Financial Accounting Problem Questions

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Chapter 1

Learning objectives At the end of this chapter, you should be able to: LO 1.1 explain what is meant by the term ‘accounting’

LO 1.2 explain the difference between management accounting, financial accounting and tax accounting

LO 1.3 identify the main users of accounting information, and the main purposes for which the information is used

LO 1.4 identify the limitations of accounting information

LO 1.5 discuss the factors that influence the choice of accounting systems for different types of organisations

LO 1.6 demonstrate an understanding of the regulatory and environmental considerations that can influence accounting decisions

LO 1.7 explain what is meant by the term ‘economic consequences’ and relate this to the choice of accounting policies

LO 1.8 identify career opportunities for accountants.

Introduction to accounting

Copyright 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 Hancock, Phil, et al. Contemporary Accounting, Cengage, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/deakin/detail.action?docID=6135923. Created from deakin on 2021-03-22 07:05:47.

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Chapter 1 IntroductIon to accountIng 5

Introduction This chapter discusses the role of accounting, its uses and its users. It will also give you an appreciation of the role of accounting within a business organisation and in its dealings with others. We introduce some ideas about the ways accounting helps managers to meet business objectives by, for example, providing the information necessary to make a decision about buying or renting premises. The ways that the size and type of the organisation affect its accounting will be discussed. For example, in a small family restaurant the accounting requirements are much less complex than in a large business such as Woolworths Limited.

accounting (Chapter 1) The process of identifying, measuring and communicating economic information to permit informed judgement and decisions by users of the information.

Figure 1.1 What is accounting?WHAT IS ACCOUNTING?

Often called the ‘Language of Business’

Accounting involves:

- recording - retrieving - storing - summarising - sorting - presenting

...info in various reports and analyses into an easily accessible format

Budget wisely to ensure that your cash outflows (tuition fees, etc.) are not greater than your cash inflows (monthly allowance)

Example: $

Also, while there are many shareholders who rely upon published financial statements for information about the financial performance and position of Woolworths, this is not the case with a small family restaurant. In this chapter we discuss the information required by the internal stakeholders, like managers, and those external to the organisation, like shareholders. The information provided to managers is referred to as management accounting, while the information provided to external users is called financial accounting. We discuss the relationships and linkages between management and financial accounting. Another function of accounting worthy of mention is tax accounting, where information is provided to the government for the purpose of levying taxes.

Another factor that both affects and is affected by accounting is the commercial environment. The commercial environment can influence accounting through government legislation such as the adoption of a new corporations act or through the introduction of a goods and services tax (GST). Accounting can also be affected by changes in technology. For instance, developments in information technology have allowed accounting information to be provided more quickly and efficiently, enabling different decisions to be made than might otherwise have been the case. In addition to accounting in the business sector, we also briefly discuss accounting in the public and not-for-profit sectors. Finally, we look at the limitations of accounting information. As with most sources of information, there are imperfections. From this brief résumé we can see that the accounting activity interacts with all levels of business.

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6 part 1 FInancIaL accountIng

Accounts are normally seen as a series of figures. These figures are, in fact, a convenient way of summarising and reporting information that would be indigestible in narrative form. If you were asked to provide a report that gives details of the value of everything you own, it would be simpler to use figures to represent the value rather than words. The value of some things (e.g. good health, lead-free petrol or an academic qualification) is difficult to express or analyse in numerical terms, but this has not stopped people assigning a monetary value to them.

In order to understand the role and importance of accounting in the context of business organisations, we need to decide what ‘accounting’ means. If you were to look up the word ‘account’ in Roget’s Thesaurus you would be directed to words such as ‘report’ and ‘narration’. It is also referred to as commercial arithmetic, double-entry bookkeeping and so on. These alternatives imply totally different things: a report is something that conveys information for a particular purpose, while commercial arithmetic implies a mechanical exercise following agreed rules or principles.

Besides problems about what accounting can and should document, other issues need to be considered; for example, whether a numerical format is the best format for presenting the information. We also need to consider who the report is for and what its purpose is. For instance, you may give different accounts of your car’s condition to a prospective buyer and to a mechanic. In both cases the description could be true, but the prospective buyer may be given general details about the car’s performance while the mechanic is told about the car’s problems. So we can see that the question of defining accounting has many facets: what you report, how you report, who you are reporting to and for what purpose. We shall look at these issues in more detail later in this chapter. First, let us get a better idea of how accounting is generally understood by examining some definitions from the accounting literature.

1.1 What is accounting? There are a number of definitions of ‘accounting’ and they have changed over time in response to the changing accounting environment. One definition that has stood the test of time is that given by the American Accounting Association in A Statement of Basic Accounting Theory (also known as ASOBAT), which defines accounting as:

the process of identifying, measuring and communicating economic information to permit informed judgement and decisions by users of the information.

[1966, page 1]

First, this definition states the purpose of accounting. Second, it states that accounting has a number of components – some technical (such as measuring the data), some analytical (such as identifying the data) and some that require further information (such as the communication of this economic information to users: who are these users and what form does this information take?). Finally, the definition implies that the information has value in the decision-making process. The definition assumes that economic information concerns any situation in which a choice must be made involving scarce resources.

Another definition was offered by the American Institute of Certified Public Accountants (AICPA) in the 1973 Trueblood Report (Objectives of Financial Statements), which looks to the role of accounting in decision making. The report lists 12 objectives that emphasise this decision-making process. They can be summarised as follows: » to provide information, through financial statements, for the making of economic decisions » to provide information for predicting, comparing and evaluating the effectiveness of management’s use

of scarce resources

value (Chapter 1) An item’s equivalence in money.

double-entry bookkeeping (Chapter 1) The system developed for recording accounting information based on the concept that every transaction affects two or more components of the balance sheet (accounting) equation.

LO 1.1 explain what is meant by the term ‘accounting’.

financial statements (Chapter 1) The means of conveying a concise picture of the profitability and financial position of a business to management and interested outside parties.

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Key concept 1.1: Accounting

Important points made in these definitions are that: » accounting is about quantitative information » the information is likely to be financial in nature » it should be useful for decision making in the allocation of scarce resources.

quantitative (Chapter 1) The amount or size of information.

Chapter 1 IntroductIon to accountIng 7

» to provide information to predict and evaluate the going concern of an entity » to provide information on earnings, cash flows, profitability and the financial position of the entity.

The usefulness of accounting information for decision making is reinforced by accounting concepts (known as the conceptual framework or the Framework), discussed in more detail in Chapter 2.

The conceptual framework gives us a clue to the fact that accounting is closely related to other disciplines (we are recording economic data) and it also gives us some clue as to the uses of accounting information; that is, for reporting on what has happened and as an aid to decision making and control of the business or organisation (‘the entity’).

A definition from the Macmillan Dictionary of Accounting (Parker 1986) states:

accounting, in broad terms, is the preparation and communication to users of financial and economic information. The information ideally possesses certain qualitative characteristics. Accounting involves the measurement, usually in monetary terms, of transactions and other events pertaining to accounting entities. Accounting information is used for stewardship, control and decision making.

This suggests that accounting information has a key role in the running of a successful organisation. The use of accounting information for business decision making is also brought out clearly in the

definition given by the American Accounting Principles Board in 1970:

Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action.

[APB 4]

The fact that accounting is described as a service activity reinforces the point made earlier: in order to understand the usefulness of accounting, we need to know who uses it and for what purpose.

going concern (Chapter 1) The assumption that a business will continue to operate in the future without any intention to liquidate or to significantly reduce its scale of operations.

entity (Chapter 1) A fictional or notional being, such as a business, club, company or partnership, in respect of which financial statements occur and accounts are kept.

cash (Chapter 1) Cash on hand and cash equivalents.

