Solution Manual for An Introduction to Accounting Accountability in Organisations and Society, 2nd E

Solutions Manual Chapter 1: What is Accounting?

1.1 Different people will have a different perspective about what constitutes ‘accounting’. At the core, it involves providing an ‘account’ to another party, or to help us achieve certain outcomes. As the book (pp. 3–4) notes, at a very broad level, ‘accounting’ can be defined as: a process of collecting, summarising, analysing and communicating information to enable users of that information to make informed decisions. It involves the provision of information about aspects of the performance of an organisation to a particular group of people with an interest, or stake, in the organisation – we call these parties stakeholders.

At the outset, it is emphasised that ‘accounting’ goes beyond just providing financial or economic measures and it goes beyond simply providing information for ‘business purposes’.

1.2 As pages 7–8 of the book explain with respect to the role of accounting: •

•

•

•

‘Accounting’ provides information (financial, social, and environmental) to guide decisions by people both within (internal to) the organisation and people outside (external to) the organisation; The information collected and reported will be influenced by what aspects of performance management believes it needs to monitor, control, and/or improve as well as what aspects of performance it believes it needs to disclose to people outside the organisation; ‘Accounting’ provides the mechanism by which organisations can inform stakeholders about the extent to which the actions for which an organisation is deemed to be responsible have actually been fulfilled; Reporting provides a vehicle for an organisation to be accountable to various stakeholders, and the accounts being reported do not all have to be prepared in financial terms.

1.3 This book emphasises that accounting can be quite a technical process which can create various social and environmental effects. Some examples of how accounting reports can create social impacts would include: •

A balance sheet might be prepared which suggests that the level of debt of an organisation might be so high that the organisation might not be able to pay its debts as and when they fall due. As a result of receiving this information, customers and suppliers might decide it is too risky to transact with the organisation. At the extreme this could cause the organisation to no longer be able to operate and this might lead to

Deegan 2e_Solutions Manual

•

•

•

2

losses of jobs as well as reduced demands for goods and services from other organisations, all of which might create social impacts.

An account might be released about employee injury rates. As a result of this information being produced this could create innovation in work practices and better safety, all of which would generate social benefits.

An account might be released projecting the cost of manufacturing a product under two alternative scenarios which might be to maintain the current workforce and produce the products manually, or to replace the workforce with machinery. If the financial costs of the second alternative are lower, then this might lead to the retrenchment of staff, and this would cause social costs.

An organisation might produce an account of its wastewater which shows that large amounts of polluted water from the factory are being released into the river. As a result of seeing this data, management might put in place water recycling initiatives, and this will generate environmental benefits.

1.4 The practice of accounting can lead to the generation of reports that might or might not be generated in financial terms. We might have financial accounts, social accounts, and environmental accounts. We might also have accounts that integrate information about the financial, social and environmental performance of an organisation.

1.5 This question emphasises the subjective nature of decisions pertaining to accountability and ‘accounting’. That is, the answer provided here is a matter of personal opinion. If we believe that an organisation has a responsibility to minimise its environmental impacts, then we would believe that it needs to be accountable for such impacts, thereby necessitating the need to provide an ‘account’. The decision about ‘to whom to report?’ is also subjective, but in broad terms, those stakeholders impacted (positively or negatively) by the impacts have a right to related information.

1.6 We often receive a variety of ‘accounts’ from different organisations, even though they might not be identified specifically as accounting. Accounting is everywhere!

• • • • •

For example, when we receive our phone bill, that is an account of what charges we have incurred.

When we look at a food label for information about nutrition, that is an ‘account’.

If you go to McDonald’s for a burger there will be information about the kilojoules associated with each meal – that is an ‘account’.

When our children tell us what they did with their pocket money – that is an ‘account’.

When we receive information about the visitors to a music festival, how much alcohol they consumed, what sort of injuries were incurred – that is an ‘account’.

The point to be made here is that ‘accounting’ and ‘accounts’ can take on many forms.

1.7 For information to be ‘useful’ it needs to have certain attributes, or characteristics.

Primarily, or fundamentally, the information needs to be relevant (be capable of changing a decision) and faithfully represent (be reliable and therefore ideally be free from error, complete and balanced) what it purports to represent. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

To further enhance the usefulness of information, the information should also be comparable (to enable comparisons across time, and between organisations at a point in time); be verifiable (meaning if different people had access to the same underlying data they would derive the same measures); be understandable to the recipients intended to receive it; and the information should be produced on a timely basis (old information tends to lose its relevance, albeit could become more reliable if further auditing or verification of the data is being undertaken).

1.8 If information is not relevant then it really does not matter how reliable (or representationally faithful) it is. However, if information is likely to be relevant, then it is then very important that the information is reliable, otherwise wrong decisions might be made on the basis of this information which in turn can have potentially costly implications. Useful information should have both relevance and reliability.

1.9 Accountants are very powerful members of society. Many decisions are made on the basis of accounting information and these decisions can have a multitude of social and environmental implications. Further, ‘accounting’ for something tends to make that aspect of an organisation’s operations visible. Conversely, if something is not accounted for then it might go unnoticed and unmanaged. Accountants and the ‘accounts’ they generate therefore can impact how much support an organisation receives from different stakeholders. To make informed decisions requires relevant and reliable information.

Information gives us the ‘power’ to make informed decisions, and ‘accountants’ provide such information. They therefore can be seen as, in a sense, distributing power (the power to make informed decisions).

1.10 Page 6 of Chapter 1 defined a stakeholder as: any group or individual who can affect, or is affected by, the achievement of an organisation’s objectives.

Therefore, the stakeholders of an organisation could include owners or investors, loan providers, employees, customers, suppliers, government and local communities.

If managers define their stakeholders broadly, and if they believe they have a responsibility to provide information to stakeholders about how those stakeholders are influenced/impacted by the organisation then the nature of the ‘accounting’ undertaken will tend to be broad in nature. As page 8 notes, if we were to embrace a narrow view that an organisation was only responsible for its financial performance and that the responsibility for such performance was restricted simply to a narrow group of stakeholders such as owners (shareholders) and loan providers (creditors), then such an organisation might decide to only produce financial accounts, and those accounts would only be distributed to owners and creditors. This would be considered a very restricted, or narrow, view of accountability.

By contrast, if an organisation’s managers believed that they also had a responsibility for the organisation’s social and environmental performance, and that this responsibility is extended to all affected stakeholders, then such an organisation would also produce © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

various social and environmental accounts (as well as financial accounts) and would generally not restrict access to such accounts (for example, they might make the information available on their website). This would represent a broader view of accountability.

1.11 The students’ answers to this will vary widely. What should be of interest is whether they have considered they are a stakeholder of a particular organisation because of the impacts they have on that organisation, or because of the impacts the organisation has on them. For example, they might consider they are a stakeholder of their university because of the way the university can impact them through the quality of the education provided, the values that the university might instil, and the ‘contacts’ that the university has helped to create. They might also consider they are a stakeholder of the university because of the money they provide to the university through student fees, and how the student’s efforts and opinions can influence the ‘success’ of the university in such pursuits as attracting further students.

1.12 Again, who is a stakeholder of a university would be matter of opinion. Students should be able to justify why they identified an organisation/individual as a stakeholder and perhaps they might consider discussing some of the information the various stakeholders should receive about the organisation’s performance. Some stakeholders would include: • • • • • • • • • • •

Students Staff Funding institutions Local businesses Travel providers Residents around the university Recruitment agencies Government agencies Overseas education agents Local community and sporting groups Local support networks

1.13 No they would not. A manager who considers that the organisation has a narrow set of responsibilities (such as to maximise profits) might consider stakeholders to be current and potential investors, lenders and creditors. By contrast, a manager who thinks that an organisation has a responsibility for its social and environmental impacts and for the health and safety of employees throughout its supply chain would have a much broader notion of the organisation’s ‘stakeholders’ and would have a much broader view about the nature of ‘accounting’ to be employed, and therefore about the nature of the ‘accounts’ to be produced.

1.14 Again, this is a matter of judgement – but hopefully students will say ‘yes!’ By considering the environment and future generations as stakeholders this will act to increase the range of aspects of performance that need to be measured, controlled and reported. It is also consistent with the notion of sustainable development. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

1.15 There could be many answers here. Answers could include: (a) profits generated for the year; amounts owed to creditors; fair value of property, plant and equipment; financial cost of inventory (b) details of training provided to staff (perhaps information about the amount spent on training within the year, the nature of the training, and who received the training); details of workplace injuries; details of support for local sporting clubs; details of efforts undertaken to ensure that workers within the supply chain are treated fairly. (c) amount of water used or recycled within the year; amount of greenhouse gases generated during the year (with information about what activities generated the GHGs, how the emissions were calculated, whether there were targets, whether the targets were achieved, and if targets weren’t achieved then what remedial action is in place); information about any environmental prosecutions against the organisation.

1.16 (a) The answer to this would be directly related to the perceptions held about the responsibilities of the organisation and how far these responsibilities extend. If a relatively broad approach to stakeholder identification is used, then the general manager would gather information about the various social and environmental impacts being created as a result of the organisation’s operations (and this consideration should extend across the supply chains of the organisation and also extend across the life cycle of the organisation’s products and services) and who was being impacted. Some prioritisation of these impacts would then be required to determine which stakeholders particularly need to be considered. (b) Following on from the above, the decision about what to report is directly influenced by why the organisation is reporting, and the related judgement about to whom it is reporting – see the accountability model on page 20. The decision about what to report will be determined through some form of stakeholder engagement with the stakeholders identified as described above.

1.17 As page 9 and 10 of the book indicate, a useful definition of ‘accountability’ is provided by Gray, Adams and Owen (2014, p. 50), this being: The duty to provide an account or reckoning of those actions for which one is held responsible.

Gray, Adams and Owen (2014) also emphasise that accountability involves two key responsibilities or duties: 1. to undertake certain actions (or to refrain from taking actions) in accordance with the expectations of a group of stakeholders 2. to provide a reckoning, or account, of those actions to the stakeholders.

We can also consider the following definitions of accountability: Accountability involves an obligation to answer for one’s decisions and actions when authority to act on behalf of one party (the principal) is transferred to another (the agent) … Accountability requires openness, transparency and the © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

provision of information, and the acceptance of responsibility for one’s actions.

Source: Barton (2006), p. 257.

Accountability is acknowledging, assuming responsibility for and being transparent about the impacts of your policies, decisions, actions, products and associated performance. Source: AccountAbility (2008), p. 6.

[Accountability is] the obligation of an individual or organization to account for its activities, accept responsibility for them, and to disclose the results in a transparent manner. Source: BusinessDictionary (2017).

1.18 This is best summarised by Figure 1.2 on page 9 of the book:

What the diagram depicts is that here is a direct relationship between the responsibilities (or duties) that managers believe their organisation has, and the accepted accountabilities. The argument is that, if the managers of an organisation accept a responsibility to particular stakeholders for certain aspects of performance, then they also accept that those stakeholders have a right to information about those aspects of the organisation’s performance.

1.19 Again, different managers will do this differently. If we look at Figure 1.2 provided above then it is really all about determining what the responsibilities of an organisation are, and that ultimately influences to whom the organisation owes an accountability.

1.20 No, we would not expect all organisations within the same industry to generate and provide the same accounts, as different managers will have different perceptions (perhaps because of differences in the managers’ age, background, culture, education, professional affiliations, and so forth) of organisational responsibilities and accountabilities. Nevertheless, there can be some level of commonality within an industry across time as some disclosure practices within an industry effectively become institutionalised and thereafter become accepted as the legitimate way to report. Also, within an industry, the organisations would have similar stakeholders and similar impacts, therefore there would be an expectation that reporting would be similar – but there would still be some differences. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

1.21 Accounting is both a technical and social practice. It is a very technical practice, with quite detailed rules about how particular aspects of performance, or particular resources, are to be measured and reported. For example, large organisations are typically required to prepare financial statements that comply with various corporations law stipulations and accounting standards – some of which can be quite complicated. Other forms of accounting that address aspects of an organisation’s social and environmental performance can also be very technical in nature. For example, in many countries, there are government bodies that have developed water accounting standards, which explain how to prepare and present reports involving the recognition, quantification, presentation and disclosure of particular items relating to water use. Many countries also require particular measurement practices to be used by large organisations regarding the greenhouse gas emissions that have been generated as a result of their operations.

Approaches to accounting for occupational health and safety, which relates to a component of an organisation’s social performance, can also be very technical in nature, with different forms of injury being defined and measured in specific ways.

The way in which the readers of the various accounts then use the data can ultimately generate various social impacts. Various people throughout society use accounting reports to make decisions. If this was not the case, then preparing the reports would fundamentally be a waste of time. And the decisions the account readers will make, such as whether they will continue to support an organisation, can have various social implications. For example, if we decide to invest in a company because of the reports we have received then this will potentially create employment opportunities which would lead to social benefits. If a report is released which shows that a company is generating a great deal of waste/pollution then this might reduce the demand consumers have for its products. This might create some negative social impacts through the potentially lost jobs, but it could create positive environmental benefits if the polluting activities are discontinued.

1.22 The statement that ‘information provides power’ refers to the perspective that to make an informed decision requires relevant and reliable information. Those stakeholders that have relevant and reliable information are likely to make better decisions than those without. In a sense, the useful information provides the stakeholders with power to make better decisions relative to those stakeholders without such information.

1.23 If an organisation reports information that suggests that it might not be able to pay its debts as and when they fall due then this might have consequences for the support the organisation receives from various stakeholders, such as investors, lenders, suppliers, prospective employees, customers, and so forth. With reducing financial support, the organisation might need to stop producing particular goods or services, employing staff, acquiring materials from other organisations, contributing to local community initiatives, paying taxes, and so forth. This can all create various social costs.

1.24. The responsibilities that we believe an organisation has in terms of the types and breadth of responsibilities, and to whom those responsibilities are owed, will be influenced by our own values and beliefs. Our values and beliefs will be influenced by © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

various factors including our family and friends, our workplace, our education, the professional associations we are members of, the sporting clubs we are members of, our culture, our religion, and the types of news media we read or listen to.

1.25 There is a general view that a manager cannot manage something in the absence of collecting appropriate information. That is, ‘you cannot manage what you don’t measure’. What aspects of performance are to be managed will depend upon the perceived responsibilities of the organisation. Other factors to consider will be perceptions about the relevance and reliability of the data to be collected, available measurement and reporting frameworks, and costs and benefits associated with collecting particular information.

1.26 Expectations about the responsibilities and accountabilities of organisations change across time and this has direct implications for the types of accounts being produced. For example, a number of decades ago there was little attention from the community on issues associated with the treatment of workers within supply chains. This has changed however, and now people expect organisations to report information about how it ensures that workers employed in supply chains are properly treated. The same sorts of comments can also possibly be made about issues relating to climate change and animal welfare. Changes in the way markets are organised (for example, greater globalisation and greater outsourcing) and in how members of society interact (for example, evolving social media and an increasing reliance on cashless transactions) will also lead to changes in how accounting is undertaken.

1.27 The answers to these questions ultimately relate to the ‘why report?’ question which is the first step in our four-step accountability model. The answer to this question then influences the following three steps, which are the ‘to whom to report?’, the ‘what to report?’ and the how to report? (a) For example, as pages 23 and 24 of the book note, if an organisation’s reporting is motivated exclusively by managerial reasoning and strategising (for example, it is primarily focused on increasing the wealth of the owners and/or managers), the stakeholders to whom that organisation’s reporting is directed might be narrowly defined as those who hold and exercise the greatest economic power, or influence, over the organisation. Conversely, reporting motivated by ethical/moral reasoning will seek to address the information needs of a broader range of stakeholders.

Specifically, a broader ethical approach to reporting would direct the reports towards those stakeholders most affected by the operations of the organisation, regardless of the economic or other power held by those stakeholders, and would focus on issues such as various stakeholders’ ‘right to know’. (b) Once we have answers to the ‘why report?’ and ‘to whom to report?’ questions we can then answer the ‘what to report?’ question. For example, if we have decided that the targeted recipients of the information are shareholders, then we might decide that the most relevant information is information about the financial performance and financial position of the organisation. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

(c) Once we have addressed the first three steps of our four-step accountability model we can then determine where the information is best reported. For example, if we have arrived at the decision that investors are our targeted audience and we believe that financial reports are what they want/need then we might produce financial statements and make them available on the organisation’s website. We would reasonably assume that all investors would have access to the internet.

1.28 There will obviously be many different answers to these questions and these differences will be due to differences in opinions about a university’s responsibilities and accountabilities. Some possible answers to this are provided in the following table (note that this only represents a very limited number of the possible answers).

Question

Answer

(a) To whom should a university provide accounts?

Current, prospective, and former students, government, staff, suppliers, lenders, local communities.

(b) What information should be included within the accounts?

Number of students enrolled in different programs, trends in enrolments, amount of government funding, amount of funds coming from different categories of students, cash flows, assets, obligations, emissions data, waste generated, water consumed, initiatives to reduce environmental impacts, support of various community-based projects, sporting programs.

(c) How/ where would a It would be expected that most of the information would be university report provided on the university’s website. Various measurement these accounts? and reporting frameworks would be used, perhaps to measure and report financial performance, GHG emissions, waste generated, water used, and so forth.

1.29 (a) What information the bank collects and reports will be influenced by the bank managers’ perceptions of responsibilities and accountabilities. Whether the information produced by the bank will satisfy our needs or wants for information will be related to the bank’s motivations for reporting. The information we, as stakeholders of the bank, will want will also be influenced by our expectations about how a bank should operate. If we, for example, believe that a bank has responsibility for how the funds it advances to businesses are used, then we might want information about its lending policies. For example, does it loan funds to gambling-related organisations, organisations that mine coal, organisations with poor labour practices, and so forth. By contrast, if we were only interested in making financial gains then we might simply want information about the social financial performance and financial position of the bank. (b) Whether the bank reports the information will be influenced by various factors, such as whether the managers believe they have a responsibility and associated accountability © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

in relation to particular aspects of performance. Other factors to consider would be perceptions about the relevance and reliability of the information and the costs and benefits associated with collecting and reporting the information. The availability of appropriate measurement and reporting frameworks will also impact the disclosures being made.

1.30 As social media has changed this has influenced the reporting approaches adopted by organisations. Social media provides a ‘timely’ way in which organisations can report and companies often use social media to respond to criticisms in the news media, or to quickly provide information in relation to a crisis that might have arisen. Most organisations now have Facebook, Twitter and LinkedIn accounts and often use YouTube to share information with different stakeholders. Accountants need to be familiar with such media, as well as the advantages and disadvantages associated with using them.

1.31 As we know from page 24 of the book, in his widely cited book Capitalism and Freedom, Friedman (1962, p. 133) rejected the view that corporate managers have any moral obligations or responsibilities, noting that such a view shows a fundamental misconception of the character and nature of a free economy.

In such an economy, there is one and only one social responsibility of business [and that is] to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.

Managers who agree with Friedman’s narrow perspective on corporate responsibilities might not be in favour of collecting and disclosing information about social and environmental performance unless they felt that disclosure would ultimately lead to financial benefits that favour investors. Additionally, they would not be responsive to the concerns held by those stakeholders who do not have the power to influence the successful operations of an organisation.

1.32 This question should generate a number of different answers. The answers will be influenced by perceptions about what are the responsibilities of an airport in terms of to whom the organisation has accountability, and for what aspects of performance it is accountable. If we are to accept that stakeholders impacted by an organisation have a right to information about how that organisation is working to reduce (or not) those impacts, then information about the impacts should be reported.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 2: Organisations and their reporting boundaries 2.1

When we are discussing the reporting boundary of an organisation, we are referring to the judgements that have been made by its managers in respect of how far the responsibilities of the organisation have been extended both in terms of which stakeholders the organisation owes accountability to, and for what aspects of performance it should be accountable.

Because different managers will have different perceptions of organisational responsibilities, this means they will have different perceptions of which accountabilities an organisation should accept and the types of accounts it should prepare. So, although two organisations might be very similar, the perspectives of their managers might be very different, and therefore the accounts the respective organisations decide to produce might be very different which reflects a different perspective about the organisational boundary.

2.2

When we are discussing internal reporting we are referring to information that is collected for use within the organisation by managers to manage the organisation.

When we discuss external reporting, we are referring to information that an organisation produces for the use of stakeholders outside the organisation. Some of the information used internally for management purposes might also be released externally to stakeholders.

2.3

A resource can be broadly defined as something that has value in the sense that it allows an organisation (or indeed, society) to undertake an activity so as to enable it to achieve a desired outcome. At issue is whether accountants should only record and report information about the usage of, and potential damage to, resources controlled by the organisation, or if we should consider impacts on the resources not owned or controlled by the organisation; for example, upon the environment (these resources might also be referred to as shared resources or public resources).

In the absence of any regulation requiring disclosure, the decision to measure and report particular social or environmental information is generally made by managers in consultation with their accounting teams. It would be hoped that if an organisation is causing significant impacts to particular resources (including natural, human-based and social-based resources), then it would provide some account of such impacts. Again, if the managers think they have a responsibility for ensuring that particular resources are not adversely impacted by their operations, then they are accepting an accountability with respect to that resource. Consequently, they should generate various accounts to enable them to monitor, control and improve their performance with regards to the respective resources, and to provide relevant information to stakeholders.

Deegan 2e_Solutions Manual

2

2.4

Management accounting is a broad term referring to information produced for internal decision making by managers; that is, information that is required for various decisions pertaining to aspects associated with planning, monitoring and control, including information that relates to financial, social or environmental performance. The management accountant is somebody who collects, analyses and/or reports such information. The information necessarily collected for internal management decisionmaking (management accounting information) could also form the basis for reports that are to be released publicly.

2.5

Financial accounting is typically considered to be that branch of accounting that generates financial reports for use by people outside the organisation; for example, investors or lenders who want to monitor the performance of a company they have invested in, or loaned funds to. Financial accounting is very heavily regulated, whereas management accounting is basically unregulated.

The purpose of financial accounting/reporting is generally to provide information about the financial performance and position of an organisation. The main audience for these reports is generally considered to be the managers and owners of the organisation, as well as others with a financial stake in it, such as those who are owed money by the organisation (for example, lenders and creditors). There will also be other groups with an interest in the financial performance of an organisation. For example, employees will want to know how well the organisation is being managed financially in order to understand how secure their employment is, or perhaps whether the organisation can afford to pay higher wages. Customers will be interested in the financial performance of an organisation in order to assess whether the organisation will be able to continue supplying goods or services, or perhaps whether it appears that the organisation is too profitable and can therefore afford to reduce the selling prices of its goods and services.

2.6

We argue that accounting is not a one-size-fits-all practice because how we account for an organisation depends on factors such as: • •

•

•

the various resources it uses, which can create different types of impacts for different stakeholders and therefore different accountabilities where its operations are being conducted, which may be in highly populated areas with many potentially affected stakeholders, or in areas of significant environmental or cultural importance the differing perceptions of managers on why they should be reporting, which in turn will influence to whom they have accountability, and to which aspects of performance the accounts should relate managers’ perceptions of the information demands, or needs, of different stakeholder groups.

Because different managers will have different views about the above questions, they will tend to provide sets of accounts that are different to those provided by other managers. Therefore, one approach to accounting that might be relevant to the

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

managers of one organisation might not be relevant to the managers of another organisation. There is not a ‘one-size-fits-all’.

2.7 (a)

(b)

(c)

A sole trader – or, as it is also often called, a sole proprietorship – is considered to be in existence when one individual owns a business and is responsible for all of its debts.

Sole traders, which are much more numerous than partnerships or companies, are generally established to generate a profit, but organisations that are sole traders might also have as their principal goals the achievement of various social or environmental outcomes. Relative to other forms of business, a sole trader usually is small in terms of total income, profits and the number of employees. Many small businesses – such as milk bars, restaurants, newsagents, landscapers, plumbers, painters and caterers – are sole traders. In a sole trader, the owner is also typically the manager. A sole trader is not a separate legal entity, so for legal purposes the business is not separate to the owner’s non-business affairs. As such, the business is not separately taxed but rather the earnings are included in the owner’s personal tax return. A sole trader is not difficult to set up. Apart from having to comply with certain tax obligations, there are generally no specific accounting requirements that apply to sole traders. Sole traders do not have to apply the multitude of accounting standards issued by organisations such as the IASB, and they can be flexible with their reporting, but like all organisations they still need to do some forms of accounting.

A partnership exists when two or more people come together with a common purpose, usually to make a profit. Like a sole trader, partnerships tend to be small businesses, although there can be exceptions; for example, some legal and accounting partnerships can be very large. Within a partnership, people with different skills and resources might come together. The profit is generally shared according to a partnership agreement, although in many jurisdictions there is no legal requirement for such a formal arrangement to exist. That is, depending on the actions of individuals, a partnership can be considered to be in existence even in the absence of a formal partnership agreement.

A partnership is considered for accounting purposes to be a separate entity; that is, an entity that is separate to the individual partners such that the individual assets and liabilities of the partners, which have not been contributed to the partnership, are not considered to be part of the assets and liabilities of the partnership. However, like a sole trader, for legal purposes the partnership is not a separate legal entity. As such, the partners have unlimited liability for the obligations of the partnership, meaning that if the resources of the partnership are insufficient to meet its debts, then the partners’ individual assets can, by law, be seized to pay those debts (and the assets will not necessarily be seized on the basis of the partners’ percentage of ownership).

A company is an entity that has a separate legal identity from that of its owners. Each owner of a company owns shares in it and hence is considered to be a shareholder.

Shareholders generally have no liability for debts other than if they still owe some amounts on the shares they have acquired. That is, the liability of a shareholder is generally limited to the amount they have agreed to pay for their shares. Hence, unlike

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

2.8

2.9

4

sole traders and partnerships, companies are considered to be limited liability organisations. Limited liability encourages people to invest in a company even when they have very little, or nothing, to do with its ongoing management. That is, there is usually a separation of ownership and management, particularly in larger companies.

The shares are transferable to others and might be traded on a securities exchange (stock exchange) if they relate to public companies, which are allowed to offer their shares for sale to the public. Because there is generally a separation between the ownership and management of a company, the owners will often depend on receiving accounts from the company to inform them as to how the managers have used the shareholders’ funds, as well as accounts about what the managers intend to do in the future. This can be contrasted with sole traders and partners in a partnership who, because they are usually involved in the ongoing management of the organisation, will not depend on some form of general-purpose financial statements being released by the organisation. Shareholders in large companies, however, will not have access to information particularly tailored to their own needs. Rather, they will receive generalpurpose reports which meet the needs of all shareholders.

This might be because the different managers will have different perceptions (perhaps because of differences in the managers’ age, background, culture, education, professional affiliations, and so forth) of organisational responsibilities and accountabilities. Nevertheless, there can be some level of uniformity of accounting practices between organisations within an industry as some disclosure practices within an industry effectively become ‘institutionalised’ and thereafter become accepted as the legitimate way to report. Also, within an industry, the organisations would have similar stakeholders, would use similar resources and would generate similar impacts, therefore there would be an expectation that reporting would be similar – but there would still be some differences.

We can refer to Figure 2.2, reproduced below. Arguably, it is a responsibility of managers to understand what resources are used as inputs, and what outputs are generated by an organisation. Without knowing this, the use of resources and their related impacts cannot be managed. Managers need to prioritise which resource inputs, and what outputs/outcomes/impacts are the most important to manage. Without some diagram – such as Figure 2.2, this would not be possible.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

2.10 External costs are often referred to as externalities, which can be defined as impacts that an entity has on parties external to the organisation, where such parties are not the buyers or sellers of particular goods or services, or did not agree to, or take part in, the activities causing the externality.

For example, the damage to a reef caused by an oil tanker would impact many people other than just the buyers or sellers of the oil, and these impacts will not all be measurable in monetary terms – they would be considered external costs.

When most manufacturers of goods produce something, they generally create some level of pollution that impacts people beyond either the producer or the customer – they create external costs. Because it is very problematic to try and attempt to place a monetary value on many external costs, they often are not reflected in the prices of particular goods or services. In a sense, this is a failing of many of our pricing systems – many externalities simply fail to be factored into the prices we pay.

If we were to consider the full costs to society of particular products, then we would need to consider both the private costs and the external costs. However, while external costs might be difficult to quantify in monetary terms, we can still provide a description of the costs that have arisen. That is, we can provide a description of the impacts an organisation’s operations have had on particular environments and/or societies, even if we cannot place a monetary value on such costs. Not all organisations will try to account for their externalities.

2.11 In the book we have defined costs as: A measure, either expressed in financial or non-financial terms, of the value of resources consumed or impacted as a result of the operations of an organisation.

Costs can include both ‘private costs’ and ‘social and environmental costs’ (‘external costs’).

Some introductory accounting textbooks only consider those costs that can be measured in financial terms and which represent financial costs directly (privately) incurred by the organisation. The concept of ‘costs’ embraced in this book is much broader than this. We will also be considering many ‘costs’ that are not measured in financial terms. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

That is, we will also be considering costs that organisations create in relation to resources not directly controlled by the organisation.

2.12 (a)

(b)

There are many similarities between the accounting done by sole traders and partnerships. For the majority of sole traders and partnerships, the focus will be on financial measures of performance rather than on measures of social and/or environmental performance. There will also be no expectation that the financial reports will be prepared in accordance with accounting standards. Because there could be potential conflicts between partners, the accounts of a partnership are more likely to be audited than the accounts of a sole trader. Partnership accounts will provide details to the partners of their individual contributions, drawings, profit share and partnership balance.

There would tend to be many differences between the information required by a sole trader compared with the information required by a shareholder of a large public company. Because there is generally a separation between the ownership and management of a company, the owners will often depend on receiving accounts from the company to inform them as to how the managers have used the shareholders’ funds, as well as accounts about what the managers intend to do in the future. This can be contrasted with sole traders and partners in a partnership who, because they are usually involved in the ongoing management of the organisation, will not depend on some form of general-purpose financial statements being released by the organisation.

Shareholders in large companies, however, will not have access to information particularly tailored to their own needs. Rather, they will receive general-purpose reports which meet the needs of all shareholders. These reports will also typically be subjected to an audit by an independent third party.

2.13 (a)

(b)

(c)

(d)

Organisations rely on financial resources in order to meet the various expenses they incur. If an organisation is a business organisation, then information about profits is necessary. It provides an indication of how efficiently the assets of the organisation are being used.

Information about the use of water and its sources should arguably be collected for management and reporting purposes particularly if the organisation is operating in an area where the level of consumption of water by the organisation is important to other stakeholders. This would particularly be the case in areas or times of water shortage.

It is a matter of opinion how far the responsibilities and accountabilities of the organisation extend. From an ethical perspective an organisation should arguably provide an account of how workers within the supply chain are treated.

With growing awareness about the significance of climate change, managers are increasingly being expected to take actions to minimise CO2 emissions. This would particularly be the case for organisations that generate large emissions of CO2.

Managers of organisations that emit high amounts of CO2 would also be expected to

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

report information about planned initiatives to reduce emissions together with information comparing past emissions with targeted emissions. (e) Again, this is a matter of opinion. Managers that embrace a high level of responsibility for the impacts of their operations will consider and report information about the emissions generated by its suppliers. This represents a broader ‘life cycle’ approach to managing the impacts of the organisation’s goods and services. A number of organisations (in the minority at this stage) are starting to report information about the emissions generated across supply chains. One organisation to commence doing this is the large global miner, BHP. 2.14 The financial accounts prepared by a public company would be considered to be general purpose financial reports and would comply with accounting standards. The financial reports of a public company would be available on the organisation’s website.

The financial accounts prepared by a private company would typically not be prepared in accordance with accounting standards and would not generally be available to the public on the organisation’s website. The reports produced by a public company must also be audited by a qualified financial statement auditor. This is not a strict requirement for a private company unless a required number of shareholders vote for such an audit.

Public companies are typically very large with a diverse group of stakeholders, and they will create various economic, social and environmental impacts that will influence the lives of a vast array of people. As such, and because of the broader reach of the impacts of public companies relative to many other forms of organisations, they tend to report a variety of financial, social and environmental information to a large crosssection of stakeholders, and will use a variety of reporting frameworks. By contrast, private companies would typically not produce detailed social and environmental accounts.

Accounting for the range of social, environmental and financial impacts it creates for a diverse group of stakeholders means that a public company would tend to have a broad reporting boundary. Various aspects of the company’s performance would be relevant to people both within the organisation (who need to manage these aspects) as well as those outside the organisation. By contrast, the ‘reporting boundary’ of a private company would be relatively narrow.

2.15 The information an organisation elects to report will depend on how far it extends its reporting boundary, and which impacted resources it believes it has responsibility for.

Some of the information that could be publicly reported includes: • • • • • •

what caused the leak and what was done to stop the leak what the financial costs associated with the oil leak have been. what environmental damage has occurred in both the short and long term (being very clear about the various types of negative impacts) the actions being taken to reduce these negative impacts the actions taken to ensure this type of event will not happen again what it has learned from the catastrophe

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

• •

8

what operating procedures failed how its emergency response procedures worked or did not work.

2.16 There could be various outputs or impacts of a museum. There will be a multitude of possible answers to this question. Museums are established to create various social benefits, including to contribute to knowledge and to preserve important historical and cultural artefacts. Some of the positive outputs and impacts would include: • • • • • •

A contribution to knowledge Preservation of important historical and cultural artefacts Providing resources necessary for research Providing employment opportunities Providing enjoyment to various members of society A source of demand for local food and accommodation providers

Some negative outputs or impacts could include: • • •

Waste Noise Carbon emissions through use of energy within the museum and by people attending the museum.

For those outputs that can be measured in financial terms then, we would expect to find them recorded within the financial statements which would typically be made available on the organisation’s website.

For those impacts that are not financial in nature we might expect to find details within social or environmental reports or on other dedicated pages on the museum’s website.

However, whether the information is collected and reported will depend upon whether the museum managers believe they have a responsibility and accountability for the particular impacts.

2.17 (a)

(b)

Different managers will have different demands for information depending upon what aspects of the performance of Dhaka Textiles that they believe are important. For example, apart from information about product quality and price they might also want to know about the social and environmental performance of the supplier. The types of information that might be demanded would include information about product costs; quality; delivery times; delivery costs; social policies; environmental policies; how the organisation monitors its compliance with policy; whether the organisation outsources production, and if so, what checks and monitoring practices does it have in place with regards to those organisations to which it outsources.

Again, different managers would collect different information. Some information would relate to ongoing checks of quality, price, and delivery times. If commitments have been made by the supplier that certain social and environmental policies would be applied, then it would be necessary to periodically monitor the compliance with these policies. It is also common for organisations such as T-shirt Tommy Ltd to organise

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

(c) (d)

9

regular factory audits of suppliers to check on the health and safety of workers, and these audits are often undertaken by independent third parties.

This information would generally be considered as management accounting because the information would be collected to inform decisions being made by managers.

If managers believe they have an accountability for various aspects of their supply chain, then they would tend to report related information to stakeholders outside the organisation. It has become very common for organisations to report information about how it is monitoring the activities of organisations within its supply chains, particular where the operations involve workers located within developing countries.

2.18 It is indeed bewildering that many universities pay very little attention to accounting issues associated with social and environmental performance. Also, many universities pay little attention within their accounting programs to issues associated with organisational responsibilities and accountabilities. This might reflect a view held by some lecturers that the main responsibilities and accountabilities of organisations – particularly business organisations – are to general profits/wealth for the owners and to generate economic benefits within society. However, what we might argue is that the social and environmental performance of organisations is just as important (or more important?) than its financial performance. As such, perhaps equal time should be devoted to social and environmental performance reporting.

The other point to be made is that educational programs tend to become ‘institutionalised’. That is, a particular way of doing something (such as how ‘accounting’ is taught) becomes commonly accepted and it can be difficult for somebody to come along and try to make fundamental changes to how something is done.

2.19 Answers cannot be provided to this question as it depends upon what organisations were selected by the students. What students will hopefully see is that organisations are producing various ‘accounts’ of their social and environmental performance and that what one organisation reports can be very different from what other organisations report. Differences in the ‘reporting boundaries’ of the different organisations might also be apparent. Students will also see that particular reporting frameworks or guidance documents might be utilised or referred to (such as the GRI Sustainability Reporting Standards or the United Nations SDGs), and that some reports will be subject to independent third-party assurance/verification.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 3: An introduction to management accounting 3.1

Some people hold the view that to be able to objectively account for the performance and position of an organisation an accountant should have nothing to do with the decisions that ultimately lead to the results that are generated by an organisation’s operations. However, this ignores many of the skills accountants have, and the contribution they can make. An accountant who has good critical thinking skills should be able to add important value to an organisation and its stakeholders. Therefore, the accountant should contribute to the management of an organisation (an exception to this is the external auditor appointed to provide an independent opinion of the accounting reports being released by an organisation).

3.2

The target audience of management accounts are the managers. The focus of the management accounts will be influenced by what aspects of performance the managers prioritise in terms of achieving the organisation’s missions and goals. This, in turn, will be influenced by the managers’ perspectives about their responsibilities pertaining to managing the organisation.

Whether managers elect to release information from their management accounts to external stakeholders will be influenced by whether they believe they are accountable to such stakeholders in respect of particular aspects of performance, or whether they believe that it is in the best interests of the organisation to disclose the information.

Considerations of the relevance of the information to stakeholders will also be relevant, as will issues to do with the reliability or representational faithfulness of the information (if unreliable information is provided to stakeholders then this could have potential legal implications for the organisation if stakeholders use the information and make inappropriate decisions as a result of using the information). Considerations of competitive advantage will also influence the public disclosure of certain information.

3.3

By critical thinking, we mean making reasoned judgements that are well considered, logical, and based on asking the right questions (developing the right problems) and collecting the appropriate supporting information. Critical thinking is a highly valued skill that is expected of accountants. Accountants have a key role in planning, monitoring and controlling organisational behaviour. Such activities need to include considerations of the long run and the short run, and sustainability-related issues, as well as consideration of the various ways in which an organisation can add value.

Critical thinking is necessary to all of this.

3.4

While collecting too little information is detrimental for decision making, collecting and supplying vast amounts of information can also be detrimental to decision making.

It can lead to what is known as information overload, which occurs when the amount of

Deegan 2e_Solutions Manual

2

information being provided to an individual or organisation exceeds their ability to process that information. It is commonly accepted that individuals have a limit in relation to how much information they can meaningfully assimilate at any one time.

There comes a point when too much information can actually lead to a reduction in the quality of the decisions being made. One role of the accountant is to determine the optimal amount of relevant information to provide to managers. It is therefore important that those people involved in an accounting function restrict the available information to that which is both relevant to, and understandable by, managers. Similar considerations are also required when determining how much information to provide to external stakeholders.

3.5

Yes. All decisions require some form of costs-versus-benefits test to be applied, including decisions about what information to collect. While difficult to assess, particularly as some costs and benefits might be non-monetary in nature, a consideration of costs versus benefits will tend to limit the amount of information that is collected. If the relevant information is costly to collect and analyse, and if the benefit to decision making is perceived as minimal, then a rational decision should be made to not collect the information.

3.6

Generally speaking, with the assistance of accountants, management: (a) identifies a problem; (b) collects relevant information to potentially solve the problem; (c) determines alternative courses of action and the consequences of each; (d) evaluates alternative courses of action and identifies the best one(s) in terms of achieving the organisation’s goals; (e) makes a decision; (f) implements an action; (g) monitors and evaluates performance pertaining to the chosen actions; and (h) revises plans in light of performance/feedback (and the cycle continues).

The first five points above can be referred to as part of the planning stage.

