Financial Accounting: An Integrated Approach 0170349683, 9780170349680
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6TH EDITION
r
Fin an cial Accounting
An I n t e g r a t e d
Approach
Ken Trotman E l i z a b e t h Carson Michael Gibbins
CENGAGE Learning' Financial accounting: an integrated approach 6th Edition Ken Trotman Elizabeth Carson Michael Gibbins
Publishing manager: Dorothy Chiu Publishing editor: Geoff Howard Developmental editors: Duncan Campbell-Avenell; James Cole; Lydia Crisp Senior project editor: Tanya Simmons Art direction: Danielle Maccarone Permissions/Photo researcher: Helen Mammides Editor: Pete Cruttenden Proofreader: Penelope Goodes Indexer: Julie King Text designer: Christina Neri; Fiona Byrne Cover designer: Chris Starr (MakeWork) Cover: Chris Starr (MakeWork) Typeset by Cenveo Publisher Services Any URLs contained in this publication were checked for currency during the production process. Note, however, that the publisher cannot vouch for the ongoing currency of URLs.
© 2016 Cengage Learning Australia Pty Limited Copyright Notice This Work is copyright. No part of this Work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without prior written permission of the Publisher. Except as permitted under the Copyright Act 1968, for example any fair dealing for the purposes of private study, research, criticism or review, subject to certain limitations. These limitations include: Restricting the copying to a maximum of one chapter or 10% of this book, whichever is greater; providing an appropriate notice and warning with the copies of the Work disseminated; taking all reasonable steps to limit access to these copies to people authorised to receive these copies; ensuring you hold the appropriate Licences issued by the Copyright Agency Limited (“CAL”), supply a remuneration notice to CAL and pay any required fees. For details of CAL licences and remuneration notices please contact CAL at Level 15, 233 Castlereagh Street, Sydney NSW 2000, Tel: (02) 9394 7600, Fax: (02) 9394 7601 Email: [email protected] Website: www.copyright.com.au For product information and technology assistance, in Australia call 1300 790 853; in New Zealand call 0800 449 725 For permission to use material from this text or product, please email [email protected] National Library of Australia Cataloguing-in-Publication Data Trotman, K. T. (Kenneth Thomas), author. Financial accounting : an integrated approach/Ken Trotman, Elizabeth Carson, Michael Gibbins. Sixth edition. 9780170349680 (paperback) Includes index. Subjects: Accounting-Textbooks. Other Creators/Contributors: Carson, Elizabeth, author. Gibbins, Michael, 1942-author. 657.044
Cengage Learning Australia Level 7, 80 Dorcas Street South Melbourne, Victoria Australia 3205 Cengage Learning New Zealand Unit 4B Rosedale Office Park 331 Rosedale Road, Albany, North Shore 0632, NZ For learning solutions, visit cengage.com.au Printed in China by 1010 Printing International Limited. 1 2 3 4 5 6 7 19 18 17 16 15
1
Intro du ction to financial accounting
2
M easuring and evaluating financial position and financial perform ance
1 41
A P P E N D IX T O C H A P T E R 2 : B ackground: sole tra d e rs , p a rtn e rs h ip s , com p a n ie s an d Financing
3
80
The d o u b le -e n try system
85
A P P E N D IX T O C H A P T E R 3 : A b rie f h is to ry o f e a rly ac c o u n tin g
133
4
R ecord-keeping
139
5
Accrual accounting a d justm e nts
183
6
Financial repo rting principles, accounting standards and au d itin g
235
7
Internal control and cash
283
8
Accounts receivable and fu rth e r reco rd -kee ping
315
9
Inventory
357
10
N oncurrent assets
385
11
Liabilities
423
A P P E N D IX T O C H A P T E R 11: F u tu re cash flow s: p re s e n t va lu e an alysis
458
12
C om pleting the balance sheet
463
13
Revenue and expense recognition: additiona l concepts
491
14
The sta te m e n t o f cash flow s
527
15
Financial sta te m e n t analysis
575
16
A ccounting policy choices
635
17
S u staina bility repo rting
657
Appendix: W oolw orths Lim ited Annual R eport 2014
687
Glossary
734
Index
745
P reface
xiii
G uide to th e te x t
xiv
G uide to th e on lin e resources
xvi
A b o u t th e a u th o rs A c k n o w le d g e m e n ts
xviii xx
CHAPTER 1 In tro du ction to financial accounting
1
Chapter overview
1
1.1 1.2
Use and preparation of accounting
2
Financial accounting
2
1.3 1.4
Who uses financial accounting information?
3
The people involved in financial accounting
5
1.5
Accrual accounting
8
1.6 1.7
The key financial statements
12
Relationships between the financial statements
17
1.8
Financial statement assumptions
21
1.9
Is accounting really important?
22
Practice problems Key terms Flomework and discussion to develop understanding
26 27 27
CHAPTER 2 M easuring and evaluating financial position and financial perform ance
41
Chapter overview
41
2.1 2.2
Introduction to the balance sheet
43
Explanations of the three balance sheet categories: assets, liabilities and eguity
45
2.3 2.4
Some preliminary analysis of the Sound and Lightbalance sheet
48
A closer look at the balance sheet
50
2.5
Maintaining the accounting eguation
54
2.6 2.7
Managers and the balance sheet
56
The income statement
57
2.8
Connecting balance sheets and income statements
60
2.9 2.10
A closer look at the income statement
63
Capital markets, managers and performance evaluation
65
Practice problems Key terms Homework and discussion to develop understanding
67 68 68
Contents
APPENDIX TO CHAPTER 2: B ackground: sole tra d ers, p artnerships, com panies and financing A2.1 Four kinds of business organisation A2.2
Business financing
CHAPTER 3 The d o u b le -e n try system
v ii
80 80 83
85
Chapter overview
85
3.1 3.2
Transaction analysis
86
Transaction analysis extended
88
3.3
Recording transactions: double-entry bookkeeping
94
3.4 3.5
More about accounts
98
How debits and credits work
99
3.6
Debits and credits, revenues and expenses
102
3.7 3.8
Arranging accounts on the balance sheet
108
More journal entries
110
3.9
Cash versus accrual accounting revisited
112
3.10
Example: Simone's jewellery business
114
Practice problems Key terms Homework and discussion to develop understanding
APPENDIX TO CHAPTER 3: A b rie f history o f early accountin g A3.1 Mesopotamia to Rome: 4500 BC to AD 400
117 119 119
133 134
A3.2
The Middle Ages to the Renaissance: AD 4 0 0 -5 0 0
134
A3.3 A3.4
Britain: 1500 to the early 1800s
135
Financial accounting's recent history
136
Notes
138
CHAPTER 4 R ecord-keeping
139
Chapter overview
139
4.1 4.2
The importance of good records
140
Financial accounting's transactional filter
140
4.3 4.4
Accounting's 'books' and records
143
Example: Northern Star Theatre Company
155
4.5
Another illustrative example
164
4.6
Electronic commerce
169
4.7
Managers, bookkeeping and control
170
Practice problems Key terms Homework and discussion to develop understanding Note
171 172 172 182
v iii
Contents
CHAPTER 5 Accrual accounting adjustm e nts Chapter overview
183 183
5.1
Conceptual foundation of accrual accounting
185
5 .2
Accrual accounting adjustments
192
5 .3
Multi-colum n worksheets
200
5 .4
The financial period
204
5 .5
Contra accounts
204
5 .6
Illustrative example
207
5 .7
Managers and accrual accounting assumptions
213
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 6 Financial re p o rtin g principles, accounting standards and au d itin g Chapter overview
215 217 217
235 235
6.1
Introduction: accounting standards and principles
236
6 .2
Accounting principles and the use of accounting information
236
6 .3
Framework for the preparation and presentation of financial statements
238
6 .4
Assets and liabilities: valuation and measurement
245
6 .5
Accounting regulation in Australia
249
6.6
International financial reporting standards
251
6 .7
The annual report and financial statements
252
6.8
The external auditor's report
254
6 .9
The nature of a profession and professional ethics
257
6 .1 0
Capital markets
260
6.11
Contracts and financial accounting information
265
6 .1 2
Managers and financial accounting standards
267
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 7 Internal control and cash Chapter overview Internal control
7.1
269 269 270 281
283 283 284
7 .2
Internal control of cash
287
7 .3
Bank reconciliations
290
7 .4
Performing a bank reconciliation from information in cash journals
294
7 .5
Petty cash
297
7 .6
Disclosure of internal control in annual reports
298
7 .7
Managers and internal control
299
Contents
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 8 Accounts receivable and fu rth e r reco rd -kee ping Chapter overview
IX
300 301 301 314
315 315
8 .1
Receivables
316
8 .2
Control accounts and contra accounts
317
8 .3
Accounts receivable and contra accounts
317
8 .4
Illustrative example
323
8 .5
Trade discount and cash discount
327
8.6
Detailed recording using special journals, subsidiary ledgers and control accounts
328
8 .7
Prime entry records: special journals
330
8.8
Subsidiary ledgers and control accounts
330
8 .9
Operation of special journals and subsidiary ledgers
331
8 .1 0
Role of general journal and general ledger
337
Practice problems Key terms Homework and discussion to develop understanding Notes
CHAPTER 9 Inventory Chapter overview 9.1 Inventory control
338 340 340 355
357 357 358
9 .2
Accounting entries for perpetual and periodic inventory
360
9 .3
Inventory valuation and cost of goods sold
364
9 .4
More about inventory cost flow assumptions
366
9 .5
An example: Meeix Ltd
368
9 .6
Lower of cost and net realisable value rule
371
9 .7
Retail inventory and standard costs
372
9 .8
Disclosure of inventory accounting policies
373
9 .9
Managers and the valuation of inventory
Practice problems Key terms Homework and discussion to develop understanding Note
CHAPTER 10 N oncurrent assets Chapter overview 1 0 .1
The cost of an asset: basic components
374 375 376 376 384
385 385 386
1 0 .2
Depreciation of assets and depreciation expense
387
1 0 .3
Depreciation bases and methods
390
X
Contents
10.4 10.5
Depreciation example
395
Gains and losses on noncurrent asset disposals
397
10.6
Asset impairment
398
10.7 10.8
Asset revaluations
401
Intangible assets
403
10.9
Goodwill
406
10.10 Finance leases 10.11 Managers and noncurrent assets
408
Practice problems Key terms Homework and discussion to develop understanding
409 409 410
CHAPTER 11 Lia bilities
407
423
Chapter overview
423
11.1
What is a liability?
424
11.2
General measurement principles
425
11.3 11.4
Financial statement presentation of liabilities
426
Payables
428
11.5
Interest-bearing liabilities - short-term
429
11.6 11.7
Interest-bearing liabilities - long-term
431
Tax liabilities
433
11.8
Provisions
433
11.9 11.10
Contingent liabilities
437
'Off balance sheet' financing
439
11.11
Goods and services tax
439
Practice problems Key terms Homework and discussion to develop understanding
APPENDIX TO CHAPTER 11: F u tu re cash Flows:p resen t value analysis A11.1 Future cash flows A11.2 Interest and present value Notes
458 458 459 462
CHAPTER 12 C om pleting the balance sheet Chapter overview Intercorporate investments and corporate groups
12.1 12.2
444 445 445
463 463 464
Consolidations
467
12.3 12.4
Shareholders' eguity
470
Share capital
471
12.5
Reserves
474
12.6 12.7
Retained profits and dividends
475
Cash dividends
476
Contents
12.8 12.9
XI
Bonus issues and share splits
477
Managers, investments and shareholders' equity
479
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 13 Revenue and expense recognition: additiona l concepts
480 481 481
491
Chapter overview
491
13.1
Revenues
492
13.2
Revenue recognition
493
13.3 13.4
The expenses concept: the Framework
501
Statement of profit or loss and other comprehensive income
502
13.5
Statement of changes in equity
507
13.6 13.7
'What if'(effects) analysis
508
Managers and the recognition of revenues and expenses
Practice problems Key terms Homework and discussion to develop understanding
CHAPTER 14 The sta te m e n t o f cash flow s
511 512 513 513
527
Chapter overview
527
14.1
The purpose of cash flow analysis
528
14.2
Overview of the statement of cash flows
529
14.3 14.4
Preparation using the direct method
533
Interpreting a statement of cash flows (direct method)
543
14.5
Preparation using the indirect method
545
14.6 14.7
Interpreting a statement of cash flows (indirect method)
548
Cash flow and the manager
Practice problems Key terms Homework and discussion to develop understanding Note
CHAPTER 15 Financial sta te m e n t analysis
549 550 552 552 573
575
Chapter overview
575
15.1
Investment and relative return
576
15.2 15.3
Introduction to financial statement analysis
576
Common size statements
578
15.4
Woolworths Limited: an example company
579
15.5 15.6
Financial statement ratio analysis
581
Integrative ratio analysis
591
15.7
Financial statement ratio analysis example
594
x ii
Contents
15.8
Interpretation of cash flow information
605
15.9 'What if' effects, ratios and cash flow 15.10 Measuring a manager's performance
607
Practice problems Key terms Homework and discussion to develop understanding
612 613 614
CHAPTER 16 A ccounting policy choices
610
635
Chapter overview
635
16.1
Introduction
636
16.2 16.3
Background to accounting policy choices
636
Inventory valuation and COGS: effects
640
16.4
Depreciation effects analysis
641
16.5 16.6
Intangibles effects analysis
642
Accounting policy disclosure
643
16.7
Accounting policy choices: management's objectives
643
Practice problems Key terms Homework and discussion to develop understanding
645 645 645
CHAPTER 17 S u staina bility repo rting
657
Chapter overview
657
17.1
What is sustainability reporting?
658
17.2
What is reported in sustainability reports?
659
17.3
Do stakeholders require more than financial reporting?
661
17.4
Why do organisations produce sustainability reports?
662
17.5 17.6
Criteria for sustainability reporting
664
Trends in sustainability reporting
667
17.7
Energy efficiency as an im portant example of sustainability
669
17.8
Integrated reporting
676
Practice problems Key terms Homework and discussion to develop understanding Notes
APPENDIX W oolw orths Lim ited Annual R eport 2014
682 682 682 686
687
G lossary
734
In dex
745
O n e q u e s tio n I h a v e b e e n fre q u e n tly a s ke d s in ce w ritin g the first e d itio n o f this b o o k is: w h y w rite a n in tro d u c to ry a c c o u n tin g te x tb o o k ? First, I h a v e b e e n in v o lv e d in te a c h in g in tro d u c to ry fin a n c ia l a c c o u n tin g fo r o v e r 3 5 y e a rs . I e n jo y try in g to g e t a cro ss the in tro d u c to ry c o n c e p ts . S e c o n d , I h a v e b e e n s u rp rise d a t th e d iffe re n c e s b e tw e e n h o w in tro d u c to ry a c c o u n tin g is ta u g h t in m ost u n d e rg ra d u a te p ro g ra m s a n d h o w it is ta u g h t in M B A courses in the U n ite d States a n d A u s tra lia . T h irty y e a rs a g o th e re w e re g o o d re a so n s fo r the d iffe re n c e s , as m ost o f o u r firsty e a r u n d e rg ra d u a te students w e re a c c o u n tin g m a jo rs . This is n o t th e c a s e to d a y . T h ird , w h e n I a s k a tte n d e e s a t e x e cu tive e d u c a tio n p ro g ra m s w h a t th e ir a c c o u n tin g b a c k g ro u n d is, m a n y re s p o n d th a t th e y d id first-year a c c o u n tin g 10 -p lu s y e a rs a g o b u t fo u n d it b o rin g ! W ith this in m in d , I trie d to a d d to a n u n d e rg ra d u a te b o o k s o m e o f the fea tu re s th a t M B A s a n d e xe cu tive s seem to e n jo y . W e d o n 't w a n t o u r students re tu rn in g in 1 0 y e a rs a n d s u g g e s tin g o u r courses a re b o rin g ! T a lk in g a b o u t c o m p a n ie s a n d re la tin g the m a te ria l to a n n u a l reports a n d n e w s p a p e r a rtic le s helps students to g e t interested. W ith a ll o f th e a b o v e in m in d , w e set a b o u t in c o rp o ra tin g the fo llo w in g in th e b o o k . First, w e h a v e tried to m a ke c le a r to students the im p o rta n c e o f a c c o u n tin g in fo rm a tio n b y fre q u e n t re fe re n ce to cu rre n t m a te ria l. S e c o n d , as c o m p a n ie s a re the m ost c o m m o n business o rg a n is a tio n s in A u s tra lia to d a y , w e start b y w ritin g a b o u t c o m p a n ie s , ra th e r th a n s p e n d in g m a n y in tro d u c to ry c h a p te rs c o n c e n tra tin g o n so le tra d e rs. T h ird , to k e e p this b o o k 's m a te ria l in te re stin g a n d re le va n t, w e h a v e m a d e fre q u e n t re fe re n ce s to th e c o n te n t o f a n n u a l reports. S tudents le a rn a b o u t real c o m p a n ie s a n d c a n fo llo w th e ir p e rfo rm a n c e in the n e w s p a p e rs o r the s h a re m a rke t if th e y w is h . Fourth, w e b e lie v e th a t th e d e p th o f te c h n ic a l k n o w le d g e in this b o o k w ill c h a lle n g e b o th a c c o u n tin g a n d n o n -a c c o u n tin g m a jo rs. The first e d itio n o f this te x tb o o k w a s a d a p te d from the s e co n d e d itio n o f the best-selling C a n a d ia n in tro d u c to ry fin a n c ia l a c c o u n tin g te x tb o o k o f the s a m e n a m e w ritte n b y M ic h a e l G ib b in s . In the A u s tra lian e d itio n , w e h a ve a d d e d e ig h t c h a p te rs as w e ll as re o rie n tin g the m a te ria l to w a rd s the A u s tra lia n c o n te xt. O u r sixth e d itio n in c o rp o ra te s a n e w C h a p te r 8 o n re ce iva b le s. P reviously the re ce iv a b le s m a te ria l w a s p a rt o f the e a rly c h a p te rs o n a c c ru a l a c c o u n tin g (p a rtic u la rly C h a p te r 5 ). B y m o v in g it to C h a p te r 8 w e h a ve m a d e C h a p te r 5 m o re m a n a g e a b le ; it a ls o a llo w e d us to a d d re ss re ce iv a b le s in m o re d e ta il, in c lu d in g the use o f s u b s id ia ry le d g e rs. In a d d itio n , s u sta in a b ility re p o rtin g has b e e n m o ve d to C h a p te r 1 7 a n d linked w ith in te g ra te d re p o rtin g . These s u sta in a b ility reports h a ve b e c o m e v e ry c o m m o n a n d a re in c re a s in g ly im p o rta nt. The m ost a ttra c tiv e fea tu re s o f the fifth e d itio n h a v e b e e n re ta in e d : a n e a sy-to -re a d style w ith a w e a lth o f extra cts from c o m p a n y a n n u a l re p o rts, n e w s p a p e rs a n d m a g a z in e s , 'H o w 's y o u r u n d e rs ta n d in g ? ' a c tiv ity q u e stio n s th ro u g h o u t e a c h c h a p te r, q u e stio n s a t th e e n d o f e a c h c h a p te r re la tin g to real a n n u a l re p o rts, as w e ll as a set o f ca se s w ith q u e stio n s re la tin g to the W o o lw o rth s Lim ited A n n u a l R eport 2 0 1 4 (a p p e n d ix a t the e n d o f the b o o k ). S tudents sh o u ld ta k e a d v a n ta g e o f th e a n c illa ry m a te ria l th a t g o e s w ith this b o o k , in p a rtic u la r the C o u rs e M a te w e b s ite , w h ic h in c lu d e s re visio n q u iz z e s , p ra c tic e q u e s tio n s , a n n o ta te d w e b lin k s a n d m uch in te ra c tiv e m a te ria l. A ls o , the p u b lis h e r has m a d e a v a ila b le a suite o f a d d itio n a l resources fo r instructors. S tudents m a y like to a ls o o b ta in th e a c c o m p a n y in g S tu d y G u id e , w h ic h p ro v id e s num erous a d d itio n a l que stio n s. W e trust th a t y o u w ill e n jo y the b o o k . Ken T rotm an
XIV
Guide to the text A s you re a d th is te x t you w ill fin d a n u m b e r of fe a tu r e s in e v e ry c h a p te r to e n h a n c e y o u r s tu d y of a c c o u n tin g an d h e lp you u n d e rs ta n d h o w th e th e o r y is a p p lie d in th e r e a l w o rld .
C H A P T E R O P E N IN G FE A TURES
The learning objectives and chapter overview give you a clear sense of what topics each chapter will cover and what you should be able to do after reading the chapter
F EA TURES W I T H I N C H A P T E R S
The three m ain e lem ents o f a b a la n c e sheet a re assets, lia b ilitie s a n d shareholders'equity.
Key term s in bold highlight important accounting terminology. Definitions for these terms can be found at the end of the book in the glossary.
H O W 'S Y O U R U N D E R S T A N D IN G ?
How ’s your understanding activity questions throughout each chapter help you to reinforce your understanding of key concepts as you progress through the text, providing you with the opportunity to reflect and revise important material. H O W 'S Y O U R U N D E R S T A N D IN G ? H ere is a question you should be able to answer, based on what you have ju st read. If you can't answer it, it would be best to re-read the material. What are the two main things that financial accounting measures? Your answer should be: financial performance and financial position.
s
A t th e en d of ea c h c h a p te r y o u ’ll fin d s e v e r a l to o ls to h e lp you to re v ie w , p ra c tic e an d e x te n d y o u r k n o w le d g e of th e key le a rn in g o u tc o m e s . Practice problems give you the opportunity to test your knowledge and consolidate your learning. A list of key terms from the chapter have been provided to help with your revision. The homework and discussion to develop understanding section provides you with discussion questions, problems, and cases to help you with your revision.
xvi
Guide to the ontine resources FOR T H E IN S T R U C T O R C e n g a g e L e a rn in g is p le a s e d to p ro v id e you w ith a s e le c tio n of re s o u rc e s th a t w ill h e lp you p re p a re y o u r le c tu r e s an d a s s e s s m e n ts . T h e s e te a c h in g to o ls a re a c c e s s ib le via h ttp ://lo g in .c e n g a g e .c o m .
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h e l p s y o u b u ild a f u l l y i n t e g r a t e d u n d e rs ta n d in g of fin a n c ia l a c c o u n tin g a n d m a n a g e m e n t a c c o u n t i n g . You ca n buy th e M a n a g e m e n t A c c o u n tin g e B o o k d ire c t fr o m C e n g a g e B ra in .
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About the authors Ken Trotman is S c ie n tia Professor in th e S ch o o l o f A c c o u n tin g a t the U n ive rsity o f N e w S outh W a le s . H e has a n M C o m (H o n s ) from th e U n ive rsity o f N e w S outh W a le s a n d a PhD fro m th e A u s tra lia n G ra d u a te S ch o o l o f M a n a g e m e n t (U N S W ). H e is a F e llo w o f b o th C h a rte re d A c c o u n ta n ts A u s tra lia a n d N e w Z e a la n d a n d C P A A u s tra lia . K en's m a jo r re se a rch interests in c lu d e e x a m in in g th e p ro c e s s in g o f in fo rm a tio n b y users o f a c c o u n tin g reports a n d a u d ito rs , a n d the fa cto rs th a t a ffe c t the q u a lity o f th e ir d e c is io n s . H e has re ce iv e d the fo llo w in g a w a rd s fro m th e A m e ric a n A c c o u n tin g A s s o c ia tio n : 2 0 0 1 O u ts ta n d in g E d u c a to r A w a r d b y the A u d it S e c tio n , 2 0 0 8 C o n trib u tio n A w a r d
N o ta b le C o n trib u tio n to the A u d itin g Literature A w a r d , 2 0 0 9 N o ta b le (Lifetime) in B e h a v io ra l A c c o u n tin g Literature, a n d 2 0 1 4
B e h a v io ra l O u ts ta n d in g D o c to ra l
D issertation S u p e rv iso r A w a r d . H e re c e iv e d the O u ts ta n d in g C o n trib u tio n to the A c c o u n tin g R esearch Literature A w a r d b y the A c c o u n tin g A s s o c ia tio n o f A u s tra lia a n d N e w Z e a la n d (A A A N Z ) in 1 9 9 9 . H is research has resulted in him b e in g m a d e a F e llo w o f th e A c a d e m y o f S o c ia l S c ie n c e s in A u s tra lia . H e is a fo rm e r p re s id e n t o f the A A A N Z , a fo rm e r C o o p e rs & L y b ra n d v is itin g re se a rch p ro fe s so r a n d D ire c to r o f R esearch fo r th e a u d it se ctio n o f th e A m e ric a n A c c o u n tin g A s s o c ia tio n . H e has o v e r 4 0 y e a rs o f u n ive rsity te a c h in g e x p e rie n c e , m uch o f w h ic h has c o v e re d in tro d u c to ry a c c o u n tin g . In a d d itio n to te a c h in g in the S ch o o l o f B usiness, U N S W , he has ta u g h t a t the U n ive rsity o f Illin o is a t U rb a n a - C h a m p a ig n , C o rn e ll U n ive rsity a n d th e U n ive rsity o f M ic h ig a n . H e has e x te n sive c o n s u ltin g e x p e rie n c e a n d has c o n d u c te d m a n y e x e c u tiv e tra in in g p ro g ra m s in b o th the p riv a te a n d p u b lic sectors. H e has p u b lis h e d w id e ly in A u s tra lia n a n d in te rn a tio n a l re se a rch jo u rn a ls a n d is o n th e e d ito ria l b o a rd s o f num erous le a d in g in te rn a tio n a l research jo u rn a ls. In 2 0 1 1 he w a s in d u c te d in to the A u s tra lia n A c c o u n tin g H a ll o f Fam e.
Elizabeth Carson is a P rofessor in fin a n c ia l a c c o u n tin g a n d a u d itin g a t th e U n ive rs ity o f N e w S outh W a le s . E liz a b e th 's rese a rch interests in c lu d e e c o n o m ic s o f g lo b a l a n d n a tio n a l a u d it m arkets, in d u stry s p e c ia lis a tio n b y a u d ito rs a n d a u d it re p o rtin g . H e r PhD in v e s tig a tin g g lo b a l a u d it firm n e tw o rks a n d g lo b a l in d u stry s p e c ia lis a tio n
b y a u d it firm s w a s a w a rd e d
the A m e ric a n A c c o u n tin g A s s o c ia tio n A u d itin g
S ectio n
O u ts ta n d in g D isse rta tio n A w a r d in 2 0 0 8 . H e r w o rk has a p p e a re d in le a d in g a c a d e m ic jo u rn a ls in c lu d in g The A c c o u n tin g R e vie w , A u d itin g : A J o u rn a l o f P ra c tic e a n d T h e o ry a n d A c c o u n tin g a n d F in a n ce . E liza b e th te a c h e s a t p o s tg ra d u a te level in fin a n c ia l a c c o u n tin g a n d a u d itin g , as w e ll as s u p e rv is in g re se a rch students in the H o n o u rs , M P h il a n d PhD p ro g ra m s . S he re c e iv e d the Pearson E d u c a tio n A c c o u n tin g Lecturer o f the Y e a r a w a rd fo r her d e v e lo p m e n t o f the 'A c c o u n tin g : A U ser P ersp e ctive ' s u b je c t in th e M a s te rs o f C o m m e rc e p ro g ra m . P rior to jo in in g a c a d e m ia , she w o rk e d w ith P ric e w a te rh o u se C o o p e rs (P w C ) a n d is q u a lifie d as a c h a rte re d a c c o u n ta n t.
M ichael G ibbins is th e W in s p e a r Professor o f A c c o u n tin g in th e Fa cu lty o f Business, U n ive rsity o f A lb e rta . H e has a B C o m fro m the U n ive rs ity o f British C o lu m b ia , a n M B A fro m Y o rk U n ive rsity a n d a PhD in a c c o u n tin g a n d p s y c h o lo g y fro m C o rn e ll U n ive rsity. H e o b ta in e d his c h a rte re d a c c o u n ta n c y d e s ig n a tio n in the P rince G e o r g e o ffic e o f w h a t is n o w D e lo itte & T o u ch e . H e has he ld a p p o in tm e n ts a t Q u e e n s U n ive rsity S ch o o l o f Business, th e C a n a d ia n Institute o f C h a rte re d A c c o u n ta n ts a n d th e U n ive rsity o f British C o lu m b ia . H is research a n d te a c h in g interests lie in h o w p e o p le m a ke d e c is io n s a n d ju d g e m e n ts, a n d in th e w a y a c c o u n tin g in fo rm a tio n is used in m a k in g im p o rta n t d e c is io n s in business a n d o th e r e c o n o m ic spheres. A p a rtic u la r interest is in the p ro fe s sio n a l ju d g e m e n t o f p u b lic a c c o u n ta n ts , m a n a g e rs a n d o th e r p ro fe s sio n a ls w h o c o p e w ith th e pressures a n d risks o f m o d e rn business life. H e has p u b lis h e d w id e ly o n ju d g e m e n t,
About the authors
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a c c o u n tin g , fin a n c ia l d is c lo s u re a n d e d u c a tio n a l su b je cts; is a fo rm e r e d ito r o f the C a n a d ia n a c c o u n tin g resea rch jo u rn a l C o n te m p o ra ry A c c o u n tin g R esearch; has b e e n o n th e e d ito ria l b o a rd s o f num erous a c a d e m ic jo u rn a ls; a n d is a c tiv e in th e C a n a d ia n A c a d e m ic A c c o u n tin g A s s o c ia tio n , the A m e ric a n A c c o u n tin g A s s o c ia tio n a n d o th e r p ro fe s s io n a l b o d ie s . H e has re c e iv e d a n u m b e r o f e d u c a tio n a n d te a c h in g a w a rd s a n d in 1 9 8 8 he re c e iv e d th e h o n o u r o f b e c o m in g a F e llo w o f b o th th e A lb e rta a n d British C o lu m b ia Institutes o f C h a rte re d A c c o u n ta n ts . M ik e is n o w retired a n d lives in E d m o n to n , C a n a d a .
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Acknowledgem ents The c o m p le tio n o f this b o o k w a s o n ly a c h ie v e d w ith th e h e lp o f m a n y in d iv id u a ls . M y g re a te s t thanks g o to m y fo rm e r c o lle a g u e , the late G o r d o n H o w itt. O v e r 4 0 y e a rs a g o G o rd o n
in s p ire d m y interest in
a c c o u n tin g . H e ta u g h t m e first-ye a r a c c o u n tin g a n d su b se q u e n tly as a sta ff m e m b e r p ro v id e d m e w ith g u id a n c e a n d s u p p o rt. W ith o u t his h e lp I c o u ld n o t h a v e w ritte n this b o o k . D u rin g the first e d itio n he e n c o u ra g e d m e, re g u la rly c h e c k e d o n p ro g re s s, c o n tin u a lly re a d d ra fts, p ro v id e d m a n y q u e s tio n s , a u th o re d the s o lutions m a n u a l a n d g e n e ra lly o ffe re d frie n d s h ip a n d su p p o rt. This s u p p o rt c o n tin u e d w ith th e re v ie w in g o f the s e c o n d e d itio n . For 5 0 y e a rs he m a d e a n o u ts ta n d in g c o n trib u tio n to a c c o u n tin g e d u c a tio n a t the U n ive rsity o f N e w S outh W a le s . I c e rta in ly h a v e n e ve r m et a m o re d e d ic a te d a c c o u n tin g te a c h e r. It has b e e n a p riv ile g e to w o rk w ith him a n d w e a ll miss his in s p ira tio n . M y c o -a u th o r M ik e G ib b in s w a s kin d e n o u g h to in v ite m e to a d a p t his o rig in a l C a n a d ia n te x tb o o k . M ik e has a n o u ts ta n d in g re p u ta tio n as a re se a rc h e r a n d I like d his v e rs io n o f the b o o k so m uch th a t I d e c id e d to ta k e o n the task o f c o -a u th o r. M y n e w c o -a u th o r, Professor E liza b e th C a rs o n , has p ro v id e d m e w ith m a n y he lp fu l s u g g e stio n s o n p re vio u s e d itio n s o f the b o o k a n d has h e lp e d to re s h a p e m a n y parts o f this n e w e d itio n o f the b o o k . M y life has b e e n m a d e m uch e a s ie r w ith the h e lp o f s o m e v e ry c a p a b le re se a rch assistants. S ta ff a t the U n ive rsity o f N e w S outh W a le s a n d s o m e o th e r universities h a v e b e e n g e n e ro u s in p ro v id in g m e w ith m a te ria l. M ic h a e l Pennisi p ro v id e d m a te ria l o n G S T a n d m a te ria l o n s u b s id ia ry le d g e rs , n o w in C h a p te r 8. A th o l C a rrin g to n a n d G o rd o n H o w itt p ro v id e d m e w ith s o m e m a te ria l in C h a p te r 5 , as w e ll as num erous q u e stio n s, a n d M a lc o lm M ille r w ith s o m e m a te ria l in C h a p te r 8 . R osina M la d e n o v ic p ro v id e d s o m e m a te ria l fo r C h a p te rs 8 a n d 9 as w e ll as num erous c o m m e n ts o n the b o o k . G e rry G a lle y w ro te s u b sta n tia l s e ctio n s o f C h a p te r 1 1. N o e l H a rd in g p ro v id e d m a te ria l fo r C h a p te r 8 . C h a p te r 1 7 w a s la rg e ly w ritte n b y A n d re w T rotm an w ith e x c e lle n t inputs fro m T a n y a F ie d le r a n d S a ra h A d a m s as w e ll as a d v ic e fro m R o g e r S im nett a n d P atricia S tro n g . K ate M o r g a n has re w ritte n C h a p te r 1 7 fo r the sixth e d itio n as w e ll as p ro v id in g m a te ria l fo r m a n y c h a p te rs. Q u e s tio n s w e re a ls o p ro v id e d b y K evin C la rk e , V ic to ria C lo u t, C la u d ia G o rm ily , D e a n H a n lo n , N o e l H a rd in g , C a m e ro n H o o p e r, A n d r e w J a ck so n , H e le n K a n g , Je ffre y K n a p p , C h ris P oullaos, P atricia S tro n g a n d Per Tronnes. M a lc o lm M ille r a n d D ia n e M a y o r g a h a v e p ro v id e d a d v ic e o n te c h n ic a l issues o v e r the y e a rs . O th e r useful c o m m e n ts w e re p ro v id e d b y pre se n t a n d e x -U N S W staff in c lu d in g K a r M in g C h o n g , R obert C z e rn k o w s k i, N e il F a rg h e r, R oger G ib s o n , W e n d y G re e n , N o e l H a rd in g , A n d r e w J a ck so n , A m n a K h a lifa , J a n ic e Loftus, D ia n e M a y o r g a , R ich a rd Petty, B a ljit S id h u a n d R oger S im nett. O v e r v a rio u s e d itio n s , a d v ic e fro m S te p h e n B ah (U n ive rsity o f N e w c a s tle ), Peter C a re y (M o n a s h U nive rsity), Peter C o lle tt (U n ive rsity o f T a s m a n ia ), Russell C ra ig , Linda E nglish (U n ive rsity o f S yd n e y ), V ic Fatseas (C h a rle s Sturt U n ive rsity), J a ck F la n a g a n , D e a n H a n lo n (M o n a s h U n ive rsity), Jan H o llin g d a le (B ond U niversity) a n d G re g W h ittre d (U n ive rsity o f A u c k la n d ) w a s a p p re c ia te d . C e n g a g e Learning a ls o a rra n g e d fo r use o f s o m e m a te ria l in C h a p te r 6 fro m the US b o o k b y I. S o lo m o n , L. W ith e r , P. V a rg o a n d L. Plunkett. K en Tro tm a n
Acknowledgements
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C e n g a g e Learning w o u ld a ls o like to th a n k the fo llo w in g re v ie w e rs , w h o p ro v id e d h e lp fu l a n d useful c o m m e n ts w h ile this e d itio n w a s b e in g d e v e lo p e d : A b d e l H a la b i, M o n a sh University Dean H anlon, M o n a sh University C hristina James-Overheu, University o f Southern Q ueensland Y ou n g d e o k Lim, University o f N e w South W a le s M a ria M u c c ia ro n e , M u rd o ch University Karen N ic ita , N orth S ydney Institute o f TAFE (M e a d o w b a n k) Dr A fza lu r Rashid, University o f Southern Q ueensland Jackie Y ong, University o f N e w ca stle .
Introduction to Financial accounting ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: describe the basic purpose of financial accounting identify the users o f accounting inform ation a n d the decisions they m ake that require accounting inform ation identify the people w h o a re involved in financial accounting describe how accrual accounting differs from cash accounting calculate accrual profit for an organisation explain the basic contents of the three key financial statements and describe the purpose of each statement describe the basic principles an d assumptions o f accounting explain w h y accounting is im portant.
C H A PTER O VE R VIEW A c c o u n tin g has b e e n d e s c rib e d as th e 'la n g u a g e o f b u sin e s s '. It p ro v id e s m a n a g e rs w ith in o rg a n is a tio n s a n d th ose o u ts id e th e o rg a n is a tio n (e .g . in ve sto rs a n d c re d ito rs ) w ith in fo rm a tio n a b o u t th e fin a n c ia l p e rfo rm a n c e a n d fin a n c ia l p o s itio n o f th e business. R e g ardless o f w h a t ty p e o f c a re e r y o u pu rsu e , a c c o u n tin g in fo rm a tio n w ill h a ve im p o rta n t effe cts on y o u . This c h a p te r in tro d u c e s y o u to fin a n c ia l a c c o u n tin g a n d illu s tra te s som e useful a c c o u n tin g c o n c e p ts a n d te c h n i qu es. It o u tlin e s a w a y o f th in k in g a b o u t fin a n c ia l a c c o u n tin g th a t w ill be im p o rta n t to y o u r c a re e r, w h e th e r y o u b e c o m e a n a c c o u n ta n t o r a user o f a c c o u n tin g in business o r in o th e r w a lk s o f life . Y ou a re in tro d u c e d to th e s o c ia l se ttin g o f fin a n c ia l a c c o u n tin g a n d som e o f th e p e o p le in v o lv e d . F in a n c ia l a c c o u n tin g is c o m p le x a n d re q u ire s s o u n d ju d g e m e n t b e ca u s e it a tte m p ts to serve th e ne ed s o f a ll these p e o p le , n o t a ll o f w h o m n e c e s s a rily see th in g s th e sa m e w a y . Y ou a re then in tro d u c e d to o n e o f th e c o rn e rs to n e s o f h o w fin a n c ia l a c c o u n tin g w o rk s : a c c ru a l a c c o u n tin g , th e b ro a d fra m e w o rk w ith in w h ic h fin a n c ia l a c c o u n tin g re p o rts a re p re p a re d . Y ou a re a ls o in tro d u c e d to th e th re e k e y fin a n c ia l state m e nts a n d th e b a s ic fin a n c ia l sta te m e n t a s su m p tio n s . E x a m p le s fro m th e fin a n c ia l press w ill h e lp c o n v in c e y o u o f th e im p o rta n c e o f a c c o u n tin g in fo rm a tio n .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
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1.1
Use and preparation of accounting
Use Financial accounting has value because the inform ation it produces is used in a variety o f w a ys. Users include m anagers, investors, bankers, fin a n cia l analysts a n d m any others. Such p e o p le study accounting to learn h o w to use inform ation effectively a n d to d o their jobs better. For accountants, this inform ation is essential to the services they provide.
P reparation A ccounting is a co m p le x human activity. A ccounting inform ation doesn't just happen: it is produced by a large set of people, activities a n d computers. To be effective users o f the inform ation, p e o p le need to kn o w som ething a b o u t h o w and w h y the inform ation is prepared. Accountants' expertise is all a b o u t the h o w a nd the w h y. The dem and for useful inform ation shapes h o w fin a n cia l accounting inform ation is prepared; for exam ple, w hen producing annual o r monthly perform ance reports. H o w it is prepared shapes its use; for exam ple, in financial analysis a n d m anagerial decisions.
FOR YOUR INTEREST L e a rn in g te r m in o lo g y is im p o rta n t. T o h e lp y o u w ith th a t, th is b o o k has a g lo s s a ry o f te rm s a t th e b a c k on pa ge 7 3 4 . I f y o u ’re n o t s u re w h a t a te r m m e a n s , lo o k it u p rig h t aw ay. A c c o u n tin g is a c h a lle n g in g d is c ip lin e th a t in v o lv e s m a n y c a p a b ilitie s : a s s ig n in g n u m b e rs t o re p re s e n t fin a n c ia l p h e n o m e n a ; p ro v id in g e x p la n a tio n s o f th o s e n u m b e rs ; a n a ly s in g and v e rify in g th e in fo rm a tio n p re p a re d b y o th e rs ; u n d e rs ta n d in g th e n e e d s o f th o s e w h o use a c c o u n tin g ’s re p o rts to m a k e d e c is io n s ; e n g a g in g in o ra l, w r itte n an d e le c tro n ic c o m m u n ic a tio n w ith th e m a n y p e o p le in v o lv e d in an o rg a n is a tio n ’s fin a n c ia l a c tiv itie s ; an d m a in ta in in g ju d g e m e n t th a t is s o u n d , o b je c tiv e and e th ic a l. M u c h o f th e c h a lle n g e o f a c c o u n tin g is in fig u rin g o u t w h ic h n u m b e rs t o use and d e c id in g w h a t th e n u m b e rs te ll us. A d d in g an d s u b tra c tin g th e n u m b e rs is o fte n th e ea sy p a rt. T h is m a ke s a c c o u n tin g b o th e a sie r and h a rd e r t o le a rn th a n y o u m ig h t ha ve th o u g h t. A c c o u n t in g is ro o te d in th e fin a n c ia l s e ttin g , an d has its o w n v o c a b u la ry , so d o n ’t e x p e c t it all t o m a k e p e r fe c t sense a t th e b e g in n in g . It w ill ta k e a w h ile f o r y o u t o a c q u ire th e k n o w le d g e th a t c re a te s an u n d e rs ta n d in g o f bu siness an d a c c o u n tin g as th e y re a lly a re in o u r w o rld . T h is u n d e rs ta n d in g w ill be based o n y o u r k n o w le d g e o f b o th c o n c e p ts and te c h n iq u e s , and o f th e v ie w p o in ts o f b o th a c c o u n ta n ts an d th e users o f a c c o u n tin g . T h e g o in g w ill n o t all be easy, b u t i f y o u g iv e it y o u r b e s t e f f o r t , y o u m a y be s u rp ris e d a t th e h ig h level o f s o p h is tic a tio n y o u w ill re a c h . H e re is o n e im p o r ta n t s u g g e s tio n . T h e o n ly w a y to le a rn a c c o u n tin g is t o do p ro b le m s . It is v ita l th a t y o u d o m o re th a n ju s t rea d th e e x a m p le s . A f t e r re a d in g th e c h a p te r, c o m e b a c k and d o th e e x a m p le s t o c h e c k y o u r u n d e rs ta n d in g .
1.2
Financial accounting
A ccounting is a process o f identifying, measuring a nd com m unicating e conom ic inform ation to a llo w inform ed decisions by the users o f that inform ation. A ccounting systems are often described as either fin a n cia l accounting systems (w here p e rio d ic Financial statements are p rovided to external decision-m akers, such as investors, creditors and customers) o r m anagem ent accounting systems (including inform ation for planning an d perform ance reports to m anagers throughout the o rganisation; that is, internal decision-makers).
CHAPTER 1 Introduction to Financial accounting
3
Financial accounting measures an enterprise's perform ance over time an d its position (status) at a point in time, and does so in Australian dollars, US dollars, yen, euros o r w h a te ve r currency is ju dged relevant to the enterprise. This m easurem ent o f financial perform ance a nd financial position is d o n e for all sorts o f enterprises: large and small businesses, governments from local to national levels, universities, charities, churches, clubs, international associations an d m any others. The fin a n cia l statements, w h ich a re fin a n cia l accounting's reports, summarise the measurements o f fin a n cia l perform ance a nd fin a n cia l position in standard w a ys thought to be useful in evaluating w hether the enterprise has d o n e w e ll a n d is in g o o d shape. These fin a n cia l statements include notes, w h ich contain m any w o rd s (sometimes dozens o f pages) o f e xplanation a nd interpretation, in a d d itio n to the numbers. The statements report on the e co n o m ic an d fin a n cia l matters a nd are largely for the use o f p e o p le outside the enterprise, such as investors, lenders, club members, regulatory agencies a nd taxation authorities. In summary: •
F inancial perform ance is the generation o f n e w resources from day-to-day operations over a p eriod o f time.
•
F inancial position is the enterprise's set o f fin a n cia l resources a nd o b lig a tio n s at a point in time.
•
F inancial statements are the reports describing fin a n cia l perform ance a nd position (e.g. the b a la n ce sheet an d the incom e statement).
•
N o te s are part o f the statements, a d d in g explanations to the numbers. As w e w ill see throughout this book, fin a n cia l perform ance a nd position are highly related. G o o d perform ance is
likely to lead to a healthy fin a n cia l position; if a c o m p a n y has been m aking profits, it w ill p ro b a b ly build up resources. O n the other hand, a healthy fin a n cia l position facilitates perform ance; if you have lots o f resources com p a red to o b lig a tio n s, the c o m p a n y can undertake activities that lead to g o o d perform ance. A nother branch o f a ccounting, m anagem ent acco u n tin g , is oriented to w a rd s helping m anagers a nd others inside the enterprise, in contrast to fin a n cia l accounting's m ore external focus. W h ile m anagem ent accounting is not exam ined in this book, students interested in h o w fin a n cia l accounting measures m anagerial perform ance w ill find frequent references to the relationship betw een m anagers a nd fin a n cia l a ccounting. In the end, all forms of accounting exist to help p e o p le such as m anagers, investors, bankers, legislators an d the public make fin a n cial decisions.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le t o a n s w e r, based o n w h a t y o u ha ve ju s t rea d. I f y o u c a n ’t a n s w e r it, it w o u ld be b e s t to r e -re a d th e m a te ria l. W h a t a re th e tw o m a in th in g s th a t fin a n c ia l a c c o u n tin g m e a s u re s ? Y o u r a n s w e r s h o u ld be : fin a n c ia l p e rfo rm a n c e an d fin a n c ia l p o s itio n .
1.3
Who uses financial accounting inform ation?
This b o o k w ill sh o w you the m any w a ys in w h ich fin a n cia l accounting has been shaped by the developm ent of business an d society. Financial accounting helps: •
stock market investors d e c id e w hether to buy, sell o r hold shares o f com panies
•
banks a nd other lenders d e c id e w hether or not to lend
•
m anagers run enterprises on b ehalf o f ow ners, members o r citizens (in a d d itio n to the help pro vid e d by m anagem ent accounting a nd other sources of inform ation)
•
m anagem ent b y p ro vid in g basic fin a n cia l records for the purposes o f day-to-day m anagem ent, control, insurance an d fraud prevention
•
governm ents in m onitoring the actions of enterprises an d in assessing taxes, such as incom e tax an d the g o ods an d services tax (GST).
4
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W h o le books can be, a nd have been, w ritten a b o u t each of these functions. Though this b o o k em phasises externally oriented fin a n cia l accounting for business firms, d o n 't forget that there are m any other organisations that use, and are affected by, acco u n tin g . W h e n w o rd s like 'o rg a n isa tio n ', 'c o m p a n y ' o r 'enterprise' are used, the im plications often g o w e ll beyond business firms. The centre o f our interest in this b o o k - fin a n cia l accounting for the enterprise - operates w ith in a nd serves a com plex social setting. It seeks to m onitor a n d report on fin a n cia l events initiated by o r h a p p e n in g to the enterprise. A ccounting is not a passive force w ithin the social setting: it tells us w h a t is g o in g on, but in so d o in g it affects our decisions and actions a n d , therefore, also affects w h a t is g o in g on. The social setting is com posed of m any people, including groups, com panies, institutions a n d other parties interested in, o r having an influence on, the com pany's fin a n cia l acco u n tin g . As w e w ill see m any times in this book, these parties d o not share the sam e interest in the com pany's a ccounting, a nd m ay even be in com petition o r conflict w ith each other. M o s t w ill be in the same country as the c o m p a n y an d its m anagem ent but, increasingly, com panies and other enterprises are op e ra tin g internationally. The other groups interested in, a nd affecting, the com pany's financial accounting m ay be located a n yw h e re on the planet. Let's consider some possible users o f the fin a n cia l statements o f a listed com pany: •
A com pany's bo a rd o f directors m anages the c o m p a n y on behalf o f its shareholders. O n e function o f the b oard, w h ich involves the fin a n cia l statements, is hiring the com pany's to p op e ra tin g m anagem ent - e sp e cia lly the chief executive office r (CEO). Suppose you are a mem ber o f the b o a rd a n d are preparing for a discussion at the next board m eeting. The bo a rd evaluates the C E O 's perform ance continuously, w h ich is its responsibility. The financial statements have been p rovided to the bo a rd prior to the m eeting, a nd w ill be a m ajor contribution to this evaluation.
•
A com pany's shares a re listed (i.e. can be bought a nd sold) on the Australian Stock Exchange (ASX). Suppose you are a fin a n cia l analyst for an investment d e a le r an d a re preparing a report projecting future earnings and m aking recom m endations a b o u t w hether the com pany's shares are w orth buying, keeping if a lre a d y held, or instead should be sold. You have the fin a n cia l statements an d w ill use them to support yo u r report.
•
A c om pany has several hundred m illion dollars in bank bo rro w in g s, a nd lines o f credit (pre-authorised b o rro w in g capability) for millions o f dollars m ore. Suppose you are a com m ercial lending o ffice r for a bank, conducting a regular review o f the com pany's b o rro w in g status. You must consider the q u a lity of the com pany's financial perform ance a nd assets (m any o f w h ich have been assigned as security on bank loans, an d therefore could be seized if the c o m p a n y doesn't p a y its loans b a ck on schedule). Financial perform ance is im portant because net profit generates cash to p a y loans, a nd a g o o d past record suggests that the c o m p a n y is likely to be a b le to earn profit in the future. You have requested the fin a n cia l statements to use in your review .
•
A c o m p a n y depends on a large num ber o f suppliers to o b ta in g o o d s a nd services. Suppose you a re the sales m anager of a stationery supplier an d are considering signing a long-term contract to supply the com p a n y. You w a n t to sign the contract because yo u r c o m p a n y needs the business, but you have to be satisfied that your shipments w ill be p a id for. M o re positively, you hope that if you d o a g o o d jo b , you w ill have an opportunity to g ro w w ith the com pany. M o s t of the inform ation you need has been received a lre a d y, but you have o b ta in e d the financial statements an d are review ing them as you make yo u r final decisions a b o u t the contract. In summary, these scenarios in d ica te the fo llo w in g reasons for using the com pany's fin a n cia l statements:
•
evaluation o f the C E O 's perform ance by a mem ber o f the b o a rd o f directors
•
preparation o f 'b u y ', 'sell' o r 'h o ld ' recom m endations b y a fin a n cia l analyst
•
review of the com pany's b o rro w in g status by a ba n k lending officer
•
developm ent o f a supply contract w ith the c o m p a n y by a stationery supplier's sales m anager. These scenarios have been chosen to a d d to your insight into the use o f fin a n cia l accounting inform ation. They
are not com plete. In all cases, the fin a n cia l statements w o u ld be o nly part o f the inform ation used in the d e cisio n making process. A lso, there are m any other uses for fin a n cia l statements, some o f w h ich m ight make different dem ands on the q u a lity o f the inform ation from those discussed here.
CHAPTER 1 Introduction to Financial accounting
5
FOR YOUR INTEREST A b o v e w e n o te d th a t fin a n c ia l s ta te m e n ts w o u ld be o n ly p a rt o f th e in fo r m a tio n used b y v a rio u s g ro u p s s u ch as in v e s to rs an d m a n a g e m e n t in d e c is io n -m a k in g . A n o th e r im p o r ta n t ty p e o f in fo r m a tio n is s u s ta in a b ility re p o rtin g . T h e se re p o rts in c lu d e in fo r m a tio n o n e c o n o m ic , e n v iro n m e n ta l, s o cia l and s a fe ty p e rfo rm a n c e . F o r e x a m p le , th e y c o u ld in c lu d e in fo rm a tio n o n c a rb o n e m is s io n s , e n e rg y usage, e m p lo y e e s a fe ty , c o m m u n ity in v o lv e m e n t, e tc . W e in tro d u c e th is m a te ria l in C h a p te r 17, as m a n y c o m p a n ie s n o w in c lu d e th is in fo rm a tio n in th e ir a n n u a l re p o rts o r s e p a ra te s u s ta in a b ility re p o rts .
1.4 The people involved in financial accounting The main participants in the art o f fin a n cia l accounting are: •
the inform ation users (the decision-makers)
•
the inform ation preparers, w h o put together the inform ation to fa cilita te the users' decision-m aking
•
the auditors, w h o assist the users by enhancing the c re d ib ility o f the inform ation, p roviding a professional opin ion a b o u t the fairness an d appropriateness o f the inform ation.
Users (decision-m akers) In fin a n cia l acco u n tin g , a user o r decision-m aker is som eone w h o makes decisions on the basis o f the fin a n cial statements, on his or her o w n behalf, o r on behalf o f a com p a n y, bank o r other o rganisation. Ultim ately, the nature and contents o f fin a n cia l statements a re functions o f the dem and for decision inform ation from users. If user de m a n d is the fundam ental reason for fin a n cia l statements, understanding the de m a n d is important. A user's main de m a n d is for the c re d ib le p e rio d ic reporting o f an enterprise's fin a n cia l position a nd perform ance: •
C re d ib le means that the inform ation in the reports (the fin a n cia l statements) app e a rs to be sufficiently trustworthy an d com petently prepared for it to be used to make decisions. There is a co st-b e n e fit issue here: huge am ounts of m oney could be spent trying to make the reports absolutely perfect, but since that m oney w o u ld have to com e out o f the enterprise's funds, spending it w o u ld make its perform ance a nd position poorer. Users, such as ow ners and m anagers, m ay not w a n t that to h appen, so cre d ib ility is a relative co n d itio n , not an absolute one. A ccounting inform ation has to be w orth its cost.
•
P eriodic means that users can expect reports on some regular basis (such as ye a rly o r quarterly). The longer the w a it, the m ore solid is the inform ation. But w a itin g a long tim e for inform ation is not desirable: users are w illin g to a c ce p t some im precision in the inform ation in return for p e rio d ic reports w ith timely, decision-relevant inform ation. The main groups o f users a re as follow s:
•
O w n e rs are individual business ow ners, such as proprietors, partners a nd other entrepreneurs; in dividual investors (shareholders) in shares on stock markets w h o can vote on c o m p a n y affairs; com panies that invest in other com panies; superannuation funds an d other institutions that invest in com panies; a nd p e o p le w ith quasi-ow nership interests, such as members o f clubs o r voters in local councils. In respect o f com panies, shareholders o w n portions o f the co rp o ra tio n - shares that can be bought an d sold - but the co rp o ra tio n is a legal entity existing separately from its shareholder ow ners. Investors purchase shares in a c o m p a n y w ith the hope o f g a in in g in tw o w a ys: receiving a portion o f the co m p a n y's p rofit in the form o f dividends, a n d being a b le to sell their shares in the future a t a price higher than they p a id .
•
Potential ow ners are p e o p le o f the same sort as the ow ners listed a b o ve , w h o d o not at present have funds invested in the enterprise but m ay be considering m aking such an investment. Because potential ow ners often buy shares from present ow ners - fo r exam ple, b y trading shares on the stock market - rather than investing directly,
6
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
there is often a sig n ifica n t difference in outlook betw een present ow ners, w h o m ay w ish to sell their shares for as much as possible, an d potential ow ners, w h o w o u ld like to p a y as little as possible. •
C reditors a n d p o te n tia l creditors are suppliers, banks, bondholders, em ployees an d others w h o have lent m oney to the enterprise, w h o are o w e d funds in return for supplying som ething o f value, o r w h o a re considering taking on such a role. C reditors d o not have the legal control o f the enterprise that ow ners have, but they often have a large say in enterprise decisions, e sp e cia lly if the enterprise gets into difficulty. In cases o f extreme difficulty, creditors m ay have the right to take over control o f the enterprise from the ow ners. Sometimes the difference betw een creditors an d ow ners is hard to discern because it m ay d e p e n d on subtle legalities a b o u t w h o has w h a t rights, and some p e o p le m ay p la y both roles for a given enterprise. For exam ple, an o w n e r invests m oney in a business, but in a d d itio n m ay lend the business further money, becom ing a creditor as w e ll as an ow ner. C reditors need to d e c id e w hether to supply g o o d s o r services to the firm on credit.
•
M a n a g e rs a re those w h o run the enterprise on b ehalf o f the ow ners. They have a g re a t interest in the w a y accounting reports on their activities an d results. They use the inform ation for p la n n in g , controlling a nd organising the activities o f the entity. O ften m anagers' salaries an d bonuses, a nd the likelihood of staying in their jobs, are directly affected by the contents o f the fin a n cia l statements. In small businesses in particular, the o w n e r m ay also be the main m anager.
•
Em ployees a n d their unions o r other associations are interested in the enterprise's a b ility to p a y w a g e s, m aintain em ploym ent levels a nd keep such promises as p a yin g superannuation contributions. Financial inform ation can be used to assess jo b security.
•
Regulators a n d other governm ent b o d ie s a n d agencies a re groups that m ay use the fin a n cia l statements as a basis to evaluate w h e th e r the enterprise is fo llo w in g various rules an d agreem ents.
•
F inancial a n d m arket analysts a re p e o p le w h o study com panies' perform ances a nd prepare reports for others by analysing those com panies. Analysts often make recom m endations a b o u t w hether to invest, sell o r d o neither.
•
C om petitors m ay use the fin a n cia l statements to try to understand the enterprise's operations for the purpose of m aking life m ore difficu lt for the enterprise. Sometimes, for exam ple, m anagers are reluctant to disclose inform ation to shareholders, because com petitors can then also o btain it an d act to reduce the enterprise's prospects.
•
A cco u n tin g researchers are p e o p le - mostly university academ ics, but also some based in accounting firms and other organisations - w h o study accounting w ith the o b je ctive o f understanding it a nd contributing to its im provem ent.
•
Customers need to consider if the entity is fin a n cia lly sound. This is particularly im portant w hen customers are required to p a y am ounts in a d va n ce . It is also im portant if customers rely on the w arranties p rovided by the entity.
•
M iscellaneou s third parties a re various other p e o p le w h o m ay get access to an enterprise's fin a n cia l statements and use them in various w a ys . O n c e statements have been issued, m any p e o p le m ay make use o f them. For exam ple, politicians m ay make judgem ents a b o u t industry e fficie n cy o r taxation levels, journalists m ay w rite stories a b o u t em ploym ent practices, a nd judges m ay evaluate the enterprise's a b ility to p a y if it loses a lawsuit. Think about all these users a nd decisions! It is a gre a t c h a lle n g e to d e ve lo p one set o f p e rio d ic financial
statements for an enterprise so that it can be useful for all. Perhaps you w ill not be surprised to kn o w that there is much controversy a b o u t w hether fin a n cia l statements d o this w e ll, a nd w h e th e r fin a n cia l accounting methods serve some users o r decisions better than others. F low likely is it that you, the reader, w ill use accounting inform ation in the future? If you plan to be an accountant, the value of studying fin a n cia l accounting is clear. It m ay not be so clear, how ever, if you have other plans, such as a career in m anagem ent, m arketing, finance, e n gineering, la w , human resources o r production. To pro vid e some perspective to those o f you not planning an accounting career, an d to help you understand the m anagers you w ill w o rk w ith if you d o becom e an accountant o r auditor, comments w ill be m ade frequently about m anagers an d fin a n cia l a ccounting.
CHAPTER 1 Introduction to Financial accounting
7
Financial accounting is directly relevant to m anagers because it reports on the m anagers' perform ance as decision-m akers, caretakers o f the enterprise, representatives o f the ow ners, legal officers o f the enterprise, a nd so on. A ny m anager cannot help but be interested in h o w her or his perform ance is being measured a nd in h o w that perform ance is analysed, projected a nd otherw ise evaluated. M a n a g e rs ' bonuses, prom otions, dismissals, transfers and other rew ards an d penalties are often directly based on the numbers an d com m entaries prepared by accountants. Every m anager should have an intim ate understanding o f h o w accounting is measuring his o r her perform ance a n d should be a b le to conduct a 'reasonableness check' o f the inform ation being p ro vid e d . It is critical for m anagers to understand the im p a ct o f every decision they are m aking on accounting numbers as these numbers w ill measure their perform ance. H ere are a fe w exam ples o f h o w non-accounting m anagers m ay use accounting inform ation. M a rke tin g m anagers need to understand the fin a n cia l statements of potential customers to determ ine w hich customers to focus on an d w h ich ones to extend credit to. Purchasing m anagers need to understand suppliers' finan cia l statements to make sure they have the c a p a city to supply in the long term. Human resources m anagers use accounting inform ation in salary negotiations, an d inform ation systems designers need to include the accounting inform ation system in their design. If you are extrem ely talented a nd have d e c id e d to make your fortune as a sports star or m usician, you still need to know a b o u t acco u n tin g . W e suggest that understanding the fin a n cia l statements o f the S ydney C ricket G ro u n d or the O p e ra House w o u ld be o f benefit in negotiating w ith those organisations.
Preparers (decision facilita tors) T w o main groups are responsible for the inform ation in the fin a n cia l statements: •
M a n a g e rs are responsible for running an enterprise, including issuing accounting an d other inform ation, and controlling its fin a n cia l affairs. The fact that m anagers are also users, a n d a re vita lly interested in the results, has created a fundam ental conflict o f interest fo r them a nd has led to the developm ent o f the aud itin g function (see below ). M a n a g e rs are often referred to, as a g roup, as m anagem ent.
•
A ccountants have the jo b o f shaping the fin a n cia l statements by a p p ly in g the principles o f accounting to the enterprise's records, under the direction o f m anagem ent. M a n y accountants a re members o f professional societies, such as C PA A ustralia, C hartered A ccountants in A ustralia a n d N e w Z e a la n d , an d the H ong Kong Society of A ccountants. A ccountants an d their professional bodies also often have a u d itin g experience and interests, a nd sometimes aud itin g roles, but the task of p reparing the fin a n cia l statements is quite different in p rin ciple from the task o f verifying those statements once they are prepared.
A u ditors (cre d ib ility enhancers) Auditors report on the c re d ib ility o f the enterprise's fin a n cia l statements, on b e h a lf o f ow ners an d others. Auditors have the jo b of assisting the users by verifying that the fin a n cia l statements have been prepared fairly, com petently an d in a m anner consistent w ith acce p te d accounting principles. The aud itin g role is a very o ld one, arising because users dem a n d e d some assurance that m anagers' reports on their perform ance w e re not self-serving, biased o r d o w n rig h t untruthful. This b o o k refers frequently to external auditors, w h o report on the fin a n cia l statements on b ehalf o f external users, but there are also internal auditors, w h o w o rk w ithin the enterprise to support the c re d ib ility of inform ation being used b y m anagem ent, an d other auditors (such as tax auditors, w h o verify taxpayers' com putation o f tax). W h ile external auditors m ay be asked for a d v ice in p re paring the statements, e sp e cia lly for small com panies, they must a vo id responsibility for the statements because their role is to scrutinise the preparation process. They cannot cre d ibly a udit statements they have prepared! (Professional accountants often d o prepare fin a n cia l statements, but in so d o ing they are not acting as external auditors, a nd they make this cle a r in covering letters an d footnotes attached to the statements.) The external auditors are form ally a p p o in te d by the ow ners; for exam ple, at the annual shareholders' m eeting. But an enterprise's external a u d ito r is not perm itted to be an o w n e r or m anager o f the enterprise. For exam ple, they cannot o w n shares in the c o m p a n y an d they cannot a ct as a director o r m anager of the co m p a n y, even for a small
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
8
part o f the year. This is to ensure that the a u d ito r is fin a n cia lly an d ethically independent a n d can therefore be objective a b o u t the enterprise's fin a n cia l affairs. Independence a nd o b je ctivity a re fundam ental ideas that you w ill encounter frequently in this book. External auditors m ay w o rk a lo n e o r in partnership w ith other auditors in accounting firms. Som e o f these firms are very large, having thousands of partners an d tens o f thousands o f em ployees, a nd offices in m any cities and countries. A ccounting firms offer their clients not o nly external aud itin g but also a d vice on incom e tax, accounting, com puter systems an d m any other fin a n cia l an d business topics. H ow ever, if they conduct the a u d it there are rules in place a bout w h a t other services they can p rovide, as auditors cannot be involved in aud itin g their o w n w o rk, or creating a n y conflict-of-interest problem s. M a n a g in g this requires co n sid e ra b le professional skill a nd attention to the ethics and rules o f professional conduct. W h e th e r this is being d o n e successfully is a matter o f much controversy at present. In Australia, as w e ll as in m any overseas countries, there has been a d d itio n a l regulation a im e d a t im proving the independen ce o f auditors. The large accounting firms annually spend m any millions o f dollars on their independence a nd quality-control systems.
People and ethics Ethics, m entioned a b o ve , w ill be raised throughout this book. Ethical issues can arise in just a b o u t a n y area of accounting. H ere a re some exam ples, all o f them real: •
An enterprise has been sued by a recently fired e m ployee w h o claim s that the dismissed w a s based on the em ployee's a g e , a nd therefore broke em ploym ent law s. The enterprise's general m anager denies any im propriety. The enterprise's chief accountant, w h o personally feels that the form er em ployee's claim is justified, has suggested to the boss that the law suit should be m entioned in a note to the fin a n cia l statements, so that users o f the statements w ill kn o w there is a potential for loss if the form er em ployee w ins. The general m anager feels that the chief accountant should ignore the law suit in p re paring the fin a n cia l statements, to a v o id em barrassm ent and the a p p e a ra n c e o f adm itting guilt. The general m anager fears that such an a p p a re nt adm ission could be used against the enterprise in court an d so could cause the enterprise to lose the lawsuit. W h a t should the chief accountant d o ?
•
W h ile d o in g an audit, the external a u d ito r learns that the enterprise m ay have been cheating o ne o f its customers. The customer, w h o is un a w a re o f this a nd quite h a p p y w ith things, is another client o f the auditor. The auditor, w h o is bound by rules o f conduct designed to protect the c o n fid e n tia lity o f inform ation g a in e d during the audit, knows that saying anything to a n yo n e could result in m ajor lawsuits. Should the a u d ito r just keep quiet a b o u t w h a t w a s found?
•
A third enterprise's general m anager is p a id a bonus each year, calculated as a percentage o f profit. The general m anager is considering a proposed ch a n g e o f depreciation method that w ill reduce d e p re cia tio n expense and therefore raise accrual profit an d increase the general m anager's bonus. Should the general m anager refuse to im plem ent the accounting ch a n g e, request that the bonus calculation ignore the change, o r just g o a h e a d and e n jo y the higher bonus? These illustrative problem s d o not have easy answers, so none are offered here. They are dilem m as for the chief
accountant, the a u d ito r an d the general m anager. This b o o k w ill address ethical issues from tim e to time, helping you to sharpen your ethical sense a lo n g w ith your accounting kn o w le d g e - the tw o are inseparable.
1.5
Accrual accounting
Financial accounting's task of p ro ducing fin a n cia l statements is a co m p le x one. For even a small business, thousands o f events (transactions) have to be recorded an d their fin a n cia l effects evaluated. For large corporations such as BHP Billiton, Lend Lease, Rio Tinto, W o o lw o rth s , A M P , Q a n ta s an d W e s tp a c , o r organisations such as the University of N e w South W a le s , Brisbane C ity C o u n cil o r the Red Cross, the num ber o f annual transactions runs into the m illions or billions. Frequently, w hen the tim e comes to prepare the fin a n cia l statements, some transactions have not been com pleted, are in dispute o r have an otherw ise unclear status. Here a re exam ples in w h ich a p p ro p ria te figures m ay be difficult to determ ine:
CHAPTER 1 Introduction to Financial accounting
•
9
The value o f W e s tp a c 's overseas loans (i.e. the m oney actu a lly to be received b a ck from those loans) depends on the health o f the b o rro w in g countries' econom ies, stability in international money-transfer arrangem ents (often disrupted by w ars, politics a nd natural disasters) an d the relative values of various countries' currencies, w h ich , like nickel prices, can ch a n g e a lot from d a y to d a y.
•
The value of donations prom ised to the Red Cross but not yet received depends on h o w com m itted donors a re to actu a lly producing the cash. This com m itm ent can be affected by unem ploym ent, rising prices for fo o d a nd other g o o d s the donors need, an d other factors beyond the Red Cross's control.
•
The am ount o f profit that should be recognised during the ye a r by Leighton H oldings for the construction o f a m ajor b rid g e that w ill take tw o years to com plete w ill d e p e n d on future expenses. To c o p e w ith these com plexities, fin a n cia l accounting for most businesses an d organisations uses the accrual
accounting a p p ro a ch . U nder an accrual accounting system, the im pact of transactions on the fin a n cia l statements is recognised in the tim e periods during w h ich revenues an d expenses occur, rather than w hen the cash is received or p a id . Formal definitions o f revenues a nd expenses can be quite c o m p lica te d , a nd a re left to C h a p te r 2. A t this stage, w e w ill pro vid e exam ples o f the main types o f revenues an d expenses. The main form o f revenue is usually the sale o f g o o d s or services; for exam ple, the sale o f coffee m achines for $ 4 5 0 0 0 o r carrying out the installation o f a n ew com puter system for $ 3 0 0 0 0 0 . O th e r revenues include interest on investments held, dividends received on shares an d rent from premises o w n e d by the com pany. Expenses include the costs of services an d resources consum ed in the process o f generating revenues. Examples o f costs incurred are w a g e s, electricity, travel an d rent. An exam ple o f resources consum ed is de p re cia tion. O rga n isa tio n s d e p re cia te the cost o f an asset (such as a m otor vehicle o r a printing machine) over the useful life o f the asset; that is, each ye a r a percentage o f the cost of the asset becom es an expense. These assets are helping in generating revenue; therefore, a share o f the cost should be treated as an expense in each accounting period during w h ich the asset helps generate revenue. W h y d o w e d e p re cia te the cost of an asset over its useful life rather than treat the cost o f the asset as an expense in the first year? The reason is that the asset is used over m any years an d helps generate revenue over m any periods. This de p re cia tio n expense is m atched to the revenues earned during the p e riod. N o te that estimates need to be m ade. For exam ple, a printing m achine that cost $ 4 8 0 0 0 0 w o u ld have annual dep re cia tio n o f $ 1 2 0 0 0 0 , $ 9 6 0 0 0 o r $ 8 0 0 0 0 , d e p e n d in g on w hether its estim ated life is four, five o r six years; that is, the judgem ent on the useful life o f the m achine has an im pact on p rofit each year.
HOW'S YOUR UNDERSTANDING? L is t th e m a in re v e n u e s an d e x p e n s e s f o r a c o ffe e c a r t y o u see o n c a m p u s o r in th e c ity . Y o u r a n sw e rs s h o u ld be as fo llo w s . T h e m a in re v e n u e w ill c o m e fr o m c o ffe e sales. I f all sales a re cash sales it w o u ld be th e cash re c e iv e d f o r th e c o ffe e s sold . B u t n o te th a t s o m e c u s to m e rs m a y ha ve an a c c o u n t w h e re all c o ffe e s sold t o th e m are re c o rd e d an d th e n th e y pa y th e w h o le a m o u n t th e fo llo w in g m o n th o n re c e ip t o f an in v o ic e . N o te th a t u n d e r a c c ru a l a c c o u n tin g it is th e d e liv e ry o f th e s e rv ic e (i.e . h a n d in g o v e r th e c u p o f c o ffe e ) th a t re s u lts in re v e n u e b e in g re c o g n is e d . L ik e ly e x p e n s e s in c lu d e : •
th e c o s t o f c o ffe e
•
th e c o s t o f c u p s
•
w ag es
•
r e n t o f sp a c e (e .g . t o th e u n iv e rs ity )
•
d e p re c ia tio n o n th e c o ffe e m a c h in e .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
10
Accrual accounting versus cash accounting Before considering these com plexities, let's consider the basic differences betw een cash accounting an d accrual accounting. •
C ash a ccou n tin g involves recording revenues an d expenses a t the tim e the cash is received o r p a id . This is reasonably precise, because the accountant knows w h e th e r cash has been p a id o r received an d the exact am ount is easily determ ined (from accounting books o r bank statements).
•
H ow ever, often the tim ing o f cash flo w is in a different accounting period from the substance o f the transaction. Examples include selling inventory on credit; w hen a contractor fixes m achinery but w ill not be p a id until a later accounting p e riod; o r the use o f m achinery, w h ich reduces its future useful life. As noted a b o v e (but w orth repeating), a ccru a l a ccounting incorporates these com plexities b y re co rd in g revenues a n d expenses a t the time they occur, not w hen cash is received. To c om pare cash profit w ith accrual profit, consider the fo llo w in g :
•
A c o m p a n y makes credit sales o f $ 1 0 0 0 0 0 in June, w h ich w ill be collected in July. U nder an accrual system, $ 1 0 0 0 0 0 revenue w o u ld be included in June, w hereas under a cash system the am ount w o u ld be recognised in July.
•
A contractor carries out repair w o rk for your c o m p a n y in June for $ 2 0 0 0 0 , but the bill w ill not be p a id until July. U nder an accrual system, the expense w o u ld be recognised in June, but under a cash system it w o u ld not be recognised until July.
•
U nder accrual accounting there w ill be an a llo ca tio n o f the cost o f equipm ent to expenses over several accounting periods to recognise the consum ption o f the equipm ent's future e co n o m ic value. This is ca lle d d e p re cia tio n . If some new equipm ent cost $ 8 0 0 0 0 a nd has a life of e ig h t years, $ 1 0 0 0 0 de p re cia tio n w o u ld be included in expenses each year.
HOW'S YOUR UNDERSTANDING? In J u n e , a c o m p a n y m a ke s cash sales o f $ 1 0 0 0 0 and c re d it sales o f $ 2 0 0 0 0 (a ll t o be c o lle c te d in J u ly J. It pays w ag es o f $ 6 0 0 0 and o w e s $ 1 0 0 0 f o r J u n e e x p e n s e s ( t o be paid in J u ly J.
1 2
W h a t is p r o fit u s in g cash a c c o u n tin g ? W h a t is p r o fit u s in g a c c ru a l a c c o u n tin g ? Y o u r a n sw e rs s h o u ld be:
1
$10 0 0 0 - $ 6 0 0 0 = $ 4 0 0 0
2
$10 0 0 0 + $ 2 0 0 0 0 - $ 6 0 0 0 - $ 1 0 0 0 = $ 2 3 0 0 0 .
Using accrual accounting to prepare financial statem ents Using the accrual accounting a p p ro a ch in p re paring the fin a n cia l statements, attempts are m ade to: •
include all the cash receipts a nd payments that have a lre a d y happe n e d ; for exam ple, cash sale a n d cash paym ent fo r w a g e s
•
incorporate future cash receipts a nd payments that should be expected, based on existing transactions; for exam ple, it is necessary to include the credit sale n o w , although the cash w ill not arrive until the next period
•
measure the value o f incom plete transactions; for exam ple, estim ate the likely am ount o f accounts receivable that w ill not be collected, a nd treat the am ount as an expense o f this ye a r
•
estim ate figures w hen exact amounts are unknow n; for exam ple, estim ate the am ount o f interest due from the bank at year-end, even though the b a n k does not a d d the interest to yo u r account for another tw o months - the am ount is interest revenue
CHAPTER 1 Introduction to Financial accounting
•
11
make an e co n o m ica lly m eaningful overall assessment of a w k w a rd problem s; for exam ple, a customer is suing you for $ l m illion because o f a faulty product. You a g re e to p a y $ 2 0 0 0 0 0 in settlement now , but the client takes the matter to court, w ith the case to be held next year. You need to determ ine if there is an expense in this year. C o m p lica tio n s such as this can be left to later chapters, but it is im portant to realise early that there are com plications in determ ining profit.
Estim ates and assessm ents N o tic e the use o f the w o rd s 'estim ate' an d 'assessment' a b o ve . This illustrates the need for judgem ents w hen preparing fin a n cia l statements. Further exam ples o f estimates for the situations described earlier for W e s tp a c , Red Cross a nd Leighton H o ld in g s a re as follow s. •
In ord e r to ju d g e the value o f W e s tp a c 's uncollected loans, som eone studies the loan repaym ent record o f various countries for W e s tp a c a nd estimates h o w much m oney the bank w ill be a b le to collect.
•
To help the Red Cross make its spending plans, som eone advises the Red Cross on h o w much o f the prom ised donations is likely to be received.
•
Som eone calculates the costs involved in bu ild in g the b rid g e to this point. Based on such estimates as the percentage o f the jo b com pleted, he o r she also estimates the total likely profit o f bu ild in g the b rid g e and determines the percentage o f profit to be included in this period.
•
All com panies have to estim ate the am ount o f m oney o w in g to em ployees at the end o f each year.
The im portance o f good ju d g e m e n t A ccrual accounting has been d e ve lo p e d because fin a n cia l statements cannot be based on merely the routine accounting records o f w h a t has h a p pened. M e a su rin g e conom ic perform ance is m ore co m p le x than that, an d the a p p ro p ria te measures can be elusive o r can d e p e n d on one's point o f v ie w . M a n y augm entations to the transactional record (estimates, adjustments, judgem ents a nd verbal explanations) must be m ade so that the statements w ill be m eaningful. The resulting statements, therefore, d e p e n d to a g re a t extent on the q u a lity a nd fairness of such augm entations. M a n a g e rs, accountants a nd auditors must use their judgem ent constantly. Financial a ccounting, because it relies on m any judgem ents, is fa r more im precise than most p e o p le (even many regular users of fin a n cia l statements) realise. To help students understand the reality o f modern fin a n cia l accounting, this b o o k spends much space on the real-life im precisions o f p reparing a nd using fin a n cia l statements. A ccrual accounting is therefore the presumed method in this book, though there w ill be some com parisons betw een it and sim ple cash-based a ccounting. M o d e rn fin a n cia l accounting starts w ith cash receipts an d paym ents, then builds a very large accrual accounting process in a d d itio n to the cash records in o rd e r to pro vid e the sophisticated measures o f fina n cia l perform ance an d position that to d a y's w o rld dem ands.
FOR YOUR INTEREST M a n y o f y o u w ill e n d u p w o rk in g as a c c o u n ta n ts o r m a n a g e rs f o r o rg a n is a tio n s th a t o p e ra te in m a n y c o u n trie s . T h is b o o k s h o u ld e q u ip y o u t o u n d e rs ta n d th e fin a n c ia l s ta te m e n ts p re p a re d in m o s t c o u n trie s , in c lu d in g A u s tra lia , th e U n ite d S ta te s , th e U n ite d K in g d o m , C a n a d a , N e w Z e a la n d , C h in a , S in g a p o re , FHong K o n g , In d o n e s ia , M a la y s ia and m a n y o th e rs . T h e m e th o d s o f p re p a rin g fin a n c ia l s ta te m e n ts in th e s e c o u n trie s are v e ry s im ila r. A ll use th e a c c ru a l a c c o u n tin g s y s te m in tro d u c e d in th is c h a p te r. W it h th e in tr o d u c tio n o f In te rn a tio n a l F in a n c ia l R e p o rtin g S ta n d a rd s (IF R S ) in 2 0 0 5 , d iffe re n c e s b e tw e e n fin a n c ia l r e p o rtin g in th e s e c o u n trie s a re lik e ly to be v e ry sm all.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
12
1.6
The key financial statem ents
O rganisations are required to p ro vid e the fo llo w in g types o f inform ation that are relevant to user needs: financial position, fina n cia l perform ance, fin a n cin g activities a nd investing activities. The key finan cia l statements that p ro vid e this inform ation are: a balance sheet, w h ich shows the fin a n cia l position at a point in time; an income statem ent, w h ich measures fin a n cia l perform ance over a d e fined p eriod (such as a month o r a year) b y deducting expenses from revenues during the p eriod to o btain profit for the p e riod; a nd a statem ent of cash flows, w h ich shows the sources a n d uses o f cash during the p e riod. Both fin a n cin g a nd investing activities are included in this statement.
Balance sheet Exhibit 1.1 provides an exam ple o f a sim ple b a la n ce sheet. The b a la n ce sheet shows an o rg anisation's resources and claim s on resources a t a particular point in time. The hea d in g provides the c o m p a n y name, the title o f the report and the date a t w h ich the fin a n cia l position is show n. The three main elements o f a b a la n ce sheet are assets, liabilities and shareholders' equity. In this case, the o rganisation is a co m p a n y, a n d shareholders' equity is described as shareholders' equity. If the organisation w e re a sole trader o r partnership, it w o u ld be ca lle d proprietor's equity or partners' equity, respectively.
ASSETS Assets are the future e conom ic benefits that are controlled by an organisation as a result o f past transactions o r other past events. The value o f every asset needs to be m easurable in m onetary terms. A brief discussion o f the assets in Exhibit 1.1 w ill make you fa m ilia r w ith the term inology.
CHAPTER 1 Introduction to Financial accounting
13
•
The cash at bank a ccount records deposits an d w ith d ra w a ls from a bank.
•
A ccounts receivable (also ca lle d debtors) represents am ounts o w in g from customers for g o o d s o r services pro vid e d to them. Accounts receivable is shown net, w h ich indicates the am ount that m anagem ent expects to co lle ct from customers after a llo w a n ce s have been m ade for likely uncollectable amounts.
• •
Inventory g e n e ra lly represents the cost o f stock on hand; that is, unsold products. Property, plant an d equipm ent includes items such as land, buildings, equipm ent, motor vehicles, com puters and furniture. Assets can be financed in one o f tw o w a ys: liabilities a n d /o r shareholders' equity: Assets = Liabilities + S h areh o ld ers' eq u ity
LIABILITIES L ia b ilitie s a re the future sacrifices o f econom ic benefits that an organisation is presently o b lig e d to make to other organisations o r individuals as a result o f past transactions or events. For exam ple, suppliers providing goods on credit and em ployees carrying out w o rk are exam ples o f past transactions that lead to liabilities. Liabilities can be legally o w e d debts, such as loans from the bank, m ortgages or amounts due to suppliers. H ow ever, they also can be estimates o f future payments based on past agreements, such as those arising from promises o f future benefits to employees for long service leave, or o f w arranty repairs for customers w hen products break d o w n . Liabilities involve the future use of assets, usually cash, o r the perform ance of future services. An exam ple o f the form er is paying cash to reduce a liability. An exam ple of providing a future service w o u ld be carrying out w arranty repairs on products previously sold. Four exam ples o f liabilities in Exhibit 1.1 a re a cco u n ts p ayable, w a g e s p a ya b le , provision for em ployee entitlements an d long-term loans. •
A ccounts p a y a b le (often c a lle d trade creditors) is the am ount o w e d to various suppliers for g o o d s o r services they have pro vid e d to an organisation.
•
W a g e s p a y a b le (also called accrued w ages) is for w o rk done by employees, but for w hich they have not been paid.
•
Provision for e m ployee entitlements refers to entitlements em ployees accum ulate as a result of past w o rk , such as h o lid a y leave, sick leave, long service leave a nd superannuation.
•
Long-term loans a re loans that are not re p a ya b le w ithin a year.
SH A R EH O LD ER S' E Q U ITY Shareholders' equity is the excess o f assets over liabilities. It is a residual claim o f the shareholders on the assets o f the organisation. S hareholders' equity consists o f tw o main elements: share c a p ita l an d re ta in e d p ro fits . • •
Share c a p ita l is the am ount that ow ners have directly invested in the com pany. R etained profits represent the total cum ulative amounts o f profits that the c o m p a n y has retained in the business rather than distributed as dividends. The relationship betw een assets, liabilities an d shareholders' equity can be expressed in the fo llo w in g a cco u n tin g
e q u a tio n : Assets = Liabilities + S h areh o ld ers' eq u ity This equation shows that the resources o f an enterprise are funded from tw o types o f sources: d e b t o r equity. The effects o f transactions on this equation are discussed in C h a p te r 2 . A t this point you should note that the equation balances a t every point in time.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
14
HOW'S YOUR UNDERSTANDING? F o r e a ch o f th e fo llo w in g ite m s s ta te w h e th e r th e y are assets ( A ) , lia b ilitie s (L ), s h a re h o ld e rs ’ e q u ity (S E ) o r n o t lis te d in th e b a la n c e s h e e t:
1 a c c o u n ts re c e iv a b le 2 a c c o u n ts p a ya b le 3
sales re v e n u e
4 s h a re c a p ita l 5 e q u ip m e n t 6 loans Y o u r a n sw e rs s h o u ld be: 1
A
2
L
3
N o t lis te d in th e b a la n c e s h e e t
4 SE 5 A 6 L
C om parative balance sheets N o te that the b a la n ce sheet in Exhibit 1.1 shows numbers for 2 0 1 5 an d 2 0 1 6 . The changes from 2 0 1 5 to 2 0 1 6 provide the reader w ith inform ation a b o u t w h a t is h ap p e n in g to various a ccount balances; for exam ple, cash a t bank has increased from $ 1 4 0 0 to $ 2 0 0 0 . The statement does not tell us the reasons for the ch a n g e, but it is possible to obtain inform ation on the c h a n g e in this a ccount in the statement o f cash flow s p rovided in Exhibit 1.3 (to be discussed later). W h ile some o f the reasons for the changes in other balances a re too c o m p lica te d for this introductory chapter, you w ill be a b le to understand the changes after you have com pleted the next tw o chapters (w e w ill return to Exhibit 1.1 in C h a p te r 2). For no w , consider some prelim inary ideas: •
W h a t w o u ld be a likely e xplanation for the increase in accounts receivable? M o s t likely credit sales (this w o u ld increase accounts receivable) are greater than cash received from customers related to credit sales (this w o u ld decrease accounts receivable).
•
W h a t does the increase in share ca p ita l m ean? This norm ally indicates that there have been shares issued during
•
The long-term loans have decreased from $ 3 3 6 0 0 to $ 3 0 0 0 0 , in d ica tin g the c o m p a n y has b o rro w e d less than
the year.
it has repaid on the loans.
HOW'S YOUR UNDERSTANDING? 1
I f th e balances o f to ta l assets and sh a re h o ld e rs’ e q u ity are $ 1 0 0 0 0 0 and $ 4 0 0 0 0 , re sp e ctive ly, w h a t is th e balance o f to ta l liabilities?
2
I f th e balances o f to ta l liabilities and sh a re h o ld e rs’ e q u ity are $ 2 0 0 0 0 0 and $ 3 0 0 0 0 0 , re sp e ctive ly, w h a t is th e balance o f to ta l assets?
3
G ive n th e balances o f assets $ 3 0 0 0 0 0 , liabilities $ 2 0 0 0 0 0 and share capital $ 6 0 0 0 0 , w h a t is th e balance o f re ta in e d p ro fits ? Y o u r answers should be: $ 6 0 0 0 0 , $ 5 0 0 0 0 0 and $ 4 0 0 0 0 .
CHAPTER 1 Introduction to Financial accounting
15
Income sta te m e n t In previous years, the incom e statement w a s called the profit a nd loss statement. Som e com panies m ay continue to use that term inology w ithin their internal reports, so you should at least be a w a re o f it. The incom e statement provides inform ation on an o rg a nisation's p ro fita b ility for a period o f time. It matches revenues during a p eriod aga in st expenses incurred in earning the revenues. The difference is the p ro fit (revenue greater than expenses) o r loss (expenses greater than revenue). Recall that under an accrual accounting system, the cash related to the revenue o r expense does not have to be received o r p a id in o rd e r for the revenue o r expense to be included in the incom e statement. Discussion of w hen revenue a nd expenses are recognised is included in C h a p te r 2. Exhibit 1 .2 provides an exam ple of a sim plified incom e statement. Sales is the o nly revenue item listed. The next item in the incom e statement is co st o f goods sold (COGS). For a retailer, this w o u ld be the purchase price of the g o o d s that a re sold. For exam ple, if a retailer sells 1 0 0 items at $ 2 0 each a nd the cost price of each o f the items is $ 8 , sales revenue w o u ld be $ 2 0 0 0 ($ 2 0 x
1 0 0 ) a nd cost o f g o o d s sold w o u ld be
$ 8 0 0 ($ 8 x 1 0 0 ). The difference betw een sales revenue a nd cost o f g o o d s sold is called gross p r o fit (also gross m argin).
EXHIBIT 1.2 IN C O M E S T A T E M E N T FOR TH E YEAR ENDED 3 0 JUNE 2 0 1 6
$000 Sales revenue
$000 21 000
Less Cost of goods sold
8 000
Gross profit
13 000
Less Operating expenses Salaries
2 500
Depreciation
500
Electricity
300
Travel
300
Other
400
Operating profit before tax
4000 9 000
Less Income tax expense
3 000
Operating profit after tax
6 000
The incom e statement also lists various o perating expenses, as show n in Exhibit 1 .2 . These costs relate to the dayto-day running o f the business. M a n y other op e ra tin g expenses, such as advertising, staff training, m aintenance, telephone an d motor vehicle expenses, could also be included. Deducting these op e ra tin g expenses from gross p rofit gives op e ra tin g p ro fit b e fo re ta x. Tax is then deducted to g ive o p erating profit after tax. The p rofit figure o f $ 6 m illion can be p a id out in d ividends to shareholders o r retained in the business. This is the connecting link betw een the b a la n ce sheet a nd the incom e statement. The ope n in g b a la n ce o f retained profits plus the profit fo r the ye a r minus dividends equals the closing b a la n ce o f retained profits as shown in the bala nce sheet.
16
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C om panies pro vid e a separate statement o r note to the accounts sh o w in g the ch a n g e in retained p rofit for the year. For exam ple, if XYZ's o p e n in g retained profits w e re $ 2 4 m illion, net p rofit for the ye a r w a s $ 6 m illion and dividends o f $ 3 m illion w e re d e cla re d a nd p a id , w e w o u ld see the fo llo w in g statement in the notes to the accounts for retained profits. $ million 1 Opening balance
24
+ Net profit
_6
- Dividends declared and paid
_3
Closing balance
27
30
S tate m ent o f cash flow s Because revenues reported usually d o not equal cash collected a nd expenses d o not equal cash p a id , net profit is different from the ch a n g e in cash for the p e riod. The statement o f cash flow s shows the changes during the period in one b alance sheet account, nam ely cash. It shows the receipt o f cash a nd the paym ent o f cash. A cco u n tin g sta n d a rd s require com panies to present this statement in their published fin a n cia l statements. Individual transactions are norm ally split into the fo llo w in g three categories: 1 2
o p e ra tin g a c tiv itie s : related to the provision o f g o o d s a nd services in v e stin g a c tiv itie s : related to the acquisition an d disposal o f certain noncurrent assets, including property, plant and equipm ent
3
Financing a c tiv itie s : related to c h a n g in g the size a nd com position o f the fin a n cia l structure o f the entity, including equity and certain b orrow ings. Exhibit 1 .3 provides an exam ple o f a statement o f cash flow s. U nder cash flow s from o p erating activities, it shows
that the c o m p a n y received $ 1 7 m illion from customers, an d p a id $ 7 .7 m illion an d $ 2 .5 m illion to suppliers and em ployees respectively, as w e ll as p a yin g $ 4 .3 m illion in other op e ra tin g costs.
CHAPTER 1 Introduction to Financial accounting
17
N o te that these figures are not the sam e as those in the incom e statement. For exam ple, the c o m p a n y could have m ade $ 21 m illion in credit sales, but o n ly collected $ 1 7 m illion from customers by the end o f the year. There w a s only on e investing item, being the cash p a id for a n e w m achine. C ash flow s from fin a n cin g activities sh o w that the c o m p a n y received $ 4 m illion from an issue o f shares, but p a id b a ck a $ 3 .6 m illion ba n k loan. The net effect on cash o f all of the a b o v e transactions w a s an increase o f $ 6 0 0 0 0 0 . W h e n a d d e d to the o p e n in g b a la n ce of $ 1 .4 m illion, it shows a closing b a la n ce o f $ 2 m illion, w h ich is also the figure shown under cash in the bala nce sheet. Statements o f cash flow s w ill be discussed in detail in C h a p te r 14.
FOR YOUR INTEREST J u s t a re m in d e r th a t in th e s e e a rly c h a p te rs m a k e s u re y o u g o to th e g lo s sa ry w h e n y o u e n c o u n te r a n e w te rm .
1.7
Relationships between the financial statem ents
Exhibit 1 .4 shows the main relationships betw een the various fin a n cia l statements. W e have a b b re via te d the bala nce sheet, the incom e statement a nd the cash flo w statement in Exhibits 1 .1 , 1 .2 an d 1.3 to make the relationship clearer. The cash flo w statement explains the ch a n g e in cash in the b a la n ce sheet from $ 1 4 0 0 to $ 2 0 0 0 . This ch a n g e w ill be from cash flow s from o p e ra tin g , investing a nd financing activities, a nd a closer exam ination o f Exhibit 1.3 w ill sh o w w h ich cash flow s have the m ajor im pact. N e t p rofit o f $ 6 0 0 0 for the ye a r app e a rs in the incom e statement, a n d this am ount increases retained profits. H o w this w orks can be seen in the note on retained profits, w h ich has increased from $ 2 4 0 0 0 to $ 2 7 0 0 0 , du e to the net profit for the ye a r less the dividends d e cla re d and p a id ; that is, the am ount o f net p rofit not used for d ividends increases the b a la n ce of retained profits.
EXHIBIT 1.4 R ELA TIO N SH IP S B ETW EEN TH E STA TE M E N TS (BASED ON EXHIBITS 1.1 TO 1.3)
Balance Sheet Cash
2016
Cash Flow Statement
2015
2,000
1,400
Other assets
11 8,000
114,000
Total assets
1 ,4 0 0 — > 2 ,0 0 0
115,400
Income statement 24,000 6 ,00 0 30,000
— Dividends
From financing activities
Revenues
21,000
Expenses*
15,000
Net profit
3,000 27,000 6 ,0 0 0
18
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? I f th e o p e n in g b a la n c e in re ta in e d p r o fits is $ 1 0 0 0 0 0 , n e t p r o fit a fte r ta x is $ 6 0 0 0 0 an d d iv id e n d s d e c la re d and pa id is $ 4 0 0 0 0 , w h a t is th e b a la n c e o f re ta in e d p ro fits a t y e a r-e n d ? Y o u r a n s w e r s h o u ld be : $ 1 0 0 0 0 0 + $ 6 0 0 0 0 — $ 4 0 0 0 0 = $ 1 2 0 0 0 0 .
Dem ands on the qu a lity o f financial accounting in fo rm a tio n Let's think about w h a t the users o f fin a n cia l inform ation (such as the board o f directors, the analyst, the banker a nd the supplier discussed in section 1 .3 ] m ight reasonably expect o f the fin a n cia l statements. The im portant accounting concepts and principles involved are described in italics. 1
The financial statements need to contain inform ation that is useful to those w h o are making the decisions. The inform ation must have value in helping the financial analyst o r the bank lending officer make their recom m endation. In addition, the inform ation to be provided needs to be supplied in a tim ely manner. For exam ple, some o f the decisions by the board o f directors, the analyst, an d the banker an d the supplier noted earlier need to be m ade at a certain point in time. W h ile the outcom e o f a particular contract m ay be relevant inform ation, the decisions often cannot w a it until that contract has been finalised. This is the c o n ce p t o f relevance, tf inform ation is to assist users in m aking decisions a b o u t the a llo ca tio n o f scarce resources, it should help them make, confirm o r correct pre d ictio n s a b o u t the outcom es o f past, present or future events.
2
The financial statements should not be d e lib e ra te ly m isleading. They should be free from bias. They should not be designed to lead users tow ards conclusions that are desired by the preparers. If accounting inform ation is to tell p eople a b o u t the e co n o m ic forces affecting the co m p a n y, an d the business arrangem ents the c o m p a n y has m ade to deal w ith those forces, it should connect to such im portant underlying phenom ena. The ba n k loans officer w o u ld w a n t to feel confident that the statements w e re not prepared in such a w a y as to make the co m p a n y a p p e a r to be a better lending risk than it is. Sim ilarly, the b o a rd o f directors w o u ld w a n t the statements to provide an objective portrayal o f the C E O 's perform ance in running the com p a n y. This is the criterion o f 'faithful representation', previously referred to as reliability. The fin a n cia l statements should report the eco n o m ic substance o f events h a p p e n in g to the com pany, a n d the numbers should measure the events neutrally, neither overstating n o r understating their im pact. Reliable inform ation w ill, w ith o u t bias o r undue error, faithfully represent those transactions a n d events that have occurred. To have p e rfe ct faithful representation the fin a n cia l inform ation needs to be com plete, neutral a n d free from error. W h ile such perfection is seldom com pletely a c h ie va b le , the b o a rd o f d irectors' o b je ctive is to m axim ise these qualifies.
3
Preparing fin a n cia l statements, like a n y other activity, costs m oney an d takes time. M o s t p e o p le w o u ld be satisfied if the statements w e re fa ir in relation to the im portant things an d w o u ld not mind a fe w m inor errors in them, e specially if preventing small errors w o u ld cost the c o m p a n y m oney (reducing the com pany's p rofit an d cash flow ) o r d e la y the release o f the statements. A sales m anager w o u ld not w a n t to w a it for the statements w h ile accountants c h a n g ed the cost o f the com pany's inventory o f unsold items (part of the m ulti-m illion-dollar inventory account) from $ 1 1 8 9 to $ 1 1 9 9 . This is the criterion o f m a te ria lity (significance). The m ateriality c o n ce p t is c o n ce rn e d w ith assessing w hether om ission, misstatement o r non-disclosure o f a p ie c e o f inform ation w o u ld a ffe ct the decisions o f users o f the a ccounting reports. Just w h a t is o r is no t m aterial is a m atter o f judgem ent, a n d has been the subject o f considerable research a n d study b y accountants a n d auditors. Usually, p e o p le ju d g e m ateriality b y considering the size o f a possible error c o m p a re d to the net p ro fit o r the to ta l assets. For exam ple, an acco u n ta n t o r a u d ito r m ight ju d g e that an error o ver 5 p e r cent o f net p ro fit o r 1 p e r cent o f total assets is m aterial a n d a sm aller one is not. But, as you m ight expect, the m ateriality jud ge m e n t dep e n d s on a n y p a rticu la r uses o f the inform ation that are expected, a n d on w hether the error moves the p ro fit to a loss o r violates some loan co ndition.
CHAPTER 1 Introduction to Financial accounting
19
4 There needs to be some standard a g a in st w h ich an accounting method o r num ber can be jud g e d . The fin a n cial analyst w o u ld like to kn o w that the com pany's fin a n cia l statements w e re presented fairly, in all m aterial respects, given acce p te d current methods. In the incom e statement, for exam ple, sales revenue should mean w h a t a kn o w le d g e a b le analyst o r other user w o u ld expect for such a com pany. The c o m p a n y is actually a g ro u p of com panies, so its fin a n cia l statements are co n so lid a te d , a n d it w o u ld be reasonable to expect that the com pany's method of ca lculating co n so lid a te d figures w a s proper. This is w here generally accepted accounting principles (GAAP) com e in. To assure the users that a cce p te d m ethods have been fo llo w e d , the auditor's report also says that the auditor's o p in io n is that the statements have been p re p a re d in a cco rd a n ce w ith g e n e ra lly a c ce p te d a cco u n tin g principles. This does not m ean that on e p a rticular m ethod has been fo llo w e d : G A A P often include several a cce p ta b le methods, d e p e n d in g on the circumstances. Therefore, the a u d ito r is saying that the co m p a n y's a cco u n tin g methods, a n d the resulting figures, are a p p ro p ria te to its circumstances. 5
The previous criteria in d ica te that the fin a n cia l statements necessarily reflect judgem ent on the part o f the preparers. A lso, the figures in the statements are summaries o f m any accounts; for exam ple, 'accounts receivable' an d 'long-term d e b t' m ay include dozens o r thousands o f different customers o r debts. The bank loan officer m ay w a n t to kn o w w h a t sort o f long-term debts the c o m p a n y has, so that they m ay be evaluated a g a in st the bank b o rro w in g by the co m p a n y. The bank w o u ld not w a n t other creditors to interfere w ith the co m p a n y's a b ility to pay b a ck the bank. The fin a n cia l analyst m ay w a n t to kn o w if the c o m p a n y has m ade commitments to issue more shares (such as in a plan to m otivate senior m anagem ent b y issuing shares to them ch e a p ly if they perform w ell), because those m ight reduce the equity o f a n yo n e buying the shares now . This raises the p rin cip le o f disclosure. The fin a n cia l statements include a la rg e num ber o f notes a n d account descriptions intended to m ake it cle a r to the re a d e r w hich im portant a cco u n tin g methods have been fo llo w e d (especially if those methods are no t w h a t m ight be expected) a n d to p ro vid e supplem entary inform ation on debts, share ca p ita l, commitments, la w suits a n d other things thought to b e helpful, o r necessary, in understanding the statements. Disclosure b e y o n d the a cco u n tin g figures is b e co m in g increasingly extensive: m a n y p a g e s o f notes often a c co m p a n y the set o f statements, a n d com panies disclose a d d itio n a l inform ation to taxation authorities, to securities regulators (such as the A ustralian Securities a n d Investments C om m ission a n d the US Securities a n d E xchange Com m ission) a n d to im portant other parties w h o have a reason to g e t the inform ation (such as the bank loan o ffice r a n d the fin a n cia l analyst).
6
The b o a rd , the banker, the analyst an d the supplier w o u ld like inform ation they can understand. U ndoubtedly, their a b ility to understand w ill depe n d on their kn o w le d g e o f a ccounting, as fin a n cia l reports are p repared for users w h o have a reasonable kn o w le d g e o f business including acco u n tin g . H opefully this w ill be you in a fe w years. This p rin cip le is c a lle d understandability. Reports should b e p re p a re d h a vin g re g a rd to the interests o f users w h o are w illin g to exercise d ilig e n c e in e xa m in in g the reports, a n d w h o possess the skills a n d a b ility to co m p re he n d co n te m p o ra ry a cco u n tin g practices.
7
The banker an d the fin a n cia l analyst are also involved w ith other com panies. They w o u ld like to be a b le to c o m p a re the co m p a n y's fin a n cia l statements w ith those o f sim ilar com panies. It m ay be difficult to be sure that a c o m p a n y is perform ing w e ll o r b a d ly in an absolute sense, but it can a lw a ys be co m p a red to others, as long as the fin a n cia l statements have been prepared in a c o m p a ra b le w a y . You w ill not b e surprised that this p rin cip le is c a lle d comparability. It w ill b e im portant w hen w e re view techniques fo r fin a n cia l statement analysis in C h a p te r 15 .
8 The banker, the analyst a nd the bo a rd o f directors w ill also w a n t to study the trend in fin a n cia l perform ance and position over time. Is the net profit im proving over time, o r d e te riorating? H o w a b o u t liquidity? O r the ratio of debt-to-equity fin a n cin g ? It is im portant to kn o w if sig n ifica n t events have h a p pened to make com parisons over tim e difficult o r even im possible. It is also im portant to kn o w if the c o m p a n y has ch a n g ed its accounting methods over time, because such changes m ay affect the c o m p a ra b ility o f the accounting figures from y e a r to year.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
20
K eeping the same accounting methods over tim e is ca lle d consistency. If the c o m p a n y is fo llo w in g G A AP , consistent methods w ill be used, o r the reader o f the statements w ill be told if a ch a n g e has been m ade, an d w h a t the effects o f changes in accounting methods a re (if they are material). N o te that consistency does not mean that a c o m p a n y has to use the sam e accounting method in all parts o f the co m p a n y. For exam ple, different d epreciation methods can be used for different assets. W e can form alise some o f the a b o v e ideas by relating them to the conceptual fram ew ork put out by the Australian A ccounting Standards B oard (AASB) in its docum ent Fram ew ork for the P reparation a n d Presentation o f Financial Statements (hereafter c a lle d the Framework). The Fram ework, w h ich w a s revised in D ecem ber 20 1 3, notes that these qualitative characteristics a re the attributes that make the inform ation in the fin a n cia l reports useful to users. It lists tw o fundam ental qualitative characteristics: relevance a n d faithful representation. In a d d itio n , it notes that c o m p a rab ility, verifiability, timelines a n d understandability are characteristics that enhance the tw o fundam ental characteristics. In summary, the qualitative characteristics set out in the Fram ew ork are: 1
2
Fundamental q u alitative characteristics: -
relevance
-
faithful representation.
Enhancing qualitative characteristics: -
c o m p a ra b ility
-
ve rifiability
-
timeliness
-
understandability.
The terms 'relevance' a nd 'faithful representation' w e re discussed earlier. If you are not sure o f their m eaning, you should g o back a nd re-read those descriptions. B elo w w e e la b o ra te on the four enhancing q u alitative characteristics (based on the Framework). •
C o m p a ra b ility : inform ation a b o u t o ne organisation is m ore useful w hen it can be co m p a red w ith sim ilar inform ation from another organisation an d also is co m p a ra b le over time w ithin the same organisation.
•
V erifiability: the numbers in the fin a n cia l statements can be verified directly by looking a t docum entation (e.g. the cost price o f equipm ent) o r through direct observation (e.g. counting cash o r inventory). They can also be verified indirectly by checking inputs to a model form ula a nd recalculating the outputs.
• •
Timeliness: p ro vid in g inform ation in tim e for the user to incorporate the inform ation in their decisions. U nderstandability: inform ation is m ore useful if it is understandable to inform ed decision-m akers. U nderstandability can be increased b y presenting inform ation in a cle a r an d concise manner.
FOR YOUR INTEREST T h e a c c o u n tin g p ro fe s s io n has b e e n c ritic is e d f o r th e in c re a s e d c o m p le x ity o f fin a n c ia l re p o rts , w h e re th e n o te s to th e a c c o u n ts c an e x c e e d 5 0 pages. O n e re a so n is th e in c re a s e d c o m p le x ity o f tra n s a c tio n s an d th e in c re a s e d n e e d f o r e s tim a te s . F o r e x a m p le , w h e n s e n io r e x e c u tiv e s are o n ly p a id a sala ry, r e p o rtin g o f e x e c u tiv e re m u n e ra tio n is m u c h e a s ie r th a n w h e n th e y g e t a d d itio n a l sh a re o p tio n s an d v a rio u s in c e n tiv e s based o n a c c o u n tin g n u m b e rs . A ls o , g iv e n th e legal c o n s e q u e n c e s and p e n a ltie s f o r o m is s io n o f re q u ire d d a ta , it is lik e ly f o r m a n a g e m e n t to o v e r - r e p o r t r a th e r th a n u n d e r - r e p o r t w h e n th e r e is u n c e rta in ty . T h e re are ta s k fo rc e s and c o m m itte e s c o n s id e rin g th e s e issues a t p re s e n t.
CHAPTER 1 Introduction to Financial accounting
21
T ra d e -o ffs am ong accounting principles If you think a b o u t the criteria a nd principles m entioned a b o ve (i.e. relevance, reliability, m ateriality, conform ance w ith G A A P , disclosure, understandability, c o m p a ra b ility a n d consistency), you m ay see that they d o not a lw a ys fit together w e ll. For exam ple, it w o u ld seem sensible to propose that the m ore faithfully representative the accounting inform ation is, the better. You can achieve this by being very careful a b o u t h o w you prepare it, checking it carefully a nd having the auditors com e in a nd verify it, a nd m aybe even w a itin g until some m ajor uncertainties are resolved, so you d o not have to estim ate them. It also seems sensible that decision-m akers need inform ation that is relevant to their decisions w hen they are making them. This means that inform ation should be timely: p e o p le should not have to w a it for the inform ation they need. In this light, let's consider a c o m p a n y trying to report on its lia b ility to em ployees for long service leave. It has thousands o f em ployees w h o w ill take this tim e o ff over the next 4 0 years, if they d o not leave (voluntarily or involuntarilyl). The d o lla r am ount of long service leave p a id w ill d e p e n d on h o w much the em ployees earn w hen they take the leave, an d that is not yet know n for most o f them. The am ount of leave depends on h o w long the em ployees have been w ith the firm. U nder most a w a rd s, it starts to accum ulate after 1 0 o r 15 years o f service. For each extra ye a r o f service it increases a t different rates. If the em ployee leaves before 1 0 years o f service, no am ount norm ally needs to be p a id unless the em ployee's leaving w a s involuntary. F lo w is that for a mass o f uncertainty? A n y num ber you com e up w ith for the long service leave lia b ility w ill be based on all sorts o f estimates o f unknown future events. Therefore, to ge t a lia b ility figure that faithfully represents the liability, you really have to w a it 2 0 o r 3 0 years until most o f the em ployees have retired or taken their leave. You can a lw a ys expect to get m ore reliable da ta b y just w a itin g a w h ile , even years, to see h o w things turn out. But w a itin g 2 0 or 3 0 years w ill hardly p ro vid e tim ely inform ation that is relevant to decisions such as those being m ade by the board o f directors, the investment analyst, the banker a nd the supplier m entioned a b o ve . Such decisions require the best inform ation w e can com e up w ith no w , even if it is necessarily based on estimates a nd assumptions. As time passes, faithful representation rises an d relevance falls, so w e have to try to find some m id p o in t w h e re there is enough o f both, even though w e m ay prefer even m ore o f o ne o r both of these attributes.
1.8
Financial statem ent assumptions
N o w that you have seen the fin a n cia l statements an d the basic principles upon w h ich accounting relies, it is im portant to understand some basic assumptions underlying current accounting practice an d the preparation o f fin a n cial statements. The fo llo w in g concepts (or assumptions) are discussed b e lo w : accrual basis, g o in g co n ce rn , a cco u n tin g e n tity , accounting p e riod, m onetary a nd historical cost. •
A cc ru a l basis: fin a n cia l reports are prepared on the accrual basis o f acco u n tin g ; that is, the effects o f transactions an d other events a re recognised as they occur, regardless o f w hether cash is received o r p a id at that time.
•
G o in g concern: fin a n cia l statements are prepared on the premise that the organisation w ill continue operations as a g o in g concern in the foreseeable future. If this is not the case, it is necessary to report the liq uidation values of an o rg anisation's assets.
•
A cco u n tin g entity: under this concept, the accounting entity is separate an d distinguishable from its ow ners. For exam ple, the accounting entity o f a sole trader is differentiated from the fin a n cia l affairs of the o w n e r. Sim ilarly, a c o m p a n y is a separate entity from its shareholders. If either the sole trader o r a shareholder o f a c o m p a n y goes out a nd buys a n e w set o f g o lf clubs, it m ay affect his o r her personal finances but does not affect the accounting entity. A ccounting entities d o not necessarily correspond to legal entities. For exam ple, as noted a b o ve , the personal fin a n cia l affairs o f the sole trader can be separated from the finances o f the business, although there is no legal distinction. This co n ce p t puts a b o u n d a ry on the transactions that are to be recorded for a n y particular accounting entity. It also a llo w s the o w n e r to evaluate the perform ance o f the business.
•
A cco u n tin g p e rio d : the life o f a business needs to be d iv id e d into discrete periods to evaluate perform ance for that period. D ividing the life o f an organisation into equal periods to determ ine profit o r loss for that period is know n as the accounting period concept. The time periods are arbitrary, but most organisations report at least
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
22
annually, w ith large com panies preparing half-yearly a nd quarterly fin a n cia l statements for outside purposes (in some countries) an d at least m onthly (sometimes m ore frequently) fin a n cia l statements for m anagem ent purposes. •
M o n e ta ry : accounting transactions need to be m easured in a com m on denom inator, w h ich in A ustralia is, not surprisingly, the Australian d o lla r. This a llo w s com parisons across periods an d across different com panies. Transactions that cannot be reasonably assigned a d o lla r value are not included in the accounts. This concept also assumes that the value o f the m onetary unit is constant over time, w h ich ignores inflation.
•
H istorical cost: under the historical cost concept, assets are initially recorded at cost. As you w ill see in later chapters, m any assets, such as inventory, w ill still be recorded at cost in the balance sheet in subsequent periods although their value has increased. Some other assets - such as property, plant a nd equipm ent - can be revalued periodically. Thus, in reading a balance sheet it is important to note at w h a t valuation the assets are being recorded. Some o f these basic concepts have a lre a d y been briefly m entioned e arlier in this chapter, a n d all w ill be referred
to a g a in throughout the book.
1.9
Is accounting really im portant?
The econom y as a w hole Financial accounting is perceived b y m any to have contributed to our most recent w o rld w id e fin a n cia l crisis. C o n sid e r the introduction to 'H o w D id Financial Reporting C ontribute to the Financial C risis?' by M a ry Barth an d W a y n e Landsman, European A cco u n tin g Review, VoL 19, N o . 3 , 2 0 1 0 : T h e F in a n cia l C ris is th a t began m id w a y th ro u g h 2 0 0 7 a n d c o n tin u e d th ro u g h th e e n d o f 2 0 0 8 re s u lte d in th e c o lla p s e o f n u m e ro u s c o m m e rc ia l an d in v e s tm e n t ba nks . . . T h e n e a r c o lla p se o f th e fin a n c ia l s e c to r has re s u lte d in th e g re a te s t e c o n o m ic c o n tra c tio n th a t th e U S an d E u ro p e have seen sin c e th e e n d o f th e S e c o n d W o rld W a r . . . C a lls f o r a c tio n to p re v e n t a re p e a t o f th e F in a n cia l C ris is have also to u c h e d o n a c c o u n tin g sta n d a rd s e ttin g a n d th e w a y in w h ic h a c c o u n tin g in fo rm a tio n ( o r la ck t h e r e o f) c o n trib u te d to th e F in a n cia l C risis.
The authors pro vid e insights into w hether inform ation a v a ila b le to investors w a s sufficiently transparent to make a p p ro p ria te judgem ents re garding the values a nd riskiness o f bank assets a nd liabilities. In case you a re not convinced that accounting numbers (profit a n d b a la n ce sheet figures) are im portant, w e hope the fo llo w in g ne w spaper extracts m ay convince you. Q uotes o f this type a p p e a r in the fin a n cia l section o f most new spapers every d a y. The quotes are ones w e thought you m ight find interesting. They clearly sh o w that a lot of em phasis is placed on accounting figures (especially profits) in decision-m aking b y m anagem ent a nd by users such as shareholders and creditors, co rp o ra te boards a nd consum er groups, as w e ll as their im pact on a range o f other com m unity groups.
Used by m anagem ent in m aking business decisions The fo llo w in g exam ples illustrate the im portance accounting numbers have on m anagem ent decisions to contract and expand the business, w h ich in turn affect em ployees, suppliers, contractors a nd the econom y. The a v a ila b ility o f large sums o f cash, undraw n d e b t facilities, a nd g ro w in g cash flow s e n a b le com panies take a d va n ta g e of opportunities as they em erge. O n the other hand, businesses a re often put up for sale w hen they cannot provide the fin a n cia l perform ance (as measured by accounting numbers) to g ive investors the return they w a n t. C onsider the fo llo w in g tw o exam ples: •
'Earnings before interest a nd tax soared 8 6 per cent to $1 14.1 m illion. The strong result helped push CSR into a net cash position o f $ 5 .7 m illion. G iven its pristine b a la n ce sheet, C re d it Suisse analyst A n d re w Peros estimates CSR has up to $ 3 5 0 m illion o f fire p o w e r to spend on acquisitions' ('CSR profits soar as house bu ild in g gathers momentum, A ustralian Financial Review, 6 N o ve m b er 2 0 1 4 ).
•
'Q a n ta s has announced plans to cut 1 0 0 0 jobs an d defer c a p ita l spending. The a irlin e has also raised the prospect o f selling assets, such as a irp o rt terminal leases a nd a m inority stake in its frequent flyer business, to help raise m ore cash' ('M o o d y 's d o w n g ra d e s Q a n ta s to junk', A ustralian Financial Review, 1 O January 2 0 1 4 ).
CHAPTER 1 Introduction to Financial accounting
23
Used by shareholders for de cisio n-m akin g purposes (and im pact on shareholders) Both g o o d an d ba d accounting news often has a b ig im pact on the share market (see C h a p te r 6 for a more sophisticated discussion). In particular, w hen com panies announce ba d news their share prices are usually adversely affected, as show n by the fo llo w in g illustrations. •
'The tremors from C entro's adm issions shook the stock market. A lre a d y spooked by higher than expected US inflation numbers, it lost $ 4 4 billion in its largest one-day slide since A ugust 1 0 ... A t the sam e time, forecast earnings have been slashed' (R. H arley a nd M . Dunckley, 'C re d it Crisis S avages C e n tro ', A ustralian Financial Review, 1 8 D ecem ber 2 0 0 7 ).
•
'Investors in surfwear g ro u p B illabong have lost more than $ 4 0 0 million after the co m p a n y issued a shock earnings d o w n g ra d e that prom pted a 4 4 per cent plunge in the com pany's share price and rattled an a lre a d y fragile retail sector' (Blair Speedy, 'B illabong profit w ip e o u t costs investors $ 4 1 3 m ', The Australian, 2 0 Decem ber 201 1).
•
'U G L's share price, w h ich fell alm ost 15 per cent on Thursday fo llo w in g an announcem ent the p o w e r plant had cost blow outs o f alm ost $ 2 0 0 m illion, fell 4 3 c to $ 5 .4 6 on Friday as analysts slashed earnings forecasts' ('UGL faces scrutiny over disclosure', S ydney M o rn in g H erald, 8 - 9 N o ve m b e r 2 0 1 4 ).
•
'The shares w e n t into freefall after the c o m p a n y fin a lly announced to the market on O c to b e r 2 7 it w o u ld be stripped o f $1 9 .6 m illion in funding a nd w o u ld take a $ 5 m illion hit to its bottom-line profits in 2 0 1 4 - 1 5 ' ('U nder fire V ocation chief buys as restructure loom s', A ustralian Financial Review, 4 N o ve m b e r 2 0 1 4 ).
Used by bankers and o th e r cre d ito r groups Bankers use accounting numbers to d e c id e w hether to lend, to determ ine the level o f risk an d often the interest rate to charge. Rating agencies such as S tandard & Poor's a nd M o o d y 's use accounting numbers to g ive their credit ratings, w h ich have an im pact on the interest rates com panies have to pay. •
'[S]hares in C entro a nd the associated C entro Retail Trust both plunged 2 6 b yesterday ... as the g ro u p w a s forced to a d m it more b ad news a b o u t its d e b t a nd foreign e xch a n g e positions ... The co m p a n y's lenders g a ve it until February 15 to com e up w ith a refinancing plan ... the c o m p a n y announced another asset sale as it tries to bolster its b a la n ce sheet' (M . Dunckley an d B. W ilm o t, 'C entro acts to a p p e a se banks', A ustralian Financial Review, 16 J a n u a ry 2 0 0 8 ).
•
'S tandard & Poor's said Q ueensland's strong b a la n ce sheet ensured it kept its A A A credit rating yesterday, but it w a rn e d o f a w e a ke n in g o f underlying governm ent finances over the next fe w years as it rolls out its multibilliond o lla r infrastructure p rogram ' (M . Ludlow, 'Resource states w id e n revenue g a p ', A ustralian F inancial Review, 1 1 January 2 0 0 7 ).
•
'Ratings a g e n c y M o o d y 's has stripped W estern A ustralia o f its A A A rating, w a rn in g o f vo la tility in its revenue base an d an "optim istic" forecast for iron o re prices ... blam ing the state's o n g o in g d e ficit position, the deterioration in its d e b t metrics a nd a g ro w in g risk this trend m ay not be reversed soon' ( 'W A loses A A A rating', The Australian, 2 5 August 2 0 1 4 ).
Used by corporate boards in rew arding and rem oving executives M o s t executive com pensation schemes include perform ance bonuses, an d accounting numbers a re key com ponents o f these perform ance hurdles. •
'M r N orris's remuneration has rocketed from a b o u t $ 9 .2 m illion in 2 0 0 9 . The bulk o f the increase is du e to incentive-based perform ance rights, w h ich rose to $ 6 .4 m illion from $ 1 .9 m illion. The ba n k met targets for profits an d customer satisfaction' (Vesna Poljak an d John Kehoe, 'C B A chief's $ 1 6 .2 m w a g e tips the scales', W e e ke n d A ustralian F inancial Review, 1 8 - 1 9 S eptem ber 2 0 1 0 ).
•
'The most notable ch a n g e w a s in bonuses, w ith all executives forfeiting a t least 15 per cent o f their short-term incentive payments after net profit fell 9 8 per cent in 2 0 0 9 - 1 0 ' (Luke Forrestal, 'D o w n e r cuts p a y cheques', A ustralian F inancial Review, 2 8 Septem ber 2 0 1 0 ).
24
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
'Treasury W in e s Estates is seeking shareholder a p p ro va l to g ra n t chief executive M ic h a e l C la rk rights to acq u ire up to 7 6 4 0 0 0 shares a t no cost if the w in e m a ke r meets perform ance hurdles ... earnings must g ro w m ore than 15 per cent' ('Stocks to w a tch at close on Friday', S ydney M o rn in g H erald, 7 N o ve m b e r 2 0 1 4 ).
•
'A lan Joyce is the latest high-profile C E O to g ive up a bonus a nd p a y rise ... "It's absolutely a p p ro p ria te that w hen c om pa n y returns g o d o w n executive p a y should g o d o w n as w e ll," M r Joyce said. "It has been an extrem ely tough ye a r for Q a n ta s shareholders an d w h a t w e w a n t to sh o w is that my p a y has to have a huge correlation w ith the p ro fita b ility o f the c o m p a n y"' ('N o bonus o r p a y rise for Joyce at Q a n ta s', A ustralian Financial Review, 2 0 A ugust 2 01 2).
•
'The take-home p a y for Q a n ta s chief executive A lan Joyce has risen b y just over $1 m illion to $ 3 .3 m illion this ye a r ... His latest p a cka g e included $ 2 .1 m illion in base pay, a cash bonus o f $ 7 7 5 0 0 0 an d a further $ 3 8 8 0 0 0 in deferred shares ... The shortterm bonus is m easured on a range o f factors including underlying pre tax profit' ('Q a n ta s chief A la n Joyce gets $ 1 m raise', The A g e , 6 Septem ber 2 01 3).
•
'RIO Tinto chief executive Tom A lbanese's remuneration rose 3 1 .4 per cent in 2 0 1 0 after exce e d in g his targets on various fronts including the com pany's stellar earnings results' ('Rio Tinto C E O Tom A lbanese's p a y jumps 31 pc in 2 0 1 0 ', The Australian, 1 6 M a rc h 2 0 1 1).
Used by unions and m an ag em e nt in ne go tia tin g w age agreem ents In p a y disputes, both m anagers a nd unions often use accounting numbers to support their case. For exam ple, the higher the profits, the m ore likely the p a y increases. •
'The union representing S ydney bus drivers a p o lo g is e d to commuters for c a llin g a 2 4 -hour strike. The union argued that negotiations had broken d o w n a nd pointed out that the State Transit A uthority "posted a profit o f more than $ 4 5 m illion last fin a n cia l ye a r but bus drivers w e re being asked to a c ce p t cuts to basic conditions before they could get a fa ir p a y rise"' ('Sydney bus strike c a lle d ', S ydney M o rn in g H erald, 1 7 D ecem ber 2 0 0 9 ).
Im pact on the co m m u n ity and consum ers In relation to moving the Australian G ra n d Prix: •
'The d w in d lin g lure o f the race a m ong the co rp o ra te set can also be seen in sales revenues, w h ich fell from $ 4 0 m illion in 1 9 9 6 to $ 2 4 .5 m illion last y e a r' (B. Butler an d M . H aw thorne, 'Race d ro w n in g in a sea o f red', S ydney M o rn in g H erald, 1 9 M a rc h 20 1 1). W h a t w e w a tch on television:
•
'Ten N e tw o rk H o ld in g s says it w ill relaunch its d ig ita l sports channel "O n e " w ith general content in M a y , as it released results sh o w in g a 1 6 per cent fall in first half net profit' ('Ten's profit d ro p is unacceptable: M u rd o c h ', S ydney M o rn in g H erald, 7 A pril 2 0 1 1).
•
'$ 2 5 4 m illion to be slashed from A B C 's b u dget ... staff w ill be told on M o n d a y w h a t program s a nd services w ill be a x e d ' ('A B C boss w arns o f "sig n ifican t" jo b losses, program m ing cuts', S ydney M o rn in g H erald, 21 N o ve m b e r 2 0 1 4 ). O n customers:
•
'The w id e r im pact o f the co lla p se o f kitchen supplier K leenm aid last w e e k is expected to be even more d a m a g in g than the $ 7 6 m illion it ow es to banks, customers, em ployees, suppliers, franchisee ow ners a nd the adm inistrators ... U p to 4 5 0 0 customers are collectively o w e d $ 2 7 m illion for fully o r p a rtia lly p a id kitchens' (M ichelle Singer, 'K leenm aid: M o re pain on the w a y ', A ustralian F inancial Review, 2 4 A pril 2 0 0 9 ).
•
'despite the a irlin e hours earlier announcing the $ 2 5 2 m illion half-year underlying loss a nd plans to cut 5 0 0 0 jobs a n d close routes' (M att O 'S u lliva n a nd James M a ssola , 'Q a n ta s cuts 5 0 0 0 jobs, posts $ 2 5 2 m illion first half loss', S ydney M o rn in g H erald, 2 7 February 2 0 1 4 ).
CHAPTER 1 Introduction to Financial accounting
25
Im pact on em ployees and jobs A ccounting numbers can lead to co rp o ra te failure, w ith resulting consequences for w orkers. •
'Telstra w ill slash at least 6 0 0 0 jobs, o r 15 per cent of its w orkforce, over three years as it seeks to return earnings to last year's levels an d revive its share price despite uncertainty a b o u t its $1 1 billion de a l w ith Labor's national b ro a d b a n d netw ork' (Dom inic W h ite , 'Telstra to slash a t least 6 0 0 0 jobs', A ustralian Financial Review, 3 0 S eptem ber 2 0 1 0 ).
•
'In Q a n ta s's case, this resulted in last w e e k's announcem ent to slash 1 0 0 0 jobs an d record a pre-tax loss of betw een $ 2 5 0 m illion an d $ 3 0 0 m illion for the first half of this fin a n cia l y e a r' ('Q antas needs to make radical changes o r b o o k a ticket to a irline heaven', A ustralian F inancial Review, 9 D ecem ber 2 0 1 3).
•
'D evereux said H olden's parent, G e n e ra l M o to rs, had all the inform ation needed to d e c id e that a business case for m anufacturing in A ustralia no longer existed ... A total o f 2 9 0 0 jobs to g o at H olden, multiples o f that likely to g o in Australian supplier co m p a n ie s' ('H olden loss shows need for reform ', S ydney M o rn in g H erald, 1 2 D ecem ber 2 0 1 3).
26
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A C lassification o f item s Listed b e lo w a re b a la n ce s a t 3 0 June 2 0 1 6 .
$ Cash at bank Inventory Sales Wages Cost of goods sold Share capital Accounts payable
1
C la s s ify e a ch a c c o u n t as a n asset, lia b ility , reven ue , e x p e n s e o r e q u ity .
2
P re p a re an in c o m e state m e nt fo r th e p e rio d e n d in g 3 0 June 2 0 1 6 .
3
P re p a re a b a la n c e sheet a t 3 0 June 2 0 1 6 .
210000 60000 210000 40000 70000 140 00 0 30000
PRACTICE PROBLEM B A ccrual p ro fit 1
D u rin g th e a c c o u n tin g p e rio d , G re e n Lim ited re c e ive d $ 7 5 0 0 0 0 fro m sales a n d p a id o u t $ 5 8 0 0 0 0 in w a g e s a n d o th e r expe nses. H o w e v e r, a n e x tra $ 2 6 0 0 0 0 w o rth o f sales w e re m a d e d u rin g th e y e a r b u t th e cash has n o t be en c o lle c te d y e t. The c o m p a n y a ls o o w e s $ 2 4 0 0 0 0 fo r v a rio u s expe nses. W h a t is th e a c c ru a l p ro fit?
2
G re e n Lim ited p u rc h a s e d 3 0 0 0 item s fo r $ 5 e a ch on c re d it a n d sells 2 0 0 0 o f these item s o n c re d it fo r $ 8 . W h a t is th e sales reven ue a n d c o st o f g o o d s sold fo r th e p e rio d ?
PRACTICE PROBLEM C Calculate share h o ld e rs' e q u ity G iv e n th e fo llo w in g in fo rm a tio n re la tin g to P enguin Ltd, w h a t is th e b a la n c e o f s h a re h o ld e rs ' e q u ity?
$ Property, plant and equipment
1500000
Accounts receivable
400000
Cash
100 00 0
Inventory
500000
Bank loan
250000
Wages payable
90000
CHAPTER 1 Introduction to Financial accounting
27
KEY TERMS Accountant Accounting Accounting entity Accounting eguation Accounting principles Accounting standards Accounts payable Accounts receivable Accrual accounting Accrual profit Balance sheet Comparability Cost of goods sold (COGS) Depreciation
Dividends Expense Financial performance Financial position Financial statements Financing activities Generally accepted accounting principles (GAAP) Going concern Gross profit Income statement Inventory Investing activities Investors
Liabilities Materiality Measurement Net profit Operating activities Profit Profit before tax Relevance Retained profits Revenues Share capital Statement of cash Flows Timeliness Understandability
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This section starts w ith simpler discussion questions that revise some o f the basic concepts, w hich are then follow ed by a set o f problems.
DISCUSSION QUESTIONS 1
W h a t is th e b a s ic p u rp o s e o f fin a n c ia l a c c o u n tin g ?
2
D istin g u ish b e tw e e n fin a n c ia l p e rfo rm a n c e a n d fin a n c ia l p o s itio n .
3
W h a t is th e d iffe re n c e b e tw e e n fin a n c ia l a n d m a n a g e m e n t a c c o u n tin g ?
4
W h o a re th e m a in p a rtie s th a t c o m p ris e th e s o c ia l setting o f a c c o u n tin g ?
5
W h a t is m e a n t b y c re d ib le p e rio d ic re p o rtin g ? W h a t prevents o rg a n is a tio n s fro m m a k in g fin a n c ia l statem ents in c re a s in g ly c re d ib le ? (C o n s id e r c o s t-b e n e fit im p lic a tio n s .)
6 List fo u r im p o rta n t users o f fin a n c ia l a c c o u n tin g a n d d e s c rib e th e use th a t e a ch user w o u ld m a ke o f the in fo rm a tio n . 7
D o a ll users o f fin a n c ia l a c c o u n tin g h a ve th e sam e in fo rm a tio n needs? W h y , o r w h y not?
8
List som e s im ila ritie s a n d d iffe re n c e s b e tw e e n the need fo r fin a n c ia l in fo rm a tio n b e tw e e n s h a re h o ld e rs a n d b a n ke rs.
9
List fiv e situ a tio n s in w h ic h ju d g e m e n t is re q u ire d b y th e p re p a re rs o f fin a n c ia l in fo rm a tio n .
1 0 W h a t do es an a u d it a c h ie v e ? 11 D e s crib e w h a t is m e a n t b y a c c ru a l a c c o u n tin g . H o w do es it d iffe r fro m cash a c c o u n tin g ? 12 W h o uses a c c ru a l a c c o u n tin g ? 13 W h ic h o f th e fo llo w in g term s w o u ld y o u see in fin a n c ia l statem ents p re p a re d u n d e r (a) a c c ru a l a c c o u n tin g a n d (b) cash a c c o u n tin g : a cco u n ts p a y a b le , a c co u n ts re c e iv a b le , cash a n d in ve n to ry? 14 W h a t a re th e th re e key fin a n c ia l statem ents, a n d w h a t re le v a n t in fo rm a tio n d o th e y p ro v id e to users o f a c c o u n tin g reports? 15 E x p la in , in s im p le term s, e a ch o f th e fo llo w in g fin a n c ia l a c c o u n tin g assu m p tio n s: a a c c o u n tin g e n tity
b
a c c o u n tin g p e rio d
c
m o n e ta ry
d
h is to ric a l cost
e
g o in g c o n c e rn
f
m a te ria lity .
28
16
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
D o y o u th in k le ctu rers sh o u ld h a ve th e rig h t to use th e ir o w n ju d g e m e n t in d e te rm in in g s u b je c t g ra d e s , o r sh o u ld those g ra d e s be b a se d o n o b je c tiv e ly set e xam s a d m in is te re d b y s om e on e o th e r th a n lecturers? W h y ? D o y o u th in k c o m p a n ie s ' m a n a g e m e n t sh o u ld h a ve th e rig h t to c h o o se th e a c c o u n tin g p o lic ie s a n d m e tho ds b y w h ic h th e ir p e rfo rm a n c e is m e a su re d ? W h y ? H o w d o these tw o cases d iffe r, if a t all?
PROBLEMS PROBLEM 1.1 C alculate accrual acco u n tin g p ro fit John S m ith set up his o w n c a te rin g business o n 1 July 2 0 1 5 . D u rin g th e 12 m onths up to 3 0 June 2 0 1 6 th e fo llo w in g tra n sa ctio n s o c c u rre d : 1
John p u t $ 1 0 0 0 0 o f his o w n m o n e y in to th e business.
2
H e b o rro w e d $ 2 0 0 0 0 fro m the b a n k fo r o n e y e a r a t 5 p e r c e n t p e r a n n u m , w ith in tere st to be p a id a t th e e n d o f th e lo a n .
3
H e p a id $ 1 0 4 0 0 in w a g e s a n d o w e d $ 3 0 0 0 in w a g e s fo r w o rk d o n e .
4
H e b o u g h t c a te rin g e q u ip m e n t fo r $ 6 0 0 0 , w h ic h has a n e x p e c te d useful life o f th re e y e a rs .
5
H e p a id o th e r expe nses o f $ 1 2 3 0 0 .
6 John sent b ills fo r $ 6 0 0 0 0 to custom ers fo r w o rk p e rfo rm e d b e tw e e n 1 July 2 0 1 5 a n d 3 0 June 2 0 1 6 . By 3 0 June he h a d re c e ive d $ 4 5 0 0 0 a n d e x p e c te d th e o th e r $ 1 5 0 0 0 b y A u g u s t. U sing th e c o n c e p ts o f a c c ru a l a c c o u n tin g , c a lc u la te J o h n 's p ro fit fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 1.2 Prepare a balance sheet and calculate p ro fit 1
G iv e n the fo llo w in g b a la n c e s , p re p a re a b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r Palm T ree Lim ited.
$ Bank loan Share capital Wages payable Accounts payable Inventory Cash at bank Buildings
2
40000 160 00 0 60000 80000 140 00 0 50000 200000
Retained profits
90000
Accounts receivable
40000
The c o m p a n y d id n o t d e c la re a n y d iv id e n d s d u rin g th e y e a r. Its b a la n c e in re ta in e d p ro fits a t th e start o f th e y e a r w a s $ 6 0 0 0 0 . W h a t is th e p ro fit fo r th e y e a r?
CHAPTER 1 Introduction to Financial accounting
29
PROBLEM 1.3 C ontent o f fin a n cia l sta te m e n ts C o n s id e r th e list o f a c co u n ts g iv e n a n d c a te g o ris e them as a n asset, lia b ility o r s h a re h o ld e rs ' e q u ity item th a t w o u ld a p p e a r on th e b a la n c e sheet o r a re ven ue o r e x p e n s e th a t w o u ld a p p e a r o n th e in c o m e state m e nt b y tic k in g the a p p ro p ria te co lu m n .
PROBLEM 1.4 W hat are various people's in te re sts in fin a n cia l accounting? B rie fly d e s c rib e w h a t e a ch o f th e fo llo w in g p e o p le w o u ld lik e ly w a n t to le a rn fro m th e fin a n c ia l statem ents o f B ran dX Ltd, a n d h o w e a ch m ig h t be a ffe c te d if th e statem ents s h o w e d g o o d o r b a d fin a n c ia l p e rfo rm a n c e o r fin a n c ia l p o s itio n . 1 The c h ie f e x e c u tiv e o ffic e r (C E O ) o f th e c o m p a n y 2
The c o m p a n y 's c h ie f a c c o u n ta n t
3
The c h a irp e rs o n o f th e c o m p a n y 's b o a rd o f d ire c to rs (the b o a rd e v a lu a te s th e p re s id e n t's p e rfo rm a n c e on b e h a lf o f th e s h a re h o ld e rs)
4 The p a rtn e r o f a u d itin g firm D im b le b y & C o ., fo r w h o m B ra n d X is a c lie n t 5
The lo c a l m a n a g e r o f ta x c o lle c tio n s fo r th e A u s tra lia n T a x a tio n O ffic e
6 John Flatstone, w h o o w n s 1 0 0 shares o f B ran dX 7
M ild re d Evans, w h o is th in k in g o f b u y in g som e shares o f th e c o m p a n y
8 The lo c a l m a n a g e r o f B ig B ank, w h ic h has m a d e a la rg e lo a n to B ran dX
PROBLEM 1.5 W hat are various people's in te re sts in fin a n cia l accounting? B rie fly d e s c rib e w h a t e a c h o f th e fo llo w in g g ro u p s w o u ld like to k n o w fro m th e fin a n c ia l statem ents o f th e S w an s F o o tb a ll C lu b . 1 The C E O 2
The p la y e rs
3
The s u p p o rte rs
4 The s u p p lie rs o f m e a t pies a n d b e e r fo r ho m e ga m e s
30
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.6 Users and th e ir needs A c c o u n tin g in fo rm a tio n is d e m a n d e d b y a w id e ra n g e o f users, in c lu d in g s h a re h o ld e rs , c o m p a n y m a n a g e m e n t, s u p p lie rs , b a n k e rs , tra d e un io ns, th e A u s tra lia n S ecuritie s a n d Investm ents C o m m is sio n (ASIC ) a n d th e A u s tra lia n T a x a tio n O ffic e (A T O ). W h ic h user is lik e ly to seek e a ch o f th e fo llo w in g types o f in fo rm a tio n ? 1 The lik e lih o o d o f th e c o m p a n y m e eting its in tere st pa ym e n ts o n tim e
2 The p ro fita b ility o f e a c h d iv is io n in th e c o m p a n y
3
The fin a n c ia l p o s itio n a n d p e rfo rm a n c e o f a c o m p a n y issuing shares to th e p u b lic fo r th e firs t tim e
4
The pro sp e c ts fo r fu tu re d iv id e n d pa ym e n ts
5
The p ro b a b ility th a t th e c o m p a n y w ill be a b le to p a y fo r its p u rch ases on tim e
6 The p ro fita b ility o f th e c o m p a n y b a se d o n th e ta x la w
7 The p ro fita b ility o f th e c o m p a n y since th e last c o n tra c t w ith e m p lo y e e s w a s s ig n e d .
PROBLEM 1.7 A ccrual p ro fit B rick Lim ited m a d e cash sales o f $ 5 5 0 0 0 0 a n d c re d it sales o f $ 3 7 0 0 0 0 ( $ 2 2 0 0 0 0 o f w h ic h h a d be en c o lle c te d b y y e a r-e n d ). It p a id $ 4 1 0 0 0 0 in expe nses a n d o w e d $ 2 3 0 0 0 0 a t y e a r-e n d . W h a t w a s th e a c c ru a l p ro fit?
PROBLEM 1.8 A ccrual p ro fit 1
D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , French H o rn Ltd m a d e cash sales o f $ 1 0 0 0 0 0 , c re d it sales o f $ 2 0 0 0 0 0 ( $ 5 0 0 0 0 o f w h ic h w e re still to be c o lle c te d a t y e a r-e n d ), a n d re c e iv e d $ 2 5 0 0 0 o w in g fro m c re d it sales, w h ic h o c c u rre d in M a y 2 0 1 5 . W h a t is French H o rn 's sales reven ue fo r th e y e a r e n d e d 3 0 June 2 0 1 6?
2 A ls o d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , French H o rn p a id $ 6 0 0 0 0 a n d o w e d $ 1 0 0 0 0 in e m p lo y e e w a g e s . O f th e $ 6 0 0 0 0 p a id , $ 5 0 0 0 re la te d to w a g e s p a y a b le as a t 3 0 June 2 0 1 5 . W h a t is th e to ta l o f French H o rn 's a c c ru a l a c c o u n tin g expenses?
3
W h a t is French H o rn 's a c c ru a l a c c o u n tin g p ro fit fo r th e y e a r e n d e d 3 0 June 2 0 1 6?
PROBLEM 1.9 C alculate accrual acco u n tin g p ro fit Fred Jones s ta rte d a c o n s u ltin g business on 1 M a rc h 2 0 1 6 . D u rin g th e p e rio d up to 3 0 June 2 0 1 6 , th e fo llo w in g tra n sa ctio n s o c c u rre d : 1 Fred p u t $ 1 0 0 0 0 o f his o w n m o n e y in to th e business. 2
H e b o rro w e d $ 3 0 0 0 0 fro m th e b a n k a t 1 0 p e r c e n t p e r an n u m fo r o n e y e a r w ith in tere st to be re p a id a t th e en d o f the lo a n .
3
H e sent b ills fo r $ 3 5 0 0 0 to custom ers fo r w o rk p e rfo rm e d . By 3 0 June he h a d re c e ive d $ 3 0 0 0 0 a n d e x p e c te d th e o th e r $ 5 0 0 0 in July.
4
H e b o u g h t a c o m p u te r fo r $ 8 1 0 0 th a t has an e x p e c te d useful life o f th re e y e a rs .
5
H e p a id $ 1 2 0 0 0 in w a g e s .
6
H e p a id o th e r expe nses o f $ 2 0 0 0 0 .
7
H e re c e ive d a $ 5 0 0 b ill fo r a d v e rtis in g (a p p e a re d in n e w s p a p e rs in M a y ; w ill be p a id in July). U sing th e c o n c e p ts o f a c c ru a l a c c o u n tin g , c a lc u la te F red's p ro fit fo r th e fo u r m onths e n d in g 3 0 June 2 0 1 6 .
PROBLEM 1.10 Com paring n e t p ro fits and cash flo w K in g s fo rd C ustom s w a s fo u n d e d o n 1 July 2 0 1 6 . A t th e e n d o f firs t y e a r's o p e ra tio n s , th e fo llo w in g s u m m a ry o f its a c tiv itie s has be en p re p a re d b y th e o w n e r. 1
B o rro w e d cash o f $ 6 0 0 0 0 fro m C A A B ank.
2
E m p lo ye es e a rn e d $ 9 6 8 0 0 o f w a g e s , o f w h ic h $ 4 0 0 0 0 is to be p a id in th e ne xt a c c o u n tin g p e rio d .
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3
P erform e d custom ise d services th a t g e n e ra te d sales re ven ue o f $ 2 4 3 3 0 0 , o f w h ic h $ 1 0 0 0 0 0 re m a in e d u n co lle cte d a t th e e n d o f th e y e a r.
4
O th e r o p e ra tin g expe nses, in c lu d in g p h o n e b ills a n d e le c tric ity a m o u n tin g to $ 2 6 8 0 0 , w e re in c u rre d d u rin g the y e a r. O f this a m o u n t, $ 1 0 0 0 0 re m a in e d u n p a id a t th e e n d o f th e y e a r. S h o w the e ffe c t o n net p ro fit a n d cash o f e a ch o f th e a b o v e tra n s a c tio n s fo r this a c c o u n tin g p e rio d .
PROBLEM 1.11 C ontents o f fin a n c ia l sta te m e n ts M a tc h e a ch item w ith th e fin a n c ia l state m e nt it w o u ld a p p e a r in b y tic k in g th e a p p ro p ria te co lu m n . Item
Balance sheet
Income statement
Statement of cash flows
Wages expense Cash paid for equipment Cash at bank Equipment Cash flow from customers Accounts payable Cash paid to employees Sales revenue
PROBLEM 1.12 C ontents o f fin a n c ia l sta te m e n ts M a tc h e a ch item w ith th e fin a n c ia l state m e nt th a t it w o u ld a p p e a r in b y tic k in g th e a p p ro p ria te co lu m n .
32
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.13 C lassification o f item s Listed b e lo w a re b a la n ce s fo r 2 0 1 6 .
$ Accounts receivable Sales Electricity Retained profits Loan Transportation costs
1
C la s s ify e a ch a c c o u n t as a n asset, lia b ility , reven ue , e x p e n s e o r e q u ity .
2
P re p a re an in c o m e state m e nt fo r th e p e rio d e n d in g 31 D e c e m b e r 2 0 1 6 .
80000 250000 30000 50000 200000 1 0 0 00
PROBLEM 1.14 M atching fin a n cia l sta te m e n t item s to s ta te m e n t categories R a in d ro p H o ld in g s Ltd is a p u b lic c o m p a n y . B e lo w a re item s ta ke n fro m its re c e n t c o n s o lid a te d b a la n c e sheet a n d c o n s o lid a te d in co m e statem ent. N o te th a t d iffe re n t c o m p a n ie s use s lig h tly d iffe re n t titles fo r th e sam e item . M a rk e a ch item in th e fo llo w in g list as a n asset (A), lia b ility (L) o r s h a re h o ld e rs ' e q u ity (SE) th a t w o u ld a p p e a r on the b a la n c e sheet, o r reven ue (R) o r e x p e n s e (E) th a t w o u ld a p p e a r on th e in co m e statem ent. 1 P ro p e rty p la n t a n d e q u ip m e n t
2
Sales reven ue
3
T ra d e a n d o th e r p a y a b le s
4 A d v e rtis in g costs 5
P rovisions
6
In ve nto ries
7 8 9
R evenue re c e ive d in a d v a n c e
P rep aym e nts Reserves
1 0 C a s h a n d cash e q u iv a le n ts 11 D e p re c ia tio n 12 C o s t o f sales
PROBLEM 1.15 M atching cash flo w sta te m e n t item s to categories The fo llo w in g item s w e re ta ke n fro m a re c e n t cash flo w statem ent. N o te th a t d iffe re n t c o m p a n ie s use s lig h tly d iffe re n t titles fo r th e sam e item . M a rk e a ch item in th e list as a cash flo w fro m o p e ra tin g a c tiv itie s (O ), in ve stin g a c tiv itie s (I) o r fin a n c in g a c tiv itie s (F). 1 C a s h p a id to e m p lo y e e s
2 C a s h b o rro w e d fro m th e b a n k 3
C a s h p ro c e e d s re c e iv e d fro m sale o f investm ent in a n o th e r c o m p a n y
4
In co m e ta xe s p a id
5
R ep a ym e n t o f lo a n p rin c ip a l
CHAPTER 1 Introduction to Financial accounting
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6 C a s h re c e iv e d in return fo r issue o f sh a re c a p ita l
7 C a s h re c e iv e d fro m custom ers 8
Purchases o f p ro p e rty , p la n t a n d e q u ip m e n t
9 C a s h p a id to s u p p lie rs 10 C a s h p a id fo r d iv id e n d s to s h a re h o ld e rs 11 R ep a ym e n t o f lo a n interest
PROBLEM 1.16 A cco u n tin g equation M r Sm iles o p e n e d his fru it s h o p a t th e b e g in n in g o f last y e a r. By th e e n d o f th a t y e a r he h a d th e fo llo w in g assets a n d lia b ilitie s : $000 Assets Cash
350
Fruit
600
Total assets
950
Liabilities Suppliers payable
280
Wages payable
128
Total liabilities
408
1
W h a t is M r S m ile s' s h a re h o ld e rs ' e q u ity in his fru it s h o p a t th e e n d o f th e y e a r?
2
If M r S m ile s' in itia l in ve stm en t w a s $ 5 0 0 0 0 0 , w h a t w a s his p ro fit fo r th e y e a r?
PROBLEM 1.17 The a cco u n tin g equation C a rd ig a n Ltd has to ta l assets o f $ 1 5 0 0 0 0 a n d lia b ilitie s th a t a d d up to $ 7 0 0 0 0 as a t 3 0 June 2 0 1 5 . 1
W h a t is C a rd ig a n 's s h a re h o ld e rs ' e q u ity as a t 3 0 June 2 0 1 5 ?
2
D u rin g th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l assets in cre a s e b y $ 6 3 0 0 0 w h ile to ta l lia b ilitie s in cre a s e b y $ 2 5 0 0 0 . W h a t is th e a m o u n t o f C a rd ig a n 's s h a re h o ld e rs ' e q u ity on 3 0 June 2 0 1 6?
3
N o w assum e th a t in th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l lia b ilitie s in cre a s e b y $ 2 0 0 0 0 a n d its s h a re h o ld e rs ' e q u ity d e cre ases b y $ 1 2 0 0 0 . O n 3 0 June 2 0 1 6 , w h a t is th e level o f C a rd ig a n 's to ta l assets?
4 A ssum e th a t in th e y e a r to 3 0 June 2 0 1 6 , C a rd ig a n 's to ta l assets d o u b le w h ile its s h a re h o ld e rs ' e q u ity re m a in s u n c h a n g e d . W h a t a re its to ta l lia b ilitie s as a t 3 0 June 2 0 1 6?
PROBLEM 1.18 The a cco u n tin g equation Use th e a c c o u n tin g e q u a tio n to a n s w e r th e fo llo w in g qu e stio n s. 1
P illo w Ltd h a lv e d its lia b ilitie s d u rin g th e y e a r. A t th e b e g in n in g o f th e y e a r, th e a m o u n t o f to ta l assets w a s $ 8 0 0 0 0 a n d o w n e rs ' e q u ity w a s $ 5 0 0 0 0 . W h a t is th e a m o u n t o f P illo w 's to ta l lia b ilitie s a t th e e n d o f th e y e a r?
2
B u ffa lo Ltd b e g a n th e y e a r w ith assets o f $ 6 0 0 0 0 a n d lia b ilitie s o f $ 2 5 0 0 0 . N e t p ro fit fo r th e y e a r w a s $ 4 3 0 0 0 . W h a t is th e a m o u n t o f o w n e rs ' e q u ity a t th e e n d o f th e y e a r?
3
D u rin g th e last fin a n c ia l y e a r, S p a rk le Industries trip le d th e a m o u n t o f its assets. A t th e e n d o f th e y e a r, to ta l lia b ilitie s a m o u n te d to $ 5 7 0 0 0 w h ile o w n e rs ' e q u ity w a s $ 1 5 0 0 0 . W h a t w a s th e a m o u n t o f to ta l assets a t the b e g in n in g o f the y e a r?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1.19 Incom e sta te m e n t G iv e n th e fo llo w in g in fo rm a tio n , p re p a re an in c o m e state m e nt fo r G e rk e Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
$ Rent expense
30000
Cost of goods sold
100000
Sales
250000
Wages
75 000
Advertising
25 000
Training expense
8 000
PROBLEM 1.20 Incom e sta te m e n t e an income statement for the year ended 3 0 .
$ Sales
48 000
Cost of goods sold
21 000
Wages
8 000
Electricity
4000
Travel
2 000
Advertising
1 000
PROBLEM 1.21 Prepare a balance sheet and calculate p ro fit 1
G iv e n the fo llo w in g b a la n c e s , p re p a re a b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r B ricks Ltd.
$ Bank loan
100000
Share capital
400000
Accounts payable
60000
Taxes payable
40000
Inventory Cash
2
150000 50000
Land and buildings
500000
Retained profits
200000
Accounts receivable
100000
The c o m p a n y d id n o t d e c la re a n y d iv id e n d s d u rin g th e y e a r. Its b a la n c e in re ta in e d p ro fits a t th e start o f th e y e a r w a s $1 2 0 0 0 0 . W h a t is th e p ro fit fig u re fo r th e y e a r?
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PROBLEM 1.22 Analysing revenues and expenses and preparing an incom e s ta te m e n t A ssum e y o u a re th e o w n e r o f D o u b le C a fe , a c o ffe e sh o p in S y d n e y 's C B D . A t th e e n d o f June 2 0 1 6 , y o u fin d (fo r June o n ly) th is in fo rm a tio n : 1 Sales, as p e r cash re g is te r re c o rd s, o f $ 4 7 0 0 0 , plus sales on c re d it (tw o b irth d a y p a rtie s) o f $ 7 5 0 . 2
The c o st o f g o o d s sold d u rin g June h a d c o st $ 1 6 0 0 0 co n s is tin g o f c o ffe e , cups a n d cake s.
3
D u rin g th e m o nth , a c c o rd in g to th e c h e q u e b o o k , y o u p a id $ 1 4 0 0 0 fo r s a la rie s , rent, a d v e rtis in g a n d o th e r exp e n se s; h o w e v e r, y o u h a ve no t y e t p a id th e $ 6 8 0 m o n th ly b ill fo r e le c tric ity fo r June.
O n th e basis o f th e d a ta g iv e n (d is re g a rd in co m e taxes), w h a t w a s th e a m o u n t o f net p ro fit fo r June? S h o w c o m p u ta tio n s .
PROBLEM 1.23 C alculate share h o ld e rs' e q u ity G o m e z Lim ited has th e fo llo w in g assets a n d lia b ilitie s .
$ Loan
180 00 0
Cash
90000
Accounts payable
110 00 0
Accounts receivable
170 00 0
Equipment
200000
1
C la s s ify e a ch b a la n c e as a n asset o r a lia b ility .
2
C a lc u la te s h a re h o ld e rs ' e q u ity .
PROBLEM 1.24 C alculate share h o ld e rs' e q u ity G iv e n th e fo llo w in g in fo rm a tio n re la tin g to S trip es Ltd, w h a t is th e b a la n c e o f s h a re h o ld e rs ' e q u ity?
$ Land and buildings
2 800000
Accounts payable
250000
Cash and cash equivalents
340000
Inventory
410000
Bank loan
600000
Taxes payable
104 00 0
PROBLEM 1.25 Id e n tity som e a cco u n tin g concepts and p rinciples Id e n tify th e a c c o u n tin g c o n c e p ts o r p rin c ip le s th a t re la te to e a ch o f th e fo llo w in g sentences a n d e x p la in w h a t e ffe c t th e c o n c e p ts o r p rin c ip le s h a ve on fin a n c ia l statem ents: 1
Users o f fin a n c ia l statem ents sh o u ld be a b le to b e lie v e th a t th e nu m b ers re p re s e n t re a l events.
2
F in a n c ia l statem ents sh o u ld a v o id un du e o p tim is m a b o u t th e fu ture .
3
It is h a rd to say a b s o lu te ly if a c o m p a n y is p e rfo rm in g w e ll o r b a d ly , b u t y o u c a n e v a lu a te its re la tive p e rfo rm a n ce .
4
F in a n c ia l a c c o u n tin g sh o u ld be h e lp fu l bo th in u n d e rs ta n d in g th e p a st a n d lo o k in g a h e a d to th e fu ture .
5
The c o n te n t o f fin a n c ia l statem ents sh o u ld no t d e p e n d o n w h o p re p a re s them .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
36
PROBLEM 1.26 A cco u n tin g assum ptions C o n s id e r th e fo llo w in g statem ents re la tin g to h o w w e m ig h t a c c o u n t fo r c e rta in tra n s a c tio n s o r events. W h a t a c c o u n tin g a s su m p tio n o r p rin c ip le u n d e rlie s e a ch ? 1 'In v e n to ry is re c o rd e d a t cost unless th e net re a lis a b le v a lu e o f in v e n to ry is b e lo w cost. In th a t case , in v e n to ry is w ritte n d o w n to th e net re a lis a b le v a lu e .'
2
'A c c o u n tin g fin a n c ia l statem ents a re p rim a rily b a se d on h is to ric a l costs. T h e y s h o u ld , h o w e v e r, be p rim a rily a b o u t th e c o n te m p o ra ry cash v a lu e o f a c o m p a n y 's net a sse ts.'
3
'A t th e e n d o f e a ch p e rio d , a c o m p a n y has to c a lc u la te a n y sa la rie s th a t h a ve a c c ru e d , a n d re c o g n is e an e x p e n s e a n d a lia b ility fo r th a t a m o u n t.'
4
'If a c o m p a n y c h a n g e s its d e p re c ia tio n p o lic y , it needs to d isc lo se (in th e notes to th e fin a n c ia l statem ents) the
5
'M a n y businesses d o no t re c o rd " fr e ig h t in " as p a rt o f th e a c q u is itio n cost o f in v e n to ry , b u t a n y fre ig h t c h a rg e s o f th e p e rio d , w h ic h a re n o rm a lly sm all a m ou nts, a re e x p e n s e d in th e gross p ro fit section o f th e in co m e s ta te m e n t.'
n a tu re o f th e c h a n g e , a n d its fin a n c ia l e ffe c ts.'
PROBLEM 1.27 Q ualitative characteristics The F ra m e w o r k f o r th e P re p a r a tio n a n d P re s e n ta tio n o f F in a n c ia l S ta te m e n ts e x a m in e s th e c h a ra c te ris tic s o f a c c o u n tin g in fo rm a tio n th a t m a ke this in fo rm a tio n useful fo r d e c is io n -m a k in g . It a ls o p o in ts o u t th a t v a rio u s lim ita tio n s , w h ic h a re in h e re n t in th e m e asure m en t a n d re p o rtin g pro ce ss, m a y necessitate tra d e -o ffs b e tw e e n these lim ita tio n s a n d th e p o s itiv e c h a ra c te ris tic s o f useful in fo rm a tio n . 1 B rie fly d e s c rib e th e fo llo w in g c h a ra c te ris tic s o f useful a c c o u n tin g in fo rm a tio n :
2
3
a
re le v a n c e
b
re lia b ility
c
u n d e rs ta n d a b ility
d
c o m p a ra b ility .
For e a ch o f th e fo llo w in g p a irs o f in fo rm a tio n c h a ra c te ris tic s , g iv e an e x a m p le o f a s itu a tio n in w h ic h o n e o f the c h a ra c te ris tic s m a y be s a c rific e d in return fo r a g a in in th e o th e r:
a
re le v a n c e a n d re lia b ility
b
re le v a n c e a n d c o m p a ra b ility
c
re le v a n c e a n d u n d e rs ta n d a b ility .
W h a t c rite rio n sh o u ld be used to e v a lu a te tra d e -o ffs b e tw e e n in fo rm a tio n c h a ra c te ris tic s ?
PROBLEM 1.28 Prim ary assum ptions made in prep a rin g fin a n cia l statem ents K e lly o p e n e d a p h o to g ra p h y business in a sm all s h o p th a t she re n te d fro m a la rg e re ta ile r, E astfield Lim ited . She p a id th e first m o n th 's ren t o f $ 4 0 0 b y w ritin g a c h e q u e fro m he r p e rso n a l a c c o u n t. K e lly to o k som e o f he r o w n p h o to g ra p h y e q u ip m e n t a n d m a te ria ls (w o rth $ 5 0 0 0 ) in to th e s h o p , a n d a ls o b o u g h t so m e n e w c a m e ra s so th a t she c o u ld ta k e p ictu re s o f he r custom ers w ith th e best a v a ila b le te c h n o lo g y . The c a m e ra s h a d a re c o m m e n d e d re ta il p ric e o f $ 2 5 0 0 b u t she w a s a b le to b u y them on sale fo r $ 2 2 0 0 , c h a rg in g them to he r p e rso n a l c re d it c a rd . K elly's first c u sto m e r p a id he r $ 9 0 0 fo r a set o f p o rtra its , so she o p e n e d a b a n k a c c o u n t fo r th e c o m p a n y . H e r o th e r custom ers h a ve no t y e t p a id her, o w in g a to ta l o f $ 3 1 0 0 . A t th e e n d o f th e first m o nth o f business, K e lly p re p a re d the fo llo w in g fin a n c ia l statem ents (see ne xt p a g e ).
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KELLY'S PROFESSIONAL PHOTOGRAPHY BALANCE SHEET AS AT 31 MAY 20 16 $ Cash Equipment
$
900 2 500
Shareholders' equity
3 400
3 400 3 400
KELLY'S PROFESSIONAL PHOTOGRAPHY INCOME STATEMENT FOR THE MONTH ENDED 31 MAY 2 0 1 6 Sales
4000
Rent Equipment
400 2 500
2 900
1 too
Net profit
Id e n tify th e a ssu m p tio n s th a t K e lly has v io la te d , a n d e x p la in h o w e a c h even t sh o u ld h a ve been h a n d le d . P rep are a c o rre c te d b a la n c e sheet a n d in co m e statem ent.
PROBLEM 1.29 Discuss e th ica l problem s Discuss th e e x a m p le s o f e th ic a l p ro b le m s g iv e n a t th e e n d o f s e ctio n 1 .4 . W h a t e th ic a l issues d o y o u see? W h a t d o y o u th in k th e c h ie f a c c o u n ta n t, th e a u d ito r a n d the g e n e ra l m a n a g e r s h o u ld do?
CASES CASE 1A
W oolworths Limited
Refer to th e e x tra c ts o f th e 2 0 1 4 a n n u a l re p o rt o f W o o lw o rth s Lim ited in th e b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to th e c o n s o lid a te d a cco u n ts. 1 P ro v id e in d ic a to rs th a t W o o lw o rth s uses a c c ru a l a c c o u n tin g .
2 W h a t w e re to ta l assets a t 2 9 June 2 0 1 4 ? 3 W h a t w e re to ta l lia b ilitie s a t 2 9 June 2 0 1 4 ? 4 W h a t w a s s h a re h o ld e rs ' e q u ity a t 2 9 June 2 0 1 4 ? 5
State th e a c c o u n tin g e q u a tio n in d o lla r fig u re s a t 2 9 June 2 0 1 4 .
6
W h a t w a s th e net p ro fit b e fo re ta x?
7
W h a t w a s th e net p ro fit a fte r ta x?
8
W h a t w e re th e la rg e s t cash in flo w a n d o u tflo w re la tin g to o p e ra tin g a c tiv itie s ?
9 G iv e tw o rea so ns w h y th e cash flo w fro m o p e ra tio n s is a d iffe re n t fig u re fro m o p e ra tin g p ro fit a fte r ta x. 10 D id its to ta l assets in cre a s e o r d e c re a s e o v e r th e last y e a r? 11 H o w m uch in v e n to ry (in d o lla rs) d id W o o lw o rth s h a ve as a t 2 9 June 2 0 1 4 ? 12 O n w h a t d a te do es W o o lw o rth s ' m ost re c e n t re p o rtin g y e a r e n d ? 13 For h o w m a n y y e a rs do es it pre se n t c o m p le te :
a
b a la n c e sheets?
b
in co m e statem ents?
c
cash flo w statem ents?
14 A re its fin a n c ia l statem ents a u d ite d b y an in d e p e n d e n t firm ? W h o is th e a u d ito r fo r th e c o m p a n y ?
38
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 1B________________ Accrual and cash profit in measuring performance W in g s Ltd is a n a irlin e services c o m p a n y w ith a p la n t n e a r S y d n e y A ir p o r t a n d se rvice centres in s eve ral states. It p ro v id e s m eals, serviettes a n d o th e r fo o d -re la te d item s, c le a n in g , in te rio r m a in te n a n c e a n d s eve ral o th e r services to v a rio u s a irlin e s . The c o m p a n y has be en fa irly successful, th o u g h recessions a n d th e d e re g u la tio n o f a ir service s ha ve p u t s ig n ific a n t pressure o n its o p e ra tio n s . W h e n th e c o m p a n y b e g a n in th e la te 1 9 7 0 s , it h a d a re la tiv e ly w e a k fin a n c ia l p o s itio n (m a in ly b e ca u s e o f b o rro w in g to g e t set up) a n d its fin a n c ia l p e rfo rm a n c e , w h ile s a tis fa c to ry , has no t e n a b le d it to re d u c e its d e b t lo a d v e ry m uch. It seem s th a t e v e ry tim e th e c o m p a n y gets a little a h e a d , n e w e q u ip m e n t m ust b e p u rc h a s e d o r n e w p ro d u c t lines d e v e lo p e d , a n d th e c o m p a n y fin d s itself b o rro w in g a g a in . A re c e n t y e a r p ro v id e s a g o o d e x a m p le . The c o m p a n y 's a c c ru a l p ro fit w a s $ 1 8 8 0 0 0 a n d its cash p ro fit w a s $ 2 4 1 0 0 0 . (The d iffe re n c e resulted b e ca u s e o f a d e p re c ia tio n e x p e n s e o f $ 9 6 0 0 0 a n d u n co lle cte d reven ue b e in g $ 4 3 0 0 0 h ig h e r a t th e e n d o f th e y e a r th a n a t th e b e g in n in g . In th e c o m p a n y 's fin a n c ia l statem ents, th e p h ra s e 'n e t p ro fit fo r th e y e a r' w a s used to d e s c rib e th e a c c ru a l p ro fit a n d 'c a s h g e n e ra te d b y o p e ra tio n s ' d e s c rib e d th e cash p ro fit.) The g e n e ra l m a n a g e r h a d lo o k e d fo rw a rd to using som e o f th e cash to p a y de bts, b u t la te in th e y e a r the c o m p a n y h a d to b u y n e w fo o d -h a n d lin g a n d w ra p p in g e q u ip m e n t fo r $ 2 0 6 0 0 0 to m eet revised s ta n d a rd s a n n o u n c e d b y its a irlin e custom ers. T h e re fo re , th e c o m p a n y e n d e d up o n ly a fe w th o u s a n d d o lla rs a h e a d in cash , no t e n o u g h to m a ke m uch o f a d e n t in its de bts. The g e n e ra l m a n a g e r has a re g u la r h a lf-y e a rly m e eting w ith th e c o m p a n y 's e x te rn a l a u d ito r to discuss a c c o u n tin g a n d a u d itin g issues. A fte r th e a b o v e results w e re k n o w n , th e g e n e ra l m a n a g e r p h o n e d th e a u d ito r a n d m a d e th e fo llo w in g c om m en ts: 'I th o u g h t I'd ask y o u to th in k a b o u t a fe w th in g s b e fo re o u r m e eting n e xt w e e k . W h e n it com es to o u r a c c o u n tin g , I th in k th e c o m p a n y has to o m a n y m asters a n d to o m a n y m easures. W h a t I m e an is first th a t to o m a n y p e o p le a re c o n c e rn e d w ith w h a t o u r fin a n c ia l statem ents say. W h y c a n 't w e just p re p a re fin a n c ia l statem ents th a t m eet m y needs as g e n e ra l m a n a g e r? W h y d o w e h a ve to w o rry a b o u t a ll th e o th e r p e o p le o u ts id e the c o m p a n y ? S om etim es I'm n o t even sure w h o a ll those o th e r p e o p le a re , since y o u a c co u n ta n ts a n d a u d ito rs often just ta lk a b o u t " u s e rs " w ith o u t b e in g to o c le a r w h a t y o u m e an . A ls o , I'm c o n fu se d b y th e e x is te n ce o f b o th a " n e t p ro fit" fig u re a n d a "c a s h g e n e ra te d b y o p e ra tio n s " fig u re in o u r fin a n c ia l statem ents. W h y c a n 't w e just h a ve o n e o r the o th e r to m e asure o u r p e rfo rm a n c e ? ' The g e n e ra l m a n a g e r ra is e d issues th a t w ill b e a d d re s s e d fre q u e n tly as this b o o k d e v e lo p s y o u r u n d e rs ta n d in g . But fo r n o w , w h a t w o u ld y o u s a y to th e g e n e ra l m a n a g e r?
CASE 1C
Audit and ethics issues
R ead th e fo llo w in g e x tra c t.
T h e o v e ra ll o b je c tiv e o f th e fin a n c ia l s ta te m e n t a u d it is t o a d d c r e d ib ility t o m a n a g e m e n t’s fin a n c ia l r e p o r ts . . .
Essential C om p on en t E v e ry fin a n c ia l m a r k e t, a n d s u b s e q u e n tly all fin a n c ia l re g u la to rs , re lie s o n th e e x is te n c e o f m e a n in g fu l an d re lia b le fin a n c ia l s ta te m e n ts . T h e external audit p ro v id e s t h e e s s e n tia l c o m p o n e n t o f in d e p e n d e n t a s s u ra n c e , w h ic h is n e c e s s a ry f o r t h e p ro v is io n o f re lia b le fin a n c ia l s ta te m e n ts . . . T h e h ig h q u a lity a u d it d e liv e re d in 2 0 0 9 is a t o t a lly d if fe r e n t s e rv ic e th a n th e a u d it t h a t w o u ld ha ve b e e n o f f e r e d as little as 1 0 y e a rs a g o . W h a t has re m a in e d c o n s ta n t o v e r th is tim e is th e v a lu e o f th e in d e p e n d e n t a s s u ra n c e p ro v id e d b y t h e a u d it p ro c e s s . . .
E xpe ctation Gap T h e re is a s e g m e n t o f th e m a r k e t t h a t sees an e x te rn a l a u d it as t h e g u a ra n te e a g a in s t p o o r m a n a g e m e n t b e h a v io u r, q u e s tio n a b le b u sin e ss d e c is io n s a n d , u ltim a te ly , a g a in s t c o r p o r a te fa ilu re . . . W e a re all w e ll a w a re t h a t a c o r p o r a te fa ilu re d o e s n o t a lw a y s e q u a te t o an a u d it fa ilu re . Source: Richard Deutsch, ‘A udits add C redibility’, Charter, Septem ber 2 0 0 9 .
CHAPTER 1 Introduction to Financial accounting
1
W h a t is m e a n t b y in d e p e n d e n t assu ran ce ?
2
G iv e som e e x a m p le s o f la c k o f in d e p e n d e n c e .
3
C o m m e n t on th e statem ents in th e p a ra g ra p h h e a d e d 'E x p e c ta tio n G a p '.
4
H o w d o m a n a g e m e n t's a n d a u d ito rs ' re s p o n s ib ilitie s d iffe r?
5
W h y is th e in te g rity o f m a n a g e m e n t im p o rta n t to th e fin a n c ia l re p o rtin g process?
COURSEMATE
WEBSITE RESOURCES
0 C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m
p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
39
Measuring and evaluating Financial position and Financial perFormance ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: describe the contents of a bala n c e sheet carry out prelim inary analysis based on the contents of a b a la n c e sheet determ ine w h a t business activities result in changes in a b a la n c e sheet determ ine w h ether an item should be included as an asset or a liability in the b a la n c e sheet show h o w specific activities affect each item in the b a la n c e sheet p re p a re a bala n c e sheet determ ine the effect o f transactions on revenue and expenses p re p a re an incom e statement explain the nature of each o f the items in the b a la n c e sheet a n d incom e statem ent for a public com pany describe the contents of the note reconciling opening an d closing retained profits explain the im portance of both financial statements to m anagers.
CHAPTER OVERVIEW C h a p te r 1 in tro d u c e d a c c ru a l a c c o u n tin g , th e k e y fin a n c ia l state m e nts a n d th e users a n d p re p a re rs o f these state m ents. N o w w e tu rn to th re e c h a p te rs th a t set o u t fin a n c ia l a c c o u n tin g 's results a n d o u tlin e th e re c o rd -k e e p in g system th a t le a d s to th ose results. This c h a p te r fo cu ses o n th e c o n te n t a n d use o f th e state m e nts m e a s u rin g fin a n c ia l p o s itio n a t a p a rtic u la r d a te (a b a la n c e sheet) a n d m e a s u rin g fin a n c ia l p e rfo rm a n c e (an in c o m e state m e nt) o v e r a p e rio d . C h a p te rs 3 a n d 4 c o n s id e r h o w th e d o u b le -e n try system p ro d u c e s a c c o u n ts a n d h o w these a c c o u n ts a re a s s e m b le d to g e th e r to fo rm fin a n c ia l state m e nts. The b a la n c e shee t is fin a n c ia l a c c o u n tin g 's o ld e s t a n d m ost b a s ic re p o rt. It m e asure s th e e n te rp ris e 's fin a n c ia l p o s itio n a t a p a rtic u la r d a te a n d is th e b a sis fo r m uch fin a n c ia l a n a ly s is . F ig u re 2 .1 o u tlin e s w h a t y o u w ill le a rn in th e n e xt th re e c h a p te rs :
•
p r o c e d u r e s a n d te c h n iq u e s : h o w th e doub le-entry accounting system p ro d u c e s a c c o u n ts , a n d h o w to a s se m b le
a b a la n c e sheet a n d a n in c o m e s ta te m e n t fro m th ose a c c o u n ts
•
c o n c e p ts a n d p r in c ip le s : w h y th e b a la n c e sheet a n d in c o m e s ta te m e n t a re im p o rta n t, w h y th e y a re a rra n g e d as
th e y a re , a n d som e in te re s tin g h is to ry a b o u t w h e re th e y c a m e fro m
•
a n a ly s is a n d d e c is io n s : u sin g th e fin a n c ia l state m e nts to u n d e rs ta n d h o w a n e n te rp ris e is p u t to g e th e r
fin a n c ia lly a n d h o w it d o e s its bu siness, a n d u sin g it to d o som e a n a ly s is o f th e e n te rp ris e 's fin a n c ia l h e a lth a n d p e rfo rm a n c e .
42
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FIGURE 2.1
The how, why and uses of accounting
The b a la n c e shee t s u m m arises, a t a p a rtic u la r d a te , th e e n te rp ris e 's fin a n c ia l p o s itio n as a c c o u n tin g m easures it, in th re e c a te g o rie s o f lists: •
re s o u rc e s (such a s c a sh , p ro d u c ts o n h a n d , la n d a n d b u ild in g s ) c a lle d assets
•
o b lig a t io n s (such as lo a n s o w in g a n d d e b ts to s u p p lie rs) c a lle d lia b ilitie s
•
o w n e r s ' in te re s ts (w h a t's le ft a fte r s u b tra c tin g th e o b lig a tio n s fro m th e resources) c a lle d e q u ity .
The in d iv id u a l item s in e a c h o f these lists a re c a lle d a c c o u n ts , so o v e r th e c e n tu rie s th e ta s k o f p re p a rin g them has b e e n n a m e d a c c o u n tin g , a n d th e p e o p le w h o d o it a re a c c o u n ta n ts . A ll these w o rd s a re d e riv e d fro m 'c o u n t', w h ic h is w h e re a c c o u n tin g b e g a n : just c o u n tin g th in g s a n d lis tin g th e m . The b a la n c e shee t p o rtra y s th e e n te rp ris e b y a rra n g in g its lists o f a c co u n ts so th a t th e assets sum to th e sam e to ta l a s th e o th e r tw o lists, a n d se ttin g th em b e s id e (o r b e lo w ) e a c h o th e r, s o m e th in g like this:
Assets
Liabilities and equity
Item a
$$
Item x
$$
Item b
_$$
Item y
_$$
Etc.
$$
Etc.
$$
Total
T$$
Total
T$$
B ecau se th e le ft to ta l e q u a ls th e rig h t to ta l, a c c o u n ta n ts s a y th a t th e y b a la n c e - h e n c e th e n a m e b a la n c e sheet. The u n d e rly in g a c c o u n tin g system m a in ta in s th is b a la n c e b y m a k in g sure th a t a n y c h a n g e s in o n e s id e o f th e b a l a n c e shee t a re m a tc h e d b y c h a n g e s in th e o th e r s id e . This re q u ire s th a t e a c h c h a n g e b e re c o rd e d tw ic e , so th e a c c o u n tin g system is c a lle d d o u b le -e n try . The b a la n c e shee t tu rns o u t to b e th e a c c u m u la tio n o f e v e ry th in g fin a n c ia l a c c o u n tin g has re c o rd e d a b o u t th e e n te rp ris e s in c e th e d a y th e e n te rp ris e b e g a n , so it is th e fu n d a m e n ta l c u m u la tiv e a c c o u n tin g re c o rd , a n d is th e a n c h o r to w h ic h a ll th e o th e r fin a n c ia l state m e nts a re tie d . The b a la n c e sheet p ro v id e s im p o rta n t in fo rm a tio n a b o u t th e e n te rp ris e 's fin a n c ia l stru c tu re a n d s tre n g th , b u t its d e s c rip tio n o f th e e n te rp ris e 's fin a n c ia l p o s itio n is n o t th e o n ly s to ry to be to ld . Its p ic tu re is sta tic: it tells us w h a t th e p o s itio n is. M o s t m a n a g e rs , o w n e rs a n d c re d ito rs a ls o w a n t to k n o w h o w w e ll th e e n te rp ris e is p e rfo rm in g a n d h o w it g o t to w h e re it is. To p ro v id e th a t e x p la n a tio n , w e ne ed to m e a s u re fin a n c ia l p e rfo rm a n c e . This is p ro v id e d b y a n in c o m e sta te m e n t (often c a lle d a p ro fit a n d loss s ta te m e n t in te rn a lly w ith in o rg a n is a tio n s ). C o rp o ra tio n s - w h ic h a re le g a lly in c o rp o ra te d c o m p a n ie s such as Q a n ta s , C o m m o n w e a lth B a n k, T e lstra, BHP B illito n , W o o lw o rth s a n d th o u s a n d s o f lo c a l, n a tio n a l a n d in te rn a tio n a l bu sinesses - p ro d u c e fin a n c ia l statem ents a t le a st a n n u a lly . S o d o m a n y o th e r k in d s o f o rg a n is a tio n s , such as th e C ity o f B ris b a n e , th e S a lv a tio n A rm y , th e G o v e rn m e n t o f A u s tra lia a n d y o u r u n iv e rs ity 's s tu d e n t u n io n . (W e m a in ly fo cu s o n businesses, e s p e c ia lly c o rp o ra tio n s , b u t o th e r k in d s o f o rg a n is a tio n s a re c o n s id e re d w h e re a p p ro p ria te .) For la rg e c o rp o ra tio n s , e s p e c ia lly p u b lic c o m p a n ie s w h o s e share s a re tra d e d o n stock m a rke ts, th e fin a n c ia l state ments a re in c lu d e d in a la rg e r d o c u m e n t c a lle d a n annual report. A n a n n u a l re p o rt ty p ic a lly b e g in s w ith n a rra tiv e m a te ria l o n the c o rp o ra tio n 's p e rfo rm a n c e a n d pro sp ects, m oves on to a n e xte n sive discussion a n d a n a ly s is b y m a n a g e m e n t, then turns to th e fin a n c ia l statem ents: th e b a la n c e sheet, th e in c o m e state m e nt a n d th e state m e nt o f cash flo w s . The first tw o a re discussed in this c h a p te r, a n d th e state m e nt o f cash flo w s is d iscusse d in C h a p te r 1 4 .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2.1
43
Introduction to the balance sheet
The balance sheet is only one o f the set o f financial statements, each of w hich is im portant for particular uses. H ow ever, as the summary of the double-entry system, the balance sheet is a critical part o f financial accounting. It balances, containing tw o lists that have the same d o lla r total and together describe the enterprise's financial position at a particular date. The first list is the enterprise's fin a n cia l resources at that d ate, as measured by the fin a n cia l accounting methods you w ill learn. These resources, called a s s e t s , include the enterprise's cash, accounts receivable (money customers have prom ised to pay), inventory (goods for sale), land, buildings, equipm ent a nd m any other resources that the enterprise has accum ulated an d can use in the future. The second list is the sources, o r fin a n cin g , o f those resources at that d a te - a g a in , as measured b y fin a n cial accounting methods. •
These fin a n cin g sources include existing o b lig a tio n s that w ill have to be p a id in the future, such as loans from the bank, amounts d ue to be p a id to em ployees a n d suppliers (w ages p a y a b le a nd accounts p a y a b le respectively), m ortgages an d other long-term b o rrow in g s, a n d m any other debts. Som e estimates o f future payments are also included, although they m ay not be le g a lly o w e d just yet, such as promises to p a y e m ployee long service leave an d estim ated future w a rra n ty costs based on the expected w a rra n ty expenses related to sales a lre a d y m ade. All these legal o b lig a tio n s a nd estimates together are c a lle d liabilities.
•
The list o f sources also includes amounts received from ow ners, w h ich norm ally involve perm anent fin a n cin g and d o not have to be re paid, plus a n y past accrual profits that have not been p a id out to the ow ners. O w n e rs can fin a n ce an enterprise b y contributing m oney to the enterprise, or by not taking profit out of the enterprise, as w e w ill see. The ow ners' investment is c a lle d ow ners' equity, o r just equity. (For corporations, w h ich a re o w n e d by shareholders, the term is usually shareholders' equity, w h ile for unincorporated businesses the terms ow ners' c a p ita l o r partners' c a p ita l are likely to be used. All o f these terms just mean ow ners' equity.) Because the b a la n ce sheet balances, the total am ount o f assets must equal the total o f liabilities plus equity.
Arithm etically, the accounting equation (often c a lle d the b a la n ce sheet equation) therefore is: Sum of assets = Sum of liabilities + Sum of eq u ity This gives us the accounting equation: Assets = Liabilities + S h areh o ld ers' eq u ity This equation is fundam ental to financial accounting. Accounting procedures are designed to create and m aintain this equality at all times. For exam ple, if you obtain $ 1 0 0 by b o rrow ing from the bank, your balance sheet w o u ld list the $ 1 0 0 cash you received as a resource and the $ 1 0 0 o b lig a tio n to repay as a liability. By m aintaining this equality, financial accounting ensures that all the financing sources that g o w ith the resources are identified, and vice versa. This balanced p a ir of lists is one of the main reasons for financial accounting's value as an inform ation system. The tw o lists are put side by side, o r the first a b o v e the second, as in the standard style show n in Figure 2 .2 . F o r m a t o f b a la n c e s h e e t
(all figures are as of a particular date) OR
Side-by-side style
Vertical style
A ss ets :
L ia b ilitie s :
A ss ets :
Useful financial resources
Obligations to be paid
Useful financial resources
E q u ity :
Obligations to be paid
L ia b ilitie s :
Owners' investment
E q u ity : In b o t h c a s e s , s u m A = s u m L + s u m E
FIGURE 2.2
Balance sheet
Owners’ investment
44
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Exhibit 2.1 is a sim ple exam ple o f a b a la n ce sheet using the side-by-side style to em phasise the e q u a lity o f the tw o lists, w ith assets on the left a n d liabilities a nd equity on the right. Explanations o f the terms used in the b a la n ce sheet fo llo w the exam ple.
EXHIBIT 2.1
SOUND AND LIGHT LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 6 (IN TH O U SA N D S OF DOLLARS)
* Equipment (net) = Cost —Accumulated depreciation = $272 000 —$122 000 = $150 000
Let's review some features o f this b a la n ce sheet: •
The title identifies the enterprise (Sound an d Light Ltd), the point in tim e a t w h ich it is d ra w n up (3 0 June 2 0 1 6 )
•
The b alance sheet balances! As at 3 0 June 2 0 1 6 , total assets of $ 4 9 5 0 0 0 are exactly equalled by the total
and the currency in w h ich am ounts a re m easured (thousands o f dollars). sources of these assets (i.e. liabilities an d shareholders' equity). It is a summary, so w e cannot tell exactly w hich source produced w h ich asset o r assets; for exam ple, the $ 5 0 0 0 0 o f cash cam e partly from bank b o rro w in g and partly from other sources, such as past profits. (M o re a b o u t sources shortly.) •
Assets are usually separated into shorter-term ones (current assets) an d longer-term ones (noncurrent assets). (M ore a bout these categories be lo w .)
•
Like assets, liabilities are usually separated into shorter-term ones (current liabilities) a nd longer-term ones (noncurrent liabilities).
•
The b a la n ce sheet shows several in dividual accounts, telling us a b o u t the com pany's particular fin a n cia l structure. For exam ple, the c o m p a n y expects to receive $ 7 5 0 0 0 from customers an d ow es $ 7 3 0 0 0 to its suppliers. The c o m p a n y ow es $ 3 0 0 0 0 to the b a n k but has chosen not to p a y it all back, keeping m ore than that ( $ 5 0 0 0 0 ) on hand as cash. (These accounts a re usually a g g re g ate s o f m any sm aller accounts; for exam ple, there is an account for each customer w h o ow es m oney to Sound an d Light.)
•
The $ 4 9 5 0 0 0 o f assets have been fin a n ce d by $ 1 9 0 0 0 0 ($ 1 0 3 0 0 0 + $ 8 7 0 0 0 ) of liabilities a nd $ 3 0 5 0 0 0 o f ow ners' equity.
•
N o te : the accounting equation a lw a ys balances: Assets = Liabilities + Equity
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
45
2.2 Explanations of the three balance sheet categories: assets, liabilities and equity Assets Assets are a mixture o f the resources that the c o m p a n y needs to d o business - for instance, products to sell a nd a buildin g to ope ra te from - a nd the resources that it has accum ulated as a result o f d o in g business, including amounts due from customers for past sales. You can think o f assets as e co n o m ic resources that have p ro b a b le future benefits that are controlled by the entity. M o re form ally, assets a re resources controlled by the entity as a result o f past events an d from w h ich future econom ic benefits a re expected to flo w to the entity. Based on this definition, assets need to have three essential characteristics: •
Future econom ic benefits because the assets are used to provide goods and services for exchange, w ith the objective of generating net cash flow s (e.g. through the sale o f the asset o r the sale o f the output produced through the use of the asset). C onsider the fo llo w in g exam ples o f assets and h o w they provide future econom ic benefits. Cash balances are beneficial because o f their com m and over the future econom ic benefits they provide. Assets such as accounts receivable are direct claims to cash inflows (receipt o f paym ent from accounts receivable); prepayments (e.g. prepaid rent) provide rights to receive services in the future; inventories can be exchanged for cash o r claims to cash, property, plant and equipment; a nd patents can provide goods o r services.
•
C o n tro l b y the entity relates to the c a p a c ity o f an entity to benefit from the asset in pursuing its objectives a nd to d e n y o r regulate the access o f others. For exam ple, if a c o m p a n y ow ns a truck it can prevent others from using it. Som e future e conom ic benefits w ill not be controlled b y an entity, because the entity cannot d e n y others access to the benefits o f the asset; for exam ple, a property d e ve lo p e r w h o builds units an d is required by the local council to put in a public park as part of the project. If the park is open to the general public w ith o u t charge, then the d e ve lo p e r does not have control over the asset a nd the public park w o u ld not be included as an asset for the property developer.
•
O ccurrence o f p a st transactions o r other p a st events means that the transaction or other event g ivin g the entity control over the future e conom ic benefits must have occurred. M o s t assets are o b ta in ed by an entity by using cash, credit (prom ise to p a y in the future) o r barter transactions. Sound a n d Light's assets include cash, accounts receivable, inventory, land an d equipm ent. O th e r 'assets' of
Sound a nd Light m ight include h a p p y em ployees, a safe w o rkin g environm ent an d the benefit o f some market research on w h ich products w ill be p o p u la r in the future - yet these d o not d irectly a p p e a r on its b a la n ce sheet. There is a distinction betw een the assets that accounting recognises a nd these other 'assets'. There are objective, standard measures for the e co n o m ic control o f the first g ro u p a nd for dem onstrating the p ro b a b ility o f future benefits that w ill eventuate for the first g roup, but not for the second g ro u p . For exam ple, in the first g roup, an inventory o f m achine parts is o w n e d by the enterprise a nd has a d o lla r cost that can be easily verified. The benefit w ill com e from future use o r selling the inventory. In the second g roup, a h a p p y e m ployee is, in theory, m ore productive than an unhappy em ployee, but it is difficult to measure re liably (with a n y consistency) h o w much m ore productive a very h a ppy em ployee is co m pared w ith an em ployee w h o is o n ly m ildly happy. M o re o ver, at least in our society, an enterprise does not o w n its em ployees! A ccounting g e n e ra lly records assets only w h e re there is econom ic control; that is, w h e re the value o f the asset can be re liably measured an d it is p ro b a b le the future benefits w ill eventuate. The expenditure for market research w ill not q u a lify as an asset because it is not possible, a t the d a te of expenditure, to establish that it is p ro b a b le that the future benefits w ill eventuate. This places limits on the scope of the fin a n cia l statements. In summary, an asset is o n ly recognised in the b a la n ce sheet w hen (a) it is p ro b a b le that future e co n o m ic benefits w ill eventuate, an d (b) the asset possesses a cost o r other value that can be re liably measured. W e w ill discuss these com plications in m ore detail in C h a p te r 6.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Assets are usually separated into shorter-term ones (current assets) a nd longer-term ones (noncurrent assets). Current assets a re those that are expected to be used, sold o r collected w ithin the next year. N oncurrent assets, therefore, are expected to have benefits for m ore than a y e a r into the future. Sound a nd Light has $ 2 4 5 0 0 0 in current assets a n d $ 2 5 0 0 0 0 in noncurrent assets.
HOW'S YOUR UNDERSTANDING? W h ic h o f th e fo llo w in g w o u ld n o t be in c lu d e d as assets in th e b a la n c e s h e e t: a c c o u n ts re c e iv a b le , e q u ip m e n t, s h a re c a p ita l, in v e n to ry an d a c c o u n ts p a ya b le ? Y o u r a n s w e r s h o u ld be : sh a re c a p ita l (S E ) and a c c o u n ts p a y a b le (L ).
Liabilities Liabilities are p ro b a b le debts o r o b lig a tio n s that result from an entity's past transactions (e.g. som eone p roviding them w ith a service) an d w ill be p a id for w ith assets (e.g. cash) o r services (e.g. p ro vid in g a service that som eone else has a lre a d y p a id the entity for). M o re form ally, liabilities are present o b lig a tio n s of the entity arising from past events, the settlements o f w h ich a re expected to result in an o u tflo w from the entity o f resources e m b o d yin g econom ic benefits. There are tw o essential characteristics o f liabilities. First, a present o b lig a tio n exists a nd the o b lig a tio n involves settlement in the future via the sacrifice o f future econom ic benefits. M o s t o b lig a tio n s a re le g a lly enforceable; for exam ple, they arise out o f contractual arrangem ents, including m oney b o rro w e d , amounts o w in g on assets purchased o r for services p ro vid e d , or o b lig a tio n s to pro vid e services to parties w h o have p a id in a d va n ce . O b lig a tio n s can also be im posed on the entity, including dam ages a w a rd e d by courts, w orkers' com pensation claim s and income tax payable. O b lig a tio n s can also arise from normal business practice, custom a nd a desire to m aintain g o o d business relations o r act in an eq u ita ble manner. If, for exam ple, an entity decides as a matter of p o licy to rectify faults in its products even w hen these becom e a p p a re nt after the w a rra n ty p eriod has e xpired, the w a rra n ty am ounts that a re expected to be e xpended in respect of g o o d s a lre a d y sold are liabilities. The other essential characteristic of a lia b ility is that it has adverse fin a n cia l consequences for the entity, in that the entity is o b lig e d to sacrifice e co n o m ic benefits to o ne o r m ore entities. Thus, the existence of a lia b ility depends on the present o b lig a tio n being such that the legal, social, p o litica l or econom ic consequences o f fa ilin g to honour the o b lig a tio n leave the entity little, if any, discretion to a vo id the future sacrifice o f e conom ic benefits to another entity. For exam ple, an entity p lacing an o rd e r for the purchase o f g o o d s w o u ld not norm ally g ive rise to a lia b ility, since the entity w o u ld norm ally have the discretion to a v o id the future sacrifice o f econom ic benefits by being a b le to cancel the order. The receipt o f the g o o d s w o u ld norm ally be the event that w o u ld create the liability. Liabilities include amounts o w e d to creditors, such as banks an d suppliers, o r am ounts estim ated to be due later, such as h o lid a y an d long service leave payments to em ployees, estim ated future incom e taxes o r interest bu ild in g up on a bank loan. For exam ple, if an electrician has d o n e repair w o rk on a c o m p a n y b u ild in g , the electrician w ill be o w e d m oney (accounts p a yable). The electrician has d o n e the w o rk (past transaction) a nd the c o m p a n y has a present o b lig a tio n . N o t all liabilities a re expected to be p a id in cash; some are 'p a id ' b y p ro vid in g g o o d s o r services. An exam ple is a deposit received from a customer for g o o d s to be shipped later. The enterprise has the m oney (an asset) and records a corresponding lia b ility for the deposit, but expects to g ive the customer the agreed-upon g o o d s to d ischarge the liability. In the m eantim e, the customer has a claim on the enterprise, expecting to get either the g o o d s o r the cash back if the g o o d s are not supplied. Sound an d Light's liabilities include am ounts o w in g to the bank (bank overdraft) and amounts o w in g to suppliers (accounts payable) a nd a long-term loan. Follow ing the same rule as for assets, liabilities g e n e ra lly include o nly o b lig a tio n s that can be re liably measured. If you are in d e b t to a friend fo r $ 1 0 , that w o u ld a p p e a r on yo u r b a la n ce sheet. H ow ever, if you are 'in d e b t' to a friend for saving your life, that w o u ld not a p p e a r on yo u r b a la n ce sheet. The requirem ent that the o b lig a tio n has
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arisen from a past transaction means that a prom ise to p a y is a lia b ility if the enterprise has a lre a d y received the benefit; for exam ple, if it has received cash from the bank o r g o o d s from a supplier or hard w o rk from an em ployee expecting a pension. An expectation to p a y later is not a liability if the transaction bringing the benefit has not happened. For exam ple, an agreem ent to b o rro w before the cash has been received is not a liability, nor is an order to purchase something before the goods have arrived. Because some o f these expected or possible future events m ay result in future payments, even if they d o not meet the definition o f a liability an d so d o not a p p e a r in the balance sheet, they are sometimes described in the notes to the financial statem ents so that the users o f the financial statement are a w a re of them. Like assets, liabilities a re usually separated into shorter-term ones (current liabilities) an d longer-term ones (noncurrent liabilities). C urrent liabilities are those that are due (expected to be p a id o r otherw ise discharged) w ithin the next year. N oncurrent liabilities, therefore, a re du e m ore than a ye a r into the future. Som e liabilities, such as many house m ortgages, extend for years into the future, but a re partly p a id each year, so the b a la n ce sheet w o u ld show both a current an d a noncurrent portion for them. Sound an d Light has $ 1 0 3 0 0 0 in current liabilities an d $ 8 7 0 0 0 in noncurrent liabilities.
HOW'S YOUR UNDERSTANDING? 1
W h ic h o f th e fo llo w in g are lia b ilitie s : a c c o u n ts re c e iv a b le , in v e n to ry , a c c o u n ts p a ya b le , w ag es p a ya b le and ta x e s p a ya b le ?
2
W o u ld an a g re e m e n t to b o rro w m o n e y fr o m th e b a n k in th r e e m o n th s ’ tim e a p p e a r in th e b a la n c e s h e e t?
Y o u r a n sw e rs s h o u ld be:
1 A c c o u n ts p a ya b le , w ag es p a y a b le and ta x e s pa ya b le . 2 N o , th e tra n s a c tio n b rin g in g th e b e n e fit has n o t h a p p e n e d .
Equity Equity is the ow ners' interest in the enterprise. •
Equity can be derived from direct contributions the ow ners have m ade, o r from the accum ulation o f profits that the ow ners have chosen not to w ith d ra w . For a com p a n y, this w o u ld mean profits that have not been distributed as dividends.
•
The details o f the ow ners' equity section o f the b a la n ce sheet d e p e n d on the legal structure o f the enterprise and
•
The b a la n ce sheet does not distinguish betw een assets w h o se sources are liabilities an d assets pro vid e d by
its ow n e rsh ip arrangem ents (exam ined later in this chapter).
ow ners. C o m p le x fin a n cia l events make this im practical, so the assets represent a pool o f resources p rovided by all sources. •
The ow ners' interest can also be considered as a 'residual' o f the sum o f the assets minus the o b lig a tio n s the enterprise has taken on. (If A = L + E, the equation can also be w ritten A — L = E.) Because the b a la n ce o f the shareholders' equity figure equals assets minus liabilities, this residual o r net concept
o f equity is often referred to as the b o o k value o f the w h o le enterprise. B ook value is an arithm etically va lid idea, as the equation on the previous p a g e shows. But it m ay not tell us very much. For exam ple, if Sound a nd Light suddenly w e n t out o f business, the ow ners w o u ld be unlikely to receive exactly the equity o f $ 3 0 5 0 0 0 , because n o b o d y knows w h a t the assets w o u ld fetch if they had to be sold o ff all at once, an d the liabilities perhaps w o u ld be settled for som ething other than the expected future payments used to record them. Sim ilarly, if the ow ners d e c id e d to sell the business, the price they w o u ld ge t w o u ld d e p e n d on their a nd the buyers' view s as to the future success o f the business, not just on the accum ulated assets an d liabilities recorded in the b a lan ce sheet. Thus, the am ount w o u ld be very unlikely to equal the b a la n ce sheet equity figure.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Shareholders' equity is g e n e ra lly based on historical transactions, a nd does not, except by c o in cid e n ce , equal the current m arket value o f the w h o le business. M a n y high-technology a n d internet com panies a t the start of this century had small equity am ounts in their b a la n ce sheets but huge stock market values (market ca p ita lisa tio n , o r the share price times the num ber o f shares outstanding). The stock market m ay have been considering all sorts o f 'assets' not included b y accounting, such as com petitive strength o r smart em ployees, a n d /o r expecting g o o d future perform ance. M a n y o f these share prices have subsequently d ro p p e d , but there often are differences betw een the shareholder equity section o f the b a la n ce sheet a nd the current market price o f the com pany. C ontributions from ow ners can com e in m any forms, including the issue o f share c a p ita l an d the o b ta in in g o f past profits (discussed below ). For a corp o ra tio n like Sound an d Light, the most usual is share ca p ita l: p e o p le g ive the corporation m oney in e xch a n g e for shares, w h ich are portions o f ow n e rsh ip interest. Sound an d Light ow ners (shareholders) have contributed $1 3 0 0 0 0 to the co rp o ra tio n . For exam ple, some ow ners p ro b a b ly contributed cash to get Sound and Light started, so they w o u ld be a m ong the sources o f the cash asset. M a n y co rp o ra tio n s' shares, also c alled stocks in some countries (such as the United States), are traded on stock markets (e.g. the Australian Stock Exchange). In such markets, shares are traded betw een ow ners; the corporations issuing the shares receive m oney only w hen the shares are issued by them to the first ow ners. Therefore, trades subsequent to the initial share issue are not reflected in the co rp o ra tio n 's share ca p ita l; these trades a re transactions for the ow ners, not fo r the co rp o ra tio n . Past profit retained, usually called retained profits (or retained earnings), represents past accrual p rofit not yet given to ow ners. (The terms 'e arnings', 'in co m e ' a nd 'p ro fit' a re used pretty much interchangeably, but they all refer to accrual profit, as described in C h a p te r 1.) As w e 'll see in later chapters, earning profit means that there w ill be more assets (such as cash) a n d /o r fe w e r liabilities, so profit is a source of assets. Sound a n d Light has $ 1 7 5 0 0 0 in retained profits, w h ich means it has $ 1 7 5 0 0 0 m ore in assets than it w o u ld have had if those profits had all been p a id out. The ow ners could have w ith d ra w n cash o r other assets from the c o m p a n y (for instance, by d e claring themselves a d ivid e n d , w h ich is a paym ent o f some o f the retained profits to the owners), but they have chosen instead to leave the assets in the c o rp o ra tio n . Thus, those assets are resources o f the co rp o ra tio n an d retained profits are their source. The corporation can use the assets to earn m ore profit in the future. Since E = A — L, it is arithm etically possible for equity to be negative. If the assets a re less than the liabilities, w hich w o u ld ind ica te an enterprise has m ore o b lig a tio n s than resources (not a g o o d position to be ini), the equity, and therefore the enterprise's b o o k value, w ill be negative. Such a situation is a sign o f serious fin a n cia l problems and is likely to be fo llo w e d by insolvency.
HOW'S YOUR UNDERSTANDING? I f asse ts are re s o u rc e s , w h a t are th e p o ss ib le s o u rc e s f o r th e s e assets? Y o u r a n s w e r s h o u ld be : L ia b ilitie s , s h a re c a p ita l an d re ta in e d p ro fits .
2.3 Some prelim inary analysis of the Sound and Light balance sheet From the Sound an d Light b a la n ce sheet, w e can an sw e r some questions a b o u t the co rp o ra tio n 's fin a n cia l co n d itio n : 1
Is the enterprise soundly fin a n ce d ? Sound an d Light has fin a n ce d its $ 4 9 5 0 0 0 in assets by b o rro w in g $ 1 0 3 0 0 0 short-term a nd $ 8 7 0 0 0 long-term, a nd b y getting $ 1 3 0 0 0 0 in contributions from ow ners a n d not p aying past earnings o f $ 1 7 5 0 0 0 out to ow ners. Its $ 4 9 5 0 0 0 in assets a re therefore financed by $ 1 9 0 0 0 0 (3 8 .4 per cent) from creditors a n d $ 3 0 5 0 0 0 (6 1 .6 per cent) from the ow ners. Its debt-to-equity ratio is $ 1 9 0 / $ 3 0 5 = 6 2 .3 per cent (often w ritten 0 .6 2 :1 ) . So, Sound a nd Light is not much in debt, proportionately. W h a t w o u ld you think if the creditors w e re o w e d $ 4 5 0 0 0 0 a n d the shareholders' equity w a s o n ly $ 4 5 0 0 0 ? This
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w o u ld be a debt-to-equity ratio o f $ 4 5 0 / $ 4 5 = 1 0 0 0 per cent (1 0 :1 ), much m ore risky for the creditors because a lot m ore o f their m oney than the ow ners' m oney w o u ld be a t risk if the c o m p a n y ran into trouble. 2
C a n the enterprise p a y its bills on tim e? Sound a n d Light ow es $ 1 0 3 0 0 0 in the short term an d has only $ 5 0 0 0 0 in cash. Therefore, to p a y its bills it w ill have to co lle ct cash from its customers, either by getting them to p a y w h a t they a lre a d y o w e o r by selling them some inventory for cash. There is likely no problem here: collections an d sales, a nd payments to creditors, are p ro b a b ly g o in g on continuously. The c o m p a n y has $ 2 4 5 0 0 0 of current assets that it should be a b le to turn into cash to p a y the $ 1 0 3 0 0 0 of current liabilities. It is said to have $ 2 4 5 0 0 0 — $ 1 0 3 0 0 0 = $ 1 4 2 0 0 0 in working capital an d a w o rkin g c a p ita l ratio (also ca lle d the current ratio) of $ 2 4 5 / $ 1 0 3 , o r 2 .3 8 . The w o rkin g ca p ita l is positive, an d the ratio indicates there is m ore than tw ice as much current assets as current liabilities, so Sound a nd Light app e a rs to be fine.
3
You can see that if the c o m p a n y had a slo w p eriod o f sales o r collections, it could have difficulty p a yin g its bills. But if you w e re concerned a b o u t the com pany's a b ility to sell inventory to p a y its bills, you could calculate the q u ick ratio (also c a lle d the a c id test ratio). It is like the w o rkin g c a p ita l ratio, but has o nly cash, very short-term investments that could be sold, a nd accounts receivable in its num erator. For Sound a nd Light, the q u ick ratio w o u ld be ( $ 5 0 0 0 0 + $ 7 5 0 0 0 ) / $ 1 0 3 0 0 0 = 1 .2 1 . The c o m p a n y could p a y its current liabilities w ithout having to sell inventory. W h a t w o u ld you think if the c o m p a n y had o nly $ 1 0 0 0 0 in cash an d $ 1 6 0 0 0 0 in inventory? In that case, though its w o rkin g c a p ita l a nd w o rkin g ca p ita l ratio w o u ld be the same, it w o u ld likely be overstocked an d short o f cash, an d m ight have trouble p a yin g bills. N o w the q u ick ratio w o u ld be ( $ 1 0 0 0 0 + $ 7 5 0 0 0 ) / $ 1 0 3 0 0 0 = 0 .8 3 . The c o m p a n y w o u ld have to sell some inventory to meet its current liabilities. All ratios are o n ly indicators. They require interpretation of the specific circumstances of each enterprise, so w e d o n 't kn o w from our calculations if the c o m p a n y is in trouble, but a lo w q u ick ratio w o u ld g ive a signal to look further into the situation.
4
Should the ow ners d e cla re themselves a d ivid e n d ? If so, h o w large should it be? Legally, the b o a rd o f directors (w ho m a n a g e the c o m p a n y on behalf o f the shareholders) a re a b le to d e cla re a d ivid e n d to shareholders of $ 1 7 5 0 0 0 , the full am ount o f the retained earnings. But there is not nearly enough cash fo r that. Those past earnings have been reinvested in inventory, land, equipm ent a nd so on, an d are therefore not sitting around in cash w a itin g to be p a id to ow ners. This is true o f nearly all com panies: they invest past earnings in o p erating assets, so d o not have a lot o f cash on hand. P robably a d ivid e n d o f m ore than a b o u t $ 2 5 0 0 0 , o n ly one-seventh o f the retained earnings, w o u ld cause Sound a nd Light some cash strain. W h a t w o u ld you think if the c o m p any had no land or equipm ent but $ 3 0 0 0 0 0 in cash instead? It w o u ld a p p e a r to be cash-rich in that case, and should either invest the cash productively o r p a y a d ivid e n d to the ow ners so they can d o w h a t they like w ith the m oney.
5
Equipm ent (net) of $ 1 5 0 0 0 0 is represented b y the cost o f the equipm ent $ 2 7 2 0 0 0 less accum ulated depreciation o f $1 2 2 0 0 0 . In calcu la tin g its profit, Sound an d Light has deducted dep re cia tio n on its equipm ent as an expense. The profit that is in the retained profits part o f the equity is, therefore, sm aller than it w o u ld have been w ith o u t this deduction. The accum ulated am ount o f that expense, built up over the years, is deducted from the assets in the b a la n ce sheet to sh o w h o w much o f the econom ic value o f the assets is estim ated to have been used up so far. Accum ulated d e p re cia tio n is therefore a 'n e g a tive asset' used to reduce the am ounts of other assets. In this case, the equipm ent cost $ 2 7 2 0 0 0 , a g a in st w h ich dep re cia tio n o f $1 2 2 0 0 0 has accum ulated, so the 'net' b o o k value o f the equipm ent is the rem ainder: $ 1 5 0 0 0 0 . (It is normal for the b a la n ce sheet to report o n ly the net am ount an d g ive cost a n d accum ulated de p re cia tio n am ounts in the notes.) C o m p a rin g the cost and the accum ulated dep re cia tio n tells us som ething a b o u t the a g e o f the equipm ent. The $1 2 2 0 0 0 accum ulated d e p re cia tio n is less than half the equipm ent's cost, so the c o m p a n y estimates that less than half the econom ic value o f the equipm ent has been used. W h a t w o u ld you think if the accum ulated d e p re cia tio n w e re $ 2 5 0 0 0 0 ? The equipm ent w o u ld be nearing the end o f its estim ated life.
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Common presentation styles for balance sheets So you see that the b a la n ce sheet provides interesting inform ation if you kn o w h o w to read it. Y our skill in reading it w ill g ro w as you w o rk w ith it. There are different styles o f presentation for the b a la n ce sheet; all sh o w the same inform ation, but they a re arra n g e d differently. Exhibit 2.1 show ed you the side-by-side form at for Sound a n d Light Ltd. In Exhibit 2 .2 , the vertical form at is show n, w h ich has becom e far m ore com m on. It shows assets less liabilities equals shareholders' equity.
2.4
A closer look at the balance sheet
To g a in further insights into the content of a b a la n ce sheet, w e w ill exam ine the content o f C h e z Ltd's b a la n ce sheet, shown in Exhibit 2 .3 . •
It is com parative: it contains figures both for the most recent ye a r an d for the preceding ye a r to help the users recognise changes. It is standard practice for the m ore recent figures to be to the left, closer to the w o rd s describing those figures.
•
For clarity, the figures a re show n in thousands o f dollars, not e xact am ounts to the cent.
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HOW'S YOUR UNDERSTANDING? A s s e m b le a b a la n c e s h e e t f o r N o r th e r n L td fr o m th e fo llo w in g in fo r m a tio n , and c o m m e n t o n th e c o m p a n y ’s fin a n c ia l p o s itio n a t th a t p o in t in tim e : •
sh a re c a p ita l $ 1 0 0 0
•
a c c o u n ts re c e iv a b le $ 1 1 0 0
•
a c c o u n ts p a ya b le $ 2 1 0 0
•
in v e n to ry $ 1 7 0 0
•
re ta in e d p ro fits $ 2 2 0 0
•
cash $ 5 0 0
•
e q u ip m e n t $ 2 0 0 0 . Y o u r a n s w e r s h o u ld be : c u r r e n t assets $ 3 3 0 0 , n o n c u r r e n t assets $ 2 0 0 0 ; to ta l assets $ 5 3 0 0 ; c u r r e n t
lia b ilitie s $ 2 1 0 0 , n o n c u r r e n t lia b ilitie s $ 0 ; c o n trib u te d c a p ita l $ 1 0 0 0 , re ta in e d p ro fits $ 2 2 0 0 ; and to ta l lia b ilitie s and e q u ity $ 5 3 0 0 . W o rk in g c a p ita l is $ 1 2 0 0 ; th e w o rk in g c a p ita l ra tio is 1 .5 7 , so it is n o t as s tro n g c u r r e n tly as S o u n d and L ig h t is. L ia b ilitie s o f $ 2 1 0 0 a re 3 9 .6 p e r c e n t o f to ta l s o u rc e s , w ith a d e b t - t o - e q u it y ra tio o f 6 5 .6 p e r c e n t, so th e c o m p a n y ’s fin a n c in g is s im ila r to S o u n d an d L ig h t’s, th o u g h all o f its lia b ilitie s are c u r r e n t, w h ic h is u n u s u a l. W ith $ 5 0 0 c a sh , it d o e s n o t ha ve e n o u g h cash t o p a y all o f its $ 2 2 0 0 re ta in e d p r o fits t o s h a re h o ld e rs as d iv id e n d s i f it w a n te d to . •
•
References are norm ally m ade to various notes. It is not possible to explain every im portant item on the fa ce o f the b a la n ce sheet, so extensive e xp la n a to ry notes are referred to a nd a p p e n d e d to most b a la n ce sheets. C hez's notes are not p rovided here because they raise issues w e have not yet covered. Remember to lo o k for notes w hen you are using fin a n cia l statements.
•
The co m p a n y has m any different kinds o f asset, liability and equity accounts. They are not necessarily easy to classify into the categories you sa w in the Sound a nd Light Ltd exam ple. You p ro b a b ly w o n 't understand all the accounts and h o w the co m p a n y has categorised them; that understanding w ill deve lo p as you w o rk through the book.
•
The b a la n ce d a te is 31 M a y , not 3 0 J u n e . The end o f the taxation year, 3 0 J u n e , is the most p o p u la r accounting year-end (financial year-end), but m any com panies choose other dates, particularly subsidiaries o f US com panies, am ong w h o m 31 D ecem ber is popular. Som e e xplanation of the deta ile d content o f b a la n ce sheets w ill be helpful no w , before some exam ples of
preparing b a la n ce sheets a re given. Som e o f C hez's assets w e re described in C h a p te r 1: cash, accounts receivable a nd inventory. Property, plant and equipm ent is split into land, buildings, equipm ent, a nd furniture a nd fittings. M a n y A ustralian com panies n o w show property, plant an d equipm ent as on e item on the fa ce of the b a la n ce sheet (e.g. equipm ent net = $ 1 0 0 0 0 ) , w ith the split-up in o ne o f the notes to the accounts (e.g. equipm ent — accum ulated d e p re cia tio n : $ 4 0 0 0 0 0 — $ 3 0 0 0 0 0 = $ 1 0 0 0 0 0 ). N o te that land is not d e p re cia te d , but buildings, equipm ent, an d furniture a n d fittings are shown net, m eaning that accum ulated d e p re cia tio n has been d educted. The e xact am ount o f the accum ulated d e p re cia tio n d educted w ill be show n in the notes. For exam ple, if plant an d equipm ent cost $1 m illion an d had an expected life o f five years, the am ount o f d e p re cia tio n each ye a r w o u ld be $ 2 0 0 0 0 0 . A fter three years, accum ulated d e p re cia tio n w o u ld be $ 6 0 0 0 0 0 ($ 2 0 0 0 0 0 + $ 2 0 0 0 0 0 + $ 2 0 0 0 0 0 ).
52
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 2.3 • BALANCE SH EET AS A T 31 M A Y (IN TH O U SA N D S OF DOLLARS)
2016
2015
$
$
8 952
6 336
Assets Current assets Cash and cash equivalents Investments
1 8516
5179
Accounts receivable
26 396
18 069
Inventory
22 831
20427
Prepayments
3586
2015
80281
52 026
Land
23 205
23 205
Buildings (net)
26282
25911
Equipment (net)
35 120
36 630
4 864
4140
Total current assets
Noncurrent assets
Furniture and fittings (net) Intangibles (net)
2 398
3 586
91 869
93472
172 15 0
145498
Accounts payable
7984
6443
Accrued expenses
5 740
3491
Income taxes payable
3 248
2 756
Provision for employee entitlements
4 898
1 598
Dividends payable
5 925
2 883
27795
17171
Long-term loans
23 856
21 805
Provision for employee entitlements
1 4006
13 647
Total noncurrent liabilities
37 862
35452
Total noncurrent assets
Total assets Liabilities and shareholders' equity Current liabilities
Total current liabilities
Noncurrent liabilities
Total liabilities
65 657
52 623
106493
92 875
Share capital
23 961
23 961
Retained profits
8 2 5 32
68914
106493
92 875
Net assets Shareholders' equity
Total shareholders' equity
C h e z Ltd also has some other assets that w e re not introduced in C h a p te r 1, including investments, prepaym ents, property, plant a nd equipm ent (net), a n d intangibles. •
Investments are short-term; that is, included under current assets - a nd could be shares in other com panies (such as the C om m onw ealth Bank o r W o o lw o rth s), w h ich C h e z intends to convert to cash w ithin a year.
•
Prepaym ents (or p re p a id expenses) a re amounts that have been p a id in a d va n ce but for w h ich the benefits have not yet been received. For exam ple, if w e p a y a 12-month insurance premium on 1 A pril 2 0 1 5 , at 31 M a y
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
53
2 0 1 5 w e w ill have a prepaym ent equal to ten-twelfths o f the am ount p a id . Prepayments are assets because they represent future e co n o m ic benefits. •
The property, plant an d equipm ent (PPE) w ill be recorded at cost net o f accum ulated d e p re cia tio n . Each ye a r d e p re cia tio n expense is calculated an d the sum o f these d e p re cia tio n expenses is ca lle d accum ulated d e p re cia tio n . D epreciation expense an d accum ulated de p re cia tio n are discussed in m ore detail in C h a p te r 5 . W h e n you see the w o rd 'net' after PPE it means accum ulated d e p re cia tio n has been deducted from cost.
•
Intangible assets a re noncurrent assets that have no physical substance, such as copyrights, patents, tradem arks, brand names a n d g o o d w ill. They a re discussed in C h a p te r 10. C h e z Ltd includes m any liabilities that have not yet been discussed. Accounts p a y a b le a nd long-term loans w e re
described in C h a p te r 1. T w o others are accrued expenses a nd provision for em ployee entitlements. •
Accrued expenses relate to expenses that have been incurred during the ye a r but not yet p a id . C o n sid e r tw o exam ples. Assume C h e z Ltd pays salaries an d w a g e s every tw o w eeks for w o rk d o n e in the previous tw o w eeks. If the last p a y d a y w a s 1 9 M a y , the c o m p a n y w o u ld o w e em ployees salaries an d w a g e s from 2 0 M a y to 31 M a y . This is ca lle d accrued w a g e s o r w a g e s p a ya b le . A nother exam ple o f accrued expenses could be the am ount o w in g to the electricity co m p a n y. If it bills you quarterly a nd the last bill w a s for the p eriod e n ding 3 0 A p ril, you w o u ld o w e the c o m p a n y for one month's electricity at the end o f the accounting p e riod. This w o u ld also form part of accrued expenses. Income taxes p a y a b le is the am ount p a y a b le to the tax o ffice in the next year.
•
Provision for e m ployee entitlements relates to long service leave, h o lid a y p a y a nd some superannuation. It is an estim ate, based on years o f service, o f the am ounts o w in g to em ployees that w ill have to be p a id in future periods. The provision for e m ployee entitlements has both current a nd noncurrent proportions, d e p e n d in g on w hen the am ounts a re likely to be p a id .
W here do the figures come from ? A full understanding o f w h a t assets a nd liabilities are an d h o w to measure them w ill take time an d m any exam ples. O n e thing you m ay be w o n d e rin g a b o u t is w h e re the figures used to measure these things com e from. This is a d e e p and controversial question indeed. O n ly a superficial an sw e r can be given now , but after a fe w m ore chapters you w ill have a d e e p e r understanding o f it. A ccounting is g e n e ra lly a historical measurement system: it records w h a t has h a p pened, not w h a t w ill happen o r w o u ld have h a p pened if conditions had been different. Therefore, asset a n d lia b ility values are derived from the past. Assets are g e n e ra lly valued at w h a t they cost w hen they w e re a cquired, a nd liabilities are g e n e ra lly valued at w h a t w a s p ro m ise d w hen the o b lig a tio n arose. In most countries, assets a nd liabilities a re not valued at the current prices they m ight fetch if sold right no w . This is som ething that confuses m any users: looking at a b a la n ce sheet in the United States, for exam ple, a user m ight think that assets such as land an d buildings are shown a t w h a t those assets w o u ld be w orth right n o w if they w e re sold. They are, instead, valued at w h a t they cost w hen they w ere acquired. The differences in these values can be large. For exam ple, a c o m p a n y m ay have bought land in the d o w n to w n area o f a city 2 0 years a g o for $ 1 0 0 0 0 0 . The land m ay n o w be w orth millions o f dollars. But the b a la n ce sheet norm ally w ill sh o w the land asset at a figure o f $ 1 0 0 0 0 0 , its o rig in a l cost. This is because the o n ly thing that has happened is that the land w a s a cq u ire d 2 0 years a g o , a nd the cost incurred then can be verified. N o th ing further has h a p pened: the land has not been sold, so its current value is hypothetical an d difficult to verify. H ow ever, in A ustralia certain assets can be revalued in the b a la n ce sheet to current market prices. They are show n at either independent valuation or directors' valuation. This im portant valuation issue is discussed in m ore detail in C h a p te r 10. The b a la n ce sheets o f most Australian com panies actu a lly sh o w a little less detail than our C h e z Ltd exam ple. For exam ple, under liabilities it is quite normal to have a heading 'p a y a b le s', w h ich includes accounts p a y a b le and accrued expenses. The split-up o f these amounts is then given in the notes to the accounts.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
54
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n y o u r re a d in g o f th is c h a p te r:
1 2
C o m m e n t o n th e s h o r t- t e r m fin a n c ia l p o s itio n o f C h e z L td . P re p a re th e b a la n c e s h e e t o f M ik e ’s T y re R e p a ir (o w n e r, M ik e ) fr o m th e fo llo w in g a c c o u n t ba la n ce s: b a n k o v e rd ra ft, $ 2 5 0 ;
a c c o u n ts
re c e iv a b le , $ 6 4 0 ;
in v e n to ry o f s u p p lie s, $ 2 1 0 ; e q u ip m e n t c o s t, $ 8 9 0 ;
a c c u m u la te d d e p re c ia tio n o n e q u ip m e n t, $ 4 7 0 ; a c c o u n ts p a ya b le , $ 3 6 0 ; s h a re h o ld e rs ’ e q u ity , $ 6 6 0 . Y o u r a n sw e rs s h o u ld be:
1
W o rk in g c a p ita l is $ 5 2 4 8 6 0 0 0 ; c u r r e n t ra tio is 2 .8 9 :1 . T h e in te r p r e ta tio n o f th e w o rk in g c a p ita l ra tio d e p e n d s v e ry m u c h on th e n a tu re o f th e e n te rp ris e an d its w a y o f d o in g bu siness. H o w e v e r, y o u c an see th a t C h e z L td is in q u ite a s tro n g p o s itio n ; c u r r e n t assets a re a lm o s t th r e e tim e s c u r r e n t lia b ilitie s .
2 T o ta l assets o f $ 1 2 7 0 ( 6 4 0 + 2 1 0 + 8 9 0 — 4 7 0 ) an d to ta l lia b ilitie s o f $ 6 1 0 ( 2 5 0 + 3 6 0 ) , g iv in g n e t assets o f $ 6 6 0 an d o w n e rs ’ e q u ity also o f $ 6 6 0 .
2.5
M aintaining the accounting equation
In sections 2.1 a nd 2 .2 the accounting equation w a s introduced: Assets = Liabilities + S h areh o ld ers' equity An understanding o f this equation is fundam ental to your understanding o f the b a la n ce sheet an d the w h o le accounting recording process. Financial accounting is said to use the double-entry system, w h e re b y the accounting equation is a lw a ys kept in ba la n ce . If an asset goes up, a lia b ility or equity must g o up too (or another asset must g o d ow n). If a lia b ility goes up, an asset must g o up too, o r an equity o r another lia b ility must g o d o w n . H ere a re some exam ples, using the b a la n ce sheet descriptions in the Sound an d Light exam ple in section 2.1 a nd the equation A ] = Li + Ei to represent the b a la n ce sheet before the events: •
cash o f $ 1 0 0 o b ta in e d from an o w n e r for shares: 'cash' asset up, 'share c a p ita l issued' equity up, so A i + $ 1 0 0 = Li + E , + $ 1 0 0
•
$ 1 2 0 collected from a customer: 'cash' asset up, 'accounts receivable' asset d o w n , so A i + $ 1 0 0 + $ 1 2 0 —
•
g o o d s for sale costing $1 3 0 received from a supplier: 'inventory' asset up, 'accounts p a y a b le ' lia b ility up, so A i
$ 1 2 0 = Li + E i + $ 1 0 0
+ $ 1 0 0 + $ 1 2 0 — $ 1 2 0 + $ 1 3 0 = Ln + $ 1 3 0 + Ei + $ 1 0 0 . A fter these three events, the n ew b a la n ce sheet is $ 2 3 0 higher on both sides a nd so still in balance: A , + $ 2 3 0 (net) = L, + $ 1 3 0 + E, + $ 1 0 0 The key point is that the equation w ill a lw a ys be in ba la n ce . The equation w o u ld b a la n ce before recording these transactions a n d w ill b a la n ce after the transactions have been recorded. W e cover transaction analysis in more detail in C h a p te r 3 , including e x p a n din g the equation to incorporate revenue and expenses. So at this point w e w ill just consider transactions that o n ly have an im pact on the bala n ce sheet. Assume that, at 3 0 June 2 0 1 6 , FGH Ltd had cash o f $ 2 0 0 0 0 0 an d share c a p ita l o f $ 2 0 0 0 0 0 . N o te that the accounting equation balances at this point. In fact, the equation w ill b a la n ce after w e record every transaction. C onsider the im pact o f each o f the fo llo w in g transactions: 1
The c o m p a n y receives $ 4 0 0 0 0 0 from the issue o f shares ( 2 0 0 0 0 0 shares at $ 2 each). This transaction increases an asset (cash at bank) a nd increases shareholders' equity account (share capital).
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2
55
The c o m p a n y purchases n e w equipm ent fo r $ 5 0 0 0 0 0 , p a yin g cash to the supplier. This transaction increases on e asset (equipment) a nd decreases another asset (cash).
3
The c o m p a n y borrow s $ 2 0 0 0 0 0 from the bank. This transaction increases an asset (cash a t bank) a nd increases a lia b ility (loan).
4
The c o m p a n y purchases inventory on credit for $ 1 5 0 0 0 0 . This transaction increases a lia b ility (accounts payable) a nd increases an asset (inventory).
5
The c o m p a n y pays $ 5 0 0 0 0 to accounts p a ya b le . This transaction decreases an asset (cash) an d a lia b ility (accounts payable). Each of the a b o v e transactions is recorded in Exhibit 2 .4 an d the n e w b a la n ce sheet a t 31 July 2 0 1 6 app e a rs in
Exhibit 2 .5 .
EXHIBIT 2 .5 BALANCE SH EET AS A T 31 JULY 2 0 1 6
Assets
$
Current assets Cash
250000
Inventory
150 00 0 400000
Noncurrent assets Equipment at cost
Liabilities
500000
Accounts payable
Long-term loans
200000
Total liabilities
300000
Shareholders' equity
Retained profits
900000
100000
Noncurrent liabilities
Share capital
Total assets
$
Current liabilities
600000 0
Total shareholders' equity
600000
Total liabilities and shareholders' equity
900000
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
56
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be a b le to c o m p le te , based o n w h a t y o u ha ve rea d. W h a t is th e e f fe c t o f e a ch o f th e fo llo w in g tra n s a c tio n s on to ta l assets?
1 2 3 4 5
P u rc h a s e d e q u ip m e n t f o r $ 2 0 0 0 0 0 cash. P u rc h a s e d in v e n to ry f o r $ 3 0 0 0 0 o n c re d it. R e c e iv e d a loan o f $ 5 0 0 0 0 fr o m th e ba nk. R e c e iv e d $ 2 0 0 0 0 fr o m a c c o u n ts re c e iv a b le . Issued a d d itio n a l share s o f $ 3 0 0 0 0 0 . Y o u r a n sw e rs s h o u ld be:
1 2 3 4 5
N o e f fe c t: e q u ip m e n t in c re a s e s b u t cash d e cre a s e s . In cre a se s b y $ 3 0 0 0 0 (in v e n to ry ). In cre a se s b y $ 5 0 0 0 0 (c a s h ). N o e f fe c t: ca sh in c re a s e s b u t a c c o u n ts re c e iv a b le d e cre a s e s . In cre a se s b y $ 3 0 0 0 0 0 (c a s h ).
2.6
Managers and the balance sheet
W h y d o m anagers care a b o u t their co m p a n ie s' b a la n ce sheets? The basic reason is that m any outsiders do, including ow ners, creditors, tax authorities an d unions. Read a n y issue of a business new sp a p e r o r m a g a zin e and you w ill see frequent references to the im portance o f the b a la n ce sheet a n d levels o f d ebt. For exam ple: R o b L td w a s an a ttr a c tiv e p r o s p e c t b e c a u s e it ha d a s tro n g b a la n c e s h e e t. T h in n L td has a w e a k fin a n c ia l s tru c tu re . M a n a g e m e n t m u s t so lv e th is p ro b le m b e fo re r is k -s h y in v e s to rs ca n be e x p e c te d t o ta k e an in te r e s t in th e c o m p a n y . H u g e L td has la rg e ca sh re s e rv e s , so o n e ca n o n ly g u e ss t h a t m a n a g e m e n t is lo o k in g t o b u y a n o th e r c o m p a n y t o a d d t o H u g e ’s c o n s o lid a te d g ro u p . X L td ’s d e b t - t o - e q u it y ra tio is h ig h f o r th e in d u s try . T h e u n d e rly in g s tre n g th o f P B ’s b a la n c e s h e e t is h a rd t o ig n o re . T h e a d v a n ta g e o f Q u e e n s la n d ’s s tro n g b a la n c e s h e e t w as t h a t it e n a b le d th e s ta te t o w ith s ta n d a n y u n e x p e c te d s h o ck s. W e s tfie ld has g ro w n b e c a u s e it has a v e r y c o n s e rv a tiv e b a la n c e s h e e t t h a t p ro v id e s o p p o r tu n itie s .
The b a lance sheet reports w h a t the organisation's position (assets, liabilities a nd shareholders' equity) is a t a point in tim e (the fin a n cia l year-end o r a n y other da te on w h ich the b a la n ce sheet is prepared). It shows the assets (resources) that m anagem ent has chosen to a cq u ire for the o rganisation, a nd h o w m anagem ent has d e c id e d to finance those assets. Therefore, it provides a useful picture o f the state o f the c o m p a n y a nd is used b y m any outsiders to evaluate the q u a lity o f m anagem ent's decisions on o b ta in in g , d e p lo y in g a nd fin a n cin g assets. For better o r w orse, it is the summary o f all the inform ation recognised by accounting a nd is, to m any peo p le , the basic score ca rd of m anagem ent's stewardship o f the com p a n y. The b a lance sheet does not directly state h o w m anagem ent has perform ed in using assets to earn profit. Such inform ation is contained in the incom e statement, but all o f it correlates w ith the basic double-entry inform ation contained in the b a la n ce sheet. G o o d p rofit perform ance, for exam ple, is reflected in increased assets and shareholders' equity (retained profits). The strengths an d weaknesses o f the b a la n ce sheet, w h ich w ill be explored throughout this book, are therefore fundam entally im portant to m anagers, w h o are responsible for m anaging com panies' assets a n d liabilities. M a n a g e rs ' o w n salaries, prom otions, careers a nd reputations d e p e n d on other people's decisions (such as investors' decisions to buy an d sell shares) w h ich , in turn, rest to some extent on b a la n ce sheet inform ation.
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
2.7
57
The income statem ent
A business exists over a period o f time. If the ow ners a nd m anagers a re successful, it m ay prosper for a long time. Suppose a measure o f the co m p a n y's fin a n cia l perform ance is desired for com parison w ith other com panies, for assessing incom e tax, for help in d e c id in g h o w much to sell the c o m p a n y for, o r for m any other reasons w e w ill com e to. H o w could such perform ance be m easured? W e m ight measure the com pany's fin a n cia l perform ance by closing it d o w n , selling off all its assets, p a yin g off all its liabilities an d discovering h o w much is left for the ow ners. G o o d perform ance w o u ld be in d ica te d if the m oney left for the ow ners plus the am ounts they w ith d re w over the years w e re greater than the am ount they put in w hen they founded the com p a n y, perhaps adjusted for inflation over that tim e an d for the ow ners' costs in raising the m oney they put in. But killing the business to measure h o w w e ll it has been d o in g is a little drastic! W a itin g until it dies o f natural causes hardly seems a n y better: m any com panies have outlasted m any generations o f ow ners a n d m anagers. It w o u ld be m ore useful to measure perform ance over selected shorter periods o f time: annually, every three months (quarterly) o r on a m onthly basis. People could then make their decisions a b o u t investing in the c o m p a n y o r getting out, a nd hiring m anagers or firing them, w hen they w a n te d to d o so. This is w h e re the incom e statement becom es useful. This statement uses accrual accounting to measure fin a n cial perform ance over a period o f time, usually a year, six months, three months o r o ne month, in d ica tin g the bottom line net p rofit fo r the p e riod, calculated as revenues minus expenses. N e t pro fit fo r the period = Revenues - Expenses fo r the period
Revenues and expenses Recall that in section 1 .5 the concepts o f revenues a nd expenses w e re introduced. As part o f the conceptual fram ew ork o f acco u n tin g , o fficia l pronouncem ents d e ve lo p e d definitions o f revenues an d expenses. They w e re deve lo p e d to be a p p lic a b le to a range o f measurement models an d to include some transactions unique to the public sector. C onsequently, the definitions are difficult to fo llo w , especially for students in their second w e e k o f an accounting course. As a result, w e w ill defer discussion o f these definitions until C h a p te r 13. B elow are some fundam ental definitions that cover most revenues a nd expenses.
R EVENUES Revenues a re described here as increases in the com pany's w ealth arising from the provision o f services o r the sale of g o o d s to customers. W e a lth increases because customers: •
p a y cash for g o o d s o r services
•
prom ise to p a y cash (such promises a re c a lle d accounts receivable for g o o d s an d services)
•
(more rarely) p a y w ith other forms o f w e a lth , such as by p roviding other assets to the c o m p a n y o r fo rg ivin g debts o w e d by the c o m p a n y for g o o d s a nd services. If, in return for services o r g o o d s, a customer p a id $ 1 0 0 0 in cash, another customer prom ised to p a y $ 1 0 0 0
later, another g a ve the c o m p a n y $ 1 0 0 0 in equipm ent, o r another fo rg a ve a $ 1 0 0 0 d e b t the c o m p a n y had o w e d the customer, each w o u ld be ca lle d a revenue o f $ 1 0 0 0 . Interest a nd dividends received a re also exam ples o f revenue because they are increases in w ealth as a result of provid in g a service (lending o r investing m oney in another organisation). The key test for revenue recognition is w hether the g o o d s o r services have been rendered (e.g. delivery to customers o r the provision of a service). Revenue recognition can becom e quite c o m p lica te d for some com panies. For exam ple, if a c o m p a n y received a contract to build a n e w h ig h w a y from Brisbane to M e lb o u rn e , w hen w o u ld revenue be recognised? This a n d other m ore c o m p lica te d questions concerning revenue recognition w ill be addressed in C h a p te r 1 3.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
58
EXPENSES Expenses are the opposite o f revenues. They are decreases in the com pany's w ealth that are incurred in order to earn revenue. W e a lth decreases because operating costs have to be p a id ; customers have to be given the goods they have paid for; long-term assets w e a r out as they are used to earn revenue; a nd liabilities m ay be incurred as part o f the process. If, as p a rt o f its attem pt to earn revenues, the c o m p a n y p a id $ 6 0 0 in rent, o r the g o o d s bought by a customer cost the c o m p a n y $ 6 0 0 to provide, the equipm ent d e p re cia te d b y $ 6 0 0 , o r the c o m p a n y prom ised to p a y an em ployee $ 6 0 0 in w a g e s later on for w o rk a lre a d y com pleted, each o f these w o u ld be c a lle d an expense o f $ 6 0 0 . A m ajor expense c a te g o ry that sometimes causes confusion is the cost of g o o d s sold (C O G S ) expense. In the exam ples a bove , if the g o o d s bought by the customer cost the c o m p a n y $ 6 0 0 to p rovide, $ 6 0 0 is the cost o f the goods sold that earned revenue o f $ 1 0 0 0 . The revenue is w h a t the customer agrees to pay; the cost o f g o o d s sold is w h a t it costs the enterprise to pro vid e those g o o d s. Therefore, a transaction w ith a customer w h o is buying g o o d s has tw o aspects: •
the enterprise is better off because o f the revenue g a in e d
•
the enterprise is w orse off because o f the cost o f the g o o d s that the customer takes a w a y . W h e n the enterprise buys the goods for sale, they begin on the balance sheet in the asset account 'inventory of unsold
g o o d s'. W h e n they are sold, their cost is transferred from the asset account to the expense account 'cost o f g o o d s sold'. This is done as a separate accounting activity from recording the revenue, because it is a separate econom ic event. W h e th e r the enterprise makes m oney on the deal depends on w hether the revenue g a in e d is greater than the cost o f goods sold (plus any other expenses incurred to make the sale, such as sales commissions and shipping costs).
PROFIT Both revenues a n d expenses a re measured by fo llo w in g the concepts o f accrual acco u n tin g ; therefore, they represent increases o r decreases in w e a lth , w hether o r not cash receipts o r payments occur at the same time. As net p rofit is the difference betw een revenues a n d expenses, it represents the net in flo w o f w ealth to the c o m p a n y during the period. The reporting o f net p rofit means that the c o m p a n y has becom e w e a lth ie r during the p e riod. If net profit is negative; that is, if revenues a re less than expenses - it is instead called n e t loss, a nd represents a net o u tflo w o f w ealth. In this case, the c o m p a n y has becom e less w e a lth y. Expenses include all the costs o f earning the revenues, including incom e an d other taxes, but they d o not include paym ent o f returns to ow ners (w ithdraw als by sole traders o r partners, o r dividends to shareholders of com panies). Payments, o r promises o f paym ent, o f returns to ow ners (such as w hen a co m p a n y's b o a rd o f directors declares - or promises - a dividend) are considered to be distributions o f net profit to ow ners. The undistributed rem ainder is kept in the c o m p a n y as retained profits.
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be a b le to c o m p le te , based o n w h a t y o u ha ve rea d. C a lc u la te th e to ta l re v e n u e and e x p e n s e s f o r th e m o n th o f J u n e 2 0 1 6 , g iv e n th e fo llo w in g :
1 2 3 4
C r e d it sales o f $ 2 0 0 0 0 0 m a d e in J u n e ; 5 0 p e r c e n t to be c o lle c te d in J u n e . C a s h sales o f $ 3 0 0 0 0 0 . R e c e iv e d $ 2 0 0 0 0 as a d e p o s it fr o m a c u s to m e r in J u n e f o r a j o b to be c a rrie d o u t in J u ly . P aid salaries o f $ 4 0 0 0 0 ; $ 1 0 0 0 0 re la te d to w o rk c a rrie d o u t in M a y and $ 3 0 0 0 0 re la te d to J u n e w o rk .
5 P aid r e n t f o r th e m o n th o f J u n e o f $ 6 0 0 0 o n 7 J u n e . 6 R e c e iv e d a bill f o r $ 1 5 0 0 fr o m an e le c tric ia n f o r w o rk d o n e o n 2 0 J u n e . T h is w ill be paid n e x t m o n th . Y o u r a n sw e rs s h o u ld be : re v e n u e $ 2 0 0 0 0 0 + $ 3 0 0 0 0 0 ; e x p e n s e s $ 3 0 0 0 0 + $ 6 0 0 0 + $ 1 5 0 0 .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
59
The relationship o f p ro fit for the period to retained profits Retained profits is the sum o f past net profits, measured since the c o m p a n y b e gan, minus dividends d e cla re d (even if not yet paid) to ow ners since the b e g in n in g . Retained profits from the end o f the preceding p eriod (year, quarter, month or w hatever) a re therefore increased b y profits for the p eriod an d reduced b y a n y dividends. Retained profits at end of period
= Retained profits at beginning of period + Net profit (or - Net loss) for the period — Dividends declared during the period
An alternative form at to sh o w the ch a n g e in retained profits is: Start with retained profits, beginning of period (end of previous period)
XXXX
Add net profit for the period
XXXX
Deduct dividends declared during the period
(XXXX)
Equals retained profits, end of period
XXXX
In the a b o ve exam ple, the co m p a n y earned a profit. If the co m p a n y performed badly, the profit could be negative (expenses greater than revenues, producing a net loss instead), an d in that case, the net loss is deducted from the beginning retained profits. If things get really ba d , retained profits can also be negative (losses having overw helm ed profits). You m ight be interested to know that you can, if you have the pa st records, g o b ack year by year, figuring out how much profit w a s a d d e d to retained profits each year an d h o w much in dividends w a s deducted. You could g o all the w a y b ack to the first d a y of the com pany, w hen there had not yet been a ny profit and, therefore, not yet any retained profits. Retained profits is therefore like an onion: you can keep peeling a w a y each year's layer until you have peeled it all a w a y and a re back to zero. You can sim ilarly peel a w a y each year's transactions in every balance sheet account; for exam ple, you can trace all the changes in cash back to the very beginning. For this reason, the balance sheet can be said to reflect everything that has ever been recorded in the accounts: it is the accum ulation o f everything that has happened from w hen the co m p a n y began until now . A ccounting really is a historical inform ation system! In a co m p a n y, the bo a rd o f directors is the senior level o f m anagem ent, op e ra tin g the c o m p a n y on behalf o f the ow ners. W h e n the b o a rd declares a d ivid e n d , the am ount is deducted from retained profits at that time. A t that point, the c o m p a n y has a lia b ility to the ow ners, w h ich it pays o ff later by sending the ow ners the prom ised cash. This involves tw o principles o f fin a n cia l accounting: 1
Transactions w ith ow ners, o f w h ich the main exam ple is dividends, are taken out o f retained profits. They are not an expense, an d therefore are not deducted in calculating profit for the period.
2
O w n e rs can be creditors too, if they a re o w e d d ividends o r have lent the c o m p a n y m oney in a d d itio n to the shares they bought.
HOW'S YOUR UNDERSTANDING? H e re is an e x e rc is e y o u s h o u ld be ab le to c o m p le te , based o n w h a t y o u ha ve rea d. T h e fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 6 :
a
Issued s hare s to in v e s to rs f o r $ 1 0 0 0 0 0 cash,
b
B o rro w e d $61 0 0 0 fr o m th e bank,
c
P u rc h a s e d e q u ip m e n t f o r $17 0 0 0 cash,
d
P u rc h a s e d $ 7 2 3 0 0 0 o f a d d itio n a l in v e n to ry o n c re d it.
e
S o ld $1 141 9 0 0 o f p ro d u c ts t o c u s to m e rs on c re d it; c o s t o f th e g o o d s w as $ 7 0 0 0 0 0 .
f
In c u rre d $ 2 1 8 2 0 0 in s e llin g e x p e n s e s , p a y in g 8 0 p e r c e n t in cash an d o w in g th e re s t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
g
Paid cash dividends o f $16 0 0 0
h
E arned $ 4 0 0 0 in te re s t on in v e stm e n ts, re ce ivin g 7 5 p e r c e n t in cash,
i 1 2 3
In c u rre d $ 2 9 0 0 in in te re s t expense to be paid a t th e b e g in n in g o f n e x t year. W h a t was re ve n u e fo r th e year? W h a t are expenses fo r th e year? W h a t is th e n e t p ro fit? Y o u r answers should be:
1 2 3
$1 141 9 0 0
+ $ 4 0 0 0 = $1
1 45 9 0 0
$ 7 0 0 0 0 0 + $ 2 1 8 2 0 0 + $ 2 9 0 0 = $921 1 0 0 $1 1 4 5 0 0 0 - $921 1 0 0 = $ 2 2 3 9 0 0 .
2.8 Connecting balance sheets and income statements The b a la n ce sheet shows all assets, liabilities an d shareholders' equity accounts at a point in time. Usually the b alance sheet is com parative, show ing the accounts a t both the b e g inning o f the incom e statement's p eriod (i.e. the end o f the previous period) an d a t the end o f the incom e statement's p e riod, a nd therefore show ing both the beginning retained profits an d the e n ding retained profits. Assets at beginning
=
Liabilities + equity (including retained profits) at beginning
Assets at end
=
Liabilities + equity (including retained profits) at end
Change in assets
=
Change in liabilities + change in equity (including retained profits)
Suppose a co rp o ra tio n had assets of $1 2 0 0 at the b e g inning o f a ye a r a nd $ 1 4 5 0 at the end, an d liabilities of $ 7 5 0 at the beg in n in g a n d $ 9 0 0 at the end. W e can d e d u ce that its equity w a s $ 4 5 0 a t the b e ginning an d $ 5 5 0 at the end (i.e. Assets — Liabilities = Equity). These d a ta p roduce the fo llo w in g calculation o f the changes in the b alance sheet categories: Assets
1
Equity 1
Liabilities
Beginning:
$1 200
=
$750
+
$450
Ending:
$1 450
=
$900
+
$550
Changes:
$ 250
=
$150
+
$100
W h e re d id the ch a n g e in equity com e from ? Upon investigation, w e find out that the c o m p a n y issued m ore share c apital o f $ 4 0 , earned profit of $ 1 8 5 an d d e cla re d a d ivid e n d o f $ 1 2 5 . Thus: $
71
Share capital change: Equity increase due to issued share capital
40
Retained profits change: Equity increase due to profit Equity decrease due to declaration of dividend Change in equity between the two balance sheets
185 (125)
60 100
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61
W e know w h a t the profit w a s, but not w h a t the c o m p a n y d id to earn it. This is w h a t the profit an d loss com ponent o f the incom e statement is for: describing the revenues a nd expenses that produced the $1 8 5 profit. But once w e have that, it is useful to kn o w h o w that factors in to the b a la n ce sheet. The net profit is part o f the ch a n g e in retained profits, w h ich in turn is part of the c h a n g e in the b a la n ce sheet over that p e riod. The statement (or note) show in g changes in retained profits therefore 'knits' the b a la n ce sheet a nd the incom e statement together by show ing that the net profit is part o f the ch a n g e in the b a la n ce sheet over the p e riod. (Accountants refer to this knitting together as the articulation o f the tw o statements.) Profit is part o f the ch a n g e in retained profits fo r the p e riod, therefore: P rofit is p a rt o f the e q u ity com ponent of the accounting eq u atio n M a k e sure you understand h o w this w orks: •
A revenue increases w e a lth , so it either increases assets o r decreases liabilities, an d therefore increases equity.
•
An expense decreases w e a lth , so it either decreases assets o r increases liabilities, a nd therefore decreases equity.
•
Positive net p ro fit has the overall effect o f increasing assets a n d /o r decreasing liabilities, an d therefore increases equity (increases due to revenues exceed decreases due to expenses).
•
A net loss, w h ich is negative net profit, does the o pposite, decreasing equity (decreases due to expenses exceed increases d ue to revenues). A t this stage make sure you g ra sp the idea that p rofit is part o f equity through retained profits. N o te that in
C h a p te r 1 3 you w ill see that the full incom e statement includes other equity changes that articulate through to the b a lan ce sheet.
FOR YOUR INTEREST P eople s o m e tim e s th in k th a t th e w h o le balance o f re ta in e d p ro fits is available to pay dividends. Legally th a t m ay be tru e , b u t p ra c tic a lly it is v e ry u n lik e ly to be tru e , because p r o fit co m e s fro m changes in all th e fo rm s o f w e a lth on th e balance sheet. A c o m p a n y th a t has m ade go o d p ro fits and used th e m o n e y earned to invest in new p la n t and e q u ip m e n t, fo r exam ple, w o u ld have to sell th e p la n t and e q u ip m e n t i f it w e re to pay o u t all th e re ta in e d p ro fits as dividends. A lso , since p r o fit is based on accrual a c co u n tin g , it is re p re se n te d by changes in n o n -c a s h a c co u n ts such as a c co u n ts receivable (u n c o lle c te d revenues) and a c co u n ts payable (u n p aid expenses), so th e p ro fit in re ta in e d p ro fits is n o t all cash, and th e c o m p a n y m ig h t have to cle a r up all its receivables and payables to g e t th e cash to pay a big d ividend. The ow n e rs m ay n o t even w a n t a d ividend: m any co m p a n ie s th a t pay sm all o r no dividends have e x c e lle n t share prices on th e s to c k m a rk e t, because shareholders believe th a t th e co m p a n ie s w ill g ro w and p ro sp e r i f th e m o n e y th a t co u ld have been paid as dividends is instead k e p t inside th e c o m p a n y and used to m ake p ro fita b le business in v e stm e n ts.
An exam ple o f a rtic u la tio n betw een the balance sheet and the incom e sta te m e n t Bratwurst Ltd had the fo llo w in g b a la n ce sheet at the end o f 2 0 1 5 (beginning o f 2 0 1 6 ): assets $ 5 0 0 0 , liabilities $ 3 0 0 0 a nd equity $ 2 0 0 0 . •
The b e ginning equity figure w a s m ade up o f the shareholders' invested share c a p ita l o f $ 5 0 0 plus retained profit accum ulated to the end o f 2 0 1 5 o f $ 1 5 0 0 . (That $ 1 5 0 0 w a s therefore the sum o f all the net profits the c o m p any had ever had up to the end o f 2 0 1 5 minus all the d ividends ever d e cla re d to ow ners up to that point.)
•
During 2 0 1 6 , the c o m p a n y had revenues o f $1 1 0 0 0 a nd expenses o f $ 1 0 0 0 0 , a nd d e cla re d d ividends to ow ners o f $ 3 0 0 .
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•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A t the end of 2 0 1 6 , the c o m p a n y had assets o f $ 5 9 0 0 , liabilities o f $ 3 2 0 0 a nd equity o f $ 2 7 0 0 , m ade up o f the shareholders' invested share ca p ita l o f $ 5 0 0 plus retained profits of $ 2 2 0 0 . Exhibit 2 .6 shows the relationship.
You can see several things from this exam ple: •
W e have used the term 'retained profits' instead o f 'retained earnings'. Both are used in A ustralia, but the former is m ore com m on. In the United States a nd C a n a d a , 'retained earnings' is much m ore com m on.
•
The incom e statement's bottom line is transferred to the statement of retained profits, w h ich is g e n e ra lly shown as a note to the b a la n ce sheet.
•
The retained profits note's bottom line is transferred to the b a la n ce sheet, show ing that the statements tie together (articulate) through retained profits. In a d d itio n , asset a n d /o r lia b ility accounts in the b a la n ce sheet also have to ch a n g e to reflect the w ealth changes
that revenues and expenses involve. These changes keep the b a la n ce sheet in b a la n ce w ith the ch a n g e in retained profits. This is true for all com panies, not just sim ple ones like Bratwurst Ltd. The Bratwurst exam ple also shows that the profit inform ation an d the retained profit note could be said to be detailed explanations o f the c h a n g e in the b a la n ce sheet's retained profits figure. But the b a la n ce sheet could instead have had the fo llo w in g form at under the retained profits part o f shareholders' equity:
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63
Retained profits Beginning balance A dd Revenues
1 500 1 1 000 12 500
D e d u c t Expenses
1 0000 2
D e d u c t Dividends declared
Ending balance
500 300
2 200
The inform ation is there, but putting all this on the b a la n ce sheet w o u ld make it rather cluttered, a nd there w o u ld hardly be room to pro vid e a n y details a b o u t the various revenues, expenses an d d ividends. A lso, the co n ce p t o f profit as a measure o f perform ance w o u ld be obscured.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
In fin a n cia l a c c o u n tin g , w h a t is a re ve n u e and w h a t is an expense?
2
S uppose B ra tw u rs t L td ’s a c c o u n tin g re co rd s show ed th e fo llo w in g fo r th e n e x t year, 2 0 1 7 : revenues earned $ 1 4 2 0 0 , cash c o lle c te d fro m c u s to m e rs $13 8 0 0 , expenses in c u rre d $12 9 0 0 , dividends declared $ 6 0 0 and dividends paid in cash $ 5 0 0 . (R e m e m b e r, re ta in e d p ro fits equalled $ 2 2 0 0 a t th e end o f 2 0 1 6 .) W h a t was B ra tw u rs t’s n e t p r o fit fo r 2 0 1 7 and its re ta in e d p ro fits as a t th e end o f 2017? Y o u r answers should be: $14 2 0 0 - $12 9 0 0 = $ 1 3 0 0 ; and $ 2 2 0 0 + $ 1 3 0 0 - $ 6 0 0 = $ 2 9 0 0 .
2.9
A closer look at the income statem ent
S ocial an d e co n o m ic forces have helped to produce an incom e statement that is m ore co m p le x than the sim ple Bratwurst Ltd exam ple you s a w earlier. See Exhibit 2 .7 for T a b co rp H o ld in g s' Income statement. A m ong the things you m ay notice as you review the tw o statements are: •
The incom e statement covers a p eriod o f tim e (years e n ding 3 0 June in this case), not a point in time, as the b a la n ce sheet does. It also is shown in millions o f dollars.
•
As you a lre a d y s a w w ith the b a la n ce sheets, extensive e xp lanatory notes a re norm ally referred to on the incom e statement a nd a p p e n d e d to them. The notes a re not attached here. The content of such notes is important, how ever, so some comments are m ade a b o u t that b e lo w , a nd further attention w ill be p a id to it in later chapters.
• •
A t the to p o f the statement, the total revenue fo r the ye a r is disclosed as $ 2 0 3 9 .8 million. Expenses (including em ploym ent costs o f $ 1 6 5 .1 m illion an d com m issions/fees of $ 7 7 0 .8 million) are then deducted to ge t o p erating profit before incom e tax.
•
Incom e tax is levied on a com pany's profit because it is le g a lly separate from its ow ners. Such tax is usually a percentage of profit before incom e tax (though there are m any com plications). Income tax expense o f $ 7 5 .1 m illion a n d loss from discontinued operations, net o f tax ($ 1 9 .5 million), are deducted to ge t 'o p e ra tin g profit after incom e tax' o f $ 1 2 9 .9 million.
•
Loss on profits from discontinued operations (parts of the business that are no longer in operation) are norm ally deducted to g ive a clearer indication o f profits from continuing operations, w h ich is m ore useful for predicting future profits.
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•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o te that the governm ent taxes a nd levies ( $ 3 4 9 .5 million) are not incom e tax. There a re separate taxes related to the g a m ing industry.
•
In 201 3 there w a s mention o f im pairm ent. This is w h e re com panies need to reduce the value o f some o f their assets b e lo w cost a nd is e xp la in e d in C h a p te r 10.
EXHIBIT 2.7
TABCORP HOLDINGS LIMITED IN C O M E S T A T E M E N T FOR TH E YEAR ENDED 3 0 JUNE 2 0 1 4
2014
Revenue
2013
$m
$m
2 0 3 9 .8
2 003.2
0 .7
8.5
Government taxes and levies
(349.5)
(334.1)
Commissions and fees
(770.8)
(763.1)
Employment costs
(165.1)
(154.2)
Other income
Communications and technology costs Depreciation and amortisation Impairment Property costs
(75.9)
(85.2)
(164.4)
(151.1)
-
(18.6)
(41.3)
(40.3)
(38.1)
(36.8)
Other expenses
(113.7)
(106.2)
Profit before income tax expense and net finance costs
3 2 1 .7
322.1
Advertising and promotions
3.4
Finance income
3.1
Finance costs
(100.6)
(106.8)
Profit from continuing operations before income tax expense
22 4.5
218.4
Income tax expense
(75.1)
Profit from continuing operations after income tax
149.4
(70.8) 147.6
Discontinued operations Loss from discontinued operations, net of tax
(19.5)
(21.0)
N et profit after tax
129.9
126.6
S ou rce : T a b c o rp H o ld in g s Lim ited, A n n u a l R ep ort 2 0 1 4 .
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: I f th e o p e n in g balance o f re ta in e d p ro fits is $ 8 5 0 0 0 0 , n e t p r o fit b e fo re ta x $ 1 5 0 0 0 0 , n e t p r o fit a fte r ta x $ 1 2 0 0 0 0 , and $ 7 0 0 0 0 o f dividends w e re d e cla re d , w h a t is th e clo sing balance o f re ta in e d p ro fits ? Y o u r answ er should be: $ 9 0 0 0 0 0 ( 8 5 0 0 0 0 + 1 2 0 0 0 0 - 7 0 0 0 0 ) .
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
65
FOR YOUR INTEREST B o th in A u s tra lia and in te rn a tio n a lly th e label fo r th e s ta te m e n t th a t provides th e p r o fit fig u re has changed o fte n o v e r re c e n t decades; exam ples in c lu d e p r o fit and loss s ta te m e n t, s ta te m e n t o f fin a n cia l p e rfo rm a n c e and in c o m e s ta te m e n t. Y o u should be aw are o f th e se nam e changes as som e co m p a n ie s m ay re ta in th e o ld e r nam es fo r in te rn a l d o c u m e n ts because o f m anagers’ fa m ilia rity w ith th e m . F o r exam ple, th e use o f th e te rm ‘p r o fit and loss s ta te m e n t’ is still c o m m o n in m a n y com panies.
2.10 Capital markets, managers and performance evaluation The profit figure, as disclosed in the incom e statement, has m ajor im pacts on m anagers' salaries, prom otions, careers and reputations - e sp e cia lly w h e re c a p ita l markets such as stock markets a re concerned. M a n a g e rs o f large, publicly traded com panies a re under constant pressure because o f the spotlight on profits an d its com ponents. Business and social observers often com m ent that this spotlight is too intense; that there is m ore to m anagerial perform ance than the profit figure. An indication o f the im portance p laced on the 'bottom line' can be found in alm ost a n y issue of a financial new spaper, such as The A ustralian o r the A ustralian F inancial Review, in their regular announcem ents o f com panies' annual a n d /o r half-yearly profits. These announcem ents presum ably are meant to focus on the crucial bits of inform ation. The emphasis is on profit. There is alm ost never a n y d a ta a b o u t non-financial perform ance, longer-term issues o r other aspects o f m anagers' efforts. This is not to say that these other factors a re not considered a t some point, but w hen announcem ents tend to stress earnings, other things can be overlooked. The announcem ents sh o w sales, profits before tax (pre-tax), net p rofit after tax (net), earnings per share (EPS), interim a nd final dividends per share (which includes the d a te o f paym ent; 'ff' signifies the d ivid e n d is fully franked, m eaning that tax has a lre a d y been p a id on the profits by the co m p a n y; 'p ' means it is partly franked) a nd the present share price, w h ich includes the ch a n g e from the previous d a y (shares last). Som e figures are converted to per-share da ta (roughly, these a re the profit figure d iv id e d by the num ber of o rd in a ry shares issued by the com pany). Per-share amounts are thought to be helpful to the user w h o ow ns o r is thinking o f buying a particular num ber o f shares a nd w o n d e rs w h a t portion o f the co m p a n y's results can be related to that num ber of shares. If you o w n n shares of X Limited, you can say that your shares earned $ 0 ,5 5 5 p e r share in the 2 0 1 6 fin a n cia l year, up from $ 0 .4 8 1 per share in the previous fin a n cia l year. Share price inform ation is given for the current period. For exam ple, it shows that the share price o f X Limited at the last sale the previous d a y w a s $ 5 .3 6 , w h ich w a s d o w n 4 .2 cents on the previous d a y's closing price. W h e n the fin a n cia l statements are p roduced, a nd announcem ents like Exhibit 2 .8 are m ade from them, the statements w ill reflect the sam e things, the same m anagem ent decisions. Therefore, share prices w ill g o up o r d o w n w hen investors receive news a b o u t a c o m p a n y that changes the attractiveness o f its shares. If this news comes out before the fin a n cia l statements a nd the a b o v e announcem ents (which is usually the case, e sp e cia lly for w ell-know n com panies that are frequently in the news), then the share price w ill a lre a d y have ch a n g ed in the m anner to be expected from the announcem ents. If an announcem ent (surprisingly g o o d o r b a d results) is not expected, then the share prices w ill ch a n g e w hen the announcem ent is m ade, because the announcem ent is the news. In either case, share market prices an d p rofit announcem ents tend to end up m oving in the same direction, an d therefore are correlated.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
M a n a g e rs o f com panies w ith traded shares a re therefore keenly a w a re o f a ccounting's profit measurement, because accounting is tracking factors that investors are concerned about. If the investors d o not learn a b o u t these factors from other sources, they w ill certainly learn a b o u t them from the accounting statements. The incom e statement is also im portant for managers of smaller com panies o r private com panies. W h ile their shares are not traded, managers and o w n e r-m a n a g e rs o f smaller com panies are as concerned as managers of larger com panies are a bout m anagem ent bonuses, incom e tax a nd other effects o f profit figures. M a n a g e rs o f m any com panies - e specially, but not only, larger corporations - g o to great lengths to explain their perform ance to investors an d to p e o p le on w hom investors rely, such as share market analysts a n d business journalists. Therefore, every m anager should be conversant w ith h o w her o r his perform ance is measured in the incom e statement - because a lot o f other p e o p le are!
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
67
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A C alculate n e t p ro fit A ssum e this is th e firs t y e a r o f o p e ra tio n s fo r the c o m p a n y . U sing th e fo llo w in g in fo rm a tio n c a lc u la te net p ro fit b e fo re ta x.
$ Credit sales
300000
Cash sales
100 00 0
Cash received from accounts receivable
160 00 0
Cost of goods sold
70000
Cash purchases of inventory
90000
Operating expenses paid
80000
Operating expense incurred during the year but owing at year-end
30000
PRACTICE PROBLEM B Prepare a balance sheet a p p ro p ria te ly classified From th e fo llo w in g in fo rm a tio n , p re p a re a b a la n c e sheet, a p p ro p ria te ly c la s s ifie d , as a t 3 0 June 2 0 1 6 fo r PSM Lim ited. $000 Share capital
108518
Cash
11 636
Accounts payable
43 091
Investments ($3 371 000 held for short-term investment) Retained profits Prepayments
5 458 28 546 3 958
Accounts receivable
47515
Long-term borrowings
30 866
Inventory
66479
Provisions for employee entitlements ($30 9 1 9 0 0 0 due within one year)
34888
Property, plant and equipment
67760
Other long-term assets
42 742
Other receivables (due in more than one year)
PRACTICE PROBLEM C Revenues and expenses The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 6 . 1 Issued shares to investors fo r cash . 2
P ro v id e d services to custom ers, re c e iv in g p a rt in cash a n d th e rest on c re d it.
3
In cu rre d a d v e rtis in g e x p e n s e , p a id in cash .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
68
4
C o lle c te d cash fro m a c co u n ts re c e iv a b le .
5
R e p a id a b a n k lo a n .
6
P urchased e q u ip m e n t on c re d it.
7
B o u g h t in v e n to ry fo r cash .
8
S old g o o d s on c re d it (C O G S e q u a ls 6 0 p e r c e n t o f sales).
9
P aid w a g e s e x p e n s e fo r th e p e rio d .
10 R eceived a lo a n fro m th e b a n k . 11 In cu rre d m a in te n a n c e ex p e n s e , p a id cash .
12 D e c la re d a n d p a id a cash d iv id e n d to investors. For e a c h o f th e tra n s a c tio n s , in d ic a te th e e ffe c t (+ fo r in cre a s e a n d — fo r de cre a s e ) o f e a ch tra n s a c tio n on revenues, expe nses a n d net p ro fit. W r ite N E if th e re is no effect.
PRACTICE PROBLEM D Incom e sta te m e n t and balance sheet Isa b e lle Lim ited sta rte d business o n 1 S e p te m b e r 2 0 1 6 . D u rin g th e first m o nth in business th e fo llo w in g tra n s a c tio n s o c c u rre d . a Issued s h a re c a p ita l, $ 1 0 0 0 0 0 .
b
P aid o n e m o n th 's ren t o f $ 2 0 0 0 .
c
P ro v id e d services to custom ers on c re d it, $ 3 0 0 0 0 ; $ 1 1 0 0 0 o f this a m o u n t h a d been re c e ive d b y th e e n d o f the m onth.
d
P aid w a g e s o f $ 7 0 0 0 .
e
R eceived a $ 1 0 0 0 b ill fo r c le a n in g services o n th e n e w ly re n te d p ro p e rty fo r th e c le a n in g d o n e . The b ill w ill be p a id in O c to b e r.
Required: 1
P re p a re an in c o m e state m e nt fo r th e m onth o f S e p te m b e r 2 0 1 6 .
2
P re p a re a b a la n c e sheet a t 3 0 S e p te m b e r 2 0 1 6 .
KEY TERMS Accounts Accrued expenses Accumulated depreciation Annual report Assets Bank overdraft Current assets Current liabilities
Current ratio Double-entry accounting Income tax expense Income tax payable Intangible assets Market value Net loss Noncurrent assets
Noncurrent liabilities Notes to the Financial statements Prepayments (prepaid expenses) Provision Statement of retained profits Stewardship Working capital
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
D e fin e th e fo llo w in g term s in y o u r o w n w o rd s :
a
re ven ue
b
expense
c
net p ro fit
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
d
d iv id e n d
e
re ta in e d p ro fits
f
s h a re h o ld e rs ' e q u ity .
2
W h a t is th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t assets?
3
W h a t is th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t lia b ilitie s ?
4
D o lia b ilitie s a lw a y s in v o lv e fu tu re pa ym e n ts o f cash?
5
S u g g e st tw o w a y s re ta in e d p ro fits m a y d e cre a s e .
6
H o w c a n a b a la n c e sheet a n s w e r th e fo llo w in g qu estio ns: a Is a c o m p a n y fin a n c ia lly sound?
7
69
b
C a n a c o m p a n y p a y its bills on tim e?
c
S ho uld th e b o a rd o f d ire c to rs d e c la re a d iv id e n d ?
d
H o w o ld is th e e q u ip m e n t?
E x p la in th e m a in d iffe re n c e s b e tw e e n th e a lte rn a tiv e m e tho ds o f setting o u t a b a la n c e sheet: th e side -by-sid e style a n d th e v e rtic a l style.
8
List fo u r lia b ilitie s th a t c a n be e ith e r c u rre n t o r n o n c u rre n t lia b ilitie s . W h a t d e te rm in e s th e ir c a te g o ris a tio n ?
9
The C E O o f a la rg e A u s tra lia n c o m p a n y a n n o u n c e d a t a recen t s h a re h o ld e rs ' m e e tin g : 'O u r p e o p le a re o u r g re a te s t a sse ts.' If this is th e case , w h y a re th e y n o t in c lu d e d in th e b a la n c e sheet?
10 E x p la in th e fo llo w in g in n o n -te ch n ic a l la n g u a g e th a t a business p e rso n w h o has n o t re a d this te xt w o u ld u n d e rsta n d : a W h y is net p ro fit p a rt o f s h a re h o ld e rs ' e q u ity?
b
If net p ro fit is p a rt o f s h a re h o ld e rs ' e q u ity , w h y is it ne ce ssary to h a ve a s e p a ra te in c o m e statem ent? W h y not just re p o rt net p ro fit o n th e b a la n c e sheet?
c
W h y a re d iv id e n d s to s h a re h o ld e rs no t c o n s id e re d to be an e x p e n s e in c a lc u la tin g net p ro fit? E m p lo ye e w a g e s a re c o n s id e re d to be an e x p e n s e , as is th e cost o f p ro d u c ts d e liv e re d to custom ers, a n d s h a re h o ld e rs m ust be k e p t h a p p y , as m ust e m p lo y e e s a n d custom ers.
11 W h y a re in v e n to ry a n d acco un ts re c e iv a b le n o rm a lly c u rre n t ra th e r th a n n o n c u rre n t assets? W h e n w o u ld th e y be n o n c u rre n t assets?
12 P ro v id e o n e e x a m p le e a ch o f investm ents, in ta n g ib le s , p re p a ym e n ts a n d a c c ru e d expe nses. 13 P ro v id e an in d ic a to r o f w h e th e r a c o m p a n y is fin a n c ia lly soun d. 14 P ro v id e an in d ic a to r o f w h e th e r a c o m p a n y c a n p a y its b ills on tim e. 15 C o n s id e r a n y c o m p a n y y o u a re fa m ilia r w ith o r in tere ste d in a n d m a ke a list o f a ll th e p e o p le w h o m ig h t be in tere ste d in its b a la n c e sheet. M a k e y o u r list using th e fo llo w in g h e a d in g s :
Person (decision-maker)
Use (decision to be made)
T ry to th in k a b o u t th e 'u s e ' issue b ro a d ly : y o u r list c o u ld e a s ily be a lo n g o n e . Y ou m ig h t m a ke it even m o re b ro a d b y in c lu d in g p e o p le y o u th in k m ig h t like to use th e b a la n c e shee t b u t w h o s e needs a re no t served b y it as y o u u n d e rsta n d it, o r w h o d o n o t h a ve tim e ly access to it. 16 'F in a n c ia l re p o rts a re no lo n g e r tim e ly to d a y .' D iscuss. 1 7 W r ite a p a ra g ra p h in w h ic h y o u id e n tify a n o n -a cc o u n tin g c a re e r y o u o r s o m e o n e y o u k n o w m a y pursue, a n d e x p la in th e in tere st in b a la n c e sheet in fo rm a tio n th a t this c a re e r m ig h t e n ta il. If y o u re a lly c a n n o t see a n y re la tio n s h ip b e tw e e n th a t c a re e r a n d a n y th in g re p o rte d in a b a la n c e sheet, e x p la in w h y not. 18 C a n a s in g le b a la n c e sheet e v e r satisfy a ll th e users o f a c o m p a n y 's fin a n c ia l statem ents, o r sh o u ld th e re be d iffe re n t b a la n c e sheets p re p a re d to m eet th e d iffe rin g needs o f users? W r ite a p a ra g ra p h g iv in g y o u r c o n s id e re d v ie w s .
19 'Y o u c a n h a ve a p e rfe c tly a c c u ra te b a la n c e sheet 5 0 y e a rs a fte r y e a r-e n d .' D iscuss. 2 0 E x p la in w h y th e d iffe re n c e b e tw e e n c u rre n t a n d n o n c u rre n t lia b ilitie s is im p o rta n t to a c o m p a n y . 21 E x p la in th e d iffe re n c e b e tw e e n an a c c ru a l a n d a p ro v is io n .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
70
PROBLEMS PROBLEM 2.1 Classifying accounts on a balance sheet B e lo w a re som e o f th e acco un ts o f M o n e y M a k in g Ltd: 1 W a g e s p a y a b le
2
S h a re c a p ita l
3
C a s h a n d cash e q u iv a le n ts
4
In ve n to ry
5
B o rro w in g s
6
P rovision fo r e m p lo y e e en titlem en ts (cu rre n t p o rtio n )
7
In co m e ta xe s p a y a b le
8
E q u ip m e n t
9
P rep aym e nts State w h e th e r e a ch w o u ld be c la s s ifie d as a n asset, a lia b ility o r s h a re h o ld e r e q u ity .
PROBLEM 2.2 In te rp re tin g balance sheets 1
'T he c o m p a n y is in a p o s itio n to u tilise a s trong b a la n c e sheet to m a ke a c q u is itio n s th a t sh o u ld b o o s t its e a rn in g s p e r s h a re .'
2
'T he c o m p a n y has m a in ta in e d a s trong b a la n c e sheet a n d h a d a m p le c a p a c ity to e x p a n d its b u siness.'
3
'T he a b ility to g e a r th e c o m p a n y 's b a la n c e sheet to p ro d u c e a m o re e ffic ie n t c a p ita l structure is a key to a successful fu tu re .'
Discuss th e im p lic a tio n s o f e a ch o f th e statem ents fro m th e p o in t o f v ie w o f th e com m en ts m a d e on th e ir b a la n c e sheets.
PROBLEM 2.3 Prepare a classified balance sheet From th e fo llo w in g in fo rm a tio n , p re p a re a b a la n c e sheet, a p p ro p ria te ly c la s s ifie d , as a t 3 0 June 2 0 1 6 fo r In co b Ltd.
1
T
Share capital
161 000
Property, plant and equipment, at cost
550000
Accounts payable
61 000
Accounts receivable
68 000
Cash and cash equivalents
43 000
Notes payable
30000
Prepayments
1 0000
Long-term debt, excluding current portion
200000
Long-term investments
110 00 0
Provision for employee entitlements (noncurrent) Retained profits Income taxes payable
34000 184000 32 000
Inventory
81 000
Patents and trademarks
55 000
Current portion of long-term debt Accumulated depreciation
25 000 190000
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
71
PROBLEM 2 .4 Prepare a classified balance sheet Based on the fo llo w in g in fo rm a tio n , p re p a re an a p p ro p ria te ly c la s sifie d b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r JKL Lim ited. 1
$000 Share capital Cash Accounts payable
45 092 63 382 105344
Retained profits
39 346
Accounts receivable
98 264
Interest-bearing liabilities (current)
192370
Inventories
110234
Provisions (current) Property, plant and equipment
70 876 181148
PROBLEM 2 .5 Explain balance sheet ideas to a business executive Y ou a re the e x e c u tiv e assistant to S te p h a n e S o ld e n , a p a rtic u la rly h a rd -d riv in g a n d successful o w n e r o f a c h a in o f re stau ran ts. N o t lo n g a g o , S olde n a n d y o u w e re fly in g to a n o th e r c ity , a n d th e in flig h t film w a s so b a d th e tw o o f y o u e n d e d up ta lk in g a b o u t a ll sorts o f th in g s. O n e s u b je c t w a s S o ld e n 's im p a tie n c e w ith a c c o u n ta n ts a n d a c c o u n tin g w h ic h , p ro b a b ly be ca u se the a n n u a l a u d it o f th e c o m p a n y 's a c co u n ts w a s then ta k in g p la c e , seem ed p a rtic u la rly s tro n g . H o w w o u ld y o u re s p o n d to th e fo llo w in g q u e s tio n s fro m S olde n? 1 'T he m a in th in g th a t sticks in m y m in d a b o u t th e b a la n c e sheet is th a t th e th in g b a la n c e s ! W h o cares? W h y sh o u ld it m a tte r? ' 2
3
'M y a u d ito r keeps w a n tin g to ta lk to m e a b o u t w h a t th e b a la n c e sheet says a b o u t th e c o m p a n y 's fin a n ce s a n d h o w I've m a n a g e d th em . But I a lw a y s lo o k to th e fu tu re - w h y sh o u ld I c a re a b o u t th e b a la n c e shee t w h e n it's just a " s n a p s h o t" o f h is to ry ? ' 'Last y e a r, I h a d a re a lly g o o d id e a a b o u t th e b a la n c e sheet. Y ou k n o w , I c o n s id e r o u r re s ta u ra n t m a n a g e rs to be th e m ost im p o rta n t asset th e c o m p a n y has. I w a s g o in g to h a ve th e m a n a g e rs a d d e d to th e b a la n c e sheet as assets, so it w o u ld s h o w a ll o u r assets. But th e a c c o u n ta n ts a n d a u d ito rs d id n 't seem in tere ste d in m y id e a . W h y no t? '
4
'S o m e o n e to ld m e o n c e th a t th e b a la n c e sheet is a p h o to g ra p h o f th e business a t a p a rtic u la r in sta n t in tim e , a n d th a t y o u h a ve to be c a re fu l b e ca u s e som e a c c o u n ta n t m ig h t h a ve to u c h e d up th e p h o to , a irb ru s h e d a w a y the w a rts . W h a t d id th e y m e an ? Isn't th e b a la n c e sheet an e x a c t list o f a ll th e c o m p a n y 's assets a n d lia b ilitie s ? '
C la s s ify e a ch item as it w o u ld be re p o rte d on a b a la n c e sheet using th e fo llo w in g c a te g o rie s : c u rre n t asset, no n c u rre n t asset, c u rre n t lia b ility , n o n c u rre n t lia b ility a n d s h a re h o ld e rs ' e q u ity .
PROBLEM 2 .6 Prepare sim ple balance sheet, notes, 'w hat i f analysis S c a llo p s G a lo re Ltd is a s e a fo o d e a te ry s p e c ia lis in g in shellfish a n d soups. The prem ises a re ren ted a n d a ll sales a re fo r cash , so th e c o m p a n y has o n ly a fe w b a la n c e sheet a c co u n ts. The a c co u n ts, as a t 3 0 June 2 0 1 6 , a re as fo llo w s .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Food supplies cost Equipment cost Other supplies cost
2 100 64900 4500
Cash at bank
2 200
Payable to suppliers
5 300
Long-term loan Wages payable
25 000 900
Share capital
1 0000
Accumulated depreciation
27400
Retained profits
5 100
Required: 1
P re p a re a b a la n c e sheet fo r S c a llo p s G a lo re Ltd as a t 3 0 June 2 0 1 6 . In clu de a n y notes to th e b a la n c e sheet th a t y o u th in k m ig h t be useful.
2
C o m m e n t on th e c o m p a n y 's fin a n c ia l p o s itio n as s h o w n b y y o u r b a la n c e sheet.
3
S u p p o se , w h e n y o u w e re re v ie w in g th e c o m p a n y 's a cco u n ts a fte r p re p a rin g th e b a la n c e sheet, y o u fo u n d an e rro r in th e re c o rd s. The c o m p a n y h a d p a id a s u p p lie r $ 2 9 0 0 , b u t th a t p a y m e n t h a d in a d v e rte n tly no t been d e d u c te d fro m th e c o m p a n y 's b a n k a c c o u n t re c o rd o r fro m its re c o rd o f a c co u n ts p a y a b le to s u p p lie rs . Y ou d e c id e d to re c o rd th a t p a y m e n t. W h a t ch a n g e s resulted in th e b a la n c e sheet y o u p re p a re d in q u e s tio n 1 a n d in y o u r com m en ts in q u e s tio n 2?
PROBLEM 2.7 Prepare a classified balance sheet From th e fo llo w in g in fo rm a tio n , p re p a re a n a p p ro p ria te ly c la s s ifie d b a la n c e sheet as a t 3 0 June 2 0 1 6 fo r M S P O Lim ited.
$000 Share capital
67358
Cash
31 691
Accounts payable
52 672
Retained profits
39 346
Receivables ($1 549 000 due in more than one year)
49132
Interest-bearing liabilities ($8 732 000 due this year)
96185
Intangibles
49 053
Deferred tax liabilities
4962
Inventories
55 117
Provisions ($31 704 000 due within one year)
35 438
Property, plant and equipment
90574
Reserves Deferred tax assets
7 320 16 974
Other long-term assets (financial assets)
2416
Other current assets (prepayments)
8 324
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PROBLEM 2 .8 C orrecting a balance sheet F in ew in es Lim ited b e g a n business on 1 J u ly 2 0 1 5 , p ro d u c in g a n d s e llin g w in e . O n e y e a r la te r, th e c o m p a n y 's n e w ly a p p o in te d a c c o u n ta n t, A l Beer, needs to p ro d u c e a b a la n c e sheet fo r a m e eting o f c o m p a n y executive s. U n fo rtu n a te ly , A l is m o re s kille d a t w in e m a k in g th a n he is a t a c c o u n tin g , a n d has req ue ste d y o u r a d v ic e . H e show s y o u th e fo llo w in g b a la n c e sheet he has p re p a re d . FINEWINES LIMITED BALANCE SHEET AS AT 3 0 JUNE 20 16 Assets
Liabilities and shareholders' equity
Cash
4 340
Net profit for the year Inventory of grapes
24720 9 800
Accounts payable
Accounts receivable
10460
Share capital
40000
Kitchen equipment
50 800
10680
A ssum e th a t th e a c c o u n t b a la n c e s A l has used a re c o rre c t. P rep are a c o rre c te d b a la n c e sheet. P ro v id e an e x p la n a tio n o f th e m a in d iffe re n c e s b e tw e e n y o u r b a la n c e sheet a n d th e o n e A l p re p a re d .
PROBLEM 2 .9 Basic balance sheet, n e t p ro fit and retained p ro fits ideas LB Ltd h a d th e fo llo w in g recen t b a la n c e sheet as a t 3 0 S e p te m b e r 2 0 1 6 : Cash Inventory Land
1 642 480 3 100
Mortgage Share capital Retained profits
5 222
500 3 500 1 222 5 222
1
W h y is 'la n d ' on th e b a la n c e sheet, a n d w h a t do es it represent?
2
O n 5 O c to b e r 2 0 1 6 , th e c o m p a n y b o rro w e d $ 2 4 1 0 fro m th e b a n k a n d used th e m o n e y im m e d ia te ly to b u y m o re la n d . W h a t w a s th e to ta l d o lla r fig u re o f th e c o m p a n y 's assets a fte r this p o in t?
3
W h y d id th e c o m p a n y no t just use th e $ 3 5 0 0 s h a re c a p ita l to b u y m o re la n d in ste a d o f b o rro w in g fro m the bank?
4
E x p la in w h a t 're ta in e d p ro fits ' represents.
5
For th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e c o m p a n y 's revenues w e re $ 1 0 1 1 6 a n d its expe nses (in c lu d in g in c o m e tax) w e re $ 9 8 8 1 . D u rin g th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e c o m p a n y d e c la re d d iv id e n d s o f $1 2 0 . W h a t w a s th e b a la n c e in re ta in e d p ro fits a t th e b e g in n in g o f th a t y e a r (1 O c to b e r 2 0 1 5 )?
6
If the 2 0 1 6 expe nses w e re $1 1 6 0 0 in ste a d o f th e fig u re in p o in t 5 , a n d th e c o m p a n y d id n o t d e c la re a n y d iv id e n d s , w h a t w o u ld th e re ta in e d p ro fits be a t 3 0 S e p te m b e r 2 0 1 6 ? H o w w o u ld y o u in te rp re t this nu m b er?
PROBLEM 2.10 Incom e s ta te m e n t and balance sheet The fo llo w in g a c c o u n t b a la n c e s a re ta ke n fro m th e b o o ks o f C e n tu ry C in e m a s on 31 D e c e m b e r 2 0 1 6 . R evenues a n d expe nses a re fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . The re ta in e d p ro fits b a la n c e is as a t 1 J a n u a ry 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
$ Accounts receivable
13 450
Accounts payable
1 3 9 10
Advertising expense
42 780
Cash
4610
Confectionery sales
12 300
Cost of confectionery sold
1 0 5 00
Electricity expense
5 090
Furniture and fittings
34000
Inventory
18 000
Land and buildings
60000
Loan payable
35 000
Projection equipment
41 000
Rent expense
33 200
Retained profits, 1 January 2016
59 720
Share capital
60000
Ticket revenue
81 700
1
P re p a re an in c o m e state m e nt fo r C e n tu ry C in e m a s fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
2
P re p a re a note fo r re ta in e d p ro fits fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
P re p a re a b a la n c e sheet as a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 2.11 Com paring p ro fit w ith cash Flow G o ld C o a s t C ustom s w a s o rg a n is e d o n 1 July 2 0 1 6 . A t th e en d o f th e firs t y e a r o f o p e ra tio n s th e o w n e r p re p a re d th e fo llo w in g s u m m a ry o f its a c tiv itie s . 1 C u s to m is e d c a r services p e rfo rm e d fo r custom ers, $1 3 7 7 5 0 , o f w h ic h $ 2 2 4 0 0 re m a in e d u n co lle cte d a t th e en d o f the y e a r. 2
C a s h b o rro w e d fro m th e b a n k , $ 8 0 0 0 0 .
3
E q u ip m e n t p u rc h a s e d fo r $ 4 5 0 0 0 cash a t th e e n d o f th e y e a r to be used in th e business fo r tw o y e a rs s ta rtin g th e ne xt y e a r.
4
W a g e s e a rn e d b y e m p lo y e e s , $ 6 7 6 0 0 , o f w h ic h 2 0 p e r c e n t re m a in e d u n p a id a t th e e n d o f th e y e a r.
5
O th e r o p e ra tin g expe nses, $ 4 6 0 2 0 , o f w h ic h $1 2 0 0 0 re m a in e d u n p a id a t th e e n d o f th e y e a r. S h o w th e e ffe c t on net p ro fit a n d cash o f e a ch o f th e a b o v e tra n sa ctio n s.
PROBLEM 2.12 Indicate the e ffe cts o f tra n sa ctio n s W ith re sp e ct to th e c u rre n t a c c o u n tin g p e rio d , s h o w th e e ffe c t o f th e fo llo w in g tra n s a c tio n s on net p ro fit a n d cash fo r th e p e rio d . 1 P urchase in v e n to ry on cash fo r $ 4 0 0 0 0 . 2
R e c o rd in g d e p re c ia tio n o f $ 1 0 0 0 0 .
3
C re d it sale o f a s ervice fo r $ 3 0 0 0 0 .
4
P aym e nt o f a cash d iv id e n d o f $ 8 0 0 0 .
5
P aym e nt o f s a la ry fo r th e c u rre n t p e rio d o f $ 2 0 0 0 0 .
6
Interest p a y m e n t on a lo a n o f $ 7 0 0 0 .
7
R ep a ym e n t o f a lo a n o f $ 1 0 0 0 0 0 .
8
P aym e nt o f a n in v o ic e fo r a d v e rtis in g o f $ 1 3 0 0 0 th a t h a d been re c o rd e d as a n e x p e n s e in th e p re vio u s p e rio d .
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PROBLEM 2.13 E ffe ct o f tra n sa ctio n s on assets, lia b ilitie s and shareholders' e q u ity W h a t is th e e ffe c t on assets, lia b ilitie s a n d s h a re h o ld e rs ' e q u ity o f e a ch o f th e fo llo w in g tra n sa ctio n s? 1 C o n trib u te cash to th e c o m p a n y in return fo r shares.
2
B o rro w m o n e y fro m th e b a n k .
3
R eceive p a y m e n t fro m a d e b to r.
4
P urchase in v e n to ry o n c re d it.
5
P urchase in v e n to ry fo r cash.
6
Pay a c co u n ts p a y a b le .
7
R eceive in tere st th a t w a s d u e fro m th e p re vio u s a c c o u n tin g p e rio d .
8
P urchase fu rn itu re a n d fittin g s on c re d it.
9
A n o w n e r's c o n trib u tio n o f his m o to r v e h ic le to th e c o m p a n y in return fo r a d d itio n a l shares.
PROBLEM 2.14 E ffects o f tra n sa ctio n s on assets, lia b ilitie s and shareholders' e q u ity W h a t is th e e ffe c t on assets, lia b ilitie s a n d s h a re h o ld e rs ' e q u ity o f e a ch o f th e fo llo w in g tra n sa ctio n s? Use the n o ta tio n s 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t'. 1
O w n e rs o f th e c o m p a n y c o n trib u te m o to r ve h icle s in return fo r a d d itio n a l shares.
2
R eceive p a y m e n t fro m a c co u n ts re c e iv a b le .
3
P urchase e q u ip m e n t fo r cash .
4
Issue shares to p a y o ff a long -term lo a n .
5
Pay am o u n ts o w e d to a cco u n ts p a y a b le .
6
Sell in v e n to ry fo r cash a t a p ric e h ig h e r th a n its cost.
7
P urchase in v e n to ry o n c re d it.
8
Pay s a la rie s to e m p lo y e e s .
PROBLEM 2.15 Balance sheet and incom e s ta te m e n t e ffects o f Failure to record transactions U sing th e n o ta tio n s 'in c re a s e ', 'd e c re a s e ' a n d 'n o e ffe c t', in d ic a te th e e ffe c t on assets, lia b ilitie s , s h a re h o ld e rs ' e q u ity a n d ne t p ro fit b e fo re ta x o f fa ilin g to re c o rd e a ch o f th e fo llo w in g in d e p e n d e n t tra n sa ctio n s o r events: 1 A $ 2 0 0 0 0 0 p ie c e o f e q u ip m e n t p u rc h a s e d o n c re d it.
2
In ve n to ry o f $ 3 0 0 0 0 p u rc h a s e d on a c co u n t.
3
S ale o f in v e n to ry (co sting $ 3 0 0 0 0 ) on c re d it fo r $ 5 0 0 0 0 .
4
A lo a n re c e ive d fro m th e b a n k fo r $ 8 0 0 0 0 .
5
P aym e nt o f w a g e s o f $ 1 0 0 0 0 0 fo r th e p e rio d .
PROBLEM 2.16 Recording o f assets State w h e th e r o r n o t an asset sh o u ld be re c o rd e d in th e b a la n c e sheet o f XYZ Ltd as a t 3 0 June 2 0 1 6 in e a ch o f the fo llo w in g s itu a tio n s . State th e a m o u n t (if an y) o f th e asset, a n d a n y a s su m p tio n s m a d e . 1 O n 15 M a y 2 0 1 6 , X YZ Ltd p a id In su ra nce Ltd $ 2 0 0 0 0 fo r an in su ra n c e p re m iu m . The p re m iu m cove rs losses in c u rre d du e to fire , th eft o r o th e r causes up to 1 4 M a y 2 0 1 7 .
2
X YZ Ltd p a id $ 1 5 0 0 0 fo r a p a te n t in A p r il 2 0 1 6 .
3
X YZ Ltd has just h ire d a n e w g e n e ra l m a n a g e r w h o is an e x p e rt in th e business c a rrie d on b y X YZ Ltd. W ith the h e lp o f this p e rso n , th e c o m p a n y is e x p e c te d to in cre a s e its a n n u a l p ro fits b y $ 5 0 0 0 0 0 . The g e n e ra l m a n a g e r's s a la ry is $ 3 0 0 0 0 0 p e r an n u m .
4
X YZ Ltd p u rc h a s e d la n d in 2 0 0 9 fo r $ 1 0 0 0 0 0 . The m a rke t v a lu e o f this la n d is $ 1 5 0 0 0 0 as a t 3 0 June 2 0 1 6 .
5
A m a c h in e is p u rc h a s e d fo r $1 m illio n a n d costs a n a d d itio n a l $ 4 0 0 0 0 0 to in sta ll.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 2.17 Recording o f lia b ilitie s State w h e th e r o r n o t e a c h o f th e fo llo w in g events w o u ld result in a lia b ility b e in g re c o g n is e d in th e a cco u n ts a t 3 0 June. 1 Taxes fo r th e y e a r e n d e d 3 0 June, w h ic h a re no t p a y a b le until O c to b e r. 2
W a g e s to be p a id on 2 July to c o v e r th e tw o -w e e k p e rio d up to 3 0 June.
3
The c o m p a n y sells w a s h in g m a ch in e s a n d g ive s a o n e -y e a r w a rra n ty to re p a ir o r re p la c e a n y fa u lty m a ch in es.
4
A c o n s tru c tio n c o m p a n y receives a $ 1 0 m illio n a d v a n c e in June o n a c o n tra c t. The w o rk w ill c o m m e n ce in July.
5
The c o m p a n y has s ig n e d a c o n tra c t to p a y its m a n a g in g d ire c to r $1 m illio n p e r a n n u m (in fla tio n a d ju ste d ) fo r the n e xt fo u r y e a rs .
PROBLEM 2.18 Recognise revenue C a lc u la te th e to ta l reven ue fo r th e m o nth o f F e b ru a ry 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 C re d it sales o f $ 1 0 0 0 0 0 m a d e in F e b ru a ry ; 5 0 p e r c e n t to be c o lle c te d in F e b ru a ry. 2
C a s h sales o f $ 1 5 0 0 0 0 .
3
R eceived re n ta l reven ue o f $ 5 0 0 0 fo r th e m o nth o f F e b ru a ry.
4
Interest o f $ 8 0 0 0 is c re d ite d to th e c o m p a n y b a n k statem ent. It relate s to in tere st e a rn e d fo r th e six m onths fro m 1 A u g u s t 2 0 1 5 to 31 J a n u a ry 2 0 1 6 .
5
R eceived $ 1 0 0 0 0 as a d e p o s it fro m a c u sto m e r fo r a jo b to b e c a rrie d o u t in M a rc h .
PROBLEM 2.19 Recognise revenue C o p ie r Ltd m a n u fa c tu re s a n d sells sm all ho m e p h o to c o p ie rs to hom es a n d sm all businesses; it a ls o sells c a rtrid g e s to g o in th e c o p ie rs a n d m o n th ly m a g a z in e s on ru n n in g a sm all business. C o n s id e r th e fo llo w in g tra n sa ctio n s: 1 It d e liv e rs 1 0 p h o to c o p ie rs ; th e c u sto m e r p ro m ises to p a y $ 2 0 0 0 0 w ith in tw o m onths. 2
It bu ys a m o to r v e h ic le w ith a list (o r 's tic k e r') p ric e o f $ 4 1 0 0 0 fo r $ 3 1 2 0 0 cash.
3
It receives o rd e rs fo r 1 0 0 0 in k c a rtrid g e s fro m custom ers fo r $ 1 8 e a ch fo r fu tu re d e liv e ry . The term s re q u ire p a y m e n t in fu ll w ith in 3 0 d a y s o f d e liv e ry .
4
It c o m p le te s p ro d u c tio n o f th e in k c a rtrid g e s d e s c rib e d in p o in t 3 a n d d e liv e rs th e o rd e r.
5
It issues $ 2 m illio n in n e w shares.
6
It receives a to ta l o f $ 3 6 0 0 fro m su b s crib e rs to th e m a g a z in e . The s u b s c rip tio n s c o v e r a fu ll 1 2 e d itio n s fo r the y e a r. O n ly th e firs t e d itio n has be en po ste d to custom ers.
For e a ch o f th e a b o v e tra n s a c tio n s , state if reven ue is to be re c o g n is e d in th e c u rre n t fin a n c ia l y e a r, a n d in d ic a te the reven ue a c c o u n t title a n d a m o u n t. If reven ue is no t to be re c o g n is e d this y e a r, e x p la in w h y .
PROBLEM 2 .2 0 Recognise expenses C a lc u la te th e to ta l expe nses fo r th e m o nth o f F e b ru a ry 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 P aid s a la rie s o f $ 2 0 0 0 0 ; $ 5 0 0 0 re la te d to w o rk c a rrie d o u t in J a n u a ry a n d $ 1 5 0 0 0 re la te d to F e b ru a ry w o rk . 2
P aid c o m m is sio n expe nses o f $ 1 0 0 0 0 in F e b ru a ry. The c o m m is sio n re la te d to J a n u a ry sales.
3
P aid re n t fo r th e m onth o f F e b ru a ry o f $ 3 0 0 0 o n 9 F e b ru a ry.
4
R eceived a b ill fo r $ 7 5 0 fro m a p lu m b e r fo r re p a ir w o rk d o n e on 2 5 F e b ru a ry. This w ill be p a id n e xt m o nth.
5
P aid a n $ 8 0 0 0 0 d e p o s it o n a b lo c k o f la n d .
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PROBLEM 2.21 R ecognising expenses C a lc u la te th e to ta l expe nses fo r th e m onth o f June 2 0 1 6 , g iv e n th e fo llo w in g tra n sa ctio n s. 1 P aid sa la rie s o f $ 6 0 0 0 0 ; $ 5 0 0 0 0 re la te d to w o rk c a rrie d o u t in M a y 2 0 1 6 a n d $ 1 0 0 0 0 re la te d to June 2016.
2 A p h o n e b ill fo r $ 1 2 0 0 w a s re c e ive d fo r th e u sag e on June. This a m o u n t w ill be p a id o n 1 July 2 0 1 6 . 3
A $ 6 5 0 0 0 d e p o s it w a s p a id fo r a b lo c k o f la n d .
4
P aid rent fo r th e m onth o f June o f $ 6 0 0 0 on 1 June 2 0 1 6 .
5
A c o m m is sio n e x p e n s e o f $ 8 0 0 0 w a s p a id in June. The c o m m is sio n re la te d to A p r il sales.
PROBLEM 2 .2 2 When is revenue earn e d ? Is reven ue e a rn e d fro m th e fo llo w in g tra n sa ctio n s? G iv e reasons fo r y o u r an sw e rs. 1 G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 9 5 0 0 .
2 G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 6 0 0 0 . 3
G o o d s c o stin g $ 6 0 0 0 a re s o ld fo r $ 4 5 0 0 .
4 A s u rv e y o r sends an a c c o u n t fo r $ 1 5 0 0 0 to a b u ild e r fo r w o rk in c o n n e c tio n w ith a s u b d iv is io n o f a b lo c k o f la n d . 5
A n e le c tric a l store p ro v id e s a fre e s ervice o n a te le v is io n set d u rin g th e w a rra n ty p e rio d . The cost to th e store w a s $250.
6 A n in ve stm en t c o m p a n y receive s a d iv id e n d o f $ 8 0 0 0 o n o n e o f its investm ents.
7 G o o d s c o stin g $ 1 0 0 a re s o ld fo r $ 1 6 0 . Instead o f p a y in g fo r th e g o o d s , th e c u stom er c le a n s th e store's w in d o w s . This c le a n in g is n o rm a lly c a rrie d o u t b y an o u ts id e c o n tra c to r a t a cost o f $1 6 0 .
PROBLEM 2 .2 3 A ccountants, ethics and the balance sheet A s has been in d ic a te d seve ral tim es so fa r (in s ection 2 .7 , fo r e x a m p le ), m a n a g e rs o f businesses a n d o th e r o rg a n is a tio n s a re v e ry c o n c e rn e d a b o u t h o w th e b a la n c e sheet reflects th e ir m a n a g e m e n t o f th e e n te rp ris e . This is v e ry u n d e rs ta n d a b le , a n d g e n e ra lly a p p ro p ria te to o , b e ca u s e such c o n c e rn is lik e ly to m a ke m a n a g e rs w a n t to d o a g o o d jo b o f m a n a g in g . But it c a n a ls o le a d to a te m p ta tio n to a lte r th e in fo rm a tio n in a m a n a g e r's fa v o u r. The p o s s ib ility o f such a te m p ta tio n is p a rt o f th e rea so n a u d ito rs a re e m p lo y e d to e x a m in e fin a n c ia l statem ents, in c lu d in g th e b a la n c e sheet. This te m p ta tio n c a n a ls o p ro d u c e e th ic a l p ro b le m s fo r p ro fe s s io n a l a c co u n ta n ts e m p lo y e d b y th e e n te rp ris e . O n th e o n e h a n d , such an a c c o u n ta n t is b o u n d b y th e e th ic a l rules o f th e p ro fe s sio n to see th a t p ro p e r a c c o u n tin g m e tho ds a re fo llo w e d in p re p a rin g th e c o m p a n y 's b a la n c e sheet, w h ic h w o u ld im p ly th a t th e in fo rm a tio n sh o u ld no t be a lte re d in m a n a g e m e n t's fa v o u r. O n th e o th e r h a n d , such an a c c o u n ta n t w o rk s fo r s e n io r m a n a g e m e n t a n d is lik e ly to b e b o u n d b y th e c o n tra c t o f e m p lo y m e n t to p u t th e e n te rp ris e 's interests first. W h a t do es such an a c c o u n ta n t (such as th e c h ie f a c c o u n ta n t re s p o n s ib le fo r p re p a rin g th e e n te rp ris e 's fin a n c ia l statem ents) d o if s e n io r m a n a g e m e n t (such as th e g e n e ra l m a n a g e r) w a n ts to a lte r th e b a la n c e sheet to m a ke th in g s lo o k be tte r a n d m akes a g o o d c a se th a t such an a c tio n w ill h e lp th e e n te rp ris e g e t b a n k lo a n s a n d th e o th e r a ssista n ce it needs? Discuss th is s itu a tio n fro m th e v ie w p o in t o f bo th th e g e n e ra l m a n a g e r a n d th e c h ie f a c c o u n ta n t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASES CASE 2A
W oolworths Limited
Refer to th e e x tra c ts o f th e 2 0 1 4 a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to th e c o n s o lid a te d acco un ts. 1 A t w h a t p o in t in tim e is th e b a la n c e sheet d ra w n up? 2
W h a t is th e c u rre n c y in w h ic h a c co u n ts in th e b a la n c e sheet a re m e asure d?
3
Illustrate h o w th e 2 0 1 4 b a la n c e sheet o f W o o lw o rth s Lim ited b a la n ce s.
4
H o w w e re th e assets fin a n c e d ?
5
H o w is th e 'n e t assets' fig u re d e te rm in e d ?
6
W h a t a re th e b a la n c e s o f c u rre n t assets, c u rre n t lia b ilitie s , n o n c u rre n t assets a n d n o n c u rre n t lia b ilitie s a t 2 9 June 2014?
7
W h a t is th e b a la n c e o f w o rk in g c a p ita l a t 2 9 June 2 0 1 4 ?
8 W h a t d iv id e n d s w e re p a id d u rin g th e y e a r? 9
W h a t is th e a m o u n t o f s h a re c a p ita l issued?
1 0 W h a t c o m p a n ie s w o u ld be in c lu d e d in th e c o n s o lid a te d fig u re s? 11 W h a t is c o st o f g o o d s s o ld fo r W o o lw o rth s in 2 0 1 4 ? 12 For W o o lw o rth s in 2 0 1 4 , a re th e net p ro fits fro m o rd in a ry a c tiv itie s a fte r ta x a n d th e c h a n g e in th e cash b a la n c e th e sam e am ounts? 13 W h a t is th e a m o u n t o f net p ro fit fo r 2 0 1 4 ? 14 W h a t a m o u n t o f reven ue w a s e a rn e d in 2 0 1 4 ? 15 H o w m uch in v e n to ry (in d o lla rs) do e s th e c o m p a n y h a ve as a t 2 9 June 2 0 1 4 ? 16 By w h a t a m o u n t d id cash a n d cash e q u iv a le n ts c h a n g e d u rin g th e m ost recen t y e a r?
CASE 2B___________________________ Interpreting balance sheets 1
'Q a n ta s A irw a y s . . . la u n c h in g a $ 5 0 0 m illio n c a p ita l ra is in g to stre n g th e n its b a la n c e sheet a n d c o n tin u e fu n d in g a fle e t u p g ra d e b e fo re c o n d itio n s w o rs e n . . . " A s trong b a la n c e sheet fo r us w ill be c ritic a l g o in g fo r w a r d ," s a id M r J o yce . . . A irlin e s g lo b a lly a re stee lin g fo r $ U S 5 b illio n ($ 7 .8 b illio n ) in losses this y e a r a lo n e as th e y g ra p p le w ith p lu n g in g d e m a n d . . . ' (A u s tr a lia n F in a n c ia l R e v ie w , 5 F e b ru a ry 2 0 0 9 ) .
2
'A N Z last n ig h t ru le d o u t a c a p ita l-ra is in g in th e s h o rt te rm , d e c la rin g its b a la n c e shee t w a s a m o n g th e s trong est o f th e m a jo r A u s tra lia n b a n k s. S p e c u la tio n h a d m o u n te d th a t A N Z w o u ld ta p s h a re h o ld e rs fo r e x tra fu nds to b o o s t c a p ita l ra tio s . . . ' (A u s tr a lia n F in a n c ia l R e v ie w , 1 3 F e b ru a ry 2 0 0 9 ) .
3
'A M P has jo in e d th e e v e r-g ro w in g list o f c o m p a n ie s to cu t d iv id e n d s d u rin g th e e a rn in g s season . . . to s treng th en its b a la n c e sheet as its cash flo w c o n tin u e s to be b a tte re d . . . The c ritic a l p rio rity is to m a in ta in b a la n c e sheet streng th to c o n tin u e w ith s ta n d in g th e o n g o in g v o la tility . . . ' ( W e e k e n d A u s tr a lia n F in a n c ia l R e v ie w , 1 4 - 1 5 F e b ru a ry 2 0 0 9 ) .
4
'M s W e s tw a te r s a id th e a d v a n ta g e o f Q u e e n s la n d 's stro n g b a la n c e sheet w a s th a t it e n a b le d th e state to w ith s ta n d a n y u n e x p e cte d sh o c ks ' (A u s tr a lia n F in a n c ia l R e v ie w , 11 J a n u a ry 2 0 0 7 ) .
Required: Discuss th e im p lic a tio n s o f e a ch o f th e qu ote s fro m th e p o in t o f v ie w o f th e com m en ts m a d e o n th e ir b a la n c e sheets.
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
79
CASE 2C______________The importance of balance sheets in making decisions R ead th e fo llo w in g e x tra c t.
T e lstra talks dow n T3 buyback b y C o lin K r u g e r T e ls tra . . . has p o u re d c o ld w a te r o n t h e p r o s p e c t o f a s ig n ific a n t s h a re b u y b a c k . . . ‘W e ’v e g o t a s tro n g b a la n c e s h e e t b u t w e d o n ’t w a n t t o w e a k e n t h a t b a la n c e s h e e t . . .’ B r o k e r r e p o r ts h a ve e s tim a te d T e ls tra c o u ld b u y b a c k $ 1 0 b illio n in [s h a re s ] . . .
w ith o u t h a v in g a
s ig n ific a n t e f f e c t o n th e c o m p a n y ’s d e b t ra tin g . . .’ Source: C. Kruger, Telstra Talks Down T3 Buyback’, Sydney Morning Herald, 2 2 M arch 2 0 0 5 .
Required: 1 W h a t is m e a n t b y a s h a re b u y b a c k ? 2
W h a t is m e a n t b y a d e b t ra tin g ? W h y is it im p o rta n t?
3
W h a t ro le do e s th e b a la n c e sheet p la y in th e d e c is io n s fo r Telstra d iscusse d in this a rtic le ?
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m
p r e p a r a tio n to o ls . >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
>
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
80
APPENDIX TO CHAPTER 2
Background: sole traders, partnerships, companies and Financing To help you further understand the b a la n ce sheet, read the fo llo w in g background m aterial. This section focuses on the right-hand side o f the accounting equation, exam ining h o w the form o f business organisation determines the w a y ow ners' equity is shown on the b a la n ce sheet a nd outlining h o w both right-hand terms in d ica te h o w the assets are financed. This book's glossary w ill also help you to understand the term inology. There are m any im portant forms o f o rganisation, such as businesses organised as partnerships, com panies or cooperatives, an d non-business organisations such as clubs, charities, governments an d p o litica l parties. H ow ever, they cannot all be described here. Instead, w e w ill focus on four main kinds of business organisations a n d their main methods of financing.
A2.1
Four kinds of business organisation
You have seen that each b a la n ce sheet has an ow ners' equity section. The exam ples o f Sound an d Light Ltd and C h e z Ltd indicated that the equity could be considered to be o f tw o general kinds for a business enterprise: •
directly contributed equity, in w h ich ow ners have p rovided m oney o r other assets to the enterprise
•
indirectly contributed equity (retained profits), in w h ich ow ners have a llo w e d profits earned b y the enterprise to remain there, to help earn m ore profits in the future. The legal m eaning o f being an o w n e r depends on w h a t kind o f organisation exists. The equity section o f the
b alance sheet reflects that legal m eaning, so that ow ners an d other users w ill understand the status o f their equity. Four main kinds o f business organisations are the sole trader, the partnership, the c o m p a n y an d the co rp o ra te group.
Sole trader A sole trader (sole proprietorship) is a business o w n e d by o ne person (the proprietor). It does not le g a lly exist separately from the ow n e r. Because the business does not exist as a separate legal entity, it is said to be unincorporated. If S im one, a jew eller, just starts up a business o ne d a y on her o w n w ith o u t further legal steps, the business is a sole trader. Legally, such a business is not distinguishable from Sim one's non-business affairs. If she w ishes, she can use the business cash to buy groceries (although separate records of business transactions must be kept for tax purposes), a nd if she does not p a y her business bills, her creditors can claim aga in st a n y non-business assets she has. Because a sole trader has no separate legal existence, the equity section o f the b a la n ce sheet does not necessarily distinguish betw een the o w n e r's direct contributions to the business a nd the indirect contributions by retained profits. Both kinds o f equity are sim ply lum ped together as ow ners' c a p ita l. The ow ners' equity section o f the b alance sheet just says: I O w ners'equity Owners' capital
I $xxxx
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
81
Partnership A partnership is also unincorporated, but it has m ore than one ow n e r. Partnerships are not separate legal entities, and all partners a re personally responsible for the debts o f the partnership. A g a in , the ow ners' personal assets can be claim e d b y business creditors, so there is the same, som ew hat arbitrary, distinction betw een business affairs and personal affairs. The fact that there is m ore than one o w n e r introduces some form ality into the business. For exam ple, there is (or should be) an agreem ent a b o u t h o w the profits o f the business are to be split am ong the partners an d a b o u t h ow much each partner can w ith d ra w from the business. Because stress can d e ve lo p in partnerships, states an d countries have partnership law s that pro vid e some structure if the partners d o not d o so themselves. A partnership's ow ners' equity section of the b a la n ce sheet, like that for a sole trader, does not necessarily distinguish betw een ow ners' direct contributions a nd retained profits. The o n ly difference is that each o w n e r's total c a p ita l is identified on the fa ce o f the b a lan ce sheet (or, if there are m any partners, as in firms o f law yers, accountants o r engineers, in a separate schedule). Therefore, the ow ners' equity section o f the partnership's b a la n ce sheet shows: I O w ners'equity
$
Partners' capital: Partner A
xxxx
Partner B
xxxx
Partner C
xxxx
Total capital
xxxx
W h e n an individual w ishes to leave the partnership, it is necessary to o btain the permission o f existing partners to transfer o w nership to a n ew partner. As w ith sole traders, partnerships a re not legal entities, but for accounting purposes they are considered as a separate entity from the partners.
Company C om p a n ie s a re legal entities established under C o rporations Law. The co m p a n y's c a p ita l is d iv id e d into shares, and the ow ners are called shareholders. C o m p a n ie s are separate legal entities; therefore, they can buy, o w n a nd sell assets, enter into contracts in their o w n right, an d sue an d be sued. The m ajor a d va n ta g e o f a c o m p a n y structure is that a c o m p a n y has lim ited lia b ility in the event o f its failure. This means that shareholders are not lia b le for debts incurred by a c o m p a n y once their shares have been p a id for in full; that is, their lia b ility is lim ited to the u n paid am ount on a n y shares bought. A ll com panies that have lim ited lia b ility have the w o rd 'Lim ited' o r 'Ltd' after their name. O th e r advantages o f a c o m p a n y structure include the ease o f transfer of o w n e rsh ip an d increased b o rro w in g pow e r. The shares o f public com panies can g e n e ra lly be sold freely, a n d transfer o f o w nership does not affect the continuity o f operations. Stock exchanges pro vid e a convenient means for the disposal an d acquisition o f shares and for m aking known the prices that sellers a re w illin g to a cce p t an d that buyers are prepared to offer. In the case o f the death o f a shareholder in a co m p a n y, ow n e rsh ip o f the share norm ally passes to the beneficiary o f the deceased shareholder, w ith o u t interruption to the activities of the com pany. A c o m p a n y has a v a ila b le to it a num ber o f sources o f funds that a re d e nied to a sole proprietorship o r a partnership. Debentures or unsecured notes m ay be issued b y a co m p a n y. A debenture is a docum ent that evidences an undertaking by a c o m p a n y to repay a particular am ount a t o r before an a g re e d d ate, a n d to p a y interest a t an a gree d rate at specified intervals. The d e b t m ay be secured by a specific c h a rg e over certain assets, o r by a 'flo a ting
82
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
c harge' over all the assets o f the com p a n y. H ig h ly regarded com panies m ay be a b le to o btain funds w ith o u t p le d g in g assets; that is, b y the issue o f unsecured notes o r the a cce p ta n ce o f deposits. Because o f these advantages, particularly lim ited lia b ility, most business enterprises are com panies. Even your local new sagent, chemist o r corner shop is likely to have a d o p te d a c o m p a n y structure. C om panies can be either public o r private com panies. The main difference is that public com panies can invite the public to subscribe to their share ca p ita l using a docum ent c a lle d a prospectus. A private c o m p a n y (denoted b y 'Pty' in the name) cannot invite the public to subscribe for shares. They also have limits on the num ber of shareholders (maximum 5 0 ) a nd other restrictions on the transferability of the shares. Private com panies have certain exem ptions regarding requirements to pro vid e full fin a n cia l statements an d the a ppointm ent o f auditors. Listed public com panies are those public com panies that have chosen to be listed on the Australian Stock Exchange. This listing assists trading in the com pany's shares a nd helps in the raising o f funds. H ow ever, it does involve a d d itio n a l disclosure to the stock exchange. C om panies can be very com plex; just tw o com plexities w ill be m entioned here.
