BA606 FINANCIAL ACCOUNTING

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BA606 FINANCIAL ACCOUNTING

• Professor Garry Carnegie
• Lectures 11 12

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Lecture 11 Cash flow statement

• Introduction
• Funds statement
• Definition of funds
• Reporting cash flow information
• Accounting standards

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Introduction

• The cash flow statement is one of four financial
  statements resulting from the financial reporting
  process
• The cash flow statement provides information
  about an entitys operating, investing and
  financing activities
• Prior to the requirement to prepare cash flow
  statements in Australia, it was necessary to
  prepare funds statements

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Funds statement

• The funds statement was also known as a
  statement of funds flow or a statement of
  sources and applications of funds
• This statement was deemed to be necessary as the
  balance sheet and income statement did not
  present a complete picture of an entitys
  economic activities
• The statement was seen as necessary to summarise
  investing and financing activities

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Funds statement

• The first Australian accounting standard on this
  topic was issued in 1983
• This standard adopted the total resources
  concept of funds
• The standard did not require the disclosure of
  cash flow information
• AASB 1026 Cash Flow Statements was issued in
  December 1991
• Now, AASB 107 (of the same title) applies

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Definition of funds

• An increase in funds is a source of funds
• A decrease in funds is a use of funds
• The use of funds is also known as the
  application of funds
• There are three conceptions of funds
• - Cash
• - Working capital
• - Total resources

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Definition of funds

• Cash
• Where funds are interpreted as cash, any
  transaction that increases cash is a source of
  funds and any transaction that reduces cash is a
  use or an application of funds
• Cash flow statements are prepared for use
  monitoring an entitys cash movements

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Definition of funds

• According to the Framework, information
  concerning cash movements of an entity is useful
  in order to assess its investing, financing and
  operating activities during the reporting period.
  This information is useful in providing the user
  with a basis to assess the ability of the entity
  to generate cash and cash equivalents and the
  needs of the entity to utilise those cash flows
  (para. 18)

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Definition of funds

• Sources of cash
• - Decrease in assets
• - Increase in liabilities
• Uses of cash
• - Increase in assets
• - Decrease in liabilities

10
Definition of funds

• Working capital
• Working capital is measured as current assets
  less current liabilities
• An increase in working capital is a source of
  funds
• A decrease in working capital is an application
  (or use) of funds

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Definition of funds

• An increase in working capital occurs when there
  is an increase in total current assets without a
  corresponding increase in total current
  liabilities
• A decrease in working capital occurs in the
  opposite circumstances
• The difference between sources and uses of
  working capital will be equal to the change in
  working capital between successive balance sheets

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Definition of funds

• Total resources
• This conception of funds is based on an
  interpretation of the balance sheet as a
  statement which shows the sources of an entitys
  resources and how those resources have been used
• This approach, as mentioned earlier, was adopted
  in the first Australian accounting standard on
  the funds statement

13
Definition of funds

• Under this view of funds, the obligations side of
  the balance sheet shows the financial resources
  that have been provided by lenders and
  shareholders and the assets side of the balance
  sheet shows how these resources have been used

14
Definition of funds

• Any transaction that increases liabilities or
  equity is a source of funds
• Any transaction that reduces liabilities or
  equity is a use of funds
• Any transaction that increases assets is a use of
  funds
• Any transaction that reduces assets is a source
  of funds

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Reporting cash flow information

• Cash flow reporting is justified on the grounds
  that such information is useful in providing
  users of financial reports with a basis to assess
  the ability of the entity to generate cash and
  cash equivalents and the needs of the entity to
  utilise those cash flows (AASB 107, Objective
  also see AASB101, para. 111)
• Cash flow information is shown by preparing a
  cash flow statement which classifies cash flows
  during a period from operating, investing and
  financing activities (Objective)

16
Reporting cash flow information

• The cash flow statement complements the income
  statement and the balance sheet
• It is an essential component of the financial
  reporting process

17
Reporting cash flow information

• When used in conjunction with other financial
  statements, the cash flow statement provides
  information that enables users to evaluate the
  changes in net assets of an entity, its financial
  structure (including its liquidity and solvency)
  and its ability to affect the amounts and timing
  of cash flows in order to adapt to changing
  circumstances and opportunities (AASB 107, para.
  4, emphasis in original)

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Accounting standards

• Definitions are found in para. 6
• Cash and cash equivalents are elaborated upon in
  paras. 7- 9
• Classification of cash flows into operating,
  investing and financing activities (para. 10
  also see paras. 11 and 12)

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Accounting standards

• For discussion of operating activities (see
  paras. 13 to 15) investing activities (para. 16)
  and financing activities (para. 17)
• The reporting of cash flows from operating
  activities is to be made using the direct method
  or approach or the indirect method or approach

20
Accounting standards

• Under the direct method major classes of gross
  cash receipts and gross cash payments are
  disclosed para. 18(a) also see para. 19
• Under the indirect method profit or loss is
  adjusted for the effects of transactions of a
  non-cash nature, any deferrals or accruals of
  past or future operating cash receipts or
  payments, and items of income or expense
  associated with investing or financing cash
  flows para. 18(b) also see para.20

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Accounting standards
22
Accounting standards

• When an entity uses the direct method, a
  reconciliation of cash flows arising from
  operating activities to profit or lass shall be
  disclosed in the financial report (para.
  Aus20.1)
• Reporting cash flows from investing and financing
  activities (para. 21)
• Reporting cash flows on a net basis is permitted
  for operating, investing or financing activities
  under certain circumstances only as specified
  (para. 22 also see paras. 23 and 24)