3.7

Having clear and well-articulated plans, and sharing these plans with potential providers of funds, will act to reduce the potential funder’s uncertainty and their perceived risk, and this will likely enable the organisation to attract funds at a lower cost than might otherwise be possible. For example, lenders will likely charge lower interest rates because of the perceived lower levels of risk. Further, if the actual results generated by an organisation subsequently compare favourably with the organisation’s projected budgets (targeted results), then this suggests that the managers and accountants of the organisation understand the operating environment in which they are working, and this could further reduce the risks perceived by investors and lenders, thereby further reducing the costs of attracting funds. ‘Sensible planning’ is an indicator of the presence of ‘sensible management’.

3.8

Organisations typically have a ‘mission statement’. Larger organisations will generally document their mission in writing and make this publicly available, such as on a

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

corporate website. An organisation’s mission reflects its core purpose and focus, and generally does not change that often; for example, it might stay unaltered for several years. It represents a guiding principle. The mission – if well written – acts to identify what aspects of performance are considered important, and it provides overall direction for the managers.

3.9

One of the components of planning is evaluating alternative courses of action and identifying the best one(s) in terms of achieving the organisation’s goals. In undertaking this phase of planning, some form of screening might be undertaken. There might be a strict rule that certain activities or products shall not be made, or acquired, because of concerns about their risks or impacts on particular parts of society, or on the environment. This would be referred to as negative screening.

Alternatively, some form of positive screening might be applied which requires that certain activities or products have certain attributes, such as utilising processes that are environmentally or socially responsible. Such screening might require a relatively complex analysis of factors such as product safety, pollution (which might include an analysis of what forms of power are being used in different processes along the supply chain, such as solar, hydro or wind power), the workplace health and safety practices of potential suppliers, and so forth.

3.10 A focus on sustainable development is considered to represent a longer-term view or perspective, as a failure to consider sustainability-related issues might generate shortterm economic benefits but arguably will be detrimental to the long-term operations, and therefore success, of the organisation. Society has ever-increasing expectations with regards to the treatment of people, animals, and care for the environment, so failure to consider such factors will be bad for business in the longer run.

As organisations embrace sustainability, they are effectively increasing the range of the stakeholders they accept responsibility for, and to whom they owe a level of accountability. Organisations that are embracing sustainability in the fullest sense will consider the implications of their operations on future generations – and this is clearly a longer-term perspective.

3.11 As accountants, we do tend to emphasise short-term (annual) performance through our practices of dividing the life of the organisation up into somewhat artificial periods of time – say one year – and calculating the profit for that period of time. Managers are also often rewarded in terms of measures of performance such as annual profits. This can have the effect of discouraging them from, for example, making long-term investments in new technologies (including those that will provide longer-term social and environmental benefits). The problem associated with being shorter term in focus is that we might undertake strategies which are good in the short-run, but not good in the longer-run. For example, we might choose to use cheaper and less safe equipment in our factory because that will generate higher profits in the next period, but in the longer run there could be workplace injuries which are not only bad for workers, but also bad for the long-term prosperity of the organisation. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

3.12 Variable costs are the costs that change as a result of changing production or service volume. That is, they vary as the volume of activity changes.

Fixed costs are considered to be those costs that do not change in a particular period as the volume of production or services changes.

Some costs might have fixed and variable components. Such costs are referred to as semi-fixed or semi-variable costs, or mixed costs.

3.13 ‘Cost behaviour’ refers to the way in which ‘costs’ (and we can refer to both financial and non-financial costs) react relative to some form of activity, such as how they might react as certain products are manufactured, or certain equipment is used. One of the key components of planning is understanding the costs that will be generated by the proposed activities of an organisation, including how these costs will change, or ‘behave’, as a result of changes in the level or volume of activity. Managers, accountants and many stakeholders will be interested in how costs ‘behave’.

If we are able to understand cost behaviour, then this means that targets or budgets of costs can be prepared and subsequently compared with actual costs. Understanding costs is a necessary precondition for implementing initiatives to reduce certain costs, or inefficiencies, and therefore adding ‘value’ at various points in the operations of an organisation.

Managers need reliable information about the costs of the goods or services they supply so that they can determine that selling prices are at least adequate to cover these costs as well as to generate profits and the required cash flows. Knowledge of costs will also enable managers to determine whether it is feasible to supply particular goods or services at the prices that the market is prepared to pay. In some cases, it is possible that the price the market is prepared to pay is not greater than the costs the organisation will incur to supply the goods or services, thereby making the supply of the goods or services not feasible.

3.14 The costs that are variable and fixed are as follows: Cost Factory rent Insurance expense Supervisor’s salary Foam core Fibreglass Resin Surfboard shaper labour Surfboard sander labour TOTAL

Variable cost per surfboard

$150 $45 $25 $55 $75 $350 per surfboard

Fixed cost $20 000 per month $1000 per month $5000 per month

$26 000 per month

The formula to predict the total financial cost for a given level of surfboard production will be: © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

Total Financial Cost = Fixed Costs + (variable cost per unit of output X level of output) Which will be: Total Financial Cost = $26 000 + ($350 X number of surfboards produced). If 500 surfboards are produced then this will equate to: $26 000 + ($350 X 500) = $201 000 3.15 Costs might be fixed only over a particular (relevant) range of activities. When we identify a cost as being fixed, we mean that such costs could change but will be relatively constant, or fixed, over the short to medium term (perhaps the next year) as long as production volumes stay within a relevant range of activity.

Costs might only be considered fixed for a particular range of activities, beyond which they will increase and then stay constant for a given range of activities, beyond which they might rise again in a step-like manner. For example, because of increased production, we might need to lease an additional factory which would then enable a greater amount of production. If production continues to increase, then further down the track yet another building might be required, and so forth.

3.16 The relevant range is the range of production output, or volume, in which our expectations regarding cost behaviour are expected to hold. That is, this is the range of activities in which our fixed costs are expected to stay the same in total and our variable costs per unit are expected to be constant. This is important, as activity that goes beyond the relevant range may result in the costs being significantly different.

3.17 Production output of wetsuits

Total production costs

Highest

5000

$27 500

Lowest

1000

$7 000

Difference

4000

$20 500

The variable component would be calculated by dividing the increase in costs by the change in volume of activity which will give us $20 500 ÷ 4000 = $5.125 per unit.

Given that an output level of 5000 gives a total cost of $27 500 then the fixed component of the costs might be estimated at $27 500 – (5000 X $5.125) = $1875. The cost function could then be represented as: Total production costs = fixed costs + (variable cost per unit X output) = $1875 + $5.125 X If we expect a production output of 2500 units then the predicted costs would be $1875 + ($5.125 X 2500) = $14 687.50.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

3.18 The contribution margin per unit is the difference between the revenue per unit and the variable costs per unit, that is: Contribution margin per unit = revenue per unit − variable cost per unit The total contribution margin of a product or service is the difference between the total sales revenue and the total variable costs generated from a particular product or service, that is: Sales revenue − variable costs Managers need to know the contribution margin to determine what the incremental contribution to profits is from each item of a good or service sold. Knowledge of the contribution margin is also important for determining whether the price being charged for the organisation’s goods or services is enough to enable the organisation to achieve its objectives (an increase in the sales price will increase the contribution margin).

Contribution margin also needs to be known so as to determine the break-even point and the total number of goods or services to sell in order to make a particular profit.

3.19 If another organisation can produce particular goods or services at lower cost, or more efficiently than the organisation, then it might be appropriate to outsource the production to other organisations. By doing so, the organisation might also be able to utilise any spare production capacity for producing an alternative product or service that might generate better returns (add greater value).

The decision to make an item or buy it (outsource it) therefore relies on an analysis of those costs and revenues that change as a result of the decision. That is, we need to focus on the relevant costs and relevant revenues, which are those that will arise in the future and differ between options.

It is important however to make sure that the other organisation to which we might outsource our production holds similar ‘values’ to the organisation, and does not generate unacceptable social or environmental impacts. The quality of the goods or services being produced would also be required to meet certain standards.

3.20 The break-even point occurs when the total financial costs equal the total financial revenues, resulting in the profit for a period being zero. It will generally be calculated in number of units of the product or service, and involves dividing the total fixed costs by the contribution margin per unit: Break-even point = total fixed costs ÷ contribution margin per unit Managers need to know the break-even point as this indicates the level of production an organisation must reach before it covers its costs and can then start to generate a profit.

3.21 We need firstly to calculate the variable costs per unit, and determine the fixed costs.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

The costs that are variable and fixed are as follows: Cost Factory rent Insurance expense Supervisor’s salary Rubber material Velcro Labour TOTAL

Variable cost per leg rope

$9 $2 $3 $14 per leg rope

Fixed cost $1000 per month $200 per month $3000 per month

$4200 per month

The contribution margin per unit is the difference between the revenue per unit and the variable costs per unit; that is: Contribution margin per unit = revenue per unit − variable cost per unit = $34 – $14 = $20 per leg rope Break-even point = total fixed costs ÷ contribution margin per unit = $4200 ÷ $20 = 210 leg ropes 3.22 The margin of safety is determined as follows: Actual or predicted level of activity in units − break-even level of activity in units This is referred to as the margin of safety because it calculates the number of units of a product or service that can be lost before an organisation reaches a level of activity that results in the organisation making a loss. In this case, the margin of safety is 90 units, determined as: 300 – 210 = 90 3.23 Accountants need to be critical thinkers. By critical thinking, we mean making reasoned judgements that are well considered, logical, and based on asking the right questions (developing the right problems) and collecting the appropriate supporting information.

As part of being a critical thinker, there is an expectation that accountants – particularly those that contribute relatively more value to an organisation – have certain core skills that allow them to think in an organised, knowledgeable way, as well as communicate their ideas clearly, which in itself requires solid interpersonal skills. Some of the skills that effective accountants will have include: • • • • •

intellectual skills; technical and functional skills; personal skills; organisational and business management skills; and interpersonal and communication skills.

3.24 No. In principle, the managers of an organisation should consider all of the ‘costs’ that the organisation creates as a result of its activities. The extent to which certain variable costs of a non-financial nature are monitored and controlled will in part be influenced © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

by the effects/impacts these costs have on different stakeholders. Therefore, we might focus on those resources which are relatively scarce, or which potentially create the greatest environmental or social impacts. For example, if water is scarce, then we can calculate the amount of water being used per unit of product – effectively, the variable cost per unit as described in ‘amount of water’ rather than in monetary terms. We can also calculate the amount of energy required to produce each unit of product, particularly if the energy is coming from a source that generates relatively greater carbon emissions (for example, the energy is coming from a coal-fired power station).

However, if we have an abundance of clean energy (such as from wind-powered turbines), we might not be too concerned from an environmental perspective about the amount of power being consumed 3.25 High fixed costs accompanied by low variable costs are often referred to as a situation of high operating gearing. When fixed costs increase, perhaps because additional property, plant and equipment are rented, then this can act to increase the amount of products or services that need to be sold to break even. Because the break-even point increases, this is considered to have increased the operating gearing of the organisation as a higher quantity of goods or services must be processed and sold before the organisation can cover its costs (that is, break even). This increases the risk to the organisation.

As a general rule, capital-intensive processes (those that rely relatively more on machinery than on people) tend to be more highly geared operationally, and therefore they are relatively riskier in times of reducing market demand.

3.26 The required units of products or service required to be sold to generate a required profit will be calculated by adding the desired profit to the total fixed costs and then dividing this by the contribution margin per unit.

Cost Factory rent Heating equipment rent Unprocessed wax Energy cost Packaging TOTAL

Variable cost per block of wax

$1 $0.20 $0.30 $1.50 per block of wax

Fixed cost $600 per month $400 per month

$1000 per month

The contribution margin per block of was is $4.00 – $1.50 = $2.50.

The required number of bocks of wax that need to be produced and sold to make a profit of $3000 per month is: ($3000 + $1500) ÷ $2.50 = 1600 blocks 3.27 We need to convert the after-tax profit into a pre-tax profit, to ensure that the profit figure used in the subsequent calculation includes the tax component/amount. In this question, this equates to a pre-tax profit of $2500 ÷ (1 − tax rate) = $2500 ÷ 0.7 = $3571. We add this amount to the fixed costs and then divide this total by the contribution margin: © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

($3571 + $1000) ÷ $2.50 = 1829 blocks of wax (rounding up to the nearest full block) 3.28 In the longer run, an organisation needs to be able to cover both its variable costs and fixed costs, and also hopefully generate a profit. Therefore, in general it would be inappropriate to sell goods or service slightly above the variable costs as this might not enable the organisation to pay for the fixed costs.

In considering a special order, managers need to consider whether they have sufficient excess production capacity (that is, whether they have the ability to produce the goods or services without affecting the ongoing production of goods or services to satisfy preexisting orders) to satisfy the order, and whether the incremental revenue exceeds the incremental costs. If the incremental revenues exceed the incremental costs, then they might consider accepting a special order.

Organisations need to be careful that other customers do not react adversely if they are to find out that particular customers have been given special low-price deals on goods or services. That is, special orders can create some reputational damage if existing customers find out that new customers have been provided with much better deals.

Ultimately, some customers might cease buying goods or services from the organisation.

3.29 Where there is a constraining factor such as a limited availability of energy, production capacity, or skills, then an organisation will try to maximise the contribution per unit of the scarce, or constraining, factor.

Shoes

T-shirts

Hats

Market demand

50 000

15 000

30 000

Sales price

$88

$45

$27

Variable cost

$27

$10

$11

Contribution margin per unit

$61

$35

$16

Watts of power required per unit

3

2

1

Contribution per watt

$20.33

$17.50

$16.00

As we can see, each product has a positive contribution margin per unit. In the absence of any constraints on available resources, each of the products would be produced to the extent necessary to satisfy market demand. However, because there are restrictions on the amount of energy available then we will need to determine the maximum return that we can generate for the available energy that we have.

Because shoes generate the greatest contribution per watt of power then we will try to satisfy the full market demand for shoes. This will utilise 150 000 watts of the available power (50 000 X 3) leaving 50 000 available watts. These watts of energy would then be dedicated to producing the product with the next highest contribution margin per unit of the scarce factor of production. This is T-shirts, such that 15 000 T-shirts would © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

be produced. This will utilise 30 000 watts of the available power (15 000 X 2) leaving 20 000 available watts. These watts of energy would then be dedicated to producing hats such that 20 000 hats would be produced.

3.30 (a) This question is designed to require the students to think about which costs would arise as a result of making the choice to make the soup, and to consider how such costs will change (behave) as volume of activity changes. In this question we will only include financial costs.

Some of the variable costs would relate to the raw materials used to produce the soup, which would include the chicken, chicken stock, noodles, bok choy, bean sprouts, spring onions, soy sauce and chili, cups and spoons provided to customers (hopefully recyclable).

The fixed costs would include the licence fees, cart rental cost, and cooking equipment rental. (b) To answer this question, we have assumed the following costs, to enable us to generate the following answers (obviously students will have different answers but the aim is to encourage students to consider the incremental costs and revenues): Cost Food licence Cart rental Cooking equipment rental Chicken Chicken stock Noodles Bok choy Bean sprouts Spring onions Soy sauce Chili Cup and spoon TOTAL

Variable cost per bowl of soup

$0.40 $0.10 $0.20 $0.20 $0.15 $0.05 $0.05 $0.05 $0.10 $1.30 per bowl of soup

Fixed cost $500 per month $500 per month $400 per month

$1400 per month

To consider the appropriate price to charge, we need to think of the available capacity, and the demand for soup. Perhaps we believe that a cost of $6.00 per bowl of soup would be reasonable. This would mean a contribution margin of $4.70 per bowl of soup, and 298 bowls of soup would need to be sold per month to break even.

If it is believed that the activity should reasonably be expected to generate a profit before tax of $4000 per month, then this would mean that 1149 bowls of soup would need to be sold each month. Assuming 20 work days per month, this would be about 58 bowls a day, which would probably seem very reasonable and achievable. Obviously some ‘market analysis’ would be necessary before embarking on this venture.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 4: Budgeting as a means of organisational planning and control 4.1

Budgeting is essential for efficient operations and for organisational survival. By committing to an ongoing budgeting process this will act to: •

•

•

•

•

Provide a means of operationalising the organisation’s strategic plan. If done properly, the budget should be constructed with the organisation’s mission, objectives and strategic plans in place.

Create a framework to understand the interconnectivity of the various activities being undertaken within the organisation. A properly constructed budget requires managers and accountants to understand how the different components of an organisation relate to one another and this is vital to the management of an organisation and to identifying potential risks and opportunities.

The process of budgeting requires managers at various levels to plan ahead and to formalise plans. This necessarily requires managers to think about the future and to make forecasts about activity levels, associated costs, cash requirements, raw material requirements, labour needs, and required sources of funding. This is all important to the ongoing viability of the organisation.

Provide an early warning system of when resource constraints might particularly need to be addressed, and to help ensure sufficient goods and services will be available to meet particular peaks in demand.

Provide a basis for evaluating future performance and to create benchmarks for managers throughout the organisation.

4.2

There will generally be a difference between sales revenue and cash received from customers in a given period. The reason for this is that a great deal of the sales made to customers are made on credit terms. That is, a sale might be made today with the customer taking control of the good or service, but the related cash might not be received by the organisation until some time later. Perhaps the customer used a credit card and the business will therefore need to wait on the credit card provider to subsequently provide the cash, or perhaps the customer has approved credit facilities with the organisation that entitles the customer to pay for the purchases on a date after they have taken control of the goods or services. There is also the possibility that a customer that is sold goods or services on credit terms might never subsequently pay the amount due, perhaps because the customer encounters liquidity problems.

4.3

The master budget, sometimes referred to as the annual budget, is a comprehensive set of budgets that provide coverage of an organisation’s activities. The master budget

Deegan 2e_Solutions Manual

2

consists of several interdependent budgets that together create a reasonably cohesive organisational plan for a specified period of time. The master budget can include: •

•

4.4

the operating budgets, which include the sales budget, the production budgets and the various cost budgets that follow (such as the direct materials budget, direct labour budget, manufacturing overhead expenses budget, and selling and administrative overhead expenses budget) the financial budgets, which include the cash budget, budgeted income statement (also referred to as the budgeted statement of financial performance), and budgeted balance sheet (also referred to as the budgeted statement of financial position).

As Figure 4.2 on page 166 shows, for a manufacturing organisation sales are typically the starting point in the budgeting process. The determination of targeted/budgeted sales might be influenced by industry and market trends, general market conditions, expected promotion and advertising, pricing policies, past sales, actions of competitors, technological developments, and so forth. If, at the extreme, no sales are projected, then logically there should be no production, and therefore no need for materials, labour and so forth.

As Figure 4.2 also shows, once target sales have been determined based upon the sales forecast (which needs to be realistic, and therefore not too optimistic or too pessimistic), the number of units that need to be produced to satisfy those sales can be calculated. The level of production is not normally the same as the level of sales, as stock (inventory) on hand at the beginning of the period needs to be taken into account, as does the need for sufficient stock at the end of the period. In turn, once the required units of production are known, the quantity of materials needed for production can also be determined, as well as how much labour is needed. Further budgets will then follow.

4.5

The other budgets, such as the sales budget, production budget, direct materials budget, direct labour budget, and various overhead expenses budgets all have implications for either cash inflows or cash outflows. Therefore, the cash budget which provides details about projected cash inflows and outflows necessarily needs to be prepared after the other operating budgets have been prepared.

4.6

Whilst in general, it is preferable to have more cash than less cash, it is not efficient to have large amounts of cash. An organisation should not aim to hold too much cash as cash itself is not a productive asset. That is, leaving cash in a simple deposit account earns an organisation very little, or no, interest revenue. If an organisation discovers it has surplus cash, then it should consider putting the cash to more productive uses, although not ones that would significantly increase the risks to the organisation.

The act of preparing a cash budget will highlight periods of excess cash, as well as periods in which there could be cash shortages if other actions are not taken.

4.7

A ‘budget variance’ represents a difference between actual performance and budgeted performance. The reasons for both favourable and unfavourable variances need to be

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

understood. That is, even if a budget variance is favourable, the managers need to understand the reason why the variance arose – perhaps they did not fully understand how costs behave, or the actual demand within the market. If actual performance is not in accordance with budgeted, or targeted, performance, then the related processes can be deemed to be out of control. Managers then need to know why, and how, to get the process back under control. Once an understanding of why a variance occurred – whether it is positive or negative – then this might signal a need to make adjustments to existing budgets and plans.

4.8

The initial budget(s) to be constructed would relate to the activity, or activities, which tend to drive all of the other activities within the organisation. In this chapter we simplified our analysis by considering organisations that only produced one product and the balance of the budgets within the master budget were driven by the sales and related production of this one product. In practice, it will be much more complicated than this – albeit the process is based upon the same general principles.

Within a university we would initially consider the many activities which drive the balance of the activities within the organisation. In doing so, a very sophisticated modelling process would be required that would include the input of many people throughout the organisation. Budgets would initially be prepared for many activities, some of which would relate to: •

•

•

Number of projected students to be taught across different courses (and different courses will have different teaching and other resource requirements). The number of students to be taught will then have various implications for other budgets pertaining to health support, sports and recreation facilities, library facilities, cleaning requirements, teaching staff, teaching spaces, graduation ceremony requirements, and so forth.

Research projects being undertaken. Different research projects will have different resource requirements, and some will be funded externally. The research-related plans of a university will also have implications for research training provided to staff, conference funding, and so forth.

Community projects and support. It is an expectation that universities provide a variety of services to the broader community. These will also have various budgetary implications.

We have only identified some of the activities that would drive further activities within a university. Students are encouraged to think about what other activities would drive the need to create subsequent budgets.

4.9

If budgetary targets are extremely hard to achieve then this would generally be considered to be demotivational. Research generally indicates that budgetary-related targets should be demanding but nevertheless achievable. That is, they should not be too easy, nor should they be too hard. Budgets must be set at a level that provides

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

challenges and which stretches the capabilities of managers, but again, this should not be too difficult.

4.10 The principles are the same, but the individual budgets would have some differences.

Both organisations would consider their mission, objectives, and strategic plans when developing their budgetary plans. Both types of organisations would start their master budget with a sales budget. However, for a retailer there would not be a production budget. Instead there would be a purchases budget. A retailer would not have a manufacturing overheads expenses budget, but it would have other overheads – such as selling and administrative overheads expenses, which will require a budget. A retailer would also not have a direct materials budget. Both organisations would generate a budgeted income statement, a cash budget and a budgeted balance sheet.

4.11 Budgetary slack can be defined as the difference between the revenue, cost or other targets that have been set opportunistically by managers, and those that would have been set if they were determined objectively. That is, when managers are being assessed in terms of targets or key performance indicators that are linked to budgets, they might choose to introduce some ‘slack’ into the calculations so as to make the targets or KPIs easier to achieve. This would increase the likelihood that they would receive any bonuses or awards that are linked to meeting or exceeding budgetary requirements/targets.

4.12 Target sales in units (from sales budget)

25 000

Add: required closing inventory

4 000

Subtract: opening inventory

(1 000)

Required production in units

28 000

4.13 Closing inventory in units = Opening inventory in units + units produced – number of units sold.

Rearranging this equation provides us with: Number of units sold = Opening inventory in units + units produced – closing inventory in units =10 000 + 100 000 – 5000 = 105 000 units sold.

The cost of sales for the financial year would be determined as: Opening inventory

$85 000

Production costs during the year

$900 000 $985 000

Less closing inventory

$45 000

Cost of goods sold

$940 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

4.14 The main audience for the budgets – those to whom the budgets are directed – are the managers within the organisation. Budgetary information would not typically be made publicly available, particularly information that relates to the costing of various processes and future plans for production, change and so forth. To release such information publicly would mean that particular stakeholders, such as competitors, could obtain it, which could be damaging to the future prospects of the organisation.

Also, there could potentially be a number of reputational and legal implications for an organisation if budgetary plans were publicly released and people made decisions on the basis of those plans, only for the plans to subsequently fail to be achieved.

That said, organisations will often release some aspects of their budgets that are not too sensitive, highlighting specific targets, whether they have been achieved, and if not, the initiatives in place to help them get back ‘in control’, and on track, to achieve targets.

4.15 One of the central purposes of preparing a budget is to provide a mechanism for evaluating future performance. Budgets create targets that are expected to be achieved on the basis of knowledge and expectations held at the time the budgets were created.

Where actual performance is subsequently shown to deviate from budgeted (targeted) performance, then the reason for this variance needs to be investigated and understood.

If there was a variance due to a random occurrence, then little can be done to address it.

Some variances that are not random might also be beyond control; for example, changes in the political stability of particular countries, or unexpected severe storms that might have caused problems for an organisation.

It is also possible that the variance could be the result of an unrealistic budget (target) initially being set, or a budget that was poorly constructed in the first place. Where variances are deemed to be significant, they need to be investigated, understood and, where possible, addressed, so as to prevent the same problems arising in the future. The variance might indicate that managers and accountants did not properly understand how costs behaved, or perhaps they made errors in predicting sales demand, or product prices. Further investigation will generate further knowledge that can be used to modify existing budgetary plans.

4.16 In a short period, such as a week, it is very difficult to predict certain facts, such as how many units would be sold, if the related cash will be received, if repairs will be undertaken, and so forth. However, as we extend the time period, it is easier to make predictions without worrying about the possibility of daily or weekly fluctuations in activity. Things tend to balance out over longer periods. For example, whilst sales might be down in one week, they might be up in the next week but nevertheless be fairly constant on a month-to-month basis. Also, whilst it could be difficult to determine whether repairs would be undertaken in a particular week, there would be an expectation that a certain amount of repairs would be necessary on a yearly basis.

4.17 If the head of the organisation was provided with a bonus that is linked to increasing the number of students then that person – if motivated by personal wealth – might put © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

in place various policies which would focus on increasing the quantity of students rather than increasing the quality/ability of the student cohort. For example, to attract more students and therefore greater total student fees, entrance scores might be lowered, expectations about prior learning removed or reduced, and necessary language skills might be reduced or removed altogether. This will have direct implications for what can be taught to students, and how it is taught. Because it is generally unacceptable to have high failure rates within universities, this could lead to lecturers simplifying the material taught to the students and simplifying the required assessment processes. Evidence suggests that whilst a policy of focusing on increasing student numbers might have positive impacts in the short term, in the longer term there will be reputational damage to the university and better students will tend to avoid attending such institutions. Also, the better university staff will eventually get frustrated and will move to other institutions with higher entrance requirements. Perhaps if the head of the university was given bonuses tied to the abilities of those students entering the institution then a fixation on student numbers and related cash flows might be avoided.

4.18 A static budget is not directly useful for performing activities such as a ‘what if?’ analysis. A static budget is prepared based on one set of projections – perhaps about sales (as per the sales budget) – and this set of projections then drives the level of activity, and associated costs, that are reported in the other budgets that make up the respective components of the master budget. That is, only one level of activity is applied with consequential effects through all the related budgets, which means the managers of the organisation would subsequently compare actual revenues and costs that were generated at different levels of activity to those used to develop the master budget. In practice, it is unlikely that actual sales would exactly match projected sales.

Therefore, the static budget is only appropriate for evaluating the performance of managers when the actual level of activity is very close to that used within the master budget.

Variable costs are expected to change as activity levels change. Therefore, a master budget prepared on the basis of a certain (static) level of activity will not be very useful for assessing how managers have controlled those costs that are considered to be variable if the actual activity level – for example, the sales made – is quite different.

However, the static budget can still be useful for assessing managers’ performance in controlling fixed manufacturing costs and fixed selling and administrative costs, as long as the level of activity is within the bounds of that in which such costs are expected to remain fixed (the relevant range).

As a solution to the limitations associated with a static budget, a flexible budget can be prepared that adapts (or ‘flexes’) to changing circumstances. A flexible budget recalculates the total production costs based upon the alternative amounts of production or sales. For example, the sales level that appears in the sales budget could be adjusted, as this would all be done using a particular spreadsheet application. Changes made in the sales budget should in turn flow through to the various budgets that come after (rely © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

upon) the sales budget. As long as production remains within the identified relevant range, then fixed costs should not change. Of course, an organisation needs to be very clear about identifying fixed costs and variable costs, as well as knowing about the relevant range, but that should already have been determined. Flexible budgets therefore provide a more valid comparison of actual and budgeted costs when activity levels deviate from initial plans or expectations.

4.19 Whenever targets are set for managers based on one component of an overall master budget, great care must be taken to ensure that maximising a particular measure does not then have negative implications for some other operations/functions/outcomes within an organisation. As the chapter emphasises, the establishment of various interdependent budgets needs much careful thinking.

One example might be where a sales manager, who has no direct responsibility for collection of amounts of debts outstanding, is provided with a bonus linked to quantity and value of sales. Such a manager might choose to increase sales by whatever means possible – including selling the goods on credit to people with limited ability to pay – without having regard to issues associated with whether they will ultimately pay for the goods acquired. In such a situation, the manager might increase sales, and receive a bonus, but the organisation might actually make losses on the sales. A more sensible approach would be to base the bonus on sales that have actually been paid for by the customer.

4.20 In terms of measuring ‘customer satisfaction’ – which is something that is important to the success of an organisation – we could use various approaches. For example, we might ask an independent third party to perform some form of engagement with a random and representative sample of customers to specifically ask them – perhaps by way of questionnaires or interviews – to rank their level of satisfaction, perhaps using some scale. They could also be asked questions about whether they would recommend the organisation and its products, or whether they would return as a customer. The questions asked could be tailored to align with the goals of the organisation.

Other possible measures of ‘customer satisfaction’ could be linked to data about the number of customers who subsequently acquire further goods or services, or the amount of returned goods.

In relation to the health and safety of employees, we firstly need to determine whether we are only considering those in the direct employment of the organisation, or whether we extend the range of our responsibility and accountability to workers employed within the organisation’s supply chain. If we are considering supply chains, then we might require, as part of a negotiated supply agreement, that we have independent factory audits undertaken regularly by third party auditors who then provide us with some form of opinion on the treatment of workers.

Other measures that could be used in relation to assessing the health and safety of employees would include data about incidents of non-compliance with occupational © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

health and safety requirements/laws, workplace accidents categorised by some level of severity and number, extent of training provided to employees on health and safety, number of successful inspections/audits undertaken of workplaces, the existence and maintenance of risk registers, regulatory investigations instigated by various authorities, whether best practice health and safety controls are in place, the number and financial amount of workers’ compensation claims, the amount of lost work days recorded in a period, and the results of employee surveys about the ‘climate of safety’ within the organisation.

To encourage managers to embrace the above measures, their rewards could be linked to related-performance indicators. In terms of customer surveys, a bonus might be payable if satisfaction levels are above a certain level on a particular scale for a period of time. Bonuses might also be linked to the quantity of returning customers, or to low levels of returned goods.

In relation to health and safety-related bonuses, managers with related responsibilities might only receive a bonus if no workplace-related incidents of a particular severity occur in a given period, or if lost days due to injury are kept below a designated maximum. Bonuses might also be paid on the basis of whether favourable opinions were provided by employees to independent workplace auditors.

4.21 Outsourcing the production of goods and services can create various risks and opportunities. There is always the risk that the organisation’s own perspectives of social and environmental responsibilities will not be shared by the supplier. When outsourcing to developing countries the risks can be considered to be even higher as the expectations of what is reasonable within a developing country context can be very different from the expectations in a developed country.

Willy Wetsuits might require the supplier to meet particular social and environmental targets; otherwise the supply arrangement might be revoked. Referring to the social performance indicators suggested within the Global Reporting Initiative’s Sustainability Reporting Standards, some of the targets might be based on the results of independent factory audits undertaken by appropriately qualified assurance/audit providers. Some of the non-financial targets might relate to: • • • • • • • •

Employees being allowed to be members of labour unions; There is an absence of child labour; There is an absence of forced or compulsory labour; Factories have passed minimum safety requirements; Employees have minimum training in occupational health and safety issues; Men and women are paid a ‘fair wage’; Maternity leave is available for women; There are clear structures in place to eliminate sexual harassment.

4.22 Best practice budgetary targets would need to be established in relation to water usage and use of recycled water. Different sources of water should be used for different © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

processes. For example, washing of bottles and equipment might use a different category of water from that used to make the drinks. More water efficient cleaning and production technologies could also be investigated. Life cycle analysis of the production of soft drinks in these locations would have helped highlight the levels of water use, and signalled the need to consider the impacts this use of water might have on surrounding communities. The managers also perhaps need to make the judgement whether it is actually socially responsible to produce soft drinks in that region, given the water scarcity, or whether it is appropriate to only produce soft drinks in those months where higher rainfall is expected.

To encourage managers to embrace water-saving technologies, managerial bonuses could be linked to the amount of reduction in water usage and the amount of increase in the use of recycled water.

4.23 (a) Radical Surfing School Sales Budget for the year ending 31 December 2026 GOLD

SILVER

BRONZE

Target sales

100

200

400

Selling price

$8000

$4000

$2000

Total sales revenue

$800 000

$800 000

$800 000

TOTAL

$2 400 000

(b) Radical Surfing School Labour Budget for the year ending 31 December 2026 2026 Coaching director

$250 000

Coaches (3)

$360 000

Trainers (2)

$180 000

Administrative staff (3)

$240 000

Medical staff (1)

$70 000

Total

$1,100 000

Radical Surfing School Budget of Non-Labour Costs for the year ending 31 December 2026 Variable costs Surfing supplies $50 X 700 students

$35 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

Fixed costs Advertising

$40 000

Insurance

$100 000

Rental of wave pool

$400 000

Total

$575 000

(c) Radical Surfing School Budgeted Income Statement for the year ending 31 December 2026 Sales

$2 400 000

Less: Costs directly related to providing the service Coaching and medical staff

$860 000

Administrative staff

$240 000

Surfing supplies

$35 000

Rental of wave pool

$400 000

Advertising expenses

$40 000

Insurance expenses

$100 000

Profit

$1 675 000 $725 000

4.24 (a)

(b)

Community expectations are changing in relation to the use of palm oil. In some countries, through the destruction of vital rainforests, entire habitats of species such as orangutans have been wiped out to make way for oil palm trees. Many consumers are now expecting that organisations use palm oil from sustainable plantations. Therefore, it does seem reasonable that the marketing manager will have concerns about the potential impact of any move away from sustainable palm oil. Hopefully the concern would not only be because of a potential loss of a bonus, but also because the use of non-sustainable palm oil is simply wrong. As condemnation of unsustainable palm oil farming practices continues to grow, then this will create further financial risks for companies that use palm oil from non-sustainable sources.

In terms of the potential ‘costs’, these would include the destruction of rain forests with the associated destruction of key habitats for various flora and fauna. The implications of climate change are also quite significant given rain forests play an important role in carbon sequestration. The additional transportation also has implications for the use of energy and the related carbon emissions. Whilst the use of this unsustainable oil will create some employment opportunities in South East Asia, there will be lost job

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

(c)

(d)

(e)

11

opportunities in Australia. Of course, the higher financial profits – at least in the short run – might enable the organisation to employ more staff and also to pay greater taxes within Australia – and there could be social benefits associated with that. But in the long run it is a very risky strategy to undertake actions which can be considered to be counter to a quest towards sustainable development.

Most of these social and environmental costs and benefits would not be captured in the budgets unless the organisation attempts to measure its contribution to climate change or attempts to measure its impact on endangered species.

In the long run it can be detrimental to an organisation to pay rewards which focus on short-term measures of performance, such as annual profits. This could particularly be the case if the managers in question are approaching retirement. Bonuses paid to managers need to incorporate considerations of both the short-term and the long-term.

Hopefully the CEO will reject the move to unsustainable palm oil because from a socially responsible perspective such a move would be wrong. However, if the CEO is motivated by short-term financial gain, then the CEO might put their own self-interest above the interests of current and future generations, and the interests of the other inhabitants of the planet.

4.25 (a) Farelly Shirts Sales Budget for year ending 31 December 2026 Q1

Q2

Q3

Q4

Total

Target sales

25 000

27 000

30 000

30 000

112 000

Selling price

$130

$130

$130

$130

$130

$3 510 000

$3 900 000

$3 900 000

$14 560 000

Total $3 250 000 sales revenue

(b) Farelly Shirts Production Budget for year ending 31 December 2026

Expected sales in units (from Sales Budget) Add: Desired closing inventory

Q1

Q2

Q3

Q4

Total

25 000

27 000

30 000

30 000

112 000

5000

5000

5000

5000

5000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Deduct: Opening inventory Required production in units

12

(2500)

(5000)

(5000)

(5000)

(2500)

27 500

27 000

30 000

30 000

114 500

(c) Farelly Shirts Direct Materials Budget for year ending 31 December 2026 Q1

Q2

Q3

Q4

Total

Units to be produced (from the Production Budget)

27 500

27 000

30 000

30 000

114 500

Material cost per shirt $50 (1.25 m X $40) Cost of material required for production Target ending inventory of material (1250 m X $40) Total materials required Less opening inventory materials (for first quarter is 625 X $40) Total cost materials purchases

$50

$50

$50

$50

$50

$1 375 000

$1 350 000

$1 500 000

$1 500 000

$5 725 000

$50 000

$50 000

$50 000

$50 000

$50 000

$1 425 000

$1 400 000

$1 550 000

$1 550 000

$5 775 000

$25 000

$50 000

$50 000

$50 000

$25 000

$1 400 000

$1 350 000

$1 500 000

$1 500 000

$5 750 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

(d) Farelly Shirts Direct Labour Budget for year ending 31 December 2026

Units to be produced (from the Production budget) Labour time per shirt (hours) Total hours required Labour cost per hour Total labour cost

Q1

Q2

Q3

Q4

Total

27 500

27 000

30 000

30 000

114 500

2.5

2.5

2.5

2.5

2.5

68 750

67 500

75 000

75 000

286 250

$20

$20

$20

$20

$20

$1 375 000

$1 350 000

$1 500 000

$1 500 000

$5 725 000

(e) Farelly Shirts Manufacturing Overhead Expenses Budget for year ending 31 December 2026 Q1

Q2

Q3

Q4

Total

27 500

27 000

30 000

30 000

114 500

Indirect materials $68 750 at $2.50 / shirt Electricity at $55 000 $2.00 / shirt Maintenance$0.50 $13 750 / shirt Fixed costs

$67 500

$75 000

$75 000

$286 250

$54 000

$60 000

$60 000

$229 000

$13 500

$15 000

$15 000

$57 250

Supervisor’s salary Factory rent

$60 000

$60 000

$60 000

$60 000

$240 000

$65 000

$65 000

$65 000

$65 000

$260 000

Rates and insurance Total

$20 000

$20 000

$20 000

$20 000

$80 000

$282 500

$280 000

$295 000

$295 000

$1 152 500

Production as per the production budget Variable costs

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

(f) Farelly Shirts Selling and Administrative Overhead Expenses Budget for year ending 31 December 2026 Q1

Q2

Q3

Q4

Total

25 000

27 000

30 000

30 000

112 000

$175 000

$189 000

$210 000

$210 000

$784 000

Advertising

$20 000

$20 000

$20 000

$20 000

$80 000

Office salaries

$40 000

$40 000

$40 000

$40 000

$160 000

Rent on admin building

$25 000

$25 000

$25 000

$25 000

$100 000

Rates and insurance

$5000

$5000

$5000

$5000

$20 000

Total

$265 000

$279 000

$300 000

$300 000

$1 144 000

Target Sales Variable costs Freight @ $7 per shirt Fixed costs

(g) Before completing the cash budget we also need to determine the cash receipts from customers and the cash payments made to suppliers: Farelly Shirts Expected Cash Receipts from Customers / year ending 31 December 2026 Q1 Opening debtors

$95 000

First Quarter Sales $3 250 000 Second Quarter Sales $3 510 000 Third Quarter Sales $3 900 000 Fourth Quarter Sales $3 900 000 Cash collected from customers

$2 925 000

Q2

Q3

Q4

$325 000 $3 159 000

$351 000 $3 510 000

$390 000 $3 510 000

$3 020 000

$3 484 000

$3 861 000

$3 900 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

15

Farelly Shirts Cash Payments for Materials for year ending 31 December 2026 Q1 Opening amount payable to suppliers: $30 000 First Quarter Purchases $1 400 000 Second Quarter Purchases $1 350 000 Third Quarter Purchases $1 500 000 Fourth Quarter Purchases $1 500 000 Cash paid to suppliers

Q2

Q3

Q4

$30 000

$1 190 000

$210 000

$1 147 500

$202 500

$1 275 000

$225 000

$1 275 000

$1 220 000

$1 357 500

$1 477 500

$1 500 000

Farelly Shirts Cash Budget for year ending 31 December 2026 Q1

Q2

Q3

Q4

$3 020 000

$3 484 000

$3 861 000

$3 900 000

For materials

$1 220 000

$1 357 500

$1 477 500

$1 500 000

Direct labour

$1 375 000

$1 350 000

$1 500 000

$1 500 000

Manufacturing overhead Selling and admin

$282 500

$280 000

$295 000

$295 000

$265 000

$279 000

$300 000

$300 000

Total payments

$3 142 500

$3 266 500

$3 572 500

$3 595 000

Total cash flow from operations Cash flows from Investing activities Invest new machine

($122 500)

$217 500

$288 500

$305 000

-

($100 000)

-

Cash flows from operations Cash receipts From sales Deduct payments

-

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Total cash flows from investing activities Cash Flows from Financing activities Borrowings needed achieve minimum cash balance of $25 000 (repaid as soon as possible, assumed incur no interest costs) Payment to owners Total cash flows from financing activities Total cash flows for the Quarter Opening cash for the Quarter Closing balance cash

16

-

-

($100 000)

-

$247 500*

($97 500)*

(68 500)*

(81 000)*

($120 000)

($120 000)

($120 000)

($120 000)

$127 500

($217 500)

($188 500)

($201 000)

$5 000

$0

$0

$104 000

$20 000

$25 000

$25 000

$25 000

$25 000

$25 000

$25 000

$129 000

*This amount relates to senior management’s wish to maintain a minimum cash balance of $25 000. In Quarter 1, $247 500 had to be borrowed to ensure a closing cash balance of $25 000. This amount will be paid back over the next three Quarters to the extent that the closing cash balance in each respective Quarter would otherwise be above $25 000. It is assumed that there are no interest costs for this amount.

