Enviro Flo Case Study Flashcards
Accounting
The provision of information about aspects of the performance of, and resources held or controlled by an entity to a particular
group of people with an interest, or stake in the organisation, we can call these parties stakeholders (include internal and external).
The role of accounting
The broad role of ‘accounting’, and of an organisational report is to inform relevant ‘stakeholder’s about the extent to which the actions for which an organisation is deemed to be responsible have actually been fulfilled.
Accountability
Accountability is concerned with the relationships between
groups, individuals, organisations and the rights to information that such relationships entail. Simply stated, accountability is
the duty to provide an account of the actions for which one is
held responsible. The nature of the relationships and the
attendant rights to information are contextually determined by
the society in which the relationship occurs.
The two duties of accountability
- To undertake certain actions to meet stakeholders
expectation - To provide a reckoning or ‘account’ of those actions to the stakeholders
Accountability model
Assessments or decisions that need to be made as part of
the process of reporting aspects of an organisation’s
performance: WHY, WHO, WHAT, HOW
WHY
Why would an entity disclose information?
• to comply with legal requirements;
• an ethically motivated desire to ensure that the organisation benefits
society
WHO
Who are the stakeholders to whom the accounts will be
directed?
• Motivated by managerial reasoning and strategising
reporting to those who hold and exercise the greatest
economic power
• Motivated by ethical/moral reasoning the reports direct towards those stakeholders most affected by the operations of the
WHAT
What types of disclosures will be made?
This all really depends upon judgements we make about the organisations responsibilities and accountabilities. The broader perspective we take of organisational responsibilities and stakeholders, then the broader our ‘accounts’ become.
HOW
How should the information be disclosed?
The production of an account/report that addresses or stakeholders’ information needs. Various reporting frameworks and conventions are available and can address different aspects of performance
Non financial accounts
If an organisation is considered to be accountable for its water
consumption, or its greenhouse gas emissions, then such ‘accounts’ may be presented in physical (non-monetary) terms. They might be used both internally and externally.
Organisation
A collection of people who work toward a common
goal or objective
2 types of organisations
For profit
Not for profit
For profit
‘for-profit’ organisations are those that are created to generate profits typically for owners (shareholders).
Not for profit
‘Not-for-profit’ organisations, by contrast, are organisations
that are established to satisfy particular needs such as education and environmental protection.
Ownership types of organisations
Sole trader
Partnerships
Company - private, public, group
Sole trader advantages
easy set up
absolute control
no specific accounting requirements
Sole trader disadvantages
Unlimited liability
Limited life
Sole risk bearer (and profit recipient)
Partnerships advantages
easy set up
sharing of risks and profit
reports do not have to comply to accounting standards
Partnerships disadvantages
Mutual agency - each partner is an agency of the business
unlimited liability
limited life- will often discontinue on departure of a partner
Company advantages
Separate legal entity
Limited liability
indefinite life
Company disadvantages
More complicated to form
Might have to comply with accounting standards depending on size of company
Private compnay
In Australia, private companies are denoted by “Pty Ltd”. Often family owned or amongst a small shareholder group;Not permitted to offer shares
to the public. In Australia,
restricted to 50 shareholders
Public company
The most common form of public companies are those that offer their shares to the public and the obligation of shareholders is restricted to any amount unpaid on those shares. There is a separation between ownership and control in public companies. Public companies have quite a significant number of reporting obligations. This raises
various monitoring and reporting issues.
Supply chain
the network between an organisation and its
suppliers as necessary to produce and distribute a
specific good or service. Organisations often outsource aspects of their operations to other unrelated organisations –
these are part of the ‘supply chain’
Resources
A resource can be broadly defined as something that has
value in the sense that it allows an entity to accomplish
an activity so as to achieve a desired outcome. Organisations will use or rely upon a variety of ‘resources’ when performing their operations
Externalities
Impacts that an entity has on parties external to the
organisation where such parties did not agree to or take part in the activities causing the externality. Externalities can be viewed as positive externalities (benefits) or negative externalities (costs)
Accountable organisation
an organisation
that has the responsibility to provide accounts to its stakeholders
Sole trader
Sole trader is where one individual controls and manages a business and is responsible for
all of its debts. In a sole trader, the owner is also typically the
manager. A sole trader is not a separate legal entity so business is not separate to the
person’s non-business affairs. As such, the business is not separately taxed but the
earnings are included in the total earnings of the owner.
Sole trader flexibility
A sole trader is not difficult to set up. Apart from having to comply with tax requirements,
there are generally no specific accounting requirements applying to sole traders. Sole
traders do not have to apply accounting standards and can be flexible with their reporting,
but they still need to do accounting.
Partnerships
A partnership exists when two or more people come together with a common purpose and
usually for the purpose of making a profit. The profit would generally be shared according to the ‘partnership agreement’.
