Accy 131 Notes PDF

Accounting 131 Notes Week 1 - Acts of Parliament Regarding Financial Reporting (GAAP = Generally Accepted Accounting Practices) (XRB = External reporting Boards) ( GPFR - General purpose financial reports = are intended to meet the needs of users who are not in a position to require an entity to pr...

Accounting 131 Notes Week 1 - Acts of Parliament Regarding Financial Reporting (GAAP = Generally Accepted Accounting Practices) (XRB = External reporting Boards) ( GPFR - General purpose financial reports = are intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs) Financial Reporting Act 2013 - Gives legislative authority to the XRB to issue financial reporting and auditing standards - XRB determines GAAP Financial Markets Conduct Act 2013 - Requires FMC reporting entities to prepare, audit and lodge financial statements in accordance with GAAP. Companies Act 1993 - Requires large companies, overseas companies or subsidiaries of overseas companies to prepare, audit and lodge financial statements in accordance with GAAP Charities Act 2005 - Requires registered charities to produce and audit financial reports Public Finance Act 1989 and Crown Entities Act 2004 - Require state sector bodies to produce financial reports under GAAP and have them audited Local Government Act 2002 - Local Bodies and council controlled organizations Structure of Financial Reporting in NZ Based on a 2 sector, multi standards accounting For Profit entities - Tier 1 & 2 Not for Profit Entities - Tier 1 2 3 4 Public Sector Entities - Tier 1 2 3 4 Whose policies are the rules? There are various government agencies and organizations whose role is to enforce reporting laws and ensure that businesses are behaving according to ethical standards. These include XRB, FMA, NZX, CAANZ, CPA aus. Auditors Various acts require the financial reports of certain entities to be audited Main duty of auditors is to make a report declaring whether the financial statements fairly reflect the entities financial performance, financial position and cash flows and whether they have been prepared in accordance with GAAP. Week 2 - Bookkeeping principles and General Ledger Including in these notes Analyze the effect of accounting transactions and events on the basic accounting equation. Explain what an account is and how it helps in the recording process Define debits and credits and explain how they are used to record accounting transactions. Identify basic steps in the recording process. Explain what a journal is and how it helps in the recording process. Explain what a general ledger is and how it helps the recording process. Explain posting and how it helps in the recording process Understand the basic process and main features of the GST The Recording process Accounting Transactions and events Transactions are external exchanges of something of value between 2 or more entities. Events include price increases in assets during an accounting period or the allocation of the cost of the long lived assets of an entity to different accounting periods. Accounting transactions and events must be recorded because they have an effect on assets liabilities equity. Assets= Liabilities+equity for analyzing transactions Eg Summary of Accounting transaction Each transaction is analyzed in terms of its effect on assets, liabilities and equity. The two sides of the accounting equation must always be equal. ASSETS MUST EQUALS LIABILITIES PLUS EQUITY. The cause of each change in equity must be indicated Analyzing transactions Any increase to the left hand side of the equation is a debt. These represent applications or uses of funds. Funds can be used or applied to acquire assets, pay expenses, pay for distributions to investors. Any increase in the right hand side of the equation is called a credit. These represent sources of funds. Funds can come from borrowing, income generated by the organisation, or contributions from investors. Debits and Credits Debit Left side Dr Credit Right Side Cr Assets Increase Debit ( Normal Debit) Decrease Credit Liabilities Decrease Debit Increase Credit ( Normal balance) Share Capital Decrease Debit , Increase Credit ( Norm Balance) Retained Earnings Decrease Debit , Increase Credit ( Norm Balance) Dividends Increase debit ( norm balance) Decrease credit Expenses Increase Debit ( Norm Balance) , Decrease credit Revenues Decrease debit, Increase credit ( normal balance) Equity Relationships Steps in the recording process 1. Analyze each transaction in terms of its effects on the accounts 2. Enter transaction information in a journal 3. Transfer POST journal information to appropriate accounts in ledger A journal is a chronological record of all transactions Discloses the complete effect of a transaction This helps prevent errors as debit and credit amounts are easily compared. Individual asset accounts ( Equipment, Land, Supplies, Cash) Individual liability accounts ( Interest P, Salaries P, Accounts Payable, Loan) Individual equity accounts ( Salaries E, Service R, Share Capital, Retained earnings) Posting Posting is the procedure of transferring journal entries to ledger accounts 1. Enter date in account to be debited 2. Enter name of ledger account to be credited 3. Enter amount to be debited 4. Ticket account number in general journal to show entry is posted 5. Repeat for the credit side The Trial Balance A trial balance is a list of all the accounts and their balance at a given time listed in order as they appear in a general ledger It proves the mathematical equality of debits and credits after posting 1. List account numbers titles and balance 2. Total debit and credit columns 3. Verify equality of debit and credit columns Limitations of a trial balance Errors not detected in a trial balance - A transaction is not journaled - A correct journal entry is not posted - A journal entry is posted twice - Incorrect accounts used in journalising or posting - Offsetting errors made in recording the amount of a transaction Introductions GST Overview of GST act The GST is a tax on the supply of goods and services by a registered person in the course of furtherance of their taxable activity. Supply involves any transaction for consideration Registered person is someone registered with the IRD for GST purposes Taxable activity is continuous or regular activity involving the supply of goods and services. GST rate is 15% in NZ. GST Act Means that an accounting system also needs to account for GST on all transactions Most business, charities, schools, government entities are registered but note that certain transactions are excluded ( Residential rents, financial services, exported goods and services) Because GST is collected on behalf of the government, it will not go through the profit and loss account - not a cost of business. It is only a balance sheet item ( recorded as the net amount owing to or from the IRD) Reason Debit Credit Retailed purchases 10 tables on credit for 440 Inventory 10x400 = 4000 GST Paid 400 Accounts payable 4400 Retailer returns 3 tables Accounts Payable 1320 Inventory 1200 GST Paid 120 Retailer sells 5 tables for 550 Accounts receivable 2750 GST Collected 250 Sales 2500 Cost of Sales 2000 Inventory 2000 Customer returns one table Sales return 500 GST Collected 50 Accy Receivable 550 Inventory 400 COS 400 Customer pays account within discount period Cash 2200x98% = 2156 Discount allowed 200x2% = 40 ACCy Receivable 2200 Remitting GST to IRD GST collected is less than GST paid refunded by IRD GST COllected 196 Cash 70 GST PAid 266 Remitting GST to taxation authority GST Collected 200 GST Paid 160 Cash 40 Week 3 Learning objectives Understand the role of the balance sheet and describe the steps that need to be undertaken to prepare a balance sheet. Define assets, liabilities and equity. Explain the criteria that need to be satisfied for asset, liabilities and equity recognition. Explain how to measure various classes of assets, liabilities and equity. Understand some of the limitations of the balance sheet. The balance sheet provides info about the businesses financial position Presented in the form ( assets - liabilities = owners equity) it provides info about info at that point in time. Reports assets and claims on those assets ( liabilities and equity) at a specific point in time ( snapshot) Based on the basic accounting equation 1. assets= liabilities + equity 2. Assets - liabilities = equity Assets must balance to the claims on assets. Why prepare a balance sheet? - To help determine the ability of an organization to pay debts For example, current assets might be compared with current liabilities - To help determine the ability to change the nature of operations. For example, what proportion of the total assets are held in property, plant and equipment that is potentially specialized in nature? - To assist in determining the value of an organization, However, many valuable ‘assets’ might not be recognised - To determine the sources of funding, The greater the reliance on debt, the greater the risk - To help determine the efficiency of management, For example, profit might be compared with total assets or total shareholder funds Lots of questions can be answered through the balance sheet. 1. How much cash? 2. Ending balance of accounts receivable? 3. Amount of inventory at year end? 4. Historical cost of property, plant and equipment – PPE? 5. Net value of PPE? 6. Fair value of PPE? 7. Net value of intangible assets? 8. Net value of investments? 9. How much is owned in total? 10. Ending balance of accounts payable? 11. How much is owed to employees? 12. How much is owed to the government? 13. Total short- and long-term liabilities? 14. Amount of owners’ contribution? 15. Accumulated retained earnings? 16. Total claims to assets? The definitions Asset: A present economic resource controlled by the entity as a result of past events Liability: a present obligation of the entity to transfer an economic resource as a result of the past events. Equity: the residual interest in the assets of the entity after deducting all of its liabilities. Recognising assets An asset or liability is recognised only if recognition of that asset or liability and any resulting income,expenses or changes in equity provides users of a financial statement with information that is useful, that is with relevant info about the asset or liability. A faithful representation of the asset or liability and any resulting income, expenses, or changes in equity. Relevance To satisfy the test of ‘relevance’ Existence uncertainty - Existence uncertainty refers to uncertainty about whether an asset or liability exists - So does the right actually exist - Levels of probability associated with expected future inflows of economic benefits - If there is a low probability then info about the asset might not be relevant Faithful representation What is the level of measurement uncertainty If measurement uncertainty is high, then a faithful representation of an asset might not be possible. Factors to consider before recognising an asset - Whether the item has the potential to generate future economic benefits - Whether the item is controlled by the organization - Whether there is any existence uncertainty - The probability of expected inflows or outflows of economic benefits - Whether there is any measurement uncertainty Sun Ltd has paid for what it believed to be a right to publish and distribute a well-known novel. However, another organization – Moon Ltd - has notified Sun Ltd that they believe these rights are legally held by Moon Ltd. Should Sun Ltd recognise an asset? At this point there is some uncertainty about whether an asset or liability exists. But