1.2 For what purpose is accounting information used? Accounting information can be used on at least two levels: that of the individual and that of the organisation (or entity). At the individual level, people can use accounting information to help them control the level of their expenditure, to assist in planning future levels of expenditure, to help them raise additional finance (through, for example, mortgages or hire-purchase) and decide the best way to spend their money. So we can see that for the individual, accounting can have three functions: planning, controlling and decision support.

At the level of the entity, accounting is used to control the activities of the organisation, to plan future activities, to assist in raising finance and to report the activities and success of the entity to interested parties and to the government to determine taxes payable.

An entity also uses accounting in planning, controlling and decision making (which are all internal activities or functions). The major difference between the two levels is that in the case of an entity, accounting also has

LO 1.2 explain the difference between management accounting, financial accounting and tax accounting.

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8 part 1 FInancIaL accountIng

an external function: providing information to people outside the entity. This external function is usually met through the provision of financial statements or financial reports, and is often referred to as financial accounting. The external users require the information that is contained in the financial statements to use in the decision-making process, or to evaluate what management has done with money invested in the business. The financial statements must be prepared in accordance with Generally Accepted Accounting Principles (GAAP). For individuals, the main external users are likely to be banks and the government for tax purposes.

Organisations also must report their activities to the government for the purposes of paying tax. The preparation of the activities of the organisation must be in accordance with the tax rules as specified in the tax legislation. This arm of financial accounting is often called tax accounting, where the objective is to report the activities of the organisation in compliance with the tax rules so that the organisation pays the minimum amount of tax to the government. The tax rules and GAAP rules are not always identical and thus accounting profit differs from taxable income. Hence the reference to ‘two sets of books’, which does not mean an organisation is engaged in deceit or misrepresenting its state of affairs.

Besides meeting the needs of external users, the system that produces the financial accounting reports and tax returns also meets some of the needs of internal users. One need is to analyse the results of past actions. This requires information on actual outcomes. These can then be evaluated against the projected outcomes, and reasons for differences can be identified so that appropriate actions can be taken. This is only one of a number of needs that managers have. Their other needs are met through different reports that are based upon information provided by the internal accounting system.

The internal accounting system, which may be in addition to the system that underpins the external financial reporting system, is often referred to as the management accounting function. The major difference between financial accounting and management accounting is that management accounting is primarily directed towards providing information of specific use to managers.

It is important to realise that the financial statements prepared for external users in accordance with GAAP provide a summary of the outcomes of the decisions made by managers. The two types of accounting are therefore interconnected and this can best be demonstrated by the following example. In 1999, Woolworths introduced its Project Refresh strategy, which focused on improving business processes and efficiencies throughout its supply chain. The supply chain can be described as movement of a product or raw material (apples) from its original source (fruit grower) to the customer (you). We discuss the supply chain and its management in more detail in Chapter 14. As a result of Project Refresh, Woolworths achieved significant reductions in costs of goods by several billion dollars. The very successful strategy, initially tracked and recorded through the management accounting system, was reported to the external users (shareholders) through increased profits in the published financial statements. While we cover financial accounting in Chapters 1 to 11 and management accounting in Chapters 12 to 18, it is important to keep in mind that the two are connected and interdependent.

Financial accounting information, which is often less detailed, has many users apart from managers. This leads us to the question posed below.

1.3 Who uses accounting information? Whether accounting information relates to the activities of an individual or to a business entity, its users can be placed in two broad categories: » those inside the entity, such as managers or, in the case of a small business, the owner » those outside the entity, including banks, analysts, the government, tax authorities, investors, creditors

and trade unions.

financial accounting (Chapter 1) That part of an accounting system that tries to meet the needs of various external user groups.

accounting system (Chapter 1) A collection of source documents, records, procedures, management policies and data-processing methods used to convert economic data into useful information.

management accounting (Chapter 1) That part of an accounting system that tries to meet the needs of management and internal users.

creditor (Chapter 1) A person or entity to whom a debt is owed.

LO 1.3 Identify the main users of accounting information, and the main purposes for which the information is used.

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Stop and think 1

What are the needs of internal users? Can you identify any other needs of internal users? If so, can you suggest how these would be met?

Chapter 1 IntroductIon to accountIng 9

Internal users The major internal user of accounting information is the management of an entity. For a small entity this is likely to be the owner, or a small number of individuals in the case of a partnership. However, many businesses are much larger and are owned by numerous individuals or groups of individuals, as is the case with large entities such as Woolworths, National Australia Bank or Woodside Limited.

Often the major investors themselves are owned by others, as is the case with the major financial institutions. In such a situation, it is extremely unlikely that the actual owners would or could take an active part in the day-to-day running of the entity. Consider the chaos if all the people who bought shares in Woolworths tried to take an active part in the day-to-day running of that business. Instead, these owners or shareholders delegate the authority for the day-to-day running to a group of directors and managers.

These directors and managers are involved in the routine decision-making activities of the entity and their information needs are equivalent to that of the small business owner. These needs are normally met by unpublished reports of various kinds, usually based on information provided through both the financial accounting system and the management accounting system. The exact nature of the reports varies from entity to entity. A department store may require information about the profitability of each of its departments, whereas a factory producing a small number of different products is likely to require information about the profitability of each product.

The form of each report will also vary according to its purpose. If the purpose of the report is to assist management, it needs to show the past transactions and performance, probably measured against some predetermined standard. For planning purposes, though, a forecast of what is likely to happen in the future is more important. These different forms of reports and ways of grouping information are normally referred to under the heading of ‘management accounting’.

As stated earlier, management accounting is the focus of the second part of this book. At this stage it is worth briefly summarising the different categories of management accounting reports. To do this we need to make some generalisations about the needs of managers and to categorise those needs. In practice, of course, there is a certain amount of overlap between the categories but we need not concern ourselves with this at present. The broad categories that we have referred to in terms of the needs of managers can be found in Table 1.1.

Rather than getting deeply involved at this stage, let us first look at the other broad area we identified – the needs of users outside the entity: the external users. We shall be returning to the needs of internal users in more detail in Chapter 12.

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Key concept 1.2: Financial accounting

Financial accounting can be thought of as the part of the accounting system that tries to meet the needs of various external user groups. It does this by means of an annual report, which includes a statement of comprehensive income (and possibly an income statement), a statement of financial position (sometimes called a balance sheet), a statement of changes in equity, a statement of cash flows, notes to the financial statements, information required by law and any additional information the entity wishes to supply.

10 part 1 FInancIaL accountIng

External users We need to establish who the external users are. The potential users can be divided into three groups, as follows: » resource providers: employees, lenders (those who lend money to the entity; for example, bankers),

creditors, suppliers (those who supply the entity with goods and services) and, in the case of business entities, investors (that is, shareholders – the owners of the entity)

» recipients of goods and services: those who benefit from the provision of goods and services by the reporting entity; that is, customers

» parties performing a review or oversight function: government, trade unions and special interest groups acting on behalf of the general public; for example, Greenpeace. These groups are normally provided with information by means of published financial statements

prepared in accordance with GAAP, except for governments which as stated earlier receive information about an organisation’s activities based on tax rules. In order to decide to what extent the financial statements meet the needs of the external users and to understand more fully the importance of accounting, we shall briefly discuss the needs of the external users listed above (see also Figure 1.2).

Owners and shareholders In the case of small entities the owners are likely to be actively engaged in the day-to-day operations of the entity. In these small entities, the owners’ needs are often met by the management accounting information and reports.

lenders (Chapter 1) Persons or organisations which permit the temporary use of money; for example, in return for payment.