Unlimited liability
Like a sole trader, there is unlimited liability and all partners are liable for the debts incurred. That is, if there are not enough assets within the partnership to satisfy
obligations, then the personal assets of each partner may be used to satisfy the debt;
Internal perspective of measurement
That is, from an ‘internal’ perspective, managers want to make informed decisions to
achieve particular goals. They need information to do this.
External perspective of measurement
For example, from an ‘external’ perspective, investors in a company might want to
know about the profits, resources, and liabilities of the company so that they can evaluate the security of their investment and the prospects for future dividends and
capital growth. A bank might also want to know about the profits, resources, and liabilities of a borrower so that it can assess the likelihood that a loan will be repaid.
LSO’S and regulations
Large organisations are required by accounting regulations to report the same types of financial accounting information to external stakeholders.
Management accounting
A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking”. what information is collected and used will depend on the objectives/mission of the organisation, the types of resources being used, the values/ethics of the managers, and so forth. Accounting for management purposes is a process based on professional judgment and the internal aspect of accounting is generally considered to be ‘unregulated’
Factors that influence external reporting
Regulation
Stakeholders needs/demands
Manage powerful stakeholders
Manage perceived legitimacy
Increase manager wealth
Location/culture
Regulation
Some things are reported because there is no alternative – the organisation ‘has to’ or otherwise face sanction.For example, taxation authorities will require various reports of a financial nature. Other government departments might require information about different environmental matters (for example, emissions of some substances, creation of some forms of waste) or social matters (such as aspects of occupational health and safety). Some forms of organisations, for example companies, will have quite extensive financial reporting requirements as imposed by corporations’ law.
Stakeholders needs and demands
Managers might also believe that different stakeholders have ‘rights-to-know’ about particular aspects of the organisations’ performance. Owners (shareholders of companies) of the business require information so as to enable them to monitor their investments.
Manage powerful stakeholders
The production of particular accounts might be undertaken for strategic business reasons so as to manage those stakeholders who have the power to influence the operations of the organisation. (Think sweatshops, other controversies that led to organisational change)
Manage perceived legitimacy
Organisations will change their external reporting around the time of particular crises. Reporting which is reactive to crises is more about organisational survival than about ‘true’ accountability.
Increase wealth
For example, managers might have shares in an organisation, or have bonuses linked to ‘profits’. If they produce particular information or accounts this might increase share price, and their own wealth. That is, there could always be private, self-interest incentives for managers to produce particular accounts or results.
Location
The location of an organisation. Some cultures have greater demand for information (or transparency) than others or have different expectations in relation to ‘performance’.
Three types of internal/external reporting
Financial reporting
Social reporting
Environmental reporting
Financial reporting
Financial accounts are generated through the process of ‘financial accounting’.The objective of financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Large companies must follow IFRS (International Financial Reporting Standards)
Social reporting
Social accounts are generated through the process of social accounting. Social accounting will provide information about an organisation’s interaction with, and associated impacts upon, particular societies. Social and environmental performance is not generally addressed by the financial accounting standards released by the IASB. The Global Reporting Initiative’s Sustainability Reporting Guidelines provide a number of ‘indicators’ against which organisation can report.
Environmental reporting
Environmental accounts are generated through the process of environmental accounting. Environmental accounting can address an organisation’s impact on living and non-living natural systems. The Global Reporting Initiative’s Sustainability Reporting Guidelines provide a number of ‘indicators’ against which organisation can report.
Factors that influence internal reporting examples
personal values, stakeholder pressure, their basis of remuneration, the scarcity of and/or the ecological importance of the resources they are using, their professional and educational background.
Sustainability Reporting
Addresses the three aspects of reporting (financial, social and environmental)
The separation between management accounting and financial accounting
In this course we will not provide an artificial delineation
between management accounting and financial accounting. This separation is artificial: Product ‘cost’ has relevance to stakeholders inside and outside the organisation. Planning occurs before we report the results: Discussing financial accounting prior to other aspects of ‘accounting’ seems to be inconsistent with reality. Much of the information that is necessary for managing a
business also has relevance to stakeholders not directly
involved in the management of the organisation.
Planning
‘Planning’ is central to managing a business. Planning should be a continuous process which should start well before an organisation commences operations. The plan provides a benchmark against which future
performance can be assessed. Factors such as the organisation’s mission, resources and the expectations of stakeholders need to be considered.
Planning for value creation
An organisation would be expected to create ‘value’ for various stakeholders. The value creation should ideally occur in an ecologically and socially sustainable and responsible manner. Value creation requires clear vision, strategy, and planning. Value creation relies upon well functioning corporate governance.
Porter’s Value chain
Porter (1985) describes the sequence of activities undertaken by an organisation as a ‘value chain’. Well performing organisations create relatively more value from the various steps involved in acquiring and transforming resources into products and
services.
