chapter 12 horngren ♦ harrison ♦ bamber ♦ best ♦ fraser ♦ willett the framework of...

Chapter 12

HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

The Framework of Accounting

1 - 2Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia

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


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


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 ?


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.


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.


Objective 1

Describe the accounting standard-setting process

in Australia



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.



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.



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.


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.



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.



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.



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.



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).


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


Objective 2

Understand the nature of the conceptual framework for

financial reporting


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?


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.


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


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.


Objective 3

Understand the objective of financial reporting


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.


Objective 4

Understand the general principles of financial

reporting practice


Useful Information

What makes accounting information useful?Relevance ReliabilityComparabilityUnderstandabilityMateriality TimelinessCost versus Benefit


Relevance

Relevant information is information that is needed by users for making their decisions.

Financial reports should include all and only relevant information.

Decisions may be about a lot of things including;Past - has management been a good steward?Future - will management perform?


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.


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?


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?


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.


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.


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.


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) ?


Objective 5

Apply different profit recognition rules


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.


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.


AASB 1004 Revenue

Three conditions for revenue can be recorded:control of the goods has passed to the

purchasercollectibility of the revenue is probableamount can be easily measured


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.


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

Down payment $200,000 (year 1)

Plus three annual payments:

Year 2 $250,000

Year 3 $260,000

Year 4 $290,000


Instalment Method

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


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

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

Instalment Method

Instalment Method


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).



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 contractdegree of completion.



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 revenuerevenue equal to costs is recognised and

nil profits reportedall profits are reported upon completion.



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.


Objective 6

Show how accounting and reporting principles affect the disclosure of financial

information


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.


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 changereason for the changeeffect of the change on net profits.


Accounting Policy Changes

A change in an accounting principle;a change in an accounting methode.g. FIFO to weighted average.

A change in an accounting estimate;as the business alters earlier expectationse.g. the life of an asset is extended

start with current book value and calculate depreciation on the remaining years


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.


Objective 7

Understand how market values are used in

financial statements


Historical Cost

Transactions are recorded at historical cost - what was paid for assets or expenses.

The information is:reliablerelatively easy to identifyobjectiveusually recorded for commercial reasons.


Conservatism

Allows the ‘write down’ of inventory and other assets if their net realisable value falls below purchase price.

So we do not always use historical cost. But what if the value goes up? Especially non-current assets like land

and buildings purchased many years earlier.


Market Value

Less reliable than historic cost but may be more relevant.

Could disclose market values in the notes and not alter the figures in the balance sheet.

Could increase profits and increase assets, (but only if the asset was sold).

Could increase assets and increase owners’ equity - AASB 1041 (IAS 16)


Effect of Inflation

Revaluation is part of the answer. In times of high levels of inflation not only

non-current assets are significantly effected.

Even monetary itemsBorrow money ten years agoPay it off with ‘cheaper’ dollars today


End of Lecture 12

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