV GZRGPUGHQTCRGTKQF

Interest cover ratio (times interest earned) The interest cover ratio measures the amount of profit available to cover interest expense. That is the operating profit, which is the profit before interest and taxes. The ratio may be calculated as follows: +PVGTGUVEQXGTTCVKQ

1RGTCVKPIRTQƂV +PVGTGUVGZRGPUG

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The ratio for Alexis Ltd for the year ended 31 March 2016 is: 243 +PVGTGUVEQXGTTCVKQ VKOGU 18

This ratio shows that the level of profit is considerably higher than the level of interest expense. Thus, a significant fall in profits could occur before profit levels failed to cover interest expense. The lower the level of operating profit coverage, the greater the risk to lenders that interest payments will not be met. There will also be a greater risk to the shareholders that the lenders will take action against the business to recover the interest due.

ACTIVITY 8.5 Calculate the gearing ratio and interest coverage ratios for Alexis Ltd for the year ended 31 March 2017. What do you deduce from a comparison of the gearing ratios of Alexis Ltd over the two years?

Over the period since the global financial crisis, gearing ratios have trended downwards. Real World 8.2 provides an indication of the way gearing ratios have moved since 2009, and some of the implications of the use of high levels of debt. Since that time, capital raisings have continued, with a consequent reduction in gearing. In spite of this, questions continue regarding the use of debt, both at a corporate level and at a personal level.

REAL WORLD 8.2 Changing gear In early 2009 Jeremy Grant wrote an article in the Financial Times commenting on a changing level of debt in corporate structures, as a result of the global financial crisis. There had been a move to much more conservative balance sheets linked to a number of new issues of capital. Gearing—as measured by net debt as a proportion of shareholders’ funds, which had run at an average of about 30% over the last 20 years, was expected to come down to about 20% and stay for some time. The point was made that reducing gearing was not easy, especially for the most indebted companies, and new equity raising would not be easy for companies with highly leveraged balance sheets. Source: Grant, Jeremy, ‘Gearing levels set to plummet’, Financial Times, 10 February 2009. © The Financial Times Limited 2009. All rights reserved. FT and ‘Financial Times’ are trademarks of The Financial Times Ltd. Pearson Australia is responsible for providing this adaptation of the original article.

While it needs to be recognised that this article was written from a British perspective, which faced a more recessionary environment than Australia, the trends identified were fairly universal. There is little doubt that, since the time of the writing of this article, much has taken place that reinforces these points. In an article written early in 2016, Paul Kelly argued that the failure of economies to recover from the GFC crisis had led to ‘weak growth, low or negative interest rates, rising asset prices, more inequality and poor

investment’. Interest rates are still very low, a fact which may encourage greater use of debt. Whether the world has learned from the GFC remains a moot point. It has been argued that the weight of debt has grown in the wake of the GFC and is crushing the ability of the global economy to return to growth. Satyajit Das (a well-known consultant and former banker) stated: ‘Ultimately, excessive debt resembles a Ponzi scheme. Nations, business, and individuals need to borrow ever increasing amounts to repay existing borrowing and maintain economic growth’ (Thieberger). Emerging markets corporate debt has moved from just over 45% of GDP to just under 75% of GDP (Creighton). Sources: Paul Kelly, ‘Staying smart in dangerous post-GFC world’, The Australian, 13 April 2016. Victoria Thieberger, ‘Das sees little hope for a world deep in debt’, The Australian, 18 February 2016. Adam Creighton, ‘Debt rise a worry for global growth’, The Australian, 30 September 2015.