INBOUND LOGISTICS OPERATION OUTBOUND LOGISTICS SALES AND MARKETING SERVICING
4 support activities in the value chain
Admin, finacne infrastructure
Human resources management
Product & Tech development
Procurement
Output of the value chain
Value added, decreased costs, better profit margin
Inbound logistics
E.g. quality control, receiving, raw materials control, supply schedules
Operation
E.g. manufacturing, packaging, production control, quality control, maintenance
Outbound logistics
E.g. finishing goods, order handling, dispatch, delivery, invoicing
Sales and marketing
E.g. customer management, order taking, promotion, sales analysis, market research
Servicing
E.g. warranty, maintenance, education and training, upgrades
Admin, finance infrastructure
E.g. legal, accounting, financial management
Human resources management
E.g. personnel, lay recruitment, training, staff planning
Product & Tech development
E.g. product and process design, production engineering, market testing, R&D
Procurement
E.g. supplier management, funding, subcontracting, specification
What roles do professional accountants in business perform?
- As creators of value
- As enablers of value
- As preservers of value
- As reporters of value
The accountants role in organising
Encouraging and rewarding the right behaviours. Allocates resources to add value and achieve goals.
Structures incentives to align behaviour with organisational goals.
Enablers of value
As enablers of value, by informing and guiding managerial and operational decision making and implementation of strategy for achieving sustainable value creation, and the planning, monitoring, and improvement of supporting processes.
Preservers of value
As preservers of value, by ensuring the protection of a sustainable value creation
strategy against strategic, operational, and financial risks, and ensuring compliance with
regulations, standards, and good practices.
Reporters of value
As reporters of value, by enabling the transparent communication of the delivery of sustainable value to stakeholders’.
Creators of value
As creators of value, by taking leadership roles in the design and implementation of
strategies, policies, plans, structures, and governance measures that set the course for delivering sustainable value creation.
Things shareholders might find valuable
Maximisation of dividends, maximisation of share value.
Things local employees might find valuable
Payment of wages, safe and healthy work environment, promotion and training opportunities, reputation of the organisation.
Things employees in offshore supply factories might find valuable
A safe and healthy work environment, ‘liveable’ wages.
Things customers might find valuable
Low price, high quality, positive social impact, positive environmental impact,
reliable after sales service.
Things local communities might find valuable
Contribution to local community activities, safe place of work for local residents, low social and environmental impacts.
Things suppliers might find valuable
Reliable payment, ongoing support for the products/services of the supplier.
Life cycle analysis
Evaluates a product or service across its entire life
(from ‘cradle to grave’). Addresses some of the social or environmental impacts generated across the lifecycle of the product or service. Identifies areas where improvements can be made. One form of LCA has been referred to as ‘Eco Balance’
Life cycle costing analysis
What aspects are to be included and what not? For some Life-cycle cost analysis (LCCA) is a tool to determine the most cost-effective
option among different competing alternatives to purchase, own, operate,
maintain and, finally, dispose of an object or process, when each is equally appropriate to be implemented on technical grounds.
Balanced scorecard
Originally developed by Kaplan and David Norton as a performance measurement framework that added strategic non-financial performance measures to the traditional financial measures essentially “Balancing” the performance measurement.
The four perspectives of performance in regards to the balanced scorecard
Financial
Customer
Business processes
Innovation and learning
The view is that a focus on customer, business processes, and innovation and learning in turn leads to better financial performance outcomes.
Consideration of costs
An important aspect of performance measurement is the considerations of the costs being incurred.
• the costs of the goods or services they supply – determines an
adequate price.
• An inaccurate pricing system can result in inappropriate prices.
• In terms of costs we can consider various cost concepts:
Cost Concepts
Relevant costs
Variable costs
Fixed costs
Relevant costs
Relevant costs: are those that will change as a result of a particular decision. They can include both fixed and variable costs. They will occur in the future.They will differ between alternative course of action. They will be influenced by factors such as the mission of
the organisation, its culture, its stakeholders’ expectations, and so forth.
Variable costs
These are the costs that change as a result of changing production or service volume. They will occur in the future. They relate to particular activities. What we include as variable costs will be influenced by what costs management believes are relevant. Variable costs do not need to be restricted to quantifiable/financial costs.
Fixed costs
Generally considered to be
those costs that do not change in a particular period as the volume of production or services changes. They might be fixed only over a particular (relevant) range of activities. They do not have to be just financial.
Contribution margin in financial terms
• The total contribution margin = total sales revenue - the total
variable costs
• The contribution margin per unit = the revenue per unit - the
variable costs per unit.
Contribution margin
Calculating the contribution margin per unit allows us to
determine how much the sale of each item of product or
service contributes to the financial profit. All things being equal, items with a high turnover would be
expected to have a lower contribution margin per unit than items with a lower turnover.
