Corporate Financial Reporting and Analysis

Topic 1: Nature and Regulation of Companies and Company Operations

Dr Isabel Gordon

Lecture Objectives
Understand differences between public and private companies Appreciate why financial reporting regulations exist Prepare financial statements Critically analyse these financial statements using the Framework criterion for definitions of A, L, OE, R, E

Lecture Outline
1. 2. 3. 4. Nature and types of companies Regulation of companies Why is financial reporting regulated? Revision: the analysis of transactions.

Preparation of the financial statements: -the statement of income and other comprehensive income -retained earnings and the statement of changes in equity -statement of financial position

Lecture Outline (contd)

5. The elements of financial reporting: Assets, liabilities, owners equity, revenue, expenses 6. Accounting policies 7. Brief review of company accounting entries

References
Leo, Hoggett and Sweeting (LHS) Chapters 1 and 3 Useful internet websites (see course outline p.11)

1. Nature and types of companies

Legal nature of company: separate legal identity legal entity distinct from owners - distinguish from partnerships and sole traders - companies act through agents e.g. shareholders elect a board of
directors to act on their behalf

Limited liability of owners

1. Nature and types of companies

Companies in Australia administered under Corporations Act Types of companies 1. Proprietary (private) companies Pty. Ltd. Cannot raise funds from the public Usually not a reporting entity

1. Nature and types of companies

2. Public Companies Limited (Ltd.) Entitled to raise funds from the public May be listed or unlisted

2. Regulation of companies
1) Corporations Law Companies must: keep proper accounting records; prepare yearly and half-yearly financial statements; ensure financial statements comply with accounting standards.

2. Regulation of companies
2) Accounting Standards Australian Accounting Standards Board (AASB) Responsible for issuing accounting standards for all public and private sector entities. Standards have backing of the Corporations Law.

2. Regulation of companies
3) Australian Stock Exchange Listing rules require that companies disclose certain information. Aim for disclosure of information necessary for fully informed stock market. 4) Australian Securities and Investment Commission (ASIC) Administers Corporations Law, including compliance with Accounting Standards.

2. Regulation of companies
5) International Accounting Standards Board (IASB) Attempting to converge or harmonise accounting standards throughout the world.

3. Why is financial reporting regulated?

Who prepares financial reports? Only those entities with interested users are required to prepare financial statements. e.g. BHP Billiton as a publicly listed company is more likely to have interested users rather than the local corner store with one owner

3. Why is financial reporting regulated?

Why do we prepare financial statements? Provide information that is useful for making economic decisions.
(a) resource providers: shareholders, lenders, employees; (b) recipients of goods and services: customers, taxpayers; (c) oversight groups: regulatory agencies, media, unions;

3. Why is financial reporting regulated?

Characteristics that accounting information should have to be useful for decision making

-relevance (predictive; feedback; timely) -faithfully represented (verifiable; reliable; free from bias) Other characteristics: - comparability & consistency - materiality

3. Why is financial reporting regulated?

3. Why is financial reporting regulated?

Management of the publicly listed company is accountable to the owners (shareholders) so management must provide an account to shareholders Accounting standards aim to provide information to users that is useful for economic decision making (forward looking) Stewardship (backward looking)

4. Revision: the analysis of transactions

Transactions are analysed from the point of view of the entity being accounted for. Each transaction is analysed by determining how it has affected the accounting equation: A = L + OE The effect of each transaction on the accounting equation will be balanced The aggregate effect of all transactions on the accounting equation must also balance

Revision: the analysis of transactions Example: a firm purchases $500 worth of supplies on credit. What are the impacts of this transaction? i) increases assets and increases liabilities ii) specific asset is supplies, specific liability is account payable.

Revision: the analysis of transactions Example: a firm pays monthly wages and salaries of $25,000. What are the impacts of this transaction? i) decreases assets and increases expenses (note that we can also think of the increase in the expense as a decrease in owners equity) ii) specific asset is cash at bank, specific expense account is wages and salaries.

Revision: the analysis of transactions

Transactions involving capital contributions, revenues, expenses or dividends will always affect the owners equity since they reflect increases or decreases in the owners claim on the entity When recording transactions think through the following steps: - Classification: What elements of the equation are affected as a result of the transaction? - Change: Has that element increased or decreased as a result of the transaction? - Items affected: What specific items are affected?

