Chapter 12

1. The Framework of Accounting Chapter 12 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

2. Objectives 1. Describe the accounting setting process in Australia 2. Understand the nature of the conceptual framework for financial reporting 3. Understand the objective of financial reporting 4. Understand the general principles of financial reporting practices

3. Objectives 5. Apply different profit recognition rules 6. Show how accounting and reporting principles affect the disclosure of financial information 7. Understand how market values are used in financial statements

4. What does 2 + 2 = • Many people think because accounting is based on numbers, everything in accounting is mathematically precise. • If you sell two bottles of coke at $2 each you receive $4 - Cr Sales $4 - no problems ! • But what is the cost of goods sold if you have purchased some bottles for $1 and others for $1.10 - Dr COGS $2 or $2.05 or $2.10 or $2.20 ?

5. What does 2 + 2 = • If you are a mineral exploration company and you drill two holes which cost $2m each, and discover a rich oil deposit in one • Do you have: • A $2m asset ? • A $4m asset ? • A $200m to $400m asset ? • Numbers may be mathematically precise but the situations often are not.

6. Accounting Standards • Aim of accounting standards is to improve the usefulness of financial statements. • Australian accounting standards were developed to suit users in the Australian economic environment. • With increased globalisation, international harmonisation of accounting standards is now now timetabled for 2005.

7. Objective 1 Describe the accounting standard-setting process in Australia

8. Accounting Standards • The first Australian accounting standards were issued in 1946. • They described existing practice - but were intended to provide uniformity. • Today many standard setting bodies are developing conceptual frameworks aimed at giving a logical and consistent basis for the standards issued.

9. Accounting Standards • There is a technical component to accounting. • Double-entry bookkeeping rules need to be clearly understood. • Once we leave the basic measurement procedures issues become less clear. • Even simple depreciation and inventory calculations introduce choice.

10. Accounting Standards • The measurement and disclosure of economic events is not always clear and objective. • Accounting standards restrict choice and therefore have economic consequences. • A due process has been put in place to develop accounting standards.

11. Standard Setting Process • Different users (interest groups) may prefer different measurements. • New accounting regulations require the disclosure of COGS (AASB 1018 Statement of Financial Performance or what was once referred to as the Profit and Loss Statement) • Not an issue for large diversified entities. • But for single product entities it is important.

12. Standard Setting Process • This introduces a political dimension into the standard-setting process. • Often the conflict is between; • Managers who do not want information revealed. • Investors and creditors who want to know what management is doing with their money.

13. Standard Setting Process • The two major professional bodies; • Institute of Chartered Accountants in Australia (ICAA) • CPA Australia (CPAA) Established the Australian Accounting Research Foundation (AARF) which through the Accounting Standards Board (ASB) issued standards since the 1960’s.

14. Standard Setting Process • AASB standards were binding on members of the professional bodies but they did not have legal backing. • In 1983 government set up Accounting Standards Review Board (AARB) to review all accounting standards and issue as Approved Accounting Standards - which had legal backing.

15. Standard Setting Process • In 1988 ASB and the AARB were merged and in 1991 the Australian Accounting Standards Board (AASB) was established. • 1994 Urgent Issues Group (UIG) was set up to look at (you guessed it) urgent issues. • The enforcement of accounting standards and other corporations law is undertaken by Australian Securities and Investments Commission (ASIC).

16. Standard Setting Due Process • AASB - The main body responsibly for developing accounting standards; • usually issues “Exposure Drafts” for public comment. • meets with the “Consultative Group” which has representatives from identified interest groups. • provides info. at http://www.aasb.com.au

17. Objective 2 Understand the nature of the conceptual framework for financial reporting

18. Conceptual Framework • Up to now we have looked at concepts and principles in isolation. • Collectively they should be logically related and come from a consistent foundation. • Is it necessary to have a framework that defines the nature and function of financial accounting?

19. Accounting Principles • Accounting principles: • differ from natural laws - do not attempt to describe physical phenomena. • define measurement procedures, calculations and forms of presentation. • draw their authority from acceptance in the business community.

20. Statements of Accounting Concepts • In Australia the AASB has issued four Statements of Accounting Concepts (SACs). • SAC 1 ‘Definition of the Reporting Entity’ • SAC 2 ‘Objectives of General Purpose Financial Statements’ • SAC 3 ‘Qualitative Characteristics of Financial Information’ • SAC 4 ‘Definition and Recognition of the Elements of Financial Statements

21. Reporting Entity • In the first lecture the accounting entity concept separated the business from other businesses and the owner. • The separation allows the measurement of financial performance and position. • Issue is simple for a sole trader but more complex for large companies with subsidiaries, joint ventures and other investments.

22. Objective 3 Understand the objective of financial reporting

23. Basic Objective... • is to ‘provide information useful to users for making and evaluating decisions about the allocation of scarce resources’. • “Useful” - depends on the user, the decision to be made and the resources to be allocated. • Users include: • Resource providers, recipients of goods and services, reviewers.

24. Objective 4 Understand the general principles of financial reporting practice

25. Useful Information • What makes accounting information useful? • Relevance • Reliability • Comparability • Understandability • Materiality • Timeliness • Cost versus Benefit

26. Relevance • Relevant information is information that is needed by users for making their decisions. • Financial reports should include alland onlyrelevant information. • Decisions may be about a lot of things including; • Past - has management been a good steward? • Future - will management perform?

