accounting for management decisions

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia

ACCOUNTING FOR MANAGEMENT DECISIONS

WEEK 2

DIFFERENT ACCOUNTING ENTITIES AND CORPORATE GOVERNANCE

READING: TEXT CHAPTER 2


Learning Objectives

• Discuss the nature of sole proprietorships

• Discuss the nature of partnerships

• Discuss the nature of companies

• Discuss corporate governance and the role of directors

• Distinguish between different types of companies

• Analyse the capital of companies

• Identify and discuss the role of the alternative regulatory bodies in company operations and financial reporting


The Nature of Sole Proprietorships

Learning Objective: Discuss the nature of sole proprietorships

• No separate legal entity (as distinct from a separate accounting entity)

• Limited life (restricted to the period the owner continues to operate the business in)

• Unlimited liability (the owner is fully responsible for the debts and obligations of the business)

• Minimum reporting regulations (minimal compared with other entity structures)

• Limited access to funds (restricted to the personal resources of a single owner)

• Low establishment costs (comparatively much lower compared to other entity structures)


The Nature of Sole Proprietorships cont’d

Some advantages of sole proprietorships include:

• Simple and inexpensive to establish and operate

• Minimal financial reporting regulations

• Ownership and management are normally combined

• Financial rewards flow directly to the owner

• Timely decision-making is possible


The Nature of PartnershipsLearning Objective: Discuss the nature of partnerships

A partnership may be described as: The relationship that exists between two or more persons carrying on a business with a view to profit.

• The relationship may be established by a formal partnership agreement or an informal arrangement between the parties, or it may be inferred by the actions of two or more individuals.

• The partnership maintains individual records of each partner’s transactions according to:• Resource contributions (capital)• Resource withdrawals (drawings)• Share of undistributed profits (either current or retained earnings)


The Characteristics of Partnerships

• No separate legal entity

• Limited life

• Unlimited liability• Mutual agency (each partner is responsible for the actions of

the other partners)• Co-ownership of assets (the partnership assets are owned by

the partners in aggregate, not individually)

• Co-ownership of profits (equally or in agreed proportions)• Limited membership (a restriction on the number of partners

allowed. Normally twenty is the limit. Some exemptions exist e.g. accounting practices)

• Increased regulation (most states have Partnership Acts for direction of activities and rights and responsibilities of partners)


Partnership Agreements

• Important to have a detailed and formal agreement so that most potential problems can be avoided

• Issues not covered by the partnership agreement will be governed by law

Some examples of ‘default’ legal rules that an agreement may cover include:• No entitlement of partners to a salary or wage• Partners not entitled to interest on capital contributed• Equal shares of profits and losses


The Nature of CompaniesLearning Objective: Discuss the nature of companies

There are a number of company types, the most common being the company limited by shares, or ‘limited company’

A limited company may be defined as: An artificial legal person which has an identity separate from that of those who own and manage it.

Ownership interest is broken down into ‘shares’ hence the term ‘shareholders’ to describe the owners, who have invested in the business.


Characteristics of Companies

• Separate legal entity (a limited company has the legal

capacity of a person and is separate from those who own

the entity i.e. can sue and be sued, buy, borrow, lend and

employ in its own right as a legal person)

• Unlimited (perpetual) life (the life of the company is

indefinite and not related to the life of the owners)

• Limited liability (the entity is responsible for its own

debts and obligations because it is a legal person.

Shareholder’s obligations cease upon full payment of the

agreed price of their shares.)