because relevance and representational faithfulness are two criteria needed to be satisfied in order for recognition, this case should not be recognised as an asset. Venus Ltd has some inventory of paisley shirts. Because of changes in fashion tastes, such shirts are now not in great demand Management thinks there is a chance of about 10% that they will be able to sell the Shirts. Should the shirts be recognised as an asset? In this case there is only a 10% chance that Venus can sell the shirts, low probability, info about the assets therefore is not likely to be relevant, therefore shouldn’t be recognised as an asset. Mars Ltd constructed a wave making surf park in Central Australia, hundreds of kilometers away from a major town. It developed the park to sell to investors. However, there is a high level of uncertainty as to how much the park could be sold for. Estimates are anywhere between $100 million and $1 million. Should the park be recognised as an asset? Measurement uncertainty arises when monetary amounts cannot be directly observed and must be estimated. It is not usual for measurement uncertainty to exist for assets. However, if the level of uncertainty in measuring an asset, which we refer to as measurement uncertainty, is so high that it is questionable whether a sufficiently faithful representation can be provided, then an asset should not be recognised. Since there is a high degree of measurement uncertainty with respect to the park, it is appropriate to NOT include the park with the other assets. Measuring assets Once we have determines than asset - Satisfies the definition of an asset - Meets the recognition criteria that the related information is relevant and representationally faithful Next step is to assign a measurement to the asset. Measurement Whilst it might seem appropriate that all assets of all types will be measured in the same way, perhaps at cost or at fair value. Not the case. Assets and liabilities are measured in a variety of ways depending upon the type, or class, of the assets in question. For example, accounting standards require that - Inventory is measured at a lower of the cost and net realizable value - Non current assets such as PPE can be measured at a historical cost less accumulated depreciation or they can be measured at fair value - Leased assets are measured at the present value of the future expected lease payments So what does the total shown in the balance sheet ( Total Assets) actually represent Amounts that are receivable from customers within the next 12 months are shown at their “face value” with an associated allowance for Doubtful debts Inventory - Assets held for sale in the ordinary course of business - In the process of production for sale - In the form of materials or supplies to be consumed in the production process, or in the rendering or services - Accounting standards require inventory to be measured at the lower of cost and net realizable value, need to understand meaning of cost and net realizable value Cost of Inventory The “cost” of inventory includes those costs associated with bringing the inventories to their present location and condition and include. Cost of purchase - including the purchase price, important duties and other taxes together with the required transportation and handling costs necessary to move the inventory to the location of sale Cost of conversion - the costs necessary to complete the inventory and include direct labor and other costs allocated to activities such as labeling and packaging Other costs incurred in bringing the inventory to its current condition and location - might include the costs of modifications necessary to meet the needs of specific customers. Net Realisable Value NRV is the estimated proceeds of sale less the estimated costs of completion and costs to sell. For example, if an organization believes it can sell an item of inventory for $700 after it incurs additional manufacturing costs of $50 and advertising costs of $40 the NRV of inventory is $610 If the NRV of inventory falls below cost, it must be written down to the value that it could be expected to be sold for, less the incremental costs associated with creating the sale. It needs to be noted that inventory could be worth many times the amount that is reported within the balance sheet. Eg inventory might have a cost of 100,000, but might be saleable for 600,000, accounting standards require the lower number to be reported in this case 100,000. Therefore just because the balance sheet attributed a particular monetary value to inventory, ( 100,000) it could nevertheless be worth much more than this amount ( 600,000) PPE Is initially recorded as a cost - The costs necessarily incurred to acquire the asset, and to bring it to the initial location of use, and in the condition necessary for use. - Cost would therefore include - The assets purchase price, including import duties and non refundable purchase taxes,after deducting trade discounts and rebates - Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management - Subsequent to initial acquisition ( at cost), PPE can be measured at cost or fair value, since PPE won't last forever it needs to be depreciated Depreciation - Is the measure of consumption of the economic benefits embodied in an asset whether arising from use, the passing of time or obsolescence - Depreciation is an EXPENSE which represents the allocation of the cost the asset less its residual value over its useful life - Start depreciating an asset when an asset is first put into use, or is held ready for use - All assets can be depreciated except Land - There is no GST on depreciation as it is a non cash expense and does not involve the supply of goods or service. Journal entries for depreciation DR depreciation expense $__ CR ( Asset name) Accumulated Depreciation $__ Effect of depreciation on balance sheet In balance sheet Equipment at cost $X Less accumulated depreciation $Y Carrying amount $X-Y The carrying amount is the cost price less the accumulated depreciation Depreciation Method 1. Straight Line 2. Diminishing Value 3. Sum of Digits Method 4. Units of Production basis Straight Line Depreciation Cost-Residual Value / Useful Life An equal amount is charged against profit each year of the assets useful life. Same charge each year. Furniture LTD paid 30,000 for machinery, estimated useful life for machinery is 3 years with 3000 residual value Using Straight Line Method 30,000-3000 / 3 = 9000 Year 1 Year 2 Year 3 Carrying amount start year Annual Depreciation expense Carrying amount end of year Because PPE can be measured ad cost, the amount presented in the balance sheet might be well below its fair value. Eg an organization might have bought land and buildings 25 years ago for 1 million its fair value is now 50 mil, pursuant to accounting standards, the organization can actually disclose the land and buildings at just 1 million if it chooses so. Financial instruments A financial instrument must have a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Eg contract to purchase asset on credit, business loan, share issues Classifications, financial asset, financial liability, equity, compound instrument. Marketable securities The general practice is to measure such investment at their fair value, with this amount being updated at the end of each accounting period. Increases in fair value are treated as income of the accounting period in which the change in fair value occurs, whilst decreases in fair value are treated as expenses of an accounting period. Any dividends received during the accounting period are treated as income. Intangible assets Intangible assets are non-monetary assets without physical substance - copyrights , patents, brand names, publishing titles, franchise agreements, goodwill, and R&D - Within accounting standards, there are strict requirements about the intangible assets that are allowed to be recognised in the financial statements - Generally speaking, only externally acquired intangible assets can be recognised for balance sheet purposes - Those intangible assets that have been developed internally, are not permitted to be recognised and shown in the balance sheet - The implication of this is that many valuable intangible assets do not ever appear on the balance sheets - This potentially undermines the potential usefulness, and relevance, of the balance sheet. Recognising liabilities 1 must meet the definition of a liability Must meet the tests of relevance ( is there existence uncertainty, what is the perceived probability of outflows of economic benefits) Faithful representation, is there a high degree of measurement uncertainty. Examples Nutrition Ltd has just received notice that a customer who was hurt when using a product bought from Nutrition Ltd is taking legal action against the company for compensation for injuries and loss of earnings. It is unclear whether the action of the customer will succeed, and it is also unclear what level of compensation might be paid. Should Nutrition Ltd recognise a liability? There would seem to be high uncertainty whether an obligation exists – therefore there is a high level of existence uncertainty. This undermines the potential relevance of related information. There would also be high levels of measurement uncertainty in terms of placing a financial amount on the obligation. This acts to undermine the representational faithfulness of related information. A liability would not be recognised in relation to the legal action being taken by the customer. Contingent liabilities arise when The obligation is dependent upon a future event or the probability associated with the outflow of economic benefits as assessed as low. The obligation cannot be measured reliability at a given point in time If the contingent liabilities is material - Info is required to be disclosed in the notes to the financial statements - A contingent liability note might be appropriate for the legal action just discussed. The general principle is that liabilities expected to be paid within 12 months are measured at their face value Liabilities due to be paid beyond 12 months shall be measured at their present value Leases A contract, or a part of a contract that conveys the right to use an asset for a period of time in exchange for consideration. Does it matter who is the assets owner, who has the control over the asset. A lease exists when the customer controls the use of the underlying asset throughout the period of use, meaning that the customer: Obtains substantially all of the economic benefits from the use of the identified asset throughout the period of use; and Directs the use of the asset throughout the period of use, which means the lessee has the ability to change how, and for what purpose, the asset is used during the contractual term. Under the lease contract, the lessor conveys the right to use an asset to a lessee in exchange for consideration – lease payments throughout a period of time – lease term. – Lessor: the individual/firm providing an asset and receiving payments at established dates. – Lessee: the individual/firm obtaining the right to use the asset and having an obligation to pay the lessor at established dates. – Lease payments: fixed payments (excluding service cost component, if any) + (if included in the lease contract) residual value guarantee and/or price of a purchase option. – Lease term: the period for which a lessee has the right to use the underlying asset, from the commencement date of the contract. Based on expectations about whether lessee is likely to exercise an option to extend the lease term. Recognising measuring equity. Equity = Assets - Liabilities