The books of rules of International Financial Reporting Standards is over 3,600 pages long this year; and the equivalent book of US rules is much longer.
In many entities, especially large ones, most of the owners are not the day-to-day managers. This is why financial reporting is necessary. However, there is a horrible risk that the managers (including the accountants in the company) will overstate success or hide problems when they report to outsiders. This is why independent experts are needed to check on the information reported by the managers.
Another field related to accounting is finance, which is concerned with the raising of money and how to best use it. Finance addresses such questions as: If a company wishes to expand, should it borrow money or should it get more money from its owners? If a company has spare money, should it invest in new projects, pay dividends to the shareholders, buy back its own shares, or pay off its debts? How much a company’s share price move when it announces a particular level of profit? What strategy should investors in stocks and bonds use in order to out-perform the general stock market?
In practice, nearly all the world’s important companies are really groups of entities which operate together.
The common feature of all these international influences on accounting is that commercial developments have brought accounting advances. Not surprisingly, leading commercial nations in any period are the leading innovators in accounting.
A balance sheet is a document designed to show the state of affairs of an entity at a particular date. Its official name is “statement of financial position.” The balance sheet is the culmination of a long and complex process of recording and then analyzing all the transactions of an entity. If the balance sheet does not balance, mistakes have been made during the preparation process; and they will have to be found.
The public tends to regard the balance sheet, which contains lots of big numbers and yet apparently magically arrives at the same figure twice, as proof of both the complicated nature of accountancy and of the technical competence and reliability of the accountants and auditors involved. However, reduced to its simplest, a balance sheet consists of 2 lists. The first is a list of the resources that are under the control of the entity — a list of assets. The word “asset” derives from the Latin ad satis via Norman French assetz (sufficient), in the essence that such items could be used to satisfy debts.
The second list of items on the balance sheet shows where the assets came from, in other words, the monetary amounts of the sources from which the entity obtained its present stock of resources. Since those sources will require repayment or recompense in some way, it follows that this second list can also be regarded as a list of claims by others against the resources of the entity.
An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Note that the definition refers to “control” not to “ownership.” This was a conscious decision by accountants in the English-speaking world. For example, American Airlines do not own many of their planes. For tax or other reasons, they lease the planes from financial institutions. However, the airlines control the use of the planes for most of their economic lives. Accountants treat the planes as assets of the airlines not of the finance companies which own them.
The final part of the definition (expected benefits) is the point of the asset: no benefits, not asset.
Notice that the cash is an asset, in other words, a resource, whereas the equity capital is a claim on the business by the owner, although usually there is no legal obligation for a business to repay its owners unless the business is closed down.
The separation of the entity from the owner is implied by showing the owner’s contribution as a claim / source. Without this separation, the affairs of the owner and the business would become tangled up, so that the success of the entity would be unclear.
Amounts that must be paid to outsiders (not to the owners) are called “liabilities.” This word derives from the word “liable,” meaning tied, bound, or obliged by law.
Claims by the owners, which are not expected to be paid back to them, are not called liabilities, but the owner’s equity.
It would be possible to prepare a new balance sheet after each transaction.
It is time-consuming to measure both the assets and the expenses. Judgment is required because there will be doubt about which category to put some costs into. For example, if money is spent on research or advertising, does that create an asset or is it an expense? Consequently, in practice, 2 solutions are available:
- Expenses = resources used up in the period. Therefore, Assets = the rest of the resources.
- Assets = resources with remaining future benefits at the period end. Therefore, Expenses = the rest of the resources.
Cash decreases might be good, such as:
- Buying useful machines that will last for 10 years
- Paying off loans that required high interest payments
- Doing R&D
Cash increases might be bad, such as:
- Selling buildings that are needed for operations
- Borrowing money at a high interest rate
- Giving big discounts to customers if they pay quickly
- Not paying suppliers
Among other things, this chapter addresses the following questions: What exactly is an asset? Why are staff not assets? How (and why) are assets divided into groups on balance sheets? Why are different assets measured differently? What is the difference between depreciation and impairment? Why are various expected expenses and losses not accounted for as liabilities? Why are income statements shown in 2 parts with “earnings” in the middle? How can an investor decide which company to lend to or buy shares in? How could managers use accounting to mislead investors?
Many non-accountants make the reasonable assumption that assets are valued at what they are worth. However, what does that mean? Which of the measures is “worth”? In practice, any measure except historical cost is difficult to calculate, and different accountants would come to different estimates. Furthermore, if is not clear that today’s value (e.g. of selling) is relevant for an asset that will probably not be sold (e.g. the head office). So, in practice, accountants measure most assets on a cost basis. That approach is easy, cheap, and reliable.