27. Reliability • Reliable information ‘can be depended upon to be represent faithfully, without bias or undue error, the transactions or events it represents’. • Verifiability is an important element - independent attestability, an outside expert (the auditor) would agree the information is objective and honest. • Measured within the accounting framework.

28. Comparability • Comparable information; ‘users are able to discern and evaluate similarities in and differences between the nature and effect of transactions and events, at one time and over time, within or between entities’. • Consistency aids comparability. • Decisions are not made in isolation. • Is this business doing better this year? • Is this business doing better than that?

29. Understandability • ‘Comprehend its meaning’. • It is not always possible to report complex business transactions and events (e.g. derivatives) both accurately and simply. • Financial reports should always be prepared to be as informative as possible - not to obscure the meaning. • But what level of knowledge can a user be expected to have?

30. Materiality • ‘Business must perform strictly proper accounting only for items and transactions that are significant to the financial statements’ (AASB 1031). • Material if its omission, misstatement or non-disclosure effect decisions. • Reduces the cost of accounting - how? • E.g. low value assets may be expensed rather than capitalised and depreciated.

31. Timeliness • Without undue delay. • Information loses its relevance if there is a delay in reporting. • E.g. last week’s share price. • The Australian Stock Exchange requires companies listed on the exchange to announce information publicly - partly to prevent selective disclosure and ‘insider’ trading.

32. Cost verses Benefit • Is the cost of collecting and providing info. likely to exceed the benefit to users. • Costs and benefits may be borne by different groups. • As a small investor in Telstra I may want to know the current market value of their ‘copper’ network - but what cost to Telstra? • Cost is often used as an excuse not to disclose.

33. A Dilemma • Accounting information should be relevant, reliable, understandable etc. • In accounting for bad debts should we use: • The direct write-off method which is reliable ? • The provision method which matched and may be considered more relevant (and also conservative) ?

34. Objective 5 Apply different profit recognition rules

35. When and How Much • The profit recognition principle provides guidance on the timing and amount of profit to record - or more precisely revenue and expense recognition. • Profits should recorded when earned and not before.

36. Easy and Difficult • Interest and rent accrue with the passage of time. • Most sales and many services, revenue is recognised at a point in time. • Some businesses there are many phases in the earning of profits; • from customers ordering to the end of warranty period.

37. AASB 1004 Revenue • Three conditions for revenue can be recorded: • control of the goods has passed to the purchaser • collectibility of the revenue is probable • amount can be easily measured

38. Four Methods • Sales method; sales for cash and on credit. • Collection method; if receipt of cash is uncertain. • Instalment method; for instalment sales - provides same overall gross profit as the sales method - difference is the period/s in which it is recognised. • Percentage-of-completion method.

39. Instalment Method • Real estate developer sells land; Down payment $200,000 (year 1) Plus three annual payments: Year 2 $250,000 Year 3 $260,000 Year 4 $290,000

40. Instalment Method • If land cost $660,000 • Gross Profit = • $1,000,000 - $660,000 = $340,000 • G.P. % = 340,000 / $1,000,000 = 34%

41. Instalment Method Year Collection x G.P.% = G.P. 1 $200,000 x 34% = $68,000 2 $250,000 x 34% = $85,000 3 $260,000 x 34% = $88,400 4 $290,000 x 34% = $98,600 Total $1,000,000 $340,000

42. Percentage-of-Completion Method • Especially construction projects that extend over several periods. • Profit is recognised as the work is performed. • Need to be able to readily estimate total profit and percentage of project completed (may be calculated by dividing costs incurred this period by total estimated project costs).

43. Percentage-of-Completion Method • Total project revenue can then be multiplied by the percentage of completion to calculate revenue this period • Calculated revenue less actual expenses equals profit. • To use this method businesses need to be able to reliably estimate both; • the outcome of the contract • degree of completion.

44. Percentage-of-Completion Method • Where estimates are not possible AASB 1009 requires; • costs incurred to be recognised as an expense. • Where it is probable cost will be covered by revenue • revenue equal to costs is recognised and nil profits reported • all profits are reported upon completion.

45. Percentage-of-Completion Method • If a loss is likely on the contract the full amount of the expected loss should be taken up immediately - even if the construction has not commenced. • An example of conservatism - do not anticipate any profits but anticipate all losses.

46. Objective 6 Show how accounting and reporting principles affect the disclosure of financial information

47. Disclosure: Accounting Policies • AASB 1001 (IAS 1) requires a summary of accounting policies be given in the initial section of the notes. • The specific accounting principles, bases or rules adopted. • Describe the measurement basic e.g. H.C. • Give the method of accounting when there is choice e.g. method of depreciation.

48. Accounting Policy Changes • Consistency is important for comparability. • Consistency does not mean accounting policies or procedures can not change • If a change is made the company should reveal: • nature of the change • reason for the change • effect of the change on net profits.

49. Accounting Policy Changes • A change in an accounting principle; • a change in an accounting method • e.g. FIFO to weighted average. • A change in an accounting estimate; • as the business alters earlier expectations • e.g. the life of an asset is extended • start with current book value and calculate depreciation on the remaining years

50. Subsequent Events • There is period of time between the end of the financial year and the publishing of the financial statements. • Major business events may occur in this time. • If the event provides information about conditions existing at balance date then the financial statements need adjusting. • If it is a new major event it needs to be revealed in the notes to the accounts.