Financial Accounting For Cocoa Ltd.

Choice of Depreciation

Discuss about the Financial Accounting for Cocoa Ltd.

Cocoa Ltd is carrying out the business of departmental store and applied Straight-line method for depreciation for the year ended 30^th June 2015. The company is earning very high profit and expecting to maintain the same during 2016 and 2017. However, the economists are expecting that in the coming years that is, in 2018 and 2019. Based on the forecasting of economists the company approached their accountant to show less profit in 2016 and 2017 and wants to transfer it to 2018 and 2019, if possible. To implement the requirement, their accountant suggested them to change their method of depreciation from Straight-line method to Sum-of-years-digit method.

Andrea, the accountant of Cocoa Limited was facing a problem, as she was worried regarding the renewal of her contract with the company. In spite of the fact that she was fully conscious that her act was not ethical, nonetheless she made the alteration in the financial report. Thus, the probable impact of this act is as follows:

• Communities, Governments, customers, suppliers, creditors, managers, shareholders will be affected as they will not be able to know the true position of the company
• It will lead to lack of transparency, integrity and contravention of objectivity.

AASB 116 recommends various acceptable method of depreciation that suggests the systematic allotment of cost over the useful life of the asset. AASB does not stipulates any particular method of depreciation to be applied by any company. An organization can apply any of the acceptable method for calculating depreciation (Laing and Perrin 2014). However, paragraph 60 of the AASB explains that the chosen method must result in best indication of sample in which the probable future economic benefits of the assets are expected to be absorbed by the entity. The method of depreciation should be reassessed at the end of each accounting year and should report if there is any change in the method of depreciation. Generally, once a company adopts a particular method of depreciation, they should apply it constantly over the useful life of the asset. All the companies are needed to disclose the chosen method of depreciation in the annual report (AASB 2015).

Straight-line method of depreciation states equal amount of deduction as depreciation for each year over the useful life of the asset. As per the straight-line method, depreciation is calculated by the following formula: 

Depreciation = Cost-Estimated residual value)/estimated useful life (Paull 2016).

Sum of the years method of depreciation:

Under the sum of years method of calculating depreciation, the amount of depreciation decreases over years continuously. Under this method, more amount of depreciation will be written off in the beginning as compared to the ending years. The depreciation is calculated using the following formula:

Depreciation = Reverse working life digit*(Cost of fixed asset- Scrap)/Sum of life years digit (Hastings 2015).

This method of depreciation is also called as SYD method. One of the important objectives under this method is that it charges more amount of depreciation in the beginning years as more of the fixed assets are utilized in the beginning years as they are bought new. Therefore, the first year’s depreciation are calculated by multiplying the fixed asset’s cost with the end year’s digit ratio and sum of working life year’s digits. In the same way, depreciation are calculated over the all year and the amount of depreciation will decrease fast (Haddadi 2014).

Straight-line method

Objective: the main objective of this standard is to advise the accounting treatment for fixed asset so that the users of the financial statement can distinguish the data about the company’s investment. The major issue in fixed asset’s accounting are the identification of the asset, determining their scrap value and their useful life, charges of depreciation and impairment charges, if any (Laing and Perrin 2014).

Application: This standard is applicable to:

• All the companies those are required to prepare the financial statements and reports with consideration to Part 2M.3 of the Corporation Act and which is a reporting company
• Financial statements of general purpose for each reporting company (Newberry 2014). 

Ethics and the value of ethical consideration have taken an important place as the stress placed on company’s business by the creditors, shareholders and other interested parties who can be affected by the financial performance.  It is not unexpected therefore that a recent assessment of investment management firms exposed that approximately three-quarters of the participants felt that unethical performance, such as insider trading, personal trading, and fraudulent financial reporting are the segments for big concern. Another assessment pointed out that approximately half of more than 700 human resource experts said that they feel stress to negotiate their organizations’ values of ethical conduct of business (Zadek, Evans and Pruzan 2013).