Revision: the analysis of transactions

Gloria Ltd was incorporated by Glory and Ria on 1 January, 2012. Each owner contributed $30,000 cash into the business in return for shares. The initial capital contributions would effect the accounting equation as follows: Assets = Liabilities + Owners Equity
Cash Issued Capital

+ 60000

+ 60000

Revision: the analysis of transactions

Recall the normal balances of accounts:
Asset accounts normally debit balance Liability accounts normally credit balance Owners equity accounts normally credit balance Expense accounts normally debit balance Revenue accounts normally debit balance Dividend accounts normally debit balance

Revision: the analysis of transactions

The Statement of Financial Position after the capital contribution on 1 January, 2012:
Gloria Ltd Statement of Financial Position as at 1 January, 2012
Assets Cash 60,000 -Liabilities 0 60,000 Represented by: Owners' Equity Issued capital 60,000

Revision: the analysis of transactions Note how we can derive the basic accounting equation from the Statement of Financial Position Recall the rules of debits and credits:
Assets Dr Cr Liabilities Cr Dr

Increase Decrease

Borrowed $40,000 from Mountain Bank. Interest at 8% p.a is due on 31 December each year. The principal is repayable in full on 31 December 2015.

2
2 3 3 10

Paid $14,400 cash for 12 months rent in advance on store.

Purchased $8,000 in store fittings on credit. Purchased a computer for use in the store for $4,000 cash. Purchased a video library for $30,000. A deposit of $10,000 cash was paid. The balance is due in February. Received $3,000 cash from video rentals

14
18 20

Paid wages $2,500

Received $2,800 cash from video rentals Paid amount owing on store fittings

21
23 25

Paid for advertising in local paper $200

Invoiced local high school for $1,500 in video rentals. Paid for telephone calls $195

26

Received $300 each from thirty customers to join the VIP Programme. The Programme allows them unlimited rentals for the next 12 months.
Received $3,300 cash from video rentals

27

28
31 31 31

Paid wages $2,500

Received amount owing from local high school Paid the following expenses in cash: Postage $165, Electricity $185 Paid a $400 dividend to each owner (Above example adapted from Martin Bugeja notes)

General Journal
Date
1/1

Explanation
Cash at bank Issued Capital (Contribution of capital by proprietor)

Post ref

Debit 60000

Credit

60000

2/1

Cash at bank Loan (Borrowed money from a bank)

Prepaid rent Cash at bank (Paid 12 months rent) Store fittings Accounts payable (Purchased fittings on credit)

40000
40000 14400 14400 8000

2/1

2/1

8000 4000
4000

3/1

Computer Cash at bank (Purchased a computer for cash)

General Journal
Date
3/1

Explanation
Video library Cash at bank Accounts payable (Purchased a video library)

Post ref

Debit 30000

Credit 10000 20000

10/1

Cash at bank Rental revenue (Received cash from rentals)

Wages expense Cash at bank (Paid wages) Cash at bank Rental revenue (Received cash from rentals) Accounts payable Cash at bank (Paid amount owing on fittings)

3000
3000 2500 2500 2800

14/1

18/1

2800 8000
8000

20/1

General Journal
Date
21/1

Explanation
Advertising expense Cash at bank (Paid advertising)
Accounts receivable Rental revenue (Billed customer for rentals) Telephone expense Cash at bank (Paid telephone)

Post ref

Debit 200

Credit
200

23/1

1500 1500 195

25/1

195 9000
9000

26/1

Cash at bank Unearned revenue (Received revenue in advance)

Cash at bank Rental revenue (Received cash from rentals)

27/1

3300

3300

General Journal
Date
28/1

Explanation
Wages expense Cash at bank (Paid wages)
Cash at bank Accounts receivable (Received amount owing on account)

Post ref

Debit 2500

Credit

2500 1500 1500

31/1

31/1

Postage expense Electricity expense Cash at bank (Paid postage and electricity)
Dividends Cash at bank (Paid dividend)

165 185 350

800

31/1

800

Trial Balance
Next, we can post transactions from general journal to general ledger and do trial balance on next two slides