Forms o f share capital People becom e ow ners o f a c o m p a n y b y buying shares that g ive them voting pow ers o r other rights. W h e n a share is first issued by a com p a n y, the m oney received for it is put in the com pany's b a n k account a n d the source of that asset is called share ca p ita l, w h ich is an ow ners' equity item. If the person w h o p a id the c o m p a n y for that share later sells it to som eone else, the m oney for that sale goes to the person w h o o w n e d the share, not to the co m p a n y. Therefore, the com pany's share c a p ita l shows o n ly the am ount received b y it the first tim e the share is sold. M o s t o f the m illions of share sales and purchases that take p la ce on the w o rld 's stock exchanges every d a y have no effect on com panies' b alance sheet accounts for share c a p ita l, because they are trades a m ong ow ners, not issues b y the com panies. There are several classes o f shares, including: •
o rd in a ry shares: ow ners o f these vote; they a re the com pany's basic (residual) ow ners, the ones w h o d e c id e w h o w ill be on the b o a rd o f directors that m anages the c o m p a n y for the ow ners an d declares d ividends to ow ners
•
preference shares o r otherw ise s p e cia l shares: ow ners usually d o not vote, but in return they have rights, such as receiving a fixed d ivid e n d each ye a r a n d , in some cases, a preference in asset distributions if the c o m p a n y liquidates
•
Class A , C lass B a n d other such categorisations: w hether these are m ore like o rd in a ry shares or preference shares depends on the specific rights they carry. M a n y com panies use these va g u e terms because the com plexity of rights often prevents a sim ple categorisation such as o rd in a ry o r preference. The face of the balance sheet or the notes to the accounts w ill list all the kinds o f shares the com pany is authorised to issue,
specify any special rights and show the amount of share capital issued so far for each kind of share. The cash received for such share capital is the property of the com pany: the owners (i.e. shareholders, or stockholders as they are often also called, especially in the United States) have no right to get the money b a c k - except in specific circumstances.
Retained profits Profits o f a c o m p a n y can be p a id to the ow ners in the form of a d ivid e n d o r retained w ithin the com p a n y. The b alance sheet shows the am ount of a n y retained profits (past profits minus past dividends) as a separate ow ners' equity item. Thus, in a d d itio n to its lists o f assets an d liabilities, a com pany's b a la n ce sheet has an ow ners' equity section show ing various legal details to assist current a n d future ow ners:
CHAPTER 2 Measuring and evaluating Financial position and Financial performance
I Shareholders'equity
83
$
Share capital: Class A shares (for example)
xxxx
Class B shares (for example)
xxxx
Total issued capital
xxxx
Retained profits
xxxx
Total shareholders' equity
xxxx
Items other than issued c a p ita l an d retained profits m ay a p p e a r in a com pany's ow ners' equity. Such items reflect legal a nd accounting com plexities that a re not im portant at this point. These items (including reserves) w ill be discussed in C h a p te r 1 2.
Corporate group M a n y com panies you are fa m ilia r w ith , such as BHP Billiton, CSR, the C o m m onw ealth Bank an d W o o lw o rth s , are not single com panies but are rather groups o f many, often hundreds, o f com panies. The b a la n ce sheet o f such a corpo ra te g ro u p attempts to represent w h a t that g ro u p looks like as a 'c o n so lid a te d ' e conom ic entity, although there is no such entity legally. D oing this requires co m p le x accounting techniques that a re mostly beyond the scope o f this book. The b a la n ce sheet o f a co rp o ra te g ro u p looks like that o f a single co m p a n y, w ith the shareholders' equity section representing the equity of the prim ary, o r parent, c o m p a n y in the g roup. In C h a p te r 1 0 , a brief exam ination w ill be m ade of the assumptions behind fin a n cia l statements for co rp o ra te groups. For no w , rem em ber that such consolidated fin a n cia l statements are a g g re g ate s o f m any le g a lly separate com panies. A summary o f the different kinds o f business organisations is given in Exhibit A 2 . 1.
EXHIBIT A2.1
KINDS OF BUSINESS ORGANISATIONS
Kind
Legality
Owner(s)
Equity accounts
Sole trader
Not separate from owner
One proprietor
Capital and retained profits are combined
Partnership
Not separate from owners
Several or many partners
Capital and retained profits are combined but each partner's total is calculated separately
Company
Separate from owners
Usually several or many shareholders
Legal share capital is disclosed separately from retained profits
Corporate group
Consists of legally separate companies
Usually several or many shareholders
Legal share capital of parent company is disclosed separately from retained profits
A2.2
Business financing
The b a la n ce sheet's right side lists the sources o f the assets listed on its left side. As this b o o k proceeds, m any details a bou t both sides o f the b a la n ce sheet w ill be e xp la in e d . For n o w , here is a list o f the main sources:
C urrent lia b ilitie s (due w ith in a year) •
Loans from banks d ue on de m a n d o r otherw ise, at least potentially p a y a b le sooner rather than later.
•
Financing p rovided by suppliers a nd other trade creditors b y a llo w in g the enterprise to o btain credit for its purchases a nd p a y for them later
84
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W a g e s earned by, but not yet p a id to, em ployees a nd taxes w ith h e ld from them that are to be turned over to the taxation authorities
•
O th e r am ounts that w ill be p a id in the next ye a r related to such em ployee benefits as h o lid a y p a y a nd long service leave
•
Estimates of am ounts o w in g for things such as po w e r, interest charges, legal costs a nd other debts bu ild in g up, but not yet actu a lly billed to the enterprise
•
Incom e and other taxes o w e d b y the enterprise
•
D ividends o w e d b y the enterprise (if it is a com pany), d e cla re d by the board o f director, but not yet p a id to the shareholders
•
Short-term portions o f longer-term debts, such as the prin cipa l payments due over the next ye a r on long-term m ortgages.
N oncurrent lia b ilitie s (debts due m ore than a year in the future) •
M o rtg a g e s a n d other debts extending over several years
•
C ertain long-term liabilities, such as special loans from ow ners in a d d itio n to their share c a p ita l, long-term tax estimates and estim ated liabilities for amounts to be p a id to em ployees in the future.
O wners' equity •
For a sole trader: ow ner's c a p ita l (contributed c a p ita l a nd profit not w ith d ra w n b y the ow ner)
•
For a partnership: ow ners' c a p ita l (contributed c a p ita l a nd profits not w ith d ra w n b y the owners)
•
For a co m p a n y: share ca p ita l received for each kind of share plus retained profits (plus some other items if legal or accounting com plexities require them).
The double-entry system ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO carry out transaction analysis a n d determ ine the im pact of transactions on elements of bala n c e sheets an d incom e statements describe how debits a n d credits w o rk in the double-entry accounting system record transactions using debits an d credits p re p a re journal entries determ ine the bala n c e of an account after a series o f transactions describe the norm al b a la n c e for the follow ing types of accounts: assets, liabilities, equity, revenues a n d expenses explain w h y financial accounting has becom e m ore sophisticated over the centuries
C H A PTER O VE R VIEW In C h a p te r 2 w e d isc u s se d th e im p o rta n c e o f th e b a la n c e sheet a n d in c o m e sta te m e n t to m a n a g e rs . It is th e re fo re c ritic a l th a t e v e ry m a n a g e r u n d e rs ta n d s th e im p a c t o f tra n s a c tio n s o n these fin a n c ia l re p o rts . This c h a p te r p ro v id e s th ose skills b y e x te n d in g tra n s a c tio n a l a n a ly s is , w h ic h c o n s id e rs th e im p a c t o f s p e c ific tra n s a c tio n s o n th e a c c o u n t in g e q u a tio n . A g o o d u n d e rs ta n d in g o f tra n s a c tio n a l a n a ly s is w ill m a k e th e rest o f th is b o o k e a s ie r to fo llo w . A s w e ll a s b e in g c ritic a l fo r m a n a g e rs a n d o th e r users o f a c c o u n tin g re p o rts , tra n s a c tio n a l a n a ly s is is im p o rta n t to p re p a re rs o f fin a n c ia l in fo rm a tio n , a s it fo rm s th e b a sis o f th e d o u b le -e n try system . The d o u b le -e n try system in v o lv in g d e b its a n d c re d its - w h ic h fo rm s th e b a sis o f m o d e rn a c c o u n tin g - is then d e s c rib e d . W e use th is system to p re p a re jo u rn a l e n trie s a n d (via th e use o f spre a d s h e e ts ) to p re p a re fin a n c ia l statem ents. P re p a rin g fin a n c ia l state m e nts b y th e fu ll a c c o u n tin g p ro ce ss is le ft to C h a p te r 4 . W ith th e e x te n d e d k n o w le d g e o f tra n s a c tio n a n a ly s is , w e w ill illu s tra te th e d iffe re n c e s b e tw e e n a c c ru a l a n d ca sh a c c o u n tin g .
86
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FOR YO UR
IN T E R E S T
B e lo w is an o b s e rv a tio n fr o m an e x p e rie n c e d p r a c titio n e r c o n c e rn in g d o u b le e n try : I p e rs o n a lly b e lie ve th a t i f y o u c a n ’t u n d e rs ta n d th e d e b its an d c re d its o f a c lie n t’s bu sin e ss, y o u c a n ’t
p o ss ib ly
u n d e rs ta n d
w h e re
issues
in
th e ir
bu siness
or
p ro ce ss e s
c an
o c c u r.
It is
fu n d a m e n ta l to b e in g a g o o d a c c o u n ta n t, a u d ito r o r bu siness a d viso r. Source: Fiona Campbell, Partner, A u d it Services, Ernst & Young
3.1 Transaction analysis The purpose o f this section is to extend your k n o w le d g e o f h o w various transactions affect the accounting e quation. In this section w e concentrate on transactions that affect the b a la n ce sheet. In section 3 .2 , the accounting equation is e x p anded to sho w the effect on the incom e statement. Transaction analysis is a useful w a y o f understanding h o w any transaction o r event affects a co m p a n y's fin a n cia l statements. Recall that the basic accounting equation is: Assets = Liabilities + S h areh o ld ers' equity A fter each transaction, the total assets must a lw a ys equal the total liabilities a nd shareholders' equity. This equality remains regardless o f the type o f transaction. To illustrate, consider the fo llo w in g transactions for LRM Ltd for M a rc h 2 0 1 6 . 1
Shareholders invested $ 2 0 0 0 0 0 cash in the business. The effect o f this transaction is to increase cash (an asset) and increase share c a p ita l (a shareholders' equity account).
2
Land a n d bu ild in g s w e re p u rch a se d for $ 3 0 0 0 0 0 , w h ich is fin a n ce d b y a loan from the seller re p a ya b le in five years. For this transaction, land a nd buildings (an asset) is increased. This is financed through a loan, so loan (a lia b ility account) is also increased. N o te that this transaction does not affect shareholders' equity. The shareholders d o not have a n y m ore o r less equity in the com pany, as assets an d liabilities increased by the same am ount. N o te that after these first tw o transactions the accounting equation is still in ba la n ce , as w ill be the case after every transaction.
3
Inventory w orth $ 5 0 0 0 0 w as b o u g h t on credit. Inventory is purchased for $ 5 0 0 0 0 , w ith an agreem ent to pay the suppliers at a later d a te (usually 3 0 days after the da te o f sale). A g a in , both an asset an d a lia b ility are increased. In this case they a re inventory (asset) a nd accounts p a y a b le (liability).
4
E quipm ent w orth $ 9 0 0 0 0 w as p u rch a se d b y p a y in g $ 2 0 0 0 0 cash a n d signing an agreem ent to p a y the rem ainder in 9 0 days. This involves the purchase o f equipm ent (increase in an asset), w h ich is financed by both p aying out cash (an asset) a nd incurring a lia b ility, w h ich in this case is notes p a ya b le . N otes p a y a b le differs from accounts p a y a b le because the lia b ility is evidenced by a prom issory note o r bill o f exchange. N otes p a y a b le increased by $ 7 0 0 0 0 .
5
D a m a g e d inventory that w as p u rch a se d on cre dit a t a cost o f $ 5 0 0 0 w as returned to the supplier. This reverses part of transaction 3. The d a m a g e d inventory is returned to the supplier, thus decreasing inventory (an asset). As less m oney is n o w o w e d to the suppliers, accounts p a y a b le (a liability) is also reduced.
6
P aid $ 3 0 0 0 0 on accounts p a y a b le . This results in the lia b ility (accounts payable) being reduced b y a paym ent that reduces an asset (cash).
7
Purchased $ 1 0 0 0 0 inventory using cash. All o f the a b o ve six transactions have affected both sides o f the equation. H ow ever, this transaction affects o nly the asset side. It results in one asset (inventory) increasing a nd another asset (cash) decreasing. A g a in , after all transactions have been recorded, the accounting equation balances.
CHAPTER 3 The d o u b le -e n try system
87
A summary o f the effect o f each o f these transactions is shown in Exhibit 3 .1 . Based on the totals o f the accounting equation in Exhibit 3 .1 , a b a la n ce sheet is produced in Exhibit 3 .2 . As this is a n e w organisation and none o f the transactions affected revenues o r expenses, there is a z e ro b a la n ce for retained profits. N o te that at this stage neither interest on the loan nor d e p re cia tio n on the buildings a n d o ffice equipm ent has been included.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
88
H O W 'S Y O U R
U N D E R S T A N D IN G ?
H e re a re th r e e q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
I f a c o m p a n y re c e iv e s $ 1 0 0 0 0
2
Y o u p u rc h a s e $ 5 0 0 0 o f in v e n to ry on c re d it. W h a t e f f e c t w ill it ha ve o n th e a c c o u n tin g e q u a tio n ?
cash fr o m
its a c c o u n ts re c e iv a b le , w h a t e f fe c t w ill it ha ve o n th e
a c c o u n tin g e q u a tio n ?
3
D id e ith e r o f th e a b o v e tra n s a c tio n s a f fe c t p r o fit f o r th e p e rio d ? Y o u r a n sw e rs s h o u ld be:
1
C a s h a t b a n k (a n a s se t) in c re a s e s and a c c o u n ts re c e iv a b le (a n a s se t) d e cre a s e s .
2
In v e n to ry (a n a s se t) in c re a s e s and a c c o u n ts p a ya b le (a lia b ility ) in cre a s e s.
3
N o , b e c a u s e n e ith e r tra n s a c tio n a ffe c te d re v e n u e s o r ex p e n s e s .
3.2
Transaction analysis extended
W e w ill n o w e xp a n d the LRM transaction analysis exam ple in section 3.1 to include some revenue a nd expense transactions. To d o this w e w ill e xp a n d the accounting equation as follow s: A ssets = L ia b ilitie s + S h a re h o ld e rs ' e q u ity A ssets = L ia b ilitie s + Issues c a p ita l + O p e n in g re ta in e d p ro fits + N e t p r o fit - D iv id e n d s A ssets = L ia b ilitie s + Issues c a p ita l + O p e n in g re ta in e d p ro fits + R e ve n u e - E xpenses - D iv id e n d s Recall from section 3.1 that, after the initial transactions w e re recorded, the closing balances w e re as follow s as at 31 M a rc h 2 0 1 6 for LRM Ltd: $ Cash Inventory Land and buildings Equipment
140 00 0 5 5 000
300000 90000
Accounts payable
15 000
Notes payable
70000
Loans
300000
Share capital
200000
C onsider the fo llo w in g a d d itio n a l transactions for the month o f A pril 2 0 1 6 : 8
C ash sales o f $ 3 0 0 0 0 w ere m ade. The cost o f the g o o d s that w e re so ld a m ounted to $ 1 2 0 0 0 . This transaction has tw o effects: o ne to recognise revenue a nd increase assets; the other to recognise an expense and decrease assets. A cash sale o f $ 3 0 0 0 0 w a s m ade. This increases a revenue account (sales revenue) and increases an asset (cash). W e are also told that cost o f g o o d s sold, often a b b re via te d as C O G S , am ounted to $1 2 0 0 0 . C ost of g o o d s sold is w h a t the c o m p a n y pays to a cq u ire the g o o d s that customers buy. It is not the same as sales revenue, but is rather an expense the c o m p a n y incurs to ge t sales revenue. In this case the expense (C O G S ) increases by $ 1 2 0 0 0 an d inventory (an asset) decreases by $ 1 2 0 0 0 ; that is, the goods w hen purchased w e re a d d e d to inventory, a n d n o w that they are sold, inventory is decreased.
CHAPTER 3 The d o u b le -e n try system
9
89
C re d it sales o f $ 4 0 0 0 0 w e re m ade. The C O G S w a s $ 1 6 0 0 0 . This transaction has the sam e effect on the accounting equation as transaction 8, except that accounts receivable (an asset) is increased instead o f cash (another asset). Because it w a s a credit sale, paym ent w ill be received in the future rather than now . Sales revenue a nd accounts receivable increase by $ 4 0 0 0 0 , inventory decreases by $ 1 6 0 0 0 an d cost o f g o ods sold increases by $ 1 6 0 0 0 .
10
Payments o f $ 8 0 0 0 w e re m ade to suppliers. In this transaction, a paym ent w a s m ade an d therefore cash (an asset) decreases. In a d d itio n , the paym ent to creditors reduces accounts p a ya b le , a lia b ility account.
11
P aid w a g e s o f $ 2 0 0 0 0 for the first tw o weeks o f A p ril. W a g e s a re an expense for the p e riod. The paym ent of w a g e s in this transaction increases this expense an d reduces the cash a ccount (an asset).
12
R eceived an advertising invoice fo r $ 2 0 0 0 for a ra d io advertisem ent b ro a d ca st on 5 A pril. The b ill w ill b e p a id next month. The c o m p a n y receives an invoice for services that have a lre a d y been pro vid e d to it. The expense should be recognised in the period w hen the service w a s received. Therefore, an expense account (advertising) w ill be increased by $ 2 0 0 0 a nd a lia b ility account (accounts payable) w ill increase by $ 2 0 0 0 , as the am ount has not yet been p a id .
13
R eceived $ 2 5 0 0 0 from accounts receivable. This results in o ne asset (cash) increasing an d another asset (accounts receivable) d ecreasing. N o revenue is recognised as that occurred e arlier w hen the sale w a s m ade (see transaction 9).
14
A t the e n d o f the month $ 18 0 0 0 is o w in g in w a g e s for the last tw o w eeks o f the month. It is due to be p a id on 1 M a y . The em ployees have carried out the w o rk but have not yet been p a id because the next p a y d a y falls on the first d a y of the fo llo w in g month. As they have d o n e the w o rk , an expense account (wages) increases by $ 1 8 0 0 0 . A lso, as the am ount is o w e d to them, a lia b ility acco u n t (w ages payable) increases b y $ 1 8 0 0 0 . A summary o f the effect o f these transactions is p rovided in Exhibit 3 .3 . Based on the totals o f the columns in
Exhibit 3 .3 , an incom e statement an d a b a la n ce sheet w e re p repared, as show n in Exhibits 3 .4 a nd 3 .5 . The incom e statement is based on the revenue an d expense columns in Exhibit 3 .3 . The retained profits figure (same as profit for the p eriod as there is no o p e n in g b a la n ce o f retained profits a nd no d ividends declared), together w ith the share c a p ita l account a nd the other assets a nd liabilities accounts, pro vid e the inform ation for the b a la n ce sheet.
R einforcing the relationship betw een three principal financial statem ents W o rk through this next exam ple slo w ly to make sure you understand basic transaction analysis an d h o w it im pacts the three fin a n cia l statements: incom e statement, b a la n ce sheet a nd statement o f cash flow s. Assume all o p e n in g balances are zero. 1
Issue shares for cash, $ 8 0 0 0 0 .
2
B orrow cash from the bank, $ 2 0 0 0 0 .
3
Purchase inventory on credit, $ 3 5 0 0 0 .
4
Sell inventory (costing $ 3 0 0 0 0 ) for $ 7 0 0 0 0 on credit.
5
Pay accounts p a ya b le , $ 2 0 0 0 0 .
6
Receive $ 4 0 0 0 0 from accounts receivable.
7
Pay rent, $ 5 0 0 0 .
8
Pay w a g e s of $ 2 0 0 0 0 a nd o w e $ 4 0 0 0 in w a g e s a t the end o f the month.
9
Purchase equipm ent for cash, $ 5 0 0 0 0 .
10 Pay d ividends o f $ 3 0 0 0 . First, let's consider the full transaction analysis in Exhibit 3 .6 . Then in Exhibit 3 .7 the headings have been condensed into C ash, O th e r Assets, Liabilities a n d S hareholders' Equity to sh o w h o w all this inform ation is used to construct the b a la n ce sheet, incom e statement an d the statement o f cash flo w . Take your tim e an d fo llo w through each transaction.
o
LRM LTD TRANSACTION ANALYSIS
B
Assets Transaction Balance 8
Cash
Accounts receivable
Inventory
Land and buildings
Accounts payable
200000
Expenses
30000
-1 2 0 0 0
40000
-1 6 0 0 0
- 8 000
- 8 000
-20000
12
- 2 000
2 000 25 000
- 2 5 000
167000
15 000
14 Total
300000
Revenues
-1 6 0 0 0
-2 0 0 0 0
13
Share capital
55 000
11
70000
Loans
- 1 2 000
10
15 000
W ages payable
30000 40000
90000
Notes payable
140000
9
300000
Equipment
Liabilities + shareholders' equity
27000
300000
90000
$599000
9000
=
$599000
70000
18 000
_______
_______
______
-1 8 0 0 0
1 8 0 00
300000
200000
70000
-6 8 0 0 0
Dividend
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 3.3
CHAPTER 3 The d o u b le -e n try system
91
EXHIBIT 3.5 BALANCE SHEET AS AT 3 0 A P R IL 2 0 1 6
Assets
$
Current assets Cash Accounts receivable Inventory
Liabilities and shareholders' equity Current liabilities
167000
Accounts payable
15 000
Notes payable
27000
Wages payable
Noncurrent assets Land and building
18 000
Noncurrent liabilities 300000 90000 390000
Loans
300000
Total liabilities
397000
Shareholders' equity Share capital Retained profits*
Total assets
9 000 70000
97000
209000
Office equipment
$
599000
200000 2 000
Total shareholders' equity
202000
Total liabilities and SE
599000
* Retained profits = opening retained profits (0) + profit (2000) - dividends declared (0) = 2000
co t>o
TRANSACTION ANALYSIS
Liabilities + shareholders' equity
Assets Transaction
Cash
1
80000
2
20000
Accounts receivable
Accounts payable
70000
5
(20000)
6
40000
7
(5 000)
8
(20000)
9
(50000)
Accrued expenses
Expenses
Dividend
35 000
(30000)
70000 (
(30000)
20000 )
(40000) (5 000) (24000)
4000 50000
(3 000) 42 000
Revenues 80000
35 000
4
10
Equipment
20000
3
Total
Inventory
30000
5 000
50000
127000 :
15 000 127000
4 000
______
______
______
______
(3 000)
20000
80000
70000
(59 000)
(3 000)
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 3.6
EXHIBIT 3.7
LRM LTD RELATIONSHIP OF TRANSACTION ANALYSIS TO THE FINANCIAL STATEMENTS
Source data for cash flow statement
Source data for income statement
l Balance Sheet Current assets
- (20 000] + 40 000 + (5000] + (20 000] b 80 000 + 20 000 + (3000)
Cash Receivables Inventory
$
Accounts payable Accrued expense Bank loan
50 000
Issued capital Retained profits Total
N o n c u r r e n t a s s e ts
Equipment Total
Liabilities
42 000 30 000 5 000
$ 15 4 20 39
000 000 000 000
S h a r e h o ld e r s 'e q u it y
127 000
80 000 8 00 0 • 127 000
CHAPTER 3 The double-entry system
Source data for balance sheet
(X)
OJ
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
94
HOW'S YOUR UNDERSTANDING? W h a t im p a c t w ill each o f th e fo llo w in g have on p r o fit fo r th e perio d ?
1 2 3 4 5
P urchase in v e n to ry on c re d it fo r $ 2 0 0 0 0 . Sell goods on c re d it fo r $ 3 0 0 0 0 (c o s t o f goods sold was $14 0 0 0 ) . Pay a cco u n ts payable o f $ 2 0 0 0 0 . R eceive $ 3 0 0 0 0 fro m a c co u n ts receivable. Pay $ 1 0 0 0 0 fo r wages d u rin g th e p e rio d , and ow e $ 2 0 0 0 fo r o th e r w o rk do n e d u rin g th is p e rio d th a t will n o t be paid to n e x t period. Y o u r answers should be: 0 ; $16 0 0 0 ; 0 ; 0 ; and $12 0 0 0 .
3.3
Recording transactions: double-entry bookkeeping
The accounting equation discussed in section 3 .2 is a useful technique for understanding h o w transactions can affect financial statements. H ow ever, it can be very u n w ie ld y w hen there are m any accounts an d a large num ber of transactions. A system o f accounting involving debits an d credits w a s invented centuries a g o an d is still used today. O n e w a y to understand this double-entry system is to start w ith the b a la n ce sheet. As noted in the previous section, the statement balances (this is w h y it is ca lle d a b a la n ce sheet); that is, the d o lla r value o f all the resources on the left is equal to the d o lla r value o f all the sources on the right. If the b a la n ce sheet is to ba la n ce , every transaction and a d ju s tm e n t must also ba la n ce ; that is, their effects on the tw o sides o f the statement must be e qual. To reinforce the earlier discussion on transaction analysis, consider the fo llo w in g : •
If a resource (asset) is increased, (a) a source (lia b ility o r equity) must be increased by the sam e amount; o r (b) another resource decreased by the sam e am ount; o r (c) there must be some mixture o f source increases a nd other resource decreases that equals the o rig in a l resource's increase. For exam ple, if the asset increased w a s inventory by $ 2 0 0 , (a) there could be an increase in accounts p a y a b le of $ 2 0 0 ; (b) there could be a decrease in cash of $ 2 0 0 ; and (c) there could be an increase in accounts p a y a b le o f $ 1 5 0 an d a decrease in cash o f $ 5 0 .
•
C onversely, if a resource is decreased, (a) a source must be decreased b y the same am ount; o r (b) another resource increased by the sam e amount; o r (c) some mixture o f source increases/decreases an d other resource increases that equals the o rig in a l resource's decrease. For exam ple, if cash is the resource that decreases by $ 5 0 0 , (a) there could be a loan decreasing by $ 5 0 0 ; (b) there could be equipm ent increasing by $ 5 0 0 ; an d (c) there could be equipm ent increasing by $ 4 5 0 0 an d loan increasing b y $ 4 0 0 0 . This is just arithm etic. D ouble entry is a form o f a lg e b ra ic notation, in w h ich an equation (the accounting equation)
must be m aintained. For reasons that a re n o w largely lost in the mists o f time, increases to resources (assets), on the left side, a re called debits, and increases to sources (liabilities a nd equity), on the right side, are c a lle d credits. Perhaps confusingly, decreases on the left side a re also ca lle d credits, an d decreases on the right side a re also ca lle d debits. Financial accounting uses o nly tw o names to cover the four kinds o f effects, w h ich w ill turn out to have some advantages as w e learn m ore a b o u t the w a y accounting w orks. Thus, the b a la n ce sheet looks like this: Left side: Resources (Assets)
Right side: Sources (Liabilities, Equity)
Increases: debits
Increases: credits
Decreases: credits
Decreases: debits
Sum of resources
= Sum of sources
Assets
= Liabilities + Equity
Debits
= Credits
CHAPTER 3 The d o u b le -e n try system
95
M o s t students a re confused b y these terms, debits an d credits. To a v o id this confusion, sim ply think o f a d e b it as a left-hand-side entry an d a credit as a right-hand-side entry. An a n a lo g y m ay assist. W h e n you drive, you stop a t red lights an d g o on green. This is a convention. If it had been set up the op p o site w a y , the system w o u ld still w ork. H ow ever, c h a n g in g the system n o w o r d o in g the op p o site has some disastrous effects. The sam e a p plies w ith debits and credits. They could have been set up the o p p o site w a y around, but they w eren't. C o n sid e r the fo llo w in g summary: Type of account
Normal balance
Increases result in
Decreases result in
Assets
Debit
Debit
Credit
Liabilities
Credit
Credit
Debit
Shareholders' equity
Credit
Credit
Debit
expressed in terms o f the accounting equation as follow s: Assets Debit to increase
Credit to decrease
=
Liabilities Debit to decrease
+
Credit to increase
Shareholders' equity Debit to decrease
Credit to increase
Every transaction, w ith o u t exception, has tw o (or more) effects. O n e requires a d e b it entry an d on e requires a credit entry. The recording of increases to assets on the d e b it side a nd decreases on the credit side is the op p o site to that o f liabilities a nd shareholders' equity. It therefore provides the a d d itio n a l control on a ccuracy, in that the sum of the d e b it balances must equal the sum o f the credit balances. To understand this process, you need to be a w a re o f some terms: •
A ccounting records certain kinds o f events m easured in the country's currency (dollars in Australia). W e w ill call those events transactions, a w o rd used a fe w times a lready.
•
A cco u n tin g 's w a y o f recording transactions is c a lle d the 'entry', an d the method follow s the double-entry record keeping system described b y Pacioli 5 0 0 years a g o . (Entries are summarised in records usually ca lle d journals, so they a re also c a lle d jo u rn a l entries.)
•
The entries are transferred to an d summarised in accounts, w h ich lie behind all the amounts an d descriptions show n on the b a la n ce sheet. Each account has a num erical b a la n ce that is either a d e b it o r a credit. (All the accounts collected together are usually referred to as a ledger.)
•
As you know , it is im portant that all the accounts together p roduce a ba la n ce d b a la n ce sheet. Before preparing the b a la n ce sheet from the accounts, accountants usually make a list o f the account balances from the ledger and make sure that the sum o f all the d e b it balances equals the sum o f all the credit balances. Because you never kn o w for sure if it w ill w o rk, this list is ca lle d the tria l balance!
•
Finally, the fin a n cia l statements a re prepared. In this chapter, w e concentrate on mastering journal entries a nd pro vid e a sim ple spreadsheet method of
m aintaining a ccount balances. The use o f such tools as ledgers a nd trial balances is left to C h a p te r 4 , w hen w e describe the full accounting process.
Two sim ple exam ples o f double en try P U R C H A S IN G , O N CREDIT, G O O D S FO R RESALE •
The resource (an asset) is an a d d itio n to the enterprise's in ve n to r/ (unsold products).
•
The source (a liability) is that an o b lig a tio n is created to p a y the supplier.
96
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
If the g o o d s cost, say, $ 4 5 2 , w e have: •
a d e b it o f $ 4 5 2 : an a d d itio n to the account for the resource, in this case the inventory o f unsold products
•
a credit o f $ 4 5 2 : an a d d itio n to the account for the source, in this case the o b lig a tio n to the supplier, usually called accounts pa ya b le . The b a lance sheet stays in b a la n ce because of this d o u b le entry, because both resources an d sources are
increased (are 'up') b y $ 4 5 2 : Resources
Sources
Up (debit) $452
Up (credit) $452
Assets up $452
Liabilities up $452 (no change in equity)
B O R R O W IN G M O N E Y F R O M THE B A N K O N A L O N G -T E R M L O A N •
The resource (asset) is an a d d itio n to the am ount o f cash on hand.
•
The source (a lia b ility a g a in ) is that an o b lig a tio n is created to repay the bank.
If the b o rrow ed cash is, say, $ 1 0 0 0 , w e have: •
an ad d itio n to the asset 'cash', so total resources g o up $ 1 0 0 0
•
an ad d itio n to the lia b ility 'long-term bank lo a n ', so the total sources also g o up $ 1 0 0 0 . A g a in , the b a la n ce sheet stays in balance: Resources
Sources
Up (debit) $1000
Up (credit) $1000
Assets up $ 1000
Liabilities up $ 1000 (no change in equity)
These transactions w o u ld be recorded as follow s: DR CR DR CR
Inventory
452
Accounts payable Cash
452 1 000
Bank loan
1 000
N o te that debits a re a b b re via te d to DR an d credits to CR, as is customary.
SUMMARY These are sim ple exam ples, but they illustrate several features o f the bookkeeping system. (For hundreds o f years, accounting records w e re kept in bound books. In spite o f the advent o f computers, 'b o o ks' are still used by m any enterprises, as w e w ill see.) Som e features illustrated by the exam ples include the fo llo w in g : •
Each double-entry record names on e (or more) accounts that are de b ite d, an d on e (or more) that are credited. Accounts contain all the transaction records an d a n y adjustments, an d therefore reflect everything recorded in the system. The cash account, for exam ple, lists all transactions a n d adjustments that have affected cash. Accounts are used directly in p reparing the b a la n ce sheet a n d the incom e statement.
•
The double-entry records shown in the exam ple are c a lle d journal entries. A journal entry can list as many accounts as a re needed to record the transaction, but for each journal entry, the sum o f the debits must e q u a l the sum o f the credits. If not, the accounting equation w ill not be m aintained (the 'b o o ks' w ill not balance).
CHAPTER 3 The d o u b le -e n try system
97
FOR YOUR INTEREST A n in te re s tin g a s p e c t o f a tra n s a c tio n is th a t, b e c a u s e it is an e x c h a n g e , b o th p a rtie s t o th e e x c h a n g e w o u ld re c o rd it, e a ch fr o m th a t p a rty ’s p o in t o f v ie w . I f E n te rp ris e A ga in s cash f o r a lo an fr o m
E n te rp ris e B,
E n te rp ris e A w o u ld re c o rd an in c re a s e in cash (a d e b it) an d in a lo a n lia b ility (a c re d it) , w h ile E n te rp ris e B w o u ld re c o rd a d e c re a s e in cash (a c re d it) an d an in c re a s e in an a s se t f o r th e lo an re c e iv a b le , to be c o lle c te d (a d e b it). H e re are e x a m p le s o f s o m e e x c h a n g e s and h o w b o th p a rtie s w o u ld re c o rd th e tw o a s p e c ts o f e a c h . T h e re is a tr a d itio n o f re c o rd in g th e d e b its f ir s t in th e d o u b le e n try . T h a t is s o m e tim e s d is re g a rd e d h e re , so th a t y o u c an see th e p a rallels b e tw e e n P a rty A ’s an d P a rty B ’s re c o rd s .
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
W h a t are th e e ffe c ts o n th e b a la n c e s h e e t o f th e fo llo w in g tra n s a c tio n ? W h a tz is L td re c e iv e d $ 2 0 0 0 0 cash fr o m a s h a re h o ld e r in re tu rn f o r $ 5 0 0 0 in n e w ly issu ed share s an d p ro m is e d t o p a y th e s h a re h o ld e r th e o t h e r $ 1 5 0 0 0 b a c k a t th e e n d o f th r e e years.
2
W h a t is th e jo u r n a l e n tr y to re c o rd th e fo llo w in g tra n s a c tio n , in w h ic h W h a tz is used th e cash fr o m th e s h a re h o ld e r? T h e c o m p a n y b o u g h t a la rg e tr u c k , w h ic h c o s t $ 8 9 0 0 0 , b y p u ttin g $ 2 0 0 0 0 d o w n in cash an d fin a n c in g ( b o rro w in g ) th e re s t fr o m th e t r u c k d e a le r’s fin a n c e c o m p a n y .
Y o u r a n sw e rs s h o u ld be:
1
C a s h up $ 2 0 0 0 0 , sh a re c a p ita l up $ 5 0 0 0 an d lo n g - t e r m lo an up $ 1 5 0 0 0 . T h e re s u lt is to ta l in c re a s e to assets $ 2 0 0 0 0 , and to ta l in c re a s e to s o u rc e s o f assets $ 2 0 0 0 0 .
2
D R T ru c k $ 8 9 0 0 0 , C R C a s h $ 2 0 0 0 0 and C R T ru c k lo an $ 6 9 0 0 0 . T h e re s u lt is n e t to ta l in c re a s e to assets $ 6 9 0 0 0 , an d to ta l in c re a s e to s o u rc e s o f asse ts $ 6 9 0 0 0 ; to ta l d e b its $ 8 9 0 0 0 an d to ta l c re d its $89 00 0.
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
98
3.4
More about accounts
The b a lance sheet an d the incom e statement are prepared from the underlying accounts, w h ich have been recorded using the double-entry system so that the sum o f the dollars in all the d e b it accounts equals the sum in all the credit accounts. But w h a t is an account, exactly? H ere's a w o rkin g d e finition: an a cco u n t is a re co rd o f the d o lla r am ounts com prising a p a rticu la r asset, lia b ility, equity, revenue o r expense. The net effect o f these am ounts is a d e b it o r credit, and is c alled the account's balance. B elow are some exam ples of h o w account balances a re ca lculated. M o d e rn com puterised accounting systems can produce accounts in various formats thought to be useful, but they all use the arithm etic illustrated b e lo w . •
If the enterprise's cash b egan at $ 5 0 0 a n d there w a s a receipt o f $ 4 0 0 a nd o ne o f $ 7 5 0 , a n d a paym ent of $ 3 0 0 and one o f $ 5 2 5 , the cash asset account w o u ld sh o w a b a la n ce o f $ 8 2 5 (a d e b it because there is a positive b a la n ce in this asset account). Cash = $ 5 0 0 D R + $ 4 0 0 D R + $ 7 5 0 D R - $ 3 0 0 C R - $ 5 2 5 C R = $ 8 2 5 D R
•
If share c a p ita l b egan a t $ 1 0 0 0 an d m ore shares w e re sold for $ 4 0 0 (w hich, let's say, caused the cash receipt above), the share c a p ita l equity a ccount w o u ld sh o w a b a la n ce of $ 1 4 0 0 (a credit because there is a positive b alance in this equity account). S h are capital = S 1 0 0 0 C R + S 4 0 0 C R = S 1 4 0 0 C R
•
If am ounts o w in g to trade creditors b egan at $ 9 5 0 a n d a cre d ito r w a s p a id $ 3 0 0 (the first paym ent above), the accounts p a y a b le lia b ility a ccount w o u ld sh o w a b a la n ce o f $ 6 5 0 (a credit because there is a positive b a la n ce in this lia b ility account). Accounts p a y a b le = S 9 5 0 C R - S 3 0 0 D R = S 6 5 0 C R
•
If a cash collection from a customer w a s m ade for $ 7 5 0 (the second cash receipt above), the accounts receivable account, w ith a b a la n ce of, say, $ 2 0 0 0 before the collection, w o u ld reduce by an am ount o f $ 7 5 0 (a credit because this reduces the accounts receivable asset, w h ich has been transformed into cash through the collection transaction). Accounts receivab le = $ 2 0 0 0 D R - $ 7 5 0 C R = $ 1 2 5 0 D R
•
If a $ 5 2 5 cash paym ent (the second cash paym ent above) w a s m ade on the com pany's b a n k loan, a lia b ility account w ith a nam e like 'b a n k lo a n ' w o u ld be d e b ite d w ith this paym ent. Suppose the loan had a b a la n ce of $ 15 0 0 0 before the paym ent. The account b ala n ce w o u ld then be calculated to sh o w the deduction of the paym ent. B ank lo an (p a rt of liabilities) = $ 1 5 0 0 0 C R - $ 5 2 5 D R = $ 1 4 4 7 5 C R
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HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
G a r f L td had a c c o u n ts re c e iv a b le a t th e b e g in n in g o f th e y e a r o f $ 5 2 9 0 . D u rin g th e y e a r, it had re v e n u e fr o m sales o n c re d it o f $ 3 9 6 2 0 an d c o lle c te d $41 0 8 0 fr o m its c u s to m e rs . W h a t w as th e b a la n c e o f a c c o u n ts re c e iv a b le a t th e e n d o f th e y e a r?
2
G a r f L td ’s n e t p r o fit f o r th is y e a r w as $ 2 9 4 0 , an d it d e c la re d $ 9 0 0 in d iv id e n d s to its s h a re h o ld e rs d u rin g th e y e a r. R e ta in e d p ro fits w e re $ 7 4 1 0 a t th e b e g in n in g o f th e y e a r. W h a t is th e b a la n c e o f re ta in e d p ro fits a c c o u n t a t th e e n d o f th e y e a r?
Y o u r a n sw e rs s h o u ld be:
1
$ 3 8 3 0 ( r e m e m b e r a c c o u n ts re c e iv a b le g o up via c re d it sales an d d o w n b y re c e ip ts fr o m
2
$ 9 4 5 0 ( r e m e m b e r re ta in e d p r o fits g o up w h e n th e r e is a p r o fit b u t g o d o w n w h e n a d iv id e n d is d e c la re d
a c c o u n ts
re c e iv a b le )
b e c a u s e it is a d is trib u tio n o f p r o fit to s h a re h o ld e rs .)
3.5
How debits and credits work
Let's consider an exam ple: C a p p u M a n ia Ltd, a small c o m p a n y that operates a coffee shop on the ground flo o r o f an office b u ild in g . Exhibit 3 .8 shows the com pany's b a la n ce sheet at the end o fju n e 2 0 1 5 . EXHIBIT 3 .8
CAPPUMANIA LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 5
Assets
$
Current assets
Liabilities and shareholders' equity
$
Current liabilities
Cash
4000
Inventory of unsold food Inventory of supplies
Accounts payable
1 200
800
Taxes payable
600
1 900
Total liabilities
1 800
6700
Noncurrent liabilities
Noncurrent assets
Loan
5 000
Total liabilities
6 800
Equipment
9000
Shareholders' equity
Accumulated depreciation
(1 500)
Share capital
3 000
7500
Retained profits
4400
Total shareholders' equity
Total assest
14 200
Total liabilities and shareholders' equity
7400 14 200
N o w let's see h o w the fo llo w in g four transactions, all h a p p e n in g on 1 July 2 0 1 5 , are recorded using accounting's double-entry method (ignoring the details o f the particular com puter or m anual record-keeping system): 1
C a p p u M a n ia pays $ 5 0 0 o f its taxes o w in g .
2
C a p p u M a n ia buys $ 4 5 0 m ore supplies, p aying $ 1 0 0 cash a n d o w in g the rest.
3
A shareholder is given m ore shares in return for personally p aying $ 1 1 0 0 on the equipm ent loan.
4
C a p p u M a n ia buys a n e w coffee m achine for $ 2 0 0 cash.
100
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Let's look at the entries. 1
Resource effect: C ash is reduced. Cash is an asset, so a decrease in an asset w o u ld be a credit. S ource effect: Tax lia b ility is reduced. A lia b ility is reduced, so the effect w o u ld be a debit. Entry:
1
$ DR
Taxes payable (liability)
CR
$
500
Cash (asset)
500
Double-entry m ethod: There is both a DR a nd a CR a nd the tw o are the same. (The tradition is to list the DR(s) first in an entry.) 2
Resource effects: Inventory is increased by $ 4 5 0 . It is an asset, an d an increase in asset is a d e b it. C ash is decreased by $ 1 0 0 so this is a credit, as a bove. S ource effect: The lia b ility to suppliers is increased by $ 3 5 0 . An increase in a lia b ility results in a credit. Entry:
D ouble-entry m ethod: There are both DRs a nd CRs, an d the sum o f the DRs equals the sum o f the CRs. (An entry can have a n y num ber o f DRs an d CRs as long as the sums o f each a re equal.) N o te that this d e b it entry could have been achieved b y tw o entries:
3
Resource effect: N o n e . S ource effects: The equipm ent loan, a lia b ility, is decreased $1 1 0 0 , so this is a debit. The share ca p ita l, an equity, is increased $1 1 0 0 , so this is a credit. Entry:
1
$ DR CR
Loan (liability)
$
1 to o
Share capital (equity)
1 to o
D ouble-entry m ethod: This transaction affects o nly the right side of the b a la n ce sheet, but the statement stays in b alance because on e a ccount on the right side goes up a nd another goes d o w n .
CHAPTER 3 The d o u b le -e n try system
4
101
Resource effects: Equipment, an asset, is increased $ 2 0 0 , so this is a debit. C ash is decreased $ 2 0 0 , w h ich is a credit as in transactions l an d 2. S ource effect: N o n e . Entry:
I
$ DR
Equipment (asset)
CR
Cash (asset)
s|
200 200
Double-entry m ethod: This transaction also affects o n ly o ne side o f the b a la n ce sheet - this time, the assets side - but a g a in the b a la n ce d entry keeps the b a la n ce sheet in balance. These journal entries form part o f the accounting cycle, w h ich records accounting transactions. The sequences of procedures by w h ich these transactions enter the fin a n cia l statements are discussed in C h a p te r 4 . For an illustration of h o w a journal entry affects the b a la n ce sheet, these entries are recorded here b y a d d in g them to, o r subtracting them from, the previous (3 0 June) balances in the accounts. This is d o n e in Exhibit 3 .9 , using a com puter spreadsheet form at (in this case, M ic ro so ft Excel, but the particular spreadsheet does not matter). A rbitrarily, the debits are recorded as positive an d the credits as negative. This does not mean debits a re g o o d a nd credits a re b a d ! It is sim ply an accounting convention. You can see from the spreadsheet that at 3 0 J u n e the total o f a d d in g all the debits a nd subtracting all the credits is zero. The transaction entries a re in b a la n ce because the sum o f the debits equals the sum o f the credits. The l July d e b it balances also equal the credit balances.
EXHIBIT 3.9
CAPPUMANIA LTD EXAM PLE IN SPR EA D SH EET FORM
* The numbers in brackets have been added to the spreadsheet printout to refer to the events and transactions described in the text.
102
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
It w o u ld be unlikely that another b a la n ce sheet w o u ld be p repared, just one d a y after the 3 0 June one, but to com plete the exam ple, let's see h o w the d e b it balances w o u ld also equal the credit balances, after recording the four transactions (see Exhibit 3 .1 0 ).
EXHIBIT 3.10
CAPPUMANIA LTD BALANCE SHEET AS A T 1 JULY 2 0 1 5
HOW'S YOUR UNDERSTANDING? S uppose th a t on 1 J u ly 2 0 1 5 a fift h tra n s a c tio n had o c c u rre d : C a p p u M a n ia repaid $ 8 0 0 on its loan to th e bank. W h a t w o u ld th e fo llo w in g revised fig u re s have been on th e 1 J u ly 2 0 1 5 balance s h e e t: cash, c u rre n t assets, to ta l assets, to ta l liabilities and sh a re h o ld e rs’ e q u ity? Y o u r answers should be: $ 2 4 0 0 , $ 5 5 5 0 , $13 2 5 0 , $ 4 7 5 0 and $ 8 5 0 0 .
3.6
Debits and credits, revenues and expenses
In section 3 .5 , you s a w h o w entries a n d accounts w e re used to record events as transactions in the double-entry accounting system. In the C a p p u M a n ia Ltd exam ple, this w a s lim ited to b a la n ce sheet accounts. Let's e xp a n d the exam ple to bring in revenue a nd expense accounts. To keep the exam ple uncluttered, w e g ro u p all the co m p a n y's activities for the ye a r ended 3 0 J u n e 2 0 1 6 into the fo llo w in g summary list. First, the econom ic events to be recorded: 1
Revenue for 2 0 1 6 w a s $ 8 9 7 4 0 . The coffee b ar does mostly cash business, so o f this, $ 8 5 2 5 0 w a s in cash and the rest w a s on credit.
2
G eneral expenses for 2 0 1 6 , not including dep re cia tio n o r incom e tax, totalled $ 6 7 2 3 0 . M o s t o f the expenses w e re on credit, for coffee supplies an d so on, so o f this, o n ly $ 21 2 0 w a s in cash.
CHAPTER 3 The d o u b le -e n try system
3
103
A t the end of the year, it turned out that unsold food on hand cost $ 5 5 0 and supplies on hand (mainly paper cups and plastic spoons) cost $ 1 7 4 0 . Therefore, the food inventory account has to be reduced by $ 2 5 0 ($ 8 0 0 - $ 5 5 0 ) and the supplies inventory account has to be reduced by $ 6 1 0 ($ 2 3 5 0 - $ 1 7 4 0 ). Using up these inventories is part of the cost of earning revenue, so these reductions w ill be included in the com pany's general expenses. W e could have described these expenses here as a C O G S expense and put them as a separate expense category.
4
D epreciation expense for the ye a r w a s $ 2 3 8 0 .
5
The co m p a n y's incom e tax expense for 2 0 1 6 w a s estim ated as $ 4 4 6 0 . (This is an estim ate because, until the incom e tax authorities issue a form al assessment o f tax, the c o m p a n y does not kn o w for sure w h a t its tax w ill be for the year.)
6
The com pany's b o a rd o f directors d e cla re d a d ivid e n d o f $ 1 0 0 0 . C ash inflow s an d outflow s b y 3 0 J u n e 2 0 1 6 not a lre a d y m entioned:
7
C ollections o f the revenue on credit totalled $ 3 3 3 0 .
8
Payments to suppliers totalled $ 5 9 4 2 0 .
9
The c o m p a n y p a id $ 3 0 0 0 tow ards its incom e tax.
10 O n ly $ 8 0 0 o f the d ivid e n d had been p a id . Before recording these transactions, w e w ill extend the d e b it/c re d it rules to revenue a n d expense items. To help you understand the entries, rem em ber that because profit is a part o f retained profits, w h ich is an equity a ccount and therefore a credit account on the b a la n ce sheet, anything that helps p rofit is a credit. A revenue is therefore a credit b a lan ce account. C onversely, anything that reduces profit reduces retained profits a nd equity, a n d is therefore a d ebit. An expense is therefore a d e b it b a la n ce account. W h e n d ividends are d e cla re d , they are deducted from retained profits, therefore such deductions are debits because they reduce equity. All this produces the fo llo w in g table o f double-entry a ccounting's debits a nd credits: Debits
Credits
Increases in assets
Decreases in assets
Decreases in liabilities
Increases in liabilities
Decreases in equity:
Increases in equity:
Dividends declared
Contributed capital
Expenses
Revenues
For com pleteness, the summary pro vid e d in section 3 .3 is extended as shown b e lo w :
N o te that one w a y o f decreasing retained profits is to d e cla re a d ivid e n d , w h ich results in a d e b it entry. To further dem onstrate this, the accounting equation can be rewritten in T-account form at as follow s: Assets Debit to increase
Credit to decrease
Liabilities Debit to decrease
Credit to increase
M
Shareholders' equity Debit to decrease
Credit to increase
104
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Increases in assets a re debits; increases in liabilities o r shareholders' equity a re credits. As noted earlier, shareholders' equity accounts include share c a p ita l, retained profits, revenue a nd expenses. Remember, increases in expenses reduce shareholders' equity a nd are, therefore, debits, w h ile an increase in revenue increases shareholders' equity and is, therefore, a credit. The revenue an d expense accounts can thus be show n as: Revenue Debit to decrease
Credit to increase
Expenses Debit to increase
Credit to decrease
H ere are the journal entries for the 10 items given earlier:
Revenue Cash (assets increased) Accounts receivable (assets increased)
85 250 4490
Revenue (equity increased)
2
89740
General expenses General expenses (equity decreased)
67230
2 120
Cash (assets decreased) Accounts payable (liabilities increased)
3
65 110
Using up of inventories General expenses (equity decreased)
250
Inventory of unsold food (assets decreased) General expenses (equity decreased)
250 610
Inventory of supplies (assets decreased)
4
610
Depreciation of equipment Depreciation expense (equity decreased)
2 380
Accumulated depreciation (assets decreased)
5
2 380
Estimated income tax expense Income tax expense (equity decreased)
4460
Taxes payable (liabilities increased)
6
4460
Dividend declared Retained profits (equity decreased)
1000 1000
Dividend payable (liabilities increased)
7
Collections of accounts receivable Cash (assets increased)
3 330
Accounts receivable (assets decreased)
8
3 330
Payments of accounts payable Accounts payable (liabilities decreased)
59420
Cash (assets decreased)
9
59420
Payments towards income tax Taxes payable (liabilities decreased)
3 000
Cash (assets decreased)
10
3 000
Payment towards dividend Dividend payable (liabilities decreased) Cash (assets decreased)
800
800
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105
W e can enter these 10 entries into the co m p a n y's accounts, using the spreadsheet basis you s a w in section 3 .5 . The resulting spreadsheet is shown in Exhibit 3 .1 1 . N o te that the 1 July 2 0 1 5 figures, w h ich are w h a t w e e nded up w ith in Exhibit 3 .9 , are n o w in the first colum n, as the starting figures. Some n ew accounts (such as accounts receivable an d revenue) are needed to record the entries: the titles o f these are show n in italics.
EXHIBIT 3.11
CAPPUMANIA LTD EXAMPLE IN SPREADSHEET FORM (CONTINUED FROM EXHIBIT 3.9)
* The numbers in brackets have been added to the spreadsheet printout to refer to the 10 events and transactions described in the text.
You can see that everything is still in ba la n ce . The sums o f the debits an d credits in the 1 0 entries a re $ 2 3 2 2 2 0 , and the 3 0 June 2 0 1 6 accounts a d d up to ze ro (rem ember that, a rbitrarily, debits are show n as positive am ounts and credits as negative ones).
106
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
To highlight the calculation o f profit from the e x p a n de d set o f accounts, a second version o f the spreadsheet is shown in Exhibit 3 . 1 2 . It is the sam e as in Exhibit 3 . 1 1, except that the b a la n ce sheet accounts an d the profit and loss accounts (part o f the incom e statement) are n o w separately subtotalled. You w ill see that profit (the difference betw een the revenue an d expense accounts) equals $ 1 4 8 1 0 . It is a credit, w h ich is w h a t equity is. A lso note that, w ithout the revenue a nd expense accounts, the b a la n ce sheet accounts are out o f b a la n ce by the sam e $ 1 4 8 1 0 . In C h a p te r 4 , you w ill see h o w these revenue a nd expense accounts are closed off. A separate note w ill sh o w that the profit figure w ill be transferred to retained profits; that is, o p e n in g retained profits plus net profit for the ye a r minus d ivid e n d declare d equals closing retained profits (4 4 0 0 + 1 4 8 1 0 — 1 0 0 0 = 1 8 2 1 0 ). A figure o f $ 1 8 2 1 0 w ill a p p e a r as the b a la n ce o f the retained profits a ccount in the b a la n ce sheet.
EXHIBIT 3.12
CAPPUMANIA LTD
EXA M PLE IN SPR EA D SH EET FORM (C O N TIN U E D ) (W IT H SUBTO TALS TO SHO W PROFIT C A LC ULATIO N)
CHAPTER 3 The d o u b le -e n try system
107
The com pany's incom e statement sh ow in g profit for the y e a r is show n in Exhibit 3 . 1 3. The b a la n ce sheet is given in Exhibit 3 . 14 .
EXHIBIT 3.14
CAPPUMANIA LTD BALANCE SH EET AS A T 3 0 JUNE 2 0 1 6
* Opening balance + Net profit — Dividends declared = Closing balance 4 4 0 0 + 14 81 0 - 1000 = 18 210
This exam ple has illustrated h o w accounting accum ulates inform ation a b o u t activities a nd h o w the fin a n cial statements are prepared from the accounts that are p roduced as the inform ation is accum ulated. You can see h o w the tw o fin a n cia l statements fit together (articulate) because they a re all based on the d o u ble entry accounting system: •
A set o f accounts is created w h ich is in b a la n ce (sum o f all the d e b it a ccount balances = sum o f all the credit a ccount balances). From these accounts a re produced: -
the incom e statement, the bottom line (net profit after tax) o f w h ich is transferred to a note to the accounts sh o w in g a statement o f retained profits, the bottom line (ending retained profits) of w h ich is transferred to
-
the b a la n ce sheet, w h ich summarises all the accounts.
108
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A ctivities affecting profit therefore affect the b a la n ce sheet through the double-entry system. Looking b ack a t the entries a bove, for exam ple: •
Entry 1 increased the b a la n ce sheet's assets an d increased revenue on the incom e statement (thereby also increasing profit, w h ich is transferred to retained profits, therefore increasing equity, w h ich keeps the bala n ce sheet in balance).
•
Entry 2 decreased the b a la n ce sheet's assets a nd increased its liabilities a nd increased expenses on the incom e statement (thereby also decreasing profit, therefore decreasing equity, w h ich keeps the b a la n ce sheet in balance). You w ill see this sort o f relationship a m ong the fin a n cia l statements m any times. It is the basis o f one o f the most
im portant uses o f fin a n cia l statements: analysing the fin a n cia l statements in o rd e r to evaluate fin a n cia l perform ance and financial position.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
A t th e end o f 2 0 1 5 , H in to n H a ts Ltd had retained p ro fits o f $ 2 9 4 9 0 . D u rin g 2 0 1 6 , it had revenue o f $112 3 5 0 , general expenses o f $ 9 1 1 7 0 , depreciation expense o f $ 6 2 1 0 and in co m e tax expense o f $ 3 4 2 0 . D ividends o f $ 5 0 0 0 w ere declared d uring 2 0 1 6 . W h a t was th e balance o f retained p ro fits at th e end o f 2 0 1 6 ?
2
I f th e c o m p a n y paid $ 1 2 0 0 cash fo r th e re n t on its shop fo r th e last m o n th o f 2 0 1 6 , w h a t w o u ld this e v e n t do to : assets, liabilities, p r o fit fo r 2 0 1 6 , re ta in e d p ro fits and e q u ity?
Y o u r answers should be: 1
$36 0 4 0
2
D o w n $ 1 2 0 0 ; no e ffe c t; dow n $ 1 2 0 0 ; dow n $ 1 2 0 0 ; and do w n $ 1 2 0 0 .
3.7
Arranging accounts on the balance sheet
In the Sound and Light exam ple (C hapter 2) an d the C a p p u M a n ia exam ple (this chapter), you s a w that accounts w e re organised into the statement's main categories: current assets, noncurrent assets, current liabilities, noncurrent liabilities and equity. This w a s d o n e because the arrangem ent o f accounts is m eant to convey inform ation beyond the account balances themselves. The placem ent o f each a ccount tells the reader o f the b a la n ce sheet w h a t kind of account it is: a short-term asset o r a long-term one; a short-term lia b ility o r a long-term one; o r an equity. This enables the calculation o f m eaningful ratios an d other analyses. The b a la n ce sheet is said to be classified, because accounts are classified into m eaningful categories. This means that the accountant p reparing the b a la n ce sheet has to look into an account w ith a title like 'b a n k lo a n ', for exam ple, an d determ ine w hether it should be included in current liabilities o r noncurrent liabilities. M o v in g items around w ith in the b a la n ce sheet (or w ithin other fin a n cia l statements) is called redassiFication, an d is d o n e by accountants w h enever it is thought to im prove the inform ativeness o f the financial statement.
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109
Three exam ples o f account classification C U R R EN T A N D N O N C U R R E N T P O R T IO N S O F N O N C U R R E N T LIABILITIES M a n y noncurrent liabilities, such as m ortgages, bonds an d debentures, require regular payments, so although most of the d e b t is noncurrent, not all o f it is. Accountants therefore reclassify the am ount to be p a id on the prin cipa l o f the d e b t w ith in the next ye a r into current liabilities, an d sh o w o n ly the residual (due more than a ye a r a w a y) as noncurrent. (Any interest o w in g but not yet p a id w o u ld be treated as a separate lia b ility. If it is due to be p a id w ithin the y e a r it is a current liability.)
B A N K O VER D RA FTS Suppose a c o m p a n y has a b a n k overdraft o f $ 5 0 0 , w h ich means that its cash-in-bank asset is negative (the ba n k has a llo w e d the c o m p a n y to remove $ 5 0 0 m ore cash from the account than there w a s in it, in effect lending the c o m p a n y the $ 5 0 0 ). The co m p a n y's other assets total $ l 2 4 0 0 . Its net assets are therefore $ l 1 9 0 0 , an d this is also the total o f its liabilities an d shareholders' equity. There a re at least tw o w a ys o f presenting this inform ation: Other assets of $ 12 4 00 minus bank overdraft of $500
=
Liabilities and shareholders' equity of $1 1 900
=
Liabilities and shareholders'equity of $1 1 900 plus bank overdraft of $500
or Other assets of $ 12 4 00
For bank overdrafts, it is custom ary to use the second method, to move the negative ba n k am ount to the other side o f the b a la n ce sheet. Even if the c o m p a n y norm ally has cash in the bank so that the a ccount is norm ally an asset, the a ccount is a lia b ility at this point because the bank has, in effect, lent the c o m p a n y $ 5 0 0 an d w ill w a n t the m oney back.
N E G A T IV E A M O U N T S LEFT A S D E D U C T IO N S Som e ne g a tive am ounts are left as d eductions, not m oved to the other side to m ake them positive, as w a s d o n e w ith the overdraft. A ccum ulated d e p re cia tio n is an im portant e x a m p le o f a n e g a tive -b a la n ce acco u n t. (In practice , this is often ca lle d a contra asset an d is discussed further in C h a p te r 5 .) It is the am ount o f all the d e p re cia tio n c a lcu la te d to d a te on assets such as b u ild in g s a n d equipm ent. For a ccum ulated d e p re cia tio n , there are a t least tw o a p p ro p ria te w a ys o f presenting the inform ation, all o f w h ich m aintain the b a la n c e sheet equa tion : 1
It could be disclosed separately as a deduction on the left side o f the b a la n ce sheet, as w a s used in the Sound an d Light an d C a p p u M a n ia b a la n ce sheets. This is sometimes used, but if there a re a lot of different kinds of assets a nd d e p re cia tio n am ounts, it can make the b a la n ce sheet a little cluttered.
2
It could be d educted from the assets' cost, a nd just the net b o o k value could be disclosed on the b a la n ce sheet, so that accum ulated de p re cia tio n is not m entioned on the fa ce o f the statement. This method, w h ich is most com m on, w o u ld be a c co m p a n ie d b y a note to the fin a n cia l statements, listing the cost an d accum ulated d e p re cia tio n amounts separately, so keeping the b a la n ce sheet uncluttered a nd a llo w in g some a d d itio n a l explanations o f the figures if that w e re thought useful.
110
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: P re p a re th e asse t side o f a b a la n c e s h e e t f o r M ik e ’s T y re R e p a ir L td fr o m th e fo llo w in g a m o u n ts : cash on h a n d $ 9 0 , a c c o u n ts re c e iv a b le $ 6 4 0 , in v e n to ry $ 2 1 0 , e q u ip m e n t c o s t $ 8 9 0 an d a c c u m u la te d d e p re c ia tio n o n e q u ip m e n t $ 4 7 0 . Y o u r a n s w e r s h o u ld be: $
$
Current assets
90
Cash at bank Accounts receivable
640
Inventory
210
940 Noncurrent assets Equipment
890
Accumulated depreciation
(470)
Total assets
3.8
420 1 360
More journal entries
You w ill discover further in C h a p te r 4 that the accounting process is reasonably m echanical on ce you have created your journal entries. C re a tin g journal entries is critical to your general understanding o f a ccounting. The better you understand this (and the earlier sections that g a v e you the k n o w le d g e to d o this section), the easier you w ill find the rest o f the course. A fe w extra hours on this m aterial w ill save you m any m ore hours later in this subject and subsequent subjects. Let's g o b a ck to the LRM exam ple from sections 3.1 a n d 3 .2 an d prepare the journal entries. The 1 4 transactions are repeated here for convenience. 1 2
Shareholders invest $ 2 0 0 0 0 0 cash in the business. Land and bu ild in g is purchased for $ 3 0 0 0 0 0 , w h ich is fin a n ce d by a loan from the seller re p a ya b le in five years.
3 4
Inventory w orth $ 5 0 0 0 0 is bought on account. Equipm ent w orth $ 9 0 0 0 0 is purchased by p a yin g $ 2 0 0 0 0 cash an d signing an agreem ent to p a y the rem ainder in 9 0 days.
5
D am aged inventory that w a s purchased on credit at a cost o f $ 5 0 0 0 w a s returned to the supplier.
6 $ 3 0 0 0 0 is p a id on accounts p a ya b le . 7
$ 1 0 0 0 0 o f inventory is purchased using cash.
8 C ash sales of $ 3 0 0 0 0 w e re m ade. The cost o f the g o o d s that w e re sold am ounted to $ 1 2 0 0 0 . 9
C re d it sales o f $ 4 0 0 0 0 w e re m ade. The cost o f g o o d s sold w a s $ 1 6 0 0 0 .
10 Payments o f $ 8 0 0 0 w e re m ade to suppliers. 11 Paid w a g e s o f $ 2 0 0 0 0 for the first tw o w eeks o f A pril. 12 Received an advertising invoice for $ 2 0 0 0 for a ra d io advertisem ent broadcast on 5 A p ril. The bill w ill be p a id next month.
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111
13 Received $ 2 5 0 0 0 from accounts receivable. 1 4 A t the end o f the month, $1 8 0 0 0 is o w in g in w a g e s for the last tw o w eeks o f the month. It is due to be p a id on 1 M ay. B elow are the relevant journal entries an d the reasons for the d e b it an d credit entries. Before looking at these journal entries, try to d o them yourself. If you are not getting them correct, g o b a ck to sections 3.1 a nd 3 .2 for further detail on h o w the transactions affect the specific accounts. JOURNAL ENTRIES FOR LRM LTD $ 1
DR CR
Reason: 2
Reason:
$
200000
Share capital
200000
Cash (asset) increases; share capital (shareholders' equity) increases DR CR
3
Cash
Land and buildings
300000
Long-term loan
300000
Land and buildings (asset) increases; long-term loan (liability) increases DR CR
Inventory
50000
Accounts payable
50000
Reason:
Inventory (asset) increases; accounts payable (liability) increases
4
DR
Equipment
CR
Cash
20000
CR
Notes payable
70000
Reason: 5
Equipment (asset) increases; cash (asset) decreases; notes payable (liability) increases DR CR
Accounts payable
Reason:
Accounts payable (liability) decreases; inventory (asset) decreases DR
Reason:
Accounts payable (liability) decreases; cash (asset) decreases
CR
DR CR
Accounts payable
Inventory
Inventory (asset) increases; cash (asset) decreases DR
CR
Cash
9
DR
CR Reason:
10000 10000
30000 30000 12 000
Inventory
Cash (asset) increases; sales revenue (revenue) increases; COGS (expense) increases; inventory (asset) decreases
DR
30000
Sales revenue Cost of goods sold
Reason:
CR
30000
Cash
8
DR
5 000
Cash
Reason:
CR
5 000
Inventory
6
7
90000
Accounts receivable
12 000
40000
Sales revenue Cost of goods sold Inventory
Accounts receivable (asset) increases; sales revenue (revenue) increases; cost of goods sold (expense) increases; inventory (asset) decreases
40000 16000 16000
»
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
112
10
DR CR
Accounts payable
8 000
Reason:
Accounts payable (liability) decreases; cash (asset) decreases
11
DR
Reason:
Wages expense (expense) increases; cash (asset) decreases
CR
12
DR CR
Wages expense
20000
Advertising expense
13
DR
14
Cash
2 000
25 000
Accounts receivable
25 000
Cash (asset) increases; accounts receivable (asset) decreases DR CR
Reason:
2 000
Accounts payable
Advertising expense (expense) increases; accounts payable (liability) increases
CR
20000
Cash
Reason:
Reason:
8 000
Cash
Wages expense
18 000
Wages payable
18 000
Wages expense (expense) increases; wages payable (liability) increases
HOW'S YOUR UNDERSTANDING? T o re v is e th e a b o v e p o in t c o n s id e r th e fo llo w in g in fo r m a tio n . W h ic h o f th e fo llo w in g tra n s a c tio n s w o u ld in c re a s e o r d e c re a s e p r o fit in J u n e :
1
C r e d it sales o f $ 5 0 0 in J u n e w ith cash re c e iv e d in A u g u s t.
2
R e c e iv e d $ 3 0 0 cash in J u n e fr o m a c c o u n ts re c e iv a b le a t th e e n d o f M a y .
3
R e c e iv e d an e le c tric ity bill in J u n e fo r $ 1 6 0 w h ic h relates to e le c tric ity used in J u n e ; th e bill w ill be paid in J u ly ).
Y o u r a n sw e rs s h o u ld be:
1
In cre a se s p ro fit.
2
D o e s n o t im p a c t p r o fit (i.e . in c re a s e s c a sh , d e c re a s e s a c c o u n ts re c e iv a b le ).
3
D e c re a s e s p ro fit.
3.9
Cash versus accrual accounting revisited
In C h a p te r 1 you learnt that the predom inant method o f accounting is ca lle d accrual acco u n tin g . It is used b y all large businesses, an d in the last d e c a d e has also been used b y public sector organisations an d not-for-profit organisations. U nder an accrual accounting system, the im pact o f transactions is recognised in the p eriod w hen revenues and expenses occur - w h ich m ay or m ay not be the sam e p eriod in w h ich the cash is received. For exam ple, a cash sale o f $ 1 0 0 0 w o u ld increase both sales revenue (and therefore accrued profit) a nd cash (increase cash; increase sales revenue). H ow ever, a credit sale o f $ 1 0 0 0 in M a y w ith cash collected in July w o u ld increase sales revenue in M a y , but not increase cash until July (increase accounts receivable; increase sales revenue). W h e n the m oney is received in July, cash w o u ld increase but it w o u ld have no im pact on revenue (increase cash; decrease accounts receivable).
CHAPTER 3 The do u b le -e n try system
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Figure 3.1 summarises the w a y accrual fin a n cia l accounting inform ation is assem bled, an d gives exam ples. •
The foundation is cash transactions, w h ich even the simplest accounting records include.
•
M o s t accounting systems also include credit transactions, because most enterprises extend credit to customers a n d /o r use cre d it from their suppliers an d em ployees.
L e v e ls o f fin a n c ia l a c c o u n t in g
Often uncertain, complex and unclear
S o m e e x a m p le s
Debt and share contract details Possible lawsuit outcomes Choices of accounting methods
Estimated pension payments Wear and tear on building Future income taxes
Unsold goods expected to be sold Estimated income tax payable Insurance paid in advance
Amounts due from customer Amounts due to suppliers Unpaid employee wages
Usually certain, verifiable and clear
FIGURE 3.1
•
Cash or cheques received Cash or cheques paid Direct bank transactions
Levels of accrual accounting•
Short-term a nd long-term adjustments a re needed in preparing fin a n cia l statements, unless the com pany's accounting system is sophisticated enough to have a lre a d y built them in (some are, though there are a lw a ys new issues to be d e a lt w ith as the w o rld keeps changing).
•
Extensive narrative an d supplem entary disclosures (especially the notes to the fin a n cia l statements) are m ade, sometimes using m any m ore pages than the statements themselves do. The result is that accrual accounting is a very co m p le x inform ation system, a nd it w ill take the rest o f this b o o k to
introduce you to it properly. H ow ever, n o w that you have covered transaction analysis, it should start to becom e easier to fo llo w . So let's review some key points a b o u t accrual a ccounting. •
Revenue is recognised in the period in w h ich the g o o d is delivered o r the service is p rovided. Revenue can be recorded regardless o f w hen cash is received.
• •
C ash can be received in the sam e period as revenue is recognised (e.g. cash sales). Revenue can be recognised in o ne p e riod, an d the cash is not received until the fo llo w in g period (e.g. credit sales).
114
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C ash can be received in one p e riod, but the service is not p rovided until a later p eriod an d , therefore, revenue w ill not be recognised until the later p eriod (e.g. customer pays a dep o sit on services to be pro vid e d in a later period).
•
Expenses are recognised in the p eriod in w h ich the expense is incurred. A g a in this is regardless o f w hen cash is p a id . For exam ple, if an em ployee w orks 10 days in a month a nd the w a g e rate is $ 2 0 0 a d a y, the expense is $ 2 0 0 0 for the month. This is regardless o f w hether all or part o f the $ 2 0 0 0 is p a id in this month, a future month o r a previous month.
3.10
Example: Simone's jew ellery business
H ere is an exam ple of h o w accrual accounting w orks. The exam ple is o f a small business, one you should be a b le to im agine easily, but the accounting issues it raises are exactly the same as those fa ce d by b ig businesses. Sim one w orks in an o ffice during the d a y, but in the evenings a n d on w eekends she makes silver jew ellery in a studio she has set up in her basement. The jew ellery is sold in local craft shops, an d Sim one keeps a separate bank account to deposit the cash from her sales an d to p a y the bills for supplies. A ccounting is a w a y o f portraying an enterprise; another w a y , a visual im age, m ay help you. Try to picture Sim one w orking in her studio, d riving around to craft shops to d eliver her products a nd collect cash, a n d relaxing w ith her friends w hen things are g o in g w e ll. It is im portant that accounting's reports be consistent w ith the reality o f her business, so keep the im age in mind as this exam ple develops.
2016 as first year in business For 2 0 1 6 , her first ye a r in business, Sim one received $ 4 3 5 0 in cash from the craft shops for sales o f her jew ellery and p a id $ 1 6 7 0 in cash for silver an d other supplies an d expenses. H o w much m oney d id she make from her business in 2 0 1 6 ? The sim ple answ er is that she m ade a cash p rofit of $ 2 6 8 0 ( $ 4 3 5 0 cash collected minus $ 1 6 7 0 cash p a id out). H er bank b a lance increased by that am ount during the year. This is a sim ple, understandable calculation. The notion behind accrual accounting is that m aybe the sim ple calculation is to o sim ple; that it really does not properly measure w h a t Sim one a ccom plished during the year. A ccrual accounting tries to take into account a number o f things. •
A t the end of the year, Sim one w a s still o w e d $ 3 1 0 for sales by on e craft shop because the o w n e r had been out w hen she stopped by. The shop p a id her a fe w w eeks later, but shouldn't that am ount be counted as revenue for the ye a r the sales w e re m ade? It w a s a credit transaction in that year, not a cash transaction yet. The am ount w as legally o w e d to Sim one at the end o f the ye a r a nd she expected to collect the cash.
•
A t the end o f the year, Sim one had some u n paid bills for business expenses totalling $ 8 5 . She p a id those early in the next year, but a ren't they really expenses for the ye a r in w h ich she incurred them, rather than for the y e a r in w h ich she p a id them ? She has bills for these, so they represent other credit transactions, but this time involving promises by Sim one to p a y rather than b y her customers to p a y her.
•
In m aking the jew ellery, she used some equipm ent she had bought earlier for $ 1 2 0 0 . If the equipm ent is expected to last a b o u t 1 0 years, shouldn't the w e a r a n d tear on it during the ye a r be counted as an expense? It is not easy to figure out h o w much w e a r a n d tear results from a particular p e riod, but say that Sim one feels that the ye a r w a s a normal one o f the 1 0 years the equipm ent should last for. The cost o f the w e a r a nd tear, therefore, w a s about 1 0 per cent of the o rig in a l cost o f the equipm ent, o r $ 1 2 0 . (This $ 1 2 0 figure is w h a t accountants call d e p reciation. It can be calculated in several w a ys, as w e w ill see later on.) This is an exam ple o f a long-term estim ate o r expectation. People have all sorts o f disagreem ents a b o u t d e p re cia tio n because it involves the prediction o f an uncertain future (along w ith other reasons w e 'll lo o k at).
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By using these three a d d itio n a l pieces o f inform ation, accrual accounting w o u ld calculate Sim one's accrual profit for the ye a r 2 0 1 6 (her first ye a r in business) in the fo llo w in g w a y , taking into a ccount the various estimates and incom plete transactions described: SIMONE'S JEWELLERY BUSINESS CALCULATION OF ACCRUAL PROFIT FOR THE YEAR 2 0 1 6 Revenue ($4350 collected plus $310 still to be received)
$4 660
Expenses ($1670 paid plus $85 unpaid plus $ 120 estimated depreciation)
Accrual profit based on the information provided
1 875 $2 785
A ccrual accounting can an d does handle m any m ore com plexities than the three included a b o ve . Even w ith this uncom plicated exam ple, you can see that the $ 2 7 8 5 accrual profit is a m ore com plete measure o f Sim one's business perform ance than is the cash profit o f $ 2 6 8 0 , w h ich is the ch a n g e in cash b a la n ce a lone. (Accrual profit is not necessarily higher than cash profit - it just happens to be so in this exam ple.) •
N o te that there are m ore items w e d id not consider at this early stage of the book. W h a t a b o u t the costs of using the room in her basem ent for her studio a n d her ca r for deliveries? Should some calculation o f such costs be m ade, although it w o u ld be difficult to be exact a b o u t them ? W h a t a b o u t incom e tax? If she has to p a y incom e tax on w h a t she earns from her business, should that tax also be deducted as a business expense? W h a t a bout unused supplies at the end o f the p e rio d ? H o w a re g o o d s a nd services taxes (GST) handled? For no w , let's not becom e mired in such com plexities! Remember that accrual accounting tries to pro vid e a more
thorough measurement o f fin a n cia l perform ance an d other aspects o f an enterprise than sim ple cash-based accounting. In o rd e r to d o so, it incorporates m ore co m p le x ideas, as w e ll as estimates a nd judgem ents. M u ch of your task is to understand the com plexities, estimates a nd judgements so that you w ill be a b le to understand the resulting fin a n cia l statements an d w h a t they say a b o u t the enterprise.
Impact o f opening balances on the Simone example To finish the exam ple o f Sim one's business, let's extend it to the case in w h ich 2 0 1 6 w a s not her first ye a r in business; that is, 2 0 1 6 w a s just a normal business year. That means she m ay have had uncollected sales an d u n paid bills at the end o f 2 0 1 5 (beginning o f 2 0 1 6 ). W o u ld those o p e n in g balances make a n y difference to the cash profit calculation for 2 0 1 6 ? N o , they w o u ld n 't - they d o n 't involve a n y ch a n g e in cash receipts o r payments during the year. W o u ld they make a n y difference to the accrual profit calculation for 2 0 1 6 ? Yes, they w o u ld . Let's see how . To keep the exam ple uncluttered, let's use exactly the sam e numbers a g a in , but a d d tw o n e w items as at the end o f 2 0 1 5 : accounts receivable (credit sales m ade for w h ich the cash has not yet been received), $ 2 4 0 ; an d accounts p a y a b le (unpaid bills), $ 5 0 . W h a t effect d o these have on the accrual profit calculation? Som e o f the $ 4 3 5 0 cash received in 2 0 1 6 w a s not for that year's sales, but rather covered collecting $ 2 4 0 revenue that w a s part o f the accrual profit calculation in the previous year, 2 0 1 5 . That am ount has to be subtracted from $ 4 3 5 0 in the 2 0 1 6 accrual p rofit calculation because it w a s a lre a d y in the 2 0 1 5 accrual profit a nd shouldn't be counted tw ice. The $ 5 0 o f u n paid bills at the end o f 2 0 1 5 w e re included in the cash payments in 2 0 1 6 ; therefore, they w e re counted in the 2 0 1 6 expenses a b o ve , although they had a lre a d y been included in the 2 0 1 5 expenses. C onsequently, they a re deducted from the 2 0 1 6 expenses because they d o n 't belong in 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o w here's Sim one's accrual profit if 2 0 16 w a s not her first year: SIMONE'S JEWELLERY BUSINESS REVISED CALCULATION OF ACCRUAL PROFIT FOR THE YEAR 20 16 Revenue ($4350 collected, minus $240 from 2015, plus $310 still to be received)
$4420
Expenses ($1670 paid, minus $50 from 2015, plus $85 unpaid at the end of 2015, plus $120 estimated depreciation for 2015)
1 825 ______
Accrual profit based on the information provided
$2 595
C ash profit is still $ 2 6 8 0 - unaffected b y the n e w inform ation. But accrual p rofit is ch a n g ed , as it a lw a ys is, by non-cash items existing at both the b e ginning a nd the end o f the year.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve j u s t re a d , b u t n o te it is a b it m o re d iffic u lt b e ca u s e it has o p e n in g ba la n ce s o f a c c o u n ts re c e iv a b le and a c c o u n ts p a ya b le . I f y o u c a n ’t a n s w e r th e m , it w o u ld be b e s t t o re -re a d th e m a te ria l. F re d s ta rte d his d e liv e ry b u sin e ss a fe w y e a rs ag o. T h is y e a r, he c o lle c te d $ 4 7 0 0 0 fr o m his c u s to m e rs and paid $21 0 0 0
in ex p e n s e s . A t th e b e g in n in g o f th is y e a r, his c u s to m e rs o w e d $ 3 5 0 0 an d he o w e d his
s u p p lie rs $ 7 0 0 . A t th e e n d o f th is y e a r, his c u s to m e rs o w e h im $ 3 2 0 0 ; he o w e s his s u p p lie rs $ 1 4 5 0 ; and his tr u c k d e p re c ia tio n f o r th e y e a r w as $ 4 6 0 0 . U s in g ju s t th is in fo rm a tio n :
1
W h a t is th is y e a r’s cash p r o fit?
2
W h a t is th is y e a r’s a c c ru a l p r o fit?
Y o u r a n sw e rs s h o u ld be:
1
C a s h p r o fit is $ 2 6 0 0 0 ( $ 4 7 0 0 0 cash re c e ip ts - $21 0 0 0 cash p a y m e n ts ).
2
A c c ru a l p r o fit is $ 2 0 3 5 0 (re v e n u e o f $ 4 7 0 0 0 - $ 3 5 0 0 + $ 3 2 0 0 = $ 4 6 7 0 0 ; e x p e n s e s o f $21 0 0 0 $ 7 0 0 + $ 1 4 5 0 + $ 4 6 0 0 = $ 2 6 3 5 0 ).
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117
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Transaction analysis Flashy Fashions Ltd is a sm all c o m p a n y in a c o a s ta l to w n . It rents its pre m ises a n d its sales a re a ll o n c re d it. It has o n ly th re e expe nses: cost o f g o o d s s o ld , rent a n d in c o m e ta x. A t th e e n d o f its p re v io u s fin a n c ia l y e a r, 3 0 S e p te m b e r 2 0 1 5 , Flashy's b a la n c e shee t w a s as fo llo w s : FLASHY FASHIONS LTD BALANCE SHEET AS AT 3 0 SEPTEMBER 20 16 Assets
$
Current assets
Equities Current liabilities
Cash
800
Accounts payable
600
Accounts receivable
400
Rent payable
300
Inventory
900
Shareholders' equity Share capital
500
Retained profits
700
2 100
2100
a
D u rin g th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , the fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's ac co u n ts, R evenue fro m c re d it sales $ 1 0 0 0 0 .
b
C o lle c tio n s fro m custom ers $ 9 6 0 0 .
c
Purchases o n c re d it o f in v e n to ry fo r sale $ 6 1 0 0 .
d
Paym ents to s u p p lie rs $ 6 3 0 0 .
e
C o s t o f g o o d s sold $ 6 4 0 0 .
f
Rent c h a rg e d b y th e la n d lo rd $ 2 4 0 0 .
g
Rent p a id to th e la n d lo rd $ 2 9 0 0 (d e cre a s in g th e lia b ility ),
h
In co m e ta x p a y a b le fo r th e y e a r $ 3 5 0 .
i
C a s h d iv id e n d s d e c la re d a n d p a id to s h a re h o ld e rs $ 4 5 0 .
R e q u ire d : 1 P re p a re tra n s a c tio n a n a lys is fo r e a c h o f th e a b o v e item s.
2
P re p a re an in co m e state m e nt a n d a b a la n c e sheet.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEM B Com plete the expanded acco u n tin g equation C a lc u la te th e m issing fig u re in e a c h o f th e fo llo w in g s itu a tio n s : Current assets
Noncurrent assets
Current liabilities
Noncurrent liabilities
Share capital
Opening retained profits
Revenue
Expense
Dividend
1
50000
200000
25 000
50000
?
5 000
25 000
15 000
0
2
150 00 0
600000
75 000
150 00 0
450000
30000
150 00 0
?
0 0 0
3
150 00 0
600000
75 000
150 00 0
450000
120000
135 000
?
4
?
250000
25 000
50000
250000
50000
45 000
30000
PRACTICE PROBLEM C Transaction analysis and jo u rn a l entries B e lo w is th e a b rid g e d b a la n c e sheet fo r N e w c o m b e Ltd as a t 31 M a y 2 0 1 6 . 1 Assets Cash
$ 90000
1
Liabilities and shareholders' equity Accounts payable
110 00 0
Accounts receivable
106000
Long-term loan
240000
Inventory
118 000
Share capital
200000
Prepayments
45 000
Equipment
400000
Accumulated depreciation
(125 000)
Retained profits
634000
84000
634000
The fo llo w in g tra n s a c tio n s o c c u r d u rin g June: a R eceived $ 2 3 0 0 0 fro m a c co u n ts re c e iv a b le , b
A d d itio n a l shares w o rth $ 8 0 0 0 0 a re issued,
c
In ve n to ry (co sting $ 3 2 0 0 0 ) is s o ld o n c re d it fo r $ 7 6 0 0 0 .
d
R e c o g n itio n o f $ 4 0 0 0 o f d e p re c ia tio n e xpe nse,
e
O f th e lo a n , $ 6 0 0 0 0 is re p a id ,
f
A d m in is tra tiv e expe nses o f $ 7 0 0 0 a re p a id ,
g
A to ta l o f $ 9 0 0 0 o f p re p a ym e n ts a re used up.
h
P aym e nt o f w a g e s o f $ 1 3 0 0 0 .
i
P urchase o f $ 2 8 0 0 0 w o rth o f in v e n to ry fo r cash,
j
D iv id e n d s o f $ 6 0 0 0 a re p a id ,
k
P aym e nt o f $ 3 6 0 0 0 o f a c co u n ts p a y a b le .
R e q u ire d : 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n s a c tio n s o n th e a c c o u n tin g e q u a tio n . 2
P re p a re an in c o m e state m e nt fo r th e m onth o f June a n d a b a la n c e sheet fo r N e w c o m b e Ltd a t 3 0 June 2 0 1 6 .
3
For e a ch o f th e a b o v e tra n sa ctio n s, w h a t is th e e ffe c t o n net p ro fit, to ta l assets, to ta l lia b ilitie s a n d s h a re h o ld e rs ' e q u ity ? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
4
P re p a re jo u rn a l en trie s fo r e a ch o f th e 11 tra n sa ctio n s a b o v e .
CHAPTER 3 The d o u b le -e n try system
Adjustment(s) Ratios
119
Reclassification Trial balance
This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
1
If a n asset in cre ases, list w h a t else m a y h a ve h a p p e n e d to th e a c c o u n tin g e q u a tio n .
2
W h ic h o f th e fo llo w in g is n o t p o ssib le? a
O n e lia b ility in cre ases a n d a n o th e r lia b ility in cre ases,
b
S h a re h o ld e rs ' e q u ity in cre ases a n d lia b ilitie s d e cre a s e ,
c
Assets in cre a s e a n d lia b ilitie s d e cre a s e .
3
W h y do es an in cre a s e in revenues result in an in cre a s e in s h a re h o ld e rs ' e q u ity ? W h a t o th e r p a rt o f the a c c o u n tin g e q u a tio n is lik e ly to be a ffe c te d ?
4
W h y d o e s an in cre a s e in expe nses result in a d e cre a s e in s h a re h o ld e rs ' e q u ity ? W h a t o th e r p a rt o f the a c c o u n tin g e q u a tio n is lik e ly to be a ffe c te d ?
5
G iv e th re e e x a m p le s o f a n asset th a t c o u ld d e cre a s e w h e n an e x p e n s e is in cre a s e d .
6 W h ic h a c co u n ts n o rm a lly h a ve a d e b it b a la n c e a n d w h ic h n o rm a lly h a ve a c re d it b a la n c e ? 7
C h o o s e five tra n s a c tio n s a n d s h o w bo th th e resou rce e ffe c t a n d th e so u rce effect.
8
E x p la in h o w th e b a la n c e sheet a n d th e in c o m e state m e nt a rtic u la te .
9
List som e o f th e la rg e r expe nses y o u w o u ld e x p e c t to see in th e in co m e statem ents fo r th e fo llo w in g o rg a n is a tio n s : a W o o lw o rth s b
C o m m o n w e a lth B ank
c
Red C ross
d
A u s tra lia n N a v y
PROBLEM 3.1 Transactions P ro v id e illu s tra tio n s o f th e fo llo w in g tra n sa ctio n s re la tin g to a lo c a l re ta ile r: 1
O n e asset is e x c h a n g e d fo r a n o th e r.
2
A n asset a n d a lia b ility in cre a s e b y th e sam e a m o u n t.
3
A n asset a n d re ven ue in cre a s e b y th e sam e a m o u n t.
4
O n e lia b ility is e x c h a n g e d fo r a n o th e r.
5
A n asset a n d a lia b ility a re re d u c e d b y th e sam e a m o u n t.
6 A lia b ility a n d a n e x p e n s e a re in c re a s e d b y th e sam e a m o u n t. 7
A n asset a n d s h a re h o ld e rs ' e q u ity a re in cre a s e d b y th e sam e a m o u n t.
8 A n asset is re d u c e d a n d an e x p e n s e is in cre a s e d b y th e sam e a m o u n t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3.2 Com plete tra n sa ctio n analysis and prepare fin a n cia l statem ents The fo llo w in g tra n s a c tio n s o c c u rre d fo r th e m o nth o f N o v e m b e r 2 0 1 6 fo r H o a d Ltd: a The c o m p a n y w a s in c o rp o ra te d , w ith s h a re h o ld e rs in ve stin g $ 2 0 0 0 0 0 in cash , b
P urchased in v e n to ry fo r cash , $ 2 0 0 0 0 .
c
P aid $ 4 0 0 0 fo r a m o n th 's rent on th e prem ises,
d
P urchased in v e n to ry on c re d it, $ 3 0 0 0 0 .
e
R eceived an a d v e rtis in g b ill fo r a n e w s p a p e r a d ve rtis e m e n t to p ro m o te th e n e w c o m p a n y . The $ 1 0 0 0 b ill w ill be p a id in D e c e m b e r.
f
In ve n to ry w ith a c o st o f $ 4 0 0 0 0 w a s s o ld o n c re d it fo r $ 9 0 0 0 0 .
g
P aid $ 2 5 0 0 0 o f a c co u n ts p a y a b le ,
h
R eceived $ 3 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
i
P aid w a g e s o f $ 1 5 0 0 0 .
j
P aid sales c o m m is sio n a t th e ra te o f 1 p e r c e n t o n sales m a d e d u rin g th e m o nth,
k
P urchased a n e w c o m p u te r fo r $ 6 0 0 0 ; p a id $ 3 0 0 0 in cash a n d $ 3 0 0 0 to be p a id in 15 m onths tim e.
I
O w e d e m p lo y e e s $ 2 0 0 0 in w a g e s a t th e e n d o f th e m onth.
R e q u ire d : 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n s a c tio n s o n th e a c c o u n tin g e q u a tio n . 2
P re p a re an in c o m e state m e nt a n d a b a la n c e sheet a t 3 0 N o v e m b e r 2 0 1 6 .
3
P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n a n d d e te rm in e th e b a la n c e fo r e a c h a c c o u n t.
4
For e a c h tra n s a c tio n a to I, w h a t is th e e ffe c t on net p ro fit a n d to ta l assets? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
PROBLEM 3.3 E ffe ct o f tra n sa ctio n s The fo llo w in g tra n sa ctio n s o c c u rre d fo r G ilc h re s t Ltd (assum e a ll b e g in n in g b a la n ce s = 0) d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . a Issued shares fo r $ 7 0 0 0 0 0 cash . b
S ig n e d a c o n tra c t on 1 O c to b e r 2 0 1 6 fo r $ 2 0 0 0 0 0 to s u p p ly c o n s u ltin g a d v ic e . R eceived an a d v a n c e o f $ 3 0 0 0 0 . A t 31 D e c e m b e r n o n e o f th e c o n s u ltin g a d v ic e h a d y e t be en p ro v id e d ,
c
P urchased $ 2 0 0 0 0 0 o f in v e n to ry ; p a id $ 9 0 0 0 0 cash w ith th e re m a in d e r on a c c o u n t,
d
S old $ 3 0 0 0 0 0 o f p ro d u cts to custom ers o n a c c o u n t; cost o f p ro d u c ts w a s $ 1 4 0 0 0 0 .
e
C o lle c te d $1 2 0 0 0 0 cash fro m custom ers in p o in t (d).
f
P aid $ 7 0 0 0 0 in w a g e s to e m p lo y e e s d u rin g th e y e a r; a t y e a r-e n d w a g e s o f $ 8 0 0 0 a re o w e d to e m p lo y e e s fo r w o rk d o n e in D e c e m b e r 2 0 1 6 , to be p a id in 2 0 1 7 .
g
E arn ed $ 1 0 0 0 0 in tere st o n investm ents, re c e iv in g 7 0 p e r c e n t in cash .
h
R eceived an e le c tric ity b ill in D e c e m b e r 2 0 1 6 fo r $ 4 0 0 0 c o v e rin g e le c tric ity c h a rg e s fo r D e c e m b e r 2 0 1 6 . The b ill w ill be p a id in J a n u a ry 2 0 1 7 .
i
P aid $ 2 0 0 0 0 cash fo r s u p p lie s re c e ive d d u rin g 2 0 1 6 . A t y e a r-e n d $ 7 0 0 0 o f su p p lie s w e re still o n h a n d (i.e. h a d n o t be en used up).
j
D e c la re d a n d p a id $ 3 0 0 0 0 in cash d iv id e n d s to s h a re h o ld e rs.
CHAPTER 3 The d o u b le -e n try system
121
For e a ch o f th e a b o v e tra n s a c tio n s , events o r fa cts, in d ic a te th e im p a c t on revenues, exp e n se s, assets a n d lia b ilitie s d u rin g 2 0 1 6 b y p la c in g a + o r - s ig n (+ fo r in cre a s e a n d - fo r de cre ase) to in d ic a te d ire c tio n in th e a p p ro p ria te b o x . W r ite N E if th e re is no effect. In clu d e d o lla r a m ou nts.
PROBLEM 3.4 N et p ro fit and to ta l assets D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , th e fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's a cco u n ts o f B org Lim ited. a Issue s h a re c a p ita l o f $ 5 0 0 0 0 0 . b
C re d it sales, $ 3 0 0 0 0 0 .
c
C a s h sales, $1 2 0 0 0 .
d
C o lle c tio n s fro m a c co u n ts re c e iv a b le , $ 3 0 0 0 0 0 .
e
Purchases o f in v e n to ry on c re d it, $ 1 4 0 0 0 0 .
f
Paym ents o f a cco u n ts p a y a b le , $ 1 0 0 0 0 0 .
g
C o s t o f g o o d s sold , $ 1 6 0 0 0 0 .
h
W a g e s e x p e n s e , $ 1 8 0 0 0 0 , n o t y e t p a id ,
i
W a g e s p a id , $ 4 4 0 0 0 (re d u c e w a g e s p a y a b le ),
j
C a s h d iv id e n d s , $ 4 0 0 0 0 , d e c la re d a n d p a id .
W h a t is th e s e p a ra te e ffe c t o f e a ch o f th e tra n sa ctio n s on net p ro fit a n d to ta l assets?
PROBLEM 3.5 Com plete the expanded a cco u n tin g equation C a lc u la te th e m issing fig u re in e a ch o f th e fo llo w in g situ a tio n s : Current assets 1
100000
Noncurrent assets 400000
Current liabilities 50000
Noncurrent liabilities 100000
Share capital
Opening retained profits ?
Revenue
10000
Expenses
Dividends
50000
30000
0 0 0
2
100000
400000
50000
100000
300000
20000
100000
?
3
100000
400000
50000
100000
300000
80000
90000
?
4
?
500000
50000
100000
500000
100000
90000
60000
0
5
100000
400000
50000
100000
300000
20000
100000
50000
?
6
100000
500000
50000
100000
300000
?
100000
50000
20000
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3 .6 A scertain the unknow ns in the acco u n tin g equation Find th e u n kn o w n s fo r LAP Ltd g iv e n th e fo llo w in g in fo rm a tio n : $m Assets 1 July 2015
$m
600
Liabilities 1 July 2015
Assets 30 June 2016
?
?
Liabilities 30 June 2016
300
Share capital 1 July 2015
180
Share capital 30 June 2016
190
Retained profits 1 July 2015
200
Retained profits 30 June 2016
Revenues for the year
800
Expenses for the year
650
Dividends
?
50
PROBLEM 3 .7 Prepare a balance sheet trom sim ple tran sa ctions South S h o re M a n u fa c tu rin g Ltd h a d this b a la n c e sheet: BALANCE SHEET AS AT 3 0 JUNE 2 0 1 6 | Assets
$
Current assets
Liabilities and shareholders' equity
$
Current liabilities
Cash
24000
Bank overdraft
53 000
Accounts receivable
89000
Accounts payable
78 000
Taxes payable
13 000
Current part of mortgage
18 000
Inventories, cost
111 00 0
Prepayments
7000 231000
Noncurrent assets
162 00 0
Noncurrent liabilities
Land, cost
78000
Factory and equipment, cost
584000
Accumulated depreciation
(198 000)
386000
Mortgage, less current
214000
Employee entitlements
66 000
Loan from shareholders
100 00 0 380000
Shareholders' equity Share capital
55 000
Retained profits
98 000 153 000
695000
D u rin g J u ly 2 0 1 6 , S outh S h o re M a n u fa c tu rin g e x p e rie n c e d th e fo llo w in g tra n sa ctio n s: a A n a m o u n t o f $ 1 0 0 0 0 o f th e s h a re h o ld e rs ' lo a n w a s re p a id , b
A c u stom er p a id o n e o f th e a c co u n ts re c e iv a b le , $1 1 2 4 0 .
c
A d d itio n a l in v e n to ry c o stin g $ 5 3 2 0 w a s p u rc h a s e d o n c re d it,
d
The c o m p a n y issued n e w shares fo r $ 2 2 0 0 0 cash .
695 000
CHAPTER 3 The d o u b le -e n try system
e
123
The p ro ce e d s o f th e sh a re issue w e re used to re d u c e th e b a n k o v e rd ra ft.
f
M o re la n d c o stin g $ 5 2 0 0 0 w a s p u rc h a s e d fo r $1 2 0 0 0 cash plus a n e w long -term m o rtg a g e fo r th e rest,
g
M o re fa c to ry e q u ip m e n t c o stin g $ 3 1 9 0 0 w a s p u rc h a s e d o n c re d it, w ith $1 3 9 0 0 d u e in six m onths a n d th e rest d u e in 2 4 m onths.
Required: 1 P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n . 2
P re p a re a n e w b a la n c e sheet fo r th e c o m p a n y as a t 31 J u ly 2 0 1 6 .
PROBLEM 3 .8 Prepare a balance sheet from sim ple transactions N o rth S ho re M a n u fa c tu rin g Ltd h a d this b a la n c e sheet: BALANCE SHEET AS AT 3 0 JUNE 20 16 Assets
$
Current assets
Liabilities and shareholders' equity Current liabilities
Cash
20 000
Accounts payable
80000
Accounts receivable
70 000
Taxes paya ble
20000
Inventories, cost
1 10 000
Wages payable
200000
Noncurrent assets
1 0 0 00 110 00 0
Noncurrent liabilities
Land, cost
200000
Mortgage, loan
200000
Plant and equipment
400 000
Provision for employee entitlements
100000
Accum. depreciation
(100 000)
600000
300000
Shareholders' equity Share capital Retained profits
200000 90000 290000
700000
700000
D u rin g July 2 0 1 6 , N o rth S h o re M a n u fa c tu rin g e x p e rie n c e d th e fo llo w in g tra n sa ctio n s: a A n a m o u n t o f $ 8 0 0 0 o f a c co u n ts p a y a b le w a s p a id , b
A c u sto m e r p a id o n e o f th e a c co u n ts re c e iv a b le , $ 13 2 8 0 .
c
A d d itio n a l in v e n to ry c o stin g $ 8 0 0 0 w a s p u rc h a s e d o n c re d it,
d
The c o m p a n y issued n e w shares fo r $ 5 0 0 0 0 cash,
e
The p ro ce e d s o f th e sh a re issue w e re used to re d u c e th e m o rtg a g e lo a n .
f
M o re la n d c o stin g $ 5 4 0 0 0 w a s p u rc h a s e d fo r $ 1 4 0 0 0 cash plus a n e w long -term m o rtg a g e fo r th e rest,
g
M o re e q u ip m e n t c o stin g $ 3 3 9 0 0 w a s p u rc h a s e d on c re d it, w ith $1 3 9 0 0 d u e in tw o m onths.
Required: 1 P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n . 2
P re p a re a n e w b a la n c e sheet fo r th e c o m p a n y as a t 31 J u ly 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3 .9 Com plete tra n sa ctio n analysis and show e ffe c t on n e t p r o fit/to ta l assets The a b rid g e d b a la n c e sheet fo r R oche Ltd a t 31 A u g u s t 2 0 1 6 w a s as fo llo w s : Assets
$
Liabilities and shareholders' equity
1 10 000
Accounts receivable
410000
Long-term loan
310000
Inventory
610000
Share capital
910000
Retained profits
250000
Prepayments Equipment Accumulated depreciation
80000
Accounts payable
$
Cash
210000
610000 140000 1 680000
1680000
The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g S e p te m b e r: a P aid $ 1 0 0 0 0 0 o f a cco u n ts p a y a b le , b
R eceived $ 3 0 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
c
P urchased in v e n to ry on c re d it fo r $ 2 0 0 0 0 0 .
d
M a d e c re d it sales o f $ 7 0 0 0 0 0 (C O G S w a s $ 4 5 0 0 0 0 ) .
e
A d m in is tra tiv e expe nses o f $ 3 0 0 0 0 w e re p a id in cash,
f
D e p re c ia tio n o f $ 1 0 0 0 0 w a s re c o g n is e d ,
g
P rep aym e nts o f $ 1 0 0 0 0 e x p ire d d u rin g th e m onth,
h
D iv id e n d s o f $ 2 0 0 0 0 w e re p a id ,
i
P aid b a c k $ 1 0 0 0 0 0 on th e lo a n ,
j
Issued a d d itio n a l shares w o rth $ 5 0 0 0 0 0 .
k
P aid th e w a g e s b ill o f $ 5 0 0 0 0 .
Required: 1 S h o w th e e ffe c t o f the a b o v e tra n sa ctio n s on th e a c c o u n tin g e q u a tio n . 2
P re p a re jo u rn a l en trie s fo r e a ch tra n s a c tio n a n d d e te rm in e th e b a la n c e s o f the a cco u n ts.
3
W h a t is th e e ffe c t on net p ro fit a n d to ta l assets? W r ite 'in c re a s e ', 'd e c re a s e ' o r 'n o e ffe c t' fo r e a ch tra n s a c tio n .
PROBLEM 3.1 0 Transaction analysis The fo llo w in g tra n s a c tio n s p e rta in to R osew all Ltd fo r N o v e m b e r 2 0 1 5 . 1 The c o m p a n y w a s in c o rp o ra te d , w ith s h a re h o ld e rs in ve stin g $ 2 5 0 0 0 0 in cash . 2
P urchased $ 4 3 0 0 0 w o rth o f in v e n to ry on c re d it.
3
Rent o f $ 8 0 0 0 w a s p a id .
4
M a d e c re d it sales o f $ 1 1 0 0 0 0 (C O G S w a s $ 4 5 0 0 0 ).
5
R eceived th e $ 2 0 0 0 b ill fo r a n a d v e rtis in g c a m p a ig n to p ro m o te th e n e w c o m p a n y . This a m o u n t w ill be p a id in D e c e m b e r.
6
In ve n to ry w a s p u rc h a s e d fo r $ 2 7 0 0 0 cash .
7
P aid $ 3 0 0 0 0 o f a c co u n ts p a y a b le .
8 W a g e s o f $ 2 4 0 0 0 w e re p a id (w a g e s e xpe nse). 9
R eceived $ 4 5 0 0 0 fro m a c co u n ts re c e iv a b le .
1 0 Sales c o m m is sio n w a s p a id a t th e ra te o f 1 p e r c e n t o f to ta l m o n th ly sales. 11 P urchased n e w m a c h in e ry a t a cost o f $ 9 0 0 0 . O f this, $ 4 0 0 0 w a s p a id in cash w ith th e re m a in d e r to be p a id in 1 5 m o n th s' tim e. 12 O w e d e m p lo y e e s $ 3 5 0 0 in w a g e s a t th e e n d o f N o v e m b e r. 13 D e p re c ia tio n o n th e n e w e q u ip m e n t e q u a lle d $ 1 0 0 0 .
CHAPTER 3 The d o u b le -e n try system
125
14 Interest o f $ 6 0 0 0 is o w e d b y th e b a n k a t th e e n d o f N o v e m b e r. It w ill be re c e iv e d in J a n u a ry 2 0 1 6 . 15 R eceived $ 8 0 0 0 fro m a c lie n t. S ervices to th e c lie n t w ill be p ro v id e d in D e c e m b e r. 16 S evera l investors s o ld th e ir shares to o th e r investors. S h o w th e e ffe c t o f e a ch o f th e a b o v e tra n sa ctio n s on th e a c c o u n tin g e q u a tio n .
PROBLEM 3.11 Examples o f tran sa ctio n s P ro v id e a n e x a m p le o f a tra n s a c tio n w h e re : 1 o n e asset in cre ases a n d a n o th e r asset de cre a se s
2
an asset in cre ases a n d a lia b ility in cre ases
3
an asset in cre ases a n d s h a re h o ld e rs ' e q u ity in cre ases
4
s h a re h o ld e rs ' e q u ity in cre ases a n d lia b ilitie s d e cre a s e
5
an asset d e cre a s e s a n d a lia b ility de cre ases
6 o n e lia b ility in cre ases a n d a n o th e r lia b ility de cre ases 7
an asset d e cre a s e s a n d s h a re h o ld e rs ' e q u ity d e cre ases.
PROBLEM 3.12 Transaction analysis - revenue and expenses UL starte d business on 1 July 2 0 1 6 , a n d h a d th e fo llo w in g tra n s a c tio n s o n 1 July: a Issued 3 0 0 0 0 0 shares o f $1 fo r $ 3 0 0 0 0 0 cash .
b
B o u g h t e q u ip m e n t fo r $ 2 0 0 0 0 0 , p a y in g cash . The e q u ip m e n t has a fiv e -y e a r life,
c
B o u g h t $ 5 0 0 0 0 w o rth o f in v e n to ry o n c re d it,
d
P aid $ 8 0 0 0 fo r a y e a r's rent on a b u ild in g .
e
T o o k o u t a tw o -y e a r $ 2 0 0 0 0 0 b a n k lo a n a t an in tere st ra te o f 1 0 p e r c e n t p e r a n n u m . The in tere st is not p a y a b le until th e e n d o f th e lo a n . B etw e en 1 July a n d 31 D e c e m b e r, th e fo llo w in g tra n s a c tio n s o c c u rre d :
f
S old in v e n to ry th a t c o st $ 3 0 0 0 0 fo r $ 7 0 0 0 0 . A ll sales w e re on c re d it,
g
P aid $ 4 0 0 0 0 to s u p p lie rs o f in v e n to ry fo r th e c re d it pu rch ases in p o in t (c), a b o v e ,
h
C o lle c te d $ 5 0 0 0 0 fro m custom ers,
i
P aid sa la rie s o f $ 1 0 0 0 0 .
j
R eceived $ 4 0 0 0 fo r a jo b to be c o m p le te d in F e b ru a ry 2 0 1 7 . O n 31 D e c e m b e r:
k
S a la rie s o f $ 3 0 0 0 w e re o w in g to staff.
I
O w e d $ 8 0 0 0 b y th e b a n k fo r interest.
For th e p e rio d 1 J u ly to 31 D e c e m b e r 2 0 1 6 : 1 List a ll revenues (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent. 2
List a ll expe nses (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent.
PROBLEM 3.13 Id e n tify in g a cco u n t title s B e lo w a re som e in d e p e n d e n t h y p o th e tic a l s itu a tio n s . 1 A c o m p a n y pa ys its s h a re h o ld e rs a $ 9 0 0 0 0 cash d iv id e n d . 2
A c o m p a n y b o rro w s $ 2 5 0 0 0 fro m th e lo c a l b a n k a n d sign s a six-m onth note fo r th e lo a n .
3
A c o m p a n y pu rch ases 5 0 0 o rd in a ry shares o f W o o lw o rth s Lim ited fo r $ 1 5 0 0 0 .
4
A c o m p a n y pu rch ases a b lo c k o f la n d fo r $ 4 0 0 0 0 0 cash . A n a p p ra is e r fo r th e b u y e r v a lu e d th e la n d a t $425 000.
5
A c o m p a n y bu ys th re e fa x m a ch in e s fo r o ffic e use, fo r w h ic h it sign s a no te p ro m is in g to p a y $ 1 5 0 0 w ith in six m onths.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6 A c o m p a n y signs a lease a g re e m e n t fo r a w a re h o u s e ; the rent is $ 1 5 0 0 0 p e r m o nth . U p o n s ig n in g the d o c u m e n t, th e re ta ile r p a ys $ 4 5 0 0 0 to th e o w n e r o f th e b u ild in g (assum e no s e cu rity d e p o sit).
7
A c o m p a n y pu rch ases a n e w d e liv e ry tru ck fo r $ 6 3 0 0 0 cash th a t has a list p ric e o f $ 6 9 0 0 0 .
8 A c o m p a n y a c q u ire s a p a te n t on a n e w d ig ita l te c h n o lo g y , p a y in g $ 3 0 0 0 0 0 cash a n d s ig n in g a $ 6 0 0 0 0 0 note p a y a b le d u e in tw o y e a rs . In d ic a te th e a p p ro p ria te a c c o u n t titles, if a n y , a ffe c te d b y e a ch o f th e events d e s c rib e d a b o v e . A n s w e r in term s o f ch a n g e s in a c c o u n t b a la n c e s (in c re a s e /d e c re a s e ). In clu de th e d o lla r a m o u n t.
PROBLEM 3.14 Id e n tify in g a cco u n t title s B e lo w a re som e tra n s a c tio n s fo r a re ta ile r. 1
The c o m p a n y o rd e rs 2 0 d is p la y stands fo r $ 3 0 0 e a c h , to be d e liv e re d n e xt m onth.
2
The c o m p a n y re p a y s $ 4 0 0 0 p rin c ip a l o n its lo a n (ig n o re interest).
3
The c o m p a n y sells 1 0 0 0 0 0 shares fo r $ 1 2 p e r sh a re to investors.
4
The c o m p a n y signs a c o n tra c t fo r c o n s tru c tio n o f a n e w re s id e n tia l b u ild in g fo r $ 6 0 0 0 0 0 a n d p a ys $ 5 0 0 0 0 as th e in itia l p a y m e n t fo r c o n s tru c tio n .
5
The c o m p a n y hires a n e w C F O . The C F O 's re m u n e ra tio n p a c k a g e in clu d e s s a la ry o f $ 3 0 0 0 0 0 p e r a n n u m plus s u p e ra n n u a tio n . The C F O starts w o rk in tw o m o n th s' tim e.
6 The c o m p a n y p u rch ases a w e ll-e s ta b lis h e d b ra n d na m e fo r $ 1 7 0 0 0 0 cash . In d ic a te th e a p p ro p ria te a c c o u n t titles, if a n y , a ffe c te d b y e a ch o f th e events d e s c rib e d a b o v e . A n s w e r in term s o f ch a n g e s in a c c o u n t b a la n c e s (in c re a s e /d e c re a s e ). In clu de th e d o lla r a m o u n t.
PROBLEM 3.15 N orm al balances o f accounts W h a t w o u ld be th e n o rm a l b a la n c e (DR o r CR) fo r e a ch o f th e fo llo w in g a c c o u n t titles? 1 A c co u n ts re c e iv a b le 2
A c co u n ts p a y a b le
3
In ve n to ry
4
P rovision fo r e m p lo y e e en titlem en ts
5
Taxes p a y a b le
6
R eta in ed p ro fits
7
S h a re c a p ita l
8
Investm ents
9
P lant a n d e q u ip m e n t
1 0 A c c ru e d expe nses 11 P rep aym e nts
PROBLEM 3.16 A cco u n t cla ssifica tio n and D r/C r rules Select H arvests Lim ited is a n a g ric u ltu ra l c o m p a n y , th e c o re o p e ra tio n s o f w h ic h in vo lv e o rc h a rd d e v e lo p m e n t a n d , o rc h a rd m a n a g e m e n t, as w e ll as s u p p ly o f a lm o n d s to th e A u s tra lia n a n d o ve rse a s m arkets. The fo llo w in g a re a c co u n ts fro m a b a la n c e sheet fo r th e y e a r e n d e d 3 0 June 2 0 1 4 o f S elect H arvests Lim ited. 1 P rop erty, p la n t a n d e q u ip m e n t
2
In tere st-b earing lia b ilitie s (long-term )
3
In ve nto ries
4
R eta in ed p ro fits
5
C a s h a n d cash e q u iv a le n ts
6
P rovisions (long-term )
7
C u rre n t ta x lia b ilitie s
CHAPTER 3 The d o u b le -e n try system
127
8 T ra d e a n d o th e r re c e iva b le s 9
In ta n g ib le assets
1 0 T ra d e a n d o th e r p a y a b le s (short-term ) 11 B io lo g ic a l assets - a lm o n d trees 12 C o n trib u te d e q u ity . For e a ch a c c o u n t, in d ic a te h o w it n o rm a lly sh o u ld be c a te g o ris e d on a c la s s ifie d b a la n c e sheet. A ls o s h o w w h e th e r th e a c c o u n t n o rm a lly has a d e b it (DR) o r c re d it b a la n c e (CR).
PROBLEM 3.17 Id e n tify d e b it and cre d it balances, and prepare a balance sheet BM L P roducts Ltd m a n u fa c tu re s a n d sells c h ild re n 's to ys. H e re a re th e c o m p a n y 's b a la n c e sheet a cco u n ts as a t 3 0 June 2 0 1 6 , in a lp h a b e tic a l o rd e r.
s1
$ Accumulated depreciation
63 700
Owing from customers
Bank account balance
14 300
Owing to suppliers
21 900
Retained earnings
47500
Share capital issued
25 000
Bank loan Building Cash on hand
21 200 102 10 0
Short-term part of mortgage
8 000
600
Unpaid employee wages
1 800
Fixtures and equipment
37900
Unsold finished products
29600
Land
48 000
Unused office supplies
Long-term part of mortgage owing
71 000
Unused product raw materials
Employees' tax not yet remitted
2 500
6 200
1 400 18 700
1
D e c id e w h ic h a c co u n ts h a ve d e b it b a la n c e s a n d w h ic h h a ve c re d it b a la n c e s . A c c o rd in g to th e c o m p a n y 's a c c o u n tin g system , to ta l d e b its = to ta l c re d its = $ 2 6 0 7 0 0 .
2
Based on y o u r a n s w e r to q u e s tio n 1, p re p a re th e c o m p a n y 's 3 0 June 2 0 1 6 b a la n c e sheet fro m th e a b o v e a c co u n ts.
3
R ew rite th e b a la n c e sheet using a c c o u n t titles th a t y o u a re m o re lik e ly to see in a c tu a l fin a n c ia l statem ents.
4
C o m m e n t b rie fly on th e c o m p a n y 's fin a n c ia l c o n d itio n , as s h o w n b y the b a la n c e sheet.
PROBLEM 3.1 8 Explain and w rite entries For changes in account balances H e re a re som e a c c o u n t ch a n g e s th a t h a ve o c c u rre d to Lotus Ltd. For e a ch o f th e item s, w rite in a fe w w o rd s w h a t w o u ld h a ve c a u s e d th e c h a n g e s a n d w rite a jo u rn a l e n try to a c c o u n t fo r them . 1 C a s h up $ 1 0 0 0 0 ; s e rvice reven ue up $ 1 0 0 0 0 . 2
W a g e s e x p e n s e up $ 8 0 0 0 ; cash d o w n $ 1 0 0 0 0 ; w a g e s p a y a b le d o w n $ 2 0 0 0 .
3
A c c o u n ts p a y a b le d o w n $ 3 2 2 0 , cash d o w n $ 3 2 2 0 .
4
In co m e ta x e x p e n s e up $ 5 9 0 0 , cash d o w n $ 5 0 0 0 , in co m e ta x p a y a b le up $ 9 0 0 .
5
C a s h up $ 3 5 0 , c u sto m e r d e p o s its lia b ility up $ 3 5 0 .
6 A u d itin g e x p e n s e up $ 3 0 0 0 , a c co u n ts p a y a b le up $ 2 4 0 0 , cash d o w n $ 6 0 0 . 7
E q u ip m e n t up $ 5 2 0 0 , s h a re c a p ita l up $ 5 2 0 0 .
8 C a s h up $ 2 4 0 0 , a c co u n ts re c e iv a b le up $ 6 6 0 0 , reven ue up $ 9 0 0 0 , in v e n to ry d o w n $ 5 5 0 0 , C O G S exp e n se up $ 5 5 0 0 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 3.19 Prepare sim ple jo u rn a l entries P re p a re jo u rn a l en trie s fo r th e fo llo w in g tra n s a c tio n s in June 2 0 1 6 . 1 B o rro w e d $ 1 0 0 0 0 0 cash fro m th e b a n k a n d s ig n e d a note d u e in tw o ye a rs . 2
P urchased in v e n to ry c o s tin g $ 1 5 0 0 0 on c re d it.
3
S old in v e n to ry c o stin g $ 1 2 0 0 0 to custom ers fo r $ 2 0 0 0 0 on a c co u n t.
4
R eceived a $ 5 0 0 0 d e p o s it o n a re n ta l p ro p e rty to be re n te d fo r th e m onth o f J a n u a ry 2 0 1 7 .
5
R eceived $ 1 0 0 0 0 fro m a c u sto m e r in q u e s tio n 3 .
PROBLEM 3 .2 0 Prepare jo u rn a l entries DRAGONS LTD BALANCE SHEET AS AT 3 0 JUNE 20 15
D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , th e fo llo w in g in fo rm a tio n w a s re c o rd e d in th e c o m p a n y 's ac co u n ts: 1 C re d it sales, $ 2 0 0 0 0 0 . 2
C a s h sales, $ 6 0 0 0 .
3
C o lle c tio n s fro m custom ers, $ 1 5 0 0 0 0 .
4
Purchases o f in v e n to ry on c re d it, $ 7 0 0 0 0 .
5
Paym ents o f a cco u n ts p a y a b le , $ 5 0 0 0 0 .
6 C o s t o f g o o d s so ld , $ 8 0 0 0 0 . 7
W a g e s ex p e n s e , $ 9 0 0 0 0 , n o t y e t p a id .
8 W a g e s p a id , $ 2 2 0 0 0 . 9
P aid ta x p a y a b le , $ 6 0 0 0 .
1 0 C a s h d iv id e n d s o f $ 2 0 0 0 0 , d e c la re d a n d p a id . P rep are jo u rn a l en trie s, an in co m e state m e nt fo r th e y e a r e n d e d 3 0 June 2 0 1 6 a n d a b a la n c e sheet as a t 3 0 June 2016.
PROBLEM 3.21 Prepare a s ta te m e n t o f reta in e d p ro fits The a c co u n ts fo r A u s tra lia n RST Lim ited fo r 3 0 June 2 0 1 6 in c lu d e d th e fo llo w in g (in a lp h a b e tic a l o rd e r):
$000 Dividends declared
49444
DR
Income tax expense
571
DR
Operating profit before tax
58 884
CR
Retained profits, beginning of year
35 697
CR
P rep are a state m e nt s h o w in g c lo s in g re ta in e d p ro fits.
CHAPTER 3 The d o u b le -e n try system
129
PROBLEM 3 .2 2 Retained p ro fits The a c co u n ts fo r P rentice R etail Ltd fo r last y e a r in c lu d e d th e fo llo w in g (in a lp h a b e tic a l o rd e r):
$ Dividends declared
87000
Income tax expense
145210
DR
23 570
CR
Miscellaneous revenue from investments Operating expenses
1 703470
DR
354290
CR
2 111 480
CR
Retained profits, beginning of year Revenue from sales
DR
C a lc u la te net p ro fit, a n d p re p a re a no te to s h o w th e c h a n g e in re ta in e d p ro fits fo r th e y e a r.
PROBLEM 3 .2 3 Cash balance and accrual acco u n tin g p ro fit U sing th e fo llo w in g in fo rm a tio n fo r D a v id T ours, c a lc u la te : 1 th e cash in b a n k as a t th e e n d o f 2 0 1 6
2 th e 2 0 1 6 a c c ru a l a c c o u n tin g p ro fit.
s Owing from customers as at the end of 2015 (collected in 2016)
1 000
Owing from customers as at the end of 201 6 (collected in 201 7)
850
Cash collected from customers during 2016 for 2016 trips
68 990
Payable to suppliers as at the end of 2015 (paid in 2016)
1 480
Cash paid to suppliers during 2016 for 2016 expenses
36910
Payable to suppliers as at the end of 2016 (payable in 2017)
2 650
Depreciation on equipment during 2016
3 740
Cash in bank as at the end of 2015
1 2430
PROBLEM 3 .2 4 R econciliation o f cash p ro fit and accrual p ro fit Turku S ervices C o m p a n y h a d a cash p ro fit fo r its first y e a r in business o f $ 6 7 4 5 0 a n d an a c c ru a l p ro fit o f $ 4 9 8 6 0 . S h o w h o w th e tw o am ou nts re c o n c ile , using th e fo llo w in g in fo rm a tio n : 1 U n c o lle c te d reven ue a t th e e n d o f th e y e a r w a s $ 1 8 7 3 0 . 2
U n p a id b ills fo r expe nses a t th e e n d o f th e y e a r to ta lle d $ 2 4 8 8 0 .
3
Expenses fo r th e n e xt y e a r, p a id a lre a d y , to ta lle d $ 2 3 0 0 .
4
D e p re c ia tio n o n th e c o m p a n y 's e q u ip m e n t w a s $1 3 7 4 0 fo r th e y e a r.
PROBLEM 3 .2 5 C alculate accrual p ro fit and change in cash 'I just d o n 't u n d e rsta n d it!' B a rry h a d re c e ive d his a c c o u n ta n t's c a lc u la tio n o f his business p ro fit, s h o w in g a n a c c ru a l p ro fit fo r his firs t y e a r in business o f $ 4 5 2 9 0 . 'If I m a d e so m uch m o n e y, w h y d o n 't I h a ve it in th e b a n k ? M y b a n k a c c o u n t show s o n ly $ 1 5 0 4 0 on h a n d !'
130
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
B a rry o p e ra te s B a rry S u p p ly , w h ic h p ro v id e s s ta tio n e ry a n d o ffic e su p p lie s to business custom ers. H e has no store, just a sm all re n te d w a re h o u s e , a n d o n ly o n e e m p lo y e e . H e re a re th e d a ta th a t B a rry a n d his a c c o u n ta n t used. E x p la in c le a rly to B a rry : 1
H o w th e a c c o u n ta n t c a lc u la te d th e $ 4 5 2 9 0 p ro fit.
2
W h y th e re is o n ly $ 1 5 0 4 0 on h a n d .
Collected from customers during the year
143 710
Still owing from customers at the end of the year (collected next year) Paid for products to resell and for other expenses, including wages, during the year
15 220 128 670
Owing for products and other expenses at the end of the year (paid next year)
9 040
Cost of unsold products on hand at the end of the year (all sold next year)
26 070
Depreciation on equipment during the year
2 000
PROBLEM 3 .2 6 Prepare Financial sta te m e n ts From accounts
»
$ Salaries expense
71 000
DR
Dividends declared
1 1000
DR
2 800
CR
Accumulated depreciation
94000
CR
Land
63 000
DR
Cash at bank
18 000
DR
Employee benefits expense
13 100
DR
Income tax expense
6900
DR
5 400
CR
Credit sales revenue
346200
CR
Income tax payable
Tax deductions payable Accounts receivable
1 6400
DR
Inventory on hand
68 000
DR
Cash sales revenue
21 600
CR
Prepaid insurance
2 400
DR
Dividends payable
5 500
CR
Beginning retained profits
92 800
CR
26 700
DR
Accounts payable
41 000
CR
Cost of goods sold
161 600
DR
Interest revenue
1 700
CR
Insurance expense
11 200
DR
Building
243 000
DR
200000
CR
Trucks and equipment
182500
DR
31 100
DR
Salaries payable
4100
CR
114000
CR
Miscellaneous expenses
8 200
DR
21 800
CR
Interest expense
16 800
DR
Depreciation expense
Share capital Office expenses Mortgage payable Bank loan owing
1
Look a t th e list o f a c co u n ts (in no p a rtic u la r o rd e r) o f G e e w h iz P rod uctio ns a t 3 0 N o v e m b e r 2 0 1 5 a n d d e c id e w h ic h ones a re in co m e state m e nt acco un ts.
2
C a lc u la te net p ro fit b a se d o n y o u r a n s w e r to q u e s tio n 1.
3
C a lc u la te e n d in g re ta in e d p ro fits b a se d on y o u r a n s w e r to q u e s tio n 2 .
4
5
P re p a re th e fo llo w in g fin a n c ia l statem ents, d e m o n s tra tin g th a t y o u r a n sw e rs to q u e s tio n s 2 a n d 3 a re c o rre c t, a
In co m e state m e nt fo r th e y e a r e n d e d 3 0 N o v e m b e r 2 0 1 5 .
b
A note c a lc u la tin g re ta in e d p ro fits fo r th e y e a r e n d e d o n th a t d a te ,
c
B a la n c e sheet a t 3 0 N o v e m b e r 2 0 1 5 .
C o m m e n t b rie fly o n w h a t th e fin a n c ia l statem ents s h o w a b o u t th e c o m p a n y 's p e rfo rm a n c e fo r 2 0 1 5 , a n d its fin a n c ia l p o s itio n a t 3 0 N o v e m b e r 2 0 1 5 .
CHAPTER 3 The d o u b le -e n try system
131
PROBLEM 3 .2 7 P ro fit and loss sm o o th in g and ethics In co m e (p ro fit) s m o o th in g is a w a y o f m a n ip u la tin g a c o m p a n y 's net p ro fit in o rd e r to c re a te a d e s ire d im p re ss io n o f m a n a g e m e n t's c a p a b ility a n d p e rfo rm a n c e . O th e r kind s o f p ro fit m a n ip u la tio n b y m a n a g e m e n t h a ve a lso been a lle g e d . D o y o u th in k it is e th ic a l fo r m a n a g e m e n t to m a n ip u la te th e fig u re s b y w h ic h its p e rfo rm a n c e is m easure d? W h y o r w h y not?
CASES CASE 3A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 W h a t p e rio d is c o v e re d b y th e in c o m e statem ent? 2
List th e m a in type s o f revenues.
3
List som e o f th e la rg e r expe nses in c u rre d in e a rn in g reven ue .
4
W h a t a re in tere st e x p e n s e a n d in tere st re ven ue fo r th e y e a r?
5
W h a t is c o st o f g o o d s s o ld fo r th e y e a r?
6
W h a t is to ta l d e p re c ia tio n a n d a m o rtis a tio n fo r th e y e a r?
7
E x p la in th e c h a n g e in re ta in e d p ro fits fro m 2 0 1 3 to 2 0 1 4 .
8 W h a t is in c o m e ta x e x p e n s e fo r th e y e a r? 9
W h a t a re th e b a s ic e a rn in g s p e r s h a re fo r 2 0 1 4 ?
1 0 W h a t w o u ld be th e n o rm a l b a la n c e (DR o r CR) o f e a ch o f th e fo llo w in g a c co u n ts in c lu d e d in th e W o o lw o rth s Lim ited b a la n c e sheet o r th e re le v a n t notes: tra d e d e b to rs , in v e n to ry , investm ents, la n d a n d b u ild in g s , a d v a n c e s to e m p lo y e e s , tra d e c re d ito rs , p ro v is io n fo r in c o m e ta x , p ro v is io n fo r d iv id e n d s a n d re ta in e d pro fits? 11 In W o o lw o rth s ' 2 0 1 4 b a la n c e sheet, w h a t w o u ld be th e n o rm a l b a la n c e (d e b it o r c re d it) fo r in ve n to rie s , re c e iv a b le s , in ta n g ib le s , a c co u n ts p a y a b le a n d re ta in e d p ro fit?
CASE 3B_______________________ Financial reporting on the internet This b o o k m e ntion s th e w e b p a g e s fo r m a n y c o m p a n ie s . In cre a s in g ly , c o rp o ra tio n s a n d o th e r o rg a n is a tio n s a re p u ttin g o u t d e ta ile d in fo rm a tio n a b o u t them selves on th e in te rn e t. But h o w g o o d is th a t in fo rm a tio n ? Is it e a s y to fin d in th e c o m p a n y 's w e b m a te ria l? Is it up to d a te ? Is it d is p la y e d usefully? C a n it be d o w n lo a d e d e a s ily ? This is a case y o u c a n c o n s tru c t fo r y o u rs e lf, a n d discuss in class e ith e r b y c o m p a rin g v a rio u s c o m p a n ie s o r b y c o m p a rin g v a rio u s p e o p le 's re a ctio n s to th e sam e c o m p a n y . Pick a c o m p a n y th a t interests y o u o r th a t is a s s ig n e d b y y o u r in stru cto r. G o to its w e b s ite a n d see w h a t is th ere re g a rd in g th e c o m p a n y 's fin a n c ia l statem ents. If y o u d o n 't k n o w th e c o m p a n y 's w e b a d d re ss , ty p e th e c o m p a n y na m e in to y o u r search e n g in e a n d y o u 'll lik e ly g e t to it e a s ily . O n c e y o u g e t to th e c o m p a n y 's w e b p a g e , s ta rt y o u r e x a m in a tio n a n d c o n s id e r q u e s tio n s such as th ose b e lo w , w h ic h c o u ld be a d d re s s e d in a re p o rt o r in a class discu ssio n : 1
H o w a ttra c tiv e a n d us e r-frie n d ly is th e in itia l w e b p a g e ? Does it c o n c e n tra te on m a rk e tin g th e c o m p a n y 's p ro d u cts , p ro v id in g g e n e ra l in fo rm a tio n , te llin g y o u a b o u t re c e n t m e d ia a tte n tio n d ire c te d to w a rd s th e c o m p a n y , o r o th e r pu rpo se s?
2
H o w e a s y is it to fin d th e c o m p a n y 's fin a n c ia l in fo rm a tio n , if it is th e re a t a ll? (M a n y w e b p a g e s d ire c t y o u to 'In v e s to r in fo rm a tio n ' o r som e such a re a fo r fin a n c ia l in fo rm a tio n , others s p e c ify th e fin a n c ia l rep orts d ire c tly , w h ile others m a ke it q u ite h a rd to fin d .)
3
H o w m uch do es th e c o m p a n y tell y o u a b o u t itself to h e lp y o u p u t th e fin a n c ia l in fo rm a tio n in co n te xt? C a n y o u e a s ily re la te th e b a c k g ro u n d to th e fin a n c ia l m a te ria l, o r d o y o u h a ve to ju m p a ll o v e r th e w e b s ite to fin d it a ll?
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4
H o w useful d o y o u fin d th e fin a n c ia l statem ents to be? A re th e y up to d a te , a re th e y a n a ly s e d o r c o m m e n te d u p o n b y th e c o m p a n y , a n d a re th e y re la te d to recen t events a ffe c tin g th e c o m p a n y o r just p lu n k e d on th e w e b as is? (You c o u ld lo o k fo r a m a n a g e m e n t disc u s sio n a n d a n a lys is section if th e b a la n c e sheet is just in c lu d e d in the c o m p a n y 's c u rre n t a n n u a l re p o rt, po ste d as is on the w e b .)
5
A re th e b a la n c e sheet, in c o m e state m e nt a n d s u p p o rtin g m a te ria l e a s y to d o w n lo a d a n d / o r p rin t? W o u ld th e y be re a d ily a v a ila b le fo r in se rtio n in an a n a lys is o f th e c o m p a n y ?
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APPENDIX TO CHAPTER 3
A brief history of early accounting W ith the o ve rvie w o f the double-entry accounting system taken ca re of, w e can n o w pro vid e a historical review , because understanding h o w w e g o t to w h e re w e are helps in understanding w h y w e d o w h a t w e d o n o w (and h o w to d o it). Financial accounting is an ancient inform ation system, w ith m any of its ideas o rig in a tin g hundreds of years a g o . Like other co m p le x human inventions, fin a n cia l accounting d id not just a p p e a r one d a y fully form ed. It has deve lo p e d over thousands o f years a nd has been thoroughly intertw ined w ith the developm ent o f civilisation. A science w riter, quoting a b re w e ry ow n e r, had this to say on the to p ic o f accounting a n d beer: Whatever the reason, [the early farmers in Mesopotamia] grew grain [and] ‘if you have grain, you need storehouses; if you have storehouses, you need accountants; if you have accountants, bang - you’re on the road to civilisation’ (or the world’s frst audit).
O u r focus here is on a ccounting, not on history. N evertheless, the past has a bearing on a ccounting, in that accounting evolves as business, governm ent a nd other institutions in society evolve. As the needs for inform ation chan g e, accounting changes to meet those needs. A ccounting's evolution is not a lw a ys smooth, a n d not a lw ays efficient. A t a n y given time there a re aspects o f accounting that m ay not seem to fit current needs w e ll, but over time w e can expect that accounting w ill, as it has in the past, meet those needs if they persist. W h e n com m erce consisted m ainly o f trading a m ong fam ilies o r tribal units, inform ation dem ands w e re not c o m p lica te d . M o n e y had not been invented, so even the sim ple fin a n cia l reports you s a w in C h a p te r l could not have been prepared. People w o u ld w a n t to kn o w w h a t they had on hand, a nd w o u ld need some sort of docum entation to a cco m p a n y shipments, so that they an d their customers w o u ld a g re e on w h a t w a s being tra d e d . To meet such needs, accounting began as sim ple list-making. Lists o f the fam ily's o r tribe's resources w e re particularly im portant a n d , later, lists o f debts to other tribes o r fam ilies. Later still, as com m ercial activities becam e m ore com plex, fam ilies b egan to e m p lo y others to run aspects of their businesses an d began also to create large business units w ith several locations. A ccounting also had to becom e m ore com plex, p ro vid in g records that could be used to m onitor the activities o f em ployees a nd businesses in far-flung locations. People found that they needed to be a b le to verify w h a t em ployees an d traders said w a s h a p p e n in g . Because o f these needs, the practice o f having systematic records that could be a u dited later w a s begun. To help you understand h o w present-day fin a n cia l accounting concepts a n d techniques arose, w e start w ith a brief history taking us from a b o u t 4 5 0 0 BC in M e s o p o ta m ia to the early 1 8 0 0 s in England. W e then cover the tw o succeeding centuries, brin g in g the history up to the present. Keep in mind that the purpose o f this review is to help you understand a ccounting, not to explain general history. Because m odern accrual a ccounting, as practised in A ustralia a nd much o f the rest o f the w o rld , has its roots in the developm ent o f W estern civilisation, our review o f accounting history is oriented to that developm ent. The interesting stories o f the developm ent o f accounting in other parts o f the w o rld , such as C h in a , India a nd A frica , are therefore not included. The comments b e lo w are necessarily brief. If you w o u ld like to read further, some reading suggestions on accounting history are pro vid e d a t the end o f the a p p e n d ix .2
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A3.1
Mesopotamia to Rome: 4500 BC to AD 400
For a society to de m a n d acco u n tin g , it must have active trade an d com m erce, a basic level o f w ritin g , methods of measuring and ca lcu la tin g , a nd a medium o f e xchange or currency.3 The earliest known civilisation w ith an active record-keeping system flourished in M e so p o ta m ia (n o w Iraq a nd Syria). G e n e ra lly, a com m on la n g u a g e (such as B abylonian) existed for business, a nd there w a s also a g o o d system o f numbers an d currency, a nd record-keeping using c la y tablets. As fa r as w e know , o rd in a ry merchants an d general traders d id not keep o fficia l records. O ffic ia ls o f the governm ent a n d religious leaders o f the temples d e c id e d w h a t records w e re to be m aintained for o fficia l purposes, and scribes d id the record-keeping. A scribe w a s a p p re n tice d for m any years to master the craft o f recording taxes, customs duties, tem ple offerings an d trade betw een governments an d tem ples. Records consisted o f counts a nd lists of grain, cattle and other resources, an d o f o b lig a tio n s arising from trade. W e can still see that to d a y: the b a la n ce sheet o f a n y enterprise includes items such as unsold products a n d equipm ent, a nd trade o b lig a tio n s such as am ounts due from customers a nd due to suppliers. All these figures are summaries supported by d e ta ile d lists. W h e n a scribe determ ined that a particular record w a s com plete a nd correct, the scribe's seal w a s pressed into a c la y tablet to certify that this w a s so, an d the tablet w a s baked to prevent alteration. The scribe w a s a forerunner of today's accountants a nd auditors. (H ow ever, to d a y's auditors d o not use seals; instead, they sign an a u d it report to indicate that the fin a n cia l statements a re fa irly presented.) This scribe-based form o f record-keeping w a s used for m any years, spreading across lands an d tim e to Egypt, G re e ce a nd Rome. M e d ia other than c la y tablets, such as papyrus, w e re used as tim e passed.5 (Do you suppose p e o p le accustom ed to c la y tablets w o u ld have resisted the introduction o f papyrus, just as some p e o p le accustom ed to pencil an d p a p e r resisted the introduction o f computers for accounting?) Trade and com m erce g re w over thousands o f years, from small fa m ily operations to very large activities involving kings, religious leaders a n d various levels o f governm ent. For exam ple, as G re e k civilisation spread a nd then the Roman Empire e xp a n de d greatly, adm inistrative regions w e re o rganised in conquered lands in o rd e r to sim plify governing them. These regions w e re m anaged by local adm inistrators o r governors, w h o generally could neither read nor w rite. W h e n accounting o f their m anagem ent w a s required, an o fficia l o f the central governm ent w o u ld com e out and listen to an oral report. This event w a s, therefore, a 'h e a rin g ', a n d the listening o fficia l w a s there to 'a u d it' (from the Latin w o rd for 'h e a r'). Today, the person w h o comes to inspect an d a p p ro ve the fin a n cia l statements o f an enterprise is calle d an auditor, though a lot m ore goes on to d a y than just listening.
A3.2 The Middle Ages to the Renaissance: AD 4 0 0 -5 0 0 W ith the fall o f the Roman Empire in a b o u t the fifth century A D , both trade an d associated record-keeping becam e stagnant in Europe, though activities still continued in C onstantinople, the M id d le East, India, C h in a an d elsewhere. In Europe, a greater stimulus to trade b egan w ith the p eriod of the C rusades, around the eleventh century, w hen kings and princes could not themselves pro vid e the material to support their retinues o f crusaders bound for the H o ly Land. This w a s a prosperous time for the lesser nobles a nd private merchants, w h o supplied the crusaders from ports such as Venice. A shift o f supply an d e conom ic p o w e r from governments to the private sector b e gan, a nd large merchant banks deve lo p e d , such as those of the M e d ic i in Florence. These banks becam e heavily involved in the businesses and governments they helped to finance. Because o f all these activities, a m ore exact system of record-keeping w a s d e ve lo p e d in ord e r to keep track of materials supplied, cash received a nd spent a n d , especially, w h o o w e d w hom h o w much m oney.6 For the traders, merchants and bankers, the stimulus pro vid e d by the C rusades set record-keeping o ff in a m ore o rganised and systematic direction. The n e w direction w a s m ade possible also by refinements in the use o f numbers an d arithm etic
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that had taken p la ce in A ra b countries during Europe's M id d le A ges. The num ber system w e use in accounting an d in our d a ily lives o rig in a te d from these refinements. The exact w a y in w h ich accounting or, m ore precisely, the record-keeping basis o f accounting w e call bookkeeping, evolved during this busy time is a subject o f d e b a te am ong accounting historians. A m ajor event, how ever, w a s the publication in 14 9 4 of a treatise on 'double-entry' b o okkeeping b y Friar Pacioli o f Venice. In the book, he referred to the method as an established procedure that had been in use in the M e d ic i banks o f Italy an d in other businesses for some time. Pacioli's b o o k w a s an im portant contribution to the kn o w le d g e of a lg e b ra and arithm etic, a nd o f value sp e cifica lly because o f its deta ile d description an d c o d ifica tio n o f the double-entry system. It w a s ra p id ly translated into all the m ajor European languages an d , using these translations, European scholars extended Pacioli's ideas.
D o u b le -e n try bookkeeping Pacioli's concepts w e re revolutionary but sound: they form the fundam ental basis of m odem fin a n cia l accounting, provid in g a method of pulling together all the lists o f resources a nd o b lig a tio n s in a w a y that helps to prevent errors. The id e a is that each trade o r other com m ercial transaction is recorded (entered) tw ice , hence the descriptor 'double-entry': •
o n ce to recognise the resource involved in the transaction
•
o n ce to recognise the source o r effect o f that resource change. Instead o f the disconnected lists that existed before double-entry bookkeeping w a s invented, the lists of resources
and sources w e re n o w connected to each other. N o w a b a la n ce sheet o f the modern kind could be prepared. Double-entry b o o kkeeping, w h ich m ight be seen as a pretty humdrum sort o f activity, turns out to have a solid conceptual basis an d a long a nd im portant history. If a d o lla r am ount (or an am ount in a n y other medium o f e xch a n g e - pounds, francs, yen, marks an d so on) can be assigned to each transaction, that am ount can be used to record both the resources an d sources sides o f each. Then, by a d d in g up all the resources amounts a nd all the sources amounts, the tw o sides a ct as a check on each other. If errors are m ade, they are likely to be found because the tw o sides w ill not a d d up to the sam e amount. If they d o a d d up, w e say they 'b a la n c e '. H ence, the 'b a la n c e sheet', w h ich shows that the tw o sides d o a d d up. The record-keeping system Pacioli described to the w o rld is one o f the most far-reaching o f human inventions.
A3.3
Britain: 1500 to the early 1800s
Before Pacioli, English record-keeping had much in com m on w ith Roman methods used hundreds o f years earlier. 'S tew ards' w e re e m ployed to m anage the properties o f the English aristocracy, much as local governors had been in Roman-held areas. In 1 3 0 0 , O x fo rd University offered an accounting course: Roman record-keeping for stew ards.7 The co n ce p t o f stew ardship - o f a person m a naging som ething on behalf o f som eone else - is still an im portant aspect o f acco u n tin g . It is often said, for exam ple, that an enterprise's fin a n cia l statements dem onstrate the q u a lity of m anagem ent's stew ardship o f the enterprise on b ehalf of its ow ners. In the several hundred years after Pacioli's treatise, accounting d e ve lo p e d to suit the social an d business circumstances o f each country. France, for exam ple, had a strong, centralised governm ent a nd d e ve lo p e d a national accounting system w ritten b y a central bo a rd o f adm inistrators. O n the other hand, England (w hich in com bination w ith its neighbours becam e G re a t Britain) had less governm ent involvem ent in com m erce an d trade, a nd a smaller civil service, an d relied m ore heavily on the initiatives o f the private sector a nd the courts.8 The fin a n cia l accounting system n o w used in A ustralia, N e w Z e a la n d , the United Kingdom , C a n a d a , the United States a nd m any other countries relies heavily on the precedents set in England during this p e riod. The English a p p ro a ch used Pacioli's double-entry system for record-keeping a nd built the fin a n cia l statements' reporting system on that. O th e r countries, including A ustralia, have d e ve lo p e d that further.
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Financial accounting in continental Europe d e ve lo p e d on a som ew hat different path, as it d id in Russia, C hina, Japan and m any other countries. H ow ever, the B ritish-A m erican-A ustralian a p p ro a ch is still g a in in g popularity w o rld w id e ; for exam ple, C h in a a d o p te d it for much of its fin a n cia l reporting in the early 1 9 9 0 s . Efforts are being m ade w o rld w id e to 'harm onise' fin a n cia l accounting to assist international trade, an d the sort o f fin a n cia l accounting set out in this b o o k seems likely to becom e the international standard.
FOR YOUR INTEREST J o h n C r o a k e r ( 1 7 8 8 - 1 8 2 4 ) w as an E n g lis h -b o rn
b a n k c le rk w h o w as c o n v ic te d o f e m b e z z le m e n t and
s e n te n c e d t o tra n s p o rta tio n f o r 14 y e a rs to th e c o lo n y o f N e w S o u th W a le s . H e w as g ra n te d an im m e d ia te t ic k e t o f leave b y G o v e r n o r M a c q u a rie and w as e m p lo y e d as a c le rk in th e ju d ic ia r y . H is a rriva l in N e w S o u th W a le s c o in c id e d w ith th e e s ta b lis h m e n t o f th e B a n k o f N e w S o u th W a le s (n o w k n o w n as W e s tp a c ), and C ro a k e r s e t up its b o o k k e e p in g p ro c e d u re s a c c o rd in g to th e s y s te m o f d o u b le e n try . N o t o n ly d id he in tr o d u c e d o u b le - e n tr y b o o k k e e p in g t o th e b a n k b u t ‘th e r e are g o o d re a so n s f o r b e lie v in g th a t he in tro d u c e d th e s y s te m t o th e c o lo n y as a w h o le ’. Source: J. Booker and R. Craig, John Croaker: Convict Embezzler, M elbourne University Press, 2 0 0 0 , p. 19.
Until the m id -1 6 0 0 s , accounting a nd record-keeping (bookkeeping) w e re largely synonym ous. Records w e re a private matter for the attention o f the lord, m erchant or banker. But then a sig n ifica n t developm ent occurred: the advent o f com panies that sold shares o f o w n e rsh ip to private citizens. These citizens could not all c ro w d into the com pany's o ffice to inspect the records, even if they could understand them. This produced a dem and for some form o f reporting to the shareholders; for fin a n cia l statements that could be relied on as accurate summaries o f the records. There w a s a dem and that the b a la n ce sheet be m ore deta ile d in its description o f the ow ners' equity an d the changes in it than had been necessary before there had been such dispersed ow nership. There w a s even some dem and for regulation o f such reports. For exam ple, in 1 6 5 7 O liv e r C ro m w e ll, as Regent o f England, requested that the East India C o m p a n y publish its b a la n ce sheet.9 A ccounting w a s on its w a y to d e ve lo p in g the standards o f calculation and disclosure that are very im portant in m odern accounting a nd distinguish accounting from the underlying practice of record-keeping. Progress in this direction w a s not ra p id , but it g a in e d momentum w ith the Industrial Revolution. The d e velopin g Industrial Revolution o f the late 1 7 0 0 s a nd early 1 8 0 0 s helped to fuel the em erging com m ercial sector of Britain, a nd accounting practices becam e an im portant part o f this. In 1 8 2 5 , the British Parliament eased hundred-year-old prohibitions on trading shares in com panies, a nd the modern era o f share markets a nd publicly o w n e d com panies b egan in earnest. A fe w years later, Parliament required annual audits o f the b a la n ce sheets of such com panies. A ccounting a nd aud itin g continued to d e ve lo p in response to the c h a n g in g needs o f the society of w hich they w e re a part. From then on, accounting's emphasis shifted from record-keeping to the ch o ice of accounting method, professional ethics an d the various standards a nd law s governing fin a n cia l reporting a nd fin a n cia l disclosure.
A3.4
Financial accounting's recent history
D evelopm ents in the nin etee nth ce ntu ry10 Until the early 1 8 0 0 s , most business enterprises w e re form ed for specific ventures, w e re fin a n ce d by a fe w w e a lth y ow ners and w e re d isb a n d e d w hen the ventures w e re com pleted. The sharing o f profits am ong the ow ners o f the enterprise o r venture to o k p la ce a t the end, w hen all the assets w e re sold, the liabilities w e re p a id o ff a nd the net am ount rem aining w a s then distributed. As industrialisation increased, large industrial plants began replacing
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short-term ventures as the m ajor form of business enterprise, a n d the traditional method o f fin a n cin g a nd profit-sharing w a s no longer a cce p ta b le . The large cost o f constructing an d m aintaining these m ore capital-intensive enterprises w a s often m ore than a fe w ow ners could afford, an d the long life o f the assets m ade w a itin g for the w in d in g up o f the enterprise before sharing profits an unsatisfactory o ption. Various pieces o f co m p a n ie s' legislation w e re introduced in Britain in the 1 8 3 0 s , 1 8 4 0 s an d 1 8 5 0 s . This legislation a llo w e d com panies to sell shares in stock markets (w hich, because the initial issuing o f shares provides c a p ita l - that is, equity funds for the com panies - are also called c a p ita l markets). The legislation also characterised a m ajor feature o f com panies: lia b ility o f the com pany's ow ners to the com pany's creditors w a s, an d still is, lim ited to the am ount o f the ow ners' u n paid ca p ita l in the co m p a n y. The justification for the lim ited lia b ility feature w a s that individual investors could not a lw a ys be a w a re of the actions o f the directors they elected o r the m anagers w h o w ere, in turn, e n g a g e d by the directors. Therefore, investors should not be lia b le for a n y more than the am ount o f m oney they invested in the enterprise. But no investors w o u ld w a n t to lose even that, so as c a p ita l markets d e ve lo p e d , the dem and for inform ation a b o u t the corporations involved g re w . The lim ited lia b ility o f its ow ners, a nd an existence separate from its ow ners, are tw o factors that largely d efine the c orpo ra tio n . M o d e rn law s a nd business practices co m p lica te the o peration o f c a p ita l markets an d can reduce the protection o f lim ited lia b ility, but the idea that a co rp o ra tio n is a 'le g a l person', a b le to act on its o w n and survive changes in its ow ners, is still central to business. In fin a n cia l acco u n tin g , the focus is on the e conom ic entity that is exch a n g in g physical an d fin a n cia l g o o d s a nd promises w ith other e conom ic entities, but since law s began to define w h a t corporations are (and sometimes w h a t proprietorships, partnerships an d co rp o ra te groups are, too), accounting also must reflect the legal nature of econom ic exchanges a nd the structure o f the organisation. An im portant legal issue is the sharing o f profits. The problem of h o w to ensure the fa ir calculation a nd sharing of ow ne rsh ip interests led legislators to require that a corporation present its b a la n ce sheet annually to its shareholders and that an a u d ito r be present to report to the shareholders on the v a lid ity of that fin a n cia l statement. Legislation also required that a n y annual payments to shareholders should not com e out o f the sale of, o r a decrease in the value of, a corpo ra tio n 's long-term c a p ita l assets. Such payments should be m ade out o f monies earned ye a rly from these assets after all y e a rly debts a re p a id . W e can think o f 'm onies earned ye a rly' as revenues, a nd 'ye a rly debts' as expenses, so this meant, roughly, that payments to shareholders should com e out o f ye a rly profit. This is close to the d ivid end requirem ent p la ce d on most corporations to d a y (dividends can norm ally o nly be p a id out o f net profit). C o rporations began to com pute profit in statements o r schedules separate from the b a la n ce sheet, so that they could dem onstrate that they had perform ed w e ll enough to perm it the distribution o f d ividends or the issuing o f m ore shares. As businesses g re w in size a nd com plexity, the de m a n d for inform ation on fin a n cia l perform ance increased. The static picture presented b y the b a la n ce sheet w a s not g o o d enough for the em erging stock markets, for the increasingly large g ro u p o f non-ow ner professional m anagers, o r for governm ents that w ish e d to evaluate (and tax!) businesses' perform ance (to mention just a fe w o f the groups interested in evaluating perform ance). The profit a nd loss statement (n o w c a lle d an incom e statement in Australia) has com e into its o w n as a central part o f fin a n cia l reporting in the last 1 0 0 years, a nd its measurement o f fin a n cia l perform ance is central to e conom ic activity an d perform ance evaluation in most o f the w o rld . In responding to these dem ands for better perform ance inform ation, accountants w e re lim ited by a lack of accounting theories o r conventions to illustrate a nd d efine h o w to prepare b a la n ce sheets a n d incom e statements. There w a s no n a tio n ally o rg anised association o f accountants in Britain until the end o f the 1 8 0 0 s (although the Accountants' Society o f Edinburgh received a royal charter in 1 8 5 4 , an event that led to the term 'chartered accountant'). Financial accounting methods d e ve lo p e d on a case-by-case basis, w ith no overall plan o r concepts throughout this period. Some m odel fin a ncia l statements a nd exam ples from legislation w e re being used, an d incom e statements w e re becom ing established. H ow ever, as business an d com m ercial activity continued to increase, it w a s becom ing necessary to establish a rational basis (principles) for preparing fin a n cia l statements a nd for extending these principles to n ew settings.
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Tow ards the end o f the 1 8 0 0 s , several British court cases had established that accountants a nd auditors had to d e c id e w h a t w e re p roper an d fa ir fin a n cia l statements, an d could not expect courts an d legislatures to d e c id e for them. A prom inent accountant, Ernest C o o p e r, v o ice d his concern in 1 8 9 4 : 'The a lre a d y sufficient responsibilities and anxieties of an A ud ito r w ill be extended beyond those known o f a n y trade o r p ro fe s sio n .'11 A ccounting w a s on its w a y to form ulating the professional rights, responsibilities a nd criteria for com petence, as had the a lre a d y established professions o f la w , engineering a nd m edicine.
FOR YOUR INTEREST S e rg e a n t J e re m ia h M u r p h y h o ld s a u n iq u e p la c e in A u s tra lia n c o m m e rc ia l h is to ry as b e in g th e f ir s t p e rs o n in A u s tra lia [w h o s e a ffa irs w e re re c o rd e d as a le d g e r a c c o u n t p re p a re d w ith in a d o u b le - e n tr y a c c o u n tin g s y s te m ]. H is b a n k d e p o s it on 5 A p r il 1817 w as th e f ir s t d e p o s it ta k e n b y th e B a n k o f N e w S o u th W a le s . T h e re c o rd in g o f th is d e p o s it a p p e a rs t o p ro v id e th e e a rlie s t a r te fa c t th a t has s u rv iv e d o f th e o p e ra tio n o f a d o u b le - e n tr y a c c o u n tin g s y s te m in c o lo n ia l A u s tra lia . Source: R. Craig, ‘Jeremiah M urphy: Bank A cco u n t N o. V, Australian CPA, D ecem ber 1998, pp. 6 8 - 9 .
N O TES 1
Stone, J., 'B ig B rewhaha o f 1 8 0 0 B C ', D isco ver, January 1 9 9 1 , p. 14. (The w ords quoted in the excerpt are those o f Fritz M a y ta g , o w n e r o f the A nchor Brewing C o m p a n y o f San Francisco.) 2 Information a b o ut the history o f accounting and business is published in m any places. A variety o f professional a n d a ca d e m ic journals have show n an interest in such m aterial, and there is a journal devoted sp ecifically to it: the A c c o u n tin g H isto ria n s Jo urnal. See also the references below . 3 Coustourous, G . J., A c c o u n tin g in the G o ld e n A g e o f G re e c e : A Response to S o c io e c o n o m ic C h a n g e s , C enter for International Education and Research in A ccounting, University o f Illinois, C h a m p a ig n , 1 9 7 9 . 4 Keister, O . R., T h e M ech a nics o f M eso p ota m ia n Record-Keeping', in C hatfield, M . (e d .), C o n te m p o ra ry S tudies in the E vo lu tion o f A c c o u n tin g Thought, Dickenson Publishing C o m p a n y Ltd, Belmont, 1 9 6 8 , pp. 1 2 - 2 0 . 5 O . ten H ave, The H is to ry o f A c c o u n tin g , B ay Books, Palo A lto, 1 9 7 6 , pp. 2 7 - 3 0 . 6 Ibid., pp. 3 0 - 4 6 . 7 C hatfield, M ., 'English M e d ie va l Book-keeping: Exchequer and M a n o r', C o n te m p o ra ry S tudies in the E vo lu tion o f A c c o u n tin g Thought, p. 3 6 . 8 Ibid., pp. 5 6 - 7 4 . 9 O . ten H ave, H istory, p. 6 7 . 1 0 Some o f the ideas in this section w ere developed w ith reference to Ross Skinner's A c c o u n tin g S tand ard s in Evolution, Holt, Rinehart & W inston, Toronto, 1 9 8 7 . For a com prehensive treatment o f the developm ent o f accounting standards, see part 1 o f Skinner's book. 11 Ibid., p. 2 3 .
Record-keeping ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO describe the im portance of goo d record-keeping describe the criteria used to determ ine if an event involves an accounting transaction identify accounting transactions explain the various steps in the accounting cycle describe w h a t source documents exist and how they provide d a ta for the accounting system p re p a re journal entries post to ledg er accounts a n d calculate the closing balances p re p a re a trial balance p re p a re closing entries a n d explain the need for these closing entries p re p a re financial statements from the trial balance.
C H A PTER O VE R VIEW This c h a p te r c o ve rs th e pro ce sses b y w h ic h tra n s a c tio n s a re re c o rd e d in th e a c c o u n tin g system . It d e s c rib e s th e c ri te ria th a t a re used to d e te rm in e if a n a c c o u n tin g tra n s a c tio n o c c u rs . It th en c o n s id e rs th e b a s ic steps in th e a c c o u n t in g c y c le : so u rce d o c u m e n ts , jo u rn a l e n trie s, p o s tin g to le d g e rs , tria l b a la n c e s , a d ju s tin g e n trie s, c lo s in g e n trie s a n d th e p re p a ra tio n o f fin a n c ia l statem ents.
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4.1
The importance of good records
This chapter em phasises a very basic part o f a ccounting: the record-keeping (bookkeeping) procedures that form the records on w h ich accounting inform ation is built. C om plete and accurate records are im portant: they pro vid e the observations a nd the history o f the enterprise. W ith o u t know ing w h a t has happe n e d , investors an d m anagers cannot make plans for the future, evaluate alternatives properly or learn from past actions. In to d a y's com plex business environm ent - e sp e cia lly since enterprises have becom e very large - the num ber o f events (or transactions, as w e w ill call them) is much too g re a t for a n yo n e to keep track o f w ithout keeping accurate records (written or, these days, mostly on com puter). Records pro vid e the basis for extrapolations into the future, the inform ation for evaluating an d re w a rd in g perform ance, a nd a basis for internal control over the existence an d q u a lity o f an enterprise's assets. R ecord-keeping, how ever, does cost money; therefore, records should be w orth their cost. H o w co m p le x a nd sophisticated to make one's records is a business decision, much like decisions such as h o w to price o r market one's product.
4.2
Financial accounting's transactional filter
A ccounting is an inform ation system to filter an d summarise d a ta . Inform ation systems select observations from the w o rld , collect those results into d a ta banks, an d org a n ise a nd summarise the d a ta to produce specific kinds of inform ation. This is useful because decision-m akers cannot c o p e w ith masses o f ra w , unorganised observations, and it is econ o m ica lly efficient to have one system o rganise da ta into inform ation on behalf o f the various users. The d a ily new sp a p e r is an e ve ryd a y exam ple o f o rg anising an d sum m arising. The editors g ro u p stories and features so that you kn o w w h e re to look for w h a t you w a n t. There is a sports section, an entertainm ent section, a p a g e fo r letters to the editor, a nd so on. W h ile no n e w sp a p e r contains exactly w h a t you w a n t, it gets close enough to w h a t most p e o p le w a n t so that it can be published a t a lo w cost co m p a red w ith w h a t it w o u ld cost you to hire reporters to get inform ation just for you. In ord e r to make this w o rk, every inform ation system has to be choosy: it must filter all the a v a ila b le d a ta a nd pick w h a t is relevant to its purpose. You d o n 't expect the n e w spaper to contain glossy reproductions o f Rembrandt paintings suitable for fram ing, or to print the grades you received in your university courses: you g o to other inform ation sources for such things. An inform ation system such as fin a n cia l accounting is inherently lim ited. It can report o nly w h a t its sensors p ick up as it seeks out da ta or filters d a ta from the mass o f o n g o in g events. N o inform ation system tells you 'the truth', and certainly not 'the w h o le truth', because it can o n ly pass a lo n g inform ation based on w h a t it has been designed or perm itted to gather as d a ta . Figure 4 .1 represents the situation. The g a p in the w a ll is the system's filter o r 'w in d o w on the w o rld '. O n c e a p ie ce o f ra w d a ta is adm itted, recording activity takes p la ce an d it is stored in a bank o f d a ta (in accounting: stored in m anual o r com puterised accounts, ledgers, journals ['the b o o ks'] an d supporting records). The data in this bank are then o rg anised to p roduce usable inform ation (in acco u n tin g : fin a n cia l statements a nd reports). In accounting , w e g e n e ra lly refer to the left part o f the d ia g ra m - the d a ta recording an d some routine classifying and summarising - as b o o kkeeping. W e refer to the right part, the turning o f d a ta into inform ation for users, as accounting o r reporting. Financial accounting inform ation is co ntained in the system's final product, the financial statements a n d notes.
Ongoing events in the world
FIGURE 4.1
Steps in the accounting information system
*
Classifying Summarising Organising
-------► Information
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A ccounting reports a re based on, a nd are lim ited by, the d a ta that is collected. Therefore, if you are to understand the reports, you have to understand h o w accounting filters, notices an d chooses events to record into its d a ta bank. Financial accounting's filter, its w in d o w on the w o rld , is the transaction. G en e ra lly, if an event is a transaction, it is recorded in fin a n cia l a ccounting's d a ta b a se ; if it is not, the routine accounting system ignores the event. (You'll see in C h a p te r 5 that o ne o f the reasons for accrual accounting techniques is to pro vid e for events that the transaction-based record-keeping system has ignored o r treated im properly.) The fo llo w in g are exam ples o f external accounting transactions. They should be recorded routinely by the accounting system: 1
The payroll departm ent pays em ployees b y deposits to their b a n k accounts.
2
A customer pays, in cash, an a ccount o w in g since last month a nd gets a receipt.
3
A sales clerk prepares an invoice for a customer for the sale o f g o o d s the customer is taking w ith her a nd promises to p a y for.
4
The bank charges b a n k fees on an account.
5
The storeroom receives a shipm ent o f spare parts for the delivery trucks, a lo n g w ith an invoice from the parts supplier. There is no lim it to the num ber o r kinds o f transactions that human ingenuity can devise. A ccounting has to deal
w ith them, an d must ch a n g e as they ch a n g e. N o w a d a y s , m any com panies have to handle internet transactions and those h a p p ening through w e b pages an d other areas o f e-com merce, all o f w h ich have fundam entally ch a n ged m any accounting systems. Transactions a re partly d e fined b y the legal an d e co n o m ic system. In our society, promises to p a y can be enforced in the courts, so they are considered transactions, as in exam ple 3 a b o ve . In general, there a re tw o main kinds o f transactions im portant in a ccounting: cash transactions, w h ich feature the concurrent e xch a n g e o f cash, and credit transactions, w h ich feature (partially o r fully) promises to e xchange cash in the future. The fo llo w in g a re exam ples of events that are not accounting transactions an d that w ill therefore not be recorded routinely, if at all, by the accounting system: 1
The chief executive officer (CEO) o f the c o m p a n y breaks her leg w h ile skiing.
2
The credit departm ent m anager decides that a particular customer is p ro b a b ly never g o in g to p a y the account he ow es.
3
The main w arehouse burns to the ground overnight.
4
A customer orders a m achine to be delivered next month.
5
Real estate reports in d ica te the com pany's land has g o n e up in value by 1 4 per cent since last year. Som e such events m ay be brought into the system by special adjustments to the routine recording system that w e
w ill learn a b o u t later. Events 2 a n d 3 are exam ples. But m any are never included in fin a n cia l accounting's inform ation system. Event 1 is an exam ple. O th e r events a re recorded o n ly after som ething m ore has happe n e d . Event 4 is recorded by the accounting system o nly w hen the m achine is delivered, an d in Australian acco u n tin g , event 5 is recorded o n ly if directors d e c id e to revalue land. Human ingenuity comes in here a g a in : some large o r innovative com panies have accounting systems that routinely record events that are not transactions and that other (or smaller) com panies w o u ld ignore o r leave to be done as special adjustments. Some exam ples are internal transfers of goods from departm ent to departm ent in the com pany, monthly changes in the market values o f investments, estimated profit earned on partly com pleted construction contracts, and revisions in estimates for future w arranty payments. These m ay be included for various reasons; for instance, because other inform ation systems in the com pany provide the necessary data so they can be used easily, or because m anagem ent believes more finely tuned accounting inform ation to be useful in decision-m aking.
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W h a t distinguishes accounting transactions, such as in the first list a b o ve , from the sorts o f events in the second list? All of those in the second list m ay be im portant e co n o m ica lly, but they are not routinely recorded by the accounting system. In order to q u a lify as a fin a n cia l accounting transaction, an event must norm ally have all five of the fo llo w in g characteristics: •
Three fundam ental e co n o m ic a nd legal characteristics: -
exchange: the event must involve an e xch a n ge o f g o o d s, money, fin a n cia l instruments (such as cheques), legal
-
past: the e xch a n g e must have happe n e d , even if just seconds a g o (financial accounting is essentially a histori
promises o r other items o f e co n o m ic value c a l inform ation system) -
external: the e xchange must have been betw een the entity being accounted for a nd som eone else, such as a customer, an o w n e r, a supplier, an em ployee, a banker o r a tax collector (the e xch a n g e must have been across the entity's boundary, so to speak).
•
T w o supplem entary characteristics: -
evidence: there must be some docum entation o f w h a t has h a p pened (recorded on p a p e r or electronically) dollars: the event must be m easurable in dollars o r the currency unit relevant in the country w h e re the transac tion happe n e d .
The fo llo w in g transaction characteristics d e fin e the nature an d value o f fin a n cia l accounting inform ation. •
First, transactions are linked to the legal a nd e conom ic co n ce p t o f an exchange: com pleting a contract b y giving o r receiving consideration in return for the g o o d s or services that ch a n g e hands. The transactional basis of fina n cia l accounting thus has roots in the fundam ental legal a nd e conom ic processes by w h ich society and business operate. It is no a c cid e n t that accounting recognises, as transactions, events that have a b ro a d e r legal and business im portance too.
•
S econd, they constitute a large part o f the underlying rationale for the historical cost basis o f a ccounting, w h ich is firm ly founded on the transaction. If a transaction has h a p p e n e d , it should be in the accounting system a nd in the fina n cia l statements. It is history. If it has not yet h a p p e n e d , it is not yet the sam e sort of legal event a nd w ill not yet be in the historical accounting system. W e can figure out h o w to get some events that have not h a p pened into accounting a n y w a y , but they often d o not fit in w e ll, a nd can be controversial, because reasonable p e o p le often disagree on w hether to bring them in a nd h o w to bring them in.
•
Third, the characteristics of the transaction pro vid e the basis on w h ich the records can be verified (audited) later as part of the process o f ensuring that the accounting inform ation is cre d ib le . Events that d o not have these characteristics are difficult to verify later, an d therefore inevitably lack c re d ib ility as measures o f financial perform ance o r position. Let's look at the five events from the list o f accounting transactions on p a g e I 4 l (1 to 5) a nd see that they fit the
set o f transaction characteristics: Exchange
Past exchange
External party
Evidence
1
Money
2
Money
Dollars
Yes
Employee
Direct deposit
Direct deposit
Yes
Customer
Receipt
Cash
3
Goods, promise
Yes
Customer
Invoice
Price
4
Money
Yes
Bank
Bank statement
Cash
5
Goods, promise
Yes
Supplier
Invoice
Price
The five events in the subsequent list on p a g e 1 4 1 , w h ich a re no t accounting transactions, lack several characteristics, especially that o f being a past e co no m ic exchange. (Event 4 , for exam ple, is not yet an e xchange because the m achine hasn't yet been delivered.) W h a t if an accountant is not satisfied w ith the set o f d a ta recorded b y an accounting system a nd w ishes to adjust those d a ta to reflect some event he o r she thinks is im portant in measuring fin a n cia l perform ance o r position? This can
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be d o n e by recording special alterations to the da ta b a n k ca lle d 'adjustm ents' o r adjusting journal entries, w hich introduce n e w da ta or alter the recording o f previous d a ta . D eciding w hether to make such adjustments and determ ining the d o lla r am ounts to use in them require expertise a n d g o o d judgem ent, since they involve events that are not exchanges, are not a lw a ys a cco m p a n ie d by normal evidence, or are not readily m easurable in dollars. Y ou'll see much m ore a b o u t adjustments in the discussion o f accrual accounting in C h a p te r 5 . M o s t o f this b o o k involves the accounting (right-hand) side o f the e arlier inform ation system d ia g ra m : d e c id in g on adjustments, d e c id in g on reporting form at, m aking supplem entary notes an d other such activities. D on't forget that the basic transactional recording system underlies the w h o le process, an d the p receding definition o f w h a t is and isn't an external transaction gives the accounting system much o f its va lu a b le objectivity. H ow ever, also note that accrual accounting is designed to g o beyond external transactions an d a d d a further layer o f inform ation related to internal transactions such as d e p re cia tio n , u n p a id w a g e s an d prepaym ents. These are discussed in m ore detail in C h a p te r 5 .
HOW'S YOUR UNDERSTANDING? W h ic h o f th e fo llo w in g tra n s a c tio n s w o u ld be re c o rd e d in th e a c c o u n tin g s y s te m f o r O ra n g e L im ite d ?
1 2 3 4
Issue o f sh a re s b y O ra n g e L im ite d to th e p u b lic . S ale o f s hare s fr o m s o m e s h a re h o ld e rs o f O ra n g e L im ite d t o n e w s h a re h o ld e rs . O ra n g e L im ite d re c e iv e d a p u rc h a s e o r d e r f o r th e s u p p ly o f 1 0 0 m e tre s o f w ire . O ra n g e L im ite d d e liv e re d th e a b o v e o rd e re d w ire to th e c u s to m e r. Y o u r a n s w e r s h o u ld be : 1 an d 4 .
4.3
Accounting's 'books' and records
A ccounting cycle Figure 4 .2 shows the sequence o f accounting procedures from the o rig in a l docum entary e vidence of a transaction (source documents) to the preparation o f fin a n cia l statements. The source docum ents are the basis for journal entries, w h ich in turn a re posted to the general ledger accounts as a means o f summarising the transactions. A trial b a la n ce is then taken out to ensure that the total o f the debits equals the total o f the credits. End-of-period accruals, corrections a nd other adjustments (covered in detail in C h a p te r 5) are then incorporated via a d d itio n a l journal entries. A post-adjustment trial b a la n ce is taken out to ensure the total o f the debits still equals the total o f the credits. Further journal entries then close the revenue, expenses a nd d ivid e n d amounts to retained profits to make all o f those accounts' balances ze ro in preparation for the next period's step 1. (The b a lan ce sheet accounts continue into the next period an d so are not closed.) Financial statements are then prepared.
The un de rlyin g accounting system This section summarises some o f the m echanics of the accounting system behind steps 1 to 9 in Figure 4 .2 , to show you h o w transactions are summarised into the fin a n cia l statements. Keep in m ind, though, that this is a basic description: much has been left out in orde r to keep the portrayal clear. These days, for most com panies, m any o f the 'books' referred to b e lo w a re a ctually electronic records in com puter systems.
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FIGURE 4.2
Steps in the accounting cycle
Source docum ents and the tra nsactional cycle A ccounting record-keeping depends upon sets o f docum ents to sh o w that transactions have occurred. Such docum ents are kept so that the accounting records can be checked a nd verified to correct errors. They also permit a u d iting, and can be used if there is a dispute or to support incom e tax claim s a nd other legal actions. The transactions themselves reflect various events in op e ra tin g a business. H ere are some exam ples from a real com pany, Labelcraft Pty Ltd.1 1
Labelcraft, a manufacturer o f self-adhesive labels an d cartons, is located in S ydney. To manufacture these products it orders ink, p a p e r an d c a rd b o a rd , am ong other things. O rd e rin g the kinds o f m aterials it needs to produce products customers w ill w a n t is an im portant early step. O rd e rin g is not an accounting transaction, so orders are not recorded in the accounts, but docum enting an d keeping track o f them is very im portant to Labelcraft, so it uses purchase order forms for this through its o nline system for ordering (this is very sim ilar to w hen you order online an d items g o to a shopping cart). The items ordered are listed in detail so they can be checked against w h a t actu a lly arrives from the supplier. The am ount o f g o o d s a nd services tax (GST) is a d d e d . The accounting entries for G ST a re covered in C h a p te r 1 1.
2
W h e n ordered items arrive, they are checked aga in st purchase orders an d the supplier's packing slips, to ensure all is correct. W h e n Labelcraft accepts a delivery, this is an accounting transaction, a nd a purchases record is created to support the transaction d e b it Inventory (asset] a n d c re d it A ccounts p a y a b le (liability!. If the c o m p a n y needed to return some g o o d s to suppliers, it is recorded as w e ll, in just the o p p o site w a y : c re d it Inventory and d e b it A ccounts p a y a b le .
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W h e n Labelcraft pays the supplier, it is usually by electronic transfer o f funds (or for some small suppliers a cheque is w ritten). A c o p y o f that is the source docum ent for recording the transaction d e b it A ccounts p a y a b le a nd credit C ash (bank).
4
Selling the products is w h a t Labelcraft is in business to d o . W h e n a sale is m ade, a sales invoice is prepared, specifying various useful details. A c o p y o f this invoice supports the transaction d e b it A ccounts receivable and c re d it Sales revenue. (Through the com pany's com puterised inventory system, the sales invoice also supports recording the cost o f the g o o d s taken by the customer, d e b it C ost o f g o o d s so ld expense a nd cre d it Inventory.) You w ill cover the cost o f g o o d s sold calculation for a m anufacturing firm in a later part o f the course on m anagem ent accounting (for m ore inform ation on m anagem ent a ccounting, log on to C o u rse M a te a nd see this text's M a n a g e m e n t A ccounting supplement). It is determ ined based on the am ount o f m aterial, labour and overhead incurred in the production process. The am ount on the invoice w ill include GST. For exam ple, if the total am ount c h a rg e d is $ 7 0 7 .3 0 , it includes $ 6 4 .3 0 GST. In effect, Labelcraft is collecting this am ount on b ehalf of the governm ent. W h ile the entries w ill be show n in m ore detail in C h a p te r 11, the journal entry w ill be: d e b it A ccounts receivable $ 7 0 7 .3 0 (i.e. the am ount o w e d by the debtor), c re d it Sales revenue b y $ 6 4 3 .0 0 (i.e. revenue earned by the com pany) an d cre d it G S T lia b ility a cco u n t w ith $ 6 4 .3 0 (i.e. the am ount being collected in G ST on b ehalf o f the governm ent). The paym ent is for the am ount Labelcraft is being ch a rg e d by the supplier, even if this is less than the 'list p rice '. If the terms o f paym ent a llo w a discount for early paym ent, this requires a d d itio n a l entries w h ich a re covered in C h a p te r 8.
5
C ollecting from customers is the last event w e illustrate. W h e n a customer pays Labelcraft, the paym ent is listed in the d a y's collections. That list is the source docum ent to support the transaction d e b it Cash (bank) an d cre d it Accounts receivable. It also supports the bank deposit m ade that d a y, so that if there are problems, som eone can start w ith the monthly bank statement a nd trace the deposits shown on it b a ck to the payments by individual customers.
6 Labelcraft, like m any businesses, relies on credit cards an d electronic funds transfer for customers' payments on some sales. W h e n a customer pays by credit ca rd , the credit ca rd slip is d eposited into the ba n k just like cash or a cheque (the credit ca rd c o m p a n y bills Labelcraft for its fee monthly). Some customers p a y Labelcraft by electronic funds transfer (EFT) w h ich has becom e very com m on for m any organisations, both large an d small. W ith o u t keeping track of EFTs an d credit ca rd paym ents, Labelcraft w o u ld have little idea o f w h a t its bank balances should be. Labelcraft also uses other kinds o f docum ents. It has m ore electronic transfers; for exam ple, p a yin g all em ployees by direct dep o sit into their b a n k accounts. There are m any kinds o f docum ents used by various com panies. Each c o m p a n y a dapts docum ents to its o w n needs, e sp e cia lly to pro vid e legal an d taxation e vidence an d to support accounting transactions records. You can count on tw o things re garding a n y co m p a n y, governm ent, sports clu b or other org a n isa tio n : (1 ) it w ill have various docum ents to b ack up its accounting system; an d (2) those docum ents w ill be suited to that organisation a n d so m ight not be quite like those o f a n y other organisations.
Journal entries Based on source docum ents, accounting transactions are recorded by p reparing journal entries. Because this is w hen the business event is first recorded by the accounting system, these basic transactional records a re often called books o f o rig in a l entry. Journal entries w e re introduced in C h a p te r 3 to illustrate the use of debits a nd credits. Journal entries p rovide, in chro n o lo g ica l order, a record o f all the transactions recorded by an org a n isa tio n . Journal entries can take many different forms, d e p e n d in g on such factors as the size o f the o rganisation, the frequency of transactions an d the frequency of p ro vid in g reports. In this section w e describe the simplest form, known as a general journal entry. You had some practice in p re paring journal entries in C h a p te r 3 , but it is w orth reinforcing here. C o n sid e r the fo llo w in g transactions: • •
A consulting c o m p a n y provides services to a client a nd sends it an invoice (source docum ent) for $ 1 0 0 0 0 . The c o m p a n y buys a motor vehicle for $ 3 0 0 0 0 , p a yin g $1 2 0 0 0 cash an d o w in g $1 8 0 0 0 to be p a id in tw o years.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
These w o u ld be recorded as follow s:
N o te that an alternative form at for the journal entries often puts the d e b it (DR) a nd credit (CR) before each account rather than as headings to the right-hand colum n. For exam ple: DR CR
Accounts receivable Consulting revenue
10000 1 0 0 00
Both methods are a cce p ta b le . From the a b o ve journal entries, the fo llo w in g should be noted: •
All journal entries have one o r m ore accounts d e b ite d a nd one o r m ore accounts credited. A journal entry can list as m any accounts as a re needed to record the transaction, but each journal entry must be recorded so that the sum o f the debits equals the sum o f the credits for that entry. If not, the accounting equation w ill not be m aintained (the books w ill not balance).
•
It is traditional for the debits to be listed first in each journal entry a nd for the debits to be w ritten to the left a nd the credits to the right. N e ith e r of these is arithm etically necessary, but keeping a consistent style helps keep the records understandable.
•
It is custom ary to om it the d o lla r signs in w ritin g the entries. The transaction has to be m easurable in dollars, so putting in d o lla r signs is thought to be redundant.
•
It is also traditional to w rite a short e xplanation called a narration b e lo w each entry as a m em orandum of w h a t the recorded transaction w a s about. A g a in , this is not necessary, but it helps to make the record understandable.
•
Every journal entry should also be d a te d , an d is usually num bered, so there is no d o u b t a b o u t w hen the transaction w a s recorded. The d a te can have im portant legal an d tax im plications, an d , o f course, it is necessary to know w h ich fin a n cia l p eriod a transaction belongs to w hen fin a n cia l statements are being prepared.
•
A posting reference is given to indicate the ledger account to w hich each journal entry is posted. This number can be obtained from the com pany's chart of accounts. In d e cid in g w h a t accounts to use, accountants deve lo p a chart o f accounts an d use it to determine the nam e of the account that is affected by a transaction. A chart of accounts is a listing of the titles o f all accounts. For exam ple, assets m ay be numbered 1 to 9 9 , liabilities 1 0 0 to 1 9 9 , shareholders' equity 2 0 0 to 2 9 9 , revenues 3 0 0 to 3 9 9 and expenses 4 0 0 to 4 9 9 . This allow s room for expansion over time as new account titles are required for new types o f transactions. An illustration is provided in section 4 .5 . Enterprises w ith m any transactions to record - this is most enterprises - d o not create a separate journal entry
for each transaction, but instead use special records for each frequent, routine kind o f transaction, such as a sales journal, a cash receipts journal, a cash payments journal an d a purchases journal. These are illustrated in C h a p te r 8.
CHAPTER 4
Record-keeping
147
Alm ost all bookkeeping systems a re com puterised. These systems m ay o r m ay not produce records that look like the preceding exam ples, but they have the sam e arithm etical o b je ctive o f keeping all the debits equal to all the credits. You s a w spreadsheet printout exam ples in C h a p te r 3 , but spreadsheets a re a little cum bersom e for handling large numbers o f transactions, so most enterprises use special accounting softw are.
HOW'S YOUR UNDERSTANDING? W h a t is th e jo u r n a l e n tr y f o r th e sale o f g o o d s o n c re d it f o r $ 8 0 0 0 0 th a t c o s t $ 5 0 0 0 0 ? Y o u r a n s w e r s h o u ld be: DR
Accounts receivable
CR
Sales revenue
DR CR
COGS
$80000 $80000 $50000
Inventory
$50000
Posting to ledgers C onsid e r a situation w h e re , during the month, thousands o f journal entries w e re w ritten, o f w h ich 2 0 per cent included either a d e b it o r credit to the cash account. If you w e re asked the b a la n ce o f the cash account a t the end of the month, h o w w o u ld you find out? O n e o ption is to get the o p e n in g ba la n ce , a d d on all d e b it entries affecting cash and d educt all credit entries affecting cash. But d o in g this is time-consuming, an d it w o u ld be preferable to have a source that w ill g ive you the b a la n ce o f the account at a n y point in time. Such a source is a ledger. Ledgers are books (or com puter records) that have a separate p a g e o r a ccount c o d e for each in dividual a ccount referred to in the books o f o rig in a l entry. Each area o r p a g e contains a summary o f all the transactions relating to that particular account and, therefore, posted to it. H ere is an exam ple o f the 'cash in bank' a ccount for a com p a n y: Cash in bank Date
Description
Entry no.
Debits
Credits
Balance
0 2 /1 2 /1 6
First deposit
1
10000
1 0 0 00 DR
0 2 /1 2 /1 6
Deposit
3
1 146
11 146 DR
0 2 /1 2 /1 6
Cheque
7
678
10468 DR
0 2 /1 2 /1 6
Cheque
8
2 341
8 127 DR
You see the id e a . Each a ccount is really just a convenient summary o f the entries affecting it. In turn, the bala nce sheet is a summary o f all the a ccount balances. The general ledger is the com plete set o f all the accounts (assets, liabilities, equity accounts, revenues an d expenses) that lie behind the fin a n cia l statements. You m ight w a n t to think o f the ledger as a set o f a ccount pages (real pages, such as in the bound books the bookkeepers o f o ld used, o r representations in a com puter system), such as the o ne a b o ve , in w h ich the sum o f all the d e b it b a la n ce accounts equals the sum o f all the credit b a la n ce accounts. The picture in Figure 4 .3 , using the accounting equation form at a nd including the cash in bank account a b o ve , m ight be useful.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A s s e ts
FIGURE 4.3
L ia b ilitie s a n d E q u ity
Ledgers
For dem onstration an d analysis purposes, accountants a nd accounting instructors often use a sim plified version of an account c alle d a T-account, w h ich includes o nly the debits a nd credits columns o f the account, w ith o u t calculating the b a la n ce after every entry. A T-account version o f the a b o v e cash account exam ple w o u ld look like this: Cash in bank DR
CR
1 0000
678
1 146
2 341
8 127
The b a lance o f $ 8 1 2 7 is sim ply the am ount by w h ich the d e b it entries exceed the credit entries. N o te that the normal b a la n ce o f asset accounts is a d e b it an d the normal b a la n ce o f liabilities a nd equity accounts is a credit balance. (Also note that, as revenues increase equity, their normal b a la n ce is a credit a n d , as expenses reduce equity, their normal b a la n ce is a debit.) By convention, left-hand entries to ledgers are ca lle d debits an d right-hand entries are ca lle d credits. H ere is an exam ple o f some ledger accounts: Cash DR
Loans CR
DR
CR
CHAPTER 4
Record-keeping
149
Recall our e arlier d e b it/c re d it conventions from C h a p te r 3: •
For asset accounts, increases are recorded on the left-hand side (i.e. debit) a nd decreases are recorded on the right-hand side (i.e. credit).
•
For liabilities a nd shareholders' equity accounts, the o p p o site occurs. Increases are recorded on the right-hand side (credit) a nd decreases are recorded on the left-hand side (debit). General journal DR Accounts receivable
CR
10 000
Consulting revenue
Accounts receivable
10000
2
Consulring revenue
DR
CR
31 6
DR
1 CR
10000
1 0 0 00
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TE 1
W e th a n k Terry R ow ne y, C E O o f La belcraft, fo r p ro v id in g these e x a m p le s.
Accrual accounting adjustments ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: explain how the tim ing of revenue an d expense recognition differs from cash inflows a n d outflows explain the purpose of accrual accounting adjustments describe prepaym ents, accrued revenue, accrued expenses, revenue received in a d v a n c e , d e p re ciatio n , doubtful debts a n d contra accounts calculate the im pact on the financial statements of accrual accounting adjustments p re p a re journal entries for accrual accounting adjustments show the im pact on the financial statements and p re p a re journal entries for the depreciation of assets a n d the sale of assets
CHAPTER OVERVIEW A c c ru a l a c c o u n tin g e xists b e c a u s e ca sh flo w in fo rm a tio n is n o t c o m p le te e n o u g h to assess fin a n c ia l p e rfo rm a n c e o r fin a n c ia l p o s itio n . K e e p in g tra c k o f ca sh flo w is c ru c ia l fo r bu siness success, b u t it is n o t e n o u g h . W e h a v e to g o b e y o n d ca sh flo w to assess e c o n o m ic p e rfo rm a n c e m o re b ro a d ly a n d to assess non-cash re so u rce s a n d o b lig a tio n s . W e d o th is a lth o u g h it fo rc e s us to m a ke estim a te s, ju d g e m e n ts a n d o th e r a c c o u n tin g c h o ic e s th a t, in tu rn , m a ke th e results less p re c is e th a n w e w o u ld w is h , a n d m o re s u b je c tiv e th a n tra n s a c tio n -b a s e d ca sh flo w fig u re s . Im a g in e th e fo llo w in g c o n v e rs a tio n b e tw e e n a s tu d e n t a n d a re la tiv e , w h o is a ls o a p ro fe s s io n a l a c c o u n ta n t: A c c o u n ta n t:
W e ll, y o u s p e n t th e s um m er w o rk in g a t H ig h -cla s s B o u tiq u e . H o w d id y o u d o ?
S tu d e n t:
I h a d a g re a t tim e . M e t som e g re a t p e o p le , le a rn e d a lo t a b o u t re ta ilin g , a n d h a ve d e c id e d to
A c c o u n ta n t:
N o , I m e a n t h o w d id y o u d o fin a n c ia lly ?
S tu d e n t:
Let's see. I re c e iv e d $ 4 2 6 0 o v e r th e th re e m onths. I h a ve $ 2 3 3 0 left in th e b a n k , so I gu ess I m ust
m a jo r in m a rk e tin g .
h a ve s p e n t $ 1 9 3 0 . G e e , $ 2 3 3 0 d o e s n 't seem m uch fo r a s u m m e r's w o rk ! But th e b o u tiq u e still o w e s m e fo r m y last w e e k o f w o rk . A c c o u n ta n t:
W h a t d id y o u s p e n d th e $ 1 9 3 0 on?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
S tu d e n t:
I b le w so m e o f th e m o n e y on b e e r a n d e n te rta in m e n t, a n d on th a t trip to th e G o ld C o a s t. But I a lso b o u g h t n e w c lo th e s fo r sem ester o n e , a n d I h a ve th e n e w c o m p u te r, a n d th e iP a d I g o t so th a t I m ig h t be a b le to ta k e b e tte r no tes in class a n d pa ss a c c o u n tin g .
A c c o u n ta n t:
D o n 't fo rg e t y o u h a ve to p a y y o u r U n c le A l b a c k th e m o n e y he le nt y o u in N o v e m b e r. T h a t's in y o u r b a n k a c c o u n t to o . Y o u p ro m is e d to p a y h im , plus in tere st, a t th e e n d o f th e sum m er. A n d then th e re 's y o u r u n iv e rs ity fees fo r n e xt y e a r; som e o f th ose h a ve b e e n p a id . A n d d id n 't y o u s a y th a t y o u o w e d a frie n d s o m e th in g fo r p e tro l fo r th a t tr ip to th e G o ld C o a s t a n d y o u h a d a lre a d y b o u g h t b o o k s in a d v a n c e b e c a u s e th e a c c o u n tin g o n e lo o k e d so in te re stin g ?
S tu d e n t:
I d o n 't th in k w e s h o u ld c o u n t th e fees b e ca u s e it d o e s n 't re a lly a p p ly un til I e n ro l. A lth o u g h I guess th a t's w h y I w a s w o rk in g . N o w I'm n o t sure if I h a d a g o o d s um m er o r not!
This e x a m p le illu s tra te s m a n y o f th e issues a c c ru a l a c c o u n tin g trie s to d e a l w ith , in c lu d in g th e fo llo w in g : •
The m o re y o u th in k a b o u t it, th e m o re c o m p le x m e a s u rin g p e rfo rm a n c e a n d p o s itio n seem s to b e , a n d th e less s a tis fa c to ry ca sh b y itse lf seem s to be a s a m e a su re .
•
S om e o f w h a t is e a rn e d m a y n o t y e t h a ve b e e n re c e iv e d in ca sh (p a y m e n t fo r th e la st w e e k o f w o rk ).
•
S im ila rly , so m e costs in c u rre d m a y n o t y e t h a ve b e e n p a id (the p e tro l fo r th e trip ).
•
S om e c a sh p a y m e n ts result in re so u rce s still h a v in g e c o n o m ic v a lu e a t th e e n d o f th e p e rio d (the iP a d , th e c o m p u te r a n d m a y b e th e clo th e s).
•
S om e c a sh re c e ip ts result in o b lig a tio n s still o u ts ta n d in g a t th e e n d o f th e p e rio d (U n cle A l's lo a n ).
•
The lo n g e r-te rm re so u rce s m a y h a ve d e te rio ra te d d u rin g th e p e rio d (n o t a ll th e c lo th e s p u rc h a s e d d u rin g th e s u m m er w ill still b e v a lu a b le b e c a u s e fa s h io n s c h a n g e , a n d th e iP a d a n d th e c o m p u te r a re n o w used item s).
•
O b lig a tio n s m a y b u ild up d u rin g th e p e rio d (the in te re st o n U n c le A l's lo a n ).
•
T h e re is o fte n d o u b t a b o u t w h e th e r som e th in g s s h o u ld b e in c lu d e d in m e a s u rin g p e rfo rm a n c e fo r a g iv e n
•
G e n e ra lly , h o w d o w e re la te th e tim in g o f c a sh flo w s to th e p e rio d w e 'r e c o n c e rn e d w ith ? M o s t o f th e a b o v e
p e rio d o r p o s itio n a t a g iv e n p o in t in tim e (the u n iv e rs ity fees). item s in v o lv e cash flo w s s o o n e r o r la te r; th e a w k w a rd case s a re u s u a lly th ose w h e n th e p e rio d in w h ic h th e ca sh m oves a n d th e p e rio d fo r w h ic h w e 'r e m e a s u rin g p e rfo rm a n c e d o n 't m a tch . T h in k o f a c c ru a l a c c o u n tin g as a n a tte m p t to m e a s u re e c o n o m ic p e rfo rm a n c e a n d fin a n c ia l p o s itio n in a m o re c o m p le x w a y th a n just b y u s in g c a sh . T h e re is a lw a y s a tra d e -o ff h e re : th e c lo s e r to c a s h , th e m o re p re c is e th e m e a su re , b u t a ls o th e m o re lim ite d a n d less in fo rm a tiv e th e in fo rm a tio n . The m o re a c c o u n ta n ts try to m a ke th e fin a n c ia l state m e nts e c o n o m ic a lly re le v a n t, th e m o re th e y m ust in c lu d e e s tim a te s a n d o th e r sources o f im p re c is io n o r e rro r.
CHAPTER 5 Accrual accounting adjustm ents
185
HOW'S YOUR UNDERSTANDING? A s re v is io n o f th e ba sic c o n c e p ts o f cash an d a c c ru a l a c c o u n tin g , c o m p le te th e fo llo w in g p ro b le m . W ith
re s p e c t to
th e
c u r r e n t a c c o u n tin g
p e rio d , s ta te w h e th e r e a ch
o f th e fo llo w in g
in d e p e n d e n t
tra n s a c tio n s : (a ) in c re a s e s e x p e n s e s ; ( b ) d e c re a s e s c a sh ; o r ( c ) b o th .
1
R e c o g n itio n o f d e p re c ia tio n
2
R e p a y m e n t o f a loan
3
P a y m e n t o f a cash d iv id e n d
4
P a y m e n t o f an a d v e rtis in g in v o ic e th a t w as re c o rd e d as an e x p e n s e in th e p re v io u s p e rio d
5
P a y m e n t o f w ag es f o r th e p e rio d
6 P u rc h a s e o f a b lo c k o f land f o r cash Y o u r a n sw e rs s h o u ld be:
1 in c re a s e s e x p e n s e s 2 d e c re a s e s cash 3
d e c re a s e s cash
4
d e c re a s e s cash
5
b o th
6 d e c re a s e s cash
5.1
Conceptual foundation of accrual accounting
A ccrual accounting is the d o m in a n t form o f fin a n cia l accounting in the w o rld to d a y. This cha p te r builds on the foundation la id in e arlier chapters; it explains w h y accrual accounting exists a n d distinguishes the accrual-basis from cash-basis a ccounting. A ccrual accounting is based on the id e a that events, estimates an d judgem ents that are im portant to the measurement o f fin a n cia l perform ance a n d position should be recognised by entries in the accounts (and therefore reflected in the fin a n cia l statements). This is regardless o f w hether o r not they are yet to be, o r a lre a d y have been, realised b y cash received o r p a id out. To slightly oversim plify, w e m ight say that the o b je ctive is to recognise e conom ic flow s in a d d itio n to cash flow s. To c la rify this id e a , w e w ill focus on revenue a nd expense recognition. Let's build the accrual accounting a p p ro a ch from some basics. These three cornerstones have com e up a lre a d y in this book, but w e ll g ive them brief definitions a g a in , then build from there. W e w ill com e b a ck to these concepts in C h a p te r 1 3 to p ro vid e the m ore inclusive concepts outlined in the revised International A ccounting Standards. •
Revenues are inflow s o f e co n o m ic resources from customers, earned through p ro vid in g g o o d s o r services. You m ight say that com panies are in business to earn revenues.
•
Expenses are outflow s o f econom ic resources to em ployees, suppliers, taxation authorities an d others, resulting from business activities, to generate revenue a nd serve customers. You m ight say that incurring expenses is the cost o f earning revenues.
•
N e t p ro fit is the difference betw een revenues a nd expenses over a period o f time, such as a month, a quarter o r a year. You m ight say that net profit is the measure o f success in generating m ore revenues than it costs to d o so. N o te some features o f these cornerstones:
•
Revenues an d expenses refer to inflow s a nd outflow s o f e conom ic resources. These flow s m ay be represented by the kinds o f events recognised by the transactional record-keeping system described in C h a p te r 4 , but they m ay also involve other phenom ena such as those discussed in section 5 .2 . In particular, they m ay involve phenom ena that arise before o r after cash changes hands, as w e ll as a t the point o f the cash flo w .
186
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N e t profit is depen d e n t on h o w revenues a nd expenses are measured. A ccountants d o n 't (or shouldn't) choose the profit num ber first, then force revenues a nd expenses to result in that number, but instead measure revenues and expenses as best they can, then let net profit be w h a te ve r the difference is betw een properly measured revenues and expenses.
A conceptual system for accrual p ro fit m easurem ent A ccrual accounting's purpose is to extend the measurement o f fin a n cia l perform ance an d fin a n cia l position by recognising phenom ena before an d after cash flow s, as w e ll as a t the p o in t o f cash flow s (which cash basis accounting a lre a d y does). W e need a system, therefore, that covers the fo llo w in g types o f events: 1
re c o g n itio n o f revenue (resource inflow ) o r expense (resource outflow ) a t the sam e tim e as cash in flo w o r o utflow
2
recognition o f revenue (resource inflow) o r expense (resource outflow ) before cash in flo w o r o utflow
3
recognition o f revenue (resource inflow) o r expense (resource outflow ) after cash in flo w o r outflow . A ccrual accounting derives its value from recognising transactions in categories 2 a n d 3 . These a llo w
measurement o f perform ance a n d position to be spread out over time. C a te g o ry 2 extends the tim e horizon out prior to the cash flo w , a nd c a te g o ry 3 extends the time horizon out subsequent to the cash flo w . C a te g o ry 1 a lre a d y exists in the cash basis o f a ccounting, so the accrual method includes the cash basis. As w ill be illustrated b e lo w , it also does much more.
Im plem enting the accrual fra m ew o rk As you review the fo llo w in g exam ples, try to think a b o u t the general accrual accounting fram ew ork they represent. They are not the o n ly exam ples that could be listed, but they w ill help you understand the concept, so that you can choose o r understand an accounting entry o r fin a n cia l statement item that you m ight not have seen before. Think about the patterns rather than trying to memorise the entries. Think a b o u t h o w accrual accounting recognises revenue w hen it is earned a nd recognises expenses w hen they are incurred, regardless o f w hen the cash is collected. In the fo llo w in g illustration, w e first sh o w the effect o f the transactions on the accounting e q uation, then sh o w the journal entry b elo w . This should reinforce your understanding o f journal entries. In considering each o f the entries b e lo w , rem em ber the accounting equation must a lw a ys ba la n ce : A = L + SE. An increase in revenue increases SE w h ile an increase in an expense decreases SE.
1 RECOGNITION OF REVENUE OR EXPENSE AT THE SAME TIME AS CASH INFLOW OR OUTFLOW These exam ples are sim ple cash-basis revenue a n d expense transactions, w h ich you have seen in earlier chapters. W e present them a g a in here to pro vid e a com plete picture of revenue a nd expense accounting under the accrual basis. R evenues
•
A retail shop records a cash sale to a customer. T C ash
$48
T Sales revenue
$48 $ DR CR
Cash Sales
$
48 48
CHAPTER 5 Accrual accounting adjustm ents
187
An investor records a d ivid e n d cheque received from BHP Billiton. T Cash
$150
T D ividend revenue
$150 $
DR CR
Cash
$
150
Dividend revenue
150
E x p e n se s
•
A c o m p a n y pays A cm e Rug C leaners to sham poo the carpets in its customer w a itin g area. T O ffic e expenses
$245
$ Cash
$245
N o te that increasing an expense reduces equity. $ DR CR
•
Office expense
$
245
Cash
245
A c o m p a n y makes a d onation to the accounting departm ent o f the local university to sup research. T D onation expense
$10000
$ Cash
$10000 $ DR CR
Donation expense
$
10000
Cash
10000
2 RECOGNITION OF REVENUE OR EXPENSE PRIOR TO CASH FLOW In the fo llo w in g situations, the revenue or expense is recognised before the cash in flo w o r ou tflo w . U nder accrual accounting, the revenue should be recognised (recorded in the accounting records) w hen it is earned, not w hen the cash is collected. Sim ilarly, expenses should be recognised in the period in w h ich the expense is incurred, not w hen the cash is p a id . Assume the year-end is 3 0 Ju n e. R evenues
•
A la w ye r performs services for a client in June 2 0 1 6 a nd bills the client $ 5 0 0 to be p a id w ithin 3 0 days. T Accounts receivable
$500
T Fee revenue
$500
$ DR
Accounts receivable
CR
Fee revenue
$
500 500
188
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
E x p e n se s
A c o m p a n y receives a $ 2 4 0 0 advertising bill on 1 0 June 2 0 1 6 , p a y a b le w ithin 3 0 days. T A dvertising expense
$2400
T Accounts p a ya b le
$2400 $
DR CR
Advertising expense
$
2400
Accounts payable
2400
A manufacturer estimates that it w ill incur future w a rra n ty costs o f $ 3 0 0 0 in the 2 0 1 6 financial sold in the 2 0 1 6 fin a n cia l year. (The w a rra n ty expense should be recognised in 2 0 1 6 , since w h ich the sales revenue w a s recognised a nd the w a rra n ty expense relates to that sale.) T W a rra n ty expense
$3000
T W a rra n ty lia b ility
$3000
(W a rra n ty lia b ility is sometimes c a lle d provision fo r w a rra n ty expense.) $ DR CR
Warranty expense
$
3 000
Warranty liability
3 000
O n 3 0 June 2 0 1 6 , a c o m p a n y calculates that its 2 0 1 6 incom e taxes are $ 1 8 5 0 . The com taxes b y 1 0 O c to b e r 2 0 1 6 T Income tax expense
$1850
T Income tax p a y a b le
$1850 $
DR CR
Income tax expense
$
1 850
Income tax payable
1 850
In the a b o v e exam ples, revenue an d expenses a re recognised before the cash flo w transactions. W h e n the cash flow s occur, there is no longer a need to recognise revenue or expense. The cash flow s w ill be recorded as offsets to the assets and liabilities created w hen the revenues an d expenses w e re initially recorded. For exam ple, the paym ent o f the tax bill w ill decrease cash an d decrease incom e tax p a ya b le . These entries a re illustrated b e lo w .
3 CASH COLLECTIONS OR PAYMENTS RELATED TO PREVIOUSLY RECOGNISED REVENUES AN D EXPENSES R evenues
•
The law yer receives full paym ent from her client in July 2 0 1 6 . T C ash
$500
i Accounts receivable
$500 $
DR CR
Cash Accounts receivable
$
500 500
CHAPTER 5 Accrual accounting adjustm ents
189
E x p e n se s
•
The advertising expense is p a id on 1 0 July 2 0 1 6 . i Accounts p a y a b le
$2400
i C ash
$2400 $ DR CR
Accounts payable
$
2400
Cash
2400
The manufacturer makes payments under the w a rra n ty in July 2 0 1 6 $ W a rra n ty lia b ility
$3000
$ Cash
$3000 $ DR CR
Warranty liability
$
3 000
Cash
3 000
The c o m p a n y pays a cheque to the A ustralian Taxation O ffic e on 10 O c to b e r 2 0 1 6 . 1 Income tax p a y a b le
$1850
$ Cash
$1850 $ DR CR
4
Income tax payable
$
1 850
Cash
1 850
CASH INFLOW OR OUTFLOW BEFORE REVENUE AND EXPENSE RECOGNITION
In the fo llo w in g situations, the revenue o r expense is recognised after the cash in flo w o r ou tflo w . U nder accrual accounting, the revenue should be recognised w hen it is earned, not w hen the cash is collected. Sim ilarly, expenses should be recognised in the p eriod in w h ich the expense is incurred, not w hen the cash is p a id . R evenues
•
A la w ye r receives an a d va n ce o f $ 2 5 0 0 from a client for future services. The revenue w ill not be earned until a later d a te w hen services are perform ed. R ecognition o f revenue is deferred until the service has been perform ed. T C ash
$2500
T Custom er d e p o sits*
$2500
* (This is also called 'unearned revenue' o r 'revenue received in a d va n ce '.) $
DR CR
Cash Customer deposits
$
2 500 2 500
190
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Expenses •
In June 2 0 1 6 , D o g w o o d Limited pays $ 4 0 0 for a one-year fire insurance p o licy that becom es effective l July 2 0 1 6 . The insurance premium provides co ve ra ge for one year, a nd should be recognised as a 2 0 1 7 expense. Expense recognition is deferred until 2 0 1 7 . T Prepaid insurance
$400
i C ash
$400 $ DR CR
•
Prepaid insurance
$
400
Cash
400
In July 2 0 16 , D o g w o o d Lirrlited purchases, for $ 4 0 0 0 0 0 in cash, a n ew building to be used as a retail location. D o g w o o d estimates that thi3 building w ill be useful for 101years. The building w ill be used to p roduce revenues over 1 0 future years. Recognition o f an expense for the cost o f using the building (depreciation expense) w ill be d e fe rre d . T Building
$400000
$ Cash
$400000 $
•
DR
Building
CR
Cash
$
400000 400000
D o g w o o d Limited purchases $ 5 0 0 0 w orth o f stereo com ponents from a supplier for cash. D o g w o o d intends to resell these items to its customers. The purchases represent an asset (inventory), an d recognising the cost as an expense is deferred until revenue is recognised through sales to customers. T Inventory
$5000
$ Cash
$5000 $ DR CR
Inventory
$
5 000
Cash
5 000
5 RECOGNITION OF REVENUE OR EXPENSE AFTER CASH INFLOW OR OUTFLOW Revenues •
The la w ye r com pletes the w o rk prom ised for the client. The revenue has n o w been earned a nd should be recognised. i Custom er deposits
$2500
T Fee revenue
$2500 $ DR
Customer deposits
CR
Fee revenue
$
2 500 2 500
CHAPTER 5 Accrual accounting adjustm ents
191
Expenses •
D o g w o o d 's fire insurance p o licy expires in June 2 0 17 . C o ve ra g e has been used during the ye a r e nded 3 0 June 2 0 1 7 ; therefore, the cost o f insurance used up should be recognised as an expense. T Insurance expense
$400
i Prepaid insurance
$400 $
DR CR
Insurance expense
$
400
Prepaid insurance
400
D o g w o o d recognises a portion o f the cost o f the bu ild in g as an op e ra tin g expense. T D epreciation expense
$4000
T Accum ulated d epreciation
$4000 $
DR CR
Depreciation expense
$
4000
Accumulated depreciation
4000
D o g w o o d sells all o f the stereo com ponents to customers. The cost o f the inventory sold is an revenue from the sale. T C ost of g o o d s sold
$5000
1 Inventory
$5000 $ DR CR
Cost of goods sold Inventory
$
5 000 5000
SUMMARY Based on the a bove: •
You can say that accrual accounting makes much o f the b a la n ce sheet into a sort o f 'h o ld in g a re a ' for incom plete revenue an d expense events. For exam ple, w e record a credit sale as revenue a nd set up the related accounts receivable until cash is subsequently collected.
•
You can see h o w accrual accounting spreads out these events over time. For exam ple, a building is o rig in a lly recorded as an asset, a nd the cost is p e rio d ica lly recognised as a dep re cia tio n expense over the useful life of the asset. There a re com plications, but the general pattern behind accrual accounting's revenue a nd expense recognition
system is as follow s: •
The recognition o f revenue before cash collection is d o n e by creating an asset account (accounts receivable, usually), w h ich stands in for the e conom ic value g a in e d until the cash has been collected.
•
The recognition o f an expense before cash paym ent is d o n e b y creating a lia b ility account (such as accounts p a ya b le , w a g e s p a y a b le o r tax payable), w h ich stands in for the e co n o m ic value lost until the cash is p a id .
•
R ecognition o f unearned revenue w hen cash is collected is pro vid e d for by creating a lia b ility a ccount (called 'unearned revenue' o r 'revenue received in a d va n ce '), w h ich represents the com m itm ent to the customer until the e co n o m ic value is g a in e d by p ro vid in g the g o o d s o r services the customer has p a id for. Revenue is later recognised w hen the g o o d s o r services are actu a lly p rovided.
192
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
An asset account (such as prepaym ents, inventory or machinery) is created w hen cash is p a id . These assets represent the a v a ila b le resource until the econom ic value is lost b y consum ing the asset. Assets can be acquired by promises to pay, not just b y cash; therefore, journal entries m ight credit accounts p a ya b le , m ortgage p a y a b le o r other liabilities rather than cash. But you can see that the 'asset' side o f these entries still represents resources that are to be consum ed later. A ccrual accounting recognises the expense w hen the consum ption happens, not w hen the asset is a cq u ire d , no matter h o w it is a cquired.
•
N o t all cash flow s involve revenues o r expenses. Such flow s have to be included in the accounts, but as they d o not affect profit, they are lim ited to b a la n ce sheet accounts. There are other events even further rem oved from the profit calculation. Some exam ples o f these a re the receipt o f cash from an issue o f share ca p ita l, the disbursement o f cash to make a m ortgage paym ent, the disbursem ent of cash to p a y for an investment in another com pany, and the receipt o f cash from a b a n k loan. These exam ples w e re intended to help you think a b o u t w h a t is g o in g on, an d see that there is a pattern behind
the great variety of entries used in accrual acco u n tin g . For exam ple, the fo llo w in g are all exam ples o f asset consum ption: •
reduction in the e conom ic value o f a building (credit accum ulated d e p re cia tio n ; d e b it d e p re cia tio n expense)
•
reduction in inventory as g o o d s a re sold (credit inventory; d e b it cost o f g o o d s sold)
•
reduction in supplies assets as supplies a re used (credit supplies inventory; d e b it supplies expense)
•
reduction o f p re p a id insurance asset as the c o ve ra g e is used (credit p re p a id insurance; d e b it insurance expense).
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1 2
P rovide an exam ple w h e re th e cash received is equal to , g re a te r th a n o r less th a n th e re ve n u e earned. In w h a t w ay can it be said th a t d e p re cia tio n expense and c o s t o f goods sold expense are exam ples o f th e sam e th in g ? Y o u r answers should be:
1
C ash sale; re c e ip t o f p a y m e n t by a c o m p a n y such as an airline w ith th e service to be d e live re d in n e xt
2
T h e y b o th re su lt in an expense w hen assets are used up (e.g. e q u ip m e n t and in v e n to ry ).
fin a n cia l year; and c re d it sale.
5.2
Accrual accounting adjustm ents
The transactional records pro vid e the foundation o f the fin a n cia l accounting system. In order to im plem ent the accrual accounting system outlined a b o ve , such records usually require adjustments. Adjustments involve the im plem entation o f routine accruals, such as those in d ica te d in section 5 .1 : revenues earned but not yet collected, expenses incurred but not yet p a id , cash received from customers before the related revenues have been earned, a nd consum ption of assets. The degree to w h ich accrual adjustments are needed in a n y accounting system depends on the sophistication of the system: sophisticated accounting systems m ay g o beyond the transactional records a nd routinely include many adjustments that, for sim pler systems, a re m ade at year-end in a special set o f journal entries. M a n y large com panies have monthly accruals for interest expenses an d other expenses as they build up, a nd m onthly adjustments for depreciation and other consum ptions o f assets. M a n y small com panies d o n 't bother until annual fin a n cia l statements are needed.
CHAPTER 5 Accrual accounting adjustm ents
193
A ccrual accounting adjustments fo llo w the sam e double-entry form at as d o the transactional records: •
A fter each adjustm ent, the accounting equation w ill still balance.
•
Som e a c c o u n t/s must be de b ite d.
•
Som e a c c o u n t/s must be credited.
•
The sum of the debits must equal the sum o f the credits. A ccountants call such adjustments 'adjusting journal entries'. Their purpose is to a ugm ent the transaction-based
(especially cash-based) figures (outlined in C h a p te r 4) to a d d to the story told by the transactional records. They im plem ent accrual accounting. The o b je ctive o f accrual accounting is to im prove the measurement o f fin a n cia l perform ance a n d position. H ow ever, because different choices can be m ade a b o u t w h a t accounts need to be adjusted an d by h o w much, accrual accounting can be a mechanism for m anipulating results an d p ro ducing m isleading reports. Therefore, the auditors g ive particular attention to the kinds o f accrual adjustments a c o m p a n y makes. M o s t o f the criticism of finan cia l reporting is directed at subjective accrual adjustments - m ade using judgem ent - rather than at the more objective, ve rifia b le transactional records. In spite o f this subjectivity a nd criticism , most accountants believe the accrual accounting basis to be superior to the cash basis, because it provides a m ore com plete record that is also m ore representative o f e conom ic perform ance than the cash basis. There a re four main types of routine adjustments that need to be accounted for: •
expiration o f assets
•
unearned revenues
•
accrual o f unrecorded expenses
•
accrual o f unrecorded revenues.
Expiration o f assets Prepaym ents (prepaid expenses) are assets that arise because an expenditure has been m ade, but there is still value extending into the future. They are usually classified as current assets because the Future value usually continues only into the next year. H ow ever, sometimes the value extends beyond a year, a nd the c o m p a n y m ay then a p p ro p ria te ly show a noncurrent p re p a id expense. Prepaid expenses arise w h enever the paym ent schedule for an expense does not match the com pany's fin a n cia l p e riod, such as for annual insurance premiums w hen the p o licy da te is not the financia l year-end, o r council rates that are based on the council's rate assessment schedule rather than on the com pany's fin a n cia l period. Prepayments are not assets in the same w a y as are receivables (to be collected in cash) or inventories (to be sold for cash). They arise from accrual acco u n tin g , in cases w h e re the expense recognition follow s the cash flo w . This is conce p tu a lly the sam e reason inventories a n d equipm ent a re on the b a la n ce sheet: som ething o f value exists; therefore, its cost should not yet be deducted as an expense. Here, the value is in the fact that, having spent the m oney alre a d y, the c o m p a n y w ill not have to spend it in the next p e riod. Alternatively, the value can be considered to be the fa ct that they a re entitled to a service in the future for w h ich they have a lre a d y p a id . So, p re p a id expenses d o not necessarily have a n y market value, but they have an e conom ic value because future resources w ill not have to be expe n de d . As the assets are consum ed in the process o f earning revenue, a portion o f the cost is w ritten o ff in each period as an expense. For exam ple, in the case o f prepaym ents, such as p re p a id insurance, one-twelfth o f the premium w o u ld be used up each month, resulting in a reduction in an asset (prepayments) a nd an increase in an expense (insurance expense). The accounting for prepaym ents w orks as fo llo w s. W h e n an am ount is p a id - for, say, an insurance premium prepaym ents (an asset) is increased a nd cash (an asset) decreases. A t the end o f the accounting p e riod, some o f the prepaym ent w ill have been used up. Therefore, the am ount o f the asset is reduced an d the expired portion o f the asset is treated as an expense. C o n sid e r the fo llo w in g exam ple.
194
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
O n 1 June 2 0 1 6 , a c o m p a n y pays $ 2 4 0 0 0 for a one-year insurance po licy. The accounts w o u ld be affected as follow s.
As one-twelfth o f the asset w a s used up in June (i.e. an expense o f $ 2 0 0 0 ), the closing b a la n ce of the asset is $ 22000 . The journal entry w o u ld be:
These accounts n o w a p p e a r as follow s: Insurance expense
Prepayments 24000
1 /6 Bal.
3 0 /6
2 000
3 0 /6
2 000
22 000
The prepaym ent b a la n ce o f $ 2 2 0 0 0 represents 1 1 months o f insurance that is p re p a id a nd w o u ld be shown in the b a lance sheet at 3 0 June 2 0 1 6 as a current asset. The insurance expense a ccount w o u ld a p p e a r on the June incom e statement. The transfer from the asset a ccount (prepayments) to the expense account (insurance expense) w ill continue each month for the next 1 1 months, b y w h ich time the asset w ill have a ze ro balance. You should note that there is an alternative w a y o f treating prepaym ents, w h ich m any com panies also use. In this case they treat the initial cash paym ent as an expense, then at the end o f the period reduce the expense by the am ount that has not been used up, thus creating an asset (prepayments). The effect on the accounting equation w o u ld be as follow s:
The journal entries w o u ld a p p e a r as follow s: $ 1 June
30 June
DR
Insurance expense
CR
Cash
DR
Prepayments
CR
Insurance expense
s|
24000 24000 22000 22 000
CHAPTER 5 Accrual accounting adjustm ents
195
These accounts n o w a p p e a r as follow s: Prepayments 3 0 /6
Bal.
22 000
Insurance expense 1 /6 3 0 /6 Bal.
24000
3 0 /6
22 000
2 000
As you can see, the balances in the prepaym ents an d the insurance expense at 3 0 June are identical under both methods. In this b o o k w e w ill g e n e ra lly use the first method. Prepayments a re sometimes show n on the fa ce of the b a la n ce sheet (the Telstra exam ple) o r included in other assets an d disclosed separately in the notes to the accounts (theJB Hi-Fi exam ple). Exhibit 5 . 1 shows that Telstra has $ 3 2 9 m illion of prepaym ents classified as current assets a nd shown on the fa ce of its 2 0 14 b a la n ce sheet. In contrast, JB Hi-Fi Limited, in its 2 0 1 4 annual report, shows prepaym ents in the notes as part o f 'other current assets'.
196
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A nother exam ple of the expiration o f assets is the using up o f supplies. For exam ple, on 3 June a c o m p a n y purchases supplies costing $ l 0 0 0 0 , w h ich it pays cash for. A t 3 0 J u n e , it is ascertained that $ 3 0 0 0 o f the supplies remains unused. Therefore, the b a la n ce o f the asset account (supplies) needs to be reduced b y $ 7 0 0 0 ( $ 1 0 0 0 0 $ 3 0 0 0 ). The fact that $ 7 0 0 0 o f supplies has been used up results in an expense.
The supplies expense b a la n ce o f $ 7 0 0 0 w o u ld a p p e a r in the June incom e statement. The supplies b a la n ce o f $ 3 0 0 0 w o u ld a p p e a r as a current asset in the b a la nce sheet as at 3 0 Ju n e. The journal entries w o u ld a p p e a r as follow s: $ 3 June
30 June
DR
Supplies
CR
Cash
DR CR
$
1 0 0 00 1 0000
Supplies expense
7000
Supplies
7000
A nother exam ple o f reducing the b a la n ce o f an asset a nd treating it as an expense upon consum ption is d e p reciation. This co n ce p t has been introduced earlier, an d w ill be discussed in section 5 .5 o f this cha p te r a n d , in m ore detail, in C h a p te r 10.
U nearned revenues Unearned revenue is future revenue w h e re the cash has been received in a d va n ce o f earning revenue. Alternative names for the unearned revenue account include 'revenue received in a d v a n ce ', 'advances from customers' and 'custom er deposits'. They relate to collections from customers for g o o d s o r services not yet p ro vid e d ; therefore, the revenue cannot yet be recognised. Examples include deposits from customers for jobs, insurance premiums received, yearly m aga zin e subscriptions received, g o lf club m em bership fees a nd rental incom e received in a d va n ce . For exam ple, a c o m p a n y that sells m agazines by subscription w o u ld usually receive these am ounts in a d va n ce , then send out m agazines each month. Assume that at the start o f the ye a r the c o m p a n y receives subscriptions o f $ 2 4 0 0 0 0 and has prom ised to send out m agazines for 1 2 months. A t the time o f collection, the am ount received w o u ld be a lia b ility because g o o d s o r services are o w in g to the subscriber. As each m a g a zin e is delivered, the lia b ility is reduced and revenue can be recognised.
January
+240000
Monthly
The journal entries w o u ld be as follow s:
+ 2 40 0 0 0 -2 0 0 0 0
+20000
CHAPTER 5 Accrual accounting adjustm ents
197
Each month, as the m a g a zin e is sent out, the fo llo w in g journal entry w o u ld be posted:
Q a n ta s A irw a ys Limited, in its 'Statement o f S ignificant A ccounting Policies' in its 2 0 1 4 A n n u a l Report, provides the fo llo w in g details on unearned revenue (described as 'revenue received in adva n ce '): P a s s e n g e r re v e n u e an d f r e ig h t re v e n u e is re c o g n is e d w h e n p a s s e n g e rs o r f r e ig h t a re u p lifte d . . . . R e c e ip ts f o r a d v a n c e d p a s s e n g e r t ic k e t sales o r f r e ig h t sales w h ic h ha ve n o t y e t b e e n a v a ile d o r re c o g n is e d as re v e n u e a re d e fe rre d o n th e b a la n c e s h e e t as re v e n u e re c e iv e d in a d v a n c e . Source: Q antas Airways Lim ited, Annual Report 2014.
This note indicates that w hen the cash is received, cash (an asset) w ill be d e b ite d a nd revenue received in a d va n ce (a liability) w ill be credited. W h e n passengers take their flight o r their ticket expires, the revenue received in a d va n ce account w o u ld be reduced (debited) an d revenue increased (credited). Q antas, like many other com panies including Telstra, refers to 'unearned revenue' as 'revenue received in advance'; that is, both terms can be used interchangeably. N o te that revenue received in advance is its largest current liability. In its 2 0 1 4 A nnual Report, Q antas has $ 3 4 0 6 million in current liabilities under the heading 'Revenue received in advance'. Qantas Group Note
2014
2013
$m
$m
18
1 851
1 844
Revenue received in advance
19
3 406
3 047
Interest-bearing liabilities
20
1 210
835
Other financial liabilities
25
182
86
Provisions
21
876
835
7525
6647
Current liabilities Payables
Total current liabilities
Source: Q a n ta s A irw a ys Limited,
A n n u a l R eport 2 0 1 4 .
Unearned revenue is also large in some service industries such as telecom m unications. As an exam ple, w hen you p a y your phone rental in a d va n ce , the paym ent received by Telstra w o u ld increase cash an d increase revenue received in a d va n ce . As it provides the service, the revenue w o u ld be increased a nd the lia b ility decreased. In previous annual reports, Telstra has noted that revenue received in a d va n ce consists m ainly o f revenue from p roviding access to the fixed a nd m obile netw ork a nd directories advertising revenue. This revenue is initially recorded as a lia b ility an d then transferred to earned revenue in line w ith its revenue recognition policies. The Institute o f C hartered A ccountants A ustralia (ICAA), in its 2 0 1 4 fin a n cia l statements, includes fees in a d va nce o f $ 3 6 0 6 4 . In note 1 0 , it describes them as follow s:
Source: The Institute o f C hartered Accountants Australia (ICAA),
2 0 1 4 F in a n c ia l Statem ents.
198
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
N o te that these items a re included in the lia b ility section because, a t year-end, the IC A A has not yet p rovided the service. They are recognised as revenue in the fo llo w in g year; that is, the ye a r the IC A A provides the service. Similarly, CPA Australia, in the notes to its financial statements for the ye a r ended 3 1 Decem ber 2 01 3, states that: T h e s u b s c rip tio n y e a r ru n s f r o m 1 J a n u a ry t o 31 D e c e m b e r . S u b s c r ip tio n s a re p a ya b le a n n u a lly in a d v a n c e . O n ly th o s e m e m b e rs h ip fe e s a n d s u b s c rip tio n p a y m e n ts t h a t a re a ttrib u ta b le t o th e c u r r e n t fin a n c ia l y e a r a re re c o g n is e d
as re v e n u e . F e e s a n d s u b s c rip tio n
p a y m e n ts t h a t re la te t o
fu tu re
p e rio d s a re s h o w n
in th e S ta te m e n t o f fin a n c ia l p o s itio n as s u b s c rip tio n s a n d fe e s in a d v a n c e u n d e r t h e h e a d in g o f C u r r e n t lia b ilitie s - o th e r. Source: C P A Australia, 2013 Annual Report.
Accrual o f unrecorded expenses This adjustm ent involves determ ining w h ich expenses have been incurred b y the o rganisation (but not p a id in cash) during a particular period o f tim e - g e n e ra lly a month. This usually involves checking w h ich invoices have been received from suppliers, incorporating that inform ation into the accounting system as accounts p a ya b le , a nd making estimates for expenses for w h ich invoices have not yet been received (e.g. telephone, electricity a nd accounting fees). G e n e ra lly speaking, accounts p a y a b le includes trade suppliers, but accrued expenses include other expenses incurred in running the business. A ccrued expenses are expenses that have been incurred during the current period but w ill not be p a id until the fo llo w in g period. A com m on exam ple is w a g e s. Because the end o f the p a y p eriod a nd the end of the financial period occur on different days, it is necessary to include an accrual for w a g e s p a y a b le from the d a te o f last paym ent to the d a y on w h ich the accounting period finishes; that is, the em ployees have d o n e the w o rk but w ill not be p a id for this w o rk until after the end o f the fin a n cia l year. Therefore, at year-end, the organisation has a lia b ility. It is usually called 'accrued w a g e s ' o r 'w a g e s p a y a b le '. For exam ple, assume w a g e s are p a id w e e kly (on Thursday) to cover the previous five w o rkin g days before the Thursday. If 3 0 June falls on a Friday, tw o d a ys' w a g e s w ill be o w in g at 3 0 June. If the w e e kly w a g e s bill is $ 5 0 0 0 0 0 , then $ 2 0 0 0 0 0 (Thursday a nd Friday) w ill be o w in g .
30 June
+200000
-2 0 0 0 0 0
Total
+200000
-2 0 0 0 0 0
W a g e s expense is increased because it is an expense o f the p e riod, an d accrued w a g e s (or w a g e s payable) is increased because there is a lia b ility at the end of the p e riod. O th e r exam ples o f accruals w o u ld be interest expense and electricity charges o w in g at the end of a period. The journal entry w ill be: $ 30 June
DR CR
Wages expense Accrued wages
$
200000 200000
CHAPTER 5 Accrual accounting adjustm ents
199
The 2 01 3 annual report o f D avid Jones Limited shows the fo llo w in g :
Source: D avid Jones Ltd,
A n n u a l R eport 2 0 1 3 .
The a b o v e shows that for 2 0 1 3 , the $ 2 6 1 8 4 0 0 0 0 in payables includes other payables an d accruals of $ 1 3 2 4 2 7 0 0 0 . C o n sid e r the effect on p rofit for the p eriod a nd current liabilities if these items had not been included. Liabilities w o u ld sh o w $ 1 3 2 4 2 7 0 0 0 less, an d expenses w o u ld also be $ 1 3 2 4 2 7 0 0 0 less. You can see that these adjustments can have a m ajor im pact on the fin a n cia l statements. Consistent w ith the D avid Jones Limited exam ple a b o ve , accruals are norm ally included in the current liabilities section under the heading 'P ayables', a nd the am ount o f the accrual is show n separately in the notes to the accounts. H ow ever, if they are large enough, they a re show n on the fa ce o f the b a la n ce sheet.
Accrual o f unrecorded revenues The accrual o f unrecorded revenues occurs w hen a service has been p rovided but cash w ill not be received until the fo llo w in g p e riod. C om m on exam ples o f accrued revenues include interest receivable on loans, commissions earned and unbilled revenues. For exam ple, assume a c o m p a n y deposited $ 5 0 0 0 0 0 w ith a bank fo r on e ye a r at 4 per cent on 1 January 2 0 1 6 (interest p a y a b le at the end of the period). A t 3 0 June 2 0 1 6 , it w o u ld have earned $ 1 0 0 0 0 interest, although the total interest of $ 2 0 0 0 0 w o u ld not be received until 31 D ecem ber 2 0 1 6 . A ccrued interest (also ca lle d 'interest receivable'), w h ich is an asset, w o u ld be increased by $ 1 0 0 0 0 , and interest revenue w o u ld be increased by $ 1 0 0 0 0 .
A ccrued revenue (or interest receivable) is a current asset that w ill a p p e a r in the b a la n ce sheet, a nd interest revenue is a revenue account that w ill a p p e a r in the incom e statement for the y e a r e nded 3 0 J u n e 2 0 1 6 . The journal entry w o u ld be: $ 30 June
DR CR
Accrued revenue Interest revenue
*
1 0 0 00 10000
1
200
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
An interesting exam ple o f accrued revenue is p rovided in the 2 0 1 4 Telstra accounts. Telstra bills its customers either m onthly o r quarterly. W h e n it bills customers, it increases accounts receivable an d increases sales revenue. W h e n the cash is received, cash is increased a nd accounts receivable is decreased. H ow ever, at 3 0 J u n e there w ill be a lot o f telephone calls that have been m ade but not yet b illed. For exam ple, if you receive a bill on 1 June (and you are billed quarterly), you w ill not receive another bill until 1 Septem ber. As telephone calls have been m ade in June, Telstra has p rovided the service; therefore, it is entitled to recognise the revenue. Telstra's fin a n cia l statements (note 10) show accrued revenue of $1 1 5 5 m illion ($ 1 0 9 3 m illion in 2 01 3) under current assets. That is, at the end o f the year, it increased accrued revenue an d increased sales revenue.
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
W h a t e f f e c t w o u ld fa ilu re to m a k e a d ju s tm e n ts f o r a c c ru e d e x p e n s e s ha ve o n th e in c o m e s ta te m e n t and th e b a la n c e s h e e t?
2
A c o m p a n y has a $ 5 0 0 0 0 b a la n c e in th e c o m p a n y ’s u n e a rn e d s e rv ic e re v e n u e a c c o u n t. W h e re w o u ld th is a c c o u n t a p p e a r in th e b a la n c e s h e e t? Y o u r a n sw e rs s h o u ld be:
1
In c o m e s ta te m e n t: e x p e n s e s w o u ld be u n d e rs ta te d an d th e r e fo r e p r o fit o v e rs ta te d . B a la n c e s h e e t: lia b ilitie s w o u ld be u n d e rs ta te d an d re ta in e d p r o fits w o u ld be o v e rs ta te d (b e c a u s e p r o fit was o v e rs ta te d )).
2
L ia b ilitie s (p ro b a b ly c u r r e n t lia b ilitie s , a s s u m in g th a t th e s e rv ic e w ill be c a rrie d o u t w ith in a y e a r).
5.3
M ulti-colum n worksheets
M ulti-colum n worksheets are a useful d e vice to help you prepare fin a n cia l statements w h e re there a re m any adjusting entries. For exam ple, a 10-colum n adjusted w orksheet, start w ith the pre-adjusted trial b a la n ce (columns 1 a nd 2), then include adjusting entries (columns 3 a nd 4 ), fo llo w e d by the adjusted trial balance (columns 5 a nd 6), incom e statement numbers (columns 7 a n d 8) a nd b a la n ce sheet numbers (columns 9 an d 10). W h e re adjusting entries refer to a particular ledger a ccount in the pre-adjusted trial b a la n ce (e.g. prepayments), the am ount o f the adjusting entry should be entered in the a p p ro p ria te adjustm ent column o p p o site the relevant ledger account. W h e n the d e b it o r credit part of the adjusting entry refers to a ledger account that is not in the unadjusted trial balance, the nam e o f that le d g e r a ccount should be a d d e d to the bottom o f the trial b a la n ce a n d the am ount entered o p posite it in the a p p ro p ria te adjustm ent colum n. To further illustrate the a b o v e adjustments, consider the trial b a la n ce in Exhibit 5 .2 an d the fo llo w in g inform ation: •
The c o m p a n y prepares accounts annually.
•
Ending office supplies on hand w a s $ 1 3 m illion.
•
Prepayments related to insurance policies taken out on 1 O c to b e r 2 0 1 6 for on e year.
•
Unearned revenue relates to a six-month service agreem ent starting on 1 N ovem ber.
•
A t the end o f the year, w a g e s of $ 3 m illion w e re still o w in g .
•
An electricity bill w a s received on 1 O January show ing that electricity costs for D ecem ber 2 0 1 6 w e re $ 2 m illion.
•
O f the cash b alance, $ 2 7 m illion w a s on fixed dep o sit w ith the bank. The accrued interest at the end o f the year w a s $ l million.
CHAPTER 5 Accrual accounting adjustm ents
201
The fo llo w in g journal entries w o u ld be required:
1
$m Dec. 31
DR CR
Office supplies expense
$m
17
Office supplies
17
To record supplies used during the period Dec. 31
DR CR
Insurance expense
10
Prepayments
10
To record expiration of insurance coverage Dec. 31
DR
Unearned revenue
CR
Fees revenue
DR
Wages expense
10 10
Recognising revenue for fulfilling part of service contract Dec. 31
CR
3
Accrued expenses
3
To record accrued salaries a t year-end Dec. 31
DR CR
Electricity expense
2
Accrued expenses
2
To record accrued electricity a t year-end Dec. 31
DR CR
Accrued revenue
1
Interest revenue
1
To record accrued revenue a t year-end
A fter these entries have been posted to the ledger accounts, a multi-column w orksheet such as Exhibit 5 .3 could be used to p ro vid e an adjusted trial b a la n ce an d inputs for the incom e statement an d b a la n ce sheet in Exhibit 5 .4 .
1
202
EXHIBIT 5.3
WESTBANK LIMITED
Trial balance Account Nam e Cash
Debit
Adjustments
Credit
Debit
Adjusted trial balance
Credit
Debit
Income statement
Credit
Debit
Balance sheet
Credit
Debit
Credit
30
30
30
Accounts receivable
180
180
180
Inventory
220
220
220
Office supplies
30
17
13
13
Prepayments
40
10
30
30
Accrued revenue
0
1
Accounts payable
150
Unearned revenue
30
Accrued expenses
0
Loan Share capital Retained profits Sales Interest revenue Fees revenue
1
10 5
1 150
150
20
20
5
5
100
100
100
80
80
80
40
40
950
950
950
40
50
1
51
51
0
10
10
10
Cost of goods sold
300
Insurance expense
100
10
110
110
Wages expense
400
3
403
403
Electricity expense
20
2
22
22
Other expenses
80
80
80
Office supplies expense
300
0
17
300
17
17
Net profit
79 1400
1400
43
43
1 406
1 406
1011
79 1011
474
474
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
T R IA L BALANCE A T 31 DECEM BER 2 0 1 6
CHAPTER 5 Accrual accounting adjustm ents
EXHIBIT 5.4
WESTBANK LIMITED IN C O M E S TA T E M E N T FOR TH E M O NTH ENDING 31 DECEM BER 2 0 1 6
BALANCE SHEET AS AT 31 DECEM BER 2 0 1 6
* Closing retained profits = 4 0 + 79 = 119
203
204
5.4
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The financial period
Financial statements all have a tim e dim ension. Balance sheets are prepared as at specific points in time, a n d incom e statements cover specified periods o f time. Business, an d other e conom ic activities, carries on continuously. Therefore, if the financial statements are to be a t (or begin an d end at) particular dates, fin a n cia l accounting must som ehow find a w a y to separate all those activities into periods. M a k in g effective cut-offs for revenues an d expenses is a m ajor problem for accrual acco u n tin g . M u ch effort is put into determ ining w hether revenues are p laced in the a p p ro p ria te years, w hether there a re bills outstanding for expenses that should be taken into account, w hether inventories of g o o d s a nd supplies are actu a lly on hand, a nd so on. It is generally harder to d o this if an enterprise has larger an d less frequent revenue a nd expense transactions; and easier, therefore, if enterprises have m any short a nd sim ple transactions. But even then it can be difficult to keep track o f just w here the enterprise stands if there a re thousands o f transactions in process across a year-end. W h e n should the fin a n cia l (accounting) ye a r begin an d end? C om p a n ie s have an initial ch o ice , but once they make it, reasons relating to habit, an d legal an d tax rules, usually force them to stay w ith that c h o ice indefinitely. They m ay select a fin a n cia l year-end that is a relatively quiet time, so that there a ren't m any unfinished transactions in process, and the revenue an d expense cut-offs can be m ade more cleanly. A large m ajority o f Australian public com panies have 3 0 June as their fin a n cia l year-end. O n e reason for this is that it coincides w ith the end o f the tax year. H ow ever, this is certainly not the o n ly reason to use 3 0 June, as it is possible in A ustralia to use a substituted accounting p eriod for taxation purposes, p rovided permission is received from the Australian Taxation O ffic e . Financial year-ends va ry substantially betw een countries. For exam ple, in the United States, C a n a d a , S in g a p ore an d M a la y s ia , 31 D ecem ber is the most com m on date, w h ile in the United K ingdom , N e w Z e a la n d an d Japan, 31 M a rc h is most com m on. Examples o f A ustralian com panies w ith b a la n ce dates other than 3 0 J u n e include those show n b e lo w . Date
Company
31 March
James Hardie Industries Macquarie Bank
31 July
Washington H Soul Pattinson
31 August
Ten Network Holdings Limited
30 September
Orica Australia Australia and New Zealand Banking Group Westpac National Australia Bank
31 December
Coca-Cola Amatil Caltex
5.5
Contra accounts
Just about every b a la n ce sheet a ccount can be considered to be a control account. C ash is a record o f the cash that should be there if it w e re counted. A ccounts receivable is the sum o f all the individual customers' accounts. Inventory is the am ount that should be found if the c o m p a n y lists o r counts all the unsold g o o d s physically on hand. Accounts p a y a b le is the sum o f all the individual suppliers' accounts. The num ber o f shares outstanding should be tra ce a b le to the share c a p ita l account. (The particular ow ners m ay ch a n g e, for exam ple, because of trading on the stock market, but the c o m p a n y should a lw a ys kn o w h o w m any shares it has issued an d w h a t it o rig in a lly received for them.) Even the property, plant a nd equipm ent asset accounts are controls, as all the assets w h o se costs are included should be physically present. The value o f all these accounts as control accounts is that the am ounts in them should be supported by, or reconcilable to, d e ta ile d lists o r subsidiary ledgers, o r some such background d a ta . W h a t d o w e d o , then, w hen w e
CHAPTER 5 Accrual accounting adjustm ents
205
w a n t to make a ch a n g e in a b a la n ce sheet account w ith o u t ch a n g in g the underlying records a nd lists? H ere are some exam ples o f w hen w e m ight w a n t to ch a n g e an asset a ccount an d w h y, at the same time, w e m ight be reluctant to d o it: •
W e have becom e w o rrie d that w e m ight not collect all the accounts receivable, so, for conservatism a nd proper p rofit measurement, w e w a n t to recognise that w e have p ro b a b ly suffered some 'b a d debts' expense. H ow ever, w e d o not w a n t to ch a n g e the accounts receivable control account because it should correspond to the list of customers' accounts, a nd w e have not yet given up on collecting a n y accounts receivable, so the control feature is still useful. W e address this issue in C h a p te r 8.
•
The property an d plant assets are being used up e co n o m ica lly so w e w a n t to record d e p re cia tio n expense as part o f our profit measurement. H ow ever, w e d o not w a n t to ch a n g e the asset cost account balances because their costs a re not ch a n g in g , but rather their e conom ic values a re being used. W e address this issue b e lo w . In these examples, the financial statement objectives of proper asset valuation an d profit measurement seem to conflict
w ith m aintaining the accounts for control purposes. To address this problem a 'contra account' has been invented to a llo w us to recognise expenses and related value changes to assets w ithout changing the control account. It is useful both for profit measurement and to preserve the internal control aspects of the accounts. Therefore, it provides a bridge between accounting's role in internal control (which is outlined in C hapter 7) and in financial statement preparation. C ontra accounts have balances that are in the o p p o site direction to those o f the control a ccount w ith w h ich they are associated. For exam ple, contra asset accounts have credit balances that are 'co n tra ' the assets' d e b it balances. They are m ainly used fo r m a naging expense accruals separately from the asset accounts to w h ich they relate. Therefore, they keep the accruals from being m ixed into those accounts. C ontra accounts o n ly have m eaning in conjunction w ith the control accounts to w h ich they are m atched. W e ll see b e lo w h o w this works. H ere w e w ill focus o n ly on one very com m on use o f contra accounts: accum ulated dep re cia tio n (amortisation). Virtually all enterprises have this account. The a ccount illustrates h o w the accounting system can meet o ne o b je ctive (expense recognition) an d a vo id com prom ising another o b je ctive (control) by creating an account that recognises expenses but does not c h a n g e the control a ccount related to those expenses (asset costs).
A ccum ulated depreciation (am ortisation ) C ontra accounts are used to accum ulate d e p re cia tio n on fixed assets, such as buildings an d equipm ent. For exam ple, for equipm ent w h ich cost $ 5 0 0 0 0 0 a nd has a life o f 5 years, the annual dep re cia tio n c h a rg e of $ 1 0 0 0 0 0 w o u ld be recognised as follow s:
1 DR CR
$ Depreciation expense
s1
100000
Accumulated depreciation
100 00 0
The d e b it is an expense account in the incom e statement. The credit is a contra asset account. The credit side of the journal entry could have been to the asset a ccount 'B u ild in g '. Instead the contra a ccount is used, so that by leaving the asset cost a ccount a lone, the b a la n ce sheet presents the acquisition cost o f the asset a lo n g w ith the accum ulated am ount o f expense that has been recognised to d ate. S ho w in g both these items a llo w s users to make a rough guess as to h o w long the asset has been in service. Remember that accum ulated de p re cia tio n on the bala nce sheet is the am ount o f dep re cia tio n accum ulated over the life o f the asset to date, w hereas the am ount o f d epreciation charg e d this ye a r (to match the revenues the asset consum ption is presum ed to have helped generate) can be determ ined from the d e p re cia tio n expense acco u n t in the incom e statement. Let's lo o k a t a sim ple exam ple involving an electrician's purchase of a n ew truck. The truck cost $ 5 0 0 0 0 a nd an annual dep re cia tio n expense o f $ 8 0 0 0 w a s determ ined. Each year, the d e p re cia tio n expense a ccount w o u ld be increased by $ 8 0 0 0 a nd the contra asset a ccount (called 'accum ulated d e p re cia tio n ') w o u ld be increased by $ 8 0 0 0 . (In C h a p te r 1 0 w e discuss various d e p re cia tio n methods. H ere w e introduce the most im portant method c alled straight-line dep re cia tio n (see p a g e 3 9 1 ).)
206
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The journal entry w o u ld be:
1
s|
$
DR
Depreciation expense
CR
8000
Accumulated depreciation
8000
O n the b alan ce sheet, the asset a ccount for the truck's cost w o u ld continue to sh o w a b a la n ce o f $ 5 0 0 0 0 , but each ye a r the accum ulated dep re cia tio n contra asset a ccount w o u ld increase b y $ 8 0 0 0 . Deducting accum ulated depreciation from the long-term asset acco u n t leaves a figure known as the net book value. So w e w o u ld have: Cost
Accumulated depreciation
Net book value
$
$
$
Date of purchase
50000
0
50000
End of first year
50000
8 000
42 000
End of second year
50000
16 000
34000
If the truck w e re sold at a n y time, the cost w o u ld be rem oved from the ledger, but so w o u ld the contra account. The contra is m eaningful o n ly in com parison to the cost - w hen the truck is g o n e , neither a ccount is needed any more. Suppose the truck w e re sold fo r $ 3 7 0 0 0 at the end of the second year. A t this point, the accum ulated depreciation is $ 1 6 0 0 0 ( $ 8 0 0 0 + $ 8 0 0 0 ) an d the b o o k value is $ 3 4 0 0 0 ( $ 5 0 0 0 0 - $ 1 6 0 0 0 ) . If the c o m p a n y receives $ 3 7 0 0 0 , it makes a g a in of $ 3 0 0 0 . This g a in (usually called gain on sale o r profit on sale) is a revenue item. These effects a re shown as follow s: = Liabilities
Purchase
Cash
Truck
-5 0 0 0 0
+50000
Accumulated depreciation
Year 1
+ Equity Revenue
- 8 000
Year 2
Expense
- 8 000
- 8 000
- 8 000
Subtotal
-5 0 0 0 0
+50000
-1 6 0 0 0
-1 6 0 0 0
Sale of truck
+37000
-5 0 0 0 0
+16000
+3 000
The journal entry is:
The gain on sale is just the difference betw een the proceeds an d the net b o o k value at the d a te o f sale. If the proceeds had been $ 2 9 0 0 0 instead, the d e b it to cash w o u ld have been $ 2 9 0 0 0 a nd there w o u ld have been a d e b it to loss on sale (an 'other expense' account in the incom e statement) for $ 5 0 0 0 , the difference betw een the proceeds and the net b o o k value. W h e n non-physical assets, such as licences, patents a nd tradem arks, are am ortised, the accum ulated am ortisation account is used instead of accum ulated d e p re cia tio n . G a in s, losses an d write-offs on such assets are calculated just as for the physical assets illustrated a b o ve .
CHAPTER 5 Accrual accounting adjustm ents
5.6
207
Illustrative example
B elow , w e pro vid e an exam ple to reinforce the material covered in C hapters 4 a n d 5 . It covers journal entries, posting to the ledger, trial ba la n ce , adjustments, closing entries an d preparation o f fin a n cia l statements. Scanlon Limited had the fo llo w in g trial b a la n ce at 1 January 2 0 1 6 :
During January 2 0 1 6 , the fo llo w in g transactions occurred: a
C ash sales $ 7 0 0 0 0 0 .
b
C re d it sales $ 6 1 0 0 0 0 0 .
c
C ost o f g o o d s sold $ 3 0 0 0 0 0 0 .
d
Inventory purchased on credit $ 2 6 0 0 0 0 0 .
e
C ash collected from customers $ 5 8 0 0 0 0 0 .
f
C ash p a id to suppliers $ 2 8 0 0 0 0 0 .
g
Paid incom e tax liability.
h
Paid salaries $ 1 2 0 0 0 0 0 , com m ission $ 6 0 0 0 0 0 , other o perating expenses $ 1 0 0 0 0 0 .
i
Paid $ 4 0 0 0 0 for insurance.
j
Paid $ 3 0 0 0 0 in rent (the c o m p a n y debits p re p a id rent),
k
D epreciation expense is calculated a t 1 2 per cent per annum on cost.
I
C lo sin g balances in the p re p a id insurance a nd p re p a id rent accounts at the end o f January 2 0 1 6 should be $ 7 0 0 0 0 a nd $ 6 0 0 0 0 , respectively.
m The $ 1 0 0 0 0 0 revenue received in a d v a n ce related to a service contract that has n o w been fulfilled in w h o le , n
The bank ow es Scanlon Ltd $ 5 0 0 0 for interest a t the end o f January. The fo llo w in g steps w ill be carried out:
1
Prepare journal entries for the a b o ve transactions (Exhibit 5 .5 ).
2
Enter the o p e n in g balances in the ledger accounts a n d post the journal entries to the ledger (Exhibit 5 .6 ).
3
Prepare a trial b a la n ce at 31 January 2 0 1 6 (Exhibit 5 .7 ).
4
Prepare closing entries (Exhibit 5 .8 ).
5
Prepare a post-closing trial b a la n ce (Exhibit 5 .9 ).
6 Prepare an incom e statement for the month o f January 2 0 1 6 a n d a b a la n ce sheet as at 31 January 2 0 1 6 (Exhibits 5 .1 0 a nd 5.1 1).
208
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Before preparing the fin a n cia l statements, the revenue a n d expense accounts are closed via the closing journal entries (Exhibit 5 .8 ). They start w ith a ze ro b a la n ce in the next accounting p eriod to e n a b le profit for that period to be calculated. A fter posting these journal entries, a post-closing trial b a la n ce is prepared (Exhibit 5 .9 ). The incom e statement and the b a la n ce sheet are p rovided in Exhibits 5 .1 0 a n d 5 . 1 1 .
CHAPTER 5 Accrual accounting adjustm ents
209
» 1
31 Jan. 16
Insurance expense
30000
Prepaid insurance
30000
To record insurance expense for the month 1
31 Jan. 16
Rent expense
20000
Prepaid rent
20000
To record rent expense for the month m
31 Jan. 16
Revenue received in advance
100000
Service fee revenue
100 00 0
To record the earning of service fee revenue for the month n
31 Jan. 16
Accrued revenue
5 000
Interest revenue
5 000
To record the earning of interest revenue for month
EXHIBIT 5.6
SCANLON LIMITED LEDGER ACCOUNTS
Cash Bal. b /d
Accounts receivable
200000
f
2 800000
a
700000
g
500000
e
5 800000
h
1900000
i
40000
j
30000
Bal. c /d
1430000
Bal. b /d
700000
600000
Bal. c /d
2 600000
900000
Bal. b /d
60000
Prepaid insurance c
Bal. c /d
3 000000 300000
i
3 300000
300000
i
Bal. b /d
50000
3 1 /1 /1 2
30000
Bal. c /d
80000 Bal. b /d
40000
1 Bal. c /d
30000 70000
1 0 0 00 0
Prepaid rent Bal. b /d
6700000
6700000
3 300000 Bal. b /d
5 800000
900000
6 700000 Bal. b /d
Inventory
d
e
b 6100000
1430000
6700000 Bal. b /d
Bal. b /d
100 00 0
70000
Equipment 1
20000
Bal. b /d
1000000
60000 80000
60000
Accrued revenue n
5 000
Accumulated depreciation Bal. b /d
200000 k
10000 210000
»
210
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
» Accounts payable f
2 800000
Revenue received in advance
Bal. b /d
500000 d
Bal. c /d
m
300000
g
3100000
Bal. b /d
500000
300000
Bal. b /d
Bal. b /d
570000
Bal. b /d
n
Salaries expense m
100000
h 1200000
Cost of goods sold
600000
Insurance expense 1
30000
1
20000
O ther expenses
Commission expense
Depreciation expense k
10000
6100000 6 800000
2 265 000
h
700000
b
Interest revenue
Service fee revenue
100000
a
320000 1 945 000
h
420000
Sales
Retained profits
3 000000
500000
Bal. b /d
Loan
c
100000
Share capital
3100000 Bal. b /d
1 0 0 00 0
Income tax payable
2 600000
Rent expense
5 000
CHAPTER 5 Accrual accounting adjustm ents
Loan
570000
Share capital
420000
Retained profits
320000
Sales
6 800000
Service fee revenue
100 00 0
Interest revenue
5 000
Cost of goods sold
3 000000
Salaries expense
1 2 0 0000
Depreciation expense
1 0000
Insurance expense
30000
Rent expense
20000
Commission expense
600000
Other expenses
100000 8 725 000
8 725 000
211
212
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 5.10
SCANLON LTD IN C O M E S TA T E M E N T FOR TH E M O N TH ENDING 31 JANUARY 2 0 1 6
CHAPTER 5 Accrual accounting adjustm ents
5.7
213
Managers and accrual accounting assumptions
A ccrual a ccounting's purpose is to move beyond cash flow s to w a rd s a b ro a d e r e co n o m ic co n ce p t o f profit and financia l position. From a m anager's point o f v ie w , this has several im portant im plications: •
As a m ore inclusive w a y of measuring perform ance an d position, accrual accounting should reflect m ore o f w h a t a m anager is trying to d o than cash flo w can. This should make accrual accounting attractive to m anagers w h o w a n t to be evaluated fa irly an d w h o are interested in co m p a rin g their com panies w ith others.
•
This attractiveness depends on h o w com plete accrual accounting is in representing m anagers' perform ance. Here, there is a lim itation that often frustrates m anagers: accrual a ccounting, based on the historical transaction base o f record-keeping, is better suited to measuring past perform ance than to looking into the future, as m anagers are inclined to do .
214
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A ccounting runs into a fundam ental problem here. W h ile m anagers' expectations are a main reason for their actions, accounting cannot observe their expectations, but o n ly their actions. (Expectations are not observable in general, so this is not just a problem for accounting.) So, accounting reports the results of actions, not the reasons for those actions (except b y im plication). M a n a g e rs m ay therefore feel that the accounting statements are incom plete because they miss the 'w h y ' behind the revenues, expenses, assets a nd liabilities.
•
To m any peo p le , profits should be defined as changes in the value of the com p a n y. Econom ic earnings can be defined as increases in value. V alue changes are a function o f perform ance, but also o f expectations an d o f the market prices for assets a n d w h o le com panies. The evidence-based accounting procedures for revenue recognition a nd expense recognition, an d m atching them to measure profit, m ay not relate very w e ll to econom ic concepts o f earnings, o r to m anagers' struggles to increase the value o f their com panies.
•
A ccrual accounting's procedures require e vidence to support entries an d conservatism in estim ating the effects of future events (provide for expected losses, but not for expected gains until they occur). To m anagers seeking an even-handed evaluation o f their perform ance, accounting m ay seem overly sceptical a b o u t the future and d o w n w a rd ly biased in its measures. A ccrual accounting goes beyond cash flow s, a nd m anagers m ay w ish that it w e n t further, to recognise their optim ism a b o u t the future m ore than it does.
•
The criteria for w hen a nd h o w to recognise revenues an d expenses are in e sca p a b ly judgem ental, a nd therefore have both an a rb itra ry a nd a subjective aspect. Earlier chapters have suggested that some m anagers m ay be m otivated to m anipulate accounting results, a n d accrual accounting procedures can be a w a y o f d o in g this. H ow ever, it should also be said that m any m anagers find accrual accounting to o loose an d flexible an d w o u ld prefer less estim ation an d subjectivity. Prudence a nd conservatism a re also traits of m any m anagers, not just of accountants a nd auditors!
•
M o d e rn finan ce theory, w h ich is influential in the evaluations b y fin a n cia l markets, banks a nd takeover specialists, makes much o f cash flow s, but, as you have seen, cash flo w does not necessarily connect w e ll w ith accrual accounting's profit figure. This connection is w orse the shorter the period (e.g. cash flo w an d accrual profit are p ro b a b ly sim ilar over a l O-year p e riod, but a re unlikely to be sim ilar over a month). A nother reason, therefore, for m anagers to take fin a n cia l accounting seriously is so that they can kn o w w hen the
accounting measures seem a p p ro p ria te an d w hen they d o not. A ccrual accounting has m any adva n ta g e s a nd is very w id e ly used, but m anagers should not a c ce p t it uncritically. As a future m anager, you can be alm ost certain that accrual accounting numbers w ill affect your perform ance evaluation in your career. It is a lw a ys g o o d to know the rules by w h ich you are being evaluated a nd often rew a rd e d .
CHAPTER 5 Accrual accounting adjustm ents
215
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A A d ju s tin g jo u rn a l entries It is th e e n d o f In te rn a tio n a l F a brics Ltd's fin a n c ia l y e a r. Y ou a re w o rk in g on th e c o m p a n y 's fin a n c ia l statem ents, a n d h a ve d is c o v e re d th e item s a - f listed b e lo w . For e a ch item : 1 State w h e th e r o r no t th e item re q u ire s th a t an a d ju s tm e n t be m a d e in th e c o m p a n y 's a c co u n ts a c c o rd in g to the p rin c ip le s o f a c c ru a l a c c o u n tin g . 2
If th e a n s w e r to q u e s tio n 1 is yes, w rite a jo u rn a l e n try to a d ju s t th e c o m p a n y 's a c co u n ts. a
$ 3 2 0 0 o f sales m a d e on a c c o u n t just b e fo re th e e n d o f th e fin a n c ia l y e a r w a s n o t re c o rd e d until the b e g in n in g o f th e n e xt y e a r.
b
The cost o f g o o d s s o ld fo r those sales, to ta llin g $1 9 0 0 , has no t y e t be en re c o g n is e d .
c
D u rin g the y e a r, d e p o s its o f $ 5 3 0 0 w e re m a d e b y custom ers on s p e c ia l o rd e rs a n d w e re c re d ite d to the d e p o s it lia b ility a c c o u n t. D e p o sits o f $ 1 4 0 0 a re still b e in g h e ld , b u t a ll th e o th e r s p e c ia l o rd e rs h a ve been c o m p le te d a n d th e custom ers h a ve p a id th e rest o f th e p ric e fo r th ose o rd e rs (those p a ym e n ts a re in c lu d e d in sales revenue).
d
M a in te n a n c e expe nses seem ed ra th e r h ig h , a n d on in v e s tig a tio n it tu rn e d o u t th a t an a d d itio n to the c o m p a n y 's store, c o n s tru c te d o v e r a p e rio d o f seve ral m onths a t a cost o f $ 6 2 3 2 0 , h a d been in c lu d e d in the m a in te n a n c e expe nses.
e
The c o m p a n y 's a u d ito rs sent a b ill fo r $ 2 3 5 0 fo r th e y e a r's a u d it w o rk ,
f
Just b e fo re th e y e a r-e n d , the c o m p a n y b o u g h t a m o to r v e h ic le fo r $ 1 7 2 2 0 o n c re d it.
PRACTICE PROBLEM B Revenues as expenses The fo llo w in g tra n s a c tio n s o c c u rre d b e tw e e n 1 July 2 0 1 5 a n d 3 0 June 2 0 1 6 fo r A K H Lim ited, a
Issued sh a re c a p ita l fo r $ 6 0 0 0 0 0 cash,
b
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it,
c
P aid $ 5 6 0 0 0 to a c co u n ts p a y a b le .
d
S old in v e n to ry c o stin g $1 2 0 0 0 0 fo r $ 3 4 0 0 0 0 . A ll sales a re on c re d it,
e
R eceived $ 2 2 0 0 0 0 fro m a c co u n ts re c e iv a b le ,
f
P aid d iv id e n d s o f $ 6 0 0 0 0 .
g
B o rro w e d $ 2 0 0 0 0 0 on 1 July 2 0 1 5 . The lo a n is d u e on 3 0 June 2 0 1 8 a n d c a rrie s a 1 0 p e r c e n t p .a . interest rate. P aid $ 8 0 0 0 in tere st on this lo a n d u rin g 2 0 1 6 .
h
P aid w a g e s o f $ 1 8 0 0 0 0 ; w a g e s o f $ 4 0 0 0 0 h a d be en e a rn e d b y e m p lo y e e s b u t n o t p a id a t y e a r-e n d .
i
O n 1 June re c e ive d a d e p o s it o f $ 8 0 0 0 0 fo r w o rk to be c a rrie d o u t in th e n e xt y e a r,
j
U sed $ 2 2 0 0 0 o f e le c tric ity d u rin g th e y e a r fo r w h ic h th e c o m p a n y has n o t y e t be en b ille d ,
k
P aid a $ 2 4 0 0 0 in su ra n c e p o lic y on 1 O c to b e r 2 0 1 5 , c o v e rin g 1 O c to b e r 2 0 1 5 to 3 0 S e p te m b e r 2 0 1 6 .
Required: 1
List a ll revenues fo r th e y e a r (in c lu d in g d o lla r a m ou nts).
2
List a ll expe nses fo r th e y e a r (in c lu d in g d o lla r am ou nts).
3
By h o w m uch d id th e cash b a la n c e in cre a s e d u rin g th e y e a r?
216
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEM C A cco u n tin g tra n sa ctio n s: re co n stru ctio n required The b a la n c e sheet a n d in co m e state m e nt o f R econ stru ction Lim ited a re re p ro d u c e d b e lo w . RECONSTRUCTION LIMITED BALANCE SHEET 3 1 /1 2 /2 0 1 6 Assets
$
Cash
Prepaid insurance
$ 5 000
-
Accounts receivable
3 1 /1 2 /2 0 1 5
40000
27000
3 000
2 000
Equipment
90000
90000
less Accumulated depreciation
(31 000)
(22 000)
Motor vehicle
25 000
25 000
less Accumulated depreciation
(10000)
Total assets
117000
122 000
500
1 000
Wages payable
6000
4000
Interest payable
2 500
3 000
(5 000)
Liabilities Accounts payable
Income tax payable
2 000
-
Long-term loan
50000
50000
Total liabilities
59000
60000
$ 58000
$ 62 000
Net assets
Shareholders' equity Share capital
39000
39 000
Retained profits
19000
23 000
$ 58000
$ 62 000
Total shareholders' equity
RECONSTRUCTION LIMITED INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20 16 $ Fees revenue Depreciation expense
(14000)
Electricity expense
(8 000)
Insurance expense
(17000)
Interest expense Rent expense Stationery expense Wages expense Profit/(loss) before tax
$ 105 000
(4500) (24000) (3 500) (38 000)
(109 000) (4000)
Income tax expense
0
Profit/(loss) aftertax
(4000)
CHAPTER 5 Accrual accounting adjustm ents
1
H o w m uch cash w a s p a id fo r in su ra n c e d u rin g th e y e a r?
2
H o w m uch cash w a s p a id fo r e le c tric ity d u rin g th e y e a r?
3
H o w m uch cash w a s p a id fo r in tere st d u rin g th e y e a r?
217
4
H o w m uch cash w a s p a id fo r in co m e ta x d u rin g th e y e a r?
5
The last m o n th ly rent p a y m e n t w a s m a d e on 1 5 D e c e m b e r 2 0 1 6 . M o n th ly rent is $ 2 0 0 0 p e r m o nth . H o w m uch re n t is o w in g as a t th e e n d o f th e y e a r?
6
R econ stru ction Lim ited d e p re c ia te s th e m o to r v e h ic le (the c o m p a n y o w n s o n e ve h icle ) using s tra ig h t-lin e d e p re c ia tio n w ith no re s id u a l v a lu e . O n w h a t d a te w a s th e m o to r v e h ic le p u rch a s e d ?
KEY TERMS Accrued revenues Adjusted trial balance Amortisation Contra account
Contra asset Expense recognition Gains Gain on sale
Loss on sale Net book value Recognition Revenue recognition
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
DISCUSSION QUESTIONS 1
E x p la in th e d iffe re n c e b e tw e e n a re ven ue a n d a cash re c e ip t.
2
G iv e e x a m p le s o f item s th a t a re re ven ue fo r a g iv e n p e rio d b u t n o t re c e ip ts fo r th a t p e rio d , item s th a t a re receipts b u t n o t reven ue , a n d item s th a t a re bo th reven ue a n d receipts.
3
E x p la in th e d iffe re n c e b e tw e e n an e x p e n s e a n d a cash d isb u rs e m e n t.
4
G iv e e x a m p le s o f item s th a t a re expe nses fo r a g iv e n p e rio d b u t n o t disb u rse m e n ts fo r th a t p e rio d , item s th a t a re d isb u rs e m e n ts b u t no t expe nses, a n d item s th a t a re b o th expe nses a n d d isb ursem e nts.
5
O u tlin e som e b a sic d iffe re n c e s b e tw e e n cash a c c o u n tin g a n d a c c ru a l a c c o u n tin g .
6
'T he c lo s e r to c a sh , th e m o re pre cise th e m e a s u re .' Discuss this state m e nt w ith respe ct to cash a n d a c c ru a l a c c o u n tin g .
7
'T he m o re th a t a c co u n ta n ts try to m a ke fin a n c ia l statem ents e c o n o m ic a lly re le v a n t, th e m o re th e y m ust in c lu d e estim ates a n d o th e r sources o f im p re c is io n o r e rro r.' D iscuss.
8 W h a t is th e p u rp o s e o f a c c ru a l a c c o u n tin g adju stm en ts? 9
For e a ch o f th e a c c ru a l a c c o u n tin g ad ju stm en ts, e x p la in th e im p a c t o n p ro fit fo r th e p e rio d a n d th e b a la n c e sheet.
10 Y o u r o ld sch o o l frie n d has jo in e d th e m a in te n a n c e g ro u p o f a la rg e a irlin e . H e asks y o u th e fo llo w in g q u e s tio n : 'O u r custom ers p a y us la rg e am o u n ts o f cash b u t w e c a ll this a lia b ility . S u re ly it has to in cre a s e p ro fits ? ' H o w w o u ld y o u a n sw e r? 11 The a c c o u n ta n t a t a la rg e m in in g c o m p a n y tells y o u th a t th e y h a ve som e c o n tra c to rs w h o d o th e w o rk b u t often d o n 't g e t a ro u n d to b illin g fo r a b o u t th re e m onths a fte r th e jo b is c o m p le te . She notes: 'It's g re a t fo r o u r cash flo w , b u t causes us lots o f w o rk a t y e a r-e n d .' E x p la in this com m en t.
12 W h a t is th e p u rp o s e o f d e p re c ia tin g n o n c u rre n t assets? 13 W h a t is th e d iffe re n c e b e tw e e n d e p re c ia tio n a n d a c c u m u la te d d e p re c ia tio n ?
14 For a m a n a g e r th in k in g a b o u t d is p o s in g o f som e assets, w h y is b o o k v a lu e im p o rta n t?
218
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
15 Discuss th e fo llo w in g : a
S p e a k in g p o s itiv e ly , it m ig h t be s a id th a t a c c ru a l a c c o u n tin g im p ro ve s o n th e cash flo w in fo rm a tio n . S p e a k in g n e g a tiv e ly , it m ig h t be s a id th a t a c c ru a l a c c o u n tin g messes up th e p ic tu re b y in tro d u c in g non-cash flo w fa cto rs. W h e th e r o r no t y o u like th e result th e y a c h ie v e , h o w d o a c c ru a l a c c o u n tin g en trie s w o rk to a lte r th e cash flo w story?
b
W h y c a n it be s a id th a t tim in g is a t th e c e n tre o f a c c ru a l a c c o u n tin g ?
16 R espond, in p o in t fo rm , to th e fo llo w in g c o m p la in t b y a bu sinessperson : 'I fin d m o d e rn fin a n c ia l a c c o u n tin g re a lly a n n o y in g . The ba sis o f fin a n c ia l streng th is th e a v a ila b ility a n d use o f re a l resources, such as cash a n d m a c h in e ry , y e t a c c ru a l a c c o u n tin g p ro d u ce s a p ro fit m e asure th a t is d e lib e ra te ly d iffe re n t fro m th e cash return e a rn e d b y th e business. W h y is this so? W h y sh o u ld a c c ru a l a c c o u n tin g d iv e rg e fro m th e m e a su re m e n t o f cash flo w ? ' 1 7 O n 31 D e c e m b e r, th e e n d o f th e a c c o u n tin g p e rio d o f U ltra C o rp ., the c o m p a n y a c c o u n ta n t is a b o u t to m a ke som e ad ju stm en ts. D e s crib e a set o f c ircu m s ta n ce s w h e re , in m a k in g th e ty p ic a l y e a r-e n d ad ju stm en ts: a a n e x p e n s e is d e b ite d a n d a lia b ility is c re d ite d b
a n e x p e n s e is d e b ite d a n d an asset c o n tra a c c o u n t is c re d ite d
c
a n asset is d e b ite d a n d reven ue is c re d ite d
d
a lia b ility is d e b ite d a n d reven ue is c re d ite d .
18 A business e x e c u tiv e re m a rk e d : 'A c c o u n ta n ts use a d u a l s ta n d a rd fo r m e a s u rin g assets. Som e a re on th e b a la n c e sheet be ca u se th e y h a ve re a l fu tu re e c o n o m ic v a lu e . O th e rs a re th e re o n ly be ca u se th e y 're left o v e r fro m the p ro fit m e asure m en t pro ce ss - sort o f expe nses w a itin g to be d e d u c te d . S im ila rly w ith lia b ilitie s : som e a re re a lly o w e d b u t som e a re just le fto vers o f th e a c c ru a l a c c o u n tin g pro ce ss fo r m e a s u rin g p ro fit'. Discuss this re m a rk , c itin g e x a m p le s o f assets a n d lia b ilitie s th a t m ig h t fit th e e x e c u tiv e 's fo u r c a te g o rie s . 1 9 N o w th a t y o u a re a fa m o u s b u sin e ssp e rso n , y o u a re fre q u e n tly a s ke d to m a ke a fte r-d in n e r spee ch es on business to p ic s . W ith o u t th in k in g a b o u t it to o m uch, y o u a g re e d to m a ke a spee ch o n a c c ru a l a c c o u n tin g to a class o f g ra d u a tin g business students. N o w y o u h a ve to th in k o f s o m e th in g to say, a n d y o u h a ve d e c id e d to e n title y o u r ta lk , 'W h y m a n a g e rs like m e like a c c ru a l a c c o u n tin g a n d w h y w e w o rry a b o u t it'. List th e to p ic s y o u p la n to ta lk a b o u t u n d e r this h e a d in g . 2 0 A businessperson y o u k n o w has just re c e iv e d th e fin a n c ia l statem ents o f a c o m p a n y in w h ic h th a t p e rso n o w n s share s. A n s w e r th e fo llo w in g qu e stio n s a s ke d b y th e pe rso n . T ry to a n s w e r w ith o u t ja rg o n , a n d use e x a m p le s th a t w ill m a ke y o u r a n sw e rs c le a r. a 'I'v e been to ld th a t these a c c ru a l a c c o u n tin g nu m b ers a re " m a in ly a m a tte r o f tim in g " . W h a t do es th a t m ean?' b
'I see th a t th e c o m p a n y has a no te in its fin a n c ia l statem ents d e s c rib in g its "re v e n u e re c o g n itio n " m e tho d. W h y w o u ld I w a n t to k n o w th a t? '
c
'I k n o w fro m m y business e x p e rie n c e th a t som etim es y o u c o lle c t cash so o n e r o r la te r th a n y o u e x p e ct. C ustom ers m a y h a ve c a sh , o r not, fo r a ll sorts o f reasons th a t h a ve n o th in g to d o w ith y o u . I u n d e rs ta n d th a t a c c ru a l a c c o u n tin g takes this in to a c c o u n t so th a t it d o e s n 't m a tte r w h e n cash is c o lle c te d , y o u g e t th e sam e re v e n u e fig u re a n y w a y . Is th is tru e ? '
d
'I u n d e rs ta n d th a t a c co u n ta n ts try to be sure th a t revenues a n d expe nses " m a tc h " , so th e p ro fit y o u g e t b y s u b tra c tin g expe nses fro m revenues m akes sense. It seems q u ite a p p ro p ria te . But w h a t e ffe c t, if a n y , d o e s this m a tc h in g p ro c e d u re h a ve on th e b a la n c e sheet fig u re s ? '
21 If m a n a g e m e n t w is h e d to o v e rs ta te p ro fit d u rin g th e y e a r, c o n s id e r th e im p lic a tio n s fo r e a c h o f th e fo llo w in g a d ju stm e n ts (that is, w h a t a c tio n s c o u ld be ta ke n b y fra u d u le n t m a n a g e m e n t to in cre a s e pro fits?): a p re p a y m e n ts b
u n e a rn e d reven ue
c
a c c ru e d expenses
d
a c c ru e d reven ue .
2 2 A c c ru a l-b a s e d fin a n c ia l re p o rts p re p a re d b y d e p a rtm e n ts o r g o ve rn m e n ts w ill d iffe r s ig n ific a n tly fro m c ash -ba se d re p o rts c o v e rin g th e sam e p e rio d . P ro v id e som e e x a m p le s o f th e in fo rm a tio n p ro v id e d in a c c ru a l-b a s e d fin a n c ia l re p o rts b u t n o t c ash -ba se d fin a n c ia l rep orts.
CHAPTER 5 Accrual accounting adjustm ents
219
PROBLEMS PROBLEM 5.1 Cash versus accrual acco u n tin g East H ills Ltd b e g a n business on 1 July 2 0 1 5 w ith e a ch o f th e tw o o w n e rs c o n trib u tin g $ 2 0 0 0 0 cash . The c o m p a n y p a id $ 2 2 0 0 in a d v a n c e fo r a tw o -y e a r le ase o f its re ta il pre m ises. In ve n to ry w o rth $ 3 5 0 0 w a s p u rc h a s e d in th e first m onth o f o p e ra tio n ; b y 3 0 June 2 0 1 6 , $ 1 2 0 0 o f th a t in v e n to ry re m a in e d . S ales reven ue o f $ 9 1 0 0 w a s in v o ic e d d u rin g th e y e a r, a lth o u g h $ 1 6 0 0 o f this a m o u n t is y e t to be c o lle c te d . D u rin g th e y e a r, w a g e s to ta llin g $ 1 3 0 0 w e re p a id to e m p lo y e e s a n d $ 9 0 0 w a s p a id fo r v a rio u s a d m in is tra tiv e expe nses. The c o m p a n y re c e ive d a n a d v e rtis in g in v o ic e fo r $1 1 0 0 as w e ll as a u tilitie s b ill fo r $ 3 8 5 ; these a re y e t to be p a id as a t 3 0 June 2 0 1 6 . 1
P re p a re a c ash -ba sis in co m e state m e nt fo r East H ills Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
2
P re p a re an a c cru a l-b a s is in co m e state m e nt fo r East H ills Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 5 .2 Cash versus accrual acco u n tin g G re e n fin g e rs Ltd o p e n e d a g a rd e n in g c o n s u ltin g c o m p a n y on 1 A u g u s t 2 0 1 6 w ith e a ch o f th e tw o o w n e rs c o n trib u tin g $ 1 0 0 0 0 cash . A o n e -y e a r b a n k lo a n o f $ 4 0 0 0 0 a t 12 p e r c e n t p e r an n u m w a s o b ta in e d fro m the b a n k o n 1 A u g u s t, w ith p rin c ip a l a n d in tere st to be re p a id a t th e e n d o f th e lo a n . A n in su ra n c e p o lic y fo r 12 m onths w a s ta ke n o u t o n 1 A u g u s t 2 0 1 6 fo r $ 6 0 0 . T h re e m o n th s' o ffic e re n ta l fo r $ 9 0 0 w a s p a id in a d v a n c e on 1 A u g u s t 2 0 1 6 . C o n s u ltin g re ven ue o f $ 1 0 0 0 0 w a s e a rn e d d u rin g th e m o nth , bu t $ 6 0 0 0 h a d n o t be en re c e iv e d a t th e en d o f A u g u s t. A tru ck th a t cost $ 3 6 0 0 0 w a s p a id fo r in cash on 1 A u g u s t. It h a d an e x p e c te d life o f th re e y e a rs a n d z e ro re s id u a l v a lu e . C a s h expe nses d u rin g th e m onth w e re : w a g e s , $ 6 0 0 ; o th e r expe nses, $ 4 0 0 . U n p a id b ills a t m o n th 's en d w e re : e le c tric ity , $ 1 0 0 ; w a g e s , $ 2 0 0 . P re p a re an in c o m e state m e nt fo r A u g u s t 2 0 1 6 u n d e r (a) an a c c ru a l ba sis a n d (b) a cash basis o f a c c o u n tin g .
PROBLEM 5 .3 Journal entries State E n te rta in m e n t (State) w ill be h o sting a c o n c e rt on 2 9 A u g u s t 2 0 1 4 . State has th e fo llo w in g tra n s a c tio n s in A u g u s t 2 0 1 4 a s s o c ia te d w ith th e c o n c e rt a n d its business. P re p a re th e jo u rn a l en trie s (fo r 1 -3 ) in g o o d fo rm using th e m ost a p p ro p ria te a c c o u n t titles (as re fe re n ce d in th e ta b le b e lo w ). A c c o u n ts P a y a b le
C o n c e rt E q u ip m e n t
P re p a id V e n u e E xp e n s e
A c c o u n ts R e c e iv a b le
C o n c e rt R evenue
R e ta in e d E a rn in g s
B u ild in g
L o ng-te rm In ve stm e n t
U n e a rn e d R evenue
C ash
N o te P a y a b le
V e n u e E xp e n s e
C o s t o f G o o d s S o ld
N o te R e c e iv a b le
W a g e s E xp e n s e
T ra n sa ctio n s: 1 State sold 1 0 0 0 0 tickets a n d c o lle c te d p a y m e n t on 1 A u g u s t fo r th e 2 9 A u g u s t c o n c e rt. T ickets w e re p ric e d a t $ 3 0 each. 2
State p a id $ 8 0 0 0 0 cash to TEK A re n a on 4 A u g u s t to host th e 2 9 A u g u s t c o n c e rt.
3
State p e rfo rm e d th e c o n c e rt on 2 9 A u g u s t. (N o te : th e re a re tw o tra n sa ctio n s ne ce ssary to be re c o rd e d fo r 'D ' (2 9 A u g u s t).
220
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5 .4 Revenue, expenses and cash P an am a Ltd p ro v id e s o n e -d a y tra in in g p ro g ra m s in a c c o u n tin g . It c h a rg e s $ 7 0 0 0 p e r d a y . The fo llo w in g events o c c u rre d fo r th e c o m p a n y in th e m o nth o f June 2 0 1 6 . a R eceived $ 3 0 0 0 0 fro m a c co u n ts re c e iv a b le fo r sales in p re vio u s m onths, b
P aid th re e m o n th s' ren t o f $ 3 6 0 0 0 c o v e rin g 1 June 2 0 1 6 to 3 0 A u g u s t 2 0 1 6 .
c
R eceived o rd e rs fo r 6 0 d a y s ' tra in in g d u rin g th e m o nth . D e liv e re d 5 0 d a ys o f th e tra in in g d u rin g th e m o nth a n d re c e iv e d p a y m e n t fo r 3 0 o f these d a ys .
d
S ig n e d a c o n tra c t to d e s ig n a s p e c ia l p ro g ra m fo r la w y e rs a t a p ric e o f $ 5 0 0 0 0 . D esign w ill c o m m e n ce in July. R eceived a $ 6 0 0 0 d e p o sit.
e
P aid $ 5 0 0 0 0 0 fo r n e w e q u ip m e n t on 1 June a n d $ 1 0 0 0 0 0 to in sta ll it. The e q u ip m e n t has a life o f 10 y e a rs ,
f
A c o n tra c t w a s s ig n e d w ith a n e w C E O fo r $1 0 0 0 0 0 0 p e r y e a r. The C E O w ill start o n 1 July,
g
P aid w a g e s d u rin g th e p e rio d o f $ 6 0 0 0 0 w ith a c c ru e d w a g e s o f $ 1 0 0 0 0 o w in g a t th e e n d o f th e m o nth,
h
D e c la re d a n d p a id a d iv id e n d o f $ 4 0 0 0 0 .
i
S old a p ie c e o f e q u ip m e n t th a t c o st $1 6 0 0 0 0 (a c c u m u la te d d e p re c ia tio n $ 1 2 0 0 0 0 ) fo r $ 3 2 0 0 0 .
j
W ro te d o w n th e v a lu e o f d a m a g e d in v e n to ry b y $ 3 6 0 0 .
k
B o rro w e d $ 2 4 0 0 0 o n 1 June fro m th e b a n k a t 1 0 p e r c e n t p e r a n n u m . Interest a n d p rin c ip a l re p a y a b le in 10 m onths.
Required: 1 D e te rm in e to ta l reven ue fo r th e m onth o f June 2 0 1 6 . 2
List a ll expe nses fo r th e m onth o f June 2 0 1 6 (in c lu d in g d o lla r am ou nts).
3
A ssum e an o p e n in g b a la n c e in th e cash a c c o u n t o f $ 6 0 0 0 0 0 . W h a t is th e c lo s in g b a la n c e o f th is a c co u n t?
PROBLEM 5 .5 Revenue and expenses R evesby Ltd starte d business on 1 July 2 0 1 6 a n d h a d th e fo llo w in g tra n s a c tio n s on 1 July: a Issued 5 0 0 0 0 0 shares o f $1 fo r $ 5 0 0 0 0 0 cash. b
B o u g h t e q u ip m e n t fo r $ 4 0 0 0 0 0 , p a y in g cash . The e q u ip m e n t has a fiv e -y e a r life,
c
B o u g h t $ 9 0 0 0 0 in v e n to ry on c re d it,
d
P aid $ 1 0 0 0 0 fo r a y e a r's re n t on a b u ild in g .
e
T o o k o u t a tw o -y e a r $ 4 0 0 0 0 0 b a n k lo a n a t an in te re st ra te o f 8 p e r c e n t p e r a n n u m . The in tere st is no t p a y a b le un til th e e n d o f th e lo a n .
B etw een 1 J u ly a n d 31 D e c e m b e r, th e fo llo w in g tra n s a c tio n s o c c u rre d : f
S old in v e n to ry th a t cost $ 8 0 0 0 0 fo r $ 1 4 0 0 0 0 . A ll sales w e re o n c re d it,
g
P aid $ 5 0 0 0 0 to s u p p lie rs o f in v e n to ry fo r th e c re d it pu rch ases in (c) a b o v e ,
h
C o lle c te d $ 9 0 0 0 0 fro m custom ers,
i
P aid s a la rie s o f $ 2 0 0 0 0 .
j
R eceived an $ 8 0 0 0 d e p o s it fro m a c u sto m e r fo r w o rk to b e c o m p le te d n e xt F e b ru a ry. O n 31 D e c e m b e r:
k
S a la rie s o f $ 6 0 0 0 h a d be en e a rn e d b u t n o t p a id .
I
O w e d $ 1 5 0 0 0 b y th e b a n k fo r interest.
1
List a ll revenues (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in co m e statem ent.
2
List a ll expe nses (in c lu d in g d o lla r am ou nts) th a t w ill a p p e a r in th e in c o m e statem ent.
For th e p e rio d 1 J u ly to 31 D e c e m b e r 2 0 1 6 :
3
List a ll cash in flo w s a n d o u tflo w s . W h ic h o f them re fe r to o p e ra tio n s (refe r to C h a p te r 1)?
4
P re p a re a b a la n c e sheet a t 31 D e c e m b e r 2 0 1 6 .
CHAPTER 5 Accrual accounting adjustm ents
221
PROBLEM 5 .6 Revenues, expenses and lia b ilitie s PADSTOW LTD BALANCE SHEET AS AT 31 DECEMBER 2015 | Assets
$
C ash
168000
A c c o u n ts p a y a b le
A c c o u n ts re c e iv a b le
312000
W a g e s p a y a b le
In v e n to ry
320000
P re p a id re n t e x p e n s e
88 0 0 0
Total current assets
>1
Liabilities
200000 16000
U n e a rn e d re v e n u e
256000
Total current liabilities
472000
888000
L o ng-te rm d e b t
0
Land
1520000
Total liabilities
472000
E q u ip m e n t
3 200000
Shareholders' equity
Less a c c u m u la te d d e p re c ia tio n
Total noncurrent assets
T o ta l assets
(6 4 0 0 0 0 ) 4080000
4968000
S h a re c a p ita l
4 240000
R e ta in e d p ro fits
256000
Total shareholders' equity
4496000
Total liabilities and shareholders' equity
4968000
The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 fo r P a d sto w Ltd: a Issued sh a re c a p ita l fo r $ 3 0 0 0 0 0 cash. b
E x p ira tio n o f p re p a id ren t e x p e n s e (i.e . p re p a id re n t e x p e n s e b a la n c e to z e ro ),
c
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it,
d
P aid $ 5 6 0 0 0 to a c co u n ts p a y a b le .
e
S old in v e n to ry c o stin g $1 2 0 0 0 0 fo r $ 3 4 0 0 0 0 . A ll sales a re on c re d it,
f
C o lle c te d $ 1 0 6 0 0 0 fro m a c co u n ts re c e iv a b le .
g
D e p re c ia te d e q u ip m e n t fo r th e y e a r using th e s tra ig h t-lin e m e th o d (1 0 p e r c e n t p e r a n n u m ),
h
D iv id e n d s p a id to ta lle d $ 5 0 0 0 0 .
i
B o rro w e d $ 1 5 0 0 0 0 on 1 J a n u a ry 2 0 1 6 . The lo a n is d u e on 3 0 June 2 0 1 8 a n d c a rrie s a 1 0 p e r c e n t p e r an n u m in tere st rate. P aid $ 1 3 0 0 0 in tere st on this lo a n d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
j
O n 1 A p ril p a id $ 3 0 0 0 0 fo r a n in su ra n c e p o lic y c o v e rin g 1 A p ril 2 0 1 6 to 31 M a rc h 2 0 1 7 .
k
P aid w a g e s o f $ 1 6 0 0 0 0 ; w a g e s o f $ 3 0 0 0 0 h a d be en e a rn e d b u t n o t p a id to th e first p a y p e rio d in 2 0 1 7 .
I
Is o w e d $ 9 5 0 0 in in tere st fro m th e b a n k a t y e a r-e n d .
m A t 31 D e c e m b e r 2 0 1 6 th e u n e a rn e d reven ue a c c o u n t b a la n c e h a d re d u c e d to $ 5 0 0 0 . Required: 1 List a ll revenues (in c lu d in g d o lla r am ounts) th a t w ill a p p e a r in th e in c o m e state m e nt fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . 2
List a ll expe nses (in c lu d in g d o lla r a m ou nts, ig n o rin g ta x a tio n ) th a t w ill a p p e a r in th e in c o m e state m e nt fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
List a ll c u rre n t lia b ilitie s a t 31 D e c e m b e r 2 0 1 6 (in c lu d in g d o lla r a m ou nts).
PROBLEM 5 .7 E ffe ct on revenue, expenses, assets and lia b ilitie s The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g 2 0 1 5 - 1 6 fo r S e d a n a Ltd, w h o s e y e a r-e n d is 3 0 June 2 0 1 6 . 1 Issued sh a re c a p ita l fo r $ 4 0 0 0 0 0 cash. 2
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it.
3
S old in v e n to ry c o stin g $ 6 0 0 0 0 fo r $ 1 9 0 0 0 0 . A ll sales a re o n c re d it.
4
R eceived $ 1 0 0 0 0 0 fro m a c co u n ts re c e iv a b le .
5
P aid d iv id e n d s o f $ 4 0 0 0 0 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6
P aid $ 3 2 OOO to a cco u n ts p a y a b le .
7
P aid w a g e s o f $ 9 0 0 0 0 ; w a g e s o f $ 1 0 0 0 0 h a d be en e a rn e d b y e m p lo y e e s b u t n o t p a id a t y e a r-e n d .
8 O n 1 June 2 0 1 6 re c e iv e d a d e p o s it o f $ 7 0 0 0 0 fo r w o rk to be c a rrie d o u t in th e ne xt y e a r. 9
U sed $ 1 5 0 0 0 o f e le c tric ity d u rin g th e y e a r fo r w h ic h th e c o m p a n y has n o t y e t be en in v o ic e d .
1 0 P urchased su p p lie s c o stin g $ 4 0 0 0 on c re d it; a t y e a r-e n d $ 8 0 0 o f these su p p lie s re m a in e d . 11 P aid a $ 2 4 0 0 0 in su ra n c e p o lic y on 1 O c to b e r 2 0 1 5 , c o v e rin g 1 O c to b e r 2 0 1 5 to 3 0 S e p te m b e r 2 0 1 6 . For e a ch o f the a b o v e tra n sa ctio n s, events o r facts, in d ic a te the im p a c t on revenues, expenses, assets a n d lia b ilitie s fo r the y e a r e n d e d 3 0 June 2 0 1 6 b y p la c in g a + o r — s ig n (+ fo r in cre a se a n d — fo r de cre ase) to in d ic a te d ire c tio n in the a p p ro p ria te b o x . W r ite N E if th ere is no effect. In clu de d o lla r am ou nts. Be sure to p la c e a n a n s w e r in e v e ry bo x.
PROBLEM 5 .8 A d ju stm e n ts The fin a n c ia l y e a r-e n d fo r R iv e rw o o d Ltd is 3 0 June. a P re p a id in su ra n c e as a t 1 July 2 0 1 5 w a s $ 4 0 0 0 . This rep resents th e cost o f a o n e -y e a r in su ra n c e p o lic y th a t e x p ire s o n 1 M a rc h 2 0 1 6 . b
F la m in g o w a s e n title d to a d iv id e n d re ven ue o f $ 5 0 0 0 w h ic h w ill no t be re c e iv e d until m id-July,
c
C o m m is sio n s to sales p e rso n n e l fo r th e fiv e -d a y w o rk in g w e e k e n d in g 2 J u ly 2 0 1 6 , to ta llin g $ 9 6 0 0 , w ill be p a id on 2 July.
d
Sales revenue fo r the y e a r in c lu d e d $ 5 7 0 o f custom er de po sits fo r p ro du cts th a t ha ve no t y e t been s h ip p e d to them ,
e
A to ta l o f $ 9 0 0 w o rth o f s ta tio n e ry w a s c h a rg e d to th e o ffic e s u p p lie s e x p e n s e d u rin g th e y e a r. O n 3 0 June, a b o u t $ 4 9 0 w o rth o f s ta tio n e ry is still c o n s id e re d useful fo r n e xt y e a r,
f
The c o m p a n y has a b a n k lo a n a n d p a ys in tere st a n n u a lly (in arre a rs) o n 31 D e c e m b e r. The e s tim a te d interest cost fo r th e c a le n d a r y e a r e n d e d 31 D e c e m b e r 2 0 1 6 is $ 5 0 0 .
Required: 1 S h o w th e e ffe c t o f e a ch o f th e a b o v e o n th e a c c o u n tin g e q u a tio n a t 3 0 June 2 0 1 6 . 2
G iv e th e a d ju s tin g jo u rn a l e n try fo r e a ch o f th e a b o v e s itu a tio n s on 3 0 June 2 0 1 6 .
PROBLEM 5 .9 A d ju stm e n ts - acco u n tin g equation M o te ls Ltd o p e ra te s th re e m otels in la rg e c o u n try centre s. The a c co u n ts fo r th e y e a r e n d e d 3 0 June 2 0 1 6 h a ve been fin a lis e d , w ith th e e x c e p tio n o f a n y ad ju stm e n ts th a t m a y result fro m th e fo llo w in g : a Bonuses d u e to th e m otel m a n a g e rs to ta llin g $ 3 0 0 0 0 h a ve no t y e t be en re c o rd e d . b
O n 1 O c to b e r 2 0 1 5 , a c o m p re h e n s iv e in s u ra n c e p o lic y c o v e rin g b u ild in g a n d contents w a s ta ke n o u t fo r the y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e a n n u a l p re m iu m o f $ 2 4 0 0 b e in g p a id on 1 N o v e m b e r 2 0 1 5 .
c
Interest on investm ents a m o u n tin g to $ 6 0 0 is d u e b u t has no t y e t been re c e ive d ,
d
A p a y m e n t o f $ 9 0 0 fo r e m b o ss e d s ta tio n e ry w a s c h a rg e d , in e rro r, to th e a d v e rtis in g a c co u n t.
CHAPTER 5 Accrual accounting adjustm ents
223
e
A n a m o u n t o f $ 4 5 0 0 s p e n t o n a la p to p c o m p u te r w a s c h a rg e d to th e o ffic e expe nses a c c o u n t in ste a d o f the o ffic e e q u ip m e n t a c co u n t.
f
In M a y , c o m m is sio n o f $ 3 6 0 w a s re c e ive d in a d v a n c e fo r th e six m onths e n d in g 31 O c to b e r 2 0 1 6 .
g
A t 3 0 June 2 0 1 6 , a c c ru e d e le c tric ity c h a rg e s w e re $ 9 2 .
Required: 1 S h o w th e im p a c t o f e a ch tra n s a c tio n on th e a c c o u n tin g e q u a tio n . 2
P ro v id e jo u rn a l en trie s.
PROBLEM 5.1 0 Prepare a d ju stin g jo u rn a l entries i t necessary The a c c o u n ta n t fo r S u p e r O ffic e S u p p lie s Ltd (SO S) is re v ie w in g th e y e a r-e n d u n a d ju s te d tria l b a la n c e a n d c o n s id e rin g th e fo llo w in g item s o f in fo rm a tio n . For e a ch item , d e c id e if a n a d ju s tm e n t to th e a cco u n ts is necessary. If it is, w rite a jo u rn a l e n try to m a ke th e a d ju stm e n t. 1 A s h ip m e n t o f in v e n to ry th a t a rriv e d la te on th e last d a y o f th e y e a r w a s n o t re c o rd e d . The s h ip m e n t cost $ 1 3 1 0 0 , a n d w a s p a id fo r ro u tin e ly a b o u t th re e w e e ks la ter. 2
The a c c o u n ta n t d e te rm in e d th a t a m a jo r sales o rd e r h a d be en fille d on th e last d a y o f th e y e a r, a lth o u g h it w a s n o t re c o rd e d until th re e d a ys la te r. The o rd e r w a s fo r $ 7 2 0 0 , a n d th e g o o d s s u p p lie d h a d cost S O S $ 3 3 0 0 . The c u sto m e r p a id tw o w e e ks la ter.
3
In th e last fe w d a ys o f th e y e a r, th e c o m p a n y 's sh a re p ric e on th e A u s tra lia n S to ck E x ch a n g e fell a b o u t $ 0 .4 0 p e r share . The c o m p a n y has 5 0 0 0 0 0 shares issued.
4
T h ere has be en an e rro r in c a lc u la tin g d e p re c ia tio n e x p e n s e d u rin g th e y e a r. To c o rre c t th e e rro r, a n a d d itio n a l e x p e n s e o f $ 1 4 5 0 0 w o u ld ne ed to be re c o rd e d .
5
A re v ie w o f th e w a rra n ty lia b ility in d ic a te d th a t th e lia b ility sh o u ld be in c re a s e d b y $ 7 8 0 .
6 A t a b o a rd o f d ire c to rs m e eting on th e last d a y o f th e y e a r, th e c o m p a n y 's p re s id e n t a n d o th e r s e n io r executive s w e re a w a rd e d raises to ta llin g $ 1 1 1 0 0 a n n u a lly , to b e g in th e ne xt d a y . 7
The c o m p a n y b o u g h t 1 2 m o n th s' b u ild in g in su ra n c e tw o m onths b e fo re th e e n d o f th e y e a r, a t a c o st o f $ 2 4 0 0 , a n d d e b ite d th e cost to in su ra n c e ex p e n s e .
8 O n e o f th e cash re c e ip ts c re d ite d to sales reven ue tu rn e d o u t to be a d e p o s it o f $ 4 0 0 m a d e b y a c u sto m e r on an o rd e r th a t w ill b e fille d a w e e k a fte r th e e n d o f th e y e a r.
PROBLEM 5.11 Prepaym ents and accrued expense 1
In a recen t a n n u a l re p o rt th e fo llo w in g in fo rm a tio n is p ro v id e d :
P re p a y m e n ts
2016
2015
$m
$m
5 0 .8
5 2 .0
A ssum e th is a m o u n t a ll re la te d to in su ra n c e a n d th a t $ 7 0 m illio n cash w a s p a id d u rin g th e y e a r to the in su ra n c e c o m p a n y . W h a t is the in su ra n c e e x p e n s e fo r th e 2 0 1 6 fin a n c ia l y e a r? 2
A la rg e soft d rin k m a n u fa c tu re r, in a recen t a n n u a l re p o rt, in c lu d e d an a m o u n t o f $ 3 0 6 .7 m illio n in a c c ru e d c h a rg e s ($ 2 9 7 .1 m illio n in 2 0 1 5 ) . A ssum e th a t a ll these a c c ru e d c h a rg e s re la te d to w a g e s . If th e w a g e s p a id d u rin g th e y e a r w e re $ 5 0 0 m illio n , w h a t w a s th e w a g e s e x p e n s e fo r 2 0 1 6?
3
In note 1 0 o f its 3 0 S e p te m b e r 2 0 1 6 a n n u a l re p o rt, O K Lim ited show s th e fo llo w in g :
P re p a y m e n t a n d o th e r assets
2016
2015
$m
$m
3 6 .2
3 4 .4
A ssum e th a t this a m o u n t is a ll re la te d to in su ra n c e a n d th a t $ 3 0 m illio n cash w a s p a id d u rin g th e y e a r to the in su ra n c e c o m p a n y . W h a t is the in su ra n c e e x p e n s e fo r th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5.12 A d ju s tin g e n try to r accrued expenses 1
2
E m p lo ye es o f D o n o v a n Ltd a re p a id e v e ry F rid a y fo r th e fiv e -d a y w o rk in g w e e k fro m M o n d a y to F rid a y . The w e e k ly w a g e s e x p e n s e is $1 15 0 0 0 . The a c c o u n tin g y e a r-e n d is 31 D e c e m b e r. A ssum e this fa lls on a T h u rsd a y , a
P re p a re th e a d ju s tin g e n try fo r th e y e a r-e n d .
b
If no a d ju s tin g e n try is m a d e on 31 D e c e m b e r, w h a t w ill be th e im p a c t on net p ro fit? W h a t w ill th e e rro rs in th e b a la n c e sheet be?
c
W h a t is th e jo u rn a l e n try m a d e o n 1 J a n u a ry w h e n th e s ta ff a re p a id ?
O n 1 July 2 0 1 6 , D o n o v a n o b ta in e d a b a n k lo a n o f $ 1 0 0 0 0 0 a t 1 2 p e r c e n t interest, p a y a b le y e a rly in a rre a rs . The a c c o u n tin g y e a r-e n d is 31 D e c e m b e r. a
W h a t is th e a d ju s tin g e n try re q u ire d on 31 D e c e m b e r 2 0 1 6 ?
b
The c o m p a n y 's a c c o u n ta n t fo rg e ts to p re p a re th e a b o v e e n try. W h a t w ill th e e ffe c t o f this o m is sio n be on D o n o v a n 's fin a n c ia l statem ents?
c
P re p a re th e jo u rn a l e n try fo r 1 July 2 0 1 7 , w h e n th e firs t in tere st p a y m e n t is m a d e .
PROBLEM 5.13 Journal entries o f revenue received in advance In a re c e n t a n n u a l re p o rt o f Telstra, th e fo llo w in g a p p e a rs as th e fin a n c ia l p o lic y o n in s ta lla tio n a n d c o n n e c tio n fe e reven ue re c e iv e d in a d v a n c e : In s ta lla tio n a n d c o n n e c tio n fe e re v e n u e s t h a t a re n o t c o n s id e re d t o be s e p a ra te u n its o f a c c o u n tin g a re d e fe rre d a n d re c o g n is e d o v e r t h e a v e ra g e e s tim a te d c u s to m e r life . In c r e m e n ta l c o s ts d ir e c tly re la te d t o th e s e re v e n u e s a re a lso d e fe rre d an d a m o rtis e d o v e r th e c u s to m e r c o n t r a c t life in a c c o r d a n c e w ith n o te 2 .1 2 (d ). Source: Telstra C orporation Limited, 2014 Balance Sheet.
1
W h a t jo u rn a l en trie s w o u ld be p u t th ro u g h w h e n th e cash is re c e ive d ?
2
W h a t jo u rn a l e n try w o u ld be p u t th ro u g h w h e n th e reven ue is re c o g n is e d ?
PROBLEM 5.14 A d ju stm e n ts entries Parkes Ltd's a n n u a l a c c o u n tin g y e a r en ds on 3 0 June. It is 3 0 June 2 0 1 6 a n d a ll o f th e 2 0 1 6 en trie s e x c e p t the fo llo w in g a d ju s tin g en trie s h a ve be en m a d e . a O n 1 A p r il 2 0 1 6 th e c o m p a n y b o rro w e d $ 4 0 0 0 0 fro m a lo ca l b a n k a t 5 p e r c e n t p e r an n u m interest. The p rin c ip a l a n d in tere st a re p a y a b le on 3 0 June 2 0 1 7 . The b o rro w in g w a s c o rre c tly re c o rd e d bu t no a d ju stm e n t has be en m a d e fo r interest. b
O n 1 M a rc h 2 0 1 6 Parkes c o lle c te d s ix m o n th s 're n t o f $1 6 8 0 0 . A t th a t d a te Parkes d e b ite d C a s h a n d c re d ite d U n e a rn e d rent re ven ue fo r $ 1 6 8 0 0 .
c
O n 1 O c to b e r 2 0 1 6 Parkes p a id a o n e -y e a r p re m iu m fo r fire in su ra n c e , $ 1 8 0 0 0 , fo r c o v e ra g e s ta rtin g on th a t d a te . C a s h w a s c re d ite d a n d P re p a id in su ra n c e w a s d e b ite d fo r this a m o u n t.
d
A t 3 0 June 2 0 1 6 w a g e s e a rn e d b y e m p lo y e e s to ta lle d $ 3 8 0 0 0 . The e m p lo y e e s w ill be p a id in July 2 0 1 6 .
e
O n 3 0 June 2 0 1 6 th e c o m p a n y e s tim a te d it o w e d $ 6 0 0 0 fo r 2 0 1 6 e le c tric ity costs. The a m o u n t w ill be p a id w h e n th e in v o ic e is re c e ive d in July 2 0 1 6 .
f
O ffic e s u p p lie s o n h a n d a t 3 0 June 2 0 1 6 to ta lle d $ 1 4 0 0 . A d d itio n a l o ffic e su p p lie s c o s tin g $ 2 4 0 0 w e re p u rc h a s e d a n d d e b ite d to O ffic e su p p lie s (asset a c co u n t). The c o u n t o f su p p lie s o n h a n d a t y e a r-e n d w a s $ 8 0 0 .
CHAPTER 5 Accrual accounting adjustm ents
225
Required: 1
U sing th e fo llo w in g h e a d in g s , in d ic a te th e e ffe c t o f e a ch a d ju s tin g e n try a n d th e a m o u n t o f th e e ffe c t. Use + fo r in c re a s e , — fo r d e c re a s e a n d N E fo r no effect.
2
P re p a re th e a d ju s tin g jo u rn a l en trie s.
PROBLEM 5.15 A d ju s tin g jo u rn a l entries The a n n u a l a c c o u n tin g p e rio d fo r DEF Ltd en ds on 3 0 June. P re p a re a d ju s tin g e n trie s fo r e a ch o f th e fo llo w in g : 1 DEF w a s e n title d to a c o m m is sio n o f $ 2 0 0 0 d u rin g June, b u t th e c o m m is sio n w ill no t be re c e ive d un til July. 2
W a g e s o f $ 3 0 0 0 fo r th e fiv e -d a y w o rk p e rio d e n d in g 3 July w ill be p a id on 3 July. This is a F rid a y .
3
DEF Ltd has a $ 1 0 0 0 0 0 fix e d d e p o s it a t 12 p e r cent, w h e re in tere st is p a id in a rre a rs on 3 0 A p ril a n d 3 0 N o v e m b e r.
4
The o ffic e s u p p lie s a c c o u n t h a d an o p e n in g b a la n c e o f $ 1 0 0 0 on 1 J u ly 2 0 1 5 . S u p p lie s o f $ 8 0 0 0 w e re p u rc h a s e d d u rin g th e y e a r, a n d $ 9 0 0 o f s u p p lie s a re o n h a n d o n 3 0 June 2 0 1 6 .
PROBLEM 5.16 A d ju s tin g e n try to r pre p a id expense M N O Ltd p u rc h a s e d a o n e -y e a r in su ra n c e p o lic y on 1 A p r il. The e n tire p re m iu m o f $ 6 0 0 0 w a s re c o rd e d b y d e b itin g p re p a y m e n ts . Y e a r-e n d is 3 0 June. 1 G iv e th e 3 0 June a d ju s tin g e n try. 2
W h a t a m o u n t sh o u ld be re p o rte d in th e 3 0 June b a la n c e sheet fo r p re p a ym e n ts?
3
If no a d ju s tin g e n try w a s m a d e on 3 0 June, b y h o w m uch w o u ld net p ro fit be o v e rs ta te d o r u n d e rsta te d ? W o u ld assets be o v e rs ta te d o r u n d e rsta te d ?
4
W h a t w o u ld y o u r a d ju s tin g e n try in q u e s tio n 1 be if th e p re m iu m o f $ 6 0 0 0 w a s re c o rd e d b y d e b itin g in su ra n c e e xpe nse?
PROBLEM 5.17 A d ju s tin g e n try For accrued expense A B C Ltd p a y s its e m p lo y e e s e v e ry F rid a y fo r a fiv e -d a y w o rk in g w e e k fro m M o n d a y to F rid a y . The w e e k ly p a y ro ll am o u n ts to $ 1 5 0 0 0 0 . The a c c o u n tin g y e a r-e n d is 3 0 June. 1 A s su m in g th a t 3 0 June fa lls o n W e d n e s d a y , g iv e th e y e a r-e n d a d ju s tin g e n try. 2
If no a d ju s tin g e n try w a s m a d e on 3 0 June, b y h o w m uch w o u ld net p ro fit b e o v e rs ta te d o r u n d e rsta te d ? W h a t e rro rs w o u ld be in the b a la n c e sheet?
3
G iv e th e e n try to p a y th e s ta ff o n 2 July.
PROBLEM 5.1 8 A d ju s tin g e n try For revenue received in advance X YZ Ltd rents o n e o ffic e to a te n a n t w h o p a id th re e m o n th s' ren t in a d v a n c e o n 1 June. The firm c re d ite d u n e a rn e d re n ta l re ven ue to re c o rd th e $ 6 0 0 0 re c e iv e d . Y e a r-e n d is 3 0 June. 1 P re p a re th e a d ju s tin g e n try fo r 3 0 June. 2
W h a t w o u ld be th e effects o n th e firm 's fin a n c ia l statem ents if th e a d ju s tin g e n try w a s o m itte d ?
3
P re p a re th e e n try in th e n e xt p e rio d to re c o g n is e th e re m a in in g p o rtio n o f th e rent reven ue .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5.19 E ffects o f errors on the fin a n cia l sta te m e n ts C B D m a d e th e fo llo w in g e rro rs in a d ju s tin g th e a cco u n ts a t y e a r-e n d (3 0 June). a D id n o t a c c ru e $ 1 4 0 0 o w e d to th e c o m p a n y b y a n o th e r c o m p a n y re n tin g p a rt o f th e b u ild in g as a s to ra g e fa c ility . b
D id no t re c o rd $ 1 5 0 0 0 d e p re c ia tio n on e q u ip m e n t c o stin g $ 1 15 0 0 0 .
c
F a ile d to a d ju s t th e U n e a rn e d fe e re ven ue a c c o u n t to re fle c t th a t $ 1 5 0 0 w a s e a rn e d b y th e e n d o f th e y e a r.
d
R e co rd e d a full y e a r o f a c c ru e d in tere st e x p e n s e on a $ 1 7 0 0 0 , 9 p e r c e n t lo a n p a y a b le th a t has been o u ts ta n d in g o n ly since 31 M a y .
e
F a ile d to a d ju s t P re p a id in su ra n c e to re fle c t th a t $ 6 5 0 o f in su ra n c e c o v e ra g e has be en used.
Required: 1
U sing th e fo llo w in g h e a d in g s , in d ic a te th e e ffe c t o f e a ch e rro r a n d th e a m o u n t o f th e e ffe c t (i.e. th e d iffe re n c e b e tw e e n th e e n try th a t w a s o r w a s no t m a d e a n d th e e n try th a t sh o u ld h a ve be en m a d e ). Use 0 if th e e ffe c t overstates th e item , U if th e e ffe c t un derstates th e item , a n d N E if th e re is no effect.
Balance sheet Transaction
Assets
Liabilities
Shareholders' equity
Income statement Revenues
Expenses
Net profit
(a) (b) \CI (d) (e) 2
For e a ch e rro r, p re p a re th e a d ju s tin g jo u rn a l e n try: a
th a t w a s m a d e (if any)
b
th a t sh o u ld h a ve been m a d e a t y e a r-e n d .
PROBLEM 5 .2 0 A d ju stin g jo u rn a l entries J in d a b in e B oa t Ltd stores a n d c le a n s b o a ts fo r custom ers. It is c o m p le tin g th e a c c o u n t process fo r th e y e a r just e n d e d 3 0 June 2 0 1 6 . The tra n s a c tio n s d u rin g 2 0 1 6 h a ve be en jo u rn a lis e d a n d p o ste d . The fo llo w in g d a ta w ith re s p e ct to a d ju s tin g en trie s is a v a ila b le : 1 J in d a b in e c le a n e d th re e b o a ts fo r custom ers a t th e e n d o f June, b u t d id n o t re c o rd th e s ervice fo r $ 2 7 0 0 . 2
O n 1 M a y 2 0 1 6 , J in d a b in e p a id $ 1 2 0 0 to th e lo c a l n e w s p a p e r fo r a n a d ve rtis e m e n t to run e a ch T h u rsd a y fo r 1 2 w e e ks . A ll a d s h a ve be en run e x c e p t fo r th re e T h ursd ays in J u ly to c o m p le te th e 12 -w e e k c o n tra c t.
3
J in d a b in e b o rro w e d $ 2 5 0 0 0 0 a t 1 2 p e r c e n t a n n u a l in tere st ra te on 1 N o v e m b e r 2 0 1 6 to e x p a n d its s to ra g e fa c ility . The lo a n re q u ire s J in d a b in e to p a y th e in tere st q u a rte rly until th e note is re p a id in tw o y e a rs . J in d a b in e p a id q u a rte rly in tere st o n 1 F e b ru a ry a n d 1 M a y .
4
J in d a b in e re c e ive d $ 4 5 0 0 on 1 June 2 0 1 6 to store a s a ilb o a t fo r w in te r un til 1 N o v e m b e r 2 0 1 7 . J in d a b in e c re d ite d th e fu ll a m o u n t to U n e a rn e d s to ra g e reven ue on 1 June.
5
J in d a b in e 's b o a t-liftin g e q u ip m e n t cost $ 2 2 0 0 0 0 ; $ 2 2 0 0 0 w a s th e e s tim a te d d e p re c ia tio n in 2 0 1 6 .
6
B o a t-re p a ir su p p lie s on h a n d a t 1 J u ly 2 0 1 5 to ta lle d $1 6 5 0 0 . R e p a ir su p p lie s p u rc h a s e d d e b ite d to S u p p lie s on h a n d d u rin g th e y e a r a m o u n te d to $ 4 6 0 0 0 . The y e a r-e n d c o u n t s h o w e d $ 1 2 4 0 0 o f su p p lie s on h a n d .