Break even point
The break even point occurs:
• When the total financial costs equal the total financial
revenues (profit is zero).
• It is calculated by dividing the total fixed costs by the
contribution margin per unit.
Break even point graph
Photo in favourites 21/3/2018
You know that Sam is pretty incredible right?
Target financial profit
Organisations will often have a target profit in mind when performing their operations. this takes into account various factors including expectations of owners, the risks inherent in the operations and opportunity costs of alternative options.
Target financial profit calculation
The business can determine the required units of products or service required to be sold,
to generate a required profit. To do this the following formula is used
Required units of products = (target financial profit + total
fixed costs) ÷ contribution margin per unit
EXAMPLE OF HOW THE BSC CAN LEAD TO BETTER FINANCIAL PERFORMANCE
a focus on innovation and learning should lead to more efficient (less costly) processes which can lead to better (and less expensive) products and
happier customers which in turn will lead to improved financial performance.
Eco balance example
Photo in favourites 21/3
BSC example
Photo in favourites 21/3
Budget
A detailed plan (in financial and non-financial terms) of
management activities for a certain time period – normally a 12-month period. The budget essentially reflects the short-term goals of the primary decision-makers.
Why budgeting is important
The budget is one of the most important means of
communication and coordination. The budget is an essential tool for planning, organising and controlling activities.
The Master (Annual) Budget
The master budget is a comprehensive set of budgets that cover all aspects of a firm’s activities. The master budget consists of several interdependent
budgets
Operating budgets
Financial budgets
Operating budgets
Operating budgets include the sales budget and the various cost budgets
Financial budgets
Financial budgets consist of the budgeted statement of
financial performance, the budgeted statement of financial position, the cash budgets
Sales budget
A detailed summary of the estimated sales units and revenues from the organisation’s products for the budgeted year. Its based on the sales forecast, which involves estimating which products will be sold and in what quantities. Sales forecasting is a critical step in the budgeting process and market research is often used.
Cost budgets for manufacturing firms
• A production budget, which has cost budgets for direct
materials, direct labour and overheads.
• Budgets for marketing, general and administrative expenses.
Cost budgets for retailers and wholesalers
- A purchasing budget, will be used to determine the quantity and cost of goods purchased for resale.
- Budgets for marketing, general and administrative expenses.
The financial budgets
Cash budget
Budgeted income statement
Budgeted balance sheet
Sales budget format
Business Sales Budget for the year ending
Expected sales units
Selling price
Total Sales revenue
Photo 1
Production budget format
Business Production Budget for the year ending
Expected sales (units)
Add: Desired ending inventory
Less: Beginning inventory
Required production units
Photo 2
Material budget format
Business Material Budget for the year ending
Units to be produced Material cost per unit Cost of material required for production Target ending materials inventory Total material required Less: Beginning materials inventory Total cost of materials purchases
Photo 3
Labour budget format
Business Labour Budget for the year ending
Units to be produced Labour time per unit Total required labour hours Labour cost per hour Total labour cost
Photo 4
Overhead budget format
Photo 5
Sales and administrative expenses budget
Photo 6
Cash budget format
BUSINESS
CASH BUDGET
FOR THE TWO MONTHS ENDED
Beginning cash balance Add: Receipts etc Total Available Cash Less: Disbursements etc Excess (deficiency) of available cash over disbursements Financing Borrowings Repayments Ending Cash balance
Photo 7
Behavioural aspects of budgeting
Budgets affect virtually all people in an organisation:
• Those who prepare the budget;
• Those who use the budget for decision making; and
• Those whose performance is evaluated using the
budget.
3 approaches to budgeting
Participative budgeting
Top-down budgeting
Bottom-up budgeting
Participative budgeting
managers at all levels develop
their budgets.
Top down budgeting
senior managers impose budget targets.
Bottom up budgeting
lower managerial and operations levels play an active part in budget setting
Production budget
A production budget includes cost budgets for direct materials, direct labour and
overheads. Direct materials are those physical resources used to manufacture a product,
e.g. wood used for creating a desk is considered a direct material. Direct Labour is the
cost of the human resources such as labourers who work to create the product, e.g., the
payment for the cabinet maker who constructs the desk but excludes costs of managers
and sales people. These costs that relate only to the manufacturing process are
described as direct. Overheads are the other resources used in the production process
such as cost of electricity or heating for the factory.
Budgets for marketing, general and administrative expenses
General and administrative
expenses include resources used for activities other than the manufacturing process, e.g.
advertising costs, payments to managers and accountants, repayment of interest on
loans.
Cash budget
Expected cash receipts and planned cash payments. The timing of all cash movements is important to identify cash shortages and cash surpluses.
Budgeted statement of financial performance (profit and loss)
Shows expected
revenues and planned expenses for the budget period.