Reviewing the statement of cash flows, it perhaps would be advisable for the owners to reconsider their withdrawal of $120 000 in the first two quarters as this would reduce the need to borrow external funds which might attract interest expenses. They could defer the owner withdrawals to the last quarter when surplus cash would be available.

The cash flows from operating activities are negative in the first quarter, but positive in the other three quarters. An organisation cannot sustain operations if cash flows from operations are negative. As long as the cash flows from operations are positive, and able to provide enough for other cash flow requirements, including a reasonable payment to owners, then there might not be of great concern.

(h)

In compiling the budgeted income statement, we need to determine the costs of the inventory that was sold – referred to as the ‘costs of goods sold’. The costs of the

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

17

inventory that is still on hand at the end of each period is not considered to be an expense of the related sales as the inventory has not been sold but is available for sale in the next period. Inventory on hand at the end of the accounting period is considered to be an ‘asset’, and not an expense of the period.

The costs of the inventory will generally include the manufacturing variable costs plus an apportioned amount of the manufacturing fixed costs. We can allocate the fixed manufacturing costs to each item of inventory (to each shirt in this instance) by dividing the total fixed manufacturing costs of the period by the number of shirts produced in that period. Costs that do not relate to the manufacturing process – such as those shown in the selling and administrative expenses overhead budget – will not be included within the cost of the inventory but will be treated as an expense of the period in which they were incurred.

The costs of inventory can be determined as follows: Variable manufacturing costs Direct materials per shirt

$50

Direct labour per shirt

$50

Variable manufacturing overhead per unit per shirt: Indirect materials

$2.50

Electricity

$2.00

Maintenance on machines

$0.50

Total variable manufacturing costs per shirt

$5.00 $105.00

Fixed manufacturing costs Factory supervisor’s salary

$240 000

Factory rent

$260 000

Rates and insurance on factory

$80 000 $580 000

Divided by the number of shirts produced Fixed manufacturing cost per shirt Total fixed and variable costs per shirt

114 500 $5.0655 $110.0655

Having calculated the cost per shirt of $110.0655 we can then calculate the cost of sales. The cost of sales equals the cost of opening inventory (which we were advised was $260 000) plus the costs of production for the period, less the cost of inventory still on hand at the end of the year (closing inventory).

Therefore, the cost of sales for the year is:

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

18

Cost of opening inventory (2500 shirts)

$260 000

Cost of production for the year: 114 500 X $110.0655

$12 602 500 $12 862 500

Less cost of closing inventory: 5000 X $110.0655

$550 328

Cost of sales

$12 312 172

We are now in a position to prepare the budgeted income statement which will show the total revenues for the year less the total expenses for the year: Farelly Shirts Budgeted income statement for the year ended 30 June 2026 Sales

$14 560 000

Less: Cost of sales

$12 312 172

Gross Profit

$2 247 828

Less selling and administrative expenses Freight to customers

$784 000

Advertising

$80 000

Office salaries

$160 000

Rent on administrative building

$100 000

Rates and insurance on administrative building

$20 000

Profit

$1 144 000 $1 103 828

Note the difference between profits and cash flows. Profit for the year, as calculated is projected to be $1 103 828, but the projected cash balance is projected to increase by only $109 000 across the year. The reasons why cash flows will be different to profits will include: • • •

•

some costs will be incurred in different periods than when they are paid (for example, the purchase of inventory) the cash-flows associated with some revenue will not be received until after the actual sale (for example, the customers paid for the shirts after the actual sale) some of the cash payments will not be considered as expenses (for example, the drawings made by the owners will not be considered as an expense but they reduce cash) some of the costs incurred were included in the cost of closing inventory which is an ‘asset’ rather than an ‘expense’.

For all of the above reasons there will be a difference between cash flows and profits. At the extreme a very profitable organisation might nevertheless fail because of poor cash

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

19

management. At this stage you do not need to get too concerned if you do not understand why some cash payments create ‘expenses’ and others do not as we will address such issues when we start studying financial accounting from Chapter 7.

In relation to the income statement, a few observations can be made. The profit represents 7.6% of total sales revenue. This seems low and some benchmarking against other similar organisations should be undertaken. Perhaps there are some inefficiencies that need to be rectified. Also, the gross profit only represents 15.44% of sales revenue. Again, this seems very low and should be investigated. The freight costs – which amount to 5.4% of sales, also seem high. Perhaps alternative freight options need to be considered.

The results also show that the organisation is only charging $130 for a product that has manufacturing (variable and fixed manufacturing costs) of $110.0655. This seems to be quite a low mark-up on cost. The organisation should investigate whether the market would be prepared to pay a higher amount for shirts without drastically impacting sales quantities.

Almost half of the cost relates to materials. Alternative suppliers should be investigated although quality needs to be kept in mind, as does the social and environmental performance of the alternative suppliers. The organisation might also consider outsourcing production of the shirts to cheaper overseas suppliers – however a careful review of the social and environmental impacts of such a move would be warranted before any decision was made.

4.26 Student answers will vary.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 5: Performance measurement and evaluation – further considerations 5.1

LCA is the process of analysing or evaluating a product or service across its entire life, often referred to as analysing a product or service from the ‘cradle to the grave’. For example, for a product, the LCA might start with a review of impacts associated with the extraction of the required raw materials and end with a consideration of what happens to the product at the end of its life; that is, on disposal.

Many accountants would never have performed any form of LCA, but arguably they should. Managers should be made aware of the various impacts created as a result of their decisions to produce the goods and services they supply, and LCA provides such knowledge. Without some form of LCA managers might simply be unaware of the impacts being generated from their goods and services, and therefore might not contemplate implementing actions to reduce the impacts.

Therefore, accountants should be aware of LCA. LCA will potentially identify various social, environmental and financial costs/impacts that could be associated with particular activities and for which managers might have an associated responsibility and accountability.

5.2

The answer to this really depends upon what we believe are the responsibilities and associated accountabilities of managers and how far these accountabilities and responsibilities should extend. For example, judgements need to be made about whether an organisation accepts responsibilities to communities in which the raw materials are extracted (which may, for example, be located within developing countries). This said, it does seem highly appropriate that before managers decide to undertake certain activities – such as starting the production of a new line – they should be aware of the various associated and related impacts both in financial terms, and also in social and environmental terms. A failure to consider and manage such impacts would seem to be irresponsible.

5.3

The answer to this depends upon our own views about organisational accountability. If we believe an organisation has an accountability for the impacts created by the goods and services it provides (and hopefully we do!), then an organisation should publicly disclose details of its lifecycle analysis. Many organisations do disclose such information.

It can also be argued that different stakeholders have a right to know about the various impacts caused by an organisation’s goods and services.

Deegan 2e_Solutions Manual

2

Also, from the perspective of competitive advantage, organisations that publicly disclose information about LCA will potentially find that stakeholders react positively to them because of the accountability they have elected to demonstrate. Further, with the results of LCA being made available, stakeholders will have better information about which organisations they should support, and to the extent that stakeholders care about sustainability, and factor it into their decisions, then this will create positive implications for future generations.

5.4

Managers might disclose such information because they believe they have a responsibility to provide an ‘account’ of the impacts created by their activities. Further, because of their beliefs about sustainability, they might believe it is important for stakeholders to have better information to enable the stakeholders to make informed choices about which organisations should be supported from a broader sustainability perspective.

Managers might also make such disclosures because it could generate a competitive advantage for their organisation, as some stakeholders might prefer to support an organisation that is trying to be transparent about the various impacts created across the lifecycle of an organisation’s goods and services.

5.5

This is another answer that really depends upon our own views about organisational responsibilities and associated accountabilities. Different students will have different opinions. However, ethically, if a decision is made to sell animals to particular customers, then it would seem to be the morally right thing to investigate – before a sales transaction is made – whether the customers are likely to have values that are consistent with respecting the welfare of animals.

Arguably, organisations should consider and report information about what happens to the animals and what policies and procedures are in place to minimise the likelihood of animals being treated in an unethical way.

As communities increasingly consider animal welfare, there will be greater demand for organisations that use or supply animals to disclose information about how the suffering of animals has been reduced (or ideally eliminated). Organisations that fail to do so might (hopefully) find that their operations will not attract stakeholder support, and that they will ultimately go out of business.

5.6

Eco-efficiency is generally considered to mean ‘doing more with less’. That is, to be able to produce more of a given good or service with the same quantity of raw materials (or to produce the same amount of goods and services with less raw materials).

However, whether we should be producing a particular good or service in the first place is a different issue to consider. For example, we might be able to produce extremely powerful cars with less materials and energy than other organisations, which is reflective of being eco-efficient. But this does necessarily mean that we should be producing such cars. Eco-efficiency is generally consistent with a ‘business as usual’ approach, albeit the ‘business’ might be more efficient (which will create cost savings).

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5.7

3

The answer to this is based on personal opinion. Arguably, if managers decide to produce, or have produced for them, particular items, then they should accept a responsibility for what happens to these products once they reach the end of their life.

For example, if the materials involved in making a mobile phone are potentially poisonous when taken to landfill then managers should take reasonable actions to either ensure that there are available processes in place to recycle the phone, or that different materials (perhaps biodegradable) be used to manufacture the phone.

A great deal of the problems we have with the many severely contaminated sites throughout the world (and perhaps sustainability generally) is because managers, and consumers, do not care about what happens to the products once they reach the end of their useful life. People, including managers, often embrace the view that it is ‘not my problem’ once I throw an item away – but this is very irresponsible and disregards the rights of future generations.

However, a number of organisations are now implementing practices that address what happens to their products once they are no longer useful. For example, some organisations require consumers to return the products to them at the end of their useful life upon which the organisation recycles the product. Some organisations are also establishing what they are referring to as ‘closed loop systems’ in which the aim is to make all of the components of a product recyclable and which therefore reduces the likelihood of any material going to landfill. This is necessary if we are to properly address the issue of sustainable development.

5.8

The circular economy approach to production refers to processes that are designed to eliminate waste and pollution and in which products and related materials are designed to remain in productive use rather than, perhaps, going to landfill. While the concept is something of an ‘ideal’, all managers should arguably aim towards operating in a way that is consistent with a circular economy. Not only will wastes be reduced, but typically large cost savings, and some other income streams, will eventuate. It encourages innovation that is necessary for sustainable development.

5.9

(a) This depends upon whether we believe that the managers of an organisation are accountable for what happens to the property, plant and equipment they acquire once the assets reach the end of their useful life. If we believe they are ‘accountable’ then we would expect them to provide an account.

The scrapping of ships can have many negative social and environmental impacts if they are sent to some locations (such as some ship-breaking yards in developing countries that fail to implement ‘leading edge’ social and environmental requirements with many deaths occurring and great damage done to the environment). It would seem reasonable to argue that an organisation should provide an account of what happens to the ships they acquired some years earlier.

There are a number of interest groups (such as the Shipbreaking Platform – see www.shipbreakingplatform.org) that are now independently reporting information about what the world’s largest shipping companies are doing with their ships when they

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

are decommissioned from service. Many stakeholders are now using this information to voice their concerns about various organisations. Indeed, in recent times a large superannuation fund in Norway – Norway's Government Pension Fund – ‘blacklisted’ four shipping carriers because of those companies’ contribution to the systematic violations of human rights and international environmental conventions. The companies acted in this way in order to get the highest scrap price for their end-of-life vessels. The action by the Fund is one of the first known instances where shipping companies have been significantly financially sanctioned with respect to the negative social and environmental impacts from ship recycling. The Fund’s sanctions might be expected to provide important impetus for increasing the responsibility and accountability of shipping companies. (b) Again, this is a matter of opinion, but arguably an organisation should provide details of its policies with respect to how it deals with ships once they are no longer of use. By creating such policies this also effectively motivates the organisation to think in advance about its responsibilities and necessary governance structures.

5.10 Life cycle costing (LCC) seeks to place a cost on the various inputs (resources used), outputs (including wastes and emissions) and the impacts created by an organisation’s operations, and attribute such costs to particular activities and products. LCC is a management tool that assists an organisation to select the most cost-effective alternative from among competing alternatives, once the costs of purchasing, operating, maintaining and, ultimately, disposing of a product are taken into account.

In undertaking LCC, managers need to make decisions about what costs they intend to consider. From a practical perspective it may be impractical for managers to attempt to place a monetary value on many of the externalities associated with the activities. That is, it may become too impractical or even too confusing to implement LCC if, at the start of the analysis, there are too many aspects being addressed. Therefore, a limited number of significant social and environmental impacts might be identified for the purpose of analysis.

It needs to be stressed that the ‘costs’ identified in LCC do not necessarily all need to be measured in financial terms and it is very important to also use various forms of qualitative measurements as well as non-monetary quantitative measurements. Final decisions will then require managers to develop a system to prioritise various items of non-financial information.

5.11 Such a decision would represent a ‘capital investment decision’ which requires careful analysis. Any decisions made will need to also consider the organisation’s mission and goals (which might, for example, require a reduction in GHG emissions over coming years). Some factors to consider would include: • • •

Whether the trucks suit the required purpose; for example, in terms of load space, expected useful life.

The upfront acquisition cost.

Whether interest-free financing is available from the supplier.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

• •

• • • • •

• • •

5

What the likely resale price would be.

The maintenance costs and environmental implications associated with maintenance (for example, what oils/batteries do the trucks use, and can these be recycled?)

Ongoing fuel costs.

Emission levels of the trucks.

The social and environmental performance of the manufacturers/suppliers of the trucks.

The safety rating of the trucks.

The recyclability of the trucks at the end of their useful life (some manufacturers are starting to develop ‘closed loop systems’ in which nearly all of the vehicle can be recycled/reused).

The payback period and whether it is consistent with organisational requirements.

The net present value of the cash flows associated with different trucks.

The internal rate of return on different truck options.

Whilst the above list is not exhaustive, it indicates that many factors need to be considered, not all of which will be measured in financial terms. Therefore, the ultimate decision needs to consider a mixture of both financial and non-financial factors.

5.12 Material flow cost accounting (MFCA) focuses on recording the inputs of particular materials into a production process, and the outputs, including wastes, that come from that process. Measurements can be made in both physical and monetary terms.

The resulting information can act as a motivator for organisations and managers to seek opportunities to reduce the use of various materials and simultaneously generate financial benefits and a reduction in adverse environmental impacts.

5.13 A flow model assigns physical values to the material being used within a particular product or process. Once an appropriate system boundary has been agreed (for example, is the flow modelling just going to look at a single product, or the operations of a whole factory), it is widely accepted that the first step in implementing MFCA is to develop a basic understanding of the flows of material and energy throughout the organisation and this is achieved through developing a visual representation which is the ‘flow model’. The depiction provided by the flow model is also commonly referred to as a ‘mass balance’, ‘input-output balance’ or an ‘eco-balance’.

5.14 The aim of MFCA is to improve both environmental and financial performance through the more efficient use of materials. This culminates in what is often referred to as the win–win scenario (a ‘win’ in terms of financial savings, and a ‘win’ in terms of reduced environmental impact).

The implementation of MFCA requires the development of frameworks that track and quantify the flows of materials through an organisation in both physical and monetary terms. The information generated through this analysis can then be used to identify opportunities to reduce material usage, improve the efficiency with which materials and © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

energy are used, and this can all lead to reduced expenses, and therefore improved financial performance.

MFCA can also be used to track the amount and type of waste being generated in different processes. By tracking what is actually going into waste, managers and their accountants should be able to actually determine the financial cost of the waste. This will likely motivate them to reduce the waste which will also be accompanied by improved financial performance.

5.15 Material Cost Flow Accounting can provide environmental benefits because, if performed properly, it can lead to more efficient resource usage. The process of MFCA identifies and records the energy and materials being used within a process and therefore identifies opportunities for reduction in resource usage. That is, the information generated through this analysis can then be used to identify opportunities to reduce material usage, improve the efficiency with which materials and energy are used, and reduce the adverse environmental impacts and associated costs of such impacts. The process effectively maps resource inputs and related outputs, including waste, and it is generally accepted that managers are more likely to manage what is measured, than what is not.

By tracking what is actually going into waste, managers should also be better able to understand the environmental implications of the waste as they will know its components, and the relative amount of each. Informed remedial actions to reduce waste can result.

We know that the greater the use of energy, the greater the emissions of CO2 – which contributes to climate change if that energy is being generated by the use of fossil fuels.

To the extent that MFCA leads to a reduction in energy use, then this has positive implications for climate change.

Tracking the use of water – within MFCA – is also important for the environment, particularly if water is relatively scarce in the area of operations. The greater the use of water, potentially the greater amount of wastewater being released in the environment.

5.16 As has been discussed in the textbook, it is quite common for organisations to implement new operating and production processes that require less use of people, all as a means of reducing the ‘costs’ of the organisation, and for increasing its ‘profitability’. But this represents a very restricted perspective of ‘costs’. A broader perspective of costs would also consider the implications (‘social costs’) associated with reducing the amount of employment opportunities within an organisation.

As Chapter 5 explains, when organisations make capital investment decisions, managers need to consider the various expected future costs and benefits associated with the investment – including the social and environmental costs. Furthermore, managers need to determine whether the acquisition is likely to be compatible with the organisation’s mission and goals.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

To the extent that an organisation has objectives that include accepting responsibilities to its workforce then the organisation should accept a responsibility and accountability for any implications that result from the acquisition of new machinery. Every effort should be made to reduce the hardship imposed on employees, and the organisation should publicly report information (provide an ‘account’) about the initiatives that were implemented for displaced employees.

5.17 As we know from reading Chapter 5, the cost of dealing with the waste paper includes costs beyond simply the amount paid to external organisations who come to periodically collect the paper.

There could be various approaches to attributing a cost to an organisation’s waste paper. Perhaps we might collect data over a representative period and then extrapolate to determine an annual cost.

As part of this process we might manually separate the waste paper into different categories, and then try to trace the sources of the waste paper and then try to attribute a cost. We would call this a form of ‘waste-paper audit’.

For example, does it appear to be paper that came from paper that was acquired by the organisation for printing purposes, or is the paper some form of wrapping or packaging?

If the paper that has gone through onsite photocopiers, then we might try to attribute part of the cost of the acquiring and running the photocopiers to each sheet of paper (in addition to the purchase price of each sheet). We might then determine the number of photo-copied pages that went into the rubbish during a particular period and attribute a cost to this stream of waste.

We might also have a stream of waste that is paper that was acquired from external sources, and where those external organisations had already printed material upon the paper. We would need to identify the major sources of the printed material, and the likely costs per sheet of paper. The paper might represent wastage from advertising brochures that were unused. If so, we would need to determine these costs.

Once we have attempted to attribute a financial cost to the waste paper for the period of analysis (which might, perhaps, be a week) we could then use this to determine an annual cost. What organisations will find, generally, is that once calculated, this cost can be quite large and much more than was expected.

With knowledge of these costs, managers might then be motivated to put in place controls to manage or restrict the amount of paper being used. For example, a formal policy might be developed that prohibits the printing of emails or other documents which can sensibly be saved as ‘soft copies’. There might also be a requirement that printing must be double-sided without exception. Further, printing might only be possible through the use of staff cards and the quantity of printing can then be attributed to different employees where a limit is placed on the amount of printing permitted within different periods, beyond which authorisation is required. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

5.18 Strategically, for an organisation to succeed, consideration needs to be given to a number of different performance measures that effectively link together to enable an organisation to achieve its strategic priorities. The BSC provides such a linkage.

The Balanced Scorecard seeks to translate an organisation’s mission and related strategies into a set of performance measures that then provide a framework for strategically managing the organisation. Information pertaining to the respective performance measures is subsequently collected to assess how well the managers are achieving particular objectives.

The performance measures developed within the Balanced Scorecard framework – and which are determined after considering the organisation’s missions and objectives – will represent a ‘balanced’ mixture of both financial and non-financial performance measures. Many organisations use the BSC as a fundamental element of their planning, monitoring and control.

5.19 Within the BSC as developed by Kaplan and Norton (1992) there are four perspectives that can be generally applied to any business entity, these being: • • • •

The financial perspective – how do we look to shareholders?

The customer perspective – how do customers see/view us?

The internal business perspective – what must we excel at?

The learning and growth perspective – how can we continue to improve and add value?

These ‘perspectives’ provide a focal point for developing related goals which are then linked to specific performance measures (indicators). There are various logical linkages between each of the four perspectives. For example, the policies and procedures in place to educate and train staff (part of the learning and growth perspective) will influence how things are done within the organisation (part of the internal business perspective).

In turn, the way things are done within the organisation will influence the products and services provided to customers (the customer perspective), and this will in turn influence customer support and ultimately the profitability of the organisation (the financial perspective). That is, there is a causal relationship that occurs in a bottom-up direction.

The overall mission of the organisation should inform the development of the goals under each perspective. Once we know the goals, we can then develop some measures to identify whether we appear to be achieving our goals. It is advised that there should be no more than 16 performance measures in total – otherwise the framework becomes somewhat unmanageable.

5.20 Under the BSC, goals and performance measures will be attributed to each perspective, of which there are commonly four. The goals to be achieved under each perspective shall be consistent with the mission of the organisation, which should be clearly articulated. A review of the mission will inform the designer of the BSC about the need © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

to incorporate financial, social, and/or environmental-based objectives and performance measures within the BSC. The performance measures, which will represent a balance between financial and nonfinancial performance measures (and ideally there should be about four performance measures per perspective) will then be linked to each objective.

Therefore, in summary, the goals listed under each perspective are developed based upon the overall mission of the organisation, and the performance measures to be used are in turn based upon the objectives.

5.21 As Learning Exercise 5.9 (page 249) notes, to the extent that an organisation is large enough to enable it to have sufficient resources and expertise, then it should consider using all three management approaches. The three different management techniques can work together in a way that is very useful.

For example, LCA allows managers to understand the various phases of the life cycle of a product or service, and the associated impacts. This can highlight various risks and opportunities and, therefore, factors that warrant attention. Consideration can also be given as to whether the impacts created throughout the life cycle are consistent with the organisation’s mission and objectives. Knowledge of the life cycle of a product then assists an organisation to perform its MFCA. The application of MFCA requires managers to understand the flow of materials throughout an organisation, and knowledge from LCA will help in preparing the required flow models.

Therefore, although they perform different, and valuable, functions, both LCA and MFCA can constructively be used together.

The BSC allows managers to strategically develop goals under particular perspectives, together with linked measures. Knowledge gained through LCA and MFCA can highlight specific areas that need to be prioritised and addressed, and this should influence the goals and performance measures utilised with the BSC approach.

5.22 The decisions about which major investments to make in respect of property, plant and equipment are often referred to as capital investment decisions and they are made to improve the operations of an organisation. Capital investment decisions are long-term decisions by managers. In determining the acceptability of potential capital investments, managers need to consider the various expected future costs and benefits associated with the investment. These would include related financial, social, and environmental costs.

5.23 When considering the acquisition of an item of property, plant or equipment, there are many issues to consider; for example, we need to consider the initial acquisition costs and the ongoing running and maintenance costs (including any associated licensing or registration requirements). In doing so we might also consider the payback period, the net present value of the project using the required discount rate, and the internal rate of return from the investment. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

Furthermore, it needs to be determined whether the acquisition is likely to be compatible with the organisation’s mission and goals – perhaps goals that have been established through the use of the BSC. Also, we would need to identify who will take responsibility for monitoring and evaluating the subsequent performance of any new capital investment.

The likely social and environmental impacts of the asset throughout its expected life also need to be considered in the investment decision. In this regard, some form of LCA of projected performance would be useful, as would the application of MFCA, in order to answer such questions as the following: •

• •

•

•

When operating, is this asset likely to generate waste or consume relatively high levels of materials, and how does this compare with the currently used machinery and available alternatives?

How energy-efficient is the asset likely to be, and will this efficiency change as the investment gets older?

What will happen to the asset at the end of its life cycle? Can it be recycled?

Will it end up in landfill, and if so, what are the likely environmental implications?

Would the acquisition of this asset result in the loss of jobs for many people?

For example, if a new mechanised process is acquired, will this displace workers who previously performed the work manually? Will the loss of jobs be consistent with the organisation’s mission and values? What responsibility, if any, will be taken for displaced employees?

With the various impacts in mind, how would different stakeholders view the acquisition of the asset? That is, will it enhance the reputation, or image, of the organisation?

Decisions about which property, plant and machinery to acquire (and, indeed, in respect of all investments) therefore need to consider a mixture of financial and non-financial factors.

5.24 Hopefully students will disagree with this statement. Many social and environmental impacts or factors cannot be quantified in monetary terms but that does not mean they are not important. For example, various emissions or various safety issues cannot be quantified in monetary terms but they nevertheless need to be considered when making capital investment decisions. As another example, we might have considered a machine but find that it generates a great deal of noise that could upset local residents, or that it was built in a factory associated with modern slavery. Such qualitative factors could, and arguably should, mean we would not consider this machine as a potential investment.

5.25 There could be various non-financial factors to consider, including: • • •

Is the acquisition consistent with the vision and mission of the organisation Reliability of the truck Useful life

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

• • • • • • • •

11

Availability of parts and service and recyclability of used parts Fuel efficiency Emissions Safety rating Recyclability at the end of its useful life Noise The health and safety standards in place at the manufacturer The environmental standards applied by the manufacturer and within the manufacturers supply chain

5.26 The payback period is an approach commonly used to assess a prospective investment.

It addresses the question of how long it will take to recoup the cash that was spent on acquiring the investment. That is, how many years will it take for the sum of net cash inflows generated by the investment to equal the original cash investment? In some cases, the net cash inflows might actually relate to savings that are possible from acquiring a new machine.

The general rule is that the smaller the payback period the better, particularly if the organisation is operating in a relatively risky industry. All else being equal, managers will generally select the project with the shortest payback period.

5.27 There are various advantages to using the payback period method, including that it is very easy to understand and to calculate, and it does consider risk in the sense that we will reduce the required payback period for those projects deemed to be relatively risky.

In terms of disadvantages, the payback period method ignores the cash flows that occur after the payback period has been reached. Furthermore, the payback period does not consider the time value of money. That is, cash flows received in different years are all considered on the same basis without any discounting of those cash flows to be received in later years.

5.28 The accounting rate of return (ARR) is calculated by dividing the average incremental return (or profit) derived from (or traceable to) an investment (or the net savings generated by an investment) by the average investment made in the asset; that is: ARR = (Average annual profit from the asset ÷ Average investment required to earn that profit) × 100% In calculating each period’s profits (or net savings), we need to acknowledge the reduction in the value of the acquired asset over time, that is, we need to acknowledge depreciation. That is, when calculating the ARR, we will also include expenses that do not directly impact cash flows.

5.29 In terms of the advantages of the ARR method, like the payback method it is easy to understand and easy to calculate. However, also like the payback method, a disadvantage is that it ignores the time value of money.

5.30 The present value associated with a particular project is determined by discounting all future expected cash flows back to a present value by applying a particular © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12

discount/interest rate. The greater the discount rate applied, the lower the present value.

Therefore, the statement is correct.

5.31 The decision rule applying the NPV method is quite simple, and would be that the NPV needs to be positive, which means that the proposed project is at least generating the required rate of return (which is the discount rate applied to the expected future cash flows).

By contrast, if the NPV is negative, then we would reject the potential project.

5.32 The application of the internal rate of return method (IRR) relies upon using a discount rate like the net present value method. However, IRR requires the determination of the discount rate that would cause the present value of all the cash outflows pertaining to the investment to be equal to the present value of all the cash inflows. That is, it determines the discount rate which, when applied to all the cash flows associated with the project, will generate a NPV of precisely zero.

The IRR informs managers about what the expected rate of return on the investment is, given the predictions about future cash flows. This is then used to compare against the organisation’s required rate of return for that type of investment. If the IRR is higher than the target rate – which is often referred to as the hurdle rate – then the project will be accepted. If there are competing projects, then the project with the highest IRR will be the one selected.

Various spreadsheet applications can be used to determine the IRR. It can also be calculated with many calculators. In the absence of having the appropriate calculator or spreadsheet application, determining the IRR is a matter of trial and error.

5.33

One of the important final parts of the capital investment review process is the postimplementation review (audit) which would involve managers assessing the prior decisions and the accuracy of any cash flow and other projections that had previously been made and used. Lessons learned can then flow through to subsequent capital investment appraisals. If it was found that projections previously made differed from actual results then it needs to be ensured that such errors will not flow through to future capital investment decisions. A post implementation review will also highlight other issues – good and bad – that were ignored in the initial investment decision, but which should be considered in future decisions. No projections about future costs and benefits, and so forth, will always be fully correct so there will always be something to learn from a post implementation review.

5.34 (a) The payback period We can calculate the annual net cash flows as being (and we have assumed that the income and expenses remain the same in each year and that the expenses and cashflows occur in the same period):

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

Income Pinball games sales: 4500 x $2 Fixed costs Annual insurance costs: Annual electricity costs Annual maintenance contract

$9 000 $1 000 $1 600 $2 400 $5 000 $4 000

Net annual cash flows Year

1 2 3

Amount to ‘pay back’ as at the start of the year (the residual of $500 is expected to be received in year 5) 11 500 7 500 3 500

Net cash flows for the year

Cumulative amount paid back at the end of the year

4 000 4 000 4 000

4 000 8 000 12 000

Amount still to ‘pay back’ at the end of the year

7 500 3 500 At the end of the year there is a surplus of $500 The payback period of this investment is therefore slightly less than 3 years (if cash flows were uniform then the pinball machine is paid back in 2 years plus 10.5 months).

As the decision rule is that the payback period is less than five years then this criterion is satisfied. b. The accounting rate of return We know the incremental cash flows that are expected to arise following the investment in the pinball machine. Because the machine is only expected to last 5 years, we must also consider the amount by which the machine has fallen in value throughout each year. That is, we must also consider the depreciation costs associated with using up the asset over its useful life, which is five years. We know the asset cost $11 500 and we expect it to have a residual value of $500 in five years’ time. We can calculate annual depreciation expense as Acquisition cost−expected residual value expected useful life of asset

=

$11 500−$500 5

= $2200 per year

The average incremental returns (profits) for the 5 years equals: ($4000 – $2200) + ($4000 – $2200) + ($4000 – $2200) + ($4000 – $2200) + ($4000 – $2200) + all divided by 5 = $1800

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

The average investment in the machine is: 𝐴𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 2

=

$11 500+$500 2

= $6000

Average annual profit from the asset

Therefore, the ARR = Average investment required to earn that profit x 100% $1800

= $6000 x 100% = 30 per cent All things being equal, the higher the ARR the better. An ARR of 30 per cent would generally be considered to be a very good rate. It satisfies the decision rule stipulated by the management of Brighton Fish and Chips Shop which was that the rate must exceed 20 per cent. c. The NPV method We will use the following table to work out the net present value of the capital investment. Management has said that they want to apply an interest rate of 12 per cent to this type of investment.

Year

1

Cash flow (undiscounted) $ (11 500) 4 000 4 000 4 000 4 000 4 500

Discount factor 1 (1 + k)n 1.00000 0.89286 0.79719 0.71178 0.63552 0.56743

Present value of cash flows $ (11 500) 3 571.44 3 188.79 2 847.13 2 542.08 2 553.44 $3 202.88

2 3 4 5 Total net present value from this initiative Using an interest rate of 12 per cent, the present value of the cash flows is positive. This therefore meets the decision rule set by the managers of Brighton Fish and Chips Shop. d. The IRR The IRR is the rate of interest which when used to discount all the expected cash flows associated with the project will cause the NPV to be zero. That is, we need to find the rate of interest (which we depict as ‘k’) that makes the PV of the net cash flows equal to zero. That is, in this case: [4000 ÷ (1 + k)] + [4000 ÷ (1 + k)2] + [4000 ÷ (1 + k)3] + [4000 ÷ (1 + k)4] + [4000 ÷ (1 + k)5] + [500 ÷ (1 + k)5] – 11 500 = 0 Through trial and error, we can find that the discount rate is just over 22 per cent. This would generally be considered to be a very good return. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

15

Overall decision to purchase, or not In terms of the four tools we have just applied, this proposal satisfies all the requirements stipulated by the managers of Brighton Fish and Chips Shop. However, prior to accepting the project, consideration should be also given to other factors. Does the proposed investment perform in a way that is consistent with the organisation’s missions and goals? Are there any other opportunities that would provide better returns and which might be able to be pursued if this investment is not made? Also, are there any environmental or social implications throughout the lifecycle of the investment that are inconsistent with the responsibilities that the managers accept? In the absence of any negative information in these respects, the managers of the Brighton Fish and Chips Shop should probably pursue this investment opportunity.

5.35 a. The payback period We can calculate the annual net cash flows as being (and we have assumed that the income and expenses remain the same each year and that the costs and cashflows occur in the same period): Savings Fruit pickers’ salaries to no longer be paid Variable costs Fuel costs: Fixed costs Annual insurance cost: $10 000 Annual registration costs $3 000 Annual maintenance contract $4 000 Net annual cash flows

Year

1 2 3 4

Amount to ‘pay back’ as at the start of the year 200 000 143 000 86 000 29 000

Net cash flows for the year (represented by the savings in variable costs) 57 000 57 000 57 000 57 000

$80 000 $6 000

$17 000

$23 000 $57 000

Cumulative amount paid back at the end of the year

Amount still to ‘pay back’ at the end of the year

57 000 114 000 171 000 228 000

143 000 86 000 29 000 At the end of the year there is a surplus of $28 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

16

The payback period of this investment is therefore approximately 3.5 years. This satisfies the decision rule provided by management which was a payback period of less than 6 years. b. The accounting rate of return We know the incremental cash flows that are expected to arise following the investment in the new fruit-picking machine. Because the machine is only expected to last 8 years, we must also consider the amount by which the machine has fallen in value throughout each year. That is, we must also consider the depreciation costs associated with using up the asset over its useful life, which is eight years. We know the asset cost $200 000 and we expect it to have a residual value in eight years’ time of $10 000. We can calculate annual depreciation expense as: Acquisition cost − expected residual value expected useful life of asset

=

$200 000 − $10 000 8

= $23 750 per year

The average incremental returns (profits) for the 8 years equals: ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) + ($57 000 – $23 750) all divided by 8 = $33 250 The average investment in the machine is: 𝐴𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑜𝑛 𝑐𝑜𝑠𝑡 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 2

=

$200 000+$10 000 2

= $105 000

Average annual profit from the asset

Therefore, the ARR = Average investment required to earn that profit x 100% $33 250

= $105 000 x 100% = 31.67 per cent All things being equal, the higher the ARR the better. An ARR of 31.67 per cent would generally be considered to be a good rate. It satisfies the decision rule stipulated by the management of Big Apple Farming Company which was that the rate must exceed 18 per cent. c. The NPV method We will use the following table to work out the net present value of the capital investment. Management has said that they want to apply an interest rate of 10 per cent to this type of investment.

Year

Cash flow (undiscounted) $

1

(200 000) 57 000 57 000

2

Discount factor 1 (1 + k)n 1.00000 0.90909 0.82645

Present value of cash flows $ (200 000) 51 818 47 107

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3 4 5 6 7 8

17

57 000 57 000 57 000 57 000 57 000 57 000 10 000

0.75131 0.68301 0.62092 0.56447 0.51316 0.46651

42 825 38 932 35 393 32 175 29 250 26 591 4 665 $108 756

Total net present value from this initiative Using an interest rate of 10 per cent, the present value of the cash flows is positive. This therefore meets the decision rule set by the managers of Big Apple Farming Company.

d. The IRR The IRR is the rate of interest which, when used to discount all the expected cash flows associated with the project, will cause the NPV to be zero. That is, we need to find the rate of interest (which we depict as ‘k’) that makes the PV of the net cash flows equal to zero. That is, [57 000 ÷ (1 + k)] + [57 000 ÷ (1 + k)2] + [57 000 ÷ (1 + k)3] + [57 000 ÷ (1 + k)4] + [57 000 ÷ (1 + k)5] + [57 000 ÷ (1 + k)6] + [57 000 ÷ (1 + k)7] + [57 000 ÷ (1 + k)8] + [10 000 ÷ (1 + k)8] – 200 000 = 0 Through trial and error we can find that the discount rate is just above 23 per cent. This would generally be considered to be a good return.

Overall decision to purchase, or not In terms of the four tools we have just applied, this proposal satisfies all the requirements stipulated by the managers of Big Apple Farming Company. However, prior to accepting the project, consideration should be also given to other factors. Does the proposed investment perform in a way that is consistent with the organisation’s missions and goals? Are there any other opportunities that would provide better returns and which might be able to be pursued if this investment is not made? Also, are there any environmental or social implications throughout the lifecycle of the investment that are inconsistent with the responsibilities that the managers accept? In the absence of any negative information in these respects, the managers of the Big Apple Farming Company should probably pursue this investment opportunity.

5.36 Obviously, there are many ways this can be done, so the BSC that follows is just one possible version.

Given the mission of the organisation, it seems there are three key issues that the organisation wants to focus upon:

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

• • •

18

Being a leading zoo (and we need to determine what ‘leading’ means in this context); Being an organisation that focuses on animal welfare; and Being an organisation that plays an important role in preserving rare and endangered species.

From what we are told, profitability does not seem to be a key objective of the zoo.

Nevertheless, financial viability is clearly a priority given the zoo wants to grow over the next five years to become the most popular zoo in the country and to be able to operate in a way that does not rely upon government funding. It is also a key objective that the organisation be known as a leading research centre.

With the above in mind, the following table identifies some objectives (the objectives that are in bold are the ones that were specifically identified by the organisation) and some related performance measures. We have purposely limited the number of performance measures in an effort to keep the management of the BSC feasible.