7
W a g e s e a rn e d b y e m p lo y e e s d u rin g June 2 0 1 6 , u n p a id a n d u n re c o rd e d a t 3 0 June 2 0 1 6 , a m o u n te d to $ 3 8 0 0 . The n e xt p a y ro ll d a te w ill be 5 July 2 0 1 6 . P re p a re th e a d ju s tin g en trie s th a t sh o u ld be re c o rd e d fo r J in d a b in e a t 3 0 June 2 0 1 6 .
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227
PROBLEM 5.21 Classifying balance sheet item s A n a d ju s te d tria l b a la n c e a t 31 D e c e m b e r 2 0 1 6 fo r a to y m a n u fa c tu re r is g iv e n b e lo w :
Accounts receivable
Debit
Credit
$
$
295000
Accounts payable Property, plant and equipment
120000 1000000
Accumulated depreciation
400000
Income tax payable
40000
Revenue received in advance
10000
Prepaid expenses
20000
Accrued wages Inventory
25 000 200000
Cash
60000
Accrued revenue
20000
Long-term debt
100000
Share capital
700000
Retained profits at 1 January 2016
150000
Sales Cost of goods sold Depreciation expense Other operating expenses Income tax expense
800000 500000 20000 150000 80000 2345000
1
In th e b a la n c e sheet, p re p a re d a t 31 D e c e m b e r 2 0 1 6 : a
2
2345000
W h a t w o u ld be th e b a la n c e o f to ta l c u rre n t assets?
b
W h a t w o u ld be th e b a la n c e o f to ta l c u rre n t lia b ilitie s ?
c
W h a t w o u ld be th e b a la n c e o f to ta l n o n c u rre n t assets?
d
W h a t w o u ld be th e c lo s in g b a la n c e o f re ta in e d p ro fit?
W h a t w a s th e b a la n c e o f th e a c c u m u la te d d e p re c ia tio n a c c o u n t a t 31 D e c e m b e r 2 0 1 5 , a ssu m ing n o p ro p e rty , p la n t a n d e q u ip m e n t w a s d is p o s e d o f d u rin g th e y e a r?
PROBLEM 5 .2 2 A cco u n tin g cycle W a n C h a i Lim ited is a sm all w h o le s a le r o f e le c tro n ic c o m p o n e n ts lo c a te d n e a r H o n g K o n g 's c e n tra l business d is tric t. The firm has p ro v id e d a y e a r-e n d b a la n c e sheet a t 3 0 June 2 0 1 6 a n d a s u m m a ry o f a ll the tra n s a c tio n s th a t o c c u rre d in th e m onth o f July 2 0 1 6 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W A N CHAI LIMITED BALANCE SHEET AS AT 3 0 JUNE 20 16 7 Current assets Cash
324000
Accounts receivable Inventory
906000 1 332 000
Prepaid insurance
42 000
Prepaid rent Total current assets
144000 2 748 000
Noncurrent assets Buildings and equipment
324000
Accumulated depreciation
(804000)
Total noncurrent assets
2 436 000
Total assets
51 84000
Current liabilities Accounts payable
1620000
Accrued wages
264000
Unearned revenue
348 000
Total current liabilities
2 232 000
Noncurrent liabilities Loan
1 200000
Total noncurrent liabilities
1 200000
Shareholders' equity Share capital
1 420000
Retained profits
332 000
Total shareholders' equity
1 752 000
Total liabilities and shareholders' equity
51 84000
The tra n sa ctio n s a re as fo llo w s : a P aid w a g e s o u ts ta n d in g a t th e e n d o f June. b
M a d e c re d it sales o f $1 2 5 4 0 0 0 . (The cost o f th ose g o o d s s o ld w a s $ 7 5 0 0 0 0 . )
c
P aid $ 1 0 2 0 0 0 0 to a c co u n ts p a y a b le ,
d
P urchased $ 4 8 0 0 0 0 in v e n to ry on c re d it.
e
P aid cash fo r a n a n n u a l in su ra n c e p re m iu m o f $ 5 0 4 0 0 0 (1 2-m on th p o lic y c o m m e n c in g 1 A u g u s t 2 0 1 6 ) .
f
R eceived $1 6 8 0 0 0 0 fro m d e b to rs .
g
M a d e cash sales to ta llin g $ 2 7 0 0 0 0 . (The cost o f those g o o d s s o ld w a s $ 1 9 2 0 0 0 .)
h
Interest on th e lo a n is a t 1 0 p e r c e n t p e r an n u m a n d w ill be p a id in S e p te m b e r,
i
The w o rk re la te d to u n e a rn e d reven ue w a s c o m p le te d .
j
P aid w a g e s e x p e n s e o f $1 8 6 0 0 0 fo r July. W a g e s o w in g a t th e e n d o f July a re $ 6 0 0 0 0 .
k
P aid re n t fo r A u g u s t o f $ 1 4 4 0 0 0 . (Rent is p a y a b le m o n th ly in a d v a n c e , a t $ 1 4 4 0 0 0 p e r m onth.)
I
P aid a d m in is tra tiv e expe nses, in c u rre d d u rin g th e m o nth , o f $1 2 6 0 0 0 .
m
D e p re c ia tio n is c a lc u la te d m o n th ly a t 2 0 p e r c e n t p e r a n n u m fo r p la n t a n d e q u ip m e n t, b a se d o n cost,
n
C o m m is sio n s a re d e te rm in e d o n th e last d a y o f th e m onth a t $ 1 3 2 0 0 . T h e y w ill be p a id ne xt m onth,
o
The c o m p a n y is o w e d $ 1 0 0 0 0 in in tere st fro m th e b a n k a t th e e n d o f July.
CHAPTER 5 Accrual accounting adjustm ents
229
U sing W a n C h a i Lim ite d 's p re vio u s b a la n c e sheet as a s ta rtin g p o in t, p re p a re th e fo llo w in g d a ta fo r th e m onth e n d in g 31 J u ly 2 0 1 6 : 1 J o u rn a l en trie s a n d le d g e r a cco u n ts. 2
Post-adjustm ent tria l b a la n c e .
3
B a la n c e sheet a n d In co m e statem ent.
PROBLEM 5 .2 3 Recording a d ju s tin g entries and preparing a balance sheet and incom e s ta te m e n t SRP Ltd has th e fo llo w in g u n a d ju s te d tria l b a la n c e a t 31 D e c e m b e r 2 0 1 5 . Account titles
Cash
Debit
Credit
$
$
19 600
Accounts receivable
7000
Supplies
1 300
Prepaid insurance Equipment
900 27000
Accumulated depreciation Other assets
12 000 5100
Accounts payable
7500
Share capital (3000 shares outstanding all year)
16000
Retained profit
10 300
Service revenue COGS
48 000 32 900 93 800
93 800
D a ta no t y e t re c o rd e d a t 31 D e c e m b e r 2 0 1 5 in c lu d e th e fo llo w in g : a
D e p re c ia tio n e x p e n s e fo r 2 0 1 5 w a s $ 3 0 0 0 .
b
In su ra nce e x p ire d d u rin g 2 0 1 5 w a s $ 4 5 0 .
c
W a g e s e a rn e d b y e m p lo y e e s b u t no t y e t p a id on 31 D e c e m b e r 2 0 1 5 w a s $ 2 1 0 0 .
d
The su p p lie s c o u n to n 31 D e c e m b e r 2 0 1 5 re fle c te d $ 8 0 0 re m a in in g su p p lie s on h a n d to be used in 2 0 1 6 .
e
In co m e ta x e x p e n s e w a s $ 3 1 5 0 .
Required: 1 R ecord th e 2 0 1 5 a d ju s tin g e n trie s. 2
P re p a re a n in c o m e state m e nt a n d a c la s s ifie d b a la n c e sheet fo r 2 0 1 5 to in c lu d e th e effects o f th e p re c e d in g five tra n sa ctio n s.
3
P re p a re c lo s in g en trie s.
PROBLEM 5 .2 4 Ten-colum n w orksheet Refer to th e S c a n lo n e x a m p le in th e c h a p te r. C o m p le te a 10 -co lu m n w o rk s h e e t s e p a ra tin g o u t tra n s a c tio n k o n w a rd s as a d ju s tin g e n trie s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 5 .2 5 Com prehensive exam ple in clu d in g a m u lti-c o lu m n w orksheet CANBERRA LIMITED BALANCE SHEET AS AT 31 DECEMBER 2 0 1 4 1 Assets
$
Current assets
Liabilities
s 1
Current liabilities
Cash
21 000
Account payable
27000
Accounts receivable
39000
Unearned revenue
32 000
Inventory
40000
Total current liabilities
59000
Prepaid rent
11 000
Total current assets
111000
Noncurrent assets
Noncurrent liabilities Long-term debt
0
Total noncurrent liabilities
0
Land
100000
Total liabilities
Property and equipment
400000
Net assets
Accumulated depreciation
(80000)
Intangible assets (net)
90000
Total noncurrent assets
510000
621000
562000
Shareholders' equity Share capital Retained profits
Total assets
59 000
Total shareholders' equity
520000 42 000 562000
The fo llo w in g tra n s a c tio n s o c c u rre d fo r C a n b e rra Lim ited in 2 0 1 5 : a Issued s h a re c a p ita l fo r $ 2 0 0 0 0 0 cash , b
P urchased $ 3 5 0 0 0 o f in v e n to ry on c re d it,
c
P aid $ 2 8 0 0 0 to a cco u n ts p a y a b le .
d
S old in v e n to ry c o stin g $ 6 0 0 0 0 fo r $ 2 7 0 0 0 0 . A ll sales a re on c re d it,
e
C o lle c te d $ 5 2 0 0 0 fro m custom ers.
f
P re p a id $1 2 0 0 0 ren t fo r th e y e a r c o m m e n c in g 1 J a n u a ry 2 0 1 5 .
g
D e p re c ia te d p ro p e rty a n d e q u ip m e n t fo r th e y e a r using th e s tra ig h t-lin e m e th o d (2 0 p e r c e n t p e r an n u m ),
h
D iv id e n d s d e c la re d a n d p a id to ta lle d $ 3 0 0 0 0 .
i
B o rro w e d $ 1 0 0 0 0 0 on 1 J u ly 2 0 1 4 . The lo a n is d u e on 3 0 June 2 0 1 6 a n d c a rrie s a 1 0 p e r c e n t p .a . interest rate. P aid $ 4 0 0 0 in tere st on th is lo a n d u rin g 2 0 1 5 .
j
On
k
P aid w a g e s o f $ 9 0 0 0 0 ; w a g e s o f $ 2 0 0 0 0 h a d be en e a rn e d b u t n o t p a id .
1 N ovem ber
I
R eceived in tere st o f $ 5 0 0 0 in cash fro m th e b a n k .
p a id $ 2 4 0 0 0 fo r a n in su ra n c e p o lic y c o v e rin g
1 N ovem ber 2 0 1 4
to 31 O c to b e r 2 0 1 5 .
O n 31 D e c e m b e r 2 0 1 5 : m The u n e a rn e d re ven ue a c c o u n t h a d a b a la n c e o f $ 5 0 0 0 . n
A c c ru e d in te re st reven ue h a d a b a la n c e o f $ 2 0 0 0 .
Required: 1
P re p a re jo u rn a l en trie s fo r th e a b o v e tra n sa ctio n s.
2
P re p a re le d g e rs.
3
P re p a re c lo s in g e n trie s.
4
P re p a re a 10 -c o lu m n w o rk sh e e t.
5
P re p a re an in c o m e state m e nt a n d b a la n c e sheet fo r C a n b e rra Lim ited fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 5 .
CHAPTER 5 Accrual accounting adjustm ents
231
PROBLEM 5 .2 6 Accrual versus cash acco u n tin g The b a la n c e sheet o f A B C Ltd as a t 31 D e c e m b e r 2 0 1 5 a n d th e cash re ce ip ts a n d pa ym e n ts fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 a re s h o w n b e lo w . ABC LTD BALANCE SHEET AS AT 31 DECEMBER 2015 $ Assets
$ Liabilities
Cash
5 000
Accounts payable
1 0000 80000
Accounts receivable
10000
Bank loan
Inventory
20000
Shareholders' equity
Plant and equipment
200000
Share capital
Land
100 00 0
Retained profits
Total
335 000
Total
200000 45 000 335000
CASH RECEIPTS A N D DISBURSEMENTS FOR THE YEAR ENDED 31 DECEMBER 20 16 $ Receipts
$ Disbursements
Cash sales
150 00 0
Salaries
65 000
Total collected from accounts receivable
100 00 0
Repairs
2 000
Rates and taxes
3 000
Interest
6000
Total payments to Accounts payable Insurance 250000
130 00 0 8 000 214000
A d d itio n a l in fo rm a tio n : a A s a t 31 D e c e m b e r 2 0 1 6 , th e b a la n c e o f a c co u n ts re c e iv a b le w a s $ 2 5 0 0 0 a n d th e b a la n c e o f a c co u n ts p a y a b le w a s $ 1 5 0 0 0 . b
S a la rie s a re n o w p a id m o n th ly o n th e s e co n d o f th e m o nth fo r th e p re c e d in g m o nth . W a g e s a n d s a la rie s to ta l $ 7 0 0 0 fo r th e m onth o f D e c e m b e r. This w a s p a id on 2 J a n u a ry 2 0 1 7 .
c
P lant a n d e q u ip m e n t is s h o w n net o f a c c u m u la te d d e p re c ia tio n o f $ 5 0 0 0 0 . D e p re c ia tio n e x p e n s e fo r th e y e a r is c a lc u la te d using th e s tra ig h t-lin e m e th o d a t 1 0 p e r c e n t p e r an n u m .
d
The b a n k lo a n a ccru e s in tere st a t a ra te o f 1 0 p e r c e n t p e r a n n u m , p a y a b le on 3 0 M a rc h a n d 3 0 S e p te m b e r. The lo a n w a s ta ke n o u t on 31 D e c e m b e r 2 0 1 5 .
e
A p h y s ic a l s to c kta ke , as a t 31 D e c e m b e r 2 0 1 6 , re v e a le d th a t in v e n to ry c o s tin g $ 2 3 0 0 0 w a s on h a n d . C o s t o f g o o d s s o ld fo r the y e a r w a s c a lc u la te d a s $ 1 3 2 0 0 0 .
f
The in su ra n c e p re m iu m o f $ 8 0 0 0 p ro v id e s c o v e r fo r th e y e a r e n d e d 3 0 S e p te m b e r 2 0 1 7 .
R e q u ire d : 1 C a lc u la te th e fo llo w in g : a
to ta l sales fo r th e p e rio d
b
gross p ro fit
c
sa la rie s e x p e n s e a n d a c c ru e d s a la rie s
d
in tere st e x p e n s e a n d a c c ru e d interest
e
in su ra n c e e x p e n s e a n d p re p a id in su ra n ce .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
2
W h a t w a s th e p ro fit/(lo s s ) fo r th e p e rio d ?
3
P re p a re th e b a la n c e sheet as a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 5 .2 7 C alculating accrual in fo rm a tio n From cash in fo rm a tio n The fo llo w in g in fo rm a tio n has be en e x tra c te d fro m th e a cco u n ts o f PQR Ltd. PQR LTD BALANCE SHEET AS AT 3 0 JUNE 20 15 Assets
$
$
Liabilities and shareholders' equity
Cash
25 000
Accounts payable
Accounts receivable
1 4000
Revenue received in advance
32 000
Accrued interest
Inventory Plant and equipment
150 00 0
Accumulated depreciation
40000
110 00 0
$ 19 000 8 000 1 000
Loan
25 000
Share capital
80000
Retained profits
48 000
181 000
181 00 0
CASH RECEIPTS FOR THE YEAR ENDED 3 0 JUNE 20 16 $ Cash sales
92 000
Receipts from accounts receivable
385000 477000
CASH PAYMENTS FOR THE YEAR ENDED 3 0 JUNE 20 16 $ Payments for accounts payable
172 00 0
Repayment of loan ($25 000) and interest ($2000)
27000
Administrative expenses
46000
Dividend payment
31 000 276000
A d d itio n a l in fo rm a tio n : a B alan ce s as a t 3 0 June 2 0 1 6 :
Inventory
$20000
Accounts receivable
$24000
b
C re d it pu rch ases o f in v e n to ry to ta lle d $ 1 7 6 0 0 0 fo r th e y e a r.
c
The services re la tin g to th e re ven ue re c e ive d in a d v a n c e a t 3 0 June 2 0 1 5 w e re p ro v id e d d u rin g th e y e a r,
d
N o a d d itio n s o r d is p o s a ls o f p la n t a n d e q u ip m e n t w e re m a d e d u rin g th e p e rio d . The d e p re c ia tio n ra te is 2 0 p e r c e n t p e r a n n u m . The s tra ig h t-lin e m e th o d is used.
CHAPTER 5 Accrual accounting adjustm ents
233
e
A d m in is tra tiv e expe nses in c lu d e d a p re p a y m e n t o f $ 4 0 0 0 fo r J u ly 2 0 1 6 .
f
A c c ru e d in tere st o n 3 0 June 2 0 1 5 re la te d to th e lo a n w h ic h w a s re p a id d u rin g th e y e a r. T here is no a c c ru e d in tere st as a t 3 0 June 2 0 1 6 .
R e q u ire d : 1 C a lc u la te to ta l reven ue fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . 2
List a ll expe nses fo r th e y e a r (in c lu d in g d o lla r a m ou nts).
3
C a lc u la te th e b a la n c e o f cash as a t 3 0 June 2 0 1 6 .
4
P ro v id e a b a la n c e sheet as a t 3 0 June 2 0 1 6 .
CASES CASE 5A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in th e a p p e n d ix a t th e b a c k o f th e b o o k . A ll qu e stio n s re la te to th e c o n s o lid a te d a cco u n ts. 1 Is th e re a n y in d ic a tio n o f th e fo llo w in g in th e a cco u n ts: a
p re p a ym e n ts?
b
u n e a rn e d revenue?
c
a c c ru e d expenses?
d
a c c ru e d revenues?
2
W h y w o u ld W o o lw o rth s Lim ited use 2 9 June 2 0 1 4 (3 0 June 2 0 1 3) ra th e r th a n 3 0 June as th e fin a n c ia l year-e nd?
3
W h a t is th e net b o o k v a lu e fo r: a
fre e h o ld la n d , w a re h o u s e s , re ta il a n d o th e r p ro p e rtie s ?
b
p la n t a n d e q u ip m e n t?
4
G iv e e x a m p le s fro m W o o lw o rth s ' fin a n c ia l statem ents to in d ic a te th a t it uses a c c ru a l a c c o u n tin g .
5
W h a t is th e d e p re c ia tio n fo r th e y e a r on p la n t a n d e q u ip m e n t a n d w h a t is th e b a la n c e o f a c c u m u la te d d e p re c ia tio n a t y e a r-e n d fo r p la n t a n d e q u ip m e n t?
CASE 5B_________________________Accrual accounting adjustm ents G o to th e fin a n c ia l statem ents o f Telstra Lim ited a n d fin d w h e re th e fo llo w in g item s a re lo c a te d (they w ill be on the b a la n c e sheet o r in o n e o f th e notes re la te d to th e b a la n c e sheet): 1 P rep aym e nts 2
A c c ru e d expe nses
3
U n e a rn e d reven ue
4
A c c ru e d reven ue .
State w h e re y o u fo u n d th e item s a n d th e d o lla r a m o u n t o f e a c h . If an item is listed u n d e r a d iffe re n t na m e , state w h a t it is.
CASE 5C________________________ Accrual accounting adjustm ents G o to th e fin a n c ia l statem ents o f JB Hi-Fi Lim ited a n d fin d w h e re th e fo llo w in g item s a re lo c a te d (they w ill be on the b a la n c e sheet o r in o n e o f th e notes re la te d to th e b a la n c e sheet): 1 P rep aym e nts 2
A c c ru e d expe nses
3
U n e a rn e d reven ue
4
A c c ru e d reven ue .
State w h e re y o u fo u n d th e item s a n d th e d o lla r a m o u n t o f e a c h . If an item is listed u n d e r a d iffe re n t na m e , state w h a t it is.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
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f C o u rs e M a te Go to h ttp ://lo g in .c e n g a g e b ra in .c o m to access CourseMate, your online study tool for Financial Accounting. CourseMate brings chapter concepts to life with interactive learning, study and exam preparation tools. >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Financial reporting principles, accounting standards and auditing ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE explain w h y financial accounting has authoritative standards and accounting principles (G AA P) explain G A A P and its com ponents describe the set of principles a n d concepts that g u id e the p rep aratio n o f financial reports explain the principles of financial accounting a n d h o w each directly affects the process of financial accounting define assets, liabilities and equity, a n d determ ine w h ether certain items m eet these definitions determ ine w h en an asset or liability is to be recognised list and explain the contents of annual reports in A ustralia explain the nature a n d purpose of an a u d it describe the types of a u d it reports issued m ake judgem ents on the a p p ro p ria te responses to certain ethical dilem m as describe the w a y in w hich c ap ital markets op e ra te describe the role o f financial accounting inform ation in c ap ital markets explain w h a t is m eant by an efficient c ap ital m arket explain the im plications for financial accounting for business contract arrangem ents.
CHAPTER OVERVIEW This is th e la st o f th e s ix c h a p te rs in tro d u c in g th e fin a n c ia l state m e nts. It has fe w n u m b e rs . (P erh ap s th e b re a k fro m n u m b e rs w ill h e lp th e p re v io u s m a te ria l settle in to y o u r u n d e rs ta n d in g !) In ste a d , th is c h a p te r fo cu ses on th e la rg e system o f s ta n d a rd s a n d p rin c ip le s th a t g o v e rn th e w a y a c c o u n ta n ts a s se m b le th e n u m b e rs . W e h a ve seen th a t a c c ru a l a c c o u n tin g a n d even tra n s a c tio n re c o rd in g re q u ire ju d g e m e n t a n d m a n a g e ria l d e c is io n s . N o w w e w ill d e lv e in to th e c o n c e p ts th a t g u id e th e a c c o u n ta n ts a n d th e a c c o u n tin g . Both d o in g a c c o u n tin g a n d usin g a c c o u n tin g in fo rm a tio n re q u ire a so lid c o n c e p tu a l u n d e rs ta n d in g , in a d d itio n to b e in g a b le to w o rk w ith th e n u m b ers. A c c o u n tin g in fo rm a tio n d o e s n 't just a p p e a r; it fo llo w s a c c e p te d s ta n d a rd s o f p re p a ra tio n , fo rm a t a n d disc lo su re , o r sh o u ld fo llo w th em . A c c o u n tin g s ta n d a rd s a n d p rin c ip le s a re n o t just 'th e o ry ': th e y a re a set o f v e ry p ra c tic a l g u id e lin e s th a t a c co u n ta n ts a n d m a n a g e rs fo llo w e v e ry d a y . This c h a p te r is a fo u n d a tio n fo r s u cc e e d in g c h a p te rs , w h ic h g e t in to th e s p e c ifics o f d o in g a c c o u n tin g a n d m a k in g a c c o u n tin g c h o ice s, a n d use th e p rin c ip le s fro m this c h a p te r c o n tin u o u s ly . If y o u a re g o in g to be a user o f a c c o u n tin g re p o rts, it is no t o n ly im p o rta n t to u n d e rsta n d the a b o v e b u t a ls o to be a w a re o f th e b ro a d e r c o n te n t o f a n a n n u a l re p o rt, h o w to in te rp re t a n a u d it re p o rt, a n d h o w a c c o u n tin g nu m b ers a re used in c a p ita l m a rke ts a n d c o n tra c tu a l a rra n g e m e n ts .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6.1 Introduction: accounting standards and principles B elow is a quote from a C a n a d ia n courtroom . It is a nice illustration o f just h o w im portant accounting standards are. La dies a n d g e n tle m e n o f th e j u r y , I p u t it t o y o u t h a t th e d e fe n d a n ts , M a r k e t D a r lin g In c .’s t o p m a n a g e rs o n tria l h e re , w ilfu lly c ir c u m v e n te d a c c o u n tin g s ta n d a rd s in p re p a rin g th e s e t o f fin a n c ia l s ta te m e n ts t h a t a re th e h e a rt o f th is law su it. W h e n in v e s to rs , o r d in a r y C a n a d ia n s lik e y o u rs e lv e s , b o u g h t M a r k e t D a r lin g sh a re s, t h e y w e re p u tt in g t h e ir fa ith in th e c o m p a n y as w e ll as t h e ir sa vin g s, a n d p a rt o f t h a t fa ith w as t h a t th e y w o u ld g e t h o n e s t in fo r m a tio n in th e c o m p a n y ’s fin a n c ia l re p o rts . T h a t fa ith w a s d e s tro y e d b y th e c o m p a n y ’s s e lf-s e r v in g a c c o u n tin g , a n d th e e v id e n c e s h o w s t h a t s u c h a c c o u n tin g also led t o t h e c o lla p s e o f th e w h o le b u sin e ss a n d th e loss o f in v e s to rs ’ m o n e y as w e ll as t h e ir fa ith . I’ll s u m m a ris e th e m a in p a rts o f th is sad s to ry : •
M a r k e t D a rlin g b e g a n te n y e a rs a g o w ith a so lid b u sin e ss c o n c e p t a n d g o o d e m p lo y e e s . B u t to p
•
T o fu e l th e ra p id g r o w th th o s e m a n a g e rs w a n te d , th e c o m p a n y n e e d e d la rg e a m o u n ts o f m o n e y , w h ic h it
m a n a g e rs , th e r e a t th e d e fe n d a n ts ’ ta b le , w a n te d fa s te r g r o w th .
g o t f r o m sh a re issu es a n d b a n k b o rr o w in g , a n d s p e n t o n in c re a s in g ly g ra n d io s e a n d d u b io u s in v e s tm e n ts a n d a c q u is itio n s o f o t h e r c o m p a n ie s . •
T o c o n v in c e in v e s to rs a n d le n d e rs t h a t it w as d o in g w e ll, a n d so ke e p t h e ir m o n e y c o m in g in , th e
•
T o p m a n a g e rs fo u n d a c c o u n tin g to o c o n s e rv a tiv e a n d c a u tio u s f o r t h e ir lik in g , so th e y s ta r te d t o fin d
c o m p a n y ha d t o s h o w s tro n g g r o w th in e a rn in g s .
w a y s o f r e p o r tin g re v e n u e s t h a t w e re n o t re al a n d d e la y in g e x p e n s e s , a n d so p ro d u c e d a r tific ia lly h ig h e a rn in g s , re ta in e d e a rn in g s a n d a s s e ts lik e re c e iv a b le s a n d in v e n to rie s . •
T h e c o n tin u o u s a n d in c re a s in g d e m a n d f o r e a rn in g s g r o w th b e c a m e a tre a d m ill. T h e c o m p a n y be g a n m a k in g b u sin e ss d e a ls a n d a c q u irin g o t h e r c o m p a n ie s b e c a u s e t h e y m a d e th e a c c o u n tin g n u m b e rs lo o k g o o d , n o t b e c a u s e th e y m a d e b u s in e s s se nse . T r u s tin g in v e s to rs s u p p o r te d th e c o m p a n y , a n d th e sh a re p ric e ro s e m o r e th a n te n fo ld in a fe w ye a rs .
•
G e t t in g in c re a s in g ly g o o d a c c o u n tin g re s u lts b e c a m e th e w h o le g o a l. B u t it w as a h o u s e o f c a rd s . T h e a c c o u n tin g w as u n fa ir, u n re lia b le , u n c o n v e n tio n a l, u n c o n s e rv a tiv e , a n d u ltim a te ly u n b e lie v a b le . W h e n in v e s to rs re a lis e d th is , th e y ran f o r c o v e r, a n d t h e sh a re p ric e c o lla p s e d . F a ith fu l in v e s to rs lo s t t h e ir s h irts , w h e n th e s h a re p ric e fe ll o v e r 9 5 p e r c e n t in a fe w w e e k s a n d t h e c o m p a n y w as fo r c e d in to b a n k ru p tc y .
•
La d ie s a n d g e n tle m e n , th is law s u it is fu n d a m e n ta lly a b o u t a c c o u n tin g s ta n d a rd s a n d th e c o m p a n y ’s fa ilu re t o fo llo w th e m . I f th e c o m p a n y ha d fo llo w e d a c c e p te d a c c o u n tin g s ta n d a rd s , in s te a d o f t r y in g to g e t a ro u n d t h e m , it w o u ld n o t ha ve g o tte n in to th is m e ss , in v e s to rs w o u ld n o t h a ve s u ffe r e d th e h u g e losses, a n d y o u w o u ld n o t be h e re t h in k in g a b o u t a c c o u n tin g o n th is fin e s u m m e r’s day.
N o d oubt m any of you reading this b o o k w ill one d a y be 'to p m anagers', but let's make sure you are not referred to as 'to p m anagers, there a t the defendants' ta b le '.
6.2 Accounting principles and the use of accounting inform ation H o w d o accountants d e c id e w h a t accounting is needed a nd then put their decisions into practice? This section outlines the conceptual background that guides accountants.
D oing accounting
takes expert know ledge,
considerable experience a n d continuous attention to n e w problem s an d solutions. C oncepts a nd principles are very im portant in accounting, because they form a lo g ica l structure that practising accountants use every d a y to consider problem s, make o r recom m end decisions a nd explain solutions.
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A p p lyin g accounting standards a nd principles depends on the particular accounting entity: the enterprise for w h ich the accounting is being d o n e . The local coffee shop is just as a p p ro p ria te an entity to be accounted fo r as are the groups o f corporations m aking up W o o lw o rth s or W e s tp a c , but decision criteria w o u ld im ply different accounting needs for the coffee shop entity, the retailer o r the bank, so g e n e ra lly a cce p te d accounting principles w o u ld be a p p lie d differently for these entities. (M o re a b o u t this in the 'For your interest' b ox a t the end of this section.) Financial accounting has a surprisingly large set o f concepts an d principles to g u id e accountants in preparing finan cia l statements, auditors in verifying them an d users in interpreting them. A very large am ount has been written a bou t the conceptual a nd theoretical side of acco u n tin g , a n d , as you s a w earlier, several groups are involved in setting fin a n cia l accounting standards a nd otherw ise regulating accounting inform ation. All this m aterial occupies m any metres o f library shelves an d much space in com puter databases. This section w ill g ive you a glim pse o f the conceptual structure behind fin a n cia l accounting b y focusing on some concepts of particular value to the users o f accounting inform ation. These concepts have been de d u ced by accountants, researchers an d standard-setters from lo g ic a nd the observation o f g o o d practices, a nd they a re used to g u id e everyone w h o prepares, audits, uses a nd studies fin a n cia l accounting. A phrase often used in relation to accounting's conceptual structure is 'g e n e ra lly acce p te d accounting principles' (GAAP). These a re the rules, standards a nd usual practices that com panies a re expected to fo llo w w hen p re paring their fin a n cia l statements. They a re a com bination o f the authoritative standards an d concept statements issued b y accounting standard-setters - such as the Australian A ccounting Standards B oard (AASB) and the Financial A ccounting Standards Board (FASB) in the United States - a nd the acce p te d w a ys of d o in g accounting that a re not included in such standards. Y ear by year, the set o f authoritative standards gets larger, but the w o rld continues to increase in com plexity, so the standards a re never extensive enough to include everything. Perhaps they should not try to cover everything, because if they d id , fin a n cia l accounting w o u ld be bound by a boring, inflexible set o f rules. The developm ent o f G A A P can be traced b a ck to the evolution o f fin a n cia l acco u n tin g , as w e ll as to the efforts of standard-setting bodies that attem pted to im prove accounting principles an d practices b y increasing the authoritative, docum ented part o f G A A P . Until the twentieth century w a s w e ll under w a y , authoritative accounting standards d id not exist. The catalyst that produced increased fin a n cia l disclosure a nd brought m ore rules governing it w a s the stock market crash o f 1 9 2 9 . Poor fin a n cia l reporting a nd disclosure w e re seen as contributing to the crash. It w a s argued that, had investors been better inform ed, they could have m ade sounder fin a n cia l decisions, thus preventing the stock market co lla p se an d its harmful e co n o m ic a n d social consequences. In A ustralia, the main G A A P consist of accounting standards a n d the conceptual fram ew ork. It all sounds a bit com plex, but if w e describe them o ne b y o ne it should becom e clearer. Think o f them as a p a c ka g e that together forms G A AP . W h ile , for m any years, there w e re significant differences in accounting standards betw een countries, recently the International A ccounting Standards Board (IASB) issued a w h o le series of accounting standards. The AASB uses the IASB pronouncem ents as the 'fo u n d atio n ' pronouncem ents, to w h ich it adds material d e ta ilin g the scope and a p p lic a b ility of a pronouncem ent in the Australian environm ent. A dd itio n s a re m ade, w h e re necessary, to broaden the content to cover sectors not addressed by an IASB pronouncem ent, an d dom estic, regulatory o r other issues. G e n e ra l concepts a nd principles to be used in preparing an d presenting fin a n cia l statements are set out in the Fram ew ork for the Preparation a n d Presentation o f F inancial Statements. (This is cited in the Australian A ccounting Standards an d in this b o o k as the Framework.) This Fram ew ork has im portant im plications, so w e n o w devote a com plete section to its coverage.
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FOR YOUR INTEREST W h ile w e ha ve G A A P , it is v e ry im p o r ta n t to c o n s id e r th e n e e d t o f i t th e a c c o u n tin g to th e c irc u m s ta n c e s o f th e p a rtic u la r a c c o u n tin g e n tity . H o w e v e r, i f y o u alw ays c h a n g e d e v e ry th in g to s u it e a ch e n te rp ris e , th e re w o u ld be n o s ta n d a rd s le ft an d n o c o m p a ra b ility to o t h e r e n te rp ris e s . I f e v e ry c o u rs e in th e u n iv e rs ity used a u n iq u e g ra d in g s y s te m , y o u c o u ld n ’t c o m p a re h o w y o u d id in d iffe r e n t c o u rs e s , o r c o m p u te a g r a d e - p o in t ave ra g e . H e re , v e ry b rie fly , a re th r e e e x a m p le s o f a c c o u n tin g d iffic u ltie s th a t fa c e a c c o u n ta n ts and m a n a g e rs . •
T h e A B C , as w e ll as c h a n n e ls N in e , T e n an d S e v e n , ha ve n a tio n a l T V n e tw o rk s in A u s tra lia . T h e A B C is p u b lic ly o w n e d , la rg e ly fin a n c e d b y th e g o v e r n m e n t o f A u s tra lia , an d is n o t g e n e ra lly s u p p o s e d to be tr y in g to m a k e a p r o fit, w h ile th e th r e e c o m m e rc ia l c h a n n e ls a re lis te d c o m p a n ie s an d a re d e fin ite ly tr y in g to m a k e a p r o fit. S h o u ld all f o u r use th e sa m e a c c o u n tin g m e th o d s , so th a t th e y m a y be c o m p a re d , o r do e s th e A B C ’s p u b lic o w n e rs h ip an d m a n d a te m e a n th a t its a c c o u n tin g s h o u ld be d iffe re n t? (T h e A B C ’s a c c o u n tin g w as v e ry d iffe r e n t 15 y e a rs ago fr o m th a t o f a p r o fit- m a k in g c o m p a n y , b u t its a c c o u n tin g has b e e n g e ttin g less an d less d iffe r e n t o v e r th e y e a rs .)
•
B e c a u s e c o m p a n ie s c a n n o t ‘o w n ’ th e ir e m p lo y e e s , all th o s e g re a t e m p lo y e e s a re n o t s h o w n o n th e b a la n ce s h e e t o f Q a n ta s , B H P o r U N S W A u s tra lia . B u t w h a t a b o u t a s p o rts te a m like th e S y d n e y S w an s o r M a n c h e s te r U n ite d ? T h e se te a m s o fte n p a y m illio n s o f d o lla rs f o r th e rig h t to ha ve p a rtic u la r p la y e rs play f o r th e m . H o w s h o u ld th e te a m a c c o u n t f o r s u c h s u m s ? A r e th e y assets o r e x p e n s e s ? I f th e y a re assets, h o w lo n g d o th e y la st? S h o u ld th e y be a m o rtis e d o v e r th e ‘u s e fu l life ’ o f th e p la y e r c o n c e rn e d ? T h a t w o u ld be to tr e a t th e p la y e r r a th e r like a m a c h in e o r a b u ild in g , b u t m a y b e , in an e c o n o m ic sense, t h a t ’s w h a t th e p la y e r is. (T h e a c tu a l p la y e rs a re n o t o n th e b a la n c e s h e e ts o f s o m e m a jo r s p o rtin g te a m s p a rtic u la rly in th e U n ite d S ta te s , b u t th e c o s ts to g e t th e m a re , and m a n y te a m s in d e e d a m o rtis e s u c h c o s ts o v e r th e le n g th o f tim e th e p la y e rs a re th o u g h t to be u s e fu l - an e x c e e d in g ly d iffic u lt e s tim a tio n to d o , w h e n an in ju ry , f o r e x a m p le , c a n re n d e r a s ta r p la y e r p r e tty w e ll useless lo n g b e fo re age w o u ld be e x p e c te d t o d o th e s a m e .)
•
H o w d o y o u fig u re o u t th e p ro fita b ility o f a b ig film like o n e o f th e S ta r W a rs s e rie s? S u c h a film s h o u ld a t tr a c t lo ts o f p e o p le t o th e th e a tr e s o o n a f te r it c o m e s o u t, b u t it w ill ( o r m ig h t) g e n e ra te o t h e r re v e n u e s f o r y e a rs , s u ch as d o w n lo a d s o r D V D sales, T V s c re e n in g s , p r o d u c t tie - in s an d b o o k s . (T h is is o n e o f a c c o u n tin g ’s h a rd e s t p ro b le m s . T h e re ha ve b e e n m a jo r la w s u its b e tw e e n p e o p le w h o are s u p p o s e d t o sh a re p r o fits fr o m film s an d d isa g re e a b o u t h o w s u c h p r o fits s h o u ld be c a lc u la te d , e s p e c ia lly h o w to fa c t o r in s u c h u n k n o w n s as fu tu r e re v e n u e s .)
6.3 Framework for the preparation and presentation of financial statem ents The Fram ew ork issued b y the AASB sets out the concepts that underlie the preparation o f fin a n cia l reports for external users. The Fram ew ork includes c o ve ra g e of: •
the objectives o f fin a n cia l reports
•
the assumptions underlying fin a n cia l reports
•
the qualitative characteristics that determ ine the usefulness o f fin a n cia l reports
•
the definition o f the elements from w h ich fin a n cia l reports are constructed: assets, liabilities, equity, incom e and expenses
•
recognition an d measurement o f the elements o f fin a n cia l statements.
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Some o f these items w ill sound fam iliar. For exam ple, in C hapter 1 w e discussed the basic qualitative characteristics that determ ine the usefulness o f financial reports, an d in C hapter 2 w e introduced you to definitions o f the key elements o f the financial statements, including assets a nd liabilities. These concepts w ill be e xp anded on here before w e take a more detailed look at the various bala n ce sheet, incom e statement a nd cash flo w elements in the later chapters. The Fram ew ork makes a distinction betw een general purpose fin a n cia l statements a nd special purpose financial statements. The Fram ew ork deals w ith general purpose fin a n cia l statements (as does this book). These general purpose fin a n cia l statements are a im ed at the com m on inform ation needs o f a w id e range o f users. These users gene ra lly have to rely on the fin a n cia l report as their m ajor source o f fin a n cia l inform ation. S pecial purpose reports, such as prospectuses for the issue o f shares, are outside the scope o f the Framework. In C h a p te r 1, you w e re introduced to the users o f fin a n cia l reports. These include: investors, em ployees, lenders, suppliers an d other trade creditors, customers, governments a nd their agencies, an d the public. The Framework takes the v ie w that investors, lenders and other creditors are the main users o f the financial reports, as the objective of general purpose financial reports is to provide information to existing and potential investors, lenders and other creditors to a llo w them to make decisions about providing resources to the organisation (Framework, 201 3, O B 2). The Fram ew ork also recognises that the users o f inform ation a b o u t not-for-profit organisations m ay be different and their resource a llo ca tio n decisions m ay differ. For exam ple, they include donors, taxpayers, recipients o f the services (e.g. the community) a n d parties p ro vid in g an oversight role (e.g. Parliament).
The objective o f financial reports The o b je ctive o f fin a n cia l reports is to pro vid e inform ation a b o u t fin a n cia l position, fin a n cia l perform ance a nd cash flow s that is useful to users in m aking e conom ic decisions. These econom ic decisions, w hich w ill vary depending on the user, generally require an evaluation of the ability of the entity to generate cash in the future. Users are interested in the timing of that cash generation and the level of certainty; that is, how likely it is that the cash w ill be generated. This future cash generation is an important determinant of the ability of the entity to pay dividends to shareholders, w ages to employees, interest to lenders and tax to the government. The Framework argues that decisions by potential users depend on the returns they expect (e.g. dividends, interest and capital gains/losses) and that expectations about returns depend on the assessments about the amount, timing and uncertainty of future cash flows. To help predict future cash flow s users need to kn o w about: •
the econom ic resources (e.g. land an d buildings, equipm ent a nd patents) that the entity controls
•
the claim s aga in st the entity (e.g. am ounts o w in g ) a n d h o w effectively a nd efficiently m anagem ent a nd the board have disch a rg e d their duties (Fram ework, 2 01 3 , O B 3 an d 4).
•
inform ation a b o u t the nature an d am ounts o f these resources a nd claim s related to the fin a n cia l position o f the entity. This inform ation helps users identify strengths a nd weaknesses, the entity's liq u id ity a nd solvency, a nd its need for a d d itio n a l fin a n ce a nd likelihood o f a ttaining it. In a d d itio n to kn o w in g a b o u t the present level o f resources a nd claim s, users also need to kn o w a b o u t changes in
these am ounts from both fin a n cia l perform ance a nd other transactions such as b o rro w in g m oney (e.g. bank loans) and issuing shares. Information on fin a n cia l perform ance (as measured by calculating the profit from the organisation) is useful for a num ber o f reasons: •
It helps users understand w h a t return shareholders get on their equity (return on equity) w h ich indicates h o w efficiently a n d effectively the organisation has used its resources.
•
Inform ation a b o u t the v a ria b ility o f this return a nd its com ponents (discussed in detail in C h a p te r 15 under ratios) helps assess future cash flow s (Fram ework, 2 0 1 3 , O B 15 -1 6 ).
U nderlying assum ptions T w o key assumptions in the preparation o f fin a n cia l statements are the use o f the accrual basis a nd the g o in g concern concept.
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A C C R U A L BASIS O F A C C O U N T IN G Financial reports are prepared on the accrual basis of accounting. As outlined earlier in the book, the accrual basis recognises the effects of transactions and events w hen they occur (which m ay or may not be w hen the cash is received). This use of accrual accounting probably does not surprise you, as w e have been using it since C hapter 1. The Framework emphasises that the use of accrual accounting provides a better basis for assessing an entity's past and future performance than information only related to cash receipts and cash payments during a period (Framework, 201 3, O B 17). Financial reports are norm ally prepared on the assumption that the entity w ill continue in o p eration for the foreseeable future. If this is not the case, a nd the entity intends o r needs to liquidate, it is necessary to prepare the financial reports on a basis other than historical cost. C o n sid e r the fo llo w in g exam ple. Assume last ye a r your university com pletely rem odelled yo u r classrooms w ith n ew carpet, tiered seating an d n e w inbuilt projection equipm ent. U nder historical cost, the cost o f all those renovations w o u ld be recorded as an asset a n d then d epreciated over the life o f the asset. If the costs w e re $ 1 0 m illion an d dep re cia tio n in ye a r 1 w a s $1 m illion, the b o o k value (cost — accum ulated depreciation) w o u ld be $ 9 m illion. This is the am ount that w o u ld a p p e a r on the b alance sheet. Frtowever, if the governm ent closed your university — that is, it is no longer a g o in g concern — the assets w o u ld need to be recorded a t liq uidation value. B asically, they w o u ld be recorded at w h a t they could be sold for. N o te that there is not much o f a secondhand market for tiered seating to fit a certain size of room , o r carpet that has been cut to fit that room . Liquidation value in this case w o u ld be a lot less than historical b o o k value. W h ile the Fram ew ork o n ly lists accrual accounting an d g o in g concern as the basic assumptions o f financial reporting, m any authors, including us, w o u ld also include the accounting entity, accounting period an d the monetary assumptions that w e described in C h a p te r 1 as key underlying assumptions. The Fram ew ork (201 3) also notes that fin a n cia l perform ance is reflected by past cash flow s a nd that these past cash flow s help users assess future cash flow s.
FOR YOUR INTEREST In th e pa st, g o v e rn m e n ts and g o v e rn m e n t d e p a rtm e n ts used cash r a th e r th a n a c c ru a l a c c o u n tin g . In 1991 th e N S W G o v e r n m e n t in tro d u c e d a c c ru a l a c c o u n tin g , an d in 1 9 9 8 th e C o m m o n w e a lth G o v e r n m e n t m o v e d to a c c ru a l a c c o u n tin g . A ll o t h e r s ta te s an d te r rito r ie s n o w also use a c c ru a l a c c o u n tin g .
Q ualitative characteristics o f financial repo rting Q u a lita tive characteristics are the attributes that make the inform ation p rovided in fin a n cia l reports useful to users. These qualitative attributes are categorised as fundam ental o r enhancing. The fundam ental q ualitative characteristics o f inform ation are: •
relevance
•
faithful representation. The enhancing q u alitative characteristics o f inform ation are:
•
c o m p a rab ility
•
verifia b ility
•
timeliness
•
understandability. The Fram ework states that the four characteristics enhance inform ation that is both relevant and faithfully represented.
You w ill recall (we hope) that these w e re discussed in C h a p te r 1. You should refer to section 1 .7 for the definitions of each. W ith the a d d itio n a l know ledge you have g a in e d from the last five chapters, some a d d itio n a l obseivations can be m ade at this stage a bout the four enhancing characteristics to make inform ation both relevant an d faithfully represented.
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In terms o f c o m p a rab ility, G A A P contains m any deta ile d rules w ith several industry exceptions a n d alternative accounting policies for the same transactions. This can result in com panies com ing to technically com petent conclusions that m ay be inconsistent w ith the underlying econom ic substance o f a particular transaction. All these exceptions a nd alternative treatments certainly lead to some difficulties in m aking com parisons across com panies. Analysts often com e up w ith their o w n standard w a y o f presenting accounting d a ta by taking published fin a n cial d a ta a n d converting it to their o w n requirements.
2
Verification relates to faithful representation of e co n o m ic phenom ena. V erification can be direct (e.g. counting inventory o r cash) o r indirect, through checking the inputs to a m odel, formula o r other techniques related to measurement (e.g. the calculation o f d epreciation).
3
Timeliness refers to having inform ation a v a ila b le w hen users need to make their decisions. H ow ever, having inform ation earlier rather than later can mean that it is less com plete. For exam ple, certain estimates becom e more accurate over time (e.g. the estim ate o f uncollectible accounts receivable, discussed in C h a p te r 8 , o r the obsolescence o f inventory, discussed in C h a p te r 9). Liabilities related to certain past acts m ay also becom e more accurately m easured as time passes. H ow ever, the characteristic o f timeliness incorporates the idea that it is im portant to have the inform ation w hen the decision is being m ade.
4
U nderstandabilily: The Fram ew ork states that users a re expected to have a reasonable kn o w le d g e o f business, eco n o m ic activities an d a ccounting, a n d a w illingness to study the inform ation w ith reasonable d ilig e n ce. H ow ever, there is a caveat: inform ation a b o u t co m p le x matters, if relevant to users, should not be excluded on the grounds that it is too difficult for users to understand. O v e r the last 1 0 years there have been m any claim s from sophisticated users o f accounting reports that the
com plexity in accounting has becom e so great that even experts have trouble understanding a published set of finan cia l reports. These concerns have been expressed in both A ustralia a nd overseas. O n e exam ple is the 2 0 0 8 Pozen Report, the Progress Report o f the A d v is o ry C om m ittee on Improvements to Financial R eporting to the U nited States Securities a n d Exchange Com m ission. The Pozen C om m ittee's o b je ctive w a s to exam ine the US fin a n cial reporting system a n d make recom m endations to increase the usefulness o f fin a n cia l reports to investors, creditors and other users w h ile reducing the com plexity o f the reporting system. The Pozen C om m ittee w a s particularly critical o f the com plexity caused b y m ore an d m ore deta ile d accounting standards, as a huge increase in com plexity makes it difficult for investors to understand the econom ic substance o f transactions a nd the entity's overall fin a n cia l position and perform ance. This also m ade it difficult for preparers to properly a p p ly G A A P an d com m unicate the econom ic substance o f transactions an d events; an d for others to audit, analyse an d regulate a co m p a n y's fin a n cia l reporting. W h a t does all this mean for you as an introductory accounting student? These accounting standards are continually being considered around the w o rld . Som e im portant changes in accounting have a lre a d y occurred and others are still em erging. A ccounting is not static; the better you understand the basic fundam entals o f a ccounting, the better you w ill be a b le to c o p e w ith these changes.
Elem ents o f financial statem ents The key elements of financial statements related to financial position are assets, liabilities and equity; those related to financial performance are income and expenses. These elements w ere introduced in earlier chapters, particularly C hapter 2. In earlier chapters w e referred to revenues, w hich, as you w ill see below , are one of the subelements of income.
ASSETS Assets are resources controlled by an entity as a result o f past events, a nd from w h ich future e conom ic benefits are expected to flo w to the entity. Let's consider some aspects o f the definition: •
The a b o ve definition specifies the essential features o f an asset, but not the criteria that need to be met before assets are recognised in the balance sheet; that is, the definition includes items that m ay not be included in the balance sheet because o f such factors as the reliability o f the measurement. These criteria are discussed later in this section.
•
'Future econom ic benefits' refers to the asset's potential to contribute to the flo w of cash (or cash equivalents) to the entity. This may be singly or in com bination w ith other assets. It m ay include assets (such as equipment) producing
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goods or services that are sold; it m ay be the ca p a city to reduce cash outflows (alternative manufacturing processes that reduce the cost of production); it m ay be resources that are convertible to cash (such as receivables or inventory). •
W h ile m any assets have physical form (such as property, plant a nd equipm ent [PPE]), this is not essential, as for
•
W h ile the right o f ow nership is com m on for m any assets (such as receivables or property), it is not essential; for
patents, tradem arks a nd copyrights (usually ca lle d intangibles).
exam ple, a lease o f equipm ent can be an asset if the entity controls the benefits that are expected to flo w to the entity. •
An asset must be as a result o f a past transaction o r other past events. This w ill norm ally be purchasing or producing the asset, but other exam ples could be the discovery o f mineral o r oil deposits, o r property given b y the governm ent as part o f a developm ent plan.
•
C ontrol by the entity relates to the ca p a city o f an entity to benefit from the asset in pursuing its objectives and to deny o r regulate the access o f others. The entity controlling the asset is the one that can exchange it, use it to provide goods or services, a nd charge others for its use. Although the a b ility to control the future econom ic benefits m ay be a result o f legally enforceable rights, this is not an essential characteristic o f an asset. For exam ple, under a lease agreem ent, the o w n e r (lessor) m ay transfer to the lessee control over the leased property for a certain period o f time. If the entity cannot d e n y others access to the benefits o f the asset, these future econom ic benefits w ill not be
controlled by the entity. For exam ple, consider a property de ve lo p e r w h o builds a series o f townhouses, a nd is required by the local council to put in road improvements o r a public park as part o f the project. If access to the road o r the park is open to the general public w ith o u t ch a rg e , then the de ve lo p e r does not have control over the asset.
ASSET R E C O G N IT IO N A further question addressed by the Fram ew ork is the criteria that should be used to recognise assets. Recognition refers to the reporting o f an item on the fa ce o f the fin a n cia l statements. For assets, the relevant fin a n cia l statement is the b a la n ce sheet. The Fram ew ork states that an asset should be recognised w hen an d o n ly w hen: •
It is p ro b a b le that a n y future econom ic benefits associated w ith the item w ill flo w to the entity.
•
The item has a cost o r value that can be measured w ith reliability. The term 'p ro b a b le ' means that the chance o f the future econom ic benefits arising is more likely rather than less
likely. For exam ple, a credit sale to a reputable customer still involves some p ro b a b ility that the am ount w ill not be collected. F-lowever, if the likelihood of non-receipt is remote at reporting date, the am ount o w in g to the entity w o u ld satisfy the criteria for recognition as an asset. For some expenditures, such as those on exploration, and research and developm ent, the degree o f certainty that the item w ill satisfy the criteria for recognition o f an asset often does not exist. For an asset to satisfy the recognition criteria, it is also necessary that it possess a cost o r other value that can be measured reliably. In most cases, assets have a cost that can be re liably measured; for exam ple, m otor vehicles, inventory o r equipm ent. An exam ple w h e re this is not the case is a m ining c o m p a n y that m ay have discovered, a t an imm aterial cost, some e vidence o f minerals on its exploration site, but a t the d a te o f reporting does not know the extent o f the minerals o r their value.
FOR YOUR INTEREST Y o u m a y have h e a rd C E O s say th a t th e ir s t a f f a re th e ir b ig g e s t a sse t. Y e t y o u w ill ha ve n o te d th a t s t a f f are n o t lis te d o n a n y b a la n c e s h e e t. O n e o f th e re a so n s is th e d iffic u lty o f p u ttin g a v a lu e o n s ta ff. In th e 1 9 7 0 s and 1 9 8 0 s , th e r e w as a lo t o f a c c o u n tin g re s e a rc h c a lle d h u m a n re s o u rc e a c c o u n tin g , w h ic h e x a m in e d th is q u e s tio n . S o m e s u g g e s tio n s f o r v a lu in g s ta ff in c lu d e d : •
all c o s ts s p e n t o n th e s t a f f m e m b e r (s u c h as th e c o s t o f tra in in g )
•
th e p re s e n t v a lu e o f th e fu tu r e cash th e s t a f f m e m b e r w ill g e n e ra te
•
th e c o s t o f tr a in in g a re p la c e m e n t.
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LIABILITIES A lia b ility is a present o b lig a tio n o f the entity arising from past events, the settlement o f w h ich is expected to result in an o u tflo w from the entity of resources e m b o d yin g e conom ic benefits. A g a in , w e should consider some o f the content o f this definition from the Framework: •
As w ith assets, this definition identifies essential features, but does not specify criteria for including the lia b ility on the b a la n ce sheet (this is covered below ).
•
Past transactions w o u ld include the a cq u irin g o f g o o d s a nd services (accounts p a yable), em ployees perform ing w o rk (w ages p a y a b le or provision o f e m ployee entitlements), the use o f m oney from the bank (interest payable), receipt o f a b a n k loan (bank loan), sale o f g o o d s (provision for w arranty) an d receipt o f cash in a d va n ce of p ro vid in g a service (revenue received in advance).
•
The existence o f a lia b ility depends on the present o b lig a tio n being such that the legal, social, p o litica l or e co n o m ic consequences o f fa ilin g to honour the o b lig a tio n leave the entity little, if any, discretion to a vo id the future sacrifice o f e co n o m ic benefits to another entity. For exam ple, an entity p la cin g an o rd e r for the purchase of g o o d s w o u ld not norm ally g ive rise to a liability, since the entity w o u ld norm ally have the discretion to a vo id the future sacrifice o f econom ic benefits by being a b le to cancel the order. The receipt o f the g o o d s w o u ld norm ally be the event that w o u ld create the lia b ility. F-lowever, if the g o o d s w e re to be m ade to the specifications o f the purchaser, it m ight not be possible to cancel the ord e r after the supplier com m enced manufacture o f the g oods, w ith o u t significant penalties. In these circum stances, a lia b ility w o u ld exist w hen the supplier com m enced manufacture o f the g oods.
•
Settlement o f a present o b lig a tio n can occur via: -
paym ent o f cash
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transfer o f other assets (e.g. a c o m p a n y has received a dep o sit on a p ie ce o f equipm ent it is p ro vid in g ; it later transfers that equipm ent to the person w h o p a id the deposit)
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provision o f services, w h e re am ounts have been received in a d va n ce o f services being p rovided (as w hen there has been a receipt o f cash for a future a irlin e flight), the lia b ility is later rem oved by p ro vid in g the service (i.e. p ro vid in g the flight for the passenger)
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replacem ent o f an o b lig a tio n w ith another o b lig a tio n (e.g. accrued expenses m ay later becom e accounts pay a b le w hen the c o m p a n y receives an invoice from the supplier)
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conversion o f the o b lig a tio n to equity (e.g. issuing shares to a c o m p a n y to extinguish a debt).
There a re tw o essential criteria for the recognition o f a liability: •
It is p ro b a b le that a n y future sacrifice o f econom ic benefits associated w ith the item w ill flo w to o r from the entity.
•
The item has a cost o r value that can be measured reliably. The term 'p ro b a b le ' means that the cha n ce o f the future sacrifice o f e conom ic benefits being required is more
likely rather than less likely. This p ro b a b ility can range from virtual certainty to highly unlikely. An exam ple o f virtual certainty w o u ld be that w a g e s during the month o f June are due to be p a id on 1 July. An exam ple o f it being highly unlikely w o u ld be that the c o m p a n y has guaranteed a loan from the b a n k to a highly pro fita b le subsidiary; the future sacrifice o f e co n o m ic benefits w o u ld o n ly occur if the subsidiary defaulted on the loan. W h ile the first exam ple w o u ld meet the criteria for recognition o f a lia b ility, the second exam ple w o u ld not. The second essential criterion is that the am ount o f the lia b ility can be re liably estim ated. V erifia b le e vidence of the am ounts to be p a id a nd the dates o f paym ent are a v a ila b le for m any liabilities (such as payments to creditors and repaym ents o f loans). FJowever, some p ro b a b le future sacrifices o f e co n o m ic benefits, such as lawsuits, cannot be reliably estim ated, a nd therefore a re not included as a lia b ility at this point in time. In betw een the a b o ve exam ples are future sacrifices related to future w a rra n ty expenses on products a lre a d y sold. These can norm ally be estim ated reliably based on previous experience w ith the products. Sim ilarly, estimates o f e m ployee entitlements can usually be estim ated on the basis o f past history a nd a ctuarial estimates.
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E Q U ITY Equity is defined in the Fram ew ork as the residual interest in the assets o f the entity after deduction o f its liabilities; that is, the difference betw een the am ounts assigned to its assets an d liabilities represents an elem ent o f the b a la n ce sheet that is referred to as equity (i.e. A = L + SE; SE = A - L). O th e r names b y w h ich equity is sometimes known include ow ners' equity, shareholders' equity a nd shareholders' funds. In the Fram ework, the a p p ro a ch taken o f defin in g equity as a residual is based on the v ie w that equity cannot be defined independently o f the other elements com prising the b a la n ce sheet. A cc o rd in g ly, the concepts o f assets and liabilities must be d e fined before a definition o f equity can be m ade ope ra tio n a l. Equity ranks after liabilities as a claim to the assets of an entity. In the event of the entity being w o u n d up, all liabilities must be met before a distribution can be m ade to the entity's owners. This characteristic implies that equity is a residual interest - it is the claim to the net assets o f the entity; that is, to the assets after liabilities have been deducted.
IN C O M E Income is defined in the Fram ew ork as 'increases in econom ic benefits during the accounting p eriod in the form of inflow s o r enhancem ents o f assets o r decreases in liabilities that result in increases in equity, other than relating to contributions from equity participants'. This tells you that such things as the issue o f shares w o u ld not be included. The above definition o f income has tw o components: revenue (which w e have discussed in earlier chapters) and gains. Revenue arises in the course of ordinary activities of the entity, such as sales, fees, interest, rent, royalties and commissions. G ains refer to other items that meet the definition of income. G ains include the sale of a noncurrent asset above book value (cost minus accumulated depreciation). G ains are normally reported separately in the incom e statement. The recognition o f incom e occurs sim ultaneously w ith the recognition o f increases in assets (such as an increase in assets from the sale o f g o o d s or services) an d decreases in liabilities (such as a decrease in liabilities because another party has w a iv e d a d e b t p ayable). The future e conom ic benefit related to the increase in asset o r decrease in lia b ility must be reliably measured. In earlier chapters w e noted that the specific recognition o f revenue occurred w hen the g o o d s o r services w e re provided. Policies such as this are a im ed at restricting the recognition o f revenue to those items that can be measured reliably.
EXPENSES U nder the Fram ework, expenses are defined as decreases in e co n o m ic benefits during the accounting p eriod in the form of outflow s o f assets (such as cash p a id for w a g e s), depletions o f assets (such as dep re cia tio n o f equipm ent or expiration o f prepayments) o r incurrences o f liabilities (such as increase in provision for em ployee entitlements) that result in decreases in equity (retained profits decrease), other than those resulting in distributions to equity holders (dividends are not expenses). This definition o f expenses includes expenses that arise in the o rd in a ry course o f the business as w e ll as losses. Examples of the form er include cost o f g o o d s sold (C O G S ), w a g e s a nd d e p re cia tio n . They usually take the form of depletion in assets such as cash (wages), inventory (C O G S ) o r PPE (depreciation). Losses include those resulting from disasters, such as fire o r flo o d , a nd from the disposal o f assets w h e re the asset is sold for less than its b o o k value (cost minus accum ulated depreciation). Expenses are recognised in the incom e statement w hen there is a decrease in future e conom ic benefits related to either a decrease in asset (such as de p re cia tio n o f equipm ent o r cash p a id for w a g e s) o r an increase in a lia b ility (increase in electricity p a y a b le or an increase in the provision for em ployee entitlements) that can be reliably measured. The recognition of the expense occurs at the same tim e - the other side of the double-entry system - w ith the recognition o f the decrease in asset or increase in liability. M a tch in g involves trying to line up measures of econom ic inflow s w ith outflow s. It involves the simultaneous recognition o f revenues w ith related expenses. For exam ple, the recognition o f cost of g o o d s sold expense a t the same time as the revenue from the sale (recall in e arlier chapters DR C O G S , CR Inventory, DR Accounts receivable and CR Sales revenue). Sim ilarly, sales commission w o u ld be taken up in the sam e p eriod as the sales revenue to w hich it relates.
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M easurem ent o f the elem ents o f financial statem ents The Fram ew ork describes measurement as the process o f determ ining the m onetary amounts that the elements o f the finan cia l statements a re to be recognised at a nd included in the b a la n ce sheet (assets, liabilities an d equity) an d the incom e statement (incom e an d expenses). The Fram ew ork sets out a num ber o f different measurement bases that are em ployed to different degrees, an d in varying com binations, in fin a n cia l reports. In p a ra g ra p h 1 0 0 o f the Fram ew ork the fo llo w in g are identified: •
H isto rica l cost: Assets are recorded a t the am ount o f cash o r cash equivalents p a id o r the fa ir value o f the consideration given to acq u ire them at the time of their acquisition. Liabilities a re recorded a t the am ount of proceeds received in e xch a n g e for the o b lig a tio n or, in some circumstances (e.g. incom e taxes), at the am ounts of cash o r cash equivalents expected to be p a id to satisfy the lia b ility in the normal course o f business.
•
C urrent cost: Assets a re carried at the am ount of cash o r cash equivalents that w o u ld have to be p a id if the same o r an equivalent asset w a s a cq u ire d currently. Liabilities are carried a t the undiscounted am ount o f cash o r cash equivalents that w o u ld be required to settle the o b lig a tio n currently.
•
Realisable (settlement) value: Assets are ca rried a t the am ount o f cash o r cash equivalents that could currently be o b ta in e d b y selling the asset in an o rderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted am ounts o f cash o r cash equivalents expected to be p a id to satisfy the liabilities in the normal course o f business.
•
Present value: Assets are carried at the present discounted value o f the future net cash inflow s that the item is expected to generate in the normal course o f business. Liabilities are ca rried at the present discounted value o f the future net cash outflow s that a re expected to be required to settle the liabilities in the normal course o f business.
6.4
Assets and liabilities: valuation and measurement
W h e n w e look a t fin a n cia l inform ation, w h a t d o the numbers (the numeric values assigned to assets a nd liabilities) m ean? The asset valuation question is both com plex a nd controversial. You m ay intuitively think that the assets should be valued at w h a t they are w orth, but w h a t does that m ean? There are five basic methods often suggested for measuring (valuing) assets an d liabilities: •
historical cost
•
price-level-adjusted historical cost
•
current or market value (value in exchange)
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value in use (or present value)
•
liq uidation value. As you read the description below of each measurement and valuation method, think about w hich one you believe is
appropriate, and in w hich circumstances. There is a lot of variety and personal judgement within generally accepted accounting principles, so no one method, even the main one (historical cost), is considered to be the best in all circumstances. Asset an d lia b ility valuation is often controversial, partly because o f a concern that the values should be useful in people's decision-m aking an d a suspicion that historical cost values are not as useful as those that look m ore to the future. W o u ld you drive yo u r ca r looking o n ly in the rear-view mirror to see w h e re you have been, an d not looking out the front w in d o w to see w h e re you are g o in g ? O n e w o rry is that historical cost valuation, the most com m on method, positions fin a n cia l statements to o much in the past, w hen there are e q u a lly im portant needs to recognise changes in market conditions an d to predict the future w hen making decisions. T w o controversies w ill serve as exam ples. For asset valuation, o ne issue is w hether market values m ay actu a lly be better than historical cost, at least in some cases, such as for the fin a n cia l an d m onetary assets of banks a nd sim ilar finan cia l institutions. For lia b ility valuation, an issue is w hether o b lig a tio n s due w e ll into the future, such as w a rra n ty o b liga tio n s, should be valued at the 'present value' o f the likely future payments (future cash flow s minus interest lost by w a itin g for the money), rather than just at the estim ated future cash o u tflo w itself, as is d o n e now . N o w let's turn to the five valuation methods.
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H istorical cost H istorical cost, otherw ise known as acquisition cost, values assets at the am ount p a id o r prom ised to a cq u ire the assets, and values liabilities a t the amounts of a n y associated promises. These amounts can g e n e ra lly be found by referring to transactional evidence, such as invoices, receipts o r contracts. The a b ility to docum ent the cost o f the asset is a m ajor reason w h y historical cost is the usual valuation method for most assets an d liabilities. A nother p rincipal reason is that an enterprise w ill rarely purchase assets o r make promises for their purchase for m ore than the enterprise believes them to be w orth. If you believe that an asset w ill pro vid e you w ith $ 1 0 0 0 0 w orth of productive ca p a city, you w ill not rationally p a y or prom ise m ore than $ 1 0 0 0 0 for it. U nder this method, an asset valued at historical cost is valued at its expected low est o r most conservative value o f future benefits at the d a te o f acquisition. In most cases, G A A P im ply the use of historical costs, unless some other valuation basis is m ore a p p ro p ria te and is sp e cifically disclosed in the fin a n cia l statements. For exam ple, note 1 o f BHP Billiton Pic's 2 0 1 4 financial statements states: 'entity accounts a re prepared ... using the historical cost convention, [w h ich has] been a p p lie d on a consistent basis w ith the ye a r e nded 3 0 J u n e 2 0 1 3 '. Some a d d itio n a l points in connection w ith this method are w orth noting: •
A t the point o f acquisition, historical cost = market value = value in use (present value), in most cases. W e assume that rational p e o p le w o u ld o nly p a y w h a t the asset is w orth to them in the future in their business, a nd that, in general, such use valuation w o u ld therefore tend to determ ine the market value of the asset.
•
M u ch o f the criticism o f historical cost has to d o w ith tim e issues. If a piece o f land w a s purchased 1 0 years a g o for $ 5 0 0 0 0 , this has little m eaning to d a y . Is the land w orth $ 2 0 0 0 0 0 o r $ 1 0 0 ? That is som ething you d o not know w ith historical cost.
•
If an asset's market value later falls b e lo w its original cost, the asset m ay be written d o w n to the market value. This violation o f strict historical cost accounting is very much part o f generally accepted accounting principles. It is behind tw o im portant accounting phenom ena: 'w riting d o w n ' o f unproductive assets an d the 'lo w e r o f cost o r market' rule used in valuing inventories and some other current assets. You w ill see more a bout these later in this book. C oncerns over h o w assets are valued using historical cost have led p e o p le to suggest alternative methods for
valuing assets an d liabilities on the b a la n ce sheet. Som e o f the m ore p o p u la r alternatives are show n b e lo w .
P rice -le ve l-a d ju ste d historical cost This a p p ro a ch , first proposed early in the tw entieth century, adjusts for changes in the value or purchasing p o w e r of the d o lla r (the measuring unit), rather than for changes in the values of particular assets. The historical cost values of the assets and liabilities a re adjusted for changes in the value of the d o lla r (using eco n o m y-w id e indices, such as the C onsum er Price Index) since the assets w e re a cq u ire d o r the liabilities w e re incurred. W h ile this method has been used in the past by some com panies a n d by some countries that had high inflation, it has not found much favour in A ustralia o r N orth A m erica. O n e reason for its lack o f p o p u la rity is that if historical cost is unsatisfactory co m pared to current values, adjusting the cost for inflation still makes it unsatisfactory, o nly n o w less understandable.
C urrent or m arket value (value in exchange) This a p p ro a ch records the individual assets an d liabilities a t their current particular market value. It focuses on the individual values o f the asset an d lia b ility items, not on changes in the d o lla r itself, as price-level-adjusted accounting does. It assumes that value is market-determined a n d that profit should be measured using changes over tim e in market values. The argum ent is that if, for exam ple, yo u r house's market w orth is greater to d a y than yesterday, you have m ade m oney on it to d a y, even if you have not sold it. If its market w orth is less, you have lost m oney on it, even if you have not sold it. This method has been the subject o f much w ritin g a n d experim entation, an d has some theoretical attraction. H ow ever, it does create difficulties a nd costs in estim ating current values. Current value accounting can use either input o r output values, o r a mixture of these. •
Input m arket value, o r entry value, refers to the am ount it w o u ld cost to bring the asset into the c o m p a n y if it w e re not currently in it. It is usually measured b y estim ating replacem ent cost, to purchase the asset a g a in , or reproduction cost, to make the asset a g a in . The same idea holds for the hypothetical re-borrow ing o f liabilities.
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O u tp u t m arket value, or exit value, is the am ount an asset is w orth if it w e re sold n o w (in other w o rd s, its net realisable value) o r the am ount that a lia b ility could be p a id o ff at now , usually m easured by quoted prices, app ra isa ls a nd sim ilar estimates.
•
Fair value is an alternative asset valuation method that you w ill see more an d more often. It is very sim ilar to market value, except it does not require a market value to exist. Fair value is the am ount of the consideration that w o u ld be agreed upon in an arm's-length transaction between know ledgeable, w illin g parties w h o are under no compulsion to act. This is a hypothetical am ount ('w ould be agreed'), but is supposed to represent a potential market transaction between tw o free agents, both know le d g e a b le and w illin g , a nd not related to each other ('arm's-length'). Fair value is being used increasingly internationally. Further reference to fa ir value is m ade in C h a p te r 10.
Value in use (present value) This a p p ro a ch considers that value flow s from the w a y the c o m p a n y w ill use the asset to generate future cash flow s. •
V alue in use is usually estim ated by ca lculating the net present value o f future cash inflow s (the cash flow s minus lost interest im plied by w a itin g for the cash) expected to be generated by the asset, o r cash outflow s it w ill make unnecessary.
•
Present value is the future cash flow s minus lost future interest im plied by w a itin g for the cash. For exam ple, suppose you are getting $ 1 in a year. If you had m oney now , you w o u ld be a b le to earn 1 0 per cent on it, but b y w a itin g a year, you g ive up that interest. The present value of the $ 1 is the am ount before the lost interest: the am ount that w o u ld build up to $1 in a ye a r at 1 0 per cent. That w o u ld be 91 cents. In a year, 91 cents at 1 0 per cent w o u ld earn 9 cents interest, bringing the total to the $1 you w ill get in a year. The present value (91 cents) is thus a lw a ys smaller than the future cash paym ent ($ 1 ), w h ich is said to be 'discounted' to a lo w er am ount to remove the effects o f future interest. Present value is covered further in the a p p e n d ix to C h a p te r 1 1. For exam ple, a m achine m ight be valued a cco rd in g to the products that it w ill make a nd that w ill be sold. M o d e rn
theories o f fin a n ce an d m anagem ent accounting presume that value in use, measured by the net present value, is an a p p ro p ria te method for m anagerial decisions a b o u t asset acquisition a nd fin a n cin g . M o re o ver, m any p e ople presume it underlies market values, but the a p p ro a ch has been little used in producing fin a n cia l accounting numbers.
FOR YOUR INTEREST T h e a b o v e d is c u s s io n o f fa ir v a lu e an d v a lu e in use is p a rtic u la rly im p o r ta n t f o r a c c o u n ta n ts in th e p re s e n t e n v iro n m e n t, as a c c o u n tin g s ta n d a rd s re q u ire d ire c to rs to e n s u re th e c a rry in g v a lu e o f an a s se t (c o s t m in u s a c c u m u la te d d e p re c ia tio n )) d o e s n o t e x c e e d its re c o v e ra b le a m o u n t. T h is re d u c tio n is c a lle d an im p a irm e n t loss an d is re c o g n is e d in th e in c o m e s ta te m e n t w ith th e e x p e n s e s . T h is is d isc u s se d in s e c tio n 1 0 .6 o f C h a p te r 1 0 . T h e re y o u w ill le a rn th a t ‘re c o v e ra b le a m o u n t’ re fe rs t o th e h ig h e r o f fa ir v a lu e less th e c o s t to sell th e asset an d th e a s s e t’s v a lu e in use. T h e re fo re , i f y o u are n o t s u re w h a t th e te rm s ‘fa ir v a lu e ’ and ‘v a lu e in u s e ’ m e a n , g o b a c k and re -re a d th e la st fe w pages.
Liquidation value Liquidation value is like output market value, but is used on a 'g o in g out o f business, sell it for w h a t you c a n ' basis. It is the value that the com pany's assets w o u ld bring upon being sold, a nd the value that liabilities w o u ld be p a id o ff for, if the w h o le c o m p a n y w e n t out o f business. It is used w hen the c o m p a n y is not felt to be a g o in g concern; that is, if its continued v ia b ility cannot be assumed. Therefore, the reader o f fin a n cia l statements that have been prepared on the historical cost basis should be entitled to presume that the c o m p a n y in question is a g o in g concern. This presum ption is an im portant part o f fin a n cial
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accounting, but every ye a r it turns out to be w ro n g for some com panies that unexpectedly fail. Such b a d outcomes remind us that g o o d judgem ent is required in selecting the valuation basis, as w ith other aspects o f financial accounting. The judgem ent that a c o m p a n y is a g o in g concern, an d should therefore use historical cost accounting, w ill turn out to be w ro n g if the c o m p a n y fails. C onversely, a judgem ent that a c o m p a n y is not a g o in g concern m ight be self-fulfilling: it m ight p a n ic creditors an d investors, a nd result in c o m p a n y failure.
An exam ple: cu rre n t m arket value as an a lterna tive to historical cost Let's look a t a realistic a nd relevant exam ple. In most countries, there are m any com panies that specialise in a cquiring and d e veloping real estate for o ffice buildings, shopping centres, industrial plants, housing developm ents a nd m any other uses. As you p ro b a b ly know , real estate values are highly va ria b le , w ith frequent boom s an d busts. Let's consider tw o fictional real estate developm ent com panies o perating in the S ydney market. They are c a lle d O x b rid g e and B ram view : •
O x b rid g e has undeveloped land, bought during a dow nturn in the S ydney real estate market, that cost $ 5 million and has an estim ated current market (output) value o f $ 8 m illion. The co m p a n y's net profit has been a bout $ 7 0 0 0 0 0 per ye a r in the last fe w years.
•
B ram view also has undeveloped land, c o m p a ra b le to O x b rid g e 's , except it w a s bought during an overheated period o f the S ydney market at a cost o f $1 1 m illion. Its estim ated current m arket value is also $ 8 m illion, and the com pany's net p rofit has also been a b o u t $ 7 0 0 0 0 0 per year. The tw o pieces o f land are a b o u t the same, but the com panies' historical-cost-based b a la n ce sheets certainly d o
not look the same: •
O x b rid g e : undeveloped land, at cost $ 5 million
•
B ram view : undeveloped land, at cost $1 1 million. A lso, O x b rid g e w ill sh o w a higher ratio o f net profit to total assets, in d ica tin g a p p a re ntly stronger perform ance
than Bram view , because its total assets w ill be lo w e r than B ram view 's. N o w , w e could argue that this is as it should be; that B ram view has not really d o n e as w e ll because, in hindsight, too much w a s p a id for the land. But another argum ent is that, since the tw o pieces of land are c o m p a ra b le econom ic assets, net profit should be related to the econom ic value (such as the market value) o f the assets, not to costs that d e p e n d on historical events rather than currently relevant econom ic conditions. Let's consider the id e a o f c h a n g in g both co m p a n ie s' asset valuations for the land to current market value. Using the concepts from e arlier in this book, w h a t m ight be some pros an d cons o f this idea? Pros include the fo llo w in g : •
m ore relevant valuation for users in assessing the com pany's value
•
m ore useful for co m p a rin g com panies w ith sim ilar e conom ic assets
•
fairer w a y o f relating perform ance (income) to the e co n o m ic value that m anagers a re m a naging on behalf of ow ners
•
m ore tim ely d a ta than the 'obsolete' cost figures
•
not costly to im plem ent (unless real estate appraisers have to be paid)
•
understandable to users w h o know som ething a b o u t real estate. C ons include the fo llo w in g :
•
less-reliable numbers, because they a re based on the estim ated selling value o f land that has not been sold
•
less-consistent b a la n ce sheet values, because real estate values tend to va ry a great d e a l over time
•
not transaction based, an d therefore not easily ve rifia b le
•
can be costly if valuations need to be p a id for
•
no effect on cash flo w directly o r through incom e tax, because the land has not been sold, so there m ight be d o u b t that m oving the fin a n cia l statement numbers around in the absence o f real econom ic effects w o u ld be very helpful to anyone.
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You can p ro b a b ly a d d m ore pros a nd cons. W e d o n 't kn o w the sig n ifica n ce (materiality) o f the land valuation issue to the co m p a n ie s' fin a n cia l statements, o r the incom e tax an d other consequences o f c h a n g in g the accounting numbers. But you should see that the accounting concepts are useful in figuring out w h a t the a p p ro p ria te accounting procedure to use w o u ld be.
6.5
Accounting regulation in Australia1
Earlier chapters have em phasised the im portance o f fin a n cia l accounting inform ation to various user groups. C re d ib le financia l reporting is hard to ach ie ve w ith o u t an accounting regulatory system. Effective regulation depends on the existence o f accounting rules based on the a p p ro p ria te concepts to g u id e inform ation processing an d disclosure. Also necessary is an enforcem ent mechanism that ensures sufficient c o m p lia n ce w ith the rules. The C o rp o ra te Law E conom ic Reform Program A c t 1 9 9 9 (CLERP A ct 1 9 9 9 ), w h ich cam e into effect on 1 January 2 0 0 0 , m odified the institutional arrangem ents for the setting o f accounting standards in A ustralia, recognising that fin a n cia l reporting requirements can p la y an im portant role in Australian com panies' a b ility to com pete effectively an d efficiently in a g lo b a l environm ent. The purpose o f this section is to pro vid e an o ve rvie w o f the A ustralian regulatory system as it relates to co rporate finan cia l reporting. Figure 6.1 depicts the main elements in the system.
The governm ent's role is highlighted in Figure 6 .1 . A fter an agreem ent w ith the states a n d the N orthern Territory in 1 9 9 0 , the Federal G overnm ent took over the responsibility for com panies an d securities la w in order to overcom e the constitutional obstacles. The b ro a d legal fram ew ork for co rp o ra te fin a n cia l reporting is set out in the C orp o ra tio ns A c t 2 0 0 1 , w ith subordinate detail contained in the C o rp o ra tio ns Regulations 2 0 0 1 . A lso show n in are tw o statutory bodies established by the A ustralian Securities a n d Investments Com m ission A c t 2 0 0 1 : the A ustralian Securities an d Investments Com m ission (ASIC) a nd the Financial Reporting C o u n cil (FRC). Both p la y an im portant role in the o peration a nd oversight o f fin a n cia l reporting in A ustralia. A S IC is the a g e n c y ch a rged w ith the adm inistration a nd enforcem ent o f the C o rp o ra tio ns A c t 2 0 0 1 , w h ile the FRC is responsible for b ro a dly overseeing the accounting a nd aud itin g standard-setting process in the private a nd public sectors.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The role of ASIC is to regulate and enforce laws that promote honesty and fairness in financial markets, products and services, and in Australian companies. In doing so, it underpins the strength, growth and international reputation of Australia's financial markets. As part of this role, it monitors com pliance w ith accounting standards and takes appropriate enforcement action w here necessary. ASIC's responsibilities include oversight of the audit function, including the registration of auditors and enforcing auditor independence. In this latter role it operates an auditor inspection program of all the large audit firms and some of the smaller ones. Each year it publicly reports on the findings of this inspection process. A SIC regulates Australian com panies, fin a n cia l markets, fin a n cia l services organisations an d professionals w h o deal and advise in investments, superannuation, insurance, deposit-taking a n d credit. Its roles include: •
t h e c o n s u m e r c r e d it re g u la to r: A S I C lic e n s e s a n d re g u la te s p e o p le a n d b u sin e ss e s e n g a g in g in c o n s u m e r
•
t h e m a rk e ts re g u la to r : A S I C assesses h o w e ffe c tiv e ly a u th o ris e d fin a n c ia l m a rk e ts a re c o m p ly in g w ith
c r e d it a c tiv itie s (in c lu d in g b a n ks , c r e d it u n io n s , fin a n c e c o m p a n ie s , a n d m o rtg a g e a n d fin a n c e b ro k e rs )
t h e ir legal o b lig a tio n s t o o p e ra te fa ir, o r d e r ly a n d tra n s p a re n t m a rk e ts . A S I C has re s p o n s ib ility f o r th e s u p e rv is io n o f tra d in g o n A u s tr a lia ’s d o m e s tic lic e n s e d e q u ity , d e riv a tiv e s a n d f u tu r e s m a rk e ts •
t h e fin a n c ia l s e rv ic e s re g u la to r: A S I C lic e n s e s a n d m o n ito rs fin a n c ia l s e rv ic e s b u sin e ss e s t o e n s u re t h a t th e y o p e ra te e ffic ie n tly , h o n e s tly a n d fa irly , f o r e x a m p le s u p e ra n n u a tio n , m a n a g e d fu n d s , s h a re s an d c o m p a n y s e c u ritie s , d e riv a tiv e s a n d in s u ra n c e . Source: Australian Securities and Investments Com m ission website ( http://w w w .asic.gov.aU /about-asic/w hat-w e-do/our-role/#w ho).
The other statutory b o d y, the FRC, is an a d viso ry council that sets the general strategic direction for the developm ent o f accounting standards. It reports to the Treasurer, w h o also ap p o in ts the members o f the FRC. M em bers' appointm ents are based on nom inations put fo rw a rd by key stakeholder groups: representatives from the business com m unity, the public sector, regulatory agencies a nd the professional accounting bodies. These groups all have an interest in the standard-setting process, a nd representation on the FRC a llo w s them an opportunity to provide input to the process, resulting in greater o w n e rsh ip o f the resulting standards. The FRC's mem bership, b ro a d ly based upon a variety o f stakeholder groups, enables the accounting standard-setting process to be m ore responsive to the needs o f the users an d preparers o f fin a n cia l statements. O n e of the key functions o f the FRC is to oversee the o peration o f the Australian A ccounting Standards Board (AASB). The AASB prepares, approves an d issues accounting standards for the purposes o f the C o rporations A c t 2 0 0 1 , and for the public an d not-for-profit sectors. It com prises a full-time chairperson, a p p o in te d by the Treasurer, and nine part-time members. M em bers a re a p p o in te d by the FRC, selected on the basis of their k n o w le d g e and experience in business, acco u n tin g , la w or governm ent. The FRC is also responsible for a p p ro vin g the priorities, business plan, budget a nd staffing arrangem ents o f the AASB. H ow ever, it cannot influence the A ASB's technical deliberations, an d , therefore, the content o f particular accounting standards. The FRC also oversees the A ud itin g an d Assurance Standards B oard (AUASB). The A UASB is responsible for the developm ent an d m aintenance o f aud itin g a nd assurance standards. It consists of 1 0 members a p p o in te d by the FRC, w ith the chairperson a p p o in te d by the Treasurer. In a d d itio n to this regulatory fram ew ork, accountants w ill belong to the accounting profession, represented in A ustralia b y C PA Australia, C hartered Accountants A ustralia a nd N e w Z e a la n d (C A A N Z ) a nd the Institute of Public A ccountants (IPA). The Australian professional accounting bodies have established the A ccounting Professional and Ethical Standards B oard (APESB). This b o d y issues standards to establish a n d m onitor the indepe n d e n ce a nd ethical behaviour of professional accountants. O f particular interest is APES 1 10 C o d e o f Ethics fo r Professional Accountants, w hich is discussed in section 6 .9 o f this chapter. C om panies that are listed on the Australian Securities Exchange Limited (ASX) must com ply w ith ASX listing rules if they wish to remain listed on the ASX. The listing rules may be enforced by the ASX's po w e r o f suspension o r delisting. M oreover, the rules have statutory backing in the C orporations A c t 2 0 0 1 , as a court order m ay be obtained to enforce them. Corporate governance is an im portant aspect o f ASX rules. The rules require a c o m p a n y to state w hether it has an audit com m ittee a n d , if it does not, to explain w h y not. In a d d itio n , com panies a re required to state, in their annual reports, the main co rp o ra te gove rn a n ce practices they had in p la ce during the reporting p e riod. To assist com panies, an indicative list o f co rp o ra te governance recom m endations are not in the ASX Listing Rules themselves - they are published by the ASX-convened C o rp o ra te G o ve rn a n ce C o u n cil, w h ich brings together various business shareholder
CHAPTER 6 Financial reporting principles, accounting standards and auditing
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and industry groups. U nder the ASX Listing Rules, ASX-listed entities are required to benchm ark their co rporate govern a n ce practices aga in st the C o u n cil's recom m endations a n d , w h e re they d o not conform , to disclose that fact and the reasons w h y (see Exhibit 6 . 1). EXHIBIT 6.1
THE ESSENTIAL CORPORATE GOVERNANCE PRINCIPLES
1
Lay solid foundations for management and oversight: A listed entity should establish and disclose the respective
2
Structure the board to add value: A listed entity should have a board of an appropriate size, composition, skills and
3
Act ethically and responsibly: A listed entity should act ethically and responsibly.
4
Safeguard integrity in corporate reporting: A listed entity should have formal and rigorous processes that
5
M ake timely and balanced disclosure: A listed entity should make timely and balanced disclosure of all matters
roles and responsibilities of its board and management and how their performance is monitored and evaluated. commitment to enable it to discharge its duties effectively.
independently verify and safeguard the integrity of its corporate reporting. concerning it that a reasonable person would expect to have a material effect on the price or value of its securities. 6
Respect the rights of security holders: A listed entity should respect the rights of its security holders by providing them with appropriate information and facilities to allow them to exercise those rights effectively.
7
Recognise and manage risk: A listed entity should establish a sound risk management framework and periodically review the effectiveness of that framework.
8
Remunerate fairly and responsibly: A listed entity should pay director remuneration sufficient to attract and retain high quality directors and design its executive remuneration to attract, retain and motivate high quality senior executives and to align their interests with the creation of value for security holders. Source: ASX C o rp o ra te G o vernance C ouncil,
C o rp o ra te G o v e rn a n c e P rincip le s a n d R eco m m e n da tio ns,
3rd Edition, ASX, Sydney, 2 0 1 4 , p. 3.
6.6
International financial reporting standards
Interna tio na l accounting standards As in business a n d econom ics generally, international issues have com e to the fore in fin a n cia l acco u n tin g . The grow th in com panies accessing d e b t a nd equity c a p ita l outside their national borders has substantially increased the need for a single set o f high-quality, understandable, enfo rce a b le an d g lo b a lly acce p te d accounting standards. In 1 9 7 3 , the International A ccounting Standards B oard w a s established to d e ve lo p a single set o f international accounting standards. The benefit o f establishing a single set o f g lo b a l accounting standards w a s that it enables c a p ita l providers to assess a nd c o m p a re intercom pany perform ance in a much m ore m eaningful, effective and efficient w a y than w a s possible w hen hundreds o f countries set their o w n accounting standards. These international fin a n cia l reporting standards (referred to as IFRSs) a re now , a lo n g w ith US G A AP , on e o f the tw o g lo b a lly recognised fin a n cia l reporting standards. W h ile the a d o p tio n of IFRSs in most m ajor c a p ita l markets except the United States represents a co nsiderable achievem ent for the IASB, there is still uncertainty a b o u t the a d o p tio n o f IFRSs by the USA. Since 2 0 0 1 , the IASB and the US Financial A ccounting Standards Board (FASB) have been a ctively w o rkin g tow ards convergence o f IFRSs and US G A AP . C on ve rg e n ce means that both fin a n cia l reporting fram ew orks w ill be a like so that international trade, stock markets, transfers o f funds a n d other international business could be assisted, or at least not im peded. Both boards have also a c kn o w le d g e d their com m itm ent to d e ve lo p in g high-quality, c o m p a tib le accounting standards that can be used for both dom estic a n d cross-border fin a n cia l reporting. Flow ever, progress on key convergence projects has been described as m ixed a nd has been slow er than a n ticip a te d . N evertheless, w h ile the US Securities an d Exchange Com m ission (SEC) continues to propose potential mechanisms that, if met, could lead to the use o f IFRSs in the US c a p ita l market, m any prom inent accountants suggest that it could be m any m ore years before fin a n cia l accounting standard-setting boards ach ie ve their g o a l o f a single g lo b a l set o f accounting standards.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6.7
The annual report and financial statem ents
Financial reporting is im portant for m any organisations. All incorporated com panies, a nd most other legally constituted organisations, are required to prepare a set o f fin a n cia l statements, at least annually, that explains their financial perform ance a nd position. Listed com panies, w h ich are those w h o se shares a re traded on a stock exchange, issue half-yearly fin a n cia l inform ation. M o s t sole traders an d partnerships also prepare annual financial statements, a t their bankers' request o r for inclusion w ith the proprietor's or partners' incom e tax returns, even if there are no other reasons for d o in g so. A ccounting standards require a com plete set o f fin a n cia l statements, w ith five com ponents: •
a statement o f fin a n cia l position at the end o f the period (com m only referred to as a b a la n ce sheet)
•
a statement o f p rofit or loss a nd other com prehensive incom e for the period (com m only referred to as an incom e statement)
•
a statement o f changes in equity for the period
•
a statement o f cash flow s for the period
•
notes to the fin a n cia l statements, com prising a summary of significant accounting policies a nd other explanatory inform ation. N o te that accounting standards n o w use the term 'a statement o f profit a nd loss an d other com prehensive incom e
for the p e rio d ', but state that other titles can be used. For exam ple, 'in co m e statement' an d 'statement of com prehensive incom e' a re com m only used b y m any com panies. B alance sheets have been discussed in e arlier chapters. The profit a nd loss com ponent o f the incom e statement w a s discussed in e arlier chapters, a nd other com prehensive incom e w ill be discussed in C h a p te r 1 3. The statement o f cash flow s w a s introduced in C h a p te r 1. Recall that the statement o f cash flow s depicts cash inflow s a n d cash outflow s under three categories: o p e ra tin g , investing a nd fin a n cin g . These categories w ill be covered in m ore detail in C h a p te r 14. The statement o f changes in equity reports changes in equity d ue to profit or loss, other com prehensive incom e (which w ill be referred to in C h a p te r 1 3) a n d transactions w ith ow ners related to the issue o f shares and dividends. Finally, notes to the fin a n cia l statements pro vid e a d d itio n a l detail on the items in the fin a n cia l statements. N o te 1 to the fin a n cia l report describes the entity's accounting policies (such as dep re cia tio n methods, w h a t is included in the costs o f assets, a nd h o w provisions for e m ployee entitlements are calculated). Subsequent notes provide m ore details on specific items in the fin a n cia l statements; for exam ple, there w ill be a note on revenues, expenses, receivables, inventory a nd PPE, a nd for each there w ill be a b re akdow n o f the content shown on the fa ce o f the incom e statement a nd the b a la n ce sheet. Public com panies an d other organisations include their set o f fin a n cia l statements in a much larger annual report. This report usually contains: 1
summary d a ta on the co m p a n y's perform ance for the ye a r - usually in a g ra p h ica l o r other easy-to-read form and com parisons g o in g b a ck five o r m ore years
2 a letter to the com pany's shareholders from the chairperson o f the board of directors; it often includes highlights of the perform ance fo r the ye a r a nd plans for the future 3
an often-extensive chief executive officer's report, including a description o f the e conom ic, fin a n cia l an d other factors behind the com pany's business, usually broken d o w n by its main products o r departm ents
4
for listed com panies, a co rp o ra te governance statement, w h ich is required under ASX regulations; this w o u ld include such items as the com position an d m em bership o f the bo a rd o f directors, the remuneration p o licy for directors, the a v a ila b ility o f independent professional a d v ice to directors, the com position o f the a u d it committee, procedures for identifying a nd m a naging business risks, a n d a statement o f ethical standards
5
the set o f fin a n cia l statements, co ntaining the statement o f fin a n cia l position (the b a la n ce sheet), the statement of profit and loss an d other com prehensive incom e (the incom e statement), the statement o f changes in equity, the statement o f cash flow s a nd notes to the accounts
CHAPTER 6 Financial reporting principles, accounting standards and auditing
6
253
a directors' statement, required by the C o rp o ra tio ns A c t 2 0 0 1 , w h ich includes a statement b y the directors that they have been given a w ritten a nd signed decla ra tio n by the C E O (or m a n a g in g director) a nd the chief financial o ffice r (CFO) that the fin a n cia l records o f the listed entity for the fin a n cia l ye a r have been properly m aintained in a cco rd a n ce w ith the C o rp o ra tio ns A c t 2 0 0 1 , that the fin a n cia l statements a n d notes to the accounts co m p ly w ith the accounting standards, that the fin a n cia l statements an d notes to the accounts present a true an d fa ir v ie w , and a n y other matter prescribed by regulations; the directors also pro vid e an o p in io n on w hether the c o m p a n y can p a y its debts as a nd w hen they fall due
7
An independent audit report: the auditor's report on the truth an d fairness o f the set o f fin a n cia l statements; the contents o f the statements a nd their notes a re the responsibility o f m anagem ent, a nd the auditor's report consists of the auditor's o p in io n a b o u t those statements an d notes (you should be sceptical o f fin a n cia l statements that have not been a u dited o r those w h o se a u d it report is not attached); the auditor's report is discussed in section 6 .8
8 a directors' report, w h ich includes such items as the names of the directors, the prin cipa l activities of the com pany, the op e ra tin g results, significant changes in the state o f affairs o f the co m p a n y, certain inform ation on directors, a report on dire cto r a nd executive rem uneration, a decla ra tio n by the directors that they have received a declaration b y the C E O /C F O a b o u t the entity's fin a n cia l records a nd fin a n cia l statements, an d inform ation a b o u t the entity's operations, fin a n cia l position an d business strategies a nd prospects for future fin a n cia l years 9
for listed com panies, inform ation on substantial shareholders, the distribution o f ow n e rsh ip o f shares, the 2 0 largest shareholders an d the voting rights o f shareholders
10 sustainability reporting: reports on sustainability perform ance including environm ental factors (e.g. e nergy usage, ca rbon emissions an d w a te r usage), safety (products an d workers), com m unity (contributions an d effect), labour policies etc.; sometimes there w ill be separate reports an d sometimes they w ill be included in the annual report, or sometimes in both (in C h a p te r 1 7 w e discuss sustainability in m ore detail). 11 other voluntary inform ation: -
graphs a nd other pictorial supplements
-
details a b o u t such matters as products, business policies a nd business objectives
-
lists o f senior m anagers a nd various policies, including training an d safety, a nd human resource m anagem ent.
If you have not seen an annual report, you m ight find it interesting to brow se through one. M o s t public com panies have their most recent annual reports (as w e ll as some m ore current fin a n cia l inform ation) on their w ebsite. In the a p p e n d ix o f this book, the 2 0 1 4 fin a n cia l statements a nd notes o f W o o lw o rth s Limited can be found, plus the auditor's report an d the directors' d eclaration.
Full versus concise financial reports T raditionally, in A ustralia, all o f the a b o v e inform ation w a s co ntained in on e set o f fin a n cia l statements. The C orp o ra tio ns A c t 2 0 0 1 n o w requires the publication o f both full general purpose financial reports (GPFR) and concise fin a n cia l reports. The full set o f fin a n cia l statements contains a b a la n ce sheet, an incom e statement, a statement o f c h a n g e in equity and a statement o f cash flow s. In a d d itio n , it contains all o f the notes to the fin a n cia l statements, the auditor's report and the directors' d e cla ra tio n . It m ay also contain various other pieces of inform ation the c o m p a n y decides to include. Shareholders can elect to receive this report. The concise fin a n cia l statements are sent to all shareholders, w ith a statement that the report is a concise report and that the GPFR w ill be sent to the shareholder if requested. The content o f the concise report is d ra w n up in a cco rd a n ce w ith the relevant accounting standards, an d all disclosures must be derived from the GPFR. W h ile there are minimum content requirements, there is scope for a d d itio n a l content, w h ich w ill va ry w ith regard to the particular circumstances o f the organisation a nd the expected needs o f the users. The concise fin a n cia l statements include a b a la n ce sheet, an incom e statement, a statement o f ch a n g e in equity and a statement o f cash flow s, as these must be presented, as in GPFR. In a d d itio n , there must be a discussion and analysis of these fin a n cia l statements to assist the user's understanding.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Examples o f the discussion a nd analysis include: Statement
Examples of discussion and analysis
Income statement
•
T rends in re v e n u e
•
The e ffe c ts o f s ig n ific a n t e c o n o m ic eve n ts, o r o th e r eve n ts, o n th e o p e ra tio n s o f th e e n tity
Balance sheet
Statement of changes in equity
Statement of cash flows
•
The m a in in flu e n c e s o n th e c o s t o f o p e ra tio n s
•
M e a s u re s o f f in a n c ia l p e rfo rm a n c e
•
C h a n g e s in th e c o m p o s itio n o f assets
•
S ig n ific a n t m o v e m e n ts in a c c o u n t b a la n c e s
•
The re la tio n s h ip b e tw e e n d e b t a n d e q u ity
•
C h a n g e s in th e c o m p o s itio n o f s h a re c a p ita l d u e to s h a re b u y b a c k s , s h a re d iv id e n d s a n d s h a re issu a n ce s
•
T re n d s in d iv id e n d s p a id to e q u ity h o ld e rs
•
The e ffe c ts o f c h a n g e s in a c c o u n tin g p o lic ie s
•
S ig n ific a n t c h a n g e s in re ta in e d p ro fits
•
C h a n g e s in c a s h flo w s fro m o p e ra tio n s
•
F in a n c in g o f c a p ita l e x p e n d itu r e p ro g r a m s
•
S e rv ic in g a n d re p a y m e n t o f b o r r o w in g
In a d d itio n , there w ill be a variety o f other disclosures, including segm ent inform ation (separate disclosures o f revenues, profits an d assets for the main segm ent o f the business).
6.8
The external auditor's report2
Several references to auditors w e re m ade a b o ve . The auditor's report is norm ally a routine statement b y the auditors that provides an o p in io n on w hether the fin a n cia l statements present a true a nd fa ir v ie w an d a re in a cco rd a n ce w ith accounting standards. H ow ever, if it is not routine, the auditors are trying to tell the users som ething they think is im portant. The auditor's report m ay be q u a lifie d in some w a y , in d ica tin g that the auditors have some concern a bout the statements. In extreme cases, the report m ay even 'd e n y ' the fairness o f the statements, saying that the auditors have some very serious objections. This is c a lle d an adverse o p in io n . W e discuss the various types o f a u d it reports b elow . W h ile you have p ro b a b ly heard o f the term 'a u d it', it w ill help to be a w a re o f the b ro a d e r term of 'assurance'. Assurance is an expression o f a conclusion on particular subject matter o r inform ation (e.g. fin a n cia l statements or levels o f greenhouse gas emissions) that is intended to increase the co n fid e n ce o f the users of that inform ation. Figure 6 .2 illustrates different levels o f assurance. As you can see, an a u d it of fin a n cia l statements is a reasonable assurance engagem ent. The a u d ito r provides an o p in io n on w hether the fin a n cia l statements p ro vid e a true a nd fair v ie w and w hether they are in a cco rd a n ce w ith accounting standards. The fact that an a u d it provides a reasonable level o f assurance rather than absolute assurance means that the a u d ito r is not guaranteeing the fin a n cia l statements are correct. This is the case because, as you have a lre a d y discovered, there are numerous estimates a nd judgements in the financial reports, an d some accounting numbers are contingent on future events (e.g. w hether inventory can be sold, and w hether accounts receivable can be collected). In a d d itio n , it is im practical for an a u d ito r to test every transaction. For exam ple, consider h o w m any transactions per ye a r com panies like W o o lw o rth s a nd the C om m onw ealth Bank w o u ld have. So external a u d itin g refers to the evaluation o f an o rg a nisation's fin a n cia l statements by an a u d ito r w h o should be independent o f the m anagem ent o f the o rganisation. The role o f the external a u d ito r has tw o fundam ental parts: •
to have an independent, unbiased a nd professional perspective
•
to render a com petent o p in io n on w hether the fin a n cia l statements present a true a nd fa ir vie w .
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More Absolute assurance - for example, a guarantee
Reasonable assurance - for example, an audit of financial statements Assurance obtained Limited assurance - for example, a review of financial statements
No assurance - for example, preparing financial statements on behalf of management (technically called a compilation engagement) Less Source: C PA Australia,
FIGURE 6.2
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Levels of assurance
Let's begin w ith independence. M a n a g e m e n t prepares the fin a n cia l statements a nd the a u d ito r provides an o pinio n on those fin a n cia l statements. The a u d ito r needs to be independent from m anagem ent. Auditors a re members o f professional associations, such as C P A A ustralia o r C hartered A ccountants A ustralia an d N e w Z e a la n d . O verseas equivalents include the Am erican Institute o f C ertified Public A ccountants, the C a n a d ia n Institute of C hartered A ccountants, the Institute of C hartered A ccountants o f E ngland an d W a le s , the H ong Kong S ociety o f A ccountants, the Institute o f C hartered Accountants o f N e w Z e a la n d , the Institute o f C ertified Public A ccountants o f S in g a p ore and the M a la y s ia n Institute o f A ccountants. A fundam ental objective of these professional associations is to protect society by ensuring the professionalism and independence of the external auditors w h o belong to them. Protecting society should be consistent w ith protecting the professional reputations o f the association's members. To this end, there are com plex rules o f professional ethics that prohibit the external auditor from having a financial interest - directly and in most indirect w a ys as w e ll - in the client com panies or other organisations being audited. These rules, and sim ilar ones related to other relationships between the auditor a nd the client, are intended to ensure that the auditor has no personal interest in w hether the financial statements report one kind o f perform ance o r another. In other w ords, the auditor should be an unbiased, professionally sceptical reviewer o f the financial statements and not som eone w h o w ants the result to turn out one w a y o r another. M a in ta in in g this indepe n d e n ce is not easy, because the auditors are business entrepreneurs themselves a nd their clients p a y them for d o in g the audit. The idea is that indepe n d e n ce is m aintained because the a u d ito r is a p p o in te d by, a n d reports to, the shareholders, not m anagem ent. Since the fin a n cia l statements are reports on m anagem ent's stew ardship perform ance, the a u d ito r is presumed to be w o rkin g for the shareholders in verifying m anagem ent's reports. In practice, how ever, external auditors must have a close w o rkin g relationship w ith their client's m anagem ent personnel in o rd e r to o btain the necessary inform ation to carry out the audit. Recent legislative changes overseas a n d in A ustralia (such as the S a rb a n e s -O x le y A c t 2 0 0 2 in the United States and CLERP 9 in Australia) have strengthened the indepe n d e n ce o f a u d it firms by such requirements as (a) the rotation o f au d it partners every five years; an d (b) banning the provision of m any non-audit services (such as consulting) b y the firm carrying out the audit. In a d d itio n , the large a u d it firms have spent m illions o f dollars recently im proving quality controls over indepe n d e n ce a nd the a u d it process. The second part o f the auditor's role is to render a com petent o p in io n on the fin a n cia l statements. If you refer to an a udit report, such as that for W o o lw o rth s Limited in the a p p e n d ix of this book, you w ill see that it says the auditors have reached an o p in io n as to w hether the fin a n cia l statements have been properly d ra w n up to g ive a true a nd fa ir v ie w in a cco rd a n ce w ith the provisions o f the C orp o ra tio ns A c t 2 0 0 1 a nd a p p lic a b le accounting standards. As
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noted a bove, it is an o p in io n , not a guarantee; nor does it say that the c o m p a n y has perform ed w e ll o r b a d ly. It sim ply says that the perform ance a nd the position have been m easured a nd presented in a g e n e ra lly a c ce p te d and unbiased w a y . G iven the com plexity o f a ccounting, aud itin g a n d business in general, the auditor's o p in io n is fundam entally a professional judgem ent. The a u d ito r not o nly must be com petent, but also must w e ig h all sorts o f factors in arriving at h is /h e r o p in io n . A ud itin g firms in N orth A m erica have sponsored a gre a t de a l o f research into the professional judgem ent o f auditors. The results of much of this research have been incorporated into international practices, including those in A ustralia. The form and content o f the auditor's report changes every fe w years as auditors rethink h o w best to com m unicate w ith the users o f fin a n cia l statements. Because the auditors are form ally reporting to the shareholders o f the com pany, not to m anagem ent, the report is usually sp e cifica lly addressed to the shareholders (the owners). The usual title o f the report is 'Independent auditor's report'. T yp ically an a u d it report w o u ld : 1
identify the co m p a n y, the set o f statements a nd their d ate, a nd state that the statements are the responsibility of m anagem ent
2 state that the directors a re responsible for p re paring the fin a n cia l statements an d for the internal controls (see C h a p te r 7) o f the c o m p a n y 3
include a statement that the auditors are responsible for aud itin g the fin a n cia l statements a nd that the audit involves perform ing procedures to o btain e vidence a b o u t the am ounts an d disclosures in the fin a n cia l report; and also that the e vidence o b ta in e d is sufficient a nd a p p ro p ria te to pro vid e a basis for the a u d it o p in io n
4 5
include a statement b y the a u d ito r confirm ing that they have met the required indepe n d e n ce standards present the auditor's o p in io n that the fin a n cia l statements g ive a true a nd fa ir v ie w , a nd that they a re in a cco rd a n ce w ith the provisions o f the C o rporations A c t 2 0 0 1 a nd accounting standards. You should expect most auditors' reports to be w o rd e d pretty much the same. This is called an unm odified report.
A ny nonstandard w o rd in g is likely to be a w a rn in g to a n yo n e p lanning to use the fin a n cia l statements in d e cisio n m aking. The auditor's report contains the auditor's o p in io n on the fin a n cia l statements. The most com m on type o f audit report is an unm odified report. An unm odified auditor's report indicates that the a u d ito r believes the financial statements present a true an d fa ir v ie w an d a re in a cco rd a n ce w ith accounting standards a nd relevant legislation. M o d ifie d auditor's reports a re issued w hen the a u d ito r believes the fin a n cia l statements contain a material misstatement, o r w hen the a u d ito r is unable to o btain enough e vidence to form an o p in io n . The fo llo w in g ta b le sets out the different types o f m odified auditor's reports that m ay be issued in these situations. Type of modified audit opinion
Description
Situations w here this type of report may be issued
Examples
Qualified or 'except for' opinion
The opinion states the financial statements present a true and fair view, and are in accordance with accounting standards except for the effect of a specific matter or matters.
A qualified opinion is issued when a specific part of the financial statements contains a material misstatement or adequate evidence cannot be obtained in a specific, material area, and the rest of the financial statements are found to present a true and fair view, in accordance with accounting standards.
The auditor has a different view on the valuation of an asset from that applied by management in the financial statements, but the rest of the financial statements were found to be free of material misstatements.
A disclaimer of opinion is issued when the auditor cannot obtain adequate evidence to form an opinion on the financial statements overall.
The company's financial reporting information system is damaged and key data is lost, meaning adequate evidence is not available to support the disclosures in the financial statements.
The issues are described in a separate paragraph within the report.
Disclaimer of opinion
The auditor cannot reach an opinion overall on the financial statements and therefore disclaims any opinion on it.
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Adverse opinion
The opinion states that the auditor believes the financial statements d o n o t present a true and fair view, and are n o t in accordance with accounting standards.
Source: CPA Australia,
An adverse opinion is issued when the auditor believes misstatements are so pervasive that the financial statements do not present a true and fair view, or are not in accordance with accounting standards.
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The auditor believes that management has applied an inappropriate financial reporting framework in preparing the financial statements.
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In certain, lim ited circumstances, the a u d ito r w ill issue an unqualified o p in io n , but w ill d ra w attention to or em phasise a matter that is relevant to the users o f the a u d it report, but is not o f such a nature that it affects the audit o p in io n . For exam ple, there m ay be a m ajor uncertainty that could affect the com pany's a b ility to remain a g o in g concern, but this uncertainty is a d e q u a te ly disclosed by the com pany. It is a p a ra g ra p h norm ally after the standard o pinio n p a ra g ra p h that highlights a matter affecting the fin a n cia l report, w h ich is included in a note to the financial statements that m ore extensively discusses it. The main idea is to alert the reader to the facts in this note.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1 T h e g e n e ra l m a n a g e r o f a s m a ll c o m p a n y re c e n tly said: ‘W e n e e d t o ha ve an e x te rn a l a u d ito r f o r o u r fin a n c ia l s ta te m e n ts so w e c a n g u a ra n te e th e ir a c c u ra c y to o u r b a n k .’ W ill th a t be th e re s u lt i f an a u d ito r is a p p o in te d ?
2 A n a u d ito r c a n n o t o b ta in s u ffic ie n t e v id e n c e as to th e v a lu a tio n o f an asset. T h e re s t o f th e fin a n c ia l s ta te m e n ts are fo u n d to p re s e n t a tr u e an d fa ir v ie w in a c c o rd a n c e w ith a c c o u n tin g s ta n d a rd s . W h a t ty p e o f a u d it r e p o r t w o u ld be issu ed ? Y o u r a n sw e rs s h o u ld be:
1 A n a u d ito r d o e s n o t g u a ra n te e th e a c c u ra c y o f fin a n c ia l s ta te m e n ts b u t p ro v id e s an o p in io n o n w h e th e r th e fin a n c ia l s ta te m e n ts s h o w a tr u e an d fa ir v ie w and a re in c o m p lia n c e w ith a c c o u n tin g s ta n d a rd s .
2 A n ‘e x c e p t f o r ’ o p in io n .
6.9 The nature of a profession and professional ethics M a n y o f the p e o p le involved in fin a n cia l accounting consider themselves to be professionals. Evolving systems of standards, such as G A A P , w o rk reasonably w e ll, partly because professionals, w h o are both expert a nd ethical, are involved. Ethical behaviour comes from personal standards plus various w ritten codes o f ethical conduct. For m any p e o p le to d a y, there is a strong concern w ith being professional. There are, how ever, certain occupations that have established status as 'the professions'. In to d a y's w o rld , some groups that have this status are physicians, law yers, engineers, architects an d professional accountants. Part o f the reason these groups stand out is that entry into each o f them requires a post-secondary education, including training an d exam ination by practitioners, a nd members are bound b y a c o d e of conduct o r professional ethics. M em bers o f each professional g ro u p usually e n jo y a m o n o p o ly in their particular area o f expertise. Associations o f architects, physicians, engineers, law yers a nd other members of le g a lly recognised professions can all prevent p e o p le from c a llin g themselves members o f their particular professions an d practising in that c a p a city. Such groups have to convince the public, as represented b y governm ents, for exam ple, that they have expertise and a p p ro p ria te codes o f ethical conduct, but also that entrance to their area o f expertise should be regulated for the public g o o d .
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In A ustralia, C hartered A ccountants A ustralia an d N e w Z e a la n d (CA), C PA A ustralia (CPA) an d the Institute of Public A ccountants (IPA) are the professional accounting bodies. There are no legal requirements governing the em ploym ent o f accountants in A ustralia, although some specialist accounting functions (such as a u d itin g , taxation and liquidation) are subject to statutory requirements. H ow ever, professional designations, such as C A , C P A an d IPA, are protected by la w , a n d can o n ly be attained if you meet the various requirements specified b y the relevant accounting body. For these accountants, there a re both pow ers an d restrictions (e.g. advertising must meet certain standards of content and decorum). The rights that a particular profession enjoys com e in return for promises m ade concerning the q u a lity an d ethics o f its mem bers' w o rk. If a professional accountant has not lived up to the standards o f conduct held by the profession, he o r she can be reprim anded o r expelled by the profession a n d /o r sued in court. (Anyone can be sued, o f course, but professionals are usually held to a higher standard o f perform ance than are non-professionals.) All told, being in a profession has m any advantages (including service to society, m o n o p o ly over an area of w ork, co lle g ia l support, social prestige a nd g o o d pay), but one must rem em ber that in return there is the social responsibility o f d isch a rg in g one's duties com petently an d in a cco rd a n ce w ith the profession's c o d e o f ethics. Professional codes o f ethics involve not o nly behaving in a professional m anner (i.e. w ith integrity an d objectivity), but also m aintaining the level o f expertise required in o rd e r to perform skilfully. This involves fo llo w in g procedures that w ill, o r should, ensure that high standards o f w o rk a nd perform ance are met, an d exercising inform ed judgem ent. For members o f the professional accounting bodies there are ethical standards, including APES 1 1 0 C o d e o f Ethics for Professional A ccountants. This C o d e notes that the m ark o f the accounting profession is its a cce p ta n ce o f the responsibility to act in the public interest. The C o d e sets out five fundam ental principles, w h ich are outlined b e lo w : 1
Integrity: an o b lig a tio n on accountants to be straightforw ard a nd honest in professional an d business relationships. This includes fa ir d e a lin g an d truthfulness.
2
O b je c tiv ity: an o b lig a tio n on accountants not to com prom ise their professional o r business judgem ent because of bias, conflict o f interest o r the undue influence o f others.
3
Professional com petence a n d du e care: the p rin ciple of professional com petence a nd d ue care, w h ich imposes the fo llo w in g o b lig a tio n s on accountants: -
to m aintain professional k n o w le d g e an d skill at the level required to ensure com petent professional service to act d ilig e n tly in a cco rd a n ce w ith a p p lic a b le technical an d professional standards w hen p ro vid in g their services.
4
C onfidentiality: an o b lig a tio n to refrain from: -
disclosing confidential inform ation a cq u ire d through business relationships w ith o u t p roper an d specific author
-
using confidential inform ation a cq u ire d as a result of professional an d business relationships to their
ity from the client o r em ployer adva n ta g e .
5
Professional behaviour: an o b lig a tio n on accountants to c o m p ly w ith relevant law s a nd a v o id actions that m ay discredit the accounting profession; for exam ple, m aking d isp a ra g in g references o r unsubstantiated com parisons to the w o rk o f others. C o m p lia n c e w ith the fundam ental principles m ay be affected by various threats, including the fo llo w in g :
•
self-interest threats, such as a fin a n cia l interest in the client, undue d e p e n d e n ce on the total fees of a client, o r a loan to o r from a client
•
self-review threats, such as aud itin g systems on reports in w h o se design o r developm ent you had been involved
•
a d v o c a c y threats, such as prom oting shares in a listed c o m p a n y w hen you are also a u d ito r of that co m p a n y
•
fam iliarity threats, such as having a close o r im m ediate fam ily relationship w ith a director o r officer o f a client, o r a
•
intim idation threats, such as being threatened w ith dismissal, o r being pressured to reduce the extent o f the w o rk
long association w ith senior personnel o f an a u d it client
perform ed in o rd e r to reduce fees (ad a p te d from APES I 10 C o d e o f Ethics for Professional Accountants).
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Various safeguards to elim inate o r reduce the threats to an a cce p ta b le level a re d e ve lo p e d b y the profession, by legislation an d in the w o rk environm ent. For exam ple, accounting firms involved in a u d it w o rk have a vast range of rules related to their staff o w n in g shares, an d e la b o ra te procedures to ensure that taking on a n ew client w ill not create indepe n d e n ce problem s; for exam ple, taking on an a u d it w hen another part o f the firm has d e ve lo p e d the inform ation system as part o f a consulting role.
Ethical issues H ere are exam ples o f ethical problem s that m ay be faced by professional accountants. W h a t w o u ld you, as a mem ber o f a professional b o d y or as som eone w h o m ay rely on accounting inform ation or auditors' reports, consider to be a p p ro p ria te ethical behaviour in each case? 1
M a ry w orks for a Big 4 accounting firm, an d is part o f the team d o in g the external a u d it o f W e s tw a rd Industries Ltd. Staff at W e s tw a rd a re all very friendly, a nd M a ry is offered the cha n ce to buy o ne o f the co m p a n y's highq u a lity sound systems for o n ly a b o u t half the usual price. Should she a c ce p t the d e a l?
2
A n d re w is also on the W e s tw a rd external a u d it team . H e is a mem ber o f a local foo tb a ll team . During drinks after a g am e, he hears a mem ber o f another team boast o f cheating W e s tw a rd system atically by over-billing on printing invoices. Should he tell W e s tw a rd ?
3
Lisa a n d Sean fall in love an d d e c id e to marry. Both are professional accountants: Lisa is the chief accountant of W e s tw a rd , responsible for p re paring all the com pany's fin a n cia l statements, a nd Sean is a partner of a Big 4 firm an d is in ch a rg e o f the external a u d it o f the co m p a n y. Should Sean turn the a u d it over to another partner, or perhaps even ask the accounting firm to resign as a u d ito r (because as a partner, he shares in the firm 's profits from all audits)?
4
M ic h e lle is another mem ber o f the W e s tw a rd external a u d it team . During some a u d it tests, she discovers that W e s tw a rd e n g a g e d in some business activities that a p p e a r to be ille g a l. Breaking that particular la w can bring large fines an d even jail terms. Should M ic h e lle g o to the p o lice?
5
Erin w orks for the same Big 4 firm. During the a u d it o f Basic Electronics Ltd, she discovers that an e m ployee of Basic is o vercharging W e s tw a rd by a p p ly in g too high a mark-up to services contracted w ith W e s tw a rd . Documents in d ica te that Basic's m anagem ent is a w a re o f this a nd is h a p p y to be getting a w a y w ith it, because it has a m aterial effect on Basic's profit. Should she tell the m anagem ent of Basic that she knows w h a t they are d o in g ? Should she tell Sean, the partner responsible for the W e s tw a rd a u d it? Should she tell W e s tw a rd ?
6 G e o rg e is a partner o f the sam e Big 4 firm. For years, his father has o w n e d a fe w shares o f W e s tw a rd , am ong a w h o le portfolio o f shares o f m any com panies. His father has just d ie d an d w ille d all the shares to G e o rg e . Should he sell the W e s tw a rd shares? O n e of the m ore interesting an d c h a lle n g in g aspects o f being a professional is d e a lin g w ith such ethical issues. Some o f these exam ples d o not have cle a r answers, but here are some ideas: 1
External auditors a re supposed to be independent scrutineers o f their clients' fin a n cia l affairs. M a ry should p ro b a b ly not a c ce p t the d e a l, unless it is a v a ila b le to a n yo n e w h o turns up at a retail store, because a c ce p tin g it w o u ld underm ine her independence. Being frie n d ly w ith clients is fine, but auditors also have to m aintain some distance from clients to protect their indepe n d e n ce an d integrity.
2
A n d re w should tell W e s tw a rd w h a t he heard a nd suggest that they look into their printing costs. W h e n d o in g their w o rk , auditors a cq u ire a g re a t deal o f confidential inform ation a b o u t their clients a nd must be very careful a b o u t h o w they use it. In this case, the inform ation w a s not a cq u ire d under circumstances o f confidentiality. A n d re w m ay find himself in court over the issue, how ever, so he m ay need to seek legal a d v ice before speaking to W e s tw a rd .
3
Sean needs to take some action to remove himself from the jo b o f aud itin g his w ife 's w o rk - to protect both her an d his integrity. The firm alm ost certainly has rules a b o u t such relationships. It is likely that these involve transferring the jo b to another partner a nd keeping Sean entirely ignorant o f the w o rk on the W e s tw a rd audit. The firm m ight have to resign the audit.
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M ic h e lle 's situation is very com plex. There is a mixture o f inform ation that w a s a cq u ire d c o n fid e n tia lly an d a duty to society. M u ch m ore has to be know n before a n y a d v ice could be offered to M ic h e lle . A t the very least, M ic h e lle and the firm w o u ld have to ge t legal a d vice im m ediately. The boards o f directors o f most large com panies have a u d it committees to g ive the auditors a w a y to bring criticisms o f m anagem ent to the board's attention. M ic h e lle 's firm w o u ld likely raise this w ith W e s tw a rd 's a u d it committee.
5
Erin's is another very com plex situation. Erin is responsible fo r protecting the c o n fid e n tia lity o f her client, Basic, and w o u ld get in trouble if she told another c o m p a n y w h a t she had learned on the audit. H ow ever, her firm is also responsible to both clients. A g a in , she an d the firm w o u ld need im m ediate legal ad vice .
6 M o s t firms have rules p ro hibiting members o f the firm from having an interest in a n y clients a u dited by the firm. G e o rg e w o u ld have to sell his shares in W e s tw a rd im m ediately.
6.10
Capital markets
Share m arkets and o th e r m arkets tor financial capital As business corporations d e ve lo p e d , o w n e rsh ip rights in them w e re sold m ore a n d m ore bro a d ly. The ow ners (shareholders) began to invest in several businesses at o n ce a n d to buy a n d sell their shares from a n d to each other. To facilitate the buying a nd selling (trading) o f shares am ong investors, share markets - organised as stock exchanges - deve lo p e d . T o d a y there are m any such exchanges, including the m ajor international ones in N e w York, London, Tokyo, Paris a nd Toronto. The A ustralian Securities Exchange (ASX) is also a large equities market, a nd the largest in the Southern Hem isphere. Brokers, investment banks, market analysts an d others conduct, assist in and advise on trading. Trading goes on in m ore than just the shares o f co m p a n ie s. For e xa m p le , there is a lso the tra d in g o f rights (using terms such as 'w a rra n t' o r 'o p tio n s') to buy o r sell shares in the future, to convert from o n e kind o f share to another, to receive d ivid e n d s a n d to perform a w id e va rie ty o f other future a ctions. N e w rights, a n d fin a n cia l instruments to co n ve y such rights, a re b e in g invented a n d tra d e d all the tim e. S pecial markets have been d e v e lo p e d fo r som e o f these, such as an o ptions e xch a n g e in C h ic a g o , but m any are tra d e d on regular stock exchanges, inclu d in g the ASX. C o rp o ra te a n d governm ent bonds a re also tra d e d , a n d there is such a va rie ty of fin a n cia l instruments that the distinction betw een o w n e rs h ip shares, cre d ito rsh ip bonds a n d other rights a nd instruments is often blurred. For e xa m p le , som e bonds ca rry the right to be converted into shares a t the o p tio n of the holder. M a n y exchanges an d over-the-counter markets use com puterised trading systems for the listed com panies w hose shares and other securities (the usual general nam e for all these shares, bonds an d other fin a n cia l instruments) are traded on the exchanges an d other markets. Furthermore, it is becom ing increasingly com m on for investors to buy or sell securities anyw h e re in the w o rld 2 4 hours a d a y. Taken together, all these exchanges, markets a nd buying and selling activities are usually c a lle d c a p ita l markets. They include both share trading an d trading o f all the other securities that corporations an d governm ents use to fin a n ce their assets. It is im portant to em phasise that these markets ope ra te quite separately from the organisations that initially issue the securities. For exam ple: •
W h e n a c o m p a n y decides to issue some shares, these securities a re offered to the market(s), a nd the c o m p a n y receives the proceeds o f the initial sale o f them (less commissions to brokers a nd others involved). A fter that, how ever, the c o m p a n y ceases to be a direct particip a n t. Investors buy the securities from each other a nd sell them to each other w ith no particip a tio n from the com p a n y.
•
Investors m ay even a ct in the fa ce o f o p p o sitio n from the com pany; for exam ple, an investor m ay try to get enough shares together to ge t voting control o f the c o m p a n y (a takeover). There is a lw a ys a risk fo r public com panies (com panies w h o se shares members o f the public are a b le to buy o r sell from each other w ithout permission o f the com panies) that the markets w ill behave in w a ys com panies d o not like.
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The c o m p a n y m ay announce a n ew m anagem ent team that it expects w ill im prove the com pany's perform ance, but its share price m ay fall because the p e o p le buying an d selling the shares d o not like the n e w team , a nd more p e o p le w a n t to sell their shares than w a n t to buy them, producing a fall in the share price.
•
The markets often create new securities out of the ones the co m p a n y initially issued, then trade those. For exam ple, a share m ay carry the right to buy another share in the future. That right m ay be bought an d sold separately on the market, so that you could ow n the share w ithout any such right, o r the right w ithout any such share. To prepare you for fin a n cia l accounting analysis, five particular aspects o f c a p ita l markets are outlined in this
section. These are: •
the w a y securities are traded an d security prices are established
•
the role o f inform ation (such as accounting reports) in such a market
•
the idea o f a 'risky return'
•
the fact that markets are 'a g g re g a te s'
•
the co n ce p t of 'm arket inform ational e fficiency'. These aspects, a m ong m any others, are d e a lt w ith in capital m arket theory. This theory is very down-to-earth,
and incorporates much p ractical kn o w le d g e o f h o w markets w o rk. It has been a pow erful impetus to econom ics, finance a nd accounting research, a nd to changes in the w a y c a p ita l markets are o perated.
Security trading and security prices C a p ita l markets w o rk in the sam e w a y as a n y market. People trade (buy a n d sell) w h a t they o w n for som ething else, usually m oney o r a prom ise o f it. •
There a re p e o p le w h o o w n securities, such as shares in BHP Billiton. Som e o f these a re w illin g to sell their shares, if the price is right. If no one w a s w illin g to sell at a n y price, there w o u ld be no trading!
•
There are p e o p le w h o d o n 't o w n a n y securities, but w h o are w illin g to buy them, if the price is right. If no one w a s w illin g to buy at a n y price, there w o u ld be no tra d in g ! Let's call the first g ro u p the sellers a nd the second g ro u p the buyers. Suppose w e had the fo llo w in g list o f possible prices of BHP shares: Price
Sellers' willingness to sell
Buyers' willingness to buy
$19
Everyone would sell
No one would buy
$18
Most would sell
A few would buy
$17
Half would sell
Half would buy
$16
Some would sell
Most would buy
$15
None would sell
All would buy
Y ou'll recognise from this hypothetical list o f prices that w e have a supply curve an d a de m a n d curve. C a p ita l market prices a re set by the interaction betw een those w a n tin g to sell an d those w a n tin g to buy. A t a price o f $ l 9, there w o u ld be lots o f shares for sale but no buyers; at a price o f $ 1 5 , there w o u ld be lots o f buyers but no sellers. Each d a y's market price fo r the shares is set by the b a la n ce betw een p e o p le w illin g to buy an d p e o p le w illin g to sell: •
If there a re m ore sellers than buyers, the price w ill fall, roughly d o w n to the level at w h ich there is an equal num ber o f buyers an d sellers (or at least, shares d e m a n d e d an d shares for sale).
•
If there a re m ore buyers than sellers, the price w ill rise, roughly up to the level at w h ich there is an equal num ber of sellers an d buyers (or shares for sale a nd shares dem anded). In the a b o ve exam ple, w e w o u ld expect the buyers a n d sellers to a g re e to trade (buy a nd sell) a t a price of
around $ 1 7 . So if w e looked up BHP Billiton's shares in the new spaper's listing o f ASX prices, w e w o u ld expect to see to d a y's price to be a b o u t $ 17 . But the d a ily price is set by the pressures o f supply an d de m a n d , so it w ill vary, d e p e n d in g on h o w m any buyers an d sellers make offers to buy o r sell. Therefore, it w ill va ry around $ 1 7 as those pressures vary.
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Role o f in fo rm a tio n in a capital m arket W h y w o u ld the pressures o f supply a nd dem and vary? B roadly speaking, there are three kinds o f reasons that are of interest in accounting analysis: •
N o inform ation-based tra d in g : The circumstances o f some buyers a nd sellers m ay require them to sell, o r even buy, alm ost regardless o f anything to d o w ith the particular c o m p a n y w h o se shares a re being traded. An o w n e r o f some shares m ay d ie a n d the estate m ay have to sell the shares in ord e r to distribute the m oney to the beneficiaries o f the o w n e r's w ill, o r an institutional investor, such as a superannuation fund, m ay need some cash to p a y superannuation o r other payments. A person m ay w in a lottery a nd buy shares in a m a naged fund (an investment consisting o f a sam ple o f shares of m any com panies), so that the mutual fund in turn has to buy some shares. Therefore, some trading is likely to be occurring continuously for reasons relating to raising o r spending a v a ila b le cash. Such trading is referred to as liq u id ity trading.
•
G e n e ra l inform ation-based tra d in g : C o m p a n ie s w h o se shares are traded a re part o f a general e conom ic system, and some general events m ay m odify people's view s on the w isd o m of investing in anything. As a result, this m ay cause changes in all o r most shares traded on an exchange. The share price o f com panies such as BHP Billiton m ay therefore ch a n g e, a lo n g w ith the rest. Examples o f such general events a re changes in national interest rates, announcem ents o f trends such as inflation o r consum er con fid e n ce , w ars, illness o r the death o f im portant people, and elections that ch a n g e the party in po w e r. If the Australian G overnm ent announced a n e w special tax on c o m p a n y profits, w e m ight expect pretty w e ll every com pany's share price to fall, including BHP Billiton's, because investors w o u ld see this as hurting every com pany's future profits an d , therefore, the returns investors w o u ld get from o w n in g shares in a n y com pany. M a rk e t-w id e price changes com ing from the e co n o m ic system are often c alle d systemic effects. Som e o f the trades m ay happen because investors think some com panies w ill be hurt o r helped m ore than others, an d some investors m ay be getting out o f that market altogether b y selling their shares and buying g o ld o r real estate instead.
•
S pecific inform ation-based tra d in g : Inform ation sp e cifica lly a b o u t BHP Billiton's future prospects m ay also cause changes in the w illingness of p e o p le to buy o r sell its shares. For exam ple, if BHP Billiton announced that it w a s g o in g to buy a m ining co m p a n y, some p e o p le m ay like that idea (and, w a n tin g to buy, increase the dem and for shares) and other p e o p le m ay dislike the id e a (and, w a n tin g to sell, increase the supply of shares). If most p e o p le think that BHP Billiton buying the other c o m p a n y is a g o o d idea, the share price w ill rise; if most p e o p le think it is a bad idea, the share price w ill fall. This phenom enon, in w h ich share prices are influenced by an d reflect a person's evaluation a b o u t the im pact o r m eaning o f an event (and their desire, therefore, to hold on to o r sell their shares), is very im portant for understanding share prices an d a ccounting's inform ation role. W e can say that the share market prices the inform ation, in that the ch a n g e in the trading price o f the shares (up, d o w n , o r not at all) is a measure o f the value o f the inform ation to the market. H arking b ack to the accounting concepts, w e m ight say that in a share market sense, decision-relevant inform ation is m aterial to the market if know ing a b o u t it changes, or w o u ld chang e, a security's market price or, perhaps, w o u ld prom pt trading (buying an d selling) even if the net effect on price w e re zero. A great am ount o f analysis an d research in acco u n tin g , fin a n ce a nd econom ics uses this idea to measure the
app a re nt value o f all sorts o f c o m p a n ^s p e c ific inform ation, such as a com pany's annual announcem ent o f its net profit (earnings announcem ent), announcem ents o f changes in m anagem ent an d news a b o u t other events initiated by o r affecting the com pany. (Presuming that a ch a n g e in share market prices is a measure o f inform ation's value requires some faith in the market system as a social g o o d a n d co n fid e n ce in the market's a b ility to respond appro p ria te ly, o r efficiently, to inform ation.)
Return and risk The return you earn by o w n in g a security (a share o r bond) is the sum of: •
the cash you get (from dividends o r interest payments) plus
•
the c hange (hopefully an increase) in the market price o f the security.
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You get a cash return plus a holding g a in o r c a p ita l g a in (or loss). C a p ita l market theory develops much o f its p o w e r from analysing the nature o f these tw o kinds o f returns, particularly the second kind. If the security you o w n varies in market price, that variation is, a cco rd in g to the theory, a measure o f the risk from o w n in g the security, since prices could g o up o r d o w n . Risk is calculated as the v a ria n ce o r standard deviation o f the prices around the a v e rage price - o r trend in a v e ra g e price - of that security. A risky security, therefore, is on e w h o se price varies all over the place. As described a b o ve , a security's price m ay v a ry because the w h o le share market o r bond m arket is g o in g up o r d o w n , o r because of inform ation that is specific to that security o r to the c o m p a n y issuing the security. So, a nalytica lly, the risk is separated into: • •
system atic risk: the portion o f the security's variation that relates to o r correlates w ith variation in the overall market unsystematic risk: the security's o w n residual variation not related to the market. Beta (a term com ing from the m athem atical model used to relate a firm 's returns to those o f the market overall) is a measure o f the security's relationship to overall market variations. Securities can be classified a cco rd in g to this relationship: a lo w beta security's prices va ry less than overall market prices d o , w h ile a high beta security's prices va ry m ore than the market does. Risk can be controlled to some extent b y holding a variety o f securities w ith different betas. M o re w ill be said
a bou t this in the section on agg re g ate s b e lo w . A natural question at this point m ight be: 'D oes accounting inform ation (especially profit o r cash flow ) help to predict security prices an d , therefore, risks an d returns?' M a rk e t prices a re pretty hard to predict, full stop. Therefore, accounting inform ation isn't much help, but neither is anything else. H ow ever, accounting inform ation can be helpful indirectly. W h e n im portant events that d o affect security prices are also represented in the accounting inform ation (perhaps later on, since accounting reports com e out o n ly quarterly o r annually), the accounting inform ation w ill indirectly be predictive, too. It depends on h o w w e ll accounting represents the o rig in a l event: it seems that if phenom ena reported in the accounting inform ation have a cle a r econom ic m eaning (such as w hen they represent an im pact on cash o r risk), they d o have some increm ental predictive value. A fter the fact, how ever, it is cle a r that accounting inform ation (especially profit) does correlate highly w ith market prices. The longer the a c c o u n tin g -p ric e relationship is measured, o rd in a rily the better it is: accounting profit, for exam ple, usually correlates better w ith share prices over several years than over a fe w months. A ccounting does relate to w h a te ve r affects markets, though c a llin g the shots in a d va n ce is hardl
A ggregates Security markets involve a g g re g a te behaviour. C a p ita l market theory proposes that a sensible investor w ill invest in a g ro u p of securities termed a po rtfo lio . By choosing a g ro u p w ith various in dividual betas (risk measured by variation in returns), the investor can assem ble a portfolio w ith w h a te ve r overall risk the investor w ishes. G e nerally, a portfolio is less risky than a n y individual security because, by a d d in g together a g ro u p o f securities w ith different unsystematic risks, the unique variations in each p a rtia lly cancel each other out. W h e n the price of on e goes up, another price m ay g o d o w n . Thus, a portfolio is a w a y of diversifying a w a y the unsystematic risk. Portfolio thinking has becom e pervasive in the investment com m unity. M o s t research on the im pact o f accounting inform ation assumes that investors have portfolios o f securities, a nd com panies accounting fo r their o w n investments (such as m arketable securities a nd superannuation funds) increasingly make the sam e assumption.
M arket in fo rm a tio n a l efficiency Efficiency o f inform ation use means that markets respond so q uickly a nd sm oothly to inform ation that o n ce the inform ation becom es public, its effects a re im m ediately reflected in prices through the trading o f securities. People w h o think the inform ation implies that they should buy, d o so, from p e o p le w h o think that they should sell. This fast response means that if the market is efficient, you c a n 't use p u b licly a v a ila b le inform ation (such as public fin a n cial statements everyone can read) to 'b e a t' the market; by the tim e you have the inform ation an d can act, the market w ill a lre a d y have reacted to the inform ation a nd p roduced a n ew trading price that reflects that inform ation. You, as an individual trader, d o n 't have the p o w e r to d o much a b o u t the price that the overall sum o f buys a nd sells has
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produced, so, unless you can trade on your inform ation before a n yone else knows it, you w ill find that the price a lre a d y reflects the value o f the inform ation. If everyone gets an accounting report at the same time, p ro b a b ly only those traders nim ble enough to act im m ediately w ill be a b le to take a d va n ta g e o f a n y news in the report. (M ore comments on w hether accounting reports a re likely to be news a re m ade below .) C a p ita l markets ope ra te on inform ation, but they d o so in light o f expectations a lre a d y form ed, in a c co rd a n ce w ith w h a t w a s a lre a d y know n. Therefore, the markets tend to respond to n ew inform ation o n ly if it is unexpected. The argum ent can be m ade that for an efficient capital m arket, o n ly the unexpected portion o f earnings (or o f a n y other such item o r announcem ent) is inform ation to the market. The market w ill not respond much to fin a n cia l results that are exactly as everyone expected. There a lw a ys is some response, though, because various market traders have different expectations and beliefs - these differences make the markets w ork! Research indicates that some markets (such as the N e w York Stock Exchange) are quite efficient w ith respect to publicly a v a ila b le inform ation, but exceptions have been found. The research is by no means conclusive, a n d the behaviour of m any markets is not w e ll understood (the Australian Securities Exchange, for exam ple, has been studied much less than the N e w Y ork Stock Exchange). Because inform ational e fficie n cy is a difficult phenom enon to dem onstrate conclusively, it is often called a hypothesis a b o u t h o w markets w o rk: the efficient m arket hypothesis. Securities commissions, such as the US Securities a n d Exchange Com m ission a n d the Australian Securities and Investments C om m ission, are responsible for ensuring that securities trading is as fa ir as possible. O n e problem securities commissions w o rry a b o u t is so-called asym m etric inform ation. Some market traders know m ore than others d o about a security a n d , therefore, could potentially take a d va n ta g e o f the m ore ignorant traders. If you kn o w that bad things are a h e a d , you sell to p e o p le w h o d o n 't know that the price w ill fall w hen everyone learns a b o u t the bad things, o r if you kn o w that g o o d things are a h e a d , you buy from p e o p le w h o d o n 't kn o w their shares are w orth m ore than they think. A m ajor role of fin a n cia l accounting is to reduce inform ation asymmetries b y producing inform ation that informs everyone. An exam ple o f the effects o f asym m etric inform ation is that p e o p le on the 'in sid e ' o f the c o m p a n y m ight use their private kno w le d g e to take a d va n ta g e o f other investors. Such insiders can buy or sell before other investors learn about som ething a n d , therefore, before the market can reach a n e w price based on the inform ation. If you w e re a senior executive o f a com pany, a n d you knew that to m o rro w the c o m p a n y w a s to release an unexpectedly g o o d earnings report that w o u ld cause the share price to rise, you could buy to d a y from share sellers w h o w e re ignorant of w h a t you knew. Securities com missions require that a n y significant inform ation be released q uickly an d to everyone at once, and they keep an eye on insider tra d in g , w h ich is illegal. Insider trading law s pro h ib it insider tra d in g , a n d it can result in very large fines as w e ll as jail sentences. Financial statements a re o ne o f the w a ys in w h ich com panies disclose inform ation a b o u t themselves to outsiders. Securities markets certainly p a y attention to fin a n cia l accounting inform ation, but in a w o rld in w h ich m any p e o p le buy a n d sell bonds, shares a nd options several times a d a y, half-yearly o r annual fin a n cia l statements o n ly provide part o f the picture. M u ch o f the inform ation in the fin a n cia l statements leaks out over the year, in press releases, announcem ents an d o fficia l inform ation filings w ith securities commissions o r stock exchanges. For exam ple, the audit o f a com pany's 3 0 June fin a n cia l statements m ay be com pleted in A ugust a n d the fin a n cia l statements printed and issued in N ovem b er, but throughout the prior y e a r there w ill have been announcem ents a b o u t im portant events. N o t surprisingly, accounting research shows that share price changes g e n e ra lly happen before the o fficia l earnings reports are released, a nd this is m ore likely to happen for larger firms a b o u t w h ich there tends to be m ore inform ation a v a ila b le betw een accounting reports. There is, therefore, a continual flo w o f financial-statem ent-related inform ation an d other significant inform ation from public com panies to securities markets. The general id e a is that inform ation should be released as soon as it is know n, so that general market traders a re not d isa d va n ta g e d , co m p a red w ith insiders. This helps to keep the system fa ir for all, but it should also assist the market's p ricing system to reflect inform ed evaluations o f co m p a n ie s' prospects, so that the market prices a re consistent w ith society's overall interest in the a p p ro p ria te a llo ca tio n o f econom ic resources. A cornerstone p o lic y for stock exchanges is that all persons investing in securities listed on the e xch a n g e have equal access to inform ation that m ay affect investment decisions. Investor co n fid e n ce in the integrity o f an e xchange
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requires tim ely disclosure o f m aterial inform ation concerning the com panies listed on the exchange, w ith the result that all participants in the market have equal opportunities concerning securities tra d in g . Trading on an e xch a n g e can be affected b y both m aterial inform ation a n d the existence o f rumours and speculation. In this case, an e xch a n g e m ay require an announcem ent from a c o m p a n y as to w hether such rumours and speculation are factual o r not.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
I f a p a rtic u la r c a p ita l m a rk e t is d e s c rib e d as b e in g e f fic ie n t, w h a t d o e s th a t im p ly a b o u t th e ro le and u s e fu ln e s s o f fin a n c ia l a c c o u n tin g in fo rm a tio n in th a t m a rk e t?
2
W h y is tim e ly d is c lo s u re o f fin a n c ia l a c c o u n tin g in fo r m a tio n an d o t h e r in fo r m a tio n im p o r ta n t to c a p ita l m a rk e ts ? Y o u r a n sw e rs s h o u ld be:
1
I f a p a rtic u la r m a rk e t is d e s c rib e d as b e in g e ffic ie n t, it im p lie s th a t p u b lic ly a vailab le in fo rm a tio n (s u c h as p u b lic fin a n c ia l s ta te m e n ts e v e ry o n e c an re a d ) c a n n o t be used to ‘b e a t’ th e m a rk e t. B y th e tim e an in v e s to r o b ta in s th e in fo r m a tio n an d c a n a c t on it, th e m a rk e t w o u ld a lre a d y ha ve re a c te d t o th e in fo r m a tio n and in c o rp o ra te d it in to sh a re p ric e s .
2
T im e ly d is c lo s u re o f in fo r m a tio n is im p o r ta n t to c a p ita l m a rk e ts in o rd e r to e lim in a te s o m e tra d e rs g a in in g an a d v a n ta g e o v e r o th e rs b y h a v in g th e in fo rm a tio n e a rlie r.
6.11
Contracts and financial accounting inform ation
Reporting to ca p ita l markets is not all that fin a n cia l accounting is g o o d for - o r that m anagers w o rry about. Financial accounting plays m any other roles that are im portant to m anagers an d other parties. Such accounting inform ation is used in resource-allocation decisions m ade b y governm ents, in assessing incom e taxes, in negotiations w ith a nd by labour unions, an d perhaps also in enhancing o r attacking the p o litica l p o w e r o f certain groups (such as the corpo ra te sector) in society. This section has some ideas a b o u t the contractual relationships am ong p e o p le involved in a business, a nd a bout a consequent role o f accounting inform ation in h o w such contracts w o rk . There has been much research on contracts, as on c a p ita l markets. The area goes b y several other names, w ith differences that are not im portant to this discussion, including agency theory, principal-agent theory an d positive accounting theory. In a contract, p e o p le a g re e to d o things on each other's behalf a nd to be com pensated for d o in g so properly. For exam ple, m anagers, auditors, law yers o r physicians are entrusted w ith acting on behalf o f on e or more other p e ople (the ow ners, creditors, defendants o r patients). C ontracts m ay be form ally w ritten ones (such as le g a lly bin d ing indentures p roviding protection to bondholders), less-formal em ploym ent contracts o r supplier agreem ents or inform al arrangem ents such as a handshake betw een partners. The person w h o is to d o som ething a nd be com pensated is often called the agent, an d the person w h o w ants it d o n e is the p rin cip a l. M a n y contracts involve both parties d o in g things for the other, a nd in a n y case, it is usually assumed that a va lid contract requires that both parties entered into it freely, because both expect to benefit. There is a fundam ental characteristic of contracts a m ong self-interested participants: the p e o p le are unlikely to have the same interests. C o n flict of interests is not v ie w e d as being b a d , but rather as being the natural state of affairs. For exam ple, if the a g e n t is to pro vid e effort on behalf o f the p rin cipa l, it w o u ld be natural for the a g e n t to w a n t to w o rk less hard than the prin cipa l w ishes. For the agent, effort is costly a nd m ight therefore be m inim ised, w hereas the prin cipa l w o u ld w a n t the agent's effort to be m axim ised.
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In the contract setting, accounting has a m ajor role in reporting on w h a t the a g e n t d id on behalf o f the p rincipal. This is the stew ardship role of accounting inform ation (in m onitoring the past stew ardship o f the agent, such as c o m p a n y m anagers, on behalf o f the prin cipa l, such as the ow ners or shareholders), as distinct from the futureoriented, decision-m aking role o f such inform ation in c a p ita l markets. N o w the focus is on h o w the m anagers behave, rather than on h o w the ca p ita l market (consisting o f shareholders a nd potential shareholders) behaves. You can think o f the inform ation produced by fin a n cia l accounting as resulting from the w ish b y the various parties to provide incentives and controls over each other's behaviour, especially agents' behaviour. This w ish exists because agents are assumed to w a n t to act in their o w n interests, a n d , in the absence o f a p p ro p ria te incentives an d controls, their interests are assumed not necessarily to co in cid e w ith those of their principals. From this point o f v ie w , accounting inform ation is a part o f the contract, a nd should serve the m onitoring an d other needs o f the contracting parties. Principals a nd agents specify w h a t they need a nd accounting serves that, so accounting is useful, a n d not in a n y sense 'right' o r 'w ro n g '. If conditions ch a n g e betw een various parties, accounting (and auditing) w ill ch a n g e to meet the n ew conditions. Principals an d agents w ill dem and w h a te ve r inform ation they require to m anag e the contractual relationship betw een them, a nd inform ation, therefore, can be ju dged o nly in terms o f that specific relationship. Is it w h a t they need, or isn't it? H ere is an exam ple. Suppose the shareholders of Lakewood Limited w a n te d m anagem ent to w o rk hard to m axim ise the price o f Lakew ood's shares, w h ich are traded on a stock exchange. The higher the price, the better the return w ill be to the ow ners from o w n in g the shares, an d the higher their w ealth w ill be. The ow ners might, through their representatives on Lakew ood's board o f directors, propose a m anagem ent contract that specifies that the top m anagers get no salary, but instead ge t 2 0 per cent o f the ch a n g e in the com pany's share price over each year. The to p m anagers m ight w e ll reply that this is too risky for them, because all sorts o f things m ight affect share price, including things over w h ich they have no control, such as w ars, recessions o r other unexpected problem s. The share price could g o up, but it m ight as likely g o d o w n . The m anagers m ay then propose that they should be p a id a flat salary o f $ 2 0 0 0 0 0 each, regardless o f changes in share price, believing that the ow ners should take the risks. This isn't w h a t the ow ners w a n t, because they a re concerned that the m anagers w ill not be sufficiently conscientious if they are guaranteed a salary regardless o f perform ance. Therefore, the tw o parties negotiate. Finally, a contract is a g re e d upon. Suppose it says that the m anagers w ill get $ 1 5 0 0 0 0 each, plus perform ance bonuses o f 5 per cent o f the annual net incom e a nd 3 per cent of the increase in share price, w ith no penalty for negative incom e or negative ch a n g e in share price, but w ith no bonuses then either. (The ow ners, interested in m axim ising the share price, a nd the m anagers, feeling that they have m ore control over net incom e than share price, w o u ld in this case have a g reed to include both factors in the bonus calculation.) M a n a g e m e n t com pensation contracts a re often very com plex, a nd a subcom m ittee of the b o a rd o f directors m ay be created sp e cifica lly to design an d m onitor such contracts. Securities commissions increasingly require public com panies to disclose the nature of such contracts a nd the com pensation that results from them, especially for the chief executive o ffice r an d other senior m anagers. M a n a g e m e n t com pensation contracts - in w h ich p a y depends on perform ance, and w h ich p a y o ff in shares o r options to buy shares ch e a p ly, in a d d itio n to cash - have becom e very com m on in recent years. The result is that the m anagers, as agents for the ow ners (the principals), have a g re e d to w o rk for the ow ners, and the ow ners have a g re e d to e m p lo y the m anagers. Both parties have entered into the contract for their o w n reasons, and both are satisfied w ith it (or they w o u ld not have agreed). N o w the ow ners can use fin a n cia l accounting inform ation to m onitor the m anagers' perform ance a nd to calculate their bonuses based on net incom e. Both parties, because o f their contract, are interested in the accounting inform ation, an d neither w o u ld be satisfied w ithout accounting. They m ay specify in their contract that G A A P be used to calculate net incom e, for the sake of convenience or because they prefer it that w a y . They also m ay specify other w a ys o f ca lculating net incom e that they think are to their mutual a d va n ta g e . If m any com panies have these sorts o f bonus arrangem ents o r other incentive contracts in w h ich financial accounting inform ation plays a role, there can be strong pressures on the developm ent of G A A P o r o fficia l accounting standards in directions that im prove the effectiveness o f such contracts. These pressures are likely to be in sim ilar directions to those of, say, ca p ita l markets, because the ow ners a re trading their shares on such markets. They w ill not
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be exactly the same, though, because the m anagers have to a g re e to the contracts too, a nd m ay not w a n t, for exam ple, to be a r as much risk as the c a p ita l market m ight like them to. There is also a cle a r role for auditors in the smooth functioning o f contracts. If the m anagers a re responsible for the accounting inform ation an d are being p a id on the basis o f it, the ow ners (w ho are perhaps some distance from the com pany's offices a nd in a n y case w o u ld not w a n t to have to sh o w up to ask questions a b o u t accounting) m ay not be inclined to trust the m anagers' figures, an d w o u ld prefer having an outside a u d ito r evaluate them. A d d in g c re d ib ility to m anagem ent's inform ation is the oldest reason for a u d itin g , a nd still central to it. There are m any kinds o f form al a nd inform al contracts, w ith m any parties other than m anagers (such as suppliers, associated com panies, foreign business partners an d governments) that m ay use fin a n cia l accounting inform ation. The parties to such contracts w ill necessarily have an interest in the fin a n cia l statements, in G A AP , in au d itin g , a n d in the other aspects o f fin a n cia l acco u n tin g . They w ill, therefore, act as part o f the system o f inform ation dem and and use that shapes acco u n tin g . Some o f the contracts that are likely to be o f interest from a fin a n cia l accounting point of v ie w include m anagem ent com pensation contracts (as illustrated above), labour contracts, contracts w ith suppliers a n d /o r customers, an d fin a n cia l contracts, such as those d ra w n up for issuance o f bonds, other d e b t o r equity. O n e reason for w ritten contracts is the co n flict of interests mentioned earlier. For exam ple, bondholders receive a claim on the co m p a n y, o r its assets, that has a higher legal priority than the shareholders' residual claim . A contract, such as a bond indenture, is w ritten specifying the e xact rights o f the bondholders. The indenture m ight say that if the com pany's w o rkin g c a p ita l falls b e lo w a certain level, the bondholders have the right to dem and e a rly paym ent o r some other penalty. This doesn't remove the conflict o f interests, but cla rifyin g the situation makes everyone's assessments o f the com pany's perform ance a nd prospects m ore inform ed.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le t o a n s w e r based o n w h a t y o u ha ve ju s t rea d. I f y o u c a n ’t a n s w e r it, it w o u ld be b e s t to re -re a d th e m a te ria l. G re e n L im ite d has a s e t o f m a n a g e m e n t b o n u s c o n tra c ts f o r its s e n io r e x e c u tiv e s , s p e c ify in g th a t th e ir pay w ill be based p a rtly o n h o w w e ll th e c o m p a n y p e rfo rm s . B ro w n L im ite d , h o w e v e r, j u s t pays its m a n a g e rs a fla t salary. W h a t d iffe re n c e s w o u ld y o u e x p e c t in th e a ttitu d e s o f th e tw o g ro u p s o f m a n a g e rs to th e ir c o m p a n y ’s fin a n c ia l s ta te m e n ts ? Y o u r a n s w e r s h o u ld be: Y o u w o u ld e x p e c t th e m a n a g e rs o f G re e n L im ite d t o be m o re in te re s te d in th e fin a n c ia l s ta te m e n ts r e fle c tin g p o s itiv e p e rfo rm a n c e , as th e ir re m u n e ra tio n is d ir e c tly re la te d to fin a n c ia l p e rfo rm a n c e o f th e c o m p a n y . T h is m a y in c re a s e th e c h a n c e s o f th e m s e le c tin g a c c o u n tin g p o lic ie s th a t in c re a s e th e c o m p a n y ’s p r o fit (s e e C h a p te r 1 6 ) and m a y also in c re a s e th e lik e lih o o d o f fin a n c ia l s ta te m e n t fra u d .
6.12
Managers and financial accounting standards
M a n a g e rs m ay be interested in accounting standards for several reasons. O n the positive side, standards should: •
make reports on m anagers' perform ance clearer
•
make it easier to make com parisons w ith other com panies
•
reduce the costs o f accounting (each c o m p a n y w o u ld not have to w o rk through an d invent accounting methods on its ow n)
• •
increase the co m p a n y's cre d ib ility in the eyes o f im portant users w h o utilise fin a n cia l statements in general help to evaluate the conceptual a nd numerical effects o f accounting choices a nd business decisions m anagers m ay have to make.
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O n the negative side: •
Standards m ay specify general methods that d o not w o rk w e ll for, o r even mismeasure, some specific com panies o r situations.
•
N o t all m anagers m ay w ish to be measured clearly o r have their com pany's perform ance easily co m p a red w ith that o f other com panies.
• •
Som e com ple x standards m ay be quite costly to fo llo w for some com panies. N e w standards m ay cause difficulty fo r loan agreem ents, bonus plans o r other arrangem ents that d e p e n d on accounting inform ation, an d w e re a g reed to before the im plem entation o f the n ew standards. W ith reasons like these, it should be no surprise that the senior m anagem ent o f m any com panies (and o f the firms
o f auditors w h o have the com panies as clients) take accounting standards very seriously. M a n y com panies seek to influence accounting standards through lo b b yin g standard-setters, lo b b yin g securities com missions a nd other governm ent agencies, a nd d o in g their o w n studies into the effects o f proposed standards. O n e o f the main reasons that top m anagers o f public com panies p a y close attention to their com panies' fin a n cia l statements, earnings announcem ents an d other disclosures is that share markets an d other securities markets respond q uickly to inform ation, and d o so in a cco rd a n ce w ith the value o f that inform ation to the market traders. The less a c o m p a n y is in the public eye o r the less it is involved in various securities markets, the less it is disciplined by such markets. H ow ever, even private com panies are not immune to such d iscipline, because they often com pete o r coop e ra te w ith , o r are suppliers to o r customers of, m ore d irectly affected com panies, an d also because even private ow ners often w ish to sell their com panies, b o rro w heavily o r take other action that brings their perform ance inform ation under scrutiny (e.g. com m on w a ys o f calculating the value of a private business make extensive use of fin a n cia l statements, a nd the perform ance an d trends they reveal). M a n a g e rs also p a y close attention to their co m p a n ie s' fin a n cia l statement figures, because im portant contracts are based on those, e xp licitly o r indirectly. M a n y to p m anagers are com pensated based on the p rofit shown in the financial statements, a nd m any o w n shares in their com panies. In a d d itio n , if the c o m p a n y is a public com p a n y, the to p m anagers m ay lose their jobs if stock market prices d e cline o r fail to rise as the bo a rd of directors wishes.
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PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Asset reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w g ive s rise to an asset u n d e r th e d e fin itio n a n d c h a ra c te ris tic s w ith in th e F ra m e w o rk . If so, s h o w th e a m o u n t o f th e asset. W h a t w o u ld th e asset be c a lle d ? 1 A te m p o ra ry excess o f cash is used to p u rch a s e shares in BHP B illito n fo r $ 8 5 0 0 .
2
A d e p o s it o f $ 5 0 0 0 is p a id on c u sto m -d e s ig n e d e q u ip m e n t to be c o m p le te d a n d d e liv e re d ne xt y e a r. The to ta l p u rch a s e p ric e o f this e q u ip m e n t w ill be $ 2 0 0 0 0 .
3
A s u p p lie r sends n o tic e th a t $ 9 0 0 w o rth o f ra w m a te ria ls has been s h ip p e d b y fre ig h t, w ith p a y m e n t d u e in 3 0 d a ys . The b u y e r o b ta in s title to th e g o o d s as soon as th e y a re s h ip p e d b y th e seller.
4
A c u sto m e r p laces an o rd e r fo r $ 6 0 0 w o rth o f g o o d s .
5
A p ro d u c tio n m a n a g e r has be en h ire d to ov e rs e e th e c o m p a n y 's o p e ra tio n s , w ith e m p lo y m e n t c o m m e n c in g next m o nth . O n e -tw e lfth o f th e a n n u a l s a la ry o f $ 9 6 0 0 0 is to be p a id a t th e e n d o f e a ch m o nth w o rk e d .
6
In ve n to ry is a c q u ire d a t a list p ric e o f $ 1 2 0 0 , w ith p a y m e n t m a d e in tim e to secure a 2 p e r c e n t d is c o u n t fo r p ro m p t settlem ent. C a s h d isc o u n ts a re tre a te d as a re d u c tio n in th e a c q u is itio n cost o f th e in ve n to ry.
PRACTICE PROBLEM B L ia b ility reco g n itio n In d ic a te w h e th e r o r no t e a ch o f th e fo llo w in g events im m e d ia te ly g ive s rise to th e re c o g n itio n o f a lia b ility . If a lia b ility is re c o g n is e d , state th e a c c o u n t title a n d th e a m o u n t. 1 A firm s ig n s a c o n tra c t to p u rch a s e a t least $ 4 0 0 0 0 w o rth o f m e rc h a n d is e d u rin g th e ne xt tw o m onths.
2
A c h e q u e fo r $ 2 4 0 fo r a tw o -y e a r s u b s c rip tio n to a m a g a z in e is re c e ive d .
3
A c o n s tru c tio n c o m p a n y a g re e s to b u ild a b rid g e fo r $ 2 m illio n . A d o w n p a y m e n t o f $ 2 0 0 0 0 0 is re c e iv e d u p o n s ig n in g th e c o n tra c t, a n d th e re m a in d e r is d u e w h e n th e b rid g e is c o m p le te d .
4
D u rin g th e last p a y p e rio d , e m p lo y e e s e a rn e d w a g e s a m o u n tin g to $ 2 4 5 0 0 fo r w h ic h th e y h a ve no t be en p a id . The e m p lo y e r is a ls o lia b le fo r p a y ro ll taxes o f 8 p e r c e n t o f th e w a g e s e a rn e d .
5
A c o m p a n y is in fo rm e d b y a p re vio u s e m p lo y e e th a t he is s uin g the c o m p a n y fo r $ 3 0 0 0 0 0 fo r w ro n g fu l d ism issa l.
KEY TERMS Accounting policies Agency theory Agent Audit committee Audit report Bonds Bond market
Capital market theory Corporate governance Current market value Current value accounting Efficient capital market Efficient market hypothesis Fair value
General purpose Financial reports Net present value Price-level-adjusted historical cost Principal-agent theory Replacement cost
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HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
D IS C U S S IO N Q U E S T IO N S 1
W h a t a re th e fu n d a m e n ta l q u a lita tiv e c h a ra c te ris tic s o f useful fin a n c ia l in fo rm a tio n a n d w h a t a re th e e n h a n c in g c h a ra c te ris tic s ?
2
P ro v id e an e x a m p le o f tra d e -o ffs a m o n g a c c o u n tin g p rin c ip le s .
3
The F ra m e w o rk states th a t u n d e rs ta n d a b ility is an e n h a n c in g q u a lita tiv e c h a ra c te ris tic . Is this co n s is te n t w ith the
4
D e fin e an asset. W h a t a re th e esse ntial c h a ra c te ris tic s o f an asset?
5
D e fin e a lia b ility . W h a t a re th e esse ntial c h a ra c te ris tic s o f a lia b ility ?
6
D e s crib e e a ch o f th e fo llo w in g m e thods fo r m e a s u rin g assets a n d lia b ilitie s : a h is to ric a l cost
h u g e c o m p le x ity in fin a n c ia l statem ents?
7
b
p rice -le v e l-a d ju s te d h is to ric a l cost
c
m a rk e t v a lu e
d
v a lu e in use
e
liq u id a tio n v a lu e
C o m p a re th e c o n ce p ts o f v a lu e in use a n d v a lu e in e x c h a n g e .
8 A rg u e bo th fo r, a n d a g a in s t, th e fo llo w in g p ro p o s itio n : 'H is to ric a l cost a c c o u n tin g is irre le v a n t to users' d e c is io n m a k in g .' 9
W h y is e th ics so im p o rta n t to a p ro fe s sio n ? Is th e re re a lly a ne ce ssity fo r e th ic a l g u id a n c e fo r m e m b ers o f a p ro fe ssio n ?
1 0 W r ite a p a ra g ra p h o r tw o d iscu ssin g th e fo llo w in g to p ic : 'T he o n ly th in g w o rs e th a n th e la rg e a n d c o m p le x set o f p ra c tic e s , s ta n d a rd s a n d th e o rie s th a t m a ke up G A A P w o u ld be if th e re w e re no such th in g as G A A P .' 11 W h a t statem ents a re in c lu d e d in a c o m p le te set o f fin a n c ia l statem ents? 12 W h a t is th e p u rp o s e o f th e notes to th e fin a n c ia l statem ents? 13 G o to th e w e b p a g e fo r a listed c o m p a n y , fin d its a n n u a l re p o rt a n d d e s c rib e th e c ontents o f th e C E O 's re p o rt. 14 W h a t p u rp o s e d o e s th e a u d ito r's re p o rt serve? 15 W h a t a re th e type s o f a u d it re p o rts , a n d w h a t do es e a ch in d ic a te to th e users o f fin a n c ia l statem ents? 16 In a d d itio n to th e fin a n c ia l statem ents, w h a t else is in c lu d e d in an a n n u a l re p o rt? 1 7 A u d ito rs p la y an im p o rta n t ro le in th e fin a n c ia l re p o rtin g system , a n d th e ir in d e p e n d e n c e fro m th e ir c lie n ts is an esse ntial fe a tu re o f this system . W h y is such in d e p e n d e n c e c o n s id e re d necessary? W h y is it d iffic u lt to m a in ta in ? 18 a b
T o a n in ve sto r, w h a t v a lu e has been a d d e d to th e fin a n c ia l statem ents b y th e a u d ito r's re p o rt? W h y ? S ug g e st som e lim ita tio n s re g a rd in g th e v a lu e o f th e a u d ito r's re p o rt th a t an in ve sto r sh o u ld be a w a re of.
1 9 D o y o u th in k n o t-fo r-p ro fit o rg a n is a tio n s sh o u ld fo llo w the sam e G A A P th a t business e n te rp rise s d o ? W h y , o r w h y not? 2 0 G iv e e x a m p le s o f cases w h e re th e re is a c o n flic t o f in tere st b e tw e e n p re p a re rs o f fin a n c ia l statem ents a n d users o f them . 21 S h o u ld a s e n io r fin a n c ia l m a n a g e r w h o w o rk s fo r a c o m p a n y , a n d is a p ro fe s s io n a l a c c o u n ta n t, h a ve to m eet the sam e s ta n d a rd s o f p ro fe s s io n a l ethics as d o e s a c o lle a g u e w h o is a n e x te rn a l a u d ito r in p u b lic p ra c tic e ? W h y , o r w h y not? 2 2 W h a t is th e ro le o f in fo rm a tio n in a c a p ita l m arket? 2 3 W h a t is m e a n t b y th e e ffic ie n t m a rke t h ypo the sis? 2 4 W h a t is th e m a jo r p u rp o s e o f a stock e x c h a n g e ? 2 5 E x p la in th e term s 'a g e n c y th e o ry ' a n d 's te w a rd s h ip '.
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2 6 B rie fly d e s c rib e tw o im p o rta n t im p lic a tio n s c a p ita l m a rke t th e o ry has fo r th e use o f a c c o u n tin g in fo rm a tio n . 2 7 B rie fly d e s c rib e tw o im p o rta n t im p lic a tio n s a g e n c y (co ntra ct) th e o ry has fo r th e use o f a c c o u n tin g in fo rm a tio n . 2 8 It a p p e a rs th a t som e to p m a n a g e rs a tte m p t to m a n a g e th e ir c o m p a n ie s ' fin a n c ia l disc lo su re , in c lu d in g th e ir fin a n c ia l a c c o u n tin g , to a lte r th e sto ry e a ch d isc lo su re tells. W h y m ig h t m a n a g e rs b e m o tiv a te d to d o this?
2 9 W h y sh o u ld th e s h a re h o ld e rs o f a la rg e , p u b lic ly tra d e d c o m p a n y w a n t to h a ve th e c o m p a n y 's fin a n c ia l statem ents a u d ite d ? 3 0 The a u d ito rs ' re p o rt is n o rm a lly w ritte n using s ta n d a rd w o rd in g . The id e a is th a t, if th in g s a re n o t a ll rig h t, v a ria tio n s fro m th e s ta n d a rd w o rd in g w ill a le rt users o f th e fin a n c ia l statem ents. Is th a t consisten t, o r in co nsistent, w ith c a p ita l m a rke t th e o ry ?
PROBLEMS PROBLEM 6.1 Can Financial sta te m e n ts m eet various needs? The c h a irp e rs o n o f th e b o a rd o f d ire c to rs o f a la rg e p u b lic c o m p a n y s a id in fru s tra tio n : 'T he c o m p a n y 's w ritte n a n d u n w ritte n c o n tra cts w ith its s h a re h o ld e rs a re so d iffe re n t fro m those w ith its m a n a g e rs th a t it's im p o s s ib le to d e s ig n fin a n c ia l statem ents th a t w ill m eet th e needs o f b o th s h a re h o ld e rs a n d m a n a g e rs '. W h a t d o y o u th ink?
PROBLEM 6 .2 Financial sta te m e n t assum ptions Listed b e lo w , in jo u rn a l e n try fo rm , a re c e rta in u n re la te d a c c o u n tin g s itu a tio n s a n d (w h e re a p p lic a b le ) the a c c o u n tin g tre a tm e n t th a t has be en fo llo w e d b y th e firm s c o n c e rn e d . 1 Y Z Ltd has p u rc h a s e d , fo r $ 2 m illio n , a c o m p u te r th a t it e xp e cts to use fo r th re e y e a rs . A t th e e n d o f this p e rio d , it p la n s to a c q u ire , fo r $ 4 .5 m illio n , a fa s te r c o m p u te r w ith g re a tly in cre a s e d s to ra g e c a p a c ity . The d ire c to rs d e c id e d to 'p ro v id e fo r o n e -th ird o f th e e s tim a te d cost o f a n e w c o m p u te r d u rin g th e c u rre n t y e a r'.
Accounting treatment: DR CR
2
Depreciation expense Accumulated depreciation
$1 5 0 0 0 0 0 $1 5 0 0 0 0 0
D u rin g th e c u rre n t y e a r, g e o lo g is ts a n d e n g in e e rs h ire d b y th e D uchess O il C o m p a n y re vised u p w a rd s the e s tim a te d v a lu e o f n a tu ra l g a s a n d o il on p ro p e rty le a se d b y th e c o m p a n y . The d ire c to rs in stru cted the a c c o u n ta n t to re c o rd g o o d w ill o f $ 5 m illio n , th e e s tim a te d v a lu e o f g a s a n d o il d e p o sits in excess o f p re vio u s estim ates.
Accounting treatment: DR CR
Goodwill Gain on revaluation of gas and oil deposits
$5 0 0 0 0 0 0 $5 0 0 0 0 0 0
3
The b o a rd o f d ire c to rs o f Ryan C o rp o ra tio n disp oses o f a m a jo r seg m e n t o f th e e n te rp ris e , b u t o m its a n y m e ntion o f this in th e a n n u a l re p o rt 'to p ro te c t th e interests o f s h a re h o ld e rs '. P rofit is c o rre c tly stated a n d to ta l fig u re s in the b a la n c e sheet a re c o rre c t in to ta l.
4
Z ig -Z a g Ltd c h a n g e s its m e th o d o f d e p re c ia tio n e v e ry th re e y e a rs , b u t c le a rly discloses th e c h a n g e in its p u b lis h e d fin a n c ia l statem ents.
5
The fin a n c ia l y e a r o f S a tu ra te d Ltd en ds o n 31 D e c e m b e r. It is n o w 21 J a n u a ry , a n d fin a n c ia l statem ents fo r the y e a r just e n d e d a re b e in g p re p a re d . O n 1 0 J a n u a ry , a c y c lo n e d e s tro y e d a w a re h o u s e s e rvicin g th e no rth e rn p a rt o f th e c o u n try , a n d m ost o f the in ve n to rie s sto re d in th e w a re h o u s e w e re re n d e re d w o rth le s s . B ecause th ere
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is som e d o u b t c o n c e rn in g th e p a y m e n t o f th e in su ra n c e p re m iu m b y th e d u e d a te , it re m a in s unsettled as to w h e th e r th e loss is in fa c t c o v e re d b y in su ra n c e . This p o s s ib le loss w a s re fle c te d in th e fin a n c ia l statem ents fo r the y e a r just e n d e d .
Accounting treatment: DR
Cyclone loss
$450000
CR
Inventory
$450000
6
It has be en c u s to m a ry fo r HPB Ltd, o n e o f th e c o u n try 's la rg e s t c o rp o ra tio n s , to c a p ita lis e a n d d e p re c ia te a ll n e w ly a c q u ire d assets c o stin g m o re th a n $ 2 0 0 . This y e a r, th e b o a rd o f d ire c to rs has in stru cted th a t, in fu ture , a ll a c q u is itio n s o f less th a n $ 5 0 0 a re to be im m e d ia te ly w ritte n o ff as expe nses.
7
B N M In su ra nce, b y a c tio n o f th e b o a rd o f d ire c to rs , w ro te d o w n th e v a lu e o f its h e a d o ffic e b u ild in g to a n o m in a l a m o u n t o f $ 1 . The o b je c tiv e w a s to b o lste r its p o lic y h o ld e rs ' c o n fid e n c e in th e fin a n c ia l streng th o f th e e n te rp ris e b y o b v io u s ly u n d e rsta tin g assets.
Accounting treatment: DR
Retained profits
$ 1 9 9 9 9 999
CR
Buildings
$ 1 9 9 9 9 999
In e a c h o f th e g iv e n s itu a tio n s , in d ic a te w h ic h b a sic a c c o u n tin g a ssu m p tio n s a re in v o lv e d , a n d w h e th e r th e y ha ve be en used a p p ro p ria te ly . In those s itu a tio n s w h e re y o u c o n s id e r th a t th e a c c o u n tin g a s su m p tio n s h a ve n o t be en used a p p ro p ria te ly , discuss th e e ffe c t o f this d e p a rtu re fro m n o rm a l p ra c tic e o n th e fin a n c ia l statem ents. The a c c o u n tin g a ssu m p tio n s w e re set o u t in s e ctio n 1 .8 o f C h a p te r 1.
PROBLEM 6 .3 A cco u n tin g concepts and econom ic agents 1
E x p la in w h y e a ch o f th e fo llo w in g c o n c e p ts is im p o rta n t in re la tio n to fin a n c ia l re p o rtin g to m arkets a n d o th e r e c o n o m ic a g e n ts th a t re ly on such re p o rtin g : a
2 3
e c o n o m ic e n tity assu m p tio n
b
h is to ric a l c o st ba sis o f a c c o u n tin g
c
fa ith fu l re p re s e n ta tio n
d
g e n e ra lly a c c e p te d a c c o u n tin g p rin c ip le s
e
p ro fe s s io n a l e th ics o f th e a c co u n ta n ts a n d / o r a u d ito rs in v o lv e d in p ro d u c in g fin a n c ia l statem ents.
H o w h a ve e a ch o f these c o n c e p ts be en in c o rp o ra te d in to th e fin a n c ia l statem ents o f a la rg e p u b lic c o m p a n y y ou k n o w a b o u t? G iv e s p e c ific e x a m p le s. N o w a p p ly these id e a s to a sm all p riv a te c o m p a n y , such as y o u r lo ca l T h ai ta k e a w a y , n e w s a g e n t o r p h a rm a c y . A re these c o n c e p ts still re levant? W h y o r w h y not?
PROBLEM 6 .4 U sefulness o f acco u n tin g concepts and p rinciples Jason is a h a rd -d riv in g , im p a tie n t business e x e c u tive . Y ou w o rk fo r h im , a n d c a n fe el th e g re y h a ir s p ro u tin g on y o u r h e a d fro m a ll th e pressure. O n e d a y , he returns fro m a lunch m e e tin g w ith his a c c o u n ta n t a n d says, 'T h a t a c c o u n ta n t to ld m e th a t th e re a re a c c o u n tin g c o n c e p ts a n d p rin c ip le s th a t tell m e im p o rta n t th in g s a b o u t w h y m y fin a n c ia l statem ents a re useful, w h y th e y a re w o rth a ll th e m o n e y th e y cost to p ro d u c e a n d a u d it. I'm n o t c o n v in c e d .' C h o o s e a n y fiv e o f th e c o n c e p ts a n d p rin c ip le s listed in section 6 .3 , a n d e x p la in to Jason w h y those five a re useful. M a k e y o u r e x p la n a tio n s b rie f a n d to th e p o in t: Jaso n hates lo n g w in d e d a n sw e rs!
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PROBLEM 6 .5 Id e n tify som e a cco u n tin g concepts and p rinciples Id e n tify th e a c c o u n tin g c o n c e p ts o r p rin c ip le s th a t re la te to e a ch o f th e fo llo w in g sentences, a n d e x p la in w h a t e ffe c t th e c o n c e p ts o r p rin c ip le s h a ve on fin a n c ia l statem ents: 1 Users o f fin a n c ia l statem ents sh o u ld be a b le to b e lie v e th a t th e nu m b ers re p re s e n t re a l events. 2
F in a n c ia l statem ents sh o u ld a v o id un du e o p tim is m a b o u t th e fu ture .
3
It is h a rd to s a y a b s o lu te ly if a c o m p a n y is p e rfo rm in g w e ll o r b a d ly , b u t y o u c a n e v a lu a te its re la tive p e rfo rm a n c e .
4
F in a n c ia l a c c o u n tin g sh o u ld be h e lp fu l bo th in u n d e rs ta n d in g th e p a st a n d lo o k in g a h e a d to th e fu ture .
PROBLEM 6 .6 Q ualitative characteristics The F ra m e w o r k f o r th e P re p a r a tio n a n d P re s e n ta tio n o f F in a n c ia l S ta te m e n ts e x a m in e s th e c h a ra c te ris tic s o f a c c o u n tin g in fo rm a tio n th a t m a ke this in fo rm a tio n useful fo r d e c is io n -m a k in g . It a ls o p o in ts o u t th a t v a rio u s lim ita tio n s , w h ic h a re in h e re n t in th e m e asure m en t a n d re p o rtin g process, m a y necessitate tra d e -o ffs b e tw e e n these lim ita tio n s a n d th e p o s itiv e c h a ra c te ris tic s o f useful in fo rm a tio n . 1 B rie fly d e s c rib e th e fo llo w in g c h a ra c te ris tic s o f useful a c c o u n tin g in fo rm a tio n :
2
a
re le v a n c e
b
fa ith fu l re p re s e n ta tio n
c
u n d e rs ta n d a b ility
d
c o m p a ra b ility
e
tim eliness
f
v e rific a tio n .
For e a ch o f th e fo llo w in g p a irs o f in fo rm a tio n c h a ra c te ris tic s , g iv e a n e x a m p le o f a s itu a tio n in w h ic h o n e o f the c h a ra c te ris tic s m a y be s a c rific e d in return fo r a g a in in th e o th e r: a
re le v a n c e a n d v e rific a tio n
b
fa ith fu l re p re s e n ta tio n a n d tim eline ss
c
c o m p a ra b ility a n d re le v a n c e
d
re le v a n c e a n d u n d e rs ta n d a b ility .
PROBLEM 6 .7 R ecognition in accordance w ith standards and th e Fram ew ork For e a c h o f item s 1 - 5 liste d b e lo w , state w h e th e r, in a c c o rd a n c e w ith e x is tin g a c c o u n tin g s ta n d a rd s a n d the F ra m e w o rk , it w o u ld be re c o g n is e d as: a an asset b
a lia b ility
c
a c o n tin g e n t lia b ility
d
reven ue
e
an exp e n se
f
n o n e o f th e a b o v e .
1
Items: a p ro v is io n fo r a n n u a l le ave
2
$1 m illio n p a y a b le u n d e r a g u a ra n te e in th e e v e n t o f a th ird p a rty b e in g u n a b le to p a y
3
p u rc h a s e d g o o d w ill
4
a p a te n t
5
th e excess o f re se a rch a n d d e v e lo p m e n t costs o v e r th e e x p e c te d fu tu re e c o n o m ic be ne fits o f th e p ro je c t.
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PROBLEM 6.8 R ecognition o f an asset The g e n e ra l m a n a g e r o f T e lco Lim ited is c o n s id e rin g s p e n d in g $ 1 5 m illio n on th e d e v e lo p m e n t o f a n e w m o b ile p h o n e th a t c a n a ls o be used as a te le v is io n . W h a t c o n d itio n s w o u ld ne ed to be m et b e fo re th e $ 1 0 m illio n c a n be re c o g n is e d as an asset on th e b a la n c e sheet?
PROBLEM 6.9 C onceptual com ponents o f asset cost The n e w a c c o u n ta n t fo r M a c ta g g a rt Industries is w o n d e rin g h o w to c a lc u la te th e cost o f a n e w m a c h in e th e c o m p a n y has just in sta lle d . E x p la in b rie fly w h e th e r o r no t y o u th in k e a ch o f th e fo llo w in g item s sh o u ld be p a rt o f th e m a c h in e 's cost, a n d w h y : 1 th e in v o ic e p ric e o f th e m a ch in e
2
sales ta x p a id o n th e m a ch in e
3
s h ip p in g c h a rg e s to g e t th e m a c h in e to th e c o m p a n y 's fa c to ry
4
th e cost o f th e fa c to ry m a n a g e r's trip to th e m a c h in e m a n u fa c tu re r's p la n t to c h o o se th e m a ch in e
5
th e cost o f p a in tin g th e m a c h in e lig h t g re e n , as o th e r m a ch in e s in th e fa c to ry a re p a in te d
6 e s tim a te d reven ue lost b e ca u s e th e m a c h in e a rriv e d late 7
th e cost o f s u b s ta n d a rd p ro d u c ts m a d e w h ile th e fa c to ry p e rso n n e l w e re le a rn in g h o w to o p e ra te th e m a c h in e (all th ro w n a w a y so as n o t to d a m a g e th e c o m p a n y 's re p u ta tio n fo r q u a lity pro du cts)
8
in tere st cost on th e b a n k lo a n used to fin a n c e th e m a c h in e 's p u rch a s e
9
th e cost o f m o vin g th re e o th e r m a ch in e s in th e fa c to ry to m a ke ro o m fo r th e n e w on e.
PROBLEM 6.10 D eterm ine asset costs from various possible com ponents D e te rm in e th e costs th a t w o u ld a p p e a r on th e b a la n c e sheet o f Sm ith C o . Ltd, in re la tio n to la n d a n d a b u ild in g , b a se d on th e fo llo w in g in fo rm a tio n : Purchase price of plant site
175 000
Building materials (includes $ 10 000 in materials wasted because of worker inexperience)
700 000
Machinery installation charges
40000
Grading and draining plant site
20000
Labour costs of construction (Smith Co. used its own workers to build the plant rather than laying them off because business was slack. However, the labour to build the plant cost $40000 more than outside contractors would have charged, because of inside workers' inexperience and inefficiency.) Machinery purchase cost
500 000
1000 000
Machinery delivery charges
10000
Parking lot grading and paving
60000
Replacement of building windows shot out by vandals before production start-up Architect's fees
7 000 40000
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PROBLEM 6.11 Asset reco g n itio n State w h e th e r o r no t a n asset sh o u ld be re c o rd e d in th e b a la n c e shee t o f LMR Ltd as a t 3 0 June 2 0 1 6 in e a ch o f the fo llo w in g s itu a tio n s . In d ic a te th e a m o u n t o f th e asset (if an y) a n d a n y a s su m p tio n s m a d e . 1 O n 1 5 M a y 2 0 1 6 , LMR Ltd p a id $ 1 0 0 0 0 fo r a n in su ra n c e p re m iu m . The p re m iu m co ve rs losses in c u rre d in the p e rio d up to 1 4 M a y 2 0 1 7 . 2
LMR Ltd p a id $ 1 0 0 0 0 0 fo r a p a te n t in A p r il 2 0 1 6 .
3
LMR Ltd has just h ire d a n e w g e n e ra l m a n a g e r w h o is an e x p e rt in th e business c a rrie d on b y LMR Ltd. W ith the h e lp o f this p e rso n , th e c o m p a n y is e x p e c te d to in cre a s e its a n n u a l p ro fits b y $ 8 5 0 0 0 0 . The g e n e ra l m a n a g e r's s a la ry is $ 4 5 0 0 0 0 p e r an n u m .
4
LMR Ltd p u rc h a s e d la n d in 1 9 9 4 fo r $ 5 0 0 0 0 0 . The m a rke t v a lu e o f this la n d is $ 7 5 0 0 0 0 as a t 3 0 June 2 0 1 6 .
5
O n 2 9 June 2 0 1 6 , LMR Ltd p a id $ 9 0 0 0 0 0 fo r a p rin tin g s ervice business c o n s is tin g o f m a ch in e s w o rth $ 5 0 0 0 0 0 a n d a list o f 7 5 e s ta b lis h e d clie nts.
6 O v e r th e y e a rs , LMR Ltd has c re a te d g o o d w ill a m o n g its c lie n ts so th a t it n o w e n jo ys g o o d re la tio n s w ith o v e r 2 0 0 0 custom ers. It is e s tim a te d th a t if th e business w a s sold , as a t 3 0 June 2 0 1 6 , LMR Ltd c o u ld d e m a n d an a d d itio n a l $ 4 0 0 0 0 0 a b o v e th e sale p ric e o f its p h y s ic a l assets. 7
A m a c h in e is p u rc h a s e d fo r $ 5 0 0 0 0 0 a n d costs a n a d d itio n a l $ 2 0 0 0 0 0 to in sta ll.
PROBLEM 6.12 R ecognition o f assets For e a ch s itu a tio n b e lo w , state w h e th e r an asset w o u ld be re c o g n is e d in th e b a la n c e sheet. If th e a n s w e r is no , state w h ic h o f th e esse ntial c h a ra c te ris tic s re la tin g to assets has n o t be en m et. 1 E q u ip m e n t is p u rc h a s e d on c re d it. 2
C a s h is re c e iv e d fro m a cash sale.
3
A y e a rly in su ra n c e p o lic y is p a id in a d v a n c e .
4
A d e p a rtm e n t store receive s g o o d s fro m a m a n u fa c tu re r on c o n s ig n m e n t. A c o n s ig n m e n t is a s e llin g a rra n g e m e n t w h e re b y a c o m p a n y (co n s ig n o r) ships g o o d s to a n a g e n t (the d e p a rtm e n t store), w h o a g re e s to sell th e g o o d s on b e h a lf o f th e c o m p a n y fo r a c o m m is sio n . U n d e r th e a g re e m e n t, title to th e g o o d s re m a in s w ith th e c o n s ig n o r until th e g o o d s a re sold to a th ird p a rty .
5
Land is d o n a te d to a s p o rtin g a s s o c ia tio n .
6 A s p o rtin g a s s o c ia tio n receives a g ra n t fro m th e lo c a l c o u n c il to b u ild a n e w te n n is c o u rt. 7
A p a te n t is p u rc h a s e d using cash .
8 M o n e y is spen t on resea rch a n d d e v e lo p m e n t th a t is u n lik e ly to le a d to a n y n e w p ro d u c t in th e n e a r fu ture , bu t has th e p o te n tia l to le a d to d e ve lo p m e n ts in th e lo ng term .
9 A c o m p a n y hires a n e w g e n e ra l m a n a g e r w h o has a re p u ta tio n fo r in c re a s in g p ro fits in he r first y e a r w ith a n y n e w e m p lo y e r. 1 0 BHP shares a re p u rc h a s e d fo r cash. 11 A c o u n c il s w im m in g p o o l o ffe rs fre e a d m is s io n to ra te p a y e rs w h o p ro v id e id e n tific a tio n . 12 A lu x u ry re so rt pa ve s a g ra v e l ro a d fro m th e h ig h w a y to th e resort. The ro a d c a n a ls o be used b y others to g e t to a n u m b e r o f s p o rtin g fa c ilitie s in th e a re a , in c lu d in g a g o lf co u rs e th a t is no t o w n e d b y th e resort. 13 A n e w p rin tin g press is a c q u ire d . 14 A p ie c e o f e q u ip m e n t has a w ritte n -d o w n v a lu e o f $ 1 0 0 0 0 0 , a n d is no lo n g e r used b y th e c o m p a n y . It has no s c ra p v a lu e .
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PROBLEM 6.13 Id e n tify item s as assets, lia b ilitie s o r ow ners' e q u ity State whether or not, and why, each of the following items is likely to be an asset, a liability or an owners' equity account (perhaps both an asset and a liability in some cases) of the company indicated: Company
Item
1
News Corporation
List of subscribers to a magazine
2
Qantas
Funds collected from employees, to be repaid to them after retirement as superannuation
3
Westpac
Westpac's satisfied customers
4
Any company
Lawsuit against the company by a builder who alleges the company failed to pay for work done on the company's premises
5
Any company
Land that the company has agreed to sell to a real estate developer once it has been surveyed
6
Westpac
Westpac's dissatisfied customers
7
Fairfax Media
Australian Financial Review's skilled group of editors and reporters
8
Ampolex
Oil discovered on Ampolex's property, but still underground and likely to stay there for many years
9
Sydney Football Club
Players under contract to the team
10
Harvey Norman
Deposits received from customers of Harvey Norman for furniture not yet delivered to them
11
Woolworths
Profits earned by Woolworths, but not yet paid out to the owners as dividends
12
FedEx
A fleet of delivery trucks leased by FedEx from several truck-leasing firms
13
Hertz
A car Hertz leases to a real estate salesperson
14
Telstra
Funds owing to Telstra by a customer who recently declared bankruptcy
15
Qantas
The phrase 'The Flying Kangaroo' and the logo, both registered trademarks
16
Westfield Holdings
The parking lot surrounding Roselands Shopping Mall, Sydney
17
Wesfarmers
A guarantee Wesfarmers has made on a bank loan owed by an associated company
18
New beer company
A newly developed beer with reduced calories that has yet to be approved by the government
PROBLEM 6.14 R ecognition o f lia b ility BRK Lim ited is b e in g sued fo r $ 3 .5 m illio n b y a c lie n t fo r d e fa m a tio n resultin g fro m statem ents m a d e in n e w s p a p e rs b y o n e o f its e x e c u tive s. In e a ch o f th e s itu a tio n s b e lo w , state w h e th e r a lia b ility sh o u ld be re c o g n is e d in th e b a la n c e sheet. 1 BRK receive s le g a l a d v ic e th a t it is u n lik e ly th a t th e c la im w ill be successful. 2
BRK receive s le g a l a d v ic e th a t th e c la im has a b o u t a 5 0 p e r c e n t c h a n c e o f b e in g successful.
3
BRK receives le g a l a d v ic e th a t th e c la im is lik e ly to be successful, w ith d a m a g e s s o m e w h e re b e tw e e n $ 5 0 0 0 0 0 a n d $ 3 m illio n .
4
BRK o ffers th e c lie n t $1 m illio n in full settlem ent, b u t th e c lie n t refuses.
5
A t y e a r-e n d , BRK is in fo rm e d th a t le g a l costs to d a te a re $ 4 0 0 0 0 0 , a n d th e y w ill in cre a s e s u b s ta n tia lly in the n e w y e a r, d e p e n d in g o n w h e th e r th e m a tte r g o e s to c o u rt o r not.
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PROBLEM 6.15 R ecognition o f lia b ilitie s in th e balance sheet State w h e th e r o r no t e a ch o f the fo llo w in g events w o u ld result in a lia b ility b e in g re co g n is e d in the acco un ts a t 3 0 June. If so, w h a t w ill the lia b ility be c a lle d ? If not, e x p la in the reasons w h y it w o u ld no t be re co g n is e d as a lia b ility . 1 Taxes fo r th e y e a r e n d e d 3 0 June, w h ic h a re no t p a y a b le until O c to b e r. 2
W a g e s to be p a id on 2 July to c o v e r th e tw o -w e e k p e rio d up to 3 0 June.
3 The c o m p a n y sells w a s h in g m a ch in e s a n d g ive s a o n e -y e a r w a rra n ty to re p a ir o r re p la c e a n y fa u lty m a ch in e s. 4 A c o n s tru c tio n c o m p a n y receives a $ 5 m illio n a d v a n c e in June fo r a c o n tra c t. The w o rk w ill c o m m e n ce in July. 5 6
The c o m p a n y has s ig n e d a c o n tra c t to p a y its m a n a g in g d ire c to r $ 5 0 0 0 0 0 p e r a n n u m (in fla tio n a d ju ste d ) fo r th e n e xt fo u r y e a rs . O n 1 June, th e c o m p a n y is in fo rm e d th a t it is b e in g sued fo r d a m a g e s o f $1 m illio n c a u s e d b y a fa u lty p ro d u c t. The c o m p a n y d e n ie s lia b ility .
7
The c o m p a n y w ill g o to a rb itra tio n in J u ly to d e te rm in e th e a m o u n t o f p a y m e n t to re p a ir e n v iro n m e n ta l d a m a g e c a u s e d b y o n e o f its fa cto rie s .
PROBLEM 6.16 R ecognition o f lia b ilitie s S a m a n th a is th e a c c o u n ta n t fo r P rio r Ltd. H o w w o u ld y o u a d v is e he r to a c c o u n t fo r th e fo llo w in g item s in th e fin a n c ia l statem ents, as a t 3 0 June 2 0 1 6? 1 A p ro d u c tio n m a n a g e r w a s a p p o in te d o n 1 M a y 2 0 1 6 u n d e r a tw o -y e a r c o n tra c t th a t specifies an a n n u a l s a la ry o f $ 5 0 0 0 0 fo r e a ch o f th e tw o y e a rs . The c o n tra c t c a n be te rm in a te d w ith s ix m o n th s' n o tic e fro m e ith e r p a rty . 2
The c o m p a n y p a ys , in to a b o n u s p o o l, 5 p e r c e n t o f th e p ro fits re p o rte d a t th e e n d o f June fo r d is trib u tio n to p a rtic ip a tin g e m p lo y e e s .
3 A s u b s id ia ry o f P rio r Ltd has just be en p la c e d in re c e iv e rs h ip . In A p r il 2 0 1 6 , P rio r Ltd s ig n e d as g u a ra n to r fo r an $ 8 0 0 0 0 0 tw o -y e a r lo a n fro m a fin a n c e c o m p a n y to th e s u b s id ia ry .
4
Based o n his e x p e rie n c e s in p re vio u s y e a rs , th e c u stom er se rvice m a n a g e r e xp e cts w a rra n ty c la im s a g a in s t sales m a d e d u rin g 2 0 1 6 to a m o u n t to $ 7 0 0 0 0 .
5
G o w e r a n d C o . is s uin g P rio r Ltd fo r b re a c h o f c o n tra c t. S a m a n th a th inks G o w e r a n d C o . w ill p ro b a b ly lose th e case.
PROBLEM 6.17 L ia b ility reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w results in a lia b ility u n d e r th e d e fin itio n s a n d c h a ra c te ris tic s w ith in th e F ra m e w o rk . If so, s h o w th e a m o u n t o f th e lia b ility . W h a t w o u ld th e lia b ility be c a lle d ? 1 A b a n k lo a n o f $ 1 0 0 0 0 is o b ta in e d , w ith th e c o m p a n y s ig n in g a n a g re e m e n t to re p a y th e a m o u n t in s ix m onths, to g e th e r w ith in tere st o f 8 p e r c e n t p e r an n u m . 2
E le ctricity used in th e pa st m o nth , w o rth $ 2 3 0 , has no t be en p a id fo r.
3 A $ 3 0 0 0 c h e q u e is re c e iv e d fro m a te n a n t fo r th re e m o n th s' ren t in a d v a n c e . 4 A c o m p a n y sign s a tw o -y e a r e m p lo y m e n t c o n tra c t w ith a m a rk e tin g m a n a g e r. E m p lo ym e n t b e g in s n e xt m onth, a t a c o n tra c t p ric e o f $ 1 5 0 0 0 0 p e r y e a r.
PROBLEM 6.18 E ffects o f an asset acco u n tin g change to m arket from cost B e a u p o rt Ltd o w n s s eve ral p a rce ls o f la n d in th e S y d n e y a re a . The a re a has been s u b je c t to w id e sw in g s in real estate v a lu e s , a n d th e g e n e ra l m a n a g e r is d o u b tfu l th a t th e h is to ric a l cost ba sis is a p p ro p ria te fo r use in a c c o u n tin g fo r th e c o m p a n y 's la n d a n d b u ild in g s . G iv e short b u t c a re fu l a n sw e rs to th e fo llo w in g q u e s tio n s a s ke d b y th e g e n e ra l m a n a g e r. 1 'If w e c h a n g e d to m a rk e t v a lu e s fo r th e re a l estate, in ste a d o f cost, w o u ld th a t m a ke o u r b a la n c e sheet lo o k be tte r o r w o rs e ? ' 2
'S im ila rly fo r p ro fit: w o u ld using m a rk e t v a lu e in ste a d o f cost m a ke us lo o k m o re p ro fita b le o r less p ro fita b le ? '
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3
'D o e s it m a tte r w h a t w e d o , as lo n g as w e d isc lo se bo th cost a n d m a rke t v a lu e s o m e w h e re in o u r fin a n c ia l state m e nts?'
4
In w h a t w a y d o th e g e n e ra l m a n a g e r's qu e stio n s re fle c t a c h o ic e b e tw e e n th e c o n c e p ts o f v a lu e in use a n d v a lu e in e x c h a n g e ?
5
W h a t o th e r bases fo r v a lu in g th e p a rce ls o f la n d a n d b u ild in g s w o u ld be a v a ila b le to th e c o m p a n y ?
PROBLEM 6.19 A u th o rita tiv e standards, ca p ita l m arkets and contracts M a n y o f th e a c c o u n tin g m e tho ds y o u a re s tu d y in g in this b o o k a re b a se d on a u th o rita tiv e s ta n d a rd s (such as A A S B S tatem ents), w h ic h a tte m p t to s p e c ify h o w c o m p a n ie s ' fin a n c ia l a c c o u n tin g sh o u ld be d o n e . Such s ta n d a rd s d o n 't c o v e r e v e ry th in g : c o m p a n ie s m ust still m a ke m a n y ch o ice s w h e n th e y a re p re p a rin g th e ir fin a n c ia l statem ents. W h y a re th e re a u th o rita tiv e s ta n d a rd s fo r c o m p a n ie s to fo llo w ? W h y d o n 't th e y c o v e r e v e ry th in g ? S h o u ld w e h a ve m o re o r fe w e r o f them ? S itu a te y o u r a n s w e r in th e c o n te x t o f th is c h a p te r's th e o rie s a b o u t in fo rm a tio n use.
PROBLEM 6.20 A u d ito rs and Forecast in fo rm a tio n R ecently, th e re has be en pressure to e x p a n d th e ro le o f a u d ito rs , b e ca u s e investors a n d o th e r g ro u p s a re d e m a n d in g m o re fo rw a rd -lo o k in g in fo rm a tio n . If these d e m a n d s a re m et, a u d ito rs m a y be e x p e c te d to re v ie w th e p la n s a n d fo re ca sts o f a c o m p a n y th a t w ill be re p o rtin g to th e p u b lic , a n d to d e te rm in e th e fa irn e ss o f such fo rw a rd -lo o k in g fin a n c ia l statem ents. Discuss th e im p lic a tio n s o f this e x p a n d e d ro le fo r a u d ito rs , using such c o n ce p ts as in d e p e n d e n c e , in fo rm a tio n v a lu e , c o m p a ra b ility , a g e n c y th e o ry , c a p ita l m a rk e t th e o ry , re le v a n c e , re lia b ility , o b je c tiv ity a n d a n y o th e r c o n c e p ts th a t y o u feel a re im p o rta n t.
PROBLEM 6.21 C apital m arkets, a u d ito rs and co n tra cts 1
O n 31 O c to b e r 2 0 1 5 , an a lys ts p re d ic te d th a t th e e a rn in g s p e r sh a re o f O a k e s Ltd w o u ld e q u a l $ 4 .8 0 fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 5 . A c tu a l results w e re a n n o u n c e d o n 2 7 F e b ru a ry 2 0 1 6 . E a rn in g s p e r s h a re fo r 2 0 1 5 c a m e to $ 3 .9 5 . C o n s id e r th e th re e da tes no te d a b o v e (31 O c to b e r 2 0 1 5 , 31 D e c e m b e r 2 0 1 5 a n d 2 7 F e b ru a ry 2 0 1 6 ) . O n w h ic h o f these da tes w o u ld y o u e x p e c t to see s h a re p rice s re a c t to e a rn in g s in fo rm a tio n ? W h y ? C a n y o u p re d ic t th e d ire c tio n in w h ic h s h a re p rice s w o u ld re a c t on a n y o f these dates? E x p la in w h y o r w h y not.
2
E x p la in th e im p o rta n c e o f th e a u d it fu n c tio n in th e c o n te x t o f a la rg e c o m p a n y w h e re th e o w n e rs h ip (co m p o s e d o f a la rg e n u m b e r o f p riv a te investors) a n d th e m a n a g e m e n t a re s e p a ra te d . T o w h o m a re th e a u d ito rs p rim a rily re s p o n s ib le ? By w h o m a re th e y h ire d ? W h a t w o u ld th e investors e x p e c t o f th e a u d ito rs ? D o y o u r a n sw e rs in d ic a te a n y th in g th a t is in co n s iste n t w ith th e a u d ito r's ro le as a n in d e p e n d e n t p a rty?
3
A g e n c y th e o ry d e sc rib e s th e p ro b le m s th a t a re in h e re n t w h e n o n e p a rty (the p rin c ip a l) hires a s eco nd p a rty (the a g e n t) to d o w o rk on th e fo rm e r's b e h a lf. C h o o s e o n e c o n tra c tu a l re la tio n s h ip e x is tin g b e tw e e n pa rtie s c o n n e c te d w ith a c o rp o ra tio n a n d d e s c rib e this re la tio n s h ip in an a g e n c y th e o ry co n te xt.
PROBLEM 6.22 Threats to an a u d ito r's independence Pat is th e p a rtn e r on th e a u d it o f H a rd w o o d E m p o riu m Ltd. C o m m e n t on w h e th e r o r not, a n d w h y , e a c h o f the fo llo w in g m a y b e a th re a t to Pat's in d e p e n d e n c e . 1 Pat a n d th e c h ie f fin a n c ia l o ffic e r o f H a rd w o o d E m p o riu m p la y g o lf to g e th e r e v e ry fe w w e e ks. 2
D u rin g th e a u d it, Pat no tices th a t th e c o m p a n y has a serious p ro b le m w ith its c o m p u te r system . P at's a c c o u n tin g firm is then h ire d b y H a rd w o o d E m p o riu m to d o a m a jo r re d e s ig n o f the system , fo r a la rg e fee.
3
A s p a rt o f th e c o m p le tio n o f th e a u d it, Pat w o rk s w ith th e c o m p a n y to d e te rm in e its lik e ly in c o m e ta x lia b ility fo r th e y e a r, in c lu d in g h e lp in g to p re p a re th e c o m p a n y 's in c o m e ta x returns. Pat b ills th e c o m p a n y fo r th e ta x a d v ic e s e p a ra te ly fro m th e a u d it fee.
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4
Pat's fo rm e r assistant on th e H a rd w o o d E m p o riu m a u d it is h ire d b y th e c o m p a n y as th e c h ie f fin a n c ia l a c c o u n ta n t, w h o is re s p o n s ib le fo r p re p a rin g a ll th e c o m p a n y 's fin a n c ia l statem ents.
5
Pat is a s ke d to s u b m it a b id on th e a u d it fe e fo r ne xt y e a r's H a rd w o o d E m p o riu m a u d it, in c o m p e titio n w ith s eve ral o th e r a c c o u n tin g firm s. Pat d e c id e s to s u b m it a v e ry lo w b id b e ca u s e th e reven ue fro m ta x a n d c o n s u ltin g services w o u ld m a ke up fo r th e lo w e r a u d it reven ue .
PROBLEM 6.23 Ethics For e a ch o f the fo llo w in g situ a tio n s , state w h ic h o f th e fu n d a m e n ta l p rin c ip le s h a ve be en b re a c h e d : 1 m a k in g a m a te ria lly fa lse state m e nt
2 tw o a c c o u n ta n ts on a p la n e a fte r a fe w beers d iscu ssin g fu tu re plan s o f a ta x a tio n c lie n t
3 o w n in g shares in an a u d it c lie n t 4
a d v e rtis in g th a t y o u r firm 's c lie n ts h a ve fe w e r ta x a u d its th a n clie nts o f o th e r firm s
5
n o t p ro v id in g a d e q u a te tra in in g fo r y o u r a u d it staff.
PROBLEM 6.24 Ethics From th e fo llo w in g list: a self-interest b
s e lf-re vie w
c
advocacy
d
fa m ilia rity
e
in tim id a tio n
state w h a t ty p e o f th re a t e a ch o f th e fo llo w in g s itu a tio n s p ro v id e s : 1 Y o u r c lie n t is s u ffe rin g fin a n c ia l h a rd s h ip , a n d has a d v is e d y o u th a t unless a u d it fees a re d ro p p e d b y 5 0 p e r cent th e c lie n t w ill p u t th e a u d it o u t to te n d e r. 2
A n a u d it c lie n t has te m p o ra ry s ta ff s h o rta g e s, a n d a n o th e r d iv is io n o f y o u r firm p ro v id e s s ta ff to h e lp o u t in p re p a rin g th e fin a n c ia l statem ents.
3 Y o u r m a jo r a u d it c lie n t is g ro w in g q u ic k ly , a n d n o w a c co u n ts fo r 4 0 p e r c e n t o f y o u r to ta l fees. 4
A n a u d it c lie n t in fo rm s y o u th a t th e C F O is re tirin g n e xt y e a r, a n d asks y o u to ta k e th e jo b a fte r c o m p le tio n o f this y e a r's a u d it.
PROBLEM 6.25 Ethics From th e fo llo w in g list: a self-interest b
s e lf-re vie w
c
advocacy
d
fa m ilia rity
e
in tim id a tio n
1
state w h a t ty p e o f th re a t e a ch o f th e fo llo w in g s itu a tio n s p ro v id e s : Y ou h a ve be en p a rtn e r on C K T Ltd fo r o v e r 2 0 y e a rs . The c lie n t has a re p u ta tio n fo r p ro d u c in g v e ry h ig h -q u a lity a c co u n ts.
2
Y ou c o m p le te d th e a u d it b e lo w b u d g e t this y e a r as y o u h a d th e b e n e fit o f a n e w s tre a m lin e d in fo rm a tio n system d e v e lo p e d b y y o u r firm .
3 Y ou a re e x c ite d b e ca u s e y o u g o on a m o n th 's h o lid a y th e n e xt d a y . Y ou fin d an unusual tra n s a c tio n b u t w h e n y o u m e n tio n it to y o u r s u p e rv is o r he re m in d s y o u to c o n s id e r th e need to fo llo w up , a n d th a t if y o u d o so y o u w ill ne ed to c o m p le te this b e fo re y o u g o on h o lid a y s . 4
Y ou in h e rit $ 2 0 0 0 0 o f shares in a c lie n t th a t y o u a u d it.
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PROBLEM 6 .2 6 C apital m arkets and c o n tra cts to r a corporation
Choose any large, well-known corporation you are interested in, and answer the following questions, based on your choice. 1 What kinds of capital markets are likely to be important to the company? 2 Suppose those capital markets are efficient, and an unexpected and important piece of information about the company is released. What is likely to happen? Would it make a difference if the markets expected the information? 3 List some of the explicit, implicit or even casual contractual relationships between the company and other internal or external parties that are likely to be important to the company's success.
CASES
Refer to th e fu ll fin a n c ia l statem ents o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to the c o n s o lid a te d a cco u n ts. 1 Find e a c h o f th e fo llo w in g a n d in d ic a te th e p a g e :
2
a
s u m m a ry d a ta on th e c o m p a n y 's p e rfo rm a n c e
b
a letter to s h a re h o ld e rs fro m th e c o m p a n y 's c h a irp e rs o n o f th e b o a rd o f d ire c to rs o r m a n a g in g d ire c to r
c
m a n a g e m e n t discussion a n d a n a lys is
d
a c o rp o ra te g o v e rn a n c e statem ent
e
th e d ire c to rs ' state m e nt
f
th e a u d ito r's re p o rt
g
th e d ire c to rs 'd e c la ra tio n
h
th e fiv e -y e a r su m m a ry.
W h o is th e a u d ito r?
3
W h a t a re th e m a in item s c o v e re d in th e a u d ito r's re p o rt?
4
W h a t a re th e m a in item s c o v e re d in th e d ire c to rs ' statem ent?
5
W h a t a re th e m a in item s a d d re s s e d in th e c o rp o ra te g o v e rn a n c e statem ent?
6
W h a t ris k-m a n a g e m e n t p o lic ie s a re discussed?
7
W h a t do es th e c o m p a n y s a y a b o u t c o rp o ra te e th ic a l sta n d a rd s?
8
P ro v id e e x a m p le s fro m th e a c co u n ts o f th e a c c o u n tin g p rin c ip le s o f m a te ria lity a n d c o m p a ra b ility fro m note 1 o f th e acco un ts.
9
Id e n tify tw o d iffe re n t g ro u p s o f users o f fin a n c ia l statem ents o f W o o lw o rth s Lim ited, a
W h a t d e cisio n s d o th e y m a ke b a se d on c o rp o ra te fin a n c ia l statem ents?
b
W h a t s p e c ific c o m p o n e n ts o f th e W o o lw o rth s Lim ited fin a n c ia l statem ents w o u ld th e y b e m ost in tere ste d in?
1 0 Peruse the list o f assets in th e b a la n c e sheet a n d th e re la te d notes. H o w a re th e assets v a lu e d ? A re th e re 'a s se ts' th a t a re left o u t th a t y o u w o u ld h a ve e x p e c te d to see? 11 H o w a re th e c o n c e p ts o f fa ir v a lu e a n d v a lu e in use used b y W o o lw o rth s ? 12 W o o lw o rth s Lim ited a ls o in clu d e s a section in its rep orts title d 'D o in g th e rig h t th in g '. W ith in this section o f the re p o rt th e m a n a g e m e n t o f W o o lw o rth s Lim ited suggests th e firm is c o m m itte d to 'm a x im is in g th e s o c ia l, e c o n o m ic a n d e n v iro n m e n ta l be ne fits o f its bu siness'. W h a t m easures o f p e rfo rm a n c e a re p ro v id e d to those s ta k e h o ld e rs o th e r th a n th e s h a re h o ld e rs a n d d e b t ho ld ers o f th e firm ? 13 W h a t stock e x c h a n g e is W o o lw o rth s Lim ited listed on? H o w m a n y shares a re issued? Look up a n e w s p a p e r o r o n lin e to d is c o v e r its sh a re p ric e . 14 List th re e a c c o u n tin g -re la te d events th a t a re lik e ly to in cre a s e th e c o m p a n y 's s h a re p ric e . 15 A re th e re a n y fo rm s o f in ce n tive c o n tra cts in p la c e fo r executive s (see W o o lw o rth s ' w e b p a g e )?
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CASE 6B
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Assets and liabilities
R ead th e fo llo w in g fa cts:
T h e m e r g e r b e tw e e n S o u th c o r p a n d R o s e m o u n t re s u lte d in la rg e losses f o r S o u th c o r p re s u ltin g in a $ 6 4 2 . 5 m illio n w rite d o w n o f g o o d w ill a n d a $ 2 4 0 m illio n w rite d o w n o f th e v a lu e o f th e R o s e m o u n t b ra n d . A ls o th e c o m p a n y re c o r d e d a $ 9 5 m illio n in o n e - o f f p ro v is io n s a n d re s tr u c tu r in g c o s ts .
1
U sing th e d e fin itio n o f an asset, e x p la in w h y th e assets d iscusse d w ith in this e x tra c t w o u ld be w ritte n d o w n .
2
W h a t a c c o u n tin g c o n c e p ts w o u ld h a ve been c o n s id e re d w h e n d e te rm in in g th e w rite d o w n o f assets?
3
U sing th e d e fin itio n o f a lia b ility , e x p la in w h y th e p ro v is io n d iscusse d w ith in th is e x tra c t m a y h a ve be en c re a te d .
4
S h o w th e e ffe c t on p ro fit o f e a ch o f th e am o u n ts o f $ 6 4 2 .5 m illio n , $ 2 4 0 m illio n a n d $ 9 5 m illio n . W h a t o th e r a c co u n ts w o u ld be a ffe c te d ?
5
P ro v id e p o ss ib le jo u rn a l en trie s fo r th e item s in q u e s tio n 4 .
CASE 6C
Executive compensation plans
Find som e n e w s p a p e r o r m a g a z in e a rticle s a b o u t e x e c u tiv e c o m p e n s a tio n . W ith c a p ita l m a rke t a n d a g e n c y (co ntra ct) th e o ry as a b a c k g ro u n d , discuss th e c o m p e n s a tio n used b y e a ch c o m p a n y . 1 W h a t fe a tu re s o f e a ch p la n re la te to th e p e rfo rm a n c e o f th e c o m p a n y 's shares on th e stock m arket? 2
W h a t fe a tu re s o f e a ch p la n re la te to m a n a g e m e n t's s te w a rd s h ip o f th e c o m p a n y on b e h a lf o f th e s h a re h o ld e rs?
3
W h a t ro le do es a c c o u n tin g in fo rm a tio n p la y in c o m p e n s a tio n fo r e a ch c o m p a n y ?
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Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TES 1 2
This section is heavily based on m aterial provided b y M alco lm M ille r. A d d itio n a l m aterial w as provided b y M ah ree n H asan, Roger S im nettand D iane M a y o rg a . Parts o f this section rely on inform ation in A G u id e to U n d e rs ta n d in g A u d itin g a n d A s s u ra n c e : Listed C o m p a n ie s 2 0 1 4 . W e thank A m ir G h a n d a r for his a d vice on this area.
Internal control and cash ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: outline the com ponents of a goo d internal control system describe m anagem ent's responsibilities for m aintaining control over an enterprise's assets pro vide inform ation for evaluating an internal control system a n d for purposes such as fraud prevention develop internal control procedures to protect cash explain the role o f bank reconciliations as p a rt o f an internal control system p re p a re a bank reconciliation statem ent explain the use o f petty cash as an internal control for cash.
C H A PTER O VE R VIEW This chapter looks at the importance of a good internal control system. The basic techniques for designing an inter nal control system are discussed. This chapter also considers the internal controls which exist for one important asset, cash. Some emphasis is given to the bank reconciliation, which is a key internal control over cash.
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7.1
Internal control
Internal control should be, a nd is, an im portant issue in most organisations. The reason is that internal controls increase e fficien cy a nd effectiveness o f operations, reduce risk o f asset loss, help ensure the re lia b ility o f financial statements and help ensure c o m p lia n ce w ith law s a nd regulations. These four items a re all critical for all enterprises, irrespective o f size. In te rn a l c o n t r o l is: a p ro c e s s , e f fe c te d b y an e n t it y ’s b o a rd o f d ire c to rs , m a n a g e m e n t a n d o t h e r p e rs o n n e l, d e s ig n e d t o p ro v id e re a s o n a b le a s s u ra n c e re g a rd in g th e a c h ie v e m e n t o f o b je c tiv e s in th e fo llo w in g c a te g o rie s : 1
e ffe c tiv e n e s s a n d e ff ic ie n c y o f o p e ra tio n s , in c lu d in g s a fe g u a rd in g a ssets a g a in s t loss
2
re lia b ility o f in te rn a l an d e x te rn a l fin a n c ia l a n d n o n - fin a n c ia l r e p o r tin g
3
c o m p lia n c e w ith a p p lic a b le law s a n d re g u la tio n s . Source: The Internal Control—Integrated Framework by th e C o m m itte e o f Sponsoring Organizations o f th e Treadway Com m ission C CO SO 2013).
Let's consider some o f the points in this d efinition. First, internal control is not one event o r circum stance but a process integrated w ith other basic m anagem ent processes, including planning a nd m onitoring. Its effectiveness is a state o r condition of the process at one o r more points in time; that is, particular parts o f the process w o rkin g on particular days. It is affected by the actions o f p e o p le in the organisation including m anagem ent, the b o a rd o f directors a nd other personnel. It has an im pact on p e o p le in the o rganisation; for exam ple, m anagem ent sets 'the tone at the to p ', w h ich affects integrity an d ethics a nd other positive control features. The chief executive o ffice r (CEO) is ultimately responsible for internal control. M a n a g e m e n t is a cco u n ta b le to the bo a rd o f directors, a nd this bo a rd provides governance, g u id a n c e an d oversight to the o rganisation. O th e r personnel a re also involved as they provide inform ation used in the internal control system a nd take actions needed to affect controls, such as authorising the paym ent o f an account. Internal control affects the w o rkin g life o f most personnel; for exam ple, having an im pact on w h a t responsibility they have a nd lim iting the authority they have (such as being authorised to make payments up to $ 5 0 0 0 ). Internal control, regardless o f h o w w e ll it is ope ra te d an d designed, can o n ly pro vid e reasonable assurance rather than absolute assurance to m anagem ent an d the board o f directors regarding the achievem ent o f an entity's objectives. All internal control systems have certain inherent lim itations. First, they are lim ited by the problem s of human judgem ent. Even if a control system is w e ll d esigned, individuals m ay make judgem ent mistakes, including misunderstanding instructions. S econd, m anagers m ay override effective internal control systems; that is, override prescribed policies o r procedures, such as increasing revenue to cover up falls in profits, enhancing reported profit to meet analysts' forecasts o r covering up breaches o f bank b o rro w in g conditions. Third, collusion betw een tw o or more individuals can result in control failures. Finally, internal controls cost money, a n d there are a lw a ys cost-versus-benefit discussions in im plem enting an d checking on controls; for exam ple, you w o u ld not spend $1 m illion a ye a r protecting inventory that w a s w orth $ 1 0 0 0 0 . Finally, internal control should be a d a p ta b le to the size a nd structure of the organisation. The internal controls you w o u ld expect at W o o lw o rth s w ill be very different from those you see a t your local family-run corner shop. Internal control covers three objectives: •
effectiveness an d efficiency of operations that relate to the entity's basic business objectives a n d sa feguarding of resources
•
reliability o f internal a n d external fin a n cia l a nd non-financial reporting, including published fin a n cia l statements, such as extracts of fin a n cia l d a ta from these statements (e.g. earnings announcem ents)
•
c o m p lia n ce w ith the law s a nd regulations to w h ich the entity is subject.
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Based on the a b o ve three objectives, internal controls can be considered to be effective for each o f the three categories if m anagem ent a nd the bo a rd o f directors have reasonable assurance that: •
they understand the extent to w h ich the organisation's objectives are being a chieved; for exam ple, particular returns on investment
•
fin a n cia l statements are being p repared reliably
•
there is co m p lia n ce w ith relevant law s a nd regulations.
1
C o n tro l environm ent: The control environm ent incorporates all the w ritten policies a nd procedures of the
Internal control consists o f the fo llo w in g five interrelated com ponents: organisation as w e ll as the unwritten practices o f those w ithin an o rganisation. The control environm ent sets the tone o f an o rganisation, influencing the control consciousness of its people. It is the foundation for all other com ponents of internal control, p roviding d isciplin e an d structure. C ontrol environm ent factors include the integrity, ethical values an d com petence o f the entity's peo p le ; m anagem ent's p h ilosophy an d o perating style; the w a y m anagem ent assigns authority a nd responsibility, a nd organises an d develops its peo p le ; an d the attention and direction p rovided by the bo a rd o f directors. 2
Risk assessment: Every entity faces a variety o f risks from external a nd internal sources that must be assessed. A precondition to risk assessment is establishm ent o f objectives, linked at different levels a nd internally consistent. Risk assessment is the identification a nd analysis o f relevant risks that m ay adversely im pact the achievem ent o f the org a nisation's objectives. This forms a basis for determ ining h o w the risks should be m ana g e d . Because eco n o m ic, industry, regulatory an d op e ra tin g conditions w ill continue to ch a n g e, mechanisms are needed to identify a nd d e a l w ith the special risks associated w ith ch a n g e, both internal a nd external.
3
C o n tro l activities: C ontrol activities are the policies an d procedures that help to ensure m anagem ent directives are carried out. They help to ensure that necessary actions are taken to address risks to achievem ent of the entity's objectives. C ontrol activities occur throughout the o rganisation, at all levels an d in all functions. They m ay be preventative o r detective in nature an d include both m anual a nd autom ated processes. They include a range of activities as diverse as approvals, authorisations, verifications, reconciliations, reviews of o p erating perform ance, security o f assets an d s e g re g a tio n o f d u tie s.
4 Inform ation a n d com m unication: Pertinent inform ation must be identified, captured a nd com m unicated in a form an d a tim efram e that e n a b le p e o p le to carry out their responsibilities. Inform ation systems p roduce reports co n ta in in g o p e ra tio n a l, fin a n cia l an d com pliance-related inform ation, w h ich make it possible to run a n d control the business. They de a l not o nly w ith internally generated d a ta but also inform ation a b o u t external events, activities an d conditions necessary to inform ed business decision-m aking an d external reporting. Effective com m unication also must occur in a b ro a d e r sense, flo w in g d o w n , across a nd up the o rganisation. All personnel must receive a cle a r message from to p m anagem ent that control responsibilities must be taken seriously. They must understand their o w n role in the internal control system, as w e ll as h o w individual activities relate to the w o rk of others. They must have a means o f com m unicating significant inform ation upstream. There also needs to be effective com m unication w ith external parties, such as customers, suppliers, regulators a n d shareholders.
5
M o n ito rin g : Internal control systems need to be m onitored - a process that assesses the q u a lity o f the system's perform ance over time. This is a ccom plished through o n g o in g m onitoring activities, separate evaluations o r a co m b in a tio n o f the tw o . O n g o in g m onitoring occurs in the course o f operations. It includes regular m anagem ent an d supervisory activities, an d other actions personnel take in perform ing their duties. The scope a nd frequency of separate evaluations w ill d e p e n d prim arily on an assessment o f risks an d the effectiveness o f o n g o in g m onitoring procedures. Internal control deficiencies should be reported upstream, w ith serious matters reported to top m anagem ent a nd the b o a rd (ad a p te d from C om m ittee o f Sponsoring O rg a n iza tio n s o f the T re a d w a y Com m ission [C O S O ] 2 0 1 3 , Internal C o n tro l - Integrated Fram ew ork). All the a b o v e five com ponents are relevant to each o f our previously stated three objectives. For each o b je ctive
(such as reliability of fin a n cia l reporting), all five com ponents must be present a nd function effectively to dem onstrate that internal control over the re lia b ility o f fin a n cia l reporting is effective.
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Control activities W h ile all o f the a b o v e com ponents o f internal control a re im portant, for illustration here w e pro vid e four exam ples of control activities: •
Toptlevel review s: M a n a g e rs carry out reviews o f actual perform ance co m pared to budgets, forecasts a n d prior period results. They assess w h ich targets are being a chieved. M a n a g e m e n t actions taken to analyse progress m ade and to fo llo w up on reporting actions are exam ples o f control activities.
•
Inform ation processing: C ontrols are used to check a ccuracy, completeness an d correct authorisation of transactions. Data entered is subject to e d it checks, such as no payroll am ount a b o v e $x. There is m atching to a p p ro ve d control files (e.g. a customer's order is acce p te d o nly after reference to an a p p ro ve d customer file) and a credit limit. N um erical sequences o f transactions are accounted for, such as a missing invoice number. File totals are co m p a red a nd reconciled w ith control accounts (e.g. the accounts receivable general ledger must reconcile w ith the accounts receivable subsidiary ledger).
•
S eparate record-keeping from h a n d lin g assets: An effective w a y of p roviding security over assets like cash, accounts receivable a n d inventories is to have records sh o w in g h o w much o f each asset is supposed to be on hand at a n y time. H ow ever, if the person w h o physically handles the asset (say, cash) also keeps the records o f it, errors o r fraud can be hidden by altering the records. A ccountants call the separation o f record-keeping and handling assets 'segregation o f duties'. O n e person collects the cash w h ile another person m aintains the cash records. If one o r the other makes a mistake, a difference w ill arise betw een the count o f cash on hand a nd w h a t the record shows should be on hand. This difference can then be investigated an d the cause corrected. S egregation o f duties can also be used w ithin the record-keeping system. For exam ple, o ne person can m aintain the general ledger, w ith the total accounts receivable account, a nd another can m aintain the accounts receivable subsidiary ledger, w ith the d e ta ile d list o f customer accounts. It is hard for smaller enterprises w ith fe w em ployees to spread the jobs around enough to segregate all the im portant tasks, but it should be d o n e as much as possible. If segregation o f duties do e sn 't exist, the boss needs to keep a close eye on im portant assets, such as cash and inventories.
•
Physically p ro te ct sensitive assets: This control method is rather obvious, but is easy to overlook. Sensitive assets, such as cash, inventories an d com puter equipm ent, should be behind lock an d key, kept in particular storage areas, or otherw ise protected from unauthorised o r casual access. M a n y enterprises a re slo p p y a b o u t access to their inventories, in particular, a nd sometimes protection is a g o o d id e a for assets you m ight not think of. For exam ple, m any manufacturers p roduce scrap as a by-product, a n d the scrap can be very valuable. O n e manufacturer put its scrap in the backyard an d found out later that thousands o f dollars' w orth had been lifted over the b a ck fence a nd sold on the scrap market. Examples o f physical controls include safes, locked storage areas, security guards a nd em ployee identification cards. Electronic devices a re being used w ith increased frequency; for exam ple, most university libraries have e lectronically co d e d their books so that an alarm goes o ff if a n yone tries to remove them w ith o u t first taking them to the front desk to have them checked out. There is much m ore to internal control than the points listed a b o ve . D esigning effective control systems requires an
understanding o f m anagem ent's objectives; a sensitivity to the co st-b e n e fit b a la n ce needed betw een tight, but costly, controls and loose, but cheap, controls; k n o w le d g e o f com puter systems a nd other record-keeping m ethods; and considerable insight into the subtleties o f human m otivation a n d behaviour. It also requires some com m on sense: com plete protection is not possible, a nd tying the enterprise up in red ta p e to g a in com plete protection is not w h a t a g o o d internal control system should do . Some specific exam ples o f internal control procedures include: •
independent a p p ro v a l a n d review : for exam ple, the authorisation o f purchase orders o r sales invoices; subsequent review o f large a nd unusual transactions; a n d a p p ro va l o f transactions over a certain limit (such as g ivin g credit over $ 1 0 0 0 0 0 )
•
m atching ind e pendently g e n e ra te d docum ents: for exam ple, m atching sales invoices a nd shipping docum ents to ensure all items shipped a re invoiced; m atching purchase orders an d receiving reports w ith paym ent vouchers to ensure goods w e re actu a lly ordered
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•
prenum bering a n d sequence checking o f docum ents: for exam ple, prenum bering shipping docum ents, sales
•
com parison w ith inde p e n d e n t third-party inform ation: for exam ple, ba n k re c o n c ilia tio n s o f ledger accounts w ith
•
can ce lla tio n o f docum entation: for exam ple, physically stam ping 'p a id ' on an invoice presented for paym ent;
invoices, cheques o r vouchers to prevent unauthorised use
b a n k statements (see section 7 .3 )
d e fa cin g spoiled o r cancelled cheques to prevent them being used •
segregation o f duties relating to transaction initiation, a p p ro v a l a n d re cording: for exam ple, the person w h o handles the physical asset (such as cash inventory) should not also be involved in the recording o f the transactions
•
d e m a n d in g timeliness o f operations: for exam ple, the prom pt dep o sit of cash receipts an d depositing cash intact; that is, not rem oving part o f it to p a y for small p e tty cash items.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: P ro v id e an e x a m p le o f e a ch o f th e fo llo w in g c o n tro ls :
1 in fo r m a tio n c o n tro ls 2 s e p a ra te r e c o r d - k e e p in g fr o m h a n d lin g o f assets 3
p h y s ic a l p r o te c tio n o f s e n s itiv e assets. Y o u r a n sw e rs s h o u ld be:
1
P a s sw o rd a c ce ss f o r a u th o ris e d users, e d it c h e c k s an d n o p a y m e n t g re a te r th a n $x.
2
T h e p e rs o n w h o re c o rd s cash tra n s a c tio n s d o e s n o t p h y s ic a lly h a n d le cash .
3
L o c k s , s w ip e -c a rd a c ce ss t o a p p ro v e d e m p lo y e e s , an d v id e o c a m e ra s in sh o p s.
7.2
Internal control of cash
C ash is the asset that is usually most susceptible to theft because o f its liquid, a nd g e n e ra lly anonym ous, nature.
A REAL CASE M ik e , a ju n io r a u d ito r, w as a ssign ed t o d o a s u rp ris e c o u n t o f th e cash o n h a n d a t a lo ca l c lo th in g s h o p . T h e cash c o u n te d w as s h o rt c o m p a re d w ith w h a t w as e x p e c te d , based o n th e a u d ito rs ’ p ro je c tio n s o f cash fr o m sales an d b a n k d e p o s it re c o rd s . M ik e w as a c c u s e d b y th e s h o p ’s a c c o u n tin g c le rk o f s te a lin g th e c a sh h im s e lf w h ile c o u n tin g it, an d he had to ca ll th e p o lic e an d in s is t th a t th e y s e a rc h h im an d so d e m o n s tra te th a t he had n o t s to le n it. It tu r n e d o u t th a t th e a c c o u n tin g c le rk had b e e n s te a lin g cash and c o v e rin g up th e th e fts b y c h a n g in g th e sales re c o rd s : a c la ssic case o f p o o r in te rn a l c o n tro l th ro u g h la ck o f s e g re g a tio n o f d u tie s , b e c a u s e th e c le rk had a cce ss to b o th th e cash an d th e re c o rd s o f th e cash . T h e t h e f t w as d is c o v e re d o n ly b e ca u s e M ik e ’s s u rp ris e cash c o u n t re fe rre d t o sales re c o rd s th a t th e c le rk had n o t y e t a lte re d to c o v e r u p th e s h o rta g e . T h e c le rk w as fire d an d p ro m is e d to m a k e re s titu tio n , th o u g h it w as d if f ic u lt to te ll h o w m u c h had b e e n ta k e n b e ca u s e sales re c o rd s had b e e n a lte re d f o r s eve ral years. T h e o w n e r o f th e s to re w as c ritic a l o f th e a u d ito rs f o r ‘n o t p re v e n tin g th e loss’, b u t th e a u d ito rs s h o w e d th a t th e y had in d e e d w a rn e d th e o w n e r, w h o had said th a t it w o u ld be to o e x p e n s iv e t o e m p lo y s o m e o n e else t o k e e p th e sales re c o rd s o r c o n tro l th e cash.
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For cash sales, a com m on control is to have locked-in sales registers o r other carefully controlled records. Registers (such as you w o u ld see a t a n y supermarket) usually print a consecutive num ber on the locked-in ta p e for each transaction. The access key is kept b y a single person, perhaps a supervisor, w h o balances cash to sale records. The proceeds that should have been received w ill be recorded on the tape. The person w h o keeps the key should count the cash w ith the cashier, c o m p a re it w ith the sales proceeds, a nd check that the ta p e numbers a re consecutive from one person's shift to that o f the next person. If this sort o f system is to w o rk, there has to be no collusion betw een the p eople controlling the cash an d checking the records - often, collusion is difficult to prevent, so having yet another person provide overall m onitoring o f the process is a g o o d id e a . W ith the greater use o f credit cards a nd the advent o f electronic com m erce, there are n o w m any forms o f 'cash' needing control attention, including currency, cheques, g ift cards, direct payments, credit cards a nd electronic funds transfers.
A REAL CASE A large c o m p a n y established a ‘p e tty cash’ fu n d in its fr o n t o ffic e to be used to pay fo r sm all purchases such as o ffic e supplies and c o u rie r charges. The re c e p tio n is t was given a fu n d o f $ 1 0 0 0 , in cash, and w hen m o s t o f th a t was s pent, s u b m itte d all th e re ce ip ts in an en ve lo p e and was re fu n d e d th e cash s p e n t, to b rin g th e p e tty cash fu n d back up to $ 1 0 0 0 . The in te rn a l c o n tro l, th e re fo re , was th a t, a t any tim e , th e re c e p tio n is t should have cash on hand plus re ce ip ts fo r p a ym e n ts to ta llin g $ 1 0 0 0 . W h a t th e c o m p a n y did n o t kn o w was th a t th e re c e p tio n is t was involved w ith th e d e live ry d riv e r fro m th e s to re fro m w h ich th e c o m p a n y g o t m o s t o f its o ffic e supplies, and nearly all invoices fro m th a t c o m p a n y paid th ro u g h p e tty cash w e re in fla te d . The c o m p a n y paid fa r m o re th a n it should have fo r th e supplies, b u t no one knew because th e people w h o g o t th e supplies did n o t see th e invoices, w h ich w e re k e p t by th e re c e p tio n is t as evidence o f cash payouts. The p e ople w h o re im b u rse d th e re c e p tio n is t had n o t seen th e o ffic e supplies, so did n o t know th e invoices w e re in fla te d . The th e fts and th e c o llu sio n b e tw e e n th e re c e p tio n is t and th e d riv e r w e re d isco ve re d lo n g a fte r th e tw o had m oved to a n o th e r c ity : s o m e o n e n o tic e d th a t o ffic e supplies co sts w e re lo w e r th a n th e y used to be! The c o m p a n y has no g o o d idea o f h o w m u c h was s to le n , b u t it believes th a t it was m a n y th o u sa n d s o f dollars o ve r th e years. Tw o points should be n o te d a b o u t th is fra u d . F irs t, overall m o n ito rin g o f p e tty cash su m m a rie s by a supervisor w ould p ro b a b ly have picked th is up. S eco n d , th e se are n o t th e typ e s o f expenses th a t should be paid fo r o u t o f p e tty cash.
A nother w a y to control cash from sales is to have m ulti-copied, prenum bered sales invoices. The invoice copies are then rem oved b y on e person. For cash sales, the amounts are cross-checked aga in st cash records, an d for credit sales, the am ounts are cross-checked aga in st accounts receivable records. A n y ga p s in the num erical continuity o f the invoices are investigated. For this control to w o rk, supervisors must ensure that an invoice is prepared for each sales transaction. An a d d itio n a l control is to regularly check inventory an d c o m p a re it w ith the sales records. This should prevent, o r at least detect, som eone selling inventory an d pocketing the cash. Take, for exam ple, the M a y fie ld Pro S hop, w h ich recorded sales o f g o o d s for the month that had a cost price of $ 1 0 0 0 0 a cco rd in g to the invoice copies in the locked box. If the inventory at the start o f the month w a s w orth $ 2 5 0 0 0 and a t the end o f the month w a s w orth $ 1 4 0 0 0 (based on the retail price of the goods), the shop should have sold $ 1 1 0 0 0 w orth of g o o d s. The $ 1 0 0 0 difference could be the result o f on e o f the fo llo w in g : •
S om eone could have kept $ 1 0 0 0 w orth of cash from sales an d not w ritten a n y invoices for those sales.
•
S om eone could have shoplifted $ 1 0 0 0 w orth of g oods.
•
The inventory could be inaccurate, o r other errors could have occurred.
CHAPTER 7 Internal control and cash
289
Thus, there could be other reasons for shortfalls besides theft by em ployees, but keeping track o f cash and inventory together is one method of highlighting the possibilities a nd investigating them. C ash collections received through the mail are norm ally in the form o f cheques (but not alw ays). You w o u ld be surprised at the variety o f w a ys in w h ich cheques received by a c o m p a n y a re m ade out. These include cheques being m ade out to cash, to the salesperson w h o m ade the sale o r to some other c o m p a n y o ffic ia l. O v e r the years, there have been m any exam ples o f staff rem oving these cheques an d banking them in their o w n accounts. Therefore, let's consider some basic controls to prevent this from happ e n in g : •
The mail should be open e d by m ore than on e person.
•
C heques should be endorsed w ith a stam p to prevent the possibility o f them being presented to a bank for
•
A list o f cheques received, including amounts a nd customer names, should be prepared.
cashing, o r for depositing in some other account.
•
C o p ie s should be distributed to the cashier w ith the cheques for banking, to the general ledger clerk for posting, an d to the accounts receivable section for upd a ting o f the subsidiary records.
•
People o p e n in g the mail should not also have duties related to the cashiers o r record-keeping. These procedures a re based on the separation o f record-keeping from h andling assets. There also needs to be g o o d internal control over the paym ent o f cash. Internal controls are needed to prevent
paym ent for g o o d s o r services that have not been received o r paym ent o f an invoice m ore than once. Som e internal controls that a re used by most larger com panies include the fo llo w in g : •
Payments should o n ly be m ade if docum entation has been properly authorised. Before authorising the paym ent, a staff mem ber should ensure that the relevant invoice is a c co m p a n ie d by some e vidence o f ordering an d receiving the g o o d s o r service (such as a c o p y o f the purchase o rd e r a nd g o o d s received advice).
•
The cheques should be signed by tw o staff members w h o are independent o f invoice a p p ro va l a nd accounting
•
The o rig in a l invoice should be stam ped 'p a id ' to ensure that it is not subsequently represented for paym ent.
duties.
The exam ples of cash control problem s are presented here to illustrate the fa ct that accounting records have a variety o f uses beyond the preparation o f fin a n cia l statements. The exam ples a re not intended to suggest that em ployees o r customers a re crooks. Their intention is to sh o w that m anagem ent must be prudent in meeting its responsibility o f g o o d stew ardship in taking ca re o f the ow ners' assets. Part o f that responsibility lies in not putting em ployees, o r others, in such p o o rly controlled situations that they a re tem pted to steal. It also involves a d e q u a tely p ayin g p e o p le w ith the responsibility for cash so that they d o not start thinking o f themselves as un d e rp aid , and therefore deserving o f m ore m oney from the com pany!
A REAL CASE A n a rm o u re d t r u c k c o m p a n y had d e v e lo p e d a g o o d b u sin e ss p ic k in g up cash fr o m s u p e rm a rk e ts and o th e r s to re s and d e liv e rin g it to ba nks. T h e c o m p a n y tru s te d its e m p lo y e e s and had n e v e r had p ro b le m s . U s u a lly th e tru c k s w e re s ta ffe d b y tw o p e o p le : a d riv e r an d a s e c o n d p e rs o n w h o ro d e in th e b a ck . T h e tw o had t o sign v a rio u s fo rm s a n d , in a sense, th e y k e p t an e y e o n e a ch o t h e r so n o o n e g o t te m p te d : th e r e w as o fte n a m illio n d o lla rs o r m o re in u n m a rk e d , u n tra c e a b le cash in th e tr u c k . S o m e tim e s , th o u g h , o n e o f th e tw o p e o p le w as s ic k , o n h o lid a y s , o r c a lle d aw a y o n s o m e e rra n d f o r th e c o m p a n y , and th e r e w o u ld b e ju s t o n e p e rs o n to d riv e th e tr u c k and c o lle c t th e m o n e y . O n o n e d a y like th a t, th e r e w as a p a rtic u la rly la rg e a m o u n t o f m o n e y in th e tr u c k , an d th e d riv e r, a p p a re n tly o n im p u ls e , ju s t to o k it an d d e p a rte d f o r fo re ig n p a rts !
290
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
7.3
Bank reconciliations1
M a n y com panies w ill still have m any cash receipts an d disbursements during a given accounting period. Because of the high frequency o f transactions a nd the potential for error, the a ccu ra cy o f the cash b a la n ce in the general ledger (or your cheque book) should be exam ined p e rio d ica lly. This process, called a b a n k reconciliation, is based on the cash account and a docum ent ca lle d a bank statement, w h ich is received from the bank, usually monthly.
Bank statem ents versus cash accounts Businesses and individuals receive m onthly b a n k statements for every ba n k a ccount they m aintain. An exam ple o f a bank statement app e a rs in Exhibit 7 .1 . Bank statements summarise the a ctivity in a bank account an d report the ending m onthly balance. It is im portant to understand that although the cash account o f a de p o sito r (such as Johnson M anufacturing) is an asset, the depositor's account is carried on the bank's records as a lia b ility. C onsequently, debits and other debits by the bank rec/ucejohnson's account, w h ile deposits an d other credits increase the account.
EXHIBIT 7.1
SYDNEY CITY BANK, GEORGE STREET BRANCH BANK S TA TE M E N T
Johnson Manufacturing Corporation
Account no.
1 Anzac Parade Peakhurst N S W 2 2 1 0
0008564201
Page no. 1 Statement period 3 1 /7 /1 6 -3 1 /8 /1 6
Date
Particulars
Debit
Credit
Current balance ($)
1 0 0 3 1 .8 7
2 9 5 3 9 . 3 7 CR
3 1 /7
B a la n c e
0 1 /8
D e p o s it
1 9 5 0 7 . 5 0 CR
0 4 /8
C h e q u e no. 6 3 0
6 7 9 1 .4 5
2 2 7 4 7 . 9 2 CR
0 9 /8
C h e q u e no. 6 2 8
6 7 5 .1 8
2 2 0 7 2 . 7 4 CR
0 9 /8
C h e q u e no. 6 2 9
3 7 5 .0 0
21 6 9 7 . 7 4 CR
1 0 /8
C h e q u e no. 63 1
5 4 0 .2 0
1 2 /8
D ire c t d e p o s it
21 1 5 7 . 5 4 CR 4 9 2 5 .7 5
2 6 0 8 3 . 2 9 CR
5 2 4 2 .7 0
31 3 2 5 . 9 9 CR
fro m C o m p a n y A 1 2 /8
D e p o s it
1 5 /8
C h e q u e no. 6 3 3
7 2 8 .4 0
1 6 /8
C h e q u e no. 6 3 2
7 9 0 .0 3
1 8 /8
D ire c t d e p o s it fro m C om pany B
3 0 5 9 7 . 5 9 CR 2 9 8 0 7 . 5 6 CR 4 6 0 0 .8 0
3 4 4 0 8 . 3 6 CR
1 9 /8
C h e q u e no. 6 3 4
3 5 7 4 .2 4
3 0 8 3 4 . 1 2 CR
2 2 /8
C h e q u e no. 6 3 5
13 4 2 6 .4 0
1 7 4 0 7 . 7 2 CR
2 2 /8
D ire c t d e b it to
1 0 0 0 0 .0 0
7 4 0 7 . 7 2 CR
In s u ra n c e Ltd 2 5 /8
D e p o s it
2 6 /8
C h e q u e no. 6 3 7
2 4 7 0 .8 0
9 3 1 2 .2 8
2 6 /8
C h e q u e no. 6 3 9
7 4 0 .1 5
2 9 /8
D e p o s it
3 1 /8
B a n k c h a rg e s
3 1 /8
Intere st
1 6 7 2 0 . 0 0 CR 1 4 2 4 9 . 2 0 CR 1 3 5 0 9 . 0 5 CR
7 9 9 0 .1 0 1 4 7 .9 0
21 4 9 9 . 1 5 CR 21 3 5 1 . 2 5 CR
7 5 .0 0
Total debits
Total credits
4 0 2 5 9 .7 5
4 2 1 7 8 .5 0
21 4 2 6 . 2 5 CR
CHAPTER 7 Internal control and cash
291
A t the end o f a month, the bank statement cash b a la n ce a n d the com pany's cash records w ill norm ally not agree. A m ajor reason for this discre p a n cy is the tim ing differences associated w ith the use o f a bank account. Tim ing differences result in an item being recorded on the depositor's books o r the bank's books, but not both, in a given accounting p e riod. C om m on exam ples o f tim ing differences include the fo llo w in g : •
Items reflected on the com pany's records but not yet reported on the ba n k statement, such as: -
deposits in transit: receipts entered in a firm's accounts but not yet processed by the bank (e.g. a com pany
-
outstanding cheques: cheques written by a business but not yet presented to the bank. Outstanding cheques are
could record certain cheques on the last d a y of the month, but not take the deposits to the bank until the next day) determined by com paring cheques reported on the bank statement against cheques written on the company's records. •
Items reported on the bank statement but not yet entered in the com pany's records, such as: -
non-sufficient funds (NSF) cheques: customer cheques d e posited but returned because o f lack of funds; these cheques are reported on the bank statement via a d e b it mem o notation, because the ba n k has reduced the depositor's account
-
bank charges
-
electronic funds transfer transactions, in particular receipts from customers m ay not have been recorded in the com pany's records
-
in te re s t earned on the account.
In a d d itio n to tim ing differences, errors m ay cause a d iscre p a n cy betw een the bank statement b a la n ce and c o m p a n y accounting records. Errors can be m ade b y either the c o m p a n y o r the bank an d must be corrected as quickly as possible. For m any com panies there has been an increase in direct debits (paym ent direct from a co m p a n y's b a n k account to another individual or com pany's bank account) o r direct credits (receipt direct from another individual o r a c o m p a n y to a com pany's bank account). The use of direct transfers from on e a ccount to another elim inates some of the a b o v e difficulties (in relation to tim ing), but ca re should be taken to ensure that these transactions are recorded in the co m p a n y's records, as w e ll as being alert to errors caused b y transfers m ade to or from incorrect accounts.
The reconciliation process Several different types o f reconciliations can be prepared. O n e com m only encountered form involves determ ining the am ount o f cash a c o m p a n y has control over an d the reports on its end-of-period b a la n ce sheet. An exam ple appears in Exhibit 7 .2 .
292
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The exhibit dem onstrates the purpose o f a reconciliation; that is, w e strive to isolate specific items that cause a difference betw een the depositor's records a nd the bank statement ba la n ce . The accountant considers these items and adjusts one cash b a la n ce or the other to bring both balances into agreem ent. If the balances d o not a g re e a nd the reconciling items are deem ed correct, there is an excellent cha n ce that a record-keeping error has been m ade. Errors must be identified, then a d d e d o r subtracted on the reconciliation to arrive at the corrected cash ba la n ce . For exam ple, if a cheque w ritten b y a firm for $ 9 4 .5 0 w a s incorrectly entered into the accounting records as $ 4 9 .5 0 , the accounting records w o u ld be overstated by $ 4 5 .0 0 ($ 9 4 .5 0 - $ 4 9 .5 0 ). This am ount ($ 4 5 ) should therefore be d educted from the e n ding cash b a la n ce per c o m p a n y records, since the com pany's books are in error. The bank, o f course, w ill d educt the correct am ount o f the transaction ( $ 9 4 .5 0 ) w hen the cheque is received for paym ent. The reconciliation, then, not o n ly highlights tim ing differences but also identifies errors m ade by either the bank o r the depositor. M o s t bank re co n cilia tio n s con ta in adjustm ents to both the e n d in g cash b a la n c e per b a n k statem ent a n d the e n d in g b a la n c e per c o m p a n y records. A fter the re co n cilia tio n is co m p le te d , g e n e ra l jo u rn a l entries must be p re p a re d fo r adjustm ents m a d e to c o m p a n y records. These adjustm ents a re necessary to u p d a te the cash acco u n t (and others) in relation to the co rrection o f c o m p a n y errors a n d inform ation a lre a d y processed b y the bank. It is im portant to note that no journal entries a re needed fo r adjustm ents m ade to the e n d in g b a n k statement b a la n ce . These adjustm ents reflect items that have a lre a d y been recorded in a c o m p a n y's accounts; thus, no further u p d a ting is necessary. H ere is an exam ple. Exhibit 7 .3 contains summarised d a ta a n d the bank reconciliation o f Johnson M a n ufacturing C o rporation for the month e nded 31 A ugust 2 0 1 6 . It w ill help if you refer to Johnson's bank statement (in Exhibit 7 .1 ), w hich serves as the source for much o f the inform ation presented. The reconciliation reveals on e increase to the b a n k statement cash ba la n ce : the deposit that w a s recorded prior to month-end but a w a itin g deposit. Johnson had control over each of these items as o f 31 August, an d they should be included in the e n ding cash balance. The decrease in the ba n k statement cash b a la n ce w a s caused by cheques Johnson had w ritten that had not yet cleared the bank. The bank w ill receive these cheques shortly, a nd the funds w ill then be deducted from the com pany's account. The increase to c o m p a n y records arose from the direct deposit received but not recorded an d interest, both of w hich a p p e a r on the b a n k statement. These funds have n o w been deposited in Johnson's b a n k account a n d must therefore be entered in the com pany's records. The deduction for the bank charges is on the b a n k statement but not as yet in the com pany's ledger. The error in recording cheque no. 6 2 8 w a s discovered during the reconciliation. Because the bank deducted the correct am ount o f the cheque, an adjustm ent to Johnson's records is required to bring them into agreem ent w ith those of the bank. N o te that, as the c o m p a n y is o w e d m oney, it has an asset; therefore, it w ill sh o w up as a d e b it b a la n ce in the bank reconciliation ($21 9 8 3 .2 5 DR). H ow ever, as the ba n k ow es m oney, it has a lia b ility; therefore, the am ount w ill show up as a credit b a la n ce in the bank records ($21 9 8 3 .2 5 CR). O n com pletion o f the reconciliation, journal entries are needed for all the items that affect c o m p a n y records. The fo llo w in g entries w ill be m ade on 31 August.
CHAPTER 7 Internal control and cash
EXHIBIT 7.3
293
JOHNSON MANUFACTURING CORPORATION D ATA A N D BANK RECONCILIATION
Bank reconciliation 31 August 2 0 1 6 $ E n d in g b a la n c e p e r b a n k sta te m e n t
$ 2 1 4 2 6 .2 5
A d d : O u ts ta n d in g d e p o s it
CR
1 8 5 0 .0 0 2 3 2 7 6 .2 5
D e d u c t: O u ts ta n d in g c h e q u e s N o. 638
4 1 0 .0 0
N o. 640
3 2 0 .0 0
N o . 641
2 4 0 .0 0
N o. 642
3 2 3 .0 0
Adjusted cash balance: bank Ending balance per company records A d d : D ire c t d e p o s it n o t p re v io u s ly re c o rd e d Intere st
1 2 9 3 .0 0
21 9 8 3 .2 5
CR
1 7 4 7 3 .3 5
DR
4 6 0 0 .8 0 7 5 .0 0
4 6 7 5 .8 0 2 2 1 4 9 .1 5
D e d u c t: B a n k c h a rg e s E rro r in re c o rd in g c h e q u e n o . 6 2 8
Adjusted cash balance: company record
1 4 7 .9 0 1 8 .0 0
1 6 5 .9 0
21 9 8 3 .2 5
DR
294
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The first entry reflects the increase in cash caused by the direct credit an d interest. The second entry shows bank charges for $ 1 4 7 .9 0 . Finally, the error in recording cheque no. 6 2 8 w a s found to involve a paym ent on account; thus, accounts p a y a b le must be d e b ite d . These entries a llo w Johnson's records to reflect the true am ount o f cash held by the firm.
7.4 Performing a bank reconciliation from inform ation in cash journals In section 7 .3 , you w e re given lists o f outstanding deposits, outstanding cheques an d errors in ba n k charges, etc. In this section w e w ill sh o w you h o w to find this inform ation b y co m p a rin g the content o f the ba n k statement an d the organisation's cash records (cash receipts journal a nd cash payments journal). N o te that a cash receipts journal (CRJ) lists all payments received, a nd a cash payments journal (CPJ) records all cheques issued in cheque num ber o rd e r and direct payments m ade in paym ent num ber order. The fo llo w in g steps should be undertaken to com plete the bank reconciliation statem ent.2
STEP 1 •
G o through last month's bank reconciliation statement, ticking off a n y am ounts that w e re outstanding last month (such as unpresented cheques a nd outstanding deposits) a nd a p p e a r on this month's bank statement.
•
G o through the b a n k statement a nd tick o ff items a p p e a rin g both there a nd in the cash journals (tick them o ff in both places).
•
Errors: if you see a n y cheques o r deposits that are recorded incorrectly by the business o r the b a n k (e.g. a transposition error), de a l w ith these as follow s: -
If the bank has m ade a mistake, inform the bank o f its error an d list it in the bank reconciliation.
-
If the business has m ade a mistake, correct the relevant cash journal (CPJ o r CRJ).
STEP 2 •
G o through the bank statements to see w h a t am ounts remain unticked. These unticked am ounts m ay be dishonoured cheques, interest o r cash transactions m ade directly through the bank a nd not yet recorded in the books. These should be entered into the a p p ro p ria te CRJ o r CPJ. A fter entering them, tick them in the journals and the bank statements.
•
G o through the cash journals to see if there a re a n y unticked am ounts in the CRJ an d CPJ. These w ill represent outstanding deposits an d outstanding (unpresented) cheques, respectively.
STEP 3 •
If the CRJ and the CPJ have not yet been totalled an d posted to the bank ledger account, this should be d one.
STEP 4 •
Prepare a ba n k reconciliation statement in a form sim ilar to that show n in Exhibit 7 .2 .
ILLUSTRATIVE EXAMPLE The bank reconciliation prepared by O n s lo w Ltd, as at 31 M a rc h 2 0 1 6 , sh o w e d a dep o sit in transit o f $ 6 1 0 and the fo llo w in g outstanding cheques: no. 2 0 4 for $ 6 1 5 a nd no. 2 21 for $ 9 0 . The b a la n ce - as per the cash at bank account in the general ledger o f O n s lo w Ltd a t 31 M a rc h 2 0 1 6 - w a s $ 4 6 6 7 DR.
CHAPTER 7 Internal control and cash
295
Bank statement Date
Particulars
2016
Debit
Credit
Balance
$
$
$
B a la n c e
A p r il
1
4 7 6 2 CR
D C - M a r tin
2
DC - H ughes
3
222
3
D D - C a r le a s e
3
D e p o s it
6
204
6
D e p o s it
115
5 4 8 7 CR 5 4 3 1 CR
300
5 1 3 1 CR 630
5 7 6 1 CR
615
10
D C - K h a lifa
10
224
13
D e p o s it
15
DC -J a n e
5 1 4 6 CR 220
5 3 6 6 CR
105
5 4 7 1 CR
196
5 2 7 5 CR 832
6 1 0 7 CR
50
6 1 5 7 CR
17
D e p o s it
17
226
852
5 4 1 2 CR
17
NSF
312
5 1 0 0 CR
20
225
846
4 2 5 4 CR
22
D C - M ic h a e l
24
SC
27 29
107
6 2 6 4 CR
56
4310C R
24
4 2 8 6 CR
227
100
4 1 8 6 CR
228
409
3 7 7 7 CR SC s e rv ic e c h a rg e
D C D ire c t c r e d it
D D D ire c t d e b it
From the cash receipts journal Date
5 3 7 2 CR
56
N S F n o n ■sufficient fu n d s
A p r il
610
From the cash payments journal
Amount
Date
Cheque no.
Amount
$
A p r il
2
115
3
222
56
3
630
3
223
124
$
6
220
10
224
169
10
105
14
225
846
13
832
17
226
852
17
107
23
227
100
21
56
28
228
409
30
403
29
229
900
2468
29
230
556
S u b to ta l
S u b to ta l
4012
N o tice: For a n y errors assume the bank's records are correct.
296
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Take the a b o v e inform ation a nd tick off, on the bank statement, a n y outstanding cheques or outstanding deposits from the M a rc h bank reconciliation. N o te that the $ 6 1 0 outstanding dep o sit is included on the bank statement on 1 A pril, and the unpresented cheque no. 22 1 is still unpresented.
•
C o m p a re the am ounts on the ba n k statement w ith those in the cash journal. The unticked am ounts on the bank statements refer to a direct credit from Jane o f $ 5 0 , a dishonoured cheque for $ 31 2 (i.e. the person w h o sent the cheque to O n s lo w d id not have sufficient funds in the account), bank fees o f $ 2 4 an d direct d e b it for a ca r lease o f $ 3 0 0 . In a d d itio n , there is an error of $ 2 7 fo r cheque no. 2 2 4 to Energy Australia. As a result o f the a b o ve , the cash journals w o u ld be adjusted as follow s: Cash receipts journals S u b to ta l
2468
D ire c t c r e d it - Ja n e
50
NSF
-3 1 2 $2 206
Cash payments journal S u b to ta l
4012
E rro r n o . 2 2 4
27
B a n k c h a rg e s
24
D ire c t d e b it - C a r le a s e
300 $4363
These am ounts w o u ld then be posted to the cash at bank general ledger account. • Cash a t bank B a l. b / d
4667
P a y m e n ts
4 363
R e ceipts
2 206
B a l. c / d
2510
6 873 B a l. b / d
•
6 873
$2510
The unticked am ounts in the cash receipts journal an d the cash payments journal represent outstanding deposits (deposit in transit) an d outstanding cheques (unpresented cheques).
•
These outstanding deposits w o u ld be a d d e d to the b a la n ce (as per the bank statement) an d the unpresented cheques w o u ld be deducted.
N o te: the unpresented cheques include no. 2 2 1 , w hich w a s outstanding in the previous ba n k reconciliation.
CHAPTER 7 Internal control and cash
7.5
297
Petty cash3
A nother elem ent in the control o f cash is a petty cash system. U nder this system, a fund is established for use in m aking small paym ents, e sp e cia lly those that a re im practical or uneconom ical to make by cheque. Examples o f such payments include those for m inor items like taxi fares an d other m iscellaneous o ffice needs. A petty cash fund is created b y cashing a cheque d ra w n on the com pany's regular cheque account. The proceeds from the cheque, w h ich a re sufficient to cover payments for a short p eriod o f time (such as several weeks), are then p laced in a petty cash box that is controlled by an individual know n as the fund custodian. The custodian supervises the fund a n d is held a cco u n ta b le for a n y discrepancies. Assuming the petty cash fund is established at $ 2 0 0 , the necessary journal entry follow s. The petty cash account is an asset. $ P etty c a s h C ash
$
200 200
To e s ta b lis h p e tty c a s h fu n d
M aking disbursem ents from the fund As payments are m ade from the fund, the custodian com pletes a form know n as a petty cash voucher. Each voucher indicates the am ount p a id , the purpose o f the expenditure, the d a te of the expenditure a nd the individual receiving the m oney. A lo n g w ith invoices a nd receipts, petty cash vouchers are used as e vidence o f disbursements. The com pleted voucher is p laced in the petty cash box by the custodian. A lthough a paym ent has been m ade, no journal entry is recorded at this time. Preparing a form al journal entry for every disbursem ent w o u ld g ive rise to consid e ra b le bookkeeping w o rk an d posting, all fo r relatively small am ounts. A t all times, the fo llo w in g relationship should be true: $ C a s h re m a in in g in th e fu n d
XXX
Plus: P etty c a s h v o u c h e rs
XXX
O r ig in a l a m o u n t o f th e fu n d
200
R eplenishing the fund The petty cash fund is replenished w hen the am ount o f cash in the fund becom es lo w . For instance, assume that a count o f the petty cash on hand totalled $ 3 2 .4 0 . Vouchers revealed that the fo llo w in g expenses had been incurred: postage $ 2 7 .5 0 , o ffice supplies $ 5 0 .8 0 , transportation $ 7 3 .4 0 an d coffee $ 1 5 .9 0 . The journal entry to record replenishm ent is as follow s:
P o s ta g e e x p e n s e O ffic e s u p p lie s e x p e n s e T r a n s p o rta tio n e x p e n s e M is c e lla n e o u s e x p e n s e C ash To re p le n is h p e tty c a s h fu n d
N o tic e that the credit is to the cash a ccount an d not petty cash. A lthough disbursements have been m ade from the petty cash box, the fund is restocked b y w ritin g a cheque for $ 1 6 7 .6 0 on the co m p a n y's regular cheque account. Thus, paym ent (and replenishment) is really from cash.
298
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
In ad d itio n to being restocked w hen the fund is lo w , petty cash is also replenished at the end o f each accounting period. This procedure is necessary because no form al journal entries have been recorded for individual fund disbursements. Replenishment requires a journal entry, thereby ensuring that expenditures a re c h a rg e d to the period in w hich they arose.
Errors in the p e tty cash fund O cca s io n a lly , the sum o f the petty cash vouchers a nd the cash in the fund w ill not equal the o rig in a l fund balance. This discrepancy usually occurs because o f errors m ade by the fund custodian - some being in the com pany's favour and some not. In such cases, the cash short a nd over account is em p lo ye d . C ash short a nd over is d e b ite d to record a shortage o r credited to recognise an o ve ra g e at the time the fund is replenished. The shortage is classified as a miscellaneous expense, a n d the o ve ra g e as a m iscellaneous revenue item.
7.6
Disclosure of internal control in annual reports
Australian com panies that a re listed w ith the Australian Securities Exchange (ASX) a re n o w required to include a section in their annual reports on co rp o ra te governance. A num ber o f com panies include a description o f their internal control systems in this section. Examples from the annual reports o f BHP Billiton Limited an d T a b co rp H o ld in g s Limited are given in Exhibits 7 .4 an d 7 .5 .
EXHIBIT 7.4
BHP BILLITON LIMITED EXTRACT FROM 2 0 1 4 A N N U A L REPORT
Effectiveness of systems of internal control and risk management In d e le g a tin g a u th o rity to th e C E O , th e B o a rd h a s e s ta b lis h e d C E O lim its set o u t in th e B o a rd G o v e rn a n c e D o c u m e n t. Lim its o n th e C E O 's a u th o rity re q u ire th e C E O to e n s u re th a t th e re is a system o f c o n tro l in p la c e f o r id e n tify in g a n d m a n a g in g ris k in th e G ro u p . T h e D ire c to rs , th ro u g h th e R A C , re v ie w th e system s th a t h a v e b e e n e s ta b lis h e d fo r th is p u rp o s e a n d r e g u la r ly re v ie w th e ir e ffe c tiv e n e s s . T he se re v ie w s in c lu d e a s se s sin g w h e th e r p ro c e s s e s c o n tin u e to m e e t e v o lv in g e x te rn a l g o v e rn a n c e re q u ire m e n ts . T h e R A C is re s p o n s ib le fo r th e o v e rs ig h t o f ris k m a n a g e m e n t a n d re v ie w s th e in te rn a l c o n tro ls a n d ris k m a n a g e m e n t system s. In u n d e rta k in g th is ro le , th e R A C re v ie w s th e fo llo w in g : •
p ro c e d u re s fo r id e n tify in g b u sin e ss a n d o p e ra tio n a l risks a n d c o n tro llin g th e ir fin a n c ia l im p a c t o n th e G ro u p a n d th e o p e ra tio n a l e ffe c tiv e n e s s o f th e p o lic ie s a n d p ro c e d u re s re la te d to ris k a n d c o n tro l;
•
b u d g e tin g a n d fo re c a s tin g system s, fin a n c ia l re p o r tin g system s a n d c o n tro ls ;
•
p o lic ie s a n d p ra c tic e s p u t in p la c e b y th e C E O f o r d e te c tin g , re p o r tin g a n d p re v e n tin g fra u d a n d s e rio u s b re a c h e s o f b u sin e ss c o n d u c t a n d w h is tle -b lo w in g p ro c e d u re s ;
•
p ro c e d u re s fo r e n s u rin g c o m p lia n c e w ith re le v a n t re g u la to r y a n d le g a l re q u ire m e n ts ;
•
a rra n g e m e n ts fo r p ro te c tin g in te lle c tu a l p r o p e rty a n d o th e r n o n -p h y s ic a l assets;
•
o p e ra tio n a l e ffe c tiv e n e s s o f th e B usin ess R A C s tru ctu re s;
•
o v e rs e e in g th e a d e q u a c y o f th e in te rn a l c o n tro ls a n d a llo c a tio n o f re s p o n s ib ilitie s fo r m o n ito rin g in te rn a l fin a n c ia l c o n tro ls .
Source: BHP Billiton Ltd,
A n n u a l R eport 2 0 1 4 .
CHAPTER 7 Internal control and cash
EXHIBIT 7.5
299
TABCORP HOLDINGS LIMITED EXTRACT FROM 2 0 1 4 A N N U A L REPORT
12. Internal control fram ew ork T h e G r o u p 's s tra te g ic p la n . . . a n d a d e ta ile d b u d g e t a re p r e p a re d a n n u a lly a n d s u b je c t to th e a p p r o v a l o f th e B o a rd . F o re ca sts fo r th e T a b c o r p G ro u p a n d e a c h o f th e o p e ra tin g b u sin e ss u n its a re re g u la r ly u p d a te d a n d re p o rte d to th e B o a rd th ro u g h o u t th e y e a r to e n a b le D ire c to rs to m o n ito r p e rfo rm a n c e a g a in s t th e a n n u a l b u d g e t. T h e T a b c o r p G r o u p h a s d e ta ile d p ro c e d u r a l g u id e lin e s f o r th e a p p r o v a l o f c a p ita l e x p e n d itu re in c lu d in g a n n u a l b u d g e tin g , re v ie w a n d a p p r o v a l o f in d iv id u a l p ro p o s a ls a n d s p e c ific leve ls o f a u th o rity b e tw e e n th e B o a rd , th e M a n a g in g D ire c to r a n d C h ie f E x e c u tiv e O ffic e r a n d o th e r le ve ls o f m a n a g e m e n t. Processes fo r th e in v e s tm e n t o f s u rp lu s c a s h , m a n a g e m e n t o f d e b t a n d c u rre n c y , a n d in te re s t ra te ris k m a n a g e m e n t h a v e b e e n a p p ro v e d b y th e B o a rd a n d a re th e s u b je c t o f o n g o in g re p o r tin g to th e B o a rd . T a b c o r p e n te rs in to in te re s t ra te s w a p s a n d c ro s s c u rre n c y s w a p s to h e d g e in te re s t ra te a n d fo re ig n e x c h a n g e ris k o n d e b t. T h e T a b c o r p G r o u p T re a s u ry d e p a rtm e n t is re s p o n s ib le fo r m a n a g in g th e T a b c o r p G r o u p 's fin a n c e fa c ilitie s a n d in te re s t ra te , c r e d it, liq u id ity a n d c u rre n c y risks in lin e w ith p o lic ie s set b y th e B o a rd . T h e T a b c o r p G r o u p 's in te rn a l c o n tro l s tru c tu re is re v ie w e d a n d a p p ro v e d b y th e B o a rd A u d it, R isk a n d C o m p lia n c e C o m m itte e . T his in c lu d e s th e ro le p e rfo rm e d b y th e G r o u p 's in te rn a l a u d it, ris k m a n a g e m e n t a n d c o m p lia n c e fu n c tio n s . T h e T a b c o r p G r o u p 's in te rn a l a u d it fu n c tio n is re s o u rc e d b y T a b c o rp e m p lo y e e s a n d s u p p le m e n te d b y re le v a n t in d u s try e x p e rts , a n d is in d e p e n d e n t o f th e e x te rn a l a u d ito r . In te rn a l a u d it re p o rts a re re g u la r ly s u b m itte d to th e C h ie f F in a n c ia l O ffic e r, to th e A u d it, R isk a n d C o m p lia n c e C o m m itte e a n d , w h e re a p p r o p r ia te , to th e B o a rd . T h e A u d it, R isk a n d C o m p lia n c e C o m m itte e a p p ro v e s th e in te rn a l a u d it p la n a n n u a lly . T a b c o r p 's G e n e ra l M a n a g e r A u d it, R isk a n d C o m p lia n c e re p o rts to th e C h ie f F in a n c ia l O ffic e r , a n d is a c c o u n ta b le to th e C h a ir m a n o f th e A u d it, R isk a n d C o m p lia n c e C o m m itte e r e g a r d in g th e G r o u p 's ris k , c o m p lia n c e a n d in te rn a l a u d it fu n c tio n s .
Source: T a b co rp H oldings Limited,
A n n u a l R eport 2 0 1 4 .
N o te some com m on aspects of these descriptions: •
The b o a rd of directors has responsibility for the internal control system.
•
The role o f the a u d it com m ittee in the evaluation o f internal controls is noted.
•
O p e ra tin g budgets are used to m onitor perform ance.
•
Internal audits are an im portant part o f the internal control system.
•
C ontrols a re im portant in certain key areas including Treasury.
•
There are clearly d e fined guidelines for c a p ita l investment.
7.7
Managers and internal control
As noted earlier, internal control is the responsibility o f m anagem ent. Internal controls a re fundam ental to the accurate recording o f transactions an d reliable fin a n cia l reports. A system of internal control should minimise a n d , w h e re possible, elim inate errors a nd irregularities. Errors are unintentional mistakes w hereas irregularities a re intentional. Even w ith a strong system o f internal control, errors can still occur, but the system should detect these errors. Irregularities should also be detected, except w h e re there is collusion (tw o o r
m ore em ployees w o rkin g together to cover up the irregularities) or m anagem ent override
(m anagem ent using its p o w e r to instruct em ployees to ignore a particular control). Thus, no system o f internal control can elim inate, w ith certainty, all errors an d irregularities, but it can decrease substantially the possibility o f them occurring an d increase the chances o f detecting them. An im portant question for m anagem ent is h o w much internal control is necessary. As each a d d itio n a l control is a d d e d , the risk o f error a nd irregularity decreases, but there is a cost for im plem enting the controls. Therefore, a c o s tbenefit analysis is required. H ow ever, this isdifficult to d o because the benefits o f having the controls a re often difficult to quantify. It becom es a matter o f judgem ent on the part o f m anagem ent as its estim ate o f the potential losses from errors a nd irregularities is co m p a red w ith the cost o f a d d itio n a l controls.
300
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Explain the natu re and purpose o f in te rn a l c o n tro l to a m anager A frie n d , Jane t, has a c c e p te d a jo b as th e g e n e ra l m a n a g e r o f a lo c a l c o m p a n y . D u rin g a m e e tin g y o u a tte n d e d , an a c c o u n ta n t m e n tio n e d to J a n e t th a t she w o u ld be re s p o n s ib le fo r in te rn a l c o n tro l w ith in th e c o m p a n y . W h e n the a c c o u n ta n t left th e ro o m , J a n e t tu rn e d to y o u a n d aske d , 'W h a t is in te rn a l c o n tro l a n d w h y sh o u ld I c a re a b o u t it? ' A n s w e r Ja n e t's q u e s tio n , using c le a r la n g u a g e w ith o u t te c h n ic a l ja rg o n .
PRACTICE PROBLEM B Prepare a bank re co n cilia tio n s ta te m e n t and explain the need For cash records The b a n k re c o n c ilia tio n m a d e b y Johnson Ltd on 31 A u g u s t 2 0 1 6 s h o w e d a d e p o s it in tra n s it o f $ 5 7 0 a n d tw o o u ts ta n d in g cheq ue s: no. 5 9 7 fo r $ 2 6 0 a n d no . 6 0 3 fo r $ 1 8 0 . The a d ju s te d b a la n c e p e r b o o ks o n 31 A u g u s t w a s $ 7 9 8 0 d e b it. The b a n k state m e nt s h o w n b e lo w is a v a ila b le fo r S e p te m b e r. A list o f d e p o s its m a d e a n d cheq ue s w ritte n d u rin g S e p te m b e r is s h o w n here: Deposits made
Cheques written $
S e p t.
$
1
350
607
450
4
420
No.
608
325
8
296
609
192
12
580
610
285
16
404
611
410
24
535
612
242
29
256
613
214
430
614
453
3 271
615
357
616
262
30
3 190
The cash a t b a n k a c c o u n t b a la n c e on 3 0 S e p te m b e r w a s $ 8 0 6 1 . In re v ie w in g th e c h e q u e s, th e b o o k k e e p e r d is c o v e re d th a t c h e q u e no. 6 1 0 , w ritte n fo r $ 2 5 8 fo r a re p a irs ex p e n s e , w a s re c o rd e d in th e cash p a ym e n ts jo u rn a l as $ 2 8 5 . The 're tu rn ' item fo r $ 3 3 5 , w h ic h John so n d e p o s ite d on 2 4 S e p te m b e r, w a s a p a y m e n t o n a c c o u n t fro m c u stom er D. Lewis (d is h o n o u re d c h e q u e ).
CHAPTER 7 Internal control and cash
301
Bank statement Johnson Ltd Newtown, NSW
DR
CR
3 0 September 2 0 1 6
Brought forward
$
31 Aug. 1 Sept
7 850 CR Cash/cheques 603
570 180
8 42 0 CR 8 240 CR
2 Sept
Cash/cheques
350
8 59 0 CR
5 Sept.
Cash/cheques
420
9010C R
608
325
8 685 CR
607
450
8 235 CR
8 Sept.
610
258
7 9 77 CR
9 Sept.
609
192
7 7 8 5 CR
Cash/cheques
296
8081 CR
15 Sept.
Cash/cheques
580
8 661 CR
17 Sept
Cash/cheques
612
25 Sept
30 Sept
242
8 4 1 9 CR 404
8 823 CR
611
410
8 4 1 3 CR
614
453
7 960 CR
Cash/cheques
535
8 495 CR
Cash/cheques
256
8 751 CR
Return Bank fee
335
8 4 1 6 CR
15
8 401 CR
1
P re p a re a b a n k re c o n c ilia tio n state m e nt fo r John so n Ltd a t 3 0 S e p te m b e r.
2
P re p a re th e ne ce ssa ry g e n e ra l jo u rn a l en trie s to b rin g th e cash a t b a n k a c c o u n t up-to-date as a t 3 0 S e p te m b e r 2016.
3
C o u ld a business d isp e n s e w ith its o w n cash re c o rd s a n d re ly e n tire ly on b a n k statem ents?
KEY TERMS Bank reconciliations Interest
Petty cash
Segregation of duties
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
DISCUSSION QUESTIONS 1
W h a t is in te rn a l c o n tro l?
2
List th e m a in c o m p o n e n ts o f in te rn a l c o n tro l.
3
W h y is in te rn a l c o n tro l o v e r cash so c ritic a l?
4
W h a t type s o f o rg a n is a tio n s ne ed strong in te rn a l c o n tro ls o v e r in ve n to ry?
5
W h a t is s e g re g a tio n o f du tie s? P ro v id e th re e e x a m p le s.
302
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
6
List fo u r im p o rta n t in te rn a l co n tro ls o v e r cash.
7
P ro v id e th re e s p e c ific in te rn a l c o n tro l p ro c e d u re s fo r: a cash b
in v e n to ry
c
a cco u n ts re c e iv a b le .
8 W h a t is th e p u rp o s e o f th e b a n k re c o n c ilia tio n statem ent? 9
If a c o m p a n y is o w e d $ 1 0 0 0 0 0 b y th e b a n k , w h y w o u ld it a p p e a r as a DR in th e c o m p a n y 's le d g e r a cco u n ts a n d a CR on th e b a n k statem ent?
10 W h y d o o u ts ta n d in g (un pre sen ted ) cheq ue s o c c u r a t m onth-end? 11 H o w do es a p e tty cash system a c t as an in te rn a l c o n tro l?
12 'N o system o f in te rn a l c o n tro l is p e rfe c t. T here a re a lw a y s in h e re n t lim ita tio n s .' D iscuss. 13 W h a t do es th e c o n c e p t o f 're a s o n a b le a s s u ra n c e ' m e an w ith respe ct to an in te rn a l c o n tro l system ? 14 W h y it is im p o rta n t to p e rfo rm c o s t-b e n e fit a n a lys is w h e n d e s ig n in g a n in te rn a l c o n tro l system ? 15 O u tlin e th e im p o rta n c e o f e a ch o f the fo llo w in g in an in te rn a l c o n tro l system fo r cash : a
th a t a ll cash sh o u ld be b a n k e d d a ily , in ta c t
b
th e b a n k re c o n c ilia tio n statem ent
c th e s e g re g a tio n o f d u tie s fo r th e m a il o p e n e r, th e c a s h ie r, th e g e n e ra l le d g e r-k e e p e r a n d th e re c e iv a b le le d g e r clerk.
16 A s ch o o l frie n d w h o has jo in e d a n e w c o m p a n y tells y o u th a t th e c o m p a n y has m a n y c o n tro ls o v e r cash . H e asks y o u to e x p la in w h y th e fo llo w in g c o n tro ls exist. a M a il o p e n in g is c a rrie d o u t b y tw o in d iv id u a ls . T h ey w o n 't a llo w th e c a s h ie r o r th e a cco u n ts re c e iv a b le c le rk to o p e n th e m a il, a lth o u g h th e y h a ve s p a re tim e d u rin g th e m o rn in g , b
M a il o p e n in g is tim e -c o n su m in g be ca u se th e c o m p a n y re q u ire s th a t a ll c heq ue s be cro ssed 'n o t n e g o tia b le ' a n d re c o rd e d on a listing o f a ll c heq ue s re c e ive d .
c
B ecause th e c a s h ie r a ls o has fre e tim e la te in th e a fte rn o o n , y o u r frie n d s u g g e s te d th a t th e c a s h ie r re c e ive the b a n k -v a lid a te d d e p o s it slips, b u t th e c o m p a n y insisted th a t th e slips be re tu rn e d to s om e on e else fo r c h e c k in g ,
d
The c o m p a n y do e s h a ve sm all expe nses, so it w o u ld be useful to use som e o f th e d a ily cash re ce ip ts to p a y th em . In ste ad , th e y a re fo rc e d to b a n k th e re c e ip ts in ta c t a n d set up a p e tty cash system to p a y fo r th e sm all expe nses.
e
The c a s h ie r takes fle x itim e e v e ry W e d n e s d a y a fte rn o o n , as he likes to a tte n d the lo c a l ra c e m e e tin g . H e a s ke d m a n a g e m e n t a b o u t no t b a n k in g on W e d n e s d a y , k e e p in g th e W e d n e s d a y re ce ip ts in the safe, then c o m b in in g them w ith T h u rs d a y 's re ce ip ts, b u t th e c o m p a n y w o u ld no t g iv e p e rm iss io n fo r this.
17 The b a n k re c o n c ilia tio n o f X Y Z Ltd revea ls a s ig n ific a n t b a n k e rro r in X Y Z's fa v o u r th a t w ill p ro b a b ly g o u n d e te c te d . A s th e a c c o u n ta n t, y o u c o n ta c t th e g e n e ra l m a n a g e r, w h o suggests th a t th e b a n k has p ro b a b ly m a d e e rro rs in its fa v o u r in th e pa st a n d th a t th e b a n k sh o u ld n o t be in fo rm e d o f its e rro r. W h a t sh o u ld y o u do ?
18 W ith re sp e ct to th e in te rn a l c o n tro l o v e r cash , p ro v id e an e x a m p le o f e a ch o f th e fo llo w in g : a
in d e p e n d e n t checks a n d re vie w s
b
a p p ro v a l o f tra n sa ctio n s
c
m a tc h in g d o cu m e n ts
d
p re n u m b e rin g a n d se q u e n ce c h e c kin g
e
re c o n c ilia tio n to o u ts id e in fo rm a tio n
f
access restrictio ns.
19 Discuss th e fo llo w in g statem ents: a
In te rn a l c o n tro l is th e re s p o n s ib ility o f th e a c c o u n ta n ts in an o rg a n is a tio n ,
b
A p ro p e rly d e s ig n e d system o f in te rn a l c o n tro l o v e r cash sh o u ld p re ve n t e m p lo y e e th e ft o f cash.
2 0 Discuss th e re la tio n s h ip b e tw e e n th e c o rp o ra te m a n a g e r's re s p o n s ib ility fo r in te rn a l c o n tro l a n d his o r her re s p o n s ib ility to e a rn p ro fit fo r th e sh a re h o ld e rs.
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PROBLEMS PROBLEM 7.1 Describe weaknesses in in te rn a l co n tro l The fo llo w in g in cid e n ts to o k p la c e in th e D G C o m p a n y : 1 Fred, th e m a il o p e n e r, c o n v e rte d a c h e q u e p a y a b le to th e D G C o m p a n y fo r his p e rso n a l use. W h e n he w a s d o in g th e b a n k re c o n c ilia tio n , Fred tre a te d th e m issing a m o u n t as a d e p o s it in tra n sit.
2
K y lie , th e c a s h ie r, p o ck e te d cash re c e ive d o v e r th e c o u n te r fro m custom ers p a y in g th e ir a c co u n ts. She then w ro te o ff th e re c e iv a b le s as u n c o lle c ta b le .
3
Joe w ro te o u t a c o m p a n y c h e q u e to p a y fo r c o n s tru c tio n d o n e a t his hom e.
4
Bill collects th e cash fro m v e n d in g m a ch in e s a n d keeps a b o u t 2 0 p e r c e n t fo r him self.
5
Liz in fla te s th e hours she w o rk s on th e tim e sheets.
For e a ch in c id e n t, d e s c rib e th e in te rn a l c o n tro l w e a kn e ss th a t m a d e th e in c id e n t p o ss ib le a n d d e s c rib e p ro c e d u re s th a t w o u ld re m o v e e a ch w e a kn e ss .
PROBLEM 7 .2 Id e n tity vio la te d com ponents o f in te rn a l co n tro l In e a ch o f th e fo llo w in g cases, w h a t c o m p o n e n t o f g o o d in te rn a l c o n tro l is b e in g v io la te d (if a n y)? (See s ection 7 .1 if y o u c a n 't re m e m b e r th e c o m p o n e n ts.) 1 T o u g h Ltd pa ys a ll its e m p lo y e e s m in im u m w a g e s a n d do es no t h a ve p le a s a n t w o rk in g c o n d itio n s .
2
Fred is a v e ry c o n s cie n tio u s e m p lo y e e w h o do es such a g o o d jo b th a t he do es p re tty m uch a ll o f W h is p Ltd's o ffic e tasks.
3
G a ra n d Ltd has a s o p h is tic a te d in te rn a l c o n tro l system th a t p rints o u t v a rio u s re p o rts o n d is c re p a n c ie s , w h ic h c o m p a n y m a n a g e m e n t asks th e a c c o u n tin g clerks to in v e s tig a te a n d resolve.
4
John runs a sm all w a re h o u s in g business. H e 's p ro u d o f s a vin g m o n e y on a c c o u n tin g . For e x a m p le , th e rea so n he g ive s fo r no t k e e p in g tra c k o f pu rch ases a n d ship m e nts o f g o o d s is th a t he c a n 'lo o k a t th e shelves a n d see if e v e ry th in g is a ll rig h t'.
5
W ild w o o d R estaurant is p ro u d o f its 'fa m ily a p p ro a c h ' to its e m p lo y e e s , ta k in g g re a t c a re to m a ke them feel im p o rta n t a n d tru ste d. E veryo ne has a key to th e re s ta u ra n t a n d s eve ral e m p lo y e e s c a n o fte n be fo u n d th e re a fte r ho urs, h e lp in g to c le a n a n d p re p a re fo r th e ne xt d a y .
6
H a d le e C o rp 's fo u n d e r, g e ttin g o n in y e a rs , has tu rn e d th e C E O 's jo b o v e r to his p la y b o y son w h o is q u ite in tere ste d in horse ra c in g a n d turns up a t th e o ffic e o n ly o c c a s io n a lly .
PROBLEM 7 .3 In te rn a l c o n tro l and fra u d C o n s id e r th e fo llo w in g tw o cases o f fra u d . 1 T h ere h a ve be en re c e n t re p o rte d in cid e n ts o f a tte m p te d fra u d o n a v a rie ty o f o rg a n is a tio n s . The fra u d involves s e n d in g in vo ice s fo r services o r p ro d u cts no t o rd e re d o r req ue ste d b y th e o rg a n is a tio n . T h ey te nd to be fo r a d v e rtis in g o r listin g in a p u b lic a tio n . The in vo ic e s c a n lo o k v e ry c re d ib le .
2
O v e r a fo u r-ye a r p e rio d , a p a y ro ll c lerk o f a la rg e supe rm a rket c h a in stole m ore th an $ 2 .5 m illio n fro m her e m p lo y e r. She supe rvised a safe c o n ta in in g a $ 2 0 0 0 0 cash flo a t th a t c o ve re d staff w a g e s , cash ad va nces a n d pe tty cash. A s the flo a t ran lo w she o rd e re d m ore cash, bu t fa lsifie d the acco un ts to h id e the m o n e y she to o k fo r herself. O u tlin e th e in te rn a l c o n tro ls th a t w o u ld be lik e ly to p re ve n t, o r a t le ast d e tect, th e a b o v e fra u d s a t an e a rlie r d a te .
PROBLEM 7 .4 Recomm end im provem ents in in te rn a l c o n tro l o f cash in a church You have been a p p o in te d to the finan ce com m ittee o f y o u r local church. The collections fo r S un da y services a re taken up b y a team o f ushers. A t the end o f each service the head usher counts the cash, then puts the total o f the cash count a n d the cash in the safe. O n M o n d a y s, the church treasurer, w h o has been d o in g the jo b fo r the last 15 years, re-counts the cash, deducts a flo a t to p a y fo r incidental church expenses d u rin g the w ee k, deposits the b a la n ce a n d records it in the church records. The church treasurer takes frequent overseas trips, so w he n he is a w a y the takings accum ulate in the safe until he returns. R ecom m end im p ro ve m e n ts in c o n tro l p ro ce d u re s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 7 .5 Explain cash c o n tro l procedures and id e n tity in te rn a l c o n tro l weaknesses 1
2
T h ere a re a n u m b e r o f p ro c e d u re s th a t a firm m a y e m p lo y to s a fe g u a rd cash . These p ro ce d u re s a re k n o w n as cash c o n tro l p ro c e d u re s . List fiv e e x a m p le s o f cash c o n tro l p ro c e d u re s a n d e x p la in th e ir fu n c tio n . F o llo w the e x a m p le g iv e n b e lo w :
Cash control procedure
Function
Physical safeguards over cash, such as a safe
To help protect the unbanked cash overnight until it can be banked the next day
Id e n tify th e in te rn a l c o n tro l w e a kn e sse s in th e fo llo w in g tw o cases a n d sugg est a w a y o f im p ro v in g e a ch s itu a tio n . a
A s u p p lie r w a s p a id tw ic e fo r th e sam e s h ip m e n t. O n e p a y m e n t w a s m a d e u p o n re c e ip t o f th e in v o ic e a n d th e s eco nd p a y m e n t u p o n re c e ip t o f th e m o n th ly state m e nt. The first p a y m e n t w a s n o t listed o n th e statem ent, as it a rriv e d a fte r th e state m e nt d a te .
b
The c a s h ie r p o c k e te d cash he re c e iv e d o v e r th e c o u n te r fro m a fe w custom ers w h o h a d p a id th e ir a c co u n ts. The c a s h ie r then w ro te th e a cco u n ts re c e iv a b le o ff as u n c o lle c ta b le .
PROBLEM 7 .6 Id e n tity objectives o t in te rn a l c o n tro l and explain how th e tt m ay be prevented E k u m b a b a Ltd is a sm all w h o le s a le r o f m o d e l a e ro p la n e s . It o n ly has a fe w e m p lo y e e s . The o w n e r o f th e business, w h o is a ls o th e m a n a g e r, m akes d a ily d e p o sits o f c u sto m e rs' c heq ue s in to th e firm 's b a n k a c c o u n t a n d w rite s a ll cheq ue s issued b y th e firm . H e a ls o re c o n cile s th e m o n th ly state m e nt w ith th e b o o ks w h e n th e b a n k state m e nt is re c e ive d in th e m a il. The assistant to th e o w n e r re n d e rs s e c re ta ria l services, w h ic h in c lu d e ta k in g d ic ta tio n , ty p in g letters a n d p ro ce ss in g a ll m a il - bo th in c o m in g a n d o u tg o in g . Each d a y , th e assistant g ive s th e o w n e r th e c heq ue s re c e ive d fro m custom ers. The v o u c h e rs a tta c h e d to th e cheq ue s a re s e p a ra te d b y th e assistant a n d sent to th e b o o k k e e p e r, a lo n g w ith a n y o th e r re m itta n c e a d vice s th a t h a ve be en e n clo s e d w ith the cheq ue s. The b o o k k e e p e r m akes p ro m p t en trie s to c re d it cu sto m e rs' a cco u n ts fo r th e ir re m itta n c e . From these a c co u n ts, the b o o k k e e p e r p re p a re s m o n th ly statem ents fo r m a ilin g to custom ers. O th e r e m p lo y e e s in c lu d e m a rk e tin g a n d w a re h o u s e p e rso n n e l. It is p o ss ib le th a t th e o w n e r's assistant takes c u sto m e rs' cheq ue s (d e p o s itin g them in his o r he r o w n ac co u n t) a n d de stro ys th e re m itta n c e a d v ic e s a n d vo u ch e rs a c c o m p a n y in g these cheq ue s. H o w w o u ld such a th e ft b e c o n c e a le d ? W h a t p re c a u tio n s c o u ld p re ve n t th e th e ft a n d / o r its c o n c e a lm e n t?
PROBLEM 7 .7 Top m anagem ent re sp o n s ib ility to r in te rn a l co n tro l The p ro u d o w n e r o f B eedle Ltd, a successful high-tech c o m p a n y , is v e ry g o o d a t h irin g a n d m o tiv a tin g e x ce lle n t p e o p le to d e v e lo p a n d sell p ro d u cts . D e le g a tio n is the key, says th e o w n e r. 'H ire g o o d p e o p le a n d g e t o u t o f th e ir w a y !' A s p a rt o f this p h ilo s o p h y , th e o w n e r h ire d th e best a c co u n ta n ts a v a ila b le a n d tu rn e d a ll th e a c c o u n tin g , c o n tro l a n d fin a n c e fu n c tio n s o v e r to them . The o w n e r c o n c e n tra te s on s tra te g y a n d business p la n n in g , a n d the c o m p a n y has g ro w n s te a d ily fo r s eve ral y e a rs . E x p la in to th e o w n e r the to p m a n a g e m e n t re s p o n s ib ilitie s th a t a re b e in g n e g le cte d here. G iv e n th a t th e c o m p a n y is so successful, do es such n e g le ct re a lly m atter?
PROBLEM 7 .8 Id e n tity m issing Features o t in te rn a l co n tro l R ead th e fo llo w in g d e s c rip tio n o f a sports c lu b . W h ic h fe a tu re s o f g o o d in te rn a l c o n tro l seem to be m issin g? A re a n y o f those fe atu res o ffse t b y streng th s in o th e r are a s ? The c lu b e a rn s reven ue fro m m e m b e rs ' fees, se llin g tickets to its ga m e s a n d a d v e rtis in g in its p ro g ra m s . A d v e rtis in g re c e ip ts a re m a in ly b y c h e q u e . O th e r re c e ip ts a re p rim a rily cash , w ith a n in c re a s in g p e rc e n ta g e b y c re d it c a rd . M o s t e x p e n d itu re s a re in cash , e x c e p t fo r e q u ip m e n t, fa c ility rentals a n d th e th re e e m p lo y e e s ' p a y ,
CHAPTER 7 Internal control and cash
305
w h ic h a re a ll d o n e b y c h e q u e . O n e e m p lo y e e do es som e c o a c h in g , sche du les ga m e s a n d c o o rd in a te s p la y e rs a n d o ffic ia ls . The s eco nd e m p lo y e e (w h o is m a rrie d to th e first) lo oks a fte r e q u ip m e n t, p re p a re s re n ta l fa c ilitie s fo r g a m e s, m akes tra v e l a rra n g e m e n ts a n d d o e s v a rio u s m isce lla n e o u s jo b s . The th ird e m p lo y e e looks a fte r cash , p a y ro ll a n d a c c o u n tin g . The c lu b 's b o a rd o f d ire c to rs meets m o n th ly a n d a lw a y s has m o n th ly (or a n n u a l) fin a n c ia l re p o rts to s crutinise . A ll th re e e m p lo y e e s a re m e m b ers o f th e b o a rd , a n d o th e r b o a rd m e m b ers re ly o n them . The c lu b has a ren ted o ffic e /s to re ro o m w h e re a ll e m p lo y e e s w o rk m ost o f th e tim e , a n d w h e re a ll th e c lu b 's e q u ip m e n t a n d v a rio u s su p p lie s a re s to re d . C a s h , c heq ue s a n d c re d it c a rd slips a re d e p o s ite d in to th e b a n k e v e ry tw o w e e ks , a n d p a y m e n t c heq ue s a re issued as n e e d e d . C ash expe nses a re p a id o u t o f cash c o lle c te d fro m m e m b e rs ' fees a n d tic k e t sales, so o fte n th e re is no t e n o u g h cash to b o th e r d e p o s itin g . S om etim es th e re is no t e n o u g h cash to p a y cash expe nses, in w h ic h ca se th e th ird e m p lo y e e , w h o is a u th o ris e d to s ig n a ll c h e q u e s, just w rite s a c h e q u e to 'c a s h ' a n d cashes it a t th e n e a rb y b a n k w h e re th e c lu b 's b a n k a c c o u n t is m a in ta in e d . The b o a rd o f d ire c to rs discusses a ll m a jo r trip s, e q u ip m e n t pu rch ases a n d o th e r la rg e e x p e n d itu re s in a d v a n c e a n d g ive s g e n e ra l a p p ro v a ls (or d e n ia ls) to th e e m p lo y e e s , w h o then lo o k a fte r th e d e ta ils .
PROBLEM 7 .9 Prepare a re p o rt on in te rn a l co n tro l The N S W G o lf S o c ie ty o p e ra te s a m useum fo r th e b e n e fit a n d e n jo y m e n t o f pre se n t a n d p o te n tia l g o lfe rs . D u rin g ho urs w h e n th e m useum is o p e n to th e p u b lic , tw o clerks, w h o a re p o s itio n e d a t th e e n tra n c e , c o lle c t a $ 5 a d m is s io n fe e fro m e a ch no n -m e m b e r p a tro n . M e m b e rs o f g o lf c lu b s a re p e rm itte d to e n te r fre e o f c h a rg e u p o n p re se n ta tio n o f th e ir m e m b e rs h ip c a rd s . A t th e e n d o f e a ch d a y , o n e o f th e clerks d e liv e rs th e p ro ce e d s to th e a c c o u n ta n t. The a c c o u n ta n t coun ts the cash in th e p re se n c e o f th e c le rk a n d p laces it in a safe . Each F rid a y a fte rn o o n th e a c c o u n ta n t a n d o n e o f th e clerks d e liv e r a ll th e cash he ld in th e safe to th e b a n k , a n d re c e ive a n a u th e n tic a te d d e p o s it s lip , w h ic h p ro v id e s th e basis fo r th e w e e k ly e n try in th e cash re ce ip ts jo u rn a l. The b o a rd o f d ire c to rs o f th e G o lf S o c ie ty has id e n tifie d a ne ed to im p ro v e th e system o f in te rn a l c o n tro l o v e r cash a d m is s io n fees. The b o a rd has d e te rm in e d th a t th e cost o f in s ta llin g turnstiles fo r sales bo oth s o r o th e rw is e a lte rin g th e p h y s ic a l la y o u t o f th e m useum w ill g re a tly e x c e e d a n y b e n e fits th a t m a y be d e riv e d . R e q u ire d : id e n tify w e a kn e sse s in th e e x is tin g system o f in te rn a l c o n tro l o v e r cash a d m is s io n fees a n d re c o m m e n d an im p ro v e m e n t fo r e a ch o f th e w e a kn e sse s y o u id e n tify .
PROBLEM 7.10 Prepare jo u rn a l entries re la tin g to p e tty cash A p e tty cash fu n d o f $ 1 0 0 w a s e s ta b lis h e d on 1 June 2 0 1 6 b y G re e n Ltd. D isbursem en ts w e re m a d e d u rin g June as fo llo w s : 1 Voucher no.
Voucher date
Amount $
Details
i
3 June
20.00
2
6 June
6.00
Postage
3
7 June
15.50
Staff tea supplies
4
8 June
20.00
Postage
5
10 June
9.50
Fares
6
1 1 June
4.80
Stationery
7
15 June
20.00
8
17 June
7.50
Fares
9
24 June
10.00
Taxis
10
28 June
17.00
Staff tea supplies
Fares
Postage
R eim bu rse m e nt c heq ue s w e re d ra w n on 1 6 June a n d 3 0 June. P re p a re jo u rn a l en trie s to re c o rd th e e s ta b lish m e n t a n d re p le n is h m e n t o f th e fu n d .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 7.11 Prepare jo u rn a l entries re la tin g to p e tty cash A p e tty cash fu n d o f $ 2 5 0 w a s set up b y S n o d g ra s s Ltd o n 1 A u g u s t b y d ra w in g c h e q u e no . 2 3 2 . T ra n sa ctio n s re la tin g to pe tty cash in A u g u s t w e re as fo llo w s : Voucher no.
Dale Aug 1
Amount $ 250.00
3
53
25.00
4
54
5.00
7
55
19.00
56
750
Details
1
Establishment of fund (chq. no. 232) Staff tea supplies Fares Taxi Fares
10
57
3.00
15
59
24.00
Postage
19
60
5.00
61
28.00
Taxi
62
15.00
Donation to charity
Taxi Reimbursement of fund (chq. no. 241)
24
Fares
25
63
22.50
Stationery supplies
26
64
110.00
Entertaining clients
31
65
7.00
Fares Reimbursement of fund (chq. no. 244)
P re p a re jo u rn a l e n trie s to re c o rd th e tra n s a c tio n s d u rin g A u g u s t.
PROBLEM 7.12 Sim ple bank re co n cilia tio n R econ cile H e n ry 's m onth-end b a n k a c c o u n t b a la n c e a n d , b a se d on y o u r a n a ly s is , in d ic a te w h a t c o rre c tio n s y ou w o u ld m a ke to H e n ry 's record s: 1
m o nth-end b a n k b a la n c e a c c o rd in g to th e b a n k 's statem ent, $ 8 7 9 1
2
m o nth-end b a n k b a la n c e a c c o rd in g to H e n ry 's re c o rd s, $ 7 3 7 1
3
o u ts ta n d in g c heq ue s (not pro ce sse d b y th e b a n k yet), $ 1 8 7 7
4
o u ts ta n d in g d e p o s it (no t pro ce sse d b y th e b a n k yet), $ 2 5 0
5
b a n k c h a rg e s H e n ry d id no t k n o w a b o u t, $ 4 3
6
s om e on e e lse 's c h e q u e p u t th ro u g h H e n ry 's a c c o u n t b y th e b a n k , $ 1 8 5
7
in tere st on th e b a n k b a la n c e c re d ite d to H e n ry b y th e b a n k b u t no t k n o w n to H e n ry, $ 2 1 .
PROBLEM 7.13 Explain w hy bank re co n cilia tio n sta te m e n ts are prepared, and then prepare one 1
W h y a re b a n k re c o n c ilia tio n statem ents p re p a re d ? U n d e r w h a t c ircu m s ta n ce s w o u ld it be un ne ce ssary to p re p a re a b a n k r e c o n c ilia tio n sta te m e n t?
2
Y ou h a ve be en s u p p lie d w ith th e fo llo w in g in fo rm a tio n p ro d u c e d b y c o m p a rin g th e re c o rd s o f th e S w ift C o m p a n y w ith its m ost re c e n t b a n k statem ent: a
d e b it b a la n c e as p e r cash a t b a n k a c c o u n t in le d g e r as a t 3 0 June, $1 2 6 4 4 .4 0
b
c re d it b a la n c e as p e r b a n k state m e nt as a t 3 0 June, $ 1 6 8 6 0 .3 0
c
d e p o s its no t re fle c te d o n b a n k statem ent, $1 8 8 0 .0 0
CHAPTER 7 Internal control and cash
d
307
un p re se n te d c heq ue s 3 0 June, $ 6 1 8 5 .9 0
e
b a n k c h a rg e on b a n k state m e nt no t re c o rd e d in b o o ks, $ 3 0 .0 0
f
e rro r b y b a n k - S w itch C o m p a n y c h e q u e c h a rg e d to S w ift C o m p a n y 's a c c o u n t, $ 4 2 0 .0 0
g
c h e q u e fo r a d v e rtis in g e x p e n s e , $ 4 8 0 .0 0 , in c o rre c tly re c o rd e d in b o o ks as $ 8 4 0 .0 0 .
3
P re p a re a b a n k re c o n c ilia tio n state m e nt as a t 3 0 June.
4
P re p a re en trie s in g e n e ra l jo u rn a l fo rm to u p d a te th e re c o rd s o f th e S w ift C o m p a n y .
PROBLEM 7.14 Sim ple bank re co n cilia tio n O n 3 0 June 2 0 1 6 , th e b a n k a c c o u n t fo r H olm es T ra d e rs s h o w e d a d e b it b a la n c e o f $ 1 3 4 1 8 a n d th e b a n k state m e nt s h o w e d a c re d it b a la n c e o f $ 2 0 2 0 8 . A c o m p a ris o n o f th e tw o sets o f re c o rd s d isc lo se d : 1
th a t th e re w a s a b a n k c h a rg e o f $ 1 0
2
th a t a d ire c t c re d it fro m Em m a a n d Tim Lim ited h a d be en re c e ive d fo r $ 1 0 0 0 b u t w a s no t in c lu d e d in the c o m p a n y 's re c o rd s
3
th a t th e d a te o f a d e p o s it o f $ 2 4 5 0 w a s s h o w n b y H olm es T ra d e rs as 3 0 June 2 0 1 6 , w h e re a s th e b a n k d id no t re c o rd th e d e p o s it until 1 July 2 0 1 6
4
u n p re se n te d c heq ue s to ta llin g $ 8 2 5 0 . P re p a re a b a n k re c o n c ilia tio n state m e nt a t 3 0 June 2 0 1 6 .
PROBLEM 7.15 Bank re co n cilia tio n sta te m e n ts A S B Lim ited re c e iv e d its b a n k state m e nt fo r th e m onth e n d in g 3 0 June, a n d re c o n c ile d th e state m e nt b a la n c e to the 3 0 June b a la n c e in th e C a s h a c c o u n t. The re c o n c ile d b a la n c e w a s d e te rm in e d to be $ 4 8 0 0 . The re c o n c ilia tio n in c lu d e d th e fo llo w in g item s: a D ep osits in tra n s it w e re $ 2 1 0 0 . b
O u ts ta n d in g c heq ue s to ta lle d $ 3 0 0 0 .
c
B an k fees o f $ 5 0 w e re s h o w n on th e b a n k state m e nt as a d e d u c tio n .
d
A n N S F c h e q u e fro m a c u stom er fo r $ 4 0 0 w a s in c lu d e d on th e b a n k statem ent. The firm h a d n o t be en p re v io u s ly n o tifie d th a t th e c h e q u e h a d be en re tu rn e d fo r in s u ffic ie n t funds,
e
In clu d e d in th e pre se nte d c heq ue s w a s a c h e q u e a c tu a lly w ritte n fo r $ 8 9 0 . H o w e v e r, it has be en re c o rd e d b y the b a n k as a d is b u rs e m e n t o f $ 9 8 0 .
Required: 1 W h a t w a s th e b a la n c e in A S B L im ited 's cash a c c o u n t b e fo re re c o g n is in g a n y o f th e a b o v e re c o n c ilin g item s?
2
W h a t w a s th e b a la n c e s h o w n o n th e b a n k state m e nt b e fo re re c o g n is in g a n y o f th e a b o v e re c o n c ilin g item s?
3
P re p a re a n y ne ce ssary a d ju s tin g jo u rn a l e n trie s.
PROBLEM 7.16 Bank re co n cilia tio n s ta te m e n t A A A Lim ited re c e iv e d its b a n k state m e nt fo r th e m onth e n d in g 3 0 June, a n d re c o n c ile d th e state m e nt b a la n c e to the 3 0 June b a la n c e in th e C a s h a c c o u n t. The re c o n c ile d b a la n c e w a s d e te rm in e d to be $ 5 0 0 0 . The re c o n c ilia tio n in c lu d e d th e fo llo w in g item s: a D ep osits in tra n s it w e re $ 2 0 0 0 . b
O u ts ta n d in g c heq ue s to ta lle d $ 3 0 0 0 .
c
Interest re ven ue o f $ 3 0 w a s s h o w n o n th e b a n k statem ent.
d
A n N S F c h e q u e fro m a c u stom er fo r $ 4 0 0 w a s in c lu d e d on th e b a n k statem ent. The firm h a d n o t be en p re v io u s ly n o tifie d th a t th e c h e q u e h a d be en re tu rn e d fo r in s u ffic ie n t funds.
Required: 1 W h a t w a s th e b a la n c e in A A A L im ited 's cash a c c o u n t b e fo re re c o g n is in g a n y o f th e a b o v e re c o n c ilin g item s?
2
W h a t w a s th e b a la n c e s h o w n o n th e b a n k state m e nt b e fo re re c o g n is in g a n y o f th e a b o v e re c o n c ilin g item s?
3
P re p a re a n y ne ce ssary a d ju s tin g jo u rn a l e n trie s.
308
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 7.17 Prepare a bank re co n cilia tio n s ta te m e n t The b o o k k e e p e r a t C o v in g to n Ltd un d e rta k e s a b a n k re c o n c ilia tio n a t th e e n d o f e v e ry m o nth . O n 31 A u g u s t, the b a n k re c o n c ilia tio n s h o w e d a d e p o s it in tra n s it o f $ 6 5 0 a n d tw o o u ts ta n d in g cheq ue s (no. 4 6 3 fo r $ 1 7 0 a n d no. 4 7 1 fo r $ 3 5 0 ) . The a d ju s te d cash b a la n c e in th e c o m p a n y re c o rd s w a s $ 5 9 0 6 d e b it. The c o m p a n y 's S e p te m b e r b a n k state m e nt is s h o w n b e lo w . Stole Bank Bank statement Covington Ltd
Statement period
Kensington, NSW
3 1 /8 /2 0 1 6 - 3 0 /9 /2 0 1 6 DR
31 Aug.
Balance brought forward
1 Sept.
Deposit
2 Sept.
Deposit 482 Deposit
7 Sept.
471
8 Sept.
Deposit
CR
650
6426
CR
590
7016
CR
6 756
CR
7096
CR
340 350
Deposit 484
350
12 Sept.
483
850
14 Sept.
Deposit
6 746
CR
420
7166
CR
210
7376
CR
7026
CR
6176
CR
6 986
CR
6 246
CR
6526
CR
5 846
CR
6 606
CR
810
487
$ 5 776
260
5 Sept.
11 Sept.
CR
740
19 Sept.
Deposit
280
21 Sept.
485
25 Sept.
Deposit
28 Sept.
486
630
5 976
CR
30 Sept.
480
430
5 546
CR
5 564
CR
5 553
CR
680 760
Interest
18
Bank charges
11
C o m p a n y re c o rd s in d ic a te th e fo llo w in g d e p o s its m a d e a n d cheq ue s w ritte n d u rin g S e p te m b e r: Deposits made
Cheques written
$
No.
Sept. 2
590
479
240
5
340
480
430
8
420
481
345
11
210
482
260
14
810
483
850
19
280
484
350
25
760
485
680
29
630
486
360
4040
487
740
$
4255
CHAPTER 7 Internal control and cash
309
The cash a t b a n k a c c o u n t b a la n c e on 3 0 S e p te m b e r w a s $ 5 6 9 1 . In re v ie w in g cheq ue s, a m ista ke w a s d is c o v e re d : c h e q u e no . 4 8 6 , w ritte n fo r a d v e rtis in g expe nses o f $ 6 3 0 , w a s re c o rd e d in th e cash p a ym e n ts jo u rn a l as $ 3 6 0 . 1
P re p a re th e ne ce ssa ry jo u rn a l e n trie s to b rin g th e cash a t b a n k a c c o u n t up to d a te as a t 3 0 S e p te m b e r.
2
P re p a re a b a n k re c o n c ilia tio n state m e nt fo r C o v in g to n Ltd a t 3 0 S e p te m b e r.
PROBLEM 7.18 Prepare a bank re co n cilia tio n s ta te m e n t The fo llo w in g in fo rm a tio n com e s fro m th e re c o rd s o f A n th e a 's H o m e w a re s. From the cash receipts records:
From the cash payments records:
$
Date April
Cheque no.
$
1
687
2
570
415
8
805
3
571
82
15
412
5
572
137
22
903
8
574
1 315
29
246
11
575
642
15
576
701
17
577
240
20
578
194
23
579
311
27
580
293
28
581
114
From the general ledger Cash a t bank
Account no. 111
Date
Item
March 31
Balance
Post ref
Debit
Credit
Balance 2 5 9 4 DR
Bank statement Statement period 3 1 /3 /2 0 1 6 - 3 0 /4 /2 0 1 6 $ March
31
Balance brought forward
April
1
Deposit
3
568
4
570
8
3 657
CR
4 344
CR
372
3 972
CR
415
3 557
CR
4 362
CR
4 225
CR
687
Deposit 572
9
Direct credit
10
574
11 14 15
Deposit
16
571
19
NSF
805 137
4921
CR
1 513
696
3 408
CR
575
642
2 766
CR
552
435
2331
CR
2 743
CR
82
2661
CR
421
2 240
CR
412
310
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
20
576
22
701
Deposit
903
1 539
CR
2442
CR
578
194
2 248
CR
25
560
97
2 151
CR
27
5 77
240
1 911
CR
30
581
1 14
1 797
CR
1 855
CR
1 831
CR
Interest
58
Bank charges
24
The N S F c h e q u e w a s re c e iv e d fro m B ond E nterprises, a d e b to r. The d ire c t c re d it represents a $ 6 5 0 b ill c o lle c te d b y th e b a n k , plus interest. C h e q u e no. 5 7 3 w a s p re p a re d im p ro p e rly a n d has been c a n c e lle d . C h e q u e no . 5 7 4 fo r a p u rch a s e o f in v e n to ry w a s in c o rre c tly re c o rd e d as a cash p a y m e n t o f $ 1 3 1 5 in ste a d o f $ 1 5 1 3 . O n 31 M a rc h , the o n ly re c o n c ilin g item s w e re a series o f un p re se n te d cheq ue s: no. 5 5 2 a t $ 4 3 5 , no . 5 6 0 a t $ 9 7 , no. 5 6 2 a t $ 1 5 9 a n d no . 5 6 8 a t $ 3 7 2 . P re p a re a b a n k re c o n c ilia tio n state m e nt fo r A n th e a 's H o m e w a re s a t 3 0 A p r il, a n d a n y ne ce ssary a d ju s tin g jo u rn a l e n trie s.
PROBLEM 7.19 Prepare a bank re co n cilia tio n s ta te m e n t w ith o verdraft The fo llo w in g in fo rm a tio n com e s fro m th e re c o rd s o f B etty's B ou tiq u e . From the cash receipts records: Date 2 0 1 6
From the cash payments records:
Cash (DR) amount
Date 2 0 1 6
Cheque no.
Amount
Nov.
1
721
28
2
722
566
$ Nov. 1
1 828
7
2 024
$
14
6480
3
723
832
21
5 292
4
724
54
30
3 884
5
726
10
10
727
11 492
11
728
1 418
20
729
2 492
21
730
152
22
731
10000
From the general ledger: Cash a t bank
Account no. 111
Date Item Oct. 31
Balance
Post ref.
