Mahesh started a computer business on 1 June 2012 by the name Smart Business. The business operates at Shah Alam, Selangor. Besides the main activities of selling and buying computers, hardware and software, Mahesh also provides computer training and services. The business operates as a sole proprietorship with a cash contribution of RM200,000. He employed fifteen employees including Encik Farid who was appointed as an accountant. Encik Farid with a professional certification is responsible for handling all accounting records.
At the beginning of the operation, Mahesh bought a few computers using funds from the business and one of the computer was taken home as a present for his son. All the computers were recorded and depreciated using the declining method. However, commencing from 2014, the depreciation method will be changed to straight line basis. Mahesh expects to sell about 30% of computers for cash. From the credit sales, 70% are expected to be collected in full in the month of the sale and the remainder in the following month. When Encik Farid is in doubt on the amount of revenue or expense, he takes a view that it is better for him to understate rather than overstate the net income.
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Over the last three years some computer retail businesses have declined whilst others have discontinued their operations. However, Mahesh’s business is still in a strong financial position, with a 34% increase in gross profits and he has no plan to cease operations. However, Encik Farid has prepared the financial statements of the business on the assumption that the business might close and liquidate at any time. In addition, Smart Business recognises expenses when they are incurred during the period rather than when paid. Revenues are recognised when they are earned, not when the cash is received from customers.
Discuss the qualitative characteristics, accounting principles, assumptions and constraints apply in the above case.
(Total: 15 marks)
Based on the case of Smart Business, there are a few questionable desisons that are made by Mahesh and his acountant, Encik Farid. In order to access these actions and decisions, I will break the discussion using the following subtopics:
1) Qualitative characteristics
Qualitative characters of accounting information is important as it assist in decision making. In order for information to be decison-useful, it has to be understandable. This means, users must understand the information and it’s context for decision making.
The primary decision-specific qualities that make accounting information useful are relevance one of the primary decision-specific qualities that make accounting information useful; made up of predictive value and/or feedback value, and timeliness.and reliabilitythe extent to which information is verifiable, representationally faithful, and neutral.. Both are critical. No matter how reliable, if information is not relevant to the decision at hand, it is useless. Conversely, relevant information is of little value if it cannot be relied on.
In this case, relevance of accounting information is used by Encik Farid because based on the market condition of the business, he has made it clear that although the company may be blooming, there is a risk faced by the industry. This brings the concept of going concern. Information provided by Encik Farid on going concern will assist users of the financial statement on their expectations (Feedback Value); it will assist users in forecasting (Forecast Value); and its timeline where keeping users informed on the threat the industry may bring (Timeliness). In terms of reliability, the information provided by Encik Farid does not give a 100% reliable picture. The few characters surrounding reliability which Encik Farid needs to include in his statements are Verifiability (the information can be verified objectively – in this case complied because he is concern about the future of the company), Objectivity (information is not biased – in this case not compiled because the information is biased to indicate the company is not doing well when indeed it is), Trustworthy (information is based on actual result – in this case not complied because the true economic activity is that the company is doing well). Hence, for primary characteristics, Smart Business has failed because of the decision Encik Farid made to prepare the financial statements of the business on the assumption that the business might close and liquidate at any time. He should record the right information but put in the notes to the statements the problems surrounding other competitors in the computer retail business.
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Two secondary qualitative characteristics important to decision usefulness are comparability and consistency. Comparability the ability to help users see similarities and differences among events and conditions.is the ability to help users see similarities and differences between events and conditions. Closely related to comparability is the notion that consistency permits valid comparisons between different perioof accounting practices over time permits valid comparisons between different periods.
In this case, consistency is not used as Smart Business will change their depreciation method within 2 years of commencements. However, this is not against the law as FRS 116: Property, Plant and Equipment allows a company to review its depreciation method annually and change the method if a new method reflected a better useful life of the assets. In order to be consistent, the company must show a calculation between both the methods used for users to compare the difference between both methods for their judgement. Encik Farid needs to ensure that the same depreciation method is used throughout the accounting period. The new method can only be used in a new accounting period. In this case, it should be 1 June 2014, and not the start of 2014 (i.e. 1 January 2014). As for comparability with different companies, the case does not provide an indication of the method used by companies. Hence, I would not be able to comment on the comparability characteristics to different companies within the same industry.