Examples of companies that have run into problems because of their levels of debt include the following: ● Glencore merged with Xstrata, one of the world’s biggest mining companies in 2013, as part of a long-running expansion program. At the time the CEO, Ivan Glasenberg,

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raised the question, ‘Will commodity prices stay strong … and justify putting this much money into an assetrich company? Have we done the right thing? This is my biggest fear.’ More than two years later, these fears had become a reality, as declining prices hit copper and coal. Losses for the first half of 2015 were US$676 million and the share price fell by nearly three-quarters. Glencore had an estimated net debt of US$50 billion. A US$10 billion reduction plan was developed which included suspension of dividends and capital raising of US$2.5 billion (Patterson and Miller). By mid-December the debt reduction target had been revised to US$13 billion and ‘$US8.7bn had already [been] achieved or locked in’. ‘If all goes according to plan, it will have reduced its overall net debt from its peak of almost $US50bn to about $US33bn by the end of next year’ (2016) (Bartholomeusz). Sources: Scott Patterson & John W Miller, ‘High flying Glencore brought to heel’, The Weekend Australian, 3–4 October 2015. Stephen Bartholomeusz, ‘Blindsided miners Glencore and Anglo rush to fix balance sheet blues’, The Weekend Australian, 12–13 December 2015.

● Arrium was the result of a spin-off from BHP Billiton, which initially was quite successful. From 2008 debt levels soared and earnings plummeted. Debt rose from $645 million in 2005 to $2 billion in 2008. Iron ore prices (which had become a major factor in Arrium’s earnings) fell from US$190 a tonne at its peak to US$54

in April 2016. In April 2016 the company went into administration. Source: Barry Fitzgerald, ‘Promising start before ill-timed iron ore push’, The Australian, 8 April 2016.

There are examples where companies have benefited from reductions in debt. One such example is Fortescue, which has embarked on a strategy of debt and cost reduction. Source: Sarah-Jane Tasker, ‘Fortescue slashes debt and costs’, The Australian, 29 January 2016.

● BHP spin-off South 32 provides another example of deliberate debt reduction. It reduced its debt by a further US$81 million over the latter part of 2015 to US$115 million. It had more than US$400 million in net debt at the start of the financial year. At the end of 2015 it was seen as one of the laziest balance sheets in Australia’s mining sector. Source: Paul Garvey, ‘South 32 cuts its debts further’, The Australian, 22 January 2016.

We have also seen a considerable number of capital raisings, many of which have been rights issues, with a general aim of reducing leverage. This area will be covered in more detail in Chapter 14. All of the examples included here must be seen as ongoing, and you should find it useful, as time goes by, to examine what has happened in all of these cases since the time of writing.

An aside on personal debt So far in the chapter we have been concerned with levels of corporate debt. However, similar concerns now exist regarding levels of government and personal (or household) debt. Don Stammer in his article, ‘Avoid future shocks: six steps for managing rising household debt, good and bad’ (27 October 2015, The Australian, News Corp Australia), identified the size of the problem as far as household debt is concerned. Below is an outline of the extent of the increase in levels of household debt between 1995 and 2015: • The household debt to assets ratio almost doubled from around 15% to 30%. • The interest payments to income ratio went from about 6% in 1995 through about 12% in 2010, to about 9% in 2015. • The debt to income ratio increased from around 60% to approximately 150%. Household savings were close to 10% in 2015, a figure which was as high as it had been for the last 20 years. Interest rates at that time were extremely low, which makes debt seemingly affordable, but then has the potential to lead to a very high debt to income ratio. Even moderate increases in interest rates can impose a burden on many households. The figure for debt to income can only be justified if we assume that the chance of increased interest rates is extremely low. In the latter half of the article, Stammer provided some guidance for managing household debt, which is summarised below. • Each household should keep detailed track of its indebtedness.

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• Separate debt into good and bad debt. ‘Good debt would include … borrowings for the family home, investments and education.’ ‘Bad debt would include debt to pay for borrowing living expenses and holidays.’ • Avoid high-cost borrowing, e.g credit card debt. • ‘… consider having part of your loan carry a fixed interest rate.’ • Avoid borrowing for investment when markets are booming, but invest in gloomy times. • Recognise that with a geared portfolio there is some debt within the portfolio. Interestingly, Stammer pointed out that the average (non-financial) listed company had debt equal to 55% of its equity value. In The Age Money supplement of 11 February 2015, there was an article on how to escape the debt spiral. The article discussed reasons why some people find themselves in the debt trap, as well as ways of resolving the issue. The steps included the following: • • • • •

Stop denying that you have a problem. Critically examine your money flows, both in and out. Work out how you are going to pay off your debts. Consolidate your debt. (The article identifies a variety of ways in which this can be done.) Cancel or cut up credit cards. Develop a plan to reduce your debt. Set yourself a target. Source: Christine Long, ‘Many ways to escape the debt spiral’, MoneyAge, 11 February 2015.