Needs of managers

Need Explanation

Stewardship Stewardship is when managers need to protect the entity’s economic resources (normally referred to as assets) from, for example, theft, fraud and wastage.

Planning Managers need to plan activities so that finance can be raised, marketing and promotional campaigns set up and production plans made.

Control Managers need to control the activities of the entity. This includes measures such as setting sales targets, managing human resources, and ensuring that there are sufficient raw materials to meet the demands of production and sufficient goods in stock to satisfy customer demand. It will also include identifying where targets can be set.

Decision making Managers need to make specific decisions. For example, should we produce the item ourselves or buy it in? How much will it cost to produce a particular item? How much money will we need in order to run the entity?

Table 1.1

stewardship (Chapter 1) The need to protect a firm’s economic resources (normally referred to as assets) from theft, fraud, wastage and so on.

assets (Chapter 1) An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. (IASB Conceptual Framework, para. 4.3 and 4.4)

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Chapter 1 IntroductIon to accountIng 11

As the entity grows, however, it is likely that the owners will become divorced from its immediate and routine operations. Therefore, the owners will not have access to the management accounting information, which in any case may be too detailed for their requirements. This is the case in organisations listed on a stock exchange. (A listed or quoted organisation is one whose shares are traded in an open market where demand and supply govern the price of the share.) It is also the case in a number of other types of entities, such as public sector and not-for-profit entities, where the functions of management are carried out by people on behalf of the major stakeholders/owners.

In all these cases, the owners/major stakeholders need to know: » whether the entity has done as well as it should have done » whether the managers have looked after, and made good use of, the resources of the entity.

In order to evaluate whether the entity has done well and whether resources have been adequately used, it is necessary to compare the results of different entities. Information of this type is normally based on past results, and under certain conditions it can be provided by financial statements.

Owners/major stakeholders also need to know how the entity is going to fare in the future. Financial accounting is unlikely to provide this information for a variety of reasons, in particular because it is largely, if not exclusively, based on the past. Past results may be taken into account as one piece of information among many when one is trying to predict the future, but in a changing world it is unlikely that past results will be repeated because conditions will have changed.

Although there are limitations concerning the usefulness of the information in annual reports, they are often the only form of report available to an owner/major stakeholder who is not involved in the day-to-day activities of the business. Such users therefore have to base their decisions on this information, despite its inadequacies. For example, students can study the financial statements of various universities to see how much money they spend on resources such as the library and computing before deciding which university to choose for their courses.

In practice, the shareholder’s involvement in this process of making comparisons (in the case of a listed organisation) is likely to be fairly indirect. This is because most of the information contained in the annual report has already been looked at by the owner’s professional advisers – accountants, stockbrokers or financial analysts. The investor and owner are likely to base their decision on the professional advice they receive, rather than relying upon their own interpretation of the information. This is not to say that they will rely exclusively on expert information or that they will not use the information provided in the annual reports to assist with their decision. The reality is likely to be a mixture, the balance of which will depend on the degree of financial sophistication of the shareholders or owners. The less sophisticated they are, the more reliance they will have to place on their expert advisers. For example, a shareholder – who is, after all, a part-owner – may seek accounting advice when attempting to understand the accounting information contained in the annual report, to decide whether to sell his or her shares.

Lenders People and organisations lend money in order to earn a return on that money. They are, therefore, interested in whether the entity is making sufficient profit to provide them with their return (usually in the form of interest). This information is normally provided in the statement of comprehensive income or an income statement. Lenders are also interested in ensuring that the entity will be able to repay the money it has borrowed; therefore they need to ascertain what resources an entity controls and what it owes. This information is normally provided in the statement of financial position (also called the balance sheet).

Research has shown that, in practice, bankers use a mixture of different approaches to arrive at a lending decision. The choice of approach is related to the size of the entity. In the case of smaller entities, the security-based approach predominates. This approach emphasises the availability of economic resources to

stock exchange (Chapter 1) A market for the buying and selling of stocks and shares in which supply and demand govern price.

interest (Chapter 1) A charge made for the use of money.

comprehensive income (Chapter 1) The sum of profit for the year and other comprehensive income.

income statement (Chapter 1) A financial report listing the income, expenses and net profit or net loss of a business (entity) for a time period.

balance sheet (Chapter 1) A statement that shows all the resources controlled by an entity and all the obligations due by the entity at one point in time.

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12 part 1 FInancIaL accountIng

meet repayments in the event of business failure, and the emphasis is clearly on the statement of financial position or balance sheet. However, with very large businesses the approach towards a lending decision is more likely to be the ‘going concern’ variety where the emphasis is on the profitability of the entity.

Suppliers of goods Goods can either be supplied on the basis that they are paid for when they are supplied, or that they will be paid for at some agreed date in the future. In each case the supplier will be interested to know whether the entity is likely to stay in business and whether it is likely to expand or contract. Both these needs relate to the future; therefore, they can never be adequately met by information in the annual report because this relates to the past.

Suppliers of goods who are not paid immediately will be interested in assessing the likelihood of getting paid. This assessment is partially helped by the annual report: the balance sheet shows what resources are controlled by the entity and what is owed, and also gives an indication of the liquidity of the controlled resources. However, the balance sheet has limited usefulness for predicting the future. Often the information is many months out of date by the time it is made public, because in most cases it is only published annually.

Customers Like suppliers, customers are interested in an entity’s ability to survive and, therefore, carry on supplying them with goods. For example, if you are assembling cars you need to be sure that the suppliers of components are not about to go bankrupt. The importance of this has increased with the introduction of techniques such as just-in-time management. (Briefly, this means that inventories of parts at the production centre are kept to a minimum, reducing the cost of storage space and parts. Parts are delivered to the production centre just in time, before the inventories run out.) We discuss inventories in more detail in Chapter 8. The customers in this situation need to see that the entity is profitable, that it has sufficient resources to pay what it owes, and that it is likely to remain in business and supply components efficiently and on time. Some of these information needs are met, at least partially, by the financial statements.

Employees Employees depend on the survival of the entity for their wages and therefore are interested in whether the entity is likely to survive. In the long term, an entity needs to make a profit in order to survive. The statement of comprehensive income or income statement may assist the employee in assessing the future viability of the organisation. The employee may also be interested in ascertaining how well the entity is doing, compared with other similar entities, for the purposes of wage negotiations – although the accounts are only useful for this purpose if certain conditions are met (these are explored later in this book). The accounts can also be used internally for wage negotiations because they provide evidence of the organisation’s level of profitability and ability to pay.

The government The government uses accounting information for a number of purposes, the most obvious of which is the levying of taxes. For this purpose it needs to know how much taxable income has been made. The profit an organisation reports to shareholders in its statement of comprehensive income or income statement is based on the application of GAAP, which we will discuss in Chapter 7. However, the profit upon which an organisation is assessed for tax purposes is based on the application of the tax rules and regulations and is the domain of tax accounting. While these rules are often identical to accounting rules, there are instances

liquidity (Chapter 1) The ability of a business to satisfy its short-term obligations. Liquidity refers to the ease with which assets can be converted to cash in the normal course of business.

just-in-time management (Chapter 1) A management technique designed to lower the costs of holding high levels of stock.

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Stop and think 2

Who are the main external users of accounting information? What are some of the main purposes for which that information is used and which accounting reports are they likely to use?

Chapter 1 IntroductIon to accountIng 13

where they differ. For example, a government may exempt certain income from taxation as an incentive to participants in that industry. This was the case with the gold industry in Australia for many years. Exempt income was not included in gold producers’ calculations of their taxable income; however, as it was still income, it was included in their income statements for reporting to shareholders. The government also uses accounting information to produce industry statistics for purposes such as regulation.