Debit
Credit
Balance 4 930 DR
CHAPTER 7 Internal control and cash
Wolfpac National Bank Date
Statement of Betty's Boutique
Particulars
Debit
Credit
Balance
$
$
$
2016 Nov.
Code:
1
Balance
2
700
200
2
707
1 000
2
Deposit
4
720
920
7 2 7 8 CR
4
721
28
7 2 5 0 CR
6
723
832
6 4 1 8 CR
8
724
54
8
Deposit
12
726
10
8 3 7 8 CR
12
NSF
30
8 3 4 8 CR
14
728
1 814
15
Deposit
22
Deposit
24
727
26 26
7 5 7 0 CR 7 3 7 0 CR 6 370 CR 1 828
8 198 CR
6 364 CR 2 024
8 3 8 8 CR
6 5 3 4 CR 6480
1 3 0 14 CR
5 292
1 8 3 0 6 CR
11492
6 814 CR
730
152
6 662 CR
731
10000
3 338 DR
26
DC
30
SC
30
IN
311
816 8
2 53 0 DR 84
D C - Direct credit
IN - Interest
D D - Direct debit
SC - Service charge
2 522 DR
2 446 DR
NSF - Non-sufficient funds
The N SF c h e q u e w a s re c e ive d fro m J. P in d a r, a d e b to r. The d ire c t c re d it rep resents a n $ 8 0 0 b ill c o lle c te d b y the b a n k , plus interest. C h e q u e no. 7 2 5 w a s p re p a re d im p ro p e rly a n d has be en c a n c e lle d . C h e q u e no . 7 2 8 fo r a p u rch a s e o f in v e n to ry w a s in c o rre c tly re c o rd e d as a cash p a y m e n t o f $ 1 4 1 8 in ste a d o f $ 1 8 1 4 . O n 1 N o v e m b e r, th e re w e re o n ly th e fo llo w in g u n p re se n te d cheq ue s as re c o n c ilin g item s: no. 7 0 0 a t $ 2 0 0 , no. 7 0 7 a t $ 1 0 0 0 , no. 7 1 9 a t $ 5 2 0 a n d no. 7 2 0 a t $ 9 2 0 . P re p a re a b a n k re c o n c ilia tio n state m e nt, as a t 3 0 N o v e m b e r 2 0 1 6 , a n d a n y ne ce ssary a d ju s tin g jo u rn a l e n trie s.
PROBLEM 7 .2 0 Prepare a re p o rt on in te rn a l c o n tro l Following em bezzlem ent F o llo w in g th e e m b e z z le m e n t o f $ 5 0 0 0 0 fro m E asy-G o P in b a ll T ra d e rs , y o u h a ve be en a s ke d to a p p ra is e the in fo rm a tio n system o f th e business, w ith p a rtic u la r re fe re n ce to th e in te rn a l c o n tro l p ro c e d u re s . A n in v e s tig a tio n soon disclo ses th a t th e re is, in fa c t, no system a n d in te rn a l c o n tro l is n e ith e r u n d e rsto o d n o r p ra c tis e d . M a n y pa ym e n ts a re m a d e fro m cash ta ke n s tra ig h t fro m th e cash re g is te r, a n d w h e n it is ne ce ssary to d r a w a c h e q u e it m a y be s ig n e d b y a n y o n e m e m b e r o f th e o ffic e staff. The b a n k state m e nt has no t been re c o n c ile d fo r seve ral y e a rs . The w e e k ly p a y ro ll n o rm a lly a m o u n ts to a p p ro x im a te ly $ 5 0 0 0 , b u t last w e e k it w a s p re p a re d b y an a c co u n ts c le rk , Ian P ilfer. P ilfer w ro te o u t a c h e q u e fo r $ 5 0 0 0 0 , re c o rd e d $ 5 0 0 0 on th e c h e q u e bu tt, s ig n e d the c h e q u e h im s e lf a n d d ro v e th e firm 's c a r to th e b a n k to c o lle c t th e p a y ro ll. The p o lic e h a ve be en u n a b le to lo ca te P ilfer, th e m issing m o n e y o r th e v e h icle . P re p a re a re p o rt fo r th e m a n a g e m e n t o f E asy-G o P in b a ll T ra d e rs , m a k in g p a rtic u la r re fe re n ce to: 1 th e p u rp o s e o f the b a n k re c o n c ilia tio n statem ent
2
d e fic ie n c ie s in th e p ro c e d u re s fo llo w e d b y th e business w ith re sp e ct to cash
3
th e c h a n g e s y o u w o u ld re c o m m e n d to s a fe g u a rd th e firm 's liq u id assets in th e fu ture .
312
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 7.21 Prepare a re p o rt on in te rn a l co n tro l A u n iv e rs ity re c e n tly o p e n e d a p a rk in g sta tio n o n its lo w e r ca m p u s a re a fo r th e b e n e fit o f th e students. A g u a rd has be en e n g a g e d to p a tro l th e c a r p a rk a n d issue p a rk in g stickers to u n iv e rs ity students w h o s u b m it a n a p p lic a tio n fo rm a n d s h o w e v id e n c e o f e n ro lm e n t. W h e n th e s tic ke r is a ffix e d to th e c a r, th e stu d e n t m a y p a rk in th e c a r p a rk fo r six hours b y p la c in g a d o lla r in th e p a rk in g m eter. The g u a rd inspects th e stickers o n a ll p a rk e d ca rs to d e te rm in e th a t o n ly students a re p a rk in g in th e lot. H e a ls o looks a t th e tim e g a u g e s to ensure th a t th e m e ter show s th e ne ce ssary fees h a ve be en p a id . The c o m p le te d a p p lic a tio n fo rm s a re m a in ta in e d in th e g u a rd 's o ffic e . U sing a m aster key, th e g u a rd e m p tie s th e m eters w e e k ly a n d d e liv e rs th e cash to th e u n iv e rs ity 's c e n tra l store d e p a rtm e n t, w h e re a c le rk o p e n s it, m a n u a lly co u n ts th e c o in s, puts th e cash in a safe a n d re c o rd s th e to ta l o n a w e e k ly cash re p o rt. The re p o rt is sent to th e u n iv e rs ity 's a c c o u n tin g d e p a rtm e n t. The d a y fo llo w in g th e cash c o u n t, th e u n iv e rs ity c a s h ie r p icks up th e cash a n d m a n u a lly re-counts it, p re p a re s th e d e p o s it s lip a n d m akes th e d e p o s it a t th e b a n k . The d e p o s it s lip , a u th e n tic a te d b y th e b a n k te lle r, is sent to th e a c c o u n tin g d e p a rtm e n t, w h e re it is file d w ith th e w e e k ly cash re p o rt. D e s crib e a n y w e a kn e sse s in th e e x is tin g system . For e a ch w e a kn e ss , re c o m m e n d a t le ast o n e im p ro v e m e n t to s treng th en th e in te rn a l a c c o u n tin g c o n tro l o v e r th e p a rk in g sta tio n cash receipts.
PROBLEM 7 .2 2 Prepare a re p o rt on in te rn a l co n tro l C a rd s h a rk Ltd su p p lie s b o xe s o f B ig Bash c ric k e t c a rd s to v a rio u s c a rd s w a p shops a ro u n d A u s tra lia . The c o m p a n y has m o re th a n 1 0 0 sm all c lie n ts p u rc h a s in g bo xe s o f c a rd s on c re d it. C re d it term s a re net 3 0 d a y s , w ith p a ym e n ts m o stly b e in g m a d e b y m a il. O v e r th e p a st fe w m onths, o rd e rs h a ve be en a t a h ig h level, re fle c tin g an u p s w in g in in tere st in c ric k e t c a rd s . This has m e a n t a m a rk e d in cre a s e in bo th th e v o lu m e o f m a il c o m in g in to th e o ffic e a n d in d iv id u a ls p a y in g o v e r th e c o u n te r. M a il is o p e n e d b y th e o ffic e ju n io r, S a lly Letter, a n d s e p a ra te d in to p a ym e n ts on a c co u n ts a n d o th e r m a il. She a lso receives a n y m o nies th a t c o m e d ire c tly o v e r th e c o u n te r. S a lly sends th e m o n e y to th e c a s h ie r, Sam M o n e y b a g s , w h o puts it in th e safe to a w a it b a n k in g . The key to th e safe is h e ld b y th e a cco u n ts c le rk , S a ra Post. A t th e e n d o f th e w e e k , S a ra takes th e m o n e y to th e b a n k a n d uses th e b a n k -sta m p e d d e p o s it s lip to w rite up th e cash receipts b o o k . M o n th ly re c o n c ilia tio n s o f th e b a n k a c c o u n t a re p re p a re d b y S a ra . Based o n this d e s c rip tio n o f C a rd s h a rk Ltd's cash re ce ip ts system : 1 Id e n tify th e p o te n tia l p ro b le m s w ith S a ra Post's d u tie s. 2
O th e r th a n re a s s ig n in g d u tie s a n d re s p o n s ib ilitie s , g iv e th re e re c o m m e n d a tio n s in o rd e r to im p ro v e th e c u rre n t system o f h a n d lin g cash receipts.
CASES CASE 7A
Woolworths Limited
Refer to th e 2 0 1 4 a n n u a l re p o rt o f W o o lw o rth s Lim ited a v a ila b le at: w w w .w o o lw o rth s lim ite d .c o m .a u /a n n u a lre p o rt/ 2 0 1 4 /in d e x .h tm l. 1 A re th e re a n y referen ce s to in te rn a l c o n tro l b y W o o lw o rth s Lim ited? 2
W h a t d e ta ils a re p ro v id e d a b o u t th e in te rn a l a u d it fu n c tio n ?
CHAPTER 7 Internal control and cash
CASE 7B
313
Internal control disclosures
F o llo w in g is a n e x c e rp t fro m th e 2 0 1 4 a n n u a l re p o rt o f BHP B illito n .
BHP Billiton Management’s assessment of our internal control over financial reporting O u r m a n a g e m e n t is re s p o n s ib le f o r e s ta b lis h in g an d m a in ta in in g a d e q u a te in te rn a l c o n t r o l o v e r fin a n c ia l r e p o r tin g (a s d e fin e d in R u le 1 3 a - 1 5 ( 0 a n d 1 5 d - 1 5 ( f ) u n d e r th e U S S e cu ritie s E xc h a n g e A c t o f 1 9 3 4 ). U n d e r th e
s u p e rv is io n
and
w ith
th e
p a rtic ip a tio n
o f o u r m a n a g e m e n t, in c lu d in g
our C E O
and
CFO,
th e
e ffe c tiv e n e s s o f th e G r o u p ’s in te rn a l c o n t r o l o v e r fin a n c ia l r e p o r tin g has b e e n e v a lu a te d b a sed o n th e fr a m e w o r k a n d c r ite r ia e s ta b lis h e d in In te rn a l C o n tr o ls -
In te g r a te d F r a m e w o rk , issu ed b y t h e S p o n s o rin g
O rg a n iz a tio n o f th e T re a d w a y C o m m is s io n ( C O S O ) . B ased o n th is e v a lu a tio n , m a n a g e m e n t has c o n c lu d e d t h a t in te rn a l c o n t r o l o v e r fin a n c ia l r e p o r tin g w as e ff e c t iv e as a t 3 0 J u n e 2 0 1 4 . T h e re w e re n o m a te ria l w e a k n e s s e s in t h e G r o u p ’s in te rn a l c o n tr o ls o v e r fin a n c ia l r e p o r tin g id e n tifie d b y m a n a g e m e n t. B e c a u s e o f its in h e r e n t lim ita tio n s , in te rn a l c o n tr o l o v e r fin a n c ia l r e p o r tin g m a y n o t p r e v e n t o r d e te c t m is s ta te m e n ts a n d , e v e n w h e n d e te rm in e d t o be e ffe c tiv e , c a n o n ly p ro v id e re a s o n a b le a s s u ra n c e w ith re s p e c t t o
fin a n c ia l
s ta te m e n t
p re p a ra tio n
and
p re s e n ta tio n .
A ls o ,
p r o je c tio n s
o f any
e v a lu a tio n
of
e ffe c tiv e n e s s t o f u t u r e p e rio d s a re s u b je c t t o th e risk t h a t c o n tr o ls m a y b e c o m e in a d e q u a te b e c a u s e o f c h a n g e s in c o n d itio n s , o r t h a t t h e d e g re e o f c o m p lia n c e w ith th e p o lic ie s o r p r o c e d u re s m a y d e te rio ra te . B H P B illito n has e n g a g e d o u r in d e p e n d e n t re g is te re d p u b lic a c c o u n tin g f ir m s , K P M G a n d K P M G L L P , to issu e an a u d it r e p o r t o n o u r in te rn a l c o n t r o l o v e r fin a n c ia l r e p o r tin g f o r in c lu s io n in th e F in a n c ia l S ta te m e n ts s e c tio n o f th is A n n u a l R e p o r t o n F o r m 2 0 - F as file d w ith th e S E C . T h e re h a ve b e e n n o c h a n g e s in o u r in te rn a l c o n t r o l o v e r fin a n c ia l r e p o r tin g d u rin g F Y 2 0 1 4 t h a t have m a te ria lly a ffe c te d , o r a re re a s o n a b ly lik e ly t o m a te r ia lly a f f e c t , o u r in te rn a l c o n tr o l o v e r fin a n c ia l re p o r tin g . Source: B H P Billiton Lim ited, 2014 Annual Report.
1
W h o is re s p o n s ib le fo r in te rn a l c o n tro l?
2
W h y d o e s BHP re fe r to th e US S e c u ritie s E x c h a n g e A c t o f 1 9 3 4 ?
3
W h y c a n in te rn a l co n tro ls p ro v id e o n ly re a s o n a b le a s su ra n ce th a t business risks w ill b e fu lly m itig a te d ?
CASE 7C
Internal controls over non-financial risks
A n u m b e r o f c o u n trie s h a ve in tro d u c e d (or a re c o n s id e rin g th e in tro d u c tio n of) re g u la to ry re fo rm o v e r g re e n h o u s e g a s e m issions in a n e ffo rt to c u rb th e effects o f c lim a te c h a n g e . These c o u n trie s in c lu d e A u s tra lia , South A fric a , C h in a , In d ia , th e U n ite d States a n d som e E u ro p e a n c o u n trie s. For c o m p a n ie s o p e ra tin g in th e e n e rg y in d u strie s these p ro p o s e d re g u la tio n s m a y h a ve a severe im p a c t on th e ir fu tu re o p e ra tio n s . W h ile in 2 0 1 4 A u s tra lia w ith d re w its c a rb o n ta x , S outh A fric a is p la n n in g to in tro d u c e a c a rb o n ta x in 2 0 1 6 a n d c a rb o n p ric in g is b e in g c o n s id e re d in o th e r ju ris d ic tio n s . A c c o rd in g ly , a n y b re a c h o f these re g u la tio n s m a y le a d to fin a n c ia l p e n a ltie s a n d loss o f re p u ta tio n . W h a t in te rn a l c o n tro l processes c o u ld c o m p a n ie s (e s p e c ia lly m u ltin a tio n a l c o m p a n ie s ) a ffe c te d b y these reform s p u t in p la c e to m in im is e th e risks a s s o c ia te d w ith a b re a c h ?
CASE 7D_____________________ Internal controls over intangible assets For m a n y c o m p a n ie s , th e ir m ost v a lu a b le assets a re no t th e ir cash a n d th e ir in v e n to ry b u t th e ir in ta n g ib le assets. These in ta n g ib le assets m a y in c lu d e b ra n d nam es, m a sth e a d s, pa ten ts a n d item s th a t a re tra d e m a rk e d o r c o v e re d b y c o p y rig h t. 1
W h a t in te rn a l c o n tro l p ro c e d u re s c a n be p u t in p la c e b y c o m p a n ie s to p ro te c t th e ir: a
b ra n d nam es?
b
patents?
c
tra d e m a rk s /c o p y rig h t?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
2
The c o n tro l p ro ce d u re s y o u h a ve id e n tifie d in q u e s tio n 1 w ill v a ry b y h o w m uch th e y cost a n d w h a t b e n e fit m a y be d e riv e d . For e a ch item o f in te lle c tu a l p ro p e rty , id e n tify a v e ry c o stly p ro c e d u re th a t c o u ld be e m p lo y e d a n d a v e ry in e x p e n s iv e p ro c e d u re .
3
P erform a c o s t-b e n e fit a n a lys is a n d id e n tify w h e th e r y o u re c o m m e n d y o u r c o stly o r y o u r in e x p e n s iv e p ro c e d u re b y e x a m in in g th e p o te n tia l b e n e fit th a t c o u ld be o b ta in e d b y th e c o m p a n y re la tiv e to its costs.
CASE 7E
The ethics of facilitation payments
In som e c o u n trie s it is k n o w n th a t pa ym e n ts c a n be m a d e to lo c a l p u b lic servants to s pee d up th e a p p ro v a l o f pe rm its, lice nces a n d o th e r processes. These h a ve be en c a lle d fa c ilita tio n pa ym e n ts b u t c o u ld o th e rw is e be te rm e d b rib e s . W h ile c o u n trie s such as th e U n ite d States a n d th e U n ite d K in g d o m h a ve b a n n e d c o m p a n ie s h e a d q u a rte re d in th e ir c o u n trie s m a k in g fa c ilita tio n p a ym e n ts, o th e r c o u n trie s a re y e t to d o so. 1 2
W h a t is th e d iffe re n c e , if a n y , b e tw e e n a fa c ilita tio n p a y m e n t a n d a b rib e ? Discuss w h e th e r y o u w o u ld c o n s id e r th e fo llo w in g s itu a tio n s as b e in g a fa c ilita tio n p a y m e n t o r a b rib e ?
a
a c o m p a n y pa ys $ 1 0 0 to a lo c a l o ffic ia l to a rra n g e fo r fa st a p p ro v a l o f a v is a fo r th e o versea s m a n a g in g d ire c to r to v is it
b
a c o m p a n y p a ys $ 1 0 0 0 0 0 to a lo c a l o ffic ia l to s u p p o rt th e c o m p a n y 's te n d e r b id to p ro v id e services to the lo c a l g o v e rn m e n t
c
a c o m p a n y d o cu m e n ts a $ 1 0 0 0 0 0 p a y m e n t to a lo c a l o ffic ia l in th e m inutes o f th e b o a rd m e eting a n d it is a p p ro v e d b y th e b o a rd o f d ire c to rs
d
a c o m p a n y c la im s a ta x d e d u c tio n fo r th e $ 1 0 0 p a y m e n t to th e lo c a l o ffic ia l
e
th e m a n a g in g d ire c to r be lie ve s th a t a ll pa ym e n ts a re fa c ilita tio n pa ym e n ts be ca u se 'th a t is h o w business is d o n e here a n d e v e ry o n e else is d o in g it'.
C0URSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
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Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
NOTES 1 2 3
Section 7 .3 is a d a p te d w ith permission from L. Solom on, L. W a lte r, P. V argo & L. Plunkett, F in a n c ia l A c c o u n tin g , South-W estern C o lle g e Publishing, C incinnati, O h io , 1 9 9 6 . The m aterial for these steps w as provided b y Rosina M la d e n o v ic , as w e re some questions. A number o f the questions w ere provided b y Kevin C larke, G o rd o n H ow itt, C la u d ia G orm ly, C hris Poullaos, Rosina M la d e n o v ic and Peter Roebuck. Section 7 .5 is a d a p te d from the source listed in note 1.
Accounts receivable and further record-keeping ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: understand the principles o f recording sales transactions in accordance with accrual accounting understand the use of contra accounts for recording of doubtful debts p re p a re journal entries for m an aging accounts receivable including increasing the a llo w a n c e for doubtful debts a n d w riting off b a d debts dem onstrate the financial statem ent im pacts o f doubtful debts and b a d debts calculate trad e discounts for e a rly paym ent o f accounts receivable a n d p a y a b le a n d record a p p ro p ria te ly understand the role of special journals, subsidiary ledgers an d control accounts w ithin the accounting recording system be a b le to record transactions using special journals, subsidiary ledgers a n d control accounts.
CHAPTER OVERVIEW This c h a p te r c o ve rs k e y issues re la te d to sales reven ue s. This in c lu d e s a d e ta ile d d is c u s s io n o f h o w to a c c o u n t fo r sales m a d e w h e re th e cash has n o t y e t b e e n re c e iv e d (a c co u n ts re c e iv a b le ), a s w e ll a s h o w a c c o u n ta n ts a n tic ip a te th a t n o t a ll o f th e c re d it e x te n d e d to c u stom ers o f th e bu siness w ill b e re p a id in fu ll. W e c o n s id e r h o w a c c o u n ta n ts a n d m a n a g e rs d e a l w ith u n p a id c lie n t a c c o u n ts a n d th e d iffe rin g a p p ro a c h e s th a t c a n b e ta k e n . W e g o d e e p e r in to th e a c c o u n tin g re c o rd in g system w ith a d is c u s s io n o f th e use o f s p e c ia l jo u rn a ls , s u b s id ia ry le d g e rs a n d c o n tro l a c c o u n ts , w h ic h is re le v a n t fo r th ose students w is h in g to a c q u ire a d e ta ile d k n o w le d g e o f a c c o u n tin g re c o rd in g system s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
8.1
Receivables
Receivables are an asset that occurs w hen a service has been p rovided but cash w ill not be received until the fo llo w in g period. C om m on exam ples o f receivables include accounts receivable, interest receivable on loans, com missions earned an d unbilled revenues. For exam ple, let's consider the exam ple o f Telstra, a telecom m unications c o m p a n y that bills its customers m onthly o r quarterly. W h e n it bills customers, it increases accounts receivable and increases sales revenue. W h e n the cash is received, cash is increased an d accounts receivable is decreased. N o te that this later entry does not affect profit because the revenue w a s recognised at the point o f sale not w hen cash w a s received. The journal entries w o u ld be: A t tim e o f s a le :
$ DR
A c c o u n ts re c e iv a b le
CR
S a le s re v e n u e
$
10000 10000
W h e n c a s h is re c e iv e d : DR
C ash
CR
10000
A c c o u n ts re c e iv a b le
10 0 0 0
You w ill recall that accounts receivable is a current asset that w ill a p p e a r in the b a la n ce sheet, an d sales revenue is a revenue account that w ill a p p e a r in the incom e statement for the y e a r e nded 3 0 J u n e 2 0 1 6 . Let's consider another type o f unrecorded revenue that you s a w in C h a p te r 5 . For exam ple, assume a c o m p a n y deposited $ 3 0 0 0 0 0 w ith a bank for o ne ye a r at 1 0 per cent on 1 M a rc h 2 0 1 6 (interest p a y a b le at the end o f the period). A t 3 0 June 2 0 1 6 , they w o u ld have earned $ 1 0 0 0 0 interest, although the total interest o f $ 3 0 0 0 0 w o u ld not be received until 2 8 February 2 0 1 7 . A ccrued interest (also called interest receivable), w h ich is an asset, w o u ld be increased by $ 1 0 0 0 0 , an d interest revenue w o u ld be increased by $ 1 0 0 0 0 . Assets Accrued revenue
Liabilities
Equity Interest revenue
3 0 June
+10000
+10000
T o ta l
+10000
+10000
A ccrued revenue (or interest receivable) is a current asset that w ill a p p e a r in the b a la n ce sheet, a n d interest revenue is a revenue a ccount that w ill a p p e a r in the incom e statement for the y e a r e nded 3 0 June 2 0 1 6 . The journal entry w o u ld be:
1 3 0 Ju n e
$ DR CR
A c c ru e d re v e n u e In te re st re v e n u e
s1
10000 10000
Recall that w e discussed h o w Telstra bills it customers. FJowever, at 3 0 June there w ill be a lot o f telephone calls that have been m ade but not yet b illed. For exam ple, if you receive a bill on 1 June (and you are billed quarterly), you w ill not receive another bill until 1 Septem ber. As telephone calls have been m ade in June, Telstra has pro vid e d the service; therefore, it is entitled to recognise the revenue. Telstra's fin a n cia l statements (see Exhibit 8 .1 ) sh o w accrued revenue o f $1 1 5 5 m illion ($ 1 0 9 3 m illion in 2 01 3) under current assets. That is, at the end o f the year, it increased accrued revenue a nd increased sales revenue.
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317
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
W h a t e f fe c t w o u ld fa ilu re to m a k e a d ju s tm e n ts f o r a c c ru e d re v e n u e ha ve o n th e b a la n c e s h e e t and th e in c o m e s ta te m e n t?
2 A c o m p a n y has a $ 5 0 0 0 0 b a la n c e in th e c o m p a n y ’s a c c ru e d re v e n u e a c c o u n t. W h e re w o u ld th is a c c o u n t a p p e a r in th e b a la n c e s h e e t? Y o u r a n sw e rs s h o u ld be:
1
In c o m e s ta te m e n t: re v e n u e w o u ld be u n d e rs ta te d an d th e r e fo r e p r o fit u n d e rs ta te d . B a la n c e s h e e t: assets w o u ld be u n d e rs ta te d and re ta in e d p r o fits w o u ld be u n d e rs ta te d (b e c a u s e p r o fit w as u n d e rs ta te d ).
2 A s s e ts (p ro b a b ly c u r r e n t asse ts, a s s u m in g th a t th e a m o u n t w ill be re c e iv e d w ith in a y e a r).
8.2
Control accounts and contra accounts
Just a b o u t every b a la n ce sheet a ccount w ill be m ade up o f m any items. W e call them control accounts. Cash is a record o f the cash that should be there if it w e re counted. Accounts receivable is the sum o f all the individual customers' accounts. Inventory is the am ount that should be found if the c o m p a n y lists o r counts all the unsold g o ods physically on hand. Accounts p a y a b le is the sum o f all the individual suppliers' accounts. The num ber o f shares outstanding should be tra ce a b le to the share ca p ita l account. (The particular ow ners m ay ch a n g e, for exam ple, because o f trading on the stock market, but the c o m p a n y should a lw a ys kn o w h o w m any shares it has issued and w h a t it o rig in a lly received for them.) Even the property, plant a n d equipm ent asset accounts are control accounts, as all the assets w h o se costs a re included should be physically present. The value o f all these accounts as control accounts is that the am ounts in them should be supported by, or recon cila b le to, deta ile d lists or s u b s id ia y ledgers, o r some such b ackground d a ta . W h a t d o w e d o , then, w hen w e w a n t to make a ch a n g e in a b a la n ce sheet account w ith o u t c h a n g in g the underlying records a nd lists? In C h a p te r 5 w e introduced the idea o f a contra account to a llo w us to recognise expenses a n d related value changes to assets w ith o u t c h a n g in g the control account. The exam ple w e considered in C h a p te r 5 w a s accum ulated d e p re cia tio n , w h ich w a s deducted from the cost o f the asset to g ive the b o o k value o f the asset that is show n on the face o f the b a la n ce sheet. So here is another form o f contra account: •
W e have becom e w o rrie d that w e m ight not collect all the accounts receivable, so, for conservatism and proper profit measurement, w e w a n t to recognise that w e anticipate that there w ill be some 'b a d debts'. H ow ever, w e d o not w a n t to change the accounts receivable control account because it should correspond to the list of customers' accounts, an d w e have not yet given up on collecting a n y accounts receivable, so the control feature is still useful. Recall from C h a p te r 5 that contra accounts have balances that are in the op p o site d irection to those o f the control
accounts w ith w h ich they are associated. For exam ple, contra asset accounts have credit balances that are 'contra' the assets' d e b it balances. H ere w e w ill focus o nly on one o f the most com m on uses of contra accounts: a llo w in g for doubtful accounts receivable. H ere the asset, accounts receivable, w ill have a d e b it b a la n ce a nd the contra account, a llo w a n c e for doubtful debts, w ill have a credit balance.
8.3
Accounts receivable and contra accounts
Before considering the use of the contra account c a lle d allowance For doubtFul debts, w e w ill pro vid e a brief overvie w o f the asset to w h ich it relates, accounts receivable. M o s t accounts receivable are re co g n ise d but uncollected revenue, created by the accrual accounting e n ty : DR accounts receivable, CR sales revenue. Such receivables arise from the com pany's day-to-day business activities an d are therefore often ca lle d trade receivables. They are included in current assets because they a re usually expected to be collected w ith in one year.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
V aluation o f accounts receivable Receivables are valued on the b a la n ce sheet a t the lo w e r o f cost o r net realisable value. 'C ost' here is the orig in a l transaction value o f the sale that g a ve rise to the receivable, plus a n y subsequent interest charges. N e t realisable value is the am ount expected to be collected (the cash value o f the receivable, if you like). There is often collection uncertainty, and com panies often experience difficulties in collection, especially as tim e passes after the sale. So, if the co llectable am ount is n o w expected to be lo w e r than o rig in a lly a n ticip a te d , the receivable must be reduced to an estim ated co llecta b le am ount. The method for d o in g this involves subtracting an a llo w a n c e for doubtful accounts from the accounts receivable balance. The estim ated co lle cta b le am ount is gross accounts receivable minus the a llo w a n c e for doubtful debts. Therefore, the a llo w a n c e functions to adjust the net value d o w n to the lo w e r o f cost (original value) an d the current estim ated co llectable am ount. O n the b a la n ce sheet, accounts receivable are valued at this net am ount. Australian com panies show in the notes to the fin a n cia l statements the am ount o f the a llo w a n c e for doubtful debts deducted from gross accounts receivable. For exam ple, Telstra C o rp o ra tio n Limited, in its 2 0 1 4 b a la n ce sheet, shows receivables of $ 4 1 7 2 0 0 0 0 0 0 in the current assets section. This am ount is net accounts receivable a nd its breakup is show n in note 1 0 of the accounts as shown in Exhibit 8 .1 .
EXHIBIT 8.1
TELSTRA CORPORATION LIMITED NOTE 10: TR A D E AND O THER RECEIVABLES
Source: Telstra Corporation Limited, Annual Report 2014, notes to financial statements.
Trade receivables are show n a t their gross am ount ( $ 2 9 5 0 m illion), an d the a llo w a n c e for doubtful debts ($1 2 0 million) is deducted.
O ther receivables There are tw o other main kinds o f receivables. If these are large, they are show n separately, but if not, they are usually just lumped together under the hea d in g 'O th e r debtors'. The first kind is notes receivable. These are supported by a signed contract betw een buyer an d seller that specifies a paym ent schedule, an interest rate a n d , often, other legal details. Such notes are often used for large a n d /o r long-term receivables, such as sales o f m otor vehicles, houses o r a p p lia n ce s, an d loans by banks a nd finance com panies (long-term receivables w o u ld be properly classified as noncurrent rather than current assets). N otes are shown at present value (only interest that has built up so far is included in the asset, not future interest).
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319
The second kind is loans to em ployees, officers an d shareholders, loans to associated com panies, tax refunds the c o m p a n y is w a itin g for a n d other receivables not arising from revenue transactions. They a re accounted for and valued much as normal trade receivables a n d notes receivable are, but because some m ay arise from peculiar circumstances, com panies often disclose the reasons for them a nd explain other circumstances a b o u t them. They are often included under the heading 'O th e r debtors'.
Allow ance for d o u b tfu l debts This section discusses further the a llo w a n c e fo r doubtful debts. W h e n a c o m p a n y sells to a customer on account, there w ill a lw a ys be some risk that the customer w ill fail to pay. Therefore, a portion o f the sales on account w ill be doubtful, a n d that portion should be deducted from revenue in determ ining profit for the p e riod. This is c a lle d a bad debts expense. The transaction analysis for the creation of an a llo w a n c e for doubtful debts based on some estim ate o f the likely level o f doubtful debts is: T
Bad debts expense
T
A llo w a n c e for doubtful debts ( ito ta l assets).
N o te that the a llo w a n c e for doubtful debts is a contra asset account, w h ich means that w hen w e increase the a llo w a n c e w e a re actu a lly reducing total assets. Let's assume that the c o m p a n y determines - b y past experience or current e vidence o f customers' troubles - that a b o u t $ 5 0 0 o f sales on a ccount are not likely to be p a id . The journal entry to recognise the expense is: $ DR CR
Bad debts expense
$
500
Allowance for doubtful debts
500
The credit in this entry is a g a in to a contra asset account, just as it is for depreciation. (However, d o n 't forget that accumulated depreciation is in the noncurrent assets section o f the balance sheet, w h ile this one is generally in the current assets section.) The reason for not deducting the am ount directly from the accounts receivable asset is that even after the usual collection time has passed, the com pany m ay still try to collect on the accounts and, therefore, doesn't w a n t to alter the accounts receivable amount. The list of individual accounts should have the same total as that o f the accounts receivable account for control reasons, so the account should not be changed just because collection is doubtful. Eventually, after pursuing a non-paying customer for months, a c o m p a n y m ay d e c id e to w rite the account off. A nother journal entry is then needed. Suppose the a ccount in question equals $ 1 0 0 (it w a s on e o f the risky ones contem plated w hen the a llo w a n c e w a s created above), then the transaction effect w o u ld be to reduce the a llo w a n c e for doubtful debts an d reduce accounts receivable, both b y $ 1 0 0 . The journal entry is:
1 DR CR
$ Allowance for doubtful debts Accounts receivable
$
100 100
This entry elim inates the account from the books of the c o m p a n y com pletely, but yo u 'll notice that it does not affect expenses (and, therefore, profit); that effect w a s created w hen the a llo w a n c e a nd the expense w e re recognised earlier. N o te that this w rite -o ff is handled differently from the noncurrent asset write-offs described earlier. The reason is that the a llo w a n c e for doubtful debts is considered to a p p ly to the w h o le list of accounts receivable, in a g g re g ate . W e d o n 't necessarily kn o w w h ich specific accounts receivable w e re p rovided for. For exam ple, the $ 5 0 0 a llo w a n c e for doubtful debts w a s p ro b a b ly based on an a ve ra g e experience; for exam ple, 15 per cent o f accounts over 6 0 days o ld w ill not be collected. W e d o n 't need to kn o w w h ich accounts in o rd e r to make such an a llo w a n c e for the a g g re g a te risk being taken.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Bad d e b t write-offs can also th ro w the system out if they are large enough. For exam ple, in the a b o ve case, w h a t if a customer account for $ 8 0 0 had to be w ritten off? That's m ore than there is in the a llo w a n ce ! There are methods for adjusting the a llo w a n c e to take such problem s into account, but this b o o k w ill not include them beyond the next brief exam ple. It is possible to ope ra te a com pany's accounting system w ith o u t an a llo w a n c e for doubtful accounts. Bad debts can be w ritten o ff d irectly to accounts receivable using the so-called direct w rite -o ff method. This is used w hen a c o m p a n y has fe w accounts receivable o r w hen a large a ccount not contem plated in the a llo w a n c e account suddenly goes b a d . Suppose an a ccount totalling $ 1 5 0 0 is to be w ritten off directly. Then the entry w o u ld be:
This is equivalent to a llo w in g for it first, then w ritin g it o ff using the entries shown earlier:
As this exam ple shows, the a llo w a n c e can be seen as a tem porary holding account for am ounts the co m p a n y believes w ill not be collected, based on past experience an d an assessment of outstanding accounts. H ow ever, during the holding p e riod, an expense has been recognised a nd the asset value on the b a la n ce sheet has been reduced. Using an a llo w a n c e a ccount is usually preferable to direct w rite-off, not o nly because o f the internal control advantages the contra account provides, but also because the a llo w a n c e provides a w a y to have an expense before the c o m p a n y gives up on collection. Therefore, it is g e n e ra lly m ore conservative in its effects on the b a la n ce sheet and the incom e statement. H ere is a final exam ple o f the use a n d effect of an a llo w a n c e fo r doubtful debts contra account. •
Jellyroll Sweets Ltd sells chocolates to retail stores. A t the end o f 2 0 1 5 , it had accounts receivable o f $ 5 3 0 0 0 and an a llo w a n c e for doubtful debts o f $ 3 1 0 0 . Therefore, the estim ated c o lle cta b le am ount o f the accounts receivable w a s $ 4 9 9 0 0 at the end o f 2 0 1 5 .
•
During 2 0 1 6 , the c o m p a n y had credit sales o f $ 4 3 2 8 0 0 a nd collected $ 4 1 7 4 0 0 from customers. Therefore, at the end o f 2 0 1 6 , the accounts receivable stood a t $ 6 8 4 0 0 ($ 5 3 0 0 0 + $ 4 3 2 8 0 0 — $ 4 1 7 4 0 0 ) .
•
A t that point, the sales m anager w e n t through the list o f accounts receivable a n d determ ined that accounts totalling $ 1 2 0 0 w e re pretty much hopeless a nd should be w ritten off. Furthermore, an a g g re g a te a llo w a n c e account at the end o f 2 0 1 6 o f $ 4 2 0 0 w a s required. The am ount o f the a llo w a n c e w a s based on the percentage o f the debtors that had not p a id in the past. It also to o k into account the ageing of accounts receivable a nd the state o f the econom y. The effect o f the a b o v e is to w rite o ff b ad debts by decreasing the a llo w a n c e for doubtful debts an d decreasing
the accounts receivable, both by $1 2 0 0 . The doubtful debts are a llo w e d for by increasing the b ad debts expense account and increasing the a llo w a n c e fo r doubtful debts by $ 2 3 0 0 . The journal entries to accom plish w h a t is needed are show n b e lo w . $ DR CR
Allowance for doubtful debts Accounts receivable
$
1 200 1 200
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321
A llo w for doubtful ones:
The accounts receivable b a la n ce is n o w $ 6 7 2 0 0 ( $ 6 8 4 0 0 — $ 1 2 0 0 ) an d the contra b a la n ce is $ 4 2 0 0 . Therefore: •
The estim ated co lle cta b le value o f the accounts receivable (the net b a la n ce sheet value) is $ 6 3 0 0 0 at the end of 2016.
•
Bad debts expense for 2 0 1 6 is $ 2 3 0 0 .
•
The w rite-off of the hopeless debts ($1 2 0 0 ) cleared it out o f the list o f receivables, but d id not affect either profit or the net b a la n ce sheet value. The purposes o f contra accounts are, like most other things in a ccounting, to pro vid e useful inform ation to the
readers o f fin a n cia l statements a n d /o r to assist in accounting's internal control functions. Internal control w as discussed in C h a p te r 7 .
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: F lim sy ’s a c co u n ts receivable a t th e end o f 2 0 1 6 to ta lle d $ 7 8 4 9 0 . The allow ance fo r d o u b tfu l d e b ts had been $ 2 3 1 0 , b u t it was d e cid e d th a t th is w o u ld be increased by $ 1 5 6 0 , th e n $ 1 1 0 0 in hopeless a cco u n ts w ould be w ritte n o ff. W h a t is th e value o f th e receivables and th e allow ance fo r d o u b tfu l d e b ts in th e balance sheet as show n on th e balance s h e e t a t th e end o f 2 0 1 6 , and th e bad d e b ts expense fo r 2 0 1 6 ? Y o u r answers should be: .
R eceivables: $ 7 8 4 9 0 - $ 1 1 0 0 = $ 7 7 3 9 0
•
A llo w a n c e fo r d o u b tfu l d e b ts: $ 2 3 1 0 + $ 1 5 6 0 — $ 1 1 0 0 = $ 2 7 7 0
•
Bad d e b ts expense: $ 1 5 6 0 .
A geing o f accounts receivable1 W h e n determ ining an estim ate for uncollectible accounts, com panies can use tw o app ro a ch e s: the incom e statement a p p ro a ch an d the b a la n ce sheet a p p ro a ch . Irrespective o f the a p p ro a ch used, the journal entry is the same (however, the am ounts m ay - a nd often d o - differ). As their names suggest, the incom e statement a p p ro ach focuses on the incom e statement an d calculates the b a la n ce o f the Bad debts expense account, w h ile the bala nce sheet a p p ro a ch focuses on the B alance sheet an d calculates the b a la n ce o f the A llo w a n c e for doubtful debts account. The incom e statement a p p ro a ch relies on the historical relationship (or an estim ate o f the current relationship) betw een credit sales an d the am ount o f those sales unlikely to be collected. For exam ple, past experience m ight suggest that ba d debts are a b o u t 2 per cent o f net credit sales each year. This percentage is then m ultiplied by net credit sales to estim ate the b a d debts expense. The journal entries are illustrated in the fo llo w in g exam ple.
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The C F O o f A nna Limited tells you that her past experience suggests that 2 per cent o f credit sales becom e uncollectable. A nna's credit sales for this ye a r w e re $ 6 4 0 0 0 0 . Using the incom e statement a p p ro a ch , A nna Limited needs to record:
N o te that the incom e statement a p p ro a ch can easily overstate or understate the level o f b a d debts being recognised as econom ic a n d market conditions ch a n g e. For exam ple, an e co n o m ic dow nturn m ay mean that historic percentages o f credit sales not collected m ay be understated. G e n e ra lly speaking the b a la n ce sheet a p p ro a ch is m ore forw ard-loo kin g than the incom e statement a p p ro a ch . The b alance sheet a p p ro a ch is based on the belief that the o ld e r the account receivable, the greater the p ro b a b ility that the am ount w ill not be collected. This method calculates w h a t the b a la n ce o f A llo w a n c e for doubtful debts should be. D on't forget that the A llo w a n c e fo r doubtful debts is a b a la n ce sheet account an d w ill have an o p ening b alance that w ill need to be considered in the determ ination of the am ount o f the journal entry. The am ount o f the increase required to get the A llo w a n c e for doubtful debts to the desired am ount w ill be the Bad debts expense for the period. Let's look at an another exam ple. The C F O o f Elsa Limited has prepared a schedule based on her past experience indicating the fo llo w in g percentages o f accounts receivable that have been w ritten off as ba d . Age category
Percentage 1
Not yet due
i
1-30 days overdue
3
31 -60 days overdue
9
61-90 days overdue
16
Over 90 days overdue
25
The present b a la n ce of the A llo w a n c e for doubtful debts is $ 1 2 0 0 CR. As at 3 0 June, the a g e in g o f accounts receivable revealed the fo llo w in g : Not yet due
$73 000
1-30 days overdue
$12 000
31 -60 days overdue
$ 5 000
61-90 days overdue
$ 3 000
Over 90 days overdue
$ 1 300
To determ ine the required adjustm ent to the A llo w a n c e for doubtful debts, the C F O prepares a schedule as follow s:
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D on't forget that the A llo w a n c e for doubtful debts has an o p e n in g b a la n ce of $ 1 2 0 0 CR. As the calculated b a lan ce for the A llo w a n c e for doubtful debts is $ 2 3 4 5 , an a d d itio n a l $ 1 1 4 5 w ill need to be a d d e d to this account using the fo llo w in g journal entry:
1 DR CR
$ Bad debts expense
$
1 145
Allowance for doubtful debts
1 145
N o te that it is not uncom m on for the A llo w a n c e for doubtful debts to have a d e b it b a la n ce during the year; this can happen w hen m ore debts have been w ritten o ff than have been p rovided for. In the a b o ve exam ple, if the o p en in g b a la n ce o f the A llo w a n c e for doubtful debts had been $ 3 5 0 DR (instead of $1 2 0 0 CR), the a p p ro p ria te journal entry w o u ld have been: $ DR CR
8.4
Bad debts expense Allowance for doubtful debts
$
2 695 2 695
Illustrative example
Recall the Scanlon Limited com prehensive exam ple in section 5 .6 . During January 2 0 1 6 , some a d d itio n a l transactions occurred: 0 Follow ing an analysis of past experience, it w a s d e c id e d that a llo w a n c e for doubtful debts should be $ 4 3 6 8 0 p
Bad debts o f $ 8 0 0 0 w e re w ritten off. The fo llo w in g steps w ill be carried out:
1 2
Prepare journal entries for the a b o ve transactions (Exhibit 8 .2 ). Enter the o p e n in g balances in the relevant ledger accounts (Accounts Receivable an d A llo w a n c e for Doubtful Debts) an d post the journal entries to the ledger (Exhibit 8 .3 ).
3
Prepare a revised trial b a la n ce at 31 January 2 0 1 6 (Exhibit 8 .4 ).
4
Prepare a n e w set o f closing entries (Exhibit 8 .5 ).
5
Prepare a post-closing trial b a la n ce (Exhibit 8 .6 ).
6 Prepare an incom e statement for the month o f January 2 0 1 6 an d a revised b a la n ce sheet as at 31 January 2 0 1 6 (Exhibits 8 .7 a n d 8 .8 ).
EXHIBIT 8.2
SCANLON LIMITED JOURNAL ENTRIES
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 8.3
SCANLON LIMITED SELECTED LEDGER ACCOUNTS
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325
» Bad debts expense
43 680
Depreciation expense
10000
Insurance expense
30000
Rent expense
20000
Commission expense
600000
Other expenses
100000
8760680
EXHIBIT 8.6
8 760680
SCANLON LTD REVISED PO ST-C LO SING TR IA L BALANCE
»
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
» Allowance for doubtful debts
35 680
Accumulated depreciation
210000
Accounts payable
300000
Revenue received in advance
0
Income tax payable
0
Loan
570000
Share capital
420000
Retained profits
22 21320
3757000
EXHIBIT 8.7
3 757000
SCANLON LTD REVISED INCOM E S TA T E M E N T FOR TH E M O N TH ENDING 31 JAN U A R Y 2 0 1 6
EXHIBIT 8.8
SCANLON LTD REVISED BALANCE SHEET AS A T 31 JANUARY 2 0 1 6
»
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327
Noncurrent assets Equipment Accumulated depreciation
1 000000 210000
Total assets
790000 3511320
Liabilities Current liabilities Accounts payable
300000
Noncurrent liabilities Loan Total liabilities N et assets
570000 870000 26 41320
Shareholders' equity Share capital Retained profits*
420000 22 21320 26 41320
* Closing retained profits = 1 901 320 + 320000 = 2221 320
Before preparing the fin a n cia l statements, the revenue a nd expense accounts are closed via the closing journal entries (Exhibit 8 .5 ). They start w ith a ze ro b a la n ce in the next accounting p eriod to e n a b le profit fo r that p eriod to be calculated. A fter posting these journal entries, a post-closing trial b a la n ce is p repared (Exhibit 8 .6 ). The incom e statement and the b a la n ce sheet are p rovided in Exhibits 8 .7 an d 8 .8 .
8.5
Trade discount and cash discount
Before w e move on to the recording process using special journals an d subsidiary ledgers, it is d e sira b le to distinguish betw een tw o forms o f discount that m ay relate to both accounts receivable an d accounts p a ya b le : trade discount a nd cash discount. Each represents a reduction in the am ount that a customer ultim ately pays a ve n d o r for g o o d s o r services supplied. H ow ever, the tw o types d iffe r in purpose an d in the w a y they are custom arily recorded in accounting systems.
Trade discount Trade discount, w h e re c o m p a tib le w ith trade practices legislation, is a means o f adjusting the actual price ch a rg e d to a customer from a standard 'list p rice'. Usually, the am ount o f reduction depends on the c a te g o ry o f customer o r their normal volum e o f business. For exam ple, a manufacturer m ay sell at list price to the general public, but a llo w a discount of 4 0 per cent o ff list price to retailers a n d a discount o f 5 5 per cent to w holesalers. A lthough the am ount of such discount is o cca sio n a lly recorded in the books o f account, most enterprises, w hether receiving o r g ivin g the discount, record o nly the net am ount o f the transaction. This is because the effect o f a trade discount is merely to set an actual price for the transaction.
Cash discount A cash discount, in contrast, is a co n d itio n a l adjustm ent after determ ining the actual selling price a t w h ich the transaction takes place. It is an incentive for prom pt settlement o f debts a nd is a llo w e d o n ly if there is c o m p lia n ce w ith paym ent terms. It is not, therefore, a ch a n g e in the price o f the o rig in a l sales transaction, a nd is g e n e ra lly recorded as an a d d itio n a l transaction.
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A com m on arrangem ent is to extend credit terms such as 2 . 5 / 1 0 , n / 3 0 . This means that a discount of 2 .5 per cent m ay be deducted from the am ount due if paym ent is m ade w ithin 1 0 days; otherw ise, the net am ount (with no early paym ent discount but after adjusting for a n y trade discount) is p a y a b le w ithin 3 0 days. Thus, if sales totalling $ 4 0 0 w e re m ade to a particular customer during A pril on the a b o v e terms, $ 1 0 could be deducted from the paym ent if settlement w a s m ade in the discount p e riod. In the first instance, the gross selling price is recorded b y both parties. If discount is a llo w e d , it is com m only recorded as a discount a llo w e d expense for the seller an d as a discount received revenue b y the purchaser. W e w ill dem onstrate the recording o f these transactions in the cash receipts and cash payments journals, respectively, in the next section.
8.6 Detailed recording using special journals, subsidiary ledgers and control accounts2 This section is most relevant to students w h o require a m ore deta ile d kn o w le d g e o f recording systems. Before g o in g on, let's remind ourselves o f the accounting cycle, as summarised in Figure 8 .1 . U p until this point, w e have assumed that the e conom ic events captured in the accounting system a re initially recorded in a general journal, then summarised through posting to the general ledger. Such a system is fine for a business w ith a small set of transactions. H ow ever, if you think b a ck on the sorts of transactions you have a lre a d y recorded (and im a g ine a more com plex business), you w ill have noticed that m any o f the transactions have com m on elements; for exam ple, many transactions involve cash collections or payments. G iven this feature, special systems can be put in p la ce that a llo w a m ore efficient recording process for com m on transactions. These systems support an d feed into the recording, classifying and sum marising processes shown in Figure 8 .1 .
FIGURE 8.1
The accounting cycle
Rather than all the accounting inform ation being captured in one journal a nd posted to on e ledger, a system o f special journals an d subsidiary ledgers can be used to stream line the recording, storage an d categorisation of d a ta . S pecial journals are designed to a llo w the easy recording of the most com m on transactions undertaken by a business, w h ile subsidiary ledgers represent a deta ile d analysis o f the inform ation that is eventually transferred to a general ledger account. In w h a t follo w s, special journals a nd subsidiary ledgers are described in a m anual fram ew ork to help you understand the relational nature o f the databases used in a m ore sophisticated accounting system. S im ilar 'structures' and processes a re used in com puterised systems. W h ile
m any com puterised accounting systems d o not
require the use o f special journals, the journals can be produced by the system to pro vid e summaries o f transactions, if required.
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Sales journal
Let's briefly look a t one exam ple o f h o w a com m on transaction for some businesses - credit sales - can be recorded in a system that uses special journals a nd subsidiary ledgers. Figure 8 .2 shows the receipt o f an ord e r from a customer w h o is a llo w e d to buy from a business on credit. W h e n the customer receives the product o r service, a sales invoice is issued to the customer show ing the product o r service he o r she has bought, the am ount o w e d and w hen it needs to be p a id by. The sales invoice becom es the source docum ent that is used to record inform ation in the accounting system. In this case, the business transaction is recorded in a special journal called a sales journal, because it is used to record all inform ation a b o u t credit sales. A t the same time, the customer's account is upd a te d in the subsidiary ledger to sh o w that he or she ow es m oney to the business. P eriodically, inform ation from the business's journals (including the sales journal) is transferred to the general ledger. This inform ation is a summary o f the more d e ta ile d records contained in the special journals a nd subsidiary ledgers. O n ly a summary o f all the inform ation needs to a p p e a r in the main accounting system if there a re subsystems that contain m ore deta ile d records. In Figure 8 .2 , a general ledger account c a lle d accounts receivable (also known as debtors) is supported by some form of deta ile d record sh o w in g h o w much each d e b to r ow es the c o m p a n y an d w hen he or she is expected to pay. This is the inform ation contained in the subsidiary ledger. It is not much use kn o w in g that you a re o w e d $ 9 0 0 0 0 0 from debtors in total w ith o u t know ing exactly w h o ow es you w h a t am ounts a nd w hen you expect them to be received! For exam ple, the $ 9 0 0 0 0 0 in the general ledger m ay be m ade up o f the fo llo w in g three accounts in the subsidiary debtors' ledger: M . A ndrew s, $ 1 0 0 0 0 0 ; T. Blake, $ 3 0 0 0 0 0 ; an d A . C ra w fo rd , $ 5 0 0 0 0 0 . W h e n e v e r o ne o f these customers buys from the business on credit, that transaction is recorded in the sales journal an d the inform ation is used to u p date the subsidiary ledger. Refer to the inform ation flo w d iagram s at Figures 8.1 an d 8 .2 as you learn m ore a b o u t special journals and subsidiary ledgers.
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8.7
Prime entry records: special journals
The most com m on transactions undertaken by a business can be recorded in special journals. T ypically, special journals are established to record the fo llo w in g transactions: Special journal
Transactions recorded
Sales journal
Credit sales of inventory
Purchases journal
Credit purchases of inventory
Cash receipts journal
All cash inflows (including cash sales)
Cash payments journal
All cash outflows (including cash purchases)
•
In a special journal, each entry represents a transaction that belongs to the same class as others in the same journal. These special journals are used in a d d itio n to a general journal. Transactions that a re not recorded in a special journal a re recorded in a general journal (e.g. d e p re cia tio n , adjustments for prepaym ents an d other accruals). A pa rt from recording efficiency, other advantages o f special journals are: •
Amounts can be posted from special journals to the general ledger as totals rather than as individual journal entries.
•
M o re than o ne user can u p date the accounting system, because it consists o f a num ber o f related subsystems. For exam ple, the general ledger, the debtors' subsidiary ledger a nd the inventory subsidiary ledger could be updated by different individuals.
•
The com m on nature o f transactions elim inates the need for narrations.
•
Inform ation such as invoice or receipt num ber m ay be recorded in special columns p rovided for the purpose.
•
A dditional information can be recorded in a particular journal for convenience because it is a vailable from the source document evidencing the transaction. For example, discount expense is generally recorded in the cash receipts journal because it is obtained from the duplicate receipt (which also shows the net amount of cash received).
8.8
Subsidiary ledgers and control accounts
The most com m on w a y o f a cco m m o d a tin g the need for deta ile d records in the accounting system, w ith o u t grossly e x panding the num ber of separate accounts in the general ledger, is to use subsidiary ledgers an d control accounts. As a lre a d y m entioned, a subsidiary ledger is a set o f ledger accounts that collectively represents a d e ta ile d analysis o f one general ledger a ccount c la ss ifica tio n . The relevant ledger a ccount in the general ledger is know n as a control account. The accu ra cy o f the d e ta ile d accounts in the subsidiary ledger can be p e rio d ica lly checked aga in st the a g g re g a te data an d b a la n ce contained in the control account. S ubsidiary ledgers d o not form part o f the general ledger. They are separate ledgers that sh o w m ore detail a b o u t a general ledger account (such as debtors). Examples o f general ledger accounts that have subsidiary ledgers are: •
d e b to rs /a c co u n ts receivable: a separate a ccount for each d e b to r
•
c re d ito rs/a cc o u n ts p a y a b le : a separate a ccount for each creditor
•
property, p la n t a n d equipm ent: separate records o f each piece o f property, plant a nd equipm ent - it is often called an asset register
•
ra w materials inventory: separate records o f each type o f ra w m aterial held
•
finished g o o d s inventory: separate records o f each type o f finished g o o d held. In each o f these exam ples, the same p rin ciple ap p lie s. Every entry m ade to an a ccount in the subsidiary ledger is
contained w ithin an a g g re g a te am ount in a general ledger control account. It follow s that the total o f all d e b it entries m ade to individual accounts in the subsidiary ledger must be equal to the debits m ade to the control account. Sim ilarly, all credit entries m ade w ill be the same, in a g g re g a te , betw een the subsidiary ledger a nd the control account. From this it follow s that, at a n y time, w hen all required entries have been m ade in both records, the total o f the b alance a p p e a rin g in the accounts in the subsidiary ledger should equal the b a la n ce a p p e a rin g in the control account in the general ledger. If these am ounts d o not a gree, it signals errors in one o r both records.
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A p a rt from p roviding a check on a ccuracy, subsidiary ledgers e n a b le a n y desired am ount o f detail to be m aintained to explain the com position o f a selected general ledger account, w ith o u t o ve rlo a d in g that ledger. In some cases, subsidiary ledger accounts can include statistical d a ta an d w ritten comments as w e ll as d o lla r values. For exam ple, the subsidiary ledger for equipm ent w ill include inform ation beyond o rig in a l cost a n d accum ulated d e p re cia tio n . It is likely to also include d a te o f purchase, location in the organisation (e.g. a t B urw ood factory), an identification num ber (which is also p la ce d on the equipm ent for internal control purposes) a n d , possibly, details of m aintenance, w a rra n ty a nd so on.
8.9 Operation of special journals and subsidiary ledgers To illustrate the o peration o f accounting systems using special journals a nd subsidiary ledgers, w e w ill exam ine their operation for the fo llo w in g transactions: •
credit sales
•
credit purchases
•
cash receipts
•
cash payments.
Credit sales Exhibit 8 .9 shows an extract from a sales journal in a business that uses the perpetual method to record inventory: EXHIBIT 8.9
SALES JOURNAL EXAMPLE
Sales journal Date 2 0 1 6
Invoice no.
July
Customer
Page S I Post ref.
COGS
Accounts receivable
5
0001
M. Andrews
50000
100000
5
0002
T. Blake
150 00 0
300000
20
0003
A. Crawford
250000
500000
450000
900000
(104/400)
(102/350)
H a d each o f the credit sales been recorded in a general journal, each w o u ld have a p p e a re d as:
The purpose o f special journals is to elim inate the need for such deta ile d recording in a general journal an d the general ledger. O n ly the total for a suitable period (typically a month in a m anual system) is posted to the general ledger. The general ledger acco u n t into w h ich the total is posted is ca lle d a control account because a g g re g ate am ounts a re posted to it. These totals are referenced in the general le d g e r a ccount to the source of the inform ation; in this case, the sales journal. If the sales journal in our exam ple represents all the credit sales for the p e riod, o n ly the total $ 9 0 0 0 0 0 w o u ld be d e b ite d to accounts receivable (account 10 2 ) an d credited to sales revenue (account 3 5 0 )
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
and $ 4 5 0 0 0 0 d e b ite d to C O G S (account 1 0 4 ) a nd credited to inventory (account 4 0 0 ). The amounts a re posted directly from the sales journal; there is no need to record the inform ation a g a in in a general journal. A subsidiary ledger a ccount m ight be established for each customer w h o buys on credit. The in dividual accounts in the debtors' ledger can be kept up to d a te b y posting each line o f the sales journal to the a p p ro p ria te a ccount in the subsidiary ledger. For exam ple, the first entry in the sales journal show n e arlier is recorded in the subsidiary ledger as a d e b it to the account o f M . A ndrew s, the second to T. Blake an d the third to A . C ra w fo rd . Part o f this process is illustrated at Exhibit 8 .1 0 : note that the accounts for Blake an d C ra w fo rd are not show n, but w o u ld be updated in a sim ilar manner. The use o f the posting reference S I in the ledger accounts indicates that the inform ation in these accounts comes from p a g e S I o f the sales journal. The tick in the posting reference column o f the sales journal indicates that the am ount has been posted to the subsidiary ledger.
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333
A t the end o f the p e riod, the total o f the subsidiary ledgers can be checked aga in st the b a la n ce o f the accounts receivable control account. That is, if w e a d d up the b a la n ce in the accounts for A ndrew s, Blake a nd C ra w fo rd , it should a g re e w ith the b a la n ce o f the accounts receivable control account.
C redit purchases In its simplest form, the purchases journal is o nly used for recording the acquisition o f g o o d s, on credit, that are intended for resale. The relevant source docum ent is the purchase invoice from the supplier, w h ich is m atched against the d e liv e r/ docket an d a c o p y o f the o fficia l purchase o rd e r to ensure that the g o o d s have been delivered in a satisfactory condition a n d that the a g re e d price has been ch a rg e d . Assume that the fo llo w in g credit purchases o f furniture for resale w e re m ade during July 2 0 1 6 :
The purchases journal is illustrated in Exhibit 8 . 1 1 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
In this case, note that P. Renton an d J. Q u in c y expect paym ent w ith in 3 0 days (their paym ent terms a re n / 3 0 and no discount is a v a ila b le for e a rly payment). R. Lemon a llo w s a discount o f 2 per cent if paym ent is received w ithin 1 0 days; otherw ise, the net am ount is expected w ithin 3 0 days of purchase. Because w e 're not certain that paym ent w ill be m ade w ithin the discount p e riod, the full am ount o w in g is recorded in the journal, not 9 8 per cent o f $ 3 5 0 0 . If w e d o qu a lify for the discount, our o b lig a tio n of $ 3 5 0 0 is satisfied a nd the discount received ($ 7 0 ) adjusts the am ount o f cash eventually p a id to R. Lemon ($ 3 4 3 0 ). As w ith the sales journal, subsidiary ledgers are updated each d a y for each cre d ito r a nd for each item of inventory. In Exhibit 8 . 1 1 , o n ly the acco u n t o f P. Renton is show n; a sim ilar process w o u ld be fo llo w e d to update the accounts o f J. Q u in c y a n d R. Lemon in the subsidiary ledger. The inventory subsidiary ledger is not shown. A t the end of the p e riod, the inventory control a ccount in the general ledger is d e b ite d w ith the total o f $ 5 2 2 0 and the creditors account is co rre sp on d in gly credited. A lternative treatments for the recording o f inventories are discussed in C h a p te r 9. C re d it transactions involving the acquisition of fixed assets o r items to be ch a rg e d to expense accounts, such as repairs, m aintenance, printing an d stationery, are often recorded in a general journal. H ow ever, the a b o ve purchases journal can easily be e xp a n de d to include columns for other items, if they occur frequently.
Cash receipts The source docum ent p ro vid in g e vidence o f a cash receipt is usually a d u p lica te o f the receipt given to a customer to a c kn o w le d g e paym ent. Alternatively, a list o f cheques received o r a direct dep o sit recorded on a bank account statement can serve as the source docum ent. A cash receipts journal is designed to meet the specific needs o f an enterprise, so analysis columns are created for the types o f cash in flo w that occur most frequently. In most businesses, these a re likely to include payments received from debtors a n d , possibly, cash sales. In a d d itio n to specific analysis columns, there is also a need for a sundry or m iscellaneous column for cash receipts not otherw ise identified by a specific column that represents a particular general ledger account. Examples o f sundry cash receipts include proceeds from the sale o f fixed assets, refunds by creditors an d n ew c a p ita l o r m o rtgage fu nding. If a cash discount is a llo w e d to debtors, a discount expense colum n is typ ica lly included in the cash receipts journal. Exhibit 8 . 1 2 illustrates the process o f recording an d posting inform ation a b o u t cash receipts. In contrast to the sales and purchases journals, separate columns a re used to represent the d e b it a nd credit sides o f transactions. The 3 July entry represents a cash sale. In this case, the d e b it an d credit amounts are equal. The next tw o entries represent the receipt of am ounts o w in g from customers. These amounts w e re previously recorded in the sales journal. Assuming that w e offer discount terms o f 2 / 1 0 , n / 3 0 , A . C ra w fo rd qualifies for a discount an d o n ly pays $ 4 9 0 0 0 0 o f the $ 5 0 0 0 0 0 o w in g . The b a la n ce is a fin a n cia l expense o f the business known as discount a llo w e d . N o sundry accounts w e re affected by cash receipts during the p e riod. If they had been, each item w o u ld be individually posted to the relevant general le d g e r account. The column total c a n 't be posted because the am ount represents the im pact o f transactions on a num ber o f general ledger accounts. In a d d itio n to the postings to the general ledger, each item a p p e a rin g in the debtors column is posted as a credit to the account o f the particular d e b to r in the debtors' subsidiary ledger. N o te that the a ccount for A . C ra w fo rd is not shown in the subsidiary ledger.
Cash paym ents The source docum ent for cash payments is usually a d u p lica te o f a cheque o r a cheque butt. There is usually supporting evidence such as statements a nd invoices from creditors, a receipt issued b y the recipient o r a payroll analysis certified as correct by a responsible staff mem ber. The bank statement provides e vidence o f the am ount of interest c h arged on a n y overdraft, together w ith inform ation a b o u t other bank charges an d fees. In its simplest form, the cash payments journal com prises o ne column w h ich lists the am ounts o f the cheques d ra w n by the business aga in st its b a n k account. H ow ever, to minimise postings a nd to pro vid e an analysis of payments, separate columns m ay be p rovided to record entries affecting those ledger accounts frequently involved. A sundry or miscellaneous colum n is necessary for those am ounts w h ich are to be posted to accounts for w h ich there is no specific analysis colum n.
CHAPTER 8 Accounts receivable and Further record-keeping
335
In the cash payments journal illustrated in Exhibit 8.1 3 , the am ount o f each paym ent is recorded in the cash at bank colum n a nd then entered, a cco rd in g to the nature o f the paym ent, either in o ne o f the analysis columns or d iv id e d over m ore than one colum n. For payments to creditors, the am ount p a id is entered into the b a n k column and a n y discount received is entered in the discount received colum n. The total o f these tw o am ounts is then entered in the creditors (accounts payable) colum n: this is the total am ount by w h ich accounts p a y a b le has decreased. The
336
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
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337
individual names o f creditors are also included so the entry can be used to u p date the creditors' subsidiary ledger. Thus, w hen the journal is totalled at the end o f each period, the a g g re g a te o f the b a n k a nd discount revenue columns should equal the sum of the totals o f all the analysis columns, including the sundry colum n. This reflects the d o u ble entry analysis o f cash paym ents, w h ich , in all cases, involves a credit to bank o r discount revenue a nd a corresponding d e b it to some other account. In this case, postings to the general ledger occur as follow s: 1
D ebit each account for w h ich there is a specific analysis column w ith the total o f that colum n.
2
D ebit each a ccount for w h ich there is an individual entry in the sundry column w ith the am ount o f that entry. Do not post the total o f the sundry colum n.
3 C re d it bank w ith the total o f the bank colum n. 4
C re d it the discount received account for the am ount o f the discount received. It should be noted that it makes no difference in the double-entry system w hether bank is an asset or a lia b ility
(because it is in overdraft). In either case, a cash paym ent is a credit because it either reduces the ba n k asset or increases the bank overdraft liability. In general, it is d e sira b le in all books of prim e entry (journals) to p ro vid e a reference to the source docum ent for each entry. In the cash payments journal, this is usually do n e by recording the cheque num ber associated w ith each paym ent. This also facilitates preparation o f bank reconciliation statements (covered in C h a p te r 7). In a d d itio n to the postings to the general ledger m ade at the end o f the p e riod, each individual item in the creditors column w ill be posted as a d e b it to the relevant individual creditor's a ccount in the creditors' ledger.
8.10
Role of general journal and general ledger
M o s t of an o rg anisation's transactions a re recorded in special journals. There is, how ever, still a role for a general journal. A general journal is used to record a num ber o f im portant transactions, such as: •
sales an d purchase returns
•
credit transactions other than those related to inventory, such as the purchase o f equipm ent
•
adjusting entries
•
closing entries. As w e have a lre a d y seen, each entry in a general journal is in d ivid u a lly posted to the a p p ro p ria te a ccount in the
general ledger. A t the end o f a p e riod, all fin a n cia l inform ation w ill be posted to the general ledger, either as an individual entry sourced from a general journal (or from a sundry column in a special journal) o r in a g g re g a te form from the columns o f the various special journals. O n c e all the fin a n cia l inform ation has been posted to the general ledger, the reporting process represented in Figure 8.1 can begin an d the accounting cycle can start a g a in .
338
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A E stim ation o f allow ance fo r d o u b tfu l debts The C F O o f O la f Lim ited has p re p a re d a sch e d u le b a se d on he r p a st e x p e rie n c e in d ic a tin g th e fo llo w in g p e rce n ta g e s o f a c co u n ts re c e iv a b le th a t h a ve been w ritte n o ff as b a d . Age category
Percentage 1
Not yet due
i
1-3 0 days overdue
3
31 - 6 0 days overdue
10
61 -9 0 days overdue
25
Over 90 days overdue
50
The pre se nt b a la n c e o f th e A llo w a n c e fo r d o u b tfu l d e b ts is $ 1 0 0 0 CR. A s as 3 0 June, th e a g e in g o f a cco u n ts re c e iv a b le re v e a le d th e fo llo w in g :
1
Not yet due
$95000
1-3 0 days overdue
$25000
31 - 6 0 days overdue
$1 1 000
61 - 9 0 days overdue
$ 4000
Over 90 days overdue
$ 2 000
P re p a re a s ch e d u le o f a g e in g o f a c co u n ts re c e iv a b le to d e te rm in e th e d e s ire d c lo s in g b a la n c e o f A llo w a n c e fo r d o u b tfu l de bts.
2
P re p a re th e jo u rn a l e n try to re c o rd th e c lo s in g b a la n c e o f A llo w a n c e fo r d o u b tfu l de bts.
PRACTICE PROBLEM B R econciliation o f su b sid ia ry ledgers w ith co n tro l accounts M . K in g Ltd, w h o le s a le r, m a in ta in s s u b s id ia ry le d g e rs fo r d e b to rs a n d c re d ito rs . The g e n e ra l le d g e r tria l b a la n c e a t 1 J a n u a ry 2 0 1 6 is as set o u t b e lo w . M . KING LTD TRIAL BALANCE AS AT 1 JANUARY 2 0 1 6 DR $
$
Share capital
CR $ 20000
Creditors: Adler Barnes
1 000 800
1 800
Mortgage loan Bank
1 0 0 00 2000
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339
Debtors: Xavier
400
Young
800
Zoeller
900
2 100
Inventory
4000
Premises
18 000
Fixtures and fittings
5 700 31 800
TRANSACTIONS FOR THE M O NTH OF JANUARY Sales journal
Purchases journal Sales
COGS
$
$
$
Young
300
100
Barnes
1 600
Zoeller
600
300
Barnes
5 000
Xavier
700
350
1 600
750
6600
CASH RECEIPTS JOURNAL Debtors
Sundry
Bank
$
$
$
3 000
3000
Rent Young
800
Zoeller
300
Dividends Xavier
800 300 4000
4000
7000
8 500
Sundry
Bank
400 1 500
400
CASH PAYMENTS JOURNAL Debtors $ Salaries expense Barnes
$ 700
400
400
800
Rent expense Adler
$ 700
800
600 1 400
600
1 too
2 500
1
Post fro m th e jo u rn a ls to th e g e n e ra l le d g e r a n d to th e d e b to rs a n d c re d ito rs s u b s id ia ry le dg ers.
2
P re p a re s u p p o rtin g sche du les o f d e b to rs a n d c re d ito rs a t 31 J a n u a ry 2 0 1 6 a n d a g re e w ith th e b a la n c e s in the c o n tro l a cco u n ts.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
KEY TERMS Ageing of accounts receivable Allowance For doubtful debts Bad debts expense Classification
Control accounts Direct write-off Net realisable value Notes receivable
Present value Trade discount Trade receivables Write-off
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This section starts with simpler discussion questions that revise some of the basic concepts, which are then followed by a set of problems. D IS C U S S IO N Q U E S T IO N S 1
P ro v id e e x a m p le s o f a c co u n ts th a t w o u ld be in c lu d e d u n d e r th e h e a d in g 'R e c e iv a b le s ' in th e b a la n c e sheet.
2
W h a t is th e d iffe re n c e b e tw e e n a c co u n ts re c e iv a b le a n d a c c ru e d revenue?
3
W h ic h o f th e fo llo w in g c o m p a n ie s is lik e ly to h a ve lo w a cco u n ts re c e iv a b le in c o m p a ris o n to to ta l sales: W o o lw o rth s , C o c a -C o la a n d Q B E Insurance?
4
W h a t is th e d iffe re n c e b e tw e e n a b a d d e b t a n d a d o u b tfu l d e b t?
5
W h y d o c o m p a n ie s h a ve an a llo w a n c e fo r d o u b tfu l de bts?
6 O u tlin e th e in co m e state m e nt a p p ro a c h to c a lc u la tin g th e b a d de bts e xpe nse. 7
O u tlin e th e b a la n c e sheet a p p ro a c h to c a lc u la tin g th e a llo w a n c e fo r d o u b tfu l de bts. W h a t is a n im p o rta n t step to re m e m b e r in this a p p ro a c h ?
8 W h a t pu rpo se s a re served b y s p e c ia l jo u rn a ls ? W h a t c o n tro l in fo rm a tio n c o u ld be m a d e m o re re a d ily a v a ila b le to m a n a g e m e n t as a result o f th e ir use?
9
W h a t c o n s id e ra tio n s d e te rm in e w h e th e r a s p e c ia l jo u rn a l sh o u ld be b ro u g h t in to use ra th e r th a n p la c in g entries in th e g e n e ra l jo u rn a l? Is th e ne ed fo r a g e n e ra l jo u rn a l e v e r e lim in a te d ?
10 O n w h a t sh o u ld y o u b a se y o u r sele ction o f th e s p e c ia l a n a lys is c olu m n s to be in c lu d e d in th e cash pa ym e n ts jo u rn a l? 11 W h y sh o u ld th e sale o f a fix e d asset no t be re c o rd e d in a s im p le sales jo u rn a l?
12 W h ic h s p e c ia l jo u rn a l h a n d le s th e fo llo w in g types o f tra n sa ctio n s? a cash sales b
c re d it sales
c
re c e ip ts fro m d e b to rs
d
pa ym e n ts to c re d ito rs
e
cash pu rch ases
f
c re d it pu rch ases
13 W h a t is th e p u rp o s e o f a s u b s id ia ry le d g e r? 14 W h a t a re th e a d v a n ta g e s o f a s u b s id ia ry le d g e r? 15 If a c u sto m e r's a c c o u n t in th e d e b to rs le d g e r show s a c re d it b a la n c e , d o e s th is ne ce ss a rily in d ic a te th a t an e rro r has be en m a de ?
16 Does th e d o u b le -e n try p rin c ip le o f a n e q u a l v a lu e o f d e b its a n d c re d its in th e system cease to a p p ly w h e n s u b s id ia ry le d g e rs a re b e in g e m p lo y e d ?
17 'S u b s id ia ry le d g e rs in v o lv e u n n e ce ssa ry d u p lic a tio n , in cre a s e th e o p p o rtu n ity fo r e rro r a n d in v o lv e a b re a c h o f th e d o u b le -e n try p rin c ip le . U n d e r n o c ircu m s ta n ce s c a n th e ir use be ju s tifie d .' C o m m e n t c ritic a lly .
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341
PROBLEMS PROBLEM 8.1 Revision o f revenues and expenses (in cluding bad debts) ADELAIDE LTD BALANCE SHEET AS AT 31 DECEMBER 2015 | Assets
$
Liabilities
Cash
168 000
Accounts payable
Accounts receivable (net of allowance of $12 000)
312000
Wages payable Unearned revenue
256000
Inventory
320000
Total Current liabilities
472 000
Prepaid rent expense
Total Current assets
88 000
Long-term debt
0
Total Liabilities
472 000
1 520000
Shareholders' equity
Equipment
3 200000
Share capital
Total Noncurrent assets
16 000
888000
Land
Less accumulated depreciation
200000
(640000) 4080000
Retained profits
Total Shareholders' equity
4240000 256000 4 4 9 6 000
Total Liabilities and Total Assets
4 968 000
Shareholders' equity
4968000
The fo llo w in g tra n s a c tio n s o c c u rre d d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 fo r A d e la id e Ltd: a Issued sh a re c a p ita l fo r $ 3 0 0 0 0 0 cash. b
E x p ira tio n o f p re p a id ren t e x p e n s e (i.e . p re p a id re n t e x p e n s e b a la n c e to z e ro ),
c
P urchased $ 7 0 0 0 0 o f in v e n to ry on c re d it,
d
P aid $ 5 6 0 0 0 to a c co u n ts p a y a b le .
e
S old in v e n to ry c o stin g $ 1 2 0 0 0 0 fo r $ 3 4 0 0 0 0 . A ll sales a re on c re d it,
f
C o lle c te d $ 1 0 6 0 0 0 fro m a c co u n ts re c e iv a b le .
g
D e p re c ia te d e q u ip m e n t fo r th e y e a r using th e s tra ig h t-lin e m e th o d (1 0 p e r c e n t p e r a n n u m ),
h
D iv id e n d s p a id to ta lle d $ 5 0 0 0 0 .
i
B o rro w e d $ 1 5 0 0 0 0 on 1 J a n u a ry 2 0 1 6 . The lo a n is d u e on 3 0 June 2 0 1 8 a n d c a rrie s a 1 0 p e r c e n t p e r
j
O n 1 A p ril p a id $ 3 0 0 0 0 fo r a n in su ra n c e p o lic y c o v e rin g 1 A p ril 2 0 1 6 to 31 M a rc h 2 0 1 7 .
k
P aid w a g e s o f $ 1 6 0 0 0 0 ; w a g e s o f $ 3 0 0 0 0 h a d be en e a rn e d b u t n o t p a id to th e first p a y p e rio d in 2 0 1 6 .
I
Is o w e d $ 9 5 0 0 in in tere st fro m th e b a n k a t y e a r-e n d .
m
W ro te o ff a b a d d e b t fo r S y d n e y Ltd fo r $ 3 0 0 0 as th e c o m p a n y w e n t in to b a n k ru p tc y . In cre a se d th e a llo w a n c e fo r d o u b tfu l d e b ts to $ 1 3 0 0 0 .
n
A t 31 D e c e m b e r 2 0 1 6 th e u n e a rn e d reven ue a c c o u n t b a la n c e h a d re d u c e d to $ 5 0 0 0 .
an n u m in tere st rate. P aid $ 1 3 0 0 0 in tere st on this lo a n d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
R e q u ire d : 1 List a ll revenues (in c lu d in g d o lla r am ounts) th a t w ill a p p e a r in th e in c o m e state m e nt fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . 2
List a ll expe nses (in c lu d in g d o lla r a m ou nts, ig n o rin g ta x a tio n ) th a t w ill a p p e a r in th e in c o m e state m e nt fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
List a ll c u rre n t assets a t 31 D e c e m b e r 2 0 1 6 (in c lu d in g d o lla r am ounts).
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 8.2 A d ju stm e n ts - acco u n tin g equation S w a n Ltd o p e ra te s th re e m otels in la rg e c o u n try centre s. The a cco u n ts fo r th e y e a r e n d e d 3 0 June 2 0 1 6 h a ve been fin a lis e d , w ith th e e x c e p tio n o f a n y ad ju stm e n ts th a t m a y result fro m th e fo llo w in g : a Bonuses d u e to th e m otel m a n a g e rs to ta llin g $1 2 0 0 0 h a ve no t y e t be en re c o rd e d .
b
O n 1 O c to b e r 2 0 1 5 , a c o m p re h e n s iv e in s u ra n c e p o lic y c o v e rin g b u ild in g a n d contents w a s ta ke n o u t fo r the y e a r e n d e d 3 0 S e p te m b e r 2 0 1 6 , th e a n n u a l p re m iu m o f $ 2 4 0 0 b e in g p a id on 1 N o v e m b e r 2 0 1 5 .
c
Interest on investm ents a m o u n tin g to $ 4 5 0 is d u e b u t has no t y e t been re c e ive d ,
d
A p a y m e n t o f $ 9 0 0 fo r e m b o ss e d s ta tio n e ry w a s c h a rg e d , in e rro r, to th e a d v e rtis in g a c co u n t,
e
The a c co u n ts re c e iv a b le b a la n c e is $ 1 7 1 5 0 0 . A llo w a n c e fo r d o u b tfu l d e b ts is $ 7 0 0 0 . B ad de bts o f $ 3 5 0 a re to be w ritte n o ff. A llo w a n c e fo r d o u b tfu l d e b ts is to be a d ju s te d to stan d a t 5 p e r c e n t o f a cco u n ts re c e iv a b le ,
f
A n a m o u n t o f $ 4 5 0 0 spen t on a la p to p c o m p u te r w a s c h a rg e d to th e o ffic e expe nses a c c o u n t in ste a d o f the o ffic e e q u ip m e n t a c co u n t.
g
In M a y , c o m m is sio n o f $ 3 6 0 w a s re c e ive d in a d v a n c e fo r th e s ix m onths e n d in g 31 O c to b e r 2 0 1 6 .
h
A t 3 0 June 2 0 1 6 , a c c ru e d e le c tric ity c h a rg e s w e re $ 9 2 .
R e q u ire d : 1 S h o w th e im p a c t o f e a ch tra n s a c tio n on th e a c c o u n tin g e q u a tio n . 2
P ro v id e jo u rn a l e n trie s.
PROBLEM 8.3 Im pact o f tra n sa ctio n s on fin a n cia l sta te m e n ts M a n a g e m e n t o f J ane Lim ited a re in tere ste d in th e d ire c tio n a l e ffe c t (i.e . in cre a s e , d e c re a s e o r no effect) on net p ro fit b e fo re ta x a n d to ta l assets fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , if th e fo llo w in g o c c u rre d fro m J a n u a ry to June 2 0 1 6 . 1 P ayin g b a c k a lo a n o f $ 2 0 0 0 0 0 . 2
P urcha sing in v e n to ry o f $ 1 0 0 0 0 0 on c re d it.
3
R eceivin g $ 1 0 0 0 0 fo r a jo b to b e d o n e in July.
4
M a k in g sales o f $ 2 0 0 0 0 0 on c re d it fo r g o o d s th a t cost $ 8 0 0 0 0 .
5 C h a n g in g th e d e p re c ia tio n p o lic y b y re d u c in g th e e s tim a te d life o f c e rta in e q u ip m e n t. 6
P re p a y in g in su ra n c e on 3 0 June 2 0 1 6 fo r $ 5 0 0 0 0 . The p o lic y co ve rs th e y e a r c o m m e n c in g J u ly 2 0 1 6 .
7
In cre a sin g th e a llo w a n c e fo r d o u b tfu l d e b ts b y $ 8 0 0 0 0 .
8
Interest reven ue is a c c ru e d a t 3 0 June, a n d is $ 5 0 0 0 .
9
A c c o u n ts re c e iv a b le to ta llin g $ 1 0 0 0 0 a re fo u n d to be u n c o lle c ta b le . The c u rre n t b a la n c e o f a llo w a n c e fo r d o u b tfu l de bts is $ 1 0 0 0 0 0 .
PROBLEM 8.4 C alculate bad d e b t expense and allow ance For d o u b tfu l debts W in d h o o k T e ch n o lo g ie s Ltd has be en h a v in g d iffic u lty c o lle c tin g its a c co u n ts re c e iv a b le . For th e y e a r 2 0 1 6 , the c o m p a n y in c re a s e d th e a llo w a n c e fo r d o u b tfu l a c co u n ts b y $ 4 3 0 0 0 , b rin g in g th e b a la n c e to $ 7 1 0 0 0 . A t th e en d o f 2 0 1 6 , a c co u n ts re c e iv a b le e q u a lle d $ 4 1 5 0 0 0 . W h e n th e y e a r-e n d a u d it w a s b e in g d o n e , it w a s d e c id e d to p ro v id e a fu rth e r $ 5 4 0 0 0 o f a c co u n ts re c e iv a b le th a t w e re d o u b tfu l, a n d w rite -o ff $ 3 6 0 0 0 o f a c co u n ts re c e iv a b le p re v io u s ly d e e m e d d o u b tfu l. C a lc u la te th e fo llo w in g : 1 b a d de bts e x p e n s e fo r 2 0 1 6
2 a llo w a n c e fo r d o u b tfu l d e b ts a t th e e n d o f 2 0 1 6 3
e s tim a te d c o lle c ta b le v a lu e o f a cco u n ts re c e iv a b le a t th e e n d o f 2 0 1 6 .
CHAPTER 8 Accounts receivable and Further record-keeping
343
PROBLEM 8.5 Q uestions a b o u t accounts receivable and d o u b tfu l accounts D ra g o n D esign s Ltd h a d th e fo llo w in g g e n e ra l le d g e r a cco u n ts fo r last y e a r, using th e T -accoun t fo rm a t. A ll the c o m p a n y 's sales a re o n c re d it to re ta il stores across th e c o u n try . The firs t a m o u n t in e a ch a c c o u n t is th e b a la n c e a t th e b e g in n in g o f th e y e a r; th e last a m o u n t, u n d e r th e so lid line, is th e b a la n c e a t th e e n d o f th e y e a r. O th e r am o u n ts a re tra n s a c tio n s a n d a d ju stm en ts d u rin g th e y e a r. Accounts receivable
Allowance for doubtful debts
244620 1 693 784
1 599 005 8293
Bad debts expense
11 9 1 4
0
9117
9117
12 7 3 8
9117
8293
331 106
1
W h a t w a s th e c o m p a n y 's re ven ue fo r th e y e a r?
2
H o w m uch w a s c o lle c te d on a c c o u n t o f re ven ue fo r th e y e a r
3
H o w m uch o f th e u n co lle cte d reven ue d id th e c o m p a n y g iv e up o n d u rin g th e y e a r?
4
W h a t w a s th e e x p e n s e th e c o m p a n y in c u rre d fro m ta k in g th e risk o f e x te n d in g c re d it to custom ers d u rin g th e y e a r?
5 W h a t w a s th e e s tim a te d c o lle c ta b le v a lu e o f th e a c co u n ts re c e iv a b le a t th e e n d o f th e y e a r? 6 W h a t w a s th e e s tim a te d c o lle c ta b le v a lu e o f th e a c co u n ts re c e iv a b le b e fo re th e y e a r-e n d w rite -o ff o f u n c o lle c ta b le acco un ts?
PROBLEM 8.6 D o u b tfu l debts OJ Ltd has be en h a v in g d iffic u lty c o lle c tin g its a c co u n ts re c e iv a b le . For th e y e a r 2 0 1 6 , th e c o m p a n y in c re a s e d the a llo w a n c e fo r d o u b tfu l a c co u n ts b y $ 4 8 0 0 0 , b rin g in g th e b a la n c e to $ 7 0 0 0 0 . A t th e e n d o f 2 0 1 6 , a cco u n ts re c e iv a b le e q u a lle d $ 4 2 5 0 0 0 . W h e n th e y e a r-e n d a u d it w a s b e in g d o n e , it w a s d e c id e d to p ro v id e fo r a n o th e r $ 5 0 0 0 0 o f a c co u n ts re c e iv a b le th a t w e re d o u b tfu l a n d w rite o ff $ 3 2 0 0 0 o f a c co u n ts re c e iv a b le p re v io u s ly d e e m e d d o u b tfu l. C a lc u la te th e fo llo w in g : 1
b a d debts e x p e n s e fo r 2 0 1 6
2 a llo w a n c e fo r d o u b tfu l de bts a t th e e n d o f 2 0 1 6 3
e s tim a te d c o lle c ta b le v a lu e o f a c co u n ts re c e iv a b le a t th e e n d o f 2 0 1 6 .
PROBLEM 8.7 D o u b tfu l debts O n 1 July 2 0 1 5 , M o rto n Lim ited h a d a cco u n ts re c e iv a b le o f $ 5 3 0 0 0 a n d a n a llo w a n c e fo r d o u b tfu l d e b ts o f $ 3 1 0 0 . D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , c re d it sales a m o u n te d to $ 4 3 2 5 0 0 a n d cash c o lle c te d fro m custom ers w a s $ 4 1 7 4 0 0 . A t th e e n d o f th e fin a n c ia l y e a r, th e c re d it m a n a g e r d e c id e d th a t a cco u n ts to ta llin g $ 1 2 0 0 sh o u ld be w ritte n o ff as b a d de bts a n d th e a llo w a n c e fo r d o u b tfu l de bts in cre a s e d to $ 4 2 0 0 . 1 W h a t w a s th e e s tim a te d c o lle c ta b le v a lu e o f a c co u n ts re c e iv a b le as a t 3 0 June 2 0 1 6?
2 W h a t w a s th e a m o u n t o f th e b a d de bts e x p e n s e fo r th e y e a r e n d e d 3 0 June 2 0 1 6 ? 3
W h a t a re th e m a in rea so ns fo r using th e a llo w a n c e m e th o d o f a c c o u n tin g fo r b a d d e b ts ra th e r th a n th e d ire c t w rite -o ff m e tho d?
344
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 8.8 A d ju s tin g entries and fin a n cia l sta te m e n ts The tria l b a la n c e s h o w n b e lo w has be en e x tra c te d fro m th e g e n e ra l le d g e r o f R. Jam es E le ctro nics Ltd a t 3 0 June 2 0 1 6 . The fo llo w in g fa cts c a m e to lig h t a fte r th e tria l b a la n c e w a s c o m p le te d : a In ve stig a tio n o f a c re d it b a la n c e in a d e b to r's a c c o u n t in th e s u b s id ia ry le d g e r s h o w e d th a t a c re d it sale o f g o o d s in M a y fo r $ 8 0 0 h a d no t be en re c o rd e d . b
The last d a y o f th e p e rio d , 3 0 June 2 0 1 6 , w a s a W e d n e s d a y . The s ta ff a re p a id o n F rid a y fo r a fiv e -d a y w o rk in g w e e k th a t en ds o n F rid a y . Sales s a la rie s a re $ 2 0 3 5 p e r w e e k a n d o ffic e s a la rie s a re $ 4 7 5 p e r w e e k .
c
E le ctricity expe nses o f $ 3 5 0 h a ve been in c u rre d , bu t no t b ille d a n d no t re c o g n is e d . T e le p h o n e expe nses o f $ 2 0 0 h a ve been in c u rre d (in re sp e ct o f calls) d u rin g June, b u t n o t re c o g n is e d .
d
Rent e x p e n s e in clu d e s a n a m o u n t o f $ 6 0 0 p re p a id fo r th e firs t tw o w e e k s o f July 2 0 1 6 .
e
D e p re c ia tio n o f $ 2 4 0 0 is to be c h a rg e d on o ffic e e q u ip m e n t a n d d e p re c ia tio n o f $ 2 8 0 5 is to be c h a rg e d on d e m o n s tra tio n e q u ip m e n t.
f
Interest on a lo a n is a t th e ra te o f 1 2 p e r c e n t p e r a n n u m , p a y a b le q u a rte rly in a d v a n c e o n th e last d a y o f e a ch q u a rte r. The lo a n w a s m a d e on 1 O c to b e r 2 0 1 5 .
g
B ad de bts o f $ 7 0 0 a re to be w ritte n o ff, a n d th e a llo w a n c e fo r d o u b tfu l de bts is to be 2 p e r c e n t o f d e b to rs .
D e b to rs A d v e rtis in g E le c tric ity O ffic e e q u ip m e n t P o s ta g e a n d te le p h o n e
Debit
Credit
$
$
407700 81 8 0 0 5 400 24000 9 300
In v e n to ry
145000
C o s t o f g o o d s s o ld
689900
Loans
160200
A llo w a n c e fo r d o u b tfu l d e b ts Rent
8 800 16 0 0 0
S a le s s a la rie s
105 800
O ffic e s a la rie s
24 800
S a le s
1 105 800
A c c u m u la te d d e p re c ia tio n : S a le s d e m o n s tra tio n e q u ip m e n t
3 300
O ffic e e q u ip m e n t
4 800
S a le s d e m o n s tra tio n e q u ip m e n t
22 000
S h a re c a p ita l
50000
R e ta in e d p ro fits
61 5 0 0
L o ng-te rm lo a n In te re st o n lo a n G e n e ra l o ffic e e x p e n s e s
160000 19 2 0 0 3 500 1554400
1
P re p a re g e n e ra l jo u rn a l en trie s fo r a n y p e rio d -e n d ad ju stm en ts fo r th e a b o v e item s.
2
P re p a re an in c o m e state m e nt fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
3
P re p a re a b a la n c e sheet as a t 3 0 June 2 0 1 6 , s u ita b ly c la s s ifie d .
1554400
CHAPTER 8 Accounts receivable and Further record-keeping
PROBLEM 8.9 C alculate accrual n e t p ro fit from various accounts Pottery G a lo re Ltd has just fin is h e d its 2 0 1 6 fin a n c ia l y e a r. From th e fo llo w in g d a ta , c a lc u la te net p ro fit.
s C o lle c tio n s fro m c r e d it cu s to m e rs d u rin g 2 0 1 6
174 320
A c c o u n ts re c e iv a b le , e n d o f 2 0 1 5
11 380
A c c o u n ts re c e iv a b le , e n d o f 2 0 1 6
9440
A llo w a n c e fo r d o u b tfu l d e b ts , e n d o f 2 0 1 5
890
A llo w a n c e fo r d o u b tfu l d e b ts , e n d o f 2 0 1 6
1 130
B a d d e b ts w ritte n o ff d u rin g 2 0 1 6
520
P a y m e n ts to s u p p lie rs a n d e m p lo y e e s d u rin g 2 0 1 6
165 690
A c c o u n ts a n d w a g e s p a y a b le , e n d o f 2 0 1 5
127 7 0
A c c o u n ts a n d w a g e s p a y a b le , e n d o f 2 0 1 6
155 1 0
In v e n to ry o f u n s o ld g o o d s , e n d o f 2 0 1 5
21 3 4 0
In v e n to ry o f u n s o ld g o o d s , e n d o f 2 0 1 6
24650
B a n k lo a n , e n d o f 2 0 1 6
12 0 0 0
T h e lo a n w a s ta k e n o u t a m o n th b e fo re th e e n d o f 2 0 1 6 a t a n in te re s t ra te o f 8 p e r c e n t. N o in te re s t h a s y e t b e e n p a id , b e fo re ta x , fo r 2 0 1 6 .
PROBLEM 8.10 D o u b tfu l debts P eakhurst Lim ited h a d th e fo llo w in g tria l b a la n c e a t 1 J a n u a ry 2 0 1 6 : Debit
Credit
$
$
C ash
200000
A c c o u n ts re c e iv a b le
600000
In v e n to ry
700000
P re p a id in s u ra n c e P re p a id re n t E q u ip m e n t
60000 50000 1000000
A llo w a n c e fo r d o u b tfu l d e b ts
20000
A c c u m u la te d d e p re c ia tio n
200000
A c c o u n ts p a y a b le
500000
R e v e n u e re c e iv e d in a d v a n c e
100000
In c o m e ta x p a y a b le
500000
Loan
570000
S h a re c a p ita l
400000
R e ta in e d p ro fits
320000 2610000
2610000
Y ou a re g iv e n th e fo llo w in g a d d itio n a l in fo rm a tio n fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 : a
B ad d e b ts o f $ 8 0 0 0 w e re w ritte n o ff.
b
It w a s d e c id e d th a t a llo w a n c e fo r d o u b tfu l d e b ts sh o u ld be 4 p e r c e n t o f a c co u n ts re c e iv a b le .
345
346
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
R e q u ire d : 1
P re p a re jo u rn a l en trie s fo r these tra n s a c tio n s .
2
S h o w th e le d g e r a c co u n ts fo r th e fo llo w in g fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 : a
a cco u n ts re c e iv a b le
b
a llo w a n c e fo r d o u b tfu l de bts
c
b a d de bts e x p e n s e
PROBLEM 8.11 Incom e s ta te m e n t approach S m a rkly Lim ited uses th e in c o m e state m e nt a p p ro a c h to a c c o u n t fo r b a d d e b ts a n d p ro v is io n fo r d o u b tfu l d e b ts . The fo llo w in g in fo rm a tio n is a v a ila b le : 1
Past e x p e rie n c e suggests th a t 1 p e r c e n t o f ne t c re d it sales w ill b e co m e u n c o lle c tib le .
2
C re d it sales fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , $ 3 2 0 0 0 0 0 .
3
C a s h sales fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , $ 7 0 0 0 0 0 .
4
B ad d e b ts w ritte n o ff d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , $ 1 7 0 0 0 .
5
Present b a la n c e o f p ro v is io n fo r d o u b tfu l d e b ts a c c o u n t, $ 2 1 0 0 0 .
P rep are th e ne ce ssary jo u rn a l e n try o r en trie s to a c c o u n t fo r b a d de bts fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . S h o w a ll w o rk in g s .
PROBLEM 8.12 Balance sheet approach S p rin ta y Lim ited uses th e b a la n c e sheet a p p ro a c h to a c c o u n t fo r its b a d de bts e x p e n s e a n d p ro v is io n fo r d o u b tfu l de bts. Past e x p e rie n c e in d ic a te s th e fo llo w in g p e rce n ta g e s o f a c co u n ts re c e iv a b le th a t h a ve be en w ritte n o ff as b a d . Age category
Percentage
Not yet due
1
1-30 days
3
31 -6 0 days
15
61 -9 0 days
35
Over 91 days overdue
60
A s a t 3 0 June 2 0 1 6 , th e a g e in g o f a c co u n ts re c e iv a b le re v e a le d th e fo llo w in g : Not yet due
$85000
1-30 days
$25000
31 -6 0 days
$ 9000
61 -9 0 days
$ 5 000
Over 91 days overdue
$ 2 000
A t pre se nt th e p ro v is io n fo r d o u b tfu l d e b ts le d g e r a c c o u n t is as fo llo w s : Dale
Details
1 July 2015
Opening balance
Debit
Credit
Balance
15 September 2015
Accounts receivable
1 800
2 300 CR
27 November 2015
Accounts receivable
900
1 400 CR
15 March 2016
Accounts receivable
1 200
200 CR
19 June 2016
Accounts receivable
500
300 DR
4100CR
P rep are th e ne ce ssary jo u rn a l e n try o r en trie s to re c o rd b a d de bts e x p e n s e fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . S h o w a ll w o rk in g s .
CHAPTER 8 Accounts receivable and Further record-keeping
347
PROBLEM 8.13 Com prehensive exam ple in clu d in g a m u lti-c o lu m n w orksheet Psyche Books Ltd is a b o o k s h o p s p e c ia lis in g in p s y c h o lo g y te xtb o o ks . Psyche B ooks has the fo llo w in g b a la n c e sheet as a t 3 0 S e p te m b e r 2 0 1 6 : Account name
Account no.
$
Assets Current assets Cash
1010
106000
Accounts receivable
1020
161 400
Inventory
1040
251 000
Prepaid insurance
1050
12 000
Prepaid rent
1060
45 000
Noncurrent assets Buildings
1100
1 400000
Accumulated depreciation - buildings
1105
(175 000)
Motor vehicle
1200
45 000
Accumulated depreciation - motor vehicle
1205
(9 000)
Total assets
1 225 000
36000 1 807600
Liabilities Current liabilities Accounts payable
2010
94000
Interest payable
2020
48 000
Income tax payable
2030
47000
Salaries payable
2040
25 000
Provision for employee entitlements
2050
14000
Accrued expenses
2060
12400
Noncurrent liabilities Bank loan
2100
900000 1 140400
Shareholders' equity Share capital
3010
400000
Retained earnings
3020
267200
Total liabilities and equity
1807600
A d d itio n a l In fo rm a tio n : 1
Psyche Books uses p e rp e tu a l in v e n to ry system s a n d a ll its te x tb o o k s a re sold a t a 3 0 p e r c e n t m a rk-u p.
2
B u ild in g s a re d e p re c ia te d a t 2 .5 p e r c e n t p .a .
3
M o to r v e h ic le has a useful life o f 1 0 y e a rs a n d is d e p re c ia te d usin g th e s tra ig h t-lin e m e tho d.
348
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Psyche B ooks uses th e fo llo w in g c h a rt o f a c co u n ts: Account name
Account no.
Account name
Account no.
Cash
1010
Share capital
3010
Accounts receivable
1020
Retained earnings
3020
Sales
4000
Inventory
1040
COGS
5010
Prepaid insurance
1050
Interest expense
5020
Prepaid rent
1060
Income tax expense
5030
Prepaid advertising
1070
Salaries expense
5040
Buildings
1100
Accumulated depreciation - buildings
1105
Sundry expenses
5060
Motor vehicle
1200
Accumulated depreciation - motor vehicle
1205
Advertising expense
5070
Accounts payable
2010
Insurance expense
5080
Interest payable
2020
Rent expense
5090
Income tax payable
2030
Bad debts expense
5100
Salaries payable
2040
Inventory devaluation expense
5110
Provision for employee entitlements
2050
Depreciation expense - buildings
5120
Accrued expenses
2060
Depreciation expense - motor vehicle
5130
Bank loan
2100
Profit and loss summary
6000
The fo llo w in g events to o k p la c e in O c to b e r 2 0 1 6 : 01 October
Paid salaries.
03 October
Paid accrued expenses in full.
06 October
Credit sales, $78 650.
07 October
Cash sales for the week amounted to $ 17 849.
08 October
Paid interest on bank loan, as well as $1 2 000 towards the principal.
1 1 October
Paid $2000 for an advertisement in a local newspaper. The advertisement is going to be published every Saturday for 8 weeks, starting on 13 October.
12 October
Received $109456 from debtors.
14 October
Cash sales for the week amounted to $9815.
15 October
Paid $86 250 to creditors.
16 October
Ordered $ 1 17 920 worth of inventory.
18 October
Credit sales, $104546.
21 October
Received the order placed on 16 October. Cash sales for the week amounted to $ 1534.
28 October
Paid income tax to ATO in full. Cash sales for the week amounted to $819.
29 October
Received $86 000 from debtors.
30 October
One of Psyche Books' employees decided to take his annual leave; he was paid $5500.
A t the e n d o f th e m o nth th e fo llo w in g events o c c u rre d : S om e o f th e stock o f Psyche Books w a s re c o rd e d a t $ 5 0 0 0 b u t w a s e s ta b lis h e d to h a ve a net re a lis a b le v a lu e of $200. Interest on b a n k lo a n a c c ru e d a t th e en d o f th e m onth is $ 4 6 0 0 0 . D e p re c ia tio n w a s c h a rg e d to th e b u ild in g s a n d m o to r v e h ic le a t th e e n d o f th e m onth. M o n th ly ren t fo r Psyche B o o ks' h e a d o ffic e w a s $ 5 0 0 0 a n d is p a y a b le on th e firs t o f e v e ry m onth in a d v a n c e .
CHAPTER 8 Accounts receivable and Further record-keeping
349
e
P re p a id in su ra n c e w a s o rig in a lly fo r tw o y e a rs , p u rc h a s e d o n 1 J a n u a ry 2 0 1 6 .
f
The c o m p a n y p o lic y is to k e e p a llo w a n c e fo r d o u b tfu l d e b ts a t th e e n d o f th e m o nth e q u a l to 3 p e r c e n t o f to ta l c re d it sales fo r th e m onth.
g
O w e d s a la rie s a t th e e n d o f th e m o nth , $ 2 2 5 0 0 .
h
E le ctricity c h a rg e s fo r th e m o nth a re e s tim a te d to b e $ 2 7 6 0 ; p h o n e c h a rg e s fo r th e m onth a re e s tim a te d to be $8900.
R e q u ire d : 1
P re p a re jo u rn a l en trie s fo r th e a b o v e tra n sa ctio n s.
2
E nter th e o p e n in g b a la n c e s in th e le d g e r a cco u n ts a n d p o st th e jo u rn a l en trie s to th e le d g e r.
3
P re p a re a 10 -c o lu m n w o rk sh e e t.
4
P re p a re a n d p o st th e a d ju s tin g en trie s. Enter these en trie s in to th e w o rk s h e e t.
5
P re p a re pre -clo sin g tria l b a la n c e a t 31 O c to b e r 2 0 1 6 .
6
P re p a re c lo s in g en trie s.
7
P re p a re post-clo sing tria l b a la n c e .
8
P re p a re an in co m e state m e nt fo r th e m o nth o f O c to b e r 2 0 1 6 a n d a b a la n c e sheet as a t 31 O c to b e r 2 0 1 6 .
PROBLEM 8.14 Preparation o f c o n tro l accounts S m ithers Ltd, a m a n u fa c tu re r, m a in ta in s s u b s id ia ry le d g e rs fo r c re d ito rs a n d d e b to rs . A t 3 0 June 2 0 1 6 , th e to ta l a m o u n t o w in g to th e business b y tra d e d e b to rs a m o u n te d to $ 4 8 5 0 a n d th e to ta l a m o u n t o w e d b y th e business to its s u p p lie rs a m o u n te d to $ 3 9 7 6 . The fo llo w in g is a s u m m a ry o f th e tra n s a c tio n s fo r th e m onth o f J u ly 2 0 1 6 .
I
sI Credit sales
8 626
Cash sales
2 374
Credit purchases
6945
Cash received from debtors
9 253
Cash paid to creditors
6575
Cash purchases
1 600
Promissory notes from customers
420
Discount received from creditors
56
Discount allowed to debtors
78
Creditors charged interest on overdue accounts
25
Freight paid and charged to debtors
22
P re p a re th e d e b to rs a n d c re d ito rs c o n tro l ac co u n ts, as th e y w o u ld a p p e a r in th e g e n e ra l le d g e r, a n d b rin g d o w n th e b a la n ce s as a t 31 July 2 0 1 6 . D is re g a rd a n y tra n s a c tio n s th a t d o n o t re la te to e ith e r o f these ac co u n ts.
PROBLEM 8.15 P reparation a cco u n tin g fo r cash and receivables H a rd y Ltd p ro v id e s c ru is e tours fo r seniors. H a rd y Ltd p ro v id e s these to urs to fo u r to u r p ro v id e rs : A Ltd, F Ltd, N Ltd a n d Y Ltd.
350
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The fo llo w in g w a s e x tra c te d fro m th e sche du le o f d e b to rs: 2015
2016
$
$
A Ltd
(a)
29432
Ltd
65 147
94564
N Ltd
(b)
47733
Ltd
29 924
(c)
F
Y
The fo llo w in g w a s e x tra c te d fro m th e sales jo u rn a l: Particulars
Invoice No.
A Ltd
0501
Accounts receivable $ 25 365
Ltd
0502
(d)
N Ltd
0503
15 000
F
N Ltd
0504
21 463
A Ltd
0505
51 156
N Ltd
0506
11 270
The fo llo w in g w a s e x tra c te d fro m th e cash receipts jo u rn a l: Particulars
Accounts receivable $
A Ltd
30000
Y
Ltd
9924
F
Ltd
15 677
N Ltd
24376
A Ltd
22 365
Ltd
23 742
A Ltd
19050
F
The fo llo w in g in fo rm a tio n is a ls o a v a ila b le (b e fo re a n y w rite -o ffs): 2015
Total cash receipts Accounts receivable control Total credit sales Allowance for doubtful debts Bad debts expense
2016
$
$
289563
350742
(e)
191729
251 764
(f)
7552
(g)
14372
(h)
N o fu rth e r sales w e re m a d e d u rin g th e y e a r to Y Ltd, a n d it w a s d e c id e d a t th e e n d o f th e y e a r th a t his re m a in in g a c c o u n t w o u ld be w ritte n o ff a g a in s t th e A llo w a n c e fo r d o u b tfu l d e b ts . The c lo s in g b a la n c e o f th e a llo w a n c e fo r d o u b tfu l d e b ts fo r 2 0 1 6 is 3 p e r c e n t o f to ta l c re d it sales fo r th e y e a r. 1 C a lc u la te th e m issin g fig u re s (a) th ro u g h (h). S h o w a ll w o rk in g s , a
A Ltd (o p e n in g ba la n ce )
b
N Ltd (o p e n in g ba la n ce )
c
Y Ltd (closing b a la n c e - b e fo re w rite -o ff)
CHAPTER 8 Accounts receivable and Further record-keeping
2
d
F Ltd (sales)
e
A c co u n ts re c e iv a b le c o n tro l (o p e n in g ba la n ce )
f
T o tal c re d it sales fo r 2 0 1 6
g
A llo w a n c e fo r d o u b tfu l de bts fo r 2 0 1 6 (clo s in g ba la n ce )
h
B ad de bts e x p e n s e fo r 2 0 1 6
351
U sing th e g e n e ra l jo u rn a l fo rm a t, c o m p le te th e fo llo w in g jo u rn a l en trie s (as a t th e e n d o f 2 0 1 6 ) : a
W rite -o ff th e re m a in in g b a la n c e o f Y Ltd's a c co u n t,
b
R ecognise th e b a d de bts e x p e n s e fo r th e y e a r.
PROBLEM 8.16 Specialised jo u rn a ls A d re n a lin e Ltd p ro v id e s tours fo r a d ve n tu re rs , such as m o u n ta in c lim b in g , b u n g e e ju m p in g , w h a le w a tc h in g a n d w h ite -w a te r ra ftin g . A d v e n tu re s-U n Ltd p ro v id e s these tours to fo u r to u r p ro v id e rs : A n n a , Fred, N a ta lie a n d Y u k i. A ll sales a re o n c re d it. The fo llo w in g w a s e x tra c te d fro m th e sche du le o f d e b to rs: 2015
2016
$
$
Anna Fred
(a)
32432
56 841
89577
(b)
48 830
28 674
(c)
Natalie Yuki The fo llo w in g w a s e x tra c te d fro m th e sales jo u rn a l: Particulars
Invoice no.
Accounts receivable
Anna
0501
Fred
0502
(d)
Natalie
0503
14 978
$ 26653
Natalie
0504
23 286
Anna
0505
53 561
Natalie
0506
10060
The fo llo w in g w a s e x tra c te d fro m th e cash receipts jo u rn a l: Particulars
Accounts receivable $
Anna
30220
Yuki
10249
Fred
14788
Natalie
25 763
Anna
23 356
Fred
24427
Anna
19016
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The fo llo w in g in fo rm a tio n is a ls o a v a ila b le (b e fo re a n y b a d d e b t w rite -o ffs):
Accounts receivable control Total credit sales
2015
2016
$
$
(e)
189264
266067
(f)
7982
(g)
14372
(h)
Allowance for doubtful debts Bad debts expense
N o fu rth e r sales w e re m a d e d u rin g th e y e a r to Y u k i, a n d it w a s d e c id e d a t th e e n d o f th e y e a r th a t his re m a in in g a c c o u n t w o u ld be w ritte n o ff a g a in s t th e a llo w a n c e fo r d o u b tfu l de bts. The c lo s in g b a la n c e o f th e a llo w a n c e fo r d o u b tfu l de bts fo r 2 0 1 5 is 3 p e r c e n t o f to ta l c re d it sales fo r the y e a r. 1
C a lc u la te th e m issin g fig u re s (a) th ro u g h (h). S h o w a ll w o rk in g s .
2
C o m p le te th e jo u rn a l en trie s re la te d to A llo w a n c e fo r d o u b tfu l d e b ts a c co u n t.
PROBLEM 8.17 Specialised jo u rn a ls and su b sid ia ry ledgers J u p ite r Ltd uses m ulti-co lum n cash re ce ip ts a n d cash pa ym e n ts jo u rn a ls , a n d m a in ta in s c o n tro l a c co u n ts fo r a c co u n ts re c e iv a b le a n d a c co u n ts p a y a b le , s u p p o rte d b y s u b s id ia ry le d g e rs. B alan ce s in th e s u b s id ia ry le d g e rs a t 1 June 2 0 1 6 w e re as fo llo w s : Accounts receivable
Accounts payable $
Milky Way
3 000
$ Venus
Mars
14000
Mercury
Constellation
10000
Sun
6 000 10000 6 000
During June 201 6, the following amounts were received and paid: June
2
Paid Venus $6000.
3
Milky Way paid an amount owing of $1 100, less $30 discount.
8
Cash sales, $500.
10
Paid an amount owing to Sun of $4000, less $40 discount.
15
Mars paid $7000 and was allowed $100 discount.
16
Purchased goods for cash, $3000.
29
Constellation paid $8000, less $200 discount.
30
Paid Mercury $5000, discount of $200 was lost.
W r ite up th e cash re ce ip ts jo u rn a l a n d th e cash pa ym e n ts jo u rn a l. Use s e p a ra te c o lu m n s fo r b a n k , d is c o u n t a llo w e d , a c co u n ts re c e iv a b le , cash sales, d is c o u n t re c e ive d , a c co u n ts p a y a b le a n d (cash) pu rch ases. Post fro m these jo u rn a ls to b o th th e g e n e ra l le d g e r a n d th e s u b s id ia ry le d g e rs a n d p re p a re sche du les o f a c co u n ts re c e iv a b le a n d a c co u n ts p a y a b le as a t 3 0 June 2 0 1 6 .
CHAPTER 8 Accounts receivable and Further record-keeping
353
PROBLEM 8.1 8 Preparation o f c o n tro l accounts P re p a re d e b to rs a n d c re d ito rs c o n tro l a c co u n ts fo r th e y e a r c o m m e n c in g 1 July 2 0 1 5 fro m th e fo llo w in g in fo rm a tio n : Balances a t 1 July 2 0 1 5 $ Debtors control
15425
Creditors control
9 870
Summary of transactions to 3 0 June 2016: $ Credit sales
101 700
Cash sales
3 540
Credit purchases
71 620
Cash purchases
3215
Cash paid to creditors
45 280
Discount allowed by suppliers
560
Discount given to debtors
725
Cash received from debtors
61 590
PROBLEM 8.19 S ubsidiary ledgers and co n tro l accounts Jam es S te w a rt o w n s a g e n e ra l store in a c o u n try to w n . H e keeps tw o s u b s id ia ry le d g e rs (an a c co u n ts re c e iv a b le le d g e r a n d an a c co u n ts p a y a b le le d g e r) a n d a g e n e ra l le d g e r. B alan ce s in th e s u b s id ia ry le d g e rs as a t 31 M a rc h 2 0 1 6 w e re as fo llo w s : Accounts receivable
Accounts payable $
$
Brown
900
Blue
580
Green
700
Red
1 500
White
460
2 080
2 060 Transactions for the month April 2 0 1 6 Sales journal Date
Particulars
$
Purchase journal Date
Particulars
April 7
Red
2 000 1 120
$
2016 April 2
White
1 240
13
Brown
2 400
16
Blue
16
Sage
1 160
20
Sage
200
20
Ruby
1 700
22
Grey
750
6500
4070
»
354
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Cash receipts journal Date
Particulars
2016 Apr
2
Sales
4
White
Page 35
Cash sales
Accounts receivable
Bank
Sales discount
$
$
$
$
560
560 460
7
Sales
10
Green
200
15
Brown
25
Ruby
450
350
10
350
910
196
4
900
875
25
700
682
18
2260
3113
57
Bank
Purchases discount
$
$
$
75
75
Cash payments journal Date
Particulars
2016 Apr
Accounts payable
Page 29 Sundries
$ 4
Purchases
10
Insurance
14
Red
250
20
Advertising
150
150
20
Wages
140
140
24
Blue
27
Rent
1 500
1 700
3 200
250 1 465
1 655 100
100
715
3 835
35
45
80
1
Post fro m th e jo u rn a ls to th e a cco u n ts re c e iv a b le a n d a cco u n ts p a y a b le c o n tro l a c co u n ts in th e g e n e ra l le d g e r, a n d to th e a cco u n ts re c e iv a b le a n d a c co u n ts p a y a b le le d g e rs.
2
P re p a re s u p p o rtin g sche du les o f a c co u n ts re c e iv a b le a n d a cco u n ts p a y a b le a t 3 0 A p r il 2 0 1 6 , a n d a g re e w ith th e b a la n c e s in th e c o n tro l ac co u n ts.
CASES CASE 8A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu estio ns re la te to the c o n s o lid a te d a cco u n ts. 1 H o w w e re tra d e d e b to rs v a lu e d in th e acco un ts? 2
D u rin g th e y e a r, h o w m uch w a s w ritte n o ff in b a d debts? H o w d id this c o m p a re w ith th e p re vio u s y e a r?
3
W h a t w o u ld th e jo u rn a l e n try h a ve been to re c o rd b a d debts?
CHAPTER 8 Accounts receivable and Further record-keeping
CASE 8B
355
Telstra Limited
The fo llo w in g is a n e x tra c t fro m T e lstra's 2 0 1 4 fin a n c ia l statem ents (N o te 1 0 (a )). Telstra Group As at 30 June 2014
Not past due
1
2013
Gross
Allowance
Gross
Allowance
$m
$m
$m
$m
2 297
(25)
2817
(13)
Past due 0-30 days
631
(12)
598
(32)
Past due 31 -6 0 days
135
(8)
176
(16)
Past due 61 -9 0 days
62
(12)
72
(16)
Past due 9 1 -1 2 0 days
49
(10)
49
(14)
Past 120 days
93
(53)
124
(89)
3 267
(120)
3 836
(180)
C a lc u la te th e p e rce n ta g e s used b y Telstra in 2 0 1 3 a n d 2 0 1 4 .
2 C o m m e n t on h o w th e p e rce n ta g e s h a ve c h a n g e d b e tw e e n 2 0 1 3 a n d 2 0 1 4 .
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m
p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TES 1 2
M a te ria l related to a g e in g o f accounts receivable w a s provided b y N o e l H arding. M a te ria l relating to expanded bookkeeping w as provided by A thol C arrington and G o rd o n H o w itt and rewritten b y M ich a e l Pennisi.
Inventory ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO explain the difference betw een perpetual a n d periodic inventory systems develop effective inventory controls analyse the effect of inventory transactions on the financial statements p re p a re journal entries for transactions under both the periodic a n d perpetual methods calculate the cost of inventory in acc o rd a n ce with accounting standards discuss the different types o f cost flo w assumptions calculate the im pact o f different cost flo w assumptions on profit determ ination an d inventory valuation a p p ly the low er o f cost a n d net realisable value rule to the m easurem ent of inventory interpret the inventory disclosure policies o f A ustralian com panies explain w h y inventory v aluation is im portant to m anagers.
CHAPTER OVERVIEW For m a n y c o m p a n ie s , in v e n to ry is o n e o f th e ir la rg e s t assets. In th is c h a p te r, w e c o n s id e r in v e n to ry c o n tro l a n d v a ri ou s a s p e cts o f in v e n to ry a c c o u n tin g . In v e n to ry a c c o u n tin g a ffe c ts b o th th e b a la n c e sheet (the v a lu e o f th e in v e n to ry asset) a n d th e e x p e n s e re c o g n is e d fo r th e use o f in v e n to ry (C ost o f g o o d s sold [C O G S ] e x p e n s e in th e in c o m e state m e nt).
358
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
9.1
Inventory control
C h a p te r 7 em phasised the im portance o f keeping accurate records to pro vid e inform ation fo r both internal and external users. M a n y o f the records that a re kept have to d o w ith the control o f inventory. Inventory control is an im portant issue for m anagem ent because a high percentage of w o rkin g c a p ita l m ay be tied up in inventory. Inventory m ay be perishable o r becom e obsolete if held too long, a n d , d ue to the physical attributes o f some types of inventory, there m ay be a g re a t potential for theft. Several different inventory control systems m ay be used, d e p e n d in g on the nature o f the inventory a n d the objectives o f m anagem ent. The methods e xp la in e d b e lo w are the tw o that a re most com m only used by business. Each provides a different am ount o f inform ation a t a different cost. It is im portant to note that the c h o ice o f inventory control system is a record-keeping ch o ice as o p p o sed to a reporting ch o ice : m anagem ent is sim ply d e c id in g h o w to record the inventory. H o w inventory is reported on the fin a n cia l statements is d e a lt w ith in later sections o f this chapter.
The perpetual inven to ry control m ethod To date, in the textbook w e have been using the perpetual inventory system as it is most com m only used in practice. W h e n inventory is purchased, an asset increases (inventory) a nd either an asset decreases (cash) o r a lia b ility increases (accounts p a yable). W h e n the inventory is sold, an asset (inventory) decreases an d an expense increases (C O G S ). W h e n an ord e r o f inventory items is received, the quantity received is a d d e d to the q uantity recorded as being a lre a d y on hand. W h e n items are sold, they are deducted from the recorded quantity. Therefore, the perpetual inventory method shows h o w m any items are supposed to be on hand at a n y time. The steps o f the perpetual inventory method are as follow s: •
Take the quantity on hand at the b e ginning o f the period.
•
A d d the quantity purchased during the period.
•
D educt the quantity sold during the period.
•
This equals the quantity that should be on hand a t the end o f the period. The nam e 'perpetual inventory control' comes from the idea that the accounting system has a continuously
updated figure for the am ount that should be on hand. If a physical count o f the inventory fails to sh o w that quantity, the c o m p a n y knows that some items have been lost o r stolen, o r that there has been an error in the records. Just as for cash, bank accounts an d accounts receivable, the records pro vid e accounting control in a d d itio n to a n y physical protection. The accounting records tell the c o m p a n y w h a t should be on hand. If the cost o f items is included in the count a lo n g w ith the quantity, the perpetual record can be used to estim ate the total cost o f inventory a t a n y time, w ith o u t having to bother counting a nd p ricing everything. B eginning in vento ry cost (support w ith physical count if desired) + Cost o f purchases of in vento ry (records) - Cost o f in vento ry sold (records) = Ending in vento ry cost (support w ith physical count if desired) In most o f the exam ples so far in this text, it has been assumed that the perpetual control method has been used, because each inventory purchase has been recorded as debits to inventory asset, an d C O G S has been credited to the asset and d e b ite d to C O G S expense. The perpetual method provides a d d itio n a l m anagem ent inform ation. Suppose that after the a b o v e calculation, the expected ending in v e n to ry c o st w a s $ 1 0 0 0 0 0 , but a stocktake to confirm that sh o w e d o n ly $ 9 6 5 0 0 of inventory on hand. M a n a g e m e n t w o u ld kn o w there had been a $ 3 5 0 0 shortage o r other error, a nd could intensify controls over inventory if that w e re thought to be cost-effective. (If it cost $ 1 0 0 0 0 to im prove the controls, m anagem ent m ight w e ll conclude that losing $ 3 5 0 0 w a s the c h e a p er option.) The inventory asset account w o u ld be adjusted to match the count by an adjusting entry to reduce inventory and increase an expense. The accounts w o u ld then sh o w the expense being incurred b y the im perfect control.
CHAPTER 9
Inventory
359
If there w a s m ore inventory on hand than expected, there could instead be an inventory o v e ra g e a ccount (i.e. a credit b a la n ce - so a sort o f negative expense). M o re inventory on hand than expected w o u ld p ro b a b ly in d ica te an error som ew here, as it is unlikely that a n yo n e w o u ld break in a nd a d d inventory. The o v e ra g e /s h o rta g e expense a ccount w o u ld p ro b a b ly be included w ith C O G S in the incom e statement, as m anagem ent w o u ld usually consider this inform ation to be an internal matter. Nevertheless, one w o u ld hope it w o u ld not be large enough to be m aterial in its effect on C O G S .
The periodic co un t m ethod W h e n g o o d s are bought, they are put on the shelf o r in the storeroom , an d w hen they a re sold o r used, they are taken o ff the shelf o r out o f the storeroom . W ith the perpetual control system, records are kept o f every o ne o f these movements to pro vid e expected quantities o r values on hand. H ow ever, if com plete records o f such inventory changes a re not kept, the enterprise does not have records to in d ica te w h a t should be on hand. The o n ly w a y to tell w h a t is on hand is to g o a n d count it. Because this sort o f counting tends to be d o n e o n ly p e rio d ica lly, w hen an inventory figure is needed for fin a n cia l statements o r insurance purposes, this method is called the p e rio d ic inventory method. W h ile there m ay be other features o f internal control present, such as physical protection a n d insurance, the p e rio d ic count method lacks the parallel record-keeping that gives the perpetual method its value. There is no w a y to reconcile counts to records in ord e r to discover errors, but it is sim ple a nd ch e a p to o p erate, because no continuing records are kept. Record-keeping does cost m oney! The calculation to w o rk out the cost o f g o o d s sold under a p e rio d ic inventory system is as follow s: B eginning in vento ry (count) + Purchases (records) - Ending in vento ry (count) = In vento ry sold (deduced); th a t is, cost o f goods sold Because w h a t has been sold is inferred, rather than know n from records, you can see that it m ight not all have been sold. Som e could have been lost, stolen, e va porated a nd so on. So under the p e rio d ic method, C O G S expense (cost of counted b e g in n in g inventory + cost o f purchases - cost o f counted e n ding inventory) includes all these other possibilities. If the p e rio d ic method is used, other forms o f control need to exist to in d ica te theft an d so on. For exam ple, unexpected changes in the ratio o f C O G S to sales should be investigated.
Inventory: cost and benefits o f controls The perpetual method can be costly in terms o f record-keeping. M a n a g e m e n t must p a y som eone to record, sort and com p ile the inform ation. W h a t type o f business uses a perpetual system? The local c a r dea le rsh ip is a g o o d exam ple. C ars a re expensive; therefore, a large investment must be m ade if a g o o d supply is to be on hand for customers to choose from. The high value o f cars, an d the need to keep track o f them for registration an d insurance purposes, mean that serial numbers a n d other types o f identification inform ation are re a d ily a v a ila b le a nd usually recorded in various places. C ars have a high risk o f becom ing obsolete because consum er preferences ch a n g e, and the cost o f theft is high even if o nly on e ca r is stolen. Because of the relatively small quantity o f cars sold by most dealerships, record-keeping costs a re not high. Sim ilarly, com panies selling other expensive items, such as television sets, stereos, refrigerators, jew ellery o r furniture, use the perpetual method. In the past, m any organisations that had a large num ber o f sales, particularly of items w ith relatively lo w value, used the p e rio d ic inventory method because of its lo w e r costs. H ow ever, w ith the co n sid e ra b le increase in computerbased inventory systems, most organisations n o w use the perpetual system because o f its advantages in controlling inventory. For exam ple, m any retail com panies have cash registers that use o p tica l scanners to read the barcodes attached to products. These read the sales price an d also u p date the inventory records. H ave you w o n d e re d recently w h y w hen you return an item of clothing to a departm ent store to e xch a n g e it for a different size, the cashier scans both the returned item a nd the replacem ent item? As the sales price is g e n e ra lly the same, the usual reason is to update inventory records. This not o n ly assists w ith control but also helps w ith planning for o rdering a d d itio n a l inventory.
360
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: D o e s y o u r u n iv e rs ity b o o k s h o p use a p e rp e tu a l o r p e rio d ic in v e n to ry s y s te m ? W h y ? Y o u r a n s w e r s h o u ld be : A lm o s t c e rta in ly y o u w ill fin d th e y use p e rp e tu a l. I f y o u ask th e m i f th e y ha ve a c e rta in
b o o k th e y w ill c h e c k in th e ir c o m p u te r in v e n to ry re c o rd s . T h e re a so n s f o r th is in c lu d e b e tte r
re o rd e rin g an d c o n tro l o f th e ft.
9.2 Accounting entries for perpetual and periodic inventory Brinkworth Ltd uses a perpetual accounting control system for its inventory. It has the fo llo w in g data for a recent period.
si ■ Beginning accounts receivable
40000
$ Beginning inventory
Purchases during period (all cash)
114 00 0
Sales (all credit)
Cash collected in period
115000
Ending inventory count
23 000 150 00 0 28 000
The com pany's mark-up is 5 0 per cent on cost (i.e. the selling price is 1 5 0 per cent o f cost). Just to make it easier, w e ll assume that all sales, purchases an d collections w e re in single transactions. First, w e w ill consider the im pact on the accounting equation. $ a
b
c
Purchases
Sales
Cost of goods sold
d
Adjustment
e
Collections
Increase inventory
114 00 0
Decrease cash
114 00 0
Increase accounts receivable
150 00 0
Increase sales revenue
150 00 0
Increase COGS
100 00 0
Decrease inventory
100 00 0
Increase inventory shortage expense (see below) Decrease inventory
9 000 9 000
Increase cash
115 000
Decrease accounts receivable
115 000
H ere is a summary o f the journal entries for the perpetual system.
a
Purchases
Inventory
DR
CR
$
$
114 00 0
Cash
114000
P u rch a se s d u r in g th e p e rio d .
b
Sales
Accounts receivable Sales revenue S a le s o n c r e d it d u rin g th e p e rio d .
150 00 0 150000
»
CHAPTER 9
»
c
Cost of goods sold
COGS expense
Inventory
361
100 00 0
100000
Inventory C O G S e x p e n s e : $ 1 5 0 0 0 0 re v e n u e m in u s 5 0 p e r c e n t m a rk -u p o n co st.
d
Count adjustment
Inventory shortage expense
9 000
Inventory
9 000
S h o rta g e ; re c o r d in d ic a te s in v e n to ry s h o u ld b e $ 2 3 0 0 0 + $ 1 14 0 0 0 - $ 1 0 0 0 0 0 = $ 3 7 0 0 0 b u t o n ly $ 2 8 0 0 0 is o n h a n d .
e
Collections
Cash
115 00 0 Accounts receivable
115000
C u s to m e r c o lle c tio n s d u r in g th e p e rio d .
Let's review tw o accounts here to ensure that you see h o w the accounting figures help w ith the control. $
Inventory account: Beginning cost balance Purchases
23 000 114000
Cost of goods sold Expected balance on hand
(100000) 37000
The stock take showed less than expected on hand: Adjustment for loss Revised ending balance
(9 000) 28 000
Accounts receivable account: Beginning
40000
Sales
150000
Collections
(115 000)
Ending balance
75 000
W e can check w ith the customers o r otherw ise verify that this am ount really is a co lle cta b le asset. Let's n o w consider the accounting entries under the p e rio d ic method.
s| a
b
c
Purchases
Sales
Collections
Purchase expense increases
114 00 0
Cash decreases
114 00 0
Accounts receivable increases
150 00 0
Sales revenue increases
150 00 0
Cash increases
115 00 0
Accounts receivable decreases
115 00 0
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The journal entries for the p e rio d ic inventory system are as follow s.
a
Purchases
Purchase expense
DR
CR
$
$
114 00 0
Cash
114 00 0
P u rch a se s d u rin g th e p e rio d .
b
Sales
Accounts receivable
150 00 0 150 00 0
Sales revenue S a le s o n c r e d it d u rin g th e p e rio d .
c
Collections
Cash
115 00 0 Accounts receivable
115 00 0
C u s to m e r c o lle c tio n s d u rin g th e p e rio d .
N o te that under the p e rio d ic method there a re no journal entries for C O G S a nd inventory shortage (entries [c] and [d ] under the perpetual method). C O G S is not affected at the time o f sale. It is calculated a t the end o f the accounting period b y a d d in g purchases for the p eriod to o p e n in g inventory an d then deducting closing inventory. Inventory shortages are not know n, because there a re no inventory records w ith w h ich to co m p a re the stock count total. U nder the p e rio d ic inventory method, no adjustm ent has yet been m ade to the inventory a ccount to sh o w that it is different at the end o f the period from w h a t it w a s at the b e g inning o f the p eriod (because o f purchases a nd sales). This adjustm ent to the inventory a ccount w ill occur in the closing entries. If the c o m p a n y d id use the p e rio d ic count m ethod, w e w o u ld have the $ 2 3 0 0 0 from the b e g in n in g , plus the $1 1 4 0 0 0 purchased, less the $ 2 8 0 0 0 counted at the end, for an a p p a re n t C O G S o f $ 1 0 9 0 0 0 . You can see that, had w e had the perpetual records, w e w o u ld kn o w that this fig u re is a ctu a lly the sum o f the $ 1 0 0 0 0 0 cost o f g o o d s really sold a n d the $ 9 0 0 0 shortage. Both m ethods have the sam e revenue a n d the sam e total expense ( $ 1 0 9 0 0 0 ) , but they d iffe r in the inform ation they p ro vid e to m anagem ent a b o u t w h a t is g o in g on.
C om paring perpetual and periodic inven to ry system s The gross profit calculation under both methods is show n b e lo w .
PERPETUAL IN V E N T O R Y SYSTEM
$ Sales Less: COGS Less: Inventory shortage Gross profit
150000 100000 9000
109000 41 000
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363
PER IO DIC IN V E N T O R Y SYSTEM
$ Sales
$ 150 00 0
Cost of goods sold: Opening inventory
23 000
Purchases
114000
Cost of goods available for sale
137000
Less: Ending inventory
28 000
COGS
109 00 0
Gross profit
41 000
In C h a p te r 4 w e discussed closing entries. The closing entries under the perpetual an d p e rio d ic methods are shown b elow :
PERPETUAL M E T H O D
Profit and loss summary
DR
CR
$
$
109000
COGS expense
100 00 0
Inventory shortage expense Sales revenue
9 000 150000
Profit and loss summary
150 00 0
PER IO DIC M E T H O D
Profit and loss summary
137 000
Purchases
114 00 0
Inventory (beginning) Inventory (ending) Sales revenue Profit and loss summary
23 000 28 000 150000 178 000
U nder both methods, the profit a nd loss summary account an d the inventory account w ill have the sam e balances. (Later in this cha p te r you w ill see situations w h e re this is not the case, because of certain inventory cost flow assumptions that have been m ade.)
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PERPETUAL M E T H O D Profit and loss summary 109000 Bal. c /d
Inventory
j 150 00 0
Bal. b /d
41 000 150 00 0
23 000
100000
114000
9000
150 00 0 Bal. b /d
Bal. c /d
41 000
137000 Bal. b /d
28 000 137000
28 000
PER IO DIC M E T H O D Profit and loss summary 137 00 0 Bal. c /d
Inventory 178 00 0
41 000 1 7 8 00 0
Bal. b /d
23 000
Bal. b /d
28 000
23 000
178 00 0 Bal. b /d
41 000
C heck the o p enin g b a la n ce in the in ve n to r/ accounts, then fo llo w the posting from the journal entries to the ledgers to ensure that you can see w h a t is h a p p e n in g . Using both methods, $ 41 0 0 0 is the b a la n ce o f profit a nd loss summary to be transferred to retained profits, an d the inventory b a la n ce to be carried fo rw a rd to next period is $ 2 8 0 0 0 .
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: G ra n o t Ltd uses th e p e rp e tu a l in v e n to ry m e th o d . A t th e b e g in n in g o f th e m o n th , in v e n to ry c o s tin g $ 1 4 5 8 9 0 was on hand. P urchases fo r th e m o n th to ta lle d $ 2 6 7 5 4 0 and c o s t o f goods re co rd e d as sold to ta lle d $ 2 5 8 3 1 0 . A t th e end o f th e m o n th , a c o u n t show ed in v e n to ry c o s tin g $152 7 3 0 to be on hand. W h a t, i f a n y th in g , was th e in v e n to ry s h o rta g e fo r th e m o n th ? Y o u r answ er should be: 1 4 5 8 9 0 + 2 6 7 5 4 0 — 2 5 8 3 1 0 = 1 5 5 1 2 0 ; th a t is, $ 1 5 5 1 2 0 should be on hand. This is co m p a re d to th e c o u n t o f $152 7 3 0 and you can see th a t th e re is a s h o rta g e o f $ 2 3 9 0 .
9.3
Inventory valuation and cost of goods sold
Inventory accoun tin g , like accounting for other current assets, uses a m odified version o f the standard historical cost valuation basis: lo w e r of cost a nd net realisable value. Because inventory is expected to be turned into cash (sold), or otherw ise consum ed w ithin the next year, it is a current asset. M o re o ver, because it is norm ally a current asset, generally a ccepte d accounting principles require that a n y im pairm ent in the asset's value be recognised in the period in w h ich the im pairm ent occurred - not later, w hen the asset is sold. N e t realisable value is used o n ly if it is lo w e r than cost, so the historical cost basis is dep a rte d from o n ly in o ne direction, d o w n , if that is needed. This is an a p p lic a tio n o f accounting conservatism: 'a n ticip a te no gains but a llo w for all losses'. In this section, w e briefly review h o w to determ ine cost. Inventory accounting affects both the b a la n ce sheet (inventory valuation) an d the incom e statement via the expense recognised fo r the use o f inventory (C O G S expense).
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365
Cost o f inventory It is easy to say that the total cost of inventory is just the sum of quantity times unit cost for all the inventory items. In order to w o rk out the cost of each individual unit, w e m ay need to get further information. Under accounting standards, the cost of inventory includes all the costs o f purchase, costs of conversion and other costs incurred in bringing inventory to its current location and condition. This means that the cost of inventory includes, in addition to the purchase price, any taxes on the purchase as w ell as transportation and handling costs. Costs of conversion are relevant if inventories are manufactured and includes costs of production such as labour and overheads (more on this is covered in our online management accounting chapters). Costs that are not included in the cost of inventory include administrative costs, selling costs and costs o f storage. N o w that w e have w orked out the cost o f inventory, w e can consider inventory cost flo w assumptions.
Inventory cost flo w assum ptions Inventory costs are very sim ple to calculate w hen the cost o f an item in inventory remains constant. H ow ever, assume that an item w a s purchased a t various times throughout the year. Take an exam ple w h e re there w a s an ope n ing inventory o f 2 0 0 items that cost $ 5 0 each. During the year, the price steadily increased, w ith subsequent purchases o f 1 0 0 a t $ 5 1 , 2 0 0 a t $ 5 3 , 2 0 0 at $ 5 4 , a n d 1 0 0 at $ 5 5 . All the items w e re stored together, a nd 4 0 0 w e re rem oved from inventory for sale during the year. W h a t is the C O G S an d w h a t is the value o f closing inventory? It all depends on w hether the items rem oved w e re those that cost $ 5 0 , $ 5 1 , $ 5 3 , $ 5 4 o r $ 5 5 . Im agine the trouble caused by keeping track of the cost o f each a nd every item rem oved from inventory. In practice, the actual cost of individual inventory items is tracked only for high-value items (e.g. houses, motor vehicles, aircraft and expensive jewellery) that can be identified by serial numbers and other methods. This method is often called specific identification. As the cost of keeping records decreases, because of computerisation, more items w ill be a b le to be tracked this w a y. However, serial numbers or other w ays to identify specific inventory items are needed. Because, for the most part, it is not w o rth w h ile o r even possible to keep track o f the cost o f in dividual items in inventory, most com panies calculate their b a la n ce sheet inventory cost an d C O G S expense b y assum ing some flo w o f costs through the business. W e d o n 't w a n t to have to kn o w exactly w h ich ones are on hand, or w h ich have been sold, so w e make assumptions. To illustrate the effects o f different assumptions, w e w ill first use a sim ple exam ple based on the p e rio d ic inventory control method, in w h ich no records are kept o f changes in inventory levels during the accounting p e riod. If the perpetual control method w e re used, the calculations w o u ld be m ore co m p le x (you'll see those later in the M e e ix Ltd exam ple in section 9 .5 ). The fo llo w in g scenario involves inventory purchased for resale (such as a retailer w o u ld purchase), but the ideas w o rk just as w e ll for inventory m anufactured b y a co m p a n y. In that case, cost o f purchases is replaced by cost of g o o d s m anufactured. C o n sid e r the fo llo w in g d a ta : • •
Inventory at b e ginning o f p e riod: 1 2 0 units costing $ 2 each. Purchases during p eriod (in the order in w h ich they happened): 1 0 0 units costing $ 3 each an d 1 1 0 units costing $ 4 each.
•
Sales during p eriod (based on an e n ding inventory o f 1 5 0 units): 1 8 0 units. The cost o f g o o d s a v a ila b le for sale equals the cost o f the o p e n in g inventory plus the cost o f those purchased (or
manufactured). So w e have 1 2 0 x $ 2 = $ 2 4 0 , plus 1 0 0 x $ 3 = $ 3 0 0 , plus 1 1 0 x $ 4 = $ 4 4 0 , for a total cost o f g o o d s a v a ila b le o f $ 9 8 0 . O u r problem is h o w to a llo ca te the $ 9 8 0 betw een the incom e statement for the period (C O G S expense) a n d the b a lan ce sheet at the end of the p eriod (ending inventory asset). There are three com m on inventory cost flo w assumptions that are used around the w o rld :
•
First in, first out (FIFO) assumes that the first items a cq u ire d a re the first ones sold a n d , therefore, that a n y ending inventory on hand consists o f the most recently a cq u ire d units (recent costs on the b a la n ce sheet, o ld e r costs in C O G S expense).
•
W e ig h te d a ve ra g e cost (AVGE) assumes e n ding inventory an d C O G S are com posed o f a mixture o f o ld and n e w units.
•
Last in, first out (LIFO) assumes the op p o site o f FIFO, saying that a n y inventory on hand consists o f the oldest units (older costs on the b a la n ce sheet, recent costs in C O G S expense).
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Exhibit 9.1 shows the three different assumptions o f inventory cost flo w . In each case, the sum o f the e n d in g b a la n ce sheet asset valuation a n d the C O G S expense is $ 9 8 0 . The different cost flo w assumptions just a llo ca te this
available cost differently betw een the balance sheet valuation a nd the expense in the incom e statement. EXHIBIT 9.1
INVENTORY COST FLOW ASSUMPTIONS FIFO, AVGE A N D LIFO
Method
Ending inventory asset
COGS expense
FIFO
(110 x $4) + (40 x $3) = $560
$ 9 8 0 -$ 5 6 0 = $420 ([120 x $2]* [60 x $3])
AVGE
LIFO
150 x $2.97 = $445
$ 9 8 0 -$ 4 4 5 = $535
Average unit cost = $ 9 8 0/3 3 0 = $2.97 (rounded)
(180 x $2.97 = $535)
(120 x $2) + (30 x $3) =$330
$ 9 8 0 -$ 3 3 0 = $650 ([110 x $4] + [70 x $3] = $650)
9.4
More about inventory cost flow assumptions
The a b o v e exam ple introduced three cost flo w assumptions - FIFO, A VG E a nd LIFO - a nd related to the p e rio d ic method. W e know from section 9 . 1 that internal control over inventory m ay mean using the p e rio d ic or perpetual methods. If w e put the three cost flo w assumptions aga in st the tw o control methods, w e ge t the fo llo w in g : Assumption
Periodic control
Perpetual control
FIFO
FIFO
FIFO
AVGE
Weighted average
Moving weighted average
LIFO
Periodic LIFO
Perpetual LIFO
FIFO is not affected by the inventory control method because it just assigns the most recent cost to w h a te ve r is on hand. The other tw o methods a re affected b y the control method, because they d e p e n d on w h a t w e kn o w a b o u t w h a t happened to inventory levels during the p e riod. This gives us five potential methods: FIFO a n d tw o versions each of AVG E a nd LIFO. (There is a sixth, specific identification, as you have a lre a d y seen. Further, at the end o f this section, tw o m ore methods are mentioned briefly. In fact, there are a t least eight different w a ys to account for inventory cost!) In A ustralia, the LIFO method is not a llo w e d to be used for either fin a n cia l reporting o r tax purposes. Flow ever, w e w ill include it because the contrast w ith FIFO a nd m oving a ve ra g e m ay help you understand the latter ones, a n d because LIFO is very com m on in the United States, so you w ill see it mentioned in m any US financial statements. Let's exam ine these assumptions a nd their interaction w ith internal control methods further. Remember that, because each assumption allocates the a v a ila b le inventory cost betw een the inventory asset a nd the C O G S expense differently, the c h o ice of assumption has an effect on both the incom e statement a nd the b a la n ce sheet. The significance o f the effect depends on h o w much purchase (or m anufacturing) costs per unit rise o r fall during the period. If there is little c h a n g e in these costs, the various methods w ill sh o w very sim ilar results. FIFO assigns the m ore recent purchase costs to the inventory asset a ccount a n d , therefore, o ld e r costs to the C O G S expense account: •
It is used because it is convenient a nd produces inventory asset values that are close to current costs, w h ich seems to m any p e o p le to be a p p ro p ria te fo r a current asset.
•
It is convenient because all you really need to d o is keep your purchase invoices a n d , w hen you kn o w h o w many units are on hand, just g o through recent invoices to find the costs.
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•
Inventory
367
For exam ple, suppose there are 6 2 0 boxes o f chocolates on hand at 3 0 June, a nd recent purchase invoices sh o w e d the fo llo w in g costs: 2 9 June, 2 6 0 boxes a t $ 3 .2 0 ; 14June, 3 1 0 boxes a t $ 3 .3 5 ; 1 June, 2 1 0 b o x e s a t $ 3 ; an d so on. The FIFO e n ding inventory is found by starting w ith the most recent purchase a nd g o in g b a ck in tim e until all the ones on hand are accounted for (w orking on assum ption, since w e d o not really kn o w w hen any particular b ox w a s purchased). So the FIFO cost here w o u ld be:
(260
x
$ 3 .2 0 ) + (310
x
$3 .3 5 ) + ([620
-
260
-
310
=
50]
x
$ 3 ) o r $2 0 2 0 .5 0
You d o n 't need com plicated records, just a pile o f invoices. Also, it doesn't matter w h a t the internal control method is, because all you need to know is the quantity on hand, w hether determ ined by count o r b y perpetual records. A fe w key facts a b o u t FIFO: • •
FIFO is the most p o p u la r cost flo w assumption for inventories for larger A ustralian com panies. FIFO is considered a p p ro p ria te for a current asset by m any p e o p le because it is the most reasonable method of physically m oving inventory, e sp e cia lly inventory that is perishable o r subject to changes in style o r features, such as groceries, clothing an d other retail products. Picture a shelf in a gro ce ry store. FIFO assumes that n e w stock is p la ce d behind o ld e r stock on the shelf, so that the inventory keeps m oving fo rw a rd on the shelf. In A ustralia, accounting standards require that the cost flo w reflects the underlying physical flo w of the g o o d s in question. This is not the case in the United States. The AVG E method assigns the a v a ila b le cost e q u a lly to the inventory asset an d to C O G S expense. In the
exam ple in Exhibit 9 .1 , both inventory asset an d C O G S used the sam e $ 2 .9 7 average cost per unit. N o te that w hen prices a re rising, a v e ra g e cost shows a higher C O G S (low er profit) a nd lo w e r inventory b a la n ce sheet figures than the FIFO method. LIFO is, on the fa ce o f it, a strange valuation method. It assumes that the newest items a re sold first an d , therefore, that the oldest are the ones left on hand. In the extreme, this w o u ld im ply that the gro ce ry store's first loaves of bread are still at the b a ck o f the shelf, years later (possibly 1 0 0 years later). FJowever, note that in the United States the cost flo w assumption used for accounting purposes does not have to match the physical flo w o f items. So rest assured that w h ile A m erican bread m ay not be as tasty as Australian b read, it is not that old ! A fe w key facts a b o u t UFO: •
UFO is used in the United States for on e very practical reason: it is an a llo w a b le method for incom e tax purposes. FJowever, it can o n ly be used for tax purposes if it is also used for accounting purposes. In a p eriod o f rising purchase costs (inflation), w h ich is pretty much constantly the case, it produces a higher C O G S expense an d a lo w e r inventory asset value co m p a red w ith FIFO or A VG E . Therefore, LIFO also produces lo w e r profit a nd lo w er incom e tax, if it can be used for tax purposes.
•
As noted earlier, it is not perm issible to use LIFO in A ustralia for accounting o r taxation purposes. In some countries, such as C a n a d a , it is an a llo w a b le method for accounting but not for incom e tax purposes, so a C a n a d ia n c o m p a n y using it for the fin a n cia l statements w o u ld have to com pute inventory values all over a g a in using on e o f the other methods w hen d o in g its incom e tax return.
•
It can also be a rgued that LIFO matches revenues w ith expenses m ore a d e q u a te ly than the other tw o methods do. For exam ple, if a c o m p a n y changes its selling prices as its purchase costs ch a n g e, its revenues reflect recent price changes, an d it then seems a p p ro p ria te to d educt the m ore recent purchase costs as C O G S expense aga in st the revenues. The trouble is that LIFO produces inventory asset values that are based on o ld e r purchase costs, an d this can substantially underestim ate the asset value.
•
It w o u ld be nice to use current purchase prices for C O G S expense an d for the b a la n ce sheet inventory value. But that c a n 't be d o n e if w e stick to the historical cost accounting basis: the books w o u ld n 't b a la n ce because some of the units w o u ld have been purchased at o ld e r costs a nd those costs w o u ld be in the accounts too, in the inventory asset o r expense accounts. (There have been proposals to use current costs, such as replacem ent costs, in both statement figures, but these are not presently permitted to be used in practice.)
•
LIFO is affected by w hether its am ounts are determ ined using the p e rio d ic or perpetual control methods, as the fo llo w in g exam ple w ill show .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
9.5
An example: Meeix Ltd
A m ong the products M e e ix Ltd purchases a nd sells is G lo o p . M e e ix Ltd b egan last ye a r w ith 1OOO units o f G lo o p on hand a t a cost o f $ 4 each, an d during the ye a r its purchase an d sales records sh o w e d the fo llo w in g . I Date
Units purchased
Units sold
Units on hand
Jan. 1
1 000
Feb. 15 Mar. 20
350 600
Apr. 30 Sept. 12
800
Dec. 11 1 400
$5
500 1 300
200
$4
650 1 250
750
Purchase price
$6
1 100
1 300
The chart in Figure 9.1 shows h o w the quantities o f G lo o p c h a n g ed during the year.
FIGURE 9.1
In v e n to ry b a la n ce s and ch a n g e s, M e e ix's G lo o p
Inventory under d iffe re n t cost flo w assum ptions N o te that the cost flo w assumptions w o u ld identify the e n ding inventory's l 10 0 units as follow s. FIFO •
l 10 0 = 8 0 0 most recently bought + 3 0 0 o f those bought 2 0 M a rc h .
AVGE •
A n n u a l w e ig h te d : l 10 0 = a proportionate mixture o f those on hand at the b e g inning an d those bought 2 0
•
M o v in g : the first a v e ra g e is the l 2 5 0 on hand at 2 0 M a rc h , a p ro portionate mixture o f those on hand at
M a rc h and l 2 September. beginning + those bought 2 0 M a rc h ; second a verage, the l 3 0 0 , is a p ro portionate mixture o f the first a ve ra g e (on hand 3 0 April) a nd those bought l 2 September.
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LIFO •
P eriodic: the ups a n d d o w n s during the ye a r a re not known (no records kept), so the 1 1 0 0 = 1 0 0 0 on hand at b e g in n in g + 1 0 0 bought 2 0 M a rc h .
•
Perpetual: during the year, the inventory hit a minimum o f 5 0 0 , so that's all o f the b e g in n in g items that could still be on hand at the end; therefore, 1 1 0 0 = 5 0 0 from b e g inning + 6 0 0 bought 1 2 Septem ber.
N o w w e can g o on w ith the calculations. Regardless o f the cost flo w assumption used, w e know that the b e g inning inventory cost is $ 4 0 0 0 an d that purchases costing $ 7 8 0 0 ( 6 0 0 x $ 5 + 8 0 0 x $ 6 ) w e re m ade. A va ila b le cost, therefore, is the sum o f b e g inning inventory an d purchases, w h ich is $ 11 8 0 0 . C onsequently, as long as the historical cost basis o f accounting is used, a n y inventory cost a llo ca tio n method must p roduce $1 1 8 0 0 as the sum of the e n ding inventory asset a nd C O G S expense. You m ight think o f it this w a y : A v a ila b le fo r sale = G o n e + Still here B eginning in vento ry + Purchases = C O G S expense + Ending inventory The left side equals $1 1 8 0 0 , so the right side must result in the sam e total. This gives us w a ys to check our calculations. If w e calculate the C O G S expense an d the e n ding inventory asset cost separately, they must a d d up to $ 1 1 8 0 0 . As a short cut, w e can calculate either the expense o r the asset value, an d d e d u ce the other b y deducting it from $1 1 8 0 0 . This is easier than d o in g it tw ice , but the calculations b e lo w w ill include both the expense an d the asset so that you can see h o w it all w orks. Based on the patterns show n in Figure 9 .1 , an d the summary o f each m ethod's assumption a b o u t the ending inventory quantity, here are the calculations for e n ding inventory cost an d C O G S .
FIFO METHOD
A lternatively, the calculations can be d o n e as follow s. Dale
Purchases |
n
Cost of goods sold
Ending inventory
$
$
Jan. 1
1 000 at $4 = 4 000
Feb. 15 Mar. 20
350 at $4 = 1 400
650 at $4 = 2 600 650 at $4 = 2 600
600 at $5 = 3 000
600 at $5 = 3 000 Apr. 30
Sept. 12 Dec. 11
650 at $4 = 2 600 100 at $5 = 5 0 0
50 0 at $5 = 2 500
200 at $5 = 1 000
300 at $5 = 1 500
800 at $6 = 4 800
800 at $6 = 4 800
800 at $6 = 4 800 $ 5 500
$ 6 300
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
AVGE METHOD Annual weighted average
s| Average cost = $11 800 / (1000 + 600 + 800) = $4,917 (rounded) Ending inventory cost: 1 100 x $4,917
5 408
COGS expense: 1300 x $4,917
6 392 $11 800
Moving weighted average The m oving a ve ra g e w orks the same w a y as annual w e ig h te d a ve ra g e , but is recalculated after each purchase, w e ig h te d in a cco rd a n ce w ith the inventory on hand at that point.
LIFO METHOD Periodic basis
Perpetual basis The perpetual records a llo w us to determ ine w hether it is reasonable to assume that all the o rig in a l 1 0 0 0 units are still on hand. In this exam ple, it is not reasonable, because at o ne point the inventory w a s d o w n to 5 0 0 units, so that 'layer' of cost has been partly used up. The calculation reflects the cost layer inform ation a v a ila b le from the records.
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The fo llo w in g summarises the M e e ix exam ple's results. Cost method
FIFO
Ending inventory asset
COGS expense
Total cost available
$
$
$
6 300
5 500
11 800
AVGE Annual
5408
6 392
11 800
Moving
5 957
5 843
11 800
Periodic
4500
7300
11 800
Perpetual
5 600
6 200
11 800
LIFO
This exam ple illustrates a result that is com m on w hen using these methods. In a period o f rising purchase prices, as w a s found here: •
FIFO tends to have the highest inventory asset value and lowest C O G S expense (and therefore the highest net profit).
•
LIFO tends to have the low est inventory asset value an d highest C O G S (and therefore the low est net profit).
•
A VG E tends to be betw een the other tw o in asset values, C O G S a n d net profit. If purchase prices a re falling, the positions o f FIFO a nd LIFO reverse, w ith FIFO tending to have the low est net
profit an d LIFO the highest. The A VG E method tends, a g a in , to be betw een the other tw o . W h ile falling prices are less com m on, they can occur in some industries (such as com puter software). The m ore cost prices rise (or fall) during a p e riod, the larger the differences w ill be betw een the methods. The differences tend to be sm aller w hen inventory turnover is high. This is because price changes occurring during the time that inventory is held a re sm aller a nd the size o f the inventory asset relative to C O G S expense is smaller. If a perpetual LIFO o r m oving a v e ra g e method is being used, the differences can also be in unexpected directions, d e p e n d in g on c o in cid e n ta l increases o r decreases in inventory levels. The LIFO perpetual e n ding inventory for M e e ix is higher than the annual a v e ra g e e n ding inventory because a large am ount o f the b e g in n in g inventory w a s sold, so the LIFO perpetual method used this inform ation, but the annual a ve ra g e d id not. The relationships am ong the methods can also stray from the typical pattern if purchase price changes an d inventory quantities are m oving in oppo site directions; for exam ple, if inventory levels are fa llin g but prices a re rising, o r vice versa.
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: Filo Ltd uses a p e rp e tu a l in v e n to ry syste m . It has o p e n in g in v e n to ry o f 2 0 0 ite m s, w h ich c o s t $ 1 0 each. It purchased a n o th e r 5 0 0 ite m s a t $12 each and 3 0 0 ite m s at $13 each d u rin g th e p e riod. It has 1 0 0 ite m s in c losing in v e n to ry . W h a t is th e clo sing in v e n to ry va lu a tio n and th e C O G S fo r th e p eriod using F IF O and L IF O ? Y o u r answ er should be: F IF O : c lo sing in v e n to ry = $ 1 3 0 0 ; C O G S = $ 1 0 6 0 0 . L IF O : c lo sing in v e n to ry = $ 1 0 0 0 ; and C O G S = $ 1 0 9 0 0 .
9.6
Lower of cost and net realisable value rule
The lo w e r o f cost a n d net realisable value rule states that the value o f inventory should be w ritten d o w n from the cost price to the market price in situations w h e re market is b e lo w cost. In A ustralia, market is d e fined as net realisable value. N e t realisable value is the estim ated selling price less costs to com plete (such as putting it in a box) o r sell the items. A g a in , the focus is on items w h o se net realisable value is b e lo w cost, so w e a re concerned w ith items w hose
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
selling prices are falling o r items that have been d a m a g e d , have becom e obsolete, or a re no longer in style so w e c a n 't sell them for w h a t w e thought w e could. The measurement o f the lo w e r o f cost a nd net realisable value should be d o n e on an item-by-item basis. W h e n this is im possible because o f the large num ber o f hom ogeneous items having an insignificant cost, the rule can be a p p lie d for a g ro u p of items. B asically, to calculate the lo w e r o f cost an d net realisable value, w e just take the cost o f the items a nd match those costs a gain st the net realisable value a nd use the lo w e r as the b a la n ce sheet inventory value. In practice, com panies usually focus m ainly on items w h o se values are likely to be im paired (as m ight be identified during the physical count), rather than calcu la tin g net realisable value for everything. For exam ple, if inventory that costs $ 1 0 0 0 had a net realisable value at year-end o f $ 8 0 0 , it w o u ld be necessary to w rite d o w n an asset (inventory) an d increase an expense (inventory w rite -d o w n expense). The journal entry w o u ld be: $ DR CR
Inventory write-down expense
$
200
Inventory
200
N o te that the decision to w rite d o w n the inventory has resulted in a $ 2 0 0 reduction in profit for the p e riod. You can im agine that, if this figure w e re large, m anagers m ight not w a n t to w rite d o w n the value o f inventory. Disputes betw een m anagem ent an d auditors arise over these issues. C onsider a c o m p a n y w h ich has three products: X, Y a n d Z.
The inventory value under lower of cost and net realisable value is $ 4 9 0 0 (1 0 0 x $ 5 + 3 0 0 x $ 8 + 2 0 0 x $ 10). In this case, inventory of $ 3 0 0 w ould be written dow n because Y is presently included in the records at $ 2 7 0 0 (3 0 0 x $9).
9.7
Retail inventory and standard costs
The retail inventory method - w h ich , as you m ight expect, is most a p p lic a b le to retailers' inventories - com bines purchase costs a nd selling prices into a single calculation, o r estimate. This is like the perpetual method, except that records are based on selling prices o f g o o d s rather than just quantities o r costs. In the retail inventory control method, a departm ent or branch is c h a rg e d w ith the total selling value (sales price times quantity) o f all items for sale delivered to it. Revenue from sales is then deducted from this total value as the items are sold. This ties inventory control to cash control. A t a n y point in time, the departm ent o r branch should have inventory, plus cash from sales m ade since the last revenue report, plus records o f sales on credit o r via credit cards, equal to the current total retail value. The method proceeds as follow s: •
Start w ith the retail price o f all g o o d s received b y the departm ent (on hand a t the b e g inning o f the p eriod plus received during the period).
•
D educt the departm ent's sales (connected to cash, cheque, electronic funds transfer an d credit ca rd control procedures).
•
D ifference equals inventory that should be on hand, priced at retail. If a physical count, w ith items priced at retail, fails to produce the expected total retail value, the c o m p a n y knows
that some items have been lost or stolen, o r that there has been an error in the records. An adjustm ent for the shortage o r o verage can be m ade in the same w a y as for the perpetual method. The total cost of the inventory can be estim ated at a n y time by d educting the a ve ra g e mark-up from the current total retail value. The retail method is,
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how ever, a little c o m p lica te d in practice, because o f the need to keep track o f m arkdow ns, returned g o o d s, special sale prices a n d other price adjustments if the method is to w o rk accurately. O n e other p o p u la r method for valuing inventory, w h ich is used in A ustralia, is standard costs. You w ill learn a bout this method in detail if you take a course in m anagem ent accounting o r cost acco u n tin g . It is a p p lic a b le to inventories m anufactured by the com pany, a nd uses estim ated costs based on standard production costs a nd volumes. It is a predeterm ined cost that is a p p lie d to all movements in inventories, including o p e n in g a nd closing balances, purchases a n d sales. For exam ple, if the standard cost is $ 2 0 an d the c o m p a n y sold 2 0 0 0 units during the year, and had 3 0 0 in stock at year-end, the C O G S w o u ld be $ 4 0 0 0 0 ($ 2 0 x 2 0 0 0 ) a n d the closing inventory w o u ld be $ 6 0 0 0 ( $ 2 0 x 3 0 0 ).
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
H o w does a c o m p a n y d e cid e w h ich m e th o d to use in d e te rm in in g th e c o s t o f in v e n to ry ?
2
M e e ix Ltd also sto cks a p e t fo o d called D o g ’s B re a kfa st, w h ich it c o n tro ls using th e p e rio d ic in v e n to ry m e th o d . Last year, th e re w e re 2 0 0 cra te s o f D o g ’s B re a kfa st on hand a t th e b e g in n in g o f th e year. D u rin g th e year, 1 5 0 0 cra te s w e re purchased and 1 4 5 0 cra te s w e re sold. The cra te s on hand a t th e b e g in n ing c o s t $ 4 0 0 each. T h e re w e re th re e purchases: e a rly in th e year, 5 0 0 cra te s c o s tin g $ 4 0 4 each w ere purch a se d ; th e n 6 0 0 cra te s c o s tin g $ 3 9 0 each; and near th e end o f th e year, 4 0 0 cra te s co stin g $ 3 8 4 .5 0 . W h a t w o u ld be th e c o s t o f th e in v e n to ry a t th e end o f th e ye a r and th e C O G S expense u n d e r (a ) F IF O , (b ) A V G E and (c ) L IF O 7 Y o u r answers should be:
1
The c h o ic e o f m e th o d fo r d e te rm in in g th e c o s t o f in v e n to ry depends on th e n a tu re o f th e business,
2
(a ) $ 9 6 1 2 5 , $ 5 7 3 6 7 5 ; (b ) $ 9 8 5 0 0 , $571 3 0 0 ; (c ) $ 1 0 0 2 0 0 ; $ 5 6 9 6 0 0 .
p ro d u c ts sold, e tc . Ideally, in v e n to ry flo w assum ptions should a p p ro xim a te th e actual in v e n to ry flo w .
9.8
Disclosure of inventory accounting policies
A ccounting standards require that the fin a n cia l reports disclose the value o f inventory split betw een current and noncurrent assets an d further split into the fo llo w in g classes: (a) ra w materials a nd stores, (b) work-in-progress, (c) finished g o o d s, a nd (d) land held for resale. In a d d itio n , it requires disclosure o f the general basis for inventory valuation (specific identification, a ve ra g e , FIFO o r standard cost) an d the methods used to assign costs to inventory quantities (such as h o w overhead is a llo ca te d to inventories that a re manufactured). Examples o f inventory policies, as given in the note covering statements o f accounting policies, a re as follow s:
CSR LIMITED In v e n to rie s a re v a lu e d a t t h e lo w e r o f c o s t a n d n e t re a lis a b le va lu e . C o s ts in c lu d e d in in v e n to rie s c o n s is t o f m a te ria ls , la b o u r a n d
m a n u fa c tu rin g o v e rh e a d s w h ic h
a re re la te d t o
th e
p u rc h a s e a n d p r o d u c tio n
of
in v e n to rie s . T h e v a lu e o f in v e n to rie s is d e riv e d b y th e m e th o d m o s t a p p ro p ria te t o e a c h p a rtic u la r class o f in v e n to rie s . T h e m a jo r p o rtio n is v a lu e d o n e ith e r a f ir s t - i n - f i r s t - o u t o r a v e ra g e c o s t basis. Source: C SR Lim ited, Annual Report 2014.
WESFARMERS LIMITED In v e n to rie s a re v a lu e d a t th e lo w e r o f c o s t a n d n e t re a lis a b le va lu e . T h e n e t re a lis a b le v a lu e o f in v e n to rie s is th e e s tim a te d s e llin g p ric e in th e o r d in a r y c o u rs e o f b u sin e ss less e s tim a te d c o s ts t o sell.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C o s ts in c u rr e d in b rin g in g e a c h p r o d u c t t o its p re s e n t lo c a tio n a n d c o n d itio n a re a c c o u n te d f o r as fo llo w s :
-
Raw materials - p u rc h a s e c o s t o n a w e ig h te d a v e ra g e basis. Manufactured fnished goods and work in progress - c o s t o f d ir e c t m a te ria ls a n d la b o u r a n d a p r o p o r tio n o f m a n u fa c tu rin g o v e rh e a d s ba sed o n n o rm a l o p e ra tin g c a p a c ity , b u t e x c lu d in g b o rr o w in g c o s ts . W o r k in p ro g re s s a lso in c lu d e s r u n - o f - m in e c o a l s to c k s f o r th e R e s o u rc e s d iv is io n , c o n s is tin g o f p r o d u c tio n c o s ts o f d rillin g , b la s tin g a n d o v e rb u rd e n re m o v a l.
-
Retail and wholesale merchandise fnished goods - p u rc h a s e c o s t o n a w e ig h te d a v e ra g e basis, a f t e r d e d u c t in g a n y s e ttle m e n t d is c o u n t a n d in c lu d in g lo g is tic s e x p e n s e s in c u rr e d in b rin g in g t h e in v e n to rie s t o th e ir p re s e n t lo c a tio n a n d c o n d itio n .
V o lu m e - r e la te d s u p p lie r re b a te s , a n d s u p p lie r p ro m o tio n a l re b a te s w h e re th e y e x c e e d s p e n d o n p r o m o tio n a l a c tiv itie s , a re re c o g n is e d as a re d u c tio n in th e c o s t o f in v e n to ry . Source: W esfarm ers Limited, Annual Report 2014.
PAPERLINX LIMITED In v e n to rie s a re v a lu e d a t th e lo w e r o f c o s t (in c lu d in g an a p p ro p ria te p r o p o r tio n o f fix e d a n d v a ria b le o v e rh e a d s ) a n d n e t re a lis a b le v a lu e in th e n o rm a l c o u rs e o f b u siness. T h e c o s t o f in v e n to rie s is ba sed o n th e f ir s t - in
f ir s t - o u t o r w e ig h te d a v e ra g e p rin c ip le a n d in c lu d e s
e x p e n d itu r e in c u rr e d in a c q u irin g th e in v e n to rie s a n d b rin g in g th e m t o t h e ir e x is tin g lo c a tio n a n d c o n d itio n . In th e ca se o f m a n u fa c tu re d in v e n to rie s a n d w o r k in p ro g re s s , c o s t in c lu d e s an a p p ro p ria te s h a re o f o v e rh e a d s ba sed o n n o rm a l o p e ra tin g c a p a c ity . T h e p ro v is io n f o r im p a ir m e n t losses is b a sed o n an a g e in g a n alysis. N e t re a lis a b le v a lu e is th e e s tim a te d s e llin g p ric e in th e o r d in a r y c o u rs e o f bu sin e ss , less th e e s tim a te d c o s ts o f c o m p le tio n a n d s e llin g e x p e n s e s. Source: Paperlinx Limited, Annual Report 2014.
The a b o v e disclosures sh o w that, in practice, FIFO a nd w e ig h te d a ve ra g e a re com m only used to determ ine the cost o f inventory. W ith in the on e o rganisation, m ore than o ne method can be used a nd it m ay va ry betw een the type o f product o r the class o f inventories (ra w m aterial, w ork-in-progress or finished goods). All o f the disclosures refer to the fact that inventories are valued at the lo w e r o f cost a n d net realisable value. For m anufacturing firms, overhead costs are reported in the cost o f g o o d s m anufactured. M a n u fa ctu rin g costs are beyond the scope o f this book, a nd w ill be discussed in a m anagem ent accounting subject.
9.9
Managers and the valuation of inventory
M a n a g e rs have to make im portant decisions a b o u t the inventory control system they w ish to im plement. W h ile , for control purposes, the perpetual method has adva n ta g e s over the p e rio d ic method, it has a higher cost. The valuation o f inventory is im portant to m anagers because it affects C O G S (and therefore profit) a nd the b alance sheet - via the value o f inventory. Both profit figures a nd b a la n ce sheet figures affect m anagers' perform ance reports. Therefore, m anagers need to understand the effect, across time, o f different cost flo w assumptions on financial statements. M a n a g e rs also need to make some im portant judgem ents related to inventory valuation; for exam ple, w h ich cost flo w assumption most closely represents the actual physical flo w ? W h a t inventory items have a net realisable value w hich is lo w e r than cost?
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PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Periodic and p e rp e tu a l in ve n to ry co n tro l calculation s Y ou a re th e s e n io r a c c o u n ta n t fo r a shoe w h o le s a le r th a t uses th e p e rio d ic in v e n to ry m e th o d . Y ou h a ve d e te rm in e d th e fo llo w in g in fo rm a tio n fro m y o u r c o m p a n y 's re c o rd s, w h ic h y o u assum e is c o rre c t: a In ve n to ry o f $ 2 4 6 7 2 0 w a s on h a n d a t th e start o f th e y e a r. b
Purchases fo r th e y e a r to ta lle d $1 6 9 0 0 0 0 . O f this, $1 4 1 2 0 0 0 w a s p u rc h a s e d o n a c c o u n t; th a t is, a c co u n ts p a y a b le w a s c re d ite d fo r this a m o u n t a t th e tim e o f th e p u rch a se ,
c
The e n d in g b a la n c e in a cco u n ts p a y a b le w a s $ 4 7 5 0 0 h ig h e r th a n th e o p e n in g b a la n c e ,
d
A y e a r-e n d in v e n to ry c o u n t re v e a le d in v e n to ry o f $ 3 2 4 8 0 0 .
Required: 1
C a lc u la te C O G S a c c o rd in g to th e p e rio d ic in v e n to ry m e th o d .
2 A ssum e n o w th a t y o u r c o m p a n y uses th e p e rp e tu a l m e th o d o f in v e n to ry c o n tro l, a n d th a t y o u r re c o rd s s h o w th a t $1 5 4 8 3 2 5 o f in v e n to ry (at cost) w a s s o ld d u rin g th e y e a r. W h a t is th e a d ju s tm e n t n e e d e d to c o rre c t the re c o rd s, g iv e n th e in v e n to ry c o u n t in item (d) a b o v e ? W h a t m ig h t th e ne ed fo r this a d ju s tm e n t in d ic a te a b o u t c o m p a n y o p e ra tio n s ?
PRACTICE PROBLEM B LIFO, FIFO and AVGE in ve n to ry cost calculations The fo llo w in g pu rch ases o f in v e n to ry w e re m a d e b y A n v il Ltd in A p ril: Date
Number of units purchased
Per unit amount
Total cost
$
$
Apr. 2
100
5
500
Apr. 15
200
6
1200
Apr. 23
50
7
350
350
Sales o f in v e n to ry d u rin g A p ril w e re : Date
No. of units sold
Apr. 6
70
Apr. 13
120
Apr. 18
200 390
1
A n v il's in v e n to ry on 1 A p r il co n siste d o f 1 5 0 units v a lu e d a t $ 4 e a c h . C a lc u la te C O G S fo r A p r il, using: a
LIFO
b
FIFO
c
w e ig h te d a n n u a l a v e ra g e in v e n to ry cost flo w assu m p tio n s. A ssum e th a t A n v il uses a p e rio d ic in v e n to ry c o n tro l system .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
2
C a lc u la te e n d in g in v e n to ry valu es u n d e r e a ch o f th e th re e m e tho ds a b o v e as a t 3 0 A p ril.
3
S u p p o se th a t th e m a rk e t p ric e fo r these units w a s o n ly $ 5 p e r u n it a t 3 0 A p r il, a n d th e lo w e r o f c o st o r m a rke t v a lu a tio n is a p p lie d to e a c h un it in d iv id u a lly . R edo q u e s tio n 2 .
4
R edo q u e s tio n s 1 , 2 a n d 3 , a ssu m in g th a t A n v il uses a p e rp e tu a l in v e n to ry c o n tro l system .
KEY TERMS Available cost Average cost (AVGE) Balance sheet valuation
Cost Flow assumptions First in, First out (FIFO) Inventory cost
Inventory turnover Last in, First out (LIFO)
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
E x p la in th e d iffe re n c e b e tw e e n th e p e rio d ic in v e n to ry system a n d th e p e rp e tu a l in v e n to ry system .
2
H o w has te c h n o lo g y in flu e n c e d th e c h o ic e o f a p e rio d ic o r p e rp e tu a l in v e n to ry system ?
3
H o w is C O G S d e te rm in e d u n d e r bo th th e p e rp e tu a l a n d p e rio d ic in v e n to ry system s?
4
C o m p a re th e p e rio d ic a n d p e rp e tu a l system s as a c o n tro l d e vice .
5
W h a t sorts o f o rg a n is a tio n s a re lik e ly to use th e p e rio d ic in v e n to ry system ?
6
L in d e r w h a t c ircu m s ta n ce s w ill th e p e rp e tu a l a n d p e rio d ic in v e n to ry system s g iv e th e sam e C O G S fig u re ? H o w c a n this o c c u r if o n e m e th o d tre ats pu rch ases as a n asset a n d th e o th e r m e th o d treats pu rch ases as a n expe nse?
7
H o w is in v e n to ry s h o rta g e d e te c te d u n d e r th e p e rp e tu a l a n d p e rio d ic in v e n to ry m ethods?
8
W h a t is in c lu d e d in th e cost o f in ve n to ry? W h a t is n o t in c lu d e d in th e cost o f in ve n to ry?
9
W h a t do es th e term 'in v e n to ry c o st flo w a s s u m p tio n ' m ean?
1 0 E x p la in th e im p a c t o n th e fin a n c ia l statem ents o f using FIFO, w e ig h te d a v e ra g e a n d LIFO. W h e n w o u ld th e th ree m e thods g iv e s im ila r p ro fit fig u re s? W h e n w o u ld th e y g iv e id e n tic a l p ro fit figure s? 11 W h ic h c o st flo w a s su m p tio n d o y o u b e lie v e g ive s th e m ost a p p ro p ria te asset fig u re in tim es o f ris in g prices? 12 E x p la in th e c o n c e p t o f lo w e r o f c o st a n d net re a lis a b le v a lu e fo r in ve n to ry. 13 W h y is th e v a lu a tio n o f in v e n to ry im p o rta n t to m a n a g e rs ? 14 L in d e r w h ic h c ircu m s ta n ce s w o u ld e a ch o f th e fo llo w in g in v e n to ry cost flo w a ssu m p tio n s be a p p ro p ria te ? a s p e c ific id e n tific a tio n (a c tu a l cost o f item s o n hand) b
LIFO c o st flo w a s su m p tio n
c
a v e ra g e cost flo w assu m p tio n
d
FIFO cost flo w a s su m p tio n
e
c o st estim a te v ia d e d u c tio n o f m a rk-u p fro m se llin g p ric e (e .g . re ta il m ethod)
15 A re in ve n to rie s a lw a y s c u rre n t assets? 16 W h a t is th e c o n n e c tio n (if an y) b e tw e e n a c o m p a n y 's reven ue re c o g n itio n p o lic y a n d its in v e n to ry cost d e te rm in a tio n p o lic y ? 1 7 S u p p o se y o u w e re a s h a re h o ld e r in a c o m p a n y th a t s w itc h e d its in v e n to ry c o stin g m e th o d fro m FIFO to w e ig h te d a v e ra g e a n d , as a result, th e c o m p a n y 's re p o rte d net p ro fit d ro p p e d b y $ 2 m illio n . W h a t w o u ld be y o u r re a c tio n ? E x p la in . 18 If m a n a g e m e n t o v e rs ta te d th e v a lu a tio n o f in v e n to ry , w o u ld it a ffe c t p ro fit fo r th e y e a r?
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377
PROBLEMS PROBLEM 9.1 FIFO and LIFO in ve n to ry cost calculation s The fo llo w in g tra n s a c tio n s o c c u rre d in re la tio n to th e w id g e t in v e n to ry o f H a c k a c k Ltd d u rin g th e m onth o f July. Date J u ly
Transaction 1
B e g a n o p e ra tio n s b y p u rc h a s in g 3 0 0 w id g e ts fo r $ 6 . 0 0 e a c h
8
S o ld 5 0 w id g e ts fo r $ 7 . 0 0 e a c h
12
S o ld 1 5 0 w id g e ts fo r $ 7 . 0 0 e a c h
13
B o u g h t 5 0 0 w id g e ts fo r $ 5 . 0 0 e a c h
20
S o ld 4 0 0 w id g e ts a t $ 6 . 0 0 e a c h
22
S o ld a fu rth e r 1 0 0 w id g e ts a t $ 5 . 5 0 e a c h
24
B o u g h t a fu rth e r 2 0 0 w id g e ts a t $ 4 . 0 0 e a c h
29
S o ld 1 5 0 w id g e ts a t $ 5 . 0 0 e a c h
C a lc u la te th e C O G S a n d gross p ro fit fo r July, a ssu m ing a p e rp e tu a l in v e n to ry system is e m p lo y e d : 1 usin g FIFO 2
usin g LIFO
PROBLEM 9.2 C alculations For p e rp e tu a l versus p e rio d ic in ventory R a z z a m a ta z z Ltd uses a p e rp e tu a l in v e n to ry c o n tro l system . The fo llo w in g d a ta a re a v a ila b le :
$ In v e n to ry o n h a n d a t th e b e g in n in g o f th e y e a r ( 1 0 0 0 0 0 u n its a t $ 5 c o s t e a ch )
500000
P u rch a se s fo r th e y e a r ( 8 5 0 0 0 0 u n its a t $ 5 c o s t e a ch )
4250000
S a le s fo r th e y e a r (8 6 5 0 0 0 u n its a t $ 1 1 p r ic e e a c h )
9515000
In v e n to ry o n h a n d a t e n d o f th e y e a r ( 7 0 0 0 0 u n its a t $ 5 c o s t e a ch )
350000
1
C a lc u la te th e C O G S e x p e n s e fo r th e y e a r, b a se d o n th e c o m p a n y 's p e rp e tu a l in v e n to ry system .
2
If th e c o m p a n y h a d be en using th e p e rio d ic in v e n to ry m e th o d , w h a t w o u ld th e C O G S e x p e n s e fo r th e y e a r ha ve been?
3
A p e rp e tu a l system costs m o n e y to o p e ra te . Is it lik e ly to be w o rth w h ile fo r R a z z a m a ta z z ?
PROBLEM 9.3 Journal entries For p e rp e tu a l and p e riodic inventory The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c c o u n tin g re c o rd s o f Frog Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 :
$ In v e n to ry 1 J u ly 2 0 1 5
40000
P u rch a se s (a ll c re d it)
120000
S a le s (a ll c re d it)
210000
In v e n to ry 3 0 Ju n e 2 0 1 6
19 8 0 0
O p e r a tin g e x p e n s e s (a ll ca sh)
35 000
T h e c o m p a n y 's m a rk -u p is 5 0 p e r c e n t o n co st.
378
1
2
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A s su m in g a ll pu rch ases a n d sales w e re in s in g le tra n s a c tio n s , p re p a re s u m m a ry jo u rn a l en trie s a n d clo s in g en trie s usin g: a
p e rp e tu a l in v e n to ry
b
p e rio d ic in ve n to ry.
P re p a re in co m e statem ents fo r th e y e a r e n d e d 3 0 June 2 0 1 6 using b o th in v e n to ry systems.
PROBLEM 9.4 Journal entries to r p e rp e tu a l and p e rio d ic in ve ntory The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c c o u n tin g re c o rd s o f B ra g g Ltd fo r y e a r e n d e d 3 0 June 2 0 1 6 :
$ In v e n to ry 1 J u ly 2 0 1 5
30000
P u rch a se s (a ll c re d it)
110000
S a le s (a ll c re d it)
180000
In v e n to ry 3 0 Ju n e 2 0 1 6
18 6 0 0
O p e r a tin g e x p e n s e s (all ca sh )
35 000
T h e c o m p a n y 's m a rk -u p is 5 0 p e r c e n t o n c o s t
1
2
A s su m in g a ll pu rch ases a n d sales w e re in s in g le tra n s a c tio n s , p re p a re s u m m a ry jo u rn a l en trie s a n d clo s in g en trie s usin g: a
p e rp e tu a l in v e n to ry
b
p e rio d ic in ve n to ry.
P re p a re in co m e statem ents fo r th e y e a r e n d e d 3 0 June 2 0 1 6 using b o th in v e n to ry systems.
PROBLEM 9.5 E ffects o f change from p e rp e tu a l to p e rio d ic in ventory F rog m o rton Fashions b e g a n the p e rio d w ith in ve n to ry c o stin g $ 3 0 0 0 0 . D u rin g the p e rio d , $ 1 2 5 0 0 0 o f a d d itio n a l in ve n to ry w a s p u rch a s e d . A t the en d o f the p e rio d , a p h ys ic a l c o u n t s h o w e d th a t in ve n to ry costing $ 3 8 0 0 0 w a s on h a n d . The firm 's p e rp e tu a l in ve n to ry system sh o w e d th a t in ve n to ry c osting $ 1 1 4 0 0 0 h a d been sold d u rin g th e p e rio d . The g e n e ra l m a n a g e r says, 'It's a b o th e r k e e p in g tra c k o f o u r in v e n to ry th e w a y w e d o - o u r p e rp e tu a l system re q u ire s co n tin u o u s a tte n tio n to in v e n to ry costs. W h a t if w e just used th e p e rio d ic m e th o d ? W h a t d iffe re n c e w o u ld it m a k e ? ' G iv e y o u r re p ly .
PROBLEM 9.6 COG S/closing in ve n to ry XYZ c o m m e n c e d o p e ra tio n s on 1 June 2 0 1 6 s e llin g o n e ty p e o f sh irt. The c o m p a n y uses FIFO (first in , first out) a n d p e rp e tu a l in v e n to ry c o n tro l. The June in v e n to ry a n d sales re c o rd s fo r th e shirts w e re as fo llo w s : Date Ju ne
Purchase price unit
Units purchased
1
$1 1
1 500
1500
10
$12
900
2 400
$14
600
12 17
300
23 27
$13
$15
Selling price per unit
$15
200
Units on hand
2 100 2 700
1800
$15
700
$17
1 500
29 30
Units sold
900 2 400 1 700 1 900
CHAPTER 9
1
C a lc u la te C O G S fo r th e m onth e n d e d 3 0 June 2 0 1 6 .
2
C a lc u la te th e c o st o f e n d in g in v e n to ry as a t 3 0 June 2 0 1 6 .
Inventory
379
3
C a lc u la te gro ss p ro fit fo r th e m o nth e n d e d 3 0 June 2 0 1 6 .
4
A ssum e th a t o n 3 0 June, a to ta l o f 4 0 0 units (not 2 0 0 units) w e re p u rc h a s e d fo r $ 1 5 e a c h . C a lc u la te th e gross p ro fit fo r th e m onth e n d e d 3 0 June 2 0 1 6 , b a se d on this a ssu m p tio n .
PROBLEM 9.7 FIFO, LIFO, low er o f cost and n e t realisable value D iz z y L izzy, a n e n tre p re n e u ria l fo rtu n e te lle r, a ls o sells ta ro t c a rd s as a p ro fita b le s id e lin e to he r h ig h ly successful te le p h o n e c la irv o y a n t s e rvice . The fo llo w in g in fo rm a tio n relates to tra n s a c tio n s c o n c e rn in g in v e n to ry fo r th e y e a r 1 J a n u a ry 2 0 1 6 to 31 D e c e m b e r 2 0 1 6 . Date
Purchased
Sold
1 10 @ $5
1 /1 /1 6 1 0 /2 /1 6
80 @ $6
1 4 /4 /1 6 9 /5 /1 6
60 110 @ $7
2 4 /7 /1 6 2 1 /1 0 /1 6
120 10 0 @ $8
1 2 /1 1 /1 6 T o ta l
1
2
Balance
90 290
270
A s su m in g th a t a p e rp e tu a l system o f in v e n to ry flo w is used, c a lc u la te th e C O G S a n d c lo s in g in v e n to ry fo r: a
FIFO
b
LIFO.
Y ou e s tim a te th a t in th e c u rre n t m a rke t th e net re a lis a b le v a lu e o f ta ro t c a rd s is $ 5 p e r unit. D o y o u need to m a ke a n y a d ju stm en ts to e ith e r o f y o u r c a lc u la tio n s a b o v e to a p p ly th e lo w e r o f cost a n d net re a lis a b le v a lu e rule? If so, c a lc u la te th e a d ju stm e n t.
PROBLEM 9.8 Cost Flow assum ptions The B a b yS tyle C o m p a n y is a re ta il firm b u y in g a n d s e lling a s in g le p ro d u c t: p ra m s fo r b a b ie s . A system o f p e rp e tu a l in v e n to ry is e m p lo y e d . D u rin g th e six m onths e n d e d 3 0 June 2 0 1 6 th e in v e n to ry a c tiv ity w a s as fo llo w s : Purchases J a n u a r y c o m m e n c e d b u siiness, b u y in g 2 0 u n its a t $ 5 p e r u n it M a rc h
3 0 u n its a t $ 6 p e r u n it
M ay
3 5 u n its a t $ 7 p e r u n it
Sales
1
F e b ru a ry
1 5 u n its a t $ 1 0 p e r u n it
A p r il
3 0 u n its a t $1 1 p e r u n it
Ju n e
3 0 u n its a t $ 1 2 p e r u n it
C a lc u la te th e C O G S fo r th e six m onths a n d th e c lo s in g b a la n c e o f in v e n to ry , a s su m in g : a
LIFO
b
FIFO
c
M o v in g a v e ra g e .
380
2
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W h a t is th e gro ss p ro fit fo r th e p e rio d , a s su m in g : a
LIFO?
b
FIFO?
c
M o v in g a v e ra g e ?
3
B rie fly d e sc rib e a cost-based in ve n to ry v a lu a tio n m ethod o th e r than LIFO, FIFO o r W e ig h te d /M o v in g a v e ra g e cost.
4
C o m p a re th e effects o f LIFO a n d FIFO o n b a la n c e sheet v a lu a tio n o f in v e n to ry a n d net p ro fit in p e rio d s of:
5
a
ris in g price s
b
fa llin g price s
In w h a t c ircu m sta n ce s w ill a c co u n ta n ts d e p a rt fro m a cost-based v a lu a tio n fo r in ve n to rie s ?
PROBLEM 9.9 FIFO, LIFO, n e t realisable value The fo llo w in g d a ta relates to Fay Ltd, a c o m p a n y th a t buys a n d sells o n ly o n e p ro d u c t: | Date M ay
1
2
3
Transaction 1
1 0 0 0 u n its o n h a n d a t $ 6 p e r u n it
2
P u rc h a s e d 1 2 0 0 u n its fo r $ 7 p e r u n it
11
8 0 0 u n its w e r e s o ld f o r $ 7 . 5 0 p e r u n it
22
9 0 0 u n its w e r e p u rc h a s e d fo r $ 7 . 5 0 p e r u n it
30
1 1 0 0 u n its w e r e s o ld fo r $ 8 . 0 0 p e r u n it.
C a lc u la te th e cost o f e n d in g in v e n to ry a n d th e C O G S , a s su m in g : a
a p e rp e tu a l system usin g th e LIFO cost flo w a s su m p tio n
b
a p e rio d ic system usin g th e w e ig h te d a v e ra g e m e tho d.
A ssum e th a t, a t th e e n d o f th e m o nth, y o u d is c o v e r th a t th e net re a lis a b le v a lu e o f e a ch item is $ 6 .5 0 . C a lc u la te a n d p re p a re th e jo u rn a l e n try to a d ju s t in v e n to ry re c o rd s, if re q u ire d , a ssu m in g : a
p e rp e tu a l system using th e LIFO c o st flo w a s su m p tio n
b
p e rio d ic system using th e w e ig h te d a v e ra g e m e tho d.
W ith o u t re p e rfo rm in g a n y c a lc u la tio n s , b rie fly e x p la in the p o te n tia l effects on th e c o m p a n y 's fin a n c ia l statem ents if a FIFO ra th e r th a n a LIFO in v e n to ry c o st flo w a s su m p tio n w a s a d o p te d .
PROBLEM 9.10 FIFO, LIFO and n e t realisable value H a m is h 's S lo t C a rs Pty Lim ited is a n im p o rte r o f h ig h -q u a lity ra c in g tra cks a n d slot c a rs. The fo llo w in g a re e xtra cts fro m th e c o m p a n y 's fin a n c ia l statem ents fo r th e y e a r e n d e d 31 M a rc h 2 0 1 6 . N o t e 1 - A c c o u n tin g p o lic ie s I n v e n to r y
Inventories on hand and in tra n sit are valued at th e low er o f co st and n e t realisable value. C o s t is d e te rm in ed using periodic F IF O m e th o d o lo g y fo r slot cars and perpetual m oving w eighted average fo r racing tracks.
N o t e 9 - In v e n to r y
A t 31 March 2 0 1 6 Quantity S lo t c a rs R a c in g tra c k s (T yp e A )
Price $
Total $
250
0 .5 0
1 2 5 .0 0
12
1 5 0 .0 0
1 8 0 0 .0 0 1 9 2 5 .0 0
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Inventory
381
The fo llo w in g in fo rm a tio n relates to transactions du ring th e m o n th o f A p ril 20 16: W e e k ended 6 A p ril 2 0 1 6
1 Sales
Purchases
3 April: 150 slot cars at $ 1.00 each
4 April: 350 slot cars at $0.47 each
3 April: 2 racing track sets (Type A) at $220 each
4 April: 2 racing track sets (Type A) at $160 each
On 5 April, a racing track set (Type A) was discovered to have been stolen. W e e k ended 13 A p ril 2 0 1 6
| Sales 1 1 April: 380 slot cars at $1.00 each
Purchases 12 April: 300 slot cars at $0.50 each
W e e k ended 2 0 A p ril 2 0 1 6
Sales
Purchases
19 April: 280 slot cars at $1.00 each
17 April: 150 slot cars at $0.50 each
16 April: 1 racing track set (Type A) at $220 each
18 April: 2 racing track sets (Type A) at $170 each
W e e k ended 2 7 A p ril 2 0 1 6
Sales
Purchases
24 April: 300 slot cars at $1.00 each
23 April: 350 slot cars at $0.55 each
26 April: 4 racing track sets (Type A) at $220 each A d d it io n a l in f o r m a t io n
A physical c o u n t o f slot cars in th e shop fo llo w in g close o f business on 3 0 A p ril 2 0 1 6 indicated th e re w ere 2 9 0 slot cars and e igh t racing tra c k sets (T ype A ) on hand.
1
C a lc u la te C O G S fo r A p r il 2 0 1 6 a n d c lo s in g in v e n to ry as a t 3 0 A p r il 2 0 1 6 fo r slot c a rs a n d fo r ra c in g tra c k sets.
2
O n a v e ra g e , prices o f slot cars have increased o v e r the last fe w m onths. If the c o m p a n y d e c id e d to c h a n g e its in ve nto ry p o lic y fo r slot cars fro m FIFO to LIFO, e x p la in the like ly d ire c tio n o f the im p a c t on p ro fit fo r the m onth o f A p ril 2 0 1 6 .
3
O n 3 0 A p ril 2 0 1 6 a n e w type o f ra c in g tra ck set (Type B) w a s released b y the su p p lie r a n d is like ly to be v e ry p o p u la r. The c o m p a n y estim ates th a t to sell its in ve nto ry o f ty p e A ra c in g tra ck sets d u rin g M a y 2 0 1 6 it w ill need to d iscou nt them to $ 1 3 2 . W h a t jo u rn a l e ntry, if a n y, should be re c o rd e d in A p ril 2 0 1 6 in relation to this in form ation?
PROBLEM 9.11 FIFO and LIFO in ve n to ry cost calculation s The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c c o u n tin g re c o rd s o f G o ld e n Ltd fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 . G o ld e n Ltd uses a p e rp e tu a l in v e n to ry system .
382
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
D e te rm in e the cost o f e n d in g in v e n to ry as a t 31 D e c e m b e r 2 0 1 6 a n d th e cost o f g o o d s s o ld a n d gross p ro fit fo r the y e a r e n d e d 31 D e c e m b e r 2 0 1 6 a s su m in g : 1 FIFO 2
LIFO.
PROBLEM 9.12 FIFO and LIFO in ve n to ry cost calculation s The fo llo w in g tra n s a c tio n s re la te to a c o m p u te r g a m e sold b y W ile y Louvres Ltd fo r th e p e rio d 1 J a n u a ry to 31 D e c e m b e r 2 0 1 6 : | Date
1
Transaction
January 1
Beginning inventory - 4 units @ $ 150
March 3
Purchased 5 units @ $160
April 9
Sold 6 units
M ay 10
Purchased 5 units @ $165
August 22
Sold 4 units
D e te rm in e th e cost o f e n d in g in v e n to ry as a t 31 D e c e m b e r 2 0 1 6 a n d th e C O G S fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 , a s su m in g : a
a p e rio d ic system a n d th e FIFO m e tho d
b
a p e rio d ic system a n d th e LIFO m e tho d
c
a p e rp e tu a l system a n d th e LIFO m e tho d
d
a p e rp e tu a l system a n d th e FIFO m e tho d. S h o w s u p p o rtin g c a lc u la tio n s fo r e a c h case.
2
A s th e a b o v e d a ta s h o w , no units o f th e c o m p u te r g a m e w e re sold in th e last fo u r m onths o f th e y e a r. The m a rk e tin g m a n a g e r is c o n c e rn e d th a t th e cost o f th e re m a in in g ga m e s w ill n o t be re c o v e re d . E x p la in w h a t effect, if a n y , th e re w o u ld be on th e fin a n c ia l statem ents if th e fo llo w in g o c c u rre d : a
The net re a lis a b le v a lu e o f th e g a m e , as a t 31 D e c e m b e r, w a s e s tim a te d a t $ 1 5 2 p e r un it a n d LIFO w a s used in c o n ju n c tio n w ith th e p e rp e tu a l system .
b
The net re a lis a b le v a lu e o f th e g a m e , as a t 31 D e c e m b e r, w a s e s tim a te d a t $ 1 5 5 p e r u n it a n d FIFO w a s used in c o n ju n c tio n w ith th e p e rio d ic system .
c
The net re a lis a b le v a lu e o f th e g a m e , as a t 31 D e c e m b e r, w a s e s tim a te d a t $ 1 5 2 p e r un it a n d LIFO w a s used in c o n ju n c tio n w ith th e p e rio d ic system . S h o w c a lc u la tio n s to s u p p o rt y o u r a n sw e rs .
PROBLEM 9.13 Analyse various possible in ve n to ry costing policies Y a n g Ltd has been in business fo r th re e y e a rs a n d pa ys in c o m e ta x a t 3 0 p e r cent. The c o m p a n y m a n a g e s its in ve n to rie s w e ll, so th e re a re no s ig n ific a n t in ve n to rie s fo r w h ic h cost is less th a n net re a lis a b le v a lu e . H e re a re the c o m p a n y 's in v e n to ry asset a n d C O G S e x p e n s e fo r th e p a st th re e y e a rs , c o m p u te d u n d e r e a ch o f th re e m e thods: 2016
2015
2014
$
$
$
Ending inventory
112 00 0
148 00 0
115 00 0
COGS expense
636000
867000
585000
FIFO
AVGE Ending inventory
108 00 0
126 00 0
106000
COGS expense
618000
880000
594000
CHAPTER 9
»
Inventory
383
LIFO Ending inventory
104 00 0
1 1 8 00 0
92000
COGS expense
614000
874000
608 000
600000
900000
700000
Purchases in each year
1
D e te rm in e th e in v e n to ry c o st p o lic y th a t w o u ld p ro d u c e th e h ig h e st a n d lo w e st p ro fit in e a ch y e a r a n d c a lc u la te th e e ffe c t on net p ro fit o f c h o o s in g th e fo rm e r o v e r th e la tte r.
2
G iv e n th e v a ria tio n o f results y o u o b s e rv e d in q u e s tio n 1, h o w sh o u ld a c o m p a n y c h o o se its in v e n to ry cost p o lic y ?
PROBLEM 9.14 Inve n to ry co st and m arket calculation s W in e d a rk Sea Ltd sells p rin ts o f c la ssic p a in tin g s . The p rin ts a re d o n e on e x p e n s iv e p a p e r a n d a re q u ite costly. P ricin g th e p rints to sell is h a rd b e ca u s e th e p o p u la rity o f a p rin t is d iffic u lt to p re d ic t. S om etim es prints d o n 't sell w e ll a t a ll a n d a re then d is p o s e d o f in b u lk fo r use in hotels a n d m otels. H e re a re d a ta o n tw o prints: Print X Units
Print Y
Cost per unit
Units
$ Inventory, 1 January 201 6
Cost per unit $
4
340
11
500
January-June
10
350
25
480
July-December
15
330
30
510
Purchases during 2016:
Sales during 2016
1
2
23
38
C a lc u la te th e fo llo w in g : a
In ve n to ry cost, 31 D e c e m b e r 2 0 1 6 , fo r Print X, FIFO ba sis
b
C O G S , 2 0 1 6 , fo r Print Y , A V G E basis
P rint Y h a s n 't s o ld since S e p te m b e r. N o o n e seem s to like it a n y m o re. A n out-of-tow n hotel has o ffe re d $ 1 0 0 fo r e a ch Print Y th a t W in e d a rk has left, if W in e d a rk w ill p a y th e $ 1 0 p e r p rin t s h ip p in g cost. W h a t a m o u n t w o u ld y o u sugg est be used fo r th e in v e n to ry o f P rint Y o n th e 31 D e c e m b e r 2 0 1 6 b a la n c e sheet? W h y ?
PROBLEM 9.15 Inve n to ry and Fraud In ve n to ry is an asset th a t is c o m m o n ly s u b je c t to fra u d . In o n e fa m o u s ca se in th e U n ite d States, m a n a g e rs used fic titio u s in v e n to ry pu rch ases to p e rp e tu a te a m assive in v e n to ry fra u d . M in iS c rib e C o rp o ra tio n w a s a c o m p a n y th a t m a n u fa c tu re d a n d s o ld c o m p u te r e q u ip m e n t. The fra u d in v o lv e d p la c in g b rick s in th e bo xe s d e s ig n e d fo r m e rc h a n d is e , s h ip p in g them to custom ers a n d re c o rd in g a sale w h e n th e b o x w a s s h ip p e d .1 1 W h a t w o u ld be th e e ffe c t on th e in c o m e state m e nt a n d th e b a la n c e sheet o f s h ip p in g b rick s a n d re c o rd in g those sh ip m e n ts as sales? 2
W o u ld this fra u d be e ffe c tiv e in th e lo ng run?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASES CASE 9A
Woolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu estio ns re la te to the c o n s o lid a te d a cco u n ts. 1 W o u ld y o u e x p e c t W o o lw o rth s Lim ited to use a p e rp e tu a l o r p e rio d ic m e th o d o f in v e n to ry v a lu a tio n ? 2
Does th e c o m p a n y a p p ly th e lo w e r o f cost a n d net re a lis a b le v a lu e rule? W h e re is th is no ted ?
3
W h a t cost flo w a ssu m p tio ns a re used to v a lu e in ve n to ry?
CASE 9B
Inventory w rite-down
Treasury Wine faces class action over US disclosure T re a s u ry W in e E s ta te s , t h e w o r ld ’s la rg e s t p u r e - p la y w in e m a k e r, s h o c k e d m a rk e ts a n d in v e s to rs in J u ly w h e n it a d m itte d an o v e rs u p p ly o f p o o r a n d u n w a n te d w in e in th e U n ite d S ta te s w o u ld t r ig g e r a $ 1 6 0 m illio n w r it e d o w n a n d in c lu d e a $ 3 5 m illio n c h a rg e t o d e s tro y p a s t - its - d a te w in e s to c k s . T h e p r o f it w a rn in g a n d w r i t e - o f f saw T re a s u ry W in e E s ta te s s h a re s p lu n g e m o r e th a n 12 p e r c e n t a n d la te r led t o th e e je c tio n o f its c h ie f e x e c u tiv e , D a v id D e a rie . Source: Eli G reenblat, Sydney Morning Herald, 2 8 O cto b er, 2013.
1
W h a t w o u ld be th e jo u rn a l e n try fo r th e w rite -d o w n s ?
2
W h y w o u ld a w rite -d o w n in in v e n to ry le a d to a d e c lin e in sh a re p rice ?
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m p r e p a r a tio n to o ls . >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
>
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
NOTE 1
For more inform ation about the M in iS crib e case refer to h ttp ://a rtic le s .la tim e s .c o m /1 9 9 4 -0 8 -0 9 /b u s in e s s /fi-2 5 2 8 9 _ l_ d is k -d riv e .
Noncurrent assets ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: calculate the cost of an asset explain the concept o f depreciation calculate the am ount of depreciation using different d epreciation methods explain how the different methods of depreciation have an im pact on profit and the b a la n c e sheet explain how the purchase an d sale of a noncurrent asset affects the financial statements a n d the perform ance of m anagers p re p a re journal entries for the purchase, sale and depreciation o f equipm ent identify the m ain types o f intangible assets explain w h a t is m ean by im pairm ent p re p a re the accounting entries for asset revaluations explain the disclosure requirements for noncurrent assets.
CHAPTER OVERVIEW In th is c h a p te r w e w ill c o n s id e r th re e m a jo r c a te g o rie s o f n o n c u rre n t assets: p ro p e rty , p la n t a n d e q u ip m e n t; in ta n g i b le assets; a n d g o o d w ill. 'P ro p e rty , p la n t a n d e q u ip m e n t' refers to lo n g -te rm assets th a t a re a c q u ire d b y a n o r g a n i s a tio n fo r use in th e o rg a n is a tio n , o v e r tw o o r m o re a c c o u n tin g p e rio d s , fo r th e p ro d u c tio n o f g o o d s a n d service s. E x a m p le s in c lu d e la n d , b u ild in g s , m a c h in e ry , e q u ip m e n t, fu rn itu re , fittin g s a n d m o to r v e h ic le s . In ta n g ib le assets a re id e n tifia b le n o n -m o n e ta ry assets th a t d o n o t h a ve a v is ib le p h y s ic a l e x is te n ce , u n lik e la n d , b u ild in g s , e q u ip m e n t a n d so o n . E x a m p le s o f in ta n g ib le assets in c lu d e p a te n ts , c o p y rig h ts a n d in te rn e t d o m a in na m e s. G o o d w ill a n d in ta n g ib le assets w ill be d e s c rib e d la te r in th e c h a p te r.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
10.1 The cost of an asset: basic components The basic premise o f historical cost valuation is to use the cost o f an asset, at acquisition, to value that asset on the b alance sheet. O n the surface, this looks sim ple: you buy a truck for $ 2 5 0 0 0 an d value the truck at $ 2 5 0 0 0 . H ow ever, there is often m ore to the cost o f an asset than just the sim ple invoice cost o r direct cost. For exam ple, w hen you purchase a b ig com puterised m anufacturing m achine, it m ay cost you $ 5 0 0 0 0 0 for the actual m achine. But in order to use the m achine, certain environm ental conditions must exist, such as tem perature control, a raised floor for w irin g a n d a fire protection system. Therefore, a section o f the factory must be renovated to meet the specifications of the m achine. These costs, known as installation costs, are a g o o d exam ple o f expenditures that are a com ponent o f the asset's cost. O verall, the cost o f an asset includes all those costs required to install it re a d y fo r use. That can sometimes be difficult to determ ine. For exam ple, suppose an enterprise constructs a specialised n e w m anufacturing m achine, using some o f its regular em ployees an d resources. The cost o f such assets, w h ich an enterprise constructs for itself rather than buying finished, w ill obviously include the cost of ra w materials a nd labour needed to make them. But should the interest on monies b o rro w e d to fin a n ce the project be included? This is a matter of judgem ent, an d depends on the situation. Sometimes interest is included in the cost o f such assets; most of the tim e it is not. Enterprises often have policies for h o w to determ ine w hether expenditures, such as interest, a re included in assets' costs. These policies are designed to ensure that there is consistency in calcula tin g cost a nd to fit the accounting to the enterprise's particular circumstances. Usually, note 1 to the fin a n cia l statements discloses the p o lic y w ith respect to interest. D eciding w h a t to include in an asset's cost can make quite a difference to the enterprise's fin a n cia l statements. Suppose G o n d o la Ltd has spent $ 1 0 0 0 0 0 this ye a r on supervisors' salaries in connection w ith setting up a new mountain g o n d o la ride a t M o u n t Kosciuszko. If that cost is just deducted from revenue as an expense this year, that w ill reduce profit a n d incom e tax expense. But if the cost is a d d e d to the g o n d o la ride asset instead, total assets w ill be higher, and this year's p rofit an d incom e tax expense w ill be higher too. O v e r the next several years, profits and incom e tax expenses w ill be lo w e r because o f higher d e p re cia tio n on the higher asset cost. So, a sid e from accounting a p p ro p ria te ly a n d fa irly for the asset, the decision a b o u t h o w to handle the supervisors' salaries w ill affect profit, assets a n d incom e tax expenses this year, an d in several future years. This decision is often c a lle d the c apitalising versus e xp e n sin g c h o ice (including the expenditure w ith the assets versus deducting it as an expense in the current year), a nd you w ill see it several times in this book. In summary, the com ponents o f the cost o f an asset include all those costs that a re required to make it suitable for the purpose intended, w hether it be making a m achine usable in the production process o r brin g in g inventory into saleable cond itio n . Some com m on com ponents o f the cost o f an asset are listed in Exhibit 1 0 .1 .
EXHIBIT 10.1
COMMON COMPONENTS OF ASSET COST LAND, B U ILD IN G S, E Q U IP M E N T
a
Land: • • •
b
B uilding (purchased): • • •
c
purchase price, including real estate agent com m issions costs o f obtaining clear title, such as legal fees and title searches costs o f clearing, rem oving unw anted structures, draining and landscaping, purchase price renovation and upgrading costs to make it suitable fo r the intended use initial painting and decoration,
B uilding (self-constructed): • • •
materials costs labour costs (including em ployee benefits arising d irectly fro m co n stru ctio n ) excavating, surveying, engineering and design costs
• •
insurance w h ile co n stru ctin g the building perhaps som e overhead costs and even financing costs incurred during co nstruction.
»
CHAPTER 10
d
N oncurrent assets
387
Purchased equipment: • purchase price including taxes • tran sp o rta tio n costs • installation costs • testing costs • overhauls th a t extend the equipm ent's life o r increase its value (betterm ents).
In the years fo llo w in g acquisition, the question o f w hether the asset cost should be ch a n g ed w ill c ro p up a g a in w hen repairs must be m ade. W h e n a m ajor repair or a p p a re nt im provem ent in the asset is d one, the question to ask yourself is w hether the asset's productivity o r e fficie n cy has been im proved, o r its useful life extended. If so, there has been a betterm ent o f the asset a nd the cost o f that should be ca p ita lise d (a d d e d to the cost o f the asset). If not, the cost should just be ch a rg e d to an expense, such as an a ccount ca lle d repairs a nd m aintenance expense.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: M a g n u s F a b ric a to rs L td has ju s t c o n s tr u c te d a n e w fa c to r y b u ild in g u s in g c o m p a n y e m p lo y e e s and e q u ip m e n t f o r m o s t o f th e w o rk . T h e c o m p a n y ’s a c c o u n ta n t has said: V a r io u s c o s ts m u s t be c a p ita lis e d to p ro d u c e an a p p ro p ria te b a la n c e s h e e t fig u re f o r th e b u ild in g ’s c o s t.’ W h ic h o f th e fo llo w in g c o s ts s h o u ld be in c lu d e d : a r c h ite c t’s c o s ts , re m o v a l o f th e o ld fa c to r y , e x c a v a tio n , th e a m o u n t paid to w o rk e rs w h o d id th e c o n s tr u c tio n , e m p lo y e e b e n e fit c o s ts to s t a f f w o rk in g o n th e c o n s tr u c tio n , an d an e s tim a te o f c o s ts to m a in ta in th e fa c to r y o v e r th e n e x t fiv e y e a rs ? Y o u r a n sw e r shou ld be: all o f th e ab ove c o sts w o u ld be in c lu d e d e x c e p t ‘an e s tim a te o f c o sts to m a in ta in th e fa c to ry o v e r th e n e x t fiv e y e a rs ’. T h is is a fu tu re c o s t th a t w o u ld be in clu d e d in expenses in ea ch o f th e fiv e years.
10.2
Depreciation of assets and depreciation expense
Assets such as property, plant an d equipm ent have value because the c o m p a n y intends to receive econom ic benefits from using them in the future. H ow ever, w ith the exception of land, all these assets must eventually be retired from service. Therefore, w hen purchasing an asset such as a building o r equipm ent, the rational purchaser w ill at least have an a p p ro xim a te idea o f h o w much benefit the asset w ill p rovide. For exam ple, w hen buying a piece of equipm ent to slice bread, the baker must have a reasonable id e a o f h o w m any years the equipm ent w ill last o r h o w m any loaves it w ill slice before it w ears out. If w e can estim ate h o w m any loaves it w ill slice, w e can then d educt the cost of the m achine from revenue (in calculating profit) a part a t a time, over the num ber o f years it w ill take to bake that m any loaves o f b read. The process o f a llo ca tin g the cost over years of benefit is ca lle d d e p re cia tio n , a n d the annual deduction from revenue is de p re cia tio n expense. A ll property, plant a nd equipm ent assets - except land - are d epre cia te d under generally acce p te d accounting principles (GAAP). A short com m ent on term inology m ay be helpful here. This section, an d this b o o k in general, use the terms 'am ortisation', 'd e p re cia tio n ' a nd 'd e p le tio n '. In Australia, d e p re cia tio n is used w hen physical assets, such as buildings an d equipm ent, are involved; d epletion is used w hen w a stin g assets, such as tim ber sales o r o re bodies, are involved; a n d am ortisation is used w hen various intangible assets an d leases a re involved. The usage is c h ang in g in some countries (such as C a n a d a ) tow ards using the term 'am ortisation' in all three cases. Several questions need to be answ ered before w e present exam ples o f de p re cia tio n m ethods. These are outlined b elow .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W hy allocate the cost? Assets are resources o f the enterprise that a re used to generate revenue for the ow ners a n d , ultim ately, a return on their investment. O n e o f the objectives o f accrual accounting is to attem pt to match expenses w ith the revenue earned. In the case o f long-lived assets, the cost w ill benefit m any periods in w h ich revenue is earned. Therefore, some method is needed to a llo ca te the cost o f long-lived assets over their useful lives. If the w h o le asset cost w a s deducted from profit in the p eriod in w h ich it w a s a cq u ire d , that w o u ld make that period's profit relatively lo w , a nd subsequent periods' profits relatively high. It w o u ld also mean that an asset that has further benefits is not recognised. So, depreciation spreads the cost of the asset out over all the periods that share in the consum ption o f the asset's econom ic value. For exam ple: •
A bread slicer costs $ 5 0 0 0 a nd w ill have no value after e ig h t years. Therefore, d e p re cia tio n o f $ 5 0 0 0 over eight years ($ 6 2 5 o f de p re cia tio n expense each year) shows that using up the slicer's value over those e ig h t years costs us som ething. W e have a $ 5 0 0 0 asset n o w ; in eight years w e w ill have no asset.
•
This cost a llo ca tio n system is som ew hat arbitrary, because it is based on expectations that occur w hen the asset is acqu ire d , not on tracking changes in market value; for exam ple, over the tim e the asset is used. O v e r that time, the cost and resale value of slicers m ay keep c h a n g in g due to inflation, market conditions o r te chnological change. W e m ay be a b le to resell the slicer for o n ly $ 3 0 0 0 after o ne year, so perhaps the e co n o m ic value used up in that y e a r is $ 2 0 0 0 . N evertheless, if our de p re cia tio n method specifies $ 6 2 5 per year, that is w h a t w e use. It is essential to understand that the accounting co n ce p t of de p re cia tio n involves an a llo ca tio n o f cost in o rd e r to
measure profit. It is not a system to track value changes in assets o r to measure the current value o f those assets in the b alance sheet. D epreciation recognises an expense (based on historical cost) that it is presumed matches the revenue generated by using up the asset's econom ic value. The b a la n ce sheet shows the net o f the asset's o rig in a l cost minus accum ulated d e p re cia tio n : it does not mean the asset's current value is that net amount. In the a b o v e exam ple, after one year, the b a la n ce sheet shows the slicer a t $ 4 3 7 5 ( $ 5 0 0 0 cost less $ 6 2 5 ), not at $ 3 0 0 0 o r a n y other measure o f current value. The accounting m eaning o f dep re cia tio n is very specific: an allo ca tio n o f cost as a d eduction from p ro fit over the useful life o f the asset.
W hy no t depreciate land? The basic answ er to this question is that land's e co n om ic value is not considered to d e clin e through use. •
As a m achine is used in a production process it w ears out. O th e r natural processes, such as w in d , rain, rust,
•
There are also non-physical causes of e co n o m ic am ortisation. A m achine can becom e obsolete w ith the advent of
fatigue and corrosion, all keep assets from p ro vid in g benefit indefinitely.
new er a n d faster m achines; econom ic conditions in an area can result in the closure o f a plant that has many productive years left but cannot be pro fita b le a n y more. W h ile your m obile phone could last five years, new developm ents an d fashion m ay mean you no longer find it useful after tw o years. Land is considered to be immune from all this, and is therefore not d e p re cia te d . If e vidence o f a loss o f land value does a p p e a r, the land's cost can be reduced to a revised value, but that is a special case a nd is an im pairm ent (or w rite-dow n) rather than d e p re cia tio n . Im pairm ent is discussed later in this chapter.
W hen does cost allocation (depreciation expense) begin? D epreciation is meant to pro vid e an expense to match the e co n o m ic benefit o b ta in ed from the use o f the asset. Therefore, w hen the asset is put to use an d the benefit begins to be realised, de p re cia tio n expense should b egin. In C h a p te r 5 , journal entries for d e p re cia tin g assets as part o f accrual accounting w e re e xp la in e d . The general pattern is to capitalise costs incurred on the asset before putting it into service, an d then, w hen the asset is put into service, to depreciate those costs. This pattern is illustrated in the chart in Figure 1 0 .1 . The line sloping d o w n w a rd from cost need not be a straight one, as you w ill see.
CHAPTER 10
a cquisition o f asset
FIGURE 10.1
N oncurrent assets
asset is put into service
389
service life
When does depreciation begin?
O n c e the asset has been put into service, further costs involved in pa in tin g , m aintenance, repairs an d so on are n o w considered to be expenses - they a re part of the cost o f keeping the asset on its planned path o f d e cline over its useful life. If a cost that is incurred after the asset goes into service sig n ifica n tly changes that asset's e conom ic value in earning revenue o r extends its useful life, such a betterment m ay properly be ca p ita lise d as part o f the asset's cost, then d e p re cia te d a lo n g w ith the rest o f the asset's cost.
Other questions Does de p re cia tio n affect cash flo w ? Is it exact? W h a t effect does it have on incom e tax? D epreciation is recognised by the fo llo w in g journal entry: DR CR
Depreciation expense Accumulated depreciation
Accum ulated dep re cia tio n is a contra asset. The entry has no cash com ponent. Therefore, d e p re cia tio n has no cash effect. D epreciation, no matter h o w carefully it is calculated, is never exact. It involves a prediction o f e co n o m ic use and useful life, an d such a prediction can easily be w ro n g . A n y dep re cia tio n am ount is fundam entally arbitrary; for that reason, most com panies prefer fa irly sim ple calculations rather than co m p le x guesses! In A ustralia, a nd most other countries, a c o m p a n y does not necessarily have the sam e dep re cia tio n figure for accounting a nd tax purposes. For exam ple, the c o m p a n y m ay believe the asset has a life o f 1 0 years a nd therefore depre cia te it at 10 per cent per ye a r for accounting purposes. Tax rules m ay stipulate (or pro vid e a dvisory rates under self-assessment) that it is to be d e p re cia te d over l 2 years; that is, at 8 .3 3 per cent per year. Thus, the c h o ice for accounting purposes does not affect the tax p a id . D epreciation does not match actual market value changes in assets, it has no cash effect an d it is an estim ate only! W h a t g o o d is it? That's a question often asked, a nd the an sw e r goes b a ck to the m atching criterion a nd the historical cost basis of accrual a ccounting. W e know that some e conom ic value is being used up as a d e p re cia b le asset is used to earn revenue. W e end up w ith a w a y of spreading the cost out over the useful life o f the asset that matches the presum ed consum ption o f that cost w ith the benefits (revenue) g a in e d from that use.
390
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: Y o u p u t in to s e rv ic e a $ 5 0 0 0 0 0 m a c h in e o n 1 J u ly 2 0 1 6 . It has an e s tim a te d u s e fu l life o f fiv e years.
1 2
A t 3 0 J u n e 2 0 1 9 , w h a t is th e a c c u m u la te d d e p re c ia tio n an d w h a t is th e b o o k v a lu e ? H o w w o u ld it a p p e a r in th e b a la n c e s h e e t a t 3 0 J u n e 2 0 1 9 ? Y o u r a n s w e r s h o u ld be:
1 2
$300 000; $200 000. E q u ip m e n t
500 000
— A c c u m u la te d d e p re c ia tio n
300 000
E q u ip m e n t ( n e t)
200 000
10.3
Depreciation bases and methods
Several d e precia tio n methods are com m only used to d a y. Different methods attem pt to a p p ro xim a te different econom ic use patterns for the assets over their lives. In each case, the purpose is to match the d e p re cia tio n expense for each period w ith the presumed econom ic benefit o b ta in ed during that p e riod, often in a sim ple w a y , since depreciation is an estim ate rather than an exact measure of value changes. As noted in section 5 .5 , w h ich discusses contra accounts, the accum ulated d e p re cia tio n a ccount is a b a la n ce sheet offset account to the asset cost account. O v e r time, it accum ulates the total o f the dep re cia tio n expense recorded over the years. There are three basic assumptions a b o u t h o w an asset brings econom ic benefit, a nd one general kind of depreciation for each assum ption: Assumption 1 S p r e a d e v e n ly o v e r th e a s se t's life
Kind of cost allocation S tra ig h t-lin e
The consumption of economic benefits is equal throughout an asset's useful life.
Expense is the same each year of the useful life.
2 H ig h e s t in th e e a r ly y e a rs a n d d e c re a s e s o v e r th e a s s e t's life
R e d u c in g b a la n c e m e th o d
The consumption of economic benefits is higher in the earlier years than in the later years.
Expense is larger in the earlier years than in the later years.
3 V a r ia b le o v e r th e a s se t's life
U n its o f p r o d u c tio n
The consumption of economic benefits varies according to how much production is achieved each year.
Expense depends on each year's volume of production.
These three general kinds of d e p re cia tio n methods a re co m p a red g ra p h ica lly in Figure 1 0 .2 . Each has a different depreciation expense per p eriod a n d a different pattern o f b o o k value. (Book value equals cost minus accum ulated d e p reciation, so, because cost is constant, the b o o k value pattern com es from the accum ulation of the d epreciation.) Let's see h o w to calculate dep re cia tio n using the three different bases.
S tra ig h t-lin e depreciation Straight-line d e p re cia tio n , d e p icte d in the to p panel o f Figure 1 0 .2 , is the simplest a nd most w id e ly used o f all the depreciation m ethods. Three pieces o f inform ation are necessary in ord e r to calculate straight-line de p re cia tio n . •
cost o f the asset: the total cost to be d e p re cia te d over time (the am ount ca p ita lise d to the d a te the asset is put into service)
•
estim ated useful life o f the asset: the num ber o f periods for w h ich the asset is expected to benefit the enterprise
CHAPTER 10
Depreciation m ethod
Estimated value o f the asset in generating revenue, per period
N oncurrent assets
391
Resulting book value o f the asset at the end of the period
Straight-line
P e rio d s
Reducing balance
Units o f production
FIGURE 10.2 •
Three depreciation methods
estim ated salvage value: the am ount expected to be recovered via the sale o f the asset a t the end o f its useful life - w h ich is likely to be o n ly an educated guess, an d is often assumed to be ze ro for purposes of calculating d e p re cia tio n over long periods o f time. The formula for straight-line dep re cia tio n is: _ . . r . , Cost m inus estim ated salv a g e va lu e D epreciatio n fo r o n e p erio d = — ---------- j------- . , , --------j-----------------;— pr Estim ated useful life (num ber o f periods) Using the a b o v e form ula, annual dep re cia tio n on a d e live ry truck used by a local business w o u ld be calculated
this w a y : •
C ost o f the truck = $ 5 0 0 0
•
Estimated useful life = six years
•
Estimated sa lva g e value after six years = $ 8 0 0 .
_
. .
,
5 0 0 0 -8 0 0
D epreciatio n fo r one y e a r = --------- -r--------=
700
392
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A t the end o f the first year, the net b o o k value o f the truck w ill be: Cost - Total depreciation to date
=
$5000 - $700
=
$4300
Each ye a r the fo llo w in g journal entry w o u ld be m ade: $ DR
Depreciation expense
CR
$
700
Accumulated depreciation
700
D epreciation expense for each o f the six years w ill be $ 7 0 0 , reducing the b o o k value by $ 7 0 0 per year. As shown in Figure 1 0 .2 , the constant expense produces a linear increase in accum ulated de p re cia tio n a n d , therefore, a linear d ecline in b o o k value. A com m on practice for m any firms is to assume the sa lva g e value (or residual value) o f the asset to be zero, w hich then enables d e p re cia tio n to be expressed in terms o f percentages instead o f years. For exam ple, a c o m p a n y m ight use straight-line dep re cia tio n expressed as 1 6 .6 6 per cent o f historical cost, rather than as a term o f six years. The effect on the fin a n cia l statements o f d e p re cia tio n can most clearly be seen by constructing a d epreciation schedule. Assume equipm ent cost $ 3 0 0 0 0 0 an d has a three-year expected life w ith no sa lva g e value a nd that straight-line d e pre cia tio n is used. The d a te o f acquisition is labelled Y ear 0 . Year
Depreciation expense
Accumulated depreciation
Net book value
1
100000
100 00 0
200000
2
100000
200000
100 00 0
3
100000
300000
0
0
300000
O n the face of the b a la n ce sheet it is normal to put the net b o o k value w ith a note to the fin a n cia l statements show ing cost price ( $ 3 0 0 0 0 0 ) an d the accum ulated d e p re cia tio n . For exam ple, at Y ear 1 the fa ce o f the b a la n ce sheet w o u ld show :
1 Equipment (net)
$ 2 0 0000
The note to the fin a n cia l statements a t Y ear 1 w o u ld show : $ Equipment (cost)
300000
Accumulated depreciation
100 00 0
Equipment (net)
200000
Reducing balance m ethod Som e assets contribute m ore o f their benefit to the enterprise in the early parts o f their lives. For exam ple, a new com puter m ay benefit the c o m p a n y g re a tly w hen it is first purchased, but because of q uickly c h a n g in g te chnology and c h anging needs as the c o m p a n y gro w s, this same com puter m ay be relegated to less im portant tasks w ithin a fe w years o f its purchase, as better computers a re a cq u ire d . Therefore, even though the com puter w ill continue to benefit the com p a n y, most o f its econom ic value has been consum ed near the b e g in n in g of its life. In Australia, the reducing b a la n ce method is the next most com m on dep re cia tio n method after straight-line.
CHAPTER 10
N oncurrent assets
393
Inform ation needed for this procedure is: •
cost o f the asset
•
a ccum ulated d e p re cia tio n : total d e p re cia tio n recorded since the acquisition o f the asset
•
d e p re cia tio n rate: the percentage o f the b o o k value (cost minus d e p re cia tio n to date) of the asset that is to be d e p re cia te d in the period. The formula for the reducing b a la n ce method is: D epreciation fo r one p eriod = (Cost - A ccum ulated d epreciation) = R em aining b o o k v a lu e of the asset
X X
Rate Rate
Let's use the reducing b a la n ce method to calculate d e p re cia tio n for the six-year life o f the same truck you sa w a bove . W ith this method, the d e p re cia tio n rate is established such that, over the asset's life, the cost w ill be fully d e pre cia te d . D oing this exactly requires com plex a lg e b ra , so a p p ro xim a te rates are usually used. For exam ple, Australian com panies that use this method norm ally use 1 5 0 per cent o f the straight-line percentage, assuming no salva g e value. This is w h a t m any o f them use for taxation purposes. The truck has a life o f six years (straight-line depreciation is 1 6 .6 6 per cent per year). Because 1 5 0 per cent of the straight-line rate w o u ld be 2 5 per cent, w e w ill use 2 5 per cent to approxim ate the econom ic consumption pattern: •
cost = $ 5 0 0 0
•
d e p re cia tio n to d a te = $ 0 (at beginning)
•
d e p re cia tio n rate = 2 5 per cent. Year 1 Depreciation for the year
= ($5000 - $0) x 25% = $1250
Accumulated depreciation to date
= $1250
Remaining book value
= $3750 (i.e. 5 0 0 0 - 1250)
Year 2 Depreciation for the year
= ($ 5 0 0 0 -$ 1 2 5 0 ) x 25% = $938 (cents rounded up)
Accumulated depreciation to date
= $2188
Remaining book value
= $2812
Depreciation expense gets smaller with each year.
Year 3 Depreciation for the year
= ($ 5 0 0 0 -$ 2 1 8 8 ) x 25% = $703
Accumulated depreciation to date
= $2891 (2188 + 703)
Remaining book value
= $2109
Year 4 Depreciation for the year
= ($ 5 0 0 0 -$ 2 8 9 1 ) x 25% = $527
Accumulated depreciation to date
= $3418 (2891 + 5 27 )
Remaining book value
= $1582
Year 5 Depreciation for the year
= ($ 5 0 0 0 -$ 3 4 1 8) x 25% = $396
Accumulated depreciation to date
= $ 3 8 1 4 (3 4 1 8 + 396)
Remaining book value
= $1186
394
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Year 6 Depreciation for the year
= ($ 5 0 0 0 - $3814) x 25% = $297
Accumulated depreciation to date
= $41 11 (3814 + 297)
Remaining book value
=$889
A lthough, in this exam ple, the rem aining b o o k value o f the truck at the end of five years is fa irly close to the expected salvag e value o f the truck o f $ 7 0 0 , reducing balance depreciation does not norm ally take salvage value into account. C onsequently, the b o o k value at the end o f six years w o u ld be the sam e w hether o r not the c o m p a n y expected to recover a n y o f the cost o f the truck. The second panel of the chart in Figure 1 0 .2 shows the kind of patterns o f dep re cia tio n expense a nd b o o k value w e calculated for the truck. The expense a nd b o o k value lines are curved lines rather than straight lines. The reducing b a la n ce percentage is sometimes calculated using the fo llo w in g form ula, w h ich is a p p lie d to the o riginal cost. r= 1 w h e re r = re q u ire d depreciatio n rate n = estim ated life in years s = estim ated s a lv a g e v a lu e c = o rig in a l cost This form ula operates satisfactorily o n ly if the estim ated salvage value is substantially greater than zero, as the result is very sensitive to small movements near zero. If an asset has an o rig in a l cost o f $ 3 0 0 0 0 , a life o f five years an d an estim ated sa lva g e value o f $ 5 0 0 0 , the rate w o u ld be:
1 v30 ooo=
3 0 % a PPro x im a te |y
U n its -o f-p ro d u c tio n depreciation and depletion The econom ic consum ption o f m any assets is not necessarily a function of time, but rather o f use. For exam ple, it m ay make m ore sense to say that the delivery truck is expected to last so m any kilometres rather than so m any years. The consum ption o f natural resources (wasting assets) is also often accounted for using units o f production, because the value to the enterprise o f a stand of tim ber, o r an oil w e ll, is tied to the num ber o f trees rem aining to be felled o r the am ount o f oil left to be recovered. Therefore, the units-of-production method o f de p re cia tio n is also used to com pute the depletion o f natural resources. To com pute the d e p re cia tio n o r d epletion per unit of usage, the fo llo w in g inform ation is needed: •
cost o f the asset
•
estim ated sa lva g e value
•
estim ated num ber o f units to b e p ro d u c e d d uring the life o f the asset: the estim ated num ber o f tonnes o f ore extracted from a mine, the estim ated num ber o f kilometres that the delivery truck w ill travel o r another production measure. The formula for com puting units-of-production depreciation is: D epreciatio n o r depletion fo r o n e unit _ of use o r production (e.g. a kilom etre)
Cost - Estim ated salv a g e v a lu e Estim ated no. of units of use o r production d u rin g life
CHAPTER 10
N oncurrent assets
395
To determ ine de p re cia tio n for the year, the c h a rg e per unit is m ultiplied by the num ber o f actual units p roduced or used. Using the delivery truck as an exam ple a g a in , dep re cia tio n o f the truck over its expected useful life m ight be: •
cost = $ 5 0 0 0
•
estim ated sa lva g e value = $ 8 0 0
•
estim ated num ber o f kilometres to be driven = 2 1 0 0 0 0 . _ . . . $ 5 0 0 0 -$ 8 0 0 D epreciation p e r km = - 2 1 0 0 0 0 = $ 0 .0 2 d e p re c ia tio n /k m
Year 1
If the truck is driven 2 0 0 0 0 kilometres during the year, the dep re cia tio n c h a rg e for the ye a r w ill be: $ 0 .0 2 x 2 0 0 0 0 = $ 4 0 0 Year 2
If the truck is driven 8 0 0 0 0 kilometres during the second year, the de p re cia tio n c h a rg e for the ye a r w ill be: $ 0 .0 2 x 8 0 0 0 0 = $ 1 6 0 0 Year 3
If the truck is driven 6 5 0 0 0 kilometres during the year, the dep re cia tio n c h a rg e for the ye a r w ill be: $ 0 .0 2 x 6 5 0 0 0 = $ 1 3 0 0 Year 4
Suppose the truck is driven 5 0 0 0 0 kilometres during the year. H ow ever, after 4 5 0 0 0 kilometres, the truck w ill be fully d e p re cia te d (i.e. it has been driven the estim ated 2 1 0 0 0 0 kilometres). Therefore, the de p re cia tio n c h a rg e for the y e a r w ill be just the rem aining $ 9 0 0 , w h ich is less than $ 0 .0 2 x 5 0 0 0 0 km. The bottom panel in Figure 1 0 .2 illustrates units-of-production d e p re cia tio n . It is the o nly method that can result in the annual dep re cia tio n expense g o in g up a nd d o w n from p eriod to period. D epletion of a w a stin g asset a nd units-of-production dep re cia tio n o f a fixed asset are com puted in the same manner, but depletion refers to the physical consum ption o f an asset, rather than just the e conom ic consum ption. For the tim ber sa lva g e value m ay be the value o f the land after all the tim ber has been cut. In A ustralia, this method is often used in the m ining industry.
10.4
Depreciation example
H ere is an exam ple. G re c o Limited has purchased a factory at a cost o f $ 2 3 m illion (not including land). The general m anager w ants to know w h a t difference it w o u ld make if the c o m p a n y used straight-line, reducing b a la n ce o r units-ofproduction de p re cia tio n . •
Estimated useful life is 2 0 years, during w h ich tim e the c o m p a n y plans to make a b o u t 1 0 0 m illion boxes of its standard product.
•
Estimated sa lva g e value after the end o f the useful life is $ 5 million.
•
If reducing b a la n ce d e p re cia tio n w e re used, assume 1 0 per cent per ye a r on the reducing balance.
•
Production plans call for production, over the next six years, o f four, nine, nine, eight, nine a nd five m illion boxes per year, an d likely stable production o f a b o u t four m illion boxes per ye a r for the rem aining 14 years. The resulting d e p re cia tio n bases w o u ld be:
•
straight-line: $ 2 3 0 0 0 0 0 0 — $ 5 0 0 0 0 0 0 = $ 1 8 0 0 0 0 0 0 over 2 0 years (5 per cent o f base per year)
•
reducing ba la n ce : $ 2 3 0 0 0 0 0 0 - accum ulated dep re cia tio n x 10% per year
•
units-of-production: $ 1 8 0 0 0 0 0 0 / 1 0 0 0 0 0 0 0 0 boxes = $ 0 .1 8 per box produced.
396
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
If everything turns out as expected, the annual d e p re cia tio n expense fo r the next 2 0 years w ill be as follow s: Straight-line expense $
Reducing balance Begin book value
1Jnits-af-production
expense
Expense
$
$
$
1
900000
23000000
2 300000
720000
2
900000
20700000
2 070000
1 620000
3
900000
18 6 3 0 0 0 0
1 863 000
1 620000
4
900000
16767000
1 676 000
1440000
5
900000
15090300
1 509 030
1 620000
6
900000
13581270
1358127
900000
7
900000
12223143
1222314
720000
8
900000
11 000 829
1100083
720000
9
900000
9 900746
990075
720000
10
900000
8 9 1 06 7 1
891 067
720000
11
900000
8019604
801 960
720000
12
900000
7217644
721 764
720000
13
900000
6 4 9 5 880
649588
720000
14
900000
5 846 29 2
584629
720000
15
900000
5261663
526166
720000
16
900000
4735497
473550
720000
17
900000
4261947
426195
720000
18
900000
3 835 752
383 575
720000
19
900000
3452177
345218
720000
20
900000
3106959
310696
720000
20203037
18000000
Total
18000000
A t the end o f 2 0 years, if everything w orks out as expected, the b o o k value o f the factory w ill be: •
straight-line: $ 2 3 0 0 0 0 0 0 — $1 8 0 0 0 0 0 0 = $ 5 0 0 0 0 0 0
•
reducing balance: $ 2 3 0 0 0 0 0 0 — $ 2 0 2 0 3 0 3 7 = $ 2 7 9 6 9 6 3
•
units-of-production: $ 2 3 0 0 0 0 0 0 — $ 1 8 0 0 0 0 0 0 = $ 5 0 0 0 0 0 0 If, at the end o f 2 0 years, the factory is sold, there w ill be a g a in o r a loss on the sale that w ill equal the sale
proceeds minus the b o o k value. The proceeds m ay not be the expected $ 5 m illion. If they are not, there w ill be a g a in o r loss on the sale for even the simplest method (i.e. straight-line). The reducing b a la n ce method, on the other hand, w ill be a little o ff target at the end o f 2 0 years, w ith a b o o k value o f less than $ 3 m illion. In fact, it w ill reach a $ 5 m illion b o o k value in the fifteenth year. If the expected $ 5 m illion salvage value is actu a lly o b ta in e d at the end o f 2 0 years, the reducing b a la n ce method w ill result in a g a in of $ 2 2 0 3 7 3 7 ($ 5 m illion proceeds minus $ 2 7 9 6 2 6 3 b o o k value) from the sale at the d a te o f sale. This is really a correction o f the over-depreciation that the reducing b a la n ce method produced. The method w ill have been off target by this $ 2 2 0 3 7 3 7 amount. The units-of-production method w ill alm ost certainly result in a b o o k value that is not exactly equal to $ 5 million, even though it is planned to equal that. This is because the actual production w ill be very unlikely to exactly equal 1 0 0 m illion boxes over 2 0 years. W h ic h e v e r method is a d o p te d , the c o m p a n y can a lw a ys adjust its calculations later if the expectations a bout length o f useful life o r salvage value begin to look seriously inaccurate. For now , note that it is usual to a llo ca te the rem aining b o o k value over the rem aining useful life. For exam ple, an asset w a s expected to have a useful rem aining
CHAPTER 10
N oncurrent assets
397
life o f 1 0 years, but after the fifth ye a r it had a b o o k value o f $ 6 0 0 0 0 ; it w a s d e c id e d that it w o u ld o n ly be used for another three years. The dep re cia tio n for each o f the last three years w o u ld be $ 2 0 0 0 0 . M o s t Australian com panies use straight-line dep re cia tio n unless this w o u ld lead to m isleading fin a n cia l statements.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: E x p la in to th e g e n e ra l m a n a g e r o f C o ld Lake M a n u fa c tu r in g L td , w h ic h o p e n e d f o r bu siness a t th e b e g in n in g o f th is y e a r, w h a t d e p re c ia tio n e x p e n s e is s u p p o s e d t o a c c o m p lis h and th e c rite ria y o u w o u ld re c o m m e n d th e c o m p a n y use in c h o o s in g th e m o s t a p p ro p ria te m e th o d . Y o u r a n s w e r s h o u ld be : D e p re c ia tio n e x p e n s e is used in o r d e r t o a llo c a te th e c o s t o f lo n g -liv e d assets o v e r th e ir u s e fu l lives. T h e m o s t a p p ro p ria te m e th o d w o u ld m a tc h th e d e p re c ia tio n e x p e n s e f o r e a ch p e rio d w ith th e p re s u m e d e c o n o m ic b e n e fit o b ta in e d d u rin g th a t p e rio d .
10.5
Gains and losses on noncurrent asset disposals
G a in s an d losses have been m entioned a nd illustrated in various w a ys since C h a p te r 4 . This section is intended to pull the ideas together fo r you a nd sh o w you h o w they a re partly the consequences o f accounting p o lic y choices. In the a b o v e G re co exam ple (see section 1 0 .4 ), there w a s a possibility o f a g a in o r a loss on the sale o f the factory in the tw entieth year. W h e n a noncurrent asset is sold, it could be handled as o rd in a ry revenues are: the proceeds could be a d d e d to revenue a nd the b o o k value o f the asset a d d e d to the C O G S . But this w o u ld mix the d a y to -d a y revenues from the activities o f the enterprise w ith the o ccasional (and, presum ably, less e co n o m ically important) revenues resulting from reducing long-term fixed assets o r other investments. Therefore, such events a re kept separate from o rd in a ry revenues via the fo llo w in g kind o f journal entry, w h ich w e have seen before: DR
Cash or non-trade receivables (proceeds)
XXXX
DR
Accumulated depreciation on that asset (all that has accumulated)
XXXX
DR
Loss (or CR gain on sale)
XXXX
CR
Noncurrent asset (for original cost)
or
XXXX XXXX
The g a in o r loss is just the difference betw een the proceeds a nd the b o o k value (cost minus accum ulated d e p re cia tio n , if any). H ere is an exam ple. C o m p a n y X has a truck that cost $ 8 4 0 0 0 . The accum ulated d e p re cia tio n at the da te o f sale is $ 4 6 0 0 0 . Therefore, b o o k value is $ 3 8 0 0 0 a t the d a te o f sale. •
If the c o m p a n y sells the truck for $ 5 2 0 0 0 , there is a g a in on sale o f $ 1 4 0 0 0 ( $ 5 2 0 0 0 — $ 3 8 0 0 0 ) . The journal entry w o u ld be:
1
$ DR
Cash
52 000
DR
Accumulated depreciation
46 000
*1
CR
Truck
84000
CR
Gain on sale
1 4000
398
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
If the c o m p a n y sells it for $ 3 0 0 0 0 , there is a loss on sale o f $ 8 0 0 0 ( $ 3 8 0 0 0 — $ 3 0 0 0 0 ) . The journal entry w o u ld be:
I
$ DR
Cash
30000
DR
Accumulated depreciation
46 000
DR
Loss on sale
CR
Truck
8 000 84000
Think o f gains an d losses as dep re cia tio n corrections: •
If the c o m p a n y knew in a d va n ce w h a t the proceeds w o u ld be a n d w hen the sale w o u ld happen, it could have d epreciated the asset d o w n exactly to the proceeds am ount by that d ate. So, if the proceeds equal b o o k value, there is no g a in o r loss.
•
If the proceeds are less than b o o k value, there is a loss: in effect, m ore de p re cia tio n is needed an d that's w h a t the loss really is.
•
If the proceeds a re m ore than b o o k value, there is a g a in : in effect, too much dep re cia tio n w a s taken, an d the g a in is really just that excess (w hich caused the lo w e r b o o k value) being recognised.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: A c o m p a n y sells a p ie c e o f e q u ip m e n t (c o s t $ 4 0 0 0 0
and a c c u m u la te d d e p re c ia tio n $ 2 5 0 0 0 0 f o r
$ 5 0 0 0 cash. W h a t w o u ld be th e jo u r n a l e n try ? Y o u r a n s w e r s h o u ld be: DR
Cash
DR
Loss on sale
5 000
DR Accumulated depreciation CR
10.6
10000 25 000
Equipment
40000
Asset im pairm ent
In A ustralia, directors need to ensure that the carrying am ount o f an asset does not exceed the recoverable am ount. If the carrying value is greater than the recoverable amount, the asset is said to be im paired an d an im pairm ent loss is recognised and the asset w ritten d o w n to its recoverable am ount. Recoverable am ount is the higher o f fa ir value less costs to sell (w here fa ir value is the am ount for w h ich an asset could be exch a n g e d betw een k n o w le d g e a b le , w illin g parties in an arm 's length transaction) a nd value in use (the present value of future cash flow s expected to be derived from the asset). For exam ple, if an a irlin e has a plane w ith a carrying value o f $ 8 0 m illion, the recoverable am ount is the higher o f w h a t som eone (e.g. another airline) w ill p a y to buy the plane o r the expected future cash flow s from flying the plane over the rem ainder o f its expected life (cash inflow s from ticket sales less cash outflow s related to those flights). W h e n the asset is im paired (i.e. recoverable am ount is less than carrying value) it is necessary that an im pairm ent loss is recognised a nd the asset w ritten d o w n to the recoverable amount. This im pairm ent loss is recognised in the incom e statement.
CHAPTER 10
N oncurrent assets
399
If it is a non-depreciable asset (e.g. land) then: DR
Impairment loss
CR
Land
If it is a d e p re cia b le asset (e.g. equipm ent) then: DR
Impairment loss
CR
Accumulated depreciation - Equipment
In the latter case, the accum ulated de p re cia tio n is effectively brought fo rw a rd in time; that is, the expense is recognised in an earlier p eriod than o rig in a lly expected. A t each reporting d ate, com panies need to assess w hether there is a n y in dication that im pairm ent should be fully o r partly reversed. W h e n the carrying value o f a previously im paired asset is greater than its recoverable amount, a c o m p a n y can reverse the im pairm ent but this am ount cannot result in the carrying am ount being greater than w h a t it w o u ld have been w ith o u t the previous im pairm ent; that is, you c a n 't revalue a b o v e cost - accum ulated d epreciation under the cost method. As noted a b o ve , the im pairm ent losses are shown in the incom e statement, a nd if large a re shown as a separate item usually labelled as 'Im pairm ent'.
FOR YOUR INTEREST T h e fo llo w in g e x tr a c t fr o m F a irfa x M e d ia s h o w s im p a irm e n t o n th e fa c e o f th e in c o m e s ta te m e n t as o n e o f f o u r c a te g o rie s o f e x p e n s e s an d th e n give s m o re d e ta il in th e n o te s . FAIRFAX MEDIA LIMITED CONSOLIDATED INCOME STATEMENT FOR THE PERIOD ENDED 2 0 JUNE 2 0 1 4 Consolidated Note
2 9 June 2 0 1 4 $0 00
$0 00
Expenses from operations excluding impairment, depreciation, amortisation and finance costs
3(A)
(1 585 928)
(1 690 820)
Depreciation and amortisation
3(B)
(93 517)
(100762)
(23 459)
(459938)
(25 302)
(66571)
Impairment of intangibles, investments and property, plant and equipment Finance costs
3(C)
Source: Fairfax M e d ia ,
3 0 June 20 13
A n n u a l R eport 2 0 1 4 .
O n th e o t h e r h a n d , w h e n im p a irm e n t a m o u n ts a re s m a ll, th e ite m w ill o fte n be in c lu d e d as p a rt o f a la rg e r a m o u n t o n th e fa c e o f th e in c o m e s ta te m e n t an d th e n s h o w n s e p a ra te ly in a n o te . F o r e x a m p le , H a rv e y N o rm a n
H o ld in g s
L im ite d has A d m in is tr a tiv e e x p e n s e s o f $ 4 2 7 .6
m illio n o n th e fa c e o f th e in c o m e
s ta te m e n t, w h ic h in c lu d e s an a m o u n t o f $ 7 7 .8 5 m illio n in d e p re c ia tio n , a m o rtis a tio n and im p a irm e n t p ro v id e d in N o te 4 as fo llo w s : Depreciation, amortisation and impairment: (included in administrative expenses line in the Income Statement) Depreciation of: Buildings and leasehold land Plant and equipment
7656
5 339
60 742
73 504
»
400
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Amortisation of: Computer software Licences
9007
10688
228
-
195
60
Impairment of: Capitalised IT projects Other assets Total depreciation, amortisation and impairment
22
6
77850
89597
Source: H arvey N o rm an H oldings Limited,
A n n u a l R ep o rt 2 0 1 4 .
T h is a m o u n t is in c lu d e d in th e n o te s ra th e r th a n o n th e fa c e o f th e in c o m e s ta te m e n t b e c a u s e it is sm all c o m p a re d w ith th e to ta l ex p e n s e s .
HOW'S YOUR UNDERSTANDING? H e re is a ty p ic a l d e s c rip tio n o f ‘ Im p a irm e n t’, e x tra c te d fr o m
N o te 1 o f th e 2 0 1 4 fin a n c ia l s ta te m e n ts o f
H a rv e y N o rm a n H o ld in g s L im ite d : Im p a ir m e n t T h e c a rr y in g v a lu e s o f p la n t a n d e q u ip m e n t a re re v ie w e d f o r im p a ir m e n t w h e n e v e n ts o r c h a n g e s in c irc u m s ta n c e s in d ic a te th e c a rr y in g v a lu e m a y n o t be re c o v e ra b le . F o r an a s se t t h a t d o e s n o t g e n e ra te la rg e ly in d e p e n d e n t ca sh in flo w s , th e re c o v e ra b le a m o u n t is d e te rm in e d f o r th e c a s h - g e n e ra tin g u n it t o w h ic h th e a s s e t b e lo n g s . I f a n y s u c h in d ic a tio n e x is ts a n d w h e re t h e c a rr y in g v a lu e s e x c e e d th e e s tim a te d re c o v e ra b le a m o u n t, th e a ssets o r c a s h - g e n e ra tin g u n its a re w r it te n d o w n t o t h e ir re c o v e ra b le a m o u n t. T h e re c o v e ra b le a m o u n t o f p la n t a n d e q u ip m e n t is th e g r e a te r o f fa ir v a lu e less c o s ts t o sell a n d v a lu e in use. In assessing v a lu e in use, t h e e s tim a te d f u t u r e ca sh flo w s a re d is c o u n te d t o t h e ir p re s e n t v a lu e u s in g a p r e - ta x d is c o u n t ra te t h a t r e fle c ts c u r r e n t m a r k e t a s s e s s m e n ts o f t h e
tim e Value of m oney a n d th e risks
s p e c ific t o t h e asset. F o r p la n t a n d e q u ip m e n t, im p a ir m e n t losses a re re c o g n is e d in t h e in c o m e s ta te m e n t. Source: H arvey N o rm a n H oldings Lim ited, A nnual Report 2014.
F ro m w h a t y o u ha ve re a d , t r y t o d e fin e e a ch o f th e fo llo w in g te rm s fr o m th e a b o v e e x tra c t:
1 2 3 4
c a rry in g v a lu e o f p la n t and e q u ip m e n t re c o v e ra b le a m o u n t fa ir v a lu e less c o s ts to sell v a lu e in use Y o u r a n sw e rs s h o u ld be:
1
C o s t m in u s a c c u m u la te d d e p re c ia tio n .
2
R e fe rs t o w h ic h e v e r is h ig h e r: an a s s e t’s fa ir v a lu e less th e c o s ts t o sell it o r an a s s e t’s v a lu e in use.
3 T h e a m o u n t f o r w h ic h an asset c o u ld be e x c h a n g e d b e tw e e n k n o w le d g e a b le , w illin g p a rtie s in an a rm ’s -le n g th tra n s a c tio n less c o sts.
4 T h e p re s e n t v a lu e o f fu tu r e cash flo w s e x p e c te d to arise fr o m th e c o n tin u in g use o f an a s se t an d fr o m its disD osal a t th e e n d o f its u s e fu l life .
CHAPTER 10
10.7
N oncurrent assets
401
Asset revaluations
Australian com panies a re a llo w e d to partly d e p a rt from historical cost by revaluing noncurrent assets. W h ile this is also a llo w e d in N e w Z e a la n d a nd the United K ingdom , it is not g enerally permitted in m any countries including the United States. A ccounting standards state that each class o f noncurrent assets must be m easured using either (a) the cost model o r (b) the revaluation m odel, w h ich has a fa ir value basis. Class o f asset refers to the c a te g o ry o f assets; for exam ple, land, buildings, equipm ent, motor vehicles, o ffice equipm ent a nd aircraft. U nder the cost m odel, after recognition of an asset, the asset is carried at cost less accum ulated d e p re cia tio n a nd a n y accum ulated im pairm ent losses, but this carrying am ount cannot exceed the recoverable amount. U nder the revaluation m odel, after recognition of an asset, the asset w h o se fa ir value can be measured re liably is carried at a revalued amount, w h ich is the fa ir value at the d a te of revaluation less a n y subsequent accum ulated depre cia tio n a n d subsequent accum ulated im pairm ent losses. Fair value is defined as the am ount for w h ich an asset could be exch a n g e d betw een kn o w le d g e a b le , w illin g parties in an arm 's length transaction. In determ ining fa ir value, market prices are used if there is an active a nd liquid market for the asset. If not, the best a v a ila b le e vidence is used; for exam ple, current market prices o f sim ilar assets, prices of recent transactions o f sim ilar assets o r appraisals by professional valuers. Assets can either be revalued upw ards (revaluation increment) o r d o w n w a rd s (revaluation decrem ent) from their carrying amounts (often ca lle d b o o k value). The accounting standards on revaluations have the purpose of ensuring that users o f the fin a n cia l statements have relevant a n d reliable inform ation for evaluating the perform ance, finan cia l position, financing an d investing o f the organisation. W h e n there is an increment, the am ount o f the increm ent goes directly to the shareholders' equity section of the b a lan ce sheet under the heading of 'revaluation surplus' (previously ca lle d 'an asset revaluation reserve'). (The conce p t o f a reserve is discussed in m ore detail in C h a p te r 1 2.) So if you see a b a la n ce in the revaluation reserve, it sim ply tells you the am ount by w h ich assets have been revalued over time. For exam ple, if land is revalued from $ 1 1 m illion to $ 1 2 m illion, both the land account a nd the revaluation surplus a ccount w o u ld increase by $1 million. Flow ever, because o f conservatism, if there w a s a revaluation decrem ent to $ 1 0 m illion, the decrem ent w o u ld be recognised as an expense in the incom e statement. That is, an expense (loss on devaluation o f land) w o u ld increase, and land w o u ld decrease. In summary, increments in asset valuations d o not g e n e ra lly affect profit directly, but decrem ents d o reduce the profit for the ye a r (see exceptions below ). A lso note that changes in asset valuation (except for land) result in different d e p re cia tio n expenses in subsequent years. W h e n a class of noncurrent assets is measured on the fair value basis, revaluations need to be m ade regularly to ensure that the carrying am ount does not materially differ from fair value. Revaluing every three years is quite com m on. The standards state that w hen an asset is revalued, all assets w ithin the same class o f assets should also be valued at the same time on a consistent basis. For exam ple, if o ne block o f land is revalued, all other blocks o f land should be revalued on a consistent basis; sim ilarly for buildings, plant a nd equipm ent. There is an exception, in that for d o w n w a rd revaluations o f a particular noncurrent asset, the revaluation o f all other assets in that class is not required. N o te that a d o w n w a rd s revaluation o f a noncurrent asset must be undertaken w hen its carrying am ount is greater than its recoverable am ount. W h e n the fa ir value basis is used, the required disclosures include the effective d a te of the revaluation, the method a nd sig n ifican t assumptions used in determ ining fa ir value a nd w hether an independent valuation has been o b ta in ed . N o w let's consider the debits an d credits. W h e re there is an asset revaluation increment, the am ount o f the increm ent is credited to a revaluation surplus. For exam ple, if land is revalued from $1 1 m illion to $1 2 m illion, the entry w o u ld be: $ DR CR
Land Revaluation surplus
$
1000000 1000000
402
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
H ow ever, if there had been a revaluation decrem ent to $ 1 0 m illion, the decrem ent w o u ld be recognised in an incom e statement account. The entry w o u ld be: $ DR CR
Loss on devaluation of land
$
1000000
Land
1000000
A g a in , there are exceptions. If an increm ent reverses a revaluation decrem ent previously recognised as an expense in the incom e statement w ith respect to that sam e class o f assets, the increm ent w o u ld be recognised as incom e. Sim ilarly, if a revaluation decrem ent reverses a preceding revaluation increm ent that w a s credited to revaluation surplus for the sam e class o f assets, it w ill be d e b ite d directly to the revaluation surplus. Further com plications arise w hen w e consider assets that are d e p re cia te d , such as equipm ent. Australian accounting standards a llo w entities to choose one o f tw o treatments to acco u n t for accum ulated d e p re cia tio n a t the date o f revaluation. The most w id e ly used treatment is described b e lo w . A t the tim e o f revaluation, the accum ulated dep re cia tio n on those assets is credited to the asset account. The asset account is then increased o r decreased by the am ount o f the revaluation increments or decrem ents. For exam ple, if equipm ent cost $ 2 m illion (with accum ulated d e p re cia tio n o f $ 5 0 0 0 0 0 ) an d w a s revalued to $ 2 5 0 0 0 0 0 , the entries w o u ld be: $ DR CR
Accumulated depreciation
$
500000
Equipment
500000
This entry has transferred the relevant accum ulated d e p re cia tio n as an offset to the equipm ent account. The equipm ent is n o w carried at a net b a la n ce o f $1 5 0 0 0 0 0 . To revalue it to $ 2 5 0 0 0 0 0 , the fo llo w in g entry w o u ld occur: $ DR CR
Equipment Revaluation surplus
$
1000000 1000000
W h e n the asset previously revalued is sold, the g a in o r loss on disposal is measured as the difference betw een the carrying value a t the tim e o f disposal a nd the net proceeds. You w ill cover these issues, a nd other more a d va n ce d matters, in subsequent courses. W e realise that the a b o v e sections are difficult for an introductory book. H ow ever, a t least b y seeing the journal entries, even if you d o n 't fully understand them at this stage, you w ill be in a better position to com prehend the m eaning a n d value o f the noncurrent assets section an d the revaluation surplus in the b a la n ce sheet.
CHAPTER 10
N oncurrent assets
403
FOR YOUR INTEREST H e re is a ty p ic a l d e s c rip tio n o f revaluations fro m H a rv e y N o rm a n H o ld in g s L im ite d . R e v a lu a tio n o f o w n e r-o c c u p ie d p ro p e rtie s F o llo w in g in itia l r e c o g n itio n a t c o s t, o w n e r - o c c u p ie d la n d a n d b u ild in g s a re c a rrie d a t a re v a lu e d a m o u n t, w h ic h is th e fa ir v a lu e a t th e d a te o f th e re v a lu a tio n less a n y s u b s e q u e n t a c c u m u la te d d e p re c ia tio n o n b u ild in g s a n d le a s e h o ld la n d a n d a c c u m u la te d im p a ir m e n t losses. F a ir v a lu e is d e te rm in e d b y re fe re n c e t o m a r k e t-b a s e d e v id e n c e , w h ic h is th e a m o u n t f o r w h ic h th e a ssets c o u ld be e x c h a n g e d b e tw e e n a k n o w le d g e a b le w illin g b u y e r an d a k n o w le d g e a b le w illin g s e lle r in an a r m ’s le n g th tra n s a c tio n as a t th e v a lu a tio n d a te . O w n e r - o c c u p ie d p ro p e rtie s , u p o n a n y re v a lu a tio n , a re v a lu e d a t f a ir v a lu e , d e te rm in e d b y in d e p e n d e n t lic e n s e d v a lu e rs , o r d ir e c to r s ’ v a lu a tio n s w h e re n e c e s s a ry . A n y re v a lu a tio n s u rp lu s is c r e d ite d t o t h e a s s e t re v a lu a tio n re s e rv e in c lu d e d in th e e q u ity s e c tio n o f th e s ta te m e n t o f fin a n c ia l p o s itio n
u n le ss it re v e rs e s a re v a lu a tio n
d e c re a s e o f th e s a m e a s s e t p re v io u s ly
re c o g n is e d in t h e in c o m e s ta te m e n t. A n y re v a lu a tio n d e fic it is re c o g n is e d in th e in c o m e s ta te m e n t u n le s s it d ir e c tly o ffs e ts a p re v io u s s u rp lu s o f th e sa m e a s s e t in th e a s s e t re v a lu a tio n re s e rv e . In a d d itio n , a n y a c c u m u la te d d e p re c ia tio n as a t re v a lu a tio n d a te is e lim in a te d a g a in s t th e g ro s s c a rry in g a m o u n t o f th e a s se t a n d t h e n e t a m o u n t is re s ta te d t o th e re v a lu e d a m o u n t o f t h e a s se t. U p o n d isp o sa l, a n y re v a lu a tio n re s e rv e re la tin g t o t h e p a rtic u la r a s s e t b e in g so ld is tra n s fe rr e d t o re ta in e d e a rn in g s . V a lu a tio n s a re p e rfo rm e d w ith s u ff ic ie n t re g u la r ity t o e n s u re t h a t t h e c a rr y in g a m o u n t d o e s n o t d if fe r m a te ria lly f r o m th e a s s e t’s fa ir v a lu e a t th e b a la n c e d a te . Source: H arvey N o rm a n H oldings Lim ited, A nnual Report 2014.
10.8
Intangible assets
Intangible assets are id entifiable, non-m onetary assets that d o not have a visible physical existence, unlike land, buildings o r equipm ent. Examples o f in ta n g ib le assets include: •
patents, copyrights, trademarks a nd other such legal property; for exam ple, the 2 0 1 4 b a la n ce sheet o f Telstra describes 'A cq u ire d in ta n g ib le assets' as follow s: W e a c q u ire o t h e r in ta n g ib le a ssets e ith e r as p a rt o f a b u sin e ss c o m b in a tio n o r t h r o u g h s e p a ra te a c q u is itio n . In ta n g ib le a ssets a c q u ire d in a b u sin e ss c o m b in a tio n a re re c o r d e d a t t h e ir fa ir v a lu e a t th e d a te o f a c q u is itio n a n d re c o g n is e d s e p a ra te ly f r o m g o o d w ill. In ta n g ib le a ssets a c q u ire d t h r o u g h s p e c ific a c q u is itio n a re re c o rd e d a t c o s t. W e a p p ly m a n a g e m e n t ju d g e m e n t t o d e te rm in e th e a p p ro p ria te fa ir v a lu e o f id e n tifia b le in ta n g ib le assets. In ta n g ib le a ssets t h a t a re c o n s id e re d t o ha ve a f in it e life a re a m o rtis e d o n a s tra ig h t lin e basis o v e r th e p e rio d o f e x p e c te d b e n e fit. In ta n g ib le a ssets t h a t a re c o n s id e re d t o h a ve an in d e fin ite life a re n o t a m o rtis e d b u t te s te d f o r im p a ir m e n t o n an a n n u a l basis o r w h e n an in d ic a tio n o f im p a ir m e n t e x is ts in a c c o rd a n c e w ith n o te 2 .9 ( a ) . Source: Telstra C orporation Limited, Annual Report 2014 balance sheet.
Thus, an asset is created for these items. If the asset has a finite life, it is then am ortised over the p eriod during w h ich the c o m p a n y believes the items w ill pro vid e benefit. If it is not considered to have a finite life, an im pairm ent
404
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
test is carried out annually to determ ine if the value of the asset is to be w ritten d o w n . N o te the am ount o f the w rite d o w n w o u ld reduce profit for the period: •
b ra n d names, w h ich can be registered to m aintain exclusive use; for exam ple, tw o brand names you m ay be fa m ilia r w ith , C o ca -C o la an d B illa b o n g , a re both listed as intangibles in the respective b a la n ce sheets o f C o ca C o la A m atil Limited an d B illabong International Limited:
COCA-COLA AMATIL LIMITED In ta n g ib le a ssets a c q u ire d s e p a ra te ly a re c a p ita lis e d a t c o s t a n d f r o m a b u sin e ss c o m b in a tio n a re c a p ita lis e d a t fa ir v a lu e as a t th e d a te o f a c q u is itio n . F o llo w in g in itia l re c o g n itio n , t h e c o s t m o d e l is a p p lie d t o e a c h class o f in ta n g ib le asset. T h e e s tim a te d u s e fu l lives o f e x is tin g fin it e lived in ta n g ib le assets f o r th e c u r r e n t a n d p r io r y e a r a re as fo llo w s C u s to m e r lis ts
5 y e a rs
B ra n d n a m e s a n d tra d e m a r k s
4 0 t o 5 0 y e a rs
S o ftw a re d e v e lo p m e n t a s se ts
3 t o 1 0 y e a rs Source: C oca -C o la A m atil Limited, Annual Report 2013.
O n the other hand, B illabong shows brands in their b a la n ce sheet a t historical cost. H ow ever, they are not am ortised as the Directors are of the v ie w that the recorded brands have an indefinite life. •
franchises, distributorships an d other such rights to sell som eone else's products in a certain g e o g ra p h ica l area, including M c D o n a ld 's Restaurants, M id a s M ufflers, B ob Jane T-mart an d Pizza Hut, w h e re the local o p e ra to r has p a id for the right to use the nam e a nd sell the products.
•
deferred charges, such as incorporation costs, fin a n cin g costs, an d other items that are really long-term pre p a id expenses. O n e such exam ple from an annual report o f deferred charges is:
Alumina Limited Borrowing costs B o r ro w in g c o s ts c o m p ris e in te r e s t p a ya b le o n b o rro w in g s c a lc u la te d u s in g t h e e ffe c tiv e in te r e s t ra te m e th o d a n d a m o r tis a tio n o f c a p ita lis e d f a c ilit y fe e s . B o r ro w in g c o s ts in c u rr e d f o r th e c o n s tr u c tio n o f a n y q u a lify in g a s se t a re c a p ita lis e d d u rin g th e tim e t h a t it is re q u ire d t o c o m p le te a n d p re p a re th e a s s e t f o r its in te n d e d use o r sale. O t h e r b o rr o w in g c o s ts a re e x p e n s e d . Source: Alum ina Lim ited, Annual Report 2013-14.
•
developm ent costs (including product developm ent costs a nd mineral exploration costs), w h ich a re ca pitalised and later expensed a t the time they earn revenue in the future. The Australian A ccounting Standards a llo w developm ent costs to be recognised as an in ta n g ib le asset if the entity can dem onstrate the fo llo w in g : -
It is technically feasible to com plete the in ta n g ib le asset so that it w ill be a v a ila b le for use o r sale.
-
The entity intends to com plete the in ta n g ib le asset a nd use or sell it.
-
The intan g ib le asset w ill generate p ro b a b le future e co n o m ic benefits; that is, the entity can dem onstrate that
-
A de q u a te technical, fin a n cia l a nd other resources are a v a ila b le to com plete the developm ent an d to use or
-
The costs can be measured reliably.
there is a market for the output or, if it is to be used internally, the usefulness o f the in ta n g ib le asset. sell the in ta n g ib le asset. C onversely, the Australian A ccounting Standards require organisations to c h a rg e all research costs to an expense account w hen they a re incurred. O rganisations a re sp e cifica lly p ro hibited from c a p ita lisin g a n y expenditure associated w ith internally generated brands, mastheads, publishing titles, customer lists an d sim ilar items. A n y costs associated w ith the developm ent o f these items must be expensed as incurred.
CHAPTER 10
N oncurrent assets
405
W hat are intangible assets w orth? Because such assets a re intangible, their existence an d value m ay be doubtful. G e n e ra lly, the m ore clearly id entifia b le - that is, c a p a b le o f being separated from the entity an d sold, o r arising from a contractual o r legal right and docum ented the assets a re (especially via external e vidence such as contracts an d legal documents), the less difficulty they pose. H ow ever, even for clearly o w n e d assets such as patents an d franchises, there m ay be consid e ra b le d o u b t a b o u t their future e conom ic value. For exam ple, w h a t is a M c D o n a ld 's franchise w orth? It depends on ever-changing consum er tastes, on w hether a com petitor does o r doesn't open across the street, a nd on m any other business a n d e co n o m ic factors. Difficulties in valuing brand names an d trademarks also abo u n d . For assets such as product developm ent expenditures, there is often a real question as to w hether they belong on the b a la n ce sheet at all. C a p ita lisin g expenditures on such items m ay a p p e a r to create better m atching, an d is usually seen to be p roper by those making such expenditures, but this depends on w h e th e r they w ill ever return future value. W ill the great n e w product sell? W ill it produce revenues greater than costs? This is a difficult judgem ent to make, and m any p e o p le have conclu d e d that such assets should not a p p e a r on the b a la n ce sheet. These p e o p le favour conservatism in accounting a nd are concerned a b o u t m anipulation o r just feel that recognising such assets is not fa ir o r a p p ro p ria te . As noted a b o ve , Australian A ccounting Standards require developm ent expenditures to be expensed im m ediately an d not ca p ita lise d , unless the costs meet the strict criteria noted earlier.
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: I f a c o m p a n y capitalises d e v e lo p m e n t costs o f $1 m illio n instead o f e xpensing th e m in th e c u rre n t year, w h a t is th e im p a c t on th e fin a n cia l s ta te m e n ts (assum e e xp e cte d b e n e fits fo r fiv e years)? Y o u r answ er should be: If expensed, th e $1 m illio n goes to expense in Y e a r l and th e re is no balance sheet e ffe c t; i f capitalised, $1 m illio n goes to th e balance sh e e t and th e n each ye a r $ 2 0 0 0 0 0 goes to a m o rtisa tio n expense (in c o m e s ta te m e n t) and th e asset in th e balance sh e e t is decreased by $ 2 0 0 0 0 0 (a c c u m u la te d a m o rtis a tio n ).
Cost of intangibles The cost of intangibles is determ ined in the sam e w a y as that o f a n y other asset: purchase cost a nd other expenditures m ade prior to putting the asset into service (getting e co n o m ic benefits from it). There m ay be substantial a m b ig uity a bou t the cost o f internally d e ve lo p e d assets - such as developm ent expenditures - because it m ay be difficult to separate w h a t w a s spent to d e ve lo p the asset from normal expenses incurred. As noted a b o ve , internally generated brands, mastheads, customer lists an d sim ilar items cannot be ca p ita lise d (m ade an asset), an d are therefore expenses. For this reason, m any com panies d e clin e to recognise (capitalise) such assets.
Am ortisation or im p a irm e n t of intangibles U nder Australian A ccounting Standards, an entity is required to assess w hether a useful life is finite o r indefinite. If finite, the in ta n g ib le is am ortised. Determ ining le g a l useful life m ay be fa irly straightforw ard for assets that are supported by contracts o r other docum ents - such as leases that have a specified term (as d o most franchises) and patents that a re g o o d for a specific num ber o f years - but w hether this is also the e co n o m ic useful life is harder to say. W h e n an entity determines that an in ta n g ib le asset has an indefinite useful life, then the asset is not subject to am ortisation. H ow ever, the entity w o u ld need to test annually for im pairm ent, by co m p a rin g the asset's carrying am ount w ith its recoverable am ount. A n y excess o f the carrying am ount over its recoverable am ount w o u ld need to be im m ediately recognised as an im pairm ent in the incom e statement; that is, it reduces net profit as w e ll as the am ount o f the asset recorded in the b a la n ce sheet.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
As an exam ple o f both finite an d infinite lives o f intangibles, consider the fo llo w in g extracts on intangibles from N o te 1 of the 2 0 1 3 fin a n cia l statements o f C o ca -C o la A m atil Limited. T h e u s e fu l lives o f th e s e in ta n g ib le a ssets a re assessed t o be e ith e r f in it e o r in d e fin ite . W h e r e a m o r tis a tio n is c h a rg e d o n a s s e ts w ith f in it e lives, th is e x p e n s e is ta k e n t o th e in c o m e s ta te m e n t a n d c h a rg e d o n a s tra ig h t lin e basis. In ta n g ib le a ssets w ith in d e fin ite lives a re te s te d f o r im p a ir m e n t a t le a s t a n n u a lly a t th e ca sh g e n e r a tin g u n it leve l. U s e fu l lives a re also e x a m in e d o n an a n n u a l basis a n d a d ju s tm e n ts , w h e re a p p lic a b le , a re m a d e o n a p ro s p e c tiv e basis. In ta n g ib le assets, e x c lu d in g s o ftw a r e d e v e lo p m e n t assets, c r e a te d w ith in th e b u s in e s s a re n o t c a p ita lis e d an d c o s ts a re ta k e n t o t h e in c o m e s ta te m e n t w h e n in c u rre d . Source: C oca -C o la A m atil Limited, Annual Report 2013.
The largest in ta n g ib le asset for H arvey N o rm a n H oldings Limited is com puter softw are, w h ich is included in the b alance sheet at $ 7 7 .9 m illion. They note that: C o m p u te r s o ftw a r e is c a rrie d a t c o s t less a c c u m u la te d a m o r tis a tio n a n d a c c u m u la te d im p a ir m e n t losses. T h e in ta n g ib le a s s e t has b e e n assessed as h a v in g a f in it e life a n d is a m o rtis e d u s in g t h e s t r a ig h t- lin e m e th o d o v e r a p e rio d o f n o g r e a te r th a n 9 . 5 y e a rs . I f im p a ir m e n t in d ic a to r s a re p re s e n t, th e re c o v e ra b le a m o u n t is e s tim a te d a n d an im p a ir m e n t loss is re c o g n is e d t o th e e x te n t t h a t th e re c o v e ra b le a m o u n t is lo w e r th a n th e c a rr y in g a m o u n t. Source: Harvey N orm an Holdings Limited, Annual Report 2014.
10.9
Goodwill
G o o d w ill arises w hen m ore is p a id for a g ro u p of assets, such as a w h o le business, than the assets seem to be w orth individually. The rationale for p aying the a d d itio n a l am ount m ay be based on such factors as h o w the business is organised o r the num ber o f customers it has. As a result, there is an asset c a lle d g o o d w ill that keeps the accounts in balance. H ere is an exam ple. G re a t Limited buys all the business assets o f Small for $ 8 0 0 0 0 0 cash. The best estim ate o f the fa ir market values o f those assets are: •
receivables, $ 6 0 0 0 0
•
inventories, $1 1 0 0 0 0
•
land, $ 1 0 0 0 0 0
•
building, $ 2 6 0 0 0 0
•
equipm ent, $1 3 0 0 0 0
•
total, $ 6 6 0 0 0 0
•
no liabilities a re assumed b y G re a t Limited. G re a t Limited w o u ld record the purchase as follow s: $ DR
A c c o u n ts re c e iv a b le
$
60000
DR
In v e n to rie s
110000
DR
La nd
100000
DR
B u ild in g s
260000
DR
E q u ip m e n t
130000
CR
C ash
800000
N o problem . Except that the entry doesn't ba la n ce ! So a n ew account ca lle d 'g o o d w ill' is created an d d e bited w ith $ 1 4 0 0 0 0 , w h ich is the $ 8 0 0 0 0 0 cost o f the w h o le minus $ 6 6 0 0 0 0 : the sum of the fa ir values of the parts. This keeps the books in ba la n ce , but creates an account for w h ich the value an d m eaning are unclear. If g o o d w ill
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407
represents unrecorded a nd u n identifiable assets, w h a t a re they? If it represents a g o o d location, g o o d m anagers or 'synergy' w ith the operations of G re a t Limited, w h a t are these things really w o rth ? H o w much future value d o they have? H o w long w ill this value last? Purchased g o o d w ill is measured as the excess of the cost o f acquisition o f another entity over the fa ir value o f the id entifia b le net assets (net assets = assets - liabilities) a cquired. For accounting purposes, it is im portant that you understand the difference betw een externally a nd internally generated g o o d w ill. The situation discussed in the previous p a ra g ra p h refers to externally generated g o o d w ill, w hich is recognised by the accounting system. This is a transaction, supported by docum entation, that shows h o w much w a s p a id . Som e judgem ents then need to be m ade a b o u t the fa ir value o f the assets, w ith the rem ainder being g o o d w ill. H ow ever, if an organisation builds up the business b y such methods as better m anagem ent an d im proving the friendliness o f staff, this w o u ld be c a lle d internally generated g o o d w ill, w h ich w o u ld not be included in the finan cia l statements. W h ile som eone else m ay n o w be w illin g to p a y more for the business, this extra value is not represented in the accounts. There are a num ber o f reasons for this, but at this stage note that difficulty in measuring this am ount is one reason w h y it is not included. Internally d e ve lo p e d g o o d w ill is never c a p ita lise d ; for exam ple, expenditures on o ffice parties that create h a p p y em ployees are expensed, not cap ita lise d . Follow ing the acquisition o f g o o d w ill, rather than am ortising it over a deem ed useful life (as w a s previously the case in Australia), an entity w ill test it for im pairm ent on an annual basis, o r m ore frequently, if events o r changes in circumstances in d ica te that the g o o d w ill's carrying value has decreased b e lo w its recoverable amount. C o n sid e r the fo llo w in g description from N o te 1 o f C o ca -C o la A m atil Limited's 2 0 1 3 fin a n cia l statements on g o o d w ill. G o o d w ill is th e e x c e s s o f th e c o s t o f an a c q u is itio n o v e r th e f a ir v a lu e o f th e n e t a ssets a c q u ire d . G o o d w ill is n o t a m o r tis e d b u t w ill be te s te d a n n u a lly o r m o r e f r e q u e n tly i f re q u ire d , f o r a n y im p a ir m e n t in th e c a rr y in g a m o u n t. Im p a irm e n t is d e te rm in e d b y as se s sin g th e re c o v e ra b le a m o u n t o f th e ca sh g e n e r a tin g u n it t o w h ic h th e g o o d w ill re la te s . Source: C oca-C ola A m atil Lim ited, Annual Report 2013.
10.10
Finance leases
Leases are rental agreem ents in w h ich on e individual (a lessee) pays, to the o w n e r o f a property (lessor), a certain am ount in return for the right to use that property over a predeterm ined p e riod. The property could be a b u ild in g, a motor vehicle, equipm ent, aircraft, computers, o r furniture an d fittings. Before the issuing o f accounting standards on leases, there w a s some concern that com panies w e re using leases to a v o id putting assets an d liabilities on the b a lan ce sheet. For exam ple, instead o f b o rro w in g $ 1 0 0 0 0 0 from a bank to buy a n ew piece of equipm ent (resulting in assets a nd liabilities both increasing by $ 1 0 0 0 0 0 ) , some com panies w e re using an alternative form of financin g , nam ely leases, a nd a v o id in g the need to include the asset a nd related lia b ility on the b a la n ce sheet. As a result, the A ustralian A ccounting Standards d e fined tw o types o f leases: fin a n ce leases (called c a p ita l leases in the United States) a n d o p erating leases. Leases are classified as fin a n ce leases w hen all the risks a nd benefits incidental to ow nership are substantially transferred to the lessee. Finance leases a re included on the b a la n ce sheet as follow s: •
The cost is the present value of the future lease payments using an a p p ro p ria te interest rate usually found in the lease agreem ent (discussed in the a p p e n d ix to C h a p te r 1 1).
•
A t the same time, the present value o f those payments is recorded as a liability. Therefore, the journal entry to put the leases on the b a la n ce sheet is: DR CR
Finance lease asset Finance lease obligations liability
XXXX XXXX
408
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A fter that: 1
The leased asset is am ortised, just as the o w n e d assets a re d e p re cia te d , fo llo w in g a p o licy that is consistent w ith that used for o w n e d assets but also taking into a ccount the terms o f the lease.
2
The lia b ility is reduced as payments are m ade on the lease. Each paym ent is d iv id e d into p rincipal a nd interest portions, so that o n ly the prin cipa l portion is deducted from the lia b ility an d the rest is considered interest expense. This m aintains the lia b ility at the present value o f the rem aining lease payments.
3
Therefore, the expenses for using the leased asset a re am ortisation an d interest. Such amounts are usually com bined w ith other am ortisation a nd interest expenses, because the intent is to represent the e co n o m ic situation fairly.
4 Various particulars o f sig n ifica n t c a p ita l leases are usually disclosed in the notes to the fin a n cia l statements so that the readers o f the statements m ay ju d g e the effects o f such capitalisation. S eparate disclosure is usual for the lease o bligatio n s lia b ility, the terms o f the lease, an d related am ortisation a n d interest expenses. The result o f these procedures is that the leased asset is treated essentially as if it w e re o w n e d . A ccrual accounting recognises the econom ic value o f the asset an d disregards the legalities o f w h o ow ns it. If the lease does not result in the econom ic e quivalence o f ow n e rsh ip (e.g. if it is really a rental situation w h e re the o w n e r continues to d o the repairs a nd m aintenance, g e n e ra lly controls the asset an d regains use o f the asset after a certain period), the lease is termed an o p erating lease. For such leases, there is no asset o r lease o b lig a tio n lia b ility recognised, a n d the lease payments are just expensed as rent expense. If the o p erating lease is significant to the com pany, some o f its particulars m ay be disclosed in the notes to the fin a n cia l statements.
10.11
Managers and noncurrent assets
M a n a g e rs need to make m any judgements related to noncurrent assets. Examples include: •
W h a t should be included in the cost o f an asset, a nd over w h a t p eriod should it be d e p re cia te d ?
•
W h e n should assets be revalued, a nd w h o should d o the revaluation?
•
Should developm ent costs be ca p ita lise d or expensed?
•
O v e r w h a t period should intangibles be am ortised, o r are they subject to an im pairm ent test?
•
W h a t value should be put on brand names, tradem arks a nd so on? All the a b o v e decisions w ill affect the valuation o f assets, w h ich in turn affects certain perform ance measures, such
as return on assets (ROA), w h ich m anagers are responsible for. All o f the a b o v e judgem ents (except the u p w a rd revaluation o f assets) w ill affect the enterprise's profit figure, w h ich is a g a in a key in d ica to r o f m anagem ent perform ance.
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409
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Depreciation, calculations, entries and effects A t th e b e g in n in g o f 2 0 1 5 , G a rris o n Ltd a c q u ire d m a c h in e ry th a t c o st $ 1 0 0 0 0 0 , h a d a useful life o f 1 0 y e a rs a n d z e ro s c ra p v a lu e . D u rin g 2 0 1 5 a n d 2 0 1 6 , th e c o m p a n y d e p re c ia te d th is m a c h in e ry using th e s tra ig h t-lin e m e tho d. 1 C a lc u la te th e d e p re c ia tio n e x p e n s e G a rris o n has re c o g n is e d fo r 2 0 1 5 a n d 2 0 1 6 a n d w rite a jo u rn a l e n try to re c o rd e ith e r y e a r's a m o u n t. 2
C a lc u la te th e d e p re c ia tio n e x p e n s e G a rris o n w o u ld h a ve re c o rd e d , h a d it been using th e re d u c in g b a la n c e m e th o d fo r 2 0 1 5 a n d 2 0 1 6 (assum e a d e p re c ia tio n ra te o f 2 0 p e r cent).
3
C a lc u la te th e effects o f c h a n g in g fro m s tra ig h t-lin e to re d u c in g b a la n c e on th e fo llo w in g :
a
th e b a la n c e shee t a t th e e n d o f 2 0 1 5
b
th e in co m e state m e nt fo r 2 0 1 6
c
th e b a la n c e shee t a t th e e n d o f 2 0 1 6 .
PRACTICE PROBLEM B D eterm inin g the cost o f n o n cu rre n t assets O n 1 J a n u a ry 2 0 1 6 , C o m b o Ltd p u rc h a s e d a fa c to ry (a n d th e la n d on w h ic h it sto o d ), to g e th e r w ith th e m a c h in e ry in it, fo r $ 7 0 0 0 0 0 in to ta l. The in d e p e n d e n tly d e te rm in e d a p p ra is a l v a lu e s w e re :
$ Land
320000
Building
180000
Machinery
200000
In J a n u a ry , a p o rtio n o f th e b u ild in g w a s d e m o lis h e d , a t a cost o f $ 1 2 0 0 , to a llo w fo r th e e x te n sio n o f the b u ild in g to house n e w m a c h in e ry . T w o h u n d re d d o lla rs w a s re c e iv e d fo r m a te ria ls s a lv a g e d fro m th e d e m o litio n . H o w e v e r, in th e co u rs e o f th e d e m o litio n , e x is tin g m a c h in e ry w a s d a m a g e d , re q u irin g e x p e n d itu re o f $ 4 0 0 on re p a irs . This a m o u n t w a s no t re c o v e ra b le fro m th e d e m o litio n c o m p a n y . In F e b ru a ry a n d M a rc h th e exte n sio n s w e re b u ilt. C o n s tru c tio n costs w e re $ 4 0 0 0 0 , a rc h ite c t's fees w e re $ 4 0 0 0 a n d le g a l fees w e re $ 5 0 0 . In A p r il, n e w m a c h in e ry w a s p u rc h a s e d fo r $ 5 0 0 0 0 (list p ric e ). Sales ta x o f 4 p e r c e n t w a s p a id , as w e re fre ig h t a n d in s ta lla tio n costs o f $ 7 5 0 . In a d d itio n , $ 5 0 0 w a s spen t on m a k in g c h a n g e s to an e x is tin g m a c h in e to e x te n d its useful life. 1 If a b a la n c e sheet w a s to be p re p a re d a t th e e n d o f A p ril 2 0 1 6 , w h a t a m o u n ts w o u ld be s h o w n fo r th e cost o f la n d , b u ild in g s a n d m a c h in e ry? P re p a re s e p a ra te schedules, listin g in d iv id u a l c o m p o n e n ts o f th e c o st o f la n d , b u ild in g s a n d m a c h in e ry , to s u p p o rt y o u r a n s w e r. 2
W h a t is th e e ffe c t o n s h a re h o ld e rs ' e q u ity o f th e a b o v e tra n sa ctio n s (if a n y ), a ssu m in g a ll pa ym e n ts w e re m a d e in cash ? B rie fly e x p la in y o u r a n sw e r.
KEY TERMS Betterment Capitalisation Carrying amount expensing Impairment loss
Recoverable amount Reducing balance depreciation Revaluation Revaluation decrement Revaluation increment
Time value of money Units-of-production depreciation Value in use
410
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
W h a t is in c lu d e d in th e cost o f an asset?
2
W h a t is th e p u rp o s e o f d e p re c ia tio n ?
3
'W ith o u t d e p re c ia tio n , th e asset v a lu e s in th e b a la n c e sheet w o u ld n o t be a p p ro p ria te .' D iscuss.
4
W h a t ju d g e m e n ts ne ed to be m a d e b y m a n a g e rs a n d a c co u n ta n ts in c a lc u la tin g d e p re c ia tio n ?
5
W h a t d iffe re n t m e thods o f d e p re c ia tio n a re a v a ila b le ? H o w d o th e m e thods a ffe c t p ro fit fo r th e y e a r?
6
H o w d o g a in s a n d losses on d is p o s a l a ffe c t th e fin a n c ia l statem ents?
7
W h a t is th e p u rp o s e o f a n asset re v a lu a tio n ?
8 W h a t is th e im p a c t o n th e p ro fit fo r th e y e a r if a p a rc e l o f la n d is re v a lu e d u p w a rd s ? 9
W h a t is re c o v e ra b le a m o u n t?
1 0 List fiv e d iffe re n t type s o f in ta n g ib le s . 11 W h a t is g o o d w ill? H o w is it v a lu e d in th e b a la n c e sheet? 12 P ro v id e th re e e x a m p le s o f d e fe rre d e x p e n d itu re . W h e re w o u ld th e y a p p e a r in th e fin a n c ia l statem ents? 13 W h a t d e te rm in e s w h e th e r d e v e lo p m e n t costs a re c a p ita lis e d o r e xp e n s e d ? 14 W h y re c o rd d e p re c ia tio n e x p e n s e b y d e b itin g th e e x p e n s e a n d c re d itin g a c c u m u la te d d e p re c ia tio n ? W h y not just c re d it th e asset cost so th a t th e b a la n c e sheet show s just th e re m a in in g u n d e p re c ia te d cost? (A fte r a ll, the la tte r m e th o d is used fo r p re p a id expenses.) 15 U n d e r w h a t c ircu m s ta n ce s w o u ld th e fo llo w in g d e p re c ia tio n p o lic ie s be a p p ro p ria te ? a s tra ig h t-lin e (even p e rio d ic expe nses o v e r th e asse t's life)
b
re d u c in g b a la n c e (d e c lin in g p e rio d ic expe nses o v e r th e asset's life)
c
u n its -o f-p ro d u ctio n (v a ria b le p e rio d ic expe nses d e p e n d in g o n th e use o f th e asset)
16 B rie fly e x p la in w h a t is m e a n t b y th e statem ent: 'U n d e r h is to ric cost a c c o u n tin g , d e p re c ia tio n is a process o f a llo c a tio n .' In clu d e in y o u r a n s w e r som e re fe re n ce to th e key a ssu m p tio ns th a t s u p p o rt th e v ie w o f d e p re c ia tio n as a n a llo c a tio n pro ce ss, a n d a b rie f e x p la n a tio n as to w h y th e re s id u a l v a lu e o f d e p re c ia b le n o n c u rre n t assets is n o t 'd e p re c ia te d '. 1 7 W h y is c a p ita lis in g costs such as in ta n g ib le assets a re a s o n a b le id e a ? W h y is it no t such a g o o d id e a ? 18 E x p la in c le a rly w h y , a n d h o w , c a p ita lis in g th e costs o f a d e v e lo p m e n t p ro je c t as a d e fe rre d costs asset a ffe c ts the in c o m e state m e nt a n d th e b a la n c e sheet. 1 9 If an asset is le a s e d , it is no t o w n e d . H o w c a n a c c o u n tin g s ta n d a rd s th a t re q u ire th e c re a tio n o f a b a la n c e sheet a c c o u n t fo r these le ased assets be ju stifie d ? 2 0 If a lease is tre a te d as a fin a n c e lease ra th e r th a n a n o p e ra tin g lease, w h a t effects d o e s th a t h a ve on th e b a la n c e sheet a n d th e in co m e statem ent? 21 'T his d e p re c ia tio n business a p p e a rs to in v o lv e a lo t o f g u e s s w o rk . To c a lc u la te th e a n n u a l c h a rg e y o u guess the life o f th e asset, its s c ra p v a lu e a n d e x p e c te d p a tte rn o f re d u c tio n in v a lu e . Y ou tell us th a t th e re is a c h o ic e o f m e thods a v a ila b le a n d th a t no m e th o d c a n be c la im e d to be c o rre c t in p a rtic u la r circu m s ta n ce s. Y ou a d m it th a t th e ra te o f d e p re c ia tio n c h a rg e d fo r ta x a tio n pu rpo se s d iffe rs fro m th e ra te used in th e a c c o u n tin g re c o rd s. It seems to m e th a t th e c o m p a n y w ill run in to d iffic u ltie s w ith th e ta x a tio n d e p a rtm e n t.' D iscuss.
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PROBLEMS PROBLEM 10.1 C lassify expenditure as assets or expenses A n n e a n d T o n y o w n a gu estho use a n d spen t th e fo llo w in g : 1 P urchased a n e w a ir c o n d itio n in g u n it ($ 1 2 0 0 0 ) a n d h a d it in sta lle d ($ 4 0 0 0 ). 2
S p e n t $ 3 0 0 0 0 0 c o n s tru c tin g a n e x te n sio n to th e gu esthouse.
3
S p e n t $ 1 5 0 0 0 p a in tin g th e e x te n sio n .
4
S p e n t $ 1 5 0 0 d e m o lis h in g an o ld b u ild in g th a t w a s o n th e site o f th e e x te n sio n .
5
S p e n t $1 8 0 0 0 p a in tin g th e o ld section o f th e gu esthouse.
6
S p e n t $ 4 5 0 0 0 re p la c in g c a rp e ts w ith flo o rb o a rd s in th e o rig in a l section o f th e gu estho use.
7
S p e n t $1 3 0 0 0 re p la c in g e x is tin g c a rp e ts in th e o rig in a l section o f th e gu estho use.
8 S p e n t $ 9 0 0 on n e w c u rta in s (the o ld ones w e re d e s tro y e d b y a guest). For e a ch item , state w h e th e r it is an asset o r a n e x p e n s e . If a n asset, state th e a m o u n t it w o u ld be re c o rd e d at.
PROBLEM 10.2 Cost o f an asset O n 1 July 2 0 1 6 , M a n ly Ltd p u rc h a s e d som e e q u ip m e n t fo r use in its o p e ra tio n s . The useful life o f th e e q u ip m e n t is e s tim a te d to be 1 0 y e a rs . The c o m p a n y h a d m a d e th e fo llo w in g e x p e n d itu re s : a p u rch a s e p ric e o f th e m a c h in e (as p e r in v o ic e ), $1 0 0 0 0 0 0 b
fre ig h t e x p e n s e p a id fo r b y th e seller (as p e r th e sales a g re e m e n t), $ 1 7 0 0 0
c
in s ta lla tio n cost, p a id in cash , $ 2 3 0 0 0 .
Required: 1 W h a t is th e to ta l c o st o f th e asset? 2
W h a t is th e d e p re c ia tio n e x p e n s e fo r y e a r 1, assu m ing s tra ig h t-lin e d e p re c ia tio n is used?
3
W h a t is th e b a la n c e o f a c c u m u la te d d e p re c ia tio n a t 3 0 June 2 0 1 8?
PROBLEM 10.3 C lassify expenditure as assets or expenses C la s s ify th e fo llo w in g e x p e n d itu re s as an asset o r a n e x p e n s e , a n d state y o u r reasons w h y . 1 A Ltd b o u g h t th re e n e w c a rs fo r its sales te a m , fo r a cost o f $1 2 0 0 0 0 . T w o ca rs w e re a ir-c o n d itio n e d a t a c o st o f $ 8 0 0 0 , a n d a m o b ile p h o n e w a s in sta lle d in o n e o f th e ca rs fo r $ 1 0 0 0 . 2
B Ltd b o u g h t a n e w po in t-of-sale in v e n to ry system fo r $ 1 5 0 0 0 0 a n d tra in e d tw o e m p lo y e e s to use it, a t a cost o f
3
C Ltd has spen t $ 1 5 0 0 0 d e v e lo p in g a n e w p ro d u c t c a lle d D a v o Plus. D e v e lo p m e n t is no t y e t c o m p le te . A t a re c e n t b o a rd m e e tin g , d ire c to rs v o te d to c o n tin u e d e ve lo p m e n t.
4
D Ltd p a id fo r an e q u ip m e n t o v e rh a u l th a t is e s tim a te d to h a ve in c re a s e d th e p ro d u c tiv e c a p a c ity o f the e q u ip m e n t b y 1 5 p e r cent, bu t it has no t in c re a s e d its useful life.
$ 1 5 0 0 0 . T w o m onths la te r, bo th e m p lo y e e s left, a n d an a d d itio n a l $ 1 0 0 0 0 w a s spent tra in in g a re p la c e m e n t.
PROBLEM 10.4 Cost o f an asset, depreciation The fo llo w in g events to o k p la c e a t F re d d ie C h o o P a in tin g d u rin g 2 0 1 6 : a O n 1 J a n u a ry , F re d d ie b o u g h t a v a n fo r $ 3 0 0 0 0 . H e h a d a to ol chest a n d side racks fo r la d d e rs in sta lled fo r a to ta l cost o f $ 5 0 0 0 . H e p a id an a d d itio n a l $ 1 0 0 0 to a s ig n w rite r to p a in t his na m e a lo n g th e s id e o f the v a n . The tru ck is e x p e cte d to last fo r fo u r y e a rs a n d then be sold fo r $ 8 0 0 . F re d d ie uses s traig ht-line d e p re c ia tio n , b
O n 1 A p r il, F re d d ie p u rc h a s e d 1 0 cases o f p a in t rollers a t a u c tio n fo r $ 3 2 0 0 (m a rke t v a lu e , $ 3 8 0 0 ) . F re d d ie w ill use a ll th e p a in t ro lle rs this y e a r a n d n e xt y e a r (5 0 p e r c e n t e a ch y e a r). The p a in t rollers h a ve n o s a lv a g e v a lu e a t th e e n d o f th is tim e.
c
O n 1 F e b ru a ry, F re d d ie p a id S y d n e y C o u n c il $ 4 5 0 0 fo r a th re e -y e a r lice n c e (1 F e b ru a ry 2 0 1 6 to 31 J a n u a ry 2 0 1 9 ) to o p e ra te his business.
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Required: 1
W h a t cost w o u ld be a s s ig n e d to: a
th e v a n ?
b
th e p a in t rollers?
2
D e te rm in e th e a m o u n t o f d e p re c ia tio n , o r o th e r ex p e n s e , to be re c o rd e d fo r e a c h asset fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 .
3
W h e re w ill these assets a p p e a r on F re d d ie 's b a la n c e sheet as a t 31 D e c e m b e r 2 0 1 6?
PROBLEM 1 0 .5 D e p re d a tio n calculation s L a w n m o w in g Lim ited has p u rc h a s e d a g ro u p o f n e w la w n m o w e rs fo r $ 2 0 0 0 0 . The frie n d e xp e cts th e m o w e rs to last fiv e y e a rs a n d to h a ve n e g lig ib le resale v a lu e a t th a t p o in t. The frie n d 's business p la n p ro je c ts cu ttin g 5 0 0 0 la w n s o v e r th e fiv e y e a rs , w ith p e r-ye a r p ro je c tio n s o f 5 0 0 , 1 0 0 0 , 1 2 0 0 , 1 8 0 0 a n d 5 0 0 la w n s o v e r the fiv e y e a rs . 1 C a lc u la te th e a c c u m u la te d d e p re c ia tio n b a la n c e a t th e e n d o f th e s e co n d y e a r usin g e a ch o f th e fo llo w in g d e p re c ia tio n bases: a
s tra ig h t-lin e
b
re d u c in g b a la n c e (2 5 p e r c e n t rate)
c
u n its -o f-p ro d u ctio n .
2
Based on y o u r c a lc u la tio n s , w h ic h d e p re c ia tio n basis w o u ld p ro d u c e th e h ig h e st re ta in e d p ro fits a t th e e n d o f the s eco nd y e a r?
3
If th e 2 5 p e r c e n t re d u c in g b a la n c e m e th o d is used, a c c u m u la te d d e p re c ia tio n w ill be $ 1 5 2 5 4 a t th e en d o f the fifth y e a r. S u p p o se th a t, on th e first d a y o f th e sixth y e a r, a ll th e la w n m o w e rs a re s o ld as ju n k fo r $ 1 0 0 cash in to ta l. Ig n o rin g in co m e ta xe s, c a lc u la te th e loss o n sale th a t w o u ld be re c o rd e d th a t d a y .
PROBLEM 1 0 .6 D epreciation m ethods and selection o f m ethod D o m b e y & Son a c q u ire d a n e w m a c h in e on 1 J a n u a ry 2 0 1 3 a t a c o st o f $1 3 5 0 0 0 . F re ig h t a n d in s ta lla tio n c h a rg e s a m o u n te d to $ 2 5 0 0 0 . The m a c h in e w a s e x p e c te d to h a ve a useful life o f fo u r y e a rs a n d a re s id u a l v a lu e a t th e en d o f th a t p e rio d o f $ 1 0 0 0 0 . D u rin g its useful life, it w a s e x p e c te d to be o p e ra te d fo r 2 5 0 0 0 hours. 1 P re p a re a ta b le s h o w in g th e a n n u a l d e p re c ia tio n e x p e n s e re la tin g to th e m a c h in e fo r e a ch o f th e y e a rs e n d in g 31 D e c e m b e r 2 0 1 3 , 2 0 1 4 , 2 0 1 5 a n d 2 0 1 6 using:
2
a
th e s tra ig h t-lin e m e tho d
b
th e re d u c in g b a la n c e m e tho d.
A s su m in g th a t D o m b e y & Son h a d used th e u n its -o f-p ro d u ctio n m e th o d , a n d th a t th e m a c h in e h a d been o p e ra te d fo r 7 0 0 0 ho urs d u rin g th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 , s h o w th e jo u rn a l e n try to re c o rd th e d e p re c ia tio n e x p e n s e fo r th a t y e a r.
3
H o w sh o u ld D o m b e y & Son d e c id e w h ic h d e p re c ia tio n m e th o d to use? W ill th e c h o ic e o f d e p re c ia tio n m e tho d h a ve a n y e ffe c t o n th e re p o rte d p ro fit a n d fin a n c ia l p o s itio n o f D o m b e y & Son o v e r the life o f th e asset?
PROBLEM 1 0 .7 D epreciation ca lcu la tio n s and selection o f m ethod A n item o f e q u ip m e n t w a s p u rc h a s e d on 1 July 2 0 0 8 a t a cost o f $ 6 2 5 0 0 0 . It w a s e s tim a te d to h a ve a useful life o f fo u r y e a rs a n d a s a lv a g e v a lu e a t th e e n d o f th a t p e rio d o f $ 2 5 0 0 0 . 1 C a lc u la te th e d e p re c ia tio n e x p e n s e th a t w o u ld be c h a rg e d w ith re sp e ct to this e q u ip m e n t in e a ch o f the y e a rs e n d in g 3 0 J u n e 2 0 1 3 , 2 0 1 4 , 2 0 1 5 a n d 2 0 1 6 using:
2
a
th e s tra ig h t-lin e m e tho d
b
th e re d u c in g b a la n c e m e th o d (use 4 0 p e r c e n t rate).
O u tlin e th e m a in fa cto rs to be c o n s id e re d in se le ctin g a n a p p ro p ria te d e p re c ia tio n m e tho d.
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PROBLEM 1 0 .8 D e p re d a tio n calculations, entries, e ffe cts and choice A t th e b e g in n in g o f 2 0 1 5 , SD C o rp o ra tio n a c q u ire d m a c h in e ry th a t cost $ 1 0 0 0 0 0 a n d h a d a n a n tic ip a te d useful life o f 1 0 y e a rs . SD C o rp o ra tio n d e p re c ia te d this m a c h in e ry fo r 2 0 1 5 a n d 2 0 1 6 , using th e s tra ig h t-lin e m e tho d. D u rin g 2 0 1 7 , it d e c id e d to c h a n g e to th e re d u c in g b a la n c e m e th o d o f d e p re c ia tio n . 1 P re p a re th e jo u rn a l e n try to re c o rd d e p re c ia tio n e x p e n s e fo r 2 0 1 6 , using th e s tra ig h t-lin e m e tho d. 2
P re p a re th e jo u rn a l e n try to re c o rd d e p re c ia tio n e x p e n s e fo r 2 0 1 6 using th e re d u c in g b a la n c e m e th o d , a t a rate o f 2 0 p e r cent.
3
S h o w th e effects o f c h a n g in g fro m th e s tra ig h t-lin e m e th o d to th e 2 0 p e r c e n t re d u c in g b a la n c e m e th o d on :
4
a
th e net p ro fit b e fo re ta x fo r 2 0 1 6
b
th e to ta l assets fo r 2 0 1 6 .
In w h a t c ircu m sta n ce s is th e use o f re d u c in g b a la n c e d e p re c ia tio n m o re a p p ro p ria te th a n using th e s tra ig h t-lin e m e tho d?
PROBLEM 1 0 .9 D epreciation and g a in /lo s s ca lcu la tion s and effects F red 's F re ig h th a u lin g Ltd has a sm all fle e t o f d e liv e ry trucks. Each o n e is d e p re c ia te d on th e re d u c in g b a la n c e m e th o d (rate 2 0 p e r c e n t; h a lf o f th a t in th e y e a r o f a c q u is itio n a n d in th e y e a r o f d is p o s a l) w ith no s a lv a g e v a lu e . T ruck 4 w a s p u rc h a s e d on 1 J u ly 2 0 1 3 fo r $ 4 6 0 0 0 , a n d sold th re e y e a rs la te r, on 3 0 June 2 0 1 6 , fo r $ 1 5 0 0 0 . The c o m p a n y 's fin a n c ia l y e a r-e n d is 31 D e c e m b e r. 1 W h a t w a s th e to ta l d e p re c ia tio n on tru c k 4 to the d a te o f its d is p o s a l? 2
Based on y o u r a n s w e r to q u e s tio n 1, w rite a jo u rn a l e n try to re c o rd th e d is p o s a l o f tru c k 4 .
3
R edo q u e s tio n s 1 a n d 2 , a ssu m in g th e c o m p a n y uses s tra ig h t-lin e d e p re c ia tio n a t 15 p e r c e n t p e r y e a r a n d an e s tim a te d s a lv a g e v a lu e o f $ 6 0 0 0 .
4
C a lc u la te th e d iffe re n t effects o f th e tw o d e p re c ia tio n m e thods on th e c o m p a n y 's 2 0 1 6 p ro fit. Ig n o re in c o m e ta x effects.
5
W h a t im p lic a tio n s (if a n y) w o u ld th e use o f d iffe re n t d e p re c ia tio n m e tho ds b y th e c o m p a n y h a ve fo r p o te n tia l c re d ito rs o r investors?
6 The use o f d iffe re n t d e p re c ia tio n m e tho ds c o u ld a ffe c t fin a n c ia l p e rfo rm a n c e c o m p a ris o n s b e tw e e n fin a n c ia l y e a rs fo r a p a rtic u la r c o m p a n y , a n d b e tw e e n d iffe re n t c o m p a n ie s fo r th e sam e fin a n c ia l y e a r. H o w a re these d iffe re n c e s m itig a te d ?
PROBLEM 10 .1 0 T -accounts For depreciation The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c co u n ts o f E q u ip m e n t Ltd. $000
Equipment, 1 July 2015
2 500
Equipment, 30 June 2016
3 900
Accumulated depreciation - equipment, 1 July 2015
600
Accumulated depreciation - equipment, 30 June 2016
400
Equipment sold during the year - cost price
900
- accumulated depreciation
250
- proceeds
700
W h a t w a s th e d e p re c ia tio n e x p e n s e fo r e q u ip m e n t fo r th e y e a r?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 10.11 D epreciation from an annual re p o rt B e lo w is a note fro m E a s tw o o d Ltd's recen t a n n u a l re p o rt: 1 S u m m a ry o f s ig n ific a n t a c c o u n tin g p o lic ie s o n n o n - c u r r e n t assets
P ro p e rty and e q u ip m e n t - P ro p e rty and eq u ip m e n t is re corded at co st and de preciation is calculated on a s tra ig h t-lin e basis. Buildings and im p ro vem en ts have an expected useful life o f 1 5 - 3 0 years, w hile th e expected useful life o f eq uipm ent is 4 - 1 5 years and fu rn itu re and fittin g s is 5 - 1 0 years. F o r 2 0 1 6 and 20 1 5 , th e assets included in p ro p e rty and eq uipm ent are as follow s:
Land Buildings and improvements
2016 $ (000s)
20 15 $ (000s)
59 778
57 850
150172
149172
Equipment, furniture and fittings
27 850
27706
Leasehold improvements
14695
16 699
252495
251 42 7
Less: Accumulated depreciation
(55 383) 197112
(50000) 201 42 7
1
If E a s tw o o d Ltd d id no t sell a n y p ro p e rty a n d e q u ip m e n t in 2 0 1 6 , w h a t d e p re c ia tio n e x p e n s e w o u ld h a ve been re c o rd e d fo r 2 0 1 6?
2
A ssum e th a t E a s tw o o d Ltd d id n o t re c o rd its d e p re c ia tio n e x p e n s e in 2 0 1 6 . W h a t is th e e ffe c t o f this e rro r on the fo llo w in g ?
3
a
p ro fit
b
c u rre n t assets
c
n o n -cu rre n t assets
W h a t w a s th e c o st o f th e la n d p u rch a s e d ?
PROBLEM 10.12 Various d epreciation m ethods O n 1 J a n u a ry 2 0 1 6 , Y ip Ltd a c q u ire d a d d itio n a l e q u ip m e n t a t a cost o f $ 1 2 0 0 0 0 , less a tra d e disco u n t o f 2 5 p e r cent. The terms o f pa ym e n t w e re 2 / 1 0 , n / 3 0 . Paym ent w a s m a d e on 2 0 J a n u a ry 2 0 1 6 . Freight charg es w e re $ 7 5 0 0 an d in sta llatio n a n d testing cost $ 2 5 0 0 . The e q u ip m e n t w a s e x p e c te d to h a ve a useful life o f fiv e y e a rs a n d a s a lv a g e v a lu e o f $ 3 1 2 5 . D u rin g its life , the e q u ip m e n t w a s e x p e c te d to p ro d u c e 7 7 5 0 0 0 units o f o u tp u t. D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , th e e q u ip m e n t w a s used to p ro d u c e 7 0 0 0 0 units. C a lc u la te th e d e p re c ia tio n e x p e n s e to be c h a rg e d in th e a c co u n ts o f Y ip Ltd, w ith re s p e ct to th is n e w e q u ip m e n t fo r the fin a n c ia l y e a r e n d e d 3 0 June 2 0 1 6 , using: 1 th e re d u c in g b a la n c e m e th o d (assum ing a ra te o f 5 0 p e r cent)
2 th e s tra ig h t-lin e m e tho d 3
th e u n its -o f-p ro d u ctio n m e tho d.
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PROBLEM 10.13 Com parison o f m ethods o f depreciation A lle y Lim ited re c e n tly p u rc h a s e d c e rta in m a n u fa c tu rin g e q u ip m e n t fo r $ 8 1 0 0 0 0 . The e q u ip m e n t is e x p e c te d to ha ve a useful life o f fo u r y e a rs a n d a s a lv a g e v a lu e o f $ 1 0 0 0 0 . The m a n a g e r o f A lle y Lim ited w ish e s to k n o w th e e ffe c t th a t v a rio u s d e p re c ia tio n m e tho ds w ill h a ve on th e re p o rte d p ro fit o f th e c o m p a n y a n d asks y o u to p re p a re a sch e d u le c o m p a rin g th e s tra ig h t-lin e a n d th e re d u c in g b a la n c e m e tho ds o f d e p re c ia tio n (use 0 . 6 6 6 7 fo r re d u c in g b a la n c e ). 1 C a lc u la te th e a n n u a l d e p re c ia tio n e x p e n s e a n d e n d -o f-ye a r c a rry in g a m o u n t o f th e e q u ip m e n t fo r e a ch y e a r o f its e s tim a te d useful life. S h o w y o u r w o rk in g s . 2
W h a t a re th e m a in fa c to rs th a t a re lik e ly to in flu e n c e th e useful life o f a d e p re c ia b le asset? W h a t fa cto rs a re lik e ly to in flu e n c e th e m a n a g e r in sele cting a d e p re c ia tio n m e tho d?
PROBLEM 10.14 Com parison o f d epreciation m ethods Part A W a k in g H ou rs Ltd o w n s a n ig h tc lu b in th e c e n tre o f S y d n e y. In a m a jo r re fu rb is h m e n t, it p u rc h a s e d a n e w sound system a n d a n e w lig h tin g system on 1 A p ril 2 0 1 6 . The s o u n d system cost $ 2 7 0 0 0 to p u rch a s e a n d $ 3 5 0 0 to in sta ll. The lig h tin g system cost $ 4 4 0 0 0 . The soun d system has a useful life o f fiv e y e a rs a n d th e lig h tin g system , fo u r y e a rs . Both a re d e p re c ia te d on a s tra ig h t-lin e b a sis, assu m ing no re s id u a l v a lu e . 1 W h a t is th e c o st a n d th e w ritte n -d o w n v a lu e fo r th e assets d iscusse d a b o v e as a t 31 D e c e m b e r 2 0 1 6 ? 2
W o u ld W a k in g H o u rs ' p ro fit be h ig h e r o r lo w e r fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 if it h a d a d o p te d the d im in is h in g v a lu e m e th o d o f d e p re c ia tio n (use 1 5 0 p e r c e n t o f s tra ig h t-lin e rate)? Use th e sam e d a ta in the q u e s tio n a b o v e to c a lc u la te y o u r a n sw e r.
Part B This q u e s tio n c o n tin u e s th e s c e n a rio o u tlin e d a b o v e . O n 1 M a y 2 0 1 6 , it w a s fo u n d th a t th e lig h tin g system w a s no lo n g e r fla s h in g u ltra v io le t rays in tim e w ith the m usic (as it s h o u ld ). It cost $ 7 0 0 to h a ve this fix e d . O n 1 O c to b e r 2 0 1 6 , $ 5 0 0 0 w a s s p e n t to g iv e th e soun d system a h e a v ie r bass b e a t. W h a t is th e a p p ro p ria te a c c o u n tin g tre a tm e n t fo r th e events th a t o c c u rre d on 1 M a y 2 0 1 6 a n d 1 O c to b e r 2016?
