Financial Accounting Principles And Analysis Performance

The use of future estimates in financial statements

Discuss about the Financial Accounting Principles and Analysis Performance.

1. ‘Although the statement of financial performance is a record of past achievement, the calculations required for certain expenses involve estimates of the future.’ What is meant by this statement? Can you think of examples where estimates of the future are used?

In the words of Afonso and Sousa (2012), the financial statements of the current year of a particular company reflects the working process and expenses beard by it along with the amount of profit earned of the previous year.  It also contains some estimates belonging to the future. In the words of Beatty and Liao (2014), the following estimates of the future are considerably the assets and liabilities that are included in the financial performance of the past achievements being a part of the future estimates. However, the companies have to adhere to the International Financial Reporting Standards to regulate the involvement of the future estimates in the financial statements of the past or current year.               

The assets and liabilities that are included in the present financial statements and are a part of the future estimation. The different assets and liabilities are connected with the different aspects of the future estimates. As observed by Board (2015), it has also been witnessed that the past transactions give rise to flow of the economic benefits of the future leading to an inflow and outflow for the same. The inclusions of the expenses associated being a part of the present financial statement of the company is not a new concept. As stated by Altman et al. (2013), in a virtual manner it has been observed that the amounts of the financial statements of today require the future estimates of the same. The amount of loan receivables reflects the amount that the bank is expected to receive back from the borrowers. According to Christensen and Nikolaev (2013), the amount of loan is determined as per the amount promised and is adjusted in accordance with the money’s time value in the future years. The estimated of the allocation of the loan amount along the future years in determined on the basis of facts and circumstances of the current year.   

The future estimates that are considered in the past and current records of the company may precisely be the various reserves and provisions made by the company in context of the future contingencies and to bear the future uncertain losses. These are namely provision for bad debts and provision for depreciation. The amount of bad debts refers to the amount that has been estimated to arise from the receivable accounts that have not been collected but are issued by the company. The provision for bad debts follows the accrual basis of accounting. The purpose of making a provision for bad debts is to channelize the impact of bad debts in the early reporting periods.  

Difference between cash flow and profit or loss account

On the other hand, the provision for depreciation consists of the collected value of the depreciation of all the assets of the company. This facilitates the company in realizing the value of the asset in the current year. in the words of Radebaugh (2014), as and when the company decides to sell off the assets then the total amount of depreciation is deducted from the cost of the asset the residual is then further deducted from the sale value of the asset. In this way a company can ascertain whether the sale assets has made a loss or earned profit for the company.  

2:

To,

The Proprietor,

Pat Stewart,

Business name,                                                                                                Date:

Dear Mr. Pat,

Subject: Response to accounting related concern

I have come to know about your concern over the difference existing between financial performance as reflected in the cash flow statement and the profit or loss account. Please find my response to the same below:

Please note that the financial performance indicated by the cash flow statement of your company does not match with the profits level shown by the profit or loss account, which is quite obvious. The reason being the different accounting approach followed in case of preparing the two financial statements. Cash flow statement is prepared under cash basis of accounting whereas profit or loss account is prepared under the accrual basis of accounting. This difference in the application of accounting approach causes difference between the results revealed by cash flow statement and profit or loss account.

You also need to understand that cash and profits are different from each other, both are not same at all. Cash is the amount of money that the business have at any particular time to meet business expenses. On the contrary, profit represent the excess of revenues over expenditures in a business. In other words, profit indicates the amount of money that a business is making from the capital investments. Here, it is important to note that profit is recorded in the books when a sale is made whereas cash flow is recorded actually when the cash is received from the concerned customer.

Cash flow statement is prepared under cash basis of accounting and thus it records the outflow and inflow of cash as and when the same takes place in the business. On the contrary, profit or loss account which is prepared under the accrual basis of accounting considers the total revenue and expenses that accrue during a particular accounting period in the business, irrespective of actual cash flow regarding the accounting items. Difference between the two can be easily demonstrated through an easy example. For instance, a business pays $1000 as rent per month to the landlord however for the last two months’ rent has not been paid and thus due. In such a case, the actual cash flow during the 12 months’ period was $1000 * 10 = $10,000 and this amount would be shown in the cash flow statement. On the contrary, in case of profit or loss account, entire rent for the year of $1000 * 12 = $ 12,000 would be shown as an expense with 2 months’ rent of $2,000 as an outstanding expense. This makes the cash balance higher whereas profit amount gets lowered due to such transactions.

The concept of depreciation

To sum up, under cash basis of accounting, revenues are recorded in the financial statements when these are actually received and expenses are recorded when the same is paid from business cash. On the other hand, under accrual basis of accounting, revenues are recorded at the time when the same is earned and expenses are recorded when the same gets accrue.

