1 The Role of Accounting

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1 5 1 The Role of Accounting Accounting Information Accounting provides financial information for a variety of entities to enable them to make informed judgements and decisions. It is important that you know and understand the following accounting terminology and use it appropriately throughout the course when writing responses to short answer theory questions and accounting reports. A definition of Accounting is as follows: Accounting is the process of identifying, measuring, recording and communicating financial information in order to permit informed judgements and decisions by users of information. Data is anything that can be measured and given a value (unstructured facts) eg lists of sales figures, bank deposits, number of hours worked by employees. Information when figures are summarised or rearranged in a structured fashion eg table showing names of employees, total hours worked per week and wages received by each employee. Data and Information used in making decisions include: Quantitative Data is information expressed in numerical form and which is measurable. It is referred to as objective information (can be verified or proven Qualitative Information is all other information such as legal, social, environmental or ethical matters; state of the economy, short term versus long term, efficiency versus effectiveness, and the business owner s personal values; It is referred to as subjective information (intuitive, biased or personal). Financial Information may include budgets, ratios, sales results and current interest rates. Non Financial information may include benchmarks, staff turnover and market share. Qualitative Characteristics of Accounting Information Qualitative characteristics of accounting information in general purpose financial reports cannot be expressed by a numerical or dollar value, eg value of a good employee, and the effect of government policies such as changes in trading hours. These characteristics are categorised into three groups: Selection of Financial Information Relevance Financial information must have value in terms of assisting users in making and evaluating decisions about the allocation of financial, physical and human resources. It must reflect accountability by the preparers of financial information. Reliability Financial information must be free from bias and undue error. Materiality Information may be relevant in the general operations of an enterprise but might not be of significance when the entity is reporting. A small business may round off to the nearest $10 whereas a large business may round off to the nearest $1 000 as this still presents an accurate picture of the business.

2 6 SACE Stage 2 Accounting Essentials Workbook Presentation of Financial Information Comparability This is achieved by comparing an entity at one point in time and over time or an entity with other entities at one point in time and over time. Consistent methods of accounting must be used from one period to the next so that meaningful comparisons can be made. Notes may be included when changes have been made to the method of valuation of the figures. This reflects the Consistency Concept. Understandability Financial information must be presented in a form that assists users in its understanding. We therefore need to consider who are the users of the information. As an example, the presentation of the Income Statement and the Balance Sheet, with the various classifications, assist the users to better understand these reports. This is particularly helpful when the users have limited accounting knowledge. Constraints on Qualitative Characteristics Timeliness Financial information may lose its relevance if there is a long time span before the information is presented to interested parties. Therefore, financial statements such as the Income Statement and Balance Sheet are prepared regularly, eg monthly, quarterly or yearly so that managers can make decisions to ensure the business stays on track to achieve its objectives. Costs Versus Benefits Accountants need to consider whether the provision of certain financial information will stimulate more benefits than the costs incurred. For example, the cost of gathering market research data should be less than the benefits that this data will provide to the business. That is, the increase in revenue and ultimately profits, should outweigh the overall costs. Functions of Accounting The three main functions of accounting are to: Provide Information for Decision Making Information is provided through financial figures produced from the data collected. Written reports accompany these figures. Decisions are aided by accurate and timely information that is provided in a form that is easily understood by users outside the profession. Assist in Discharging Accountability Accountability means being held responsible to another authority for actions carried out. Accountants have the responsibility to provide information to enable users to make informed judgments about the performance, financial position, investing, and compliance of the reporting entity. Help Evaluate Performance There are two types of reports that provide financial information to interested parties to enable them to make relevant decisions. General Purpose Reports will allow an evaluation of the overall performance of the business. They indicate the performance of management in using resources efficiently, earning profits, and achieving financial stability. There are three general purpose reports: The Income Statement shows the performance of the business for a particular period of time. It shows the revenue and expenses and the resulting profit or loss. The Balance Sheet shows the financial position of the business at a particular point in time. It lists the Assets, Liabilities and Owner s Equity. The Statement of Cash Flows is a financial report that indicates the movement of cash receipts and payments resulting from transactions with parties outside the enterprise over a given a period of time.

