MCD2010 Accounting 1

Topic 1 Accounting in Action

Reference: Principles of Accounting and Finance (Second edition) (Carey 2010) Chapter 1
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Learning Objectives
At the end of this topic you should be able to:
1. explain what accounting is; 2. understand the role and value of accounting information; 3. understand the role of corporate governance in enhancing the quality of financial reporting; 4. identify the users and uses of accounting; 5. understand why ethics is a fundamental business concept; 6. understand the importance of sustainability, and sustainable reporting, for business; 7. understand how accounting standards have been regulated and developed; 8. explain the nature of a reporting entity; 9. state the basic accounting equation, and define assets, liabilities and owners equity; 10. understand the two recognition criteria that must be met before an item can be included in the financial statements; 11. understand the four financial statements; 12. explain the qualitative characteristics of accounting information.
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Lecture Overview
What is accounting? Why is accounting important? The accounting conceptual framework An overview of the financial statements Other accounting issues

What is accounting?
An information system or process that:

Identifies Records Communicates

economic events of an entity to interested users.

What is Accounting? (continued)

The Accounting Process

Why is Accounting Important ?

Accounting information conveys information about business performance to others. Decisions are made based on the information provided. Poor accounting practices by businesses can produce information that is inaccurate or misleading. This can lead to corporate collapses and financial ruin for many people involved.

The role of accounting

To assist people in making decisions about the allocation of scarce resources. Accounting measures business activity, and processes it into reports to enable communication of the information to users who are or are to the entity.

Internal users
Managers who plan, organise and run the business
e.g. marketing managers, production supervisors, chief financial officers, other employees.

Detailed and frequent information is needed by these managers to make business decisions on a day-by-day basis.

External users
Vary in their nature and information requirements.
Investors e.g. Shareholders (use information to make decisions to buy, hold or sell shares)

Creditors e.g. Suppliers, (use information to evaluate risks of giving credit and lending money)
Government and regulatory bodies e.g. ATO, ASIC (use information to determine an entitys compliance with rules and regulations)
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History of regulation of accounting

Over time, Generally Accepted Accounting Principles (GAAP) have developed to guide the practice of accounting. As entities grew in size and complexity, more formal rules for accounting were required. Today, accounting standards are mandatory for many entities to follow in the preparation of financial statements.
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History of regulation of accounting (continued)

Australia has adopted standards that are consistent with those produced by the International Accounting Standards Board (IASB). While these accounting standards provide rules for dealing with various accounting issues, there exists an underlying conceptual framework upon which the standards are based. This framework attempts to derive a theory for determining the information to be provided in financial statements.
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The Australian Conceptual Framework in summary:

SAC 1 defines a SAC 2 provides the objective of general purpose financial statements The Framework explains the objective of general purpose financial statements; qualitative characteristics of information; as well as the definition and recognition criteria for the five elements of accounting.

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Statement of Accounting Concepts (SAC)1

Definition of the Reporting Entity Defines a Reporting Entity as any entity in which it is reasonable to expect the existence of users who depend on general-purpose financial statements for information to enable them to make economic decisions.

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SAC 1 (continued)
Factors to help determine whether dependent users are likely to exist: Separation of management from economic interest Economic or political importance /influence Financial characteristics

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Why is this definition important?

Entities defined as reporting entities must produce general purpose financial statements in compliance with accounting standards and make them publicly available so the dependent users can access the information for their decision making. Not all entities are reporting entities, even though they produce annual financial statements.

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Statement of Accounting Concepts (SAC) 2

Objective of General Purpose Financial Reporting General purpose financial reporting focuses on providing information to meet the common information needs of users who are unable to command the preparation of reports tailored to their particular information needs. This highlights the fact that reports are prepared for .
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AASB Framework
Adapted from the IASB Framework, it contains the following: Objective of financial statements Assumptions underlying financial statements Qualitative characteristics of financial statements Elements of financial statements Recognition criteria for the elements of financial statements.
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AASB Framework objectives of financial statements

To provide information:

About the financial position, performance and cash flows of an entity that is useful in making economic decisions. Showing the results of accountability of management for the resources entrusted to it.

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AASB Framework qualitative characteristics of financial statements

Provide guidance for entities that need to prepare financial statements as to the qualities of the information that should be contained in them. The two characteristics are relevance and faithful representation (the latter is proposed to replace the current qualitative characteristic of reliability)
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Relevance
Relevant financial information influences users decisions by: Helping them to form predictions about the outcomes of past, present or future events and/or Confirming or correcting their past evaluations
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Faithful representation
Information that is faithfully represented is free from material error and bias and is able to be depended upon to represent the transactions or events that it claims to represent.
Factors affecting faithful representation include:
Neutrality Substance over form Completeness Accuracy
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Qualitative Characteristics of Financial Information (as proposed)

The Hierarchy
Relevance
Predictive Confirmatory Neutrality

1. Fundamental

Faithful Representation
Understandability

Substance over Form

Completeness Accuracy

2. Enhancing

Verifiability Comparability Timeliness

Materiality

3. Constraints
Cost v Benefit
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Enhancing characteristics and constraints

Additional characteristics help to ensure the information contained in the reports, and the way it is presented, provide the maximum benefit to users. Constraints consider the limitations faced when choosing the information that is to be included in the statements.

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AASB Framework elements of financial statements

There are five elements of accounting: Assets Liabilities Owners Equity Income Expenses

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1. Assets
Definition: a resource controlled by the entity as a result of a past transaction or other past events and from which future economic benefits are expected to flow to the entity Essential characteristics: Future economic benefits Under control of entity (rather than owned) Result of past transaction
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Assets - Example
Mikes Inner City Cab Service purchased a taxi for $49,000 to carry passengers around Melbourne.