Objective

Performance measures

FINANCIAL PERSPECTIVE To be self-sufficient financially and not require funding support from government Growth in cash reserves

Increasing revenue from visitors Increasing donor support Increasing amount of money held in cash and other liquid assets Reduced operating costs

CUSTOMER PERSPECTIVE Within five years, to be the most popular zoo in the country in terms of visitor numbers

Ongoing growth in visitor numbers High level of visitor satisfaction Increasing percentage share of total zoosector visitor numbers

INTERNAL BUSINESS STRUCTURE To be known as a leading research centre with respect to protecting rare and endangered species of animals

Increased publications in well recognised journals that deal with rare and endangered species

To increase the numbers of rare and endangered specifies bred within the zoo

Increasing citations of the research being undertaken by the organisation

To have systems in place that ensure animals are treated in a way that is respectful and safeguards their welfare

Pass all requirements set by independent animal welfare auditors/assessors

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

19

To increase the numbers of rare and endangered species released back into their natural habitat

Increase the number of rare and endangered species bred within the zoo

LEARNING AND GROWTH Staff that have knowledge of latest research in respect of preserving rare and endangered species

Increasing number of relevant conferences attended by staff

Staff that have relevant higher degrees

Increase in number of staff holding higher research degrees

Increase the number of leading international researchers who visit the zoo

Increase in number of research collaborations with other zoos.

Causal relationship between the various performance measures adopted at Eastern Plains Zoo Perspective Financial

Customer

Performance measures Increasing revenue from Increasing amount of Increase in cash reduced operating visitors donor support and other liquid assets costs

Ongoing growth in visitor numbers

High level of visitor satisfaction

Internal business processes Increased publications Increasing by staff citations

Learning and growth

No. of relevant conferences attended by staff

Increasing higher degree qualifications of staff

Increasing share of total zoo sector visitors

Pass independent Increase no. of animal welfare audit bred rare/endang. animals

Increase in number of research collaborations with other zoos

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 6: The external reporting of social and environmental information 6.1

Chapter 1 provides a number of definitions of accountability. As Chapter 1 discusses, these definitions note a linkage between perceptions of responsibilities and perceptions of accountabilities. If an organisation is deemed to have a responsibility and an associated accountability for a particular aspect of its performance, then the expectation is that it should provide an ‘account’ with respect to the performance.

6.2

Environmental reporting, which is a component of corporate social responsibility reporting, would include reporting to an organisation’s stakeholders about an organisation’s impact (directly and indirectly) on living and non-living natural systems, including its impacts on land, air, water and ecosystems.

More specifically, environmental reporting might involve the disclosure of information about: • • • • • • • • • •

materials used effluent and waste generated energy consumed emissions (including CO2) generated water consumed impacts of transportation environmental assessments and impacts of suppliers wastewater generated and impacts of this wastewater impacts (positive and negative) on biodiversity compliance with environmental regulations.

In most countries there are some mandatory requirements about the types of environmental information that must be publicly reported (for example, about the emissions of certain greenhouse gases or the release of certain chemicals). However much environmental reporting is undertaken on a voluntary basis and therefore shows great variation between different reporting entities.

6.3

Social reporting, which is a component of corporate social-responsibility reporting, provides information about an organisation’s interaction (directly and indirectly) with, and associated impacts on, particular societies. Social reports might provide information about an organisation’s: • • •

training of employees diversity and equal opportunity policies as they relate to employees health and safety aspects of products

Deegan 2e_Solutions Manual

• • • • • •

2

support of community projects treatment of employees within the supply chain actions taken to respect indigenous cultures and values customer privacy policies compliance with occupational health and safety requirements compliance with various social codes of conduct.

In most countries there are some mandatory requirements about the types of social information that must be publicly reported (for example, in recent times Modern Slavery Acts have been introduced in some countries. These require – for larger organisations – various disclosures pertaining to the potential use of forced labour or human trafficking with supply chains). However much social reporting is undertaken on a voluntary basis and therefore shows great variation between different reporting entities.

6.4

Because the reporting of social and environmental information is predominantly a voluntary exercise, it is important that that we understand why managers might have made the decision to report (and there is a great deal of research that addresses this issue). Knowing what motivated managers to report will influence our perceptions about whether we should rely upon such information.

There are many possible reasons why an organisation might produce a corporate social responsibility report. These will not be mutually exclusive, meaning that there can be a mixture of reasons why managers might produce a report. The reasons include the following: •

• • •

• • • • • 6.5

because managers believe they have a responsibility to provide an account of their social and environmental performance to various stakeholders, particularly those that are potentially adversely impacted by the operations of the organisation as a means of managing particular stakeholder groups because powerful stakeholders want or expect the information as a response to particular environmental or social crises (for example, the disclosures might be made in an effort to repair the legitimacy or reputation of the organisation following a major social or environmental event) as a means of assisting the identification of significant social and environmental risks and opportunities for competitive advantage to assist the financial performance of the organisation as a means of attracting and retaining quality staff to counter any moves by government to introduce more onerous social and environmental reporting requirements.

There are many different views about the meaning of corporate social responsibility and corporate social responsibility reporting.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

One commonly accepted definition of corporate social responsibility was provided by the Commission of European Communities (as quoted within Chapter 6), which describes CSR as: https://doodle.com/meeting/participate/id/e59R71ve/vote a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis. Being socially responsible means not only fulfilling legal expectations, but also going beyond compliance and investing more into human capital, the environment and the relations with stakeholders.

Source: Commission of European Communities (2001), p. 6.

Ideally, an organisation should be clear about what it identifies as its corporate social responsibilities, given that different teams of managers will perceive their responsibilities differently. Good reporting would see an organisation disclose information about the stakeholders to whom it believes it has key obligations, and to clearly articulate the aspects of performance those obligations and responsibilities relate to.

Corporate social responsibility reporting is reporting that provides evidence of how an organisation has addressed, and performed, the social responsibilities it has identified itself as accepting. Because different teams of managers will have different perceptions of their organisational responsibilities, they will have different perceptions of their related accountabilities. Therefore, in the absence of some form of regulated standardisation, different organisations can be expected to produce different ‘accounts’.

6.6

As the chapter has explained, we will not all agree about what the social responsibilities of an organisation are. Our perceptions of responsibilities will be influenced by various factors, perhaps including our culture, nationality, education, professional affiliations, sporting affiliations, age, gender, religion and so forth. Differences in perceptions about organisational responsibilities will ultimately influence the types of, and focus of, the ‘accounts’ that we believe an organisation should produce.

6.7

Integrated reporting can take a variety of forms and can be defined in a number of ways, but it would generally be perceived as involving the generation of reports that integrate information about the social, economic/financial and environmental implications/impacts of an organisation’s operations.

For a long time, there has been a lack of integration in the different reports that organisations typically release. Most larger organisations produce an annual report that includes a number of financial statements and associated note disclosures, as required by financial accounting standards, corporations law and securities exchange listing requirements. The same organisations also often release a quite separate CSR or sustainability report. However, there is often little or no link between the separate reports (and they are often prepared by different people), and this has led to calls for a form of reporting – integrated reporting – in which various types of information

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

necessary for assessing and evaluating a company’s performance are reported in a comprehensive fashion and within an integrated report.

This would seem to be a good idea, as if done properly, an integrated report would provide insights into the economic, social and environmental implications created by the decisions made by managers. Integrated reporting should provide a vehicle for improving the accountability of an organisation.

The International Integrated Reporting Council (IIRC) is a major organisation associated with promoting a particular approach to integrated reporting. But it needs to be remembered that this is just one possible approach, albeit an approach that is gaining much ‘traction’ within the business community. As Chapter 6 suggests, there are many questionable aspects to the model of integrated reporting promulgated by the IIRC (for example, the apparent fixation on satisfying the information needs of the providers of financial capital, the limited consideration of ‘accountability’, and the view that the environment can reasonably be traded off to increase the value of other ‘capitals’). But this does not mean the concept of integrated reporting is without merit.

6.8

Chapter 6 noted that the GRI had identified some potential benefits that will result from releasing a CSR/sustainability report. Some of these benefits would relate to how the organisation is managed, whereas other benefits relate to how the organisation is perceived by external stakeholders.

Internal benefits for companies and organisations can include: • • • • • • •

Increased understanding of risks and opportunities associated with various aspects of social and environmental performance Emphasising and understanding the link between financial and non-financial performance Influencing long-term management strategy and policy, and business plans in a way that creates improvements in social and environmental performance Streamlining processes, reducing costs and improving efficiency Benchmarking and assessing sustainability performance with respect to laws, norms, codes, performance standards, and voluntary initiatives Reducing the potential of being implicated in publicised environmental, social and governance failures Increasing the ability to compare/benchmark performance internally, and between organisations and sectors.

External benefits of sustainability reporting can include: • • •

Mitigating – or reversing – negative environmental, social and governance impacts Improving reputation and brand loyalty Enabling external stakeholders to understand the organisation’s value, and tangible and intangible assets

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

•

5

Demonstrating how the organisation influences, and is influenced by, expectations about sustainable development.

There is a general view that when an organisation commits to reporting, then this requires the organisation to better understand the factors that impact its performance.

This increased awareness can expose various risks, and opportunities for improvement.

6.9

Yes, it is very likely that an increase in news media attention towards a particular social or environmental issue will influence the respective organisation’s – and perhaps the industry’s – reporting practices. There is much available research that supports this relationship. The argument generally adopted is that the news media has the ability to shape community perceptions and when the news media runs a story – particularly a negative story – then this can cause a ‘legitimacy crisis’ for an organisation (and also perhaps the entire industry) and organisations (and sometimes other organisations within the industry as well) will respond to this heightened concern by making particular disclosures. The disclosures are made – according to many researchers – to win back or defend the organisation’s legitimacy. The general proposition is that organisations will tend to report about issues that are of concern to society, but will often fail to report information about issues that society does not consider important.

6.10 This really depends on our perception of organisational responsibility and accountability. If we believe that our overwhelming responsibility is to shareholders (referred to as a ‘shareholder primacy perspective’) then we might believe that we should only produce a CSR report if doing so is expected to be beneficial to the shareholders. Such a view, however, would not be consistent with the values that are inherent within the textbook and which are consistent with a much broader perspective of organisational responsibility and accountability.

There are many views on the responsibilities of business. At one extreme are the views of the famous economist Milton Friedman. In his widely cited book Capitalism and Freedom, Friedman rejects the view that corporate managers have any moral obligations or responsibilities. He notes (1962, p. 133) that such a view: shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business [and that is] to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.

At the other end of the ‘responsibility spectrum’ are those who hold the view that managers should manage the organisation for the benefit of all stakeholders, not just those with control over scarce resources. In practice, organisations would be expected to embrace a view of organisational responsibility that is somewhere between these two extremes.

As noted above, a fixation on undertaking activities because they are directly beneficial to shareholders is often referred to as the ‘shareholder primacy perspective’. The notion © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

of being socially responsible and ‘shareholder primacy’ are fairly well at odds with each other – being socially responsible requires due concern to be given to all stakeholders (current and future).

If we accept that an organisation has a responsibility to its ‘stakeholders’, then the more broadly an organisation defines its stakeholders the greater the responsibilities and associated accountabilities it will tend to accept.

6.11 Three reporting frameworks discussed in Chapter 6 were: • • •

The Global Reporting Initiative Sustainability Reporting Standards; The International Integrated Reporting Council International <IR> Framework; The Sustainability Accounting Standards Boards Sustainability Accounting Standards.

The most commonly used framework is that of the GRI. Many large companies throughout the world apply the standards developed by the GRI. 6.12 There could be a variety of reasons why there has been a significant increase in the number of organisations producing CSR reports. At the core, however, is that society generally has – for whatever reason – shown a heightened awareness of the importance of, and necessity for, all organisations (and people generally) to act in a socially responsible manner and to accept accountability for social and environmental performance. Organisations that fail to respond will lose stakeholder support.

The increased penetration of the news media, and social media, has also placed the ‘spotlight’ on many activities and impacts that were formerly unknown, or were in the ‘shadows’. Organisations have been obliged to react to this increased community awareness.

The increasing knowledge about the parlous state of the environment and the increased scientific knowledge associated with climate change has also caused many stakeholders to demand that organisations be more accountable for their performance. Also, in recent decades there have been many news stories on the poor treatment of workers throughout global supply chains and this has caused many stakeholders to demand organisations be more accountable for the treatment of workers related to their goods and services. There have also been a number of significant environmental catastrophes in recent decades and this has further fuelled calls for greater corporate accountability.

Various institutional investors, lending bodies, and superannuation funds are increasingly reviewing the social and environmental credentials of organisations as part of their investment appraisal activities, thereby providing further motivation for organisations to report. Different industry bodies are also now requiring their members to produce CSR reports (perhaps to bolster the legitimacy of the respective industry).

As more and more organisations report, then the practice of reporting also tends to become effectively ‘institutionalised’, and mutually reinforcing, and those organisations that do not report then tend to stand out as some form of recalcitrant.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

CSR reporting is now an expected activity of organisations, particularly larger organisations.

6.13 The ‘Universal Standard’ known as GRI 1 includes the ‘reporting principles’ that need to be adopted by reporters in relation to report content and report quality.

In relation to report content, it is deemed that a good quality report should address: • • • •

impact material topics due process stakeholder.

Each of these four key concepts are explained within GRI 1.

In relation to report quality, the reporting principles within GRI are: • • • • • • •

Accuracy Clarity Comparability Completeness Sustainability context Timeliness Verifiability

Each of these reporting quality principles are also explained within GRI 1. These reporting quality principles have much in common with the prescribed qualitative characteristics promoted in other reporting frameworks, such as the Conceptual Framework for Financial Reporting developed by the International Accounting Standards Board.

6.14 The principles for defining report content as identified by the GRI are: • • • •

impact; material topics; due process; stakeholder.

These principles help to put in context the rest of the information being provided by an organisation and therefore increase the understandability associated with the information.

The principles for defining report quality as identified by the GRI are: • • • • • • •

Accuracy; Clarity; Comparability; Completeness; Sustainability context; Timeliness; Verifiability.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7

Deegan 2e_Solutions Manual

8

The ‘quality’ of information is considered important in enabling stakeholders to make sound and reasonable assessments of an organisation, and to take appropriate actions.

These attributes (or qualitative characteristics) that sustainability-related information should have are similar to the attributes identified as being relevant to all accounting information (see Chapter 1). That is, the principles and qualitative characteristics described above are very similar to the qualitative characteristics that are typically promoted in relation to financial reporting and other forms of reporting.

6.15 This is a matter of opinion. The preferred answer would be ‘yes’ but there would be many managers who might challenge that.

As we know, a commonly used definition of stakeholders is ‘any group or individual who can affect, or is affected by, the achievement of the organisation’s objectives’.

Some managers will prioritise the information demands of the power stakeholders (those ‘who can affect’ the organisation), whereas other managers will also consider the rights to know of those stakeholders who do not direct have the ability to impact the operations of the organisation but who are nevertheless impacted by the organisation (those who are ‘affected by’ the organisation).

Arguably, if an organisation impacts the lives of particular stakeholders, then those stakeholders do have a right to receive information from the organisation about what the organisation is doing to address and ideally eliminate the negative impacts. The organisation has a moral or ethical responsibility to provide such information.

6.16 This is a matter of opinion and links back to determinations made about to whom an organisation is responsible, and for what aspects of performance it is responsible. If we believe that managers have a responsibility to future generations as well as to present generations who will be negatively impacted climate change (which will be most people) then we would believe they do have a responsibility for reducing their contribution to climate change. Unfortunately, however, for centuries most managers did not appear to embrace any responsibility or accountability with respect to climate change and that is why we have the crisis we have now. We all have a responsibility to reduce the contributions we make to climate change.

6.17 Yes, there are measurement frameworks for measuring GHG emissions, one such framework being the Greenhouse Gas Protocol.

The GHG Protocol is one of the most widely used international accounting tools for quantifying greenhouse gas emissions. Pursuant to the GHG Protocol, emissions can be divided into three categories: • •

Scope 1 – those emissions directly occurring from sources that are owned or controlled by an institution.

Scope 2 – emissions generated in the production of electricity consumed by an organisation, where that electricity is generated outside the organisation’s measurement boundary.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

•

9

Scope 3 – all the other indirect emissions that are a consequence of the activities of an organisation, but occur from sources not owned or controlled by the organisation.

6.18 Some of the risks and opportunities that climate change creates for organisations have been identified by the Task Force on Climate-related Financial Disclosures (see page 324 of textbook).

Some of the risks include: • • • • • • • •

Increased costs associated with generating GHG emissions (perhaps through taxes and fines) Regulated restrictions to be enforced in relation to existing products and services Increasing possibility of litigation against the organisation Changing customer behaviour Increased costs of some materials Damage created by increased severity of weather events, including those related to rising sea levels and rising temperatures Changing supplies of necessary resources, such as water Costs incurred in transition to lower emission practices.

Some of the opportunities include: • • • • • • • • •

Encourage recycling which can create savings and environmental benefits More energy-efficient plant and equipment to be used More efficient transportation options Reduced water and energy consumption Government incentives for cleaner technologies Use of carbon markets Development of low-emission goods and services Increased returns by being reactive to changing consumer demands Resource substitution/diversification opportunities

These risks and opportunities should be disclosed by an organisation. Different stakeholders will base their decisions about whether to support an organisation (perhaps whether to consume the organisation’s goods and services, whether to work for an organisation, whether to invest in an organisation, and so forth) upon whether organisations are proactively considering how climate change will impact their organisation (the risks and the opportunities), and on the basis of what actions organisations are taking to mitigate their contribution to climate change. Organisations that fail to make climate-related disclosures will likely find that their level of support is eroded.

6.19 We would expect organisations, particularly those organisations that are larger and operating in carbon-intensive industries, to make public disclosures in relation to their carbon-related emissions, targets, and initiatives to reduce their contribution to climate change. We can argue this from an ethical (or normative) perspective, and on the basis © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

that managers do have a responsibility and accountability to reduce their organisation’s contribution to climate change. This responsibility is to both current and future inhabitants of the planet.

From a managerial perspective we could also expect organisations to make disclosures because a failure to do so will likely have negative implications for the success of the business, particularly for those larger organisations that are operating in industries known to significantly contribute to climate change. Not addressing climate change in an open and transparent way no longer represents an appropriate way to do business.

Climate change poses many risks and opportunities to organisations, and different stakeholders are expecting organisations to report how those risks and opportunities are being addressed within the organisation. Stakeholders want to know what governance policies have been put in place to address climate change. A failure to address climate change will increasingly raise the perceived risks associated with an organisation and ultimately this could lead to the demise of an organisation. Climate change is no longer something that business organisations can ignore.

6.20 Modern slavery’ refers to the use of human trafficking or forced labour that amounts to slavery, or slavery-like practices. It can include forced or involuntary labour (and in some parts of the world includes some government run labour camps), debt bonded labour, labour coerced through threat, human trafficking, traditional slavery, domestic servitude and child labour all of which can potentially exist throughout an organisation’s supply chains. It directly links to United Nations Sustainable Development Goal 8. According to the International Labour Organization (ILO) Forced Labour Convention, 1930 (No. 29), ‘forced or compulsory labour’ is all work or service that is exacted from any person under the threat of a penalty and for which the person has not offered himself or herself voluntarily. It is generally accepted that organisations should have governance practices in place that reduce the risk that modern slavery exists within its supply chains.

6.21 Again, the answer to this question depends upon our views about the responsibilities of organisations and their managers (to whom, and for what). Do organisations have a responsibility for how their suppliers – which would typically be unrelated – treat their workers? That said, hopefully we all believe that organisations should take actions to eliminate modern slavery from their supply chains. They should seek to acquire their goods and services from suppliers that treat their workers fairly.

The reality is that modern slavery exists and has existed for countless centuries.

Various estimates suggest that over 40 million people worldwide are currently victims of modern slavery. Many of the products we have all bought would have involved the use of modern slavery. For example, many clothes are manufactured in factories that use modern slavery. Other industries, such as mining, agriculture, machine manufacturing and so forth are known to adopt modern slavery practices. Clearly this is unethical and immoral, but in the pursuit of higher profits many organisations globally have elected to turn a ‘blind eye’ to the labour practices being applied by their © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

11

suppliers. However, this is changing, and many countries are now implementing modern slavery laws that require senior managers to consider the risks that modern slavery exists within their supply chains. Further, the news media and social media is increasingly being used as a means to expose modern slavery. With heightened concern about modern slavery globally, organisations that are exposed as being linked to modern slavery can be expected to be penalised by various stakeholders, including by their customers, lenders, shareholders and their socially conscious employees.

6.22 If we believe that managers have a responsibility for ensuring that modern slavery does not exists within their supply chains, then we would also tend to believe that managers have an accountability with respect to what they are doing to identify and eliminate modern slavery from their supply chains. This then leads to an expectation that managers will provide ‘accounts’ about how they are addressing the risks that modern slavery exists across their supply chains.

Globally, many organisations now produce publicly available ‘modern slavery statements’ in which they provide information about the steps they are taking, across their supply chains, to address and monitor the risk that modern slavery is present within their supply chains. In many countries this is a legal requirement for larger companies.

6.23 The 17 UN SDGs have been developed by the UN as part of a resolution in 2015 entitled ‘Transforming Our World: The 2030 Agenda for Sustainable Development’, which was agreed to by all member states of the UN. The aim is to provide guidelines and targets for countries to adopt in accordance with their own priorities and the social and environmental challenges of the world at large. The SDGs provide a ‘common lens’ through which organisations can review and report their progress towards sustainable development. Each SDG is supported by various components of documentation and guidance. The 17 SDGs are supported by 169 underlying targets, with 231 indicators (see https://unstats.un.org/sdgs/indicators/indicators-list).

Organisations are encouraged to focus upon those goals on which their activities are most likely to have significant impacts. The view taken by the UN is that addressing the SDGs requires a partnership of governments, the private sector, civil society and citizens in order to leave a better planet for future generations to enjoy. In accordance with this view, managers of organisations should pay attention to them.

6.24 Again, this depends upon our beliefs about managers’ responsibilities and associated accountabilities.

Arguably, the planet is in big trouble both environmentally and socially. For centuries, people and organisations have failed to consider issues to do with sustainability.

Current consumption patterns and business operations are unsustainable. Current and future generations need us all to embrace sustainable development. Managers should embrace policies and goals that are consistent with sustainable development and the UN SDGs provide a framework of goals, targets, and indicators, that managers can embrace. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12

More and more organisations are providing information about how the organisation has embraced the UN SDGs and how successful their strategies have been in moving towards these goals. It is not unreasonable to argue that all managers, particularly those in larger organisations, should disclose information about if, and how their organisation is addressing the UN SDGs. These goals have gained acceptance internationally and seem to be a useful approach to addressing the need to become more sustainable.

6.25 When a CSR report is prepared within an organisation there is always the very real possibility that the report – as with other reports – has been prepared in a biased manner and does not provide a fair reflection of the performance of an organisation. An independent review of a CSR report, if undertaken by a qualified and reputable assurance provider, acts to increase the credibility of the report. This acts to increase the ‘value’ of the report in terms of its ability to provide a relevant and representationally faithful account of the social and environmental performance of an organisation.

Various social and environmental aspects of organisational performance create risks for an organisation and for its stakeholders. If an organisation is able to produce a CSR report which is deemed by stakeholders to be credible, then this will decrease the stakeholders’ perceived risk, and this might enable the organisation to attract funds at a lower cost than might otherwise be possible.

Having a CSR report that has been subjected to an independent review might attract stakeholders to an organisation that would not otherwise be interested in the organisation. That is, some stakeholders might have a decision rule that they will only deal with an organisation that is able to provide an independently assured account of its social and environmental performance.

6.26 A counter account represents an account produced by stakeholders other than management and which does not necessarily reflect the views of management. Counter accounts are also referred to as ‘alternative accounts’ or ‘shadow accounts’.

On balance, it is a good idea for a sustainability report to incorporate ‘counter accounts’, although in practice such accounts are rarely included in corporate sustainability reports.

The inclusion of counter accounts could generate a number of benefits or advantages, such as: • • •

They could help to encourage debate and can potentially change/transform the views of managers about how to manage an organisation Encourage democratic interaction within an organisation and foster the notion that the managers of an organisation take alternative views seriously The production of alternative views would seem particularly relevant to areas associated with ‘sustainability’ given the many possible perspectives on prioritising different social and environmental aspects and impacts

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

• •

13

The inclusion of alternative views/accounts can prompt further analysis by managers and this could lead to the creation of various opportunities By being aware of alternative views, and showing some response thereto, this might reduce the risks that an organisation might otherwise be exposed to.

6.27 It is not a straightforward exercise to determine what particular information to include in a CSR report. Reference can be made to such documents as the GRI Sustainability Reporting Standards. However, disclosure decisions need to take into account the specific environmental and social context within which the organisation is operating.

If the disclosure decisions made by managers are motivated by ethical considerations, then what is disclosed will be based upon a careful consideration of the responsibilities of the organisation. The extent of these responsibilities will be influenced by various considerations such as whether the organisation is operating near areas of important biodiversity, of important cultural significance to particular people, of water shortage, and so forth.

Decisions about what to disclose should also be supported by analysis gained through such activities as life cycle analysis or material flow cost accounting (see Chapter 5).

Managers should also consider the information demands of different stakeholders, and it would be appropriate to undertake periodic stakeholder engagement exercises to determine stakeholder views about what information should be disclosed. In this regard, managers often tend to take particular notice of the information demands of ‘powerful’ stakeholders – those that have control of resources necessary to an organisation. Of course, from an ethical perspective, the organisation should take into account the expectations and needs of all stakeholders that are impacted by the operations of the organisation.

6.28 There is much research that shows that when a particular social or environmental crisis occurs, and which potentially threatens the legitimacy/reputation of the organisation, then managers will respond by making disclosures that aim at winning back the stakeholder support that was potentially lost.

For example, if an organisation is associated with a major environmental crisis – perhaps they caused a massive oil leak that killed much marine life – managers might make disclosures to divert stakeholder attention to other more positive aspects of the organisation’s operations (such as particular community-based projects that it is involved with, or to particular environmental awards that it has won in the past).

It can be quite naïve to simply believe that managers are always making particular disclosures because they think they believe they have a responsibility to make the disclosures. Healthy scepticism is always warranted. Much research indeed shows that corporate social and environmental disclosures are often motivated by a desire to legitimise the operations of the organisation.

If some managers are shown to be making disclosures of a reactionary nature – for example, in reaction to negative news stories being circulated about their operations, or © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

those of other members of their industry – then such disclosures would seem to be more about managing stakeholders than about demonstrating proper levels of accountability.

This is a cause for concern. If organisations really wanted to demonstrate high levels of accountability, they would not wait until something goes wrong, or some crisis arises, before they started making disclosures. Any real efforts to address sustainable development requires open, objective, and transparent disclosures. Reporting that is reactive to crises is not consistent with what is required to address sustainable development.

As noted, there is much evidence that organisations do make social and environmental disclosure in order to legitimise their organisation and/or the industry in which they operate. Some researchers have argued that these legitimising disclosures can act to enable an organisation to keep operating in a ‘business-as-usual’ manner when what might have been needed – from a broader social and environmental perspective – is for an organisation to be forced to change its business/operating practices.

6.29 Firstly, it needs to be noted that the Framework developed by the IIRC is one approach to integrated reporting. There are also other approaches to integrated reporting.

However, the IIRC Framework has become an approach to integrated reporting that has gained much prominence. Despite its acceptance by many business organisations, the IIRC Framework does seem to have many significant limitations. For example: •

•

•

•

The notion of ‘accountability’ receives little attention. The Framework does not really address the meaning of accountability, nor does it consider the information needs of stakeholders beyond those stakeholders that provide financial capital.

The Framework focuses on ‘value creation’ but from the perspective of the providers of financial capital. Investors, in general, are notoriously short term in orientation and tend to focus on financial gains, rather than considering social and environmental costs and benefits. Therefore, it is difficult from a logical perspective to understand how this focus on value creation from the perspective of investors (which has little to do with broader notions of ‘accountability’) can help the long-term sustainability of business operations, or provide any real hope in addressing problems such as climate change. Surely there is a high degree of incompatibility between value creation from the perspective of shareholders, and environmental and social sustainability?

Providers of financial capital are perceived to be the primary users of integrated reports. This reflects a ‘shareholder primacy’ perspective being adopted by the IIRC. This limits the potential of integrated reports to improve accountability.

The Framework relies on the analysis of ‘capitals’ – and a view that it is appropriate to transfer ‘value’ from one capital to another. One of these capitals – ‘natural capital’ (the environment) is considered in a very organisation-centric manner – the environment is considered from the perspective of how it ‘supports the past, current or future prosperity of an organisation’. This projects the view that it is appropriate to trade off the environment against other capitals

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

15

in order to create ‘value’, and in particular, ‘value’ from the perspective of providers of financial capital. This view is one of the reasons why the planet is in the parlous state it is in.

6.30 Organisations have an infinite number of social and environmental impacts, so some prioritisation is necessary.

Organisations should, within their reports, clearly describe the decision rules they used to determine what information to include, and what not to include within a CSR report.

This is important, as it helps the reader to place the information into context and therefore to make it more understandable. Without this background information, readers could be left guessing why managers decided to include particular information in the report.

It is important for readers to know which stakeholders were engaged as part of the reporting process, what they were asked about their information needs, and how this engagement (or materiality determination process) culminated in the report that was released. Again, this helps to put the reporting information into context.

6.31 Some initial factors to consider in determining what aspects of social and environmental performance to include in a CSR report could include: •

•

•

•

•

Why has the organisation decided to prepare a CSR report? This will influence how the report is developed. For example, if the report is being developed primarily to advance the profitability and wealth of the organisation and/or to appease the interests of powerful stakeholders, then the report would be quite different to a report that is predicated around providing information to those stakeholders most impacted by the operations of the organisation. As we have discussed elsewhere, decisions about why to report impact judgements about to whom to report, and what to report.

The level of funding available to produce the report – this will impact the extent of reporting that can be undertaken and whether, perhaps, the report can be subject to some form of independent assurance.

What reporting expertise is available ‘in house’? This will impact the cost of preparing the report and potentially the range of factors that can be addressed within the report.

How the organisation interprets sustainability – that is, how committed to ‘sustainable development’ is the organisation (importantly, how committed are the most senior executives of the organisation?) and from the perspective of the organisation, what does ‘sustainable development’ mean/involve?

What is the social and environmental context of the organisation (water sources and availability, sources of energy, reliance on unskilled labour, usage of potentially toxic materials, dangers associated with products, reliance on imports from developing countries, and so forth). This will influence what aspects of social and environmental performance might particularly require focus.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

•

•

•

•

• •

•

•

16

Linked to the above point, the lifecycle of the organisation’s major goods and services. Before preparing a CSR report, knowledge should be acquired about the lifecycle of the goods and services and the related impacts and risks created by the goods and services from ‘cradle to grave’.

Whether there has been any form of material flow cost accounting. This will help to provide necessary information about inputs and outputs of the organisation, including important information about waste.

The extent of engagement already undertaken with stakeholders to determine their information needs. That is, what has already been done with respect to the materiality determination process? What funding is available to undertake such processes.

Whether we should incorporate the views/opinions of different stakeholder groups within the CSR report – that is, whether senior management are receptive to the inclusion of ‘counter accounts’ and whether different stakeholder groups would be prepared to contribute such accounts to the CSR report.

What are the alternative reporting and measurement frameworks and their respective relevance, advantages and disadvantages?

Review examples of ‘best practice’ reporting to provide some insight into what a ‘high quality report’ will address (perhaps gather the reports of recent winners from various sustainability reporting awards).

Be aware of what other organisations in the industry are doing (they might report some information that we have not considered but which might nevertheless be important) and in the light of the information, consider whether some sector-based benchmarking is ultimately possible Potential legal implications from reporting. From a pragmatic perspective it is important that we understand what the legal ramifications might be if we report certain information.

6.32 This statement seems to be very sensible and largely related to climate change. Climate change, and other significant ongoing environmental and social damage, has overwhelmingly been ignored by most organisations because they have focused on short-term profitability rather than longer term sustainability. They have put the interests of current-day investors above the interests of future generations. Profits have risen, investors’ wealth has increased while at the same time climate change and other environmental damage has quickened, various low-lying countries have been put under threat, and many species made extinct.

The ‘business as usual model’ which prioritises profits and which promotes the use of inexpensive fossil fuels, and which fails to consider the externalities caused by business, can logically not be maintained if we want to address sustainability.

Sustainability requires decision making to be longer term in nature and not fixated on the implications for the next accounting period’s profits. Sustainability requires a revolution in how corporate accounting has traditionally been undertaken and for organisations to be openly accountable about their social and environmental impacts. If © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

17

all organisations are transparent about their social and environmental impacts (and arguably this will probably require regulation) then concerned stakeholders will have the information necessary to make informed decisions about what organisations to support, and what organisations not to support.

6.33 At a very fundamental (and somewhat pessimistic) level, if all organisations continue to effectively ignore sustainability and continue to embrace decision-making models based upon furthering the interests of capital providers (over and above other stakeholders), then ultimately there will be no business for them to remain in. Social systems would collapse, food sources would be destroyed. Ultimately people die because environments cannot sustain life, and without people there is no business!

Simple logic (right?).

If organisations collect and report information about sustainability, then this raises information about the sustainability-related risks and opportunities that could then be addressed. What is measured potentially gets managed. Further, given the mounting concerns about the state of the planet, it is getting harder to comprehend how an organisation that demonstrates limited social and environmental accountability can continue to garner community support.

Therefore, for a variety of reasons, if organisations ignore sustainability then ‘sooner or later’ they will no longer be in operation.

6.34 There is no set answer to this question. However, students should/could identify: • • • • •

• • • • • • • • • •

what organisation they looked at what reports were reviewed and what they were labelled what types of social, economic and environmental information were reported whether the organisation properly explained its social and environmental context whether the organisation provides information about how managers are incentivised, and in particular whether bonuses are linked to aspects of social and environmental performance whether social and environmental targets were reported together with information about past performance relative to targets how the organisation interprets ‘sustainability’ and ‘sustainable development’ the perceived risks and opportunities associated with climate change and how these are being addressed what reporting frameworks were used by the organisation what measurement frameworks might have been used by the organisation what stakeholders contributed to the report and how they contributed how the organisation determined what information to report, that is, what was the ‘materiality determination process’? the stakeholders to which the report seems to be aimed whether the report was reasonably understandable whether the CSR report was subject to some form of independent assurance

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

•

whether the report appeared to be balanced in its presentation (for example, was both ‘good’ and ‘bad’ information reported).

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18

Solutions Manual Chapter 7: An introduction to financial accounting 7.1 The elements of financial accounting are: • • • • •

Assets; Liabilities; Equity; Income; Expenses.

7.2 Element Asset Liability Equity Income

Expense

Definition A present economic resource controlled by the entity as a result of past events A present obligation of the entity to transfer an economic resource as a result of past events The residual interest in the assets of the entity after deducting all its liabilities Increases in assets, or decreases of liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims Decreases in assets, or increases of liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims

7.3

The balance sheet is a financial statement, also referred to as the statement of financial position, that provides information about the assets, liabilities, and owners’ equity of an organisation as at a period in time (the reporting date). It is often presented in the form of A – L = OE.

7.4

The income statement is a financial statement, also often referred to as a statement of profit or loss, that provides information about the profit, or loss, of an organisation for a period of time (the accounting period). Profit reflects the difference between the income and expenses generated and incurred within the accounting period.

7.5

The accounting equation is: Asset = Liabilities + Owners’ Equity Rearranged, this becomes: Owners’ Equity = Assets – Liabilities

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

2

Therefore, in this case Owners’ Equity = $1 500 000 – $1 100 000 = $400 000 7.6

Assets and liabilities appear within the balance sheet, and the difference between the two represents equity which is also reported within the balance sheet. Equity represents the residual interest, or claim of the owners, in the net assets of the organisation.

7.7

The answer to this question really depends upon how broadly we define ‘resources’. As Chapter 2 of this textbook discusses, a resource could be broadly defined as something that has value in the sense that it allows an organisation to undertake an activity so as to enable it to achieve a desired outcome.

For financial reporting purposes, an organisation will typically only report about those resources it uses as part of its business if it controls those resources and can place a monetary value on them.

We learned that ‘control’ was an important component of the definition of an ‘asset’ for financial reporting purposes. Resources are considered to be controlled when an organisation can deny, or regulate, the access of other people to the resources. Apart from ‘control’, and as noted above, another requirement that must exist before a resource is recognised for financial reporting purposes is that it is capable of being measured in financial terms.

Organisations will also draw upon many other resources that they do not control in order to operate, such as: • • •

natural resources (for example, air, water) human-based resources (factory labour, managerial labour, intellectual capital) social or community-based resources/infrastructure (roads, waterways, universities, hospitals).

These can all be considered resources necessary to the organisation, but they would not be considered resources that are owned or controlled by the organisation. Therefore, they would not be shown (recognised) within the financial statements. If a particular resource is not shown in the financial statements as an asset of the organisation, then the implication is that the use of, or negative impact upon, that resource would typically not be shown as an expense of that organisation when determining its financial profits.

7.8

An organisation that is a going concern is one that is considered likely to continue operating into the foreseeable future, and without the likelihood of encountering any problems that could result in the organisation being wound up/discontinued.

Unless there is evidence to the contrary, the financial accountant typically assumes that an organisation (the accounting entity) will continue operating into the foreseeable future. This has various implications for how assets, liabilities, income and expenses are measured. For example, whilst a specialised item of equipment might not easily be able to be sold, it would have value to an organisation over time from its use – referred to as ‘value-in-use’. However, if it had to be quickly sold (perhaps the organisation was no longer a going concern) then it might have minimal or no financial value.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

The general principle is that if it is considered that an organisation is not a going concern (for example, the organisation does not appear able to pay its debts as and when they fall due, and therefore is likely to be wound up), then financial statements have to be prepared on another basis – for example, on the basis of liquidation values.

This means that the assets would have to be measured in a way that reflects how much they could be sold for in a fairly short period of time.

7.9

A conceptual framework of financial reporting sets out the concepts that underlie the preparation and presentation of general purpose financial statements. Effectively, it provides the basic structure for financial reporting. It provides ‘high level’ guidance on such things as the: • • • • • •

objective of general purpose financial reporting qualitative characteristics of useful financial information elements of financial statements principles for the recognition and derecognition of the elements of financial reporting measurement principles principles for presentation and disclosure.

More specifically, the purpose of the Conceptual Framework can be summarised as follows: (a) assist accounting standard-setters to develop accounting standards that are based on consistent concepts (b) assist preparers of financial statements to develop consistent accounting policies when no accounting standard applies to a particular transaction or other event, or when an accounting standard allows a choice of accounting policy (c) assist all parties to understand and interpret accounting standards.

7.10 Pursuant to the entity principle (or concept), the accountant is only to recognise transactions and events that affect the financial performance and/or position of the reporting organisation. The organisation is considered as being separate from the owners and other entities such that the personal transactions of the owners are to be kept separate from those of the organisation. Impacts upon other organisations are to be ignored unless the event also impacts the financial resources, or financial obligations, of the reporting organisation.

Therefore, if an organisation creates adverse social or environmental impacts on other stakeholders who are separate to the organisation, and if these impacts will have no effect on the resources controlled by the entity (its ‘assets’), and will not create any financial obligations (liabilities) for the organisation, then they will typically be ignored for financial reporting purposes.

Students need to appreciate that measures of financial performance, such as ‘profits’, therefore are far from being a ‘holistic’ measure of organisational performance.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

7.11 Information is considered relevant if it can influence the decisions of users of the information. That is, financial accounting information is regarded as relevant if it is considered capable of influencing the decisions of users of the financial statements. If information is considered to be relevant, then the implication is that it should be reported (subject to the information providing a faithful representation of the underlying transaction or event and that the benefits to be derived from using the information exceed the costs associated with providing the information).

