BA606 FINANCIAL ACCOUNTING

1. BA606 FINANCIAL ACCOUNTING Professor Garry Carnegie Lectures 19 & 20

2. Lectures 19 and 20 : Further financial reporting issues • Introduction • Differential reporting • Materiality • Events occurring after balance date • Accounting polices, changes in accounting estimates and errors • Related party transactions • Financial reporting by segments

3. Introduction • There is a large array of issues in financial reporting which command the attention of preparers, users and auditors of financial reports • Such issues have an important influence on the preparation of a entity’s financial reports • Some of these further issues are addressed

4. Differential reporting • Some argue that the financial reports of all entities should be prepared in conformance with accounting standards • Others argue for differential reporting • In other words, significant differences are perceived to exist between entities, such as on the basis of size, to enable certain entities to adopt different recognition, measurement and disclosure practices

5. Differential reporting • Three key justifications, all based on size, are as follows: - Costs of complying with accounting standards are significantly greater for small entities - Information needs for users in the case of small entities are likely to be less elaborate than for larger entities and, therefore, are different - Users of the financial reports of small entities are usually able to obtain financial and other information to suit their special decision needs

6. Differential reporting • APS 1 and SAC 1 reflect the notion of differential reporting by indicating that general purpose financial reports are required to be prepared by “reporting entities” • These two pronouncements, of course, are to be interpreted as per SAC 1 (see paras. 19-22)

7. Differential reporting • The First Corporate Simplification Act 1995 (Cwth) introduced changes to corporations legislation covering the classification of companies for financial reporting purposes • Companies are now classified for reporting purposes into four categories

8. Differential reporting • Disclosing entities • Public companies • Large proprietary companies • Small proprietary companies

9. Differential reporting • Disclosing entities • Disclosing entities are those with listed securities • These entities have the most onerous financial reporting requirements • Such entities must prepare financial reports in accordance with AASB accounting standards

10. Differential reporting • Public companies • These are all companies other than proprietary companies • Public companies are required to prepare financial reports • Such reports are to be prepared in accordance with AASB accounting standards where public companies are reporting entities

11. Differential reporting • Large proprietary companies • Under sec 45A(3) of the Corporations Act 2001, large proprietary companies are those which satisfy two of the following tests: - consolidated gross operating revenue is $25 million or more - consolidated gross assets is $12.5 million or more - the company and the entity it controls have 50 or more employees

12. Differential reporting • Large proprietary companies are required to prepare financial reports • These financial reports are to be prepared in accordance with AASB accounting standards where such companies are reporting entities

13. Differential reporting • Small proprietary companies • These proprietary companies are those which are not large proprietary companies • Under certain conditions found in sec 292(2) of the Corporations Act 2001, small proprietary companies do not have to prepare financial reports

14. Materiality • Under the Framework, “the relevance of information is affected by its nature and materiality” (para. 29) • Materiality “provides a threshold or cut-off point” (para. 30) • AASB 1031 “Materiality in Financial Statement” was issued in September 1995 • It is not based on a IASB accounting standard

15. Materiality • AASB 1031 has, however, been revised and reissued to ensure consistency with other recently-issued AASB accounting standards • The effects of AASB 1031 on Australian financial reporting are difficult to identify and assess • Key paras. of AASB 1031 include paras. 9 (material information), para. 12 (determining materiality), paras. 13 and 15 (material amounts) and para. 19 (comparing items with directly related items)

16. Events occurring after balance date • For listed Australian companies, there exists a maximum reporting lag of three months from financial year end to the date of publishing financial reports • During this period, there may be transactions and other events that, if known to users, would modify their interpretation of the published financial reports • Such events are known as “subsequent events” or events “occurring after balance date”

17. Events occurring after balance date • Such events are of two types: • Those that clarify or provide new evidence about conditions that existed at the reporting date • Those that relate to new conditions arising after the reporting date

18. Events occurring after balance date • AASB 110 “Events After the Balance Sheet Date” defines “events after balance date” (para. 3) and distinguishes between two types of events occurring after the reporting date known as “adjusting events” and “non-adjusting events”