2) Accounting Principles
Here we will discuss the basic accounting principles used by Smart Business in the process of identifying, measuring, evaluation and reporting financial information. These basic principles include:
i) Principle of Income Recognition
Smart Business recognises expenses when they are incurred during the period rather than when paid. Revenues are recognised when they are earned, not when the cash is received from customers. This is a correct income recongnition method as income is recognised at an accrual method. You can recognise the future incoming money as an asset under Debtor’s account. This is a situation where we will recongnise income & expense when the ownership has been transfered to the right person. In the case of Smart Business, there is a credit transaction that is involved with the sale. Encik Farih can recognise the 30% of cash upon reciept (cash basis). The balance will go under debtor account (accrual basis). When the cash is received (within the next 2 months), then Encik Farid will debit the cash being received and credit the debtor account to indicate all payments has been received.
ii) Principle of Matching
This principle highlights that each expense must be matched with it’s revenue. The matching of revenue with expense will be done when the transaction is complete. In this case, Encik Farid has failed this principle as he manupulates the revenue and expense to take the view that is bettter to understate rather than overstate net income.
iii) Principle of Full Disclosure
This just means that all relevant information which will be useful to the users of financial statement be included in the notes to the accounts. This will assist in the decision making process for users. In the case of smart business, the following must be included in the notes
- Change of depreciation method (include calculation of both methods)
- Going concern of the firm and it’s surrounding competitiors
iv) Principlet of Historical Cost
This spells out the need for company to recognise it’s assets at it’s historical cost. However, there are companies who also uses fair value view to report it’s assests. For the purpose of this case, there is no indication of the value of the resources being used.
3) Accounting Assumptions
There are 4 accounting assumptions for smart business and it’s users that are accepted by both.
i) Assumption of separate entity
This means that a business and it’s owner are separate entities. Assets or expenses from the owner & the business cannot be reported as one. Both are treated and reported separately from its accounting entity activities. In this case, Mahesh has failed to comply with this assumption as he has taken as company’s asset and given as a gift to his child. This will give users the assumption that the computer was used for business when not 100% is used. To avoid this, Mahesh can actually purchase the computer from Smart Business and then give as a gift. If this happens, the ownership has been trasferred out of the company and this transaction must be showed by Encik Farid to indicate reduction in assets.
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ii) Assumption of going concern
This assumes that a company will continue to exist and operate in the future. This ties in with the principle of historical cost where depreciation method assumes the company will exist for a number of years, at least until the asset has been fully depreciated. Preparing financial statements on a going concern assumption is in line with MASB 1: Presentation of Financial Statements. Smart Business has instead prepared it’s statement as though it will be liquidated in the near future. This will be a mistatement since they are in good shape and has the ability to continue its business. Hence, the financial statement must be prepared as a going concern entity.
iii) Assumption of monetary unit
This assumption just tells that the economic activites are measured and valued in currency unit. This is in contrast with barter system. In this case, as indicated in the first paragraph of the case study, ringgit malaysia (RM) was used. Hence, all transaction must be converted into RM for the purpose of users to the financial statements in Malaysia. If their main users are in a different country, it does not stop Smart Business to also include another monetary unit in it’s financial statements. However, the RM must be the main monetory unit in its financial statements.
iv) Assumption of accounting period
This is the period in which a company reports its financial standings. The general accounting period is 1 year. In the case of Smart Business, the accounting period should start from 1 June 2012 to 31 May 2013. This would be a full year in which the financial reports must be produceed. Notwithstanding the compulsory provision of annual report, Smart Business may chose to produce interim reports, i.e. quartely, monthly, etc. However, the 1 year full report is for statutory purposes.
4) Accounting Constraints
Despite all the principles, assumptions, characters that has been imposed on companies to comply in preparations of their financial statements, there are certainly some accounting contrainst that obstruct the company to comply with them. Here, we will discuss 2 contrainst relevant to Smart Business.
i) Cost-benefit relationship
Financial reporting is not cost free because companies must spend time and money to collect, process, analyze and disseminate relevant information. In deciding what to include in a financial reporting, companies must weigh the costs of providing particular information against the benefits that can be derived from using the information. Therefore, companies may not require particular accounting measurements or disclosures if the costs of implementing them exceed the benefits accrued to users of the information. Hence, Smart Business may only chose not to implement as new reporting (i.e. another depreciation method) as the cost of calculating the new method may not be worth while for the benefits it may reap. The cost-benefit constraint of accounting may limit the scope of the financial information provided in an effort to control reporting costs.
The materiality constraint allows companies to omit certain information that is immaterial and won’t have an impact or influence on information users. In other words, companies must include all information that has a material impact on their overall financial performance. Companies determine the materiality of information based on its relative size and importance. When the amount involved is relatively small or the nature of the information at issue is unimportant, companies may resort to the materiality constraint not to report the information. Hence, Smart Business may at it’s own judgement decide to have high threshold limit to recognise it’s materiality. In this case, Mahesh would have only taken one small computer for his son, and due to the materiality of this item (considering the value of 1 computer against a few hundreds), Encik Farid may chose not to include them in the statements. This may again cloud the users judgement as they may think that Smart Business is being managed properly.