PROBLEM 10.15 Journal e n try fo r asset disposal E xtract fro m b a la n c e sheets a t 3 0 June:
2016
2015
$
$
Equipment
980000
821 000
Accumulated depreciation
400000
320000
Equipment net
480000
501 000
A d d itio n a l in fo rm a tio n : i D e p re c ia tio n e x p e n s e fo r th e y e a r is $ 1 3 0 0 0 0 . ii C a s h p ro ce e d s fo r d is p o s a l o f e q u ip m e n t d u rin g th e y e a r a m o u n te d to $1 1 0 0 0 0 , resultin g in a loss on sale of $ 2 0 0 0 0 . P re p a re th e jo u rn a l e n try fo r th e d is p o s a l o f e q u ip m e n t.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 10.16 Asset disposal E xtract fro m b a la n c e sheets a t 3 0 June:
2017
2016
$
$
Equipment
820000
700000
Accumulated depreciation
400000
340000
Equipment net
420000
360000
A d d itio n a l in fo rm a tio n : i P urchased a d d itio n a l e q u ip m e n t fo r $ 2 0 0 0 0 0 . ii
P roceeds fro m th e sale o f e q u ip m e n t w a s $ 6 0 0 0 0 w ith a g a in o n sale o f $ 2 0 0 0 0 .
P re p a re the jo u rn a l e n try fo r th e sale o f e q u ip m e n t.
PROBLEM 10.17 Asset disposal Q u ic k Express, a le a d in g c o u rie r c o m p a n y , s o ld a sm all d e liv e ry tru ck th a t h a d be en used in th e business fo r five y e a rs . The re c o rd s o f th e c o m p a n y re fle c te d th e fo llo w in g : Delivery truck cost
$47 000
Accumulated depreciation
$39 000
W h a t is th e jo u rn a l e n try fo r th e d is p o s a l o f th e tru ck , a ssu m in g th a t th e tru ck s o ld fo r: 1 $ 8 0 0 0 cash? 2
$ 9 0 0 0 cash?
3
$ 7 1 0 0 cash?
PROBLEM 10 .1 8 Repairs versus ca p ita lisin g G ib b s Ltd o p e ra te s a m a n u fa c tu rin g fa c ility to p ro d u c e its key p ro d u cts . O n 1 July 2 0 1 6 , th e b a la n c e o f an e q u ip m e n t a c c o u n t w a s as fo llo w s : Manufacturing equipment
$120000
Accumulated depreciation
$ 78000
D u rin g th e 2 0 1 7 fin a n c ia l y e a r, G ib b s Ltd in c u rre d th e fo llo w in g expe nses: Equipment maintenance and repairs
$ 1 000
Major equipment upgrade to improve efficiency
$35 000
The e q u ip m e n t has an e x p e c te d useful life o f 2 0 y e a rs , a n d re s id u a l v a lu e is $ 7 2 0 0 . G ib b s Ltd d e p re c ia te s e q u ip m e n t on a s tra ig h t-lin e basis. 1 W h a t is th e jo u rn a l e n try th a t w a s m a d e o n 3 0 June 2 0 1 6 fo r d e p re c ia tio n on m a n u fa c tu rin g e q u ip m e n t? 2
In d ic a te the effects o f th e tw o e x p e n d itu re s d u rin g 2 0 1 7 o n assets, lia b ilitie s a n d s h a re h o ld e rs ' e q u ity .
3
G iv e th e jo u rn a l en trie s to re c o rd th e tw o e x p e n d itu re s d u rin g th e 2 0 1 7 fin a n c ia l y e a r.
CHAPTER 10
N oncurrent assets
417
PROBLEM 10.19 C orrecting errors re la tin g to n o n cu rre n t assets The fo llo w in g e rro rs w e re d is c o v e re d in th e b o o ks o f th e D e e p A p p re c ia tio n C o m p a n y d u rin g th e c u rre n t y e a r, b e fo re th e b o o ks w e re c lo s e d as a t 31 D e c e m b e r. 1 D e p re c ia tio n o f $ 2 1 4 0 re la tin g to m a c h in e ry w a s in c o rre c tly c re d ite d to th e a c c u m u la te d d e p re c ia tio n b u ild in g s a c co u n t. 2
A m a c h in e w ith a cost o f $ 2 2 5 0 0 a n d a c c u m u la te d d e p re c ia tio n to th e d a te o f sale o f $ 1 6 0 0 0 w a s s o ld fo r $ 8 0 0 0 . The sale w a s re c o rd e d b y d e b itin g th e cash a t b a n k a c c o u n t a n d c re d itin g th e m a c h in e ry a c c o u n t fo r $8000.
3
The cost o f d e liv e ry e q u ip m e n t p u rc h a s e d o n 1 July fo r $ 7 9 0 0 w a s d e b ite d to th e pu rch ases a c c o u n t. The e q u ip m e n t has a useful life o f fo u r y e a rs a n d e s tim a te d re s id u a l v a lu e o f $ 9 0 0 . S tra ig h t-lin e d e p re c ia tio n is used
4
The cost o f in s ta llin g lig h tin g in th e c o m p a n y c a r p a rk ( $ 1 2 0 0 0 ) w a s c h a rg e d to th e m a in te n a n c e e x p e n s e a c c o u n t on 4 J a n u a ry , th e d a te o f p u rch a s e . The lights h a ve a useful life o f e ig h t y e a rs a n d no re s id u a l v a lu e . A ssum e s tra ig h t-lin e d e p re c ia tio n .
fo r d e liv e ry e q u ip m e n t.
P re p a re g e n e ra l jo u rn a l e n trie s to c o rre c t th e e rro rs (if th e re a re a n y).
PROBLEM 1 0 .2 0 C orrection o f errors and revaluation o f n o n cu rre n t assets D u rin g th e a u d it o f th e acco un ts o f H o g a rth Ltd fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 , it w a s d is c o v e re d th a t the fo llo w in g e rro rs h a d be en m a d e d u rin g the y e a r: 1 S tore fixtu re s th a t h a d cost $ 1 2 0 0 0 w e re s o ld fo r $ 1 2 0 0 cash . The a c c u m u la te d d e p re c ia tio n a t th e d a te o f sale w a s $ 8 5 0 0 . The sale w a s re c o rd e d b y a d e b it to cash a t b a n k a n d a c re d it to store fixtu re s fo r $ 1 2 0 0 . 2
O n 1 J u ly 2 0 1 6 , a fe n c e w a s e re cte d a ro u n d th e c o m p a n y 's o ffic e b u ild in g a t a cost o f $ 9 0 0 0 . This w a s c h a rg e d to m a in te n a n c e ex p e n s e . The fe n c e is e x p e c te d to h a ve a useful life o f 1 0 y e a rs a n d no re s id u a l v a lu e . A ssum e s tra ig h t-lin e d e p re c ia tio n .
3
A tru c k w a s p u rc h a s e d on 1 J a n u a ry 2 0 1 6 a t a c o st o f $ 1 0 0 0 0 . This w a s d e b ite d to th e pu rch ases a c c o u n t. The tru ck is e x p e c te d to h a ve a useful life o f fo u r y e a rs a n d a re s id u a l v a lu e o f $1 2 9 6 . It is to be d e p re c ia te d b y the re d u c in g b a la n c e m e th o d (use 4 0 p e r cent).
4
A n o th e r b lo c k o f la n d , w h ic h w a s p u rc h a s e d fo r $ 2 0 0 0 0 in 2 0 0 5 a n d re v a lu e d a t $ 2 5 0 0 0 d u rin g 2 0 1 4 , w a s fo u n d to h a ve a fa ir v a lu e o f o n ly $ 1 5 0 0 0 a t 31 D e c e m b e r 2 0 1 6 . N o e n try has be en m a d e y e t to re c o rd th e fa ll in th e v a lu e o f this la n d .
P re p a re g e n e ra l jo u rn a l en trie s to c o rre c t th e a b o v e e rro rs, to g e th e r w ith a n y ne ce ssary a d ju s tin g e n trie s as a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 10.21 Revaluation o f n o n cu rre n t assets E a g le h a w k Ltd h a d th e fo llo w in g n o n c u rre n t asset on its b a la n c e sheet o n 3 0 June 2 0 1 5 . The c o m p a n y a d o p ts a p o lic y o f d e p re c ia tin g a ll re le v a n t item s on a s tra ig h t-lin e basis a t an a n n u a l ra te o f 1 0 p e r cent.
$ Building Accumulated depreciation
200000 (50000) 150 00 0
1
W h a t is th e c a rry in g a m o u n t o f th e b u ild in g o n 1 J a n u a ry 2 0 1 6 ?
2
O n 1 J a n u a ry 2 0 1 6 , th e d ire c to rs o f E a g le h a w k d e c id e to re v a lu e th e b u ild in g to $ 4 0 0 0 0 0 to re fle c t its m a rke t v a lu e . P re p a re th e ne ce ssary jo u rn a l en trie s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1 0 .2 2 Revaluation o f n o n cu rre n t assets K in g fis h e r Ltd h a d th e fo llo w in g n o n c u rre n t assets on its b a la n c e sheet a t 3 0 June 2 0 1 4 :
$ Land Building Accumulated depreciation
$ 320000
150000 30000
120 00 0 440000
O n 1 J u ly 2 0 1 4 , th e la n d w a s re v a lu e d to $ 3 0 0 0 0 0 , a n d th e p la n t a n d e q u ip m e n t w a s re v a lu e d to $ 1 4 0 0 0 0 . O n e y e a r la te r, o n 1 J u ly 2 0 1 5 , th e re c o v e ra b le a m o u n t o f th e p la n t a n d e q u ip m e n t w a s d e te rm in e d to be $ 1 0 0 0 0 0 , a n d it w a s re v a lu e d a c c o rd in g ly . D e p re c ia tio n fo r a ll re le v a n t item s is stra ig h t-lin e , a t an a n n u a l ra te o f 1 0 p e r cent. 1 P re p a re jo u rn a l en trie s to re c o rd th e re v a lu a tio n o f th e la n d on 1 July 2 0 1 4 . 2
P re p a re jo u rn a l en trie s to re c o rd th e re v a lu a tio n o f th e p la n t a n d e q u ip m e n t o n 1 J u ly 2 0 1 4 .
3
P re p a re jo u rn a l en trie s to re c o rd th e re v a lu a tio n o f th e p la n t a n d e q u ip m e n t o n 1 J u ly 2 0 1 5 .
4
A s su m in g th a t th e re a re no a c q u is itio n s o r d is p o s a ls o f n o n c u rre n t assets, c o n s tru c t th e N o n c u rre n t assets section o f K in g fis h e r's b a la n c e sheet as a t 3 0 June 2 0 1 6 .
PROBLEM 1 0 .2 3 Im p a irm e n t A n a irlin e 's p ro p e rty , p la n t a n d e q u ip m e n t a c c o u n t in clu d e s a p la n e th a t cost $ 1 0 m illio n a n d has a c c u m u la te d d e p re c ia tio n o f $ 6 m illio n . The p la n e c a n be sold fo r $ 3 m illio n . The pre se n t v a lu e o f fu tu re cash flo w is $ 3 .5 m illio n . 1 C a lc u la te : a
2
b o o k v a lu e
b
re c o v e ra b le a m o u n t
c
fa ir v a lu e
d
v a lu e in use.
W h a t is th e a m o u n t o f im p a irm e n t?
PROBLEM 1 0 .2 4 A m o rtis a tio n and asset im p a irm e n t H ig g in s Ltd has fo u r in ta n g ib le assets on its fin a n c ia l statem ents. M a n a g e m e n t is in tere ste d in th e a m o rtis a tio n o f e a ch o f these assets. B e lo w is in fo rm a tio n a b o u t e a ch o f th e in ta n g ib le assets: a Patent: O n 1 July 2 0 1 6 , H ig g in s Ltd p u rc h a s e d a p a te n t a t a cost o f $ 6 0 0 0 0 cash . The e s tim a te d useful life o f th e p a te n t is 15 y e a rs . b
C o p y rig h t: O n 1 July 2 0 1 6 , H ig g in s Ltd p u rc h a s e d a c o p y rig h t fo r $ 3 6 6 0 0 cash . The e s tim a te d useful life o f th e c o p y rig h t is 1 2 ye a rs .
c
Licence: O n 1 July 2 0 1 6 , H ig g in s Ltd o b ta in e d a s p e c ia l lice n c e fro m th e N S W G o v e rn m e n t fo r $ 3 5 0 0 0 c a sh . This lice n c e a llo w s th e c o m p a n y to p ro v id e a s p e c ia l se rvice fo r a p e rio d o f seven y e a rs ,
d
G o o d w ill: O n 1 July 2 0 1 6 , H ig g in s Ltd a c q u ire d a n o th e r c o m p a n y , T a rg e t Ltd, fo r a cash c o n s id e ra tio n o f $1 0 0 0 0 0 0 . The a c q u is itio n p ric e in clude s g o o d w ill o f $ 9 0 0 0 0 , w h ic h is e x p e c te d h a ve a n in d e fin ite life.
Required: 1
W h a t a m o u n t o f a m o rtis a tio n sh o u ld be re c o rd e d fo r e a ch o f th e a b o v e o n 3 0 June 2 0 1 7 ?
2
For e a ch o f th e a b o v e , w h a t is th e a m o u n t th a t w ill be re c o rd e d o n th e b a la n c e sheet on 3 0 June 2 0 1 8?
3
O n 1 July 2 0 1 7 , H ig g in s Ltd fin d s th a t d e m a n d fo r th e c o p y rig h te d p ro d u c t is lo w e r th a n e x p e c te d . It be lie ve s fa ir v a lu e o f th e c o p y rig h t to be $ 1 7 5 0 0 . W h a t a m o u n t o f im p a irm e n t, if a n y , sh o u ld be re c o rd e d ?
CHAPTER 10
N oncurrent assets
419
PROBLEM 1 0 .2 5 C alculate any g o o d w ill on a business purchase F o o fa ra w Ltd p a id $ 2 0 0 0 0 0 fo r th e la n d , b u ild in g s , in ve n to rie s a n d a c co u n ts p a y a b le o f a n o th e r business th a t w ill b e co m e a b ra n c h . The assets (a fte r d e d u c tin g th e a c co u n ts p a y a b le o f $ 5 0 0 0 0 ) h a d a n a g g re g a te fa ir m a rke t v a lu e of $ 1 8 7 0 0 0 . 1 W h a t (if a n y th in g ) is th e resultin g asset o n F o o fa ra w 's b a la n c e sheet? 2
If F o o fa ra w h a d p a id $ 1 8 5 0 0 0 , w h a t w o u ld be y o u r a n s w e r to q u e s tio n 1 ?
PROBLEM 1 0 .2 6 Journal e n try For a business a cq u isitio n Big Ideas Ltd d e c id e d to b u y p a rts o f a c o m p e tito r's business, w h ic h w a s cu ttin g b a c k o p e ra tio n s . For a p ric e o f $ 4 .2 m illio n ($1 m illio n d o w n p a y m e n t a n d th e rest in fo u r e q u a l a n n u a l in sta lm ents, plus interest a t 1 2 p e r c e n t p e r a n n u m ), Big Ideas g o t in v e n to ry it v a lu e d a t $ 2 8 0 0 0 0 , la n d it v a lu e d a t $ 1 .5 m illio n , a re ta il store b u ild in g it v a lu e d a t $ 1 .8 m illio n , fu rn itu re a n d e q u ip m e n t it v a lu e d a t $ 4 7 0 0 0 0 a n d som e d e a le rs h ip rig h ts it v a lu e d a t $ 4 0 0 0 0 . Big Ideas a ls o a g re e d to p a y a b a n k lo a n o f $ 1 3 0 0 0 0 secu red b y th e in ve n to ry. W r ite a jo u rn a l e n try to re c o rd B ig Ideas Ltd's p u rch a se .
CASES CASE 10A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 The c o m p a n y d e p re c ia te s 'p la n t a n d e q u ip m e n t'. P ro v id e e x a m p le s o f p la n t a n d e q u ip m e n t. 2
A re b u ild in g s d e p re c ia te d ?
3
W h a t is th e to ta l d e p re c ia tio n a n d a m o rtis a tio n fo r th e y e a r?
4
H o w m uch d id th e a c c u m u la te d d e p re c ia tio n a n d a c c u m u la te d a m o rtis a tio n a cco u n ts in cre a s e by?
5
W h y a re n 't th e a n sw e rs to qu e stio n s 3 a n d 4 th e sam e?
6 W h a t m e th o d o f cost a llo c a tio n is used b y th e c o m p a n y to d e te rm in e d e p re c ia tio n ? 7
D id W o o lw o rth s d is p o s e o f (e.g. sell) a n y p ro p e rty , p la n t a n d e q u ip m e n t d u rin g 2 0 1 3 ? If so, d id it m a ke a p ro fit o r loss on these sales? H o w w o u ld this p ro fit o r loss be c a lc u la te d ?
8
D oes th e c o m p a n y re v a lu e u p w a rd s a n y p ro p e rty , p la n t a n d e q u ip m e n t? If so, h o w fre q u e n tly?
9
W h a t in ta n g ib le s do es th e c o m p a n y have? H o w a re th e y v a lu e d ? O v e r w h a t p e rio d a re th e y a m o rtise d ? W h e re a re th e y lo c a te d in th e fin a n c ia l statem ents?
1 0 C o m p a n ie s c a n h a ve bo th o p e ra tin g a n d fin a n c e leases. W h e n do es W o o lw o rth s d isc lo se in fo rm a tio n on o p e ra tin g leases? 11 W h a t do es W o o lw o rth s s a y a b o u t re c o v e ra b le a m ou nt? 12 W h a t do e s W o o lw o rth s s a y a b o u t im p a irm e n t o f ta n g ib le assets?
CASE 10B____________________ Accounting policy for noncurrent assets S h o w n b e lo w is th e a c c o u n tin g p o lic y fo r B ora l a t 3 0 June 2 0 1 4 f o r p ro p e rty , p la n t a n d e q u ip m e n t.
Property, p la nt and e q u i p m e n t Owned assets: Ite m s o f p r o p e rty , p la n t a n d e q u ip m e n t a re s ta te d a t c o s t o r d e e m e d c o s t less a c c u m u la te d d e p re c ia tio n a n d im p a ir m e n t losses. T h e c o s t o f s e lf - c o n s tr u c t e d a ssets in c lu d e s th e c o s t o f m a te ria ls , d ir e c t la b o u r a n d an a p p ro p ria te p r o p o r tio n o f p r o d u c tio n o v e rh e a d s . A s s e s s m e n t o f im p a ir m e n t loss is m a d e in a c c o rd a n c e w ith th e im p a ir m e n t p o lic y .
420
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Leased p la n t an d e q u ip m e n t: Leases u n d e r w h ic h th e G r o u p a s su m e s s u b s ta n tia lly all th e ris k a n d re w a rd s o f o w n e rs h ip a re c la s s ifie d as fin a n c e leases. O t h e r leases a re c la s s ifie d as o p e ra tin g leases. F in a n c e leases are c a p ita lis e d . A lease a s se t a n d a lease lia b ility e q u a l t o th e p re s e n t va lu e o f th e m in im u m lease p a y m e n ts are r e c o r d e d a t th e in c e p tio n o f t h e lease. Lease lia b ilitie s a re re d u c e d b y re p a y m e n ts o f p rin c ip a l. T h e in te re s t c o m p o n e n ts o f t h e lease p a y m e n ts a re e x p e n s e d . C o n tin g e n t re n ta ls a re e x p e n s e d as in c u rre d . O p e r a tin g leases a re n o t c a p ita lis e d an d lease c o s ts a re e x p e n s e d . D e p re c ia tio n : Ite m s o f p r o p e rty , p la n t a n d e q u ip m e n t, in c lu d in g b u ild in g s a n d le a s e h o ld p r o p e r ty b u t e x c lu d in g fr e e h o ld la n d , a re d e p re c ia te d u s in g th e s tr a ig h t- lin e m e th o d o v e r t h e ir e x p e c te d u s e fu l lives. A s s e ts a re d e p re c ia te d f r o m th e d a te o f a c q u is itio n o r , in re s p e c t o f in te rn a lly c o n s tr u c te d assets, f r o m th e tim e an a s s e t is c o m p le te d a n d h e ld re a d y f o r use. Q u a r r y s trip p in g a ssets a re a m o rtis e d o v e r th e e x p e c te d life o f th e id e n tifie d re s o u rc e s u s in g th e u n its o f p r o d u c tio n m e th o d . Source: Boral Lim ited, Annual Report 2014.
1
S h o w th e e ffe c t o f a c q u is itio n , d is p o s a l, le a s in g a n d d e p re c ia tio n on th e a c c o u n tin g e q u a tio n .
2
W h a t d e p re c ia tio n m e tho ds a re used b y th e c o m p a n y ? W h a t d e te rm in e s w h ic h m e th o d g ive s th e la rg e r d e p re c ia tio n in a y e a r? W o u ld th e to ta l d e p re c ia tio n o v e r th e life o f th e asset d iffe r b e tw e e n m ethods?
3
W h a t ju d g m e n ts d o a c c o u n ta n ts need to m a ke in c a lc u la tin g d e p re c ia tio n , a n d h o w d o these ju d g m e n ts im p a c t p ro fit?
4
P ro v id e th re e a c tio n s b y m a n a g e m e n t th a t c o u ld m o ve p ro fit fro m o n e a c c o u n tin g p e rio d to a n o th e r.
CASE 10C___________________________________Intangibles S h o w n b e lo w a re th e a c c o u n tin g p o lic y d isclo sure s fo r F a irfa x M e d ia on in ta n g ib le s in 2 0 1 4 .
(E) INTANGIBLES (i) Goodwill G o o d w ill re p re s e n ts th e e x c e s s o f c o s t o f an a c q u is itio n o v e r th e fa ir v a lu e o f t h e G r o u p ’s s h a re o f th e n e t id e n tifia b le a ssets o f th e a c q u ire d e n tit y a t th e d a te o f a c q u is itio n . G o o d w ill o n a c q u is itio n s o f s u b s id ia rie s is in c lu d e d in in ta n g ib le assets. G o o d w ill o n a c q u is itio n s o f a s s o c ia te s a n d j o i n t v e n tu re s is in c lu d e d in th e in v e s tm e n t in a s s o c ia te s a n d j o i n t v e n tu re s . G o o d w ill is n o t a m o rtis e d . I t is c a rrie d a t c o s t less a c c u m u la te d im p a ir m e n t losses. Im p a irm e n t losses re la tin g t o g o o d w ill c a n n o t be re v e rs e d in f u t u r e p e rio d s . G o o d w ill is a llo c a te d t o a C G U f o r th e p u rp o s e s o f im p a ir m e n t te s tin g . Im p a irm e n t is d e te rm in e d f o r g o o d w ill b y as se s sin g th e re c o v e ra b le a m o u n t o f e a c h C G U ( o r g r o u p o f C G U s ) t o w h ic h g o o d w ill re la te s . R e fe r t o N o t e 1 ( D ). G a in s a n d losses o n th e d isp o sa l o f an e n tit y in c lu d e th e c a rr y in g a m o u n t o f g o o d w ill re la tin g t o th e e n tit y d is p o s e d .
(ii) Other intangible assets M a s th e a d s a n d tra d e n a m e s T h e m a jo r ity o f m a s th e a d s a n d tra d e n a m e s ha ve b e e n assessed t o ha ve in d e fin ite u s e fu l lives. A c c o r d in g ly , th e y a re n o t a m o rtis e d a n d a re c a rrie d a t c o s t less a c c u m u la te d im p a irm e n t losses. M a s th e a d s an d tra d e n a m e s are te s te d f o r im p a irm e n t in a c c o rd a n c e w ith N o t e 1 (D ). T h e G r o u p ’s m a s th e a d s an d tra d e n a m e s o p e ra te in e s ta b lis h e d m a rk e ts w ith lim ite d lic e n c e c o n d itio n s a n d a re e x p e c te d t o c o n tin u e t o c o m p le m e n t th e G r o u p ’s n e w m e d ia in itia tiv e s . O n th is basis, th e D ir e c to r s h a ve d e te rm in e d t h a t th e
m a jo r ity o f m a s th e a d s a n d tra d e n a m e s ha ve in d e fin ite
lives as th e r e is no
fo re s e e a b le lim it t o th e p e rio d o v e r w h ic h th e a ssets a re e x p e c te d t o g e n e ra te n e t c a s h in flo w s f o r th e G ro u p . T h e re a re a sm a ll n u m b e r o f tra d e n a m e s t h a t ha ve b e e n assessed t o h a ve a d e fin ite u s e fu l life a n d a re a m o r tis e d u s in g a s t r a ig h t- lin e m e th o d o v e r t w e n t y ye a rs .
»
CHAPTER 10
N oncurrent assets
421
» R a d io licences R a d io lic e n c e s , b e in g c o m m e rc ia l ra d io lic e n c e s h e ld b y th e c o n s o lid a te d e n tit y u n d e r th e p ro v is io n s o f th e B ro a d c a s tin g S e rv ic e s A c t 1 9 9 2 , ha ve b e e n assessed t o ha ve in d e fin ite u s e fu l lives. A c c o r d in g ly , th e y a re n o t a m o rtis e d
a n d a re c a rrie d a t c o s t less a c c u m u la te d
im p a ir m e n t losses. R a d io lic e n c e s a re te s te d f o r
im p a ir m e n t in a c c o rd a n c e w ith N o t e 1 (D ). S o ftw a re , d atab a ses an d w eb s ites C o m p u te r s o ftw a r e lic e n c e s a n d d a ta b a s e s a c q u ire d a re c a p ita lis e d as an in ta n g ib le asset. In te rn a l a n d e x te rn a l c o s ts d ir e c tly in c u rr e d in th e p u rc h a s e o r d e v e lo p m e n t o f s o ftw a r e o r d a ta b a se s a re c a p ita lis e d , in c lu d in g s u b s e q u e n t u p g ra d e s a n d e n h a n c e m e n ts w h e n it is p ro b a b le t h a t th e y w ill g e n e ra te f u t u r e e c o n o m ic b e n e fits a ttr ib u ta b le t o th e c o n s o lid a te d e n tity . T h e s e c o s ts a re a m o rtis e d u s in g th e s t r a ig h t- lin e m e th o d o v e r th r e e to six ye a rs . In te rn a l a n d e x te rn a l c o s ts d ir e c tly in c u rr e d in th e d e v e lo p m e n t o f w e b s ite s a re c a p ita lis e d a n d a m o rtis e d u s in g a s tr a ig h t- lin e m e th o d o v e r tw o t o f o u r ye a rs . Source: Fairfax M edia Lim ited, Annual Report 2014.
1
E x p la in w h a t e a ch o f th e fo llo w in g w o u ld re p re se n t fo r F a irfa x M e d ia :
a
m a sthea ds
b
tra d e n a m e s
c
g o o d w ill.
2
E x p la in w h y ra d io lice nces, w e b site s a n d c o m p u te r s o ftw a re a re tre a te d as assets.
3
W h a t is an a lte rn a tiv e a c c o u n tin g tre a tm e n t to c a p ita lis in g s o ftw a re costs? W h a t im p a c t w o u ld a c h a n g e to this o th e r m e th o d h a ve on th e fin a n c ia l statem ents?
4
H o w w o u ld th e p e rio d o f a m o rtis a tio n be d e te rm in e d ?
5
W h a t im p a c t do es a m o ve fro m a n a m o rtis a tio n p e rio d o f fiv e y e a rs to six y e a rs h a ve on th e fin a n c ia l statem ents?
CASE10D
Asset valuations
Qantas m ay w rite dow n a irc ra ft fleet: broker B y S c o tt R o ch fo rt Q a n ta s , u n d e r p re s s u re as ris in g fu e l p ric e s c lo u d its p r o f it o u tlo o k , c o u ld be fo r c e d t o m a s s iv e ly w r ite d o w n th e v a lu e o f its 2 1 3 a ir c r a ft . . . . . . R e fe r rin g t o th e 2 0 0 4 a n n u a l r e p o r t, in w h ic h Q a n ta s re p o r te d t h e $ 9 . 4 b illio n v a lu e o f its f le e t w as $ 2 .6 b illio n a b o v e m a r k e t v a lu e , a re c e n t M a c q u a r ie E q u itie s n o te said th e c a r r ie r ’s w e a k p r o f it o u tlo o k ‘c o u ld c h a lle n g e in -u s e v a lu a tio n s ’ i f t h is c o n tin u e d . . . . M r H u x fo r d said ‘it m ig h t n o t be u n re a lis tic t o s u g g e s t t h a t as a re s u lt o f c h a n g in g m a r k e t c o n d itio n s f o r o il a n d (fo r e ig n e x c h a n g e ) ra te s o v e r th e m e d iu m t e r m ’ t h a t Q a n ta s c o u ld h a s te n th e d e p re c ia tio n o f its a ir c r a ft o r o p t f o r a m a ss iv e w r ite - d o w n . . . . D u e t o th e in t r o d u c tio n o f In te rn a tio n a l F in a n c ia l R e p o rtin g S ta n d a rd s , Q a n ta s ha d t o w rite d o w n th e v a lu e o f its lo y a lty s c h e m e b y $ 7 4 9 m illio n in J u n e la st y e a r. Source: The Age, 10 July 2 0 0 6 .
1
W h a t is m e a n t b y in-use v a lu a tio n s ? H o w do es a p ro fit o u tlo o k c h a lle n g e in-use v a lu a tio n s ?
2
W h a t is th e im p a c t o n th e fin a n c ia l statem ents o f h a ste n in g d e p re c ia tio n o n a irc ra ft o r a m assive w rite -d o w n in th e fin a n c ia l statem ents?
3
W h y w a s th e lo y a lty sche m e c o n s id e re d an asset? W h a t w a s th e im p a c t o f w ritin g d o w n th e v a lu e b y $ 7 4 9 m illio n ?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 1QE________________________ Judgements in asset valuations C o n s id e r th e fo llo w in g e x tra c t fro m th e fin a n c ia l statem ents o f H a rv e y N o rm a n H o ld in g s Lim ited:
P ro p e rty, plant and equipm ent P la n t a n d e q u ip m e n t a ssets a re s ta te d a t h is to ric a l c o s t less a c c u m u la te d d e p re c ia tio n a n d a n y a c c u m u la te d im p a ir m e n t losses. La n d a n d b u ild in g s a re m e a s u re d a t fa ir v a lu e less a c c u m u la te d d e p re c ia tio n o n b u ild in g s a n d le a s e h o ld la n d a n d a n y im p a ir m e n t losses re c o g n is e d a t th e d a te o f th e re v a lu a tio n . V a lu a tio n s are p e rfo rm e d f r e q u e n tly t o e n s u re t h a t th e f a ir v a lu e o f a re v a lu e d a s s e t d o e s n o t d if fe r m a te r ia lly f r o m its c a rr y in g a m o u n t. D e p re c ia tio n is c a lc u la te d o n a s t r a ig h t- lin e basis o v e r th e e s tim a te d u s e fu l life o f th e a s se t as fo llo w s : •
La n d - n o t d e p re c ia te d
•
L e a s e h o ld la n d - lease te r m
•
B u ild in g s u n d e r c o n s tr u c tio n - n o t d e p re c ia te d
•
B u ild in g s - 2 0 t o 4 0 y e a rs
•
O w n e d p la n t a n d e q u ip m e n t - 3 t o 2 0 y e a rs
•
P la n t a n d e q u ip m e n t u n d e r fin a n c e lease - 1 t o 1 0 ye a rs . T h e a s s e ts ’ re sid u a l va lu e s, u s e fu l lives a n d a m o r tis a tio n m e th o d s a re re v ie w e d , a n d a d ju s te d i f a p p ro p ria te ,
a t e a c h fin a n c ia l y e a r e n d . Source: Harvey N orm an Holdings Lim ited, 2014 Annual Report.
List a n y ju d g e m e n ts th a t need to be m a d e b y m a n a g e m e n t in th e a b o v e e x tra c t th a t w ill h a ve an e ffe c t on the in co m e statem ent.
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Liabilities ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: define a liability a n d outline the essential characteristics o f liabilities explain the basic m easurem ent principles for liabilities outline the financial statem ent presentation for liabilities pro vide accounting entries for current liabilities including accounts p a y a b le , notes p a y a b le , short-term accruals an d em p lo yee deductions understand h o w to account for G ST understand the alternatives for com p an y financing explain the different types o f long-term debt account for the issue of debentures explain how a provision differs from other types o f liabilities, and w hen it can be recognised identify and exp lain the purpose of contingent liabilities explain the content o f the liability notes to financial statements o f larg e A ustralian com panies.
C H A PTER O VE R V IE W 1 C h a p te rs 7 to 1 0 c o v e re d , in som e d e ta il, p a rtic u la r ty p e s o f assets: c a sh , in v e n to ry , a c c o u n ts re c e iv a b le a n d n o n c u rre n t assets. This c h a p te r p ro v id e s a m o re d e ta ile d c o v e ra g e o f lia b ilitie s , w h ic h w e re in tro d u c e d th ro u g h o u t C h a p te rs 1 to 6 o f th e b o o k .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
11.1
W hat is a liability?
You m ay recall the fo llo w in g discussion o f liabilities from C h a p te r 6 . W e have repeated it here to a llo w instructors to cover this chapte r earlier if they w ish. A lso, an understanding o f this m aterial is critical for the rem ainder o f the chapter. The Fram ew ork fo r the P reparation a n d Presentation o f F inancial Statements defines a lia b ility as 'a present o b lig a tio n o f the entity arising from past events, the settlement o f w h ich is expected to result in an o u tflo w from the entity o f resources e m b o d yin g e co n o m ic benefits'. There are tw o essential characteristics o f liabilities: •
A present o b lig a tio n exists.
•
The o b lig a tio n involves settlement in the future via the sacrifice o f service potential o r future e conom ic benefits. M o s t obligations are legally enforceable; for exam ple, if they arise out o f contractual arrangements including money
borrow ed (e.g. loans), amounts o w in g on assets purchased or services provided (e.g. accounts payable) o r obligations to provide services to parties w h o have p a id in ad va n ce (e.g. unearned revenue). O b lig a tio n s can also be im posed on the entity, including dam ages a w a rd e d b y courts, w orkers' com pensation claims and incom e tax payable. W h ile most obligations are legally enforceable, the Framework states that obligations can also arise from normal business practice, custom and a desire to maintain g o o d business relations or to act in an equitable manner; that is, to d o w h a t one ought to d o in the pursuit of one's objectives rather than only w h a t one is legally required to do. An exam ple of such obligations occurs w hen a profit-seeking entity, based on moral considerations, undertakes to rectify faults in one of its products even w here these becom e apparent after the w arranty period has expired. As a result, the amounts expected to be sacrificed in accordance w ith this policy in relation to goods a lready sold w o u ld constitute an obligation. Another exam ple of these obligations occurs w hen an entity has a policy o f paying periodic bonuses to employees even though it is not contractually bound to d o so, and bonuses for the current reporting period have not yet been paid. The Fram ew ork also outlines the im portance o f distinguishing
betw een
present o b lig a tio n s a n d future
commitments. The mere intention to sacrifice e co n o m ic benefits in the future is not sufficient to g ive rise to a liability. For exam ple, the m anagem ent o f an entity m ay d e c id e to a cq u ire assets in the future. Such a decision does not, of itself, create a present o b lig a tio n . A lia b ility w o u ld norm ally o nly arise w hen the entity has a cq u ire d the assets a nd is o b lig e d to p a y for them. Typical contractual terms are met fo llo w in g the delivery o r installation o f assets. F-lowever, long-term construction contracts often require progressive payments fo llo w in g com pletion o f specified stages o f asset construction. U nder these circumstances, a lia b ility is recorded for a n y outstanding payments. The other essential characteristic o f a lia b ility is that it has adverse fin a n cia l consequences for the entity in that the entity is o b lig e d to sacrifice e co n o m ic benefits to another entity o r entities. Therefore, the existence o f a lia b ility depends on the present o b lig a tio n being such that the legal, social, p o litica l o r econom ic consequences o f fa ilin g to honour the o b lig a tio n leave the entity little, if any, discretion to a vo id the future sacrifice o f e conom ic benefits to another entity. For exam ple, assume an entity places an o rd e r fo r the purchase of g o o d s. This action w o u ld not norm ally g ive rise to a lia b ility, since the entity w o u ld norm ally have the discretion to a v o id the future sacrifice of econom ic benefits by being a b le to cancel the order. The receipt o f the g o o d s w o u ld norm ally be the event that w o u ld create the lia b ility. FJowever, if the g o o d s w e re to be m ade to the specifications o f the purchaser, it m ight not be possible to cancel the order after, say, the supplier com m enced manufacture o f the g o o d s, w ith o u t significant penalties. In these circumstances, a lia b ility w o u ld exist w hen the supplier com m enced manufacture o f the g oods. There are tw o essential criteria for the recognition of a liability: •
It is p ro b a b le that the future sacrifice o f e co n o m ic benefits w ill be required.
•
The am ount o f the lia b ility can be m easured reliably. The term 'p ro b a b le ' means that the cha n ce o f the future sacrifice of econom ic benefit being required is m ore likely
rather than less likely. This p ro b a b ility can range from virtual certainty to being highly unlikely. An exam ple o f virtual certainty w o u ld be that w a g e s during the month of June a re due to be p a id on 1 July. An exam ple o f som ething that is highly unlikely w o u ld be that the c o m p a n y has guaranteed a loan from the ba n k to a highly pro fita b le subsidiary; the future sacrifice of e co n o m ic benefits w o u ld o nly occur if the subsidiary defaulted on the loan. W h ile the first exam ple w o u ld meet the criteria for recognition o f a lia b ility, the second exam ple w o u ld not.
CHAPTER 11 Liabilities
425
The second essential criterion is that the am ount o f the lia b ility can be re liably estim ated. V erifia b le e vidence of the am ounts to be p a id a nd the dates o f paym ent a re a v a ila b le for the m ajority o f liabilities (such as payments to creditors an d repaym ents o f loans). O th e r liabilities such as o b lig a tio n s to p a y future product w a rra n ty expenses are less certain, but can norm ally be estim ated re liably based on experiences w ith previous w a rra n ty claim s. H ow ever, w here the p ro b a b ility o f paym ent is less certain or cannot be re liably estim ated - such as possible da m a g e s arising from lawsuits - a lia b ility is not recognised at this point in time. Nevertheless, to ensure that users are a d e q u a tely inform ed a b o u t these liabilities, footnote disclosure is required w h e re the inform ation is likely to be relevant to users in their decision-m aking.
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: W h ic h o f th e fo llo w in g m e e t th e d e fin itio n and re c o g n itio n c rite ria fo r liabilities and w o u ld be in clu d e d in th e fin a n cia l s ta te m e n ts ? If th e ite m w o u ld be in clu d e d , list th e nam e o f th e liability.
1 2 3 4 5
A m o u n ts o w in g to suppliers fo r goods received. A m o u n ts o w in g to e m p lo ye e s fo r w o rk d o n e d u rin g th e ye a r b u t n o t y e t paid. A n o rd e r placed fo r $ 1 0 0 0 0 fo r in v e n to ry . A m o u n ts o w in g in holidays to be ta ke n in fu tu re years. C ash re ce ive d by an airline fo r th e purchase o f a tic k e t to th e U n ite d S ta te s n e x t m o n th . Y o u r answers should be:
1 2 3 4 5
Yes (a c c o u n ts payable) Yes (a cc ru e d wages) No Yes (p ro visio n fo r e m p lo y e e e n title m e n ts ) Yes (u n e a rn e d re ve n u e ).
11.2
General measurement principles
This section summarises the basic principles an d im portant things you should kn o w a b o u t the measurement of liabilities, their valuation on the b a la n ce sheet a nd their connection to profit measurement. O n ly some parts w ill be new to you, but you should find the summary useful. M o n e ta ry liabilities (such as accounts p a ya b le , n o te s paya b le a nd loans) a re m easured at the present value (PV) o f the cash flow s associated w ith their service an d eventual paym ent. PV is determ ined by discounting the cash flow s at the rate o f interest im plicit in the o rig in a l contract o r other arrangem ent. A p p lica tio n o f this p rin ciple means that most m onetary liabilities are recognised in the fin a n cia l statements at their fa ce value. Items that are expected to be settled in the short term - such as trade creditors, accruals a n d current tax p a y a b le - a re recognised at their face value because the rate o f interest im plicit in the contracts or other arrangem ents relating to those items is zero. (H ow ever, a p a y a b le that is subject to settlement discount is shown net o f such discount.) In subsequent periods, m onetary liabilities a re adjusted to reflect a n y payments m ade to p a rtia lly d isch a rg e the lia b ility, but they are not adjusted for a n y valuation changes. S im ilar principles a p p ly for non-m onetary liabilities (e.g. provisions, discussed in section 1 1.8). H ow ever, an initial estim ate is g enerally required to measure the expected future cash flow s a nd the carrying am ount is, subsequently, adjusted to reflect revised estimates arising over future periods. The a b o ve principles have some im portant im plications: •
The a p p lic a tio n o f historical cost accounting to liabilities means that the amounts for most liabilities are those that
•
There is no recognition o f non-historical interpretations o f the d ebt, even if the e conom ic m eaning o f the d ebt
arose w hen the d e b t w a s incurred. This is norm ally the same am ount as w ill a ctually be p a id .
w o u ld increase because o f such recognition. Three things, therefore, that are not recognised are:
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
-
interest that w ill have to be p a id but has not yet accrued; for exam ple, if a d e b t is due in tw o years, o nly the in terest o w e d at year-end is a d d e d , not the interest for the next tw o years
-
inflation, even though being in d e b t during a p eriod o f inflation is a g o o d idea, because you p a y b a ck w ith dollars that a re w orth less than those you bo rro w e d
-
market value changes in public debt; for exam ple, if interest rates have risen so much that a bond issued for $ 1 0 0 0 , but n o w p a yin g an unattractive interest rate, is currently selling on the bond market for o n ly $ 7 8 0 , current rules d o not permit a d o w n w a rd revaluation o f the d e b t lia b ility to reflect the lo w e r market value in the b a la n ce sheet an d the g a in in the incom e statement.
•
Unless there is e vidence to the contrary, the c o m p a n y is assumed to be a 'g o in g concern' a n d , therefore, debts are shown at the am ounts that w o u ld norm ally be p a id , a nd are expected to be p a id , not a t some other liquidation value that m ight be negotiated w ith creditors if the c o m p a n y g o t into serious fin a n cia l trouble.
•
For im portant debts, some o f the legal details a re disclosed (usually by w a y o f a specific footnote or under the financial instruments footnote). The main details here are the interest rate on the d e b t (especially for noncurrent debts), a n y assets o r other securities given, repaym ent terms, a nd a n y special conditions, such as being convertible to equity.
•
W h e n a lia b ility increases on e o f the fo llo w in g w ill also occur: -
an expense w ill increase (e.g. w a g e s e x p e n s e /w a g e s p a ya b le ; e m ployee entitlement e xp e n se /p ro v is io n for em ployee benefits)
-
an asset w ill increase (e.g. c a s h /lo a n ; in ve n to ry/a cco u n ts payable)
-
another lia b ility w ill decrease (accounts p a y a b le /n o te s payable).
11.3
Financial statem ent presentation of liabilities
To assist users o f fin a n cia l reports in understanding the nature o f liabilities, they (like assets) are norm ally presented in the b alance sheet under current a n d noncurrent subcategories - unless presenting in broad o rd e r of their liq u id ity provides m ore relevant an d reliable inform ation. A current lia b ility is one that is expected to be settled w ithin 1 2 months o f the reporting d a te o r in the normal course o f the entity's op e ra tin g cycle, w h e re this can be clearly identified. All other liabilities are considered to be noncurrent (or long-term) liabilities. Thus, the prin cipa l difference betw een current a nd noncurrent liabilities is just their tim ing. For exam ple, a bank loan du e in five months is shown as a current lia b ility, w h ile on e du e in five years is a noncurrent liability. Their due dates m ay be the prim ary feature that distinguishes them. Sim ilarly, an accrual for an expense that is expected to be p a id in five months is a current lia b ility, w h ile one that is expected to be p a id in 15 months is a noncurrent lia b ility. Both are accruals used for p rofit measurement but they m ay d iffe r prim arily in tim ing. Because noncurrent liabilities tend to be harder to estim ate as the future is further a w a y , there m ay be m ore practical com plexities for noncurrent liabilities than for current ones.
FOR YOUR INTEREST W h e n a u d ito rs are e x a m in in g th e a c c o u n ts , th e y pa y p a rtic u la r a tte n tio n t o e n s u rin g th a t n o c u r r e n t lia b ilitie s ha ve b e e n le ft o u t o f th e b a la n c e s h e e t, b e ca u s e an u n d e rs ta te m e n t o f lia b ilitie s re s u lts in th e o v e rs ta te m e n t o f p r o fits ( th in k b a c k to th e a c c o u n tin g e q u a tio n ; f o r e x a m p le , w h e n a lia b ility is u n d e rs ta te d an e x p e n s e is u s u a lly u n d e rs ta te d ). B a n ks a re asked to p ro v id e w r itte n c o n fir m a tio n o f lo an s, p a y m e n ts in th e n e x t p e rio d are re v ie w e d to see i f a n y a re f o r lia b ilitie s an d c o rre s p o n d in g e x p e n s e s th a t s h o u ld ha ve b e e n re c o rd e d in th is p e rio d , an d a c c ru a ls f o r u n p a id w ag es, in c o m e ta x e s , in te re s t and o t h e r e x p e n s e s are c h e c k e d .
CHAPTER 11 Liabilities
427
C la rifyin g w h ich liabilities are current, a nd w h ich are not, is im portant for several reasons. The total current liabilities are part o f the calculation o f w o rkin g c a p ita l, an d the w o rkin g c a p ita l ratio (current assets
current
liabilities) is very im portant in assessing an enterprise's fin a n cia l strength. M a n y o f the current lia b ility accounts are accruals of expenses, so ensuring profit is measured properly requires that the accruals a re right. As is true o f assets, liabilities a re significant both for their effect on b a la n ce sheet valuation an d their connection to profit measurement. Their prin cipa l effect on p rofit measurement is through their association w ith expenses. Expenses arise from consum ing the e co n o m ic value of assets, such as inventory or fixed assets, but also from incurring liabilities. The incurrence o f liabilities arises from expense recognition p rio r to the cash flo w . Such accruals include accounts p a ya b le , incom e tax p a ya b le , em ployee entitlement lia b ility (provision for em ployee entitlements) a nd w a rra n ty lia b ility (provision for w arranties) - topics that have been m entioned in e arlier chapters an d are exam ined in this chapter. Liabilities are sometimes associated w ith revenues, too, such as via the unearned revenue lia b ility for revenue collected before it is earned. H ow ever, their main im portance to profit measurement is through expenses. Current an d noncurrent liabilities a re further classified a cco rd in g to their nature (liquidity, expected tim ing of settlement, source, security o r other conditions attached to them). Consistent w ith this a p p ro a ch , the fo llo w in g line items (having a separate line for each item) are required disclosures on the fa ce o f the b a la n ce sheet: payables, interest-bearing liabilities, tax liabilities an d provisions. The minimum disclosure requirements in A ustralia, an d the typical items that a re included under the subheading totals, are illustrated in Figure 1 1 .1 .
Source: © Commonwealth of Australia 201 2.
A d d itio n a l line items can be a d d e d w h e re they a id the users in their understanding o f the fin a n cia l statement. For exam ple, W o o lw o rth s Limited in note 1 3 to its accounts split trade an d other payables into accounts p a y a b le ($ 4 6 5 7 .1 m), accruals ($ 1 2 2 7 .6 m ) an d unearned incom e ( $ 1 2 1.6m ) (see the a p p e n d ix at the end of this book). This separation of payables is clearly relevant for understanding the sig n ifica n ce o f these items. Let us n o w consider the different types o f liabilities show n in the b a la n ce sheet, an d the accounting procedures for them.
428
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
11.4
Payables
The most com m on types o f payables a re accounts p a y a b le an d accruals. A ccounts p a y a b le (also ca lle d trade payables o r trade creditors) a re the am ounts o w e d to suppliers for the purchase o f inventory, supplies an d services. These purchases are usually on open account, m eaning that they are purchased on credit, a nd paym ent is to be m ade w ithin a short period o f tim e fo llo w in g delivery, such as w ithin 3 0 days. W h e n the invoice for the g o o d or service is received, either an asset a ccount (such as inventory o r supplies asset) o r an expense account (such as advertising expense o r repairs expense) is d e b ite d an d accounts p a y a b le is credited. W h e n the creditor is p a id , accounts p a y a b le is d e b ite d an d cash is credited. Such transactions w e re considered in C hapters 3 a nd 4 . In contrast w ith accounts p a ya b le , accruals are liabilities to p a y for g o o d s o r services that have been received or supplied but have not been invoiced or the am ount is yet to be form ally a g re e d w ith the supplier. Accruals are a product o f the m atching process behind profit measurement. They are usually determ ined very carefully, because if they are not, an im precise cut-off o f the expenses betw een the relevant accounting periods w o u ld make both the current year's and next year's profit w ro n g . As a result, on e w o u ld be overstated an d one understated. That is, om itting an accrued expense w ill overstate the year's profit. These short-term accruals w e re discussed in C h a p te r 5 . Typical accruals include accrued interest a nd accrued w a g e s (or w a g e s p ayable), but can include other estimates such as the am ounts o w in g to contractors w h o have not yet sent an invoice in but w h o have d o n e the w o rk during the financial period. O th e r exam ples o f these include an estim ate fo r electricity a nd other utilities that have been used in the accounting period but the invoice for actual usage has not been received. These a re accounted for by an adjusting journal entry involving a d e b it to an expense a ccount a nd a credit to a current lia b ility account. O ther accruals relate to collecting m oney on b e h a lf o f others the enterprise then o w e s - deducting incom e tax, superannuation contributions, union dues, an d m any other deductions from em ployees' pay. Y ou've p ro b a b ly experienced these e m p lo ye e d e d u c tio n s . For exam ple, you think you have earned, say, $ 2 5 0 , but yo u r p a y cheque is, say, o n ly $1 8 0 because o f all the deductions. The e m ployer is acting as a channel to ge t your incom e tax and other contributions to the governm ent, the union, the m edical insurer or w herever it is to go . Em ployee deductions have some com plications that the accounting system has to handle. O n e is that each deduction norm ally has to be sent to a different place; for exam ple, incom e tax deducted goes to the governm ent, union dues deducted g o the union, an d so on. A second co m p lica tio n is that the em ployer often has to p a y on-costs in ad d itio n to the am ount deducted from the em ployee. S uperannuation, an d m any kinds of m edical insurance and other insurance, are exam ples. Therefore, the w a g e s the em ployee earns are not the o n ly expense the em ployer incurs. Suppose an em ployee earns $ 1 1 0 0 a w e e k an d the fo llo w in g deductions a re m ade: incom e tax $ 3 0 0 , superannuation $ 5 0 , union dues $ 4 0 a n d m edical co ve ra g e $ 6 5 . Therefore, the e m ployee w ill o nly receive a net take-home p a y o f $ 6 4 5 . In a d d itio n , the em ployer has to p a y some on-costs: superannuation $ 4 5 , w orkers' com pensation insurance $ 1 5 an d payroll tax due $ 6 7 . So, to the em ployer, the total cost o f having the e m ployee for the period is $1 1 0 0 plus benefits, o r $1 2 2 7 . Let's see h o w the accounting records w o u ld sh o w all this (in the tw o entries b e lo w or on e co m bined entry):
CHAPTER 11 Liabilities
429
In the a b o v e exam ple, superannuation contributions a re m ade by both the em ployee an d the em ployer, w h ich is com m on practice. Accruals are often reported as part of accounts a n d other payables rather than reported separately in the footnotes to the fin a n cia l statements. O th e r payables that m ay be separately listed in the footnotes include other (non trade) creditors, foreign currency hedges o r currency s w a p payables, amounts d ue on construction contracts, and g o o d s a nd services tax payables (GST). (Accounting for GST is considered in section 1 1 .1 1 .)
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: W h y is it im p o r ta n t t o m e a s u re c u r r e n t lia b ilitie s a c c u ra te ly ? Y o u r a n s w e r s h o u ld be : It is im p o r ta n t t o g e t th e c u r r e n t lia b ilitie s m e a s u re d p ro p e rly b e ca u s e th e to ta l c u r r e n t lia b ilitie s a re p a rt o f th e c a lc u la tio n o f ra tio s s u c h as w o rk in g c a p ita l, c u r r e n t ra tio and q u ic k ra tio , w h ic h are im p o r ta n t f o r assessing th e liq u id ity and s o lv e n c y o f a c o m p a n y .
Unearned revenue, although strictly a deferral, is also often included under accruals. Unearned revenue can arise from customer deposits, other revenue received in a d va n ce , o r an o ve rp a id accounts receivable. A lthough not necessarily a legal d ebt, unearned revenue is an e conom ic one, in that the enterprise has received the cash but has not yet earned the m oney. In a business sense, it is also a d ebt, because it w o u ld be p o o r business practice to collect m oney in a d va n ce from customers an d refuse to either d o the a g re e d revenue-earning w o rk o r return the m oney.
11.5
Interest-bearing liabilities - sh o rt-te rm 2
Short-term interest-bearing liabilities prim arily include b a n k overdrafts, notes p a y a b le a nd various forms o f d ebt securities, such as bank loans a n d b orrow ings. A ba n k overdraft provides a c o m p a n y w ith a line of credit up to a pre-established amount, a nd avoids the cost o f a p p ly in g for small loans. N otes p a y a b le (sometimes ca lle d bills p a y a b le o r bills o f exchange) a re w ritten promises (prom issory notes) to repay a loan plus interest a t a specified d ate to a ba n k o r other lender. Im portantly, the interest-bearing characteristic a nd the w ritten docum entation distinguish notes p a y a b le from accounts p a ya b le . N otes m ay be issued w hen m erchandise or other assets a re purchased w h e re trade credit is not a v a ila b le o r is im practical. They m ay also be issued to creditors to tem porarily satisfy an a ccount p a y a b le created earlier. For exam ple, assume that a business issues a 9 0 d a y , 1 2 per cent note for $ 1 0 0 0 , d a te d 1 A ugust 2 0 1 6 to M u rra y Ltd for a $ 1 0 0 0 overdue account. The entry to record the issuance o f the note is as follow s: $ Aug. 1
DR
Accounts payable
CR
Notes payable
$
1 000 1 000
Issu e d a 9 0 -d a y , 1 2 p e r c e n t n o te o n a c c o u n t
W h e n the note matures, the entry to record the paym ent o f $ 1 0 0 0 prin cipa l plus $ 3 0 interest ($ 1 0 0 0 x 1 2% x 9 0 / 3 6 5 rounded to the nearest dollar) is as follow s: $ Oct. 30
DR
Notes payable
DR
Interest expense
CR
s
1 000 30
Cash
P a id p r in c ip a l a n d in te re s t d u e o n n o te
1 030
1
430
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
If the note had not matured at year-end, it w o u ld be necessary to take up the accrued interest (debit interest expense; credit interest payable). N otes p a y a b le entries are presented from the v ie w p o in t o f the borrow er. To illustrate this, the fo llo w in g entries are journalised for a b o rro w e r (Bow den Ltd), w h ich issues a note p a y a b le to a cre d ito r (Coker Ltd) (recall that the term inology 2 / 1 0 , n / 3 0 means that a 2 per cent discount w ill be given if p a id w ithin 1 0 days; otherw ise the full am ount is due w ith in 3 0 days): $ 1 May. Bowden Ltd purchased inventory on account from
DR
Coker Ltd, $ 1 0 0 0 0 , 2 /1 0 , n /3 0.
CR
31 May. Bowden Ltd issued a 60-day, 12% note for
DR
$ 10 000 to Coker Ltd on account.
CR
30 July. Bowden Ltd paid Coker Ltd the amount due on the
DR
Notes payable
DR
Interest expense
note of 31 May. Interest $ 1 0 0 00 x 12% x 6 0 /3 6 5 .
CR
Inventory
si
1 0000
Accounts payable Accounts payable
1 0000 1 0000
Notes payable
1 0000 1 0000 197
Cash
1 0 1 97
N otes m ay also be issued w hen m oney is b o rro w e d from banks. These are often called com m ercial bills pa ya b le . A lthough the terms m ay vary, m any banks w o u ld a c ce p t an interest-bearing note for the am ount of the loan from the borrow er. For exam ple, assume that on 1 9 Septem ber, a firm borrow s $ 4 0 0 0 from First N a tio n a l Bank by g ivin g the bank a 9 0 -d a y , 15 per cent note. The entry to record the receipt of cash a nd the issuance o f the note is as follow s: $ Sept. 19
DR CR
Cash
$
4000
Notes payable
4 000
Is s u e d a 9 0 -d a y , 15 per c e n t n o te to th e b a n k
O n the due d a te o f the note (1 8 D ecem ber), the b o rro w e r ow es $ 4 0 0 0 , the prin cipa l o f the note, plus interest o f $ 1 5 0 ( $ 4 0 0 0 x 15% x 9 0 / 3 6 5 ) . The entry to record the paym ent o f the note is as follow s: $ Dec. 18
DR
Notes payable
DR
Interest expense
CR
4000 148
Cash
P a id p r in c ip a l a n d in te re s t d u e o n n o te
It is im portant to understand that a de b t m ay com prise a current an d a noncurrent com ponent. In o rd e r to determ ine current liabilities properly, G A A P requires that if there is a noncurrent d e b t on w h ich some paym ent is to be m ade w ithin the next year, that paym ent be included in current liabilities. So a single d e b t is split into tw o parts: current a n d noncurrent. This does not affect the legal d e b t in the slightest: it is d o n e to meet the presentation objectives outlined above. There's a tw ist here you should w a tch for that is consistent w ith the rule o f not recognising future interest. In a cco rd a n ce w ith the a b o ve points, it's o n ly the p rin c ip a l portion p a y a b le in the next ye a r that's called current. Suppose, for exam ple, that Jocelyn ow es $ 71 0 0 0 on her m ortgage a nd during the next ye a r must make 12 m onthly payments of $ 1 0 0 0 , including interest. If the interest w ill am ount to $ 6 4 0 0 over the next year, her b alance sheet w ill sh o w a current lia b ility o f $ 5 6 0 0 ( $ 1 2 0 0 0 — $ 6 4 0 0 ) a nd a noncurrent lia b ility o f $ 6 5 4 0 0 ($71 0 0 0 — $ 5 6 0 0 ) . The $ 6 4 0 0 that w ill be next year's interest is ignored at this point because it has not yet accrued. H er total d e b t is $ 71 0 0 0 ( $ 5 6 0 0 + $ 6 5 4 0 0 ) , not $ 7 7 4 0 0 o r $ 8 3 0 0 0 .
CHAPTER 11 Liabilities
11.6
431
Interest-bearing liabilities - long-term
Before considering long-term interest-bearing liabilities, it is inform ative to consider alternative forms of external c o m p a n y fin a n cin g . The basic alternative forms a re equity c a p ita l o r d e b t c a p ita l. In a d d itio n , there a re hybrid forms that exhibit both d e b t an d equity characteristics. These alternatives are show n in Figure 1 1 .2 .
FIGURE 11.2
Alternative forms of external company financing
Follow ing incorporation, most com panies have an o n g o in g need for external sources o f fin a n ce to fund current operations a nd strategic g row th plans. C o rp o ra te m anagem ent w e ig h up the costs a nd benefits o f equity an d d ebt ca p ita l, a nd fin a n cia l instruments that have characteristics o f both d e b t a nd equity (hybrid securities), in choosing their optim al c a p ita l structure. Equity (share) c a p ita l is exam ined in C h a p te r l 2. In this section, w e w ill consider the accounting treatment o f alternative types o f d e b t a n d hybrid securities.
Alternative forms of debt capital Long-term d e b t fin a n cin g can com e in various forms. C om m on forms a re m ortgages, debentures a nd unsecured notes, and private loans. These are distinguished on the basis o f the am ount o f security a v a ila b le to protect the lender. Various com binations of these securities m ay exist at a n y on e time in a com pany's ca p ita l structure. A debenture is a general kind o f loan that is sim ply a contract betw een the c o m p a n y a n d the holder that a c kno w le d g e s the receipt o f funds in e xch a n g e for a series o f payments at a fixed rate on preset dates over the term o f the debenture. These m ay be issued to a single individual or m ay be issued to the general public. A debenture must be fully secured over the issuing com pany's assets. A debenture secured o n ly by first m ortgage over real estate is described as a m ortgage or, m ore form ally, as a m o rtgage debenture. The lender can claim title to those assets if the c o m p a n y does not make the a g re e d payments on time. In contrast to debentures, an unsecured note is a d e b t that is not secured by a c h a rg e over c o m p a n y assets but, in other respects, is sim ilar in form at a nd in o peration to a debenture. Flow ever, because o f the absence o f security, these d e b t securities are much less com m on than debentures o r other types of securities. Loans are the most com m on type o f d e b t financing for short-term a nd sm aller loans, a nd are taken out w ith banks, other fin a n cia l institutions or com m only, for private com panies, from shareholders. These loans m ay be secured o r unsecured over c o m p any assets. The lender m ay also require the b o rro w in g com pany's directors to pro vid e personal guarantees in cases w here there is c o n sid e ra b le uncertainty a b o u t repaym ent a n d /o r the liq uidation value o f the b o rro w in g com pany's assets.
432
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C ontractual terms for d e b t securities are specified in loan agreem ents (or a clause in the debenture trust deed). These terms provid e a set of specifications that the b o rro w e r must meet, otherw ise the lender can de m a n d paym ent or take other punitive action. Such specifications m ay require the b o rro w e r to m aintain a particular level o f w o rkin g ca p ita l, o r a particular w o rkin g ca p ita l ratio, a particular debt-to-equity ratio, o r meet other conditions d e fined on the financial statements. (Such agreem ents m ay tem pt m anagem ent to choose accounting policies d esigned to help the financial statements meet the a g reed specifications.)
A C C O U N T IN G FO R DEBENTURES B elow , as an illustration, w e sh o w the accounting entries for debentures. The entries for other forms o f long-term de b t w ill be left to m ore a d va n ce d courses. The public issue o f debentures o r notes requires a prospectus to be issued. An a p p ro ve d trustee must be a p p o in te d , and the trustee administers a debenture trust d e e d . In most cases, debentures a re issued a t fa ce value and are either fully p a id o r p a id by instalments. As a result o f a $ 1 0 m illion debenture issue, cash w o u ld increase by $ 1 0 m illion and debenture liabilities w o u ld be increased b y $ 1 0 million. DR
Cash at bank
CR
10000000
Debentures
10000000
Discounts or premiums on noncurrent debts Som etim es, noncurrent d e b t (including debentures) is issued a t a discount o r a prem ium . S uppose an enterprise decides to b o rro w using a debenture issue that is co m p o se d o f $ 1 0 0 0 debentures ca rryin g 7 per cent interest. W h a t happens w h e n , if the debenture issue is all ready, interest rates in the market fo r such debentures rise to, say, 8 per cent? Lenders w o u ld not w a n t a 7 per cent debenture. Therefore, the enterprise sells the debentures a t a discount (i.e. a lo w e r price), such that the am ount the lender pays w ill earn 8 per cent. The lender gives the c o m p a n y less than $ 1 0 0 0 fo r each debenture, a n d that lo w e r am ount is such that the $ 7 0 interest (7 per cent of $ 1 0 0 0 ) represents the 8 per cent the lender w a n ts. If the interest rates have fallen, say, to 6 per cent, the lender w ill be w illin g to p a y m ore than $ 1 0 0 0 fo r each debenture, such that the $ 7 0 interest represents the 6 per cent return the lender w ants. So, the enterprise gets a prem ium for the debentures, m ore than $ 1 0 0 0 e a ch . (This e xp la n a tio n is a little sim p lifie d ; the present va lu e c a lcu la tio n s b e hind debenture prices are in clu d e d in the a p p e n d ix to this chapter.) H ere is an illustration: an issue o f 1 0 0 0 0 $ 1 0 0 0 debentures - therefore having a total legal d e b t of $ 1 0 m illion - has sold fo r a total o f either $ 8 7 6 0 0 0 0 (a discount) o r $1 1 1 8 0 0 0 0 (a premium). (The selling prices can be said to be the a p p ro p ria te p rice for that debenture at p re va ilin g market interest rates. Therefore, in the first case, the debenture pays interest a t a rate b e lo w m arket rates, a nd in the second case, pays a t a rate a b o v e market rates.) A t the d a te o f issue o f the debentures, the proceeds a n d the discount, o r prem ium , a re recorded this w a y : Discount
$
DR
Cash (proceeds)
CR
Debenture
DR
Debenture discount
$
8 760000 10000000 1 240000
Premium
$
DR
Cash (proceeds)
CR
Debenture
CR
Debenture premium
$
1 1 1 80 000 10000000 1180000
The debenture a ccount is a liability. But so is the discount o r premium. The premium o r discount account w orks as a contra account, to ch a n g e the valuation o f the lia b ility w ith o u t ch a n g in g the legal de b t account. (The premium is a credit b alance account, so it is not o p p o site in sign to debentures, as contra accounts like the a llo w a n c e fo r doubtful
CHAPTER 11 Liabilities
433
accounts a nd accum ulated dep re cia tio n are.) The legal d e b t is w h a t has to be re paid; the discount o r premium is just an adjustm ent to get the proceeds to an am ount that w ill bring the debenture market the return it requires. So, on the d a y of issue, the enterprise's b a la n ce sheet w o u ld sh o w a lia b ility c a lle d debenture, at the am ount o f $ 8 7 6 0 0 0 0 (in the case o f the discount: $ 1 0 0 0 0 0 0 0 — $1 2 4 0 0 0 0 ) o r $1 1 1 8 0 0 0 0 (in the case o f the premium: $ 1 0 0 0 0 0 0 0 + $ 1 1 8 0 0 0 0 ) . Thus, the reported lia b ility meets the historical cost criterion: it is w h a t w a s received for the debentures. H ow ever, the am ount o f the proceeds is not w h a t w ill eventually be repaid to the lenders. This am ount is $ 1 0 m illion in both cases. So, the discount o r premium is am ortised over the p eriod until the debentures are due. It therefore shrinks a w a y until on the du e d a te it is ze ro an d the $ 1 0 m illion is correctly shown as the d e b t on that date. The period's am ortisation am ount is included w ith interest expense reported in the calculation o f net profit. The discount is a d e b it, so am ortising it a d d s to the interest expense, m aking the reported expense higher than the $ 7 0 cash interest p a id per debenture. This makes sense, as the reason fo r the discount is that the debenture market dem a n d e d a rate higher than 7 per cent, a nd by selling the debentures a t a discount, the enterprise pro vid e d that. The real interest cost is higher than $ 7 0 . In the case o f a premium, the am ortisation reduces the reported interest expense, w h ich a g a in makes sense because the debenture market w a s h a p p y w ith a rate lo w e r than 7 per cent and by selling the debentures at a premium, the enterprise pro vid e d that. Thus, the reported interest expense approxim ates the market rate d e m a n d e d w hen the debentures w e re sold. If you a lre a d y understand the co n ce p t o f present value (in the a p p e n d ix to this cha p te r an d in m any introductory quantitative methods courses), you w ill see that w h a t is h a p p ening is that the debenture, adjusted by the unam ortised discount or premium, is being shown on the b a la n ce sheet at the present value o f the debenture (calculated a t the market interest rate in effect w hen the debenture w a s issued). M e th o d s for calculating am ortisation o f a discount or premium are in m ore a d va n ce d accounting books.
11.7 Tax liabilities There are tw o types o f incom e tax liabilities recognised in the b a la n ce sheet. The first is a current lia b ility for incom e taxes due to the tax authorities (called incom e tax p ayable). The second type o f incom e tax lia b ility is for a noncurrent lia b ility arising from tem porary differences betw een the tax calculated for accounting purposes a nd the assessable tax calculated b y tax authorities. These differences arise because tax authorities d o not a lw a ys require that the same method be a d o p te d for incom e tax purposes as used for accounting purposes. For exam ple, m any com panies use a s traight-line depreciation method to d e p re cia te items o f plant or equipm ent in their accounting systems. H ow ever, tax authorities a llo w com panies to use a straight-line method o r an accelerated method for incom e tax purposes. Because o f this o ption, m any com panies that use a straight-line method for accounting purposes a d o p t an accelerated depreciation method for tax purposes to o b ta in the early benefit o f the a llo w a b le deductions. As a consequence, the carrying am ount o f an asset (e.g. equipm ent) reported in the accounting records at the end o f the first p eriod w ill exceed the carrying am ount (the tax base) used for tax purposes. Put another w a y , the am ount o f assessable e conom ic benefits (assessable amounts) shown in the accounting records for the asset w ill exceed the am ount that w ill be a llo w e d in future periods as a deduction for tax purposes. This difference is an assessable tem porary difference a nd the o b lig a tio n to settle the resulting incom e taxes in future periods is a d e fe rre d tax lia b ility. (The o p p o site situation w o u ld lead to a d e d u ctib le tem porary difference - a deferred tax asset.) This to p ic can get very c o m p lica te d so further details are left to a m ore a d va n ce d course.
11.8
Provisions
Provisions are also exam ples o f liabilities. They are liabilities for w h ich the am ount or tim ing o f the future sacrifice of econom ic benefits that w ill be m ade is uncertain. W h ile other liabilities, such as accounts p a y a b le an d accruals, m ay involve some uncertainty, this uncertainty is g e n e ra lly insignificant an d therefore does not create m ajor measurement problem s.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C onsistent w ith the conceptual fram ew ork a p p ro a ch , AASB 1 3 7 notes that a provision shall be recognised w hen: (a ) an e n tit y has a p re s e n t o b lig a tio n as a re s u lt o f a p a s t e v e n t; ( b ) it is p ro b a b le t h a t an o u tf lo w o f re s o u rc e s e m b o d y in g e c o n o m ic b e n e fits w ill be re q u ire d t o s e ttle th e o b lig a tio n ; an d ( c ) a re lia b le e s tim a te c a n be m a d e o f th e a m o u n t o f th e o b lig a tio n . Source: © C om m onw ealth o f Australia 2012.
If these conditions a re not met, a provision w ill not be recognised a nd instead a contingent lia b ility w ill be disclosed in the notes (see Section 1 1 .9). The a b o v e definition o f a provision refers to the need for there to be a present o b lig a tio n . In most cases the present o b lig a tio n w ill be cle a r (such as annual leave, long service leave o r w arranties), but the am ount o r tim ing is uncertain. H ow ever, in some cases, such as lawsuits, the present o b lig a tio n is less clear. In this case a past event is deem ed to g ive rise to a present o b lig a tio n if it is m ore likely than not that a present o b lig a tio n exists at the bala n ce date; that is, professional judgem ent by the accountant is needed. In this case it m ay be necessary to seek a d d itio n a l evidence from other experts (such as legal experts). The present o b lig a tio n means that the entity must have no realistic alternative but to make the future sacrifice of econom ic benefits to settle the o b lig a tio n (e.g. p a y cash, re p la ce inventory, o r use labour fo r rew ork o r to fix a deficiency). As stated earlier, the most com m on form o f present o b lig a tio n is a legal o b lig a tio n to some external party. H ow ever, there are also constructive o b lig a tio n s that leave the entity w ith no realistic alternative but to make future sacrifices o f econ o m ic benefits. Examples o f entities w ith constructive o b lig a tio n s that constitute provisions a re as follow s: 1
C onsider an entity that has d e ve lo p e d a d e ta ile d form al plan for a restructuring an d announced its main features to those affected but has not entered into a n y contracts to carry out the restructuring. As a result o f its actions, the entity has no realistic alternative but to proceed w ith the restructuring.
2 An entity makes a public announcem ent that it w ill match the fin a n cia l assistance pro vid e d by other entities to victims o f a specific natural disaster. For exam ple, it is com m on p ractice for some firms to match the donations of their em ployees. Because o f custom an d moral considerations, the entity has no realistic alternative but to provide the assistance. Provisions on ly include o b lig a tio n s from past events a nd they exist independently of the entity's future actions. For exam ple, a penalty for past unlaw ful trade practices w ill require the sacrifice o f future e conom ic benefits to settle the fine, and it exists regardless o f future actions o f the entity. H ow ever, the mere intention to make a future sacrifice of econom ic benefit is not sufficient to g ive rise to a present o b lig a tio n , even if the sacrifice is necessary for the continuation o f the entity's operations. For exam ple, an entity d e c id in g to u p g ra d e equipm ent in the future in ord e r to m aintain com petition does not o f itself create a present o b lig a tio n . In recognising a provision, it is necessary to make the best estim ate o f the consideration required to settle the present o b lig a tio n at the reporting d a te w h ile taking into account the uncertainties surrounding the events and circumstances that affect the provision. In m aking this best estim ate it is necessary to take into account inform ation o b tained betw een the reporting d a te (such as 3 0 June) a nd the com pletion o f the fin a n cia l report. For exam ple, a large num ber o f returns from customers soon after the reporting da te m ay have an im pact on the provision for w a rra n ty expenses. T w o exam ples o f accounting fo r provisions are p rovided b e lo w . 1
W a rra n ty lia b ility (provision for w arranties): the estim ated future cost o f p roviding w a rra n ty service for products a lre a d y sold (revenue a lre a d y recognised). In the period in w h ich a product is sold, an expense is recognised to match to the revenue by the expense recognition entry: d e b it w a rra n ty expense, credit provision for w a rra n ty liability. W h e n a w a rra n ty cost is incurred, the lia b ility is reduced by the paym ent: d e b it w a rra n ty lia b ility, credit cash; o r if a replacem ent product is p ro vid e d : d e b it w a rra n ty lia b ility, credit inventory. If, as is likely, some o f the w a rra n ty cost w ill be p a id w ith in the next year, that am ount is included in current liabilities.
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FOR YOUR INTEREST In th e 1 9 6 0 s , G e n e ra l M o to r s in th e U n ite d S ta te s p ro d u c e d a little re a r-e n g in e d c a r c a lle d th e C o rv a ir. It w as p o p u la r an d s e e m e d tr o u b le - fr e e . T h e re w e re c lu b s o f C o rv a ir d e v o te e s . G M d id n o t ha ve to ha ve a v e ry la rg e w a rra n ty p ro v is io n f o r th e C o rv a ir. B u t th e n R a lp h N a d e r ’s fa m o u s b o o k U n s a fe a t A n y S p e e d c a m e o u t, c ritic is in g th e C o rv a ir as w e ll as o t h e r c a rs. P e o p le re tu rn e d to th e ir c a r d e a le rs in d ro v e s , c o m p la in in g a b o u t th e ir C o rv a irs . S u d d e n ly , G M had to in c re a s e its w a rra n ty p ro v is io n , c u r r e n t an d n o n c u rre n t, b e c a u s e o f th e c o s t o f fix in g real o r im a g in e d p ro b le m s . Its w a rra n ty e x p e n s e e s tim a te s had b e e n a p p ro p ria te u n d e r p re v io u s c o n d itio n s b u t w as s u d d e n ly fo u n d t o be in s u ffic ie n t b y th e u n a n tic ip a te d e v e n t o f N a d e r ’s b o o k . I t ’s an e x a m p le o f th e u n a v o id a b le fa c t th a t a c c ru a l a c c o u n tin g e s tim a te s o f th e fu tu r e , n o m a tte r h o w c a re fu lly m a d e , c an ea sily tu r n o u t la te r t o ha ve b e e n w ro n g .
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d : T h e a c c o u n tin g re c o rd s o f G iz m o P ty L td s h o w e d th a t a t 1 J a n u a ry 2 0 1 6 , p ro v is io n f o r w a rra n ty c la im s was $ 7 4 0 0 , an d f o r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 , sales w e re $ 2 6 0 0 0 0 . In th e p a st, G iz m o ’s w a rra n ty e x p e n s e has b e e n 9 p e r c e n t o f sales an d th is ra te is again e x p e c te d f o r n e x t y e a r. D u rin g th e c u r r e n t p e rio d , G iz m o paid $ 1 4 0 3 2 t o s a tis fy w a rra n ty c la im s .
1 2
W h a t is G iz m o ’s w a rra n ty e x p e n s e f o r th e y e a r to 31 D e c e m b e r 2 0 1 6 ? W h a t is th e c lo s in g b a la n c e o f p ro v is io n f o r w a rra n ty c la im s re c o rd e d o n th e b a la n c e s h e e t as a t 31 D e c e m b e r 2 0 1 6 ? Y o u r a n sw e rs s h o u ld be:
1 9% x 2 6 0 0 0 0 = 2 3 4 0 0 2 7 4 0 0 + 2 3 4 0 0 - 1 4 032 = 16768.
2 Provision for em ployee entitlements: part o f the co n d itio n s o f e m ploym ent fo r most staff is that they receive annual ho lid a ys (they m ay take them in the current y e a r o r they m ay a ccru e them to take in subsequent years) a n d , if they stay a certain num ber o f years w ith the sam e c o m p a n y, they a re entitled to long service leave. For e xa m p le , afte r 1 0 years o f service they m ay receive six w e e ks' leave. The am ount o f leave increases the lo n g e r they rem ain w ith the c o m p a n y. So, each y e a r the c o m p a n y w ill d e b it annual leave expense a n d long service leave (LSL) expense a n d c re d it an a p p ro p ria te lia b ility a cco u n t (e.g. provision for annual leave a n d /o r provision for LSL). There a re lots o f assum ptions that need to be m ade in d eterm ining the d o lla r a m ount o f the lia b ility , in clu d in g estim ates o f staff turnover a n d future salaries. W e w ill leave these c o m p lica tio n s to later courses. As an exam ple, assume a c o m p a n y starts accruing long service leave for staff after five years. They have d e cid e d not to accrue a n y earlier than this because they find, on a ve ra g e , that they have a high staff turnover in the early years a n d , therefore, these staff d o n 't eventually get long service leave. Assume the c o m p a n y (based on past history relating to length o f em ploym ent an d estim ated future salaries) determines that the long service leave expense for a
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p a rtic u la r e m p lo y e e fo r y ears six to 1 0 is $ 1 0 0 0 0 p e r y e a r. A ls o assum e that, in y e a r 1 1, th e staff m e m b e r takes lo n g se rvice le a v e . In this s im p lifie d e x a m p le , the a c c o u n tin g e q u a tio n w o u ld lo o k like this: A
=L
+ SE
Cash
Provision for long service leave
Long service leave expense
6
+10000
+10000
7
+10000
+10000
8
+10000
+10000
9
+10000
+10000
+10000
+10000
Year
10 11
-5 0 0 0 0
-5 0 0 0 0
T hat is, th e p ro visio n w ill b u ild u p e a c h y e a r to $ 5 0 0 0 0 in y e a r 1 0 . In y e a r 1 1, w h e n th e person takes th e le a v e th e lia b ility is re d u c e d to z e ro (d e b it p ro visio n fo r lo n g s e rvice le a v e , c re d it cash).
FOR YOUR INTEREST S t a f f o fte n w o n d e r w h y m e m b e rs o f m a n a g e m e n t w a n t th e m to ta k e lo n g s e rv ic e leave. O n e re a so n is th a t s a la ry ra te s g e n e ra lly in c re a s e , so m a n a g e m e n t w a n ts th e m to ta k e th e le ave a t th e lo w e r ra te . O f t e n m o re im p o r ta n t is th e im p a c t on th e fin a n c ia l s ta te m e n ts . W h e n a p e rs o n ta k e s lo n g s e rv ic e leave, cash d e cre a s e s and a lia b ility d e c re a s e s (p ro v is io n f o r L S L ). T h e re fo re , it d o e s n o t re d u c e p r o fit (as e x p e n s e s w e re ta k e n up in e a rlie r y e a rs ). H o w e v e r, i f th e e m p lo y e e had n o t ta k e n le ave, th e e n tr y w o u ld be d e b it w ag es e x p e n s e and c re d it cash , b o th f o r $ 1 0 0 0 0 (b a s e d o n th e e x a m p le a b o v e ). In th is case , th e r e is a w ag es e x p e n s e in th is p e rio d a n d , th e r e fo r e , p r o fit w ill d e c re a s e . In b o th cases cash re m a in s th e sam e . T h u s, b y g e ttin g s t a f f t o ta k e lo n g s e rv ic e leave, it has n o e f fe c t o n cash b u t has th e d u a l b e n e fits o f in c re a s in g p ro fits and re d u c in g lia b ilitie s .
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: W h ic h o f th e fo llo w in g w o u ld be in c lu d e d u n d e r p ro v is io n s ?
1 T h e c o m p a n y d e c id e s t o u p g ra d e e q u ip m e n t n e x t y e a r; th e c o s t w ill be $ 1 0 0 0 0 0 . 2 T h e c o m p a n y re c e iv e s an in v o ic e f o r $ 1 0 0 0 0 f o r an a d v e rtis e m e n t th a t a p p e a re d in th e lo ca l p a p e r. 3 T h e c o m p a n y p ro d u c e s te le v is io n s an d e s tim a te s th a t w a rra n ty c o s ts o v e r th e n e x t tw o y e a rs w ill be $40 000.
4 A c o m p a n y o w e s e m p lo y e e s a to ta l o f 4 0 5 d a y s ’ p a y in h o lid a y s a t y e a r-e n d b u t is u n c e rta in w h e n th e y w ill ta k e th e pay. Y o u r a n sw e rs s h o u ld be:
1 N o lia b ility 2 A c c o u n ts p a ya b le b u t n o t a p ro v is io n 3 P ro v is io n f o r w a rra n ty 4 P ro v is io n f o r e m p lo y e e e n title m e n ts .
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11.9 Contingent liabilities AASB 1 3 7 defines contingent liabilities as: (a )
a p o s s ib le o b lig a tio n t h a t a ris e s f r o m p a s t e v e n ts a n d w h o s e e x is te n c e w ill be c o n fir m e d o n ly b y th e o c c u r r e n c e o r n o n - o c c u r r e n c e o f o n e o r m o r e u n c e rta in f u t u r e e v e n ts n o t w h o lly w ith in th e c o n t r o l o f th e e n tity ; o r
(b )
a p re s e n t o b lig a tio n t h a t a ris e s f r o m p a s t e v e n ts b u t is n o t re c o g n is e d b e c a u s e : ( i)
it is n o t p ro b a b le t h a t an o u tf lo w o f re s o u rc e s e m b o d y in g e c o n o m ic b e n e fits w ill be re q u ire d to s e ttle th e o b lig a tio n ; o r
( ii)
th e a m o u n t o f th e o b lig a tio n c a n n o t be m e a s u re d w ith s u ff ic ie n t re lia b ility . Source: © C om m onw ealth o f Australia 2012.
There are tw o types o f contingent liabilities. O n e type is possible liabilities that arise from past events, the existence o f w h ich w ill be confirm ed o nly b y the occurrence o r non-occurrence of o ne o r more uncertain future events not w h o lly w ithin the control of the entity. An exam ple o f this w o u ld occur w hen a tax a u d it o f the entity is in progress and the taxation authority has expressed concern about, but not yet d is a llo w e d , particular incom e tax deductions claim e d in previous reporting periods. This gives rise to a possible present o b lig a tio n fo r a d d itio n a l incom e taxes; but the entity can o btain independent a d v ice that the deductions w e re claim ed correctly an d dispute a n y d is a llo w a n ce of the deductions. The other type o f contingent lia b ility is the type w h e re existence is not in d o u b t but the liabilities fail either o r both o f the criteria for recognition. The fo llo w in g a re exam ples o f circumstances that g ive rise to liabilities that d o not meet the criteria for recognition, a nd therefore are contingent liabilities: •
the entity has p rovided a firm guarantee o r indem nity to a fin a n cie r for a loan taken out by another entity, a n d at the reporting da te default on the loan is less than p ro b a b le
•
the entity is making o r d e fending a claim for unspecified da m a g e s a nd no am ount o f the claim (including its minimum amount) can be measured re liably as a t the reporting d ate, given the nature o f the claim . AASB 1 3 7 provides the decision flo w chart in Figure 1 1 .3 . The purpose of this decision flo w chart is to
summarise the main recognition a nd disclosure requirements o f the S tandard for provisions a nd contingent liabilities. A p p e n d ix A o f AASB 1 3 7 provides a summary o f the main requirements o f AASB 1 3 7 w ith respect to provisions and contingent liabilities. Where, as a result of past events, there may be an outflow of resources embodying future economic benefits in settlement of (a) a present obligation; or (b) a possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity: There is a present obligation that probably requires an outflow of resources.
There is a possible obligation or a present obligation that may, but probably will not, require an outflow of resources.
There is a possible obligation or a present obligation where the likelihood of an outflow of resources is remote.
A provision is recognised (paragraph 14).
No provision is recognised (paragraph 27).
No provision is recognised (paragraph 27).
Disclosures are required for the provision (paragraphs 84 and 85).
Disclosures are required for the contingent liability (paragraph 86).
No disclosure is required (paragraph 86).
Source: h ttp ://w w w .a a s b .g o v .a u /a d m in /file /c o n te n tl0 5 /c 9 /A A S B l 3 7 _ 0 7 -0 4 _ C O M P o c tl0 _ 0 1 -l 1 .pdf.
M o s t im portant to note is that contingent liabilities are not recognised in the b a la n ce sheet, but a re separately disclosed in the notes to the accounts.
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438
Start
FIGURE 11.3
Provisions and contingent liabilities Source: h ttp ://w w w .a a s b .g o v .a u /a d m in /file /c o n te n tl0 5 /c 9 /A A S B l 3 7 _ 0 7 -0 4 _ C O M P o c tl0 _ 0 l-l l .pdf.
HOW'S YOUR UNDERSTANDING? T h e fo llo w in g n o te re la tin g t o c o n tin g e n t lia b ilitie s is ta k e n fr o m th e fin a n c ia l s ta te m e n ts o f M a k e b e lie v e L im ite d . Legal a c tio n s e x is t a g a in s t a c o m p a n y re la tin g t o a c la im f o r d a m a g e s in re s p e c t o f a p r o d u c t w a rra n ty . L ia b ility is n o t a d m itte d and th e c o m p a n y w ill d e fe n d th e a c tio n . P ro fe s s io n a l legal a d v ic e in d ic a te s th a t n o loss w ill re s u lt fr o m th e s e c la im s .
1 2
B r ie fly e x p la in w h y th e c o n tin g e n t lia b ility o u tlin e d a b o v e w ill n o t a p p e a r on th e c o m p a n y ’s b a la n c e s h e e t. F ro m th e p e rs p e c tiv e o f a p ro s p e c tiv e in v e s to r, b rie fly disc u s s th e im p o rta n c e o f d is c lo s in g c o n tin g e n t lia b ilitie s in a c o m p a n y ’s fin a n c ia l s ta te m e n ts . Y o u r a n sw e rs s h o u ld be:
1
It is n o t p ro b a b le th a t th e fu tu r e s a c rific e o f e c o n o m ic b e n e fits w ill be re q u ire d . A ls o th e a m o u n t c a n n o t be m e a s u re d re lia b ly . T h e e x is te n c e o f th e lia b ility w ill o n ly be c o n firm e d b y th e o c c u rre n c e o r n o n o c c u rre n c e o f o n e o r m o re u n c e rta in e v e n ts (e .g . c o u r t h e a rin g ) n o t w h o lly w ith in th e c o n tro l o f th e e n tity .
2
It m a ke s th e in v e s to r a w a re o f p o te n tia l lia b ilitie s and ex p e n s e s .
CHAPTER 11 Liabilities
11.10
439
'Off balance sheet' financing
Sometimes com panies w ill a rra n g e for sources o f fin a n cin g that d o not meet the accounting definition o f a lia b ility or an equity item an d , as a result, this source o f fin a n cin g does not a p p e a r on the b a la n ce sheet. Because o f this treatment, fin a n cia l statement users m ay be concerned that such sources o f fin a n cin g a re sought b y m anagem ent because they d o not a p p e a r on the b a la n ce sheet an d , therefore, d o not affect the debt-to-equity ratio, the current ratio o r other measures. In some circum stances, such sources o f financing m ight not be disclosed at a ll, so that the user w o u ld not be a w a re o f the fin a n cia l com m itm ent they im ply. This concern led accounting standards to deem one such source - long-term leasing o f im portant fixed assets - to be equivalent to a lia b ility an d require its recognition and disclosure, as described earlier. W h e re leases are classified as fin a n ce leases, this source o f financing has consequently been brought onto the b a la n ce sheet as a fin a n ce lease liability, w h e re its econom ic substance is really like a m ortgage o r other noncurrent o b lig a tio n . N e w fin a n cia l arrangem ents a re being invented all the time, a n d the im pact they have on the b a la n ce sheet (or m ight have d e p e n d in g on the co m p a n y's accounting policies) is likely to be a factor in their a c ce p ta b ility and popularity. Four exam ples of fin a n cin g that m ay not be w e ll reported in the fin a n cia l statements include: •
o rd in a ry rental a nd leasing contracts, particularly non-cancellable o p erating leases that m ay be structured to a v o id a fin a n ce lease classification
• •
long-term purchase commitments to get fa vo u ra b le terms the sale of rights to collect accounts receivable (securitisations) so as to speed up the cash in flo w in return for taking on potential o b lig a tio n s to the party buying those rights
•
the use o f joint ventures, partnerships, associated com panies o r other types o f entities (like the special purposes entities used by Enron) to b o rro w m oney so that the commitments d o not sh o w up on the parent com pany's b a la n ce sheet. Fortunately, com panies make m andatory an d voluntary footnote disclosures a b o u t m any of the a b o v e off balance
sheet financing activities, so the extent of these activities can be assessed. Analysts an d other users o f financial inform ation often use these footnotes to make adjustments to the reported fin a n cia l statement numbers. For exam ple, the underlying lia b ility associated w ith op e ra tin g lease commitments a nd c a p ita l commitments can be estim ated from the prescribed footnote disclosures. Flow ever, these adjustments m ay be error-prone, because future commitments are not required to be discounted to present value. Follow ing the G lo b a l Financial Crisis, there is a renew ed effort by international accounting standard-setters to address the ga p s in the accounting rules that a llo w o ff b a la n ce sheet financing to continue.
11.11
Goods and services tax
This section covers A ustralia's g o o d s an d services tax (GST), including the lia b ility a ccount GST p a ya b le . This account is included in the payables section o f the b a la n ce sheet. W e have left GST until now , so that it can be discussed in detail w ith o u t interrupting the e arlier flo w o f the chapter. W e have a lre a d y seen that com panies p a y taxes to the Australian G overnm ent that are levied on their profit. Like other expenses, incom e tax expense is subtracted from revenue to determ ine the fin a n cia l perform ance o f a c o m p any over a p e riod; that is, the com pany's net profit o r loss. W h ile c o m p a n y taxes have a direct im pact on fin a n cial perform ance, com panies an d other organisations can also be affected by the other tw o types o f tax that form part of the taxation system: direct (personal) taxes a nd indirect taxes. W h ile a c o m p a n y is not, in itself, lia b le for these types o f tax, it acts as an a g e n t for the Australian Taxation O ffic e (ATO) in its collection an d rem ittance activities. For exam ple, w h ile em ployees a re in d ivid u a lly lia b le for personal incom e tax on their salaries o r w a g e s, com panies are required to w ith h o ld this tax w hen they p a y their em ployees an d remit it to the A T O under the Pay As You G o (PAYG) w ith h o ld in g system. From the com pany's perspective, salaries a nd w a g e s p a id to em ployees are an o p erating expense. That portion o f the salary o r w a g e that is w ith h e ld does not ch a n g e the o perating expense o f the com pany, but does create a lia b ility to a third party, the A T O . A ccounting for such taxes as PAYG is covered in section 1 1 .4 .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C om panies are also affected by indirect taxes. The most com m on exam ples of indirect taxes a re sales tax (usually levied on the final retail sale o f finished goods) a nd w h a t are c a lle d value-added taxes. M a n y countries, including N e w Z e a la n d , the United K ingdom a nd C a n a d a , ope ra te a system o f value-added tax. In Australia, a 1 0 per cent value-added tax known as a g o o d s an d services tax (GST) w a s introduced on 1 July 2 0 0 0 . A G ST is a broad-based consum ption tax: b ro a d based because it a p p lie s to most transactions in the econom y, a nd consum ption because it applies to the am ounts spent on g o o d s, services a nd activities. Figure 1 1 .4 highlights the key features o f the Australian GST system. The choices a v a ila b le to a business under the G ST system d e p e n d on turnover, a co n ce p t roughly equivalent to total annual revenue. If a business is registered for the GST, it collects 1 0 per cent tax on its sales on behalf o f the governm ent. Sm aller businesses have the c h o ice of accounting for GST on either a cash o r accrual basis. This c h o ice is independent o f w hether the business uses cash or accrual accounting to prepare its fin a n cia l statements. Sm aller businesses are also a b le to remit am ounts to the A T O quarterly o r monthly. Since February 2 0 0 1 , some businesses w ith an annual turnover of $ 2 m illion o r less have had the c h o ice to p a y G ST instalments quarterly a nd lo d g e a G ST return annually. Large businesses account for the GST on an accrual basis a nd remit am ounts monthly. GST is recorded in the accounting system as part of the process o f p reparing the b a la n ce sheet. It also a ids in the preparation o f a Business A ctivity Statement (BAS), w h ich includes a G ST return a nd is submitted to the A TO . The fo llo w in g exam ples illustrate h o w the GST system operates. The simplest case is that o f a supply chain w ith tw o parties. Let's assume that R. C han provides $ 1 0 0 0 of consulting services to M . Baker. U nder the G ST system, the consulting services represent a ta xa b le supply (services are supplied b y R. C han to M . Baker) a nd 1 0 per cent GST is a d d e d to the price p a id for the service, as illustrated in Figure 1 1 .5 . W e see that M . Baker acquires consulting services in e xch a n g e for $1 1 0 0 . From the perspective o f R. C han, $1 1 0 0 is to be collected; $ 1 0 0 0 o f this am ount represents revenue for the services supplied a nd $ 1 0 0 represents the GST collected on b ehalf o f the A T O , to be remitted a t the end of the tax p e riod. The fo llo w in g journal entry records the transaction: $ DR
Cash or accounts receivable
CR
Revenue
CR
GST payable
$
1 to o 1 000 to o
The GST p a y a b le a ccount is a current lia b ility a ccount that accum ulates the GST collected on all a p p lic a b le sales. W h e n the G ST that is due is p a id to the A T O , the lia b ility a ccount is reduced. A t a n y d ate, the G ST p a y a b le account shows w h a t has been collected but not yet remitted. It is, therefore, a control a ccount for the seller's o b lig a tio n to the governm ent. It shows the w a y the seller has been a channel for the governm ent's money, because it goes up w hen sales subject to G ST are m ade a nd d o w n w hen the m oney is sent to the A TO . Because M . Baker is the final consumer, this exam ple is sim ilar to the o peration of a sales tax system, except that the tax is being levied on the provision o f a service. FJowever, things a re usually a bit m ore c o m p lica te d than this, because R. C han is likely to have to p a y GST on purchases it has m ade from suppliers. Let's assume that R. C han pays $ 4 4 for p a p e r supplies from P. Lee. A value-added tax system, such as the GST, operates through the collection o f G ST each tim e a ta xa b le supply is m ade in the supply chain. In this case, the p a p e r represents a taxa b le supply, so G ST is included in the price p a id b y R. C h a n . To w o rk out the am ount o f GST, w e can d iv id e the price by 1 1: $ 4 4 / 1 1 = $ 4 . FJowever, because R. C han is registered for G ST a nd intends to use the p a p e r fo r business purposes, it becom es a c re d ita b le acquisition for R. C h a n . This means that R. C han is a b le to deduct a n y GST on its o w n purchases an d expenses from the am ount to be sent to the A T O . Therefore, the G ST due to the governm ent is the difference betw een G ST collected a nd G ST p a id . In this w a y , the effective responsibility for the paym ent of G ST is shifted a lo n g the supply chain. If w e extend our sim ple exam ple, w e can see h o w this w orks (see Figure 1 1.6).
CHAPTER 11 Liabilities
Is the entity carrying on an enterprise?
Cannot register for GST
^ Yes
FIGURE 11.4
Simplified flow chart showing the main elements of the GST system for Australian business
441
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FIGURE 11.5
Simple model o f the GST system as it affects tw o parties
There are a num ber o f things to notice in this exam ple: •
P. Lee has no business inputs, because it is the first link in the supply chain a n d , therefore, has no cre d ita b le acquisitions. O n making a ta xa b le supply to R. C h a n , P. Lee collects $ 4 G ST an d remits the am ount to the A TO .
•
R. C han pays GST on its acquisitions a nd collects GST w hen it supplies consulting services. The am ount remitted to the A T O is the difference betw een the G ST p a id a n d collected in a n y tax period. In the a b o v e exam ple, R. C han pays $ 4 GST to P. Lee a n d collects $ 10 0 from M . Baker. The difference o f $ 9 6 is remitted to the A TO .
•
M . Baker pays $ 1 0 0 G ST on the consulting services bought from R. C h a n . Because M . Baker is the final
•
The A T O continues to receive a total o f $ 1 0 0 .
consumer, there is no GST collection to offset the G ST paym ent.
So h o w does R. C han record its purchase of p a p e r supplies? The first thing to note is that part of the $ 4 4 p a id to P. Lee is for GST, a nd this provides an input tax credit o f $ 4 for R. C h a n . The p a p e r itself is valued at $ 4 0 . The fo llo w in g journal entry records the transaction:
Assuming that the G ST collected in a business is usually greater than the G ST p a id , the G ST recoverable account could be treated as a contra account to the G ST p a y a b le account. It is possible for the GST p a y a b le a ccount to be a d e b it (an asset) if the c o m p a n y makes particularly large purchases an d has small sales in a given p e riod. For exam ple, this m ight occur if a business acquires noncurrent assets, w h e re the G ST p a id is cla im e d im m ediately as an input tax credit in the current tax p e riod. Alternatively, the G ST recoverable a ccount could be classified as a current asset, and only the net am ount o f the G ST recoverable a nd GST p a y a b le accounts a p p e a r in the b a la n ce sheet. If a business does not m aintain extensive subsidiary records for GST, it m ight be easier for that business to clear the GST recoverable an d G ST p a y a b le accounts to another account at the end o f a tax p e riod. This a llo w s a record to be kept o f the net am ount o w in g o r refundable for a period in such a clearing account, an d resets the other accounts to accum ulate inform ation for the n ew period.
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O u r discussion suggests a num ber of generalisations: •
G ST is not a business tax. The main im pact for business m ight be on cash flo w p lanning because o f differences in tim ing betw een GST p a id a nd collected.
• •
The final consum er bears the cost, because he o r she is not a b le to claim input tax credits on acquisitions. If input tax credits are a va ila b le , a n y G ST p a id does not becom e part of an expense o r the cost o f the acquisition o f an asset.
•
A n y GST collected does not form part o f a business's revenue.
•
G ST is collected a t each point in the supply chain, brin g in g fo rw a rd the collection o f tax. This same pattern is repeated in every enterprise op e ra tin g in the A ustralian econom y! N o w , let's consider three special cases:
1
Private use: The GST system a llo w s input tax credits to be cla im e d o nly to the extent that the acquisition relates to a business purpose o r the operations o f an enterprise.
2
GST-free supplies: In this case, G ST is not c h a rg e d w hen g o o d s o r services are supplied to customers, but input tax credits can be claim ed for a n y G ST p a id on business inputs. Examples of GST-free supplies a re fresh food items, health a nd m edical care, education services an d childcare.
3
Input ta xe d supplies: Here, G ST is not ch a rg e d w hen g o o d s o r services are supplied to customers, but there is no entitlement to input tax credits. Effectively, the business is deem ed to be the final consumer. Examples include fin a n cia l services a nd residential rents. To illustrate the effect o f the last tw o cases, let's redo the journal entries w e recorded in our last exam ple. In the
case o f GST-free supplies, the journal entries becom e:
DR CR
Cash or accounts receivable
DR
Supplies expense/asset
DR
GST recoverable
CR
1 000
Revenue
1 000 40 4
Cash/payable
44
N o te : there is no GST collected on supply, but GST can be recovered for business inputs.
In contrast, the journal entries for input taxed supplies are: $ DR CR DR CR
Cash or accounts receivable Revenue Supplies expense/asset Cash/payable
$
1 000 1 000 44 44
N o te: there is no GST collected on supply, and the full am ount p a id or p a ya b le for inputs is the expense recognised or the cost o f acquisition for an asset.
There is much m ore to the operation of the tax system than can be covered in this brief introduction. For those w h o are interested, current inform ation can be o b ta in e d at: h ttp ://w w w .a to .g o v .a u . As you w ill find, tax is a very c halle n g in g a nd d yn a m ic area!
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A W arranty accruals B alm e r Ltd has a w a rra n ty p la n . E stim ated w a rra n ty lia b ility w a s $ 5 0 0 0 0 a t th e b e g in n in g o f th e y e a r. Based o n the c o m p a n y 's sales fo r th e y e a r, w a rra n ty s e rvice c o stin g $ 7 8 5 0 0 in w a g e s a n d o th e r costs, plus $ 6 2 0 0 0 in re p la c e m e n t p ro d u cts , w a s e x p e c te d to h a ve to be p ro v id e d e v e n tu a lly . A c tu a l e x p e n d itu re s fo r th e y e a r w e re $ 8 4 0 0 0 in w a g e s a n d o th e r costs a n d $ 7 8 0 0 0 in re p la c e m e n t p ro d u cts . 1 C a lc u la te w a rra n ty e x p e n s e fo r th e y e a r a n d e s tim a te d w a rra n ty lia b ility a t th e e n d o f th e y e a r. 2
W r ite o n e o r m o re jo u rn a l en trie s to re c o rd B alm e r Ltd's w a rra n ty e x p e rie n c e fo r th e y e a r.
PRACTICE PROBLEM B A cco u n tin g For GST B a rb a rin o Ltd u n d e rta k e s c o n s u ltin g services fo r la rg e fo o d -p ro c e s s in g e n te rp rise s. The c o m p a n y is re g is te re d fo r G ST, a n d a c co u n ts fo r G S T on th e cash basis. A t th e e n d o f M a rc h 2 0 1 6 , th e G S T p a y a b le a c c o u n t h a d a b a la n c e o f $ 4 0 0 a n d th e G S T re c o v e ra b le a c c o u n t a b a la n c e o f $ 1 4 4 . D u rin g A p ril 2 0 1 6 , B a rb a rin o Ltd re c o rd e d these tra n sa ctio n s: 6 April
Received from FCD Ltd the sum of $4000 + $400 for GST.
8 April
Received from VKL Ltd the sum of $4950 (including GST).
15 April
Sent cheque to the ATO for the net amount of GST payable for the March.
P rep are g e n e ra l jo u rn a l en trie s to a c c o u n t fo r th e m onth o f A p ril.
PRACTICE PROBLEM C Events givin g rise to lia b ilitie s The fo llo w in g events o c c u rre d d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 fo r P lum ber Lim ited. 1 O p e n in g b a la n c e o f a c c ru e d s a la rie s w a s $ 1 0 0 0 0 . W a g e s e x p e n s e fo r th e y e a r w a s $ 6 3 0 0 0 0 a n d cash p a id fo r s a la rie s w a s $ 6 0 0 0 0 0 . 2
O n 1 M a y 2 0 1 6 , P lum ber s ig n e d a three-m onth 1 2 p e r c e n t p e r a n n u m note p a y a b le to p u rch a s e a n e w
3
O n 15 M a y 2 0 1 6 , P lum ber re c e ive d re n t in a d v a n c e o f $ 6 0 0 0 fro m W Y Z fo r a three-m onth lease o f prem ises.
4
June sales to ta lle d $ 2 1 2 0 0 0 . P lum ber c o lle c te d G S T o f 1 0 p e r c e n t o n this a m o u n t. This is d u e to be p a id to the ta x o ffic e b y th e seventh d a y o f th e m onth fo llo w in g c o lle c tio n .
5
E le ctricity c h a rg e s o f $ 4 0 0 0 0 fro m 2 4 A p r il to 2 3 June a re p a y a b le o n 1 0 July.
m a c h in e c o stin g $ 4 8 0 0 0 . Interest a n d p rin c ip a l a re p a id a t m a tu rity.
6
O n 3 0 June 2 0 1 6 , P lum ber to o k o u t a lo a n fo r $1 1 0 0 0 0 fro m O s c a r B ank. R ep aym en ts o f p rin c ip a l a re s c h e d u le d e v e n ly o v e r a fiv e -y e a r p e rio d . Interest on th e lo a n is p a id in th e y e a r it is in c u rre d .
7
P lu m b er's m a in p ro d u c t is b a c k e d b y w a rra n ty . Sales o f this p ro d u c t fo r th e y e a r to ta lle d $ 4 4 5 0 0 0 . The o p e n in g b a la n c e o f p ro v is io n fo r w a rra n ty c la im s w a s $ 1 0 6 0 0 . D u rin g th e y e a r, P lum ber's w a rra n ty e x p e n s e w a s $ 3 1 7 0 0 a n d c la im s p a id to custom ers to ta lle d $ 2 5 2 0 0 .
For e a ch item , in d ic a te th e a c c o u n t a n d th e a m o u n t to be in c lu d e d as a c u rre n t lia b ility on P lu m b er's b a la n c e sheet.
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445
PRACTICE PROBLEM D Provisions B a lm e r Ltd starte d th e y e a r w ith a lo n g s ervice le ave (LSL) lia b ility o f $ 4 2 0 0 0 fo r its long -term e m p lo y e e s . D u rin g the y e a r, e m p lo y e e s a c c ru e d LSL en titlem en ts w ith a pre se n t v a lu e o f $ 1 4 7 6 0 0 a n d th e c o m p a n y p a id $ 1 5 7 4 0 0 to e m p lo y e e s fo r LSL ta ke n d u rin g th e y e a r. C a lc u la te th e a m o u n t o f th e LSL e x p e n s e fo r th e y e a r a n d th e LSL lia b ility a t th e e n d o f th e y e a r.
KEY TERMS Accelerated depreciation Employee deductions
Line of credit Notes payable
OFF balance sheet Financing Straight-line depreciation
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
DISCUSSION QUESTIONS 1
D e fin e a lia b ility .
2
List fo u r c a te g o rie s o f lia b ilitie s .
3
E x p la in th e re la tio n s h ip b e tw e e n lia b ilitie s a n d expe nses. P ro vid e fiv e e x a m p le s w h e re th e y bo th in cre a s e a t the sam e tim e.
4
W h y is th e d is tin c tio n b e tw e e n c u rre n t a n d n o n c u rre n t lia b ilitie s im p o rta n t?
5
W h y a re e a ch o f th e fo llo w in g item s c la s s ifie d as lia b ilitie s : p ro v is io n fo r w a rra n ty , p ro v is io n fo r lo n g service le a v e , u n e a rn e d reven ue , G S T p a y a b le a n d in co m e ta x d e d u c tio n s du e?
6 W h y a re som e lia b ilitie s in te re st-b e a rin g a n d others a re not? 7
W h a t a re th e th re e sources o f fu n d in g a v a ila b le to c o m p a n ie s ?
8 W h a t is th e d iffe re n c e b e tw e e n a p a y a b le a n d a p ro v is io n ? 9
W h a t a re e x a m p le s o f p ro visio n s ?
1 0 P ro v id e e x a m p le s o f p ro visio n s fo r e m p lo y e e en titlem en ts. 11 E x p la in th e d iffe re n c e b e tw e e n a lia b ility a n d a c o n tin g e n t lia b ility . 12 E x p la in w h y c o n tin g e n t lia b ilitie s d o no t a p p e a r on th e b a la n c e sheet. G iv e tw o e x a m p le s o f a c o n tin g e n t lia b ility . 13 P ro v id e an e x a m p le o f an in sta nce w h e re a la w s u it w o u ld be c la s s ifie d as (a) a lia b ility o r (b) a c o n tin g e n t lia b ility . 14 W h y m ig h t c o m p a n ie s use o ff b a la n c e sheet fin a n c in g ? 15 W h a t is th e d iffe re n c e , if a n y , b e tw e e n lia b ilitie s a n d le g a lly e n fo rc e a b le debts?
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEMS PROBLEM 11.1 C urrent lia b ilitie s The fo llo w in g d a ta is e x tra c te d fro m th e a c c o u n tin g re c o rd s o f A B C Lim ited a t 3 0 June 2 0 1 6 .
$ Equipment
400000
Accounts receivable
90000
Accounts payable
30000
Cash
10000
Accrued salaries
6000
Unearned revenue
8 000
Accrued interest revenue
5 000
Allowance for doubtful debts
3 000
Provision for holiday pay
7000
Accumulated depreciation Sales
50000 200000
Cost of sales
80000
Depreciation
20000
Other operating expenses
60000
W h a t is th e b a la n c e o f c u rre n t lia b ilitie s a t 3 0 June 2 0 1 6?
PROBLEM 11.2 W hat is a lia b ility ? R espond to th e q u e s tio n a s ke d in e a ch c o m m e n t b e lo w . 1
'W a rra n tie s a re h o n o u re d as p a rt o f g o o d business p ra c tic e : k e e p y o u r custom ers h a p p y . W h e th e r to h o n o u r a c la im , a n d h o w m uch cost to in cu r, a re m a n a g e ria l ju d g e m e n ts th a t d e p e n d on h o w g o o d th e c u stom er is, w h a t th e re p u ta tio n effects a re , a n d so o n . T h e re fo re , w a rra n tie s a re d is c re tio n a ry p e rio d expe nses like d o n a tio n s . T h ere is no a c c ru a l fo r fu tu re d o n a tio n s , so w h y is th e re an a c c ru a l fo r fu tu re w a rra n ty costs?'
2
'E m p lo y e e s ta k e th e ir lo n g s ervice le a v e y e a rs a n d y e a rs in to th e fu ture . W h e th e r th e re is a n y lo n g s ervice le ave d e p e n d s on w h e th e r th e e m p lo y e e keeps w o rk in g fo r th e c o m p a n y a n d h o w lo n g th e e m p lo y e e w o rk s fo r the c o m p a n y . T h e re fo re , lo ng s ervice le a v e costs c a n o n ly be re a lis tic a lly d e te rm in e d w h e n th e y a re b e in g p a id in th e fu tu re . W h y s h o u ld n 't th e y be e x p e n s e d th e n , ra th e r th a n n o w ? '
PROBLEM 11.3 Recording and re p o rtin g cu rre n t lia b ilitie s M e rry la n d C o m p a n y c o m p le te d th e fo llo w in g tra n s a c tio n s d u rin g 2 0 1 5 - 2 0 1 6 . The a n n u a l a c c o u n tin g p e rio d en ds 3 0 June 2 0 1 6 . a P urchased in v e n to ry o n c re d it a t cost o f $ 13 8 0 0 ; p e rp e tu a l in v e n to ry system is used, b
R eceived a c u sto m e r d e p o s it o f $ 1 7 0 0 0 fro m LPQ Ltd fo r services to be re n d e re d in th e fu ture ,
c
B o rro w e d $ 9 0 0 0 0 0 fro m th e b a n k b y g iv in g th e b a n k a six-m on th, 9 p e r c e n t in te re st-b e a rin g note p a y a b le ,
d
P erform e d $ 7 0 0 0 o f th e services p a id fo r b y LPQ; th e rest w ill be re n d e re d in A u g u s t 2 0 1 6 .
e
R eceived th e e le c tric ity b ill fo r $ 2 6 7 8 0 w h ic h w ill be p a id in e a rly July.
f
O n 1 June 2 0 1 6 re c e iv e d rent in a d v a n c e o f $ 1 8 6 0 0 fro m SFT Ltd fo r a th ree-m on th le ase o f prem ises fro m 1 June to 31 A u g u s t 2 0 1 6 .
g
W a g e s a c c ru e d in th e last w e e k ly p a y ro ll a m o u n te d to $ 1 2 5 0 0 a n d w ill be p a id on 5 J u ly 2 0 1 6 .
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Required: 1
P re p a re jo u rn a l en trie s fo r e a ch o f these tra n sa ctio n s.
2
P re p a re a ll a d ju s tin g e n trie s re q u ire d on 3 0 June 2 0 1 6 .
PROBLEM 11.4 Id e n tify in g cu rre n t lia b ilitie s Note
2016 $m
Current liabilities Trade and other payables*
15
4093
Provisions*
16
394
17(a)
1 990
17(f)
634
Borrowings* Derivative financial liabilities Current tax payables
404
Revenue received in advance*
1 018
Liabilities classified as held for sale
12
5
Total current liabilities
8538
E x p la in w h a t is lik e ly to be in c lu d e d in e a ch o f th e item s m a rke d w ith a n a ste risk (* ). H in t: th is c o m p a n y is in the te le c o m m u n ic a tio n s in d u stry.
PROBLEM 11.5 Id e n tify in g cu rre n t lia b ilitie s Note
2016
20 15
$m
$m
Current liabilities Payables*
19
1 738
1 750
Revenue received in advance*
20
3 067
3 167
Interest-bearing liabilities*
21
577
630
Other financial liabilities
25
397
242
Provisions*
22
456
448
Liabilities classified as held for sale
13
Total current liabilities
-
4
6 235
6 241
E x p la in w h a t is lik e ly to be in c lu d e d in e a ch o f th e item s m a rke d w ith a n a ste risk (* ). H in t: th is c o m p a n y is in the a irlin e in d u stry.
PROBLEM 11.6 Im pact on fin a n cia l sta te m e n ts T o b y Lim ited b o rro w e d $ 7 5 0 0 0 0 0 0 cash on th e last d a y o f th e fin a n c ia l y e a r (31 D e c e m b e r 2 0 1 6 ) to be p a id b a c k in s ix y e a rs . The m o n e y w a s used on th e sam e d a y to re d u c e th e c o m p a n y 's short-term b a n k lo an s b y $ 2 5 0 0 0 0 0 0 a n d to b u y a d d itio n a l e q u ip m e n t fo r $ 5 0 0 0 0 0 0 0 . C a lc u la te th e c h a n g e s in th e fo llo w in g as a result o f th e a b o v e tra n sa ctio n s: 1
to ta l c u rre n t assets
2 to ta l assets
448
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
3
to ta l c u rre n t lia b ilitie s
4
w o rk in g c a p ita l ra tio (cu rre n t assets 4- c u rre n t lia b ilitie s )
5
to ta l s h a re h o ld e rs ' e q u ity
6
net p ro fit fo r th e y e a r e n d e d o n th e d a y o f th e b o rro w in g .
PROBLEM 11.7 Entries For notes payable A business issued a 6 0 -d a y , 9 p e r c e n t note fo r $ 2 0 0 0 0 fo r cash . J o u rn a lis e th e e n trie s to re c o rd : 1
th e issu an ce o f th e note
2 th e p a y m e n t o f th e no te a t m a tu rity, in c lu d in g interest.
PROBLEM 11.8 R ecognition o f lia b ilitie s State w h e th e r th e fo llo w in g w o u ld be re c o g n is e d as a lia b ility . If so, w h a t a c c o u n t na m e w o u ld y o u use? 1
The c o m p a n y has a le g a l o b lig a tio n v ia c o n tra c t to re p a ir a n y d e fic ie n c ie s o c c u rrin g in th e firs t tw o y e a rs in the b u ild in g s it constructs.
2
The c o m p a n y has no le g a l o b lig a tio n b u t as a m a tte r o f couse it re p a irs a n y d e fic ie n c ie s o c c u rrin g in the firs t tw o y e a rs in th e b u ild in g s it constructs. This p o lic y has h e lp e d it re ta in a g o o d re p u ta tio n in th e in d u stry .
3
Based on th e p re lim in a ry fin a n c ia l results th e c o m p a n y e xp e cts to p a y a bo nu s o f $1 m illio n to staff. The c o m p a n y has n o w p a id bonuses to s ta ff fo r th e last 1 0 y e a rs .
4
A t th e e n d o f th e y e a r it is c a lc u la te d th a t s ta ff h a ve on a v e ra g e ta ke n 1 3 o f th e ir 2 0 d a ys o f a n n u a l leave.
5
The c o m p a n y has s ig n e d th e c o n tra c t to p u rch a s e a p ie c e o f e q u ip m e n t w o rth $ 3 0 0 0 0 0 . The e q u ip m e n t w ill be d e liv e re d to it in th re e w e e ks a n d w ill be in sta lle d in th e fo llo w in g w e e k .
6
The c o m p a n y has g u a ra n te e d a lo a n o f $ 1 .2 m illio n fo r o n e o f its v e ry p ro fita b le s u b s id ia rie s .
PROBLEM 11.9 Answ er questions a b o u t debentu re discounts and prem ium s The C E O o f R edstone Ltd has just been d iscu ssin g a p la n n e d n e w d e b e n tu re issue w ith th e fin a n c ia l a d vise rs, a n d has c o m e to y o u w ith som e resultin g a c c o u n tin g q u e s tio n s . A n s w e r e a ch o f th e fo llo w in g : 1
'W e a re th in k in g o f setting th e in tere st ra te on th e d e b e n tu re s a little a b o v e c u rre n t m a rke t rates, to m a ke them m o re a ttra c tiv e . I'm to ld th is w ill p ro d u c e a b a la n c e sheet lia b ility h ig h e r th a n th e fa c e v a lu e o f th e de b e n tu re s. H o w do es th is h a p p e n ? '
2
'Y o u r a n s w e r to m y firs t q u e s tio n is tro u b lin g . H o w c a n it m a ke sense to s h o w a lia b ility h ig h e r th a n th e a m o u n t w e w ill h a ve to p a y w h e n th e d e b e n tu re s a re du e? W h a t w ill w e d o w ith th e d iffe re n c e th e n ? '
PROBLEM 11.10 Entries For d isco u n tin g notes payable N a tio n a l E le ctric L igh ting Ltd issues a 9 0 -d a y note fo r $ 5 0 0 0 0 0 to H o m e Products S u p p ly Ltd fo r m e rch a n d is e in v e n to ry . H o m e P roducts d isc o u n ts th e no te a t 1 0 p e r cent. 1 J o u rn a lis e N a tio n a l E le ctric's en trie s to re c o rd :
2
a
th e issu an ce o f th e note
b
th e p a y m e n t o f th e note a t m a tu rity.
J o u rn a lise H o m e P rod ucts' en trie s to re c o rd : a
th e recei p t o f th e note
b
th e re c e ip t o f th e p a y m e n t o f th e no te a t m a tu rity.
CHAPTER 11 Liabilities
449
PROBLEM 11.11 Bond d isco u n t or prem ium calculations H e re a re th re e cases re la te d to issu an ce o f bo n d s. • A Ltd issued 1 0 0 0 0 $ 1 0 0 b o n d s a n d re c e ive d $ 9 7 .5 0 cash fo r e a ch . •
B Ltd p la n n e d to issue 1 0 0 0 0 $ 1 0 0 b o n d s b u t fo u n d th a t th e p la n n e d in tere st ra te o f 7 p e r c e n t w a s lo w e r th an m a rk e t rates, a n d so re c e ive d $ 9 1 5 0 0 0 fo r them .
•
C Ltd issued 1 0 0 0 0 $ 1 0 0 b o n d s fo r a p re m iu m o f 5 p e r c e n t on fa c e v a lu e .
1
For e a ch case: C a lc u la te th e a m o u n t o f a n y d is c o u n t o r p re m iu m on issue o f th e bo n d s.
2
R ecord th e issue o f th e b o n d s.
3
State w h e th e r in tere st e x p e n s e o v e r th e life o f th e b o n d s w ill be h ig h e r, lo w e r o r th e sam e as th e cash interest p a id on th e b o n d e a ch y e a r.
PROBLEM 11.12 Borrow ings 1
2
3
T w e e d s m u ir Land Ltd has a s u b s ta n tia l m o rtg a g e d e b t. The d e b t w a s $ 1 3 4 9 9 2 7 6 a t th e b e g in n in g o f this y e a r. M o rtg a g e p a ym e n ts o f $ 3 8 8 8 5 4 1 w e re m a d e d u rin g th e y e a r a n d th e m o rtg a g e b a la n c e w a s $ 1 0 8 5 1 2 9 9 a t th e e n d o f th e y e a r. N o n e w b o rro w in g w a s m a d e this y e a r. N e x t y e a r, th e pa ym e n ts re q u ire d to ta l $ 4 1 0 5 6 4 0 a n d , if th e re is no n e w b o rro w in g , th e m o rtg a g e b a la n c e w ill be $ 7 7 4 2 8 7 9 a t th e e n d o f n e xt y e a r. C a lc u la te : a
in tere st e x p e n s e fo r this y e a r
b
c u rre n t p o rtio n o f th e m o rtg a g e lia b ility a t th e e n d o f this y e a r
c
n o n c u rre n t m o rtg a g e lia b ility a t th e e n d o f this y e a r.
Y o h o Portals Ltd issued $ 1 0 0 0 firs t-m o rtg a g e b o n d s th a t h a ve a to ta l fa c e v a lu e o f $ 4 0 m illio n a n d c a rry a 7 . 2 p e r c e n t in tere st rate. T h e y w e re n o t w e ll re c e iv e d b y th e b o n d m a rke t, so Y o h o re c e ive d o n ly $ 3 7 6 5 7 4 2 0 fo r them . a
R ecord th e b o n d issue
b
c a lc u la te th e b a la n c e sheet lia b ility fo r th e b o n d s, as o f th e issue d a te .
R e g a rd in g q u e s tio n 2 , w ill Y o h o 's in tere st expe nses fo r th e b o n d s be m o re o r less th a n 7 .2 p e r c e n t tim es the fa c e v a lu e ($ 2 8 8 0 0 0 0 ) ? W h y ?
PROBLEM 11.13 Analysis o f leave provisions A n e x tra c t fro m an a n n u a l re p o rt is p ro v id e d here. Note 2 . Schedule of leave entitlements Recreation leave
Extended leave
Total provisions
2016
20 15
2016
20 15
2016
2015
$
$
$
$
$
$
Balance 1 July
98515
105 771
274855
244 172
373370
3 4 9 94 3
Paid during year
51315
86 751
83 0
21 350
52145
108101
47200
19 020
274025
222 822
321 225
241 842
67875
79495
51884
52 033
119759
131528
Liability 30 June
115075
98515
325909
274 855
440984
373 370
Current
115075
98515
310847
267120
425922
365 635
—
15062
7735
15062
7735
98515
325909
274 855
440984
373 370
Provided during year
Noncurrent Total liability
-
115075
450
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
1
W h a t d o y o u th in k re c re a tio n le ave a n d e x te n d e d le ave a re lik e ly to in clu d e ?
2
W h a t w a s th e o p e n in g b a la n c e o f re c re a tio n le a v e as a t 1 J u ly 2 0 1 5 ?
3
By d o lla r v a lu e , d id th e s ta ff ta k e m o re re c re a tio n le a v e o r e x te n d e d le a v e in 2 0 1 6 ?
4
By d o lla r v a lu e , d id th e s ta ff a c c ru e (b e co m e e n title d to) m o re re c re a tio n le a v e o r e x te n d e d le a v e in 2 0 1 6 ?
5
W h y has th e e x te n d e d le a v e p ro v is io n in cre a s e d b y $ 5 1 0 5 4 fro m 2 0 1 5 to 2 0 1 6?
PROBLEM 11.14 Provisions S h o u ld a p ro v is io n be re c o g n is e d in th e fo llo w in g situ a tio n s? 1
A fu rn a c e has a lin in g th a t needs to be re p la c e d e v e ry fiv e y e a rs fo r te c h n ic a l rea so ns. A t th e re p o rtin g d a te , the lin in g has be en in use fo r th re e y e a rs .
2
A n a irlin e is re q u ire d b y la w to o v e rh a u l its a irc ra ft o n c e e v e ry th re e y e a rs .
3
U n d e r n e w le g is la tio n , a n e n tity is re q u ire d to fit sm oke filters to its fa c to rie s b y 31 D e c e m b e r 2 0 1 5 , a n d en tities th a t d o n o t c o m p ly w ill be fin e d o r re q u ire d to p a y p e n a ltie s. A s a t 3 0 June 2 0 1 5 , th e e n tity has no t fitte d the sm oke filte rs . S h o u ld a p ro v is io n be re c o g n is e d a t 3 0 June 2 0 1 5 a n d 3 0 June 2 0 1 6 ?
PROBLEM 11.15 Provisions The h o a rd in g o f a n n u a l le a v e b y staff c a n le a d to la rg e lia b ilitie s o n th e b a la n c e sheet a n d in e ffe c tiv e staff. 1 E x p la in h o w s ta ff no t ta k in g a n n u a l le a v e c a n le a d to lia b ilitie s on th e b a la n c e sheet. 2
S om e o rg a n is a tio n s fo rc e s ta ff to ta k e a ll o f th e ir a n n u a l le a v e fo r he alth rea so ns, b u t a ls o to im p ro v e the fin a n c ia l statem ents. W h a t im p a c t w o u ld th is a c tio n h a ve on the:
a
in c o m e statem ent?
b
b a la n c e sheet?
c sta te m e n t o f cash flo w s? A ssum e th a t no a d d itio n a l staff a re h ire d to re p la c e them w h ile on le ave.
PROBLEM 11.16 A ccrual p ro d u c t w a rra n ty P recision A u d io C o m p a n y w a rra n ts its p ro d u c ts fo r o n e y e a r. The e s tim a te d p ro d u c t w a rra n ty is 3 p e r c e n t o f sales. A ssum e th a t sales w e re $ 6 0 0 0 0 0 fo r J a n u a ry . In F e b ru a ry, a c u stom er re c e ive d w a rra n ty re p a irs re q u irin g $ 3 1 0 w o rth o f p a rts a n d $ 4 6 0 w o rth o f la b o u r. 1 J o u rn a lis e th e a d ju s tin g e n try re q u ire d a t 31 J a n u a ry , th e en d o f th e firs t m o nth o f th e c u rre n t y e a r, to re c o rd the a c c ru e d p ro d u c t w a rra n ty . 2
J o u rn a lis e th e e n try to re c o rd th e w a rra n ty w o rk p ro v id e d in F e b ru a ry.
PROBLEM 11.17 Accrued p ro d u c t w arra n ty D u rin g a re c e n t y e a r, M o to re lla Ltd h a d sales o f $ 2 9 3 9 8 m illio n . A n a n a lys is o f M o to re lla 's p ro d u c t w a rra n ty p a y a b le a c c o u n t fo r th e y e a r w a s as fo llo w s :
$m | Product warranty payable, January 1
337
Product warranty expense
226
Warranty claims paid Product warranty payable, December 31
1
D e te rm in e th e p ro d u c t w a rra n ty e x p e n s e as a p e rc e n ta g e o f sales.
2
R ecord th e a d ju s tin g e n try fo r th e p ro d u c t w a rra n ty e x p e n s e fo r th e y e a r.
(230) $333
CHAPTER 11 Liabilities
451
PROBLEM 11.18 L ia b ilitie s in Financial sta te m e n ts N o te s 1 3 a n d 1 4 fo r th e fin a n c ia l statem ents o f Emm Lim ited a re s h o w n b e lo w . Note 13. Creditors and borrowings Consolidated 2016
2015
2016
20 15
$000
$000
$000
$000
231 473
217868
75 394
65 5 67
Current Trade creditors and accruals Loans - unsecured Bank loans - unsecured
54 7
-
-
-
72 804
64262
64000
60000
-
217126
214624
304824
282130
356520
340191
150 00 0
115 00 0
150000
115 00 0
Amounts owing to controlled entities
-
Noncurrent Promissory notes Loans - unsecured Bank loans - unsecured
1 160
20970
970
20970
305 43 7
150 00 0
300000
150 00 0
-
114400
129635
285970
565370
415 605
-
456597
Note 14. Provisions Current Self-insurance Employee leave entitlements Warranty and service on goods sold Dividends (Note 16) Income tax (Note 4B)
6 048
5 041
-
-
31 006
30779
11 241
1 0 9 90
8 404
6 962
2212
2 436
28691
37559
28691
37559
5 566
24606
9 267
1 794
79715
104 94 7
51411
52 779
250
250
250
250
41 613
36110
18 668
15 548
961
708
542
548
42 824
37068
19460
16 346
Noncurrent Self-insurance Employer leave entitlements Warranty and service of goods sold
1
P ro v id e e x a m p le s o f tra d e c re d ito rs a n d a c cru a ls.
2
A ssum e th a t th e re a re no n e w lo a n s (unsecured) d u rin g th e y e a r. W h a t jo u rn a l e n trie s w o u ld h a ve been m a d e d u rin g th e y e a r?
3
The b a n k lo a n o f $ 1 5 0 m illio n in 2 0 1 6 is re p a y a b le d u rin g 2 0 1 7 . W h a t jo u rn a l e n try w o u ld be m a d e w ith re sp e ct to long -term u n se cu red b a n k loans d u rin g th e y e a r?
4
A ssum e th a t a to ta l o f $ 6 m illio n w a s p a id in w a rra n ty costs d u rin g 2 0 1 6 . W h a t w a s th e w a rra n ty e x p e n s e fo r 2016?
5
W h a t w o u ld be in c lu d e d in th e p ro v is io n fo r e m p lo y e e le a v e en titlem en ts? W h y is it b o th a c u rre n t a n d a n o n c u rre n t lia b ility ? W h a t jo u rn a l e n try is m a d e to in cre a s e th is a m o u n t?
452
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 11.19 C urrent and n o n cu rre n t lia b ility calculation s C o n s id e r th e fo llo w in g : a John Ltd's m o rtg a g e o f $ 8 4 2 5 0 0 re q u ire s pa ym e n ts o f $1 1 2 0 0 e a ch m o nth . D u rin g th e n e xt y e a r th e interest c o m p o n e n t o f th e pa ym e n ts w ill e q u a l $ 6 1 2 3 2 . b
F rie d a Ltd's m o rtg a g e o f $ 2 3 2 2 0 0 re q u ire s pa ym e n ts o f $ 6 0 0 0 0 o v e r th e n e xt y e a r. By th e e n d o f n e xt y e a r th e p rin c ip a l d u e on th e m o rtg a g e w ill h a ve g o n e d o w n to $1 8 9 4 0 0 .
c
G ra h a m Ltd's $ 8 7 4 3 6 m o rtg a g e re q u ire s m o n th ly pa ym e n ts o f $ 1 5 0 0 plus interest. D u rin g th e n e xt y e a r pa ym e n ts w ill to ta l $ 2 5 6 7 4 .
1
In e a c h case , c a lc u la te : c u rre n t lia b ility a t th e e n d o f this y e a r
2
n o n c u rre n t lia b ility a t th e e n d o f this y e a r
3
in tere st e x p e n s e fo r th e n e xt y e a r.
PROBLEM 11.20 L ia b ilitie s and c o n tin g e n t lia b ilitie s For e a c h o f th e fo llo w in g s itu a tio n s , d e te rm in e w h e th e r th e c o m p a n y sh o u ld (a) re p o rt a lia b ility o n th e b a la n c e sheet, (b) d is c lo s e c o n tin g e n t lia b ility o r (c) n o t re p o rt th e s itu a tio n . Justify a n d e x p la in y o u r c o n c lu sio n s . 1 A c a r m a n u fa c tu re r in tro d u c e s a n e w m o d e l. Past e x p e rie n c e in d ic a te s th a t th e re w ill be som e w a rra n ty expenses b u t b e ca u s e th e d e s ig n o f th e c a r is so d iffe re n t fro m a n y th in g p re v io u s ly on th e m a rk e t th e a m o u n t o f the w a rra n tie s c a n n o t be re a s o n a b ly e s tim a te d . 2
A n e m p lo y e e has sug g e ste d th a t o n e o f th e c o m p a n y 's best-selling p ro d u c ts m a y in frin g e on a n o th e r c o m p a n y 's p a te n t. If th e o th e r c o m p a n y d is c o v e rs th e in frin g e m e n t a n d files a la w s u it, th e c o m p a n y c o u ld lose m illio n s.
3
A c o m p a n y has p o llu te d a riv e r d u rin g th e la n d d e v e lo p m e n t fo r a n e w c o n s tru c tio n p ro je c t. U n d e r e n v iro n m e n ta l la w s , c le a n -u p a c tio n is re q u ire d u p o n th e c o m p le tio n o f th e p ro je c t. The d e v e lo p m e n t p ro je c t w ill ta k e six to 1 0 y e a rs to c o m p le te . C u rre n t e s tim a tio n o f th e cost to c le a n up th e riv e r am o u n ts to $ 2 - 3 m illio n .
4
The c o u rt a n n o u n c e d a d e c is io n o n a p ro d u c t lia b ility la w s u it a n d fo u n d th a t th e c o m p a n y is lia b le fo r $ 1 m illio n . M a n a g e m e n t pla n s to a p p e a l a n d be lie ve s th a t it w ill w in . H o w e v e r le g a l a d v ic e suggests th a t th e c h a n c e o f w in n in g is m in im a l.
5
A key c u sto m e r has c o m p la in e d a b o u t th e q u a lity o f
a m a jo r c o n s tru c tio n p ro je c t a n d has a c la im fo r
c o m p e n s a tio n . W h ile y o u b e lie v e th e c la im is u n re a s o n a b le , to m a in ta in th e g o o d w ill a n d re p u ta tio n , the c o m p a n y has d e c id e d to m a ke $ 2 5 0 0 0 0 in re p a irs n e xt y e a r w ith o u t c h a rg e .
6 A c o m p a n y is b e in g sued fo r a loss c a u s e d b y a fa u lty p ro d u c t is th e cause o f th e loss, a ll le g a l p a rtie s in v o lv e d th e loss.
p ro d u c t. H o w e v e r, w h ile th e re is a g re e m e n t th a t the d is a g re e a b o u t th e d o lla r a m o u n t th a t w a s c a u s e d b y
PROBLEM 11.21 C ontingent lia b ilitie s S evera l m onths a g o , E n d u ra n c e B attery C o m p a n y e x p e rie n c e d a h a z a rd o u s m a te ria ls s p ill a t o n e o f its p la n ts. A s a result, th e state E n v iro n m e n ta l P rotection A g e n c y (EPA) fin e d the c o m p a n y $ 1 7 0 0 0 0 . The c o m p a n y is co n te stin g the fin e . In a d d itio n , a n e m p lo y e e is se e kin g $ 5 0 0 0 0 0 d a m a g e s re la te d to th e s p ill. Last, b u t n o t least, a ho m e o w n e r has sued th e c o m p a n y fo r $ 1 2 0 0 0 0 . The ho m e o w n e r lives 4 0 k ilo m etres fro m th e p la n t, b u t b e lie ve s th a t the in c id e n t has re d u c e d th e h o m e 's resale v a lu e b y $1 2 0 0 0 0 . E n d u ra n c e B a tte ry's le g a l coun se l be lie ve s th a t it is p ro b a b le th a t th e EPA fin e w ill s ta n d . In a d d itio n , counsel in d ic a te s th a t a n ou t-of-cou rt settlem ent o f $ 2 5 0 0 0 0 has re c e n tly be en re a c h e d w ith th e e m p lo y e e . The fin a l p a p e rs w ill be s ig n e d ne xt w e e k . C o u n s e l be lie ve s th a t th e ho m e o w n e r's c a se is m uch w e a k e r, a n d w ill be d e c id e d in fa v o u r o f E n d u ra n c e B attery. O th e r litig a tio n re la te d to th e s p ill is p o ss ib le , b u t th e d a m a g e am o u n ts a re u n ce rta in . 1 W h a t lia b ility w o u ld be s h o w n in th e b a la n c e sheet? S h o w th e jo u rn a l e n try. 2
P re p a re a fo o tn o te d isc lo su re re la tin g to this in c id e n t.
CHAPTER 11 Liabilities
453
PROBLEM 11.22 C ontingent lia b ilitie s The fo llo w in g fo o tn o te is to be in c lu d e d in th e fin a n c ia l statem ents o f PQ Ltd. T h e c o m p a n y is b e in g su ed b y X L td f o r th e c o m p a n y ’s a lle g e d w ilfu l a n d d e lib e ra te v io la tio n o f a p a te n t. T h e s u it se e ks u n s p e c ifie d m o n e ta ry d a m a g e s as w e ll as an in ju n c tio n a g a in s t th e c o m p a n y ’s o p e ra tio n s . It also se e ks d a m a g e s a n d la w y e rs ’ fe e s an d c o s ts . T h e c o m p a n y b e lie v e s t h a t it has m e r ito r io u s d e fe n c e s a g a in s t th is s u it a n d in te n d s t o v ig o ro u s ly d e fe n d its e lf. T h e c o m p a n y c o u ld be f o r c e d t o in c u r m a te ria l e x p e n s e s d u rin g th is d e fe n c e a n d in th e e v e n t it w e re t o lose th is s u it, its b u sin e ss w o u ld be h a rm e d .
S h o u ld a lia b ility re c o rd e d b y PQ Ltd fo r this c o n tin g e n t lia b ility ? W h y , o r w h y not?
PROBLEM 11.23 GST re p o rtin g A B C Ltd u n d e rta ke s c o n s u ltin g services fo r s u s ta in a b ility issues. The c o m p a n y is re g is te re d fo r G S T a n d a cco u n ts fo r G S T o n a cash b a sis. D u rin g June 2 0 1 6 A B C Ltd re c o rd e d these tra n sa ctio n s: 10 June
Received $6000 + GST for consulting on energy usage
18 June
Received $3850 (including GST) for consulting on workplace injury reduction
22 June
Purchased computer equipment for use in the ABC business. The cost of equipment was $2000 + GST.
H o w m uch G S T is p a y a b le b y A B C fo r th e m o nth o f June?
PROBLEM 11.24 GST re p o rtin g T o n y C h e n g re c e n tly o p e n e d a re s ta u ra n t in H o b a rt s e rvin g A s ia n C re o le fo o d , as w e ll as e x p o rtin g its o w n b ra n d o f s p ic e m ixtu re . The business is re g is te re d fo r G S T, a n d a cco u n ts fo r G S T o n an a c c ru a l basis using a m o n th ly ta x p e rio d . S u m m a ris e d b e lo w a re th e events th a t ne ed to be c o n s id e re d in p re p a rin g th e Business A c tiv ity S ta tem en t fo r June 2 0 1 6 : 1 O n 2 June, a g rin d in g m a c h in e w a s a c q u ire d fo r $ 1 1 0 0 (in c lu d in g G ST). It is e s tim a te d th a t 8 5 p e r c e n t o f the g rin d e r's u sag e w ill b e fo r th e re s ta u ra n t business a n d th e rest to m a ke s p ic e m ixtu re fo r e x p o rt. 2
Fresh fo o d w a s p u rc h a s e d fo r $ 6 5 0 0 0 (GST free).
3
In vo ice s fo r o th e r pu rch ases to ta lle d $ 9 9 0 0 . A t th e e n d o f th e m o nth , in v e n to ry to th e v a lu e o f $ 2 3 0 w a s still in store a n d C h e n g still o w e d $ 2 4 7 5 .
4
C a s h sales in th e re s ta u ra n t w e re $ 2 6 4 0 0 0 , in c lu d in g G ST.
5
C re d it sales o f s p ic e m ixtu re to ta lle d $1 3 5 0 0 , o f w h ic h o n ly $1 2 0 0 0 w a s c o lle c te d d u rin g th e m onth.
6 The re s ta u ra n t o w n e r estim ates th a t 5 p e r c e n t o f a ll a c q u is itio n s a re fo r p riv a te use. D e te rm in e th e fo llo w in g item s fo r T o n y C h e n g 's Business A c tiv ity S ta tem en t fo r th e m o nth o f June:
454
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASES
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 H o w a re W o o lw o rth s ' c u rre n t a n d n o n c u rre n t lia b ilitie s d e s c rib e d on th e fa c e o f th e b a la n c e sheet? W h a t a re the m a in lia b ilitie s ? 2
W h a t is in c lu d e d in c o n tin g e n t lia b ilitie s ?
3
D id W o o lw o rth s b o rro w m o re m o n e y fro m th e b a n k d u rin g th e y e a r?
4
W h a t d o e m p lo y e e e n titlem en ts in clu d e ?
CASE 11B___________Determ ining financial statem ent effects of various liabilities
Nadoc Lim ited N a d o c d e s ig n s a n d m a n u fa c tu re s a d iv e rs ifie d p r o d u c t ra n g e f o r t h e in te rn a tio n a l h ig h - f r e q u e n c y ra d io , s a te llite a n d m e ta l d e te c tio n m a rk e ts . T h e 2 0 1 5 a n n u a l r e p o r t f o r N a d o c c o n ta in e d th e fo llo w in g n o te :
W a r ra n ty A
p ro v is io n is m a d e f o r th e g r o u p ’s e s tim a te d lia b ility o n all p r o d u c ts so ld a n d s till u n d e r w a rra n ty , an d
in c lu d e s c la im s a lre a d y re c e iv e d . T h e e s tim a te is b a sed o n th e g r o u p ’s w a r ra n ty e x p e rie n c e o v e r p re v io u s ye a rs .
20 . Provisions 20 15
2014
$0 00
$000
Employee benefits
2 592
2 637
Warranty repairs
2 846
2 496
5438
5 133
3476
3451
2 496
1 551
Current
Non-current Employee benefits
Reconciliation of w arranty provisions Carrying amount at beginning of year Provisions made during the year
1 860
2 293
Payments made during the year
(1 510)
(1 348)
2 846
2 496
1
E x p la in w h a t w o u ld be in c lu d e d in th e w a rra n ty re p a irs lia b ility a n d h o w it w o u ld be c a lc u la te d .
2
W h y has th e lia b ility in cre a s e d ?
3
E x p la in w h a t w o u ld be in c lu d e d in th e e m p lo y e e b e ne fits lia b ility a n d h o w it w o u ld be c a lc u la te d .
CHAPTER 11 Liabilities
455
CASE 11C__________ Determ ining financial statem ent effects of various liabilities 1
S h o w n b e lo w is th e note fro m B lu eS cop e Steel Lim ited a t 3 0 June 2 0 1 4 s h o w in g c u rre n t p ro v is io n s a n d d e ta ile d d e s c rip tio n s o f som e p ro v is io n s as no ted .
BlueScope Steel Limited Notes to the consolidated financial statements 30 June 2 0 1 4 2 7 Current liabilities - Provisions Consolidated
Employee benefits - annual leave Employee benefits - long service leave Employee benefits - redundancy (a) Employee benefits - other
2014
20 13
$M
$M
74.9
65.5
137.9
134.7
40.3
11.2
122.3
109.7
Restructure (b)
35.3
31.3
Product claims (c)
24.8
24.6
Workers' compensation (d)
15.6
13.8
7.2
3.8
44.3
32.4
Restoration and rehabilitation (e) Carbon emissions (f) Other
6.1
14.8
5 08.7
441.8
(a) Redun da nc y In J u n e 2 0 1 4 , C o a te d a n d In d u s tria l P r o d u c ts A u s tr a lia ( C lP A ) re c o g n is e d $ 3 3 . 0 M in re d u n d a n c y p ro v is io n f o r m a n u fa c tu rin g a n d o v e rh e a d c o s t r e d u c tio n in itia tiv e s . In a d d itio n , B lu e S c o p e D is tr ib u tio n ra is e d a $ 6 . 0 M re d u n d a n c y p ro v is io n in re la tio n t o in te g r a tio n o f th e a c q u is itio n o f O n e S te e l S h e e t & C o il p ro c e s s in g and d is trib u tio n b u sin e ss e s in S y d n e y , B ris b a n e , a n d A d e la id e f r o m A r r iu m L im ite d in A p r il 2 0 1 4 . T h e re m a in in g e m p lo y e e re d u n d a n c y p ro v is io n b a la n c e r e fle c ts a ra n g e o f in te rn a l re o rg a n is a tio n s . A ll re d u n d a n c ie s a re e x p e c te d t o ta k e e f f e c t w ith in 12 m o n th s o f th e r e p o r tin g d a te .
(b) Restructure T h e c u r r e n t p e rio d r e s tr u c tu r in g p ro v is io n in c lu d e s $ 1 7 .4 M in G lo b a l B u ild in g S o lu tio n s f o r B u ild in g s C h in a in re la tio n t o o u r C h in a o p e ra tio n s an d $ 5 . 4 M re c o g n is e d in C o a te d a n d In d u s tria l P r o d u c ts A u s tr a lia a s s o c ia te d w ith v a rio u s b u sin e ss r e s tru c tu rin g . A d d itio n a lly , th e p ro v is io n in c lu d e s $ 2 3 . 5 M
( c u r r e n t $ 9 . 6 M , $ 1 3 .9 M
n o n - c u r r e n t ) f o r in c u rr e d a n d e s tim a te d f u t u r e c o s ts a ris in g f r o m th e c lo s u re o f th e N o . 6 B la s t fu rn a c e a t P o r t K e m b la a n d o t h e r e q u ip m e n t t o r e fle c t th e re d u c e d iro n m a k in g c a p a c ity , as a n n o u n c e d o n 2 2 A u g u s t
2011. T h e re m a in in g re s tr u c tu r in g p ro v is io n s re la te t o th e B u ild in g P r o d u c ts N o r th A m e r ic a a n d A u s tr a lia B u ild in g C o m p o n e n ts a n d D is tr ib u tio n s e g m e n ts t o c o v e r e s tim a te d f u t u r e c o s ts o f a n n o u n c e d s ite c lo s u re s . T h e m a jo r ity o f th e p ro v is io n s a re e x p e c te d t o be u tilis e d w ith in t h e n e x t tw o t o t h r e e ye a rs .
(c) Produc t claims A p ro v is io n f o r p r o d u c t c la im s is re c o g n is e d a t th e r e p o r tin g d a te a n d is m e a s u re d ba sed o n m o d e lle d d a ta c o m b in in g sales v o lu m e s w ith p a s t e x p e rie n c e s o f re p a ir a n d re p la c e m e n t le ve ls in c o n ju n c tio n w ith a n y s p e c ific a lly id e n tifie d p r o d u c t fa u lts . D u e t o th e n a tu re o f th is p ro v is io n , u n c e r ta in ty is in h e r e n t in th e c a lc u la tio n o f th e e x te n t a n d t im in g o f p r e d ic te d f u t u r e c la im s c o s ts .
456
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
(d) W or ke rs ' c o m pe ns ation In A u s tr a lia
and
c o m p e n s a tio n .
N o r th
A m e r ic a ,
P ro v is io n s a re
B lu e S c o p e
re c o g n is e d
S te e l
ba sed o n
L im ite d
is a re g is te re d
c a lc u la tio n s
p e rfo rm e d
s e lf- in s u r e r f o r
b y an
w o rk e rs ’
e x te rn a l a c tu a ry . A
c o n t in g e n t lia b ility e x is ts in re la tio n t o g u a ra n te e s g iv e n t o v a rio u s s ta te w o r k e r s ’ c o m p e n s a tio n a u th o ritie s , d u e t o s e lf-in s u ra n c e p r e re q u is ite s ( r e f e r n o te 4 0 ) . F o r th e G ro u p , an a c tu a ria lly d e te rm in e d a s se t o f $ 2 4 . 9 M
( 2 0 1 3 : $ 4 1 . 2 M ) has b e e n re c o g n is e d f o r
e x p e c te d f u t u r e re im b u rs e m e n ts a s s o c ia te d w ith w o r k e r s ’ c o m p e n s a tio n re c o v e rie s f r o m t h ir d p a rtie s . T h is a m o u n t is in c lu d e d in n o n - c u r r e n t o t h e r re c e iv a b le s ( r e f e r t o n o te 1 6 ) as th e r e is n o legal rig h t o f o f f s e t a g a in s t th e w o r k e r s ’ c o m p e n s a tio n p ro v is io n .
(e) Restoration and r eha bilita tio n R e s to r a tio n a n d re h a b ilita tio n
p ro v is io n s in c lu d e e n v iro n m e n ta l lia b ilitie s ba sed u p o n th e a s s e s s m e n t o f
B lu e S c o p e D is tr ib u tio n s ite s fo llo w in g th e a c q u is itio n o f S m o r g o n S te e l L im ite d ’s D is tr ib u tio n b u sin e ss in A u g u s t 2 0 0 7 . T h is c u r r e n t p ro v is io n to ta ls $ 2 . 9 M ( 2 0 1 3 : $ 3 . 5 M ) . O t h e r re s to r a tio n a n d re h a b ilita tio n n o n - c u r r e n t p ro v is io n s o f $ 1 3 .6 M ( 2 0 1 3 : $ 9 . 4 M ) e x is t f o r N e w Z e a la n d S te e l in re la tio n t o its o p e ra tio n o f tw o iro n sand m in e s ( r e f e r t o n o te 31 ). T h e s e p ro v is io n s ha ve b e e n c la s s ifie d as n o n - c u r r e n t as th e t im in g o f p a y m e n ts to re m e d y th e s e s ite s w ill n o t be m a d e u n til th e d is ta n t f u t u r e u p o n c e s s a tio n o f t h e ir o p e ra tio n s . T h e e x te n t o f th e s e f u t u r e c o s ts re m a in s u n c e rta in d u e t o p o s s ib ilitie s o f c h a n g e d s ite c o n d itio n s . A d d itio n a lly , as p a rt o f th e A u s tr a lia n
b u sin e ss a c q u is itio n s , O r r c o n
a n d F ie ld e rs M a n u fa c tu r in g in
F e b ru a ry 2 0 1 4 a n d P a c ific S te e l G r o u p in N e w Z e a la n d S te e l L im ite d in J u n e 2 0 1 4 , a $11.5 M m a k e -g o o d p ro v is io n has b e e n re c o g n is e d o n a c q u is itio n , re p r e s e n tin g th e e s tim a te d fa ir v a lu e t o m a k e g o o d leased p re m is e s ( r e f e r t o n o te 4 4 ( a ) ) . T h e b a la n c e o f th e p ro v is io n re la te s t o v a rio u s b u sin e ss e s t h a t h a ve re c o rd e d p ro v is io n s in re la tio n to leased s ite s t h a t re q u ire r e c tific a tio n a n d re s to r a tio n w o r k a t th e e n d o f t h e ir re s p e c tiv e lease p e rio d s .
(f) Carbon emissions T h e G r o u p is a p a rtic ip a n t in th e N e w Z e a la n d G o v e r n m e n t ’s u n c a p p e d E m is s io n s T ra d in g S c h e m e , e ffe c tiv e f r o m 1 J u ly 2 0 1 0 . T h e A u s tr a lia n G o v e r n m e n t C a r b o n P r ic in g M e c h a n is m S c h e m e , w h ic h c a m e in to e f f e c t f r o m 1 J u ly 2 0 1 2 , w as a b o lis h e d b y th e A u s tr a lia n F e d e ra l G o v e r n m e n t, e ffe c tiv e 1 J u ly 2 0 1 4 . T h e p ro v is io n re p re s e n ts th e v a lu e o f p e rm its p a ya b le u n d e r b o th s c h e m e s f o r th e y e a r e n d in g 3 0 J u n e 2 0 1 4 a n d is m e a s u re d w ith re fe re n c e t o th e c a rr y in g a m o u n t o f e m is s io n u n its ( E U s ) h e ld w ith a n y e x c e s s m e a s u re d a t t h e c u r r e n t m a r k e t v a lu e o f E U s . Source: BlueScope Steel Lim ited, Annual Report 2013/14.
State h o w e a ch o f th e fo llo w in g fits th e d e fin itio n o f a lia b ility : 1 p ro v is io n fo r e m p lo y e e be ne fits 2
p ro v is io n fo r restructure
3
p ro v is io n fo r p ro d u c t c la im s
4
p ro v is io n fo r w o rk e rs ' c o m p e n s a tio n
5
p ro v is io n fo r re s to ra tio n a n d re h a b ilita tio n
6
p ro v is io n fo r c a rb o n em issions.
CASE 11D
Current versus noncurrent liabilities
In an im p o rta n t le g a l case , th e A u s tra lia n S e cu ritie s a n d Investm ents C o m m is sio n successfully sued th e d ire c to rs a n d th e C h ie f F in a n c ia l O ffic e r o f C e n tro fo r fa ilin g to d is c h a rg e th e ir d u tie s w ith d u e c a re a n d d ilig e n c e in re la tio n to a p p ro v in g th e fin a n c ia l rep orts fo r th re e p ro p e rty trusts - C e n tro P rop erties Ltd, C e n tro P ro p e rty Trust a n d C e n tro R etail Trust - fo r th e y e a r e n d e d 3 0 June 2 0 0 7 .
CHAPTER 11 Liabilities
457
A S IC a lle g e d th a t th e fin a n c ia l re p o rts c o n ta in e d m a te ria l m isstatem ents, in p a rtic u la r th a t a p p ro x im a te ly A $ 1 .5 b illio n o f in te re st-b e a rin g lia b ilitie s w e re w ro n g ly c la s s ifie d as n o n -cu rre n t lia b ilitie s , ra th e r th a n c u rre n t lia b ilitie s .3 1 W h a t d iffe re n c e do es it m a ke w h e th e r th e $ 1 .5 b illio n is d is c lo s e d as a c u rre n t o r n o n c u rre n t lia b ility ? 2
D o y o u b e lie v e it sh o u ld be p a rt o f th e d ire c to rs ' s ta tu to ry o b lig a tio n s to ensure fin a n c ia l statem ents a re not m a te ria lly m isstated?
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
Go to h ttp ://lo g in .c e n g a g e b ra in .c o m to access CourseMate, your online study tool for Financial Accounting. CourseMate brings chapter concepts to life with interactive learning, study and exam preparation tools. >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
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Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
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Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
458
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
APPENDIX TO CHAPTER 11
Future cash flows: present value analysis A11.1
Future cash flows
An im portant w a y o f thinking a b o u t future cash flow s is present value (PV) o r discounted cash flo w (DCF) analysis. Future cash flow s are not the same as present ones, because you have to w a it fo r them. Because you have to w a it, you lose interest o r other returns you could have earned if you had had the cash sooner. D etailed PV or DCF techniques are exam ined in m anagem ent accounting an d fin a n ce courses, an d you m ay w ell have seen them a lre a d y in econom ics o r business statistics courses. In this section, the basic ideas w ill be outlined to help you understand the valuation o f liabilities, to prepare you for the fin a n cia l analysis to fo llo w in C h a p te r 15, and to help you think a b o u t h o w traders in c a p ita l markets m ay use expectations o f future cash flow s an d future interest rates w hen d e c id in g on prices o f securities.
Interest and the time value of money In W estern society, it is perm issible - even expected - that the o w n e r o f c a p ita l should c h a rg e a person w h o w ants to use that c a p ita l a fee fo r that use. The fee is c a lle d interest, an d is com puted by a p p ly in g a specified percentage rate to the am ount lent, w h ich can be referred to as either the investment o r the p rin cipa l. For exam ple, an 8 per cent interest rate on a $ 2 0 0 loan w o u ld p roduce annual interest o f $ 1 6 ($ 2 0 0 x 0 .0 8 ). The existence o f interest, w hich builds up as time passes, gives m oney a time value. Flere are some sim ple formulas you p ro b a b ly a lre a d y kn o w (P = prin cipa l o r investment; i = interest rate): A n n u a l interest = P x i A m o u n t d u e a t the end of one y e a r = P(1 + i) A m o u n t d u e a fte r n y e a rs ; w ith a n n u a l c o m p ound ing, if no paym ents a t all a re m a d e = P(1 + i)n Suppose a loan provides for repaym ent o f the p rincipal plus interest after several years, w ith no payments in the m eantim e. If the interest is co m p o u n d e d , w h ich is norm ally the case, that means interest builds up on the u n paid interest as w e ll as on the u n paid prin cipa l. In order to kn o w h o w this w orks, you need to know h o w frequently interest com pounds. Do you get interest on the interest: •
as soon as a n y interest arises (continuous co m pounding)?
•
after a d a y's interest has been a d d e d (d a ily co m pounding)?
•
after a month's interest has been a d d e d (m onthly co m pounding)?
•
only after a year's interest has been a d d e d (annual com p o u n d in g )?
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Here's an exam ple o f annual c o m p o u n d in g . W e have the same $ 2 0 0 , 8 per cent loan as a b o ve , w h ich is to be repaid in five years w ith annual c o m p o u n d in g . W e can then calculate the am ount that the loan has built up to at the end of each ye a r (its future value; FV below ) as follow s: Year
FV a t beginning of year
Annual interest at 8 per cent
FV a t end of year
$
$
$
1
200.00
16.00
216.00
2
216.00
17.28
233.28
3
233.28
18.66
251.94
4
251.94
20.16
272.10
5
272.10
2 1.77
293.87
You can see that the FV increases every year. Using the third formula a b o ve , w e can calculate the FV at the end of a n y year: End o f y e a r 3 : FV = P (1 + i ) n = $ 2 0 0 (1 + 0 .0 8 ) 3 = $ 2 5 1 .9 4 End o f y e a r 5 : F V = $ 2 0 0 (1 + 0 .0 8 ) 5 = $ 2 9 3 .8 7
A11.2
Interest and present value
The co n ce p t o f interest can be 'turned on its head' by considering w h a t you lose by w a itin g some p eriod o f tim e for your m oney, or, putting it another w a y , w h a t a future paym ent is w orth in present terms if you assume your m oney should earn interest betw een n o w a nd w hen you ge t it back. Suppose som eone promises to g ive you $ l 0 0 a y e a r from now . If you w e re given the m oney n o w instead, y o u 'd be earning 9 per cent interest on it. Therefore, if y o u 'd had some am ount o f P n o w an d earned 9 per cent on it, y o u 'd be in the same position as you w ill be after w a itin g the year. Using the second form ula a b o ve , $ 1 0 0 = P( 1 + 0 .0 9 ), w here P is the am ount you could have earned interest on. Solving for P w e get P = $ 1 0 0 /( 1 .0 9 ) = $ 9 1 .7 4 . If you had $ 9 1 .7 4 , you could have invested it at 9 per cent and ended up w ith $ 1 0 0 ( $ 9 1 .7 4 + [0 .0 9 x $ 9 1 .7 4 ] = $ 1 0 0 ) a t the end o f the year. W e say that $ 9 1 .7 4 is the present value o f $ 1 0 0 received after w a itin g on e year, 'discounted at 9 per cent'. This present value c o n ce p t is another w a y o f thinking o f the time value o f money: it reminds us that as long as w e w a it for cash that could have earned interest, w e lose the interest that w e could have earned. This idea is referred to as an opportunity cost, w h ich you m ay recall from introductory econom ics. As long as the interest rate is greater than zero, present value is less than the actual future am ount o f cash that w ill be received. A na lo g ou s to the a b o ve interest formulas are the fo llo w in g present value formulas (w here C = future cash flo w , and i = interest rate): Present v a lu e w a itin g o n e y e a r
1
Present v a lu e w a itin g n y e a rs w ith no paym ents in the m ean tim e, , C interest com pound ed a n n u a lly '
,
,
O+'T
C om bining these tw o , present v a lu e of a constant cash p a y m e n t o v e r n y e a rs , « C ( 1 interest com pounded a n n u a lly = ’ (
1
-
0
".
460
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Therefore, the present value o f $ 1 0 0 0 received three years from no w , discounted at an opportunity cost interest rate o f 1 2 per cent, w o u ld be $ 71 1 .7 8 ; that is, $ 1 0 0 0 d iv id e d by (1.1 2 )3. The phrase 'op p o rtu n ity cost' is often used because, by w a itin g three years for the $ 1 0 0 0 , you lose the o p p ortunity to invest your m oney at 1 2 per cent in the meantime. H ere's an exam ple o f present value calculations. A c o m p a n y is considering an investment that w ill cost $ 1 0 0 0 0 and w ill return $ 2 4 0 0 a t the end o f each ye a r for five years. This looks g o o d : 2 4 per cent o f the investment cost received each year, a total o f $1 2 0 0 0 b a ck on the $ 1 0 0 0 0 invested. To make the investment, the c o m p a n y w ill have to b o rro w at an interest rate o f 7 per cent. Should it g o a h e a d w ith the investment? Before w e d o the calculations, note three things a b o u t problem s like this: •
W h a t w e are trying to determ ine is if the m oney com ing in is equivalent to a cost of c a p ita l o f 7 per cent. If the c o m p a n y has to raise its m oney a t 7 per cent, it w ill w a n t the investments it makes to return a t least that. A greater rate o f return w o u ld be desirable, otherw ise there w o u ld be little point in investing, but 7 per cent is the minimum a c ce p ta b le return.
•
The idea o f present value analysis is to take the future returns an d subtract the 7 per cent that the c o m p a n y has to p a y on its b o rro w in g , to determ ine if, after considering the b o rro w in g cost, the returns equal the $ 1 0 0 0 0 that has to be invested. Is the present value o f the future cash flow s e q u a l to the present cost o u tla y that has to b e m ade to g e t those flows?
•
The 2 4 per cent quoted a b o v e is irrelevant to the analysis. It com pares the annual return to the investment cost, but it does not consider the interest cost o f w a itin g several years for some o f that return. The w h o le idea o f present value analysis is to build that interest cost, the time value o f m oney, into the analysis. H ere's the present value analysis:
•
Using the second present value form ula a bove: $
•
PV of first year's return is $ 2 4 0 0 /(1 .0 7 )1
2 242.99
PV of second year's return is $ 2 4 0 0 /(1 .07)2
2 096.25
PV of third year's return is $ 2 4 0 0 /(1 .07)3
1 959.11
PV of fourth year's return is $ 2 4 0 0 /(1 ,07)4
1 830.95
PV of fifth year's return is $ 2 4 0 0 /(1 ,07)5
1 7 1 1.1 7
Total PV
9 840.47
Since the annual flow s are constant, the third present value form ula a b o v e could have been used instead: PV = ( $ 2 4 0 0 /0 .0 7 ) ( l - [ 1 /1 . 0 7 ] 5) = $ 9 8 4 0 .4 8 This is the same an sw e r as could have been o b ta in e d using the second present value form ula. W e can d ra w the
needed conclusion from this, an d also see the effects o f w a itin g for returns: •
The conclusion is that the investment is not a g o o d id e a . It w ill cost $ 1 0 0 0 0 , but after calcu la tin g the interest cost o f w a itin g for the m oney to be returned, the present value o f the $ 1 2 0 0 0 returned is o n ly $ 9 8 4 0 . Therefore, the investment is returning less than the 7 per cent rate the c o m p a n y has to p a y to fin a n ce it. It's close, but still not attractive.
•
From the annual calculations a b o ve , you can see that the present value o f the $ 2 4 0 0 is smaller the longer w e w a it for it. The $ 2 4 0 0 received after on e ye a r has a PV o f $ 2 2 4 3 , but the $ 2 4 0 0 received after four years has a PV of $1 8 3 1 . This is a necessary result: the longer the w a it, the lo w e r the PV, because the greater is the am ount o f interest assumed included in the cash flo w a n d , therefore, the lo w e r is the residual PV.
CHAPTER 11 Liabilities
461
Some present value exam ples As you s a w in the exam ple a b o ve , the co n ce p t of present value is very useful in evaluating investment possibilities a h e a d o f time. H ere are some m ore exam ples. •
Suppose you a re offered the cha n ce to invest $ 2 0 0 0 in a project that w ill p a y you b ack $ 4 5 0 0 after six years. Is it a g o o d d e a l? Suppose, alternatively, you could invest your $ 2 0 0 0 a t l 1 per cent. The present value of the $ 4 5 0 0 in six years is $ 4 5 0 0 / ( 1 + 0 .1 1 )6, o r $ 2 4 0 6 . Therefore, the present value of w h a t yo u 'll ge t ($ 2 4 0 6 ) exceeds your cost ($ 2 0 0 0 ), a nd it does seem a g o o d deal.
•
Usually, in m odern fin a n cia l arrangem ents, blended payments are m ade to cover the specified interest plus some paym ent on the prin cipa l. House m ortgages a nd ca r loans are tw o com m on exam ples. In such cases, to understand w h a t is g o in g on, w e have to separate the return on investment (the interest) from the return of investment (repaym ent o f the principal). H ere is an exam ple: a loan of $ 7 9 9 8 , carrying an interest rate o f 1 0 per cent, is being repaid by a blended
annual paym ent o f $ 21 10 , w h ich is m ade at the end o f each year. This w ill cover all interest, an d p a y o ff the principa l as w e ll, in five years. In such a case, the interest am ount gets sm aller every ye a r because the principal b a lan ce is fa llin g , but the rate o f return on investment is a constant 1 0 per cent. Date
Total blended payment
Return on investment (interest)
Residual paid on principal
$
$
$
Loan date
Principal balance $ 7998
1 year later
2110
80 0 *
1 310
6688
2 years later
2110
669
1441
5 247
3 years later
2110
525
1 585
3 662
4 years later
2110
366
1 744
1 918 0
5 years later
2110
192
1 918
10550
2552
7998
* $800 = $7998 x 0.10; $669 = $6688 x 0.10; and so on
Using this exam ple, the present value of $ 2 1 1 0 p a id every ye a r for five years, discounted a t 1 0 per cent, com p o u n d e d annually, is $ 7 9 9 8 . This is ($21 1 0 /0 . 1 0 ) (1 — 1/ [ 1 .1 0 ] 5): check it an d see.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: W h a t is th e p re s e n t v a lu e o f $ 3 0 0 , w h ic h y o u w ill re c e iv e a fte r tw o y e a rs , i f y o u r o p p o r tu n ity c o s t o f w a itin g is 11 p e r c e n t? Y o u r a n s w e r s h o u ld be : $ 2 4 3 . 4 9 , w h ic h is $ 3 0 0 / [ 1 + 0.1112.
462
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
NOTES 1 2 3
W e gratefully a ck n o w le d g e that sections o f this chapter w e re w ritten by Professor G erry G allery, Q ueensland University o f Technology. This section is a d a pte d from W a rre n , C ., Reeve, J. and Fess, P., A c c o u n tin g , Thomson Learning, South W estern C o lle ge Publishing, C incinnati, 2 0 0 2 . M o re inform ation a b o ut the C entro case is a va ila b le a t http://theconversation.com /centro-fortescue-actions-all-part-of-a-highstakes-gam efor-asic-14 1 4 .
Completing the balance sheet ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: pro vide the accounting entries for both short-term a n d long-term investments c o m p are bala n c e sheet a n d incom e statem ent effects o f using the cost versus equity method interpret a set of financial statements that include both equity a n d consolidated accounting inform ation p re p a re the accounting entries for changes in shareholders' equity explain the com ponents of the shareholders' equity section o f a bala n c e sheet p re p a re the accounting entries for dividends, bonus issues a n d other items affecting shareholders' equity describe the disclosure requirements for liabilities an d shareholders' equity.
CHAPTER OVERVIEW The firs t m a jo r p u rp o s e o f th is c h a p te r is to c o m p le te y o u r u n d e rs ta n d in g o f th e b a la n c e sheet b y p ro v id in g y o u w ith a n in tro d u c to ry d isc u s sio n o f a c c o u n tin g fo r a c o m p a n y 's in ve stm en ts. W h ile in ve stm en ts a re in c lu d e d in th e asset s e ctio n o f th e b a la n c e sheet, c e rta in ty p e s o f in ve stm en ts ne ed to be c o n s o lid a te d (see s e ctio n 1 2 .2 ) w ith th e w h o le b a la n c e sheet a n d , th e re fo re , a ls o h a ve a n im p a c t o n th e lia b ilitie s a n d s h a re h o ld e rs ' e q u ity s e ctio n s o f th e b a la n c e sheet. O n e c o m p le x a rra n g e m e n t is c o rp o ra te g ro u p s th a t a re c re a te d b y th e g ro w th o f a s in g le c o m p a n y , o r b y business c o m b in a tio n s , in to a g ro u p o f c o m p a n ie s . O th e r a rra n g e m e n ts in c lu d e th e a c q u is itio n o f o n e c o m p a n y b y a n o th e r, a n d th e m e rg e r o f c o m p a n ie s . A c c o u n tin g fo r c o rp o ra te g ro u p s a ls o has a s ig n ific a n t im p a c t o n p ro fit m e a s u re m e n t a n d o n th e asset s e ctio n o f th e b a la n c e sheet, a n d th e re fo re c o u ld h a v e be en c o v e re d e a rlie r. It is a n e x a m p le o f a n a c c o u n tin g m e th o d th a t is v e ry c o m p le x in p ra c tic e , b u t has p rin c ip le s th a t a re u n d e rs ta n d a b le w ith o u t th e p ra c tic a l c o m p le x itie s . It is a ls o p a rt o f th e g o a l o f u n d e rs ta n d in g a c o rp o ra te set o f fin a n c ia l statem ents b e c a u s e , a s w e s a w in C h a p te r 2 , m ost a re c o n s o lid a te d , p o rtra y in g c o rp o ra te g ro u p s . The o th e r k e y p u rp o s e o f th is c h a p te r is to c o v e r th e s h a re h o ld e rs ' e q u ity s e ctio n o f th e b a la n c e sheet. In C h a p te r 1 1, w e c o n s id e re d lia b ilitie s ; h e re w e c o n s id e r th e o th e r m a in c o m p o n e n t o f th e s h a re h o ld e rs ' e q u ity p a rt o f th e b a la n c e sheet. M o s t o f th e section s in th is c h a p te r a re n o t d e ta ile d , fo r tw o re a so n s: w e h a ve e n c o u n te re d m a n y o f th e issues a lre a d y w h e n c o n s id e rin g assets a n d a c c ru a l a c c o u n tin g , a n d th e a c c o u n tin g p ra c tic e s fo r m a n y e q u ity item s a re v e ry c o m p le x - b e y o n d w h a t th is in tro d u c to ry b o o k c a n s e n s ib ly c o v e r. O v e ra ll, th e o b je c tiv e s o f th is c h a p te r a re to set o u t som e im p o rta n t p rin c ip le s a b o u t in ve stm en ts a n d s h a re h o ld e rs ' e q u ity a c c o u n tin g th a t w ill p ro v id e a g e n e ra l u n d e rs ta n d in g o f to p ic s th a t a re c o v e re d m o re fu lly in a d v a n c e d a c c o u n tin g courses. The g o a l is to h e lp y o u u n d e rs ta n d w h a t y o u see o n a ty p ic a l c o rp o ra te b a la n c e shee t a n d in its a c c o m p a n y in g notes.
464
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
12.1 Intercorporate investments and corporate groups M o d e m business organisations, especially large ones, a re often groups o f separately incorporated com panies. You w ill have heard terms like 'takeover', 'parent' a nd 'subsidiary': these all com e from the phenom enon o f g rouping corporations together. Lend Lease C o rp o ra tio n , N a tio n a l A ustralia Bank, W esfarm ers, BHP a n d Rio Tinto are exam ples o f organisations that are actu a lly m ade up o f several, even hundreds, o f com panies. Such groups are linked in m any w a ys, including being linked by: •
form al ow ne rsh ip o f all or parts o f each mem ber b y o ne o r m ore o f the g roup; for exam ple, W esfarm ers ow ns C oles Supermarkets, Bunnings, O ffice w orks, Target an d Kmart
•
internal patterns of perform ance reporting, m otivation a nd prom otion that enco u ra g e m anagers an d other em ployees to feel part o f the larger g roup; for exam ple, the general m anager o f o ne c o m p a n y m ay have been prom oted from another c o m p a n y in the g ro u p a nd m ay be prom oted to yet another, if he or she does w e ll in one o f the operations. M o s t o f the fin a n cia l statements included in published annual reports a re co n so lid a te d ; that is, they are really
those o f groups o f com panies. A ccounting for co rp o ra te groups is a c o m p lica te d part o f fin a n cia l acco u n tin g , a nd is covered in detail in a d va n ce d courses. This b o o k o n ly introduces you to the main principles behind it, an d shows you h o w to a p p ly the principles to d o some basic calculations. In this section, w e cover w h e re on e c o m p a n y buys shares in another w ith the intention o f hold in g these investments short-term an d in the long-term.
S h o rt-te rm investm ents Short-term investments are securities that m anagem ent intends to hold for less than on e year. These investments are held prim arily to put extra cash to w o rk. They include shares, com m ercial p a p e r (such as notes issued by finance com panies), governm ent bonds an d Treasury bills, short-term m oney market investments a nd term deposits in banks. N o t all o f these are really intercorporate investm ents, in that there m ay not be a n y o w nership o r business relationship connecting the holder o f the security to the issuer. Because there is no intention to hold such investments for long o r to try to influence the operations o r policies o f the organisations that issued the securities, such investments a re included in current assets - usually under the heading of m arketable securities. The investments are valued at the lower of cost or m arket value (net realisable value). Recall that it is the low e r o f cost an d market an d therefore the short-term investments cannot be valued a b o v e cost. D ividends and interest from such investments are usually included in other revenue. W ild ro s e Ltd has short-term investments costing $ 5 2 0 0 0 0 . Suppose the investments' market value slipped to $ 4 8 4 0 0 0 on b a la n ce d ate. W h a t w o u ld happen to profit, given the lo w e r of cost o r net realisable value rule? The difference, $ 3 6 0 0 0 , w o u ld be included as an expense. Profit before tax w o u ld g o d o w n b y $ 3 6 0 0 0 . The journal entry w o u ld be: $ DR
Loss on marketable securities
CR
Marketable securities
$
36 000 36000
If the value o f the investments then increased to $ 5 4 0 0 0 0 , the value o f the investments can be w ritten up to $ 5 2 0 0 0 0 , but not a b o v e this o rig in a l cost. Suppose, instead, that the investments' market value w e n t up to $ 5 8 5 0 0 0 . In this case, the market value o f the security is greater than cost, but the unrealised g a in is not recorded, a nd the m arketable securities are recorded at cost.
CHAPTER 12 Completing the balance sheet
465
L o n g -te rm investm ents Long-term investments are investments that m anagem ent does not intend to convert to cash w ithin o ne year. These include both d e b t an d equity securities. O n ly the latter a re discussed here. Long-term investment in shares can be accounted for using the cost method, the equity m ethod o r the consolidation method. The specific circumstances w here each are used are discussed b e lo w .
COST METHOD U nder the cost method, the investment is recorded a t the cost o f acquisition. For exam ple, if a c o m p a n y purchases shares for $ 5 0 0 0 0 0 , the entry w o u ld be: $ DR
Investment
CR
Cash
$
5 00 000 500000
W h e n dividends o f $ 2 0 0 0 0 are received on those shares, the entry is: $ DR CR
Cash
$
20000
Dividend revenue
20000
Consistent w ith the treatment o f other noncurrent assets (see C h a p te r 10), the investment account can be revalued p e rio d ica lly.
EQUITY METHOD W h e n an investing c o m p a n y has significant influence over, but not control of, an investee co m p a n y, the investee c o m p a n y is an associated company o f the investor. In this case, the investor, in its fin a n cia l statements, accounts for the associate by using the equity method o f a ccounting. U nder this basis, the investing c o m p a n y includes in its incom e statement an d b a la n ce sheet its share o f earnings by the investee co m p a n y, because it is in a position to significantly influence that co m p a n y's perform ance. U nder the equity basis: •
The investment asset is still valued initially a t cost, as it w a s for the cost basis.
•
As the investee c o m p a n y earns profit (or incurs losses), the asset is increased for the investing com pany's share of that p rofit (or decreased for its share of losses), a nd that share is included in the investing co m p a n y's revenue. This is an accrual o f revenue that the investing c o m p a n y is entitled to, so it is taking credit for its share o f the investee's p rofit (increase in retained profits). O th e r revenue is credited w ith this share an d the investment asset a ccount is d e b ite d, so the asset account is treated like an account receivable for the accrued revenue.
•
W h e n the investee c o m p a n y pays a d ivid e n d , the investing c o m p a n y receives some o f the accrued revenue as its share o f the d ivid e n d , so the d ivid e n d received is deducted from the investment asset account, just as collection of an account receivable w o u ld be deducted from the account receivable asset. The d ivid e n d is not ca lle d revenue b y the investing co m p a n y, because the revenue has a lre a d y been accrued; instead, the d ivid e n d is deducted from the investment asset because it is considered a return o f some o f the m oney invested.
•
There are some other m ore c o m p lica te d features of equity accounting w e w ill not get into here. Before considering an exam ple, it should be noted that the use o f the equity method requires that the investor have
significa n t influence over the investee com pany. AASB 1 2 8 (pa ra g ra p h 3) defines significant influence as 'the p o w e r to pa rticip a te in the fin a n cia l a nd op e ra tin g p o lic y decisions o f the investee'. This p o w e r is not control o r joint control over the investee's policies. G e n e ra lly, the higher the percentage shareholding an investor has, the greater the likely influence it w ill have. As a general rule, w h e re an investor holds 2 0 per cent o r m ore of the shares o f a com p a n y, it can be presum ed that the investor has significant influence over the co m p a n y, unless there is e vidence to the contrary.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Assume XYZ buys 3 0 per cent o f the shares o f A B C Ltd for $ 1 m illion on 1 July 2 0 1 5 . O n 3 0 June 2 0 1 6 , A B C records an after-tax profit o f $ 2 4 0 0 0 0 , from w h ich it pays a d ivid e n d o f $ 9 0 0 0 0 . The journal entries w o u ld be as follow s: 2015 July 1
$ DR
Investments
CR
Cash
$
1 000000 1000000
To re c o r d a c q u is itio n o f th e in v e s tm e n t
2016 July 1
DR
Investments
CR
72 000
Share of associated company's profits
72000
To e q u ity a c c o u n t 3 0 p e r c e n t o f a s s o c ia te d c o m p a n y 's p ro fits
July 1
DR
Cash
CR
27000
Investments
27000
To re c o r d re c e ip t o f d iv id e n d s
To further cla rify the differences betw een the cost basis an d the equity basis, consider the fo llo w in g summary o f h o w the tw o methods w o rk (ignoring com plexities, including a n y asset revaluations). Cost basis
Equity basis
Initial carrying value of the investor's intercorporate investment asset
Original cost
Original cost
Investor's share of profit earned by investee
Nothing done
Add to investment asset and to other revenue
Investor's share of dividend paid by investee
Add to cash and to other revenue
Add to cash and deduct from investment asset
Resulting balance sheet value of the investor's intercorporate investment asset
Original cost
Original cost plus accrued profit share minus share of dividends received by investor
H ere is an exam ple. G ra n d Ltd a cq u ire d investments in other com panies on 1 January 2 0 1 6 . 1
1 4 5 0 0 0 shares (2 9 per cent o f the voting interest) in B Ltd w e re purchased for $ 4 6 4 0 0 0 0 cash.
2
O n 3 0 June 2 0 1 6 , B Ltd announced its earnings per share for the first six months o f 2 0 1 6 a t $ 2 .1 0 per share.
3
O n 1 0 D ecem ber, B Ltd p a id d ividends to shareholders at $ 1 .6 0 per share.
4
O n 31 D ecem ber, B Ltd announced its earnings per share for the full y e a r at $ 3 .9 0 per share (i.e. an a d d itio n a l $ 1 .8 0 since 30June). The effects o f items 1 to 4 on the fin a n cia l statements o f G ra n d Ltd at the end o f 2 0 1 6 are as follow s:
•
Investment in B Ltd (cost basis): 1
Long-term investment asset starts out a t the purchase price of $ 4 6 4 0 0 0 0 (cash reduced b y same amount).
2
Earnings announcem ent is ignored for accounting purposes.
3
Cash received an d d ivid e n d revenue are recorded for $ 2 3 2 0 0 0 (1 4 5 0 0 0 shares x $ 1 .6 0 ).
4
Earnings announcem ent is ignored for accounting purposes.
Using the cost basis, G ra n d Ltd's fin a n cia l statements, as at 31 D ecem ber 2 0 1 6 , w ill therefore include for B Ltd: $ Investment in B Ltd (noncurrent asset) Dividend revenue (in other revenue)
4640000 232 000
CHAPTER 12 Completing the balance sheet
•
467
Investment in B Ltd (equity basis): 1
Long-term investment asset starts out at the purchase price o f $ 4 6 4 0 0 0 0 , the same as if the cost basis w e re used.
2
Upon earnings announcem ent, both investment revenue an d investment asset a re increased by $ 3 0 4 5 0 0 ( 1 4 5 0 0 0 shares x $ 2 .1 0 ).
3
Cash is increased by, an d investment asset is reduced by, $ 2 3 2 0 0 0 ( 1 4 5 0 0 0 shares x $ 1 .6 0 ): the d ivid e n d is therefore deem ed to be a return to G ra n d Ltd o f some o f its investment an d this is w h y the investment am ount is reduced.
4
Upon earnings announcem ent, both investment revenue an d investment asset a re increased by $ 2 6 1 0 0 0 (1 4 5 0 0 0 shares x $ 1 .8 0 ).
Using the equity basis, G ra n d Ltd's financial statements, as at 31 Decem ber 2 0 1 6 , w ill therefore include for B Ltd:
S Investment in B Ltd (noncurrent asset)
I
4 9 7 3 500
($4 640 000 + $304 500 - $232 000 + $261 000) Investment revenue (in other revenue in the income statement) ($ 3 0 4 5 0 0 + $261 000)
565500
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: G re te l L td b u ys a n o n - c o n tr o llin g n u m b e r o f H a n s e l L td share s f o r $ 4 6 0 0 0 0 . D u rin g th e y e a r, G re te l re c e iv e s a $ 4 5 0 0 0 d iv id e n d fr o m H a n s e l. A t th e e n d o f th e y e a r, H a n s e l re p o rts a n e t p r o fit. I f G r e te l’s p ro p o rtio n o f th e H a n s e l v o tin g share s is a p p lie d to H a n s e l’s n e t p r o fit, th e re s u ltin g fig u re is $ 7 8 5 0 0 . 1
2
W h a t re v e n u e fr o m its in v e s tm e n t in H a n s e l w ill G re te l r e p o r t i f it is u s in g : a
th e c o s t basis?
b
th e e q u ity basis?
W h a t is th e in v e s tm e n t in H a n s e l asse t o n G r e te l’s b o o k s a t th e e n d o f th e y e a r usin g: a
th e c o s t basis?
b
th e e q u ity basis?
Y o u r a n sw e rs s h o u ld be: 1
2
a
$45 0 0 0
b
$78 5 0 0
a
$460 000
b
$ 4 9 3 5 0 0 Ci.e. $ 4 6 0 0 0 0 + $ 7 8 5 0 0 -
12.2
$ 4 5 0 0 0 = $ 4 9 3 5 0 0 ).
Consolidations
C onsolidations are g e n e ra lly beyond the scope o f an introductory fin a n cia l accounting textbook. H ow ever, before you read a set o f fin a n cia l statements, you need to at least understand the very basics o f co n solidation. Therefore, w e have included a section here. W e w ill leave it up to your instructor to d e c id e the level o f detail to cover. W h e re the investor (X) has control over another entity (Y), X is referred to as a parent entity, Y is the subsidiary entity, an d the com bination o f X an d Y is c a lle d the e conom ic entity. C ontrol is p o w e r to govern the fin a n cia l and opera tin g policies o f an entity so as to o btain benefits from its activities. W h e th e r an entity has control over another entity is a lw a ys a matter o f judgem ent a n d , a c co rd in g ly, involves the a p p lic a tio n o f professional skill an d judgem ent on the part o f the p reparer (and auditor) o f fin a n cia l reports. W h ile o w n in g over 5 0 per cent o f the shares o f a c o m p a n y norm ally results in the investor having control, control can also
468
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
exist w here, for exam ple, the investor has the c a p a city to do m in a te the com position o f the bo a rd o r the c a p a city to control the m ajority o f votes cast a t a meeting o f the b o a rd of directors or at a general m eeting. This m ay occur, for exam ple, w hen an investor has less than 5 0 per cent o f the shares o f another entity, but the ow n e rsh ip o f the rem ainder o f the shares is w id e ly dispersed. W h e re control exists, accounting uses a technique ca lle d consolidation to present the parent c o m p a n y an d all of its subsidiaries as on e e conom ic entity. W h ile there is a consolidated entity for accounting purposes, there is no consolidated entity for most legal purposes. Rather, it is le g a lly a g ro u p o f separate com panies w ith connected ow nership. The idea is to present the g ro u p o f com panies as if it w e re a single entity. This method is thought to represent the econom ic an d business circumstances m ore faithfully than w o u ld reporting separate statements for all the le g a lly separate com panies and leaving the user to try to a d d them together. C o n solidation uses a sim ple id e a : to prepare the fin a n cia l statements o f a g ro u p o f com panies, put the b a la n ce sheets and the incom e statements a nd other statements for all the com panies side by side a n d , mostly, a d d them up. The consolidated cash figure w ill be the sum o f all o f the com panies' cash figures, the consolidated sales figure w ill be the sum o f their sales figures, a nd so on. To a p p ly this sim ple idea to the com plexities o f modern businesses, a quite c om plicate d set o f G A A P for co nsolidation has arisen. In this book, the com plexities w ill be left out in favour o f a focus on four main issues in consolidation accounting: •
determ ining w h a t to d o if the parent c o m p a n y ow ns less than 1 0 0 per cent o f the subsidiary's voting shares
•
determ ining the asset a nd lia b ility values that are to be a d d e d together
•
determ ining a n y g o o d w ill arising from the acquisition price p a id by the parent
•
determ ining co n so lid a te d profit.
M in o rity interests M inority interest (also c a lle d non-controlling interest) refers to the interests of the shareholders w h o have shares not o w n e d by the parent co m p a n y. For exam ple, if a c o m p a n y buys 8 0 per cent o f a subsidiary's shares, the rem aining 2 0 per cent belongs to m inority interests (m inority shareholders). O n co n solidation, all o f the assets a nd liabilities of the subsidiary are included in the co n so lid a te d b a la n ce sheet. This provides the reader w ith the total assets and liabilities under the control o f the parent co m p a n y. The m inority interest in the net assets (assets less liabilities) is shown separately in the shareholders' equity section o f the b a la n ce sheet. Exhibit 1 2.1 shows an exam ple o f the disclosure o f non-controlling interests in the consolidated Financial statem ents o f CSR Limited. It can be seen that for 2 0 1 4 , $ 5 5 .2 m illion o f the net assets o f $1 1 5 3 .8 m illion w a s o w n e d by non-controlling interests an d the rem ainder w a s o w n e d b y the shareholders o f CSR Limited ($ 1 0 9 8 .6 m illion).
CHAPTER 12 Completing the balance sheet
469
Asset and lia b ility values The idea o f consolidation is just to a d d the accounts together: the parent's accounts receivable are a d d e d to the subsidiary's accounts receivable, the land is a d d e d to the land, the accounts p a y a b le are a d d e d to the accounts p a ya b le , a nd so on. But some changes to the parent's an d subsidiary's b a la n ce sheets a re m ade before the a d d in g together is d one. O n e such ch a n g e is that a n y intercom pany balances are offset aga in st each other. If S Ltd ow es P Ltd $ 4 0 0 0 0 , for exam ple, that w o u ld be on S Ltd's b a la n ce sheet as an a ccount p a y a b le a nd on P Ltd's bala nce sheet as an a ccount receivable. If the consolidated b a la n ce sheet is to represent the tw o com panies as if they w e re one entity, this $ 4 0 0 0 0 am ount is an internal matter to the co m b in e d entity: it is not o w e d to o r receivable from anyone outside the entity, so it is not like the other accounts p a y a b le a nd accounts receivable. Therefore, it is just left out o f the co n so lid a te d figures b y elim inating the intercom pany receivable aga in st the intercom pany pa ya ble. (Intercom pany sales a nd expenses, such as m anagem ent fees, a re also left out o f the profit a nd loss account, a nd any profit m ade by on e c o m p a n y in d e a lin g w ith the other is left out as w e ll. Elim inating these can be com plex.) A nother exam ple is the acco u n t for the parent com pany's investment in the subsidiary, w h ich is also an intercom pany account, so it too is elim inated in the co n solidation.
G oodwill arising on consolidation W h a t if P Ltd p a id m ore for the shares o f S Ltd than the sum o f the fa ir values o f S Ltd's assets minus its lia b ilitie s? This indicates that P Ltd is b uying som ething else n o t on S Ltd's b a la n c e sheet - som ething in a d d itio n to all the in d ivid u a l parts o f S Ltd. This som ething is c a lle d consolidated goodwill o r g o o d w ill a rising on c o n so lid a tio n . It m ight represent g o o d m anagers, a g o o d lo ca tio n , faithful customers, econom ies o f scale w ith the parent co m p a n y, reduced c o m p e titio n , o r other factors the parent c o m p a n y to o k into a cco u n t in a g re e in g to a p rice fo r the subsidiary's shares. G o o d w ill asset = Cost o f p aren t's investm ent Parent's portion of net assets (fa ir values of subsidiary's assets - fa ir values of its liabilities) For exam ple, if Very Big Ltd p a id $ 1 2 0 0 0 0 0 for 8 0 per cent of the voting shares o f N o t So Big Ltd, a n d , at that date, Very Big evaluated N o t So Big's assets to be w orth $ 4 3 0 0 0 0 0 a n d its liabilities to be $ 3 0 0 0 0 0 0 , then consolidated g o o d w ill at d a te o f acquisition w o u ld be $ 1 6 0 0 0 0 ( $ 1 2 0 0 0 0 0
— 0 .8 0 ($ 4 3 0 0 0 0 0 —
$3 0 0 0 0 0 0 )). G o o d w ill is show n a m ong the noncurrent assets on the consolidated b a la n ce sheet, a nd it is subjected to im pairm ent testing on a sim ilar basis to other noncurrent assets.
Consolidated incom e statem ents C o nso lida te d incom e statements are prepared by co m b in in g the revenues a n d expenses o f the parent c o m p a n y and all its subsidiaries. This is d o n e after elim inating a n y transactions betw een these entities. For exam ple, intercom pany sales an d expenses, such as m anagem ent fees, a re left out o f the consolidated incom e statements, a nd a n y profit m ade b y one c o m p a n y in d e a lin g w ith the other is also left out. A n y im pairm ent losses a re also recorded. A n y share o f profits o f the subsidiaries that belongs to non-controlling interests is also deducted.
470
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d : 1
W h e re d o n o n - c o n tr o llin g in te re s ts a p p e a r in th e b a la n c e s h e e t? W h a t d o th e y re p re s e n t?
2
X L td is th e p a re n t c o m p a n y w ith sales o f $1 m illio n . Y L td , a s u b s id ia ry , had sales o f $ 5 0 0 0 0 0 , w h ic h in c lu d e d $ 1 0 0 0 0 0 o f sales t o X L td . W h a t w as th e c o n s o lid a te d sales fig u re ? Y o u r a n sw e rs s h o u ld be:
1
N o n - c o n tr o llin g in te re s ts a p pe ars s e p a ra te ly in th e s h a re h o ld e rs ’ e q u ity s e c tio n o f th e c o n s o lid a te d b a la n ce s h e e t. It re p re s e n ts th e in te re s ts o f th e s h a re h o ld e rs w h o have shares n o t o w n e d b y th e p a re n t c o m p a n y .
2
$1400 000.
12.3
Shareholders' equity
The shareholders' equity section o f the b a la n ce sheet has three main com ponents: •
share capital
•
reserves
•
retained pro fits/a ccu m u la te d losses. A ccounting standards require that each o f these be disclosed separately. The purpose o f keeping them separate is
related to the co n ce p t o f capital m aintenance. Linder this concept, profit is o n ly earned after the c a p ita l of the c o m p a n y has been m aintained. D ividends can o n ly be p a id w hen there are retained profits a nd revenue reserves to cover them; that is, they cannot be p a id out o f issued ca p ita l. This is to ensure that the o rig in a l c a p ita l is m aintained w ithin the com pa n y, w h ich benefits the creditors because the am ount o f ca p ita l (in the form o f net assets) is a v a ila b le for repaym ent o f the creditors. So w h a t does the b a la n ce o f shareholders' equity represent? First, recall the basic accounting equation introduced in C h a p te r 1: Assets = Liabilities + S h areh o ld ers' equity or Assets - Liabilities = S h arehold ers' eq u ity Shareholders' equity, therefore, represents the difference betw een assets a nd liabilities; that is, net assets. It shows h o w these net assets have been financed. For exam ple, consider the fo llo w in g sam ple b a la n ce sheet: 1 Assets Cash
1 000
Accounts receivable
10000
Property, plant and equipment
89000
Total assets
100 00 0
Liabilities Accounts payable
Total liabilities Net assets
5 000 5 000 95 000
Shareholders' equity Share capital General reserves
70000 6000
Retained profits
19000
Total shareholders' equity
95 000
CHAPTER 12 Completing the balance sheet
471
General reserves w ill be discussed in section 1 2 .5 . For no w , assume that they w e re created b y d e b itin g retained profits an d crediting general reserves. Total shareholders' equity o f $ 9 5 0 0 0 indicates that net assets o f $ 9 5 0 0 0 have been financed b y o rig in a l contributions from ow ners (share capital) o f $ 7 0 0 0 0 a n d $ 2 5 0 0 0 ( $ 1 9 0 0 0 + $ 6 0 0 0 ) from past accum ulated profits that have not been distributed in dividends. The transfer of $ 6 0 0 0 from retained profits to general reserves provides a signal to users that this $ 6 0 0 0 is unlikely to be p a id out in dividends in the future, although it is still le g a lly possible to d o so. N o te that neither retained profits ($1 9 0 0 0 ) nor general reserves ($ 6 0 0 0 ) in d ica te there is cash o r some 'p o t of g o ld ' for this amount. In fact, in the a b o v e exam ple you can see that cash o nly totals $ 1 0 0 0 . Share ca p ita l, reserves a nd retained profits are n o w discussed in sections 1 2 .4 , 1 2 .5 a nd 1 2 .6 , respectively.
12.4
Share capital
The m ajority o f shares issued by com panies a re o rd in a ry shares, w h ich confer no special rights o r privileges on their holders. The o rd in a ry shareholders a re the main risk-takers o f com panies, because they d o n 't receive a d ivid end unless a d e q u a te profits a re earned. There is, how ever, no upper limit to the rate o f d ivid e n d that m ay be recom m ended by the directors if profits permit. N o rm a lly, the holders o f o rd in a ry shares have full voting rights. Preference shares confer special rights on their holders. G e n e ra lly, these involve priority w ith respect to dividends at a prescribed rate a n d , in a d d itio n , the holders m ay e n jo y preferential treatment w ith respect to the return o f ca pital if the c o m p a n y terminates in a liquidation or w in d in g up. Profits must be a v a ila b le before a n y dividends m ay be decla re d an d , to protect the interests o f preference shareholders, provision is g e n e ra lly m ade for the priority o f unpaid preference d ividends to accum ulate from y e a r to ye a r until profits are a d e q u a te . Shares w ith this entitlement are termed cum ulative preference shares. A c o m p a n y m ay also issue p a rticip a tin g preference shares, w h ich means that, after the fixed am ount o f preferred d ivid e n d is p a id , preference shareholders m ay p a rticip a te in other dividends w ith the o rd in a ry shareholders if profits exceed a specified level. A p a rt from some d e fined exceptions under the C orporations A c t 2 0 0 1 , a c o m p a n y invites the public to subscribe for shares b y issuing a prospectus, w h ich contains the relevant a p p lic a tio n form. The content o f the prospectus must conform w ith the requirements o f the C o rporations A c t 2 0 0 1 an d must contain an a u d it report. The prospectus is designed to inform potential shareholders, o r their advisers, a b o u t the fin a n cia l position o f the co m p a n y, its prospects and the rights attached to the securities being issued. In its simplest form, the journal entry for the issue o f 1 0 0 0 0 0 fully p a id $ 2 .5 0 o rd in a ry shares w o u ld be:
s|
$ DR CR
Cash
250000
Share capital
250000
This form is a p p ro p ria te w h e re the shares are issued to an institutional investor o r w h e re the share issue is adm inistered by an underwriter. Public com panies can also issue shares d irectly to the public, based on a prospectus. Assume that the a b o v e issue o f 1 0 0 0 0 0 shares at $ 2 .5 0 w e re all p a y a b le a t the tim e of a p p lic a tio n . In this case, the paym ent of $ 2 5 0 0 0 0 must be held in a special cash trust account, since the bo a rd o f directors has not yet form ally resolved to issue the shares to the a p plicants. The journal entry w o u ld be: $ DR CR
Cash trust Application
$
250000 250000
To re c o r d re c e ip t o f c a s h o f $ 2 . 5 0 p e r s h a re o n 1 0 0 0 0 0 sh a re s.
472
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
O n c e the minimum subscription is received a nd the directors a llo t the shares to the applicants, the am ount o f m oney p a id b y successful a p plicants w o u ld be transferred from the cash trust account to the cash a t bank account.
If there had been excess a p p lic a tio n funds, the a p p lic a tio n m oney o f the unsuccessful a p p lica n ts w o u ld be refunded w ith the fo llo w in g entry:
The last step is to transfer the b a la n ce from the a p p lic a tio n account to the share c a p ita l account, as the shareholders have n o w been issued w ith shares: $ DR
Application
CR
$
250000
Share capital
250000
The b a lance sheet under shareholders' equity w o u ld sh o w an am ount o f $ 2 5 0 0 0 0 under share ca p ita l. For most Australian com panies, the full paym ent for shares is required at the tim e o f issue. As a result, for the m ajority of com panies, the entries discussed a b o ve w ill be all you need to know . H ow ever, it is possible for a c o m p a n y to require shareholders to p a y the am ounts in instalments. In this case, the entries becom e a little more com plex and are discussed b e lo w . Assume that the conditions o f the earlier share issue o f 1 0 0 0 0 0 shares at $ 2 .5 0 required $ 1 .7 0 per share d o w n paym ent w ith the a p p lica tio n . O n allotment, another $ 0 .5 0 is due, and a further $ 0 .3 0 is due w hen determ ined b y the board o f directors. The a p p lication m oney w as received on 1 0 A pril. O n 2 8 A pril, the shares w e re issued (or allotted), w ith the am ount p a ya b le on allotm ent received on 1 0 M a y . O n 1 2 July, the directors called for the rem aining am ount o w in g on the shares, w hich w a s received on 2 8 July. The journal entries w o u ld be as follows:
Apr. 10
Cash trust
DR
CR
$
$
170 00 0
Applications
170 00 0
C a s h re c e iv e d o n a p p lic a tio n
Apr. 28
Cash at bank
170 00 0
Cash trust
170 00 0
T ra n s fe r to c a s h a t b a n k o n a llo tm e n t
Apr. 28
Application
170 00 0
Share capital
170 00 0
To re c o r d th e a m o u n ts d u e o n a p p lic a tio n
Apr. 28
Allotment Share capital A llo tm e n t a m o u n t o f 5 0 ce n ts p e r s h a re
50000 50000
»
CHAPTER 12 Completing the balance sheet
M a y 10
C ash a t ba nk
473
50000
A llo tm e n t
50000
A llo tm e n t m o n e y re c e iv e d J u ly 12
C a ll
30000
S h a re c a p ita l
30000
C a ll o f 3 0 ce n ts p e r s h a re J u ly 2 8
30000
C ash a t ba nk C a ll
30000
R e c e ip t o f c a ll m o n e y
The general ledger accounts w o u ld a p p e a r as follow s:
If these w e re the o n ly transactions for the com p a n y, the b a la n ce sheet w o u ld a p p e a r as follow s: 1 Assets C ash
$ 250000
Shareholders' equity S h a re c a p ita l
250000
The issue o f share c a p ita l can get much m ore com plex, a nd topics such as oversubscription, undersubscription, forfeiture o f shares, reissue o f forfeited shares an d the issue o f preference shares are left until later courses. So far, w e have been d e a lin g w ith the issue of shares. A com m on p ractice at present is for com panies to buy b a ck their o w n shares. Share buybacks occur w hen com panies have surplus cash an d they use this to buy b ack their o w n shares, thus reducing the num ber of shares issued an d the d o lla r am ount of shareholders' equity. If they can m aintain profits at a p p ro xim a te ly the sam e level, this action w ill result in increases in such ratios as return on equity and earnings per share.
474
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The overall im p a ct on the accounting equation o f a share bu yb a ck is to decrease an asset (cash) a n d decrease shareholders' equity. In terms o f debits an d credits, the credit entry w ill be to cash. C om p a n ie s are a llo w e d some flexibility in w h ich shareholders' equity acco u n t to d e b it. Three possibilities are share c a p ita l, retained profits and reserves. In the unlikely event that shares w e re bought b a ck at the sam e price as they w e re issued, the d e b it entry w o u ld be to share ca p ita l. If they w e re bought b a ck at a price a b o v e the issue price, a possibility w o u ld be to d e b it the share c a p ita l a ccount for the am ount o f the issue price an d d e b it retained profits o r a reserve a ccount for the a d d itio n a l amount.
12.5
Reserves
Reserves are not defined in the C o rporations A c t 2 0 0 1 , the Australian A ccounting Standards o r the Statements of A ccounting C oncepts of the Fram ew ork for the P reparation a n d Presentation o f F inancial Statements. H ow ever, nearly every annual report you p ick up w ill have reserves included in the b a la n ce sheet c a te g o ry o f shareholders' equity. Reserves can take m any different forms, a n d the term inology betw een com panies varies greatly, w h ich is not surprising given the lack of professional g u id a n ce . A ccounting standard AASB 101 requires the disclosure o f reserves in the b a la n ce sheet a nd requires further disclosure in the notes for each class o f reserves, a description o f the nature a nd purpose o f the reserve, the am ount of the reserve at the b e ginning o f the fin a n cia l year, the nature an d am ount of changes during the year, an d the am ount at the end o f the fin a n cia l year. It is im portant to understand the nature o f each type o f reserve a ccount in a co m p a n y's fin a n cia l statements because, under the C orp o ra tio ns A c t 2 0 0 1 , dividends can o nly be p a id out o f profits. It is, therefore, im portant to know w hether each reserve a ccount is a form o f accum ulated profits o r not. O n e type o f reserve is based on C orporations A c t 2 0 0 1 requirements; nam ely, c a p ita l redem ption reserves created w hen preference shares are redeem ed out o f profits. These reserves cannot be used to p a y a cash d ivid e n d . O th e r reserves m ay be created by the a p p ro p ria tio n o f profits an d the revaluation o f noncurrent assets. These w o u ld include general reserves and revaluation surpluses. C ash d ividends can be p a id out o f general reserves. C a se la w indicates that cash dividends can be p a id out o f across-the-board revaluation o f assets, but it is uncertain w hether cash d ividends can be p a id out o f a selective or partial revaluation. Three o f the m ore com m on reserves you a re likely to com e across are the general reserve, the revaluation surplus and the foreign currency translation reserve. The general reserve account is an am ount transferred from retained profits by the entry d e b it retained profits (i.e. decrease in a shareholders' equity account) a nd credit general reserve (i.e. an increase in a shareholders' equity account). The purpose o f this transfer is often to in d ica te to shareholders that the am ount o f the transfer is unlikely to be p a id out in dividends a nd w ill be retained in the business. H ow ever, the directors can later d e c id e to transfer the am ount b ack to retained profits. As a result, the entry does not ach ie ve a great d eal, as there is no ch a n g e in w h e re funds are invested, nor are the amounts earm arked for specific future use. A nother reserve a ccount that w a s discussed in C h a p te r 1 0 w a s the revaluation surplus (previously c a lle d the asset revaluation reserve). Recall that the entry to revalue, say, land a nd buildings upw ards w as: $ DR CR
L a n d a n d b u ild in g s R e v a lu a tio n s u rp lu s
$
XXX XXX
A third com m on exam ple o f a reserve account is the foreign currency translation reserve that relates to e xchange differences, w hich arise in translating the accounts o f a self-sustaining foreign operation into dom estic currency. A g a in , these issues are left to a more a d va n ce d accounting course.
CHAPTER 12 Completing the balance sheet
12.6
475
Retained profits and dividends
Students an d users of accounting reports often have problem s w ith interpreting w h a t a b a la n ce in retained profits means. The retained profits b a la n ce shows the am ount o f profits a c o m p a n y has m ade over time, less a n y dividends d ecla re d . So if a c o m p a n y had never d e cla re d a n y divid e n d s, its retained profits acco u n t w o u ld equal all profits ever m ade since inception. A large b a la n ce in retained profits does not mean there is a 'p o t of g o ld ' set a sid e fo r future use. N o r does it mean there is cash a v a ila b le to p a y e m ployee entitlements if the c o m p a n y fails. It sim ply tells you the maximum am ount o f dividends that can be p a id in the future (assuming the c o m p a n y has the cash to p a y the dividends). Let's consider four com panies, A , B, C a nd D:
C ash P ro p e rty , p la n t a n d e q u ip m e n t (PPE) T o ta l assets
A
B
c
D
$
$
$
$
2 000
25 000
2 000
25 000
98 000
75 000
68 000
20000
100000
100000
70000
45 000
C u rre n t lia b ilitie s
10000
10000
10000
10000
Loan
40000
40000
10000
0
R e ta in e d p ro fits
20000
20000
20000
5 000
S h a re c a p ita l
30000
30000
30000
30000
100000
100000
70000
45 000
Each c o m p a n y has been in existence for five years, has issued share c a p ita l o f $ 3 0 0 0 0 , has current liabilities of $ 1 0 0 0 0 a nd earned profits o f $ 2 0 0 0 0 . D is the o nly c o m p a n y that has d e cla re d an d p a id d ividends (dividends of $ 15 0 0 0 have been paid). Even though the four com panies have received the same cash from the issue o f shares, earned the same profits and have the sam e current liabilities, they have used cash in very different w a ys . C o m p a n y A has taken a grow th strategy w ith the largest PPE a nd has b o rro w e d ( $ 4 0 0 0 0 ) to be used w ith cash generated through share issues and profits to buy PPE. C o m p a n y B is sim ilar except it has not g ro w n as q uickly a nd has higher am ounts in cash but less PPE. C o m p a n y C is the sam e as C o m p a n y A , except it has b o rro w e d $ 3 0 0 0 0 less an d has $ 3 0 0 0 0 less in PPE. So note that A , B a nd C all have the sam e retained profits but they d o n 't all have the same am ount o f cash to p a y bills and have different levels o f assets. C o m p a n y D is different in that it has p a id out $ 1 5 0 0 0 in dividends ( $ 2 0 0 0 0 — $ 5 0 0 0 ) an d it has not b o rro w e d . C onsequently, it has not been in a position to ob ta in PPE to the sam e level as the other three firms.
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: In th e above exam ple, assum e th a t each c o m p a n y earned $ 8 0 0 0 p r o fit in th e n e x t year. W h a t w o u ld be th e m a x im u m a m o u n t o f dividends each c o m p a n y co u ld pay o u t n e x t year? Y o u r answ er should be: C o m p a n ie s A , B and C : $ 2 0 0 0 0 + $ 8 0 0 0 = $ 2 8 0 0 0 ; C o m p a n y D : $ 5 0 0 0 + $ 8 0 0 0 = $13 0 0 0 . ( N o te th e se are m a x im u m a m o u n ts and w h e th e r th e y have s u ffic ie n t cash o r w ished to pay o u t th is m u c h in dividends is a d iffe re n t question.))
476
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A note outlining the changes in retained profits w a s shown in C h a p te r 2 . The contents o f this note can n o w be e x p anded to include a transfer to reserves a n d is shown b e lo w .
In the a b o v e exam ple, you can see that there a re four main w a ys in w h ich the b a la n ce o f retained profits changes: •
a profit o r loss for the ye a r (from the incom e statement)
•
changes in accounting policies that g ive retroactive effect to the changes, w ith a n y resulting revenue o r expense directly adjusted to retained profits; that is, instead o f adjusting this year's revenue o r expense, w e adjust retained profit, w hich is w h e re the previous year's profits are
•
dividends p a id during the ye a r
•
a transfer to o r from a reserve, such as a general reserve o r the foreign currency translation reserve - if it w e re a transfer to a reserve, then the reserve a ccount w o u ld be credited a n d retained profits de b ite d.
12.7
Cash dividends
D ividends m ay be p rovided for on the basis of share ca p ita l, o r p a id a cco rd in g to the num ber o f shares held. W ith respect to the former, a d ivid e n d o f 5 per cent could be d e cla re d , w h ich means that 5 per cent o f the share c a p ita l is p a id . W ith respect to the latter method, the d ivid e n d is d e cla re d on the per-share basis, such as 2 0 cents per share, w hich w o u ld mean that a shareholder w ith 5 0 0 0 shares w o u ld receive $ 1 0 0 0 . G enerally, com panies have the right to make a paym ent o f interim an d final d ividends. Interim d ividends are usually authorised by the board o f directors during the year, based on an expectation o f a d e q u a te profits. W h e n an interim d ivid e n d is d e cla re d , there is a d e b it to retained profits an d a credit to d ividends p a ya b le . W h e n p a id , dividends p a y a b le is d e b ite d a nd cash is credited. For exam ple, assume XYZ Ltd d e cla re d an interim d ivid e n d on 15 January 2 0 1 6 o f 3 cents per share (one m illion issued shares) an d p a id it on 4 February 2 0 1 6 . The journal entries for the 2 0 1 6 financia l y e a r w o u ld be:
Jan. 15
R e ta in e d p ro fits
DR
CR
$
$
30000
D iv id e n d s p a y a b le
30000
To re c o r d d e c la ra tio n o f in te rim d iv id e n d F eb . 4
D iv id e n d s p a y a b le C ash
30000 30000
To re c o r d p a y m e n t o f in te rim d iv id e n d
Directors recom m end a final d ivid e n d to be authorised b y the shareholders at the annual general meeting o f the com pany, w hich is held after the end o f the com pany's fin a n cia l year. Shareholders m ay not increase the am ount beyond that recom m ended by directors, but m ay reject o r reduce the recom m ended am ount. FJowever, they alm ost
CHAPTER 12 Completing the balance sheet
477
invariab ly ratify the directors' resolution. In previous years, entities recognised a lia b ility for d ividends in the bala nce sheet w hen that d ivid e n d w a s d e cla re d after the reporting d a te but before the com pletion o f the fin a n cia l statements. Because o f the a d o p tio n o f international accounting standards, a lia b ility can no longer be raised at b a la n ce sheet date if the d ivid e n d is d e cla re d after that d ate. D ividends are n o w pro vid e d for in the period in w h ich they are d ecla re d . G iven that final dividends are d e cla re d after the b a la n ce sheet d a te but before com pletion o f the financial report, entities n o w disclose final d ividends in the notes as an event occurring after b a la n ce d a te (AASB 1 10 parag ra p h s 1 2 an d 1 3). For exam ple, assume that XYZ Ltd, at a meeting on 1 A ugust 2 0 1 6 , recom m ended a final d ivid e n d o f 1 0 cents per share on its 1 m illion shares. The d ivid e n d is authorised by shareholders at an annual general meeting on 2 8 S eptem ber 2 0 1 6 an d the direct credits fo r the d ivid e n d payments are lo d g e d w ith the ba n k on 5 O c to b e r 2 0 1 6 . The journal entry w o u ld be as follow s:
W h e n the final d ivid e n d is p a id on 5 O c to b e r, the journal entry is: O c t. 5
D iv id e n d s p a y a b le
100000
C ash
100000
C o n sid e r n o w w hether the a b o ve journal entry w o u ld be a n y different if the b o a rd had d e c id e d to recom m end the d ivid e n d on 3 0 June 2 0 1 6 . The an sw e r is no, because the n ew accounting standards d o not permit recognition o f a d ivid e n d a t the com pany's reporting da te unless the d ivid e n d has been d e cla re d a nd is not subject to further a p p ro va l (e.g. b y shareholders at the annual general meeting). As noted earlier, dividends can o n ly be p a id out o f profits, including both this year's profit a nd previous years' profits. Therefore, directors must ensure that profits are le g a lly a v a ila b le before they recom m end a certain level o f dividends. They also need to ensure that there w ill be a d e q u a te cash a v a ila b le to p a y the d ivid e nd. C hanges in dividends are im portant signals to shareholders; therefore, directors need to exercise ca re in determ ining the level o f dividends each year.
12.8
Bonus issues and share splits
D ividends d o not have to be cash divid e n d s. C o m p a n ie s can also issue share dividends, w h ich are norm ally called
bonus issues in A ustralia. C o n sid e r the case o f a c o m p a n y that has five m illion fully p a id o rd in a ry shares. Assume it has the fo llo w in g shareholders' equity section at 1 August 2 0 1 6 .
Assume that on 1 0 August, the c o m p a n y declares a 1 :4 bonus issue out of the revaluation surplus. This means that for every four shares in existence, o ne a d d itio n a l share w ill be issued to shareholders at no charge. The shares w e re issued on 3 Septem ber. The journal entries w o u ld be as follow s:
478
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A u g . 10
B o n u s issu e d e c la re d
DR
CR
$
$
1250000
B on us issu e p a y a b le
1250000
To re c o r d d e c la ra tio n o f b o n u s issu e A u g . 10
R e v a lu a tio n su rp lu s
1250000 1250000
B on us issu e d e c la re d To re c o r d re d u c tio n o f re v a lu a tio n s u rp lu s S e p t. 3
B o n u s issu e p a y a b le
1250000
S h a re c a p ita l
1250000
The shareholders' equity section of the b a la n ce sheet before an d after the bonus issue w o u ld a p p e a r as follow s: Before bonus issue
After bonus issue
$
$
S h a re c a p ita l
5 000000
6 250000
R e v a lu a tio n s u rp lu s
1 800000
550000
R e ta in e d p ro fits
1400000
1400000
Total shareholders' equity
8200000
8200000
Shareholders' equity
N o te that total shareholders' equity has rem ained constant an d that there has been o n ly internal movement w ithin the shareholders' equity section o f the b a la n ce sheet. H ave shareholders g a in e d from this issue? Shareholders w ill only g a in if the market value o f the co m b in e d shares is greater than it w a s before the bonus issue. Total shareholders' funds have rem ained constant, so it is unlikely that the value o f the firm has increased. If a shareholder o w n e d 5 per cent o f the c o m p a n y shares before the bonus issue, he o r she w o u ld still o w n 5 per cent after the bonus issue. Thus, the share market w ill norm ally adjust the price o f the shares a c co rd in g ly so the total value o f each shareholder's shares remains the same. H ow ever, if it is believed that the bonus issue w ill be a c c o m p a n ie d by increased total dividends (e.g. w hen the d ivid e n d per share remains the same), the share market w ill in co rp o ra te this inform ation in determ ining the n e w share price. So w h y d o com panies make bonus issues? There are a num ber o f potential reasons. First, they pro vid e a return to shareholders w ith o u t affecting cash. W h ile the value o f that return has been questioned a b o ve , m any shareholders m ay perceive it to be a benefit. S econd, it reduces the market price of each share, w h ich m ay make the shares a v a ila b le to a w id e r range o f investors. Third, it can be used to ca p ita lise reserves; that is, turn them into perm anent share ca p ita l. Fourth, they can be a useful takeover defence by forcing the offerer to w ith d ra w a nd resubmit the offer o r extend the o rig in a l offer price to the new ly created shares.
Share splits sim ply increase the num ber o f shares a va ila b le . For exam ple, a c o m p a n y has 1 0 0 0 0 0 fully paid-up shares. If there w a s a 2:1 share split, there w o u ld be 2 0 0 0 0 0 shares. The share split does not c h a n g e the bala n ce o f a n y of the shareholders' equity accounts. For exam ple, share ca p ita l is $ 2 0 0 0 0 0 before a n d after the share split. Therefore, no journal entry is required to record the share split. The purpose o f the share split is g e n e ra lly to reduce the unit market price o f each share so that the shares are a p p e a lin g to a w id e r range o f investors.
CHAPTER 12 Completing the balance sheet
479
12.9 Managers, investments and shareholders' equity In earlier chapters, w e em phasised the im portance o f the fin a n cia l position o f a co m p a n y. Items such as total assets, total liabilities a nd total shareholders' equity form the basis o f perform ance measures that can be used to evaluate the c o m p a n y a nd its m anagers. M a n y o f these indicators, such as return on total assets a nd the ratio o f d e b t to equity, have been mentioned previously, an d w ill be covered in detail in C h a p te r 15. Therefore, it is im portant that m anagers understand h o w decisions they make affect some b a la n ce sheet items such as investments and shareholders' equity. W h e n purchasing shares, investment m anagers need to be a w a re that the percentage o f shares they buy w ill affect the influence o r control they have over the investment, w h ich in turn affects h o w these investments are accounted for in the fin a n cia l statements. Decisions on d ividends, bonus issues a n d so on w ill affect the closing b a la n ce sheet. An understanding o f the nature o f retained profits an d the various reserve accounts is im portant in determ ining the level o f dividends that can be p a id or the am ount o f a bonus issue.
480
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A E q u ity and cost bases o f acco u n tin g fo r an investm ent B axte r Investm ents Ltd o w n s 2 3 p e r c e n t o f th e v o tin g shares o f B lu e b ird H ote l Ltd. It b o u g h t them last y e a r fo r $1 5 0 0 0 0 0 a n d , s in c e th e n , B lu e b ird has re p o rte d ne t p ro fit o f $ 4 0 0 0 0 0 a n d d e c la re d d iv id e n d s to ta llin g $1 6 0 0 0 0 . B axte r a c c o u n ts fo r its in ve stm en t in B lu e b ird on th e c o st basis. 1
2
G iv e th e fig u re s fo r: a
th e re ven ue B a x te r w ill h a ve re c o g n is e d fro m its in ve stm en t s in c e a c q u is itio n
b
th e pre se n t b a la n c e in th e c o m p a n y 's b a la n c e sheet a c c o u n t fo r in ve stm en t in B lu e b ird H ote l Ltd.
G iv e th e sam e fig u re s req ue ste d in q u e s tio n 1 if B axte r a c c o u n te d fo r its in ve stm en t on th e e q u ity basis.
PRACTICE PROBLEM B Cost versus e q u ity m ethod O n 1 J a n u a ry 2 0 1 6 , Y Ltd a c q u ire d 1 0 0 0 0 0 shares (3 0 p e r c e n t o f th e v o tin g interest) in P Ltd fo r $ 9 0 0 0 0 0 cash. O n 3 0 June 2 0 1 6 , P Ltd a n n o u n c e d its e a rn in g s p e r s h a re fo r th e first s ix m onths o f 2 0 1 6 a t $ 2 .0 0 p e r s h a re . O n 2 0 N o v e m b e r, P Ltd p a id d iv id e n d s to s h a re h o ld e rs a t $ 1 .2 0 p e r share . O n 31 D e c e m b e r 2 0 1 6 , P Ltd a n n o u n c e d its e a rn in g s p e r s h a re fo r 2 0 1 6 a t $ 3 .5 0 p e r sh a re (i.e . $ 1 .5 0 a d d itio n a l s in c e 3 0 June). 1 If Y Ltd used th e cost b a sis, w h a t w a s th e b a la n c e sheet v a lu e o f its in ve stm en t in P Ltd a t 31 D e c e m b e r 2 0 1 6? 2
If Y Ltd used th e cost m e th o d , w h a t d iv id e n d re ven ue d id it re c o rd fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 in re sp e ct o f its in ve stm en t in P Ltd?
3
If Y Ltd used th e c o st m e th o d , w h a t w o u ld h a ve be en th e im p a c t o f P Ltd's 3 0 June 2 0 1 6 e a rn in g s a n n o u n c e m e n t?
4
If Y Ltd used th e e q u ity b a sis, w h a t w a s the b a la n c e shee t v a lu e o f its in ve stm en t in P Ltd a t 31 D e c e m b e r 2 0 1 6 ?
5
If Y Ltd used th e e q u ity b a sis, w h a t re ven ue d id it re c o rd fo r y e a r e n d e d 31 D e c e m b e r 2 0 1 6 in re sp e ct o f its in ve stm en t in P Ltd?
6
If Y Ltd used th e e q u ity m e th o d , w h a t w o u ld h a ve be en th e im p a c t o f P Ltd's 31 D e c e m b e r 2 0 1 6 e a rn in g s a n n o u n c e m e n t?
PRACTICE PROBLEM C Prepare an incom e sta te m e n t and d etails o f sh areholders' e q u ity P ro v id e d b e lo w a re c e rta in b a la n ce s o f Jones Ltd a t 3 0 June 2 0 1 6 . DR $ S h a re c a p ita l
CR $ 200000
G e n e ra l re s e rv e
20 000
R e ta in e d p ro fits
30 000
R e v a lu a tio n s u rp lu s
18 0 0 0
P ro fit b e fo re ta x
32 000
In te rim d iv id e n d (p a id 31 J a n u a r y 2 0 1 6 )
5 000
CHAPTER 12 Completing the balance sheet
481
A d d itio n a l in fo rm a tio n : 1
P ro v id e fo r ta x a tio n o n 2 0 1 6 p ro fits, $ 1 5 0 0 0 .
2
P ro v id e fo r fin a l d iv id e n d th a t h a d be en d e c la re d a n d a p p ro v e d b e fo re th e re p o rtin g d a te , $ 6 0 0 0 .
3
T ra n sfe r $ 1 2 0 0 0 to g e n e ra l reserve.
C o m p le te th e in c o m e state m e nt a n d re c o n c ile re ta in e d p ro fits fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , a n d s h o w h o w the s h a re h o ld e rs ' e q u ity section w o u ld a p p e a r in th e b a la n c e sheet as a t 3 0 June 2 0 1 6 .
PRACTICE PROBLEM D Retained p ro fits The fo llo w in g tra n s a c tio n s o c c u rre d in th e 2 0 1 6 fin a n c ia l y e a r. The o p e n in g b a la n c e o f re ta in e d p ro fits w a s $ 20000 .
a
S ha res w e re issued (4 0 0 0 a t $ 4 e a ch ).
b
$ 2 5 0 0 w o rth o f in v e n to ry w a s p u rc h a s e d on c re d it a n d has n o t y e t be en sold ,
c
The c o m p a n y m a d e a net loss fo r th e p e rio d o f $ 4 2 5 0 .
d
The c o m p a n y m o ve d $ 5 5 0 fro m th e g e n e ra l reserve to re ta in e d p ro fits,
e
D iv id e n d s o f $ 5 0 0 0 w e re d e c la re d a n d p a id .
R e q u ire d : 1 W h a t is th e c lo s in g b a la n c e o f re ta in e d pro fits? 2
H o w m uch d id to ta l s h a re h o ld e rs ' e q u ity in cre a s e d u rin g th e y e a r?
Associated company Bonus issues Capital maintenance Consolidated Financial statement Consolidated goodwill Earnings per share
Equity method Foreign currency translationreserve General reserves Intercorporate investment Lower of cost or market value Minority interest
Return on equity Share buybacks Share dividends Share splits Significant influence
This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f pro b le m s .
1
W h a t is th e d iffe re n c e b e tw e e n a short-term in ve stm en t a n d a long-term investm ent?
2
E x p la in th e d iffe re n c e b e tw e e n th e e q u ity m e th o d a n d th e cost m e th o d fo r th e v a lu a tio n o f investm ents.
3
W h a t is c o n s o lid a tio n ?
4
W h a t is m e a n t b y n o n -c o n tro llin g interests in the b a la n c e sheet?
5
List th re e e x a m p le s o f reserves.
6 A c o m p a n y d e c id e s to s p lit its e x is tin g shares in h a lf (i.e . re p la c e e a ch e x is tin g s h a re w ith tw o shares). W h a t im p a c t w ill it h a ve on th e b a la n c e sheet? 7
W h a t is th e d iffe re n c e b e tw e e n lia b ilitie s a n d e q u ity?
8
E x p la in th e c o n d itio n s th a t m ust be m et b e fo re a fin a l cash d iv id e n d m a y be p a id to th e o rd in a ry s h a re h o ld e rs o f a com pany.
9
E x p la in h o w th e fo llo w in g b e n e fit fro m th e issue o f sh a re d iv id e n d s (bo nu s shares): a
e x is tin g s h a re h o ld e rs
b
fu tu re s h a re h o ld e rs
c
th e c o m p a n y .
482
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
1 0 W h y d o e s a s u b s id ia ry h a ve to be c o n s o lid a te d w ith th e p a re n t's acco un ts? 11 S in ce it is th e sum o f m o re th a n o n e c o m p a n y , w o n 't a c o n s o lid a te d b a la n c e sheet pre se n t a s tro n g e r fin a n c ia l p ic tu re th a n th e p a re n t's u n c o n s o lid a te d b a la n c e sheet does? 12 W h a t do es g o o d w ill o n c o n s o lid a tio n on th e c o n s o lid a te d b a la n c e sheet m ean? 13 W h a t p u rp o s e is served b y tra n s fe rrin g am o u n ts fro m re ta in e d p ro fits to reserves, w h e n th e am o u n ts m a y be tra n s fe rre d b a c k if th e d ire c to rs so d e c id e ? 14 Expl a in th e a c c o u n tin g d iffe re n c e s b e tw e e n a b o n u s issue (share d iv id e n d ) a n d a sh a re sp lit.
PROBLEMS PROBLEM 12.1 E q u ity and cost bases o f acco u n tin g fo r an investm ent H o t Ltd buys a 3 0 p e r c e n t s h a re in C h illi Ltd fo r $ 6 4 m illio n . T o tal p ro fit fo r th e y e a r fo r C h illi Ltd is $ 4 4 m illio n , a n d H o t Ltd receives $ 4 m illio n in d iv id e n d s fro m M u s ta rd . 1 U sing th e c o st m e th o d , w h a t w o u ld be th e reven ue a n d investm ent a cco u n ts a t y e a r-e n d fo r this investm ent? 2
U sing th e e q u ity m e th o d , w h a t w o u ld be th e reven ue re c o g n is e d fo r th is in ve stm en t d u rin g th e y e a r?
3
U sing th e e q u ity m e th o d , w h a t w o u ld be th e y e a r-e n d v a lu e o f the in ve stm en t in C h illi?
PROBLEM 12.2 E q u ity and cost bases o f acco u n tin g fo r an investm ent O n 1 M a rc h 2 0 1 6 , R om eo Ltd a c q u ire d a 3 4 p e r c e n t s h a re ( 2 0 0 0 0 shares) in J u lie t Ltd fo r $ 6 8 0 0 0 0 . O n 3 0 June 2 0 1 6 , J u lie t a n n o u n c e d e a rn in g s a t $ 3 .8 0 p e r sh a re a n d a lso p a id o u t d iv id e n d s o f $ 1 .6 0 p e r share . 1
U sing th e c o st m e th o d , w h a t is th e v a lu e o f th e investm ent in J u lie t Ltd, as listed o n R om eo's b a la n c e sheet?
2
U sing th e c o st m e th o d , w h a t is th e v a lu e o f th e reven ue fro m this in ve stm en t re c o rd e d b y Rom eo?
3
U sing th e e q u ity m e th o d , w h a t is th e v a lu e o f th e in ve stm en t in J u lie t Ltd, as listed on R om eo's b a la n c e sheet?
4
U sing th e e q u ity m e th o d , w h a t is th e v a lu e o f th e reven ue fro m this in ve stm en t re c o rd e d b y R om eo?
PROBLEM 12.3 Cost and e q u ity m ethods O n 1 July 2 0 1 4 , K okos Ltd a c q u ire d a 2 5 p e r c e n t in tere st in Pier Ltd fo r $ 2 2 0 0 0 0 in cash . K okos Ltd has n o o th e r investm ents. Extracts fro m Pier Ltd's fin a n c ia l statem ents fo r th e y e a rs e n d e d 3 0 June 2 0 1 5 a n d 3 0 June 2 0 1 6 a re as fo llo w s : 3 0 /6 /2 0 1 6
Net profit Dividends paid (30 March) 1
3 0 /6 /2 0 1 5
$
$
250000
180000
(15 000)
(15 000)
For th e y e a r e n d e d 3 0 June 2 0 1 5 , p re p a re th e jo u rn a l en trie s fo r K okos Ltd to a c c o u n t fo r its in ve stm en t in Pier Ltd u n d e r the:
2
3
a
c o st m e tho d
b
e q u ity m e tho d.
C a lc u la te th e pre se n t v a lu e in K okos Ltd's b a la n c e sheet fo r investm ent in Pier Ltd as a t 3 0 June 2 0 1 6 u n d e r the: a
c o st m e tho d
b
e q u ity m e tho d.
W h a t is m e a n t b y an in ve sting c o m p a n y h a v in g a s ig n ific a n t in flu e n c e o v e r an investee c o m p a n y ?
CHAPTER 12 Completing the balance sheet
483
PROBLEM 12.4 E q u ity m ethod Rosno G ro u p Lim ite d 's 2 0 1 6 b a la n c e sheet in clude s a lin e th a t show s th a t 'Investm e nts a c c o u n te d fo r using the e q u ity m e th o d in cre a s e d fro m $ 3 0 . 2 m to $ 3 3 .4 m '. 1 W h e re in th e b a la n c e sheet w o u ld this a m o u n t be sh o w n ? 2
In th e notes to th e a c co u n ts R osno s how s th e item s th a t in cre a s e a n d d e cre a s e this a c c o u n t. W h a t w o u ld be the m a in item th a t in c re a s e d th e b a la n c e a n d o n e th a t d e c re a s e d th e b a la n c e ?
3
If R osno h a d used th e cost m e th o d in ste a d o f th e e q u ity m e th o d w o u ld th e a c c o u n t investm ents a c c o u n te d fo r using th e e q u ity m e th o d be h ig h e r o r lo w e r?
PROBLEM 12.5 E q u ity basis o f acco u n tin g versus co nsolid ation In te rn a tio n a l Printers Ltd o w n s 4 5 p e r c e n t o f th e v o tin g shares o f N o m a d Printers Ltd. It a c q u ire d th e shares seve ral y e a rs a g o fo r $ 1 0 m illio n . N o m a d lost m o n e y fo r som e y e a rs a fte r a c q u is itio n , b u t has re c e n tly b e g u n to be p ro fita b le . S in ce In te rn a tio n a l a c q u ire d its sh a re s, N o m a d has h a d losses to ta llin g $ 7 9 0 0 0 0 a n d p ro fits to ta llin g $ 9 4 0 0 0 0 , fo r a to ta l net p ro fit since a c q u is itio n o f $ 1 5 0 0 0 0 . Last y e a r, N o m a d p a id its first d iv id e n d , $ 1 0 0 0 0 0 . 1
In te rn a tio n a l a c co u n ts fo r its in ve stm en t in N o m a d o n th e c o st b a sis. W h a t is th e pre se nt fig u re fo r investm ent in N o m a d on th e b a la n c e sheet o f In te rn a tio n a l?
2
In te rn a tio n a l presents statem ents using th e e q u ity m e th o d . W h a t do es this m e an? W h a t w o u ld be th e p re se nt fig u re fo r in ve stm en t in N o m a d on th e b a la n c e sheet o f In te rn a tio n a l using th e e q u ity m e tho d?
3
W h a t d iffe re n c e w o u ld it m a ke to th e b a la n c e sheet o f In te rn a tio n a l if th e N o m a d in ve stm en t w e re c o n s o lid a te d in ste a d o f using th e e q u ity m e tho d?
4
S u p p o se th a t In te rn a tio n a l h a d b o u g h t 6 5 p e r c e n t o f th e N o m a d v o tin g shares fo r its $ 1 0 m illio n a n d th a t, a t th a t d a te , th e fo llo w in g v a lu e s e x is te d fo r N o m a d : b o o k v a lu e o f assets, $1 8 m illio n ; sum o f fa ir v a lu e s o f assets, $ 1 9 m illio n ; b o o k v a lu e o f lia b ilitie s , $ 7 m illio n ; a n d sum o f fa ir v a lu e s o f lia b ilitie s , $ 1 0 m illio n . C a lc u la te the g o o d w ill th a t w o u ld h a ve been s h o w n o n th e c o n s o lid a te d b a la n c e sheet o f In te rn a tio n a l if th e N o m a d in ve stm en t h a d be en c o n s o lid a te d a t th a t d a te .
PROBLEM 12.6 Basic con so lid a te d figures Peach Fu rn itu re has d e c id e d to p u rch a s e 6 5 p e r c e n t o f B a n a n a A p p lia n c e s Ltd fo r $ 4 3 m illio n in cash . The tw o c o m p a n ie s ' b a la n c e sheets, as a t a c q u is itio n d a te , a re (in m illio n s o f d o lla rs ): Peach
Banana
Peach
Banana
$m
$m
$m
$m
Assets
Liabilities and equity
Cash equivalent assets
112
10
Cash equivalent liabilities
128
0
Other current assets
304
45
Other current liabilities
160
10
Noncurrent assets (net)
432
25
Noncurrent liabilities
272
15
Share capital
160
15
128
40
848
80
Retained profits 848
80
Peach Fu rn itu re has e v a lu a te d a ll o f B a n a n a 's assets a n d lia b ilitie s as h a v in g fa ir v a lu e e q u a l to b o o k v a lu e , e x c e p t fo r its n o n c u rre n t assets, w h ic h Peach F u rn itu re be lie ve s h a ve a fa ir v a lu e o f $ 3 3 m illio n . C a lc u la te th e c o n s o lid a te d g o o d w ill th a t w o u ld a p p e a r o n th e c o n s o lid a te d b a la n c e sheet a t a c q u is itio n d a te .
484
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 12.7 E xplanation o f consolid ated sta te m e n ts In 2 0 1 6 , P arent C o m p a n y a c q u ire d 8 0 p e r c e n t o f th e o u ts ta n d in g v o tin g shares o f S u b s id ia ry C o m p a n y , e s ta b lis h in g c o n tro l o v e r th e b o a rd o f d ire c to rs . P arent C o m p a n y used th e cost m e th o d o f a c c o u n tin g fo r the in ve stm en t d u rin g th e y e a r, b u t p re p a re d c o n s o lid a te d fin a n c ia l statem ents a t th e e n d o f th e y e a r. The c o n s o lid a te d fin a n c ia l statem ents a re su m m a rise d b e lo w : Parent
Subsidiary
Consolidated
$
$
$
Cash
14000
15 000
29 000
Accounts receivable
27000
24000
45 000
Inventory Property, plant and equipment Investments in Subsidiary Company
18 500
11500
30000
110000
80500
190500
92 000
-
-
Intangible assets
Current liabilities Noncurrent liabilities
-
-
5 200
261500
131 000
299700
37000
11500
42 500
5 000
3 000
8 000
Non-controlling interests Share capital Retained earnings
-
-
25 200
125000
75 000
125000
94500
41 500
99 000
261 500
131000
299700
110000
77000
167000
Cost of goods sold
70000
42500
96500
Operating expenses
22 000
21 500
43 500
Revenue
Non-controlling interest
-
-
4500
Net profit
18 000
13 000
22500
Retained earnings, beginning of year
89000
33 500
89000
Dividends
12 500
5 000
12 500
94500
41 500
99000
1
E x p la in th e m e a n in g o f th e a cco u n ts a p p e a rin g on th e c o n s o lid a te d b a la n c e sheet th a t d o n o t a p p e a r on e ith e r o f the u n c o n s o lid a te d b a la n c e sheets.
2
C e rta in a c co u n ts a n d am o u n ts fro m th e u n c o n s o lid a te d state m e nt d o no t a p p e a r o n th e c o n s o lid a te d statem ents. Id e n tify these a m o u n ts a n d a cco u n ts a n d e x p la in w h y th e y a re e lim in a te d in th e c o n s o lid a tio n .
3
A c co u n ts re c e iv a b le a n d a cco u n ts p a y a b le on th e u n c o n s o lid a te d state m e nt d o n o t to ta l to th e a m o u n t s h o w n on th e c o n s o lid a te d statem ents. W h a t is th e m ost lik e ly rea so n fo r this?
PROBLEM 12.8 Valuation o f investm ents The fo llo w in g shares w e re he ld b y R oxby Pty Ltd a t 3 0 June 2 0 1 6 . Share
Riley Ltd
M arket
Cost
$
$
115 000
110000
Blytheswood Ltd
80000
90000
Roland Ltd
15 000
45 000
210000
245000
Total
CHAPTER 12 Completing the balance sheet
1
P re p a re th e jo u rn a l e n try fo r 3 0 June 2 0 1 6 to re d u c e th e shares to th e lo w e r o f c o st o r net re a lis a b le v a lu e .
2
W h a t is th e re a s o n in g b e h in d this en try? H o w w o u ld it be re fle c te d in th e fin a n c ia l statem ents?
485
PROBLEM 12.9 Issue o f shares The fo llo w in g tra n s a c tio n s re la te to th e issue o f shares b y T in d a le Ltd. Date
Transaction
20 16 Feb. 1
The public was invited to make an application for 100 000 shares at $ 1.00 each, 20c per share being payable on application.
Feb. 28
Applications were received for 70 000 shares.
Mar. 15
The directors allotted 60000 shares and the successful applicants were advised that 30c per share was due on allotment.
Mar. 31
The balance due on allotment was received.
May 1
A first call of 25c per share was made.
May 31
$ 14 000 was received with respect to the first call.
R ecord th e a b o v e tra n s a c tio n s in th e a p p ro p ria te jo u rn a ls , a n d p re p a re a note to th e a c co u n ts s h o w in g th e c a p ita l structure a t 31 M a y 2 0 1 6 .
PROBLEM 12.10 O versubscriptions 1
P re p a re jo u rn a l en trie s fo r e a ch o f th e fo llo w in g tra n sa ctio n s: a b
XYZ Ltd issues 2 0 0 0 0 0 shares to an in s titu tio n a l in ve sto r o n 1 0 O c to b e r 2 0 1 6 fo r $ 2 .9 0 a share , In S ep tem be r 2 0 1 6 , A B C Ltd issued a prospectus o ffe rin g 5 0 0 0 0 0 shares a t $ 3 .0 0 p e r share , a ll p a y a b le a t the tim e o f a p p lic a tio n . O n 1 5 O c to b e r, $ 1 8 0 0 0 0 0 ha d been receive d, a n d the d ire cto rs a llo tte d the 5 0 0 0 0 0 shares to subscribers in p ro p o rtio n to th e ir a p p lic a tio n s a n d re fu n d e d the b a la n c e o f the a p p lic a tio n m onies,
c
A ssum e th a t in p a rt (b) $ 2 .0 0 w a s p a y a b le on a p p lic a tio n , $ 0 .5 0 o n a llo tm e n t a n d $ 0 .5 0 on c a ll, a n d th ere w a s no o v e rs u b s c rip tio n .
2
P repare the sh a re h o ld e rs' e q u ity section o f the b a la n c e sheet fo r A B C Ltd a fte r the tra nsa ction s in question 1, p a rt (c) h a ve o c c u rre d , a ssu m ing th a t re ta in e d p ro fits w e re $ 1 0 0 0 0 0 a n d th a t th e re w e re no o th e r reserves.
PROBLEM 12.11 S hareholders' e q u ity The s h a re h o ld e rs ' e q u ity s ection o f J o u rn a l Lim ited is re p ro d u c e d b e lo w .
Share capital
2016
20 15
$
$
1 400000
1 300000
Reserves
150000
200000
Retained profits
250000
350000
1800000
1850000
Total shareholders' equity 1
P ro v id e tw o p la u s ib le reasons fo r th e re d u c tio n in re ta in e d p ro fits b e tw e e n 2 0 1 5 a n d 2 0 1 6 .
2
List th re e e x a m p le s o f w h a t c o u ld be in c lu d e d in reserves.
3
G iv e p o ss ib le reasons fo r th e c h a n g e in s h a re c a p ita l.
4
The m a n a g e r o f J o u rn a l Lim ited is c o n te m p la tin g a bo nu s issue. W h a t im p a c t w o u ld a bo nu s issue ( $ 1 0 0 0 0 0 ) h a ve o n to ta l s h a re h o ld e rs ' e q u ity?
486
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 12.12 S hareholders' e q u ity R e p ro d u ce d b e lo w is th e s h a re h o ld e rs ' e q u ity section o f th e b a la n c e sheet o f Lo co m o tio n Lim ited. Consolidated
Parent
Note
2016 $
$
$
$
Share capital
23
314
298
314
298
Reserves
24
206
194
175
182
391
342
103
95
Retained profits Non-controlling interests
25
20 15
2016
20 15
13
12
-
-
924
846
592
575
1
B rie fly d e s c rib e w h a t in fo rm a tio n w o u ld be c o n ta in e d in no te 2 3 .
2
W h a t is th e d iffe re n c e b e tw e e n th e p a re n t a n d c o n s o lid a te d colum ns?
3
A p a rt fro m th e g e n e ra l reserve, list tw o o th e r c o m m o n reserves th a t m ig h t be s h o w n in note 2 4 .
4
W h a t m ig h t h a ve c a u s e d th e m o ve m e n t in re ta in e d p ro fits fro m 2 0 1 5 to 2 0 1 6?
5
W h a t a re n o n -c o n tro llin g interests? W h y m ig h t th e y h a ve in cre a s e d ?
PROBLEM 12.13 Reserves C o n s id e r th e fo llo w in g no te o n reserves in an a n n u a l re p o rt. Note 2 4 Reserves Consolidated entity
Parent entity
2016
20 15
2016
2015
$000
$0 00
$000
$0 00
Revaluation surplus
22 051
22 308
22 824
22 824
Foreign currency translation reserve
54536
(5 941)
76587
16 367
22 824
22 824
22 308
22 308
22 824
22 824
Composition
-
-
Movements Revaluation surplus Opening balance Transfer to retained profits Closing balance
(257) 22 051
22 308
22 824
22 824
Foreign currency translation reserve Opening balance Net exchange, differences on translation
(5 941) 64435
47758 (53 699)
-
-
_
_
-
-
of foreign controlled entities, net of hedge Transfer to retained profits Closing balance
(3 958) 54536
_ (5 941)
CHAPTER 12 Completing the balance sheet
1
H o w m uch o f th e $ 7 6 5 8 7 w o u ld be s h o w n on th e fa c e o f th e b a la n c e sheet?
2
C o u ld a bo nu s issue be m a d e o u t o f:
3
a
th e re v a lu a tio n surplus?
b
th e g e n e ra l reserve?
487
If th e c o m p a n y w a n te d to in cre a s e g e n e ra l reserves to $ 1 0 m illio n , w h a t jo u rn a l e n try w o u ld b e m a d e ?
PROBLEM 12.14 Share buyback The C F O o f X Lim ited is c o n c e rn e d th a t th e n e w in ve stm en t o p p o rtu n itie s a v a ila b le to th e firm p ro v id e a lo w e r a v e ra g e return th a n o th e r investm ents th e y p re se n tly h o ld . She is c o n s id e rin g th e p o s s ib ility o f a s h a re b u y b a c k . 1 W h a t is m e a n t b y a s h a re b u y b a c k ? 2
W h y d o c o m p a n ie s b u y b a c k th e ir o w n shares?
3
W h a t fa cto rs w o u ld im p a c t th e tim in g o f th e b u y b a c k ?
4
W h a t b a la n c e sheet a cco u n ts w o u ld be a ffe c te d b y th e b u y b a c k ?
5
Is p ro fit o r e a rn in g s p e r s h a re a ffe c te d b y th e s h a re b u y b a c k ?
PROBLEM 12.15 Explain th e na tu re o f certain reserves The note o n reserves is p ro v id e d b e lo w . E x p la in th e n a tu re o f e a ch o f th e reserves. Note 17 Reserves Consolidated
Company
2016
2015
2016
20 15
$000
$000
$000
$0 00
26 874
26494
23 896
23 896
Capital Balance at start of year Transfer from retained profits Balance at end of year
-
380
-
-
26 874
26 874
23 896
23 896
13337
13 337
13010
13010
31 188
31 704
157923
15 590
General Balance at start and end of year Asset revaluation Balance at start of year Increase (decrease) arising from revaluation of freehold land and buildings and investments Balance at end of year
—
(516)
(16700)
142333
31 188
31 188
141223
157923
Balance at start of year
6575
2 825
47
47
Translation adjustment on controlled foreign entities' financial statements
(1 197)
3 750
—
—
Balance at end of year
5 378
6575
47
Foreign currency translation
47
488
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 12.16 Issue o f shares, bonus issues and revaluations The a b rid g e d b a la n c e sheet o f B race Ltd, a t 3 0 June 2 0 1 6 , w a s as fo llo w s : BRACE LTD BALANCE SHEET AS AT 3 0 JUNE 20 16 $
$
Inventories
10000
Trade creditors
60000
Trade debtors
20000
Bank overdraft
40000
Plant
100000
Share capital (shares of $ 1)
200000
Freehold premises
270000
Retained profits
100000
400000
400000
Fifty th o u s a n d shares w e re issued to th e p u b lic a t $ 1 .5 0 p e r s h a re , w ith th e fu ll a m o u n t o f $ 1 .5 0 p e r sh a re b e in g p a y a b le on a p p lic a tio n . A p p lic a tio n s w e re re c e ive d fo r 8 0 0 0 0 shares, a n d a re fu n d w a s m a d e to th e unsuccessful a p p lic a n ts . The fre e h o ld prem ises w e re re v a lu e d a t $ 3 5 0 0 0 0 . The d ire c to rs re so lve d to m a ke a bonus issue o f o n e fu lly p a id sh a re a t a v a lu e o f $ 1 .5 0 fo r e v e ry five shares h e ld (in c lu d in g th e 5 0 0 0 0 re c e n tly issued). For this p u rp o se , it w a s d e c id e d th a t th e fu ll c re d it b a la n ce s in th e re v a lu a tio n s urplus a c co u n ts w o u ld b e used, a lo n g w ith a p o rtio n o f th e re ta in e d p ro fits a c co u n t. A s su m in g th a t no o th e r tra n s a c tio n s to o k p la c e , re c o rd th e a b o v e tra n s a c tio n s in th e jo u rn a l, p o st to th e le d g e r a n d p re p a re th e b a la n c e sheet.
PROBLEM 12.17 Prepare an incom e sta te m e n t and d etails o f sh areholders' e q u ity P ro v id e d b e lo w a re c e rta in b a la n ce s o f W e ld o n Ltd a t 3 0 June 2 0 1 6 . DR
CR
$
$
Share capital
125000
General reserve
18 000
Retained profits
25 000
Revaluation surplus
20000
Profit before tax Interim dividend (paid 31 January 2016)
22 000 5 600
A d d itio n a l in fo rm a tio n : 1 P ro v id e fo r ta x a tio n o n 2 0 1 6 p ro fits , $ 9 0 0 0 . 2
P ro v id e fo r a fin a l d iv id e n d th a t h a d be en d e c la re d a n d a p p ro v e d b e fo re re p o rtin g d a te , $ 2 8 0 0 .
3
T ra n sfe r $ 1 0 0 0 0 to g e n e ra l reserve.
C o m p le te th e in c o m e state m e nt a n d note o f re ta in e d p ro fits fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , a n d s h o w h o w the s h a re h o ld e rs ' e q u ity section w o u ld a p p e a r in th e b a la n c e sheet as a t 3 0 June 2 0 1 6 .
CHAPTER 12 Completing the balance sheet
489
PROBLEM 12.18 Prepare Financial sta te m e n ts O n 31 M a y 2 0 1 6 , th e fo llo w in g fig u re s w e re e x tra c te d fro m th e g e n e ra l le d g e r o f Leonora Ltd. DR
CR
$ Share capital
$ 156000
Retained profits
20000
Mortgage
27000
Plant Cash Goodwill Accounts receivable
200000 6100 15 000 7400
Accounts payable Prepayments
5 200 620
Accrued expenses
470
Accumulated depreciation
55 000
Inventory
84450
Government bonds
10000
General reserve Land
17900 100000
Profit before tax
142000 423570
423570
A d d itio n a l in fo rm a tio n : O n 31 M a y 2 0 1 6 , th e d ire c to rs o f Le on ora Ltd re so lve d to: a p ro v id e fo r e s tim a te d ta x lia b ility , $ 6 5 0 0 0 b
tra n sfe r $ 2 1 0 0 to g e n e ra l reserve
c
p ro p o s e a d iv id e n d a t th e ra te o f 5 p e r c e n t on s h a re c a p ita l.
R e q u ire d : 1
P re p a re an in co m e state m e nt a n d a no te o f re ta in e d p ro fits fo r th e y e a r e n d e d 31 M a y 2 0 1 6 .
2
P re p a re a b a la n c e sheet as a t 31 M a y 2 0 1 6 .
CASES
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 W h a t in fo rm a tio n d o e s W o o lw o rth s p ro v id e a b o u t its c o n s o lid a tio n p o lic ie s in its notes on s ig n ific a n t a c c o u n tin g p o lic ie s? 2
H o w a re investm ents v a lu e d ?
3
W h a t do e s g o o d w ill in th e b a la n c e sheet rep resent? H as g o o d w ill been im p a ire d d u rin g th e y e a r?
4
D oes W o o lw o rth s p ro v id e a n y e q u ity a c c o u n tin g in fo rm a tio n (see th e in c o m e statem ent, b a la n c e sheet a n d notes to th e a cco u n ts).
5
H o w m a n y shares w e re issued d u rin g th e y e a r?
6
W e re th e re a n y tra n sfe rs b e tw e e n g e n e ra l reserves a n d re ta in e d p ro fits d u rin g th e y e a r?
490
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 12B_______________________ Shareholders' equity and liabilities The s h a re h o ld e rs ' e q u ity s ection o f CSR L im ited 's 2 0 1 4 b a la n c e sheet is s h o w n b e lo w . CSR Ltd and its controlled entities
CSR Group Note
Net assets
2014
20 13
$m
$m
1 153.8
1 086.6
Equity Issued capital
23
1042.2
1042.2
Reserves
24
17.0
17.4
Retained profits
39.4
Equity attributable to shareholders
(24.8)
1 098.6
1 034.8
55.2
51.8
1 153.8
1 086.6
of CSR Limited Non-controlling interests
25
Total equity
Source: CSR Limited, Annual Report 2014. 1
W h a t w o u ld y o u e x p e c t to be in c lu d e d in notes 2 3 , 2 4 a n d 2 5 ?
2
E x p la in w h a t is m e a n t b y n o n -c o n tro llin g interests.
3
R eta in ed p ro fits h a ve in cre a s e d fro m $ (2 4 .8 ) m illio n to $ 3 9 .4 m illio n . W h a t item s w o u ld be used to re c o n c ile these tw o fig u re s?
4
W h a t do es n e g a tiv e re ta in e d p ro fits in d ic a te ?
COURSEMATE
WEBSITE RESOURCES
f C o u rs e M a te
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Revenue and expense recognition: additional concepts ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE distinguish betw een the terms 'in co m e' an d 'revenue' explain the criteria used to d e cid e w h ether revenue should be recognised explain the criteria used to d e cid e w h ether expenses should be recognised calculate the am ount of incom e a n d revenue that should be recognised in a particular period calculate the im pact on profit of different revenue recognition methods understand the contents o f a statem ent o f profit or loss a n d other com prehensive incom e interpret the disclosures of accounting policies on revenue and recognition provided in annual reports understand the contents o f a statem ent o f changes in equity.
CHAPTER OVERVIEW This c h a p te r discusses th e c o n c e p ts o f in c o m e a n d ex p e n s e s , in c lu d in g th e ir re c o g n itio n , in m o re d e ta il. In co m e in c lu d e s b o th reven ue s a n d g a in s ; h o w e v e r, th is c h a p te r c o n c e n tra te s o n re v e n u e re c o g n itio n . O rg a n is a tio n s m ust c h o o s e a n a p p ro p ria te p o in t a t w h ic h to re c o g n is e re ve n u e . S e v e ra l a lte rn a tiv e s a re a v a ila b le , a n d th is im p o rta n t d e c is io n is a t th e c o re o f th is c h a p te r. T h e c o n te n t o f in c o m e state m e nts a n d s tate m e nts o f c h a n g e s in e q u ity is a lso disc u s se d w ith in th e c h a p te r.
492
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
13.1
Revenues
Revenues are one form of incom e. The Fram ew ork defines incom e as 'increases in e co n o m ic benefits during the reporting period in the form of inflow s o r enhancem ents of assets o r decreases o f liabilities that result in increases in equity, other than those relating to contributions from equity participants'. N o doubt this definition looks pretty c o m p lica te d . Remember that not all revenue is as sim ple as selling a product for cash, and new forms of revenue are being created all the time. Thus a definition o f revenue that can handle many different situations is needed. So let's consider some o f the phrases in this d efinition. 'Inflow s o r enhancem ents of assets' includes receiving cash, receivables (a prom ise to p a y you at a later date) o r other g o o d s o r services (e.g. free advertising space) in e xch a n g e fo r g o o d s o r services that the selling c o m p a n y has p rovided. W h ile less com m on, incom e can result from the settlement o f liabilities. For exam ple, the selling c o m p a n y m ay pro vid e g o o d s o r services to another c o m p a n y it o w e d m oney to in settlement o f an o b lig a tio n to repay an outstanding loan; that is, by p roviding the g o o d s o r services it no longer has to repay the loan. Thus you can see that the recognition o f incom e occurs sim ultaneously w ith the recognition o f the increase in the asset o r the decrease in lia b ility. That is, you need to know w hen an asset o r lia b ility is recognised in ord e r to kn o w w hether incom e is recognised. A nother point a b o u t the definition is that there must be an increase in equity, other than those relating to contribution for shareholders (i.e. issue of shares is not revenue). A lso note that if equity is to increase, either assets increase or liabilities must decrease; that is, A — L = SE. W e w ill n o w consider five exam ples an d you can use the a b o v e discussion to d e c id e if they meet the definition of revenue. 1
A com pany sells a box of printer paper for $1 2 cash. There is an inflow of econom ic benefit (there is an increase in assets, cash); there is an increase in equity as the asset increases (SE = A - L) and therefore revenue can be recognised.
2 A w holesaler sells 1 0 0 0 boxes o f p a p e r for $ 8 0 0 0 on credit. There is an in flo w o f e conom ic benefit (there is an increase in assets, accounts receivable); there is an increase in equity as the asset increases (SE = A - L) and therefore there is revenue.
3 A painting c o m p a n y ow es the bank $ 2 0 0 0 0 , but because it has cash flo w problem s it has been having difficulty in repaying the am ount. The bank agrees to fo rg ive the d e b t in return for the c o m p a n y painting its head office. The c o m p a n y carries out the painting jo b . There is an in flo w o f e co n o m ic benefit (loan does not have to be pa id in the future); there is an increase in equity as a lia b ility decreases (SE = A - L) a nd therefore there is revenue.
4 A c o m p a n y borrow s $ 1 0 m illion from the bank. H ere there is no increase in equity as both assets an d liabilities increase by the same am ount (A - L = SE) an d therefore revenue is not recognised.
5 A c o m p a n y issues 1 0 0 0 0 shares at $ 8 to existing shareholders. W h ile equity increases (i.e. both assets and shareholder equity increases), this is a contribution from equity participants a nd is not included as revenue a cco rd in g to the definition of revenue. Furthermore, incom e encom passes both revenue an d gains. Revenue is incom e that arises during the course o f the o rd in a ry activities o f an entity; exam ples o f revenue include sales, fees, interest, divid e n d s, royalties a n d rent. G ains are incom e that arise from the disposal o f noncurrent assets o r from the revaluation o f current a nd noncurrent assets, such as m arketable securities a nd long-term investments, respectively. Thus, under the Fram ework, w hether incom e is revenue o r a g a in is a matter o f professional judgem ent that depends upon w hether the incom e arises 'in the course o f the o rd in a ry activities o f the entity'.
FOR YOUR INTEREST T h e S e c u ritie s and E x c h a n g e C o m m is s io n (S E C ) in th e U n ite d S ta te s re g u la rly re p o rts th e S E C ’s e n fo rc e m e n t a c tio n s th a t are based o n im p ro p e r is su e r fin a n c ia l re p o rtin g , fra u d , a u d it fa ilu re o r a u d ito r in d e p e n d e n c e v io la tio n s . H u n d re d s are c h a rg e d w ith fra u d in c o n n e c tio n w ith re p o rtin g v io la tio n s , m a n y o f w h ic h re s u lt in le n g th y ja il s e n te n c e s . T h e g re a te s t n u m b e r o f a c tio n s g e n e ra lly re la te to im p ro p e r re v e n u e re c o g n itio n .
CHAPTER 13 Revenue and expense recognition: additional concepts
13.2
493
Revenue recognition
Reliability versus decision relevance It can be said that p rofit over the life of an enterprise is easy to determ ine. A t the end o f the enterprise's life, all expenses have resulted in cash outflow s, an d all the revenue earned has resulted in cash inflow s. There is no need for estimates; the results are know n w ith certainty. Profit for the life o f the firm is sim ply the difference betw een the total cash contributed to the business by the ow ners a nd the total cash w ith d ra w n by the ow ners plus a n y cash rem aining at the end. The difficulty in reporting profit p e rio d ica lly - w h ich is h o w e co n o m ic decision-m akers require inform ation a bout the operations o f a firm - is that o f fin d in g a w a y to put the essentially continuous operations o f a firm into discrete time periods. The result is that profit determ ined earlier, so that it is relevant for evaluating the enterprise's perform ance over shorter decision periods, is u n a v o id a b ly subject to estimates an d judgem ents, because the w h o le story is never know n until the end, but no one w ants to w a it fo r the end. These judgem ents include w h a t proportion o f the revenue on a construction jo b o r a service agreem ent goes in this year; w h a t proportion o f rent p a id is an expense this ye a r versus an asset at the end of the ye a r (called prepayments); w h a t am ount of w a g e s has been earned this year, regardless o f w hether it has been p a id yet; an d over w h a t p eriod the equipm ent should be dep re cia te d . W e are b a ck to the ever-present trade-off betw een reliability an d relevance in profit measurement. If revenues and expenses are recognised earlier, so that they are m ore relevant for decision-m aking, they w ill not be as reliable as they w o u ld be if recognition w a s d e la ye d until later, w hen outcom es o f the various e conom ic activities are better know n. Figure 13.1 illustrates the trade-off.
Critical event sim plification If w e are to d escribe the firm 's operations for a given p eriod b y ca lculating the profit for that p e riod, w e must de fin e a means by w h ich w e can measure the am ount o f profit that can be attributed to that p e riod. W e accom plish this by: •
defin in g h o w much revenue can be recognised in that period
then •
determ ining the expenses that w e re incurred to generate the revenue. Profit - the value a d d e d by the activities o f the firm - is just the difference betw een the recognised revenue an d the
recognised expenses. But w h a t are the revenues, o r the expenses, for a p e rio d ? From an e conom ic a n d business point o f v ie w , profit is earned by a w id e variety of actions taken by the firm . There is a w h o le sequence o f activities that are intended to help generate profit. This process therefore generates revenue an d incurs expenses, including, for exam ple: •
org a n isin g the firm in the first place
•
buying o r building the premises
•
buying o r making inventory
494
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
•
advertising
•
receiving an order
•
selling the g o o d o r service
•
delivering to the customer
•
billing the customer
•
collecting cash
•
providing w a rra n ty service. H o w should w e recognise revenue w hen there is such a series o f activities as those listed a b o ve ? Should w e
recognise it a bit at a tim e as each activity is carried out? This w o u ld a p p ro xim a te the econom ic process underlying the business. This w o u ld be relevant, but by the same token it w o u ld be very subjective an d im precise, because it is difficult to say w h a t each activity actually adds. For exam ple, h o w d o you tell, w hen the c o m p a n y is just being organised, w h a t revenue that form o f o rganisation w ill help to generate? It w o u ld also be expensive to im plement, w ith armies of accountants scurrying a b o u t measuring minute value changes generated by the various activities and w ritin g masses of journal entries to recognise each value change. Instead, for greater o b je ctivity a n d ve rifia b ility an d lo w e r accounting costs, accountants usually choose one activity in the sort o f sequence a b o v e as the critical event in the revenue-generation sequence that can be readily docum ented, and recognise all o f the revenue at that point. This is a sim plification because, clearly, some revenue could have been recognised w hen e arlier activities w e re carried out, an d p ro b a b ly some should be recognised w hen later activities take place. For some com panies, such as those building big projects like p o w e r stations, pipelines, highw ays, tunnels an d bridges, it is w o rth w h ile estim ating revenue at several points a lo n g the w a y (see later discussion on percentage of completion methods), but for most the sim plification o f the critical event is fo llo w e d . The m o st c o m m o n c ritic a l e v e n t u s e d is the p o in t o f d e liv e ry o f the g o o d s o r services to the custom er.
It should be noted that sometimes quite a fe w of these events happen at the same tim e a nd delivery is very easy to determ ine. For exam ple, if you g o into a fast fo o d chain an d buy a burger an d drink, the order, sale, delivery, billing and cash received all are likely to happen together. If you g o to a different shop a nd buy some custom-made shirts, the sale occurs w hen you a re measured a n d ag ree to buy, w ith billing (being told 'it w ill cost you $ 1 0 0 ') and possibly cash p a id occurring a t the sam e time; delivery m ay be a w e e k later. Possibly o nly part o f the cash w ill be p a id on that d a y o f sale an d the rem ainder p a id later. N o w consider buying an a irlin e ticket from S ydney to M elb o u rn e . W h e n you g o online, the b illin g, sale an d paym ent (via credit card) w ill all happen in a very short period and then delivery o f the flig h t w ill occur later w hen the flig h t takes off. N o te that Q a n ta s refers to this as 'w hen passengers and freight a re uplifted'. It gets m ore c o m p lica te d if you buy an around-the-w orld ticket an d delivery occurs in stages. A t this point you can see that these events can ge t c o m p lica te d . C o n sid e r an Australian m ining c o m p a n y selling iron ore to a manufacturer in C h in a . The sale m ay occur in 2 0 1 6 w ith a g re e d delivery dates at a g re e d prices over the next three years. In this case, w h a t is m eant by delivery? Is it w hen the ore is taken out of the gro u n d , put into trucks, the trucks arrive at the Australian w h a rf, lo a d e d onto the ship, arrives at the C hinese w h a rf o r w hen it arrives at the C hinese factory? O n e w o u ld have to g o to the contract to d e c id e w h a t w a s considered delivery. Payments could be tied to delivery, they could be in a d va n ce , o r they could be after delivery (e.g. p a y a b le in 1 0 , 3 0 o r 6 0 days).
Criteria for revenue recognition Revenue recognition, then, becom es the first step in determ ining profit for the p e riod. The revenue recognition criteria discussed b e lo w have been form ulated for the purpose o f m aking sure that revenue w ill be recognised o n ly w hen there is o b jective e vidence that revenue has indeed been earned. The fo llo w in g four criteria must norm ally all be met in order for revenue to be recognised. For most firms, the a ctivity nearest to fitting these criteria is chosen as the critical event.
CHAPTER 13 Revenue and expense recognition: additional concepts
495
The key conditions for recognising revenue a re as follow s: 1
S ignificant risks an d rew ards o f o w n e rsh ip have been transferred to the buyer. This norm ally coincides w ith the transferring o f legal title (e.g. the contract betw een the Australian m iner an d the C hinese manufacturer could stipulate w hen o w nership changes hands, such as w hen the iron ore leaves the Australian port) o r the passing of possession to the buyer (e.g. the sales assistant passes you the product you bought, such as a burger, a pen o r a com puter). There are exam ples w hen the c o m p a n y retains significant risks o f ow n e rsh ip an d therefore revenue is not recognised. For exam ple: -
w hen the receipt o f the revenue is contingent on the buyer deriving certain revenue. O w n e rs o f shopping centres often ch a rg e the shops a fixed fee plus a percentage o f sales. Revenue related to the latter cannot nor m ally be recognised until the shop has m ade sales. This m ay be ascertained a t the end o f a p eriod - a month, a quarter o r a year.
-
w hen a sale includes both sh ip p in g an d installation an d the installation has not been com pleted. G en e ra lly, revenue is recognised here w hen substantially all o f the procedures have been p rovided, so a judgem ent is needed w hen this occurs. Is it w hen 1 0 0 per cent o f the services have been perform ed, o r 9 0 per cent or 8 0 per cent?
-
w hen buyers have the right to cancel a sale a n d the seller m ay be uncertain a b o u t the p ro b a b ility o f returns. For exam ple, a n e w ly established c o m p a n y m ay guarantee full refunds for a particular product for up to three months after the sale. In this case there is likely to be a lot of uncertainty a b o u t the p ro b a b ility of return, an d the recognition o f revenue (or part o f it) m ay be deferred to the end o f the three-month p e riod. O n the other hand, an established retailer such as M y e r or D avid Jones m ay have a refund p o licy w hen the customer is not satis fie d . In the latter case, revenue w o u ld be recognised at the tim e of sale if the retail store can re liably estim ate future returns a nd recognise a lia b ility (and related expenses) at that point for returns based on its previous experience. N o te a g a in the judgem ent involved in this situation.
2
The am ount o f revenue must be a b le to be re liably measured. For exam ple, a publishing c o m p a n y m ay publish a n e w b o o k an d w h ile it m ay have com pleted the production process the am ount o f revenue w ill not be know n as it depends on future sales. The author m ay have com pleted all o f their w o rk but a g a in revenue for the author cannot be reasonably m easured a t this point.
3
It is p ro b a b le that the econom ic benefits related to a transaction w ill flo w to the seller. This is norm ally the case an d a c o m p a n y does not usually sell to customers it believes w ill not pay. H ow ever, unusual circumstances such as w hether a foreign governm ent w ill g ive permission for the funds to be transferred m ay mean that the revenue recognition w ill be d e la ye d until this permission is given.
4
Expenses related to the earning o f the revenue can be re liably measured. A ccounting standards (e.g. AASB 1 8) suggest that revenues an d expenses that relate to the sam e transaction should be recognised simultaneously. This process is ca lle d m atching o f revenues a nd expenses. The basic idea is that expense accounts should be increased in the sam e accounting p eriod as the revenue (to w h ich the expense relates) w a s recognised. Examples o f such expenses are w a rra n ty expense a nd em ployee entitlements. The journal entry for these expenses is to d e b it the expense account an d credit the relevant lia b ility a ccount (e.g. provision for w a rra n ty, provision for em ployee entitlements). These types o f expenses can g e n e ra lly be re liably m easured based on past experience. H ow ever, w hen these expenses cannot be re liably measured, revenue cannot be recognised at this point. For recognition o f revenue from the rendering o f services there is the a d d itio n a l issue o f the stage o f com pletion of
the transaction at the end o f the accounting p e riod. For revenue to be recognised, it is necessary that the stage of com pletion can be re liably measured. Such measurement is usually d o n e in one o f the fo llo w in g three w ays: •
a survey o f the w o rk perform ed to da te
•
services perform ed as a percentage o f the total services perform ed
•
the proportion of the costs on the project incurred to d a te co m pared to the total costs to be incurred on the project. Both engineers an d accountants are likely to ge t involved in these estimates.
496
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
To deal w ith m any o f the a b o v e problem s, there a re several points in the revenue-earning process at w hich revenue is com m only recognised, though, as noted a b o ve , point o f sale or d e live ry is the most com m on. You'll see those points b elo w . To recognise the earning of revenue w hen the critical event has taken place, w e make the fo llo w in g recognition entry: DR
Cash or accounts receivable or unearned revenue liability
CR
XXXX
Revenue
XXXX
Let's take a closer look a t the four most com m only used methods o f revenue recognition, a nd a fifth, very conservative, method.
A T P O IN T O F SALE O R DELIVERY For most retail, service an d m anufacturing businesses, revenue is recognised w hen the product o r service is sold. 'S old' is usually defined as being w hen the g o o d s o r services have been shipped to the purchaser; that is, w hen legal title passes to the purchaser. •
A t that point, substantially all of the service has been perform ed, significant risks an d rew ards associated w ith o w nership have been transferred to the buyer, terms a n d price have been set, a nd cash has been received or there is an agreem ent to p a y it in the future (e.g. accounts receivable).
•
Even though there is some risk involved in extending credit, this can usually be a d e q u a te ly estim ated and deducted from the gross revenue by w a y o f the ba d debts expense account.
•
A nother risk at the point o f sale is the possibility of returns an d the likely service o b lig a tio n under the w arranties for the product o r service sold. A g a in , this can usually be a d e q u a te ly estim ated an d recognised as an expense o f the business and m atched aga in st the revenue of that period. Point of sale or delivery is such a com m on revenue recognition method that most com panies d o not mention in
their financial statements that they a re using it. You are expected to assume it is the method being used if you are not told otherw ise, as you p ro b a b ly w o u ld be if a n y o f the other four methods b e lo w w e re used.
D U R IN G P R O D U C T IO N Sometimes, the earnings process extends w e ll beyond one fin a n cia l p e riod, as is the case in bu ild in g construction, road building, ship building an d other lengthy processes. In such situations, if a firm w a ite d until the point o f delivery to recognise revenue, it m ight report no revenue for on e o r m ore years, then, w hen the project w a s com plete, report all the revenue. This w o u ld distort the perform ance picture o f the c o m p a n y for the duration o f the project: some years w ith no revenue, then one ye a r w ith huge revenue, even though the c o m p a n y w a s w o rkin g faithfully on the contract all a lo n g . There are not likely to be m any projects g o in g on a t o n ce (few , a n y w a y , in com parison to the num ber of sales m ade by a g ro ce ry retailer), a nd projects include enough docum entation that the value a d d e d can usually be estim ated a n d verified. Therefore, in an attem pt to pro vid e users w ith useful inform ation a nd reflect the econom ics of w h a t is h appenin g , revenue m ay be recognised during production. (This also means recognising expenses and, therefore, profit during production.) The percentage o f com pletion method is the most com m on w a y o f recognising revenue during production. This method entails determ ining w h a t proportion of the project has been com pleted during the y e a r a nd recognising that proportion of total expected revenue, expenses (costs) an d , therefore, profit. O ften this is d o n e by measuring the proportion o f expected total costs incurred during the period. In o rd e r to recognise revenue in this manner, total costs must be reasonably determ inable, the contract price (total revenue) must be reasonably certain a nd there must be reasonable assurance of paym ent. The frequent use o f the w o rd 're a so n a b le ' here shows that a lot of judgem ent is required in using this method! Let's assume G re e n w a y C onstruction had a large, three-year project w ith total revenue o f $ 4 m illion a nd total costs o f $ 3 .4 m illion. (Before expense recognition, project costs a re c h a rg e d to an inventory account for costs of
CHAPTER 13 Revenue and expense recognition: additional concepts
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construction in process. Like other inventories, this a ccount holds costs until they are expensed.) Total p rofit for the project over the three years w a s, therefore, $ 6 0 0 0 0 0 . The project w a s 2 0 per cent com pleted at the end o f the first year, 6 5 per cent com pleted at the end o f the second ye a r a nd 1 0 0 per cent com pleted at the end o f the third year. Ignoring com plications that arise w hen revenues an d costs d o not w o rk out as expected, here are journal entries to im plem ent the percentage o f com pletion revenue (and m atched expense) recognition during production. (For presentation purposes, all am ounts are in thousands o f dollars.)
Percentage of contract done in the year
Year 1
Year 2
20%
45%
35%
$000
$000
$000
Year 3
Revenue recognition: DR CR
Accounts receivable
800
Revenue
1 800 800
1 400 1 800
1 400
P e rc e n ta g e e a rn e d e a c h y e a r
Expense recognition: DR CR
Cost of goods sold expense
680
Construction in process inventory
1 530 680
1 190 1 530
1 190
P e rc e n ta g e o f e x p e n s e s e a c h y e a r R e s u ltin g p r o f it e a c h y e a r
120
270
210
You can see the tim ing effect o f accrual accounting here. The annual entries have the effect o f sp reading the $ 6 0 0 0 0 0 project profit out over the three years: 2 0 per cent to the first year, 4 5 per cent to the second an d 3 5 per cent to the third.
O N C O M P L E T IO N O F P R O D U C T IO N In the percentage of com pletion method, revenue is recognised as the w o rk proceeds. It is also possible to w a it until the w o rk is all d o n e a nd recognise the revenue then. This is like the point-of-sale method, except that if the w o rk took a long time, perhaps several accounting periods, then it is very conservative, because no revenue w o u ld be recognised for a long time, then all o f it at once. In the G re e n w a y Construction exam ple a b o ve , if revenue, a n d the associated expenses, w e re recognised on com pletion o f the production, the project profit w o u ld be: •
$ 0 in ye a r 1
•
$ 0 in ye a r 2
•
$ 6 0 0 0 0 0 in ye a r 3.
•
$ 1 2 0 0 0 0 lo w e r in ye a r 1
•
$ 2 7 0 0 0 0 lo w e r in ye a r 2
C o m p a re d to the percentage o f com pletion method, profit w o u ld be:
•
$ 3 9 0 0 0 0 h ig h e r in ye a r 3 ( $ 6 0 0 0 0 0 — $ 2 1 0 0 0 0 ) . Therefore, if the c o m p a n y w a n te d to kn o w w h a t w o u ld happen ('w h a t if') if it c h a n g ed to the com pletion of
production (or com pleted contract) method, there is the answ er, ignoring incom e tax. N o te that if a c o m p a n y has a reasonably large num ber o f construction contracts (say 2 5 construction sites g o in g at once) an d an a p p ro xim a te ly equal num ber of projects a re com pleted each year, it is possible that the percentage o f com pletion an d com pleted contract methods w o u ld g ive sim ilar profits.
W H E N C A S H IS RECEIVED If there is serious d o u b t as to the co lle cta b ility o f cash from a revenue-generating transaction, revenue recognition is d e laye d until the collection has actu a lly taken place. This does not mean that a n y tim e a business extends credit to a customer, revenue recognition is d e la ye d ; this is o n ly the case w hen the risk is gre a t a n d the am ount to be collected cannot be reasonably determ ined, o r is not sufficiently p redictable.
498
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
For exam ple, certain real estate transactions that a re speculative in nature a n d /o r for w h ich the collection o f cash is contingent upon some future condition (such as the purchasers o f a shopping centre successfully leasing a certain percentage o f the space) w ill not be recognised as revenue until the cash is received. A nother exam ple of revenue recognition at time o f collection is the instalment sales method. W h e n the m ajority of the revenue w ill com e in over a long series o f instalments, a nd there is substantial uncertainty that a given customer w ill actually make all the payments, the revenue is recognised in stages as the cash comes in. The instalment sales method has some com plexities, but in p rin ciple it is just a w a y o f recognising revenue on a cash-received basis.
A T S O M E P O IN T AFTER C A S H H A S BEEN RECEIVED The first, second an d third revenue recognition methods a b o v e use accrual a ccounting, w h ile method 4 uses the cash basis for recognising revenue. It is also possible to defer recognition for some tim e after the cash has been collected. Even though cash has been received, all revenue m ay not be recognised im m ediately because o f a particular circum stance, such as a guaranteed dep o sit refund p o lic y o r a p o lic y o f 'satisfaction guaranteed o r m oney back'. A current lia b ility account (unearned revenue) is credited w hen the cash is collected: DR
Cash
CR
Unearned revenue or deposits received liability
Revenue w ill be recognised a t a point in the future, norm ally after the refund tim e has expired o r the required after delivery service has been perform ed: DR
Unearned revenue or deposits received liability
CR
Revenue
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: In 2 0 1 6 , F lim s y C o n s tr u c tio n L td has re c o g n is e d 3 8 p e r c e n t o f th e to ta l e x p e c te d re v e n u e fr o m a c o n t r a c t t o b u ild a h o u s e e x te n s io n . T h e to ta l c o n t r a c t p ric e is $ 4 3 0 0 0 , and F lim s y e x p e c ts its c o s ts f o r th e c o n t r a c t t o be $ 2 9 5 0 0 . C o s ts so fa r ha ve b e e n in line w ith e x p e c ta tio n s . H o w m u c h c o n t r a c t e x p e n s e s h o u ld F lim s y re c o g n is e f o r 2 0 1 6 an d w h a t w o u ld th e re s u ltin g c o n t r a c t p r o fit be f o r 2 0 1 6 ? Y o u r a n s w e r s h o u ld be : $11 2 1 0 ; $ 5 1 3 0 .
Example of revenue recognition Leighton H oldings Limited is a large Australian c o m p a n y that is involved in long-term contracts. The relevant note from its 2 0 1 4 accounts is as follow s: L E IG H T O N H O L D IN G S R E V E N U E R E C O G N IT IO N R e v e n u e f r o m c o n s tr u c tio n c o n t r a c tin g s e rv ic e s is re c o g n is e d u s in g th e p e rc e n ta g e c o m p le te m e th o d . S ta g e o f c o m p le tio n is m e a s u re d b y re fe re n c e t o c o s ts in c u rr e d t o d a te as a p e rc e n ta g e o f e s tim a te d to ta l c o s ts f o r e a c h c o n t r a c t. W h e r e th e p r o je c t re s u lt c a n be re lia b ly e s tim a te d , c o n t r a c t re v e n u e a n d e x p e n s e s a re re c o g n is e d in th e in c o m e s ta te m e n t as in c u rr e d . W h e r e th e p r o je c t re s u lt c a n n o t be re lia b ly e s tim a te d , p r o fits a re d e fe rre d a n d th e d iffe r e n c e b e tw e e n re v e n u e a n d e x p e n s e s is c a rrie d fo rw a rd as e ith e r a c o n t r a c t re c e iv a b le o r c o n t r a c t p a ya b le . O n c e th e c o n t r a c t re s u lt c a n be re lia b ly e s tim a te d , th e p r o f it e a rn e d t o t h a t p o in t is re c o g n is e d im m e d ia te ly . Source: Leighton Holdings Limited.
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Som e key points in the a b o v e disclosure by Leighton H oldings are: it uses the percentage o f com pletion basis on construction contracts; percentage o f com pletion is based on costs incurred to d a te co m p a red to the total estim ated costs o f the project; a n d revenue a nd expenses are o n ly recognised w hen they can be re liably measured. N o te that this is often difficu lt in the construction industry. For exam ple, total expenses for the w h o le project m ay be difficult to determ ine due to uncertainty. (For exam ple, h o w hard is the rock to be d rilled through? W h a t w ill be the total of restoration costs?).
FOR YOUR INTEREST M a n y s tu d ie s , p a rtic u la rly in th e U n ite d S ta te s , ha ve n o te d th e p re v a le n c e o f im p ro p e r re v e n u e re c o g n itio n . S o m e e x a m p le s in c lu d e : • •
h o ld in g b o o k s o p e n a fte r th e c lo s e o f a r e p o rtin g p e rio d (s u c h as h o ld in g th e m o p e n f o r an e x tra fiv e d a ys ) b ill and h o ld (e .g . p ro v id in g in c e n tiv e s to c u s to m e rs to w rite p u rc h a s e o rd e rs b e fo re th e c u s to m e r ne ed s th e g o o d s , an d th e n h o ld in g th e g o o d s u n til th e c u s to m e r re q u e s ts d e liv e ry )
•
re c o g n is in g all th e re v e n u e re la te d to th e c o n t r a c t u p f r o n t a t th e tim e o f sale, e ve n th o u g h th e r e w e re
•
fic titio u s re v e n u e (e .g . m a k in g fr a u d u le n t a d ju s tm e n ts to sales n u m b e rs ).
‘m u ltip le e le m e n t de als w h e re s ig n ific a n t fu tu r e s e rv ic e s o r fu tu r e p ro d u c ts w e re to be d e liv e re d la te r’
S O M E SPECIFIC EXAMPLES H ere are some exam ples of revenue recognition o f organisations you m ay be a w a re of. For each situation, state w hether revenue w o u ld be recognised in D ecem ber 2 0 1 6 . 1
In D ecem ber 2 0 1 6 you d ro p into M c D o n a ld 's on the w a y hom e from university an d buy dinner; the cost is $ 1 0 .1 4 . M c D o n a ld 's w o u ld recognise revenue on the d a te you visited for $ 1 0 .1 4 .
2 You buy a n ew M a z d a 3 from your local d e a le r in N o ve m b e r 2 0 1 6 , p a y a $ 2 0 0 0 dep o sit a nd the ca r is delivered on 7 D ecem ber. The total cost is $ 2 7 8 0 0 . O n the d a y o f delivery revenue o f $ 2 7 8 0 0 w o u ld be recognised.
3 Assume the C ricket W o rld C u p is to be held around Australian cities across N o ve m b e r-D e c e m b e r 2 0 1 6 . All tickets are sold out in June 2 0 1 5 . Revenue for each g a m e w o u ld likely be recognised on the d a y the g a m e is com pleted. The revenue for each g a m e is the num ber o f tickets sold times the price of those tickets.
4 You d e c id e to visit friends on the G o ld C o a st from 21 D ecem ber 2 0 1 6 to 4 January 2 0 1 7 . You buy your G antas ticket in Septem ber fo r $ 2 4 0 ($ 1 2 0 each w a y) an d c h a rg e it to your credit card. A irlines g enerally recognise revenue at the tim e o f takeoff, so $ 1 2 0 w o u ld be recognised on 21 D ecem ber and $1 2 0 on 7 J a n u ary.
5 Y our university offers summer classes for $ 3 0 0 0 per subject a nd you have enrolled in the subject 'A d va n ced A cc o u n tin g ', w h ich consists o f 1 2 three-hour classes. Four classes each are held in D ecem ber, January and February. You p a y the fees in Decem ber. The university w o u ld recognise 4/ i 2 o f $ 3 0 0 0 (i.e. $ 1 0 0 0 ) in D ecem ber as this represents the percentage of the service it has provided.
6 Fairfax M e d ia has a p o p u la r co o king m a g a zin e w ith 12 issues per year. During D ecem ber 2 0 1 6 it receives $ 3 7 2 0 0 0 in subscriptions. The m a g a zin e w ill be sent to the subscribers on the first d a y o f each month for the 1 2 months in 2 0 1 7 . There is nil revenue in 2 0 1 6 , w ith 1/ i 2 each month in 2 0 1 7 .
500
7
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A N Z Stadium in S ydney has a large num ber o f members w h o p a y a ye a rly subscription a nd in return have access to the rugby league (e.g. State o f O rig in ), rugby union (e.g. Bledisloe C up), soccer (internationals) a nd T w e n ty2 0 cricket. If the annual m em bership fee is p a id in D ecem ber 2 0 1 6 , on w h a t basis w ill the organisation recognise revenue throughout 2 0 1 7 ? The most likely revenue recognition w ill be 1/ i 2 per month. There are other possibilities including recognising a percentage of the revenue on the com pletion o f each event. This becom es m ore com plex because o f differences in prices o f tickets betw een events.
M easurem ent of revenue Revenue is measured at the fa ir value o f the consideration received o r receivable. H ere fa ir value is the am ount that the asset could be e xchanged betw een kn o w le d g e a b le , w illin g parties in an arm 's length transaction (AASB 1 1 8); that is, the am ount a g reed betw een the buyer a nd the seller. In m any cases this am ount is determ ined by the seller (e.g. fast fo o d chain, gro ce ry shop or petrol station) an d the buyer has a ch o ice . In other cases there w ill be some negotiation; for exam ple, buying a ca r o r a house. If there are a n y trade discounts given, the revenue is recorded net o f those discounts. For exam ple, if the list price o f a television is $ 1 0 0 0 but the retail store sells it for $ 9 0 0 , it is the $ 9 0 0 that is recorded as revenue. Sim ilarly, if bulk discounts a re given, it is the discounted price that is recorded. If a shirt sells for $ 5 0 but if you buy tw o the price per shirt is $ 3 5 , in this case sales revenue is $ 3 5 x 2 = $ 7 0 .
FOR YOUR INTEREST I f a c o m p a n y sells a p r o d u c t f o r $ 1 0 0 b u t also p ro v id e s c e rta in c u s to m e rs w ith d is c o u n t c o u p o n s o f 15 p e r c e n t, th e c o m p a n y s h o u ld re c o g n is e re v e n u e o f $ 8 5 . It s h o u ld also be n o te d th a t re v e n u e o n ly in c lu d e s th e g ro s s in flo w s re c e iv e d o r re c e iv a b le b y th e e n tit y on its o w n a c c o u n t; th a t is, i f it c o lle c ts a m o u n ts o n b e h a lf o f th ir d p a rtie s (e .g . G S T ), th e y are n o t re v e n u e . A ls o i f an e n tit y is in an a g e n c y re la tio n s h ip w h e re it c o lle c ts a m o u n ts on b e h a lf o f a p rin c ip a l (e .g . tra v e l a g e n ts on b e h a lf o f an a irlin e ), re v e n u e w o u ld be th e a m o u n t o f th e c o m m is s io n , n o t th e to ta l a irfa re .
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: W h e n y o u g o in to an A u s tra lia P o s t s h o p y o u m a y n o tic e o n th e w all th a t y o u c an pa y c e rta in b ills th e re ; f o r e x a m p le , e le c tr ic ity , w a te r o r o t h e r u tilitie s . T h a t is, A u s tra lia P o s t c o lle c ts th e p a y m e n t o n b e h a lf o f a n o th e r c o m p a n y . 1
H o w m u c h re v e n u e d o e s A u s tra lia P o s t re c o g n is e i f it c o lle c ts th e cash f o r a $ 1 0 0 in v o ic e f o r E n e rg y L td an d k e e p s 1 p e r c e n t?
2
H o w m u c h d o e s E n e rg y L td re c o g n is e as re v e n u e ? Y o u r a n sw e rs s h o u ld be:
1 1 p e r c e n t o f $ 1 0 0 = $1; th a t is, re v e n u e o n ly in c lu d e s g ro s s in flo w s re c e iv e d b y th e e n tit y o n its o w n b e h a lf, n o t a m o u n ts c o lle c te d o n b e h a lf o f th ir d p a rtie s. 2
T h e re v e n u e is $ 1 0 0 an d $1 w o u ld be c o lle c tio n e x p e n s e s . N o te th a t th is give s a p r o fit o f $ 9 9 . I f th e c o m p a n y o n ly re c o rd e d $ 9 9 as re v e n u e an d n o e x p e n s e , p r o fit w o u ld be th e s a m e b u t n o te th a t it do e s im p a c t v a rio u s ra tio s ( to be d isc u s se d in m o re d e ta il in C h a p te r 15 ).
CHAPTER 13 Revenue and expense recognition: additional concepts
13.3
501
The expenses concept: the Framework
The Fram ew ork states that 'expenses are decreases in e co n o m ic benefits during the accounting period in the form of outflow s o r depletions o f assets o r incurrences o f liabilities that result in decreases in equity, other than those relating to distributions to equity participants'. This definition o f expenses encom passes losses as w e ll as expenses arising in the course o f the o rd in a ry activities o f the entity. Expenses arising during the course o f the o rd in a ry activities o f the business represent e co n o m ic benefits that are consum ed during the current accounting p e riod, such as w hen p re p a id insurance an d stationery supplies are used. In a d d itio n , there w ill be an o u tflo w o f future econom ic benefits in a future accounting p eriod as a result o f incurring a lia b ility for electricity in the current accounting p e riod. Som e other expenses are w a g e s an d salaries, d e p re cia tion, cost of g o o d s sold, rent an d interest. N o te that fo r all o f the expenses listed a b o v e there w ill either be a decrease in an asset (cash, inventory, equipm ent, prepaym ents, supplies asset etc.) o r an increase in a lia b ility (salaries pa ya ble, interest p a y a b le etc.). This means, in effect, that recognition of expenses occurs simultaneously w ith the recognition of an increase in liabilities o r a decrease in assets. Examples include the accrual o f em ployee entitlements o r the depre cia tio n o f equipm ent. Examples of losses include losses from disasters such as fire an d flo o d , as w e ll as those arising from the disposal o f noncurrent assets. The definition o f expenses also includes unrealised losses; for exam ple, those arising from the effects o f inventory value fa llin g b e lo w cost. W h e n losses are recognised in the incom e statement, they are usually disp la ye d separately because kn o w le d g e o f them is useful for m aking e co n o m ic decisions. A cc o rd in g to the Fram ework, an expense should be recognised w h e n , a n d o n ly w hen: •
it is p ro b a b le that the consum ption o r loss o f future e conom ic benefits resulting in a reduction in assets a n d /o r an increase in liabilities has occurred
•
the consum ption o r loss o f future e conom ic benefits can be measured reliably. M o s t expenses result from the production or delivery o f g o o d s a nd services during the accounting p e riod, a nd the
large m ajority of these involve little o r no uncertainty that e conom ic benefits have been consum ed; for exam ple, cost o f g o o d s sold, cost o f e m ployee services, a n d supplies a nd equipm ent used. Flow ever, in some cases there w ill be uncertainty. For exam ple, it m ay be difficult to determ ine w h e th e r the future econom ic benefits e m b o d ie d in noncurrent assets have suffered com m ercial im pairm ent (in a d d itio n to physical w e a r a nd tear) during the reporting period. In a d d itio n , g e n e ra lly the consum ption o r loss o f econom ic benefits w ill be c a p a b le o f being measured w ith a high d e g re e o f reliability. Flow ever, in some cases this measurement w ill be subject to estimates (such as future w a rra n ty claims). In such cases, w hether an item w o u ld q u a lify as an expense depends on w hether the estimates can be m ade reliably. In general, estimates such as w arranties, long service leave, doubtful debts an d so on can be m ade re liably based on past experience, an d a re therefore recognised as expenses. Flow ever, some provisions (for exam ple, product lia b ility claims) can be subject to a high level o f uncertainty. If they are c a p a b le o f reliable measurement, they should be included on the b a la n ce sheet as a liability. The Fram ew ork also notes that 'expenses are recognised in the incom e statement on the basis o f a direct association betw een the costs incurred a nd the earning o f specific items o f incom e. This process, com m only referred to as the m atching of costs w ith revenues, involves the simultaneous o r com bined recognition o f revenues and expenses that result directly an d jointly from the sam e transactions o r other events.' An exam ple is cost o f g o o d s sold, w h ich is g enerally recognised at the time o f sale of the item. That is, w e recognise inventory as an asset w hen it is purchased an d then later it is treated as an expense w hen the inventory is sold. For exam ple, if 1 0 0 items that cost $ 1 0 each are sold on credit for $ 1 3 the journal entry you learnt in C h a p te r 3 w a s: DR
Accounts receivable
CR
Sales revenue
DR CR
Cost of goods sold Inventory
1 300 1 300 1 000 1 000
502
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Let's a p p ly the Fram ew ork rules to a series o f transactions to determ ine if they should be recognised as an expense: 1
W a g e s are p a id to an em ployee (these w a g e s have not previously been recorded as a liability): econom ic benefits are consum ed; there is a decrease in an asset, cash; therefore there is a decrease in equity (SE = A - L); an expense is recognised.
2 W a g e s are o w e d to an em ployee for w o rk d o n e during the p e riod: e co n o m ic benefits have been consum ed; there is an increase in liabilities, w a g e s p a ya b le ; therefore there is a decrease in equity (SE = A - L); an expense is recognised.
3 W a g e s p a y a b le from the previous ye a r are p a id during the year: an asset decreases (cash) a nd a lia b ility decreases (w ages p a yable); therefore there is no ch a n g e in equity (SE = A - L); no expense is recognised.
4
Purchase o f a m achine for cash: there is a consum ption o f econom ic benefit; one asset (cash) decreases and another asset (equipment) increases; there is no ch a n g e in equity (SE = A - L); no expense is recognised.
5 A t the start o f the ye a r the b a la n ce in p re p a id rent am ounts to $1 2 0 0 0 a nd covers the p eriod from 1 July 2 0 1 6 to 31 July 2 0 1 6 . Is there an expense on 31 July? Econom ic resources have been consum ed in July; assets (prepayments) decrease a nd therefore equity decreases (SE = A - L); there is an expense o f $ 1 0 0 0 recognised.
FOR YOUR INTEREST F a ilu re to re c o rd e x p e n s e s c a n ha ve s e rio u s c o n s e q u e n c e s . T h e m o s t p r o m in e n t e x a m p le o f a c o m p a n y im p ro p e rly c a p ita lis in g (i.e . m a k in g an e x p e n d itu re an a s se t) in v o lv e d W o r ld C o m in th e U n ite d S ta te s in th e e a rly 2 0 0 0 s , w h ic h
o v e rs ta te d
p r o fit b y a p p ro x im a te ly $ 9
b illio n . T h is w as a lle g e d ly a c c o m p lis h e d
by
im p ro p e rly re d u c in g its o p e ra tin g e x p e n s e s b y tr e a tin g th e m as c a p ita l asse ts; th a t is, tr e a tin g th e m as an asse t and a m o rtis in g th e a s se t o v e r tim e . A s a re s u lt, th e c o m p a n y m a te ria lly u n d e rs ta te d e x p e n s e s an d o v e rs ta te d p r o fits in o r d e r to m e e t a n a ly s ts ’ fo re c a s ts .
13.4 Statem ent of profit or loss and other comprehensive income In A ustralia, under AASB 101 (pa ra g ra p h 8 1 ), the nam e o f the key statement in published fin a n cia l statements providing inform ation on a com pany's fin a n cia l perform ance is the statement o f profit o r loss an d other com prehensive incom e (also known as the statement o f com prehensive incom e). C om m only, you w ill see com panies present tw o statements, the first o f w h ich uses the fa m ilia r title o f incom e statement to present profit o r loss inform ation as w ell as a separate statement o f other com prehensive incom e. Exhibits 1 3.1 an d 1 3 .2 sh o w h o w Fairfax M e d ia presents its financia l perform ance inform ation as tw o separate statements. C om prehensive incom e is d e fined as the c h a n g e in equity during the period other than changes associated w ith transactions w ith ow ners in their c a p a c ity as ow ners. C om prehensive incom e is broken d o w n into profit o r loss and other com prehensive incom e. O th e r com prehensive incom e is not very helpfully defined in AASB 101 (pa ra g ra p h 7) as items o f incom e a nd expense that a re not required o r perm itted to be recognised in profit o r loss. Fortunately, some exam ples assist us to understand this d efinition. Items that w o u ld be included in other com prehensive incom e are changes in the revaluation surplus (due to revaluation o f property, plant a nd equipm ent o r in ta n g ib le assets; see C h a p te r 10); remeasurement o f d e fined benefit plans for corporate-sponsored superannuation funds; gains an d losses on translation of foreign fin a n cia l statements; an d a num ber o f co m p le x issues related to the a p p lic a tio n o f fa ir values o f financial instruments (fair value w a s discussed in C h a p te r 6). You can see some o f these in the Fairfax 2 0 1 4 Statement of C om prehensive Incom e presented in Exhibit 1 3 .1 . You m ay also be pleased that w e w o n 't be covering these in detail here but rather in later accounting courses.
CHAPTER 13 Revenue and expense recognition: additional concepts
EXHIBIT 13.1
503
FAIRFAX MEDIA LIMITED C O N SO LIDATED S TA T E M E N T OF C O M PR EH EN SIVE INCOM E FOR TH E PERIOD ENDED 2 9 JUNE 2 0 1 4
CONSOLIDATED Note
2 9 June 2 0 1 4
3 0 June 2 0 1 3
$ '0 0 0
$ '0 0 0
225168
(971)
Net profit/(loss) after income tax expense
Other comprehensive income Items that may be reclassified to profit or loss:
70 7
Changes in fair value of available for sale financial assets
511
Changes in fair value of cash flow hedges Changes in value of net investment hedges Exchange differences on translation of foreign operations Income tax relating to these items
296
6
3407
(11 23 1)
(18431)
22 45 1
28 033
3387
4532
518
2 353
Items that will not be reclassified to profit or loss: Actuarial gain on defined benefit plans Income tax relating to these items
(149)
6
Other comprehensive income for the period, net of tax Total comprehensive income for the period
(702)
16194
19488
241 362
1 8517
736
15461
Total comprehensive income is attributable to: Non-controlling interest Owners of the parent
240626
3 056
241 362
1 8517
Source: Fairfax M ed ici Limited,
A n n u a l R eport 2 0 1 4 .
The fo llo w in g is required to be included in the statement o f profit o r loss a nd other com prehensive incom e disclosures under AASB 1 0 1 : 1
revenues
2 expenses 3
fin a n ce costs
4
gains an d loss related to reclassification o r d e recognition o f fin a n cia l assets
5
shares o f net profits o r losses o f associates an d joint ventures accounted for using the equity method (discussed in C h a p te r 1 2)
6 incom e tax expense 7
discontinued operations (AASB 5)
8
profit o r loss
9
profit o r loss attributable to non-controlling interests a nd ow ners o f the parent
10 com prehensive incom e attributable to non-controlling interests an d ow ners o f the parent 11 total other com prehensive incom e 12 com prehensive incom e for the p e riod, being the total profit o r loss a nd other com prehensive incom e. Som e further explanations o f the terms a b o v e are n o w given: •
For m aterial incom e o r expense items, the nature an d the am ount should be separately disclosed. Examples include inventory o r property, plant an d equipm ent w rite-dow ns, restructuring costs, disposals of property, plant an d equipm ent o r investments, discontinued operations o r litigation settlements.
504
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The equity method refers to the situation in w h ich an investing c o m p a n y has sig n ifica n t influence over, but not control of, an investee c o m p a n y (an investee c o m p a n y is c a lle d an associate c o m p a n y o f the investor). Using the equity method, the investing c o m p a n y includes, in its incom e statement, its share o f earnings of the investee com pany, because it is in a position to significantly influence that com pany's perform ance (refer to C h a p te r 1 2).
•
O utside equity interests in net profit is a deduction from profit. It is an am ount reflecting the share of profit, earned by consolidated com panies, that is attributed to ow ners other than the parent co m p a n y. For exam ple, if CSR ow ns 8 0 per cent o f a co m p a n y, 1 0 0 per cent o f the incom e a nd expenses a re included in the consolidated figures, but 2 0 per cent o f that com pany's net profit is deducted as an outside equity interest, so that consolidated net profit only includes CSR's 8 0 per cent share. As illustrative exam ples, w e have in Exhibits 1 3 .2 a nd 1 3 .3 the incom e statements for both Fairfax M e d ia Limited
and Q antas. N o te the fo llo w in g sim ilarities an d differences (numbers refer to the numbers at the left side o f each financial statement): 1
Both statements are labelled 'Incom e Statement for the ye a r ended 2 9 / 3 0 June 2 0 1 4 '.
2
Both show columns for the consolidated g ro u p (Q antas refers to this as the Q a n ta s G ro u p ); that is, the co m p a n y and the entities it controls com b in e d .
3
Q antas figures a re in m illions, w h ile Fairfax figures are in thousands.
4
Both show revenue (Fairfax $1 9 8 7 .6 m illion; Q a n ta s $ 1 5 3 5 2 million). Both d iv id e up the revenue on the fa ce of the incom e statement. Som e other com panies d o it in the notes.
EXHIBIT 13.2 1
FAIRFAX MEDIA LIMITED CO N SO LID A TED INCOM E S T A T E M E N T FOR TH E PERIOD ENDED 2 9 JUNE 2 0 1 4
2
CONSOLIDATED Note
3
2 9 June 2 0 1 4
3 0 June 2 0 1 3
$000
$000
Continuing operations Revenue from operations
2(A)
1856762
2010488
Other revenue and income
2(B)
130806
34902
1987568
2 045 390
4
Total revenue and income
5
Share of net profits/jlosses) of associates and joint ventures
6
12(C)
8007
(2 239)
Expenses from operations excluding impairment, depreciation, amortisation and finance costs
3(A)
(1 5 8 5 9 2 8 )
(1 690 820)
Depreciation and amortisation
3(B)
(93 517)
(100762)
(23459)
(459 938)
Impairment of intangibles, investments and property, plant and equipment 7
Finance costs
7
Net profit/(loss) from continuing operations before income tax expense
8
Income tax expense
3(C)
6
Net profit/(loss) from continuing operations after income tax expense
(25 302)
(66571)
267369
(274940)
(42 201)
(37912)
225 168
(312 852)
Discontinued operations Net profit from discontinued operations after income tax expense 8
Net profit/(loss) after income tax expense
5
-
225 168
311 881 (971)
Net profit/(loss) is attributable to: Noncontrolling interest Owners of the parent
736
15461
224432
(16432)
225 168
(971)
Source: Fairfax M e d ia Limited,
A n n u a l R ep o rt 2 0 1 4 .
CHAPTER 13 Revenue and expense recognition: additional concepts
5
505
Fairfax shows 'share o f net profits/flosses) o f associates a nd joint ventures' o f $ 8 m illion as a separate line on the fa ce o f the statement. For Q a n ta s, this figure, w h ich is referred to as 'share o f net loss o f investments accounted for under the equity m ethod', is a loss a nd shown ( $ 6 6 million) under expenditure.
6 Q antas shows earnings before interest and tax (EBIT) (negative) ($ 3 7 7 2 million) They refer to it as statutory lo s s / (profit) before incom e tax expense a nd net finance costs. Fairfax shows expenses from operations, before deducting depreciation, am ortisation im pairm ent a nd finance costs ($ 1 5 8 5 .9 million) (if a subtotal w as taken here it w o u ld be called EBITDA; that is, earnings before interest, tax, depreciation and amortisation). D epreciation, amortisation, asset impairm ent and finance costs are then deducted. For Fairfax, more details o f the expenses are shown in the notes. Q antas provides more details of its expenses on the face of the report. The three biggest expenses are: m anpow er and staff related ( $ 3 7 1 7 million), fuel ($ 4 4 6 1 million) and aircraft operating va ria b le ($ 3 1 4 2 million). 7
Both com panies a d d on fin a n ce incom e (interest revenue) a nd d educt fin a n ce costs (m ainly interest expense) to obtain net fin a n ce costs a nd then statutory p rofit before incom e tax (Q antas $ 2 0 4 m illion). Fairfax refers to fin a n ce costs ( $ 2 5 .3 million) to ge t net p rofit/(loss) from operations before incom e tax expense ( $ 2 6 7 .4 million)
8
Both com panies d educt incom e tax expense o r a d d incom e tax benefits to arrive at the net profit figure (Fairfax $ (4 2 .2 ) m illion dedu ctio n ; Q a n ta s $1 1 3 3 m illion benefit). The net p rofit figure is sometimes described as the 'bottom line'; Fairfax m ade a profit of $ 2 2 5 .2 m illion an d Q a n ta s m ade a loss o f $ 2 8 4 3 million.
506
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
It is interesting h o w things ch a n g e. In the last edition o f the book, w h ich had the 2 01 1 numbers, Q a n ta s m ade a profit o f $ 2 4 9 m illion an d Fairfax m ade a loss o f $ 3 8 9 .7 million. A ccounting standards require that com panies present an analysis of expenses using a classification based on either the nature o f the expenses or their function w ithin the entity - w h ich e ve r provides inform ation that is reliable and m ore relevant to the decision-m aking needs o f users. The c h o ice is likely to d e p e n d on historical a nd industry factors as w e ll as the nature of the business. AASB 101 para g ra p h s 1 0 2 - 1 0 3 explain the alternative presentation formats as follow s: T h e f ir s t f o r m o f a n a lysis is th e ‘ n a tu re o f e x p e n s e m e t h o d ’. E x p e n s e s a re a g g re g a te d in th e s ta te m e n t o f p r o f it o r loss a c c o r d in g t o t h e ir n a tu re ( f o r e x a m p le , d e p re c ia tio n , p u rc h a s e s o f m a te ria ls , t r a n s p o r t c o s ts , e m p lo y e e b e n e fits a n d a d v e rtis in g c o s ts ), a n d a re n o t re a llo c a te d a m o n g v a rio u s fu n c tio n s w ith in th e e n tity . T h is m e th o d m a y be s im p le t o a p p ly b e c a u s e n o a llo c a tio n s o f e x p e n s e s t o fu n c tio n a l c la s s ific a tio n s a re n e c e s s a ry . A n e x a m p le o f a c la s s ific a tio n u s in g th e n a tu re o f e x p e n s e m e th o d is as fo llo w s :
Revenue
X
Other income
X
Changes in inventories of finished goods and work in progress
X
Raw materials and consumables used
X
Employee benefits expense
X
Depreciation and amortisation expense
X
Other expenses
X
Total expenses
IX)
Profit before tax
X
T h e s e c o n d f o r m o f an a lysis is t h e ‘fu n c tio n o f e x p e n s e ’ o r ‘c o s t o f sa le s’ m e th o d a n d cla s s ifie s e x p e n s e s a c c o r d in g t o t h e ir fu n c tio n as p a rt o f c o s t o f sales o r, f o r e x a m p le , th e c o s ts o f d is trib u tio n o r a d m in is tra tiv e a c tiv itie s . A t a m in im u m , an e n tit y d is c lo s e s its c o s t o f sales u n d e r th is m e th o d s e p a ra te ly f r o m o t h e r e x p e n s e s. T h is m e th o d c a n p r o v id e m o re re le v a n t in fo r m a tio n t o u s e rs th a n th e c la s s ific a tio n o f e x p e n s e s b y n a tu re , b u t a llo c a tin g c o s ts t o fu n c tio n s m a y re q u ire a r b itr a r y a llo c a tio n s a n d in v o lv e c o n s id e ra b le ju d g e m e n t. A n e x a m p le o f a c la s s ific a tio n u s in g th e fu n c tio n o f e x p e n s e m e th o d is as fo llo w s :
Revenue
X
Cost of sales
IX)
Gross profit
X
Other income
X
Distribution costs
(X)
Administrative expenses
(X)
Other expenses
IX)
Profit before tax
X
Source: © C om m onw ealth o f Australia 2 0 1 4 . A ll legislation herein is reproduced b y permission but does not purport to be the official o r authorised version. It is subject to C om m onw ealth o f Australia copyright. The C o p y rig h t A c t 1 9 6 8 permits certain reproduction a n d publication o f C om m onw ealth legislation. For reproduction publication beyond that permitted by the Act, permission should be sought in w ritin g from the C om m onw ealth a va ila b le from the Australian A ccounting Standards Board. Requests in the first instance should be addressed to the Adm inistration Director, Australian A ccounting S tandards Board, PO Box 2 0 4 , C ollins Street W est, M elbourne, Victoria, 8 0 0 7 .
CHAPTER 13 Revenue and expense recognition: additional concepts
507
O n e w a y to think o f the d iffe re n ce betw een the tw o methods o f presentation o f expenses is as fo llo w s. In the nature o f expense m ethod all d e p re cia tio n costs a re g ro u p e d together, but in the function m ethod instead of s h o w in g these in on e fig u re they w o u ld be split across functions: d e p re cia tio n a n d e m p lo ye e benefits w o u ld be included in cost o f sales (d e p re cia tio n o f fa cto ry equipm ent; fa cto ry w a g e s); in distribution costs (d e p re cia tio n of d e live ry vans; salaries o f d e live ry drivers) a n d in adm inistrative costs (d e p re cia tio n o f o ffic e com puters and adm in istra tive w a g e s).
13.5 Statem ent of changes in equity In a d d itio n to the b a la n ce sheet, the statement o f profit o r loss a nd other com prehensive incom e, the statement o f cash flow s an d the notes to the fin a n cia l statements, there is n o w a requirem ent for a statement of changes in equity. W h ile most items o f incom e an d expense are included in an incom e statement, AASB 101 (pa ra g ra p h 8 8 ) requires an entity to 'recognise all items o f incom e a n d expense in a p eriod in profit o r loss unless an Australian A ccounting Standard requires o r permits otherw ise'. S ituations w h e re items outside the current p e rio d m ay be in clu d e d a re fa irly rare a n d in clu d e correction o f errors a n d the effect o f changes in a cco u n tin g p o licie s. O th e r A ustralian A cco u n tin g S tandards require som e gains a n d losses (such as revaluation increases a n d decreases, p a rticu la r fo re ig n e xch a n g e differences, g a in s o r losses on rem easuring ava ila b le -fo r-sa le fin a n cia l assets, a n d related am ounts o f current ta x a n d deferred tax) to be recog n ise d d ire ctly as ch a n g es in equ ity. Because it is im p o rta nt to c o n sid e r all items o f in co m e a n d expense in assessing changes in an entity's fin a n cia l position betw een tw o reporting dates, this S tandard requires the presentation o f a statem ent o f changes in e q u ity that highlights an entity's total incom e an d expenses, in clu d ing those that a re re cognised d ire ctly in equity. W h ile the a b o v e gains an d losses a re beyond the scope o f this b o o k (except asset revaluations, w h ich w e re discussed in C h a p te r 10), you w ill see these statements o f changes in equity in annual reports; therefore, it is useful to know w h a t they are trying to achieve. The id e a is that the statement o f changes in equity is to pro vid e a full picture of all incom e an d expense items, regardless o f w hether they w e re included in the incom e statement o r recognised direct to equity.