7.12 From a financial reporting perspective, ‘control’ is a key component of the definition of an asset. As we learned, assets are defined as: a present economic resource controlled by the entity as a result of past events.

Therefore, if a resource is not controlled, then it is not an ‘asset’ for financial reporting purposes and will not be disclosed within the financial reports. Of course, information about the resource and its usage could be reported within other documents, such as within the organisation’s social and environmental report, or sustainability report (if it produces such documents).

7.13 For financial reporting purposes, those assets that are considered to be held for the short term are the ones that are deemed to be current assets. Such assets would include cash and all those other assets that are expected to be converted into cash, or consumed, within the next 12 months, or within the organisation’s normal operating cycle. More specifically, the accounting standard that addresses the presentation of financial statements (which at the international level is IAS 1: Presentation of Financial Statements) says: An entity shall classify an asset as current when: (a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realise the asset within twelve months after the reporting period; or (d) the asset is cash or a cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

An entity shall classify all other assets as non-current.

Source: International Accounting Standards Board (2018c).

The above requirements make reference to the normal operating cycle, which is the average period of time between the initial acquisition of particular assets for processing, and the time at which cash is ultimately realised in relation to disposing of those assets.

Current assets are typically those assets that are used in the day-to-day activities of a business and include cash, short-term money market deposits, inventory (stock) and accounts receivable (trade debtors).

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

The classification rules for liabilities are similar to those for assets. Current liabilities are those obligations that will be settled in the near term; for example, within the next 12 months. According to the accounting standard pertaining to the presentation of financial statements (IAS 1), an entity shall classify a liability as ‘current’ when: (a) it expects to settle the liability in its normal operating cycle; (b) it holds the liability primarily for the purposes of trading; (c) the liability is due to be settled within twelve months after the end of the reporting period; or (d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.

An entity shall classify all other liabilities as non-current.

Source: International Accounting Standards Board (2018c).

Current liabilities would include such obligations as accounts payable (which might relate to the acquisition of stock), loans repayable within 12 months, or revenue received in advance of actually providing the related goods or services.

7.14 Owners’ equity will be increased by profits – which arises when income exceeds expenses (I – E) – as well as increased by contributions from owners (C). By contrast, owners’ equity will be decreased by distributions made to owners (D). Therefore, closing owners’ equity equals: Opening Owners’ Equity + Profits + Contributions – Distributions Given profits is the difference between income and expenses, that is: $125 000 + ($670 000 – $325 000) + $35 000 – $12 000 = $493 000 7.15 Differentiating between current and non-current liabilities can provide useful information about those obligations that need to be settled (paid) relatively soon.

Similarly, differentiating between current assets and non-current assets provides useful information about those assets that are more likely to converted to cash in the near term relative to those that are not.

If we compare current assets to current liabilities, then this provides one indicator of whether the organisation will be likely to be able to pay its debts as and when they fall due and whether it will be able to fund its operations over the coming months.

The ratio derived from dividing current assets by current liabilities is referred to as the ‘current ratio’. There is a very general rule that the current ratio should not fall below 1.

If the ratio is above 1, then the general conclusion often made is that the organisation will be able to meet the debts that are payable within the next 12 months. The lower this number gets, the greater the assumed difficulty an organisation will have in meeting its short-term liabilities. A current ratio of, say, 1.2 would indicate that the organisation has $1.20 of current assets for every $1 of current liabilities.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

7.16 A contingent liability is a liability that will ultimately arise only if something specific happens in the future to turn it into a present liability (such as the organisation losing legal action that has been taken against it). That is, there might only be a liability if a specific future event occurs.

Contingent liabilities are also considered to exist when an organisation might have a present obligation, but the obligation either cannot be measured reliably, or the probabilities associated with the future flows of economic benefit have been assessed as having low probability.

Therefore, contingent liabilities do not appear in the financial statements (balance sheet) because they relate to obligations that might arise if something else happens in the future, or if current uncertainties are resolved.

The notes that accompany an organisation’s financial statements will include details of the contingent liabilities known to exist. Because contingent liabilities can potentially have significant impacts upon an organisation it is always recommended that readers of financial reports search for the related contingent liabilities note and study it carefully.

7.17 Because there is less separation between the ownership and management of a sole trader or partnership relative to a company, the owners within a sole trader or partnership would be able to obtain information that specifically satisfies their respective needs and there would be less need to have regulation to protect their rights to information. This can be contrasted to the shareholders within a large public company who typically would have nothing to do with the ongoing management of the organisation and who would rely upon rules (regulations) that require the organisation to prepare general purpose financial reporting information to generally satisfy the shareholders’ information needs. Shareholders individually have little power to demand information and hence regulation is in place to ensure that they are regularly provided with information that meets certain standards.

Large public companies also have the power to create various economic, social and environmental impacts across society and this also justifies regulation that requires them to be transparent about the financial resources under their control and about their financial performance and related profitability. Because of the separation between owners and managers within large public companies, regulation requires that the financial reports prepared by the large public companies also be subjected to an independent audit by an appropriately qualified auditor. The need for an audit is not so apparent within sole traders and partnerships.

7.18 All relevant information should be provided to interested stakeholders to the extent that it is representationally faithful, and to the extent that the benefits to arise from the disclosure exceed the related costs (and determining these costs and benefits will not necessarily be an easy exercise.

7.19 General purpose financial statements (GPFSs) are financial statements that are prepared to satisfy the general information needs of a broad cross-section of potential readers. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

Being ‘general purpose’ in nature, they cannot be expected to satisfy all information needs – that’s why they are called ‘general purpose’.

GPFSs would include, for example, a balance sheet, income statement, statement of cash flows, statement of changes in equity and supporting notes. These general purpose financial statements comply with accounting standards and are intended to meet the information needs common to users of financial information, who are unable to command the preparation of financial statements tailored to suit their own specific information needs. For example, the financial statements prepared by large companies listed on securities exchanges would be GPFSs as the individual shareholders would typically not have the power to demand or require the company to provide information to satisfy their individual needs. Therefore these shareholders will receive general purpose documents that generally (but not specifically) meet their information needs.

General purpose financial statements are also an efficient way for large organisations to provide one set of information to potentially thousands of stakeholders. The general principle is that GPFSs should be prepared by organisations where there are stakeholders who have a significant financial interest in the organisation but these stakeholders do not otherwise have the power to command the preparation of information to satisfy their information needs.

7.20 In terms of the objective of general purpose financial reporting, paragraph 1.2 of the Conceptual Framework states: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments (b) providing or settling loans and other forms of credit (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources.

Parts (a) and (b) above relate to the information needed to help users of financial statements to assess the prospects for future net cash inflows to the entity and to inform their future investment or lending decisions (resource allocation decisions) with respect to the reporting entity. This is linked to the notion of ‘decision usefulness’. That is, investors and lenders will find it useful to their resource allocation decisions to have information about an organisation’s financial performance and financial position.

When the Conceptual Framework was revised and re-released in 2018, part (c) above was added. This additional component relates to what is known as ‘stewardship’. The IASB’s use of the term ‘stewardship’ is consistent with the general understanding of that term, which means the careful and responsible management of something entrusted to one’s care. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

7.21 The fundamental qualitative characteristics—which are characteristics that financial information must possess to be useful to the primary users of general purpose financial reports—identified in the Conceptual Framework are ‘relevance’ and ‘faithful representation’. They are ‘fundamental’ because without these characteristics, information would not be useful – useful information needs both these attributes.

In discussing the need for information to be both relevant and faithfully represented, paragraph 2.20 of the Conceptual Framework states: Information must be both relevant and provide a faithful representation of what it purports to represent if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

7.22 Apart from the ‘fundamental’ qualitative characteristics of relevance and faithful representation, the Conceptual Framework also identifies a number of ‘enhancing qualitative characteristics’ (which are important, but rank after fundamental qualitative characteristics in order of importance). These ‘enhancing qualitative characteristics’ are • • • •

comparability, verifiability, timeliness, and understandability.

The fundamental qualitative characteristics are the first characteristics that typically need to be considered. That is why they are called ‘fundamental’. Once those characteristics have been established as potentially existing for particular information, then the relevance and/or the faithful representation of financial information can be further enhanced by considering issues associated with comparability, verifiability, timeliness and understandability. Efforts to increase the comparability, verifiability, timeliness and understandability of the financial information can also effectively ‘feed back’ to improve (that is, ‘enhance’) the relevance and representational faithfulness of the information. Therefore, they are ‘enhancing’ characteristics as they further enhance the usefulness of information that was already considered to be relevant and representational faithful.

7.23 For information to be useful it needs to be both relevant and provide a faithful representation of what it purports to represent. Good decisions cannot be made on the basis of a faithful representation of irrelevant transactions or events. Nor can good decisions be made on the basis of unfaithful representations of relevant transactions and events. Therefore, if information is not relevant and/or representationally faithful then it should not be disclosed.

If information is potentially relevant, but it is not representationally faithful then such information could lead to potentially costly decisions being made by the users of the information as the information might not provide a sound reflection of what it purports to represent. That is, users might rely upon information and make decisions that © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

ultimately are wrong. This can lead to legal action taken against the organisation involved with disclosing the information and or with any auditors that provided an opinion (wrongly) that the information was representationally faithful. Therefore, if information is of the nature that would reasonably be expected to influence decisions then the party disclosing the information needs to take proper efforts to make sure the information is representationally faithful/reliable.

If information is irrelevant then arguably it does not matter if it is representationally faithful or not as it was not likely to influence decisions.

7.24 No, such damage would not be considered as an expense of the business. Expenses are defined in the Conceptual Framework as: decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

Therefore, to the extent that the outflow of resources does not relate to a payment (distribution) to the owners then the recognition of an expense arises at the same time as: i. ii.

the initial recognition of a liability, or an increase in the carrying amount of a liability; or the derecognition of an asset, or a decrease in the carrying amount of an asset.

The private residence would not be an ‘asset’ of the business (for example, it is not ‘controlled’ by the business and will not provide future economic benefits to the business), therefore any related damage would not be considered an expense. This is further reinforced by the entity principle which requires the assets of the owner (and any impacts to such assets) to be kept quite separate from the accounts of the business.

7.25 For larger organisations there would be a greater separation between the ownership and management of the organisation. This means that those people with investments in the organisation will typically have no direct knowledge of the actual functioning of the organisation. Therefore, people such as investors (and potential investors, and lenders and creditors) would be reliant upon being provided with information so that they are able to understand how the organisation is performing and to be able to understand the financial position of the organisation. This information should meet certain standards (in relation to issues such as relevance and representational faithfulness) and regulation can be put in place to help ensure this.

Larger organisations also tend to create greater economic, social and environmental impacts throughout society, and this again provides some justification for arguing that they should be made (regulated) to have some accountability in terms of the resources entrusted to them, and for how those resources have been used.

For smaller organisations there will be less separation between the ownership and management, and this has the effect of reducing the relative need for regulation. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

Smaller organisations also have less economic (and social and environmental) impacts, further decreasing the relative need for regulation of financial reporting.

7.26 Whilst the life of an organisation might be indefinite, an accountant nevertheless determines the financial performance of the organisation for smaller periods of time – for example, for six or 12 months, or some other arbitrary period of time. This period of time is referred to as the accounting period. It can also be referred to as the reporting period. Common accounting periods would be 12-month periods ending on either 31 December each year, or 30 June each year.

Breaking up the life of an organisation into smaller periods of time is necessary in order to be able to devise indicators for how well, or otherwise, the organisation is performing (one indicator might be the profits for the period). It would not make sense to wait until the organisation ceases to operate, which might, for example, be 50 years after it started, before we work out the total returns/profits that have been generated by the organisation.

At the end of each accounting period the assets, liabilities and equity would be reported ‘as at’ that date.

7.27 Yes, there can be dysfunctional effects that arise as a result of dividing the life of the organisation up into smaller periods of time – referred to as ‘accounting periods’. While it is understandable that we need to create separate accounting periods, separating the life of a business into relatively short periods of time can create a variety of potentially dysfunctional effects.

The problem is that, by being required to calculate profits for smaller periods of time (such as a year), managers might undertake activities that are aimed at maximising profits in the short run, but which might not be in the interests of the organisation’s long-term objectives. For example, if a manager is fixated on the reported profits for a given year (perhaps they are receiving a bonus linked to profits for the year) then they might select those strategies/options which generate profits quickly rather than those options which might be in the longer-term interests of the organisation, or society.

As another example, managers might decide to adopt production processes that generate a large amount of carbon-related emissions because such processes are less expensive from a financial accounting perspective and will enable greater profits to be generated in the forthcoming years. This ignores the longer-term implications for climate change and therefore for future generations.

Because of the potentially dysfunctional effects, managers should not be evaluated and regarded solely in terms of short-term measures of performance such as ‘profits’. Other longer-term performance indicators should also be incorporated within the processes used to assess and reward their performance.

7.28 This means, for example, that income is recognised when it is earned (which is not necessarily when the related cash is ultimately received), and expenses are recognised

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

11

as the expense is incurred or consumed (which is not necessarily at the same time as the related cash payment is made).

Accrual accounting can be contrasted with cash accounting, which is undertaken on a cash basis, whereby transactions and events are only recorded if they affect cash (that is, if they result in a cash inflow or cash outflow). Paragraph 1.7 of the Conceptual Framework for Financial Reporting provides justification for using accrual accounting rather than cash accounting by stating: Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.

In the absence of evidence to the contrary, we can assume that financial reports have been prepared on an accrual basis.

7.29 No, they certainly do not, and this is because of the way we define ‘assets’ and the way we define ‘expenses’ for financial reporting purposes. Of course, the extent of the ‘costs’ that we believe are excluded from the income statement depends on how broadly we define ‘costs’ and how broadly we believe the responsibilities of an organisation extend. Conversely, if we simply equated ‘costs’ with ‘expenses’ as defined by financial reporting practices then we might not consider there are any excluded costs.

As chapter 2 discusses, often, costs are simply calculated as the amount of money that needs to be paid by an organisation to buy something or produce something or perhaps repair something. Such calculated costs are often referred to as private costs.

However, there are other costs that are not necessarily measurable in monetary terms which might also be significant, and which we might call external costs. External costs are often referred to as externalities, which can be defined as ‘impacts that an entity has on parties external to the organisation, where such parties are not the buyers or sellers of particular goods or services, or did not agree to, or take part in, the activities causing the externality’.

As we know, from a financial reporting perspective, expenses are defined as: decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

The implication of this definition is that if a resource is used (or damaged) but that resource is not ‘controlled’, then it would not have been considered as an ‘asset’ of the organisation. Therefore, its use, or damage, would not be considered to be an ‘expense’ of the organisation and therefore the impacts upon this resource would not be included © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12

in total expenses as reported within the financial reports (and would also therefore not have had the implication of reducing reported ‘profits’). Therefore, we need to take care in interpreting the meaning of ‘profits’ in terms of what it actually reflects.

7.30

Expenses are defined in the Conceptual Framework as: decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

The recognition of an expense therefore arises at the same time as: (i) (ii)

the initial recognition of a liability, or an increase in the carrying amount of liability; or the derecognition of an asset, or a decrease in the carrying amount of an asset.

Applying the above definition, CO2 emissions would not be considered as ‘expenses’ from a financial accounting perspective unless some associated fines or taxes were imposed (such as carbon-related taxes). Whilst emissions of CO2 are creating climate change and immense social and environmental problems globally, because of the way we define assets, and because of the way we apply the ‘entity principle’ within financial accounting, these impacts will be ignored for financial reporting purposes. The atmosphere is not an ‘asset’ of an organisation (it is not ‘controlled’), therefore its use or abuse is not an ‘expense’ of the organisation.

7.31 No. The lost earnings would represent an opportunity cost. Opportunity costs do not fit within the definition of an ‘expense’ as used within financial reporting.

7.32 a b c d e f g h Total

A 15 000 6 000 (6 000) 3 000 1 000 (500) (700) (50) 17 750

+

E

+

D

=

L

+

I

+

C 15 000

+

15 000

3000 1000 (500) 600

600 700 +

1300

+

50 50

=

1100

+

3000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

7.33 Date a b

c d e f g h I j Total

A 20 000 10 000 (10 000) 12 000 700 (700) 12 000

+

E

+

D

=

L

+

I

+

C 20 000

+

20 000

12 000 700 (700)

800 900

(900) (100)

800 12 000 100

31 000

+

Paint Supplies

Office equip.

1700

+

100

=

800

Insur.

Interest

Supplies used

+

12 000

7.34 Date

Cash

1/10 2/10

10 000 (6 000) 30 000

2/10 6/10 15/10 21/10 27/10 28/10 29/10 30/10 Totals

Rent

Draw.

(5 000) (2 000) (550) (1 000) 33 450

Bank Loan

Sales

Contrib.

10 000

6000 30 000 5000

(2 000) 10 000

Accts payable

5000 2000

(3000)

3000

10 000 (5000)

2000 550 1000 2000

6000

2000

2000

550

3000

1000

-

30 000

10 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10 000

Deegan 2e_Solutions Manual

14

Balance Sheet of Shane’s Painting as at 31 October 2024 $ Current assets Cash at bank Paint supplies Non-current assets Office equipment Total assets Non-current liabilities Bank loan Total Liabilities Net assets Owners’ equity Retained earnings* Capital contributions

33 450 2 000 6 000 41 450 30 000 30 000 11 450

1 450 10 000 $11 450 *Profits that are left in the business and not distributed are called ‘Retained Earnings’. In this case it is the $2450 profit, less the $1000 drawings.

The above balance sheet is of the form, A – L = OE. Balance sheets can also be presented in the form A = L + OE. Income Statement for Shane’s Painting for month ending 31 October 2024 $ Income Sales revenue Expenses Supplies used Rent expense Insurance expense Interest expense Profit

10 000 (3 000) (2 000) (2 000) (550) 2 450

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7.35 Date

Cash

1/10

15 000

2/10

(8 000)

4/10

25 000

6/10

(3 000)

7/10

Dec. Supplies

MV

Office equip

Insur.

Rent

Supplies used

Elect.

Draw.

(3 000)

22/10

12 000

28/10

(4 000)

29/10

(2 500)

29/10

(700)

30/10

(1 000)

Totals

29,800

Bank Loan

Sales

15 000

Cont.

30 000 8000 25 000

3000 4000

15/10

Accts payable

4000 3000

(3000)

3000

12 000 (4000)

2500 700 1000 4000

15 000

8000

3000

2500

3000

700

1000

-

25 000

12 000

30 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

16

Balance Sheet of Beachley Decorations as at 31 October 31 2024 $ Current assets Cash Decorating supplies Non-current assets Motor vehicle Office equipment Total assets Non-current liabilities Bank loan Total Liabilities Net assets Owners’ equity Retained earnings* Capital contributions

29 800 4 000 15 000 8 000 56 800 25 000 25 000 31 800

1 800 30 000 $31 800 *Profits that are left in the business and not distributed are called ‘Retained Earnings’. In this case it is the $2800 profit, less the $1000 drawings.

The above balance sheet is of the form, A – L = OE. Balance sheets can also be presented in the form A = L + OE.

Income Statement for Beachley Decorations for month ending 31 October 2024 $ Income Sales revenue Expenses Supplies used Rent expense Insurance expense Electricity expense Profit

12 000 (3 000) (2 500) (3 000) (700) 2 800

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 8: Recording transactions in journals and ledgers – more detail on the financial accounting process 8.1

A source document provides evidence of, or verifies the existence of, a transaction or event that influences one or more of the five elements of financial accounting. Source documents are the source of original financial accounting data. For example, an electricity bill and a sales invoice are both source documents and provide evidence – perhaps for the first time – that the assets of an organisation, or its liabilities, have changed, which might also have consequences for the owners’ equity of the organisation. Transactions should not be entered in the journal without some form of source document. It is the data that is recorded on the source document that is entered into the journal.

8.2 (a) Source document for a sale of inventory – sales invoice generated by the organisation (b) Source document for a purchase of inventory – purchase invoice from the supplier (c) Source document for the acquisition of machinery – purchase invoice from seller 8.3

Ledger accounts accumulate the effects of transactions and events, as recorded within the journal, that impact a specific type of asset, liability, equity item, income or expense type. The various ledger accounts being used by an organisation will be shown in that organisation’s chart of accounts. Ledger accounts will have a debit or credit balance.

8.4

Double-entry accounting reflects the principle that every financial transaction has equal and opposite effects on at least two different accounts. Double-entry accounting utilises debits and credits and requires that a debit to one account shall be offset by a credit to another account (or in sum, to more than one other account), such that the sum of all debits must equal the sum of all credits. The double entry accounting system is built upon the basic accounting equation which is A = L + OE, which can be expanded to A + E + D = L + I + C. An increase to the left-hand of the equation is a debit whilst an increase to the right-hand side of the equation is a credit (and vice versa).

8.5

No, it is not a new approach. Historical evidence suggests that this form of accounting has been in existence for over 600 years. The words debit and credit can be traced back to Latin.

8.6

Whilst the life of an organisation might be indefinite, an accountant nevertheless determines the financial performance of the organisation for smaller periods of time – for example, for six or 12 months, or some other arbitrary period of time. This period of

Deegan 2e_Solutions Manual

2

time is referred to as the accounting period. It can also be referred to as the reporting period. It represents the timespan over which managers elect to report the transactions or events that affect the organisation.

The financial performance will be reported for the accounting period which means that the expenses and income generated in that period will be reported, together with the resulting profit. Assets, liabilities, and equity will also be reported as at the end of each reporting period.

8.7

The journal is the first point of entry into the financial accounting system for transactions/events. This is why the journal is often referred to as the book of prime (or original) entry. It is the first place we record the financial effects of a transaction, or event, appearing on a source document.

In recording the effects of a transaction or event evidenced by a source document, we need to identify which accounts are affected. There will be an individual ledger account that records increases and decreases in a specific type of asset, liability, income expense, or equity item.

The journal will show the date of the transaction, the accounts effected by the transaction, the monetary amount of the transaction, with some accounts being debited and matching credits being attributed to other accounts. The journal will also have a narration, which is a brief explanation of each transaction. No transaction shall be recorded in the ledger without first appearing in the journal.

8.8

This refers to the practice of transposing or transferring the amount recorded with the journal for a particular transaction and event to the specific ledger account identified in the journal. When transactions are posted from the journal to the ledger account, the debit entries in the journal go to the debit column (the left-hand column) in the respective ledger account, and the credit entries in the journal go to the credit column (the right-hand column) of the respective ledger account.

8.9

The ledger is the place where all the ledger accounts reside. A ledger account contains a record of transactions. It is a separate record or account that is assigned to a specific type of asset, liability, equity item, revenue, or expense type. The various ledger accounts being used will be shown in the chart of accounts.

Every account identified in the chart of accounts has its own account in the ledger. The ledger accounts are where all the transactions relating to that particular account are accumulated to provide a balance for that particular account.

Every type of asset, liability, equity, expense and income, which the organisation seeks to separately collect and report information about will have a separate ledger account in which all transactions that impact that specific ledger account (and remember, these transactions are initially recorded within a journal before they are ‘posted’ to the ledger) are recorded.

8.10 The trial balance is a listing of the ledger accounts, and their balances, at the end of an accounting period. The total of all the accounts with debit balances in the trial balance © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

must equal the total of all accounts with credit balances (otherwise a mistake has occurred). The trial balance allows for a level of checking. It provides no new information – just a summary of the ledger account balances.

If every journal entry is made with equal debits and credits (as it should be), then the total of all the ledger accounts with debit balances will equal the total of all the ledger accounts with credit balances. The trial balance allows us to test whether the debit balances equal the credit balances before we proceed towards preparing the financial statements. If our trial balance shows that these amounts do not balance, then we have made a mistake. This mistake would need to be identified and corrected.

8.11 To determine what accounts are being used by an organisation – different organisations will use different accounts – reference can be made to the organisation’s chart of accounts. The chart of accounts provides a list of the accounts, typically giving an account number and account name for each one, with these classified under the respective element of accounting to which they belong.

8.12 (a) It is also common for organisations to pay for services in advance of receiving them.

For example, an organisation might pay to rent a factory for the following six months.

This payment is for a future economic benefit and would represent an asset called a prepayment. It is an asset because the organisation has a right to receive a future economic benefit, in this case the use of a building for the next six months, as a result of making the payment.

At the end of the accounting period, an adjusting journal entry would need to be made to account for the amount of the prepayment that has been consumed, or used up, by the organisation. This would then represent an expense. (b) Organisations often receive a payment for services in advance of performing the required service. This would be referred to as revenue received in advance. For example, an insurance company will typically charge (or invoice) its clients for insurance to be provided for the next 12 months. When insurance companies initially receive this amount, the correct financial accounting treatment for the insurance company is to treat the amount received as a liability, referred to as something like ‘Insurance revenue received in advance’. It is a liability because the organisation has a present obligation arising from past transactions to provide economic benefits (in this case, insurance services) to another organisation. However, as time passes, the insurance company will earn this income as it provides the insurance services, and the liability will decrease as the related income is earned. Once all contracted services have been performed, the liability will no longer exist and all the related revenue would have been recognised. (c) Organisations often perform services or sell goods prior to actually receiving cash from the customer. This gives rise to revenue earned but not received. Rather than receiving cash for the good or service the organisation provides, it receives a claim to cash – which is an asset, and which we might refer to as a receivable (or a debtor). © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

The general principle is that if an organisation has an enforceable right to collect the cash at a future point in time (an asset), then it can recognise the income in advance of receiving the cash. When the organisation eventually receives the cash, it will substitute one asset (cash) for another asset (the account receivable). It will not recognise income yet again when it ultimately receives the cash, as that would represent a case of double counting the income, given that the organisation previously recognised this income.

8.13 The term ‘adjusting journal entries’ typically refers to adjustments that are made at the end of the accounting period, and within the journal, to reflect the use of the accrual basis of accounting. For example, the organisation might have performed services for a customer, but the cash has not been received within the accounting period. This would be referred to as ‘income earned but not received’. Without some form of adjusting entry, the income would not be recognised and the amount receivable from the customer (an asset) would also not be recognised. In this case the adjusting journal entry would recognise the receivable (with a debit to accounts receivable) and the related income (with a credit to sales).

Apart from adjustments to recognise income earned but not received (which is what we have just discussed), adjusting journal entries might also relate to: • • • •

Expenses incurred but not yet paid; Income received in advance of providing the good or service; Prepayments; and Depreciation.

Unless adjusting journal entries have been initiated, the financial performance reported for an organisation would be wrongly stated, and therefore not representationally faithful.

8.14 Income and expense accounts are ‘closed off’ at the end of the accounting period. As new accounting periods (reporting periods) commence, we would expect the balance of all the various revenue and expense accounts to subsequently begin the new accounting period with a zero balance. This is necessary so that we can record the expenses and income for that period of time, and so that income and those expenses are not mixed in with the expenses and income of previous accounting periods. By contrast, the balance of assets and liabilities will carry forward to future accounting periods and does not get closed off – that is, if we have an asset or liability at the end of an accounting period, we will also have an asset or liability at the start of the next accounting period. For example, if we have cash or buildings at the close of business on 31 December, and if that is the end of the accounting period, then at the start of the next day (the new accounting period), we would still have the cash and the buildings.

Returning to income and expenses – in an effort to create a zero balance in expenses and income accounts in preparation for the next accounting period, we need to transfer the balances at the end of the reporting period to another ledger account, which we refer to as the ‘profit or loss summary account’. This account will then have all expenses and © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

income transferred to it, meaning that its balance will be the profit, or loss, for the accounting period. The balance of this account will in turn be closed off to an equity account. In the case of a sole trader, the profit or loss would be transferred to the owners’ capital account.

During the accounting period, the owner might have also withdrawn assets from the business for personal use. Because it is usual for information to be produced to show how much was withdrawn by owners within an accounting period, drawings are also closed off at the end of the accounting period.

8.15 The ‘balance’ of an account refers to whether it has a net debit or credit balance. To determine the balance of each ledger account: • • • •

We add all the debit entries for each ledger account.

We add all the credit entries for each ledger account.

The balance of the ledger account will be the difference between the two columns.

This is done for each account in the ledger.

A common practice is to add an amount on the side with the lesser total to make the columns balance (equal), and this will be referred to as the ‘closing balance’.

Asset accounts normally have a debit balance, meaning that the total value of the debits to specific asset ledger accounts should exceed the total value of the credits.

Conversely, liability accounts normally have a credit balance, with the credit entries exceeding the debit balances.

8.16 These steps are summarised in Figure 8.5 on page 466.

8.17 No, it is not right. For example, whilst an increase in assets is reflected by a debit to the respective asset account (and an increase in assets would generally be considered to be a ‘good thing’), an increase in expenses would also be reflected by a debit to the respective expense accounts (and generally speaking, an increase in expenses might not be considered to be a ‘good thing’). Further, an increase in income is reflected by a credit to the respective income account – so credit entries might also – for certain accounts – be considered as beneficial to an organisation. Therefore, debits or credits are neither good nor bad. It really depends on what element of accounting that we are discussing.

8.18 A debit entry is an adjustment made to a ledger account pursuant to the double entry accounting system. Debit entries arise when we record: • • • • • •

An increase in an asset; An increase in an expense; An increase in distributions to owners; A decrease in liabilities; A decrease in income (perhaps we adjust a previous entry); A decrease in contributions from owners (perhaps we adjust a previous entry).

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8.19 A credit entry is an adjustment made to a ledger account pursuant to the double entry accounting system. Credit entries arise when we record: • • • • • •

An increase in a liability; An increase in income; An increase in contributions from owners; A decrease in assets; A decrease in an expense (perhaps we adjust a previous entry); A decrease in distributions to owners (perhaps we adjust a previous entry).

8.20 This is the cornerstone of the double entry accounting system. For every transaction that is recorded, the total credits must equal the total credits, otherwise there has been an error.

Using our expanded accounting equation of A + E + D = L + I + C, an increase in the left-hand side is, by convention, represented by a debit entry. For the equation to balance, this increase which is a debit (perhaps in an asset) must be matched by an increase in the right-hand side of the equation which is a credit (perhaps an increase in liabilities), or by a decrease in another account on the left-hand side of the equation which would also be a credit (perhaps a decrease in cash).

Again, debits must equal credits, or there is an error and the equation will not balance.

8.21 (a) inventory – a debit balance (b) accounts receivable – a debit balance (c) furniture – a debit balance (d) accounts payable – a credit balance (e) bank loan – a credit balance (f) electricity expense – a debit balance (g) sales income – a credit balance (h) capital – a credit balance

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6

Deegan 2e_Solutions Manual

7

8.22 Account

What is the normal balance? (debit or credit)

Would a debit entry increase or decrease the account?

Would a credit entry increase or decrease the account?

Inventory

Debit

Increase

Decrease

Accounts Payable

Credit

Decrease

Increase

Sales Income

Credit

Decrease

Increase

Furniture

Debit

Increase

Decrease

Accounts Receivable

Debit

Increase

Decrease

Wages Expense

Debit

Increase

Decrease

8.23 Account Number

Date

Account Names

5 Jan

Wages Expense Cash at Bank (Payment of wages with cash)

10 000

Inventory Accounts Payable (Acquisition of inventory on credit)

150 000

Office Furniture Cash at Bank (Acquisition of office furniture for cash)

50 000

Accounts Payable Cash at Bank (Payment of accounts payable)

150 000

10 Jan

12 Jan

17 Jan

Debit ($)

Credit ($)

10 000

150 000

50 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

150 000

Deegan 2e_Solutions Manual

8

8.24 Account Number

Date

Account Names

1 July

Cash at Bank Inventory Capital Account – Robert August (To recognise capital contributed by Robert August)

100 000 140 000

Accounts Receivable Cost of Goods Sold Sales Inventory (To recognise the sale of inventory on credit terms)

200 000 120 000

Prepaid insurance Cash at Bank (To recognise prepayment of insurance)

20 000

Cash at Bank Accounts Receivable (To recognise receipt of cash from debtor)

200 000

4 July

9 July

10 July

Debit ($)

Credit ($)

240 000

200 000 120 000

20 000

200 000

8.25 Date

Account Names

31 Dec Rent Expense

Account Number

Debit ($)

15 000

Prepaid Rent (To recognise rent expense for three months) 31 Jan

Income received in Advance Service Revenue (To recognise revenue earned in the accounting period)

Credit($)

15 000

20 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20 000

Deegan 2e_Solutions Manual

9

8.26 Date

Account Names

Account No.

31 Jan

Rent expense Prepaid Rent (To recognise rent expense) Service Income Received in Advance Service Income (To recognise service income earned)

325 110

10 000

145 240

20 000

Wages Expense Accrued Wages Expense (To recognise wages expenses incurred but not paid)

300 150

3 000

31 Jan

31 Jan

Debit ($)

Credit ($)

10 000

20 000

3 000

Adjusted Trial Balance for Bob Mac Services as at 31 December 2025 Account Number

Account Name

100

Cash

100 000

105

Accounts Receivable

40 000

110

Prepaid Rent

20 000

125

Computer Equipment

20 000

140

Accounts Payable

30 000

145

Service Income Received In Advance

40 000

150

Accrued Wages

3 000

160

Bank Loan

25 000

201

Bob Mac, Capital Account

25 000

210

Drawings

240

Service Income

300

Wages Expense

103 000

320

Advertising Expense

15 000

325

Rent Expense

30 000

330

Electricity Expense

2 000

340

Interest Expense

3 000

Totals

Debits ($)

Credits ($)

10 000 220 000

343 000

343 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

8.27 Date

Account Names

Account Number

Debit ($)

31 Jan

Consulting Income Profit or Loss Summary To close off Sales Income to P or L Summary

240 380

205 000

Profit or Loss Summary Wages Expense Advertising Expense Rent Expense Electricity Expense Interest Expense To close off expenses to P or L Summary

380 300 310 320 330 340

165 000

Profit or Loss Summary Mac Coy, Capital Account To transfer the balance of P or L summary to Capital Account

380 201

40 000

Mac Coy, Capital Account Drawings To transfer the balance of Drawings to the Capital Account

201 210

5 000

31 Jan

31 Jan

31 Jan

Credit ($)

205 000

90 000 25 000 40 000 5 000 5 000

40 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5 000

Deegan 2e_Solutions Manual

11

8.28 General Journal

Page 1 Account Debit ($) Number

Date

Account Name

1 Jan 2025

Cash at Bank R. Keith, Capital Account (Owner contributed cash)

100 201

100 000

Van – Motor Vehicle Cash at Bank (Acquired motor vehicle with cash)

135 100

45 000

Musical Instrument Maintenance Equipment Cash at Bank (Acquired maintenance equipment with cash)

130 100

9 000

Cash at Bank Bank Loan (Bank loan taken out)

100 170

25 000

Cash at Bank Performance Income (Performed musical services for cash)

100 250

15 000

Wages Expense Cash at Bank (Paid wages expense)

320 100

1 000

Travelling Expense Cash at Bank (Paid for travelling expenses)

310 100

600

Motor Vehicle Repairs Cash at Bank (Paid for repairs to van)

340 100

1 900

Musical Instrument Cash at Bank (Acquired musical equipment for cash)

125 100

3 000

1 Jan 2025

1 Jan 2025

3 Jan 2025

5 Jan 2025

5 Jan 2025

8 Jan 2025

11 Jan 2025

14 Jan 2025

Credit ($)

100 000

45 000

9 000

25 000

15 000

1 000

600

1 900

3 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14 Jan 2025

14 Jan 2025

12

Accounts Receivable Performance Income (Performed musical services on credit terms)

110 250

10 000

Wages Expense Cash at Bank (Paid wages expense)

320 100

1,200

General Journal

10 000

1,200

Page 2

Date

Accounts

21 Jan 2025

Advertising Expenses Accounts Payable (To recognise unpaid advertising expenses)

22 Jan 2025

Accounts Receivable Performance Income (Performed musical services on credit terms)

110 250

15 000

Wages Expense Cash at Bank (Paid wages expense)

320 100

2 000

Musical Equipment Cash at Bank (Acquisition of musical equipment for cash)

125 100

13 000

Travelling Expense Cash at Bank (Paid for travelling expenses)

310 100

500

Cash at Bank Accounts Receivable (Received amount due from an account receivable)

100 110

10 000

Accounts Receivable Performance Income (Performed musical services on credit terms)

110 250

10 000

Wages Expense Cash at Bank (Paid wages expense)

320 100

1 500

22 Jan 2025

22 Jan 2025

22 Jan 2025

24 Jan 2025

25 Jan 2025

25 Jan 2025

Account Debit Credit Number 350 5 500 160 5 500

15 000

2 000

13 000

500

10 000

10 000

1 500

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

25 Jan 2025

28 Jan 2025

31 Jan 2025

13

Travelling Expenses Cash at Bank (Paid for travelling expenses)

310 100

900

Interest Expense Cash at Bank (Interest expense paid)

360 100

1 000

Drawings Cash at Bank (Owner withdrew cash)

210 100

15 000

900

1 000

15 000

Once we have entered the details of the various transactions into the journal, our next task is to post each journal transaction to the respective ledger accounts. Once the above journal entries are transferred to the ledger accounts, the ledger accounts would appear as follows: 100 Cash at Bank Date

Detail

Jnl

Debit

ref

amount

Date

Detail

Jnl

Credit

ref

amount

1 Jan 2025

R Keith, Cap. Act

1

100 000

1 Jan 2025

Van – Motor Vehicle

1

45 000

3 Jan 2025

Bank Loan

1

25 000

1 Jan 2025

Mus Instrum. Maint Equip

1

9 000

5 Jan 2025

Performance Income

1

15 000

5 Jan 2025

Wages Expense

1

1 000

24 Jan 2025

Accounts Receivable

2

10 000

8 Jan 2025

Travelling Expenses

1

600

11 Jan 2025

MV Repairs

1

1 900

14 Jan 2025

Musical Instruments

1

3 000

14 Jan 2025

Wages Expense

1

1 200

22 Jan 2025

Wages Expense

2

2 000

22 Jan 2025

Musical Instruments

2

13 000

22 Jan 2025

Travelling Expense

2

500

25 Jan 2025

Wages Expense

2

1 500

25 Jan 2025

Travelling Expense

2

900

28 Jan 2025

Interest Expense

2

1 000

31 Jan 2025

Drawings

2

15 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

110 Accounts Receivable Date

Detail

Jnl ref

Debit

Date

Detail

amount

14 Jan 2025

Performance Income

1

10 000

22 Jan 2025

Performance Income

2

15 000

25 Jan 2025

Performance Income

2

10 000

Jnl

Debit

Jnl

Credit

ref

amount

24 Jan 2025

Cash at Bank

2

10 000

Date

Detail

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

125 Musical Instruments Date

Detail

ref

amount

14 Jan 2025

Accounts Payable

1

3 000

22 Jan 2025

Cash at Bank

2

13 000

130 Musical Instrument Maintenance Equipment Date

Detail

Jnl ref

1 Jan 2025

Cash at Bank

Debit

Date

Detail

amount

1

9 000

Jnl

Debit

135 Van – Motor Vehicle Date

Detail

ref 1 Jan 2025

Cash at Bank

Date

Detail

amount

1

45 000

Jnl

Debit

160 Accounts Payable Date

Detail

ref

Date

Detail

amount 21 Jan 2025

Advertising Expenses

2

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5 500

Deegan 2e_Solutions Manual

15

170 Bank Loan Date

Detail

Jnl ref

Debit

Date

Detail

amount

Jnl

Credit

ref

amount

3 Jan 2025

Cash at Bank

1

25 000

Date

Detail

Jnl

Credit

ref

amount

201 R. Keith, Capital Account Date

Detail

Jnl ref

Debit amount

1 Jan 2025

Cash at Bank

1

100 000

Date

Detail

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

210 Drawings Date

Detail

Jnl ref

31 Jan 2025

Cash at Bank

Debit amount

2

15 000

Jnl

Debit

250 Performance Income Date

Detail

ref

Date

Detail

amount 5 Jan 2025

Cash at Bank

1

15 000

14 Jan 2025

Accounts Receivable

1

10 000

22 Jan 2025

Accounts Receivable

2

15 000

25 Jan 2025

Accounts Receivable

2

10 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

16

310 Travelling Expenses Date

Detail

Jnl ref

Debit

Date

Detail

amount

8 Jan 2025

Cash at Bank

1

600

22 Jan 2025

Cash at Bank

2

500

25 Jan 2025

Cash at Bank

2

900

Jnl

Credit

ref

amount

320 Wages Expense Date

Detail

Jnl ref

Debit

Date

Detail

Jnl ref

amount

amount

5 Jan 2025

Cash at Bank

1

1 000

14 Jan 2025

Cash at Bank

1

1 200

22 Jan 2025

Cash at Bank

2

2 000

25 Jan 2025

Cash at Bank

2

1 500

Credit

330 Motor Vehicle Repairs Date

Detail

Jnl ref

11 Jan 2025

Cash at Bank

1

Debit

Date

Detail

Jnl ref

Credit amount

amount 1 900

350 Advertising Expenses Date

Detail

Jnl ref

21 Jan 2025

Accounts Payable

2

Debit

Date

Detail

Jnl ref

Credit amount

amount 5 500

360 Interest Expense Date

Detail

Jnl ref

28 Jan 2025

Cash at Bank

2

Debit amount

Date

Detail

Jnl ref

Credit amount

1 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

17

Once we have posted the journal entries, we need to determine the balance of each ledger account. We have not shown that step here – but it needs to be done in the same manner as shown in Exhibit 8.3 (p. 405). Once we have the balance of each ledger account, we would then prepare a trial balance. This is shown below. As we know, the total of all accounts with debit balances must equal the total of all accounts with credit balances.

