Company Accounting Assessment - Case Study Example

Company Accounting Assessment The conceptual framework for financial accounting and reporting is a constitution, which contains a logical system of unified objectives and fundamentals, which leads to consistent standards that prescribe the nature, functions and limits of financial accounting and reporting. The fundamentals are the underlined concepts of accounting that guides the choice of events to be accounted for, the measurement of those events (transactions) and the means of summarizing and communicating them to concerned parties. In addition, new and emerging issues should be quickly solved by reference to an existing framework of basic theory. Over the years, numerous organizations, committees and interested individuals have developed and published their own conceptual framework, but no single framework has been universally accepted and relied on in practice. In general, conceptual framework for financial reporting is based on three levels. I. Objective of financial reporting and financial statements: the objectives of financial reporting and financial statements are derived from the needs of external users of accounting information. According to AASB (2004), stating the objectives of financial statements would be simple if all the external users had the same needs and interests, but this is not the case. II. Qualitative characteristics of accounting information: reported accounting information should be free of bias intended to achieve a predetermined result or to provoke a certain mode of behaviour. Freedom from bias is essential, for instance, financial statements designed solely to influence the action of investors could be damaging to the needs of the creditors and other major user group for financial statements. Accounting information should show an agreement between a measure and real world phenomenon that the measure is supposed to represent. For instance, if a company report sales amounting to, say, $170 million in its income statement when actually the sale amounted to $ 150 million, then the company statements are not faithful representation of the real fact. Accounting information should show consensus between different measures. Amenc and Le Sourd (2003) observe that the truth of accounting information should be verifiable by examination of evidence of underlying facts. The user of this information should be able to see the similarities and differences among events and conditions. Information that has been measured and reported in a similar manner is considered comparable (Black, 2003). Comparability of the financial statements of a business enterprise from one accounting period to the next is essential if favourable and unfavourable trends in the enterprise are to be identified. However, differences in the operating policies among different enterprises results in the adoption of various accounting practices in such areas as valuation of inventories and depreciation of plant assets. Whatever practice adopted the company has to be consistent in its application. This will permit valid comparison between different accounting periods (Weygandt, et al., 2009). However, it does not imply that a defective accounting principle should not be changed. Accounting principles and methods changes in response to changes in the environment of accounting. When an accounting change is desirable, it should be made together with disclosure of the change. In addition, it should show its effect in money measurement on the reported net income of the accounting period in which the change is made. III. Recognition and measurement concept: the concept explains how, when and which financial elements and transactions should be recognized, measured and reported by the system of accounting. The concept serves as guidelines for developing rational responses to controversial financial reporting issues. Every firm is supposed to abide by the “Generally Accepted Accounting Principles” (GAAP). Therefore, firms should prepare their financial statements in an acceptable manner so that they can be compared with the previous year’s statement and to some extent with the statements of other enterprises. The accounting principles must be developed in relation to the stated objective of financial reporting and financial statements. According to Brown and Matysiak (2007), the activities of a business enterprise should be separated and distinguished from those of its owners and other business entities. A business enterprise is assumed to be a going concern; therefore, probable future benefits should be recorded as assets and probable future outlays as liabilities. This affects the classification of assets and liabilities in the balance sheet. The matching principle requires that after the revenue of an accounting period has been determined the cost related to this revenue must be deducted (from the revenue) to measure the net income. The revenue should be recognized when realizable and earned (Donald, et al., 2009). Under AASB 112, deferred tax assets (DTAs) is recognizable for deduction of temporary differences, tax losses and tax credits that have not been used as much as taxable profit is probable. DTAs cause a decline in tax payments of future income. They are considered as assets since they are prepaid, which can be misleading, in as much as assets are concerned. Deferred tax liabilities (DTLs) are measured at the rate of tax expected to be applicable during the settlement of liability. DTAs cause a rise in tax payments of future income. They are considered liabilities since they are accrued, which can be