In certain cases, the government is both owner and customer (e.g. some state energy commissions) or public watchdog (e.g. the Environmental Protection Authority). It can combine any one of these roles with other roles, such as regulatory authority (e.g. Australian Securities and Investments Commission). The government uses accounting information for all these purposes.

The general public The general public requires many different types of information about entities in both the public and private sectors. Much of this information is not supplied directly by financial statements. For example, the public might be interested in a organisation’s environmental performance, which we expand upon in the next section, or its stance on fair trade issues.

This summary shows that the users of accounting information and the uses to which it can be put are many and varied. It is clear that accounting information has effects both within organisations and in the wider commercial environment in which entities operate and in which we live. It should also be clear that this wider environment can use accounting as a tool for entity control. Before going on to consider in detail the impact of accounting upon the commercial environment and vice versa, we should first consider the limitations of accounting information in order to put its potential impact in context.

taxable income (Chapter 1) The amount of profit, as determined by the Taxation Commissioner, on which the current income tax liability is calculated.

Customers Should we purchase products

or services?

Organisation

Employees Should we work for the

organisation?

General public Is the organisation being

environmentally responsible?

Government How much fees and taxes

to pay?

Suppliers Should we supply goods on

credit?

Lenders Should we lend money?

Owners/shareholders Should we buy/sell shares?

Figure 1.2 Why external users might use accounting information

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14 part 1 FInancIaL accountIng

1.4 Limits on the usefulness of accounting information It has to be stressed that accounting is only one of a number of sources of information available to decision makers. Other sources of information might be just as important as, if not more important than, the information contained in the accounts that are available to decision makers – for example, integrated and sustainability reports, discussed in Chapter 3.

To give you a flavour of what we are talking about, research into bankers’ lending practices (referred to earlier) shows that a banker’s personal interview with a client is as important as financial information. This is probably because accounting generally reports only on financial items (i.e. those items that can be expressed in financial, or monetary, terms) whereas the information that bankers are trying to derive from the interview is more qualitative (i.e. an impression of the ability of the applicant to run a successful business). It is also possible that the information that accounting provides is only of secondary importance; this would be the case where new technology has made the precise costing of a product irrelevant because the product is obsolete due to the change in technology.

How useful is past information? In general, financial accounting information relates to the past, whereas the decisions that need to be taken normally relate to the future. Therefore, unless the past is a reasonable predictor of the future, financial statements will have some (albeit limited) value for this purpose. In the real world, because of the impact of such factors as changes in technology, innovations, fashions and inflation, the past is unlikely to be a very good predictor of the future. Of course, we are not referring here to management accounting, which as we will see in Chapters 12 to 18 is very much focused on improving the future performance of an organisation.

What value is included? Besides these problems, there is also the question of what is and what is not included in the financial accounts. For instance, some items (which it is generally agreed should be included in financial reports) are difficult to measure with any accuracy; therefore, the figures become subjective. A good example of this problem is an unfinished building. How do we decide on a figure to represent something that is only half-complete? Another example is the problem of deciding how long something is going to last. A car, for instance, loses value the older it gets. A business might decide that a car ceases to be useful to it after four or five years, but this is to some extent an arbitrary decision because there are many older cars that still serve a useful purpose.

What items are included? In addition to the problem of deciding how long things will last or what stage of completion has been reached, certain items are difficult to quantify in terms of value and are not easily included in financial reports. For example, the value of a football club is dependent on its ability to attract supporters; this, in turn, is dependent on its ability to succeed, which is dependent on the abilities of the players, and so on. However, it is difficult to decide what value to place on a player because this value will vary according to, for example, the player’s fitness. Even so, football clubs in the Australian Football League do attempt to quantify the value of their players. In the United Kingdom, Europe and the United States, basketball, baseball, soccer and gridiron teams also follow this practice.

What about the impact of economy-wide issues? In addition to the questions raised above, there are many factors concerned with the natural and commercial environment that need to be taken into account but cannot be adequately included in accounts, although they may be quantifiable in monetary terms. Examples are the potential market for the product, tariff restrictions, export subsidies and environmental issues. If information about these factors were included in the annual reports of a business, a loss of competitive advantage could result.

LO 1.4 Identify the limitations of accounting information.

qualitative (Chapter 1) The nature or characteristics of information.

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What are the limitations of accounting information?

Chapter 1 IntroductIon to accountIng 15

What about inflation? Finally, we have to deal with the fact that accounting information is expressed in monetary terms and assumes that the monetary unit is stable over time. This is patently not the case. Although there has been much discussion of the problems of accounting in times of inflation, no agreed solution has yet been found.

We can conclude that, while accounting provides some information that is useful to decision makers, it is important to bear in mind that: » the information is only a part of that which is necessary to make effective decisions » accounting is an inexact science and depends on a number of judgements and estimates » the end result of the accounting process can only be as good as the inputs, and in times of rising prices

some of these inputs are of dubious value » accounting systems can be counterproductive; for example, the maximisation of a division’s profit may

not always ensure the maximisation of the profit of the entity. Nevertheless, it is clear that accounting is vital to the running of a healthy and prosperous entity and, arguably,

it is also an essential prerequisite for a prosperous economy. It will therefore be useful to look at accounting in the wider context of an entity and its regulatory environment. We will now examine how the accounting function interacts with and is different from other business functions. We will also examine the various factors that influence the choice of an accounting system – including regulatory and environmental considerations.

Accounting as a business function Theoretically, the accounting department, like the personnel department, operates in an advisory capacity only – providing information for managers to make decisions. In practice, however, the financial elements controlled by the accounting function and the information it generates are so central to the operation of the entity that the influence of accounting is often pervasive. Although accounting is essential to the smooth running of the business, it does not have as direct an impact as, for example, the buying department or the production line. Its effects are generally subtler, although they may in certain instances be very obvious. For example, if the accounting information indicates that expenses are too high, this may have dramatic repercussions in other functional areas. Training and recruitment budgets may be immediately frozen, affecting the work of the personnel department and other operating departments, and possibly reducing both staffing and skills. Alternatively, a decision may be taken to stop expenditure on a current advertising campaign, therefore having a direct effect on the work of the marketing department.

Accounting can have unintended effects, too. For example, if sales representatives are judged solely on their sales, this may lead them to sell goods to customers who are unlikely to pay in order to achieve the sales targets that have been set. It can also be a very dangerous tool if used in the wrong way. For example, targets could be set to achieve cost savings on a production line with no account taken of the effect on quality or employee safety.

The importance of accounting within a business should not be underestimated. It provides the basic information by which managers and owners can judge whether the business is meeting its objectives. Its importance is shown by the high salaries that accountants can command and by the prevalence of accountants on the boards of directors of our major public organisations.

Accounting is also different from other business functions in that it is not only a function but also an industry. The accounting industry sells accounting and other advisory services to other businesses and is itself a major employer of graduate labour.

expenses (Chapter 1) Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. (IASB Conceptual Framework, para. 4.69)

budgets (Chapter 1) A short- and long-term plan of action, expressed in monetary terms, for the future operating activities of a business.

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1.5 Choice of accounting systems Accounting is used within business to evaluate alternative strategies – such as making a component or buying it in from a supplier. Therefore, it shapes business plans and activities. At the same time, accounting is itself a function of the type of activity that a business engages in and of the strategies a business adopts. In other words, the accounting system not only influences business strategies but is itself influenced by the goals, size and structure of the organisation. For example, the accounting system that is appropriate for a local builder who does one job at a time and who can clearly identify the amount of time and materials being used on that job is not appropriate for a manufacturing plant that uses one building and many machines to produce multiple products all at the same time. In the latter case, a much more sophisticated system of accounting is required to identify the materials used and the labour inputs for a specific product. Accounting systems are variable and depend on the type of activities a business engages in, and on the levels of activity.