As a residual the amount assigned to equity is the excess of the amounts assigned to assets over the amounts assigned to liabilities. Therefore , the criteria for the recognition of assets and liabilities effectively provide the criteria for the recognition of equity. There is therefore no need for separate recognition criteria or measurement rules for equity. For example, if assets have been measured at $12,500,000 and liabilities at $10,000,000, then the measure of equity would simply be the difference between the two, which in this case would be $2,500,000. Reported ‘total assets’ does not represent the fair value of all the assets, or the cost, or replacement value of them. Reported ‘total assets’ does not include many valuable assets, such as its labor force, key intellectual capital, valuable customer and supplier networks, internally developed intangibles, and so forth. There are many professional judgments required when determining existence uncertainty, probabilities of inflows and outflows of economic benefits, and measurement uncertainty Also potential for creative accounting. Week 4 Financial Statements The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making their decision about providing resources to the entity. Key statements are Income statement, statement of comprehensive income, Balance Sheet, statement of cash flows, statement of changes in equity. Income Statement Purpose: measure and report how much profit the business has generated over a period. Profit or loss is the difference between Income and Expenses Income is made up of revenue ( earned from operating activities) and Gains usually earned from non operating activities Expenses are outflows of resources usually to generate income. Cash vs Accrual recognition of income Cash based accounting recognises income when cash is received Accrual based accounting recognises income on the basis that it has been earned irrespective of whether the cash receipt is in arrears or in advance. An example of accrual-based transaction recognition are long-term construction contracts where a proportion of the total expected income on the contract is recognised at the percentage of completion if certain criteria are met. If Lily Limited received $45,000 in cash for goods sold in the year and was owed $5,000 for sales on credit at the end of the year, what was the income for the year? Dr Cash 45,000 Cr Sales 45,000 Dr Accounts Receivable 5,000 Cr Sales 5,000 Income for the year = 45,000 + 5,000 = 50,000 Revenue recognition criteria Accounting divides the economic life of a business into artificial time periods ( period assumption) At what point of the operating cycle should revenue be recognised The conceptual framework provides guidance regarding income recognition which also applied to revenue. Criteria for the recognition of revenues and expenses facilitate the recording of revenues and expenses in a given accounting period. Under the Conceptual Framework, income and expenses should be recognised at the same time as the recognition of changes in assets and liabilities, i.e. when these changes can be faithfully represented. Generally, revenue is recognised when the service is or when the goods are delivered. The simultaneous recognition of income and related expenses, referred to as the matching of costs and income, arises from the recognition of changes in assets and liabilities. In the accounting standard, NZ IFRS 15 Revenue from Contracts with Customers, revenue is recognised when an entity satisfies a performance obligation in a contract. The following conditions must be met: the contract has been approved by parties to the contract; each party’s rights in relation to the goods or services to be transferred have been identified; the payment terms have been identified; the contract has commercial substance; and it is probable that the consideration to which the entity is entitled in exchange for the goods or services will be collected. NZ IFRS 15 Revenue from Contracts with Customers Required to resolve inconsistencies in application of existing standards in revenue recognition. A five-step framework is adopted to identify when revenue should be recognised. 1. Identify the contract(s) with a customer 2. Identify the separate performance obligations 3. Determine the transaction price 4. Allocate the transaction price 5. Recognise revenue when a performance obligation is satisfied Expenses = decreases in assets, or increases in liabilities, that result in decreases in equity which are not due to distributions to the owner(s) (holders of equity claims). Conceptual framework provides guidance: Expenses should be recognised when and only when the decreases in assets or increases in liabilities that result in decreases in equity can be faithfully represented. The cash payments match the expenses for the period (the benefits used up) The cash payments are less than the expenses for the period (‘accrued’). The cash expenses are more than the expenses for the period (‘prepaid’). Adjusting entries are necessary to make sure  - Revenues and expenses are recorded in the correct accounting period (accounting period concept) - Recognition criteria are followed for assets, liabilities, revenues and expenses ( Conceptual framework criteria) Types of adjusting entries Prepayments - Prepaid expenses: Amounts paid in cash and recorded as assets until used - Revenue received in advance: amounts received from customers and recorded as a liability until services performed or goods delivered Accruals - Accrued revenues: amounts not yet received and recorded for which goods or services have been provided - Accrued expenses: amounts not yet paid or recorded for goods or services already received. The amount paid in cash during 20X1 for rent is $4,000 including $500 for part of 20X2. What is the rent expense for the year 20X1? How is the $500 for part of 20X2 dealt with in the financial statements? $500 is the prepaid expense which is an asset. The rent expense for 20X1 is only $3,500. Dr Prepaid Rent 500 Dr Rent Expense 3,500 Cr Cash 4,000 Jupiter Limited received $10,000 from Mars Limited in 20X1 for the design work to be completed for Mars Limited in 20X2. How should $10,000 be recognised in 20X1? 10,000 is an unearned revenue – liability. Dr Cash 10,000 Cr Unearned Revenue 10,000 Lily Limited provided consulting service to Rose Limited in 20X1 and sent Rose Limited an invoice of $20,000. Rose Limited did not pay the invoice until early 20X2. How should the $20,000 be recorded in 20X1? Dr Accounts Receivable 20,000 Cr Revenue 20,000 The amount paid in cash during the year 20X1 for power is $1,000. The amount owed at the end of the year is $200. What is the power expense for the year 20X1? The power expense of the year 20X1 is $1,000 + $200 = $1,200. Dr Power Expense 1,200 Cr Cash 1,000 Cr Accounts Payable 200 Profits and Cash It is important to note that ‘profit’ and ‘net cash movement’ are not the same Profit is a measure of achievement, or productive effort, rather than of cash generated While making a profit will increase wealth, cash is only one form in which that wealth may be held by a business The differences arise from the requirement to apply the accrual basis of accounting. Merchandising operations Merchandising businesses buy and resell inventory. Revenues are referred to as sales revenue. Expenses are divided into two categories: –cost of sales (cost of goods sold – COGS) –operating expenses. Merchandising businesses buy and resell inventory. Revenues are referred to as sales revenue. Expenses are divided into two categories: –cost of sales (cost of goods sold – COGS) –operating expenses. Recording sales of inventories Two entries are required 1 to record the sale of goods 2 to record the cost of sales Operating expenses Cost of making the sale Eg advertising, delivery expense Admin Expenses Cost of operating activities of the general accounting and personnel offices Eg salaries and rent Financial expenses Costs of financing the business eg interest expense, discount allowed. Week 5 Understand the use of accounting software for transaction processing. Explain the motivation and benefits of using enterprise resource planning – ERP systems. Explain XBRL and its role in reporting systems. Appreciate new technologies and how they may impact the future of accounting. Introduction to XERO accounting software. Different accounting systems or technologies are used to capture transactions and produce reports for planning and decision making. They are developed based on business size and complexity. Different functionality for different types of organization. Systems and technologies: – Accounting software packages (e.g., XERO, MYOB). – Enterprise Resource Planning Systems – ERP. – eXtensible Business Reporting Language – XBRL. – Cloud computing, artificial intelligence, big data, blockchain, and bitcoin. A main principle of computerized accounting information systems is that they provide efficiency and effectiveness in recording business transactions. Accounting systems that are flexible and cost effective contribute significantly in helping organization achieve their goals, eg XERO ERP collects, processes and stores data in a centralized database and shares up-to-date information across business processes so that business activities can be coordinated. ERP helps to integrate the different aspects of an organization’s operations with its traditional accounting information system. It is an effective means of capturing data and providing information to managers to facilitate communication and decision-making among operational and financial departments within an organization. (Manufacturing, Supply chain management, Project management, Financial Management) ERP System ( Enterprise Resource Planning) Historically AIS systems only catered for accounting functions and processing of functional transactions. Eg a sale process through specialised accounting software results in a debit to accounts receivable and a credit to sales. Thus, missing other non financial information about the sale such as time of the sale, name of the salesperson and customer can also be important details for decision making. ERP systems cater for a hybrid of functions ( accounting, sales, human resources) ERP supported processes ERP systems capture 4 major areas ( Sales Marketing, Finance, Manufacturing, Human Resources) An ERP system links these areas as well as suppliers and customers. Integrates all departments and functions in a business. Business process supported by ERP systems. ERP systems support key business processes - Revenye sales or order to cash - Payments, purchases or purchase to pay - Production, manufacturing or conversion - Human resources and payroll - General ledger and financial reporting Each key business process brings tiger different functions and divisions. E.g., the revenue process brings together the sales and marketing department and accounts receivable in the accounting department (which records the sales), while manufacturing (which produces the product or service to sell) brings together human resources (which provides the sales, finance and manufacturing staff for the revenue process to be executed). ERP Systems Financial accounting ( General ledger and financial reporting) Controlling and profitability analysis: Management accounting and decision making. Human resources management and payroll process Sales and distribution. Revenue process Materials manegement, Production planning and execution, quality management, warehouse management and plan management. Financial accounting Processes monetary transactions Collects transactional data to prepare the balance sheet, income