Trial Balance for Musical Pipeline as at 31 January 2025 Account Number

Account Name

100

Cash at Bank

54 400

110

Accounts Receivable

25 000

125

Musical Instruments

16 000

130

Musical Instrum. Maintenance Equip.

9 000

135

Motor Vehicle - Van

45 000

160

Accounts Payable

5 500

170

Bank Loan

25 000

201

R. Keith, Capital Account

100 000

210

Drawings

250

Performance income

310

Travelling Expenses

2 000

320

Wages Expense

5 700

330

Motor Vehicle Repairs

1 900

350

Advertising Expenses

5 500

360

Interest Expense

1 000

Totals

Debits ($)

Credits ($)

15 000 50 000

180 500

180 500

Once we have prepared the above trial balance we are then in a position to prepare the Statement of Profit or Loss for the organisation. In this question there are no end of accounting period adjusting entries required for such things as income earned but not received, expenses incurred but not yet paid, income received in advance, prepayments, and depreciation.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

18

Musical Pipeline Profit or loss statement for the month ending 31 January 2025 $ Income Performance Income Expenses Travelling Expenses Wages expense Motor Vehicle Repairs Advertising Expenses Interest Expense Profit

50 000 (2 000) (5 700) (1 900) (5 500) (1 000) 33 900

We need to prepare our closing journal entries so that we can transfer income, expenses, and drawings to the Capital Account of R. Keith. Preparing and posting the closing entries to the respective ledger accounts will also ensure that the balances of all the expense, income and drawings accounts will be zero at the commencement of the next accounting period. The closing journal entries would be: General Journal

Page 3

Date

Account Names

Account Number

31 Jan

Performance Income Profit or Loss Summary To close off Performance Income to P or L Summary

250 220

50 000

Profit or Loss Summary Travelling Expense Wages Expense Motor Vehicle Repairs Advertising Expenses Interest Expense To close off expenses to P or L Summary

220 310 320 330 350 360

16,100

Profit or Loss Summary R. Keith, Capital Account To transfer the balance of P or L summary to Capital Account

220 201

33 900

R. Keith, Capital Account Drawings To transfer the balance of Drawings to the Capital Account

201 210

15 000

31 Jan

31 Jan

31 Jan

Debit ($)

Credit ($)

50 000

2 000 5,700 1 900 5 500 1 000

33 900

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15 000

Deegan 2e_Solutions Manual

19

We would then post the above closing journal entries to the respective ledger account and the account balances would be calculated. We have not shown that step here – but it needs to be done. Once the closing entries have been posted to the ledger accounts we would be left with the following trial balance which will only include asset, liability, and equity accounts.

The Post-Closing Entry Trial Balance of Musical Pipeline as at 31 January 2025 Account Number

Account Names

100

Cash at Bank

54 400

110

Accounts Receivable

25 000

125

Musical Instruments

16 000

130

Musical Instruments Maint. Equip.

9 000

135

Motor Vehicle – Van

45 000

160

Accounts Payable

5 500

170

Bank Loan

25 000

201

R. Keith, Capital Account

118 900

Totals

Debits ($)

149 400

Credits ($)

149 400

Having performed all of these steps, we are now in a position to finally produce the Balance Sheet. As we can see, the following balance sheet is in the form of A – L = OE.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

20

Balance Sheet of Musical Pipeline As at 31 January 2025 $ Current assets Cash at Bank Accounts Receivable Non-Current assets Musical Instruments Musical Instruments Maintenance Equipment Motor Vehicle – Van Total assets

54 400 25 000 79 400 16 000 9 000 45 000 70 000 149 400

Current liabilities Accounts Payable Non-Current Liabilities Bank Loan Total Liabilities Net assets

25 000 30 500 118 900

Represented by: Owners’ equity R. Keith, Capital account

118 900

5 500

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

21

8.29 General Journal

Page 1 Account Debit ($) Number

Date

Account Names

1 Jan 2025

Cash at Bank L. Beachley, Capital Account (Owner contributed cash)

100 201

70 000

Van – Motor Vehicle Cash at Bank (Acquired motor vehicle with cash)

140 100

45 000

Surfing Equipment for Hire Cash at Bank (Acquired maintenance equipment with cash)

120 100

11 000

Surfing Equipment for Hire Cash at Bank (Acquired surfing equipment with cash)

120 100

7 500

Surfboard Repair Equipment Cash at Bank (Acquired equipment for making repairs)

130 100

2 500

Cash at Bank Bank Loan (Bank loan taken out)

100 170

15 000

Accounts Receivable Income from Surfing Lessons (Provided surfing lessons on credit terms)

110 230

6 000

Wages Expense Cash at Bank (Paid wages expense)

310 100

800

Travelling Expenses Cash at Bank (Paid for travelling expenses) Motor Vehicle Repairs Cash at Bank (Paid for repairs to van)

300 100

500

330 100

2 900

1 Jan 2025

1 Jan 2025

1 Jan 2025

1 Jan 2025

3 Jan 2025

5 Jan 2025

5 Jan 2025

8 Jan 2025

11 Jan 2025

Credit ($)

70 000

45 000

11 000

7 500

2 500

15 000

6 000

800

500

2 900

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12 Jan 2025

14 Jan 2025

14 Jan 2025

14 Jan 2025

22

Cash at Bank Accounts Receivable

100 110

6 000

Surfing Equipment for Hire Cash at Bank (Acquired surfing equipment for cash)

120 100

4 000

Cash at Bank Income from Surfing Lessons (Provided surfing lessons on credit terms)

100 230

8 000

Wages Expense Cash at Bank (paid wages expense)

310 100

800

6 000

4 000

8 000

800

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

23

General Journal

Page 2

Date

Accounts

21 Jan 2025

Advertising Expenses Accounts Payable (To recognise unpaid advertising expenses)

22 Jan 2025

Accounts Receivable Income from Surfing Lessons (Provided surfing lessons on credit terms)

110 230

10 000

Wages Expense Cash at Bank (Paid wages expense)

310 100

800

Surfing Equipment for Hire Cash at Bank (Acquired surfing equipment for cash)

120 100

3 000

Travelling Expense Cash at Bank (Paid for travelling expenses)

300 100

600

Cash at Bank Accounts Receivable (Received amount due from an account receivable)

100 110

10 000

Accounts Receivable Income from Surf Lessons (Provided surfing lessons on credit terms)

110 230

12 000

Wages Expense Cash at Bank (Paid wages expense)

310 100

1 000

Travelling Expenses Cash at Bank (Paid for travelling expenses)

300 100

900

Interest Expense Cash at Bank (Interest expense paid)

350 100

600

22 Jan 2025

22 Jan 2025

22 Jan 2025

24 Jan 2025

25 Jan 2025

25 Jan 2025

25 Jan 2025

28 Jan 2025

Account Debit Credit Number 340 6 000 150 6 000

10 000

800

3 000

600

10 000

12 000

1 000

900

600

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

31 Jan 2025

24

Drawings Cash at Bank (Owner withdrew cash)

210 100

10 000 10 000

Once we have entered the details of the various transactions into the journal, our next task is to post each journal transaction to the respective ledger accounts. Once the above journal entries are transferred to the ledger accounts, the ledger accounts would appear as follows: 100 Cash at Bank Date

Detail

Jnl

Debit

ref

amount

Date

Detail

Jnl

Credit

ref

amount

1 Jan 2025

L Beachley, Cap. Act

1

70 000

1 Jan 2025

Van – Motor Vehicle

1

45 000

3 Jan 2025

Bank Loan

1

15 000

1 Jan 2025

Surf Equip for Hire

1

11 000

12 Jan 2025

Accounts Receivable

1

6 000

1 Jan 2025

Surf Equip for Hire

1

7 500

14 Jan 2025

Inc from Surf Less

1

8 000

1 Jan 2025

Surf Equip for Hire

1

2 500

24 Jan 2025

Accounts Receivable

2

10 000

5 Jan 2025

Wages Expense

1

800

8 Jan 2025

Travelling Expenses

1

500

11 Jan 2025

MV Repairs

1

2 900

14 Jan 2025

Surf Equip for Hire

1

4 000

14 Jan 2025

Wages Expense

1

800

22 Jan 2025

Wages Expense

2

800

22 Jan 2025

Surf Equip for Hire

2

3 000

22 Jan 2025

Travelling Expenses

2

600

25 Jan 2025

Wages Expense

2

1 000

25 Jan 2025

Travelling Expenses

2

900

28 Jan 2025

Interest Expense

2

600

31 Jan 2025

Drawings

2

10 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

25

110 Accounts Receivable Date

Detail

Jnl ref

Debit

Date

Detail

amount

5 Jan 2025

Income Surf Less

1

6 000

12 Jan 2025

Cash at Bank

22 Jan 2025

Income Surf Less

2

10 000

24 Jan 2025

Cash at Bank

25 Jan 2025

Income Surf Less

2

12 000

Date

Detail

Jnl

Credit

ref

amount

2

6 000 10 000

120 Surfing Equipment for Hire Date

Detail

Jnl ref

Debit amount

1 Jan 2025

Cash at Bank

1

11 000

1 Jan 2025

Cash at Bank

1

7 500

14 Jan 2025

Cash at Bank

1

4 000

22 Jan 2025

Cash at Bank

2

3 000

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

130 Surfboard Repair Equipment Date

Detail

Jnl ref

1 Jan 2025

Cash at Bank

Debit

Date

Detail

amount

1

2 500

Jnl

Debit

140 Van – Motor Vehicle Date

Detail

ref 1 Jan 2025

Cash at Bank

1

amount

Date

Detail

45 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

26

150 Accounts Payable Date

Detail

Jnl ref

Debit

Date

Detail

amount

Jnl

Credit

ref

amount

21 Jan 2025

Advertising Expenses

2

6 000

Date

Detail

Jnl

Credit

ref

amount

170 Bank Loan Date

Detail

Jnl ref

Debit amount

3 Jan 2025

Cash at Bank

1

15 000

Date

Detail

Jnl

Credit

ref

amount

201 L Beachley, Capital Account Date

Detail

Jnl ref

Debit amount

1 Jan 2025

Cash at Bank

1

70 000

Date

Detail

Jnl

Credit

ref

amount

Jnl

Credit

ref

amount

210 Drawings Date

Detail

Jnl ref

31 Jan 2025

Cash at Bank

2

Debit amount 10 000

230 Income from Surf Lessons Date

Detail

Jnl ref

Debit

Date

Detail

amount 5 Jan 2025

Cash at Bank

1

6 000

14 Jan 2025

Accounts Receivable

1

8 000

22 Jan 2025

Accounts Receivable

2

10 000

25 Jan 2025

Accounts Receivable

2

12 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

27

300 Travelling Expenses Date

Detail

Jnl ref

Debit

Date

Detail

amount

8 Jan 2025

Cash at Bank

1

500

22 Jan 2025

Cash at Bank

2

600

25 Jan 2025

Cash at Bank

2

900

Jnl

Credit

ref

amount

310 Wages Expense Date

Detail

Jnl ref

Debit

Date

Detail

Jnl ref

amount

amount

5 Jan 2025

Cash at Bank

1

800

14 Jan 2025

Cash at Bank

1

800

22 Jan 2025

Cash at Bank

2

800

25 Jan 2025

Cash at Bank

2

1000

Credit

330 Motor Vehicle Repairs Date

Detail

Jnl ref

11 Jan 2025

Cash at Bank

1

Debit

Date

Detail

Jnl ref

Credit amount

amount 2900

340 Advertising Expenses Date

Detail

Jnl ref

21 Jan 2025

Accounts Payable

2

Debit amount

Date

Detail

Jnl ref

Credit amount

6000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

28

350 Interest Expense Date

Jnl

Detail

ref 28 Jan 2025

Cash at Bank

Debit

Date

Detail

Jnl ref

amount

amount

2

Credit

600

Once we have posted the journal entries, we need to determine the balance of each ledger account. We have not shown that step here – but it needs to be done in the same manner as shown in Exhibit 8.3. Once we have the balance of each ledger account, we would then prepare a trial balance. This is shown below. As we know, the total of all accounts with debit balances must equal the total of all accounts with credit balances.

Trial Balance for Surf to the Beach as at 31 January 2025 Account Number

Account Name

100

Cash at Bank

17 100

110

Accounts Receivable

12 000

120

Surfing Equipment for Hire

25 500

130

Surfboard Repair Equipment

2 500

140

Motor Vehicle – Van

45 000

150

Accounts Payable

6 000

170

Bank Loan

15 000

201

L. Beachley, Capital Account

70 000

210

Drawings

230

Income from Surf Lessons

300

Travelling Expenses

2 000

310

Wages Expense

3 400

330

Motor Vehicle Repairs

2 900

340

Advertising Expenses

6 000

350

Interest Expense

Totals

Debits ($)

Credits ($)

10 000 36 000

600 127 000

127 000

Once we have prepared the above trial balance we are then in a position to prepare the Statement of Profit or Loss for the organisation. In this question there are no end of accounting period adjusting entries required for such things as income earned but not received, expenses incurred but not yet paid, income received in advance, prepayments, and depreciation. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

29

Surf to the Beach Profit or loss statement for the month ending 31 January 2025 $ Income Income from Surfing Lessons 36 000 Expenses Travelling Expenses (2 000) Wages expense (3 400) Motor Vehicle Repairs (2 900) Advertising Expenses (6 000) Interest Expense (600) Profit 21,100 We need to prepare our closing journal entries so that we can transfer income, expenses, and drawings to the Capital Account of L. Beachley. Preparing and posting the closing entries to the respective ledger accounts will also ensure that the balances of all the expense, income and drawings accounts will be zero at the commencement of the next accounting period. The closing journal entries would be: General Journal

Page 3

Date

Account Names

Account Number

31 Jan

Income from Surf Lessons Profit or Loss Summary To close off Performance Income to P or L Summary

230 220

36 000

Profit or Loss Summary Travelling Expenses Wages Expense Motor Vehicle Repairs Advertising Expenses Interest Expense To close off expenses to P or L Summary

220 300 310 330 340 350

14 900

Profit or Loss Summary L. Beachley, Capital Account To transfer the balance of P or L summary to Capital Account

220 201

21 100

L. Beachley, Capital Account Drawings To transfer the balance of Drawings to the Capital Account

201 210

10 000

31 Jan

31 Jan

31 Jan

Debit ($)

Credit ($)

36 000

2 000 3 400 2 900 6 000 600

21 100

10 000

We would then post the above closing journal entries to the respective ledger account and the account balances would be calculated. We have not shown that step here – but it needs to be done. Once the © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

30

closing entries have been posted to the ledger accounts we would be left with the following trial balance which will only include asset, liability, and equity accounts.

The Post-Closing Entry Trial Balance of Surf to the Beach as at 31 January 2025 Account Number

Account Names

100

Cash at Bank

17 100

110

Accounts Receivable

12 000

120

Surfing Equipment for Hire

25 500

130

Surfboard Repair Equipment

2 500

140

Motor Vehicle – Van

45 000

150

Accounts Payable

6 000

170

Bank Loan

15 000

201

L. Beachley, Capital Account

81 100

Totals

Debits ($)

102 100

Credits ($)

102 100

Having performed all of these steps, we are now in a position to finally produce the Balance Sheet. As we can see, the following balance sheet is in the form of A – L = OE.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

31

Balance Sheet of Surf to the Beach As at 31 January 2025 $ Current assets Cash at Bank Accounts Receivable Non-Current assets Surfing Equipment for Hire Surfboard Repair Equipment Motor Vehicle – Van Total assets

17 100 12 000 29 100 25 500 2 500 45 000 73 000 102 100

Current liabilities Accounts Payable Non-Current liabilities Bank Loan Total liabilities Net assets

15 000 21 000 81 100

Represented by: Owners’ equity L. Beachley, Capital account

81 100

6 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 9: The balance sheet 9.1

The balance sheet provides information about the financial position of an organisation as at a particular point in time. This means that it provides information about the monetary values assigned to the assets held by the organisation, together with information about the monetary values assigned to the liabilities of the organisation, as well as to the owners’ equity. The balance sheet will provide insights into: • •

• • •

9.2

the ability of the organisation to pay its debts as and when they fall due; the ability of the organisation to change its operations (the balance sheet provides information about available cash and cash equivalents as well as how much of the organisation’s resources is invested in non-current assets which would not be easily sold); the value of the organisation; the sources of funding of the organisation; the efficiency with which the organisation is being operated (by knowing what the total assets of the organisation are, then, for example, this can then be related to financial performance measures such as sales and profits to provide an indication of how efficiently the assets of the organisation are being used).

According to the Conceptual Framework for Financial Reporting: Recognition is the process of capturing for inclusion in the statement of financial position (balance sheet), or the statement of financial performance (income statement), an item that meets the definition of one of the elements of financial statements – an asset, liability, equity, income or expenses. Recognition involves depicting the item in one of those statements – either alone or in aggregation with other items – in words and by a monetary amount, and including that amount in one or more totals in that statement.

Therefore, and simply stated, a transaction or event is considered as having been ‘recognised’ if it is included within a financial statement, either individually or aggregated with other items presented in that financial statement.

9.3

An asset should be recognised for financial reporting purposes if it satisfies the definition of an asset and if the related information is deemed to be both relevant and representationally faithful. As the Conceptual Framework for Financial Reporting states: Only items that meet the definition of an asset, a liability or equity are recognised in the statement of financial position. Similarly, only items that meet the definition

Deegan 2e_Solutions Manual

2

of income and expenses are recognised in the statement of financial performance.

However, not all items that meet the definition of one of those elements are recognised.

The Conceptual Framework further states: An asset or liability is recognised only if recognition of that asset or liability and any resulting income, expenses or changes in equity provides users of financial statements with information that is useful; that is, with: a. relevant information about the asset or liability, and about any resulting income, expenses or changes in equity; and b. a faithful representation of the asset or liability and any resulting income, expenses, or changes in equity.

9.4

Retained earnings is part of equity (or ‘owners’ equity’) and within a company would be disclosed as part of shareholders’ funds.

Retained earnings (or as it is sometimes called, retained profits) represents the accumulation of past profits, less the past dividends that have been paid or proposed by the organisation. Sometimes transfers might be made from retained earnings to other reserves which are part of equity, and sometimes transfers might be made to retained earnings from other reserves.

9.5

As we indicated in Chapter 2, a ‘resource’ can be defined as something that has value in the sense that it allows an organisation to undertake an activity so as to enable it to achieve a desired outcome. Some resources that would not appear in the financial statements include: • • • • •

An organisation’s workforce and their knowledge and skills Waterways used by the organisation Roads used by the organisation The air used by an organisation Many intangible assets controlled by the organisation.

Many of these resources are not recognised because the reporting entity does not ‘control’ the resources. In respect of intangible assets, many intangible assets are not recognised because of the rules within accounting standards which prohibit the recognition of most internally developed intangible assets.

9.6

One important factor to consider in determining whether a faithful representation of an asset can be provided is potential ‘measurement uncertainty’ which refers to uncertainty that arises when monetary amounts in financial reports cannot be observed directly and must instead be estimated. If the measurement uncertainty is deemed to be sufficiently high, then it might be decided that it is inappropriate to recognise the asset for balance sheet purposes as the amount might not be considered representationally faithful.

9.7

See Table 9.1 on page 536 of the book.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

9.8

Because different classes of assets are measured in different ways this raises (additivity) issues when we add them together to derive a balance of ‘total assets’. This total will not represent cost, fair value, or present value. Rather it simply represents the addition of various asset measurements that have been made using different bases of measurement. Over time, many people have argued that it is illogical to add valuations together when the bases of the valuations are different (and there is merit to this argument), but by convention accountants do simply add these balances together. This represents a very real limitation of financial reporting and we need to be careful when considering the meaning of the ‘total assets’ of an organisation.

9.9

Depreciation represents the systematic periodic allocation of the cost, or fair value, of a non-current asset over the periods expected to benefit from the use of the asset. The amount calculated is referred to as a depreciation expense. As an allocation process, depreciation therefore does not represent a valuation process; that is, depreciation expense does not represent the decrease in the market value, or fair value, of an asset.

9.10 In calculating depreciation expense, we must make three broad judgements about the following: i.

ii.

iii.

The depreciable base. This is the total amount to be depreciated and often is simply the cost of the item less its expected residual value (the residual value being the amount expected to be received on disposal of the asset at the end of its useful life).

The asset’s useful life. This is based on professional judgement and is influenced by considerations of the expected usage of the asset, expected wear and tear on the asset, likelihood of the asset becoming technically or commercially obsolete as alternative technologies become available, and any legal or similar restrictions placed upon the use of the asset.

The appropriate method of cost apportionment of the asset. The managers and accountant need to make judgements about the pattern of benefits to be generated by the asset. If the pattern of benefits is expected to be fairly uniform, with the economic benefits being equally shared across different accounting periods, then an approach that allocates the depreciable amount equally to each future accounting period would seem appropriate.

9.11 The managers and accountant need to make judgements about the pattern of benefits to be generated by the asset. If the pattern of benefits is expected to be fairly uniform, with the economic benefits being equally shared across different accounting periods, then an approach that allocates the depreciable amount equally to each future accounting period would seem appropriate. We would call this the ‘straight-line method’ of depreciation.

By contrast, if we believe that the economic benefits from the asset are consumed relatively more in the earlier accounting periods, then we would use a method that © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

recognises higher depreciation expenses in the earlier years, such as the ‘diminishing balance method’ of depreciation (to be discussed shortly).

As another alternative, if the asset’s productive capacity is limited to a given level of output, then we might use the ‘units-of-production method’ in which each unit of production is allocated a certain amount of depreciation expense.

9.12 There is a general requirement within accounting standards (specifically within IAS 2: Inventory) that inventory shall be measured at ‘the lower of cost and net realisable value’. This means that the lower value is required to be selected from the two values that are determined for the inventory’s: • •

cost and net realisable value.

The ‘cost’ of inventory includes those costs associated with bringing the inventories to their present location and condition. Such costs include: • • •

costs of purchase costs of conversion other costs incurred in bringing the inventory to its current condition and location.

Net realisable value is the estimated proceeds of sale less the estimated costs of completion and costs to sell.

So, effectively, if the net realisable value of inventory falls below its cost, then it needs to be written down to the value that it could be expected to be sold for, less the incremental costs associated with creating the sale.

9.13 An allowance for doubtful debts is recognised to account for the fact that not all debtors will ultimately pay and is designed to be offset against the accounts receivable balance.

The allowance for doubtful debts represents management’s, and the accountant’s, best estimate of the amount of the accounts receivable that will not ultimately be received from customers. Therefore, professional judgement is involved. Because it is an estimation based on past experience, it will not necessarily reflect the actual amounts that will subsequently be collected. What is actually collected in the future accounting period could differ significantly from expectations – only time will tell (this is a particular example of where the value of an asset is based upon professional judgement, which necessarily involves a degree of measurement uncertainty). If actual collections from accounts receivable significantly differ from expectations, then management should adjust its estimation techniques in order to bring the allowance for doubtful debts more into alignment with actual results, making the allowance for doubtful debts more relevant and representationally faithful.

The allowance for doubtful debts is an example of a contra account, which is an account that is offset against another account. The allowance for doubtful debts is offset against accounts receivable. When the balance of the allowance for doubtful debts is subtracted from the balance of accounts receivable, the result represents the net © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

realisable value of the accounts receivable. That is, it represents how much of the accounts receivable the organisation realistically expects to receive.

9.14 People who have not studied accounting might reasonably believe that ‘total assets’ represents the fair value of the assets at the reporting date. That is, they might believe that what is reported reflects the cash that could be generated if management decided to sell all the assets. However, as we know, this is not the case as many assets are recorded at cost which might be well below their fair value. The monetary measure assigned to particular assets might also be based upon the economic benefits expected to be generated from their use (referred to as ‘value-in-use’) and such assets might actually not have any monetary value if they had to be sold immediately. Again, many people unskilled in financial accounting might not understand this.

9.15 It is generally accepted that information about the fair values of assets is more relevant than measuring assets at cost. However, depending upon how ‘fair value’ is measured, the reliability or representational faithfulness of the amount reported for fair value might be less reliable than measures based on cost.

The cost of an asset can be confirmed by reference to supporting source documents, such as purchase invoices – in which case the amount reported for the ‘cost’ of the asset would have high representational faithfulness, even though the measure might not be very relevant if the fair value of the asset is greatly different to its cost.

If an asset is of the type that is frequently traded and where fair values can be readily determined from publicly available information then the measure of fair value would be expected to be relatively reliable (representationally faithful). However, if the asset is seldom traded and some form of modelling of expected cash flows needs to be undertaken to derive the fair value, then the measure might not have such a high level of representational faithfulness.

9.16 Property, plant and equipment are initially recorded at cost, which effectively includes all the costs necessarily incurred to acquire the asset, and to bring it to the initial location of use, and in the condition necessary for use. ‘Cost’ would therefore include: • •

the asset’s purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management, including installation and assembly costs, as well as those costs associated with initially testing the performance of the asset prior to it being placed into use.

9.17 Many people look at the balance of reported equity – which is assets minus liabilities (or ‘net assets’) – to gain an insight into the value of the organisation. Generally speaking, the greater the net assets of an organisation, the greater the perceived value of an organisation.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

However, although the measures reported within the balance sheet will provide an indication of the value or financial worth of the organisation, we really need to be clear about what we mean by ‘value’. The value that is reported in the balance sheet is the value calculated by applying the measurement requirements within various accounting standards, some of which require assets to be measured at cost, fair value, or present value and liabilities to be measured at face value or present value.

Further, many valuable resources are not reported within the balance sheet due to the organisation not having control over the resource, or because of professional judgements about ‘measurement uncertainty, ‘existence uncertainty’, or due to low levels of probability associated with expected future flows of economic benefits. Also, accounting standards prohibit the recognition of most internally developed intangible assets. Further still, and as indicated above, many assets measured at cost will be reported at an amount that might be far less than their fair value.

Therefore, it is true that the balance sheet provides an indication of the ‘value’ of an organisation, but we must remember that it is an imperfect measure of value.

9.18 Yes, the general rule is that leased assets shall be recognised for balance sheet purposes unless the lease is for a very short period of time, or for a very small financial amount.

Remember that the definition of assets relies upon control rather than legal ownership.

Therefore, if a lease arrangement gives the managers of an organisation control over an asset, then to the extent that the related economic benefits can be measured with reasonable reliability (that is, there is limited ‘measurement uncertainty’), and to the extent that the leased asset has more than a low probability of generating future economic benefits, then asset recognition would be appropriate.

When an organisation signs the leasing contract they are also accepting an obligation (a liability) to make future lease payments for the duration of the lease. Therefore, in terms of the basic accounting equation of A = L + OE, when an organisation enters into a lease, the accountants will increase both assets and liabilities.

The leased assets and the lease liability are required by accounting standards to be measured at the present value of the lease payments if the leasing period is greater than 12 months.

9.19 For the machinery to be considered to be an asset for balance sheet purposes it must satisfy the definition of an asset (which requires consideration of whether there is ‘control’, potential future economic benefits, and a consideration of whether the transaction or event leading to control has already occurred), and the related information must be both relevant and representationally faithful.

In this case it sounds as if there is a low probability that future economic benefits will be generated by the asset (meaning that information about the asset might not satisfy the test of relevance) and therefore it looks like it would be inappropriate to show the machinery as an asset. Also, there is probably a high level of measurement uncertainty,

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

thereby undermining the representational faithfulness of any measure that might be attributed to the machinery. This provides further support for the view that the assets should not be recognised within the financial statements as an asset.

If the asset is no longer to be recognised as an asset then as associated impairment loss would be recognised.

9.20 If the probability associated with expected future flows of economic benefits is assessed as low, then the related information would fail the test of ‘relevance’ thereby meaning that the resource shall not be recognised as an asset for financial statement purposes. As such, any related expenditure would be treated as an expense.

9.21 Fair value is a basis of financial measurement that is to be applied to specified types of assets. ‘Fair value’ is the amount for which an asset could be exchanged in an orderly transaction on a given date between knowledgeable and willing parties that are not related to each other (that is, they are at ‘arm’s length’).

9.22 The recoverable amount of an asset refers to the monetary value that is expected to be generated by the asset. It represents the value that the organisation expects to be able to recover from the asset as a result of selling the asset, or through the ongoing use of the asset. Consistent with this, within accounting standards, the recoverable amount of an asset is defined as the higher of an asset’s fair value less costs of disposal (sometimes called net selling price), and its value in use.

The ‘value in use’ of an asset refers to the net cash flows that an asset is expected to generate throughout its remaining useful life, and it is measured as the net present value of the cash flows, or other economic benefits, that an asset generates for a specific organisation under a specific use.

There is a general principle that assets should not be included within the financial accounts at amounts in excess of their recoverable amount. If an asset is in the accounts at more than its recoverable amount, then an impairment loss needs to be recognised.

Because of these general principles, accountants need to understand the meaning of recoverable amount and need to understand how to determine the recoverable amount of various types of assets.

9.23 The recoverable amount of the asset, which is the higher of the fair value of the asset less costs of disposal, and its value in use, is to be compared with the carrying amount of the asset, and if the recoverable amount is less than the carrying amount of the asset, then an impairment loss must be recognised. This is a general requirement for all assets.

The recognition of an impairment loss has the effect of reducing the carrying amount of the asset and increasing the expenses of the organisation (thereby reducing owners’ equity).

9.24 Yes. Impairment losses should not be confused with depreciation. Depreciation is an allocation of the cost, or revalued amount, of an asset over its useful life, and is not a © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

valuation process. Even if an asset has been depreciated, it is possible that a subsequent impairment loss will still need to be recognised if the depreciated amount is higher than the expected recoverable amount of the asset. If an impairment loss has been recognised, then future depreciation will subsequently be based upon the revised carrying amount of the asset.

9.25 A contingent liability can be defined as an obligation that is payable contingent upon a future event, or an existing obligation that has a low probability of culminating in an outflow of economic benefits from an organisation, and/or is currently not measurable with sufficient reliability.

The general principle is that a liability does not meet the definition and recognition criteria if it: • • •

has a high level of measurement uncertainty; has a low probability of culminating in an outflow of economic benefits; or is contingent upon the occurrence of a future event.

However, to the extent that the liability – if it occurs – is potentially of significant monetary value, then some form of disclosure should be made within the notes to the financial statements. In effect, this provides a warning to the readers of the financial statements about the possibility (not probability) of a future significant payment being required.

9.26 Pursuant to the relevant accounting standard (IAS 37: Provisions, Contingent Liabilities and Contingent Assets), when a contingent liability is disclosed within the notes to the financial statements, the contingent liability note should disclose the nature of the contingent liability and, where practicable: a. an estimate of its financial effect; b. an indication of the uncertainties relating to the amount or timing of any outflow; and c. the possibility of any related reimbursement.

Financial statement readers should be diligent and know to look through the notes to the financial statements to see if there are some reported contingent liabilities.

Contingent liabilities will not be recorded within the balance sheet, but knowledge of their existence could influence judgements being made about the organisation in question.

9.27 Yes, senior executives of large organisations arguably should have knowledge of financial accounting.

The information in financial statements influences the decisions of various stakeholders and given this potential influence it does seem reasonable that executives should understand what is being disclosed by their organisation. That is, they should have a broad understanding of generally accepted accounting principles. In many countries it is also a requirement that certain senior executives must sign a statement to the effect © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

that accounting standards have been followed to generate the financial statements and that the financial statements provide a fair and reasonable depiction of the financial performance and financial position of the organisation. How executives could sign such documents without reasonable knowledge of financial accounting is far from clear.

Financial accounts also include information which should be useful to senior executives such as information about the different assets within the organisation, the respective valuations, and the various obligations. Again, this implies that executives should understand financial accounting.

Further, some knowledge of financial accounting will enable executives to understand why some resources and some obligations might not be reported within the balance sheet.

The senior executives of large organisations typically negotiate financial accountingbased agreements with managers (for example, profit-sharing bonus schemes might be negotiated with managers) and with the providers of debt funds (for example, there might be a debt-to-asset constraint or an interest coverage clause in a lending agreement). Without knowledge of financial accounting it is again difficult to understand how senior executives could logically negotiate such contractual arrangements.

Of course, there can be a counter argument that senior executives might employ accountants to explain the meaning of various accounts and accounting terms.

However, the view here is that this is not enough to absolve the executives of having a reasonable knowledge of financial accounting.

9.28 As indicated many times throughout Chapter 9, accountants necessarily make many judgements about what might or might not happen in the future, for example, in relation to the following: •

•

•

•

Accounts receivable – many judgements need to be made in relation to the ultimate collectability of amounts owing by debtors, and this influences the allowance for doubtful debts and the doubtful debts expense.

Inventory – many judgements need to be made about net realisable value, and such judgements will influence the carrying amount of inventory and any potential inventory write-down expenses.

Property, plant and equipment – many judgements need to be made about assets’ useful lives, residual values, patterns of use, recoverable amounts and fair values.

All such judgements will influence reported assets as well as expenses such as depreciation expense and impairment expense.

Liability provisions – many judgements need to be made about the amount of the ultimate payment, the timing of the payment, and the appropriate interest rate to apply. These judgements will impact both reported liabilities and expenses.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

Different judgements will potentially create significant differences in the reported assets, liabilities, income, expenses and, therefore, equity.

Therefore, because of the significant amount of professional judgement required throughout the financial accounting process it would be very unlikely that different teams of accountants working independently would generate the same financial statements.

9.29 (a) Yes, they can measure some classes of property, plant and equipment at cost and others at fair value. This choice is permitted by the accounting standard pertaining to property, plant and equipment. (b) The total of property, plant and equipment represents a mixture of measurements (some classes at cost and some at fair value) so if some classes of property, plant and equipment are measured at cost and some at fair value then the total for all property, plant and equipment will be neither cost or fair value – it will be a mixture of both. (c) Yes, depreciation expenses will be affected by a revaluation. Depreciation expenses will then be based on the revalued amount less expected residual amount. An upward revaluation to fair value will therefore lead to an increase in depreciation expense and a consequent reduction in profit.

9.30 Ideally, they have revalued the property, plant and equipment because they believe it provides a more relevant and representationally faithful measure of the asset than the previous measurement being used, which might have been ‘cost’. With the passing of time, measurements of some assets – when based on their cost – might show little association to their fair value. For example, if land was acquired 20 years ago at a cost of $500 000, but has a fair value of $10 million, then its cost might not be relevant to many stakeholders. What might be more relevant to the users of the financial statements is its fair value.

Managers might also have other incentives to revalue their assets. Perhaps they have borrowed funds and as part of the borrowing agreement they have agreed, within a debt contract, that their total debt shall not exceed a specific percentage of their total assets, otherwise they will be in ‘technical default’ of the loan agreement and might be required to immediately repay the borrowed funds. For example, they might have agreed that their total debt shall be less than 60 per cent of their total assets. If their total assets were $100 million and their total debt was $61 million, then they would have defaulted on the loan agreement and might have to immediately pay back the borrowed funds. The accounting equation would be represented as: A = L + OE 100 = 61 + 39

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

11

However, if they revalued their assets by $5 million the accounting equation would become: 105 = 61 + 44 and the debt would now be less than 60 per cent of their total assets and they would no longer be in ‘technical default’ of the loan agreement.

Research has also indicated that when managers seek to offer shares in their company to the public (through what is referred to as an ‘initial public offering’) they often revalue their assets upwardly beforehand to thereby signal to the market place that their organisation is worth more. Research has also shown that asset revaluations are also sometimes employed when organisations are the subject of efforts to be taken over (that is, there are ‘take-over bids’ being made) with the belief that the revalued assets presented in balance sheets will make it more costly for others to try and seize control of the company.

9.31 A general approach adopted within financial accounting is to capitalise expenditures that increase the likely future economic benefits expected to be generated by an asset relative to its original state, but expense those subsequent expenditures that simply maintain a given level of services from an asset.

Because payments made on repairs and maintenance only maintain an asset’s life or current condition, then such payments will be treated as expenses.

9.32 A provision is an estimated liability for which there is greater uncertainty regarding the amount, and/or timing, of the payment relative to what there is for other liabilities. That is, provisions relate to payments that the organisation is obliged to make in the future, but for which the actual amount, whilst reasonably measurable, cannot be measured with absolute precision. For example, a bank loan would not be considered to be a provision as the amount that needs to be paid is known, and no estimation is needed.

Examples of a provision would include a provision for warranty repairs, employee benefits, or site rehabilitation.

The amount to be recognised for these forms of liabilities will be the best estimate of the expenditure required to settle the obligation. Where a provision is not expected to be settled for more than a year, then it will be discounted to its present value. The interest rate to be used will take into account the time value of money, and the risks specific to the particular liability.

9.33 Yes, there is a difference in how they are measured. For liabilities that are due for payment within 12 months, the general principle is that they shall be recognised at their ‘face value’. That is, they are not discounted to their present value.

By contrast, for liabilities that are due for payment in 12 months or more, there is a general requirement that they be discounted to their present value and the payments made to the debtholder (lender) will comprise an interest component and a principal repayment component. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12

9.34 No, we do not need recognition criteria or measurement rules for equity. Given that equity is the residual interest in the assets of an entity, and given that the amount assigned to equity will equal the excess of the amounts assigned to assets over the amounts assigned to liabilities (that is, it equals ‘net assets’), the criteria for the recognition of assets and liabilities, and the measurement rules used to measure the assets and the liabilities, effectively provide the criteria for the recognition and measurement of equity. There is therefore no need for separate recognition criteria or measurement rules for equity.

9.35 Goodwill represents the future economic benefits that are expected to be generated as a result of factors such as efficient management, reliable suppliers, existing customer base, and so forth. Goodwill is often referred to as an unidentifiable intangible asset. It is an intangible asset that cannot be sold separately – rather, it is an inherent part of the overall business.

Goodwill is generally recognised when one organisation acquires another organisation, or part thereof, and is measured as the excess of the fair value of the purchase price over the fair value of the identifiable net assets of the organisation acquired. Goodwill can also be internally developed; however accounting standards prohibit the recognition of internally developed goodwill. Goodwill is not permitted to be revalued but it shall regularly be tested for impairment. If it has been impaired, then an impairment loss must be recognised.