I firmly believe that the above explanations would surely clear your doubts relating to the matter.

Yours sincerely,

Name

3

Critically examine the following statements about depreciation.

Depreciation is a valuation adjustment.

According to Misopoulos et al. (2014), the term depreciation refers to the amount attained on the deterioration in the valuation of the fixed assets along a specified time period. It is the method by which the company allocates the cost of various tangible fixed assets along its useful life. The depreciation of these stated assets do not involve a flow of cash and allows writing off the assets’ value over time. According to Braun et al. (2015), the depreciation expense shows the amount of the value of the asset that has been used over the years. Therefore it can be said that the amount of depreciation charged is the valuation of adjustment of the assets account. The deprivation that occurs in the assets of the company for a particular year is not directly deducted from the value of the assets in the assets account. As observed by Fenna (2013), a separate account for charging the amount of depreciation is prepared by the company wherein the rate of depreciation according to the decision of the company is charged upon and deducted from the accumulated amount. According to Ryan (2012), the residual value left upon after charging depreciation for the given years is the actual price of depreciated asset in that particular year.

The following can be explained by an example wherein a company purchases machinery    for a value of 1 lakh rupees. As stated by Lovell (2014), the company may choose to write the entire cost of the assets in one year or it may choose to write the value of the asset over its expected term of life that is 10 years. The portion of the cost of the assets that is being depreciated each year is treated in the form of depreciation expense on the company’s income statement. This shows the way in which the value of the asset is adjusted every year. In short, as said by Matherly and Burney (2013), the company transfers a portion of the cost of the assets from the balance sheet of the company to the income statement of the same during each particular year of the life of the assets.

There is no point in depreciating buildings because their value increases.

In this regard it may be stated that the value of the buildings do not increase over time, the land on whom the building has been constructed increases in value. In the words of Gregory and Smith (2016), the concept of depreciation is not applicable on the fixed assets such as land because the value of the same increases over time. According to Caria and Rodrigues (2014), as the land is a limited resource therefore the value of it does not decreases and remains at a higher value. On the other hand, the buildings undergo depreciation on account of innovation and reconstruction of the same. In the words of Watts and Zuo (2016), the materials that had been used for the construction of the buildings had a certain cost and are not a limited resource therefore the buildings are a depreciable asset. Further, the buildings that are used for the purpose of office uses and production purposes as well as warehousing require to be depreciated to ascertain the financial statements of the company.       

4 . Why would a business choose to make the following entity structure changes?

(a) From a proprietorship or partnership to a private company.

A business entity engaged in a partnership form of business has to deal with a lot of disadvantages such as disagreement between the partners, bearing of risks and liability, heavy taxation etc. In a partnership form of business the partners may not agree on all matters in context of the firm. This causes a conflict between the partners and as a result hampers the productivity of the business. Furthermore, the partners of the partnership business firm are subjected to unlimited liability. According to Collins et al. (2012), this puts the partners in an unstable situation in case the firm incurs a loss the expenses in this regard have to be borne by the partners. They may also require using their personal properties and assets to rectify the expenses on account of the loss incurred.  

On the other hand in a private limited company, as stated by Armstrong et al. (2016), the liabilities of the shareholder are limited and this is considered to be the most important advantage of a public company. In case of any loss in the company, the shareholders do not require to give up their personal assets to meet the expenses of the losses. The public limited companies in a way protect the wealth of the shareholders and do not compel the shareholders to put their resources at risk.

In addition to the above, the decision making in a private limited company is conducted on the basis of majority votes. The voting system is undertaken to make an effective decision. According to Tawiah and Benjamin (2015), this eradicates the chances of disagreement of the shareholders regarding a specific decision and therefore the chances of conflict in between the shareholders are minimal in a private limited company. As the advantages of a private company are more beneficial than a partnership form of business therefore a business entity might consider changing the business structure from a partnership form of business to a private company.       

(b) From a public company to a private company.

The setting up of a public company requires a lot of investment and time and is also difficult to set up. The business is also not commenced from the date of the company’s incorporation. The business secrets of a public company are difficult to maintain as the annual accounts of the same are published. The decisions in a public company regarding the business and other areas are often delayed leading to loss in business. In the words of Herndon et al. (2014), the separation of the ownership from the management of a public company reduces the efficiency of the company. There is also a possibility of clash between the management department and the shareholders of the company.

On the other hand, the workings of a private company are undertaken by the shareholders of the company. All the decisions in context of the business of the company are undertaken by the shareholders without any interference of the government regulation and policies as is the case of a public company. In addition to this,  as opinionated by Pashang et al. (2014), the chain of communication between the shareholders and the employees are of advanced level ensuring a good flow of exchange of ideas and problems. This in turn ensures that the conflict in between the management and the owners are kept to the minimal. As the advantages of a private company are more than a public company hence a business enterprise may consider the following structural changes in the business entity.