statement, and statement of cash flow. Integrates accounts receivable and accounts payable submodules to maintain customer and vendor balances. Control and profitability analysis Management accounting modules Collects data for internal reports and decision making Reports Cost center performance and profit center performance and budget analysis Analysis of sales, cost and budgets for effective cost and revenue control in organizations. Human resources Module for recruitment management and administration of personnel payroll processing and personal training and travel. Captures employee details, distribution of pay and training and travel information. Module for revenue or sales order to cash process. Records customer orders and ability to pay, fulfils customer orders and provides order status. Materials management module: Product availability. – Financial accounting: Sales transactions to general ledger. Materials Management Related to the payment or purchase to pay process, including the management of productis Processes for purchase requisitions and purchase orders Connects with financial accounting module. ERP system may bhave modules that extend the internal capabilities to suppliers and customers are Supply chain managemt (SCM) customer relationship management (CRM) XBRL is also called “bar codes for reporting”. It makes reporting accurate and efficient in most respects and allows unique tags to be associated with reported data. XBRL is the emerging standard for electronic communication of business and financial data. Instead of financial information being a block of text, XBRL provides a computer readable tag for each item of data. XBRL adopts a semantic approach by attaching meaning to strings of text. XRRL is used to save costs and streamline processes XBRL Concepts HTML: Hyper Text Markup Language is used by a web browser to display a web page. XML: eXtensible Markup Language is used for encoding documents electronically. It uses metadata – data that describes other data. XBRL is a variant of XML, used in the business environment. Allows use of HTML and XML standards. Enables data manipulation through the internet XBRL tags contain more data than just content XBRL tags specify what the piece of data is and how it is used and makes it searchable XBRL provides a consistent taxonomy Internal and external taxonomies are the dictionaries that define each accounting item that can be tagged in XBRL. Xero accounting software Well known, popular with small businesses and simple and easy to use Avaiable on the go 24/7, accessible on variety of electronic devices, integrates with other software and apps as well as financial institutions for access to up to date business bank accounts. Provides access to various accounting functions via the home page. The dashboard can be set up to show briefly how a business is performing. Features within XERO that support main business functions. 1. Dashboard – the home page: Easy monitoring of current and overdue sales invoices and bills, bank accounts, general ledger account ‘watch list’, total cash in/out. 2. Accounts:  Access main functions such as bank accounts, sales, purchases, inventory, expense claims and fixed assets. 3. Payroll: – Employee details, pay runs, leave entitlements, timesheets, and superannuation. 4. Reports: – Customise and access many reports under the categories of financial, tax, accounting, fixed assets, sales, purchases, inventory and payroll. 5. Contacts: Access to all customer, supplier and employee details. 6. Settings: – Organisational, connectivity, reporting and features such as document templates. Week 6 - Accounting Ratios Financial Statement Analysis The role of financial Statement analysis Financial statement analysis is the process of reviewing and evaluating an entities financial statements, including the - Income statement and comprehensive income statements - Balance sheet - Cash flow statement - Statement of changes in equity - Notes to the financial statement The goal of such analysis is to develop an understanding of the entities financial performance and stability and its likely future prospects. This may enable more effective decisions to be made about the entity. Who performs financial statement analysis - Accountaings ( financial and management) - Board of directors - Analysts ( buy side and sell side) - Investors, Bankers, Auditors, Businesspeople, employees Why Undertake financial statement Analysis. How well entities utilises various assets such as inventory and fixed assets. Entities ability to pay short-term obliglations as they come due. Entities financial leverage and ability to meet its long term obliglations How well entities generate operating profits and net profits from its sales. The relative valuation of entities. Why Undertake financial statement analysis Form an opinion as the entities past and future financial health, predict future rewards and risks, make informed decisions about whether and how to support the entity. How financial statement analysis can be performed 1.Simple Comparison: A simple comparison of this year’s amount (perhaps of a particular expense or revenue item) with the previous year’s amount might be undertaken. This can be referred to as a form of Horizontal Analysis. 2. Ratio Analysis: When a ratio analysis is applied, particular amounts within the financial statements are compared with other amounts within the financial statements, which can be referred to as a form of Vertical Analysis. 3. Trend Analysis: Trend analysis occurs when we can look at various financial indicators – perhaps accounting ratios – over a number of accounting periods to see if there is a pattern of improvement or deterioration. 4. Comparison with Benchmarks: Different performance measures, which might be encapsulated in various ratios, might be compared with those of other entities, or to industry averages, in order to ‘benchmark’ how the entity is performing relative to other entities. Using accounting ratios A ratio is a relationship between two quantities normally expressed as one divided by the other. Ratio analysis can be considered a form of vertical analysis, wherein one number from a financial statement can be compared with another number from the financial statements of the same year. Ratio analysis is also often combined with horizontal analysis, wherein ratios are compared over time to determine trends. It can also be combined with benchmarking, where ratios are compared between entities or against industry averages. Key steps in financial ratio analysis , Identify info users and their needs, calculate appropriate rations and interpret and evaluate the results. Common Size analysis A vertical common size balance sheet expresses all balance sheet accountants as a percentage of total assets A vertical common size income statement expresses all income statements items as a percentage of sales Ratio analysis Calculations Activity, Liquidity, Solvency, Profitability and Valuation Ratios. Activity Ratios Liquidity Ratios Solvency Ratios Profitability Ratios Profitability ratios provide an insight into the ability of an entity to generate profit Therefore, this category of accounting ratios is appropriate in respect of entities that are established to generate profits but might not be relevant for evaluating the performance of not-for-profit entities or PBES. Valuation ratios - EPS - P/E - P/S - P/B - P/CF Dupont Analysis Ratio Analysis Advantages - Project future earnings and cash flow  - Evaluate a firms flexibility ( the ability to grow and meet obligations even when unexpected circumstances arise) - Assess managements performance - Evaluate changes in the firm and industry overtime - Compare the firm with industry competitors Ratio Analysis Disadvantages - Financial ratios are not useful when viewed in isolation. They are only informative when compared to those of other firms or to the firms historical performance - Comparisons with other firms are made more difficult by different accounting treatments. This is particularly important when comparing US firms to non-US firms - It is difficult to find comparable industry ratios when analyzing firms that operate in multiple industries. - Conclusion cannot be made by calculating a single ratio. All ratios must be reviewed relative to one another - Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values. It is important to note that the definitions of ratios can vary widely among the analytical community. For example, some analysts using all liabilities when measuring leverage, while other analysts only use interest bearing obligations. Therefore consistency is important. Reasonable values of ratios can differ among industries. Note to Financial Statements We can find very important information in notes that accompany the financial statements So, as well as reviewing the financial statements as part of our analysis, we could also spend time carefully reading through the many pages of accompanying notes. Accounting policies – E.g., as there can be a choice between alternative measurement bases for some assets and liabilities, it is important to ensure that if two or more entities are being compared, they should ideally be applying the same policies, or else the comparison can be misleading. – Interested shareholders should be familiar with the accounting policies being used by an entity to generate its financial statements prior to reviewing those financial statements. Significant events occurring after the end of the accounting period – Many important things can happen in the period between the end of the reporting period and the date of release of the financial statements to the stakeholders. – Therefore, when reviewing financial statements, you should always remember to look through the notes for information about such events, as they might create impacts material to future financial performance and financial position. Contingent liabilities – A contingent liability is an obligation that is payable contingent upon a future event or an obligation that is not probable (in terms of resource outflows) or is not measurable with sufficient reliability. – At the extreme, if things ‘go bad’ contingent liabilities can potentially threaten the ongoing existence of an entity. – Analysts must make sure to carefully study contingent liability notes. Remuneration policies – This is a disclosure requirement within many countries. – Managers in entities typically receive bonuses. – These bonuses will often be based on accounting numbers and often on particular accounting ratios. – The central idea behind such bonuses is that they motivate certain behaviours. – The disclosures about bonuses inform the reader/analyst about certain priorities of the entity and what types of performance the entity appears particularly intent on improving. – The information can also potentially help the reader/analyst identify risks and inconsistencies in the actions and rhetoric of an entity. Accounting based debt contracts When borrowing funds an entity will often negotiate agreements that use various accounting-based covenants. These might use accounting ratios. We should factor consideration of various accounting based contracts into our analysis if the info about the existence of accounting based contractual arrangements is publicly available. Entities that are close to breaching accounting based debt contracts are indeed more likely to opportunistically adopt. Accounting methods which are asset and income increasing. Week 7 - Audit and Controls and Assurance Understand Key Auditor Interactions, Governance, Explain the need for internal controls and internal auditing, understand the need for