Budgeted statement of financial position (balance sheet)
Expected assets and liabilities
at the end of budget period.
Why report social and environmental information
It is generally accepted that organisations do have a responsibility for their social and environmental performance. The reporting could be part of a process to ‘manage’ various stakeholders.
Is social and environmental reporting accounting
This is ‘accounting’ despite the absence of measurements in financial terms.
CSR
Corporate social responsibility (CSR) generally refers to the responsibilities an organisation accepts over and above the law and the way in which it focuses its attention on the well-being of various stakeholders and the environment. CSR reporting provides information about how an organisation has addressed its social and environmental responsibilities.
Sustainable development
Sustainable Development is the development that meets the needs of the present world without compromising the ability of future generations to meet their own needs. Sustainability reporting provides insights into how organisations are performing in relation to the goal of ‘sustainable development’.
How/where are we reporting social and environmental
This form of reporting is largely voluntary. There are a number of reporting frameworks available to use such as GRI and the integrated reporting framework
Integrated reporting framework
The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates value over time. An integrated report benefits all stakeholders interested in an organization’s ability to create value over time, including employees, customers, suppliers, business partners, local communities, legislators, regulators and policy-makers.
Dangers of a failure to report
A failure to report could undermine the ‘legitimacy’ of the organisation.
The financial statements
• Balance sheet (known as statement of financial position)
• Income statement (known as a statement of comprehensive
income)
• The statement of changes in equity
• The statement of cash flows
• Notes to Financial statements
Principles
CHER@MCG
Accounting entity
Accounting period
Monetary unit assumption
Going concern
Accrual basis of accounting
Conservatism
Accounting entity
The accountant is only to recognise transactions and events, which affect the financial performance or position of the organisation. The organisation is separate from the owners and other entities.
Accounting period
Whilst the life of an organisation might be considered to be indefinite, the accountant nevertheless determines the financial performance of the entity for smaller periods – for example, for 6 or 12 months. This can create a variety of potentially dysfunctional effects as will be discussed elsewhere in this course.
Monetary unit assumption
The practice of financial accounting typically only recognises transactions or events if a related monetary value can be assigned to them. This also creates some dysfunctional effects that we will consider elsewhere in this course.
Going concern
Unless there is evidence to the contrary, the financial accountant assumes that the organisation (the accounting entity) will continue operating into the foreseeable future. This has various implications for how various assets, liabilities, income and expenses are measured.
If it is considered that the going concern assumption is not appropriate (for example, it is not able to pay its debts as and when they fall due), then financial statements have to be prepared on another basis – for example, on the basis of liquidation values.
Accrual basis of accounting
Financial accounting is general done on an ‘accruals basis’. This means, for example, that income is recognised when it is earned (which is not necessarily when the
related cash is actually received), and expenses are recognised as the expense isincurred (which is not necessarily the same time as when the related cash payment is made). Accrual accounting can be contrasted with accounting, which is undertaken on a ‘cash basis’.
Conservatism
This generally accepted concept assumes that financial accountants shall not overstate the value of assets and shall not understate the value of liabilities.
GPFS VS SPFS
• General Purpose Financial Reports (GPFR)
− prepared to meet the information needs common to
users who are unable to command reports to meet
their own needs.
• Special Purpose Financial Reports (SPFR):
− prepared to suit a specific purpose for a special
group.
5 elements of the financial statements
Assets Liabilities Equity Income Expenses
Assets
A resource controlled by the
entity as a result of past events
and from which future economic benefits are expected to flow to the entity.
Liabilities
A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Equity
The residual interest in the assets of the entity after deducting all its liabilities (will be increased by contributions and income, and reduced by drawings and expenses). For a company, equity might be made up of number of components, for example: • Share capital • Retained earnings • Reserves
Income
Income Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity,
other than those relating to
contributions from equity
participants.
Expenses
Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities
that result in decreases in equity, other than those relating to distributions to equity participants
The accounting equation
A simple representation of the accounting equation:
Assets (A) = Liability (L) + Owner’s Equity (OE) i.e. when an organisation has assets, certain parties – either owners, or external creditors - will have a claim against those assets. The total of assets will balance the total of liabilities and owners equity. This will be reflected within the balance sheet.
Expanding the accounting equation
• Our original equation was:
A = L + OE
• Owners equity will be influenced by profits – which is the difference between
income (I) and expenses (E) – as well as by contributions (C) from owners, and distributions/Drawings (D) made to owners
• That is changes in owners equity equals:
OE = (profits/Loss) + Capital
(I - E) + C - D
• Substituting this equation into the original accounting equation (above) gives us:
A = L + I - E + C - D
The double entry effect
• One business transaction will affect at least two
accounts.
• After recording the transaction, the accounting
equation keeps balance.