Characteristics of Companies cont’d

• Company ownership of assets (assets owned by the company in its own right as a legal person)

• Company profits belong to the shareholders (profits are either distributed or retained for the benefit of shareholders)

• Extensive membership (some forms of companies may be limited, but public companies e.g. Westpac, Telstra often exceed 250,000 initial shareholders)


Characteristics of Companies cont’d

• Separation of ownership and management (usually a separate specialist management team exists outside the ownership interest, although increasingly managers are also shareholders)

• Extensive regulation (much stricter requirements due to ‘limited liability’ benefit granted to owners. Corporations Act, ASIC, ASX, accounting standards all govern reporting to shareholders and markets)


Companies Advantages

• Separation of ownership and management• Perpetual existence• Separate legal entity• Owners have limited liability• Greater access to ownership funding • Potentially greater access to debt funding• Potential taxation advantages• Potential increases in share values when

listed on the ASX


Companies Disadvantages

• Extensive regulation

• Higher establishment costs

• Subject to more public scrutiny

• Owners not able to watch everything

• Pressure for short-term performance

• Loss or dilution of original ownership control

• Income tax is paid on every dollar of profit earned (no tax-free threshold)


Corporate Governance and The Role of DirectorsLearning Objective: Discuss corporate governance and the role of directors

Corporate governance: The system by which corporations are directed and controlled

Directors: Individuals elected to act as the most senior level of management in a company


Corporate Governance and The Role of Directors cont’d

• The Board of Directors is the most senior level of

management in a company

• A limited company must have at least one director

• Directors are elected by the shareholders

• Shareholder interests should be the guiding principle

for a director’s governance decisions

• Directors are also subject to a framework of rules

based on the principles of Disclosure, Accountability

and Fairness


Disclosure, Accountability and Fairness

• Disclosure (lies at the heart of good corporate governance, is all about adequate and timely information being available to investors)

• Accountability (involves defining the roles and duties of directors and establishing an adequate monitoring process which may include external auditing)

• Fairness (is about directors not benefiting from ‘inside information’. The law and ASX have imposed regulations that restrict directors’ ability to buy and sell shares of the business)


Public and Proprietary (Private) CompaniesLearning Objective: Distinguish between different types of companies

Public Proprietary

Company name includes ‘Ltd’ ‘Pty Ltd’

Public sale of shares Yes No

Typical size Large Smaller

Extent of regulation Extensive Moderate

Raise monies from public Yes Some restrictions

Subject to reporting requirements

Yes Depends on size


Public and Proprietary (Private) Companies cont’d

• Public companies and ‘large’ proprietary companies must prepare annual financial reports - including financial statements and directors’ reports

• ‘Small’ proprietary companies do not have these requirements unless requested by ASIC or by at least 5% of members

• To be ‘small’, they must satisfy at least 2 of:• Consolidated gross operating revenue < $10 million• Consolidated gross assets at end of year < $5 million• Must employ < 50 employees at end of year


Capital of Limited CompaniesLearning Objective: Analyse the capital of companies

Different types of shares Different types of Reserves

Owners' Claim(Shareholders' Equity)

Shares(investment by ‘owners’)

Reserves(Profits and gains subsequently made)

Ordinary Preference Other Retained ProfitsGeneral Other


Capital of Limited Companies cont’d

The basic division - an example (refer example 2.1 on page 45):

Several people decide to start a new company They estimate they will need $50,000 to obtain

assets to run the business Between them, they raise the cash to buy shares in

the company, which issues 50,000 shares at $1 each

The balance sheet at this point would be:Net Assets (all in cash) $50,000Shareholder’s equityShare capital - 50,000 shares $50,000


Capital of Limited Companies cont’d

The company buys the necessary assets and inventory and starts to trade

During the first year it makes a profit of $10,000 and the shareholders (owners) make no drawings

At the end of the first year the summarised balance sheet is:

Net assets (various assets less liabilities) $60,000

Shareholder’s equity

Share capital - 50,000 shares $50,000

Reserves (retained profits) $10,000

$60,000


The Capital of Limited Companies cont’d

• The profit is shown in a ‘reserve’ known as ‘retained profits’ and is kept separate from shareholders equity

• Retained profits are not added to shareholders equity due to Corporations Act restrictions on the maximum drawings of capital (or dividends) the owners can make


Share Capital

Shares are the basic units of ownership of the business

• All companies issue ‘ordinary shares’ which are the main risk-bearing shares of the company.