Organisation goals Clearly, the organisation’s goals will have a major impact on the accounting system it uses. For example, developing an accounting system with the primary purpose of measuring profit would be wholly inappropriate for a not-for-profit entity such as a government or public sector entity. Similarly, the requirements, in terms of accounting reports, will be very different in the cases of a workers’ cooperative, a profit-oriented organisation and the Department of Education and Training. The cooperative’s members are likely to be more interested in their pay and their share of the surplus generated than in the entity’s profitability. Shareholders in an organisation, on the other hand, are likely to be more interested in judging overall profitability and comparing that with alternative investments. In the case of the Department of Education and Training it may be that the owners, that is, the general public, are primarily interested in the service they have received rather than the department’s profitability.

Organisation structure Furthermore, the way in which an organisation is structured determines the type of accounting system that is needed. If a brewery operates all of its hotels by putting managers into them, it will need an accounting system that allows for the payment of regular salaries and bonuses based upon achieving preset targets. These targets are normally set in terms of barrelage so the brewery will need to know what the normal barrelage of each hotel is, the mark-up on items such as spirits and soft drinks and the approximate mix of sales in order to ensure that its managers are not misappropriating the profits. If, though, it establishes its organisation so that each publican is a tenant of the brewery, a different accounting system will be required, because the publicans are not paid a salary or bonus – their remuneration comes from the profits they make from selling the beers, wines and spirits.

Organisation size We have already alluded to the effect the size of an organisation has on its accounting system. The larger and more disparate the organisation is, the greater the need for organisational controls. These are achieved through a system of accountability that makes managers responsible for the performance of their divisions and provides reports that can be used by senior managers to evaluate the performance of their subordinates and of the organisation as a whole.

As we have already mentioned, it is vital that the accounting system is tailored to the needs of the organisation. If it is not, management may be unable to control the organisation and may have dysfunctional effects. Frequently, in the case of a small business, little accounting information is available on a day-to-day basis. This may be because the operations are sufficiently simple not to warrant much information, but is more likely to be because the owner does not have the skills to produce the information, and the costs of hiring the necessary expertise are perceived as outweighing the potential benefits. It is often the case in small businesses that the only time detailed accounting reports are produced is at the end of the financial year to meet the needs of the tax collector or when the bank demands them as a prerequisite to granting a loan or extending an overdraft.

LO 1.5 Discuss the factors that influence the choice of accounting systems for different types of organisations.

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Chapter 1 IntroductIon to accountIng 17

1.6 Regulatory and environmental considerations In general, the environmental aspects of a business that interact significantly with accounting are the state, technology and labour. Accounting is also affected by, and affects, the economy. For example, a country such as Zimbabwe, which suffers from hyperinflation, out of necessity uses costs other than original costs in its accounting reports because the value of the monetary unit in which accounting information is expressed changes so quickly. We have already discussed the potential uses of accounting information by employees and their organisations, such as trade unions. We have also mentioned different forms of organisations such as not-for-profit organisations. In the case of most small not-for-profit organisations, there is no requirement for the publication of accounting information, whereas for organisations, the form and content of their annual reports is laid down by legislation in the Corporations Act 2001.

The Corporations Act specifies Australian Accounting Standards (referred to as AASB Accounting Standards) for organisations that are reporting entities; the setting of these standards is discussed in Chapter 2. All public sector reporting entities must also comply with all Australian Accounting Standards, except in cases where the Treasurer’s Instructions vary or amend a standard. A similar situation prevails in most Western countries, although the importance of legislation in relation to accounting standards varies from country to country. Similarly, reporting requirements are different in non-capitalist countries where the importance afforded to the income statement is considerably less.

Developments in technology have also had a major impact upon the function of accounting. These have allowed accountants to free themselves from the mundane tasks of recording and to become more involved in decision support and strategic issues. At another level, new technology has imposed and is still imposing challenges to accounting thought. Systems that were appropriate in a labour-intensive environment are found to be lacking in the age of flexible manufacturing systems, such as just-in-time management and computer-controlled manufacturing environments. In its 2015 report, Australia’s Future Work Force, the Committee for the Economic Development of Australia estimated there was a 94 per cent chance that the position of accountant won’t exist in 2030. This is based on the impact of outsourcing and technology taking over basic bookkeeping functions. However, this is strongly disputed by the professional accounting bodies. While the role is evolving, there will still be a need for professionals to interpret the accounting numbers and provide advice as many accounting firms now do.

1.7 Economic consequences of accounting information The development of accounting standards is the responsibility of the appropriate accounting standard- setting board. We discuss the development of accounting standards in Chapter 2. The selection of appropriate accounting policies for an entity is the responsibility of management. Where an accounting standard exists, the policies must comply with the standard. In some cases the standard allows a choice of policies and in other cases no standard exists. In these instances, the management of an entity can choose the most appropriate accounting policy.

As we will see in Chapter 2, the primary objective in selecting particular accounting standards is to provide useful information to the users of financial statements. As preparers of financial statements incur

LO 1.6 Demonstrate an understanding of the regulatory and environmental considerations that can influence accounting decisions.

AASB Accounting Standards (Chapter 1) The standards issued by the Australian Accounting Standards Board.

LO 1.7 explain what is meant by the term ‘economic consequences’ and relate this to the choice of accounting policies.

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costs in complying with accounting standards, the standard setters attempt only to impose requirements where the expected benefits exceed costs.

Managers do not necessarily adopt the same objectives when they select appropriate accounting policies for their organisation. Earlier in this chapter we commented that there would be chaos if all the people who bought shares in Woolworths tried to take an active part in the day-to-day running of that business. Instead, these owners or shareholders delegate the authority for the day-to-day running to a group of directors and managers through contractual arrangements. Jensen and Meckling (1976) believe that contracts between two parties (such as shareholders and management) result in an agency relationship. They define an agency relationship as ‘a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent’ (Jensen and Meckling, 1976, p. 309). Thus, in a contract between shareholders and managers, shareholders are the principals and managers are the agents.

Many of these contracts are written. They include formal contracts between equity (or share) holders and the organisation’s management (e.g. the memorandum and articles of association, management compensation schemes and employee share ownership schemes), debt holders and management (e.g. debenture trust deeds) and less formal contracts in the form of the organisation’s business structure (e.g. the hierarchical managerial chain of command and creating divisions serve to define the nature of interactions between managers). While all types of contracts are vital to the survival of an organisation, the contracts between shareholders and managers and debt holders and managers/shareholders have attracted the most attention in the accounting research literature and can affect the wealth of managers and organisations through: » compensation plans » debt contracts » political costs.

Compensation plans Many entities reward their managers through a fixed salary and an annual bonus. The bonus may be determined as a percentage of net profit. The bonus scheme, it is argued, provides an incentive to managers to increase net profit. Increases in net profit are in the best interests of shareholders. Therefore, the bonus scheme is intended to align the interests of managers more closely to those of shareholders.

However, a consequence of the bonus scheme is that managers may also be motivated to increase reported profit by the appropriate selection of profit-increasing accounting policies. Therefore, this strategy may increase reported profit when the underlying profitability of the entity has not increased. This has been described as a cosmetic increase in profits rather than a real increase in profits.