19. Events occurring after balance date • Adjusting events are “those that provide evidence of conditions that existed at the reporting date” (para. 3) • Non-adjusting events are “those that are indicative of conditions that arose after the reporting date” (para. 3)

20. Events occurring after balance date • Para. 8 stipulates that “an entity shall adjust the amounts recognised in its financial statements to reflect adjusting events after the reporting date” • Para. 9 provides examples of adjusting events • Para. 10 states that “an entity shall not adjust the amounts recognised in its financial statements to reflect non-adjusting events after the reporting date”

21. Events occurring after balance date • The non-disclosure of material non-adjusting events could, however, influence economic decisions made on the basis of the relevant financial reports • Para. 21 deals with these circumstances and requires disclosure in the form of notes which does not result in any adjustments to the financial results (see para. 22 for examples)

22. Events occurring after balance date • Para. 14 deals with events after balance date that have an impact on the entity’s ability to continue as a going concern • An entity is prohibited from using the going concern basis should management determine, in the period after the reporting date, that the entity is likely to cease trading or to liquidate (also see paras. 15 and 16)

23. Accounting policies • The “choice of accounting methods” has previously been examined • Choices made by management impacts on the relevance and reliability of an entity’s financial report • Choice involves the selection and modification of accounting policies and the use of professional judgment in making estimates and in correcting errors

24. Accounting policies • Accounting standards are intended to reduce the choice of accounting policies • Such moves are intended to enhance the relevance and reliability of financial reporting, as well as its comparability, and the reduce the scope for “creative” accounting • The creative use of accounting policies, however, cannot be eliminated

25. Accounting policies • AASB 108 “Accounting Policies, Changes in Accounting Estimates and Errors” applies to the selection and alteration of policies and in the correction of errors • “Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial reports” (para. 5)

26. Accounting policies • AASB 108 deals with the following topics: - Selection and application of accounting policies - Changes in accounting policies - Changes in accounting estimates - Errors

27. Accounting policies • Selection and application of accounting policies • Policies as required under specific Australian Accounting Standards are to be applied (para. 7) • In the absence of a specific accounting standard, para. 10 applies • In making judgments required under para. 10, apply the Framework (para. 11) • Explore other standards issued elsewhere and relevant authoritative literature (para. 12)

28. Accounting policies • Changes in accounting policies • Justification for accounting policy changes are specified (para. 14) • Circumstances are identified which are not accounting policy changes (para. 16) • Requirements for applying changes in accounting policies are identified (paras. 19 and 22)

29. Accounting policies • Limitations on retrospective application are identified (paras. 23 to 25) • Disclosure of changes in accounting policy are prescribed (paras. 28 to 30)

30. Accounting policies • Changes in accounting estimates • A “change in accounting estimates” is defined in para. 5 • Estimates may need to be revised as circumstances change or as new information becomes available as per paras. 36 and 37 • Disclosure of changes in estimates is required under paras. 39 and 40

31. Accounting policies • Errors • Errors can be made and are made in the recognition, measurement and disclosure of elements of financial statements • Errors of a material nature are to be corrected retrospectively under para. 42 • Limitations on retrospective restatement are outlined in paras. 43 to 45 • Disclosure requirements (see para. 49)

32. Related party transactions • Entities are “related parties” in accounting if one entity can significantly influence the operating, financial and investing policies of another or if several entities are subject to significant influence from the same entity • Related parties include company directors as they are able to influence an entity’s operating, financial and investing policies

33. Related party transactions • Related parties include: - Executives and the entities they manage - A parent company and a subsidiary company - Subsidiaries of the same parent

34. Related party transactions • Transactions between related parties are of interest to users because they expose the entity to risks, or provide opportunities that would not have otherwise existed without the relationship • Implications arise from the ability of one party to enter into transactions with a related party at amounts other than fair value

35. Related party transactions • Such implications include: - A related party may gain personal benefit - Related parties may “create” profits and assets - Related party transactions may be used to minimise tax - Related party transactions may be used to defraud third parties