5.

As a first-year accounting student, Irene is confused. She thought she was learning that accrual accounting provided more useful information about the financial performance and position of an organization than the statement of cash flows. The statement of cash flows is a step in the wrong direction in her opinion. Help Irene with her dilemma.

In context of the above question as opinioned by Biddle (2015), the preparation of cash flow is based on cash basis of accounting whereas the preparation of the income statement follows the accrual basis of accounting. In the cash basis of accounting the revenues are being recognized when they are actual received by the company and not merely earned. Similarly, the expenses of the company are also releasized only when they are paid for in actual by the company. The preliminary nature of expenses is not considered in the cash basis of accounting. Furthermore, the income or revenue received in advance is also not taken into considered. In the words of Oulasvirta (2014), the cash flow follows the accounting basis of cash and therefore includes only the revenues and expenses that have also been received and paid by the company.

On the other hand, the accrual basis of accounting the revenues and expenses are realized at the time when they are earned. For example, the accounting services made by an accountant in the month of December garnered a sum of 10,000. However, the actual amount will be receivable in the month of January. Here, the revenue earned will be treated in the month of December and not in the month of January. This constitutes of the accrual basis of accounting. The income statement of a company is prepared on the accrual basis of accounting. This signifies that the income statement of a company consists of the revenue that has been earned by the company but may not have been received by the same. Similarly, the expenses stated in the income statement may be future contingencies that have at present not been incurred.

In a similar way if the utilities used up by the company will be mentioned in the bill of January that was used in the month of December. Now if the cash basis of accounting is followed then the bill be paid and written in the month of December whereas if the accrual basis of accounting is prepared then the following will be treated in the month of January.

In the words of Wang et al. (2016), as the cash flow and income statement of a company is prepared on the basis of two different accounting approach therefore there is a subsequent possibility that the cash flow may display an increment in cash whereas the income statement I displaying a loss for the company. Similarly, the cash flow may show a decrease in the amount of cash whereas on the contrary the income statement is showing a profit for the company. Such differences are beneficial for the company a it provides the necessary help required in the better understanding of the areas in which the company requires to make changes so as to earn more profit. Furthermore, the income statement of accompany that follows the accrual basis of accounting reflects the revenue earned by the company and the cash flow of a company that follows the cash basis of accounting shows the actual flow of cash in context of the revenue earned.

6. An accountant prepared a statement of financial position for a business using the horizontal layout. In this statement, the capital of the owner was shown next to the liabilities. This confused the owner, who argued: ‘My capital is my major asset and so should be shown as an asset on the statement of financial position.’ How would you explain this misunderstanding to the owner?

The balance sheet of a company displays the capital, assets and liabilities of the same at the end of each financial year. The owner of a company invests the personal assets in the company in the form of capital in order to earn a subsequent return upon the amount of money invested. Here, the owners’ capital is treated in the form of an investment and not as an asset. The investments made for the business proceedings of the company form a part of liability for the business. In this context, the owner of the capital has to understand that the amount that is an asset for him becomes a liability for the business. The business is treated as a completely separate entity from the owner. In case the company suffers a loss then in that case the liabilities of the business do not form a part of the owner’s personal liability.

The business entity is a separate entity from the owner. The business is not registered with the name of the owner but by the name of the company. As far as capital is concerned, it is shown of the liability side of the balance sheet. The term capital can widely be explained as the amount of capital employed by the company in context of the assets owned by the company. As said by Corsetti  et al. (2013), the assets of the company are a sum total of the fixed assets as well as the working capital. Here, it must be noted that the employed capital of a company are shown on the assets side of the company’s balance sheet. On the other hand the sources of fund equal in amount to the capital employed are shown on the liability side of the company’s balance sheet. The balance of the sources of fund might also involve the loan taken for the purpose of the business as well as the provisions created to meet the expected loss or expense that is yet not mentioned in the company’s balance sheet.

The confusion of the owner regarding the treatment of capital as a liability for the company and not as an asset can be eradicated only if the business is treated to be a separate entity from its owner. For the purpose of conducting a business sufficient amount of fund is required. The sources of fund may be the owners’ personal fund or it may be borrowed fund. The business receives both the funds for conducting the business. Here, it may be seen that the owner is also investing the personal capital into the business and therefore the capital becomes a liability for the business and not for the owner. If so ever the company is closed or sold off at the assets’ book value than the after the liabilities of the company has been meet the money that is left will be returned to the owner. Therefore, the fund provided by the owner for the business purpose id treated as liability and not as asset for the company.  

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