audit committee. Governance is the exercise of economic and administrative authority to manage an entities affairs, applicable to all entities. Concerned with processes by which decisions are made and implemented so that the entities affairs are conducted properly and in accordance with the laws and other applicable regulations. Objective for an auditor: the effectiveness of the assurance engagement is a function of the auditors relationship with the entities management and the governance body. The auditor and governance ISAs NZ provide examples of the auditors interactions with those charged with governance. ISA 250, consideration of laws and regulations in an audit of financial statements. ISA 260, Communication with those charged with governance. ISA 265, Communcating deficiencies in internal control to those charged with governance and management ISA 315, IDentifying and assessing the risks of material misstatements through understanding the Entity and its environment. ISA 330, The auditors responses to assessed risks. Issues in governance RIsk Management and internal control Effective governance and accountability based on effective functioning of internal control and risk management. RIsk management is the culture, process and system established to manage opportunities and minismse or control risks. Internal control The term controls refers to any aspect of one or more of the components of internal control. Internal control is the process designed, implemented and maintained by those charged with governance, management and other personnel provide reasonable assurance about the achievement of the entities objectives with regard to, reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. COSO : Internal control and integrated framework Committee of Sponsoring Organisations of the treadway Commission. Five elements of Internal control - Control Activities - RIsk Assesment - The control Environment - Information and Communication - Monitioring Control prevents and detects CRIME ( Anagram used to remeber 5 internal controls) Internal Audit encompasses examination and evaluation of - Adequacy and effectiveness of governance and internal control structure - The quality of performance - The procedures of risk identification and management - Mechanisms to ensure regulatory compliance Supplements the work of independent auditors Internal auditors should Review the reliability and integrity of financial and operating information Review the systems established to ensure compliance with policies, plans, procedures, laws and regulations Assess risks within and outside the business Review the means of minimizing risks Appraise the economy and efficiency of resources Review operations or programs. Criteria external auditors use to assess the performance of the internal auditor include - Organisational status - Should report to the highest level of management and free of any operational responsibility. Need to be free to communicate with external auditors - Scope of internal auditing - External auditors consider the nature and extent of the internal auditors - Technical competence. - Internal audit function should be performed by those with technical training and proficiency - Due professional care - Internal audit should be planned, supervised, reviewed and documented  - External auditors should consider the adequacy of audit manuals, work programs and internal audit working Operational Auditing Examines the use of resources to evaluate whether they are being used in the most efficient and effective manner. Three approaches Risk Based audit approach - Identify areas of greatest risk and make an audit program - Distinguishes between control adequacy ( what should be) and control effectiveness ( what is) - Values for money approach - Defines attributes of effectiveness and focuses on effectiveness, efficiency and economy of operation from customer viewpoints. - Process audit approach - Examines the effectiveness of process and distinguishes value added from non value added activities, building the control framework into the process. Operational Auditing - Five Phases Preliminary preparation - gain a comprehensive understanding of the organisation Field survey - identify problem areas and sensitive issues Program development - step by step program Audit application - detailed review Reporting and follow up - with senior management and the audit committee Skill sets of an internal auditor Internal auditors require a broad range of skills such as Strong business acumen Canvassing leading ideas from around the globe Forming solid partnershups with the risk function and management Being innovative in the way they report. Audit Committees Enhance effective accountability within organisation in both the private and public sectors Facilitate participating of independent directions in governance process Provide a forum where directors, management and auditors can discuss and resolve issues relating to management risk and financial reporting obliglations. Audit Committes should  - Be of sufficient size, independence and technical expertise to discharge its mandate effectively - Be made up of only independent directors - Include members who are all financially literate - Include at least one member with financial expertise - Include some members who have an understand of the industry The role and objectives of the audit committee - Assist directors in discharging their responsibilities - Improve the credibility and objectivity of the accounting process - Improve the effectiveness of the internal and external audit functions and facilitate communications between the board and the internal and external auditors - Facilitate the independence of the internal and external auditrs - Strengthen the role and influence of the non executive directs - Foster an ethical culture throughout the organization Relationships of the audit committee with the internal and external auditors Assurance and Auditing Defined. An assurange engagement is defined as an engagement in which an assurance practitiorner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria Auditing is the accumulation and evaluation of evidence about the information. The degree of corespondence between the information and established criteria is ascertained. Results are communicated to interested users. Auditors should be competent and independent. Auditing of financial statements is the most common assurance. Audtiing of financial statement is the most common assurance engagement. Assurance and auditing defined Whom the auditor prepares their report eg shareholders, creditors and employees. Responsible party - the person or organisation responsible for preparing the financial statements eg company management Subject matter - that which the auditor is expressing a conclusion eg financial reports Criteria - the rules or principles by which the subject matter is being evalusated , eg accounting standards and interpretations and and corporation laws. Overall objectives of the auditor F/S Auditor To obtain reasonable assurance whether the F/S are free from material misstatements due to fraud or error, thereby enabling the auditor to express an opinion on whether the F/S are prepared, in all material respects, in accordance with an applicable financial reporting framework. To report on the F/S and communicate as required by ISAs in accordance with the auditors findings. Professional standards, ISA, the auditor is performed in accordance with ISA ( International standards of auditing) Who is required to have a financial statement audit All companies considered FMC reporting entities ( FMC) expanded definition os issuer companies. For non-FMC entities all large companies. A large company other than an overseas company or subsidiary of oversea company has assets or revenue. Assets worth ? 60M or Revenues > 30 m for 2 consecutive periods. Different assurance services The most common assurance services are - Financial report audits: An engagement designed to express an opinion about whether the report is prepared in all material respects in accordance with a financial reporting framework - Compliance audits: Involves gathering evidence to ascertain whether rules, policies procedures, laws and regulations have been followed - Performance audit: Refers to the economy, efficiency and effectiveness of an organization's activities - Comprehensive audit: Combines elements of financial report audit,compliance audit and performance audit and often occurs in the Public sector. - Internal audit Provides assurance of financial report audit compliance audit and performance audit - CSR assurance Provides assurance about various aspects of an organisations activities. Often contains elemts of performance audits, compliance audits, internal control assessments and reviews. Includes voluntary reporting about environmental, employee and social subject matter. Incorporates both financial and non-financial information Auditor must consider environment issues on their clients financial reports even if reports do not include any disclosures. Preparers and Auditors It is the responsibility of those charged with governance to prepare the financial statements. The information should include the following attributes. Relevant: has an impact on the decisions made by users regarding the performance of the entity Reliable. Information is free from material misstatements (errors or fraud) Comparable. Information needs to be comparable through time. Comparable against the same entity over time and against other entities. Understandable. Users need to be able to interpret the information presented in order to make decisions True and Fair requires the consistent and faithful application of an applicable framework when preparing a report. Auditors responsibilities relating to the audit Professional skepticism - being independent of the entity and having a questioning mind to thoroughly investigate all evidence presented. Professional judgement - use of judgement based on level of expertise, knowledge and training obtained by the auditor Due Care - being diligent applying standards and documenting each stage of the audit process. Three tiers of assurance providers in NZ and Aus Assurance services are provided by accounting and consulting firms First tier comprises of the “ Big 4” which includes Deloitte, Ernst and Young, KPMG, and PWC Mid tier compromises of firms with significant presence and most have international affiliations, Grant Thorndon, BDO…. Next tier is made up of local accounting firms. Demand for audit and assurance services The users of the financial statements are not limited to the shareholders or owners of the business. Other users can include: Investors: can include current or potential investors. Decisions include to buy, hold or sell stake in the organization. Suppliers: may want to assess whether the entity can pay them back for goods supplied. Customers: may look into going concern if it is to rely on the entity for goods. Lenders: to assess whether loan repayments can be made as and when they fall due. Employees: to assess whether they can pay entitlements, and stability may be assessed for job security. Governments: whether the entity is complying with regulations and paying appropriate taxes. General public: whether they should associate with the entity (future employee, customer or supplier,) what it does and plans to do in future. Reasons why users demand financial reports include:  Remoteness: users do not have access to information themselves. Complexity: users do not have knowledge to be able to make disclosure choices. Competing incentives: users may find it difficult to identify when the incentives