3 Chapter 1 The Role of Accounting Special Purpose Reports will allow the performance of individuals and groups within the organisation to be evaluated by management or interested external users. Evaluation may be achieved through the calculation of ratios and analysis of comparative figures. Results are compared with previous periods figures and with figures from other enterprises in the same industry. There are many special purpose reports which can be used depending of the nature and requirements of each individual business. Reports indicating Sales Forecasts, Budgets for various departments of a business, Ageing Analysis of Debtors, are some of the special purpose reports that an enterprise may utilise. 7 Users of Accounting Information Those who use accounting information are referred to as the stakeholders. These individuals or groups may come from within the business (internal) or from outside the business (external). Internal and External Users Internal Users include all levels of management and other governing bodies of an organisation, eg owners, managers, executives of clubs and boards of directors. Internal stakeholders make decisions on various aspects of the operation of the organisation, such as financing, personnel, production and marketing. External Users include present or potential investors and present or potential creditors. They make decisions for themselves regarding future investment in a business, the provision of goods or services, or the extension of credit to the business. Other external users include economic planners, employees and trade unions, financial advisers, general public, government authorities, government planners, pressure groups, regulatory agencies, Australian Securities Exchange and taxation authorities. External stakeholders are interested in the organisation s performance and financial position. They want to evaluate how efficiently and profitably management and the organisation have used the resources entrusted to them (financial stability and returns on investment). They are using the financial information to ensure that correct procedures or regulations are being adhered to, or produce necessary data or statistics. For example, the Taxation Department uses the financial information to assess the tax liability of the business. Users and Uses of Accounting Information Stakeholders Shareholders Lenders/Creditors Employees Government Customers Managers General Public Examples of decisions for which information is needed To buy, sell or hold shares; to compare prices with returns on shares, and to identify dividend payout trends. To increase, reduce or keep constant the levels of loans or credit. To claim salary increases or to change employment. To raise taxation, or to examine the organisation s impact on the environment. To remain loyal to products, and to buy products. To determine the level at which to conduct operations; to change pricing policies; to control customers accounts; to determine business expansion policies, sales trends of products, dividend payout; to borrow, and repay loans. To assess the economic and social impact of an organisation, eg the impact of a mining company s activities on the physical environment.

4 8 SACE Stage 2 Accounting Essentials Workbook Decision Making The Decision Making Process uses both quantitative and qualitative data. Quantitative data is provided by the Accounting Process. (The Accounting Process involves the collection, processing, analysis of data and the reporting of financial information.). Qualitative data includes current social, legal and ethical issues. How can decisions be made by external and internal users Decision making involves a choice between alternate courses of action based on relevant information. Most business decisions will involve considering quantitative information in order to reduce expenses and increase profits for the business. However it is important that any decision which is made, also considers other factors which may influence the decision. This information is known qualitative information. Typical types of decisions which may be faced by a business are: How much should be produced? What price should be charged? Should we purchase a new fleet of vehicles? How should the new fleet be financed? How can sales be expanded? How can the wages expenses be reduced? No two decisions are exactly the same but all seem to follow similar steps in arriving at a successful answer. Many decision-making models have been developed to show these steps. The following is an example of one of the decision-making models, which can be used by businesses. The Decision Making Process Any decisions made should use a planned process in which the issue that needs a decision is identified, options are considered and a procedure for executing the decision is provided. The following describes a decision making process which may be used by an organisation. CLARIFY ANALYSE CHOOSE EXECUTE 1 CLARIFY The clarification stage involves setting the decision in its context by giving some thought to: Objectives Problem diagnosis Constraints Objectives Any good decision made will be judged successful in terms of helping an organisation better achieve its goals. It follows that the first step in making a decision should be to consider those goals (or objectives). There is a range of objectives a business may have: Maximising profits. Growth and size. Diversification. Providing a safe, secure workplace. Taking over competitors. An important thing to consider when making decisions is the goal you are working towards. The way the decision affects the achievement of that goal is ultimately the criterion by which that decision is judged.