The factors, which increased the concern about ethics, are internationalization of the economy that has a combination of socioeconomic and cultures and systems. Progressively, a company cannot presume that what is measured as appropriate in its domestic market would be suitable in any other market. Technological know-how has helped the globalization tendency and made the impact of illegal decision and corporate dishonesty more transparent. Increasing competition raised the stress to cut corners, to earn an economical edge. The significance of meeting the forecasts for net income and Earnings per share has radically increased the enticements for companies to influence their earnings to meet the analysed target. Finally, increasing the expectations of public for ethical corporate activities and the capability to use the legal system to be remunerated for illegal and unethical corporate activities have enlarged the risk of organizational and personal liability. Expectations of high level of ethical corporate behaviour are increasing, as organizations face economic and legal punishment for practicing illegal and unethical activities (Harrison and Van der Laan Smith 2015).

Corporate governance states the application of power over corporate entities. Corporate transparency explains the degree to which a corporation’s activities are noticeable by outsiders. Transparency is one of the major steps to corporate governance and assures that management will not engage in unlawful and improper activities as their behaviour will be examined. To attain transparency, a company should accept accurate accounting policies, make full disclosure of company’s data and make disclosure of divergence of interests of the controlling shareholders or directors (Michelon and Parbonetti 2012).  A major aspect of ‘good’ governance is ‘transparency’, which integrates a system of balances and checks among the board of management, directors, stakeholders and auditors. Disclosure of significant issues concerning the company shall be reported in timely and balanced manner to assure that all investors have right to use the factual and clear information. In total, it increases the behaviour and control and that sustain efficient accountability for performance result. A company is more probable to attain better result when corporate governance practices of transparency are given importance within the organization. On the other hand, firms with poor corporate governance are not likely to perform better in the long-run (Al-Maghzom, Hussainey and Aly 2016). 

Sum of the years method of depreciation

Change in the method of depreciation is allowed only under the following circumstances:

• Application of new method is needed by the accounting standard or law
• Change is required for better management of annual statements

When the depreciation method is changed, the amount of depreciation shall be recalculated with consideration to the new method beginning from the date of the asset coming into use. The shortfall or surplus resulting from the recalculation shall be adjusted in the books of accounts through recording an adjusting entry. If the change results into shortfall, the shortfall shall be adjusted against the profit and loss account and in case of surplus, the surplus amount shall be added to the profit and loss account. As per the accounting policy the effect of change in method of depreciation should be computed and disclosed in the annual statement (Stunguriene and Christauskas 2014).

Shareholders are the person, who has substantial interest in the investment and earnings of the company. Shareholders represent considerably a wide group as they involve any person who is interested in success and failures of the company. This group involves not only the shareholders but also the communities, customer, creditors and government.  

Depreciation is regarded as non-cash transaction as it is an modification to the net earnings that permits the organizations to write off the definite amount from the value of the asset over its useful life. Shareholder’s equity is utilized to recognise the company’s equity. Higher amount of net revenue raises the shareholder’s equity by increasing the retained earnings (Rice and Weber 2012).

Expense of Depreciation is a metric used in concluding adjusted total income for the purpose of tax. The AASB require companies to circulate statement of net revenue. As a result, the companies circulate that one, which presents a lower amount of net income. The statement of net income is not prepared with the investor’s consideration. The most perceptive investor only adds back the depreciation to net revenue in order to verify actual operating revenue.

While expenditure of depreciation is stated in the statement of income, equity of stockholders is presented in the statement of financial position. It presents that fraction of company’s properties that are held in absolute form and not from the funds, which are borrowed. The equation of statement of financial position is, assets equals to stockholders’ equity plus liabilities. Only if a firm has $0 equity for stockholders’ then only payment for all the assets are made with debt funds and vice versa. Stockholders’ equity involves retained earnings from generated revenue and investment funds arrived from issuing stock each year. High amount of net income results into a high amount of retained earnings that increases shareholders’ equity, especially when the received cash is utilized to disburse obligations. As depreciation is not an example of real cash incident, it is tough understand how it really influences the equity in a company (Ioannou and Serafeim 2014).

Consumers make their decision about investment based on the financial statement. They assess the performance of the company as per the statements of accounts. If the required transactions are not disclosed properly or are misstated, it will influence the customer’s decision and they will not be able to take proper decision (Kim et al. 2012).