of management have been over-represented. Reliability: as decisions are being made based on information presented, it is important that it be reliable.08/29/2024 Theoretical frameworks Agency explains the relationship between owners and managers. Due to the remoteness of the owners from the entity, the owners have an incentive to hire an auditor to assess information provided by management. Theoretical frameworks : information hypotheses Information hypotheses explains the demand for external audits Auditing as an information risk reducing activity The need for reliable information, users demand that information be audited to aid in decision making. Theoretical frameworks - Insurance hypotheis Auditing provides investors a form of insurance The insurance hypothesis predicts that auditors are demanded ( so that they may be sued in case their is a business failure The law provides some degree of recourse against the auditor The auditors depending on how the courts reasoning works, act as an indemnifier against investment losses. Demand in a voluntary setting It is becoming more common to voluntarily disclose CSR information in various forms. This is a stakeholders are demanding information regarding the entities impact on the environment and actions taken to reduce their impact Entities are not required to have CSR disclosures assured These services are provided to meet user demands for high quality, reliable information and to demonstrate a high level of CSR. Different audit opinions Audit opinions are contained in audit reports provided by the auditor An unmodified audit report contains an unqualified or clean opinion All others reports are modified opinions A report can be unqualified modified report when an emphasis of matter is added. An emphasis of matter is used so that the reader can pay appropriate attention to the issue raised but does not change the auditors opinion. Week 8 Professional Ethics - What defines a professional - Making a distinction between a professional and a technical expert in fields like accounting and auditing holds significance - To enable a group to possess vocational expertise, like financial auditors, to become professional suggests that its members share common principles, ethical boundaries, and a genuine dedication to performing at their highest level - A professional is often anticipated to serve the broader public interest and uphold ethical standards, even in situations where it may pose challenges Understanding ethical issues The knowledge of ethics is important to the profession Ethics is concerned with the evaluation of choices where options are not clear or where there is no absolute right or wrong answer The study and practice of ethics enable an accountant to critically examine a situation in which there is a conflict of loyalties and interests, involving issues that relate to roles and responsibilities. Generally ethical behaviour requires - An understanding of ethical issues, a framework within which a responsible decision can be made and an awareness of the consequences of such decisions. The word ethics is derived from the greek word ethos meaning character whereas ‘ morality’ focuses on the good and bad of human behaviour, ethics focuses on what is right and wrong and how and why people act in a certain manner./ Ethics focuses on a study of choices, standards and behaviours. The nature of ethics ( teleology) consequentialism - utilirianism Forward looking rationale Deontology ( non-consequentialism) past or present Virtue ethics - act morally based on character Ethical relativism - environment based Regulating the accounting profession The requirements with which professional accountants must comply with Technical standards such as ISAs The code of ethics - the code is designed to encourage ideal behaviour it should be realistic and enforceable Ethical and other standards governing behaviour set by professional bodies and national standard- setters such as XRB The requirements of accounting standards,company law and securities regulations Co regulation of audit independence and standard setting Government intervening in the regulation of accountants and financial reporting PES 1 (Revised): Professional and Ethical Standard (Issued December 2018). New version: periods beginning on or after 15 Dec 2023. An assurance practitioner that is required to apply this Standard is required to apply it as follows: Parts 1: Complying with the Code, Fundamental Principles and Conceptual Framework. Part 2: Assurance Practitioners Performing Professional Activities Pursuant to their Relationship with the Firm. Part 3: Application of the Code, Fundamental Principles and Conceptual Framework. Part 4A: Independence for Audit and Review Engagements. Part 4B: Independence for Assurance Engagements Other than Audit and Review Engagements. Purpose of the code Professional and ethical standard 1, international code of ethics for assurance practitionaers defines Fundamental ethical principles ( intergrity, objectivity, competence, confidentiality, conduct) for practitioners, highlighting their responsibility to the public interest The code provides a framework for practitioners to - Identify, assess and manage threats to complying with these ethical principles - Offereing guidance on various topics to apply this framework effectively For audits, reviews, and other assurance engagements the code establishes IIS NZ derived from this framework to maintain independence in these specific professional roles. Fundamental principles of professional ethics 110 the fundamental principles Sections where the fundamental principles are located within PES 1 111 - Integrity - Being straightforward and honest in all professional and business relationships, which means Not knowingly being associated with materially false or misleading statements or statements made recklessly 112 - Objectivity - Avoiding bias, conflicts of interest, or external pressures overpowering professional or business decisions is crucial. Objectivity, a mental state, can exist without complete independence. Independence, vital for assurance tasks like audits and reviews, demands both:independence of mind, independence in appearance. 113 - Professional competence and Due care - Maintaining expertise, professional knowledge and skill to deliver services to clients or employers diligently, complying with technical and professional standards. Competence demands the following: Sound judgement in applying professional knowledge; Ongoing education and continuing professional development (CPD) to stay current with business, professional and technical developments;Keep up-to-date with changes in regulations. Training, supervision, and awareness of service limitations for clients and employers. 114 - Confidentiality - The principle of confidentiality necessitates that the professional abstains from revealing information obtained through professional or business relationships unless authorized by the client or legally obligated. Additionally, it mandates refraining from exploiting confidential data for personal gain or that of others, such as avoiding insider trading. These obligations extend to information shared by potential clients and employers and continue even after the professional relationship ends. Practicing confidentiality also involves vigilance against accidental disclosures to close associates, family members, or in social settings. 115 - Professional Behaviour -Complying with relevant laws and regulations and avoiding any action that discredits the profession. Be honest in representations to current and prospective clients. Do not claim to provide services they cannot provide, or qualifications they do not possess, or experience they do not have. Do not undermine reputation of, or quality of work produced by, others. Auditor Independence Auditors’ independence is challenging to uphold despite its apparent simplicity. Maintaining independence in appearance, where auditors are perceived to be independent, is particularly difficult. Since auditors are remunerated by the entities they assess, stringent standards for independence are crucial. While objectivity is a mental state distinct from independence, both are essential for assurance engagements. Independence, akin to objectivity, requires a certain mindset. Yet, the aspect of appearing independent is equally vital. This implies avoiding situations that might compromise integrity, objectivity, or skepticism in the eyes of external observers. Therefore, independence = the ability to act with integrity, objectivity and with professional scepticism (questioning mind) Threats to Auditor Independence: Independence may be threatened by: Self-interest: involves the threat of inappropriate influence from financial or other personal interests. Self-review: pertains to the effective evaluation of one's own work or that of colleagues within the same firm or employer. When assurance team need to form an opinion on their own work or work done by others in their firm. Advocacy: represents the danger of compromising objectivity by excessively advocating for a client's or employer's position. This Can lead to questioning of auditor’s objectivity. Familiarity: the threat of developing excessive sympathy or a predisposition to accept the work due to an excessively long or close relationship with a client or employer. Assurance staff canbecome too sensitive to needs of client and lose objectivity due to familiar Intimidation: the threat actual or perceived pressures may deter one from acting objectively. Safeguards implemented by the profession Requirements for entering the profession, including educational, training, and experience criteria, intertwine with the necessity for continuous professional development. Corporate governance regulations, which demand discussion or approval of audit and non audit services by the governing bodies. Professional standards and pronouncements, along with the monitoring and disciplinary procedures governed by professional and regulatory bodies. The duty to report breaches of ethical requirements, ‘whistle blowing’ mechanisms facilitating the exposure of unethical behaviour External legal reviews of reports by professional accountants. Firm-wide or engagement-specific safeguard Leadership highlights the importance of complying with professional ethics and the public interest. Quality control and review measures are in place for all client engagements. Policies to ensure the disclosure of all relationships or interests, with different partners and teams having separate reporting lines. Senior management oversees the safeguarding system. Timely communication of policies and procedures extends to all partners and professional staff. Using different partners and staff for non-assurance services provided to an assurance client, as well as rotating senior team members. Involving another firm to perform or re-perform part of the engagement Safeguards created by the client Appointment of an independent firm to ratify the engagement Competence of employees Internal procedures to ensure objective decisions on engagements Proper corporate governance structure with appropriate oversight and communications. Week 9 - Pricing Decisions Determining the appropriate price for goods and services having both short-term and long term consequences for businesses. How should managers of organisations price their products and services. What is the crucial role of demand and supply. Pricing decisions is fundamental to business survival and success - especially in a competitive market. An organisations ability to set correct prices depends on the nature of the market it operates in. Several