misleading, in as much as liabilities are concerned. Revenues are considered earned when the business enterprise has completed what it must do in order to have entitlement to the benefit represented by the revenue. Furthermore, financial statements should be complete in the sense of improving all information necessary to users of the statements (Fess and Warren, 2004). AASB 112 recognizes tax as an expense to the firm, and a tax rate is subjected to the net profit of the firm during that year. When that tax is due, but the firm has not paid, it is treated as a liability to the firm. It is referred to as “deferred tax liability”. This is right since they existed at the balance sheet date, and there is a probability they will have to be paid (Picker, 2009). This meets the definition of current liabilities. Once in a while the government may lower the tax rate applicable after the firm has submitted its tax returns. The firm is entitled to the excess tax it had paid, which becomes a prepaid tax expense by the firm. AASB 112 rightly classifies this as current assets, and the firm will use it to settle its tax expense of the succeeding period. This reduces the tax payment for this period. Recognition of Deferred Taxes Both companies (FGL and CCL) recognize tax in the accounting period it is payable when net income has been made. Tax is an expense chargeable against the net income. The amount that is not paid (though it is payable) is recognized as deferred taxes. These amounts are accumulated in the deferred taxes account. Accounting Treatment for Deferred Taxes In both companies, deferred tax assets are treated as noncurrent assets, and deferred tax liabilities are treated as noncurrent liabilities. Therefore, DTAs and DTLs are balance sheet items. DTAs are probable future economic benefits controlled by the firms as a result of their previous transaction with the Government. Therefore, they are assets to the company and should be treated, as such, to indicate the correct financial position of the firms. DTLs are external liabilities because they have to be paid to an external party (the government). These are probable future sacrifices of economic benefit, which arise from previous obligation of the companies, to make payment to the government as a result of their business activities. Disclosure of Deferred Taxes In both companies, DTAs and DTLs are disclosed in the notes to the financial accounts. The obligations of DTAs and DTLs are probable; therefore, they are not contingent assets and liabilities respectively. They require the creation of provisions in order for them to be assets and liabilities. Amount of Deferred Taxes Company Amount of Deferred Taxes 2010 2009 2008 DTAs DTLs DTAs DTLs DTAs DTLs Foster’s Group Limited ASX Code: FGL 330.0 555.2 425.4 695.5 317.7 724.7 Coca-Cola Amatil Ltd ASX Code: CCL 1.2 190.8 1.1 157.4 - 138.7 Impact of Deferred Taxes on Financial Statements DTAs decrease income tax payments in the future while DTLs increases income tax payments in the future. Therefore, including deferred taxes will cause a change in earnings after tax (EAT). Furthermore, DTAs are considered to be assets while DTLs are considered to be liabilities. This will have the effect of changing the value of assets and liabilities reported in the balance sheet of the companies. Including DTAs will lower the fixed assets turnover, total assets turnover and return on investment (ROI) since DTAs are treated as noncurrent assets. The impact of deferred taxes on debt ratio will depend on the net balance of deferred taxes. The debt ratio will be higher if DTLs are more than DTAs, and lower if DTAs are more than DTLs. Impact on Users’ Decision Making Process The primary objective of financial reporting is to provide useful information for decision makers (Greite, 2007). Users of accounting information do not have similar needs and interests; therefore, since these financial statements serve a variety of users, the needs of some of the users receive more emphasis than the need of others. The ultimate measure of the performance of the firm is not the firm’s earnings but how investors value the earnings. A low return on investment will discourage existing investors and scare potential investors. If a decision maintains or increases the firm’s overall value, it is acceptable from a financial view point (Greuning, 2005). References AASB (Australian Accounting Standards Board), 2004. Framework for the Preparation and Presentation of Financial Statements. Melbourne: Australian Accounting Standards Board. Amenc, N. and Le Sourd, V., 2003. Portfolio theory and performance analysis. New Jersey: John Wiley and Sons. Black, G., 2003. Students' Guide to Accounting and Financial Reporting Standards. London: Financial Times Prentice Hall. Brown, G.R. and Matysiak, G.A., 2007. Real Estate Investment: A Capital Market Approach. London: Financial Times. Donald, E. et al., 2009. Intermediate Accounting. New Jersey: John Wiley and Sons. Fess, E. and Warren, C., 2004. Accounting principles. Canada: Southwestern Company. Greite, S., 2007. The Development of the Australian Accounting Standards after the End of the G4+1. Sydney: GRIN Verlag. Greuning, H. V., 2005. International financial reporting standards: a practical guide. New York: Routledge. Horngren, C. T. & Harrison, W. T., 2007. Accounting (7th edition). Upper Saddle River, NJ: Pearson Prentice Hall. Picker, R., 2009. Australian accounting standards. Australia: John Wiley & Sons Australia, Limited Weygandt, J. et al., 2009. Managerial Accounting: Tools for Business Decision Making. New York: John Wiley and Sons. Read More