5 Chapter 1 The Role of Accounting Problem Diagnosis A good decision relies on a sound understanding of the problem. Before making a decision, you must be able to identify and clarify the exact nature of the problem. 9 A typical problem may be a large drop in sales. Diagnosis may reveal many possible reasons for this problem: An economic downturn. Successful advertising by a competitor. Poor quality of goods. Inefficient sales staff. The root cause of the problem needs to be identified if the right decision is to be made. Different problem diagnosis leads to different decisions. For example, the downturn in sales could be attributed to poor sales staff and therefore the business may proceed on a staff training program at a great cost to the business. If at the end of this training sales still do not improve, then the problem was probably diagnosed incorrectly. The downturn in sales could have been a result of the poor quality of stock. Constraints Identify the constraints that restrict the decisions you can make. There is no point wasting time considering options unavailable to you. Constraints can be External or Internal An internal constraint is a constraint imposed by the characteristics of the business for example, location, qualifications of employees, level of gearing. An external constraint is one imposed by factors outside the influence of the business; for example a decision to start a business will be influenced by council zoning. Early identification of the constraints surrounding a decision can make the decision making process more efficient. Summary Objectives: What do we really want to achieve? Problem Diagnosis: Exactly what is the decision about? Constraints: What things will restrict us in making the decision? 2 ANALYSE This stage involves doing the research and fact finding necessary to provide a sound base of information to support the decision-making. It involves two steps: Information Ideas Information This involves the gathering of facts, figures and information that may shed light on the problem and potential solution. This information may be quantitative information (numeric, can be measured) such as budgets, ratios, sales results, current interest rates, Income Statement and Balance Sheet results, or qualitative information, such as social, legal, environmental and ethical information. The information will have to be collected, processed, presented and interpreted.

6 10 SACE Stage 2 Accounting Essentials Workbook For example a business wishing to expand its premises will need to find information about: Cost of extensions. Alternative sites. Cost of additional labour and equipment. Local government regulations. Ideas Involves a series of ideas or possible solutions that will present themselves. The information gathered will support or not support these ideas. If the information confirms that the ideas may be reasonable solutions, those ideas will form the basis of alternatives for further consideration. Ideas can arise at any stage. For example the business considering expansion may develop the following ideas. Move to a different location and build a completely new factory. Buy the building next door and demolish it to make the space necessary. Sub-contract some of the work out so that physical expansion is not necessary. Stay as they are. Summary Information: Facts and figures relevant to the decision. Ideas: For possible solutions. 3 CHOOSE This third stage of the model is the stage where the decision is made. Choices are made between small numbers of alternatives. This involves two steps: Short list the alternatives Make a choice and confirm how it is to be executed Short list the alternatives A consideration of the ideas and information gathered will narrow the decision down to a small number of alternatives. Each of these alternatives will have its own advantages and disadvantages and the detailed feasibility of each alternative needs closer consideration. Management is influenced by the following social and ethical issues in decision making. Personal and social values. Environmental impact studies. Ethical investments. Technological developments. For example if the business considering expansion, moves to a new location and builds a larger factory, the following are some of the factors that need to be considered. ADVANTAGES more space set the factory up as they want it get new equipment DISADVANTAGES cost business will be closed for some time problems of travel for staff Make a choice and confirm how it is to be executed Once the alternatives have been reduced, the specific details of the favoured alternatives need to be looked at closely. This ensures that they are technically feasible and that they can be achieved.

