Topic 10 - Revisiting Financial Statement Analysis (2): Accounting Policy Choice

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This article is a topic within the subject Accounting 1B.

Contents

Required Reading

Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 681-693.

Accounting Policy Choice

[1] Accounting policy choice is a decision made in advance about how, when & whether to record or recognise something.

Management needs to use judgement in choosing accounting policies (depreciation, inventories, revenue recognition & asset expenditure or expense etc.) under GAAP/Accounting Standards. Need choice to cater for diverse firms & efficiency. Accrual accounting necessitates choice as we try provide the economic reality of a firms performance – requires judgement. Policy choice should be based on the 4 key accounting principles reliability, relevance, comparability & understandibility etc.

Fungibility

There is of fungibility with assets & expenses. Expenses are the using up of assets while assets are stored expenses, only a timing difference exists. Earnings management can lead to underestimated earnings if assets are recognised as expenses.

There is fungibility with revenue, liabilities & equity. They all represent an inflow of economic resources but are classified differently. E.g. unearned revenue -> Revenue -> Equity

Incentives & Disclosure

  • Report Overestimated Profit – meet analyst expectations, executive compensation & share issue
  • Report Underestimated Profit – new CEO, privatisation, tax

Disclosure of Accounting Policy occurs in the notes to financial statements

  • Significant Accounting Policies
  • Any Changes in Accounting Policy (Dual Effect Changes, Classification & Disclosure – only effect B/S)
    • Nature & reasons for change
    • Financial effects of the change
    • Changes must be applied retrospectively – adjust previous year for comparison & equity account

Examples

[2] Change from straight line depreciation ($500,000) to reducing balance ($600,000). Tax = 36%

  • P/L - depreciation expense increases by $100,000, tax expense decreases by $36,000, Profit decreases by $64,000
  • B/S - assets (carrying value) decrease by $100,000, tax liability decreases by $36,000, equity decreases by $64,000
    • Change in profit = change in net asset value = change in equity
  • Cash - no effect in year 1, increase in cash by $36,000 in year 2

Change from FIFO to WACM – an increase in COGS of $300. Tax = 30%

  • P/L - COGS increases by $300, tax expense decreases by $90, profit decreases by $210
  • B/S - inventory decreases by $300, tax liability decreases by $90, net asset value or equity decreases by $210
  • Cash - no effect in year 1, higher cash in year 2

Gold ltd is going to recognise revenue earlier. Accounts Receivable at 31 Dec 2009 rises by $7,000 & $16,000 in 2010. Tax = 30%

  • Revenue increased in 2009 by $7,000 (decrease in 2010 by $7,000)
  • Revenue increased in 2010 by $16,000 - $7,000 = $9,000
  • Revenue decreased in 2011 by $16,000
  • 2010
    • P/L - revenue increased by $9,000, tax expense increased by $2700, profit increased by $6300
    • B/S - receivables increased by $9,000, tax liabilities increase by $2700, net asset value increased by $6300
    • Cash - decrease in cash

End

This is the end of this topic. Click Accounting 1B to go back to the main subject page for Accounting 1B

References

Textbook refers to Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning

  1. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 682
  2. ASB, UNSW
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