STATEMENT OF CHANGES IN EQUITY 106
A n e n tit y shall p re s e n t a s ta te m e n t o f c h a n g e s in e q u ity as re q u ire d b y p a ra g ra p h 1 0 . T h e s ta te m e n t o f c h a n g e s in e q u ity in c lu d e s th e fo llo w in g in fo r m a tio n :
(a )
to ta l c o m p re h e n s iv e in c o m e f o r th e p e rio d , s h o w in g s e p a ra te ly th e to ta l a m o u n ts a ttr ib u ta b le t o o w n e rs
(b )
f o r e a c h c o m p o n e n t o f e q u ity , th e e f f e c t s o f re tr o s p e c tiv e a p p lic a tio n o r re tr o s p e c tiv e re s ta te m e n t
(c )
[d e le te d b y th e IA S B ]
(d )
f o r e a c h c o m p o n e n t o f e q u ity , a re c o n c ilia tio n b e tw e e n th e c a rr y in g a m o u n t a t t h e b e g in n in g a n d th e
o f th e p a re n t a n d n o n - c o n t r o llin g in te re s ts ;
re c o g n is e d in a c c o r d a n c e w ith A A S B 1 0 8 ; an d
e n d o f t h e p e rio d , s e p a ra te ly d is c lo s in g c h a n g e s re s u ltin g f r o m : ( i)
p r o f it o r loss;
( ii)
o t h e r c o m p re h e n s iv e in c o m e ; an d
( iii)
tra n s a c tio n s w ith o w n e rs in t h e ir c a p a c ity as o w n e rs , s h o w in g s e p a ra te ly c o n tr ib u tio n s b y a n d d is trib u tio n s t o o w n e rs a n d c h a n g e s in o w n e rs h ip in te re s ts in s u b s id ia rie s t h a t d o n o t re s u lt in loss o f c o n tro l. Source: © C om m onw ealth o f Australia 2014.
W h ile the a b o v e is quite com plex, o ne im portant issue that is far m ore straightforw ard is the item in p a ragraph 1 0 6 (d) a b o ve ; that is, the c h a n g e in retained earnings (retained profits) for the p e riod. You w ill recall from earlier
508
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
discussions in this b o o k (C hapter 2) that retained profits represent profits earned b y the entity over its life that have not been distributed as dividends. Therefore, for each entity there w ill be a note (or part of the statement o f changes in equity) sh o w in g , for retained earnings:
13.6
Balance at the start of the period
X
+ / —changes in accounting policy or correction of errors
X
Restated balance
X
Profit/(Loss) for the period
X
Other comprehensive income
X
Total comprehensive income for the period
X
Less dividends
X
Balance at the end of the period
X
'W hat if' (effects) analysis
Suppose you are a fin a n cia l analyst trying to determ ine w h a t a recently released set o f fin a n cia l statements tells you about a com pan y's perform ance. You can d o various standard analyses (as w ill be described in C h a p te r 15), but before you d o that you find that the com pany's accounting isn't quite c o m p a ra b le to that of another c o m p a n y you w a n t to c om pare it to, o r that the c o m p a n y has used an accounting method you d o n 't a g re e w ith . You therefore w a n t to alter the numbers to sh o w a 'w h a t if' scenario if the c o m p a n y used the other com pany's accounting method, o r a method you d o a g re e w ith. O r perhaps you are the m a n aging dire cto r o f a co m p a n y, an d you are assessing some alternative accounting methods to determ ine w h ich w o u ld be the most a p p ro p ria te for the com pany. You know that there a re restrictions on the com pany's debt-to-equity ratio that have been im posed by a m ajor lender, an d that there a re expectations o f the year's net profit resulting from a forecast you m ade during a speech e arlier in the year. You also kn o w that various financial analysts exam ine your co m p a n y's perform ance quite closely an d that, if that perform ance declines, your bonus and even yo u r jo b could be in je o p a rd y. You therefore w a n t to know w h a t the effects on the com pany's financial statements w o u ld be if the c o m p a n y a d o p te d each alternative accounting method. Such questions a re very com m on in business. A nsw ering them requires analysis o f the accounting inform ation: w e 'll call this 'what if* (effects) analysis. The a b ility to analyse accounting inform ation to tell m anagers, bankers and others w h a t difference various accounting choices, o r business events in general, w o u ld make to the financial statements is very im portant to accountants. If you are g o in g to be an accountant, you have to d e ve lo p this skill. If you are not g o in g to be an accountant, you should have some id e a o f w h a t the accountants a re d o in g in such analyses, so that you can evaluate the results they g ive you. You m ay even w a n t to d o some basic analysis yourself. C om puter spreadsheets are particularly g o o d for this sort o f analysis, but you have to know w h a t to tell the spreadsheet to do.
Examples of 'w h a t if' (effects) analysis A g o o d w a y to think a b o u t w h a t w o u ld result if one method w e re used instead o f another, or if o ne event happened instead o f another, is to figure out the accounting numbers both w a ys a nd co m p a re them. There a re shortcuts to this, and if you see one, g o a h e a d a nd use it! But for now , let's take the longer (and hopefully clearer) w a y .
EXAMPLE A : R EVEN U E R E C O G N IT IO N , D U R IN G O R AFTER P R O D U C T IO N In section 1 3 .2 , you sa w the exam ple o f G re e n w a y C onstruction, w h ich uses percentage of com pletion to recognise its construction revenues a nd expenses. Suppose the com pany's banker, w h o w a s more fa m ilia r w ith revenue
CHAPTER 13 Revenue and expense recognition: additional concepts
509
recognition at com pletion o f production (i.e. on com pletion of the contract), w a n te d to kn o w w h a t difference there w o u ld be to p rofit if the com pletion of production method w e re used instead. The percentage o f com pletion project profit (totalling $ 6 0 0 0 0 0 over three years) w a s: •
$ 1 2 0 0 0 0 for ye a r 1
•
$ 2 7 0 0 0 0 for ye a r 2
•
$ 2 1 0 0 0 0 for ye a r 3.
•
$ 0 in ye a r 1
•
$ 0 in ye a r 2
•
$ 6 0 0 0 0 0 in ye a r 3.
•
$ 1 2 0 0 0 0 lo w e r in ye a r 1
•
$ 2 7 0 0 0 0 lo w e r in ye a r 2
•
$ 3 9 0 0 0 0 h igher in ye a r 3.
If revenue a nd expenses w e re recognised o n ly at com pletion o f the project, the project p rofit w o u ld be:
So the answ er to the banker's question w o u ld be that profit w o u ld be:
There has been no ch a n g e in the three-year total, but the ye a rly figures are rearranged if the com pletion of production method is used. E x a m p le s o f in c o m e ta x e ffe c ts in th is a n a ly s is
Suppose G re e n w a y C onstruction pays incom e tax at a rate o f 3 0 per cent. W h a t effect w o u ld that have on our figures a b o ve ? The answ er is that the incom e tax reduces all the effects by the tax rate, because that proportion goes to the governm ent. As yo u 'll see b e lo w , a useful rule is to just m ultiply the before-tax effect by (1 — tax rate), in this case (1 - 0 .3 0 ) = 0 .7 0 . H ere is a ta b le of the effects, before an d after incom e tax (for presentation purposes, G re e n w a y 's figures a re in thousands o f dollars): Greenway Year
Gross effect
Tax effect
A fter-tax effect
100%
30%
70%
$
$
$
1
(120000)
(36000)
(84000)
2
(270000)
(81 000)
(189000)
3
390000
117000
273 000
0
0
0
Total
Income tax reduces both positive a nd negative differences. The assumption here is that an increased profit is taxed, an d a decreased profit produces tax savings (by reducing tax p a y a b le on other profit o r creating tax credits that can be used to get refunds on past years' taxes o r reduce future taxes). W ith o u t kn o w in g the details o f the incom e tax la w (which a re beyond the scope o f this book), w e cannot say for sure h o w much o f the incom e tax effect is current an d h o w much is deferred.
EXAMPLE B: N E T O F TA X A N A LY S IS Revenues a nd expenses can be considered to increase o r decrease incom e taxes on their o w n , a nd therefore the effects on net profit o f changes in revenues an d expenses can be estim ated directly, net o f tax, once the incom e tax
510
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
rate is know n (or appro xim a te d ). Here's h o w it w orks. Suppose A lca tra z Fencing Ltd has o ne revenue, on e expense and an incom e tax rate o f 3 0 per cent. Its incom e statement m ight look like this:
Revenue
1 000
Expense
700
Profit before income tax
300
Income tax expense (30%)
90
Net profit
210
N o te that the net profit is 7 0 per cent o f the p rofit before tax. W e can state this in a form ula, as suggested a bove: N e t pro fit = (1 - ta x rate) x Profit b efo re incom e ta x You can look at net profit as the residual after the incom e tax has been d educted. But this w orks just as w e ll for the revenues and expenses. Suppose w e recast the incom e statement as if the revenues a nd expenses w e re taxed directly, so that they are show n net of tax, a nd the incom e tax effect is, therefore, included in them rather than being a separate expense: Original
Net of la x
$
$
1 000
700
Expense (net = $700 x (1 —0.30))
700
490
Profit before income tax
300
Revenue (net = $1000 x (1 - 0.30))
Income tax expense (30%) Net profit
90 210
210
The net-of-tax w a y o f looking a t things can be very useful a n a lytica lly. Suppose the general m anager o f A lca tra z Fencing has a plan to increase revenue by $ 2 0 0 w ith o u t a n y increase in the $ 7 0 0 expense. W h a t w o u ld that d o to net profit? The n ew net profit w o u ld be higher by $ 2 0 0 x (1 — 0 .3 0 ) = $ 1 4 0 , a nd so w o u ld be $ 3 5 0 ( $ 2 1 0 + $ 1 4 0 ). There is no need to recalculate the w h o le incom e statement. If you are doubtful, you can a lw a ys d o the analysis the longer w a y , by recalculating the incom e statement:
N et-of-tax analysis g o t us to this a n s w e r m o re q u ic k ly b y fo cu sin g just on w h a t changes.
CHAPTER 13 Revenue and expense recognition: additional concepts
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HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d :
1
A c o m p a n y had re v e n u e s o f $ 1 0 4 9 9 . 7 m illio n in a re c e n t y e a r. Its in c o m e ta x ra te w as 3 0 p e r c e n t. I f its re v e n u e s in c re a s e d b y 2 p e r c e n t, w ith n o e f fe c t o n e x p e n s e s o t h e r th a n in c o m e ta x , w h a t w o u ld be th e e f f e c t o n n e t p r o fit f o r th a t y e a r?
2
H in to n L td has fo u n d an e r r o r in its re v e n u e a c c o u n t: an in v o ic e f o r $ 1 4 0 0 w as re c o rd e d as re v e n u e in 2 0 1 5 w h e n it s h o u ld ha ve b e e n re c o rd e d in 2 0 1 6 . T h e c o m p a n y ’s in c o m e ta x ra te is 3 0 p e r c e n t an d th e re w as n o c o rre s p o n d in g e r r o r in c o s t o f g o o d s s o ld . W h a t is th e e f fe c t o f th e e r r o r o n : a
2 0 1 5 n e t p r o fit;
b
2 0 1 5 cash fr o m o p e ra tio n s ;
c
2 0 1 6 n e t p r o fit;
d
re ta in e d p r o fits a t th e e n d o f 2 0 1 5 ;
e
re ta in e d p r o fits a t th e e n d o f 2 0 1 6 ?
Y o u r a n sw e rs s h o u ld be:
1
R e v e n u e e f fe c t = 2% x $ 1 0 4 9 9 . 7 = $ 2 1 0 .0 m illio n m o re re v e n u e . N e t p r o fit e f f e c t = $ 2 1 0 (1 — 0 . 3 0 )
2
$ 1 4 0 0 (1 — 0 . 3 0 ) = $ 9 8 0 to o h ig h ; n o cash e f fe c t; $ 9 8 0 to o lo w ; $ 9 8 0 to o h ig h ; n o e f f e c t as th e s u m
= $ 1 4 7 .0 m illio n h ig h e r.
o f 2 0 1 5 an d 2 0 1 6 p r o fits is u n a ffe c te d .
13.7 Managers and the recognition of revenues and expenses Profit determ ination is of vital interest to both shareholders a nd m anagers, as it is a key com ponent in their perform ance evaluation. As profit depends on revenue recognition a n d expense recognition, an understanding of these concepts is im portant w hen various decision alternatives a re being considered b y m anagem ent. Revenue an d expense recognition also require m any different judgem ents by m anagers. For exam ple, assume a c o m p a n y is involved in long-term contracts a nd uses the percentage o f com pletion method to recognise revenues. T w o exam ples of judgem ents that need to be m ade b y m anagem ent are: (a) h o w to calculate the percentage of com pletion; an d (b) at w h a t point the outcom e o f the contract can be re liably estim ated. W ith respect to the first point, m anagers must d e c id e w hether to use such methods as physical estimates, or the proportion of costs incurred to date co m p a red to the estim ated total costs. W h ile the outcom e o f a contract is never certain until it is com pleted, the percentage o f com pletion method a llo w s m anagers to recognise profit earlier, p rovided the outcom e is reliably estim ated.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Revenue reco g n itio n Discuss w h e n th e fo llo w in g o rg a n is a tio n s a re lik e ly to re c o g n is e revenue. 1 C P A A u s tra lia fo r m e m b e rs h ip fees. 2
The U n iv e rs ity o f N e w South W a le s fo r s tu d e n t tu itio n fees.
3
The M e lb o u rn e C ric k e t G ro u n d .
4
A n a d v e rtis in g c o m p a n y th a t p ro d u ce s a n d a rra n g e s fo r th e a irin g o f a n a d ve rtis e m e n t on TV.
5
A re ta ile r o f p h o to c o p y in g m a ch in e s to un iversitie s. The cost in clu d e s fre e s e rvicin g fo r tw o y e a rs .
6
A g o lf m a n u fa c tu re r th a t p ro v id e s g o lf e q u ip m e n t to g o lf courses fo r sale. The g o lf co u rse ho ld s them fo r six m onths to try to sell them a n d if no t returns them to th e g o lf m a n u fa c tu re r. The g o lf courses a re no t in v o ic e d until th e y sell the g o lf club s.
PRACTICE PROBLEM B Expense reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w g ive s rise to a re ven ue o r a n e x p e n s e u n d e r th e F ra m e w o rk . If th e y d o , w h a t w o u ld be th e o th e r s id e o f th e tra n s a c tio n ? 1 A b a n k lo a n o f $ 3 0 0 0 0 is o b ta in e d , w ith th e c o m p a n y s ig n in g a n a g re e m e n t to re p a y th e a m o u n t in s ix m onths, to g e th e r w ith in tere st o f 6 p e r cent. 2
E le ctricity used in th e p a st m o nth, w o rth $ 1 5 4 0 , has n o t been p a id fo r.
3
A $ 7 0 0 0 c h e q u e is re c e iv e d fro m a te n a n t fo r th re e m o nth s' rent in a d v a n c e .
4
A c o m p a n y s ig n s a tw o -y e a r e m p lo y m e n t c o n tra c t w ith a m a rk e tin g m a n a g e r fo r $ 2 5 0 0 0 0 p e r y e a r. The m a rk e tin g m a n a g e r w ill start w o rk ne xt m onth.
5
W a g e s o f $ 3 4 0 0 0 a re o w in g to e m p lo y e e s a t y e a r e n d fo r w o rk d o n e d u rin g th e y e a r.
PRACTICE PROBLEM C Percentage o f com pletion versus com pleted c o n tra ct O n 1 J a n u a ry 2 0 1 4 , R om ulus Ltd s ig n e d a c o n tra c t w o rth $ 2 1 0 0 0 0 0 0 to co n s tru c t a lig h t ra il fro m H e re to T here. The lig h t ra il w a s to be b u ilt o v e r th re e y e a rs , w ith p ro g re ss pa ym e n ts o f $ 7 0 0 0 0 0 0 to be m a d e a t th e e n d o f e a ch y e a r. E stim ated costs w e re $ 1 5 0 0 0 0 0 0 a n d th e fo llo w in g costs in c u rre d a n d p a id b y R om ulus Ltd w e re in a c c o rd a n c e w ith estim ates a n d re p re s e n te d th e p e rc e n ta g e c o m p le te d in e a ch y e a r: 20 14 $8 0 0 0 0 0 0 2015 $5 0 0 0 0 0 0 20 16 $2 0 0 0 0 0 0 The p ro je c t w a s c o m p le te d in D e c e m b e r 2 0 1 6 . 1 U sing th e p e rc e n ta g e o f c o m p le tio n m e th o d , w h a t p ro fit w o u ld R om ulus Ltd re p o rt in 2 0 1 4 ? 2
U sing th e p e rc e n ta g e o f c o m p le tio n m e th o d , w h a t p ro fit w o u ld R om ulus Ltd re p o rt in 2 0 1 5 ?
3
U sing th e p e rc e n ta g e o f c o m p le tio n m e th o d , w h a t p ro fit w o u ld R om ulus Ltd re p o rt in 2 0 1 6 ?
4
U sing th e c o m p le tio n o f p ro d u c tio n m e th o d , w h a t
p ro fit w o u ld R om ulus Ltd re p o rt in 2 0 1 6?
CHAPTER 13 Revenue and expense recognition: additional concepts
513
KEY TERMS Earnings before interest and tax (EBIT)
Earnings before interest, tax, depreciation and amortisation (EBITDA)
Net-of-tax analysis Percentage of completion 'What if' (effects) analysis
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r d iscu ssio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h th a t a re then fo llo w e d b y a set o f pro b le m s .
DISCUSSION QUESTIONS 1
P ro v id e an e x a m p le o f a tra d e -o ff b e tw e e n re le v a n c e a n d re lia b ility fo r reven ue re c o g n itio n .
2
W h a t c rite ria a re used to re c o g n is e revenue?
3
C o m p a re re ven ue re c o g n itio n u n d e r th e p e rc e n ta g e o f c o m p le tio n a n d c o m p le te d c o n tra c t m e thods.
4
W h a t c o n d itio n s ne ed to be m et b e fo re in c o m e /re v e n u e c a n be re c o g n is e d ?
5
W h a t c o n d itio n s ne ed to be m et b e fo re expe nses c a n be re c o g n is e d ?
6
A n in co m e state m e nt s how s p ro fit a n d loss fo r th e p e rio d a n d to ta l c h a n g e s in e q u ity o th e r th a n th ose resulting fro m tra n sa ctio n s w ith o w n e rs as o w n e rs . P ro vid e th re e e x a m p le s o f these c h a n g e s in e q u ity .
7
Y ou a re to ld b y a frie n d w h o b u ild s u p sta irs exte nsion s to houses th a t he estim ates th e p ro fit on a jo b a t th e tim e o f q u o tin g , a n d re co g n ise s 1 0 p e r c e n t o f p ro fit e a c h w e e k b a se d on th e fa c t th a t m ost jo b s ta k e 1 0 w e e ks . D o y o u a g re e w ith his a p p ro a c h ?
8
E x p la in w h y reven ue is som etim es re c o g n is e d a t th e p o in t o f sale . W h e n w o u ld it be a p p ro p ria te to re c o g n is e re ven ue a t th e tim e o f p ro d u c tio n ?
9
D e s crib e th e m a tc h in g p rin c ip le . H o w is it d e a lt w ith in th e F ra m e w o rk ?
1 0 W o u ld a la rg e w rite -d o w n o f in v e n to ry th a t has b e co m e o b s o le te be in c lu d e d as a n e x tra o rd in a ry item ? W h y , o r w h y not? 11 W h a t is th e m a in b e n e fit o f p ro v id in g s e p a ra te d is c lo s u re o f s ig n ific a n t items?
PROBLEMS PROBLEM 13.1 Revenue reco g n itio n Discuss w h e n e a ch o f th e fo llo w in g businesses w o u ld be lik e ly to re c o g n is e revenues: 1 A s h ip b u ild in g c o m p a n y . 2
A m a g a z in e c o m p a n y fo r w h ic h y e a rly s u b s c rip tio n s a re re c e iv e d y e a rly in a d v a n c e a n d w h e re th e m a g a z in e s a re p o ste d e a c h m onth.
3
A c o a l-m in in g c o m p a n y th a t has a long -term c o n tra c t to s u p p ly a lo c a l c o m p a n y a t a set p ric e .
4
A p rin te r.
5
A n in s ta lle r o f h o t-w a te r system s.
6
A te le c o m m u n ic a tio n s c o m p a n y th a t p ro v id e s lo c a l a n d in terstate calls.
7
A n a irlin e .
8 A re a l estate d e v e lo p e r w h o constructs 's p e c u la tiv e ' houses a n d la te r sells them . 9
A n e n g in e e rin g business th a t receive s o rd e rs fo r s p e c ia l-p u rp o s e m a c h in e ry a c c o m p a n ie d b y d e p o sits.
1 0 A m e a t p ie stan d a t a fo o tb a ll g ro u n d .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 13.2 Revenue reco g n itio n State w h e th e r e a ch o f th e fo llo w in g w o u ld b e re c o g n is e d as re ven ue u n d e r th e F ra m e w o rk . 1 Issue o f shares fo r $ 4 m illio n . 2
C a s h sales b y a re ta ile r o f $1 3 0 0 0 0 .
3
C re d it sales o f $ 3 6 0 0 0 0 b y a m a n u fa c tu re r o f re frig e ra to rs .
4
S old e q u ip m e n t to a c o m p a n y fo r $ 4 0 0 0 0 0 . The e q u ip m e n t has be en d e liv e re d .
5
R eceived an o rd e r fo r c u sto m -d e s ig n e d in v ita tio n s . A g re e d to c o m p le te in tw o w e e ks . R eceived $ 9 0 0 d e p o s it w ith re m a in in g $ 4 0 0 to be p a id on d e liv e ry .
6
A c o m p a n y receives a y e a r's re n t in a d v a n c e . The te n a n t c a n n o t w ith d r a w fro m th e c o n tra c t.
PROBLEM 13.3 Expense reco g n itio n For e a ch o f th e fo llo w in g expe nses state w h a t th e o th e r s id e o f th e jo u rn a l e n try w o u ld be. If it is no t an e x p e n s e , w rite 'n o e x p e n s e '. 1
In su ra nce e x p e n s e (a m o u n t p a id last y e a r).
2
W a g e s (to be p a id n e xt p e rio d ).
3
A d v e rtis in g th a t a p p e a re d o n TV last w e e k a n d th e in v o ic e to be p a id n e xt m onth.
4
D iv id e n d p ro p o s e d a n d p a id .
5
S u p p lie s (re c o rd e d as asset supp lie s) used up d u rin g th e p e rio d .
6
D e p re c ia tio n .
PROBLEM 13.4 Revenue and expense re co g n itio n L e arn ing Ltd p ro v id e s o n e -d a y tra in in g p ro g ra m s o n a c c o u n tin g . It c h a rg e s $ 4 0 0 0 p e r d a y . The fo llo w in g events o c c u rre d d u rin g M a y 2 0 1 6 . a
R eceived $ 2 0 0 0 0 fro m a c co u n ts re c e iv a b le fo r sales in p re vio u s m onths,
b
P aid th re e m o n th s' ren t o f $ 8 0 0 0 th a t cove rs th e p e rio d 1 M a y 2 0 1 6 to 31 J u ly 2 0 1 6 .
c
R eceived o rd e rs fo r 6 0 d a ys o f tra in in g d u rin g th e m o nth . D e liv e re d 4 0 o f th e d a ys o f tra in in g d u rin g the
d
S ig n e d a c o n tra c t to d e s ig n a s p e c ia l p ro g ra m fo r la w y e rs a t a p ric e o f $ 2 0 0 0 0 . D esign w ill c o m m e n ce in July. R eceived a $ 5 0 0 0 d e p o sit,
m o nth a n d re c e ive d p a y m e n t fo r 3 0 o f these da ys.
e
P aid $ 4 0 0 0 0 0 fo r n e w e q u ip m e n t a n d $ 2 0 0 0 0 to in sta ll it.
f
A c o n tra c t w a s s ig n e d w ith a n e w C E O fo r $ 7 0 0 0 0 0 p e r y e a r. The C E O w ill start on 1 July,
g
P aid w a g e s d u rin g th e p e rio d o f $ 6 0 0 0 0 w ith a c c ru e d w a g e s o f $ 5 0 0 0 o w in g a t th e e n d o f th e m onth,
h
B o rro w e d $ 1 2 0 0 0 o n 1 M a y fro m th e b a n k a t 1 0 p e r c e n t p e r a n n u m . Interest a n d p rin c ip a l re p a y a b le in th re e m onths.
R e q u ire d : 1 D e te rm in e to ta l reven ue fo r th e m onth o f M a y 2 0 1 6 . 2
List a ll expe nses fo r th e m onth o f M a y 2 0 1 6 .
PROBLEM 13.5 Likely revenue re co g n itio n policies to r various cases W h e n is a sale a sale? W h e n do es the a c c o u n tin g system re c o g n is e revenue as h a v in g been e a rn e d ? In d ic a te w h a t y o u th in k w o u ld be the revenue re c o g n itio n p o lic y in e a ch o f the fo llo w in g cases. R em em ber to th in k a b o u t: (a) w h e th e r the g e n e ra l c rite ria fo r revenue re c o g n itio n ha ve been m et; (b) th e c o n c e p t o f a 'c ritic a l eve n t' fo r revenues reco g n ise d a ll a t o n c e ; a n d (c) th e p ro p o rtio n a te re c o g n itio n th a t is a v a ila b le fo r revenue e a rn e d o v e r several a c c o u n tin g p e rio d s: 1
c o ffe e s h o p sales o f c o ffe e
2
sales o f h o using s u b d iv is io n s
CHAPTER 13 Revenue and expense recognition: additional concepts
3
515
sales o f n a tu ra l g a s to businesses a n d resid ences
4
m a g a z in e s u b s c rip tio n sales
5
tic k e t sales fo r co n ce rts
6
in sta lm e n t sales o f a p p lia n c e s a n d fu rn itu re
7
re ven ue fro m sales o f p o tte ry o n c o n s ig n m e n t th ro u g h lo c a l c ra ft shops
8 a TV s ta tio n 's reven ue fro m a d v e rtis in g d u rin g sports p ro g ra m s 9
revenues fro m sales o f m a n u fa c tu re d p lu m b in g p ro d u cts
1 0 c o m p u te r store sales o f s o ftw a re 11 d e p a rtm e n t store reven ue fro m c lo th in g sales (som e p e o p le p a y c a sh ; som e use th e ir store c re d it c a rd s ; som e use o th e r c re d it c a rd s ; a n d som e return th e ir pu rch ases a fte r d e c id in g th e y d o n 't like them ) 12 y o u r u n iv e rs ity 's reven ue fro m stu d e n t tu itio n fees 13 a c h a rity 's revenues fro m d o n a tio n s 14 a g a rd e n e r's revenues fro m c o n tra c t la n d s c a p in g w o rk fo r ho m e o w n e rs .
PROBLEM 13.6 Real com pany's revenue, expense recognition U sing th e fin a n c ia l statem ents o f a n y c o m p a n y y o u a re in tere ste d in, w rite a c o m p re h e n s iv e re v ie w o f th e c o m p a n y 's re ven ue a n d e x p e n s e re c o g n itio n p o lic ie s . C o v e r such p o in ts as: 1
w h a t th e n a tu re o f th e c o m p a n y 's business is a n d h o w it e a rn s its re ven ue a n d in cu rs its expenses.
2
w h a t th e c o m p a n y 's fin a n c ia l statem ents a n d notes d isc lo se a b o u t its im p o rta n t reven ue a n d e x p e n s e re c o g n itio n p o lic ie s .
3
b a se d o n 1 a n d 2 , a n d on y o u r o w n th in k in g a b o u t th e c o m p a n y , th e a p p ro p ria te n e s s o f th e c o m p a n y 's reven ue a n d e x p e n s e p o lic ie s a n d th e qu estio ns o r c o n c e rn s th a t y o u h a ve a b o u t them .
PROBLEM 13.7 Choose su ita b le revenue re co g n itio n policies In e a ch o f th e fo llo w in g in d e p e n d e n t cases, in d ic a te w h e n y o u th in k the c o m p a n y in q u e s tio n sh o u ld re c o g n is e reven ue . S u p p o rt y o u r d e c is io n w ith re fe re n ce to th e g e n e ra lly a c c e p te d c rite ria fo r re ven ue re c o g n itio n . 1
O u tb a c k G o ld m ines a n d refines g o ld . To sell th e g o ld , th e c o m p a n y w a its until it feels th e m a rke t p ric e is fa v o u ra b le . The c o m p a n y c a n , if it w is h e s , sell its e n tire in v e n to ry o f g o ld a t a n y tim e a t th e p re v a ilin g m a rke t p ric e .
2
C ra z y F re d d ie sells c h e a p fu rn itu re on an in sta lm e n t p la n . H is custom ers ta k e d e liv e ry o f th e fu rn itu re a fte r m a k in g a d o w n p a ym e n t. O v e r th e p a st y e a r, C ra z y F re d d ie has h a d to repossess o v e r 5 0 p e r c e n t o f the fu rn itu re so ld , b e ca u s e o f custom ers d e fa u ltin g o n pa ym e n ts.
3
Tom a n d M a rk 's C o n s tru c tio n un d e rta k e s long -term c o n s tru c tio n c o n tra cts. The c o m p a n y o n ly a c ce p ts c o n tra cts th a t w ill p a y a fix e d fe e . C osts c a n be e s tim a te d w ith re a s o n a b le a c c u ra c y , a n d th e re has ne ve r be en a p ro b le m c o lle c tin g fro m custom ers.
4
C e c ily C e d ric is a to y m a n u fa c tu re r p ro d u c in g toys th a t a re s h ip p e d to v a rio u s re ta il custom ers u p o n re c e ip t o f th e ir p u rch a s e o rd e rs . Sales a re b ille d a fte r s h ip m e n t. The c o m p a n y estim ates th a t a p p ro x im a te ly 2 p e r c e n t o f c re d it sales p ro v e to be u n c o lle c ta b le .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1 3 .8 Id e n tify item s as revenues or expenses State w h e th e r o r not, a n d w h y , e a ch o f th e fo llo w in g item s is lik e ly to be a reven ue o r an e x p e n s e fo r this y e a r fo r the c o m p a n y in d ic a te d : Company
Item
1
Amcor
Cost of advertising for new employees
2
Telstra
Collection of old accounts from customers who had skipped town and were tracked down by a collection agency
3
National Australia Bank
Cost of renovating its main Perth branch
4
Woolworths
Increased value of the land under certain department stores
5
Subway
Food sold to customers who paid with their Visa cards
6
Harvey Norman
Money paid by customers in advance on special furniture orders
7
Westpac
A lawsuit by a customer who fell down the escalator and was injured
8
Mount Isa Mines
Cost of issuing new shares to raise funds for exploration
9
Ford Motor Co.
Income taxes paid in the United States
10
BHP Billiton
Special good-performance bonuses promised this year but not to be paid until next year
11
BHP Billiton
Special dividend to owners, all of whom are also employees
12
Woolworths
Decreased value of the land under some of its inner-city locations
13
Amcor
Cost of scientific research aimed at developing new products
14
Rio Tinto
Estimated amount of money needed to provide long service leave to this year's employees to be paid in the future
15
Coles
Goods lost to shoplifting
16
Coles
Salary of a floorwalker who tries to catch shoplifters
17
Leighton Construction
Contract payments to be received over the next five years for construction work on a large bridge project
PROBLEM 13.9 Expense reco g n itio n In d ic a te w h e th e r e a ch o f th e events d e s c rib e d b e lo w g ive s rise to a n e x p e n s e u n d e r th e F ra m e w o rk . If th e e v e n t do es g iv e rise to an e x p e n s e , w h a t w o u ld be th e o th e r s id e o f th e tra n s a c tio n ? 1 A te m p o ra ry excess o f cash is used to p u rch a s e $ 4 0 0 0 0 o f shares in BHP B illito n . 2
$ 1 0 0 0 0 is p a id as a d e p o s it on c u sto m -d e s ig n e d e q u ip m e n t, to be c o m p le te d a n d d e liv e re d n e xt y e a r. The to ta l p u rch a s e p ric e o f this e q u ip m e n t w ill be $ 5 0 0 0 0 .
3
A s u p p lie r sends n o tic e th a t $ 1 0 0 0 o f ra w m a te ria ls h a ve be en s h ip p e d b y fre ig h t, w ith p a y m e n t d u e in 3 0 d a y s . The b u y e r o b ta in s title to th e g o o d s as soon as th e y a re s h ip p e d b y th e seller.
4
A c u stom er p laces an o rd e r fo r $ 8 0 0 w o rth o f g o o d s .
5
A p ro d u c tio n m a n a g e r has be en h ire d to ov e rs e e th e c o m p a n y 's o p e ra tio n s , w ith e m p lo y m e n t c o m m e n c in g next m o nth . O n e -tw e lfth o f th e a n n u a l s a la ry o f $ 1 0 8 0 0 0 is to be p a id a t th e e n d o f e a c h m onth w o rk e d .
6
In ve n to ry is a c q u ire d a t a list p ric e o f $ 1 5 0 0 , w ith p a y m e n t m a d e in tim e to secure a 2 p e r c e n t d is c o u n t fo r p ro m p t settlem ent. C a s h d isc o u n ts a re tre a te d as a re d u c tio n in th e a c q u is itio n cost o f th e in ve n to ry.
PROBLEM 13.10 Recomm end revenue and expense re co g n itio n p o lic y G a ry S la p s tic k P rom otion s Ltd (GSP) a c q u ire d th e rig hts to use th e nam es o f a n u m b e r o f fo o tb a ll p la y e rs o n life-sized stuffed d o lls it pu rch ases fro m a to y m a n u fa c tu re r. The d o lls a re m a rke te d th ro u g h m a il-o rd e r a d ve rtis e m e n ts in the TV -listings inserts o f la rg e n e w s p a p e rs . W h e n an o rd e r is re c e iv e d (w ith a m o n e y o rd e r, c h e q u e o r c re d it c a rd
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nu m b er), G SP c o n ta cts th e to y m a n u fa c tu re r. The to y m a n u fa c tu re r is re s p o n s ib le fo r m a n u fa c tu rin g a n d s h ip p in g the d o ll to th e lu ck y b o y o r g irl. G SP is n o tifie d a t th e tim e o f s h ip m e n t. The c u stom er has th e o p tio n o f re tu rn in g th e d o ll w ith in tw o w e e ks o f th e d a y it is re c e iv e d . G SP p a ys th e to y m a n u fa c tu re r w ith in 3 0 d a y s o f d e liv e ry . R esponse to the d o lls this C h ris tm a s has been o v e rw h e lm in g . In fa c t, th e to y m a n u fa c tu re r is w o rk in g e x tra shifts to try a n d k e e p up w ith th e d e m a n d . 1
Id e n tify th re e p o in ts in tim e a t w h ic h G SP c o u ld re c o g n is e reven ue o n th e d o lls . W h ic h w o u ld y o u re c o m m e n d ? W hy?
2
Id e n tify tw o d iffe re n t p o in ts in tim e a t w h ic h th e to y m a n u fa c tu re r c o u ld re c o g n is e reven ue o n th e do lls.
3
Discuss h o w G SP sh o u ld a c c o u n t fo r its pa ym e n ts to fo o tb a ll p la y e rs fo r th e rig h t to use th e ir nam es. (Assum e th a t e a ch p la y e r is p a id a lu m p sum in itia lly a n d a ro y a lty o n e a ch d o ll s o ld th a t uses his nam e.)
PROBLEM 13.11 E ffects analysis: expensing versus capitalising, plus tax The c o n tro lle r o f S q u iffle Ltd is h a v in g som e d isa g re e m e n ts w ith s e n io r m a n a g e m e n t a b o u t som e c o m p a n y a c c o u n tin g p o lic ie s . S q u iffle , in business fo r o n ly a y e a r, has c a p ita lis e d $ 6 7 0 0 0 in d e v e lo p m e n t costs. The c o n tro lle r a rg u e s th a t such costs sh o u ld be e x p e n s e d in ste a d . A ssum e th a t this a c c o u n tin g p o lic y affects c u rre n t in co m e ta x lia b ility a n d th a t th e c o m p a n y 's in co m e ta x ra te is 3 0 p e r cent. W h a t w o u ld th e c o n tro lle r's p ro p o s a l d o to : 1 th e c u rre n t y e a r's net p ro fit? 2
th e c u rre n t y e a r's cash flo w ?
3
w o rk in g c a p ita l a t th e e n d o f th e c u rre n t y e a r?
PROBLEM 13.12 B u ilder's revenues, expenses and assets A b u ild e r fo rm e d a c o n s tru c tio n c o m p a n y in S e p te m b e r. A fte r seve ral m onths o f e ffo rt, th e c o m p a n y c o m p le te d a re s id e n c e a t a to ta l cost o f $ 7 0 0 0 0 a n d a d v e rtis e d it fo r sale . By 31 D e c e m b e r, th e c o m p a n y h a d re c e iv e d th ree o ffe rs : o n e o f $ 7 8 0 0 0 c a s h ; a n o th e r o f $ 8 3 0 0 0 to be p a id in m o n th ly in sta lm ents o v e r 2 0 y e a rs a t 1 0 p e r cent a n n u a l in tere st; a n d a n o th e r o f $ 5 0 0 0 0 cash plus a re s id e n tia l lot w o rth $ 3 1 0 0 0 . The b u ild e r d e c id e d to w a it fo r a h ig h e r o ffe r, w h ic h he seem ed c e rta in to ge t. 1 W h a t w a s th e a m o u n t o f th e c o n s tru c tio n c o m p a n y 's re ven ue fo r th e y e a r? 2
H o w m uch w e re its expenses?
3
In w h a t fo rm , if a n y , w e re its assets o n 31 D e ce m b e r?
4
T a k in g e a ch o ffe r s e p a ra te ly , assum e th e o ffe rs w e re a c c e p te d a n d c a lc u la te th e a m o u n t o f reven ue a n d exp e n se fo r th e fo ur-m o nth p e rio d e n d e d 31 D e c e m b e r in e a ch case. A ssum e th at, fo r e a c h s itu a tio n , th e sale w a s settled o n 2 6 D e c e m b e r.
PROBLEM 13.13 Franchise revenue am o u n ts and policies P ic kin ' C h ic k e n Ltd a n d C o u n try D e lig h t Ltd bo th sell fra n ch is e s fo r th e ir c h ic k e n re s ta u ra n ts. The p u rc h a s e r o f the fra n c h is e (the fra n ch is e e ) receives th e rig h t to use P ic k in ' C h ic k e n 's o r C o u n try D e lig h t's p ro d u cts a n d b e n e fit fro m n a tio n a l tra in in g a n d a d v e rtis in g p ro g ra m s fo r 1 0 y e a rs . The bu ye rs a g re e to p a y $ 5 0 0 0 0 fo r a fra n c h is e . O f this a m o u n t, $ 2 0 0 0 0 is p a id u p o n s ig n in g th e a g re e m e n t a n d th e re m a in d e r is p a y a b le in fiv e e q u a l a n n u a l instalm ents o f $ 6 0 0 0 e a ch . P ic kin ' C h ic k e n re co g n ise s a ll fra n c h is e reven ue w h e n fra n c h is e a g re e m e n ts a re s ig n e d . C o u n try D e lig h t re co g n ise s fra n c h is e re ven ue as cash is re c e iv e d . In 2 0 0 9 , th e c o m p a n ie s e a c h s o ld e ig h t fra n ch is e s . In 2 0 1 4 , th e y e a ch s o ld five . In 2 0 1 5 a n d 2 0 1 6 , n e ith e r c o m p a n y s o ld a fra n ch is e . 1 D e te rm in e th e a m o u n t o f fra n c h is e reven ue re c o g n is e d b y e a ch c o m p a n y in 2 0 0 9 , 2 0 1 4 , 2 0 1 5 a n d 2 0 1 6 . 2
D o y o u th in k th a t re ven ue sh o u ld be re c o g n is e d w h e n th e fra n c h is e a g re e m e n t is s ig n e d , w h e n cash is re c e iv e d , o r o v e r th e life o f th e fra n c h is e a g re e m e n t? W h y ? Fully s u p p o rt y o u r a n s w e r.
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PROBLEM 13.14 Com pany tran sa ctio n s The fo llo w in g tra n s a c tio n s o c c u rre d fo r A n d re w Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 : a T h ere w a s a m a jo r c h a n g e in th e A u s tra lia n d o lla r re su ltin g in a la rg e e x c h a n g e ra te loss, b
In co m e ta x e x p e n s e fo r th e c u rre n t p e rio d w a s d e te rm in e d a t y e a r-e n d .
c
Rent w a s p re p a id fo r J u ly 2 0 1 6 .
d
Four o rd in a ry d iv id e n d s w e re d e c la re d .
e
O n e s h a re h o ld e r sold its shares in A n d re w Ltd to a n o th e r c o m p a n y . The shares w e re sold a t a loss,
f
A fire d e s tro y e d m ost o f A n d re w 's in v e n to ry . The in v e n to ry w a s un in su re d .
g
M a n a g e m e n t b e lie ve s it w ill p ro b a b ly be a b le to w in a m a jo r c o n tra c t to s ervice th e g o v e rn m e n t's co m p u te rs, a lth o u g h no e x p e n d itu re has be en in c u rre d to d a te ,
h
The p ric e o f shares o f A n d re w Ltd fell.
i
A m a jo r seg m e n t o f the business, w h ic h c o m p ris e d o n ly la n d a n d investm ents, w a s sold fo r cash . The sale p ro ce e d s w e re b e lo w th e c a rry in g a m o u n t o f th e assets,
j
A c c o u n ts p a y a b le w e re p a id ,
k
A n d re w Ltd p ro v id e d fo r fu tu re w a rra n ty c la im s .
I
D e p re c ia tio n w a s c h a rg e d on a b u ild in g ,
m A p ro v is io n w a s c re a te d fo r o b s o le te stock. n
A t a m e eting o f th e b o a rd o f d ire c to rs , it w a s d e c id e d th a t th e c o m p a n y w o u ld o b ta in fo re ig n c u rre n c y th ro u g h fo rw a rd e x c h a n g e c o n tra cts in fu ture ,
o
Interest w a s p a id fo r th e y e a r e n d e d 3 0 June 2 0 1 6 , on th a t d a te ,
p
In te rn a lly g e n e ra te d g o o d w ill d e c lin e d th ro u g h o u t th e y e a r,
q
In ve n to ry w a s sold b e lo w cost on c re d it.
r
A n d re w Ltd m a y be lia b le fo r d a m a g e s in c u rre d b y a c o n s u m e r using o n e o f its p ro d u cts . It is lik e ly th a t som e p a y m e n t w ill be re q u ire d . The a m o u n t is d e p e n d e n t u p o n th e o u tc o m e o f a c o u rt case,
s
A b a d d e b t w a s w ritte n o ff. N o a m o u n t h a d be en p ro v id e d in p re vio u s y e a rs . The d e b t re p re s e n te d 8 p e r c e n t o f y e a r-e n d d e b to rs . B ad debts o v e r th e last tw o y e a rs h a ve re p re s e n te d 1 p e r c e n t o f y e a r-e n d d e b to rs.
R e q u ire d : 1
W h ic h o f th e a b o v e tra n s a c tio n s w o u ld no t re q u ire a jo u rn a l en try?
2
W h ic h o f th e expe nses w o u ld a ffe c t th e o p e ra tin g p ro fit?
PROBLEM 13.15 In te rp re t revenue re co g n itio n notes BHP B illito n is th e w o rld 's la rg e s t d iv e rs ifie d resources c o m p a n y . Its c o re o p e ra tio n s in v o lv e p ro d u c tio n o f a lu m in iu m , c o p p e r, z in c , iro n o re , d ia m o n d s , o il a n d g a s. R ead th e fo llo w in g e x c e rp t fro m th e 2 0 1 4 a n n u a l re p o rt o f BHP B illito n . SALES R E V E N U E
R evenue fro m th e sale o f goods and disposal o f o th e r assets is recognised w hen persuasive evidence (usually in th e fo rm o f an execu ted sales ag ree m e nt) o f an arra ngem en t exists and; • th e re has been a tra n s fe r o f risks and rew ards to th e cu stom er; • no fu rth e r w ork o r processing is required by th e G ro u p ; • th e q u a n tity and q u ality o f th e goods has been de te rm in ed w ith reasonable accuracy; • th e price is fixed o r determ inable; • co lle c ta b ility is reasonably assured. Revenue is th e re fo re generally recognised w hen title passes. In th e m a jo rity o f sales f o r m ost co m m o dities, sales agreem ents specify th a t title passes on th e bill o f lading date, w hich is th e date th e c o m m o d ity is delivered to th e shipping agent. F o r these sales, revenue is recognised on th e bill o f lading date. F o r ce rtain sales (p rincip ally coal sales to adjoining po w er stations and diam ond sales), title passes and revenue is recognised w hen th e goods have been delivered. Source: B H P Billiton, Annual Report 2014.
E x p la in w h e n BHP re co g n ise s reven ue in term s th a t y o u r fe llo w students w ill u n d e rsta n d .
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PROBLEM 13.16 Percentage o f com pletion versus com pleted c o n tra ct M u lti-S to re y B u ild e rs Ltd h a d a la rg e th re e -y e a r p ro je c t w ith to ta l reven ue o f $ 8 0 0 0 0 0 0 a n d e s tim a te d to ta l costs o f $ 6 5 0 0 0 0 0 . The p ro je c t w a s 2 0 p e r c e n t c o m p le te a t th e e n d o f th e firs t y e a r, 7 0 p e r c e n t c o m p le te a t th e e n d o f the s eco nd y e a r, a n d 1 0 0 p e r c e n t c o m p le te a t th e e n d o f th e th ird y e a r. Revenues a n d costs w e re as e s tim a te d . 1 W h a t p ro fit w a s e a rn e d d u rin g th e firs t y e a r if th e p e rc e n ta g e o f c o m p le tio n m e th o d w a s used? 2
W h a t p ro fit w a s e a rn e d d u rin g th e s eco nd y e a r if th e p e rc e n ta g e o f c o m p le tio n m e th o d w a s used?
3
W h a t p ro fit w a s e a rn e d d u rin g th e th ird y e a r if th e p e rc e n ta g e o f c o m p le tio n m e th o d w a s used?
4
W h a t p ro fit w a s e a rn e d d u rin g th e s eco nd y e a r if th e c o m p le te d c o n tra c t m e th o d w a s used?
PROBLEM 13.17 Percentage o f com pletion H ig h ris e C o n stru ctio n s Ltd h a d a la rg e th re e -y e a r p ro je c t w ith to ta l re ven ue o f $ 5 0 0 0 0 0 0 a n d e s tim a te d to ta l costs o f $ 4 2 0 0 0 0 0 . The p ro je c t w a s 2 5 p e r c e n t c o m p le te a t th e e n d o f th e firs t y e a r, 5 5 p e r c e n t c o m p le te a t th e e n d o f th e s eco nd y e a r, a n d 1 0 0 p e r c e n t c o m p le te a t th e e n d o f th e th ird y e a r. Revenues a n d costs w e re as e s tim a te d . 1 W h a t p ro fit w a s e a rn e d d u rin g th e firs t y e a r if th e p e rc e n ta g e o f c o m p le tio n m e th o d w a s used? 2
W h a t p ro fit w a s e a rn e d d u rin g th e s eco nd y e a r if th e p e rc e n ta g e o f c o m p le tio n m e th o d w a s used?
PROBLEM 13.18 E ffects o f ending a p o lic y o f ca p ita lisin g advertising costs K enso Lim ited has tra d itio n a lly c a p ita lis e d a p o rtio n o f its a d v e rtis in g costs as a d e fe rre d asset. The a m o u n t o f a d v e rtis in g cost c a p ita lis e d this y e a r w a s $ 3 0 0 0 0 0 , a n d th e n e w c o m p a n y 's p o lic y is to a m o rtis e th e c a p ita lis e d a m o u n t to e x p e n s e a t 2 0 p e r c e n t p e r y e a r. A n a c c o u n ta n t su g g e ste d to th e c o m p a n y 's C F O th a t th e p o lic y o f c a p ita lis in g a d v e rtis in g sh o u ld be e n d e d be ca u se th e fu tu re e c o n o m ic b e n e fit fro m the e x p e n d itu re s is no t c le a rly d e te rm in a b le . The C F O w a n ts to k n o w w h a t e ffe c t such p o lic y ch a n g e s w o u ld h a ve (ig n o re taxes).
PROBLEM 13.19 E ffects o f ca p ita lisin g w ith tax R a n d w ic k Ltd has re c o rd e d d e v e lo p m e n t costs as a n ex p e n s e . N o w th e c o m p a n y is c o n s id e rin g re c o g n is in g these costs as a n asset. If this w a s d o n e , a d e v e lo p m e n t a c c o u n t w o u ld a p p e a r in th e c u rre n t assets. Its b a la n c e w o u ld be $ 1 4 8 6 5 0 a t th e e n d o f last y e a r a n d $1 2 3 8 6 0 a t th e e n d o f th is y e a r. The c o m p a n y 's in co m e ta x ra te is 3 0 p e r cent. C a lc u la te th e e ffe c t th a t w o u ld result on e a ch o f th e fo llo w in g if th e c o m p a n y c h a n g e d its a c c o u n tin g to re c o g n is e th e d e v e lo p m e n t costs as a n asset: 1 re ta in e d p ro fits a t th e e n d o f last y e a r 2
in c o m e ta x lia b ility a t th e e n d o f last y e a r
3
su p p lie s e x p e n s e fo r th is y e a r
4
net p ro fit fo r th is y e a r
5
c u rre n t assets a t th e e n d o f this y e a r
6
in c o m e ta x lia b ility a t th e e n d o f this y e a r
7
re ta in e d p ro fits a t th e e n d o f this y e a r
8 cash flo w fo r this y e a r 9
cash flo w fo r n e xt y e a r.
PROBLEM 1 3 .2 0 E ffects o f proposed p o lic y o f ca p ita lisin g im provem ents costs, w ith incom e tax S e n io r m a n a g e m e n t o f T e le m a rk S k iin g Ltd w is h e s to c a p ita lis e $ 2 6 5 0 0 0 0 in ski-hill im p ro v e m e n t costs e x p e n d e d th is y e a r, a n d a m o rtis e th e c a p ita lis e d costs o v e r 1 0 y e a rs , ra th e r th a n just e x p e n s in g them a ll as is n o w d o n e . The c o m p a n y 's in co m e ta x ra te is 3 0 p e r ce n t, a n d th e c o m p a n y w o u ld p la n to c o n tin u e d e d u c tin g th e costs as expenses
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in c o m p u tin g in c o m e ta x p a y a b le fo r this y e a r, a ssu m in g th e ta x a u th o ritie s w o u ld p e rm it th a t. W h a t w o u ld be the e ffe c t on this y e a r's net p ro fit a n d cash flo w fro m o p e ra tio n s if th e c o m p a n y c a p ita lis e d those costs?
PROBLEM 13.21 P ro fit on various revenue re co g n itio n bases The L a tan ae C o m p a n y p ro d u ce s a s in g le p ro d u c t a t a cost o f $ 6 e a c h , a ll o f w h ic h is p a id in cash w h e n th e u n it is p ro d u c e d . S e llin g expe nses o f $ 3 a u n it a re p a id a t th e tim e o f s h ip m e n t. The sale p ric e is $ 1 0 a u n it; a ll sales a re on a c c o u n t. N o c u sto m e r d e fa u lts a re e x p e c te d , a n d no costs a re in c u rre d a t th e tim e o f c o lle c tio n . D u rin g 2 0 1 5 , th e c o m p a n y p ro d u c e d 1 0 0 0 0 0 units, s h ip p e d 7 6 0 0 0 units a n d c o lle c te d $ 6 0 0 0 0 0 fro m custom ers. D u rin g 2 0 1 6 , it p ro d u c e d 8 0 0 0 0 units, s h ip p e d 9 0 0 0 0 units a n d c o lle c te d $ 9 5 0 0 0 0 fro m custom ers. 1 Ig n o rin g in c o m e ta x fo r n o w , d e te rm in e th e a m o u n t o f p ro fit th a t w o u ld be re p o rte d fo r e a ch o f these tw o y e a rs : a
if
reven ue a n d e x p e n s e a re re c o g n is e d a t th e tim e
o f p ro d u c tio n
b
if
reven ue a n d e x p e n s e a re re c o g n is e d a t th e tim e
o f s h ip m e n t
c
if
reven ue a n d e x p e n s e a re re c o g n is e d a t th e tim e
o f c o lle c tio n .
2
W o u ld th e asset to ta l s h o w n o n th e 31 D e c e m b e r 2 0 1 6 b a la n c e sheet be a ffe c te d b y th e th re e d iffe re n t c hoice s fo r re c o g n itio n b a sis used in q u e s tio n 1 ? W h a t w o u ld be th e a m o u n t o f a n y such d iffe re n c e ?
3
R edo q u e s tio n 1 , a ssu m in g th a t th e c o m p a n y 's in co m e ta x ra te is 3 0 p e r cent.
PROBLEM 13 .2 2 Cost ca p ita lisa tio n , re n ta l incom e issues A c o m p a n y stops a c c u m u la tin g costs (c a p ita lis in g ) in a long-term asset a c c o u n t (such as a b u ild in g asset), a n d b e g in s c h a rg in g e x p e n d itu re s to e x p e n s e a n d c a lc u la tin g d e p re c ia tio n e x p e n s e on th e asset w h e n th e asset is pu t in to s ervice a n d b e g in s to e a rn reven ue . This is u s u a lly fa irly s tra ig h tfo rw a rd , b u t c o n s id e r th e fo llo w in g . The c o m p a n y o w n s an o ffic e b u ild in g th a t is sch e d u le d to be c o m p le te ly fin is h e d on 1 S ep tem be r 2 0 1 6 . A s o f 1 July 2 0 1 6 , c o nstructio n costs to ta lle d $ 3 m illio n , in c lu d in g interest on c o nstructio n fin a n c in g o f $ 1 5 0 0 0 0 ( $ 1 0 0 0 0 fro m 1 A p ril 2 0 1 6 to 1 July 2 0 1 6). The first te n a n t m o ve d in on 1 A p ril 2 0 1 6 a n d w a s fo llo w e d b y several others. A t 1 July 2 0 1 6 , a p p ro x im a te ly 4 0 p e r cent o f th e sp a c e ha d been rented. P rojections in d ic a te th a t 7 0 p e r cent o f the o ffic e sp a c e needs to be ren ted b e fo re th e b u ild in g w ill be p ro fita b le . U n fo rtu n a te ly, the v a c a n c y rate is e xtre m e ly h ig h fo r o ffic e space in this a re a o f th e c ity be ca use o f a recen t e c o n o m ic d o w n tu rn . A v e ra g e o c c u p a n c y is 6 0 p e r cent in o th e r o ffic e b u ild in g s n e a rb y , w ith no e x p e c ta tio n o f im p ro ve m e n t fo r a t least th ree y e a rs . To d a te , rent o f $ 5 0 0 0 0 has been p a id b y the tenants, in a d d itio n to expenses a m o u n tin g to $ 1 0 0 0 0 to re im b urse the c o m p a n y fo r som e o f the utilities, c le a n in g a n d o th e r c o m m o n -a re a costs o f the b u ild in g th a t to tal $ 2 5 0 0 0 fro m 1 A p ril to 1 July 2 0 1 6 . The rental revenue, c o m m o n -a re a costs a n d co m m o n -a re a cost reim bursem ents ha ve been netted a n d c a p ita lis e d , re d u c in g co n stru ctio n costs to d a te b y $ 3 5 0 0 0 in to ta l ( $ 5 0 0 0 0 + $ 1 0 0 0 0 — $ 2 5 0 0 0 ) . M o re o v e r, th e c o n s tru c tio n costs to d a te in c lu d e $ 1 0 0 0 0 0 p a id to these te nan ts b y th e c o m p a n y to c o v e r som e o f th e ir le a s e h o ld im p ro ve m e n ts (a lte ra tio n s th e te nan ts h a d to m a ke to th e ir o ffic e s p a c e to m a ke it s u ita b le fo r th e ir use, such as in te rio r w a lls , p a in tin g a n d flo o r c o ve rin g s ). These pa ym e n ts to th e tenants w e re in d u ce m e n ts to lure them a w a y fro m th e ir o ld prem ises in o th e r n e a rb y b u ild in g s a n d in to s ig n in g long -term re n ta l a g re e m e n ts (five years) w ith th e c o m p a n y . 1 Is th e c o m p a n y c o rre c t in c a p ita lis in g som e o r a ll o f th e a b o v e item s? W h y o r w h y not?
2
W h e n m ig h t be a n a p p ro p ria te tim e to re c o rd cash receipts a n d d isb ursem e nts re la te d s tric tly to re n ta l a c tiv ity as in c o m e state m e nt item s, ra th e r th a n b a la n c e sheet item s (i.e . to re c o g n is e revenues a n d expenses)?
PROBLEM 13 .2 3 Revenue and expense re co g n itio n For a Franchiser The Pie Place Ltd (TPP) w a s starte d in 2 0 1 5 to fra n c h is e a c h a in o f fa st-fo o d outlets th a t w o u ld sell o n ly pies: m e at, c h ic k e n , s e a fo o d , a p p le a n d th e like. A s p e c ia lity w a s to be p i-p ie , a re c ip e m a d e fro m v a rio u s roots (g in g e r, g in s e n g a n d so on) a n d in ve n te d b y Jane t R a n d o lp h , th e fo u n d e r a n d o w n e r o f TPP. Jane t has d iv id e d e a ch m a jo r c ity in to p o p u la tio n sectors o f a b o u t 2 0 0 0 0 0 e a c h , a n d plan s to sell o n e fra n c h is e p e r sector. For s m a lle r c itie s, fra n ch is e s w ill c o v e r ru ra l a re a s as w e ll. The fra n ch is e s w ill be g o o d fo r 1 0 y e a rs , re n e w a b le fo r a t least tw o m o re 1 0 -y e a r p e rio d s , a n d w ill sell fo r $ 2 0 0 0 0 e a c h . Each fra n c h is e e m ust p a y TPP $ 5 0 0 0 d o w n in cash , p a y th e re m a in d e r in th re e e q u a l a n n u a l instalm ents (w ith no in te re st c h a rg e s ), a n d a g re e to
CHAPTER 13 Revenue and expense recognition: additional concepts
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b u y v a rio u s in g re d ie n ts fro m TPP. In return, TPP w ill p ro v id e e x p e rt a d v ic e (Janet's), re c ip e s , h e lp w ith lo c a tin g a n d c o n s tru c tin g th e fo o d o u tle t, m a n a g e m e n t tra in in g a n d som e n a tio n a l a d v e rtis in g . (M o st a d v e rtis in g costs w ill be c h a rg e d b a c k to th e fra n ch is e s o n a p ro ra ta basis.) H e re a re d a ta fo r TPP's firs t y e a r, e n d e d 31 A u g u s t 2 0 1 6 : Franchise agreements signed
28
Down payments received
26
Fast-food outlets opened
18
Franchise-related costs
$230000
Other general expenses
$ 55000
O n e o f th e fra n ch is e s has a lre a d y g o n e o u t o f business (h a vin g p a id o n ly th e in itia l $ 5 0 0 0 ) , tw o others o f those th a t h a ve o p e n e d d o no t lo o k as if th e y a re g o in g to m a ke it, a n d o n e o f th e u n o p e n e d fra n ch is e s looks as if it w ill ne ve r g e t g o in g . 1 List as m a n y m e thods as y o u c a n th in k o f fo r re c o g n is in g reven ue fro m fra n c h is e sales. 2
R ank th ose m e tho ds fro m le ast c o n s e rv a tiv e to m ost c o n s e rv a tive .
3
List as m a n y m e thods as y o u c a n th in k o f fo r re c o g n is in g expe nses fro m fra n ch is e -re la te d costs.
4
M a tc h e a ch e x p e n s e re c o g n itio n m e th o d to th e reven ue re c o g n itio n m e th o d th a t seem s m ost a p p ro p ria te .
5
C o m p a re the p ro fit b e fo re ta x fo r 2 0 1 6 th a t w o u ld be p ro d u c e d b y tw o o r th re e o f th e m o re re a s o n a b ly m a tch e d m e tho ds o f re c o g n is in g reven ue a n d e xpe nse.
6
C h o o s e a m a tc h e d m e th o d th a t y o u th in k w o u ld be m ost a p p ro p ria te fo r TPP.
7
D ra ft an a c c o u n tin g p o lic y fo o tn o te d e s c rib in g y o u r chosen re v e n u e /e x p e n s e re c o g n itio n m e th o d fo r TPP's 31 A u g u s t 2 0 1 6 fin a n c ia l statem ents.
CASES
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll q u e s tio n s re la te to the c o n s o lid a te d a cco u n ts. 1 W h ic h o f th e notes u n d e r s ig n ific a n t a c c o u n tin g p o lic ie s (note 1) d e a l w ith reven ue a n d e x p e n s e re c o g n itio n ? 2 3
S elect th re e notes re la te d to e x p e n s e re c o g n itio n a n d p re p a re an a lte rn a tiv e p o lic y fo r th e re c o g n itio n o f the e x p e n s e . Does y o u r a lte rn a tiv e in cre a s e o r d e c re a s e p ro fit fo r th e y e a r? Find th e d o lla r v a lu e s fo r e a ch o f th e fo llo w in g fo r 2 0 1 4 : a
to ta l sales reven ue
b
cost o f g o o d s sold
c
d e p re c ia tio n
d
in tere st exp e n se
e
in co m e ta x exp e n se
f
net p ro fit a ttrib u ta b le to o u ts id e e q u ity interests.
4
W h a t is m e a n t b y p ro fit a ttrib u ta b le to n o n -c o n tro llin g interests?
5
W h y d o e s c o m p re h e n s iv e in co m e (as re p o rte d o n th e state m e nt o f c o m p re h e n s iv e inco m e ) d iffe r fro m p ro fit fo r th e p e rio d (re p o rte d o n th e in co m e statem ent)? Id e n tify th e m a jo r item s w h ic h e x p la in this d iffe re n c e .
522
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 13B__________________________ Revenue recognition policies Q u ic k flix d e s c rib e s its a c tiv itie s as fo llo w s :
T h e p rin c ip a l a c tiv itie s o f th e C o m p a n y d u rin g th e c o u rs e o f th e fin a n c ia l y e a r w e re t h a t o f th e d e v e lo p m e n t a n d o p e ra tio n o f an o n lin e m o v ie s u b s c rip tio n a n d re ta il se rv ic e .
In its O p e ra tin g a n d F in a n c ia l R e vie w th e c o m p a n y notes:
Q u ic k flix is A u s tr a lia ’s le a d in g o n lin e m o v ie re n ta l s u b s c rip tio n s e rv ic e , o ff e r in g th e la rg e s t ra n g e o f m o v ie a n d T V s h o w s a v a ila b le a n y w h e re . S u b s c rib e rs a c c e s s t h e ir s e le c tio n o f m o v ie s a n d T V title s o n lin e a n d have t h e ir c h o ic e d e liv e re d in D V D o r B lu - r a y disc s d ir e c t t o h o m e b y p o s t. S u b s c r ip tio n p la n s a re a ffo rd a b ly p ric e d f o r all A u s tr a lia n s a n d p ro v id e a c h o ic e o f o n e , tw o o r t h r e e d is c s o u t - a t - a - t im e w ith u n lim ite d r o ta tio n s t h r o u g h o u t th e m o n th ; n o la te fe e s an d p o s ta g e in c lu d e d . L a te r th is y e a r Q u ic k flix w ill la u n c h its d ig ita l s tre a m in g s e rv ic e a c c e s s ib le o v e r th e in t e r n e t v ia c o n n e c te d T V s , p e rs o n a l c o m p u te rs a n d h a n d h e ld d e v ic e s s u c h as m o b ile p h o n e s a n d ta b le ts . Source: Q uickflix, Preliminary Final Report 2011.
O u tlin e w h e n the c o m p a n y is lik e ly to re c o g n is e reven ue fo r its m a in services.
CASE 13C__________________________ Revenue recognition policies Telstra is A u s tra lia 's la rg e s t te le c o m m u n ic a tio n s c o m p a n y . S h o w n b e lo w is a c o p y o f p a rt o f its reven ue re c o g n itio n p o lic y .
Telstra R e v e n u e r e c o g n it io n O u r c a te g o rie s o f sales re v e n u e a re re c o r d e d a f t e r d e d u c tin g sales re tu rn s , tra d e a llo w a n c e s , d is c o u n ts , sales in c e n tiv e s , d u tie s a n d ta xe s.
(a) Rendering o f services R e v e n u e f r o m th e p ro v is io n o f o u r te le c o m m u n ic a tio n s s e rv ic e s in c lu d e s te le p h o n e ca lls a n d o t h e r s e rv ic e s a n d fa c ilitie s p ro v id e d , s u c h as in t e r n e t a n d da ta . W e re c o r d re v e n u e e a rn e d f r o m : •
te le p h o n e ca lls o n c o m p le tio n o f t h e ca ll
•
o t h e r s e rv ic e s g e n e ra lly a t c o m p le tio n , o r o n a s tra ig h t lin e basis o v e r th e p e rio d o f s e rv ic e p ro v id e d , un le ss a n o th e r m e th o d b e tt e r re p re s e n ts th e s ta g e o f c o m p le tio n . In s ta lla tio n a n d c o n n e c tio n fe e re v e n u e s t h a t a re n o t c o n s id e re d t o be s e p a ra te u n its o f a c c o u n tin g are
d e fe rre d a n d re c o g n is e d o v e r t h e a v e ra g e e s tim a te d c u s to m e r life . In c r e m e n ta l c o s ts d ir e c tly re la te d t o th e s e re v e n u e s a re a lso d e fe rre d a n d a m o r tis e d o v e r t h e c u s to m e r c o n t r a c t life in a c c o r d a n c e w ith n o te 2 .1 2 (d ). In re la tio n t o b a sic a c c e s s in s ta lla tio n a n d c o n n e c tio n re v e n u e , w e a p p ly m a n a g e m e n t ju d g e m e n t t o d e te rm in e th e e s tim a te d c u s to m e r c o n t r a c t life. B ased o n o u r re v ie w s o f h is to ric a l in fo r m a tio n a n d c u s to m e r tre n d s , w e ha ve d e te rm in e d t h a t o u r a v e ra g e e s tim a te d c u s to m e r life is 5 y e a rs ( 2 0 1 3 : 5 y e a rs ).
(b) Sale o f goods O u r re v e n u e f r o m t h e sale o f g o o d s in c lu d e s re v e n u e f r o m th e sale o f c u s to m e r e q u ip m e n t a n d s im ila r g o o d s . T h is re v e n u e is re c o r d e d o n d e liv e ry o f t h e g o o d s so ld .
»
CHAPTER 13 Revenue and expense recognition: additional concepts
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» (c) Rent o f network facilities W e e a rn r e n t m a in ly f r o m a c c e s s t o re ta il a n d w h o le s a le fix e d a n d m o b ile n e tw o r k s a n d f r o m th e r e n t o f d e d ic a te d lin e s, c u s to m e r e q u ip m e n t, p r o p e rty , p la n t a n d e q u ip m e n t a n d o t h e r fa c ilitie s . T h e re v e n u e f r o m p r o v id in g a c c e s s t o th e n e tw o r k is re c o r d e d o n an a c c ru a l basis o v e r th e re n ta l p e rio d .
(d) Construction contracts W e re c o r d c o n s tr u c tio n re v e n u e a n d p r o f it o n a p e rc e n ta g e o f c o n t r a c t c o m p le tio n basis. T h e p e rc e n ta g e o f c o m p le tio n is c a lc u la te d b a sed o n e s tim a te d c o s ts t o c o m p le te th e c o n tr a c t. O u r c o n s tr u c tio n c o n tr a c ts a re c la s s ifie d a c c o r d in g t o t h e ir ty p e . T h e re a re tw o ty p e s o f c o n s tr u c tio n c o n tr a c ts : m a te ria l in te n s iv e a n d s h o rt d u ra tio n . R e v e n u e a n d p r o f it a re re c o g n is e d o n a p e rc e n ta g e o f c o m p le tio n basis u s in g th e a p p ro p ria te m e a s u re s as fo llo w s : •
f o r m a te ria l in te n s iv e p ro je c ts : (a c tu a l c o s ts d iv id e d b y p la n n e d c o s ts ) m u ltip lie d b y p la n n e d re v e n u e ,
•
f o r s h o r t d u ra tio n p ro je c ts (th o s e t h a t a re e x p e c te d t o be c o m p le te d w ith in a m o n th ) : re v e n u e s , p r o f it
in c lu d in g p r o f it
a n d c o s ts a re re c o g n is e d o n c o m p le tio n .
(e) Advertising and Directory services C la s s ifie d a d v e rtis e m e n ts a n d d is p la y a d v e rtis e m e n ts a re p u b lis h e d o n a d a ily , w e e k ly a n d m o n th ly basis an d re v e n u e s a re re c o g n is e d w h e n t h e a d v e r tis e m e n t is p u b lis h e d . A ll o f o u r Y e llo w P a g e s ® a n d W h ite P a g e s ® d ir e c t o r y p r in t re v e n u e s a re re c o g n is e d o n d e liv e ry o f th e p u b lis h e d d ire c to rie s t o c u s to m e rs ’ p re m is e s . R e v e n u e f r o m o n lin e d ire c to rie s is re c o g n is e d o v e r th e life o f s e rv ic e a g re e m e n ts , w h ic h is o n a v e ra g e o n e y e a r. V o ic e d ir e c t o r y re v e n u e s a re re c o g n is e d a t th e tim e o f p ro v id in g th e s e rv ic e t o c u s to m e rs . Source: Telstra C orporation Limited, 2014 Annual Report.
1
C o n s id e r y o u r o w n m o b ile p h o n e c o n tra c t a n d o u tlin e h o w y o u th in k Telstra (o r y o u r s u p p lie r) w o u ld re c o g n is e re ven ue fro m y o u r p la n .
2
P ro v id e an e x a m p le fo r Telstra o f d e liv e rin g o f g o o d s s o ld u n d e r S ale o f g o o d s .
3
E x p la in w h a t is m e a n t u n d e r Rent o f n e tw o rk fa c ilitie s .
4
P ro v id e an e x p la n a tio n o f w h y Telstra uses p e rc e n ta g e o f c o m p le tio n on som e p ro je c ts b u t c o m p le te d c o n tra c t on others.
5
E x p la in th e d iffe re n t reven ue m e tho ds used fo r A d v e rtis in g a n d D ire c to ry services a n d w h y th e y m a y h a ve been chosen .
CASE 13D______________________________Deferred expenditure O u tlin e d b e lo w a re a c c o u n tin g p o lic ie s fo r B o ra l a n d A G L w ith respe ct to d e fe rre d e x p e n d itu re .
Bora I 2014 D e fe r r e d e x p e n s e s E x p e n d itu r e is d e fe rre d t o th e e x te n t t h a t it is c o n s id e re d p ro b a b le t h a t f u t u r e e c o n o m ic b e n e fits e m b o d ie d in th e e x p e n d itu r e w ill e v e n tu a te a n d c a n be re lia b ly m e a s u re d . D e fe r re d e x p e n s e s in c lu d in g d e fe rre d m a in te n a n c e a re a m o rtis e d o v e r th e p e rio d in w h ic h t h e re la te d b e n e fits a re e x p e c te d t o be re a lis e d . T h e c a rr y in g v a lu e o f d e fe rre d e x p e n d itu r e is re v ie w e d in a c c o rd a n c e w ith th e p o lic y s e t o u t u n d e r im p a irm e n t. Source: Boral Lim ited, Annual Report 2014.
524
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
AGL 2014 N e t fin a n c in g c o s ts In te r e s t in c o m e is re c o g n is e d as it a c c ru e s in p r o f it o r loss, u s in g th e e ffe c tiv e in te r e s t m e th o d . F in a n c e c o s ts d ir e c tly a ttr ib u ta b le t o th e a c q u is itio n , c o n s tr u c tio n o r p r o d u c tio n o f q u a lify in g assets, a re a d d e d t o t h e c o s t o f th o s e assets. A ll o t h e r fin a n c e c o s ts a re re c o g n is e d in p r o f it o r loss in th e p e rio d in w h ic h th e y are in c u rr e d . F in a n c e c o s ts c o m p ris e in te r e s t e x p e n s e o n b o rro w in g s c a lc u la te d u s in g t h e e ffe c tiv e in te re s t m e th o d , a m o r tis a tio n o f b o rr o w in g c o s ts re la tin g t o lo n g - t e r m fin a n c in g fa c ilitie s , u n w in d in g o f th e d is c o u n t o n p ro v is io n s a n d d e fe rre d c o n s id e r a tio n , a n d g a in s a n d losses o n c e rta in h e d g in g in s tru m e n ts t h a t a re re c o g n is e d in p r o f it o r loss. Source: A G L , Annual Report 2014.
For e a ch c o m p a n y , p ro v id e a ra tio n a le fo r th e c o m p a n y tre a tin g th e e x p e n d itu re as th e asset d e fe rre d e x p e n d itu re ra th e r th a n tre a tin g it as an ex p e n s e .
CASE 13E_____________ Cricket, revenue recognition and expense recognition The S y d n e y C ric k e t G ro u n d Trust re le a se d th e fo llo w in g o ffe r:
Prem ium co lle ctab les Steve W augh fine a rt lim ite d e d itio n p rin t N o w y o u c a n o w n th is m a g n ific e n t p ie c e o f o f fic ia l A C B m e m o r a b ilia - a lim it e d e d itio n fin e a r t p r in t o f A u s tr a lia n c r ic k e t c a p ta in , S te v e W a u g h . R e n o w n e d A u s tr a lia n s p o rts a r tis t M a r k S o fila s has p ro d u c e d th is f in e a r t p r in t o f S te v e W a u g h t o h o n o u r a g r e a t c r ic k e tin g le g e n d . T h e re a re o n ly 1 5 0 0 o f th e s e lim ite d e d itio n p rin ts , e a c h o n e in d iv id u a lly s ig n e d a n d n u m b e re d b y S te v e W a u g h a n d M a r k S o fila s , w ith a c e r t if ic a t e o f a u th e n t ic it y a c c o m p a n y in g e a c h p rin t. •
R e ta il p ric e ( u n fr a m e d ) : $ 2 7 5 e a c h (p lu s $ 1 0 p o s ta g e )
•
T r u s t m e m b e r s ’ p ric e : $ 2 5 0 (p lu s $ 1 0 p o s ta g e )
•
T o o rd e r, c o m p le te th e o r d e r f o r m a n d re tu rn t o th e T r u s t
•
A llo w 3 0 d a ys f o r d e liv e ry .
1
A ssum e th e Trust is th e p ro m o te r o f th e lim ite d e d itio n p rin ts (i.e . it receive s a ll revenues a n d pa ys a ll costs). D e s crib e th e a lte rn a tiv e s th e Trust has in re la tio n to w h e n it re co g n ise s reven ue . W h ic h w o u ld y o u suggest?
2
H o w w o u ld y o u r a n s w e r d iffe r if th e Trust in c lu d e d an o ffe r th a t th e p rints c o u ld be re tu rn e d w ith in tw o m onths if th e p u rc h a s e r is no t c o m p le te ly sa tisfie d ? The p u rc h a s e r w o u ld re c e ive a re fu n d o f $ 2 0 0 .
3
A ssum e th e Trust is n o t th e p ro m o te r b u t is a se llin g a g e n t; th a t is, it sends o u t th e b ro ch u re s , c ollects th e o rd e r fo rm s, re ta in s 2 0 p e r c e n t ($ 5 5 ) p e r p rin t a n d passes th e o rd e r o n to th e p ro m o te r, w h ic h fills th e o rd e r. A ssum e a n o -refu nd p o lic y . W h e n sh o u ld th e Trust re c o g n is e revenue?
4
Does th e a c c o u n tin g p ro fe s sio n h a ve th e skills to p ro v id e th e c e rtific a te o f a u th e n tic ity ? D o y o u b e lie v e th e Trust, o r a n y o th e r s eller o f c o lle c ta b le s , is lik e ly to see a d v a n ta g e s in m e m b ers o f p ro fe s s io n a l a c c o u n tin g b o d ie s p ro v id in g this c e rtific a te o f a u th e n tic ity ?
5
A Trust m e m b e r w a s s ittin g b e h in d tw o a c c o u n tin g students a t a recen t m atch a n d h e a rd them discussing cost o f g o o d s s o ld . H e show s y o u th e a b o v e b ro c h u re , buys y o u a b e e r e a ch a n d asks y o u w h a t the C O G S w o u ld be fo r th e lim ite d e d itio n p rin t.
6
A ssum e Steve W a u g h receives a fla t fe e fo r s ig n in g th e prints. W h e n w o u ld th e Trust re c o g n is e this e xpe nse?
7
A ssum e Steve W a u g h gets p a id a c o m m is sio n b a se d o n sales. W h e n w o u ld th e Trust re c o g n is e this e xpe nse?
CHAPTER 13 Revenue and expense recognition: additional concepts
525
COURSEMATE
f C o u rs e M a te Go to h ttp ://lo g in .c e n g a g e b ra in .c o m to access CourseMate, your online study tool for Financial Accounting. CourseMate brings chapter concepts to life with interactive learning, study and exam preparation tools. >
R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
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Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
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Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
The statement oF cash Flows ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO explain the contents of a statem ent of cash flows distinguish betw een cash flo w from operations, cash flo w from investing a n d cash flo w from financing interpret a statem ent o f cash flows calculate cash flo w from operations, using both the direct a n d indirect methods p re p a re a statem ent of cash flows.
CHAPTER OVERVIEW A sta te m e n t o f ca sh flo w s p ro v id e s re le v a n t in fo rm a tio n to users a b o u t th e ca sh in flo w s a n d cash o u tflo w s o f a n e n tity d u rin g a fin a n c ia l y e a r. E v a lu a tin g th e e n tity 's c a sh m a n a g e m e n t is so im p o rta n t th a t th e result o f th is a n a ly s is , c a lle d th e s ta te m e n t o f ca sh flo w s , is in c lu d e d as p a rt o f th e set o f fin a n c ia l statem ents. S in ce 1 9 9 2 , a c c o u n tin g s ta n d a rd s h a v e re q u ire d th a t a n e n tity p re se n t a s ta te m e n t o f c a sh flo w s w ith its p u b lis h e d fin a n c ia l state m e nts. U n d e rs ta n d in g th e statem ent o f cash flo w s is im p o rta n t fo r a ll users o f a c c o u n tin g rep orts in g a in in g a be tte r in s ig h t in to th e health o f a c o m p a n y . U n d e rta k in g the d e ta ile d a n a ly s is th a t is re q u ire d fo r p re p a rin g a statem ent o f cash flo w s is a g o o d w a y to ce m e n t y o u r u n d e rs ta n d in g o f w h a t the fin a n c ia l statem ents c o n ta in a n d th e in te rre la tio n s h ip b e tw e e n in co m e statem ent a cco u n ts a n d b a la n c e sheet acco un ts.
528
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
14.1
The purpose of cash flow analysis
Perform ance in generating a d d itio n a l w ealth for the entity, as measured b y accrual profit, is very im portant to m anagers, investors, tax authorities a nd m any others. But the w o rld is a co m p le x place, a n d there is m ore to perform ance than generating accrual profit. An a d d itio n a l, im portant aspect o f perform ance is m a n a g in g the in flo w and o u tflo w of cash so that the entity has enough cash to p a y its bills, fin a n ce its g row th an d keep its b o rro w in g under control. This w ill not be a surprise to you: everyone has to w o rry a b o u t cash flo w , a b o u t h o w much cash is a va ila b le , and w h e re a d d itio n a l cash w ill com e from. N o business entity can survive w ith o u t cash. (N o r can other organisations, such as governm ents - as w e have seen in recent years w ith governments struggling to raise enough cash from taxes a nd other charges to meet their financial and social ob lig a tio n s.) Em ployees, suppliers an d tax authorities must be p a id , loans must be repaid and assets must be kept up to d ate. M a n y n e w an d established firms have had positive net profit figures, yet have still run out o f cash and g o n e bankrupt. Thus, it is im portant for present an d potential investors a nd creditors to have inform ation abou t a firm 's cash inflow s an d outflow s an d its resulting cash position. C an the firm meet all its debts and o bligations as they fall due (an a b ility com m only referred to as solvency)? Does it have enough cash a nd short-term assets n o w to cover its im m ediate debts a nd o b lig a tio n s (a condition com m only c a lle d liquidity)? Entities can ge t into difficulty by not m a n a g in g their cash properly. C onversely, some entities seem to have rather a lot o f cash, raising questions a b o u t w h a t is being d o n e w ith the cash. Keeping a large supply o f cash lying around idle is no w a y to earn a return for ow ners. The cash should be put to w o rk by m aking investments, im proving the buildings a nd equipm ent, attracting n e w customers o r p a yin g off interest-bearing debt. The cash situation can be obscured som ew hat by accrual a ccounting. Let's take an extreme exam ple. Suppose a c o m p a n y has revenue o f $ 1 0 0 0 but it is all on credit, an d none o f the customers has p a id yet. In o rd e r to generate the revenue, the c o m p a n y has expenses o f $ 7 0 0 , a nd they all have to be p a id soon. The accrual p rofit w ill be the revenue minus the expenses, o r $ 3 0 0 . Looks g o o d : a 3 0 per cent return on revenue. But the c o m p a n y is in trouble. It has no cash to p a y its expenses; instead, it has $ 1 0 0 0 o f accounts receivable, w h ich cannot be used to pay expenses unless the customers p a y or some other w a y is found to ge t cash for the receivables. The c o m p a n y is likely to w a n t to b o rro w m oney from a bank o r other lender to pro vid e it w ith the needed cash. H o w much should it b orrow ? Should it pressure the customers for paym ent? Should it ask its creditors for m ore time to p a y the $ 7 0 0 in expenses? H o w w ill it be a b le to afford a planned n e w m achine to keep its product q u a lity com petitive? All these questions concern the m anagem ent of cash, an d they are not easy to an sw e r based on the accrual accounting profit. To assist w ith such questions, the statement o f cash flow s provides inform ation a b o u t a firm 's generation an d use o f cash and highly liquid short-term assets, an d , therefore, assists in evaluating the firm 's fin a n cia l v ia b ility. The analysis o f cash flow s provides different inform ation from the summary o f accrual-based perform ance in the incom e statement. N um erous times e arlier in the b o o k it w a s show n that accrual profit is not the same as cash profit. If you are not sure w h y, g o b a ck to the early part o f C h a p te r 5 for exam ples. Som e revenues an d expenses d o not involve an in flo w o r o u tflo w o f cash in the present p e riod. The exam ple o f uncollected revenue has a lre a d y been m entioned. D epreciation is another exam ple here: the cash flo w h a p pened close to w hen the asset w a s a cq u ire d , so the depreciation expense does not involve a n y current cash flo w . The purpose of the analysis o f cash flo w is, therefore, tw o fo ld : •
to produce a measure o f perform ance that is based on d a ^ to -d a y cash flo w : cash generated by o rd in a ry business activities, instead o f accrual acco u n tin g . This measure, w h ich w e have c a lle d cash profit, an d w h ich the statement of cash flow s calls cash flo w from operations, does not im ply that accrual p rofit is in va lid ; rather, it provides a different perspective on perform ance an d therefore enhances the inform ation for users.
•
to incorporate other non-operating cash inflow s a nd outflow s, such as from investing in n ew assets, selling old ones, b o rro w in g o r repaying debts, o b ta in in g n ew c a p ita l from shareholders o r p a yin g dividends to shareholders. By including these non-operating cash flow s, the statement o f cash flow s can pro vid e a com plete description o f h o w the firm 's cash w a s m a naged during the p e riod. It can tell the full story o f w h y the firm has more, o r less, cash at the end o f the period than it had a t the b e g in n in g .
CHAPTER 14 The statem ent o f cash flows
529
W ith all this inform ation, the user can evaluate m anagem ent's strategy fo r m a naging cash an d make a better judgem ent of the com pany's liquidity, solvency, risk an d opportunities than could be m ade just from the b a la n ce sheet and incom e statement.
14.2
Overview of the statem ent of cash flows
C lassification o f cash flo w transactions A ccounting standards suggest that fo r profit-seeking organisations it w o u ld be normal to d iv id e cash flo w transactions into o perating activities, investing activities a n d fin a n cin g activities. • •
O p e ra tin g activities are those activities that relate to the provision o f g o o d s an d services. Investing activities are those activities that relate to the acquisition a n d disposal o f noncurrent assets, including property, plant, equipm ent an d other productive assets, an d investments such as securities, that d o not fall w ithin the definition o f cash.
•
Financing activities a re those activities that relate to c h a n g in g the size an d com position o f the fin a n cia l structure of the entity, including equity, a nd b o rrow ings not fa llin g w ithin the definition o f cash. Exhibit 14.1 provides the classification o f typical cash inflow s an d outflow s. N o te that accounting standards d o
a llo w some variation on the classifications under some circumstances but this does g ive you the basics.
EXHIBIT 14.1
CLASSIFICATION OF CASH FLOW TRANSACTIONS O PERATING , IN VESTIN G AND FINANCING
O perating receipts from:
Investing receipts from:
Financing receipts from:
Sale of goods and services
Sale of property, plant and equipment
Issue of shares
Interest or dividends received
Sale of shares held as investments
Borrowings
Payments for:
Payments for:
Payments for:
Purchase of inventory
Acquisition of property, plant and equipment
Dividend distributions
Wages of employees
Acquisition of shares and notes for investment purposes
Share buybacks
Taxes to governments
Repayment of borrowings
Interest to lenders
Form at o f the sta te m e n t o f cash flow s The statement o f cash flow s, like the other statements, has a standard form at (see Exhibit 14 .2 ). It is useful to know, because variations from that form at m ay be a signal o f special circumstances o r problems. Som e im portant features o f this form at are: 1 2
The statement o f cash flow s covers the sam e p eriod as the incom e statement. C ash includes some equivalents: very liquid near-cash assets that can be turned into cash w ith o u t a n y risk of loss, such as dem and bank deposits a n d certificates w ith a maturity o f three months o r less.
3
W h ile the form at is traditional, recent changes to International Financial Reporting Standards d o a llo w some alternative classifications. For exam ple, interest p a id is a llo w e d to be included under fin a n cin g activities.
4
In some cases, cash m ay include tem porary negative bank balances (overdrafts) if they are just a result o f cash m anagem ent activity an d the bank balances regularly va ry from positive to negative.
530
5
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The statement o f cash flow s follow s some rules to ensure that its focus stays on cash. For exam ple, if a d ivid e n d has been de cla re d but not all p a id , o nly the p a id part is included in the statement of cash flo w s' fin a n cin g activities section. A nother exam ple: if there is an account p a y a b le for a noncurrent asset, the investing activities figure shows o nly the am ount p a id so far.
6 Follow ing on from point 4 , a n y asset acquisitions, b o rro w in g o r share issues that are d o n e w ith o u t cash - such as a cquiring land in return for shares - a re excluded from the statement o f cash flow s. (They w o u ld be disclosed in a note to the statement o f cash flows.) 7
A ny o f the numbers in the statement o f cash flow s can be positive o r negative, a cco rd in g to w h a t happened during the p e riod. For exam ple, a really b a d ye a r can result in cash from operations being negative, in w h ich case it m ight be described as cash used in operations! As another exam ple, a c o m p a n y undergoing significant restructuring could have m ore cash com ing in from selling o ff assets than g o in g out to buy more, so its investing section could be a positive cash in flo w instead of the usual cash outflow .
8
D eriving the cash flo w from day-to-day operations is o ne o f the main reasons for having the cash flo w analysis. The cash from operations figure takes a w a y accrual accounting's m any adjustments, w h ich a re very im portant in measuring profit but obscure the cash effects. To em phasise this, statements o f cash flow s in m any countries begin w ith the net profit figure, then e xp licitly remove the effects o f changes in accounts receivable, accounts pa ya b le , depreciation an d other accruals. This is ca lle d the indirect method o f deriving cash from operations, as distinct from the direct method of just listing o p erating cash receipts an d d educting op e ra tin g cash payments (also called disbursements). In Australia, the direct method is used w ith a note sh o w in g the indirect method. Figure 14.1 com pares the tw o methods, both o f w h ich end up w ith the sam e figure for cash from operations.
CHAPTER 14 The statem ent o f cash flows
D ir e c t m e t h o d
531
In d ir e c t m e t h o d
H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: C o n s id e r th e fo llo w in g ite m s : •
cash sales, $ 1 0 0 0 0 0
•
c re d it sales, $ 2 5 0 0 0 0
•
cash re c e iv e d fr o m a c c o u n ts re c e iv a b le , $ 1 7 0 0 0 0
•
b o rro w in g s fr o m th e b a n k , $ 8 0 0 0 0
•
issue o f sh a re s, $ 1 5 0 0 0 0 W h a t is cash flo w fr o m o p e ra tio n s ? Y o u r a n s w e r s h o u ld be : $ 1 0 0 0 0 0 + $ 1 7 0 0 0 0 = $ 2 7 0 0 0 0 .
D irect versus in d ire ct m ethod o f repo rting cash flo w from operations Cash flow from operations can be reported using either the direct method o r the indirect method. The direct method of cash flow analysis reports gross cash inflow s an d gross cash outflow s. An exam ple o f using the direct method is show n fo rX Y Z Limited in Exhibit 1 4 .3 . The inform ation for the direct method can be o b ta in ed by: 1
using the accounting system, w h ich d irectly records a nd analyses the cash flow s in relation to the cash transaction (see below )
2 adjusting sales, cost of sales a n d other profit a nd loss items for non-cash items (to be illustrated in section 1 4 .3 ).
532
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
For an illustration o f the first method, refer to the Reval Limited exam ple in Exhibits 4 . 1 0 a nd 4 .1 1 o f C h a p te r 4 . The statement of cash flow s (including cash flo w from operations) could be o b ta in ed b y dissecting the general ledger account cash in Exhibit 4 .1 1. You m ay need to refer to Exhibit 4 . 1 0 to o btain further details o f some o f these transactions. By sum marising the entries in the cash ledger acco u n t w e can see the fo llo w in g : $ 1
Opening balance
25 000
2
Cash from accounts receivable
30000
3
Cash sales
20000
4
Cash from mortgage loan
35 000
5
Payments to accounts payable
15 000
6
Payments for repairs and maintenance
7
Purchase of land
500 40000
8
Payments of cash for wages
12 000
9
Purchase of plant and equipment for cash
20000
10
Closing balance
22 500
CHAPTER 14 The statem ent o f cash flows
533
Items 2, 3, 5 , 6 an d 8 all affect cash flo w from operations. Item 4 w o u ld be classified under financing activities. Items 7 a nd 9 w o u ld be classified as investing activities. The cash flo w from operations w o u ld be calculated as follows: $ Receipts from customers (30000 + 20 0 00 )
50000
Payments to suppliers and employees (15 000 + 500 + 12 000)
(27 5 0 0 )
Cash flow from operations
22 500
A full statement o f cash flow s from Reval Limited is shown in Exhibit 1 4 .4 .
Australian A ccounting Standards require the direct method o f presentation for cash flo w from operations because it provides inform ation that is not otherw ise a v a ila b le in the b a la n ce sheet an d the incom e statement. A ccounting Standards suggest that it provides a m ore useful basis for estim ating future cash flow s than the indirect method, w hich shows o n ly the net am ount o f cash flow s from op e ra tin g activities an d does not report the individual com ponents of cash flow s from operations. U nder the indirect method, the accrual-based profit figure is adjusted to ge t the cash flo w from operations by a d d in g o r subtracting: •
adjustments to remove accruals for non-cash expenses (or revenues) arising from noncurrent asset changes, such as de p re cia tio n expense, an d p rofit or loss on the sale o f noncurrent assets
•
adjustments to remove accruals for uncollected revenues, revenues received in advance, prepaid expenses and unpaid expenses, represented by changes in non-cash w orking capital accounts (current assets and current liabilities). The indirect method w ill be discussed further in section 1 4 .5 .
14.3
Preparation using the direct m ethod1
U nder the direct method o f presenting cash flow s from operations, it is necessary to calculate cash receipts from customers, payments to suppliers a nd em ployees, an d other expense an d revenue items affecting cash flow s. The cash flow s from investing an d fin a n cin g are then calculated.
534
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
W e w ill use the inform ation in Exhibits 1 4 .5 an d 1 4 .6 to illustrate the direct method.
EXHIBIT 14.6
MICHAEL LIMITED C O M PA R A TIVE BALANCE SHEETS AS A T 3 0 JUNE 2 0 1 5 A N D 2 0 1 6
2016
2015
$
$
Cash
25 000
40000
Accounts receivable
90000
70000
Inventory
62 000
45 000
8 000
5 000
185000
160 00 0
Land
400000
200000
Equipment (at cost)
280000
150 00 0
Current assets
Prepaid insurance Total current assets Noncurrent assets
Less: Accumulated depreciation
(58 000)
(45 000)
Total noncurrent assets
622000
305000
Total assets
807000
465000
60000
40000
Wages payable
4000
7000
Income tax payable
6000
5 000
Interest payable
11000
10000
Total current liabilities
81 000
62 000
Current liabilities Accounts payable
»
CHAPTER 14 The statem ent o f cash flows
535
Noncurrent liabilities Loans payable
250000
200000
Total liabilities
331 000
262000
Net assets
476000
203000
367000
163000
Shareholders' equity Issued capital Asset revaluation surplus
50000
0
Retained profits
59 000
40000
476000
203000
Total shareholders' equity A d d itio n a l inform ation: • All purchases are on credit. •
A ccounts p a ya b le o n ly relates to inventory.
•
Loans p a ya b le o f $ 1 5 0 0 0 0 w ere p a id b a ck during the year.
•
The land w a s revalued upw ards by $ 5 0 0 0 0 .
•
Equipment that cost $ 3 0 0 0 0 w a s sold during the year.
Cash flow s from op erating activities To determ ine the cash flow s from operations using the direct method, it is necessary to convert the accrual-based figures to a cash basis for each o f the items outlined b e lo w . The inform ation for this section o f the cash flo w comes from the incom e statement an d the balances for current assets a nd current liabilities in the b a la n ce sheet.
CASH RECEIPTS FROM CUSTOMERS C ash receipts from customers w ill not be the same as sales, because not all accounts receivable w ill have p a id by year-end. C ash received from customers w ill be less than sales if the b a la n ce o f accounts receivable increases and w ill be greater than sales if the accounts receivable b a la n ce decreases. Therefore, to determ ine the cash received from customers, w e need the sales figure from the incom e statement a nd the o p e n in g an d closing balances of accounts receivable from the b a la n ce sheet. To understand the relationship betw een accounts receivable, sales a n d cash received from customers, you may need to think through the debits a nd credits affecting the accounts receivable account. To keep things sim ple a t this stage, w e w ill assume that all sales are on credit an d that there are no b a d debts. Accounts receivable increases w hen credit sales are m ade: DR CR
Accounts receivable Sales
Accounts receivable decreases w hen cash is received: DR CR
Cash Accounts receivable
As a result, the accounts receivable a ccount w o u ld norm ally a p p e a r as follow s: Accounts receivable Opening balance Credit sales Closing balance
Cash received from customers
536
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A lternatively, for the accounts receivable account it can be expressed as follow s: Opening balance + credit sales - cash received from customers = closing balance or Cash received from customers = credit sales + opening balance - closing balance
For M ic h a e l Limited, w h o se fin a n cia l statements are shown in Exhibits 1 4 .5 a nd 1 4 .6 , the cash receipts for customers can be determ ined given that w e kn o w that the o p e n in g a nd closing balances o f accounts receivable w e re $ 7 0 0 0 0 and $ 9 0 0 0 0 , respectively; a n d , from the incom e statement, that credit sales w e re $ 4 2 1 0 0 0 .
A lternatively, using the form ula a bove: Cash received from customers = 421 0 0 0 + 7 0 0 0 0 - 9 0 0 0 0 = 401 0 0 0
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: It is im p o rta n t fo r yo u to u n d e rsta n d w h a t goes in to an a c co u n ts receivable a c c o u n t and an in v e n to ry a c c o u n t. W h a t is th e jo u rn a l e n try fo r c re d it sales o f $ 1 0 0 0 0 0 o f goods th a t c o s t th e c o m p a n y $ 7 0 0 0 0 ? Y o u r answ er should be: DR CR DR CR
A c c o u n ts re c e iv a b le
100000
S ales
100000
COGS
70000
In v e n to ry
70000
C A S H PAID T O SUPPLIERS To calculate the cash p a id to suppliers requires a tw o-stage process. First, it is necessary to calculate the am ount of purchases. This can be found from the inventory account, given that you know the o p e n in g a nd closing balances of inventory from the b a la n ce sheet an d the cost of g o o d s sold used in ca lculating net profit. Recall that the main journal entries that affect accounts p a y a b le a re as follow s: •
purchase o f inventory on credit (assuming p e rp e tu a l inventory m ethod]:
DR CR
•
In v e n to ry A c c o u n ts p a y a b le •
paym ent to suppliers:
DR CR
A c c o u n ts p a y a b le C ash
CHAPTER 14 The statem ent o f cash flows
537
Assuming that all inventory is purchased on credit, w e can determ ine the cash p a id to suppliers fo r inventory by M ic h a e l Limited as fo llo w s. N o te that the missing figures calculated in each T-account are in bo ld to make the exam ple easier to fo llo w .
By solving for the missing purchases figure in the in v e n to y a ccount a n d transferring it to accounts p a y a b le via the d o u b le -e n ty system (i.e. DR, CR Accounts p a yable), w e can w o rk out the am ount o f missing cash p a id to suppliers. If you prefer, solve the a b o v e a lg e b ra ica lly. From the a b o ve you can determ ine that: Purchases = COGS + Closing inventory - Opening inventory
= 151000 + 6 2 0 0 0 -4 5 0 0 0 = 168000 and Payment to suppliers = Purchases + Opening accounts payable - Closing accounts payable
= 168000 + 4 0 0 0 0 -6 0 0 0 0 = 148000
P A Y M E N TS T O O TH E R SUPPLIERS FO R SERVICES, A N D T O EMPLOYEES U nder an accrual system, paym ent for expenses such as w a g e s, interest, insurance, tax, electricity, rent a nd so on m ay be the same, o r more, o r less than the actual expense figure in the incom e statement. The differences result because of increases/decreases in p rep a ym e n ts/a ccru a ls. For exam ple, in M ic h a e l Limited, p re p a id insurance increases from $ 5 0 0 0 to $ 8 0 0 0 ; therefore, the paym ent for insurance is $ 3 0 0 0 greater than the expense for the period. W a g e s p a y a b le reduces from $ 7 0 0 0 to $ 4 0 0 0 , w h ich means that the paym ent for w a g e s w a s $ 3 0 0 0 greater than the expense o f the p e riod. Taxes p a y a b le an d interest p a y a b le both increased by $ 1 0 0 0 during the year, m eaning that both expense amounts w e re $ 1 0 0 0 greater than the cash p a id . There are no other b a la n ce sheet accounts in d ica tin g further accrual o f expenses o r prepaym ents. Therefore, the other expenses c a te g o ry in the incom e statement o f $ 3 7 0 0 0 w a s all p a id in cash. The d e p re cia tio n am ount of $ 2 0 0 0 0 does not affect cash, an d therefore is not included in the statement o f cash flow s (recall that the entry for depre cia tio n is DR dep re cia tio n expense, CR accum ulated d e p re cia tio n , thus cash is not affected). Sim ilarly, the loss on the sale o f equipm ent does not affect cash. W e w ill n o w determ ine the cash p a id for insurance, w a g e s, interest a n d taxes. First, w e w ill consider insurance. W h e n an insurance premium is p a id , the entry is: DR CR
P re p a id in s u ra n c e C ash
A t the end o f the accounting p e riod, the insurance expense is determ ined by the am ount o f insurance used up: DR CR
In s u ra n c e e x p e n s e P re p a id in s u ra n c e
538
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
For M ic h a e l Limited, the cash paym ent for insurance can be determ ined as follow s, given that w e kn o w the o p ening and closing b a la n ce for insurance from the co m p a rative b a la n ce sheets, an d the insurance expense from the incom e statement. Prepaid insurance O p e n in g b a la n c e
5 000
16000
C ash C lo s in g b a la n c e
In s u ra n c e e x p e n s e
13 0 0 0
8 000
A lternatively, using a form ula: Closing prepaid insurance = Opening prepaid insurance + Payments - Insurance expense
Therefore: Payment for insurance = Insurance expense + Closing prepaid insurance - Opening prepaid insurance
= 13000 + 8 0 0 0 -5 0 0 0 = 16000 The cash payments for w a g e s can be determ ined, given that w e kn o w the o p e n in g a n d closing balances of w a g e s p a y a b le from the co m p a rative b a la n ce sheets, a nd the w a g e s expense from the incom e statement. W ages payable O p e n in g b a la n c e
103000
C ash
7000
W a g e s expense
100000
C lo s in g b a la n c e
4000
The cash p a id for w a g e s is $ 1 0 3 0 0 0 . A lternatively, by form ula w e have: Closing wages payable = Opening wages payable + Wages expense - Cash paid for wages Cash paid for wages = Wages expense + Opening wages payable - Closing wages payable
= 100000 + 7000 - 4000 = $103000 The cash payments for interest can be determ ined in a sim ilar manner. Interest payable
19 0 0 0
C ash
O p e n in g b a la n c e
10000
1n te re s t e x p e n s e
20000
C lo s in g b a la n c e
11 0 0 0
A lternatively, by form ula, w e have: Closing interest payable = Opening interest payable + Interest expense - Cash paid for interest
Therefore: Cash paid for interest = Interest expense + Opening interest payable - Closing interest payable =
20000 + 1 0 0 0 0 -1 1 0 0 0
= 19000
CHAPTER 14 The statem ent o f cash flows
539
Finally, w e w ill calculate the taxes p a id during the year. Recall that w hen tax is calculated a t the end of the year, the journal entry is: DR
In c o m e ta x e x p e n s e
CR
P ro v is io n f o r in c o m e ta x
W h e n the am ount is p a id : DR
P ro v is io n f o r in c o m e ta x
CR
C ash
Provision for income tax O p e n in g b a la n c e
26000
C ash
5 000
In c o m e ta x e x p e n s e
27 000
C lo s in g b a la n c e
6000
The cash p a id for incom e taxes during the year, determ ined from the provision for incom e tax ledger account, is show n to be $ 2 6 0 0 0 . Alternatively, b y formula it could be calculated as follow s: Closing provision for income tax = Opening provision for income tax + Income tax expense - Income tax paid
Therefore: Income tax paid = Income tax expense + Opening provision for income tax -
Closing provision for income tax
= 27000 + 5 0 0 0 -6 0 0 0 = 26000 C a lcu la tio n o f incom e tax p a id becom es a little m ore co m p lica te d w hen deferred tax is introduced; therefore, the cash flo w im plications are left to later courses. All the calculations necessary to sh o w the cash flow s from o p erating activities have n o w been com pleted, an d the results are show n b e lo w : I Cash flows from operating activities R e c e ip ts fro m c u sto m e rs
401 0 0 0
P a y m e n ts to s u p p lie rs
(1 4 8 0 0 0 )
P a y m e n ts f o r in s u ra n c e
(1 6 0 0 0 )
P a y m e n ts to e m p lo y e e s
(1 0 3 0 0 0 )
P a y m e n t fo r o th e r e x p e n s e s
(3 7 0 0 0 )
In te re st p a id
(1 9 0 0 0 )
In c o m e ta x p a id
(2 6 0 0 0 )
N e t c a s h p r o v id e d b y o p e ra tin g a c tiv itie s
52 000
In practice, lines 2 to 5 a b o v e are often a d d e d together a nd reported under Payments to suppliers a nd em ployees ($ 3 0 4 0 0 0 ).
540
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Cash flow s from investing activities O u r next step is to calculate cash inflow s an d outflow s from investing activities. To d o this w e need to exam ine any changes in the noncurrent assets in the b a la n ce sheets, together w ith a n y a d d itio n a l inform ation w e have on the sale o r purchase o f noncurrent assets. This a d d itio n a l inform ation m ay g ive details o f the sale o f a n y assets during the ye a r and a n y asset revaluations (up or d o w n ). W h e n there are changes in noncurrent assets, the potential explanations are an acquisition, disposal, asset revaluation o r a com bination o f the a b o ve . For M ic h a e l Limited, there are changes in tw o noncurrent assets; nam ely, land a n d equipm ent. C hanges in these accounts result from net acquisitions. It is necessary to check w h e th e r the changes are o n ly the result o f acquisitions or if some disposals a re involved. This can be ascertained by seeing if there is a n y profit o r loss on disposal in the incom e statement o r some mention o f disposals o r revaluations in the notes. For M ic h a e l Limited, a loss o f $ 4 0 0 0 on the sale of equipm ent w a s reported. A d d itio n a l inform ation provides m ore details a b o u t the sale o f equipm ent and notes the revaluation o f land. Land has increased from $ 2 0 0 0 0 0 to $ 4 0 0 0 0 0 . There is no indication o f a n y disposals o f land, an d the land w a s revalued upw ards by $ 5 0 0 0 0 (see revaluation surplus). The entry for this revaluation w o u ld have been: DR
Land
CR
R e v a lu a tio n s u rp lu s
Based on the a b o ve , land that cost $ 1 5 0 0 0 0 w a s purchased during the ye a r ( $ 2 0 0 0 0 0 — $ 5 0 0 0 0 ) . The general ledger a ccount w o u ld a p p e a r as follow s:
To calculate cash related to the purchase o r sale o f noncurrent assets that have accum ulated d e p re cia tio n , it is im portant that you recall the journal entries introduced in C h a p te r 1 0 for the sale o f a noncurrent asset. In this case w e kn o w that equipm ent that cost $ 3 0 0 0 0 w a s sold during the ye a r a nd that there w a s a loss on sale of $ 4 0 0 0 . To determ ine the purchases of equipm ent, first consider the journal entry w hen equipm ent is sold w ith a loss on sale: DR
?
C ash
DR
Loss o n sa le
DR
A c c u m u la te d d e p re c ia tio n
CR
4000
E q u ip m e n t
? 30000
W e can first determ ine the accum ulated de p re cia tio n on the equipm ent sold from the accum ulated d epreciation account, as w e kn o w o p e n in g a n d closing balances from the co m p a rative b a la n ce sheets an d dep re cia tio n expense from the incom e statement. Accumulated depreciation O p e n in g b a la n c e D is p o s a l
7000
D e p re c ia tio n C lo s in g b a la n c e
45 000 20000 58 000
CHAPTER 14 The statem ent o f cash flows
541
As show n in the a b o v e account, the accum ulated dep re cia tio n for the equipm ent sold w a s $ 7 0 0 0 . W e n o w have a d d itio n a l inform ation for the journal entry. ?
DR
C ash
DR
Loss o n s a le
4000
DR
A c c u m u la te d d e p re c ia tio n
7000
CR
E q u ip m e n t
30000
Therefore, $ l 9 0 0 0 cash w a s received from the equipm ent that w a s sold. N ext, w e can calculate the am ount o f cash p a id for the equipm ent purchased by calcu la tin g the d e b it to the equipm ent account as follow s: Equipment O p e n in g b a la n c e
150000
C ash
160000
C lo s in g b a la n c e
D is p o s a l
30000
280000
N o te that the disposal o f the equipm ent is entered in the equipm ent a ccount a t cost. N e w equipm ent at a cost o f $ 16 0 0 0 0 w a s purchased. The cash flow s from the investing activities section o f the statement o f cash flow s w o u ld a p p e a r as follow s: Cash flows from investing activities
$
P u rch a se o f la n d
(1 5 0 0 0 0 )
P u rch a se o f e q u ip m e n t
(1 6 0 0 0 0 )
P ro c e e d s fro m s a le o f e q u ip m e n t N e t c a s h used in in v e s tin g a c tiv itie s
19000 (2 9 1 0 0 0 )
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: I f a c o m p a n y sells a piece o f e q u ip m e n t w ith a b o o k value o f $ 1 0 0 0 0 0 (c o s t $ 2 5 0 0 0 0 less a c cu m u la te d d e p re cia tio n o f $ 1 5 0 0 0 0 ) fo r $ 8 0 0 0 0 , w h a t is th e jo u rn a l e n try ? Y o u r answ er should be: DR
C ash
80000
DR
Loss o n s a le
20000
DR
A c c u m u la te d d e p re c ia tio n
CR
E q u ip m e n t
150000 250000
Cash flow s from financing activities The next step is to determ ine the cash flow s from financing activities. Finance comes from internal a nd external sources. The form er is generated through operations, an d is disclosed as cash flo w from operations. External finance is generated from lenders o r shareholders. To determ ine the cash flows from financing, it is necessary to exam ine the noncurrent lia b ility accounts an d the shareholders' equity account.
542
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
For M ic h a e l Limited, loans p a y a b le has increased from $ 2 0 0 0 0 0 to $ 2 5 0 0 0 0 . The difference could be the result o f a com bin a tio n o f both de b t repaym ents a nd d e b t raising. The journal entries w o u ld be as follow s: Debt repayment DR
Lo ans p a y a b le
CR
C ash
Debt raising DR
C ash
CR
L o ans p a y a b le
W e can determ ine the am ount of d e b t raising from the general ledger account for loans p a ya b le , as w e kn o w the o p ening and closing balances as w e ll as d e b t repaym ent of $ 1 5 0 0 0 0 . Loans payable O p e n in g b a la n c e C a s h (re p a y m e n t)
150000
200000
C a s h (ra is in g )
200000
C lo s in g b a la n c e
250000
As show n, n ew d e b t of $ 2 0 0 0 0 0 w a s raised during the year. Turning n o w to the shareholders' equity accounts, you can see that issued c a p ita l increased by $ 2 0 4 0 0 0 from $ 1 6 3 0 0 0 to $ 3 6 7 0 0 0 . As there w a s no mention o f share buybacks, the difference o f $ 2 0 4 0 0 0 must have resulted from the issue o f shares. The ch a n g e in the asset revaluation surplus has a lre a d y been e xp la in e d as a revaluation o f the land a nd there is no effect on cash. Retained profits changes can result from profit o r loss from the period, o r from d ividends or transfers to o r from general reserves. As there a re no other reserve accounts besides asset revaluation reserve in this case, the transfer to o r from reserves is not a possibility. By reconstructing the retained profits accounts, w e can see the am ount o f d ividends p a id o r d e cla re d during the year, given that w e kn o w the p rofit for the year. |
Retained profits D iv id e n d s
30000
O p e n in g b a la n c e
40000
P ro fit
49000
C lo s in g b a la n c e
59000
From the a bo ve , it can be seen that d ividends total $ 3 0 0 0 0 . These could be p a id in cash (DR retained profits, CR cash) o r provided for a t b a la n ce d ate, pending ratification at the annual general m eeting. In the latter case, the entry w o u ld be: DR CR
R e ta in e d p ro fits D iv id e n d s p a y a b le
For M ic h a e l Limited, there is no d ividends p a y a b le account; therefore, all the dividends o f $ 3 0 0 0 0 must have been p a id in cash.
CHAPTER 14 The statem ent o f cash Flows
543
Based on the a b o ve , the cash flow s from fin a n cin g activities are as follow s: 1 Cash flows from financing activities
n
P ro ce e d s fro m b o rr o w in g s
200000
R e p a y m e n t o f b o rr o w in g s
(1 5 0 0 0 0 )
Issue o f sh a re s
204000
D iv id e n d s p a id N e t c a s h p r o v id e d fro m fin a n c in g a c tiv itie s
(3 0 0 0 0 ) 224000
C o m b in in g all o f the a b o ve , the full statement of cash flow s is show n in Exhibit 1 4 .7 .
14.4 Interpreting a statem ent of cash flows (direct method) To illustrate some of the inform ation you can g a in from exam ining statements o f cash flow s, w e w ill consider the statement o f cash flow s fo r a large Australian com p a n y, w h ich is show n in Exhibit 1 4 .8 W e have included the com p a rative figures for the 2 0 1 6 an d 2 0 1 5 statements of cash flow s.
544
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 14.8 STA TE M E N TS OF CASH FLOW S FOR TH E FIN A N C IA L YEARS ENDED 3 0 JUNE 2 0 1 6 AND 2 0 1 5
2016
2015
$m
$m
Cash flows from operating activities R e c e ip ts fro m cu sto m e rs
2 9 1 7 .9
2 2 0 4 .9
P a y m e n ts to s u p p lie rs a n d e m p lo y e e s
(2 6 5 7 . 3 )
(1 9 2 6 . 1 )
D iv id e n d s re c e iv e d
-
-
3 3 .5
2 3 .6
( 1 2 7 .5 )
(7 7 .0 )
F in a n c e in c o m e re c e iv e d In te re st a n d o th e r co sts o f fin a n c e p a id In c o m e ta x p a id N e t c a s h flo w s fro m o p e ra tin g a c tiv itie s
(4 9 .7 )
(5 2 .4 )
1 1 6 .9
1 7 3 .0
3 3 .0
1 7 .1
Cash flows from investing activities P ro c e e d s fro m d is p o s a l o f o th e r p r o p e rty , p la n t a n d e q u ip m e n t P a y m e n ts fo r: A d d itio n s o f in ve stm e n ts in s e c u ritie s
(3 2 .9 )
(0 .4 )
A d d itio n s o f p r o p e rty , p la n t a n d e q u ip m e n t
( 4 8 0 .8 )
(3 2 3 .7 )
A c q u is itio n s o f e n titie s a n d o p e ra tio n s (net)
( 7 7 0 .9 )
(1 2 .7 )
(1 2 5 1 . 6 )
(3 2 1 .8 )
O th e r N e t c a s h flo w s used in in v e s tin g a c tiv itie s
(2 .1 )
Cash flows from financing activities P ro c e e d s fro m issu e o f sh a re s
7 3 7 .6
5 0 .2
P ro c e e d s fro m b o rr o w in g s
6 9 5 .7
1 6 4 .3
B o rro w in g s re p a id
( 2 3 3 .5 )
(9 5 .2 )
(7 5 .9 )
(6 4 .5 )
D iv id e n d s p a id N e t c a s h flo w s (used in ) / f r o m fin a n c in g a c tiv itie s
1 1 2 3 .9
N e t in c re a s e /jd e c r e a s e ) in c a s h a n d c a s h e q u iv a le n ts C a s h a n d c a s h e q u iv a le n ts h e ld a t th e b e g in n in g o f th e fin a n c ia l y e a r
(1 0 .8 ) 3 2 6 .2
E x c h a n g e ra te a d ju s tm e n ts to c a s h a n d c a s h e q u iv a le n ts h e ld a t th e b e g in n in g o f th e fin a n c ia l y e a r C a s h a n d c a s h e q u iv a le n ts h e ld a t th e e n d o f th e fin a n c ia l y e a r
3 .7
3 1 9 .1
5 4 .8 (9 4 .0 ) 4 3 3 .5 (1 3 .3 )
3 2 6 .2
The fo llo w in g should be noted a b o u t the statement o f cash flow s in 2 0 1 6 in Exhibit 1 4 .8 : 1
C ash held rem ained fa irly constant, reducing from $ 3 2 6 .2 m illion to $3 1 9.1 million.
2
C ash flo w from operations fell from $ 1 7 3 m illion to $1 1 6 .9 m illion. W h ile receipts from customers increased, the increase in payments to suppliers an d em ployees increased by a larger amount.
3
There w e re large cash flow s for investing activities, in particular acquisition o f property, plant a nd equipm ent ( $ 4 8 0 .8 million) a nd acquisitions o f other entities ( $ 7 7 0 .9 million).
4
O n ly a small proportion o f the investing activities w a s funded by cash flo w from operations ($ 1 1 6 .9 m illion).
5
There w a s a substantial increase in fin a n cin g inflow s as a result o f the issue o f shares an d n e w b orrow ings. This a d d itio n a l fin a n ce w a s required to cover the cash outflow s for investments.
6 Linder finan cin g activities, note that some b o rrow ings w e re repaid during the y e a r ($ 2 3 3 .5 m illion) and dividends o f $ 7 5 .9 m illion w e re p a id during the year. H ow ever, there w e re sig n ifica n t a d d itio n a l b o rrow ings of $ 6 9 5 .7 m illion an d cash received from the issue o f shares.
CHAPTER 14 The statem ent o f cash flows
14.5
545
Preparation using the indirect method
The indirect m ethod of cash flow analysis is used in m any overseas countries, including C a n a d a a nd the United States (w here com panies can use either direct o r indirect, but g e n e ra lly choose the indirect method). As noted a bove, it is also necessary to sh o w this inform ation in A ustralia in a note to pro vid e the reconciliation betw een operating profit a nd cash flo w from operations. C o n sid e r for a minute w h y these tw o items should reconcile. The tw o w ill reconcile w hen you elim inate all the accruals in op e ra tin g profit, w h ich w ill ge t you b ack to a cash profit; that is, cash flo w from operations. It is im portant to note that the direct a nd indirect methods g ive the sam e results. The o n ly difference is in h o w they report cash flo w from operations. The reporting o f cash flows from investing a nd financing are identical under both methods. The indirect method o f reporting cash flo w from operations starts w ith o perating profit, then makes adjustments to this figure from non-cash items to arrive a t cash flo w from op e ra tin g activities. There a re tw o main types o f non-cash adjustments: (a) d e p re cia tio n , losses a nd gains; an d (b) credit a n d accrual transactions that form part of the calculation o f profit. To adjust for d e p re cia tio n , losses a nd items that are expenses but d o not affect cash, these items are a d d e d b ack to op e ra tin g profit. These include d e p re cia tio n , am ortisation a nd loss on the sale o f noncurrent assets. In a d d itio n , non-cash revenues such as profit on the sale o f noncurrent assets a re deducted from o perating profit. Let's take a sim ple exam ple w ith o n ly o ne adjustm ent - nam ely, dep re cia tio n - to illustrate the a b o ve . Assume a c o m p a n y has o n ly cash sales am ounting to $ 1 0 0 0 0 0 , cash expenses o f $ 6 0 0 0 0 a nd de p re cia tio n o f $ 1 0 0 0 0 . Therefore, net profit is $ 3 0 0 0 0 . Cash flo w from operations can be determ ined by d e ducting $ 6 0 0 0 0 from $ 1 0 0 0 0 0 , g ivin g $ 4 0 0 0 0 (the direct method); o r by a d d in g b a ck the $ 1 0 0 0 0 de p re cia tio n to o p erating profit of $ 3 0 0 0 0 , a g a in g ivin g cash flo w from operations o f $ 4 0 0 0 0 (the indirect method). The second type of adjustm ent removes the accruals relating to current assets an d current liabilities. For exam ple, if accounts receivable increases during a p eriod by $ 1 0 0 0 0 , credit sales w ill be greater than cash received from customers by $ 1 0 0 0 0 . U nder accrual a ccounting, sales are recognised w hen earned, w hereas the cash receipts from customers can be before, after o r at the same time as revenue recognition. Therefore, to adjust from operating profit to cash flo w from operations, it w o u ld be necessary to d educt $ 1 0 0 0 0 from op e ra tin g profit to get cash flo w from operations. This has elim inated the non-cash portion o f sales from profit. Sim ilarly, other w o rkin g c a p ita l items including inventories, prepaym ents, accounts p a y a b le a nd accrued expenses - need to be adjusted. Therefore, the fo llo w in g rules a p p ly in adjusting for w o rkin g c a p ita l changes: •
d educt from op e ra tin g profit increases in w o rkin g c a p ita l assets (debtors, inventory a nd prepayments)
•
d educt from op e ra tin g profit decreases in w o rkin g c a p ita l liabilities (accounts p a y a b le a n d accruals)
•
a d d to o p erating profit decreases in w o rkin g c a p ita l assets
•
a d d to o p erating profit increases in w o rkin g c a p ita l liabilities. W e can summarise the indirect method of ca lculating cash from operations as follow s: Operaring profit after tax +
N o n -c a s h e x p e n s e s (e .g . d e p re c ia tio n )
—
N o n -c a s h re v e n u e s (e .g . p r o fit o n s a le o f p la n t)
+
D e c re a s e in a c c o u n ts re c e iv a b le , in v e n to ry a n d p re p a y m e n ts
+
In c re a s e in a c c o u n ts p a y a b le a n d a c c ru e d e x p e n s e s
—
D e c re a s e in a c c o u n ts p a y a b le a n d a c c ru e d e x p e n s e s
— =
In c re a s e in a c c o u n ts re c e iv a b le , in v e n to ry a n d p re p a y m e n ts C a s h flo w s fro m o p e ra tin g a c tiv itie s
N o te that each o f the a b o v e accounts relate to the incom e statement: credit sales relates to accounts receivable; credit p u rc h a s e s /C O G S relates to inventory an d accounts p a ya b le ; an d prepaym ents a nd accruals relate to
546
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
expenses. It w o u ld not include current liabilities, such as d ividends p a y a b le o r short term loans, given the other side of the journal entry does not involve a n y expense o r revenue items. To illustrate the preparation o f a statement o f cash flow s using the indirect method, w e 'll redo the M ic h a e l Limited exam ple from section 1 4 .3 (see Exhibit 1 4 .9 ). E X H IB IT 1 4 .9
MICHAEL LIMITED CASH FLOW S FROM O PER ATING A C TIVITIES - IN D IR EC T M ETHO D $ O p e r a tin g p r o fit a fte r ta x
49000
D e p re c ia tio n
20000
Loss o n s a le o f e q u ip m e n t
4000
C h a n g e s in c u rre n t assets a n d lia b ilitie s : In c re a s e in a c c o u n ts re c e iv a b le
(2 0 0 0 0 )
In c re a s e in in v e n to ry
(1 7 0 0 0 )
In c re a s e in p r e p a id in s u ra n c e In c re a s e in a c c o u n ts p a y a b le
(3 0 0 0 ) 20000
In c re a s e in p r o v is io n fo r in c o m e ta x
1000
In c re a s e in in te re s t p a y a b le
1000
D e c re a s e in w a g e s p a y a b le
Cash flows from operating activities
(3 0 0 0 )
52000
You should note that the cash flo w from operations using the indirect method gives the same total cash flow s from operations as d id the direct method. To com plete the statement o f cash flow s, it w o u ld be necessary to a d d on the cash flow s from investing a nd fin a n cin g , w h ich w o u ld be exactly as outlined in Exhibit 14 .7 . C onsider the fo llo w in g extract from the cash flow statem ent o f Tam arack Systems Ltd, w h ich uses the indirect method to calculate cash flo w from operations. E X H IB IT 1 4 .1 0
TAMARACK SYSTEMS LTD S T A T E M E N T OF CASH FLOW S FOR TH E YEAR ENDED 3 0 JUNE 2 0 1 6 $
$
Cash flow from operating activities N e t p r o fit fo r th e y e a r
56 292
A d ju s tm e n ts fo r n o n -c a sh e x p e n s e s: D e p re c ia tio n o f b u ild in g
69 904
69 904
A d ju s tm e n ts fo r c h a n g e s in n o n -c a sh w o r k in g c a p ita l: A c c o u n ts re c e iv a b le In v e n to rie s
(7 6 7 0 6 ) 10815
P re p a id e x p e n s e s
5317
A c c o u n ts p a y a b le
35 98 7
In c o m e ta x e s p a y a b le
1 138
C a s h fro m o p e ra tio n s
(2 3 4 4 9 ) 102747
Investing activities A d d itio n s to la n d A d d itio n s to b u ild in g
(7 5 0 0 ) (1 7 9 9 1 4 )
(1 8 7 4 1 4 )
»
CHAPTER 14 The statem ent o f cash flows
547
Financing activities D iv id e n d p a y m e n ts
(3 0 0 0 0 )
R ep aym ent o f b o n d s ($ 2 2 0 0 0 - $ 2 0 0 0 )
(2 0 0 0 0 )
In c re a s e in lo a n
1 591
S h a re c a p ita l issu ed
50000
N e t to ta l c h a n g e in c a s h a n d e q u iv a le n ts
1 591 (8 3 0 7 6 )
C a s h a n d e q u iv a le n ts - b e g in n in g o f y e a r
34240
C a s h a n d e q u iv a le n ts - e n d o f y e a r
(4 8 8 3 6 )
W e can make several observations: •
C ash from operations w a s alm ost tw ic e accrual net p rofit ($ 1 0 2 7 4 7 versus $ 5 6 2 9 2 ).
•
C ash from operations has been severely reduced b y a large rise in accounts receivable; that is, uncollected revenue ( $ 7 6 7 0 6 ) .
•
O p e ra tio n s w e re the m ajor source of cash during the ye a r - there w a s no n e w b o rro w in g an d the issue o f shares brought in o n ly half the cash that operations d id .
•
The m ajor use o f cash w a s ad d itio n s to noncurrent assets.
•
The com pany's cash b a la n ce reversed from $ 3 4 2 4 0 to a cash d e ficit o f $ 4 8 8 3 6 .
•
The main reasons for the differences w e re the am ount o f de p re cia tio n ( $ 6 9 9 0 4 ) a n d the increase in accounts p a y a b le ($ 3 5 9 8 7 ). W e d o not kn o w the reasons for the effects show n in the statement of cash flow s, but w e certainly d o know
several things w e m ight like to ask m anagem ent about. In particular, w e m ight like to kn o w h o w m anagem ent proposes to ge t cash b ack onto the positive side.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e stio n s y o u should be able to answ er, based on w h a t y o u have ju s t read: 1
H o w does a s ta te m e n t o f cash flo w s explain w h a t happened to cash and cash equivalents d u rin g th e year?
2
The fo llo w in g changes o c c u rre d in B radee L td ’s a c co u n ts d u rin g th e past year: •
n o n -c a s h c u rre n t assets increased by $ 2 7 0
•
c o s t o f n o n c u rre n t assets increased by $ 6 0 0
•
a c cu m u la te d d e p re cia tio n increased by $ 2 5 0
•
n o n -c a s h c u rre n t liabilities increased by $ 3 4 0
•
w a rra n ty p ro visio n in n o n c u rre n t liabilities increased by $ 8 0
•
n o n c u rre n t d e b ts decreased by $ 1 2 0
•
share capital increased by $ 2 0 0
•
n e t p r o fit w as $ 4 7 5
•
$ 2 1 5 in dividends was paid.
C a lcu la te th e change in cash and cash e q u iva le n ts fo r th e year. Y o u r answers should be: 1
S ta te m e n t o f cash flo w s explains w h a t happened to cash and cash equ iva le n ts by d e m o n s tra tin g w h e re th e cash in flo w s cam e fro m and h o w th e cash was used d u rin g th e year.
2
$ 4 7 5 + $ 2 5 0 + $ 8 0 + $ 3 4 0 - $ 2 7 0 - $ 2 1 5 - $ 6 0 0 - $ 1 2 0 + $ 2 0 0 = $ 1 4 0 increase.
548
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
14.6 Interpreting a statem ent of cash flows (indirect method) The indirect method is used extensively in N orth A m erica. As noted earlier, in A ustralia the indirect method is shown as a note to the statement o f cash flow s. In Exhibit 14.1 1 w e have p rovided an exam ple that w e call Tyson Foods Limited. The exam ple is a sim plified version o f some real figures for a US co m p a n y. N o te that it is co m p a rative for three years, and that the three years va ry a g re a t d e a l in the details of their cash flow s. A g re a t d e a l o f inform ation is provided about various fin a n cin g an d investing activities. EXHIBIT 14.11
TYSON FOODS LTD CO N SO LID A TED STA TE M E N TS OF CASH FLOW S FOR TH R EE YEARS ENDED 3 0 JUNE 2 0 X 9
Cash flows from operating activities
185712
178417
149282
Depreciation
145 756
119363
106630
Am ortisation
30 753
29502
29201
695
218
816
(Increase) decrease in accounts receivable
35 344
(25 259)
(3 810)
(Increase) decrease in inventories
(66 909)
10606
(14238)
Increase (decrease) in trade accounts payable
(41 001)
7414
(6 396)
18 052
(54 381)
35 589
N et profit Adjustments to reconcile net profit to cash provided by operating activities:
Loss on dispositions o f property and equipment
N et change in other current assets and liabilities Cash provided by operating activities
308402
265880
297074
(268 682)
(107990)
(213 576)
Cash flows from investing activities Additions to property, plant and equipm ent Proceeds from sale o f property, plant and equipment N et change in other assets and liabilities Cash used for investing activities
7387
6615
15 294
(41 393)
(3 309)
(7424)
(30 26 88)
(1 0 4 6 8 4 )
(2 0 5 7 0 6 )
Cash flows from financing activities N et increase (decrease) in notes payable
(29200)
(
10000)
10000
Proceeds from long-term debt
977421
131 941
155500
Repayments o f long-term debt
(954497)
(278 694)
(246 642)
(4 951)
(2 836)
(1716)
(11 227)
(1 5 9 5 8 9 )
(8 2 8 5 8 )
Dividends paid Cash used for financing activities
(5513)
1 607
8510
Cash and cash equivalents at beginning o f year
270 60
25453
16943
Cash and cash equivalents at end of year
21547
27060
25453
Increase/jdecrease) in cash
Let's look at some o f the things Tyson's statement of cash flow s tells us. •
The com pany's cash from operations is very large in relation to its other cash flow s. This a llo w s the c o m p a n y to finance most o f its activities from this internally generated cash, rather than having to b o rro w o r issue m ore share c a pital.
•
The c o m p a n y does not keep much cash on hand relative to its annual flo w . C ash from operations has been about, or m ore than, 1 0 times that of cash on hand in each o f the three years.
CHAPTER 14 The statem ent o f cash flows
•
549
Interesting changes are suggested in the co m p a n y's relationship w ith its customers a n d suppliers. Accounts receivable had been increasing each ye a r in 2 0 x 7 a n d 2 0 x 8 , but decreased significantly in 2 0 x 9 . (It turns out that n ew arrangem ents w e re m ade to sell accounts receivable continuously to a bank, speeding up the com pany's receipt of cash.) Inventories rose quite a lot in 2 0 x 9 a n d accounts p a y a b le w e re p a id off faster: these tw o items reduced cash from operations by m ore than $ 1 0 0 million.
•
The c o m p a n y a cq u ire d m ore noncurrent assets during 2 0 x 9 . Those acquisitions cost $ 2 6 8 m illion in 2 0 x 9 , more than tw ic e w h a t w a s spent in 2 0 x 8 , an d m ore than w a s spent in 2 0 x 7 . Such acquisitions have been Tyson's m ajor use o f the cash it generates from operations.
•
These acquisitions help the c o m p a n y keep its assets renew ed as they lose their value through use. The sum o f the com pany's am ortisation a n d de p re cia tio n for the ye a r gives an indication of that lost value, w h ich is o nly a bout $ 9 0 m illion less than the spending on noncurrent assets.
•
Tyson d id a m ajor refinancing o f its long-term d e b t during 2 0 x 9 , most likely to take a d va n ta g e o f fin a n cia l market changes such as interest rate reductions. You can see that although nearly a billion dollars w a s rearranged, the net am ount o f a d d itio n a l b o rro w in g w a s small.
•
The c o m p a n y does not p a y much in dividends. This is presum ably part o f the com pany's internal financing strategy: retained profits is the largest single a ccount on the right-hand side o f the co m p a n y's 2 0 x 9 b a la n ce sheet.
•
N e t total cash flo w ('in cre a se /(d e cre a se ) in cash') is small co m p a red to the size o f the o p e ra tin g , investing an d fin a n cin g flow s. The c o m p a n y app e a rs to be d o in g a careful jo b o f b a la n cin g incom ing a nd o utgoing cash flow s.
14.7
Cash flow and the manager
M a n a g e rs a re responsible not o nly for earning profit for the com pany, but also for m a n aging cash so that bills can be p a id on time, excess b o rro w in g a nd interest costs can be a v o id e d , an d the co m p a n y's liq u id ity a nd solvency can be gene ra lly protected. Effectively em p lo yin g a v a ila b le cash so that it does not remain idle, earning nothing, is also im portant. Cash flo w an d profit are g e n e ra lly positively correlated (g o o d perform ance tends to move them both up and p o o r perform ance tends to move them both d o w n ), a n d over a long enough p eriod o f time (years), they are alm ost the same. H ow ever, in the short run, the relationship betw een cash flo w an d profit can be com plex. For exam ple, a problem new businesses can have is to g ro w too fast. O ften the product dem and an d the entrepreneurial enthusiasm are high: the business w a s founded in the hope that p e o p le w o u ld w a n t the product o r service, an d it is exciting to everyone w hen they d o ! The incom e statements o f such businesses often sh o w high profits, but the cash flo w an d the bala nce sheet m ay tell a different story. In the enthusiasm o f m aking sales a n d satisfying customers, inventory levels often get too high (m aking sure there is som ething for everyone on hand) an d collections from customers often lag (receivables get to o high as the entrepreneur concentrates on the pleasures o f selling rather than the nuisance o f collecting). The cash flo w deducts the increases in inventories an d receivables from accrual-basis net incom e, a n d m ay sh o w that opera tin g cash flow s a re small o r even negative. W h e n this happens, you d o not need cash flo w to kn o w you a re in trouble: your bank b a la n ce tells you that! But the statement of cash flo w reports the w h o le story to others, so that they can see w h a t you have a ccom plished in o b ta in in g a nd using cash in your o p e ra tin g , fin a n cin g a nd investing activities. You then have to be prepared to explain such activities to users o f the fin a n cia l statements. The statement o f cash flow s provides a measure o f m anagerial perform ance in m a naging cash, so smart m anagers must be a w a re o f h o w their efforts are reflected in it, just as they are a w a re o f the measures o f perform ance and position offered by b a la n ce sheets an d incom e statements.
550
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Prepare a schedule o f cash flow s from operating a ctivitie s F o llo w in g is th e in c o m e state m e nt fo r JKL Lim ited. JKL LIM ITED
INCOME STATEMENT FOR THE YEAR ENDED 3 0 JUNE 20 16
A d d itio n a l in fo rm a tio n : a A ll sales w e re on c re d it.
b
A c co u n ts re c e iv a b le d e c re a s e d b y $ 2 0 0 0 d u rin g th e y e a r,
c
A ll stock p u rch ases w e re on c re d it,
d
In ve n to ry in c re a s e d b y $1 8 0 0 .
e
A c co u n ts p a y a b le d e c re a s e d b y $ 3 1 0 0 d u rin g th e y e a r,
f
In co m e ta xe s p a y a b le in c re a s e d b y $ 6 0 0 d u rin g th e y e a r,
g
A ll o p e ra tin g expe nses a re p a id in cash in th e y e a r in c u rre d .
P rep are a s ch e d u le o f cash flo w s fro m o p e ra tin g a c tiv itie s using: 1 th e d ire c t m e tho d 2
th e in d ire c t m e tho d.
PRACTICE PROBLEM B C alculate cash paym ents 1 C ost of g o o d s sold = $ 2 3 0 0 0 0 0 Inventory increased from $ 3 0 0 0 0 0 to $ 6 1 0 0 0 0 Accounts p a y a b le increased from $ 2 0 0 0 0 0 to $ 2 9 5 0 0 0 R e q u ire d : c a lc u la te cash pa ym e n ts fo r pu rch ases. 2
Income tax expense for the ye a r = $ 4 8 0 0 0 Income taxes p a y a b le have increased by $ 15 0 0 0 to $ 2 0 5 0 0
R e q u ire d : c a lc u la te cash pa ym e n ts fo r in c o m e ta x.
3
Sales = $ 7 6 4 0 0 0 0 Accounts receivable increased from $1 0 0 0 0 0 0 to $1 8 7 0 0 0 0
R e q u ire d : c a lc u la te cash re c e ip ts fro m sales. 4
W a g e s expense = $ 2 3 5 0 0 0 0 W a g e s p a y a b le decreased from $ 1 4 9 0 0 0 0 to $ 1 million.
R e q u ire d : c a lc u la te cash p a id fo r w a g e s .
CHAPTER 14 The statem ent o f cash flows
PRACTICE PROBLEM C Prepare a s ta te m e n t o f cash Flows The fo llo w in g in fo rm a tio n relates to Tut Ltd. TUT LTD COMPARATIVE BALANCE SHEET AS AT 30 JUNE 20 16 2016 $0 00 Current assets -
20
Accounts receivable
Cash
143
105
Inventory
200
220
10
10
Equipment
640
450
Accumulated depreciation - equipment
(200)
(150)
Land
680
600
Motor vehicles
485
520
Accumulated depreciation - motor vehicles
(183)
Prepaid insurance
Noncurrent assets
Total assets
1 775
1 565
10
-
Current liabilities Bank overdraft Accounts payable
205
265
Income tax payable
44
70
Final dividend payable
85
60
470
430
Noncurrent liabilities Borrowings
Total liabilities
814
825
Net assets
961
740
Share capital
620
450
Revaluation surplus
210
130
Shareholders' equity
Retained profits
131
160
Total shareholders' equity
961
740
INCOME STATEMENT FOR YEAR ENDED 30 JUNE 2 0 1 6 $0 00 Sales
560
COGS
(170)
Insurance expense Other expenses
(45) (220)
Loss on sale of motor vehicles
(25)
Profit before tax
100
Income tax expense
(44)
Profit after tax
56
551
552
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A d d itio n a l in fo rm a tio n (d o lla r am o u n ts e x p re ss e d in fu ll units): 1
Land w a s re v a lu e d u p w a rd s d u rin g th e y e a r b y $ 8 0 0 0 0 .
2
M o to r v ehicles w ith an o rig in a l cost o f $ 1 4 5 0 0 0 a n d a ccu m u lated d e p re c ia tio n o f $ 6 5 0 0 0 w e re sold fo r $ 5 5 0 0 0 .
3
E q u ip m e n t to th e v a lu e o f $ 6 0 0 0 0 w a s a c q u ire d w ith the issue o f a long -term n o te. The a m o u n t p a y a b le has be en in c lu d e d in b o rro w in g s o n th e b a la n c e sheet.
P rep are a state m e nt o f cash flo w s fo r Tut Ltd fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . A ls o p re p a re a re c o n c ilia tio n o f cash fro m o p e ra tin g a c tiv itie s to net p ro fit.
KEY TERMS Direct method of cash flow analysis Indirect method of cash Flow analysis
Cash flows from financing Cash Flows From investing
Cash flow from operations Cash Flow statement
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
W h y is m a n a g in g cash flo w im p o rta n t?
2
C a n a c o m p a n y h a ve a g o o d net p ro fit a n d little cash g e n e ra te d fro m o p e ra tio n s in th e sam e y e a r? If it c a n , h o w do es th is h a p p e n ?
3
W h y is cash g e n e ra te d fro m o p e ra tio n s u s u a lly la rg e r th a n net p ro fit?
4
W h a t a re cash a n d cash e q u iva le n ts?
5
E x p la in th e d iffe re n c e b e tw e e n th e d ire c t a n d in d ire c t m e thods o f c a lc u la tin g cash flo w fro m o p e ra tio n s .
6
P ro v id e th re e e x a m p le s o f tra n s a c tio n s th a t w ill a ffe c t: a cash flo w fro m o p e ra tio n s b
cash flo w s fro m fin a n c in g a c tiv itie s
c
cash flo w s fro m in ve stin g a c tiv itie s .
7
H o w c a n cash flo w fro m o p e ra tio n s be n e g a tiv e w h e n net p ro fit is p o sitiv e ?
8
C o m p a n ie s a re re q u ire d to c la s s ify cash flo w s as e ith e r o p e ra tin g , in ve stin g o r fin a n c in g . W h ic h o f these th ree c a te g o rie s is m ost lik e ly to h a ve a net cash o u tflo w o v e r a n u m b e r o f y e a rs ? B rie fly e x p la in y o u r a n sw e r.
9
A t th e A n n u a l G e n e ra l M e e tin g o f S c o tla y Ltd, th e m a n a g in g d ire c to r m a d e th e fo llo w in g statem ent: A lth o u g h th e y e a r w as o n e c h a ra c te ris e d b y p o o r sales p e rfo rm a n c e , S c o tla y L td m a in ta in e d s tro n g o p e ra tin g ca sh flo w s . O p e r a tin g p r o f it f o r th e y e a r w a s $1 m illio n , a n d n e t o p e ra tin g ca sh flo w s w e re $ 4 m illio n . T h e d iffe r e n c e b e tw e e n o p e ra tin g p r o f it a n d o p e ra tin g ca sh flo w s is p r im a rily e x p la in e d b y d e p re c ia tio n c h a rg e s o f $ 3 m illio n . S c o tla y ’s c o n tin u in g in v e s tm e n t p ro g ra m w ill e n s u re t h a t o p e ra tin g ca sh flo w s a re e v e n h ig h e r n e x t y e a r, as d e p re c ia tio n c h a rg e s a re e x p e c te d t o in c re a s e t o $ 5 m illio n .
a
E x p la in h o w d e p re c ia tio n c h a rg e s c a n c re a te a d iffe re n c e b e tw e e n o p e ra tin g p ro fit a fte r ta x a n d net cash flo w fro m o p e ra tin g a c tiv itie s .
b
B rie fly c o m m e n t on th e v a lid ity o f th e m a n a g in g d ire c to r's p re d ic tio n o f a n in cre a s e in o p e ra tin g cash flo w s n e xt y e a r.
1 0 B rie fly e x p la in w h y m a n a g in g cash flo w is im p o rta n t fo r th e success o f a business. 11 A s e n io r fin a n c ia l e x e c u tiv e fo r a la rg e p u b lic c o m p a n y re m a rk e d to a stock m a rke t a n a lys t: I d o n ’t k n o w w h y y o u p e o p le w o r r y so m u c h a b o u t w h a t is in o u r s ta te m e n t o f ca sh flo w s . M a n a g in g ca sh flo w is o u r re s p o n s ib ility as m a n a g e rs ; it in v o lv e s p a y in g c lo s e a tte n t io n t o c a s h o n a d a ily basis. W h y d o n ’t y o u p a y a t te n tio n t o o u r p r o f it a n d ju s t f o r g e t a b o u t ca sh flo w ? W e ’ll lo o k a f t e r th a t!
R espond to th e e x e c u tiv e 's co m m e n ts. Y ou d o no t h a ve to a g re e o r d is a g re e e n tire ly .
CHAPTER 14 The statem ent o f cash flows
12
553
A business c o m m e n ta to r m a d e the fo llo w in g re m a rk d u rin g a d iscu ssio n o f th e fin a n c ia l p e rfo rm a n c e o f a la rg e , b u t s tru g g lin g , c o m p a n y : T h e s e a c c o u n ta n ts s p e n d lo ts o f m o n e y t o c r e a te c o m p lic a te d fin a n c ia l s ta te m e n ts , e s p e c ia lly in c o m e s t a t e m e n ts , w h ic h use w h a t th e y ca ll ‘a c c ru a l’ a c c o u n tin g . T h e n th e y ta k e a w a y all th e a c c ru a ls a n d s u p p o s e d ly r e tu rn us t o t h e ca sh p r o f it n u m b e r w e w o u ld ha ve ha d a n y w a y , i f th e y h a d n ’t b o th e re d w ith a c c ru a l a c c o u n t in g in th e f ir s t p la c e ! W h y d o n ’t t h e y ju s t g iv e us t h e ca sh p r o f it a n d leave it a t th a t?
If y o u w e re an a c c o u n ta n t in v o lv e d in th e d isc u s sio n , a n d e v e ry o n e tu rn e d to y o u to h e a r y o u r respo nse to the c o m m e n ta to r, w h a t w o u ld y o u say?
PROBLEMS PROBLEM 14.1 Classifying cash flow s The b e lo w item s w e re ta ke n fro m a listed c o m p a n y 's state m e nt o f cash flo w s . C la s s ify e a ch item as o p e ra tin g , in ve stin g o r fin a n c in g . For e a ch item state w h e th e r cash is in c re a s in g o r d e c re a s in g . 1 C a s h re c e iv e d fro m issue o f s h a re c a p ita l 2
C a s h re c e iv e d fro m custom ers
3
Purchases o f p ro p e rty , p la n t a n d e q u ip m e n t
4
C a s h p a id to s u p p lie rs
5
C a s h p a id fo r d iv id e n d s to s h a re h o ld e rs
6
R ep a ym e n t o f lo a n interest
7
C a s h p a id to e m p lo y e e s
8
C a s h b o rro w e d fro m th e b a n k
9
C a s h p ro ce e d s re c e ive d fro m sale o f in ve stm en t in a n o th e r c o m p a n y
10 In co m e ta xe s p a id 11 R ep a ym e n t o f lo a n p rin c ip a l 12 D iv id e n d p a id
PROBLEM 14.2 Cash flo w analysis from a cco u n t in fo rm a tio n P re p a re a state m e nt o f cash flo w s fo r G y m e a Lim ited fro m th e fo llo w in g cash a c c o u n t in fo rm a tio n .
$ Bank loan obtained Cash expenses Cash sales
70000 8 920
$ Dividends paid Employee wages and salaries paid
31 610
Income tax paid
Cash, beginning of year
68 920
Land purchased for cash
Cash, end of year
93 620
Payments to suppliers
20000 223610 1 4 9 20 81 000 513600
Collections on accounts receivable
797640
Proceeds from sale of old truck
Ordinary shares issued
110 00 0
Repayments on borrowings
80500
7000
Truck purchased ($5000 still owing)
49 000
554
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 14.3 E ffe ct o f tra n sa ctio n s on cash Flows The fin a n c ia l y e a r fo r Beta Lim ited en ds on 3 0 June 2 0 1 6 . M a n a g e m e n t has a s ke d y o u w h a t e ffe c t e a ch o f the fo llo w in g June tra n s a c tio n s w ill h a ve o n net p ro fit b e fo re ta x , cash flo w fro m o p e ra tio n s , cash flo w fro m in ve sting a n d cash flo w fro m fin a n c in g fo r th e y e a r e n d e d 3 0 June 2 0 1 6 : 1 Sent in vo ic e s fo r $ 3 0 0 0 0 to custom ers d u rin g June fo r w o rk c a rrie d o u t in June ; $ 1 1 0 0 0 o f th is h a d been c o lle c te d b y y e a r-e n d . 2
B o rro w e d $ 2 0 0 0 0 0 fro m th e b a n k on 1 0 June, w ith p rin c ip a l a n d in tere st re p a y a b le in six m onths. A c c ru e d in tere st a t 3 0 June is $ 1 7 0 0 .
3
P aid s a la rie s fo r th e m onth o f $ 7 0 0 0 0 , w ith $ 5 0 0 0 in w a g e s o w in g a t y e a r-e n d .
4
R eceived $ 2 5 0 0 0 d e p o s it on a jo b th a t w ill be c a rrie d o u t in J u ly 2 0 1 6 .
5
P aid a c co u n ts p a y a b le o f $ 3 0 0 0 0 w h ic h w a s o u ts ta n d in g a t 31 M a y 2 0 1 6 .
6
S old o ld e q u ip m e n t fo r $ 2 0 0 0 0 . The e q u ip m e n t o rig in a lly cost $ 3 0 0 0 0 0 w ith a c c u m u la te d d e p re c ia tio n a t the tim e o f sale o f $ 2 5 0 0 0 0 .
7
P urchased n e w e q u ip m e n t on 2 0 June 2 0 1 6 fo r $ 2 2 0 0 0 0 cash . D e p re c ia tio n on this e q u ip m e n t fo r June 2 0 1 6 a m o u n te d to $ 9 0 0 .
8
D e c la re d d iv id e n d s o f $ 1 8 0 0 0 0 in June 2 0 1 6 , to be p a id a fte r y e a r-e n d .
PROBLEM 14.4 Im pact o f tra n sa ctio n s on cash Flows The fin a n c ia l y e a r fo r N e v e rle ss Lim ited en ds on 3 0 June 2 0 1 6 . D u rin g th e m o nth o f June 2 0 1 6 , th e c o m p a n y has in c u rre d th e fo llo w in g tra n sa ctio n s: 1 Sent in vo ic e s fo r $ 2 0 0 0 0 to custom ers fo r w o rk c a rrie d o u t in June ; $ 5 0 0 0 o f this w a s c o lle c te d in ju n e . 2
R eceived $ 3 0 0 0 0 d e p o s it on a jo b th a t w ill be c a rrie d o u t in J u ly 2 0 1 6 .
3
P aid a c co u n ts p a y a b le $ 4 0 0 0 0 , w h ic h w a s o u ts ta n d in g on 31 M a y 2 0 1 6 .
4
S old o ld e q u ip m e n t fo r $ 2 0 0 0 0 - th e e q u ip m e n t o rig in a lly cost $ 3 0 0 0 0 0 w ith a c c u m u la te d d e p re c ia tio n a t the tim e o f sale o f $ 2 5 0 0 0 0 .
5
D e c la re d d iv id e n d s o f $ 8 0 0 0 0 to be p a id ne xt fin a n c ia l y e a r. In d ic a te th e e ffe c t (in c re a s e /d e c re a s e /n o c h a n g e ) o f e a ch tra n s a c tio n o n th e c o m p a n y 's cash flo w fro m
o p e ra tin g a c tiv itie s , in ve sting a c tiv itie s a n d fin a n c in g a c tiv itie s fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 14.5 In te rp re tin g a sta te m e n t o f cash flow s S u m m a ris e d cash flo w statem ents fo r th e y e a r e n d e d 3 0 June 2 0 1 6 . Company A
Company B
Company C
$m
$m
$m
Cash flow from operations
(100)
100
300
Cash flow from investing
(201)
(201)
(201)
Cash flow from financing
300
100
(100)
Change in cash flow
(1)
(1)
N o te that all cash flo w from financing relates to borrow ings a n d that no shares w e re issued or dividends pa id .
C o m m e n t on th e cash flo w o f th e th re e c o m p a n ie s .
(1)
CHAPTER 14 The statem ent o f cash Flows
PROBLEM 14.6 In te rp re tin g a s ta te m e n t o f cash Flows CO M O LIMITED STATEMENTS OF CASH FLOWS FOR THE YEAR ENDED 30 JUNE 20 16
Cash flows provided by operating activities: Cash receipts in the course of operations
753647
666154
Cash payments in the course of operations
(56 52 44)
(475441) 1 019
Dividends received
6316
4312
Interest paid
(27007)
(22015)
Income taxes paid
(49732)
(19 372)
117980
154 65 7
(44458)
(32 070)
Interest received
Net cash provided by operating activities
Cash flows used in investing activities: Purchase of property, plant and equipment Purchase of/proceeds from sale of businesses
(2803)
956
32 6
417
Proceeds from sale of property, plant and equipment Purchase of controlled entity
(143 259)
(46935)
Net cash used in investing activities
(173 956)
Cash flows provided by/(used in) financing activities: (12 65 00)
Repayment of borrowings
(1919)
(1 919)
Dividends paid
(45330)
(36204)
Proceeds from borrowings
96500
96500
(77249)
58 377
6204
39078
Cash at the beginning of the financial year
122946
83 868
Cash at the end of the financial year
116742
122946
Repayment of finance lease
Net cash provided by/(used in) financing activities Net increase/(decrease) in cash
1
E x p la in th e m a in d iffe re n c e s in cash flo w s b e tw e e n 2 0 1 5 a n d 2 0 1 6 .
2
C o m m e n t on C o m o 's cash flo w p o s itio n in 2 0 1 6 .
PROBLEM 14.7 In te rp re tin g cash Flows M a rlo t Lim ited re p o rte d th e fo llo w in g in fo rm a tio n on cash flo w fo r th e y e a r 2 0 1 6 .
$ Cash flows from operations
(400000)
Cash flows from investing activities
100000
Cash flows from financing activities
301 000
Net cash flows
1 000
Opening cash balance
160000
Closing cash balance
161 000
555
556
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
1
Does M a rlo t Lim ited a p p e a r to be e x p a n d in g o r c o n tra c tin g its o p e ra tio n s ?
2
D e s crib e th e a c tiv itie s th a t c o u ld e x p la in th e use o f cash flo w fo r fin a n c in g a c tiv itie s .
3
U sing o n ly th e cash flo w in fo rm a tio n pre se n te d , m a ke an assessm ent o f th e c o n d itio n o f M a rlo t Lim ited . Is it g ro w in g , m a tu re /s ta b le o r d e c lin in g ? State reasons fo r y o u r a n s w e r (in c lu d in g a n y a ssu m p tio n s y o u m ake).
PROBLEM 1 4.8 In te rp re tin g a sta te m e n t o f cash flow s O u tlin e th e fiv e m ost im p o rta n t th in g s y o u le a rn a b o u t T a b c o rp H o ld in g s Lim ited fro m th e fo llo w in g c o n s o lid a te d state m e nt o f cash flo w s fo r th e y e a r e n d e d 3 0 June 2 0 1 1 . 2011
2010
$m
$m
Cash flows from operating activities Net cash receipts in the course of operations
4 4 3 9 .3
4 280.2
Payments to suppliers, service providers and employees
(2 357.2)
(2 213.6)
Payment of government levies, betting taxes and GST
(1 075.2)
(1 038.0)
Interest revenue received
8.1
6.6
Finance costs paid
(159.2)
(155.0)
Income tax paid
(197.7)
(179.0)
Net cash flows from operating activities
658.1
701.2
(595.6)
(408.1)
Cash flows from investing activities Payment for property, plant and equipment and intangibles Proceeds from sale of property, plant and equipment and intangibles Loans advanced to customers
N et cash flows used in investing activities
2.1
2.7
(47.6)
(4.7)
(641.1)
(410.1)
Cash flows from financing activities Proceeds from issue of shares
4 27.7
-
Payment of transaction costs for share issue
(12.7)
-
Payment of transaction costs for capital reduction
(21.1)
-
Payment of transaction costs for demerger
(64.7)
-
(210.0)
(15.0)
Net repayments of short term borrowings Proceeds from long term borrowings
1 090.0
-
Repayment of long term borrowings
(938.6)
Cash reduction through demerger of entities
(124.5)
-
Dividends paid
(269.7)
(303.4)
(9.8)
(1.9)
Payments for on-market share buyback Proceeds from sale of treasury shares Loans advanced to related party
1.6
-
0.7
-
(1.0)
Net cash flows used in financing activities
(131.8)
(320.6)
Net decrease in cash held
(114.8)
Cash at beginning of year
261.9
291.4
(29.5)
Cash at end of year
147.1
261.9
S ou rce : T a b c o rp H o ld in g s Lim ited, 2 0 1 1 C o n s o lid a te d S tatem ent o f C a s h Flow s.
CHAPTER 14 The statem ent o f cash flows
PROBLEM 14.9 Prepare a cash Flow s ta te m e n t EXPRESS LTD COMPARATIVE BALANCE SHEETS FOR 2 0 1 6 A ND 20 15 2016
20 15
$
$
93
50
Current assets Cash Accounts receivable
80
60
Inventory
70
100
Prepaid insurance
40
25
283
235
315
350
90
140
Total noncurrent assets
225
210
Total assets
508
445
Accounts payable
50
35
Wages payable
25
15
Total current assets Noncurrent assets Equipment Less accumulated depreciation
Current liabilities
Rent received in advance
18
15
Accrued other expenses
20
30
113
95
Loan
90
125
Total noncurrent liabilities
90
125
Total liabilities
203
220
N et assets
305
225
Share capital
140
140
Retained earnings
165
85
Total shareholders' equity
305
225
Total current liabilities Noncurrent liabilities
Shareholders' equity
EXPRESS LTD PROFIT A ND LOSS STATEMENT FOR THE YEAR ENDED 30 JUNE 2 0 1 6 $ Sales
470
Cost of goods sold
180
Gross profit
290
Other revenue Rent
Total revenue
60 350
557
558
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Less operating expenses Wages
35
Insurance
30
Depreciation
110
Other expenses
75
Loss on disposal of equipment
4 254
Net profit
96
A d d itio n a l in fo rm a tio n : e q u ip m e n t th a t costs $ 2 0 0 w a s s o ld d u rin g the y e a r. Required: 1 P re p a re a cash flo w state m e nt e n d in g 3 0 June 2 0 1 6 .
PROBLEM 14.10 Financing and investin g a ctivitie s The fo llo w in g in fo rm a tio n relates to LL Ltd. LL LTD COMPARATIVE BALANCE SHEETS 2016
20 15
$
$
Current assets 95 000
105 00 0
Accounts receivable
Cash
330000
150 00 0
Inventory
270000
260000
1 0000
5 000
Land
540000
480000
Equipment
587000
585000
Prepaid insurance
Noncurrent assets
Accumulated depreciation - equipment
Total Assets
(332 000)
(245 000)
1 500000
1 340000
190000
360000
64000
52 000
Current liabilities Accounts payable Wages payable
Noncurrent liabilities Borrowings
Total Liabilities Net Assets
746000
488000
1 000000
900000
500000
440000
250000
240000
Shareholders' equity Share capital Asset revaluation reserve
90000
50000
Retained profits
160000
150 00 0
Total Shareholders' equity
500000
440000
CHAPTER 14 The statem ent o f cash flows
LL LTD INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20 16 $ Sales
$ 700000
Gain on sale of equipment
30000 730000
Less: Cost of goods sold
87000
Depreciation
300000
Wages expense
100000
Rent expense
9000
Insurance expenses
30000
Profit before income tax
526000 204000
Less: Income tax expense
64000
Profit/(loss) after tax
140000
A d d itio n a l in fo rm a tio n : e q u ip m e n t w ith a b o o k v a lu e o f $ 7 0 0 0 0 w a s s o ld d u rin g th e y e a r. 1 W h a t is th e jo u rn a l e n try fo r th e sale o f e q u ip m e n t?
2
C a lc u la te th e fo llo w in g : a
3
4
cash re c e ive d fro m custom ers
b
cash p a id to s u p p lie rs
c
w a g e s p a id
d
rent p a id
e
in su ra n c e p a id .
C a lc u la te th e fo llo w in g : a
cash p a id fo r la n d p u rch a s e
b
cash p a id fo r e q u ip m e n t.
C a lc u la te cash flo w fro m fin a n c in g a c tiv itie s fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 14.11 Financing and investin g a ctivitie s The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c co u n ts o f P ro p e rty Ltd:
EE3 Buildings, 1 July 2015
2 000
Buildings, 3 0 June 2016
3700
Accumulated depreciation - buildings,
1 July 2015
Accumulated depreciation - buildings, 30 June 2016
500 450
Asset revaluation reserve, 1 July 2015
2 600
Asset revaluation reserve, 30 June 2016
3 000
Borrowings, 1 July 2015
2 800
Borrowings, 3 0 June 2016
2700
Building sold during the year: Cost price
900
Accumulated depreciation
250
Proceeds Upwards revaluation of buildings
70 400
559
560
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A d d itio n a l in fo rm a tio n : a
D u rin g th e y e a r, a b u ild in g w ith a v a lu e o f $ 7 0 0 0 0 0 w a s a c q u ire d b y th e issue o f a long -term note. The a m o u n t has been in c lu d e d in b o rro w in g s .
b
Ig n o re th e e ffe c t o f u p w a rd re v a lu a tio n o f b u ild in g s o n th e a c c u m u la te d d e p re c ia tio n o f b u ild in g s .
Required: 1
W h a t w a s the a m o u n t o f b o rro w in g s re p a id d u rin g th e y e a r?
2
W h a t w a s th e d e p re c ia tio n e x p e n s e fo r b u ild in g s d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6?
3
W h a t w a s th e g a in o r loss o n th e d is p o s a l o f b u ild in g s ?
4
W h a t w a s th e v a lu e o f b u ild in g s a c q u ire d using cash d u rin g th e y e a r?
PROBLEM 14.12 Cash Flow From operations The fo llo w in g d a ta a re e x tra c te d fro m th e fin a n c ia l statem ents o f Flutes Ltd: 2016 $
$
Accounts receivable
240000
265 000
Inventory
340000
380000
80000
50000
Salaries payable Accounts payable
1
2015
280000
310000
Interest payable
1 0000
1 0000
Income tax payable
95 000
80000
A d d itio n a l in fo rm a tio n : A ll sales a re m a d e on c re d it; th e re is no a llo w a n c e fo r d o u b tfu l de bts
2
Sales reven ue , $ 8 8 0 0 0 0
3
C o s t o f g o o d s so ld , $ 6 2 0 0 0 0
4
S a la rie s ex p e n s e , $ 7 0 0 0 0
5
Interest e x p e n s e , $ 1 1 0 0 0 0
6
In co m e ta x e x p e n s e on c u rre n t y e a r's p ro fits , $ 9 5 0 0 0 .
C a lc u la te a ll cash flo w s re v e a le d b y th e a b o v e d a ta .
PROBLEM 14.13 Cash Flows For Financing and investin g The fo llo w in g d a ta a re e x tra c te d fro m th e fin a n c ia l statem ents o f H ip p o ly ta Ltd. 2016
20 15
$
$
Equipment
128000
192 00 0
Accumulated depreciation - equipment
(35 000)
(40000)
A d d itio n a l in fo rm a tio n : a P roceeds fro m sale o f e q u ip m e n t, $ 7 5 0 0 0 b
N e t b o o k v a lu e (cost less a c c u m u la te d d e p re c ia tio n ) o f e q u ip m e n t s o ld , $ 6 2 0 0 0
c
D e p re c ia tio n e x p e n s e fo r e q u ip m e n t, $ 1 7 0 0 0
d
S om e n e w e q u ip m e n t w a s p u rc h a s e d d u rin g 2 0 1 7
e
A ssum e a ll sales a n d pu rch ases o f e q u ip m e n t a re fo r cash.
CHAPTER 14 The statem ent o f cash flows
561
Required: 1
R econstruct th e jo u rn a l e n try to re c o rd th e sale o f e q u ip m e n t.
2
W h a t is th e v a lu e o f th e e q u ip m e n t p u rch a s e d ?
PROBLEM 14.14 Cash Flow From Financing The fo llo w in g d a ta a re e x tra c te d fro m th e fin a n c ia l statem ents o f Theseus Lim ited: 2016
20 15
$
$
Share capital
368000
321 000
Retained earnings
210000
198000
38 000
34000
Net profit
C a lc u la te a ll th e cash flo w s re v e a le d b y th e d a ta p ro v id e d a b o v e .
PROBLEM 14.15 Com m ent on a com pany's cash m anagem ent (in d ire c t m ethod) A x io m a tic Ltd's state m e nt o f cash flo w s fo r last y e a r is s h o w n b e lo w . P ro vid e o b s e rv a tio n s a b o u t h o w th e c o m p a n y m a n a g e d its cash d u rin g th e y e a r. AXIOMATIC LTD STATEMENT OF CASH FLOWS FOR LAST YEAR $
$
Operating: Net profit for the year
94900
Add back non-cash expenses: Depreciation expense
216800
Amortisation expense
1 4 2 00
Bad debt expense
38 900
269900
Non-cash working capital changes: Increase in accounts receivable
(143 900)
Increase in inventories
(71 600)
Increase in accounts payable
87000
Cash generated by operations
(128 500) 236300
Investing activities: Additions to noncurrent assets Proceeds on disposal of noncurrent assets
(429100) 27700
(401400)
Financing activities: Short-term bank loan
30000
Additions to noncurrent debt
343200
Repayments of noncurrent debt
(316 000)
Share capital issued
200000
Dividends paid during the year
(40000)
217200
Increase in cash for the year
52 100
Cash, beginning of year
(93 500)
Cash, end of year
(41400)
562
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 14.16 In d ire ct m eth o d The in co m e state m e nt a n d b a la n c e sheet p ro v id e th e fo llo w in g in fo rm a tio n fo r 2 0 1 6 . INCOME STATEMENT FOR YEAR ENDED 3 0 JUNE 20 16
1
C a lc u la te cash flo w s fo r o p e ra tio n s using th e in d ire c t m e th o d .
2
W h y a re th e reasons fo r th e d iffe re n c e b e tw e e n cash flo w fro m o p e ra tio n s a n d net in co m e im p o rta n t to fin a n c ia l an alysts?
PROBLEM 14.17 R econstructing account balances trom a s ta te m e n t o f cash Flows XYZ LIMITED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 30 JUNE 2 0 1 6 Consolidated 2016
2015
Cash flows from operating activities Cash receipts from customers
3 8 9 86 3
188739
Cash payments to suppliers and employees
(375 926)
(304600)
Interest received
1 572
1 368
Interest paid
(21 514)
(13 245)
Income taxes paid
(14281)
(6514)
(20286)
(134 252)
Net cash used in operating activities Cash flows from investing activities Proceeds from sale of plant and equipment Payments for plant and equipment Purchase of controlled entity
Net cash used in investing activities
375
719
(12284)
(14545)
(942)
(4609)
(12851)
(18435)
CHAPTER 14 The statem ent o f cash flows
563
Cash flows from financing activities Proceeds from issue of shares
46945
5 275
Proceeds from borrowings
112500
161 38 7
Repayment of borrowings
(100000)
-
Dividends paid
(21 656)
(18971)
Net cash provided by financing activities
37789
147691
Net increase/(decrease) in cash held
4652
(4996)
Cash at the beginning of the financial year
1 943
6 939
Cash at the end of the financial year
6595
1 943
A d d itio n a l in fo rm a tio n : a
N e t p ro fit a fte r ta x is $ 2 5 2 7 0 , w h ic h in c lu d e d a g a in o n the sale o f p la n t a n d e q u ip m e n t o f $ 2 5 0 (on p la n t a n d e q u ip m e n t th a t cost $ 2 0 0 0 ) .
b
T h ere w a s no o p e n in g o r clo s in g b a la n c e in d iv id e n d s p a y a b le .
c A c c o u n ts re c e iv a b le in c re a s e d b y $ 2 0 0 0 0 d u rin g th e y e a r. d
Interest p a y a b le a t 3 0 June 2 0 1 6 w a s $ 2 1 5 4 , a n d a t 3 0 June 2 0 1 5 w a s $ 3 7 1 2 .
Required: 1 H o w m uch w o u ld re ta in e d p ro fits h a ve in c re a s e d o r d e c re a s e d d u rin g th e y e a r, assu m ing no tra nsfers to o r fro m reserves?
2
W h a t w e re th e c o m p a n y 's sales fo r th e y e a r?
3
W h a t w a s th e b o o k v a lu e o f th e p la n t a n d e q u ip m e n t sold?
4
W h a t w a s th e in tere st e x p e n s e fo r th e y e a r?
5
Based o n ly on th e in fo rm a tio n g iv e n in th e q u e s tio n , list tw o reasons w h y net p ro fit w o u ld be h ig h e r th a n cash flo w fro m o p e ra tio n s .
PROBLEM 14.18 Cash Flow From operations (data includes bad and doubtFul debts) The fo llo w in g in fo rm a tio n is ta ke n fro m th e a c co u n ts o f R e g istra tio n Ltd fo r th e y e a r e n d e d 31 D e c e m b e r 2 0 1 6 :
$ Accounts receivable, 1 January 201 6
95 000
Accounts receivable, 31 December 2016
70000
Allowance for doubtful debts, 1 January 2016
13 000
Allowance for doubtful debts, 31 December 2016
5 000
Inventory, 1 January 2016
90000
Inventory, 31 December 2016
95 000
Accounts payable, 1 January 2016
70000
Accounts payable, 31 December 2016
60000
Credit sales
300000
Cash sales
160000
COGS
420000
Bad debts expense
1
W h a t w a s th e a m o u n t o f cash re c e iv e d fro m custom ers?
2
W h a t w a s th e a m o u n t o f cash p a id to s u p p lie rs?
12 000
564
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 14.19 Preparation o f a sta te m e n t o f cash flow s The fo llo w in g in fo rm a tio n relates to S a n d ra Lim ited. Comparative balance sheets 3 0 June 2 0 1 6
3 0 June 2 0 1 5
$0 00
$000
Cash
193
240
Accounts receivable
400
470
Current assets
Allowance for doubtful debts Inventory Prepaid insurance
(50)
(47)
420
380
30
40
605
620
Noncurrent assets Land
(80) Equipment Accumulated depreciation - equipment
Total assets
2 030 (690)
(40) 1 455 (560)
2938
2 598
Accounts payable
210
290
Accrued other expenses
120
140
Current liabilities
Interest payable
40
40
780
680
Borrowings
770
1 100
Total liabilities
1 920
2 250
330
210
Income tax payable Noncurrent liabilities
Shareholders' equity Share capital Asset revaluation reserve
60
10
628
128
Total shareholders' equity
1 018
348
Total liabilities and shareholders' equity
2938
2 598
Retained profits
CHAPTER 14 The statem ent o f cash flows
565
INCOME STATEMENT YEAR ENDED 3 0 JUNE 2 0 1 6
A d d itio n a l in fo rm a tio n (d o lla r a m o u n ts e x p re ss e d in fu ll units): a The e q u ip m e n t th a t w a s s o ld w a s o rig in a lly p u rc h a s e d b y S a n d ra Lim ited th re e y e a rs a g o a t a cost o f $ 3 0 0 0 0 0 . b
Land w ith a n o rig in a l v a lu e o f $ 2 4 0 0 0 0 w a s re v a lu e d to $ 2 9 0 0 0 0 .
Required: P re p a re a state m e nt o f cash flo w s fo r S a n d ra Lim ited fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 1 4 .2 0 Sim ple cash Flow s ta te m e n t - in d ire c t m ethod J a n a li Lim ited p re p a re s its state m e nt o f cash flo w s using th e in d ire c t m e th o d . Its b a la n c e sheet s how s th e fo llo w in g in fo rm a tio n :
Cash
3 0 /0 6 /2 0 1 6
3 0 /0 6 /2 0 1 5
$
$
81 000
87000
Inventory
205000
190000
Equipment
270000
260000
Accumulated depreciation
Accounts payable Long-term loan Share capital Retained profits
(75 000)
(70000)
481 000
467000
130000
142000
85 000
75 000
230000
230000
36000
20000
481 000
467000
A d d itio n a l in fo rm a tio n : a N e t p ro fit fo r th e y e a r e n d e d 3 0 June 2 0 1 6 w a s $ 3 0 0 0 0 . b
N o e q u ip m e n t w a s d is p o s e d o f d u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 . N o pa ym e n ts w e re m a d e o n th e lo n g term lo a n .
566
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C a lc u la te e a ch o f th e fo llo w in g a m ou nts: 1
N e t cash flo w fro m o p e ra tin g a c tiv itie s
2
N e t cash flo w fro m in ve sting a c tiv itie s
3
N e t cash flo w fro m fin a n c in g a c tiv itie s .
PROBLEM 14.21 Preparation o f a sta te m e n t o f cash flo w A n in co m e state m e nt a n d a c o m p a ra tiv e b a la n c e sheet fo r B o ra c h io Ltd a re as fo llo w s : BORACHIO LTD COMPARATIVE BALANCE SHEET AS AT 30 JUNE 2 0 1 6 AN D 2015 2016 $0 00 Cash
162
144
Accounts receivable
145
128
Allowance for doubtful debt
(16)
(12)
Inventory
175
190
9
6
Prepaid insurance Long-term investments
205
163
Land
172
149
Equipment
449
4 37
Accumulated depreciation - equipment
(214)
(149)
Total assets
1087
1056
Accounts payable
87
51
Accrued expenses
27
11
9
9
44
23
Interest payable Income tax payable Final dividends payable
16
12
Bonds payable
100
250
Share capital
490
420
Retained earnings
314
280
1087
1056
Total liabilities and shareholders' equity
BORACHIO LTD INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20 16 $0 00 Sales
$0 00 1520
COGS
(1 110) 410
G ro s s P ro fit
Operating expenses Bad debts expense Insurance expense
(15) (9)
Depreciation expense
(65)
Other operating expenses
(85)
Total operating expenses
(174) 236
»
CHAPTER 14 The statem ent o f cash flows
567
Other income: Dividends received
5
Other expenses: Interest expense
(25)
Loss on disposal of land
(18) (38)
Income before income tax
198
Income tax
88
Net profit
110
The fo llo w in g a d d itio n a l in fo rm a tio n d u rin g th e y e a r w a s o b ta in e d fro m a n e x a m in a tio n o f th e le d g e r: a A p a rc e l o f la n d w ith a n o rig in a l c o st o f $ 6 0 0 0 0 w a s so ld , b
A ll sales o v e r th e y e a r a re m a d e on c re d it.
Required: 1
P re p a re a state m e nt o f cash flo w s (d ire c t m ethod) fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
2
P re p a re a re c o n c ilia tio n state m e nt (in d ire c t m ethod) fo r th e y e a r e n d e d 3 0 June 2 0 1 6 .
PROBLEM 14 .2 2 Ethics o f cash flo w m a n ip u la tio n T here is a n in te re stin g e th ic a l issue b e h in d th e v e ry re a so n th a t th e state m e nt o f cash flo w s is th o u g h t b y som e p e o p le to h a ve a d v a n ta g e s o v e r th e in co m e statem ent. The rea so n is th a t p e o p le a re o fte n m istrustful o f th e in c o m e statem ent b e ca u s e th e y fe el its a c c ru a l a c c o u n tin g m e tho ds c a n be used to m a n ip u la te net p ro fit as a m e asure o f p e rfo rm a n c e , a n d th e y th in k th a t th e cash flo w fig u re s a re m o re 'r e a l'. For e x a m p le , a c o m p a n y m ig h t c la im la rg e revenues, no t y e t c o lle c te d , th a t m a ke its reven ue h ig h e r (via th e e n try DR a c c o u n ts re c e iv a b le , CR reven ue ). H o w e v e r, if th e cash has no t be en c o lle c te d , th e in cre a s e in a c co u n ts re c e iv a b le w ill be d e d u c te d fro m net p ro fit on th e state m e nt o f cash flo w s , a n d th e la c k o f 're a l' cash in flo w w ill be a p p a re n t b e ca u s e cash fro m o p e ra tio n s w ill b e lo w e r th a n w o u ld be e x p e c te d fro m th e p ro fit n u m b e r. T h e re fo re , it is th o u g h t th e state m e nt o f cash flo w s ' cash fro m o p e ra tio n s fig u re is m o re b e lie v a b le th a n net p ro fit a n d w ill e v e n , if it is v e ry d iffe re n t fro m net p ro fit, u n m a sk m a n ip u la tio n s o f the net p ro fit. The e th ic a l issue is th a t it is p o ss ib le to m a n ip u la te th e cash flo w fig u re s to o . For e x a m p le , a c o m p a n y m ig h t a c c e le ra te o r d e la y re c e iv a b le s c o lle c tio n s in o rd e r to c h a n g e th e cash flo w fig u re s - w h e th e r o r n o t th e net p ro fit is a ls o b e in g m a n ip u la te d . T h ere m a y be a d iffe re n c e fro m m a n ip u la tin g net p ro fit, h o w e v e r, b e ca u s e c h a n g in g cash flo w fig u re s re q u ire s re a l a c tio n s th a t a ffe c t custom ers o r s u p p lie rs o r e m p lo y e e s . T h e re fo re , th e re a re real c o n s e q u e n ce s, such as irrita tin g custom ers o r h a v in g to o ffe r in d u ce m e n ts fo r e a rly p a y m e n t. N e ve rth e le ss, it c an be d o n e . It seem s th a t m ost p e o p le w o u ld fe el th a t a lte rin g th e a c c ru a ls just to m a ke net p ro fit b e tte r (or w o rs e , o r sm oo the r) is e th ic a lly q u e s tio n a b le , even if it is u n d e rs ta n d a b le b e ca u s e o f th e w a y m a n a g e m e n t is e v a lu a te d a n d re w a rd e d . But is a lte rin g th e cash flo w e th ic a lly q u e s tio n a b le ? Is th e re a n e th ic a l p ro b le m if m a n a g e m e n t d e c id e s to p u t pressure on custom ers to a c c e le ra te c o lle c tio n s a n d im p ro v e th e c o m p a n y 's cash p o s itio n ? It s oun ds like g o o d m a n a g e m e n t, no t like m a n ip u la tio n . S u g g e st tw o o r th re e w a y s , n o t in c lu d e d a b o v e , in w h ic h o p e ra tin g , in ve stin g o r fin a n c in g cash flo w s c o u ld be a lte re d fro m th e ir n o rm a l levels. For e a c h , discuss w h e th e r, o r u n d e r w h a t c o n d itio n s , y o u w o u ld th in k th e re is an e th ic a l p ro b le m w ith such a n a lte ra tio n .
568
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASES CASE14A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . A ll qu e stio n s re la te to the c o n s o lid a te d a cco u n ts. 1 W h a t a re th e m a in c o m p o n e n ts o f cash flo w s fro m o p e ra tin g a c tiv itie s ? 2
W h a t a re th e m a in c o m p o n e n ts o f cash flo w s fro m in ve stin g a c tiv itie s ?
3
W h a t a re th e m a in c o m p o n e n ts o f cash flo w s fro m fin a n c in g a c tiv itie s ?
4
R econ cile th e d iv id e n d s p a id a n d p ro v id e d fig u re in th e re ta in e d p ro fits no te w ith d iv id e n d s p a id in th e cash flo w statem ent.
5
W h a t do es th e c o m p a n y d e fin e as cash a n d cash e q u iva le n ts?
6
H o w do es th e cash flo w state m e nt re la te b a c k to th e b a la n c e sheet?
7
List fiv e key th in g s y o u le a rn a b o u t this c o m p a n y fro m its state m e nt o f cash flo w s .
CASE 14B
Statem ent of cash flows for Qantas Ltd QANTAS GROUP Notes
2014
20 13
$m
$m
CASH FLOWS FROM OPERATING ACTIVITIES Cash receipts from customers Cash payments to suppliers and employees (excluding cash payments to employees for redundancies)
16582 (1 5 0 4 1 )
1 432
Cash generated from operations Cash payments to employees for redundancies Interest received Interest paid
Income taxes paid
(144)
74
no
(254)
(229)
(2) 26
1 541
(185)
4
Dividends received from investments accounted for under the equity method
Net cash from operating activities
16 7 2 0 (1 5 2 8 8 )
142 (3)
1 069
1417
(1 161)
(1 24 7 )
(34)
(61)
-
(24)
(72)
(73)
18
(12)
CASH FLOWS FROM INVESTING ACTIVITIES Payments for property, plant and equipment and intangible assets Interest paid and capitalised on qualifying assets Payments for the acquisition of controlled entities, net of cash acquired Payments for investments accounted for under the equity method Net receipts/(payments) for aircraft assigned to investments accounted for under the equity method Proceeds from disposal of property, plant and equipment
5
141
32
Proceeds from sale and operating leaseback of non-current assets
-
8
Proceeds from disposal of controlled entities, net of cash disposed
70
18
Proceeds from disposal of investments accounted for under the equity method
-
189
Net (loans to)/proceeds from repayment of loans from investments accounted for under the equity method
(21)
125
Net cash used in investing activities
(1 06 9 )
(1 04 5 )
»
CHAPTER 14 The statem ent o f cash flows
»
569
CASH FLOWS FROM FINANCING ACTIVITIES Payments for shares bought back
2
Payments for treasury shares
(63) -
Proceeds from borrowings
717
Repayments of borrowings
(1 027)
Proceeds from sale and finance leaseback of non-current assets
564
Net payments for aircraft security deposits and hedges related to debt
(17)
Dividends paid to non-controlling interests
(36) (16) 846 (1 494) 83 (336) -
(1)
Net cash provided by/(used in) financing activities
173
(953)
Net increase/(decrease) in cash and cash equivalents held
173
(581)
Cash and cash equivalents at the beginning of the year
2 829
Effects of exchange rate changes on cash and cash equivalents
Cash and cash equivalents a t the end of the year
(1) 10
Source: Q antas A irw a ys Limited,
3001
3 398 12 2 829
2 0 1 4 C o n s o lid a te d C a s h F lo w Statem ent.
1
W h a t d o y o u le a rn a b o u t Q a n ta s fro m th e state m e nt o f cash flo w s fo r th e y e a r e n d e d 3 0 June 2 0 1 4 ?
2
W h a t a re th e m a jo r c h a n g e s b e tw e e n th e tw o ye a rs?
CASE 14C____________Interpreting the One. Tel Limited statem ent of cash flows S h o w n b e lo w a re th e 1 9 9 9 a n d 2 0 0 0 cash flo w statem ents fo r O n e .T e l Lim ited , a te le c o m m u n ic a tio n s c o m p a n y th a t w a s d e lis te d in 2 0 0 1 . Consolidated 2000
1999
$m
$m
Cash flow from operating activities Receipts from customers
510.9
300.1
Payments to suppliers and employees
(684.8)
(328.1)
16.9
1.9
(11.9)
(3.5)
Interest received Interest and other borrowing costs paid Income tax refunded Net cash used by operating activities
-
0.7
(168.9)
(28.9)
-
1.6
Cash flow from investing activities Proceeds from sale of investments Proceeds from sale of plant and equipment Payment for plant and equipment Purchase of licences Purchase of controlled entities Payment of deferred consideration Loans provided to wholly owned entities Loans provided to other parties Net cash used by investing activities
-
19.2
(87.5)
(34.0)
(525.6)
(9.5)
-
(6.9)
(1.8)
-
-
-
-
(2.6)
(614.9)
(32.2)
570
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Cash flow from financing activities Proceeds from issue of shares
818.5
280.3
Proceeds from borrowings
139.8
59.0
Finance lease principal repayments
(11.2)
Dividends paid
(4.2)
(1.8)
Share buyback
(2.5) (106.4)
-
Net cash provided by financing activities
945.3
226.2
Net increase in cash held
161.5
165.1
Cash and cash equivalents at beginning of year
172.6
Exchange rate adjustment
8.4
1.6
Cash and cash equivalents at end of year
(0.9)
335.7
172.6 Source: O ne.Tel Limited.
1
O u tlin e w h a t y o u c a n le a rn a b o u t O n e .T e l fro m th e a b o v e state m e nt o f cash flo w s.
2
W h ic h fa cto rs in th e state m e nt o f cash flo w s in d ic a te th a t th e c o m p a n y w o u ld fa il w ith in o n e y e a r, a n d w h ic h fa c to rs in d ic a te th e y w o u ld not?
CASE 14D
Variations in the pattern of cash Plows
Shown below is the 2 0 1 4 statement o f cash flows for Telstra Lim ited. Explain these changes in the pattern of cash flows between 2 0 1 4 and 2 0 1 3 .
TELSTRA GROUP Year ended 30 June Note
2014
2013
$m
$m
Cash flows from operating activities Receipts from customers (inclusive of goods and services tax (GST))
28950
28585
Payments to suppliers and to employees (inclusive of GST)
(18710)
(18 803)
Government grants received Net cash generated by operations Income taxes paid
Net cash provided by operating activities
20(a)
147
77
1 0 3 87
9 859
(1 774)
(1 500)
8613
8 359
(2 868)
(2 818)
Cash flows from investing activities Payments for: - property, plant and equipment - intangible assets Capital expenditure (before investments) - shares in controlled entities (net of cash acquired)
20(c)
- payments for joint ventures and associated entities
26(f)
- payments for other investments Total capital expenditure (including investments)
(894)
(1 691)
(3 762)
(4509)
(165)
(9)
(3)
(8)
(88)
(19)
(4018)
(4545)
»
CHAPTER 14 The statem ent o f cash flows
»
571
Proceeds from: - sale of property, plant and equipment
94
57
-
12
2 397
693
- sale of intangible assets - sale of shares in controlled entities (net of cash disposed)
20(d)
- sale of businesses (net of cash disposed) Proceeds from finance lease principal amounts
-
4
98
64
Loans to joint ventures and associated entities
-
Interest received
150
Settlement of hedges in net investments
(21) 4
Investments in financial instruments Dividends received Distributions received from Foxtel Partnership
6
(1) 236 (11) -
1
1
165
155
Net cash used in investing activities
(1 130)
(3 335)
Operating cash flows less investing cash flows
7483
5 024
Cash flows from financing activities Proceeds from borrowings
1 572
2 074
Repayment of borrowings
(1 387)
(4042)
(91)
(97)
-
52
3
4
Repayment of finance lease principal amounts Proceeds from sale and finance lease back transactions Staff repayments of share loans Purchase of shares for employee share plans
(61)
-
Proceeds received from exercise of equity instruments
29
29
Finance costs paid
(947)
(1 037)
Issue of equity by controlled entities
20(c)
160
-
Payment for share buy-back of non-controlling interests
20(c)
(149)
(1)
Proceeds from sale of controlled entity shares on behalf of non controlling interests Dividends paid to equity holders of Telstra Entity
8 4
-
(3 545)
(3 480)
(22)
(28)
Net cash used in financing activities
(4430)
(6526)
Net increase/(decrease) in cash and cash equivalents
3 053
(1 502)
Cash and cash equivalents at the beginning of the year
2 479
3 945
Dividends paid to non-controlling interests
Effects of exchange rate changes on cash and cash equivalents
Cash and cash equivalents a t the end of the year
(5) 20(b)
5 527
Source: Telstra C orporation Limited,
36 2479
2 0 ] 4 A n n u a l Report.
572
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 14E______________ Interpreting a cash flow statem ent for two retailers S h o w n b e lo w a re e xtra cts fro m th e 2 0 1 4 state m e nt o f cash flo w s fro m tw o A u s tra lia n c o m p a n ie s , M y e r H o ld in g s Lim ited a n d H a rv e y N o rm a n H o ld in g s Lim ited. 2014
20 13
5 2 weeks
52 weeks
$ '0 0 0
$ '0 0 0
Receipts from customers (inclusive of goods and services tax)
3042312
3 051 474
Payments to suppliers and employees (inclusive of goods and services tax)
(2785 366)
(2751 713)
Cash flows from operating activities
Other income
256946
299761
6 356
45 7
Interest paid
(22443)
(26411)
Tax paid
(49283)
(48 282)
Net cash inflow from operating activities
191 57 6 Source: M y e r H oldings Limited,
225525
2 0 1 4 A n n u a l Report.
Consolidated
Cash flows from operating activities Net receipts from franchisees Receipts from customers Payments to suppliers and employees Distributions received from joint ventures GST paid Interest received
June 2 0 1 4
June 2 0 1 3
$000
$000
lnflows/(Outflows) 871251
737966
1590489
1 393 735
(1 994315)
(1 797970)
15512
11 632
(39087)
(28425)
8 874
11 672
Interest and other costs of finance paid
(36583)
(45 945)
Income taxes paid
(78 626)
(44764)
1 420
1 316
338935
239217
Dividends received Net Cash Flows From Operating Activities
Source: H arvey N orm an H oldings Limited,
1
State w h a t y o u le a rn fro m th e tw o statem ents.
2
W h ic h d o y o u fin d to be m o re in fo rm a tiv e ?
2 0 1 4 A n n u a l Report.
CHAPTER 14 The statem ent o f cash flows
CASE14F
573
Interpreting a cash flow statem ent
O b ta in th e cash flo w state m e nt fro m B illa b o n g In te rn a tio n a l Lim ite d 's 2 0 1 4 A n n u a l R ep ort a n d c o m m e n t on w h a t y o u le a rn a b o u t cash flo w fro m o p e ra tin g a c tiv itie s , cash flo w fro m in ve stin g a c tiv itie s a n d cash flo w fro m fin a n c in g a c tiv itie s . O u tlin e th e five m ost im p o rta n t th in g s y o u le a rn fro m B illa b o n g In te rn a tio n a l Lim ited 's 2 0 1 4 cash flo w statem ent.
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>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TE 1
Useful inform ation for this section w as provided b y Professors Jack Flanagan and G re g W h ittre d.
Financial statement analysis ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: describe the objectives of financial statem ent analysis identify the limitations of financial statem ent analysis p re p a re com m on size statements calculate com m only used ratios to analyse a firm's profitability, activity, liquidity a n d financial structure use ratios to analyse a n d evalu ate a firm 's financial perform ance and financial position explain and use the Du Pont system o f integrative ratio analysis.
CHAPTER OVERVIEW W ith th e b a c k g ro u n d y o u n o w h a ve on th e c o n te n t o f fin a n c ia l state m e nts a n d h o w fin a n c ia l m a rke ts w o rk , y o u a re re a d y to c a rry o u t fin a n c ia l sta te m e n t a n a ly s is . This c h a p te r p ro v id e s y o u w ith to o ls fo r th e a n a ly s is a n d e v a lu a tio n o f fin a n c ia l p o s itio n a n d p e rfo rm a n c e . The m a in fo cu s is o n ra tio a n a ly s is , b u t a n a ly s is o f cash flo w (w h ic h y o u firs t e n c o u n te re d in C h a p te r 1 4 ) is re v is ite d , a n d th e re a re m o re e x a m p le s o f 'w h a t if' effe cts a n a ly s is . W h e n y o u e v a lu a te a c o m p a n y 's p e rfo rm a n c e , y o u ne ed to e v a lu a te it re la tiv e to th e c o m p a n y 's c irc u m s ta n c e s ; fo r e x a m p le , c o m p a ris o n s w ith p re v io u s y e a rs o r w ith s im ila r c o m p a n ie s b a s e d on s iz e o r o n in d u stry . R atio a n a ly s is is th e m a in te c h n iq u e d e s c rib e d in th is c h a p te r. R atios a re g ro u p e d in s p e c ific c a te g o rie s : p ro fit a b ility , a c tiv ity , liq u id ity a n d fin a n c ia l s tru c tu re , w h ic h p ro v id e in s ig h t in to a c o m p a n y 's o v e ra ll p e rfo rm a n c e .
576
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
15.1
Investm ent and relative return
An investment is m ade to earn a return. The return is usually thought o f in relation to the am ount o f the investment required to earn it. For exam ple, you m ight be pleased w ith a $ 1 0 0 0 annual return if you had invested $ 2 0 0 0 , but disap p o in te d if you had invested $ 2 m illion. O n e w a y to relate the tw o com ponents is via return on investment, in w hich the return is the numerator an d the initial investment is the denom inator: R elative return (return on investm ent) = R etu rn /ln vestm en t Later, w e w ill exam ine relative returns, such as return on investment (ROI), in m ore depth. For n o w , note that w e need to have some w a y o f measuring both return an d investment if w e are to calculate (and evaluate) relative return. M uch o f fina n cia l statement analysis is based on ratios such as ROI. Som e points you should rem em ber a bout ratios are as follow s: •
The purpose o f a ratio is to produce a scale-free, relative measure o f a c o m p a n y that can be used to co m p a re w ith other com panies, or other years for the sam e co m p a n y. Such a measure is scale-free because both num erator and denom in a to r are usually measured in the same units (dollars), w h ich are both related to the size o f the com pany. A large c o m p a n y w ill have a larger investment than a small one, a n d should be expected to have a larger return as w e ll, but a ratio like ROI cancels out some o f the effects of size, an d so a llo w s the large an d small com panies to be usefully co m p a red .
•
The ratio w ill be unreliable as a com parison, or even m isleading o r useless, unless its num erator is a p p ro p ria te . This means that the numerator must be properly ca lculated, as w e ll as suitable for the com parison being m ade. The w o rd 'return' in ROI could be defined in various w a ys , such as net profit, earnings before interest a nd tax (EBIT) or cash flo w from operations. The a p p ro p ria te c h o ice o f num erator depends on the context o f the analysis, as w e w ill discuss further. A lso, the role of G A A P a nd other rules in m aking figures such as net profit m eaningful is very im portant to the conclusions that m ay be d ra w n from ratio analysis.
•
These same points a p p ly e q u a lly to the de n o m in a to r o f the ratio. Possible denom inators include total assets, gross assets and shareholders' equity. A dd itio n a lly , sometimes a doubtful o r am biguous accounting method can create a problem in both the num erator an d the denom inator, brin g in g the w h o le ratio into question. An exam ple here is that if a c o m p a n y chooses a revenue recognition method that increases net profit, it w ill also make the retained earnings figure inflated, throw ing into question one o f the most w id e ly used ROI-type ratios, c a lle d return on equity (ROE), w hich is calculated as net profit d iv id e d by equity (which includes retained earnings).
15.2
Introduction to financial statem ent analysis
The purpose o f fin a n cia l statement analysis is to use the fin a n cia l statements to evaluate an enterprise's financial perform ance and fin a n cia l position. Therefore, the value o f the analysis depends on the q u a lity o f the underlying financial statements as w e ll as the analysis undertaken.
Financial evaluation is not ju s t calculation W h e n you have com pleted this chapter, you w ill be a b le to take a set o f fin a n cia l statements o f alm ost a n y co m p a n y and make an evaluation o f its perform ance an d position. Remember that such an evaluation is not just a calcu la tio n ; it is also a judgem ent based on the calculations that make sense for that c o m p a n y an d is based on d e ve lo p in g a substantial b o d y o f kn o w le d g e a b o u t the co m p a n y. The m ore you kn o w a b o u t a co m p a n y, its business, its industry, its m anagem ent a nd its accounting methods, the m ore useful a nd c re d ib le yo u r analysis w ill be. Financial accounting inform ation is not used in a vacuum ; it is part o f a vast a rra y o f inform ation a v a ila b le to investors, creditors, m anagers a nd others. Its use is affected by its o w n quality, such as w hether a com pany's financial statements have been carefully prepared a nd a re c o m p a ra b le w ith other co m p a n ie s' statements. Use is also affected by the a v a ila b ility o f other sources o f inform ation that m ay contain all o r part o f w h a t is in the fin a n cia l statements. Remember the idea from the discussion o f c a p ita l market research in C h a p te r 6 : it is difficult to 'b e a t the market' using
CHAPTER 15 Financial statem ent analysis
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financia l statements, because the statements reflect events w h ich are know n to market participants, a n d other sources o f inform ation a re also a v a ila b le to those investing in the sharem arket. You should a lw a ys v ie w fin a n cia l accounting inform ation as part of a netw ork o f inform ation, not as a stand-alone item. To explain a nd illustrate various techniques, how ever, this cha p te r deals w ith them separately.
Preparation for in te llig e n t analysis Unless you kn o w w h y yo u 're d o in g a fin a n cia l statement analysis - that is, w h a t decision o r evaluation is dependent on it - you c a n 't ge t very fa r w ith it. A lso, unless you have substantial k n o w le d g e o f the enterprise, you c a n 't interpret the figures your analysis produces; for exam ple, w h a t is g o o d perform ance for a n e w c o m p a n y in a troubled industry m ay be unsatisfactory for an established c o m p a n y in a prosperous industry. M u ch o f fin a n cia l analysis involves ratios. They have little m eaning on their o w n : they are merely indicators that can be interpreted a n d used m eaningfully o nly w ith a g o o d understanding o f the co m p a n y, its industry a n d the accounting policies used in p reparing the fin a n cia l statements. The scale-free nature o f a ratio means that it allow s com parisons over certain periods o f time, am ong com panies o f different sizes a nd w ith other indicators such as interest rates o r share prices. But it also can be tem pting to think that w hen you have calculated a ratio, you have som ething m eaningful in itself. W h ile there is some fundam ental m eaning in each ratio, as you w ill see, w h a t the com parisons mean to the analyst's decision must be a d d e d b y the analyst, using kn o w le d g e a n d inform ation beyond ratios. Therefore, in ord e r to d o an intelligent an d useful fin a n cia l statement analysis, you should d o the fo llo w in g : 1
Learn a b o u t the enterprise, its circumstances a n d its plans. This is essential in a n y real analysis: d o n 't be misled by the lim ited inform ation given for the exam ples in this book. Be sure to o btain the latest annual report for the enterprise (you w ill find it on its w ebsite). The annual report's descriptive sections including the m anagem ent discussion a nd analysis a nd the footnotes to the fin a n cia l statements w ill help you learn a b o u t the enterprise.
2
O b ta in a cle a r understanding o f the decision or evaluation to w h ich the analysis w ill contribute, w h o the decision m aker is (investor, lender, cre d ito r o r managem ent) an d w h a t assistance he o r she requires.
3
C a lcu la te the ratios, trends a n d other figures that a p p ly to your specific problem . D on't calculate every possible ratio.
4
Find w h a te ve r co m p a rative inform ation you can to pro vid e a fram e of reference for your analysis. Industry d ata, reports b y other analysts, results for sim ilar com panies o r the sam e c o m p a n y in other years a nd other such inform ation is often plentiful.
5
Focus on the a n a lytica l results that are most sig n ifica n t to the decision-m aker's circum stances, a nd integrate and org a n ise the analysis so that it w ill be o f most help to the decision-m aker. There are m any sources o f inform ation regarding com panies to help you becom e kn o w le d g e a b le a b o u t them and
a b le to p la ce your analysis in context. As you m ight expect, there is m ore inform ation a b o u t large com panies than small ones, a nd m ore a b o u t p u b licly listed com panies (those w h o se shares an d other securities a re listed on stock exchanges) than a b o u t private ones (those that a re closely held by a fe w owners). C o m p a n y w ebsites w ill generally make a v a ila b le fin a n cia l statements an d other useful inform ation a b o u t the c o m p a n y as a starting point fo r your analysis. Preparers o f fin a n cia l statements can choose betw een a num ber o f accounting policies on w h ich to base the finan cia l inform ation. (You've seen this a lre a d y in earlier chapters, an d yo u 'll see m ore a b o u t it in C h a p te r 16.) As the analyst of these statements, you m ay w ish to recast them using other policies that you prefer before com puting a n y of the ratios. For exam ple, some analysts d educt in ta n g ib le assets, such as g o o d w ill, from assets an d shareholders' equity before com puting ratios. They reason that, because these assets a re not physical in nature, some p e o p le m ay d oub t their value. Deleting them, therefore, m ay im prove co m p a ra b ility w ith com panies that d o n 't include such assets on their b a la n ce sheets.
578
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The v a lid ity o f fin a n cia l analysis based on accounting ratios has been challe n g e d . A m ong the objections are criticisms that future plans an d expected results, not historical numbers, should be used in com puting ratios, especially liquidity ratios; current market values, not historical numbers, should be used for assets, debts a nd shareholders' equity in com puting perform ance ratios; a nd cash flo w , not accounting profit, should be used in com puting perform ance ratios. A nother o b je ctio n is that because, at least for public com panies, stock markets a nd other c a p ita l markets adjust prices o f com pa n ie s' securities as inform ation comes out, ratios based on p u b licly a v a ila b le inform ation cannot tell you anything the markets have not a lre a d y incorporated into security prices. W h ile these criticisms are controversial, they are reminders to use ratios w ith care a nd intelligence.
15.3
Common size statem ents
W h ile the em phasis in this chapter w ill be on ratio analysis, it should be noted that another useful method to analyse financial results is the common size financial statement. By calculating all b a la n ce sheet figures as percentages of total assets and all incom e statement figures as a percentage o f total revenue, the size o f the c o m p a n y can be a p proxim ately factored out. This procedure assists in co m p a rin g com panies o f different sizes an d in spotting trends over tim e for a single com pany. For exam ple, consider the fo llo w in g incom e statement for the years ended 3 0 June 2 0 1 5 a n d 2 0 1 6 . 20 15
S a le s COGS G ro s s m a rg in
F ix ?
$0 00
1 549
1 289
387
258
1 162
1 031
O p e r a tin g e x p e n s e s A d m in is tra tio n
10 1
82
S e llin g
125
104
77
66
124
97
D is trib u tio n D e p re c ia tio n O th e r
39
O p e r a tin g p r o fit b e fo re ta x
466
32
381
696
650
iese numbers as a com m on size statement, the fo llo w in g w o u ld result: 2016
20 15
%
%
1 0 0 .0
1 0 0 .0
COGS
2 5 .0
2 0 .0
G ro s s m a rg in
7 5 .0
8 0 .0
S a le s
O p e r a tin g e x p e n s e s A d m in is tra tio n
6 .5
6 .4
S e llin g
8.1
8 .1
D is trib u tio n
5 .0
5 .1
D e p re c ia tio n
8 .0
O th e r
Z5
O p e r a tin g p r o fit b e fo re ta x
7 .5 3 0 .1 4 4 .9
2 .5
2 9 .6 5 0 .4
CHAPTER 15 Financial statem ent analysis
579
You can see that op e ra tin g profit before tax as a percentage o f sales has d ro p p e d from 5 0 .4 per cent to 4 4 .9 per cent. This ch a n g e is brought a b o u t alm ost exclusively because the C O G S expense has becom e a higher percentage o f sales. This technique can be used to identify large changes in com position o f revenues, expenses or types o f assets, liabilities an d equity.
15.4
W oolworths Limited: an example company
To help you see h o w the analyses in this chapter w o rk, they w ill be illustrated using the fin a n cia l statements of W o o lw o rth s Limited, a c o m p a n y that all Australians w ill be fa m ilia r w ith . This c o m p a n y is used in this b o o k because it provides the necessary scope for illustrating a w id e variety o f analyses. The main reason it is included, though, is to g ive you a sense o f accom plishm ent as you w o rk through this chapter. You w ill find that, w ith the accounting kno w le d g e you a lre a d y have an d the techniques outlined in this chapter, you can understand a lot a b o u t a c o m p any such as W o o lw o rth s . W h ile there w ill be some head scratching as you g o , you w ill be pleased at h o w kn o w le d g e a b le you becom e. As you are a w a re , W o o lw o rth s Limited is a large retail organisation w ith virtually all o f its operations carried out in Australia. As show n in N o te 7 of the annual report (Segment Disclosures) it has five main o p erating groups: •
A ustralian fo o d , liquor a n d petrol (including W o o lw o rth s supermarkets, B W S an d Dan M u rp h y's liquor)
•
N e w Z e a la n d supermarkets (including C o u n td o w n supermarkets)
•
general m erchandise (including Big W an d Ezibuy)
•
hotels (ALH G roup)
•
hom e im provem ent (including M asters an d H om e Tim ber a n d H ardw are). The c o m p a n y closes its books on the last S unday in June o f each year, not a t the end o f the month. The fin a n cial
period is therefore measured in w eeks. N o te that the 2 0 1 4 fin a n cia l period com prised 5 2 w eeks w hereas 20 1 3 w a s a 5 3 -w e e k p e riod, w h ich w e w ill need to keep in mind in our subsequent analysis. The a b rid g e d fin a n cia l statements from W o o lw o rth s ' 2 0 1 4 annual report a re in the a p p e n d ix at the b a ck o f this book. Before you g o further, g o to the co m p a n y's w e b site (w w w .w o o lw o rth s lim ite d .c o m .a u /a n n u a lre p o rt/2 0 1 4 ) a n d locate the co m p le te 2 0 1 4 A nnual Report a n d read its latest 'C h a irm a n 's Report' a n d 'M a n a g in g D irector's Report'. This w ill g iv e you som e b a ckg ro u n d to the c o m p a n y a n d som e insights into h o w m anagem ent has presented the perform ance o f the c o m p a n y to shareholders in 2 0 1 4 . W ith in the 2 0 1 4 fin a n cia l statements in the a p p e n d ix , find: •
the 2 0 1 4 net profit num ber (called profit attributable to equity holders o f the parent entity, $ 2 4 5 1 .7 million)
•
the 2 9 J u n e 2 0 1 4 retained earnings ($ 5 4 2 3 .1 million)
•
the increase in cash held for 2 0 1 4 ($ 6 9 .4 million)
•
cash flo w from op e ra tin g activities for 2 0 1 4 ( $ 3 4 7 2 .7 million)
•
the 2 9 June 2 0 1 4 total assets ( $ 2 4 2 0 5 .2 m illion), total liabilities ( $ 1 3 6 7 9 . 8 million) a nd shareholders' equity ( $ 1 0 5 2 5 . 4 million). As you fam iliarise yourself w ith the general content a n d form at of the fin a n cia l statements, here a re a fe w things to
keep in m ind: • •
The fin a n cia l statements are consolidated because W o o lw o rth s is really a g ro u p o f com panies. W o o lw o rth s provides figures for the prior year, 2 01 3. W e 'll make extensive use of the prior-year figures to help you understand the 2 0 1 4 figures.
•
In the auditors' report, the auditors state their o p in io n that the fin a n cia l statements g ive a true a nd fa ir v ie w o f the fin a n cia l position as at 2 9 J u n e 2 0 1 4 a nd the profit an d the perform ance for the ye a r e nded 2 9 J u n e 2 0 1 4 .
580
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Show n b e lo w are the com m on size b a la n ce sheets for W o o lw o rth s. WOOLWORTHS LIMITED C O M M O N SIZE BALANCE SHEETS* I
2 9 June 2 0 1 4 Current assets C ash T ra d e a n d o th e r re c e iv a b le s
3 0 June 2 0 1 3 1
%
%
3 .8
3 .8
3 .8
4 .4
1 9 .3
1 8 .9
A ss e ts h e ld fo r sa le
2 .6
0 .7
O th e r fin a n c ia l assets
0.1
0 .2
2 9 .6
2 8 .0
0 .4
0 .1
In v e n to rie s
T o ta l c u rre n t assets
Noncurrent assets T ra d e a n d o th e r re c e iv a b le s O th e r fin a n c ia l assets
1 .3
1 .6
P ro p e rty , p la n t a n d e q u ip m e n t
3 9 .7
4 1 .5
In ta n g ib le s
2 6 .2
2 6 .0
2 .8
2 .8
D e fe rre d ta x assets T o ta l n o n c u rre n t assets T o ta l assets
7 0 .4
7 2 .0
1 0 0 .0
1 0 0 .0
Current liabilities T ra d e a n d o th e r p a y a b le s
2 4 .8
2 4 .2
B o rro w in g s
0 .9
0 .8
C u rre n t ta x lia b ilitie s
0 .7
0 .9
O th e r fin a n c ia l lia b ilitie s
0 .7
0 .7
P ro v is io n s
4 .1
4 .3
3 1 .2
3 0 .9
1 7 .1
1 9 .1
O th e r fin a n c ia l lia b ilitie s
4 .8
4 .5
P ro v is io n s
2 .3
2 .5
O th e r
1.1
1 .2
T o ta l n o n c u rre n t lia b ilitie s
2 5 .3
2 7 .3
T o ta l lia b ilitie s
5 6 .5
5 8 .2
N e t assets
4 3 .5
4 1 .8
2 0 .0
2 0 .3
T o ta l c u rre n t lia b ilitie s
Noncurrent liabilities B o rro w in g s
Equity Issued c a p ita l S h a re s h e ld in tru st
(0 .9 )
(0 .8 )
R eserves
0 .8
0 .1
R e ta in e d e a rn in g s
2 2 .5
2 1 .0
E q u ity a ttrib u ta b le to th e m e m b e rs o f W o o lw o r th s L im ite d
4 2 .4
4 0 .6
M in o r it y in te re s t T o ta l e q u ity
1.1
1 .2
4 3 .5
4 1 .8
* Some rounding errors occur.
Source: the a b o ve calculations are based on data from h ttp ://w w w .w o o lw o rth s lim ite d .c o m .a u /a n n u a lre p o rt/2 0 1 4 /in d e x .h tm l (accessed 1 1 Decem ber 2 0 1 4 ).
CHAPTER 15 Financial statem ent analysis
581
A fter com m on sizing the b a la n ce sheets o f W o o lw o rth s for 2 0 1 3 a nd 2 0 1 4 , w e can see there has been no m ajor ch a n g e in the structure o f this statement. Total noncurrent assets have decreased from 7 2 .0 per cent to 7 0 .4 per cent, because of the relative decrease in property, plant an d equipm ent. U nder current assets, cash has rem ained steady at 3 .8 per cent, w h ile inventories have increased from l 8 .9 per cent to l 9 .3 per cent. The m ajority o f the increase in current assets is due to assets being held for sale in the short term increasing from 0 .7 per cent to 2 .6 per cent, resulting in a net increase o f l .6 per cent in current assets. W o o lw o rth s ' leverage (gearing) has decreased from 5 8 .2 per cent to 5 6 .5 per cent. C urrent trade a nd other payables increased from 2 4 .2 per cent to 2 4 .8 per cent, w h ile current b o rrow ings increased from 0 .8 per cent to 0 .9 per cent. U nder noncurrent liabilities, there is a decrease in b o rrow ings (from l 9.1 per cent to 17.1 per cent), w h ich is prim arily responsible fo r the 2 .0 per cent decrease in total noncurrent liabilities (2 7 .3 per cent to 2 5 .3 per cent). O ve ra ll, w e can see net assets have increased from 4 1 .8 per cent to 4 3 .5 per cent, m ainly as a result o f the decrease in total liabilities. G iven the accounting e quation, this is obviously reflected in an equal increase in total equity. This indicates that 4 3 .5 per cent o f total assets a re fin a n ce d from shareholders' equity.
15.5
Financial statem ent ratio analysis
By n o w you should be fa m ilia r enough w ith W o o lw o rth s ' fin a n cia l statements to know w h e re to look for inform ation. Let's turn n o w to consider h o w w e use ratios to analyse the fin a n cia l statements. The various kinds o f ratios that could be used to analyse a com pany's fin a n cia l perform ance an d position are outlined in the fo llo w in g pages. (There are m ore ratios that could be ca lculated, but this is a m eaningful set to start w ith for most types o f com panies. O ften other ratios that could be calculated are industry-specific a nd you should research those if you are focused on analysing a particular industry.) Each ratio is illustrated by sh o w in g h o w it is calculated from W o o lw o rth s ' fin a n cia l statements in the a p p e n d ix at the b ack o f this book. Som e interpretive and com p a rative comments are m ade as illustrations, but the main purpose of this section is to sh o w you h o w to calculate the ratios. M o s t figures b e lo w a re given in millions o f dollars, as they are in W o o lw o rth s ' statements. Ratios a re calculated here to tw o d e cim a l places. They could be d o n e to m ore d e cim a l places, but that w o u ld be false accuracy, because the ratios d e p e n d on all sorts o f judgem ents a n d estimates m ade in assem bling the fin a n cia l statements and, therefore, should not be thought of as precise quantities, but rather as indicators.
P ro fita b ility ratios RETURN O N EQUITY Sometimes ca lle d return on shareholders' funds or return on net w orth, return on equity is calculated as o perating profit after tax d iv id e d by total shareholders' equity. O p e ra tin g profit after tax g e n e ra lly excludes a n y e xtraordinary items or one-off items. Users o f fin a n cia l inform ation (e.g. bankers an d share analysts) can choose h o w they calculate these ratios d e p e n d in g on the purpose o f their assessment. In our case, there is a small profit from discontinued operations ( $ 9 .7 million) in 2 01 3 , w h ich w ill o n ly have a small im pact on the 2 0 1 3 calculations so w e w ill use 'Profit for the p e rio d '. Return on equity (ROE) indicates h o w much return the c o m p a n y is generating on the historically accum ulated shareholders' investment (contributed share ca p ita l, reserves an d retained earnings). S hareholders' equity can be taken straight from the b a la n ce sheet o r can be com puted from the accounting equation as total assets minus total liabilities. The d enom inator can be year-end equity or a v e ra g e equity over the year; for a g ro w in g com pany, y o u 'd expect a slightly larger ROE figure for the latter. For W o o lw o rth s , ROE (based on year-end equity) fo r the last tw o years has been: $ 2 4 5 8 .4 / $ 1 0 5 2 5 .4 = 2 3 .3 6 % (for 2 0 1 4 ) $ 2 2 6 4 .6 / $ 9 3 0 0 .5 = 2 4 .3 5 % (for 2 0 1 3 ) You can see that there has been a small decrease in ROE from 2 4 .3 5 to 2 3 .3 6 per cent; how ever, both numbers are pretty high - that is, a 2 3 per cent-plus return on an investment is norm ally considered g o o d news. You can further understand the ch a n g e in the ratio by looking at its com ponents. The numerator has increased from $ 2 2 6 4 .6 million
582
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
to $ 2 4 5 8 .4 m illion. The de n o m in a to r has also increased a t a significant rate from $ 9 3 0 0 .5 m illion to $ 1 0 5 2 5 . 4 m illion, as per the last line in the b a la n ce sheet (total equity) o f W o o lw o rth s . The main changes in total equity are the increases in retained earnings, issued ca p ita l an d reserves betw een 2 0 1 3 a n d 2 0 1 4 . The effect of changes in shareholders' equity on profit for the year m ay depend on w hen the change occurred. For exam ple, if a large increase occurred in ju ly 201 3, you w o u ld expect profits to increase more than if it had increased in M a y 2 0 1 4 , because the additional shareholders' funds w e re a va ila b le for use for a longer period. For internal purposes, a com pany w ould be a b le to calculate a more accurate return on equity figure by calculating the average equity over the year, w hich w ill vary depending on such things as w hen n e w shares are issued or w hen dividends are paid. N o te that differences betw een versions o f ratios a re com m on. They are usually not large an d , as long as you calculate your ratio in the sam e w a y from ye a r to year, you should be a b le to spot m ajor changes an d trends regardless o f h o w you calculated the ratio. Users o f fin a n cia l inform ation (for exam ple, bankers an d share analysts) can choose h o w they calculate these ratios d e p e n d in g on the purpose o f their calculation.
RETURN O N ASSETS A key concern o f m anagers is to determ ine the return they earn on the assets under their control. Return on assets (ROA) can be ca lculated as follow s: R Q A _ O p e ra tin g p ro fit a fte r ta x ^ ~ Total assets For W o o lw o rth s , these figures a re as follow s: $ 2 4 5 8 .4 / $ 2 4 2 0 5 .2 = 1 0 .1 6 % (for 2 0 1 4 ) $ 2 2 6 4 .6 / $ 2 2 2 5 0 .2 = 1 0 .1 8 % (for 2 0 1 3 ) Different com panies use different versions o f the num erator. These include o p erating profit after tax, operating profit after tax but before interest expense, a nd op e ra tin g profit before tax a nd interest expense. For the denom inator, the total assets figure can be the year-end figure o r the a ve ra g e over the year. O th e r versions o f the d enom inator include gross assets (i.e. total assets before accum ulated de p re cia tio n is deducted) an d net assets e m ployed (usually total assets minus current liabilities). W e have given you some alternatives so that you can exercise some ca re w hen com paring ratios calculated a n d presented by different com panies. A g a in , pro vid e d a consistent method is used by a c o m p a n y each year, the m ajor trends should sh o w up. You can see the value of being a b le to calculate ratios that you understand yourself, because the versions produced b y com panies m ay not be very clear, since each co m p a n y fits the ratios to its o w n circumstances. An alternative R O A is often calculated using earnings before interest a nd tax (EBIT). This ratio is calculated as earnings before interest an d tax d iv id e d by total assets. EBIT is a measure o f profit based on the op e ra tin g profit before interest a n d taxes are deducted. As EBIT is not a lw a ys shown in the fin a n cia l statements, it can be calculated by a d d in g interest b a ck to net p rofit before tax (i.e. EBIT equals net profit before tax plus interest). For W o o lw o rth s , it is shown in the incom e statement as $ 3 7 7 5 .2 0 m illion in 2 0 1 4 an d $ 3 5 9 4 .6 m illion in 20 1 3. For W o o lw o rth s , the alternative return on assets figures using EBIT are: $ 3 7 7 5 .2 / $ 2 4 2 0 5 .2 = 1 5 .6 0 % (for 2 0 1 4 ) $ 3 5 9 4 .6 / $ 2 2 2 5 0 . 2 = 1 6 .1 6 % (for 2 0 1 3 ) N o te that both the R O A an d the alternative R O A ratios have slightly decreased from 2 0 1 3 to 2 0 1 4 , indicating that the c o m p a n y is earning a lo w e r return on the assets under its control. You m ay be w o n d e rin g w h a t the relationship is betw een changes in ROE an d changes in R O A betw een 2 0 1 3 and 2 0 1 4 . Leverage provides the link betw een R O A a nd ROE. W h ile w e w ill consider the Du Pont form ula in more detail in section 1 5 .6 , at this stage it should be noted that: ROE = R O A x Leverage The leverage ratio is d e fined as: Leveraae = ____ Total assets_____ ® S h a rehold ers' eq u ity
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The ratio measures the proportion o f equity funding in the asset base. The higher the ratio, the sm aller the shareholders' funding o f assets, an d the greater the proportion o f total assets that must have been funded by debt. For W o o lw o rth s , the relationship is as follow s for 2 0 1 4 : 2014
Ratio
$ 2 4 5 8 .4
ROE = ROA = L e v e ra g e
$ 2 2 6 4 .6
$ 1 0 5 2 5 .4
$ 9 3 0 0 .5
2 3 .3 6 %
2 4 .3 5 %
$ 2 4 5 8 .4
$ 2 2 6 4 .6
$ 2 4 2 0 5 .2
$ 2 2 2 5 0 .2
1 0 .1 6 %
1 0 .1 8 %
$ 2 4 2 0 5 .2
$ 2 2 2 5 0 .2
$ 1 0 5 2 5 .4 =
2013
2 .3 0
$ 9 3 0 0 .5 2 .3 9
R O E = R O A x L e v e ra g e ROE
=
1 0 .1 6 x 2 .3 0
1 0 .1 8 x 2 . 3 9
=
2 3 .3 6 % *
2 4 .3 5 % *
Rounding errors will occur.
In this case, w h ile R O A has rem ained stable, leverage has decreased, w ith the overall im p a ct being to decrease ROE. A lternative R O A indicates the com pany's a b ility to generate a return on its assets before considering the cost of finan cin g those assets (interest) or taxes. It helps in jud g in g w hether b o rro w in g is w o rth w h ile . Presumably, if it costs x per cent to b o rro w m oney, the c o m p a n y should expect to earn at least x per cent on the assets a cq u ire d w ith the money.
PROFIT M A R G IN Profit margin is often calculated as op e ra tin g profit after tax (OPAT) d iv id e d by sales. Profit m argin indicates the percentage o f sales revenue that ends up as profit, so it is the a ve ra g e profit on each d o lla r o f sales. For exam ple, a 1 0 per cent profit m argin w o u ld mean that 1 0 cents in net profit, after incom e tax a n d all other expenses, is generated from each d o lla r o f sales, on a verage. It is a useful measure o f perform ance, a n d gives some indication of pricing strategy o r com petition intensity. You m ight expect a discount retailer in a com petitive market to have a lo w profit m argin, an d an upm arket je w e lle r to have a high m argin, for exam ple. For W o o lw o rth s , the profit margins for 2 0 1 4 a nd 2 0 1 3 can be calculated as shown b e lo w . Revenue from the sale o f g o o d s is pro vid e d in the incom e statement. O p e ra tin g p ro fit a fte r ta x /S a le s $ 2 4 5 8 .4 / $ 6 0 7 7 2 .8 = 4 .0 5 % (for 2 0 1 4 ) $ 2 2 6 4 .6 / $ 5 8 5 1 6 . 4 = 3 .8 7 % (for 2 0 1 3 ) An alternative version of profit m argin can be calculated by d iv id in g EBIT b y sales revenue. For W o o lw o rth s Limited, this w o u ld result in the fo llo w in g ratios: EBIT/Sales $ 3 7 7 5 .2 / $ 6 0 7 7 2 .8 = 6 .2 1 % (for 2 0 1 4 ) $ 3 5 9 4 . 6 / $ 5 8 5 1 6 .4 = 6 .1 4 % (for 2 0 1 3 ) These ratios a re labelled as 'EBIT to Sales (1)' in the Five Y ear Sum mary. For 2 0 1 4 , the EBIT-to-sales ratios are for the Australian fo o d an d liquor business (6 .9 8 per cent), N e w Z e a la n d supermarkets (5 .2 3 per cent), general m erchandise (3 .5 1 per cent), hotels (1 8 .7 1 per cent) a nd losses on hom e im provem ent (-1 1 .0 6 per cent). You can find these on p a g e 8 9 o f W o o lw o rth s ' A n n u a l Report 2 0 1 4 . By splitting these up into d ivisional ratios, it is much easier to fo llo w trends.
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GROSS M A R G IN A lso known as the gross profit ratio, this is calculated as gross profit d iv id e d by sales. W o o lw o rth s ' gross profit is shown on its incom e statement. If this w e re not disclosed, you could calculate it as sales minus cost o f g o o d s sold. The gross m argin provides a further in dication o f the com pany's product pricing an d product mix. For exam ple, a gross m argin o f 3 3 per cent indicates that the com pany's a ve ra g e mark-up on cost is 5 0 per cent (revenue equals 1 5 0 per cent o f cost, so cost is 6 7 per cent o f revenue a nd gross m argin is 3 3 per cent). This is a rough in d ica to r only, especially for com panies w ith a variety o f products o r unstable markets. For W o o lw o rth s , the gross m argin is calculated as follow s: Gross p ro fit/S a le s $ 1 6 4 7 7 . 6 / $ 6 0 7 7 2 .8 = 2 7 .1 1 % (fo r 2 0 1 4 ) $ 15 7 6 1 . 5 / $ 5 8 5 1 6 .4 = 2 6 .9 4 % (fo r 2 0 1 3 ) G ross m argin has increased from 2 01 3 to 2 0 1 4 . This partly explains the im provem ent in the profit m argin; that is, an increase in a profit m argin is either due to a better gross m argin ratio o r a fall in expenses as a percentage of total sales.
CASH FLO W TO TOTAL ASSETS C ash flo w to total assets is calculated as cash generated by operations d iv id e d by total assets. C ash generated by operations is found in the statement o f cash flow s, a nd total assets m ay be the year-end b a la n ce sheet figure o r an a verage o f the b e g inning a nd e n ding figures. This ratio relates the co m p a n y's a b ility to generate cash resources to its size, w h ich a p pro xim a te ly factors out size. It provides an alternative return measure to ROA, focusing on cash return rather than on accrual profit return as used in ROA. For W o o lw o rth s Limited, using year-end assets, the ratio w a s 1 4 .3 5 per cent in 2 0 1 4 ( 3 4 7 2 .7 d iv id e d by 2 4 2 0 5 .2 ) and 1 2 .2 2 per cent in 2 0 1 3 ( 2 7 1 9 .9 d iv id e d by 2 2 2 5 0 .2 ) - an increase.
EA R N IN G S PER SHARE This ratio is calculated as (operating p rofit after tax minus d ividends on preference shares) d ivid e d by w e ig h te d a verage num ber o f o rd in a ry shares outstanding. Earnings per share (EPS) relates earnings attributable to o rd in a ry shares to the num ber o f o rd in a ry shares issued. A ccounting standards require basic earnings per share to be disclosed in every set o f accounts. The num erator is operating profit after tax minus a n y preference divid e n d s. For consolidated fin a n cia l statements, the profit figure is arrived at after deducting outside equity in the op e ra tin g profit. The w e ig h te d a v e ra g e num ber o f o rd in a ry shares issued is provided in the annual report, as it could not be calculated by outsiders. It can becom e quite a co m p lica te d calculation, and w ill be discussed further in later courses. If a c o m p a n y has potential commitments to issue further shares - such as in stock-option plans to m otivate senior m anagem ent, o r preference shares o r d e b t convertible to o rd in a ry shares at the o ption o f the holder o f the preference shares - the potential effect o f the exercise o f such commitments is calculated by show ing both basic EPS an d fully diluted EPS. ('D ilution' refers to the potential low ering o f return to present shareholders resulting from other people's exercising rights arising from commitments a lre a d y m ade by the com pany.) For W o o lw o rth s Limited, the earnings per share is show n on the incom e statements for 2 0 1 4 a nd 2 0 1 3 as 1 9 6 .5 cents per share a nd 1 8 2 .6 cents per share, respectively. It is also noted that diluted earnings per share is slightly sm aller at 1 9 5 .6 cents per share (1 8 1 .8 cents per share in 2 0 1 3 ). The calculation of earnings per share is show n in note 21 o f W o o lw o rth s ' fin a n cia l report.
PRICE-TO -EARNING S RATIO This is calculated as current market price per share d iv id e d by EPS. The price-to-earnings (PE) ratio relates the accounting earnings a nd market price o f the shares, but since the relationship betw een such earnings an d changes in share market prices is not straightforw ard (as noted in C h a p te r 6), the interpretation o f PE is controversial. Nevertheless, it is a w id e ly used ratio, a p p e a rin g in m any publications a nd analyses o f com panies. M a n y new spapers around the w o rld include PE in their d a ily summaries o f each com pany's share market trades a nd prices.
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The idea is that, because market price should reflect the market's expectation o f future perform ance, PE com pares the present perform ance w ith those expectations. A c o m p a n y w ith a high PE is expected to sh o w greater future perform ance than its present level, w h ile on e w ith a lo w PE is not expected to d o much better in the future. High-PE com panies a re those that are p o p u la r and have g o o d share prices, w h ile low-PE com panies a re not as popular, having lo w share prices relative to their present earnings. PE is highly subject to general increases an d decreases in market prices, so it is difficult to interpret over time, a nd is m ore useful w hen co m p a rin g sim ilar com panies listed in the same stock market at the same time. For W o o lw o rth s , the o rd in a ry shares had a closing price on the A ustralian Stock Exchange of $ 3 5 .6 6 in the ye a r ended 2 9 June 2 0 1 4 , an d $ 3 2 .8 1 in the ye a r e nded 3 0 June 2 0 1 3 . The closing PE ratio w a s, therefore, a bout 1 8 .1 5 times for 2 0 1 4 ( $ 3 5 .6 6 d iv id e d by $ 1 ,9 6 5 ) a n d 1 7 .9 7 times for 2 0 1 3 ($ 3 2 .8 1 d iv id e d by $ 1 ,8 2 6 ). Because PE changes as share prices ch a n g e, w ith each announcem ent of an EPS number, it can be m onitored regularly to track changes in the market's expectations, particularly changes relative to other co m p a n ie s' PEs.
D IVID EN D PAYOUT RATIO This ratio is calculated as annual dividends d e cla re d per share d iv id e d by EPS. This is a measure o f the portion of earnings p a id to shareholders. For exam ple, if the dividend payout ratio is 0 .4 0 , 4 0 per cent o f p rofit w a s distributed to shareholders a nd the rem aining 6 0 per cent w a s kept in the c o m p a n y (retained earnings) to finance assets or reduce debts. A stable ratio w o u ld suggest that the c o m p a n y has a p o lic y o f p a yin g dividends based on profits, a nd a v a ria b le ratio w o u ld suggest that factors other than profits are im portant in the b o a rd o f directors' decisions to d e cla re dividends. For W o o lw o rth s , the Five Y ear Sum m ary indicates that d ividends w e re $ 1 .3 7 per share (7 2 cents plus 6 5 cents) in 2 0 1 4 an d $ 1 .3 3 (71 cents plus 6 2 cents) in 20 1 3, an d EPS w a s $ 1 .9 6 5 an d $ 1 .8 2 6 , so the d ivid e n d payout ratios for 2 0 1 4 a nd 2 01 3 w o u ld be 6 9 .7 2 per cent ( 1 .3 7 d iv id e d by 1 .9 6 5 ) a nd 7 2 .8 4 per cent (1 .3 3 d ivid e d by 1 .8 2 6 ) respectively; that is, W o o lw o rth s p a id out a b o u t 7 0 per cent o f its p rofit in d ividends to its shareholders in 2 0 1 4 a nd in 2 0 1 3 .
A ctivity (turnover) ratios TOTAL ASSET TURNO VER C alcu la te d as a ratio o f sales to total assets, this a nd sim ilar turnover ratios relate the com pany's d o lla r sales volum e to its size, thereby answ ering the question: h o w much sales volum e is associated w ith a d o lla r o f assets? Turnover and p ro fit/m a rg in ratios a re often useful together, because they tend to move in op p o site directions. C o m p a n ie s w ith high turnover tend to have lo w m argins, a nd those w ith lo w turnover tend to have high m argins. Those extremes represent contrary marketing strategies o r com petitive pressures: pricing lo w a nd trying fo r high volum e versus pricing high a nd m aking m ore on each unit sold. W o o lw o rth s ' total asset turnover ratio w a s 2 .5 1 times in 2 0 1 4 ( $ 6 0 7 7 2 . 8 m illion d iv id e d by $ 2 4 2 0 5 . 2 million) a nd 2 .6 3 times in 2 0 1 3 ( $ 5 8 5 1 6 . 4 m illion d iv id e d b y $ 2 2 2 5 0 .2 million). Turnover de clin e d in 2 0 1 4 because assets g re w faster than sales revenue d id . The c o m p a n y is getting fe w e r sales out of each d o lla r o f assets. The asset turnover ratio should also be considered together w ith the profit m argin ratio a n d the return on assets ratio: ROA N e t p ro fit Total assets
= _ -
P rofit m a rg in N e t pro fit Sales
X
x
Asset turnover Sales Total assets
It can be seen from the a b o v e equations that a ch a n g e in R O A can be the result o f either a ch a n g e in the profit m argin, a ch a n g e in asset turnover, or both. If it is the p rofit m argin, you can drill d o w n further to find the reason for the ch a n g e (e.g. by looking at the gross m argin ratio, expe n se s/sa le s ratios an d com m on size statements using the incom e statements). These w e re discussed e arlier in this chapter. If the ch a n g e is a result o f asset turnover, it is possible to drill d o w n further by looking at such ratios as inventory turnover an d accounts receivable turnover, w hich are discussed b e lo w .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The calculations for W o o lw o rth s are as follow s using net profit after tax.
2014
Return on assets
=
Profit margin
X
Asset turnover
2 4 5 8 .4
=
2 4 5 8 .4
X
6 0 7 7 2 .8
4 .0 5 %
X
2 .5 1 tim e s
2 2 6 4 .6
X
5 8 5 1 6 .4
X
2 . 6 3 tim e s
2 4 2 0 5 .2
2013
6 0 7 7 2 .8
1 0 .1 6 %
=
2 2 6 4 .6
=
2 2 2 5 0 .2 1 0 .1 8 %
2 4 2 0 5 .2
5 8 5 1 6 .4 =
3 .8 7 %
2 2 2 5 0 .2
This shows that w h ile W o o lw o rth s ' return on assets is stable, underlying this is an increase in profit m argin a nd a d ecline in asset turnover. Sim ilarly, w e could d o the a b o v e analysis using the alternative R O A a nd alternative profit m argin (which uses EBIT rather than OPAT in the calculations). You can see a b o v e h o w profit m argin a nd asset turnover interact to p roduce the return on assets. In one com pany, a lo w m argin a nd a high turnover m ay generate the return. In another, a high m argin a nd a lo w turnover m ay generate the return. Profit m argin an d turnover a re likely to offset each other in generating the return on assets. This is because com petitive pressures are likely to force d o w n selling prices an d , therefore, p rofit m argins if a high turnover is desired. C onversely, if you w a n t to cater to the high-priced end o f the market, you are not likely to have much sales volum e. Think o f w h a t gre a t results y o u 'd ge t if you could ge t both high m argin an d high volum e (hence our w o rry about m onopolies), o r o f h o w disastrous things are for com panies stuck w ith both a lo w m argin a nd lo w volum e.
IN VEN TO R Y TURNO VER This is calculated as C O G S expense d iv id e d by a v e ra g e inventory assets. If there a re not large fluctuations in inventory, sometimes year-end inventory figures a re used. This ratio relates the level o f inventories to the volum e of activity. A c o m p a n y w ith lo w turnover m ay be risking obsolescence o r deterioration in its inventory a n d /o r m ay be incurring excessive storage an d insurance costs. In recent years, m any com panies have attem pted to reduce inventories to the minimum, keeping just enough on hand to meet customer dem and o r even o rdering inventory as it is dem anded by customers (as in the 'just in tim e' method o f m inim ising inventories w ith o u t running out o f stock and irritating customers). For W o o lw o rth s Limited, inventories w e re $ 4 6 9 3 .2 m illion for 2 0 1 4 , an d $ 4 2 0 5 .4 m illion for 2 0 1 3 . These result in turnovers relative to C O G S o f 9 .4 8 times for 2 0 1 4 ( $ 4 4 4 7 4 . 6 m illion d iv id e d b y $ 4 6 9 3 .2 m illion) and 1 0 .2 0 times for 2 01 3 ($ 4 2 91 2 .6 d iv id e d by $ 4 2 0 5 .4 million). Inventory turnover can be converted to measure h o w long, in days, inventory is held on a verage. This can be achieved by d iv id in g 3 6 5 by the inventory turnover rate. This is usually referred to as days' inventory on hand or num ber o f days' stock. For W o o lw o rth s Limited, converting the a b o v e inventory turnover ratios w e get 3 8 .5 0 days (3 6 5 d iv id e d by 9 .4 8 ) an d 3 5 .7 8 days (3 6 5 d ivid e d b y 1 0 .2 0 ) for 2 0 1 4 a n d 2 01 3, respectively. This indicates that it is taking a little longer on a v e ra g e to sell the inventory.
DEBTORS TURNO VER A lso c alled accounts receivable turnover, this ratio is calculated by d iv id in g credit sales by trade debtors. As credit and cash sales are not disclosed separately in an annual report, it is necessary to make some assumptions a b o u t the percentage o f sales that a re on credit. For com panies w h e re most sales are on credit (such as BHP, CSR o r Telstra), it is normal to use the sales figure given in the annual report. As cash sales are collected im m ediately, using this figure for retailers such as W o o lw o rth s or C oles M y e r is meaningless, as most o f their sales a re for cash. The trade debtors' figure in the ratio refers to gross trade debtors (i.e. before d e ducting the a llo w a n c e for doubtful debts). A g a in , either year-end o r a ve ra g e trade debtors can be used, w ith the latter com m on particularly w h e re there are substantial fluctuations in debtors.
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This ratio can be converted into a tim e period often c a lle d days in debtors o r days sales in receivables. This ratio indicates h o w m any days it takes, on a ve ra g e , to collect a d a y's sales revenue. It becom es size a b le w hen accounts receivable becom e larger relative to sales, so a large collection ratio is a negative signal, raising questions a b o u t the com pany's policies o f g ranting credit a nd the vig o u r o f its collection attempts. The ratio is subject to significant seasonal changes for m any com panies, usually rising during heavy selling periods (such as just before Christmas for a retailer) a nd fa llin g during slo w times. As w e d o not know the percentage o f W o o lw o rth s ' sales that are on credit, calculation o f the accounts receivable turnover ratio w ill be rather uninform ative. H ow ever, for illustrative purposes w e w ill sh o w you h o w to calculate it using the inform ation in the annual report, plus an assumption that 2 per cent o f W o o lw o rth s ' sales in 2 0 1 4 w e re on credit. 2014 2% of sales (2% of $60 772.8 m)
$1 215.46 m
Gross trade receivables (current) in Note 8 ([$247.6 m + $17.8 m])
$265.4 m
Accounts receivable turnover (1 215.46 m H- 265.4 m)
4.58 times
Days in accounts receivable (365
79.69 days
4.58)
It is noted that not all ratios are im portant for all com panies. W h ile days in debtors is critical for m any com panies that sell everything on credit, this is not the case fo r W o o lw o rth s , w h e re a large percentage o f sales a re cash sales.
L iq u id ity ratios C U R R EN T R A TIO C urrent ratio is calculated as current assets d iv id e d by current liabilities. This ratio has a lre a d y been used several times in this book. It indicates w hether the c o m p a n y has enough short-term assets to cover its short-term debts. A ratio a b o ve 1 indicates that w o rkin g c a p ita l is positive (current assets exceed current liabilities), a nd a ratio b e lo w 1 indicates that w o rkin g c a p ita l is negative. G e nerally, the higher the ratio, the greater the fin a n cia l stability a n d the lo w e r the risk for both creditors an d ow ners. H ow ever, the ratio should not be too high, because that m ay in d ica te that the c o m p a n y is not reinvesting in long-term assets to m aintain future productivity. A lso, a high current ratio can actu a lly indicate problem s if inventories a re getting larger than they should o r collections o f receivables are s lo w in g d o w n . The current ratio is a very com m only used indicator. M a n y writers use a rough rule that says the current ratio should be around 2 (tw ice as much in current assets as current liabilities), but this is sim plistic. M a n y large com panies regularly ope ra te w ith a current ratio closer to 1 than 2 . The ratio's interpretation depends on the specific circumstances of each com pany. Interpretation of it is also com plex, because it is a static ratio, measuring financial position a t a point in tim e a n d not considering a n y future cash flow s the c o m p a n y m ay be a b le to generate to pay its debts. This ratio is most useful for com panies that have cash flow s that a re relatively smooth during the year, an d hardest to interpret for those that have unusual assets or liabilities o r d e p e n d on future cash flow s to p a y current debts. An exam ple o f the latter w o u ld be a c o m p a n y that ow ns a rented b u ild in g . There m ay be fe w current assets a nd large current liabilities for m ortgage payments, but as long as the bu ild in g is mostly rented a nd rental revenue is steady, the c o m p a n y is not in difficulty, even though its current ratio is lo w . H ow ever, it is m ore at risk than a sim ilar c o m p any w ith a higher current ratio, because that c o m p a n y could m ore easily w e a th e r a loss o f tenants because o f a recession o r the o p e n in g o f a com peting b uilding. W o o lw o rth s ' current ratio w a s 0 .9 5 times a t the end o f 2 0 1 4 ( $ 7 1 7 4 .8 m illion d iv id e d by $ 7 5 5 8 .2 million) and 0 .9 1 times at the end o f 2 0 1 3 ($ 6 2 2 6 .1 m illion d iv id e d by $ 6 8 6 6 .0 m illion). The Five Y ear Summary shows that this is the highest the ratio has been in the last five years. W h ile the ratio appears lo w - current assets is less than current liabilities - this ratio level is reasonably com m on for la rg e Australian com panies, particularly those w ith a relatively q u ick cash flow cycle. In fact, W o o lw o rth s can buy inventory, a n d in general can sell it a nd ge t its cash before it has to p a y its accounts p a ya b le . G iven this cash flo w cycle, a lo w current ratio is o f less concern.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Q U IC K R A TIO The q u ick ratio is also called the a c id test. It is calculated as (cash plus accounts receivable plus short-term investments) d iv id e d by current liabilities. This is a m ore d e m a n d in g version o f the current ratio, a nd indicates w hether current liabilities could be p a id w ith o u t having to sell the inventory; that is, it is generally the sam e as the current ratio, except inventory is rem oved from the numerator. The ratio is particularly useful for com panies that cannot convert inventory into cash quickly if necessary. This is not norm ally the case for retail com panies. As a result, the q u ick ratio norm ally has little sig n ifica n ce for retailers such as W o o lw o rth s Limited. If ca lculated, it w o u ld be $ 9 2 2 .6 m illion plus $ 9 2 5 .7 m illion plus $1 2 .7 m illion, d iv id e d by $ 7 5 5 8 .2 m illion = 0 .2 5 times.
INTEREST C O V E R A G E R A TIO Usually calculated as EBIT d iv id e d b y net interest expense, interest c o ve ra g e ratio an d sim ilar c o ve ra g e ratios based on cash flo w figures in d ica te the d e g re e to w h ich fin a n cia l commitments (in this case, those to p a y interest on debts) are covered by the com pany's a b ility to generate p rofit o r cash flo w . (N e t interest refers to the difference betw een interest expense an d interest revenue.) A lo w c o ve ra g e ratio (generally b e lo w 3) indicates that the c o m p a n y is not operating at a sufficiently pro fita b le level to cover the interest o b lig a tio n com fortably, a nd m ay also be a w a rn in g of solvency problem s (difficulty in meeting o b lig a tio n s over the long term). For W o o lw o rth s , net interest expense (net fin an cin g costs) is shown in note 3. The interest c o ve ra g e ratio, calculated using the a b o v e form ula, is a very healthy 1 4 .5 1 times in 2 0 1 4 ( 3 7 7 5 .2 d iv id e d by 2 6 0 .1 ) and 9 .4 6 times in 2 0 1 3 ( 3 5 9 4 .6 d iv id e d by 3 7 9 .8 ).
Financial structu re ratios D E B T-TO -E Q U ITY R A TIO This is generally calculated as total liabilities d iv id e d b y total shareholders' equity. This ratio measures the proportion o f borro w in g to ow ners' investment (including retained earnings). Therefore, it indicates the com pany's p o licy regarding financin g o f its assets. A ratio greater than 1 indicates that the assets are financed mostly w ith d ebt, w h ile a ratio o f less than 1 indicates that the assets a re fin a n ce d mostly w ith equity. A high ratio is a w a rn in g a b o u t risk: the c o m p a n y is heavily in d e b t relative to its equity an d m ay be vulnerable to interest rate increases, a general tightening o f credit or creditor nervousness. (A high ratio also indicates that the c o m p a n y is highly g e a re d o r leveraged, w hich means that it has b o rro w e d to increase its assets over the am ount that could be a cq u ire d w ith ow ners' funds alone, and hopes thereby to increase returns an d benefit the owners.) W o o lw o rth s ' b a la n ce sheet makes this calculation straightforw ard, by totalling both liabilities a nd shareholders' equity. Thus, the ratio fo r 2 0 1 4 is 1 .3 0 times ($ 1 3 6 7 9 .8 m illion d iv id e d by $ 1 0 5 2 5 .4 million) an d for 2 0 1 3 is 1 .3 9 times ( $ 1 2 9 4 9 . 7 m illion d iv id e d by $ 9 3 0 0 .5 m illion). These ratios sh o w that the c o m p a n y relies on de b t m ore than on equity, but that its relative reliance on d e b t decreased during 2 0 1 4 .
DEBT-TO-ASSETS R A TIO This ratio is calculated by d iv id in g total liabilities by total liabilities plus shareholders' equity. This is equivalent to d iv id in g total liabilities by total assets (given that total assets equal total liabilities a nd shareholders' equity). This ratio w ill be correlated w ith the debt-to-equity ratio, a nd indicates the proportion of assets financed by liabilities. For W o o lw o rth s Limited, this ratio equals 5 6 .5 2 per cent ($ 1 3 6 7 9 .8 m illion d iv id e d b y $ 2 4 2 0 5 .2 million) for 2 0 1 4 and 5 8 .2 0 per cent ($ 1 2 9 4 9 . 7 m illion d iv id e d by $ 2 2 2 5 0 .2 million) for 2 0 1 3 . C onsistent w ith the debt-toequity ratio, this ratio a g a in shows an increase in reliance on liabilities to fin a n ce assets. The d eb t-to -a s s e ts ratio can also be calculated b y just co m p a rin g long-term d e b t o r external d e b t to assets. O ther variations are possible. For exam ple, W o o lw o rth s , in its Five Y ear Summary, includes a serviced g e a rin g ratio o f 2 6 .1 7 per cent in 2 0 1 4 . In the notes to the Five Y ear Summary, serviced g e a rin g is defined as cash and borrow ings together w ith the hedging related to those b o rrow ings d iv id e d b y cash a nd bo rro w in g s together w ith the hedging related to those b o rro w in g plus total equity.
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589
LEVERAGE R A TIO This is defined as total liabilities plus shareholders' equity all d iv id e d b y shareholders' equity. G iven the accounting equation, it can also be d e fined as total assets d iv id e d by shareholders' equity. The ratio considers h o w much of assets is financed by equity. The higher the ratio, the sm aller the proportion o f total assets funded by shareholders' equity, an d , therefore, the more that is funded b y debt. For W o o lw o rth s , the leverage ratio w a s 2 .3 0 times (2 4 2 0 5 .2 d iv id e d b y 1 0 5 2 5 .4 ) in 2 0 1 4 a nd 2 .3 9 times (2 2 2 5 0 .2 d iv id e d by 9 3 0 0 .5 ) in 20 1 3.
SUMMARY Ratios are a q u ick method o f breaking the inform ation in the fin a n cia l statements d o w n into a form that a llo w s for co m p a ra b ility w ith sim ilar com panies a nd w ith the fin a n cia l perform ance of the c o m p a n y over a num ber o f years. Ratios also offer the a d va n ta g e that different ratios consider different parts o f a com pany's perform ance. Thus, if you d o not w a n t to investigate anything m ore a b o u t a c o m p a n y than its liquidity, you m ight o n ly calculate liq u id ity ratios, such as the q u ick a nd current ratios. Users rely on m ore than ratios a nd other calculations from the fin a n cia l statements w hen analysing a com pany's perform ance. They also rely on the parts o f the annual report that precede the fin a n cia l statements, the auditor's report, notes to the fin a n cia l statements, reports by various analysts, personal k n o w le d g e o f m anagem ent, news m edia reports an d much more. Som e possible pieces o f inform ation that users could find in the first part of an annual report include m anagem ent's interpretation o f past a nd prospective perform ance, n ew ventures o r g row th strategies for the c o m p any and indications o f the areas o f operations that w e re undergoing stress o r change. N otes to fin a n cia l statements pro vid e further explanations o f some key areas in the statements, as you s a w in the calculation of ratios for W o o lw o rth s . These can include inform ation a b o u t a com pany's accounting p o lic y for particular accounts, deta ile d calculations o f h o w some account values w e re determ ined, a nd notifications o f any accounting p o licy changes, sig n ifica n t litigation a n d other possibly significant items. All this inform ation, a lo n g w ith the statements themselves, a nd a n y ratios o r other analyses, helps users ge t a w ell-rounded picture o f the com pany. Exhibit 15.1 summarises our ratio calculations.
HOW'S YOUR UNDERSTANDING? H e re are tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ’v e ju s t re a d : 1 2
H o w w e ll d id W o o lw o rth s p e rfo rm in 2 0 1 4 c o m p a re d w ith 2 0 1 3 ? W h ic h c o m p a n ie s w o u ld W o o lw o rth s c o m p a re its fin a n c ia l p e rfo rm a n c e w ith ? A n s w e rs :
1
H in t : y o u s h o u ld assess W o o lw o r th s ’ p e rfo rm a n c e b y e x a m in in g c h a n g e s f o r e a ch g ro u p o f ra tio s as a basis f o r fo r m in g y o u r o v e ra ll c o n c lu s io n .
2
W o o lw o rth s sh o u ld c o m p a re its fin a n c ia l p e rfo rm a n c e w ith c o m p a n ie s th a t o p e ra te in th e sa m e in d u s try ; fo r e x a m p le , W e s fa rm e rs /C o le s w o u ld be a local e x a m p le . Y o u m a y also c o n s id e r W o o lw o rth s ’ in te rn a tio n a l peers.
590
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 15.1 Ratio
RATIO CALCULATIONS Num erator
Denominator
Profitability ratios Return on equity
Operating profit after tax
Shareholders' equity
Return on assets
Operating profit after tax
Total assets
Alternative return on assets
Earnings before interest and tax
Total assets
Profit margin
Operating profit after tax
Sales
Alternative profit margin
Earnings before interest and tax
Sales
Gross margin
Sales - COGS
Sales
Cash flow to total assets
Cash provided by operations
Total assets
Earnings per share
Operating profit after tax - preference share dividends
Weighted average number of ordinary shares outstanding
Price-to-earnings ratio
Market price per share
Earnings per share
Dividend payout ratio
Annual dividends declared per share
Earnings per share
Total asset turnover
Sales
Total assets
Inventory turnover
COGS
Inventory
Days in inventory
365
Inventory turnover ratio
Debtors turnover
Credit sales
Trade debtors
Days in debtors
365
Debtors turnover ratio
Current (working capital) ratio
Current assets
Current liabilities
Quick ratio
Cash + accounts receivable + short-term investments
Current liabilities
Interest coverage ratio
Earnings before interest and tax
Net interest expense
Debt-to-equity ratio
Total liabilities
Total shareholders' equity
Debt-to-assets ratio
Total liabilities
Total assets
Leverage ratio
Total assets
Total shareholders' equity
Activity (turnover) ratios
Liquidity ratios
Financial structure ratios
Cash flo w ratios The use o f cash flo w inform ation, particularly cash flo w from operations, a llo w s the analyst to determ ine both the cash sufficiency and cash e fficie n cy o f an entity. C ash sufficiency ratios exam ine w hen the entity is generating enough cash flow s for paym ent o f such items as dividends, asset purchases an d repaym ent o f d ebt. C ash flo w efficiency ratios consider the relationship betw een cash from operations an d certain incom e statement a nd b a la n ce sheet items. They exam ine h o w efficient the entity is in generating cash from operations in relation to sales, profit a nd total assets. Exhibit 15 .2 provides you w ith a sam ple of potential cash flo w ratios you can use.
CHAPTER 15 Financial statem ent analysis
EXHIBIT 15.2
591
CASH FLOW RATIOS Formula
Ratio
Indication
Sufficiency ratios Cash flow adequacy
Cash from operations Dividends paid+Asset purchases+Long-term debt paid
Long-term debt payment
Long-term debt payments Cash from operations
Dividend payout
Dividends Cash from operations
Reinvestment
Asset purchases Cash from operations
Debt coverage
Total debt Cash from operations
Depreciationamortisation impact*
Ability to generate cash to cover primary cash requirements. A value greater than 1 deemed satisfactory cover Adequacy measure for contractual payments Payout ratio measure for discretionary distributions Outlay ratio measure for discretionary investments Coverage - used as payback how many years, at current flows, it will take to retire debt
Depreciation+amortisation Cash from operations
Ratio of non-cash items to cash from operations
Efficiency ratios Cash flow to sales
Cash from operations Sales revenue
Operations index
Cash from operations Income from continuing operations
Cash flow return on assets
Ratio of sales dollar realised as cash from operations Measures cash-generating productivity of continuing operations
Cash from operations Total assets
Measures return on assets (on cash generation basis)
* Comparison of this ratio with the reinvestment ratio can indicate the adequacy of a firm's reinvestment and the maintenance of its asset base. Over time, the reinvestment ratio should exceed this ratio to ensure sufficient replacement of assets at higher current costs.
Source: R. Juchau a n d P. Ross, 'Putting Cash into Ratios',
15.6
A u s tra lia n A c c o u n ta n t,
N o ve m be r 19 9 4 , pp. 2 9 - 3 6 .
Integrative ratio analysis
W ith inform ation a b o u t a c o m p a n y a nd k n o w le d g e o f the purpose o f the analysis, the long list o f ratios in section 1 5 .5 can be used to reveal m any things a b o u t a co m p a n y. You have learned much a b o u t W o o lw o rth s , but it may not be obvious h o w to pull all the inform ation together into an overall picture of the com pany's perform ance. It is clear that the c o m p a n y is perform ing w e ll, an d that its perform ance g e n e ra lly im proved across 2 0 1 4 an d 20 1 3. C a n w e fit the ratios together m ore system atically? C an w e use the fa ct that the ratios a re all calculated on the sam e financial statement figures a nd therefore tend to connect to each other? W e started to d o this earlier by sh o w in g the link betw een R O A a nd ROE, as w e ll as the com ponents of ROA. The system w e w ill use to link ratios together is known as the Du Pont system o f ratio analysis. This nam e is used because Du Pont w a s the first c o m p a n y to form ally integrate the system into its o rg a nisational an d control system b ack in the 19 2 0 s . The Du Pont formula uses the idea o f leverage. This is an im portant o b je ctive an d consequence of b o rro w in g m oney, w h ich can then be used to generate returns. Leverage, also ca lle d trading on the equity, Financial leverage and g e a rin g , w orks like this: 1
M ic h a e l G runion w ants to invest $ 15 0 0 0 in a real estate project.
2
G runion has $ 5 0 0 0 a v a ila b le in personal funds.
3
So, G runion borrow s $ 1 0 0 0 0 from the ba n k at 1 1 per cent interest.
4
G runion invests the total $ 15 0 0 0 in the project an d receives an annual return o f $ 2 1 0 0 .
5
The project's return is 1 4 per cent before tax ( $ 2 1 0 0 / $ 15 0 0 0 ).
592
6
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
O u t o f that, G runion pays the bank interest (1 1 per cent o f $ 1 0 0 0 0 = $1 10 0 ).
7 G runion keeps the rest ( $ 2 1 0 0 — $ 1 1 0 0 = $ 1 0 0 0 ). 8
G runion's before-tax return on the equity invested is 2 0 per cent ($ 10 0 0 / $ 5 0 0 0 ) . N o t b a d ! The project returns 14 per cent, but G runion gets 2 0 per cent on the equity invested. The reason is that
G runion has borro w e d a t 1 1 per cent but has used the b o rro w e d funds to earn 1 4 per cent. The extra 3 per cent return on the b o rro w e d funds is G runion's to keep in return for taking the risk of investing in the project: •
O verall return = 1 4 per cent on $ 15 0 0 0 = $ 2 1 0 0 .
•
Paid to the bank = 1 1 per cent on $ 1 0 0 0 0 = $ 1 1 0 0 .
•
Kept by G run io n : 14 per cent on $ 5 0 0 0 o w n funds + 3 per cent on $ 1 0 0 0 0 b o rro w e d funds.
•
G runion's return = the 1 4 per cent ($ 7 0 0 ) + the 3 per cent ($ 3 0 0 ) = $ 1 0 0 0 , w h ich is 2 0 per cent of the $5000. G runion has benefited from leverage: b o rro w in g m oney to earn m oney. Leverage is a g o o d w a y to increase your return, as long as you can ensure that the project's total rate o f return is
greater than your b o rro w in g cost. It's a d o u b le-edged sw o rd , though, because leverage can hit you hard if returns are lo w or negative. Suppose G runion's real estate project returns o nly 7 per cent. Then look w h a t happens: •
O verall return = 7 per cent on $ 15 0 0 0 = $ 1 0 5 0 .
•
Paid to the bank = 1 1 per cent on $ 1 0 0 0 0 = $ 1 1 0 0 .
•
Kept by G run io n : 7 per cent on o w n funds minus 4 per cent on $ 1 0 0 0 0 b o rro w e d funds.
•
G runion's return = 7 per cent ($ 3 5 0 ) - 4 per cent ($ 4 0 0 ) = —$ 5 0 , w h ich is -1 per cent o f $ 5 0 0 0 . G runion has been hurt b y leverage. So, in this case, G runion loses on every dollar borrow ed, because the project returns less than the cost of borrow ing. It's
not such a great deal a ny more! G runion is losing 1 per cent on the equity invested, but if just that equity had been invested, with no borrow ing, G runion w o u ld have m ade 7 per cent, the project's return. Leverage is n ow hurting, not helping. N o w that you have this basic understanding of leverage, w e w ill return to the Du Pont system. The relationships am ong the various ratios a nd h o w they connect to the fin a n cia l statements a re show n in Figure 1 5 .1 . As stated in section 1 5 .5 , the relationship betw een the return on equity ratio an d its tw o com ponents can be seen b elow . ROE
=
ROA
O p e ra tin g p ro fit a fte r ta x S h a rehold ers' e q u ity
_
O p e ra tin g p ro fit a fte r ta x Total assets
X
Leverage ____ Total assets S h a rehold ers' eq u ity
N o tic e that, for the a b o v e relationship, the measure o f profit used in the return on assets (ROA) formula is operating profit after tax. This is used because it is consistent w ith the profit measure used for ROE. The a b o ve equation shows that ROE can be e xp la in e d by tw o factors: R O A an d leverage. Both these factors can in turn be explained by factors to the right o f them, in Figure 1 5 .1 . The a b o ve analysis can be m ade m ore sophisticated if so desired. For exam ple, in the 2 0 1 4 W o o lw o rth s ' financial report, p a g e 9 2 provides the inform ation shown in Exhibit 1 5 .3 , w h ich is a m ore deta ile d use o f the Du Pont form ula. N o te that if you m ultiply the first five ratios together, everything w ill cancel out except N P a T /a v e ra g e shareholders' equity. Flow ever, by looking at the five ratios individually, w e can see w h a t com ponent is ch a n g in g and h o w it affects ROE. A cc o rd ing to the 2 0 1 4 annual report, the aim o f W o o lw o rth s is to: •
extend leadership in fo o d an d liquor (com parable sales, EBIT grow th a nd market share)
•
m aintain a track record o f bu ild in g n ew g row th businesses
•
put in place the enablers for grow th
•
m axim ise shareholder value.
CHAPTER 15 Financial statem ent analysis
593
N o te that not all the numbers in Exhibit 1 5 .3 are identical to those used in the chapter, as some o f the a b o ve ratios use averages based on inform ation that is often not in an annual report (such as m onthly balances).
Sales Cost of goods sold Operating expenses
Income statement
Interest Taxation
Cash
+ Receivables
+ Inventory
+ Property, plant and equipment + Intangibles
Balance sheet
Accounts payable + Provisions
+ Short-term loans + Long-term loans + Shareholders' equity
FIGURE 15.1
DU PONT SYSTEM OF RATIO ANALYSIS
594
15.7
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Financial statem ent ratio analysis example
The analyses in this an d the next tw o sections use the 3 0 June 2 0 1 6 fin a n cia l inform ation o f Transport Limited presented in Exhibits 1 5 .4 to 1 5 .7 .
CHAPTER 15 Financial statem ent analysis
» Noncurrent liabilities
76 7 .8
702.8
Long-term debt (Note 14)
3 0 7 5 .3
3 348.9
Future income taxes (Note 7)
1 386.1
1 295.8
Total noncurrent liabilities
5 2 2 9 .2
5 347.5
Total liabilities
6 5 1 7 .4
6302.1
Net assets
3 9 8 2 .4
3 654.6
1 4 2 1 .0
1 4 1 2 .7
Deferred liabilities (Note 16)
Shareholders' equity (Note 19) Share capital
77 .0
88.0
Retained earnings
2 4 8 4 .4
2 153.9
Total equity
3 9 8 2 .4
3 654.6
Foreign currency translation adjustments
595
596
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
EXHIBIT 15.6
TRANSPORT LIMITED S TA T E M E N T OF CONSO LIDATED CASH FLOW S
2016 $m
2015
2014
$m
$m
Operating activities Receipts from customers
39 4 5 .1
3 4 0 4 .5
3 6 2 1 .0
Payments to suppliers and employees
(27 80 .0)
(2 8 1 8 . 9 )
(2 5 1 2 . 6 )
Interest paid
(231.2)
( 2 3 6 .0 )
(2 4 0 .2 )
Income tax paid
(147.9)
( 4 3 .9 )
(1 0 4 .7 )
Net cash provided by operating activities
78 6 .0
3 0 5 .7
7 6 3 .5
(673.8)
( 6 8 6 .6 )
(5 5 8 .5 )
(2.5)
( 2 1 .9 )
Investing activities Additions to properties (Note 12) Other investments Net proceeds from disposal of properties
10.2
8 .2
4 .0 3 .5
(666.1)
( 7 0 0 .3 )
(5 5 1 .0 )
(81.7)
( 8 0 .8 )
( 8 0 .8 )
2.5
2 .0
2 .0
Issuance of long-term debt
193.7
6 9 9 .8
Repayment of long-term debt
(16.1)
( 3 7 6 .6 )
(4 0 5 .7 )
Cash provided by (used in) financing activities
98 .4
2 4 4 .4
(4 8 4 .5 )
Cash used in investing activities
Financing activities Dividends paid Issuance of shares
-
Cash position Increase (decrease) in net cash
21 8.3
( 1 5 0 .2 )
(2 7 2 .0 )
Net cash at beginning of year
134.7
2 8 4 .9
5 5 6 .9
Net cash at end of year
35 3 .0
1 3 4 .7
2 8 4 .9
To make sure you are fa m ilia r w ith the Transport fin a n cia l statements, a nd so are ready to start the analysis, answ er the fo llo w in g questions: •
W h a t w e re the com pany's total assets a t 3 0 June 2 0 1 6 ? W a s that m ore o r less than for 2 0 1 5 ?
•
W h a t w a s the total equity o f the c o m p a n y at 3 0 June 2 0 1 6 ?
•
W h a t w a s the co m p a n y's net profit for the ye a r ended 3 0 June 2 0 1 6 ? W h a t w e re the main revenues and expenses that led to this profit?
CHAPTER 15 Financial statem ent analysis
•
597
H o w much cash w a s generated by operations for the ye a r e nded 3 0 June 2 0 1 6 ? D id the c o m p a n y end up w ith m ore o r less cash at the end o f the y e a r than at the b e g in n in g ?
•
H o w much d id accounts receivable changes contribute to the increases a nd decreases in non-cash w o rking
•
W h a t is the link betw een the statement o f cash flow s a nd the b a la n ce sheet?
•
W h a t is the link betw een the b a la n ce sheet a nd the incom e statement?
c a p ita l used in calcu la tin g cash from operations in 2 0 1 6 ?
A range o f ratios that could be used to analyse a com pany's fin a n cia l perform ance an d position are outlined in the fo llo w in g pages. Each ratio is illustrated by sh o w in g h o w it is calculated from the Transport statements. Som e interpretive a nd co m p a rative comments are m ade as illustrations, but the main purpose o f this section is to sh o w you h o w to extract the needed inform ation from the statements a nd figure out the ratios. M o s t figures b e lo w are given in millions o f dollars, as they a re in Transport's statements. Ratios a re calculated arbitra rily to three d e cim a l places. They could be d o n e to m ore decim als, but that w o u ld be false accuracy, because the ratios d e p e n d on all sorts o f judgem ents a n d estimates m ade in assem bling the fin a n cia l statements and, therefore, should not be thought of as precise quantities, but rather as indicators. This section's ratios a re summarised in Exhibit 1 5 .9 , near the end o f the section. They all should be used in com bination w ith each other, because each has o nly part o f the story to tell, but to help you see their main uses, they are g ro u p e d into four categories: •
perform ance ratios
•
activity (turnover) ratios
•
fin a n cia l structure ratios
•
liq u id ity a nd solvency w a rn in g ratios.
Perform ance ratios RETURN O N E Q U ITY Transport's ROE (based on year-end equity) for the last tw o years w as: •
2 0 1 6 : $ 41 3 . 0 / $ 3 9 8 2 . 4 = 1 0 .4 %
•
2 0 1 5 : $ 4 0 1 .3 / $ 3 6 5 4 . 6 = 1 1.0% . The profit return relative to equity w a s in the range o f m any co m p a n ie s' ROE. The 2 0 1 6 return w a s a little lo w er
than 2 0 1 5 . Both profit an d equity w e re higher at the end o f 2 0 1 6 than a t the end of 2 0 1 5 , but equity g re w p ropo rtio n a lly m ore at 9 .0 per cent ( ( $ 3 9 8 2 .4 — $ 3 6 5 4 .6 ) /$ 3 6 5 4 . 6 ) than profit a t 2 .9 per cent (($ 4 1 3 .0 — $ 4 0 1 .3 ) /4 0 1 . 3 ) . The analyses to com e w ill tell us more a b o u t h o w the ROE cam e a b o u t a n d h o w it relates to other indicators.
RETURN O N ASSETS Return on assets is often also c a lle d return on investment (or ROI): Transport's ROA, based on year-end assets, w a s: •
2 0 1 6 : $ 41 3 . 0 / $ 1 0 4 9 9 .8 = 3 .9 %
•
2 0 1 5 : $ 4 0 1 .3 / $ 9 9 5 6 . 7 = 4 .0 % . These ROAs w e re lo w to m oderate. In the present environm ent, a higher rate could be o b ta in ed on fixed deposit
w ith the bank. Transport has earned less than this on its assets, but is taking m ore risk to earn its returns than you m ight take on bank deposits, so it should be a b le to d o better.
ROE A N D R O A These tw o relative return ratios m ay be co m p a red , as is d o n e in the ta b le b e lo w . W h e n e ve r the ROE exceeds the ROA, it means the c o m p a n y is m aking extra m oney for the ow ners by b o rro w in g to make the assets greater than they w o u ld be w ith just equity funding.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
In both years, leverage (as show n in the table) m ore than d o u b le d the ROA: •
2 0 1 6 : $ 1 0 4 9 9 . 8 / $ 3 9 8 2 . 4 = 2 .6 4 times
•
2 0 1 5 : $ 9 9 5 6 . 7 / $ 3 6 5 4 . 6 = 2 .7 2 times. TRANSPORT LIMITED ROE AN D ROA ROE
ROA
Leverage
2016
10.4%
3.9%
2.64 times
2015
11.0%
4.0%
2.72 times
N ote: ROE = ROA x Leverage (with some rounding differences)
SALES RETURN (OR PROFIT MARGIN) Transport's sales return for 2 0 1 6 w a s 0 .1 0 6 ($41 3 . 0 / $ 3 9 0 2 . 9 ) , a nd for 2 0 1 5 w a s 0.1 1 0 ( $ 4 0 1 , 3 / $ 3 6 6 0 .7 ) . Transport earned 1 0 .6 cents per d o lla r o f revenue in 2 0 1 6 a nd 1 1 cents in 2 0 1 5 : •
2 0 1 6 : ($41 3 . 0 / $ 3 9 0 2 . 9 ) = 10.6%
•
2 0 1 5 : ( $ 4 0 1 .3 / $ 3 6 6 0 . 7 ) = 11.0% . The com bina tio n o f freight revenue g row th o f 7 .2 per cent (($ 3 7 2 8 .8 — $ 3 4 7 9 .3 ) /$ 3 4 7 9 . 3 ) , w h ile controlling
operating expenses, w h ich increased o n ly 0 .3 5 per cent (($ 3 1 8 6 .3 — $ 3 1 7 5 .1 ) / $ 3 1 7 5 .1 ), w o u ld lead to an increase in the profit m argin. The positive outcom e w a s offset by increases in non-operating costs an d lo w e r foreign exchange gains on long-term debt.
GROSS MARGIN (OR PROFIT RATIO) G ross m argin (or profit ratio) cannot be calculated for Transport. The c o m p a n y sells services, not products, so it has no C O G S to report. It is a rem inder that fin a n cia l statement analysis is depen d e n t on the contents o f the fin a n cia l statements. W e cannot analyse inform ation w e d o not have, or that w o u ld be irrelevant o r in a p p lic a b le to the particular c o m p a n y w e are analysing.
CO M M O N SIZE INCOME STATEMENT H ow ever, there a re other w a ys o f relating Transport's revenues a nd expenses. Using the com m on size incom e statement show n b e lo w , the various categories o f expenses can be related to revenue, a n d that is a b o u t all that can be done. C om m on size com parisons can be d o n e using a variety o f assumptions. To illustrate the analysis, here are com m on size percentages for the three years included in Transport's incom e statement. Freight revenue could have been used as the baseline, because freight is Transport's main business, but to connect w ith other analyses being illustrated, total revenue is used here. This is a judgem ent, o f the sort the analyst a lw a ys has to make. To further illustrate judgem ent, some incom e statement items w e re g ro u p e d an d others w e re not; different groupings m ay lead to different conclusions. All percentages w e re rounded to on e decim al place. TRANSPORT LIMITED C O M M O N SIZE INCOME STATEMENTS 2016
20 15
2014
%
%
%
95.5
95.0
94.7
Revenues Freight Other Total
4.5
5.0
5.3
100.0
100.0
100.0
»
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Operating expenses Wages and employee benefits
32.3
31.8
31.2
Fuel
11.3
10.8
9.8
Other expenses
38.1
44.2
36.0
Operating profit
18.3
13.2
23.0
Foreign exchange gain
(2.4)
(5.7)
(0.4)
Interest and other charges
6.5
6.9
7.2
Income tax expense
3.7
1.1
2.9
10.5
10.9
13.3
Net profit
T w o interesting trends are im m ediately a pparent: op e ra tin g expenses as a percentage of sales have increased each year, a nd interest an d other charges have been fa llin g . The reduction in interest a nd other charges has been insufficient to offset the rising op e ra tin g costs: •
freight sales g row th ( $ 3 7 2 8 .8 - $ 3 4 7 9 . 3 ) / $ 3 4 7 9 . 3 = 7 .2 %
•
op e ra tin g expense g row th ($31 8 6 .3 — $ 3 1 7 5 .1 ) / $ 3 1 7 5 .1 = 0 .3 5 % .
CASH FLOW TO TOTAL ASSETS Transport's cash flo w to assets ratios w ere: •
2 0 1 6 : $ 7 8 6 . 0 / $ 1 0 4 9 9 .8 = 7 .5 %
•
2 0 1 5 : $ 3 0 5 . 7 / $ 9 9 5 6 . 7 = 3.1% . C ash flo w to total assets in 2 0 1 6 w a s more than d o u b le that of 2 0 1 5 . A review o f the statement of cash flow s
reveals the m ajor cause o f this c h a n g e as the reduction o f cash used up by other op e ra tin g activities. The cash provided by operations in 2 0 1 5 appears unusually lo w , w ith 2 0 1 6 being a return to a m ore normal level. C ash flo w to total assets is also higher than ROA, w h ich is w h a t w e should expect, since op e ra tin g cash flow s should provide funds for n ew assets to replace those that are w e a rin g out.
EARNINGS PER SHARE Transport had no discontinued operations, but it d id have commitments potentially requiring it to issue m ore shares (stock options). Therefore, the incom e statement shown at the b e g in n in g o f this section shows tw o EPS figures for each year: •
2 0 1 6 : basic EPS = $ 2 .6 0 ; diluted EPS = $ 2 .6 0
•
2 0 1 5 : basic EPS = $ 2 .5 3 ; diluted EPS = $ 2 .5 2 . The w e ig h te d a v e ra g e num ber o f com m on shares outstanding during 2 0 1 6 w a s 1 5 8 .7 m illion (1 5 8 .5 m illion for
2 0 1 5 ). The dilutive effect o f the outstanding share options is quite small: less than $ 0 .0 1 in 2 0 1 6 an d o n ly $ 0 .0 1 in 2 0 1 5 . This indicates Transport has granted o n ly a relatively small num ber o f stock options to its em ployees in recent years.
BOOK VALUE PER SHARE Book value per share is calculated as (shareholders' equity - preference sh a re s)/n u m b e r o f com m on shares issued. W e have not discussed this ratio earlier, so a bit m ore detail is p rovided here. S im ilar to EPS, this ratio relates the portion o f the shareholders' equity attributable to the residual com m on shareholders to the num ber o f shares outstanding, a nd so brings the c o m p a n y b a la n ce sheet d o w n to the level o f the in dividual shareholder. It is not really a perform ance ratio, but shareholders' equity does include retained earnings, so it incorporates accum ulated perform ance. Because the b a la n ce sheet's figures d o not reflect the current market value o f most assets o r of the c o m p a n y as a w h o le , m any p e o p le feel that b o o k value per share is a largely m eaningless ratio. O th e r p e o p le feel that, as an accum ulation, it is less subject to m anipulation than annual earnings, an d some accounting research uses b o o k value per share as a preferred measure to EPS. In a n y case, you w ill see it m entioned in m any financial publications.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Using the same 1 5 8 .7 m illion shares outstanding at the end o f 2 0 1 6 , an d the 1 5 8 .5 m illion shares outstanding at the end o f D ecem ber 2 0 1 5 (a small num ber having been issued under stock o ption plans) for 2 0 1 6 , Transport's b o o k value per com m on share w as: •
2 0 1 6 : $ 3 9 8 2 . 4 / 1 5 8 . 7 = $ 2 5 .0 9
•
2 0 1 5 : $ 3 6 5 4 . 6 / 1 5 8 . 5 = $ 2 3 .0 6 . N orm a lly, b o o k value per share increases as retained earnings accum ulate a nd n ew shares are issued. Indeed,
the increase in b o o k value per share o f $ 2 .0 3 ( $ 2 5 .0 9 — $ 2 3 .0 6 ) is very close to the increase in retained earnings per share, $ 2 .0 8 (($ 2 4 8 4 .4 - $ 2 1 5 3 . 9 J / 1 5 8 .7 ). The com pany's closing share price on 31 D ecem ber 2 0 1 6 w a s $ 4 1 .1 0 , so its p rice to b o o k ratio w a s 1 .6 4 ( $ 4 1 , 1 0 / $ 2 5 . 0 9 from above). Thus the com pany's m arket c a p ita lisa tio n w a s 6 4 per cent higher than its b o o k value. W ith 1 5 8 .7 m illion shares outstanding, the stock market valued Transport at a b o u t $ 6 .5 billion, co m p a red to its equity b o o k value o f around $ 4 billion. This is not a g re a t premium, but numerous com panies that had much higher premiums (because o f stratospheric share prices an d not much b o o k value to b a ck them up) have crashed to earth you m ay recall co rp o ra te collapses such as Enron, W o rld C o m , HIH a nd O ne.Tel. Transport is being valued as a stable but unexciting co m p a n y, w h ich fits w ith the stability in earnings an d cash flow s w e have seen in e arlier ratios.
PRICE-TO-EARNINGS RATIO Transport's stock price has fluctuated som ew hat throughout 2 0 1 5 an d 2 0 1 6 , but the trend has been to fa irly steady grow th. Using the year-end closing prices, w h ich a re close to the highs fo r the year, gives a conservative v ie w o f the price-to-earnings ratio: • •
2 0 1 6 : PE = $ 4 1 , 1 0 / $ 2 . 6 0 = 1 5 .8 times 2 0 1 5 : PE = $ 3 6 . 5 8 / $ 2 . 5 3 = 1 4 .5 times. This is a solid PE, a g a in in d ica tin g that the market sees Transport as a g o o d , fa irly safe investment - no high-flyer,
but not likely to suddenly g o bust either. M a n y PE ratios in recent years w e re high, co m p a red to historical trends. To get an idea of the range o f PEs, check the fin a n cia l section o f your d a ily n e w sp a p e r o r the business section o f a news w ebsite.
DIVIDEND PAYOUT RATIO The d ivid e n d payout ratio is calculated as annual com m on dividends d e cla re d per share d iv id e d by EPS; or, if dividends per share are not disclosed, just dividends d e cla re d d ivid e d by net profit. This is a measure of the portion of earnings p a id to shareholders. For exam ple, if the d ivid e n d payout ratio is 0 .4 0 , then 4 0 per cent o f profit w as distributed to shareholders, an d the rem aining 6 0 per cent w a s kept in the c o m p a n y (retained earnings) to finance assets o r reduce debts. A stable ratio w o u ld suggest that the c o m p a n y has a p o lic y o f p a yin g d ividends based on earnings, and a v a ria b le ratio w o u ld suggest that factors other than earnings are im portant in the b o a rd of directors' decisions to d ecla re dividends. Transport has o nly a short history o f d ivid e n d payouts. W e can learn the total dividends am ount each ye a r from the statement o f retained earnings. Using this inform ation a nd the a v e ra g e num ber of shares outstanding, an estim ate o f annual dividends can be calculated. From the inform ation in Exhibit 1 5 .8 , w e can infer that Transport appears to be conservative an d stable. It appears that the b o a rd o f directors has chosen to fo llo w a p o lic y o f conservative stable d ividends in the am ount of about $ 0 .5 2 per share ye a rly o r 2 0 per cent of total net profit. The d ividend payout ratio is usually consistent w ith the com pany's PE ratio. Fast-growing com panies a re often strapped for cash, so p a y little o r no divid e n d s, p loughing earnings b a ck into m ore g ro w th . People hold the shares of such com panies because they expect g row th in share price, not dividends, an d because of such expectations of future grow th, the PE ratios o f such com panies are usually high. In contrast, p e o p le invest in some duller, but safer, com panies not because they expect high share price grow th but because they expect regular dividends. Transport pays m ore than ze ro dividends, but w ith its supply o f cash could have p a id a higher percentage o f earnings than it d id . This reinforces the g ro w in g conclusion from these ratios that Transport is a solid, m oderate co m p a n y, not a highgrow th one - as w e w o u ld expect from a transport c o m p a n y that is m ore than 1 0 0 years o ld .
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A ctivity (turnover) ratios TOTAL ASSET TURNOVER Using year-end assets, Transport's total asset turnovers w ere: •
2 0 1 6 : $ 3 9 0 2 . 9 / $ 10 4 9 9 . 8 = 0 . 3 7 2 times
•
2 0 1 5 : $ 3 6 6 0 . 7 / $ 9 9 5 6 . 7 = 0 .3 6 8 times.
•
These turnover ratios are very lo w . They are much b e lo w those that most com panies have. Transport takes nearly
T w o observations are indicated. three years to earn a d o lla r o f revenue on each d o lla r o f assets. These are much lo w e r than W o o lw o rth s . But w h a t w o u ld w e expect? Transport has thousands o f truck depots, m aintenance shops an d so on. W o o lw o rth s is a retailer, d e p e n d in g on high sales volum e. It is a rem inder to consider the kind o f c o m p a n y being analysed, an d a rem inder that there are no absolute ratios, o n ly relative com parisons. •
Transport's asset turnover im proved slightly from 2 0 1 5 to 2 0 1 6 . This im provem ent is the result o f higher g row th in revenues, 6 .6 per cent ( ( $ 3 9 0 2 .9 — $ 3 6 6 0 .7 ) /$ 3 6 6 0 . 7 ) , than in assets, 5 .5 per cent ( ( $ 1 0 4 9 9 .8 — $ 9 9 5 6 .7 ) /$ 9 9 5 6 . 7 ) . W h ile the ch a n g e is small, it is another indication o f the stability o f Transport.
INVENTORY TURNOVER As w e have a lre a d y seen, Transport does not have a C O G S , a n d its b a la n ce sheet indicates its inventories are just supplies for running the transport, not g o o d s for sale, so w e cannot calculate a m eaningful inventory turnover ratio. Using Transport as the exam ple c o m p a n y has this shortcom ing, but it does not mean the inventory turnover ratio is not im portant or useful. It is very im portant fo r evaluating retailers an d other sellers o f g oods.
DEBTORS TURNOVER Debtors turnover is also known as receivables turnover, often c a lle d days' sales in receivables: Transport's collection ratios w ere: •
2 0 1 6 : $ 4 3 4 . 7 / ( $ 3 9 0 2 . 9 / 3 6 5 ) = 4 0 . 7 days
•
2 0 1 5 : $ 3 9 5 . 7 / ( $ 3 6 6 0 . 7 / 3 6 5 ) = 3 9 .5 days. It w o u ld be preferable to use o n ly revenue from credit sales in the denom inator, since cash sales are collected
im m ediately, but fe w com panies break their revenue figures d o w n to separate cash revenue. It takes the c o m p a n y a b o u t a month an d one-third, on a verage, to collect from its customers. This is reasonable time: most customers p a y monthly, a nd Transport has governm ent agencies a nd other relatively slo w payers a m ong its customers.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Financing ratios DEBT-TO-EQUITY RATIO Transport's debt-to-equity ratios w ere: • •
2 0 1 6 : $ 6 5 1 7 . 4 / $ 3 9 8 2 . 4 = 1 .6 4 times 2 0 1 5 : $ 6 3 0 2 .1 / $ 3 6 5 4 . 6 = 1 .7 2 times. The debt-to-equity ratio certainly shows that Transport is leveraged, relying m ore on d e b t than on equity, but that
its relative reliance on d e b t is decreasing.
LONG-TERM DEBT-TO-EQUITY RATIO A nother version o f debt-to-equity ratio is long-term debt-to-equity ratio, ca lculated as (long-term loans + m ortgages + bonds + sim ilar long-term debts) d iv id e d b y total equity. This ratio has m any versions, d e p e n d in g on w h ich specific items the analyst decides to include as debt. It is frequently referred to as the debt-to-equity ratio, under the a p p a re nt assumption that longer-term d e b t is m ore relevant to evaluating risk a nd fin a n cin g strategy than are the accrual and non-interest-bearing com ponents o f total liabilities. For Transport, this ratio involves just the one long-term d e b t figure on the b a la n ce sheet. N o t including the debt's tiny current portion, the resulting ratios w ere: •
2 0 1 6 : $ 3 0 7 5 . 3 / $ 3 9 8 2 . 4 = 0 . 7 7 times
•
2 0 1 5 : $ 3 3 4 8 . 9 / $ 3 6 5 4 . 6 = 0 .9 2 times. A g a in w e see the d o w n w a rd trend in Transport's reliance on debt.
DEBT-TO-ASSETS RATIO Using total liabilities, the ratios for Transport w ere: •
2 0 1 6 : $ 6 5 1 7 . 4 / $ 1 0 4 9 9 .8 = 0 .6 2 times
•
2 0 1 5 : $ 6 3 0 2 .1 / $ 9 9 5 6 . 7 = 0 .6 3 times. The pattern is the same as for the d e b t/e q u ity ratios.
L iq u id ity and solvency w a rn in g ratios CURRENT RATIO (WORKING CAPITAL RATIO) Transport's w o rkin g c a p ita l ratio ch a n g ed o n ly slightly in 2 0 1 6 : • •
2 0 1 6 : $ 9 9 2 . 0 / $ 1 2 8 8 .2 = 0 . 7 7 times 2 0 1 5 : $ 7 2 4 . 2 / $ 9 5 4 . 6 = 0 .7 6 times. This ratio shows Transport's w o rkin g c a p ita l position to be negative; that is, there are insufficient current assets on
hand to repay all current liabilities. W e have noted throughout that Transport is a very stable co m p a n y. It is also the case that Transport generates its revenue using its long-term assets to pro vid e service rather than selling its current assets, as in the case w ith retailers. Thus, b y using its current revenues as earned an d collected, Transport is a b le to meet the required payments o f expenses an d current liabilities despite the w o rkin g ca p ita l deficit.
QUICK RATIO (ACID TEST RATIO) Using the a c id test ratio is likely to be inform ative if a com pany's w o rkin g c a p ita l includes large amounts of inventories that w o u ld have to be sold to p a y bills, o r large p re p a id expenses that have d ra in e d cash. Transport doesn't have either o f these, so the q u ick ratio w ill not tell us much m ore than the w o rkin g c a p ita l ratio does, but let's calculate it a n y w a y . The ratio is show n b elow : •
2 0 1 6 : ( $ 3 5 3 . 0 + $ 4 3 4 . 7 ) / $ 1 2 8 8 .2 = 0 .6 1 times
•
2 0 1 5 : ($ 1 3 4 .7 + $ 3 9 5 . 7 ) / $ 9 5 4 . 6 = 0 .5 6 times.
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This shows Transport to have liquid assets equal to o n ly 6 0 per cent o f its current liabilities. This is lo w , but is likely adeq u a te , assuming Transport could match its payments to a t least some of its suppliers roughly to the tim e it takes to collect from its o w n customers.
INTEREST COVERAGE RATIO The interest c o ve ra g e ratio is usually calculated as (profit before interest expense an d incom e tax) d iv id e d b y net interest expense. Transport's interest co ve ra g e ratios, using the net interest expense from N o te 6 used in e arlier ratios, w ere: •
2 0 1 6 : ($41 3 .0 + $ 1 4 3 .3 + $ 21 8 . 6 ) / $ 2 1 8 . 6 = 3 .5 4 times
•
2 0 1 5 : ($ 4 0 1 .3 + $ 4 1 .6 + $ 21 8 .7 ) / $ 2 1 8 .7 = 3 .0 3 times. The result here is w h a t w e w o u ld expect from the other debt-related ratios: Transport's interest c o ve ra g e is
com fortable, though w ith its decreased b o rro w in g a nd the decreased interest that goes w ith it, it is m ore com fortable than it w a s in 2 0 1 5 .
Concluding com m ents ab ou t the ratios calculated The ratios a re summarised in Exhibit 1 5 .9 . Each one focuses on a different aspect o f perform ance, an d the com parison o f each w ith the previous o r other years tells us som ething, a nd also invites us to learn m ore a b o u t the c o m p a n y so w e can understand w h a t each ratio is in d ica tin g . Com m ents integrating the story told b y all the ratios w ill be m ade in section 1 5 .8 .
604
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
FOR YOUR INTEREST H e re a re s o m e a c c o u n tin g re s e a rc h re s u lts re le v a n t t o th e v a lu e o f th e k in d o f fin a n c ia l an alysis in c lu d e d in th is c h a p te r. 1
R a tio s c o m p u te d fr o m fin a n c ia l s ta te m e n ts ha ve s o m e v a lu e in p re d ic tin g b a n k ru p tc y o r o t h e r fin a n c ia l p ro b le m s . F o r s o m e c o m p a n ie s , b u t n o t all, fin a n c ia l p ro b le m s c an be p re d ic te d s eve ral y e a rs in a d va n c e u s in g a c c o u n tin g ra tio s .
2
E v e n th o u g h a n n u a l re p o rts c o m e o u t r a th e r a lo n g tim e a f te r th e fis c a l y e a r-e n d , th e r e is e n o u g h re a c tio n b y s to c k m a rk e ts t o th e m to in d ic a te th a t an alysis o f th e re p o rts s till has s o m e th in g t o say to m a rk e t tra d e rs .
3
P e o p le c a n n o t c o p e w ith m asses o f d is a g g re g a te d d a ta : it ta k e s to o lo n g an d re q u ire s to o m u c h s p e cia l e x p e rtis e . S o, s u m m a ris in g te c h n iq u e s , s u c h as fin a n c ia l an alysis, pla y a m a jo r ro le in u s e rs ’ d e c is io n m a k in g .
4
A n a ly s ts ’ fo re c a s ts o f e a rn in g s , based p a rtly o n fin a n c ia l s ta te m e n t d a ta , d o h e lp to p re d ic t c o m p a n ie s ’ fu tu r e e a rn in g s p e rfo rm a n c e . T h e a n a lys ts c a n o fte n a n tic ip a te s ig n ific a n t c h a n g e s in e a rn in g s b e ca u s e th e y
are fo llo w in g c o m p a n ie s
c lo s e ly , so m a rk e t p ric e s
re g u la rly c h a n g e b e fo re th e
n e w fin a n c ia l
s ta te m e n ts are re le a s e d . S o m e tim e s fin a n c ia l s ta te m e n t an alysis d o e s tu r n up n e w in fo r m a tio n , a llo w in g p e o p le to f in e - t u n e th e ir e x p e c ta tio n s a b o u t fu tu r e p e rfo rm a n c e . 5
F in a n c ia l s ta te m e n t an alysis h e lp s to assess risk, and th u s h e lp s in v e s to rs c h o o s e th e share s th a t se e m a p p ro p ria te f o r th e ir ris k p re fe re n c e s .
6 F in a n c ia l s ta te m e n t an alysis is u s e fu l t o c o r ro b o ra te w h a t p e o p le a lre a d y b e lie v e a b o u t a c o m p a n y ’s p e rfo rm a n c e , p o s itio n o r risk. E v e n i f s u ch an alysis tu rn s up little th a t is ‘n e w ’, it a c ts as a c h e c k o n th e o t h e r flo w s o f in fo r m a tio n a b o u t c o m p a n ie s , b e ca u s e th e v a lid ity o f th a t in fo r m a tio n c an be v e rifie d la te r w h e n th e fin a n c ia l s ta te m e n ts c o m e o u t.
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r based o n w h a t y o u ha ve ju s t re a d . I f y o u c a n ’t a n s w e r th e m , it w o u ld be b e s t t o re -re a d th e m a te ria l. 1
H o w w e ll d id T ra n s p o rt p e r fo r m in 2 0 1 6 as c o m p a re d to 2 0 1 5 ?
2
H o w w as T ra n s p o rt’s liq u id ity a t th e e n d o f 2 0 1 6 ? Is th a t an im p ro v e m e n t o v e r 2 0 1 5 ? A n s w e rs :
1
H in t : y o u s h o u ld assess T ra n s p o rt’s p e rfo rm a n c e b y e x a m in in g c h a n g e s f o r e a ch g ro u p o f ra tio s as a basis f o r fo r m in g y o u r o v e ra ll c o n c lu s io n . C h e c k y o u r a n s w e r w ith th e s e c tio n title d ‘C o n c lu d in g c o m m e n ts a b o u t th e ra tio s c a lc u la te d ’?
2
T h e c o m p a n y ’s liq u id ity s e e m e d to im p ro v e s lig h tly a t th e e n d o f 2 0 1 6 , as d e m o n s tra te d b y in c re a s e s in th e c u r r e n t ra tio , th e q u ic k ra tio an d th e in te re s t c o v e ra g e ra tio .
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605
Interpretation of cash flow inform ation
Both in the theory o f econom ics an d fin an ce an d in the practical relationships betw een businesses a nd their ow ners and creditors, cash flo w is an im portant measure o f return. Profit for the c o m p a n y is all very w e ll, but ow ners sooner or later w a n t to receive some o f it in cash d ividends, a nd lenders w a n t cash payments to cover interest a nd p rincipal due, an d so on. Profit is revenue minus expenses, but the revenue m ay be tied up in uncollected receivables, a nd the expenses m ay either not have been p a id yet o r have been p a id in a d va n ce . In fin a n cia l statement analysis, the cash flo w statement's focus on cash provides im portant supplem entary inform ation a b o u t h o w the c o m p a n y w a s m anaged and h o w it perform ed. (To refresh yo u r m em ory o f the cash flo w statement, you should refer to C h a p te r 14.) The cash flo w statement, in co m b in a tio n w ith the incom e statement a n d b a la n ce sheet, can be used in at least the fo llo w in g w a ys. Each point is illustrated by reference to Transport's cash flo w statement: 1
Evaluate the relative sig n ifica n ce o f the cash flo w figures by relating them to the size o f the com pany's assets, liabilities, equity a nd profit. For Transport, w e s a w earlier that the ratio o f op e ra tin g cash flo w to total assets w a s larger than the return on assets in 2 0 1 6 , but a b o u t the same as R O A in 2 0 1 5 . This w o u ld seem to be the result of lower-than-norm al cash flow s from operations in 2 0 1 5 ( $ 3 0 5 .7 million), w hen less than half the 2 0 1 4 ($ 7 6 3 .5 million) o r 2 0 1 6 cash flow s ( $ 7 8 6 .0 million) w e re generated. The lower-than-usual cash flow s from operations w e re offset by increased bo rro w in g s, as seen in the cash pro vid e d b y financing activities.
2
Evaluate the com pany's relative d e p e n d e n ce on internally generated cash (from operations) versus cash generated from external fin a n cin g activities. O p e ra tin g cash flo w w a s the main source o f cash in all three years show n in Exhibit 1 5 .6 . H ow ever, in both 2 0 1 5 a nd 2 0 1 6 , Transport required long-term b o rrow ings in excess of repaym ents to fin a n ce the significant ad d itio n s to properties seen as cash used in investing.
3
Evaluate solvency (ability to p a y debts w hen due) a nd liq u id ity (having a d e q u a te reserves o f cash a nd near-cash assets). W e s a w e arlier that solvency does not seem to be a problem : Transport can cover its interest payments a n d , based on the 2 0 1 6 experience, can b o rro w long-term an d repay it w hen due. Liquidity is a little strained, but the c o m p a n y to o k m ajor action in 2 0 1 6 to b o rro w long-term an d shore up its liquidity. The cash flo w statement shows that even in 2 0 1 5 , w hen the inflow s from operations w e re unusually lo w , they still p rovided a sig n ifica n t portion o f the funds needed for investing activities.
4
Evaluate the level o f spending on long-term asset acquisitions in relation to the size of the com pany's assets and the am ount o f annual d e p re cia tio n , in order to help ju d g e w hether the c o m p a n y appears to be keeping its plant an d equipm ent up to d ate. Transport stayed a h e a d o f the g a m e in 2 0 1 6 , as it had in 2 0 1 5 , by spending 6 0 to 8 0 per cent m ore on n ew assets than w a s ch a rg e d as the de p re cia tio n on existing assets ($ 6 7 3 .8 m illion spent co m p a red to $ 4 0 7 .1 m illion d e p re cia te d in 2 0 1 6 ).
5
Evaluate the co m p a n y's d e b t versus equity fin a n cin g strategy. W e s a w that Transport is leveraged, having alm ost tw ic e as much in liabilities as equity at the end of 2 0 1 6 . Accounts p a y a b le represents 15 per cent o f the total d e b t at the end o f 2 0 1 6 , but the long-term debt-to-equity ratio is b e lo w 1, but d e clin in g over time. Looking at the cash flo w statement, w e can infer that the financing strategy is clearly to b o rro w long-term to supplem ent op e ra tin g cash flow s, not to raise m ore equity. The m arginal g row th in share c a p ita l resulted entirely from em ployees exercising stock options. The cash flo w statement reveals that equity has not been part of the financing strategy, except through letting retained earnings g ro w .
6 Evaluate the com pany's d ivid e n d p o lic y by co m p a rin g d ividends w ith both profit a nd cash flo w , a nd review ing the pattern over time. The new ly independent Transport is essentially a n e w c o m p a n y in fin a n cia l terms, even though in op e ra tin g terms it is over 1 0 0 years old . The d ivid e n d p o lic y is p ro b a b ly still evolving but, as mentioned earlier, it appears that Transport is attem pting to m aintain a constant d ivid e n d per share. This is often d o n e by com panies to pro vid e shareholders w ith a d e p e n d a b le cash flo w in the expectation that this w ill e n courage some stability in the share price. 7
Determine the relationship betw een profit a nd cash flo w to evaluate the q u a lity o f earnings (profit). Profit should be reasonably consistent w ith cash flo w , after adjusting for normal corrections such as d e p re cia tio n , a nd should not
606
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
be so far out o f line w ith cash flo w that there's some question a b o u t its va lid ity. Here, Transport's cash flo w to earnings has g e n e ra lly been healthy since 2 0 1 4 . A lthough lo w enough to be o f possible concern in 2 0 1 5 , cash flo w from op e ra tin g activities returned to e arlier levels o f a b o u t tw ic e the earnings in 2 0 1 6 . There are no indications o f earnings m anagem ent o r other threats to earnings quality.
8
Identify possible m anipulation o f the cash flo w figures, such as fa ilin g to replace inventories o r d e la yin g paym ent o f current o r noncurrent debts, by com parisons to the w a y cash flow s w e re generated in past years. Transport's operating cash flow s a re very stable. There is no indication o f anything u ntow ard in the cash flo w figures.
9
Identify either the hazards o f success, such as drains on cash flo w due to the build-up o f inventories o r accounts receivable, o r the benefits o f decline, such as cash increases d ue to shrinking inventories o r receivables. There d o n 't seem to be hazards in Transport's cash flo w inform ation. The c o m p a n y is em erging from the former corporate um brella a nd has had to take some steps to u p g ra d e liquidity, but its op e ra tin g cash flow s in d ica te robust perform ance an d a b ility to generate enough cash flo w internally to keep property an d plant assets up to date.
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be a b le to a n s w e r based o n w h a t y o u ha ve ju s t re a d . I f y o u c a n ’t a n s w e r th e m , it w o u ld be b e s t t o re v is it th e m a te ria l. 1 2
W h a t w e re th e m a in c o m p o n e n ts o f T ra n s p o rt’s 2 0 1 6 cash flo w ? H o w d o e s cash flo w in fo r m a tio n c o n trib u te to fin a n c ia l s ta te m e n t an alysis? Y o u r a n sw e rs s h o u ld be:
1
T h e m a in c o m p o n e n ts o f T ra n s p o rt’s cash flo w in 2 0 1 6 w e re re c e ip ts fr o m c u s to m e rs ( $ 3 9 4 5 .1 m illio n ) an d p a y m e n ts to s u p p lie rs and e m p lo y e e s ( $ 2 7 8 0 m illio n ).
2
C a s h flo w in fo rm a tio n c o n trib u te s to fin a n c ia l s ta te m e n t an alysis as it h e lp s to :
a
e v a lu a te th e re la tiv e s ig n ific a n c e o f th e cash flo w fig u re s
b
e v a lu a te th e c o m p a n y ’s re la tiv e d e p e n d e n c e o n in te rn a lly v e rsu s e x te rn a lly g e n e ra te d cash
c
e v a lu a te s o lv e n c y
d
e v a lu a te level o f s p e n d in g o n lo n g - t e r m a s se t a c q u is itio n s
e
e v a lu a te a c o m p a n y ’s fin a n c in g s tra te g y
f
e v a lu a te th e c o m p a n y ’s d iv id e n d p o lic y
g d e te rm in e th e re la tio n s h ip b e tw e e n p r o fit an d cash flo w and e v a lu a te q u a lity o f e a rn in g s h
id e n tify p o ss ib le m a n ip u la tio n o f cash flo w o r a c c ru a l fig u re s .
Overall conclusions from T ran sp ort Lim ited's com pany analysis H ere are some conclusions to connect the various analyses in the preceding sections to form an overall portrayal of Transport's financia l perform ance an d position.
PERFORMANCE Transport's story is o f steady, stable perform ance, show ing a mixture o f small improvements a nd small declines from 2 0 1 5 to 2 0 1 6 . Return on equity a nd return on assets de clin e d slightly, w h ile earnings per share rose a nd cash provided by operations m ore than d o u b le d . It should be noted, how ever, that this d o u b lin g o f cash flo w from operations really o nly p rovided a return to the 2 0 1 4 level. The reasons a re contained in the slight d e clin e in profit m argin, and small g row th in both revenues an d o p erating expenses, resulting in little grow th in net profit. Transport's price-to-earnings ratio a nd price-to-book ratio in d ica te that the stock market sees the c o m p a n y as a solid investment, not a high-flyer. D ividends w ill be im portant if share price grow th is low .
CHAPTER 15 Financial statem ent analysis
607
ACTIVITY (TURNOVER) The com pany's asset turnover w a s relatively slow : it is a large-asset transport co m p a n y, so that is to be expected. The bulk o f its assets are noncurrent. The com pany's revenues g re w slightly faster than its assets, p ro vid in g a small im provem ent in the asset turnover from 2 0 1 5 to 2 0 1 6 . The asset turnover im proved, in d ica tin g that the p a ce of grow th in profit w a s slightly higher than that o f assets. Receivables collections slo w e d slightly, w h ich also im pacts the asset turnover. Taken together, the a ctivity ratios a re further indications that Transport is a mature c o m p a n y that is stable an d not ra p id ly e x p a n din g o r c h a n g in g .
FINANCIAL STRUCTURE Transport w a s leveraged w ith 6 0 per cent more d e b t than equity. This means that a b o u t two-thirds o f its assets w e re provided by creditors a nd o nly one-third by ow ners. The debt-to-equity ratio has been d e c lin in g since Transport becam e independent, m ainly through the g row th o f retained earnings. M o s t o f its fin a n cin g w a s long term, like its assets: the c o m p a n y w a s fo llo w in g com m on principles o f m atching the fin a n cin g term to the assets being financed.
LIQUIDITY/SOLVENCY The c o m p a n y had negative w o rkin g c a p ita l (ratio less than 1) in both 2 0 1 6 an d 2 0 1 5 . Despite this situation, Transport is a b le to meet its current lia b ility o b lig a tio n s by generating cash from operations an d by m aintaining a b a lan ce am ong cash, accounts receivable an d accounts p a ya b le . Inventories w e re not a m ajor part o f Transport's w o rkin g ca p ita l, so the q u ick ratio w a s o n ly a little w e a ke r than the w o rkin g ca p ita l ratio. Interest c o ve ra g e w a s com fortable co m p a red both to profit a nd (as cash from operations w a s larger than profit) to cash flo w .
CASH FLOW O p e ra tin g cash flow s w e re stable a nd significant, p ro vid in g enough cash to fin a n ce property a nd plant acquisitions w ith o n ly a relatively small am ount o f external fin a n cin g in 2 0 1 6 . This left the external fin a n cin g to pro vid e a base increase in cash to help liquidity. S pending on n e w property an d plant a p p e a re d to be a b o u t enough to keep the assets up to d a te a nd to replace those w e a rin g out, but not enough for real gro w th .
OVERALL SUMMARY Transport in 2 0 1 6 w a s a stable co m p a n y, putting its affairs in ord e r an d m aintaining a healthy cash flo w a nd slightly im proved earnings a nd returns to shareholders. Long-term d ebt, a nd therefore risk, w e re reduced, helping im prove liq uid ity a nd so reducing short-term risk. The various ratios a nd stock market price perform ance a g re e d in portraying the c o m p a n y as not extreme in a n y dim ension, positively or negatively, a nd so being an attractive investment though not a high-flyer. Its market capitalisation an d price-to-earnings ratio indicated that investors expect sim ilar perform ance and m oderate g row th in the future.
15.9
'W hat if' effects, ratios and cash flow
This section continues the 'w h a t if' effects analysis exam ples to include an analysis of effects on ratios a nd cash flo w . As before, this analysis w ill be d o n e on an after-tax basis. Therefore, rem em ber the fo llo w in g general points: •
C hanges in specific accruals o r general accounting policies d o not directly affect cash, because they d o not involve cash. For exam ple, correcting a dep re cia tio n expense involves an entry to d e p re cia tio n expense (for the current year) a nd accum ulated d e p re cia tio n . Cash isn't part o f the entry. Even w hen an accrual o r accounting p o lic y ch a n g e is im plem ented in the accounts, there is no direct cash effect because, b y the nature o f accrual acco u n tin g , such choices a re im plem ented by journal entries involving b a la n ce sheet accounts other than cash (such as receivables, payables, inventories an d accum ulated d epreciation).
608
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Such changes d o g e n e ra lly affect incom e tax expense a n d lia b ility, as you have a lre a d y seen, because tax is assessed on an accrual accounting basis, by a nd large. The incom e tax effect on a n y current o r p rio r ye a r change, X, is a p p ro xim a te ly tX, w h e re t is the tax rate estim ated from the fin a n cia l statements. The after-tax effect is therefore (1 - t)X. W ith o u t d e ta ile d tax kn o w le d g e , it m ay not be possible to tell w h e th e r it is the current o r the deferred part o f the tax that is affected, but that is unlikely to matter for the purpose o f most 'w h a t if' analysis.
•
The effect on incom e tax expense a nd lia b ility is also a likely effect on accruals, a nd so involves no im m ediate cash effect either. H ow ever, there w ill be a cash effect fa irly soon, w hen the extra tax is p a id o r the tax refund is collected.
FOR YOUR INTEREST A c c o u n t in g re s e a rc h has s h o w n th a t s h a re p ric e s te n d to r e fle c t th e a b o v e analysis. I f th e r e is n o e f fe c t on cash a t all, n o w o r e v e r, th e s h a re m a rk e t is lik e ly to la rg e ly ig n o re th e c h a n g e . I f th e r e is a ta x e f fe c t, th e m a rk e t m a y re a c t in a c c o rd a n c e w ith it b e ca u s e o f its cash im p lic a tio n s . F o r e x a m p le , i f a p u b lic c o m p a n y ta k e s a w r ite - d o w n o r m a ke s a c h a n g e in a c c o u n tin g th a t re d u c e s p r o fit, b u t saves in c o m e ta x in d o in g so, th e p ric e o f its share s m ig h t rise a b it to re c o g n is e th e cash saving.
B elow , w e w ill exam ine three 'w h a t if' (effects) analysis exam ples. For each, w e w ill ask seven standard questions, just to help you see the extent o f the analysis that is possible. W e w ill ask w h a t the effect is on each o f the fo llo w in g factors:
H ere are the three exam ples (assume a 4 0 per cent incom e tax rate for all): 1
H andee H a rd w a re Ltd is considering b o rro w in g $1 m illion as a short-term loan from the bank.
2
Eastern M in in g Ltd proposes to w rite an unproductive m ine d o w n b y $ 2 5 million.
3
G ibson Ltd decides, for accounting purposes, to d e p re cia te equipm ent over 1 0 years instead of over 2 0 years. There is no ch a n g e in the tax treatment.
S olution notes: exam ple 1 The effect o f H a n d e e H a rd w a re Ltd b o rro w in g $1 m illion as a short-term loan from the b a n k on: • •
N e t profit: no effect on current p rofit (until after the b o rro w in g , w h e n interest begins to accum ulate). Tax lia b ility : no effect on incom e tax (until after the b o rro w in g , w hen interest incurred becom es a tax-deductible expense).
•
O p e ra tin g cash flo w : no effect on o perating cash flow s.
CHAPTER 15 Financial statem ent analysis
•
609
C urrent ratio: cash is a current asset an d the ba n k loan is a current lia b ility, a n d both are increased, so there is no effect on w o rkin g ca p ita l. But to think a b o u t effects on the current ratio, consider the fo llo w in g possible situations: Current assets Before
After
a
6 000000
b
6 000000
c d
Current liabilities Before
After
7000000
3 000000
7000000
5 000000
6 000000
7000000
6 000000
7000000
Current ratio Before
After
4000000
2.00
1.75
6000000
1.20
1.17
7000000
8000000
0.86
0.88
9000000
10000000
0.67
0.70
You can see from these situations that such an event drives the current ratio tow ards 1: d o w n to w a rd s 1 if it w e re higher, an d up to w a rd s 1 if it w e re low er. So, there is no effect on w o rkin g c a p ita l because it is the difference betw een current assets a nd current liabilities, an d the effects on each cancel o ne another out. But there is an effect on the current ratio, because it is current assets d iv id e d by current liabilities, a nd the effects on each d e p e n d on the level o f the ratio before the change. •
ROE: no effect until interest starts to accum ulate an d a n y revenues o r decreased costs for w h ich the m oney is used b egin. W h e th e r ROE ultim ately goes up o r d o w n depends on w hether the c o m p a n y has b o rro w e d w ise ly. For exam ple, the m oney m ay be used to p a y suppliers sooner an d ge t e a rl^p a y m e n t discounts that are greater than the interest p a id to the bank for the m oney, in w h ich case ROE w ill g o up eventually.
•
R O A: in this case, total assets increases, a nd there is no effect on profit until interest starts to accum ulate. A t this point R O A w ill decrease.
•
D /E ratio: this w ill g o up, because the c o m p a n y has m ore d e b t a n d there has been no im m ediate effect on equity (no effect on profit).
S olution notes: exam ple 2 The effect o f Eastern M in in g Ltd w ritin g an unproductive m ine d o w n b y $ 2 5 m illion on: •
N e t p ro fit before tax: the mine asset cost w ill be credited, accum ulated dep re cia tio n w ill be d e b ite d an d an expense, loss on m ine closure, w ill be d e b ite d. The full effect w o u ld be a $ 2 5 m illion reduction on current profit.
•
Tax lia b ility : p ro b a b ly some reduction in incom e tax lia b ility. The exact effect depends on resolving the tax deduction uncertainty.
•
O p e ra tin g cash flo w : no effect on cash or cash from operations.
•
C urrent ratio: no effect on w o rkin g c a p ita l o r on the current ratio, unless there w a s a reduction o f current incom e tax lia b ility. In such a case, w o rkin g c a p ita l a nd the ratio w o u ld increase.
•
ROE: profit w o u ld fall; therefore, so w o u ld ROE. The w rite-off w o u ld e q u a lly reduce profit an d equity (retained earnings after including the lo w e r profit), so the ratio's fall w o u ld be reduced a little by the d e cline in the de n o m in a to r as w e ll as the numerator.
•
R O A: like ROE, this w o u ld fall because of the effect on profit.
•
D /E ratio: this w o u ld g o up because the c o m p a n y has less equity.
S olution notes: exam ple 3 The effect o f G ib so n Ltd d e c id in g , for accounting purposes, to d e p re cia te equipm ent over 1 0 years instead of over 2 0 years w ith no ch a n g e in tax treatment on: •
N e t p ro fit: profit w o u ld decrease because o f the increased am ount o f dep re cia tio n expense.
•
Tax lia b ility : no im pact on tax as tax treatment of de p re cia tio n does not change.
•
O p e ra tin g cash flo w : no im pact on cash flo w from operations.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
•
C urrent ratio: as neither current assets nor current liabilities are affected, the current ratio w o u ld not be affected.
•
ROE: both profit a nd equity (via retained earnings) w o u ld fall by the sam e am ount. Assuming the ratio is less than 10 0 per cent, the ratio w o u ld fall.
•
R O A: both profit a nd total assets (via accum ulated depreciation) w o u ld decrease b y the sam e amount. Assuming the ratio is less than 10 0 per cent, the ratio w o u ld fall.
•
D /E ratio: w o u ld increase because equity falls because o f the d ro p in retained earnings.
HOW'S YOUR UNDERSTANDING? H e re a re tw o q u e s tio n s y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t re a d : 1
S tra p p e d L td , w h ic h has $ 1 9 0 0 0 0 in c u r r e n t asse ts an d $ 1 7 0 0 0 0 in c u r r e n t lia b ilitie s , b o rro w s $ 4 0 0 0 0 fr o m th e b a n k as a lo n g - t e r m lo a n , re p a y a b le in f o u r ye a rs . W h a t is th e e f f e c t o f th is loan o n w o rk in g c a p ita l? O n th e c u r r e n t ra tio ? O n c u r r e n t n e t p r o fit?
2
S lip s h o d L td has d is c o v e re d th a t it has n o t e s tim a te d e n o u g h w a rra n ty e x p e n s e s , b e ca u s e m o re c u s to m e rs a re r e tu rn in g p ro d u c ts f o r re p a ir th a n had b e e n e x p e c te d . T h e c o m p a n y d e c id e s t o re c o g n is e an a d d itio n a l $130 0 0 0
in n o n c u r r e n t w a rra n ty lia b ility , a n d , th e r e fo r e , in c o rre s p o n d in g e x p e n s e s . T h e c o m p a n y ’s
in c o m e ta x ra te is 3 5 p e r c e n t. W h a t w ill th is d o t o th e c u r r e n t y e a r’s n e t p r o fit? T o cash fr o m o p e ra tio n s ? T o th e c u r r e n t ra tio ? Y o u r a n sw e rs s h o u ld be: 1
U p $ 4 0 0 0 0 ; u p fr o m 1.12 t o 1 .3 5 ; n o n e im m e d ia te ly .
2
D ow n by $ 1 3 0 0 0 0
x
(1 — 0 . 3 5 ) , o r $ 8 4 5 0 0 ; no e f fe c t; n o e f f e c t b e ca u s e n o c u r r e n t assets o r
lia b ilitie s a re in v o lv e d .