Account No: 100

Account Name Cash at Bank

Debits 76655

Credits

110
150 160 170

Prepaid Rent
Store fittings Computer Video Library

14400
8000 4000 30000

200
210 215 300

Accounts Payable
Unearned revenue Loan Issued Capital

20000
9000 40000 60000

310
400 500 505

Dividends
Rental revenue Wages Expense Advertising expense

800
10600 5000 200

510
515 520

Postage Expense
Telephone Expense Electricity Expense

165
195 185 139600 139600

Relationship between financial statements

Statement of income and other comprehensive income:
Profit = (Revenues Expenses) less income tax + other comprehensive income

Statement of changes in equity:

Other comprehensive income Share capital Reserves Opening retained profits + Profit - Dividends = Closing retained profits

Relationship between financial statements

Statement of changes in equity (contd):

Reserves (contd) General reserve Revaluation surplus

Statement of financial position: Assets = Liabilities + Owners equity Where Owners equity = issued capital + retained earnings + reserves

Further information for example

Assume that Glory Ltd revalued the video library by another $1500. Entry is: Dr Video library 1500 Cr Revaluation surplus 1500
Note that the increase in value of video library is shown in other comprehensive income. (See also example in text p. 122).

Statement of income and other comprehensive income for Glory Ltd

Glory Ltd Statement of income and other comprehensive income For period ended 31 January 2012
Income Rental revenue Expenses (classified by function)
Selling expenses -advertising Administrative expenses -telephone

10600

200 195

Statement of income and other comprehensive income for Glory Ltd

-electricity -postage -wages Financial expenses -interest Total expenses Profit before income tax Income tax expense (30%) Profit for the year Other comprehensive income Gain on revaluation of video library Total comprehensive income 185 165 5000 5745 4855 (1457) 3398
1500 4898

Statement of changes in equity

Glory Ltd Statement of income and other comprehensive income For period ended 31 January 2012 Total comprehensive income for the year 4898 Share capital Balance at 1 January 2012 60000 Balance at 31 January 2012 60000 Reserves General reserve Balance at 1 January 2012 0 Balance at 31 January 2012 0

Statement of changes in equity (contd)

Revaluation surplus Balance at 1 January 2012 Gain on revaluation video library Balance at 31 January 2012 Retained earnings Balance at 1 January 2012 Profit for period Dividend paid Balance at 31 January 2012 Balance changes in equity

0 1500 1500

0 3398 (800) 2598

68996

Statement of financial position

Glory Ltd Statement of financial position As at 31 January 2012

Current assets
Cash Accounts receivable Prepaid rent 76655 0 14400 91055

Non-current assets
Store fittings Video library Computer 8000 31500 4000

Total assets

134555

Statement of financial position

Current liabilities
Unearned revenue Accounts payable Tax payable 9000 20000 1457 30457

Non-current liabilities
Loan 40000

Total liabilities
Net assets

70457
64098

Statement of financial position

Glory Ltd Statement of financial position As at 31 January 2012
Equity Share capital Reserves Retained earnings Revaluation surplus Total equity

60000
2598 1500 64098

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Recall that each transaction is analysed by determining how it has affected the accounting equation: A = L + OE

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

An entity will be affected by two types of events: external events:- sale of a product - purchase of equipment - borrowing money from bank internal events:- use of supplies by an employee - use of equipment to perform a service An event is only recorded if it affects the entitys assets, liabilities or owners equity

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Note that transactions involving capital contributions, revenues, expenses or dividends will always affect the owners equity since they reflect increases or decreases in the owners claim on the entity Eg. we can also think of the increase in the expense as a decrease in owners equity

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Question: so if we review the financial statements just prepared for Gloria Ltd, how can we determine that, after analysing each transaction, an asset, liability or owners equity exists? Answer: why dont we look to the IASBs The Framework (similar to the Conceptual Framework) for the definition of an asset, liability or owners equity?

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

The IASB Framework has definitions of A, L and OE We can see if the accounts we created e.g. Advertising expense of $195 is an expense (and, say, not an asset) We do this by checking the definition criterion of an expense and an asset in The Framework to see whether, based on our professional judgement, Advertising of $195 has defining characteristics of an expense (and not an asset)

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Asset defined as: A resource controlled by the entity as a result of past transactions or events from which future economic benefits are expected to flow to the entity. Definition criterion: 1. Future economic benefits (cash or cash equivalents) 2. Control of future economic benefits 3. Is a result of past events

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Liability defined as:

Future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events. Definition criterion: 1. Present obligation 2. Sacrifice; settlement of resources in future 3. Result of past event

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Equity defined as:

The residual interest in the assets of the entity after deduction of its liabilities.