7 Chapter 1 The Role of Accounting Any idea that seems sensible on the surface may have hidden problems that are revealed with closer scrutiny. Once these unforeseen problems are investigated a choice can be made. Summary 11 Short list the alternatives: A small number of possible solutions. Make a choice and confirm how it is to be executed: To carry out possible solutions (check for hidden problems). State how the decision is to be carried out. 4 Execute Once the decision has been made, you need to be sure it is put into practice and followed up. The best intentions can come to nothing if plans are not made to execute the decision, follow it up and check that things are going to plan. Finally, review the decision to see how well you achieved your objectives. There are three steps: Planning Controlling Reviewing Planning Once the techniques have been decided upon, precise arrangements can be made to get the job done and carry out the decision. This may involve getting quotes, preparing budgets, tendering, ordering, setting standards, specifications and deadlines. Controlling The planned activities need to be guided through to the desired outcome. This step involves following the decision through. Actual performance needs to be compared to the estimates and standards planned for. Controlling means checking that everything is going to plan and making any adjustments or corrections that may be required. Reviewing The final step is to look at outcomes of the decision. What has happened? Are objectives being achieved? Was the decision a good one? Was the diagnosis correct? Was the decision carried out in the best way? Summary Planning How to get the job done. Controlling Monitoring to ensure the plan is on track. Reviewing Analysing if the decision made achieved the desired outcomes. At this stage information is collected for decision making in the future. Remember, there are many varied decision making processes. Different textbooks outline different models. All, however, essentially involve similar components.

8 12 SACE Stage 2 Accounting Essentials Workbook Influences on Accounting Information The production of accounting information is influenced by a variety of factors: Regulatory Frameworks Australian Securities and Investment Commission, (ASIC), Australian Securities Exchange, (ASX), The Corporations Act 2001 (Cwlth). Australian Conceptual Framework provides a conceptual basis for accounting standards and the preparation of financial statements. The Needs of the Accounting Entity. Technological Developments. Social and Ethical Issues. Regulatory Frameworks Companies have to comply with the regulations set out by the Australian Securities and Investments Commission, (ASIC) (established by the government to regulate companies). Requirements of Corporations Law of Australia influences the accounting information produced for a business. ASIC prescribes the format of reports and the standards for the particulars of the reports and these are mandatory for all companies. Australian Securities Exchange, (ASX) primary purpose is to ensure that Australia s capital market is properly regulated. It imposes requirements which are compulsory for all listed companies (Listing Rules). Companies must provide half yearly reports and issue preliminary annual profit figures before the annual reports are published. The Australian Taxation Department requires information for regular remittances of the various taxes levied by Government legislation, eg annual tax returns. Australian Conceptual Frameworks and Accounting Standards The Australian Conceptual Frameworks includes the Australian Accounting Standards Board Framework. The Australian Accounting Standards Board Framework sets out the concepts that underlie the preparation and presentation of financial reports for external users. These include the rules, practices and procedures that guide the way in which financial reports are prepared so that different financial reports are comparable. In 2005, Australia adopted the international accounting standards so that financial reports could be comparable across national boundaries. This was in response to the increasing globalisation of businesses. The Australian Accounting Standards Board (AASB) has developed new AASB standards known as the Australian equivalents to International Financial Reporting Standards (AIFRSs). The conceptual framework deals with general concepts and applications and presently consists of two statements of accounting concepts (SACs). These SACs provide definitions of basic terms and rules that affect accounting procedures. These are not currently enforceable by law but give guidelines upon which financial decisions are based. SAC 1 Definition of the Reporting Entity. SAC 2 Objective of General Purpose Financial Reporting. The Needs of the Accounting Entity The way in which accounting information is presented is influenced by the needs of the accounting entity. Classification of information in reports must be done in a way that is useful to statement users. Businesses need various types of information for decision making and control and therefore require information to be presented in various ways, eg departmental reports and staff sales reports may be used in the process of appraisal.

