3/03/2014

Australian School of Business

Australian
School of
Business

Objective

Australian
School of
Business

1. Recall structures of annual report and construct simple financial

statements. (Revise Material from ACCT1501)
2. Revise the concept of double entry bookkeeping and accrual
accounting and completing t-accounts. (Revise Material from
ACCT1501).

ACCT1511
Topic 1

3. Introduction to differences between rules-based accounting and

principles-based accounting.

Rules and Principles

Additional Material

4. Demonstrate principles, conventions, and assumptions that are

consolidated in the Framework for the Preparation of Financial
Statements.

Australian
School of
Business

Conceptual Framework (Made available on Moodle)

Regulatory Constraints on Reporting

Australian
School of
Business

The Australian Securities and Investments Commission (ASIC)

administers the Corporation Act and oversees compliance.

Trotman, Gibbins & Carson 5th ed:

Chapter 6 pp. 290-312

Corporation Act 2001:

The financial statements and notes for a financial year must give
a true and fair view of: (a) the financial position and
performance of the company.....s.297
Directors report
Auditors opinion
The financial report for a financial year must comply with the
accounting standards.... s.296

Dont memorise, Understand!

ASX Listing Rules (for listed companies)

Continuous Disclosure Regime

Components of GAAP
Framework for the Preparation and Presentation of Financial
Statements (The Framework)

Australian
School of
Business

Accounting Standards

Australian
School of
Business

Generally Acceptable Accounting Principles (GAAP): common set

of standards and procedures developed by the accounting
profession

Accounting standards
Corporations Law

The International Accounting Standards Board (IASB) develops

international financial reporting standards (IFRSs)

ASX listing requirements

The AASB develops accounting standards for Australian companies

Custom and tradition

From 2005 AASB adopted most of the content and wording of the
IFRSs: Harmonisation

Dr Per Tronnes

3/03/2014

Principle vs. Rule based Accounting

Australian
School of
Business

IASB approach to standards setting is principles based

Provides general guidelines rather than specific rules for every
example
Relies on ethical use of professional judgement in applying
standards
Principles versus Rules (i.e. Flexibility vs Consistency) (see next few

What is Rule based accounting?

Australian
School of
Business

Rules-based accounting is basically a list of detailed rules that must be

followed when preparing financial statements.
Many accountants favour the prospect of using rules-based
standards, because in the absence of rules they could be brought to
court if their judgments of the financial statements were incorrect.
When there are strict rules that need to be followed, the possibility of
lawsuits is diminished.

slides)
Having a set of rules can increase accuracy and reduce the
ambiguity that can trigger aggressive reporting decisions by
management.
Problems: The complexity of rules, however, can cause
unnecessary complexity in the preparation of financial statements.
Precise requirements can sometimes compel managers to
manipulate the statements to fit what is compulsory.

What is Principle-based accounting?

Australian
School of
Business

Principles-based accounting, such as the IFRS and AASB, is used as a

conceptual basis for accountants. A simple set of key objectives are set
out to ensure good reporting.
Common examples are provided as guidance and explain the
objectives.

Although some rules are unavoidable, the guidelines or rules set

are not meant to be used for every situation. The fundamental
advantage of principles-based accounting is that its broad guidelines
can be practical for a variety of circumstances.

The Conceptual Framework

Australian
School of
Business

States the:
Objective of general purpose financial reporting
The qualitative characteristics that determine the usefulness of
information in financial statements;
The definition, recognition and measurement of the elements from
which financial statements are constructed; - i.e. assets, liabilities,
equity, expenses and revenue

Problem: principles-based guidelines may lack of specific enough

guidelines and therefore produce unreliable and inconsistent
information that makes it difficult to compare one organisation to
another

Objective of financial reports

Australian
School of
Business

The objective of financial statements is to provide information about

the financial position, financial performance and cash flows of an entity
that is useful to a wide range of users in making economic
decisions (Framework, para 12)
-Cannot accommodate all users complete information needs, as
information is financial in nature, and portray financial effects of past
transactions. (Framework, para 13)
-also show the stewardship of management. (Framework, para 14)

Dr Per Tronnes

So what is useful information?

Australian
School of
Business

What are economic decisions?