The essence of both of these articles is, as with corporate debt, debt when used wisely can enhance wealth. Used excessively or thoughtlessly, on the other hand, debt can lead to significant reductions in wealth or even financial oblivion.

Concept check 12 Financial gearing: A B C D E

+UVJGTGUWNVQHDQTTQYKPIHTQOQWVUKFGRCTVKGU +UCPKORQTVCPVHCEVQTKPCUUGUUKPIVJGTKUMKPGUUQHCƂTOoUƂPCPEKCNUVTWEVWTG %CPDGWUGFVQKPETGCUGTGVWTPUVQQYPGTU %CPTGUWNVKPKPUQNXGPE[ GI)(% #NNQHVJGCDQXG

Concept check 13 Which of the followingKUPQVCV[RKECNOGCUWTGQHƂPCPEKCNIGCTKPI! A B C D E

6QVCNCUUGVUVQVQVCNNKCDKNKVKGU Interest cover ratio 6QVCNNKCDKNKVKGUVQVQVCNQYPGTUoGSWKV[ .QPIVGTONKCDKNKVKGUVQVQVCNQYPGTUoGSWKV[ 0QPGQHVJGCDQXG GICNNCTGV[RKECNOGCUWTGUQHIGCTKPI

INVESTMENT RATIOS The following ratios have been designed to help investors assess the returns on their investment: • dividend payout ratio • dividend yield ratio

LO6 Identify the main ratios used to analyse investment performance, and apply these ratios to a business

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• earnings per share, and • price/earnings (PE) ratio.

Dividend payout ratio dividend payout ratio #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGFKXKFGPFU CPPQWPEGFHQTVJGRGTKQF VQVJGGCTPKPIUCXCKNCDNG HQTFKXKFGPFUVJCVYGTG IGPGTCVGFKPVJCVRGTKQF

The dividend payout ratio measures the proportion of earnings that a company pays out to shareholders in the form of dividends. The ratio is calculated as follows: &KXKFGPFUCPPQWPEGFHQTVJG[GCT &KXKFGPFRC[QWVTCVKQ × 100 'CTPKPIUHQTVJG[GCTCXCKNCDNGHQTFKXKFGPFU

In the case of ordinary shares, the earnings available for dividends will normally be the profit after taxation and after any preference dividends announced during the period. This ratio is normally expressed as a percentage. The dividend payout ratio for Alexis Ltd for the year ended 31 March 2016 is: &KXKFGPFRC[QWVTCVKQ

dividend cover ratio #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGGCTPKPIUCXCKNCDNG HQTFKXKFGPFUVQVJGFKXKFGPF CPPQWPEGFVQKPFKECVG JQYOCP[VKOGUVJGHQTOGT EQXGTUVJGNCVVGT

40 165

³

The information provided by this ratio is often expressed slightly differently as the dividend cover ratio. Here the calculation is: 

'CTPKPIUHQTVJG[GCTCXCKNCDNGHQTFKXKFGPF &KXKFGPFEQXGTTCVKQ &KXKFGPFCPPQWPEGFHQTVJG[GCT

In the case of Alexis Ltd (for 2016), it would be 165/40 = 4.1 times. That is to say, the earnings available for dividend cover the actual dividend paid by just over four times.

Dividend yield ratio dividend yield ratio #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGECUJTGVWTPHTQO CUJCTGVQKVUEWTTGPVOCTMGV XCNWG

The dividend yield ratio relates the cash return from a share to its current market price. This can help investors to assess the cash return on their investment in the company. The ratio is: 