9.36 No, not all the goodwill of an organisation can be recognised within the balance sheet.

Pursuant to accounting standards, goodwill shall only be recognised when it is acquired through an organisation making an acquisition of another business. Internally generated goodwill shall not be recognised within the balance sheet. This means that if the managers have created a very successful organisation with significant goodwill, this cannot be represented within the financial statements of that organisation. It can only be recognised by another organisation if they acquire the business and make a payment for the goodwill. Once acquired, accounting standards also prohibit the revaluation of goodwill but do require that goodwill be regularly tested for possible impairment.

9.37 No, this is not correct – but it does represent the sort of mistake that people without education in financial accounting can make.

We know the accounting equation of: A = L + OE An organisation might, for example, have property, plant and equipment measured at $9 million, inventory measured at $1 million, total debts of $6 million and equity of $4 million, that is: 10 = 6 + 4 The $4 million of equity might be made up of retained earnings of $2 million, a general reserve of $1 million and paid up share capital of $1 million – but there is no cash – the © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

assets are – as we have just indicated – represented by property, plant and equipment, and inventory. Equity accounts such as general reserves are often created through the transfer of retained earnings (for example, a debit to retained earnings and a credit to general reserve) – there is no direct transfer of ‘cash’.

To determine whether an organisation has cash we must actually look at the amount reported within assets – in particular at the account referred to as ‘cash at bank’.

9.38 No, it does not necessarily mean this. Using the accounting equation, the accounting equation can be represented as: A = L + OE 22 500 000 = 13 500 000 + 9 000 000 or OE = A – L 9 000 000 = 23 500 000 – 13 500 000 Assets such as inventory are required to be measured at the lower of cost and net realisable value. Therefore, when sold they might actually be worth much more than cost. Property, plant and equipment also might be measured at cost and their fair value might be much more.

Another issue is that some of the property, plant and equipment could be very specialised in nature and not easily sold. Such assets would be expected to generate economic benefits through their use (which we refer to as ‘value-in-use’), and not through their sale.

The point being made here is that it cannot be assumed that the assets reported in the balance sheet could simply be sold for their reported amounts.

9.39 Goodwill will represent the difference between the fair value of the purchase consideration paid, and the fair value of the identifiable net assets acquired.

Fair value of purchase consideration: Cash $400 000 Land, at fair value $1 100 000 Fair value of net assets acquired Carrying amount of assets $1 800 000 Excess of fair value of land over carrying amount $100 000 Fair value of assets acquired $1 900 000 Less liabilities $850 000 Goodwill

$1 500 000

$1 050 000 $450 000

While the purchased goodwill can be recognised within the balance sheet, it is not permitted to be subsequently revalued.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

There is also a requirement within the accounting standards that the purchased goodwill be reviewed at the end of each accounting period to determine whether the value has been impaired, and if it has been, the organisation is required to recognise a related impairment loss.

9.40 Using the above information, we can calculate the Allowance for Doubtful Debts as follows: 1–30 days

31–60 days

61–90 days

More than 90 days

Total $12 300 000

Amount owing

$8 000 000 $3 000 000

$900 000

$400 000

Percentage not expected to be collected

1%

3%

10%

25%

Doubtful Debt amount

$80 000

$90 000

$90 000

$100 000

$360 000

The total amount of doubtful debts therefore would be $360 000. The information about accounts receivable would be disclosed in the financial statements as follows: Accounts Receivable Less: Allowance for doubtful debts Net Accounts receivable

$12 300 000 ($360 000) $11 940 000

9.41 The ‘cost’ of inventory is required to include those costs associated with bringing the inventories to their location of sale, and to bringing them to the condition they are in at the point of sale. Such costs do not include other costs such as advertising, or costs associated with transportation away from the point of sale (only transportation costs to the point of sale are included within ‘cost’). Therefore the ‘cost’ of the inventory is: Amount paid to the supplier of the boards Import duties Transportation costs to point of sale Costs of modifying boards prior to sale

$55 000 $5 000 $ 2 500 $4 000 $66 500

9.42 The ‘cost’ of the machinery is the fair value of the assets exchanged for the machinery, and not their carrying amount in the financial accounts. Therefore, the ‘cost’ of the machinery that would be recognised in the accounts of Drouyn Corporation would be $501 000 calculated as: Cash Land, at fair value Professional fees paid in relation to the acquisition Cost of land

$100 000 $400 000 $1 000 $501 000

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

15

9.43 The ‘cost of inventory’ is said to be $290 000. The net realisable value is the estimated proceeds of sale, less estimated costs of completion and costs to sell. This would be $300 000 – $20 000 – $5000, which equals $275 000. As this is lower than the cost of $290 000, then the inventory shall be reported in the balance sheet at $275 000, which is the lower of cost and net realisable value.

As the inventory was originally recognised as an asset at the amount of $290 000 (its ‘cost’) then its value would need to be reduced to $275 000 and this write-down of $15 000 would be referred to as an ‘inventory write-down expense’, or something similar.

9.44 There are many judgements that accountants must make as part of the process of recording the effects of various transactions and events and as part of the process of generating financial reports. For example, judgements need to be made about: • • • • • • •

Whether an asset will actually generate future economic benefits; What is the likely amount of future economic benefits to be generated by an asset; What is the useful life of a depreciable asset; What is the likely residual amount of a depreciable asset; What pattern of benefits best matches the way in which a depreciable asset is used; What is the best estimate of a provision, such as a provision associated with cleaning up a site that has been contaminated by the organisation; Which accounts receivable are doubtful and might not ultimately pay their debts,

We could give many more examples, but the point is that there are many professional judgements that need to be made by financial accountants (and indeed, by all accountants), and this means that for most organisations it would be extremely unlikely that alternative teams of accountants working independently would calculate the same measures for financial performance and financial position. So, like art, there are indeed many judgements that influence the final ‘picture’ that is presented to financial statement readers. This is a fact that is typically not appreciated by many nonaccountants.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 10: The income statement and the statement of changes in equity 10.1 No, we would not expect all organisations to voluntarily produce an income statement.

For some organisations, such as smaller not-for-profit organisations, measures of financial performance such as ‘profits’ might not be relevant to the various stakeholders. Rather, information about cash flows would likely be relevant, with details about the various types of cash inflows and outflows being useful to stakeholders. Information about past and potential sources of funds would also be relevant, as would information about cash reserves and existing liabilities.

10.2 Type of account

Would it appear in the income statement?

(a) Income receivable

No. It is an asset and would appear in the balance sheet

(b) Income received in advance

No. It is a liability and would appear in the balance sheet

(c) Depreciation expense

Yes, it is an expense

(d) Accumulated depreciation

No, it is a ‘contra asset’ and would appear in the balance sheet as an offset against the related item of property, plant or equipment

(e) Contribution from owners

No, it is a contribution from owners and is not income – it is a capital inflow. It would appear in a statement of changes in equity

(f) Prepaid salary expenses

No, this would represent an asset and would appear in the balance sheet

(g) Salary expenses

Yes, it is an expense

10.3 Other comprehensive income, is defined in the IASB accounting standards as follows: Other comprehensive income comprises items of income and expense that are not recognised in profit or loss as required or permitted by other Accounting Standards.

Deegan 2e_Solutions Manual

2

‘Other comprehensive income’ – which is required to be disclosed by larger organisations that must comply with accounting standards – includes all changes in equity that have occurred during the accounting period that have not already been incorporated within ‘profit’ or ‘loss’, and which do not represent contributions by owners, or distributions to them. There are a number of accounting standards which specifically require that particular gains and losses shall not be included within profit or loss, but shall instead be included as part of other comprehensive income.

Profits and ‘other comprehensive income’ are added together to give ‘total comprehensive income’.

10.4 From an income recognition perspective, they should not be treated differently. This is because organisations typically apply ‘accrual accounting’ which means that income is recognised when it is earned, which is not necessarily when the cash is actually received. For the sales that are made on credit terms, there would be an increase in income, and an increase in accounts receivable. For the organisation that sells for cash, there will be an increase in cash at bank (asset) and an increase in income.

10.5 The accounting policies that are used by an organisation can directly impact the assets, liabilities, income and expenses of the organisation. Therefore, to place the reported numbers in context we need to know and understand what accounting policies were used to generate those financial results. For example, if an organisation has a policy of revaluing its property, plant and equipment to fair value then this will generally lead to higher assets, higher equity and higher depreciation expenses compared to an organisation that does not revalue its assets.

Therefore, before we compare the financial performance and financial position of different organisations we need to understand what accounting policies are employed, as different policies can make comparisons misleading unless some form of adjustments are undertaken prior to the comparisons being undertaken.

10.6 Type of transaction or event

When does it arise?

(a) The recognition of a prepayment

When a payment for a particular service is made in advance of receiving the service this creates an asset that is referred to as a prepayment.

(b) The recognition of an accrued expense

When a particular service has been provided to the organisation before the organisation has paid for it this creates a liability referred to as an ‘accrued expense’.

(c) The recognition of an accounts receivable

When a good or service is provided to a customer in advance of the customer paying

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

then an asset is recognised which is referred to as an accounts receivable.

10.7 Managers would use the income statement to assess their performance with respect to those aspects of financial performance for which they believe they have some accountability. Of particular relevance for a ‘for-profit’ organisation would be whether the organisation has generated sufficient profits, given the level of resources held by the organisation and the expectations held by different stakeholders. Managers would also use the information about income and expenses as a means of control – in particular, they would seek to determine whether the actual income and expenses are consistent with budgeted, or targeted, performance. If not, then some form of investigation would be warranted.

10.8 No, it would be a drawing (distribution) which would decrease equity, but which would not be an expense. This is consistent with the definition of expenses provided by the Conceptual Framework for Financial Reporting which states: Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

10.9 One of the reasons for reporting information about the financial performance (for example, profits) of a past period is that it assists stakeholders to predict future financial performance.

If particular activities are not expected to continue into the future, then the results generated by these discontinued operations might not be particularly relevant when predicting the future (although they would be relevant in assessing the past performance of the managers of an organisation). Therefore, to make judgements about likely future performance it would seem to make sense that results from ‘continuing operations’ be reported separately to results from ‘discontinued operations’.

10.10 An airline company should recognise revenue from customers at the time it provides the service. It is common that passengers pay for their travel in advance of the travel (sometimes, many months before travel). When received, this amount received is treated as a liability, perhaps labelled as ‘airfares received in advance’. That is, there would be an increase in assets (cash at bank) and a matching increase in liabilities.

When the passenger receives the service, there would be a decrease in the liability and a matching increase in airfares revenue.

10.11 If an organisation presents its expenses based on the ‘function-of-expenses’ approach, then expenses will be classified according to their function. Those costs relating to the cost of sales will be separately disclosed, as will the costs or administrative activities (and other functions that can logically be derived by adding different expenses together). This approach to disclosure can provide more-relevant information to users

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

than the classification of expenses by nature, but allocating costs to functions may require arbitrary allocations and involve considerable judgement.

The other option for larger organisations that are required to comply with accounting standards is for expenses to be classified according to their nature. If this is done, the organisation will aggregate expenses according to their nature (for example, depreciation, interest costs, transport costs, employee benefits and advertising costs) and will not reallocate them among functions within the entity. This method is relatively simple to apply because no allocations of expenses to functional classifications are necessary.

Whichever presentation format is chosen, it should be chosen on the basis of which form of presentation provides more relevant information to the financial statement readers.

10.12 Transaction or event

Would it be treated as income?

(a) Receipt of cash from an accounts receivable

No, it is not income. There would be an increase in cash at bank (an asset) and a decrease in accounts receivable (an asset).

The income would have been recognised when the sale was originally made some time earlier.

(b) Receipt of some inventory from a supplier

No, it is not income. There would be an increase in inventory (an asset) and a matching increase in accounts payable (a liability), or – if paid for with cash at the time of purchase – a decrease in cash at bank (an asset).

(c) Receipt of some office furniture from a customer in exchange for some inventory that is sold by the organisation to the customer

Yes, income would be recognised. The amount of income to be recognised would be equal to the fair value of office furniture that has been received. There would be an increase in office furniture (an asset) and an increase in sales revenue.

10.13 There could be many reasons why external stakeholders would want information about the profitability of an organisation. Some of the reasons would include: a) Investors would use the information to help assess whether the company is likely to pay dividends to them in the future.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

b) Investors would use the information to help them assess how efficiently the managers are operating the organisation (for example, they might compare profits with the total assets of the organisation, or with total shareholders’ funds). c) Lenders would use the information to help them assess whether the organisation will be able to repay borrowed funds when the funds are due for repayment. d) Employees would use the information to help them assess whether the organisation will be able to continue operating as a going concern and thereby be able to continue paying wages. e) Labour unions might use the information to help assess whether an organisation could afford to pay higher wages to the members of the union. f) Environmental groups might use the information to help them determine whether an organisation is able to realistically invest in cleaner production technologies.

10.14 No, they are not necessarily the same thing. Accounting profit is determined based upon the application of accounting standards and other generally accepted accounting procedures (including those identified within the Conceptual Framework for Financial Reporting).

Taxable profit, by contrast, is determined by applying the rules with the taxation legislation (which will differ from country to country). There can be very different rules for income and expense recognition in the taxation law compared to the recognition criteria within accounting standards and other generally accepted accounting policies. This means that it is possible for an organisation to report a profit for financial reporting purposes but a loss for taxation purposes (or vice versa).

10.15 If an item of expense or income cannot be measured reliably then it should not be recognised within the financial statements. Measurement uncertainty is something that can undermine the representational faithfulness of particular information. However, to the extent that the information is potentially material to different stakeholders, then some disclosure within the notes to the financial statements would be warranted.

10.16 Winkipop Ltd shall measure the income at the fair value of the assets received for providing the services. As the fair value of the equipment is $80 000 then this is the amount that should be recognised as income. The carrying amount of the asset in the financial accounts of Rincon Ltd is not directly relevant to Winkipop Ltd. Winkipop Ltd will increase its assets (machinery) by $80 000 and will increase its consulting services revenue by $80 000.

10.17 If the costs of individual inventory items fluctuate throughout an accounting period, which would be likely in most organisations where items are manufactured or acquired at various times throughout the year, and we cannot or do not wish to identify the specific ‘cost’ of each individual item, certain cost-flow assumptions must be made. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

During the year, inventory is likely to be purchased or manufactured at several different prices/costs. If inventories are to be measured at cost and numerous purchases have been made at different unit costs, the question arises of which of the various cost prices should be assigned to each transaction. Conceptually, a specific identification of the items sold and the items on hand at reporting date seems optimal, but this approach might be impractical to apply.

Instead of attempting to identify items specifically, a cost-flow assumption is frequently made and consistently applied in determining cost of goods sold and closing inventory. Thus, the actual physical flow of goods, and the flow of goods according to the cost-flow assumption, might be different.

In selecting a cost-flow method, management must exercise judgement to ensure that the method chosen – such as FIFO or weighted average cost – provides the most practical accounting reflection of the underlying movement of inventory.

10.18 Under the first-in, first-out (FIFO) cost-flow method of inventory valuation, the goods from beginning inventory and the earliest purchases are assumed to be the goods sold first. This would seem to be the pattern of selling behaviour in most entities. Ending inventory is assumed to be made up of the more recent purchases, or the more recently manufactured items, and thus represents a more current value of the inventory for the statement of financial position. It should be noted that this cost-flow assumption may be used even when it does not match the physical flow of goods.

While FIFO is commonly used, it is often criticised because it tends to match old or outdated inventory costs with current sales prices and by doing so tends to result in inflated profits relative to other methods such as LIFO or weighted average cost.

LIFO, which is not allowed within some countries, will generate the lowest profit.

10.19 The determination of cost of sales and closing inventory under each of the allowable cost-flow assumptions further depends on the method used to record movements in the inventory, that is, whether the periodic or perpetual inventory system is used.

We use either the perpetual or periodic inventory method to work out the number of units of inventory on hand. So, in determining cost of goods sold and the cost of closing inventory, we not only need to consider what cost-flow assumptions have been made (for example, FIFO, specific-identification or weighted-average approach).

We also need to determine whether the perpetual or periodic system is being employed to determine the actual number of units of inventory on hand. Under the periodic inventory system, inventory is counted periodically (for example, at year end) and then costed. In contrast, under the perpetual inventory system, a running total is kept of the units on hand (and possibly their value) by recording all increases and decreases as they occur.

Under the periodic system calculations of cost of goods sold are done periodically, for example, at the end of the financial period, rather than each time a sale is made. When

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

the perpetual inventory system is used, cost of goods sold and inventory balances are updated each time a sale occurs. Under the periodic system, we use a ‘purchases’ account, and cost of goods sold will be determined at the end of the period using the following formula: Cost of goods sold = Opening inventory + Purchases – Purchase returns (if any) – Closing inventory 10.20 No, as long as certain conditions are satisfied, the revenue can be recognised over ‘a period of time’. According to accounting standards (IFRS 15): An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.

Therefore, transfer of ‘control’ of the asset is a central requirement in the recognition of revenue. Revenue can be recognised over a period of time if transfer of control of the good or service occurs over time. Where performance obligations are satisfied over time and do not relate to a service, paragraph 35 of IFRS 15 permits revenue to be recognised to the extent that: •

the reporting entity’s performance creates or enhances an asset (for example, work in progress in the form of a building) that the customer controls while the asset is being created or enhanced, or

•

the entity’s performance creates an asset with no alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

10.21 The balance sheet and the income statement are both important reports, and one is not a substitute for, or more important than, the other. The income statement provides an indicator about how and why the wealth of an organisation (as measured in financial accounting terms) has changed during a period of time – known as the accounting period – as a result of the operations of the organisation. This change in wealth is also reflected by changes that have occurred to the balance sheet during the accounting period.

The information within the income statement can be used to answer questions different from the information in the balance sheet. Further, a joint consideration of information in both these financial statements can be used to answer other questions.

10.22 Some organisations subdivide income into two broad categories: revenues and gains.

Traditionally, the term revenue has been used to refer to the main areas in which an organisation generates its income – for example, sales revenue or consulting revenue.

That is, revenue is seen as arising from the ‘ordinary activities’ of an organisation. So, if we want to understand what income has been generated by the ordinary operations of an organisation then we shall focus on ‘revenues’. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

Gains, on the other hand, represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions.

The differentiation between revenues and gains is based on some degree of professional judgement, and it is very possible that something that is deemed a gain by one accountant might be deemed revenue by another.

The classification of an item as revenue or a gain will not affect the total of profit or loss, as they are both included within income.

10.23 Yes, profit is influenced by the way we measure assets and liabilities. As the Conceptual Framework for Financial Reporting states: (a) the recognition of income occurs at the same time as: (i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (ii) the derecognition of a liability, or a decrease in the carrying amount of a liability. (b) the recognition of expenses occurs at the same time as: (i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or (ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.

Therefore, how we measure assets and liabilities directly impacts reported profits; for example: • If we revalue our property, plant and equipment upwards to fair value, this will increase depreciation expense which will therefore decrease profits (depreciation expense is based on the carrying amount of the asset – if the carrying amount is increased, then so is depreciation expense, which has consequent effects on profits).

• If we measure liability provisions – such as provisions for warranty or for site remediation – at their present value, then this means there will be less expense (and less liabilities) than if we had measured them at their undiscounted value.

We could come up with many more such examples, but the point to be made is that choosing between different measurement bases for assets and liabilities will in turn impact the measurement of income and expenses, and will therefore also impact profits. The implication of this is that when trying to interpret the profits generated by an organisation we need to jointly consider the organisation’s policies for measuring its assets and liabilities.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

10.24 If we revalue our property, plant and equipment upwards to fair value, this will increase depreciation expense (because the depreciable base will increase) which will therefore decrease profits (depreciation expense is based on the carrying amount of the asset – if the carrying amount is increased, then so is depreciation expense, which has consequent effects on profits). In the presence of an upward asset revaluation, the profit on sale of the revalued asset will also tend to be lower relative to what the profit would have been if the asset had been measured at cost.

10.25 The role of the statement of changes in equity is to provide a reconciliation of opening and closing equity, and also to provide details of the various equity accounts that are impacted by the period’s total comprehensive income. It therefore shows why/how the equity accounts presented within the balance sheets have changed from one accounting period to the next. It also provides information about the effects of transactions with owners in their capacity as owners (for example, it will report information about capital contributions and drawings made by owners – for example dividends).

10.26 Yes, it can create social impacts. Different stakeholders within the community react to accounting numbers and make decisions that can in turn create various social impacts.

For example, if an organisation reports higher profits then investors might decide to invest further funds into the organisation and this can in turn create various job opportunities which in turn might create a variety of positive social impacts.

Conversely, if an organisation reports losses, then lenders and suppliers might be worried about dealing with the organisation and this could have negative implications for the scale of the organisation’s operation which in turn might lead to job redundancies within the organisation and across the supply chain.

For example, in various countries – such as Australia – it became clear that car manufacturers were having difficulties generating profits. Eventually this meant that support for the organisations fell, and ultimately an entire industry was closed with many social impacts across society.

10.27 Accounting rules included in documents such as accounting standards do change over time, meaning that over time the rules used to measure assets and liabilities change, and this means profits will also be affected.

As the rules of financial accounting can change, this can make it inappropriate to compare the profits from one accounting period with the profits calculated in another period – particularly over extended periods of time when there might be many changes – unless some form of adjustment is made.

10.28 Yes, it can be appropriate but great care must be taken to ensure that the accounting policies being employed are the same or similar in both organisations; otherwise the information and related comparisons can be misleading.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

In undertaking such a comparison, information about such factors as the following should also be considered: •

•

•

Are the organisations operating in similar geographical locations? Depending upon where an organisation is operating, the risks and opportunities can be quite different. Shareholders would generally expect a higher return for higher risk.

What level of debt funding is used by both organisations? The greater the level of debt, relative to equity, the greater the risk of the organisation and greater profit might be expected to compensate for this risk.

Where the organisation is sourcing its goods and services from. For example, they might be acquiring their goods and services from local manufacturers who utilise acceptable employee health and safety policies. By contrast, if they are sourcing products from developing countries then some thought, perhaps, should be given to whether the organisation is generating the profits at the expense of poorly treated workers.

10.29 Organisations often include financial accounting numbers in the various contractual agreements that they negotiate with stakeholders. For example, when borrowing funds from lenders (such as banks and other financial institutions), the managers of an organisation will often contractually agree to clauses (often referred to as debt covenants) that require: •

•

•

the company to maintain certain levels of profits; for example, there might be an agreement that profits must exceed total interest expenses by, say, four times those interest expenses (often referred to as an interest coverage clause); debt levels to be kept below a certain level of total assets; for example, that total debt not become more than 50 per cent of total assets (or some other measure of assets). The recognition of profits will have implications for the total assets of an organisation. the company to maintain total equity above a specific monetary amount. The greater the profits, the greater the measure of equity.

The reason why managers agree to such restrictive clauses within lending agreements – which, as we now know, are referred to as debt covenants – is that agreeing to these requirements tends to reduce the financial risks to the lenders, and therefore enables the organisations (the borrowers) to attract funds from those lenders at lower costs (lower interest rates) than might otherwise be possible.

10.30 (a) There is a general expectation that revenue shall not be recognised until such time as control of the underlying inventory item is transferred to the customer. Revenue would not be recognised at the time the order is made. If a deposit is made at the time of the order, this will initially be treated as a liability (with a corresponding increase in cash at bank).

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

11

(b) The time when the control of the boat passes to the customer would be the normal point at which revenue would be recognised unless it was determined that there was a high degree of uncertainty associated with the customer making the payment. (c) This would typically be considered as too late in the revenue recognition cycle.

10.31 No, the taxes imposed by taxation authorities in different countries will typically be levied on the basis of each country’s taxation legislation, and on what they might refer to as taxable profit (which is the profit calculated using local taxation legislation), not on the basis of the accounting profits shown in the financial statements.

Different countries have different tax rules, and will assess various items of income and expenses differently. For example, certain expenditures that we refer to as creating assets in financial accounting might be considered as deductible expenses for tax purposes. Also, certain cash inflows that we consider as financial accountants to be liabilities – for example, revenue received in advance – might be taxed as received in cash by a country’s taxation authority. Further, certain items that we consider as expenses might not be considered as expense deductions by some countries’ taxation authorities. For example, in many countries, the impairment of certain intangible assets, such as goodwill impairment, is an expense for financial accounting purposes but is not a deductible expense for taxation purposes.

Therefore, the profit that we calculate using accounting standards – which are relatively uniform across countries that use IFRS – will not necessarily be the same as the profit – ‘taxable profit’ – that an organisation generates from the perspective of the local taxation authority. Taxation rules tend to be different in every country, so the same sets of transactions and events will generate different taxable profits in different countries.

Therefore, to determine how much taxation is payable in a certain country, we cannot simply multiply the financial accounting profit (which amongst other things will be determined by applying accounting standards) by a country’s taxation rates. The difference between ‘accounting profit’ and ‘taxable profit’ can, at times, be very significant, such that in some instances, a company that reports high profits from a financial accounting perspective might actually generate no taxable profit when applying the rules within a country’s taxation legislation (and vice versa).

10.32 The stakeholders of not-for-profit organisations would not typically consider ‘profit’ as an important indicator of performance. It would generally be accepted that managers of not-for-profit organisations do not have a responsibility for maximising profits.

Not-for-profit organisations, such as environmental groups, labour unions, animal welfare associations and some educational organisations, might be more concerned with objectives other than profits, such as fulfilling particular social and/or environmental goals and objectives. Their focus might be more on ensuring that they have sufficient sources of funds than on trying to maximise any measure of profits, or © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

12

another measure of financial performance. That is, not-for-profit organisations have different responsibilities. They are not normally expected to generate profits but instead provide much-needed services. Therefore, as their responsibilities are different, their accountabilities, including their financial accountabilities, should also be different. They would nevertheless be expected to be accountable for various aspects of their financial performance, including inflows of financial support, expenses being incurred, and the overall cash flows of the organisation.

Also, we need to appreciate that even in the case of profit-seeking organisations, there are many important aspects of performance that are not financial. That is, we must always remember that financial performance measures, such as profits, are not comprehensive measures of organisational performance. Social and environmental aspects of performance should also be relevant.

10.33 No, we should not rely upon the recommendations. Changes in financial accounting rules and requirements will continue to happen as accounting standard-setters embrace new views on how different transactions and events should be accounted for from a financial accounting perspective.

Therefore, what we need to appreciate and understand is that the rules of financial accounting are not static. Rather, they regularly change, and this means that the profit or loss that we might have calculated for a specific series of transactions and events using the ‘old’ rules could actually be significantly different from the profit we would now calculate using the ‘new’ rules. That is, for exactly the same set of transactions and events, the rules adopted within the accounting standards we have at one point of time will generate different results from those results that would be generated using the accounting standards in place at a different time. As a result, this means that it is very problematic to compare current period reported profits with previous year profits.

This very real fact, that accounting measurement rules regularly change over time, is often ignored by people who nevertheless compare current year financial performance with previous years’ financial performance (it is common to see this done in the news media, thereby bringing into question the actual financial accounting knowledge of those people writing the articles). Without thinking, people undertaking this form of analysis are often comparing profits that could have been calculated using different rules – this is simply illogical, but it happens regularly. A logical approach would be to understand what changes have occurred in accounting rules and then try, as much as possible, to make adjustments before using previous period profits as a basis of comparison.

10.34 ‘Profits’ are a measure of financial performance calculated by applying generally accepted accounting principles, the guidance provided by the Conceptual Framework for Financial Reporting, and accounting standards.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

Accounting standard setters have developed accounting standards based on their beliefs about what information is likely to be relevant to stakeholders such as current and potential investors, lenders and creditors. That is, to those parties with a direct (or, potentially direct) financial stake in the organisation. To some other stakeholders, the expectation would be that organisations perform in a socially and environmentally appropriate manner and they would not directly care about profits, other than for the fact that the reported profits potentially provides an organisation with resources to undertake positive social and environmental projects.

The other point that has been emphasised within Chapter 10 is that because of the way assets are defined – with the reliance on ‘control’ – many valuable social and environmental resources will not be considered ‘assets’ of the organisation. If they are not considered assets, then their use and/or misuse will not be considered expenses unless some form of fine or tax is linked to the misuse of the resource. Therefore, as has been noted a number of times, a profitable company might be generating a variety of ‘costs’ that are not recognised within the financial accounts (and what managers do not measure they often do not manage – and we can see the impacts this has had on issues such as climate change!).

10.35 As we have stressed in Chapter 10, because of the way we define the elements of financial accounting (in particular, how we define assets and expenses), this means that many of the social and environmental costs being generated by an organisation are not encapsulated in the measure of performance known as ‘profits’.

Some examples of negative social and environmental impacts an organisation’s activities might create, but which (unfortunately) will be ignored by financial accounting practices would include the following.

•

•

•

•

Emissions of greenhouse gases. In the absence of carbon taxes or fines, an organisation can emit high levels of GHGs, thereby contributing to climate change, without having any direct impact on reported profits.

An organisation might use large amounts of water as part of its production processes. To the extent that there is a scarcity of water, this might create various social and environmental effects, many of which would be ignored by financial accounting.

In recent years, many companies in the clothing industry have been criticised for acquiring their products cheaply from factories in developing countries where the work environment is unhealthy and unsafe for workers. Because the dead and injured workers are not assets from a financial accounting perspective (they are not controlled), then reported assets will not be decreased.

Organisations often decide to reduce their expenses by sacking people within their workforce and replacing them with some form of automated technology.

This tends to increase accounting profits, because the related machinery and technology is cheaper to run than the salaries and wages that might otherwise

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

•

14

have been paid to the employees. Social costs associated with large numbers of people being unemployed would not directly be recognised within accounting profits.

Businesses that generate their income through gambling-related activities – such as casinos – often report very high profits. However, for problem gamblers, the ‘services’ supplied by casinos can create much hardship and loss. Such social costs are ignored by financial accounting.

Whilst we could provide many other examples of situations in which social and environmental costs are ignored by financial accounting, what this discussion should highlight is that an organisation that generates profits (which would likely advantage owners and managers), might also be creating a variety of social and environmental impacts that negatively impact other stakeholders.

It terms of whether this really matters, many people would argue that it certainly does matter. ‘Profits’ is a figure that is prioritised by many investors, managers, and the news media so without some modification to how financial accounting is performed, and how ‘profit’ is calculated, then it is arguable that key global issues such as climate change will not receive the priority that they necessarily should.

10.36 No, it is not ridiculous. Indeed, many accounting researchers believe that the way we do double entry accounting, and the way in which we have traditionally defined assets and expenses has meant that many significant social and environmental costs – such as the ‘costs’ associated with climate change – have simply been overlooked.

Further, because of the emphasis on profits (and changes therein) in the news media and by stakeholders such as investment analysts, this has meant that managers focus on maximising reported profits despite the social and environmental costs that might be generated at the same time.

This is made even worse by the fact that financial measures such as profits are used within many contracts negotiated with debt holders and managers. This further fixates managers’ attention on maximising profits.

10.37 In terms of contractual arrangements negotiated with managers, managers are often provided with bonuses that are linked to profits or other measures of financial performance (such as sales revenue). The rationale for this is that it is assumed that managers will work harder to maximise these financial measures if they share in some of this wealth being generated. Effectively, the use of such financial accounting-based bonus plans is assumed to align the interests of managers with the interests of the owners of the organisation.

In terms of contractual arrangements with debt holders, managers will often negotiate arrangements with debt holders that effectively reduce the risks of the lenders, thereby allowing the organisation to attract debt capital at a lower cost than would otherwise be possible. Debt covenants often include interest coverage clauses which require the

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

15

organisation’s reported profits to exceed interest expense by a specified number of times whilst the debt is outstanding. If the requirement is not satisfied, then the debt holders might be able to insist on immediate repayment of the borrowed funds.

10.38 A variety of forms of dysfunctional behaviour might arise if managers focus, or fixate, on maximising annual profit. Such behaviour might include: •

•

•

It is possible that managers, and their accountants, might perform some form of ‘creative accounting’ in which the selection of accounting policies might be based on a goal of maximising reported profits rather than to provide relevant and representationally faithful information. For example, they might ‘forget’ to recognise various expenses incurred but unpaid.

Managers might use production approaches that generate the least expenses from a financial accounting perspective, but which have significant and negative social and environmental implications associated with them.

Managers might delay certain discretionary expenditure. For example, they might decide to delay repairs and maintenance. Whilst this might lead to higher reported profits in the current financial period, it might have negative consequences for future profitability.

10.39 ‘Earnings management’ can be defined as action taken wherein accountants adopt particular accounting policies, or make particular accounting-based decisions, primarily to generate desired measures of profits/earnings. Earnings management can also occur when managers decide to undertake, or not undertake, certain transactions primarily because of the way those transactions will influence reported profits.

Managers might undertake earnings management because they know that various stakeholders might expect certain profits to be generated which might not otherwise be possible without some form of earnings management. Also financial performance measures such as profits are used in various contractual arrangements negotiated with managers and debt holders, and this can provide managers with further incentives to manage earnings.

10.40 How we evaluate this statement will largely depend upon how we interpret the meaning of ‘success’. Can we say that a successful organisation is one that makes larger profits as a result – at least in part - of making thousands of job cuts? Is profit the best measure of ‘success’? From whose perspective are we interpreting success? Is it from the shareholders’ perspective? From a broader societal perspective?

Obviously, this is all very subjective. But many people would argue that an organisation is not successful if it generated increased profits due to cutting thousands of jobs. What about the unrecognised social costs that might have resulted from the job losses? However, there are many people who equate profits with success – but we would argue that this is overly simplistic and that there are various factors that need to be considered before we can conclude that the organisation was ‘successful’.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

16

Arguably a ‘successful organisation’ is one that manages its finances well (and makes a ‘profit’), and which generates positive social and environmental outcomes.

10.41 (a) FIFO Sales of 2500 units occurred. The cost of sales comprises the beginning inventory of 500 units and the next 2000 units purchased. That is, the first items of inventory that came in were assumed to be the first ones that went out – first in, first out. The ending inventory comprises the last 400 units purchased.

Cost of sales = (500 @ $250) + (1000 @ $260) + (500 @ $290) + (500 @ $300) = $680 000 Ending inventory (for the balance sheet) = (4000 @ $300) = $120 000

(b) Weighted average cost The cost of sales and ending inventory are costed at the weighted-average price of beginning inventory and purchases.

Weighted-average cost = $800 000 ÷ 2900 units = $275.8621 per unit Cost of sales = 2500 @ $275.8621 = $689 655 Ending inventory (for the balance sheet) = 400 @ $275.8621 = $110 345 (d) LIFO The cost of sales comprises the last 2500 units purchased. The ending inventory of 400 units is assumed to comprise part of the beginning inventory purchased on 1 July 2025.

Cost of sales = (900 @ $300) + (500 @ $290) + (1000 @ $260) + (100 @ $250) = $700 000 Ending inventory (for the balance sheet) = 400 @ $250 = $100 000

10.42 (a) Cost of goods sold would be $140 500, determined as follows:

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Date 8 July 19 July 4 Sept.

17

Manufactured 250 @ $50 = $12 500

200 @ $50 = $10 000 500 @ $55 = $27 500

6 Sept.

19 Jan.

50 @ $50 = $2500 475 @ $55 = $26 125 565 @ 60 = $33 900

24 Jan. 15 Mar.

25 @ $55 = $1375 550 @ $60 = $33 000 750 @62.00= $46 500

3 April 19 June

Sold

15 @ $60 = $900 685 @$62 = $42 470 500 @ 65 = $32 500

29 June

65 @ $62 = $4030 310 @ $65 = $20 150

Balance 250 @ $50 50 @ 50 50 @ $50 500 @ $55 25 @ $55 25 @ $55 565 @ $60 15 @ $60 15 @ $60 750 @ $62 65 @ $62 65 @ $62 500 @ $65 190 @ $65

2 565 $152 900 2 375 $140 550 Closing inventory would therefore be valued at $12 350 (which is 190  $65).

Cost of goods sold would be $140 550. (b)

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Date 8 July 19 July 4 Sept.

18

Manufactured 250 @ $50 = $12 500

200 @ $50 = $10 000 500 @ $55 = $27 500

6 Sept.

19 Jan.

525 @ $54.54545 = $28 636.36 565 @ 60 = $33 900

24 Jan.

15 Mar.

29 June

Balance 250 @ $50 50 @ 50 550 @ $54.54545 25 @ $54.54545 590 @ $59.76888

575 @ $59.76888 = $34 367.11 750 @62.00= $46 500

3 April

19 June

Sold

15 @ $59.76888 765 @ $61.95625

700 @ $61.95625 = $43 369.38 500 @ 65 = $32 500

65 @ $61.95625 565 @ $64.64983

375 @ $64.64983 = $24 243.69

190 @ $64.64983

2 565 $152 900 2 375 $140 616.54 Closing inventory would therefore be valued at $12 283.47 (which is 190  $64.64983).

Cost of goods sold would be $140 616.54, determined as follows:

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 11: The statement of cash flows, and cash controls 11.1 The statement of cash flows can serve various roles, including: • • •

The statement of cash flows reports information about movements in cash (as well as in cash equivalents) for the accounting period.

It provides a reconciliation of the opening and closing balances of cash (and cash equivalents) as reported within the balance sheet.

The statement of cash flows will report the sources, and uses, of cash in terms of the net cash flows that have been generated from: o operating activities o investing activities, and o financing activities.

•

The information provided in a statement of cash flows is important in assisting various stakeholders to assess the ability of an organisation to: o pay its debts; o acquire property, plant and equipment; o pay dividends; o borrow funds and be able to service the repayments.

Insights – such as those referred to above – are not directly observable from the balance sheet, income statement or statement of changes in equity.

11.2 Cash equivalents are defined in accounting standard IAS 7: Statement of Cash Flows as ‘short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of change in value’. Cash equivalents include short-term money market deposits and bank bills to the extent that the time to conversion to cash is not greater than 90 days.

11.3 For those organisations that are required to comply with accounting standards, cash flows should be divided into those that relate to: a. operating activities b. investing activities c. financing activities.

11.4 Yes, many profitable organisations have failed because of an inability to pay debts.

There are frequently significant differences between cash flows and profits. Profitable

Deegan 2e_Solutions Manual

2

firms might fail because of poor cash management. For example, a firm might make sales that are recognised as income in the current period. However, the terms of the sale might be such that the amount will not be received for, say, three months. Meanwhile, wages and many other expenses must be paid. If the collection of the sales revenue is deferred, the organisation might not have sufficient funds to meet its expenses. It might therefore face a liquidity crisis even though its profit, which is determined on an accruals basis, might appear to be sound.

11.5 Type of account

Is it a cash equivalent?

a. Accounts receivable

No

b. Accounts payable

No

c. A money market deposit that earns a fixed 4 per cent rate of return and is repayable on demand

Yes

d. Shares in a listed company

No

e. A fixed-term bank deposit of two months

Yes

11.6 As accountants, or students of accounting, we should understand the difference between cash flows – which are reported within the statement of cash flows – and profits, which are reported within the income statement. However, it may reasonably be assumed that this difference will not be clearly understood by all users of financial statements; albeit if particular financial statement readers do not understand such differences, then arguably they should not be reading, and potentially relying on, the information contained within the financial statements.

Given the potential confusion that might arise as a result of the differences between cash flows and profits, organisations often provide a note to the financial statements that reconciles the cash flows from operating activities to the profit or loss for the period (or vice versa). This will increase the ‘understandability’ of the financial information, with ‘understandability’ being a qualitative characteristic that enhances the relevance of financial information.

11.7 When an accountant determines the income and expenses (and therefore the profit) for an accounting period, many professional judgements necessarily need to be made.

