Corporations Law Short Anwersa) Any entity which is considered a reporting entity is required to prepare a report in accordance with the requirements of the Corporations Law. Briefly explain why you agree or disagree with the above statement. A reporting entity is defined as an entity for which there are users who rely on the financial statements, generated from its financial information, as their major source of financial information. These financial statements are used in the decision making process of both internal and external users, and therefore this information must be both accurate and of appropriate detail.
In order for a general standard to be established across the accounting industry, it is important for a set of standards to be upheld by all. Therefore I agree with the statement. Under section 298 of the Corporations Law, it is stated that all companies which are reporting entities must adhere to the accounting standards issued by the Australian Accounting Standards Board (AASB). The generation of statements of financial position, financial performance and cash flow are all required under the section and they assist in giving an unbiased picture of the company's current position. With the use of the International Accounting Standards Board's conceptual framework, these reporting entities prepare reports using underlying principles in order to clearly articulate relevant information to those with a vested interest in the business. The outcome will be a reduction in the amount of asymmetric information available to external users.
Notable recent examples of falsifying financial reports include One. Tel and HIH. If precise and specific financial reports are not produced in relation to the guidelines set by Corporations Law, it is under the AASB's jurisdiction to enforce compliance. This compliance allows for a general standard to be upheld on a country-wide basis, and with the introduction of International Accounting Standards in 2005, on a world-wide basis. Therefore, an entity which is considered a reporting entity is required to prepare a report in accordance with the requirements of the Corporations Law. Without the generation of these reports, a logical and comprehensible overview of the business could not be produced and analysed.
b) On June 28 2004, an advertising agency paid $20, 000 for a computer system. The accountant for the advertising agency included the $20, 000 payment as an expense in the financial reports prepared for the year ending 30 June 2004. Using relevant accounting concepts, briefly explain why you agree, or disagree, with the accounting treatment adopted by the accountant for the above transaction. If you disagree, explain how the payment should have been accounted for.
I disagree with the way in which the accountant for the advertising agency chose to deal with this transaction. While the accounting process adopted for the transaction may be perfectly acceptable in relation to the International Accounting Standards Board's conceptual framework, there is an alternative which is highly efficient when allowing for large purchases. The process of accrual accounting, whereby revenues and expenses are recognized during the same period with no regard to the date of receipt or the payment of cash, allows for a more direct allocation of the expense over the life of the business. When revenue is reconciled to its expense, a more accurate portrayal of the company's financial position and performance can be generated.
In the scenario posed in the question, the accountant was classifying transactions using the cash accounting method. Therefore, expenses are incurred when cash leaves the business and revenues as cash enters the business. This can skew financial reports as the total expense would occur in the year ending 30 June 2004 and revenue would be immeasurable. In the case of the advertising agency the transaction must first be classified as either an increase in assets or an increase in expense. The question of the computer system's future economic benefit will have to be posed before the transaction can be classified. Obviously the business will not invest in a new technology if it does not provide this future economic benefit, therefore the transaction must be classified as an increase in fixed assets, in the form of the computer, and a decrease in current assets, in the form of an outlay of cash.
In this case the advertising agency's accountant has classified the transaction in an inefficient manner. The conceptual framework states that an expense is 'consumption or losses of future economic benefits in the form of reductions in assets or increases in liabilities of the entity'. Therefore as the computer will produce future economic benefits, it cannot be classified as an expense. Using the accrual accounting system, the computer would first be classified as an asset and depreciation would be used to calculate expense. As depreciation is the allocation of the future economic benefits over the useful life of the asset, the revenue earned from the computer system and the expenses incurred would be aligned. Therefore, instead of a lump sum expense at the purchase, the expense is incurred as the asset generates revenue.
The method of depreciation would also have to be taken into account as there are multiple techniques in which this can be recorded. The most appropriate, in this case, would be the straight-line method as the units of use would be very difficult to produce consistent results and the reducing balance method would mean that the computer was becoming less useful as time went on, and this is not the case. Using the straight-line method the expense would remain at the same rate every year, a percentage of the net realizable value. If the revenue generated in a particular period by the computer is greater than the expense incurred through depreciation, then the purchase would be considered a profitable investment. The reverse would also hold true and this measure would act as a review system for the advertising agency to be used in future decision making. Another reason to adopt the accrual system is the fact that it incorporates the possibility of the asset becoming obsolete.
If the computer system were to crash or become unusable, the accountant would simply have to write off the asset as an expense. This would not be achievable if the system had been recorded as an expense when it was purchased. In conclusion, the method used by the accountant was inefficient and would have significantly distorted both the Statement of Financial Performance and that Statement of Financial Position. The correct method was that of accrual accounting which would have reconciled the revenue generated by the computer system with the expense, the depreciation of the asset.
This would have spread the cost of the system over its useful life and would have been reflected in the financial statements of the advertising agency.