36. Related party transactions • Due to the endless possibilities for transactions of all kinds between related parties, certain disclosures are required to be made in order to identify the existence and the details of related party transactions • Requirements for related party transactions are found in AASB 124 “Related Party Disclosures”, while the formerly applicable AASB 1046 “Director and Executive Disclosures by Disclosing Entities” has been withdrawn

37. Related party transactions • A “related party” is defined in para. 9 of AASB 124 • “A ‘related party transaction’ is a transfer of resources, services or obligations between related parties, regardless of whether a price is charged” (AASB 124, para. 9) • Read Example 21.5 (H, P & H, pp. 688-689) which illustrates the application of the related party definition

38. Related party transactions • Requirements for the disclosure of related party transactions are found in paras. 12 to 22 and relate to: - Nature of the related party relationships (see paras. 12 and Aus12.1) - Compensation of key management personnel (para. 16) - Transactions and outstanding balances between related parties (paras. 17, 18 and also para. 20 for examples of transactions)

39. Related party transactions • Other key management personnel disclosures by disclosing entities are specified in paras. Aus25.1 to Aus25.9.3 • These disclosures were formerly mandated under (the now withdrawn) AASB 1046

40. Financial reporting by segments • Entities are often diversified by business or by geography or both • Different business types and different geographic locations tend to have different return and risk characteristics • Aggregated or consolidated results mask such variety unless the combined date are disaggregated into segments

41. Financial reporting by segments • Segment reporting is aimed at providing additional note-form disclosure of a diversified entity’s financial results by reporting the key financial information on its “operating segments” • The cases for and against segment financial reporting are addressed in H, P & H, pp. 615-618

42. Financial reporting by segments • In examining segment reporting, a number of implementation questions arise such as: - How should a segment be defined? - When should segment data be reported? - What segment data should be disclosed? - How should segment data be disclosed? • See H, P & H, pp. 618-620 and the current accounting standard on the topic

43. Financial reporting by segments • AASB 8 “Operating Segments” is applicable to diversified entities • The “core principle” of AASB 8 is expressed as follows: “An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates” (para. 1)

44. Financial reporting by segments • Operating segments • “An operating segment is a component of an entity: (a) that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity); (b) whose operating activities are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and (c) for which discrete financial information is available” (para. 5; emphasis in original)

45. Financial reporting by segments • Under para. 5, operating segments are to be identified on the basis of internal reports that are regularly reviewed by the entity’s chief operating decision maker (also see paras. 6-10) • In former accounting standards, the identification of segments was more “rules-based” and required the identification of two sets of segments, where applicable, one based on products of services (business segments) and the other on geographical areas (geographical segments)

46. Financial reporting by segments • Reportable segments • “An entity shall report separately information about each operating segment that: (a) has been identified in accordance with paragraphs 5-10 or results from aggregating two or more of those segments in accordance with paragraph 12; and (b) exceeds the quantitative thresholds in paragraph 13 Paragraphs 14-19 specify other situations in which separate information about an operating segment shall be reported” (para. 11)

47. Financial reporting by segments • Quantitative thresholds • “An entity shall report separately information about an operating segment that meets any of the following quantitative thresholds: (a) its reported income, including both sales to external customers and intersegment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments;

48. Financial reporting by segments (b) the absolute amount of its reported profit or loss is 10 per cent or more of the greater, in absolute amount, of (i) the combined reported profit of all operating segments that did not report a loss and (ii) the combined reported loss of all operating segments that reported a loss; (c) its assets are 10 per cent or more of the combined assets of all operating segments” (para. 13)

49. Financial reporting by segments • Paras. 14-19 are also relevant in the identification of operating segments • “If the total external revenue reported by operating segments constitutes less than 75 per cent of the entity’s revenue, additional operating segments shall be identified as reportable segments (even if they do not meet the criteria in paragraph 13) until at least 75 per cent of the entity’s revenue is included in reportable segments” (para. 15)

50. Financial reporting by segments • Disclosure • “An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates” (para. 20)