Objective and Application of AASB 116

Creditors go through the financial statements before allowing any credit to any company. If the financial statement is misstated and depending on the statement the creditors allow credit to the company, chances are there that their money may sink in future. To allow any new credit also the creditors depend on the financial statement. Therefore, if it is misstated or the material factors are not disclosed properly, creditor will not be in a position to know the company’s actual position (Ball, Jayaraman and Shivakumar 2012).

Showing less profit in one period than actual and keep it reserved for future is against the accepted principle. So the decision of general manager, Max Cocoa of Cocoa Ltd of approaching their accountant and asking her to find a way to show the less profit in next two years  that is in 2016 and 2017 and transfer the same to 2018 and 2019 is against the accepted accounting principles and ethics. On the other hand, Andrea, the accountant of Cocoa Limited was facing a problem, as she was worried regarding the renewal of her contract with the company. In spite of the fact that she was fully conscious that her act was not ethical, nonetheless she made the alteration in the financial report. She even did not disclose the fact that the company changed its method of depreciation from straight line method to sum of years digit method as she felt that Max did not explain the reason of change properly. However, the disclosure of material fact should be as the accounting principles and not as per the feeling of accountant. The accountant here should be held guilty for not disclosing the fact of changing the method of depreciation. Therefore, the company Cocoa Ltd should disclose their profit and method of changing depreciation properly in their financial statements and notes to account. 

Reference:

AASB, C.A.S., 2015. Investment Property.

Al-Maghzom, A., Hussainey, K. and Aly, D.A., 2016. Corporate Governance and Risk Disclosure: Evidence from Saudi Arabia. Corporate Ownership and Control Journal, 13(2).

Ball, R., Jayaraman, S. and Shivakumar, L., 2012. Audited financial reporting and voluntary disclosure as complements: A test of the confirmation hypothesis. Journal of Accounting and Economics, 53(1), pp.136-166.

Haddadi, M.H., 2014. The Study of Accumulated Depreciation and Stock Prices in Iranian Industries. The International Journal of Business & Management, 2(9), p.254.

Harrison, J.S. and Van der Laan Smith, J., 2015. Responsible accounting for stakeholders. Journal of Management Studies, 52(7), pp.935-960.

Hastings, N.A.J., 2015. Further Financial Topics. In Physical Asset Management (pp. 481-496). Springer International Publishing.

Ioannou, I. and Serafeim, G., 2014. The consequences of mandatory corporate sustainability reporting: evidence from four countries. Harvard Business School Research Working Paper, (11-100).

Kim, J.W., Lim, J.H. and No, W.G., 2012. The effect of first wave mandatory XBRL reporting across the financial information environment. Journal of Information Systems, 26(1), pp.127-153.

Laing, G.K. and Perrin, R.W., 2014. Deconstructing an accounting paradigm shift: AASB 116 non-current asset measurement models. International Journal of Critical Accounting, 6(5-6), pp.509-519.

Laing, G.K. and Perrin, R.W., 2014. Deconstructing an accounting paradigm shift: AASB 116 non-current asset measurement models. International Journal of Critical Accounting, 6(5-6), pp.509-519.

Michelon, G. and Parbonetti, A., 2012. The effect of corporate governance on sustainability disclosure. Journal of Management & Governance, 16(3), pp.477-509.

Newberry, S., 2014. The use of accrual accounting in New Zealand’s central government: Second thoughts. Accounting, Economics and Law, 4(3), pp.283-297.

Paull, C., 2016. Alternative assets insights: Fixed assets-a case for further inspection. Taxation in Australia, 51(6), p.325.

Rice, S.C. and Weber, D.P., 2012. How effective is internal control reporting under SOX 404? Determinants of the (non?) disclosure of existing material weaknesses. Journal of Accounting Research, 50(3), pp.811-843.

Stunguriene, S. and Christauskas, C., 2014. Benefits of Applying Different Depreciation Methods of Long-term Tangible Assets in a Company. Social Sciences, 82(4), pp.38-47.

Zadek, S., Evans, R. and Pruzan, P., 2013. Building corporate accountability: Emerging practice in social and ethical accounting and auditing. Routledge.