factors influence pricing decisions and determine the pricing approach that is followed in the organisation Approached to pricing Broadly , pricing decisions follow two main management approaches - Cost based approach Pricing decision here is focused on the cost of producing a product or rendering a service that can deliver expected return on the investment - Market based approach Pricing decisions is reached here based on the market factors and customers want. - Are these approaches exclusive , or can they be used together It depends on the market and the product Pricing decision starts from understanding the cost of the product or service ie the cost based, or based on customers desire and current competition ie market based Both approaches are influences by costs, customers, competition, political and ethical issues. Price influence Costs Cost is a critical determinant of the price of a product or service, or at least the starting point to know what price can be changed. As a rule, companies would expect to produce or provide a service if the unit selling price exceeds the variable cost of producing one more unit. An understanding of production costs is important in price setting that is attractive to customers. Several considerations are made with respect to determining the cost of product or service. Identification and use of the relevant costs for the decision. Use of the value chain analysis and life cycle costing tools. Customers are the primary source of generating revenue. They influence pricing decisions primarily through demand. Customers demand are driven by several factors including - design and feature of the product, quality of the product or service, in recent times the carbon footprint of the product and its sustainability impacts , the social values and ethical principles of the company. Pricing influence competitors Market competition is another key infleucning factor in price setting For example companies always look out for what their competitors charge for similar products or services. Competition can force companies to lower their prices than anticipated. In a globalised economy it can have implications across countries and inpacted by the currency fluctuations and interest rates. Companies must be knowledgable about the legal and political factors that impact their pricing decisions. Eg businesses are prohibited from engaging in price collusion, among other bad pricing practices. Politically, businesses that are making unusually high profits due to overprices oroducts or services, could attract public backlash that can lead to the enactment of legalisation to hugely tax or cap such profits. Approaches to pricing Cost Based Pricing Managers use cost based pricing as the starting point for pricing decisions Cost based prices are determined by adding a mark-up to some calculation of a product or service cost. The cost base can be calculated in various ways Mark up rates may originate from general industry practice or be found in trade journals. Because a mark up is added, the cost based pricing method is also called cost plus pricing. Cost based pricing can be used in many contexts inclduing tender bid pricing Various strategic factors influence the mark up for tender bids Cost based price = cost base + mark up Mark up = selling price - cost base / cost base Cost based Pricing 1 Morala have designed new hoverboard 15% markup on full cost of production , current cost of producing one hoverboard is 540. = 540*0.15 - 81 dollars = 540+81 = 621 selling price Cost Based pricing 2 What is the mark up for the hoverboard if the company wishes to icnrease the prospective selling price by 45%. Selling price 621,Increased by 45% = 621*0.45 = 279.45 621+279.45 = 900.45 Or using mark up (900.45-540) / 540 = 66.75% Cost of prudction = 540 Mark up compotent 65.75% = 540*0.6675 = 360.45 540+360.45 = 900.45 Cost based pricing facts Choosing a mark up involves setting a target to earn a particular rate of return. The target set by the company would depend on what the managers expect to deliver to owners of the company as return on their investment. In practice the cost based approach can be used along with different cost base. For example, a company may prefer to apply the cost based pricing using any of the following bases. Variable manufacturing cost, total variable cost of the product, manufacturing cost, full cost of the product. The popular practice in cost based pricing is the use of full cost Some of the advantages of using the full cost ie variable plus fixed cost include It is simple to use and apply, allows for full recovery of production costs, price stability is likely achieved, allows for long term planning and forecasting, uses readily available cost accounting data. Market based pricing Market pricing begins with target pice ( ie a price that a potential customer is willing to pay for a product or service) Determined using some measure of customer demand Managers strive to identify what customer are willing to pay Market prices are influenced by the degree of product differentiation and competition Under market based pricing, organisations with differentiated products can formally/informally incorporate consumer demand into their pricing policies As price increase,demand usually falls - the sensitivity is casued by price elasticity of demand. Price elasticity of demand is the sensitivity of sales to price changes. It is a formal way to incorporate demand into prices. Eg evidence has shown that a price increase in ciggies overtime has reduced its demand making the demand for ciggies elastic. Under market based pricing Historical information is used to estimate the effects of price changes on sales volume. It is based on understanding customers perceived value, estimates how competitors would react to a prospective price. Includes using competitors prices to establish a product/service price and using online auction websites for difficult to value products. Target pricing under market based approach Target pricing allows companies to collect data that will inform their market based pricing approach Using a target pricing technique to know customers perception is important because - There are more knowledgable customers today who demand for quality and sustainable products at appropraite prices - Pressure from low cost competitors limits the scope for increasing prices - It is becoming difficult to bounceback from , a pricing mistake, a loss of market share, loss of profitability. Cost based v market based pricing Cost based pricing is more common - major drawback is that it ignores customer demand Sales volume inapproprieatly influences price casuing a downward demand spiral. Prices calculated from readily available cost data Market based prices lead to better decisions about sales volums But it is difficult to estimate market demand and prices. Other factors of price Peak load pricing - charging different prices at different times to reduce capactiy constraints eg peak times on train increase price cheaper price Price skimming - occurs when a higher price is charged the product or service is first introduced. Penetration pricing - setting low prices when new products are introduced to increase market share Price gouging - charging a price viewed by customers as high or unreasonable. Transfer prices - are prices charged for transactions that take place within an entity. Price Discrimination Definition: Price discrimination involves charging different prices to different groups of consumers for the same product or service based on their willingness to pay1. Example: Movie theaters often charge different prices for tickets based on age groups. For instance, children and seniors might pay less than adults for the same movie Predatory Pricing Definition: Predatory pricing is the practice of setting prices extremely low with the intent to eliminate competition. Once competitors are driven out, the prices are raised to higher levels Example: A large retail chain might sell products at a loss to drive smaller competitors out of business. Once the competition is gone, the chain raises prices to recoup losses  Collusive Pricing Definition: Collusive pricing occurs when rival firms agree to set prices at a certain level, rather than competing against each other. This often leads to higher prices for consumers Example: Several airlines might agree to set similar prices for flights on certain routes, reducing competition and keeping prices high3. Dumping Definition: Dumping is when a company exports a product at a price lower than the price it normally charges in its home market. This is often done to gain market share in a foreign market Example: A steel manufacturer in Country A sells steel in Country B at a price lower than it sells in Country A, aiming to undercut local producers in Country B Pricing in not for profit entities Pricing methods for non profits tend to be more complex than for profit entities because major conern is not profit maximisation. Grants, donations, and interest from endowments help to defray costs, therefore, non profits to not always expect to recover all their costs from prices or fees. prices / fees may be based on clients income or achieving organisational goals. Most government would intervene against illegal pricing practices eg they would discourage Price discrimination - setting prices for different customers based on their looks and ethnicity Predatory pricing- the deliberate act of setting prices low to drive out competitors and then raising prices Collusive pricing - when 2 firms conspire to set prices above competitive prices, which harms consumer welfare Price dumping - whena foreign based entity sells products in a country at prices below the market valye in the country where the product is produced and the price could harm the local industry. Week 10 Cost Volume analysis Cost volume profit analysis examines the effects of changes in costs and volume on an entities profits CVP analysis is important for Planning,setting prices, determining the best product mix and making the maximum use of production facilities. CVP analysis is used by managers to evaluate the interrelationships of selling price, sales volume and sales mix and costs to plan future profits In order to plan profits, managers must estimate the selling price of each product, the variable costs required to produce and sell it, and the fixed costs expected for a given period. CVP analysis can help answer questions like What is the entities break even point ie the sales level at which the business will make neither a profit nor a loss? What will be the impact on sales volume and profit of increasing advertising costs? What level of sales must be achieved to earn a desired level of profit? What level of sales must be achieved to earn a desired level of profit? If selling prices are increased or decreased, what will be the effect on sales volume and the break even point? If a variable cost ( labour) is eliminated and replaced with a fixed cost ( eg depreciation) what would be the impact on mt profits What additional sales volume is required to offset an increase in purchasing cost? If additional plant capacity is acquired and increases fixed factory overhead cost, what will happen to profit? What is the most profitable sales mix? 5 Basic assumptions underline CVP application Costs and revenues are linear within the relevant range All costs are identifiable as variable or fixed Costs are affected only by changes in activity level All units produced are sold Sales mix is constant if there is more than one products Sales mix assumptions make CVP complicated and when it is inaccurate or difficult to estimate