Definition criterion? None, since equity not presently defined independently of an asset or liability. Main components: -issued capital -retained earnings -reserves

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Income defined as:

Inflows or other enhancements, or savings in outflows, of future economic benefits in the form of increases in assets or reductions in liabilities other than those relating to contributions from owners, that result in an increase in equity during the reporting period

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Note that income arises as a result of changes in assets and liabilities the balance sheet approach Income includes both revenue and gains

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

AASB101 Presentation of Financial Statements requires the disclosure of Total comprehensive income Represents the change in equity (net assets) during a period resulting from non owner related transactions and other events.

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Expense defined as: Consumptions or losses of future economic benefits in the form of reductions in assets or increases in liabilities of the entity, other than those relating to distributions to owners, that result in a decrease in equity during the reporting period.

5. The elements of financial reporting: Assets, liabilities, revenue, expenses, owners equity

Note that expense arises as a result of changes in assets and liabilities the balance sheet approach

General recognition criterion

Recognition criterion applied to A, L, OE, R and E: 1. It is probable that future economic benefits associated with the item will flow to/(from) the entity (more likely than less likely) 2. The item has a cost or other value that can be measured reliably

A few points to note

The definitions of A, L, OE, R and E are currently being reviewed Matching principle for R and E not as relevant There is separate accounting standard for revenue (AASB 118) but this is currently under review Expenses (such as depreciation) are normally covered in individual accounting standards e.g. Accounting for property, plant and equipment so you need to refer to these

Contingent assets and liabilities

Additional recognition criteria for provisions contained within AASB 137 Provisions, Contingent Liabilities and Contingent Assets The amount recognised should be the best estimate of the expenditure required to settle the present obligation at the reporting date

Contingent assets and liabilities

Such amount are not recognised in financial statements Disclosed by way of note
Note that the IASB proposes removal of these terms

Measurement
Measurement: how to place a monetary amount on A, L, OE, R and E? Alternatives include historic cost, current cost, replacement value, present value, fair value Most liabilities stated at face or nominal value except if settled beyond twelve months then can use present values e.g. Accounting for pensions

Classification
Note classification (of expenses) by nature or function See text p. 121-122 for classification of expenses by function e.g. Selling, administrative, financial expenses Can also classify by nature

6. Accounting policies Accounting policies are the principles, bases or rules adopted by a company in preparing and presenting its financial reports
AASB 108 Accounting Policies, changes in Accounting estimates and error covers: Setting accounting policies Changing accounting policies Disclosures in the financial statements concerning accounting policies

Accounting policies
In selecting accounting policies management should consider: Relevance Faithful representation (or Reliability) Accountability Relevant information enables users to: Make predictions or form expectations about the future performance of an entity Confirm or refute past evaluations Assess the accountability rendered by the preparers of the financial statements

Accounting policies
Faithfully represented information or Reliable information is free from material error and can be depended upon by users to represent faithfully that which it purports to represent Portraying economic substance over legal form

7.Brief review of company accounting entries

Contributed capital or issued capital e.g. Ordinary shares or preference shares issued for cash Dr cash Cr Issued capital -note that this can be done in two stages application and allotment

7.Brief review of company accounting entries

Or if other consideration received (other than cash) for issue of shares:

Dr other asset Cr issued capital

7.Brief review of company accounting entries

To increase retained profits with profit: Dr P&L summary Cr Retained profits Or if we make a loss on trading: Dr Retained earnings Cr P&L Summary

7.Brief review of company accounting entries

To transfer from retained profits to general reserve: Dr Retained profits Cr Reserve - Note effect of entry is to decrease retained earnings

7.Brief review of company accounting entries

To distribute dividend to owners/shareholders: Interim dividend: Dr Dividend declared (Ret E) Cr Cash Final dividend Dr Dividend declared Cr dividend payable, and

7.Brief review of company accounting entries

Dr Dividend payable Cr Cash When dividend paid in next accounting period

Next week
Financing Company Operations Chapter 2 text