The economic decisions that are taken by users of financial
statements require an evaluation of the ability of an entity to
generate cash and cash equivalents and of the timing and
uncertainty of their generation (framework, para. 15)
This is done through the information in the financial statements:
-Balance Sheet Financial Position.
-Income statement Financial Performance.
-Cash Flow Statement Cash Inflows and Outflows.

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The Framework

Australian
School of
Business

What attributes should financial information possess to be useful

and satisfy the users evaluation of financial reports?

Understandability

Australian
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Business

Information needs to be readily understandable by users

(Framework, para 25)

Purpose is to identify those attributes or qualitative characteristics

that financial information should possess if it is to serve the objective
of general purpose financial statements.

Users assured to have reasonable knowledge of business,

accounting, etc. (Which is why you are studying this even though
you may never work as an accountant when you graduate)

Qualitative characteristics are the attributes that make the

information provided in financial statements useful to users. The four
principal qualitative characteristics are:
understandability,
relevance,
reliability and
comparability (Framework, para 24)

That does not mean that we exclude things just because they
are complex.

Relevance

Australian
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Business

Information has the quality of relevance when it

influences the economic decisions of users by helping
them evaluate past, present or future events or
confirming, or correcting, their past evaluation.
(Framework, para. 26)
Relevance of information is affected by both its nature
and magnitude (i.e. materiality) (Framework, para. 29).

Relevance

Australian
School of
Business

Example 1: A company discloses an increase in Earnings Per Share

(EPS) from $5 to $6 since the last reporting period. The information
is relevant to investors as it may assist them in confirming their past
predictions regarding the profitability of the company and will also
help them in forecasting future trend in the earnings of the company.
Relevance is affected by the materiality of information contained in
the financial statements because only material information
influences the economic decisions of its users.

Definition: Information is material if its omission or

misstatement could influence the economic decisions.
Materiality is a threshold or cut-off point.

Relevance

Australian
School of
Business

Example 2: A default by a customer who owes $1000 to a company

having net assets of worth $10 million is not relevant to the decision
making needs of users of the financial statements. However, if the
amount of default is, say, $2 million, the information becomes
relevant to the users as it may affect their view regarding the
financial performance and position of the company.

Reliability

Australian
School of
Business

To be useful, information must also be reliable. Information has the

quality of reliability when it is free from material error and bias and
can be depended upon by users to represent faithfully that which it
either purports to represent or could reasonably be expected to
represent. (Framework, para 31).

i.e. $1000 amount is here deemed to be immaterial, whereas the

$2 million is deemed material.

Dr Per Tronnes

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Reliability Faithful Representation

Australian
School of
Business

To be reliable, information presented in the financial statements should faithfully

represent the transaction and events that occur during a period (Framework,
para 33). That is, accounting information represents what exits and what
happened.
- If information is to represent faithfully the transactions and other
events that it purports to represent, it is necessary that they are
accounted for and presented in accordance with their substance and
economic reality and not merely their legal form. (i.e. substance over form)

Substance over form requires that if substance of transaction differs from

its legal form than such transaction should be accounted for in accordance
with its substance and economic reality. The rationale behind this is that
financial information contained in the financial statements should represent
the business essence of transactions and events not merely their legal
aspects in order to present a true and fair view.

Reliability Neutrality/Free from bias

Australian
School of
Business

Information contained in the financial statements must be free from

bias. It should reflect a balanced view of the affairs of the company
without attempting to present them in a favoured light. Information
may be deliberately biased or systematically biased.
Deliberate bias: Occurs where circumstances and conditions cause
management to intentionally misstate the financial statements.

Reliability Substance over form

Example 1: A machine is leased to Company A for the entire

duration of its useful life. Although Company A is not the legal owner
of the machine, it may be recognised as an asset in its balance
sheet since Company A has control over the economic benefits that
would be derived from the use of the asset..
Example 2: If two companies swap their inventories, then they will
not be allowed to record sales because in substance no sales have
occurred.
These are application of the accountancy concept of substance over
legal form, where economic substance of a transaction takes
precedence over its legal aspects

Reliability Neutrality/Free from bias

Australian
School of
Business

Systematic bias: example

Example 1: Accounting policies within an organisation may be overly
prudent because of cultural influence of an over cautious leadership.

Australian
School of
Business

Deliberate bias: Examples

- Example 1: Managers of a company are provided bonus on the
basis of reported profit. This might tempt management to adopt
accounting policies that result in higher profits rather than those that
better reflect the company's performance inline with GAAP.
-

Example 2: A company is facing serious liquidity problems.