• Ordinary shareholders’ returns come from distributions of profit (dividends) or from increases in the value of the shares

• Normally, retaining profits will increase the value of ordinary shares


Share Capital cont’d

Dividends - transfers of assets made by a company to its shareholders

Partly-paid shares - shares on which the full issue price has not been paid, but the balance is to be paid in a series of installments or ‘calls’

Fully paid shares - shares on which the shareholders have paid the full issue price

Preference shares - shares which have a fixed rate of dividend that must be paid before any ordinary share dividends can be paid. These have higher priority in the event of the company going in to liquidation


Share Capital cont’d

– Companies may issue shares of various classes with equally various conditions, but ordinary and preference shares are the most common

– Within each class, all shares must be treated equally

– ‘Voting rights’ are normally only ascribed to holders of ordinary shares. One ordinary share normally equals one vote

– New shares can be issued at any time and they are priced at, or close to, market price. This is to ensure no disadvantage to existing shareholders since all have the same rights


Reserves

Reserves - profits and gains made by the company that have not been distributed to shareholders

The most common type of reserve is ‘retained profits’ - profits earned by the company that are held back for use within the company

Other reserves may be created in certain circumstances - a reserve is created (asset revaluation reserve) when assets are re-valued at greater than their book value


Bonus Shares

Bonus shares - reserves which are converted into shares and given ‘free’ to shareholders

A bonus issue of shares simply takes one form of shareholders’ equity (reserves) and transforms it into another form (share capital)

Bonus share issues have no impact on the net assets (total assets less total liabilities) of a company


Rights Issues

To generate additional share capital for expansion, a company may make a ‘rights issue’

These are issues of shares for cash, offered first to current shareholders (who may sell the right to others) in proportion to their existing holdings

Such shares are normally offered at a price below the prevailing market price to encourage take-up of the offer

Rights issues differ from bonus issues in that rights issues result in an asset (cash) being transferred from shareholders to the company


Transfer of Share Ownership

Stock exchange - a formal marketplace where shares may be bought and sold, and where new capital can be raised

Prices are determined according to the law of supply and demand, which in turn is determined by investor’s perceptions of future economic prospects for the companies concerned

Transfer of ownership of shares has no direct impact on the company’s business or on shareholders not involved in the transfer


Restrictions on the rights of shareholders to make capital drawings

– Limited companies are required by law to distinguish between capital that may be withdrawn by shareholders and that which may not

– The balance sheet must clearly identify the amount of non-distributable capital

– It is illegal for shareholders to withdraw that part of their claim represented by capital

– The legal provisions are in place to prevent unscrupulous activity which may disadvantage other shareholders as well as creditors and lenders


The Nature of Regulatory BodiesLearning Objective: Identify and discuss what role alternative regulatory bodies play in company operations and financial reporting

Director’s duty to account:

• To be accountable for their actions and to demonstrate good stewardship

• To provide financial reports that are ‘true and fair’ and that comply with all relevant laws as well as accounting standards

• Financial reports must include the balance sheet, the income statement, the cash flow statement, the statement of changes in owner’s equity and related notes, also the director’s declaration and director’s report

• Compliance with Corporations Act disclosure requirements• Publish the auditors report (if applicable)


The Role of Accounting Standards

– For most of the 20th century GAAP was the guiding

set of principles in Australia

– Since 2005, Australia has adopted International

Accounting Standards

– Accounting standards narrow management’s range

of methods for recording and reporting transactions,

bringing about greater consistency

There are two types of accounting standard• AASB – applies to companies and now sets all standards

• AAS – applies to other entities


The Role of the ASX in Company Accounting

Companies listed on the ASX (public companies) are subjected to further rules specified by the ASX in relation to• more frequent reporting• other matters e.g. corporate mergers/takeovers

Shareholders are responsible for appointing qualified and independent auditors to audit the company’s financial statements • audits are not mandatory for small proprietary

companies

accounting for management decisions

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