• A particular asset is effected – say increased - then
there needs to be a corresponding decrease in another
asset, or a corresponding increase in either a liability
or an equity account.
• Otherwise the equation will not balance!
Financial information is historical
Being historical in nature means that the reports will provide an indication of how management has used the funds (stewardship function). Past results might also provide an indication of future performance.
Financial accounting and regulation
Financial accounting is heavily regulated with respect to the procedures to be used to generate general purpose financial statements. By regulating financial reporting, this helps ensure that current financial reports are comparable with the organisation’s previous financial statements as well as with those of other organisations.
The objective of financial accounting
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
To satisfy this objective the Conceptual Framework identifies a number of qualitative characteristics that financial information should possess. These include:
Relevance Faithful representation Comparability Verifiability Timeliness Understandability
Relevance
(Capable of influencing the decisions of users. Would include considerations of ‘materiality’)
Faithful representation
(Ideally information should be complete, neutral and free from error).
To be useful information, it needs to be both relevant and faithfully represented. There can be some trade-offs.
Comparability
Entity uses same accounting principles each year
Different entities use the same accounting principles
Some variation in methods is allowed under the standards, but the method used must be disclosed
Verifiability
Information provided can be sourced back to a transaction or event.
Timeliness
If collection of information spans too long a period, it is no longer relevant.
Why is financial accounting regulated
Because governments have traditionally embraced a view that organisations must demonstrate a high level of accountability in relation to their financial performance and financial position – particularly large corporations – then minimum levels of disclosures have been legislated.
Tangible assets
Those assets that have a physical substance (e.g. plant and machinery, motor vehicles).
Property, plant and equipment:
Property, plant and equipment are tangible items that:
(a) are held for use in the production of, or supply of, goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period (AASB 116).
Contra accounts
A contra asset account is an account with its balance is to be the opposite of the normal balance found in an asset account. For example, an asset such as a building will be shown as a non-current asset and a contra account for depreciation will be subtracted from its value.
Provisions
An estimated liability for which there is greater uncertainty regarding the amount or timing of the amount than for a normal liability.
Current assets
expected to be sold, consumed or otherwise used to create
income within one year or within the current operating cycle of
the business.
Non current assets
An asset that is not classified as current will be classified as
non-current.
Why differentiate current and noncurrent
assets
- Indication of future cash flows.
- Identify which assets are able to sell.
- Assess some aspects of the risk of the organisation.
Assets can be measured at:
- Face value
- Net realisable value
- Present value
- Fair value
- A ‘mixed measurement’ approach
Cash is measured at
- Current asset
* Measured at ‘face value’
Debtors is measured at
• Current asset
• At ‘face value’, less an allowance for doubtful debts
• Allowance for doubtful debts is used to recognise that a
certain percentage will not ultimately pay.
Inventory is measured at
• Current asset
• Measured at the lower of cost and net realisable
value.
• Net realisable value is the estimated proceeds of
sale less costs to completion and costs to sell.
Prepayments are measured at
• Measured at amortised cost
• The expenses paid in advance
• Record at the amount that related to future services
to be provided
• E.g. rent, insurance, various service contracts
Depreciation of PPE
Depreciation is the allocation of the cost of an asset
over the periods in which benefits are expected to be
generated.
• In calculating depreciation we must make judgements
about:
• The depreciable base
• The asset’s useful life
• Appropriate method of cost apportionment:straight-line method, reducing balance method, and units of
production
Intangible assets
• Non-monetary assets without physical substance
• Required to be separately disclosed
• Only externally acquired intangible assets can be
recognised
• Exception, development expenditure as part of R & D
• General prohibition on revaluing most externally
acquired intangible assets
• Examples: brand names, mastheads and publishing titles,
licences and franchises
Straight line method of depreciation
Allow the depreciation cost to be charged evenly throughout the useful life of the asset.
Depreciation expense per annum = (cost-expected residual value)/expected useful life of the asset
Reducing balance method of depreciation
A fixed percentage is applied to the written down value of the asset
Units of production method of depreciation
The calculation of depreciation expense is based on the productive capacity and actual use of the asset
Depreciation expense per anum = (cost-expected residual value)/total estimated units * units used in the period
Current liabilities
Liabilities to be settled within the 12 months or the normal operating cycle whichever period is longer.
Non current liabilities
Liabilities not classified as current
Why differentiate current and non current liabilities
Knowing liabilities to be paid within one year, or in the normal operating cycle of the organisation, is important to lenders, financial analysts, owners, and managers of the organisation.
General principle of measuring liabilities
Liabilities due beyond 12 months reported at present
value or expected value.