However, most assets have limited useful lives: they wear out because of usage (e.g. machines) or because of time passes (e.g. patents). The obvious exception is land, which can last forever.
However, staff can resign — often with little notice. Even staff on long contracts are usually allowed or required to go quickly when they resign. So, staff are not “controlled.” For this reason, they are not treated as assets. This also means that training courses and other costs related to staff are treated as expenses rather than assets.
To be on the safe side, the sale transaction is not counted until the inventory is taken by the customer. This fits with the definition of the asset: it ceases to be the seller’s asset when control is passed to the customer by delivery.
A financial structure ration measures how much the firm is funded by the equity capital and how much by debt capital, in other words, what proportion of the funds comes from the owners and what proportion from outside lenders. This ratio is known as “gearing” or “leverage.”
The ratio of the share price to the earnings is often abbreviated to “the p/e ratio.”
p/e = Market price per share / Earnings per share
It indicates the “expensiveness” of the share. Another way of looking at this ratio is that it shows the confidence of investors. A high p/e ratio indicates a high level of confidence in the company; in other words, the market is prepared to pay a high price for a share in the company, compared to its earnings. This is because the market expects a good future for the company.
To extend the continuum of ability to mislead, there are lies, damned lies, statistics, and financial statements.
The basic reason for international differences in accounting is that the main purpose of accounting has varied by country and over time. For example, by the last quarter of the 20th century, the purpose for listed companies in the USA was to give useful information to investors to help them to predict cash flows in order to make economic decisions. By contrast, the purpose for most German companies was to calculate taxable income and prudently distribute profit.
The UK’s requirements for financial reporting and auditing have the longest history in the world. The USA has the world’s largest stock markets, the oldest stock-market regulator, and the only really important national standard-setter.
One of the distinguishing features of the UK and the USA is the greater age, size, and importance of the accountancy profession. There are far more auditors per head of population in English-speaking countries than elsewhere.
The UK was the first country to experience the industrial revolution, therefore to need large companies, therefore to need many investors / shareholders, and therefore to need limited liability companies.
In addition to limited liability, some other protection is granted by law. An important safeguard is the right to receive financial statements from the directors showing the profit of the company and its state of affairs, together with quite a lot of detailed information as required by various regulations.
- Companies to keep accounting records
- Directors to prepare annual financial statements
- Auditors to be appointed, except for certain small private companies
- Annual reports to be sent to the shareholders and made public by sending them to a government official
- The company to hold an annual general meeting of shareholders, at which directors and auditors are appointed and dividends are voted on
There is nothing like the onset of financial difficulties to place almost irresistible pressure on the directors of a company to show a position more favorable than is really the case. It is the auditors’ responsibilities to try to stop this happening, or to qualify their audit report if it does.
The principal duty of the auditor is to report upon the financial statements prepared by the directors. Note that the auditor is not in charge of preparing the statements, and cannot force the directors to change them. The culmination of the audit process is the publication of an “opinion” on whether the financial statements give a “true and fair view” (UK) or “fair representation” (USA) of the company’s cash flows, financial position and profit or loss, in the context of the prevailing law and accounting rules. The audit report can usually be found immediately before the financial statements, often about half-way through a company’s annual report.
The idea of “fairness” reflects the fact that accounting is not an exact science and that there may be a number of different ways in which to present broadly similar information. The term conveys the idea that the financial statements have been honestly prepared to reflect the facts, and are not misleading to readers.
No rule can guarantee independence and objectivity; they are personal qualities required of an auditor. Nevertheless, in most countries, the law prevents an auditor from being a director or an employee of a company (his or her client) of which he or she is an auditor, and the rules of the professional bodies further prohibit him or her from holding shares in it. Additionally, accountancy firms have their own rules to ensure that their partners and staff are seen to be as independent as possible.
However, there have certainly been cases where the auditors have got too close to the directors, partly because of all the non-audit work granted by the directors. In practice, the auditor often sees the audited company (rather than its shareholders) as “the client.”
The auditor must consider materiality and must decide what size of error or misstatement is likely to be material to a proper understanding. Certainty could only be achieved by an exhaustive examination of all transactions undertaken by a company, and it is doubtful whether absolute certainty could ever be achieved even in relation to the smallest of companies. An auditor therefore has 2 very important judgments to make, right at the start of his or her work: what is going to be material to this client, and what work is needed for the necessary level of assurance to express the “opinion”? These are only the first of many judgements.