15.10
Measuring a manager's performance
Financial statements d o n 't measure a m anager's perform ance w ith o u t sensitive a nd inform ed interpretation, an d even then, often not very satisfactorily! For exam ple, if a c o m p a n y follow s standard fin a n cia l accounting methods uncritically, m aking no attem pt to adjust them to fit its o w n circum stances, the resulting fin a n cia l statements w ill provide clear, but sometimes very arbitrary, measures o f the perform ance o f the com pany's m anagem ent. O n the other hand, if the c o m p a n y ignores standard methods entirely, d esigning its o w n accounting methods for everything, the resulting fina n cia l statements w ill pro vid e a relevant but hard-to-com pare measure o f m anagem ent perform ance. M o s t com panies are in betw een these extremes, w h ich means that there are some a rb itra ry aspects o f financial statements a n d some difficulties in co m p a rin g them. It is hard to determ ine h o w much a com pany's perform ance is really d ue to m anagem ent a nd h o w much depends on other factors, such as e conom ic trends, product price changes, union pressure a nd even pure luck (good o r bad). A lso, in most com panies m anagem ent is a g roup, so it is difficult to set one m anager's perform ance a p a rt from the group's. The result is that evaluating a m anager's perform ance w ith fin a n cia l statements requires great ca re and know le d g e o f the c o m p a n y an d its industry. The ratios and other com putations used in fin a n cia l analysis can easily co m pound the problem . Let's take the exam ple o f return on assets. C o n sid e r the case o f tw o com panies, A an d B. C o m p a n y A has assets o f $ 1 0 0 0 0 0 and EBIT o f $ 2 0 0 0 0 , for a 2 0 per cent ROA. Looks great. But the m anager is not looking into the future much, so is not keeping the com pany's assets o r m aintenance up to date. C o m p a n y B is exactly the same, except that the m anager is very a w a re o f the need to stay com petitive an d look after the assets, a nd has therefore spent $ 1 0 0 0 0 on n e w assets an d $ 2 0 0 0 on an im proved m aintenance program . As a result, B's assets a re $ 1 1 0 0 0 0 a nd its EBIT is $ 1 8 0 0 0 , for a 1 6 per cent ROA. C onsequently, A looks better than B: R O A is reduced both b y a sm aller num erator a nd a larger d enom inator in the case o f B.
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You can see that, unless the person d o in g the fin a n cia l analysis really understands the situation, the prudent and responsible m anager o f B w ill look w o rse than the neglectful m anager o f A ! C o n sid e r another exam ple o f tw o m anagers o f printing com panies. Both o f the com panies have an EBIT o f $ 1 0 0 0 0 0 . Both co m p a n ie s' o n ly m aterial asset is a printing m achine that cost $1 m illion, a nd has a life of 1 0 years. C o m p a n y C bought the m achine tw o years a g o (accum ulated dep re cia tio n $ 2 0 0 0 0 0 ; b o o k value $ 8 0 0 0 0 0 ) a nd c o m p a n y D bought its m achine four years a g o (accum ulated de p re cia tio n $ 4 0 0 0 0 0 ; b o o k value $ 6 0 0 0 0 0 ) . In this sim plified situation, c o m p a n y C w o u ld have an R O A o f 1 2 .5 per cent ( $ 1 0 0 0 0 0 / $ 8 0 0 0 0 0 ) , w h ile c o m p a n y D w o u ld have an R O A o f 1 6 .6 7 per cent ($ 1 0 0 0 0 0 / $ 6 0 0 0 0 0 ). A g a in , ca re needs to be taken in interpreting the figures a nd evaluating m anagers' perform ances based on ratios.
FOR YOUR INTEREST H e re is s o m e o f th e e v id e n c e a b o u t fin a n c ia l s ta te m e n t an alysis p ro d u c e d b y a c c o u n tin g re s e a rc h : •
I f th e fin a n c ia l s ta te m e n ts ha ve n e w o r u n e x p e c te d in fo rm a tio n (as w o u ld th o s e o f m o s t p riv a te a n d /o r s m a ll c o m p a n ie s ), an alysis o f th e m is v a lu a b le in o rd e r t o in te r p r e t th e re s u lts .
•
R a tio s c o m p u te d fr o m
fin a n c ia l s ta te m e n ts ha ve s o m e v a lu e in p re d ic tin g c o m p a n y fa ilu re o r o th e r
fin a n c ia l p ro b le m s . R e s e a rc h in d ic a te s th a t, f o r s o m e c o m p a n ie s , fin a n c ia l p ro b le m s c an be p re d ic te d s eve ral y e a rs in a d v a n c e u s in g a c c o u n tin g ra tio s . •
F in a n c ia l an alysis is an im p o r ta n t a c tiv ity in th e m o n ito r in g o f le n d in g a g re e m e n ts , m a n a g e m e n t b o n u s plans and o t h e r c o n tra c tu a l a rra n g e m e n ts . M a n y s u ch a g re e m e n ts in v o lv e an alysis b e ca u s e th e y s p e c ify th a t d e te rio ra tio n o f s o m e ra tio s (s u c h as d e b t - t o - e q u it y ) w ill tr ig g e r p e n a ltie s o r e v e n th e te rm in a tio n o f th e a g re e m e n t, o r b e ca u s e ra tio s are used in c o m p u tin g b o n u s e s o r o t h e r p a y m e n ts .
•
E v e n th o u g h a n n u a l re p o rts c o m e o u t r a th e r a lo n g tim e a fte r th e fis c a l y e a r-e n d , th e r e is e n o u g h re a c tio n b y s to c k m a rk e ts to th e m t o in d ic a te th a t an alysis o f th e re p o rts s till has s o m e th in g to say to m a rk e t tra d e rs .
•
P e o p le c a n n o t c o p e w ith m asses o f d is a g g re g a te d d a ta : it ta k e s to o lo n g t o c o m p re h e n d an d re q u ire s to o m u c h s p e cia l e x p e rtis e . T h e re fo re , s u m m a ris in g te c h n iq u e s s u ch as fin a n c ia l an alysis pla y a m a jo r ro le in u s e rs ’ d e c is io n -m a k in g .
•
A n a ly s ts ’ fo re c a s ts o f e a rn in g s , based p a rtly o n fin a n c ia l s ta te m e n t d a ta , d o h e lp t o p r e d ic t c o m p a n ie s ’ fu tu r e e a rn in g s p e rfo rm a n c e . T h e a n a lys ts o fte n c a n a n tic ip a te s ig n ific a n t c h a n g e s in e a rn in g s b e ca u s e th e y
are fo llo w in g c o m p a n ie s c lo s e ly , so m a rk e t p ric e s
re g u la rly c h a n g e
b e fo re th e
n e w fin a n c ia l
s ta te m e n ts are re le a s e d . •
R is k and re tu rn are g e n e ra lly re la te d . In v e s tm e n ts w ith a h ig h e r p o te n tia l re tu rn o fte n are ris k ie r, an d th o s e w ith a lo w ris k u s u a lly ha ve a lo w p o te n tia l re tu rn . D iffe r e n t in v e s to rs ha ve d iffe r e n t ris k p re fe re n c e s : s o m e p r e fe r to h o ld ris k y share s th a t m a y g e n e ra te h ig h re tu rn s ( o r la rg e lo s s e s !), w h ile o th e rs p r e fe r m o re s e c u re in v e s tm e n ts . F in a n c ia l s ta te m e n t an alysis h e lp s to assess ris k, an d th u s h e lp s in v e s to rs c h o o s e th e s hare s th a t s e e m a p p ro p ria te t o th e ir ris k p re fe re n c e s .
•
F in a n c ia l s ta te m e n t an alysis is u s e fu l to c o r r o b o r a te w h a t p e o p le a lre a d y b e lie v e a b o u t a c o m p a n y ’s p e rfo rm a n c e , p o s itio n o r risk. E v e n i f s u ch an alysis tu rn s up little th a t is ‘n e w ’, it a c ts as a c h e c k on th e o t h e r flo w s o f in fo r m a tio n a b o u t c o m p a n ie s , b e ca u s e th e v a lid ity o f th a t in fo r m a tio n c an be v e rifie d la te r w h e n th e fin a n c ia l s ta te m e n ts c o m e o u t. A ls o , s o m e tim e s fin a n c ia l s ta te m e n t an alysis d o e s tu r n u p n e w in fo r m a tio n , a llo w in g p e o p le to f in e - t u n e th e ir e x p e c ta tio n s a b o u t fu tu r e p e rfo rm a n c e .
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A In te g ra tin g ratios T M C Ltd, a la rg e p ro d u c e r o f te le c o m m u n ic a tio n s e q u ip m e n t, re ta ils its p ro d u c ts th ro u g h s u b u rb a n outlets. S h o w n b e lo w a re th e c a lc u la tio n s o f som e o f its key ra tio s fo r 2 0 1 6 a n d 2 0 1 5 . 2016 Return on shareholders' equity Return on total assets (ROA) Profit margin Asset turnover Days in inventory Days in debtors
13%
2011 12%
8%
9%
20%
18%
0.40 times
0.50 times
72 days
55 days
42 days
42 days
Current ratio
1.6 times
1.5 times
Quick ratio
0.7 times
1.1 times
Debt-to-equity ratio
1.4 times
1.0 times
C o m m e n t on T M C 's p ro fita b ility , asset m a n a g e m e n t, liq u id ity a n d fin a n c ia 1 structure. 2
W h y c o u ld ROE a n d R O A m o ve in d iffe re n t d ire c tio n s ?
3
W h a t c a u s e d th e fa ll in R O A ?
4
W h a t c a u s e d th e fa ll in asset tu rn o ve r?
5
W h a t c a u s e d th e in cre a s e in th e c u rre n t ra tio ?
PRACTICE PROBLEM B Ratios to m easure d iffe re n t kinds o f perform ance 1
M a n y fin a n c ia l p e rfo rm a n c e m easures a re ra tio s o f som e return o v e r som e in ve stm en t ba se . W h y is such a c o n c e p t o f p e rfo rm a n c e im p o rta n t in business?
2
W ith y o u r a n s w e r to q u e s tio n 1 in m in d , h o w m ig h t y o u m e asure th e p e rfo rm a n c e o f e a ch o f th e fo llo w in g investm ents o w n e d b y A n n M a n d e l? a
H e r $1 2 0 0 in a s aving s a c c o u n t a t S o lid B ank,
b
H e r in ve stm en t o f $ 1 5 0 0 0 in a little c o n s u ltin g business she runs,
c
H e r S la p d a s h 2 1 0 sports c a r.
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613
PRACTICE PROBLEM C Answ er questions using ra tio analysis C o m p a n y A is 1 0 0 p e r c e n t o w n e d b y M r A . The s u m m a ry o f C o m p a n y A 's fin a n c ia l state m e nt in fo rm a tio n is as fo llo w s : BALANCE SHEET AS AT 3 0 SEPTEMBER 20 16 $ Total assets
80000
Total liabilities
35 000
Total shareholders' equity
45 000
Total liabilities and shareholders' equity
80000
INCOME STATEMENT FOR THE YEAR ENDED 3 0 SEPTEMBER 2 0 1 6 $ Revenue
30000
Expenses Interest
2 000
General and operating expenses
19000
Income tax (33%)
3 000
Net profit for the year
24000 6000
Note showing changes in retained earnings for the year ended 30 September 2 0 1 6 $ Balance at beginning of the year
$ 1 7 0 00
Net profit for the year
6000
Balance at end of year
23 000
1
C a lc u la te C o m p a n y A 's return o n e q u ity fo r 2 0 1 6 .
2
C o m p a n y A is c o n s id e rin g b o rro w in g $ 5 0 0 0 0 fo r a d d itio n a l assets th a t w o u ld e a rn th e c o m p a n y th e sam e return on assets it has h is to ric a lly e a rn e d , a c c o rd in g to th e fin a n c ia l state m e nt in fo rm a tio n a b o v e . The cost o f b o rro w in g this m o n e y is 8 p e r cent. S ho uld th e c o m p a n y b o rro w th e m o ne y? (Assum e th e re a re n o a lte rn a tiv e sources o f fu n d in g .) S h o w a ll c a lc u la tio n s .
3
Place y o u rs e lf in th e ro le o f th e lo c a l b a n k m a n a g e r. M r A has a p p ro a c h e d y o u to le nd th e c o m p a n y th e re q u ire d $ 5 0 0 0 0 m e n tio n e d a b o v e . (D e ta ile d fin a n c ia l state m e nt in fo rm a tio n has a lre a d y be en pre se nte d to y o u .) W h a t a d d itio n a l in fo rm a tio n w o u ld y o u re q u ire , if a n y ? W h a t fin a n c ia l state m e nt ra tio s , in a d d itio n to those c a lc u la te d in p re vio u s p a rts o f this p ro b le m , w o u ld be useful in a id in g y o u r d e c is io n ? D o no t c a lc u la te th e ra tio s ; just m e n tio n o r d e s c rib e them .
KEY TERMS Basic earnings per share (EPS) Book value per share Cash Flow cycle Common size Financial statement Days sales in receivables
Debt-to-assets ratio Discontinued operations Dividend payout ratio Financial leverage Hedging
Leverage Leverage ratio Price-to-earnings (PE) ratio Profit margin
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s ection starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts a n d a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
W h a t is th e p u rp o s e o f fin a n c ia l state m e nt a n a lys is?
2
W h a t is a c o m m o n s iz e statem ent? W h e n is its use m ost a p p ro p ria te ?
3
W h a t in fo rm a tio n sh o u ld y o u g a th e r a b o u t a c o m p a n y b e fo re y o u start c a lc u la tin g ratios?
4
W h a t ra tio s w o u ld y o u c a lc u la te to e v a lu a te a c o m p a n y 's p ro fita b ility ?
5
W h a t ra tio s w o u ld y o u c a lc u la te to e v a lu a te a c o m p a n y 's a c tiv ity o r tu rn o v e r?
6 W h a t ra tio s w o u ld y o u c a lc u la te to e v a lu a te a c o m p a n y 's liq u id ity ? 7
W h a t ra tio s w o u ld y o u c a lc u la te to e v a lu a te a c o m p a n y 's fin a n c ia l structure?
8
E x p la in th e be ne fits o f th e Du Pont system o f ra tio a n a lys is.
9
O u tlin e som e o f th e m a in lim ita tio n s o f ra tio a n a ly s is .
1 0 List th e a d v a n ta g e s a n d d is a d v a n ta g e s y o u c a n see in using ra tio a n a lys is o f fin a n c ia l statem ents as a w a y o f e v a lu a tin g m a n a g e m e n t's p e rfo rm a n c e . For th e d is a d v a n ta g e s , try to th in k o f a w a y a ro u n d e a ch p ro b le m y ou id e n tify . 11 Use n o n -te ch n ic a l la n g u a g e to a n s w e r th e fo llo w in g : a W h a t is fin a n c ia l le ve ra g e ?
b
W h y is such le v e ra g e risky?
c
H o w do es th e Du Pont fo rm u la in c o rp o ra te le ve ra g e ?
12 In this c h a p te r y o u h a ve seen s eve ral type s o f ra tio s used to a n a ly s e fin a n c ia l statem ents a n d in fo rm a tio n , a S elect tw o type s o f ra tio s a n d d e s c rib e w h a t in fo rm a tio n is c o n v e y e d b y e a c h .
b
C a lc u la te ra tio s o f these type s fo r a n y c o m p a n y y o u a re in tere ste d in.
13 W r ite th e ro u g h notes fo r a spee ch y o u h a ve be en a s ke d to g iv e to a lo c a l in ve stm en t c lu b . The m e m b ers o f the c lu b a re a ll e x p e rie n c e d s h a re investors a n d w a n t a be tte r u n d e rs ta n d in g o f c o m p a n ie s ' a c c o u n tin g in fo rm a tio n . The to p ic o f y o u r s pee ch is 'A n a ly s is a n d use o f fin a n c ia l a c c o u n tin g in fo rm a tio n '. 14 A s e n io r m e m b e r o f a la rg e p u b lic c o m p a n y 's m a n a g e m e n t c o m p la in e d : 'A c c o u n ta n ts ' fin a n c ia l a n a lys e s d o n 't seem v e ry useful to m e. The a n a lyse s d o n 't re v e a l th e business m a n a g e m e n t fa cto rs th a t a re im p o rta n t to m y c o m p a n y 's success. T h e y a re b ia s e d to w a rd s th e p a st ra th e r th a n th e fu tu re . A n d , a n y w a y , th e sh a re m a rk e t is w a y a h e a d o f th e a c co u n ta n ts in ju d g in g th e c o m p a n y 's p e rfo rm a n c e .' C o m m e n t on th e m a n a g e r's c o m p la in t. 15 W h y is it tru e th a t c h a n g in g fin a n c ia l a c c o u n tin g a c c ru a ls do e s n o t a ffe c t cash flo w (ig n o rin g a n y ta x effect)? 16 W h y do e s c h a n g in g d e p re c ia tio n m e th o d (i.e . c h a n g in g th e d e p re c ia tio n nu m b ers in th e fin a n c ia l statem ents) c h a n g e th e d e b t-to -e q u ity ra tio ? 1 7 B rie fly e x p la in th e d iffe re n c e s in p ro fit m a rg in , asset tu rn o v e r, a c co u n ts re c e iv a b le tu rn o v e r, in v e n to ry tu rn o v e r a n d a n y o th e r im p o rta n t d iffe re n c e s b e tw e e n a re ta ile r o f fa st-m o vin g c o n s u m e r g o o d s (such as a fo o d re ta ile r), a m a n u fa c tu re r o f c o n s u m e r d u ra b le s (such as w h ite g o o d s ) a n d a m a n u fa c tu re r o r d is trib u to r o f to b a c c o p ro d u cts . 18 E x p la in h o w th e fo llo w in g a re p o ss ib le : a K y lie Lim ited has a h ig h c u rre n t ra tio , b u t has d iffic u lty p a y in g its bills,
b
Jason Lim ited has a h ig h q u ic k ra tio , bu t has d iffic u lty p a y in g its bills,
c
C ra ig Lim ited has a lo w q u ic k ra tio , b u t no d iffic u lty p a y in g its bills.
PROBLEMS PROBLEM 15.1 Common size incom e sta te m e n ts P re p a re a c o m m o n s iz e in c o m e state m e nt fo r W o o lw o rth s Lim ited fo r 2 0 1 4 a n d 2 0 1 3 . Y ou w ill ne ed to use th e d a ta in th e C o n s o lid a te d In co m e S ta tem en t fo r W o o lw o rth s Lim ited as w e ll as th e m o re d e ta ile d in fo rm a tio n p ro v id e d in N o te 2 to th e F in a n c ia l Statem ents. C o m m e n t on a n y s ig n ific a n t c h a n g e s y o u n o tice .
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615
PROBLEM 15.2 Im pact o f tra n sa ctio n s on ratios A n a ly s e th e e ffe c t o f e a ch o f th e fo llo w in g tra n s a c tio n s on th e c u rre n t ra tio , q u ic k ra tio , d e b t-to -e q u ity ra tio a n d e a rn in g s p e r s h a re . A ssum e th a t th e c u rre n t ra tio , q u ic k ra tio a n d d e b t-to -e q u ity ra tio a re e a ch g re a te r th a n 1, a n d th a t e a rn in g s p e r s h a re is p o s itiv e . D e te rm in e if th e ra tio in cre ases, de cre ases o r is u n c h a n g e d . C o n s id e r e a ch tra n s a c tio n in d e p e n d e n tly o f a ll th e o th e r tra n sa ctio n s. 1 P urchased in v e n to ry o f $ 4 8 0 0 0 on c re d it. 2
M a d e re p a y m e n ts o f $ 7 8 0 0 0 on th e long -term lo a n .
3
D e c la re d , b u t d id n o t p a y , a $ 3 1 0 0 0 cash d iv id e n d o n shares.
4
B o rro w e d an a d d itio n a l $ 5 6 0 0 0 on th e long -term lo a n .
5
S old short-term investm ents re c o rd e d in th e b a la n c e sheet a t $ 3 0 0 0 0 fo r $ 3 4 0 0 0 .
6
Issued 1 4 0 0 0 0 shares a t th e b e g in n in g o f th e fin a n c ia l p e rio d fo r cash o f $ 1 6 8 0 0 0 .
7
R eceived $ 6 0 0 0 o w in g in cash fro m a custom er.
8
R e p a id short-term lo a n s p a y a b le o f $ 5 1 0 0 0 .
PROBLEM 15.3 C alculation and in te rp re ta tio n o f ratios D a ta fo r W h ite S ta r Lim ited is as fo llo w s : WHITE STAR LIMITED BALANCE SHEET AS AT 30 JUNE 2016
20 15
$m
$m
50
330
Receivables
540
310
Inventories
450
260
1 040
900
160
140
160
140
1 200
1 040
630
510
15
10
645
520
245
195
Current assets Cash
Total current assets
Noncurrent assets Property, plant and equipment Total noncurrent assets Total assets
Current liabilities Creditors and borrowings Provisions Total current liabilities
Noncurrent liabilities Creditors and borrowings
10
15
Total noncurrent liabilities
Provisions
255
210
Total liabilities
900
730
Net assets
300
310
Shareholders' equity Share capital ($1 ordinary shares)
80
80
Reserves
35
35
Retained earnings
185
195
Total shareholders' equity
300
310
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
A d d itio n a l in fo rm a tio n : N e t o p e ra tin g p ro fit a fte r ta x is $ 2 5 m illio n (2 0 1 5 : $ 3 8 m illio n ). 1 Use th e in fo rm a tio n a b o v e to c a lc u la te fo r 2 0 1 6 a n d 2 0 1 5 : a
w o rk in g c a p ita l
b
c u rre n t ra tio
c
q u ic k ra tio
d
d e b t-to -e q u ity ra tio
e
return on e q u ity ra tio
f
e a rn in g s p e r s h a re ra tio .
2
Id e n tify tw o w a rn in g s ig n a ls th a t c o u ld h a ve n e g a tiv e im p lic a tio n s w ith respe ct to th e c o m p a n y 's a b ility to g e n e ra te cash flo w s to m eet its fu tu re needs. In e a ch case , e x p la in w h y th e s ig n a l y o u h a ve id e n tifie d c o u ld
3
A t th e a n n u a l g e n e ra l m e eting o f W h ite S ta r, th e m a n a g in g d ire c to r, M s Rose D a w s o n , m a d e th e fo llo w in g statem ent: 'R e ce n tly a n u m b e r o f a rtic le s in th e fin a n c ia l press h a ve q u e s tio n e d th e fin a n c ia l p o s itio n o f o u r c o m p a n y . This c ritic is m is to ta lly u n ju s tifie d . N e t p ro fit w a s $ 2 5 m illio n a n d to ta l assets h a ve in c re a s e d b y
re fle c t a cash flo w p ro b le m .
$ 1 6 0 m illio n . These results s h o w th a t 2 0 1 6 w a s a v e ry successful y e a r fo r W h ite S ta r.' C o m m e n t on M s D a w s o n 's statem ent.
PROBLEM 1 5.4 Im pact o f tra n sa ctio n s on ratios W in s le t Lim ited is c o n s is te n tly p ro fita b le . W in s le t's n o rm a l fin a n c ia l state m e nt re la tio n s h ip s a re as fo llo w s : Current ratio
3times
Inventory turnover
4 times
Debt-to-assets ratio
0.5 times
A d d itio n a l in fo rm a tio n : 1 W in s le t d e c la re d , b u t d id n o t p a y , a cash d iv id e n d . 2
C ustom ers re tu rn e d in v o ic e d g o o d s fo r w h ic h th e y h a d n o t p a id .
3
A c co u n ts p a y a b le w e re p a id o n th e last d a y o f th e fin a n c ia l y e a r.
4
W in s le t d e c id e d to re v a lu e la n d it h a d p u rc h a s e d m a n y y e a rs p re vio u s ly .
5
E a rly in th e fin a n c ia l y e a r, W in s le t in cre a s e d th e s e llin g p ric e o f o n e o f its p ro d u cts th a t h a d a d e m a n d in excess o f c a p a c ity . The n u m b e r o f units sold last y e a r a n d this y e a r w a s id e n tic a l.
For e a ch o f th e a b o v e tra n s a c tio n s o r events, d e te rm in e th e e ffe c t on e a ch o f th e ra tio s in th e ta b le a b o v e (in cre ase , d e cre a s e , no effect).
PROBLEM 15.5 Examine com ponents o f the re tu rn on assets ratio In fo rm a tio n ta ke n fro m th e recen t a n n u a l re p o rts o f tw o re ta il c o m p a n ie s a p p e a rs b e lo w (am ou nts in m illio n s). O n e o f these c o m p a n ie s is a d is c o u n t c h a in store a n d th e o th e r is a s p e c ia lty re ta ile r o f fa s h io n clothes.
Sales Interest expense Net profit before tax Total assets
Company X
Company Y
$m
$m
4069
4 130
42
18
245
168
2 061
1 149
W h ic h c o m p a n y is lik e ly to be th e d is c o u n t c h a in store? B rie fly e x p la in y o u r a n s w e r.
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PROBLEM 1 5.6 C alculate ra tio s and com m ent on perform ance JRP Ltd is a m a il-o rd e r business s e llin g a v a rie ty o f c o n s u m e r p ro d u cts . A t th e e n d o f 2 0 1 5 , its m a jo r s h a re h o ld e r in s tig a te d c h a n g e s in m a n a g e m e n t in o rd e r to im p ro v e p e rfo rm a n c e . The fin a n c ia l statem ents fo r th e y e a rs e n d in g 3 0 June 2 0 1 5 a n d 2 0 1 6 a re s h o w n b e lo w . INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE
Sales
9 000
8 125
Less: COGS
6 300
5 687
Gross profit
2 700
2 438
1 260
1 382
Less: Expenses: Selling and administration Interest charges
4 00
256
Profit before tax
1 040
800
Less: Tax
140
150
Net profit after la x
900
650
BALANCE SHEET AS AT 3 0 JUNE 2016
2015
$0 00
$0 00
2 400
750
Current assets Inventory Accounts receivable
1 650
1 500
Total current assets
4050
2 250
Land and buildings
3 750
3015
Machinery
1 200
1 010
Total assets
9 000
6 275
800
275
1 700
600
200
250
2 700
1 125
3 950
2 000
Share capital
1 000
1 000
Retained earnings
1 350
2150
Total shareholders' equity
2 350
3 150
Total shareholders' equity and liabilities
9000
6275
Noncurrent assets (at net book value)
Current liabilities Bank overdraft Accounts payable Provision for employee entitlements
Total current liabilities Noncurrent liabilities Bonds
Shareholders' equity
618
1
2
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C a lc u la te th e fo llo w in g ratios: a
return on assets (using EBIT)
b
asset tu rn o v e r
c
p ro fit m a rg in
d
return on s h a re h o ld e rs ' e q u ity
e
c u rre n t
f
q u ic k asset
g
in v e n to ry tu rn o v e r
h
d a y s in in v e n to ry
i
d e b to rs tu rn o v e r
j
d a y s in d e b to rs
k
d e b t-to -e q u ity
I
in tere st c o v e ra g e .
C o m m e n t on th e c o m p a n y 's p e rfo rm a n c e , in d ic a tin g a n y ch a n g e s y o u w o u ld suggest.
PROBLEM 15.7 Use o f ratios C o m p a ra tiv e b a la n c e sheets a n d in c o m e statem ents fo r E -W orths Lim ited a re g iv e n b e lo w . E-WORTHS LIMITED BALANCE SHEETS AS AT 3 0 JUNE 2 $ Current assets Cash Receivables Inventories Other
Total current assets
41
43
79
74
210
203
4
5
334
325
Noncurrent assets Property, plant and equipment
160
141
Total assets
494
466
Creditors and borrowings
77
64
Provisions
40
30
117
94
Loan
140
140
Total liabilities
257
234
N et assets
237
232
90
90
115
115
32
27
237
232
Current liabilities
Total current liabilities Noncurrent liabilities
Shareholders' equity Share capital Reserves Retained earnings
Total shareholders' equity
CHAPTER 15 Financial statem ent analysis
—
619
E-WORTHS LIMITED INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE
Sales
2015 $000
790
773
Less: COGS
(494)
(456)
Gross profit
296
317
Less: Administrative and selling expenses
(220)
(241)
Less: Interest expense
J15)
J14)
Operating profit before income tax
61
62
Income tax expense
(30)
(32)
Operating profit after income tax
31
30
D u rin g th e y e a r e n d e d 3 0 June 2 0 1 6 , E -W orths Lim ited d e c la re d a n d p a id d iv id e n d s o f $ 2 6 0 0 0 . O n 3 0 June 2 0 1 6 , th e m a rke t p ric e p e r s h a re w a s $ 2 .7 0 a n d 9 0 0 0 0 shares w e re on issue. 1
A ssum e y ou a re a b a n k e r e v a lu a tin g a request fo r a short-term lo an fro m E -W orths Lim ited. The c o m p a n y w o u ld like to b o rro w on 1 July 2 0 1 6 a n d re p a y on 31 D e ce m b e r 2 0 1 6 . N a m e a n d c a lc u la te th ree 2 0 1 6 ratios th a t you w o u ld use to d e te rm in e the lik e lih o o d th a t the c o m p a n y w ill be a b le to m a ke th e lo an re p a y m e n t w h e n it fa lls du e.
2
A ssum e y o u a re a p o te n tia l in ve sto r e v a lu a tin g a sh a re p u rch a s e in E -W o rth s Lim ited. Y ou a re lo o k in g fo r an in ve stm en t th a t w ill p ro v id e a s te a d y stream o f d iv id e n d in co m e o v e r th e y e a rs . N a m e a n d c a lc u la te th re e 2 0 1 6 ra tio s th a t y o u w o u ld use to m a ke y o u r d e c is io n a b o u t w h e th e r to b u y shares in E -W o rth s Lim ited.
3
List a n d b rie fly e x p la in th re e d is a d v a n ta g e s o f b a s in g y o u r d e cisio n s s o le ly on ra tio a n a ly s is .
4
List o th e r to o ls th a t an a lys ts a n d o th e r users o f fin a n c ia l statem ents m ig h t use to o v e rc o m e th e lim ita tio n s a s s o c ia te d w ith th e use o f ra tio s a lo n e .
PROBLEM 1 5 .8 Explain reasons For changes in ratios The fo llo w in g is a s u m m a ry o f th e in fo rm a tio n in th e fin a n c ia l statem ents o f A B C Ltd fo r th e y e a rs 2 0 1 5 a n d 2 0 1 6 . 2015 $000 Current assets
50
100
Noncurrent assets
350
200
Total assets
400
300
Current liabilities
50
50
Noncurrent liabilities
210
150
Shareholders' equity
140
100
Total liabilities and shareholders' equity
400
300
Sales
800
750
Expenses
752
720
48
30
Net profit (before interest and tax) Interest
13
10
Tax payable
14
8
Net profit after lax
21
12
620
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The m a n a g e r o f A B C Ltd has g iv e n th e fo llo w in g in fo rm a tio n re la tin g to th e firm :
Return on assets (using EBIT)
2016
20 15
%
%
12
10
Current ratio
100
200
Quick asset ratio
100
100
Debt-to-assets ratio
65
66.7
During 2016, land that cost $ 5 0 0 0 0 was revalued to $ 9 0 0 0 0
1
S u g g e st p o ss ib le reasons fo r th e c h a n g e in R O A .
2
C o m m e n t on th e ch a n g e s in liq u id ity d u rin g th e p e rio d .
3
W h a t c h a n g e s h a ve ta ke n p la c e in th e firm 's long -term fin a n c ia l p o s itio n d u rin g th e p e rio d ?
4
W h y d o e s a g re a t d e a l o f c a re ne ed to b e ta ke n in th e use a n d in te rp re ta tio n o f fin a n c ia l ratios?
PROBLEM 15.9 E ffe ct o f tra n sa ctio n s on ROA and ROE State w h e th e r th e fo llo w in g tra n sa ctio n s w o u ld a ffe c t R O A (using EBIT; p re se n tly 1 0 p e r cent), ROE (p re se n tly 1 5 p e r cent), b o th o r ne ith er: 1 asset re v a lu a tio n u p w a rd s
2
in cre a s e in in tere st exp e n se
3
in cre a s e in d e p re c ia tio n expenses
4
p u rch a s e n e w e q u ip m e n t fo r cash (ig n o re d e p re c ia tio n effects)
5
issue bo nu s shares
6
issue o rd in a ry shares to p a y o ff a lo an
7
in cre a s e th e p ro v is io n fo r lo n g s ervice le ave
8
p u rch a s e e q u ip m e n t on c re d it (ig n o re d e p re c ia tio n ).
PROBLEM 15.10 E ffe ct o f tra n sa ctio n s on ratios Fad Foods Ltd c o m p le te d a series o f tra n sa ctio n s, w h ic h a re listed b e lo w . B efore th e tra n s a c tio n s , bo th th e c u rre n t a n d q u ic k asset ra tio s w e re g re a te r th a n 1. The cash a c c o u n t has a d e b it b a la n c e . In d ic a te th e e ffe c t o f e a ch o f th e tra n s a c tio n s listed b e lo w on th e ra tio listed o p p o s ite it. For e a ch tra n s a c tio n , state w h e th e r th e ra tio w o u ld in cre a s e , d e c re a s e o r h a ve no effect. T re a t e a ch tra n s a c tio n in d e p e n d e n tly . Transaction
Ratio
1
Redeemed debentures by issuing ordinary shares
Return on equity
2
Purchased inventory on credit
Quick ratio
3
Sold inventory for cash with a 40 per cent mark-up on cost
Current ratio
4
Issued additional ordinary shares for cash
Debt-to-equity ratio
5
Collected an account receivable balance
Debtors turnover
6
Paid accounts payable
Return on assets
7
Paid accounts payable
Profit margin
CHAPTER 15 Financial statem ent analysis
621
PROBLEM 15.11 E ffe ct o f tra n sa ctio n s on ratios In d ic a te th e effects (in cre a se , d e c re a s e o r n o effect) o f e a ch o f th e fo llo w in g in d e p e n d e n t tra n s a c tio n s o n : 1 th e ra te o f return on s h a re h o ld e rs ' e q u ity
2 th e c u rre n t ra tio 3
th e d e b t-to -e q u ity ra tio .
State a n y ne ce ssary assu m p tio n s.
a
In ve n to ry c o stin g $ 4 1 0 0 0 0 is p u rc h a s e d on a c c o u n t,
b
In ve n to ry c o stin g $ 2 4 0 0 0 0 is s o ld on a c c o u n t fo r $ 3 0 0 0 0 0 .
c
C o lle c tio n s fro m custom ers on a c co u n ts re c e iv a b le to ta l $ 1 0 0 0 0 0 .
d
Paym ents to s u p p lie rs on a c co u n ts p a y a b le to ta l $ 1 6 0 0 0 0 .
e
A m a c h in e c o stin g $ 8 0 0 0 0 , on w h ic h $ 6 0 0 0 0 o f d e p re c ia tio n w a s c h a rg e d , is s o ld fo r $ 2 0 0 0 0 .
f
D iv id e n d s o f $ 8 0 0 0 0 a re d e c la re d . The d iv id e n d s w ill be p a id d u rin g th e n e xt a c c o u n tin g p e rio d ,
g
O rd in a ry shares a re issued fo r $ 1 7 5 0 0 0 .
h
A m a c h in e c o stin g $ 6 0 0 0 0 is a c q u ire d . C a s h o f $ 1 0 0 0 0 is g iv e n , a n d a no te fo r $ 5 0 0 0 0 p a y a b le five y e a rs fro m n o w is s ig n e d fo r th e b a la n c e o f p u rch a s e p ric e .
PROBLEM 15.12 E tte ct o f tra n sa ctio n s on ratios M a n a g e m e n t is in tere ste d in w h a t w o u ld h a ve been th e im p a c t on net p ro fit b e fo re ta x fo r th e y e a r e n d e d 3 0 June 2 0 1 6 a n d cash flo w fro m o p e ra tio n s fo r th e y e a r e n d e d 3 0 June 2 0 1 6 a n d th e c u rre n t ra tio a t 3 0 June 2 0 1 6 (p re se n tly 2 :1 ) if e a ch o f th e fo llo w in g tra n s a c tio n s h a d o c c u rre d in June 2 0 1 6 . To a n s w e r this q u e s tio n fo r e a ch o f th e e ig h t tra n s a c tio n s b e lo w , state 'in c re a s e ', 'd e c re a s e ' o r ' N / E ' (no effect). 1 P urchase in v e n to ry o n c re d it.
2
Sell g o o d s on c re d it w ith 5 0 p e r c e n t m a rk-u p o n cost.
3
R ecog nise a c c ru e d reven ue o f $1 8 0 0 0 .
4
C a p ita lis e resea rch a n d d e v e lo p m e n t costs th a t h a d be en tre a te d as a n e xpe nse.
5
Sell e q u ip m e n t w ith a b o o k v a lu e o f $ 5 0 0 0 0 (cost $ 1 8 0 0 0 0 ) fo r $ 1 6 0 0 0 0 .
6
In crea se th e a llo w a n c e fo r d o u b tfu l d e b ts b y $ 2 0 0 0 0 .
7
R eceive a d e p o s it o f $ 1 0 0 0 0 o n a jo b th a t w ill b e c o m m e n c e d in th e ne xt fin a n c ia l y e a r.
8
D e p re c ia te e q u ip m e n t o v e r a sh o rte r p e rio d .
PROBLEM 15.13 Evaluating fin a n cia l ratios C o m p a ra tiv e b a la n c e sheets a n d in c o m e statem ents fo r S tra d b ro k e Ltd a re g iv e n b e lo w . STRADBROKE LTD COMPARATIVE BALANCE SHEETS AS AT 31 DECEMBER 2 0 1 5 AN D 20 16 2016
20 15
$
$
Assets Current assets: Cash at bank
40000
36000
Marketable securities
42 000
50000
Accounts receivable (net)
158000
148 00 0
Inventory
420000
406000
Prepaid expenses
4000
1 0000
668000
650000
622
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Noncurrent assets: Plant and equipment Total assets
320000
282000
988000
932000
154000
128000
80000
60000
234000
186000
Liabilities Current liabilities Accounts payable Bills payable
Noncurrent liabilities Debentures
280000
280000
Total liabilities
514000
468000
Net assets
474000
464000
Shareholders' equity Preference capital Ordinary share capital Retained earnings
Total shareholders' equity
80000
80000
330000
330000
64000
54000
474000
464000
STRADBROKE LTD COMPARATIVE INCOME STATEMENTS FOR THE YEARS ENDED 31 DECEMBER 20 15 A ND 2 0 1 6
Sales revenue Less: COGS Gross profit Operating expenses Interest expense Total expenses Operating profit before income tax
2016
20 15
$
$
1580000
1 546000
988000
912000
592000
634000
440000
482000
30000
28 000
470000
510000
122000
124000
Income tax expense
60000
64000
Operating profit after income tax
62 000
60000
D u rin g 2 0 1 6 , S tra d b ro k e Ltd d e c la re d a n d p a id p re fe re n c e d iv id e n d s o f $ 5 6 0 0 a n d o rd in a ry d iv id e n d s o f $ 4 6 4 0 0 . O n 31 D e c e m b e r 2 0 1 6 , th e m a rke t p ric e p e r o rd in a ry s h a re w a s $ 5 .4 0 . 1 A ssum e y o u a re a b a n k e r e v a lu a tin g a req ue st fo r a short-term lo a n fro m S tra d b ro k e Ltd. The c o m p a n y w o u ld like to b o rro w o n 1 J a n u a ry 2 0 1 6 , w ith re p a y m e n t on 3 0 June 2 0 1 6 . N a m e a n d c a lc u la te th re e 2 0 1 6 ra tio s th a t y o u w o u ld use to d e te rm in e th e lik e lih o o d th a t the c o m p a n y w ill be a b le to m a ke th e lo a n re p a y m e n t w h e n it fa lls d u e . 2
A ssum e y o u a re a p o te n tia l in ve sto r e v a lu a tin g a sh a re p u rc h a s e in S tra d b ro k e Ltd. Y ou a re lo o k in g fo r an in ve stm en t th a t w ill p ro v id e a s te a d y stream o f d iv id e n d in co m e o v e r th e y e a rs . N a m e a n d c a lc u la te th re e 2 0 1 6 ra tio s th a t y o u w o u ld use to m a ke y o u r d e c is io n a b o u t w h e th e r to b u y shares in S tra d b ro k e Ltd.
3
List a n d b rie fly e x p la in th re e d is a d v a n ta g e s o f b a s in g y o u r d e c is io n s s o le ly on ra tio a n a lys is.
CHAPTER 15 Financial statem ent analysis
623
PROBLEM 15.14 A cco u n tin g p o lic y choice S w a ffle Ltd, in business fo r o n ly a y e a r, has c a p ita lis e d $ 5 0 0 0 0 in s o ftw a re d e v e lo p m e n t costs. The c o n tro lle r a rg u e s th a t th e costs sh o u ld be e x p e n s e d in ste a d . A ssum e th a t th is c h a n g e in p o lic y w ill in flu e n c e th e c o m p a n y 's ta x lia b ility . The c o m p a n y has a m a rg in a l ta x ra te o f 3 0 p e r c e n t o f p ro fits b e fo re ta x . H o w w o u ld th e c o n tro lle r's p ro p o s a l im p a c t on th e fo llo w in g ratios? 1 Return o n e q u ity (p re se n tly 2 0 p e r cent). 2
C u rre n t ra tio (p re se n tly 2 :1 ).
PROBLEM 15.15 Financial sta te m e n t analysis Y ou a re in tere ste d in th e shares o f Ittelson Pty Ltd. B efore in ve stin g , y o u w a n t to le a rn as m uch as p o ss ib le a b o u t the c o m p a n y . H o w e v e r, a ll y o u h a ve is a s u m m a ry o f ra tio s fo r th e c o m p a n y th a t y o u m a n a g e d to fin d on its w e b s ite : Year 1
Year 2
Sales growth
100.0
115.0
128.0
Current ratio
2.2:1
2.3:1
2.5:1
1
Acid-test (quick) ratio Accounts receivable turnover Inventory turnover
Year 3 1
1.1:1
0.9:1
0.8:1
12.5 times
10.6 times
9.4 times
8.0 times
7.2 times
6.5 times
5.8%
6.5%
7.1%
Dividend yield Dividend payout ratio
60%
50%
40%
Return on total assets
9.5%
11.0%
12.5%
7.8%
10.0%
14.0%
$1.50
$1.50
$1.00
Return on equity Dividends paid per share*
* Number of shares outstanding has not changed over the three-year period.
1
Is it b e c o m in g e a s ie r fo r th e c o m p a n y to p a y its bills as th e y fa ll du e?
2
A re custom ers p a y in g th e ir a c co u n ts a t le ast as fa st as th e y w e re in Y e a r 1 ?
3
Is th e level o f in v e n to ry in c re a s in g , d e c re a s in g o r s ta y in g th e sam e?
4
Is th e c o m p a n y 's s h a re p ric e g o in g up o r g o in g d o w n ?
5
Is th e a m o u n t o f e a rn in g s p e r sh a re in c re a s in g o r d e c re a s in g ?
6
Is th e p rice -to -e a rn in g s ra tio g o in g up o r g o in g d o w n ?
7
Is th e c o m p a n y e m p lo y in g fin a n c ia l le v e ra g e to th e a d v a n ta g e o f th e s h a re h o ld e r?
PROBLEM 15.16 Financial sta te m e n t analysis The fo llo w in g ra tio s d e s c rib e th e p e rfo rm a n c e o f R atio Ltd fo r 2 0 1 5 a n d 2 0 1 6 : Ratio
V( 2
Debt-to-equity ratio
1.36 times
1.86 times
Inventory turnover
6.70 times
8.00 times
Quick ratio
0.91 times
0.70 times
63.2%
65.0%
2.8 times
2.00 times
Gross margin Interest coverage
»
624
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Current ratio Receivables turnover
2
1.29 times
7.3 times
7.5 times
54.5 days
4 5.6 days
Return on assets
13.24%
14.40%
Return on equity
38.43%
34.97%
Days inventory on hand
1
1.89 times
C la s s ify these ra tio s in to th ose re la tin g to: a
p ro fita b ility
b
liq u id ity a n d so lve n cy
c
fin a n c in g
d
a c tiv ity .
Based on th e ra tio v a lu e s s u p p lie d , c o m m e n t on th e c o m p a n y 's p e rfo rm a n c e in 2 0 1 6 in e a ch o f th e fo llo w in g c a te g o rie s : a
p ro fita b ility
b
liq u id ity a n d so lve n cy
c
fin a n c in g
d
a c tiv ity .
In a d d itio n , note th e lim ita tio n s o f co n c lu sio n s d ra w n fro m th e p ro v id e d in fo rm a tio n , a n d in d ic a te w h a t o th e r in fo rm a tio n w o u ld be h e lp fu l in assessing th e c o m p a n y 's p e rfo rm a n c e . 3
4
5
E x p la in th e fo llo w in g : a
W h y d o th e return on assets a n d return on e q u ity ra tio s d iffe r?
b
W h y w o u ld th e return on assets ra tio be c a lc u la te d if y o u h a d a lre a d y c a lc u la te d th e return on e q u ity ra tio ? (You m a y fin d it h e lp fu l to c o n s id e r h o w these ra tio s a re c a lc u la te d .)
C o n s id e r th e in v e n to ry tu rn o v e r ra tio a n d th e d a ys in v e n to ry o n h a n d ra tio : a
W h a t in fo rm a tio n d o these ra tio s p ro v id e ?
b
From th e v ie w p o in t o f m a n a g e m e n t, w h a t a re th e lim ita tio n s re la tin g to these ratios?
D u rin g 2 0 1 6 , th e c h ie f fin a n c ia l o ffic e r (C FO ) o f R atio Ltd e m p lo y e d a n in d e p e n d e n t v a lu e r to assess th e c u rre n t v a lu e o f th e la n d a n d b u ild in g s o w n e d b y th e c o m p a n y . The v a lu e r h a d a d v is e d th e C F O th a t th e v a lu e o f the la n d a n d b u ild in g s h a d in cre a s e d b y $ 5 0 0 0 0 (1 0 p e r cent). A ssum e th a t th is in cre a s e d v a lu e is re fle c te d in the ra tio s p ro v id e d in th e firs t h a lf o f this c h a p te r. E x p la in h o w th is a c c o u n tin g p o lic y c h o ic e w o u ld h a ve a ffe c te d e a ch o f th e ratios.
PROBLEM 15.17 Financial sta te m e n t analysis The a v e ra g e in v e n to ry tu rn o v e r o f A Ltd w a s 3 . 7 9 in 2 0 1 5 a n d th e a v e ra g e d a y 's in v e n to ry on h a n d 2 0 1 6 w a s 1 4 0 .6 . 1 E x p la in th e p u rp o s e o f c a lc u la tin g th e in v e n to ry tu rn o v e r ra tio .
2
E x p la in w h a t an in v e n to ry tu rn o v e r ra tio o f 3 . 7 9 m eans.
3
Is th e 2 0 1 6 in v e n to ry tu rn o v e r ra tio fo r A Ltd an im p ro v e m e n t on th e 2 0 1 5 in v e n to ry tu rn o v e r ra tio ?
4
W h a t fa c to rs sh o u ld m a n a g e m e n t c o n s id e r w h e n in te rp re tin g these fig u re s?
PROBLEM 15.18 Use s ta te m e n t analysis to evaluate a general m anager's claim s The g e n e ra l m a n a g e r o f a m e d iu m -s iz e d m a n u fa c tu rin g c o m p a n y w a n ts to re n e w th e c o m p a n y 's o p e ra tin g lo a n . In discussions w ith th e b a n k 's le n d in g o ffic e r, th e g e n e ra l m a n a g e r says: 'A s th e a c c o m p a n y in g fin a n c ia l statem ents s h o w , o u r w o rk in g c a p ita l p o s itio n has im p ro v e d d u rin g th e p a st y e a r, a n d w e h a ve m a n a g e d to re d u c e o p e ra tin g expe nses s ig n ific a n tly .'
CHAPTER 15 Financial statem ent analysis
The p a rtia l fin a n c ia l statem ents a re s h o w n b e lo w . 2016
20 15
$
$
50000
200000
Current assets Cash Accounts receivable
250000
100000
Inventories
500000
400000
Total current assets
800000
700000
250000
200000
Current liabilities Accounts payable Operating loan
100000
100000
Total current liabilities
350000
300000
TITAN MANUFACTURING LTD INCOME STATEMENT FOR THE YEARS ENDED 31 DECEMBER 2 0 1 6 A ND 2015 2016
Sales
20 15
$
$
1 200000
1500000
Less COGS
780000
900000
Gross profit
420000
600000
Operating expenses
350000
400000
Profit before taxes
70000
200000
Income taxes
14000
40000
N et profit
56000
160000
1
E v a lu a te th e g e n e ra l m a n a g e r's c om m en ts. In c o rp o ra te a p p ro p ria te ra tio a n a lys is in y o u r disc u s sio n .
2
W h a t a d d itio n a l fin a n c ia l in fo rm a tio n (if a n y) w o u ld y o u re q u e st fro m th e g e n e ra l m a n a g e r? W h y ?
PROBLEM 15.19 In te rp re ta tio n o f discussion and analysis The fo llo w in g is a n e x tra c t fro m th e D iscussion a n d a n a lys is o f th e fin a n c ia l statem ents o f M a n u fa c tu re r Lim ited. W O RKING CAPITAL Manufacturer's days working capital in 2 0 1 6 w as 7 9 .8 days compared to 8 4 .6 days in 2 0 1 5 . This comprised the following: 2016
20 15
Inventory days held
63.8
66.5
Days sales outstanding
59.5
62.2
Days payable outstanding
43.5
44.1
E x p la in th e c o n te n t o f th e a b o v e e x tra c t a n d its im p lic a tio n s .
625
626
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1 5 .2 0 Use ra tio s to evaluate relative perform ance A frie n d has a s ke d y o u to e v a lu a te in fo rm a tio n a b o u t tw o c o m p a n ie s in th e sam e in d u stry . Y o u r frie n d w a n ts to invest in o n e o r th e o th e r, b u t no t b o th . Both c o m p a n ie s a re p u b lic ly tra d e d , starte d w ith $ 1 0 0 0 0 o f c a sh , ha ve be en in o p e ra tio n fo r e x a c tly o n e y e a r, h a ve p a id th e in tere st o w in g on th e ir long -term d e b ts to d a te , a n d ha ve d e c la re d d iv id e n d s o f $ 1 p e r share . The b e g in n in g b a la n c e sheets fo r th e tw o c o m p a n ie s a t 1 J a n u a ry 2 0 1 6 w e re as fo llo w s : 1 Alpha Company
$
Total assets
10000
Long-term debt
1 000
Shareholders' equity
Omega Company
$
Total assets
1 0000
Long-term debt
9 000
Shareholders' equity
(900 ordinary shares issued) Total assets
9 000 10000
Net profit for 2016
2 400
(100 ordinary shares issued)
1 000
Total assets
1 0000
Net profit for 2016
1 600
Y o u r frie n d says, 'A lp h a C o m p a n y seem s th e be tte r investm ent. Its return on assets is 2 4 p e r cent, a n d O m e g a 's is o n ly 1 6 p e r c e n t.' C o m m e n t o n y o u r frie n d 's o b s e rv a tio n a n d th e re la tiv e p e rfo rm a n c e o f th e c o m p a n ie s . A ls o , g iv e y o u r frie n d som e in ve stm en t a d v ic e .
PROBLEM 15.21 Perform ance evaluation using ratios In te rn a tio n a l Business C o m p u te rs (IBC) has e n jo y e d m o d e st success in p e n e tra tin g th e p e rs o n a l c o m p u te r m a rke t since it b e g a n o p e ra tio n s a fe w y e a rs a g o . A n e w c o m p u te r lin e in tro d u c e d re c e n tly has be en re c e ive d w e ll b y the g e n e ra l p u b lic . H o w e v e r, th e g e n e ra l m a n a g e r, w h o is w e ll ve rse d in e le c tro n ic s b u t n o t in a c c o u n tin g , is w o rrie d a b o u t th e fu tu re o f th e c o m p a n y . The c o m p a n y 's o p e ra tin g lo a n is a t its lim it a n d m o re cash is n e e d e d to c o n tin u e o p e ra tio n s . The b a n k w a n ts m o re in fo rm a tio n b e fo re it e xte n d s th e c o m p a n y 's c re d it lim it. The g e n e ra l m a n a g e r has a s ke d y o u , as fin a n c ia l c o n tro lle r, to d o a p re lim in a ry e v a lu a tio n o f th e c o m p a n y 's p e rfo rm a n c e , using a p p ro p ria te fin a n c ia l statem ent a n a ly s is , a n d to re c o m m e n d p o ss ib le courses o f a c tio n fo r th e c o m p a n y . The g e n e ra l m a n a g e r p a rtic u la rly w a n ts to k n o w h o w th e c o m p a n y c a n o b ta in a d d itio n a l cash . Use th e s u m m a ry fin a n c ia l in fo rm a tio n s h o w n b e lo w to d o y o u r e v a lu a tio n a n d m a ke y o u r re c o m m e n d a tio n s . INTERNATIONAL BUSINESS COMPUTERS BALANCE SHEET AS AT 31 DECEMBER
Current assets Cash
19
24
50
Marketable securities
37
37
37
Accounts receivable (trade)
544
420
257
Inventory
833
503
361
1 433
984
705
Total current assets
»
CHAPTER 15 Financial statem ent analysis
' >' >
Noncurrent assets Land
200
200
100
Buildings
350
350
200
Equipment
950
950
700
1 500
1 500
1 000
Less: Accumulated depreciation: buildings and equipment
(447)
(372)
(288)
Net noncurrent assets
1 053
1 128
712
Total assets
2 486
2112
1 41 7
Bank loan
825
570
-
Accounts payable (trade)
Current liabilities
300
215
144
Other liabilities
82
80
75
Income tax payable
48
52
50
1 255
917
269
1 000
1 000
1 000
231
195
148
Total shareholders' equity
1 231
1 195
1 148
Total liabilities and shareholders' equity
2 486
2112
1 41 7
Total current liabilities Shareholders' equity Share capital Retained earnings
INTERNATIONAL BUSINESS COMPUTERS INCOME STATEMENT FOR THE YEARS ENDED 31 DECEMBER
O th e r re la te d in fo rm a tio n in c lu d e d in to ta l expe nses: 2
2
$
$
Interest expense
89
61
-
Income tax expense
95
102
97
INTERNATIONAL BUSINESS COMPUTERS NOTE SH O W IN G CHANGES IN RETAINED EARNINGS FOR THE YEARS ENDED 31 DECEMBER i
ii
" i;i
iTi ; h
Opening retained earnings
195
148
96
Add: Net profit
116
117
112
Less: Dividends Closing retained earnings
80
70
60
231
195
148
627
628
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 1 5 .2 2 Inve n to ry valuation, depreciation and ra tio s Jeans F' A ll a n d Jeans 'R ' Us a re v e ry s im ila r c o m p a n ie s in s iz e a n d o p e ra tio n . Jeans F' A ll uses FIFO a n d the s tra ig h t-lin e d e p re c ia tio n m e th o d a n d Jeans 'R ' Us uses LIFO a n d d im in is h in g v a lu e d e p re c ia tio n . Id e n tify w h ic h c o m p a n y w ill re p o rt th e h ig h e r n u m b e r fo r e a ch o f th e fo llo w in g ra tio s : 1 c u rre n t ra tio
2
in v e n to ry tu rn o v e r
3
p ro fit m a rg in
4
return o n assets. State a n y a ssu m p tio n s y o u ne ed to m a ke in a n s w e rin g this q u e s tio n .
PROBLEM 1 5 .2 3 in d u s try -s p e c ific ratios A v a ila b le seat kilo m e tre s is a c o m m o n m e asure o f p ro d u c tiv ity in th e a irlin e in d u stry . C o s t to in c o m e ra tio s a re a key m easure o f c o m p a ris o n a c ro s s th e b a n k in g in d u stry . Sales p e r s ta ff m e m b e r o f s q u a re m etre o f a v a ila b le s p a c e a re used to c o m p a re p e rfo rm a n c e in re ta il. P atient to s ta ff ra tio s a re in c lu d e d in state g o v e rn m e n t e n te rp ris e b a rg a in in g a g re e m e n ts as p a rt o f c o n d itio n s o f e m p lo y m e n t fo r nurses. 1 C h o o s e an in d u stry a n d resea rch (or de sig n ) som e ra tio s w h ic h c o u ld be used to m easure a n d c o m p a re p e rfo rm a n c e in th a t in d u stry. 2
W h y d o so m e in d u strie s use ra tio s o u ts id e those w e h a ve c o v e re d in this c h a p te r to m easure a n d assess o rg a n is a tio n a l p e rfo rm a n c e ?
CASES CASE 15A
Woolworths' and Wesfarmers' ratios
In C h a p te r 1 5 , w e h a ve c o n s id e re d W o o lw o rth s Lim ited in d e ta il. W o o lw o rth s has a re p u ta tio n o f b e in g a d e fe n sive stock w ith be tte r th a n a v e ra g e p ro fit g ro w th a n d s te a d ily in c re a s in g returns to investors. The s u p e rm a rk e t re ta il in d u stry in A u s tra lia is d o m in a te d b y W o o lw o rth s a n d its key c o m p e tito r, C o le s S u p e rm a rke ts (w ho se p a re n t c o m p a n y is W e s fa rm e rs Lim ited). In th e last fe w y e a rs C o le s S u p e rm a rke ts has e m e rg e d as a re in v ig o ra te d c o m p e tito r to W o o lw o rth s , w ith in ve stm en t in n e w stores a n d a stro n g b ra n d in g c a m p a ig n (you m a y be fa m ilia r w ith th e 'D o w n D o w n ' jin g le ). 1 O b ta in th e W e s fa rm e rs a n n u a l re p o rt fo r 2 0 1 4 . R ead som e b a c k g ro u n d a b o u t W e s fa rm e rs (the m a n a g in g d ire c to r's re p o rt is a g o o d p la c e to start) a n d id e n tify th e o p e ra tin g d iv is io n s o f W e s fa rm e rs . H o w a re th e y s im ila r to W o o lw o rth s ' a n d h o w a re th e y d iffe re n t fro m W o o lw o rth s '? 2
The in c o m e state m e nt is o n p a g e 1 0 4 a n d b a la n c e shee t is o n p a g e 1 0 6 . U sing this in fo rm a tio n , c a lc u la te the ra tio s listed in E x h ib it 15 .1 fo r W e s fa rm e rs fo r 2 0 1 3 a n d 2 0 1 4 .
3
C o m m e n t on p ro fita b ility , a c tiv ity , liq u id ity a n d fin a n c in g fo r W e s fa rm e rs .
4
C o m p a re y o u r assessm ent o f W e s fa rm e rs on e a ch o f these a ttrib u te s w ith th e W o o lw o rth s ra tio s c a lc u la te d in this C h a p te r.
CHAPTER 15 Financial statem ent analysis
629
CASE 15B__________________________ Financial statem ent analysis A s a s e n io r in ve stm en t a n a lys t, y o u h a ve been a n a ly s in g fin a n c ia l results o f C R e ta il Ltd fo r th e last fe w y e a rs . The fo llo w in g ta b le c o m p ris e s a s u m m a ry o f th e fin a n c ia l results fo r C R e ta il Ltd. CRETAIL 2016
I
2014
20 15
Income statement S ales O th e r in c o m e COGS G ro s s p ro fit EBIT Intere st e x p e n s e
3 4 2 1 2 .0
3 3 0 1 8 .0
3 2 2 6 6 .8
9 1 .8
7 1 .9
0 .0
(2 6 1 6 0 .8 )
(2 5 3 0 5 . 3 )
(2 4 0 5 9 .5 )
8 1 4 3 .0
7 7 8 4 .6
8 2 0 7 .3
8 5 0 .9
1 0 2 7 .2
8 8 8 .1
(9 8 .9 )
(5 5 .2 )
( 1 3 .5 )
N PBT
7 5 2 .0
9 7 2 .0
8 7 4 .6
T ax expense
( 2 1 5 .6 )
( 2 8 5 .9 )
( 2 5 8 .1 )
N P A T c o n tin u in g o p e ra tio n s
5 3 6 .4
6 8 6 .1
6 1 6 .5
P ro fit fro m d is c o n tin u e d o p e ra tio n s
6 2 7 .2
N P A T a ttrib u ta b le to s h a re h o ld e rs P ro fo rm a N P A T
0 .0
(4 8 .2 )
1 1 6 3 .6
6 3 7 .9
6 1 6 .5
7 8 6 .6
6 9 2 .0
5 7 6 .0
S a le s g ro w th
3 .6 2 %
2 .3 3 %
1 9 .4 3 %
G ro s s p r o fit g ro w th
4 .6 0 %
2 5 .1 5 %
1 0 .9 4 %
2 3 .5 3 %
2 3 .3 6 %
2 5 .4 4 %
1 .5 7 %
2 .0 8 %
1 .9 1 %
1 .5 7 %
2 .0 8 %
1 .9 1 %
G ro s s m a rg in N e t p r o fit m a rg in
Du Pont analysis N e t p r o fit m a rg in A s s e t tu rn o v e r
3 . 7 5 tim e s
3 . 5 8 tim e s
3 . 5 7 tim e s
L e v e ra g e
2 . 5 4 tim e s
2 . 7 0 tim e s
2 .2 1 tim e s
1 4 .9 1 %
2 0 .0 9 %
1 5 .1 0 %
ROE
1
C o m m e n t on th e sales g ro w th o f C R e ta il Ltd fo r th e last th re e y e a rs . Discuss a n y issues o f c o n c e rn .
2
C o n s id e r th e gro ss p ro fit g ro w th a n d gross m a rg in fo r C R e ta il Ltd in 2 0 1 5 . Discuss a n y issues o f c o n c e rn .
3
If y o u w e re p a rt o f th e C R e ta il m a n a g e m e n t in 2 0 1 6 fa c in g a ta k e o v e r o ffe r, h o w w o u ld y o u p e rsu a d e s h a re h o ld e rs to re je c t th e ta k e o v e r o ffe r a n d c o n tin u e to g iv e y o u - th e m a n a g e m e n t - th e c h a n c e to im p ro v e the c o m p a n y 's p e rfo rm a n c e ? Y ou m a y w is h to re fe r to th e Du Pont a n a ly s is in y o u r a n s w e r.
CASE 15C__________________________ Financial statem ent analysis B ig B re w e ry is a la rg e A u s tra lia n b e e r b re w in g c o m p a n y . It sells to w h o le s a le rs a n d c o m m e rc ia l o u tle ts, w h ic h then d e a l d ire c tly w ith B ig B re w e ry 's ta rg e t custom ers. B ig B re w e ry 's ic o n ic beers a re a ls o e x p o rte d to N e w Z e a la n d , the U n ite d K in g d o m a n d th e U n ite d States. B ig B re w e ry m a n u fa c tu re s in v a rio u s o ffs h o re lo c a tio n s a n d , as a result, a s ig n ific a n t p ro p o rtio n o f B ig B re w e ry 's costs o f p ro d u c tio n a re in c u rre d in US d o lla rs .
630
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
BIGBREWERY LIMITED INCOME STATEMENT FOR YEAR ENDED 3 0 JUNE 20 16
BIGBREWERY LIMITED BALANCE SHEET AS AT 3 0 JUNE 2 0 1 6 Consolidated
Note
2016
20 15
$0 00
$0 00
3804
73
Current assets C ash
►
R e c e iv a b le s
1
13758
22 107
In v e n to rie s
2
61467
41 6 5 9
535
691
79564
64530
2800
6143
79176
66 620
54627
61 2 2 9
494
-
Total noncurrent assets
137097
133 992
Total assets
21 6 6 6 1
198522
P a y a b le s
28042
26513
In te re s t-b e a rin g lia b ilitie s
23846
31 6 0 8
O th e r assets
Total current assets Noncurrent assets O th e r fin a n c ia l assets P ro p e rty , p la n t a n d e q u ip m e n t In ta n g ib le assets O th e r assets
►
3
Current liabilities
C u rre n t ta x lia b ilitie s P ro visio n s
Total current liabilities
73
1 899
1828
2015
53789
62 035
»
CHAPTER 15 Financial statem ent analysis
»
Noncurrent liabilities In te re s t-b e a rin g lia b ilitie s D e fe rre d ta x lia b ilitie s P ro v is io n s
Total noncurrent liabilities Total liabilities Net assets
80898
84300
3720
623
47 4
1 245
85092
86168
138881
148203
77780
50319
60950
38 886
Equity C o n trib u te d e q u ity
4
3932
2200
R e ta in e d p ro fits
12898
9233
Total equity
77780
50319
R eserves
T h e b a la n c e s h e e ts a r e to b e r e a d in c o n ju n c t io n w i t h th e n o te s t o th e fiin a n c ia l s ta te m e n ts .
BIGBREWERY LIMITED CASH FLOW STATEMENT Consolidated
Cash flows from operating activities C a s h re c e ip ts in th e c o u rs e o f o p e ra tio n s
89336
53 265
C a s h p a y m e n ts in th e c o u rs e o f o p e ra tio n s
(89731)
(4 9 3 7 2 )
Intere st re c e iv e d B o r ro w in g co sts p a id In c o m e ta x e s p a id
Net cash used by operating activities
24
23
(6418)
(2 7 1 2 )
(58)
(1 2 3 9 )
(6847)
(3 5 )
Cash flows from investing activities P ro c e e d s o n d is p o s a l o f n o n c u rre n t assets
11 116
P a y m e n ts fo r c o n tro lle d e n titie s (n et o f c a s h a c q u ire d )
(949)
P a y m e n ts fo r d e fe rre d a c q u is itio n co s t
(494)
P a y m e n ts fo r p r o p e rty , p la n t a n d e q u ip m e n t P a y m e n ts fo r a c q u is itio n o f in ta n g ib le s
Net cash from/(used in) investing activities
5714 (2 5 5 2 8 ) -
(4676)
(4 0 1 4 )
(78)
(1 0 4 )
4919
(2 3 9 3 2 )
Cash flows from financing activities P ro c e e d s fro m issu e o f sh a re s
20011
3
P a y m e n ts fo r s h a re issu e co sts
(1 500)
-
P ro c e e d s fro m /(r e p a y m e n ts of) b o rr o w in g s
(4700)
29 710
F in a n c e le a s e a n d h ire p u rc h a s e p a y m e n ts
(4454)
(1 8 9 8 )
D iv id e n d s p a id
(2838)
(2 3 9 2 )
Net cash from financing activities
6519
Net increase/(decrease) in cash held
4591
Cash at the beginning of the financial year E ffects o f e x c h a n g e ra te flu c tu a tio n s o n th e b a la n c e s o f c a s h h e ld in fo re ig n c u rre n c ie s
Cash at the end of the financial year
73 (860) 3804
25 423 1456 (1 3 4 6 )
(3 7 ) 73
631
632
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
BIGBREWERY LIMITED SELECTED NOTES TO THE ACCOUNTS 2016
2015
$0 00
$0 00
T ra d e d e b to rs
27432
23 119
Less: A llo w a n c e fo r d o u b tfu l tra d e d e b to rs
(13829)
■1
1. RECEIVABLES Current
(1 1 3 5 )
13603 O th e r d e b to rs
21 9 8 4
5 345 (2 2 2 ) 5 123
155
123
102
13758
22 107
5 225
2016
20 15
2014
2. INVENTORIES Current 50258
28 027
13 1 1 4
P a c k a g e d b e e r, a t co st
9324
12 6 2 7
4815
P a c k a g in g m a te ria ls , a t co s t
1815
931
454
S u n d ry m e rc h a n d is e , a t c o s t
70
74
53
61467
41 6 5 9
18436
B u lk b e e r, a t co s t
2016
2015
3. PROPERTY, PLANT AN D EQUIPMENT F re e h o ld la n d - A t f a ir v a lu e
8115
4470
36 51 1
21 3 8 3
B u ild in g s - A t f a ir v a lu e
(3434)
Less: A c c u m u la te d d e p re c ia tio n
P la n t a n d e q u ip m e n t, a t co s t
33077
20 940
36153
35 362
(8232)
Less: A c c u m u la te d d e p re c ia tio n
Leased p la n t a n d e q u ip m e n t
C a p ita l w o rk -in -p ro g re s s
(5 9 0 9 )
27 92 1
29453
8967
10193
(900)
Less: A c c u m u la te d a m o rtis a tio n
(4 4 3 )
(4 7 2 )
8067
9721
1996
2 036
79176
66 620
T o ta l p r o p e rty , p la n t a n d e q u ip m e n t N e t b o o k v a lu e
2016
20 15
2014
4 . CONTRIBUTED EQUITY N u m b e r o f sh a re s
92000000
55000000
3 7 0 0 0 0 0 0 sh a re s w e r e issu e d o n 1 D e c e m b e r 2 0 1 5 . T h e m a rk e t p ric e o f s h a re s w a s $ 0 .9 5 o n 3 0 Ju n e 2 0 1 6 ( $ 0 . 9 8 o n 3 0 Ju n e 2 0 1 5 ) .
5. DIVIDENDS DECLARED D u rin g th e y e a r, d iv id e n d s o f 3 ce n ts p e r s h a re w e r e d e c la re d ( 2 0 1 5 : 4 ce n ts p e r s h a re )
55 0 0 0 0 0 0
CHAPTER 15 Financial statem ent analysis
633
1
C a lc u la te ra tio s fo r B ig B re w e ry Lim ited fo r 2 0 1 5 a n d 2 0 1 6 , usin g E x h ib it 15 .1 as a g u id e . Be sure to in c lu d e a p p ro p ria te units.
2
C o m m e n t o n th e fin a n c ia l p e rfo rm a n c e o f B ig B re w e ry in 2 0 1 6 (re la tiv e to 2 0 1 5 ) w ith re fe re n ce to th e a b o v e ra tio c a lc u la tio n s . Y ou m a y w is h to fu rth e r resea rch th e p e rfo rm a n c e o f th e b re w in g in d u s try to e n h a n c e y o u r a n s w e r.
CASE 15D
Assessing public sector performance
T ra d itio n a l m easures o f assessing fin a n c ia l p e rfo rm a n c e a n d fin a n c ia l p o s itio n in th e p riv a te sector a re o fte n not re le v a n t fo r assessing th e p e rfo rm a n c e o f p u b lic sector e n titie s. In th e p riv a te sector, o p e ra tin g p e rfo rm a n c e is c o n c e rn e d w ith p ro fita b ility , a n d fin a n c ia l p o s itio n is c o n c e rn e d w ith liq u id ity , s o lv e n cy a n d asset m a n a g e m e n t. In th e p u b lic sector, som e o f these issues a re no t a lw a y s relevant: •
P rofit is n o t an o b je c tiv e o f m a n y b u d g e t-d e p e n d e n t d e p a rtm e n ts , w h o s e a im is to d e liv e r g o o d s o r services co n s is te n t w ith g o v e rn m e n t p o lic y . A s a result, p e rfo rm a n c e needs to be m e asure d b y a w id e r ra n g e o f c rite ria .
•
In fo rm a tio n a b o u t fin a n c ia l structure is less re le v a n t, b e ca u s e th e o n g o in g v ia b ility o f b u d g e t-d e p e n d e n t b o d ie s is d e te rm in e d b y th e g o v e rn m e n t (via th e w ill o f P a rliam en t).
•
L iq u id ity issues b e co m e less im p o rta n t, be ca u se c re d ito rs k n o w th e y h a ve a c la im a g a in s t th e g o v e rn m e n t as a w h o le .
•
L iq u id ity a n d s o lv e n cy b e c o m e less im p o rta n t fro m a le n d in g p e rsp e c tiv e , be ca u se th e a g e n c ie s g e n e ra lly d o not h a ve th e a b ility to b o rro w in th e ir o w n rig h t.
G iv e n th e a b o v e d iffe re n c e s , it has b e co m e ne ce ssary fo r p u b lic sector e n titie s to d e v e lo p n e w o r m o d ifie d ratios c o m p a re d to th ose used in th e p riv a te sector. D e v e lo p som e ra tio s w h ic h c o u ld be used to e v a lu a te p e rfo rm a n c e in th e p u b lic sector. (You m a y w is h to c o n s id e r th e re la tio n s h ip b e tw e e n costs, p h y s ic a l o u tp u t a n d c h a n g e s in e ffic ie n c y .)
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R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
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C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
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E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
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Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
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Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Accounting policy choices ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: explain the im pact of accounting policy choices on financial statements describe typical accounting policy choices discuss opportunities for m anipulation o f profit by accounting policy choices and discuss the constraints on m an agem ent calculate the effects of changes in accounting policies.
CHAPTER OVERVIEW This c h a p te r d e s c rib e s w h a t a c c o u n tin g p o lic y c h o ic e s a re , h o w th e y c a n h a ve a n im p a c t o n a c o m p a n y 's p ro fit, a n d th e ro le a n d im p o rta n c e o f p ro fe s s io n a l ju d g e m e n t in a c c o u n tin g p o lic y c h o ic e s . The s ig n ific a n c e o f a c c o u n t in g p o lic y c h o ic e s is illu s tra te d w ith re s p e c t to th re e to p ic s th a t h a ve b e e n c o v e re d in e a rlie r c h a p te rs : in v e n to ry , d e p re c ia tio n a n d in ta n g ib le s .
636
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
16.1
Introduction
The m any differences a m ong organisations, the com plexity o f users' dem ands for inform ation a nd the reluctance of regulatory authorities to specify a single solution in the fa ce o f all this variation a n d com plexity e n courage a diversity o f fina n cia l accounting methods, w h ich form part o f G A A P . Thus, organisations have some choices as to h o w to prepare financia l statements to suit their circumstances. A nalysing fin a n cia l perform ance an d position, and understanding the effects o f such accounting po licy, require k n o w le d g e o f accounting m ethods, the principles of accrual accounting a n d G A A P that g u id e a nd constrain choices, a nd methods o f analysis. It is im portant to extend some o f the techniques you learned in e arlier chapters, including ratio analysis, to explore the consequences of accounting p o lic y choices a nd to d e ve lo p an understanding o f h o w to make sense o f fin a n cia l statements that reflect such choices.
16.2
Background to accounting policy choices
This section explains w h a t is m eant b y accounting p o licy choices, a nd outlines some aspects that a re w orth thinking about w hen w o rkin g through the rest o f the chapter.
W hat is an accounting policy? Im agine the fo llo w in g scenario: the bookkeeper for M e g a M e g a Stores Ltd has to d e c id e w hether o r not each sales invoice should be recorded as revenue (credit revenue, d e b it cash o r accounts receivable) a nd so, each time, phones the C E O and asks w h e th e r that invoice should be recorded. You a re p ro b a b ly thinking this is pretty silly a nd a w aste o f tim e and you w o u ld be correct in thinking that. W h a t the c o m p a n y needs to d o is d e cid e , in a d va n ce a n d in general, w h a t sort o f transaction constitutes a sale that is to be recorded as revenue. This decision can then be com m unicated to the bookkeeper, w h o can a p p ly the criteria to each invoice, an d therefore d e c id e w h a t to record w ithout phoning the C E O . In fact, it w ill be built into the softw are that is used to record the accounting d a ta . The C E O can run the c o m p a n y instead o f talking to the bookkeeper every fe w minutes. An accounting p o licy is a decision m ade in a d va n ce a b o u t how , w hen an d w h e th e r to record or recognise som ething. W h e n you choose the location o f an account in the fin a n cia l statements (such as putting it in current liabilities rather than noncurrent liabilities), you are m aking an accounting p o lic y choice! T ypically, com panies make p o lic y choices in areas such as: 1
W h a t accounting methods w ill be used: -
h o w to value receivables, including h o w to estim ate the a llo w a n c e for doubtful debts (C hapter 8)
-
h o w to value inventory including cost flo w assumptions; for exam ple, FIFO, LIFO an d w e ig h te d ave ra g e
-
w hen to recognise liabilities (C hapter 9)
-
h o w to com pute d e p re cia tio n ; for exam ple, straight-line, reducing-balance an d units-of-production (C hapter
-
w h ich expenditures on fixed assets should be ca p ita lise d (a d d e d to the asset accounts) a nd w h ich should be
(C hapter 9)
10) included w ith expenses such as repairs an d m aintenance (C hapter 10) -
h o w to com pute am ortisation on in ta n g ib le assets (C hapter 10) h o w to a ccount for long-term investments; for exam ple, cost method, equity method an d co nsolidation (C h a p ter 1 2)
-
w h ich product developm ent expenditures should be expensed a nd w h ich (if any) should be ca p ita lise d (this
-
w h a t method to use to determ ine revenue recognition for partly com pleted projects (C hapter 1 3).
chapter)
CHAPTER 16 Accounting policy choices
2
W h a t inform ation should be disclosed. Examples o f disclosure p o licy include: -
3
637
w hether to disclose details o f certain op e ra tin g expenses (C hapter 1 3)
-
h o w much to d isa g g re g a te fin a n cia l inform ation for segments o f a c o m p a n y
-
the am ount o f detail given in the accounting p o lic y c h o ice note (N o te 1 o f the fin a n cia l statements)
-
h o w much detail to pro vid e on contingent liabilities (C hapter 1 1).
H o w accounting estimates w ill be determ ined. Examples o f accounting estimates include: -
a llo w a n c e for doubtful debts
-
useful life o f plant a nd equipm ent
-
useful life o f in ta n g ib le assets subject to am ortisation
-
provision for w a rra n ty lia b ility
-
provision for em ployee entitlements.
4 W h a t events o r transactions w ill be recognised. Examples o f accounting recognition decisions include: -
w rite-dow n for inventory obsolescence (C hapter 9)
-
capitalisation o f cost of asset betterments (C hapter 10)
-
recognition of in ta n g ib le assets; for exam ple, brand names an d tradem arks (C hapter 10)
-
recognition of liabilities for contingencies that are p ro b a b le a nd can be measured re liably (C hapter 1 1)
-
recognition of revenue on p a rtia lly com pleted sales, such as under long-term contracts (C hapter 1 3).
A ccounting p o licy choices are very im portant to the interpretation a n d analysis o f the fin a n cia l statements. W ith o u t know ing h o w the statements w e re assem bled, it is difficult to use them intelligently. For this reason, the first of the notes fo llo w in g the fin a n cia l statements is usually a summary o f the com pany's sig n ifica n t accounting policies (often in N o te 1 of the fin a n cia l statements). The other notes pro vid e further details on im portant policies.
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be a b le to a n s w e r, based o n w h a t y o u ha ve ju s t rea d: In p o in t 3 a b o v e th e r e is re fe re n c e t o fiv e e s tim a te s : a llo w a n c e f o r d o u b tfu l d e b ts , u s e fu l life o f p la n t and e q u ip m e n t, u s e fu l life o f in ta n g ib le s , p ro v is io n f o r w a rra n ty lia b ility , an d p ro v is io n f o r e m p lo y e e e n title m e n ts . I f e a ch o f th e s e e s tim a te s g e ts la rg e r, w h a t is th e e f fe c t o n p r o fit in th e y e a r o f th e c h a n g e ? Y o u r a n sw e rs s h o u ld be : d e c re a s e , in c re a s e , in c re a s e , d e c re a s e and d e cre a s e .
W hy is there a choice? A cco u n tin g , in spite o f being num erical, is not m athem atically cut an d d rie d . Preparers o f fin a n cia l statements are forced to make choices, w h e th e r they like it o r not, for the fo llo w in g main reasons: 1
There is inform ation value in the location o f an acco u n t in the statements (such as current versus noncurrent lia b ility o r revenue versus other incom e). C h o ice o f location (classification) of accounts is, therefore, potentially important.
2
Even the basic transactional records o f accounting - the bookkeeping records - require decisions a b o u t w h a t is a transaction, w h ich accounts should be used, a nd h o w a nd w hen transactions a re to be recorded. For exam ple, is an am ount an asset o r repairs an d m aintenance expense?
3
The basis o f accrual a ccounting, as you have seen, is to augm ent the transactional records to produce a more com plete (in the e co n o m ic sense) picture o f the enterprise's perform ance an d position. H o w to d o this is a matter o f professional judgem ent. A ccrual accounting therefore necessitates choices a b o u t accounting figures, notes and methods. For exam ple, w h a t percentage o f a contract has been com pleted in ord e r to estim ate revenue recognition on a contract that goes over more than o ne accounting period; o r the am ount o f dep re cia tio n for the period.
638
4
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
In A ustralia, the United States, the United K ingdom , C a n a d a , N e w Z e a la n d an d m any other countries, governments an d professional accounting standard-setters have been reluctant to specify all the solutions or require all enterprises to fo llo w them. Such authorities a p p e a r to believe that choices in accounting are a p p ro p ria te , in o rd e r to fit accounting to each enterprise's circumstances, an d perhaps inevitable in our free enterprise econom ic system. Stock market participants, fin a n cia l analysts a nd others w h o rely on financial statements are expected to attain sufficient k n o w le d g e o f accounting a nd the enterprise to make inform ed decisions, just as they w o u ld w hen buying the enterprise's products o r having other interactions w ith the enterprise.
5
Because the com plete fin a n cia l statements include the figures a nd the footnotes an d other narrative disclosures, there is frequently a decision to be m ade as to w hether to adjust the figures for som ething o r to disclose it in the narrative material instead, o r even both. For exam ple, if the c o m p a n y has been sued by a disgruntled customer, should that be recorded as a lia b ility? Should it, instead, be disclosed o nly in the notes, o r recorded as a lia b ility w ith an explanatory note? O r a re none o f these a p p ro p ria te ?
How m uch freedom o f choice is there? C om panies used to have much m ore freedom than they d o n o w in d e c id in g w h a t to report a n d h o w to report. Some law s specify the use of particular reporting m ethods; fo r exam ple, inform ation a b o u t a com pany's transactions w ith its shareholders. But, m ore im portantly, there is n o w a vast a rra y o f accounting standards that ope ra te to constrain enterprises' choices a b o u t their a ccounting. In some countries certain accounting policies are not a llo w e d even though they are in others. For exam ple, LIFO is a llo w e d in the United States but prohibited in most other countries, including A ustralia. These standards are continually evolving, as evidenced by recent changes to accounting standards on h o w to treat research and developm ent and the im pairm ent of g o o d w ill. In some areas, the choices have a lre a d y been largely m ade by a standard-setting b o d y, legislators o r accepted practice. In others, there is no such g u id a n ce , an d the enterprise is free to make its o w n decisions. •
Examples of the first kind, w h ich are a lre a d y set, are the consolidation method, accounting for incom e taxes and accounting for leases. These a re still subject to revision w hen needed.
•
Examples o f the second kind, w h e re ch o ice is a llo w e d , concern w h ich de p re cia tio n methods to use, w h ich inventory cost methods to use, an d h o w to determ ine a llo w a n c e for doubtful debts.
M anipulation Does accounting p o licy c h o ice pro vid e a w a y for c o m p a n y m anagem ent to alter the picture presented in the financial statements - to present the story they w a n t to tell rather than the truth? The short an sw e r is yes. F-lowever, there is a fine line betw een choosing the accounting policies that suit the com pany's circumstances a nd therefore produce fa ir reporting, and choosing policies that tell a desired story that m ay not be fair. The vast m a jo rity o f com panies a n d their m anagers are scrupulous a b o u t their a cco u n tin g an d consider producing fa ir fin a n cia l statements to be both ethical and g o o d business practice. But w e d o learn o f com panies that have stepped over the line a n d m anipulated their financial statements to make themselves look better o r to hide some em barrassing result. F-lere are some exam ples that the user o f fin a n cia l statements m ay w a n t to consider: •
A c om pany m ay choose accounting methods for receivables, inventories, am ortisation o r a n y other accounts that tend to make profits higher than w o u ld have been produced by other methods. This could involve optim istic estimates o f earned revenue, the useful life o f assets o r the value o f patents.
•
A nother com pany, concerned a b o u t its incom e tax burden, m ight make choices that w o u ld reduce profit a n d , in this w a y , put o ff p a yin g taxes.
•
Fhaving prom ised the bank that a current ratio w o u ld be m aintained at a certain level, a c o m p a n y m ay choose accounting methods that help the ratio look as high as possible, such as classifying longer-term receivables as current assets o r short-term o b lig a tio n s as noncurrent liabilities.
CHAPTER 16 Accounting policy choices
639
There m ay be reasons for m anipulating the fin a n cia l statement figures in a n y direction, but g o o d k n o w le d g e of the enterprise m ay be necessary to predict w h a t that direction is likely to be. A d ra m a tic exam ple o f profit m anipulation is the big bath. The b ig bath method w orks in the fo llo w in g w a y : the m anagem ent of a c o m p a n y that has had a b a d ye a r m ay w rite off extra costs (e.g. w ritin g inventories, receivables or intangibles w a y d o w n ) on the assumption that the c o m p a n y is a lre a d y g o in g to be criticised, so the criticism w o n 't be much stronger if the results a p p e a r even w orse. By transferring such costs to expenses now , instead o f in later years, future expenses are reduced a n d , therefore, future profits w ill look better. The c o m p a n y w ill a p p e a r to bounce b ack quickly. M a n a g e m e n t w ill hope for praise for this recovery, even though it is not all real, because o f the m anipulation. Large write-offs becom e m ore critical w hen executive com pensation packages are tied to changes in accounting profits. For exam ple, if the com pensation p a cka g e included an incentive related to the ch a n g e in p rofit from y e a r one to ye a r three, there a re incentives for m anagem ent to w rite off some assets (e.g. obsolete inventory, increasing the a llo w a n c e for doubtful debts a nd higher d e preciation) in ye a r one, w ith the effect of decreasing year-one profit and increased profits in later years (e.g. ye a r three), than if the changes w e re not m ade in ye a r one. M a n ip u la tio n dangers can be overrated. First, m anagers cannot sim ply ch a n g e accounting policies w herever and w henever they w ish. There is a need for consistency, a nd if there is a ch a n g e it must be disclosed in the notes to the accounts, together w ith the effect o f the c h a n g e on profit. S econd, most m anagers a re honest an d anxious that their accounting be fa ir a nd truthful. M o s t consider that g o o d fin a n cia l reporting is im portant to the com pany's reputation and a b ility to b o rro w , raise share c a p ita l a nd g e n e ra lly d o business. M o s t also consider g o o d fin a n cia l reporting to be part o f g o o d business a nd professional ethics. Third, there a re m any checks in p la ce including the role o f the a udito r a nd surveillance activities b y the Australian Securities a nd Investments Com m ission (ASIC) a nd the equivalent in other countries. Flow ever, the d a n g e r o f m anipulation is a lw a ys there, so accountants, auditors a n d users w h o rely on profit a nd other measures for their decisions must be vigilant.
A few technical points •
C ash flo w : G en e ra lly, accounting p o licy c h o ice does not affect cash flo w . Policy choices a re m ade by accrual accounting entries, w h ich d o not affect cash directly. There m ay, how ever, be indirect o r eventual effects, e sp e cia lly through incom e tax. But at the instant an accounting p o licy c h o ice is im plem ented, there is no cash or cash flo w effect.
•
D ual effects o f changes: As noted in prio r chapters, an d as the a b o v e entry shows, most accounting p o licy changes affect both the b a la n ce sheet an d the incom e statement. They must affect both if they are to affect net profit. Flere are some exam ples: Balance sheet accounts
M ain income statement accounts
Accounts receivable
Revenue, bad debts expense
Inventories
COGS expense
Prepaid and accrued expenses
Various expense accounts
Property, plant and equipment assets
Depreciation expense
Intangible assets
Amortisation expense
Liabilities
Various expense accounts
Equity
None*
♦Transactions with owners, such as share capital issues and buybacks and dividends, are ordinarily not considered part of the measurement of profit. However, there are some technicalities that may allow this to be violated - this book does not cover such technicalities.
640
•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
C lassification a n d disclosure: There a re accounting p o lic y choices in tw o areas that d o not affect profit: -
C lassification policies (decisions a b o u t w h e re w ithin the b a la n ce sheet o r w h e re w ithin the incom e statement to sh o w accounts) d o not affect p rofit because they d o not involve both statements, as d o recognition policies, but instead affect o nly on e or the other.
-
Disclosure policies relate to w h a t is said a b o u t the figures in the w o rd s used in the statements an d in the notes to the statements.
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: In d ica te th e pro b a b le d ire c tio n o f th e e ffe c t o f each o f th e fo llo w in g possible a c co u n tin g p o lic y changes on th e ite m given: Effect on
1 Policy change Accrue greater employee benefits expense
Liabilities
Recognise accounts receivable sooner
Revenue
Capitalise some repairs expenses
Net profit
Disclose the board's intention to declare a dividend
Net profit
Separate a bank loan into current and long-term
Net profit
Recognise doubtful accounts sooner
Net profit
Write off damaged inventories
Net profit
Y o u r answers should be: increase, increase, increase, no e ffe c t, no e ffe c t, decrease and decrease.
16.3
Inventory valuation and COGS: effects
Refer to the M e e ix exam ple in section 9 .5 . The fo llo w in g is a summary o f the results for the M e e ix exam ple: Cost method
Ending inventory asset
COGS expense
Total cost available
$
$
$
FIFO
6 300
5 500
11 800
Weighted Average
5 957
5 843
11 800
Periodic
4500
7300
11 800
Perpetual
5 600
6200
11 800
LIFO
Let's assume M e e ix is using FIFO for its inventory o f G lo o p . W h a t w o u ld the effects on M e e ix 's financial statements be if it c h a n g ed to o ne o f the other three methods, b e ginning this ye a r (i.e. w ith o u t ch a n g in g past years and so w ithout c h a n g in g the $ 4 cost o f the 1 January inventory)? M e e ix 's incom e tax rate is 3 0 per cent. If it c h anged to m oving w e ig h te d average: •
the C O G S expense w o u ld g o up b y $ 3 4 3 ($ 5 8 4 3 — $ 5 5 0 0 ), so net profit w o u ld d e clin e by 7 0 per cent of that, o r $ 2 4 0
•
incom e tax expense a nd lia b ility w o u ld g o d o w n b y the other 3 0 per cent, o r $ 1 0 3
•
there w o u ld be no im m ediate effect on cash o r cash flo w . You should be a b le to fill in the analysis for changes to a n y o f the other methods. For your reference, the results for
changes to the other tw o are shown in the next H o w 's your understanding.
CHAPTER 16 Accounting policy choices
641
HOW'S YOUR UNDERSTANDING? H e re is a q u e stio n y o u should be able to answ er, based on w h a t yo u have ju s t read: I f M e e ix m oved fro m F IF O to : 1 2
L IF O p e rio d ic L IF O p erpetual w h a t w o u ld be th e e ffe c t on C O G S , n e t p r o fit and cash flo w ? Y o u r answ er should be:
1
C O G S expense w o u ld go up $ 1 8 0 0 , so n e t p r o fit w o u ld d e clin e by 7 0 p e r c e n t o f th a t, o r $ 1 2 6 0 . T here
2
C O G S expense w o u ld go up $ 7 0 0 , so n e t p r o fit w o u ld d e clin e by 7 0 p e r c e n t o f th a t, o r $ 4 9 0 . T h e re is
is no im m e d ia te e ffe c t on cash o r cash flo w . no im m e d ia te e ffe c t on cash o r cash flo w .
16.4
Depreciation effects analysis
This accounting p o lic y c h o ice has its main effect on profit. Use o f an accelerated method, such as reducing balance, increases d e p re cia tio n in the early years o f an asset's life, relative to the d e p re cia tio n resulting from the use o f the straight-line method. Therefore, profit w ill be lo w e r in the e a rly years if reducing b a la n ce is used, a n d higher in the later years, w hen the reducing b a la n ce dep re cia tio n falls b e lo w straight-line. Refer to the G re co Ltd exam ple in section 1 0 .4 . The results o f using various depreciation methods w e re as follows: Reducing balance Year
Straight-line expense
Begin book value
Expense
Units-of-production expense
$
$
$
$
1
900000
23 0 0 0 0 0 0
2 300000
720000
2
900000
20700000
2 070000
1 620000
3
900000
18 6 3 0 0 0 0
1 863 000
1 620000
4
900000
16767000
1 676700
1440000
5
900000
15090300
1 509030
1 620000
6
900000
13581270
1358127
900000
7
900000
12223143
1222314
720000
8
900000
1 1 000 829
1100083
720000
9
900000
9 900746
990075
720000
10
900000
8910671
891 067
720000
11
900000
8 019 604
801 960
720000
12
900000
7217644
721 764
720000
13
900000
6 4 9 5 880
649588
720000
14
900000
5 846 292
584 629
720000
15
900000
5 261 663
526166
720000
16
900000
4735497
473 550
720000
17
900000
4261947
426195
720000
18
900000
3 835 752
383575
720000
19
900000
3452177
345218
720000
20
900000
3106959
310696
720000
20203037
18000000
Total
18000000
642
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The C E O w ants to kn o w w h a t effects the de p re cia tio n c h o ice has. Som e things you could tell the C E O are: 1
The three methods o f de p re cia tio n have different effects: -
The straight-line method shows the sam e d e p re cia tio n every year.
-
The reducing b a la n ce method starts out w ith much higher dep re cia tio n than that o f the straight-line method
-
The units-of-production method starts out low er, rises, then falls b a ck in a cco rd a n ce w ith production plans.
and ends up w ith much lo w e r d e p re cia tio n . 2
A cc o rd ing ly: -
The reducing b a la n ce method w ill sh o w lo w e r net profits than straight-line in the earlier years a n d higher in the later years.
-
The result fo r the units-of-production method is g reatly different from that produced by the straight-line method in years tw o to five, but in other years they are not much different.
3
If reducing b a la n ce o r units-of-production is chosen, the c o m p a n y w ill look less pro fita b le in the early years and m ore profitable in the later years.
4
The b alance sheet effects are in the b o o k value o f the factory, a nd therefore also in the b o o k value o f the total assets o f the business, w h ich d e clin e least ra p id ly w ith the straight-line method, an d in retained profits.
5
G re c o Ltd should choose the d e p re cia tio n method that w o u ld best match its d e p re cia tio n expense to the ap p a re nt econom ic value pro vid e d b y using the factory. H ow ever, since d e p re cia tio n does not affect cash flo w o r current assets, and because in this case the straight-line method provides higher net profits in the early years, it m ight be that the C E O w ill w a n t to use that method. The C E O is likely to be concerned a b o u t the reaction to the com pany's perform ance over the next fe w years. As you s a w earlier, most large Australian com panies use straight-line, so that method p ro b a b ly also has c o m p a ra b ility w ith other com panies in G re co 's industry in its favour.
HOW'S YOUR UNDERSTANDING? H e re is a q u estio n y o u should be able to answ er, based on w h a t yo u have ju s t read: C o ld Lake m a n a g e m e n t is try in g to d e cid e w h e th e r to use s tra ig h t-lin e o r re d u cin g balance d e p re cia tio n fo r its assets. I f it used s tra ig h t-lin e , th e d e p re cia tio n expense fo r th is firs t ye a r w o u ld be $ 1 1 2 0 0 0 0 , b u t i f it used re d u cin g balance w ith th e ra te m a n a g e m e n t believes w o u ld be a p p ro p ria te , th e expense w o u ld be $1 8 6 0 0 0 0 . The c o m p a n y ’s in c o m e ta x ra te is 3 5 p e r c e n t. C a lc u la te h ow m u ch h ig h e r o r lo w e r each o f th e fo llo w in g w ould be i f th e re d u cin g balance m e th o d was used ra th e r th a n th e s tra ig h t-lin e m e th o d : d e p re cia tio n expense, n e t p ro fit, cash fro m o p e ra tio n s , n e t b o o k value o f assets, re ta in e d p ro fits , c u rre n t ratio. Y o u r answers should be: $ 7 4 0 0 0 0 h igher, $4 8 1 0 0 0 low er, no e ffe c t, $ 7 4 0 0 0 0 low er, $4 8 1 0 0 0 low er, and no e ffe c t.
16.5
Intangibles effects analysis
Let's look at an exam ple. C heckup A uto Services Ltd, w hich has been in business for one year, has a chain o f heavily advertised autom obile service centres. The com pany's incom e tax rate is 3 0 per cent. The com pany makes it a practice to capitalise a portion o f its advertising costs as a deferred asset. An accountant suggested to the com pany's financial controller that the policy of capitalising advertising should be ended because the future econom ic benefit from the expenditures is not clearly determ inable. The controller w ants to know w h a t effect such p o licy changes w o u ld have.
DATA •
The am ount o f advertising ca p ita lise d w a s $ 7 5 0 0 0 this year.
•
The ca pitalise d am ount is being am ortised at 2 0 per cent per year.
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PRESENT M E T H O D •
A m ortisation expense is $ 15 0 0 0 this ye a r (2 0 per cent o f $ 7 5 0 0 0 ).
•
Asset is $ 7 5 0 0 0 — $ 15 0 0 0 = $ 6 0 0 0 0 at end of this year.
PR O PO SED M E T H O D Expenses this y e a r w o u ld be $ 7 5 0 0 0 .
EFFECTS If advertising w e re not c a p ita lise d : •
This year's net profit w o u ld be lo w e r by 7 0 per cent o f ($ 7 5 0 0 0 — $ 15 0 0 0 ) = $ 4 2 0 0 0 .
•
Incom e tax lia b ility w o u ld g o d o w n b y $1 8 0 0 0 (the other 3 0 per cent); that is, 3 0 per cent of $ 1 6 0 0 0 .
•
Retained profits this ye a r w o u ld be lo w e r by $ 4 2 0 0 0 .
•
Assets w o u ld be lo w e r by the removal of $ 6 0 0 0 0 net ca p ita lise d advertising asset.
•
A ccounting equation proof (A = L + SE): ( $ 6 0 0 0 0 ) = ($ 1 8 0 0 0 ) + ($ 4 2 0 0 0 ).
•
N o effect on cash flo w , cash b a la n ce o r w o rkin g c a p ita l.
16.6
Accounting policy disclosure
You have seen that a c o m p a n y m ay have chosen a variety o f accounting policies to fit its circum stances. G e n e rally accep te d accounting principles require that com panies disclose w h a t their sig n ifica n t policies a re a n d a n y changes in them since the previous period. The idea is to help the users o f the fin a n cia l statements understand an d interpret the figures an d notes in the statement, as this chapter has tried to prepare you to do. A summary of the significant policies usually appears as the first of the notes to the fin a n cia l statements. The user should be a b le to tell from this note the com pany's policies for inventory, d e p re cia tio n , accounting for intercorporate investments a nd a n y other policies the c o m p a n y an d its auditors feel are necessary for an understanding o f h o w the finan cia l statements have been p repared. For an exam ple o f this accounting p o licy disclosure, see N o te 1, S ignificant accounting policies, to the W o o lw o rth s Limited fin a n cia l statements in the a p p e n d ix of this book. Policy specifics a re often not disclosed if the methods used are w h a t y o u 'd expect; for exam ple, if revenue is recognised at the point o f sale o r delivery, or if normal accruals are m ade for expenses. C hanges in accounting policies are also disclosed, including a description o f the ch ange and a calculation o f the effect the ch ange has had on the financial statements. M a n y changes have to be given retroactive effect. For exam ple, if the revenue recognition method is ch anged, financial statements from past years have to be recalculated to show them on the n ew basis. Therefore, if a co m p a n y has changed its accounting p o licy in some area, the prior year's figures in this year's annual report m ay not be the same as the ones you w o u ld have seen in last year's annual report.
16.7 Accounting policy choices: management's objectives Each chapter o f this b o o k has included a fe w w o rd s a b o u t m anagers a nd accounting to bring a m anagerial perspective to the topics a n d to help answ er the question, 'W h y should a m anager ca re a b o u t fin a n cia l a cco u n tin g ? ' In the case of accounting policy choice, the an sw e r should not be hard to see. M a n a g e m e n t is responsible for the fin a n cia l statements, as it is for other aspects o f the business, a nd must see that it chooses the best accounting policies for its c o m p a n y for several reasons: •
As this b o o k has em phasised, such choices are an inevitable consequence o f accrual a ccounting. They are part o f the judgem ental fa b ric that is a t the heart o f accrual acco u n tin g , a n d , properly m ade, they a d d to the value of the fin a n cia l statements. Im properly m ade, they detract from the value. In either case, they make a difference!
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•
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
M a n a g e m e n t is in the best position to make va lid accounting p o licy choices because m anagem ent knows the c o m p a n y best. Professional advisers can pro vid e great assistance to m anagem ent here, but m anagem ent should have the data that w ill drive rational accounting p o licy choices.
•
M an a g e m e n t's perform ance on behalf o f the ow ners is evaluated partly via the fin a n cia l statements. W h ile this provides a m otivation for self-serving m anagers to abuse accrual accounting in o rd e r to make themselves look g o o d , it also provides an opportunity for those m ore professional m anagers to create fin a n cia l measures that show the com pany's perform ance in the clearest, most va lid light. Such a portrayal should, in the long run, benefit everyone.
•
In the c o m p a n y o ve rvie w section in most annual reports, m anagem ent reviews the year's perform ance an d takes responsibility for it. This naturally leads m anagem ent to be interested in the p o licy choices behind the financial statements, not o n ly because they help determ ine h o w m anagem ent's perform ance is measured, but also because they are the responsibility o f m anagem ent.
•
A g e n c y (contract) theory, based on the idea that self-interested behaviour is to be expected o f everyone, provides a straightforw ard o b je ctive for m anagem ent's accounting p o lic y choices: to increase m anagers' share of corporate returns (and, therefore, decrease the returns o f ow ners, creditors an d em ployees). A g e n c y theory puts no negative cast on this, sim ply treating it as a natural function o f e co n o m ica lly rational behaviour. But m any p eople see this as m anipulation, an d a re very critical o f m anagers w h o a p p e a r to put their o w n interests first. Such behaviour m ay be prom pted by m anagers' concerns a b o u t their perform ance bonuses, a b o u t a vo id in g com plications due to investor o r cre d ito r nervousness re g arding p o o r perform ance o r a b o u t a v o id in g standing out as being too profitable. M a n a g e rs ' objectives are likely to be com plex, including in m any cases a sim ple w ish to 'tell it like it is' in a fa ir a nd unbiased manner. Readers of this b o o k should n o w have co n sid e ra b le sensitivity w ith regard to the position o f 'the m anager' in the
financial accounting situation a nd should be a b le to interpret o r prepare fin a n cia l statements m ore intelligently, given that sensitivity. If you are presently a m anager, or a re a im in g to be on e in the future, m any o f the techniques used should be helpful. For exam ple, the a b ility to d o , a rra n g e fo r o r at least use 'w h a t if' effects analysis forms an im portant part o f the m anager's analytical toolkit. G raduates o f accounting courses should be in a particularly g o o d position to answ e r others' 'w h a t if' questions. Financial statements are, therefore, closer to the centre o f effective m anagem ent than you m ight have im a g ine d . This closeness should m otivate m anagers to p a y close attention to their financial statements an d should m otivate others (users, accountants a nd auditors) to understand m anagem ent's role in preparing a n y fin a n cia l statements w ith w h ich they a re involved.
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PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w it h o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen th e so lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A Research and developm ent policies Y ou a re p re p a rin g the fin a n c ia l statem ents fo r Iro n o re Ltd, a n d th e C F O asks y o u to c a p ita lis e $ 2 m illio n w o rth o f d e v e lo p m e n t expe nses, p re v io u s ly re c o rd e d d u rin g th e c u rre n t fin a n c ia l y e a r. 1 W h a t jo u rn a l en trie s w o u ld y o u use to re c o rd this tra n s a c tio n ? 2
H o w w ill this tra n s a c tio n a ffe c t th e fo llo w in g statem ents? a
in co m e statem ent
b
b a la n c e sheet
c
state m e nt o f cash flo w s .
3
W h a t do es c a p ita lis in g a n e x p e n s e m ean?
4
S u g g e st reasons fo r th e C F O 's d e c is io n .
PRACTICE PROBLEM B Inve n to ry policies S h o w n b e lo w a re th e d isclo sure s w ith respe ct to in v e n to ry fo r tw o c o m p a n ie s . T h ey w e re e x tra c te d fro m N o te 1 o f th e fin a n c ia l statem ents d e s c rib in g a c c o u n tin g p o lic ie s .
Company A A t b a la n ce d a te all in v e n to rie s o n h a n d o r in tra n s it a re v a lu e d a t th e lo w e r o f c o s t an d n e t re alisable va lu e . C o s t is d e te rm in e d u s in g th e w e ig h te d a v e ra g e c o s t m e th o d , a f t e r d e d u c tin g a n y p u rc h a s e s e ttle m e n t d is c o u n t, a n d in c lu d in g lo g is tic s e x p e n s e s in c u rre d in b rin g in g th e in v e n to rie s t o th e ir p re s e n t lo c a tio n an d c o n d itio n .
Company B In v e n to rie s , in c lu d in g w o r k in p ro g re s s , a re v a lu e d a t t h e lo w e r o f c o s t a n d n e t re a lis a b le va lu e . C o s t is d e te rm in e d p rin c ip a lly o n a f ir s t in , f ir s t o u t basis a n d , in th e ca se o f m a n u fa c tu re d g o o d s , in c lu d e s d ir e c t m a te ria ls , la b o u r a n d p r o d u c tio n o v e rh e a d s .
1
W h a t a re th e m a in d iffe re n c e s in a c c o u n tin g p o lic ie s fo r in v e n to ry b e tw e e n th e tw o c o m p a n ie s ?
2
If a ll o th e r th in g s w e re e q u a l (such as sam e sales o r sam e expe nses), w h ic h c o m p a n y w o u ld h a ve th e h ig h e r p ro fit fo r th e y e a r a n d th e h ig h e r in v e n to ry fig u re ?
KEY TERMS Accounting policy choice
Big bath
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s ection starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a s ic c o n c e p ts a n d a re then fo llo w e d b y a set o f pro b le m s .
646
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
DISCUSSION QUESTIONS 1
W h a t is an a c c o u n tin g p o lic y c h o ice ?
2
In w h a t a re a s d o o rg a n is a tio n s o fte n m a ke p o lic y choice s?
3
Select fiv e a c c o u n tin g p o lic y c h o ice s. D e s crib e th e im p a c t on p ro fit a n d to ta l assets o f e a ch o f th e c h o ice s.
4
W h y is th e lo c a tio n o f a n item in th e fin a n c ia l statem ents a n a c c o u n tin g p o lic y c h o ice ?
5
W h y d o o rg a n is a tio n s h a ve a c h o ic e o n w h a t a c c o u n tin g p o lic ie s to use?
6 A re th e re a n y lim its on th e c h o ice s th a t c o m p a n ie s have? 7
A s y o u h a ve seen, th e re is a g e n e ra l c o n flic t b e tw e e n tw o fin a n c ia l re p o rtin g o b je c tiv e s . The firs t o b je c tiv e is to fit th e a c c o u n tin g to e a c h c o m p a n y 's c ircu m s ta n ce s so th a t th e re su ltin g re p o rts a re re le v a n t fo r u n d e rs ta n d in g o r e v a lu a tin g th a t c o m p a n y . The s eco nd is to m a ke a c c o u n tin g c onsisten t fro m c o m p a n y to c o m p a n y so th a t in te rc o m p a n y c o m p a ris o n s m a y be fa c ilita te d a n d th e o v e ra ll c re d ib ility o f th e in fo rm a tio n m a in ta in e d . W r ite a p a ra g ra p h g iv in g y o u r v ie w s o n h o w im p o rta n t this c o n flic t is a n d h o w (if a t all) it sh o u ld be d e a lt w ith .
8 S ho uld m a n a g e m e n t ha ve the re s p o n s ib ility a n d the a u th o rity to c hoo se c o m p a n ie s ' a c c o u n tin g p o lic ie s, o r should th a t role be som eone else's (such as the g o ve rn m e n t's , the a u d ito r's o r a n in d e p e n d e n t b o a rd 's )? If y o u th in k it shou ld be m a n a g e m e n t's role, e x p la in w h y . If y ou th in k it shou ld be som eone else's role, e x p la in w h o se , a n d w h y . 9
A c o m m e n ta to r on th e a c c o u n tin g scene re m a rk e d : 'M a n a g e m e n t m akes its a c c o u n tin g c h o ice s to serve its o w n interests, a n d th e re 's no w a y th e p o o r lo n e ly a u d ito r c a n h o ld th e fo rt o f fa irn e ss w h e n y o u c o n s id e r h o w v a g u e a n d ju d g e m e n ta l a c c ru a l a c c o u n tin g 's c rite ria fo r a c c o u n tin g p o lic y c h o ice s a re .' W h a t a re y o u r v ie w s on the c o m m e n ta to r's rem arks?
10 a
O u tlin e th e kind s o f in fo rm a tio n y o u w o u ld e x p e c t to see in a c o m p a n y 's s ig n ific a n t a c c o u n tin g p o lic ie s note to th e fin a n c ia l statem ents.
b
H o w shou ld a c o m p a n y d e c id e w h a t to in c lu d e in th a t note?
c
A business c o m m e n ta to r sug g e ste d th at, w h e n a c o m p a n y uses a n a c c o u n tin g p o lic y th a t is un usua l, its s ig n ific a n t a c c o u n tin g p o lic ie s no te sh o u ld in c lu d e a c a lc u la tio n o f th e e ffe c t on p ro fit o f using th a t p o lic y as c o m p a re d to th e m o re usual p ra c tic e . W h a t d o y o u th in k o f th a t id e a ?
11 C o m m e n t b rie fly on th e fo llo w in g rem arks b y a bu sinessperson : a 'N o o n e c ares w h a t o u r a c c o u n tin g p o lic y ch o ice s a re , be ca u se th e y h a ve no e ffe c t on th e p ric e o f the c o m p a n y 's s h a re s .' b
'Last y e a r w e sold som e e q u ip m e n t th a t h a d a b o o k v a lu e o f $ 7 0 0 0 0 fo r $ 5 4 0 0 0 . I w a s re a lly a n g ry a t o u r C E O fo r lo sin g $ 1 6 0 0 0 , a n d I n e a rly fire d h im .'
c
'I d o n 't a llo w o u r c o m p a n y to in c lu d e a n y in ta n g ib le assets on its b a la n c e sheet be ca u se I p re fe r a c o n s e rv a tiv e b a la n c e sheet th a t d o e s n 't c o n ta in q u e s tio n a b le assets.'
d
'O n c e w e h a ve e s ta b lis h e d p ro p e r a c c o u n tin g p o lic ie s , a ll those notes a t th e e n d o f th e fin a n c ia l statem ents a re re a lly a n irre le v a n t n u is a n c e .'
12 W r ite a p a ra g ra p h on e a ch o f th e fo llo w in g to p ic s , using th e p e rs p e c tiv e o n a c c o u n tin g p o lic y c h o ic e a n d m e thods p ro v id e d in th is c h a p te r: W h y th e a u d ito r's re p o rt refers to w h e th e r th e c o m p a n y 's fin a n c ia l statem ents h a ve be en p re p a re d in a c c o rd a n c e w ith G A A P .
a
b
W h y p ro fe s s io n a l ju d g e m e n t is n e e d e d in p re p a rin g fin a n c ia l statem ents.
c
W h e th e r it is ju s tifia b le to use an a g g re s s iv e (in o th e r w o rd s , e a rly in th e p ro d u c tio n -s a le -c o lle c tio n c yc le process) reven ue re c o g n itio n p o lic y .
13 A s h a re h o ld e r in a la rg e p u b lic c o m p a n y th re a te n s to sue m a n a g e m e n t, th e a u d ito rs a n d th e A A S B fo r 'a p p ro v in g c o n s e rv a tiv e a c c o u n tin g p o lic ie s th a t h a ve resulted in p o o r a p p a re n t p e rfo rm a n c e a n d lo w stock p rice s th a t h a ve re d u c e d m y in ve stm en t v a lu e '. W h a t d o y o u th in k o f th e s h a re h o ld e r's c o m p la in t?
14 D u rin g lunch w ith a s e n io r e x e c u tiv e o f a la rg e p u b lic c o m p a n y , y o u a re a s ke d to re s p o n d to seve ral com m en ts, in c lu d in g th e fo llo w in g : 'A c c o u n tin g s ta n d a rd s a n d p rin c ip le s e v o lve to o s lo w ly to ke e p up w ith th e ra p id ly c h a n g in g needs o f businesses such as o u rs. W h y d o n 't w e just ig n o re s ta n d a rd s a n d G A A P , a n d d o o u r a c c o u n tin g th e best w a y fo r o u r ne e d s? '
a
b
'I w o u ld be g la d to see o u r g o o d w ill asset w ritte n o ff. I c a n 't see th e sense in in c lu d in g such a th in g w ith the b a la n c e shee t assets a n y w a y . T o m e, it's n o t like th e o th e r assets.'
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c
'Y o u just re fe rre d to ju d g e m e n t in a p p ly in g a c c o u n tin g p rin c ip le s . T h a t's fo o lis h : ju d g e m e n t is just a w o rd p e o p le use w h e n th e y 'd p re fe r no t to fo llo w th e ru le s.'
d
'I'v e h e a rd th a t th e a u d ito rs m a y no t a g re e w ith o u r p la n n e d a c c o u n tin g c h a n g e s . W h o cares? W e c an a lw a y s c h a n g e a u d ito rs .'
15 A n e w C E O is a p p o in te d to an o rg a n is a tio n . W h y m ig h t he o r she h a ve in ce ntive s to w rite o ff p a rtic u la r c a p ita lis e d assets, w rite d o w n som e investm ents a n d w rite o ff a lo t o f b a d debts? 16 G iv e n th a t a c c o u n tin g c h o ice s p ro v id e m a n a g e m e n t w ith th e o p p o rtu n ity to a c t in its o w n self-interest, w h a t a re th e b e ne fits fo r fin a n c ia l state m e nt users o f a llo w in g m a n a g e rs to c h o o se a c c o u n tin g p o lic ie s? 1 7 R efer to th e fo llo w in g state m e nt a n d a n s w e r th e q u e s tio n s th a t fo llo w : 'In an a c c ru a l a c c o u n tin g s etting, a lte rin g p o lic ie s b y , fo r e x a m p le , c h o o s in g to c a p ita lis e ra th e r th a n e x p e n s e a n in tere st cost o r using s tra ig h t-lin e d e p re c ia tio n versus re d u c in g b a la n c e , a c h ie v e s n o th in g m o re th a n to s h ift the re c o g n itio n o f expe nses fro m o n e p e rio d to a n o th e r. C o n s e q u e n tly , across tim e , such c h o ice s o u g h t to c o u n t fo r little, if a n y th in g a t a ll.' a
O n w h a t ba sis m ig h t this h a ve be en a rg u e d ?
b
W h a t rea so ns a re th e re to s u p p o rt th e id e a th a t th e c o n c lu s io n th a t has been re a c h e d m a y be o v e rly s im p lis tic ?
PROBLEMS PROBLEM 16.1 Review question on accrual acco u n ting and a ccounting p o lic y choices DEF LIMITED BALANCE SHEET AS AT 30 JUNE 2016
2015
$
$
Current assets C ash A cco u n ts re ce iva b le A llo w a n c e fo r d o u b tfu l debts Inventory
40000
60000
650000
300000
(5 0 0 0 0 )
(5 0 0 0 0 )
700000
290000
1 340000
600000
1 800000
1 100000
Noncurrent assets E quipm ent A ccu m u la te d d e p re c ia tio n
(5 5 0 0 0 0 )
C a p ita lis e d b o rro w in g costs
200000
-
1450000
1000000
2 790000
1 600000
670000
556000
Total assets
(1 0 0 0 0 0 )
Current liabilities A ccounts p a y a b le T a x p a y a b le
60000
44000
730000
600000
580000
600000
Total liabilities
1310000
1200000
Net assets
1480000
400000
Noncurrent liabilities Loan
648
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
Shareholders' equity Share capital
1150000
250000
330000
150 00 0
1480000
400000
Sales (all on credit)
1000000
640000
Net profit after tax
200000
128000
EBIT
290000
197000
41 000
32 000
Retained profits
Tax expense
Note: no equipment was sold during the year.
1
2
a
W h a t is th e in tere st e x p e n s e fo r 2 0 1 6 ?
b
H o w m uch e q u ip m e n t w a s p u rc h a s e d d u rin g th e y e a r?
c
W h a t w a s th e d e p re c ia tio n e x p e n s e fo r 2 0 1 6?
d
W e re a n y shares issued?
e
H o w m uch in d iv id e n d s w a s p a id d u rin g 2 0 1 6 ?
f
H o w m uch cash w a s re c e iv e d fro m custom ers d u rin g th e y e a r?
g
H o w m uch w a s p a id in ta x?
R efe rring to th e in fo rm a tio n in th e q u e s tio n , p ro v id e fo u r e x a m p le s o f a c c o u n tin g p o lic y c h o ice s th a t DEF m a y h a ve m a d e in d e te rm in in g p ro fit th a t m a y h a ve in c re a s e d th is y e a r's p ro fit.
PROBLEM 16.2 Revision plu s acco u n tin g p o lic y choices QRST LIMITED BALANCE SHEET AS AT 30 JUNE 2016
2015
$
$
Current assets Cash Accounts receivable
120 00 0
100000
1000000
900000
Allowance for doubtful debts
(100000)
Inventory
780000
1 200000
(100000)
1 800000
2100000
Non-current assets Equipment Accumulated depreciation Capitalised R&D
Total assets
2 700000 (700000) -
2 600000 (1 100000) 400000
2 000000
1 900000
3 800000
4000000
1 000000
1 340000
88 000
100000
Current liabilities Accounts payable and accrued expenses Tax payable Unearned revenue
112000
0
1 200000
1440000
CHAPTER 16 Accounting policy choices
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Non-current liabilities Loan
1 200000
1 160000
Total liabilities
2 400000
2 600000
N et assets
1400000
1400000
Shareholders' equity Share capital Retained profits
1 000000
900000
400000
500000
1400000
1400000
Sales (all on credit)
1280000
2 000000
Net profit after tax
256000
400000
EBIT
394000
580000
64000
82 000
Tax expense
A d d itio n a l in fo rm a tio n : E q u ip m e n t th a t cost $1 0 0 0 0 0 0 a n d h a d a c c u m u la te d d e p re c ia tio n o f $ 6 0 0 0 0 0 w a s sold fo r $ 5 0 0 0 0 0 . 1 A s o f 3 0 June 2 0 1 6 , w h a t a m o u n t has be en p a id b y Q RST Lim ited s h a re h o ld e rs to b e co m e s h a re h o ld e rs o f the com pany? 2
W h a t a c c o u n t in th e b a la n c e sheet tells y o u th a t Q RST Lim ited has be en p ro fita b le since in c o rp o ra tio n ?
3
If y o u fin d o u t th a t th e m a rke t v a lu e o f Q RST Lim ited in v e n to ry a t 3 0 June 2 0 1 6 is $ 8 0 0 0 0 0 , w o u ld y o u in c lu d e in v e n to ry in th e b a la n c e sheet a t $ 7 8 0 0 0 0 o r $ 8 0 0 0 0 0 ?
4
W a s th e re a n y g a in o r loss o n sale o f e q u ip m e n t?
5
H o w m uch e q u ip m e n t w a s p u rc h a s e d d u rin g th e y e a r?
6 W e re a n y shares issued? 7
W e re a n y d iv id e n d s p a id ? If so, h o w m uch?
8
H o w m uch w a s p a id in ta x?
9
If c a p ita lis e d R &D h a d been e x p e n s e d , w h a t b a la n c e sheet a c co u n ts w o u ld h a ve been a ffe c te d ?
1 0 If th e c o m p a n y re c o g n is e d $ 5 0 0 0 0 e x tra o f a c c ru e d expe nses, w h a t a c co u n ts in th e b a la n c e sheet a n d the in c o m e state m e nt w o u ld be in cre a s e d o r d e cre a s e d ? 11 W h a t w o u ld be th e im p a c t on (a) th e b a la n c e sheet, a n d (b) th e in c o m e state m e nt if th e a m o u n t in u n e a rn e d re ven ue h a d be en re c o g n is e d as revenue? 12 In ve n to ry is v a lu e d using th e FIFO m e th o d . If th e p ric e o f in v e n to ry is in c re a s in g , w h a t w o u ld h a ve be en th e e ffe c t o n th e fo llo w in g if th e w e ig h te d a v e ra g e m e th o d h a d been used? a
C lo s in g in v e n to ry in th e b a la n c e sheet
b
COGS
c
N e t p ro fit
d
C ash flo w fro m o p e ra tio n s
13 W h a t w a s the d e p re c ia tio n expe nse fo r the y e a r? If th e c o m p a n y c h a n g e d to a n a c c e le ra te d m ethod o f d e p re c ia tin g n o n cu rre n t assets, w h a t w o u ld be th e effect on net p ro fit fo r the y e a r a n d e q u ip m e n t (net) a t y ear-e nd?
PROBLEM 16.3 Im pact on p ro fit and the balance sheet In d ic a te th e im p a c t th a t e a ch o f th e fo llo w in g e rro rs o r om is sio n s w o u ld h a ve on a c o m p a n y 's 2 0 1 6 net p ro fit, assets a n d lia b ilitie s . Use th e sym bols U = un d e rsta te , 0 = o v e rs ta te o r N E = no e ffe c t to in d ic a te th e im p a c t. D o lla r am ou nts a re not re q u ire d . 1 M a n a g e m e n t uses th e p e rce nta ge -o f-sale s a p p ro a c h m e th o d to c a lc u la te th e a llo w a n c e fo r d o u b tfu l ac co u n ts. M a n a g e m e n t c a lc u la te d th e a llo w a n c e fo r d o u b tfu l d e b ts on th e b a sis o f 2 p e r c e n t o f sales. H o w e v e r b y y e a re n d it w a s a w a re th a t th e ra te sh o u ld h a ve re a lly be en 3 p e r c e n t o f sales. M a n a g e m e n t do es no t a d ju s t the a llo w a n c e fo r d o u b tfu l a c co u n ts a t y e a r-e n d . Sales e q u a l $1 m illio n .
650
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
2
The c o m p a n y c a lc u la te d d e p re c ia tio n o v e r e ig h t y e a rs w h e re th e e x p e c te d life o f th e asset is fiv e y e a rs . The d iffe re n c e in d e p re c ia tio n p e r y e a r am o u n ts to $ 1 0 0 0 0 0 .
3
The c o m p a n y o w n s 2 0 p e r c e n t o f X share s, h a v in g p a id $ 2 0 0 0 0 0 fo r these shares last y e a r. D u rin g th e y e a r, X m a d e a p ro fit o f $1 m illio n a n d p a id d iv id e n d s in to ta l to a ll s h a re h o ld e rs o f $ 6 0 0 0 0 0 . The c o m p a n y used the cost m e th o d w h e n it sh o u ld h a ve used th e e q u ity m e th o d .
4
C o m p a n y sales a m o u n t to $1 m illio n a n d th e c o m p a n y estim ates th a t w a rra n ty costs w ill b e 2 p e r c e n t o f sales fo r e a ch o f th e firs t tw o y e a rs . N o w a rra n ty expe nses a re re c o rd e d in th is y e a r.
5
A u d ito rs estim a te th a t th e p ro v is io n fo r lo n g s e rvice le ave sh o u ld be $ 1 .2 m illio n , b u t th e c o m p a n y has re c o rd e d it a s $ 9 0 0 0 0 0 .
PROBLEM 1 6 .4 A ccounting p o lic y choice - im p a ct on fin a n cia l statem ents S o ftw a re Ltd is a s o ftw a re te c h n o lo g y c o m p a n y th a t b e g a n o p e ra tio n s a t th e b e g in n in g o f 2 0 1 4 . It p la n s to list on the A u s tra lia n S to ck E x ch a n g e in 2 0 1 6 . The c o m p a n y b e lie ve s th a t it c a n start s e llin g its s o ftw a re p ro g ra m fro m 2 0 1 5 (sales fo reca sts a re in th e in c o m e state m e nt b e lo w ). The s o ftw a re p ro g ra m is to be sold a n d d e liv e re d (i.e . d o w n lo a d e d ) v ia th e in te rn e t, thus a llo w in g th e c o m p a n y to a v o id p ro d u c t sales a n d d e liv e ry costs. The c o m p a n y needs to c a rry o u t resea rch a n d d e v e lo p m e n t a c tiv itie s th ro u g h o u t its life c y c le to ke e p up w ith e v e r-c h a n g in g c o m p u te r te c h n o lo g ie s . The fo llo w in g sch e d u le p ro v id e s the e x p e c te d e x p e n d itu re o n resea rch a n d d e ve lo p m e n t. Expected expenditure:
($000) 2014
Research
2015
2017
2016
1 000
600
Development
600
600
The c o m p a n y 's c u rre n t a c c o u n tin g p o lic y fo r resea rch a n d d e v e lo p m e n t costs is as fo llo w s : Research
Immediate expensing
Development
Three years' straight-line amortisation
The s u m m a ry fo re c a s t in c o m e state m e nt is as fo llo w s : SUMMARY FORECAST INCOME STATEMENT ($000)
Sales
2014
20 15
2016
2017
0
500
1 000
2 000
200
300
400
500
Less: Operating expenses Expenses relating to: Research Development Total expenses Net profit before tax
1000 -
1 200 (1 200)
600 200
200
400
500
1 200
900
0
(200)
1 too
The C F O no tices th a t as th e c o m p a n y is e x p e c te d to m a ke a loss in 2 0 1 6 , it w o u ld be d iffic u lt to g o fo r a p u b lic listin g in 2 0 1 6 . H e is c o n s id e rin g th e a c c o u n tin g p o lic y o n resea rch a n d d e v e lo p m e n t costs as fo llo w s : resea rch costs e x p e c te d to be in c u rre d in 2 0 1 6 a n d o n w a rd s w ill be c a p ita lis e d a n d a m o rtis e d o v e r th re e y e a rs , a n d d e v e lo p m e n t costs e x p e c te d to be in c u rre d in 2 0 1 5 a n d o n w a rd s w ill be im m e d ia te ly e x p e n s e d .
CHAPTER 16 Accounting policy choices
651
1
R e c alculate th e s u m m a ry fo re c a s t in co m e state m e nt to re fle c t the c h a n g e in a c c o u n tin g p o lic y fo r resea rch a n d d e v e lo p m e n t.
2
E x p la in w h y th e C F O m a y w a n t this c h a n g e .
3
W o u ld th e a b o v e c h a n g e b e co n s is te n t w ith A u s tra lia n A c c o u n tin g S ta n d a rd s ?
4
Discuss th e cash flo w im p lic a tio n s o f th e p ro p o s e d a c c o u n tin g p o lic y c h a n g e s fo r th e y e a r 2 0 1 5 o n ly .
PROBLEM 16 .5 A cco u n tin g p o lic y choice and im p a ct on tin a n cia l statem ents A B C is c o n s id e rin g issuing n e w shares to fin a n c e e x p a n s io n . The m a n a g e m e n t p re p a re d th e fo llo w in g in co m e state m e nt fo r th e p e rio d e n d in g 31 D e c e m b e r 2 0 1 6 , to be s u b m itte d to th e b o a rd o f d ire c to rs fo r its a p p ro v a l: ABC INCOME STATEMENT FOR THE PERIOD ENDING 31 DECEMBER 20 16 $m
$m
2016
20 15
Sales revenue
678.2
330.9
Expenses
(908.6)
(305.7)
Earnings before interest, tax, depreciation and amortisation (EBITDA)
(230.4)
25.2
Depreciation and amortisation Net interest (expensej/revenue Net profit/(loss) before income tax Income tax expense (30%) Net profit/(loss) after income tax
(35.3) 3.3 (262.4) (262.4)
(12.3) (1.6) 11.3 (3.4) 7.9
The C F O suggests th a t th e $ 4 5 0 m illio n spen t on m a rk e tin g costs on 1 J a n u a ry 2 0 1 6 , w h ic h is c u rre n tly tre a te d as a n e x p e n s e , sh o u ld b e c a p ita lis e d a n d a m o rtis e d o v e r th re e y e a rs in ste a d . This tre a tm e n t w a s co n s is te n t w ith tre a tm e n t o f s im ila r costs b y o th e r c o m p a n ie s he h a d p re v io u s ly w o rk e d fo r. 1
R e c alculate a n d p re p a re a n e w 2 0 1 6 in co m e state m e nt to re fle c t th e p ro p o s e d c h a n g e in th e a c c o u n tin g p o lic y fo r m a rk e tin g costs.
2
S h o u ld th e m a rk e tin g costs be c o n s id e re d a n asset? A p p ly th e re le v a n t d e fin itio n a n d re c o g n itio n c rite ria in y o u r a n s w e r.
3
Discuss th e cash flo w im p lic a tio n s o f th e p ro p o s e d a c c o u n tin g p o lic y c h a n g e fo r 2 0 1 6 a n d 2 0 1 7 .
PROBLEM 1 6 .6 A cco u n tin g p o lic y change calculation s B rig h t Ltd is a re ta ile r o f e le c tric a l p ro d u cts . The C E O o f th e c o m p a n y h a d tw o c o n c e rn s: th e c o m p a n y 's w o rs e n in g cash p o s itio n ( $ 5 0 0 0 0 cash a n d no b a n k lo a n a t the e n d o f 2 0 1 5 , a n d no cash a n d a $ 1 0 0 0 0 0 b a n k lo a n a t the e n d o f 2 0 1 6 ) a n d an in a d e q u a te level o f net p ro fit (a c c o rd in g to th e C E O ). 1 The C E O w a s co n fu se d b e ca u s e th e c o m p a n y h a d a $ 9 0 0 0 0 p ro fit, y e t seem ed , as no te d a b o v e , $ 1 5 0 0 0 0 w o rs e o ff in its cash p o s itio n . E x p la in b rie fly h o w , in g e n e ra l, th is d iffe re n c e b e tw e e n p ro fit a n d cash c h a n g e c a n happen. 2
For e a ch o f th e p ro p o s e d c h a n g e s b e lo w , c o n s id e re d s e p a ra te ly a n d in d e p e n d e n tly , c a lc u la te th e e ffe c t on 2 0 1 6 net p ro fit a n d to ta l assets as a t 31 D e c e m b e r 2 0 1 6 . A ssum e a 3 0 p e r c e n t in c o m e ta x rate. a
The C E O sugg ested re c o g n is in g reven ue a t an e a rlie r p o in t. If this w e re d o n e , net a c co u n ts re c e iv a b le w o u ld be in c re a s e d b y $1 2 0 0 0 0 a t 31 D e c e m b e r 2 0 1 5 a n d b y $ 2 3 0 0 0 0 a t 31 D e c e m b e r 2 0 1 6 .
b
The C E O sugg ested c h a n g in g th e in v e n to ry cost p o lic y to FIFO (w h ic h w o u ld still p ro d u c e costs less th a n net re a lis a b le v a lu e ). D o in g th is w o u ld in cre a s e 31 D e c e m b e r 2 0 1 5 in ve n to rie s b y $ 4 0 0 0 0 a n d 31 D e c e m b e r 2 0 1 6 in ve n to rie s b y $ 1 0 0 0 0 .
652
c
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The C E O sug g e ste d c a p ita lis in g m o re o f th e c o m p a n y 's p ro d u c t d e v e lo p m e n t costs a n d a m o rtis in g a d d itio n a l c a p ita lis e d am o u n ts o v e r fiv e y e a rs , using th e s tra ig h t-lin e m e th o d . If this w e re d o n e , $ 4 0 0 0 0 o f 2 0 1 5 expe nses w o u ld be c a p ita lis e d a t 31 D e c e m b e r 2 0 1 5 a n d $ 6 0 0 0 0 o f 2 0 1 6 expe nses w o u ld be c a p ita lis e d a t 31 D e c e m b e r 2 0 1 6 .
PROBLEM 16.7 A cco u n tin g p o lic y choice - so ftw a re developm ent costs C o m p u te r Ltd p ro v id e s th e fo llo w in g in fo rm a tio n in its 2 0 1 5 fin a n c ia l statem ents: S o ftw a re d e v e lo p m e n t co s ts
S oftw are d e velopm e nt costs are charged to p ro fit fro m o rdinary activities b e fo re inco m e tax is incu rred o r de fe rre d, w here it is expected beyond any reasonable d o u b t th a t s u ffic ie n t fu tu re benefits will be derived so as to re cover those de fe rre d costs. S oftw are d e velopm e nt costs are am ortised on a s tra ig h t-lin e basis fro m th e date th e y are held ready fo r use over th e period du ring w hich th e related be nefits are expected to be realised, b u t n o t exceeding th re e years.
Discuss th e ju d g e m e n ts to be m a d e b y th e a c c o u n ta n t. H o w do es e a ch ju d g e m e n t a ffe c t p ro fit in 2 0 1 5 a n d 2016?
PROBLEM 1 6 .8 In te re st ca p ita lisa tio n policies B o ra l L im it e d , 3 0 J u n e 2 0 1 4
F inancing costs are recognised as an expense in th e period in w hich th e y are incurred, unless th e y relate to a qualifying asset. Financing costs incu rred fo r th e co n s tru c tio n o f any qualifying asset are capitalised du ring th e period o f tim e th a t is required to co m p le te and prepare th e asset fo r its intende d use o r sale.
C o m p a re th e p o ss ib le a c c o u n tin g tre atm ents on c a p ita lis a tio n o f in tere st fo r th e c o m p a n y . H o w do es th e p o lic y on in tere st c a p ita lis a tio n h a ve a n im p a c t on p ro fit in d iffe re n t a c c o u n tin g p e rio d s?
PROBLEM 16 .9 Inve n to ry cost and e ffe cts calculation s Y ou w o rk fo r a la rg e lo c a l c o m p a n y as th e in v e n to ry m a n a g e r. The c o m p a n y uses FIFO in a c c o u n tin g fo r in ve n to ry. In June, th e c o m p a n y b e g a n to stock a n e w p ro d u c t, P ainto . The June in v e n to ry re c o rd fo r P ainto w a s : 1 Date
Purchase price
Units purchased
$10
1250
$11
1000
June 1 10 12 17
$12
1
2
2250
500
$13
C a lc u la te , usin g FIFO: a
th e c o st o f th e 3 0 June in v e n to ry o f P ainto
b
th e C O G S fo r P ainto fo r June.
C a lc u la te , usin g LIFO (eithe r p e rp e tu a l o r p e rio d ic ): a
th e c o st o f th e 3 0 June in v e n to ry o f P ainto
b
th e C O G S fo r P ainto fo r June.
2000 2500
2000
30
Units on hand 1250
250
23 27
Units sold
1500
500 2000
800
1200
CHAPTER 16 Accounting policy choices
653
PROBLEM 16.10 A cco u n tin g p o lic y choice C o n s id e r th e fo llo w in g fo o tn o te d isc lo su re fro m th e 2 0 0 5 fin a n c ia l results o f W o o lw o rth s Ltd: C o n siste n t w ith th e re quirem ents o f U IG (U rg e n t Issues G ro u p ) In te rp re ta tio n 1 0 0 2 , s e ttle m e n t discounts, rebates and o th e r purchase allowances to ta llin g $ 6 0 0 . 9 m illion c u rre n tly recognised in o th e r o p era ting revenue, these will be reclassified as a re d u c tio n in co st o f sales o f $ 4 1 8 .3 m illion, a re d u c tio n in ad m inistra tion expenses o f $36.1 m illion and as an increase in o th e r revenue fro m o rd inary activitie s o f $ 1 4 6 .5 m illion.
1
P ro v id e a jo u rn a l e n try fo r th e re c la s s ific a tio n m e n tio n e d a b o v e .
2
E x p la in th e ra tio n a le fo r tre a tin g 'se ttle m e n t disc o u n ts , reb ate s a n d o th e r p u rch a s e a llo w a n c e s ' as a re d u c tio n in cost o f sales ra th e r th a n revenue.
3
State th re e fin a n c ia l ra tio s th a t th e a b o v e a d ju s tm e n t w o u ld a ffe c t a n d h o w th e a d ju s tm e n t w o u ld a ffe c t these ra tio s (in cre a se o r d e cre a se ).
PROBLEM 16.11 Brand nam e p o lic y choices A n s e ll L im it e d , 3 0 J u n e 2 0 1 4 G o o d w ill a n d b ra n d n a m e s
G oo dw ill on acquisition is m easured at co s t being th e excess o f th e co st o f th e acquisition over th e fa ir value o f th e G ro u p ’s share o f th e n e t iden tifiab le assets acquired. G oo dw ill is n o t am ortized. Brand names are initially recorded a t co st based on inde pend ent valuation at acquisition date (w h ich equates to fa ir value). Based on th e na tu re o f th e m ajor brand names acquired by th e G ro u p , w hich are international brands th a t b e n e fit fro m co m p e titive advantages due to tech nology, innovation and p ro d u c t developm ent, it is n o t possible to m ake an a rb itra ry assessm ent th a t these brand names have a fin ite useful life, quantifiable in te rm s o f years e xcep t w here such brands are su bject to licensing agreem ents co verin g a fin ite period. Brand names su bject to a licensing arra ngem en t are am ortized over th e life o f th e arrangem ent. N o am ortization is provided against th e ca rrying value o f those brand names n o t su bject to a licensing arra ngem en t as th e G ro u p believes th a t th e lives o f such assets are in d e fin ite a t th is point. G oo dw ill and brand names are reviewed annually, o r m o re fre q u e n tly if events o r changes in circum stances indicate th a t th e ir ca rrying values m ay be im paired, and are carried a t co st less accum ulated im p a irm e n t losses. F o r th e purposes o f im p a irm e n t testing, goodw ill and brand names are allocated to cash generatin g units (w h ich equate to th e G ro u p ’s re porta ble business segm ents) upon acquisition. A cq u ire d businesses can readily be allocated to one o f th e business segm ents on th e basis o f p ro d u cts m anu fa cture d a n d /o r m arketed. Such m a n u fa ctu rin g and m arketing operations te n d to co ve r m ore than one geographical region. Im p a irm e n t is d e te rm in ed by assessing th e recoverable a m o u n t o f th e cash generatin g u n it to w hich th e goodw ill and brand names relate. W h e re th e recoverable a m o u n t o f th e cash ge nerating u n it is less than th e ca rrying value, an im p a irm e n t charge to goodw ill a n d /o r brand names is recognized in th e Inco m e S tatem ent. A n im p a irm e n t loss in re spe ct o f goodw ill is n o t reversed.
1
If a n asset is im p a ire d a n d w ritte n d o w n , w h a t is th e im p a c t on th e in co m e state m e nt a n d th e b a la n c e sheet?
2
S u g g e st tw o a lte rn a tiv e a c c o u n tin g p o lic ie s fo r a c c o u n tin g fo r b ra n d nam es.
3
W h a t w o u ld be th e im p a c t on p ro fit a n d to ta l assets fo r 2 0 1 4 o f a d o p tio n o f th e a b o v e a lte rn a tiv e p o lic ie s?
PROBLEM 16.12 M u ltip le -iss u e e ffe cts analysis E a rlw o o d Ltd has been o p e ra tin g fo r s eve ral y e a rs n o w . So fa r th e p ro fit fo r th e c u rre n t y e a r is $ 7 5 0 0 0 , b e fo re in co m e ta x . M a n a g e m e n t is c o n s id e rin g a fe w ch a n g e s a n d has a s ke d y o u r a d v ic e . The p o ss ib le c h a n g e s a re : a C h a n g e th e re ven ue re c o g n itio n p o lic y to re c o g n is e re ven ue e a rlie r in th e process. This w o u ld in cre a s e acco un ts re c e iv a b le b y $ 2 6 0 0 0 im m e d ia te ly a n d $ 2 8 0 0 0 a t th e e n d o f th e p re vio u s y e a r,
b
M a k e a m o n th ly a c c ru a l o f th e bonuses p a id to e m p lo y e e s a t th e e n d o f e a ch fisc a l y e a r. This w o u ld in cre a s e acco un ts p a y a b le b y $1 1 0 0 0 im m e d ia te ly a n d $ 7 0 0 0 a t th e e n d o f th e p re c e d in g y e a r.
654
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
c
P ostpone fo r five y e a rs re p a y m e n t o f a $1 9 0 0 0 lo a n (b y Jan to th e c o m p a n y ), w h ic h has up to n o w been c la s s ifie d as a c u rre n t lia b ility .
d
C a p ita lis e as a n asset a d e v e lo p m e n t cost o f $ 1 4 0 0 0 fo r w a g e s e x p e n s e re c o rd e d in th e p re c e d in g y e a r.
Required: 1 C a lc u la te th e net p ro fit b e fo re ta x fo r th e c u rre n t y e a r.
PROBLEM 16.13 E ffects analysis In d ic a te th e im p a c t th a t e a c h o f th e fo llo w in g e rro rs o r om is sio n s in 2 0 1 6 w o u ld h a ve o n a c o m p a n y 's 2 0 1 6 net p ro fit, assets a n d lia b ilitie s (ye ar-e nd is 31 D e ce m b e r). Place th e s ym bols U = un d e rsta te , O = o v e rs ta te o r N E = no e ffe c t in th e a p p ro p ria te b o x . Be sure to p la c e an a n s w e r in e v e ry b o x in c lu d in g d o lla r a m ou nts. 1
D id no t a c c ru e w a g e s o f $ 4 0 0 0 0 e a rn e d b y e m p lo y e e s in 2 0 1 6 b u t d u e to be p a id in 2 0 1 7 .
2
$ 7 0 0 0 0 w a s re c e ive d a n d c re d ite d to a cco u n ts re c e iv a b le ; o f this a m o u n t, $ 2 5 0 0 0 w a s in fa c t a n a d v a n c e p a y m e n t fro m a c u sto m e r fo r w o rk to be d o n e ne xt y e a r.
3
D id no t a d ju s t th e p re p a id in su ra n c e a c c o u n t to re fle c t th a t $ 1 0 0 0 o f in su ra n c e c o v e ra g e h a d be en used up.
4
R e co rd e d a full y e a r o f a c c ru e d in tere st e x p e n s e on a $ 3 0 0 0 0 , 6 p e r c e n t no te p a y a b le th a t has o n ly been o u ts ta n d in g s in c e 1 July 2 0 1 6 .
Transaction
Net profit
Assets
Liabilities
1
2 3 4
CASES CASE 16A
W oolworths Limited
Refer to th e e x tra c ts o f th e a n n u a l re p o rt o f W o o lw o rth s Lim ited in this b o o k 's a p p e n d ix . 1 P ro v id e e x a m p le s o f som e a c c o u n tin g p o lic y c h o ice s d is c lo s e d in N o te 1 o f th e acco un ts. 2
D o a n y o f th e o th e r notes p ro v id e fu rth e r d e ta ils on im p o rta n t p o lic y choice s?
3
A ssum e th e re w a s a c h a n g e o f a c c o u n tin g p o lic y to w rite o ff in ta n g ib le s o v e r 1 0 y e a rs . W h a t e ffe c t w o u ld this h a ve on net p ro fit a n d to ta l assets?
4
W o u ld a d o w n w a rd re v a lu a tio n o f liq u o r lice nces h a ve a n y e ffe c t on p ro fit?
5
W ill th e fig u re s in th e 2 0 1 3 c o lu m n o f th e 2 0 1 4 a n n u a l re p o rt be th e sam e as th e y w o u ld h a ve a p p e a re d in the 2 0 1 3 a n n u a l re p o rt?
CASE 16B___________________________ Accounting policy choices This ca se refers to som e in te re stin g a c c o u n tin g d e c is io n s a lm o s t 2 0 y e a rs a g o bu t still o f in tere st. N o te 1 fro m the 1 9 9 6 a cco u n ts o f S y d n e y H a rb o u r C a s in o H o ld in g s Lim ited notes th a t 'P re -o p e n in g expe nses consist p rim a rily o f set up costs, e s ta b lish m e n t costs a n d th e costs a s s o c ia te d w ith th e o rg a n is a tio n o f th e C a s in o lice n c e , sh a re issue a n d fin a n c e costs. P re-o pe nin g expe nses h a ve been w ritte n o ff as in c u rre d '.
CHAPTER 16 Accounting policy choices
655
P re -o p e n in g Costs for a Casino W h e n S y d n e y H a r b o u r C a s in o H o ld in g s L td o p e n e d b a c k in 1 9 9 6 it re c o r d e d $1 m illio n n e t p r o f it f o r its f ir s t six m o n th s o f o p e ra tio n s , b u t th is w as a lo t less th a n b o th p ro s p e c tu s fo re c a s ts a n d its m a in c o m p e tito r , C ro w n C a s in o in M e lb o u rn e . T h e c h a irm a n o f S y d n e y H a r b o u r C a s in o a rg u e d t h a t C r o w n ’s b e tt e r p e rfo rm a n c e w as la rg e ly d u e to a c c o u n tin g m e th o d s ra th e r th a n w ith re al o p e ra tio n s . T h e b ig d iffe r e n c e is t h a t S y d n e y H a r b o u r C a s in o tre a te d its p r e - o p e n in g c o s ts as e x p e n s e s in its f ir s t y e a r w h ile C r o w n c a p ita lis e d th o s e c o s ts . T h e re s u lt w as t h a t S y d n e y C a s in o ’s p r e - a b n o rm a l $ 2 4 . 8 m illio n p r o f it w as re d u c e d b y $ 2 2 m illio n in p r e - o p e n in g c o s ts a n d a m o r tis a tio n o f p r e - p a id re n ta ls . Its E B IT w as $ 4 7 m illio n b u t th e re s u lt w a s a lo t lo w e r th a n p r o s p e c tu s fo re c a s ts a n d re v e n u e f o r th e 1 9 9 6 fin a n c ia l y e a r w as 2 2 p e r c e n t lo w e r th a n p r o s p e c tu s fo re c a s ts a n d its p re d ic te d n e t p r o f it o f $ 3 7 m illio n . P ress a n n o u n c e m e n ts re fe rre d t o th e c a s in o ’s re n e w e d calls f o r a n e w , lo w e r ta x ra te f o r h ig h -r o lle r g a m b le rs , a n d o u tlin in g th e b e n e fits th is w o u ld b rin g t o N S W b y a d d itio n a l re v e n u e d o lla rs f o r th e g o v e rn m e n t. Source: Adapted fro m Australian Financial Review, 15 A ugust 1996.
1
E x p la in , as s im p ly as p o ss ib le , w h a t is in c lu d e d in p re -o p e n in g costs.
2
H o w do es th e a c c o u n tin g tre a tm e n t fo r p re -o p e n in g costs d iffe r b e tw e e n th e tw o ca sin o s? W h a t e ffe c t d o the d iffe re n c e s h a ve on bo th p ro fit a n d th e b a la n c e sheets o f th e tw o c o m p a n ie s ?
3
W h y m ig h t S y d n e y C a s in o h a ve chosen to a c c o u n t fo r p re -o p e n in g costs in this w a y ?
4
Is th e c h o ic e o f a c c o u n tin g m e th o d an excu se fo r n o t re a c h in g p ro fit fo reca sts?
CASE 16C
WorldCom
O n e o f th e la rg e s t fin a n c ia l state m e nt fra u d s o f this c e n tu ry in v o lv e d a US te le c o m m u n ic a tio n s c o m p a n y c a lle d W o rld C o m . The fra u d s in v o lv e d o v e rs ta tin g p ro fits b y $ 7 4 .4 b illio n (yes, b illio n !) b e tw e e n 2 0 0 1 a n d 2 0 0 2 . E x p e n d itu re th a t sh o u ld h a ve be en re c o rd e d as expe nses in 2 0 0 1 - 0 2 w a s in ste a d c a p ita lis e d ; th a t is, in c lu d e d in th e costs o f th e asset. 1
2
U sing th e a c c o u n tin g e q u a tio n , s h o w h o w th e e q u a tio n (assum e a ll e x p e n d itu re h a ve be en p a id in cash): a
w o u ld h a ve been re c o rd e d b y th e c o m p a n y
b
sh o u ld h a ve been re c o rd e d b y th e c o m p a n y .
E x p la in w h ic h o f th e fo llo w in g w o u ld be a ffe c te d b y the fra u d u le n t re p o rtin g in 2 0 0 1 - 0 2 : a
to ta l cash flo w s
b
cash flo w fro m o p e ra tio n s
c
cash flo w fro m in ve sting
d
cash flo w fro m fin a n c in g .
CASE 16D___________________________________Intangibles S h o w n b e lo w a re e x tra c ts fro m N o te 1 o f th e fin a n c ia l statem ents o f Ten N e tw o rk H o ld in g s Lim ited a n d Seven N e tw o rk Lim ited fro m p re v io u s fin a n c ia l y e a rs .
Ten N e tw o rk Television program rights T e le v is io n p r o g ra m s w h ic h a re a v a ila b le f o r b ro a d c a s t a re re c o g n is e d as an a s s e t an d s ta te d a t c o s t. S e rie s p r o g ra m s a re w r it te n o f f in fu ll u p o n in itia l a irin g . F e a tu re s a re a m o rtis e d o v e r t h e ir e s tim a te d u s e fu l lives. F u r th e r m o r e , th e c a rr y in g v a lu e s o f te le v is io n p ro g ra m rig h ts a re te s te d f o r im p a ir m e n t as s e t o u t in N o t e 1 (e).
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
T e le v is io n p r o g ra m s a t b a la n c e d a te f o r w h ic h th e te le c a s t lic e n c e p e rio d has c o m m e n c e d o r w ill c o m m e n c e in t h e s u c c e e d in g y e a r has b e e n c la s s ifie d as a c u r r e n t asset.
Seven N e tw o rk Program rights T e le v is io n p ro g ra m rig h ts a re c a rrie d a t th e lo w e r o f c o s t less a m o r tis a tio n a n d n e t re c o v e ra b le a m o u n t. C o s t c o m p ris e s a c q u is itio n o f p ro g ra m rig h ts a n d , f o r p r o g ra m s p r o d u c e d u s in g th e c o n s o lid a te d e n tit y ’s fa c ilitie s , d ir e c t la b o u r a n d m a te ria ls a n d d ir e c tly a ttr ib u ta b le fix e d a n d v a ria b le o v e rh e a d s .
Recognition T e le v is io n p ro g ra m a s se ts a n d p ro g ra m lia b ilitie s a re re c o g n is e d f r o m t h e c o m m e n c e m e n t o f th e rig h ts p e rio d o f th e c o n tr a c t. C o n tr a c t p a y m e n ts m a d e p r io r t o c o m m e n c e m e n t o f th e rig h ts p e rio d a re d is c lo s e d as a p r e p a y m e n t a n d in c lu d e d u n d e r te le v is io n p ro g ra m rig h ts a n d in v e n to rie s .
A m o rtisatio n policy T h e G r o u p ’s a m o r tis a tio n p o lic y re q u ire s th e a m o r tis a tio n o f p u rc h a s e d p ro g ra m s o n a s tra ig h t lin e basis o v e r a life o f b e tw e e n o n e a n d th r e e y e a rs f r o m c o m m e n c e m e n t o f th e rig h ts p e rio d o r o v e r th e rig h ts p e rio d o f t h e c o n t r a c t (w h ic h e v e r is th e le ss e r). P r o d u c e d p r o g ra m s a re e x p e n s e d o n te le c a s t o r in fu ll o n t h e t w e lft h m o n th a f t e r c o m p le tio n .
1
W h a t a re th e d iffe re n c e s b e tw e e n th e a c c o u n tin g p o lic ie s o f th e tw o c o m p a n ie s fo r te le v is io n p ro g ra m rights?
2
W h ic h c o m p a n y d o y o u b e lie v e has th e m o re c o n s e rv a tiv e a c c o u n tin g p o lic ie s ? W h y ?
COURSEMATE
WEBSITE RESOURCES
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R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook
>
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
Sustainability reporting
1
ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO: explain the terms 'sustainability m an agem ent' a n d 'sustainability reporting' outline w h a t is g e n erally reported in sustainability reports understand an d identify the drivers for sustainability reporting identify w h o a re the organisation's stakeholders a n d explain their inform ation needs describe the key reasons for the existence o f sustainability reporting explain recent trends in sustainability reporting explain the G lo b a l Reporting Initiative (GRI) guidelines a n d reporting criteria pro vide exam ples o f perform ance indicators used in sustainability reporting explain the reasons for the increase in assurance of sustainability reporting explain the im portance of m easurem ent a n d disclosure o f e n erg y use pro vide exam ples o f en erg y and greenhouse gas emission disclosures identify the objectives of integrated reporting identify the key critical issues a n d concerns related to integrated reporting.
CHAPTER OVERVIEW T h ro u g h C h a p te rs 1 to 1 6 y o u h a ve g a in e d k n o w le d g e o f th e c o n te n t o f th e th re e k e y fin a n c ia l state m e nts - th e b a l a n c e sheet, th e in c o m e s ta te m e n t a n d th e s ta te m e n t o f c a sh flo w s - a n d som e o th e r a s p e cts o f la rg e a n n u a l re p o rts p ro d u c e d b y c o m p a n ie s . A n e v o lv in g tre n d is to in c o rp o ra te a c o n s id e ra b le a m o u n t o f in fo rm a tio n o n issues o f sus ta in a b ility , in c lu d in g such issues a s th e c o m p a n y 's im p a c t o n th e e n v iro n m e n t, p a rtic u la rly g re e n h o u s e g a s (G H G ) e m is sio n s a n d e n e rg y u s a g e , w o r k sa fe ty, p ro d u c t s a fe ty a n d im p a c t o n th e c o m m u n ity . For som e c o m p a n ie s , this ta ke s u p m a n y p a g e s o f th e a n n u a l re p o rt, w h ile fo r o th e rs it is m o re c o n c is e . S om e c o m p a n ie s a ls o issue a s e p a ra te s u s ta in a b ility re p o rt, w h ic h o fte n is in excess o f 1 0 0 p a g e s . G iv e n th e e x p e rtis e o f a c c o u n ta n ts in m e a s u rin g a n d re p o rtin g in fo rm a tio n , it is n o t s u rp ris in g th a t a c c o u n ta n ts h a ve a m a jo r ro le in s u s ta in a b ility re p o rtin g . This c h a p te r in tro d u c e s y o u to th e c o n c e p ts o f s u s ta in a b ility re p o rtin g a n d th en c o n s id e rs a n e w fo rm o f re p o rtin g re fe rre d to a s in te g ra te d re p o rtin g . This in c lu d e s b o th fin a n c ia l a n d s u s ta in a b ility re p o rtin g , to g e th e r w ith g o v e r n a n c e a n d re m u n e ra tio n re p o rtin g , w h ic h is a ll in te g ra te d b y m a n a g e m e n t c o m m e n ta ry .
658
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
17.1
W hat is sustainability reporting?
In considering the nature of sustainability reporting, it is necessary to consider w h a t sustainable developm ent and sustainability m anagem ent are, an d w h a t sustainability inform ation is being reported. •
Sustainable developm ent is developm ent that meets the needs o f the present w ith o u t com prom ising the a b ility of future generations to meet their o w n needs.
•
S ustainability m anagem ent is concerned w ith the m aintenance a nd long-term enhancem ent o f six types o f capital that reflect an o rg a nisation's overall im pact an d w e a lth . These six types o f c a p ita l are d e fined a s :2
•
fin a n cia l c a p ita l: the pool o f funds a v a ila b le to the organisation
•
m anufactured c a p ita l: m anufactured physical objects a v a ila b le to the organisation
•
intellectual c a p ita l: know ledge-based intangibles a v a ila b le to the o rganisation, including intellectual property and systems, procedures a nd protocols
•
human c a p ita l: ca p a b ilitie s, experience a nd com petencies of individuals a v a ila b le to the organisation
•
s o cia l a n d relationship c a p ita l: the value a d d e d b y internal an d external relationships to the organisation.
•
natural c a p ita l: the environm ental resources (e.g. energy an d w ater) an d processes used by the o rganisation in the delivery o f g o o d s o r the provision o f services. These six types o f c a p ita l relate to the o rg a nisation's environm ental, social a nd e co n o m ic perform ance, w ith
environm ental perform ance related to natural ca p ita l, social perform ance related to human c a p ita l a nd social and relationship ca p ita l, a nd econom ic perform ance (including fin a n cia l perform ance discussed in e arlier chapters) relating to the org anisation's im pact on the w id e r eco n o m y in a d d itio n to its o w n m anufactured a nd fin a n cia l ca p ita l. A sustainability report provides disclosures on an o rg anisation's im pacts on the environm ent, society an d the econom y. It assists organisations in setting goals, measuring perform ance an d m a n a g in g c h a n g e in o rd e r to make their operations m ore sustainable. S ustainability reporting also helps users to understand the effects of sustainability developm ents on an o rg a nisation's activities a nd its strategies.3
HOW'S YOUR UNDERSTANDING? H e re is a q u e s tio n y o u s h o u ld be ab le to a n s w e r, based o n w h a t y o u ha ve ju s t read. S e le c t a c o m p a n y y o u a re fa m ilia r w ith , s u c h as W o o lw o rth s , Q a n ta s o r a n y o f th e b ig fo u r ba nks ( A N Z , N a tio n a l A u s tra lia B a n k , C o m m o n w e a lth B a n k , W e s tp a c ) and lo o k f o r its s u s ta in a b ility re p o rt.
How the concept of sustainability reporting has changed over time Early reports in the 19 7 0 s a nd 19 8 0 s - referred to as social accounting co rp o ra te social responsibility accounting or social responsibility accounting - w e re produced w ith the aim o f considering the o rg anisation's im pact on people. The reporting trend then m oved to environm ental reporting, w ith an em phasis on a firm 's environm ental im pacts (e.g. pollution). N ext, triple bottom line reporting w a s introduced to cover environm ental a n d social perform ance as w ell as econom ic perform ance. In the m id -2 0 0 0 s , this term inology w a s g ra d u a lly replaced by the term 'sustainability reporting'. The term 'environm ental, social a nd go ve rn a n ce ' (ESG) reporting has since been introduced to describe w here the la n g u a g e o f sustainability com es together w ith c a p ita l market term inology. It should be noted that different term inology is used b y different countries an d even across different organisations w ithin the sam e country. For exam ple, A ustralian com panies C om m onw ealth Bank an d Transurban use the term 'sustainability report', W o o lw o rth s uses 'co rp o ra te responsibility report' a nd Rio Tinto uses the term 'sustainable
CHAPTER 17 S ustainability reporting
659
developm ent review '. This b o o k uses the term 'sustainability reporting'. S ustainability reports often a p p e a r as part of the annual report, o r as a separate sustainability report o r a com b in a tio n o f these alternatives. Ideally, these reports w ill p ro vid e a ba la n ce d representation of sustainability perform ance for an o rganisation; that is, both positive and negative im pacts.
17.2
W hat is reported in sustainability reports?
As sustainability reporting is largely voluntary, w h a t is reported varies c o n sid e ra b ly d e p e n d in g on the industry involved, the needs o f stakeholders an d the view s o f m anagem ent. Examples o f disclosures include the fo llo w in g :4 1
Environmental exam ples: -
energy, including direct e nergy used, listed b y source, a nd improvements in energy usage
-
w ater, including the quantity o f w a te r w ith d ra w n an d the percentage o f w a te r reused
-
emissions, including direct a nd indirect greenhouse gas emissions a nd initiatives to reduce greenhouse gas emissions a nd the resulting achievem ents.
2
Hum an rights exam ples: -
non-discrim ination, including incidents o f discrim ination recorded a nd corrective actions taken
-
c h ild labour, including the identification o f suppliers or operations at significant risk of using ch ild labour and the corrective actions taken to contribute to the e ra d ica tio n o f child labour.
3
4
Labour practices exam ples: -
o c cu p a tio n a l health a n d safety, including the num ber o f injuries, lost days a nd deaths
-
training a n d education, including a ve ra g e hours on training p rovided to different e m ployee categories.
Society exam ples: -
lo c a l com m unities, including assessments o f the im pact (both positive a nd negative) on the local com m unity
-
anti-com petitive behaviour, including legal actions aga in st the c o m p a n y for anti-com petitive behaviour
-
com pliance, including the num ber o f sanctions a n d the m onetary value o f fines for not co m p lyin g w ith law s a nd regulations.
5
6
Product responsibility exam ples: -
customer health a n d safety, including incidents of non-com pliance w ith regulations a n d voluntary codes
-
p ro d u ct a n d service la b e llin g , including incidents of non-com pliance w ith regulations a n d voluntary codes
-
customer priva cy, including com plaints a nd breaches o f privacy.
Econom ic exam ples: -
m arket presence, including policies an d practices relating to the hiring o f locals.
The a b o v e is often show n in a mixture o f quantitative a nd q u alitative inform ation including narrative, pictures, tables an d graphs. In a d d itio n to a separate sustainability report a nd m ore deta ile d annual reports, m any com panies also include sustainability inform ation in key perform ance indicators. Exhibit 17.1 shows an extract from W e s tp a c 's summary of its perform ance in its A n n u a l R eview a n d S ustainability Report 2 0 1 4 . This summary o f non-financial results, including those on environm ent, social a nd supply chain, app e a rs directly after the summary o f fin a n cia l a nd other inform ation. In the Q antas io n g re a ch Review (Q antas' sustainability report), the perform ance metrics a re presented in the follow in g categories: Financial, Safety a nd Health, C om m unity, Customer, People and Environment. This is reproduced in Exhibit 1 7 .2 .
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E X H IB IT 17.1
WESTPAC GROUP N O N -F IN A N C IA L S U M M A R Y
Source: W e s tp a c ,
E X H IB IT 1 7 .2
A n n u a l R e v ie w a n d S u s ta in a b ility R ep o rt 2 0 1 4 .
QANTAS GROUP PERFO RM ANCE M ETRICS
Source: Q antas A irw a ys Limited,
Lon g re ach R ev ie w 2 0 1 4 .
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17.3 Do stakeholders require more than financial reporting? W ho are the stakeholders and w h a t do they w ant? S ustainability reporting involves both e n gagem ent a n d com m unication w ith stakeholders. Stakeholders are those groups in society that affect the o rganisation o r can be affected by the o rganisation. Stakeholders ty p ic a lly include shareholders, em ployees, suppliers, customers, com m unities (particularly local communities) an d the governm ent. H ow ever, some com panies can have a w id e r range o f stakeholders, including regulatory bodies, joint venture partners, o p in io n leaders, unions a nd representative groups. Different stakeholders w ill have different interests that w ill sometimes conflict; for exam ple, in terms o f the optim al num ber o f staff e m ployed, shareholders m ay have different interests from local com m unities. The num ber o f stakeholders, their level o f involvem ent an d the type o f involvem ent is also likely to va ry betw een firms. For exam ple, m ining com panies are likely to have a co n sid e ra b le stakeholder involvem ent from the local com m unity, including farmers an d traditional land ow ners. As an exam ple o f the role o f stakeholders in sustainability reporting, let's consider Transurban Limited, a toll road o w n e r an d o perator. It has assets in A ustralia a nd the United States. Transurban ow ns a nd operates m any of the roads you a re likely to have travelled on, including CityLink in M e lb o u rn e , an d the M 2 , M 5 an d M 7 m otorw ays, plus the Eastern Distributor a nd the Lane C o ve Tunnel in Sydney. Transurban's 2 0 1 4 sustainability report notes: 'O u r sustainability strategy underpins our c o rp o ra te strategy a nd reinforces Transurban's vision to 'strengthen communities through transport'.5 In 2 0 1 4 , Transurban conducted a series o f e n gagem ent sessions w ith internal a nd external stakeholders to identify the current issues a nd future priorities for its sustainability program . Included in these discussions w e re em ployees, investors, road authorities, industry leaders an d research institutions. BHP Billiton has m any international operations a nd its mines are often in remote areas o f these countries. Therefore, its activities are likely to have a b ig im pact on local com m unities. These im pacts include being a m ajor em ployer o f this g roup; effects on the local environm ent, including the use o f scarce w a te r resources in com petition w ith other users, an d its reduction o f environm ental im pacts through restoration activities; an d g ivin g b a ck to the com m unity through the support o f com m unity activities. W e w o u ld therefore expect local com m unity to be included in its list o f stakeholders, w h ich is w h a t w e find in its 2 0 1 4 sustainability report, O u r S ha re d Values. Stakeholders are listed as: •
business partners
•
com m unity-based organisations
•
customers
•
em ployees an d contractors
•
governments an d regulators
•
industry peers a nd associations
•
the investment com m unity
•
labour unions
•
local an d Indigenous communities
•
the m edia
•
non-governm ent organisations
•
shareholders
•
society partners
•
suppliers.
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S ta k e h o ld e r e n g a g e m e n t
O rganisations need to understand the w a y they affect their stakeholders. This involves identifying stakeholders and prioritising this list of stakeholders. This process is c a lle d s ta k e h o ld e r e n g a g e m e n t an d is used b y an organisation to identify, understand a nd respond to sustainability issues. The stakeholder e n gagem ent process involves the fo llo w in g steps: 1
involving stakeholders in d e ve lo p in g a n d a ch ie vin g responses to sustainability issues
2 determ ining the relevance an d sig n ifica n ce o f sustainability issues to the organisation an d its stakeholders 3
com m unicating w ith stakeholders an d responding to stakeholder issues that affect the organisation's sustainability perform ance. The fo llo w in g exam ple o f stakeholder e n gagem ent is d ra w n from BHP Billiton's 2 0 1 4 sustainability report: A s a g lo b a l c o m p a n y w e in te r a c t w ith a d iv e rs e ra n g e o f s ta k e h o ld e rs w h o re p r e s e n t o u r h o s t c o m m u n itie s , re g io n s a n d n a tio n s . O u r s ta k e h o ld e rs c a n be d e fin e d as th o s e w h o a re p o te n tia lly a f f e c te d b y o u r o p e ra tio n s o r w h o ha ve an in te r e s t in , o r in flu e n c e , w h a t w e d o . A ll o u r o p e ra tio n s a re re q u ire d t o e s ta b lis h a p p ro p ria te c h a n n e ls w h e re s ta k e h o ld e rs c a n v o ic e t h e ir p e rs p e c tiv e s a n d c o n c e rn s t h r o u g h o u t t h e life c y c le o f o u r a c tiv itie s . O u r m e th o d s a n d fr e q u e n c y o f c o m m u n ic a tin g t o a n d w ith s ta k e h o ld e rs a re as d iv e rs e as o u r s ta k e h o ld e rs . •
G lo b a lly , w e c o m m u n ic a te via o u r A n n u a l G e n e ra l M e e tin g , c o r p o r a te p u b lic a tio n s (in c lu d in g th e A n n u a l R e p o r t a n d S u s ta in a b ility R e p o r t) , o u r c o m p a n y w e b s ite ( w w w .b h p b illito n .c o m ), re le a se s t o t h e m a r k e t a n d m e d ia , a n a ly s t b rie fin g s , s p e e c h e s a n d in te rv ie w s w ith s e n io r e x e c u tiv e s .
•
A t a re g io n a l a n d lo ca l leve l . . . [w ]e lis te n t o o u r s ta k e h o ld e rs ’ e x p e c ta tio n s , c o n c e rn s a n d in te re s ts , an d ta k e th is in to a c c o u n t in o u r b u s in e s s p la n n in g p ro c e s s . I m p o r ta n tly , w e also use e n g a g e m e n t m e th o d s w h ic h a re a p p ro p ria te f o r lo ca l c u lt u r e a n d c o n te x t.
•
A s a k e y s ta k e h o ld e r g r o u p , w e a lso e n g a g e w ith o u r p e o p le (e m p lo y e e s a n d c o n tr a c to r s ) , via ta ilo re d in te rn a l c h a n n e ls . Source: B H P Billiton, Sustainability Report 2014.
17.4 Why do organisations produce sustainability reports? The num ber o f organisations p reparing sustainability reports is increasing, both in A ustralia an d in the rest o f the w o rld . H ere w e outline a range o f reasons for this trend, as identified by international fin a n cia l firm K PM G : •
D em onstrating transparency: com panies often w ish to dem onstrate their com m itm ent to m a naging environm ental, social a n d eco n o m ic im pacts a nd they can d o this through sustainability reporting.
•
C reating fin a n cia l value: in p re paring sustainability reports, com panies collect a n d analyse d a ta a nd often assess business processes. These processes can lead to opportunities for cost savings through m ore efficient use of resources and materials.
•
E nhancing reputation: it is im portant to m a n a g e stakeholders' perception o f the com pany's environm ental, social
•
A ch ie v in g continuous im provem ent: the process o f external reporting o f sustainability focuses attention on the
and econom ic dimensions a nd in d o in g so enhance the com pany's reputation.
integrity of the d a ta a nd the need for continuous im provem ent across different areas. Establishing perform ance goals and quantified targets that a re incorporated into the reports often leads to internal change. •
Im proving regulatory c o m p lia n ce : by increasing the q u a lity an d quantity o f voluntary disclosures, com panies m ay
•
Strengthening risk aw areness a n d m anagem ent: m anagem ent o f risk is a key area o f co rp o ra te gove rn a n ce and
be reducing future regulatory intervention.
sustainability reports help a c o m p a n y dem onstrate it is m a n a g in g this aspect o f risk.
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E ncouraging innovation: better understanding o f stakeholders' concerns, needs a nd expectations often leads to the developm ent o f changes w ith in the o rganisation, including innovative products an d services that meet sustainability requirements.
•
E nhancing m anagem ent systems a n d decision-m aking: sustainability reporting m ay lead to the need for more rigorous a n d accurate m anagem ent systems an d decision-m aking processes to m a n a g e its sustainability risks and opportunities.
•
Raising aw areness, m otivating a n d a lig n in g staff, a n d attracting talent: both present an d prospective em ployees have view s an d expectations a b o u t sustainability issues a nd this is a m ajor driver o f sustainability reports, w hich help to keep em ployees inform ed a nd assist the c o m p a n y to attract n e w em ployees.
•
A ttracting long-term c a p ita l a n d favourable fin a n cia l conditions: it app e a rs that an increasing num ber of investors take sustainability issues into a ccount in their decision-m aking processes. Thus the sustainability report a llo w s the c o m p a n y to inform this g ro u p a n d also investment analysts, w h ich is expected to affect the valuations o f the com p a n y.
•
M a in ta in in g a licence to o perate: m any com panies recognise the link betw een business success an d an o n g o ing licence to o p erate. Particularly in the resources sector, the issue o f a licence to ope ra te has been im portant for a num ber o f years, w ith both com m unities a n d stakeholders m ore likely to support com panies that o p e n ly report on sustainability issues.
•
Establishing com petitive p o sitio n in g a n d m arket differentiation: sustainability reporting a llo w s com panies to differentiate themselves from other com panies as w e ll as differentiating their brands, products a nd services. Source: a d a p te d from KPM G , S ustainability Reporting: A G u id e , 2 0 0 8 . A b o v e w e mention the im portance o f having a 'licence to o p e ra te '. The fo llo w in g extracts from the annual reports
o f tw o m ining com panies h ighlight the seriousnes w ith w h ich this is taken: B H P B I L L IT O N O u r C h a r t e r v a lu e o f S u s ta in a b ility is c o re t o o u r s tra te g y a n d w e in te g r a te h e a lth , s a fe ty , e n v iro n m e n ta l, s o cia l an d e c o n o m ic fa c to r s in to o u r d e c is io n - m a k in g . M a in ta in in g o u r lic e n c e t o o p e ra te as a g lo b a l c o m p a n y is d e p e n d e n t u p o n g a in in g a c c e s s t o n a tu ra l re s o u rc e s a n d e n s u rin g w e e a rn th e t r u s t o f o u r s h a re h o ld e rs , e m p lo y e e s , c o n tr a c to r s , c o m m u n itie s , c u s to m e rs a n d s u p p lie rs . Source: B H P Billiton, Annual Report 2014.
R IO T IN T O T h e s a fe ty o f o u r p e o p le , a n d o u r v a lu e s - a c c o u n ta b ility , re s p e c t, te a m w o r k a n d in t e g r it y - a re a t t h e c o re o f o u r w a y o f w o rk in g . O u r re s p o n s ib le a p p ro a c h t o m in e ra l d e v e lo p m e n t e n s u re s w e g a in a n d m a in ta in o u r lic e n c e t o o p e ra te . It m e a n s w e p ro v id e c o n fid e n c e t o o u r s ta k e h o ld e rs , a n d im p ro v e o u r a c c e s s t o th e m in e ra l re s o u rc e s , p e o p le a n d c a p ita l w e n e ed.
O u r G H G p e rfo rm a n c e is im p o r ta n t in u p h o ld in g a n d e x te n d in g o u r lic e n c e t o o p e ra te . W e a re fo c u s in g on re d u c in g th e e n e rg y in te n s ity o f o u r o p e ra tio n s as w e ll as th e c a rb o n in te n s ity o f o u r e n e rg y , in c lu d in g t h r o u g h th e d e v e lo p m e n t a n d im p le m e n ta tio n o f in n o v a tiv e te c h n o lo g ie s .
W e re c o g n iz e t h a t w e ha ve a re s p o n s ib ility t o all o u r s ta k e h o ld e rs a n d t o th e w id e r w o rld , an d so w e e n d e a v o u r to in te g ra te s u s ta in a b le d e v e lo p m e n t in to e v e ry th in g w e d o . O u r a b ility t o o p e ra te g lo b a lly is s u p p o rte d b y th is c o m m itm e n t. I t a llo w s us t o a c c e s s h ig h -q u a lity re s o u rc e s , e ffe c tiv e ly m a n a g e risks a n d o p p o r tu n itie s , e n g a g e w ith c o m m u n itie s , a n d a t t r a c t ta le n te d p e o p le - a n d it s tre n g th e n s o u r lic e n s e t o o p e ra te . Source: Rio Tinto, 2013 Annual Report.
A survey o f c o m p a n y disclosures in sustainability, the K P M G Survey o f C o rp o ra te R esponsibility R eporting 2 0 1 3 , included the to p 2 5 0 com panies listed on the Fortune G lo b a l 5 0 0 ranking for 20 1 2 (referred to as G 2 5 0 ) an d the 1 0 0 largest com panies (based on revenues) in each o f the 41 countries included in the survey (referred to as N 1 0 0 ).
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The purpose of the survey w a s to exam ine trends in public disclosure. As a consequence, the survey lim ited itself to publicly a v a ila b le inform ation in co rp o ra te responsibility o r sustainability reports, c o m p a n y w ebsites a nd annual financial reports. C o rp o ra te responsibility reports o r sim ilar inform ation issued by com panies betw een m id-201 2 and m id-201 3 w e re g e n e ra lly used. The survey indicates that m any com panies are n o w seeing co rp o ra te responsibility as core business risks and opportunities rather than a moral issue. M o re investors are a cce p tin g that social a n d environm ental factors can put c o m p a n y value at risk. This is le a d in g to the question o f w h a t is the c o m p a n y d o in g to m itigate o r m axim ise the financial im pact o f the identified social an d environm ental risks a n d opportunities. Exhibit 1 7 .3 shows that 'innovation a nd learning' an d 'im proved reputation o r b ra n d ' to p the list o f identified opportunities as a result o f environm ental a nd social reporting for the G 2 5 0 com panies as outlined in the survey.
E X H IB IT 1 7 .3
REPORTED IDENTIFIED OPPORTUNITIES AS A RESULT OF GLOBAL SOCIAL AND ENVIRONMENTAL TRENDS FOR G250 COMPANIES
In n o v a tio n (e.g. n e w p ro d u c t/s e rv ic e ) a n d le a rn in g Im p ro v e re p u ta tio n o r b ra n d (e.g. s tre n g th e n e d c o n s u m e r re la tio n s h ip s ) Im p ro v e m a rk e t p o s itio n (m a rk e t sh a re )
C o s t sa v in g s
Im p ro v e e m p lo y e e m o tiv a tio n S tre n g th e n s u p p lie r re la tio n s h ip s A c c e s s t o c a p ita l o r in c re a s e d s h a re h o ld e r v a lu e Im p ro v e d re la tio n s h ip s w ith g o v e rn m e n ta l/re g u la to r s N o o p p o r tu n itie s id e n tifie d 0
20
Source: K PM G International,
17.5
40
60
80
100
K P M G S u rv ey o f C o rp o ra te R esp o n s ib ility R ep o rtin g 2 0 1 3 .
Criteria for sustainability reporting
W h ile the disclosure o f fin a n cia l inform ation is regulated under c o m p a n y la w a nd b y accounting standards, w h a t is disclosed in sustainability reports has tra d itio n a lly been determ ined by the organisation reporting. This has led to concerns from stakeholders a b o u t completeness o f inform ation, as w e ll as very different reporting betw een organisations m aking com parisons difficult.
Suitable criteria The G lo b a l Reporting Initiative (GRI) S ustainability R eporting G u idelines are the most com m only used guidelines to a id com panies in their sustainability a n d reporting practices, w ith 7 8 per cent o f N 1 0 0 a nd 8 2 per cent of G 2 5 0 com panies a lig n e d to GRI standards as reported in the K P M G 20 1 3.
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As noted in the W o o lw o rth s 2 0 1 4 C o rp o ra te Responsibility R eport 'The GRI reporting fram ew ork sets out principles a nd indicators that organisations can use to measure an d report their eco n o m ic, environm ental a nd social perform ance.' The benefit o f using a consistent fram ew ork across com panies is that it a llo w s c o m p a ra b ility both over time an d across com panies. The GRI fram ew ork can be useful for: •
increased understanding o f risks a n d opportunities
•
em phasising the link betw een fin a n cia l an d non-financial perform ance
•
influencing long-term m anagem ent strategy an d p o licy, an d business plans
•
benchm arking an d assessing sustainability perform ance w ith respect to law s, norms, codes, perform ance standards an d voluntary initiatives
•
dem onstrating h o w the o rganisation influences a nd is influenced b y expectations a b o u t sustainable developm ent
•
co m p a rin g perform ance internally, a nd betw een organisations a n d sectors. The GRI
S ustainability R eporting
G uidelines offers
reporting
principles,
standard
disclosures a nd
an
im plem entation m anual for the preparation o f sustainability reports by organisations. The standard disclosures contain both general a nd specific disclosures. The specific disclosures are d iv id e d into three categories o f non-financial indicators: e conom ic, environm ental a n d social. The social c a te g o ry is broken d o w n further into labour practices and decent w o rk, human rights, society an d product responsibility subcategories. Examples of these specific disclosures a p p e a r in Exhibit 1 7 .4 .
E X H IB IT 1 7 .4
GRI S U S T A IN A B IL IT Y R E P O R T IN G G U ID E LIN E S '. EXAMPLES OF PERFORMANCE INDICATORS
Economic Economic performance: •
direct economic value generated and distributed, including revenues, operating costs, employee wages and benefits, payments to providers of capital, payments to government and community investments
•
financial implications and other risks and opportunities for the organisation's activities due to climate change
•
financial assistance received from government.
Market presence: •
ratios of standard entry-level wage by gender compared to local minimum wage at significant locations of operation
•
proportion of senior management hired from the local community at significant locations of operation.
Indirect economic impact: •
development and impact of infrastructure investments and services supported.
»
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
» Emissions: •
direct greenhouse gas emissions (Scope 1)
•
energy indirect greenhouse gas emissions (Scope 2)
•
other indirect greenhouse gas emissions (Scope 3)
•
reduction of greenhouse gas emissions.
Products and services: •
percentage of products sold and their packaging materials that are reclaimed, by category.
Compliance: •
monetary value of significant fines and total number of non-monetary sanctions for non-compliance with environmental laws and regulations.
3 Social 3.1 Labour practices and decent w ork Employment: •
total number and rates of new employee hires and employee turnover by age group, gender and region.
Labour/management relations: •
minimum notice periods regarding operational changes.
Occupational health and safely: •
type of injury and rates of injury, occupational diseases, lost days and absenteeism, and total number of workrelated fatalities, by region and by gender.
Diversity and equal opportunity: •
composition of governance bodies and breakdown of employees per employee category according to gender, age group, minority group membership and other indicators of diversity.
3.2 Human rights Investment: •
total number and percentage of significant investment agreements and contracts that include human rights clauses or that underwent human rights screening.
Non-discrimination: •
total number of incidents of discrimination and corrective actions taken.
Child labour: •
operations and suppliers identified as having significant risk for incidents of child labour, and measures taken to contribute to the effective abolition of child labour.
Forced and compulsory labour: •
operations and suppliers identified as having significant risk for incidents of forced or compulsory labour, and measures to contribute to the elimination of all forms of forced or compulsory labour.
3.3 Society Local communities: •
percentage of operations with implemented local community engagement, impact assessments and development programs.
Anti-corruption: •
total number and percentage of operations assessed for risks related to corruption and the significant risks identified.
Anti-competitive behaviour: •
total number of legal actions for anticompetitive behaviour, anti-trust and monopoly practices and their outcomes.
»
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» 3.4 Product responsibility Customer health and safety: •
total number of incidents of noncompliance with regulations and voluntary codes concerning the health and safety impacts of products and services during their life cycle, by type of outcomes.
Product and service labelling: •
type of product and service information required by the organisation's procedures for product and services information and labelling.
Marketing communications: •
total number of incidents of noncompliance with regulations and voluntary codes concerning marketing communications, including advertising, promotion and sponsorship, by type of outcomes.
Source: a d a pte d from GRI: G 4
17.6
S u s ta in a b ility R ep o rtin g G u id e lin e s ,
2 0 1 3 , 'Reporting Principles and S tandard Disclosures'.
Trends in sustainability reporting
The K P M G Survey o f C o rp o ra te R esponsibility R eporting 2 0 1 3 identified some interesting trends in sustainability reporting. H ere is a summary o f some o f the key findings o f this survey: •
C o rp o ra te responsibility (CR) is no longer seen as a moral issue b y m any com panies, but as a matter o f core
•
CR reporting is n o w seen as standard business practice w o rld w id e as high rates o f CR reporting w a s found
business risks a nd opportunities (p. 14).
across all regions (p. 14). •
CR inform ation being included in annual reports is n o w seen as standard business practice, w ith the survey fin d in g a sig n ifica n t increase in the num ber o f com panies reporting CR inform ation in their annual fin a n cia l results. This is n o w at 5 1 per cent, up from 2 0 per cent in 2 0 1 1 a n d 9 per cent in 2 0 0 8 (p. 1 1).
•
The use o f GRI guidelines is w id e sp re a d , w ith 7 8 per cent o f reporting com panies w o rld w id e referring to the GRI
•
The external assurance o f sustainability d a ta an d reports is also becom ing standard business practice, w ith over
•
The CR reporting rate am ong the w o rld 's largest 2 5 0 com panies has rem ained fa irly stable at 9 3 per cent (p. 22).
•
The lea d in g region for CR reporting is n o w the A m ericas, w ith 7 6 per cent o f com panies reporting on CR,
reporting guidelines in their CR reports (p. 1 2).
half the w o rld 's largest com panies (G 2 5 0 ) investing in this assurance (p. 1 2).
overtaking Europe, w h e re 7 3 per cent o f com panies report on CR. By contrast, 71 per cent of A sia -P a c ific com panies report on CR a nd in A ustralia the rate has increased to 8 2 per cent (p. 2 2 ). •
W h ile tra d itio n a lly CR reporting has been voluntary, governments an d stock exchanges around the w o rld are increasingly introducing m andatory CR reporting requirements (p. 2 4 ). T w o im portant recent trends relate to assurance a n d supply chain operations.
Assurance As discussed in C h a p te r 6 , it is m andatory for financial reports to be audited each year; how ever, for sustainability reports, assurance is voluntary. The number of large com panies having their sustainability report assured is increasing and there is a strong trend am ong com panies to have their sustainability reports assured b y independent third parties. The aim o f assurance is to va lid a te an d provide credibility to these reports. A cco rd ing to the K PM G survey, the drivers tow ards this trend o f increased assurance include increasing credibility w ith external stakeholders, meeting the requirements of sustainability indices, an d o b taining more reliable internal d a ta . The board o f directors an d top m anagem ent are more likely to use o f sustainability data w hen it is assured.
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W h ile financia l statements are a u dited by accountants, sustainability reports m ay be a u dited by a range o f thirdparty assurers including the m ajor accounting firms w h o carry out this assurance w o rk. Australia's largest public com panies em ploy a mixed a pproach as to w h o assures their sustainability reports; some are assured b y the Big Four accounting firms, w h ile others use specialist sustainability assurers w hich are outside the accounting profession. There a re also differences between com panies on w hether all the contents o f sustainability reports are assured. M a n y of the large com panies, including BHP Billiton, Rio Tinto and the C om m onw ealth Bank, have assurance on sections o f their sustainability reports, an d it is likely that they choose o n ly those areas that are o f great im portance to their stakeholders. A nother exam ple o f assurance being limited to certain subject matter is the 2 0 1 3 Transurban Sustainability Report,6 w here the auditor, Ernst & Y oung, provided assurance over five sustainability priorities determ ined by Transurban: customer safety, g e nder diversity, g e nder p a y equity, greenhouse gas emission da ta and w a te r data. As an exam ple of the procedures performed by the engagem ent teams on a sustainability report, consider the follow ing list of assurance w o rk carried out by PricewaterhouseCoopers on the Rio Tinto Sustainable Developm ent Review. • •
M a k in g e n q u irie s o f re le v a n t m a n a g e m e n t o f R io T in to E v a lu a tin g t h e d e s ig n a n d e ffe c tiv e n e s s o f th e k e y p ro c e s s e s a n d c o n tr o ls f o r c a p tu rin g , c o lla tin g an d r e p o r tin g th e p e rfo rm a n c e d a ta w ith in th e s e le c te d s u b je c t m a tte r
•
T e s tin g p e rfo rm a n c e d a ta , o n a s e le c tiv e basis, s u b s ta n tiv e ly a t b o th an o p e ra tio n a l a n d c o r p o r a te le ve l, w h ic h in c lu d e d te s tin g a t a s e le c tio n o f o p e ra tio n s a n d p ro je c ts f r o m a c ro s s A lu m in iu m , E n e rg y , Iro n O r e , C o p p e r a n d D ia m o n d s & M in e r a ls
•
U n d e rta k in g a n a ly tic a l p r o c e d u re s o v e r th e p e rfo rm a n c e d a ta
•
A s s e s s in g th e re s u lts o f c o m p u t e r a id e d d a ta an a lysis re g a rd in g th e c la s s ific a tio n o f in ju rie s re c o r d e d a t m a n a g e d o p e ra tio n s a n d p ro je c ts
•
R e v ie w in g a s a m p le o f re le v a n t m a n a g e m e n t in fo r m a tio n a n d d o c u m e n ta tio n s u p p o r tin g a s s e rtio n s m a d e in th e s e le c te d s u b je c t m a tte r. Source: Rio Tinto, 2013 Annual Report, ‘Independent Assurance Report’.
FOR YOUR INTEREST A re s e a rc h s tu d y in A u s tra lia b y M o r o n e y , W in d s o r and A w 7 fo u n d e v id e n c e th a t th e e x is te n c e o f a s su ra n ce w as a s s o c ia te d w ith e n h a n c e d q u a lity o f v o lu n ta ry e n v iro n m e n ta l d is c lo s u re s .
Supply chain operations M a n y com panies a re b e g inning to recognise that their responsibility to the environm ent a nd to society encom passes m ore than sim ply their o w n activities, an d that the activities o f their supply chain (including the various parties that supply them w ith g o o d s a n d services) m ay also have an im pact. This trend is evolving in response to stakeholders holding businesses to account for the activities o f others w ithin their supply chains, an d the potential n egative im pact on their reputation an d value. For exam ple, a particular business m ay fa ce criticism from stakeholders an d loss o f customers if o ne o f its suppliers is causing large-scale environm ental d a m a g e in the production o f its supplies. A lthough the selling c o m p a n y m ay have very g o o d internal environm ental practices, it m ay be held responsible for facilitating environm ental d a m a g e as it is purchasing from the supplier responsible for that d a m a g e . C onsequently, some com panies are creating codes o f conduct for their supply chains, w h ich their suppliers must fo llo w in order to conduct business. For exam ple, N a tio n a l A ustralia Bank (NAB) has a supplier sustainability program in place as it believes that the conduct of its suppliers can also affect its o w n sustainability perform ance a n d reputation. The program encompasses sustainability areas such as co rp o ra te governance, environm ental m anagem ent,
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occup a tio n a l health a nd safety, w o rkfo rce policies a nd human rights, risk m anagem ent, supply chain m anagem ent, com m unity a nd supplier diversity. Examples of N A B 's requirements o f suppliers in clu d e :8 •
c o m p lia n ce w ith law s
•
w ritten policies on the environm ent, safety, w o rkfo rce an d social issues, including the reporting on these issues
•
targets to reduce environm ental impacts
•
the a d o p tio n o f sim ilar codes o f conduct w hen d e a lin g w ith its o w n suppliers to m a n a g e sustainability risks.
17.7 Energy efficiency as an im portant example of sustainability W ith rising e nergy costs a nd g ro w in g concerns over the effects o f clim ate ch a n g e, the measurement, reporting and verification o f inform ation related to e nergy use, greenhouse gas emissions an d clim ate ch a n g e m ore b ro a d ly is an increasingly com m on business practice. Such inform ation is o f use to a variety o f stakeholders including: • •
business m anagers: w h o set targets in an effort to m anage costs governm ents: to inform emissions trading schemes a nd to assist in p o lic y form ulation a nd international reporting o b lig a tio n s
•
investors: w h o seek to understand h o w increasing e nergy costs a n d clim ate ch a n g e m ay im pact business strategy, perform ance an d prospects
•
other internal a n d external stakeholders: w h o are interested in understanding the environm ental im pacts of business processes. This has resulted in extensive reporting o f energy inform ation in sustainability reports. In A ustralia, the content of
sustainability reports a nd annual reports suggests a strong em phasis on resource usage (particularly w ater) and energy usage. H ere are tw o exam ples from w ell-know n Australian com panies:
QANTAS GROUP T h e Q a n ta s G r o u p a c k n o w le d g e s t h a t in o r d e r t o be s u s ta in a b le a n d g r o w in th e lo n g e r t e r m , it n e e d s to a d d re s s its e n v iro n m e n ta l im p a c t - w h ic h p re s e n ts s o m e s ig n ific a n t c h a lle n g e s . T h e a v ia tio n in d u s try is w ith in to u c h in g d is ta n c e o f an h is to r ic a g re e m e n t t o im p le m e n t a g lo b a l m a r k e tba sed m e a s u re f o r in te rn a tio n a l a v ia tio n e m is s io n s - n o o t h e r in d u s try is in t h a t p o s itio n . H o w e v e r , th is g lo b a l m e a s u re is ju s t o n e p a rt o f a b ro a d e r p a c k a g e o f in itia tiv e s t o a d d re s s o u r e n v iro n m e n ta l im p a c ts in th e air a n d o n t h e g ro u n d .
In the air O u r b ig g e s t e n v iro n m e n ta l c h a lle n g e is j e t fu e l c o m b u s tio n , w h ic h a c c o u n ts f o r a ro u n d 9 8 p e r c e n t o f o u r to ta l 11.7 m illio n to n n e a n n u a l c a rb o n f o o t p r in t. D u e t o m itig a tio n a c tiv ity a n d c a p a c ity re d u c tio n in o u r in te rn a tio n a l n e tw o r k , o u r f o o t p r in t re d u c e d b y 7 p e r c e n t in 2 0 1 3 / 2 0 1 4 . W h ile o u r in d u s try has fe w e r m itig a tio n o p tio n s c o m p a re d t o o t h e r s e c to rs , w e a re a d d re s s in g o u r e m is s io n s a t an o p e ra tio n a l leve l t h r o u g h c o n tin u e d in v e s tm e n t in fu e l e ffic ie n c y a n d f le e t re n e w a l in th e s h o r t- m e d iu m te r m a n d a v ia tio n b io fu e l d e v e lo p m e n t o v e r th e lo n g e r te rm . D u r in g 2 0 1 3 /2 0 1 4 , th e G ro u p a c c e le ra te d th e r e tir e m e n t o f o ld e r, less f u e l- e ff ic ie n t a irc ra ft in c lu d in g th e B o e in g 7 3 7 - 4 0 0 a n d B o e in g 7 6 7 , w h ile J e ts ta r to o k d e liv e ry o f f o u r fu e l e f f ic ie n t B o e in g 7 8 7 D re a m lin e rs . A G r o u p F u e l O p tim is a tio n P ro g ra m w as e s ta b lis h e d t o p r o v id e in d u s try b e s t p r a c tic e fu e l m a n a g e m e n t a n d c o o rd in a te fu e l c o n s e rv a tio n a c tiv itie s a c ro s s Q a n ta s , Q a n ta s L in k a n d J e ts ta r. S in c e it w as e s ta b lis h e d , th e p ro g ra m has saved o v e r 9 6 , 0 0 0 to n n e s o f c a rb o n p e r y e a r th ro u g h a ra n g e o f in itia tiv e s in c lu d in g a irc ra ft w e ig h t re d u c tio n , e le c tric a l g r o u n d - p o w e r u tilis a tio n an d a ir t r a f f ic m a n a g e m e n t (in c o lla b o ra tio n w ith A irs e rv ic e s A u s tra lia ). T h e p ro g ra m
is o n tr a c k t o d e liv e r f u r t h e r savings o f a s im ila r
m a g n itu d e in 2 0 1 4 /2 0 1 5 . In o r d e r t o d e liv e r a b s o lu te e m is s io n s re d u c tio n s o v e r th e m e d iu m t o lo n g t e r m , A v ia tio n b io fu e l re m a in s an im p o r ta n t s tra te g ic g o a l f o r o u r b u siness. D u r in g 2 0 1 3 / 2 0 1 4 , Q a n ta s a n d S h e ll A u s tr a lia la u n c h e d la n d m a rk re s e a rc h in to t h e e c o n o m ic v ia b ility o f p ro d u c in g a v ia tio n b io fu e l in A u s tr a lia o n a c o m m e rc ia l scale.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
T h e s tu d y f o u n d t h a t an a v ia tio n b io fu e l in d u s try in A u s tr a lia is t e c h n ic a lly v ia b le b u t s ig n ific a n t o b s ta c le s re m a in in re la tio n t o fe e d s to c k a v a ila b ility an d p ric e , in fr a s tr u c tu r e an d g o v e r n m e n t p o lic y . T h e s tu d y is a v a ila b le a t q a n ta s .c o m .a u /in fo d e ta il/a b o u t/e n v ir o n m e n t/a v ia tio n - b io fu e l- r e p o r t.p d f.
O n the ground O n th e g ro u n d , w e c o n tin u e d t o re d u c e o u r im p a c ts a n d a re w e ll o n tr a c k t o m e e t o u r e le c tr ic ity , w a te r a n d w a s te t o la n d fill ta rg e ts , w h ic h w e re all in c re a s e d b y a f u r t h e r 1 0 p e r c e n t d u rin g th e y e a r. W e la u n c h e d A u s tr a lia ’s la rg e s t tr ig e n e r a tio n p o w e r p la n t t o s u p p ly o u r S y d n e y h e a d q u a rte rs , j e t base a n d c a te rin g c e n tre w ith lo w c a rb o n e n e rg y f o r e le c tr ic ity , h e a tin g an d c o o lin g . T h e p la n t is h e lp in g c u t c a rb o n e m is s io n s b y a ro u n d 1 4 , 0 0 0 to n n e s p e r y e a r - th e e q u iv a le n t o f ta k in g 3 , 5 0 0 c a rs o f f t h e ro a d . W e also c o m p le te d a m a jo r r e fu r b is h m e n t o f o u r c o r p o r a te h e a d q u a rte rs . T h e r e fu r b is h m e n t a n d t r i g e n e r a tio n p la n t w ill re s u lt in o u r f o u r m u lti- s t o r e y o f f ic e b u ild in g s re a c h in g a N A B E R S E n e rg y ra tin g o f 5 S ta rs c o m p a re d t o t h e p re v io u s ra tin g o f 1 .5 S ta rs . Source: Q antas Airways Limited, Longreach Review 2014.
WESTPAC LIMITED D u r in g t h e y e a r, w e c o n tin u e d t o a c tiv e ly m a n a g e o u r d ir e c t e n v iro n m e n ta l f o o t p r in t - in c lu d in g re d u c in g o u r e n e rg y a n d p a p e r c o n s u m p tio n -
a n d w o r k w ith o u r c u s to m e rs , s u p p lie rs a n d o t h e r s ta k e h o ld e rs to
in flu e n c e p o s itiv e o u tc o m e s f o r o u r in d ir e c t e n v iro n m e n ta l f o o t p r in t.
Reducing our carbon emissions D u r in g th e y e a r, w e re d u c e d o u r S c o p e 1 a n d 2 e m is s io n s b y 2 .7 % , d riv e n p r im a rily b y d e c re a s e d e le c tr ic it y a n d gas use, a n d w a s te g e n e ra tio n . W e m e t o u r 2 0 1 4 e n e rg y e ff ic ie n c y ta rg e t, a c h ie v in g a r e d u c tio n o f a lm o s t 2 % in o u r e n e rg y use p e r s q u a re m e tr e a c ro s s o u r re ta il a n d c o rp o ra te n e tw o r k s in A u s tr a lia a n d N e w Z e a la n d s in c e 2 0 1 2 . In N e w Z e a la n d w e saw an o v e ra ll re d u c tio n in to ta l s c o p e 1, 2 a n d 3 e m is s io n s f o r th e f ir s t tim e s in c e 20 11. T h is w as d riv e n b y an o n g o in g fo c u s o n im p ro v in g t h e o p e ra tio n a l e ff ic ie n c y o f o u r p r o p e r ty p o r tfo lio a n d re d u c e d a ir tra v e l, a id e d b y t e c h n o lo g y im p ro v e m e n ts in c lu d in g v id e o c o n fe re n c in g . In A u s tra lia , w e im p ro v e d o u r s c o p e 1 e m is s io n s , d e s p ite in c re a s in g th e b o u n d a ry f o r o u r r e fr ig e r a n t e m is s io n s re p o r tin g . W e e x p e c t t o see f u r t h e r im p ro v e m e n ts as w e re lo c a te o u r c o r p o r a te o f f ic e te a m s t o n e w s ite s . . . W e also c o n tin u e t o im p ro v e th e e n e rg y e ff ic ie n c y o f o u r re ta il o u tle ts , in c lu d in g L E D lig h tin g in s ta lla tio n s a n d u p d a te d b ra n c h d e s ig n s ta n d a rd s t o in c o rp o ra te m o r e e n e rg y e f f ic ie n t te c h n o lo g ie s . W e re ta in e d o u r c a rb o n n e u tra l s ta tu s f o r o u r A u s tr a lia n a n d N e w Z e a la n d o p e ra tio n s , a n d re m a in c o m m it te d t o m a in ta in in g th is u n til 2 0 1 7 . Source: W estpac Limited, 2014 Annual Review and Sustainability Report.
W hat inform ation is measured and disclosed Energy and greenhouse gas disclosure typ ica lly involves the reporting o f energy, greenhouse gas emissions and clim ate-change-related inform ation. These a re related in that fossil-fuelled e nergy sources (i.e. those w ith a carbon content) result in the release o f greenhouse gas emissions w hen com busted. These an d other greenhouse gas (G H G ) emissions are believed to contribute to a phenom enon known as a n th ro p o g e n ic (hum an-induced) clim ate change. Som e countries, including A ustralia, are highly d e p endent on fossil-fuelled e nergy that results in higher greenhouse gas emissions than re n e w a b le energy. Energy inform ation is usually presented in g ig a jo u le s (GJ) o r kilo w a tt hours (kW h) an d details the quantities of energy consum ed (used) an d produced (extracted or manufactured) during the o peration o f business. Energy consum ption is generally categorised as either stationary energy (including electricity) or transport energy. There is a link betw een g row th in energy consum ption an d production a nd G H G emissions. This link is im portant as it illustrates that, for Australia, energy e fficie n cy a nd G H G m anagem ent g o hand in hand. For exam ple: •
G H G emissions derived from energy constituted a significant proportion o f A ustralia's total emissions in 2 0 0 7 .
•
A substantial proportion o f the g row th in G H G emissions m ay be attributed to stationary energy.
•
Energy efficiency is one o f the fastest a nd most cost-effective w a ys o f reducing emissions. G H G inform ation is most com m only presented in tonnes o f ca rbon d io x id e equivalent (tC 02-e) an d describes the
quantity o f emissions released as a consequence o f business activity.
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The most com m on greenhouse gas is carbon d io x id e (C O 2 ), w h ich is released through the com bustion o f fossil fuels, solid w aste a nd w o o d an d tree products. It is also frequently released during some industrial production processes an d product use, such as the m anufacture an d use o f cement. O th e r types o f greenhouse gases resulting from human activity include m ethane, nitrous o x id e a nd fluorinated gases. These different types of greenhouse gases are not equal in their im pact a nd a c c o rd in g ly have different levels o f g lo b a l w a rm in g potential (G W P ); that is, some greenhouse gases are m ore potent than others. C lim ate-change-related inform ation is narrative inform ation that is o f interest to investors an d m ay include strategic analysis, a lo n g w ith the risks, opportunities a nd governance associated w ith the physical, regulatory an d supply chain im pacts o f clim ate change.
How and w here inform ation is measured and disclosed Procedures a nd standards for the measurement an d disclosure o f energy, greenhouse gas an d clim ate-change-related inform ation have evolved over time through the w o rk o f governments an d stakeholder initiatives. The sections b e lo w pro vid e an introduction to the measurement a nd disclosure o f e nergy a nd greenhouse gas emissions d a ta , an d clim ate-change-related inform ation.
MEASUREMENT Determ ine the m ethod o f d a ta co n so lid a tio n (o rg a n isa tio n al boundary!: Before b e ginning the collection of e nergy and greenhouse gas emissions d a ta , it is im portant to consider w h ich d a ta should be included. That is, for w hich operations, s ite s /fa cilitie s , divisio n s/b u sin e ss units a nd businesses da ta should be collected, a nd then co nsolidated. Identify e n e rg y a n d emission sources: C o m p a n ie s need to identify w h ich types o f e nergy a re consum ed or produced, a nd w h ich greenhouse gases are emitted, b y the activities captured w ithin that boundary. Exhibit 17 .5 provides a typical classification of energy a nd greenhouse gas emissions sources. These energy a nd emissions sources should then be categorised a cco rd in g to w hether they are direct o r indirect, and this w ill d e p e n d on the o rg a nisational b o u n d a ry selected a bove.
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Direct energy and emissions sources result from e nergy consum ption o r production undertaken at (and greenhouse emissions arising from) operations over w h ich the business has the authority to introduce an d im plem ent operating, environm ental an d health an d safety policies. For exam ple: •
An air-conditioning unit situated w ithin a building o w n e d an d ope ra te d by C o m p a n y A w ill p roduce emissions that are a direct emissions source for C o m p a n y A .
•
Sim ilarly, a truck o w n e d an d o perated by Logistics C o m p a n y B w ill consum e fuels an d p roduce emissions, both o f w hich are in the direct control o f that com pany. That is, the c o m p a n y that ow ns a nd operates the a ir-conditioning unit has the p o w e r to determ ine w h ich a ir
conditio n in g unit it purchases (h o w efficient it is), a n d also h o w frequently it is used a nd serviced. The same is true for the c o m p a n y that ow ns a nd operates the truck.
Indirect energy and emissions sources result from e nergy consum ption o r production undertaken at (and greenhouse emissions arising from) operations over w h ich another business has the authority to introduce and im plem ent ope ra tin g , environm ental a n d health an d safety policies. H ow ever, that business is carrying out those energy- a n d em issions-generating activities on behalf o f the reporting co m p a n y. A cc o rd in g ly, the reporting c o m p a n y has indirect control over those activities. For exam ple: •
Electricity that is p roduced by large generators at a fa cility o w n e d an d o perated b y C o m p a n y A , but on behalf of the consumer, to w hom it is distributed through the electricity netw ork (the reporting business, C o m p a n y B), w ill produce emissions that are an indirect emissions source for C o m p a n y B.
•
Sim ilarly, the outsourcing of printing activities to C o m p a n y C by C o m p a n y D (the reporting entity) results in the energy consum ption a n d emissions associated w ith those printing activities n o w occurring on a site o w n e d and operated by another c o m p a n y (i.e. C o m p a n y C ). H ow ever, as the printing activities occur on behalf of C o m p a n y D, they a re an indirect emissions source for that com pany. In both instances, it can be said that the reporting entity has indirect control over the e nergy generated and
consum ed, and the G H G s emitted. This is because changes in the activities o f the reporting entity (e.g. structural, behavioural o r other changes) w ill in part determ ine the quantity a n d nature o f those energy an d emission sources. H ow ever, the reporting entity is unlikely to have control over the actual te ch n o lo g y o r fuel type used by that energy and emission source. The c o n c e p t o f scope
The concept o f scope has d e ve lo p e d in the measurement a n d disclosure of greenhouse gas emissions to distinguish betw een direct emissions an d different types of indirect emissions:
•
Scope 1 emissions are all direct emissions; that is, all emissions over w h ich a c o m p a n y has direct control. So S cope l = direct emissions.
•
Scope 2 emissions are a particular type of indirect emissions; that is, emissions over w hich a com pany has only indirect control arising from the generation o f purchased electricity, heat o r steam. So Scope 2 = indirect emissions.
•
Scope 3 emissions are all other indirect emissions; that is, all emissions over w h ich a c o m p a n y has o n ly indirect control arising from a n y emissions source other than electricity, heat o r steam purchased b y that com pany. So S cope 3 = indirect emissions (other). To illustrate these differences, w e w ill look a t the energy an d greenhouse gas emissions sources o f a fictional retail
bank. RetailBank ow ns a nd operates an o ffice building located in the S ydney C BD . RetailBank contracts Electricity Retailer A to supply electricity to the b u ilding's com m on areas a nd to RetailBank's o w n o ffice space. RetailBank does, how ever, lease out some o f the floors of the bu ild in g an d these tenants o rganise their electricity independently of RetailBank's arrangem ents w ith Electricity Retailer A . RetailBank also operates three chillers to pro vid e heating, ventilation and a ir-conditioning (HVAC) services to the b u ild in g 's inhabitants. As part o f their opera tio n , the chillers consum e electricity a nd release hydrofluorocarbons (HFCs), potent greenhouse gases. RetailBank also operates its o w n small fleet of vehicles that consum e unleaded petrol a n d are kept in the b u ild in g 's ca r parking facilities. In the m ain, how ever, em ployees o f RetailBank use taxis a nd aeroplanes fo r local, interstate a n d international travel.
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RetailBank's energy an d greenhouse gas emissions sources are as follow s: •
direct e nergy sources: the vehicle fleet
•
indirect energy sources: electricity
•
scope 1 emissions sources: the c h ille rs /H V A C system a nd the vehicle fleet
•
scope 2 emissions source: electricity
•
scope 3 emissions sources: taxis, flights a n d tenant electricity.
C a lc u la te e n e r g y a n d e m is s io n s
The measurement of energy requires an understanding o f h o w much o f a fuel has been consum ed o r produced, and the e nergy stored in that fuel per unit o f volum e. Together, these w ill p ro vid e the total e nergy content of a particular fuel. These calculations w ill not be covered in this b o o k a n d are likely to be p rovided b y specialists w ithin the organisation (for smaller com panies this w ill involve consultants). H ow ever, to pro vid e you w ith some insights into disclosures, consider the content under the Environment heading in Exhibit 17.1 on p a g e 6 6 0 . D e v e lo p b e n c h m a rk s a n d ta rg e ts
O n c e com panies have identified energy production an d consum ption, an d greenhouse gas emissions sources, and then d e ve lo p e d the c a p a city to measure these, they w ill typ ica lly set out to d e ve lo p energy efficiency a n d emissions reduction strategies. In o rd e r to m anage an d m onitor progress tow ards those strategies, com panies g e n e ra lly d e ve lop both targets a nd benchm arks. An exam ple o f targets set an d progress a g a in st objectives is pro vid e d in Exhibit 1 7 .6 .
EXHIBIT 17.6
W 0 0 L W 0 R T H S L IM IT E D S U S TA IN A B ILITY M ETRICS A N D PROGRESS - PROGRESS A G A IN S T OBJECTIVES
1
Reduce carbon emissions from our buildings by 40% by 2015 (compared to projected growth levels) • •
2
Achieve a 25% reduction in carbon emissions per square metre for new supermarkets •
3
New supermarkets built in 2014 have carbon emissions per square metre which are, on average, 25.1% lower than baseline stores
Zero food waste to landfill by 2015 (where receiving facilities are available) • •
4
Energy efficient and low carbon technology delivered an 18.7% reduction in carbon emissions, compared to original projected growth levels for 2014 Sourcing electricity from renewable sources delivered a further 14.2% reduction in emissions
The volume of recoverable food waste in our waste stream reduced by 20%, from 77% to 57% Woolworths has diverted an estimated 40,000 tonnes of food waste from landfill and we continue to identify new solutions for food waste
Reduce amount of recyclable cardboard in the waste stream to less that 1% by weight •
Weight of recyclable cardboard in supermarkets rubbish bins was 0.96%
Source: W o o lw o rth s Limited,
C o rp o ra te R e s p o n s ib ility R ep o rt 2 0 1 4 .
DISCLOSURE In practice, tw o very different types o f disclosure have evolved: 1
Regulation: governm ent regulation that seeks to:
a
i understand e nergy c o n su m p tio n /p ro d u c tio n a nd greenhouse emissions
ii m a n a g e energy co n su m p tio n /p ro d u c tio n a nd greenhouse emissions. b
other regulation (e.g. C a rb o n Disclosures Project) that seeks to understand the fin a n cia l exposure o f assets subject to the risks a nd opportunities that energy security a nd clim ate ch a n g e represent.
2
V oluntary disclosures in annual reports an d separate sustainability reports.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
D is c lo s u re to g o v e rn m e n ts
In Australia, one key form o f disclosure to governm ent is that required under the N a tio n a l G reenhouse a n d Energy R eporting A c t 2 0 0 7 (NGER). N G ER is a national program that requires large e nergy consumers an d producers and greenhouse gas emitters to disclose: •
energy production da ta
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energy consum ption da ta (direct an d indirect)
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S cope 1 emissions data
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S cope 2 emissions data
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uncertainties associated w ith the a b o v e d a ta .
C a r b o n D is c lo s u re P ro je c t
The C a rb o n Disclosure Project9 (CDP) com m enced in 2 0 0 0 . It is an international effort undertaken prim arily by institutional investors that seek to understand the clim ate ch a n g e exposure of the assets they either m a n a g e o r ow n . O v e r time, CDP has bro a d e ne d its focus to cover not o n ly clim ate c h a n g e but also w a te r an d forest-risk inform ation. Unlike the governm ent regulation a b o ve , w h ich requires disclosure, this form o f civil regulation sends annual survey requests to the largest com panies. CDP publishes an annual clim ate ch a n g e leaders index, w h ich scores com panies based both on the q u a lity o f their disclosures a n d on their e nergy an d emissions reduction achievem ents. In Australia, CDP currently requests annual inform ation from the ASX largest 2 0 0 com panies. So w h y w o u ld a c o m p a n y voluntarily respond to this extensive survey? First, the CDP states that organisations that measure their environm ental im pacts a re better a b le to m a n a g e them. S econd, disclosing clim ate ch a n g e inform ation enables organisations to: •
respond to shareholders' requests to supply c o m p a ra b le a nd relevant clim ate data
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identify opportunities to reduce greenhouse gas emissions
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take a leadership position on understanding the risks from clim ate ch a n g e, deforestation an d w a te r scarcity
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dem onstrate h o w the c o m p a n y innovates in this area
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com m unicate the resilience o f the business in regards to clim ate ch a n g e an d w a te r im pacts. As discussed in section 1 7 .6 , com panies are b e g in n in g to recognise that their responsibility to the environm ent
encom passes m ore than their o w n activities, an d that the activities o f their supply chains m ay also have an im pact. O rganisations are also starting to use the CDP platform to capture inform ation a b o u t their suppliers' a p p ro a ch e s to clim ate ch a n g e an d w a te r m anagem ent to help assess their supply chain risks. V o lu n ta r y d is c lo s u re
It is increasingly expected that com panies include e nergy a nd greenhouse gas inform ation, in the form of either stand alone sustainability reports o r as part o f an integrated annual report. W h ile no consistent reporting form at is required, the types o f inform ation expected a re sim ilar to those for the CDP. To g ive com panies g u id a n c e in the absence o f standards, Pricew aterhouseC oopers (PwC) has d e veloped A Fram ew ork fo r G reenhouse G a s R eporting to assist com panies in d e ve lo p in g a disclosure fram ew ork an d a greenhouse gas emissions statement that can be customised to fit the unique facts an d circumstances o f different types o f organisations. PwC's illustrative exam ple o f a greenhouse gas emissions statement includes: 1
A m anagem ent discussion a n d analysis-style disclosure that provides context. This can include: a
C lim ate ch a n g e risk assessment key risks a nd opportunities
b
Key perform ance indicators
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A description of co rp o ra te governance a nd perform ance
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A statement o f G H G emissions
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An independent assurance statem ent.10 Exhibit 1 7 .7 shows h o w BHP Billiton presented its energy a nd greenhouse gas emissions. Part A shows energy
usage and G H G emissions, an d Part B shows perform ance aga in st targets using trends rather than percentages.
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EXHIBIT 17.7
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BHP BILLITON OUR S U S TA IN A B ILITY PERFORM ANCE Green house gas emissions by source111
Petajoules (PJ)
Total energy use
• Electricity 49% • Fugitive 16% • Distillate and gasoline 13% Coal and coke 8% Natural gas 9% Other 5% • Fuel and process oil
Integrated
Because traditional reporting occurs in silos, it encourages thinking in silos. Integrated Reporting, on the other hand, reflects, and supports, integrated thinking - monitoring, managing and communicating the full complexity of the value creation process and how this contributes to success over time. Integrated Reporting demonstrates the extent to which integrated thinking is occurring within the organisation.
Stewardship
Financial capital
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All forms of capital
An Integrated Report displays an organisation's stewardship not only of financial capital, but also of the other 'capitals' (manufactured, human, intellectual, natural and social), their interdependence and how they contribute to success. This broader perspective requires consideration of resource usage and risks and opportunities along the organisation's full value chain.
Focus
Past, financial
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Past and future, connected, strategic
Annual reporting at present is largely focused on past financial performance and financial risks. Other reports and communications may cover other resources and relationships, but they are seldom presented in a connected way, or linked to the organisation's strategic objectives and its ability to create and sustain value in the future.
Timeframe
Short term
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Short, medium and long term
Much of the media and regulatory attention in response to the global financial crisis has focused on 'short-termism' as one contributory factor. Although short-term considerations are important in many ways, placing them in context is also essential. Integrated Reporting specifically factors in short-, medium- and long-term considerations.
Trust
N arro w disclosures
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G reater transparency
Financial reporting focuses primarily on a narrow series of mandated disclosures. Although an increasing number of organisations are improving their transparency, for example, through voluntary sustainability reporting, in absolute terms that number is still low. By emphasizing transparency, for example, covering a broader range of issues and disclosing the positive with the negative, Integrated Reporting helps to build trust.
Adaptive
Rule bound
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Responsive to individual circumstances
Today's reporting is often said to be too compliance orientated, reducing the scope for organizations to exercise an appropriate amount of judgement. W hile a certain level of compliance orientation is necessary to ensure consistency and enable comparison, Integrated Reporting offers a principles-based approach that drives greater focus on factors that are material to particular sectors and organizations. It permits an organization to disclose its unique situation in clear and understandable language.
Concise
Long and complex
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Concise and material
Long and complex reports are often impenetrable for many readers. A key objective for Integrated Reporting is to de clutter the primary report so that it covers, concisely, only the most material information.
Technology enabled
Paper based
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Technology enabled
W hile the internet and XBRL are introducing elements of technological innovation, many corporate reports are still presented as if they were entirely paper based. Integrated Reporting takes advantage of new and emerging technologies to link information within the primary report and to facilitate access to further detail online where that is appropriate. Source: International Integrated Reporting C ouncil,
A b o u t In te g ra te d R ep o rtin g
2 0 1l .
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W hat is driving the move towards integrated reporting? Integrated reporting represents a significant ch a n g e fo r our current a p p ro a ch to reporting. Listed b e lo w are some of the key drivers that have paved the w a y for the introduction o f integrated reporting. •
Internal m anagem ent drivers: O n e of the main drivers for this new form of reporting comes from reporting organisations themselves. M a n a g e rs of many organisations have found that there are benefits a va ila b le to their organisations by considering the relationships between financial a nd non-financial issues, and understanding the social, environmental and econom ic context their organisations operate in. Integrated reporting provides a platform for better understanding h ow value is created in their organisations and promoting im proved decision-m aking. Integrated reporting should also reduce the com pliance burden of reporting individually to separate stakeholder groups.
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The d e velopm ent o f sustainability metrics a n d fram ew orks: In response to escalating stakeholder dem ands for inform ation, the disclosure o f non-financial sustainability inform ation has becom e increasingly com m on. These n e w appro a ch e s have pro vid e d the inform ation an d structure that have helped m any organisations to explore the non-financial disclosures that are a crucial part o f an integrated report.
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P olicy a n d regulations: G overnm ent p o lic y has been introduced in several countries to m andate o r e n co u ra g e the reporting of non-financial inform ation, including in France, the United States, D enm ark a nd S w eden, as w e ll as the European C om m ission. In a d d itio n , several stock exchanges have voluntary or m andatory requirements to disclose non-financial inform ation, including the Bursa M a la y s ia , the S in g a p ore Stock Exchange an d the S hanghai Stock Exchange. S ustainability indices an d scores have also proliferated in recent years (such as the FTSE4Good), w h ich create an a d d itio n a l co m p lia n ce burden for listed reporting organisations. In South A frica, integrated reporting has becom e m andated for all com panies listed on the Johannesburg Stock Exchange. C o m p a n ie s fo llo w a 'c o m p ly o r e xp la in ' basis, m eaning that they must c o m p ly or, if they d o not, they have to explain w h y. The result is that most com panies pro vid e the necessary inform ation rather than fa cin g the difficulty of exp la in in g w h y the requirements a re not relevant to them. FJowever, even considering these drivers, o n ly 1 0 per cent of com panies surveyed in the K P M G Survey o f
C orp o ra te Responsibility 2 0 1 3 claim they publish integrated reports. W h ile 51 per cent of com panies say they include co rp o ra te responsibility inform ation in their annual reports, for the m ajority o f these com panies the inform ation is included in a separate section o f the annual report a nd w a s therefore not considered as integrated reporting.
W hat could integrated reporting look like? The IIRC fram ew ork defines e ig h t content elements for an integrated report. The fram ew ork does not prescribe a standard form at for the report; how ever, it poses questions for the com pany, under each o f the elements, to then identify w h a t inform ation should be reported. The e ig h t content elements d e fined in the IIRC fram ew ork for integrated reporting a re as follow s: •
O rg a n is a tio n a l overvie w a n d e x te rn a l e n v iro n m e n t: W h a t d o e s th e o rg a n iz a tio n d o a n d w h a t a re th e c irc u m s ta n c e s u n d e r w h ic h it o p e ra te s ?
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G o v e rn a n c e : H o w d o e s t h e o rg a n iz a tio n ’s g o v e rn a n c e s t r u c tu r e s u p p o r t its a b ility t o c r e a te v a lu e in th e s h o rt, m e d iu m a n d lo n g te rm ?
• •
B usiness m o d e l: W h a t is th e o r g a n iz a tio n ’s b u sin e ss m o d e l? R isks a n d o p p o rtu n itie s : W h a t a re th e s p e c ific risk s a n d o p p o r tu n itie s t h a t a f f e c t th e o rg a n iz a tio n ’s a b ility t o c r e a te v a lu e o v e r th e s h o rt, m e d iu m a n d lo n g te r m , a n d h o w is th e o rg a n iz a tio n d e a lin g w ith th e m ?
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S tra te g y a n d re so u rce a llo c a tio n : W h e r e d o e s th e o rg a n iz a tio n w a n t t o g o a n d h o w d o e s it in te n d t o g e t th e r e ?
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P e rfo rm a n c e : T o w h a t e x te n t has th e o rg a n iz a tio n a c h ie v e d its s tra te g ic o b je c tiv e s f o r th e p e rio d an d w h a t a re its o u tc o m e s in th e te r m s o f e f f e c t s o n th e c a p ita ls ?
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O u tlo o k : W h a t c h a lle n g e s a n d u n c e r ta in tie s is th e o rg a n iz a tio n lik e ly t o e n c o u n te r in p u rs u in g its s tra te g y , a n d w h a t a re th e p o te n tia l im p lic a tio n s f o r its b u sin e ss m o d e l a n d f u t u r e p e rfo rm a n c e ?
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Basis o f p re s e n ta tio n : H o w d o e s th e o rg a n iz a tio n d e te rm in e w h a t m a tte rs t o in c lu d e in th e in te g r a te d r e p o r t a n d h o w a re s u c h m a tte rs q u a lifie d o r e v a lu a te d ? Source: International Integrated R eporting C ouncil, The International IR Framework, 2013.
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
The N a tio n a l A ustralia Bank (NAB) A n n u a l R eview 2 0 1 4 is a docum ent prepared on an integrated basis. N A B participated in the IIRC Integrated Reporting Pilot Programme an d continues to produce integrated reports. N A B identified the fo llo w in g benefits o f integrated reporting:
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W e c a n m o r e c le a rly illu s tr a te w h o w e a re as a c o m p a n y a n d h o w c u ltu r e a n d c o r p o r a te re s p o n s ib ility a re
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W e c a n b e tt e r a r tic u la te h o w w e c r e a te s u s ta in a b le v a lu e f o r o u r s ta k e h o ld e rs b y b rin g in g to g e th e r
a fu n d a m e n ta l p a rt o f h o w w e d o b u siness;
m a te ria l in fo r m a tio n a b o u t o u r o p e ra tin g e n v iro n m e n t, b u sin e ss s tra te g y , g o v e rn a n c e a n d fin a n c ia l & n o n - fin a n c ia l p e rfo rm a n c e in o n e r e p o r t; •
T h e re is o n e s in g le s o u rc e , w h ic h in t u r n h e lp s s h a re h o ld e rs a n d o u r b ro a d e r s ta k e h o ld e rs fin d th e in fo r m a tio n th e y re q u ire t o m e a n in g fu lly assess o u r p e rfo rm a n c e a n d u n d e rs ta n d o u r b u s in e s s m o d e l a n d s tra te g y ; an d
•
O n e in te g r a te d r e p o r t e n a b le s m o r e e ffe c tiv e r e p o r tin g a n d e f f ic ie n t use o f re s o u rc e s . Source: National Australia Bank, Integrated Reporting, 2014.
The 'K ey Results' p a g e o f the N A B 's A n n u a l R eview 2 0 1 4 (reproduced in Exhibit 1 7 .9 ) highlights some o f the unique parts o f an integrated report
There are a num ber o f points to note a b o u t the N A B 's review docum ent. •
It is a review , not an a n n u a l report: This docum ent is offered in a d d itio n to the bank's 2 0 1 4 A n n u a l Financial Report a n d the 2 0 1 4 D ig D eeper Report (which includes further details on N A B 's C o rp o ra te Responsibility perform ance over the previous year). This shows that for N A B , integrated reporting is still being d e ve lo p e d , an d is not yet a p p ro p ria te for use as the main reporting vehicle.
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•
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The form at is brief, concise a n d linked to other inform ation: O n ly the most m aterial inform ation a b o u t N A B is co ntained in the review (it is 4 1 pages long, co m p a red w ith the l 9 6 pages of the annual report). The review points to further metrics an d inform ation that a re m ade freely a v a ila b le on the N A B w ebsite.
•
It reflects the co m p a n y's strategy a n d mission: This highlights p a g e shows cle a rly w h a t N A B 's core mission and focus are. For N A B , preserving a fin a n cia l return a n d m aintaining cash flo w an d profit levels are crucial to the success o f its o rganisation, a nd this is show n by highlighting these upfront. This p a g e also shows that N A B considers issues like em ployee engagem ent, com m unity investment an d the use o f renew ables.
•
N o n -fin a n cia l metrics are included: N o t all o f the key figures on this highlights p a g e a re fin a n cia l in nature. Em ployee e n gagem ent inform ation is a percentage, based on survey d a ta . The figure for com m unity investment is a fin a n cia l figure, but reflects an input rather than a return.
•
The a u d ie n ce for this report is varied: A variety o f users could find this inform ation useful - c a p ita l providers and those w ith a fin a n cia l stake in the o rganisation, as w e ll as em ployees, customers, com m unities an d the governm ent.
•
M e trics are linked to strategy: Linking the o rg a n isa tio n a l strategy to measurement a nd reporting is an im portant part o f an integrated report. Each o f the areas o f these highlights is linked to a strategic focus for N A B , w h ich is discussed in m ore detail later in the review .
Assurance of integrated reporting Integrated reporting does present some challenges for the assurance profession. First, the type o f inform ation contained in an integrated report is much greater. An integrated report m ay include disclosures on carbon emissions, m anagem ent strategies, customer satisfaction o r em ployee engagem ent. These represent n ew areas o f know ledge, w ith different measurement app ro a ch e s, different m ateriality levels, a nd different disclosure standards a n d regulations. These w ill require a n e w level o f expertise for assurance providers a nd the form ing o f teams o f assurance an d subject matter experts. S econd, the scope an d fle xib ility o f the integrated report a p p ro a ch further extends the ch a lle n g e for assurance providers. They w ill need to ch a n g e their a p p ro a ch as com panies move a w a y from the standardised fin a n cial reporting form at to a report that contains a variety o f m aterial issues that a re specific to an o rganisation. For exam ple, the content areas o f strategy, o rg a nisational model or future plans extend the scope o f a traditional assurance engagem ent an d also present extra risks for the assurers. The N A B A n n u a l R eview 2 0 1 4 , as shown a b o ve , has been subject to a lim ited assurance e n gagem ent b y the a udit firm Ernst & Y oung. Limited assurance means a less extensive form o f assurance than reasonable assurance, w h ich is a p p lie d to fin a n cia l statements. In the short term, most assurance o f integrated reports is likely to remain on a lim ited basis, as auditors a nd assurance providers build their experience, c a p a c ity an d skills in this are a . There is also the option for a w h o le report to be subject to a lim ited assurance process, but certain critical parts (such as disclosures on ca rbon emissions) m ay be reasonably assured (reasonable is a m ore rigorous a nd c re d ib le type o f assurance).
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FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PRACTICE PROBLEMS S olution s to p ra c tic e p ro b le m s c a n be fo u n d o n lin e a t h ttp ://lo g in .c e n g a g e b r a in .c o m . These p ro b le m s a re in te n d e d to fa c ilita te self-study a n d a d d itio n a l p ra c tic e : d o n 't lo o k a t th e s o lu tio n f o r a n y o f th e se w ith o u t g iv in g th e p r o b le m a s e rio u s tr y firs t, be ca u se o n c e y o u h a ve seen the s o lu tio n it a lw a y s looks e a s ie r th a n it is.
PRACTICE PROBLEM A 1
W h a t is th e p u rp o s e o f a s u s ta in a b ility re p o rt?
2
W h y d o c o m p a n ie s p re p a re a s ta n d -a lo n e s u s ta in a b ility rep ort?
3
W h a t d isc lo su re s a re ty p ic a lly in c lu d e d in a s u s ta in a b ility re p o rt?
KEY TERMS Direct energy and emissions sources Indirect energy and emissions sources Integrated reporting Scope 1 emissions
Scope 2 emissions Scope 3 emissions Stakeholder engagement
Sustainability management Sustainability reporting Triple bottom line reporting
HOMEWORK AND DISCUSSION TO DEVELOP UNDERSTANDING This s e ctio n starts w ith s im p le r disc u s sio n q u e s tio n s th a t revise som e o f th e b a sic c o n c e p ts, w h ic h a re then fo llo w e d b y a set o f p ro b le m s .
DISCUSSION QUESTIONS 1
W h a t type s o f in fo rm a tio n a re m issing in tra d itio n a l fin a n c ia l re p o rtin g ?
2
W h a t a re th e m a in c ritic is m s o f tra d itio n a l fin a n c ia l re p o rtin g ?
3
Based o n y o u r a c c o u n tin g k n o w le d g e to d a te , d o y o u th in k tra d itio n a l fin a n c ia l re p o rtin g p ro v id e s a ll the in fo rm a tio n s ta k e h o ld e rs re q u ire ? C o n s id e r y o u r a n s w e r b a se d o n th e v a rio u s d iffe re n t s ta k e h o ld e r req uire m e nts.
4
W h a t d o w e m e an b y th e c o n c e p t o f s u s ta in a b ility , a n d w h y do e s it m atter?
5
O u tlin e th e costs a n d be ne fits o f p re p a rin g a s u s ta in a b ility re p o rt.
6 A re th e s ta k e h o ld e rs fo r s u s ta in a b ility re p o rtin g d iffe re n t fro m th e sta k e h o ld e rs fo r tra d itio n a l fin a n c ia l re p o rtin g ? If y o u th in k th e y a re , id e n tify th e d iffe re n t g ro u p s a n d e x p la in th e ir in te re s ts /re q u ire m e n ts in th e re p o rts. 7
W h a t skills d o a c c o u n ta n ts h a ve th a t a re im p o rta n t in th e d e v e lo p m e n t o f s u s ta in a b ility rep orts?
8
E x p la in w h y s u s ta in a b ility re p o rtin g is n e ce ssary. C o n s id e r b o th th e be ne fits o f s u s ta in a b ility re p o rtin g a n d the d riv e rs fo r s u s ta in a b ility re p o rtin g in y o u r a n s w e r.
9
Id e n tify th re e type s o f KPIs used in s u s ta in a b ility rep orts.
1 0 W h a t a re the s ix key c a te g o rie s used b y th e G RI in s u s ta in a b ility rep orts? P ro vid e tw o e x a m p le s fo r e a ch c a te g o ry . 11 E x p la in som e o f th e key a rg u m e n ts on w h e th e r s u s ta in a b ility re p o rtin g sh o u ld be v o lu n ta ry o r m a n d a to ry . P ro vid e a t le ast tw o p o in ts fo r e a ch s id e o f th e a rg u m e n t. 12 C o n s id e rin g th e v a rio u s p ro fe s sio n s in v o lv e d in th e a s su ra n ce o f s u s ta in a b ility re p o rts , w h a t a re som e o f th e key te nsion s s u rro u n d in g this issue? 13 W h a t skills d o th e a c c o u n ta n ts a n d n o n -a cc o u n tin g p ro fe s sio n a ls p ro v id e in th e a s su ra n ce o f s u s ta in a b ility rep orts? 14 H o w c a n s u p p ly c h a in m a n a g e m e n t assist in ra is in g a w a re n e s s o f s u s ta in a b ility issues? P ro v id e e x a m p le s in y o u r a n s w e r. 15 Id e n tify a t least tw o s u p p ly c h a in m a n a g e m e n t p ra ctice s th a t c o m p a n ie s h a ve u n d e rta k e n to re d u c e th e ir c a rb o n fo o tp rin t.
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16 W h a t a p p ro a c h e s a re a v a ila b le fo r m e a s u rin g a c o m p a n y 's e n e rg y u s a g e a n d em issions? 1 7 W h a t is th e d iffe re n c e b e tw e e n d ire c t a n d in d ire c t e n e rg y a n d e m issions sources? 18 P ro v id e tw o e x a m p le s o f e a c h o f th e fo llo w in g : a S c o p e 1 e m issions
b
S c o p e 2 e m issions
c
S c o p e 3 em issions.
1 9 W h y a re b e n c h m a rks a n d ta rg e ts im p o rta n t? W h a t is th e d iffe re n c e b e tw e e n th e term s? 2 0 W h a t is in te g ra te d re p o rtin g ? H o w is in te g ra te d re p o rtin g d iffe re n t fro m o th e r fo rm s o f re p o rtin g ? 21 Id e n tify th e d rive rs o f in te g ra te d re p o rtin g . 2 2 W h a t a re th e key te nsion s in th e fie ld c o n c e rn in g in te g ra te d re p o rtin g ? 2 3 O u tlin e y o u r th o u g h ts on w h e th e r in te g ra te d re p o rtin g is a c h ie v a b le . 2 4 W h a t a re som e o f th e c h a lle n g e s in te g ra te d re p o rtin g m ust o ve rc o m e ? 2 5 W h o w ill re a d an in te g ra te d re p o rt? W ill a ll sta k e h o ld e rs h a ve th e sam e level o f skills o r c o m p e te n c y to u n d e rsta n d th e in te g ra te d re p o rt?
PROBLEM S PROBLEM 17.1 R elationship to GAAP D o y o u th in k th e kind s o f a c c o u n tin g c o n c e p ts a n d s ta n d a rd s illu s tra te d in C h a p te r 6 as b e in g p a rt o f G A A P c a n o r sh o u ld a p p ly to a c o m p a n y 's s u s ta in a b ility rep orts? Discuss th e pro s a n d cons o f such a n e x p a n s io n a n d in te rp re ta tio n o f G A A P , b a se d o n th e reasons y o u th in k c o m p a n ie s w o u ld w a n t to p ro d u c e s u s ta in a b ility rep orts a n d th e reasons p e o p le w o u ld w a n t to o b ta in them .
PROBLEM 17.2 Criteria The K P M G S u rv e y o f C o r p o r a te R e s p o n s ib ility R e p o r tin g 2 0 1 3 notes K P M G m e m b e r firm s c a n h e lp y o u r o rg a n is a tio n : 'B e n c h m a rk th e q u a lity o f y o u r re p o rtin g a g a in s t in d u stry p e e rs ' (K P M G S u rv e y o f C o r p o r a te R e s p o n s ib ility R e p o r tin g 2 0 1 3 , p. 8 0 ).
W h a t c rite ria a re lik e ly to be used to c a rry o u t this b e n c h m a rk in g exercise?
PROBLEM 17.3 Assurance In te rn a tio n a l surveys in d ic a te th a t m a n y c o m p a n ie s d o no t h a ve th e ir s u s ta in a b ility d a ta a n d rep orts a ssu red . 1 W h a t a re th e be ne fits o f h a v in g this in fo rm a tio n assured? 2
W h y w o u ld this a s su ra n ce n o t be p a rt o f th e a u d it o f th e fin a n c ia l statem ents?
3
W h a t ty p e o f a s su ra n ce c o u ld be g iv e n a b o u t th e s u s ta in a b ility in fo rm a tio n re p o rte d ?
PROBLEM 17.4 Scope em issions in s u s ta in a b ility re p o rtin g C o n s id e r e a c h o f th e fo llo w in g g re e n h o u s e g a s e m issions a n d d e te rm in e if th e y w o u ld b e re p o rte d u n d e r S c o p e 1, S c o p e 2 o r S c o p e 3 e m issions in th e s u s ta in a b ility re p o rt: 1 e le c tric ity 2
c a r fle e t
3
n a tu ra l g a s used in th e re p o rte r's b u ild in g
4
a ir tra ve l
5
w a s te to la n d fill
6
re n e w a b le e n e rg y .
684
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
PROBLEM 17.5 Energy e fficie n cy practices P ro vid e th re e e x a m p le s o f e n e rg y e ffic ie n c y p ra ctice s fro m an o rg a n is a tio n o f y o u r c h o ic e re p o rte d in its s u s ta in a b ility re p o rt. A d v is e w h a t th e ta rg e ts fo r 2 0 1 5 w e re a n d if it a c h ie v e d them .
PROBLEM 17.6 Id e n tify energy and greenhouse gas em issions sources S u p e rm a rk e t C o . o w n s a n d o p e ra te s a s u p e rm a rk e t lo c a te d in th e subu rbs o f M e lb o u rn e . The s u p e rm a rk e t is situ a te d w ith in a la rg e r s h o p p in g c o m p le x o w n e d a n d o p e ra te d b y P ro p e rty fu n d C o . P ro p e rty fu n d C o . su p p lie s e le c tric ity , h e a tin g , v e n tila tio n a n d a ir-c o n d itio n in g services to a ll o f th e c o m m o n a re a s o f th e c o m p le x ; h o w e v e r, S u p e rm a rk e t C o . has n e g o tia te d s e p a ra te c o n tra cts fo r e le c tric ity s u p p ly to a ll o f its s u p e rm a rke ts. S u p e rm a rk e t C o . a ls o re q u ire s e xte n sive re frig e ra tio n e q u ip m e n t to k e e p p e ris h a b le s fre sh. This e q u ip m e n t consum es e le c tric ity , b u t a ls o leaks HFCs (p o te n t g re e n h o u s e gases). A t th e b a c k o f S u p e rm a rk e t C o .'s o p e ra tio n s is a la rg e s to ra g e fa c ility in w h ic h nu m e rous fo rk lifts a re o p e ra te d to lift a n d m o ve p ro d u cts . These fo rk lifts a re p o w e re d v ia sm all LPG tanks lo c a te d on e a ch fo rk lift. P ro vid e S u p e rm a rk e t C o .'s e n e rg y a n d g re e n h o u s e g a s e m issions sources fo r th e fo llo w in g : 1 d ire c t e n e rg y sources 2
in d ire c t e n e rg y sources
3
S c o p e 1 em issions sources
4
S c o p e 2 em issions sources
5
S c o p e 3 em issions sources.
PROBLEM 17.7 Scope I, 2 and 3 em issions U n d e rg ro u n d C o a l M in e is an u n d e rg ro u n d c o a l-m in in g fa c ility th a t processes c o a l on site. A s a c o n s e q u e n ce , the U n d e rg ro u n d C o a l M in e uses la rg e q u a n titie s o f d ie s e l fo r th e on-site tra n s p o rta tio n o f th e c o a l, a n d im po rts e le c tric ity fo r th e ru n n in g o f site o ffic e s a n d th e c o a l-p ro c e s s in g p la n t. The tra n s p o rta tio n a c tiv itie s a re , h o w e v e r, o w n e d b y a c o n tra c to r th a t o p e ra te s u n d e r its o w n p o lic ie s , b u t on th e U n d e rg ro u n d C o a l M in e site. M e th a n e , a p o te n t g re e n h o u s e g a s, is re le a se d as a fu g itiv e e m ission d u rin g th e m in in g o f th e c o a l. S om e o f this m e th a n e is, h o w e v e r, c a p tu re d a n d fla re d , resultin g in th e less p o te n t g re e n h o u s e g a s c a rb o n d io x id e (an a c tiv ity k n o w n as m e th a n e d e stru ctio n ). The c o a l is s o ld to an e le c tric ity g e n e ra to r, w h ic h is re s p o n s ib le fo r th e em issions re le a se d d u rin g th e c o a l's c o m b u s tio n . Id e n tify w h ic h o f these w o u ld be S c o p e 1 , 2 a n d 3 e m ission sources to be re p o rte d in a s u s ta in a b ility re p o rt.
PROBLEM 17.8 In te g ra te d re po rtin g Refer to E x h ib it 1 7 .9 fro m th e N a tio n a l A u s tra lia B an k (N A B ) in te g ra te d re p o rt ( 2 0 1 4 A n n u a l R eview ). If y o u w e re a n e m p lo y e e o f N A B , w h ic h p ieces o f in fo rm a tio n in th e 'K e y Results' s ection w o u ld y o u fin d m ost im p o rta n t? W h y ? W o u ld this a ffe c t y o u r d e c is io n to w o rk there?
PROBLEM 17.9 In te rp re tin g s u s ta in a b ility reports G o to th e fo llo w in g w e b site s to e x a m in e th e s u s ta in a b ility re p o rts o f som e A u s tra lia n c o m p a n ie s : a Telstra: h ttp ://w w w .te ls tra .c o m .a u /a b o u tu s /c o m m u n ity -e n v iro n m e n t/re p o rts /s u s ta in a b ility -re p o rt/
b
CSL Lim ited : h ttp ://w w w .c o rp o ra te re s p o n s ib ility .c s l.c o m .a u /
c
W e s tp a c : h ttp ://w w w .w e s tp a c .c o m .a u /a b o u t-w e s tp a c /s u s ta in a b ility -a n d -c o m m u n ity /re p o rtin g -o u r-p e rfo rm a n c e / sta keholder-i m p a c t-re p o rts /
d
C o m m o n w e a lth B ank: h ttp ://w w w .c o m m b a n k .c o m .a u /a b o u t-u s /o u r-c o m p a n y /s u s ta in a b ility /o u r-a p p ro a c h / s u s ta in a b ility -re p o rtin g .a s p x
e
S to c k la n d C o rp o ra tio n : h ttp ://s to c k la n d c o rp o ra te re p o rtin g 2 0 1 4 .c o m .a u /s u s ta in a b ility -a re a .
CHAPTER 17 S ustainability reporting
685
For e a ch c o m p a n y : 1
p ro v id e tw o key p e rfo rm a n c e in d ic a to rs u n d e r e a ch o f th e fo llo w in g s ix h e a d in g s : a
e c o n o m ic
b
e n v iro n m e n t
c
la b o u r p ra ctice s a n d d e c e n t w o rk
d
hu m a n rig hts
e
so cie ty
f
p ro d u c t re s p o n s ib ility .
2
A re G RI c rite ria used?
3
W a s th e re an a s su ra n ce re p o rt? If so, w h o w a s th e a u d ito r?
4
List th e fiv e m a in th in g s y o u le a rn e d fro m re a d in g e a ch o f th e s u s ta in a b ility rep orts.
PROBLEM 17.10 In te rp re tin g s u s ta in a b ility reports G o to th e ta b le on p a g e 8 o f th e BP S u s ta in a b ility R e v ie w 2 0 1 3 (a v a ila b le a t h t tp :/ /w w w .b p .c o m /c o n t e n t /d a m / b p /p d f/s u s ta in a b ility /g ro u p -re p o rts /B P _ S u s ta in a b ility _ R e v ie w _ 2 0 1 3 .p d f). 1 W h a t a re th e tw o m ost im p o rta n t th in g s y o u le a rn a b o u t e a ch o f th e fo llo w in g ?
2
a
safe ty
b
e n v iro n m e n t
c
p e o p le .
C o m m e n t on th e fo llo w in g results: a
e n v iro n m e n t e x p e n d itu re ($ m illio n )
b
c u stom er em issions
c
d ire c t G H G em issions
d
dism issals fo r n o n -c o m p lia n c e a n d u n e th ic a l b e h a v io u r.
3
For e a ch o f th e item s in q u e s tio n 2 , o u tlin e th e d iffic u ltie s in m e a s u rin g this in d ic a to r.
4
W h a t so rt o f issues w o u ld an a u d ito r o f this re p o rt be c o n c e rn e d w ith ?
CASES CASE17A
W oolworths sustainability
O b ta in th e W o o lw o rth s 2 0 1 4 C o rp o ra te R e s p o n sib ility R ep ort (a v a ila b le a t h ttp ://w o o lw o rth s lim ite d 2 0 1 4 .c s rre p o rt.c o m .a u /d o w n lo a d s ). 1 List th re e im p o rta n t p o in ts th e C E O m akes re la tin g to s u s ta in a b ility . 2
H o w m uch m o n e y has W o o lw o rth s invested in e n e rg y e ffic ie n c y s in c e 2 0 0 9 ? List th re e e x a m p le s o f the te c h n o lo g y W o o lw o rth s has in ve ste d in.
3
H o w m uch d o e s W o o lw o rth s p re d ic t sa vin g s w ill re a ch b y 2 0 1 5 fro m this investm ent?
4
W h a t w a s W o o lw o rth s ' re d u c tio n in c a rb o n e m issions fo r 2 0 1 4 ?
5
W h a t a re W o o lw o rth s ' s u s ta in a b ility m etrics fo r 2 0 1 4 ?
6
List th re e w a y s in w h ic h W o o lw o rth s states it re d u c e d its e m issions.
7
H as e n e rg y in te n sity in c re a s e d o r d e c re a s e d o v e r th e p re vio u s tw o ye a rs?
8 W a s th e re p o rt a ssu red ? By w h o m ? Is th e assu rer a n a c c o u n tin g firm ? 9
List th re e re c o m m e n d a tio n s th e a ssu re r w o u ld like W o o lw o rth s to focus on .
1 0 W h a t re p o rtin g fra m e w o rk a n d / o r g u id e lin e s d o e s W o o lw o rth s use to re p o rt on its c o rp o ra te re s p o n s ib ility ?
686
FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH
CASE 17B
An international integrated report
N o v o N o rd is k is a n in te rn a tio n a l h e a lth c a re c o m p a n y b a se d in D e n m a rk . N o v o N o rd is k p re p a re s a n in te g ra te d re p o rt. Use th e o n lin e v e rsio n o f its A n n u a l R e p o rt 2 0 1 3 (a v a ila b le a t h ttp ://w w w .n o v o n o r d is k .c o m /a n n u a l_ re p o rt_ 2 0 1 4 .h tm l) to a n s w e r th e fo llo w in g qu estio ns: 1
L o oking a t th e 'P e rfo rm a n c e H ig h lig h ts ' (p a g e s 1 4 a n d 1 5 ), list th e a re a s th a t N o v o N o rd is k presents m etrics fo r.
2
U n d e r 'S o c ia l p e rfo rm a n c e ' on p a g e 1 5 , list th e m e tric s /in d ic a to rs used. Id e n tify w h ic h on es y o u th in k ha ve im p ro v e d fo r th e c o m p a n y .
3
H o w m uch C O 2 w a s re le a s e d fro m e n e rg y c o n s u m p tio n b y N o v o N o rd is k in 2 0 1 4 ?
4
H o w is N o v o N o rd is k tra c k in g a g a in s t C O 2 em issions ta rgets?
5
H o w do es N o v o N o rd is k 's trip le b o tto m lin e business p rin c ip le c re a te v a lu e fo r th e c o m p a n y ?
6
W h a t d o e s N o v o N o rd is k state a b o u t th e IIRC g u id e lin e s ?
7
R e vie w th e a s su ra n ce re p o rts p ro v id e d in th e d o c u m e n t. W h o is th e assu rer a n d w h a t le v e l/s o f a s su ra n ce is /a r e b e in g p ro v id e d fo r th e re p o rt?
COURSEMATE
WEBSITE RESOURCES
f CourseMate
G o to h ttp ://lo g in .c e n g a g e b ra in .c o m to a c c e s s C o u r s e M a te , y o u r o n lin e s tu d y to o l fo r F in a n c ia l A c c o u n t in g . C o u r s e M a te b rin g s c h a p te r c o n c e p ts to life w ith in te ra c tiv e le a r n in g , s tu d y a n d e x a m p r e p a r a tio n to o ls . > R ound o u t y o u r k n o w le d g e o f in tro d u c to ry a c c o u n tin g c o n c e p ts using this te xt's M a n a g e m e n t A c c o u n tin g eBook >
C o m p le te this c h a p te r's p ra c tic e p ro b le m s to e x te n d y o u r u n d e rs ta n d in g .
>
E x p lo re useful o n lin e resources th ro u g h this c h a p te r's a n n o ta te d w e b lin k s .
>
Test y o u r u n d e rs ta n d in g o f this c h a p te r b y ta k in g th e re v is io n q u iz .
>
Revise th is c h a p te r's key term s a n d c o n c e p ts w ith th e in te ra c tiv e fla s h c a rd s , g lo s s a ry a n d c ro s s w o rd .
N O TES 1
This chapter w a s jointly written by A n d re w Trotman w ith substantial input b y Tanya Fielder on section 1 7 .7 and Sarah A dam s on section 1 7 .8 on integrated reporting. Useful exam ples w e re also provided by M a ria B a la tb a ta n d Patricia Strong. 2 International Integrated Reporting C ouncil, In te rn a tio n a l IR F ra m e w o rk , h ttp ://w w w .th e iir c .o r g /w p - c o n te n t/u p lo a d s /2 0 1 3 /1 2 / 1 3 -1 2-08-THE-INTERNATIONAL-IR-FRAMEWORK-2-1 .pdf. 3 G lo b a l Reporting Initiative, G 4 S u s ta in a b ility re p o rtin g g u id e lin e s - R ep o rtin g P rinciples a n d S ta n d a rd D isclosures, h t t p s : / / w w w .g lo b a lre p o rtin g .o rg /resourcelibrary/G R IG 4-P art l-Reporting-Principles-and-Standard-Disclosures.pdf. 4 G lo b a l Reporting Initiative, G 4 S u s ta in a b ility re p o rtin g g u id e lin e s - R ep o rtin g P rinciples a n d S ta n d a rd D isclosures, h t t p s : / / w w w .g lo b a lre p o rtin g .o rg /resourcelibrary/G R IG 4-P art l-Reporting-Principles-and-Standard-Disclosures.pdf. 5 Transurban, 2 0 1 4 S u s ta in a b ility R eport, h ttp ://w w w .tr a n s u r b a n .c o m /s r l4 /. 6 Transurban, 2 0 1 4 S u s ta in a b ility R eport, h ttp ://w w w .tr a n s u r b a n .c o m /s r l4 /. 7 R. M oro ne y, C . W in d s o r & Y. T. A w (201 2), 'Evidence o f assurance enhancing the q u a lity o f voluntary environm ental disclosures: an em pirical analysis', A c c o u n tin g & Fin an ce , 5 2 (3 ), pp. 9 0 3 - 3 9 . 8 'N a tio n a l Australia Bank S upplier Sustainability Principles', h ttp ://c r.n a b .c o m .a u /d o c s /n a b -s u p p lie r-s u s ta in a b iliM p rin c ip le s .p d f. 9 C D P - D riv in g S u s ta in a b le E conom ies, h ttp s ://w w w .c d p .n e t/e n -U S /P a g e s /H o m e P a g e .a s p x . 1 0 PricewaterhouseCoopers, LLP, 2 0 1 0 , A F ra m e w o rk fo r G re e n h o u s e G a s R eporting, 'T ypico Inc: An illustration o f a statement o f greenhouse gas emissions', h ttp :/ / w w w . p w c . c o m / u s / e n / corporate-sustainabiliM clim ate-change/publications/greenhouse-gasrepo rt-typico-i nc. i htm I.
W oolw orths Lim ited ANNUAL REPORT 2014
688
Appendix: W oolw orths Lim ited A nnual R eport 2014
Consolidated Income Statement - Woolworths Limited Note
2014 52 weeks $m
2013 53 weeks 5m
60,772.8 179.4 60,952.2 (44,474.6) 16,477.6 242.7 (10,176.0) (2,769.1) 3,775.2 (277.8) 17.7 (260.1) 3,515.1 (1,056.7) 2,458.4
5 8 ,5 1 6 .4
Continuing Operations R e ve n u e fr o m th e s a le o f g o o d s
2a
O th e r o p e ra tin g re v e n u e
2a
Total revenue from continuing operations C o s t o f sa le s
Gross profit from continuing operations O th e r re v e n u e
2b
B ra n c h e x p e n s e s A d m in is tr a tio n e x p e n s e s
Earnings from continuing operations before interest and tax F in a n c ia l e x p e n s e
3
F in a n c ia l in c o m e
3
Net financing costs from continuing operations Profit from continuing operations before income tax expense In c o m e ta x e x p e n s e re la tin g to c o n tin u in g o p e ra tio n s
5a
Profit from continuing operations after income tax expense
157.7 5 8 ,6 7 4 .1 (4 2 ,9 1 2 .6 ) 15,761.5 2 4 7 .6 (9 ,7 9 9 .8 ) (2 ,6 1 4 .7 ) 3 ,5 9 4 .6 (4 1 0 .1 ) 3 0 .3 (3 7 9 .8 ) 3 ,2 1 4 .8 (9 5 9 .9 ) 2 ,2 5 4 .9
Discontinued Operations P ro fit fr o m d is c o n tin u e d o p e ra tio n s
34
Profit for the period
9.7
2,458.4
2 ,2 6 4 .6
2,451.7 6.7 2,458.4
2 ,2 5 9 .4
Profit attributable to: E q u ity h o ld e rs o f th e p a re n t e n tity N o n - c o n tr o llin g in te re s ts
Profit for the period
5 .2 2 ,2 6 4 .6
Profit attributable to equity holders of the parent entity relates to: 2,451.7 2,451.7
P ro fit fr o m c o n tin u in g o p e ra tio n s P ro fit fr o m d is c o n tin u e d o p e ra tio n s
Profit attributable to equity holders of the parent entity
2 ,2 4 9 .7 9.7 2 ,2 5 9 .4
Earnings Per Share (EPS) from continuing and discontinued operations B asic EPS (c e n ts p e r s h a re )
21
D ilu te d EPS (c e n ts p e r s h a re )
21
W e ig h te d a v e ra g e n u m b e r o f s h a re s u s e d in th e c a lc u la tio n o f B a s ic EPS ( m illio n )
21
196.5 195.6 1,248.0
1 ,2 3 7 .4
196.5 195.6
181.0
1 8 2 .6 181.8
Earnings Per Share (EPS) from continuing operations B asic EPS (c e n ts p e r s h a re )
21
D ilu te d EPS (c e n ts p e r s h a re )
21
181.8
The above consolidated income statement should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 96
Appendix: W oolw orths Lim ited A nnual Report 2014
689
Consolidated Statement of Comprehensive Income Woolworths Limited P ro fit fr o m c o n tin u in g o p e ra tio n s P ro fit fr o m d is c o n tin u e d o p e ra tio n s
Profit for the period
2014 52 weeks $m
2013 53 weeks $m
2,458.4 2,458.4
2 ,2 5 4 .9 9 .7 2 ,2 6 4 .6
Other comprehensive income/(loss) from continuing operations Items that may be reclassified subsequently to profit or loss
In c o m e ta x re la tin g to th e s e ite m s
270.3 (139.1) 46.7 (7.6)
Total items that may be reclassified subsequently to profit or loss
170.3
1 8 9 .8
(9.7) 15.1 (6.9) (1.5) 168.8
3 2 .9
M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity M o v e m e n t in th e fa ir v a lu e o f ca s h flo w h e d g e s T ra n s fe r ca s h flo w h e d g e s to th e in c o m e s ta te m e n t
1 9 7 .8 2 5 6 .4 (2 3 1 .9 ) ( 3 2 .5 )
Items that will not be reclassified to profit or loss M o v e m e n t in th e fa ir v a lu e o f in v e s tm e n ts in e q u ity s e c u ritie s A c tu a r ia l g a in s o n d e fin e d b e n e fit s u p e ra n n u a tio n p la n s In c o m e ta x re la tin g to th e s e ite m s
Total items that will not be reclassified to profit or loss Other comprehensive income for the period (net of tax) from continuing operations
12.5 ( 3 .8 ) 4 1 .6 2 3 1 .4
Other comprehensive income from discontinued operations Items that may be reclassified subsequently to profit or loss M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity
0 .3
M o v e m e n t in th e fa ir v a lu e o f ca s h flo w h e d g e s In c o m e ta x re la tin g to th e s e ite m s
Total items that may be reclassified subsequently to profit or loss Other comprehensive income for the period (net of tax) from discontinued operations T o ta l c o m p re h e n s iv e in c o m e fr o m c o n tin u in g o p e ra tio n s T o ta l c o m p re h e n s iv e in c o m e fr o m d is c o n tin u e d o p e ra tio n s
Total comprehensive income for the period
-
0 .4 (0 .1 ) 0 .6 0 .6
2,627.2 2,627.2
2 ,4 8 6 .3
2,620.5 6.7 2,627.2
2,481.1
1 0 .3 2 ,4 9 6 .6
Total comprehensive income from continuing operations attributable to: E q u ity h o ld e rs o f th e p a re n t e n tity N o n - c o n tr o llin g in te re s ts
Total comprehensive income for the period from continuing operations
5 .2 2 ,4 8 6 .3
Total comprehensive income from discontinued operations attributable to: E q u ity h o ld e rs o f th e p a re n t e n tity
Total comprehensive income for the period from discontinued operations
1 0 .3
-
1 0 .3
The above consolidated statement of comprehensive income should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 97
690
Appendix: W oolw orths Lim ited A nnual R eport 2014
Consolidated Statement of Comprehensive Income Woolworths Limited In co m e ta x on o th e r com p reh en sive incom e fro m c o n tin u in g o p e ratio n s For th e y e a r en d ed 2 9 June 2 0 1 4
B efo re ta x $m
Tax (e x p e n s e )/ b e n e fit 5m
N e t o f ta x $m
Ite m s t h a t m a y b e re c la s s ifie d s u b s e q u e n tly t o p r o f it o r lo ss
M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity M o v e m e n t in th e fa ir v a lu e o f ca s h f lo w h e d g e s T ra n s fe r ca s h f lo w h e d g e s to th e in c o m e s ta te m e n t
2 7 0 .3
( 3 5 .3 )
2 3 5 .0
(139.1)
41.7
(9 7 .4 )
4 6 .7
(1 4 .0 )
3 2 .7
177.9
(7.6)
170.3
It e m s t h a t w ill n o t b e r e c la s s if ie d t o p r o f i t o r lo s s
M o v e m e n t in th e fa ir v a lu e o f in v e s tm e n ts in e q u ity s e c u ritie s
(9 .7 )
A c tu a r ia l g a in s o n d e fin e d b e n e fit s u p e ra n n u a tio n p la n s
15.1
(6 .9 )
5.4 183.3
(6.9) (14.5)
In co m e ta x on o th e r com p reh en sive incom e fro m c o n tin u in g o p e ratio n s For th e y e a r en d ed 3 0 June 2 0 1 3
B efo re ta x $m
(9 .7 )
Tax (e x p e n s e )/ b e n e fit $m
8 .2
(1.5) 168.8
N e t o f ta x $m
Ite m s t h a t m a y b e re c la s s ifie d s u b s e q u e n tly t o p r o f it o r lo ss
M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity
1 9 7 .8
(2 5 .1 )
1 72.7
M o v e m e n t in th e fa ir v a lu e o f ca s h f lo w h e d g e s
2 5 6 .4
(7 6 .9 )
1 7 9 .5
T ra n s fe r ca s h f lo w h e d g e s to th e in c o m e s ta te m e n t
(2 3 1 .9 )
6 9 .5
(1 6 2 .4 )
222.3
(32.5)
189.8
It e m s t h a t w ill n o t b e r e c la s s if ie d t o p r o f i t o r lo s s
M o v e m e n t in th e fa ir v a lu e o f in v e s tm e n ts in e q u ity s e c u ritie s
3 2 .9
A c tu a r ia l g a in s o n d e fin e d b e n e fit s u p e ra n n u a tio n p la n s
12.5
( 3 .8 )
8 .7
45.4 267.7
(3.8) (36.3)
41.6 231.4
In co m e ta x on o th e r com p reh en sive incom e fro m d isco n tin u ed o p e ratio n s For th e y e a r en d ed 2 9 June 2 0 1 4 It e m s t h a t m a y b e r e c la s s if ie d s u b s e q u e n t ly t o p r o f i t o r lo s s
In co m e ta x on o th e r com p reh en sive incom e fro m d isco n tin u ed o p e ratio n s For th e y e a r en d ed 3 0 June 2 0 1 3
3 2 .9
B efo re ta x $m
T a x (e x p e n s e ) $m
N e t o f ta x $m
-
-
-
-
-
-
B efo re ta x $m
T a x (e x p e n s e ) $m
N e t o f ta x $m
Ite m s t h a t m a y b e re c la s s ifie d s u b s e q u e n tly t o p r o f it o r lo ss
M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity
0 .3
M o v e m e n t in th e fa ir v a lu e o f ca s h f lo w h e d g e s
0 .4
(0 .1 )
0 .3
0 .7
( 0 .1 )
0 .6
0 .3
The above consolidated statement of comprehensive income should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 98
Appendix: W oolw orths Lim ited A nnual Report 2014
691
Consolidated Balance Sheet - Woolworths Limited 2014
Note
$m
2013
$m
Current assets C a sh a n d ca s h e q u iv a le n ts T ra d e a n d o th e r re c e iv a b le s
8
In v e n to rie s
9
O th e r fin a n c ia l a s s e ts
A s s e ts c la s s ifie d as h e ld f o r sa le
10
35
Total current assets
922.6 925.7 4,693.2 12.7 6,554.2 620.6 7,174.8
8 4 9 .2 9 6 8 .6 4 ,2 0 5 .4 5 4 .2 6 ,0 7 7 .4 1 4 8 .7 6 ,2 2 6 .1
Non-current assets T ra d e a n d o th e r re c e iv a b le s O th e r fin a n c ia l a s s e ts
8 10
P ro p e rty , p la n t a n d e q u ip m e n t
11
In ta n g ib le a s s e ts
12
D e fe rre d ta x a s s e ts
5d
Total non-current assets Total assets
108.2 304.7 9,600.7 6,335.0 681.8 17,030.4 24,205.2
1 6 .6 3 5 8 .7 9 ,2 4 6 .1 5 ,7 8 4 .3 6 1 8 .4 1 6 ,02 4 .1 2 2 ,2 5 0 .2
Current liabilities T ra d e a n d o th e r p a y a b le s
13
B o rro w in g s
15
C u rre n t ta x lia b ilitie s
5c
O th e r fin a n c ia l lia b ilitie s
14
P ro v is io n s
17
Total current liabilities
6,006.3 219.5 158.9 168.2 1,005.3 7,558.2
5 ,3 9 0 .3 1 6 9 .4 1 9 3 .2 1 4 5 .9 9 6 7 .2 6 ,8 6 6 .0
Non-current liabilities B o rro w in g s
15
O th e r fin a n c ia l lia b ilitie s
14
P ro v is io n s
17
O th e r
Total non-current liabilities Total liabilities Net assets
4,136.0 1,155.2 567.4 263.0 6,121.6 13,679.8 10,525.4
4 ,2 8 2 .5 9 9 2 .6 5 4 9 .2 2 5 9 .4 6 ,0 8 3 .7 1 2 ,9 4 9 .7 9 ,3 0 0 .5
Equity Is s u e d c a p ita l
18
S h a re s h e ld in tr u s t
18
R e s e rv e s
19
R e ta in e d e a rn in g s
20
Equity attributable to equity holders of the parent entity N o n - c o n tr o llin g in te re s ts
Total equity
4,850.1 (218.9) 198.2 5,423.1 10,252.5 272.9 10,525.4
4 ,5 2 2 .7 (1 8 0 .5 ) 25.1 4,661.1 9 ,0 2 8 .4 272.1 9 ,3 0 0 .5
The above consolidated balance sheet should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 99
692
Appendix: W oolw orths Lim ited A nnual R eport 2014
Consolidated Cash Flow Statement - Woolworths Limited 2014 5 2 w ee ks
2013 5 3 w ee ks
65,851.8 39.9 (60,918.3) (348.0) 9.8 (1,162.5) 3,472.7
6 3 ,7 8 9 .8
$m
$m
C a s h F lo w s f r o m O p e r a t in g A c t iv it ie s
R e c e ip ts fr o m c u s to m e rs R e c e ip ts fr o m te n a n ts P a y m e n ts to s u p p lie rs a n d e m p lo y e e s In te re s t a n d c o s ts o f fin a n c e p a id In te re s t re c e iv e d In c o m e ta x p a id N e t c a s h p r o v id e d b y o p e r a t in g a c t iv it ie s
4 7 .0 (5 9 ,6 8 5 .1 ) (4 7 6 .7 ) 2 2 .2 (9 7 7 .3 ) 2 ,7 1 9 .9
C a s h F lo w s f r o m In v e s tin g A c t iv it ie s
P ro c e e d s fr o m th e sa le o f p ro p e rty , p la n t a n d e q u ip m e n t P ro c e e d s fr o m th e sa le o f p r o p e r ty to th e S h o p p in g C e n tre s A u s tra la s ia P ro p e r ty G ro u p P a y m e n ts f o r p ro p e rty , p la n t a n d e q u ip m e n t - p r o p e r ty d e v e lo p m e n t ( A d v a n c e s ) /r e p a y m e n ts o f p r o p e r ty re la te d re c e iv a b le s P a y m e n ts f o r p ro p e rty , p la n t a n d e q u ip m e n t (e x c lu d in g p r o p e r ty d e v e lo p m e n t) P a y m e n ts f o r in ta n g ib le a s s e ts P ro c e e d s fr o m th e sa le o f s u b s id ia rie s P a y m e n ts f o r th e p u rc h a s e o f b u s in e s s e s
181.7 12.2 (519.0) (15.9) (1,321.5) (42.3) 37.0 (371.5)
P a y m e n ts f o r th e p u rc h a s e o f in v e s tm e n ts
-
7.9 (2,031.4)
D iv id e n d s re c e iv e d N e t c a s h u s e d in in v e s tin g a c t iv it ie s
1 0 0 .3 8 0 2 .8 (7 6 7 .4 ) 1 4 .8 (1 ,1 3 6 .0 ) ( 6 6 .7 ) 1 0 5 .8 ( 2 3 5 .4 ) ( 2 8 .0 ) 8.1 (1 ,2 0 1 .7 )
C a s h F lo w s f r o m F in a n c in g A c t iv it ie s
36.1 183.0 7,859.8 (7,927.1) (1,491.1) (32.0) (0.6) (1,371.9) 69.4 4.0 849.2 922.6
P ro c e e d s fr o m th e is s u e o f e q u ity s e c u ritie s P ro c e e d s fr o m th e is s u e o f e q u ity s e c u ritie s in s u b s id ia ry to n o n - c o n tr o llin g in te re s t P ro c e e d s fr o m e x te rn a l b o rro w in g s R e p a y m e n t o f e x te rn a l b o rro w in g s D iv id e n d s p a id D iv id e n d s p a id to n o n - c o n tr o llin g in te re s ts M o v e m e n ts in e m p lo y e e s h a re p la n lo a n s N e t c a s h u s e d in fin a n c in g a c t iv it ie s N e t in c r e a s e /C d e c r e a s e ) in c a s h a n d c a s h e q u iv a le n t s h e ld
E ffe c ts o f e x c h a n g e ra te c h a n g e s o n fo re ig n c u rr e n c y h e ld C a sh a n d ca s h e q u iv a le n ts a t th e b e g in n in g o f th e p e rio d C a s h a n d c a s h e q u iv a le n t s a t t h e e n d o f t h e p e r io d
188.1 2 3 0 .0 5 ,9 7 4 .5 (6 ,5 0 1 .8 ) (1 ,3 9 6 .7 ) (2 0 .1 ) 5 .6 (1 ,5 2 0 .4 ) ( 2 .2 ) 6 .2 8 4 5 .2 8 4 9 .2
N o n - c a s h fin a n c in g a n d in v e s tin g a c t iv it ie s
In a c c o rd a n c e w ith th e C o m p a n y 's D iv id e n d R e in v e s tm e n t P lan (D R P ) 1 2 % (2 0 1 3 :1 2 % ) o f th e d iv id e n d p a id w a s re in v e s te d in th e s h a re s o f th e C o m p a n y D iv id e n d s ( N o te 6 ) Is s u a n c e o f s h a re s u n d e r th e DRP D iv id e n d s p a id o n T re a s u ry s h a re s N e t c a s h o u t f lo w
1,703.8 (206.8) (5.9) 1,491.1
1 ,5 9 7 .5 (1 9 8 .6 ) (2 .2 ) 1 ,3 9 6 .7
The above consolidated cash flow statement should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 100
Appendix: W oolw orths Lim ited A nnual Report 2014
R econciliatio n o f n e t cash p ro vid ed by o p e ra tin g a c tiv itie s to p ro fit a fte r incom e ta x e xpense: P r o f it a f t e r in c o m e t a x e x p e n s e
D e p re c ia tio n a n d a m o r tis a tio n F o re ig n e x c h a n g e lo s s e s E m p lo y e e b e n e fits e x p e n s e - s h a re b a s e d p a y m e n ts L oss o n d is p o s a l a n d w r ite o ff o f p ro p e rty , p la n t a n d e q u ip m e n t B o r ro w in g c o s ts c a p ita lis e d A m o r t is a t io n o f b o rro w in g c o s ts P ro fit fr o m sa le o f s u b s id ia rie s
2014 5 2 w ee ks $m
2013 5 3 w ee ks $m
2,458.4 996.3 21.4 50.0 2.5 (81.5) 6.5
2 ,2 6 4 .6
-
(7.9) 3.4 (50.3) (42.3) (21.2) (420.9) 524.1 34.2 3,472.7
D iv id e n d s re c e iv e d O th e r ( ln c re a s e )/d e c r e a s e in d e fe rre d ta x a s s e t D e c re a s e in c u r r e n t ta x lia b ility In c re a s e in tra d e a n d o th e r re c e iv a b le s In c re a s e in in v e n to rie s In c re a s e in tra d e p a y a b le s In c re a s e in s u n d ry p a y a b le s a n d p ro v is io n s N e t c a s h p r o v id e d b y o p e r a t in g a c t iv it ie s
693
9 6 5 .5 13.3 3 4 .9 9 .7 ( 7 7 .4 ) 6 .4 (9 .9 ) (8 .1 ) (7 .5 ) 1.8 (1 7 .2 ) (6 1 .8 ) ( 5 5 0 .3 ) 5 9 .7 9 6 .2 2 ,7 1 9 .9
A c q u is it io n o f b u s in e s s e s
D e ta ils o f th e a g g re g a te ca s h o u t f lo w re la tin g to th e a c q u is itio n o f b u s in e s s e s a n d th e a g g re g a te a s s e ts a n d lia b ilitie s o f th o s e b u s in e s s e s as a t th e d a te o f a c q u is itio n w e re as fo llo w s : - p ro p e rty , p la n t a n d e q u ip m e n t - in v e n to rie s - liq u o r a n d g a m in g lic e n c e s a n d o th e r in ta n g ib le a s s e ts - ca s h - re c e iv a b le s - d e fe rre d ta x lia b ility - a c c o u n ts p a y a b le - p ro v is io n s - o th e r lia b ilitie s N e t a s s e t s a c q u ir e d
N o n - c o n tr o llin g in te re s t s h a re o f a c q u ire d b u s in e s s e s G o o d w ill o n a c q u is itio n F a ir v a lu e o f n e t a s s e t s a c q u ir e d
16.5 35.8 67.9 0.2 17.2 (6.8) (22.4) (4.4) (2.2) 101.8 (1.6) 274.1 374.3
2 9 .8 3 0 .6 1 5 8 .5 3 .2 1 0 .9 (0 .9 ) (2 0 .0 ) ( 5 .0 ) (7 .2 ) 1 9 9 .9 (7 .2 ) 4 5 .9 2 3 8 .6
A n a ly s e d a s fo llo w s :
C o n s id e ra tio n : - ca s h p a id - c o n tin g e n t c o n s id e ra tio n T o t a l c o n s id e r a tio n
C a sh p a id Less: ca s h b a la n c e s a c q u ire d C a s h c o n s id e r a tio n p a id f o r t h e p u r c h a s e o f b u s in e s s e s , n e t o f c a s h a c q u ir e d
371.7 2.6 374.3 371.7 (0.2) 371.5
2 3 8 .6 2 3 8 .6 2 3 8 .6 ( 3 .2 ) 2 3 5 .4
Details of acquisitions are shown at Note 31.
W oolw orths Lim ited A nnual Report 2014 page 101
694
Appendix: W oolw orths Lim ited A nnual R eport 2014
Consolidated Statement of Changes in Equity Woolworths Limited For th e yea r ended 2 9 June 2 0 1 4
Balance at 1 July 2013
Issued Capital $m
4,522.7
Shares Held In Trust $m
(180.5)
H edging Reserve $m
(35.6)
Profit after income tax expense Other comprehensive income for the period (net of tax)
(64.7)
Total comprehensive income for the period (net of ta x)
-
-
Dividends paid
-
-
-
-
-
-
36.1
-
-
206.8
-
-
Issue of shares under the employee share plan and longterm incentive plans
-
46.1
-
Issue of shares to non-controlling interests
-
-
-
Equity settled share based payments expense
-
-
-
Tax provision impact of share based payments
-
-
-
Reclassification of non-controlling interests for recognition of financial liability
-
-
-
Dividends paid
-
treasury shares
Issue of shares as a result of options exercised under employee long term incentive plans Issue of shares as a result of the dividend reinvestment plan
Shares issued to/(acquired by) the W oolw orths Employee Share Trust
84.5
(84.5)
Acquisition of business
-
-
Other
-
-
Balance at 29 June 2 01 4
(6 4 .7 )
-
4,850.1
(2 18 .9)
(1 0 0 .3 )
4,336.6
(60.7)
(52.8)
For th e yea r ended 3 0 June 2 0 1 3
Balance at 25 June 2012
Profit after income tax expense
-
-
-
Other comprehensive income for the period (net of tax)
-
-
17.4
Total comprehensive income for the period (net of ta x)
-
-
17.4
Dividends paid
-
-
-
-
-
-
Issue of shares as a result of options exercised under employee long term incentive plans
188.1
-
-
Issue of shares as a result of the dividend reinvestment plan
198.6
-
-
Issue of shares under the employee share plan and longterm incentive plans
-
26.0
-
Issue of shares to non-controlling interests
-
-
-
Equity settled share based payments expense
-
-
-
Tax provision impact of share based payments
-
-
Sale of businesses
-
-
-
-
Dividends paid
-
treasury shares
Reclassification of non-controlling interests for recognition of financial liability In-specie distribution to W oolworths Limited shareholders Shares issued to/(acquired by) the W oolw orths Employee Share Trust Other Balance at 3 0 June 2013
(340.3) 145.8 (6.1) 4 ,5 2 2 .7
(145.8) (1 8 0 .5 )
-
(0.2) (3 5 .6 )
The above consolidated statement of changes in equity should be read in conjunction with the accompanying notes to the consolidated financial statements.
W oolw orths Lim ited A nnual Report 2014 page 102
Appendix: W oolw orths Lim ited A nnual Report 2014
695
F o r e ig n C u rre n c y
A sset
E q u it y
E q u it y A t t r ib u t a b le
N on-
T r a n s la t io n
R e m u n e r a tio n
R e v a lu a tio n
In s t r u m e n t
R e t a in e d
to M e m b e r s of
C o n tr o llin g
R eserve
R e se rv e
E a r n in g s
W o o lw o r t h s L im ite d
In te re sts
T o t a l E q u it y
$m
R e se rv e $m
R eserve
$m
$m
$m
$m
$m
$m
2 9 0 .6
1 6 .4
4 ,6 6 1 .1
9 ,0 2 8 .4
2 72 .1
9 ,3 0 0 .5 2 ,4 5 8 .4
(1 6 7 .3 )
(7 9 .0 )
-
-
-
2 ,4 5 1 .7
2 ,4 5 1 .7
6 .7
2 3 5 .0
-
-
(9 .7 )
8 .2
1 6 8 .8
-
1 6 8 .8
2 3 5 .0
-
-
(9 .7 )
2 ,4 5 9 .9
2 ,6 2 0 .5
6 .7
2 ,6 2 7 .2
-
-
-
-
( 1 ,7 0 3 .8 )
( 1 ,7 0 3 .8 )
-
-
-
-
5 .9
5 .9
-
5 .9
-
-
-
-
-
36.1
-
3 6.1
-
-
-
-
2 0 6 .8
-
2 0 6 .8
-
-
-
-
(4 6 .6 )
-
(0 .5 )
(3 2 .0 )
-
( 1 ,7 3 5 .8 )
(0 .5 )
-
-
-
-
-
-
1 8 3 .0
1 8 3 .0
-
5 0 .0
-
-
-
5 0 .0
-
5 0 .0
-
9.1
-
-
-
9.1
-
-
-
-
-
-
-
(1 4 1 .9 )
(1 4 1 .9 )
-
-
-
-
-
-
( 1 4 .6 )
( 1 4 .6 )
-
-
-
-
-
-
(0 .4 )
6 7 .7
3 0 3 .1
1 6 .4
( 8 8 .7 )
5 ,4 2 3 .1
1 0 ,2 5 2 .5
2 7 2 .9
1 0 ,5 2 5 .4
(111.9)
(3 4 9 .0 )
9.1
(0 .4 )
2 4 6 .2
1 6 .4
4 ,1 6 3 .4
8 ,1 8 8 .2
2 5 8 .1
8 ,4 4 6 .3
-
-
-
-
2 ,2 5 9 . 4
2 ,2 5 9 . 4
5 .2
2 ,2 6 4 . 6
1 7 3 .0
-
-
3 2 .9
8 .7
2 3 2 .0
-
2 3 2 .0
1 7 3 .0
-
-
3 2 .9
2 ,2 6 8 .1
2 ,4 9 1 .4
5 .2
2 ,4 9 6 .6
-
-
-
-
(1 ,5 9 7 .5 )
( 1 ,5 9 7 .5 )
( 2 0 .1 )
-
-
-
-
2 .2
2 .2
-
2 .2
-
-
-
-
-
188.1
-
188.1
-
-
-
-
1 9 8 .6
-
1 9 8 .6
-
-
-
11.6
-
11.6
2 3 0 .0
2 3 0 .0
-
( 1 4 .4 )
(1 ,6 1 7 .6 )
-
-
-
-
-
-
3 4 .9
-
-
-
3 4 .9
-
3 4 .9
-
2 3 .9
-
-
-
2 3 .9
-
2 3 .9
8 .7
-
-
-
-
8 .5
-
-
-
-
-
-
-
-
-
-
-
2 9 0 .6
1 6 .4
(1 7 6 .1 )
1 .0
(1 6 7 .3 )
( 7 9 .0 )
4,66 1.1
( 5 1 6 .4 )
(5 .1 )
9 ,0 2 8 .4
(1 9 7 .3 ) -
(3 .8 )
272.1
8 .5 (1 9 7 .3 ) ( 5 1 6 .4 )
(8 .9 )
9 , 3 0 0 .5
W oolw orths Lim ited A nnual Report 2014 page 103
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IES W o o lw o r t h s L im ite d (th e " C o m p a n y " ) is a c o m p a n y d o m ic ile d in A u s tra lia . T h e F in a n c ia l R e p o rt o f th e C o m p a n y fo r th e y e a r w a s fo r th e 5 2 w e e k p e rio d e n d e d 2 9 J u n e 2 0 1 4 a n d c o m p ris e s th e C o m p a n y a n d its s u b s id ia rie s (to g e th e r re fe rre d to as th e " c o n s o lid a te d e n t it y " o r " G r o u p " ) . T h e c o m p a ra tiv e y e a r w a s fo r th e 5 3 w e e k p e rio d e n d e d 3 0 J u n e 2 0 1 3 . T h e F in a n c ia l R e p o rt w a s a u th o r is e d fo r is s u e b y th e D ir e c to rs o n 2 2 S e p te m b e r 2 0 1 4 .
( A ) S ta te m e n t o f c o m pliance T h is F in a n c ia l R e p o rt is a g e n e ra l p u rp o s e fin a n c ia l r e p o r t w h ic h h a s b e e n p re p a re d in a c c o rd a n c e w it h th e C o rp o ra tio n s A c t 2 0 0 1 , A u s t r a lia n A c c o u n t in g S ta n d a rd s a n d I n t e r p r e t a t io n s , a n d c o m p lie s w it h o t h e r r e q u ir e m e n t s o f th e la w . T h e F in a n c ia l R e p o rt re p re s e n ts th e c o n s o lid a te d fin a n c ia l s ta te m e n ts o f th e G ro u p . For th e p u rp o s e s o f p re p a rin g th e c o n s o lid a te d fin a n c ia l s ta te m e n ts , th e C o m p a n y is a f o r - p r o f it e n tity . A u s tra lia n A c c o u n tin g S ta n d a rd s in c lu d e A u s tra lia n e q u iv a le n ts to In te rn a tio n a l F in a n c ia l R e p o r tin g S ta n d a rd s ('A -IF R S '). C o m p lia n c e w it h A -IF R S e n s u re s th a t th e fin a n c ia l s ta te m e n ts a n d n o te s o f th e c o n s o lid a te d e n t it y c o m p ly w it h In te rn a tio n a l F in a n c ia l R e p o rtin g S ta n d a rd s ('IF R S ').
(B ) Basis o f p re p a ra tio n T h e F in a n c ia l R e p o rt is p re s e n te d in A u s tra lia n d o lla rs . T h e F in a n c ia l R e p o rt h a s b e e n p re p a re d o n th e h is to ric a l c o s t b a s is e x c e p t fo r d e riv a tiv e fin a n c ia l in s tr u m e n ts , fin a n c ia l a s s e ts a t fa ir v a lu e th ro u g h o th e r c o m p re h e n s iv e in c o m e a n d o th e r fin a n c ia l lia b ilitie s th a t a re m e a s u re d a t re v a lu e d a m o u n ts o r fa ir v a lu e s , as e x p la in e d in th e a c c o u n tin g p o lic ie s b e lo w . T h e a c c o u n tin g p o lic ie s s e t o u t b e lo w h a ve b e e n a p p lie d c o n s is te n tly to a ll p e rio d s p re s e n te d in th e s e fin a n c ia l s ta te m e n ts , e x c e p t fo r th e im p a c t o f th e s ta n d a rd s a n d in te r p r e ta tio n s d e s c rib e d b e lo w . C e rta in c o m p a ra tiv e a m o u n ts h a v e b e e n re c la s s ifie d to c o n fo rm w it h th e c u r r e n t y e a r's p re s e n ta tio n to b e tte r re fle c t th e e c o n o m ic n a tu re o f th e a s s e ts a n d lia b ilitie s o f th e G ro u p . T h e C o m p a n y is o f a k in d re fe rre d to in A S IC C la s s O r d e r 9 8 / 1 0 0 , d a te d 10 J u ly 1 9 9 8 a n d in a c c o rd a n c e w it h th e C la s s O rd e r, a m o u n ts in th e F in a n c ia l R e p o rt h a ve b e e n ro u n d e d o f f to th e n e a re s t te n th o f a m illio n d o lla rs , u n le s s o th e r w is e s ta te d .
New and amended standards adopted by the Group In th e c u r r e n t p e rio d , th e G ro u p h a s a d o p te d a ll o f th e n e w a n d re v is e d S ta n d a rd s a n d In te r p r e ta tio n s is s u e d b y th e A u s tra lia n A c c o u n tin g S ta n d a rd s B o a rd (th e 'A A S B ') th a t a re re le v a n t to its o p e ra tio n s a n d e ffe c tiv e f o r a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J u ly 2 0 1 3 . T h e fo llo w in g a m e n d m e n ts to A u s tra lia n A c c o u n tin g S ta n d a rd s h a ve b e e n a d o p te d d u r in g th e p e rio d b u t d o n o t h a ve a m a te ria l im p a c t o n th e G ro u p . W h e r e th e re h a s b e e n a s ig n ific a n t c h a n g e in a c c o u n tin g p o lic y , a n e x p la n a tio n o f th e c h a n g e h a s b e e n p ro v id e d as fo llo w s :
■ A A S B 70 'C o n s o lid a te d F in a n c ia l S ta te m e n ts '; A A S B 10 c h a n g e s th e d e fin itio n o f c o n tro l s u c h t h a t an in v e s to r c o n tro ls an in v e s te e w h e n a ) it h a s p o w e r o v e r an in v e s te e , b) it is e x p o s e d , o r h a s rig h ts to v a ria b le re tu rn s fr o m its in v o lv e m e n t w it h th e in v e s te e , a n d c ) h a s th e a b ility to u se its p o w e r to a ffe c t its re tu rn s . A ll th re e c r ite ria m u s t be m e t fo r an in v e s to r to h a ve c o n tr o l o v e r an in v e s te e . P re v io u s ly , c o n tro l w a s d e fin e d as th e p o w e r to g o v e rn th e fin a n c ia l a n d o p e ra tin g p o lic ie s o f an e n t it y s o as to o b ta in b e n e fit fr o m its a c tiv itie s . ■ A A S B 77 'J o in t A rr a n g e m e n ts '; A A S B 11 u s e s th e p rin c ip le o f c o n tro l in A A S B 10 to d e fin e jo in t c o n tro l, a n d th e re fo r e th e d e te r m in a tio n o f w h e th e r jo in t c o n tro l e x is ts h a s c h a n g e d . T h e G ro u p is re q u ire d to c la s s ify its in te re s ts in jo in t a r ra n g e m e n ts as e ith e r jo in t o p e ra tio n s o r jo in t v e n tu re s in a c c o rd a n c e w ith th e s tr u c tu r e o f th e a rra n g e m e n t. J o in t o p e ra tio n s g iv e th e p a rtie s a r ig h t to th e u n d e r ly in g a s s e ts a n d o b lig a tio n s o f th e a rra n g e m e n t a n d a re a c c o u n te d f o r b y re c o g n is in g th e G ro u p 's s h a re o f th o s e a s s e ts a n d o b lig a tio n s . J o in t v e n tu re s g iv e th e p a rtie s a rig h t to th e n e t a s s e ts o f th e a rra n g e m e n t a n d a re a c c o u n te d fo r u s in g th e e q u ity m e th o d . ■ A A S B 72 'D is c lo s u re o f In te re s ts in O th e r E n titie s '; A A S B 12 is a n e w d is c lo s u re s ta n d a rd a n d is a p p lic a b le to e n titie s th a t h a v e in te re s ts in s u b s id ia rie s , jo in t a rra n g e m e n ts , a s s o c ia te s a n d /o r u n c o n s o lid a te d s tr u c tu r e d e n titie s . In g e n e ra l, th e a p p lic a tio n o f A A S B 12 h a s re s u lte d in m o re e x te n s iv e d is c lo s u re s in th e c o n s o lid a te d fin a n c ia l s ta te m e n ts ( r e fe r N o te 2 9 fo r d e ta ils ). ■ A A S B 13 ‘F a ir V a lu e M e a s u r e m e n t' a n d A A S B 2 0 1 1 -8 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s a ris in g fr o m A A S B 13';
A A S B 13 e s ta b lis h e s a s in g le s o u rc e o f g u id a n c e fo r d e te r m in in g th e fa ir v a lu e o f a s s e ts a n d lia b ilitie s . It d o e s n o t c h a n g e w h e n fa ir v a lu e is re q u ire d to be u se d , b u t ra th e r p ro v id e s g u id a n c e o n h o w to d e te r m in e fa ir v a lu e w h e n re q u ire d o r p e rm itte d . T h e s c o p e o f A A S B 13 is b ro a d a n d a p p lie s to b o th fin a n c ia l in s tr u m e n t ite m s a n d n o n -fin a n c ia l in s tr u m e n t ite m s w h e re o th e r A A S B s re q u ire o r p e r m it fa ir v a lu e m e a s u re m e n t (e x c lu d in g s h a re b a s e d p a y m e n ts u n d e r A A S B 2 'S h a re -b a s e d P a y m e n t' a n d le a s in g tr a n s a c tio n s w ith in th e s c o p e o f A A S B 117 ‘L e a s e s ’'). A A S B 13 d e fin e s fa ir v a lu e as th e p ric e t h a t w o u ld be re c e iv e d to s e ll an a s s e t o r p a id to tr a n s fe r a lia b ility in an o r d e rly tr a n s a c tio n in th e p rin c ip a l m a r k e t a t th e m e a s u re m e n t d a te u n d e r c u r r e n t m a r k e t c o n d itio n s . F a ir v a lu e is a n 'e x it p ric e ’ re g a rd le s s o f w h e th e r t h a t p ric e is d ir e c tly o b s e rv a b le o r e s tim a te d u s in g a n o th e r v a lu a tio n te c h n iq u e . T h e im p a c t o f a d o p tin g th is s ta n d a rd h a s re s u lte d in m o re e x te n s iv e d is c lo s u re s in th e c o n s o lid a te d fin a n c ia l s ta te m e n ts . A A S B 13 h a s b e e n a p p lie d p ro s p e c tiv e ly .
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Appendix: W oolw orths Lim ited A nnual Report 2014
A A S B 119 'E m p lo y e e B e n e fits (2 0 1 1 )' a n d A A S B 2 0 1 1 -1 0 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s a ris in g
•
A A S B C F 2 0 1 3 -1 'A m e n d m e n ts to th e A u s tr a lia n C o n c e p tu a l F ra m e w o r k '; a n d
fr o m A A S B 119 (2 0 1 1 )';
•
A A S B 2 0 1 3 - 9 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g
T h e re v is io n s to A A S B 119 h a ve re s u lte d in a m e n d m e n ts to th e G r o u p ’s a c c o u n tin g p o lic y fo r d e fin e d b e n e fit p la n s . T h e in te re s t c o s t a n d e x p e c te d re tu rn o n p la n a s s e ts u s e d in th e p re v io u s v e rs io n o f A A S B 119 a re re p la c e d w it h a 'n e t in te r e s t' a m o u n t, w h ic h is c a lc u la te d b y a p p ly in g th e d is c o u n t ra te to th e n e t d e fin e d b e n e fit a s s e t o r lia b ility . T h e im p a c t o f th is c h a n g e is im m a te r ia l to th e G ro u p a n d th e re fo r e th e re is n o r e s ta te m e n t o f c o m p a ra tiv e in fo rm a tio n . A A S B 2 0 1 1 -4 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s to R e m o v e In d iv id u a l K e y M a n a g e m e n t P e rs o n n e l D is c lo s u re R e q u ire m e n ts ';
T h is s ta n d a rd re m o v e s th e in d iv id u a l k e y m a n a g e m e n t p e rs o n n e l d is c lo s u re re q u ire m e n ts in A A S B 124 ‘R e la te d P a r ty D is c lo s u re s '. A s a re s u lt th e G ro u p o n ly d is c lo s e s th e ke y m a n a g e m e n t p e rs o n n e l c o m p e n s a tio n in to ta l a n d fo r e a c h o f th e c a te g o rie s re q u ire d in A A S B 124. In th e c u r r e n t y e a r th e in d iv id u a l k e y m a n a g e m e n t p e rs o n n e l d is c lo s u re p re v io u s ly re q u ire d b y A A S B 1 2 4 ( N o te 2 4 in th e 3 0 Ju n e 2 0 1 3 fin a n c ia l s ta te m e n ts ) is n o w d is c lo s e d in th e R e m u n e ra tio n R e p o rt d u e to an a m e n d m e n t to C o rp o ra tio n s R e g u la tio n s 2 0 0 1 is s u e d in J u n e 2 0 1 3 . A A S B 2 0 1 1 -9 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s P re s e n ta tio n o f Ite m s o f O th e r C o m p re h e n s iv e In c o m e ';
A s a re s u lt o f a m e n d m e n ts m a d e to A A S B 101 'P re s e n ta tio n o f F in a n c ia l S ta te m e n ts ', th e G ro u p h a s m o d ifie d th e p re s e n ta tio n o f ite m s o f o th e r c o m p re h e n s iv e in c o m e in its c o n s o lid a te d s ta te m e n t o f c o m p re h e n s iv e in c o m e , to p re s e n t s e p a ra te ly ite m s t h a t m a y b e re c la s s ifie d to p r o fit o r lo s s fro m th o s e th a t w o u ld n o t be. C o m p a ra tiv e in fo r m a tio n h a s b e e n re -p re s e n te d a c c o rd in g ly .
S ta n d a rd s - C o n c e p tu a l F ra m e w o rk , M a t e r ia lit y a n d F in a n c ia l In s tr u m e n ts ' ( P a r t A ).
In p re v io u s fin a n c ia l p e rio d s , th e G ro u p e a rly a d o p te d A A S B 9 ‘F in a n c ia l In s tr u m e n ts (D e c e m b e r 2 0 0 9 ) ' in c lu d in g A A S B 2 0 0 9 -1 1 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s a ris in g fr o m A A S B
9 ', A A S B 9 ‘F in a n c ia l In s tr u m e n ts ( D e c e m b e r 2 0 1 0 ) ' a n d A A S B 2 0 1 0 - 7 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s a ris in g fr o m A A S B 9 ( D e c e m b e r 2 0 0 9 ) '. A A S B 9 p ro v id e s an o p tio n to d e s ig n a te a n d m e a s u re an in v e s tm e n t in e q u ity in s tr u m e n ts a t fa ir v a lu e w it h c h a n g e s re c o g n is e d in o th e r c o m p re h e n s iv e in c o m e a n d o n ly d iv id e n d s b e in g re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t. T h e G ro u p e le c te d to a p p ly th is o p tio n . T h e a p p lic a tio n o f th is s ta n d a rd a ffe c te d a c c o u n tin g fo r th e in v e s tm e n ts in T h e W a re h o u s e G ro u p L im ite d , A u s tra lia n L e is u re a n d E n te rta in m e n t P ro p e r ty M a n a g e m e n t L im ite d (th e "A L E P ro p e r ty G r o u p " ) a n d S h o p p in g C e n tre s A u s tra la s ia P ro p e r ty G ro u p (th e "S C A P ro p e r ty G r o u p " ), a ll o f w h ic h h a ve b e e n d e s ig n a te d as fa ir v a lu e th ro u g h o th e r c o m p re h e n s iv e in c o m e . T h e s e c h a n g e s h a ve b e e n a d o p te d r e tro s p e c tiv e ly w ith n o im p a c t o n re ta in e d e a rn in g s in th e c u rr e n t o r p re v io u s fin a n c ia l y e a rs .
Issued standards and interpretations not early adopted T h e fo llo w in g s ta n d a rd s a n d A m e n d m e n ts to S ta n d a rd s w e re a v a ila b le fo r e a rly a d o p tio n a n d w e re a p p lic a b le to th e c o n s o lid a te d e n tity b u t h a ve n o t b e e n a p p lie d in th e s e fin a n c ia l s ta te m e n ts : •
T h e G ro u p h a s a p p lie d th e a m e n d m e n ts to A A S B 7 'D is c lo s u re s - O ffs e ttin g F in a n c ia l A s s e ts a n d F in a n c ia l L ia b ilitie s ' f o r th e f ir s t t im e in th e c u r r e n t ye a r. T h e a m e n d m e n ts to A A S B 7 re q u ire e n titie s to d is c lo s e in fo r m a tio n a b o u t rig h ts o f o ffs e t a n d re la te d a rra n g e m e n ts fo r fin a n c ia l in s tr u m e n ts u n d e r an e n fo rc e a b le m a s te r n e ttin g a g re e m e n t o r s im ila r a rra n g e m e n t.
S ta n d a r d s - C o n c e p tu a l F ra m e w o rk , M a t e r ia lit y a n d F in a n c ia l In s tru m e n ts ', P a rt C - F in a n c ia l In s tru m e n ts . T h is s ta n d a rd is
n o t e x p e c te d to h a v e a s ig n ific a n t im p a c t o n a m o u n ts re p o rte d in th e c o n s o lid a te d fin a n c ia l s ta te m e n ts b u t w ill re s u lt in m o re e x te n s iv e d is c lo s u re s . A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 8 ; •
•
p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 4 ; •
a ris in g fr o m th e A n n u a l Im p r o v e m e n ts 2 0 0 9 - 2 0 1 1 C y c le ’;
A A S B 2 0 1 2 -1 0 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s T ra n s itio n G u id a n c e a n d O th e r A m e n d m e n ts ';
A A S B 2 0 1 3 - 4 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - N o v a tio n o f D e riv a tiv e s a n d C o n tin u a tio n o f H e d g e A c c o u n tin g '.
A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 4 ; •
A A S B 2 0 1 3 - 5 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - In v e s tm e n t E n titie s '. A p p lie s to a n n u a l re p o r tin g p e rio d s
•
A A S B 2 0 1 4 -1 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s
a ris in g fr o m th e C o n s o lid a tio n a n d J o in t A r r a n g e m e n ts s ta n d a rd s ';
A A S B 2 0 1 2 - 9 'A m e n d m e n t to A A S B 1 0 4 8 a ris in g fr o m th e W it h d r a w a l o f A u s tr a lia n In te r p r e ta tio n 1 0 3 9 ';
A A S B 2 0 1 3 - 3 'A m e n d m e n ts to A A S B 136 - R e c o v e ra b le A m o u n t D is c lo s u re s f o r N o n - F in a n c ia l A s s e ts '. A p p lie s to a n n u a l r e p o r tin g
A A S B 128 ‘In v e s tm e n ts in A s s o c ia te s a n d J o in t V e n tu re s (2 0 1 1 )';
A A S B 2 0 1 2 - 5 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s
A A S B 2 0 1 2 - 3 'A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - O f fs e ttin g F in a n c ia l A s s e ts a n d F in a n c ia l L ia b ilitie s '. A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 4 ;
A A S B 127 'S e p a ra te F in a n c ia l S ta te m e n ts (2 0 1 1 )';
A A S B 2 0 1 1 -7 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s
A A S B 9 ‘F in a n c ia l In s tr u m e n ts (D e c e m b e r 2 0 1 3 ) ' a n d A A S B 2 0 1 3 - 9 ‘A m e n d m e n t to A u s tr a lia n A c c o u n tin g
A A S B 2 0 1 2 - 2 ‘A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - D is c lo s u re s - O f fs e ttin g F in a n c ia l A s s e ts a n d F in a n c ia l L ia b ilitie s ( A m e n d m e n ts to A A S B 7 )';
697
b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 4 ; ( P a rts A to E )'. P a rts A , B, a n d C a p p ly to a n n u a l re p o r tin g
p e rio d s b e g in n in g o n o r a fte r 1 J u ly 2 0 1 4 . P a rt D a p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 6 . P a rt E a p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 5 ;
A A S B 1 0 4 8 ‘In te r p r e ta tio n o f S ta n d a rd s (2 0 1 3 )';
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IE S C O N T IN U E D (B ) Basis o f p re p a ra tio n co ntinued
Issued standards and interpretations not early adopted continued •
A A S B 2 0 1 4 - 3 A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - A c c o u n tin g f o r A c q u is itio n s o f In te re s ts in J o in t O p e ra tio n s '.
A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 6 ; •
Fair v a lu e m e a s u re m e n ts a n d v a lu a tio n p ro c e s s e s In lin e w ith its lo n g te r m s tra te g y , d u rin g F Y 1 4 W o o lw o r t h s h a s c o n tin u e d to in v e s t in its n e w H o m e Im p r o v e m e n t J o in t V e n tu re ( 'H y d r o x ') w h ic h c o n s is ts o f H o m e T im b e r a n d H a rd w a re ( 'H T H ') a n d M a s te rs H o m e Im p r o v e m e n t ( 'M a s te r s ') , w h ic h re m a in s in its s t a r t u p p h a s e . T h e c a rr y in g a m o u n t o f n e t a s s e ts in th e to ta l H y d ro x b u s in e s s a t 2 9 Ju n e 2 0 1 4 is $ 2 .3 b illio n .
A A S B 2 0 1 4 - 4 A m e n d m e n ts to A u s tr a lia n A c c o u n tin g S ta n d a rd s - C la r ific a tio n o f A c c e p ta b le M e th o d s o f D e p re c ia tio n a n d A m o r tis a tio n '. A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g
o n o r a fte r 1 J a n u a ry 2 0 1 6 ; •
I N T 21 'L e vie s '. A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 4 ; a n d
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A A S B 14 ‘R e g u la to ry D e fe r r a l A c c o u n ts '. A p p lie s to a n n u a l
re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J a n u a ry 2 0 1 6 . A t th e d a te o f a u th o r is a tio n o f th e fin a n c ia l s ta te m e n ts , th e fo llo w in g IA S B S ta n d a rd s a n d IFR IC In te r p r e ta tio n s w e re a ls o in is s u e b u t n o t y e t e ffe c tiv e , a lth o u g h A u s tra lia n e q u iv a le n t S ta n d a rd s a n d In te rp re ta tio n s h a ve n o t y e t b e e n is s u e d : •
•
IFRS 15 'R e v e n u e fr o m C o n tr a c ts w ith C u s to m e rs '. A p p lie s to a n n u a l re p o r tin g p e rio d s b e g in n in g o n o r a fte r 1 J u ly 2017.
Critical accounting estimates T h e p re p a ra tio n o f a F in a n c ia l R e p o rt in c o n fo r m ity w ith A u s tra lia n A c c o u n tin g S ta n d a rd s re q u ire s m a n a g e m e n t to m a k e ju d g m e n ts , e s tim a te s a n d a s s u m p tio n s th a t e ffe c t th e a p p lic a tio n o f p o lic ie s a n d r e p o rte d a m o u n ts o f a s s e ts a n d lia b ilitie s , in c o m e a n d e x p e n s e s . T h e e s tim a te s a n d a s s o c ia te d a s s u m p tio n s a re b a se d o n h is to ric a l e x p e rie n c e a n d v a rio u s o th e r fa c to r s th a t a re b e lie v e d to b e re a s o n a b le u n d e r th e c irc u m s ta n c e s , th e re s u lts o f w h ic h fo r m th e b a s is o f m a k in g th e ju d g m e n ts a b o u t c a rr y in g v a lu e s o f a s s e ts a n d lia b ilitie s th a t a re n o t re a d ily a p p a r e n t fr o m o th e r s o u rc e s . A c tu a l re s u lts m a y d if f e r fr o m th e s e e s tim a te s . M a n a g e m e n t, to g e th e r w ith th e A u d it, R isk M a n a g e m e n t a n d C o m p lia n c e C o m m itte e , d e te rm in e s th e d e v e lo p m e n t, s e le c tio n a n d d is c lo s u re o f th e c o n s o lid a te d e n tity 's c ritic a l a c c o u n tin g p o lic ie s a n d e s tim a te s a n d th e a p p lic a tio n o f th e s e p o lic ie s a n d e s tim a te s . T h e e s tim a te s a n d ju d g m e n ts th a t h a ve a ris k o f c a u s in g a s ig n ific a n t a d ju s tm e n t to th e c a rr y in g a m o u n ts o f a s s e ts a n d lia b ilitie s w ith in th e n e x t fin a n c ia l y e a r a re in c lu d e d in th e fo llo w in g n o te s o r d e s c rib e d as fo llo w s :
T h e re c o v e ra b le a m o u n t o f th e b u s in e s s h a s b e e n d e te r m in e d u s in g a d is c o u n te d ca s h f lo w m o d e l w h ic h is u n d e r p in n e d b y a s s u m p tio n s a n d e s tim a te s s u c h as th e s to re ro ll o u t p la n , s to re g r o w th a n d th e t im in g o f b u s in e s s m a tu rity . C a sh flo w s a re d is c o u n te d to p re s e n t v a lu e u s in g a w e ig h te d a v e ra g e c o s t o f c a p ita l. G iv e n th e s t a r t u p n a tu re o f th e b u s in e s s , th e d is c o u n te d ca s h f lo w m o d e l is s e n s itiv e to c h a n g e s in th e te r m in a l v a lu e a n d w e ig h te d a v e ra g e c o s t o f c a p ita l as w e ll as th e a s s u m p tio n s d is c u s s e d a b o v e . A c h a n g e in a s s u m p tio n s m a y c a u s e th e c a rr y in g v a lu e o f n e t a s s e ts to e x c e e d t h e ir re c o v e ra b le a m o u n t. W o o lw o r t h s re m a in s c o m m itte d to th e jo in t v e n tu re a n d it is e x p e c te d to b e c o m e a m a te ria l p r o fit c o n t r ib u t o r fo r th e W o o lw o r t h s G ro u p . T h e e s tim a te s a n d u n d e rly in g a s s u m p tio n s a re re v ie w e d o n an o n g o in g b a sis. R e visio n s to a c c o u n tin g e s tim a te s a n d u n d e rly in g a s s u m p tio n s a re re c o g n is e d in th e p e rio d in w h ic h th e e s tim a te is re v is e d if th e re v is io n a ffe c ts o n ly th a t p e rio d ; o r in th e p e rio d a n d fu tu re p e rio d s if th e re v is io n a ffe c ts b o th c u rr e n t a n d fu tu re p e rio d s .
(C ) Basis fo r consolidatio n (i) Subsidiaries T h e s e c o n s o lid a te d fin a n c ia l s ta te m e n ts in c o rp o ra te th e a s s e ts a n d lia b ilitie s o f a ll s u b s id ia rie s o f th e C o m p a n y as a t 2 9 J u n e 2 0 1 4 a n d th e re s u lts o f a ll s u b s id ia rie s fo r th e p e rio d th e n e n d e d . S u b s id ia rie s a re a ll e n titie s o v e r w h ic h th e G ro u p h a s c o n tro l. T h e G ro u p c o n tro ls a n e n t it y w h e n th e G ro u p is e x p o s e d to , o r h a s rig h ts to , v a ria b le re tu rn s fr o m its in v o lv e m e n t w ith th e e n t it y a n d h a s th e a b ility to a ffe c t th o s e re tu rn s th ro u g h its p o w e r to d ir e c t th e a c tiv itie s o f th e e n tity . S u b s id ia rie s a re fu lly c o n s o lid a te d fr o m th e d a te o n w h ic h c o n tro l is tr a n s fe rre d to th e G ro u p . T h e y a re d e c o n s o lid a te d fr o m th e d a te th a t c o n tro l ce a s e s . N o n - c o n tr o llin g in te re s ts in th e e q u ity a n d re s u lts o f s u b s id ia rie s a re s h o w n as a s e p a ra te ite m in th e c o n s o lid a te d F in a n c ia l R e p o rt.
(ii) Transactions elim in ated on consolidation
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N o te 1 (G ) a n d 1(1) - E s tim a tio n o f u s e fu l liv e s o f a s s e ts
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N o te 1 (M ), 11 a n d 12 - Im p a ir m e n t o f ta n g ib le a n d in ta n g ib le a s s e ts
In tra -g ro u p b a la n ce s , tra n s a c tio n s a n d a n y u n re a lis e d g a in s and lo sse s o r in c o m e a n d e x p e n s e s a ris in g fro m in tra - g r o u p tra n s a c tio n s , a re e lim in a te d in p re p a rin g th e c o n s o lid a te d F in a n c ia l R e p o rt.
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N o te 1(Q ) a n d 17 - S e lf-in s u re d ris k s p ro v is io n s
(D ) Foreign cu rrency
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N o te 1 (R ) a n d 2 7 - P u t o p tio n s o v e r n o n - c o n tr o llin g in te re s ts
•
N o te 1(P ) a n d 2 4 - E m p lo y e e b e n e fits p ro v is io n s , s h a re b a s e d p a y m e n ts a n d d e fin e d b e n e fits o b lig a tio n s
T ra n s a c tio n s in fo re ig n c u rr e n c ie s a re tra n s la te d a t th e fo re ig n e x c h a n g e ra te r u lin g a t th e d a te o f th e tra n s a c tio n . A t th e e n d o f e a c h re p o r tin g p e rio d , m o n e ta r y a s s e ts a n d lia b ilitie s d e n o m in a te d in fo re ig n c u rr e n c ie s a re tra n s la te d to A u s tra lia n d o lla rs a t th e fo re ig n e x c h a n g e ra te p re v a ilin g a t th a t d a te . N o n - m o n e ta r y ite m s t h a t a re m e a s u re d in te rm s o f h is to ric a l c o s t in a fo re ig n c u rr e n c y a re n o t re tra n s la te d .
W oolw orths Lim ited A nnual Report 2014 page 106
Appendix: W oolw orths Lim ited A nnual Report 2014
E x c h a n g e d iffe re n c e s a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t in th e p e rio d in w h ic h th e y a ris e e x c e p t th a t: ■ e x c h a n g e d iffe re n c e s o n tr a n s a c tio n s e n te re d in to in o rd e r to h e d g e c e rta in fo re ig n c u rr e n c y ris k s a re r e p o rte d in itia lly in th e h e d g in g re s e rv e to th e e x te n t th e h e d g e is e ffe c tiv e ( r e fe r N o te 1 (F )); a n d ■ e x c h a n g e d iffe re n c e s o n m o n e ta r y ite m s re c e iv a b le fr o m o r p a y a b le to a fo re ig n o p e ra tio n f o r w h ic h s e ttle m e n t is n e ith e r p la n n e d n o r lik e ly to o c c u r, a n d w h ic h fo r m p a r t o f th e n e t in v e s tm e n t in a fo re ig n o p e ra tio n , a re re c o g n is e d in th e fo re ig n c u rr e n c y tra n s la tio n re s e rv e a n d re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t o n d is p o s a l o f th e n e t in v e s tm e n t.
Financial statements of foreign operations T h e a s s e ts a n d lia b ilitie s o f fo re ig n o p e ra tio n s , in c lu d in g g o o d w ill a n d fa ir v a lu e a d ju s tm e n ts a ris in g o n c o n s o lid a tio n , a re tra n s la te d to A u s tra lia n d o lla rs a t fo re ig n e x c h a n g e ra te s ru lin g a t th e b a la n c e s h e e t d a te . R e ve n u e a n d e x p e n s e ite m s a re tra n s la te d a t th e a ve ra g e e x c h a n g e ra te s fo r th e p e rio d . E xch a n g e d iffe re n c e s a ris in g o n tra n s la tio n o f fo re ig n o p e ra tio n s , if any, a re re c o g n is e d in th e fo re ig n c u rre n c y tra n s la tio n re s e rv e a n d re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t o n d is p o s a l o f th e fo re ig n o p e ra tio n .