Some spectacular corporate collapses – such as Gourmet Food Holdings (including the Rosella brand) and the Hastie Group in Australia, and Lehman Brothers and Enron in the USA – raised considerable public outcry about many issues including the use of share options as part of the remuneration packages for corporate executives. The 2008–9 Global Financial Crisis (GFC) saw a number of banks collapse amid allegations of excessive lending motivated by greed. There is a view that the use of share options creates incentives for managers to do almost anything to keep reporting large profits so that the price of the organisation’s shares continues to rise. In turn, this increases the value of the manager’s share options. Such high-profile corporate collapses have led to considerable debate about the appropriateness of using share options as part of executive remuneration, given the highly publicised impact of such a policy on financial reporting. At the G20 meeting in London in April 2009, finance ministers and central bank governors expressed a view that there should be some regulation of executive compensation.

agency relationship (Chapter 1) A contract under which one or more principals engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.

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Chapter 1 IntroductIon to accountIng 19

In Australia, listed organisations have to submit a remuneration report that key executives convey to the Annual General Meeting of shareholders. In 2011, the ‘two strike’ rule was introduced into law in Australia. The rule allows shareholders to vote to ‘spill’ the board if the remuneration report receives a ‘no’ vote of 25 per cent or more two years in a row. In May 2018 at the AMP meeting, 61.5 per cent of shareholders voted against the remuneration report, which was one of the highest for an ASX 200 company since the two-strike rule was introduced. If more than 25 per cent vote against the remuneration report in 2019, there would be a spill of the board at the annual meeting. This would mean an election of new directors. There has been no case of two strikes being recorded since the legislation was introduced in 2011.

Debt contracts Many lenders require a contract before lending money to a borrower. Such contracts may impose certain restrictions on the borrower. For example, a new loan contract may contain a clause stating that if the borrower’s debt exceeds a certain level, the loan must be immediately repaid in full. The measurement of the level of debt may be based on the total liabilities figure as reported in the borrower’s statement of financial position or balance sheet. Another common clause in debt contracts relates to the number of times the net profit covers interest expense. We will look at these and other ratios in Chapter 10.

These clauses in the debt contracts are based on accounting numbers as reported in the organisation’s financial statements. Therefore, if an entity is approaching the limits of a clause in a debt contract, there are incentives for managers to select accounting policies that allow the entity to avoid being in violation of the debt contract.

Political costs Political costs refer to the costs imposed on an entity by regulation, taxation and closer public scrutiny of its affairs. Some accountants argue that bigger organisations, like News Corporation, are subject to more political costs. Size is often measured in terms of net profit, total assets and total sales. These are all numbers determined by the application of accounting policies. Therefore, there are incentives for managers of large entities to select profit-decreasing accounting policies.

Another argument suggests that incentives exist for other types of businesses, such as telephone or electricity organisations, to choose profit-decreasing accounting policies. This choice is made at a time when the organisation wishes to increase the charges for its service. It is politically more acceptable to increase charges when reported profits have decreased.

Therefore, political costs create incentives for managers of large organisations to select accounting policies that decrease reported profits. This is clearly the reverse of the argument under compensation plans, in which the manager’s self-interest prevails. With political costs, the interests of the organisation prevail. Ultimately, if the large organisation attracts lower political costs, its managers will be rewarded.

The dual reason for selection of accounting policies The selection of appropriate accounting policies may be based on the objective of providing useful information to users, or it may be based on economic consequences. These two objectives need not be mutually exclusive and, as you read the following chapters, you should consider the role of both these objectives in the selection of accounting policies. Shareholders and lenders may initiate strategies to

economic consequences (Chapter 1) The impact of accounting policy changes on the economic position of various parties affected by the change.

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mitigate the incentives for managers to select accounting policies based on economic consequences. In this event, the selection of accounting policies is more likely to be based on the objective of providing useful information to users.

In the next section we briefly discuss the important issue of ethics in business and accounting.

Case study 1.1: SIA profit due to depreciation

By paul thompson I REFER TO your article ‘SIA hints net profit may be above $200m’ by Andrea Tan (BT, April 20). First, may I say that, for the sake of the hardworking staff, I certainly hope it is true. They would then stand a good chance of getting previously implemented wage cuts restored. Second, may I bring to investors’ attention – if they are not already aware – that SIA is engaging in earnings management, much like their peers in Europe and North America.

SIA’s earnings management makes it difficult for me to get excited about the mildly bullish sentiment surrounding SIA. While things are indeed looking up for SIA, it is worth noting that the primary reason it stands any chance of making any profit at all for the year ended March 31, 2002 boils down to what some might call an accounting sleight of hand.

I hold SIA in high regard. SIA is a high-flier in the world of aviation. It offers impeccable service, far better than any other flag carrier I have flown in. It is also one of the world’s most profitable airlines and, unlike many like the big US flag carriers and British Airways, it appears to have avoided a f ree fall into financial losses – and it has averted slashing staff numbers (the latter achievement is especially commendable).

The main reason, however, it has managed to steer clear of reporting losses for the past financial year (announcement is due in early May but SIA, for sure, already knows the score) is through a timely change in its accounting policy on the depreciation of fixed assets.

Depreciation is a major expense for airlines whose balance sheets are bulging with an expensive aircraft fleet. In its half-year report issued last October, soon after the terrorist attack on the World Trade Center, SIA said: ‘Commencing this financial year, the company changed its depreciation rate for passenger aircraft, spares and spare engines f rom 10 years to 20 per cent residual value to 15 years to 10 per cent residual value. This is to bring it more in line with airline industry practice. Aircraft depreciation charge was $133 million lower as a result.’

In other words, SIA’s policy change for the six months to Sept 30, 2001 caused expenses to be lower by $133 million and hence profit higher by the same figure. For the full year, the effect is likely to be double – that is, a boost to profits by some $266 million.

I do not doubt SIA when it says that this policy change aligns itself with industry practice. In fact, in 1999, I compared the depreciation policy of SIA with BA and found it to be more conservative. But the fact remains that had it not made this change, SIA would almost certainly be reporting a loss for the year to March 31, 2002 in the next few weeks.

paul thompson, Business Times Singapore, 25 april 2002. Business times Singapore © Singapore press holdings Limited. reproduced with permission.

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Commentary Although this article is not recent, it is an excellent example of the impact of accounting policy choice on an organisation’s reported profits. It shows how Singapore Airlines (SIA) was able to increase reported profit by a change in accounting policy. The organisation stated that the aim of this change was not to boost earnings for the year, but rather to align its depreciation policy with those of other airlines.

Stop and think 4

What are the economic consequences of accounting policy choice?

Chapter 1 IntroductIon to accountIng 21

A recurring theme in this book is how the choice of accounting policies will impact an organisation’s reported results and may be explained by the existence of contracts, as well as the objective of providing useful and relevant information to users. By the time you complete the chapters on financial accounting, you will better appreciate how the choice of accounting policies affects an organisation’s financial statements.

While SIA changed the way it accounts for the depreciation of its aircraft, the value of the aircraft did not change. Does this change in profit, resulting from a change in an accounting rule, make SIA more valuable? The answer is no, and consequently there should be no change in the value of SIA’s shares based on this higher reported profit.

1.8 Careers in accounting Accountants are employed in many different areas in both the private and public sectors. This section provides only a brief overview of the different careers for accountants.

Accounting firms Most accounting firms operate as a sole proprietorship or a partnership. The most significant firms are large firms like PricewaterhouseCoopers, Ernst & Young, KPMG and Deloitte. Large firms provide services in the areas of auditing and assurance services, tax, management advice, and insolvency and administration.

Accountants in accounting firms work in public accounting. They are members of Chartered Accountants Australia and New Zealand, CPA Australia or the Institute of Public Accountants.