9 Chapter 1 The Role of Accounting 13 Technological Developments Accounting systems are increasingly becoming computerised as software and hardware become cheaper. Reports can now be designed in different formats and information can be processed quickly, easily and more efficiently as accounting software packages are fully integrated. Information can now be provided more regularly and accurately in a format required by statement users. This supports the qualitative characteristics of financial information. Social and Ethical Issues Both the ASCPA (Australian Society of Certified Practising Accountants) and the ICAA (Institute of Chartered Accountants in Australia) have established a Code of Professional Conduct and Rules on Ethical conduct for its members. The codes and rules that members must follow deal with the following: integrity, objectivity and independence, confidentiality, professional competence, compliance with accounting, auditing and any other standards or guidelines given by the society, upholding the image of the profession and the society and public interest. (DO QUESTIONS 1-12 WHICH FOLLOW) Questions 1 Which of the following represents an external use of financial information? J ledger accounts. K an enterprise s tax return. L monthly sales reports presented to the departmental manager of a firm. M sales forecast figures. 2 Which of the following is an external user of financial information? J an owner of a business. K a shareholder. L a member of the board of directors. M a manager. 3 Which of the following represents an internal user of financial information? J an employee. K Australian Securities and Investment Commission (ASIC). L a shareholder. M board of directors. 4 The need to have accurate and unbiased information, represents the qualitative characteristic of J comparability. K relevance. L reliability. M timeliness. 5 Outline what is meant by the following terms by giving examples to illustrate your answers. (a) data (b) information

10 14 SACE Stage 2 Accounting Essentials Workbook (c) quantitative information (d) qualitative information (e) subjective value (f) objective value 6 Briefly explain the qualitative characteristics of financial information (relevance, reliability, materiality, comparability, understandability, timeliness, costs versus benefits.) (a) relevance (b) reliability (c) materiality (d) comparability (e) timeliness (f) cost versus benefits

11 Chapter 1 The Role of Accounting 7 Explain whether the following categories of stakeholders are either internal or external users of financial information and why they would be interested in the financial reports of a business. (a) owner(s) (b) employees of a business (c) potential credit providers (d) taxation authority 8 Accounting standards are meant to ensure consistent approaches to a wide range of accounting practices. (a) Who issues accounting standards? (b) What authority do accounting standards have? (c) Why would an accountant be likely to follow the accounting standards? (d) Explain why sole proprietors should follow the accounting standards even though they are not required to publicly publish their financial reports. 15

12 16 SACE Stage 2 Accounting Essentials Workbook 9 Summarise the various factors that have an influence on an entity s financial reporting What do you understand by the term accountability in relation to the roles and duties of the board of directors Explain the difference between general purpose and special purpose reports Describe the three general purpose reports

13 17 2 Accounting Entities What is an Accounting Entity? An accounting entity is any organisational unit for which accounting records are kept and about which accounting reports are prepared. Any business is seen as a separate entity for accounting purposes, regardless of its form of ownership. A business is seen by accountants to have its own existence, its own life and to be separate from the owner. The financial affairs of the owner must be kept separate from those of the business. What is a Legal Entity? The law does not see the separation of the business from the owners in the case of sole proprietors and partnerships. For a business to be seen as a separate legal entity it must be incorporated as a company with the Corporate Affairs Commission. Legal existence of incorporation is also available to clubs, societies, associations and cooperatives. Once a business is formed into a company that company has a separate existence in the eyes of the law and can be held responsible by law for its own actions. A legal entity can sue or be sued. What is a Reporting Entity? Any business or part of a business that prepares a report on its financial activities. Companies such as David Jones, Wesfarmers are required by law to prepare reports that must be distributed to shareholders. Each branch of Wesfarmers may prepare individual branch reports so each would be classified as a reporting entity. Types of Accounting Entities There are a variety of entities that use accounting information. The function of these entities can vary by: Structure this concerns the number of owners, the owner s liability. Purpose this is whether the purpose of the entity may be for profit, eg sole trader, or whether it may be a not for profit entity, eg charities, sporting or social club. Individuals Individuals are separate accounting entities. Individuals may keep financial records and also produce financial reports that may include lists of incomes, expenditures, assets and liabilities. This information may be used for loan applications or Social Welfare means tests, and in the preparation of tax returns or personal budgets. Sole Traders A sole trader is a business that is owned by one person. Sole Traders contribute most of the money and other resources needed to begin a business. Therefore they: take most of the risks stand to make all of the profit must take most of the responsibilities for the business.