Management may decide to window dress the financial statements
in a manner that improves the company's current ratios in order to
hide the gravity of the situation.

Example 3: A company is facing litigation. Although reasonable

estimate of the amount of possible settlement could be made,
management decides to discloses its inability to measure the
potential liability with sufficient reliability.

Systematic bias: Occurs where accounting systems have developed

an inherent tendency of favouring one outcome over the other over
time.

Reliability Neutrality/Free from bias

Australian
School of
Business

Reliability Prudence / Conservatism

Australian
School of
Business

Prudence requires that accountants should exercise a degree of

caution in the adoption of policies and significant estimates such that
the assets and income of the entity are not overstated whereas liability
and expenses are not understated.
There is an inherent risk that assets and income of an entity are more
likely to be overstated by the management whereas liabilities and
expenses are more likely to be understated. The risk arises from the
fact that companies often benefit from better reported profitability and
lower gearing in the form of cheaper source of finance and higher share
price.
The prudence concept helps to ensure that such bias is countered by
requiring the exercise of caution in arriving at estimates and the
adoption of accounting policies

Dr Per Tronnes

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Reliability Prudence / Conservatism

Australian
School of
Business

Reliability - Completeness

Australian
School of
Business

Example 1: Inventory is recorded at the lower of cost or net

realisable value (NRV) rather than the expected selling price. This
ensures profit on the sale of inventory is only realised when the
actual sale takes place (more in week 3)

Reliability of information contained in the financial statements is

achieved only if complete financial information is provided relevant
to the business and financial decision making needs of the users.
Therefore, information must be complete in all material respects.

Example 2: Under the revaluation method for Property Plant and

Equipment, upward revaluations taken to revaluation reserve, but
downward devaluations taken to income statement (more in week 3)

Incomplete information reduces not only the relevance of the

financial statements, it also decreases its reliability since users will
be basing their decisions on information which only presents a
partial view of the affairs of the entity.

Creates asymmetry in accounting.

Note: prudence does not require management to deliberately overstate

its liabilities and expenses or understate its assets and income. The
application of prudence should eliminate bias from financial statements
but its application should not reduce the reliability of the information.

Comparability

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School of
Business

Relevance vs. Reliability

Australian
School of
Business

Users must be able to compare the financial statements in order to

identify trends in its financial position and performance. Users must
also be able to compare the financial statements of different entities.
(Framework, para. 39)

In case where application of one accounting concept or principle

leads to a conflict with another accounting concept or principle,
accountants must consider what is best for the users of the financial
information.

Over time: Consistency of financial statements over different

accounting periods can be ensured by the application of similar
accountancy policies over a period of time. However, a change in
the accounting policies of an entity may be required in order to
improve the reliability and relevance of financial statements. This
must be disclosed (AASB 108)
Within industries: Accounting standards ensures comparability of
different entities within industry (to some degree)
Across countries: Adoption of international accounting standards
(IFRS) ensures comparability of different entities across countries
(to some degree)

An example of such a case would be the trade off between

relevance and reliability.

Relevance vs. Reliability

Australian
School of
Business

The primary decision-specific qualities that make accounting

information useful are relevance and reliability. Both are critical.
No matter how reliable, if information is not relevant to the decision
at hand, it is useless. Conversely, relevant information is of little
value if it cannot be relied on.
A trade-off often is required between various degrees of
relevance and reliability. Timely presentation of accounting
information is highly desirable as it makes the information more
relevant. But producing reliable information may take time.

Relevance vs. Reliability

Australian
School of
Business

Example 1: Accounts receivable reliably shows how much is owed

to the company, BUT how much will likely be received is more
relevant.
In doing so, the company will estimate an allowance for doubtful
debt (that is, estimating a figure for how much of what is owed to
company is not likely to be paid to the company).
That estimate makes the carrying amount of accounts
receivable more relevant, but it comes at a cost of making an
estimate (which is arguably less reliably).
It the company waited until they knew how much they received,
the information would not be so relevant anymore.

Whether reliability of information may be compromised to ensure

relevance of information is a matter of judgment that ought to be
considered in the interest of the users of the financial information.