Judgements have to be made about many things, such as when to recognise income, and the collectability of accounts receivable, and about the useful life of a non-current asset, its residual value, and the pattern of benefits to be derived from the asset when calculating depreciation expense. Many other examples could also be provided where professional judgement is required when determining income and expenses, but the point being made is that it is necessary, when accrual accounting is used, to make many © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

judgements about when income is earned and when expenses are incurred. Sometimes, these judgements might be made in a way that is not objective, and a level of bias might be introduced into the financial accounts.

By contrast, there is less ability to manipulate data reported within a statement of cash flows, as the balance of opening and closing cash and cash equivalents can be verified by reference to particular external records prepared by a third party, such as bank statements generated by a bank. Therefore, it is commonly argued that the data reported in a statement of cash flows is likely to be more reliable than profit-related data.

11.8 Organisations will typically seek to minimise the time between when they need to make payments to suppliers for inventory, and when they receive the cash from the subsequent sale of that inventory. This time period is often referred to as an organisation’s operating cycle, which the accounting standard IAS 1: Presentation of Financial Statements defines as ‘the time between the acquisition of assets for processing and their realisation in cash or cash equivalents’. The shorter the organisation’s operating cycle, the less the reliance on other funds, such as borrowings, and therefore the less the related interest expenses of the organisation. Organisations need controls to ensure that the operating cycle is kept as short as possible given the nature of the goods and services. Therefore, managers need to constantly be aware of the period of the operating cycle. Managers want to minimise the length of the time period between when they pay cash to the suppliers and when they receive cash from customers. Ideally, the timing would match, or even better, the receipt from the customer would come before the supplier needs to be paid, but this is often not possible.

11.9 Segregation of duties is an organisational control that seeks to ensure that those people who have access to particular assets, such as cash, are not the same people who account for the movements in the asset. A full segregation of duties would ensure that different individuals would initiate a transaction, approve the transaction, record the transaction and have access to the asset to which the transaction relates.

11.10 Some controls to safeguard cash would include: • • • • • • • •

All payments should have required authorisation and documentation.

All payments and receipts should be evidenced by pre-numbered documents which can later be reconciled.

Customers should be encouraged to use electronic funds transfer (ETF) to pay amounts owing to the organisation.

Payments should not be made directly from cash takings (tills).

All paid invoices are stamped with ‘PAID’.

Cash in tills shall regularly be verified against internal cash register records.

Cash should not be kept within the organisation overnight, other than ‘pettycash’.

Regular bank reconciliations should be conducted to ensure that what the organisation thinks it has in cash actually reconciles to what the bank records

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

indicate. The person undertaking the bank reconciliation should have no access to cash.

11.11 Cash received from customers = sales + opening balance of accounts receivable − closing balance of accounts receivable = $ 340 000 + $40 000 – $15 000 = $365 000 11.12 Purchases = cost of goods sold + closing balance of inventory − opening balance of inventory = $275 000 + $60 000 – $75 000 = $260 000 Cash payments to suppliers = opening balance of accounts payable − closing balance of accounts payable + purchases = $20 000 – $25 000 + $260 000 = $255 000 11.13 Cash payments in relation to an accrued expense = opening balance of accrued expense + related expense incurred during the accounting period − closing balance of accrued expense = $50 000 + $780 000 – $65 000 = $765 000 11.14 Cash payment for prepayments = closing balance of prepayment + related expense recognised during the accounting period − opening balance of the prepayment = $8 000 + $145 000 – $12 000 = $141 000 11.15 Cash received from customers where cash received is initially recorded as a liability = Closing balance of Revenue Received in Advance + revenue recognised during the accounting period – opening balance of Revenue Received in Advance = $45 000 + $670 000 – $35 000 = $680 000 11.16 Cash payments for warranty repairs = Opening balance of Provision for Warranty Repairs + Warranty Repairs Expense recognised during the accounting period – closing balance of Provision for Warranty Repairs = $24 000 + $225 000 – $52 000 = $197 000 11.17 Depreciation expense represents the allocation of the cost, or revalued amount, of an item of property, plant or equipment over the asset’s expected useful life.

Depreciation is a non-cash flow expense – that is, there is no direct cash flow accompanying the recognition of the expense. Therefore, depreciation expenses do not appear in the statement of cash flows. However, they will appear in the note that accompanies the statement of cash flows which reconciles operating profit after tax to net cash provided from operating activities.

11.18 To more fully understand the context of the financial position and liquidity of an organisation, information about available financing facilities would be relevant to the users of the financial statements. Such information provides further information for

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

stakeholders about what additional cash funding would potentially be available should the need for such funding arise.

11.19 Cash flow

Cash flow classification

a. cash paid to suppliers of inventory

Cash flows from operating activities

b. cash paid to employees

Cash flows from operating activities

c. repayment of a loan

Cash flows from financing activities

d. payment for shares in another company

Cash flows from investing activities

e. dividends received from an investment in another company

Cash flows from investing activities

f. income tax paid

Cash flows from operating activities

g. proceeds from sale of machinery

Cash flows from investing activities

h. acquisition of a new factory

Cash flows from investing activities

11.20 Cash flows from operating activities In this question, some expenses (electricity and rates and interest) are accounted for on a cash basis meaning that they are paid in cash as incurred. Therefore, these amounts can be moved directly from the income statement to the statement of cash flows. (i) Receipts from customers We can determine the cash flows from customers as: Cash from customers

= Sales + opening balance of Accounts Receivable − closing balance of Accounts Receivable = 8 400 000 + 1 750 000 − 2 100 000 = 8 050 000

(ii) Purchases of inventory Margaret River Company commences the period with $1 400 000 of inventory. After using $2 800 000 (Cost of Goods Sold), it has a closing Inventory balance of $1 680 000. Given that there are no inventory write-offs, this means that $440 000 of inventory must have been purchased. That is: Purchases = Cost of Goods Sold + closing balance of Inventory – opening balance of Inventory = 2 800 000 + 1 680 000 – 1 400 000 © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

= 3 080 000 Given that Accounts Payable has an opening balance of $1 050 000, purchases have now been calculated as $3 080 000 (see above), and the closing balance of Accounts Payable is $1 470 000, then $2 660 000 must have been paid in cash. That is: Cash payments to suppliers = Opening balance of Accounts Payable − Closing balance of Accounts Payable + purchases of inventory = 1 050 000 − 1 470 000 + 3 080 000 = 2 660 000 (iii)

Accrued expenses

In this question, salary and rental expenses are accrued prior to payment. If the opening balance of accrued expenses is $175 000, salaries and rental expenses total $2 660 000, and the closing balance is $105 000, then $2 730 000 must have been paid. That is: Cash payments on accrued expenses = Opening balance of accrued expenses + expenses incurred during the period − Closing balance of accrued expenses = 175 000 + 2 660 000 – 105 000 = 2 730 000 (iv)

Taxation expenses

If the opening balance of income tax payable is $560 000, the closing balance of income tax payable is $700 000, and the tax expense was $700 000, then $560 000 must have been paid.

That is: Cash payments for taxation = Opening balance of income tax payable − Closing balance of income tax payable + Income tax expense = 560 000 − 700 000 + 700 000 = 560 000 At this stage we can now calculate the total cash flows from operations as: Receipts from customers Payments to suppliers Payments for accrued expenses Interest payments Electricity and rates Taxation payments

$000 8 050 (2 660) (2 730) (140) (350) (560) 1 610

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

Cash flows from investment activities (i) Land As there were no sales of non-current assets and there were no non-cash acquisitions of property, plant and equipment, then all increases in property, plant and equipment must be due to cash acquisitions.

Cash acquisition of Land = Closing balance of Land − opening balance of Land = 2 800 000 – 2 100 000 = 700 000 (ii) Plant and equipment As plant and equipment increases by $1 050 000, $1 050 000 must have been acquired during the period. That is: Cash acquisition of Plant and Equipment = Closing balance of Plant and Equipment − opening balance of Plant and Equipment = 3 500 000 – 2 450 000 = 1 050 000 Total cash flows from investing activities Payment for Land Payment for Plant and Equipment

$000 (700) (1 050) (1 750)

(c) Cash flows from financing activities The only cash flow from financing relates to $420 000 from long-term loans.

Having reconciled the movements in all the balance sheet accounts we can now be comfortable that we should have identified all cash flows.

Total cash flows for the period $000 Opening cash balance Cash from operations Cash from investing Cash from financing Closing cash balance

1 190 1 610 (1 750) 420 1 470

We are now able to present a statement of cash flows for Margaret River Company.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

Margaret River Company Statement of cash flows for the year ended 30 June 2026 $000 Cash flows from operating activities Receipts from customers Payments to suppliers of inventory Payment for accrued expenses – employees and rent Payment for electricity and rates Interest paid Income taxes paid Net cash provided from operating activities (1) Cash flows from investing activities Payment for property, plant and equipment – Land Payment for property, plant and equipment – Plant and equipment Net cash provided from investing activities Cash flows from financing activities Proceeds from borrowings Net increase in cash held Cash at the beginning of the financial year Cash at the end of the financial year

8 050 (2 660) (2 730) (350) (140) (560) 1610 (700) (1 050) (1 750) 420 280 1 190 1 470

Note 1. Reconciliation of profit to net cash provided by operating activities

Operating profit after tax Depreciation – buildings Depreciation – plant and equipment Increase in income taxes payable Increase in accounts receivable Increase in inventories Increase in accounts payable Decrease in accrued expenses Net cash provided from operating activities

$000 840 350 560 140 (350) (280) 420 (70) 1 610

11.21 As Chapter 11 explains, when preparing the bank reconciliation, we firstly identify those transactions that appear in both the organisation’s own records and in the bank statement.

This then allows us to identify items that do not appear in both places, and therefore allows us to determine the reasons why the bank’s statement and the organisation’s records do not match – that is, we can then identify the reconciling items. Any unusual reconciling items would need to be investigated immediately.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Snapper Rocks Company Bank Reconciliation as at 31 January 2026 Cash balance as per bank statement

9

5 900

Add: Un-presented deposits (O.S. Wind)

2 800

Direct payments of expenses by bank (Solar Power)

1 200

Fee charged by the bank

50

Deduct: Un-presented cheque (#007)

(2 000)

Payments made directly by customer to the bank (W. Suit)

(2 000)

Cash balance as per organisation’s accounts

(5 950)

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solutions Manual Chapter 12: The analysis of organisations’ external reports 12.1 ‘Financial statement analysis’ can be defined as the process of reviewing and evaluating an organisation’s financial statements (which would include the income statement, balance sheet, statement of cash flows, and statement of changes in equity) and supporting notes in an endeavour to develop an understanding and appreciation of the organisation’s financial performance and financial stability, and its likely future prospects, thereby enabling more effective decisions to be made with respect to that organisation.

12.2 In general, financial statement analysis can be undertaken in the ways shown in the following table: Method

Explanation

Simple comparison

A simple comparison of this year’s amount (perhaps of a particular expense or revenue item) with the previous year’s amount might be undertaken. This can be referred to as a form of horizontal analysis.

Ratio analysis

When ratio analysis is applied, particular amounts within the financial statements are compared with other amounts within the financial statements. This can be referred to as a form of vertical analysis.

Trend analysis

Trend analysis occurs when we can look at various financial indicators – perhaps accounting ratios – over a number of accounting periods to see if there is a pattern of improvement or deterioration.

Comparison with benchmarks

Different performance measures, which might be encapsulated in various ratios, are compared with those of other organisations, or to industry averages, in order to ‘benchmark’ how the organisation is performing relative to other organisations.

12.3 It would seem sensible that people performing financial statement analysis should actually understand the practice of financial accounting. That is, they should understand accounting standards and other generally accepted accounting principles. If this is not the case, then they could easily misinterpret what much of the information they are using or analysing means or represents.

Deegan 2e_Solutions Manual

2

Further, those people undertaking financial statement analysis need to keep up to date with the ongoing changes in financial accounting requirements (for example, changes that occur when new accounting standards are released). Without being up to date they might wrongly compare results of accounting periods (without adjustment), when different financial accounting rules applied. This could generate misleading interpretations and judgements.

12.4 Horizontal analysis occurs when we are comparing account balances over time – for example, comparing the sales of one year with those of the next – whereas vertical analysis occurs when we compare one item of the financial statements to another item in the financial statements within a particular year of operations; for example, comparing the profit of the organisation with the sales of the organisation (which can be referred to as the profit ratio).

12.5 Arguably, the first item we should review as part of our financial statement analysis is the auditor’s report. If the opinion provided by the auditor is that a report is poorly prepared, then we might be wasting our time reviewing the financial statements.

If reports are prepared by management, then there will be incentives, at times, for managers to be less than objective. An independent expert review of a report – whether it is financial, social or environmental in focus – will, if done by a credible third party, add credibility and ‘value’ to a report.

12.6 Knowledge of the accounting policies being used by an organisation are of direct relevance to the practice of financial statement analysis.

For example, as there can be a choice between alternative measurement bases for some assets and liabilities, it is important to ensure that if two or more organisations are being compared, they should ideally be applying the same policies. Otherwise, the comparison can be misleading without some form of adjustments being performed.

Organisations will also change accounting policies over time. Often, this might be because new accounting standards have been released, or because managers and their accountants believe that previously used accounting methods no longer provide ‘relevant’ information about the financial performance, and financial position, of the organisation. Again, prior to performing an analysis of those financial statements, interested stakeholders should be familiar with the accounting policies being used by an organisation to generate its financial statements.

Calculations like ‘profits’, ‘total assets’, ‘total liabilities’ and so forth only really make sense if we understand the rules (policies) that have been used to generate the numbers – and these rules can frequently change.

12.7 A financial accounting ratio represents a relationship between two quantities, normally expressed as one divided by the other – for example, a debt-to-equity ratio is calculated by dividing total reported liabilities by total reported equity. Financial accounting ratios represent a form of vertical analysis, wherein one number from a financial statement can be compared with another number from the financial statements of the same year. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

3

12.8 If different organisations are measuring their non-current assets differently, then it can potentially be misleading to compare their respective financial statements unless some reasonable attempt is taken to adjust the financial statements of one of the entities.

If one organisation is measuring its non-current assets at fair value, then this means that its total assets might be significantly greater than those of the other entity simply because the assets are measured differently. This in turn would make unadjusted comparisons of ratios that use assets in the denominator (such as the return-on-assets ratio, or the debt-to-assets ratio) somewhat misleading.

Also, if one organisation measures its non-current assets at fair value then this will generally mean that its depreciation expenses will be higher relative to the situation that would be reported if it did not revalue its non-current assets. Also, profit on the sale of the non-current assets would generally be lower for an organisation that revalues its assets. Again, this creates problems when trying to do a comparison of the financial performance of two entities that use different accounting policies.

This emphasises the importance of carefully studying the accounting policy notes of a reporting entity before trying to interpret financial reporting data. Without studying these notes, it might not be apparent that different organisations are using different accounting policies.

12.9 While a current ratio below 1.0 might be considered to represent ‘bad news’ in terms of indicating potential concerns about an organisation’s ability to pay its debts as and when they fall due, a high number (perhaps in excess of 1.5) might indicate inefficiencies, with too much of the organisation’s funds being held in cash, accounts receivable and inventory, all of which can create their own risks and costs.

Deposits in cash typically generate low returns relative to other options (including paying off debt which might be attracting interest expenses). Therefore, it is not a good idea to have too much wealth simply residing in cash.

Having too much invested in inventory – which is also a current asset – can also have negative implications in terms of higher storage costs, insurance costs, potential inventory damage, obsolescence and theft.

Also, the greater the amount residing in debtors, the greater the potential bad and doubtful debts that might subsequently arise.

Therefore, there is a need to balance the relationship between current assets and current liabilities such that the ratio is neither too small, nor too large.

12.10 The number calculated for the price earnings ratio represents how many dollars must be invested for each dollar of earnings. That is, the price earnings ratio provides an indication of how many times earnings the share market is prepared to pay for a share.

A higher number relative to similar organisations indicates greater market acceptance of the organisation. The market might believe that the organisation with the higher price earnings ratio has relatively lower risk and/or it has good growth prospects – so a higher number seems to be a good thing. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

4

The industry to which an organisation belongs will impact the price earnings ratio, and therefore it can be inappropriate to compare the price earnings ratios of companies in different industries.

Price earnings ratios can sometimes get very high, to the point that they seem to defy explanation and are potentially indicative of an ‘overheated market’, and that a market adjustment (at the extreme, a market ‘crash’) is imminent.

12.11 The quick ratio (also called the ‘acid-test ratio’) would be useful for assessing the ability of an organisation to pay its debts in the next 2–3 months. Unlike the current ratio, the quick ratio typically excludes inventory and prepayments from the ‘current assets’ balance because inventory can take several months to be converted into cash (for example, the inventory needs to be sold and then further time needs to pass before debtors pay the amount due), and prepayments typically cannot be refunded in cash, or if they can be, it might take several months to organise any refund. That is, neither inventory or prepayments can be ‘quickly’ converted into cash.

The quick ratio also often excludes bank overdrafts from the measure of current liabilities used within the denominator of the ratio because banks often allow the overdraft to stay in place indefinitely, even though in principle it could be demanded at short notice. A bank overdraft exists when more cash is drawn from an organisation’s bank account than was deposited.

Therefore, as the quick ratio excludes those current assets and current liabilities that might not result in cash flows for more than two or three months it provides a better reflection of the ability of an organisation to pay its debts in the ‘near term’ compared to a ratio such as the current ratio.

12.12 It is generally accepted that the higher the level of debt relative to assets, the higher the risk. This is because, for debt, there are legal requirements for payments in terms of both principal and interest and these need to be paid regardless of whether the entity is generating profits. There is always a chance that an organisation might have periods when it generates losses. In such times, difficulties could arise in meeting debt obligations and this could lead to the ultimate demise of the organisation.

By contrast, for equity, there is generally no legal requirement to pay dividends.

Dividends will be paid to owners when the managers consider that there are sufficient funds available to do so.

Different organisations/industries have different abilities to support debt. For example, organisations with high variability in earnings and related cash flows could have greater trouble servicing debt in some accounting periods. Therefore, it would be ‘safer’ for such organisations to rely relatively more upon equity finance than debt finance.

12.13 A ‘significant event that occurs after the end of the reporting period’ is a significant or important event that occurs in the time period between the end of the accounting period and the date on which the financial statements are authorised for issue to shareholders, and other interested stakeholders. This period of time could be two or three months. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

5

These events might include such things as losses of major customers or major markets, major changes in foreign exchange rates that will impact the future profitability of the organisation, a significant change in the capital structure or operating structure of the organisation, uninsured losses of significant property, plant and equipment, and so forth.

These transactions and events will not be recognised within the financial statements to the extent that they are outside the accounting period, as this would breach the accounting period convention (which we discussed in Chapter 7). With this in mind, there is a requirement in the accounting standards that states that, in respect of significant events that occur after the end of the reporting period (and therefore are likely to impact the future financial performance and financial position of the organisation), but before the financial statements have been authorised for issue, the organisation will disclose in the notes to the financial statements: • •

the nature of the event an estimate of its financial effect, or a statement that such an estimate cannot be made.

Therefore, when reviewing financial statements, you should always remember to look through the notes to the statements for information about such events, as they might create material impacts to future financial performance and financial position. Such information can be very relevant for making judgements about the future financial performance and financial position of an organisation.

12.14 Yes, financial statement analysis should include a consideration of contingent liabilities. Because of uncertainties about the likelihood of future payments, or because of uncertainties about the amounts of future cash flows pertaining to a particular obligation, contingent liabilities are not included within the balance sheet. However, to the extent they are material, they shall be reported within the notes to the financial statements.

At the extreme, contingent liabilities can potentially threaten the ongoing existence of an organisation – so it is very important to be aware of them. We need to factor the potential risks associated with contingent liabilities into our analysis and subsequent decision making.

A consideration of contingent liabilities is often undertaken on a worst-case scenario basis. That is, whilst it would be unlikely for all contingent liabilities to subsequently result in cash outflows, some analysts might factor in what would happen if all of the events identified in the contingent liability note actually occurred, and how that would then impact the future viability of the organisation.

12.15 The central idea behind offering performance-related bonuses, such as bonuses linked to reported profits or to movements in share prices, is that they are designed to motivate managers to strive to achieve certain performance-related objectives. The assumption here is that managers prefer higher pay, and seek to maximise their wealth, and without © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

6

offering such incentives, managers might not work quite as hard to achieve particular performance targets. In essence, the expectation is that such bonuses align the interests of managers with those of the owners (shareholders) of the organisation.

Disclosures about the form of bonuses being offered by an organisation to its managers inform the reader/analyst about certain priorities of the organisation, and what types of performance the organisation appears particularly intent on improving. This is an important insight. Much thought generally goes into developing the structure of performance-related bonuses so as to ensure that the performance indicators used are consistent with the overall objectives and strategies of an organisation.

This information about the form and focus of performance-related bonuses can also potentially help the reader/analyst identify risks and inconsistencies in the actions and rhetoric of an organisation. For example, if an organisation has reported that superior social and environmental performance is the cornerstone of its strategies (perhaps to increase stakeholder support), but a review shows that all managers are rewarded by way of bonuses that are only linked to financial performance then we would rightly question the organisation’s real commitment to high standards of social and environmental performance. It might also cause us to question other public commitments the organisation has made.

12.16 The existence of accounting-based bonus plans can provide an incentive for managers to manipulate accounting numbers, perhaps by encouraging them to use accounting methods that are income-increasing or asset-increasing, both of which could lead to an increase in the size of a bonus. The assumption here is that managers are motivated to increase their own wealth and will pursue actions to make this happen. There is indeed much academic research that has shown that managers who receive a bonus that is linked to accounting profits will, in conjunction with their accountants, be relatively more likely (relative to managers without such bonuses) to select accounting methods that inflate profits, and therefore the size of their own bonus.

Therefore, we should factor consideration of various accounting-based contracts into our analysis if the information about the existence of accounting-based contractual arrangements is publicly available. The fact that managers are being paid accountingbased profits might, for example, explain why certain accrued expenses are lower than expected, or why the useful lives of non-current assets were revised in an upward direction (thereby decreasing periodic depreciation with a consequent increase in reported profits). Knowing this would help analysts to put particular financial numbers into their correct context.

If an organisation is rewarding its managers in terms of profits and nothing else, then this might also motivate managers to be short term in focus, which creates various risks for the organisation and therefore for its stakeholders. A potential fixation on short-term financial performance would be of relevance to financial statement analysts as it means that appropriate long-term strategies might be being overlooked by managers. Analysts

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

7

would generally hope to find that managers are rewarded in terms of a mixture of shortterm (perhaps accounting-based), and long-term performance indicators.

12.17 When borrowing funds, managers of organisations will often agree to various accounting-based debt covenants because this can lead to a perceived reduction in the perceived risks of the lenders, and therefore reduce the cost of obtaining debt funding from those lenders.

There is a general relationship between perceived risk and the cost (interest rate) that lenders will charge an organisation. Lenders can reduce their risk through negotiating accounting-based debt covenants because if an organisation (the borrower) subsequently goes into technical default of a debt covenant (for example, the company has breached a negotiated requirement that its total debt was not to exceed 60 per cent) then the lender can insist on immediate repayment. It can insist on this repayment before things get worse within the firm, at which time there might be many other stakeholders competing for repayment.

12.18 Yes, the existence of accounting-based debt covenants would be of relevance to both financial statement analysts and to the auditors of the financial statements.

The existence of certain contracts between an organisation and other stakeholders, which rely upon reported financial accounting numbers, can potentially motivate the managers of an organisation to manipulate those particular numbers in order to create favourable outcomes for the organisation and/or for themselves. Some financial accounting numbers might be identified as more susceptible to manipulation than others because of their use within particular contractual arrangements.

Having accounting-based debt covenants will at times provide incentives for managers to use accounting methods that are income-increasing or asset-increasing. For example, research shows that where an organisation is close to breaching an agreed debt covenant, such that the debts-to-assets ratio must not exceed 60 per cent, then managers often will inflate the value of assets beyond their real value in order to loosen the restriction. This is of relevance to both auditors and financial statement analysts.

Also, because an organisation can potentially be wound up if it defaults on its accounting-based lending agreements, knowledge of such agreements is useful in assessing the future of the organisation. For example, if we know that an organisation has negotiated an agreement that its debts-to-assets ratio must be kept at or below 60 per cent, and if the latest balance sheet shows that the ratio is 59 per cent, then we might be concerned that if more debt is taken on in the next financial period (or if reported assets decline), then the negotiated requirement will be breached and the organisation might be required to pay back significant amounts of funding. At the extreme, this requirement to immediately repay debt could lead to the demise of an organisation.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

8

If an organisation is close to breaching these covenants, an auditor might increase the amount of audit testing done in relation to the accounting numbers which relate to the covenant so as to be more confident that the numbers have not been manipulated.

12.19 Different social and environmental contexts provide different risks and opportunities, and different stakeholder expectations of performance. Without knowledge of an organisation’s context, it might not be easy to determine the relevance of particular social and environmental disclosures.

For example, if operations are near important aquifers, then a reader/reviewer of a report should want to know what efforts are being made to ensure that important water sources are not being contaminated. In this regard, organisations often provide information about their water use, and water-saving measures, without contextualising such disclosures. Stakeholders need to understand why such information is disclosed. If the organisation is operating in very high rainfall areas, is information about water usage really relevant? Probably not. By contrast, if the organisation is operating in low water supply environments, then it might be very important.

The above example relating to water is just one example of context, but the point being made is that managers need to explain to stakeholders the rationale for why certain disclosures are made and, by implication, why certain (perhaps expected) disclosures were not made. That is, managers need to clearly describe the materiality determination processes used within the organisation.

12.20 If we are able to determine the motivations driving managers to report particular information then we might be better placed to make a judgement about whether we should, or should not, rely upon the disclosures.

For example, if managers appear to be motivated by a desire to improve the reputation or legitimacy of the organisation then we might tend to question the representational faithfulness of the disclosures. On the other hand, if managers seem to be motivated by a desire to be open and accountable about the social and environmental impacts of their operations, then we might be more prepared to rely upon the disclosures.

Because social and environmental reporting is predominantly voluntary, it makes sense to ask ourselves why particular disclosures might have been made by managers, rather than being naïve and believing everything we read.

If the reports are audited by a reputable third party using well established auditing approaches, then we might be less concerned about managers’ motivations for making particular disclosures.

12.21 Yes, this research about managerial motivations for disclosure is relevant to people reviewing corporate social responsibility disclosures. When reviewing information prepared by management, particularly information that is voluntarily disclosed, it makes sense to have some insights into what might have motivated managers to make particular disclosures.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

9

For example, there is much research that indicates that disclosures are made for the purpose of legitimising an organisation’s operations, and this is particularly found to be the case following major social and environmental crises. As such, this evidence shows us that we need to be cautious in believing disclosures that are made by organisations in the wake of crises.

Evidence also shows that disclosures are often made for the purpose of managing particular stakeholders. Therefore, if we know that particular stakeholders, potentially those with some form of economic power over an organisation, have particular social or environmental expectations, then this might explain why managers made particular disclosures. It also potentially provides incentives for those disclosures to be biased in some respect.

Therefore, because of the evidence provided by various researchers, it seems clear that we all need to be careful when reviewing/analysing voluntarily prepared reports. We also need to place each report within the context of the events/crises occurring around that point in time, and also within the context of changing stakeholder expectations.

The evidence to date suggests that much (but not all) social and environmental disclosure appears to be motivated by profitability and survival-related considerations of managers, rather than being reflective of management accepting accountability for their social and environmental performance. This is an important insight.

12.22 Pages 730 to 733 of the textbook identify 29 issues to consider when assessing the quality of social and environmental reports.

If information within a social and environmental report is not considered to be of reasonable quality, then arguably the information should not be relied upon in forming a judgement about the social and environmental performance and commitment of an organisation.

12.23 The answer to this question will be influenced by our own views and expectations about the social responsibilities and accountabilities of organisations. If our view is that managers do have a responsibility that extends into their supply chains, and given the evidence that suggests that workers in factories within developing countries often work in very unhealthy and unsafe environments, then we might believe it is imperative for an organisation to produce ‘accounts’ of what managers are doing to ensure workers across supply chains are treated fairly.

If an organisation that sources products from factories in developing countries does not provide information relating to these workers, then we would likely question whether the reports are really addressing the organisation’s social responsibilities. Such an omission effectively undermines the perceived quality of the remainder of a social and environmental report.

With the advent of Modern Slavery Laws in many countries it will become more common to find organisations providing information about what they are doing to ensure workers throughout their supply chains are treated appropriately. © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

10

12.24 Yes, it would be a concern if managers’ claims about caring for the environment and communities are not reflected in the metrics used to motivate managers. For example, it would be highly hypocritical for an organisation to publicly claim to embrace sustainability, but to rely only upon using financial performance-related measures in the organisation’s management bonus schemes. In respect of such an organisation, it would be questionable whether we should rely upon any of its public statements.

It is commonly argued that to properly understand what the real priorities of an organisation are we should look at what aspects of performance are being used as the basis of rewarding managers. For example, if all the performance indicators used in all the bonus plans negotiated with managers incorporate measures linked to financial performance and wealth creation and nothing else, then this would be consistent with the view that the organisation overwhelmingly prioritises financial performance above social and environmental performance.

A failure to find an alignment between the public commitments made by organisations, and the way they remunerate managers, represents what is often referred to as a decoupling between the publicly promoted image of an organisation, and its actual internal functioning. The greater the level of apparent ‘decoupling’ the less we are able to rely upon any public statements being made by the managers of an organisation.

12.25 (i)

There could be various reasons why we might think it is important to know about the risks that modern slavery is present in the supply chains of an organisation, as well as knowing about what is being done to reduce those risks. For example, we might elect not to transact with any organisation that is linked with modern slavery, or which fails to check whether modern slavery is present within supply chains. We might do this on moral or ethical grounds and effectively we would be instituting what might be referred to as ‘negative screening’ which means if an organisation pursues a certain practice, then we shall not deal with it.

Alternatively, we might be interested in financial performance, and we are worried that the financial performance of the organisation will be jeopardised if the organisation is linked to modern slavery (for example, there might be boycotts from customers or capital providers).

So, our concern might be ethically driven, or financially driven. Managers are increasingly concerned about the risks that modern slavery cause for their organisation as they are aware of what can happen if modern slavery is linked to their organisation.

The reality is that modern slavery exists and that many millions of people worldwide are modern slaves. If we are concerned about the sustainability-related performance of an organisation, then we understand that sustainable development

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

11

requires that the rights of current and future generations be respected. Sustainable development is not occurring if supply chains include modern slaves.

We can expect that across future years the amount of information being disclosed by organisations, particularly larger organisations, about modern slavery will increase. (ii)

There could be various reasons why we might think it is important to know about the risks and opportunities that climate changes pose to an organisation, as well as knowing about what is being done to reduce those risks and maximise those opportunities. It is generally accepted that the future success, and indeed survival, of organisations will be very much linked to how they address the risks and opportunities that climate change presents, and these risks and opportunities relate to both the physical and transitional risks. So, from a financial performance perspective, climate change will likely impact the financial performance of organisations into the future so various stakeholders will need information about, for example, the various governance policies the organisation has in place to address the risks and opportunities associated with climate change.

Apart from wanting to know about the impacts that climate change will likely on organisations’ financial performance, many stakeholders will choose - on ethical or moral grounds - not to support organisations that are failing to address the problem in a meaningful way, regardless of whether there are financial implications.

Obviously, if we are interested in the broad notion of sustainability, and as climate change represents a massive problem to the planet, then we are interested in how organisations are addressing the problem. The expectation is that climate change related disclosures, and related assurance thereof, will increase significantly in future years.

12.26 Ratio

Formula

Calculated Amount in $000s

Return on assets

Profit Average total assets

x 100

Adjusted measure of return on assets

Profit+Interest expenses+Taxes

Return on owners’ equity

Profit

Profit ratio

Average total assets

Average owners′ 𝑒𝑞𝑢𝑖𝑡𝑦 Profit Sales revenue

x 100

x 100

x 100

= =

= =

1660 7875

x 100 = 21.08%

1660+50+700 7875

1660 3335 1660 4000

x 100 = 30.60%

x 100 = 49.81% x 100 = 41.50%

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Gross profit ratio

12

Sales revenue−cost of goods sold Sales revenue

x 100

=

4000−1100 4000

x 100 = 72.50%

Simply looking at the numbers that we have calculated above, we would probably consider that the organisation is operating very well. A return on assets of 21.08 per cent is relatively high (although we would need to consider the riskiness of the industry in which the organisation is operating). The other ratios also appear very favourable; however it is very important that the numbers are compared with competitors, with prior periods, and with budgeted targets.

12.27 Ratio

Formula

Calculated Amount $000s

Inventory turnover Debtors’ turnover Operating cash flow margin

𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 = number of times 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

=

𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 = number of times 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐚𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞

=

𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 𝐟𝐫𝐨𝐦 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐢𝐞𝐬 𝐒𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞

=

1100 315

4000 425

1450 4000

= 3.49 times

= 9.41 times

= 36.25 ¢ per dollar of sales

Inventory turnover: Looking at the above ratios it would probably be reasonable to argue that managers are not being efficient with respect to managing either inventory or debtors, and this in turn has implications for the operating cash flow margin. Of course, we need more information about the industry the organisation is operating within, and the performance of competitors as well as information about performance of the organisation in previous periods.

However, unless the organisation is selling inventory that reasonably only turns over a few times a year, an inventory turnover of less than 4 is very poor.

Debtors’ turnover: The debtors’ turnover is also not quite as good as we would hope, and it exposes the organisation to various risks associated with non-payment. With a debtors’ turnover of 9.41 this means that, on average, debtors are only paying the amounts due to the organisation every 39 days, and in most industries this would not be acceptable.

The poor debtors’ turnover and the poor inventory turnover in turn have negative implications for the length of the organisation’s operating cycle. The longer the operating cycle, the greater the reliance of the organisation on external sources of funding – such as borrowed funds that incur interest expenses.

Operating cash flow margin: The cash flows from operating activities also seems quite low and this, in part, is linked to the poor inventory turnover, and poor debtors’ turnover.

However, there is a need to compare this amount with competitors, prior period performance, and budgeted performance.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

13

Pulling it together: Looking at the information we now have in relation to Maroubra Company, it would be reasonable to assess Maroubra Company’s operating efficiency as being less than optimal. Further action would be needed in terms of understanding what is behind this apparent underlying inefficiency, and what, if anything, can be done to make the organisation more efficient.

12.28 Ratio

Formula

Calculated Amount $000s

Debt to assets

𝐓𝐨𝐭𝐚𝐥 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬

Debt to equity

=

x 100

𝐓𝐨𝐭𝐚𝐥 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐎𝐰𝐧𝐞𝐫𝐬 ′ 𝐄𝐪𝐮𝐢𝐭𝐲

=

x 100

4340 7910

4340 3570

x 100 = 54.87%

x 100 = 121.57%

Interpreting the information: On the basis of the above ratios we can see that the organisation relies more on debt than equity. But if the profitability of the current year extends into future periods then the amount of equity would grow and ultimately outstrip the total amount of debt. However, there are some concerns, given that the ‘quick ratio’ (another ratio) is below 1.0 so timely action needs to be taken to address whether sufficient funds will be available to pay the debts as and when they fall due. Given the information available, the managers were ill-advised to pay so much in dividends in 2026. The level of debt needs to be addressed reasonably urgently. Also, it needs to be understood why interest expense is as low as it is given the level of debt.

12.29 Ratio

Formula

Calculated Amount $000s

Current Quick

1160 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 = = 1.23 times 940 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 1160−310−0 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 − 𝐩𝐫𝐞𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 = = 940 −0 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 − 𝐛𝐚𝐧𝐤 𝐨𝐯𝐞𝐫𝐝𝐫𝐚𝐟𝐭

0.904 times

Interest coverage Cash flows from operating activities to current liabilities

𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐛𝐞𝐟𝐨𝐫𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱𝐞𝐬 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐨𝐬𝐭𝐬 𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 𝐟𝐫𝐨𝐦 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐢𝐞𝐬 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

=

1660+50+700

= 50 48 times =

1450 940

=

= 1.54 times

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

14

Interpreting the information: If we refer to the current ratio, that looks fine. However, the quick ratio exposes some concerns and does indicate that the organisation might have some difficulty in meeting its short-term debt obligations. Perhaps it needs to be explored whether owners can contribute funds quickly. What is clear is that the dividends paid in 2026 were too high given the nature of the liabilities in existence.

We need to know when this analysis is being undertaken. As we know, there is a time lag between the end of the accounting period (in this case, 30 June 2026) and when interested stakeholders receive the financial reports. This time period could be up to three months.

Therefore, it would be appropriate to undertake further investigation, including reviewing the notes to the financial statements (including the notes about significant events after the end of the reporting period) to see if the organisation encountered any significant difficulties in meeting its short-term liabilities.

The cash flows from operating activities to current liabilities is much too low and would require immediate attention. This low measure is also consistent with our earlier results that showed that both inventory turnover and debtors’ turnover was very low. If the inventory turnover and debtors’ turnover could be improved, then this would also have positive implications for the cash flows from operating activities to current liabilities ratio.

The interest coverage ratio is very high and therefore is not an issue of concern. But it does raise issues about how interest expense is only $50 000 when long-term loans averaged $3 470 000 for the year. This represents an interest rate of only 1.44 per cent which seems very low. Maroubra Company has potentially failed to recognise some interest expense – further investigation is warranted.

On balance, the organisation does seem to have some very real liquidity problems. Unless some sources of cash funding can be established quickly, the organisation might fail despite its profitability.

12.30 Ratio

Formula

Calculated Amount

𝐓𝐨𝐭𝐚𝐥 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬 𝐚𝐧𝐧𝐨𝐮𝐧𝐜𝐞𝐝 𝐝𝐮𝐫𝐢𝐧𝐠 𝐭𝐡𝐞 𝐚𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐩𝐞𝐫𝐢𝐨𝐝 = Dividends 𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐧 𝐢𝐬𝐬𝐮𝐞 𝐟𝐫𝐨𝐦 𝐭𝐡𝐞 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 $1 190 000 per share 1 500 000

= $0.7933 per share Dividend yield Earnings per share

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

$0.7933

= $31.20 = 2.54%

𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭𝐬 = 𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐧 𝐢𝐬𝐬𝐮𝐞 𝐟𝐫𝐨𝐦 𝐭𝐡𝐞 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 $1 660 000 1 500 000

= $1.10667 © 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deegan 2e_Solutions Manual

Price earnings ratio

15 𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

=

$31.20

= $1.10667 = 28.19 times

Interpreting the ratios: The dividend yield seems low. Comparison needs to be made with the dividend yields available on other investments, as well as to the returns on low-risk investments, including the returns on bank deposits.

The future prospects of the organisation need to be considered. If the managers of Maroubra Company have proposed paying smaller dividends because they have decided to retain funds for expansion, and for good investment opportunities within the organisation, then shareholders might be satisfied with the low dividend payments as long as there is an expectation that returns would increase in the future. We also need to remember that the total returns made by investors will also include any increase in the market value of the shares throughout the accounting period which are not reflected within these ratios.

When reviewing earnings per share we need to consider trends in this ratio. This number on its own does not mean much. For example, if Maroubra Company had 750 000 shares of $4 each rather than 1 500 000 shares of $2 (which is the same share capital), then the earnings per share would be $2.21 rather than $1.106. Earnings per share takes on greater relevance however when it is used to compute the price earnings ratio. A price earnings ratio of 28.19 is relatively high. This ratio should be compared with other organisations and if the ratios of the other organisations are significantly lower, then this might reflect the fact that the share market is viewing the company relatively favourably. Perhaps there is a belief that future profits will rise, or that the organisation is relatively less risky. The other possibility is that the share price might be overvalued – but care would need to be taken before reaching this conclusion.

© 2023 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.