invalidates CVP analysis Sales mix assumption requires that sales of products would be in constant mix - which is difficult to achieve because different products will have different cost relationships. Understanding contribution margins One of the key relationships in CVP analysis is contribution margin Contribution margin (CM) = revenue - variable costs CM can be calculated per unit - how much of each sales dollar is left to contribute towards fixed costs and profits CM cab be calculated as a ratio Eg what percent of each sales dollar is left to contribute towards fixed costs and profits. Contribution margin unit and ratio Unit selling price - unit variable cost = contribution margin unit Contribution margin ratio = contribution margin unit/ unit selling price Example Morola sells 700 hoverboards per month. Unit selling price 750, variable cost 540,fixed cost is 84000. A) Contribution margin = 525,000 - 378,000 = 147,000 To check 210x700 = 147,000 B) Contribution margin per unit = 750-540 = 210 What is the companies estimated profit if each unit is sold = C estimated profit and insights from analysis The contribution per unit indicates that for every hoverboard sold the company generates 210 to cover its fixed costs and contributes to profits. Since fixed costs is 84000 morola limited will need to sell 400 hoverboards per month ( 840,000/210) before it can make profit for that period Eg Sales ( 400x700) = 300,000 Less variable costs ( 400x540) =216,000 Conitrbution margin 84,000 Less fixed costs 84000 = estimated profit We can further confirm this analysis through any additional sale above 400 units will contribute 210 to the company profits. Since 700 units are expected to be sold, profit will be 63000 ( 300 units x 210) Sales 525,000 Less variable costs 378,000 Contribution margin 147,000 Less fixed costs 84,000 D) determine the contribution margin ratio of the company 210/750 = 0.28 or 28% Also the ratio can be found dividing contribution margin by total sales = 147,000 / 525/000 =0.28 CM ratio of 28% means that 28 cents of each sales dollar (1x0.28) contributed to fixed cost and profit in the company. How much profit will an increase in sales of 50,000 produce for the company CM ratio is 28%, 28 cents of each sales dollar contributes to the fixed cost and profit of company, easily the profit of the company would make if sales increased. 50000 increase in sales = 14000 ( 50,000 x 0,28) Break Even Analysis Break even analysis is the second key relationship for cost volume profit analysis Break even point - is the point where sales volume at which revenues and total costs are equal , so neither a profit or loss is made. Profit arises above the break even point, a loss is incurred below it. Although a break even point is not a desired performance target because of the lack of profit, it does indicate the level of activity necessary to avoid a loss. Determines the level of activity where TR = TC At the break even point there is 0 profit or loss Can be expressed in terms of sales dollars or sales units Formulas BEP in sales = variables cost + fixed costs Above can be defined as the required level of sales dollars or the equires units of sales volumes. In the equation variable costs as a percentage of unit selling price can be expressed as a dollar amount. 540/750 = 0.72 or 72% For Morola X = 0.72X + 84000 0.28X = 84000 X = 84,000/0.28 X = 300,000 Calculation for BEP in units 750X = 540 X +84000 210X = 84000 X = 84000/210 X = 400 units Contribution margin technique BEP in Unites = fixed costs / contribution margin per unit Contribution margin ratio technique BEP in sales = fixed costs / contribution margin ratio Break even analysis graphic presentation Break even point is determines visually at intersection of, total sales revenue line total costs line ( fixed plus variable) Level of activity ( unit ) recorded on a horizontal axis Dollars ( revenue and costs) are recorded on vertical axis. Net profit and loss at all levels of activity is also visually portrayed. Also known as the CVP graph because it shows cost, volume, and profits. The break even point is the intersection of all lines Profit area is the gap between red blue line at top. Loss is the opposite. Margin of Safety The difference between expected sales and break even sales It can be expressed in dollars or as a ratio It indicates the amount by which sales can drop before a loss is incurred It measures the breathing space or cushion that a business has if its expected sales fails to materialise The adequacy of margin of safety depends on the characteristics of the business For example competitive position general economic conditions. Margin of safety calculation ( in $) Margin of safety = Actual expected sales - break even sales Margin of safety ratio = margin of safety / expected sales For Morola limited If the expected sales is 700 hoverboards, BEP is 400 units or 300,000 Margin of safety = 700 - 400 = 300 units Margin of safety ratio = 300/700 = 0.43 Week 11 - Short and Long Term planning Planning involves - making future decisions in the present, establishing goals and targets ( short and long term), forward looking, scenario analysis, risks evaluation, core of management accounting tasks. Planning Planning is continuous and starts before operations commences. A plan provides a benchmark against which future performance can be assessed. Comparing actual performance with plans, and determining the reason for any variance, is referred to as the control phase of operations. Plans also provide targets which can be used as a basis to motivate and reward people undertaking roles in relation to those plans. When planning future activities and performance we should extend the focus of performance beyond just the financial. Components of planning Planning for sustainable development Sustainable development is development that meets the needs of the present world without compromising the ability of future generations to meet their own needs. Related to both intergeneration and intragenerational equality. Incorporating considerations of sustainability into our planning process necessarily means prioritising the longer term performance of an organisation Across time legislation will become more demanding with respect to social and environmental performance, markets and consumers will be more reactive to this performance. Organisation not embracing sustainability will be regarded as higher risk, which will increase the cost of attracting sources of finance. Generally speaking, the higher the perceived risk the higher the cost of finance. Short and long term planning Planning needs to be both long term and short term in orientation Supported by appropriate remuneration structures Must be aware that there are pressures which might encourage managers to be short term in orientation. Short term bonus plans, yearly calculation of profit. Short term planning for a target profit Target profit is the profit objective for a product line. Management plans for short term profit could be aimed at achieving a certain level of profit It is important to determine the sales required to achieve the target profit. Break even analysis can be expanded by adding target net profit to total costs to determine this information. This can be done using math or contribution margin technique. Since we know that BEP, profit and loss = 0, adding a target profit factor to the BEP equation will help determine the required sales. Required sales = variable costs + fixed costs + target profit The required sales can be expressed in sales dollars or sales units. EXAMPLE For morola If mgmt plans to achieve a target profit of 52,500 for the next financial period What would be the required sales For Morola Required sales = variable costs + fixed costs + target profit Calculatings of the required sales in dollars X = 0.72X + 84,000 + 52,500 = x - 0.72 = (84,000+525,00) X (1-0.72) = ( 84,000 + 52,500) 0.28 X = 136,500 X = 136,500 / 0.28 X = 487,500 Calcuation of the required sales in units 750X = 540 + 84,000 + 52,500 = (750 - 540) = (84,000 + 52,500) 210X = 136,500 X = 136,500 / 210 X = 650 units 487,500 / 750 = 650 units to check So to make a profit of 52,500 they need to sell 650 units or achieve sales of 487,500 Required sales = fixed costs + target profit / contribution margin ratio Required sales = (84,000 + 52,500) / 28% = 487,500 CVP for profit planning Management can use CVP to quickly predict effects of events such as Changes in sales revenue or costs, matching competitors discount on sales per price unit, investing in equipment ( fixed costs) in order to reduce labour ( variable costs), changes in profitability with changes in variable or fixed costs. EXAMPLE What effect a 8% discount on selling price would have on the BEP of Morola EXAMPLE 2 Increase fixed and variable costs by 10%, new investment on sales volume for BEP. Example 3 Increase variable costs by $60, MGMT decided to increase selling price to 1000, or cost reduction programme which will save 8400. What increase in sales would be needed to maintain the same level of profit Using CVP analysis with multiple products Management can use BEP with two or more products to determine with sales mix with the highest profitability. A sales mix is a relative combination of different products sold. When undertaking the analysis sales mix is assumed to be constant. BEP sales can be calculated for a mix of two or more products by determining the weighted average unit contribution margin of all products. Per unit data sales mix BEP units = Fixed costs / weighted average contribution margin. Morola example 2 hoverboards, LED and Hip Hop. Sales data mix per unit LED HOVER HIP HOP HOVER Unit selling price 750 1000 Unit variable cost 540 580 Contribution margin 210 420 Sales mix 3 1 What is total contribution margin Weighted average unit contribution margin BEP in units Per unit data sales mix for morola limited As the sales mix is based on 3 units of LED hover per 1 unit of HIP Hop for morola to break even, company must sell 240 units of LED hover ( ¾ x 320units ) and 80 units of hip hop ( ¼ of 320 units) Limited resources As with everyone, companies do not always have the resources they need to accomplish their objectives, hence they must carefully think about how available resources are allocated to achieve the optimal product mix needed to deliver the desired profit. Essentially, the management of the company will need to make the best use of limited resources to maximise net profits. Eg floor space, labour hours and skills, machine hours, need to be planned and managed If there are limitation on some part of the business management should use conitrbution margin per unit of limited resources Eg Contribution margin per unit / amount of resources needed per unit. Assume that mgmt of morola has maximum machine capacity for period is 2500 hrs, machine hours required to make each hoverboard is LED 2 hrs , hip hop , 5 hrs. Determine the contribution margin per machine hour CVP statement profit or loss CVP statement of profit or loss is used for internal decision making only Expenses are classified as variable or fixed Hence, discloses the behaviour of cost and expenses Specifically reports contribution margin in the body of the statement In contrast, traditional financial reports are produced with external users in mind Expenses are classified by function eg cost of sales and selling expenses or nature employee expenses depreciation expenses These reports do not show contribution margin Morola CVP statement of profit or loss Prepare statement of profit or loss traditional format CVP format of statement of profit or loss Contrast the traditional and CVP formats