Dr Per Tronnes

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Assumptions: things we take for granted

Australian
School of
Business

But are fundamental to accounting

Accrual basis
- the matching principle: matching expenses to the same period
when revenue is recognised.
Going concern
Economic entity
Accounting period
Monetary unit
Historical cost

Matching Principles

Australian
School of
Business

Matching principle requires that expenses incurred by an

organisation must be charged to the income statement in the
accounting period in which the revenue, to which those expenses
relate, is earned.
That is: matching expenses to the period where revenue is
earned
It is NOT: matching revenue to the period where expenses is
incurred.
Application of matching principle results in the deferral of prepaid
expenses in order to match them with the revenue earned in future
periods. Similarly, accrued expenses are charged in the income
statement in which they are incurred to match them with the current
period's revenue.

Going Concern

Australian
School of
Business

Going concern is one the fundamental assumptions in accounting on

the basis of which financial statements are prepared.
Financial statements are prepared assuming that a business entity
will continue to operate in the foreseeable future without the need or
intention on the part of management to liquidate the entity or to
significantly curtail its operational activities. Therefore, it is assumed
that the entity will realise its assets and settle its obligations in the
normal course of the business.

Dr Per Tronnes

Accruals Concept

Australian
School of
Business

Financial statements are prepared under the Accruals Concept of

accounting which requires that income and expense must be
recognised in the accounting periods to which they relate rather than
on cash basis.
An exception to this general rule is the cash flow statement
whose main purpose is to present the cash flow effects of
transaction during an accounting period.
The Accruals Concept is closely related to the matching principle
(next slide)

Matching Principle - Examples

Australian
School of
Business

Example 1: Depreciation: A major development from the application

of matching principle is the use of depreciation in the accounting for
non-current assets. Depreciation results in a systematic charge of
the cost of a fixed asset to the income statement over several
accounting periods spanning the asset's useful life during which it is
expected to generate economic benefits for the entity. Depreciation
ensures that the cost of depreciable non-current assets is not
charged to the profit & loss at once but is 'matched' against
economic benefits (revenue or cost savings) earned from the asset's
use over several accounting periods.
Example 2: COGS: The cost incurred in the manufacture or
procurement of inventory is charged to the income statement of the
accounting period in which the inventory is sold. Therefore, any
inventory remaining unsold at the end of an accounting period is
excluded from the computation of cost of goods sold.

Economic Entity

Australian
School of
Business

Financial accounting is based on the premise that the transactions

and balances of a business entity are to be accounted for separately
from its owners. The business entity is therefore considered to be
distinct from its owners for the purpose of accounting.
Therefore, any personal expenses incurred by owners of a business
will not appear in the income statement of the entity.

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Monetary unit

Australian
School of
Business

Money Measurement Concept in accounting, also known as

Measurability Concept, means that only transactions and events that
are capable of being measured in monetary terms are recognised in
the financial statements.
All transactions and events recorded in the financial statements
must be reduced to a unit of monetary currency. If it is not possible
to assign a reliable monetary value to a transaction or event, it will
not be recorded in the financial statements.
However, any material transactions and events that are not recorded
for failing to meet the measurability criteria might need to be
disclosed in the supplementary notes of financial statements to
assist the users in gaining a better understanding of the financial
performance and position of the entity.

Historical Costs

Australian
School of
Business

The cost principle or historical cost principle states that an asset

should be reported at its cost (cash or cash equivalent amount) at
the time of the exchange transaction (and should include all costs
necessary to get the asset in place and ready for use).

Accounting period

Australian
School of
Business

The time span in which certain financial events took place. The
accounting period is generally a quarter or a year and reflects all of
the financial activity that occurred during that time.
While accounting periods vary in terms of reporting dates, they must
be consistent. If one accounting period ends on June 30, the next
must begin on July 1. From an investing standpoint, the accounting
period is important because it lets potential shareholders compare
apples to apples.
But it should be appreciated that there is a certain arbitrariness to
this way of slicing up the entitys life.

What you need to do before the seminar

Australian
School of
Business

1. You must attempt all homework questions in the handout.

2. Bring the handout to the seminar in week 2.
3. You are encouraged to use the discussion board on Moodle.

Example 1, land purchased in 1992 at cost of $80,000 and still

owned by the buyer will be reported on the buyer's balance sheet at
its cost or historical cost of $80,000 even though its market value,
and inflation-adjusted cost might be very today.
(We will cover more on asset valuations in Topic 3)

Dr Per Tronnes

4. Be ready to ask questions about anything that is unclear.