• Otherwise reported at face value
Bank overdraft is measured at
- A current liability
* Measured at face value
Accounts payable is measured at
- A current liability
* Measured at face value
Provisions
• Current or non-current liabilities
• Some uncertainty about the timing or amount of the
future expenditure
• If it is not expected to be settled for more than a year
then discounted to its present value
Bonds
• Larger organisations issue bonds to borrows funds
• Form of loan, a security
• They are an instrument of indebtedness
• Obliged to pay the bondholder interest on a periodic
basis and also repay the principal at the maturity
date.
• Measured at present value
Contingent liabilities
• Obligation is dependent upon a future event or
• the obligation cannot be measured reliably at a given point
in time.
• Does not satisfy the definition or recognition criteria for
being a ‘liability’
• If the contingent liabilities is large
• information is required to be disclosed in the notes
Limitation of total reported assets
Reported ‘total assets’ does not represent the fair value of all the assets, or the cost, or replacement value of them. Reported ‘total assets’ does not include many
valuable assets, such as its labour force, key
intellectual capital, valuable customer and supplier networks and so forth.
Balance sheet
Also known as the statement of financial position.
• Provides details of the assets, liabilities and equity of an organisation at a point in time.
• Because it is ‘at a point in time’ its relevance can decrease with the passing of time.
• Based around the accounting equation of A = L + OE
• Often presented in the form A – L = OE
• Prepared at least once a year, but can be prepared more often if required.
Fair value accounting
The practice of measuring assets and liabilities at estimates of their current value.
Main benefit of the two types of accounting
Historical cost is seen as more conservative and more reliable.Fair value accounting is seen as more relevant.
Shared capital
This is the amount attributable to the amount paid by shareholders, to the company, for their shares.
Retained earnings
This is the accumulation of past profits (and losses), less aggregated dividends, and less transfers of retained earnings to reserves.
Reserves
Companies can have numerous types of equity reserves. For example, from time to time a company might transfer amounts out of retained earnings and into reserves to cover future expansion plans.
The income statement
The income statement provides details of the income and
expenses of an organisation.
Difference between income and expenses
The difference between income and expenses is profit (or
loss).
• Profit (losses) increases (decreases) owners equity, as:
OE = OE + (Income – Expenses) + C - D
The use of accrual accounting - income statement
Financial statements are typically prepared on an ‘accruals
basis’. This means that income is recognised when it is earned
and expenses are recognised when the expense is
incurred.
Many judgements required in the preparation of the income statement
• Depreciation: judgement on useful life and residual value).
• Income and expenses: judgement based on ‘probability’
and ‘measurability’.
• Revalue PP& E to fair value will increase depreciation
expense, and therefore decrease profits.
Implications of judgements
very unlikely that different accountants would derive the same ‘profits’.
The statement of changes in equity
• Equity is the residual interest in the assets of the entity after
deducting its liabilities.
• For a company, equity might be made up of number of
components, for example, JB Hi-Fi includes the following
accounts:
• Contributed equity
• Reserves
• Retained earnings
Income receivable
This arises when an organisation performs a service but has not been paid for it.
Prepayment
Occurs when a payment for a good or service is made in
advance of receiving the good or service.
• Is considered to be an asset as it provides us with a right to
a future economic benefit.
Income received in advance
• An organisation is paid for a good or service in advance.
• For example, a lawn mowing business might be paid 6
months mowing fees in advance of actually doing the
mowing.
• This would be considered to be a liability.
Accrued expenses
• Accrued expenses
• expenses have been incurred but not yet paid.
• examples include: Accrued wages; Accrued electricity;
Accrued interest.
The statement of cash flow
• The purpose of the statement of cash flows is to provide
details of the cash inflows and outflows of an organisation.
• It provides information that is not directly available from the
balance sheet or the income statement.
Items that might cause a difference between profits and cash flows include:
• depreciation and amortisation
• increases/decreases in various receivable and payable
accounts, accrued and prepaid expenses etc.
• loss/gain on sale of plant and equipment
The statement of cash flows is divided into three kinds of
activities:
- Operating Activities
- Investing Activities
- Financing Activities
Cash flows from operating activities
The principal revenue-producing activities of the entity and
other activities that are not investing and financing activities.
Cash flows from operating activities include:
• receipts from customers
• payments to suppliers and employees
• cash generated from operations
• interest paid
• income taxes paid
Cash flows from investing activities
The acquisition and/or disposal of long-term and other
investments.
Cash flows from investing activities include:
• purchase of property, plant and equipment
• proceeds from sale of equipment
• dividends received
Cash flows from financing activities
Relating to changing the size and/or composition of the
financial structure of the entity.
Cash flows from financing activities include:
• proceeds from issue of shares
• proceeds from borrowings
• repayment of borrowings
• dividends paid
Note on operating activities
Across time it would be hoped that cash flows from operations provides a large proportion of the total cash being required by the organisation.
• In the early years the cash flows from operations might be negative as the organisation establishes itself, but a business organisation cannot persist with negative cash flows from operations.
• This is an important measure of financial performance.