Industry and commerce All organisations, both large and small, employ accountants to perform many different duties. These duties include the preparation of financial statements for external reporting purposes. Large and medium-sized organisations also employ accountants in internal auditing. The internal auditor’s role is to ensure that the internal controls in the organisation are adequate to safeguard the organisation’s assets. Large and medium-sized organisations also often employ tax accountants to do all the work involved with income tax, payroll tax, GST and other indirect taxes. They also employ cost accountants, whose job is to generate information about the behaviour of costs, to help establish budgets and to generally assist management in controlling costs and establishing appropriate prices for the organisation’s products.

LO 1.8 Identify career opportunities for accountants.

auditing (Chapter 1) The examination of a company’s general- purpose financial statements by an independent external observer (the auditor) to ensure that they present a ‘true and fair’ representation of the company’s financial status. The auditor’s findings are presented in the auditor’s report.

internal controls (Chapter 1) The procedures and processes in place within a business to safeguard all assets including cash.

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Not-for-profit entities The not-for-profit (NFP) sector includes all levels of government, health, education, social services, culture and recreation, charities, business and professional associations, and others such as religious groups. Excluding the government sector, the NFP sector in Australia represented $43 billion to the gross domestic product (GDP) in 2006–7, which is the latest available figure (http://www.acnc.gov.au). As a result of its size, this sector employs many accounting graduates. Accounting for profit and NFP entities is very similar, although the absence of a profit motive does result in some differences.

The government employs many accountants, who work in all areas at the local, state and federal levels. Accountants can be found doing similar work to their private sector counterparts: preparing financial reports, auditing, tax work and cost accounting. Departments such as Treasury and the Auditor-General’s Office employ many accountants, and all departments employ some accountants to carry out all types of accounting work.

Professional membership The two major professional accounting bodies are Chartered Accountants Australia and New Zealand (CA ANZ) and Certified Practising Accountants Australia (CPAA). The Institute of Public Accountants (IPA) is another professional organisation in Australia, for accountants ‘recognised for their practical, hands-on skills and a broad understanding of the total business environment’ (www.ipaa.com.au).

The three bodies have different categories of membership. University graduates are initially admitted as associates. They must then complete a professional program and have three years’ practical experience before advancing in their membership. Finally, a public practice certificate is required for all principals in public accounting firms.

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Study tools

Summary LO 1.1

Explain what is meant by the term ‘accounting’ In this chapter we have tried to give an idea of what accounting is and how it pervades both the internal workings of organisations and the external commercial environment. It can be seen at one level as a functional area of business and at an external level as an important determinant of business survival through its effect on groups such as shareholders, lenders and employees.

LO 1.2 Explain the difference between management accounting, financial accounting and tax accounting Management accounting is prepared for internal users and is largely unregulated. Financial accounting results in financial statements prepared for external users in accordance with GAAP. Tax accounting involves the preparation of tax returns where the objective is to report the activities of the organisation in compliance with the tax rules so that the organisation pays the minimum amount of tax to the government.

LO 1.3 Identify the main users of accounting information, and the main purposes for which the information is used There are many users of accounting information and they include internal users (managers) and external users (shareholders, lenders, suppliers, customers, employees, government and the general public). We have shown that there is no perfect accounting report that will meet the needs of all users, and that the needs of users vary. For example, in the case of a small business the owner may wish to show a low profit to reduce the potential tax bill, but may need to show a high profit in order to persuade a banker to lend the business money.

LO 1.4 Identify the limitations of accounting information We have shown that accounting will be useful only if it is used correctly and if its limitations are understood. Financial accounting is based on past information and only includes those elements that meet the definition and recognition criteria for assets, liabilities, income, expenses and equity.

These definitions and recognition criteria are discussed in Chapter 2.

LO 1.5 Discuss the factors that influence the choice of accounting systems for different types of organisations The factors that influence the choice of an accounting system include the size of the organisation, the type of business activity being undertaken and whether it is simple or complex, the structure of the organisation and whether the organisation is for-profit or not-for-profit.

A failing business will still fail even though it has an excellent accounting system; on the other hand, potentially successful businesses have been allowed to go bankrupt because the accounting system did not give any warning signs or gave them notice too late to allow management to take action to rectify the situation.

LO 1.6 Demonstrate an understanding of the regulatory and environmental considerations that can influence accounting decisions The Corporations Act influences the financial reporting of companies and other entities required to register with ASIC. Developments in technology and outsourcing certain procedural bookkeeping tasks have also had a major impact upon the function of accounting.

LO 1.7 Explain what is meant by the term ‘economic consequences’ and relate this to the choice of accounting policies The economic consequences of accounting policies can influence a manager’s choice of accounting policies. Accounting numbers are used in various contracts and this, it is argued, creates incentives for managers to choose accounting policies based on their impact on the numbers in the contracts. Managerial compensation and debt contracts create incentives for managers to favour profit-increasing accounting policies. Political costs create incentives for managers of large organisations to favour profit-decreasing accounting policies.

Chapter 1 IntroductIon to accountIng 23

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LO 1.8 Identify career opportunities for accountants Accountants work in many areas and in many types of organisations. Accountants work in public accounting firms providing various services including audit and assurance, taxation, an advisory service, and insolvency and

administration. Accountants work in large, medium and small organisations preparing financial statements and all types of information for internal decision making by managers. Accountants also work in not-for-profit entities, which include all levels of government and other areas such as health, education and social services.

review questions 1 For what purposes is accounting information used:

– by the individual – by the entity or organisation?

2 Examples were given of certain limitations of accounting information. Can you give examples of your own?

3 What are some of the careers for accountants? 4 Why would employees require financial information

about an employer?

5 When would customers require financial information about a provider of a product or service?

6 Do you think companies would provide financial information if they were not required to by the Corporations Act?

7 What is the impact of technology on accounting? 8 What is the difference between management and

financial accounting?

Take it further Much has been written about the impact of technology on accounting and the potential loss of jobs as a result of automation. The 2015 publication the Australia’s Future Workforce?, published by the Committee for Economic Development of Australia, is one example. Conduct internet research to see if you can locate other more recent examples.

problems for discussion and analysis 1 Refer to the 2018 Woolworths financial statements in Appendix 1.

a What is the name of the auditing firm? b Does Woolworths include shares as part of the remuneration for employees? c Do these shares affect the determination of net profit for Woolworths?

2 In your own words, describe what you think accounting means and what accountants do in a small and very large business.

3 Discuss what information you believe would be useful to the following groups of report users: a employees b investors c regulators d suppliers of goods and services e customers.

4 If you work for an accounting firm, whose perspective should you take – the firm’s, the client’s, the user’s or your own? 5 You own and run a small supermarket. What accounting information do you need, and how often? 6 You are the manager of a small local band which are offered $1000 for a three-hour performance. What financial

(accounting) issues do you have to consider before accepting or rejecting the offer?

24 part 1 FInancIaL accountIng

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7 It was pointed out that accounting information is only a part of the input to the decision-making process. In order to expand your understanding of the role of accounting information, for the situation outlined below, identify: a the accounting information that would be relevant b any other information that would be relevant.

Head & Co. is in the business of making navigation equipment and wishes to diversify into the production of hang- gliders. The business is based in Sydney but the owners may be willing to move. The owners have little knowledge about the market for hang-gliders, but feel that there is money to be made in that field.

8 You are considering buying a small retail store selling electrical equipment. The selling agent is very enthusiastic. What non-financial information should you be requesting?

9 ‘Automation and artificial intelligence will mean there will be little demand for accountants in the future.’ Critically review this statement.