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Accounting standards

• Format of the cash flow statement (see H, P H,
  p. 604)
• Interest and dividends (para. 31 also see paras.
  32-34)
• Presentation of cash flows from operating
  activities (see H, P H, p. 605-606)

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Accounting standards

• One of the limitations of a cash flow statement
  is that it omits non-cash investing and financing
  activities, such as acquiring another entity
  through the issue of shares acquiring assets by
  assuming directly related liabilities or
  converting debt to equity
• Para. 43 requires note disclosure of investing
  and financing transactions with external parties
  that do not require the use of cash or cash
  equivalents in providing relevant information
  (also see para. 44)

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Lecture 12 The choice of accounting methods

• Introduction
• Choice by accounting standard setters
• Choice by financial report preparers

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Introduction

• Accounting standard setters and preparers are
  required to make choices among alternative
  recognition, measurement and disclosure policies
• Such choices are influenced by a range of factors
• Accounting standards themselves may implicitly or
  explicitly allow choices or broader choices may
  be available where no specific accounting
  standard exists on a particular topic

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Choice by accounting standard setters

• Accounting standard setters are charged with the
  responsibility of setting the most appropriate
  accounting policy or policies from a range of
  alternatives
• Such choices are critical as the treatments
  specified for adoption in accounting standards
  effectively determine accounting practice (or
  what is broadly known as generally accepted
  accounting practice)

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Choice by accounting standard setters

• The process of choice by accounting standard
  setters is discussed by H. P H, pp. 192-196
  with regard to four time periods
• - Ad hoc period
• - Conceptual framework period
• - Harmonisation period
• - Convergence period

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Choice by accounting standard setters

• Ad hoc period
• Dates from early 1970s to late 1980s
• Choices were largely political
• Choices were primarily determined by their
  acceptability to the business community rather
  than by their consistency with theoretical
  considerations

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Choice by accounting standard setters

• Conceptual framework period
• Dates from late 1980s to 1997
• The principal reason for establishing the
  conceptual framework was to assist accounting
  standard setters in issuing and revising
  standards
• Standards based on the conceptual framework were
  less prone to attack by lobbyists

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Choice by accounting standard setters

• Harmonisation period
• From the mid to late 1990s, support for the
  harmonisation of Australian accounting standards
  with International Accounting Standards
  strengthened
• A program was adopted to ensure greater
  consistency between Australian and IAS accounting
  standards
• This period closed in June 2002

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Choice by accounting standard setters

• Convergence period
• Dates from June 2002 when the Financial Reporting
  Council announced that AASB standards would be
  converged with accounting standards of the IASB.
• In effect, Australia adopted IASB accounting
  standards (that are known as AIFRS) for
  application to reporting periods beginning on or
  after 1 January 2005

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Choice by financial report preparers

• Preparers are to choose accounting policies and
  adopt accounting treatments that are best suited
  to particular transactions and other past events
• H, P H, pp. 197-210 discuss this choice under
  the following headings
• - Availability of choice
• - Creative accounting
• - Positive accounting theory

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Choice by financial report preparers

• Availability of choice
• Standards do not exist of all accounting topics
• Choice is often available within accounting
  standards on issue
• Professional accountants make judgements in
  specific circumstances about matters which have
  conclusions in the future, thus necessarily
  leading to the use of assumptions and estimates
  in financial reporting
• The exercise of judgement is the hallmark of the
  professional accountant

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Choice by financial report preparers

• Creative accounting
• The making of choices in order to present the
  impression desired by preparers
• Accountants may be creative in their
• - Choice of accounting policies
• - Estimates or predictions
• - Disclosure
• - Timing of transactions

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Choice by financial report preparers

• Positive accounting theories
• The key theories or research approaches are known
  as
• - Income-smoothing hypothesis
• - Contracting and agency theories

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Choice by financial report preparers

• Income-smoothing hypothesis
• Under this theory, shareholders satisfaction
  with managers increases as managers achieve
  dependable rates of growth and stable reported
  profits
• Research, especially in the late 1960s and 1970s,
  suggests inconclusive results

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Choice by financial report preparers

• Contracting and agency theories
• Individuals act to advance their own
  self-interest but appear to take the interests of
  others into account in acting in their own
  interests
• Such theories assume that individuals are wealth
  maximisers
• Accounting policy decisions with respect to
  recognition, measurement and disclosure affect
  wealth or, indeed, the determination of wealth
  for distribution to stakeholders

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Choice by financial report preparers

• Under contracting theory, a firm is a collection
  of self-interested individuals who agree to
  co-operate
• Cooperation is obtained through contracts
• The process of contracting is costly
• Contracting costs include agency costs which
  arise in agency relationships such as between the
  owner and the manager or between the debt holder
  and the manager
• Contracts include bonding and monitoring
  arrangements

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Choice by financial report preparers

• Agency costs consist of the costs incurred to
  reduce opportunistic behaviour, plus the costs of
  those forms of opportunistic behaviour that it is
  uneconomic to eliminate
• Accounting assists in contract design and also
  provides data for monitoring the terms of the
  contracts
• Accounting is not passive score-keeping and
  accounting policy decisions are not neutral
• Contracting theory predicts that agents will
  choose the form of accounting that best serves
  their self-interest

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Choice by financial report preparers

• According to H, P H (p. 210), generally
  accepted accounting principles are those that
  have been found to be cost effective in limiting
  the harmful effects of the conflicting interests
  of the parties
• Opportunistic behaviour cannot be eliminated as
  Enron and WorldCom in the United States and HIH
  and OneTel in Australia, among other recent cases
  of corporate collapse, confirm and future
  examples are surely on the way