(E ) D e riv a tiv e fin a n cia l in s tru m e n ts T h e c o n s o lid a te d e n t it y u s e s d e riv a tiv e fin a n c ia l in s tru m e n ts to h e d g e its e x p o s u re to fo re ig n e x c h a n g e a n d in te re s t ra te ris k s a ris in g fr o m o p e ra tio n a l, fin a n c in g a n d in v e s tm e n t a c tiv itie s . In a c c o rd a n c e w ith its tr e a s u r y p o lic y , th e c o n s o lid a te d e n t it y d o e s n o t h o ld o r is s u e d e riv a tiv e fin a n c ia l in s tr u m e n ts fo r tra d in g p u rp o s e s . H o w e v e r, d e riv a tiv e s th a t d o n o t q u a lify f o r h e d g e a c c o u n tin g a re a c c o u n te d f o r as tra d in g in s tru m e n ts . D e riv a tiv e fin a n c ia l in s tr u m e n ts a re re c o g n is e d in itia lly a t fa ir v a lu e o n th e d a te a d e riv a tiv e c o n tr a c t is e n te re d in to . S u b s e q u e n t to in itia l re c o g n itio n , d e riv a tiv e fin a n c ia l in s tr u m e n ts a re s ta te d a t fa ir v a lu e . T h e g a in o r lo s s o n r e m e a s u re m e n t to fa ir v a lu e is re c o g n is e d im m e d ia te ly in th e c o n s o lid a te d in c o m e s ta te m e n t u n le s s th e d e riv a tiv e s q u a lify fo r h e d g e a c c o u n tin g w h e re b y th e t im in g o f th e r e c o g n itio n o f a n y re s u lta n t g a in o r lo s s d e p e n d s on th e n a tu re o f th e h e d g e r e la tio n s h ip ( r e fe r N o te 1 (F )).
(F ) H ed g in g
(i) Cash flow hedge A ca s h flo w h e d g e is a h e d g e o f an e x p o s u re to u n c e rta in fu tu re ca s h flo w s . A ca s h flo w h e d g e re s u lts in th e u n c e rta in fu tu r e ca s h flo w s b e in g h e d g e d b a c k in to fix e d a m o u n ts . W o o lw o r t h s ' ca s h f lo w h e d g e s in c lu d e : ■ In te re s t ra te s w a p c o n tr a c ts th a t c o n v e r t f lo a tin g in te re s t ra te p a y m e n ts o n b o rro w in g s in to fix e d a m o u n ts ; ■ C ro s s c u rr e n c y in te re s t ra te s w a p s t h a t c o n v e r t fo re ig n c u rr e n c y d e n o m in a te d p rin c ip a l a n d in te re s t ra te p a y m e n ts o n o ffs h o re lo a n s in to fix e d A u s tra lia n d o lla r a m o u n ts ; a n d ■ F o rw a rd fo re ig n e x c h a n g e c o n tr a c ts th a t c o n v e r t fo re ig n c u rr e n c y d e n o m in a te d p a y m e n ts to o ffs h o re s u p p lie rs a n d in c o m e o f o ffs h o re s u b s id ia rie s in to A u s tra lia n d o lla r a m o u n ts .
699
W h e r e a d e riv a tiv e fin a n c ia l in s tr u m e n t is d e s ig n a te d as a h e d g e o f th e v a r ia b ility in ca s h flo w s o f a re c o g n is e d a s s e t o r lia b ility , o r a h ig h ly p ro b a b le fo re c a s t tra n s a c tio n , th e e ffe c tiv e p a r t o f a n y g a in o r lo s s o n th e d e riv a tiv e fin a n c ia l in s tr u m e n t is re c o g n is e d in o th e r c o m p re h e n s iv e in c o m e a n d a c c u m u la te d as a s e p a ra te re s e rv e w ith in e q u ity . W h e n th e fo re c a s t tra n s a c tio n s u b s e q u e n tly re s u lts in th e re c o g n itio n o f a n o n -fin a n c ia l a ss e t o r n o n -fin a n c ia l lia b ility , th e a s s o cia te d c u m u la tiv e g a in o r lo ss is re m o v e d fro m e q u ity a n d in c lu d e d in th e in itia l c o s t o r o th e r c a rry in g a m o u n t o f th e n o n -fin a n c ia l a ss e t o r lia b ility . If a h e d g e o f a fo re c a s t tra n s a c tio n s u b s e q u e n tly re s u lts in th e re c o g n itio n o f a fin a n c ia l a ss e t o r a fin a n c ia l lia b ility , th e n th e a s s o c ia te d g a in s a n d lo sse s th a t w e re a c c u m u la te d in e q u ity are re c la s s ifie d in to p ro fit o r loss in th e s a m e p e rio d o r p e rio d s d u rin g w h ic h th e a ss e t a c q u ire d o r lia b ility a s s u m e d a ffe c ts p ro fit o r loss (i.e. w h e n in te re s t in c o m e o r e x p e n s e is re c o g n is e d ). T h e in e ffe c tiv e p a r t o f a n y d e riv a tiv e d e s ig n a te d as a h e d g e is re c o g n is e d im m e d ia te ly in th e c o n s o lid a te d in c o m e s ta te m e n t. W h e n a h e d g in g in s tr u m e n t e x p ire s o r is s o ld , te r m in a te d o r e x e rc is e d , o r th e e n t it y re v o k e s d e s ig n a tio n o f th e h e d g e r e la tio n s h ip b u t th e h e d g e d fo re c a s t tra n s a c tio n s till is e x p e c te d to o c c u r, th e c u m u la tiv e g a in o r lo s s a t t h a t p o in t re m a in s in e q u ity a n d is re c o g n is e d in a c c o rd a n c e w it h th e a b o v e p o lic y w h e n th e tra n s a c tio n o c c u rs . If th e h e d g e d tra n s a c tio n is no lo n g e r e x p e c te d to ta k e p la c e , th e n th e c u m u la tiv e u n re a lis e d g a in o r lo s s a c c u m u la te d in e q u ity is re c la s s ifie d im m e d ia te ly in to th e c o n s o lid a te d in c o m e s ta te m e n t. G a in s o r lo s s e s re m o v e d fr o m e q u ity d u rin g th e p e rio d in re la tio n to in te re s t ra te h e d g e in s tr u m e n ts a re re c o g n is e d w ith in " n e t fin a n c in g c o s ts " in th e c o n s o lid a te d in c o m e s ta te m e n t.
(ii) Fair value hedge A fa ir v a lu e h e d g e is a h e d g e o f th e e x p o s u re to c h a n g e s in fa ir v a lu e (i.e . " m a r k - t o - m a r k e t " ) a ris in g fr o m a re c o g n is e d b a la n c e s h e e t a s s e t o r lia b ility . A fa ir v a lu e h e d g e re s u lts in th e fa ir v a lu e e x p o s u re b e in g o ffs e t. C h a n g e s in th e fa ir v a lu e o f d e riv a tiv e s th a t a re d e s ig n a te d a n d q u a lify as fa ir v a lu e h e d g e s a re re c o rd e d in th e c o n s o lid a te d in c o m e s ta te m e n t im m e d ia te ly , to g e th e r w ith a n y c h a n g e s in th e fa ir v a lu e o f th e h e d g e d a s s e t o r lia b ility th a t is a ttr ib u ta b le to th e h e d g e d risk . H e d g e a c c o u n tin g is d is c o n tin u e d w h e n th e h e d g e in s tr u m e n t e x p ire s o r is s o ld , te r m in a te d , e x e rc is e d , o r n o lo n g e r q u a lifie s fo r h e d g e a c c o u n tin g . T h e a d ju s tm e n t to th e c a r r y in g a m o u n t o f th e h e d g e d ite m a ris in g fr o m th e h e d g e d ris k is a m o r tis e d to p r o fit o r lo s s fr o m t h a t d a te .
(iii) Hedge of monetary assets and liabilities W h e n a d e riv a tiv e fin a n c ia l in s tr u m e n t is u s e d to h e d g e e c o n o m ic a lly th e fo re ig n e x c h a n g e e x p o s u re o f a re c o g n is e d m o n e ta r y a s s e t o r lia b ility , h e d g e a c c o u n tin g is n o t a p p lie d a n d a n y g a in o r lo s s o n th e h e d g in g in s tr u m e n t is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t.
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IE S C O N T IN U E D (G ) P ro p e rty , p la n t and eq u ip m e n t
T h e e x p e c te d u s e fu l liv e s a re as fo llo w s : 2014
2013
2 5 - 4 0 y e a rs
2 5 - 4 0 y e a rs
3 -1 0 y e a rs
3 -1 0 y e a rs
F re e h o ld la n d , w a re h o u s e , re ta il, d e v e lo p m e n t a n d o th e r p r o p e rtie s a re h e ld a t th e lo w e r o f c o s t le s s a c c u m u la te d d e p re c ia tio n a n d re c o v e ra b le v a lu e (re fe r N o te 1 (M )).
B u ild in g s
B o rro w in g , h o ld in g a n d d e v e lo p m e n t c o s ts o n p r o p e r ty u n d e r d e v e lo p m e n t a re c a p ita lis e d u n til c o m p le tio n o f th e d e v e lo p m e n t.
* Some immaterial assets have a useful life of greater than 10 years.
L a n d a n d b u ild in g s h e ld f o r sa le a re c la s s ifie d as c u r r e n t a s s e ts a n d a re v a lu e d a t th e lo w e r o f c o s t a n d fa ir v a lu e le s s c o s ts to se ll a n d a re n o t d e p re c ia te d .
T h e c o s t o f le a s e h o ld im p ro v e m e n ts is a m o r tis e d o v e r th e re m a in in g p e rio d o f th e in d iv id u a l le a s e s o r th e e s tim a te d u s e fu l life o f th e im p r o v e m e n t to th e c o n s o lid a te d e n tity , w h ic h e v e r is th e s h o rte r. L e a s e h o ld im p ro v e m e n ts h e ld a t th e re p o r tin g d a te a re a m o r tis e d o v e r a m a x im u m p e rio d o f 2 0 y e a rs fo r re ta il p r o p e rtie s a n d 4 0 y e a rs fo r h o te ls .
P la n t a n d e q u ip m e n t*
( b ) L e a s e h o ld im p ro v e m e n ts
Ite m s o f p la n t a n d e q u ip m e n t a re s ta te d a t c o s t le s s a c c u m u la te d d e p re c ia tio n (s e e b e lo w ) a n d im p a ir m e n t lo s s e s (re fe r N o te 1 (M )). T h e c o s t o f s e lf-c o n s tr u c te d a s s e ts in c lu d e s th e c o s t o f m a te ria ls , d ir e c t la b o u r a n d a n a p p ro p r ia te p r o p o r tio n o f o v e rh e a d s . T h e c o s t o f s e lf- c o n s tr u c te d a s s e ts a n d a c q u ire d a s s e ts in c lu d e s e s tim a te s o f th e c o s ts o f d is m a n tlin g a n d r e m o v in g th e ite m s a n d re s to rin g th e s ite o n w h ic h th e y a re lo c a te d w h e re it is p ro b a b le th a t su c h c o s ts w ill b e in c u rre d a n d c h a n g e s in th e m e a s u re m e n t o f e x is tin g lia b ilitie s a re re c o g n is e d fo r th e s e c o s ts re s u ltin g fr o m c h a n g e s in th e tim in g o r o u t f lo w o f re s o u rc e s re q u ire d to s e ttle th e o b lig a tio n o r fr o m c h a n g e s in th e d is c o u n t ra te . P ro p e r ty th a t is b e in g c o n s tr u c te d o r d e v e lo p e d f o r fu tu r e u se is c la s s ifie d as d e v e lo p m e n t p ro p e r tie s a n d s ta te d a t th e lo w e r o f c o s t le s s a c c u m u la te d d e p re c ia tio n a n d re c o v e ra b le v a lu e (re fe r N o te 1 ( M ) ) u n til c o n s tr u c tio n o r d e v e lo p m e n t is c o m p le te . W h e r e p a rts o f an ite m o f p ro p e rty , p la n t a n d e q u ip m e n t h a ve d iffe r e n t u s e fu l live s , th e y a re a c c o u n te d fo r as s e p a ra te ite m s o f p ro p e rty , p la n t a n d e q u ip m e n t.
(i) Leased assets L e a se s w h e re b y th e c o n s o lid a te d e n t it y a s s u m e s s u b s ta n tia lly a ll o f th e ris k s a n d re w a rd s o f o w n e r s h ip a re c la s s ifie d as fin a n c e le a s e s . P ro p e r ty a c q u ire d b y w a y o f a fin a n c e le a s e is s ta te d a t an a m o u n t e q u a l to th e lo w e r o f its fa ir v a lu e a n d th e p re s e n t v a lu e o f th e m in im u m le a s e p a y m e n ts a t in c e p tio n o f th e le a se, le s s a c c u m u la te d d e p re c ia tio n (s e e b e lo w ) a n d im p a ir m e n t lo s s e s ( r e fe r N o te 1 (M )). L ease p a y m e n ts a re a c c o u n te d fo r as d e s c rib e d in N o te 1 ( T ) .
(ii) D epreciation (a )
B u ild in g s , p la n t a n d e q u ip m e n t
B u ild in g s a n d p la n t c o m p ris in g lifts , a ir c o n d itio n in g , fire p ro te c tio n s y s te m s a n d o th e r in s ta lla tio n s a re d e p re c ia te d o n a s tr a ig h t- lin e b a s is o v e r th e e s tim a te d u s e fu l life o f th e a s s e t to th e c o n s o lid a te d e n tity . E s tim a te s o f re m a in in g u s e fu l liv e s a re m a d e o n a re g u la r b a s is fo r a ll a s s e ts .
( c ) P la n t a n d e q u ip m e n t
P la n t, e q u ip m e n t a n d s h o p f it t in g s ( in c lu d in g a p p lic a tio n s o ftw a r e ) a re d e p re c ia te d o n a s tr a ig h t- lin e b a s is o v e r th e e s tim a te d u s e fu l life o f th e a s s e t to th e c o n s o lid a te d e n tity . E s tim a te s o f re m a in in g u s e fu l liv e s a re m a d e o n a re g u la r b a s is fo r a ll a s s e ts . T h e e x p e c te d u s e fu l liv e s a re as fo llo w s :
P la n t a n d e q u ip m e n t*
2014
2013
2 .5 -1 0 y e a rs
2 .5 -1 0 y e a rs
* Some immaterial assets have a useful life of greater than 10 years (d )
P ro c e e d s f r o m s a le o f a s s e ts
T h e g ro s s p ro c e e d s o f a s s e t s a le s a re re c o g n is e d a t th e d a te t h a t an u n c o n d itio n a l c o n tr a c t o f sa le is e x c h a n g e d w ith th e p u rc h a s e r. T h e n e t g a in / ( n e t lo s s ) is re c o rd e d in o th e r in c o m e / ( o th e r e x p e n s e s ).
( H ) G oodw ill Business co m binations prior to 27 June 2 0 0 4 A s p a r t o f its tra n s itio n to A -IF R S , th e c o n s o lid a te d e n t it y e le c te d to re s ta te o n ly th o s e b u s in e s s c o m b in a tio n s t h a t o c c u rre d o n o r a fte r 2 7 Ju n e 2 0 0 4 . In re s p e c t o f b u s in e s s c o m b in a tio n s p rio r to 2 7 Ju n e 2 0 0 4 , g o o d w ill is in c lu d e d o n th e b a s is o f its d e e m e d c o s t, w h ic h re p re s e n ts th e a m o u n t re c o rd e d u n d e r p re v io u s A u s tra lia n G A A P .
Business co m binations since 2 7 June 2 0 0 4 A ll b u s in e s s c o m b in a tio n s a re a c c o u n te d fo r b y a p p ly in g th e p u rc h a s e m e th o d . E n titie s a n d b u s in e s s e s a c q u ire d a re a c c o u n te d fo r u s in g th e c o s t m e th o d o f a c c o u n tin g , w h e re b y fa ir v a lu e s a re a s s ig n e d to a ll th e id e n tifia b le u n d e r ly in g a s s e ts a c q u ire d a n d lia b ilitie s a s s u m e d , in c lu d in g c o n tin g e n t lia b ilitie s , a t th e d a te o f a c q u is itio n . G o o d w ill re p re s e n ts th e d iffe re n c e b e tw e e n th e c o s t o f th e a c q u is itio n a n d th e fa ir v a lu e o f th e n e t id e n tifia b le a s s e ts a c q u ire d . G o o d w ill is n o t a m o r tis e d , b u t te s te d fo r im p a ir m e n t a n n u a lly a n d w h e n e v e r a n in d ic a tio n o f im p a ir m e n t e x is ts (re fe r N o te 1 (M )). G o o d w ill is s ta te d a t c o s t le s s a n y a c c u m u la te d im p a ir m e n t lo s s e s . G o o d w ill is a llo c a te d to c a s h -g e n e ra tin g u n its . A n y im p a ir m e n t is re c o g n is e d d ir e c tly in th e c o n s o lid a te d in c o m e s ta te m e n t a n d is n o t s u b s e q u e n tly re v e rs e d .
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Appendix: W oolw orths Lim ited A nnual Report 2014
( I ) O th e r in ta n g ib les (i) Brand nam es B ra n d n a m e s re c o g n is e d b y th e c o n s o lid a te d e n t it y g e n e r a lly h a ve a n in d e fin ite u s e fu l life a n d a re n o t a m o r tis e d . E ach p e rio d , th e u s e fu l life o f th is a s s e t is re v ie w e d to d e te r m in e w h e th e r e v e n ts a n d c irc u m s ta n c e s c o n tin u e to s u p p o r t a n in d e fin ite u s e fu l life a s s e s s m e n t fo r th e a s s e t. S u c h a s s e ts a re te s te d f o r im p a ir m e n t in a c c o rd a n c e w ith th e p o lic y s ta te d in N o te 1 (M ).
(ii) Liquor licences L iq u o r lic e n c e s a re v a lu e d a t c o s t. L iq u o r lic e n c e s a re c o n s id e re d to h a v e an in d e fin ite u s e fu l life . A s a c o n s e q u e n c e , n o a m o r tis a tio n is c h a rg e d . T h e y a re te s te d fo r im p a ir m e n t a n n u a lly a n d w h e n e v e r a n in d ic a tio n o f im p a ir m e n t e x is ts . A n y im p a ir m e n t is re c o g n is e d im m e d ia te ly in th e c o n s o lid a te d in c o m e s ta te m e n t.
(iii) G am ing licences G a m in g lic e n c e s a re v a lu e d a t c o s t. G a m in g lic e n c e s a re c o n s id e re d to h a ve a n in d e fin ite u s e fu l life . A s a c o n s e q u e n c e , n o a m o r tis a tio n is c h a rg e d . T h e y a re te s te d fo r im p a ir m e n t a n n u a lly a n d w h e n e v e r a n in d ic a tio n o f im p a ir m e n t e x is ts . A n y im p a ir m e n t is re c o g n is e d im m e d ia te ly in th e c o n s o lid a te d in c o m e s ta te m e n t.
(iv ) G am ing en titlem en ts G a m in g e n title m e n ts a c q u ire d p u rs u a n t to th e V ic to r ia n G a m in g R e g u la tio n s e ffe c tiv e A u g u s t 2 0 1 2 a re v a lu e d a t c o s t. G a m in g e n title m e n ts a re a m o r tis e d o n a s tr a ig h t lin e b a s is o v e r th e life o f th e e n title m e n t w h ic h is 10 y e a rs .
(v ) Research and developm ent
701
(v i) O th e r intangible assets O th e r in ta n g ib le a s s e ts t h a t a re a c q u ire d b y th e c o n s o lid a te d e n t it y a re v a lu e d a t c o s t le s s a c c u m u la te d a m o r tis a tio n a n d a c c u m u la te d im p a ir m e n t lo s s e s . If th e a s s e ts a re c o n s id e re d to h a ve a n in d e fin ite u s e fu l life , n o a m o r tis a tio n is c h a rg e d . If th e a s s e ts h a ve a fin ite u s e fu l life , a m o r tis a tio n is c h a rg e d . E x p e n d itu re o n in te rn a lly g e n e ra te d g o o d w ill a n d b ra n d n a m e s is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t as an e x p e n s e as in c u rre d .
(J ) Financial assets Financial assets valued though other com prehensive income T h e c o n s o lid a te d e n tity 's in v e s tm e n ts in e q u ity s e c u ritie s a re d e s ig n a te d a s fin a n c ia l a s s e ts a t fa ir v a lu e th r o u g h o th e r c o m p re h e n s iv e in c o m e . T h e in v e s tm e n ts a re in itia lly m e a s u re d a t fa ir v a lu e n e t o f tra n s a c tio n c o s ts . S u b s e q u e n t to in itia l re c o g n itio n th e e q u ity in v e s tm e n ts a re m e a s u re d a t fa ir v a lu e w ith a n y c h a n g e re c o rd e d th ro u g h o th e r c o m p re h e n s iv e in c o m e . D iv id e n d in c o m e is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t in a c c o rd a n c e w ith A A S B 778 R e ve n u e .
Trade and o th e r receivables T ra d e a n d o th e r re c e iv a b le s a re s ta te d a t th e ir c o s t less im p a ir m e n t lo s s e s ( r e fe r N o te 1 (M )).
(K ) In v en to rie s In v e n to rie s a re v a lu e d a t th e lo w e r o f c o s t o r n e t re a lis a b le v a lu e .
E x p e n d itu re o n re s e a rc h a c tiv itie s , u n d e r ta k e n w ith th e p ro s p e c t o f g a in in g n e w te c h n ic a l k n o w le d g e a n d u n d e r s ta n d in g , is re c o g n is e d in th e p r o f it a n d lo s s as an e x p e n s e as in c u rre d .
C o s t in c lu d e s a ll p u rc h a s e re la te d re b a te s , s e ttle m e n t d is c o u n ts a n d o th e r c o s ts in c u rre d to b rin g in v e n to r y to its p re s e n t c o n d itio n a n d lo c a tio n fo r sa le .
E x p e n d itu re o n d e v e lo p m e n t a c tiv itie s , w h e re b y re s e a rc h fin d in g s a re a p p lie d to a p la n o r d e s ig n fo r th e p r o d u c tio n o f n e w o r s u b s ta n tia lly im p ro v e d p r o d u c ts a n d p ro c e s s e s , is c a p ita lis e d if th e p r o d u c t o r p ro c e s s is te c h n ic a lly a n d c o m m e r c ia lly fe a s ib le a n d th e c o n s o lid a te d e n t it y h a s s u ffic ie n t re s o u rc e s to c o m p le te d e v e lo p m e n t. T h e e x p e n d itu re c a p ita lis e d in c lu d e s th e c o s t o f m a te ria ls , d ir e c t la b o u r a n d a n a p p ro p r ia te p ro p o r tio n o f o v e rh e a d s .
N e t re a lis a b le v a lu e is th e e s tim a te d s e llin g p ric e in th e o rd in a ry c o u rs e o f b u s in e s s , le s s th e e s tim a te d c o s ts o f c o m p le tio n a n d s e llin g e x p e n s e s .
O th e r d e v e lo p m e n t e x p e n d itu re is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t as an e x p e n s e as in c u rre d . C a p ita lis e d d e v e lo p m e n t e x p e n d itu re is s ta te d a t c o s t le s s a c c u m u la te d a m o r tis a tio n a n d im p a ir m e n t lo s s e s ( r e fe r N o te 1 (M )).
W h e r e in v e n to ry s y s te m s d o n o t p ro v id e a p p ro p r ia te ite m le v e l in fo rm a tio n , th e re ta il m e th o d te c h n iq u e is a d o p te d in o rd e r to m e a s u re c o s t.
(L ) Cash an d cash eq u iv a le n ts C a sh a n d ca s h e q u iv a le n ts c o m p ris e ca s h b a la n c e s a n d c a ll d e p o s its w ith a n o rig in a l m a t u r it y o f th re e m o n th s o r le ss. B an k o v e rd ra fts th a t a re re p a y a b le o n d e m a n d a n d fo r m an in te g ra l p a rt o f th e c o n s o lid a te d e n tity 's ca s h m a n a g e m e n t a re in c lu d e d as a c o m p o n e n t o f ca s h a n d ca s h e q u iv a le n ts fo r th e p u rp o s e o f th e c o n s o lid a te d ca s h flo w s ta te m e n t.
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IE S C O N T IN U E D ( M ) Im p a irm e n t T h e c a rr y in g a m o u n ts o f th e c o n s o lid a te d e n tity 's ta n g ib le a s s e ts , e x c lu d in g in v e n to rie s (re fe r N o te 1( K ) ) a n d d e fe rre d ta x a s s e ts ( r e fe r N o te 1 ( V ) ) , a re re v ie w e d a t e a c h re p o r tin g d a te to d e te r m in e w h e th e r th e re is a n y in d ic a tio n o f im p a ir m e n t. If a n y s u c h in d ic a tio n e x is ts , th e a s s e t's re c o v e ra b le a m o u n t is e s tim a te d ( r e fe r b e lo w ). F o r g o o d w ill a n d o th e r in ta n g ib le a s s e ts t h a t h a ve a n in d e fin ite u s e fu l life a n d in ta n g ib le a s s e ts th a t a re n o t y e t a v a ila b le fo r use, th e re c o v e ra b le a m o u n t is e s tim a te d a n n u a lly a n d w h e n e v e r th e re is a n im p a ir m e n t in d ic a to r. A n im p a ir m e n t lo s s is re c o g n is e d w h e n e v e r th e c a r r y in g a m o u n t o f an a s s e t o r its ca s h g e n e r a tin g u n it ( 'C G U ') e x c e e d s its re c o v e ra b le a m o u n t. Im p a ir m e n t lo s s e s a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t u n le s s th e a s s e t h a s p re v io u s ly b e e n re v a lu e d , in w h ic h ca s e th e im p a ir m e n t lo s s is re c o g n is e d as a re v e rs a l to th e e x te n t o f t h a t p re v io u s re v a lu a tio n w ith a n y e x c e s s re c o g n is e d th ro u g h th e c o n s o lid a te d in c o m e s ta te m e n t.
(i)
Calculation of recoverable am ount
T h e re c o v e ra b le a m o u n t o f th e c o n s o lid a te d e n tity 's in v e s tm e n ts in h e ld - t o - m a t u r it y s e c u ritie s a n d re c e iv a b le s is c a lc u la te d as th e p re s e n t v a lu e o f e s tim a te d fu tu r e ca s h flo w s , d is c o u n te d a t th e o rig in a l e ffe c tiv e in te re s t ra te ( th a t is, th e e ffe c tiv e in te re s t ra te c o m p u te d a t in itia l r e c o g n itio n o f th e s e fin a n c ia l a s s e ts ). R e c e iv a b le s w ith a s h o r t d u ra tio n a re n o t d is c o u n te d . Im p a ir m e n t o f re c e iv a b le s is n o t re c o g n is e d u n til o b je c tiv e e v id e n c e is a v a ila b le th a t a lo s s e v e n t h a s o c c u rre d . S ig n ific a n t re c e iv a b le s a re in d iv id u a lly a s s e s s e d f o r im p a ir m e n t. Im p a ir m e n t te s tin g o f s ig n ific a n t re c e iv a b le s th a t a re n o t a s s e s s e d as im p a ir e d in d iv id u a lly is p e rfo rm e d b y p la c in g th e m in to p o r tfo lio s o f s ig n ific a n t re c e iv a b le s w ith s im ila r ris k p ro file s a n d u n d e r ta k in g a c o lle c tiv e a s s e s s m e n t o f im p a ir m e n t. N o n - s ig n ific a n t re c e iv a b le s a re n o t in d iv id u a lly a s s e s s e d . In s te a d , im p a ir m e n t te s tin g is p e r fo r m e d b y p la c in g n o n -s ig n ific a n t re c e iv a b le s in p o r tfo lio s o f s im ila r ris k p ro file s , b a s e d o n o b je c tiv e e v id e n c e fr o m h is to ric a l e x p e rie n c e a d ju s te d fo r a n y e ffe c ts o f c o n d itio n s e x is tin g a t e a c h b a la n c e d a te . T h e re c o v e ra b le a m o u n t o f o th e r a s s e ts is th e g re a te r o f th e ir fa ir v a lu e le s s c o s ts to d is p o s e a n d v a lu e in u se . In a s s e s s in g v a lu e in u se , th e e s tim a te d fu tu r e ca s h flo w s a re d is c o u n te d to t h e ir p re s e n t v a lu e u s in g a p re -ta x d is c o u n t ra te th a t r e fle c ts c u rr e n t m a r k e t a s s e s s m e n ts o f th e t im e v a lu e o f m o n e y a n d th e ris k s s p e c ific to th e a s s e t. F o r a n a s s e t th a t d o e s n o t g e n e ra te la rg e ly in d e p e n d e n t ca s h in flo w s , th e re c o v e ra b le a m o u n t is d e te r m in e d fo r th e c a s h -g e n e ra tin g u n it to w h ic h th e a s s e t b e lo n g s . Im p a ir m e n t lo s s e s re c o g n is e d in re s p e c t o f a C G U w ill be a llo c a te d f ir s t to re d u c e th e c a r r y in g a m o u n t o f a n y g o o d w ill a llo c a te d to th e C G U a n d th e n to re d u c e th e c a r r y in g a m o u n t o f th e o th e r a s s e ts in th e u n it o n a p r o -ra ta b a s is to th e ir c a rr y in g a m o u n ts .
(ii) Reversals of im p airm en t A n im p a ir m e n t lo s s in re s p e c t o f a h e ld - t o - m a t u r it y s e c u r ity o r re c e iv a b le is re v e rs e d if th e s u b s e q u e n t in c re a s e in re c o v e ra b le a m o u n t c a n be re la te d o b je c tiv e ly to an e v e n t o c c u rrin g a fte r th e im p a ir m e n t lo s s w a s re c o g n is e d . A n im p a ir m e n t lo s s in re s p e c t o f g o o d w ill is n o t re v e rs e d . In re s p e c t o f o th e r a s s e ts , a n im p a ir m e n t lo s s is re v e rs e d if th e re h a s b e e n a c h a n g e in th e e s tim a te s u se d to d e te r m in e th e re c o v e ra b le a m o u n t. A n im p a ir m e n t lo s s is re v e rs e d o n ly to th e e x te n t th a t th e a s s e t's c a r r y in g a m o u n t d o e s n o t e x c e e d th e c a rr y in g a m o u n t th a t w o u ld h a ve b e e n d e te r m in e d , n e t o f d e p re c ia tio n o r a m o r tis a tio n , if no im p a ir m e n t lo s s h a d b e e n re c o g n is e d .
( N ) C ap ital (i) D e b t and eq uity instrum ents D e b t a n d e q u ity in s tr u m e n ts a re c la s s ifie d a s e ith e r lia b ilitie s o r e q u ity in a c c o rd a n c e w it h th e s u b s ta n c e o f th e c o n tra c tu a l a rra n g e m e n t.
(ii) Transaction costs on th e issue of eq uity instrum ents T ra n s a c tio n c o s ts a ris in g o n th e is s u e o f e q u ity in s tr u m e n ts a re re c o g n is e d d ir e c tly in e q u ity as a re d u c tio n o f th e p ro c e e d s o f th e e q u ity in s tr u m e n ts to w h ic h th e c o s ts re la te . T ra n s a c tio n c o s ts a re th e c o s ts t h a t a re in c u rre d d ir e c tly in c o n n e c tio n w ith th e is s u e o f th o s e e q u ity in s tr u m e n ts a n d w h ic h w o u ld n o t h a ve b e e n in c u rre d h a d th o s e in s tr u m e n ts n o t b e e n is s u e d .
(iii) Interest and dividends In te re s t a n d d iv id e n d s a re c la s s ifie d as e x p e n s e s o r as d is tr ib u tio n s o f p r o f it c o n s is te n t w ith th e b a la n c e s h e e t c la s s ific a tio n o f th e re la te d d e b t o r e q u ity in s tr u m e n ts o r c o m p o n e n t p a rts o f c o m p o u n d in s tru m e n ts .
(O ) B orrow ings B o rro w in g s a re re c o g n is e d in itia lly a t fa ir v a lu e le s s a t tr ib u ta b le tra n s a c tio n c o s ts . S u b s e q u e n t to in itia l re c o g n itio n , b o rro w in g s a re s ta te d a t a m o r tis e d c o s t w ith a n y d iffe re n c e b e tw e e n c o s t a n d re d e m p tio n v a lu e re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t o v e r th e p e rio d o f th e b o rro w in g s . B o r ro w in g c o s ts d ir e c tly a ttr ib u ta b le to q u a lify in g a s s e ts a re c a p ita lis e d a s p a r t o f th e c o s t o f th o s e a s s e ts .
(P ) E m p loyee b e n e fits T h e C o m p a n y s p o n s o rs a S u p e ra n n u a tio n P lan (th e 'P la n ') t h a t p ro v id e s a c c u m u la tio n a n d d e fin e d b e n e fit t y p e b e n e fits to p e rm a n e n t s a la rie d e m p lo y e e s a n d th e ir d e p e n d a n ts o n r e tir e m e n t, to ta l d is a b le m e n t o r d e a th . D e fin e d b e n e fits h a ve b e e n p re s e rv e d f o r m e m b e rs o f c e rta in f o r m e r s u p e ra n n u a tio n fu n d s s p o n s o re d b y th e C o m p a n y , w h ic h is p ro v id e d fo r in th e P lan. T h e C o m p a n y 's c o m m it m e n t in re s p e c t o f a c c u m u la tio n b e n e fits u n d e r th e P lan is lim ite d to m a k in g th e s p e c ifie d c o n tr ib u tio n s in a c c o rd a n c e w ith th e R u le s o f th e P lan a n d /o r a n y s t a t u t o r y o b lig a tio n s .
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Appendix: W oolw orths Lim ited A nnual Report 2014
(i) D efined contribution plans P a y m e n ts to d e fin e d c o n tr ib u tio n r e tir e m e n t b e n e fit p la n s a re re c o g n is e d as an e x p e n s e w h e n e m p lo y e e s h a ve re n d e re d s e rv ic e e n titlin g th e m to th e c o n trib u tio n s .
(ii) D efined benefit plans T h e n e t d e fin e d b e n e fit o b lig a tio n re c o g n is e d in th e c o n s o lid a te d b a la n c e s h e e t re p re s e n ts th e a c tu a l d e fic it o r s u rp lu s in th e G ro u p 's d e fin e d b e n e fit p la n s w h ic h is c a lc u la te d b y e s tim a tin g th e a m o u n t o f fu tu r e b e n e fit t h a t e m p lo y e e s h a ve e a rn e d in th e c u r r e n t a n d p rio r p e rio d s , d is c o u n tin g th a t a m o u n t a n d d e d u c tin g th e fa ir v a lu e o f th e p la n a s s e ts . T h e c a lc u la tio n o f th e d e fin e d b e n e fit o b lig a tio n is p e r fo r m e d a t th e e n d o f e a c h a n n u a l re p o r tin g p e rio d b y a q u a lifie d a c tu a ry u s in g th e p ro je c te d u n it c r e d it m e th o d . W h e n th e c a lc u la tio n re s u lts in a p o te n tia l a s s e t f o r th e G ro u p , th e re c o g n is e d a s s e t is lim ite d to th e p re s e n t v a lu e o f e c o n o m ic b e n e fits a v a ila b le in th e fo r m o r a n y fu tu r e re fu n d s fr o m th e p la n o r re d u c tio n s in fu tu re c o n tr ib u tio n s to th e p la n . R e m e a s u re m e n ts o f th e n e t d e fin e d b e n e fit lia b ility , w h ic h c o m p ris e a c tu a ria l g a in s a n d lo s s e s , th e re tu rn o n p la n a s s e ts (e x c lu d in g in te r e s t) a n d th e e ffe c t o f th e a s s e t c e ilin g ( if a n y, e x c lu d in g in te re s t), a re re c o g n is e d im m e d ia te ly in o th e r c o m p re h e n s iv e in c o m e a n d w ill n o t be re c la s s ifie d to p r o f it o r lo ss. T h e G ro u p d e te r m in e s th e n e t in te re s t e x p e n s e (in c o m e ) on th e n e t d e fin e d b e n e fit lia b ility fo r th e p e rio d b y a p p ly in g th e d is c o u n t ra te a t th e b e g in n in g o f th e p e rio d to th e n e t d e fin e d b e n e fit lia b ility , ta k in g in to a c c o u n t a n y c h a n g e s d u rin g th e p e rio d as a re s u lt o f c o n tr ib u tio n s a n d b e n e fit p a y m e n ts . N e t in te re s t e x p e n s e (in c o m e ) , s e rv ic e c o s t a n d o th e r e x p e n s e s re la te d to d e fin e d b e n e fit p la n s a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t.
(iii) L o n g term em ployee benefits T h e c o n s o lid a te d e n tity 's n e t o b lig a tio n in re s p e c t o f lo n g te rm e m p lo y e e b e n e fits , o th e r th a n d e fin e d b e n e fit p la n s , is th e a m o u n t o f fu tu r e b e n e fit th a t e m p lo y e e s h a ve e a rn e d in re tu rn fo r t h e ir s e rv ic e in th e c u r r e n t a n d p r io r p e rio d s . T h e o b lig a tio n is c a lc u la te d u s in g e x p e c te d fu tu r e in c re a s e s in w a g e a n d s a la ry ra te s in c lu d in g re la te d o n -c o s ts a n d e x p e c te d s e ttle m e n t d a te s a n d is d is c o u n te d u s in g th e ra te s a tta c h e d to G o v e r n m e n t b o n d s a t th e b a la n c e s h e e t d a te w h ic h h a ve m a t u r it y d a te s a p p r o x im a tin g th e te r m s o f th e c o n s o lid a te d e n tity 's o b lig a tio n s .
(iv ) Share based paym ent transactions E q u ity s e ttle d s h a re b a s e d p a y m e n ts fo r m p a r t o f th e re m u n e ra tio n o f e m p lo y e e s ( in c lu d in g e x e c u tiv e s ) o f th e c o n s o lid a te d e n tity .
703
T h e c o n s o lid a te d e n t it y re c o g n is e s th e fa ir v a lu e a t th e g ra n t d a te o f e q u ity s e ttle d s h a re b a s e d p a y m e n ts (s u c h as o p tio n s o r p e rfo rm a n c e rig h ts ) as an e m p lo y e e b e n e fit e x p e n s e p r o p o r tio n a lly o v e r th e v e s tin g p e rio d w ith a c o rr e s p o n d in g in c re a s e in e q u ity . T h e fa ir v a lu e o f o p tio n s a n d p e rfo rm a n c e rig h ts w ith th e re la tiv e TSR p e rfo rm a n c e m e a s u re is c a lc u la te d a t th e d a te o f g ra n t u s in g th e M o n te - C a r lo s im u la tio n m o d e l, ta k in g in to a c c o u n t, a m o n g s t o th e r th in g s , th e im p a c t o f th e TS R c o n d itio n a n d th a t rig h t h o ld e rs a re n o t e n title d to d iv id e n d s d u r in g th e v e s tin g p e rio d . T h e fa ir v a lu e o f o p tio n s a n d p e rfo rm a n c e rig h ts w ith th e EPS a n d N P A T m e a s u re s , a n d re te n tio n rig h ts is c a lc u la te d u s in g th e B la c k -S c h o le s o p tio n p ric in g m o d e l, ta k in g in to a c c o u n t th a t rig h t h o ld e rs a re n o t e n title d to d iv id e n d s d u rin g th e v e s tin g p e rio d . T h e fa ir v a lu e p e r in s tr u m e n t is m u ltip lie d b y th e n u m b e r o f in s tr u m e n ts e x p e c te d to v e s t b a s e d o n a c h ie v e m e n t o f n o n -m a rk e t b a s e d p e rfo rm a n c e c o n d itio n s (e .g . s e rv ic e c o n d itio n s ) to d e te r m in e th e to ta l c o s t. O n v e s tin g a n d o v e r th e v e s tin g p e rio d th e a m o u n t re c o g n is e d as an e m p lo y e e b e n e fit e x p e n s e w ill b e a d ju s te d to r e fle c t th e a c tu a l n u m b e r o f o p tio n s th a t v e s t e x c e p t w h e re f o r fe itu r e is d u e to fa ilu re to a c h ie v e m a r k e t b a s e d p e rfo rm a n c e c o n d itio n s . T h e c o n s o lid a te d e n t it y o p e ra te d an E m p lo y e e S h a re P lan (E S P ) w h e re b y it p ro v id e d in te re s t fre e lo a n s to s e le c te d e m p lo y e e s to p u rc h a s e s h a re s in th e C o m p a n y . A ll s h a re s a c q u ire d u n d e r th e ESP a re h e ld b y a w h o lly o w n e d s u b s id ia ry o f W o o lw o r t h s as tr u s te e o f th e s h a re p la n tr u s t. D iv id e n d s p a id b y W o o lw o r t h s a re u s e d to re p a y th e lo a n ( a fte r p a y m e n t o f a p o r tio n o f th e d iv id e n d to th e e m p lo y e e to c o v e r a n y ta x lia b ilitie s ). T h e lo a n s a re lim ite d re c o u rs e a n d if th e e m p lo y e e e le c ts n o t to re p a y th e lo a n , th e u n d e r ly in g s h a re s a re s o ld to re c o v e r th e o u ts ta n d in g lo a n b a la n c e . T h e s e h a ve b e e n a c c o u n te d fo r as a n in - s u b s ta n c e o p tio n in th e fin a n c ia l s ta te m e n ts o f th e c o n s o lid a te d e n tity . T h is p la n w a s la s t o ffe re d in M a y 2 0 0 3 w ith lo a n s m a tu re d in M a y 2 0 1 3 . It is n o t in te n d e d to re -o p e n th is p la n to fu r t h e r o ffe rs .
(v ) W ag es and salaries and related em ployee benefits P ro v is io n is m a d e fo r b e n e fits a c c ru in g to e m p lo y e e s in re s p e c t o f w a g e s a n d s a la rie s , a n n u a l le a v e , lo n g s e rv ic e le a v e a n d s ic k le a v e w h e n it is p ro b a b le th a t s e ttle m e n t w ill b e re q u ire d a n d th e y a re c a p a b le o f b e in g re lia b ly m e a s u re d . P ro v is io n s m a d e in re s p e c t o f e m p lo y e e b e n e fits e x p e c te d to b e s e ttle d w h o lly w ith in 12 m o n th s a re re c o g n is e d a n d a re m e a s u re d a t th e ir n o m in a l v a lu e s u s in g th e re m u n e ra tio n ra te e x p e c te d to a p p ly a t th e t im e o f s e ttle m e n t. P ro v is io n s m a d e in re s p e c t o f e m p lo y e e b e n e fits w h ic h a re n o t e x p e c te d to b e s e ttle d w h o lly w ith in 12 m o n th s a re re c o g n is e d a n d m e a s u re d as th e p re s e n t v a lu e o f e x p e c te d fu tu r e p a y m e n ts to be m a d e in re s p e c t o f s e rv ic e s p ro v id e d b y e m p lo y e e s u p to p e rio d e n d . C o n s id e ra tio n is g iv e n to e x p e c te d fu tu r e w a g e a n d s a la ry le v e ls , e x p e rie n c e o f e m p lo y e e d e p a r tu r e s a n d p e rio d s o f s e rv ic e .
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IE S C O N T IN U E D (Q ) Provisions A p ro v is io n is re c o g n is e d in th e c o n s o lid a te d b a la n c e s h e e t w h e n th e c o n s o lid a te d e n t it y h a s a p re s e n t le g a l o r c o n s tr u c tiv e o b lig a tio n as a re s u lt o f a p a s t e v e n t a n d it is p ro b a b le th a t an o u t f lo w o f e c o n o m ic b e n e fits w ill b e re q u ire d to s e ttle th e o b lig a tio n . W h e n s o m e o r a ll o f th e e c o n o m ic b e n e fits re q u ire d to s e ttle a p ro v is io n a re e x p e c te d to b e re c o v e re d fr o m a th ir d p a rty , th e re c e iv a b le is re c o g n is e d as a n a s s e t if it is v ir t u a lly c e rta in th a t re c o v e ry w ill be re c e iv e d a n d th e a m o u n t o f th e re c e iv a b le ca n b e m e a s u re d re lia b ly . T h e a m o u n t re c o g n is e d as a p ro v is io n is th e b e s t e s tim a te o f th e c o n s id e ra tio n re q u ire d to s e ttle th e p re s e n t o b lig a tio n a t r e p o rtin g d a te , ta k in g in to a c c o u n t th e ris k s a n d u n c e rta in tie s s u rr o u n d in g th e o b lig a tio n . W h e r e a p ro v is io n is m e a s u re d u s in g th e ca s h flo w s e s tim a te d to s e ttle th e p re s e n t o b lig a tio n , its c a rr y in g a m o u n t is th e p re s e n t v a lu e o f th o s e ca s h flo w s .
(i) Restructuring P ro v is io n fo r r e s tr u c tu r in g is re c o g n is e d w h e n th e c o n s o lid a te d e n t it y h a s d e v e lo p e d a d e ta ile d fo r m a l p la n fo r th e r e s tr u c tu r in g a n d h a s e ith e r: •
e n te re d in to fir m c o n tr a c ts to c a rr y o u t th e re s tr u c tu r in g ; o r
•
ra is e d a v a lid e x p e c ta tio n in th o s e a ffe c te d b y th e r e s tr u c tu r in g th a t th e r e s tr u c tu r in g w ill o c c u r.
(ii) O nerous contracts A p ro v is io n fo r o n e ro u s c o n tr a c ts is re c o g n is e d w h e n th e e x p e c te d b e n e fits to be d e riv e d b y th e c o n s o lid a te d e n t it y fro m a c o n tr a c t a re lo w e r th a n th e u n a v o id a b le c o s t o f m e e tin g its o b lig a tio n s u n d e r th e c o n tra c t.
(iii) Self-insurance T h e c o n s o lid a te d e n t it y p ro v id e s f o r s e lf-in s u re d lia b ilitie s re la tin g to w o rk e rs ' c o m p e n s a tio n a n d p u b lic lia b ility c la im s . T h e p ro v is io n s fo r s u c h lia b ilitie s a re b a s e d o n in d e p e n d e n t a c tu a ria l a s s e s s m e n ts , w h ic h c o n s id e r n u m b e rs , a m o u n ts a n d d u ra tio n o f c la im s , a n d a llo w fo r fu tu r e in fla tio n a n d in v e s tm e n t re tu rn s . A llo w a n c e is in c lu d e d fo r in ju rie s w h ic h o c c u rre d b e fo re th e b a la n c e s h e e t d a te , b u t w h e re th e c la im is e x p e c te d to b e n o tifie d a fte r th e re p o r tin g d a te . T h e p ro v is io n is d is c o u n te d u s in g th e G o v e r n m e n t b o n d ra te w ith a m a t u r it y d a te a p p r o x im a tin g th e te r m o f th e c o n s o lid a te d e n tity 's o b lig a tio n .
(iv ) W a rra n ty T h e c o n s o lid a te d e n t it y p ro v id e s f o r a n tic ip a te d w a r r a n ty c o s ts w h e n th e u n d e r ly in g p ro d u c ts o r s e rv ic e s a re s o ld . T h e p ro v is io n is b a s e d u p o n h is to ric a l w a r r a n ty d a ta .
(v ) M a k e good T h e c o n s o lid a te d e n t it y h a s c e rta in o p e ra tin g le a s e s th a t re q u ire th e a s s e t to be re tu rn e d to th e le s s o r in its o rig in a l c o n d itio n . T h e s e o b lig a tio n s re la te to w e a r a n d te a r o n th e p re m is e s a n d n o t d is m a n tlin g o b lig a tio n s . T h e o p e ra tin g le a s e p a y m e n ts d o n o t in c lu d e an e le m e n t fo r re p a irs /o v e rh a u ls . A p ro v is io n fo r re fu r b is h m e n t c o s ts is re c o g n is e d o v e r th e p e rio d o f th e le a s e , m e a s u re d a t th e e x p e c te d c o s t o f re fu r b is h m e n t a t e a ch re p o r tin g d a te .
(R ) Financial lia b ilitie s (i) Trade and oth e r payables T h e s e a m o u n ts re p re s e n t lia b ilitie s fo r g o o d s a n d s e rv ic e s p ro v id e d to th e c o n s o lid a te d e n t it y w h ic h w e re u n p a id a t th e e n d o f th e p e rio d . T h e a m o u n ts a re u n s e c u re d a n d a re u s u a lly s e ttle d w ith in 4 5 d a y s o f re c o g n itio n .
(ii) Put options over non-controlling interests T h e p u t o p tio n s h e ld b y n o n - c o n tr o llin g in te re s ts a re c la s s ifie d as a fin a n c ia l lia b ility a n d a re m e a s u re d a t fa ir v a lu e o r a m u ltip le o f fu tu r e e s tim a te d e a rn in g s w h e re th is is s tip u la te d in th e a g re e m e n t w ith th e n o n - c o n tr o llin g p a rty . T h e n o n -c o n tro llin g in te re s ts c o n tin u e to h a ve a c c e s s to v o tin g rig h ts a n d d iv id e n d s in th e s u b s id ia rie s a n d c o n tin u e to be a ttr ib u te d a s h a re o f p ro fits . S u b s e q u e n t c h a n g e s in th e fin a n c ia l lia b ility a re re c o rd e d d ir e c tly in e q u ity .
(S ) R evenue recognitio n In g e n e ra l, re v e n u e is re c o g n is e d o n ly w h e n it is p ro b a b le t h a t th e e c o n o m ic b e n e fits c o m p ris in g th e re v e n u e w ill flo w to th e e n tity , th e f lo w c a n be re lia b ly m e a s u re d a n d th e e n t it y h a s tra n s fe rre d th e s ig n ific a n t ris k s a n d re w a rd s o f o w n e rs h ip . In a d d itio n to th e s e g e n e ra l c r ite ria , s p e c ific re v e n u e re c o g n itio n c r ite ria a p p ly as fo llo w s :
(i) Sales revenue S ale s re v e n u e re p re s e n ts th e re v e n u e e a rn e d fr o m th e p ro v is io n o f p r o d u c ts a n d re n d e rin g o f s e rv ic e s to p a rtie s e x te rn a l to th e c o n s o lid a te d e n tity . S ale s re v e n u e is o n ly re c o g n is e d w h e n th e s ig n ific a n t ris k s a n d re w a rd s o f o w n e r s h ip o f th e p ro d u c ts , in c lu d in g p o s s e s s io n , h a ve p a s s e d to th e b u y e r a n d f o r s e rv ic e s w h e n a r ig h t to b e c o m p e n s a te d h a s b e e n a tta in e d a n d th e s ta g e o f c o m p le tio n o f th e c o n tr a c t c a n b e r e lia b ly m e a s u re d . R e ve n u e is re c o g n is e d o n a c o m m is s io n o n ly b a s is w h e re W o o lw o r t h s a c ts as a n a g e n t r a th e r th a n a p rin c ip a l in th e tra n s a c tio n . R e ve n u e is re c o g n is e d n e t o f re tu rn s . R e ve n u e fr o m th e sa le o f c u s to m e r g if t c a rd s is re c o g n is e d w h e n th e c a rd is re d e e m e d a n d th e c u s to m e r p u rc h a s e s g o o d s u s in g th e c a rd , o r w h e n th e g if t c a rd re a c h e s its e x p ir y d a te .
(ii) Rental incom e R e n ta l in c o m e is re c o g n is e d o n a s tr a ig h t lin e b a s is o v e r th e te r m o f th e le a se.
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Appendix: W oolw orths Lim ited A nnual Report 2014
(iii) Financing incom e In te re s t in c o m e is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t as it a c c ru e s , u s in g th e e ffe c tiv e in te re s t m e th o d . D iv id e n d in c o m e is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t o n th e d a te th e e n tity 's r ig h t to re c e iv e p a y m e n t is e s ta b lis h e d w h ic h in th e ca s e o f q u o te d s e c u ritie s is th e e x -d iv id e n d d a te .
( T ) Leases L e a se s a re c la s s ifie d as fin a n c e le a s e s w h e n e v e r th e te rm s o f th e le a s e tra n s fe r s u b s ta n tia lly a ll th e ris k s a n d re w a rd s o f o w n e r s h ip to th e le s se e . A ll o th e r le a s e s a re c la s s ifie d as o p e ra tin g le a s e s .
(i) O p era tin g lease paym ents P a y m e n ts m a d e u n d e r o p e ra tin g le a s e s a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t o n a s tr a ig h t-lin e b a s is o v e r th e te r m o f th e le a se. F ixe d ra te in c re a s e s to le a s e re n ta l p a y m e n ts , e x c lu d in g c o n tin g e n t o r in d e x b a s e d re n ta l in c re a s e s , s u c h as C o n s u m e r P ric e In d e x , tu r n o v e r re n ta l a n d o th e r s im ila r in c re a s e s , a re re c o g n is e d o n a s tr a ig h t lin e b a s is o v e r th e le a s e te rm . A n a s s e t o r lia b ility a ris e s fo r th e d iffe re n c e b e tw e e n th e a m o u n t p a id a n d th e le a s e e x p e n s e b ro u g h t to a c c o u n t o n a s tr a ig h t lin e b a sis. L ease in c e n tiv e s re c e iv e d a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t as an in te g ra l p a r t o f th e to ta l le a s e e x p e n s e a n d s p re a d o v e r th e le a s e te rm .
(ii) Finance lease paym ents M in im u m le a s e p a y m e n ts m a d e u n d e r fin a n c e le a s e s a re a p p o r tio n e d b e tw e e n th e fin a n c e e x p e n s e a n d th e re d u c tio n o f th e o u ts ta n d in g lia b ility . T h e fin a n c e e x p e n s e is a llo c a te d to e a ch p e rio d d u rin g th e le a s e te r m so as to p ro d u c e a c o n s ta n t p e rio d ic ra te o f in te re s t o n th e re m a in in g b a la n c e o f th e lia b ility .
( U ) N e t fin a n cin g costs N e t fin a n c in g c o s ts c o m p ris e in te re s t p a y a b le o n b o rro w in g s c a lc u la te d u s in g th e e ffe c tiv e in te re s t m e th o d , in te re s t re c e iv a b le o n fu n d s in v e s te d , d iv id e n d in c o m e , fo re ig n e x c h a n g e g a in s a n d lo s s e s a n d g a in s a n d lo s s e s o n h e d g in g in s tr u m e n ts th a t a re re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t ( r e fe r N o te 1 (F )).
( V ) Incom e ta x In c o m e ta x in th e c o n s o lid a te d in c o m e s ta te m e n t fo r th e p e rio d s p re s e n te d c o m p ris e s c u r r e n t a n d d e fe rre d ta x . In c o m e ta x is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t e x c e p t to th e e x te n t th a t it re la te s to ite m s re c o g n is e d d ir e c tly in e q u ity , in w h ic h ca s e it is re c o g n is e d in e q u ity . W h e r e it a ris e s fr o m th e in itia l a c c o u n tin g f o r a b u s in e s s c o m b in a tio n , it is ta k e n in to a c c o u n t in th e d e te r m in a tio n o f g o o d w ill o r e xc e ss. C u rre n t ta x is th e e x p e c te d ta x p a y a b le o n th e ta x a b le in c o m e fo r th e ye a r, u s in g ta x ra te s e n a c te d o r s u b s ta n tiv e ly e n a c te d a t th e b a la n c e s h e e t d a te a n d a n y a d ju s tm e n t to ta x p a y a b le in re s p e c t o f p re v io u s y e a rs . C u rre n t ta x f o r c u r r e n t a n d p r io r p e rio d s is re c o g n is e d as a lia b ility to th e e x te n t it is u n p a id .
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D e fe rre d ta x is p ro v id e d u s in g th e b a la n c e s h e e t m e th o d , p ro v id in g fo r t e m p o r a r y d iffe re n c e s b e tw e e n th e c a rr y in g a m o u n ts o f a s s e ts a n d lia b ilitie s fo r fin a n c ia l re p o r tin g p u rp o s e s a n d th e a m o u n ts u s e d fo r ta x a tio n p u rp o s e s . In a c c o rd a n c e w ith A A S B 112 In c o m e T a xe s , th e f o llo w in g t e m p o r a r y d iffe re n c e s a re n o t p ro v id e d fo r: g o o d w ill, th e in itia l re c o g n itio n o f a s s e ts o r lia b ilitie s in a tr a n s a c tio n th a t is n o t a b u s in e s s c o m b in a tio n a n d th a t a ffe c ts n e ith e r a c c o u n tin g n o r ta x a b le p r o fit, a n d d iffe re n c e s re la tin g to in v e s tm e n ts in s u b s id ia rie s to th e e x te n t th a t th e y w ill p ro b a b ly n o t re v e rs e in th e fo re s e e a b le fu tu r e w h e re th e c o n s o lid a te d e n t it y is a b le to c o n tr o l th e re v e rs a l o f th e t e m p o r a r y d iffe re n c e s . T h e a m o u n t o f d e fe rre d ta x p ro v id e d is b a s e d o n th e e x p e c te d m a n n e r o f re a lis a tio n o r s e ttle m e n t o f th e c a rr y in g a m o u n t o f a s s e ts a n d lia b ilitie s , u s in g ta x ra te s e n a c te d o r s u b s ta n tiv e ly e n a c te d a t th e b a la n c e s h e e t d a te . A d e fe rre d ta x a s s e t is re c o g n is e d o n ly to th e e x te n t th a t it is p ro b a b le th a t fu tu r e ta x a b le p r o fits w ill b e a v a ila b le a g a in s t w h ic h th e d e d u c tib le t e m p o r a r y d iffe re n c e s o r u n u s e d ta x lo s s e s a n d ta x o ffs e ts c a n b e u tilis e d . D e fe rre d ta x a s s e ts a re re d u c e d to th e e x te n t th a t it is n o lo n g e r p ro b a b le th a t th e re la te d ta x b e n e fit w ill b e re a lis e d . A d d itio n a l in c o m e ta x e s th a t a ris e fr o m th e d is tr ib u tio n o f d iv id e n d s a re re c o g n is e d a t th e s a m e t im e as th e lia b ility to p a y th e re la te d d iv id e n d . D e fe rre d ta x a s s e ts a n d lia b ilitie s a re o ffs e t w h e n th e y re la te to in c o m e ta x e s le v ie d b y th e s a m e ta x a tio n a u th o r ity a n d th e c o n s o lid a te d e n t it y in te n d s to s e ttle its c u r r e n t ta x a s s e ts a n d lia b ilitie s o n a n e t b a sis.
( W ) N o n -c u rre n t assets (o r d isposal g ro u p s ) held fo r sale an d d is continued o p e ratio n s N o n - c u r r e n t a s s e ts (o r d is p o s a l g ro u p s ) a re c la s s ifie d as h e ld fo r sa le if th e ir c a r r y in g a m o u n t w ill be re c o v e re d p rin c ip a lly th ro u g h a s a le tra n s a c tio n r a th e r th a n c o n tin u in g u se a n d a sa le is c o n s id e re d h ig h ly p ro b a b le . T h e y a re m e a s u re d a t th e lo w e r o f th e ir c a rr y in g a m o u n t a n d fa ir v a lu e le s s c o s ts to s e ll, e x c e p t fo r a s s e ts s u c h as d e fe rre d ta x a s s e ts , a s s e ts a ris in g fr o m e m p lo y e e b e n e fits a n d fin a n c ia l a s s e ts w h ic h a re s p e c ific a lly e x e m p t fro m th is re q u ire m e n t. A n im p a ir m e n t lo s s is re c o g n is e d fo r a n y in itia l o r s u b s e q u e n t w r ite d o w n o f th e a s s e t (o r d is p o s a l g ro u p ) to fa ir v a lu e less c o s ts to sell. A g a in is re c o g n is e d fo r a n y s u b s e q u e n t in c re a s e s in fa ir va lu e less c o s ts to sell o f an a s s e t (o r d is p o s a l g ro u p ), b u t n o t in e xc e ss o f a n y c u m u la tiv e im p a ir m e n t loss p re v io u s ly re c o g n is e d . A g a in o r lo s s n o t p re v io u s ly re c o g n is e d b y th e d a te o f th e sa le o f th e n o n -c u rre n t a ss e t (o r d is p o s a l g ro u p ), is re c o g n is e d a t th e d a te o f d e re c o g n itio n . N o n c u rr e n t a s s e ts (in c lu d in g th o s e th a t a re p a rt o f a d is p o s a l g ro u p ) are n o t d e p re c ia te d o r a m o rtis e d w h ile th e y a re c la s s ifie d as h e ld fo r sale. In te re s t a n d o th e r e x p e n s e s a ttrib u ta b le to th e lia b ilitie s o f th e d is p o s a l g ro u p c la s s ifie d as h e ld fo r sa le c o n tin u e to be re c o g n is e d .
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 1 S IG N IF IC A N T A C C O U N T IN G PO LIC IE S C O N T IN U E D ( W ) N o n -c u rre n t a ssets (o r d isposal g ro u p s ) held fo r sale an d d is continued o p e ra tio n s c o ntinued N o n - c u r r e n t a s s e ts c la s s ifie d as h e ld fo r sa le a n d th e a s s e ts o f a d is p o s a l g ro u p c la s s ifie d as h e ld fo r s a le a re p re s e n te d s e p a ra te ly fr o m th e o th e r a s s e ts in th e b a la n c e s h e e t. T h e lia b ilitie s o f a d is p o s a l g ro u p c la s s ifie d as h e ld fo r s a le a re p re s e n te d s e p a ra te ly fr o m o th e r lia b ilitie s in th e b a la n c e s h e e t. A d is c o n tin u e d o p e ra tio n is a c o m p o n e n t o f th e e n tity th a t has be e n d is p o s e d o f o r is c la s s ifie d as h e ld fo r sa le a n d th a t re p re s e n ts a s e p a ra te m a jo r lin e o f b u s in e s s o r g e o g ra p h ic a l a re a o f o p e ra tio n s , is p a rt o f a s in g le c o -o rd in a te d p la n to d is p o s e o f su c h a lin e o f b u s in e s s o r a re a o f o p e ra tio n s , o r is a s u b s id ia ry a c q u ire d e x c lu s iv e ly w ith a v ie w to re sa le . T h e re s u lts o f d is c o n tin u e d o p e ra tio n s a re p re s e n te d s e p a ra te ly in th e c o n s o lid a te d in c o m e s ta te m e n t.
( X ) G oods an d services ta x R e ve n u e , e x p e n s e s a n d a s s e ts a re re c o g n is e d n e t o f th e a m o u n t o f g o o d s a n d s e rv ic e s ta x (G S T ), e x c e p t w h e re th e a m o u n t o f G S T in c u rre d is n o t re c o v e ra b le fr o m th e ta x a tio n a u th o r ity . In th e s e c irc u m s ta n c e s , th e G S T is re c o g n is e d as p a r t o f th e c o s t o f a c q u is itio n o f th e a s s e t o r as p a r t o f th e e x p e n s e . R e c e iv a b le s a n d p a y a b le s a re s ta te d w ith th e a m o u n t o f G S T in c lu d e d . T h e n e t a m o u n ts o f G S T re c o v e ra b le fro m , o r p a y a b le to , th e ta x a u th o r itie s a re in c lu d e d as a c u r r e n t a s s e t o r lia b ility in th e b a la n c e s h e e t. C a sh flo w s a re in c lu d e d in th e ca s h f lo w s ta te m e n t o n a g ro s s b a sis. T h e G S T c o m p o n e n ts o f ca s h flo w s a ris in g fr o m in v e s tin g a n d fin a n c in g a c tiv itie s w h ic h a re re c o v e ra b le fro m , o r p a y a b le to , th e ta x a u th o r itie s a re c la s s ifie d as o p e r a tin g ca s h flo w s .
( Y ) O p e ra tin g S eg m en t re p o rtin g (i) Business Segm ents R e p o rta b le s e g m e n ts a re id e n tifie d o n th e b a s is o f in te rn a l r e p o rts o n th e c o m p o n e n ts o f th e G ro u p t h a t a re re g u la rly re v ie w e d b y th e C h ie f O p e ra tin g D e c is io n M a k e r in o rd e r to a llo c a te re s o u rc e s to th e s e g m e n t a n d a s s e s s its p e rfo rm a n c e .
(ii) G eographical inform ation S e g m e n t a s s e ts a re b a s e d o n th e g e o g ra p h ic a l lo c a tio n o f th e a s s e ts . W o o lw o r t h s L im ite d o p e ra te s in A u s tra lia , N e w Z e a la n d , H o n g K o n g a n d In d ia . T h e m a jo r ity o f b u s in e s s o p e ra tio n s a re in A u s tra lia a n d N e w Z e a la n d . W o o lw o r t h s o p e ra te s in N e w Z e a la n d fo llo w in g th e a c q u is itio n o f F o o d la n d A s s o c ia te d L im ite d in th e 2 0 0 6 fin a n c ia l y e a r a n d E ziB u y H o ld in g s L im ite d in th e 2 0 1 4 fin a n c ia l ye a r. T h e g lo b a l s o u rc in g o ffic e is lo c a te d in H o n g K o n g .
(Z )
P a re n t e n tity fin a n c ia l in fo rm a tio n
F in a n c ia l in fo r m a tio n fo r th e p a re n t e n tity , W o o lw o r t h s L im ite d , d is c lo s e d in N o te 3 3 h a s b e e n p re p a re d o n th e s a m e b a s is as th e c o n s o lid a te d fin a n c ia l s ta te m e n ts , e x c e p t as s e t o u t b e lo w :
(i) Investm ents in subsidiaries In v e s tm e n ts in s u b s id ia rie s a re a c c o u n te d f o r a t c o s t.
(ii) Tax consolidation T h e C o m p a n y a n d its w h o lly - o w n e d A u s tra lia n re s id e n t e n titie s h a v e fo r m e d a ta x -c o n s o lid a te d g ro u p w ith e ffe c t fr o m 1 J u ly 2 0 0 2 a n d a re th e re fo r e ta x e d as a s in g le e n t it y fr o m th a t d a te . T h e h e a d e n t it y w ith in th e ta x c o n s o lid a te d g ro u p is W o o lw o r t h s L im ite d . T a x e x p e n s e /in c o m e , d e fe rre d ta x a s s e ts a n d d e fe rre d ta x lia b ilitie s a ris in g fr o m t e m p o r a r y d iffe re n c e s o f th e m e m b e rs o f th e ta x c o n s o lid a te d g ro u p a re re c o g n is e d b y e a c h m e m b e r o f th e ta x c o n s o lid a te d g ro u p w h e re th e m e m b e r w o u ld h a ve b e e n a b le to re c o g n is e th e d e fe rre d ta x a s s e t o r d e fe rre d ta x lia b ility o n a s ta n d a lo n e b a sis. T h e h e a d e n tity , in c o n ju n c tio n w ith o th e r m e m b e rs o f th e ta x c o n s o lid a te d g ro u p , h a s e n te re d in to a ta x fu n d in g a g re e m e n t w h ic h s e ts o u t th e fu n d in g o b lig a tio n s o f m e m b e rs o f th e ta x c o n s o lid a te d g ro u p in re s p e c t o f in c o m e ta x a m o u n ts . T h e ta x fu n d in g a rra n g e m e n ts re q u ire p a y m e n ts to th e h e a d e n t it y e q u a l to th e c u r r e n t ta x lia b ility a s s u m e d b y th e h e a d e n tity . In a d d itio n , th e h e a d e n t it y is re q u ire d to m a k e p a y m e n ts e q u a l to th e c u r r e n t ta x a s s e t a s s u m e d b y th e h e a d e n t it y in c irc u m s ta n c e s w h e re th e s u b s id ia ry m e m b e r w o u ld h a ve b e e n e n title d to re c o g n is e th e c u r r e n t ta x a s s e t o n a s ta n d a lo n e b a sis. T h e s e ta x fu n d in g a rra n g e m e n ts re s u lt in th e h e a d e n tity re c o g n is in g a n in te r - e n tity re c e iv a b le /p a y a b le e q u a l in a m o u n t to th e ta x lia b ility /a s s e t a s s u m e d . T h e in t e r - e n t it y r e c e iv a b le / p a y a b le a m o u n ts a re a t c a ll. In re s p e c t o f c a rr ie d f o r w a r d ta x lo s s e s b ro u g h t in to th e g ro u p o n c o n s o lid a tio n b y s u b s id ia ry m e m b e rs , th e h e a d e n t it y w ill p a y th e s u b s id ia ry m e m b e r fo r s u c h lo s s e s w h e n th e s e lo s s e s a re tr a n s fe rre d to th e W o o lw o r t h s L im ite d ta x c o n s o lid a te d g ro u p , w h e re th e s u b s id ia ry m e m b e r w o u ld h a ve b e e n e n title d to re c o g n is e th e b e n e fit o f th e s e lo s s e s o n a s ta n d a lo n e b a sis.
U n til th e sa le o f th e C o n s u m e r E le c tro n ic s b u s in e s s in th e 2 0 1 3 fin a n c ia l ye a r, W o o lw o r t h s o p e ra te d s to re s b a s e d in A u s tra lia a n d N e w Z e a la n d a n d h a d a b u s in e s s v e n tu re w ith T A T A in In d ia p ro v id in g b u y in g , w h o le s a le , s u p p ly c h a in a n d g e n e ra l c o n s u ltin g s e rv ic e s .
W oolw orths Lim ited A nnual Report 2014 page 114
Appendix: W oolw orths Lim ited A nnual Report 2014
707
2 P R O F IT F R O M O P E R A T IO N S - C O N T IN U IN G O P E R A T IO N S 2014 52 weeks $m
2013 53 weeks Sm
6 0 ,7 7 2 .8
5 8 ,5 1 6 .4
P ro fit fr o m c o n tin u in g o p e ra tio n s b e fo re in c o m e ta x e x p e n s e in c lu d e s th e fo llo w in g ite m s o f re v e n u e a n d e x p e n s e :
(a ) O p eratin g revenue R e ve n u e fr o m th e sa le o f g o o d s O th e r o p e ra tin g re v e n u e
1 7 9 .4
157.7
Total o p e ratin g revenue
6 0 ,9 5 2 .2
5 8 ,6 7 4 .1
(b ) O th e r revenue R ent O th e r
Total o th e r revenue Total revenue
3 9 .9
4 7 .0
2 0 2 .8
2 0 0 .6
2 4 2 .7
2 4 7 .6
61,194.9
5 8 ,9 2 1 .7
(c) Expenses D e p re c ia tio n : D e v e lo p m e n t p r o p e rtie s a n d fr e e h o ld la n d , w a re h o u s e , re ta il a n d o th e r p r o p e rtie s P la n t a n d e q u ip m e n t
41.5
4 7 .3
7 8 2 .7
7 6 2 .9
151.3
138.1
17.2
15.9
A m o r tis a tio n : L e a s e h o ld im p ro v e m e n ts G a m in g lic e n c e s O th e r in ta n g ib le a s s e ts
Total de p reciatio n and am o rtisa tio n
3 .6
1.3
9 9 6 .3
9 6 5 .5
5 1 4 .4
4 8 7 .8
E m p lo y e e b e n e fits e x p e n s e 1: P o s t e m p lo y m e n t b e n e fits E q u ity -s e ttle d s h a re b a s e d p a y m e n ts O th e r e m p lo y e e b e n e fits
Total em p lo y ee b e n efits expense N e t lo s s o n d is p o s a l a n d w r ite o f f o f p ro p e rty , p la n t a n d e q u ip m e n t
5 0 .0
3 4 .9
6 ,7 2 9 .4
6 ,4 7 8 .9
7 ,2 9 3 .8
7 ,0 0 1 .6
2 .5
9 .7
1 ,8 4 6 .3
1 ,7 0 4 .5
O p e ra tin g le a s e re n ta l e x p e n s e s : M in im u m le a s e p a y m e n ts C o n tin g e n t re n ta ls
Total o p e ratin g lease ren tal expenses 1
5 2 .4
5 9 .7
1 ,8 9 8 .7
1 ,7 6 4 .2
Employee benefits expense includes salaries and wages, superannuation (defined benefit and defined contribution plans), termination benefits, taxable value of fringe benefits, payroll tax, leave entitlements and share based payments expense. Refer to Note 24 for further information on employee benefits
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708
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 3 N E T F IN A N C IN G C O S TS - C O N T IN U IN G O P E R A T IO N S 2014 5 2 w ee ks $m
2013 5 3 w ee ks $m
F in a n c ia l e x p e n s e
In te re s t e x p e n s e - o th e r p a rtie s Less: in te re s t c a p ita lis e d ' F o re ig n e x c h a n g e lo s s
(3 5 2 .0 ) 81.5
( 4 8 2 .0 ) 7 7 .4
(7 .3 )
( 5 .5 )
(2 7 7 .8 )
(4 1 0 .1 )
F in a n c ia l in c o m e
D iv id e n d in c o m e
7.9
8.1
In te re s t in c o m e
9 .8
2 2 .2
17.7 N e t fin a n c in g c o s ts 1
3 0 .3
(2 6 0 .1 )
(3 7 9 .8 )
2014 5 2 w ee ks $m
2013 5 3 w ee ks $m
Weighted average capitalisation rate on funds borrowed generally: 7.26% (2013: 7.93%)
4 A U D IT O R S ' R E M U N E R A T IO N
A u d it o r s o f t h e p a r e n t e n t it y - D e l o i t t e T o u c h e T o h m a t s u A u s t r a lia
A u d it o r re v ie w o f th e fin a n c ia l r e p o r t
2 .5 6 9
2 .3 2 6
R e g u la to ry a n d c o m p lia n c e re la te d s e rv ic e s
0 .4 6 3
0 .0 9 0
O th e r n o n - a u d it re la te d s e rv ic e s '
1 .5 4 9
0 .4 5 1
T a x c o m p lia n c e s e rv ic e s
0 .0 2 2
0 .0 6 4
T o t a l a u d it o r s ' r e m u n e r a t io n
4 .6 0 3
2.931
0.2 7 1
0 .1 7 4
O t h e r a u d it o r s 2
A u d it o r re v ie w o f th e fin a n c ia l r e p o r t
0 .0 8 0
-
T o t a l o t h e r a u d it o r s ' r e m u n e r a t io n
0.3 5 1
0 .1 7 4
T o t a l a u d it o r s ' r e m u n e r a t io n
4 .9 5 4
3 .1 0 5
T a x c o m p lia n c e s e rv ic e s
1 2
Other non-audit related services comprise assistance on various accounting matters, assurance services in relation to debt raisings, regulatory reviews, financial due diligence and other sundry services Other auditors include international associates of Deloitte Touche Tohmatsu Australia
W oolw orths Lim ited A nnual Report 2014 page 116
Appendix: W oolw orths Lim ited A nnual Report 2014
709
5 IN C O M E T A X E S 2014 5 2 w ee ks $m
2013 5 3 w ee ks 5m
1,130 .0
9 6 5 .7
(a ) Incom e tax recognised in th e consolidated incom e sta tem e n t Incom e ta x expense comprises: C u rre n t ta x e x p e n s e A d ju s tm e n ts re c o g n is e d in th e c u r r e n t y e a r in re la tio n to th e c u r r e n t ta x o f p r io r y e a rs D e fe rre d ta x re la tin g to th e o rig in a tio n a n d re v e rs a l o f t e m p o r a r y d iffe re n c e s
Total incom e ta x expense
1 0 .2
6 .9
(8 3 .5 )
(1 0 .5 )
1 ,0 5 6 .7
9 6 2.1
Incom e ta x expense is a ttrib u ta b le to: 1 ,0 5 6 .7
9 5 9 .9
P ro fit fr o m d is c o n tin u e d o p e ra tio n s b e fo re lo s s o n re -m e a s u re m e n t
-
0 .2
P ro fit o n s a le o f s u b s id ia rie s
-
2 .0
1 ,0 5 6 .7
9 6 2.1
P ro fit fr o m c o n tin u in g o p e ra tio n s
Total incom e ta x expense N u m e r ic a l r e c o n c ilia t io n b e t w e e n t a x e x p e n s e a n d p r e - t a x n e t p r o f i t
T h e p rim a fa c ie in c o m e ta x e x p e n s e o n p re -ta x a c c o u n tin g p r o f it fr o m o p e ra tio n s re c o n c ile s to th e in c o m e ta x e x p e n s e in th e fin a n c ia l s ta te m e n ts as fo llo w s : 2014 5 2 w ee ks 5m
2013 5 3 w eeks $m
3,515.1
3 ,2 1 4 .8
P ro fit b e fo re in c o m e ta x e x p e n s e - d is c o n tin u e d o p e ra tio n s b e fo re lo s s o n re -m e a s u re m e n t
-
2 .0
P ro fit o n sa le o f s u b s id ia rie s
-
9 .9
3,515.1
3 ,2 2 6 .7
1 ,0 5 4 .5
9 6 8 .0
N o n - d e d u c tib le e x p e n s e s
18 .6
1 9 .0
Im p a c t o f d iffe re n c e s in o ffs h o re ta x ra te s
(11.2)
(9 .5 )
P ro fit b e fo re in c o m e ta x e x p e n s e - c o n tin u in g o p e ra tio n s
In c o m e ta x u s in g th e d o m e s tic c o rp o r a tio n ta x ra te o f 3 0 % (2 0 1 3 : 3 0 % ) T a x e ffe c t o f a m o u n ts w h ic h a re n o t d e d u c tib le ( ta x a b le ) in c a lc u la tin g ta x a b le in c o m e :
E x e m p t d iv id e n d in c o m e O th e r
(1 .4 )
(1 .6 )
(1 4 .0 )
( 2 0 .7 )
1 ,0 4 6 .5 U n d e r p ro v id e d in p r io r y e a rs
Incom e ta x expense
9 5 5 .2
1 0 .2
6 .9
1 ,0 5 6 .7
9 6 2.1
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710
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 5 IN C O M E T A X E S C O N T IN U E D 2014 52 weeks $m
2013 53 weeks 5m
(b ) Incom e ta x recognised in oth e r com prehensive incom e T h e fo llo w in g c u r r e n t a n d d e fe rre d a m o u n ts w e re c h a r g e d / f c r e d ite d ) to o th e r c o m p re h e n s iv e in c o m e d u r in g th e p e rio d :
C urrent tax liability T ra n s a c tio n s c h a rg e d to fo re ig n c u r r e n c y tra n s la tio n re s e rv e
1.0
T ra n s a c tio n s c r e d ite d to re m u n e ra tio n re s e rv e
(9.1)
(2 3 .9 )
(8 .1 )
(2 3 .9 )
D eferred tax C a sh flo w h e d g e s T ra n s a c tio n s c h a rg e d to fo re ig n c u rr e n c y tra n s la tio n re s e rv e A c tu a r ia l m o v e m e n ts o n d e fin e d b e n e fit p la n s
(2 7 .7 ) 34.1
7 .4 2 4 .7
6 .9
3 .8
13.3
3 5 .9
(c ) C u rre n t ta x a ssets and lia b ilitie s T h e c u r r e n t ta x lia b ility fo r th e c o n s o lid a te d e n t it y o f $ 1 5 8 .9 m illio n (2 0 1 3 : $ 1 9 3 .2 m illio n ) re p re s e n ts th e a m o u n t o f in c o m e ta x e s p a y a b le in re s p e c t o f c u r r e n t a n d p r io r fin a n c ia l p e rio d s . In a c c o rd a n c e w ith th e ta x c o n s o lid a tio n le g is la tio n , W o o lw o r t h s L im ite d , a s th e h e a d e n t it y o f th e A u s tra lia n ta x c o n s o lid a te d g ro u p h a s a s s u m e d th e c u r r e n t ta x lia b ilitie s o f th e m e m b e rs in th e ta x c o n s o lid a te d g ro u p .
2014 $m
2013 $m
(d ) D eferred tax balances D eferred tax assets comprise: T a x lo s s e s - re v e n u e
12 6.3
77.1
T e m p o r a r y d iffe re n c e s
5 5 5 .5
5 4 1 .3
6 8 1 .8
6 1 8 .4
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Appendix: W oolw orths Lim ited A nnual Report 2014
711
T a x a b le a n d d e d u c tib le d iffe re n c e s a ris e fr o m th e fo llo w in g :
2014
O p e n in g Balance $m
C re d ite d / (C h a rg e d )to incom e $m
C re d ite d / (C h a rg e d ) to O C I $m
A cq u isitio n s $m
C losing B alance $m
G ro s s d e f e r r e d t a x a s s e ts
P ro p e r ty p la n t a n d e q u ip m e n t
7 6 .9
3 .5
P ro v is io n s a n d a c c ru a ls
491.1
2 7 .4
15.3
(0 .2 )
27.7
-
4 2 .8
7.3
0 .2
( 3 4 .7 )
-
(2 7 .2 )
R e c o g n is e d ta x lo s s e s
77.1
4 9 .2
-
-
1 2 6 .3
O th e r
6 .3
0 .2
-
0 .4
0 .3
7 3 4 .6
C a sh f lo w h e d g e s U n re a lis e d fo re ig n e x c h a n g e d iffe re n c e s
6 7 4 .0
(6.1) 7 4 .0
(6 .9 )
(1 3 .7 )
(1 .0 )
7 9 .4
1.3
5 1 2.9
G r o s s d e f e r r e d t a x lia b ilitie s
In ta n g ib le a s s e ts P re p a y m e n ts O th e r
(1 4 .0 ) 0 .2
-
( 3 8 .7 )
9 .3
0 .4
(5 5 .6 )
2013
(1 4 .0 )
(2 .9 )
9 .5
6 1 8 .4
8 3 .5
O p e n in g Balance $m
C re d ite d / (C h a rg e d )to incom e $m
(7.1)
0 .4
(7 .1 )
(1 3 .3 )
(6 .8 )
C re d ite d / (C h a rg e d ) to O C I $m
A cq u isitio n s $m
(2 .7 ) (3 6 .1 ) (5 2 .8 ) 6 8 1 .8
C losing B alance $m
G ro s s d e f e r r e d t a x a s s e ts
P ro p e r ty p la n t a n d e q u ip m e n t P ro v is io n s a n d a c c ru a ls
117.4
(4 0 .3 )
4 9 2 .7
(2 .6 )
(0 .2 )
7 6 .9
( 3 .2 )
4 .2
491.1
C a sh f lo w h e d g e s
2 2 .7
-
(7 .4 )
-
15.3
U n re a lis e d fo re ig n e x c h a n g e d iffe re n c e s
2 9 .8
2 .7
( 2 5 .2 )
-
7.3
R e c o g n is e d ta x lo s s e s
2 6 .2
5 0 .9
-
77.1
O th e r
13.6 7 0 2 .4
(7 .2 ) 3 .5
(0 .1 )
-
6 .3
(3 5 .9 )
4 .0
6 7 4 .0
G ro s s d e f e r r e d t a x lia b ilitie s
In ta n g ib le a s s e ts P re p a y m e n ts O th e r
(1 4 .0 )
(1 4 .0 )
( 3 .8 )
0 .9
-
(3 9 .9 )
6.1
-
(5 7 .7 ) 6 4 4 .7
7 .0 1 0 .5
(3 5 .9 )
(4 .9 )
(2 .9 ) ( 3 8 .7 )
(4 .9 )
(5 5 .6 )
(0 .9 )
6 1 8 .4
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 6 D IV ID E N D S 2014
C en ts per share
T o tal a m o u n t $m
Franked
D a te o f paym ent
In te rim 2 0 1 4 o r d in a ry
65
8 1 5 .6
100%
24 A p r 2014
F ina l 2 0 1 3 o r d in a r y
71
8 8 8 .2
100%
11 O c t 2 0 1 3
136
1 , 7 0 3 .8
C ents per share
T o tal a m o u n t $m
Franked
D a te o f paym ent
In te rim 2 0 1 3 o rd in a ry
62
7 7 0 .6
100%
2 6 A p r 2013
F ina l 2 0 1 2 o r d in a r y
67
8 2 6 .9
100%
12 O c t 2 0 1 2
129
1 ,5 9 7 .5
T o ta l
2013
T o ta l
A ll d iv id e n d s a re f u lly fra n k e d a t a 3 0 % ra te . O n 2 9 A u g u s t 2 0 1 4 , th e B o a rd o f D ir e c to rs d e te r m in e d a fin a l d iv id e n d in re s p e c t o f th e 2 0 1 4 y e a r o f 7 2 c e n ts (2 0 1 3 : 71 c e n ts ) p e r s h a re 1 0 0 % fra n k e d a t a 3 0 % ta x ra te . T h e a m o u n t th a t w ill b e p a id o n 10 O c to b e r 2 0 1 4 (2 0 1 3 :1 1 O c to b e r 2 0 1 3 ) is e x p e c te d to be $ 9 0 7 .1 m illio n (2 0 1 3 : $ 8 8 8 . 2 m illio n ) . A s th e d iv id e n d w a s d e c la re d s u b s e q u e n t to 2 9 Ju n e 2 0 1 4 , n o p ro v is io n h a s b e e n m a d e as a t 2 9 Ju n e 2 0 1 4 .
D ivid en d R e in ves tm en t Plan (D R P ) U n d e r th e te r m s a n d c o n d itio n s o f th e DRP, e lig ib le s h a re h o ld e rs m a y e le c t to p a r tic ip a te in th e D R P in re s p e c t o f a ll o r p a r t o f th e ir s h a re h o ld in g , s u b je c t to a n y m a x im u m a n d /o r m in im u m n u m b e r o f s h a re s to p a r tic ip a te in th e D R P th a t th e D ir e c to rs m a y s p e c ify . T h e re is c u r r e n tly n o m in im u m n u m b e r o f s h a re s w h ic h a s h a re h o ld e r m a y d e s ig n a te as p a r tic ip a tin g in th e DRP. T h e m a x im u m n u m b e r o f s h a re s w h ic h a s h a re h o ld e r ( o th e r th a n b ro k e r's n o m in e e s a n d c e rta in tr u s te e s ) m a y d e s ig n a te as p a r tic ip a tin g in th e D R P is 2 0 , 0 0 0 .
Franked divid en d s 2014 $m
2013 $m
2 ,2 4 9 .5
1 ,9 4 3 .0
T h e fra n k e d p o r tio n s o f th e d iv id e n d s p ro p o s e d a s a t 2 9 Ju n e 2 0 1 4 w ill b e fra n k e d o u t o f e x is tin g fra n k in g c r e d its o r o u t o f fra n k e d c r e d its a ris in g fr o m th e p a y m e n t o f in c o m e ta x in th e p e rio d e n d e d 2 8 Ju n e 2 0 1 5 . F ra n k in g c r e d its a v a ila b le fo r th e s u b s e q u e n t fin a n c ia l y e a r 3 0 % (2 0 1 3 : 3 0 % )
T h e a b o v e a m o u n ts re p re s e n t th e b a la n c e s o f th e fra n k in g a c c o u n ts as a t th e e n d o f th e fin a n c ia l p e rio d , a d ju s te d fo r: (a ) F ra n k in g c r e d its th a t w ill a ris e fr o m th e p a y m e n t o f in c o m e ta x p a y a b le a t th e e n d o f th e fin a n c ia l p e rio d ; a n d (b ) F ra n k in g d e b its th a t w ill a ris e fr o m th e p a y m e n t o f d iv id e n d s p ro v id e d a t th e e n d o f th e fin a n c ia l p e rio d . F ra n k in g a c c o u n ts a re p re s e n te d o n a ta x p a id b a sis. T h e fra n k in g a c c o u n t b a la n c e s r e p o rte d f o r th e G ro u p a re in c lu s iv e o f $ 1 0 2 .4 m illio n (2 0 1 3 : $ 8 4 .5 m illio n ) a ttr ib u ta b le to th e n o n c o n tr o llin g in te re s t h o ld e rs .
W oolw orths Lim ited A nnual Report 2014 page 120
Appendix: W oolw orths Lim ited A nnual Report 2014
7
713
S E G M E N T D IS C LO S U R E S
T h e G ro u p h a s fiv e r e p o rta b le s e g m e n ts re la te d to c o n tin u in g o p e ra tio n s . T h e s e b u s in e s s u n its o ffe r d iffe r e n t p ro d u c ts a n d s e rv ic e s a n d a re m a n a g e d s e p a ra te ly b e c a u s e th e y re q u ire d iffe r e n t te c h n o lo g y a n d m a r k e tin g s tra te g ie s . T h e G ro u p 's re p o r ta b le s e g m e n ts a re as fo llo w s :
•
A u stra lian Food, Liquor and Petrol - p ro c u re m e n t o f fo o d a n d liq u o r a n d p e tro le u m p r o d u c ts f o r re s a le to c u s to m e rs in A u s tra lia
■ N e w Z ealan d S u p e rm ark ets - p r o c u re m e n t o f fo o d a n d liq u o r p ro d u c ts fo r re s a le to c u s to m e rs in N e w Z e a la n d •
G eneral M e rc h a n d is e - p r o c u re m e n t o f d is c o u n t g e n e ra l m e rc h a n d is e p ro d u c ts fo r re s a le to c u s to m e rs p re d o m in a n tly in A u s tra lia
■ H o tels - p ro v is io n o f le is u re a n d h o s p ita lity s e rv ic e s in c lu d in g fo o d a n d a lc o h o l, a c c o m m o d a tio n , e n te r ta in m e n t a n d g a m in g ■ H o m e Im p ro v e m e n t - p ro c u re m e n t o f h o m e im p r o v e m e n t p ro d u c ts fo r re s a le to c u s to m e rs in A u s tra lia T h e U n a llo c a te d g ro u p c o n s is ts o f th e G ro u p 's o th e r o p e ra tin g s e g m e n ts th a t a re n o t s e p a ra te ly r e p o rta b le as w e ll as v a rio u s s u p p o r t fu n c tio n s in c lu d in g p r o p e r ty a n d h e a d o ffic e c o s ts . D is c o n tin u e d o p e ra tio n s re p re s e n ts th e C o n s u m e r E le c tro n ic s s e g m e n t, w h ic h w a s th e p r o c u re m e n t o f e le c tr o n ic p r o d u c ts fo r re s a le to c u s to m e rs in A u s tra lia a n d N e w Z e a la n d a n d a w h o le s a le b u s in e s s in In d ia . T h e re a re v a ry in g le v e ls o f in te g ra tio n b e tw e e n th e A u s tra lia n F o o d , L iq u o r a n d P e tro l a n d H o te ls re p o r ta b le s e g m e n ts . T h is in c lu d e s th e c o m m o n u sa g e o f p r o p e r ty a n d s e rv ic e s , a n d s o m e c o m m o n a d m in is tr a tio n fu n c tio n s . T h e a c c o u n tin g p o lic ie s o f th e re p o rta b le s e g m e n ts a re th e s a m e as d e s c rib e d in N o te 1. P e rfo rm a n c e is m e a s u re d b a s e d o n s e g m e n t e a rn in g s b e fo re in te re s t a n d ta x (E B IT ). S e g m e n t E BIT is m e a s u re d a s m a n a g e m e n t b e lie v e s th a t s u c h in fo r m a tio n is u s e fu l in e v a lu a tin g th e re s u lts o f c e rta in s e g m e n ts re la tiv e to o th e r e n titie s th a t o p e ra te w ith in th e s e in d u s trie s . In te r-s e g m e n t p ric in g is d e te r m in e d o n an a rm 's le n g th b a sis.
G eo g rap h ical in fo rm a tio n T h e G ro u p o p e ra te s p r e d o m in a n tly in t w o p rin c ip a l g e o g ra p h ic a l a re a s - A u s tra lia a n d N e w Z e a la n d .
A u s tra lia
T o ta l C o n tin u in g O p e ra tio n s
N e w Z e a la n d
D is c o n tin u e d O p e ra tio n s 1
C o n s o lid a te d
2014 $A m
2013 (A n
2014 (A m
2013 (A m
5 9 ,1 5 8 .0
2014 $A m
2013 $A m
2014 $A m
2013 $A m
2014 JA m
2013 $A m
5 5 ,5 8 7 .3
5 3 ,9 1 6 .7
5 ,1 8 5 .5
4 ,5 9 9 .7
6 0 ,7 7 2 .8
5 8 ,5 1 6 .4
6 4 1 .6
6 0 ,7 7 2 .8
171.8
1 4 9 .9
7.6
7.8
1 7 9 .4
157.7
-
-
1 7 9 .4
157.7
2 0 5 .5
2 1 7 .4
3 7 .2
3 0 .2
2 4 2 .7
2 4 7 .6
-
0 .3
2 4 2 .7
2 4 7 .9
5 5 ,9 6 4 .6 5 4 ,2 8 4 .0
5 ,2 3 0 .3
4 ,6 3 7 .7
61,194.9
5 8 ,9 2 1 .7
_
6 4 1 .9
61,194.9
5 9 ,5 6 3 .6
3 ,5 6 9 .7
2 ,9 0 9 .8
16,217.1
15 ,21 7 .0
-
-
16,217.1
1 5 ,21 7 .0
Segm ent disclosures G eographical segm ents S ale s to c u s to m e rs O th e r o p e ra tin g re v e n u e O th e r re v e n u e
Revenue fro m extern al cu stom ers N o n - c u r r e n t a s s e ts 2 1 2
1 2 ,6 4 7 .4
1 2 ,3 0 7 .2
Discontinued operations is comprised of Consumer Electronics Australia, New Zealand and India Geographical non-current assets exclude financial instruments (fair value derivatives), deferred tax assets and intercompany receivables
M a jo r cu sto m ers R e v e n u e s fr o m n o o n e s in g le c u s to m e r a m o u n te d to g re a te r th a n 1 0 % o f th e G ro u p 's re v e n u e s in th e c u r r e n t o r p r io r p e rio d .
W oolw orths Lim ited A nnual Report 2014 page 121
714
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 7
S E G M E N T D IS C LO S U R E S C O N T IN U E D A u s tra lia n Food, L iq u o r & P e tro l1
N e w Z e a la n d S u p e rm a rk e ts
G e n e ra l M e rc h a n d is e 2345
FY14 $A m
FY13 $A m
FY14 $A m
FY13 $A m
FY14 $A m
FY13 $A m
4 8 ,2 3 5 .9
4 6 ,8 2 5 .1
5 ,1 8 5 .5
4 ,5 9 9 .7
4 ,3 5 1 .8
4 ,3 8 3 .4
171.8
1 4 9 .9
7.6
7.8
-
-
-
-
-
-
-
-
4 8 ,4 0 7 .7
4 6 ,9 7 5 .0
5,193.1
4 ,6 0 7 .5
4 ,3 5 1 .8
4 ,3 8 3 .4
4 8 ,4 0 7 .7
4 6 ,9 7 5 .0
5,193.1
4 ,6 0 7 .5
4 ,3 5 1 .8
4 ,3 8 3 .4
3 ,3 6 8 .0
3,199 .3
2 7 1 .4
2 3 6 .2
15 2.9
191.3
S e g m e n t d e p re c ia tio n a n d a m o r tis a tio n
5 7 9 .7
5 7 4 .8
9 6 .3
8 6 .0
9 4 .0
9 3 .5
C a p ita l e x p e n d itu re 7
7 8 9 .3
7 1 4 .2
140.1
12 9.2
3 6 3 .0
57 .6
Segm ent disclosures Business segm ents S a le s to c u s to m e rs O th e r o p e ra tin g re v e n u e In te r-s e g m e n t re v e n u e
S eg m ent revenue E lim in a tio n s U n a llo c a te d re v e n u e 6
Total revenue S eg m ent earnings be fo re in te re s t and tax L o ss o n S C A G ro u p p r o p e r ty tra n s a c tio n P ro fit o n s a le o f s u b s id ia rie s V ic to r ia n tr a n s p o r t f le e t re d u n d a n c y c o s ts
Earnings be fo re in te re s t and ta x N e t fin a n c in g c o s t
P rofit b e fo re incom e ta x expense Incom e ta x expense P rofit a fte r incom e ta x expense
1 2 3 4 5 6 7
Australian Food, Liquor and Petrol is comprised of supermarket and liquor stores, wholesale food and liquor in Australia, and petrol canopies. Petrol was previously disclosed as a separate segment. The 2013 comparative has been restated accordingly General Merchandise includes BIG W and EziBuy Hotels is comprised of on-premise liquor sales, food, accommodation, gaming and venue hire Unallocated is comprised of corporate head office and the property division Discontinued operations is comprised of Consumer Electronics Australia, New Zealand and India Unallocated revenue is comprised of rent and other revenue from operating activities across the Group Capital expenditure is comprised of property, plant and equipment and intangible asset additions
W oolw orths Lim ited Annual Report 2014 page 122
Appendix: W oolw orths Lim ited A nnual Report 2014
H o te ls 3
Hom e Im p ro v e m e n t
U n a llo c a te d 4
T o ta l C o n tin u in g O p e ra tio n s
FY14 $A m
FY13 $A m
FY14 $A m
FY13 $A m
FY14 $A m
FY13 $A m
1 ,4 7 2 .2
1 ,4 6 8 .9
1 ,5 2 7 .4
1 ,2 3 9 .3
-
-
-
-
-
-
-
-
-
-
7 8 1 .0
1 ,4 7 2 .2
1 ,4 6 8 .9
1,527.4
1,239.3
1 ,4 7 2 .2
1 ,4 6 8 .9
2 7 5 .4
2 6 3 .7
1,527.4 (1 6 9 .0 )
1,239.3 (1 3 8 .9 )
715
D is c o n tin u e d O p e ra tio n s 5
C o n s o lid a te d
FY14 $A m
FY13 $A m
FY14 $A m
FY13 $A m
5 9 ,1 5 8 .0
FY14 $A m
FY13 $A m
6 0 ,7 7 2 .8
5 8 ,5 1 6 .4
6 4 1 .6
6 0 ,7 7 2 .8
179.4
157.7
-
-
179.4
157.7
6 5 4 .1
7 81.0
6 5 4 .1
-
0 .2
7 81.0
6 5 4 .3
61,733.2
5 9 ,3 2 8 .2
-
6 4 1 .8
61,733.2
5 9 ,9 7 0 .0
7 8 1 .0
654.1
(7 8 1 .0 )
(6 5 4 .1 )
(7 8 1 .0 )
(6 5 4 .1 )
-
( 0 .2 )
(7 8 1 .0 )
2 4 2 .7
2 4 7 .6
2 4 2 .7
2 4 7 .6
-
0 .3
2 4 2 .7
2 4 7 .9
2 4 2 .7
2 4 7 .6
61,194.9
58,92 1 .7
-
641.9
61,194.9
5 9 ,5 6 3 .6
(1 2 3 .5 )
(9 8 .4 )
3 ,7 7 5 .2
3 ,6 5 3 .2
_
3 ,6 5 5 .7
3 ,7 7 5 .2 (2 6 0 .1 ) 3,515.1
( 3 2 .8 ) -
( 2 5 .8 ) 3 ,5 9 4 .6
(3 7 9 .8 ) 3 ,2 1 4 .8
2 .5
3 ,7 7 5 .2
-
-
-
-
9 .9
-
-
-
-
-
12.4
3 ,7 7 5 .2
-
( 0 .5 )
(2 6 0 .1 )
-
11.9
3,515.1
-
(2 .2 )
(1 ,0 5 6 .7 )
2 ,4 5 8 .4
2 ,2 5 4 .9
-
9.7
2 ,4 5 8 .4
(1 ,0 5 6 .7 )
(9 5 9 .9 )
( 6 5 4 .3 )
( 3 2 .8 ) 9 .9 ( 2 5 .8 ) 3 ,6 0 7 .0
(3 8 0 .3 ) 3 ,2 2 6 .7 (9 6 2 .1 ) 2 ,2 6 4 .6
101.2
9 8 .3
5 8 .3
4 0 .3
6 6 .8
7 2 .6
9 9 6 .3
9 6 5 .5
-
-
9 9 6 .3
9 6 5 .5
138.3
522.1
3 5 2 .2
4 1 8 .4
5 1 0 .0
531.4
2 ,2 9 2 .9
2 ,3 7 2 .9
-
2 .6
2 ,2 9 2 .9
2 ,3 7 5 .5
W oolw orths Lim ited A nnual Report 2014 page 123
716
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 8 T R A D E A N D O T H E R R EC EIVABLES 2014 $m
2013 $m
C urrent T ra d e re c e iv a b le s
2 4 7 .6
2 3 4 .2
O th e r re c e iv a b le s
369.1
4 6 4 .3
P re p a y m e n ts
3 0 9 .0
2 7 0.1
9 2 5 .7
9 6 8 .6
P re p a y m e n ts
13.2
16.1
O th e r re c e iv a b le s
9 5 .0
0 .5
1 0 8 .2
1 6 .6
N on-cu rrent
T ra d e a n d o th e r re c e iv a b le s a re p re s e n te d n e t o f im p a ir m e n t a llo w a n c e . Im p a ir m e n t p ro v is io n b a la n c e as a t 2 9 Ju n e 2 0 1 4 w a s $ 1 7.8 m illio n (2 0 1 3 : $ 1 4 .8 m illio n ) . A ll re c o v e ry ris k h a s b e e n p ro v id e d f o r in th e b a la n c e s h e e t.
9 IN V E N T O R IE S 2014 $m
2013 $m
4 ,6 9 3 .2
4 ,2 0 5 .4
4 ,6 9 3 .2
4 ,2 0 5 .4
2014 $m
2013 $m
C urrent In v e n to rie s
C o s t o f s a le s re c o rd e d d u r in g th e p e rio d w a s $ 4 4 ,4 7 4 . 6 m illio n (F Y 1 3 : $ 4 2 ,9 1 2 .6 m illio n ) .
1 0 O T H E R F IN A N C IA L A S S E TS
C urrent A t fa ir v a lu e Fair v a lu e d e riv a tiv e s C ro s s c u rr e n c y s w a p s F o rw a rd e x c h a n g e c o n tr a c ts
1 2 .4
1 4 .8
0 .3
3 9 .4
12.7
5 4 .2
N on-cu rrent A t fa ir v a lu e F air v a lu e d e riv a tiv e s
131.5
1 8 8 .7
L is te d e q u ity s e c u ritie s
137.7
137.9
In v e s tm e n t in a s s o c ia te s
3 4 .8
3 1 .4
C ro s s c u rr e n c y s w a p s
O th e r
0 .7
0 .7
3 0 4 .7
3 5 8 .7
W oolw orths Lim ited Annual Report 2014 page 124
Appendix: W oolw orths Lim ited A nnual Report 2014
717
11 P R O P E R T Y , P L A N T A N D E Q U IP M E N T 2014 $m
2013 $m
Non-current D e v e lo p m e n t p r o p e rtie s A t cost Less: A c c u m u la te d d e p re c ia tio n
1,163.7 (1.7) 1,162.0
1 ,3 0 2 .3 (1 .6 ) 1 ,3 0 0 .7
F re e h o ld la n d , w a re h o u s e , re ta il a n d o th e r p r o p e rtie s A t cost Less: A c c u m u la te d d e p re c ia tio n
2,159.2 (123.3) 2,035.9
2 ,1 2 4 .3 (1 2 8 .6 ) 1 ,9 9 5 .7
L e a s e h o ld im p ro v e m e n ts A t cost Less: A c c u m u la te d a m o r tis a tio n
2,968.0 (1,220.7) 1,747.3
(1 ,0 6 7 .4 )
12,725.1 (8,069.6) 4,655.5
( 7 ,3 3 9 .6 )
9,600.7
9 ,2 4 6 .1
2 ,7 2 9 .7
1 ,6 6 2 .3
P la n t a n d e q u ip m e n t A t cost Less: A c c u m u la te d d e p re c ia tio n
Total property, plant and equipment - net book value
1 1 ,62 7 .0
4 ,2 8 7 .4
W oolw orths Lim ited A nnual Report 2014 page 125
718
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 11 P R O P E R T Y , P L A N T A N D E Q U IP M E N T C O N T IN U E D T o ta l p ro p e rty , p la n t and e q u ip m e n t - n e t book v a lu e A n a s s e s s m e n t as to th e c a rr y in g v a lu e o f W o o lw o r t h s o w n e d p r o p e rtie s as a t 2 9 Ju n e 2 0 1 4 w a s p e rfo rm e d . T h e b a s is o f th e a s s e s s m e n t w a s a c o m b in a tio n o f e x te rn a l m a rk e t a s s e s s m e n ts a n d /o r v a lu a tio n s a n d W o o lw o r t h s ' p r o p e r ty g ro u p a s s e s s m e n ts b a s e d o n v a lu e in use. E x te rn a l v a lu a tio n s a re o b ta in e d e v e ry th re e y e a rs . B ase d o n th e m o s t re c e n t a s s e s s m e n ts , a n im p a ir m e n t p ro v is io n o f $ 8 4 .6 m illio n (2 0 1 3 : $ 7 8 .9 m illio n ) is h e ld as a t 2 9 J u n e 2 0 1 4 .
R econciliatio n o f m o v em en ts in p ro p e rty , p la n t an d eq u ip m e n t
2014 C a rry in g a m o u n t a t s ta r t o f p e rio d A d d itio n s (e x c lu d in g a d d itio n s a ris in g fro m a c q u is itio n o f b u s in e s s e s ) A d d itio n s a ris in g fr o m a c q u is itio n o f b u s in e s s e s
Freehold land, warehouse, Development retail and other properties properties $m $m
Leasehold improvements $m
Plant and equipment $m
Total $m
1 ,3 0 0 .7
1 ,9 9 5 .7
1 ,6 6 2 .3
4 ,2 8 7 .4
9 ,2 4 6 .1
4 8 5 .5
8 2 .6
2 2 0 .5
1 ,1 20 .8
1 ,9 0 9 .4
-
-
3.1
1 3 .4
( 3 .5 )
(1 9 .6 )
(1 6 3 .4 )
1 6 .5
D is p o s a ls
( 3 4 .7 )
(1 0 5 .6 )
T ra n s fe r to a s s e ts h e ld fo r sa le
( 7 0 .9 )
(4 7 1 .0 )
( 3 .5 )
(1 5 .4 )
(5 6 0 .8 )
( 0 .3 )
(4 1 .2 )
(1 5 1 .3 )
( 7 8 2 .7 )
( 9 7 5 .5 )
D e p r e c ia tio n /a m o r tis a tio n e x p e n s e T ra n s fe rs a n d o th e r E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
C arryin g a m o u n t a t end o f period
2013 C a rry in g a m o u n t a t s ta r t o f p e rio d A d d itio n s (e x c lu d in g a d d itio n s a ris in g fro m a c q u is itio n o f b u s in e s s e s ) A d d itio n s a ris in g fr o m a c q u is itio n o f b u s in e s s e s D is p o s a ls T ra n s fe r to a s s e ts h e ld fo r sa le D e p r e c ia tio n /a m o r tis a tio n e x p e n s e T ra n s fe rs a n d o th e r E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
C arryin g a m o u n t a t end o f period
(5 3 2 .7 )
5 6 7 .4
6 .9
8 .0
1 4 .4
8 .0
12.8
4 3 .6
7 8 .8
1,162.0
2 ,0 3 5 .9
1,747.3
4 ,6 5 5 .5
9 ,6 0 0 .7
Freehold land, warehouse, Development retail and other properties properties $m $m
4 9 .6
Leasehold improvements $m
Plant and equipment $m
Total $m
1 ,4 0 8 .4
2 ,7 0 0 .2
1 ,3 5 3 .3
4,127.1
9 ,5 8 9 .0
6 9 9 .7
9 9 .2
2 2 6 .7
9 2 4 .6
1 ,9 5 0 .2
-
13.9
0 .5
1 5 .4
( 4 .2 )
( 7 2 .4 )
(4 3 7 .2 )
( 8 8 2 .4 )
2 9 .8 (1 ,3 9 6 .2 )
(2 6 .1 )
( 4 3 .5 )
( 0 .5 )
(2 .3 )
( 7 2 .4 )
( 2 .4 )
( 4 4 .9 )
(1 3 8 .1 )
(7 6 2 .9 )
(9 4 8 .3 )
1 4 6 .6
2 1 5 .9
2 7 .3
3 7 .5
1 0 .6
6 .6
8 .7
3 0 .6
5 6 .5
1 ,3 0 0 .7
1 ,9 9 5 .7
1 ,6 6 2 .3
4 ,2 8 7 .4
9,2 4 6 .1
(3 5 2 .3 )
W oolw orths Lim ited Annual Report 2014 page 126
Appendix: W oolw orths Lim ited A nnual Report 2014
719
12 IN T A N G IB L E A S S E TS
2014 G o o d w ill B ra n d n a m e s L iq u o r, p e tro l a n d g a m in g lic e n c e s O th e r
Total
2013
$m
$m
3,882.4 279.1 2,073.1 100.4 6,335.0
3 ,4 0 0 .9 2 4 2 .9 2 ,0 6 5 .8 7 4 .7 5 ,7 8 4 .3
R econciliatio n o f m o v em en ts in in ta n g ib le assets
Brand names Sm
Liquor, petrol and gaming licences $m
Other Sm
Total intangibles Sm
3,400.9
242.9
2,065.8
74.7
5,784.3
274.1
2 0 .0
2 0 .0
2 7 .9
3 4 2 .0
-
0 .6
1 0 .0
-
1 0 .6
-
-
(3 .3 )
2014
Goodwill $m
C a rry in g a m o u n t a t s t a r t o f p e rio d A d d itio n s a ris in g fr o m a c q u is itio n o f b u s in e s s e s O th e r a c q u is itio n s D is p o s a ls
(3 .3 )
-
T ra n s fe rs a n d o th e r
( 0 .8 )
-
( 5 .5 )
-
-
(1 7 .2 )
211.5
1 5 .6
-
1.4
2 2 8 .5
3,882.4
279.1
2,073.1
100.4
6,335.0
2013
Goodwill $m
Brand names Sm
Liquor, petrol and gaming licences $m
Other Sm
Total intangibles Sm
C a rry in g a m o u n t a t s t a r t o f p e rio d
3,221.8
231.4
1,758.1
70.7
5,282.0
4 5 .9
-
1 5 3 .2
5 .3
2 0 4 .4
-
1.5
174.1
-
1 7 5 .6
-
-
( 0 .5 )
-
(3 .7 )
A m o r tis a tio n E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
C arryin g am o u n t a t end o f period
A d d itio n s a ris in g fr o m a c q u is itio n o f b u s in e s s e s O th e r a c q u is itio n s D is p o s a ls T ra n s fe rs a n d o th e r A m o r tis a tio n E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
C arryin g am o u n t a t end o f period
(0 .5 ) -
-
(3 .7 ) (1 5 .9 )
( 3 .6 )
(6 .3 ) (2 0 .8 )
-
-
1 3 3 .7
1 0 .0
-
(1 .3 ) -
1 4 3 .7
(1 7 .2 )
3,400.9
242.9
2,065.8
74.7
5,784.3
K ey a s su m p tio n s used in im p a irm e n t calcu lation s G o o d w ill a n d in ta n g ib le a s s e ts w it h in d e fin ite liv e s a re te s te d fo r im p a ir m e n t a n n u a lly a n d w h e n e v e r th e re is an in d ic a tio n th a t th e a s s e t m a y b e im p a ire d . A n im p a ir m e n t lo s s is re c o g n is e d w h e n e v e r th e c a rr y in g a m o u n t e x c e e d s th e re c o v e ra b le a m o u n t. T h e re c o v e ra b le a m o u n t o f th e a s s e t is th e h ig h e r o f its fa ir v a lu e le s s c o s ts to d is p o s e a n d its v a lu e in use. T h e re c o v e ra b le a m o u n t is a s s e s s e d a t th e ca s h g e n e r a tin g u n it (" C G U " ) le v e l, w h ic h is th e s m a lle s t g ro u p o f a s s e ts g e n e r a tin g ca s h in flo w s in d e p e n d e n t o f o th e r C G U s th a t b e n e fit fr o m th e u se o f th e re s p e c tiv e in ta n g ib le a s s e t. W h e r e a v a lu e in u se ( " V I U " ) m o d e l h a s b e e n u s e d , th e ca s h flo w p r o je c tio n s a re b a s e d o n th e G ro u p 's la te s t in te rn a l fo re c a s ts re v ie w e d b y th e B o a rd . For th e p u rp o s e o f th e V IU c a lc u la tio n , th e s e fo re c a s ts h a v e b e e n a d ju s te d to e x c lu d e th e c o s ts a n d b e n e fits o f e x p a n s io n a ry c a p ita l a n d d o n o t e x c e e d fiv e y e a rs . In d e te r m in in g fa ir v a lu e le s s c o s ts to d is p o s e ( " F V L C D " ), th e ca s h flo w s a re b a s e d o n th e G ro u p 's la te s t s tr a te g ic p la n h a v in g re g a rd fo r a s s u m p tio n s a n d e s tim a te s s u c h as th e s to re ro ll o u t p la n , s to re g r o w th a n d t im in g o f th e b u s in e s s m a tu rity . T h e fo re c a s ts a re e x tra p o la te d b e y o n d th e s to re ro ll o u t p e rio d b a s e d o n an e s tim a te d lo n g te r m g r o w th ra te o f 3 % w h ic h ta k e s a c c o u n t o f th e s p e c ific fe a tu r e s o f e a c h b u s in e s s u n it. T h e c o m p a n y d o e s n o t b e lie v e th a t th is e x c e e d s in d u s tr y g r o w th ra te s fo r th e b u s in e s s in w h ic h th e ca s h g e n e r a tin g u n it o p e ra te s . In th is re g a rd , th e ca s h flo w p ro je c tio n s a re b a s e d o n a s s u m p tio n s t h a t w o u ld b e c o n s id e re d ty p ic a l f o r a m a r k e t p a rtic ip a n t.
W oolw orths Lim ited Annual Report 2014 page 127
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 12 IN T A N G IB L E A S S E TS C O N T IN U E D F o r b o th V IU a n d F V L C D m o d e ls , th e te rm in a l v a lu e g r o w th is b a s e d o n an e s tim a te d lo n g t e r m g r o w th ra te o f g e n e r a lly 3 % , a n d d o n o t e x c e e d in d u s tr y g r o w th ra te s f o r th e b u s in e s s in w h ic h th e ca s h g e n e r a tin g u n it o p e ra te s . T h e ca s h flo w s a re d is c o u n te d to p re s e n t v a lu e u s in g p re -ta x d is c o u n t ra te s b e tw e e n 1 3 % a n d 1 5 % (2 0 1 3 :1 3 % a n d 1 5 % ) d e p e n d in g o n th e n a tu re o f th e b u s in e s s a n d th e c o u n tr y o f o p e ra tio n . T h e ke y a s s u m p tio n s fo r a s s e s s in g th e re c o v e ra b le a m o u n ts o f A u s tra lia n F o o d , L iq u o r a n d P e tro l, N e w Z e a la n d S u p e rm a rk e ts a n d H o te ls , b e in g th e th re e s e g m e n ts f o r w h ic h th e G ro u p c o n s id e rs g o o d w ill a n d in d e fin ite life in ta n g ib le a s s e ts a re s ig n ific a n t in c o m p a ris o n to th e to ta l g o o d w ill a n d in d e fin ite life in ta n g ib le a s s e ts re fle c te d o n th e G ro u p 's b a la n c e s h e e t a re d is c u s s e d b e lo w . T h e H o m e Im p r o v e m e n t s e g m e n t d o e s n o t h a ve a s ig n ific a n t a m o u n t o f g o o d w ill o r in d e fin ite life in ta n g ib le a s s e ts , T h e G ro u p b e lie v e s t h a t a n y re a s o n a b ly p o s s ib le c h a n g e in th e k e y a s s u m p tio n s w o u ld n o t c a u s e th e c a rr y in g v a lu e o f th e s e g m e n ts to e x c e e d its c a rr y in g a m o u n t a n d re s u lt in a m a te ria l im p a ir m e n t. K e y a s s u m p tio n s in c lu d e d is c o u n t ra te s (w h ic h h a ve b e e n e s tim a te d as d e s c rib e d a b o v e ), lo n g te r m g r o w th ra te s (te r m in a l v a lu e a s s u m p tio n s ) a n d e x p e c te d c h a n g e s in m a rg in s (s a le s g r o w th a n d C O D B re d u c tio n s ). T h e lo n g te r m g r o w th ra te s a n d e x p e c te d c h a n g e s in m a rg in s a re b a s e d o n p a s t e x p e rie n c e a n d e x p e c ta tio n s o f c h a n g e s in th e m a rk e t. T h e c o m p o n e n ts o f g o o d w ill a n d in d e fin ite u se in ta n g ib le a s s e ts b y s e g m e n t a re as fo llo w s : G o o d w ill
O th e r
B ra n d n am es
2014 $m
2013 $m
2014 $m
2013 $m
2014 $m
2013 $m
2 7 1 .4
836.1
812.1
6 .7
6.1
2 7 5 .8
2 ,0 3 6 .5
1 ,8 41 .7
2 4 3 .0
2 2 8 .4
-
-
6 7 2 .6
6 7 3 .0
-
-
1 ,7 2 5 .6
1 ,7 0 5 .2
H o m e Im p r o v e m e n t
8 0 .4
74.1
8 .4
8 .4
0 .4
0 .4
G e n e ra l M e r c h a n d is e
2 5 6 .5
-
21.0
-
-
-
0 .3
-
-
-
-
-
3 ,8 8 2 .4
3 ,4 0 0 .9
279.1
2 4 2 .9
2 ,0 0 1 .8
1 ,9 7 7 .0
A u s tra lia n F o o d , L iq u o r a n d P e tro l N e w Z e a la n d S u p e rm a rk e ts H o te ls
U n a llo c a te d
B ra n d n a m e s in c lu d e d a b o v e h a ve b e e n a s s e s s e d a s h a v in g in d e fin ite liv e s o n th e b a s is o f b ra n d s tr e n g th , o n g o in g e x p e c te d p r o f it a b ilit y a n d c o n tin u in g s u p p o rt. T h e b ra n d n a m e s in c o rp o ra te c o m p le m e n ta r y a s s e ts s u c h as s to re fo r m a ts , n e tw o r k s a n d p r o d u c t o ffe rin g s . O th e r in d e fin ite life in ta n g ib le s in c lu d e liq u o r, p e tro l a n d g a m in g lic e n c e s w h ic h h a ve b e e n a s s e s s e d as h a v in g in d e fin ite liv e s o n th e b a s is th a t th e lic e n c e s a re e x p e c te d to be re n e w e d in lin e w ith b u s in e s s c o n tin u ity re q u ire m e n ts . N o in ta n g ib le a s s e ts w e re id e n tifie d as im p a ir e d a t th e re p o r tin g d a te .
W oolw orths Lim ited A nnual Report 2014 page 128
Appendix: W oolw orths Lim ited A nnual Report 2014
721
13 T R A D E A N D O T H E R PAYABLES 2014 $m
2013 $m
A c c o u n ts p a y a b le
4,657.1
4 ,0 8 0 .0
A c c r u a ls
1,227 .6
1 ,2 0 0 .0
U n e a rn e d in c o m e
121.6
110.3
6 ,0 0 6 .3
5 ,3 9 0 .3
2014 $m
2013 $m
3 3 .5
3 2 .0
14 O T H E R F IN A N C IA L L IA B IL IT IE S
C urrent G a m in g e n title m e n t lia b ility A t fa ir v a lu e F a ir v a lu e d e riv a tiv e s
9 3 .6
96.1
C ro s s c u rr e n c y s w a p s
18.1
17.1
F o rw a rd e x c h a n g e c o n tr a c ts
21.7
0 .7
1.3
-
1 6 8 .2
1 4 5 .9
4 3 .8
7 7 .0
77 1 .2
6 3 1 .2
2 9 .4
11.2
In te re s t ra te s w a p s
C o n tin g e n t c o n s id e ra tio n
N on-cu rrent G a m in g e n title m e n t lia b ility A t fa ir v a lu e P u t o p tio n o v e r n o n - c o n tr o llin g in te re s t in H y d ro x H o ld in g s P ty L td 1 P u t o p tio n s o v e r o th e r n o n - c o n tr o llin g in te re s ts 1 F a ir v a lu e d e riv a tiv e s In te re s t ra te s w a p s
1 6 5 .6
1 7 8 .0
C ro s s c u rr e n c y s w a p s
1 4 3 .9
9 5 .2
C o n tin g e n t c o n s id e ra tio n
1.3
-
1,155.2
9 9 2 .6
1
Further information is included in Note 27
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 15
B O R R O W IN G S 2014 $m
2013 $m
S h o rt te r m m o n e y m a r k e t lo a n s 1
27 .6
1 0 2 .5
B a n k lo a n s 2
8 4 .4
6 5 .6
C urrent U nsecured
S h o rt te r m s e c u ritie s 3 F in a n c e le a s e s
1 0 5 .9
-
1.6
1.3
219.5
1 6 9 .4
3 ,4 4 1 .8
3 ,5 9 2 .9
N on-cu rrent U nsecured L o n g te r m s e c u r itie s 4 U n a m o rtis e d b o rr o w in g c o s ts 5 W o o lw o r t h s N o te s II6 F in a n c e le a s e s
Total 1 2 3 4 5 6
(3 .7 ) 6 9 3 .8
(6 .9 ) 6 9 1 .2
4.1
5 .3
4 ,1 3 6 .0
4 ,2 8 2 .5
4 ,3 5 5 .5
4 ,4 5 1 .9
Short term money market loan on an at-call basis of NZ$29.7 million (A$27.6 million) by a controlled entity was outstanding at year end (2013: NZ$62.3 million (A$52.5 million)). In 2013, Woolworths also had short term money market loans of $50.0 million NZ$90 million (A$83.7 million) and $0.7 million was drawn by controlled entities against a committed Revolving Credit Facility (2013: NZ$60.0 million (A$50.6 million)). Also included in bank loans in 2013 was $15.0 million drawn by a controlled entity against a committed Revolving Credit Facility Comprised of: US$100.0 million (A$106.0 million) from a private placement of senior notes in the United States in 2005, maturing in April 2015 $0.1 million of unamortised borrowing costs (2013: classified as non-current) Comprised of: US$400.0 million (A$423.9 million) from a private placement of senior notes in the United States in 2005, maturing: US$300.0 million in April 2017 and US$100.0 million in April 2020 (2013: US$500.0 million (A$539.6 million)) US$352.6 million (A$373.7 million) of senior notes issued into the US 144A market in the United States in 2005, maturing in November 2015 (2013: US$352.6 million (A$380.5 million)) US$896.3 million (A$949.9 million) of senior notes issued into the US 144A market in the United States in 2010, maturing: US$279.3 million in September 2015 and US$617.0 million in September 2020 (2013: US$896.3 million (A$967.2 million)) US$661.3 million (A$700.9 million) of senior notes issued into the US 144A market in the United States in 2011, maturing: US$223.3 million in April 2016 and US$438.0 million in April 2021 (2013: US$661.3 million (A$713.6 million)) $500.0 million Medium Term Notes issued in March 2011, due to mature in March 2016 (2013: $500.0 million) $500.0 million Medium Term Notes issued in March 2012, due to mature in March 2019 (2013: $500.0 million) $0.4 million external borrowings by a controlled entity (2013: $0.4 million) $4.0 million of unamortised premium on Medium Term Notes (2013: $4.8 million) $3.0 million of unamortised borrowing costs (2013: $3.6 million) $3.7 million unamortised borrowing costs relating to establishment of loan facilities/programs not utilised as at reporting date (2013: $6.9 million) $700.2 million in W oolworths Notes II were issued in November 2011 with a 25 year maturity and a non-call period of five years. This was partially offset by unamortised borrowing costs of $6.4 million (2013: $9.0 million)
W oolw orths Lim ited A nnual Report 2014 page 130
Appendix: W oolw orths Lim ited A nnual Report 2014
16
723
F IN A N C IN G A R R A N G E M E N T S
U n re s tric te d a c c e s s w a s a v a ila b le a t th e b a la n c e d a te to th e f o llo w in g lin e s o f c re d it: 2014
2013
$m
Sm
T o ta l fa c ilitie s
B a n k o v e rd ra fts B a n k lo a n fa c ilitie s
3 8 .2
3 0 .5
3 ,5 8 8 .5
3 ,6 2 9 .2
3 ,6 2 6 .7
3 ,6 5 9 .7
1 1 2 .0
168.1
1 1 2 .0
168.1
3 8 .2
3 0 .5
U s e d a t b a la n c e d a t e
B a n k lo a n fa c ilitie s
U n u s e d a t b a la n c e d a t e
B a n k o v e rd ra fts B a n k lo a n fa c ilitie s
3 ,4 7 6 .5
3,461.1
3 ,5 1 4 .7
3 ,4 9 1 .6
B a n k lo a n fa c ilitie s m a y b e d ra w n a t a n y tim e , s u b je c t to th e te r m s o f th e le n d in g a g re e m e n ts . T h e fa c ilitie s a re d e n o m in a te d in A u s tra lia n d o lla rs a n d N Z d o lla rs . T h e b a n k o v e r d r a ft fa c ilitie s m a y b e d ra w n a t a n y tim e . T h e a b o v e fa c ilitie s a re s u b je c t to c e rta in fin a n c ia l c o v e n a n ts a n d u n d e r ta k in g s . N o c o v e n a n ts h a ve b e e n b re a c h e d d u rin g th e p e rio d . T o ta l fa c ilitie s e x c lu d e W o o lw o r t h s N o te s II, B o n d s a n d M e d iu m T e rm N o te s .
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Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 17 P R O V IS IO N S 2014 $m
2013 $m
8 2 0 .4
7 6 5 .7
15 8 .7
1 5 0 .0
C urrent E m p lo y e e b e n e fits ( N o te 2 4 ) S e lf-in s u re d ris k s 1 O th e r 2
2 6 .2
51.5
1 ,0 0 5 .3
9 6 7 .2
134.1
121.8
4 2 1 .0
414.1
N on-cu rrent E m p lo y e e b e n e fits ( N o te 2 4 ) S e lf-in s u re d ris k s 1 O th e r 2
Total provisions
12.3
13.3
5 6 7 .4
5 4 9 .2
1 ,5 7 2 .7
1 ,5 1 6 .4
5 4 9 .0
M o vem en ts in self-insured risk provisions w ere as follows: B a la n c e a t s t a r t o f p e rio d
56 4.1
A d d itio n a l p ro v is io n s re c o g n is e d
1 6 4 .8
1 6 3 .6
R e d u c tio n s a ris in g fr o m p a y m e n t s / o th e r s a c rific e s o f fu tu r e e c o n o m ic b e n e fits
(1 4 6 .1 )
(1 4 3 .8 )
(3 .6 )
(5.1)
T ra n s fe rs
0 .5
0 .4
5 7 9 .7
5 6 4 .1
C u rre n t
15 8 .7
1 5 0 .0
N o n -c u rre n t
4 2 1 .0
414.1
E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
Balance a t end of period
M o v e m e n ts in o th e r provisions w ere as follows: B a la n c e a t s t a r t o f p e rio d
6 4 .8
8 0 .7
A d d itio n a l p ro v is io n s re c o g n is e d
119.0
9 4 .8
A ris in g fr o m a c q u is itio n o f c o n tro lle d e n titie s R e d u c tio n s a ris in g fr o m p a y m e n ts T ra n s fe rs
1.5
-
(1 4 6 .8 )
(1 0 6 .1 )
( 0 .8 )
( 5 .2 )
0 .8
0 .6
Balance a t end of period
3 8 .5
6 4 .8
C u rre n t
2 6 .2
51.5
N o n -c u rre n t
12.3
13.3
E ffe c t o f m o v e m e n ts in fo re ig n e x c h a n g e ra te s
1 2
The provision for self-insured risks primarily represents the estimated liability for workers compensation and public liability claims in all Woolworths' self-insured jurisdictions based on actuarial valuations Current and non-current other provisions include provisions for onerous lease contracts including those arising on acquisitions
W oolw orths Lim ited A nnual Report 2014 page 132
Appendix: W oolw orths Lim ited A nnual Report 2014
725
18 IS S U E D C A P IT A L 2014
2013
$m
$m
4 ,5 2 2 .7
4 ,3 3 6 .6
Issued and paid-up share capital 1 ,2 5 9 ,8 1 8 ,9 1 0 f u lly p a id o r d in a r y s h a re s (2 0 1 3 :1 ,2 5 0 ,1 8 7 ,9 1 0 ) F u lly p a id o r d in a r y s h a re s c a rr y o n e v o te p e r s h a re a n d th e r ig h t to d iv id e n d s
Reconciliation o f fully paid share capital B a la n c e a t b e g in n in g o f p e rio d Iss u e o f s h a re s as a re s u lt o f o p tio n s e x e rc is e d u n d e r e m p lo y e e lo n g te r m in c e n tiv e p la n s Iss u e o f s h a re s as a re s u lt o f th e d iv id e n d re in v e s tm e n t p la n A d ju s tm e n t to re fle c t th e fin a l p ro c e e d s fo r s h a re s is s u e d u n d e r th e E m p lo y e e S h a re P lan
36.1
188.1
2 0 6 .8
1 9 8 .6 (6 .1 )
-
8 4 .5
Iss u e o f s h a re s to th e W o o lw o r t h s E m p lo y e e S h a re T ru s t In -s p e c ie d is tr ib u tio n to W o o lw o r t h s L im ite d s h a re h o ld e rs a s s o c ia te d w ith c re a tio n o f th e S C A P ro p e r ty G ro u p
-
Balance a t end o f period
1 4 5 .8 (3 4 0 .3 )
4 ,8 5 0 .1
4 ,5 2 2 .7
No.(m)
No.(m)
1 ,2 5 0 .2
1,231.9
Reconciliation o f fully paid share capital B a la n c e a t b e g in n in g o f p e rio d Iss u e o f s h a re s as a re s u lt o f o p tio n s e x e rc is e d u n d e r e m p lo y e e lo n g te r m in c e n tiv e p la n s
1.4
7 .4
Iss u e o f s h a re s as a re s u lt o f th e d iv id e n d re in v e s tm e n t p la n
5 .8
6 .4
Is s u e o f s h a re s to th e W o o lw o r t h s E m p lo y e e S h a re T ru s t
B alance a t end o f period
2 .4
4 .5
1 ,2 5 9 .8
1 ,2 5 0 .2
$m
$m
Shares held in tru st Reconciliation of shares held in tru s t B a la n c e a t b e g in n in g o f p e rio d Iss u e o f s h a re s u n d e r th e E m p lo y e e S h a re P lan a n d L o n g T e rm In c e n tiv e P lan S h a re s a c q u ire d b y th e W o o lw o r t h s E m p lo y e e S h a re T ru s t
B alance a t end o f period
(1 8 0 .5 )
(6 0 .7 )
46.1
2 6 .0
( 8 4 .5 )
(1 4 5 .8 )
(2 1 8 .9 )
(1 8 0 .5 )
No.(m)
No.(m)
Reconciliation o f shares held in tru st 5 .8
2 .8
( 0 .4 )
(1 .5 )
S h a re s a c q u ire d b y th e W o o lw o r t h s E m p lo y e e S h a re T ru s t
2 .4
4 .5
B alance a t end o f period
7.8
5 .8
B a la n c e a t b e g in n in g o f p e rio d Iss u e o f s h a re s u n d e r th e E m p lo y e e S h a re P lan a n d L o n g T e rm In c e n tiv e P lan
S h a re c a p ita l H o ld e rs o f o r d in a r y s h a re s a re e n title d to re c e iv e d iv id e n d s as d e c la re d fr o m t im e to t im e a n d a re e n title d to o n e v o te p e r s h a re a t s h a re h o ld e rs ' m e e tin g s . In th e e v e n t o f w in d in g u p o f th e C o m p a n y , o r d in a r y s h a re h o ld e rs ra n k a fte r a ll o th e r s h a re h o ld e rs a n d c r e d ito r s a n d a re f u lly e n title d to a n y p ro c e e d s o f liq u id a tio n . C h a n g e s to th e th e n C o rp o ra tio n s A c t a b o lis h e d th e a u th o r is e d a n d p a r v a lu e c o n c e p t in re la tio n to s h a re c a p ita l is s u e d fr o m 1 J u ly 1 9 9 8 . T h e re fo re , th e C o m p a n y d o e s n o t h a ve a lim ite d a m o u n t o f a u th o r is e d c a p ita l a n d is s u e d s h a re s d o n o t h a ve a p a r v a lu e .
Woolworths Limited Annual Report 2014 page 133
726
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 18 IS S U E D C A P IT A L C O N T IN U E D S hare op tio n s and p e rfo rm a n c e rig h ts In a c c o rd a n c e w ith th e p ro v is io n s o f th e L o n g T e rm In c e n tiv e P lan, th e to ta l n u m b e r o f o u ts ta n d in g o p t io n s / r ig h ts o n is s u e a re as fo llo w s :
Number of options/performance rights over shares as at 2014
2013
Expiry date
4 3 4 ,4 4 6
31 D e c 13
2010
2 9 2 ,8 6 5
3 ,1 1 2 ,9 0 0
31 D e c 14
Total
2 9 2 ,8 6 5
3 ,5 4 7 ,3 4 6
O ptions 2009
Perform ance Rights 2010
-
7 2 5 ,9 3 8
31 D e c 14
2011
1 ,0 8 3 ,6 9 5
2,319,311
31 D e c 15
2012
1 ,2 6 6 ,4 3 8
1 ,3 6 7 ,5 2 7
31 D e c 16
2013
2 ,3 2 8 ,2 6 8
2 ,5 3 1 ,7 8 2
31 D e c 17
2014
2 ,0 7 6 ,4 5 2
-
31 D e c 18
Total
6 ,7 5 4 ,8 5 3
6 ,9 4 4 ,5 5 8
-
7 6 ,5 0 0
1 Feb 2 0 1 4 ,
2 8 Feb 2 0 1 4 ,
1 Jun2014
13 N o v 13, 31 Jan 14, 1 D e c 14,
2 3 N o v 13, 12 A p r 14, 11 D e c 14,
1 D e c 13, 16 A p r 14, 16 A p r 1 5
11 D e c 13, 1 Jul 14,
1 7 3 ,5 0 0
1 Jul 13, 31 D e c 13, 4 Jul 14,
9 O c t 13, 3 A p r 14, 7 Jan 15, 8 O c t 15, 2 5 Feb 16,
2 3 O c t 13, 1 Jul 14, 2 5 Feb 15, 9 O c t 15, 11 M a r 16
2 5 Feb 14, 3 S e p t 14, 11 M a r 15, 1 Jan 16,
11 M a r 14, 8 O c t 14, 18 M a r 15, 7 Jan 16,
8 2 9 ,4 5 0
8 O c t 13, 18 M a r 14, 9 O c t 14, 3 A p r 15, 4 Feb 16, 1 Jul 14, 3 0 A u g 14, 4 N o v 14, 17 M a r 15, 15 Jul 15, 3 0 A u g 15, 1 O c t 15, 13 Jan 16, 1 Jul 16, 3 0 D e c 16,
15 Jul 14, 1 S e p t 14, 2 5 N o v 14, 2 4 M a r 15, 2 9 Jul 15, 31 A u g 15, 21 O c t 15, 10 Feb 16, 9 S e p t 16, 2 4 M a r 17,
2 9 Jul 14, 1 O c t 14, 1 D e c 14, 1 M a y 15, 1 A u g 15, 1 S e p t 15, 4 N o v 15, 17 M a r 16, 2 O c t 16, 9 S e p t 17,
2 2 A u g 14, 2 O c t 14, 13 Jan 15, 15 M a y 15, 22 A ug15, 9 S e p t 15, 25 N ov15, 2 4 M a r 16, 4 N o v 16, 2 4 M a r 18,
2 6 A u g 14, 21 O c t 14, 10 Feb 15, 1 Jul 15, 26 A ug15, 3 0 S e p t 15, 1 D e c 15, 15 M a y 16, 1 D e c 16, 2 O c t 18
R etention Rights 2011
2012
2013
5 5 ,0 0 0
7 3 7 ,4 2 0
2014
2 8 6 ,2 4 3
-
Total
1 ,0 7 8 ,6 6 3
1 ,0 7 9 ,4 5 0
Total O p tio n s and Rights
8,126,381
1 1 ,5 7 1 ,3 5 4
E x e c u tiv e s h a re o p tio n s a n d p e rfo rm a n c e rig h ts c a rr y n o rig h ts to d iv id e n d s a n d n o v o tin g rig h ts . F u rth e r d e ta ils o f th e L o n g T e rm In c e n tiv e P lan a re c o n ta in e d in N o te 2 4 to th e fin a n c ia l s ta te m e n ts .
W oolw orths Lim ited A nnual Report 2014 page 134
Appendix: W oolw orths Lim ited A nnual Report 2014
727
19 RESERVES 2014 $m H e d g in g re s e rv e F o re ig n c u rr e n c y tra n s la tio n re s e rv e R e m u n e ra tio n re s e rv e
(1 0 0 .3 ) 67.7 303.1
2013 $m ( 3 5 .6 ) (1 6 7 .3 ) 2 9 0 .6
A s s e t re v a lu a tio n re s e rv e
1 6 .4
1 6 .4
E q u ity in s tr u m e n t re s e rv e
(8 8 .7 )
( 7 9 .0 )
1 9 8 .2
25.1
H ed g in g res erve T h e h e d g in g re s e rv e c o m p ris e s th e e ffe c tiv e p o r tio n o f th e c u m u la tiv e n e t c h a n g e in th e fa ir v a lu e o f ca s h f lo w h e d g in g in s tr u m e n ts re la te d to h e d g e d tr a n s a c tio n s th a t h a ve n o t y e t o c c u rre d . T h e c u m u la tiv e d e fe rre d g a in o r lo s s o n th e h e d g e is re c o g n is e d in th e c o n s o lid a te d in c o m e s ta te m e n t w h e n th e h e d g e d tra n s a c tio n im p a c ts th e p r o f it o r lo s s, c o n s is te n t w ith th e a p p lic a b le a c c o u n tin g p o lic y .
Foreign cu rre n cy tra n s la tio n res erve T h e fo re ig n c u rr e n c y tra n s la tio n re s e rv e c o m p ris e s a ll fo re ig n e x c h a n g e d iffe re n c e s a ris in g fr o m th e tra n s la tio n o f th e fin a n c ia l s ta te m e n ts o f fo re ig n o p e ra tio n s w h e re t h e ir fu n c tio n a l c u rr e n c y is d iffe r e n t to th e G ro u p 's p re s e n ta tio n c u rre n c y . G a in s a n d lo s s e s o n h e d g in g in s tr u m e n ts th a t a re d e s ig n a te d as h e d g in g in s tr u m e n ts fo r h e d g e s o f n e t in v e s tm e n ts in fo re ig n o p e ra tio n s a re a ls o in c lu d e d in th e fo re ig n c u rr e n c y tra n s la tio n re s e rv e .
R em u n eratio n res erve T h e e m p lo y e e re m u n e ra tio n re s e rv e c o m p ris e s th e fa ir v a lu e o f s h a re b a s e d p a y m e n t p la n s re c o g n is e d as an e x p e n s e in th e c o n s o lid a te d in c o m e s ta te m e n t.
A s s e t re v a lu a tio n res erve T h e a s s e t re v a lu a tio n re s e rv e a ro s e o n a c q u is itio n o f th e p re v io u s ly e q u ity a c c o u n te d in v e s tm e n t in M G W H o te ls P ty L td a n d re la te s to th e c h a n g e in fa ir v a lu e o f th e c o n s o lid a te d e n tity 's in te re s t in n o n - c u r r e n t a s s e ts fr o m th e d a te o f a c q u is itio n o f th e in itia l in v e s tm e n t to th e d a te c o n tro l w a s a c h ie v e d .
E q u ity in s tru m e n t res erve T h e e q u ity in s tr u m e n t re s e rv e a ris e s o n th e re v a lu a tio n o f in v e s tm e n ts in e q u ity s e c u ritie s . S u b s e q u e n t to in itia l re c o g n itio n , th e y a re m e a s u re d a t fa ir v a lu e w ith a n y c h a n g e s re c o rd e d th ro u g h th e e q u ity in s tr u m e n t re s e rv e .
W oolw orths Lim ited A nnual Report 2014 page 135
728
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 19 R ESERVES C O N T IN U E D 2014 $m
2013 $m
B a la n c e a t s t a r t o f p e rio d
(3 5 .6 )
(5 2 .7 )
M o v e m e n t in th e fa ir v a lu e o f ca s h f lo w h e d g e s
(139.1)
2 5 6 .4
4 6 .7
(2 3 1 .9 )
Movements H edging reserve
T ra n s fe r ca s h flo w h e d g e s to th e in c o m e s ta te m e n t D e fe rre d ta x a ris in g o n ca s h flo w h e d g e s
Balance a t end of period
27.7
(7 .4 )
(1 0 0 .3 )
( 3 5 .6 )
(1 6 7 .3 )
(3 4 1 .9 )
Foreign currency translatio n reserve (FC TR ) B a la n c e a t s t a r t o f p e rio d T ra n s fe r to e q u ity d ir e c tly a s s o c ia te d w it h a s s e ts h e ld fo r sa le
-
1.9
M o v e m e n t in tra n s la tio n o f fo re ig n o p e ra tio n s ta k e n to e q u ity
2 7 0 .3
1 97.8
T a x a ris in g o n m o v e m e n ts
(3 5 .3 )
(2 5 .1 )
67.7
(1 6 7 .3 )
Balance a t end of period R em uneration reserve B a la n c e a t s t a r t o f p e rio d
2 9 0 .6
S h a re s is s u e d b y th e W o o lw o r t h s E m p lo y e e S h a re T ru s t
( 4 6 .6 )
(1 4 .4 )
5 0 .0
3 4 .9
E q u ity s e ttle d s h a re b a s e d p a y m e n ts e x p e n s e
2 4 6 .2
9.1
2 3 .9
303.1
2 9 0 .6
B a la n c e a t s t a r t o f p e rio d
1 6 .4
1 6 .4
Balance a t end of period
1 6 .4
1 6 .4
(7 9 .0 )
(111.9)
T a x a ris in g o n m o v e m e n ts
Balance a t end of period A sset revaluation reserve
Equity instrum en t reserve B a la n c e a t s t a r t o f p e rio d M o v e m e n t in th e fa ir v a lu e o f in v e s tm e n ts in e q u ity s e c u ritie s
Balance a t end of period
(9 .7 )
3 2 .9
( 8 8 .7 )
( 7 9 .0 )
2014 $m
2013 $m
2 0 R E T A IN E D E A R N IN G S
Retained earnings a ttrib u ta b le to eq uity holders of th e parent en tity B a la n c e a t s t a r t o f th e p e rio d
4,661.1
4 ,1 6 3 .4
P ro fit a ttr ib u ta b le to e q u ity h o ld e rs o f th e p a re n t e n tity
2 ,4 5 1 .7
2 ,2 5 9 .4
A c tu a r ia l g a in o n d e fin e d b e n e fit p la n s
15.1
12.5
T a x e ffe c t o f a c tu a ria l g a in
(6 .9 )
In -s p e c ie d is tr ib u tio n to W o o lw o r t h s L im ite d s h a re h o ld e rs E m p lo y e e S h a re P lan d iv id e n d s a n d fo r fe itu r e s D iv id e n d s p a id ( N o te 6 ) D iv id e n d s p a id o n T re a s u ry s h a re s
Balance a t end of period
-
(1 ,7 0 3 .8 )
( 3 .8 ) (176.1)
1.0 (1 ,5 9 7 .5 )
5 .9
2 .2
5,423 .1
4,661.1
Woolworths Limited Annual Report 2014 page 136
Appendix: W oolw orths Lim ited A nnual Report 2014
729
21 E A R N IN G S PER S H A R E 2014 5 2 w ee ks
2013 5 3 w ee ks
1 9 6 .5
181.8
1 9 6 .5
1 8 2 .6
1 9 5 .6
181.0
1 9 5 .6
181.8
B a s ic e a r n in g s p e r s h a r e (c e n t s p e r s h a r e )
C o n tin u in g o p e ra tio n s D is c o n tin u e d o p e ra tio n s
0 .8
D ilu t e d e a r n in g s p e r s h a r e ( c e n t s p e r s h a r e )
C o n tin u in g o p e ra tio n s D is c o n tin u e d o p e ra tio n s
0 .8
B a s ic e a r n in g s p e r s h a re
T h e e a rn in g s a n d w e ig h te d a v e ra g e n u m b e r o f o r d in a ry s h a re s u s e d in th e c a lc u la tio n o f b a s ic e a rn in g s p e r s h a re a re as fo llo w s :
E a rn in g s - c o n tin u in g o p e ra tio n s (a )
$m
Sm
2 ,4 5 1 .7
2 ,2 4 9 .7
2 ,4 5 1 .7
2 ,2 5 9 .4
N o. (m )
N o. (m )
1 ,2 4 8 .0
1 ,2 3 7 .4
E a rn in g s - d is c o n tin u e d o p e ra tio n s (a ) E a r n in g s - c o n tin u in g a n d d is c o n tin u e d o p e r a t io n s ( a )
W e i g h t e d a v e r a g e n u m b e r o f o r d in a r y s h a r e s 1 ( b )
9 .7
D ilu te d ea rn in g s p e r s h are T h e e a rn in g s a n d w e ig h te d a v e ra g e n u m b e r o f o r d in a ry s h a re s a n d p o te n tia l o r d in a r y s h a re s u s e d in th e c a lc u la tio n o f d ilu te d e a rn in g s p e r s h a re a re as fo llo w s :
E a rn in g s - c o n tin u in g o p e ra tio n s (a )
Sm
$m
2 ,4 5 1 .7
2 ,2 4 9 .7
2 ,4 5 1 .7
2 ,2 5 9 .4
N o. (m )
N o. (m )
1 ,2 5 3 .2
1,243.1
9 .7
E a rn in g s - d is c o n tin u e d o p e ra tio n s (a ) E a r n in g s - c o n tin u in g a n d d is c o n tin u e d o p e r a t io n s ( a )
W e i g h t e d a v e r a g e n u m b e r o f o r d in a r y s h a r e s 1 a n d p o t e n t ia l o r d in a r y s h a r e s ( c )
(a ) E a rn in g s u s e d in th e c a lc u la tio n o f b a s ic a n d d ilu te d e a rn in g s p e r s h a re re c o n c ile s to n e t p r o f it in th e c o n s o lid a te d in c o m e s ta te m e n t a s fo llo w s :
P ro fit a ttr ib u ta b le to e q u ity h o ld e rs o f th e p a re n t e n tity
$m
$m
2 .4 5 1 .7
2 ,2 5 9 .4
2 .4 5 1 .7
2 ,2 4 9 .7
2 ,4 5 1 .7
2 ,2 5 9 .4
E a rn in g s u s e d in th e c a lc u la tio n o f b a s ic a n d d ilu te d e a rn in g s p e r s h a re fro m : C o n tin u in g o p e ra tio n s
9 .7
D is c o n tin u e d o p e ra tio n s T o t a l c o n tin u in g a n d d is c o n tin u e d o p e r a t io n s
(b ) O p tio n s a re c o n s id e re d to b e p o te n tia l o r d in a r y s h a re s a n d a re th e re fo r e e x c lu d e d fr o m th e w e ig h te d a v e ra g e n u m b e r o f o rd in a ry s h a re s u se d in th e c a lc u la tio n o f b a s ic e a rn in g s p e r s h a re . W h e r e d ilu tiv e , p o te n tia l o r d in a r y s h a re s a re in c lu d e d in th e c a lc u la tio n o f d ilu te d e a rn in g s p e r s h a re . 1
Weighted average number of shares has been adjusted to remove Treasury shares held by W oolworths Custodian Pty Ltd (as trustee of various employee trusts)
Woolworths Limited Annual Report 2014 page 137
730
Appendix: W oolw orths Lim ited A nnual R eport 2014
Notes to the Consolidated Financial Statements 21 E A R N IN G S PER S H A R E C O N T IN U E D (c ) W e ig h te d a v e ra g e n u m b e r o f o r d in a r y s h a re s a n d p o te n tia l o r d in a ry s h a re s u s e d in th e c a lc u la tio n o f d ilu te d e a rn in g s p e r s h a re re c o n c ile s to th e w e ig h te d a v e ra g e n u m b e r o f o r d in a r y s h a re s u s e d in th e c a lc u la tio n o f b a s ic e a rn in g s p e r s h a re as fo llo w s :
W e ig h te d a v e ra g e n u m b e r o f o r d in a r y s h a re s u se d in th e c a lc u la tio n o f b a s ic e a rn in g s p e r s h a re S h a re s d e e m e d to b e is s u e d fo r n o c o n s id e ra tio n in re s p e c t o f e m p lo y e e o p tio n s a n d p e rfo rm a n c e rig h ts
W e ig h te d averag e n um ber of o rd in a ry shares and p o te n tial o rd in a ry shares used in th e calcu lation of d ilu ted earnings per sh are
2014 No. (m )
2013 No. (m )
1 ,2 4 8 .0
1 ,2 3 7 .4
5 .2
5 .7
1 ,2 5 3 .2
1,243.1
F ro m 3 0 Ju n e to 12 S e p te m b e r 2 0 1 4 , 8 5 ,5 5 5 s h a re s ( fr o m 1 J u ly to 2 0 S e p te m b e r 2 0 1 3 : 2 ,3 3 9 ,8 9 9 ) h a ve b e e n is s u e d a s a re s u lt o f th e e x e rc is e o f o p tio n s g ra n te d u n d e r LTIP in J u ly 2 0 0 8 a n d J u ly 2 0 0 9 . D u rin g th is p e rio d , 3 9 ,5 1 0 re te n tio n rig h ts h a ve b e e n is s u e d . N o o th e r p e rfo rm a n c e rig h ts o r o p tio n s (2 0 1 3 : n il) h a ve b e e n is s u e d d u rin g th is p e rio d .
22
C O N T IN G E N T L IA B IL IT IE S
T h e d e ta ils a n d e s tim a te d m a x im u m a m o u n ts o f c o n tin g e n t lia b ilitie s w h ic h m a y b e c o m e p a y a b le a re s h o w n b e lo w . N o p ro v is io n has b e e n m a d e in th e fin a n c ia l s ta te m e n ts in re s p e c t o f th e s e c o n tin g e n c ie s , h o w e v e r th e re is a p ro v is io n o f $ 5 7 9 .7 m illio n fo r s e lf-in s u re d ris k s (2 0 1 3 : $ 5 6 4 .1 m illio n ) , w h ic h in c lu d e s lia b ilitie s re la tin g to w o rk e rs ' c o m p e n s a tio n c la im s , th a t h a v e b e e n re c o g n is e d in th e b a la n c e s h e e t a t b a la n c e d a te .
2014 $m
2013 $m
G uarantees B a n k g u a ra n te e s 1 W o r k e r s ' c o m p e n s a tio n s e lf-in s u ra n c e g u a ra n te e s 2
5 2 .2
4 9 .4
7 6 8 .8
7 7 9 .5
O th er O u ts ta n d in g le tte rs o f c r e d it is s u e d to s u p p lie rs
6 .0
5 .5
O th e r
3 .0
6 .5
8 3 0 .0
8 4 0 .9
1 2
This item mainly comprises guarantees relating to conditions set out in development applications and for the sale of properties in the normal course of business State WorkCover authorities require guarantees against workers' compensation self-insurance liabilities. The guarantee is based on independent actuarial advice of the outstanding liability. Guarantees held at each balance date do not equal the liability at these dates due to the timing of issuing the guarantees
In fin ity C able B e tw e e n M a r c h 2 0 1 2 a n d S e p te m b e r 2 0 1 3 , e le c tric a l c a b le p u rc h a s e d fr o m I n f in ity C a b le C o P ty L td ( I n f in it y ) w a s s o ld b y a n u m b e r o f A u s tra lia n e le c tric a l w h o le s a le rs a n d re ta ile rs in c lu d in g W o o lw o r t h s / L o w e 's jo in t v e n tu re , M a s te rs H o m e Im p r o v e m e n t a n d H o m e T im b e r a n d H a rd w a r e s to re s . W h ils t th e re is n o im m e d ia te s a fe ty ris k , th e a ffe c te d c a b le fa ils th e re q u ire d a g e in g te s ts s p e c ifie d in th e S ta n d a rd a n d c o u ld b e c o m e p re m a tu re ly b r itt le w ith age. O n 2 7 A u g u s t 2 0 1 4 , a T a sk F o rc e o f re le v a n t re g u la to rs , in c lu d in g th e A u s tra lia n C o m p e titio n a n d C o n s u m e r C o m m is s io n is s u e d a c o n s o lid a te d v o lu n ta r y S a fe ty R e ca ll N o tic e u n d e r w h ic h s u p p lie rs o f a ffe c te d c a b le w ill re m e d y a ffe c te d c o n s u m e rs h a v in g re g a rd to th e ir p a r tic u la r c irc u m s ta n c e s a n d th e re q u ire m e n ts o f th e T a sk F o rce . A re lia b le e s tim a te as to th e c o s t a s s o c ia te d w ith r e m e d ia tio n o r o th e r a c tio n re q u ire d a t th is t im e is n o t p o s s ib le .
W oolw orths Lim ited A nnual Report 2014 page 138
Appendix: W oolw orths Lim ited A nnual Report 2014
731
2 3 C O M M IT M E N T S FOR E X P E N D IT U R E 2014 $m
2013 $m
363.1
3 7 7 .7
L a te r th a n o n e ye a r, n o t la te r th a n t w o y e a rs
-
2 .3
L a te r th a n t w o y e a rs , n o t la te r th a n fiv e y e a rs
-
2 .3
363.1
3 8 2 .3
C apital expen diture co m m itm ents E s tim a te d c a p ita l e x p e n d itu re u n d e r fir m c o n tra c ts , n o t p ro v id e d fo r in th e s e fin a n c ia l s ta te m e n ts , p a y a b le : N o t la te r th a n o n e y e a r
O p era tin g lease co m m itm ents F u tu re m in im u m re n ta ls u n d e r n o n -c a n c e lla b le o p e ra tin g le a s e s n o t p ro v id e d f o r in th e s e fin a n c ia l s ta te m e n ts , p a y a b le :
1,8 1 5 .4
1,7 21 .8
L a te r th a n o n e ye a r, n o t la te r th a n fiv e y e a rs
6 ,3 5 8 .9
6 ,0 2 6 .8
L a te r th a n fiv e y e a rs
12,06 5.1
1 1 ,5 2 2 .6
N o t la te r th a n o n e y e a r
Total co m m itm e n ts fo r ex p en d itu re
2 0 ,2 3 9 .4
1 9 ,27 1 .2
2 0 ,6 0 2 .5
1 9 ,6 5 3 .5
T h e c o m m itm e n ts s e t o u t a b o v e d o n o t in c lu d e c o n tin g e n t tu r n o v e r re n ta ls , w h ic h a re c h a rg e d o n m a n y o f th e re ta il p re m is e s le a s e d b y th e c o n s o lid a te d e n tity . T h e s e re n ta ls a re c a lc u la te d a s a p e rc e n ta g e o f th e tu r n o v e r o f th e s to re o c c u p y in g th e p re m is e s , w ith th e p e rc e n ta g e a n d tu r n o v e r th re s h o ld a t w h ic h th e a d d itio n a l re n ta ls c o m m e n c e v a ry in g w ith e a c h le a s e a g re e m e n t. T h e c o n s o lid a te d e n t it y le a s e s re ta il p re m is e s a n d w a re h o u s in g fa c ilitie s w h ic h a re g e n e r a lly f o r p e rio d s u p to 4 0 y e a rs . T h e o p e ra tin g le a s e c o m m itm e n ts in c lu d e le a s e s f o r th e N o r w e s t o ffic e a n d d is tr ib u tio n c e n tre s . G e n e ra lly th e le a s e a g re e m e n ts a re fo r in itia l te rm s o f b e tw e e n 10 a n d 15 y e a rs a n d m o s t in c lu d e m u ltip le re n e w a l o p tio n s fo r a d d itio n a l fiv e y e a r te rm s . U n d e r m o s t le a s e s , th e c o n s o lid a te d e n t it y is re s p o n s ib le fo r p r o p e r ty ta x e s , in s u ra n c e , m a in te n a n c e a n d e x p e n s e s re la te d to th e le a s e d p r o p e rtie s . H o w e v e r, m a n y o f th e m o re re c e n t le a s e a g re e m e n ts h a ve b e e n n e g o tia te d o n a g ro s s o r s e m i g ro s s b a sis, w h ic h e lim in a te s o r s ig n ific a n tly re d u c e s th e le s s e e 's e x p o s u re to o p e ra tio n a l c h a rg e s a s s o c ia te d w it h th e p ro p e rtie s .
W oolw orths Lim ited A nnual Report 2014 page 139
732
Appendix: W oolw orths Lim ited A nnual R eport 2014
Independent Auditor's Report
Deloitte.
Deloitte Touche Totimatsu ABN 74 4 9 0 121 0S0 Grosvenor Place
225 George Slreet Sydney NSW 2000 PO 8o x N 2 5 0 Grosvenor Place Sydney N S W 1220 Australia D X 10307SS E Tel: +61 ( 0 ) 2 9322 7000 Fax: +61 (0 ) 2 9 3 2 2 7001 www.deloiUe.com y j
Independent Auditor’s Report to the Members of Woolworths Limited Report on the Financial Report We have audited the accompanying financial report o f Woolworths Limited (the “Company"), which comprises the consolidated balance sheet as at 29 June 2014, the consolidated income statement, the consolidated statement o f comprehensive income, the consolidated cash flow statement and the consolidated statement o f changes in equity for the 52 weeks ended on that date, notes comprising a summary o f significant accounting policies and other explanatory information, and the directors’ declaration o f the consolidated entity comprising the company and the entities it controlled at the year’s end or from time to time during the financial period as set out on pages 96 to 179. D irectors' Responsibility fo r the Financial Report The directors o f the company are responsible for the preparation o f the financial report that gives a true and fair view in accordance with Australian Accounting Standards and the Corporations Act 2001 and for such internal control as the directors determine is necessary to enable the preparation o f the financial report that gives a true and fair view and is free from material misstatement, whether due to fraud or error, in Note 1, the directors also state, in accordance with Accounting Standard AASB 101 Presentation o f Financial Statements, that the consolidated financial statements comply with International Financial Reporting Standards. Auditor’s Responsibility Our responsibility is to express an opinion on the financial report based on our audit. We conducted our audit in accordance with Australian Auditing Standards. Those standards require that we comply with relevant ethical requirements relating to audit engagements and plan and perform the audit to obtain reasonable assurance whether the financial report is free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial report. The procedures selected depend on the auditor’s judgement, including the assessment of the risks o f material misstatement o f the financial report, whether due to fraud or error. In making those risk assessments, the auditor considers internal control, relevant to the company’s preparation o f the financial report that gives a true and fair view, in order to design audit procedures that are appropriate in the circumstances, but not for the purpose o f expressing an opinion on the effectiveness of the company’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness o f accounting estimates made by the directors, as well as evaluating the overall presentation of the financial report. Liability limited by a scheme approved under Professional Standards legislation. Member of Deloitte Touche Tohrnatsu Limited
Woolworths Limited Annual Report 2014 page 180
Appendix: W oolw orths Lim ited A nnual Report 2014
733
Deloitte. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Auditor's Independence Declaration In conducting our audit, we have complied with the independence requirements o f the Corporations Act 2001. We confirm that the independence declaration required by the Corporations Act 2001 , which has been given to the directors o f Woolworths Limited, would be in the same terms if given to the directors as at the time of this auditor’s report. Opinion In our opinion: (a) the financial report o f Woolworths Limited is in accordance with the Corporations Act 2001, including: (i) giving a true and fair view o f the consolidated entity’s financial position as at 29 June 2014 and o f its performance for the period ended on that date; and (ii) complying with Australian Accounting Standards and the Corporations Regulations 2001; and (b) the consolidated financial statements also comply with International Financial Reporting Standards as disclosed in Note 1.
Report on the Remuneration Report We have audited the Remuneration Report included in pages 44 to 70 o f the directors’ report for the period ended 29 June 2014. The directors o f the company are responsible for the preparation and presentation o f the Remuneration Report in accordance with section 300A o f the Corporations Act 2001. Our responsibility is to express an opinion on the Remuneration Report, based on our audit conducted in accordance with Australian Auditing Standards. Opinion In our opinion the Remuneration Report o f Woolw'orths Limited for the period ended 29 June 2014, complies with section 300A o f the Corporations Act 2001.
DELOITTE TOUCHE TOHMATSU
A V Griffiths Partner Chartered Accountants Sydney, 22 September 2014 W o o lw o rth s L im ite d A n n u a l R e p o rt 2 0 1 4 p a g e 181
This glossary provides definitions for m any terms in fin a n cia l a ccounting. Terms a re cross-referenced to other terms w here helpful. For a d d itio n a l help in fin d in g things, consult the index at the end o f this book.
Accounting policy choice
A Accelerated depreciation a d e p re c ia tio n m e th o d , s u c h as re d u c in g b a la n c e , t h a t re c o rd s m o r e d e p re c ia tio n in th e e a rlie r y e a rs o f an a s s e t’s life , a n d less in la te r y e a rs , th a n d o e s th e s t r a ig h t- lin e m e th o d . S e e R e d u c in g balan c e d e p re c ia tio n , S tra ig h t-lin e d e p re c ia tio n .
Accounts
a d e c is io n b e tw e e n a c c e p ta b le a c c o u n tin g p o lic ie s is o f t e n n e e d e d b e c a u s e m o r e th a n o n e a c c e p ta b le p o lic y e x is ts in m a n y areas.
Accounting principles see G e n e ra lly a c c e p te d a c c o u n tin g p rin c ip les ( G A A P ) .
Accounting standards th e m a n d a tin g o f p a rtic u la r a c c o u n tin g m e th o d s o r
a s u m m a ry re c o r d o f an a s se t, lia b ility , s h a re h o ld e rs ’
p o lic ie s b y an a u th o rita tiv e b o d y . In A u s tra lia , th is is
e q u ity , re v e n u e o r e x p e n s e , in w h ic h th e e ff e c t s o f
d o n e b y t h e A u s tr a lia n A c c o u n tin g S ta n d a rd s B o a rd ,
tra n s a c tio n s , a c c ru a ls a n d a d ju s tm e n ts a re in d ic a te d in
a n d in th e U n ite d S ta te s b y t h e F in a n c ia l A c c o u n tin g
d o lla rs . S e e G e n e ra l jo u rn a l, G e n e ra l led g er.
S ta n d a rd s B o a rd . S e e A c c o u n tin g policies, G e n e ra lly a c c e p te d a c c o u n tin g p rin c ip les ( G A A P ) .
Accountant a p e rs o n w h o p e rfo rm s a c c o u n tin g fu n c tio n s .
Accounts payable
P ro fe s s io n a l a c c o u n ta n ts a re th o s e w h o a re g r a n te d
lia b ilitie s re p r e s e n tin g a m o u n ts o w e d t o s h o r t - te r m
d e s ig n a tio n s b y s e lf- r e g u la tin g b o d ie s o n th e basis o f
tra d e c r e d ito rs . O f t e n c a lle d ‘tra d e c r e d ito r s ’.
s p e c ia l tr a in in g a n d s u c c e s s fu l e x a m in a tio n . E x a m p le s o f
Accounts receivable
d e s ig n a tio n s a re C h a r te r e d A c c o u n ta n t ( C A ) an d
a m o u n ts o w in g b y d e b to rs ( c u s to m e r s ) , u s u a lly a ris in g
C e r tif ie d P ra c tis in g A c c o u n ta n t ( C P A ) s .
f r o m sales o f g o o d s o r se rv ic e s . O f t e n c a lle d ‘tra d e
Accounting th e r e c o r d - k e e p in g a n d r e p o r tin g o f a n e n te rp ris e ’s
d e b to rs ’.
Accrual accounting
p e rfo rm a n c e a n d p o s itio n in m o n e ta ry te rm s . A c c o u n tin g
th e m e th o d o f m a k in g an e c o n o m ic a lly m e a n in g fu l and
p ro v id e s th e re p o rts t h a t s u m m a ris e th e e c o n o m ic re s u lts
c o m p re h e n s iv e m e a s u re m e n t o f p e rfo rm a n c e and p o sitio n
o f m a n a g e m e n t’s d e c is io n s f o r in te rn a l use a n d f o r
b y re c o g n is in g e c o n o m ic e v e n ts re gardless o f w h e n cash
tra n s m is s io n t o e x te rn a l in te re s te d p a rtie s (s u c h as
tra n s a c tio n s h a p p e n , as o p p o se d to th e s im p le r cash basis
in v e s to rs , c r e d ito rs a n d re g u la to ry a g e n cie s ).
o f a c c o u n tin g . U n d e r th is m e th o d , re ve n u e s an d expenses
Accounting entity th e e n te rp r is e f o r w h ic h th e a c c o u n tin g is b e in g d o n e . T h e e n tit y m a y be a s in g le legal c o m p a n y o r o t h e r
(a n d re la te d assets a n d lia bilitie s) are re fle c te d in th e a c c o u n ts in th e p e rio d to w h ic h th e y re la te .
Accrual profit
o rg a n is a tio n , an e c o n o m ic u n it w ith o u t legal s ta n d in g
th e re s u lt o f s u b tra c tin g e x p e n s e s f r o m re v e n u e (s ),
(s u c h as a p r o p r ie to rs h ip ) o r a g r o u p o f c o m p a n ie s w ith
w h e n b o th k in d s o f a c c o u n ts a re c a lc u la te d b y a c c ru a l
c o n n e c te d o w n e rs h ip f o r w h ic h c o n s o lid a te d fin a n c ia l
a c c o u n tin g . S e e A c c ru a l a c c o u n tin g , N e t p ro fit.
s ta te m e n ts a re p re p a re d .
Accounting equation th e d o u b le - e n t r y a r it h m e t ic b y w h ic h A s s e ts = L ia b ilitie s + S h a re h o ld e rs ’ e q u ity .
Accounting policies
Accrued expenses an e x p e n s e re c o g n is e d in th e a c c o u n ts b e fo re p a y in g f o r it.
Accumulated depreciation a b a la n c e s h e e t a c c o u n t t h a t a c c u m u la te s to ta l
th e s p e c ific p rin c ip le s , bases, c o n v e n tio n s , ru le s an d
d e p re c ia tio n (a m o r tis a tio n ) e x p e n s e o v e r a n u m b e r o f
p r a c tic e s c h o s e n b y an e n tit y in p re p a rin g an d
y e a rs . T h e a c c o u n t b a la n c e is a c r e d it, so it is o p p o s ite
p r e s e n tin g fin a n c ia l s ta te m e n ts . F o r e x a m p le s , see th e
t o th e d e b it b a la n c e a s s e t c o s t a c c o u n t. T h e d iffe re n c e
n o te s im m e d ia te ly fo llo w in g th e fin a n c ia l s ta te m e n ts o f
b e tw e e n c o s t a n d a c c u m u la te d d e p re c ia tio n is th e b o o k
any co m p any.
v a lu e o f th e asset. A c c u m u la te d d e p re c ia tio n re la te s to
Glossary
ta n g ib le a ssets a n d a c c u m u la te d a m o r tis a tio n re la te s to
Allowance For doubtFul debts
in ta n g ib le assets. S e e A m o rtis a tio n , C o n tra ac c o u n t,
th e e s tim a te d a m o u n t o f a c c o u n ts re c e iv a b le t h a t w ill
D e p re c ia tio n .
n o t be c o lle c te d (w h ic h a re ‘d o u b t fu l’). T h e a c c o u n t, w h ic h is a c o n tra a c c o u n t t o a c c o u n ts re c e iv a b le , is
Adjusted trial balance
use d in o r d e r t o re c o g n is e th e bad d e b ts e x p e n s e
t h e lis t o f a c c o u n ts t h a t a re p re p a re d a f t e r all th e
re la te d t o s u c h d o u b tfu l a c c o u n ts , b u t w ith o u t re m o v in g
a c c ru a l a c c o u n tin g a d ju s tm e n ts a n d c o r r e c tio n s have
th o s e a c c o u n ts f r o m th e b o o k s , b e c a u s e th e f ir m w ill
b e e n m a d e , so re p r e s e n tin g th e fin a l a c c o u n t b a la n c e s
s till t r y t o c o lle c t th e a m o u n ts o w in g .
u sed in p re p a rin g t h e fin a n c ia l s ta te m e n ts . S e e A d ju s tin g e n try , T ria l balance.
Amortisation a llo c a tio n o f th e c o s t o f an in ta n g ib le a s s e t t o an
Adjusting entry
e x p e n s e a c c o u n t o v e r se ve ra l a c c o u n tin g p e rio d s to
a jo u r n a l e n tr y t o im p le m e n t a c c ru a l a c c o u n tin g b y
re c o g n is e th e ‘c o n s u m p tio n ’ o f th e a s s e t’s e c o n o m ic
re c o g n is in g , in t h e a c c o u n ts , e c o n o m ic e v e n ts t h a t a re
v a lu e as it h e lp s t o e a rn re v e n u e o v e r th o s e p e rio d s .
n o t y e t a d e q u a te ly a c c o u n te d f o r b y th e ro u tin e tra n s a c tio n a l a c c o u n tin g s y s te m . F o r e x a m p le , i f th e r e is
735
Annual report
n o tra n s a c tio n t o re ve a l th e g ra d u a l w e a r a n d te a r o f a
th e d o c u m e n t p ro v id e d a n n u a lly t o s h a re h o ld e rs b y th e
fix e d a s se t, an a d ju s tin g e n tr y m u s t be m a d e to
o f f ic e r s o f a c o m p a n y . It in c lu d e s th e fin a n c ia l
re c o g n is e th is d e p re c ia tio n .
s ta te m e n ts , th e n o te s t o t h e fin a n c ia l s ta te m e n ts , th e a u d ito r ’s r e p o r t, s u p p le m e n ta r y fin a n c ia l in fo r m a tio n ,
Adjustment
s u c h as m u lti- y e a r s u m m a rie s , a n d re p o r ts f r o m th e
see A d ju s tin g e n try .
Ageing of accounts receivable th e p ro c e s s o f c la s s ify in g a c c o u n ts re c e iv a b le b y th e tim e
c o m p a n y ’s b o a rd o f d ire c to rs a n d m a n a g e m e n t.
Assets a re s o u rc e t h a t is c o n tr o lle d b y an e n tit y as a re s u lt o f
t h a t has passed sin c e th e a c c o u n t c a m e in to e x is te n c e .
p a s t e v e n ts , a n d f r o m w h ic h f u t u r e e c o n o m ic b e n e fits
T h is c la s s ific a tio n is used as an aid t o e s tim a tin g th e
a re e x p e c te d t o f lo w t o th e e n tity .
re q u ire d a llo w a n c e f o r d o u b tfu l d e b ts f o r th e e s tim a te d a m o u n t o f u n c o lle c ta b le a c c o u n ts re c e iv a b le .
Associated company a c o m p a n y , w h ic h is n o t a s u b s id ia ry o f an in v e s to r
Agency theory
c o m p a n y , o v e r w h ic h th e in v e s to r has s ig n ific a n t
is c o n c e rn e d w ith re la tio n s h ip s b e tw e e n p e o p le in w h ic h
in flu e n c e (g e n e ra lly 2 0 - 5 0 p e r c e n t o w n e rs h ip ) b u t
o n e o r m o re o f th e m ( th e a g e n ts, su ch as m ana gers,
n o t c o n tr o l. S e e E q u ity m e th o d .
a u d ito rs an d la w ye rs) is e n tru s te d w ith a c tin g on b e h a lf o f o n e o r m o re o th e rs ( th e prin cip a ls, su ch as o w n e rs ,
Audit committee
c r e d ito rs and d e fe n d a n ts ). A g e n c y th e o ry te n d s to fo c u s
a s u b c o m m itte e o f th e b o a rd o f d ire c to rs , g e n e ra lly
o n th e s te w a rd s h ip ro le o f a c c o u n tin g in fo rm a tio n (in
c o m p ris in g n o n - e x e c u tiv e d ir e c to r s w h o liaise w ith th e
m o n ito rin g and c o n tro llin g th e ste w a rd s h ip o f th e a g e n t o n
e x te rn a l a n d in te rn a l a u d ito rs .
b e h a lf o f th e p rin c ip a l). P rin cip a ls an d a g e n ts ca n d e m a n d w h a te v e r in fo rm a tio n th e ir s p e c ific re la tio n s h ip re quires.
Audit report th e a u d ito r ’s r e p o r t o n th e t r u t h a n d fa irn e s s o f t h e s e t
Agent a p e rso n w h o is a p a rty t o a c o n tr a c t b e tw e e n h im - o r h e rs e lf a n d a n o th e r, ca lle d th e p rin c ip a l. T h e a g e n t’s ro le
o f fin a n c ia l s ta te m e n ts .
Available cost th e to ta l d o lla r a m o u n t re p re s e n te d b y th e s u m o f
is to c a rr y o u t th e w ish e s o f th e p rin c ip a l, as s p e c ifie d in
b e g in n in g in v e n to r y a n d p u rc h a s e s d u rin g th e p e rio d ,
th e c o n tra c t. S o m e e x a m p le s o f a g e n ts a re m a n a g e rs,
t h e r e f o r e re p r e s e n tin g th e t o t a l d o lla r c o s t o f in v e n to ry
a u d ito rs a n d la w ye rs, w h o a re e n tru s te d w ith a c tin g on
a v a ila b le f o r sale o r use d u rin g th e p e rio d .
b e h a lf o f o n e o r m o re o th e rs ( t h e p rin c ip a ls , s u c h as o w n e rs , c r e d ito rs a n d d e fe n d a n ts ). A ig e n ts have
Average cost (AVGE) an in v e n to r y c o s t f lo w a s s u m p tio n b y w h ic h th e c o s t o f
a s te w a rd s h ip re s p o n s ib ility t o th e p rin c ip a l. S ee
an in d iv id u a l u n it o f in v e n to r y is th e w e ig h te d a v e ra g e
S tew ardship.
c o s t o f th e b e g in n in g in v e n to ry a n d s u b s e q u e n t
Allocation
p u rc h a s e s .
s p re a d in g th e im p a c t o f an e v e n t o u t o v e r tim e , as in d e p re c ia tio n o f an a s s e t’s c o s t o v e r its u s e fu l life o r
B
re c o g n itio n o f re v e n u e f o r a lo n g - t e r m c o n t r a c t o v e r se ve ra l p e rio d s . (A llo c a tio n is also u sed, e s p e c ia lly in
Bad debts expense
m a n a g e m e n t a c c o u n tin g , t o r e fe r t o s p re a d in g th e
an e x p e n s e a c c o u n t t h a t re s u lts f r o m th e re d u c tio n in
im p a c t o f an e v e n t a c ro s s a c tiv itie s , s u c h as in a llo c a tin g
c a rr y in g v a lu e o f th o s e a c c o u n ts re c e iv a b le t h a t ha ve
H e a d O f f i c e c o s ts t o d if fe r e n t d e p a r tm e n ts o r
b e e n p ro je c te d t o be u n c o lle c ta b le o r d o u b tfu l.
a llo c a tin g o v e rh e a d t o p r o d u c t c o s ts .)
S e e A llo w a n c e fo r d o u b tfu l deb ts.
736
Glossary
Balance sheet th e lis t o f assets, lia b ilitie s a n d o w n e rs ’ e q u ity t h a t
Capital market theory d e a ls w ith th e b e h a v io u r o f a g g re g a te m a rk e ts (s u c h as
c o n s titu te s th e fo rm a l s ta te m e n t o f a c o m p a n y ’s
s h a re m a r k e ts ) a n d w ith th e ro le o f in fo r m a tio n in th e
fin a n c ia l p o s itio n a t a s p e c ifie d d a te , s u m m a ris in g , b y
o p e ra tio n o f s u c h m a rk e ts .
c a te g o r y , th e assets, lia b ilitie s a n d s h a re h o ld e rs ’ e q u ity .
Balance sheet valuation
Capitalisation th e re c o g n itio n o f an e x p e n d itu r e t h a t m a y b e n e fit a
th e a s s ig n m e n t o f n u m e ric a l v a lu e s t o th e b a la n c e
f u t u r e p e rio d as an a s se t ra th e r th a n as an e x p e n s e o f
s h e e t’s assets, lia b ilitie s a n d s h a re h o ld e rs ’ e q u ity
th e p e rio d o f its o c c u r re n c e . E x p e n d itu re s a re
a c c o u n ts .
c a p ita lis e d i f th e y a re lik e ly t o lead t o f u t u r e b e n e fits
Bank overdraft a n e g a tiv e b a n k a c c o u n t b a la n c e (w ith d ra w a ls e x c e e d in g
a n d , th u s , m e e t t h e c r ite r io n t o be an asset.
Carrying amount
d e p o s its ), w h ic h b a n ks m a y a llo w as a d e fa c t o lo a n as
th e a m o u n t a t w h ic h th e a s s e t is re c o r d e d in th e
lo n g as it is te m p o r a r y . S e e Line o f c re d it.
a c c o u n tin g re c o rd s a t a p a rtic u la r d a te . W h e n a p p lie d to
Bank reconciliations th e re c o n c ilia tio n o f a b a n k s ta te m e n t w ith th e fig u re s in a c o m p a n y ’s ca sh a t b a n k le d g e r a c c o u n t.
Basic earnings per share c a lc u la te d b y d iv id in g t h e p r o f it o f a c o m p a n y b y th e w e ig h te d a v e ra g e n u m b e r o f o r d in a r y sh a re s o u ts ta n d in g d u rin g th e y e a r.
Betterment an e x p e n d itu r e t o im p ro v e an a s s e t’s v a lu e t o th e b u sin e ss , w h ic h c o m m o n ly e x te n d s th e a s s e t’s f u n c tio n a lit y a n d /o r u s e fu l life ( m o r e t h a n ju s t re p a irs a n d m a in te n a n c e ) , a n d is a d d e d t o t h e v a lu e o f th e a s s e t (c a p ita lis e d ), n o t e x p e n s e d .
Big bath a w a y o f m a n ip u la tin g r e p o r te d p r o f it t o s h o w e v e n p o o re r re s u lts in a p o o r y e a r in o r d e r t o e n h a n c e la te r y e a rs ’ re s u lts .
Bonds
a d e p re c ia b le a s se t, ‘c a rr y in g a m o u n t’ m e a n s th e n e t a m o u n t a f t e r d e d u c tin g a c c u m u la te d d e p re c ia tio n o r a m o rtis a tio n .
Cash Flow cycle th e t im e f r o m th e p a y m e n t o f g o o d s p u rc h a s e d f o r m a n u fa c tu re o r re sale t o r e c e ip t o f ca sh f o r fin a l p r o d u c t o r sale.
Cash Flow From Financing C a s h in flo w s o r o u tflo w s f r o m fin a n c in g a c tiv itie s , in c lu d in g s h a re issues a n d b o rro w in g s .
Cash Flow From operations ca sh g e n e ra te d b y d a y - t o - d a y b u sin e ss a c tiv itie s an d h ig h lig h te d as th e f ir s t s e c tio n in th e s ta te m e n t o f cash flo w s .
Cash Flow statement see S ta te m e n t o f cash flow s.
Chart oF accounts an o rg a n is e d lis t o f th e a c c o u n ts u sed in th e a c c o u n tin g
an in s tr u m e n t o f d e b t issu e d b y an e n te rp r is e in re tu rn
s y s te m . T h is c a n be c o n tra s te d w ith th e tria l b a la n c e ,
f o r ca sh , in w h ic h a p ro m is e is m a d e t o re p a y th e d e b t
w h ic h d isp la ys all th e a c c o u n ts a n d t h e ir d e b it o r c r e d it
(u s u a lly a t a p a rtic u la r d a te o r o n a s p e c ifie d s c h e d u le )
ba la n ce s.
p lu s in te re s t.
Bond market
Classification th e c h o ic e o f w h e re in t h e fin a n c ia l s ta te m e n ts to
c a p ita l m a rk e ts in w h ic h d e b t in s tru m e n ts (b o n d s a n d
p la c e an a c c o u n t, s u c h as w h e th e r an in v e s tm e n t
s im ila r ite m s ), ra th e r th a n sh a re s, a re tra d e d .
a s s e t s h o u ld be s h o w n as a c u r r e n t a s s e t o r a
Bonus issues th e issu e o f a d d itio n a l sh a re s t o e x is tin g s h a re h o ld e rs w ith
n o n c u r r e n t asset.
Closing entries
n o c o s t in c u rr e d b y th e m . F o r e x a m p le , a t w o - f o r - o n e
jo u r n a l e n tr ie s t h a t a re re c o r d e d a t y e a r - e n d to
b o n u s issu e w o u ld in v o lv e th e issu e o f tw o a d d itio n a l
tr a n s fe r th e b a la n c e s in t e m p o r a r y a c c o u n ts
sh a re s f o r e v e ry sh a re h e ld . S e e S h a re dividends.
(re v e n u e s , e x p e n s e s a n d d iv id e n d s ) t o th e b a la n ce
Book value per share to ta l s h a re h o ld e rs ’ e q u ity d iv id e d b y th e n u m b e r o f sh a re s issu ed.
s h e e t’s a c c o u n t o f re ta in e d p r o fits , a n d s e t th o s e b a la n c e s t o z e ro in p re p a ra tio n f o r e n te rin g th e n e x t y e a r’s tra n s a c tio n s .
Common size Financial statement
c
a te c h n iq u e use d f o r a n a ly s in g fin a n c ia l s ta te m e n ts
Capital maintenance th e c o n c e p t t h a t th e o w n e rs ’ e q u ity o f a b u s in e s s s h o u ld be s u s ta in e d b e fo re d is trib u tio n s a re pa id o u t o f th e c o m p a n y t o o w n e rs .
t h a t in v o lv e s in c o m e s ta te m e n t fig u re s b e in g e x p re s s e d in p e rc e n ta g e s o f re v e n u e , an d b a la n ce s h e e t a c c o u n ts b e in g e x p re s s e d in p e rc e n ta g e s o f to ta l assets.
Glossary
Comparability
737
o p e ra tin g c y c le o f an e n te rp r is e (u s u a lly o n e y e a r). S e e
in fo r m a tio n t h a t e n a b le s u s e rs t o id e n tif y s im ila ritie s
s u c h c u r r e n t a s s e t c a te g o rie s as A c c o u n ts re ceivable,
in a n d d iffe re n c e s b e tw e e n tw o s e ts o f e c o n o m ic
In v e n to ry .
p h e n o m e n a , s u c h as tw o d if fe r e n t y e a rs o f a c o m p a n y ’s fin a n c ia l s ta te m e n ts .
Current liabilities lia b ilitie s t h a t a re e x p e c te d t o be p a id w ith in th e n o rm a l
Consolidated Financial statements
o p e ra tin g c y c le o f an e n te rp r is e (u s u a lly o n e y e a r). S e e
a m e th o d o f p r e p a rin g fin a n c ia l s ta te m e n ts f o r a g r o u p o f c o m p a n ie s lin k e d b y o w n e rs h ip as i f t h e y w e re a s in g le c o m p a n y . C o n s o lid a te d
A c c o u n ts payable.
Current market value th e e s tim a te d sale v a lu e o f an as se t, s e ttle m e n t v a lu e o f
fin a n c ia l s ta te m e n ts re c o g n is e t h a t th e
a d e b t o r tra d in g v a lu e o f an e q u ity sh are .
s e p a ra te lega l e n titie s a re c o m p o n e n ts o f o n e e c o n o m ic u n it.
Current ratio c u r r e n t a ssets d iv id e d b y c u r r e n t lia b ilitie s .
Consolidated goodwill a f o r m o f g o o d w ill a ris in g o n ly w h e n c o m p a n ie s ’ fin a n c ia l
Current value accounting a p ro p o s e d a c c o u n tin g m e th o d t h a t uses c u r r e n t o r
s ta te m e n ts a re c o m b in e d in c o n s o lid a tio n .
m a r k e t v a lu e s t o v a lu e a s se ts a n d lia b ilitie s a n d to
Contra account
c a lc u la te p r o fit.
a c c o u n ts e s ta b lis h e d t o a c c u m u la te c e rta in d e d u c tio n s f r o m an as se t, lia b ility o r o w n e rs ’ e q u ity ite m .
D
S e e A llo w a n c e fo r d o u b tfu l deb ts, A m o rtis a tio n , D e p re c ia tio n .
Contra asset an a c c o u n t t h a t n o rm a lly has a c r e d it b a la n c e , b u t is
Days sales in receivables th e ra tio o f a c c o u n ts re c e iv a b le t o th e d a ily sales, e x p re s s e d in n u m b e r o f d a y s ’ sales re p re s e n te d b y a c c o u n ts re c e iv a b le .
lo c a te d in th e a s s e t p a rt o f t h e b a la n c e s h e e t, a n d d e d u c te d f r o m th e a s s e t t o g iv e a n e t b a la n ce . E x a m p le s in c lu d e a c c u m u la te d d e p re c ia tio n an d a llo w a n c e f o r d o u b tfu l d e b ts .
Control accounts
Debt-to-assets ratio to ta l lia b ilitie s d iv id e d b y to ta l assets.
Depreciation a llo c a tio n o f th e c o s t o f a n o n c u r r e n t a s s e t t o e x p e n s e
a g e n e ra l le d g e r a c c o u n t f o r w h ic h th e r e is d e ta ile d
o v e r se ve ra l a c c o u n tin g p e rio d s t o re c o g n is e th e
an a lysis p ro v id e d in th e s u b s id ia ry le d g e r.
c o n s u m p tio n o f th e a s s e t’s e c o n o m ic v a lu e as it h e lp s to
Corporate governance t h e s y s te m b y w h ic h c o m p a n ie s a re d ire c te d a n d m a n a g e d . It in flu e n c e s h o w th e o b je c tiv e s o f th e c o m p a n y a re s e t a n d a c h ie v e d , h o w risk is
e a rn re v e n u e o v e r th o s e p e rio d s . T h e t e r m ‘d e p re c ia tio n ’ is u sed w ith re s p e c t t o ta n g ib le a s se ts, w h ile ‘a m o r tis a tio n ’ is use d w ith re s p e c t t o in ta n g ib le assets. S e e A c c u m u la te d d e p re c ia tio n , A m o rtis a tio n , S tra ig h t lin e d e p re c ia tio n .
m o n ito r e d a n d assessed, a n d h o w p e rfo rm a n c e is o p tim is e d .
Cost Flow assumptions an a s s u m p tio n m a d e a b o u t th e o r d e r in w h ic h u n its o f in v e n to r y m o v e in to a n d o u t o f an e n te rp ris e , use d to c o m p u te in v e n to r y a s s e t v a lu e a n d c o s t o f g o o d s so ld
Direct energy and emission sources e n e rg y c o n s u m p tio n o r p r o d u c tio n u n d e rta k e n a t, a n d g re e n h o u s e e m is s io n s a ris in g f r o m , o p e ra tio n s o v e r w h ic h th e b u sin e ss has th e a u th o r it y t o in tr o d u c e an d im p le m e n t o p e ra tin g , e n v iro n m e n ta l a n d h e a lth a n d s a fe ty p o lic ie s .
e x p e n s e in ca se s w h e re th e o r d e r o f flo w is n o t o r c a n n o t be id e n tifie d . P o s s ib le a s s u m p tio n s in c lu d e
Direct method oF cash Flow analysis
F I F O , L I F O a n d w e ig h te d a v e ra g e . S e e C o s t o f goods
a m e th o d o f p re p a rin g th e S ta te m e n t o f cash flow s,
sold, F irs t in , fir s t o u t, a n d Last in , fir s t o u t f o r s p e c ific
e s p e c ia lly th e ca sh f r o m o p e ra tio n s s e c tio n , u s in g
e x a m p le s .
Cost oF goods sold (COGS)
re c o rd s o f ca sh re c e ip ts a n d d is b u rs e m e n ts in s te a d o f th e a d ju s tm e n ts t o n e t in c o m e u sed in t h e m o re tra d itio n a l In d ire c t m e th o d o f cash flo w analysis.
an e x p e n s e a c c o u n t t h a t r e fle c ts th e c o s t o f g o o d s t h a t g e n e ra te d th e re v e n u e (a ls o c a lle d c o s t o f sa le s). S e e C o s t flo w as sum ptions, G ross p r o fit, In v e n to ry cost.
Current assets c a s h an d o t h e r assets, s u c h as te m p o r a r y in v e s tm e n ts , in v e n to ry , re c e iv a b le s a n d c u r r e n t p re p a y m e n ts , t h a t a re re a lis a b le o r w ill be c o n s u m e d w ith in t h e n o rm a l
Direct write-oFF th e t r a n s fe r o f th e c o s t o f an a s s e t t o an e x p e n s e o r Loss a c c o u n t b y re m o v in g th e a m o u n t e n tire ly fr o m th e a s se t a c c o u n t. U s e d in ca se s w h e re th e r e is no p r io r a llo w a n c e f o r th e e x p e n s e o r loss, so use d w h e n th e r e is n o C o n tra a c c o u n t s u c h as A llo w a n c e fo r d o u b tfu l deb ts.
738
Glossary
Discontinued operations
losses o f f u t u r e e c o n o m ic b e n e fits in t h e f o r m o f
p o rtio n s o f t h e b u s in e s s t h a t th e e n te rp r is e has d e c id e d
re d u c tio n s in a s se ts o r in c re a s e s in lia b ilitie s o f th e
t o n o t k e e p g o in g a n d /o r t o sell t o o th e rs .
e n tity , o t h e r th a n th o s e re la tin g t o d is trib u tio n s to o w n e rs , t h a t re s u lt in a d e c re a s e in e q u ity d u rin g th e
Dividend payout ratio
r e p o r tin g p e rio d . S e e A c c ru a l ac c o u n tin g , In c o m e
th e ra tio o f d iv id e n d s d e c la re d t o n e t p r o fit.
Dividends d is trib u tio n s o f a p o rtio n o f n e t p r o f it t o s h a re h o ld e rs in
s ta te m e n t, E xp en se re c o g n itio n , R evenues.
Expense recognition th e in c o rp o ra tio n o f m e a s u re s o f e x p e n s e s in c u rre d
th e c o m p a n y .
in to th e m e a s u re m e n t o f p r o f it b y e n te rin g in to th e
Double-entry accounting
a c c o u n ts t h e a m o u n t o f e x p e n s e d e te rm in e d ,
th e p r a c tic e o f re c o r d in g tw o a s p e c ts o f e a ch
a c c o r d in g t o th e f ir m ’s a c c o u n tin g p o lic ie s , t o be
tra n s a c tio n o r e v e n t: t h e re s o u rc e e f f e c t a n d th e
a ttrib u ta b le t o th e c u r r e n t p e rio d . S e e R e v e n u e
s o u rc e e f f e c t . T h o u g h m u c h e x p a n d e d s in c e its
re c o g n itio n .
in v e n tio n se ve ra l h u n d re d y e a rs a g o , it is s till th e basis o f b o o k k e e p in g a n d fin a n c ia l a c c o u n tin g .
Expensing c la s s ify in g an e x p e n d itu r e o r p ro m is e d e x p e n d itu r e
E
(a c c r u a l) as an e x p e n s e ra th e r th a n an asset. T h e o p p o s ite o f C a p ita lis a tio n .
Earnings before interest and tax (EBIT) a m e a s u re o f p r o f it ba sed o n t h e o p e ra tin g p r o f it b e fo re in te r e s t a n d ta x e s a re d e d u c te d .
Earnings before interest, tax, depreciation and amortisation (EBITDA) a m e a s u re o f p r o f it ba sed o n t h e o p e ra tin g p r o f it b e fo re d e d u c tin g in te re s t, ta x , d e p re c ia tio n an d a m o rtis a tio n .
Earnings per share (EPS) th e ra tio o f n e t p r o f it t o th e a v e ra g e n u m b e r o f o r d in a ry ( v o tin g ) sh a re s o u ts ta n d in g ; u sed t o a llo w th e o w n e r o f th e sh a re s t o re la te th e c o m p a n y ’s e a rn in g p o w e r t o th e size o f his o r h e r in v e s tm e n t.
Efficient capital market a th e o r e tic a l d e s c r ip tio n o f a c a p ita l m a r k e t w h o s e p ric e s re s p o n d q u ic k ly a n d a p p ro p ria te ly t o in fo rm a tio n .
Efficient market hypothesis th e p ro p o s a l t h a t c a p ita l m a rk e ts a c tu a lly a re e ffic ie n t, re s p o n d in g q u ic k ly , s m o o th ly a n d a p p ro p ria te ly to in fo r m a tio n . S o m e s e e m t o be e ffic ie n t; s o m e d o n o t. S e e E ffic ie n t c a p ita l m a rk e t.
Employee deductions
F Fair value th e a m o u n t f o r w h ic h an a s s e t c o u ld be e x c h a n g e d , o r a lia b ility s e ttle d , b e tw e e n k n o w le d g e a b le , w illin g p a rtie s in an a r m ’s - le n g th tra n s a c tio n .
Financial leverage see Leverage.
Financial performance th e e n te rp r is e ’s a b ility t o g e n e ra te n e w re s o u rc e s f r o m d a y - t o - d a y o p e ra tio n s o v e r a p e rio d o f tim e , via d e a lin g w ith c u s to m e rs , e m p lo y e e s a n d s u p p lie rs . M e a s u re d by th e n e t p r o f it fig u r e in t h e in c o m e s ta te m e n t.
Financial position th e e n te rp r is e ’s s e t o f a s se ts, lia b ilitie s a n d o w n e rs ’ e q u ity a t a p o in t in tim e . M e a s u re d b y th e b a la n c e s h e e t.
Financial statements th e re p o r ts f o r p e o p le w h o a re e x te rn a l t o th e e n te rp r is e ( a lth o u g h t h e y a re also o f in te r e s t t o m a n a g e m e n t) re fe rr e d t o in th e d e fin itio n o f a c c o u n tin g , w h ic h g e n e ra lly c o m p ris e a b a la n c e s h e e t,
a m o u n ts t h a t a re d e d u c te d f r o m an e m p lo y e e ’s g ro s s
an in c o m e s ta te m e n t, a s ta te m e n t o f ca sh flo w s a n d th e
sa la ry b e fo re t h e n e t a m o u n t is pa id t o h im o r h e r.
n o te s t o th e s e s ta te m e n ts .
T h e s e d e d u c tio n s in c lu d e in c o m e ta x , s u p e ra n n u a tio n , u n io n fe e s a n d h e a lth in s u ra n c e .
Equity method a m e th o d o f a c c o u n tin g f o r in te r c o r p o r a te in v e s tm e n ts u s u a lly used w h e n a c o m p a n y o w n s b e tw e e n 2 0 p e r c e n t a n d 5 0 p e r c e n t o f a n o th e r c o m p a n y . T h e in v e s tm e n t is c a rr ie d a t c o s t, a n d a n y p r o f it o r loss, m u ltip lie d b y th e p e rc e n ta g e o w n e rs h ip o f th e o w n e d c o m p a n y , is a d d e d t o o r d e d u c te d f r o m th e in v e s tm e n t. A n y d iv id e n d s re c e iv e d a re d e d u c te d f r o m th e in v e s tm e n t.
Expense
Financing activities p a rt o f th e s ta te m e n t o f ca sh flo w s f o r th o s e a c tiv itie s t h a t re la te t o th e c h a n g in g size a n d c o m p o s itio n o f th e fin a n c ia l s t r u c tu r e o f th e e n tity .
First in, First out (FIFO) an in v e n to r y c o s t flo w a s s u m p tio n b y w h ic h c o s t o f g o o d s so ld is d e te rm in e d f r o m th e c o s t o f th e b e g in n in g in v e n to ry a n d th e c o s t o f th e o ld e s t p u rc h a s e s ; th u s th e a c ro n y m F I F O , w h ic h s ta n d s f o r ‘f ir s t in , f ir s t o u t ’. It fo llo w s , t h e r e fo r e , t h a t u n d e r F I F O e n d in g in v e n to r y c o s t is d e te rm in e d f r o m th e
th e c o s t o f a ssets used a n d /o r o b lig a tio n s c r e a te d in
c o s t o f th e m o s t re c e n t p u rc h a s e s . S e e C o s t flo w
g e n e r a tin g re v e n u e . M o r e fo rm a lly , c o n s u m p tio n s o r
assum ptions.
Glossary
Foreign currency translation reserve
739
I
an a c c o u n t a ris in g as a c o n s e q u e n c e o f th e m e th o d used t o c o n v e r t fo re ig n o p e ra tio n s ’ a c c o u n tin g fig u re s in to
Impairment loss
A u s tra lia n d o lla rs f o r th e p u rp o s e o f c o m b in in g th e m w ith
th e a m o u n t b y w h ic h th e c a rr y in g a m o u n t o f an a s se t
th e fig u re s f o r A u s tra lia n o p e ra tio n s . B e c a u s e in c o m e
e x c e e d s its re c o v e ra b le a m o u n t.
s ta te m e n t a c c o u n ts a re g e n e ra lly c o n v e rte d a t a v e ra g e fo re ig n e x c h a n g e ra te s a n d b a la n ce s h e e t a c c o u n ts a re
Income statement a fin a n c ia l s ta te m e n t t h a t s u m m a ris e s t h e re v e n u e s an d
g e n e ra lly c o n v e rte d a t y e a r- e n d o r h is to ric a l ra te s,
e x p e n s e s o f a b u sin e ss f o r a s ta te d p e rio d o f t im e an d
c o n v e rte d a c c o u n ts d o n o t q u ite b a la n ce . T h e d iffe re n c e
c o m p u te s th e n e t p r o f it (re v e n u e s m in u s e x p e n s e s ).
is p u t in to e q u ity as a s e p a ra te ite m , b e ca u s e it d o e s n o t
S o m e tim e s re fe rr e d t o as a p r o f it a n d loss s ta te m e n t.
s e e m to f i t a n y w h e re else, a n d it is p a rt o f th e
S e e c o m p o n e n ts o f th e s ta te m e n t s u c h as E xp ense,
( c o n v e rte d ) re sidua l e q u ity o f th e o w n e rs .
R evenues; see also F in an c ia l p e rfo rm a n c e .
G
Income tax expense
Gain on sale ga in th a t o c c u rs w h e n a c o m p a n y re ce ive s a la rg e r a m o u n t o f p ro c e e d s f o r th e sale o f an asset th a n its b o o k value.
General journal an a c c o u n tin g re c o r d used m a in ly t o re c o r d a c c ru a l a d ju s tm e n ts jo u r n a l e n tr ie s ) n o t p ro v id e d f o r in s e p a ra te sp e c ia lis e d jo u r n a ls .
General ledger a c o lle c tio n o f in d iv id u a l a c c o u n ts t h a t s u m m a ris e s th e e n tir e fin a n c ia l a c c o u n tin g s y s te m o f an e n te rp ris e .
General reserves
an e s tim a te o f th e c u r r e n t a n d f u t u r e ( d e fe r r e d ) in c o m e ta x a ris in g f r o m t h e p r o f it , as c o m p u te d o n th e in c o m e s ta te m e n t a n d m a tc h e d t o th e re v e n u e s a n d e x p e n s e s s h o w n o n th e s ta te m e n t.
Income tax payable th e lia b ility f o r t h e a m o u n t o f in c o m e ta x d u e o n th e y e a r’s p r o fit, c a lc u la te d a c c o r d in g t o th e in c o m e ta x law , w h e th e r o r n o t it m a tc h e s th e In c o m e ta x expense.
Indirect energy and emission sources e n e rg y c o n s u m p tio n o r p r o d u c tio n u n d e rta k e n a t, an d g re e n h o u s e e m is s io n s a ris in g f r o m , o p e ra tio n s o v e r
a m o u n t o f s h a re h o ld e rs ’ fu n d s tr a n s fe rr e d f r o m re ta in e d
w h ic h a n o th e r b u s in e s s has t h e a u th o r ity t o in tr o d u c e
p r o fits . B y tr a n s fe r r in g t o th e g e n e ra l re s e rv e a c c o u n t,
a n d im p le m e n t o p e ra tin g , e n v iro n m e n ta l a n d h e a lth a n d
t h e c o m p a n y is in d ic a tin g t o s h a re h o ld e rs t h a t th is
s a fe ty p o lic ie s .
a m o u n t is n o t in te n d e d t o be d is trib u te d t o s h a re h o ld e rs in d iv id e n d s .
General purpose Financial reports fin a n c ia l re p o r ts t h a t a re p re p a re d in o r d e r t o m e e t th e in fo r m a tio n n e e d s o f a ra n g e o f u s e rs w h o a re u n a b le to c o m m a n d in fo r m a tio n d e s ig n e d f o r t h e ir in d iv id u a l, s p e c ific ne eds.
Generally accepted accounting principles (GAAP)
Indirect mettiod oF cash Flow analysis th e m e th o d o f d e riv in g th e C as h flo w fr o m o p e ra tio n s s e c tio n o f th e s ta te m e n t o f ca sh flo w s b y a d ju s tin g n e t p r o f it f o r n o n -c a s h ite m s .
Intangible assets n o n -p h y s ic a l n o n c u r r e n t a s se ts s u c h as c o p y r ig h ts , p a te n ts , tra d e m a rk s , im p o r t a n d e x p o r t lic e n c e s , o t h e r rig h ts t h a t g iv e a f ir m an e x c lu s iv e o r p re fe rr e d p o s itio n
p rin c ip le s a n d m e th o d s o f a c c o u n tin g t h a t ha ve th e
in t h e m a rk e tp la c e , a n d g o o d w ill. S e e A m o rtis a tio n ,
g e n e ra l s u p p o r t o f s ta n d a r d - s e ttin g b o d ie s , g e n e ra l
A ssets.
p r a c tic e , te x ts a n d o t h e r s o u rc e s . S e e A c c o u n tin g standards.
Going concern
Integrated reporting b rin g s t o g e th e r m a te ria l in fo r m a tio n a b o u t an o r g a n is a tio n ’s s tra te g y , g o v e rn a n c e , p e rfo rm a n c e
a fu n d a m e n ta l a s s u m p tio n in fin a n c ia l a c c o u n tin g th a t a
a n d p r o s p e c ts in a w a y t h a t r e fle c ts th e c o m m e rc ia l,
fir m w ill c o n tin u e to be fin a n c ia lly viable. If a fir m is n o t a
s o cia l a n d e n v iro n m e n ta l c o n t e x t w ith in w h ic h
g o in g c o n c e rn , n o rm a l a c c o u n tin g p rin c ip le s d o n o t apply.
it o p e ra te s . It p ro v id e s a c le a r a n d c o n c is e
Gross proFit sales re v e n u e m in u s c o s t o f g o o d s so ld . A ls o c a lle d g ro s s m a rg in .
re p r e s e n ta tio n o f h o w an o rg a n is a tio n d e m o n s tra te s s te w a rd s h ip a n d h o w it c r e a te s a n d s u s ta in s va lu e .
Intercorporate investments
H
in v e s tm e n ts b y o n e c o m p a n y in o t h e r c o m p a n ie s .
Hedging a c tio n s t h a t a re ta k e n t o a v o id o r m in im is e th e p o ssib le
S e e C o n s o lid a te d fin a n c ia l s ta te m e n ts , E q u ity m e th o d .
Interest
a d v e rs e e ff e c t s o f c h a n g e s in e x c h a n g e ra te s a n d
th e a m o u n t c h a rg e d b y a le n d e r f o r th e use o f b o rro w e d
m a r k e t p ric e s (e .g . th e p ric e o f o il).
m oney.
740
Glossary
Internal control
m o s t r e c e n t p u rch a se s. It t h e r e fo r e bases th e c o s t o f g o o d s so ld o n th e m o s t re c e n t p u rc h a s e s an d e n d in g
A p ro c e s s , b r o u g h t a b o u t b y an e n tit y ’s b o a rd o f d ire c to rs , m a n a g e m e n t a n d o t h e r p e rs o n n e l, t h a t is
in v e n to ry o n th e o ld e s t p u rch a se s. S ee C o s t flo w
d e s ig n e d t o p ro v id e re a s o n a b le a s s u ra n c e re g a rd in g th e
assum ptions, F IF O , In v e n to ry cost.
a c h ie v e m e n t o f o b je c tiv e s in th e fo llo w in g c a te g o rie s : •
e ffe c tiv e n e s s a n d e ff ic ie n c y o f o p e ra tio n s
•
re lia b ility o f fin a n c ia l r e p o r tin g
•
c o m p lia n c e w ith a p p lic a b le law s a n d re g u la tio n s .
Ledger a n y b o o k o r e le c tr o n ic re c o r d t h a t s u m m a ris e s th e tra n s a c tio n s f r o m th e b o o k s o f o rig in a l e n tr y in th e fo r m o f a c c o u n ts . S e e A c c o u n t, G e n e ra l le d g e r, Jo u rn als,
Internal transactions tra n s a c tio n s re c o r d e d b y th e e n tit y t h a t d o n o t re s u lt f r o m tra n s a c tin g w ith a t h ir d p a rty b u t a re b o o k e n trie s
T ria l balance.
Leverage th e in c re a s e d ra te o f re tu rn o n o w n e rs ’ e q u ity w h e n
o n ly ; f o r e x a m p le , d e p re c ia tio n e n tr ie s a n d u s in g up
a ssets e a rn a re tu rn la rg e r th a n th e in te r e s t ra te pa id
su p p lie s.
f o r th e d e b t fin a n c in g o f th e m . A ls o re fe rs t o a m e a s u re
Inventory
o f th e a m o u n t o f d e b t issu e d c o m p a re d t o s h a re h o ld e rs ’
g o o d s t h a t a re p u rc h a s e d o r m a n u fa c tu re d b y a
e q u ity . T h e g r e a te r th e p r o p o r tio n o f d e b t, th e h ig h e r
c o m p a n y f o r sale, re sa le o r f u r t h e r use in o p e ra tio n s ,
th e le ve ra g e .
in c lu d in g fin is h e d g o o d s , g o o d s in p ro c e s s , ra w m a te ria ls a n d s u p p lie s . S e e C u r r e n t assets, In v e n to ry cost.
Inventory cost c o m p ris e s v a rio u s m e th o d s o f d e te r m in in g t h e c o s t o f
Leverage ratio th e ra tio o f to ta l a s se ts d iv id e d b y s h a re h o ld e rs ’ e q u ity .
Liability a p re s e n t o b lig a tio n o f t h e e n tit y a ris in g f r o m p a st
in v e n to r y f o r b a la n c e s h e e t v a lu a tio n p u rp o s e s and
e v e n ts , t h e s e ttle m e n t o f w h ic h is e x p e c te d t o re s u lt in
v a lu in g c o s t o f g o o d s so ld . T h e m o r e c o m m o n m e th o d s
an o u tf lo w f r o m th e e n tit y o f re s o u rc e s e m b o d y in g
a re F I F O , L I F O a n d w e ig h te d a v e ra g e .
Inventory turnover c o s t o f g o o d s so ld e x p e n s e -j- a v e ra g e in v e n to r y assets.
e c o n o m ic b e n e fits .
Line of credit a d v a n c e a p p ro v a l f r o m a b a n k t o b o rr o w m o n e y u n d e r
Investing activities
a g re e d c o n d itio n s . A lin e o f c r e d it u s u a lly m e a n s t h a t
th e p a rt o f th e s ta te m e n t o f ca sh flo w s f o r th o s e
th e b o rr o w e r c a n g e t t h e m o n e y as n e e d e d (e .g . w h e n
a c tiv itie s in v o lv in g ca sh t h a t re la te t o t h e a c q u is itio n an d
th e b a n k a c c o u n t is o v e rd ra w n ), w ith o u t f u r t h e r
d isp o sa l o f n o n c u r r e n t assets.
a p p ro v a l.
Investors
Loss on sale
p e o p le w h o o w n in v e s tm e n ts a n d w h o , b e c a u s e o f t h e ir
th e d e fic it t h a t o c c u r s w h e n th e a s s e t’s b o o k v a lu e is
in te r e s t in th e v a lu e o f th o s e sh a re s o r b o n d s , a re
m o r e th a n th e p ro c e e d s re c e iv e d f r o m th e sale o f th e
in te re s te d in in fo r m a tio n a b o u t th e e n te rp ris e s issu in g
asset.
s u c h s h a re s a n d b o n d s.
Lower oF cost or market value a m e th o d o f v a lu in g ite m s o f in v e n to r y w h e re in v e n to r y
J
is v a lu e d a t th e lo w e r o f o rig in a l c o s t o r m a r k e t v a lu e
Journal entries
( t h a t is, N e t re alisable v a lu e ).
a re c o r d o f a tra n s a c tio n o r a c c ru a l a d ju s tm e n t t h a t lists th e a c c o u n ts a ffe c te d , a n d in w h ic h th e to ta l o f th e d e b its e q u a ls th e to ta l o f th e c re d its . S e e A c c o u n ts .
Journals
M Market value th e a m o u n t f o r w h ic h an a s s e t c o u ld be e x c h a n g e d , o r a
c h ro n o lo g ic a l o r p r im a ry re c o rd s in w h ic h a c c o u n tin g
lia b ility s e ttle d , b e tw e e n k n o w le d g e a b le , w illin g p a rtie s in
tra n s a c tio n s o f a s im ila r n a tu re a re p e rm a n e n tly
an a r m ’s - le n g th tra n s a c tio n .
re c o rd e d . S e e G e n e ra l jo u rn a l.
Materiality th e m a g n itu d e o f an o m is s io n o r m is s ta te m e n t o f
L
a c c o u n tin g in fo r m a tio n t h a t, in th e lig h t o f
Last in, First out (LIFO) a c o s t - f lo w a s s u m p tio n t h a t is th e o p p o s ite o f F IF O . L a st in , f ir s t o u t a ssum es t h a t th e u n its so ld a re fr o m th e
s u rr o u n d in g c irc u m s ta n c e s , m a k e s it p ro b a b le t h a t a re a s o n a b le p e rs o n re ly in g o n th e in fo r m a tio n w o u ld have ha d t h e ir ju d g e m e n t c h a n g e d o r in flu e n c e d b y th e o m is s io n o r m is s ta te m e n t. A d e c is io n n o t t o d is c lo s e c e rta in in fo r m a tio n m a y be m a d e b e c a u s e th e a m o u n ts
^ C o m m itte e o f Sponsoring O rganizations o f th e Treadway Commission, Integrated Control - Integrated Framework, Am erican Institute o f C e rtifie d Public A ccountants, New Jersey, Septem ber 1992.
in v o lv e d a re t o o sm a ll t o m a k e a d iffe r e n c e ( it is n o t m a te ria l).
Glossary
Measurement
o t h e r s u p p le m e n ta r y in fo r m a tio n h e lp fu l t o in te r p r e tin g th e fig u re s .
t h e a t t a c h m e n t o f d o lla r fig u re s t o a s se ts, lia b ilitie s , re v e n u e s a n d e x p e n s e s in o r d e r t o p ro d u c e th e fig u re s (v a lu e s ) o n th e b a la n c e s h e e t a n d t o e n a b le th e
0
c o m p u ta tio n o f p r o f it (re v e n u e s m in u s e x p e n s e s ) a n d
OFF balance sheet Financing
e q u ity (a s s e ts m in u s lia b ilitie s ). S e e B alan c e s h e e t v a lu a tio n .
741
m e th o d s o f o b ta in in g fin a n c in g t h a t a v o id h a v in g to re c o r d th e s o u rc e s as lia b ilitie s o r e q u ity .
Operating activities
N
th e p a rt o f a s ta te m e n t o f ca sh flo w s t h a t re la te s t o th e
Net book value
p ro v is io n o f g o o d s a n d s e rvice s.
t h e c o s t o f an a s s e t m in u s a n y a c c u m u la te d d e p re c ia tio n , a m o r tis a tio n , a llo w a n c e f o r d o u b tfu l d e b ts a n d so o n .
Net loss n e g a tiv e N e t p ro fit.
Net-oF-tax analysis a m e th o d o f d e te rm in in g th e im p a c t o f m a n a g e m e n t d e c is io n s o r a c c o u n tin g c h a n g e s b y w h ic h t h e e f f e c t s o f in c o m e ta x a re in c lu d e d t o p r o d u c e th e n e t a f t e r - t a x e f f e c t o f th e d e c is io n o r c h a n g e .
Net present value
Percentage oF completion a m e th o d o f a llo c a tin g re v e n u e (a n d a s s o c ia te d e x p e n s e s ) o v e r several fis c a l p e rio d s d u rin g w h ic h th e re v e n u e is e a rn e d . U s e d f o r lo n g - te r m c o n s tr u c tio n c o n tra c ts , fra n c h is e re v e n u e a n d s im ila r m u lti- p e r io d re ve n u e s .
Petty cash a fu n d s e t u p t o m a k e sm a ll ca sh p a y m e n ts .
Posted th e tra n s fe r o f jo u r n a l e n trie s t o le d g e r a c c o u n ts , th e r e b y
f o r a p r o je c t o r o b je c t, th e p re s e n t v a lu e o f f u t u r e ca sh
m a k in g th e m p e rm a n e n t. T h e o n ly w a y t o f ix a m is ta k e is
in flo w s m in u s th e p r e s e n t v a lu e o f f u t u r e ca sh o u tflo w s .
t o use an a d ju s tin g o r c o r r e c tin g e n tr y an d p o s t th a t.
Net profit T h e n e t p r o f it o f a b u s in e s s is th e re s id u a l a f te r d e d u c tio n o f e x p e n s e s f r o m re v e n u e s .
Net realisable value t h e fa ir m a r k e t v a lu e t h a t an a s s e t w ill b rin g i f it is so ld t h r o u g h th e usual p r o d u c t m a r k e t m in u s a n y c o m p le tio n
Prepayments e x p e n s e s t h a t ha ve b e e n p a id b u t n o t y e t in c u rr e d ; an e x p e n d itu r e re c o r d e d as a c u r r e n t a s s e t b e c a u s e th e b e n e fit w ill be o b ta in e d in th e n e a r f u t u r e (e .g . in s u ra n c e c o v e ra g e g o o d f o r t h e n e x t y e a r).
Present value
o r d isp o sa l c o s ts . S e e F a ir value, L ow er o f cost or
f u t u r e ca sh in flo w s o r o u tflo w s re d u c e d t o t h e ir p re s e n t
m a rk e t, R e p la c e m e n t cost.
a m o u n t b y re m o v in g f r o m th e m th e in te r e s t t h a t c o u ld
Noncurrent assets a ssets e x p e c te d t o b r in g b e n e fit f o r m o r e th a n o n e fis c a l y e a r.
Noncurrent liabilities lia b ilitie s e x p e c te d t o be re p a id o r o th e rw is e re m o v e d m o r e th a n o n e y e a r in th e fu tu r e .
Notes payable a c c o u n ts p a ya b le t h a t a re s u p p o r te d b y s ig n e d c o n tr a c ts o r o t h e r a g re e m e n ts a n d u s u a lly c a r r y in te re s t. O f t e n e m p lo y e d t o d e s c rib e fin a n c in g t h a t is o b ta in e d fr o m b a n ks , a n d o t h e r fin a n c ia l in s titu tio n s , an d d ra w n o n t o p ro v id e o p e ra tin g fu n d s ( o r fu n d s f o r c o n s tr u c tio n b e fo re c o m p le tio n o f p r o je c ts ) a n d o b ta in m o r e s e c u re d fin a n c in g , s u c h as a m o rtg a g e .
Notes receivable a c c o u n ts re c e iv a b le s u p p o r te d b y s ig n e d c o n tr a c ts o r o t h e r a g re e m e n ts s p e c ify in g re p a y m e n t te rm s , th e in te r e s t ra te a n d o t h e r c o n d itio n s .
Notes to the Financial statements
ha ve b e e n e a rn e d o r p a id ha d th e m o n e y b e e n o n ha n d f o r in v e s tm e n t to d a y .
Price-to-earnings ratio (P/E ratio) c a lc u la te d b y d iv id in g t h e m a r k e t p ric e o f o n e s h a re o f a c o m p a n y b y e a rn in g s p e r sh are .
Price-level-adjusted historical cost a ra re ly u s e d a s s e t v a lu a tio n m e th o d b y w h ic h th e h is to ric a l c o s t o f e a c h a s s e t is re v a lu e d f o r in fla tio n .
Principal-agent theory see A g e n c y th e o ry .
Profit th e e x c e s s o f re v e n u e s o v e r e x p e n s e s . T h e ( n e t ) p r o f it o f a b u s in e s s is th e re sid u a l a f t e r d e d u c tio n o f e x p e n s e s f r o m re v e n u e s . A ls o re fe rr e d t o as in c o m e o r e a rn in g s . S e e G ro ss p r o fit, P r o fit b e fo re tax.
Profit before tax an a m o u n t e q u a l t o re v e n u e m in u s all o t h e r o r d in a r y e x p e n s e s e x c e p t in c o m e ta x . S o m e n o n - ta x e d o r sp e cia l ite m s , s u c h as e x tr a o r d in a r y ite m s , a re p la c e d a fte r
n o te s a p p e n d e d t o th e s ta te m e n ts , p ro v id in g
in c o m e ta x has b e e n d e d u c te d , a n d a re t h e r e f o r e n o t
in fo r m a tio n a b o u t th e a c c o u n tin g p o lic ie s c h o s e n and
p a rt o f p r o f it b e fo re in c o m e ta x .
742
Glossary
Profit margin
Revaluation decrement
th e p e rc e n ta g e o f sales re v e n u e t h a t e n d s u p as p r o fit;
th e a m o u n t b y w h ic h th e re v a lu e d c a rr y in g a m o u n t o f
h e n c e it is th e a v e ra g e p r o f it f o r e a c h d o lla r o f sales.
n o n c u r r e n t as se ts, as a t th e re v a lu a tio n d a te , is less th a n its p re v io u s c a rr y in g a m o u n t.
Provision a lia b ility o f u n c e rta in tin n in g o r a m o u n t.
Revaluation increment th e a m o u n t b y w h ic h th e re v a lu e d c a rr y in g a m o u n t o f a
Purchase order
n o n c u r r e n t a s se t, as a t t h e re v a lu a tio n d a te , e x c e e d s its
a d o c u m e n t use d w h e n a fo rm a l re q u e s t t o b u y
p re v io u s c a rr y in g a m o u n t.
p r o d u c ts o r s e rv ic e s is m a d e .
Revenues
R
a class o f in c o m e re la tin g , ty p ic a lly , t o th e o r d in a ry a c tiv itie s o f an e n tity .
Ratios n u m b e rs p ro d u c e d b y d iv id in g o n e fin a n c ia l s ta te m e n t
Revenue received in advance
f ig u r e b y a n o th e r fig u re ; f o r e x a m p le , th e w o r k in g
a lia b ility a c c o u n t used f o r c u s to m e r d e p o s its o r o t h e r
c a p ita l ra tio is th e to ta l c u r r e n t a s se ts fig u r e d iv id e d b y
ca sh re c e ip ts b e fo re th e c o m p le tio n o f th e sale (e .g .
th e to ta l c u r r e n t lia b ilitie s fig u re . S ta n d a rd ra tio s a re
b e fo re d e liv e ry ).
use d t o assess a s p e c ts o f a f ir m - p a rtic u la rly p r o fita b ility , s o lv e n c y a n d liq u id ity .
Revenue recognition th e e n tr y in to th e a c c o u n ts o f th e a m o u n t o f re v e n u e
ReclassiFication
d e te rm in e d , a c c o r d in g t o th e f ir m ’s a c c o u n tin g p o lic ie s ,
a jo u r n a l e n tr y o r t h e re p o s itio n in g o f an a c c o u n t t h a t
t o be a ttr ib u ta b le t o th e c u r r e n t p e rio d . S e e A c c o u n ts
c h a n g e s th e lo c a tio n o f th e a c c o u n t w ith in th e b a la n ce
re ceiva b le , A c c ru a l a c c o u n tin g , R evenues.
s h e e t o r w ith in th e in c o m e s ta te m e n t b u t d o e s n o t a f f e c t p r o fit.
Reducing balance depreciation an a c c e le r a te d d e p re c ia tio n m e th o d b y w h ic h th e a n n u a l d e p re c ia tio n e x p e n s e is c a lc u la te d as a fix e d p e rc e n ta g e o f th e b o o k v a lu e o f th e as se t, w h ic h d e c lin e s o v e r t im e as d e p re c ia tio n is d e d u c te d . S e e A c c e le ra te d d e p re c ia tio n , D e p re c ia tio n .
Relevance th e c a p a c ity o f in fo r m a tio n t o m a k e a d iffe r e n c e in a d e c is io n b y h e lp in g u s e rs t o f o r m p r e d ic tio n s a b o u t th e o u tc o m e s o f p a st, p re s e n t a n d f u t u r e e v e n ts o r to c o n f ir m o r c o r r e c t p r io r e x p e c ta tio n s . S e e M a te ria lity , T im elin e ss.
Replacement cost th e p r ic e t h a t w ill h a ve t o be p a id in o r d e r t o re p la c e an e x is tin g a s s e t w ith a s im ila r a s s e t. T h is a m o u n t is lik e ly t o be d if f e r e n t f r o m f a ir m a r k e t v a lu e o r n e t
s Sales invoice a d o c u m e n t c o n ta in in g th e d e ta ils o f a sale.
Scope 1 emissions all d ir e c t e m is s io n s ; t h a t is, all e m is s io n s o v e r w h ic h a c o m p a n y has d ir e c t c o n tr o l.
Scope 2 emissions a p a rtic u la r ty p e o f in d ir e c t e m is s io n ; t h a t is, e m is s io n s o v e r w h ic h a c o m p a n y has o n ly in d ir e c t c o n t r o l a ris in g f r o m th e g e n e r a tio n o f p u rc h a s e d e le c tr ic ity , h e a t o r s te a m .
Scope 3 emissions all o t h e r in d ir e c t e m is s io n s ; t h a t is, all e m is s io n s o v e r w h ic h a c o m p a n y has o n ly in d ir e c t c o n t r o l a ris in g fr o m a n y e m is s io n s s o u rc e o t h e r th a n e le c tr ic ity , h e a t o r s te a m p u rc h a s e d b y t h a t c o m p a n y .
Segregation oF duties
re a lis a b le v a lu e . S e e a lso L o w e r o f c o s t o r m a r k e t
an in te rn a l c o n t r o l te c h n iq u e w h e re b y ta s k s t h a t
m e th o d .
in v o lv e s e n s itiv e as se ts, s u c h as ca sh , a c c o u n ts
Retained profits p r o fits n o t y e t d is trib u te d t o o w n e rs ; th e su m o f n e t p r o fits e a rn e d o v e r th e life o f a c o m p a n y , less d is trib u tio n s (d iv id e n d s d e c la re d ) t o o w n e rs .
Return on equity n e t p r o f it d iv id e d b y o w n e rs ’ e q u ity . T h e m o s t f r e q u e n tly u s e d ra tio f o r m e a s u rin g th e b u s in e s s ’s re tu r n t o o w n e rs .
Revaluation th e a c t o f re c o g n is in g a re a s s e s s m e n t o f th e v a lu e s o f n o n c u r r e n t a s se ts, as a t a p a rtic u la r d a te .
re c e iv a b le o r in v e n to rie s , a re d iv id e d u p so o n e p e rs o n d o e s n o t b o th h a n d le th e a s se t an d k e e p th e re c o rd s o f th e asset.
Stiare buybacks a p ro c e s s b y w h ic h a c o m p a n y b u y s its o w n s h a re s a t m a r k e t v a lu e o n th e s to c k e x c h a n g e , th e n c a n c e ls th e m t o re d u c e th e to ta l n u m b e r o f sh a re s o n issue. A llo w e d u n d e r c e rta in c o n d itio n s as s p e c ifie d in th e C o r p o r a tio n s Law .
Share capital th e p o rtio n o f a c o m p a n y ’s e q u ity o b ta in e d b y issu in g s h a re s in r e tu rn f o r ca sh o r o t h e r c o n s id e ra tio n s .
Glossary
Share dividends
743
Sustainability reporting
a d iv id e n d t h a t is pa id b y is s u in g m o r e s h a re s t o p re s e n t
a b ro a d te r m t o d e s c rib e an o rg a n is a tio n ’s r e p o r tin g o n
s h a re h o ld e rs r a th e r th a n p a y in g th e m cash.
its e n v iro n m e n ta l, s o cia l a n d e c o n o m ic p e rfo rm a n c e .
Share splits t h e re is s u e o f sh a re s in w h ic h th e n u m b e r o f n e w sh a re s is s o m e m u ltip le o f th e p re v io u s n u m b e r. F o r e x a m p le , a
T Time value of money
t w o - f o r - o n e s p lit re s u lts in a s h a re h o ld e r o w n in g tw ic e
m o n e y c a n e a rn in te re s t, so m o n e y re c e iv e d in th e
as m a n y sh a re s as b e fo re . B e c a u s e th e r e has o n ly b e e n
f u t u r e is w o r th less in p re s e n t v a lu e te r m s b e c a u s e th e
a c h a n g e in th e n u m b e r o f sh a re s, n o t in th e u n d e rly in g
lo w e r a m o u n t c a n be in v e s te d t o g r o w t o th e fu t u r e
v a lu e o f th e c o m p a n y , t h e s h a re p ric e s h o u ld fa ll in
a m o u n t. M o n e y has a tim e v a lu e b e c a u s e in te re s t
a c c o r d a n c e w ith th e s p lit ( th e r e f o r e , th e n e w sh a re s
a c c ru e s o v e r tim e .
a b o v e s h o u ld ha ve a sh a re p ric e t h a t is a b o u t h a lf th e
Timeliness
p re v io u s p ric e ).
t im e ly in fo r m a tio n is usa b le b e c a u s e it re la te s t o c u r r e n t
Significant influence
d e c is io n n e e d s. In fo r m a tio n t h a t is re c e iv e d to o la te
a c o m p a n y , w h ic h is n o t a s u b s id ia ry o f an in v e s to r
m a y n o t be usa b le b e c a u s e th e t im e f o r m a k in g th e
c o m p a n y , o v e r w h ic h th e in v e s to r has s ig n ific a n t
d e c is io n has a lre a d y passed by. S e e R eleva n ce,
in flu e n c e (g e n e ra lly 2 0 - 5 0 p e r c e n t o w n e rs h ip ) b u t
M a te ria lity .
n o t c o n tr o l. S e e E q u ity m e th o d .
Trade discount
Stakeholder engagement t h e id e n tific a tio n o f an o rg a n is a tio n ’s s ta k e h o ld e rs a n d
a r e d u c tio n in th e s e llin g p ric e s g r a n te d t o c u s to m e rs .
Trade receivables
t h e p r io ritis in g o f th is lis t o f s ta k e h o ld e rs .
A c c o u n ts re ceiva b le t h a t a ris e in th e n o rm a l c o u rs e o f
Statement of cash flows a s ta te m e n t t h a t e x p la in s th e c h a n g e s in ca sh e q u iv a le n t
b u s in e s s w ith c u s to m e rs .
Trial balance
b a la n c e s d u rin g a fis c a l p e rio d .
a lis t o f all th e g e n e ra l le d g e r a c c o u n ts a n d t h e ir
Statement of retained profits
b a la n ce s . T h e s u m o f t h e a c c o u n ts w ith d e b it b a la n c e s s h o u ld e q u a l t h e s u m o f th o s e w ith c r e d it ba la n ce s.
a fin a n c ia l s ta te m e n t o r n o te t h a t s u m m a ris e s th e c h a n g e s in re ta in e d p r o fits f o r th e y e a r.
Triple bottom line reporting
Stewardship
th e r e p o r tin g o f an o r g a n is a tio n ’s d if fe r e n t ty p e s o f c a p ita l re la te d t o e n v iro n m e n ta l, s o cia l a n d e c o n o m ic
t h e c o n c e p t t h a t s o m e p e rs o n s (s u c h as m a n a g e m e n t) a re re s p o n s ib le f o r lo o k in g a f t e r th e a s se ts a n d
p e rfo rm a n c e . M o r e c o m m o n ly re fe rr e d t o n o w as
in te re s ts o f o t h e r p e rs o n s (s u c h as s h a re h o ld e rs ),
S u s ta in a b ility re p o rtin g .
s u ita b le t o a llo w t h e s te w a rd s t o be h e ld a c c o u n ta b le
u
f o r th e a c tio n s ta k e n o n b e h a lf o f th e p rin c ip a ls . S ee
Understandability
a n d t h a t re p o r ts s h o u ld be p re p a re d t h a t w ill be
A g e n c y th e o ry .
o n e o f th e c o n c e p ts u n d e rly in g t h e p re p a ra tio n o f fin a n c ia l s ta te m e n ts is t h a t th e y s h o u ld be a b le t o be
Straight-line depreciation
u n d e r s to o d b y u s e rs w h o a re w illin g t o e x e rc is e d ilig e n c e
a m e th o d o f c o m p u tin g d e p re c ia tio n ( a m o rtis a tio n )
in e x a m in in g th e r e p o r ts an d w h o po sse ss t h e skills an d
s im p ly b y d iv id in g th e d iffe r e n c e b e tw e e n th e a s s e t’s
a b ility t o c o m p re h e n d a c c o u n tin g p ra c tic e s .
c o s t a n d its e x p e c te d sa lvage v a lu e b y th e n u m b e r o f y e a rs th e a s se t is e x p e c te d t o be used. T h e
Unearned revenue
d e p re c ia tio n e x p e n s e is d is trib u te d e v e n ly o v e r th e
a lia b ility a c c o u n t use d f o r d e p o s its o r o t h e r cash
p e rio d s t h a t c o m p ris e th e e x p e c te d u s e fu l life o f th e
re c e ip ts b e fo re th e c o m p le tio n o f th e sale (e .g . b e fo re
asset. T h e m o s t c o m m o n d e p re c ia tio n m e th o d used
d e liv e ry ). A ls o c a lle d R e v e n u e re ceive d in advance.
in A u s tra lia .
Units-oF-production depreciation
Subsidiary ledgers
a d e p re c ia tio n m e th o d w h e re th e a n n u a l d e p re c ia tio n
a s e t o f le d g e r a c c o u n ts t h a t c o lle c tiv e ly p ro v id e a
e x p e n s e v a rie s d ir e c tly w ith t h e y e a r’s p r o d u c tio n
d e ta ile d an a lysis o f o n e c o n t r o l a c c o u n t in th e g e n e ra l
v o lu m e .
le d g e r.
Sustainability management c o n c e rn e d w ith th e m a in te n a n c e a n d lo n g - t e r m
V Value in use
e n h a n c e m e n t o f d if fe r e n t ty p e s o f c a p ita l (in c lu d in g
th e p re s e n t v a lu e o f f u t u r e ca sh flo w s e x p e c te d t o a rise
h u m a n a n d s o cia l c a p ita l) t h a t r e fle c t an o r g a n is a tio n ’s
f r o m th e c o n tin u in g use o f an a s s e t a n d f r o m its
o v e ra ll im p a c t a n d w e a lth .
d isp o sa l a t t h e e n d o f its u s e fu l life .
744
Glossary
w
W rite -o ff re fe rs t o t h e e lim in a tio n o f an a s se t f r o m th e b a la n ce
'W h a t if' (effects) analysis an a lysis o f th e e ff e c t s o n fin a n c ia l s ta te m e n ts o f e c o n o m ic o r a c c o u n tin g p o lic y c h a n g e s .
W orking capital
s h e e t. I f th e r e is a C o n tra a c c o u n t a g a in s t th e a s s e t a lre a d y , th e w r i t e - o f f is m a d e a g a in s t t h e c o n tr a , so e x p e n s e a n d p r o f it a re n o t a ffe c te d . I f th e r e is n o c o n tr a a c c o u n t, th e w r i t e - o f f (a D ir e c t w r it e - o f f ) is
th e d iffe r e n c e b e tw e e n C u r r e n t assets a n d C u r r e n t
m a d e t o an e x p e n s e o r loss a c c o u n t, a n d p r o f it is
liabilities.
re d u c e d .
A A A S B 101 4 2 7 , 4 7 4 , 5 0 2 - 3 , 5 0 6 , 5 0 7 A A S B 128 4 6 5 A A S B 137 4 3 4 c o n tin g e n t liabilities d e fin itio n and flo w ch a rt 4 3 7 accelerated de pre ciatio n 4 3 3 accelerated m e thod 641 a c co u n t balances 9 8 a c co u n t classification 6 3 7 classification policies 6 4 0 exam ples 1 0 9 ac co u n ta b ility 2 8 4 , 6 7 6 accou nta nts 6 (2 ) fin ancial sta te m e n t shaping 7 a c cou nting accrual a c co u n tin g 8-11 basis (accrual) 2 4 0 ‘books’ and records 1 4 3 - 5 5 challenges 2 fo r debentures 4 3 2 early h isto ry 1 3 3 - 8 e n trie s fo r pe riodic/pe rpe tu al in ve n to ry 3 6 0 - 4 fig ure s, origin o f 5 3 fin ancial acco u n tin g 2 - 2 5 m ethod s ch oice 6 3 6 fo r provisions 4 3 4 - 5 system s 2 use and preparation o f 2 acco u n tin g cycle 143, 3 2 8 steps 14 4 acco u n tin g e n tity 21 acco u n tin g equation 3 6 0 , 4 7 0 always balances 4 4 , 5 4 , 8 6 ,1 8 6 A ssets = Liabilities + Shareholders’ eq u ity 1 3 ,4 3 exam ple 5 5 m aintaining 5 4 - 5 negative eq u ity (w here A < L) 4 8 rig h t-h a n d side 8 0 - 4 acco u n tin g num bers 2 2 - 5 orig in 5 3 acco u n tin g period 2 1 -2 acco u n tin g policy changes in 6 3 9 d e fin itio n 6 3 6 - 7 disclosure 3 8 6 , 6 4 3 acco u n tin g p o licy choices appropriateness o f 6 3 8 background 6 3 6 - 4 0 de preciation e ffe c ts analysis 6 4 1 -2 fre e d o m o f ch oice, a m o u n t 6 3 8 intangibles e ffe c ts analysis 6 4 2 - 3 in ve n to ry valuation and C O G S 6 4 0 m anagem ent’s objectives 6 4 3 - 4
m anipulation 6 3 8 - 9 n o t a ffe c tin g p ro fit 6 4 0 reasons f o r ch oice 6 3 7 - 8 tech nical points 6 3 9 - 4 0 acco u n tin g principles 7 a c cou nting in fo rm a tio n use 2 3 7 - 8 a c co u n tin g standards 16, 2 3 6 - 8 , 4 0 7 array o f 6 3 8 principles and 2 3 6 A c c o u n tin g Standards Board (A A S B ) 2 0 F ram ew ork fo r th e P reparation and Presentation o f Financial S tatem ents (F ra m e w o rk) 2 0 a c co u n tin g system s 1 4 3 - 4 in fo rm a tio n flo w in 3 2 9 a c co u n tin g y e a r-e n d (financial ye a rend) 51 accou nts 9 8 arranging on balance sheets 1 0 8 - 9 assets accou nts 155 balance sheets, individual accou nts 4 4 , 51 cash accou nts 2 9 0 - 1 classification 3 3 0 accou nts payable 13, 4 6 , 317, 4 2 5 , 4 2 8 -9 accou nts receivable 13, 3 1 6 -3 7 accrued revenue tre a tm e n t 4 6 5 cash inflo w s claim s 4 5 co n tra accou nts and 3 1 7 -2 3 days in d e btors 5 8 7 detailed re cording 3 2 8 - 9 estim ates 10 illustrative exam ple 3 2 3 - 7 increases/decreases in 14 prim e e n try records - special jo u rn a ls 3 3 0 role o f general jo u rn a ls and general ledgers 3 3 7 valuation o f 318 accrual acco u n tin g 8 -1 1 ,1 8 6 , 5 2 8 adjustm ents 1 8 5 -2 1 4 assum ptions 2 1 3 -1 4 basis 6 3 7 ,6 4 3 versus cash acco u n tin g 1 0 ,1 1 2 -1 4 co m p le x fig ure s 9 co nce ptu al acco u n tin g 1 8 5 -9 2 co n tra accou nts 2 0 4 - 6 e ffe c tiv e c u t- o ffs fo r revenues and expenses 2 0 4 estim ates and assessments 11 exam ple 2 0 7 -1 3 expenses-re ven ue earned m atch in g 3 8 8 financial period 2 0 4 fra m e w o rk im p le m entatio n 1 8 6 - 9 2
good ju d g e m e n t, im p o rta n ce o f 11 levels 113(2) managers and accrual a c cou nting assum ptions 2 1 3 -1 4 m u lti-c o lu m n w orksheets 2 0 0 - 3 using to prepare financial statem en ts 10-11 accrual basis 21 accrual p ro fit 8 , 4 8 , 5 2 8 m easurem ent, co nce ptu al system f o r 186 accruals 1 5 9 -6 1 , 4 2 8 - 9 , 6 0 7 accrued expenses 5 3 , 1 9 8 - 9 accrued in te re st 316 accrued revenues 1 9 9 - 2 0 0 accrued wages see wages payable accum ulated de preciation 4 9 , 51, 2 0 5 -6 , 39 3, 397 deducted fro m co st - ‘PPE n e t’ 5 3 accuracy 331 acid te s t ra tio 4 9 , 5 8 8 , 6 0 2 - 3 a c tiv ity (tu rn o v e r) ratios 5 8 5 - 7 , 601, 607 adjusted tria l balance 2 0 0 adjustm ents 9 4 ,1 5 9 - 6 1 accrual a c cou nting adjustm ents 1 8 5 -2 1 4 adjusting en trie s 153 versus disclosure 6 3 8 ageing o f accou nts receivable 3 2 0 , 3 2 1 -3 agency (c o n tra c t) th e o ry 2 6 5 , 6 4 4 agent 2 6 5 aggregates 2 6 3 allowance fo r d o u b tfu l debts 3 1 9 -2 3 exam ple 3 2 3 - 7 a m bigu ity 4 0 5 am ortisation 2 0 5 - 6 , 3 8 7 , 4 0 3 - 4 , 4 0 5 , 408, 433 eco n o m ic am ortisation 3 8 8 analysts 6 annual re p o rts 4 2 , 2 5 2 - 4 consolidated financial statem en ts 4 6 4 C R in fo rm a tio n in 6 6 7 disclosure o f internal co n tro l in 2 9 8 - 9 annual w eighted average 3 7 0 approvals 2 8 5 inde pend ent approval and review 2 8 6 articu la tio n 6 0 - 3 , 1 0 7 assessments, versus estim ates 11 asset im p airm en t 3 9 8 - 9 asset re cog nition 2 4 2 asset revaluations 4 0 1 - 2 assets (A ) 4 , 1 2 - 1 3 , 4 5 - 6 , 5 1 -2 , 2 4 1 -2 acco u n tin g equation 13
746
Index
all-so urces resources pool 4 7 assets accou nts 155 balance sheet c o m p o n e n t 4 3 ca rryin g a m o u n t 3 9 8 cash flo w s to to ta l assets 5 8 4 , 5 9 9 ch ara cteristics 4 5 co n tra assets 2 0 5 , 3 8 9 c u rre n t assets 4 4 , 4 6 de preciation o f 9 , 3 8 7 - 9 ec o n o m ic b e n e fit assum ptions 3 9 0 ec o n o m ic b e n e fit fro m asset use 3 8 8 , 390 e n tity -c o n tro lle d fu tu re econom ic be nefits 1 2 ,4 5 expiration o f 1 9 3 - 6 ,1 9 6 fa ir value 4 0 1 , 4 0 3 , 4 0 7 fin a n c in g o f 13 ‘flo a tin g charges’ 8 2 intangible assets 5 3 , 3 8 7 , 4 0 3 - 6 , 405 in ve n to ry and 3 5 8 inve stm e nt assets 4 6 5 lo ng -lived assets 3 8 8 m in o rity interests and 4 6 8 ‘negative assets’ 4 9 n e t assets 4 7 0 n o n c u rre n t assets 4 4 , 4 6 , 5 3 , 3 8 6 -4 0 8 , 401, 4 6 5 no n-d e p re cia b le and depreciable assets 3 9 9 o th e r ‘assets’ 4 5 reasons f o r co st allocation 3 8 8 recoverable a m o u n t 3 9 8 re pairs/im prove m e nts 3 8 7 salvage value see salvage value se cu rity o f 2 8 5 , 2 8 6 sensitive assets 2 8 6 useful life 9 , 3 8 9 - 9 0 , 4 0 5 - 6 valuation and m easure m ent 2 4 5 - 9 value 5 3 ,4 6 9 valued at co s t w hen acquired 5 3 assets costs 3 9 0 , 3 9 3 co m m o n co m p o n e n ts 3 8 6 - 7 assurance 6 6 7 - 8 o f integrated re p o rtin g 681 levels o f 2 5 5 audience (fo r re p o rts ) 681 audit c o m m itte e s 2 5 0 au diting 2 3 6 - 8 c o n fid e n tia lity in 8 m and atory 6 6 7 - 8 A u d itin g and Assurance Standards Board (A U A S B) 2 5 0 auditors 4 2 6 external au ditors 7 - 8 external a u d ito r’s re p o rt 2 5 4 - 7 financial and ethical independence 8 financial re p o rtin g checks 6 3 9 au ditors’ re ports, financial s ta te m e n t c re d ib ility 7 - 8 A ustralia n A c c o u n tin g Standards 4 0 4 - 5 , 5 3 3 d e fin itio n o f lease type s 4 0 7 A ustralian A c c o u n tin g Standards Board C AASB) 2 3 7
A ustralian Securities and Investments Commission A c t 2 0 0 1 2 4 9 A ustralia n S ecurities and Investm ents C om m ission (A S IC ) 2 4 9 - 5 0 , 6 3 9 A ustralia n S ecurities Exchange (A S X ) 2 9 8 A ustralia n S to ck E xchange (A S X ) 4 , 4 8 A ustralia n Taxation O ffic e (A T O ) 4 3 9 authorisations 2 8 5 , 2 8 6 available co st 3 6 6 average co st 3 6 7
B bad debts, o v e rs ta te m e n t/ un d e rsta te m e n t 3 2 2 bad debts expense 319 balance date 51 balance sheet valuation 3 6 6 balance sheets 4 3 - 4 , 5 0 - 3 , 3 9 2 a c co u n t classification exam ples 10 9 arranging accou nts on 1 0 8 - 9 balance sheet equation see a c cou nting equation bonus issues and share splits 4 7 7 - 8 cash dividends 4 7 6 - 7 categories 4 5 - 8 co m m o n presentation styles 5 0 co m p ara tive balance sheets 14, 5 0 - 3 , 60 c o m p le tin g 4 6 4 - 7 5 consolidations 4 6 7 - 9 e ffe c ts o f acco u n tin g policy changes 6 3 9 elem en ts 1 2 -1 4 exam ples 12, 5 2 , 5 5 see also Sound and Light balance sheet analysis features 4 4 fin a n c e leases on 4 0 7 - 8 inco m e sta te m e n ts -b a la n ce sheets, co nnection s and articu la tion betw een 6 0 - 3 individual accou nts 4 4 in te rc o rp o ra te investm ents and c o rp o ra te groups 4 6 4 - 7 m anagers and 5 6 reserves 4 7 4 retained p ro fits and dividends 4 7 5 - 6 share capital 4 7 1 - 4 shareholder e q u ity s e c tio n -c o m p a n y c u rre n t m a rke t price diffe ren ces 4 8 shareholders’ eq u ity 4 7 0 - 1 , 4 7 9 s id e -b y -sid e 4 3 - 4 u n collectib le accou nts 321 ve rtical fo rm a t 4 3 , 5 0 bank overd rafts 4 6 ,1 0 9 bank re con ciliations 2 8 7 , 2 9 0 - 4 bank statem en ts versus cash accou nts 2 9 0 - 1 illustrative exam ple 2 9 4 - 6 p e rfo rm in g fro m in fo rm a tio n in cash jo u rn a ls 2 9 4 - 6 re con ciliation process 2 9 1 - 4 steps 2 9 4
bank statem ents, versus cash accou nts 2 9 0 - 1 bankers, use o f a cco u n tin g nu m bers 2 3 basic earnings per share 5 8 4 behaviour, se lf-in te re ste d behaviour 6 4 4 be nchm arks 6 7 3 b e tte rm e n t (assets) 3 8 7 bias 18 big bath 6 3 9 Big F o u r acco u n tin g firm s 6 6 8 Billabong 4 0 4 board o f d ire cto rs 4 , 4 7 6 - 7 , 6 6 7 - 8 governance, guidance and oversight 2 8 4 bonds 2 6 0 bonus issues and share splits 4 7 7 - 8 bonuses 2 3 - 4 book value 4 7 - 8 , 3 9 0 , 3 9 2 , 3 9 4 , 3 9 6 , 642 n e t book value 2 0 6 per share 5 9 9 - 6 0 0 bookkeeping com p uterise d system s 147 m anagers and 170 b o rrow in g costs 4 0 4 b o tto m line n e t p ro fit 57, 6 5 brand names 5 3 , 4 0 4 buildings 3 8 6 - 7 business business organisation kinds 8 0 - 3 fin a n c in g 8 3 - 4 Business A c tiv ity S ta te m e n t (B A S ) 4 4 0
C capital d e b t capital 4 3 1 - 2 lo n g -te rm capital 6 6 3 ow ners’ ca p ita l/p a rtn e rs’ capital see ow ners’ eq uity share capital 13, 4 8 , 6 0 , 8 2 , 317, 4 7 1 -4 , 4 7 2 , 4 7 6 types o f 6 5 8 w orking capital 4 9 , 3 5 8 capital m aintenance 4 7 0 capital m arket th e o ry 261 capital m arkets 6 5 - 6 , 2 6 0 - 5 m arkets 2 6 0 - 5 role o f in fo rm a tio n in 2 6 2 capital re dem ption reserves 4 7 4 capitalisation 3 8 8 , 4 0 4 , 4 0 5 , 4 0 8 capitalising 5 0 2 capitalising versus expensing ch oice 3 8 6 carbon dioxide ( C O 2) 671 C arbon D isclosure P ro je ct (C D P ) 6 7 4 case law 4 7 4 cash cash c o n tro l problem s exam ple 2 8 9 cash flo w s see sta te m e n t o f cash flow s fo rm s o f 2 8 8 internal c o n tro l and 2 8 4 - 9 9 key internal c o n tro l over see bank reconciliations paid to suppliers 5 3 6 - 7 p e tty cash 2 8 7 , 2 9 7 - 8
Index
re cog nition at p o in t a fte r cash re ce ip t 4 9 8 re cog nition on cash re ce ip t 4 9 8 - 9 sources and uses see sta te m e n t o f cash flow s cash accou nting , versus accrual acco u n tin g 1 0 ,1 1 2 -1 4 cash accounts, versus bank statem en ts 2 9 0 - 1 cash a t bank a c co u n t 13 cash balances 4 5 cash disc o u n t 3 2 7 - 8 cash dividends 4 7 6 - 7 cash flo w analysis, purpose 5 2 8 - 9 cash flo w fro m operations 5 2 8 , 531 cash flo w ratios 5 9 0 - 1 cash flo w statem en ts 5 4 6 - 7 , 6 0 5 - 7 uses 6 0 5 - 6 cash flo w s 6 0 7 , 6 0 7 - 1 0 , 6 3 9 cash flo w cycle 5 8 7 cash flo w s -p ro fit relationship 5 4 9 cash inflo w s 4 5 d ire c t versus in d ire c t m eth o d o f re p o rtin g cash flo w fro m operations 5 3 1 -3 fro m fin a n c in g activitie s 5 4 1 - 3 in fo rm a tio n in te rp re ta tio n 6 0 5 - 7 fro m investing activities 5 4 0 - 1 , 5 4 5 m anagers and 5 4 9 n e t cash flo w s (a sse t-gen era te d) 4 5 tim in g in d iffe re n t a c cou nting period 10 to to ta l assets 5 8 4 , 5 9 9 cash jo u rnals, p e rfo rm in g reconciliations fro m in fo rm a tio n in 2 9 4 - 6 cash paym ents 3 3 4 - 7 cash paym ents jo u rn a l (C P J ) 2 9 4 , 3 3 6 cash receipts 3 3 4 - 5 , 5 3 5 - 6 cash receipts jo u rn a l (C R J ) 2 9 4 , 3 3 4 - 5 c h a rt o f accou nts 146 cheques 2 8 9 , 3 3 4 - 5 n o n -s u ffic ie n t fund s (N S F ) cheques 291 n o t y e t cleared 2 9 2 c h ie f e xecu tive o ffic e rs (C E O s ) 4 ,14 1 internal c o n tro l responsibility 2 8 4 Class A /B shares 8 2 classification 5 2 9 classification (a cco u n ts) 3 3 0 closing en trie s 1 5 3 - 4 ,1 6 2 - 3 , 3 6 3 C o c a -C o la 4 0 4 codes o f c o n d u c t 6 6 8 - 9 collusion 2 8 4 , 2 8 8 , 2 9 9 co m m e rcial bills payable 4 3 0 co m m o n size financial statem en ts 5 7 8 - 9 , 5 8 0 co m m o n size inco m e statem en ts 5 9 8 - 9 c o m m u n ic a tio n 2 8 5 , 661 co m m u n ity , im p a ct o f a cco u n tin g on 2 4 com panies 8 1 -2 external co m p a n y fin a n c in g fo rm s 431 in te rc o m p a n y balances, o ffs e ttin g 4 6 9 private 8 2 public 8 2 co m p ara bility 19, 2 0 , 21
com parative balance sheets 14, 5 0 - 3 , 6 0 co m p e titive positioning 6 6 3 c o m p e tito rs 6 co m p lian ce 6 6 2 com prehensive incom e, A A S B 101defined 5 0 2 - 3 c o m p u te r-b a s e d in ve n to ry system s 3 5 9 co nce ptu al acco u n tin g 1 8 5 - 9 2 co n fid e n tia lity 8 c o n flic ts o f in te re st 661 co nsistency 2 0 ,2 1 consolidated financial statem en ts 4 6 4 , 468 consolidated inco m e statem en ts 4 6 9 consolidation 4 6 7 - 9 consolidated sales fig ure s 4 6 8 data consolidation 671 goodw ill arising on 4 6 9 consum ers, im p a ct o f a c cou nting on 2 4 c o n tin g e n t liabilities 4 3 7 - 8 type s o f 4 3 7 co n tin u o u s im p ro ve m e n t 6 6 2 co n tra accou nts 2 0 4 - 6 , 317, 4 3 2 - 3 , 442 accou nts receivable and 3 1 7 -2 3 purpose 321 co n tra assets 2 0 5 , 3 8 9 c o n tra c t 318 co n tra c ts , financial a c co u n tin g in fo rm a tio n and 2 6 5 - 7 c o n tro l 4 6 7 - 8 cash c o n tro l problem s 2 8 9 c o n tro l by e n tity (assets) 4 5 c o n tro l e n viro n m e n t 2 8 5 c o n tro l failures 2 8 4 ec o n o m ic c o n tro l 4 5 internal c o n tro l 1 4 0 , 2 8 4 - 9 9 in ve n to ry - co st and be n e fits o f c o n tro l 3 5 9 m anagers and 170 c o n tro l accou nts 317, 3 2 8 -3 1 c o n tro l activities 2 8 5 , 2 8 6 - 7 exam ples 2 8 6 co p yrig h ts 5 3 , 4 0 3 c o rp o ra te boards, use o f a c cou nting num bers 2 3 - 4 c o rp o ra te governance 2 5 0 - 1 , 2 9 8 , 6 7 6 c o rp o ra te groups 8 3 , 4 6 4 - 7 links betw een 4 6 4 shareholders’ eq u ity see shareholders’ eq uity C orporate Law Econom ic Reform Program A c t 1999 (C LER P A c t 1999) 2 4 9 c o rp o ra te responsibility (C R ) 6 6 7 Corporations A c t 2 0 0 1 2 5 3 , 471 co st o f assets 3 8 6 - 7 , 3 9 3 available c o s t 3 6 6 bo rro w in g costs 4 0 4 c o s t o f conversion 3 6 5 d e velopm e nt costs 4 0 4 historical co st 2 2 , 3 6 4 , 3 8 8 installation costs 3 8 6 o f in ve n to ry 3 6 5 low er o f c o st and n e t realisable value rule 3 7 1 -2
747
overhead costs 3 7 4 standard costs 3 7 2 - 3 co st allocation see de preciation expense co st flo w assum ptions 3 6 3 , 3 6 5 -7 1 co st m ethod , fo r lo n g -te rm investm ents 4 6 5 co st o f goods sold (C O G S ) 15, 5 8 , 3 5 8 - 9 , 371, 5 7 9 , 5 8 6 in v e n to ry v a lu a tio n and 3 6 4 - 6 , 640 u n a ffe c te d at tim e o f sale 3 6 2 ‘co st o f sales’ m e thod 5 0 6 co st o f sto ck on hand 13 C P A A ustralia 7 cre d ib ility 6 6 7 - 8 credible periodic re p o rtin g dem and 5 enhancers 7 - 8 c re d it 319 c re d it te rm s extension 3 2 8 lines o f c re d it 4 2 9 purchasing on c re d it 9 5 - 6 c re d it purchases 3 3 3 - 4 c re d it ratings 2 3 c re d it sales 3 2 9 , 3 3 1 - 3 , 3 3 2 cre d ito rs 6, 4 6 , 5 9 p o te ntial cre d ito rs 6 use o f a c co u n tin g num bers 2 3 critica l events sim plification 4 9 3 - 4 C S R Lim ited 3 7 3 c u rre n t assets 4 4 , 4 6 c u rre n t liabilities 4 4 , 4 7 , 4 2 6 - 7 classification 4 2 7 due w ith in a ye ar 8 3 - 4 c u rre n t ratio 4 9 , 5 8 7 , 6 0 2 m axim ising th ro u g h acco u n tin g m ethod ch oice 6 3 8 c u rre n t value 2 4 6 - 7 c u rre n t value a c cou nting 2 4 6 - 7 custom ers 6 cash re ceipts fro m 5 3 5 - 6
D days sales in receivables 5 8 7 de bentures 8 1 -2 ,4 3 1 a c cou nting fo r 4 3 2 debits and cre d its 14 8, 2 9 0 , 4 0 1 - 2 co nfusion regarding 9 5 d ire c t debits and credits 291 revenues and expenses 1 0 2 - 8 w orkings 9 9 - 1 0 2 d e b t 1 3 ,5 4 2 co n tra c tu a l te rm s fo r de b t securities 4 3 2 c u rre n t and n o n cu rre n t com ponent 4 3 0 d o u b tfu l debts 3 1 7 -1 8 lo n g -te rm d e b t 19 n o n c u rre n t debts 4 3 2 - 3 probable debts see liabilities d e b t capital, alternative fo rm s 4 3 1 - 2 de btors see accou nts receivable de btors tu rn o v e r 5 8 6 - 7 , 601 d e b t-to -a s s e t ra tio 5 8 8 , 6 0 2 d e b t-to -e q u ity ratio 4 3 9 , 5 8 8 , 6 0 2 decision fa cilita to rs 7 decision-m a kers 5 - 7
748
Index
d e cision-m a king acco u n tin g po licy decision in advance 6 3 6 acco u n tin g re cog nition decisions 6 3 7 ec o n o m ic decisions 2 3 9 enhancing 6 6 3 m anagerial business decisions 2, 22 regarding tran saction s 6 3 7 re liab ility versus decision relevance 4 9 3 by shareholders 2 3 d e cre m e n t (revaluatio n) 4 0 1 - 2 de ductions 10 9 de fe rre d charges 4 0 4 de pletion 3 8 7 , 3 9 4 - 5 deposits in tra n sit 291 de preciation 8 ,1 0 , 3 8 7 , 5 0 7 accelerated de preciation 4 3 3 accum ulated de preciation 4 9 , 51, 5 3 , 389, 393, 397 ad justing f o r 5 4 5 o f assets 9 , 3 8 7 - 9 bases and m ethod s 3 9 0 - 5 beginning 3 8 9 de preciation e ffe c ts analysis 6 4 1 -2 exam ple 3 9 5 - 7 expression in percentage 3 9 2 fo rm u la 3 9 5 m eaning 3 8 8 n o n -d e c lin in g ec o n o m ic value o f land 3 8 8 non-d epreciab le /de preciable assets 3 9 9 rate o f 3 9 3 re cog nition 3 8 9 re ducin g balance m e thod 3 9 2 - 4 , 642 s tra ig h t-lin e m eth o d 3 9 0 - 2 , 6 4 2 u n its -o f-p ro d u c tio n de preciation and de pletion 3 9 4 - 5 , 6 4 2 de preciation expense 3 8 7 - 9 , 3 9 2 , 3 9 6 beginning 3 8 8 - 9 c o s t allocation over years o f b e n e fit 3 8 7 reasons f o r 3 8 8 de velopm e nt costs 4 0 4 d ilutio n 5 8 4 d ire c t cre d its 291 d ire c t debits 291 d ire c t energy and emissions sources 67 2 d ire c t m e thod o f cash flo w analysis d ire c t versus in d ire c t m e thod o f re p o rtin g cash flo w fro m operations 5 3 1 -5 preparation 5 3 3 - 4 3 d ire c t w rite -o ffs 3 2 0 d ire cto rs’ valuation 5 3 disbursem ents 2 9 7 - 8 disclosure 19, 21, 6 5 8 acco u n tin g po licy disclosure 3 8 6 , 6 4 3 versus a d ju stm e nt 6 3 8 C arbon D isclosure P ro je ct (C D P ) 6 7 4 co m p a n y disclosure surveys 6 6 3 - 4 disclosure policies 6 4 0 disclosure p o licy 6 3 7
en erg y disclosures 6 7 0 o f energy e ffic ie n c y in fo rm a tio n 6 7 0 -1 exam ples 6 5 9 to g o ve rn m e n t 6 7 4 o f internal c o n tro l in annual re p o rts 2 9 8 - 9 o f in ve n to ry a c cou nting policies 3 7 3 - 4 o f reserves 4 7 4 types 6 7 3 - 6 vo lu n ta ry 6 6 8 , 6 7 4 - 6 discontinued operations 5 9 9 distrib u to rsh ip 4 0 4 dividend pa yout ra tio 5 8 5 , 6 0 0 - 1 dividends 5 ,1 5 , 4 9 , 57, 4 6 5 , 471 - 4 cash dividends 4 7 6 - 7 d istrib u tio n o f p ro fit 4 7 liabilities fo r 4 7 7 paym ents 4 7 5 share dividends see bonus issues do cum en ts cancellation 2 8 7 m atch in g and ch ecking 2 8 6 - 7 d o u b le -e n try bo okkeeping 9 4 - 7 d o u b le -e n try system 41 accou nts 9 8 balance sheets, arranging accounts on 1 0 8 - 9 cash acco u n tin g versus accrual acco u n tin g 112-14 debits and cre d its 9 9 - 1 0 8 d o u b le e n try exam ples 9 5 - 6 , 11 4 -1 6 jo u rn a l en trie s 11 0-12 re co rd in g transactions - d o u b le -e n try bookkeeping 9 4 - 7 tran saction analysis 8 6 - 9 3 d o u b tfu l debts 3 1 7 -1 8 allow ance fo r 3 1 9 -2 3 drivers 6 7 9 D u P o n t system 5 9 3 - 4
E earnings b e fo re in te re st and tax CEBIT) 5 0 5 , 5 8 6 , 5 8 8 earnings b e fo re intere st, tax, de preciation and am ortisation (E B IT D A ) 5 0 5 earnings per share (E P S ) 6 5 , 4 6 6 , 4 7 4 , 584, 599 ec o n o m ic b e n e fit 3 8 8 , 3 9 0 , 3 9 2 ec o n o m ic be nefits 4 9 2 , 4 9 5 sa crificin g to e n titie s 4 2 4 ec o n o m ic disclosure 6 5 9 ec o n o m ic p e rfo rm a n ce 6 6 5 e c o n o m y see also fu tu re ec o n o m ic benefits eco n o m ic am ortisation 3 8 8 eco n o m ic c o n tro l and asset re co rd in g 4 5 as a w hole 22 e ffic ie n t capital m arket 2 6 4 e ffic ie n t m a rke t hypothesis 2 6 4 e le c tro n ic co m m e rce 1 6 9 - 7 0 e le c tro n ic funds tra n s fe r (E F T ) 1 4 5 ,1 6 9 em issions calculations 6 7 3
en erg y and greenhouse gas emissions re p o rt 6 7 5 - 6 scopes 1, 2 and 3 em issions 67 2 sources 6 7 1 -2 em ployee de ductions 4 2 8 em ployees 6 em ployee e n title m e n ts, provision fo r 13, 5 3 , 4 3 5 im p a ct o f a cco u n tin g on 2 5 paym ents to 5 3 7 - 9 e n d -o f-p e rio d balance sheet 2 9 1 -2 energy en erg y and greenhouse gas emissions re p o rt 6 7 5 - 6 sources 6 7 1 -2 energy, calculations 6 7 3 energy disclosures 6 7 0 energy e ffic ie n c y in fo rm a tio n m easure m ent and disclosed 6 7 0 - 6 sustainability exam ple 6 6 9 - 7 6 engagem ent, stakeholder en gagem ent 6 6 1 -2 en titie s acco u n tin g e n tity 21 c o n stru ctiv e obligations th a t co n s titu te provisions 4 3 4 c o n tro l by 4 5 legal e n titie s 81 parent, subsidiary and eco n o m ic 4 6 8 - 9 sa crificin g eco n o m ic be n e fits 4 6 entries ad justing 153 ad justing en trie s 153 closing en trie s 1 5 3 - 4 ,1 6 2 - 3 see also jo u rn a l entries en viron m e ntal disclosure 6 5 9 en viron m e ntal p e rfo rm a n ce 6 6 5 - 6 e q u ip m e n t 4 9 purchased eq u ip m e n t 3 8 6 - 7 see also p ro p e rty, plant and eq uipm ent e q u ity 13, 4 7 - 8 , 2 4 4 e q u ity interests 5 0 4 negative eq u ity (w h ere A < L) 4 8 ow ners’ e q u ity see ow ners’ eq u ity shareholders’ eq u ity see shareholders’ eq uity e q u ity m e thod 5 0 4 fo r lo n g -te rm inve stm e nts 4 6 5 - 7 e rro r 19 bank sta te m e n t b a la n ce -a c co u n tin g records 291 in ve n to ry and 3 5 9 in p e tty cash fu n d 2 9 8 re co rd -ke e p in g e rro r 2 9 2 estim ates acco u n tin g estim ates 6 3 7 o f a ccou nts receivable am ou nts 10 versus assessm ent 11 de preciation expenses-re ven ues estim ates 9 o f liability 4 2 5 o p tim is tic estim ates 6 3 8 ethics ethica l independence o f auditors 8
Index
ethical issues 8, 2 5 9 - 6 0 professional e thics and nature o f professions 2 5 7 - 6 0 evaluation fin ancial evaluation n o t ju s t calculation 5 7 6 - 7 o f financial p e rform a nce and position 3 p e rfo rm a n ce evaluation 6 5 - 6 events 6 3 7 event ch ara cteristics 142 executives c o rp o ra te -b o a rd rem oval o f 2 3 - 4 execu tive co m pensation schem es 2 3 - 4 , 6 3 9 expense re cog nition 185 cash co llections/p aym en ts related to previously recognised revenues/ expenses 1 8 8 - 9 cash in flo w /o u tflo w a fte r 1 9 0 -1 cash in flo w /o u tflo w b e fo re 1 8 9 - 9 0 p rio r to cash flo w 1 8 7 -8 a t same tim e as cash in flo w / o u tflo w 1 8 6 - 7 expenses 8 , 57, 5 8 , 6 1 ,1 8 5 , 2 4 4 accrued expenses 5 3 capitalising versus expensing ch oice 3 8 6 debits and credits 1 0 2 - 8 de preciation expense 3 8 7 - 9 expenses co n c e p t - th e F ram ew ork 5 0 1 - 2 e x penses-re ven ue earned m atch in g 3 8 8 inco m e ta x expense 6 3 m anagers and expense re cog nition 511 m aterial expenses 5 0 3 op era ting expenses 15 re cog nition 4 9 2 -5 1 1 reliably-m easured a m o u n t 4 9 5 tim e period o f oc cu rre n ce 9 un record ed expenses accrual 1 9 8 - 9 external a u d ito r’s re p o rt 2 5 4 - 7
F fa ir value 2 4 7 , 40 1 , 4 0 3 , 4 0 7 , 5 0 0 fa ith fu l re presen ta tion 18, 2 0 fin a n ce costs 5 0 5 fin a n ce leases 4 0 7 - 8 fin a n ce revenue 5 0 5 fin a n ce th e o ry 214 financial acco u n tin g 2 - 2 5 external fo cu s 3 im p o rta n ce o f 2 2 - 5 in fo rm a tio n quality, dem ands on 1 8 - 2 0 in fo rm a tio n users 3 - 5 key financial statem en ts 1 2 -1 7 pa rticip ants 5 - 8 preparers 7 reliance on ju d g e m e n t 11 tra d e -o ff am on g a c cou nting principles 21 transactional filte r 1 4 0 - 3 users 5 - 7 value o f 2
financial capital 6 5 8 m arkets fo r 2 6 0 - 1 Financial Crisis 22 financial leverage 591 financial pe rform a nce m easuring and evaluating 3, 4 3 - 6 6 n e t p ro fit and bo rro w in g status 4 over a defined period see incom e statem en ts financial period 2 0 4 financial position 4 7 9 m easuring and evaluating 3, 4 3 - 6 6 at a p o in t in tim e see balance sheets financial re p o rtin g 2 3 6 - 8 ch ara cteristics 2 4 0 - 1 fu ll versus concise 2 5 3 - 4 Financial R ep orting C ou ncil (F R C ) 2 4 9 - 5 0 financial re p o rtin g principles 2 3 6 - 8 financial sta te m e n t analysis acco u n tin g research results 6 0 4 cash flo w in fo rm a tio n in te rp re ta tio n 6 0 5 - 7 co m m o n size statem en ts 5 7 8 - 9 financial sta te m e n t ratio analysis 5 8 1 -9 1 , 5 9 4 - 6 0 3 integrative ra tio analysis 5 9 1 - 4 in te llig e n t analysis preparation 5 7 7 - 8 inve stm e nt and relative re tu rn 5 7 6 m anager’s pe rform a nce m easurem ent 610-11 T ransport Lim ited exam ple and conclusions 5 9 4 - 6 0 3 , 6 0 6 - 7 va lidity based on a c cou nting ratios 5 7 8 ‘w h a t i f e ffe c ts , ratios and cash flo w 6 0 7 - 1 0 W o o lw o rth s Lim ited exam ple 5 7 9 -8 1 financial statem en ts 2 ,1 2 - 1 7 ,1 5 4 - 5 , 163, 2 5 2 - 4 acco u n tin g po licy choices, im p ortan ce o f 637 assum ptions 2 1 - 2 , 2 3 9 - 4 0 au ditors’ re p o rts - financial s ta te m e n t c re d ib ility 7 - 8 co nso lidated financial s ta te m e n ts 4 6 4 elem en ts and m easurem ent 2 4 2 - 5 financial reports, objectives 2 3 9 inclusion o f e xte rna lly generated goodw ill 4 0 7 line item s f o r understanding 4 2 7 m isleading 3 9 7 notes to th e financial statem en ts 3, 19, 4 7 , 51 preparation m ethod s 11 prepa ration/prese ntation fra m e w o rk 2 3 9 - 4 5 presentation o f liabilities 4 2 6 - 7 relationships betw een 17-21 using accrual acco u n tin g to prepare 10-11 financial s tru c tu re ratios 5 8 8 - 9 , 6 0 7 fin a n c in g 8 0 - 4 , 8 3 - 4 co m p a n y fin a n c in g 431 ‘o f f balance sheet’ fin a n c in g 4 3 9
749
sources (balance sheet liabilities and e q u ity ) 4 3 fin a n c in g activitie s 16, 5 2 9 cash flo w s fro m 5 4 1 - 3 fin a n c in g ratios 6 0 2 firs t in, firs t o u t (F IF O ) cash flo w assum ption 3 6 5 , 3 6 6 - 7 , 3 6 8 - 9 , 640 m eth o d 3 6 9 flo a tin g charges 8 2 fo re ig n c u rre n c y translation reserve 4 7 4 fo re ig n c u rre n c y translation reserves 4 7 4 Fram ew ork fo r th e Preparation and Presentation o f Financial S tatem ents (F ra m e w o rk) 5 0 1 - 2 fund am ental ch ara cteristics 2 0 inco m e d e fin itio n 4 9 2 prese nt o b lig a tio n s -fu tu re co m m itm e n ts, distin ctio n 4 2 4 fran chise 4 0 4 , 4 0 5 frau d 2 8 8 , 4 9 9 ‘fu n c tio n o f expense’ m eth o d 5 0 6 fu tu re cash flow s, present value analysis 4 5 8 - 6 2 fu tu re econom ic benefits 12, 4 5 , 5 3 , 4 0 5 fu tu re sacrifice o f 4 6 see also assets fu tu re in te re st 4 3 0 fu tu re value 193
G gain on sale 2 0 6 gains 4 9 2 gains and losses 5 0 7 as depreciation co rre ctio n s 3 9 8 n o n c u rre n t assets, gains and losses on disposal 3 9 7 - 8 gearing 581 general jo u rn a ls 145, 3 3 7 general ledgers 143, 3 3 7 general purpose financial re ports (G P F R ) 2 5 3 general reserves 471, 4 7 4 generally accepted acco u n tin g principles (G A A P ) 19, 2 0 , 2 3 7 - 8 , 3 6 4 , 3 8 7 , 4 6 8 , 576 com pliance w ith 21 p o licy disclosure re quirem ents 6 3 6 , 643 regarding d e b t pa ym ent 4 3 0 G lobal Financial C risis (G F C ) 4 3 9 G lobal R ep orting Initiative (G R I), Sustainability Reporting Guidelines 6 6 4 - 5 , 6 6 4 - 7 global w arm ing p o te ntial (G W P ) 671 g o in g co n ce rn 21, 4 2 6 goods 4 generatin g n e t cash flo w s 4 5 goods fo r resale 9 5 - 6 as main fo rm o f revenue 9 sale o f goods 57 goods and services tax (G S T ) 4 2 9 , 4 3 9 -4 3 generalisations and special cases 4 4 3 G S T system m odel and exam ple 4 4 2 key features and elem en ts 4 4 0 - 1
750
Index
goodw ill 5 3 , 4 0 6 - 7 arising on co nsolidation 4 6 9 exte rna lly and intern ally generated 4 0 7 purchased goodw ill 4 0 7 g o ve rn m e n t 6 disclosure to 6 7 4 g o ve rn m e n t p o licy 6 7 9 greenhouse gas disclosures 6 7 0 greenhouse gas (G H G ) em issions 6 7 0 gross m argin see gross p r o fit 5 8 4 , 598 gross p ro fit 15, 3 6 2 - 3 G S T payable 4 3 9
H hedging 5 8 8 historical co st 2 2 , 2 4 6 , 3 6 4 , 3 8 8 historical co st valuation 3 8 6 - 7 holiday pay 5 3 H o n g K on g S o c ie ty o f A c c o u n ta n ts 7 hum an capital 6 5 8 hum an righ ts disclosure 6 5 9
I im p a irm e n t 6 4 , 3 8 8 , 3 9 9 - 4 0 0 asset im p a irm e n t 3 9 8 - 9 im p a irm e n t loss 3 9 8 intangibles, am ortisation o r im p a irm e n t 4 0 5 - 6 te stin g fo r 4 0 5 - 7 im p ro p rie ty 8 in co m e 2 4 4 m aterial inco m e 5 0 3 sta te m e n t o f com prehensive in co m e 5 0 2 - 7 in co m e statem en ts 1 2 ,1 5 -1 6 , 5 7 - 9 , 6 3 -4 , 5 0 2 -7 b o tto m line n e t p ro fit 57, 6 5 co m m o n size incom e statem en ts 5 9 8 - 9 consolidated inco m e statem en ts 469 e ffe c ts o f a cco u n tin g policy changes 6 3 9 exam ple 15 e x p lo ra to ry notes 6 3 inco m e sta te m e n ts -b a la n ce sheets, co nnection s and articu la tion betw een 6 0 - 3 n o m e nclature 6 5 p ro fit and loss co m p o n e n t 6 0 un collectib le accou nts 321 in co m e tax 5 3 9 , 6 0 8 , 6 3 9 e ffe c ts 5 0 9 p ro fit re d u c tio n - po stponing tax pa ym ent 6 3 8 in co m e tax expense 6 3 in co m e tax payable 4 6 in co rp o ra tio n 431 in c re m e n t (revaluatio n) 4 0 1 - 2 independence, o f auditors 8 inde pend ent valuation 5 3 in d ire c t en erg y and emissions sources 67 2
in d ire c t m eth o d o f cash flo w analysis d ire c t versus in d ire c t m eth o d o f re p o rtin g cash flo w fro m operations 5 3 1 -5 preparation 5 4 5 - 7 in d ire c t taxes 4 4 0 in fo rm a tio n acco u n tin g in fo rm a tio n use 2 3 7 - 8 clim a te -ch a n g e -re la te d in fo rm a tio n 671 dem and on q u ality o f 1 8 - 2 0 en erg y in fo rm a tio n and disclosure 6 7 0 - 6 flo w in a c co u n tin g system 3 2 9 in fo rm a tio n users o f financial acco u n tin g 3 - 5 m anagers’ issuing responsibility 7 p e rtin e n t in fo rm a tio n 2 8 5 processing 2 8 6 reasonableness ch e ck 7 re con ciliation fro m cash jou rn a ls in fo rm a tio n 2 9 4 - 6 role in capital m arkets 2 6 2 innovation 6 6 3 , 6 6 4 insolvency 4 8 installation costs 3 8 6 insta lm e n t sales m e thod 4 9 8 In stitu te o f C h a rte re d A c c o u n ta n ts A ustralia (IC A A ) 1 9 7 -8 intangible assets 5 3 , 3 8 7 , 4 0 3 - 6 w o rth 4 0 5 intangibles a m o rtis a tio n /im p a irm e n t 4 0 5 - 6 co s t o f 4 0 5 intangibles e ffe c ts analysis 6 4 2 - 3 integrated re p o rtin g assurance o f 681 d e fin itio n 67 7 drivers 6 7 9 IIR C fra m e w o rk 6 7 9 -8 1 I IR C principles 6 7 7 - 8 Intern atio nal Integrated R ep orting C o u n cil (IIR C ) 6 7 7 - 8 key results exam ple 6 8 0 - 1 N e w re p o rtin g d ire ctio n? 6 7 6 possible fo rm a t 6 7 9 -8 1 in te g rity 170 intelle ctu al capital 6 5 8 in te rc o rp o ra te investm ents 4 6 4 - 7 in te re st 57 fu tu re in te re st 4 3 0 in te re st earned 291 p o licy disclosure regarding in te re st 3 8 6 in te re st coverage ra tio 5 8 8 , 6 0 3 in te re st rates 2 3 in te re st receivable see accrued in te re st in te re st-b e a rin g liabilities lo n g -te rm 4 3 1 - 3 s h o rt-te rm 4 2 9 - 3 0 intern al c o n tro l 1 4 0 , 2 8 4 - 7 bank re con ciliations 2 9 0 - 6 case stud y 2 8 7 o f cash 2 8 7 - 9 co m p o n e n ts 2 8 5 d e fin itio n 2 8 4
disclosure in annual re p o rts 2 9 8 - 9 m anagers and 2 9 9 objectives-based assurances 2 8 4 - 5 p e tty cash 2 8 7 , 2 9 7 - 8 procedures examples 2 8 6 - 7 intern al m anagem ent drivers 6 7 9 International Financial R e p o rtin g Standards (IF R S ) 11 International Integrated R ep orting C ou ncil (IIR C ), integrated re p o rtin g principles 6 7 7 - 8 in ve n to ry 1 0 ,1 3 , 317 c o s t and be nefits o f c o n tro l 3 5 9 c o s t flo w assum ptions 3 6 5 -7 1 exchanges 4 5 in ve n to ry c o n tro l 3 5 8 - 9 retail in ve n to ry and standard costs 3 7 2 - 3 selling - acid te s t ra tio 4 9 valuation 3 6 4 - 6 , 3 7 4 , 6 4 0 in ve n to ry acco u n tin g policies disclosure o f 3 7 3 - 4 exam ples 3 7 3 - 4 in ve n to ry co st 3 5 8 , 3 6 5 in ve n to ry tu rn o v e r 3 7 1 ,5 8 6 ,6 0 1 investing activities 16, 5 2 9 cash flo w s fro m 5 4 0 - 1 , 5 4 5 inve stm e nt 52 in te rc o rp o ra te inve stm e nts 4 6 4 - 7 inve stm e nt assets 4 6 5 lo n g -te rm inve stm e nts 4 6 5 - 7 m anagers and 4 7 9 relative re tu rn and 5 7 6 s h o rt-te rm investm ents 4 6 4 investors 2
J jo b s , im p a ct o f a cco u n tin g on 2 5 jo u rn a l en trie s 9 5 ,1 1 0 - 1 2 ,1 4 5 - 6 , 3 6 0 -2 ,3 8 9 ,3 9 2 jo u rn a ls 14 0 cash jo u rn a ls 2 9 4 - 6 cash paym ents jo u rn a l (C P J ) 2 9 4 , 336 cash receipts jo u rn a l (C R J ) 3 3 4 - 5 purchases jo u rn a ls 3 3 3 - 4 sales jo u rn a ls 3 2 9 special jo u rn a ls 3 2 8 - 9 ju d g e m e n t 19, 3 8 6 , 4 0 7 , 5 7 6 im p o rta n ce o f 11
K key pe rform a nce indicators (K P Is) 659 K P M G S urvey o f C o rp o ra te R esponsibility R ep orting 2 0 1 3 6 6 7
L labour practices disclosure 6 5 9 land 3 8 6 n o n -d e c lin in g e conom ic value last in, firs t o u t (L IF O ) cash flo w assum ption key fa cts 3 6 7 periodic 3 6 9 , 3 7 0 -1 , 6 4 0 perpetual 3 6 9 , 3 7 0 -1 , 6 4 0
388
Index
leases 4 0 5 , 4 0 7 - 8 fin a n c e leases 4 0 7 - 8 op era ting leases 4 0 7 ledgers 9 5 ,1 4 0 ,1 4 8 exam ple 1 5 0 -1 general ledgers 143, 3 3 7 po stin g to 1 4 7 -5 1 ,1 5 8 subsidiary ledgers 1 4 9 - 5 0 , 3 2 8 - 3 7 legal p ro p e rty 4 0 3 legal title (tra n s fe r) 4 9 5 leverage 581 leverage ra tio 5 8 2 - 3 , 5 8 9 liabilities (L ) 4 6 - 7 , 2 4 3 , 2 9 0 , 4 0 7 - 8 acco u n tin g equation 13 balance sheet c o m p o n e n t 4 3 ch ara cteristics 4 6 , 4 2 4 c o n tin g e n t liabilities 4 3 7 - 8 c u rre n t liabilities 4 4 , 4 7 , 8 3 - 4 , 4 2 6 -7 d e fin itio n 1 3 , 4 2 4 - 5 exam ple 12 fin ancial sta te m e n t presentation o f 4 2 6 -7 general m easurem ent principles 4 2 5 - 6 goods and services tax (G S T ) 4 3 9 - 4 3 G S T payable a c co u n t 4 3 9 - 4 0 in te re st-b e a rin g liabilities 4 2 9 - 3 3 in ve n to ry and 3 5 8 m in o rity interests and 4 6 8 m o n e ta ry and n o n -m o n e ta ry liabilities 4 2 5 - 6 n o n c u rre n t liabilities 4 4 , 4 7 , 8 4 ,1 0 9 , 4 2 6 -7 ‘o f f balance sheet’ fin a n c in g 4 3 9 payables 4 2 8 - 9 p ro fit m easure m ent c o n n e c tio n 4 2 7 provisions 4 3 3 - 6 re cog nition criteria 4 2 4 tax liabilities 4 3 3 va luation and m easurem ent 2 4 5 - 9 value 5 3 ,4 6 9 valued at w ha t was prom ised when obligation arose 5 3 licence to operate, annual re p o rt extracts 6 6 3 lines o f c re d it 4 2 9 liquidation value 2 4 7 - 8 liq uidity ratios 5 8 7 - 8 , 6 0 2 - 3 , 6 0 7 loans 3 1 9 ,4 2 5 lo n g -te rm loans 1 3 -1 4 , 9 6 private loans 431 lo c k e d -in sales registers 2 8 8 long service leave (L S L) 21, 5 3 , 4 3 5 lo ng -lived assets 3 8 8 lo n g -te rm d e b t 19 lo n g -te rm d e b t-to -e q u ity ratio 6 0 2 lo n g -te rm investm ents co s t m eth o d 4 6 5 e q u ity m eth o d 4 6 5 - 7 lo n g -te rm loans 13, 9 6 decreases in 14 loss on sale 2 0 6 loss/losses 15 exam ples 501
im p a irm e n t loss 3 9 8 n e t loss 5 8 , 61 n o n c u rre n t assets, gains and losses on disposal 3 9 7 - 8 low er o f c o st and n e t realisable value rule 3 7 1 - 2 ,3 7 3 low er o f c o st o r m a rke t value 4 6 4
M m anagem ent enhancing system s 6 6 3 managerial business decisions 2, 2 2 m anagers as 7 objectives fo r a c cou nting policy ch oice 6 4 3 - 4 wage agreem ents ne gotia tion 2 4 m anagem ent acco u n tin g 2 internal fo cu s 3 m anagers 6, 6 5 - 6 accrual a c co u n tin g assum ptions and 2 1 3 -1 4 balance sheets and 5 6 bo okkeeping and c o n tro l 170 cash flo w s and 5 4 9 financial accou nting , relevance o f 7 financial a c co u n tin g standards and 2 6 8 - 9 internal c o n tro l and 2 9 9 in ve n to ry evaluation and 3 7 4 investm ents and 4 7 9 n o n cu rre n t assets and 4 0 8 overriding intern al co n tro l system s 2 8 4 p e rform a nce m easurem ent 610-11 p e rfo rm a n ce o f 7, 4 0 8 revenues and expenses re cog nition and 511 shareholders’ eq u ity 4 7 9 m anipulation 6 3 8 - 9 m anipulation versus s e lf-in te re s t 6 4 4 p ro fit m anipulation - big bath 6 3 9 m anu fa cture d capital 6 5 8 m anu fa cture d finished goods 3 7 4 m a rke t inform a tio n a l e ffic ie n c y 2 6 3 - 4 m a rke t value 4 8 , 2 4 6 - 7 m arkets capital m arkets 6 5 - 6 d iffe re n tia tio n 6 6 3 m arket prices 40 1 share m arkets 2 6 0 - 1 sto ck m a rke t 2 3 , 4 8 m aterial expenses 5 0 3 m aterial inco m e 5 0 3 m a te ria lity 18,21 m aterials, raw m aterials 3 7 4 m easurem ent o f e n erg y e ffic ie n c y 6 7 1 -3 o f financial pe rform a nce and position 3 M eeix changes in acco u n tin g m eth o d 6 4 0 exam ple 3 6 8 -7 1 m e trics 6 7 9 , 681 m in o rity interests 4 6 8 m o n e ta ry co st 21, 22 m o n e ta ry liabilities 4 2 5
m o n ito rin g 2 8 5 m ortgages 431 m o tiva tio n 6 6 3 m oving w eighted average m u lti-c o lu m n worksheets
751
370 2 0 0 -3
N natural capital 6 5 8 ‘nature o f expense m e th o d ’ 5 0 6 negative assets 4 9 n e t assets 4 7 0 n e t loss 5 8 , 61 n e t p ro fit 4 ,1 6 , 5 7 - 8 , 61, 6 5 ,1 8 5 - 6 , 5 0 4 - 5 , 510 n e t realisable value 318 low er o f co st and n e t realisable value rule 3 7 1 -2 low er o f co st o r m arket value 4 6 4 n e t- o f-ta x analysis 5 0 9 - 1 0 n o n -c o n tro llin g interests see m in o rity interests n o n c u rre n t assets 4 4 , 4 6 , 3 8 6 - 4 0 8 , 401, 4 6 5 disposals, gains and losses 3 9 7 - 8 intangible assets 5 3 managers and 4 0 8 n o n c u rre n t debts, discounts o r prem ium s on 4 3 2 - 3 n o n c u rre n t liabilities 4 4 , 4 7 , 4 2 6 - 7 classification 4 2 7 c u rre n t and n o n cu rre n t com ponent 109 due m ore than a ye ar in fu tu re 8 4 n o n -fin a n cia l m e trics 681 n o n -m o n e ta ry liabilities 4 2 5 - 6 n o n -s u ffic ie n t fund s (N S F ) cheques 291 notes co verin g statem en ts o f a c cou nting policies ? O r sub 3 7 3 - 4 notes payable 4 2 5 , 4 3 0 notes receivable 318 notes to th e financial statem en ts 3 ,1 9 , 4 7 , 51, 3 9 2 , 5 8 9 p o licy disclosure regarding in te re st 3 8 6 sig n ifica n t policies su m m a ry 6 4 3
0 o b je c tiv ity 4 9 4 obligations 4 3 4 - 5 co n tra c tu a l arising o f 4 6 legally en fo rce able 4 2 4 ‘o f f balance sheet’ fin a n c in g 4 3 9 op era ting activitie s 16, 5 2 9 op era ting expenses 15 op era ting leases 4 0 7 op era ting p e rfo rm a n ce reviews 2 8 5 op era ting p ro fit 6 3 , 5 7 9 , 581 op era ting p ro fit a fte r tax (O P A T ) 5 8 3 , 586 operations, discontin ued 6 3 o rd inary shares 8 2 , 471 organisations policies and procedures 2 8 5 stewardship o f 5 6 sustainability re p o rtin g reasons 6 6 2 - 4 o th e r de b to rs 3 1 8 -1 9
752
Index
otherw ise special shares 8 2 overhead costs 3 7 4 ow ners 5 c o n trib u tio n s 4 8 as c re d ito rs 5 9 po te ntial ow ners 5 - 6 ow ners’ eq u ity 8 4 balance sheet c o m p o n e n t ow nership 4 0 8 , 4 9 5
43
P Paperlinx Lim ited 3 7 4 parallel re co rd -ke e p in g 3 5 9 partnerships 81 pa rtners’ capital see ow ners’ eq u ity past transactions 4 5 - 6 patents 5 3 , 4 0 3 , 4 0 5 ( 2 ) goods o r services provision 4 5 Pay A s Y ou G o (P A Y G ) w ith holding system 4 3 9 payables 4 2 8 - 9 paym ents to em ployees 5 3 7 - 9 to suppliers 5 3 7 - 9 people, e thics and 8 percentage o f c o m p le tio n m e thod 4 9 4 , 4 9 6 -7 percentages 3 9 2 , 3 9 4 p e rform a nce 6 0 6 evaluation 6 5 - 6 financial pe rform a nce see financial pe rform a nce key p e rform a nce indicators (K P Is) 6 5 9 o f managers 7, 4 0 8 p e rfo rm a n ce bonuses 2 3 - 4 p e rfo rm a n ce indica tors 6 5 9 , 6 6 5 - 7 p e rfo rm a n ce m e trics 6 6 0 see also financial position p e rform a nce ratios 5 9 7 -6 0 1 periodic c o u n t m e th o d 3 5 9 exam ple 3 6 2 - 4 periodic inve ntory, acco u n tin g entries fo r 3 6 0 - 4 perpetual in v e n to ry -p e rio d ic in ve n to ry com parison 3 6 2 - 4 periodic re p o rtin g dem and f o r credible 5 d iffic u lty 4 9 3 perpetual in ve n to ry co n tro l m eth o d 3 5 8 - 9 exam ple 3 6 0 - 2 perpetual inve ntory, acco u n tin g entries fo r 3 6 0 - 4 perpetual in v e n to ry -p e rio d ic inve n to ry com parison 3 6 2 - 4 steps 3 5 8 p e r-share data 6 5 p e tty cash 2 8 7 case stud y 2 8 8 e rro rs in 2 9 8 m aking disbursem ents 2 9 7 replenishing 2 9 7 - 8 vo uch ers 2 9 7 p o in t o f sale o r delivery re cog nition 496
p o licy 6 7 9 acco u n tin g policy choices 6 3 6 - 4 4 classification policies 6 4 0 disclosure policies 6 4 0 disclosure p o licy 6 3 7 g o ve rn m e n t p o licy 6 7 9 in ve n to ry acco u n tin g policies, disclosure o f 3 7 3 -4 p o licy disclosure regarding in te re st 3 8 6 revenue re cog nition p o licy 197 p o st-clo s in g trial balance 154 p redictions 6 3 prefere nce shares 8 2 , 471 prepaym ents 5 2 - 3 acco u n tin g fo r 1 9 3 - 5 righ ts to receive services 4 5 present value 2 4 7 present value (P V ) 318, 4 0 7 - 8 , 4 2 5 , 433 fu tu re cash flo w s analysis 4 5 8 - 6 2 p re -ta x 15, 6 5 price m a rke t prices 40 1 se cu rity prices 261 standard price list 3 2 7 pric e -le ve l-a d ju ste d historical c o s t 2 4 5 , 246 p ric e -to -e a rn in g s (P E ) ratio 5 8 4 - 5 , 600 p rin c ip a l-a g e n t th e o ry 2 6 5 private com panies 8 2 private loans 431 proba bility 4 2 4 p ro d u ct responsibility disclosure 6 5 9 pro d u ctio n re cog nition b e fo re and a fte r 5 0 8 - 9 re cog nition du ring 4 9 6 - 7 , 5 0 8 - 9 re cog nition on c o m p le tio n 4 9 7 produ cts, unsold produ cts 13 p ro fit 15, 5 8 , 4 9 3 acco u n tin g policy ch oice e ffe c t 6 4 1 -2 accrual p ro fit 8, 4 8 ,1 8 6 , 5 2 8 cash flo w s -p ro fit relationship 5 4 9 cash p ro fit-a c c ru a l p ro fit com parison 10 co m p lica tion s in d e te rm in in g 11 de te rm in a tio n 511 d istrib u tio n /a c cu m u la tio n o f 4 7 , 5 8 gross p ro fit 15, 3 6 2 - 3 m easuring see depreciation n e t p ro fit 4 ,1 6 , 5 7 - 8 , 61, 6 5 ,1 8 5 - 6 , 510 op era ting p ro fit 6 3 , 57 9 , 581 o p tim is tic estim ates and 6 3 8 p ro fit fo r th e p e rio d -re ta in e d p ro fits relationship 5 9 p ro fit m anipulation - big bath 6 3 9 p ro fit m easure m ent c o n n e c tio n o f liabilities 4 2 7 retained p ro fits see retained p ro fits p ro fit and loss statem en ts see inco m e statem en ts p ro fit b e fo re tax 15, 6 5 p ro fit m argin 5 8 3 , 5 9 8
p ro fit ra tio 5 9 8 p ro fita b ility 15 p ro fita b ility ratios 5 8 1 - 5 pro p e rty, plant and e q u ip m e n t (P P E ) 13, 53, 387, 47 5 prospectus 8 2 , 4 3 2 , 471 provision fo r em ployee e n title m e n ts 13, 53 provisions 4 3 3 - 6 acco u n tin g fo r 4 3 4 - 5 public com panies 8 2 purchase orders 14 4 purchased goodw ill 4 0 7 purchases jo u rn a ls 3 3 3 - 4
Q Q a n ta s G ro u p 6 6 9 - 7 0 qu ick ra tio 4 9 , 5 8 8 , 6 0 2 - 3
R ratio analysis 5 9 4 - 6 0 3 exam ple 5 9 4 - 6 0 3 fo r financial statem en ts 5 8 1 -9 1 integrative ra tio analysis 5 9 1 - 4 ratios 1 0 8 , 6 0 3 , 6 0 7 - 1 0 averages use 5 9 3 calculations 5 9 0 nu m e ra to rs/d e n o m in a to rs 5 7 6 p ro fita b ility ratios 5 8 1 - 5 raw m aterials 3 7 4 reasonableness 7 rebates 3 7 4 receivables 316 reclassification 1 0 8 re con ciliation 2 8 5 bank re con ciliations 2 8 7 , 2 9 0 - 6 process 2 9 1 - 4 re co rd -ke e p in g acco u n tin g ‘books’ and re cords 1 4 3 - 5 5 detailed re cording 3 2 8 - 9 d o u b le -e n try bo okkeeping 9 4 - 7 e le c tro n ic co m m e rce 1 6 9 - 7 0 exam ples 1 5 5 - 6 9 financial acco u n tin g ’s transactional filte r 1 4 0 - 3 im p o rta n ce o f good records 14 0 m anagers, bo okkeeping and c o n tro l 170 parallel re co rd -ke e p in g 3 5 9 re co rd -ke e p in g e rro r 2 9 2 separate fro m handling assets 2 8 6 updating in ve n to ry records via co m p u te rs 3 5 9 re ducin g balance depreciation m e th o d 3 9 2 - 4 , 6 4 2 fo rm u la 3 9 3 fo rm u la - percentage 3 9 4 regulation 6 7 3 ,6 7 9 acco u n tin g regulation in A ustralia 2 4 9 -5 1 regulators 6 re gulatory co m p lian ce 6 6 2 relative re tu rn , in ve stm e n t and 5 7 6 relevance 1 8 ,2 0 - 1 re lia b ility -re le va n ce tra d e -o ffs 4 9 3
Index
re liab ility 18,21 versus decision relevance 4 9 3 re m uneration 2 3 - 4 re po rts / re po rti ng annual re ports 4 2 , 2 9 8 - 9 , 4 6 4 b rie f and concise 681 c o m p le xity o f re p o rts 2 0 credible periodic re p o rtin g 5 external au d ito r’s re p o rt 2 5 4 - 7 G lobal R ep orting Initiative (G R I) 6 6 4 , 6 6 4 -7 integrated re p o rtin g - sustainability re p o rtin g 6 7 6 -8 1 international financial re p o rtin g standards 251 Intern atio nal Financial R ep orting S tandards (IF R S ) 11 re p o rtin g dates 3 9 9 re p o rtin g fre e d o m 6 3 8 sustainability re p o rtin g 5, 6 5 8 -8 1 trip le b o tto m line re p o rtin g 6 5 8 re putation 6 6 2 , 6 6 4 researchers 6 reserves 4 7 4 capital re d e m p tio n reserves 4 7 4 general reserves 471 resources assets see assets a t a p o in t in tim e see balance sheets retail in ve n to ry m ethod , standard costs and 3 7 2 - 3 retail m erchandise finished goods 3 7 4 retained p ro fits 13, 4 8 - 9 , 5 8 , 6 1 -2 , 8 2 -3 balance in retained p ro fits 4 7 5 - 6 balance sheets and 8 2 p ro fit fo r th e p e rio d -re ta in e d p ro fits relationship 5 9 retained p ro fit fo r th e year, change in 16 re tu rn 2 6 3 - 4 re tu rn on assets (R O A ) 4 0 8 , 5 8 3 , 597 R O E and R O A 5 9 7 - 8 re tu rn on e q u ity (R O E ) 4 7 4 , 5 8 1 -2 , 597 R O E and R O A 5 9 7 - 8 re tu rn on in ve stm e n t (R O I) 5 7 6 revaluation 4 0 3 asset revaluations 4 0 1 - 2 in crem ents and de cre m e nts 4 0 1 - 2 revaluation surplus 4 7 4 revenue received in advance 153 revenue re cog nition 57 cash co llections/p aym en ts related to previously recognised revenues/ expenses 1 8 8 - 9 cash in flo w /o u tflo w a fte r 1 9 0 -1 cash in flo w /o u tflo w b e fo re 1 8 9 - 9 0 crite ria fo r 4 9 4 - 8 exam ples 4 9 8 - 5 0 0 im p ro p e r 4 9 9 key co n d itio n s 4 9 5 p rio r to cash flo w 1 8 7 - 8 a t same tim e as cash in flo w / o u tflo w 1 8 6 - 7
revenues 57, 6 1 ,1 8 5 , 4 9 2 (2 ) accrual o f 4 6 5 debits and cre d its 1 0 2 - 8 e x p enses-re ven ue earned m atch in g 3 8 8 m anagers and revenue re cog nition 511 re co g n itio n 4 9 3 - 5 0 0 reliably-m easured a m o u n t 4 9 5 revenue received in advance 153 revenues 5 0 0 tim e period o f o c cu rre n ce 9 unearned revenue 1 5 3 ,1 9 6 - 8 , 4 2 9 , 498 un record ed revenue 1 9 9 - 2 0 0 review 681 inde pend ent approval and review 2 8 6 o p era ting pe rform a nce reviews 2 8 5 to p -le v e l reviews 2 8 6 rights, shareholder righ ts 471 risk 2 6 3 - 4 risk assessm ent 2 8 5 risk m anagem ent/aw areness 6 6 2
S sales 15, 57, 6 5 cash sales 2 8 8 sales invoices 145, 2 8 8 , 3 2 9 sales jo u rn a ls 3 2 9 sales re tu rn 5 9 8 salvage value 3 9 1 - 2 , 3 9 3 - 5 scope c o n c e p t 6 7 2 - 3 Securities and E xchange C om m ission (S E C ) 4 9 2 se cu rity prices 261 se cu rity tra d in g 261 segregation o f duties 2 8 5 - 6 , 2 8 7 s e lf-in te re s t 6 4 4 sellers 4 9 5 sensitive assets 2 8 6 services 4 ge nerating n e t cash flo w s 4 5 as m ain fo rm o f revenue 9 provision o f 57 share buybacks 4 7 4 - 5 share capital 13, 4 8 , 6 0 , 317, 4 7 1 -4 , 472, 476 fo rm s o f 8 2 increases in 14 share m arkets 2 6 0 - 1 share splits 4 7 8 shareholders 5 accou nting , d e cision-m a king purposes 2 3 m in o rity intere sts 4 6 8 righ ts c o n fe rre d 471 shareholders’ e q u ity 4 7 8 shareholders’ e q u ity (S E ) 4 3 , 4 7 0 -1 , 474, 479 acco u n tin g equation 13 elem en ts 13 m anagers and 4 7 9 residual eq u ity c o n c e p t - book value 4 7 - 8 shares 4 , 5, 2 3 , 317 a llo tm e n t 4 7 2 basic earnings per share 5 8 4
753
earnings per share (E P S ) 6 5 in ve stm e n t decisions 4 7 9 o rdinary shares 8 2 , 471 pre fe re n ce shares 8 2 , 471 share prices 6 0 8 shares held 4 7 6 traded shares 6 6 tra n sfe ra b ility o f 8 2 s h o rt-te rm inve stm e nts 4 6 4 s id e -b y -sid e balance sheet fo rm a t 4 3 - 4 significance 18 social and relationship capital 6 5 8 social p e rfo rm a n ce 6 6 6 - 7 social s e ttin g 4 societal disclosure 6 5 9 sole trad ers (sole pro p rie to rsh ip ) 8 0 solvency w arning ratios 6 0 2 - 3 , 6 0 7 Sound and L igh t balance sheet analysis 4 8 - 5 0 assets and ‘assets’; n o n -c u rre n t and c u rre n t assets 4 5 - 6 liabilities 4 6 share capital, shareholders and retained p ro fit 4 8 s id e -b y -sid e fo rm a t 4 4 source do cu m e n ts 156, 3 2 9 transactional cycle and 1 4 4 - 5 special jo u rn a ls 3 2 8 - 9 advantages 3 3 0 op era tion 3 3 1 -7 prim e e n try records 3 3 0 purpose 331 stakeholder engagem ent, exam ples 6 6 1 -2 stakeholders id e n tity and re p o rtin g re quirem ents 6 6 1 -2 in fo rm a tio n use 6 6 9 role in sustainability re p o rtin g 661 standard costs 3 7 3 retail in ve n to ry and 3 7 2 - 3 standards acco u n tin g standards 16, 2 3 6 - 8 , 407, 638 A ustralian A c c o u n tin g Standards 4 0 4 , 5 3 3 , also under individual standards fin ancial a c co u n tin g standards, managers and 2 6 8 - 9 intern atio nal fin ancial re p o rtin g standards 251 Intern atio nal Financial R eporting S tandards (IF R S ) 11 sta te m e n t o f cash flo w s 1 2 ,1 4 ,1 6 -1 7 cash flo w analysis, purpose 5 2 8 - 9 cash flo w and th e m anager 5 4 9 cash flo w transactions classification 5 2 9 d ire c t m e thod preparation 5 3 3 - 4 3 d ire c t versus in d ire c t m eth o d o f re p o rtin g cash flo w fro m operations 5 3 1 -3 exam ple 16 fo rm a t 5 2 9 -3 1 in d ire c t m eth o d preparation 5 4 5 - 7 in te rp re tin g (d ire c t and in d ire c t) 5 4 3 - 4 , 5 4 8 - 9
754
Index
sta te m e n t o f com prehensive in co m e 5 0 2 - 7 sta te m e n t o f p ro fit and loss 5 0 2 - 7 sta te m e n t o f retained p ro fits 62 statem en ts bank statem en ts 2 9 0 - 1 cash flo w statem en ts 5 4 6 - 7 co m m o n size financial statem en ts 5 7 8 - 9 financial statem en ts see financial statem en ts inco m e statem en ts 1 2 ,1 5 -1 6 sta te m e n t o f cash flo w s 1 2 ,1 6 -1 7 , 5 2 8 -4 9 statem en ts o f changes in e q u ity 5 0 7 - 8 stew ardship 5 6 ,2 6 6 sto ck m arket 2 3 , 4 8 s tra ig h t-lin e depreciation m eth o d 3 9 0 - 2 , 4 3 3 , 6 4 2 fo rm u la 391 subsidiary ledgers 1 4 9 - 5 0 , 3 2 8 -3 1 op era tion 3 3 1 -7 superannuation 5 3 , 4 2 8 - 9 suppliers 4 cash paid to 5 3 6 - 7 paym ents to 5 3 7 - 9 supply chain operations 6 6 8 - 9 surveillance 6 3 9 sustainable d e velopm e nt 6 5 8 sustainability, m e trics and fram e w o rks 6 7 9 sustainability m anagem ent 6 5 8 sustainability re p o rtin g 5 co m p a n y disclosure surveys 6 6 3 - 4 co nce ptu al changes over tim e 6 5 8 - 9 crite ria fo r 6 6 4 - 7 d e fin itio n 6 5 8 - 9 en erg y e ffic ie n c y exam ple 6 6 9 - 7 6 exam ples 6 6 9 - 7 0 integrated re p o rtin g 6 7 6 -8 1 reasons f o r produ cing 6 6 2 - 4 re porte d m aterial 6 5 9 - 6 0 stakeholders’ re quirem ents 6 6 1 -2 S ustainability R ep orting G uidelines 6 6 4 - 7 tre n d s in 6 6 7 - 9
T T -a c c o u n ts 10 3 ta rg e ts 6 7 3 tax 4 3 9 goods and services tax (G S T ) see goods and services tax in d ire c t taxes 4 4 0 n e t- o f-ta x analysis 5 0 9 - 1 0 p ro fit b e fo re tax 15 tax liabilities 4 3 3 d e fe rre d tax liabilities 4 3 3 th e ft 2 8 7 - 9 th ird parties 6 th ird -p a rty in fo rm a tio n com parisons 2 8 7
tim e period ( o f o c cu rre n ce ), fo r revenues and expenses 9 tim eliness 2 0 o f operations 2 8 7 tim in g diffe ren ces 291 to p -le v e l reviews 2 8 6 to ta l asset tu rn o v e r 5 8 5 - 6 , 601 tra d e c re d ito rs see accou nts payable; accou nts payable tra d e disc o u n t 3 2 7 tra d e payables see accou nts payable tra d e receivables 317 tradem arks 5 3 , 4 0 3 tra d e -o ffs am on g acco u n tin g principles 21 re lia b ility -re le va n ce tra d e -o ffs 4 9 3 tra d in g 2 6 2 tran saction analysis 8 - 9 , 319 exam ples 8 6 - 9 3 past tran saction s/e ven ts 4 5 - 6 th re e main financial statem ents, relationship betw een 8 9 - 9 3 transactions im p a ctin g on balance sheets 5 4 - 5 transactional cycle, source d o cum en ts and 1 4 4 - 5 transactions 9 7 cash flo w transactions classification 5 2 9 c o n tro ls fo r 2 8 6 event ch ara cteristics 142 external a c co u n tin g transactions 141 exte rna lly generated goodw ill 4 0 7 F ram ew ork rules application 5 0 2 internal acco u n tin g tran saction s 143 re cog nition o f 6 3 7 re cording in jo u rn a ls 157 re co rd in g transactions - d o u b le -e n try bookkeeping 9 4 - 7 transactional filte r 1 4 0 - 3 tw o o r m ore e ffe c ts 9 5 tran spa ren cy 6 6 2 , 6 7 6 Transurban Sustainability R e p o rt 6 6 8 tren ds in sustainability re p o rtin g 6 6 2 - 3 , 6 6 7 -9 using ratios 5 8 2 trial balance 9 5 ,1 5 1 - 2 ,1 5 9 ,1 6 2 trip le b o tto m line re p o rtin g 6 5 8 tu rn o v e r ratios 5 8 5 - 7 , 60 1, 6 0 7
U u n ce rta in ty 2 1 ,4 3 3 - 4 ,5 0 1 understandability 19, 2 0 , 21 unearned revenue 1 5 3 ,1 9 6 - 8 , 4 9 8 u n in corporatio n 8 0 - 1 unions 6 wage agreem ents ne gotia tion 2 4 u n its -o f-p ro d u c tio n depreciation, fo rm u la 3 9 4 - 5 u n its -o f-p ro d u c tio n m eth o d 3 9 4 - 5 , 642
un record ed revenue 1 9 9 - 2 0 0 unsecured notes 431 unsold produ cts 13 useful life ( o f assets) 9 , 3 8 9 - 9 0 fin ite o r in d e fin ite 4 0 5 - 6
V va lidity 5 7 8 valuation o f a ccou nts receivable 318 o f assets and liabilities 2 4 5 - 9 balance sheet valuation 3 6 6 historical co st valuation 3 8 6 - 7 inde pend ent valuation o r d ire c to rs ’ valuation 5 3 in ve n to ry valuation and managers 3 7 4 value o f assets and liabilities 5 3 book value 4 7 - 8 , 3 9 0 , 3 9 2 , 3 9 4 , 396, 5 9 9 -6 0 0 c u rre n t value 2 4 6 - 7 fa ir value 2 4 7 , 4 0 1 , 4 0 3 , 4 0 7 , 5 0 0 financial value 6 6 2 fu tu re value 193 liquidation value 2 4 7 - 8 m arket value 2 4 6 - 7 m arket value o f w hole ente rprise 4 8 n e t realisable value 3 7 1 -2 , 4 6 4 prese nt value 4 0 7 - 8 , 4 3 3 salvage value 3 9 1 - 2 , 3 9 3 - 5 value in use see present value value in use 3 9 8 ve rifia b ility 2 0 , 4 9 4 ve rtical balance sheets fo rm a t 4 3 , 5 0 vo lu m e -re la te d supplier rebates 3 7 4 v o lu n ta ry disclosure 6 6 8 , 6 7 4 - 6
W wage agreem ents, ne gotia tion using acco u n tin g num bers 2 4 wages payable 13, 5 3 7 - 8 w a rra n ty lia bility 4 3 4 w ealth ge neration 5 2 8 increases and decreases in 5 7 - 8 , 61 w eighted average co s t (A V G E ) cash flo w assum ption 3 6 5 , 3 6 6 , 3 6 8 m e thod 3 7 0 W esfarm e rs Lim ited 3 7 3 - 4 W e stp a c Lim ited 6 7 0 ‘w ha t i f (e ffe c ts ) analysis 6 0 7 - 1 0 exam ples 5 0 8 - 1 0 , 6 0 8 - 1 0 ‘w ha t i f questions 6 4 4 wholesale m erchandise finished goods 3 7 4 w o rk in progress (W IP ) 3 7 4 w o rking capital 4 9 , 3 5 8 w o rking capital ra tio 4 9 , 5 8 7 , 6 0 2 , 6 3 8 w rite -d o w n see im p airm en t w rite -o ffs 3 1 9 - 2 0 , 6 3 9