10 ‘Looking at an organisation’s financial statements is like looking in the rear view mirror when driving a car.’ Discuss this statement and explain why such a statement would be made. Do you agree?

11 Tom was left some money in his mother’s will and decided that he should give up his job and go into business for himself. While the lawyers were still sorting out his mother’s estate, he started looking around for a suitable business. After a short time, he identified a small boat-building business that he felt was worth investing in. He was still uncertain about how much his mother had left him but thought that it was probably between $80 000 and $100 000. The boat-building business was for sale for $200 000 and so, assuming that he could finance the remainder, he engaged an accountant to check the books of the business and report back to him. As proof of his good faith, he deposited $2000, which he had in savings, with the business agents.

The report from the accountant confirmed his initial impression that the business was worth investing in, so he paid the accountant’s modest fee of $1000 in full. At this stage he discussed his plans more fully with his bank manager, who was duly impressed with the professional approach taken by Tom.

The bank manager pointed out that Tom had no business experience and, therefore, was a high risk from the bank’s point of view. However, in view of their long-standing relationship, the bank was prepared to take a chance and said that it would lend Tom 40 per cent of the purchase price.

On the basis of this, Tom signed a conditional agreement to buy the boat-building business. A short time after this he received a letter from his lawyers stating that his inheritance from his mother amounted to only $60 000. He could not raise the additional finance to purchase the boat-building business and so withdrew from the agreement, recovered his $2000 deposit and purchased a yacht with the intention of doing charter work to the Caribbean.

Required

Discuss the point at which, in your opinion, the accounting process should begin, giving reasons for your point of view. Pay particular attention to the dual needs of Tom as an owner and as a manager.

12 The No-Returns Rubber Company is considering setting up a new manufacturing plant that will produce rubber arbuthnots to be used in the manufacture of nuclear-powered frisbees. Discuss what information the managers are likely to require in order to make an informed decision about the viability of this project. Factors to be taken into account should include financial issues, health and safety considerations, and also the possible social and legal issues that may arise from the manufacture of non-biodegradable substances, such as rubber arbuthnots and nuclear items. Discuss how you think these considerations can be incorporated into a costing of the project.

Note to instructors: The following problems are considered more suitable for use in postgraduate courses. However, undergraduate courses may also find them useful.

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13 Scasboro Beach is a beautiful beach in Bondavia. The surrounding residential area is very attractive because of the beach and the lovely views out to the ocean. After a great deal of negotiation, the Coastal Development Company obtained a permit from the local shire council to erect a 12-storey five-star hotel, which would encroach onto the lovely beach and sand dune area. Prior to this approval, the highest building permitted at Scasboro Beach was three storeys.

Construction began immediately. At this time a legal challenge to the hotel was lodged by a local ratepayers’ association and environmental groups. They wanted the permit declared void because the planned structure would obstruct the views of existing property owners and cause damage to sand dunes in the area.

After the Coastal Development Company had invested $500 000 in the Scasboro Hotel project, a court hearing was held with the plaintiffs, which ordered demolition of the site as well as total restoration of the area. This would cost approximately $200 000. The company lost an appeal to a higher court.

Required

a Discuss how you might measure the economic value (using your understanding of what economic value means) of the project before the decision of: i the lower court ii the higher court.

b What problems do you envisage in making such measurements?

c What losses were sustained and who sustained the losses in this case? (Adapted from R.G. May, G. Mueller and T.H. Williams, A New Introduction to Financial Accounting, Prentice-Hall, 1975, Chapter 1, Exercise 1–2.)

14 At the beginning of time there was a small dwelling of cave men and women who elected themselves a leader called Ugg. Ugg’s responsibilities were to restore peace and order in the dwelling, which had become unsettled due to a recent outbreak of stealing.

Ugg was a very intelligent cave man and he began thinking that if every cave person accounted for their belongings, then less stealing would happen. Furthermore, if cave people paid him some kind of ‘due’ in respect of their belongings, thieves would be deterred because the more belongings a cave person had, the more in dues he or she would have to give Ugg. Ugg decided to call this due the ‘rock tax’.

The next day Ugg announced the rock tax to the dwelling. He explained to the cave people his thoughts from the previous day and asked for grunts of approval for the rock tax. These outweighed the grunts of disapproval so he then proceeded to outline the rock tax guidelines. These were: 1 one large brown fur equalled 50 morsels of meat 2 one small brown fur equalled 30 morsels of meat 3 one large black fur equalled two large brown furs 4 one small black fur equalled three small brown furs 5 for every 10 morsels of meat, one large rock had to be given to Ugg, which would help to build a wall around the

whole dwelling. The tax would be paid once every 300 days commencing from the next day. Ugg also said that he would personally check every cave to make sure truthful accounts were given. Two of the oldest members of the dwelling, Thug and Olga, thought Ugg’s rock tax was the best announcement they had ever

heard and proceeded to add up their furs and morsels. Thug calculated he had six large brown furs, two small brown furs and five small black furs in addition to the 34 morsels of meat he had stored in his rock-fridge. Thug had exchanged three small brown furs for his rock-fridge some 400 days ago. Olga counted two large brown furs, 10 large black furs and nine small black furs in her rock- cabin. She also counted 22 meat morsels in her rock-fridge. Olga had exchanged one large black fur for the rock-fridge 200 days ago.

Required

Imagining you lived in this dwelling, calculate: a the amount of tax that Thug and Olga should give Ugg b how Thug and Olga would pay their tax to Ugg.

26 part 1 FInancIaL accountIng

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1 Identified in the text is the need for information to enable management to carry out its duties and responsibilities in terms of stewardship, planning, control and decision making. The second part of the question should provoke a number of different answers, perhaps related to the market for the internal user’s product, competition or the economic situation. We have found that by encouraging the students to think about the alternative information needs, and the sources from which information can be derived, they are better able to see accounting in a wider context.

2 In general, for external users, the accounting reports that are normally used are the annual report or statements. Where specific reports, such as the balance sheet or income statement, are mentioned in the body of the text, these are shown below.

3 The limitations are as follows: a The information is only a part of that which is necessary to make ‘effective decisions’.

b Accountancy is, as yet, an inexact science and depends on a number of judgements, estimates, etc.

c The end result of the accounting process can only be as good as the inputs, and in times of rising prices some of these inputs are of dubious value.

d Accounting systems can be counterproductive; for example, the maximisation of a division’s profit may not always ensure the maximisation of the entity’s profit.

4 Economic consequences refer to the financial impact on an organisation from a particular accounting policy. For example, an accounting policy that requires all mining organisations to expense all exploration and development expenditure incurred would result in large losses for organisations not yet in production. Hence, this may make it difficult to attract investors to buy the organisation’s shares, despite its future prospects.

Suggested answers to stop and think exercises

Cool Value Cinemas Go to the online case and answer the questions related to Chapter 1.

Chapter 1 IntroductIon to accountIng 27

Management Various reports including specialist reports to help run the business profitably

Owners Annual report to help assess if management is doing a good job and protecting their investment

Lenders Statement of comprehensive income, income statement and statement of financial position or balance sheet to assess if the loan can be repaid and, in the event of loan repayment problems, if there is adequate security

Suppliers Statement of comprehensive income, income statement and statement of financial position or balance sheet because they are interested in issues that are similar to those of lenders

Customers Statement of comprehensive income, income statement and statement of financial position or balance sheet to determine if the entity will continue to operate – particularly if the customer has a long-term contract

Employees Profitability, therefore statement of comprehensive income and income statement to help assess ability of the entity to continue to operate

Government Statement of comprehensive income and income statement to assess payment of taxes

The public Annual report to assess the entity’s impact on areas like the environment and to assess the entity’s social policies and so on.

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