Does the taxi meet the definition of asset?

Provides future economic benefits Controlled by Mike Result of a past transaction

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2. Liabilities
Definition: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits Essential characteristics: Future sacrifice Present obligation Result of past transaction
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Liabilities - Example
Mikes Inner City Cab Service borrowed $43,000 from the State Bank to purchase the taxi.
Does the bank loan meet the definition of liability?
A present obligation exists A future sacrifice will be required Result of a past transaction
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3.

Owners Equity

Definition: the residual interest in the assets of the entity after deduction of its liabilities This definition is more of a formula, and creates the Accounting equation, the foundation of accounting: Owners Equity
or

= =

Assets

Liabilities

Assets

Liabilities + Owners Equity

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Owners Equity - Example

Mikes Inner City Cab Service has a taxi worth $49,000, and a bank loan of $43,000 owing to the State Bank. What is Mikes owners equity? Owners Equity = Assets - Liabilities

=$49,000 - 43,000

This is Mikes personal contribution to commence his business.

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4.

Income

Definition: increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants Essential characteristics: An increase in economic benefits Result in an increase in equity, but Excludes owners contributions of equity
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Income - Example
Mikes Inner City Cab Service charged a passenger $10 for a short trip in Melbourne.

Does the taxi fare meet the definition of income?

Inflow of economic benefits (cash) Contributes to an increase in equity Was NOT contributed by Mike
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5.

Expenses

Definition: decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants Essential characteristics: A decrease in economic benefits Result in a decrease in equity, but Exclude distributions to owners
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Expenses - Example
Mikes Inner City Cab Service filled up with petrol before picking up more passengers.

Does the petrol meet the definition of expense?

Decrease of economic benefits (cash) Causes a reduction in equity Was NOT a distribution to Mike
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AASB Framework Recognition Criteria for the elements

We have learned the definitions of the elements, but there are two criteria for the elements as well: Probable Occurrence Reliable Measurement An item cannot be recorded in the entitys accounts unless it satisfies both of these recognition criteria.
Note that Owners Equity does not have recognition criteria.

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General purpose financial statements

An overview of the four main statements: Income Statement Statement of Changes in Equity Statement of Financial Position Statement of Cash Flows

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Income Statement
(shows Income less Expenses and the resulting profit or loss)
SOFTBYTE Income Statement for the month ended 30 September 2009

Income Service revenues Expenses Salaries expense Rent expense Advertising expense Utilities expense Total expenses Profit

$ 4 700 $900 600 250 200 1 950 $ 2 750

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Statement of Changes in Equity

(shows how the owners wealth has changed during the period)

SOFTBYTE Statement of Changes in Equity for the month ended 30 September 2009 L. Nguyen, Capital 1/09/09 Add: Investments $15 000 Profit 2 750 Less: Drawings L. Nguyen, Capital 30/09/09 $ 0

17 750 1 300 $16 450

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Statement of Financial Position

SOFTBYTE Statement of Financial Position as at 30 September 2009

Assets Cash Accounts receivable Supplies Equipment Total assets Liabilities and owners equity Liabilities Accounts payable Owners Equity L. Nguyen, Capital Total liabilities and owners equity

$ 8 050 1 400 1 600 7 000 $18 050

$ 1 600 16 450 $18 050

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Statement of Cash Flows

SOFTBYTE Statement of Cash Flow for the month ended 30 September 2009

Cash flows from operating activities Cash receipts from customers $ 3 300 Cash payments for expenses (1 950) Net cash provided by operating activities $ 1 350 Cash flows from investing activities Purchase of equipment (7 000) Cash flows from financing activities Investments by owner 15 000 Drawings by owner (1 300) 13 700 Net increase in cash 8 050 Cash at beginning of period 0 Cash at end of period $ 8 050

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Other accounting issues

Sustainability reporting
Corporate governance

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Sustainability Reporting
Financial information is helpful in decision making, but non-financial performance measures are becoming more important to users as well. Reporting and management of non-financial performance is known as:
Sustainability reporting Corporate social responsibility reporting This has led to Bottom Line reporting.
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Sustainability Reporting (continued)

Triple bottom line refers to three components: Social bottom line (relates to employee working conditions,
safety, security, community services)

Environmental bottom line (considers how an entitys

products or operations impact on the environment)

Economic bottom line (refers to the traditional reporting of

profitability and business strategy)

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Corporate Governance
Corporate failures and collapses are costly, and impact employees, creditors, investors and others. These have prompted reform into the management of entities. Many countries have initiated regulations to encourage and promote good governance of organisations. This also aims to protect smaller investors.
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Corporate Governance (continued)

Corporate Governance defined: The system in which entities are directed or controlled, managed and administered. It influences how the objectives of a company are set and achieved, how risk is monitored and assessed, and how performance of the entity is optimised (http://www.asx.com.au)

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Corporate Governance (continued)

Corporate Governance practices include:
Regulation regarding the roles/responsibilities of directors Ensuring the goals of the entity are aligned with shareholders Preventing opportunistic behaviour of managers Disclosure of information Effective monitoring

These practices are adopted in an effort to protect shareholders and enhance the perception, reputation and prosperity of an entity.
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Corporate Governance (continued)

Australian Securities Exchange (ASX) released the Corporate Governance Principles and Recommendations in 2003, and revised them in 2007.

Eight core principles underlie good corporate governance.

While not mandatory, listed companies need to disclose their compliance and explain why these principles were not followed.
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Corporate Governance (continued)

Corporate governance is important to larger entities as the separation of ownership and control create incentives for opportunistic behavior of managers (agency costs).
i.e., managers (agents) interests do not always align with the owners (principles) interests

Financial information is used by owners to monitor the performance of managers. Sound governance practice provides further protection to owners.

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