Note on investing activities
An organisation in a ‘growth phase’ might be expected to have negative cash flows from ‘investing activities’. Positive cash flows from investing activities might be reflective of an organisation ‘selling down’ its assets.
How do we do financial statement analysis
- Simple comparison
- Ratio analysis
- Trend analysis
- Comparison to benchmarks
Accounting ratio categories
- Profitability ratios
- Efficiency ratios
- Capital structure ratios
- Liquidity ratios
- Market based ratios
Profitability ratios
- Return on assets (ROA) • Return on equity (ROE)
- Profit margin
- Gross profit margin
Return on assets
- How much profit is being generated for every dollar of assets controlled by the organisation.
- Financial statement analysis should be undertaken with care.
Return on owners equity
- Provides a measure of the profit being generated for each dollar of equity the owners have in the organisation.
- Generally, the larger the number the better and an improving trend across time is preferred.
Gross profit margin
Gives an indication of pricing strategy (mark ups) which can be compared to similar organisations.
Efficiency ratio
Inventory turnover
Debtors turnover
Inventory turnover
- Provides an indication of how many times in the accounting period the organisation turned over (sold) its inventory.
- The higher the better.
Debtors turnover
- Provides an indication of the number of times during the period that debtors turn over (pay)
- The higher the number the less the amount of cash tied up with debtors
Capital structure ratios
- Debt to assets ratio
* Debt to equity ratio
Debt to assets ratio
Is a measure of the extent to which an organisation’s assets have been funded by lenders/creditors.
• All things being equal, the greater the percentage the greater the risk of an organisation.
Debt to equity ratio
- Provides an indication of how much liabilities there are per dollar of equity.
- Shows the extent to which an organisation is dependent upon equity financing.
- All things being equal, the greater the relative level of debt financing the riskier the organisation.
- Organisations with high variability in cash flows will find it relatively risky to have higher levels of debt relative to equity.
Liquidity ratios
Current ratio
Quick ratio
cash flows from operations to current liabilities
Current ratio
- To assess whether an organisation will be able to pay its debts as and when they fall due.
- Benchmark : 1
Market based ratios
Price earnings ratio
Price earnings ratio
- Provides an indication of how many times earnings the market is prepared to pay for a share.
- A higher number relative to similar organisations indicates greater market acceptance of the organisation.
Simple comparisson
A simple comparison of this year’s figure (perhaps particular expenses or revenues) with the previous year figure (sometimes referred to as horizontal analysis) – but we need to ensure there is nothing fundamentally different about the organisation from one year to the next (or that the accounting rules being used haven’t changed since last year in a way that might hamper our comparison)
Ratio analysis
Within ratio analysis, particular line items in financial statements are compared to other line items. It is used to evaluate various aspects of a company, for example its profitability, efficiency, liquidity, or solvency. We will consider a number
Trend analysis
Look at various financial indicators – perhaps ratios – over time to see if there is a pattern of improvement or deterioration.
Profitability ratios
Looks at the ability of an organisation to make a profit (but remember, here we are looking at organisations that are established to make profits. Such analysis might not be relevant for not-for-profit entities). Determined by comparing profits against bases such as sales, assets or owners’ equity.
Efficiency ratios
Provides insight into how an organisation is managing its assets and liabilities.
Market based ratios
Provides an insight into how the market values an organisation
ROE considerations
The ROE provides a measure of the profit being generated – which ultimately might go to owners in the form of dividends – for each dollar of equity the owners have in the organisation. Provides a basis for investors to compare to other investment opportunities – The rate of return certainly should be higher than low risk returns, such as returns on bank deposits. There is no absolute ‘right’ percentage. There is a need to compare with benchmarks.
Inventory turnover considerations
A lower inventory turnover is a potential sign of inefficiency and also exposes the organisation to various risks, such as risk of spoilage or obsolescence. – But again remember this tends to be industry specific. A retailer of expensive luxury cars would be expected to have a lower inventory turnover that a fruit and vegetable shop. • A higher inventory turnover is reflective of greater efficiency in both purchasing and sales activities and potentially the need for less cash for acquiring inventory.
Cash flows from operations to current liabilities
In Module 3 we discussed the statement of cash flows and noted that one classification of cash flows was cash flows from operating activities (the other classifications being cash flows from financing activities and cash flows from investing activities).
• This measure provides an indication of the ability of an organisation to cover its financial obligations as a result of its operating activities, rather than having a reliance on cash flows from financing or investing.
• Generally, the bigger this ratio is, the better
Price earnings ratio considerations
A higher number relative to similar organisations indicates greater market acceptance of the organisation. The market might believe that the organisation has relatively lower risk and/or it has good growth prospects – so a higher number seems a good thing. • But ……sometimes these numbers can get very high to the point they seem to defy explanation and are potentially indicative of an ‘overheated market’.