&KXKFGPFRGTUJCTG sV &KXKFGPF[KGNF × 100 /CTMGVXCNWGRGTUJCTG

The letter t represents the company tax rate and this is explained below. This ratio is also expressed as a percentage. The numerator of this ratio requires some explanation. In Australia, investors are subject to income tax, with rates depending on income. Companies are also subject to income tax at the company tax rate. It is clearly not fair that investors should pay tax on income (i.e. dividends) that has already been taxed (company profits). To avoid double taxation, a system known as the ‘imputation credit’ system has been adopted. Under this system, an investor who receives a dividend from a company generally also receives a tax credit—effectively the amount of income tax that would be payable by the company. In other words, any dividend is deemed to have been paid out of profits taxed at the company tax rate. To avoid double taxation, a tax credit is ‘imputed’. This means that, assuming a company tax rate of 30%, a dividend of $70 will be given a tax credit of $30. The investor will be deemed to have received gross income of $100 ($70 + $30) and to have paid tax of $30. The ‘gross’ dividend will be calculated by multiplying the cash dividend by (1/(1 – t)), where t is the company tax rate. Hence, if dividends received are $70, the gross dividends will be $70 × (1/(1 – 0.30)), assuming the tax rate is 30%, which gives $100. So far as the individual shareholder is concerned, the tax authorities will treat the $100 as income on which 30% tax has been paid. It will then be up to the individual shareholder to make a return. You should check precisely what the company tax rate is for the particular business at the particular time. Investors may wish to compare the returns from shares with the returns from other forms of investment. As these other forms of investment are often quoted on a ‘gross’ (i.e. pre-tax) basis, it is useful to ‘gross up’ the dividend to make such comparisons. This can be done by dividing the dividend per share by (1 – t), where t is the company tax rate.

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Assuming an income tax rate of 30%, the dividend yield for Alexis Ltd for the year ended March 2016 is:  s



&KXKFGPF[KGNF



³

Note that the share capital was issued at 50¢ per share, which means that there are 600 million shares. The dividend per share is therefore $40 million/600 million = 6.7¢ per share.

Earnings per share ratio A company’s earnings per share (EPS) ratio relates the earnings generated by the company during a period (and available to shareholders) to the number of shares on issue. For ordinary shareholders, the amount available will be represented by the profit after tax (less any preference dividend where applicable). The ratio for ordinary shareholders is calculated as follows: 'CTPKPIUCXCKNCDNGVQQTFKPCT[UJCTGJQNFGTU



'CTPKPIURGTUJCTG

0WODGTQHQTFKPCT[UJCTGUKPKUUWG

In the case of Alexis Ltd, the earnings per share for the year ended 31 March 2016 will be as follows: 'CTPKPIURGTUJCTG

dividend per share #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGFKXKFGPFU CPPQWPEGFHQTCRGTKQFVQVJG PWODGTQHUJCTGUQPKUUWG earnings per share (EPS) #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGGCTPKPIU IGPGTCVGFD[VJGDWUKPGUU FWTKPICRGTKQFCPFCXCKNCDNG VQUJCTGJQNFGTUVQVJG PWODGTQHUJCTGUQPKUUWG

OKNNKQP ~ OKNNKQP

This ratio is regarded by many investment analysts as a fundamental measure of share performance. The trend in earnings per share over time is used to help assess the investment potential of a company’s shares. Although total profits can rise if ordinary shareholders invest more in the company, this will not necessarily mean that the profitability per share will rise as a result. It is not usually very helpful to compare the earnings per share of one company with those of another. Differences in capital structures can render any such comparison meaningless. However, like dividends per share, it can be very useful to monitor the changes that occur in this ratio for a particular company over time.

Price/earnings ratio The price/earnings (P/E) ratio relates the market value of a share to the earnings per share. This ratio can be calculated as follows: /CTMGVRTKEGRGTUJCTG

2TKEGGCTPKPIUTCVKQ

'CTPKPIURGTUJCTG

The P/E ratio for Alexis Ltd for the year ended 31 March 2016 will be:

price/earnings

2'|TCVKQ #PKPXGUVOGPVTCVKQVJCV TGNCVGUVJGOCTMGVXCNWGQH CUJCTGVQVJGGCTPKPIURGT UJCTG

 2TKEGGCTPKPIUTCVKQ VKOGU ~

You should note that the figure for earnings per share was calculated in the preceding section. This ratio reveals that the capital value of the share is 9.1 times higher than its current level of earnings. The ratio is, in essence, a measure of market confidence in the future of a company. The higher the P/E ratio, the greater the confidence in the company’s future earning power and, consequently, the more investors are prepared to pay in relation to the earnings stream of the company. P/E ratios are a useful guide to market confidence in the future and, therefore, can be helpful when comparing different companies. However, differences in companies’ accounting policy choices (methods) can lead to different profit and earnings per share figures, and this can distort comparisons. The reciprocal of the P/E ratio, expressed as a percentage (i.e. (earnings × 100)/market price per share), provides a measure of earnings yield. Hence, a share with a P/E ratio of 10 would have an earnings yield of 10%, whereas one with a P/E ratio of 20 would have an earnings yield of only 5%.

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ACTIVITY 8.6 Calculate the investment ratios of Alexis Ltd for the year ended 31 March 2017. What do you deduce from the investment ratios calculated for Alexis Ltd for 2016 and 2017?

Real World 8.3 provides information about the share performance of a selection of large, wellknown businesses. This type of information is provided on a daily basis by several newspapers.

REAL WORLD 8.3 Market statistics for some well-known businesses The financial press provides daily figures that show the closing price of each share, the change in price, the volume of shares traded, the year high and low prices, the dividend

yield and the price earnings ratio, as set out below. A selection of figures is given for 24 January 2017.

Vol

Year

Div

P/E

Code

Stock

Close

Move

100s

High

Low

Yield

ratio

ANZ

ANZ Banking

29.27

–13

63373

31.84

21.86

5.46

14.8

HVN

Harvey Norman

4.85

–0.02

23790

5.58

4.13

6.18

15.5

MYR

Myer Holdings

1.24

–.015

32928

1.46

.93

4.03

16.3

TLS

Telstra Corp

5.12

–.02

182608

5.86

4.7

6.05

10.8

WOW

Woolworths Ltd

24.6

+.22

47560

26.05

20.3

3.13

n/a

ALL

Aristocrat

15.34

–.02

14058

16.68

9.09

1.62

27.8

BGA

Bega Cheese

5.3

+.1

31053

7.35

3.82

1.79

27.5

BKL

Blackmores Ltd

117.98

–.02

667

213.7

97.91

3.47

20.3

VRL

Village Road

4.03

–.42

1503026

7.06

4.21

6.29

45.4

WEB

Webjet

10.67

+.05

2725

12.2

4.44

1.35

38.8

Source: ‘Industrial Shares, The Market’, The Australian Business Review, 24 January 2017. © Australian Associated Press Pty Ltd.

Concept check 14 Which of the following is not a typical investment ratio? A B C D E

&KXKFGPFRC[DCEMTCVKQ Dividend yield ratio 'CTPKPIURGTUJCTG 2TKEGGCTPKPIU 2'TCVKQ &KXKFGPFRC[QWVTCVKQ

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Concept check 15 Which ratio relates the market value of a share to the earnings per share? A B C D E

Dividend yield ratio 'CTPKPIURGTUJCTG 2TKEGGCTPKPIU 2'TCVKQ Dividend payout ratio 0QPGQHVJGCDQXG

Concept check 16 Which ratio measures the proportion of earnings that a company pays out to shareholders in the form of dividends? A B C D E

Dividend yield ratio 'CTPKPIURGTUJCTG 2TKEGGCTPKPIU 2'TCVKQ Dividend payout ratio 0QPGQHVJGCDQXG

LO7 Identify a range of other issues relating to financial analysis, including the main limitations of ratio analysis

OTHER ASPECTS OF RATIO ANALYSIS

Trend analysis It is important to see whether any trends can be detected by using ratios. Key ratios can be plotted on a graph to give a simple visual display of changes occurring over time. The trends occurring in a company may be plotted against trends in the industry as a whole for comparison purposes. An example of trend analysis is shown in Figure 8.4.

FIGURE 8.4

trend analysis #HQTOQHCPCN[UKUVJCVWUGU VTGPFUWUWCNN[ITCRJKECNN[QT D[RGTEGPVCIGCPCN[UKU

Current ratio

Graph plotting current ratio against time XYZ Ltd

6JGEWTTGPVTCVKQHQTCRCTVKEWNCTDWUKPGUU :;