The first stage of answering the above questions is to have a thorough understanding of the client’s business, without which no view can be formed about whether the financial statements reflect the client’s economic activity. The next stage is to consider the client’s accounting systems. If they look likely to produce accurate information, then the auditor may be able to carry out less work in substantiating final figures. This will be possible if the client has a good system of internal control.
Another frequent source of difference between auditors and directors is the question of the valuation of inventories. The general rule is that inventory is included in a company’s balance sheet as an asset at the lower of its cost and its net realizable value. In some cases, even the cost of inventory can be difficult to determine, especially if it has been made by the company itself: careful record keeping will be necessary and some judgement may be involved in making allocations of costs to specific items. However, the net realizable value of inventory may be even more difficult to determine, particularly if it is slow moving or relates to obsolete models.
Many frauds are not large enough to affect whether or not a fair view is given by the financial statements. The auditor cannot hope to detect or prevent all small frauds. It would be prohibitively expensive. The mere existence of an audit should have a deterrent effect since there is always the chance that fraud will be detected.
The final 2 chapters examine aspects of management accounting: decision-making and control. Among other things, this chapter addresses the following questions: What sort of decisions can management accounting help with? Why are some costs relevant and others irrelevant? How does a company decide at what volume to operate? What are indirect costs, and how are they taken into account in decisions?
Historical costs are the amounts actually spent by the entity. They are used for drawing up a set of financial statements. However, the relevant costs for decision-making are different; it is necessary to assess the economic or opportunity cost involved. Suppose that the decision is whether or not an entity should sell a building. The opportunity cost is the amount of money that the entity would forgo if it sold the building. The historical cost of the asset in this circumstance is always irrelevant. In other words, when making decisions about future activities, it is future-relevant amounts and not historical costs that matter.
The relevant costs can also be called “incremental costs.” That is, what matters is how the costs would change if the extra project were done.
Sunk costs are always irrelevant for decisions. Sunk or committed costs can be treated interchangeably because an irreversible decision will have been made.
Firms need to plan ahead. By getting involved in the budgeting process, managers are forced to do this. Without the budgeting process, managers might just carry on with their routine tasks, and then engage in crisis management. By getting managers to think ahead, they foresee problems and are in a better position to prevent them from arising.
Once the firm has determined the reasons behind the variances, it is in a better position to do something about such differences, that is, take corrective action.
When establishing a budget for a period, the quickest and easiest approach is to start with the previous period’s budget, adjusting it for expected inflation and any major expected changes. However, if an organization carries on doing that for many years, it might forget to ask whether particular activities are really needed or whether certain activities could be done more cheaply or done completely differently. Consequently, there is a good argument for demanding that managers should start from scratch each year, with “zero-base budgeting.”
DEB might well be called a craft, but one remembers that the civilized world is kept afloat by crafts such as plumbing or shoe-making. The use of the information from DEB is perhaps a series of technologies or technical arts: financial reporting and management accounting. These arts involve a great deal of judgement. Even a nice solid asset as an office building has a potential plethora of “values”: historical cost, depreciated historical cost, current replacement cost, net realizable value, discounted expected net cash inflows, and others.
Given the answers to the previous question, outsiders (e.g. bankers or shareholders) clearly need to be wary. The published financial statements rely on many estimates, and they are, in a sense, marketing documents: the company wants your money. History is replete with spectacular examples of bad reporting.
In practice, an audit firm is largely selected by a company’s CFO, who is usually a former auditor, sometimes from the audit firm selected. An auditor generally refers to the company as the “client” although the auditor is supposed to be working for the company’s shareholders. The auditor often does non-audit work for the “client,” whom it would therefore not wish to upset. Then, there is the problem that an audit firm can remain in place for decades. When a large listed company does change its auditor, it swaps from one Big-4 firm to another.
The dominance of the Big-4 is not surprising. The firms need to be big in order to operate throughout the world because their clients do. There has to be a massive investment in training and technology. Big listed companies cannot risk signaling anything less than top quality audit, so they feel that they must use the Big-4. However, the dominance is alarming. It does look anti-competitive. There is also the practical problem that, on many big deals (e.g. a take-over battle), all 4 firms are involved in some capacity, so top-level independent advice is hard to find.
Precision of communication is important, more important than ever, in our era of hair-trigger balances, when a false, or misunderstood, word may create as much disaster as a sudden thoughtless act.